Life insurance*

Do I need any? If so, how much, when, and for how long?

Life Insurance is a key part of financial planning. Although many people don’t like to think about their death, it is important to have a plan for your family and loved ones in case something happens to you. There are many ways to incorporate life insurance into your financial plan, understanding what your needs are likely to be, at different points in the future, is crucial to designing a life insurance strategy for you.

For the sake of this topic, let’s assume that you don’t have a net worth exposed to federal estate tax (approximately $5.5 million) that you want to cover using life insurance.

To figure out your insurance needs, first, you should consider whether the liquid portion of your net worth (your investments) will be available to meet the needs your life insurance is intended to cover. Namely, replacing income lost in the event of your untimely death.

The amount of life insurance you need will depend on numerous factors: your age, earning potential, life expectancy, and perhaps most importantly, existing commitments. If you are a single income household with several young children, your commitments are far greater than if you are a dual income household with grown children with their own careers.

At Hibernian, we like to create a table of responsibilities to help clients think through this issue.

You can model changes in your circumstances over five-year increments and consider how your life insurance needs may change over that time. It is good to evaluate your life insurance needs by considering the interaction of your Liabilities and your Assets.

Sample Client Facts
Married couple; both mid-40s; one working
2 children; ages 12 and 17
Household income $180,000; Annual savings $18,000
20 years left on 30-year $640,000 mortgage at 4.5%
Investment portfolio of $200,000
Plan to provide for children to age 22 (when they graduate college)
Plan to provide for 4 years of college for each child at $25,000/year

Costs of Responsibilities (Liabilities)

Responsibility Today In 5 yrs. In 10 yrs. In 15 yrs. In 20 yrs.
Spouse needs40 yrs. at $50,000/yr.35 yrs. at $50,000/yr.30 yrs. at $50,000/yr.25 yrs. at $50,000/yr.20 yrs. at $50,000/yr.
12-year-old10 yrs. at $25,000/yr.5 yrs. at $25,000/yr.graduated
17-year-old5 yrs. at $25,000/yr.graduated
Education$200,000$100,000Both graduated

The other side of the equation, your assets, is the expected value of your portfolio (for this example we simply grow the portfolio of $200,000 at 6% each year, and add the $18,000 per-year of savings).

Value of Portfolio (Assets)

TimeframeToday5 yrs.10 yrs.15 yrs.20 yrs.
6% return + $18,000/yr. savings$200,000$369,113$595,424$898,279$1,303,568

Calculating the difference at each point in time, we see a declining level of responsibility and an increasing asset base to partially cover that responsibility. The anticipated potential shortfall (shown below) is what we seek to insure against.

Difference/ Shortfall$2,886,000 $2,027,887 $1,214,576 $522,721 Surplus ($303,568)

In this rough illustration we can see that while the sample clients need almost $2,900,000 to meet their current lifetime commitments, in five years they can expect to need just over $2,077,000, in 15 years it will be almost $523,000, but in 20 years their assets will more than cover their needs.

How do we cover the anticipated potential shortfall above?

The cost of insurance is based on the amount of the policy and the length of time it is in force. A $1,000,000 policy for 20 years is much more expensive than a $500,000 for 20 years. To cover this client’s needs we could buy one 20-year $2,900,000 policy but it will be less expensive to buy insurance that more closely matches the analysis above and the calculated expectations of potential shortfalls at certain points in the future.

To approximate the liabilities calculated above we could obtain four policies as follows:

TermAmountToday5 yrs.10 yrs.15 yrs.
Policy 1: 5 year$800,000$800,000expired
Policy 2: 10 year$800,000$800,000$800,000expired
Policy 3: 15 year$750,000$750,000$750,000$750,000expired
Policy 4: 20 year$550,000$550,000$550,000$550,000$550,000
Amount of coverage for the next 5 years $2,900,000 $2,100,000 $1,300,000 $550,000

20 years from now we calculate there will be no need for life insurance for these clients.

Basic term insurance normally gives you the greatest amount of total coverage for the lowest premium, but with nothing left for you if you, fortunately, don’t need the insurance.

Having life insurance that efficiently and effectively covers your needs is an essential part of your financial plan. It is also one of the areas people avoid, forget, or incorrectly purchase. Ensure that your life insurance matches your individual circumstances to protect your family.

*Please note: Hibernian Financial Planning does not sell insurance in any form.

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