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What is the ideal ratio for insurance coverage? My insurer informs me that it must be five times my total income.
Is that so?
- Sharad Misra
Hi Sharad,
It truly disheartens me to see these ratios being touted to sell life covers.
I don't know where this figure has come from but let's say five times the income may be a national average. Even so, it is totally inappropriate.
It is like saying half the nation is freezing in the mountains and half is sweating on the plains so the average temperature of both is what everyone will be happy with.
The correct way of looking at life insurance is just how you might look at your car insurance.
I am not trying to compare you to an inanimate object; I just want you to know insurance is an economic tool and not your personal replacement.
How would you determine your car insurance?
On the basis of how much income it gives you or the petrol it saves you?
Or, on the basis of how much it would cost you if you were to lose it due to unforeseeable circumstances?
Let's take a hypothetical situation.
Assume you would have earned Rs 100 for the rest of your life. Also assume this would have just about supported your family and covered all their expenses. Out of this amount, your expenses would amount to Rs 20.
If you were to die tomorrow, the economic loss faced by your family would be the present value of Rs 80. Got it?
If you die, they are actually going to save the Rs 20 that you would have spent. The issue is, who will bring in the Rs 80 as income?
So, if you have 20 years of earning life over which you might earn Rs 80, your cover as of today might be somewhere around Rs 40. To understand how this figure has been arrived at, see how the calculation has been done below.
If you already have savings of that size today, you might not need insurance at all!
If you have liabilities (loans) or expenses/ cash outflows that will exist after your death, they get added to the insurance requirement of Rs 40.
When you look at the number of assumptions that went into those calculations, you will realise there can't be a thumb rule related to income.
I have also tried to give you an indication of how to calculate your insurance requirement and do hope it helps.
The calculation
Assumptions
You will earn Rs 100 for the rest of your life.
This amount will support your family and cover their expenses.
Economic loss
If you were to die tomorrow, the economic loss faced by your family would be the present value of Rs 80.
Rs 100 Rs 20 (your expenses) = Rs 80
If you die, they are actually going to save the Rs 20 that you would have spent.
So the insured amount must bring in the balance Rs 80.
The insured amount
If your family is going to need Rs 80, you can get insured for Rs 40.
You don't need to get invested for the entire Rs 80 because Rs 40 will be invested and your family will earn a return on this.
Basically, you need an amount, which along with the interest it earns, will replace your earnings.
How this amount is arrived at?
Let's say the annual expenses of the family are Rs 2.
The amount of return on the investment is 10%.
First year
On Rs 40, the family will earn Rs 4 as income.
Out of this Rs 4,
- Rs 2 will be withdrawn
- Rs 2 will get added back to the investment.
Second year
The family will earn Rs 4.2 = 10% of 40 (principal) + 2 (amount added back).
But, the family will have to draw say Rs 2.1 because of inflation.
So Rs 2.1 (Rs 4.2 2.1) will get added back.
The mathematical model is built so that the principal as well as the income get depleted at the end of the expected dependent period.
In simple words, Rs 40 is the present value of the earnings which might total up to 80 over the life of the insured.
Illustration: Dominic Xavier
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