Where life insurance is concerned, under-insurance is risky and over-insurance is financial profligacy. Having ‘enough’ life insurance cover can save you thousands or tens of thousands of dollars in the end. The question of “How much?” can be viewed in the context of premium and coverage amount. Ideally, both coverage and premium factors should carry equivalent weight.
There are some benchmarks that insurance advisors use in assessing your insurance need. “Ten times your annual salary” is the most common benchmark. It is a reasonable guide, but it does not help you avoid buying life insurance at regular intervals or under/over insuring yourself. Buying only the life insurance you need at a particular time can save you money in the short-term. However, it will raise your aggregate premiums and lower your returns in the long run, where cash-value plans are concerned. The best bet would be to anticipate your needs and factor these into the overall coverage.
When assessing your life insurance need, you may be better advised to use living expenses instead of income. After all, what your beneficiaries need to survive comfortably can translate into expenses. If you are missing from the picture, your family may not require 100% of the household income to survive on. If you are doing an income-based calculation, you should use a percentage of your income to arrive at a more reasonable coverage level.
A good life insurance calculator would let you estimate the total coverage you may need and observe the effects of changes in your circumstances. This is because it would provide a detailed analysis of elements such as your final expenses, first year shortfall, existing asset base and cash reserves, your future economic value and the concept of money working for you. Typical life insurance calculators would assume a static annual income with no salary increases. However, a proper needs estimator would factor in your future economic value, inclusive of salary increase. The coverage amount from this process may be higher than 10x your annual salary but it would be more representative.
You should buy as much life insurance as you can afford, but not to the detriment of other protection products. Life coverage is only one element of your financial plan. Therefore the premium that you can afford should be assessed in the context of your ability to fund other protection and accumulation products like health insurance, annuities and general insurance products. Your retirement savings should be 10% of your income, so the maximum premium you can afford for life insurance should be guided by this.
The type of plan dictates how much you could spend and the coverage you can afford. If your life insurance needs were covered exclusively by a term plan, it should not comprise more than 5% of your income. However, if you are considering a cash-value life insurance policy, your premium should not amount to more than 10% of your monthly income.
Insurers also conduct financial underwriting on life insurance applications. Generally, an insurer would not want to insure someone for more than thirty times that person’s annual income. How much insurance you should buy should be within ten to thirty times your annual salary. The premium you pay for life insurance should therefore be between five and ten percent of your monthly income. It is hardly likely that someone would need twenty times their annual income in insurance.
Anticipating needs is vital to a decision on life insurance amount. You should assess your current needs and anticipate needs based on future plans (family, business or mortgage purposes). If you can afford it now, you can purchase an amount between the actual and anticipated on a cash value plan. With a declared interest Universal Life plan, the death benefit would eventually grow to meet future increases in your life insurance needs analysis. Use and manipulate variables in the following formula to determine your coverage amount:
Life insurance need = (Total Immediate cash needs + Income Replacement Fund + First Year Shortfall) – (Accumulated savings & investments + Coverage Available).
The ‘right’ amount of coverage you need can change over time. When buying life insurance, you should anticipate future needs (mortgage protection/birth of a child) without over-extending or buying too much cash value insurance (if any). Buying enough insurance is only one piece of the life insurance puzzle, but it should be a significant aspect of your purchasing decision.