Anyone who feels the need to provide security to their family understands the important role life insurance plays in their financial plan. That’s the easy part. However, when determining the actual amount of coverage that can provide essential protection needs, many people tend to adhere to simplistic rules-of-thumb, such as a “multiple of income,” which may leave them wondering if they own too much or too little coverage. That’s not exactly the “peace-of-mind” most of us hope for when buying life insurance.
With your family’s financial future at stake, wouldn’t it be better for all concerned to simply clarify and quantify your family’s actual needs? While it does require a bit more time, some frank discussion with family members, and some number crunching, it will provide the assurance everyone needs that their financial lives are secure.
Determining your actual life insurance needs can be done in a simple four-step process:
- Identifying and clarifying your actual needs and goals
- Quantifying the need
- Determining how much existing capital or insurance is available
- Determine the amount of your capital need
Identify your actual need
It is critically important to determine, as a family, what is it you want to protect. Is it important that your family be able to maintain their current lifestyle? Is it important that your children be able to obtain a college education? These and other family goals need to be thoughtfully considered.
Quantify the need
Immediate cash needs are obligations that need to be met by the surviving family, including
- Outstanding debt (mortgage, student loans, credit cards)
- Final expenses, including funeral costs, estate settlement costs, medical expenses
- Future goals such as a college education for the children should be prefunded
Final expenses are an estimate but they shouldn’t be understated. Some financial planners suggest a figure as high as $50,000 to provide a cushion for unexpected expenses.
College funding or other family goals should be based on a present value of what you would expect to pay today factored by a rate of inflation up until the time the funds are needed.
Income replacement needs should be determined based on the amount of lost income and the ability of surviving family members to replace all or a portion of it. Quantifying the income replacement need can be a little more complicated; however, the most important thing is to use realistic assumptions. It should be based on the family’s actual budget (assuming debt obligations and future goals are paid}. The budget should be adjusted for post-dependency years when the children are on their own. Most importantly, a realistic assumption has to be made as to the ability of the surviving spouse to replace any portion of the lost income throughout his or her lifetime. For the dependency years and retirement, you can apply an estimated Social Security benefit to offset the income replacement need; however, a more conservative approach would be to exclude it from your calculation.
Determining the capital need for income replacement is obviously more complex; however, with the availability of online calculators there is no need to do it manually. The critical point of this explanation is to recognize that, when you are determining how much capital will be needed to replace your income, there are a lot of factors to consider, which a simple “multiple of income” formula cannot account for.
Determine how much capital is available
Take an inventory of your liquid assets, retirement plans and existing life insurance. If you own a business or real property, you would need to determine whether these assets are to be made available (as well as the practicality of having to liquidate them).
Determine the amount of your capital need
Simply subtract your capital available from your capital needs (immediate cash needs plus income replacement needs) to arrive at your net capital need. That is how much life insurance you need.
Life insurance is too important to rely upon guesses or simple formulas to determine the amount of coverage needed to fully protect your family. There are many factors and variables that go into determining how much life insurance is needed in any particular situation. Nothing short of a complete capital needs analysis will provide an accurate assessment of your actual life insurance need
It’s strongly recommended that you work with a qualified, objective life insurance professional who has access to a wide range of solutions from the top life insurance carriers.