Calculating how much life insurance you need is one of the most important financial decisions you will ever make. It should never be an isolated decision depending only on how much of a premium you can afford.

There are many ways in which you can determine how much insurance you need.

Method 1 - (Income Replacement Method)

This is one of the basic methods of insurance calculation and is based on your current annual income.

Insurance Needs = Annual Income * Number of years left for Retirement.

Let's say your annual income is $100,000. And you are 45 years old with 15 more years for retirement. 
In this case your insurance cover required = $100,000 * 15 = $1,500,000

Method 2 - (Income Replacement Multiplier Method)

Another way in which income replacement works is to multiply the annual income by Income Replacement Multiplier.

Insurance Needs = Annual Income * Income Replacement Multiplier.

Income Replacement Multiplier changes with age.

Age	Income Replacement Multiplier
20 -30	5 -10
30 -40	15 -20
40 -50	10 -15
50 -60	5 - 10

For example: Age 45 Annual Income = $ 100,000

Insurance Needs = Annual Income * Income Replacement Multiplier.
                           = $100,000 * (10 to 15) = $ 1,000,000 (Minimum) or 1,500,000 (Maximum)

Method 3 - (Human Life Value Method) or HLV

This method of calculating life insurance is based on contribution that one makes and would have made to her/his family in case of sudden demise.

So HLV is defined as the present value of all future income that you could expect to earn for your family's benefit. It also includes other value you expect to contribute, less personal expenses, life insurance premiums and taxes through your planned retirement date.

See this example for better understanding.

John is 40 years old and plans to retire at 60. His current salary is $ 100,000 and is expected to increase 8% every year. The current Inflation Rate is 3%. His personal expenses, life insurance premiums that he pays and taxes are around $ 40,000. His contribution to his family is rest of his salary of around $ 60,000.

Here, John's Annual Life Value (his economic contribution to his family post his expenses) is
$ 60,000 for year 1 and suppose grows 8 % every year.

Suppose John dies at 41, then the economic value he would have added every year (from age 41-60) to his family is no longer there. So to protect this economic value, John can use life insurance as a safety valve, so in case of his death, this economic value can come to the family.

Assumptions:
Present Age	40
Retirement Age	60
Gross Total Annual Income	$100,000
Less:  Self Maintenance charges (Personal expenses Food, Clothing, Petrol, Club expenses etc. That is the expenses made by him for himself when he is alive )	$20,000
Less : Tax	$10,000
Less :Insurance Premium on own life	$10,000
Present Net Annual Income (Surplus Income Generated for Family)	$60,000.00
Number of Years of Working Life:	20
Assume that Income Increases every year by:	8.00%
Current Rate of Interest Rate	9.00%
Inflation Rate	4.00%
Net Discount Rate of Interest	5.00%

If this surplus income is capitalized at a discount rate (expected net return rate) of 5 per cent per annum for 20 years, then the HLV will be =  $1,513,331.46 . The calculation is as follows

Duration	Income	Discount Factor	Present Value of Future Income
1	$60,000.00	0.952380952	$57,142.86
2	$64,800.00	0.907029478	$58,775.51
3	$69,984.00	0.863837599	$60,454.81
4	$75,582.72	0.822702475	$62,182.09
5	$81,629.34	0.783526166	$63,958.72
6	$88,159.68	0.746215397	$65,786.11
7	$95,212.46	0.71068133	$67,665.72
8	$102,829.46	0.676839362	$69,599.02
9	$111,055.81	0.644608916	$71,587.57
10	$119,940.28	0.613913254	$73,632.93
11	$129,535.50	0.584679289	$75,736.72
12	$139,898.34	0.556837418	$77,900.63
13	$151,090.21	0.530321351	$80,126.36
14	$163,177.42	0.505067953	$82,415.69
15	$176,231.62	0.481017098	$84,770.42
16	$190,330.15	0.458111522	$87,192.43
17	$205,556.56	0.436296688	$89,683.65
18	$222,001.08	0.415520655	$92,246.04
19	$239,761.17	0.395733957	$94,881.64
20	$258,942.06	0.376889483	$97,592.54
21	$279,657.43	0.358942365	$100,380.90
			$1,513,331.46

 

In short, Human Life concept arrives at an estimate of insurance cover required as on date to protect the income earners' economic value to their families including their future earning potential and capacity.

Method 4 - (Need Analysis)
In this method, you can assess your needs and the needs of your loved ones, and make a calculated assessment.
The most critical factors are the number of dependents you have, and their needs.

Other major factors to be considered are:

• Loans
• Kind of lifestyle you want to provide to your family
• Provision for non-working spouse who would no longer get an income
• Child's education
• Child's marriage
• Providing for financially dependent parents
• Special needs (If any)
• Dreams and aspirations such as contributing to charitable causes

Once you determine the above factors, you run the following calculations:

1. Lump sum needs on death of Life to be insured.
   a. Home loan payoff
   b. Car loan or any other loan payoff
   c. Child's education
   d. Child's marriage 
   e. Emergency fund post death

2. Monthly income needs

  a. Monthly expenses
  b. Income of Living spouse in case she earns, or rent or interest
  c. Shortfall = (a-b), Shortfall is a-b. Suppose, expenses are $ 50,000 and spouse's income is $ 30,000 post tax, then shortfall is $20,000 (50,000-30,000).
  d. Monthly income needs till child turns 21 or is self-sufficient:
  e. Number of years to go: For the child to reach 21 and post that for the spouse till her age of 80 or  90 years
  f. Annual income needs: Of spouse, children or dependents
  g. Total income needs: Of spouse, children or dependents

3. Calculate the total capital required to meet the lump sum Needs and Income Needs

4. Sum up the current invested assets (excluding residence, car and other personal assets)
    And current life insurance covers.

Now see the difference: Total in step 3 minus Total in Step 4, what you have calculated above. This will be the shortfall (considering that you die today) that you will need to get covered.

Picking the Right Method

The one that I prefer and is mostly followed by reputable financial planners for decades is the Needs Analysis Method or Human Life value Method. Once you determine the amount of life insurance need, just buy the lowest cost insurance plan that's available to you.

You should buy insurance after a thorough calculation of capital (lump sum needs on death such as paying off a loan, daughter's marriage or education) as well as the income needs of your family after you are gone.

Ask yourself: If something were to happen to you, what kind of corpus would your family need to maintain their current lifestyle, to fund your child's education as you had envisaged, retirement income for your wife etc.

Most middle-class as well as higher class individuals are under insured

The question they need to answer is: How long would your existing insurance suffice?

Finally, remember that your insurance needs go down over a period of time. Hence if you find yourself with a sudden windfall or have accumulated enough wealth, then you can evaluate the need to altogether terminate your insurance policy.

N.B: For calculating the human life value, an excel sheet is enclosed. Go to the TAB “Human Life Value” Feed the data and if the no of years of working life is 20 years add the first 20 values in column “E”.
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