Everyone should consider whether they need life insurance and how much life insurance cover you need to ensure that your loved ones are comfortable if the worst was to happen. Our calculations below should help you answer the question: How much life insurance cover do I need?
What is life insurance?
Life insurance is a purchased product, which will pay out a certain amount of money to specific nominees upon your death. Like all insurances, you pay insurance premiums each month until the insurance is used.
The cost of your premiums will be based on a number of factors including your age, current medical conditions, medical conditions that run in your family and your lifestyle (including if you smoke, drink, etc).
Life insurance is generally split into two products:
- Term Life Insurance
- Whole Life Insurance
There are little or no tangible advantages to taking out whole life insurance. Therefore, we are going to ignore that for the sake of this article and simply focus on term life insurance.
So, now we know what it is, how do we determine how much life insurance cover you need?
The key with the following calculation is that there is absolutely not a one-calculation fits all (no matter what the life insurance cover calculators tell you). However, when trying to work out your required level of cover, I would advise you to do the following:
- Take the net worth of your “household” (this can be easily calculated from the spreadsheet in the related article below) as a negative figure (e.g. if you have £50,000 net worth, then start your calculations with -£50,000). By household, take all immediate dependents (spouse, children, etc):
- Add funeral costs (UK average is around £3,500).
- Subtract Existing Life Insurance Cover (including Death In Service Benefits).
- Add the future expenses of your children: (average of £3,700 per year for each child from their current age to the age of 18).
- Add future university costs for children (£9,000 per year for tuition ; £5,500 per year for living expenses).
- Consider your specific situation and add X years of other household expenses if your spouse would be required to quit work, or estimate X years of child care costs if your spouse would continue to work
If you have a positive figure, then you need to identify whether this is the cover you need. To do this, you’ll need to sit down with your family, dependents or significant others to work out your specific situation. We will look at two examples to help us understand how to do this.
However, before we get to that, it’s important to reiterate that if your calculated figure is negative, you probably don’t need life insurance. Many people are in this situation and still take out life insurance because they think that it’s financially responsible. It’s not. You have to remember the Moneystepper rule of insurance.
Remember the Moneystepper insurance rule
Before we start, I would like to remind you of the Moneystepper rule for insurance:
Taking out insurance ALWAYS costs you money in the long-run. It is always negative EV. Therefore, if you can afford not to take out insurance, you shouldn’t take it out.
I’ll demonstrate this by using myself as an example. My calculation provides me with a negative figure for my required cover and hence I don’t need insurance.
However, imagine that I wanted to take out £100,000 cover over 20 years as a 30 year old. Based on a quick search, this would cost me around £7.00 per month. Many people would then say for £7.00 per month, it would be worth that small expenditure each month to obtain a £100,000 pay-out upon death.
Firstly, let’s determine the cost. £7.00 per month for 20 years totals £1,680 in insurance premiums in those 20 years. However, let’s say that we invest this money at 9% annual returns (e.g. in the stock market including dividends), then the real cost of this premium is around £4,300.
The second part of the equation is a more morbid one. How likely is it that I will die in the next 20 years? According to the 2013 figures from the ONS, the following age ranges have the deaths per 1,000:
- 30-34 years old: 0.8 per 1000 population
- 35-39 years old: 1.2 per 1000 population
- 40-44 years old: 1.7 per 1000 population
- 45-49 years old: 2.5 per 1000 population
This sets our chance of dying in the “term” is 5×0.8 + 5×1.2 + 5×1.7 + 5×2.5 = 31/1000 or 3.1%.
At the age of 30, we have a 3.1% chance of dying in the next 20 years, and hence our average payout is £3,100. In reality, our chance of dying as a non-smoker would be even less.
Therefore, if we make a loss of £1,200 (or almost 40% of the payout amount) if we take out life insurance when we don’t need it.
Calculating how much life insurance cover you need – John’s Example
Let’s take a made up individual: John. He has a wife and two young children (a 5 year-old boy and 3 year-old girl). He works for the NHS. Let’s start working down the list.
- His Moneystepper 2015 Savings Challenge graph shows that his family have a net worth of £58,000.
- He estimates funeral expenses of £4,000.
- He currently earns £23,000 per year, and has death in service cover with the NHS of two years of pay.
- His children will incur future expenses of £3,700 per year for a total of 28 years (13 years for the 5 year-old and 15 years for the 3 year-old).
- He wishes for them both to go to University, which will cost another £14,500 per year for 6 years (3 year course each).
So, our cover number is: – £58,000 + £4,000 – £46,000 + £103,600 + £87,000 = £90,600
This would suggest that this is the level of cover that John requires.
However, you will notice from our list that we haven’t considered the last point regarding child care or household expenses. This will be very personal for everyone and will require some pretty grim conversations with your loved ones.
John’s need for life insurance cover will be very different if John’s wife earns £200,000 as a hot shot lawyer or if she is currently unemployed.
After a great deal of discussion, John and his spouse determine that his wife will need to leave employment to look after their children until they go to secondary school (until the youngest is 11 years old).
This greatly changes their situation. He will need to add another 8 years of household expenses (which they estimate from the Moneystepper Savings Challenge Spreadsheet as being around £12,000 per year). Note that this needs to be altered for any expenses that will no longer be incurred (such as a mortgage as this is effectively paid off when the “net worth” is liquidated).
This bumps another £96,000 of cover required. Once again, this number will be hugely dependent on each persons’ personal situation.
Let’s take another example:
Calculating how much life insurance cover you need – Claire’s Example
Claire is 35 years old, has a partner which she has been with for 8 years, but they are not married. She works for a private company.
- Her Moneystepper 2015 Savings Challenge graph shows that she and her partner have a net worth of £5,000.
- She also estimates funeral expenses of £4,000.
- She currently earns £44,000 per year, and has death in service cover of three years pay, which she has nominated to her partner if she were to pass away.
- She has no children.
Claire’s cover number is: – £5,000 + £4,000 – £132,000 = – £133,000
Whilst Claire and her partner have a much lower net worth than John, she has a negative final number and hence she actually has no need for life insurance. Claire’s partner (her only dependant) would obviously be distraught, but financially they would not need to be supported by an additional life insurance pay-out.
How long should my life insurance policy be?
The other aspect of term life insurance is the length of the term. However, this is probably a subject to address by itself. As such, please come back tomorrow when we’ll be posting the following article:
If your calculation suggests you need life insurance…
Now, do your own calculation.
If it shows that you need life insurance cover, you can compare the best options through London & Cover, which compares leading Life Insurance providers (including Aviva, Legal & General, LV=, Prudential, Friends Provident, etc) and finds the best deal for you via the banner below: