In mathematics, “Ratio” implies how much of one thing is there compared to another. And when it comes to running a company, financial ratios are taken very seriously. Likewise, personal finance ratios should be given due importance too. As part of Firstpost’s personal finance ratio series, which started last week, today we bring you a unique type of ratio, called life insurance coverage ratio. In the past, we wrote about basic liquidity ratio, debt service ratio, leverage ratio and savings ratio.
When it comes to insurance, often the first word that strikes you is mis-selling. There are many people who buy life insurance cover which is not adequate for their needs while there are those who buy a cover more than their requirement.
While buying insurance you need to ensure the cover should be such that after you are not around, your family’s future financial needs are covered and their lifestyle does not change.
Life Insurance Coverage Ratio: Simply put, this ratio tell you how much life cover you have in relation to your annual income so that once you realize you are not adequately covered, you can take some course correction actions.
Example: The ratio can be calculate by simply adding your Networth with the death benefits amount of your current life insurance policy. This amount you need to divide by the your annual salary.
Life Insurance Coverage Ratio = Net Worth + Death Benefits / Salary
1) Let’s say your total assets are worth Rs 55 lakh, of which you have a Rs 22 lakh home loan and 13 lakh personal loan as debt.
2) Your Net worth hence is Rs 20 lakh (Asset of Rs 55 lakh- liabilities of Rs 35 lakh).
3) Now assuming you have an life insurance cover with death benefit of another Rs 20 lakh.
4) Your annual salary is 5,20,000.
Life Insurance Coverage Ratio= 2000000 + 2000000/ 520000 = 7.69
This ratio show that your have made arrangements for only 7.69 years of your family's financial needs, if you die today. Doesn't this sound scary? Obviously, we haven't taken into account inflation in this calculation, and this means that the amount of assets and life cover you leave behind may not even be enough for 7.69 years, with the current rising trend of inflation.
Are you in red zone? Ideally a ratio of 10 is good enough theoretically. But it's better to you do your own calculations and see what your financial data throws back at you. You should ideally seek help from a Certified Financial Planner for more insurance related advice if you find yourself in the red zone.