Life insurance coverage: things to consider

It is said that the reason for buying your life insurance young it the unbeatable price. This may be true, but the problem is that it is hard to map out future potential requirements for the money. And even with the unbeatable prices, you still don’t want to overpay, so it makes sense to sit down and think about possible scenarios.

There are several methods to estimate how much term life insurance coverage you need.

The simplest one is your salary times 10. This method is indeed very simple, but I’d say it is too simple. You’d hope that your salary will grow over time. Will you be underestimating your coverage if you base it on your current salary? Probably yes. Would you be taking into account specifics of your family and life situation? Probably no.

Other methods get into a more detailed analysis of your personal situation. For example D.I.M.E. method. The abbreviation stands for:

D — debts

I — income

M — mortgage

E — education

This method suggests that the amount of coverage you need consists of 4 components. Debts such as car loan, credit card debt, line of credit and other personal (non-mortgage) loans. Income replacement, i.e. as an income provider for the family, what would it mean to have day-to-day expenses for your family supplemented to a comfortable level if you were to pass unexpectedly. Mortgage, self-explanatory. Education for your kids (if applicable). Add them all together, and call up your insurance broker, right? Not so fast. There are a few more things to consider.

Your current assets. You may already have savings that can cover (at least partially) some of the obligations. For example, you may already have contributions to RESP for your kids. How much are they projected to be by the time they start post-secondary education if you stop contributing now? This amount can be deducted from the education (E) part of the coverage estimate. You may have other savings that can provide income replacement or be used towards various obligations. If you do, you may want to deduct them from your coverage estimate.

Other coverage. Many employers provide life insurance coverage as a part of benefit package. Consider if you want to rely on this insurance and deduct it from your total estimated life insurance coverage.

Time horizon. For the income (I) part of the estimate, how long should the income last for? A popular recommendation is until your kids get independent. Other things to consider is whether you have other dependents who may need support if you pass unexpectedly or if you want the payout to continue providing income replacement for longer. Considering that in Canada the life insurance payout is a lump sum non-taxable payment, it is a good idea to discuss with your beneficiaries or the executor how the lump sum should be invested to provide lasting income, balance the risks and returns, and consider taxation of the earned income.

Contributions of other family members. If you have a partner, do you need to include the full amount of your shared obligations in your personal coverage estimate? Or do you allocate it between the two of you equally? In some other proportion? This applies to the mortgage (M) and debt (D) parts of the coverage estimate. For a family, estimating the life insurance coverage should be a group project and it needs to consider differences between your and your partner’s financial situations. If you are the breadwinner, your coverage needs to be higher than your partners, and the other way around.

Coverage layering. Term life insurance is usually sold in 5-year increments (e.g. 5-, 10- 15- year term contracts). This gives you the opportunity to layer contracts and achieve variable coverage. For example if you are purchasing 3 term contracts $100,000 each with 5-, 10- and 15- year term, you will have $300,000 coverage for the first 5 years, $200,000 for the second 5 years and $100,000 for the third 5 year increment.

Looking into the future. When estimating your life insurance coverage, you should look at your future financials and not only what you have now. As years go by, your income may increase. Will this mean “lifestyle creep” resulting in higher day-to-day expenses for your family? You will be paying off debts and mortgage. 5–10 years from now, you will not need quite as much to pay off the remainder of the debt or mortgage as you do now. If you continue contributing to RESP, the requirement to cover your kids’ education will decrease. Take into account these future changes and use coverage layering to customize your coverage.

Disclaimer: I am not a certified financial planner and this article does not constitute financial advice. Please do your own research before acting on the material of this article.