Life Insurance Formulas
This page serves as a resource to provide three simple ways to calculate someone’s life insurance needs.
More advanced estate planning will call on more technical approaches and considerations.
1. Multiple-of-Income Approach
This is the simplest method of estimating your life insurance needs with the goal of replacing the primary breadwinner’s salary. It doesn’t take the specific needs of the survivors into consideration, other sources of funds, and external factors such as promotions, taxes, or inflation, and may lead to you being over or under-insured. Best suited for families with 1 child versus several. Industry standards (and a Google search) suggests 10-15x.
Current Income x Number of Years you’d like to provide financial support for survivors
2. Human Life Value Approach
This method takes more into consideration, such as age, occupation, current and future earnings. It’s more robust in determining your overall economic value if you were to die today to replace future income. It doesn’t necessarily account for funeral costs, children’s educational expenses, or other specific future needs.
- Estimate your earnings from now until retirement age. Factor in future wage increases.
- Subtract annual taxes and living expenses. Assume 30% of your salary will go to taxes.
- Select an assumed rate of return on the remaining total and subtract from gross amount.
- Add the cost of additional benefits provided through employment. Account for inflation.
3. Capital Needs Analysis
This is the most robust method for estimating life insurance coverage. In addition to replacing your salary, it also accounts for other sources of income and the specific needs of survivors. It factors in:
- Current and future income of both the insured and surviving spouse
- Immediate needs upon death (e.g., funeral expenses, debt repayment, mortgage payoff)
- Future expenses (e.g., college, weddings, long-term care expenses, retirement funding)
- Existing family assets, retirement funds, or insurance policies
Once all future needs are taken into consideration, there are then two ways to calculate how much insurance the client needs, based on how they want to utilize the funds in the future.
- Earnings-Only Approach: The survivors will live off the investment earnings of the policy without cashing in the principal value. Preferable if you want funds to be available for children after your spouse has also died. Like any investment, this method is subject to the risk of changing market interest rates. To provide a sufficient income stream, the death benefit is usually significantly higher than in the liquidation approach.
- Liquidation Approach: The surviving beneficiary utilizes a portion of the principal as well as the investment earnings. There is more risk with this approach, particularly if the investment earns less than originally predicted. The surviving spouse may not have sufficient income to live on for the remainder of their life.