Life insurance needs analysis for individuals and businesses

Why needs analysis comes first

Before anyone chooses a type of life insurance, they have to answer a simpler question: how much is needed, and for what? New York's Department of Financial Services frames it this way: life insurance bridges the gap between what your dependents will need and what will be available to them from other sources, such as Social Security, savings and investments. Marital status, number of dependents, income and wealth all shape the answer, and the need should be reviewed every few years as circumstances change.

There are two classic ways to put a number on that gap.

The human life value approach

The human life value approach measures the economic value of a person's future earnings to the family. In its simplest form you take the insured's annual earnings, subtract what the insured spends on themselves (personal maintenance), and find the present value of that net contribution over the remaining working years. It answers the question "what income does the family lose?" It ignores what the family already owns.

The needs approach

The needs approach builds the number from the family's actual obligations, then subtracts the resources already available. The typical needs are:

• Final expenses (the clean-up fund): funeral costs, last medical bills, estate settlement costs and estate taxes.
• Debt and mortgage redemption: paying off the home loan, car loans and credit cards.
• Emergency fund for unexpected costs.
• Readjustment period income: roughly the family's full income for a year or two while it adjusts to a new standard of living.
• Dependency period income: income until the youngest child is grown and out of school.
• The blackout period: the gap that begins when the youngest child turns 16 and the surviving spouse's Social Security benefit as a parent caring for children ordinarily stops, and lasts until survivor benefits can resume as early as age 60.
• Education funds for the children.
• Retirement income for the surviving spouse.

From the total, subtract existing assets, existing life insurance, group coverage and Social Security. What remains is the amount to be provided by new life insurance.

Two ways to fund income needs: capital liquidation spends down both principal and interest over the period, so it needs less insurance. Capital retention pays the family only the interest and keeps the principal intact, so it needs more insurance but leaves the principal to heirs.

Business needs

Businesses buy life insurance for different reasons, and each has a standard structure:

• Key person insurance: the business owns the policy on a vital employee, pays the premium and is the beneficiary. It replaces lost profits and pays for recruiting a replacement. Premiums are not tax-deductible; the death benefit is generally received income-tax free.
• Buy-sell agreements: owners agree in advance that a deceased owner's interest will be bought at a set price, funded by life insurance. In a cross-purchase plan each owner insures the others; in an entity (stock redemption) plan the business insures each owner and buys the interest itself.
• Business continuation and debt protection: cash to keep operating, repay business loans, or satisfy a lender (credit life insurance can secure a loan).
• Executive benefits: executive bonus plans (the employer pays the premium as deductible bonus compensation, taxable to the employee), split-dollar plans that share premium and benefits between employer and employee, and funding of nonqualified deferred compensation.

Exam tips

Needs approach equals needs minus resources. Human life value equals the economic value of lost future earnings. In key person coverage the business is owner, payor and beneficiary, and the employee is only the insured.