Most people buy term life insurance to provide for their family’s financial needs in the event that we die while they are still dependent on us. Permanent life insurance is also a useful wealth transfer tool when used for estate planning, as well as a modest savings vehicle. But far and away, life insurance is used by families to pay the mortgage, raise the children and put them through college if we die young.
Generally the first step in the life insurance buying process is to find an agent who you can trust and work comfortably with. The agent will help you to determine how much life insurance you should carry, what type(s), and from which company.
For most middle-class families, seven to ten times annual income serves as a useful guideline, assuming you have about two children and a 20-year plus mortgage. It’s a rule of thumb that many amateur agents use since it “feels right” to most couples and doesn’t present much of an argument. It makes for an “easy sale.” The problem is, every family is different and often that amount of coverage is inadequate. My recommendation is take these heuristics as only very basic guidelines.
The most common method to determine how much life insurance you should carry is called the “Human Life Value Method.” I call it “The Budweiser Beer Truck Method” – it’s the calculation that most courts will use if you die because of someone else’s negligence, say if a drunken beer delivery driver runs you down on your way home from work. In essence, it places a monetary value on your earning potential over the years until retirement. The formula uses annual income, annual expenses, number of years left until retirement and the expected inflation rate. The LIFE Foundation has an online calculator at http://www.lifehappens.org/life-insurance/human-life-value that is useful for this method.
The Human Life Value Method is the most sensible, but it is also the most expensive.
With my clients I use a relatively simple worksheet to take the various “line items” step by step to arrive at an actual insurance amount. I always find it useful to have a conversation with my clients about what they want or need for their families, rather than presupposing, for example, that they want to have college funding endowments established for each of their children, or for their spouse to “never have to work again.” Insurance planning is extremely personal.
Future articles will address the issue of how much life insurance retirees should have, life insurance and estate planning, how to “ladder” life insurance plans and which types of life insurance people should carry.
P.S. I'm having trouble formatting the Life Insurance Needs Worksheet. Please email me for a PDF copy of the sheet.
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