Insurance Needs Analysis

Determining the appropriate amount of life insurance coverage is one of the most critical tasks in financial planning. Inadequate coverage leaves families vulnerable to financial hardship, while excessive coverage wastes premium dollars that could be used for other financial goals. The CFP exam tests your understanding of various methods for calculating life insurance needs and knowing when to apply each approach.

Overview of Life Insurance Needs Analysis Methods

There are four primary methods for determining life insurance needs, each with distinct advantages and limitations:

Exam Tip: Method Selection

The CFP exam often presents scenarios requiring you to identify the most appropriate method. Human life value focuses on the insured's economic worth, while capital needs analysis focuses on survivor requirements. Know which approach addresses the client's specific situation.

Human Life Value Approach

The human life value (HLV) approach quantifies a person's economic worth by calculating the present value of their future earnings, minus amounts consumed for personal maintenance. This method views the insured person as an income-producing asset.

Calculation Components

The HLV calculation involves several steps:

1. Estimate average annual earnings over the individual's productive working years until retirement
2. Deduct personal consumption expenses including:
   • Federal and state income taxes
   • Social Security and Medicare taxes
   • Personal living expenses (typically 25-30% of after-tax income)
   • Personal insurance premiums
3. Determine the working years remaining from current age to planned retirement
4. Calculate the present value of the family's share of future earnings using an appropriate discount rate

HLV Formula

The simplified formula for human life value:

HLV = Annual Contribution to Family x Present Value Factor

Where:

• Annual Contribution = After-tax Income x (1 - Personal Consumption Rate)
• Present Value Factor = Based on years to retirement and discount rate

Example Calculation

Consider a 35-year-old earning $120,000 annually with a planned retirement at age 65:

Key Relationships in HLV

Two important principles govern the human life value approach:

Age and HLV: Younger clients have higher human life values (all else equal) because they will earn income for a longer period. As clients age, their HLV and life insurance needs typically decline.

Income and HLV: As a client's income rises, their human life value increases proportionally because more income would need to be replaced if they died prematurely.

Limitations of HLV

• Does not account for specific survivor needs (mortgage, education costs)
• Ignores existing assets and other income sources
• Does not address non-income-producing contributions (stay-at-home parents)
• May overestimate needs if family expenses would decrease after death

Capital Needs Analysis (Needs Approach)

The capital needs analysis (also called the needs approach) is the most widely used and comprehensive method for estimating life insurance coverage. Unlike HLV, this method focuses on the liability side of the family's financial picture, identifying specific needs of survivors.

Components of Capital Needs Analysis

The needs approach considers both immediate and ongoing financial requirements:

Immediate Lump-Sum Needs:

Ongoing Income Needs:

Assets to Subtract:

The Needs Formula

Insurance Need = Total Needs - Available Resources

Capital Retention vs. Capital Liquidation

Once needs are identified, there are two approaches for calculating the required death benefit:

Capital Retention Approach:

• Survivors live off investment earnings only
• Principal remains intact indefinitely
• Formula: Annual Income Need / Expected Rate of Return = Required Principal
• Example: $60,000 / 0.05 = $1,200,000 needed

Capital Liquidation Approach:

• Survivors consume both principal and earnings
• Death benefit depletes over the income period
• Requires lower death benefit than capital retention
• Uses present value of annuity calculation

Exam Tip: Inflation Adjustment

When calculating needs over long time periods, use the real rate of interest (nominal rate minus inflation) rather than nominal rates. If the expected nominal return is 6% and inflation is 3%, use 3% as the discount rate to account for rising costs over time.

Multiple of Income Method

The multiple of income method is a simplified rule of thumb that estimates life insurance needs as a multiple of the insured's annual income.

Common Multiples

Example Application

For a client earning $100,000 annually:

Limitations of Multiple of Income

This method has significant drawbacks:

• Ignores individual circumstances such as debt levels, existing assets, and specific family needs
• Does not account for existing life insurance, Social Security benefits, or spouse's income
• May overinsure or underinsure depending on the client's situation
• Does not address stay-at-home parents who have no earned income but provide valuable services
• Ignores inflation and changing financial needs over time

When to Use Multiple of Income

Despite its limitations, the multiple of income method is useful for:

• Quick initial screening to identify grossly inadequate coverage
• Providing a starting point for more detailed analysis
• Helping clients understand approximate coverage ranges
• Marketing and educational discussions

Comparing the Methods

Exam Tip: Method Comparison

CFP exam questions often ask you to identify which method is most appropriate for a given situation. Remember: HLV focuses on replacing the insured's income contribution, while capital needs analysis accounts for the complete financial picture including assets, liabilities, and specific survivor needs.

When to Review Life Insurance Needs

Life insurance is not a "set and forget" purchase. Coverage should be reviewed regularly and after major life events that significantly change financial circumstances.

Regular Review Schedule

Major Life Events Triggering Review

Marriage: A new spouse becomes financially dependent, and shared goals (mortgage, retirement) require additional protection. Coverage should increase to reflect these new obligations.

Birth or Adoption of Children: Each child adds long-term financial obligations including childcare, education, and daily expenses. The 18-22 year dependency period requires significant coverage increases.

Home Purchase: A mortgage represents a major financial obligation that survivors may struggle to maintain. Many families add coverage equal to the mortgage balance.

Divorce: Review and update beneficiaries, consider whether coverage should be maintained as part of divorce settlement, and adjust amounts based on new single-income status.

Career and Income Changes: Promotions and raises typically warrant increased coverage to replace higher income. Career changes may also affect employer-provided group life insurance.

Significant Debt Changes: New business loans, student loans for children, or paying off major debts all affect coverage needs.

Becoming a Caregiver: Taking responsibility for elderly parents or other family members creates new financial obligations that should be protected.

Approaching Retirement: As retirement approaches and children become independent, coverage needs typically decrease. Consider whether term policies should be converted or cancelled.

Health Changes: While declining health may not trigger additional coverage (due to underwriting), improved health may qualify the insured for better rates.

Policy-Specific Triggers

Summary: Insurance Needs Analysis