There are two approaches to determining how much life insurance a person requires. The first approach—the income approach—looks at how much money you can expect to earn over the course of your working life; this is your human capital, which can be viewed as an asset that you possess as a result of your natural and acquired skills and abilities. Then, you subtract taxes (since the death benefit is not taxable), subtract the expenses you would have incurred had you been alive, and set that as the amount of insurance you require.
The second approach is the expense approach. As its name suggests, this method looks at the expenses that your family will incur over the course of their lives. You then buy insurance to cover those expenses rather than to replace your income. As you can imagine, there will be a wide variation between the amounts of insurance you think you need if you use the (family) expense method as opposed to the income approach. And the larger your income, the larger this gap will be.
Thus, for example, if you make $100,000 per year and expect this number to remain fairly constant in real terms (after inflation) for the rest of your life, then the income approach might lead to about $1,000,000 in life insurance coverage, which arguably could be the present (discounted) value of your wages at some interest rate. The expense approach would compute the costs of family living expenses, such as food and education, which might only be $500,000. In this case, any number between $500,000 and $1,000,000 would be acceptable as a life insurance policy.
This brings me to another important concept of insurance. Although the pricing of insurance is a rigorous and scientific discipline, determining the amount of insurance coverage that you require is not. Many people mistakenly believe that you can never have too much insurance. I disagree. I think that there is an upper bound (the income approach) and a lower bound (the expense approach), and anything in between is fair game. Further, regardless of whether you take the income or the expense approach, your insurance needs will change over time. Obviously, families’ expenses will decline substantially as their children grow up and leave the nest. Likewise, the discounted value of wages and other income will decline with time. So there is really no justification for buying more and more life insurance as you age.
I therefore find it quite puzzling that the size of one’s life insurance policy has become a status symbol in the corporate world. Executives in their 60s boast of life insurance policies worth $10 million to which their spouses and/or beneficiaries would be entitled. This strikes me as a waste of insurance premiums—and Iwould advise sleeping with one eye open! They may be very important and knowledgeable executives with lifelong experience and wisdom, but the present value of their salaries is nowhere near $10 million and the present value of their families’ expenses is even lower. In the absence of other (non–human capital) reasons, to which I shall return momentarily, there is no need to have more life insurance as you age.
Insurance is not a good investment on a pre-tax basis because the expected discounted value of the benefits you receive is lower than the premiums you pay; otherwise the insurance company would never make a profit. Yet it is a good hedge because the uncertainty in the insurance payout is negatively correlated with your human capital.