By Michael S. Jackson, CPA
Most people are not so financially sound that they could stop working tomorrow and be able to have enough resources to support their family for a long time into the future. However, this is precisely what happens when the primary bread winner of a family dies or becomes disabled. For this reason, life and disability insurance are a critical piece of a family’s financial profile. But how does a family determine the proper amount of insurance?
Any method used to determine a family’s insurance need will be an estimate. Circumstances will change almost on a daily basis. Therefore, it is important to review the insurance need regularly and make any necessary adjustments.
Although there are certain “rules of thumb” which may be used in order to estimate the insurance need, they are very simplistic and often do not consider such important factors as the family’s current net worth or the ages of the family members. Such rules of thumb normally utilize a multiple of earnings approach.
One such rule is to estimate the amount of life insurance by multiplying the wage earner’s income by a factor of 6 to 8. Thereby, a physician earning $100,000 annually should have $600,000 to $800,000 of life insurance. A similar rule takes immediate cash needs into account. The rule is 5 times gross income plus mortgage, debts, final expenses and other special funding needs. Assume the same physician has a mortgage of $300,000, medical school debts of $100,000 and desires college funding requirements for his or her children totaling $200,000. The insurance need in this case would be $1,100,000.
As you can see the “rules of thumb” can provide a wide disparity of solutions. Without looking at a family’s entire financial profile, it is difficult, if not impossible, to accurately determine the proper amount of life or disability insurance.
The most reliable approach to determining the proper level of insurance is by way of a needs analysis. This type of analysis determines the amount of money needed to support the family and pay down outstanding liabilities, reduced by current asset holdings and future receipts of income.
The first category of need is often the most underestimated or neglected—the current cash need upon death. This category of need only exists when determining the life insurance need since disability insurance is focused on income replacement. The current cash need at death will include funeral expenses, estate settlement costs, tax liabilities, liquidation of debt, funding of education and any other special funding needs. By including debt liquidation and education funding in this category, the insured will be sure to leave the family with a roof over their heads and assures that the children will be able to attend college.
The second category is the estimated income need for the family. This amount will be different depending upon whether the needs analysis is being performed for life or disability insurance. For life insurance, the income need is determined by estimating the surviving spouse’s annual income requirements over his or her remaining life expectancy This amount will typically range from two-thirds to three-quarters of the family’s current income.
Once this amount is estimated, an assumption must be made regarding an inflation percentage. This is the amount by which the income requirement must grow each year. A second assumption must be made regarding after-tax earnings. The difference between the after-tax earnings rate and the inflation factor is the percentage which is applied to the income need in order to determine the present value of the income need. This amount represents the capital which must be set aside currently in order to ensure the surviving spouse receives the annual income each year for his or her life. Be prepared; this amount is often much higher than most people expect.
For disability insurance, the income need will typically be higher than the amount which is needed for life insurance because both spouses will be alive and the medical expenses may be higher if the bread winner is no longer able to work. The income need is then calculated in the same manner as it was for life insurance.
When calculating the income need it is important to factor into the equation the income needs for children. Often, the need will be determined through a particular age, usually 18 or 21. This calculation must be performed for both life and disability insurance needs analyses.
The income need may be reduced by an assumed amount of earnings by the spouse. However, it is common for people to disregard this amount in order to prepare for a worst case scenario when one spouse dies or becomes disabled and the other is unable to work.
The total current cash need and income needs are satisfied by the capital assets available to the family. This will typically include cash, savings and other liquid investment assets. Do not include the value of assets which will not be sold in order to generate cash, such as the family home. The capital assets will also include the present value of any pension or other retirement benefits which will become available at some point in the future.
It is also important to factor in the present value of benefits which will be received from the Social Security Administration. Upon death, the children of the decedent may be entitled to a monthly check until they reach age 18. The surviving spouse will typically begin to receive benefits at normal retirement. A disabled worker will begin to receive Social Security benefits upon meeting the Administration’s definition of total disability.
The difference between the family’s total current cash and income need, less the capital assets, is the insurance need. From this point, the family must make a personal determination whether or not to purchase insurance equal to the amount of the calculated need. Many times the calculated need will be very expensive. For example, consider a young couple in their late-20’s with two young children. Current cash requirements may include full payment on a new mortgage and funding for college education. At the same time, the surviving spouse’s income need will be very high due to the relatively long life expectancy for someone in their late-20’s. The calculated insurance need, if fully funded, may make a dent in the family’s lifestyle due to the high premium requirements for a large policy.
Many people feel more comfortable using a professional advisor to assist in determining their family’s insurance need. Unless there is a strong personal relationship with your insurance agent, consider using an independent professional such as an accountant or financial planner. These professionals will be able to provide your family with a recommendation which is not tied to selling a particular product or level of insurance.
Michael S. Jackson, CPA, a principal with the Philadelphia based firm, Martin J. Satinsky & Associates, P.C., is a certified public accountant with special expertise in personal financial planning.