How much life insurance cover should one have? This is one of the most frequent questions in the minds of an individual conducting financial planning. Life insurance has assumed significance in the pandemic era as many young lives have been lost, leaving families emotionally and economically devastated.
Insurance is a unique form of a contract which enables the transfer of risk from one party (the insured) to another party (the insurer). Insurance needs vary with people and situations and can be categorised as follows:
In this article, we will be dealing with life insurance.
Life insurance is peculiar because of the subjectivity involved. What is the value of a human life?
Life insurance is about replacing the monetary benefit that an individual provides to their family during their lifetime. This is the income that would have been available to meet their goals and expenses. This guarantees that the family does not suffer hardships and is able to meet its lifestyle and milestone goals despite the loss of the earning member of the family.
The nominee, a member of the aggrieved family, receives a lump sum amount equal to the life cover taken by the deceased. This money can then be invested in fixed deposits, or stocks or mutual funds, which would provide them a regular monthly income to meet their expenses.
Factors to be considered while calculating the value of human life:
Current income of the individual
Age of the individual and number of years to retirement
Return on investment and expected inflation
Let’s assume current income of A is Rs 10 lakh per annum. He is 33 years of age and retires at 60. Suppose a family can earn 10% return on investment per annum and rate of inflation is 6%.
This means he has 27 years of earning potential, or years left for him to make money. So, the total income earned by him till retirement is Rs 270 lakh or Rs 2.7 crore (Rs 10 lakh x 27). This should be the human life value of A.
This is not correct. His income would have increased by some percentage each year. Let’s assume it increases to cover the inflation of 6% p.a.
So in Year 1 (age 33) he earns Rs 10 lakh which increases to Rs 10.6 lakh (Rs 10 lakh + 6% of Rs 10 lakh) in Year 2 (age 34) and so on.
In his retirement year he would be earning Rs 48.22 lakh per annum. By this method he would earn Rs 6.75 crore in his remaining 27 years to retirement, So this should be his human value.
This is also not correct. We would have heard about the time value of money. A rupee received today is more valuable than a rupee received a year later. Why? This is because you could have earned returns in a year by investing the rupee received today or earned interest by lending it to somebody.
We need to calculate the discounting rate. If the return is 10% and inflation 6%, the discounting rate is about 4%, 3.77% to be precise. It is calculated as 1.1 / 1.06 -1 (1+return divided by 1+inflation minus 1).
Now we have a discounting rate (Rate) of 3.77%, years to retirement (Nper) of 27 and annual income (Pmt) of Rs 10 lakh. Human Life Value (HLV) is the present value of all future income that you could expect to earn for your family.
We will have to use the Present Value (PV) function in excel to calculate this amount. This will be PV(Discounting rate, Years to Retirement, Annual Income) or PV(Rate, Nper,Pmt). This comes to Rs 1.67 crore as shown below:
So, the insurance needed as per human life value comes to Rs. 1.67 crore and a person should take a life cover of at least this amount.