How much life insurance do I need
Determining how much life insurance is needed seems a bit of a vague area, but approached correctly it’s actually quite definable. We need to focus on what we’re insuring, and make some assumptions that let us run some calculations.
What are you insuring?
For most people, you’re not actually insuring your life. Like all insurance, you’re insuring a financial loss; the cheque from the life insurance company is to replace that dollar value that was lost. So we need to determine what the financial loss is. In other words, the loss of life is only the trigger for the financial loss and not the actual loss.
Income Replacement Insurance
For most families, the motivation for life insurance is to ensure that their family remains in their current lifestyle if someone prematurely passes away. That’s ideally what we’d like to insure – the family lifestyle or standard of living.
As we’re looking to determine a financial loss in the event of a premature death, we want to translate this concept of standard of living into something definably financial. How do we do that?
For most of us, our standard of living is based on our income. We go out to work, earn a paycheque, bring it home and it gets spent providing our family’s standard of living. It’s your income that’s driving the standard of living.
And from a financial perspective, it’s our income that’s lost in the event of our death. Our surviving family members no longer have our income, and their lifestyle suffers as a result. Therefore if we ignore ‘life’ and ‘lifestyle’ in our understanding of the purpose of life insurance for a second here, we are simply replacing our paycheque over a number of years. The paycheque is what’s lost in the event of our death. Our paycheque is definable and financial, so it’s insurable. And a replacement paycheque derived from life insurance proceeds means our family can continue to live in their current lifestyle – and mission accomplished.
How much life insurance do I need?
Now that we know that we should focus on our income over the years as the purpose of life insurance it’s straightforward to determine ‘how much life insurance do I need’. We just need a death benefit that’s sufficient to provide a stream of income over a number of years, assuming interest and inflation.
You can build a calculator like this in Excel, but for most people using common assumptions the answer simplifies quickly down to a simple rule of thumb – you should insure 10 to 15 times your gross income. Closer to the 10 times if you’re a bit older, and closer to 15 times if you’re a bit younger. 10 to 15 times your gross income will generally provide a stream of 60-80% of your gross income, over 15-25 years or so. That means that in the event of your death your family has enough income to live exactly as they are now; nobody has to sell the house and downsize, but there’s also no new money to start funding new trips to Europe or anything like that. Just enough for the same lifestyle as they have now, based on your income, and that’s the job we’re trying to do.
We use the timeframe of 15-25 years as it’s roughly equivalent to most timeframes to somewhere between retirement (when income ceases and therefore isn’t insurable) and getting the kids out of the house.
What about mortgages and debt?
This approach of insuring income means you don’t have to consider debt, RESP’s, kids university savings, or any of that stuff.
Where is the money coming from to pay off your debt? Where is the money coming from for saving for kids’ university education? All of that comes out of your income. The above approach determines a replacement income, so if you’re paying off your mortgage every month and saving out of your income then a ‘replacement’ income from life insurance will continue do exactly that. Again, we’re assuming no significant changes in lifestyle or spending habits.
Now in practice, should the worst case arrive, your family might choose to pay off debt or pay off the mortgage. Doing so means less funds available to live on (a lower ‘replacement income’) but they also need less income since they have less debt to pay down. Which is better?
In practice this is a question that would be answered after the fact – do we pay off the mortgage or not? And when you compare the scenarios where they withdraw a higher income and keep the mortgage, or have a lower income but a paid off mortgage, the calculation to determine how much life insurance you need isn’t impacted substantially. Therefore you can safely ignore specific debts, not worry about insuring your mortgage or future savings, and just focus on replacing your income when determining how much life insurance you need.
Summary
All of that tells us that we’re not insuring our life but instead we’re insuring our income – because that’s the financial loss in the event of our death. And for most of us, a good estimate of the amount of coverage we should have is 10 to 15 times our gross income. That coverage amount will ensure there’s enough money to pay the bills in their current lifestyle until the kids are out of the house and financially independent.