How to Calculate your Life Insurance Need

In this article, we'll go through the calculations involved in determining your life insurance need.

The Needs Approach lists out the things you need your life insurance to cover in the event of your immediate death, determines their present value (if the cash flows occur in the future), and sums them.  Typical life insurance needs for young families may include funeral expenses, elimination of debts, funding specific goals, and an income stream to the surviving spouse.

Let's take the example of a 32-year-old surgeon recently out of training with a stay-at-home spouse (age 30) and two children (ages 4 and 2).  The surgeon would like life insurance to cover $25,000 of funeral expenses, $300,000 to pay off private student loans, $500,000 to pay off the remaining mortgage, enough money to pay for their children's college educations, and $6,000 per month to the surviving spouse, adjusted for inflation, assumed to be 3% per year, until the surviving spouse reaches age 100 (70 years in the future).

In order to perform the time value of money calculations for the college education funding goal and ongoing income stream to the surviving spouse, we'll need some additional assumptions as follows.

The oldest child (age 4) will begin college in 14 years and need a total of $30,000 per year in today's dollars for a total of four years.  The inflation rate assumption for college expenses is 4% per year.  The youngest child (age 2) will begin college in 16 years and need a total of $30,000 per year in today's dollars for a total of four years.  The after-tax investment rate of return assumption is 7.5% per year.

The present value of the oldest child's college education needs as of the date of starting college (age 18) is calculated as follows (using a financial calculator):

FV = 0
N = 4 years
I = [(1.075/1.04)-1]*100 = 3.36538461 per year (real rate of return)
PMT_AD = +$30,000 per year (paid at the beginning of each year)
PV_@18 = -$114,265.70

You can also use Microsoft Excel and enter the above as =PV(0.0336538461,4,30000,0,1).  The above calculation is taking the series of four payments at ages 18, 19, 20, and 21, and obtaining the lump sum needed at the oldest child's age of 18 when the first payment occurs.  However, we would like to know the present value of that lump sum, which involves discounting that amount from age 18 to age 4, as follows:

FV_@18 = +$114,265.70
N = 14 years
I = [(1.075/1.04)-1]*100 = 3.36538461 per year
PMT = 0 per year
PV_@4 = -$71,889.28

If $71,889.28 were invested today (at the oldest child's age of 4) to earn 7.5% per year after-tax, this would cover the oldest child's college education needs exactly, based on the assumptions we made.

To prove this, we can calculate the college education funds needed at the oldest child's age of 18, 19, 20, and 21.  Growing at 4% per year, at age 18, the cost of college is expected to be ($30,000)(1.04¹⁴) = $51,950.29.  At age 19, the cost of college is expected to be ($30,000)(1.04¹⁵) = $54,028.31.  At age 20: $56,189.44.  At age 21: $58,437.01.

If we invest $71,889.28 today and it grows uninterrupted at 7.5% per year for 14 years, at the oldest child's age of 18, it has grown to ($71,889.28)(1.075¹⁴) = $197,871.22.  Upon which, we spend $51,950.29 for the first year of college education costs, leaving us with $145,920.93.  This grows for another year at 7.5% to $145,920.93(1.075) = $156,865.00.  Next, we subtract the second year of college education costs of $54,028.31, leaving us with $102,863.69.  This grows for another year at 7.5% to $102,863.69(1.075) = $110,549.44.  Next, we subtract the third year of college education costs of $56,189.44, leaving us with $54,360.00.  This grows for another year at 7.5% to $54,360.00(1.075) = $58,437.00.  Finally, we subtract the fourth year of college education costs of $58,437.01, a difference of one cent due to rounding error.

A similar set of calculations would show the present value of the younger child's college education needs are $67,284.32.

The present value of the income stream to the surviving spouse is calculated as follows:

FV = 0
N = 70(12) = 840 months
I = {[(1.075/1.03)-1]*100} / 12 = 0.36407767 per month
PMT_AD = +$6,000 per month (paid at the beginning of each month)
PV = -$1,575,879.45

With these calculations, we can sum the present value of the surgeon's life insurance needs as follows:

Funeral expenses: $25,000
Debt reduction: $800,000
College education funding goal: $139,174 ($71,889.28 + $67,284.32)
Surviving spouse income stream: $1,575,879
Total death benefit need: $2,540,053

From this number, we could subtract out amounts such as any cash/cash equivalents, any amounts already earmarked for college education goals, and any preexisting life insurance coverage for the surgeon, to determine how much additional life insurance coverage this surgeon should obtain to protect their family in the event of their immediate death.

Please consult with a licensed life insurance agent for more information.

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Mike McErlane, DO, MBA, CFP^®, CFA^®, RICP^®, EA, MCEP^®

Mike McErlane is the owner and founder of Comprehensive Financial Planning for Doctors, LLC based in Frisco, Texas.

Comprehensive Financial Planning for Doctors, LLC (CFPFD) is an Investment Adviser registered with the Texas State Securities Board.  Registration of an Investment Adviser does not imply any specific level of skill or training.  CFPFD only transacts business in states or jurisdictions in which it is registered or exempt from registration.  A copy of CFPFD's current disclosure brochure is available through the Securities and Exchange Commission's Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov.

The opinions and analyses described are subject to change at any time without notice.  Any information is considered general and is not intended to provide any specific advice or recommendations.  Your use of the information is at your sole risk.  You should consult with your financial advisor, attorney, tax advisor, insurance agent, or other professional advisor before taking action on any information or implementing any strategy.