Understanding Life Insurance

Understanding Life Insurance


The first step in determing your life insurance policy is to figure out how much coverage you need. We’ll then use our results from this step to help us determine the best type of life insurance.

We’re going to look at five common scenarios.

  1. Dual income with dependents (i.e family)
  2. Dual income no dependents
  3. Stay at home parents
  4. Mortgage Life Insurance
  5. Final expense

Dual Income with Dependents

Let’s assume you have some version of the stereotypical family unit. Two income earning adults with some kids and the goal is to maintain your family’s standard of living upon your death. We don’t want anyone getting rich, but we don’t want anyone going broke either.

A common reaction to this is to get mortgage life insurance. But remember the Catastrophic Financial Loss test, and how mortgage life insurance failed that test? It’s because there was no loss.

If you’re attempting to maintain a standard of living, generally you’re looking to maintain your family’s spending. It’s that spending thats maintaining the standard of living – mortgage costs, kids’ soccer practice, groceries, utiliites, and so on. Pretty much exactly what you’re spending today is what we want to maintain upon your death.

So, where’s the money coming for all this spending? Your paycheque of course. You earn your income, it goes in the bank, then gets spent over the course of the month. Now here’s the important part – when you die, we lose your paycheque, and thus we lose the ability to do all that spending, and thus we lose your family’s standard of living. And that string of events tells us what we should be insuring – your paycheque. Unlike the mortgage, if we insure your paycheque we now actually have a loss – your paycheque went away upon your death.. Replace the paycheque, the standard of living is maintained, and we’ve accomplished our goals with life insurance.

Here’s a link to a calculator that will let you figure out how much capital (and thus, how much life insurance) you need to replace your paycheque and ensure your family’s standard of living. How Much Life Insurance Do I Need Calculator. 

To actually generate a calculation, we need to make some assumptions. They are:

  • How long to replace the income? Typically that’s either until retirement, or until the kids are self sufficient.
  • Interest and inflation rate. I suggest that you use conservative assumptions so that you’re not requiring your family to be aggressive investors in the event of your death.
  • Percent of your income that’s needed to maintain the standard of living. Often that’s assumed to be 60-80%.

There is no correct answer – there is only appropriate ranges based on your assumptions. When you run this calculator you should run a variety of scenarios. That will give you a sense of a range of insurance amounts that will fit your needs. Try running the numbers using years until the kids are self-sufficient, and to retirement. Then try running 60% and 80% replacement of your income. You’ll quickly get a sense of how much life insurance you should be considering in order to get the job done properly. Often the coverage amounts end up being 10 to 15 times your gross income, which ends up being a common simplification used in the industry.

Dual Income, No Kids

This is a simplification of Dual Income with Dependents. We are assuming that each income earner is somewhat dependent on the other over time and that the loss is a portion of the other’s income. Based on that assumption, you can use our How Much Insurance Do I Need? calculator in the previous section to determine some ranges of coverage. Generally time frames are shorter and replacement percentages are smaller.

There is a common simplification you can use in this situation. If each of the partners is able to support themselves on their own income, but cannot afford the family home on their own income, we can simply insure the mortgage amount plus some amount of rounding. Then if one of the partners passes, the other has enough insurance to pay off the mortgage, they continue to live in the house and support themselves without a mortgage payment. In this case, we’re using the amount of the mortgage as a proxy for the amount of each other’s income used to pay the mortgage. This is often reasonable with dual income and no kids, but will likely leave you seriously underinsured if you have child dependents or if one partner is substantially dependent on the other’s income.

Stay at Home Parents

Stay at home parents don’t have an income that is lost upo

n death. Instead, we lose the value of their contribution to the household – child rearing and general household duties. We can place a value on those duties and assume a timeframe (say until the kids are self sufficient) then use the calculator we saw in the case of Dual Income with Dependants. 

There are two simplifications in this scenario. First if you assume a replacement value of their duties in the range of $15-$25K per year and timeframes of 15-20 years, we see results in the range of $250,000 to $500,000. A common solution is to simply choose whichever of those two numbers you feel comfortable with.

The second scenario is the assumption that the ‘value’ of both parents is the same (i.e. the income earning parent’s life isn’t ‘worth’ more than the stay at home parent). In that case, the stay at home parent would choose the same amount as the income earning parent. If the income earning parent needs $1,000,000 of life insurance, then the stay at home parent also chooses $1,000,000 of life insurance. It’s not completely justified numerically, but it does solve objections some people have about assuming different values of people’s lives.

Mortgage Life Insurance

There are two important things you should know if you’re considering mortgage life insurance. First, you should never take the mortgage life insurance offered by the banks and instead should get an individual term policy. The deficiences of bank mortgage life insurance are beyond the scope of this article, but know that the bank mortgage life insurance is very bad stuff.

Secondly, focusing on the mortgage can leave you very underinsured. As we’ve noted a couple of times, there is no loss upon death with a mortgage and instead we should be insuring income. People assume that paying off the mortgage is a proxy for standard of living but in practice it is nowhere near enough. Consider that your total paycheque is lost on your death – how much of that is going to the mortgage payment, and what’s happening to the rest of it beyond the mortgage payment?

Therefore if you’re considering mortgage life insurance you should consider if you’re insuring the right loss, and whether your beneficiares will actually be able to maintain their standard of living if only the mortgage is insured. If you’ve determined that this is what you want, then the amount of coverage you should look at would be the outstanding balance on your mortgage plus some rounding; either add 10-15% on top, or round the coverage up to the next insurance price break ($250K, $500K, $1MM).

Final Expense

At death there are some expenses that are directly related to our passing. In addition, people also often want to leave an estate, or a bit of money for their kids or grandkids. For this scenario we don’t need a fancy calculator, it’s simple addition. Add up:

– funeral costs, say $10-$20K (could be higher or lower depending on your assumptions).

– any final debts you want to pay off. Perhaps the remainder of the mortgage, or car/credit card debt.

– any amounts you’d like to leave to beneficiaries as a gift.

The total of these things (plus any other unique expenses in your situation) gives you the amount of coverage you should look at.

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