Understanding life insurance coverage ratio

Term insurance is a kind of life insurance that bears coverage for a specific period or "duration" of years. If the insured person dies within the period defined in the policy and the policy is in effect, a death benefit will be paid.

The most common difference between term insurance and life insurance schemes is that a term insurance scheme provides for death benefits only if the insured person dies within the time frame.

How much do I need?

To determine how much insurance you need, a person needs to calculate the life insurance coverage ratio. The life insurance coverage ratio is the amount of insurance coverage in relation to the policyholder's income. One of the problems India faces is the very low life insurance coverage ratio. The coverage ratio indicates the extent to which insurance is adequate. It helps to determine whether death benefits and investments are sufficient to cover the daily expenses and health of the family.

Life Insurance Coverage Ratio = (Net Worth + Death Benefits)/Annual salary or Annual income Your net worth is your total assets - total liabilities.

Let's say Ashish has total assets worth ₹50 lakh, of which he has a ₹15 lakh home loan and ₹13 lakh personal loan as debt. So, a person’s net worth is ₹22 lakh (Asset of ₹50 lakh- liabilities of ₹28 lakh)

If Ashish has a term insurance cover with a death benefit of another ₹25 lakh and the annual salary is ₹6 lakh. Then:

Life Insurance Coverage Ratio= 2800000 + 2500000/ 600000= 8.83

This life insurance coverage ratio shows that Ashish has made arrangements for only 8.83 years of his family's financial needs if he/she dies today. In most cases, a life insurance coverage ratio of 10 is descent enough however.

There are other methods to calculate this such as Underwriters Thumb Rule, Income Replacement Value and Premium as a Percentage of Income.

Underwriters Thumb Rule: Under this rule, the sum insured needed is depending upon the age and in multiples of annual salary/income. For example, individuals within the age of 20-30 years should have insurance coverage equal to 25 times the annual salary/income.

Income Replacement Value: This method is also based on a person’s annual salary/income. Required coverage is annual salary/income * years left on retirement. But it's better to decide with the help of a financial planner.