Determining How Much Life Insurance You Need

by Stephen Nelson

When considering life insurance, you’re planning and preparing for an event most of us would rather not think about. But life insurance represents a critical step in managing your personal finances and ensuring your family’s well-being. The Two Approaches to Setting Life Insurance Policy Amounts You can use one of two approaches to estimate how much life insurance you should buy: the needs approach or the replacement-income approach. Using the needs approach, you calculate the amount of life insurance necessary to cover your family’s financial needs if you die. Using the replacement-income approach, you calculate the amount of life insurance you need to equal the income your family will lose. Let’s look briefly at each approach. You need how much? Using the needs approach, you add up the amounts that represent all the needs your family will have after your death, including funeral and burial costs, uninsured medical expenses, and estate taxes. However, your family depends on you to pay for other needs, such as your child’s college tuition, business or personal debts, and food and housing expenses over time. The needs approach is somewhat limiting. The task of identifying and tallying family needs is difficult, and separating the true needs of your family from what you want for them is often impossible. Replacing Income Using the replacement-income approach for estimating life insurance requirements, you calculate the life insurance proceeds that would replace your earnings over a specified number of years after your death. Life insurance companies sometimes approximate your replacement income at four or five times your annual income. A more precise estimation considers the actual amount your family members need annually, the number of years for which they will need this amount, and the interest rate your family will earn on the life insurance proceeds, as well as inflation over the years during which your family draws on the life insurance proceeds. Note: Do remember as you quantify the income you want to replace that Social Security provides generous survivors benefits if you’ve qualified. These benefits can easily total $2,000 a month or more. Calculating Replacement-Income Amounts with Excel If you’ve got access to a computer running Microsoft Excel, the popular spreadsheet program, you can use your computer to calculate the amount of insurance you need to replace a specified number of years of income. Suppose, for example, that you want to buy enough life insurance to replace the income from a $50,000-a-year job for 15 years. If you figure your family will earn 5% on the life insurance proceeds should the worst case scenario occur, you enter the following formula into a cell in an Excel workbook to calculate the replacement income life insurance amount: =-PV(5%,15,50000) Excel returns the formula result 518,982.90 indicating that you would need roughly $520,000 of life insurance, invested at 5%, to payout $50,000 a year for 15 years. Two Calculation Tips If you want to factor in inflation because you’re trying to replace income over a long period of time, you should use a real rate of return rather a regular, or nominal, rate of return. To calculate a real rate of return, subtract the inflation rate from the interest rate in the formula. For example, if you expect 2% inflation, you could replace the formula shown earlier with this formula: =-PV(5%-2%,15,50000) Here’s a final calculation tip: You probably want to round up your number. For example, if the formula provided earlier returns the value 518982.90, you might want to round up this value to $600,000. Or $750,000. About the Author: Stephen L. Nelson CPA has written more than 150 books. His bestselling book is Quicken for Dummies, which sold more than 1,000,000 copies. His books have sold more than 4,000,000 copies in English and have been translated into more than a dozen other languages. His web site is http://www.stephenlnelson.com Source: www.isnare.com

Life insurance, the universe and everything

by Rachel Lane

If you have yet to consider taking out any life insurance, don't worry -there's plenty of information out there including consumer organisations such as which? and moneynet. Start with some simple, easy questions such as: * Would my dependents need a lump sum, such as to pay off the mortgage? * Will they need a replacement income? * Should my partner and I both take out life insurance? You need to ensure whatever life insurance cover you take out accommodates funeral expenses, an emergency fund to encompass household expenses in the short term, repayment of the mortgage, repayment of any other loans, inheritance tax, bequests in your will to people - in addition to your dependents, any other possible lump-sum expenses. Life insurance broadly falls into two categories: term life insurance (protection only) and investment type. Term insurance is the cheapest type of life insurance and provides a pay-out if the person / policy holder dies within a selected period of years. If you survive beyond the given period of years, then no pay-out is given. Investment insurance advises that you should choose a whole-of-life option which is a form of investment type policy. Whole-of-life insurance provides cover for as long as the policy holder lives. The policy must eventually pay out and therefore builds up an investment value which can be cashed in by surrendering the policy. However, it often takes many years for a surrender value to build up and in general, whole-of-life policies are expensive if your main requirement is protection, the same is true endowment policies. Endowment policies are investment insurance products which pay out upon the death of the policy holder and also if they survive. If you're considering term life insurance, bear in mind there are multiple variations encompassing increasing term insurance, increasable term insurance, decreasing term insurance, renewable term insurance, convertible term insurance, family income benefit insurance and pension linked term insurance. Increasing term insurance Increasing term insurance is just like basic term insurance, except that, as the name suggests, the level of cover increases - typically alongside the premiums. This policy is suitable for long-term insurance as increasing prices reduce the value of a fixed level of cover over policy period. Increasable term insurance Increasable term insurance provides the option of increasing the level of cover either at specific intervals (such as anniversary of policy start date) or specific events (such as marriage or birth of a child). Premiums increase for additional cover, but they are based on your health at the start of the policy, even if it has since deteriorated. Decreasing term insurance Decreasing term insurance reduces cover year on year, with the policy holder usually requiring the cover for loan repayments such as a mortgage or to cover a potential inheritance tax bill. Renewable term insurance Renewable term insurance gives the policy holder the option to extend the insurance term when it comes to an end; the premium paid is the same at the start of the term, in spite of any deterioration in the policy holder's health. This may be beneficial to parents whose children stay in full-time education longer than originally intended. Alternatively if someone cannot afford the cover for the period they want, they could take out cover for a short period and extend it later with slightly high premiums. It might be a financial jungle out there, but it's not impossible to navigate your way through to financial security. Resources: About the Author About Rachel: Rachel writes for the personal finance blog Cashzilla. http://www.cashzilla.co.uk Rachel eats a lot of Green and Black's chocolate, particularly Maya Gold -it's delicious and fair-trade too.

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