Estimating Coverage Needs

Life insurance provides payments to your beneficiaries that replaces some or all of your income if you die during the coverage period. These payments make up what is called a death benefit.

In exchange for insurance coverage, the insured person (insuree) makes periodic payments called premiums to the insurance company (insurer). To determine a policy premium, the insurer uses a method called underwriting. The insuree is also called the policyholder.

In order to be eligible for coverage, the insuree receives a certificate of insurability. This is an endorsement of the insurance company's willingness to sell a policy. A certificate of insurability is sometimes required for certain changes in policy coverage.

Most life insurance policies are taken out to replace family income in the event of an untimely death. As a result, these policies often designate a spouse, child, sibling, or parent as beneficiary. The policy may also designate more than one beneficiary.

Some types of life insurance allow you to change your premiums or stop paying them for a while. These premiums are called flexible premiums. This situation occurs if the investments that are funded by some of your premiums earn a higher-than-expected rate of return.

An expedient way of determining the right amount of coverage is to take a multiple of your annual salary. For example, a multiple of 5 and annual salary of $50,000 would equal policy coverage of $250,000. The following five steps can help you to more accurately estimate your coverage needs:

Determine your coverage period. For example, if you think the next 20 years of your life are essential to provide for a young family, a 20-year coverage period would be appropriate.

Calculate the expenses that require coverage. If you are a main breadwinner in the family and die suddenly, the family is sure to feel the financial impact. You might decide to buy a policy that insures half of your salary for the first 10 years of the policy and 25% for the subsequent 10 years.

Additionally, your death will have some expenses associated with it. Funerals routinely cost a few thousand dollars or more. You may also have other debts or funds that either need to be repaid immediately or replenished when you die.

Reduce the amount of required coverage by available assets and income. Assets that you own today can be sold to pay off debts or raise cash. Selling these assets might reduce the amount of necessary policy coverage. Additionally, any future income that your beneficiaries are expected to receive will reduce the coverage amount.

Add estimates for inflation, interest rates on savings, and taxes. Inflation leads to higher expenses in the future. If your beneficiary's income fails to grow at the same rate, your coverage may be inadequate. On the other hand, if interest rates on your savings keep pace with inflation, you shouldn't have to increase your coverage. For taxation of life insurance benefits, see IRS Pub. 525: "Taxable and Nontaxable Income."

(Note: This document is in Portable Document Format (PDF). If you do not have a PDF reader installed on your computer, you can download a version of Acrobat Reader for free at Adobe Systems' Web site.)

Find other ways to lower your premiums. Since your health is a large determinant of your premiums, consider avoiding tobacco and alcohol. A healthy medical history helps.

Skydiving, motorcycle riding, and scuba diving are activities with higher accident and fatality rates. Avoiding these kinds of "insurance risks" can help to lower your premiums.

The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.