A key component that is oftentimes overlooked by many financial advisors when creating a financial plan is the use of life insurance to protect the integrity of a family’s financial goals. One of the key risks of a family failing to meet their future financial goals is the lack of financial resources in place to account for the loss of financial security in a household due to premature death of an income earner. The duration of our lives and how long to prepare for unplanned catastrophic circumstances is far from certain. Life insurance fills the uncertainty of the unknown and helps fill the gaps and protect your family in the case that your financial resources are unable to account for loss.
In financial planning, as with all planning tasks, the first step we take in the life insurance evaluation process is the evaluation of goals and parameters. We identiy the financial needs that must be met in the event of premature death. The financial advisor should examine the time horizon of the need, cash flow sufficiency in relation to premium payment demands, and any secondary goals such as accumulation. Once the appropriate data has been collected by the financial planner, various approaches may be considered to determine the amount of life insurance needed by the client. ranging from a simple multiple of annual earnings (e.g., 10 x annual salary) to a more complex calculation involving several factors, in addition to income loss. The two most common methods are the “Human Life Value Approach” and the “Needs Approach”. When weighing the priority of permanent wealth accumulation over the temporary term insurance needs, a skilled planner might want to balance the priorities by using hybrid solutions to account for both needs accordingly.
The “Human Life Value Approach” seeks to identify a value of the insured’s life that is defined in terms of a multiple of the deceased’s annual earnings as the purchase amount. (Ex, 10x Insureds Annual Earnings) A more detailed version of this approach seeks to identify the anticipated earnings (including pay increases) over the deceased’s unfulfilled years of earnings. Expenses attributable to the proposed insured are then deducted (e.g., insurance, taxes, maintenance items, etc.). A reasonable discount rate is then applied to determine the present value of the identified earnings, and this figure becomes the target amount of insurance.
The “Financial Needs Approach”, requires a more comprehensive understanding of the financial plan and the financial advisor works to identify all needs (lump sum and cash flow/income), and then seeks to identify the needs in relation to any and all available sources of assets and/or sources of income. The steps in this process can be briefly summarized as follows:
- Identify needs – Lump sum needs – to include final expenses, mortgage/debt elimination, or other funding goals such as college funding; bequeaths, etc. Income / cash flow needs of any surviving dependents – these may generally be broken down into several measurable periods:
- Identify available offset sources – Lump sum assets, including life insurance proceeds from existing policies; investment assets, equity in the home, etc. Income sources, to include spouse’s income, any potential Social Security benefits, and other sources of income such as net rental income
- Identify shortfall – Readjustment period (generally first one to two years following death), Income needs during dependency of minor children, Income needs of surviving spouse beyond age of dependency until retirement, Income needs of surviving spouse upon retirement.
Most financial advisors specializing in the placement of life insurance fail to plan with an in-depth understanding of the client’s financial circumstance. Most insurance underwriters find it sufficient to make the determination of the amount of life insurance based on the “Human Life Value Approach”. This process does not accurately take into consideration that knowing the entire financial picture of the family financial plan might help uncover key time periods and vulnerabilities of the family’s financial circumstance that might add to or detract from the need of varying limits of insurance. Our firm uses the “Financial Needs Approach” in conjunction with a comprehensive financial plan using the eMoney financial planning software.Through the financial planning process, we can analyze the entire duration of the family’s financial plan and isolate key opportunities to protect your family from the risk of being under insured or over insured. This is a part of our financial planning process that makes us your most trusted lifetime advisor.