Most people with a family dependent on their income know that life insurance is an important part of their overall financial plan, but few know how much coverage they actually need. A recent survey shows that the majority of Canadians are underinsured, while a minority have more coverage than they need. Some life insurance agents swear by a formula when calculating life insurance needs, such as 8 times of salary, or a flat rate of half a million for everybody. But it’s most likely that these ‘methods’ of determining your life insurance needs are inaccurate. Instead, they are used by the agent to simplify his life by not having to perform the calculations manually.
So what is the right amount? The answer is that it depends. While one person may want to provide for his family for life and have all debts paid off, another person is satisfied providing an income to the surviving spouse for just 3-5 years. The former will need a vastly greater amount of coverage than the latter. But that doesn’t mean that either one is wrong; they just have a different perspective on the necessity of financial support for the surviving family members. This necessity is a major point that should be discussed before approaching an insurance advisor, and is also the biggest factor that affects how much life insurance coverage to purchase. Even though it’s not an appealing subject, it’s important to find out where you and your spouse stand, especially if your views differ dramatically like the example above.
After that discussion, it’s time to plug some numbers into a life insurance calculator. Thanks to software provided by the life insurance companies and other online life insurance calculators, all it takes is a few minutes to determine the life insurance coverage that you need. They are typically all very similar, prompting you to input cash and income needs at death, and sources of cash at death. It then subtracts your sources from your total needs to produce your total coverage required.
These typically include having a source of funds for final expenses, legal fees, taxes, an emergency fund, an education fund, and to pay off the mortgage and other debts. For example, let’s take a 35 year old male with a 35 year old wife and a newborn child. He has a mortgage of $300,000, would like an emergency fund of $5,000, final expenses of $10,000, and an education fund of $50,000. Therefore, his family requires $365,000 of liquid cash if he was to pass away tomorrow.
The other need, which may far surpass the cash need, is the need for income for his family if he dies. Assuming he is the breadwinner for the family, he will want to ensure his family can maintain its lifestyle in the event of his death. This is the tricky part of the calculation because insurance proceeds are generally paid as a lump sum, and unlike cash needs, income needs will be used over the course of many years. This involves estimating the inflation rate and also an interest rate to invest the proceeds. Since there will be one less family member, he can choose for his spouse to have 75% of his current income while the child is dependent, and 60% thereafter.
Assuming inflation of 2% and interest rate of 3% with a current income of $90,000, the amount of capital needed to provide this income stream for the spouse’s life expectancy of age 87 is $2,514,040. If he feels like this is too much and only wants to provide the income until the spouse’s age 65, then he requires $1,712,275 of capital. He requires $1,504,781 to support his family until his child reaches age 25 and $1,119,741 to support them until his child reaches 18. All of this is calculated by the software using time value of money calculations.
Adding it up to quantify your life insurance needs
To arrive at the final amount of coverage, simply add the cash and income needs together. At his death, to pay off the mortgage, provide an emergency fund, final expenses, and education fund, and to provide a stream of income until his spouse’s life expectancy of age 87, he requires $365,000+$2,514,040=$2,879,040 of life insurance. If you have other life insurance in place, such as an existing policy or group coverage from an employer, you can subtract this amount from your total life insurance needs. Just note that the availability of group life insurance will depend on your job stability and other factors that may be out of your control.
This large amount may be a surprise to most people, but that is the cost of making sure your family will never suffer financially. The premium on that amount of insurance will set you back over $100/month, even on a term-10 product, which is the least costly type of insurance (at least initially). If cost is a big concern, the easiest way to reduce it is by scaling back the income percentage required for the survivors. Choosing a lower but still comfortable amount of 50% of his current income while the child is dependent and 40% thereafter reduces the life insurance needed to a manageable $1.1 million (for providing income until the child’s age 18). Since the mortgage will be paid off and with it goes the monthly obligation, the lower percentage of income selected here may be enough for the surviving spouse.
How much life insurance do you need?
|Total life insurance required (replace 75% of income while child is dependent, 60% thereafter)||Total life insurance required (replace 50% of income while child is dependent, 40% thereafter)|
|Provide for spouse's life expectancy||$2,879,040||$2,041,027|
|Provide until spouse's retirement||$2,077,275||$1,506,517|
|Provide until youngest child reaches 25||$1,869,781||$1,368,188|
|Provide until youngest child reaches 18||$1,484,741||$1,111,494|
As you can see, even for this one case study, the amount of life insurance needed has a very wide range. What you eventually settle on will depend on your insurance objectives, and that’s something that must be thoroughly discussed with your family. After discovering the insurance needed, think about funding it with term, LifePhases, or permanent life insurance.
With that being said, how do you determine your life insurance needs?