How Much Life Insurance Do I Need?

The following is an editted excerpt from Questions and Answers on Life Insurance: The Life Insurance Toolbook. This section goes on for 23 pages in the book. I have selected key highlights to give you a sense of what the author is saying.

This is an excellent question to which there are as many answers as there are people to ask. Every advisor, financial columnist, and relative has a formula that they consider the best. This section is designed to present the various methods used, as well as the pros and cons of each method ranging from the simple to the extremely complex. As these issues deal with how to value a life, it is indeed a very complex proposition.

The method that makes the most sense to you is probably the one that may work the best for you. No method is perfect, as you are trying to hit a moving target. Life brings many changes and your needs will change with them. The more assumptions you make, the more complex you’ll make your planning, and the more chances there are that something will not work as planned. This does not mean that you should only use the simplest methods—it is to give you a concept of why it is important to actively participate in all of your planning, fully understand it, and constantly monitor it. After all, it is your money. Remarkably, the simplest formulas can often be the best.

All of the issues discussed in this question will have an impact on the amount of life insurance and other assets needed. Often the desired goals may not be financially feasible.These issues are not only financially based; they can also be extremely emotional.

Another thought to keep in mind is that as your other assets grow, such as retirement plans and investments, your need for life insurance will decrease.

These are some of the more commonly used approaches.

• Multiple of Income - This method (also known as the “human capitalization value”) uses the approach of a multiple of your annual income—typically ranging from five to eight times your annual income. This is one of the oldest and best known methods to determine how much life insurance you need, as well as one of the easiest to use. It’s also the most frequently mentioned by financial columnists in consumer publications. While simple, this earnings-multiple method misses a range of important factors. For example, it ignores household demographics, past savings, Social Security offsets, housing expenses, taxes, etc. It also ignores expected life changes and individual preferences about sustaining the living standards of survivors. It is simply a “best guess.”
• Cover Your Debts - This entails buying only enough life insurance to cover debts such as your mortgage, student loan bills, or outstanding car notes. The issues are similar to the issues for the multiple of income approach discussed above in that it misses a whole range of factors, such as not considering any future debts or needs like child care or college education costs. This method is also too simplistic to provide any real value.
• Human Life Value Concept - The human life value concept deals with human capital. Human capital is a person’s income potential. We all have a human life value. In wrongful death litigation, human life value is measured daily in court (however, the litigation value tends to be significantly different). Insuring human life value is the primary purpose of life insurance. The human life value concept goes beyond numbers and considers the entire impact caused by the loss of a human life and the value to a person’s loved ones.
• Capital Preservation and Capital Liquidation - This method can be used in conjunction with a needs analysis approach or separately as a quick calculation, if you just want do an income replacement approach on its own. Whether you are using this method strictly on its own or in conjunction with a needs analysis, once the amount of income that needs to be replaced is determined, a decision must be made as to whether the pool of capital to provide this income will be preserved or liquidated. Capital Preservation: The capital used for income replacement is left intact and the beneficiaries live off the income it produces. Capital Liquidation: The length of time of income needs to be replaced becomes a major factor in determining the capital needed for income replacement.
• Life-Cycle Model of Consumption and Savings - The life-cycle model of consumption and savings is a new approach that is based on the life-cycle model which was developed in the 1950s and 1960s by Professor Franco Modigliani and his colleagues at Massachusetts Institute of Technology. Modigliani won the Nobel Prize in 1985 for developing the model, which built on early work by Yale economist Irving Fisher in the 1920s. This model assumes that an insured’s goals are to secure the living standards of the household and ensure comparable living standards for his or her survivors. This approach is based on the fundamental goal of saving money and having insurance—the desire to avoid major disruptions in a household’s standard of living. This approach uses advanced mathematical techniques to calculate the savings and life insurance needed to balance consumption in the present with consuming in the future and to preserve a household’s living standard for survivors. This method describes how life insurance holdings are adjusted as life insurance needs change. All economic resources, tax liabilities and benefits—Social Security retirement benefits, and survivor benefits, etc.—are taken into account in the calculation, along with family demographics, tax-deferred savings, housing plans, special expenditures, estate plans, capacity to borrow, and lifestyle preferences.
• The (Capital) Needs Analysis Method - Like the earnings-multiple method, the Capital Needs Analysis method projects the income the insured will earn between now and retirement (or later) and sometimes discounts these flows. But this procedure goes further; it calculates the net contribution of the insured to the family’s living standard by subtracting the insured’s present values of future tax payments and living expenses from his or her present earnings.The net contribution of the insured is then compared with today’s spending needs of potential survivors. Such a needs analysis incorporates factors such as mortgage payments, other household expenses and special expenditures.

Comments

[Chris Harris]

I wouldn't rely much on them to be honest!
Chris Harris
http://bit.ly/duX5zU

[Jason @ Redeeming Riches]

This is a confusing topic. I don't know if you've heard of Ed Slott - the IRA Expert - but he suggests using insurance as a way to offset IRD (income in respect to a decedent) or taxes that are due on IRAs and 401ks.

That said, he suggests more than probably soem of these formulas suggest because of the fact that your assets will grow over your lifespan and you'll need more money to pay the tax.

[FA]

Insurance should atleast cover your debt amount but it should also consider a basic standard of living for your family. Priority wise debt cover and if you can afford then providing financial security for your family. This should be whole and sole purpose of loan nothing else. Further insurance investment should be purely risk covering with thinking much about returns in case of living through the policy.

[MBTN]

Life insurance is one of those things that seems simple, but it gets out of hand quite quickly. The problem is that most insurance salepeople have a vested interest in selling you as much insurance as they can, so they might not have your best interest at heart. I used to work for an insurance company (not in sales - corporate office), and while I was there, we had several settlements of class action suits because of questionable things that some of our salespeople did.

Confusion comes from the fact that many of the whole life or universal life type policies have work in a very opaque way. The assumed rates are set at the whim of the insurance company based upon factors that might not be readily apparent. With a mutual fund, you know what your have earned, you know what the expenses are, etc. That way, you can compare one mutual fund to another. With a life insurance policy, part of the cash value gets eaten up by all sorts of other factors and assumptions (mortality experience, lapse rates) which aren't published so it becomes hard to compare one company's policy to another. Even if they were readily available, doing the comparison requires an actuary by your side.

The bottom line is that for most people, it makes more sense to "buy term and invest the difference". The other types of policies are just too complex to evaluate on the merits.

[Matt]

Insurance is risk management. We all could die some time ( I almost did in 2005)and it is a matter of what would have happened when I did. There are so many factors that effect your level needed for insurance but like a snake oil salesman I do not trust most insurance agents. Heck I don't even trust most insurance companies. They sure don't have my trust because they are a BIG BUSINESS. They eaisly could have given my wife and kids a hard time stating that a preexisting condition was the cause of my death. Benifits denied. Family crushed.

Just like not having health insurance, life insurance is dependent on what sort of risk you want to take.

[MBTN]

@Matt:

I do agree with you about not trusting some insurance salespeople. However, just to be fair to the insurance companies, there is no such thing as a "pre-existing condition" exclusion like there is with health insurance. The only time a pre-existing condition comes into play is if you lie about your health on your insurance application. For instance, if you had a heart attack but you answer "no" when asked if you ever had any heart conditions, the insurance company can contest your claim.

However, in most states, there is a clause in the contract which states that after two year the insurance company can't contest your benefits even if you did misrepresent something. This is called the "incontestibility clause". Google it for more information.

The only other times the insurance company can contest the claim under most contracts is if you committed suicide (but again only within 2 years after issuing the policy), if you died as part of a war, if you died in a non-commercial plane crash, or you died doing some sort of dangerous activity (hang-gliding, auto racing). However, these exclusions vary by policy but these are the standard ones.

Like I said, insurance salespeople and companies do some unfair things, but going after you for pre-existing conditions on life insurance isn't one of them.