The Needs Analysis Approach to Determining How Much Life Insurance to Buy

In contrast with the income replacement approach, which is founded on the premise that the insurance need should be based on the income that would be lost if the insured dies, the needs approach estimates the insured’s family income needs directly. The typical needs of a family can be divided into two categories.

The first category of needs consists of lump sum cash needs at death, typically including:

  • administrative/final expenses;
  • estate settlement costs;
  • debt liquidation;
  • tax liabilities;
  • an education fund;
  • an emergency fund; and
  • any other special funding needs.

The second category of needs consists of multiperiod income needs and is comprised of:

  • an adjustment period income;
  • the surviving spouse’s income needs;
  • the children’s income needs; and
  • the spouse’s retirement needs.

Four common special needs and the types of policies used to fund those needs are as follows:

Mortgage-repayment policy – Here, all that is needed is the current amount at risk and how long that risk or need will need to be covered.

Other major-debt-repayment policies – These could be for cars, credit cards, student loans, or any other type of nonmortgage debt.

Education-fund-accumulation policy – This would be a policy to pay projected education costs for family members, if death occurred prematurely.

Estate-tax-liability policy – On estates below $12,060,000 (in 2022, with a living spouse: $24,120,000) there would be little or no federal estate tax liability. Above these amounts, an estate tax may be due. Many states now impose a state death or estate tax. While the threshold is much lower than the federal limit in those states with a state death tax, the tax can be quite significant. The purchase of life insurance could obviate the necessity of the surviving spouse selling off assets to pay state or federal estate taxes.

The income needs are met from various sources including Social Security (survivor’s income), spouse’s earnings, annuity payments, employer-provided pension survivor benefits, and investment income. The excess of income needs over the expected income from these sources must be covered by income from reinvesting a lump sum life insurance death benefit or by electing a settlement option from the insurance company.

The lump sum required to generate a predetermined monthly income depends on whether or not the capital will be depleted or preserved. Essentially, the decision to preserve some or all of the capital can be viewed as a third category of need or objective—the desire to leave something to heirs, or perhaps to a favorite charity, after the surviving spouse dies.

As a practical matter, the capital necessary to fund the spouse’s income needs is often calculated in two ways that provide an upper and lower boundary on the required capital. First, the more conservative approach is to plan to preserve capital. The required capital is then the amount that is sufficient to pay the required cash income from interest on the capital alone. This approach assures income to the surviving spouse regardless of how long the spouse may live and provides an extra margin of security. However, the cost of insurance may exceed the amount that the insured feels is affordable. The second approach is to assume that both income and capital will provide the required cash income and capital will be entirely consumed over a specified period. In general, the payout period is set equal to or slightly greater than the spouse’s remaining life expectancy. If the spouse’s remaining life expectancy is long and the assumed interest rate sufficiently high, the difference between the amount necessary if capital is preserved and the amount necessary if capital is depleted is relatively small.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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