Income Replacement Through Life Insurance

One of the most common questions in financial planning is: how much term life insurance should a person actually have? You may hear rules such as 10 times or 15 times annual income. While these thumb rules are a good starting point, a simple Excel sheet can help you understand the actual requirement better.

The basic purpose of term insurance is income replacement. If the earning member of a family dies, the family loses not just today’s salary, but the income that person could potentially have earned over the remaining working years. That future income would have supported the family’s lifestyle, regular household expenses and long-term goals such as children’s education and marriage.

Start With Four Inputs

Open an Excel sheet and enter four basic assumptions: your present age, your current annual income, your expected annual increment and the age up to which you expect to work.

Suppose a 30-year-old earns Rs 10 lakh per year and expects to work until age 55. Assume the income rises by 6 per cent every year. In the first row, enter Rs 10 lakh. In the next row, multiply the previous year’s income by 1.06. The following year, repeat the same formula and drag it down until age 55.

Thus, Rs 10 lakh becomes Rs 10.60 lakh in the next year, then approximately Rs 11.24 lakh in the year after that, and so on. When all these projected annual incomes are added together, the total is about Rs 5.9 crore.

See the Bigger Picture

That is the interesting part. A salary of Rs 10 lakh may not sound enormous when viewed for just one year. But when you look at the earning potential over the next 25-odd years, the number suddenly becomes close to Rs 6 crore. This is the income stream your family is financially dependent on.

The result also changes substantially when the assumptions change. If annual income growth is 8per cent instead of 6 per cent, the projected cumulative income rises to approximately Rs 8 crore. Similarly, a younger person with more working years ahead may have an even larger amount of future income to protect.

Use Excel to Get Perspective

This is why merely choosing an arbitrary Rs 50 lakh, Rs 1 crore or Rs 2 crore cover because the number sounds large may not tell the full story. Even the commonly used 10-15 times income rule is just a starting point and may not be sufficient. Excel makes the magnitude of your future earning capacity visible.

Of course, this calculation need not be treated as a rigid formula or an instruction to buy exactly the amount that appears on the screen. Its purpose is to give you perspective.

Term insurance is ultimately about replacing the earning capacity your family could lose if you were no longer around. Put your own numbers into a spreadsheet and project your income year by year. You may be surprised at how much you are actually expected to earn over your working life - and therefore how much financial protection your family may truly need.

(The author is a Chartered Accountant and CFA (USA). Financial Advisor. Views personal. He could be reached on 9833133605.)