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How to Determine the amount of life insurance you need

Financial Planners delve into areas outside of investments quite frequently.  One of those areas is insurance needs, and oftentimes life insurance.

The purpose of insurance is to cover a potential loss to some degree in exchange for a monthly fee.  Home, auto, renters, and other basic insurance products are fairly straightforward, and have different levels of coverage based on the individual's needs and wants.  Life insurance is not quite clear in its definition on the benefit it provides and who needs it.  In this article, I aim to breakdown what life insurance is, its use, and some misconceptions that are important to know to help one determine if it is appropriate to purchase.

What is life insurance?

Life insurance is coverage that pays out a specific dollar amount to a named beneficiary in the event that you, the policyholder, passes away.  These policies can cover your entire life or a portion, and most commonly, coverage for a set time period is usually the most suitable but not in all cases.

Different types of policies and their characteristics are covered in more depth later in this article.

How to determine if and how much insurance you need

Start with why you need it in the first place, and what you would like to cover.  Avoid using a simple calculation multiplying income or expenses by an arbitrary number to determine this.  Determining your cash flow and net excess cash flow is a great place to start too.  If you have substantial cash flow your need for life insurance may be diminished depending on your spouse’s ability to cover expenses in the event of your passing.  

The second consideration is, do I have beneficiaries or entities that would be in financial hardship if I were to pass, such as kids, parents, or a spouse.  If you have joint income with your spouse, your passing would cut that in half.  You may decide that you wish to cover a large portion of future costs purely from a planning or generosity perspective too.

Consider any debt or future goals you have next.  You may decide you want to pay for kids' college education, or not, that is completely up to you.  Perhaps you want to pay off your mortgage in the event of your passing.  

Here is a couple examples of an approach to this:

*Keep in mind that these are examples, not specific advice.  Consult with a planner to determine all variables prior to making your own planning decisions.

  1. Married couple (34,33) Two kids (2,5) Mortgage/Debt: $281,000, Income $60,000/$76,000, net excess monthly cash after expenses: $1,300, both contribute 10% to their 401(k)s.

In this example the couple would want to consider term insurance on each other that would cover debt and they can opt to cover college expenses with this policy too.  Covering the debt and college expenses greatly reduces their would be widow’s monthly expenses.  They would consider 20 year term with a death benefit in the range of $400,000-600,000 naming each other as beneficiary.

  1. Single individual (24) $123,000 per year, no debt, wants to buy a home and get married in future, maxes 401(k), excess cash flow: $2,100 month.

Here you could make an argument that they do not have a need for any life insurance as they currently do not have dependents.  You could make the case of getting a term policy for 30 years to lock in a presumably lower rate assuming future insurance needs change though.  Note that this individual does not necessarily need cash value insurance either, but may be targeted by a whole life insurance salesperson because of their higher income.

Different types of life insurance:

  • Term Life Insurance

Term life insurance is a type of life insurance that provides coverage for a specific period of time, typically ranging from 5 to 30 years. During this term, if the insured individual passes away, the policy pays out a death benefit (lump sum amount to the beneficiary) named in the policy. Term life insurance is generally much more affordable than permanent life insurance policies because it does not accrue cash value and only provides coverage for a predetermined period.

It's often chosen to cover financial obligations that diminish over time, such as mortgages or children's education expenses. At the end of the term, the policyholder can usually renew the coverage at a higher premium, convert it to a permanent policy, or let it expire.  In most cases the policyholder will typically let the policy expire at the end of the term, as they, with good planning of course, would have saved up enough in cash & investments to cover the financial risk to their dependents from passing.

Most young couples who are actively saving will find this type of policy suitable for their particular needs.

  • Whole Life Insurance & Indexed and Variable Life Insurance

Cash value life insurance, including whole life, universal life, and variable life insurance, is a type of life insurance that not only provides a death benefit but also accumulates a cash value over time.   Cash value is essentially an account that earns some form of interest or investment return depending on the type of product.  Some of the paid-in premium goes to this account while the rest covers the cost of the insurance.

A portion of the premiums paid goes into a savings component, which earns interest or investment returns. Policyholders can access this cash value through policy loans or withdrawals, often with tax advantages. Cash value life insurance offers lifelong coverage as long as premiums are paid, and the cash value can be used for various purposes such as supplementing retirement income, paying premiums, or covering emergencies. However, these policies tend to have higher premiums compared to term life insurance, sometimes 5-10 times as high, and the cash value growth may be affected by fees and market performance, especially in variable life insurance.

Cash value life insurance, given the higher premiums to the insurer and high amount of cancellations, tend to be more profitable to insurance companies, and therefore, provide a selling agent with a higher commission.  While the product itself has valid use for some planning needs it does have a tendency to be oversold.  Individuals with unique estate planning needs, own a business with partners, or have significant income and have already maxed out all other available tax advantaged accounts may consider this for their needs, if of course they actually need life insurance.  It is ill-advised to purchase this type of insurance purely as a tax benefit or investment.

Red Flags when considering life insurance from a planner’s perspective:

  • If you hear that everyone needs life insurance

Remember, life insurance is needed only if you specifically have dependents that would be in financial distress as a result of your passing, or if you have a specific cash need/goal that you want to cover in the event of your passing.  

  • Determining life insurance calculation

Sometimes, agents, advisors, and planners will make a determination on the amount of insurance you need based on a gross income calculation that does not take into account the aforementioned factors of dependent need for the death benefit, your actual expenses/net cash flow, debt, etc.  Be mindful of this, and the ‘why’ behind life insurance, and understand that it is not a black and white calculation.

  • Calling life insurance an investment

In this situation, you would be discussing a cash value life insurance product, and the agent would want to make that definitively clear.  It may or may not best suit your specific situation.  Consider the ‘why’ behind life insurance again in this situation.

  • Not discussing your cash flow prior to buying life insurance

  • Not discussing your legacy and estate goals prior to buying life insurance

  • That high cash flow or wealth = permanent life insurance need

All three of these situations are absolutely important points that must be vetted out prior to the recommendation of any life insurance product.  Especially cash flow.  If you are on a tight monthly budget, life insurance, especially cash value life insurance, may not be suitable.

The best approach to this when you are unsure what you need:

Becoming educated on life insurance in general, and seek advice or planning from a fee-only planner who is not compensated for selling a specific life insurance product is a great place to start.  

For most individuals who actually need life insurance, term life coupled with savings in their 401K or other retirement account is the simplest and most efficient way to plan.  For those with a business & partners, or have unique estate planning needs, such as a desire to leave a set amount, they could consider permanent insurance.

Personally, prior to discussing any insurance product, I aim to gather a full understanding of a person’s goals, and help the client understand and monitor their monthly cash flow.  At a bare minimum this helps ensure that they have positive cash flow and a written budget prior to recommending any product.  I also ensure that adequate saving is going towards investments, and other tax advantaged accounts as well.


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