How Much Life Insurance Coverage Do You Need?
This article is posted under Personal Finance.
If you have dependents or a family breadwinner, then you need life insurance.
If you’re not sure if you need one, then just imagine what would happen to your loved ones when you die tomorrow.
Will they be able to survive and continue living the way they are doing now, or will their lifestyle suffer and experience financial difficulties?
Moreover, when you die, all your assets get frozen, and your heirs will have to pay estate taxes to liquidate or transfer ownership. Do note that by assets, I mean all your cash deposits, properties and investments.
So also imagine, will your loved ones and heirs have the capacity to pay 20% of the value of your assets as estate taxes (which should be paid in cash, and hopefully within 6 months) when you pass away?
If the scenarios you imagined are bleak, then life insurance is your best solution.
Now that you understand why you need life insurance, the next question you need to answer is exactly how much coverage do you need?
And today, we’ll take a closer look on how exactly do you calculate this figure. Below is a step-by-step guide which I hope you find useful.
Step 1: Calculate Your Net Worth
Your net worth is simply the value of all your assets, less your total liabilities.
This means if all your assets are worth P3M and you have P1M worth of liabilities, then your net worth is P2M. If the figures are the other way around, then you have a negative net worth of P2M (or -P2M).
To help you compute your net worth, you can read this post: How To Make A Personal Statement Of Assets And Liabilities To Calculate Your Net Worth
Numbers to note in this step: ASSET VALUE and NET WORTH
Step 2: Calculate your family’s monthly living expenses
How much does your household spend in a month?
If you don’t know, then you have to start tracking your expenses now and more importantly, learn how to create a budget.
Number to note in this step: MONTHLY EXPENSES
Step 3: Compute the educational needs of your children
Every parent wants to see their child finish school, and that’s why it’s important to ensure that you’ll be able to provide for their educational needs. You can work hard and invest your money while you’re still alive, but what if you pass away before your investments have enough time to grow to cover their tuition?
Here’s a post that can help you estimate this cost: How Much Will The College Education of Your Child Cost?
Moreover, consider adding to this your child’s costs for preschool and K12 education. And you should do this for every child you have.
Number to note in this step: EDUCATIONAL COSTS
Step 4: Tabulate the numbers
Add the following, the total will be your NEEDS:
- MONTHLY EXPENSES x 60
- The number 60 is meant to give your family 5 years to “get back up on their feet”, and depending on your family’s situation, this can be as little as 24 or 2 years
- This should be the total for all your children
- This is to cover the 20% estate taxes of your assets
- This is the cost of hospitalization and/or funeral costs when you die
The formula to compute how much life insurance coverage you need it:
LIFE INSURANCE COVERAGE = NEEDS – NET WORTH
Please be careful with this formula, particularly when plugging in your net worth.
If you have a positive NET WORTH, then that value gets subtracted to your NEEDS.
But if your NET WORTH is negative, then by law of Mathematics, the “double negative” becomes a “plus sign” – which means you’ll be adding the NET WORTH and NEEDS.
The value of NEEDS will cover the immediate costs of your death (4), unfreeze your assets (3), send your children to school (2), and help them survive a few years (1).
Once your family liquidate your ASSETS, it can now be used to pay for your LIABILITIES. If you have a positive NET WORTH, what’s left can be used as a source of fund for the NEEDS (that’s why it’s subtracted) – and that’s why you can afford less insurance coverage.
If you have a negative NET WORTH, then your family needs more money to pay for them, which will be covered by the life insurance since you “added” that value to the coverage.
I hope you were able to follow all the steps and tabulation above. If not, then I hope the two examples below can help you understand this better.
- MONTHLY EXPENSES x 60: P50,000 x 60 = P3,000,000.00
- EDUCATIONAL COSTS: P1,000,000.00
- ASSET VALUE x 0.20: P3M x 0.20 = P600,000.00
- MISCELLANEOUS: P300,000.00
Positive Net Worth Breadwinner
If the ASSETS is worth P3M and this person’s LIABILITIES are worth P1M, then his NET WORTH is P2,000,000. Thus, this breadwinner’s life insurance coverage should be: P2,900,000
Negative Net Worth Breadwinner
If the ASSETS is worth P3M, but this person’s LIABILITIES are worth P4M, then his NET WORTH is -P1,000,000 (negative). Thus, this breadwinner’s life insurance coverage should be: P5,900,000
Step 5: Get a term life insurance
No use in calculating all these numbers if you don’t get life insurance in the end, so this is your fifth and final step. I recommend getting TERM LIFE INSURANCE because it is the most affordable type of life insurance.
More importantly, always remember that “Personal Finance is Personal” – so it’s best that you adjust the figures above according to your own situation.
One option is to get term-life insurance that covers only one part of the formula such as the “MONTHLY EXPENSES x 60″ part if you can’t afford getting “full coverage” now, and just get a new policy when your cashflow gets better to cover for the remainder.
Also, don’t buy life insurance from the first agent you meet. Shop around and see which one gives the best insurance quote, with consideration to the company’s stability and quality of client service.
I hope you learned something new today, and now have a better appreciation on life insurance. Should you wish to receive assistance in getting life insurance, I’d be glad to refer you to my agent.
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