There are two basic approaches to help determine the amount of life insurance one should carry, but regardless of the method used, the amount should be sufficient to accomplish one’s goals, whatever they are.
One method is known as Human Life Value (HLV), and it attempts to quantify the economic value of the life in question, and insure it accordingly. It is what an economist does in trying to establish the value of a life lost due to a wrongful death.
At the most basic level, age and earnings are two of the primary criteria used for determining the economic value of a life. For example, a 30 year old earning $100,000 per year will earn $3.5 million over the remainder of his working lifetime (provided he works to age 65). But that’s if she never receives a raise. Annual raises averaging 5% will inflate that number to over $9 million, while 3% will increase it to over $6 million.
So now that we have estimated lifetime earnings, we can make a very rudimentary calculation of HLV by applying a discount rate to those lifetime earnings, i.e., an assumed interest rate. HLV is thus calculated by applying the discount rate to the lifetime earnings.
If we use a 5% discount rate in our example, the HLV is $1,637,419 under the 5% raise scenario, and $1,096,119 using annual raises of 3%. Note: This is a very basic illustration of the HLV concept; more detailed information and more comprehensive examples can be found by googling “human life value.”
While this method gives some indication of what the life in question is worth, it does nothing to indicate what the insured’s dependents might actually need were he to die. Hence the second basic method, aptly called “Needs Analysis”. This method attempts to estimate the amount the dependents would need to continue a similar lifestyle.
There are countless variations of Needs Analysis, but in the interest of keeping things simple, the Capitalization of Earnings method will be explained. It calculates the lump sum of money at an assumed interest rate needed to produce the current after tax living expenses.
For example, if the current monthly living expenses are $5,000, then $1,000,000 would be needed at a 6% rate of return, $1,200,000 at 5%, and $1,500,000 at 4%. Notice the pattern? The higher the assumed interest rate, the lower the amount of life insurance needed.
But remember, one of the elements to indicate a need for life insurance is love, and if you truly love someone, you would never put them in a position of having to earn an unrealistic return on investment.
This is a very simplistic overview of how to estimate how much insurance to buy, but I cannot overemphasize just how simplistic it is. Professional journals routinely publish 5,000+ word articles on this very subject, so please take it for what it is, an overview.
Also remember that no method, no matter how sophisticated, will produce an exact amount; there are just too many variables and unknowns. So if you’re going to make a mistake, err on the conservative side. After all, you’re doing it out of love.