First of all, one should assess how much are the needs of his or her dependants.
Say one wishes to provide for his child in case daddy is not around to pay the bills, one has to figure out how the kid needs. If the kid needs about $1000 per month for the next 20 years before she become independent, that will come to $240,000.
Enter inflation and that figure changes. The $1000 per month that the child needs will become $1030 per month next year if the inflation is 3% per annum. Project that for 20 years, that coverage needed for the child becomes $322,445.
However, there is another school of thought. Say the unfortunate happened and the dependent receives a lump sum payout. It would not be wise to simply put the money in a POSB savings account for the 0.25% interest and spend it over a period of 20 years. The advisable course of action would be to put it in a safe investment like government bonds and drawdown on it over 20 years. If the investment can keep up exactly with inflation, the coverage needed is reduced to the original $240,000.
But still the coverage needed will not stay constant for 20 years. And the good news is, the coverage needed will actually decrease over the years. Why? This is because as every year passes, the child will be 1 year closer to achieve independence. The same principle applies for dependants like parents and spouse; for every year that passes, they are 1 year closer to their life expectancies.
Therefore, while a child in our example needs an initial coverage of $240,000, that figure becomes $234,840 ($1030 x 12 months x 19 years remaining) in the second year. In the third year, it becomes $229,154 ($1061 x 12 months x 18 years remaining). Note that the monthly expenses still increases due to inflation. While we did not include inflation after the hypothetical payout occurs, we still have to include it before the hypothetical payout happens.
If we plot the needs of 1) aging parent needing $750/mth for 30 years, 2) spouse needing $1000/mth for 40 years and 3) child needing $1000/mth for 20 years, we have a chart the looks like the following:
Add all the needs up, and we will get a Total Dependants Needs curve that looks like the following:
From the curve, it seems that person in our example needs about $1 million of insurance. However, we need to take into consideration, how much net assets the person currently owns. If he currently has more than $1 million worth of assets, he does not need insurance; his assets are enough to cover the needs of his dependant should anything happens to him.
Say this person has $100,000, invests them for a return of 3%, saves $500/mth (adjusted for inflation) and draws on his savings $1500/mth after retirement, his Total Assets over the years should look somewhat like this:
In this case, the Protection Required would be Total Protection Needs minus Total Assets:
This example is typical of many Singaporeans in their 30s when they have a few dependants and little assets to their name. This is the time where they need more insurance. As time goes by, their assets grew and their need for insurance diminishes.
On a practical note, I have not seen a term insurance that has a coverage that decreases over the years with the exception of mortgage insurances. So if one does not qualify of a mortgage insurance but still wish to have a term insurance policy that tracks the diminishing insurance needs, one can take up multiple term insurance of different terms.
For example, one can buy a $200,000 5-years insurance, a $100,000 10-years insurance and a $50,000 15-years insurance to achieve a coverage of $350,000 for the first 5 years, $150,000 for the next 5 years and $50,000 for the last 5 years.
To recap, the process of determining one’s life insurance needs, one has to:
1) Assess dependants’ needs and project them into the future
2) Assess current assets owned and future assets growth
3) Estimate how much of dependants’ needs are not cover by the assets
4) Periodically assess the needs and assets as they changes from time to time and seldom pans out as planned
P.S. There are other insurance needs that are not covered here. One important need is health insurance. But that should be relatively simple if one can take away the principles of life insurance needs.
