The benefit amount is often the first thing people think of when considering a life insurance policy. Your beneficiaries receive the benefit amount, also known as the face amount, following your passing. Every situation is unique and there is no one size fits all amount of life insurance. The factors that make it hard to get a general idea are the varying financial needs of individuals and their families, their risk tolerance, financial goals among others.
Types of Life Insurance Policies
You should be certain of the type of life insurance you’ll require before determining the precise quantity of coverage you need. There are two primary categories of life insurance: whole life and term. When compared to term life insurance, which only lasts for a certain number of years before expiring, whole life insurance is permanent and lasts the entirety of your life. The benefit amount is often the first thing people think of when considering a life insurance policy. Your beneficiaries receive the benefit amount, also known as the face amount, following your passing. Every situation is unique and there is no one size fits all amount of life insurance. The factors that make it hard to get a general idea are the varying financial needs of individuals and their families, their risk tolerance, financial goals among others.
1. Whole Life Insurance
Any sort of permanent policy with a rising cash value is referred to as whole life insurance. These insurance policies are categorized according to how their cash value increases. Traditional whole life insurance provides a guaranteed growth rate for cash value in the general account of the insurer. Another form of whole life insurance is variable life insurance, which builds cash value in investment sub-accounts controlled by the policyholder and generates returns based on market performance.
2. Term Life Insurance
The cost of term life insurance is typically lower than that of full life insurance. It only lasts for the term duration specified, which might range from one year to thirty years, or until you reach a specific age. It has no cash value component. The policy pays the face amount if you pass away during the period. If you live over the policy’s expiration date, no benefits are paid out. Most term insurance plans can be renewed with a higher premium without providing proof of insurability.
How to Calculate Your Life Insurance Coverage?
The majority of insurance brokers will utilize a life insurance calculator to calculate how much coverage you’ll need. In the past, agents have used either the needs approach or the human life value approach to determine their clients’ needs for life insurance coverage.
1. Human Life Value Approach
The human life value technique, which Dr. Solomon S. Huebner developed in 1924, is one of the earliest methods for determining the appropriate level of life insurance for a family. The death benefit is calculated using this approach by calculating your net future earnings, less taxes and living expenses up until retirement, and then discounting that into a lump sum payment in the present using a reasonable interest rate.
Discounting is the process of turning a future financial amount to its current-day equivalent. By doing this, the problem of dollar depreciation is resolved—a $100 bill today might not be worth the same tomorrow. For instance, $1 in the 1950s is equivalent to $10 today.
The human life value approach is not optimal because it doesn’t factor-in your loved ones’ actual needs. It also doesn’t account for inflation, potential pay raises, or funeral costs. As a result, you might not have enough insurance to cover your requirements or those of your family. Consequently, the Needs Approach, which we have discussed below, is more widely used today.
2. Needs Approach
Insurance agents employ the needs approach rather than the human life value approach when determining how much life insurance you’ll need because it takes a more in-depth look at your current and future financial situation. In order to calculate the lump sum required upon the insured’s death and the continuous income needs of their loved ones, your life insurance agent will gather extensive information. Your agent needs to be aware of certain of your financial aspects given below:
- Assets and debts
- Current annual income
- Current and future expenses
- Financial objectives
- Risk profile
The Needs Approach is a careful evaluation of your finances to make sure that your immediate and future requirements are satisfied, as opposed to analyzing your annual earnings for a broad number. Your beneficiaries will be able to cover important bills like funeral fees, estate taxes, and credit card debt thanks to a lump-sum benefit. Additionally, money would be available for any other immediate requirements, such as paying off your mortgage, attending to emergencies, or establishing a trust fund for a child.
Your surviving beneficiaries will probably also require an income stream to sustain a standard of living if you are the family’s principal provider and your partner is a stay-at-home parent. Family needs that are common and continuing include childcare, food, clothes, and transportation costs. For a short period of time, Social Security benefits will partially replace the lost income for your family. Your family’s future needs will be estimated through a needs assessment.
The needs approach covers both lump-sum and continuing financial demands as categories of survivor protection. For more expensive requirements or other individual applications, such as estate development, cash for living benefits, and long-term care, additional insurance can be acquired. If you have a terminal disease, certain insurers will pay a portion of your death benefit under an accelerated death benefit program.
You can also check out How to Buy a Life Insurance Policy in Seven Steps?
Is There a General Rule to Determine Your Life Insurance Coverage?
It is wise to conduct your own research of your life insurance requirements before meeting with an insurance representative. Depending on whether you want to start with a broad number or take into consideration your more specialised needs, there are many strategies to use for differing degrees of coverage.
1. Multiply Your Income by 10
The majority of financial advisors suggest that you purchase life insurance that is at least 10 times your annual income. Depending on how long you anticipate your dependents will require financial support, you may use more or less. This approach ignores your savings and assets as well as any current insurance (such as a group insurance plan). Additionally, it doesn’t list your debts by type.
2. Needs Analysis
To determine your needs for life insurance protection, you can perform a needs analysis at home. To replace your present salary for your beneficiaries, double it by the number of years you want. Additionally, you must average your total assets and liabilities. Your savings, investments, and group life insurance are considered your assets; deduct this amount from your coverage.
The significant costs that must be kept up after your death are your obligations. This includes the outstanding debt on your house, any outstanding auto loans, personal loans, dependents’ college tuition, and funeral costs. Consider your ongoing expenses for things like food, transportation, clothing, and medical care that must be saved for your beneficiaries. You will have additional coverage for this.
Your financial objectives and risk tolerance will be discussed during the needs analysis that your insurance agent does with you. Although your financial objectives influence the sort of policy you acquire, such as if you want cash value for retirement, you should take your risk profile into account when deciding how much coverage to buy.
Risk is the possibility of suffering a loss; in the case of life insurance, the risk of losing your income as a result of your passing away or developing a terminal disease is what is being covered. Your risk profile evaluates your likelihood of dying or getting sick. Consider your age and medical history. Will you require some cash to cover an anticipated illness? If you develop a terminal illness, a hybrid life insurance policy or accelerated death benefit pays a portion of your coverage.
3. The DIME Approach
The abbreviation DIME stands for debt, income, mortgage, and education. The only difference between it and the needs approach is that it ignores your accumulated assets, which are a crucial consideration when determining your need for life insurance. This strategy also ignores your living expenses, which your assets could be able to pay for.
The ‘D’ in DIME combines all of your debt, including credit card debt and projected funeral costs, but it excludes mortgage debt. Divide your income by the length of time that your beneficiaries will want continuing financial assistance. Determine how much is required to pay off your mortgage. Lastly, make an estimate of the expense of college for each of your children. The total of the four figures is your coverage amount.
Is $250,000 Enough Life Insurance?
The figure of $250,000 is often thrown around as the mean coverage. You can assess whether its right for you by dividing the sum of $250,000 by the approximate number of years you believe your loved ones will need to replace your income to quickly assess if it is sufficient. That should either disprove the notion that it is too low or confirm that it is, at the very least, a good starting point.
Consider a few instances. If you earn $50,000 a year and are considering a $250,000 death benefit, that would be equivalent to five years of income, which is typically insufficient. The cost of your mortgage and your children’s schooling would be excluded. In essence, you would be leaving your survivors to take care of these costs.
However, if you make $25,000 a year, your family would have a stream of income for 10 years. But this still excludes critical expenses. If you plan to support your beneficiaries with your income for five years and they will have enough to cover the mortgage and your dependents’ college education, this would be enough life insurance for you.
If you earn $25,000 a year, though, your family would have a source of money for 10 years. But essential costs are still not included in this. This amount of life insurance would be sufficient for you if you intended to provide for your beneficiaries for five years and ensure that they would have enough money to pay the mortgage and the tuition expenses of your dependents.