In my normal day-to-day business, most of my professional (ok, personal too because I’m obsessed with, and love, what I do) conversations revolve around how to use life insurance to coordinate all of your other financial decisions and make what you’re already doing even better, with more control and less risk.
Recently, however, with the market volatility and the COVID-19 situation we are currently experiencing, the conversation has changed a little. More and more people just want to know how much life insurance they can get – to protect their family – right now.
Most of us look at our group term insurance offered by our company and think to ourselves “that’s pretty good chunk of change right there. That should hold the fam over for a while…” And that’s about the extent of the thought put into life insurance.
Because of this, most Americans are chronically under-insured.
There are two primary methods to calculate how much life insurance you should have:
“Human Life Value”
Human Economic Value (or Human Life Value): This is a simple calculation to replace your lifetime earning potential if you were to die prematurely. Take your gross income x the number of years you have left to work (assuming age 65). Example:
$150,000 per year x 20 years = $3,000,000
“Capital Needs Analysis”
The other way is through a Capital Needs analysis. With this method, we ask how much income would we need to cover all expenses (mortgage, rent, health insurance, food, etc) so that our family does not have to change their lifestyle should anything happen to us. To calculate this, we determine how much capital we would need TODAY to generate enough interest in an account to cover all those expenses. That formula would look something like this:
(monthly expenses x 12) / (account earnings rate / 100) – liquid assets – any existing in-force insurance
Let’s break this down a little further. What we want is a death benefit that, if we were to put in an interest-bearing account, could earn enough interest every year to cover all of the expenses. So, with the following assumptions:
- Monthly expenses are $5,000
- Earnings rate = 3% (say CDs)
- Liquid Assets = $500,000
- Existing In-Force Insurance = $500,000 (say from your company benefits package)
$5,000 x 12 = $60,000 of annual Expenses
$60,000 / (3%/100) = $2,000,000 of Capital required to generate $60,000/yr at 3% interest
$2,000,000
– $500,000 of liquid assets
– $500,000 of existing insurance
= $1M of additional insurance needed.
Of these two methods, I prefer the Human Life Value method. Often with a Capital Needs Analysis, people subtract their liquid assets that are ear-marked for retirement, thereby cannibalizing a retirement asset that could have otherwise been used by the spouse or passed on to the children.