What Should Life Insurance Cover?

The book The Financial Crossroads lists all the costs life insurance should cover (which helps you determine how much life insurance you need.) Here’s their list of the expenses that should be covered by life insurance:

• Final expenses — costs that one will incur to make viewing, funeral, and burial arrangements.
• Payment of debts and mortgages — sets the surviving spouse or other heirs free from his or her largest and most demanding bills.
• Education for the children — For expected costs of private elementary or high school education and especially college.
• Needed income replacement — Is less than 100% of the spouse’s income since our calculations have already pre-paid dents, mortgages, and education. With those major expenses covered, most people will only need to replace approximately 50% of the deceased spouse’s income.

They also use 5% as the “safe” return you can expect on your money (though today, 5% is a pretty good rate if you’re looking for income-producing assets.) As such, if you need $50,000 a year in income to replace the deceased’s salary, you need $1 million ($50,000/.05) in life insurance.

Here’s our situation:

• We have enough in our emergency fund to cover the final expenses.
• We have no debt or mortgage.
• Our children’s education is about 50% funded or so (will be 100% funded in next few years).
• The difference between what we make and what we spend is rather large, so we don’t need to replace anything close to my salary with life insurance. In addition, we have a good amount saved already, so that lessens the need for a ton of insurance anyway. As such, we insure me for about five times my annual salary, which is about 10 times our annual living expenses. We have $350k of life insurance on my wife, the amount I’ve estimated we’d need to get our kids to graduation without her.
• As I said in How Much Life Insurance Do You Need?, my general formula for how much life insurance anyone needs is this:

Total need – total liquid net worth + a bit of cushion = amount of life insurance needed

I know, it’s not very precise — that’s why the “bit of cushion” is in there.

• We are probably five years away from being self-insured. At that point, we’ll still have ten years or so left on our term life insurance police, so there’s plenty of cushion built into our plans.