Term insurance is the basic product that should be a part of most financial plans. Like the Pareto’s 80/20 principle, 80 per cent or more of an individual’s risk profile is covered with two products – health and term insurance. While the importance of a plain term insurance cover is largely well-understood, deciding the size of the risk cover can be tricky.
An individual must spell out his life’s financial balance sheet corresponding to his income statement to assess the right cover. Vague thumb rules may not serve us well. It would be better to follow a rigorous analysis of our goals and the required corpus for each target to arrive at a suitable figure.
Insufficiency of thumb rules
Term insurance as a product has only one purpose – making a pay-out upon the death of the policyholder. This should imply that the product should have the highest customisation to an individual’s needs (at least rounded to the nearest round figure). But even a cursory enquiry amongst family and friends reveals that ₹1-crore term insurance is the most common figure bandied about.
Is every individual’s financial statement, comprising different assets, liabilities, dependents and children, so generic that one figure comprehensively addresses the risk? In all likelihood, some may have over-invested, and a larger proportion may have under-invested with the ₹1-crore term cover.
Another popular thumb rule is salary multipliers. Amongst all multipliers ranging from 5-10x, the latest multiplier doing the rounds is 25x, which implies a term cover of 25 times current salary. Of the many inputs ignored in using such assumption, the number of working years is crucial. This estimate (25x) likely uses a median age of buying term insurance as 40 years and assumes 25 years more of working life.
The other key assumption is the individual’s income growth. An income growth exceeding the average 5 per cent will cause risk to be under-covered. For instance, the present value of 45 years of income (25-65 years of working age), which grows at 5 per cent and is discounted at 5 per cent, will yield 45 times multiple. But with a higher income growth (6 per cent), the multiple required will be 56 times.
The right cover
One can use the asset-side approach of measuring income and investment or the liability-side approach of measuring dependents and debts. But ideally, one should list all the responsibilities that one undertakes in a lifetime, apprise the same financially to arrive at the appropriate life cover.
To use asset-side measure with an income-multiple working life, income growth or even investment risk factors must be adjusted. A higher multiple for higher working life, higher-than-average growth in income and investment risk aversion of the family. Any inheritance or past-accumulated investment corpus, depending on the spend vs save inclination, should be adjusted from the term cover required as well.
Liability-driven estimation also sheds light on the cover required. The needs of dependents are to do with housing, education, living standards and medical emergencies (which should ideally be handled by a comprehensive family-floater health cover).
With regard to education, a child today should be looking at ₹50-80 lakh in another 15 years towards college fund with a normal inflation of 5 per cent.
Living standards must be pencilled in for at least 50 years or 50 times current-year cost. For instance, to maintain ₹2-4 lakh annual maintenance expenditure today, ₹1-2 crore must be invested in a fund yielding 5 per cent to maintain spending power uneroded by inflation over the next 50 years.
A house that has been paid for need not be covered in term insurance. But in other cases, a housing loan should be added to the term insurance plan amount to cover for housing. If the policyholder picks up a housing loan along the way or any other loan including a business loan or even a gold loan, the term insurance cover must reflect the increased liability even with a new policy, if required.
So the final tally for an appropriate cover works out to ₹70-80 lakh per child’s education fund, 50 times annual maintenance, pending debts and 20 per cent more for emergencies.