Morgan Housel’s book ‘Psychology of Money’ does a great job of explaining the power of money – it can give you control over your own time. That in a nutshell is the function of life insurance. It enables financial continuity for your dependents and avoids a drain of your existing resources. So, it is quite irrefutable that adequate life cover is critical. Here, we revisit the factors that can help people determine how much life cover they need.
Most Indians continue to perceive life insurance as a savings vehicle and believe that the insurance benefit attached to such products is adequate. So, let’s clarify one thing – every earning individual with financial dependents must buy term insurance.
Take for example Arun, a 35-year-old married person with one kid and a second one on the way. He is looking to buy a term insurance and decides to rely on the general thumb rule – a life cover must be 10 times your annual income. Considering Arun earns Rs. 10 lakh per annum, the thumb rule would suggest his ideal life cover is Rs. 1 crore.
While this is a good thumb rule to determine the minimum cover required, an individual often needs more than 10 times his / her income. In other words, it is highly likely that Arun is inadequately covered. So, how can he determine his multiplier?
The DIME method is a holistic tool for assessing one’s current state of finances and future needs. So, here’s what Arun needs to know:
Debt: Your liabilities survive you and therefore provisioning for recurring debt is very important. Let’s assume Arun has an outstanding student debt of Rs. 2 lakh.
Income: Consider the number of years you want to provide an income replacement for your family and multiply your current income by that number. Assuming Arun wants to create income replacement for 5 years, he will need a corpus of at least ?50 lakh.
Mortgage: The next step is accounting for a home loan, which can derail your family’s monetary stability in your absence. Let’s assume, Arun has an outstanding home loan of Rs. 50 lakh.
Education Expense: Considering Arun is a father, he will need to create a financial corpus to support his daughter until she turns 25 years of age (typically when kids start earning). With education cost constantly on the rise, Arun will need an estimated Rs. 35 lakh until graduation of his child. With another baby on the way, he wants to make an additional provision of Rs. 50 lakh for the upbringing and education of his second child.
All these factors summed up show Arun’s future requirement, which is Rs. 1.87 crore. But there is one missing ingredient – it doesn’t account for his existing assets. Assuming he has assets worth ?20 lakh in the form of fixed deposits and mutual funds, Arun’s final financial requirement is Rs. 1.67 crore. Assuming Arun passes away after 10 years, then at a 4 per cent inflation rate per annum, he will need a life cover of Rs. 2.47 crore (nearly 25 times his current annual income).
Personal finance advisors can support you in this process. One key factor to always remember is that life insurance is not a one-time purchase. You must review your protection requirements at regular intervals, especially as you progress through various life stages.
