Everybody needs a life insurance to protect their loved ones from financial hardships in the event that your time on the planet has unexpectedly come to an end. So I wanted to write a post about life insurance. The recommendations made in this post are for people who are planning early retirement. For others, it may not work. You requirements of life insurance will be different pre and post retirement.
Pre-retirement Life Insurance
At any point in life before retirement, the amount of life insurance you need is the corpus that you would need at the time to support all your dependants for a lifetime. So basically, it is the same number as your retirement corpus you would need at that time. Lets go with an example shall we?
Find a baseline
Let's say you are 30 years old and you project that your expenses will be Rs. 50,000 per month if you were to retire at that time to live comfortably. That should include your kids school fees, living expenses, lifestyle expenses etc, but not your EMIs. Lets says you assume a 4% withdrawal rate to meet the expenses. Then you would need 50,000 * 12 / 4% = Rs. 1.5 crores to cover the expenses. This is the baseline number.
Add your liabilities
Now add in all your liabilities to that baseline number. For example if you still owe Rs. 40 lakhs to the bank for your home loan, add it. Likewise, add any other liabilities, car loans, personal loans etc. In this example that will be Rs. 1.5 crores + Rs. 40 lakhs = Rs. 1.9 crores.
Deduct your assets
Next subtract all your appreciating assets. These would be your savings, investments, real estate and so on. Don't add depreciating assets like cars, TV etc. Even when adding appreciating assets, make sure they are appreciating at a good rate (at least a couple of percents above inflation). For example, don't add a real estate which is under litigation you might lose it, or if the real estate is not in a prime location and expected to appreciate only at 5%.
If you don't own any house as part of real estate, then add in the cost of a house that you would like to own if you were to retire. Let's say you want to live in a house worth Rs. 70 lakhs, then you would arrive at Rs. 1.9 crores + Rs. 70 lakhs = Rs. 2.6 crores. Alternatively, the expenses used to arrive at the baseline number should have included a generous rent.
If you own one or more houses as part of the real estate, subtract all but one house so your family will have a roof under their head. For example if you own 2 houses, one worth Rs. 30 lakhs and another Rs. 70 lakhs, then assuming your family would prefer to live in the Rs. 70 lakhs house, subtract Rs. 30 lakhs from the previous number to arrive at Rs. 1.9 crores - Rs. 30 lakhs = Rs. 1.6 crores.
That number is the insurance cover you will need at that time. So, if you were to die on that day, your family will have access to Rs. 1.6 crores which if they allocate and use carefully, should suffice them for their life time. As an example, once your family receives Rs. 1.6 crores, they will allocate Rs. 1.5 crores (the baseline number) to retirement corpus in 70:30 split to cover their expenses. Next they can choose to sell the Rs. 30 lakhs house and add in the remaining Rs. 10 lakhs from the insurance to clear the Rs. 40 lakh loan.
Cushion it properly
There are a few nuances to the above example. If you want your family to have a less risky investment, then may be choose a 3% withdrawal rate. Think about the expenses in the future too. May be your kid is too young to go to school and your current expenses are low. In future, the expenses may go up owing to school and college fees. Take all those factors into account when accounting for retirement expenses. If you are adding or subtracting illiquid assets such as real estate, be careful as to what value to attribute to it. When in doubt go for a 20% discount on the value, in case your family needs to sell it in a hurry and cannot unlock the full value. Similarly, if you want to be extra safe, add a 20% premium to the final number. In the example above, may be you would like a cover of Rs. 1.5 crores * 1.2 (20% premium) = Rs. 1.8 crores instead.
Insurance is not investment
A final note on choosing a life insurance. Don't go with any kind of life insurance other than a term insurance. Most insurance agents try to sell you investment-cum-insurance policy or endowment policies. Don't go with them. Keep your insurance separate from your investments. You cannot mix insurance and investments. Term insurance may look like a bad investment because it does not pay anything if your survive past the term of your cover, but remember, the cover is not an investment, it is an insurance against an unexpected risk. Term insurance have very low premiums, so it should not be a worry.
Once you retire you won't need any more life insurance. At retirement, you have a big enough corpus to fund the expenses of your family for perpetuity or for a long enough time that you decided to quit working. If you were to die, your family should be able to handle finances with the corpus that you have left them with. Hopefully you have all the nominations and will lined up properly.
Reduce your costs
As you might have figured out by now, your requirement for insurance reduces as you get closer to your retirement because your assets (investments) will be going up and your liabilities (loans) will be going down. So you probably won't need that Rs. 1.6 crore cover (which you calculated at age of 30) when you are 45. Since term insurance cover cannot be changed, you could go with multiple insurance policies with varying policy periods.
Following the example, let's say you want to retire at 43. For the Rs. 1.6 crore cover you can take 2 insurance policies of Rs. 80 lakhs each, but one for 14 years and another for 7 years. So you will be paying the premiums for 2 insurances until you are 37. Then you will pay for just one policy until you retire. Although you are planning to retire at 43, keep the cover for a bit longer in case you are unable to retire on time. If you retire earlier than the policy period, you can choose to stop paying the premiums and let it lapse. You have nothing to lose.
The premiums for life insurance are so low that you don't even have to think about multiple policies. So if it is too much hassle, don't even bother splitting the policies, especially if the cover is going to be less than Rs. 70 lakhs. That is all there is to know about life insurance.