How much life insurance is enough?

Advisors should help clients do the income replacement math

By Eric Henderson, FSA, MAAA

Mr. Henderson is senior vice president of Life Insurance and Annuities for Nationwide Financial. Connect with him by e-mail: [email protected]

Many Americans make the mistake of assuming that simply having a life insurance policy means they can sleep well at night knowing their family is protected should the worst occur. Some recognize that they are underinsured. According to LIMRA, almost a third of all consumers believe they need more life insurance coverage.1

The reality is that most Americans are not even in the right ball park when it comes to having enough life insurance. Earlier this year, Nationwide Financial conducted a survey2, which shows that 98 percent of consumers who are married, partnered or have dependents, lack enough life insurance coverage to replace their income.

Do the simple math

Why is replacing income with life insurance important? It’s simple math.
The average consumer we surveyed will earn approximately $1.5 million before they retire and currently holds about $300,000 in life insurance coverage, leaving them about $1.2 million short of replacing their income with life insurance. In other words – if someone makes $50,000 a year, a $300,000 life insurance settlement replaces just 6 years of their income. If this person has 30 years until retirement, his or her family could face 24 years without any income replacement.

A $1.2 million income replacement gap could deal a devastating blow to surviving family members when you consider late life expenses such as college, weddings, retirement, health care and long-term care.
Our survey shows that the average life insurance policy currently replaces just 16 percent of the income the insured person will earn before retirement. That’s despite the fact that one-third of the consumers we surveyed said their most important consideration when purchasing life insurance was replacing their income.

The good news is that an affordable solution may be available for consumers of nearly all stripes. Consumers surveyed said they are willing to pay $99 per month on average to ensure their family can maintain its standard of living indefinitely following the death of a bread winner.
That may be enough to solve, or at least put a major dent in this problem for many consumers. For $99, a healthy 35-year-old man can purchase a 20-year term life policy worth more than $2.3 million.3 A healthy 35-year-old woman can purchase more than $2.6 million in coverage.3

One way advisors can help clients understand the income replacement concept is by urging them to think of their income as an asset. Most people insure the entire value of their largest assets, including their home or car. For most of us, the income we will earn before retirement is far more significant to the financial well-being of our family than any material possession.

Now, compare the cost for enough life insurance to replace your client’s income to what he or she pays for home and auto insurance. The average monthly cost for homeowners insurance in the U.S. is $73.4  Americans pay $65 a month on average for auto insurance.4 Many life insurers can provide a 20-year, $1.5 million term life insurance policy for $62 a month or less.3

Understanding the true cost of life insurance

A $1.2 million income replacement gap could deal a devastating blow to surviving family members when you consider late life expenses such as college, weddings, retirement, health care and long-term care

A lack of understanding of the true cost of life insurance may be part of the reason for the widespread passiveness of consumers. Less than three in ten (29 percent) of those we surveyed believe they can afford enough life insurance to replace their household income. However, according to LIMRA, consumers generally overestimate the cost of life insurance by nearly three times. 1

Another problem is overconfidence. Two-thirds (66 percent) of those with life insurance that we surveyed are somewhat or very certain they have enough to replace the income they or their spouse/partner would generate for the remainder of their working career. This stands in contrast to the $1.2 million average income replacement deficit highlighted by our survey.

Insurance professionals have a duty to help clients understand the implications of their income replacement gap. We know that consumers don’t appreciate it when their financial advisor uses scare tactics to try to make a sale. However, this scary story can have a happy ending because the cost of term life insurance is not as scary or expensive as most consumers expect. Some may dispute that it’s necessary to replace one hundred percent of potential income earned before retirement. I believe life insurance is about removing uncertainty at a time when the last thing a family wants to do is worry about money. It’s true that a surviving spouse may be able to earn more in the future, grow a life insurance settlement through investment, or remarry a wealthy person. However, the client may also lose his or her job, watch an investment portfolio shrink with a market crash, or face a costly illness. In 30 years in the insurance business, I’ve never met anyone who told me they had too much life insurance coverage after they lost a loved one.

Regardless of your thinking on this question, it’s clear that many consumers are not even close to being financially prepared for the sudden loss of income that comes when a family loses a bread winner.
At minimum, advisors should help their clients take a long hard look at their current life insurance coverage levels. Ask your client if his or her family is prepared to lose that much income without risking financial hardship. Help them understand the cost associated with closing their income replacement gap. If this leads to a more personalized solution based on thoughtful analysis of the client’s specific needs, you’re on the right track.

Our industry exists to help consumers prepare for the worst and protect what matters most. We should all take this responsibility seriously and challenge clients to do the life insurance income replacement math.
1. LIMRA’s 2012 Life Insurance Barometer study
2. Unless otherwise noted, all data in this article comes from Nationwide Financial’s Life Insurance/Income Replacement Study, which was conducted online by Harris Interactive, March 15 to March 21, 2013. The respondents were comprised of 1,163 U.S. adults, ages 24-66 that are currently married/partnered and/or have dependents, are not retired, and have household incomes of $24,000 or more. This online survey is not based on a probability sample and therefore no estimate of theoretical sampling error can be calculated.
3. Approximate costs are for a 20-year term life policy from Nationwide in best underwriting class. Costs may vary by distribution channel, age, risk class, etc. Costs are subject to change. Coverage limits may vary.
4. Insurance Information Institute Fact Book 2012