How to calculate your life insurance needs is an often asked question and many investors use quick thumb rules to get to the actual requirement.
Then there are more sophisticated methods which financial planners use to zero down on the accurate figure.
This post is about all the methods which exists and investors need to be aware of.
1. Income Multiple Thumb Rule
This rule uses a multiple to your income but is also tied down to the age of the person seeking insurance. The income you need to consider here is net income of the primary earner after deduction of personal expenses.
| Multiplier Factor for annual income | ||
| Age | Lower Factor | Upper Factor |
| 20-30 years | 5 | 10 |
| 30-40 years | 15 | 20 |
| 40-50 years | 10 | 15 |
| 50-60 years | 5 | 10 |
Just multiple your [net income – expenses] by the lower factor and upper factor above to arrive at the minimum and maximum life insurance requirement.
2. Premiums as percentage of income
This rule says that 6 percent of the breadwinner’s gross income plus an additional 1 percent for each dependent should be spent on life insurance premiums.
So if you have an annual gross income of Rs 4 lakhs and have your wife and 1 child as dependents, then your life insurance needs is calculated as per below –
(6% * 4 lakhs) + (1% * 4 lakhs * 2)
3. Income Replacement Value Method
Simply put, this method says that for the number of years left for retirement, you and/or your family need annual income each year to live their life.
So suppose you are 40 years of age and will retire at 60 and your current annual income is Rs 10 lakhs.
The calculation will be 10 lakhs * (60-40) as the life insurance requirement. In you observe for a moment, the income is being multiplied with some value and if that value changes with age, you are talking about the Income Multiple Thumb Rule (point 1 above) on how to calculate your life insurance needs.
4. Human Life Value Method (HLV)
The HLV tries to calculate all the future income that you would expect to earn for your family. Note that the significant thing with this method is that all the expenses that are done for you, the primary earner of the family, is lessened from the annual income while the calculations are done.
Let us see an example. In the below, the gross income of the individual is Rs 5 lakhs but he is spending Rs 20,000 annually on himself and is paying Rs 1,50,000 as taxes. He is also paying premiums of Rs 30,000 annually for his life insurance needs. So apart from all these, the rest of the money is left for his family for living their daily lives. This is the surplus that he generates for his family.
That money when invested at some assumed rate of return (say 8% in the below example) for the working span of the individual (15 years in the example below) gives the HLV value of the insurance requirement.
| Human Life Value Method | |
| Gross Total Income | 500,000 |
| Annual Self Maintenance Charges | 20,000 |
| Income Tax Payable | 150,000 |
| Life Insurance Policy payable | 30,000 |
| Retirement Age | 60 |
| Present Age | 45 |
| Surplus income generated for family | 300,000 |
| Working Span | 15 |
| Expected Rate of Return | 8% |
| Human Life Value | 2,773,271 |
5. Need Based Analysis
This method is the most accurate way of how to calculate your life insurance needs and is used by financial planners. While the above 4 methods used the person’s income to arrive at figures, the Needs based approach concentrates on expenses.
So this method calculates the immediate expenses the family would incur on the primary bread earner’s death plus all future expenses.
In this method, the requirement of expenses are basically arrived under 3 headings.
5a) Immediate needs at death require expenses like medical costs or funeral costs. These can go to a large extent in some cases. All the loans that the person took are also taken into account as those need to be cleared as well.
5b) Ongoing expenses will be done by the family for food, shelter, clothing, education of children and other daily living expenses.
5c) Lump sum expenses done during occasions like marriage and education of children are also accounted for.
Once you sum up all of these, the figure you arrive at is what your family needs today if you were to die. Subtract from that the life insurance you already have plus all your assets today (exclude car, residence and other personal assets), then you should arrive at the right requirement.
As you can see, this indeed is a very detailed and accurate way of assessing your life insurance requirement as compared to the other 4 methods.
Which method do you think is the best ?
Good stuff, i was aware of Income multiple thumb rule and HLV rule. In today’s world of uncertainty one must adequately be insured and family members be made aware of your insurance information. Never know what is in store tomorrow.
Have you used needs based approach ?
Yes I did use, forgot to mention that. When i took a home loan i too additional term plan of the same value.
Tried all the calculations and none seem to be practical for me. 1, 3 and 4 are giving high figures and 2 is giving too low.
I think the need based is the best way to go!
So non of the above methods are meant to arrive at the SAME figure. But they should ideally tell you what range you are at.
The need based approach is the best but ordinary investors just cannot do the number crunching. That is why financial planners exist !
You are right but I dont think ordinary investors are inclined towards financial planners. They always look for shortcuts and other methods can give a ball park figure, which is good enough.
You would be surprised that ordinary investors are warming up to the idea of financial planners contrary to what many think.
And you are also right that they look for shortcuts and either over insure or under insure themselves.
Amazing compendium of all options which may be used to do the requirement analysis. However, I am a firm believer of the last method – the need analysis. That is actually the most accurate way to get through the analysis of the insurance requirements. All other methods are probably a shortcut to reach to the results which should be arrived at via the Need method.
Check out http://insight.banyanfa.com/?p=298 where I have detailed a bit more on this method. However I must admit, the major drawback of this method is to do a full review of the finances and takes some time. But the outcomes are most accurate results.
Any comments ?
Yeah I would agree with you BFA on this. Your article is very comprehensive as well. The Needs based method is the most accurate one and I think that though is takes most time, it still is the best and so worth it.