How Much Life Insurance Coverage Do You Need?

Updated: July 23, 2020

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 properties and investments.

So also imagine, will your loved ones and heirs have the capacity to pay 6% of the value of your assets as estate taxes 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 at 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:

A. 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

B. EDUCATIONAL COSTS
This should be the total for all your children

C. ASSET VALUE x 0.06
This is to cover the 6% estate taxes of your assets

D. MISCELLANEOUS
This is the cost of hospitalization and/or funeral costs when you die

The formula to compute how much life insurance coverage you need is: 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 the 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 (D), unfreeze your assets (C), send your children to school (B), and help them survive a few years (A).

Once your family liquidates 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.

EXAMPLE COMPUTATION

NEEDS

1. MONTHLY EXPENSES x 60: P50,000 x 60 = P3,000,000.00
2. EDUCATIONAL COSTS: P1,000,000.00
3. ASSET VALUE x 0.06: P3M x 0.06 = P180,000.00
4. 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: P2,480,000

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: P5,480,000

Step 5: Get 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; and especially if your budget is tight.

More importantly, always remember that “Personal Finance is Personal” – so you should adjust the figures above according to your situation.

One option is to get life insurance that covers only one part of the formula such as the “MONTHLY EXPENSES x 60” part if you can’t afford to get “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 for life insurance.

ADDITIONAL INFORMATION:
One of my colleagues, Alvin Tabanag, shared these in the comments section, and I decided to add his points here. He writes:

The calculation can be refined further so as not to overstate the required coverage.

1. The estate tax is applied to the net estate (total assets less allowable deductions which can reach about P2M)

2. For monthly expenses include only the amount covered by the one getting the insurance. For example, if the household expenses are equally shared by the husband and wife, then only 50% of the expenses should be used in the calculation. If the husband-wife share is 60-40, then use 60% of the expenses to calculate the insurance needs of the husband.

3. The same thing applies in calculating coverage for educational needs.

To avoid understating the need the following should be considered:

1. Consider only the assets that will be used to cover living expenses and other financial needs when the insured dies. If the P3M asset above includes, say, the family’s residence, it’s unlikely that it will be sold by the heirs to cover their expenses when you go. So this should be excluded in the calculation.

2. Include any inheritance money you would like to leave your heirs.

3. Include coverage for debts if payments are not included in the monthly expenses.

4. Miscellaneous items can also include emergency funds and vacation/leisure fund (that is if you still want your family to enjoy after you’re gone).

Update:
This post has been edited to accommodate the TRAIN Law which reduces the estate tax rate from 20% to 6%.

What to do next: Click here to subscribe to our FREE newsletter.
———
Photo credits: alancleaver and imarlon