What it means
A rule of thumb might suggest insuring ten times a person's annual income, but families differ widely. Someone with a large mortgage and young children needs far more cover than someone with no dependants, which is why the needs approach starts from the family's situation.
The first step is to list the lump sums and ongoing costs the family would face if the insured person died. These typically include final expenses, outstanding debts such as the mortgage, a fund for education, and income replacement for a number of years to cover living costs.
The second step is to list existing resources, such as savings, investments, current life insurance and any employer death benefits. The shortfall between needs and resources is the amount of new cover to buy.
Financial planners use this method because it ties the premium to a specific goal. It also makes the conversation concrete for a family, since each figure can be discussed and adjusted, such as whether a spouse plans to return to work or how long the children will need support.
That conversation often reveals needs the family had not thought about. The calculation should be reviewed regularly.
Needs shrink as debts are paid off and children grow up, and rise with a new child or a bigger mortgage, so the insurance can be reduced or topped up as circumstances change. A review every couple of years, or after any major life event, keeps the cover aligned with the family's real situation.
A nuance is that income replacement needs a present value (what a future stream of money is worth today). Money set aside today can earn interest, so the lump sum needed is smaller than simply multiplying annual income by the number of years.
In practice
Real-world examples.
Example
A self-employed consultant with two young children and a large mortgage uses the needs approach and finds that his cover is $400,000 short, mainly because he had overlooked education costs.
Example
A couple in their fifties with no mortgage and grown children calculate that their needs are mainly final expenses, so they decide a small policy is enough. They put the premium they save into their retirement funds.
Example
A financial adviser running a workplace benefits seminar walks employees through the method, using each employee's debts and dependants, so that the staff do not buy more cover than they need. Employees also learn to count the death benefit their employer already provides.
Formula
Calculation
Insurance need = (Debts + Final expenses + Education fund + Income replacement fund + Other goals) - Existing resources
Worked example: a family needs the following if the main earner dies.
Mortgage and other debts = $250,000
Final expenses = $15,000
Education fund for two children = $120,000
Income replacement = $40,000 a year for 10 years = $400,000 (undiscounted, for simplicity)
Total needs = $250,000 + $15,000 + $120,000 + $400,000 = $785,000
Existing resources: savings $60,000 plus current life cover of $200,000 = $260,000
Insurance need = $785,000 - $260,000 = $525,000
The family should therefore consider about $525,000 of additional cover. A discounted calculation of the income replacement would reduce the figure somewhat.Case study
Seen in the real world.
Oakley Family Planning is an illustrative, fictional advisory practice. A new client, a 38-year-old manager, had bought a policy for ten times his salary on the advice of a friend.
The adviser listed the family's real needs: a $300,000 mortgage, $20,000 of funeral and legal costs, $150,000 for the children's education and $500,000 to replace income for ten years. Against these, the family had $100,000 of savings and the existing $400,000 policy.
Total needs came to $300,000 + $20,000 + $150,000 + $500,000 = $970,000, and existing resources were $100,000 + $400,000 = $500,000. The shortfall was therefore $970,000 - $500,000 = $470,000, which meant his old policy covered less than half of what the family would actually need. The adviser recommended adding a ten-year term policy of $470,000, which cost far less than a whole-life policy of the same size. In this illustrative story, the client also agreed to review the numbers every two years or after any major life event, such as a new child or a home move.
Watch out
Common mistakes.
- Using a salary multiple without checking the family's actual debts, dependants and goals.
- Forgetting to subtract existing savings, investments and employer cover, which leads to buying too much insurance.
- Never revisiting the calculation, when needs change as debts fall, children grow and incomes rise.
Questions
People also ask.
How is the needs approach different from the human life value approach?
The human life value approach estimates the present value of the person's future earnings, while the needs approach adds up the specific financial needs the family would face.
Should income replacement be discounted?
Ideally yes, because a lump sum invested today earns a return, so the amount needed is less than simple income multiplied by years.
Does it work for business owners?
Yes, and owners often add business debts and the cost of replacing key people to the list of needs.
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