There are three common ways to determine a client’s life insurance needs: Multiple-of-income approach, human life value approach, and capital needs analysis.
The latter two methods are more sophisticated and allow you to address the specific needs and concerns of your clients’ survivors.
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Multiple-of-Income Approach
The simplest method for estimating your clients’ life insurance needs is the multiple-of-income approach. The goal of this approach is to replace the primary breadwinner’s salary for a predetermined number of years.
Begin by multiplying the client’s current annual income by how many years they want to provide financial support for their survivors. The recommendation is to have seven to ten years of life insurance.
It’s an easy method, but it doesn’t take into account the specific needs of survivors, other sources of funds — such as the survivors’ income and investments — or different types of family structures. For example, this method may work well for a family with one child, but might not work as well for a family with six children. It also doesn’t take into account inflation or future salary increases. Using this approach may lead to over-insuring or underinsuring your clients, but it’s a start.
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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.
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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.
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No matter which method you choose to calculate your clients’ life insurance needs, it’s always a good idea to have a baseline estimate of their survivors’ future financial needs to ensure the policy will provide sufficient support. Getting a life insurance policy is the smartest thing your clients can do to show their family they care!
Need help starting the discussion? Take advantage of Life Insurance Awareness Month.
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