Life Insurance: Do You Need It?

The time-consuming part is determining exactly how much insurance you might need, because life insurance is designed to fill a gap between the financial resources your family would have after you died and what they would need. To know the size of this gap, you must know how much you own, how much you owe and how much you spend.

With that information--and a little imagination--determining your insurance needs is a cinch.

Start with a copy of your household budget and a net worth statement--a simple listing of your assets and liabilities.

With those you can figure out what you are spending today and where the income comes from. You can also determine whether your demise, or the demise of your spouse, would create some long-term financial abyss. Would your death, for example, cause your family to prematurely lose a pension that's been a pivotal part of your retirement planning? (See accompanying chart.)

* * * Don't have a budget or a net worth statement? These are easy, though somewhat time-consuming, to prepare.

If you need help, any number of articles or books are available. For example, you can go to the library and read through Chapters 3 and 4 of my book, "Kathy Kristof's Complete Book of Dollars and Sense." If you bring a notebook and pertinent financial statements--your most recent mortgage statement, showing how much you owe and a 401(k) statement, showing how much you have invested, for example--you can simply follow the work sheets in these chapters and have both your budget and net worth statement completed in a few hours.

From your list of assets, consider: What tangible assets could you liquidate--that is, sell for cash--if necessary? What assets are you willing to liquidate? What current debts could be paid off with the proceeds? Are the debts bigger than the anticipated proceeds, or would the proceeds be sufficient to pay off the debts?

If your calculations include the sale of a home, be sure to estimate the home's value conservatively--especially if you think it would need to be sold quickly. Remember, though, that even in the best of circumstances, a house can't be sold overnight. At the very least, the sale will have to go through escrow, which almost always takes more than a month.

Now from your budget, consider: What expenses would evaporate if you or your spouse died? What continuing expenses would the survivor be willing and able to cut? What added expenses might you face if one of you died?

* * * Normally, you can expect that certain expenditures--food, clothing and transportation--would be likely to decline somewhat when one member of a household dies. Other expenditures would not. Chances are your rent or mortgage expenses would stay the same and that your child-care bills would go up.

As unpleasant as it may be, imagining exactly how life would change if you or your spouse died is necessary to properly estimate your insurance needs.

The question needs to be considered separately for both spouses--even if one spouse doesn't earn outside income. That's because a stay-at-home spouse is providing valuable services--such as child care, food preparation and cleaning--that the other might have to pay for in the event of a death.

The answers to these questions will help you determine how much monthly income your survivors would need if something were to happen to you in the near future.

* * * Your next step is to consider how long they'd need that income. To do that, ask yourself:

How old are my children? Are they so young that my spouse would face either a day-care or a financial crisis if he or she had to work more hours to help close the economic gap my death would leave?

Would the children's college plans be likely to be affected by my death?

How would my death affect my spouse's retirement plans?

If your spouse is not currently working, would he or she be employable today? Or would he or she be employable in the near future without job training or further education? How long would it take to make my spouse employable? How long would it take before my spouse's income could more than make up for the income he or she would lose if I die soon?

The length of time your survivors will need income will have a pivotal effect in determining how much insurance you need. To put it simply: Some families will need income from insurance proceeds for a few years and others will need income for life. Most will fall between these two extremes.

With the information you've gleaned from going through the previous steps, fill out the work sheet on this page to come up with a rough estimate of how much life insurance you should buy.

It's wise to round that figure to the nearest $25,000 because life insurance is typically sold in coverage blocks of $10,000 to $25,000. Instead of trying to find a policy for $159,650, for example, you may choose to buy a $175,000 policy. Why not go for the $150,000 policy instead? Because you are estimating a future need, which is as much art as science. Even though you're doing this carefully, your calculations are unlikely to prove precise. Given that the people you are trying to protect are important to you, it's wise to always round up when determining how big a policy to buy.

* * *

Calculating Your Need

This work sheet will yield a rough estimate of life insurance needs. For single parents, the steps will be more complicated, partly because the financial issues will pivot on the children's ages and guardians.

1. Calculate your current monthly expenses. If you are married, record the number twice, so you can calculate the insurance need for each spouse.

2. Estimate expenses that would be eliminated if one spouse died. (For example, if you would jettison one of two cars, eliminate that car payment. If you have assets that could easily be liquidated to pay off some of your debts to reduce your monthly expenditures, factor that in.)

3. Estimate the increased monthly expenses you might have if one spouse died. (Be sure to consider items such as child care.)

4. Record the income each spouse contributes to the family budget to determine how much income would be lost in the event of either spouse's death.

5. Using the information above, estimate what each spouse's monthly expenses and income would be if the other spouse were to die. Subtract expenses from income to determine whether survivors would have a gap between the income they need and what they're likely to have in the event of a death. If you come up with a negative number, you have an insurance need.

6. For simplicity's sake, multiply the gap figure by the number of months you expect this gap to continue, for a rough estimate of how much insurance you need. (For instance, a family may figure that their income would be lower than expenses for a few years, when the children need day care and financial support, but would diminish once they became independent.) If you would expect to need income from the insurance for more than five years, you should do the calculation explained below.

7. To calculate a long-term insurance need, multiply your current monthly gap by 12 to come up with an annual amount. Then use the multipliers below to estimate the amount of insurance you should buy, according to the estimated period for which your survivors will need income.

For example, if you think your heirs will need $1,000 a month--or $12,000 annually--for 30 years, multiply $12,000 by 15.52 to see that you'll need a policy worth at least $186,240.

These multipliers assume that your heirs will earn a 5% annual inflation-adjusted return on the insurance proceeds.

10 years: 7.86

15 years: 10.54

20 years: 12.63

25 years: 14.25

30 years: 15.52

40 years: 17.28

* * * Adapted from "Kathy Kristof's Complete Book of Dollars and Sense." Printed with permission of Macmillan Publishing, New York. Write to the author in care of Personal Finance, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or kathy.kristof@latimes.com. KATHY M. KRISTOF welcomes comments and suggestions for columns but regrets that she cannot respond individually to letters and phone calls.