Life Insurance: How Much is Enough?

by Michael on Oct 10, 2012 · 6 comments

Photo of a Life Insurance Policy with a Pen

Not quite six years ago, my wife and I bought term life insurance policies. I was reminded of this when the renewal notices showed up in our mailbox this past week.

These weren’t the first life insurance policies that we bought, but they’ll probably be our last.

Why do I say this? Because by the time the term runs out, we’ll (hopefully) no longer need life insurance. These are 20 year policies that will expire right around the time our youngest finishes college.

Today I want to talk a bit about the through process that went into choosing our policies. But before we get into that, I though it would be worth first considering who actually needs life insurance coverage.

Who needs life insurance?

Though the life insurance industry doesn’t really advertise this, there are circumstances in which people don’t need life insurance. For example, if you’re single and have no dependents, you might not need coverage.

Sure, you may want enough to cover your final expenses but, if nobody depends on you for income or support, you probably don’t need any more than that. And that sort of low level coverage may have already been provided though your job.

If, on the other hand, you have dependents, then you’ll probably want enough to replace the income lost in the event of your untimely demise. Maybe not forever, but at least for awhile.

Rules of thumb

Like many aspects of personal finance, the wonderful world of life insurance is filled with rules of thumb. More often than not, you’re advised to buy a certain multiple of your annual income and leave it at that.

The problem here is determining the proper multiple. Six times your annual income? Eight? Ten? Twelve? The “right” number depends on who you talk to — and none of these estimates are grounded in (your) reality.

Instead of blindly picking a number based on what you read online, I would suggest sitting down and thinking carefully about your situation. What are your current obligations? And what (exactly) do you want your policy to provide? Your anticipated expenses are far more important that your current earnings when deciding on coverage amounts, so focus on those.

If you’re looking for a short-term solution — e.g., to support your family for a year or two until they can get back on their feet — then you can probably get away with less. If you’re looking for longer term support (e.g., to allow your spouse to stay home with your kids until they’re out of school) then you’ll obviously need more.

How much to buy?

In our case, we wanted the latter. My wife stays home with our kids (aside from occasional substitute teaching) and our goal was for that to remain possible going forward. Thus, we’d need to replace my income — and the associated health benefits (not cheap!) — for an extended period.

To simplify things, I figured it would also be good to factor in lump sums for paying off our mortgage (which we have since done) and covering the kids’ college expenses. I also included a fudge factor for inflation. After all, the benefits on a term policy don’t increase over time even though living expenses do.

In the end, I settled on a policy that was in the neighborhood of 20x my annual income from my day job. That may sound like a lot but it’s also important to keep in mind that I make a decent amount from self-employment. Here again, your expenses are a far more important consideration than your income. I’m just reporting that number for the sake of comparison.

In retrospect, this amount may have been overkill. But I was (and still am) in good health so the marginal cost for a larger policy wasn’t great. If anything, it also helped protect against the need to buy a new policy if our circumstances changed. While buying life insurance isn’t terribly onerous, it can be a bit of a hassle.

Another point here is that, if you need to replace your current policy with a new (larger) one in the future, you’ll face higher premiums per unit of coverage because you’ll be older. And that assumes that you remain in good health. If not, you’ll pay through the nose — assuming that you can even get a new policy.

Given the above, I guess you could say that by buying a slightly larger policy than needed at the time, I was insuring my insurability.

As for my wife, we settled on a policy that was roughly one-third the size of mine. While she’s not the primary breadwinner, she provides critical support for the family in other ways. If she were gone, we’d need to replace those efforts with someone to help around the house, keep an eye on the kids when I’m at work, etc.

Of course, the need for childcare doesn’t go on forever, so our needs diminish over time. In some ways, I guess this helps to offset the non-inflation-indexed nature of a term life insurance policy. In other ways, it’s a necessary evil of term life insurance. Your needs don’t stay the same over time but your coverage does.

1 Rich October 10, 2012 at 12:30 pm

We settled on an amount that was 10 times my income for my policy, and we bought enough on my wife for me to hire a nanny to help care for our kids.

2 Dylan October 10, 2012 at 2:59 pm

One response to inflation and a benefit that essentially declines in real value over time is that the insurable need also decreases over time. If what you are actually insuring is your human capital, i.e. the loss of income caused by death, the amount to replace goes down overtime. At the same time, the savings being built up for retirement (that you won’t use as much if you’re dead) is also increasing your ability to self-insure.

3 Michael October 10, 2012 at 3:07 pm

Dylan: I agree. That’s the point I was trying (perhaps unsuccessfully) to make in the first half of the last paragraph. As our kids get older (and other circumstances change) our needs decline.

Also, as you point out, our remaining (potential) earnings decrease with each passing day so the future income lost on death decreases over time. So yes, the lack of inflation indexing is arguably offset by those factors.

Of course, if you buy a “right-sized” (at the time) policy early on — e.g., when you have your first of several children — then you are setting yourself up for needing a new, bigger policy down the line because your needs will presumably increase as your family grows.

I’ve been down this road more than once, and it wasn’t until we had our last child that (I think) we got it right. πŸ™‚

4 Dylan October 10, 2012 at 3:26 pm

Agreed, but even if your expenses didn’t change, the need to insure your future earnings decreases. That’s the perspective I was trying to add. Also, don’t be too quick to assume childcare doesn’t go on forever. I thinks it tends to change form more than actually go away πŸ˜‰

5 Michael October 10, 2012 at 3:29 pm

Dylan: Fair point on childcare changing form vs. going away. πŸ™‚

Thanks for weighing in. I appreciate your perspective.

6 realone November 1, 2012 at 9:33 pm

Determining insurance is complex. One needs to include SS benefits and other sources of income vs current and expected expenses. It is also wise to get a term policy with an ability to decrease coverage in the future.

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