Welcome to Journey To Millions!
In our previous articles, we’ve shared with you some steps on how you could start your journey to millions. You now know how to establish your goals, how to compute your net worth, how to create your spending plan and how to make more money.
Specifically, on the third step, we’ve also mentioned three financial goals that you shouldn’t miss. Namely, they are building your retirement fund and emergency fund, and purchasing an appropriate life insurance.
On this post, I will be sharing with you my research about buying an appropriate life insurance, hoping to answer why you need to be insured (or not be insured) and how much insurance you really need (if any).
What is a Life Insurance?
Insurance is defined by Investopedia as a contract in which an individual or entity receives financial protection or reimbursement from an insurance company against losses. Specifically, a life insurance replaces income that would be lost in case the person insured dies. Life insurance gives you and your family peace of mind, knowing that you can still provide financial support even after your death.
How Life Insurance Works
Jack Kapoor, on the 10th Edition of his book entitled Personal Finance, shared that insurance, in general, is based on the principle of pooling risks wherein a thousand of policy holders pay a small sum of money called premium into a central pool. The pool is large enough to meet the expenses of a small number of people who actually suffer a loss. The same principle also applies to life insurance.
Here’s how life insurance works as explained by Jack Kapoor.
A person joins the risk-sharing group (the insurance company) by purchasing a policy (a contract). Under the policy, the insurance company promises to pay a sum of money at the time of the policyholder’s death to the person or persons (the beneficiaries) selected by him or her. In case of an endowment policy, the money is paid to the policyholder (the insured) if he or she is alive on the future date (the maturity date) named in the policy. The insurance company makes his promise in return for the insured’s agreement to pay it a sum of money (the premium) periodically.
Who Needs Life Insurance?
Life is uncertain. You don’t know how long you’ll live. I don’t know either. No one will know for certain, so we need to be prepared. Your dependent family members will need continuous financial support now and even when you are gone. You need a life insurance especially when the amount of money you’ve saved is still low or not enough to cover the expenses of your dependents for the years to come.
However, if your savings is enough to cover the day-to-day expenses of your family until they can be financially independent, then life insurance is no longer needed. Likewise, life insurance is not necessary if you have no dependents. As Ramit Sethi said, “Young people don’t need [life] insurance. The risk of dying at an early age is low and the payout is only useful for the spouse and kids.”
As an example, let’s look at the life of Juan. He works for a local company and earns a decent salary every month. He uses this income to support his wife and two kids. One unfortunate day, on his way to work, he was hit by a truck leaving him dead on the spot.
Upon Juan’s death, it is obvious that he can no longer support his family for he can no longer work. His wife might be hard pressed to find a job to provide for the needs of their children. Fortunately, Juan purchased a life insurance prior to his death. His wife need not worry about sustaining their children while adjusting to her husband’s death. The insurance money received by Juan’s wife can buy her time to look for a job and perhaps a guardian/nanny to care for the kids while she is away. The kids won’t need to quit school, and the family won’t need to get into debt.
How Much Life Insurance Do You Need?
Here are some ways on how to compute for the amount of life insurance you need.
- Annual Expense Method
A quick estimate, as suggested by some financial authors, is to multiply your annual expenses by a factor. Pardon me for using an equation on this post, but trust me, it is for your own good.
Amount of Life Insurance Needed = Annual Expense x Factor
For example, the annual expense of your family is at P500,000 and you want to use “10” as a factor. The insurance you need is P5 million. This is calculated using the equation above.
Amount of Life Insurance Needed = P500,000 x 10 = P5,000,000
Upon your death, your family will receive P5,000,000 from your life insurance company. If your family can save this amount in a bank and withdraw only the amount they need each year (P500,000), they can live for the next ten years even without working. To illustrate this, please look at the table below. Take note that the table is for illustration purposes only. It does not take into the account the effect of inflation in the calculation.
|Years||Insurance Available Balance||Amount Withdrawn for Annual Expense||Insurance Balance at End of Year|
In the equation, if we use a higher factor, it would result to higher life insurance coverage. This gives you more years to support your family. However, this would also mean that you might be paying a higher cost. To guide us on which factor to use, here are the factors used by financial authors.
- Jack Kapoor uses 7 as a factor. According to him, it is based on the insurance agent’s rule of thumb that a typical family will need 70% of the bread winner’s salary for seven years before they adjust to the financial consequences of the bread winner’s death.
- Bo Sanchez and Dave Ramsey uses 10 as a factor. I think they use this for simplicity of calculation and both of them believe in buying term and investing the difference (I’ll discuss this in detail on a future article).
- Suze Orman uses 20 as a factor. She said that your death is a very traumatic event for the beneficiary, therefore, giving your family the utmost financial flexibility in case you die is the best thing you can do for your loved ones.
- Dual Income, No Kids Method (Kapoor, Personal Finance)
This approach is appropriate for couples who have no dependents and they both earn as much. This also assumes that the spouse that will be left behind will continue to work after their partner’s death.
The insurance needed is the sum of the funeral expenses, half of the mortgage, half of the auto-loan, half of credit card balance, half of personal debt, and other debts.
In case one spouse earns more than the other, I think it is safe to use a different factor.
- Non-working spouse method (Kapoor, Personal Finance)
Insurance experts in the United States estimated that extra costs of up to $10,000 (P420,000) a year may be required to replace the services of a homemaker in a family with small children. These extra costs may include the cost of housekeeping, child care, more meals out, additional transportation cost, laundry services, and so on. They do not include the lost potential earnings of the surviving spouse in the calculation, who often must take time away from the job to care for the family. To estimate the life insurance amount needed using this method, use the formula below:
Amount of Life Insurance Needed = Extra Costs x (18 – age of youngest child)
The extra cost of $10,000 in the United States is equivalent to $5,200 (or roughly P220,000)in the Philippines. This is based on the consumer price index of 2014 from numbeo.com.
For example, your youngest child who lives in the Philippines is 6 years old. The life insurance you need using Non-working spouse method should be:
Amount of Life Insurance Needed = P220,000 x (18 – 6) = P2,640,000
- Family Need Method (Kapoor, Personal Finance)
This method is a detailed estimate for your life insurance needs.
- Five times your personal yearly income
- Total Approximate expenses above and beyond your daily living costs for your family
- Emergency Fund (3 to 6 months of living expenses)
- Estimated Funeral Expenses
- Your total liquid assets
The life insurance that you need is 5-(1+2+3+4). This would estimate the shortfall your family would face upon your death.
In our dynamic economy, inflation and interest rates change often. It is recommended to reevaluate your insurance whenever your situation changes substantially.
As you may notice, all of the computations require that you have knowledge on your annual expenses. Without it, it would be difficult to estimate the right amount of life insurance that you need. On our next article, we will share with you a number of risks involved in making your personal and financial decisions. We will also explore what actions you can take to manage these personal and financial risks.
For now, I’d like to ask, which of these methods do you think you’ll use? Or better, which of these methods have you applied in your life insurance search? Please share your story in the comments portion below.
Also, if you have a loved one whom you think would benefit from this article, please send him/her a link to this page. I’m betting that not a lot of people know about these things yet.
Enjoying our Journey To Millions,
Image taken from Todd Neckers Attorney At Law