Using the Premiums as Percentage of Income rule, a minimum of six percent of the insured’s gross income (as the primary income earner) should be spent on life insurance premiums. Add an additional one percent for each dependent. Once the applicant determines the percentage of the income that should be spent on life insurance premiums, the agent may advise purchasing as much life insurance as the applicant can get for that premium amount.
There are other more comprehensive methods used to calculate life insurance need. Overall, these methods are more detailed than rules of thumb and provide a more complete view of insurance needs. These methods are:
- The Family Needs Approach
- Income Replacement
- Estate Preservation and Liquidity Needs
The Family Needs Approach requires the applicant to purchase enough life insurance to allow his/her family to meet its various expenses in the event of the applicant’s death. Under the family needs approach, the applicant divides his/her family’s needs into two main categories:
- Immediate Needs at Death (Cash Needs)
- Ongoing Needs (Net Income Needs)
Once the applicant determines the total amount of his/her family’s needs, he/she may purchase enough life insurance to cover that amount.
The Income Replacement calculation is based on the theory that the purpose of life insurance is to replace the loss of the applicant’s income when he/she dies. Under this approach, the amount of life insurance the applicant should purchase is based on the value of the income that he/she can expect to earn during his/her lifetime, taking into account such factors as inflation and anticipated salary increases.
The Estate Preservation And Liquidity Needs approach attempts to calculate the amount of life insurance needed upon the applicant’s death for items such as taxes, expenses, fees, and debts, while preserving the value of his/her estate. This method takes into consideration the amount of life insurance needed to maintain the current value of his/her estate for his/her family, while providing the cash needed to cover death expenses and taxes.