Today I read another ârule of thumbâ about how much life insurance coverage we should choose. PleaseâŚIâm running out of hair to pull out.
Life insurance, for most people, exists for one reason: to create an asset base that you donât yet have which will allow those loved ones you leave behind to live comfortably after youâre 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 âcomfortableâ 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 ârules of thumbâ make me want to vomit. Theyâre not just idioticâŚtheyâll cost you either thousands of dollars in wasted insurance OR youâll leave your loved ones with less than they need.
Stay away from rules of thumb.
In the âbig boy worldâ where we donât rely on the diapers that are ârules of thumb,â we do something that really ainât that hard. We do the freikinâ math.
There are two computations youâll need to do. First, youâll need a capital needs analysis. Second, youâll need to figure out human life value.
Capital Needs Analysis
Donât be fooled by the name. All youâre doing is figuring out the bottom line âneedâ that your family should cover with insurance to survive without you.
1)Â Â Take out your current budget (donât stumble on this one!)
2)Â Â Refigure the numbers without you. How big is the budget now?
3)Â Â Figure out how much your family will need for goals. What do they need to save for retirement, college, etc?
An aside: If youâre married, donât 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 donât care if your spouse gets married after you die. I just donât want her sitting at a singles bar waiting to slow dance with the guy in the Babylon 5 tee-shirt because itâs in the flippinâ plan. Be a grown up and take care of your spouse.
4)Â Â 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)Â Â Backtrack all the shortages (if any) to a sum today that would meet the need.
6)Â Â Subtract from any shortage the amount you already have saved and a reasonable cash amount for the stuff your family will sell.
7)Â Â Boom. Any shortage left? If so, youâve just figured out how much (if any) life insurance is your bottom line âneed.â
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 âbuying what some life insurance agent told me to get.â 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 âwhat your family needs to retire without you,â youâre 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.
Thatâs why we donât stop there. We also perform a Human Life Value Analysis
What Is a Human Life Value Analysis?
Human life analysis looks at the amount youâre worth, in terms of âbringinâ home the baconâ 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 isnât just guilty/not guilty. Itâs 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 theyâd 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 youâd 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 familyâs 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 theyâre a bunch of morons who donât 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 youâll 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 âblows in the windâ because of the big number of perilous assumptions. The human life value number is usually a larger number, but assumes youâll need the deceasedâs full paycheck to continue living. Thatâs 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 youâre 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 âpoles.â From here on out, itâs more art than science. How do you feel about your need?
Generally, people chose a number closer to the capital needs analysis. Low end. Thatâs 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 realizeâŚinsurance isnât free, so whatever you choose, realize that itâll affect either the budget today or the amount your family receives if you predecease them.
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 đ
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.
True, I have the luxury of only being accountable to myself and my better half.
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….
So you’re saying the rule of thumb is about 10 years’ income?
I kid, I kid!
I did similar calculations. I ran the numbers on the budget, and chose an amount where my wife could pay off the house and then invest and life off 4% of the income, “comfortably”.
Dude, leave it to you to stir the pot ;-).
Sweet. Sounds like you did the capital needs analysis.
So…10 years then?
I couldn’t resist. I guess we did both the capital needs assessment and the life value analysis without knowing what they were called. Yay us!
Pot stirrer #2…coming in as expected. đ
This is something I’ll definitely need to get when we have a kid or if our financial situation changes so we need it.
You’re right, Lance! The little I know about your situation means that you probably have a capital need of zero.
Plus, you know where “rule of thumb” comes from, right?
I probably should, but I confess that I don’t….
Pretty sure it refers to how big the stick can be that you’re allowed to beat your spouse with.
If you’re trying to get the life insurance from said spouse….you’re probably going to want it bigger than thumb sized…..
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.
Since debt is minimal, I looked it as income replacement to either reach retirement or minimize changes in lifestyle. I never wanted to force liquidation of investments at inopportune times.
It’s all over the place at the funeral home. Some people have 250K or 500K in coverage or more and other people have policies for as little as $1000. It’s quite shocking to their families to find out that they only have $1000 in coverage.
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.
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 donât want her sitting at a singles bar waiting to slow dance with the guy in the Babylon 5 tee-shirt because itâs in the flippinâ plan. Be a grown up and take care of your spouse.”
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.
I agree, rules of thumb are a waste of time because everyone’s personal cirumstances differ. If I want to take the biggest gamble of my life I’ll go to vegas, I certainly won’t be taking it on the future welfare of my family by relying on a rule of thumb.
I’ve witnessed a number of people over the years that have passed away without life insurance and the spouse and children are not only devastated by the loss of their loved one, but then they suddenly have to scramble around to find money which leaves them very little time to mourn and recover.
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!
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?
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 needâ and itâs 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.
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).
Hmm, betting on a grieving widow getting re-hitched. Didn’t say much about the present marriage, did it?
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?
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…
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.
Most people donât 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, itâs 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 doesnât 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.
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.
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).