In India, people understand the need and importance of getting themselves insured. But how many people actively get themselves insured and their family members? The answer is not much. Even if we realize how important it is to get an insurance policy done and save our families from any sort of financial crisis after we are longer with them, but then the million dollar question that arises is ‘how to decide the amount of insurance cover’. In this article we will discuss how to calculate the insurance requirement for an individual.
Getting started
First, let us be very clear that the insurance requirement of my neighbour or my relative or my colleague has nothing to do with my insurance requirements. Each family has their own set of priorities, and they differ in their life styles and family size. Accordingly, their insurance requirements are bound to differ from each other. For example – My family consists of 4 persons and my monthly expenses are Rs. 20,000 only. Whereas, there are 3 members in my neighbour’s family, yet their monthly expenses are more than Rs. 50,000. But still, an insurance policy of say, Rs. 30, 00,000 will work for them and an insurance policy for even Rs. 50, 00,000 falls short for my family. This happens because my future requirements and my debt obligations which are absolutely different from that of my neighbour’s. From the discussion till now, it can be derived that the insurance amount should be enough to provide a cover for the following:
a) Monthly expenses
b) Repayment of debt obligations
c) Other future requirements
Understanding with the help of an example
Suppose Mr. A has a family of 4 including self, his wife and two kids. His monthly family expenses are Rs. 25,000. He has borrowed a home loan for Rs. 30 lakhs and expects an expense of Rs. 20 lakhs on his daughter’s marriage, may be after 20 years down the line. At present his long-term investments in different investment plans stood at Rs. 10 lakhs.
His debts are for Rs. 30 lakhs and investments are for Rs. 10 lakhs only. Therefore, it is clear that his debts can not be met out of his investments. Plus, he has to meet his monthly expenses of Rs. 25,000, i.e. Rs. 3, 00,000 per annum. To add to the woes, inflation will continuously keep on enhancing the monthly budget. However, for this exercise, we are ignoring the affects of inflation. Now, his insurance should be able to provide for both, his debt obligations and his monthly expenses.
In case of sudden departure of Mr. A, his family should not suffer from the hardships of a financial crisis. Therefore, even after his death, his family should keep getting Rs. 3, 00,000 per annum. Considering the tax rate of 10%, income before tax should be Rs. 3, 30,000 so as to leave Rs. 25,000 per month after giving tax.
How to get these 3.3 lakhs?
Interest from a fixed deposit normally gives a return of 8%. Therefore, an interest of Rs. 3.3 lakhs will accrue from the fixed deposits of Rs. 41, 25,000 (3, 30,000*100/8).
Returning to the example
Mr. A, therefore, requires at least Rs. 91, 25,000 (Rs. 30 lakhs for repaying home loan + Rs. 41,25,000 for monthly expenses + Rs. 20 lakhs for his daughter’s marriage).
Since he already has Rs. 10 lakhs in long-term investments, his total requirements will come down to Rs. 81, 25,000.
Working of insurance
Now, if anything unfortunate happens to Mr. A, then his family will get Rs. 81, 25,000. Out of this amount, they can pay off their home loan debt of Rs. 30 lakhs, leaving them with Rs. 51,25,000. From this balance, Rs. 41, 25,000 can be invested in fixed deposits to cover for monthly expenses and remaining Rs. 10 lakhs can be invested in equity, mutual funds or some other high yielding investment alternatives so that after 20 years the family can have Rs. 20 lakhs with them for the marriage of their princess.
