When you hedge a long stock position, you buy a quantity of puts equivalent to the number of shares. Estimating the face value of your insurance policy is trickier, because you have to make assumptions about growth of your current income stream; the investment rate of the proceeds should the policy be exercised; and the future inflation rate. In advising my clients, I assume future inflation at 2% and future returns of a diversified stock and bond portfolio at 7%. My rules of thumb for setting policy values:
10 times current income covers about 80% of the lost income.
12 times current income covers about 100% of the lost income.
15 times current income covers 100% of lost income, even taking salary increases into account.
For example, a single-income family of four, earning $100,000 a year, would be well covered with a $1.2 million policy on the primary breadwinner. A second policy on the nonworking spouse might be set at $300,000 (12 times the $25,000-a-year cost of a nanny.)
You can reduce the amount of insurance you need by the amount of liquid assets (e.g., stocks, bonds, mutual funds, retirement accounts, but not real estate), you have on hand already. In the example above, let's assume $200,000 in savings. In that case, you might reduce the policy amounts to $1 million and $100,000. However, in the event of the death of either spouse, the survivor would want to increase coverage at least until the children were self-supporting adults.
David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. Edwards was a contributor to Harry Domash's Fire Your Stock Analyst: Analyzing Stocks On Your Own available at Amazon. At the time of publication, his firm was held positions in Dell and Amazon.com, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback and invites you to send it to David Edwards.
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