Ramesh is 45 years old. He has read enough about importance of purchasing an adequate life cover. Till now, he has relied on traditional life insurance plans for life insurance. He had never given any serious thought to purchasing life insurance. Even these traditional life insurance plans are more a result of hectic tax-planning than anything else. Life cover is minimal.
He has been reading about the importance of purchasing adequate life insurance for quite some time now. Finally, he has made up his mind to purchase a term life insurance plan to bridge the life insurance gap in his portfolio.
He has used online calculators to arrive at his life insurance requirement. He has shortlisted the insurance company too. One more question remains that he needs to find an answer to: What should the tenor of his term insurance plan be? At his age, the difference between a 10 year plan and a 30 year plan for a Sum Assured of Rs 1 crore is approximately Rs 10,000 per annum. He is not sure what to do.
Before trying to answer this question, let’s find out the basic assumption behind calculating the life insurance requirement.
Note: In this post, I will not talk about any investment linked insurance plans such as traditional life insurance plans and unit linked insurance plans (ULIPs). I have expressed my dislike for such plans (especially traditional life insurance plans) in many of my earlier posts. The focus is only on term life insurance plans.
How to Calculate Life Insurance Requirement?
There are many approaches. I will list down two approaches.
- How much does the family need (in case the policyholder were to die today):
- Settle all the existing liabilities (home loans, car loans, education loans etc.)
- Achieve all the life goals (children’s education, marriage, retirement income for spouse etc.)
- Maintain and reach desired lifestyle
- Add all the amounts (1, 2 & 3) calculated (A)
- Sum the assets you have already accumulated to meet those goals/lifestyle expenses (B)
- Calculate (A)-(B) to find out your life insurance requirement
The second approach is to find out the life insurance requirement as a multiple of current annual income. For instance, if your annual income is Rs 5 lacs, you must purchase life cover of, say, 12 times your annual income; i.e., Rs 60 lacs.
It is easier to calculate the life insurance requirement using this method. The only problem is that the focus is on income rather than on expenses. Just because your income is less does not mean that your responsibilities and liabilities are lower.
I am more comfortable with the first approach.
You Don’t Need Life Insurance If You Have Enough Wealth to Fund Your Financial Goals
This is quite obvious. As seen in the previous section, life insurance merely bridges the gap between the amount required to achieve financial goals and existing savings/investments for those goals. If you already have enough savings to fund your retirement and other financial goals, then you don’t need life insurance.
For instance, if you have Rs 10 crores in your bank account and you need only Rs 1 crore to fund all your goals and retirement, there is no gap to bridge. Hence, there is no life insurance requirement.
You Are Expected to Have Enough Wealth by the Time You Retire
A life insurance plan takes care of the financial well-being of your family if you were not around. However, you must muster enough resources to fund all your goals by the time you retire. This will take care of the scenario if nothing were to happen to you.
A life Insurance plan will take care of your goals if something were to happen to you. Your investments will take care of your goals if nothing were to happen to you.
This is why you need to get both insurance and investments right. You don’t want to be in a bizarre situation where your financial goals can be achieved only if you die. However, if you stay alive, you find it difficult to fund your financial goals. If you ever find yourself in such a situation, then you have seriously messed up your financial planning.
If You Have Saved Enough by the Time You Retire, You Don’t Need Life Insurance
Simple, isn’t it? You are expected to accumulate funds sufficient to meet your financial goals and retirement needs by the time you retire. If you already have enough funds to meet all your financial goals, then you do not need any life insurance. Even if you go by second approach, you are anyways not bringing any fresh income during retirement. Hence, there is no work-related income either that you seek to replace by owning a term insurance plan.
Life Insurance Premium Increases with Both Age and Tenor
Let’s look at premium for a term insurance plan for a 40 year old non-smoker male from a major insurer.
|Rs 1 Crore
|Age: 40 years
|Age: 45 years
You can see that the annual premium increases with the tenor of the policy. This is on expected lines. The probability of policyholder dying by the age of 75 is higher than the probability of the policyholder dying by the age of 60. Hence, if the insurer issues you a plan that covers you till the age of 75, it runs the higher risk of paying the claim. The higher risk of payout reflects in the higher premium. Apart from the Tenor, the annual premium also depends on the Sum Assured and the Age of the policyholder.
How Does This Affect You?
By choosing the right tenor, you can save some money on the premium. For Ramesh, who is 45 and plans to retire by 60, there should not be any need to have life cover beyond the age of 60. Hence, he should not opt for a term of more than 15 years.
Compare the premium for tenor of 15 and 30 years. The difference is Rs 8,670 per annum. If invested at 10% p.a., this amount will grow to Rs 3.6 lacs by the time Ramesh turns 60. Instead, if Ramesh purchases life cover for 30 years, he will have to pay life insurance premium well into retirement. A further stress on already limited cash flows during retirement. If he had purchased a plan for only 15 years, the reinvested corpus would have turned Rs 23.5 lacs by the time he turns 75.
In fact, Ramesh can opt for even shorter tenor in specific cases. For instance, if he thinks he will have enough for his goals by the time he turns 55, he must purchase cover with tenor of only 10 years. Alternatively, if he feels he already has enough, there is simply no need to purchase life insurance.
Choice of life insurance tenor is also important. If chosen properly, it can save you a lot of money. Ideally, there should be no requirement of life insurance after you have retired. You must have enough savings by the time you retire to finance your retirement and other remaining financial goals. Life insurance premium will be an additional stress during retirement when your cash flows are limited. In fact, you should stop paying life insurance premium as soon as you have enough. If you have to pay life insurance premium during retirement, you have not really planned well during your working years.