Personal Finance Essentials

How to Determine the Right Amount of Coverage

Life Insurance > How to Determine the Right Amount of Coverage

The right amount of life insurance is determined by one fundamental question: who would suffer financially if you died, and how much money would they need?

Insurance is an economic issue, not purely an emotional one. Your death would be a tragedy for your loved ones. The question here is what the financial consequences would be – and whether those consequences are something you’ve planned for.

If you’re a single adult with no spouse, children or other dependents who rely on your income, you may not need life insurance at all. But if you’re married, have young children, send money to support aging parents or otherwise have people who depend on your financial contributions, you have a responsibility to make sure your death doesn’t leave them in financial jeopardy.

Several factors influence how much coverage you need:

Your age and life expectancy
Your current income and future earning potential
Your household expenses and debts
The number and ages of children or other dependents
Whether your spouse works and at what income level
How long you want the financial support to continue
Your existing assets and savings

That last factor – your attitude toward the extent of protection you want to provide – is worth thinking through carefully. Consider a 35-year-old earning $50,000 per year with three children under 10 and a spouse who stays home. Applying the cut-in-half-and-drop-a-zero formula in reverse: to replace $50,000 per year in income, that family would need approximately $1 million in life insurance coverage. Some people in that situation want their spouse to be financially secure for life. Others want to provide only enough support to allow the spouse to reestablish financially. That difference in philosophy translates directly into the amount of insurance you need.

Too often, people die leaving behind only what their employer provided – a policy equal to one or two times their salary, chosen by default rather than by decision. Their surviving spouse is then forced back into the workforce prematurely, and college becomes financially out of reach. That’s not a plan. It’s an accident. Make sure the coverage you have is the result of a deliberate choice, not indifference.

Work with an independent financial advisor – not just an insurance agent whose compensation is based on the size of the policy you buy. An advisor can help you weigh your needs objectively, consider your existing assets and determine what amount of coverage actually makes sense for your family.

Six Problems with the Coverage You Already Own

If you already have life insurance, that’s a start. But the policy you bought years ago may not be serving you well today. Here are six common problems to watch for:

1

Erosion by inflation

A policy purchased 20 or 30 years ago may provide far less real value today than it did when you bought it. A $10,000 policy bought decades ago offers very little financial protection by modern standards.
2

Too much insurance

Conversely, if your children are grown and your debts are paid, you may have more coverage than you need. If your savings and investments are sufficient, the need for a large death benefit may have diminished.
3

Wrong kind of coverage

Group insurance tied to your employer is not portable. If you leave your job, you lose the protection. An individual policy follows you regardless of where you work.
4

Paying too much

If you bought your policy before 1980, it was priced assuming you’d die in your 60s. Modern actuarial tables reflect longer life expectancies, and insurance is cheaper as a result. You may be able to get more coverage for less.
5

Invalid interest rate assumptions

If you bought universal life in the 1970s or early 1980s when the assumed rate was 15%, the accumulation account almost certainly hasn’t grown as projected. Your premiums may increase, or the policy may be at risk of lapsing.
6

Too many policies

If you determine that you need $500,000 in life insurance, buy one $500,000 policy rather than five policies of $100,000 each. Every policy includes fixed administrative costs that are unrelated to the coverage amount. Buying multiple small policies means paying those fixed costs multiple times. Consolidating coverage into fewer, larger policies keeps your overall cost lower.

Employer-Provided Life Insurance

Many employers provide life insurance as an employee benefit, often equal to one or two times your annual salary. If it’s free, accept it – free coverage is always welcome. But don’t rely on it as your primary protection.

Group life insurance disappears when your employment ends, whether you quit, get laid off or retire. Your employer can also cancel or reduce the benefit at any time. Furthermore, group policies must accept all employees regardless of health status, which means the claims rates – and therefore the costs – tend to be higher than for individual policies. If you’re in good health, you may qualify for a better individual policy at a lower price.

If your employer offers you the option to buy additional group coverage at your own expense, it’s usually better to decline that offer and purchase an individual policy independently. Talk with an advisor or agent to compare your options.

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