How Much Life Insurance Do You Need?

How Much Life Insurance Do You Need?

Ultimately, this is a question that only life insurance or properly trained  financial planning professionals can estimate with accuracy. However, there are certain guidelines for the consumer.

There are essentially three principal, but often overlapping, life insurance planning approaches:

  • Rules of Thumb
  • Human Life Value (Income Replacement) Approach
  • Family Needs Approach

Rules of Thumb. The simplest, but least reliable, rough guide used to estimate the amount of life  insurance required is six to eight times annual gross income. For example, a parent earning $50,000 per year should have between $300,000 and $400,000 of life insurance under this rule.

A similar rule that takes immediate cash needs at death into account is five times gross income plus mortgage, debts, final expenses, and any other special funding needs (e.g. college funds) (estimate final needs). For example, assume once again that a parent earns $60,000 per year, but also that the mortgage principle is $80,000, other personal debts are $10,000, final expenses are expected to be $15,000, and that $50,000 (earning interest over a course of years) is expected for the children’s college expenses. Using this rule, the parent should be insured for (5 x $60,000) plus ($80,000 + $10,000 + $15,000 + $50,000), or $455,000 total.

Another rule is that 6% of the breadwinner’s gross income plus 1% for each dependent should be spent on premiums for life insurance. Under this rule, a person with a nonworking spouse and two children should be spending about 9% of gross income on premiums for life insurance. This would acquire approximately $471,000 in permanent cash value (whole life) insurance.

Budget Tip: If budget constraints so require, the cost of this amount of insurance can be dramatically reduced by acquiring affordable term life insurance, or a blend of term and cash value coverage (For more information on this method, Click Here). At the appropriate time, that term insurance can be converted to whole life insurance, provided that it is so convertible. For instance, the same 35 year old father can acquire $471,000 yearly renewable term insurance for only $472.45 annually. A 50%/50% blend, on the other hand, would cost the sum of $2,710.75 (for $235,000 face value of whole life) and $250.15 (for $237,000 face value of term), or a total of $2,960.90 annually ($266.50 monthly).

Human Life Value (Income Replacement) Approach. Originally based on concepts used in wrongful death litigation, the human life value approach estimates life insurance needs based upon the economic value of the proposed insured to the family unit.

The first step in the analysis is to calculate the present value of an individual’s future lost after-tax earnings, while taking into account both the expected duration of employment and any reasonably expected promotions and salary increases. To this figure must be added at least two more items: (1) the value of the household and family services (repairs, maintenance, counseling, childcare, etc.), that the wage-earner would have provided had he been alive; and (2) a reserve fund to assist the family with items such as final expenses (estimate), unforeseen emergencies, immediate known needs, replacement of lost employment benefits such as medical insurance and contributions to retirement plans, an educational fund, and a retirement fund for the surviving spouse.

The second step is to subtract two items from the above figure: (1) the expense of supporting and maintaining the decedent (approximately 25% of the lost after-tax income); and (2) the present value of expected social security survivor benefits.

The third step depends upon the family’s philosophy regarding income objectives and existing savings. If the family has an interest in preserving assets and adding to them as a legacy for future generations, then the face value of life insurance must be adjusted upward to account for the fact that an untimely death will adversely affect the family’s ability to preserve assets and to save. Some additional monies will be needed to create and to preserve a legacy for future generations.

If, on the other hand, the family is willing to liquidate existing capital, then the amount of life insurance can be reduced by the amount of existing capital and income that can periodically be used to substitute for the decedent’s lost wages and services.

Family Needs Analysis. In contrast to the income replacement approach, which is founded on the premise that the insurance need should be based on the income that would be lost if the insured dies, the needs approach estimates the insured’s family income needs directly. The typical needs of a family can be divided into two categories:

  • Lump sum cash needs at death:
    • Uninsured final illness costs and expenses
    • Funeral and burial expenses
    • Estate settlement and administration costs, fees and expenses
    • Mortgage, loan and other debt liquidation
    • Estate, inheritance, property and income tax liabilities
    • An education fund
    • Emergency reserve fund for unexpected family emergencies
    • Retirement fund for the surviving spouse
    • Any other final expenses (estimate) or special funding needs
  • Multi-period income needs:
    • An adjustment period of income for the family
    • The surviving spouse’s income needs
    • The children’s income needs during a period of dependency
    • The spouse’s retirement needs.

At bottom, the idea is to use the life insurance benefit to create that amount of money that, at present value, can replicate appropriate income steams for the family’s future.

From this required amount, the insured should deduct Social Security survivor benefits that might be payable. However, he should not deduct the income stream that can be derived from the family’s existing assets, unless the family has no interest in preserving an inheritance. The analysis, in this regard, replicates the adjustments needed to accommodate the family’s investment and savings philosophy.

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