Determining how much and what type of life insurance one should purchase can be a daunting task. Buy too much and you waste hard earned money on unnecessary premiums. Buy too little and you run the risk of leaving your family financially strapped should you die.
The traditional approach to calculating one’s insurance needs involves answering questions such as “How much is your mortgage?”, “What lifestyle do you need to maintain?”, or “What school will your kids go to?” Based on the answers provided, this approach calculates a dollar amount of life insurance coverage you should have.
The problem with this Needs Analysis method is that it is limited to your needs should you die today. How much insurance you may need in the future, say 10, 20 or even 40 years from now, is outside the scope of most traditional Needs Analysis calculations. The risk of not taking future needs into consideration is that it can leave you with hefty increases in premiums when your term coverage renews or no coverage at all when you can no longer qualify due to a change in health.
Today, many insurance agents and financial advisors are embracing a relatively new approach that calculates insurance needs using a person’s Human Capital value. In simple terms, a person’s Human Capital is the present value of all their future earnings potential.
When compared directly, the Needs Analysis and Human Capital methods have a strong correlation. They both calculate the value of a loss, but from different ends of the spectrum. The Needs Analysis method looks at the effect of earning an income, whereas the Human Capital method looks at the value of income earned.
Think of it this way: You go to work each day, earn a salary, and pay taxes. The amount you have left over will allow you to qualify for a mortgage, save for retirement, and establish a lifestyle. If we then calculate the value required to replace your lost income in the event of death, we will get a Human Capital value that is consistent to the amount provided through a Needs Analysis approach.
Advantages of using the Human Capital method
The Human Capital method offers a number of advantages over a traditional Needs Analysis approach:
- Faster and easier to calculate – It requires very little information, so there is no need to provide exact amounts to questions on debts and income needs.
- Better for changing needs over time – It suggests a new value each year, so that you can purchase the type of coverage that better matches your future insurance needs.
- Broadly applicable to many insurable risks – It is not just for life insurance needs; it can also be used to calculate disability and critical illness needs.
- Not limited to lost earned income – It can also calculate lost pension and government benefits in retirement.
How Human Capital and traditional Needs Analysis work together
Bill and Mary earn $100,000 and $35,000 per year respectively. Both plan to retire in 20 years at age 65. Assuming 3 percent inflation and an investment rate of return of 5 percent, Bill’s future earnings potential over his lifetime has a present value of $1,746,000 and Mary’s is $708,000. This is their Human Capital.
As Bill and Mary age, the value of their Human Capital declines over time (see chart #1 below, blue lines). By age 65, Bill and Mary’s Human Capital is less than $400,000, which represents the value of lost government benefits from age 65 to age 90 (assumed life expectancy).
Using the grid lines, determining how much insurance is needed and the term is a relatively simple exercise. When done as part of a comprehensive analysis, Human Capital can also be compared to future liabilities and deferred taxes (red line).
Using the more traditional Needs Analysis method, we ask Bill and Mary how much is needed to cover lump-sum needs such as debts, children’s education and final expenses. We also ask them to estimate how much additional income each survivor would need in order to maintain their lifestyle.
In Chart #2 below the “Capital Needed” is compared to “Available Capital” from all sources including creditor, group and individual life insurance policies and any liquid investments they may have.
This Needs Analysis approach determines that Bill requires $1,560,000 of life insurance in the event of his death, compared to Human Capital of $1,746,000. Mary requires $550,000 compared to Human Capital of $708,000. Human Capital will usually calculate a slightly higher need when including lost income to life expectancy.
In the end, although Human Capital and traditional Needs Analysis are calculated using differing methodologies, the results are very similar. When used together, these two insurance needs calculations can be seen as providing an upper and lower limit to help one choose the right amount and type of insurance coverage that meets their needs and budget.
Note: The above analysis was done using The Razor, a financial planning software program that takes minimal time to complete and is centered on engaging clients through meaningful discussions and analysis. In addition to the core analysis, The Razor also includes a library of concepts and calculators.