Tuesday, 24 February 2015

How Much Life Insurance Is Enough?

How Much Life Insurance Is Enough?
Deciding how much life insurance you need is often trickier than you might imagine. Do you even need life insurance and if so, how much do you actually need?
The key question to consider is what risks am I trying to cover with the life insurance policy?
First of all do you need life assurance at all? If you are single and have no dependents then the answer is normally no. So what should life insurance be used to cover and how much is appropriate? The answer is fairly simple to calculate and while it takes a few steps it’s not rocket science. Let’s go through it:

1. How much debt do you have? This includes mortgages, car loans, credit cards, etc. Anything that needs to be repaid in the event of your death.
2. How much income would your family need to replace in the event of your death? Let’s assume that your current income is €25,000 per year. Using a good income producing investment strategy can comfortably yield an income of 5% per year of the amount invested. So to produce an income of €25,000 per year would require a fund of €500,000. That is the ideal amount of coverage; however, you may decide that with one less mouth to feed a replacement income of €15,000 would be sufficient. In that case an amount of €300,000 would be required. Simply take the amount of income you would want to generate and multiply by 20.

3. Money for specific events. As an example you may have a child who you would like to provide university fee’s for in the event of your death. A good university can cost upward of €10,000 per year of study, so for each child you may want to insure yourself for an additional value of €30,000 (for a 3 year course).
4. If you are retired, how much do you need to provide for your dependents to pay inheritance tax bills, burial costs or other associated expenses?

Let’s take a very typical example of a married couple with two young children. He earns €35,000 per year while she earns €20,000 per year. They own a property with a mortgage of €100,000 and have €15,000 of other debt with €25,000 of savings and investments. As the debts would be paid off by the insurance the family would save around €15,000 per year in repayments so only need to replace around €20,000 of income if the father died and €5,000 of income if the mother died. They want both children to go to university. They therefore need to cover €115,000 of debt, €60,000 of education fees and income replacement of €400,000 for him and €100,000 for her. He would therefore need total cover of €540,000 (total cover required less existing savings) and she would need cover for €240,000.
Does inflation matter? As the years pass, your cost of living usually increases. This means you need more money to keep the same standard of living; however, you also need less insurance. Why? Life insurance is meant to pay off debts and replace your income should something happen to you before you retire. Once you reach that time hopefully you will have passive income from pensions and investment income. Your mortgage should be paid off and your children should be independent by then, too.

There is no scientific approach – the above is a ballpark calculation and everyone has different circumstances and requirements. But it’s pretty close to what you need, it’s a calculation you can do yourself and it’s also much better than a wild guess!

Have a great day! Andrew Lumley-Holmes.

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