How much life insurance do I really need?

In determining how much life insurance one really requires, there are a number of factors that need to be examined.  The need for life insurance can be divided into two categories – capital needs and income needs.  

Capital needs are those that require a lump sum of capital to satisfy.  Let’s look at some of the main ones:

• The Executor’s Fund – The Executor’s Fund is a phrase used to describe money that is required to satisfy the first clause in an individual’s Last Will and Testament.  There should be enough capital available to pay your debts, any taxes due, plus the expenses of settling your estate.  Sufficient capital to pay last expenses such as funeral costs is also included in this category.
• Mortgage and/or Outstanding Debt – It is prudent to ensure that your family will not be left with the burden of debt when you die.  For the surviving spouse, being relieved of the mortgage on the family home eliminates a monthly obligation and provides him or her with an unencumbered asset.  Funds that would have been used to pay the mortgage can now be used for other purposes.
• Education Expenses: - Many, if not most, individuals would like to ensure that in the event of their premature death, their children will not be deprived of a university education.  In British Columbia, the average cost of a four- year program is approximately $25,000.  This figure does not include expenses for those not living at home.  For those who study away from home in another province or country, the cost of that four- year program could be as much as $60,000 to $100,000.  By setting aside funds from the estate to be invested, it is possible that the required funds will be available when the time comes.  The use of life insurance for this purpose is the least costly method of accomplishing this task.
• Dependent Children with Special Needs – Setting aside funds from the proceeds of life insurance in a trust ensures that those children with special needs will be financially secure after the death of the parents.
• Estate Equalization – There may be situations where, in an effort to treat the children fairly, there may be an unequal division of assets.  This often occurs where a family business is involved and those children involved in the business receive the company shares.  For the siblings who are not involved, special consideration is required to make sure they are treated equally.  This often involves leaving other assets or the proceeds of life insurance to them.  By using life insurance to equalize the estate for the benefit of the children where sufficient assets are not available frees the estate from claims under (in BC) the Wills Variation Act or similar legislation in other provinces.
• Charitable Bequests – For those with strong philanthropic interests, the use of life insurance is a proven method of making a charitable contribution both during their your lifetime and upon death. One simple method of making a charitable bequest at death is simply naming the charity as the beneficiary of a life insurance policy. Upon the death of the insured, the charity receives the proceeds of the policy while the deceased donor would receive a tax deduction equal to the proceeds on his or her final tax return.
• Emergency Fund for Survivors – Using insurance proceeds is a low- cost method of establishing an emergency fund for future unforeseen expenses of the survivors.

Income Needs refer to the ongoing income required to keep the surviving spouse and family in the same standard of living that they enjoyed prior to the death of the breadwinner.  Once the amount of income is estimated, then the amount of capital to provide such an income is calculated using an acceptable interest rate return on the invested capital.  For example, if the income for the survivors is estimated to be $50,000 per year for life before tax, then assuming a 4% rate of return, $1,250,000 of capital would be required.  This simple method would assume no encroachments on capital which would pass on to the next generation upon the death of the surviving spouse.  If capital was to reduce while providing this income, then less capital would be required at death.

In determining the exact amount of the life insurance required by an individual, there are a number of online calculators available.  

To determine how much life insurance is required, you will need to know the following:

• Is the income required before or after income tax;
• What is the acceptable rate of return on invested capital;
• For how long is the income to be paid;
• What is the rate of inflation?

Basically all the calculators use a concept known as Capital Needs Analysis.  This analysis assumes your estate to appear as a balance sheet with the income needs capitalized as a liability.  Simply, add up all your assets and subtract all of your liabilities (including the capitalized income requirement), after which you add in all the non-debt capital needs outlined above.  The number obtained from this calculation will determine how much life insurance is required.  Remember that any assets that will not be sold or liquidated upon death, (e.g. the family home) are subtracted from the asset total. Also, any registered funds such as Registered Savings Plans or Individual Pension Plans should not be used to produce income (which would result in a taxable disposition) but should be rolled over to the spouses registered plan for the spouses retirement needs.

Determining the amount and type of life insurance required can be a complicated and daunting exercise.  The online methods to assist you in this calculation should only be used as a guide to estimate your need.   Personal professional assistance is best employed before making a final decision.  After all, that is what we are here for.

Estate Planning Misconceptions

In this 5-minute webinar, we explore an important but often misunderstood area of financial planning.

Learn More