How Much Life Insurance Do You Really Need?

From time to time everyone should determine how much life insurance they need. There are basically two types of life insurance: permanent and term. Permanent life insurance (also called whole life) is effective for your entire life, as long as you keep paying the premiums. Term life insurance is only good for the duration of the term, typically 5, 10 or 20 years. Permanent life insurance is much more expensive than term for the obvious reason that permanent insurance will always have to pay out but term only has to pay out if you happen to die during the contracted term of the insurance. Most people only need term insurance. Please be aware that life insurance sales people earn more commission on the sale of a permanent life insurance product than on term insurance.
How much life insurance do you need? If you are single and have no dependents you probably don’t need any insurance. If you have dependents however you should be covered with enough insurance so that if you die the income they depend on will be replaced.
There are two common ways to calculate the need for life insurance. The first and simplest is called the Capitalization of Income. The formula is simple: annual income divided by real interest rate (rate of interest less rate of inflation). For instance if you need to replace $40,000 of income and you think you can earn 8% on an investment and the inflation rate is 3% then the formula is $40,000/(8%-3%). This is the same as $40,000 divided by 5%. So using your calculator you will find that you need $800,000 to replace that $40,000. This may sound like a lot of money but you will see that $800,000 in term life insurance bought at a relatively young age is not all that expensive. Most people pay more for their car insurance. The other thing to note is that this will provide a $40,000 income forever. If the determination is that your survivors will not need the income for that long, then the needed coverage is much smaller.
The other common way to calculate the need for life insurance is called the Capital Retention approach. This involves four steps:
Step 1: Assets – Final expenses = Cash needs
Step 2: Continuing income – Continuing expenses = Income needs
Step 3: Income needs / interest rate = Capitalized value
Step 4: Capitalized value + or – cash needs = Insurance needs
Let’s take an example to clarify this. Mrs. Jones has the following if Mr. Jones dies.
Assets (investments and cash on hand) $100,000
Final Expenses (Funeral, Mortgage, Debts) $250,000
Step one therefore shows cash needs of $150,000 ($250,000 – $100,000)
Continuing net income (Mrs. Jones salary) of $40,000
Continuing expenses (household budget) of $50,000
Step two therefore shows income needs of $10,000 ($50,000 - $40,000)
Step three calculates income needs $10,000 / 5% interest rate = $200,000 capitalized value.
Step four shows $200,000 capitalized value + $150,000 cash needs = $350,000 insurance needed.
Therefore the insurance needs in this case is $350,000.
Hopefully these two short examples show how simple it is to determine your insurance needs. Armed with this information you will be able to make informed decisions when you are next offered an insurance policy.