How Much Life Insurance Do I Actually Need?

It is guest post Friday! Today we have a guest post from Dennis Li who is the co-founder of Reeske. Dennis is going to talk about how much life insurance we actually need. As I now have two kids, a wife, and a home this is something that weighs on my mind almost daily. I used to get a plan to provide enough life insurance for my wife to live off for a couple of years. Now I am not totally sure how much we should be getting so I am very excited to hear what Dennis has to say.

Being a life insurance actuary for many years, I’m well aware of how simple the forces of nature can have devastating and unexpected consequences on a family. Statistically, there are hundreds of high earning Americans who die every day without life insurance. A couple of years ago, this concept hit home when a former colleague’s father died unexpectedly in his late 50s. Though her parents had modest savings, her father only had a Term life insurance policy from his employer, which is equivalent to one year of his salary. Despite the fact that her father made a good income, with an annual salary of 150K+, the couple lived up to their means, with frequent traveling and hobbies such as boating. They also owned an expensive home and a small boat, and the home still had a large mortgage. When the tragedy hit their family, her mother knew that she could easily sell the boat, but she was unsure if she could afford to stay in her current home with her teenage children.

Unfortunately, this story is all too common. We all know that we can’t predict the future, but we can certainly better prepare for it. Among everything we juggle to build a better future for our family, life insurance is often time one of the most critical ingredients. As buying life insurance has become easier than ever, buying the right coverage has actually become harder given the information overload, misinformation, and inadequate support.

According to LIMRA, roughly half of Americans who have life insurance are underinsured, among which 9 million households only have group life insurance coverage, usually obtained from an employer. LIMRA further estimates that people with only group life insurance have average coverage gaps of $225,000, which can certainly jeopardize the future of one’s family.

So why are so many people underinsured? Overestimating the premium cost, the complexity of the products, and distrust of insurance companies are usually what come to mind. However, another major challenge is that people are not equipped with tools to make such decisions.

What are we missing?

The right amount of life insurance coverage is, by essence, the amount of money your family would need to continue living the lifestyle they do now if you were to die today. Though it is unlikely that we can find the exact number necessary to protect your family, a good estimate includes factoring all the information we have as of today.

Traditionally, people consult financial advisors or insurance agents for their coverage needs analysis. However, as digital life insurance purchase is gaining momentum, more people have started using 8 to 15 times their annual salary as a rule of thumb, or by using a simple online calculator instead. Although having any amount of insurance coverage is undoubtedly better than having none in most situations, there are often major pitfalls with such simple approaches: it ignores household demographics, past savings, non-salary contributions, and individual preferences about sustaining the living standards of the survivors, etc.

Consider the following examples:

Example #1: Kevin is a stay home dad and decides to purchase life insurance. Since his contribution is not directly salary based, he purchases a 100K Term life insurance policy, based on ten times the annual salary he receives from freelance work from time to time. This puts his family in a risky position. In light of any adverse event, there would be major expenses incurred to replace his household contribution, such as childcare costs. In this example, using the 8-15 times salary rule of thumb or a simple online calculator will severely underestimate his life insurance coverage needs.
Example #2: Jimmy recently started a family and is shopping for a life insurance policy. He uses the online calculator, and upon entering his debt information, he went through all the expense and liabilities he could think of; however, he left out one major expense, which was the future college tuition for his children. He also listed his house as part of his assets in the process of calculating his net worth, which may not be ideal since being forced to sell the house in the face of an adverse event is probably not something he wishes upon his family.
Example #3: Jackie works for a large firm with a 200K group term life insurance policy in place. When Jackie uses the simple online calculator to buy individual life insurance on her own, her existing coverage was not accounted for, and she overestimates the coverage amount needed.
Example #4: Jackie now notices the issue and opts for another online calculator that includes her existing coverage. However, the calculator assumes the existing coverage will be there, forever. If Jackie changes jobs frequently or decides to start her own business, such an underlying assumption will then underestimate the right amount of coverage needed given group life policy is generally not portable.

The examples above are only the tip of the iceberg of what could go wrong when it comes to calculating the right life insurance coverage needed. To put everything into perspective, use the following considerations for estimating the right amount of coverage, at a higher level:

Your resources (after-tax income, household income distribution, non-salary contribution, liquid assets, and illiquid asset should be treated very differently)
All future expenses (including tuition costs) + short- and long-term debt with adjustments = financial obligation
Combining all existing life insurance policies, factoring in their effective periods = existing coverages
Financial obligation – liquid assets – existing coverages = initial coverage gap
Risk appetite
Initial coverage gap with adjustment of risk appetite Final coverage gap = how much life insurance you should get
The final coverage gap is a moving target and should be monitored at least bi-annually, go through the process above whenever your needs change or experience life events

If the above sounds confusing to you, you are not alone. We designed Reeske with the goal of making this process as simple and efficient as possible. We first have you start by answering simple, non-intrusive questions, such as your household income, assets, debt obligations, and your risk appetite. You will then receive a personalized risk analysis and proposal of the types of life insurance policies and the coverage amounts you should purchase that best align with your situation and objectives. This occurs in just a matter of minutes, free of charge.

The bottom line

So how much life insurance do I need? Well, it depends. Life insurance coverage should be highly customized, with the consideration of your personal circumstances, financial well-being, and risk appetite. Reeske can help you understand exactly what you need to better prepare your family for the future and jump start your planning process to ensure your peace of mind.