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Monday, 16 October 2017

How Much Life Insurance Do You Need?

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What a happy family - they must have
life insurance! 
Despite my son being a little over a year old, he has already managed to give me two blood noses. The first was while he was crawling over me on the bed. I was on the receiving end of a pretty solid kick to face. And the second time I guess he just wanted to see how far up my nostril he could stick his finger.

My wife claims both were accidents, but I know the little bugger better than that, and suspect revenge attacks for the time I did a sleep deprived, midnight nappy change and managed to put the dirty nappy back on instead of replacing it with a clean one (dad of the year award for me!).

The little guy has since started walking, and now that he is mobile I have realised it is probably a good time to reassess my life insurance - you know, for just in case...

In addition, I have recently been receiving a number of reader mails on life Insurance and how much is enough.

Now there are many financial plan type articles out there, and they usually contain a section around life insurance. You know, the usual “gotta look out for your family and make sure your financial plan does not derail in the unfortunate event that you can no longer bring home the bacon”- type paragraph. And yes – very valid point.

However none of these articles go on to mention how much life insurance you need to take out. And this, I guess, is with good reason. The exact amount is very dependent on individual circumstances and can be kinda difficult to work out (unless of course you are single, in which case your answer is probably 0).

Now I am of course not a financial adviser, this post is certainly not intended as financial advice, and while I cannot give you the exact formula to work out how much life insurance you should take out, I will share with you how I approach it.

Debt

The first thing I would like taken care of in the event that I am no longer around is our outstanding debt - the homeloans for our primary residence and for our investment property. (If we had any other outstanding debt such as car loans etc. I would want those squashed too). I just think it would decomplicate things, and provide some security for my wife if she owned both properties free and clear.

So I checked the outstanding amounts on our Bonds and I use this as my starting life insurance lumpsum requirement.

Living Expenses

Next, I estimated what the family's household budget would look like without me. I imagine it to be pretty similar to our cost of living in retirement, but obviously there would be some deductions:
  • One less adult on the medical aid
  • In an epic twist of irony, there will no longer be a life insurance payment needed to cover myself
  • Fewer groceries (and I suspect my wife will not need nearly as much wine if I am no longer around :))
  • And of course no monthly debt payments because those will all be settled
I also gave some thought to any additional expenses there may be. For example, I guess my wife will probably need a gardener (and as I type this I look out the window and realise that the creeper on the wall is in desperate need of a trim. It's been on some serious steroids from all the rain we recently got - sorry Cape Townians I'm really not intentionally trying to rub it in!) 

Then, from this total estimated monthly expense, I subtract the amount that will be covered by my wife's income. I could of course skip this part - but I discussed with my wife and she said she would still probably want to work. Then I also deduct the rental income from the now paid off investment property.

This leaves me with a monthly shortfall - the part that the life insurance payout will need to cover. So the question now becomes, what size lumpsum will cover this monthly shortfall in perpetuity?

Hmmm, that question sounds very similar to what lumpsum would I need to cover my living expenses so that I can retire? And luckily there is a pretty good rule of thumb for that!

I think the 4% Rule (rule of 300) is not a bad way to guesstimate how much money would be needed to cover the remaining monthly expenses - although I am throwing in a little extra, simply because the 4% Rule study was done over a 30 year period, and the money would need to last a lot longer than that if I were to kick the bucket around now. And also it's worth having a little extra just in case I underestimated somewhere or missed something.

So lumpsum required for the monthly expense shortfall = shortfall x 300 + some safety factor

I add this lumpsum to the amount required to settle debt.

Existing Insurance and Investments

Luckily I do not have to insure for the full lumpsum amount calculated above. Some of the lumpsum required will already be met by my existing investments. And since all my investments will rollover to my wife, I can subtract the value of my current portfolio from the required lumpsum.

In addition, I get some life cover from my company (compulsory as part of our pension plan). So I can also subtract this cover from the remaining amount required. Whatever is left over is the amount of life insurance I need to take out.

I then add a little more (say round up to the next R0.5 Million) as a "just in case" to cover unforeseen expenses related to wrapping up my estate, and in case I forgot something.

Will

Ah yes wills - another super exciting topic. But so so important. 

In the above calculation I factored in that my investments will roll over to my wife upon my death - and this is because it is stipulated that way in my will. Best not to assume anything and make your wishes very clear.

A Letter

Of course the life insurance payout will only serve it's purpose if it is used as it was intended. I have written my wife a letter with instructions on what to do with the money when it pays out. I still need to discuss everything with her to make sure she understands, and I should probably also give her a quick tutorial on Easy Equities (with a possible pop quiz at the end) to make sure she knows how to buy and sell stuff.

This is an often overlooked part - make sure your loved ones know what to do, otherwise the money you have left behind may not be invested as intended and it may end up not being enough. (Simon Brown of Just One Lap did a podcast on this topic - find that here.)

Reassess

Of course I will relook at this calculation on a regular(ish) basis - maybe once a year? I am thinking that as time moves on, I will find that the cover required becomes less and less because even though monthly expenses will increase with inflation, this increase should be more than offset as my investment portfolio grows and outstanding debts decrease. So the life insurance premium should become one of my deflationary expenses...

And that is pretty much how I go about it. I would love to hear about any other method anyine may have tried, or if there is anything I might have overlooked?




Till next time, Stay Stealthy!
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