Glenn Cooke is the president of InsureCan, a life insurance brokerage that offers instant online life insurance quotes from about 25 Canadian life insurance companies. Mr. Cooke offered to write an informational and non-promotional article on life insurance in exchange for a link to his site. You can find a selection of life insurance articles on his Term Life Insurance Canada website.

Many consumers struggle with determining how much insurance they need. Even after they’ve spoken to an insurance agent or broker it may still not be clear why they’ve purchased the amount they have. Is it enough? Is it too much? Is $100,000 enough? Is $1,000,000 too much?

I prefer to use a fairly simple approach to determining the right amount of life insurance. It’s based on the underlying concept of insurance – the pooling of resources to protect against a catastrophic loss.

For most of us, we want to maintain our dependents’ standard of living should we die. And it’s that standard of living that we should focus on. Not the mortgage, not the children’s education, not buying groceries. None of those qualify as catastrophic losses. In addition, most of us want to make sure we’re not overinsured.

This begs the question – how are we maintaining our current standard of living? How is the mortgage being paid? Money for the children’s future education? Groceries? For most of us the answer is our paycheque. We maintain our standard of living from our paycheque. And it’s our paycheque we lose in the event of our death. From a strictly financial perspective, that’s all most of us are – our paycheque.

If we replace the buying power of our paycheque upon our death, I think it’s a safe assumption that our dependents can continue to maintain their current standard of living. No one will be insurance rich, but we’re not leaving them in the poor house either. They continue to pay the mortgage, save for the children’s education, and eat the same brand of peanut butter.

With an income stream over a period of time we now have a very straightforward present value calculation we can do. What is the lump sum of capital needed to reproduce an income over a period of time? That lump sum of capital we assume is the amount of life insurance we need.

Let’s look at an example. Take an income earner who is 35, making $75,000 per year. Assume 5% interest and 3% inflation. Let’s further assume that we don’t need the full 75,000 to continue the standard of living. With one income I normally use a rule of thumb of 80% replacement, with two incomes I generally assume 60% replacement. In this case lets use 60% of the $75,000.

You can use our online calculator how much life insurance do I need? to run the PV calculation. Let’s start with a 30 year timeframe for complete insurance protection (we assume a 35 year old would earn an income until age 65 or for 30 years). Using inputs of 75,000 income, 60% replacement, 5% interest, 3% inflation and 30 years, the calculator returns $1,035,687.40. Yes – a million dollars. However look at the resulting table. That million dollars produces an indexed income of $45,000 for 30 years with nothing left over. Nobody got rich here, but we didn’t leave the dependents short either. Focusing on the million dollars as a large number is an emotional decision not a financial one, and could leave your dependents short.

Since all of these calculators are at best estimates of future needs, I prefer to have use a range instead of one absolute number. The second way to look at this is to assume a replacement income just until the kids are out of the house. At that point we assume the surviving partner would be financially independent and on their own. If we rerun the same case as above but with 20 years instead of 30, we end up with $754,336.02. That amount of capital produces the $45,000 of income for 20 years with nothing left over.

So in this case we should be looking at total insurance coverage in the range of $750,000 to 1,000,000. Anything less and we would be potentially underinsured.

Feel welcome to play with the assumptions in the calculator, and post any questions you may have. If you want to extend the conversation, the same premise I’ve used above can be pointed to retirement savings planning (you lose your paycheque when you retire), and it can also be used as a basis for determining the type of insurance one would consider for this type of need (what do your insurance needs look like in 25 years using this approach?).

This article has 34 comments

  1. The most important question here wasn’t even asked –> do you even need life insurance?

    There are several factors to go into, but I think it’s jumping the gun, so to speak, to just assume that everyone needs Life Insurance.

  2. I don’t think the “percent of earnings” is a valid way to calculate life insurance – what about debt and current savings?

    The method I used was to figure out the annual earnings needed for my dependents, divided by 0.05 which gave me the portfolio necessary for the income and then factored in the current debt and savings to see how much LI is needed.

    Getting insurance for too long is another money waster – just because you need $xxx thousand now doesn’t mean you will need that much in 10 years.

    You have to set your financial goals for the dependents but keep in mind that your spouse can keep working and can also meet someone else since you are not around anymore.

    Mike

  3. Canadian Capitalist

    Sol: Good point. Personally, we purchased term-life only after the kids were born.

    Mike: Good point as well. Though we each got life insurance, the scenario we were most concerned about was if something were to happen to both of us. We then estimated how much would be needed to support the kids till they were grown up and our current net worth as a buffer. That’s what made the most sense for us.

  4. I did actually touch on whether you need life insurance when I defined insurance – the pooling of resources to protect against a catastrophic loss.

    If you don’t have a catastrophic loss then there’s generally no need for insurance (or at least at that point it becomes a ‘want’ not a need). In the above example we assumed the catastrophic loss was someone’s paycheque which drives the standard of living. Keeping in mind this approach isn’t for everyone (it’s just what seems to fit the majority of folks I deal with), there’s a few times you might not see this as a catastrophic loss.

    1) You don’t see the loss of your income or your dependents standard of living as a catastrophic loss. That gets into an area known as utility theory. Would you pay 50 cents to insure the loss of a dollar? No. Would you pay $10 to protect against the loss of a million dollars. Yes, probably. If you don’t see the catastrophic loss I don’t have a problem with that. You’ve got to see a catastrophic loss first.

    2) You can self insure. Again, that means there’s no catastrophic loss, if we’re looking at standard of living as the loss. Take a look around though – are most people able to self insure? Not even close – it’s a tiny percentage of people.

    3) You don’t have dependents. Well, then there’s generally no catastrophic (financial) loss upon your death.

    In some cases the folks that suggest to me that they don’t need life insurance actually don’t need life insurance – and I’ll tell them that. However in other cases what that really means is they’re making an emotional decision not a financial one. Here’s a couple of examples:

    1) They actually haven’t looked at the concept from a financial perspective or really reviewed what’s going to happen. I’d suggest that they’re working from a position of ignorance. Get educated, do some actual review and thinking about the process. If they still see the need, but don’t want to insure then at least they’re making a decision instead of a knee jerk reaction.

    2) You can self insure. A very valid response – but very uncommon in reality for most folks. (aside: if you look at the premise in the original article, it does actually assume that later either the need isn’t there and that there’s some level of self insurance in the future). What one should be careful about is assuming they’re going to save to become self insured. What that plan actually means is they’ve recognized the need but have decided to not actually address it. This type of future ‘self-insuring’ doesn’t cover off anything if they die tomorrow. In other words, they’ve realized they need insurance but have decided to proceed without it. I’m fine with that – though I generally prefer that they make that decision once they’ve looked at the numbers and realize that they’re making an emotional decision not some sort of savvy financial choice.

    The above calc works for most people but not everyone. However it’s hard to go wrong if you review your life insurance with a few things in mind:
    – find the insurable need or the catastrophic financial loss. Make sure you can put your finger on it and say ‘Right there – that’s the loss. And that’s the amount of the loss’. If you can’t do that exact sentence, proceed with caution.
    – the insurance need generally points directly to the type of life insurance you need.
    – look at life insurance from an insurance perpsective, not some financial planning-retirement early-save for the kids type of perspective. For most people they’re better off treating life insurance as car insurance, not an RRSP. Ask yourself – would this strategy make sense to me if I was doing it with my car insurance? Anyone here save for their kids education with their car insurance company? :)

    Sol, does that make it clearer?

  5. Four pillars wrote:
    [quote]I don’t think the “percent of earnings” is a valid way to calculate life insurance – what about debt and current savings?[/quote]

    The debt part is absolutely wrong for most people when considering how much insurance they need. The current savings is pushing it as well.

    Lets say you die with a mortgage. What happened to the mortgage? Pretty much nothing. No loss there. What are you insuring again? That approach is creating wealth, not insuring loss.

    So lets say your mortgage is paid off. Who’s paying for groceries for the next 20 years? Who’s putting gas in the car? Who’s saving for retirement and putting the kids through school? All things that aren’t addressed by the idea of paying off a laundry list of debts. However if one replaces the assumed buying power of your income, then we assume they continue to pay the mortgage. And buy groceries. And save for retirement, just like they are now. In other words, they pay the mortgage with the replacement paycheque generated by the life insurance proceeds.

    Your example of dividing by .05 creates a perpetuity. Fair enough, I use a PV calc over a set period of time that I define as the length of the need.

    Removing savings from the calc is fine if you’re deciding that your dependents don’t need those savings upon your death.

    The underlying concern I have with your approach in general is that it doesn’t focus on the insurable loss. I admit, I’m very much a fundamental principles kind of person.

    A few caveats about my comments though:
    – your approach is actually fine – for you. You’ve addressed the need from a financial perspective not an emotional one. So whatever number you’ve ended up with is great. My problem with what I do is that most people are nowhere near up to speed enough to do the calc that you’ve done. The approach I’ve described is straightforward, easy to understand, and will produce a range similiar to what you’ve done with your method.
    – all life insurance needs analysis is at best an estimate. That’s why I use a range, not a number.
    – realize that if the insurance were ever paid out that this idea of creating a 20 pay annuity from the insurance proceeds probably isn’t what one would do. It might actually be better to pay down the mortgage, drop loads into RESP’s and so on. We don’t know until after the fact what’s best at that point. The best I can do is give a range of estimates.

    I admit I’m a bit surprised no one has kicked me around the block over taxes :). My response to this (again, keeping it simple and realizing that this is an estimate) is that we’re paying taxes on our current income. The interest earned on the insurance capital would also be taxable at roughly the same amount. Again with the ‘estimate’.

    So again, your calc is actually perfectly fine – it’s just likely to produce a similiar estimate to mine in a manner that’s not quite as easy to understand for folks less aware of financial matters.

  6. I like the article, and do agree with the comments that have been made.

    This is one of those tricky questions to answer and by no means is there a one size fits all solution. There are software programs, excel spreadsheets and theories available to help find the answer that makes sense for each family, but at the end of the day it’s a very personal decision.

    In my own case, I chose to use life insurance as an investment vehicle even before I was married. I know this is not a normal way of thinking for most by any means, however I truly believe in the value of tax sheltered investment growth. Saying that, I do not believe that this would have been a good decision if I wasn’t already investing in my RSP’s or didn’t have the cash flow to justify it.

    Once I was married, I increased my coverage substantially because I knew that I would probably not want to have to work the day, week or even month after I lost my wife, and I’d never want to put her in that position either. One great way of thinking about life insurance is to ensure there is enough in place so as to not not force the surviving spouse to make any substantial financial decisions within the first year of losing the most important person in their life.

    Just my thoughts, but great article and great blog CC!

    Chris

  7. You had me until the income replacement.
    A payout of life insurance is non-taxable. Income is.
    You were trying to replace 60-80% of a 75,000 yearly taxable income with a non-taxable payout. You should be using the net of a 75,000/year salary, or about 44,000. Then replace 60-80% of that.
    So using your exact example (30 years, 5/3, 60%) you only need $607K.

    Now the non-emotional part of me also says that my wife will most likely remarry and I only need to take care of my children (0r 18 years of income) so I would only need $405K of insurance.

    Just my 2 cents.

    Phil

  8. Life insurance can be useful to keep a cottage within a family. Since the cottage isn’t a primary residence, upon the death of the owner there will be a deemed disposition even if left to the child(ren). If there isn’t enough money in the estate to cover the taxes owing, the executor will have no choice but to sell it. Life insurance can be used to cover the tax bill and keep it in the family.

  9. Thanks for the response Glenn. You are correct that my method won’t work for a lot of people. My point was that the need for insurance depends a lot on where you are in life and what your goals for survivors are.

    I would assume that someone in their mid 40’s would less debt and more savings then someone in their mid 30’s (hopefully) which would mean they could self insure to some degree and won’t need as much insurance as someone who is younger. It seems that just taking a % of income ignores that scenario.

  10. A quick question for insured people. Let’s say my spouse and I are in a very frugal life style so we basically only spend one pay check to maintain the current life style, while both of us are working with about the same amount of income.

    In the case of one of us gone, the remaining pay check will maintain the same life style. In the case of both of us gone, our only kid will get all of our saving plus the insurance (not much) from our work. In the case of all of us gone the money will be wasted but who cares?

    Do we really need life insurance?

  11. Hey CC: I am a little confused with this guest post. At the outset I have no issue with a guest poster promoting his/her site or business, which (to me) is clearly why Mr. Cooke provides this piece. Blogs are conversations, and as such provide an exceptional way for people to communicate their expertise freely while promoting their services and products.

    Albeit, in your introduction you write Mr. Cooke offered to write an informational and non-promotional article on life insurance in exchange for a link to his site.

    The piece is both informational and promotional. There’s no sense in saying otherwise.

  12. Good point Phil, I was thinking that too.

  13. Canadian Capitalist

    Thrifty: What about the situation where we are gone but our kids survive? These days life insurance at work is typically one to two times annual salary. For us, we decided that it is just not enough to tide the kids over until they are grown up. So, we figured out a total replacement for the both and got insurance for half that amount for each of us.

    Squawkfox: We’ll have to disagree on whether the article is promotional because I feel otherwise. The links and words in the introduction and the link provided in the article are mine. In the article Glenn makes no mention of what he does, what services he provides etc. So, how is it promotional?

  14. CC: I’m happy to disagree. Life would be too boring otherwise. ;) I do find the article informational but posting the links to Mr. Cooke’s business (he’s the president), blog, and insurance calculators are alone a form of promotion. :)

  15. Funnily enough our insurance estimate was based on only one of us dying – more specifically me.

    If we both died, the our kids will have way too much money which might be a problem. The house would be sold (lots of equity), they would live with my sister who wouldn’t need a ton of money to keep them alive.

    If I died then they would need more money because my wife would still be around and would keep the house etc.

    Mike

  16. The example you’ve provided Glenn nearly fits me to the “T”. I’m 31 with two young ones under 4 years of age. However, we decided that 500K was sufficient and I’m having trouble with your calculator coming up with 1 million.
    Perhaps some of this resistance comes from the fact that I hate spending money on something I may never use, but I acknowledge the fact that’s required.
    Our family and I assume many people that read this blog, are living below our means. I also don’t except the fact that the more I make, the more that I need to spend.

    A couple points:
    • When one person passes away, the family expenses reduce significantly.
    • We considered life insurance as a temporary tool. Not a 20 year free ride for our partner. 500K would allow over 10+ years of no worries. That should be more then enough recovery time.
    • The 500K will be invested and collect interest.
    • Assets and debt should be considered. So if someone is leaving their significant other with a mountain of debt (i.e. negative net worth) then they need to have more insurance then those of us that have a net worth.

    This article is appropriate for those people that live pay check to pay check. While this likely appeals to the average Canadian, it probably doesn’t appeal to the regular readers of this blog. Just a thought for CC… If you don’t already do this, providing guest posters with a general description of your average reader may help focus the article.

    Regarding the comments on the promotional content of this article. I believe it was written without bias, so the introduction by CC was appropriate. It was an attempt to inform.

  17. I’m with Four Pillars and MGA regarding accounting for savings and debt when figuring out life insurance requirements. If I were to pass, my wife would promtly pay off any remaining debts (we both don’t like debt). The remaining balance to generate income or cover needs would be that much smaller. In fact, when I sat down with an insurance rep we went through all sorts of stuff (other income streams, net worth, expected needs, child care needs). I think that life insurance planning is very similar to retirement planning, only the retirement is forced and forceful. :)

  18. Four pillars wrote:
    >>>>I would assume that someone in their mid 40’s would less debt and more savings then someone in their mid 30’s (hopefully) which would mean they could self insure to some degree and won’t need as much insurance as someone who is younger.

    I’d like to think so to, but my experience has been that assuming folks from about 30-50 are still living without much in the way of assets or savings is a pretty safe bet.

    However if they are a bit older, then we just tailer the above scenario to a lower number of years in the assumptions, which decreases the amount of insurance. It’s the longer timeframe that’s the reason young folks need such a whomping big amount of insurance. They need enough of a pot of money to get the kids up and out of the house.

    This same timeframe, as I mentioned also points to the insurance type. For younger folks it points mostly to a 20 year term. For folks that are bit older (say the kids are teens or getting up there) then the fit is better with 10 year term. I’d like to recommend 30 year term for younger folks (people are keeping mortgages a lot longer and kids are staying home longer now too) but IMO the price differential between 20 and 30 year term is too great.

    I’ll go off topic here, but the product type and income replacement need eventually go away – that’s the assumption for this scenario. In 20 years, kids are gone, mortgage is gone, and so on (yes, disgregarding the fact that the need could be viewed as decreasing over that time period). At that point the need for many people changes. Because they don’t need an income over a large timeframe we don’t need the large amounts of term insurance. At that point people tend to start wanting just general clean up insurance should they die. And that points to permanent insurance. The easiest way in the future to move from term to permanent insurance is to use the ‘conversion priviledge’ inherent in many term policies. This contractually guaranteed provision lets you trade in term for a permanent product without a medical exam. That gets more important as we get older. The important thing to note is that most but not all term plans offer this. IMO this conversion priviledge is often overlooked and seldom talked about,but is a vital part of a term policy. I don’t recommend any term policies without it.

    MGA – What you’ve written is absolutely fine. My scenario is all based on assumptions. The first assumption is we’re trying to protect income (without that assumption, as has been pointed out, this analysis doesn’t make sense). The other assumptions of time, interest, % of income, inflation, etc are all assumptions. Tailor them however you like. If you decide that a 10 year timeframe is fine, then that’s exactly what you should do. In any regard, the basic calculator provides a solid ground for an estimate of the insurance amount in a format that people understand.

    WRT the discussions of cottages and other savings or investments being passed around to someone else upon death – that’s an entirely different discussion. It’s more complex than I want to discuss in detail on a blog (and in a lot of cases I pass this stuff off to client’s accountants) but let me summarize it this way:
    – if you have liquid assets, upon death they may or may not be taxable. If they are taxable, it’s likely to be substantial. But if the assets are liquid, they can pay the taxes using the assets. Not a catastrophic loss, and I wouldn’t suggest that one necessarily needs to jump up and cover off that tax bill with life insurance. That’s what some of the comments here seem to be implying they decide, and I agree. Other folks decide they instead want to cover that tax bill using life insurance – and that’s fine too.
    – if the assets are not liquid, again there are two choices if taxes are owing. First is to sell the asset, generally at fire sale prices. Again – that’s a valid decision. Others decide that they don’t want to have to sell the asset to pay a tax bill. At that point either you’ve got the cash there to pay the tax man, or you can cover off the the bill with life insurance.

    Ultimately it’s about not having a knee-jerk reaction to having too much or too little insurance, or buying this type or that type or having it or not having it. What’s important is that we’ve educated ourselves from a financial and insurance perspective instead of a product-sales perspective.

    As for the above comment on about using life insurance as an investment, the question I always ask is – do you have tax and estate planning problems? If not, then why are we talking about a solution? If you do have tax problems (other tax sheltered options like RRSP’s and the upcoming TFSA maxed out, etc) -and- you need life insurance, then some life insurance products are a viable option. The real problem with this approach? The industry has taken these types of solutions for more affluent clients and are trying to hammer the square peg into the round hole of the average person. Which upon rereading was perhaps more of an image that I was looking to create but is apt nonetheless :).

    Apologies for being so verbose. We’re talking about extremely varied topics and I’m trying to answer them all as best I can in a general fashion.

  19. Another idea I’ve heard about for Term L.I. is to step or overlap polices based on the risk you want to mitigate. So, for instance say you’re children are 8 and 10, and really should be moving out at 19-20, buy a 10 year policy to cover them while at home, and if your spouse is 20 years from retirement, get a 20 year term rather than 1 20 or 25 year term. Not my idea but something to consider.

  20. Jon202: I would not recommend that approach since you will be paying fees to support two policies. Instead, get one policy with your total required needs, and then 10 years down the line reduce your coverage.

  21. CC: In the case that we only need coverage when both my spouse and I die, is there a policy covers just that? I guess you’ve searched and found nothing?

  22. Canadian Capitalist

    Thrifty: Honestly, we didn’t look for coverage only if both of us were to die. Readers more knowledgeable on insurance matters might have more comments.

    Paolo: I don’t think (I’m not sure about this) the term insurance contract allows us to reduce our coverage later. So, the only way to get overlapping coverage is to purchase separate policies as Jon suggests.

  23. CC: you can generally reduce your coverage just by contacting the agent and requesting it. Increasing is more problematic.

    If you’re looking for coverage only if you both die at the same time – I don’t think there’s anything like that. There is joint last to die, which pays after both insureds are deceased (which may or may not be at the same time) – but I would suggest you consider exactly what’s going to happen after even one of you dies – it’s probable that you really need individual insurance policies on both of you.

    The other request I get occasionally is joint first to die which pays out after 1 deceased. There’s a variety of reasons I don’t recommend it – there’s a lot of drawbacks to these policies and the difference in cost between a joint first to die policy and two individual coverages is generally in the range of 5%. Not enough of a savings IMO to justify the drawbacks.

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  26. Good post. Many people don’t realize the economic value of their life. I often ask my clients, “If I gave you $1 million dollars today, would you work for free for the rest of your life?” The answer is always “no” because they know that they will make more than $1 million by retirement.

  27. Byron:

    I wouldn’t take that, but if you told me to stop working or earning a living i might. It costs me money in gas, maint, car payments and travel time to get to work.

    BUT if i stopped working it would save me money and IF that 1 million was not taxed it could be put into good dividend paying companies with ‘growth potential’ and the dividend tax’s are far cheaper.

    I would also not require saving for retirement since this ‘portfolio’ if structured correctly should be inflation protected and earnings and dividends ‘should’ rise accordingly.

    LOL: no life insurance would be needed since i would now be ‘self insured’. I think Derek Foster is living as mentioned about, although this is a guess as i haven’t actually read his book?

    In closing Byron if you gave me a million to do some type of work (maybe not what i am doing now) i would have to think about that.

    I also have life insurance and based it on how much my wife would need till the kids left the house. I took the initial amount and used some to pay the mortgage. Then i took that lump sum and put it into a retirement calculator to get the income she would need per yr.

    I used a 2% growth rate (assuming 3% inflation so 5% actual). I was a few thousand shy (per yr) of what she needed. I also assumed she would remarry (didn’t use the new spouse income since its unknown), but not initially of course.

    Since buying a new house recently i may buy an additional term policy (instead of mortgage insurance). I will check out the site above to find the best rates (with the best companies).

    For what its worth Squakfox is right and this is promotional and educational. Wether your actually endorsing the product or not is a whole different matter.

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  29. Great post.
    […]For most of us, we want to maintain our dependents’ standard of living should we die. And it’s that standard of living that we should focus on. Not the mortgage, not the children’s education, not buying groceries.[…]

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  31. A little more complex than my needs analysis, but it will work!

  32. Protecting your loved ones is what life insurance should be about. If you’re single and don’t own any property for example, you might not need insurance at all. It’s always a good idea to review your options though and talk with a financial advisor that can better help you understand your financial goals.

  33. the amount of insurance all depends upon your earnings, savings, lifestyle and how much you think you need later at older age and the amount you think will be OK for your family in case of any causality.

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