One of the first big questions when it comes to life insurance is: how much do I need? Below we discuss two formal calculation methods: human life value and financial need.
Human Life Value
Human life value is based on the insured’s projected future income. As a rough estimate, take the number of years you have left until retirement and multiply that by your current annual income. The product is your human life value—the total economic value your labor is expected to produce. This estimate may be refined by incorporating income increases over time instead of using your current earnings. While crude, Human life value is commonly applied in legal cases.
Financial Need is estimated by calculating the financial needs of the surviving family or dependents the insured (deceased) leaves behind. Adding up the outstanding liabilities of the household, e.g., mortgage, student loans, and car payments, along with estimated amounts for spouse and children’s food, clothing, education, medical care needs, etc., one can estimate the total dollar amount needed to take care of those left behind (survivors). Estimates may reflect coverage that lasts until those dependents can: (1) fend for themselves, in the case of children, or (2) live with dignity through retirement, in the case of spouse or other older dependents.
Insurance agents have the incentive to recommend that you buy more rather than less insurance as that increases their commission, so they may emphasize the valuation method that yields the higher number.
Using the human life value method, it’s easy to reach numbers in excess of $10 million dollars. But few families really need that level of coverage. It may be flattering to think we are “worth” $10 million, but in reality, insuring yourself to such a level may be unnecessarily expensive. Once you accept an expensive policy, you may be obligated to continue making those high payments according to the policy terms. Over time this obligation could become a serious burden.
Don’t feel that you must rigidly use one of the two aforementioned methods to arrive at the correct coverage amount for your family. Instead, carefully consider your existing assets and debts, income and expenses, number of wage-earners, as well as the ages and number of dependents. A household with a net worth of several million dollars probably doesn’t need life insurance, as existing family wealth is sufficient to meet the needs of survivors. This is known as self-insuring.
A single person without any dependents, debts, or beneficiaries may also not need coverage.
Example: You are 35 years old, and just accepted your first job at an annual salary of $200,000. Assuming retirement at age 67, an insurance agent calculates your human life value as: 32 years until retirement times $200,000 per year, which equals $6.4 million. As already noted, this is a crude estimate which ignores wage increases over your career and the time value of money.
The agent enthusiastically sends you some illustrations for $6 million of life insurance death benefit. But that amount seems excessive to you, so you set out to calculate your family’s financial need. You have a $300,000 mortgage, student loans totaling $200,000, one elderly parent, a spouse, and two children. You estimate the combined amount needed to raise two children and get them through college is $1.2 million (assuming $600,000 per child). Long-term care for your ailing parent will cost $300,000. You also feel that $2 million will be needed to support your non-working spouse through retirement. These forecasted expenses add up to $4 million dollars. You determine to ask the insurance agent to revise the quotes downward to a death benefit of $4 million instead of $6 million.
Then your spouse points out that in the event of your death the family won’t need $4 million in cash up front. Some funds will be needed immediately to pay off student loans and the mortgage, but expenses for dependents will be spread out over 15 to 20 years. Together, you work out that if the insurance amount is $2.5 million, half a million could be used to pay off all the debt and the remaining $2 million could be invested conservatively to yield a 4% return annually. Debt-free, your family could survive comfortably on the $80,000 a year gained from investments, without having to use up any of the principal.
If your spouse has a job the math changes yet again. You may only need $1.5 million of insurance. In the event of your death, half a million dollars can be used to retire all the family debt, and the remaining million dollars invested at 4% will supplement the surviving spouse’s income by a tidy $40,000 per year.
The money you save by not buying excessive insurance can be used to start 529 college savings plans for your kids or to pay down debt.
The main lesson: Just because an insurance agent’s math suggests a certain level of coverage, doesn’t mean that’s the amount you really need to buy.
Nerdwallet on How Much Life Insurance Do I Need? This article debunks some crude rules of thumb and provides a calculator to estimate life insurance needs.
Policy Genius on How Much Life Insurance Do I Need? Another article which covers similar ground, along with a calculator.
While both articles provide calculators meant to assist you in quantifying life insurance needs, they are somewhat basic. The key is to engage all household adults in the discussion and buy the right amount of insurance for your circumstances, ideally from an independent agent or competitive insurance marketplace. Some marketplace choices are provided in subsequent sections.
In the following sections we discuss the two types of life insurance: term and permanent.
 The estimate can be further refined by considering time value of money, i.e., the timing of when income is received over time.