When it comes to insurance, there are common principles and threads that exist across all forms of coverage. One of these common principles is the transference of risk. Insurance at its core is the process of reducing or transferring risk from yourself to the backs of an insurance company.
If you have car insurance, in exchange for a fee, you're reducing or transferring the risk that you might be financially responsible for an accident from yourself to the insurance company.
If you have disability insurance, you're transferring the risk that you might become disabled with no source of income from yourself to the insurance company.
The same is true of today's topic: life insurance. People purchase life insurance to reduce the risk that they might die before they are able to save enough money for their family and/or business interest(s) to be provided for after they're gone. While there may be many other factors at play, managing this risk appropriately is a core function of life insurance.
It's important then, that when purchasing life insurance, you know how much you need in the first place! It's not enough to buy life insurance if you don't know the amount that covers your risk.
So how do you know what that amount is? If you're not a financial advisor like me, and you're doing this all by yourself, how does one know if there buying too much, too little or just enough? That's what we're here to answer today.
Every financial advisor is going to have their own philosophy on calculating life insurance needs for their clients. Were going to cover two methods of calculating need that are prevalent in the insurance industry: Human Life value and The 5% Rule
Human Life Value
Human Life Value is a method of measuring the financial impact that person has on their family, business or community. If you earn an income and were to die today, that lost income is no longer available to your family and/or community, which has an impact on their financial ability. Even if you don't earn an income and are a stay-at-home spouse or caregiver, you have a financial impact. As you are likely well aware if you're in this situation, your absence would mean increased costs for your family as they tried to find someone else who can provide care for your children or elderly family members. Regardless of who you are and what you do, your presence makes a financial impact that Human Life Value aims to measure.
For life insurance, knowing a person's human life value helps advisors recommend an amount of insurance that can replace a person's financial impact upon their death. There are a couple steps to determining one's Human Life Value. Step 1 is to calculate their lost income. Let's look at an example using a person we'll call Johnny Doe.
Step 1: Determine Lost Income
Johnny Doe is a married father of two children, ages two and four. He earns $75,000 per year as an engineer, and if he were to die, he would want to replace his income to the household for 20 years. Without factoring in things like inflation or pay increases, if Johnny died today his family would miss out on his earnings of $1.5 million over the next 20 years.
One would think that if Johnny is losing $1.5 million of income over 20 years, his Human Life Value must be $1.5 million. And with a human life value of $1.5 million, maybe that's how much insurance he should purchase if he's using this method to calculate his needs. But they'd be wrong, because determining lost income is just the first step in finding the appropriate value. Step two is applying a discount factor or discount rate.
Step 2: Apply Discount Rate
Before I explain the purpose of a Discount Rate, let me first explain some assumptions financial advisors make about surviving family members after the death of a loved one.
If Johnny's family comes in my office after his death with $1.5 million and lets me know it's Johnny's legacy and they want to make sure it lasts as long as it can, as an advisor I know they won't need access to the entire $1.5 million in the first year. Johnny was only making $75,000 per year, so if his family takes that amount out of the $1.5 million, they will hopefully be fine for the next 12 months. And I wouldn't tell them to take the remaining funds and stick them in a checking or savings account, whose rates don't even keep up with inflation. I would instead recommend investing the remaining funds, with the hope of getting a conservative or moderate return each year.
By investing the funds and earning a return on these assets, Johnny's family wouldn't need $1.5 million at the time he dies. They would simply need to generate enough from investing the remaining funds that over the course of the next 20 years, their account would generate $1.5 million. This is where the Discount Rate comes into play.
The Discount Rate is, essentially, the interest rate Johnny's family feels they can earn by investing the funds they haven't spent. By applying the Discount Rate to the lost income found in step one, we can determine how much is actually needed to invest in a way that generates the $1.5 million his family needs over the 20 year period. The number we find after applying the Discount Rate is Johnny's Human Life Value
Even though Johnny's lost income over 20 years is $1.5 million, his family would only need $565,334 at his time of death, which if invested at 5% would generate $1.5 million over 20 years.
We can now add in Johnny's other goals for his insurance, such as covering his children's college and paying off debts, to find his life insurance need.
What's The Verdict On Human Life Value?
I stated that every advisor has a preference on how they calculate insurance needs. Using Human Life Value as a method is not my favorite, at least for a young professional or family. There are a couple reasons why:
First, the Discount Rate used in these calculations can give families a false and unrealistic sense of security. Even if 5% is a conservative/moderate rate of return on an investment, which I believe it to be, Human Life Value calculations assume one would get this return every single year. Unfortunately, that's not how the market works. Even if an investment AVERAGES 5% over a period of time, the resulting balance can be wildly different from an investment that returns 5% EVERY year (check out this video to see these differences in action). Using the same discount rate each year can, in my opinion, show an insurance need significantly lower than what it would be if calculated in the manner the stock market works in real life.
My second issue with Human Life Value is it doesn't take into a consideration a major goal of most people's careers: to improve their financial status. Should Johnny die today and we base his value off of his current income, we are ignoring the fact he was likely to receive pay increases over the years, some of which can be substantial if they come on the heels of a promotion or obtaining an advanced degree. Locking in his Human Life Value based on current pay ignores improvements he'd planned to make in his family's lives, or a career track he was already on at his death.
For an older person whose income is relatively stable, whose insurance costs are much higher because of their age, using Human Life Value can be a way to assess a basic level of risk and buy enough insurance to cover the necessities. But for those with many years ahead of them, I typically leave Human Life Value on the shelf when calculating insurance needs. My preferred method, is The 5% Rule.
The 5% Rule
The explanation for the 5% Rule is simple: whatever income needs your survivors have each year should be no more than 5% of your total life insurance. Should your family need $50,000 per year replaced in the event of your death, you should have life insurance of at least $1 million ($50,000 being 5% of $1 million). Should they need $100,000 per year, you should have at least $2 million of insurance.
The 5% Rule is also based on some assumptions. As an advisor, the last thing you want to tell a family that entrusted you with a loved one's life insurance proceeds, is that the money is running out. The goal for investing these funds is to last as long as it possibly can, without the stress of making adjustments to a dwindling account balance. By encouraging the surviving family to live off of no more than 5% of their account balance, the advisor hopes to invest the remaining proceeds and earn a conservative to moderate return - in this case, 5%. Should they achieve that return, at the beginning of the next year when the family needs more money, their account balance will be very close to the initial amount they receive from the insurance company.
Let's look at an example using one dollar:
While not back to the full dollar at the start of year two, we're very close, which hopefully bodes well for the longevity of this account. By using the same principles with larger amounts of income, you will quickly see how calculating insurance needs using The 5% Rule can lead to significantly larger numbers.
We'll look at an example, but before we do let me mention something I always do when calculating needs. I apply an income TARGET, meaning I don't want to use the income you make now, I want to use what you're projected to make at the top end of your career earnings. Doing so helps reduce the risk of inflation eating into your insurance's effectiveness, and also allows us to set our insurance based on what we have in store for our family's financial future. Let's apply this to Johnny, shall we?
And now that we have our income target, let's now calculate his family income needs using The 5% Rule
And lastly, let's add in the remaining items that factor into his total insurance needs.
Calculating Johnny's insurance need using Human Life Value led to a number of just over $700,000, while utilizing The 5% Rule leads to an insurance need of just under $2.2 million. And while no one likes paying for things they don't need, as an advisor who has unfortunately sat with families trying to make heads or tails of their financial picture after an income earners' death, I would much rather them have too much insurance than too little.
The Final Verdict
no matter which method you find appealing, the most important thing about this post is that it encourages you to calculate your need and find coverage. Some life insurance is better than no life insurance at all, and too few people have taken the steps to make sure their financial affairs are in order.
We've put our own life insurance calculator below. Take a few cracks at calculating the amount you might need to purchase, and then go purchase it!
LIFE INSURANCE NEEDS CALCULATOR