Let’s settle down to tackle one of the most persistent questions ever when it comes to Life Insurance:
Just actually how much cover do you need?
Ask this question to 5 different people and you’ll probably get 5 different answers.
Your kaypoh colleague: I heard hor, 1 – 2 million is not enough these days.
Your skeptical aunty: Life Insurance, no need so much one. 50,000 can settle everything already.
Your significant other: Dear, as much as possible, please. <3
Your clueless neighbour: Dunno leh, my agent settled everything for me
Your insurance agent: Your clueless neighbour is right. Let me settle it for you. Just sign here <3
While most people are happy enough to trust their agent, it never does hurt to understand the general principle behind determining coverage requirements. (At the very least, a competent agent will never begrudge explaining why he or she proposes a certain coverage amount).
It all begins with understanding what exactly does Life Insurance is meant to do for you
Life Insurance 101
Here is the first assumption about you that we are making. You are a fully functioning and economically productive human being and are worth a certain amount of money.
We estimate this by summing up all your unearned salary/income into the future. Let’s call this amount X.
You may die prematurely, thus losing all the future economic value you were supposed to generate.
Life Insurance is supposed to take care of this scenario (and others like it, at least at a financial level), by replacing all the economic value that is lost by all these unplanned catastrophes. (These include: serious illness, temporary disability, hospitalization, etc)
Ok, so much economic value should I aim to replace?
Actually you have a choice. Choices, in fact.
You will have financial obligations to meet, like paying for a mortgage. Raising children. Providing for their tertiary education. Taking care of your parents in their old age. You spend a certain amount each month, hopefully, less than you earn, just like any fiscally responsible adult. Summing up all of these expenditures into the future yields you an estimated figure Y.
So before you walk with reckless abandon in front of a speeding bus, here are your options: Buy enough coverage to replace X (your total future earnings) or Y (your total future expenditures).
Herein comes the fun (and potential confusion): Both X and Y are estimates anyway, so regardless of which you choose, it will always be up for debate. Add to that another possibility – buying enough insurance cover so that it can be invested and takes care of all your future earnings or expenditures.
Show me the maths
John is 35 years old and earns $9,000 monthly. He is expected to work till age 65. He also spends $5,500 a month, on himself and his 2 children. He has another 20 years to support his children.
An estimate of X (his total future earnings potential) = $9,000 * 12 * 30 = $3,240,000. (for simplicity we are not applying a discounted value. And who is to say his income will never change?)
An estimate of Y (his total future financial obligations) = $5,500 * 12 * 20 + $2,500 * 12 * 35 = 2,370,000 (He supports his children for another 20 years, then supports himself to the median life expectancy, age 85)
So in theory, John could choose to cover himself for 3.3 million OR 2.4 million, depending on what he wants to replace, his income or his expenses. His family may not use up all the money he leaves behind, but at least they are not left financially stranded should he die tomorrow.
But wait, there’s more! Here is another way to do this. He could also buy 2.7 million of cover and effectively replace his annual income perpetually. (or buy 1.7 million of cover to take care of his early expenditure perpetually)
Here’s how. Assuming upon John’s death, his estate receives either sum of money and invests it for a long term return of 4% per annum. They effectively replicate his income / financial obligations, which is also the intended aim.
Woah, so there is a lot of room for creative interpretation and assumptions!
No shit, sherlock. That is exactly right. Which is why the task of determining how much cover to buy is part art, part science, and part guesswork. Life expectancy changes, income changes, and financial obligations change all the time.
So back to answering the question we asked in the first place: How then do we determine how much cover to buy?
Our first response would then be: check with your financial planner, and see if he or she proposes something that is based on reasonable going concerns (like how we have laid out the scenarios).
The gist is to be able to replace your earnings, or your expenditures, or have enough investment returns to generate either.
If you like what your agent proposes, and if you can afford the cover – then go for it. Everyone is comfortable with different assumptions, with equality varied budgets to boot. Else, show him or her this article and ask how his method deviates from us, and what is his reason for doing so.
Come to think of it, just share this article with everyone you know. Because we know you’re a kind-hearted soul who wishes the best for everyone around you. And that is an assumption we are comfortable to make. #humannature
www.ClearlySurely.com aims to eradicate the knowledge gap between consumers and Life Insurance. Our Vision is that one day, every Man, Woman, and Child will be properly insured.
We are also in the midst of building a top-secret new platform that will change the way people view financial planning. PS. It does not contain lame hyperboles like “fintech” or “insurtech” or “machine-learning” or “AI”.