How much life insurance do you need?
How much life insurance you need depends largely on your financial circumstances but also, in part, on your own view of what is adequate. Also there are a number of different types of life insurance policies to suit specific needs, be it a requirement for a lump sum payment on death or a regular income stream. In this article I will help you work out how much life insurance you need and what it will cost.
There can be a number of reasons why people require life assurance but generally most of these fall into one of the following categories:
- To clear a mortgage, or other debts or pay funeral expenses
- To pay a potential Inheritance Tax (IHT) bill payable on your estate, so ensuring that your dependents receive more of your assets
- To provide an income or capital sum for you dependents in the event of your death
So I’m only going to look at the above scenarios while assuming that in each instance the need is to be met by the receipt of a tax-free lump sum. That means I’m going to consider ‘term assurance protection contracts’ here, which pay out a tax free lump sum in the event of death, within a given period of time – called the term. Term assurance contracts are used to cover most people’s post-death requirements. (term assurance contracts do not have an investment element to them as they are pure protection contracts).
So going back to the original question – how much life insurance do you need? Well a good starting point is to look at the financial requirements immediately after you die. So let’s crunch some numbers.
Life insurance calculator
STEP 1 - Mortgage
Write down the amount of your mortgage that is outstanding. I’ll use the figure of £250,000 as an example.
STEP 2 – Other debts
Write down any additional debts you may have.
I’ll assume the figure of £20,000.
STEP 3 – Inheritance tax bill (IHT)
Now calculate your rough inheritance tax (IHT) bill in the event of your death. If you young and have a relatively modest estate (i.e. the total sum of your assets) you can skip this step.
Take the value of your worldly assets which you plan to pass on. Now deduct any IHT exemptions (i.e. you don’t pay any IHT on money left to a spouse) and your IHT allowance of £325,000 (for the tax year 2015/16).
Take 40% of this figure and you have a rough estimate of the likely IHT bill upon your death
So let’s assume you have an estate of £1,000,000 (ignoring your house which is jointly owned with your spouse – as they will assume full ownership) and you are leaving half of the estate to your spouse and half to a friend.
Then £1,000,000 - £500,000 (left to your spouse) - £325,000 (your unused IHT allowance) = £175,000 is liable to IHT. Now take 40% of this figure which gives you £70,000.
STEP 4 – Dependents’ income shortfall
Now you need to work out the income requirements of your dependents – over and above their own earnings plus any income their inheritance will provide. I’ll assume your spouse will need an additional £50,000 a year tax free (ignoring inflation) for 10 years after you die.
So that’s the equivalent to a lump sum of £500,000 when you die.
STEP 5 - Existing policies
Note down details of any life insurance policies you already have, including those offered by your employer if applicable.
I’ll assume a death in service sum assured of £200,000
Now carry out the following calculation.
Step 1 + Step 2 + Step 3 + Step 4 – Step 5.
In my example that equals £250,000 + £20,000 +£70,000 + £500,000 - £200,000 = £640,000.
So this is the figure that you would need to insure in order to meet all of the above requirements if you were to die today. So you would be underinsured by this amount.
The most important step of all
If you've worked out that you are underinsured the most important thing to do for your family's sake is to take action. But most people don't realise how cheap life insurance is. For example a healthy 30 year old man could get £100,000 for just £5 a month!
After researching the market this is the best life insurance comparison site for getting the cheapest life insurance quotes online. I've personally vetted their service, which is excellent, and their knowledge will help you choose the best life insurance policy and level of cover for you. They compare life insurance policies from the biggest insurance companies and you can get quotes on Level term assurance, Mortgage Life Insurance, or Family Income Benefit.
So if you are underinsured then find out how little it costs to put it right – it will only take a few minutes.
How to reduce the cost of your life insurance needs
To insure yourself for the figure needed at the date of death you don’t have to take out just one term assurance policy with a sum assured of £640,000 (using the figures from the above example). This would be the most expensive way of insuring yourself albeit it would be the simplest.
Looking at the above example, each need exists at various different times. Let’s assume you had a repayment mortgage. In 12 years time the value of your outstanding mortgage will be greatly reduced (as you will have repaid a fair bit by then). So at that point you won’t need life cover of the full £250,000 stated in step 1. Similarly if you were to die in 12 years time your dependents’ extra income requirement will no longer exist. So your life cover need will again be lower.
The answer would be to take out a number of term assurance contracts where the policy type, the sum assured and the term of each reflected each separate need. For example, a decreasing term assurance contract could be taken out with an initial sum assured of £250,000 and a term matching that of your mortgage. A Family Income Benefit plan could be taken out to satisfy your dependents’ income requirements. This would save you money and has the additional benefit that each policy can be assigned or placed in trust for different people (a topic for another day). Also don’t forget to consider the impact of your spouse dying. Could you cope financially on your own? You may want to consider taking out a joint life insurance policy so that your mortgage is cleared should the worst happen to either of you.
This may sound a bit complicated but the good news is that once you have used the aforementioned price comparison site to find the cheapest deal, the firm behind the calculator can help refine that solution and reduce the cost further.