Revisiting The Life Insurance Rule of Thumb

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After a decade of being in the shadows of the markets, life insurance is back at center stage. This makes it a good time to revisit the life insurance rule of thumb, or how to answer when a client asks how much life insurance he or she should have.

Its a fact that the events of the past two years have made addressing asset protection a fairly easy process with clients, young and old. Most individuals have come to appreciate the importance of preparing for an untimely death. In the wake of September 11, hardly a week went by without a media story on the importance of having risk management products such as life insurance.

A June 2002 Harris Poll commissioned by Northwestern Mutual shows that nearly one in three Americans have an increased need to talk with a financial professional. This is not a surprise considering the tribulations weve experienced with the economy.

With regards to life insurance, 31% of Americans purchased more coverage following 9-11 even though 80% already had life insurance on their own, through an employer or both.

Heres the rub: Many Americans are still underinsured. Moreover, the chances are, they dont even know it. The majority of individuals with household incomes of at least $75,000 (those more prone to plan) have less than $250,000 of coverage: 76% own permanent insurance and 61% own term. Yet, 83% believe they have enough.

Whats at issue here is the seemingly never-ending confusion over the rule of thumb. Where some say its five to 10 times earnings, others offer their own calculations.

Employers typically offer life insurance benefits in the amount of two times income–a significantly insufficient number for most people. Remember, life insurance must cover more than just day-to-day expenses and, in some cases, for more than just a few years.

Another very simplistic approach–also misleading–is based on annualizing all monthly expenses, multiplying that by the number of years survivors will need financial support, and subtracting any existing savings and investments. It is a calculation that assumes the nest egg will run out in a set number of years and that the family will eventually make up the breadwinners lost income. However, this scenario does not take into account the impact of inflation, nor does it fully capture future expenses such as college education or retirement for the spouse.

The United States Department of Justice, in distributing the Victims Relief Fund to the surviving family members of those lost on September 11, outlines a process to determine the economic loss. Their tables (www.usdoj.govvictimcompensation) enumerate settlements that ranged from 4 times income to as much as 50 times current annual income for individuals of various ages and income levels. For a 40-year-old individual with $100,000 in annual income, the payout was calculated at 18 times income.

LIMRA International uses the USDOJ data as a starting point. As a rule of thumb, start with the average multiple of income from the DOJ figures–in the range of 25 times income–then deduct the value of any government benefits, existing investments or other sources of income.

Is it any wonder theres confusion on this issue? The debates over the life insurance rule of thumb are analogous to the term vs. permanent arguments: Everyone wants to simplify the matter; just the opposite is happening. Truth is, there are no cookie-cutter solutions to how much life insurance to buy. Frankly, thats the best answer we can give our clients, many of whom are skeptical of our recommendations anyway.

Instead, we should help clients obtain an adequate safety net by starting the planning process with these questions:

Does the family have a mortgage payment or any other debts?

If there are children, does insurance need to cover the cost of education? At what level? Will the kids go to a public school or their parents private school alma mater? Should there be a separate policy to provide for children from a prior marriage?

What standard of living will the survivors maintain? Will it be at the same level including amenities like vacations and club memberships?

Are there other dependent or potentially dependent individuals such as an elderly parent?

If the spouse who passes away is primarily responsible for childcare, will childcare costs be an issue?

How much has been accumulated for retirement for each spouse? How long will that amount last if either spouse dies before reaching retirement age?

Also, dont just focus on expenses, but rather review lifestyle, debt, taxes, number and ages of children, personal consumption, family wealth, blended families, disabilities within the family unit, special considerations involving owning a business, earned vs. unearned income, how much is hoped to be left to heirs, dependence on investments for income (consider current interest rate/investment return environment), realistic income potential of a surviving spouse and anticipated retirement lifestyle.

Until youve explored these and other issues you will not be able to make the best recommendation as to how much life insurance your client should have. The rule of thumb here is that there is none.

is vice president, marketing, at Northwestern Mutual. Her e-mail is janieschiltz@northwesternmutual.com.


Reproduced from National Underwriter Edition, June 9, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.