The key to determining the amount of life insurance that’s necessary is to understand what happens financially if you or your spouse dies. What income would stop? What expenses might increase, and for how long? Understanding those numbers helps you get an understanding of how much life insurance is needed. The goal is to have your loved ones be able to sustain their standard of living without having to make big sacrifices.
What’s your basic budget, now and in the future? We don’t know for sure what our expenses are going to look like in the future, but we can take a guess. For example, you might be paying for daycare expenses now, but know they will fall off in 2 years when school starts, and be eliminated when children reach a certain age. Map out what those expenses will most likely look like.
Also take stock of what expenses will drop off if you or your spouse passes away (e.g. employment related expenses, etc.), and what expenses might increase (e.g. cleaning services, taking care of finances and taxes, etc.). You should essentially have two broad budgets for life insurance planning: what income and expenses look like if spouse 1 passes away, and what it looks like if spouse 2 passes away.
Let’s take an example.
Jack and Rebecca are 35 years old. They have two daughters, a 2-year-old and a 4-year-old. Jack works full-time making $75,000 ($60,000 after-tax) and Rebecca works part-time making $50,000 ($42,000 after-tax); a monthly take-home income of $8,500. Their regular monthly expenditures, not including daycare or the mortgage is $4,000 per month. They have a mortgage with a balance of $300,000, and pay $2,000 per month towards it. Part-time daycare is $1,000 per month. Retirement savings are $1,500 per month. They have $18,000 set aside in an emergency fund, 3 months worth of expenses not including daycare. They also have some money set aside in RRSP’s, but no other investment assets.
| Budget | Monthly Amount |
| Incomes | |
| Jack’s After-Tax Income | $5,000 |
| Rebecca’s After-Tax Income | $3,500 |
| Total | $8,500 |
| Expenses | |
| Regular Expenses | $4,000 |
| Mortgage | $2,000 |
| Daycare | $1,000 |
| Total | $7,000 |
| Savings | |
| Retirement Savings | $1,500 |
In this step, you determine what Lump-Sum needs you will have to cover through insurance. This includes things like debts to be paid off, short-term lump-sum needs, like daycare costs for young children or funeral costs, and the present value of ongoing expenses and savings not covered through regular income.
If Jack were to pass away, Rebecca’s income would be $3,500 per month. She doesn’t want to go back to full-time work until the girls are 18. Rebecca estimates that her spending will be reduced by about $500 without Jack around, to $3,500. Therefore, her income will be able to cover all of the regular household spending. They both agree that if one were to pass away, they’d like the house fully paid off immediately, would want to cover their girl’s education expenses, and continue the same amount of retirement savings.
If Jack were to pass away, Rebecca would need:
| Insurance Needs if Jack Passes Away | |
| Ongoing Cash Flows | |
| After-tax Income | $3,500 |
| Regular Expenses | $3,500 |
| Surplus | $0 |
| Lump-Sum Cash Needed | |
| Mortgage | $300,000 |
| Daycare | $36,0001 |
| Retirement Savings | $277,0002 |
| Children’s Education | $40,0003 |
| Total Life Insurance Needs | $653,000 |
Rebecca will need a lump-sum of $653,000 if Jack passes away.
If Rebecca were to pass away, Jack’s income would be $5,000 per month. He expects his regular monthly expenses to increase by $500 to cover a number of the “services” Rebecca did for the family. Therefore, his expenses would be $4,500. The remaining $500 in income can go towards Jack’s retirement savings.
Jack would need:
| Insurance Needs if Rebecca Passes Away | |
| Ongoing Cash Flows | |
| After-tax Income | $5,000 |
| Regular Expenses | $4,500 |
| Surplus | $500 |
| Lump-Sum Cash Needed | |
| Mortgage | $300,000 |
| Daycare | $72,0004 |
| Retirement Savings | $185,0005 |
| Children’s Education | $40,0006 |
| Total Life Insurance Needs | $597,000 |
Jack would need a lump-sum of $597,000 if Rebecca were to pass away.
You might have insurance policies already in place, through employer group plans or private insurance. However, group plans often aren’t sufficient to cover all needs, especially if you have a young family, or your life insurance needs have changed since you took out a prior private insurance plan.
In this example, Jack and Rebecca only have retirement assets and emergency savings. They figure that the emergency savings will pay for minimal funeral costs, but want to keep the bulk of that available for any other emergencies that might come up. They also do not want to dip into retirement savings until necessary. They both have employer group benefits with their work. Jack’s group life insurance offers a 2x salary death benefit, while Rebecca’s is 1x salary. Rebecca’s parents also got a small permanent life insurance policy for her when she was young, worth $25,000.
| Insurance Needs if Jack Passes Away | Insurance Needs if Rebecca Passes Away | |
| Total Life Insurance Needs |
$653,000 |
$597,000 |
| Employer Group Plan | $150,000 | $50,000 |
| Private Insurance | $0 | $25,000 |
| Current Life Insurance Coverage | $150,000 | $75,000 |
| Additional Life Insurance Needed | $503,000 | $522,000 |
Jack’s group policy, worth $150,000, means that they need to purchase an additional $503,000 in private life insurance for him. Rebecca’s $75,000 in total insurance means that she needs an additional $522,000.
If it’s term insurance, you’ll have to choose the term of the policy. If it’s permanent insurance, you’ll have to decide on the various features or riders. I outline the difference between term and permanent insurance in a previous post.
Jack and Rebecca are mainly concerned about the next 20 years while their daughters are young and they are building up retirement and education savings. Therefore, they opt for a 10-year term insurance policy. In 10 years, they will assess where their mortgage balance is, their retirement savings, and education savings and get a new policy that suits their needs at that time.
This example was used to outline the various steps in determining how much life insurance you need depending on your situation, and your preferences. You have flexibility in terms of how much insurance you actually purchase and what types of things you insure. For example, Jack and Rebecca could have foregone education savings for their children in the event that either of them passed away. Or perhaps Rebecca would return to full-time work. Daycare would double, but so would her income. They might have said, we’ll simply cover our debts, the mortgage in this case, if one of us passes away and readjust our savings and spending. Life insurance is there to protect your loved ones in the event you die. If you have insufficient insurance, their standard of living could fall dramatically. The key is to make an informed decision by considering what would happen if you don’t have enough coverage.
