How much life insurance do I need?
Assessing your lifestyle protection needs.
By ATB Wealth 1 December 2020 5 min read
Regardless of your age and stage in life, you should regularly assess the potential financial impact of your death on those that are financially dependent on you. Your needs may change over time as your income, assets, liabilities and family situation change. Therefore, you should consult with your insurance advisor regularly.
Life insurance can generally be broken into two distinct needs:
|Lifestyle protection for your survivors||Estate planning needs|
Lifestyle protection coverage can be thought of as insuring temporary needs, whereas estate planning needs tend to be permanent in nature. However, some expenses may actually fall into both categories.
Life insurance assessment
Part 1. Assess your income replacement needs.
This stage of your assessment determines the loss to your household of your total anticipated future after tax income. The assessment considers:
- Your after tax income
- Your current age
- Your anticipated retirement age
- An important concept when determining your income replacement needs is to understand that the assessment discussed above, represents dollars earned in the future. In contrast, insurance death benefits are received as a lump sum and can be invested by your survivors upon receipt. This investment rate of return can act as a discount rate when calculating the actual amount of coverage you need in today’s dollars. This process is known as a present value calculation.
Part 2. Assess the lump sum needs your survivors may have on your death.
Consider the following:
- Debts you want to ensure are paid to $0.00 in the event of your death.
- Any final expenses you want to ensure your survivors have funds for.
- Other lump sums needed for short term planned spending.
Part 3. Add together your income replacement needs and lump sum needs; then deduct off insurance coverage you already have in place and any assets that can be liquidated by your survivors. Elements to consider are:
Review your existing coverage including:
- Personally owned policies, group coverage through work, creditor insurance policies1, or other plans.
- Think of any assets that won't be needed by your survivors and can therefore be liquidated on your death2.
Once all three parts are reviewed together, you will be able to determine the appropriate amount of life insurance you need to protect your family’s lifestyle.
Let's look at an example of all three parts at work:
Our client Mark is 45 years old and wants to retire at age 60, his after tax income is $64,000/year and he feels his family will need 100% of his net income = (60-45)*64,000*100% = $960,000.
However, Mark’s partner is the beneficiary of a policy and has the ability to invest the proceeds of death benefit for 15 years. If we use an assumed rate of return of 4%, we now calculate the present value of Mark’s future income stream by discounting the income replacement need we calculated above ($960,000) by a rate of 4% over a period of 15 years (the number of years between today and Mark’s normal retirement). A financial calculator is generally required to complete this present value calculation.
The present value of $960,000 is $533,000, in today’s dollars. Mark’s income replacement insurance need becomes $533,000 not $960,000. This will reduce the cost of coverage. Keep in mind the higher the desired return on investments generally means a high level of investment risk required.
Let’s look at our client Mark’s lump sum needs. Mark has a home with a mortgage of $275,000 outstanding and a car loan for $42,000. Mark and his partner have started RESPs for their two children but he thinks there may be a funding shortfall if no further deposits are made, so he wants to set aside another $35,000 for his kids’ education. Mark also wants to ensure that there are sufficient funds for his final expenses and wants to allocate an amount of $25,000 for this. Therefore, his total lump sum needs are ($275,000 + $42,000 + 35,000 + 25,000 ) = $377,000
Putting it all together for Mark. He needs $533,000 of coverage to replace lost income and $377,000 of coverage for lump sum expenses, for a total of $910,000. He currently has employer coverage at work, which pays two times salary as a benefit. His salary income is $85,000, therefore his benefit is $170,000. Mark also owns a $250,000 term life policy. There are no other assets he can liquidate, as his partner will need the funds for retirement. Therefore we have $910,000 - $420,000 = $490,000. Therefore, Mark needs additional coverage of $490,000.
1 Creditor insurance is typically offered to you when you are applying for a new credit product including: loans, lines of credit, mortgages and credit cards. Some institutions may allow borrowers to apply for creditor insurance after the credit product is already in place. These insurance products are subject to eligibility conditions, limitations and exclusions (which are circumstances when benefits are limited or not paid). The coverage is intended to be used exclusively to pay the balance of the insured debt to $0.00. The death benefits will be paid directly to the financial institution on your death and will not be paid to your beneficiaries.
2 When looking at liquidating assets you need to consider if your survivor would actually need those funds. For instance, if you have RRSPs, it may not be reasonable to liquidate those accounts on your death, as your spouse/partner may still need those savings to meet their long term financial needs, such as retirement. You also need to assess any potential tax loss, or other expenses arising from liquidating assets for the immediate needs of your survivors.
Creditor insurance is typically offered to you when you are applying for a new credit product including: loans, lines of credit, mortgages and credit cards. Some institutions may allow borrowers to apply for creditor insurance after the credit product is already in place. These insurance products are subject to eligibility conditions, limitations and exclusions (which are circumstances when benefits are limited or not paid). The coverage is intended to be used exclusively to pay the balance of the insured debt to $0.00. The death benefits will be paid directly to the financial institution on your death and will not be paid to your beneficiaries.
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