The most effective method to calculate your Term Insurance Cover
Breaking Bad S2E1
Walter White: Adjusting for inflation - good state college - adjusting for inflation, say $45,000 a year, two kids, four years of college...$360,000. Remaining mortgage on the home, $107,000. Home equity line, $30,000, that's $137,000. Cost of living, food, clothing, utilities, say two grand a month? I mean, that should put a dent in it, anyway. 24K a year provides for, say, ten years. That's $240,000, plus 360 plus 137...737. $737,000, that's what I need.
Remember this scene?
While you were engrossed in this captivating episode where a nervous, worried Mr. White is calculating the money his family will need after he dies, you knowingly or unknowingly learned a big lesson in calculating the term life insurance coverage you need.
You buy Term Insurance to protect family members dependent on your earnings, from any financial disruptions, when you pass away. The financial disruption will be caused by the gap between what you will leave behind and what your family actually needs.
How do you calculate this gap?
There are two major steps in calculating the gap, or the cover amount you need.
1. First, Calculate the amount you owe.
2. Then, Calculate the amount you own
The difference between these two amounts gives you the financial gap you need, to cover through term life insurance, to financially secure your dependent family members.
Let’s dig deeper.
THE AMOUNT YOU OWE
This is the amount your family will have to pay for, in the absence of the bread-winner - including short-term everyday expenses as well as long-term expenses.
This can be sub-categorized and calculated under three headers, as follows.
A. Living expenses fund: This fund is required to create a corpus that will provide regular passive income for your family’s everyday needs. You can arrive at this number by summing up all your monthly and yearly expenses such as rents, school fees, maid/ driver salaries, groceries, and other household expenses for one year.
Divide this total by the expected rate of interest. (Take this as 3% which is the current rate of interest on FDs after cutting taxes)
B. Big dreams fund: These are all the large, one-time expenses your family will incur in the long-run. In this, include all the big dreams (like your wife’s MBA, kid’s international education, kid’s destination wedding, etc.)
C. Major liabilities fund: Here, you will account for all the loans and liabilities that you owe, and your family will have to pay off when you die.
Sum all the loans you’ve taken (house loans, car loans, personal loans, etc.), any joint loans you’re liable for as well as any other loans that you’ve signed as a guarantor for. When you sum these three, you will get the total amount you owe. Next, moving to the amount you have.
THE AMOUNT YOU OWN
It might seem pretty straightforward that you will simply add up all the money and value of assets you’ve got. But, that’s where you will go wrong.
You see, not all assets have the same risk factor. Meaning, not all of them might be readily available for your family - as liquid funds to spend on their needs. So, you will have to multiply these risk-factors to plan for the worst-case scenario. Here are the risk factors you should consider.
- Existing Life Insurance Covers @ 100%
- Savings, FDs & Cash @ 100% - You can consider these amounts at a 100% value
- Equity investments @ 50% - Conservatively, take all your equity shares and equity-linked investments at half their total value
- Gold & residential property@ 0%: Practically speaking, you would not want these assets to be liquidated for grocery purchases. So, take them at zero value.
- Stock options @ 0%: As these are high-risk investments, take them at zero value. If any of them pay off, consider it a bonus.
Summing up all these numbers will give you the actual amount you own.
Now, you can calculate the total cover you will need using the formula -
But what about inflation?
For the sake of simplicity, this calculation considers a scenario where death happens today.
We strongly recommend you opt for the increasing cover option available with all leading term life insurance plans - this will ensure your cover increases systematically over a period of time beating inflation.
If you want to factor in inflation for the entire term right now, you may multiply this cover amount by 2.5 to 3X to calculate the inflation proof cover you need.
Haven't you read our eBook yet?
Our recently launched The Ridiculously Simple Guide to Term Insurance has detailed illustrated examples for the process of calculating the appropriate cover amount for oneself.
You must get a FREE copy and refer to the step-by-step process with examples - so you will never go wrong!
1. Don't go by any standard thumb-rule, for the cover amount. 2. Do a detailed calculation of the financial gap, your death can create for your dependent family. 3. Financial gap = the money you owe to the world and your family and the money you already own. 3. The difference between these two amounts, will give you the actual cover you need. 4. Opt for an increasing cover with an end cover of 2x the starting amount to factor inflation.
Mahavir is the Founder at Beshak.org. Since 2005, Mahavir has been building tech-based startups that compare and advise insurance products to individual buyers. In his last role, he was the Chief Business Officer at Coverfox. Mahavir is a recognized professional in the personal insurance field. He has contributed to leading business publications, including The Economic Times, Business Standard, Mint, DNA, and Moneycontrol