Life Insurance–Too Little or Too Much?

Life insurance is a risk management tool for both personal and business risks. In the event of the premature death of an income earner or parent, life insurance can provide tax-free cash to cover immediate expenses as well as ongoing financial support for the family.

How much life insurance you need depends on your unique circumstances such as who is dependent on your income, for how long, and what other resources are available to meet your family’s immediate and future needs.  This step-by-step guide focuses specifically on how to calculate “Term” life insurance for families in the event of a breadwinner or caregiver’s death.

There are several different ways to calculate the amount of insurance, but one of the most popular methods is the Capital Needs Analysis, which evaluates the family’s immediate cash needs as well as future income needs at the time of the insured’s death (assuming the insured’s death occurs at the time of the analysis). Below are the six steps to help determine how much insurance is needed.

1. What are the financial objectives to cover in the event of death?

Financial objectives and obligations need to be quantified. This may include how much inflation-adjusted income in the future you want to replace, the amount of debt that needs to be paid off, expenses associated with the death, and funds needed to pay for future expenses such as children’s college educations and weddings.

2. What are your current assets and liabilities?

Create a balance sheet with all assets (cash, real estate, financial assets, life insurance, etc.) and all liabilities (credit card debt, mortgage, etc.). This will help show what capital is available at your death and what liabilities you may want to pay off.

3. What are your net cash needs?

Add up the amounts you identified as needed immediately to pay off the debts and final expenses and to fund future expenses such as educations or weddings. Then identify the assets from your balance sheet available to meet those needs such as cash or proceeds from an existing life insurance policy.   The net cash shortfall is the difference between the two. For example, if your immediate cash needs add up to $665,000 and your current available cash assets are $125,000, the net cash shortfall would be $540,000.

4. What resources are available for income?

The primary sources for income from your balance sheet are your financial and income-producing assets (taxable investment accounts, IRAs, income-producing assets, business interests). Collectively this is the capital available to your family for income. In our example, let’s assume the available capital is $250,000.

5. How much capital is needed to fund the income shortfall?

After taking into account any other sources of income such as the surviving spouse’s salary and social security survivor benefits, suppose you have determined that the net income shortfall (Annual Net Income Needed) is $100,000. The net capital needed to generate that income can be determined by the following formula.

(Annual Net Income Needed ÷ Inflation Adjusted Interest Rate) + (First Year’s Payment – Existing Capital) = Net Income Capital Needed

For example: Assuming annualized returns of 5% and inflation of 2%, the inflation adjusted interest rate would be 2.94%. Let’s assume an income shortfall of $100,000 and existing capital of $250,000:

($100,000 ÷ 2.94%) + ($100,000 – $250,000) = $3,251,361

6. Final Step: Adding it all Up

The last step is to add the values from step #3 (net cash shortfall) and #5 (required net income capital). This will provide the total amount of insurance your capital needs analysis suggests:

Net Cash Needed + Net Capital Needed = Amount of Insurance

In our example, the insured might want to buy a life insurance policy with a face value of about $3.75 million.

$540,000 + $3,251,361 = $3,791,361

This analysis should be tempered by other factors such as the likelihood that the surviving spouse will remarry or return to work. This is not a one-time analysis but rather one to undertake periodically and always prior to any renewals.  The more you build up your own capital to fund cash and income needs, the less insurance you need to buy.