What are the methods of life insurance?

The covid-19 pandemic has driven home the point that taking life insurance is one of the most important financial decisions that one can make. The demand for life insurance plans spiked following the outbreak. When it comes to life insurance, term covers are the most efficient as they give maximum cover at lowest cost. Term covers are the simplest form of life insurance that pay out the sum assured if the insured dies during the term of the policy. There is no payment in case the insured person survives the term.

However, just buying life insurance is not enough. The key is to get adequate sum assured to take care of your family’s needs. But how much is enough? “Insurance protects you against unforeseen demise of the bread-earner, so that the future lifestyle or goals of the family do not get disrupted. The cover is not dependent on the present income, it is dependent on the future value of the goals that you have decided for your family," said Dheeraj Sehgal, chief distribution officer, institutional, Bajaj Allianz Life Insurance Co. Ltd.

We look at four methods—human life value, income replacement value, expense replacement method and underwriter’s thumb rule—that can help you calculate how much life cover you need.

Human life value

This method considers the economic value or human life value (HLV) of a person to the family. The concept primarily considers the value of future income, expenses, liabilities and investments.

“Under the HLV method, you need to consider your income, expenses, expected future responsibilities, and goals to determine the insurance need. This method is suggested as this gives better clarity keeping in mind the inflation," said Santosh Agarwal, chief business officer, life insurance, Policybazaar.com, an online marketplace for insurance.

If your goal is to sustain the present lifestyle of your family in the future, then determine how much it costs in today’s rupee value. This will help decide the amount of cover that you should take.

This method is recommended by most insurance companies, and many insurers have an HLV calculator on their websites.

Income replacement

Under this method, it is assumed that life insurance should replace the lost earnings of the breadwinner. One of the simplest ways to calculate your income replacement value is: insurance cover = current annual income x years left to retirement.

For example, if you are 40 years old, your yearly salary is ₹15 lakh and you plan to retire at the age of 60 years, the cover you will need is ₹3 crore ( ₹15 lakh x 20).

However, according to Melvin Joseph, a Sebi-registered investment adviser and founder of Finvin Financial Planners, one of the drawbacks of this method is that it can suggest a very high cover by considering future income.

Expense replacement

Under this method, which is recommended by financial planners, individuals need to calculate their day-to-day household expenses, loans and goals such as children’s education, as well as providing for financially dependant parents for their entire lives. The figure you reach is the total money that your family will need.

The next step is to deduct the present value of the your investments and life cover you already have. While calculating the value of your investments, exclude assets such as the house you live in home and car, as your family members are likely to continue using them. The figure you get by deducting investments and insurance cover from expenses and goals will give you an idea how much cover you need.

“I suggest expense replacement method, as it gives a more accurate picture of the insurance coverage amount and cover expenses of the survivors till the insured’s life expectancy," said Joseph.

Underwriter’s rule

For calculating the minimum cover you need, you can go by the common thumb rule of having a sum assured that is 10 times your annual income. So if your current annual income is ₹10 lakh, you should have a life cover worth at least ₹1 crore.

However, according to investment advisers, this method does not give the exact picture. “Most of the insurance companies promote insurance cover of 10 times your annual income. That is the reason it has become a thumb rule. The minimum cover should be at least 15-20 times your annual income," said Joseph. Insurance companies also offer cover of 25 times your annual income.

It’s possible that your existing cover seems inadequate either because your life value is increasing or because the value of your goals has increased or the goals have changed. If that’s the case, go for cover enhancement or buy a fresh policy. “The present creed of products has a feature of enhancing a cover at different life stages. But if your life insurance provider doesn’t offer this feature, then it might make sense to buy a second cover," said Sehgal.

The cover enhancement feature allows the sum assured to rise at different life stages chosen by you such as marriage or birth of a child by a specified amount, but do remember that this might translate into increase in the premium as well.

It makes sense to compare premiums and plans as per your requirements. Take professional help to determine the policy type and the coverage that will best fit your budget and your family’s financial needs.

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