The following article was published in the September 2000 edition of Canadian MoneySaver. For other important financial advice articles like this, Compulife recommends that you subscribe to the Canadian MoneySaver on-line magazine. The annual on-line subscription fee is only $19.99 CAD per year. Visit the Canadian MoneySaver website to learn more.
What is the value of a human life? Most have heard the story of how much you're worth if you were to break the human body down into its chemical and mineral components and sold them. You'd be lucky to be worth $10 (not counting various add-on items such as pacemakers, gold fillings, etc.).
But we know that people are worth more than that. On the opposite end of the spectrum you will have heard the phrase "he's worth millions", referring to the value of a person's property, investments, etc.
But in asking the question I'm not really looking for either answer. I am posing the question with respect to "how much life insurance" you should buy to insure that your dependents are cared for in the event of your death. In my view the majority of people are underinsured because they don't know how much they are worth.
We buy insurance to replace something that we might lose. If your house burns down you have insurance to make sure you can rebuild it. If your car is totaled in an accident you have insurance so you can get another car. When you buy life insurance you are trying to replace the value of your life. Unless you have a clone that's for sale, how do you know how much you are worth?
We know that money cannot replace you as a person, any more than fire insurance can replace the family photographs or the antique jewelry your grandmother left to you. What you get back with payment of an insurance claim is the financial value of the item that you lost. So the more precise question is, what is your financial value? What will your dependents lose if they lose you?
To digress for a moment, please remember that if you have a million dollars in the bank and you die, the million is still there. The tax man may cometh, but the point is that the asset you had didn't die; you died. What I want to examine is what YOU are worth.
A slave trader would have had the easiest time answering my question. He would have told you that the financial value of a slave was based on their ability to work and produce, and how long they could be expected to do that. And that's your financial value. You're not worth more and you're not worth less. For insurance purposes, your financial value should be based on what you can do (earn) in the future, and how long you could be expected to earn it.
Your gross annual income is the annual value of your life. You may feel you are worth more than what you are being paid, but from the point of view of your dependents, your financial value is the paycheque that you bring home.
Assume you earn $30,000 per year. If you die, your family loses the $30,000. If you are 40 years of age, and expect to work 25 more years (until you retire) then you would have provided your family with $30,000 times 25 or $750,000. There it is, that's the most that YOU are worth. If you die, that's what they lose. Buy $750,000 of life insurance and your family is in good shape if you die.
An astute investor will stop me at this point and note that this $750,000 will earn interest (or grow in a fund). Assuming you invest $750,000 at 5%, the annual interest income would be $37,500 which is more than the $30,000 you were trying to provide in the first place. Technically, $600,000 would provide $30,000 a year at 5% and the $600,000 would go on doing that forever.
By the way, so you know, a 40 year old male non-smoker in very good health can buy $600,000 of 10 year term insurance for less than $600 per year. So before you get spooked by these big numbers, it costs very little to buy that amount of life insurance if it's term insurance. For most, term is the kind to buy.
Now for those who think $600,000 is overboard, let me introduce another component to the calculation which is often overlooked: it's called inflation. "But Bob, inflation is very very low and it won't make that big a difference." I beg to differ. Assuming that inflation is 2%, and that you expect your dependents to increase the $30,000 each year by that 2% (a $600 increase in year 2, etc.), your $600,000 will be gone in 28 1/2 years (that's assuming 5% interest).
So if I wanted $30,000 per year for 25 years, based upon 2% inflation and 5% interest, what would be the lump sum amount to get the job done for just 25 years? The more precise number is $541,300. By lowering your insurance from $600,000 to $540,000, you'll be saving yourself a whopping $55 per year. So much for precision.
The next point that can be made is that I can earn more than 5% on my money; suppose I can earn 8%. OK, put 2% inflation and 8% interest into the equation and you can lower $540,000 to $410,000. That will save you $110.00 per year (less than $10 per month). At that point I would argue that 8% is not what you can expect to earn on interest bearing investments in a 2% inflationary economy; 5% is more realistic. To obtain 8% you will be asking your family to accept some risk in their investments. Are they astute enough investors for that? Is the risk that your family might not get 25 years of income worth the $110 per year in premium savings?
But assume you settle on the $410,000 amount, how many 40 year olds, making $30,000 per year, actually carry anything close to that amount of insurance?
David Chilton is an old acquaintance of mine from Kitchener-Waterloo, who became well known as the author of "The Wealthy Barber". I met him when he was offering GIC placement services while he was still in high school. Several years later, after publishing the highly successful "The Wealthy Barber", and after having done hundreds of financial seminars, David told me he was now less concerned with what kind of life insurance people were buying, and far more concerned about how much they were buying. Understanding your real financial value to your family, David had come to realize that most people don't buy big enough life insurance policies.
Trust me, your widowed spouse does not care what kind of life insurance you bought after you die. Whole life or term, dependents only care how much the death benefit was for. There are lots of people who own small amounts of expensive whole life insurance, having bought it for reasons other than the insurance value. They believe they have a great little insurance program but won't be around to find out it wasn't if they die.
The fact is that if you set out to buy the correct amount of life insurance, the chances are you'll end up with term simply because most people can't afford that amount of coverage any other way. Let me repeat myself: there is absolutely nothing wrong with buying term. It's what most people should buy.
Compulife has now added an "income replacement calculator" to our www.term4sale.com public term comparison website. Not only can you use www.term4sale.com to find out who offers the most competitive priced term products (no cost; no obligation) you can also use our site to determine how much lump sum money it takes to replace your paycheque based upon the income, inflation, interest and time factors that you enter. Give it a try. Find out what YOU are worth and how little a term policy costs to provide your family with the amount of coverage you need.