Calculating Life Insurance Needs: Capital Needs Analysis

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There are a bunch of different ways to determine how much life insurance you need, from a simple “ten times your salary” to complex Monte Carlo simulations. Somewhere in between is the “capital needs analysis”, which is often used by insurance brokers and financial planners. This is what most online life insurance calculators use (examples here, here, and ), although I like the idea of doing it by hand to play with the numbers. I have a brochure from my State Farm agent with some stats, and also found another good example in .

What is your goal?
Here’s the fun part. You get to imagine you’re dead. Will the remaining partner stay at home with the kids? Work and pay for daycare? Some people basically want to replace everything – their future income and also leave an inheritance or other lump-sum. Others want to make sure their dependents would be able to live as close to the “same life” as possible. This means staying in the same house, working (or not working) at the same jobs, driving the same cars, the same lifestyle. Then there is the “adapted life” approach, where maybe they would downsize somewhat, but have all the critical areas covered.

How much monthly income will your survivors need?
It’s usually easier to think of this monthly, and then multiply by 12. Include housing, transportation, education, childcare, insurance, entertainment, and perhaps also regular retirement savings. The average cost of daycare for a 4-year-old is around $8,000 per year. Now subtract any sources of income. The survivor’s salary, existing passive or investment income, rental income, Social Security benefits, etc.

Then, you have to decide what amount of money can create this income. Lots of guessing on your rate of return and length of withdrawal period is involved here. If you are young, you could buy an immediate annuity which will pay out about 4% inflation-adjusted a year (a certain % will be taxable). This is the same as multiplying by 25. So to create an annual income of $40,000 per year, you’d need a lump sum $1,000,000. As you get older, the payoff gets better. A more conventional approach seems to multiply by about 15.

Add in lump sum expenses
You’ll probably want to take care of debts like student loans, credit cards, funeral costs, and medical bills. A recent survey put the average funeral cost at over $6,000. If you haven’t already accounted for it above in housing, you may want to pay off the mortgage on your home or set aside money for retirement. Finally, you may want to consider the education costs of your children. The average cost for tuition + room/board for an in-state college is now nearly $14,000 per year.

Add these two big numbers up, and you have you future capital needs. You can then subtract out the insurance you have through work if you like. Finally, you should subtract your current assets, taking into account their liquidation restrictions. The difference provides an estimate of how much life insurance to shop for.

This all sounds simple, but in going through it myself there are so many variables. For starters, most couples will probably have different insurance needs for each person. Do I really want to pay off the entire house, or just allot for the mortgage payment? How many kids am I supposed to plan for? I end up with a number anywhere between $500,000 to more than $1M depending on different assumptions. (I’m open to advice here.) The good thing is that I am hoping that each $500k of coverage will only be about $30/month. I also may end up buying multiple life insurance policies as life goes on and stack them on top of each other.

If you buy a 30-year term policy with $500,000 of coverage now, at 3% annual inflation that you benefit will only be worth half as much after 23 years. But I don’t really worry about that, because for every year that I keep living, I should be saving enough that I don’t need as much coverage. And after the end of my term, we should have enough assets so as to not need any life insurance at all.

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  1. Chad @ Sentient Money says:

    Good advice. I have no need for life insurance right now (no wife or children), but I enjoy it when people challenge conventional wisdom/rules of thumb.

  2. i treat life insurance as an emergency savings, rather than a lottery. so, like you said at the end there, you should be saving enough to not need it at the end of your term. however, i doubt you would even need a 30 yr term at the rate you’re going. in 15 yrs, i’d think you guys would have enough so if something happened to one of you the other could ‘survive’ just fine off your savings/retirement portfolio at that time.

  3. Jerry Dill says:

    Life insurance should be considered a valuable investment. You must figure out how much you have saved over a certain period of time. Figuring this out and how much you will make in the next couple of years if you invest your money now is important. Many people may be surprised at how much life insurance they really need to take out.

    It’s always about percentages. Be careful not to pay too much for life insurance. It may be unnecessary.

  4. Yep. The calculators and rules of thumb are good for an easy answer, but the only way to do it is to plan what life would be like if you died tomorrow.

    Now you know why so many people would rather have a root canal than take care of their life insurance.

  5. Inflation is an important factor, but any decent life insurance calculator should take that into consideration. So if it spits out a number of $750,000 it should mean that life insurance totaling that amount should get your survivor through to retirement (or until the kids are grown, or however long you want it to last) with inflation factored in.

    A few other considerations: Social Security (your survivor should qualify if you have children), annual return on the invested portion of the insurance proceeds, and taxable insurance (employer-paid) vs. non-taxable (self-funded) insurance.

    I put together my own insurance calculator about a year ago and, surprisingly, my own estimate of insurance needs came in higher than most calculators I found. Although I don’t want to spend any more than I have to, life insurance isn’t something I skimp on either. I think of it in terms of the quality of life I want if my wife were to die; single parenthood would be hard enough but the grief would probably be crushing. Not a time to have to worry about money. So I want a reasonable financial cushion to take one major worry off the table. And I want the same for my wife if I were to die early.

  6. TarponCrest says:

    I have found that as one gets older and personal savings increases the need for life insurance decreases however ones health decreases as well thus less of a chance to get an underwriter to insure you for a guaranteed 30 year term.

    I like the idea of life insurance as a double for inheritance ( this is tax free money up tp 2,000,000.00 to the surviving beneficiary). I have calculated that the best age for the “gamble” is 58 for the purchase of a final 30 year term life insurance ( after that age it is almost impossible to get coverage for 30 year term guaranteed). I calculated that even with the highest premium I could find one would still end up getting more than what one put in to premiums ( at least 43% taking inflation into account).

    So if the gamble pays off and one gets sick and dies before age 88 (realistic for many of us specially men) then the beneficiary/s will get all the money back you paid into the policy at least 30% more (think of it as interest) and it is all TAX FREE!!. ( If you just leave the surviving party cash they will have to pay taxes on that money you left them).

    On the other hand if you live past the term date you still have all the other conventional savings and portfolio plans to cover the losses of the insurance cost. (most of the losses would have gone to taxes anyway had one just saved the life insurance premiums unless you plan very well.)

    To me it is worth the gamble since it is one of the few things I can leave to my family Tax Free. ( and they can use all my money to pay for expenses I leave behind so they don’t have to use the insurance (tax free money).

  7. As you said, rules of thumbs are great, but they really don’t indicate how much you may need. The best way to determine this is to sit down with a life insurance agent and do a needs analysis. In addition, you should re-evaluate their life insurance needs every 3-5 years. Situations change (marriage, divorce, more kids, etc.) and so should life insurance

  8. Carolyn says:

    Hello I have a life insurance policy that has cash value Im single and i have alot finicial hardship I really could use this money for living means I have no income coming in And i was wondering if i close the policy will i just get the cash value I have try every situation to turn my situation around
    do you think is a smart move thank you Carolyn

  9. clicclic says:

    I’m working with a life insurance agent right now and have learned a lot over the past few weeks.

    Two things that make sense to me (now that it’s too late for this old geezer):

    * Signing up for a whole life policy in your twenties is smart. Your premiums for the rest of your life will be seriously LOW and you will ace the physical – establishing yourself as ‘preferred’ or even higher. Inflation will ensure your premium gets cheaper and cheaper over the years.

    * Whole life can be looked at as a hedge against your own stock portfolio or even another type of investment. As you know – you can withdraw from it later in life.

    Slightly unrelated: One thing that worries me at the moment is insurance companies are having serious financial problems, just like wall street. Our entire economy seems to be built on the concept of increasing land values; when land values are decreasing, even insurance companies are shaky…

  10. Derik A. Tutt says:

    You did a great job of touching the important aspects of an insurance needs analysis. There are a lot of factors that folks should consider when purchasing life insurance. There’s a lot more to it than picking a number out of the sky that sounds good. Many times people buy the wrong type of insurance or don’t purchase enough. Thanks for spreading the word on how to arrive at an adequate figure.

  11. OK. Mr. Ping said in 2008 he would have enough money saved in 30 years that he will not need life insurance. It’s 2016. I wonder how that’s going? Any accidental injuries, critical illnesses, job loss, investment losses? Just curious. Bankrate recently reported that 63% of American consumers lack enough savings to pay for a $500 car repair or a $1,000 emergency room bill. The Financial Services Roundtable reported that one third of Americans do not have any tax deferred retirement account, not even an IRA. Another third have not saved enough for retirement. So, how many people have so much money near age 65 that they do not need any life insurance? Guess how much a new policy will cost then, after that 30 year term policy expires and you realize you still need life insurance. Will you even be in good enough health to be insurable? Sorry, but this comment that you’ll one day have so much money that you will not need life insurance seems ubiquitous. However, when one brings up the idea that we’re really not immortal, studies show that over half of the people then turn off the discussion. Sorry, only four things are certain in America: death, taxes, change, and the need for instant gratification. Too bad saving for emergencies and retirement aren’t in the list. Get permanent life insurance while your young and the insurance is cheap, and keep it. It’s better if it’s paid up by the time your 65 so you can eke a meager living out of your 30% reduced Social Security income and have the cash value and living benefits in your life insurance policy to help you make it through those serious financial emergencies. Then, you won’t have to both try to pay your living expenses and pay high monthly lifetime premiums for a small final expense policy after your term policy lapses, and you still have little or no savings (unless you’re among the most fortunate few).

    • It’s going quite well, actually. I’m confident I won’t need any life insurance by the time my term period lapses.

      Your argument is that people don’t save for retirement, so they should buy permanent life insurance? How about, people should put the money they’d put into permanent life insurance in an IRA instead.

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