FP Article 7 (To sign up for a FREE 6-lesson eCourse on Defeating Credit Card Debt, please click here.)

How Much Life Insurance Do You Really Need?

by Rajen Devadason

Insurance: An ingenious modern game of chance in which
the player is permitted to enjoy the comfortable conviction
that he is beating the man who keeps the table.

Ambrose Bierce

... figure out exactly how much life insurance you need, and then to buy more if necessary. But make sure you aren't over-insured because paying unnecessary premiums on life insurance policies will hurt your long-term ability to grow money in focused wealth accumulation instruments such as savings and investments.

It really is important for you to remember that any well put together personal financial plan must comprehensively meet three goals:

1. Wealth protection;

2. Wealth accumulation; and

3. Wealth distribution.

Now, when it comes to succeeding in all three facets of financial planning, the dictum 'first things first' comes into its own.

This reality was powerfully hammered home to me a years ago, when I read a book that my gorgeous wife Rachel gave me for Christmas.

It was a weighty coffee table book entitled The Magic of M.C. Escher (© 2000 M.C. Escher Foundation; published by Thames & Hudson Ltd).

The late Escher was, in my opinion, the greatest graphic artist who ever lived. The Dutchman's mathematically precise works often portray beguiling, but impossible, situations such as men endlessly walking 'up' four flights of stairs, arranged in a square, only to meet themselves again and again and again...
(If you'd like to see some examples of his work, click here. This particular piece is my favourite.)

In a 1955 letter to his son Arthur, Escher wrote, "I believe that producing pictures, as I do, is almost solely a question of wanting so very, very much to do it well."

We are all the same - you, Escher, and I!

You surely want to take very, very good care of your family; Escher's passion and industry led him to create very, very impressive works of art; and I desire to take very, very good care of my consulting, speaking and writing clients.

I believe if you are serious about caring intelligently for your loved ones, you should mull over this explanation in McGill's Life Insurance, published by the American College:

"Life insurance is concerned with the economic value of a human life, which is derived from its earning capacity and the financial dependence of other lives on that earning capacity."

Simply put, that means as long as you have dependants whom you care for, you need life insurance at least until you grow rich enough to be self-insured. Thankfully, products exist in every country that allow us to transfer the risk of economic loss from individuals to well-capitalised insurance companies.

I've always found it eye-opening that it was Sir Winston Churchill who said, "If I had my way I would write the word 'INSURED' over the door of every cottage and upon the blotting book of every public man: because I am convinced that, for sacrifices that are inconceivably small, families can be secured against catastrophes which otherwise would smash them up forever."

In his book, Business Insurance - Million-Dollar Concepts (© 1997 Lim Yuen Seong), my friend Lim Yuen Seong put it more succinctly, "Human capital is expensive and destructible. Protect it!"

In a later book cum manual, C@pture - The Handy Professional Aide for Financial Planners and Advisors, which the Malaysian Lim developed with Singaporean Captain (NS) Go Ashokh Menon, this interesting 6-Step Insurance Planning Process is advocated:

Step 1: Determine Insurance objectives;
Step 2: Gather Information;
Step 3: Analyse Information;
Step 4: Develop Insurance plan;
Step 5: Implement Insurance plan; and
Step 6: Periodic Reviews.

This 6-step process found in that excellent manual mirrors the Certified Financial Planner Board's 6-step financial planning process of Establishing the Client-Planner relationship; Gathering relevant data; Analysing that data; Developing the plan; Implementing the plan; and Monitoring the plan.

(As far as I know, C@pture is not available in regular bookstores, but the publisher's address is:

D' Wealth Publications (M) Sdn
Bhd, B-8-10, Block B, 8th Floor, Unit 10,
Megan Phileo Avenue,
No. 12, Jalan Yap Kwan Seng,
50450 KL, Malaysia.)

Building upon those 2 processes in my own practice, I use a variant of this 7-step algorithm (or recipe) to assess a client's true goals within the context of his or her life insurance coverage needs.

This is a 'quick-and-dirty' way of figuring out how much life insurance a person needs. Please take note that it does not take into account the eroding effects of future inflation.

I learnt a version of this algorithm back in 1998, while co-writing Financial Freedom - Your Guide to Lifetime Financial Planning with my friends and co-authors Edmond Cheah, Wong Boon Choy and Alex Sito. Sadly, that book is out of print.

(But if you're interested in checking out other, digitally downloadable ebooks I have since written, you may do so here.)

Now, going back to insurance needs calculations, please note that hypothetical dollar amounts are included here to help make things clearer. You'll need to plug in the numbers that are appropriate to your circumstances.

Let's begin:

First, assess your family's annual household expenses in your 'absence', say $100,000.

Second, add in ANNUAL investment obligations for major goals that survive you, such as your children's education funding and spouse's retirement funding, say $50,000.

The first two steps give an indication of ANNUAL budget requirements, in this case $150,000.

Third, assume a fair capitalisation rate. This refers to the average yield your survivors will be able to earn on a portfolio of savings and investments that is meant to provide passive income to replace the loss of your active income.

I tend to use 5% as a fair capitalisation rate, so I multiply the calculated annual budget need by 20 { = 1/(5%) = 1/0.05}. Here that works out to:

{ =.$150,000 x 20} = $3 million

Fourth, add on a series of final expenses including your own burial costs, say $30,000, for instance if you like the idea of a big send-off, which gives a total capital requirement of $3.03 million.

Fifth, knock off actual existing savings and investments, excluding your own home, say $730,000. That works out to $2.3 million.

Sixth, knock off anticipated payouts from existing insurance policies, say $1.5 million.

Seventh, the residual sum calculated is the amount a client is under-insured (if the sum is positive) or over-insured (if the amount is negative). In this case, the hypothetical client is $800,000 under-insured { = $2.3 million - $1.5 million}.

So, if, like Escher, you aim to do very, very well in things that matter... to your family, please run a similar analysis on yourself, for yourself!

Then plug the gaps with an appropriate insurance policy! (Please note that I do NOT sell life insurance; this article has been written to help you help yourself intelligently in this area of personal finance.)

In closing, if you are based in Malaysia, if what you've just read makes sense to you, if you are an English-speaking professional or business owner aged between 30 and 50, and if you genuinely believe you might benefit from my consulting services in the realm of financial planning and retirement planning, you're welcome to learn more about me here.

© Rajen Devadason