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?).