Everyone of us is going to die someday. So why should we insure ourselves against this inevitable event. It is not the act of dying that creates the need of life insurance. It is what happens to your loved ones if you die prematurely. Life insurance exists to give the money that you or your family do not have. So the apt name for life insurance is income and expenses insurance. If you are financially independent and you have the money that will needed by your family when you die, you do not need any life insurance.
Let us view life insurance through the risk management quadrant:
- Risk avoidance: You cannot avoid death, that is obvious.
- Risk reduction: You can decrease the cost of your life insurance by being proactive about your pursuit of good health( eg. not smoking)
- Risk assumption: If you and your family are financially independent, then you do not need life insurance.
- Risk transfer: If you and your family are not financially independent, then you need life insurance.
The essential things life insurance can give are:
- Final expenses: Expenses for your funeral and burial
- Payment of debts and mortgages: This can be paid from the life insurance proceeds completely or the life insurance proceeds can be invested, and the income and gains from it can be used to pay the debt and mortgage. It is wise to wait for at least a year before you decide how you want to do it.
- Education for children
- Needed income replacement: 50% of the deceased spouse’s income or whatever amount you think will be needed for monthly expenses and maintainance.
The next thing you want to do is to assume a safe investment return( for the education and income replacement): In the US setting you can probably assume 5% and in the Indian setting around 8%.
Let’s consider a typical family in India:
- Final expenses: 2 lakhs
- Mortgage: 35 lakhs
- Education for two kids aged 2 years and 3 years old: 10 lakhs
- Income of spouse: 12 lakhs per year( so 50% would be 6 lakhs)
Total life insurance need= 2+35+10/0.08+12/0.08= 37+ 125 + 150 = 312 lakhs= 3.12 crores. The premium for this amount per year will be around Rs. 28000.( 30 yr old male, non smoker, 20 year term, accidental death benefit rider, waiver of premium rider on critical illness) This works out to Rs. 2333 per month.
When you are buying insurance you should buy only term insurance and not buy any other insurance because it will be the cheapest and for investing and other purposes you should invest using stocks and mutual funds and not through insurance.
I hope this simple way of calculating the amount of life insurance you need is useful.