At some point of time, most people ask themselves this question: "How much life insurance do I need ?"

Some financial advisors will tell you to multiply your annual income by seven. Others will tell you to buy only enough life insurance to replace the income you are expected to make between now and retirement. Some might recommend you buy only enough life insurance to cover your present debts.

While you probably can do all of those calculations in a minute, they won't give you the right answer. Simply put, calculating your life insurance needs takes homework. It requires you to do an inventory of all of your finances, and to think long and hard about how your beneficiaries would maintain their lifestyles without you. You also must consider inflation and, if you have children, future college education costs. 

What NOT to do ? 

What's the wrong way to calculate how much life insurance you need ? Here are some common but misguided methods.

1. Multiply your annual salary by seven or eight: While it’s a simple formula, it fails to take into account your individual needs and obligations. Life insurance experts say there’s a good chance you’ll buy too little or too much coverage, simply by using a formula such as this.

2. Calculate your "human life value" : This method gives you the income you will earn from your present age until your retirement age, assuming a rate of interest that represents salary increases throughout that period. The problem is it does not take into account what your beneficiary's specific needs will be. You might end up with a figure that requires you to buy a huge amount of life insurance, possibly more than you may need. "There's all sorts of landmines in this," says Laxman Ganapati, Lead Consultant – Life & Pension Products,  "When you calculate this way, you're working with broad brush strokes."

3. Cover your debts : This involves buying only enough life insurance to cover debts such as your housing loan or outstanding car loan. This method does not consider any future debts or needs, such as retirement, college education costs or marriage of children.

A classic formula :  

Many experts say the best way to pinpoint a smart life insurance figure is through a needs analysis, which can be broken down into a simple formula: Short-term needs + long-term needs - resources = how much life insurance you need.  Laxman says this method is "probably the most accurate approach in what is an inaccurate and imprecise science."

Experts advise you do this analysis at least once every five years, or whenever you have had a major life change. For example, if you have a new baby, you have to recalculate college education needs and child-care costs. If you own a home, a housing loan is likely your biggest financial burden. Because your loan balance decreases with each payment, it's important to include those revised figures in your calculations.

Five steps to a needs analysis :

Step 1

Add up all of your short-term needs. These can be placed into three categories: final expenses, outstanding debts and emergency expenses. Among final expenses are medical and hospital expenses and any outstanding taxes that would need to be paid if you died. Among outstanding debts are credit card balances, car loan, personal loans, and all other outstanding bills. Emergency expenses should include a cash reserve for medical emergencies and repairs to your home or car.

Calculating final and emergency expenses can be complicated, because you don't have a crystal ball that tells you how much your medical or hospital expenses will be, or if you even will have any.

Step 2

Next, add up your long-term debts, which include your home loan and cost of college education.

Calculating an education fund is tricky because you have no idea where your children will be going to college. Perhaps the best method is to use the present average college cost in India and the number of years away your children are from entering college. The average college costs for the 2005-2006 academic year was Rs.50,000 to Rs.200,000 annually for a Govt. quota seat  and Rs.100,000 to Rs.400,000 for a Management quota seat.

College costs, over the past couple of years, have risen at about 8% annually, so you need to figure out what the cost will be when your child goes to college. (To calculate what costs will be in the future, see the last section: “A must-know: the equation for the future value of money.” Also be sure to calculate what the entire education will cost while taking into account the increased costs each year.)

Step 3

Next, calculate family maintenance expenses. These include such necessities as childcare, food, clothing, utility bills, entertainment, travel, and transportation. Calculate this figure based on a year's worth of expenses, then multiply that times the number of years you want to provide this income.
Once you've done that, add your short and long-term debts and your family maintenance expenses.

Step 4

Now that you've tallied all of your income needs, figure out what resources you have to meet them. To do this, add all available savings, stocks, bonds, mutual funds and existing life insurance (including group life through your employer). Also add your present salary, and assume 5 percent compounded interest each year if you expect salary increases over time.

It's important to count only liquid assets (those that could be quickly converted to cash) among your resources. You shouldn't count items such as your home or car, because selling them for cash when you're gone would mean changing your family's lifestyle.

Step 5

Subtract your resources from your total expenses. The figure you get should represent the amount of life insurance you should buy.

Don't be daunted :

Hold on ! The final figure that shows how much life insurance a person needs can be quite alarming. If you end up with an astronomical figure that requires a premium that is too high, just go through the analysis again and select areas for which you think you can allocate less money. It’s all about making adjustments to the allocations.

A must-know: the equation for the future value of money

Calculating your life insurance needs will require two equations you may have studied in school : the future and present value of money.

The future value of money equation tells you how much your money will be worth in a given number of years while earning a given rate of interest. This equation is essential if you are calculating how much money you'll need in the future because of inflation, or what your death benefit will be if you choose to invest the money at a given interest rate.

The present value of money equation tells you what your money is worth before it has been invested for a given number of years at a given rate of interest. This is important if you have an amount of money you need in the future, and you need to know how much life insurance coverage you should buy now.

If this sounds complex to you, don't fret. As long as you have a calculator, these equations are no sweat.

Here's how the future value of money equation works: Say the average college education costs are Rs.200,000 annually for a four year course, and you want to figure out how much it will cost in five years if college costs keep going up 8 percent per year. You would multiply 200,000 by 1.08 (1 represents the present cost, and .08 is 8 percent inflation) fiver times (or 1.08 to the fifth power).