There is the “12 times income” rule that people often use as a rule of thumb for how much life insurance to take out, and while that’s a great start when you have no other information for calculating life insurance needs, it misses an important point about how much to insure for, which is that as you get older and have more assets to rely on in case of death, illness, or injury, your insurance needs decrease. Conversely, if you are just starting a new family and have a mortgage, your insurance needs can be well above this.
Typically, insurance needs go something like this.
- When you are young and single, have no dependents, and no mortgage, even though you have little to no assets, your expenses are very low, so your insurance needs aren’t so great.
- When you start a family and take out a mortgage, your insurance needs are at their greatest due to the increased expenses that must be met.
- As you pay down the mortgage, build your retirement assets, and children get older, your insurance needs begin to reduce, with a large drop off as you pay off the mortgage and the kids leave home. The cost of insurance premiums tends to start ramping up much faster from around mid-to-late 40’s, so reducing the benefit with your reduced needs helps to reduce the overall cost of cover.
- As you reach retirement or financial independence, your assets cover most or all your expenses, so if you were unable to earn an income, you would still be able to meet your financial needs, making insurance unnecessary.
There is a great life insurance calculator on the moneysmart website, where you can enter your information and it spits out a number for you, but below, I will go through one way to see it calculated so you have an idea of how it works.
Quick Links
The DIME method
Term life insurance
TPD insurance
Income protection insurance
Trauma insurance
How an adviser can help
The DIME method for calculating life insurance needs
How much insurance cover you need depends on your expenses minus the income your current assets can generate.
Calculating life insurance needs can be done in more than one way. We will use the DIME method:
| D | = | Debts | (Personal debts) |
| I | = | Income | (Generate missed income to support financial dependants) |
| M | = | Mortgage | |
| E | = | Education | (Children’s education) |
For those who have no mortgage due to having not yet bought a home yet. consider adding the cost of a home in place of a mortgage in the following inusrances:
- Term life insurance (if you have a partner)
- TPD insurance.
Let’s go through an example with the following assumptions:
- A couple, both aged 32, planning to retire at 60
- Mortgage $350,000
- Car loan $20,000
- Credit card debt $10,000
- 2 children, aged 6 and 8 (15 & 13 years until the end of tertiary education)
- Breadwinner’s income $60,000 p.a. (excl. super)
- Homemaker’s income $20,000 p.a. (excl. super)
- Living expenses $50,000 p.a.
- $100,000 savings and investments inside and outside super
These are peak insurance years due to a lot of financial commitments such as a mortgage, children, and a low asset base.
Calculating an amount when you don’t know how long it will need to last
If you know how many years you need an insurance payout to last, you generally multiply the annual amount needed by the number of years. For example, if you need $50,000 p.a. for 12 years, you calculate the payout needed as $50,000 x 12 = $600,000..
However, if you don’t know how long it will be required, you divide by what is known as a discount rate, which is the formula for determining the present value of expected future cash flows. For example, if you need $50,000 p.a. and use a 4% discount rate, you calculate the payout needed as $50,000 / 4% = $1,250,000. Another way of saying “divide by 4%” is “multiply by 25” (they both come out to the same result).
If you know how many years and it is more than 25, use 25.
1. Term life insurance
| Debts | |||
| – Car loan | $20,000 | ||
| – Credit card | $10,000 | ||
| Total | $30,000 | ||
| Income | |||
| Breadwinner | |||
| Living expenses | $50,000 | ||
| Less net income of the homemaker | –$20,000 | ||
| Shortfall for the family p.a.: | $30,000 | ||
| Total (x25): | $750,000 | ||
| Homemaker | |||
| Living expenses | $50,000 | ||
| Less net income of the breadwinner | –$60,000 | ||
| Shortfall for the family p.a.: | –$10,000 | ||
| Total (None since income covers it): | $0 | ||
| Mortgage | |||
| – Mortgage | $350,000 | ||
| Total | $350,000 | ||
| Education | |||
| Let’s assume public school and $2,000 p.a. on education-related expenses. | |||
| – Child 1 $2,000 p.a. x 15 years | $30,000 | ||
| – Child 2 $2,000 p.a. x 13 years | $26,000 | ||
| Total cost of education | $56,000 | ||
| Total to insure | |||
| Breadwinner | |||
| – Debt: | $30,000 | ||
| – Income: | $750,000 | ||
| – Mortgage: | $350,000 | ||
| – Education: | $56,000 | ||
| Total: | $1,186,000 | ||
| Less existing investments in & out of super: $100,000 | |||
| Total: | $1,086,000 | ||
| Homemaker | |||
| – Debt: | $30,000 | ||
| – Income: | $0 | ||
| – Mortgage: | $350,000 | ||
| – Education: | $56,000 | ||
| Total: | $436,000 | ||
| Less existing investments in & out of super: $100,000 | |||
| Total: | $336,000 | ||
2. TPD insurance
Same as for term life, but with 2 modifications:
- Add $50,000 for any home and vehicle modifications that may be needed
- Adjustment of the income calculation.
If you have income protection insurance to age 65, you can remove a significant portion of the income section from the DIME calculation above when calculating your TPD amount since income protection can be a maximum of 75% of your salary. However, most combined term life & TPD policies won’t allow less TPD than term life.
If you don’t have income protection insurance, you may need to adjust the income section calculation of income from the DIME calculation if you calculated only until the children left for tertiary education. In that case, you would multiply by 25 to get your TPD amount rather than however many years you used for calculating the term life amount.
3. Income protection insurance
The maximum allowed is generally 75% of the gross salary.
Some policies allow the addition of super guarantee.
| Breadwinner | $60,000/12 x 75% | = | $3,750 per month |
| Homemaker | $20,000/12 x 75% | = | $1,250 per month |
This depends on your emergency fund and other assets that can be liquidated.
A longer waiting period results in a lower policy cost.
Benefits are paid at the end of the month in arrears, so a 3-month waiting period would mean the first payment is at the end of the 4th month.
Benefit period:
Shorter benefit period results in a lower cost policy.
Often recommended to retirement age.
4. Trauma insurance (if required)
These amounts are based on what was mentioned in the section on Trauma insurance. While many conditions put you out no more than 50-75k (as mentioned there), some conditions will put you out more than this. If you are unsure how much to insure for, seek personal advice, as these amounts are not based on your personal circumstances.
| For each person: | |
| Estimated medical and rehab costs | $75,000 |
| Estimated home & vehicle modifications | $50,000 |
| Total | $125,000 |
By now, you should have a good understanding of all the things that you and your dependants could not afford in an unfortunate event had you not been insured. You can also see that the calculations factor in the number of years remaining until you are financially independent. As you get older, the amounts needed for term life and TPD insurance tend to decrease as your accumulating assets can take care of more and more of what would be needed.
Don’t ever lie to an insurance company
If you lie either on an insurance application or when making a claim, the insurer has the legal right to refuse a claim – even after you paid your premium for all those years. What’s worse is that once you have a declined claim, other insurance companies can see it and refuse to insure you, making it difficult to get insurance with any insurance company again.
How an adviser can help
Typically, an adviser is recommended for life insurance for the following reasons:
- The terms and conditions are complex and a challenge for many people to understand.
- You need to know how to calculate the amounts, which are not obvious for most. Many go with something like 10-12x salary or some other non-personalised figure which may leave you underinsured (or overinsured). And while the above is a reasonable guide, an adiviser may be able to provide a more comprehensive calculation.
- You need to understand the different types of life insurance and how they interact with each other, and how your occupation, age, medical conditions, and tax rates play into the decision.
- You need to understand the difference between holding insurance inside super vs outside super.
- You need to understand whether an underwritten policy is best for you.
- You need to understand your duty of disclosure and the consequences of not disclosing everything.
It is too complex for most people and can leave you exposed if you get something important wrong when insuring without advice.
Just be aware of the financial and conflict of interest problems associated with using commission-based insurance as explained in the article on how to lower the cost of insurance.