Learn more about Life Insurance than your Insurance Agent knows part 12

So at last we are at the end of this 12 Part series! Once you have finished reading this article, I’m sure you will know more about insurance than most insurance agents out there – and at least enough to know when they are trying to dazzle you with smoke and mirrors… :) If you would like to start at the beginning, click here to go to part 1. If you would just like to go back one article to Part 11, click here.

So I promised that I would end the series by discussing how YOU can determine how much insurance you require, rather than being "told and sold". By no means does this mean that I am done commenting and educating on insurance, it just means I am done with this "primer" on insurance. I will keep on posting on insurance in the future, as well as many other topics – so make sure to subscribe to my RSS feed (link at bottom of page) if you like what I have to say.

Okay… So how much life insurance do you need? Unfortunately I have come across way too many people who have no idea why they have as much insurance as they do. The reasons range from "My father told me to get this amount" to "It sounded like a good number" to "I really don’t know". I find that very few people really know why they bought what they bought, and more importantly – HOW TO ADJUST IT AS TIME GOES ON.

A good starting point is to start with a ballpark figure based on a simple set of calculations. Trust me, they are simple. Once you understand the basic philosophy behind the ballpark calculation, you can then get more detailed with your own situation and preferences. Many calculations will vary based on your personal preferences as you will see.

To start with, we need to realize that we have two types of needs: IMMEDIATE cash requirements, and ON-GOING cash requirements.

IMMEDIATE CASH REQUIREMENTS are expenses that are incurred upon the death of a spouse. For example, one main desire is to have the mortgage paid off, along with all other debts (i.e. credit cards). A funeral would also be an immediate expense. The life-insured also may have some desires such as making sure the children’s educations are paid for and would like to have a lump sum added to the immediate requirements for this purpose. They may also want to allow for the surviving spouse to take 6 months off work for bereavement. All of these needs and desires need to be added up.

ON-GOING CASH REQUIREMENTS: normally, both spouses will have estimated how much household income will be required should one of them die to maintain the household’s lifestyle. A quick method would be to take the total household income currently and multiply by 75%. So if one person made $100,000 and the other made $50,000 (for a total of $150,000) then 75% of this number would be required to maintain the family’s lifestyle after the death of one spouse. You can also calculate the exact number if you desire by subtracting certain expenses that immediately disappear when that spouse dies (i.e. vehicle payments for their car, clothing for work, meals, hobbies, etc.) if you want to be more accurate. But certain things you’ve gotten used to (i.e. vacation with the kids to Disneyland every year) you may want to maintain and this, coupled with other expenses may be too much for one income. Depending on if the remaining spouse wants to work or focus on raising the kids, or if the remaining spouse was the "bread-winner" or not, this "on-going household income"  number can vary quite a bit.

So now we have talked about the two main types of needs: Immediate and On-Going.  But now we need to subtract what you already have in terms of assets and estimate the surviving incomes to find out what the shortfall is.  You purchase insurance for the shortfall – not the total amount of your requirements.

A very easy way to sort all of this out is with the following chart:

You can see that in the top two boxes, if you read across like a math equation you are taking the Immediate Needs at Death and subtracting from that the Immediate Resources at Death.  This would include things like current insurance in effect (i.e. if you have insurance coverage through your work benefits), savings that you would be willing to use (and this may or may not include RRSPs depending on your preference), etc.  In the above case we see that the current assets and insurance do not quite cover the immediate needs at death and there is a $105,000 shortfall.

If we move to the bottom two boxes we have the Ongoing Family Income Requirement.  In this case, the family has decided that once the mortgage and other debts are paid off, and if the children’s education funds are accounted for, then they don’t require an extravagant amount of money to keep the surviving family members’ standard of living in tact.  FURTHER, in this case the surviving spouse would like to keep working (perhaps the children are old enough to not need supervision during the day) and we need to subtract this Ongoing Family Income after Death, from the Ongoing Family Income Requirement.  In this case there is a small shortfall of $20,000 per year.

The key to that last sentence is "PER YEAR".  So $20,000 in life insurance today will only cover that deficit for 1 year and naturally the surviving spouse may require many years of covering that shortfall.  Let’s assume now that they require that shortfall for 18 years, until the kids move out of the house.  At that point, they can live on one income.  There are numerous ways to provide for this shortfall, and again it comes down to personal preference, but let’s walk through the options.

The simple way is to take 18 years and muliply by $20,000, not worrying about inflation or growth on the lump sum.  In this case that works out to $360,000.  Add that to the $105,000 in immediate needs at death and this policy would require coverage of $465,000.  After 18 years, there would be no more insurance money to use, but presumably the remaining spouse is now free of the kids living with them, and has potentially found a new partner, etc.

Another option is known as the Capital Retention Method.  In this case you calculate how much of a lump sum invested each year at a conservative rate of return (i.e. if the lump sum was put in government bonds – we’ll call it 5%) would produce $20,000 per year in interest after tax.  Working backwards: $20,000 after tax is equal to $28,500 before tax (assuming roughly 30% marginal tax rate).  $28,500 would be produced by a lump sum of $570,000.  If you add this to $105,000 you have a total coverage requirement of $675,000.  The thing to note is that they will always have the $570,000 lump sum – and many people like this method because it provides for a retirement nest egg for the surviving spouse as well as providing an ongoing income until that point.

The last main method is the Capital Depletion Method.  In this case you would encroach upon the capital such th
at each year the $20,000 w
ould be funded by the return of the investment of the lump sum PLUS selling off part of the lump sum itself.  Eventually, at the end of 18 years the lump sum will have been depleted.  Using my trusty financial calculator I can tell you that  you would need a lump sum of roughly $280,000 invested at 5% assuming a marginal tax rate of 30% to provide $20,000 in after tax income for 18 years.  Added to $105,000 gives you $385,000 in total insurance required. Again at the end of 18 years, you would have no insurance money left.

Note that I have not included the math for factoring in inflation.  You can do this easily by subtracting the inflation estimate from the rate of return estimate.  For example if you think inflation will run 3%, and you think you can get 5% on your conservative investment, then you would use 2% as the REAL rate of return on your lump sum investment.  By dividing by a smaller number you get a larger answer (i.e. a larger lump sum that will account for inflation).  And if you really want to get fancy you can factor in the time value of inlfation as well – but that’s beyond the scope of this post so I’ll just leave it be.  Suffice it to say, when factoring in inflation for the Capital Depletion method the lump sum amount increases from $280,000 to about $370,000.

A couple more points to finish off and then we’re done! Which of the above 3 methods is the best?  Perhaps the best way to figure that out is to calculate the premium costs of each.

For a 30 year old male, non-smoker:

$465,000 Term 10 would be $29.86/month (18 years x $20,000 + $105,000)

$675,000 Term 10 would be $37.25/month (Capital Retention method – lump sum invested – no depletion of principal)

$385,000 Term 10 would be $25.60/month (Capital Depletion method – lump sum invested WITH depletion of principal)

Personally I would choose the Capital Depletion method – it will be the cheaper option, while still providing the proper amount of insurance and doesn’t give your spouse THAT much of an incentive to kill you! :)  The effect of inflation doesn’t really bother me that much since over a longer course of time, I don’t think a remaining spouse will require as much ongoing assistance as time goes on for reasons mentioned above.  But it’s all up to your personal preferences…

The last point I want to make is establishing how to figure out how much goes into Term and how much goes into Whole life.  Normally you would match the need to the product (as they say).  Term is a temporary solution.  Whole life (aka permanent insurance) is a permanent solution.  The only permanent need is the need for funeral expenses. All the other expenses generally approach zero as you get older (mortgage gets paid off, kids eventually go to school, spouse eventually retires).  But no matter what, you will always have a funeral to be paid for.  In that case, you could consider a Whole Life policy on that amount ($25,000) and Term for the rest.

Generally it makes more sense to get the shorter terms (5 or 10) because as you get older and acquire more assets and pay off debts and mortgages, your need for insurance goes down.  You can always adjust the coverage you have downwards by filling out a form – and therefore reducing your costs over time.  If you get longer terms, then you are over paying if you know you are eventually going to lower your coverage at a later date.

And finally, finally: For the above scenarios, I don’t think I would even bother with the Whole Life since if you are lucky enough to die when you are old, you will have had enough time to save up for a funeral (i.e. it could be taken out of your RRSPs or other savings without impacting the financial stability of the remaining spouse) so even the funeral expense could be considered a "temporary" expense since the need to cover the expense really only exists when you are younger.

Allright, I will end the 12 part series on "Learning more about Life Insurance than your Insurance Agent knows" right here! I hope you have enjoyed the series and if you found it of interest, I would appreciate if you could spread the word so that more people can learn more about it.  I’m sure I will have some comments and clarifications to make and plan on making amendments to the series over time in order that it only gets better and better!

 Thanks for your time…

Related posts:

1. Learn more about Life Insurance than your Insurance Agent knows Part 8
2. Learn more about Life Insurance than your Insurance Agent knows Part 9
3. Learn more about Life Insurance than your Insurance Agent knows Part 6