Two principal analytical approaches are used to quantify the amount of life insurance a client needs.
Capital Needs Analysis (Capital Liquidation or Capital Retention)
The capital needs approach calculates the lump sum of capital required at death to:
- Pay off all immediate expenses (debts, final expenses, taxes).
- Provide sufficient ongoing income for survivors, either by investing the remaining capital and spending principal and interest over a defined period (liquidation) or by investing only the interest and preserving the capital intact for heirs (retention).
Steps (simplified):
- List all immediate cash needs at death (debts + final expenses + taxes).
- Estimate annual income needed by survivors.
- Calculate the capital required to generate that income over the dependency period at an assumed rate of return.
- Subtract existing assets and insurance that would be available.
- The shortfall is the insurance need.
The liquidation variant depletes principal over the projection period; the retention variant preserves capital for estate transfer. The retention approach requires a larger lump sum.
Income Replacement Approach (Human Life Value)
This approach focuses on the economic value of the insured's future earnings. The present value of the income stream the insured would have earned (net of taxes, personal expenses, and savings) over their remaining working life is the insurance need.
Formula (simplified): divide the net annual income attributable to the family by an assumed interest rate.
Example: a client earning $70,000 per year attributable to family support, assuming a 3% return, implies a human life value of approximately $2,333,000 ($70,000 / 0.03).
Limitation: the income replacement approach ignores specific debts and final expenses; it is a starting point, not a precise figure. Agents should adjust for existing assets and coverage.
Practical use: in exam scenarios, questions test whether the candidate can identify which approach is being described and whether the result is plausible given the client's situation.
Recall: What is the key difference between capital liquidation and capital retention? Which approach focuses on the present value of lost earnings?