According to LIMRA's 2016 Trends in Life Insurance Ownership study, more than 37 million household have no life insurance. Even conceding the fact that not everyone needs life insurance, that seems like an awfully high number to me.
Equally disconcerting is that 45% of households admit that they’re underinsured. If 45% admit to being underinsured, then you can bet the actual number is higher. I say that because I talk to people all the time who think that the 2-3 times salary that their employer provides is sufficient.
I have previously discussed a simple method to approximate how much coverage one might want, and that is the capitalization of earnings method. Simply divide your annual earnings by a reasonable interest rate and that is the total amount needed.
For example, if you earn $100,000 per year and you believe 5% is a reasonable rate of return, then $2 million (100,000/.05) is the total need. Subtract from that any existing coverage and that is the shortfall.
There is another method that, while maybe not as rational, can come close to approximating the total need. Ask yourself “For what lump sum of money would I agree to never work again?”
Now obviously the answer to that question will depend on a minimum of two factors, and quite possibly more. The two definite factors are age and assets. Generally, the older one is, the lower the number will be. Also, the larger one’s investment portfolio, the more likely the number will be smaller.
That’s an interesting concept, isn’t it? Many people would agree to never work again for 10 or 20 million dollars, but what is the absolute smallest amount that could get you to agree to never work again?
This exercise can help shed some light on the amount of life insurance that’s needed because most people underestimate the need. They think in terms of the lump sum instead of the income that the lump sum will generate. That is why many believe that their group term that their employer provides is sufficient.
In trying to come up with a number, remember that the lump sum can be invested to generate income, it’s just that you can’t work to generate any income. But you would still receive any pensions or social security that you qualify for.
Now whatever number you have decided upon, compare that to the amount of life insurance you have. If you have less insurance than the minimum amount that could get you to never work again, why? Because that is exactly what you are telling your beneficiaries they will do.