As an advisor I get asked this question on a regular basis. The truth is that there is no purely right answer, and it largely comes down to what you would like to have happen if/when you pass away. I do find that there are a few barriers for people when they start thinking about life insurance though, and that can cause you under insure. So here are a few considerations and then some of the constraints that we face when trying to plan for our own demise.
Debts. This is a pretty straight-forward consideration. People take the mortgage, car payments, loans and basically lump them together and want to have that paid off if/when their significant other survives them. This is general, and usually a sound practice. But the important consideration here is to review this regularly when your circumstances change. Have you purchased a new property or taken on new loans? That might seem obvious, but it is somewhat consistent that people buy insurance and set it aside. This would be a mistake though, because you might find that the insurance cannot adequately cover these borrowings.
Decreased Income. I think that this is the often overlooked piece of the equation. If the main breadwinner of the household passes away, that income is relied upon for more than just your debts! In other words, while covering debt in the first position is important there is a significant issue lurking as well. It’s cash flow. In a household with two people working and one income significantly higher than the other it might not be enough to just take care of debts because even eliminating the debt doesn’t ensure that you will have adequate cash flow. The impact doesn’t just affect your standard of living today, but it also impacts your retirement savings and lifelong planning. It’s an enormous impact that cannot be understated. The other important consideration regarding decreased earnings is the decreased earnings for the surviving partner. Will you be able to work as many hours if your spouse passes away? Factor in how many hours your spouse looks after the children, or picks them up and drops them off while you’re working. Will you require extra help around the home to complete tasks normally completed by your spouse?
Other needs and wishes. Aside from the liquidity needed to immediately satisfy things like cash flow needs and the like, there are other important factors to consider. If you’ve purchased a vacation property and would like to keep it in the family or have assets that are taxable upon death you might want to factor in that tax.
There are a couple of ways to decide on an amount that makes sense. You can use a calculator, which is effectively a needs based approach. Here you insert the debts and income required and effectively the calculator gives you a number. The two main options are based on maintaining that capital or depleting it over the years. It’s important to realise that the income shortage or potential income shortage is the most significant amount for most people. The danger or exposed issue for a lot of people is that because they are basing their insurance needs on their debts, that the debts can be covered off, yet they have a cash flow issue. So while it sounds good at the time of the discussion to think “if we have no mortgage then the cash flow becomes easy.” It might. But once you remove one income, and yet still have property taxes, maintenance, and other obligations there can still be a quantifiable cash flow need. The best thing you can do is work with someone qualified to help you best assess these risks and solutions. You can also play with the figures yourself to see what amounts look sensible for you on a site such as http://www.insureright.ca/calculator/#life which is through Manulife. It doesn’t mean you have to use them for the coverage, of course, but gives you an unbiased view of what kind of coverage amount would best suit your needs.
From there, a frank discussion with an advisor can help you ascertain the type of insurance that makes the most sense and how best to structure it.