Complete Guide on How Much You Should Invest in Life Insurance

You count every rupee that goes towards meeting your expenses so that you can save alongside for future life goals—whether it is buying a house, educating the kids, or building your retirement fund. But does it also bother you how the family will get on if you are not around? One solution to this could be buying a savings policy that combines the advantages of life insurance and investment that helps you meet your short- to medium-term financial goals.

 

So what exactly is a savings policy? And more importantly, how do you calculate what to put aside towards such a policy to ensure sufficient life cover and decent assured returns on your investment? Read on to find out:

 

What is a savings policy?

 

For those wondering if insurance can be a form of investment, a savings policy is a life insurance product with an investment component that encourages financial discipline in a policyholder through long-term savings.

 

A typical savings policy offers the insured:

• Guaranteed^# returns on investment either during the policy term or upon maturity.

• Life cover throughout the policy term.

• Optional riders¹ for further coverage.

Which savings policy insurance is best for investment?

 

A savings policy could either be an endowment savings plan, a money-back savings plan, or a unit-linked insurance plan.

 

All the savings policies mentioned above serve the dual role of an insurance and investment product. However, there are subtle differences between the products themselves. The savings policy that will best suit your needs depends on your financial goals.

 

A policyholder who survives the term of an endowment savings policy gets a lump sum amount (sum assured and any accrued bonus²) when the policy matures. It is an ideal scheme if you are looking to arrange for a sizeable lump-sum payout in the medium- to long-term to fulfil a significant financial milestone.

 

In a money-back policy, the policyholder receives a pre-determined percentage of the sum assured at regular intervals during the policy term. This scheme works well for anyone looking for a second source of income while the policy term is in force.

 

 

How much should you invest?

 

Traditionally, agents use the Human Life Value (HLV) approach to calculate insurance needs, where insurance is in multiples of earned income. The theory behind this is that insurance should replace the loss of earnings after the policyholder dies.

 

This method, though widely applied, is not an ideal method to determine insurance needs. For example, the calculations do not account for future circumstances and the financial needs of the beneficiaries. When calculating the insurance needs of beneficiaries, it assumes that the current income earned provides a satisfactory standard of living, which will remain the same going ahead.

 

A more appropriate method to calculate the required life insurance amount would be determining the financial needs of the surviving family members—the immediate need for cash if the insured dies and expenses after that. Professionals refer to this method as the Needs Approach.

 

A basic calculation based on the needs approach looks like this:

 

The life insurance needs of a family = Cash for costs immediately after a policyholder's death + The present value of family's needs – Available assets

 

The needs approach intuits the future financial needs of the beneficiary (surviving spouse). It divides the life of a surviving beneficiary into various phases—the readjustment phase after the death of an insured, child dependency phase, their needs post-child dependency phase, up to retirement, and the retirement phase.

 

All financial calculations that attempt to anticipate future needs consider the rising cost of living, also referred to as inflation, which rises at an average of 4% -6% per annum.

 

The needs approach provides a more realistic picture of the anticipated financial needs of a family.

 

Rules of thumb are another set of simple guidelines by which an individual can quickly determine his/her life insurance amount. While the insurance industry has far more sophisticated methods to determine an individual’s insurance needs, rules of thumb are a good place for a person to get started.

 

Some ‘rules of thumb’ are:

 

• Income rule: This determines one’s basic insurance needs as six to eight times his/her gross annual income.

• Income plus expenses: As the name suggests, this determines one’s insurance needs as five times their gross earnings plus any significant expenses, such as a personal or home loan, school or college fees, etc.

• Premiums as a percentage of income: This rule of thumb calculates the premium that one should spend/incur instead of defining the insurance coverage required. According to this rule, 6% of the potential policyholder’s gross income and an additional 1% for each dependent should be set aside as insurance premiums.

As mentioned earlier, rules of thumb are good to get a rough idea of one’s insurance needs with a few clicks on a simple term insurance calculator. However, it does not provide an accurate picture of how much you can or should spend on insurance. This is because the formulas do not allow for any special considerations concerning one’s life. They do not consider whether the family has more than one source of income, the actual ages of the policyholder and dependents, unexpected but significant expenses, etc.

 

The insurance industry has several specific methods to determine one’s insurance needs that include but is not limited to the family needs approach, capital retention, and capital liquidation approach.

 

Conclusion

 

Insurance planning is a crucial part of financial planning. The moment you embark on your professional journey is an ideal time to consider a savings plan. Such plans provide you with life cover and give you an early head start at savings for your future financial goals.

 

Check out Tata AIA Life Insurance that offers various savings solutions with advantages of life insurance and long-term savings with guaranteed^# returns. The plans come with additional features like tax* benefits, the flexibility on premium payments schedule, and the option to avail of a loan against certain policies.

 

L&C/Advt/2021/Jun/0916