A good life insurance policy can protect you from financial difficulties and provides assurance that your loved ones will be taken care of in the event of any mishap. However, many a times people find it difficult to estimate the appropriate value of insurance they need.
Your life insurance needs change through different stages of your life. When you are young, you may not have much need for life insurance. However, as you take on more responsibility and your family grows, your life insurance needs increase. You should periodically review your needs in order to ensure that your life insurance coverage is adequate.
There are several simple methods that can be used to estimate the life insurance needs of a person. These are rules of thumb and give you a broad idea of the amount of life insurance you should buy.
Income rule: The most basic rule of thumb is the income rule, which states that your insurance cover should be around six to eight times your gross annual income. For example, a person earning a gross annual income of Rs 100,000 should have between Rs 600,000 (6 x Rs 100,000) and Rs 800,000 (8 x Rs 100,000) in life insurance cover.
Income plus expenses: This rule considers your insurance need to be equal to five times your gross annual income plus the total of any housing or car loans, personal debt, mandatory recurring expenses such as house rent, etc, and special funding needs such as a child's education, etc. For example, assume that you earn a gross annual income of Rs 100,000 and have expenses that total Rs 2,50,000. Your insurance need would be equal to Rs 7,50,000 (Rs 100,000 x 5 + Rs 250,000).
Premiums as percentage of income: Payment of insurance premium results in outflow of disposable income. You may, therefore, not like to buy too much insurance. One should decide the quantum of insurance keeping in mind the cash-flow problems that will be created as a result of the obligation of regular outgo from salary.
In income and income plus expenses rule, you ascertain the minimum insurance you should have. Under the premium as percentage of income rule, you can plan your cash flow by committing an appropriate percentage of your income for paying life insurance premium.
Conventionally, a minimum of six percent of your gross income (as the primary income earner) should be spent on life insurance premium. Add an additional one percent for each dependant. Once you determine the percentage of your income that should be spent on life insurance premiums, you should purchase as much life insurance as you can get for that premium amount.
There are several more comprehensive methods used to calculate life insurance need. Overall, these methods are more detailed than the rules of thumb and provide a more complete view of your insurance needs.
Family need approach: The family need approach requires you to purchase enough life insurance to allow your family to meet its various expenses in the event of your death. Under the family needs approach, you divide your family's needs into two main categories:
* immediate needs at death (cash needs), and
* ongoing needs (net income needs).
Once you determine the total amount your family needs, you purchase enough life insurance to cover that amount.
Income replacement: The income replacement calculation is based on the theory that the purpose of life insurance is to replace the loss of your income in case of your premature death. Under this approach, the amount of life insurance you should purchase is based on the value of the income that you can expect to earn during your lifetime, taking into account such factors as inflation and anticipated salary increases.
Estate preservation and liquidity needs: It is a sensible choice to reassess your insurance cover if you avail a big-ticket-loan against your assets such as a housing loan or a business loan. It provides the much needed economic hedge against risk and protects your family and/or your business. The estate preservation and liquidity needs approach attempts to calculate the amount of life insurance needed upon your death for items such as debt, expenses and taxes, while preserving the value of your estate. This method takes into consideration the amount of life insurance needed to maintain the current value of your estate for your family.
You may also like to keep in mind that if your family members have independent earning capacity, you may reduce your insurance. Insurance is a protection and not really an investment. You may not get a decent rate of real return at the time of maturity of your insurance policies.
It is very important to calculate the amount of insurance one need. This is not a one-time calculation; it should be reviewed periodically and the amount of insurance should be increased or decreased accordingly. The point is that you should be adequately insured at all times while at the same time avoiding being over-insured (given the low returns vis-‘-vis other investment instruments).

Source: The Times of India