Life Insurance: How Much and What Kind To Buy

How much life insurance do you need? What type is appropriate? You should review your life insurance needs each time you have a major life event. Here is what you need to know to properly plan for your life insurance needs-to buy enough and to get the most for your money.

The prospect of planning for your family's life insurance needs may seem daunting. The array of confusing products available, coupled with the calculations needed to find the right amount of insurance, would put anyone off.

Yet the hard fact is that life insurance is an essential part of your family's financial well-being. The more you know about it before you go to your agent, the better your coverage will be. If you don't plan for your life insurance needs, the result could be a waste of thousands of dollars on inappropriate or ineffective life insurance or, worse, financial hardship due to not having enough insurance.

We've tried to make the process of buying life insurance easier and more informed by providing you with objective, unbiased information and a plan of action. This Financial Guide gives you some basic guidelines about whether and when you should purchase life insurance, and provides you with a system for determining how much you need. It also discusses the types of insurance available, their suitability for various situations, and how to comparison shop for a policy.

Do You Need Life Insurance?

The purpose of life insurance is to provide a source of income, in case of your death, for your children, dependents, or other beneficiaries. Life insurance can also serve other estate planning purposes, such as giving money to charity on your death, paying for estate taxes, or providing for a buy-out of a business interest. However we won't go into these other purposes in this guide.

Related Guide: Please see the Financial Guide: ESTATE PLANNING: How To Get Started.

Whether you need to buy life insurance depends on whether anyone is depending on your income. If you have a spouse, child, parent, or some other individual who depends on your income, you probably need life insurance. (You might also need life insurance for estate planning or business succession planning purposes.) Here are some typical insurance situations along with typical insurance needs:

Situation 1. Families or single parents with young children or other dependents. The younger your children, the more insurance you need. If both spouses earn income, then both spouses should be insured, with insurance amounts proportionate to salary amounts. If the family cannot afford to insure both wage earners, the primary wage earner should be insured first, and the secondary wage earner should be insured later on. A less expensive term policy might be used to fill an insurance gap. If one spouse does not work outside the home, insurance should be purchased to cover the absence of the services being provided by that spouse (child care, housekeeping, bookkeeping). However, if funds are limited, insurance on the non-wage earner should be secondary to insurance on the life of the wage earner.

Situation 2. Adults with no children or other dependents. If your spouse could live comfortably without your income, then you will need less insurance than the people in situation (1). However, you will still need some life insurance. At a minimum, you will want to provide for burial expenses, for paying off whatever debts you have incurred, and for providing an orderly transition for the surviving spouse. If your spouse would undergo financial hardship without your income, or if you do not have adequate savings, you may need to purchase more insurance. The amount will depend on your salary level and that of your spouse, on the amount of savings you have, and on the amount of debt you both have.

Situation 3. Single adults with no dependents. You will need only enough insurance to cover burial expenses and debts, unless you want to use insurance for estate planning purposes.

Situation 4. Children. Children generally need only enough life insurance to pay burial expenses and medical debts. In some cases, a life insurance policy might be used as a long-term savings vehicle.

Situation 5. Retirees. There is less of a need for life insurance after retirement, unless it is to be used for other estate planning purposes. You may need to provided an income for the second spouse to die if your retirement assets are not large enough. Further, you will need some insurance to pay burial expenses, final medical costs, and debts.

How Much Life Insurance Do You Need?

Determining how much insurance to buy requires you to invest some time in calculating...

• Your current annual household expenses

• Your assets, debts, and other sources of income.

We've provided a work sheet, which we will refer to in our discussion.

Tip: Find out how much insurance you need before considering which type of insurance to buy. Having enough is more important than having the right type. You should provide for your insurance needs immediately, although you can always switch to a more cost-effective or investment-oriented type of insurance later.

The ideal amount of coverage is the amount that would allow your dependents to invest the insurance proceeds after your death and maintain their desired standard of living without touching the principal. Although the old rule of thumb-to buy five, six or seven times your annual salary-may serve as a starting point, it is no substitute for making the calculations to find out how much you really need.

By using the worksheet and our explanations, you will be able to make a fairly good estimate of your insurance coverage needs. You will need to make some assumptions about your family's future.  It's important to be as accurate as possible in filling out the worksheet, since an underestimation could lead to your being underinsured, and an overestimation will lead to money wasted on unnecessary coverage.

Here is a line-by-line discussion of how to prepare the worksheet.

Line 1:Calculate The "Annual Income Needed"

Line 1 of the worksheet, "Annual Income Needed," is the amount that your survivors would need to live comfortably. It is important not to underestimate this amount. If there are recurring expenses that your family incurs but that are not shown on the list below, do not neglect to include these.

To arrive at the "Annual Income Needed," find the following amounts paid monthly. Then multiply the figure you arrive at by 12 to arrive at an annual amount. Add the following amounts:

Line 2: Subtract "Other Sources"

The next item on the worksheet represents the income that your survivors will have. If there are sources of income other than the ones listed, do not neglect to include them.

Tip: To calculate Social Security benefits, you may wish to obtain an estimate of your benefit from the Social Security Administration. You can obtain a request form by calling SSA's toll-free number-800-772-1213.
Since you cannot predict the amount your survivors will receive (it will depend on your age at death, your earnings, and the ages of your children), you may use the following as rough estimates: $4,000 per year if you have one child under 16, or $5,000 for two or more children under 16.

Do not include other insurance proceeds here; this will be accounted for later.

Line 3: Determine The "Shortfall"

Line 3 represents the shortfall, i.e., the amount you need your insurance proceeds to replace. This is determined by subtracting the "Annual Income From Other Sources" amount from the "Annual Income Needed."

Line 4: Determine the "Amount Of Proceeds Needed"

Line 4 is the amount that will generate the investment income needed to make up the annual "Shortfall" in Line 3.

The amount by which you should divide line represents the after-tax rate of return you can expect on the invested life insurance proceeds. The amount you choose to divide by depends on how conservative you want to be. It is reasonable for most people to expect an after-tax rate of return of at least 6%. But if you want to ensure that you are protected from inflation risk and interest rate risk, use the lower divisor of 4%. The middle divisor of 5% represents a "middle of the road" approach.

The amount you arrive at is the amount of death benefit (proceeds) you will need. The amount will be further adjusted as you work through the worksheet.

Line 5: Add the "Lump-Sum Expenses"

These are the items your family will have to pay for at the time of death. They differ from the "annual income needs" amounts in that they are not part of the family's everyday living expenses. Further, unlike the annual income amounts, they represent pure guesswork. If you wish to strive for a higher rate of accuracy, you can try to adjust these items for inflation, but this is not strictly necessary.

The estimate for funeral expenses should be at least $5,000. Depending on your desires and those of your family, you can adjust this figure upward.

The final medical expenses will be minimal if you have adequate health insurance. You can estimate this amount by finding out how much your policy requires you to contribute per illness.

The estate administration and probate costs can be estimated at 5% of your estate for the sake of simplicity. Your estate is the total value of your assets at death.

You will only owe federal estate taxes if your taxable estate exceeds the amount of the unified credit exemption equivalent. Your state inheritance taxes will depend on the laws in your state.

The "emergency living expenses" amount can range from three to six months' worth of family living expenses.

The "debts" amount represents debts that your family desires to pay off at your death. Normally, it does not include items that make up the "annual living expenses"-e.g., mortgage payments, car payments. However, if you decide that you wish to use insurance proceeds to pay off such expenses, then add in the amounts you estimate will be needed to pay off such debts.

As for future education expenses, it is suggested that you use an annual cost of $20,000 per child, per year, for the sake of simplicity.

Line 6: Determine the "Interim Insurance Proceeds Amount"

Subtract the "future expenses" on line 5 from the "proceeds needed" amount on line 4. This is the amount of insurance you will need to buy on your life. The amount will be further adjusted.

Line 7: Subtract the "Assets That Can Be Sold and Other Insurance"

For line 7, determine the amounts that represent assets that your survivors could liquidate to pay future expenses. Do not include any assets your survivors will be using to produce income that you included in "other sources." Also, note that you should include insurance payments and pension death benefits here, and not on the line for "other sources." This is because such proceeds will represent one-time payments, and not sources of annual income.

Line 8: Determine the "Total Insurance Needed"

Subtract the "assets that can be sold and other insurance" on line 7 from the interim insurance proceeds amount" on line 6. This is an estimate of the amount of insurance coverage you need.

Life Insurance Worksheet

Types Of Insurance

• Term, whereby you pay for coverage for a specified amount of time, and if you die during that time the insurer pays your survivors the death benefit specified; and

• Cash value, usually referred to as whole life, universal life, or permanent life insurance, where, in addition to paying a death benefit, it also provides you with some other redeemable value.

Term Insurance

For individuals age 40 or less, a term policy will almost always be less costly than a whole life policy. Although term policies do not build cash values, many are convertible to whole life policies without a physical exam. Thus, a term convertible policy may be a good option for someone who is under 40. There are various types of term insurance, which we will discuss briefly here.

• Renewable. Renewable term policy is the most common type of life insurance where the policy renews automatically on a renewable term, e.g. every year, every 5 years, every 10 years, or every 20 years--the most popular renewal term. You do not need to take a physical or verify the fact that you are employed. The premium goes up at the beginning of each new term to reflect the fact that you are older. Most renewable term policies can be renewable until you reach age 70 or so.

• Re-entry. With this type of policy, you must undergo a physical exam after a certain period, or pay an extra premium.

• Level. With level term policies, the premium is guaranteed to stay the same over a certain period. This period may be shorter than the term of the policy. Nearly all life insurance bought today is level term.

• Decreasing. With a decreasing term policy-a good option for insuring mortgage payments-the face amount of the policy decreases over time while the premium payments remain the same.
• Return of Premium. Some insurers offer term life with "return of premium". Typically, premiums are significantly higher and they require keeping the policy in force to its term.

Cash Value Insurance

There are four types of cash value life insurance: (1) whole life, (2) universal life, (3) variable universal life and (4) variable whole life. The first two types are the most common and have a guaranteed cash surrender value; in the last two types, the cash surrender value is not guaranteed.

Whole Life. This is the traditional life insurance policy. It provides a death benefit, has a cash value build-up, and sometimes pays dividends. You do not need to renew a whole life policy. As long as you pay your premiums, you will have coverage, usually until your death. The premium for a whole life policy remains the same for the amount of time you own the policy; the premium is "level" in insurance parlance. Thus, when you are younger, the premium you pay for whole life will be greater than what you would pay for term, but when you are older, the premium will be much less than a term premium. Part of each premium goes into the cash value of your policy. Your cash value, which is actually an investment, is guaranteed to grow at a fixed rate. You do not have to pay current income taxes on the growth in the cash value-it is tax-deferred.

Tip: You can borrow against your cash value at a rate that is usually better than the prevailing consumer lending rates. If you die with an outstanding loan amount, the loan amount, plus interest, will be subtracted from your death benefit.

Dividend-paying whole life policies-termed "participating" policies-are usually offered by mutual life insurance companies. Mutual life insurance companies are generally owned by policyholders, while other insurance companies are owned by shareholders. The dividends are refunds of insurance premiums that exceed a certain level. They are paid when the insurance company does well during a quarter or a year. Of course, premiums for participating policies are usually higher than those paid for non-participating policies.

Note: Term policies can also be participating, but the dividends paid are usually minimal.

Universal Life. Universal life, also known as "flexible premium adjustable life," is similar to whole life, but offers more flexibility in terms of payment of premiums and cash value growth. With a universal life policy, your monthly premium amount is first credited to your cash value. The company then deducts the cost of your death benefit and the expenses of the policy. These costs are about equal to what it would cost to buy term coverage. As with whole life, your cash value grows at a fixed minimum rate of interest. The growth of the cash value is tax-deferred, and you can borrow against it or make partial withdrawals.

Caution: A special feature of universal life is that you can vary the premium paid from month to month. You can pay more or less-within certain limits-without jeopardizing your coverage. You can even let the cash value absorb the premium. However, the danger here is that if the premium payments fall too low, your policy may lapse. While some states require the insurer to tell you when your cash value is at a dangerously low point, you will, if you live in another state, have to maintain a careful watch on the amount of cash value if premiums are skipped.

Variable Universal Life. Variable universal life allows you to choose the investment for your cash value. You have a potentially greater cash value growth, but you also have added risk, depending on the type of investment you choose.

Variable Whole Life. With variable whole life, the death benefit and cash value will depend on the performance of an investment fund that you choose. Again, you have potentially greater reward, with its accompanying risks.

How Insurance Products Differ

Here, in table form, is a summary of the different features of the various types of life insurance.

How To Shop For Insurance

In order to be able to shop for the best premiums, it's a good idea to know how premiums are calculated by insurers. Bear in mind that premiums vary among insurance companies, and it is a good idea to ask several insurers for their rates.

Insurance companies place individuals into four risk groups: preferred, standard, substandard, or uninsurable. The premiums charged will be commensurate with the category you are placed in. Thus, a standard risk will pay an average premium for similarly situated insurers.

If you have a high risk job or hobby, you will be considered substandard, a high risk. A terminal illness at the time you apply for insurance will render you uninsurable. Having some type of chronic illness will place you in the substandard category. People with conditions such as diabetes or heart disease can be insured, but will pay higher premiums.

Tip: One company's category for you may not hold with another company. Thus, it still pays to shop for insurance with other companies even though one may have labeled you "substandard."

Tip: Once an insurance company approves you for coverage, you cannot be dropped unless you stop paying your premium.

Shopping For A Policy

In most states, there are rules, set by a group of state insurance regulators, requiring the agent to calculate two types of cost indexes that can help you to shop for a policy. You can use the indexes to compare policy costs.

One type of index, the net payment index, gauges the cost of carrying your policy for the next ten or twenty years. The lower the number, the less expensive the policy. This index is useful if you are most interested in the death benefit aspect of a policy, as opposed to the investment aspect. The other type of index, the surrender cost index, is useful to those who have a high level of concern about the cash value. This index may be a negative number. The lower the number, the less expensive the policy.

These two indexes apply to term and whole life policies. With universal life policies, focus on the cash value growth and the cash surrender value to make comparisons. Cash surrender value is the amount you receive if you cancel the policy. It is not the same as cash accumulation value. If you are shown two universal life policies, and they have the same premium, death benefit, and interest rate, then the one with the higher cash surrender value is generally the better policy.

Be aware that the projections of cash values given by some insurers may use unrealistic assumptions, and therefore might be misleading.

Here are some questions to ask about policies:

• How do cash values accumulate? An early, rapid build-up is generally preferable.

• How has the policy's cash value performed in the past? You can get this information from a publication called Best Review, Life and Health. Determine how the policy performed in comparison with the company's projection and with other insurers.

• Are any special features merely bells and whistles, or do they add value for you?

• What is the company's rating with Best, Standard & Poor's, and Moody's? You can find these publications in public libraries. The rankings should be in the top three to ensure that a company has financial stability.

Government and Non-Profit Agencies

• National Insurance Consumer Helpline
  1001 Pennsylvania Avenue NW
  Washington, DC 20004
  Phone: (800) 942-4242