How do I know how much life insurance I need?
Life insurance can provide a welcome financial cushion for your dependents in the event of your death, but it isn’t always straightforward to work out how much cover you need.
Big expenses like mortgages, the cost of living and loan repayments change over time, so figuring out what level of cover you need can be difficult.
There is no one size fits all insurance solution, and the amount of cover you take out will depend on some highly individual factors.
Your personal circumstances, such as the number and needs of your dependents, your mortgage debt, as well as how much you can afford in monthly premiums, will strongly influence the level of cover you decide to take out.
How to calculate how much cover you require
Figuring out what level of cover you need will require a long, hard look at your finances, as well as considering what you want your policy to do.
If you only require cover for your funeral, your policy will be, understandably, a lot smaller than one which is designed to pay off a mortgage.
When assessing how much cover you think you’ll need, make sure to consider:
- Debts you would like to have paid off (mortgage, loans, credit cards, student loan)
- Regular, non-negotiable outgoings your dependents would struggle to pay (utility bills, council tax, food, petrol, clothing)
- Occasional/probable costs you would incur if you were around, (university fees, wedding funds)
- Any other expenses incurred as a result of your death, (funeral costs, inheritance tax).
If you are a parent, it is important to consider the unpaid work you do as well as the loss of income.
For instance, if your partner were to carry on working after you’re gone, would they incur additional expenses for childcare provision at the times you would have normally looked after the children yourself.
The effects of inflation
Despite the recent financial crisis, inflation in the UK still averages around 2 – 3% each year.
This means that the amount of life insurance you buy today will not be worth the same in 10, 20 or 40 years from now.
This change in value is something which needs to be mitigated and accounted for if you want your nest egg to still be valuable to your family several years down the line.
Cost of living today vs 10 years from now
Back in the 1970’s, you could buy a dozen eggs for 23p, fill your car up with petrol for 7p a litre and get a ticket to the cup final at Wembley for just £2.
Money changes a lot over time, and even in just the next decade, you can expect your money to devalue in price.
To give you an idea of what this means, here are some basic living expenses along with estimates of what these will cost in 10 years’ time:
- Loaf of bread: Now – £1.03, in ten years – £1.34
- A dozen eggs: Now – £2.16, in ten years – £2.90
- A litre of petrol: Now – £1.36, in ten years – £1.77
- Rent on a 3-bed house (outside of the city centre): Now – £915.18, in ten years – £1229.94.
These figures are based on a conservative estimate of the cost of living changes, but as we have seen over the past ten years, the cost of living doesn’t always rise in line with inflation.
Since 2004, we have seen the cost of living increase at a rate of four times that of inflation. When put in these terms, you can see why you need to build in an inflation element to your calculations to keep your policy at a high value.
Some insurance policies will let you take out an indexation facility, which means your policy is linked to one of the main indicators of inflation.
This can be the Retail Price Index (RPI) or the Average Earnings Index (AEI) and ensures that the value of your policy increase in line with inflation each year, helping to keep the buying power of your money strong.
Cover the mortgage
Your mortgage is undoubtedly the biggest single debt you will enter into in your lifetime.
If you’re the main breadwinner in your family, you’ll already be acutely aware of how much your family rely on you to meet the mortgage payments each month.
Some mortgage lenders require you to have adequate life cover to pay off the mortgage if you die, but if yours did not, then it’s worth putting something in place to protect your family home if you are no longer around.
Even if you did take out life insurance against your mortgage, you should regularly review the provision and ensure you have enough cover to pay both the capital and interest repayments on the mortgage if the worst should happen.
Cover loans and credit cards
If you have other debts you would like to be paid off, such as loans and credit cards, you should make sure you’ve made adequate provision for these in your calculations.
Remember to include the interest payable on the loan or credit agreement when making your calculations, and aim to over rather than underestimate the cost of all these expenses.
Once you have arranged your life insurance cover, don’t just file away the paperwork and forget about it.
Changes in your circumstances, such as having another baby, getting divorced or moving house, may mean you need to add to or reduce down your policy amount to ensure you have the right cover.