Your colleague at the office got a life cover of Rs. 75 lakhs, and you are feeling compelled to buy a life cover policy as well? Think before you follow your friend - do you really need a sum insured of Rs. 75 lakhs or more? Or may be do you need an insurance in the first place? If you approach an insurance advisor, to get an answer to your questions, you will be suggested to buy an insurance at the earliest possible, to avail the benefit of your young age. Do not fall into the trap.
Another myth defining the thumb rule for optimal amount of insurance as 10-12 times of the annual income, irrespective of the age. So an individual with 10 lakhs of annual income, will need to have an insurance coverage of Rs. 1 - 1.2 crore to stay adequately insured. However, the optimal amount of life insurance for an individual will vary based on a number of factors. Some individuals with no dependents or bequest goals may not need any insurance, whereas an individual with young children and a non-working spouse may need a significant amount of life insurance. Below are some of the key considerations to use when determining how much life insurance to purchase.
Key determinants for insurance needs
Income replacement
The primary purpose of insurance is to replace the present value of future earnings. A 65-year-old individual without children will experience an emotional loss from the premature death of a spouse, as well as some additional short-term expenses, but the economic loss will be modest (or even negative if expected spending needs fall in retirement).
Immediate financial expenses
These include direct costs associated with death, such as funeral and legal expenses. Although the costs associated vary by region, funerals can be expensive and represent a potentially sizable financial burden on the family. Additional immediate financial expenses could include covering the short-term loss of wages.
Legacy goals
In addition to income replacement, an individual may use life insurance to achieve certain legacy goals. These can include gifts to charities, bequests to family members, and estate planning.
The bottom line
To calculate the amount of insurance needed, one should estimate the amount of money needed to restore the present value of expected earnings that would have occurred if the earner remained alive. Because the purpose of life insurance is to cover the loss from an unexpected premature death, the value of life insurance should be equal family's spending needs without the human capital earner. The cost of the insurance is obviously an important consideration as well. Therefore, the 65-year-old individual without children may not need an insurance cover, as the loss of human capital in case sudden pre-mature death is negligible, whereas an individual with young children and non-working spouse may need a significant amount of insurance.