Calculating the Need for Life Insurance
For almost every financial plan we produce, we do a calculation on the need for life insurance. Why? Because most clients have someone depending on them for support. It’s also a question that the majority of our clients ask about the first time we’re engaged for services.
The solution we propose the most is called a Capital Needs Analysis. It works like this. How much money (capital) needs to show up to provide:
- An income stream as a replacement for income that has disappeared
- An amount to pay off a mortgage now there is one less income earner
- An amount for education expenses now that there is one less income earner
The biggest assumptions in our capital needs analysis calculation include the length of time this income stream needs to last, the amount of income at a flat or increasing rate to cover inflation, and whether or not the beneficiary will be changing their life that will increase or decrease their need for this income. Re-marriage might be one of those life-changing assumptions.
After we’ve come to a conclusion on the amount of capital that needs to be supplied, we have to look at current policies owned, how long they last, and at what cost. We also look at employer-related group term policies, both basic supplied to all employees and additional amounts that employees may purchase. However, we don’t like to take these work benefit amounts into our calculation since job loss usually terminates these group insurance benefits. This can also apply when an employee retires where the loss is complete or at a reduced amount.
Sometimes employer benefits can be transferred to a private policy, but that usually means a permanent policy like whole life or universal life. These are cash value policies that demand larger premiums but avoid medical underwriting. In cases where one is ill, it usually is worthwhile to make this conversion to protect the benefit, especially if a shorter life expectancy is now contemplated.
For most people, buying a private policy rather than trying to convert at much higher cost is our routine recommendation when it comes to the need for more life insurance coverage.
The second most popular method of calculating the need for life insurance, and one we don’t usually recommend, is a multiple of salary or earnings. Sometimes it’s ten times or 20 times, or even 30 times depending on your age and length of time to not earning an income.
The third most popular method and one usually promoted during a home purchase and is called mortgage insurance. In most cases, this is a 30-year term policy to cover the length of time the mortgage will last, and the amount is the beginning mortgage amount. In many cases, there are reduced medical requirements since the mortgage balance is a modest amount like $250,000. The death benefit can be the fixed amount of the beginning mortgage or a declining amount to mirror the mortgage and also reduce premium costs since the insurance company is on the hook for a lesser amount as time moves along and the balance goes down.
The fourth and final method is what I call the “Uncle Jim” method. It’s usually a knee-jerk reaction to the casual question, many times in a social setting with younger couples, where I blurt out an answer: That’s the $1 million-dollar question. So, go buy a $500,000 term policy for 30 years and a $500,000 term policy for 20 years. You cover the kids while they’re young and when your mortgage is large. Now don’t go out and do what I say, you need a capital needs analysis that takes more time, but that should help you get started in your thinking.
For most middle-class working people, those are the four most common solutions. We almost always prefer the Capital Needs Analysis version at MainStreet. If you’re a company owner, high net worth couple/individual or high-income earner couple/individual then there are more solutions and benefits beyond the scope of this article. You can always ask us questions by contacting me at firstname.lastname@example.org.