How Much Life Insurance Do I Need? This is a question every person must answer individually, based upon his or her particular circumstances. Some factors that influence the amount of life insurance required are: What debts will I leave for my family to pay? How much will my final expenses be including medical expenses, hospital bills, funeral costs, etc.? Is there a mortgage to pay off if I die? Do I want to provide income for continuing mortgage or rent payments? What ongoing income needs will my family have? Do I want to provide an education fund for my children? Should I accumulate an emergency fund? How will Social Security help if I die prematurely? How much life insurance do I already have, and is it term or permanent insurance? One approach is to analyze the various needs of the family and attempt to determine the dollars that would be required to meet those needs if a wage earner dies. One such need is for immediate cash that will: Pay final expenses that arise from the death (medical bills, funeral costs, estate administration costs) Pay off the home mortgage if desired Pay any outstanding debts (car loans, credit cards, other consumer debt) page 1 of 6
Pay any federal estate tax and state death tax. Establish emergency funds Establish education funds Business owners may have additional insurance needs. Since costs vary across the nation, it is important to personalize the amounts that might be required based on costs where you live and on personal desires. For example: One person might want an elaborate funeral, while another does not. Funds to pay for a private college or an out-of-state university will be far greater than the cost of in-state schooling at a public university. One family might have a car loan and considerable credit card debt; another family might have less debt, or none. One person might think an emergency fund should be equal to six months salary; another might want more or less in the fund. In addition to needing cash immediately, families also need regular, continuing income that can be used to: Pay for day-to-day living expenses food, clothing, transportation, school expenses, medical and dental checkups, entertainment, gifts, incidentals Pay monthly mortgage payments if there is no mortgage payoff, or rent payments if the family rents rather than owns its home Income needs can vary greatly not just by geographic location, but also by the current level of income and personal preferences. Since expenses typically increase as income rises, the income needs of a family accustomed to a high annual income will be greater than those for a household where annual income is more modest. After dollar amounts have been assigned for immediate cash needs and ongoing income needs, certain adjustments can be made page 2 of 6
before making a final determination about how much life insurance is required. Existing life insurance can reduce the need for new insurance. For example, if a $100,000 education fund is required, and there is existing life insurance in that amount or greater, this need is already taken care of. Or, suppose an emergency fund of $50,000 is desired and an existing life insurance policy can cover this amount. That need, too has been fulfilled. Other savings, such as bank accounts or certificates of deposit, might also be available to survivors to help fund the identified needs. These sources of cash can reduce the insurance need but these funds need to be available when the family needs the money. Adjustments can also be made to amounts that are required for ongoing income needs. Surviving families can usually maintain their standard of living if they receive a percentage of the income that the deceased wage earner had provided 65% to 75% is common. On the other hand, if the amount of income falls below 65% of pre-death income, the family usually must adjust its lifestyle downward. In most cases, Social Security income will be available if dependent children of a certain age are living in the home. For example, if Social Security will pay the survivors $20,000 per year, this amount can be subtracted from the required $70,000, leaving an income need of $50,000 per year for the years the benefit is available. If regular income from any other source (e.g., the deceased person s pension distributions, the surviving spouse s income) is available, this amount can also be deducted, further reducing the amount required to replace income. The final step is to decide the number of years this income amount will be required. This determination should take into account that less income may be needed as children leave home and become self-supporting, and as the surviving spouse s income increases. The human life value approach is another way to determine life insurance needs. Human life value looks at the monetary value to others of a person s future earnings. From the person s net income, the amount needed for self-maintenance is subtracted. Self-maintenance includes all personal expenses as well as income taxes, life and health insurance premiums, and any other personal costs the wage earner pays strictly to benefit him or herself. page 3 of 6
After the self-maintenance portion is subtracted, the remainder is considered to be the amount the wage earner uses to support the family. This amount is used to determine the present value of future earnings the human life value as a starting point for deciding how much life insurance is required to replace the income lost if this person dies. To find out how much income the wage earner would have brought to the family the present value of future earnings insurers use standardized tables. These tables show a base figure of annual earnings discounted by some specified percentage. The tables take into consideration the number of working years the person has until retirement, as well as several different rates at which the individual s earnings might grow in the future. Suppose the portion of a certain wage earner s annual earnings used to support dependents totals $100,000 (after subtracting income used for self-maintenance). The $100,000 earnings are discounted by 5% (a high discount rate by current standards but an average historical rate). Assume this is a man with 20 years until retirement and that he expects his earnings to grow at a rate of 6%. Taking all of these factors into consideration, the table used for this purpose will show that the human life value of this wage earner is $2,191,710. The amount of $2,191,710 becomes the starting point for determining how much life insurance is required to replace this income, taking into consideration other available life insurance and other income sources. page 4 of 6
How Much Life Insurance Do I Need? What Needs Can Life Insurance Fulfill? When an individual dies, life insurance can help with immediate cash needs such as money to: Pay final expenses arising from the death (medical and funeral bills, estate administration costs) Pay off a mortgage Pay off outstanding consumer debts (car loans, credit cards) Establish emergency funds Establish children s education funds Life insurance can also help replace money that is needed for regular, continuing income for the survivors in order to: Pay for day-to-day living expenses (food, clothing, transportation, school expenses, medical and dental checkups, entertainment, gifts, incidentals) Pay monthly mortgage or rental payments if there is no mortgage payoff Additionally, a surviving family may not need to replace 100% of the wage earner s income; from 65% to 75% of that amount may be sufficient in some cases to maintain the predeath standard of living. When these factors have been considered, determine the number of years this amount of income is needed. Income needs may be less when children become self-supporting and when the surviving spouse s earnings increase. What Is the Human Life Value Approach? This method for determining life insurance needs takes into consideration the monetary value to others of a person s future earnings. It looks at the income the wage earner spends to support him or herself and assumes the remainder of his or her earnings is spent on supporting dependents. With this figure, the present value of future earnings, also called the human life value, is calculated. Insurance companies use standardized tables to determine this amount, which becomes the starting point for identifying life insurance needs. The amount of money needed for any of these needs varies across geographic areas. Needs also vary depending on the current income, lifestyle and personal preferences of different individuals. Do the Immediate Cash and Income Needs Represent the Amount of Insurance I Should Buy? Not necessarily. Adjustments to the immediate cash needs can be made by deducting any permanent life insurance that already exists, as well as other savings available to the survivors. Adjustments can also be made for the income needs by deducting any Social Security income, a surviving spouse s income, pension distributions from the deceased person s account, and any other regular income that might be available. page 5 of 6
We want to thank you for your interest in our professional services, and for this opportunity to present a financial concept that may be pertinent in your personal circumstances. Please contact us if we can answer any questions you have, or if we can provide any additional information on this or other financial topics. page 6 of 6