Life and Health Insurance – 5 Steps to Calculating Life Insurance Needs

Life and Health Insurance can be confusing subjects.  There are many decisions to be made when considering life and health insurance.  First of all, one must first choose the type of insurance.  When considering life insurance coverage, there are a myriad of choices and the question is what type is best?  Level term, decreasing term, whole life, universal, or a hybrid type of life insurance policies are all choices under consideration.  When it comes to health insurance, should I choose an HMO or PPO?  Then, companies come into play.  What company should I choose?  What do the ratings mean?  How do I know the company I choose will be in business when I need them the most?  These are all important questions when considering life and health insurance.  With all these considerations, one of the most important choices you will make when it comes to health and life insurance coverage is concerning the age old question; How much life insurance coverage do I really need?

Life insurance calculators come in many shapes and sizes, and some are much more helpful than others when it comes to calculating your needs.  Many agents will simply give you their rule of thumb.  One such rule of thumb is that the average person needs 10 times their income when calculating income replacement for a spouse.  As a former Certified Financial Planner, I tend to take a more comprehensive approach to a needs based analysis regarding how much one needs in term of life insurance.  Here are some steps to get you started:

Step 1:  Determine what purpose exactly the money will be used for. 

Is the policy being used to generate income, cover college, pay off a mortgage, a combination of the above, or some other purpose?  This will not only help determine how much insurance you need, but what type of policy will fit that need.  Your biggest priority should be purchasing the adequate amount of insurance to fit that need.  If you can afford a term insurance policy to fund your need, but you can’t afford a whole life policy without sacrificing the amount of insurance you can get, your decision on the type of insurance you should buy will be clear.  Determine how much you need, and focus on funding that amount for that specific purpose.

Step 2:  Factor in other assets that are available to fit the need. 

There’s no need to purchase more life insurance than necessary.  Not only could buying too much life insurance coverage put a strain on your finances, but in tough times it may cause you to drop your insurance all together wasting valuable resources and defeating it’s purpose in the first place.  With that said, be sure to deduct other available assets when considering what you need.  This becomes especially important if you are purchasing life insurance coverage for income replacement purposes.  Take into consideration work policies, retirement accounts and other assets that will be available in the event of the insured’s death.  Using a retirement needs analysis calculator in conjunction with an insurance needs analysis calculator when calculating income replacement is always a good idea.  Most of all, look at the big picture.

Step 3:  Take into consideration inflation at 3%. 

If you need $40,000 today to fund a child’s college education, in 18 years, taking into considering inflation, you will need quite a bit more.  For example, using real historical inflationary numbers, 18 years ago $40,000 would have had the same purchasing power as $61,913 today.  During that period the average rate of inflation was 2.46%.  Imagine protecting a college fund for a child with the assumption it will cost $40,000, but then when the time comes it actually costs over $60,000.  In other words, inflation can make a huge difference in your life insurance needs calculation.  Generally speaking, using 3% for inflation is a good place to start.

Step 4:  Use a reasonable assumption for interest. 

Gone are the days of using 12% as a reasonable long term assumption of what you can expect to earn over the long haul.  A more conservative estimate of 6% may be more appropriate.  Furthermore, if you take into consideration your risk tolerance, using a rate lower than 6% may be more appropriate for years when you are less risk tolerant – i.e. during your retirement years.  Where this is especially important is when you are purchasing life insurance for income replacement.  For example, if you died next year, that lump sum of money will be invested to produce a return, but at the same time your beneficiary may be drawing funds out of the account to pay daily expenses.  Good calculators will show each year over the entire term of your policy factoring in interest, inflation, and exactly how much the survivor will draw as well as how much money is left in the account to produce the ongoing support.  Using a reasonable assumption for interest will increase accuracy in your predictions for future needs.

Step 5:  Use a good calculator and look at the big picture. 

Realize that if we knew exactly what our life expectancies were, the need for life insurance may be vastly different.  Since we don’t know, we have to plan accordingly.  Looking at the big picture can help put things in perspective when planning to purchase life insurance.  A conservative approach is always prudent – in other words, plan for the worst case scenario and stay within your budget to give yourself the best opportunity to follow through with your plan.  If you are using a life insurance agent to help in this process, have them explain exactly why they suggest the amount of insurance they are recommending.  If you don’t get a good answer, seek the help of a qualified professional such as a Certified Financial Planner.

In conclusion, good planning when it comes to protecting your loved ones in the form of life insurance can greatly impact how your surviving family and even generations to come can carry on without you.  Using a good life insurance needs analysis calculator, retirement needs calculator, assumptions regarding inflation and interest rates, and even soliciting the help of a qualified professional can make all the difference in the world.  Enjoy life!

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