Updated 03 December 2020
6min read
When you apply for life insurance, the provider will ask you how much cover you want. This cover is the cash lump sum that’s paid out to a chosen person when you die. So how much should this sum be?
The amount of life insurance you’ll need depends on your circumstances, such as who is financially dependent on you, their needs and lifestyle, and what other sources of income will be available when you’re no longer around. Here are some guidelines to help you calculate the right level of cover.
To know how much life insurance you need, you have to think about why you need it. Life insurance exists to provide money for your dependants after your death. It might be for a specific purpose, such as paying off the remains of your mortgage, or for general costs of living if your death would leave your family short of income.
Once you know why you need life insurance, it’s easier to work out how much it should be.
The cover you should take out will depend on a range of factors including your income, needs and of course your budget. When calculating life insurance, consider:
Naturally, the more obligations you have, the more cover you may need. Once you’ve made a full list of your financial responsibilities, write down an estimate of the monthly costs associated with each, and how long these would last for. Include both current and future costs, but only those that would affect the household in the event of your death.
If your cover is for a mortgage or debt, take the lump sum of what you owe and add a buffer for any taxes and duties.
If your cover is for income replacement, take the lump sum of income needed and multiply it by a suitable number of years (depending on how long you think it might take to replace that income). So for example if you want to insure for an income of £20,000 and make this last for 10 years, you would be looking for cover in the region of £200,000 (though possibly less if the money is invested for income). A financial adviser can help you fine-tune your figures.
It’s not compulsory to have life insurance when you buy a home, as the mortgage company can simply sell the property to recoup the loan. However, if you have dependants, life insurance is essential from a personal point of view – since you don’t want to leave your family homeless.
Life insurance for a mortgage is typically set up so that the entire mortgage will be paid off if one of the mortgage holders dies before the loan is settled. This can be achieved in one of two ways:
Whether or not you have a mortgage to pay off, you may also want to cover the day-to-day living costs of your dependants after your death. The level of cover you need will depend on their needs, ages (e.g. how long before your children grow up and start earning for themselves?), accustomed lifestyle, and of course how many of them there are.
It’s useful to think of this cover as your income replacement. A general rule of thumb is to add the monthly costs that would affect your family in the event of your death, then multiply this figure by a comfortable few years. Parents of young children, for example, might multiply by 15 years or more.
These monthly costs can be existing ones, like grocery bills, rent or council tax. They can also be future costs, like university fees.
Consider including scenarios in your planning. If you die, would circumstances change? Do you have a partner that is a stay-at-home parent or carer for an elderly relative? Will they need to work in the event of your death? If so, childcare or care home costs could be worth factoring in.
This might be important to you if your child attends a fee-paying school, or if they are going to university. Even if they are in a no-fee school, there will always be significant costs such as uniforms, equipment and school trips.
Your cover amount depends on what institutions your children attend (both now and in the future), how many children you have, and their education needs. Add the appropriate costs and, based on your children’s ages, multiply by how many years you need to cover. You might want to include a buffer for annual fee increases too. Remember the lesson every parent learns: school is always more expensive than you expect.
Outside of mortgages and income protection, you might need other debts or costs covered, from unpaid personal loans to funeral costs. Factor these in if you need them, and avoid having any other related policies.
Here’s an example of a what a life cover estimate might look like.
Peter’s annual income is £28,000. If he were to use the simplest rule-of-thumb, he could multiply this by 10 for life cover of £280,000.
Using a more detailed approach, Peter might consider that he has two young children, pays half the mortgage and wants his income covered for 10 years. His calculations would therefore look like this:
|
Expenses |
Debt |
Mortgage |
Education |
Car loan |
|
£10,000 |
|
|
Mortgage |
|
|
£80,000 |
|
Child one education |
|
|
|
£45,000 |
Child two education |
|
|
|
£45,000 |
Living expenses |
£120,000 |
|
|
|
Funeral costs |
£3,000 |
|
|
|
Total |
£123,000 |
£10,000 |
£80,000 |
£90,000 |
Grand cover total |
£303,000 |
With this more considered approach Peter ends up paying slightly higher premiums, but now knows he will have enough to put both his children through school as well as meet all their other needs – which the other approach would not have delivered.
Critical illness cover is an optional extra, which covers the financial pressures that would occur if you became seriously ill or were injured. People who opt for this cover typically go for an amount two or three times their salary, or equivalent to their mortgage.
A range of conditions are covered. Some may be more predictable than others (e.g. if you work in a physical job, a back injury may be both more likely and more damaging, as this example shows). However, in most cases you simply can’t know how likely it is that you’ll develop an illness. Ultimately, this decision will come down to your own attitude to risk and how many precautions you prefer to take.
That said, a financial adviser who specialises in protection can help you work out the probabilities and impact upon you of developing a given condition, so can recommend the most suitable level of cover.
An adviser can also ensure that you don’t get caught out by the fine print. For example, sometimes if you have combined term life insurance and critical illness cover, your policy might only pay out once (e.g. either for illness or death, but not both).
Some workplaces offer in-service death and disability cover as a benefit. Check with your employer, and see how this benefit compares to a life insurance policy, so that you don’t end up paying for something you already have.
Sometimes when you approach a provider directly, you will be told that your insurance will be more than you can afford – for instance if you have a pre-existing condition. However, you don’t have to take no for an answer. A financial adviser who specialises in insurance can usually find you an affordable policy, like this example where an injured paratrooper was first told he was uninsurable, only for his adviser to find him life and critical illness cover at standard premiums.
Remember, life insurance should be checked regularly and if necessary updated, to ensure it is still suitable for your changing needs.
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