In the last chapter, we learnt about income replacement method to calculate the term insurance cover requirement. In this chapter, we will learn about expense replacement method to calculate the term insurance cover requirement.

The basic difference between income and expense replacement methods is whether you take monthly income or monthly expenses for your term insurance cover requirement needs. In the case of monthly income, you take the difference between your retirement age and current age while in the case of monthly expenses you take the life expectancy of the younger spouse.

What is life expectancy – Life expectancy is the average period that a person may expect to live. It may be 70 years/80 years/ 90 years and for some, it may be 100 years.

Let me take an example

Expense Replacement Method Example

Ajay is 30 years old and is working in a private company earning a monthly salary of 80,000. His wife is 2 years younger than him i.e., 28 years old and their child is 2 years of age. He is planning to accumulate 25 Lakhs for their child’s higher education after 15 years i.e. when the child is 17 years old. Ajay also has an outstanding home loan of 25 Lakhs. He spends approximately 25,000 per month on his household and lifestyle expenses.

For the Expense Replacement method, you can use the following procedure.

  1. Calculate monthly expenses
  2. Age of the younger spouse
  3. Life expectancy (take minimum age limit of 85 years)

Let us calculate this with the help of the example mentioned above:

  1. Monthly expenses – Rs. 25,000
  2. Age of younger spouse – 28 years
  3. Life expectancy – 85 Years

Life Insurance cover = (Life Expectancy – age of younger spouse) * 12 months * monthly expenses

(85-28)*12*25000 = Rs. 171,00,000 = Rs. 1.71 Crore

This amount of 1.71 crore is the basic cover requirement. We need to now add all outstanding loans and various goals amount to this value.

In Ajay’s case, there is an outstanding loan of 25 Lakhs and the amount required for covering child’s higher education is 25 Lakhs. Add this 50 Lakhs to the basic cover of 1.71 crores (as explained above).

So, the total Term Insurance cover requirement would come out to be 2.21 Crores.

In case Ajay has any assets, that asset value needs to be subtracted from the total cover requirement except in cases where the asset is your self-occupied house.

Suppose Ajay had invested in PF, PPF, MF etc., to the tune of 21 Lakhs, this amount must be subtracted from the term cover of 2.1 Crores.

The new cover requirement that Ajay will need would be 2 Crores.

I’ve assumed returns over inflation as 0% i.e., if inflation is 6%, then the returns would also be 6%.

You can use our Term Insurance calculator to check the requirement for the total sum assured.

Which technique should you choose – Income replacement or expense replacement

One can choose any option that best suits their requirement, however, please ensure that you purchase a term insurance cover.

The income replacement method is simple. All you need is monthly income, current age, retirement age, and then assumptions of increment and returns.

The expense replacement method will include much more factors like monthly income, goals, liabilities and assets etc.

Let’s look at another example –

Ajay is 25 years old and is earning a salary of 1 Lakh per month. He wants to retire at age 60. What would be the insurance requirement for Ajay? Based on the calculations explained above, Ajay’s insurance cover requirement would be 4.20 Crores in this case. However, the question remains – whether insurance companies will be ready to give him a cover of 4.20 Crores?

Generally, most insurance companies follow the thumb rule that I have mentioned in the previous chapter. The maximum amount, which is allowed by insurance companies for Term Insurance cover is 15-20 times of your annual salary. Some companies also extend it to a maximum of 25 times your annual salary. Anything above 25 times become difficult to purchase.

Also, this is an overstated requirement of term insurance. If we reduce the retirement age to 40, the term insurance cover requirement will reduce drastically but that may be an understated requirement of term insurance.

The income replacement method may provider an overestimated or underestimated value of term insurance but the expense replaced method provides a more accurate estimation of term insurance cover as it includes specific goals for survivors.

Download – Life Insurance Need Calculator

Points to remember:

  • Insurance companies have thumb rule of providing maximum cover of 20-25 times of your annual income.
  • Whether it is income replacement or expense replacement, it is an absolute necessity to calculate your Term Insurance requirements and purchase a term insurance cover.