Personal Finance / Uncategorized

Guide to Financial Independence – Life Insurance

I believe that the first thing all of us should have is a life insurance. Life insurance should be the first option even before paying off debt or building an emergency fund. The simple reason is, especially if you’re the sole bread-winner, your family should have enough money to

  1. Pay off any existing loans/debts
  2. Manage major expenses like education, and
  3. Have enough left over to cover emergency expenses like illness.

A life insurance is the best way to ensure that all of your needs are met. There are 2 questions that we need to answer before we start choosing the best cover for our need.

1. How much life insurance cover do I need?

2. What type of life insurance should I choose – Term, ULIP

How much life insurance cover do I need?

The general rule of thumb is to say that you need enough cover to be able to pay off all our liabilities like home loan, vehicle loan etc. But someone like you who is thinking of financial independence would never be this naive. The insurance payout should do all the below

Cover all liabilities like home loan, vehicle loan – Let us say that you have loans totalling 30 lakhs currently existing, the insurance cover requirement is 30 lakhs

If you are the sole bread-winner, it should also provide enough monthly income for immediate future – If the monthly expense is 20000, then you should be able to invest enough in a FD or similar instrument so that expenses for the immediate future are covered. Assuming it is a FD with 7.5% interest, you will need an increase of 32lakhs. Now the total cover required is 62 lakhs.

It should cover future expenses like education, marriage etc of your children – Assuming you have 2 children and in current terms you need about 20 lakhs for education & marriage. Let us assume you need an additional cover of 15lakhs considering they will study and get married over the next 20 years and inflation. The total cover required is 77 lakhs.

It should cover expenses for your parents, if they are dependent on you – Considering monthly expense and emergencies, assume you need another 15lakhs. This increased the total cover to 92 lakhs.

It should provide enough to cover any family emergencies like illness – This is completely dependent on personal choice. If you have a good health insurance plan then the necessity is much lesser than otherwise. Assuming we need another 8 lakhs just so that we arrive at a total cover requirement of 1crore.

How much have you saved until now? – Let us say you have saved 15 lakhs and this is invest in assets that you are ok to liquidate. (I have not considered your home equity in this case). This means that your family can use this investment to offset some of their requirements. So the final insurance cover requirement ends up as 85 lakhs.

In case both spouses work – This should drastically reduce the insurance requirement. In this case the first step is to recalculate your families monthly expenses as this should reduce. The second step is to calculate how much of the financial burden can be borne by your spouse. The remainder will be the cover required for you. Calculating all step separately assuming your are the surviving partner will give the insurance cover requirement for your spouse.

What type of insurance cover should I choose?

I have already discussed the merits and demerits of choosing a Term plan vs a ULIP here. I personally believer that we should leave experts to do their jobs. In this context it means that we should leave investing to the mutual funds and the ULIP plans I have gone through until now are not good enough to justify using them as investment instrument. The cheap online term plans available now, make the case stronger to choose a term plan as your life insurance cover.

What if the insurance premium is more than I can afford now?

Not every one of us is fortunate to earn enough to manage all our needs and wants. Some of us are clever enough to have recognized the difference between needs and wants and prioritize accordingly, while others are forced to do this since their income is less. If you are in this bucket, I would expect you to not have either a home or a vehicle loan. If you have either or both, you will need to rethink your priorities immediately and figure out how to spend less and save more. Is an insurance plan more important than buying a new car, or a new TV? The best case scenario is to choose a plan based on the maximum premium you can afford.

How to choose the best term insurance plan

Now that you know the amount of cover you need, there are multiple criteria you need to evaluate to identify the term plan that suits you the best.

Age is important – The earlier you sign-up for an insurance plan, the lower your insurance premiums will be. This will not matter as you age and your income level rises, but can make a real difference when you start. Your lifestyle (smoking vs not) also has an impact on the premium.

Claims settlement ratio – This is one of the most important metric that you need to analyze before choosing the insurance provider. This tells you how many claims of the ones registered were paid by the provider and is a good indicator of reliability in settling claims

Duration of claim settlement – This is next important metric and helps us understand the efficiency of the provider. Ideally the provider should have a high ratio of claims settled in the quickest time.

Time period – Ensure that you will be covered until the time your family will be dependent on your income. In general you should get 30 years of cover in most plans

Additional benefits – there are additional covers like accident based cover that are offered at a premium. This is a personal choice and I leave it up to you to choose or reject these options.

Premium – Do shop around – there are multiple online sources with very good info – for the lowest premium.

You will have to re-look at your cover whenever there is a change in the basic requirement – if a partner stops/starts working, a child is born etc.

I have not discussed health insurance here, since both me and my wife are covered on our office plans. We have not analysed option until now due to this and I do not have enough information to share. We are thinking about a personal health insurance plan, just to reduce expenses further on, but are not sold on the idea yet.

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