Life insurance needs analysis for individuals and businesses

Why needs analysis comes first

Before recommending a policy type, a producer has to answer a simpler question: how much coverage does this person or business actually need? Needs analysis is the structured way to reach that number. It protects the client from buying too little (leaving a family or business short) and from buying too much (paying premiums for coverage no one needs). It also documents that a recommendation was suitable for the client's circumstances.

There are two classic ways to size individual coverage: the human life value approach and the needs approach.

The human life value approach

Human life value treats a person as an economic asset and asks what their future earnings are worth to the people who depend on them. The steps are:

1. Estimate the person's average annual earnings over the rest of their working life.
2. Subtract what they spend on themselves (taxes, personal living costs, their own insurance premiums), leaving the amount that actually goes to the family.
3. Multiply by the number of working years remaining.
4. Discount that stream back to a present value at an assumed interest rate.

The result is the economic loss the family would suffer from a premature death. It is a useful ceiling, and insurers use a similar logic when deciding how much coverage they will issue relative to income. Its weakness is that it ignores the family's actual obligations and the other resources already available.

The needs approach

The needs approach starts from the survivors' side. It adds up what the family will need if the insured dies today, then subtracts the resources already in place. What is left is the insurance gap.

Needs usually fall into two groups.

Lump-sum (cash) needs, paid at or soon after death:

• Final expenses: funeral and burial, last medical bills, estate settlement costs. This is often called the cleanup fund.
• Debt payoff: credit cards, car loans, personal loans.
• Mortgage: paying off the home, or funding the remaining payments.
• Emergency fund: a reserve for unexpected expenses, commonly several months of living costs.
• Education fund: college or other schooling for the children.
• Estate liquidity: cash to pay estate taxes and settlement costs without forcing a sale of assets.

Income needs, paid over time:

• Readjustment period: one or two years at close to the family's old income while the survivors adjust.
• Dependency period: income until the youngest child is self-supporting.
• Blackout period: the gap in Social Security survivor income. A surviving spouse caring for a child receives benefits until the youngest child turns 16. Those benefits stop and do not start again until the spouse reaches 60. Life insurance is often used to bridge that gap.
• Spouse's retirement income: income for the surviving spouse in later life.

From the total, subtract existing resources: savings and investments, group and individual life insurance already in force, retirement accounts, and expected Social Security survivor benefits. The remainder is the amount of new coverage to recommend.

Liquidation or retention?

Income needs can be funded in two ways, and the choice changes the face amount:

• Capital liquidation: the death benefit is invested and gradually spent down, principal and interest, until it is used up at the end of the need period. It requires less insurance.
• Capital retention: the principal is kept intact and the family lives on the investment earnings alone, so the capital remains for heirs or charity. It requires considerably more insurance.

A needs analysis is a snapshot. Marriage, a birth, a new mortgage, a divorce or a promotion all change the answer, so it should be revisited at each life event.

Needs analysis for a business

A business faces its own losses when an owner or important employee dies. The main business uses are:

• Key person insurance: the business buys, owns, pays for and is the beneficiary of coverage on an employee whose death would cost it money, such as a top salesperson, a founder or an engineer with essential knowledge. The amount is based on the person's contribution to profits or the cost of finding and training a replacement. Premiums are generally not tax-deductible, and the death benefit is generally received income tax free. Because the business is insuring an employee, the employee must be told about the coverage and consent to it.
• Buy-sell agreements: a contract that obliges the surviving owners (or the business) to buy a deceased owner's interest at a set price or by a set formula, and obliges the estate to sell. Life insurance funds the purchase.
• In a cross-purchase plan, each owner buys a policy on every other owner. With n owners that means n × (n − 1) policies, which becomes unwieldy as the number of owners grows.
• In an entity (or stock redemption) plan, the business itself owns one policy on each owner and buys back the deceased owner's interest.
• Business loan and credit protection: coverage so that a loan can be repaid if a guarantor or owner dies.
• Executive benefits: coverage used to reward or retain key employees, such as executive bonus (Section 162) plans, split-dollar arrangements and funding for nonqualified deferred compensation.

For a business, the analysis follows the same pattern as for a family: identify the dollar loss a death would cause (lost profits, the value of an ownership interest, outstanding debt, benefit promises), subtract any resources already set aside, and insure the gap.

The rule that ties it all together: total needs minus existing resources equals the amount of life insurance to recommend.