How much life insurance do I need?

Life insurance pays a cash benefit to a beneficiary upon the death of someone.

The human life value.

What is the value of a human life?  Of course, a human life has great value with regard to achievement, companionship, inspiration, and so on.  There is also the financial value of a human life.  To understand this concept, ask the question, “Does someone suffer, financially, upon the death of someone else?”  If so, there is a risk exposure related to that human life value.  There are several broad categories of human life risk exposures, including those having to do with personal needs, family needs, and business needs.  Life insurance is a device, which can replace the financial loss that results from someone’s death.  To make a wise life insurance purchase you must consider several questions, including the following:

How much death benefit do I need?

For some life insurance needs the amount is obvious – if the purpose is to guarantee repayment of a $50,000 loan, the amount is $50,000.  For other needs, like family/survivor income needs, the correct amount is not so obvious.

This problem has led to several rules of thumb, such as “five times (annual) income” or “ten times (annual) income.”  Another rule of thumb would suggest that each parent should have $500,000 of death benefit, and yet another that each parent should have $1,000,000.  It is rather obvious that rules of thumb are not specific to a given individual’s situation, so there is a risk of not being precise.  If you have too little death benefit your family will suffer, and if you have too much you are wasting your resources by paying for insurance that you don’t need (again your family suffers.)

While there is no perfect answer to this problem, there is a method which is far better than rules of thumb.  It is possible to compute the lump sum (death benefit) required to fund specific present and future cash flows to meet individual and family needs as determined by the individuals, or family.  A good financial planner can perform the appropriate calculations after determining certain assumptions regarding investment returns, taxes, and inflation.

So, there are two basic steps to determining how much life insurance you need.

1. Consider your needs.

This step requires that you identify, or estimate the amount of each specific need, and the timing of the need.  For example, satisfaction of debts might require a lump sum amount immediately upon death, while ongoing income needs for survivors would be met by a monthly or weekly income stream which increases with inflation, and college funding could require an income stream which begins in the future.

2. Compute the present value of the various cash flows defined in #1.

A good financial planner can assist you in identifying and quantifying your needs, and can bring the wisdom of experience to the process.  Life insurance planning, like life, involves uncertainty and variables.  However, by using good strategy and appropriate methods you can apply your resources to meet your needs and those of your family, while avoiding the uncertainty and waste associated with rules of thumb.


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