While there is no absolutely correct way to determine the amount of life insurance one should carry, there are two broad conceptual frameworks to help calculate an appropriate amount. Notice I said appropriate and not correct.
The “Needs Analysis” method is what is used most often, because it produces the smaller amount. This method tries to approximate the minimum amount needed to produce an income that would maintain the current lifestyle. Well what’s wrong with that? There’s no reason the survivor should experience a windfall, right?
The problem is that it takes a large lump sum to generate even a small cash flow at today’s low interest rates. How much annual income could a million dollars be expected to produce in today’s environment?
The Needs Analysis method also reduces the amount of life insurance needed by the assets already saved. For example, if the preliminary needs analysis is showing that $1,000,000 is needed and there is $250,000 in a 401(k) account, then only $750,000 is needed. This never made sense to me.
If your home is worth $1,000,000 and you have $250,000 in a 401(k), are you going to insure the home for $750,000? Only if you’re an idiot. But pundits routinely suggest that the life insurance need should be reduced by any savings and/or investments.
The Human Life Value concept was developed by Dr. Solomon Huebner and says that earning capacity is what should be insured. In other words, a 35 year old earning $100,000 per year and planning on working to age 65 should have approximately $4,000,000 in life insurance, because that is the amount that won’t be generated if he/she were to die today.
Now you can see why the Needs Analysis method is more commonly used. But only in life insurance. We insure our cars for their current value (what the industry refers to as the actual cash value) and our homes for their replacement cost, but few people insure their lives for the projected income.
My bias aside, this doesn’t seem like an area to be penny wise and pound foolish. If a mistake is to be made, it is best to err on the side of conservatism. But of course, the facts don’t matter.