Life insurance is the cornerstone of every financial plan. We’ve all heard the saying that “nothing is for certain except death and taxes.” Death isn’t a chance we are protecting against, it’s a certainty.
So how much is the right amount of life insurance? The only person who can answer correctly is your customer. When it comes to price, life insurance, in particular term insurance (which is most of what we sell), has decreased substantially over the years as we live longer and competition gets more fierce. Most people are pleasantly surprised at how inexpensive this coverage really is. Delivering the coverage your clients need at a price they can afford is most important. After all, what good is having a “Cadillac” policy if they are grossly underinsured? Conversely, what do you accomplish as your client’s agent by having just enough coverage to pay for the mortgage when there is so much more to living expenses?
Let’s start from the beginning. Life insurance is essentially designed to pay off debts and replace income. Too many Americans just cover the mortgage. Your clients (or actually, their families) won’t find out what wasn’t covered until it’s too late. Most people are shocked at how much they are financially worth to their families. If you own a house, are married and have children, and earning $50,000 a year, you are worth at least a million dollars to your family.
To determine the amount of life insurance needed, I use a “capital needs analysis.” Start by listing your client’s debts: mortgage, home equity line of credit, student loans, credit cards, car loans and the like. Add the total amount of all of these notes and then add around $10,000 to $15,000 for burial expenses.
Next, if your client has children, he needs to decide if he wants to put money aside for their education and how much for each child. Many parents of young children have no idea how much college costs. Rutgers, a public state university in New Jersey, costs around $20,000 to $25,000 a year. Private schools start in the $30,000 range and go as high as $60,000 a year. Of course, scholarships, grants and student loans all factor into the bottom-line costs, but for the purposes of this exercise, simply take an average cost today of a 4-year school, multiply it by the number of children the client has, and then subtract the percentage of the school you wish to pay for. My goal is to pay 50 percent to 75 percent of my children’s education. Add this number to the customer’s debt total. This summation of their debt, burial costs and education will be their capital needs at death.
Now determining the most important part of life insurance coverage: replacing income. Granted, if a family is living debt free, its expenses would clearly be lower than what they are now. However, a number of expenses continue even after debt is retired, such as food, property taxes, insurance, retirement savings, clothing, gas and electric. How does someone cover these expenses while caring for children? Does your client’s spouse have a marketable skill? Yes, he or she could remarry or sell the house, but let’s be real. If your spouse is young and dies unexpectedly, do you really go back to work soon? Dealing with the loss of a spouse is enough—don’t worry about money. Don’t be afraid to challenge your client on this issue.
So what is the formula for determining your income needs? First determine what your client’s annual family living expenses will be, assuming the client is deceased and the family is debt free (we took care of the debt when determining their capital needs).
Don’t make the money so tight for the surviving spouse that if the roof needs repair, he or she is in financial straits. Keep in mind for the purposes of this exercise that your client is no longer here, so their portion of the family’s expenses should be eliminated from the total. Once you arrive at that number, divide it by a reasonable interest rate that they could receive on their money (in recent years I’ve used 4 percent). If the family needed $40,000 a year (taxable) to cover expenses, that number divided by 4 percent would give them an income need of $1 million. In other words, $1 million invested with 4 percent interest would throw off $40,000 a year income to the family. This formula uses conservation of principal, which means the income to the family will continue for life and they never touch the $1 million.
Some would argue that I just inflated the amount of insurance needed by using a “conservation” of principal formula and to some degree, they’re right. However, consider that we don’t know how long our spouse will live after we’re gone, but we do know that inflation will devalue the income your spouse receives over time. Getting 4 percent right now is not real either and the surviving spouse would likely be dipping into the principal anyway to get the desired income. Finally, we have no idea what mystery expenses might come their way over the decades. Why not err on the side of caution when dealing with a certainty?
We now come to the last part in determining the right amount of life insurance for your client’s specific situation. Add capital needs (the debt you want to eliminate) to income needs, then subtract any current life insurance coverage or any other long-lasting assets you may have to offset the need. Be careful in using too many assets other than life insurance to reduce the amount of coverage needed. Many business owners tend to use their business value to reduce their need, but the reality is that it may not be the asset they thought it was, especially if they are not around to sell it.
So there you have it: an easy way to determine your client’s life insurance needs, where all information comes from the client. By asking the right questions and leading them down the path to determine their coverage needs, they could hardly provide any objections. I strongly recommend that you run through this exercise yourself as a trial run. Too often we spend so much time taking care of our customers that we forget to take care of ourselves.
What is your number? Do you have the right amount of life insurance? I imagine that most of you will find that not only are your clients underinsured, but that you are, too.