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Determining the Appropriate Amount of Life Insurance

Ensure you are properly meeting your client’s needs by understanding which approach to employ.By Glenn E. Stevick Jr., CLU, ChFC, LUTCF

By Glenn E. Stevick Jr., CLU, ChFC, LUTCF

There are several approaches you can use to determine the appropriate amount of life insurance for a client. The first, the multiple-of-income approach, may be too simplistic to properly serve your client’s needs. The other two, the financial-needs analysis and the capital-needs analysis, are more sophisticated and allow you to address a client’s specific circumstances and concerns.

Multiple-of-income approach
Some financial journalists recommend that people have life insurance and liquid assets in amounts ranging from five to seven times their annual income. This simplistic approach is easy to explain and requires few computations. But it ignores specific information about assets your client has accumulated and other sources of funds such as trusts and inheritances, and thus may overinsure or underinsure him.

More sophisticated approaches translate your client’s needs into estimated costs, and evaluate assets and existing coverage to determine how much of the funding is already in place. Any deficit between the intended goals and current financial sources is usually a candidate for additional coverage.

Financial-needs analysis approach
The financial-needs analysis approach identifies survivors’ immediate cash needs and ongoing income needs, and assumes life insurance proceeds will be liquidated to meet them. This approach estimates the family’s financial needs if the client were to die today. It takes into account both immediate and ongoing needs.

The immediate needs can be categorized as lump-sum needs at death. These require immediate cash, and may include:

  • final illness costs that insurance does not cover
  • repayment of outstanding debt
  • estate taxes
  • probate and attorney expenses
  • funeral, burial, cremation expenses
  • funds to cover survivors’ ongoing expenses
  • an emergency fund

The surviving dependent family members will also have ongoing financial needs that require continuing income until the dependents are self-supporting. These needs commonly fall in four categories:

  • readjustment income for the period immediately after death
  • dependent income continuing until the youngest child is self-sufficient
  • income for the surviving spouse, after the children are self-sufficient and before the spouse is again eligible for Social Security benefits (the blackout period)
  • surviving spouse’s income after renewed eligibility for Social Security benefits and private pension benefits

Because the purpose of life insurance is to fund the unfunded portion of these objectives, all existing funds that can provide part or all of these needs should be considered. For simplicity, you may suggest using 70 percent of the insured’s current income as the target level, rather than calculating each anticipated need. A higher or lower percentage may be more accurate depending on the family’s circumstances. Potential sources of income include Social Security, employer-provided plan benefits, group life insurance and the surviving spouse’s earnings.

Capital-needs analysis approach
The capital-needs analysis approach relies on meeting income needs with the earnings on a principal sum without liquidating that sum. It is appropriate for a client who wishes to meet the financial needs of surviving family members without the capital sum being depleted, and to leave an estate for heirs or charity.

Preserving capital requires a substantially larger capital sum than consuming it during the survivors’ remaining lifetime, thus requiring a much higher insurance recommendation than the financial-needs analysis approach, as shown in the following example:

Based on a 5 percent interest assumption, a $1 million capital sum will provide a monthly income of about $10,500 for 120 months under the financial-needs approach. At the end of that period, the capital sum will have been liquidated.

Under the capital-needs approach, a $1 million capital sum will provide a monthly income of about $4,200, but the income will continue indefinitely. To provide a monthly income of $10,500 would require a capital sum of about $2.5 million.

You may use a combination of the two approaches, liquidating some of your client’s capital and retaining some of it.

With the capital-needs method, determine the amount of life insurance proceeds as in the financial-needs approach. You prepare a personal balance sheet for the client. All the liabilities, immediate cash needs and assets that do not produce income, such as the residence, are subtracted from the total assets. The remainder is the client’s present income-producing capital. The last step is to compute the amount of additional capital needed to achieve the desired income objective, net of all other income sources.

You determine the amount of additional capital needed to meet the income objective by dividing the amount of additional income desired by the applicable interest rate representing the after-tax rate of investment return anticipated on the capital sum. For example, if $100,000 per year of additional income is desired, and the capital sum generating those income payments can realistically be expected to generate a 5 percent return after taxes, a $2 million fund is sufficient ($100,000 ÷ .05 = $2,000,000).

The choice between capital liquidation and capital retention is not necessarily an all-or-nothing decision. You may use a combination of the two approaches, liquidating some of your client’s capital and retaining some of it, as a compromise approach to filling the gap between the income needs of the survivors and the other available sources of income.

Glenn E. Stevick Jr., CLU, ChFC, LUTCF, a member of Tri-County AIFA (N.J.), is an LUTC author and editor, and assistant professor of insurance at The American College. Contact him at



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