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One of the major questions we get asked in our financial advisory practice is: “how much life insurance do I need in Canada?
While death is a topic that most people turn away from, it is as certain as the sunset; sadly, death is an inevitable path that all living beings will have to pass through at some point, hopefully not prematurely, yet such an event isn’t a matter of “if” but of “when”.
The financial impact that comes with premature death can be devastating to our loved ones or dependents when a solid financial plan for such an event isn’t implemented, as not only will it affect the survivors emotionally but financially as well.
One of the best ways we can safeguard the financial security of our loved ones is through a well-thought-out life insurance policy that has the ability to replace a person’s income.
As you may know, a life insurance policy is a contract that transfers the financial risk of one’s death to a life insurance company. In exchange for premium payments, the insurance company agrees to pay a lump-sum payment to beneficiaries upon death. This is essentially a guarantee that the dependents of the policyholder will be taken care of upon the person’s demise.
Ideally, the amount of life insurance a person should have must reflect the person’s economic value to his or her loved ones, hence, the value of a person’s life at death.
This seems paradoxical considering the fact that a price tag can’t be placed on one’s life. However, the value of human life is simply a basis for estimating as to how much the person’s value is to his loved ones (or business), hence is commonly used by insurance companies to determine the financial risks posed to a person’s dependents should premature death occurs during a person’s productive years.
There are several factors that are used to determine how much life insurance you need in Canada, and just as no two people are comparatively the same, no life insurance coverage should be the same.The combination of various factors enables insurers to evaluate the financial risk of a person’s premature death and place a ‘value’ on it. These factors are outlined below.
How Much Life Insurance Do You Need: Ways to Calculate
A lot of people get confused as to how much life insurance they really need to fully protect their loved ones from their financial obligations.
The average life insurance coverage most breadwinners carry is around $150,000.00 – $250,000.00. This may look much but if you have young kids, a mortgage, and other financial obligations, you’ll be surprised to learn just how short of an amount the average coverage is.
At the low-end, you should have more than enough life insurance coverage that at least provides your loved ones with enough capital that replaces your income, plus an amount to cover any immediate expenditures that may arise as a result of death like internment costs and final taxes.
Life Insurance Financial Needs Analysis
The methods used to determine how much life insurance you need to effectively protect your loved ones from the financial impact of death depends on your financial obligations at death. Meaning, you should have enough coverage against the financial obligations you wish to protect your loved ones from.
Standard of Living Needs Analysis
One way to compute the amount of life insurance you need is by multiplying the life insured’s gross income by 20. Say, your annual gross income amounts to $50,000.00, you should have a life insurance coverage of not less than $1,000,000.00 to effectively protect your loved one’s against loss of or reduced income in the event of premature death.
The idea is to have the necessary financial capital (money) that will continually work for your loved ones in the event of your untimely demise. Should the $1,000,000.00 payout, it should be invested, so the money works for your survivors, providing the needed income just as if the person earning the income was still there.
Say, the $1,000,000.00 principal earns 5% annual returns, ($1,000,000.00 x 5%), the family will still have the $50,000.00 annual income that the life insured earns when he or she is alive.
If the survivors are risk-averse and they choose not to invest the death benefit, they can hold on to the money or put it in a trust where they only withdraw 5% annually to provide them with the needed income. The only problem with this approach is that the capital would have consummated in the 20th year.
The standard of living needs analysis is a straightforward and simple way of computing life insurance death benefit but is usually only effective if we’re only computing an amount for income replacement purposes. This, however, does not take into account other important factors of life insurance needs computation, like final expenses and other financial obligations.
Using this method, it’s also a bit difficult to determine the life insurance needs of a stay-at-home spouse as there’s actually no set amount of income to base the 20 multiple from.
It can be quite difficult to determine as to how much life insurance a non-working spouse needs, especially when using the standard of living method but a stay-at-home spouse is of equal importance to their working counterpart.
Should a non-working partner pass-away, the working spouse may have to assume the deceased’ household obligations or hire help for the services rendered, which were usually free.
Losing a non-working spouse poses the same economic risks to the family as with losing a working spouse. If you have young kids and a household to run, you may not be able to work as actively as you may want, since you would have to assume your demised spouse obligations.
As a rule of thumb, it’s best to cover the non-working spouse with the same amount of coverage the working spouse has since the financial impact of losing a non-working spouse is technically similar to when the working spouse is lost. This is especially applicable if you have a young family to raise and a high financial obligation.
The DIME Method
DIME is an acronym that stands for:
- Debt
- Income
- Mortgage, and
- Education.
This method takes a more detailed look at a person’s finances than the standard of living method, which only multiplies a person’s income by a number of years. The DIME formula allows you to focus on the four critical financial obligations that most breadwinners carry.
- Debt: The total of all your consumer debts
- Income: The amount of capital your loved ones will need to replace your income ((annual income) / (5% or 4%) = Income Replacement Amount), ex: (30,000 annual income divided by 5% = $600,000.00) $600,000.00 is the income replacement coverage.
- Mortgage: Your mortgage balance.
- Education: This is the estimated future cost of sending your kids to college or university. You can get the figure here.
By adding all of these obligations together and subtracting them from your liquid assets, you would have a more comprehensive view of how much life insurance you would need.
I personally usually use this method in computing the life insurance needs of my clients with a bit of a twist. I add another line in this formula, called: Final Expenses, were I a lot between $25,000 – $50,000.00 to take care of any immediate cash needs that may arise upon a person’s death, thereby leaving the rest of the benefits intact to serve their individual purposes.
Income Replacement
The DIMEF Method (DIME + Final Expense) is a simple yet comprehensive way of determining how much life insurance a person need but some times, the ideal coverage is a bit too costly to some clients, if none of the two works for you, you may opt for the Income Replacement method.
The Income Replacement insurance needs analysis method focuses on just that, determining the amount needed to replace a person’s income in the event of premature death. If you read the previous method, this has been mentioned as part of the DIME Method but only focuses on one area.
If a complete amount of life insurance coverage is a bit restrictive due to budget constraints, I suggest my clients to at least implement one that replaces their income.
To compute for the amount of income replacement one needs, simply divide your annual income by a rate of return of between 4 and 5 percent, with 4 percent being on the more conservative side.
The idea is to invest the capital so the survivors live off the interest/income of the capital left by the deceased, so they can continue living the same lifestyle and still achieve the same future as when the deceased was alive.
And while an income replacement life insurance fails to cover the rest of the financial obligations, the survivors may still be able to afford their mortgage, cost of living, and bills if the income of the deceased was replaced.
The Income Replacement method of computing how much life insurance you need is similar to the Standard of Living method, but instead of multiplying a person’s income by the number of years of how long the income is needed, which is usually between 10 and 20 years, we divide the annual income with a realistic return on investment if invested.
To keep the income replacement amount intact, I always suggest that you add a buffer amount of say $50,000.00 to cover any immediate cash needs that may arise upon death, which includes internment costs and final taxes.
Life Insurance Needs Calculator
If you want a more comprehensive way of calculating your life insurance needs, the best way is to use a life insurance needs calculator.By just answering a few questions, you can get a picture of how much life insurance you’ll need to implement to fully cover your loved ones against your financial obligations.
Life Happens provide an easy to use, straightforward life insurance needs calculator that you can access here. To calculate your life insurance needs, simply click the link above and follow the step by step prompt. You can email the results to yourself or download your needs analysis as a pdf file. After which you can book an appointment with a reliable financial security advisor to help you work out a plan that works for you.
If you need help determining how much life insurance you need to protect your loved ones against the financial impact of premature death, explore different types of life insurance plans, and zero-out on a plan that fits your needs and budget, click here to book your appointment, and we will work with you in protecting your loved ones’ financial interest.
