Life Insurance: Why People Choose the Wrong Amount

Today I read another “rule of thumb” about how much life insurance coverage we should choose. Please…I’m running out of hair to pull out.

Life insurance, for most people, exists for one reason: to create an asset base that you don’t yet have which will allow those loved ones you leave behind to live comfortably after you’re gone.

If you accept my definition of why life insurance exists, ask yourself this:

How the heck does anyone with a rule of thumb know the answer these questions:


What size asset base does your family will need?

What does “comfortable” mean to you (and those you leave)?

How long until they retire/go to college/need the cash?

What does your asset base look like now?

You can see why “rules of thumb” make me want to vomit. They’re not just idiotic…they’ll cost you either thousands of dollars in wasted insurance OR you’ll leave your loved ones with less than they need.

Stay away from rules of thumb.

In the “big boy world” where we don’t rely on the diapers that are “rules of thumb,” we do something that really ain’t that hard. We do the freikin’ math.

There are two computations you’ll need to do. First, you’ll need a capital needs analysis. Second, you’ll need to figure out human life value.


Capital Needs Analysis


Don’t be fooled by the name. All you’re doing is figuring out the bottom line “need” that your family should cover with insurance to survive without you.


1)   Take out your current budget (don’t stumble on this one!)

2)   Refigure the numbers without you. How big is the budget now?

3)   Figure out how much your family will need for goals. What do they need to save for retirement, college, etc?


An aside: If you’re married, don’t be an ass and assume your spouse is going to get re-hitched when you pass away. When I was an advisor, I had some dumbs$%!s tell me that, and I about laughed them out of my office. I don’t care if your spouse gets married after you die. I just don’t want her sitting at a singles bar waiting to slow dance with the guy in the Babylon 5 tee-shirt because it’s in the flippin’ plan. Be a grown up and take care of your spouse.


4)   Check the budget against the goals. Is there enough to save AND reach the retirement/education/savings goals. If not, track the shortage and add inflation each year.

5)   Backtrack all the shortages (if any) to a sum today that would meet the need.

6)   Subtract from any shortage the amount you already have saved and a reasonable cash amount for the stuff your family will sell.

7)   Boom. Any shortage left? If so, you’ve just figured out how much (if any) life insurance is your bottom line “need.”


Why Capital Needs Analyses Are Awesome


A capital needs analysis is great because it gives you a bottom line number based on your own goals. No rule of thumb, no “buying what some life insurance agent told me to get.” You have an actual number.


Why Capital Needs Analyses Stink


Go back to my six points. ALL of these numbers are blowing in the wind. The second you look at “what your family needs to retire without you,” you’re betting on inflation, rates of return on investments, and future behavior of your loved ones. Can you predict any of this? To a degree, yes. However, you and I both know this number will be wrong.


That’s why we don’t stop there. We also perform a Human Life Value Analysis


What Is a Human Life Value Analysis?


Human life analysis looks at the amount you’re worth, in terms of “bringin’ home the bacon” if you were to die tomorrow. Have you ever seen those wrongful death lawsuits where a family is awarded millions of dollars? The big fight between the family and the insurance company isn’t just guilty/not guilty. It’s actually about how smart the deceased was about managing their own money.

In human life value you assume that a person would continue to earn money if they were to still live a normal life through retirement. You also assume they’d retire at a reasonable age, which usually is 65. Then you assume that the deceased would receive reasonable raises.

All that human life value represents is the sum that you’d earn throughout your life, present valued to a single pot of money today. In short: how big a pot of money today would make up for the family’s loss of your income.


Another aside: families and insurance companies often switch sides during a human life value argument in court. The family, hoping for a bigger pot of money, pretends they’re a bunch of morons who don’t know investments. Why? An investment savvy family might receive a smaller award because the assumed return on this money will make up the difference.  The insurance company argues that the family is incredibly savvy, so that they can award a smaller check  (because the family will be able to make up the difference in funds through investment returns).

Human life value numbers, as you can imagine, are huge (even if you are investment savvy and assume you’ll earn 8% on your pot of money).


How Much Life Insurance Should I Buy?


Now you have two numbers. The capital needs analysis produced a number that is small and “blows in the wind” because of the big number of perilous assumptions. The human life value number is usually a larger number, but assumes you’ll need the deceased’s full paycheck to continue living. That’s improbable.


The Field Goal


I used to perform these two calculations for my client and told them that now they needed to kick a field goal. If you’re not familiar with football, a field goal is a kick between two upright poles. Your correct amount of insurance is somewhere between these two number “poles.” From here on out, it’s more art than science. How do you feel about your need?

Generally, people chose a number closer to the capital needs analysis. Low end. That’s what I did. However, I had clients who wanted to be midway between the numbers and one family who only felt comfortable at the human life value number.  There is no right answer here. My clients who chose the smallest possible number would have been unhappy with more insurance. The ones who chose the full human life value would have had trouble sleeping at night with less. Just realize…insurance isn’t free, so whatever you choose, realize that it’ll affect either the budget today or the amount your family receives if you predecease them.

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  1. says

    We chose $500k each in 20 year level term. It’s enough to cover all our debts, plus enough to pay for the other things that would be difficult to otherwise pay for after the loss of income (kids’ college mainly) and produce some passive income. It bothers me when people buy huge amounts of insurance so that the survivor will just be rollin’ in the dough after their spouse dies unexpectedly. Psychologically I think it’s dangerous for someone to be worth more dead than alive, but that’s just me :)
    David W recently posted..A Closer Look at Cash Value vs Term Life InsuranceMy Profile

    • Average Joe says

      After hearing lots of clients talk about where they want to be in the field goal, I think it’s dangerous for me to assume what other people are going to want.

      • Average Joe says

        Exactly. That said, I’m like you. I want to be as close to the cap. needs number as possible. I wanted nothing to do with replacing my human life value. Don’t want Cheryl serving me mushrooms, thank you….

    • Average Joe says

      You’re right, Lance! The little I know about your situation means that you probably have a capital need of zero.

  2. says

    See, the way I look at it, Mr. PoP would need more than my income contributions if I were to kick it because if he got married again there’s no way she’d geek out on the numbers as much as I do. Plus he’ll need some extra cash to buy a nice new car and clothes to woo the ladies, right? I hear dating can be pretty expensive these days. =)

    Realistically, we make sure that we’ve got enough so the other person has plenty to pay back all outstanding debts. For now that’s good since it’s in line with the coverage our employers cover for us free of cost – so no need to knock the coverage down as we pay debt off.
    Mrs. Pop @ Planting Our Pennies recently posted..PoP Income Statement – January 2013My Profile

  3. says

    Now that I have a wife and a house, life insurance is definitely something I need to really sit down and think about. I definitely do not have my wife remarrying in the plan! That’s a really sad approach…hard to believe people actually factor that in.

    Funny about how the human life value argument…I can definitely see how insurance companies and families would switch sides.
    DC @ Young Adult Money recently posted..15 Tips for Planning and Preparing for a VacationMy Profile

  4. says

    Great post! Definitely including it in this weeks Round-Up! I’m still single so I picked a 30 year 500k cause this will cover my mortgage and car loan cause I didn’t want to leave any impossible debt to my beneficiary. I wondered if I should have done 1m like some others but after reading this feel confident with my decision.

    This was hilarious!
    “I just don’t want her sitting at a singles bar waiting to slow dance with the guy in the Babylon 5 tee-shirt because it’s in the flippin’ plan. Be a grown up and take care of your spouse.”
    John @ Fearless Men recently posted..Valentine’s Day Date-Getting Ahead Planning The Perfect Valentine DateMy Profile

  5. says

    I agree full completely. I hate the terminology “rule of thumb!” As you pointed out everyone’s situation is different and consist of complex factors. We factored in our debts (not much), current expenses, and future expenses when calculating the toal for our life insurance.

  6. says

    I really struggle with the right amount of life insurance. I think if whoever was left had enough to pay off all the debts and take a year off work if desired, that would be our ideal number. We also have our rental properties to generate some passive income or those could be sold.If I’m the one left, I would never remarry. It was hard enough to train the first husband!
    Kim@Eyesonthedollar recently posted..99 Money Problems Solved with a $999.99 GiveawayMy Profile

    • Average Joe says

      Ha! That’s funny. It took Cheryl forever, too. Obviously, I think completing these two analyses and then picking a spot between them is the way to go. You’ve clearly defined your goals…now all you need is the number. How hard is that?

  7. says

    Oh dear you post sound amazing lots of people will find this post helpful. Well I give you 3.5 stars for this helpful post. I think many people know about insurance plan but they don’t know about the “how much life coverage they need” and it’s because lots of adviser who don’t disclose the many facts with peoples. May be this is the only reason people don’t know about the same. HLV is the best idea for calculate the future needs value and I think your post will help those people who don’t know anything about the same question. Thanks.

    • Average Joe says

      Remember that HLV is usually the high number. I’m not sure HLV is the best way to go, but it tells you when you’re clearly spending too much (if you’ve gone higher than that figure).

  8. says

    Here’s a good question to be asking yourself. If I had to write you a check today in return for you to assign me every single paycheck you earn for the rest of your life . . . how much would I have to write you a check for today?

    Most younger people think 1 million dollars is a lot of money, when almost nobody I ask this question to settles for less than severall million dollars. So, what is the gap between what you really think and what your life insurance need really is?

  9. Bichon Frise says

    There’s also the analysis of, if you’re young and in good health, why not add a little to the top? It’s so cheap, and the future is so uncertain, that a little extra can only help for a small increase in premium. Not to mention…inflation – which erodes your benefit AND premium (for term, of course). Think of it as buying an option…

    • Average Joe says

      Great comment, Bichon. That’s why I love the human life value analysis…it accomplishes much of what you’re talking about. HLV is usually a big number that will completely replace your salary vs. the “just might be exactly enough” approach of the capital needs analysis. Once I have the HLV analysis, I then start looking at price vs. amount I receive (as well as term I’ll need). Bumping up is often a big value for only a few bucks.

  10. says

    Most people don’t realize, a lot of captive agents have a hard time getting their clients approved because their company has very strict underwriting guidelines.If you have any type of pre-existing condition, diabetes, high cholesterol, drug abuse, sleep apnea, congestive heart failure, it’s imperative that you relay all the facts, all your medical history, all your current history, to the insurance company.Another mistake that individuals make when having a hard time trying to get life insurance is that they choose one company hoping that they will get approved. While getting denied by an insurance company doesn’t make it impossible to get life insurance, why not get an opinion before you apply and go down the formal process. This is what we call doing a pre-questionnaire.

    • Average Joe says

      Excellent comment, Mabel. I like the pre-questionnaire, especially if it’s off the record. Life insurance companies share information using a process called the medical information bureau. When you are denied for insurance coverage it’s like you’re the person who everyone in high school is talking about….you can keep applying but everyone knows your history already.

  11. TimothyG says

    Interesting take on banishing the rule of thumb. It’s got the classic elements I usually use to decide: calculations that include income replacement and inflation, coupled with an ‘artful’ educated guess that chooses realistically. Your method is more defined, though! When people look up quote generators for life insurance quotes, they also sometimes use Life Insurance Needs Calculators (the non-profit Life Happens also has one).


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