In my previous article, we learnt whether you need Term Insurance or not. If you have reached to the conclusion that you need Term Insurance, the next question is how much Term Insurance should you opt for? Is there any thumb rule that needs to be followed while purchasing Term Insurance cover? Should I purchase it based on my annual income OR Should I purchase it based on my annual expenses? Let’s address these questions one by one.

If you are looking for an answer in one sentence, my response would be –

Term Insurance = [Annual Income *20 + Liabilities (Loans)] – Assets (FDs, Mutual Funds, all properties excluding self-occupied home, and any other investments)

This will be the amount of term insurance cover that you will require.

Is there any thumb rule to calculate Term Insurance cover requirement?

I’m sure most of you must have seen advertisements on Facebook, Google, Instagram, print media, or on television about insurance companies promoting Term Insurance cover of 1 Crore. Does that mean is 1 Crore the benchmark for purchasing Term Insurance cover? The answer is No, it is not.

Let me explain to you why most life insurance companies often advertise cover of 1 Crore.

  1. 1 Crore is a huge psychological barrier for most middle-class families. It is very difficult to achieve this amount with savings and investments at an early stage of life (barring exceptions of high monthly income families) and with Term Insurance cover, it seems achievable at least for their families if they are not around.
  2. The premium amount payable is comparatively lower for a term insurance cover of 1 Crore. For a young person aged 25-26, the premium payable may be lesser than 1,000 per month which seems very affordable. That is the reason why you might have seen insurance companies showing premiums in monthly mode and not in the yearly mode in most Term Insurance advertisements.
  3. Individuals who are earning more than 40,000/50,000 per month are normally eligible for 1 Crore term insurance cover.

Remember, life insurance companies are targeting the masses with their advertisements. These companies can show insurance coverage of 2/3 Crores but for that, they need to do very target marketing i.e., high-income individuals. This is exactly the reason why most insurance companies show advertisements for 1 Crore Term Insurance cover, which is to cover the masses.

Coming back to the question, is there any thumb rule to calculate how much Term Insurance cover you should buy?

No, there is no thumb rule and it is entirely dependent on your income, expenditure, and your assets.

However, there is a thumb rule for insurance companies on how much insurance coverage they can provide to any individual, which I will explain later.

If there is no thumb rule, how do we calculate the requirement? Let’s see, how to calculate the insurance cover requirement.

Human Life Value (HLV)

Every human being has an unlimited earning potential. You may be starting your job with a monthly salary of 25,000 per month but 10 years down the lane, you may be earning 2.50 Lakhs per month or it may be 25 Lakhs per month. Ideally, there is no way to calculate Human Life Value (HLV) but still, it needs to drill down to a certain number to manage risk for the family, if any unfortunate event happens to the breadwinner of the family. That’s where the role of income replacement and expenses replacement methods comes into the picture to calculate the Term Insurance cover requirement of an individual.

There are 2 methods of calculating the insurance requirement for an individual:

  1. Income replacement method
  2. Expense replacement method

Let’s discuss these 2 methods one by one.

  1. Income replacement method

There are 3 variables that are required to calculate insurance cover through the income replacement method –

  1. Current Income
  2. Current Age
  3. Retirement Age

Let me give you an example here – Example 1

Ajay is 35 years old and is earning a salary of 1 Lakh per month. He wants to retire at the age of 60. What would be the insurance requirement for Ajay?

In this example, Ajay’s Annual income = 1 Lakh * 12 Months = 12 Lakhs Per annum

Gap between retirement age and current age = Retirement age – Current Age = 60 Years – 35 Year = 25 Years

Term Insurance cover required = Gap between retirement age and current age X Annual income i.e. 25*12 = 300 Lakhs = 3 Crores

This is a very simple method to calculate the requirement. But the question arises – what about any increments in salary?

Let us assume that there is an average increment of 6% in Ajay’s annual salary for the next 25 years. The total amount that Ajay would have received in next 20 years would be as follows:

Year Annual Salary Year Annual Salary
1 1200000 14 2559514
2 1272000 15 2713085
3 1348320 16 2875870
4 1429219 17 3048422
5 1514972 18 3231327
6 1605871 19 3425207
7 1702223 20 3630719
8 1804356 21 3848563
9 1912618 22 4079476
10 2027375 23 4324245
11 2149017 24 4583700
12 2277958 25 4858722
13 2414636 Total 65837414

The total amount Ajay would receive from his salary in the next 25 years would be 658 Lakhs. Now, we need to know how much amount one needs to deposit in debt instruments now (for the safer side) assuming an interest rate of 6% p.a. which would generate the same income year on year (as shown in the table). For this to happen, we need to calculate the present value (PV) of the cash flow which comes out to be 3 Crores which is same as the term insurance value calculated above.

The increment and additional returns from claim amount investments just complicate the overall process. The ideal way is to multiply your annual income by the number of years remaining for retirement. Additionally, I have not deducted any personal expenses of the breadwinner, which will not be required if some unfortunate event happens to the breadwinner (just to make calculations a bit simple).

The term insurance requirement will also decrease if you assume higher returns from the sum assured i.e. cover amount.

Download- Income Replacement Calculator

In next chapter, we will discuss expenses replacement method – with calculator

Points to remember:

  • There is no thumb rule for calculating the insurance coverage requirement for you. It is dependent on your income, expenses, assets, liabilities, and goals.
  • 1 Crore coverage may be high or low cover based on your personal requirements. Do not just blindly purchase term insurance cover of 1 Crore. Remember not to go by the advertisements published by life insurance companies.