How Much Life Insurance Do You Really Need?

Most people would agree that the decision to buy life insurance is one of the biggest we make in our financial lives. And yet, as big of decision as it is, relatively few people buy enough coverage to meet even the most basic needs of their families. In the United States, the average life insurance policy held by the main breadwinner would provide enough replacement income for just 4.2 years. Of course, this is a big step up over the 6 million households that don’t have any life insurance at all.

With so much at stake, there is no reason to simply guess at the amount of coverage when it is nearly as easy to calculate a family’s precise needs. All that it requires is a few hours work, some frank talk with family members, a spreadsheet or financial needs calculator, and some number crunching. The end result will provide everyone with a better sense of why life insurance is important along with the rationale that everyone looks for in its purchase. Here are the fundamental steps to assessing your life insurance needs:

Identify Your Actual Needs

Identifying needs really comes down to matching your obligations up with your ability to cover them should the family lose the income of one of the breadwinners. It inventories debt obligations and final expenses, such as funeral and medical costs. It looks to future obligations such as college funding to ensure funds are available. It considers the ongoing income needs of family members through the various stages of life and their capacity to replace the lost income on their own. It requires a critical discussion of lifestyle needs, a surviving spouse’s ability to earn enough income, and any special circumstances. It addresses the question of whether your family should have enough to just get by, or to be able to continue to enjoy their current lifestyle. As with any extensive list of needs, they would then need to be prioritized.

Crunching the Numbers

After clarifying and prioritizing your needs, you will then need to quantify them. This is fairly easy to do for the immediate cash need, such as final expenses (including funeral and potential medical costs), debt payoff (mortgage, credit cards, etc.) and establishing funds for future goals such as a college fund (based on the percentage of costs you would expect to pay).

Quantifying income needs is a little more intricate, but it is really just a matter of establishing an actual budget for ongoing living expenses - food, clothing, medical, education, career training, recreation, utilities, transportation, etc. - assuming death occurs today. The budget should be adjusted after the child dependency years. By calculating the cumulative value of the future income stream, adjusted for inflation, and discounting to the present using a capital growth factor, you will arrive at a lump sum amount. The assumption is that this lump sum of capital that would be created by life insurance proceeds would be invested at the assumed growth rate to provide the stream of income needed.

By combining your immediate cash needs amount with your future income needs amount, then subtracting your available assets and life insurance, you will arrive at a net capital need which is the amount of additional life insurance coverage needed. We didn’t include Social Security benefits in this assessment process. If you choose to include potential payments for child dependency years, or your spouse’s retirement years, it will reduce your capital need. Some people choose to plan without it to ensure there is a sufficient “cushion” of capital available.

There are a number of free financial needs calculators available online that can help you crunch the numbers and solve for your needs with or without Social Security. It is also advisable to seek the guidance of a well-qualified and trusted financial professional who can assist you in validating your own assessment and in the search for right kind of life insurance policy.