Calculating Life Insurance

There are three common ways that insurance agents can determine the life insurance requirements of an individual: multiple income approach, human life value approach, or needs analysis.

Multiple Income Approach

The simplest way to calculate life insurance is a multiple of the individual’s income, usually five to seven times one’s income. However, one should consider existing properties and other sources of protection (Social Security, pension plans, savings—all discussed in later chapters) that may be included in the portfolio. A person needs to buy protection only for the uncovered balance.  Agents also understand the subjective preferences of families: the desire or need to prefer current consumption over future savings, natural optimism, and so forth. These topics are related to complex economic theories that are not handled in this book.

Human Life Value Approach

This method considers your client’s age, gender, occupation, current and future earnings, and employee benefits. There are several steps to determining the overall value of the client if they were to die today:

• Estimate the client’s earnings from now until a set point in the future — typically their expected retirement age. Be sure to factor in future wage increases as well.
• Subtract the insured’s annual taxes and living expenses from the total. It’s usually safe to assume 30 percent of their salary will go to taxes.
• Select an assumed rate of return on the remaining total and subtract it from the gross amount. In other words, subtract the interest you expect the money to earn.
• Add the cost of additional benefits provided through employment, such as health care, that will need to be replaced when the client dies. Remember to account for inflation.

The primary goal of this method is to replace income lost. It doesn’t necessarily account for funeral costs, children’s educational expenses, or other specific future needs.

Capital Needs Analysis

The capital needs analysis is the most widely-used approach for estimating life insurance coverage. In addition to replacing the client’s salary, it also accounts for other sources of income and the specific needs of survivors.

This method factors in:

• Current and future income of both the insured and surviving spouse
• Immediate lump-sum cash needs upon death, such as funeral expenses, debt repayment, and mortgage payoff
• Future expenses such as college, weddings, long-term care expenses, and retirement funding
• Existing family assets, retirement funds, or insurance policies

Once all future needs are taken into consideration, there are then two ways to calculate how much insurance the client needs, based on how they want to utilize the funds in the future.

• Earnings-Only Approach: The survivors will live off only the investment earnings of the policy without cashing in the principal value. This method is preferable if the client wants funds to be available for their children after their spouse has also died. Like any investment, this method is subject to the risk of changing market interest rates. To provide a sufficient income stream, the death benefit is usually significantly higher than in the liquidation approach.
• Liquidation Approach: The surviving beneficiary utilizes a portion of the principal as well as the investment earnings. There is more risk with this approach, particularly if the investment earns less than originally predicted. The surviving spouse may not have sufficient income to live on for the remainder of their life.

What type of individual or couple would benefit from each of the life insurance calculation alternatives presented above?