When considering life insurance, you’re planning and preparing for an event most of
us would rather not think about. But life insurance represents a critical step in
managing your personal finances and ensuring your family’s well-being.

The Two Approaches to Life Insurance

You can use one of two approaches to estimate how much life insurance you should
buy: the needs approach or the replacement-income approach. Using the needs
approach, you calculate the amount of life insurance necessary to cover your
family’s financial needs if you die. Using the replacement-income approach, you
calculate the amount of life insurance you need to equal the income your family will
lose. Let’s look briefly at each approach.

You need how much?

Using the needs approach, you add up the amounts that represent all the needs
your family will have after your death, including funeral and burial costs, uninsured
medical expenses, and estate taxes. However, your family depends on you to pay
for other needs, such as your child’s college tuition, business or personal debts, and
food and housing expenses over time.

The needs approach is somewhat limiting. The task of identifying and tallying family
needs is difficult, and separating the true needs of your family from what you want
for them is often impossible.

Replacing Income

Using the replacement-income approach for estimating life insurance requirements,
you calculate the life insurance proceeds that would replace your earnings over a
specified number of years after your death.

Life insurance companies sometimes approximate your replacement income at four
or five times your annual income. A more precise estimation considers the actual
amount your family members need annually, the number of years for which they will
need this amount, and the interest rate your family will earn on the life insurance
proceeds, as well as inflation over the years during which your family draws on the
life insurance proceeds.

Note: Do remember as you quantify the income you want to replace that Social
Security provides generous survivors benefits if you’ve qualified. These benefits can
easily total $2,000 a month or more.

Calculating Replacement-Income Amounts with Excel

If you’ve got access to a computer running Microsoft Excel, the popular spreadsheet
program, you can use your computer to calculate the amount of insurance you need
to replace a specified number of years of income. Suppose, for example, that you
want to buy enough life insurance to replace the income from a $50,000-a-year job
for 15 years. If you figure your family will earn 5% on the life insurance proceeds
should the worst case scenario occur, you enter the following formula into a cell in
an Excel workbook to calculate the replacement income life insurance amount:

=-PV(5%,15,50000)

Excel returns the formula result 518,982.90 indicating that you would need roughly
$520,000 of life insurance, invested at 5%, to payout $50,000 a year for 15 years.

Two Calculation Tips

If you want to factor in inflation because you’re trying to replace income over a long
period of time, you should use a real rate of return rather a regular, or nominal, rate
of return.

To calculate a real rate of return, subtract the inflation rate from the interest rate in
the formula. For example, if you expect 2% inflation, you could replace the formula
shown earlier with this formula:

=-PV(5%-2%,15,50000)

Here’s a final calculation tip: You probably want to round up your number. For
example, if the formula provided earlier returns the value 518982.90, you might
want to round up this value to $600,000. Or $750,000.