Money for Your Life: Determining Your Life Insurance Need
Life is priceless. But if you’re purchasing life insurance, a financial value needs to be assigned to it. How do you determine how much your life is worth in dollars to the family you’ll leave behind?
The thumb no longer rules
There are several rules of thumb you might have heard about when it comes to calculating your basic life insurance coverage need. Figure six to eight times your annual gross income, and maybe throw in special funding needs (e.g., college for the kids) on top of that. Or back into your answer by determining your premium expense as a percentage of your income–6%, plus an additional 1% for every dependent–and buy as much insurance as you can for that amount.
These rules of thumb are simple enough to use. Trouble is, they don’t take into consideration your individual circumstances. Consider them no more than a rough starting point.
Are you what you earn?
The human life value approach, often used in court cases involving wrongful death suits, attempts to measure your economic worth to those who would be affected by your death. Your human life value is defined as the present value of your future net earnings (adjusted for inflation) that would be used for your family’s benefit, plus the value of other services you contribute (e.g., you mow the lawn rather than pay to have it done), through your planned retirement age. The resulting figure represents the amount of life insurance coverage you should have to adequately replace your economic value to your family should you die today.
While the human life value approach is more precise than any of the rules of thumb, it still has its weak points. In one sense, it tends to overstate your family’s insurance need by failing to account for other assets and sources of income that can help support your family if you die. In another sense, it tends to understate your family’s life insurance need by failing to account for certain large lump-sum expenses that will come up only after you die– for example, final medical expenses, funeral costs, and estate settlement expenses. Finally, by focusing primarily on replacing your income, this approach may ignore the financial needs of your surviving family members.
It’s all in the family
One of the more comprehensive methods of calculating your life insurance need is the family needs approach, which assumes that the purpose of life insurance is to cover the needs of your surviving family members. Accordingly, it focuses primarily on estimating what their immediate and ongoing financial needs would be upon your death.
Your family’s immediate financial need will require cash to cover expenses incurred upon your death, such as final medical and funeral expenses. Their ongoing financial need will require an income stream to meet family expenses associated with different situations that will last until your surviving spouse’s death (e.g., child dependency, college, spousal income needs until retirement, and spousal retirement). These needs will vary depending on your spouse’s and children’s ages, whether any family member has special needs, your spouse’s capacity to earn income, your spouse’s intended retirement age, and his or her life expectancy.
Under the family needs approach, the amount of life insurance you’ll need will equal your family’s immediate need plus the present value (after other expected sources of income are deducted) of your family’s ongoing need, less the value of other assets that could meet some of these needs.
The general equation would look like this:
(Im + P[On – Xi]) – As = LIN
where Im equals the Immediate financial need at your death, P[On – Xi]) equals the Present value of your family’s Ongoing financial need less other eXpected income, and As equals the value of existing Assets available to defray some of these expenses. The result is your Life Insurance Need.
By examining in detail your family’s anticipated expenses during various periods after your death, the family needs approach provides a realistic estimate of your life insurance need. Not only does this approach offer more accurate estimates than the various rules of thumb, but it may also provide a clearer estimate of your family’s needs than the human life value approach.
For more information and help assessing your own situation, consult your financial or insurance professional.