When considering life insurance, you're planning and preparing for an event that most of us would rather not think about. But life insurance represents a critical step in managing your personal finances and ensuring your family's well-being.
The Two Approaches to Setting Life Insurance Policy Amounts
You can use one of two approaches to estimate how much life insurance you should buy: the needs approach or the replacement-income approach.
Using the needs approach, you calculate the amount of life insurance necessary to cover your family's financial needs if you die.
Using the replacement-income approach, you calculate the amount of life insurance you need to equal the income your family will lose. Let's look briefly at each approach.
You need how much?
Insuring your most valuable asset
While many people would consider their home or their car to be their most valuable asset, it's your ability to earn an income that is most important in shaping your financial future. Statistically, two thirds of working Australians will suffer an injury or illness that will sideline them for 90 days or more. The majority of these people would not be able to pay their mortgage or meet car finance and other loan commitments without adequate income insurance.
Using the needs approach, you add up the amounts that represent all the needs your family will have after your death, including funeral and burial costs, uninsured medical expenses, and estate taxes.
However, your family depends on you to pay for other needs, such as your child's college tuition, business or personal debts, and food and housing expenses over time.
The needs approach is somewhat limiting.
The task of identifying and tallying family needs is difficult, and separating the true needs of your family from what you want for them is often impossible.
Using the replacement-income approach for estimating life insurance requirements, you calculate the life insurance proceeds that would replace your earnings over a specified number of years after your death.
Life insurance companies sometimes approximate your replacement income at four or five times your annual income.
A more precise estimation considers the actual amount your family members need annually, the number of years for which they will need this amount, and the interest rate your family will earn on the life insurance proceeds, as well as inflation over the years during which your family draws on the life insurance proceeds.
Do remember, as you quantify the income you want to replace, that Social Security provides generous survivors benefits if you've qualified.
Calculating Replacement-Income Amounts with Excel
If you've got access to a computer running Microsoft Excel, the popular spreadsheet program, you can use your computer to calculate the amount of insurance you need to replace a specified number of years of income.
Suppose, for example, that you want to buy enough life insurance to replace the income from a $50,000-a-year job for 15 years.
If you figure your family will earn 5% on the life insurance proceeds should the worst case scenario occur, you enter the following formula into a cell in an Excel workbook to calculate the replacement income life insurance amount:
Excel returns the formula result 518,982.90 indicating that you would need roughly $520,000 of life insurance, invested at 5%, to payout $50,000 a year for 15 years.
Two Calculation Tips
If you want to factor in inflation because you're trying to replace income over a long period of time, you should use a real rate of return rather a regular, or nominal, rate of return.
To calculate a real rate of return, subtract the inflation rate from the interest rate in the formula.
For example, if you expect 2% inflation, you could replace the formula shown earlier with this formula:
Here's a final calculation tip:
You probably want to round up your number. For example, if the formula provided earlier returns the value 518982.90, you might want to round up this value to $600,000. Or $750,000.
Financial Services Online provides a free online calculator that uses a combination of replacing income and needs approach in helping to determine the amount of life insurance cover you may need.