If people depend on you to maintain a certain lifestyle, it’s important to consider life cover. Life insurance provides your beneficiaries with enough funds to maintain their current lifestyle in the event of your death – the point of life insurance is to limit the financial burden for those who are left behind.
This provision could be for your spouse, children or others. Dependency doesn’t always only need to be financial; for instance, you may be responsible the physical care of a relative.
There are two types of life insurance to consider: whole life and term. Whole life insurance does as it says and covers you for your entire life. Term cover is designed for a specified period, which is predetermined.
There are a number of ways to determine how much life cover is enough, and the right calculation will be determined by your personal needs, the needs of those left behind, and what you can afford.
When you may need life insurance
Not everyone needs life insurance. For instance, someone with no financial dependants or financial obligations that would affect their estate in the event of their death may not need life insurance.
There are a few instances, however, when you should consider life insurance:
- When you get married or formalise a relationship with your partner
- When you have children
- If you are responsible for taking care of someone, such as an elderly relative
- When you apply for a mortgage
- If you are the owner of a business, or a partner or key individual in a business
(In this situation, life insurance is important to protect your personal assets and/or the business assets. It might be a good idea to sit down with a financial advisor who specialises in business cover to learn more about the options.)
A caveat for those who decide that insurance is not for them yet is that their personal situation might affect the availability of cover later in life. For instance, certain health conditions might prevent someone from applying for life cover. There is also a cut-off age for those who want to apply for life insurance; in the UK, this ranges between 70 and 85.
Different formulas to use when calculating life cover needs
There are a number of formulas out there to determine your life insurance needs, and we’ve chosen four of the most popular. A good starting point is to look at the amount of debt you have and the expenses you are responsible for.
While these formulas allow you to determine a rough estimate of cover needed, it may help to sit down with a financial advisor to double-check that all your bases are covered.
The liability method
This formula is the simplest approach if you can’t afford a high insurance premium but want to square off your debt. This method works well for those who have a lot of debt and not much input to other expenses – those who don’t need to make provision for daily expenses or private education, for example.
You add all your existing debt plus a lump sum to wind up your estate. You can choose to cede your policy to a specific debt or let it pay out to the estate in the event of your death instead of directly to a beneficiary.
For example: John earns £4,500 per month and has no other expenses, apart from his debt, that would affect the household in the event of his death. His calculation looks like this:
|Overall debt outstanding
For John’s loved ones, cover of £179,000 will cover all John’s debt. The remaining payments no longer need to be made, which means they don’t affect the household. What John should add to this figure, however, are estate duties and taxes, as well as transfer duties for the property to ease the financial burden on his spouse.
The simple method
This formula simply calculates life cover as 10 to 15 times the annual income of the policyholder.
For example: Sarah earn £60,000 per annum. She is a young professional and decides to take out life cover while she’s in good health. Sarah has no debt as yet but wishes to get married within the next few years and start a family. She may need to adjust her cover later in life as her family grows and her personal position changes.
While simplistic, the simple method doesn’t take all the factors into consideration. It can also leave beneficiaries out of pocket or provide too much life cover.
The standard of living method
This formula calculates how much your financial dependants would need each year to maintain their standard of living in the event of your death. This annual figure is then multiplied by 20 years. Dependants can use 5% of the benefit each year to cover expenses. If the death benefit is well invested, it should recoup that 5% withdrawal through growth.
One situation in which this method works well is when there are no lump sum payments that need to be made towards a mortgage or other large debts, or when the remaining partner or beneficiaries are already servicing those debts. It simply allows the beneficiaries to maintain the lifestyle they did before.
The DIME formula
Perhaps one of the most comprehensive formulas, the DIME formula uses your Debt, Income, Mortgage, and Education as a guide. This method differs slightly from the standard of living method by including debt. A simple example would be: Debt + Income + Mortgage + Education = cover required.
|Debt + final expenses
|Death final expenses
In this example, Megan calculates that her family would need her income for 20 years. They would also need enough money to pay off all her debt, including her half of the mortgage. Finally, her life insurance should also make provision for the education of her two children.