What determines your need for life insurance?
Life stages and circumstances
When determining your need for life insurance, you should first consider your life stage and circumstances. Marital status, number of dependents, size and nature of financial obligations, your career stage, and your intentions to pass on your property are all factors to consider. Your need for life insurance changes as the circumstances of your life change.
Starting out
During the starting stage of life, you may just begin your career or build your family. You might not have children or dependents yet. Still, that doesn’t mean you have no financial responsibilities.
For example, student loans often require a cosigner, such as a parent or grandparent. The same applies to many car loans. If you pass away before paying off these debts, your cosigner must cover the balance. By law, cosigners remain fully responsible when a borrower defaults. Death does not erase debt.
Because of this, life insurance still matters—even early in life. A policy can protect your loved ones from financial hardship and prevent them from inheriting your unpaid obligations.
Single adult
A growing percentage of the population now falls into the single adult demographic group. This group covers a broad spectrum of ages, lifestyles, and obligations.
Family obligations – Parents
Family obligations – ParentsAlthough you may not have a spouse, your death could have a serious financial impact on other family members. If, like many adults, you are supporting your parents (either financially or with care), your death could have a major impact, both emotionally and financially. They would not only lose the support you have been providing to them, but they would also need to come up with the money for your final expenses.
Family obligations – Children
If you are a single parent, the primary financial support for your children would die with you. If you are lucky, you may have family members who would step in and help your children if you died. If you are even luckier, they will be able to provide your children with the education and lifestyle you had hoped for them. Your need for life insurance as a single parent is even greater than that of a dual-parent, dual-income household. Life insurance is a cost-effective way to make sure that your children are protected financially should anything happen to you.
Debt obligations
In this stage of life, you may still be paying for or even still accumulating education loans. You may have purchased a house or condo with a cosigner. If you died, your cosigner would be legally liable for the payments on the debt.
Protect your insurability
Another reason you may need life insurance at this stage of your life is to protect your future insurability. Once you buy a permanent, cash-value life insurance policy, it remains in effect for your entire life (assuming the premiums are paid), even if your health changes. If you experience a serious change in health, you might not be able to buy additional insurance coverage, but you would still have the permanent coverage you already own.
Dual-income couple or family
If both you and your spouse earn income, the surviving partner may manage financially after one of you dies. However, shared debts like mortgages or credit cards can make that loss much harder to handle. Adding children to the picture increases the financial strain even more.
As more people rely on your income, your need for life insurance grows. Without enough coverage, your partner may struggle to maintain your current home or lifestyle. When children depend on you, losing one breadwinner can disrupt everyday life and derail plans for private school or college.
Parents of grown children
Just because your children have grown up and left the nest doesn’t mean you do not need life insurance. You may have spent your entire adult life building an estate that you intend to pass on to your children, grandchildren, or favorite charity. You can use life insurance to ensure that the bulk of your estate passes to your heirs or designated charitable organization subject to certain tax advantages.
Part of overall financial planning
Determining your life insurance needs should not be done in isolation. Instead, it should be looked at as part of your overall financial plan, with consideration given to your goals for savings and retirement, as well as tax and estate planning. As your life changes, your financial goals may change, as well as your need for life insurance, making it important to periodically review your coverage.
Methods of calculating life insurance need
Several methods are used to calculate the appropriate level of insurance for you and your situation. While they all share common features, some methods strive to be more simplistic, while others involve more sophisticated calculations. Some of these differences are illustrated in the Table of Alternatives. You may want to determine an amount on your own, using one of the simpler methods.
Insurable interest
Before you calculate your life insurance needs, you must first confirm insurable interest.Insurable interest means you would suffer financial or emotional loss if someone passed away. You automatically have an insurable interest in your own life. However, when you insure another person, you must prove a qualifying relationship.
This relationship usually involves blood ties, marriage, or financial dependence. For example, spouses, parents, business partners, or creditors often meet this requirement.Insurance companies require proof of insurable interest before they issue a policy. Without it, you cannot legally purchase life insurance on someone else.
Family needs approach
The family needs approach is one of the more comprehensive methods of calculating your life insurance needs. It assumes that the purpose of life insurance is to cover the needs of the surviving family members. This method takes into account the immediate and ongoing needs of the surviving family members, as well as income from other sources and the value of assets that could be used to help defray the family’s expenses (such as bank accounts and real estate).
Capital retention approach
The capital retention approach is one of two calculation methods under the family needs approach. This approach assumes that the life insurance principal will
support the family indefinitely into the future. Because you will purchase more life insurance under this method, you will be in a better position if the surviving spouse lives longer than expected.
Capital liquidation approach
The capital liquidation approach is the second of two calculation methods under the family needs approach. This method does not provide as much continuing capital for the surviving spouse or heirs after the death of the surviving spouse. However, it does allow you to spend less money by purchasing a lesser amount of life insurance coverage.
Estate preservation and liquidity needs
The estate preservation and liquidity needs approach attempts to determine the amount of insurance needed at death for items such as taxes, expenses, fees, and debts while preserving the value of the estate. This method considers all the variables of family lifestyle and the total cash needed to maintain the current value of the estate while providing adequate cash needed to cover estate expenses and taxes.
Income replacement approach
The income replacement method assumes that insurance exists to replace your paycheck after your death. Instead of relying on rough estimates, this approach calculates your economic or “human life” value. It also considers future salary increases and inflation when determining coverage needs.
Although this method offers more detail than simple rules of thumb, it still has limits. For example, it does not account for unique financial situations or special family needs. In addition, it assumes your current income provides a comfortable lifestyle that will remain unchanged in the years ahead.
Rules of thumb
The rules of thumb are extremely basic calculations. They provide a starting point but fail to recognize special family circumstances or needs and focus only on the most basic components. One rule of thumb dictates that multiplying your salary by a certain number will provide an adequate level of insurance, while another calculates need based on normal living expenses.
Insurance mistakes
No insurance
The worst mistake is having a need and not having any insurance at all. Very often, people can find excuses for not buying life insurance. It’s no fun to plan for your death, for one thing. For another, there’s the tendency to think that dying won’t happen to you, only to some person you read about in the obituaries. But how many times have you heard about a young, apparently healthy person dying suddenly in a car accident, leaving behind a spouse, a young child, and no insurance? Sadly, it happens and the family faces not only emotional trauma but possibly an extremely difficult financial situation.
Not enough insurance
The majority of people with insurance are underinsured. Insufficient coverage can occur as a result of buying what is affordable instead of what is needed. Failure to review your coverage periodically could also result in insufficient insurance, even if you started with adequate levels. Inflation rates, your career, and your lifestyle may have changed. Your family could be faced with a large financial gap and left unable to maintain the current lifestyle if you died today. Consequences could include loss of the family home, scaling back of college plans, and possibly years of financial difficulty.
Too much insurance
If you purchased a large policy at one point in your life and then didn’t adjust your coverage when your insurance need was reduced, you may have too much life insurance. This is another good reason to periodically review your coverage with your financial planning professional. Periodic reviews of your insurance coverage can reveal opportunities to change your levels of coverage to match your current and projected
