The usual broad-brush suggestions for amounts of life insurance coverage are way too low. Read most any general recommendation on the subject in the financial press, and the typical rule of thumb is for 5 to 10 times annual earnings. That suggestion is never explained or justified with any analysis. Nor is any account made of an individual’s or family’s varying circumstances.

A calculation of life insurance needs is generally made overly complicated. The simplest and most sensible method, though, is to think in round numbers of the amount of income that you would want dependents to have, adjusting for inflation, and for how long in the event you died tomorrow. Be realistic about the income earning potential of a dependent spouse who may currently be out of the work force or employed on a part-time basis. And don’t bank on an assumption about your spouse’s future remarriage and the wealth or income that might bring.

So, for example, if you’re earning $100,000 and figure that your family will need every bit of that without you, that’s your income replacement target. The analysis can be refined by other factors later, such as an assumption that income will go down when children are off your payroll (and stay off). Just assume, for now, that the replacement income figure stays constant but adjusts for inflation.

What amount of investment assets will be required to generate that income? Financial planners suggest that, at retirement, consuming more than 4%-5% of principal annually will risk the distinct possibility of depleting it. So if that replacement income has to last even longer than the typical retirement period, you shouldn’t count on consuming any more than that percentage each year. Five percent should be the maximum and less is safer, especially if the investment results of the past year have any lessons for us.

Divide the income need ($100,000) by the percentage of annual capital consumption (5%) to calculate the total capital need to produce that income ($2,000,000). A more conservative 4 percent capital consumption rate means $2,500,000 is needed.

From the total capital need, subtract existing investment assets (do not include your house, for example), and then add one-time capital needs that the normal annual income won’t cover (e.g., the cost of college educations). A step-by-step table setting forth this basic calculation is contained in the “Life Insurance: How Much and What Kind” article on my website.

Put all that together, and you likely have an insurance need that is more like 20-25 times annual income than the factor of 5 or 10 that is so frequently mentioned. Don’t be alarmed; the basic cost of term insurance is low, at least for non-smokers in reasonably good health, though rates have recently trended upward after years of substantial declines.

In all likelihood, you are fully covered with the likes of car and homeowner’s insurance.  Is your future economic value to your family not at least as worthy of protection?