Are we overinsured?

Many people maintain that Canadians, believing they are doing a good thing, are taking out too much life insurance. How do you know whether you have too much or too little life insurance? There’s a very simple way of finding out.

Statistics show that, right now, nearly 18 million Canadians have a life insurance policy, with an average coverage of approximately $158,000. Together, Canadian lives are insured for some $2.8 billion. Canada is in 16th place among industrialized countries for per capita insurance coverage.

And so, comparatively, Canadians don’t seem to be overinsured; however, these numbers don’t tell us if they are adequately insured for their own personal situation. Where life insurance is concerned, each case is different, and this is the only basis on which to figure out if a person is adequately covered.

Three functions
It’s important to keep going back to the role of life insurance in financial planning. Its role is three-fold:

  • first, it replaces the income of the deceased, allowing the survivors to maintain their standard of living, not only immediately following the death, but in the long term;
  • then, it helps pay the immediate costs related to the death (especially the funeral costs) and any debts the deceased may have had;
  • and finally, it can help optimize the estate’s net value by offsetting or minimizing the impact of taxation on it.

Of these three functions, the first is the most important for most people, and also the one on which our calculations are based.

How to determine income replacement needs

To establish your life insurance needs, there’s no way of getting around it – you have to prepare a budget and figure out your present standard of living. For a couple, it’s important to establish just how much each spouse contributes to maintaining that standard of living. If, for example, one spouse brings in $80,000 and the other $40,000, it is very likely that the first will need more insurance coverage than the other. A common mistake in this regard is to have the same amount of insurance for both spouses, even if their financial contribution to the household is not the same.

If you want to be sure that your insurance coverage is adequate, you have to be very rigorous in calculating the household’s shortfall after each of the spouses dies. You have to account for all the expenses that will disappear as well as those that will be added on. You also have to calculate the capital that has already been accumulated by the couple since it also will contribute to generating replacement income.

If approached from this perspective, it is relatively simple to calculate the life insurance coverage needed for each spouse. Then, and only then, should you look at the debts, costs, taxes and other estate- related matters you “may” want to pay.

How to calculate your life insurance needs

Couple’s present cost of living, that is, the total amount of the expenses that allow the couple to maintain their present standard of living
Minus or plus
Decrease/increase in the cost of living
for the household after his/her death
Surviving spouse’s income

Capital needed to offset the shortfall
Capital already accumulated and making it possible to generate an income
Person’s life insurance needs

Times change and so do insurance needs

When you look at life insurance as capital that will help generate income to replace a shortfall, it’s easy to understand why this need has to be re-assessed at different times in your life, for example, when you get a new job, set up a household, split up, have children, take out a loan or a mortgage, etc.

In general, you can assume that your life insurance needs will be highest when you are mid-point in your active life. At that time, you often have several dependents and not a lot of savings at your disposal. But young, single people who are just starting out generally need very little life insurance since death doesn’t represent a loss of income for their survivors. At this stage in their life, it’s rather important for them to guarantee their insurability by making wise insurance choices. As well, seniors whose children are grown up and independent, and who have likely already accumulated enough capital to generate income for two people, have less need for life insurance to replace their income. Instead, they should use their income to protect the net value of their estate and soften the fiscal impact of their death on their heirs.

A complex world

The calculations suggested here wittle down the issue of life insurance to a mathematical formula, with the emotional and arbitrary components eliminated. Obviously, real life situations are often more complicated since our lives (and our households) are constantly changing. And, once the need for life insurance has been established, you have to determine what insurance product best suits your situation (term, whole or universal life).

In conclusion, if you want to know if you have too much or too little life insurance at any specific time in your life, there’s no magic formula. You have to begin by calculating the income your insurance will have to replace. Ready? Let’s take out our calculators!