Life insurance is a contract between an insured and an insurer, where the insurer promises to pay a designated beneficiary a sum of money in exchange for a premium, upon the death of the insured person. Basically insurance is a particular type of risk management.
So the question comes to everyone’s mind is that how much insurance cover a person require, in order to compensate the financial loss the family suffers in case of his death.
Let’s take an example to explain this.
Raju is 30 years old working in a multinational company. His wife is a home maker. They have 2 sons aged 1 and 3. His salary details, assets and liabilities are listed below.
So the question comes to everyone’s mind is that how much insurance cover a person require, in order to compensate the financial loss the family suffers in case of his death.
Let’s take an example to explain this.
Raju is 30 years old working in a multinational company. His wife is a home maker. They have 2 sons aged 1 and 3. His salary details, assets and liabilities are listed below.
All figures are in INR
Gross
monthly income after deducting PF, income tax etc.
|
50000
|
EMI
towards car loan
|
5000
|
EMI
towards home loan
|
10000
|
Net
income available to family
|
35000
|
After deducting the EMIs for car and home, the net income which is available to Raju is 35000 per month at this particular point of time.
This income (INR 35000) will be utilized for day to day activities, food, clothing, entertainment, emergencies, and the balance amount after all these will be saved.
In case of the unfortunate demise of Raju, the inflow of cash that Raju generates for his family (35000 per month at this particular point of time) will be stopped.
So the insurance cover that protects Raju should be roughly equivalent to the sum of all his future cash flows that he may generate, if he lives till his retirement.
In order to calculate this we have to consider the following parameters.
1) Retirement age
2) Approximate hike in his net income on an yearly basis
We are assuming that he is planning to retire at the age of 55. He expects that his increase in net income will be 6% annually.
The following table gives his expected annual net income for a period of 25 years (currently he is 30 and his retirement age is 55).
This income (INR 35000) will be utilized for day to day activities, food, clothing, entertainment, emergencies, and the balance amount after all these will be saved.
In case of the unfortunate demise of Raju, the inflow of cash that Raju generates for his family (35000 per month at this particular point of time) will be stopped.
So the insurance cover that protects Raju should be roughly equivalent to the sum of all his future cash flows that he may generate, if he lives till his retirement.
In order to calculate this we have to consider the following parameters.
1) Retirement age
2) Approximate hike in his net income on an yearly basis
We are assuming that he is planning to retire at the age of 55. He expects that his increase in net income will be 6% annually.
The following table gives his expected annual net income for a period of 25 years (currently he is 30 and his retirement age is 55).
In the first year his net income per month is 35000. So annual income for the first year will be (35000*12) = 420000.
Since he expects a 6% hike in his net income, annual net income for the second year will be
(Annual net income for the 1st year) + ((annual net income for the 1st year)*6/100)
420000 + (420000*6/100) = 445200
Similarly for the third year, annual net income will be
(Annual net income for the 2nd year) + ((annual net income for the 2nd year)*6/100)
445200 + (445200*6/100) = 471912 and so on.
Since the EMI towards car loan is for 4 years, from the fifth year onwards a sum of (5000*12) = 60000 can be added to his net income.
Also since the EMI towards home loan is for 20 years, from the 21st year onwards a total of (10000*12) = 120000 + 60000 (towards EMI of car) = 180000 can be added to his net income.
Since he expects a 6% hike in his net income, annual net income for the second year will be
(Annual net income for the 1st year) + ((annual net income for the 1st year)*6/100)
420000 + (420000*6/100) = 445200
Similarly for the third year, annual net income will be
(Annual net income for the 2nd year) + ((annual net income for the 2nd year)*6/100)
445200 + (445200*6/100) = 471912 and so on.
Since the EMI towards car loan is for 4 years, from the fifth year onwards a sum of (5000*12) = 60000 can be added to his net income.
Also since the EMI towards home loan is for 20 years, from the 21st year onwards a total of (10000*12) = 120000 + 60000 (towards EMI of car) = 180000 can be added to his net income.
So the updated net annual income after adding these amounts will
be
Sum of net annual income earned by Raju in the next 25 years, assuming an increase of 6% annually will be 24903095.02
Since these cash flows occur at uneven interval of time, we have to calculate the net present values of all these future cash inflows Raju may produce, if he is expected to live at least till his retirement.
In order to find the present values, we have to consider three important parameters.
1) Retirement age
2) Expected rate of return
3) Inflation
Since these cash flows occur at uneven interval of time, we have to calculate the net present values of all these future cash inflows Raju may produce, if he is expected to live at least till his retirement.
In order to find the present values, we have to consider three important parameters.
1) Retirement age
2) Expected rate of return
3) Inflation
Impact of inflation
In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. So over time, the value of one unit of money will go down because of the inflation effect and the same amount of money will not be able to purchase as much with that unit of money as he could have purchased earlier. In other terms, inflation eats away purchasing power over time.
So if we didn't consider inflation factor while calculating the present value, it may produce erroneous results and will have a negative impact on how much insurance cover he requires.
We are assuming that inflation for a period of 25 years will be averaged at 6 percent per annum and the rate of return for this period will be averaged at 15 percent per annum (assuming that the average equity oriented mutual fund may generate this return over this period).
So the inflation adjusted return for calculating net present value will be
((((1 + expected rate of return) / (1 + inflation rate))-1)*100)
((1+15/100) / (1+6/100) – 1)*100 = 8.4905%
To calculate the net present value, we can use MS Excel.
Steps for calculating net present value in MS Excel is given below
1) Open MS Excel and enter all the cash flows (this case his annual income over a period of 25 years)
So if we didn't consider inflation factor while calculating the present value, it may produce erroneous results and will have a negative impact on how much insurance cover he requires.
We are assuming that inflation for a period of 25 years will be averaged at 6 percent per annum and the rate of return for this period will be averaged at 15 percent per annum (assuming that the average equity oriented mutual fund may generate this return over this period).
So the inflation adjusted return for calculating net present value will be
((((1 + expected rate of return) / (1 + inflation rate))-1)*100)
((1+15/100) / (1+6/100) – 1)*100 = 8.4905%
To calculate the net present value, we can use MS Excel.
Steps for calculating net present value in MS Excel is given below
1) Open MS Excel and enter all the cash flows (this case his annual income over a period of 25 years)
Click on a blank cell and enter the following
=NPV (8.4905%, B1:B25)
The first argument is the inflation adjusted return. (Always remember to add % sign at the end of the first argument)
Second argument is the values for which we have to calculate the net present values. Since here the values are spread across cell number B1 to B25, we will mark it as B1:B25
=NPV (8.4905%, B1:B25)
The first argument is the inflation adjusted return. (Always remember to add % sign at the end of the first argument)
Second argument is the values for which we have to calculate the net present values. Since here the values are spread across cell number B1 to B25, we will mark it as B1:B25
After entering the command, press Enter and the value we get is the net present value.
In this case the net present value after executing the command is 7,938,108.08
In other words, this is the present value of all future cash flows Raju may generate if he lives till his retirement or this is the financial loss of the family if Raju die today.
Next we have to consider his assets and liabilities.
His assets (current assets as well as fixed assets except the car he owns and the house he lives in) and investments includes
Fixed deposits PF and debentures worth 10 lakhs
Gold worth 5 lakhs
Shares and mutual funds worth 3 lakhs
Plot worth 20 lakhs
Insurance cover of 10 lakhs
Total assets = 48 lakhs
His liabilities are
Car loan (EMI of 5000 for 4 years) – (5000*48) = 240000
Home loan (EMI of 10000 for 20 years) – (10000*240) = 2400000
Total liabilities = 26.4 lakhs
So the adequate insurance cover he has to take is
(Net present value of his future cash flows + liabilities – current assets and investments)
7,938,108.08 + 2640000 – 4800000 = 5778108.08
Approximately 57.7 lakhs (on the assumption that he may die at this point of time)
The below mentioned calculation is based on my assumptions and conclusions. Investors are advised to consult financial consultants before taking insurance policies/making financial decisions.
Views are personal :)
In this case the net present value after executing the command is 7,938,108.08
In other words, this is the present value of all future cash flows Raju may generate if he lives till his retirement or this is the financial loss of the family if Raju die today.
Next we have to consider his assets and liabilities.
His assets (current assets as well as fixed assets except the car he owns and the house he lives in) and investments includes
Fixed deposits PF and debentures worth 10 lakhs
Gold worth 5 lakhs
Shares and mutual funds worth 3 lakhs
Plot worth 20 lakhs
Insurance cover of 10 lakhs
Total assets = 48 lakhs
His liabilities are
Car loan (EMI of 5000 for 4 years) – (5000*48) = 240000
Home loan (EMI of 10000 for 20 years) – (10000*240) = 2400000
Total liabilities = 26.4 lakhs
So the adequate insurance cover he has to take is
(Net present value of his future cash flows + liabilities – current assets and investments)
7,938,108.08 + 2640000 – 4800000 = 5778108.08
Approximately 57.7 lakhs (on the assumption that he may die at this point of time)
The below mentioned calculation is based on my assumptions and conclusions. Investors are advised to consult financial consultants before taking insurance policies/making financial decisions.
Views are personal :)
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