People tend to struggle with determining the appropriate amount of life insurance. They often feel that they are being pushed to purchase more than necessary. Sometimes they’re right. Having too much life insurance is an unnecessary drain on the budget. Paying for something you don’t need is never a good way to get ahead.
On the other hand, life insurance is used for specific reasons. Many people have specific financial goals they would like to have addressed if they pass prematurely. Not having sufficient life insurance can leave the surviving family with unintended financial hardship.
But it doesn’t need to be a shot in the dark. You can determine what an appropriate amount of coverage is for your specific situation. Three methods are most commonly used, with each having advantages and disadvantages.
Multiples of Income
The multiples of income approach is commonly used by insurance agents. According to this approach, there is a specific multiplier that can be applied to your income to determine your insurance need. Generally, the multiple is either seven times your income or 10 times your income, but almost never eight or nine.
Pretty straightforward. Very simple. Can be done at your kitchen table in seconds. Insurance agents use it because is sounds like something reasonable and it’s very easy to understand. And it’s quick. That’s the total of its strengths.
The big weakness of the multiples of income method is that it’s just not very accurate.
It doesn’t take into account what your debt situation is, how many dependents you have, how old they are — it misses a host of important criteria. Basically, if you’re married with no kids and no debt and earn $50,000 per year, it says you need exactly the same amount of insurance as someone else who’s also married, but has five kids, a boatload of debt, and also earns $50,000 per year.
The actual reason you might use it? You’re unwilling to do anything more complex to figure it out. This approach is better than no approach at all.
Human Life Value Approach
The human life value approach determines the financial contributions expected from the insured across the remainder of their working years. The idea is to replace the financial impact of losing a family breadwinner.
The process of determining human life value is to take the annual income of the proposed insured and modify it to reflect the true effect of that income. You need to add in the cost of replacing any necessary benefits received, such as health insurance.
You also need to reduce the income for any direct expenses attributable to the proposed insured — expenses that don’t need to continue should they die. These often include a second car, clothing, and other direct expenses that wouldn’t continue in the event of their death. Then factor for taxes, arriving at a net contribution to the household on an annual basis.
Once this annual number is determined, it needs to be inflated across the time between the present and when the person would retire, then discounted back to arrive at a present value of the total of this stream of future incomes. This method first builds in raises across the rest of one's working years, then values it back to today to determine the lump sum of money needed to replace this income.
If the process seems complicated, you can just plug the information into an online calculator that does all the work for you.
The human life value method results in a more accurate number than the multiples of income approach. But it’s a lot of work — unless, of course, you use a calculator.
Plus, it can still leave you over- or underinsured. It's less likely to leave you underinsured, unless you're close to retirement and have little savings. But it can leave you considerably overinsured. This is more likely for younger people whose survivors have their own significant earning potentials.
The Needs Approach
The needs approach determines the capital needed for the surviving family to maintain their standard of living should one person in a couple die. This method is frequently used by financial advisers to determine what level of coverage is appropriate from a financial standpoint.
The needs approach considers immediate needs of funeral and other final expenses, as well as funds to pay any outstanding debts. Future goals, such as education of dependents, are added in as a present-value need.
Living expenses are considered based on any shortfall the family might have across time. This not only considers the timeframe for raising children, but ultimately through the surviving spouse’s retirement.
Often, especially when there are young children, expenses can increase when one person in a couple dies prematurely. There may be additional child care needs. There may be other financial needs in order for the family to maintain its standard of living as a single parent household.
The needs approach, done correctly, is the most cumbersome to calculate. But again, online calculators are available to save the day.
Compared with the other approaches, it does a better job. It provides a fairly reasonable estimate of the amount of life insurance a person should have, based upon their specific wishes for what happens, financially, after they’re gone.
Adding It All Up: How Much Life Insurance Should You Have?
These traditional methods are geared toward couples — generally couples with children. Single people without children generally have little or no insurance need. Single people with children can also use the needs approach to determine the appropriate amount of life insurance based upon their wishes. It just might require a little extra number crunching.
Nor do these methods consider other uses of life insurance, such as for estate planning. Generally, those decisions are made in conjunction with a trusted adviser.
Determining the need is necessary before determining what type of insurance you should have. Many needs, such as education funding, are temporary — eventually, it’s no longer something you need to pay for. Term life insurance is perfect for temporary needs.
That said, having a good handle on what level of coverage you have will allow you to work on what type or types of coverage make the most financial sense in your particular situation.
It can be tough to wade through a plethora of misinformation on insurance. Lots of self-proclaimed experts say you should buy only term policies, never permanent ones. These experts do many people a great disservice, since that advice is good for a portion of the population, but is very bad for others. Not all needs are temporary, and not all needs can be best addressed by a temporary product.
Unfortunately, the cost of life insurance is also part of the equation. If it’s not possible to afford the best type of insurance for your situation, it's better to cover your need than to ignore it.
But determine the appropriate amount of coverage before giving consideration to type or cost. That way you’ll know what you really need in order for your wishes to be carried out after your death. Who knows? It may actually end up at seven or 10 times your income. But probably not.
It’s worth doing the work to make sure your survivors are cared for. Leave the quick but inaccurate approaches for someone else.