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If you’re in the market for life insurance, there are a few things that you should take into account. The first being what type of insurance you want - term or whole life. Your decision will be highly dependent on your financial goals and the level of support you feel that your beneficiaries will need.
Term life insurance guarantees a death benefit to your beneficiaries during the policy’s selected term. Alternatively, whole life insurance covers you for life and guarantees a death benefit to your beneficiaries plus the cash value accumulation from the life of the insurance policy.
This article discusses the different approaches that you can take yourself, or with a financial planner, to determine your life insurance needs. You’ll learn about the methods and programs used to calculate how much life insurance you need. Specifically discussed are life insurance programming, capital retention method, human life value method, and two types of the financial needs analysis method.
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4 Methods of Calculating Life Insurance Needs
It’s important to determine how much life insurance you need. Not only will this prevent you from spending too much over time, but it will make sure that you and your family are secure should anything happen. Here are four methods of calculating life insurance requirements that you need to know.
Life Insurance Programming
Life insurance programming is a method that analyzes your need for capital resources upon death. Programming includes evaluating your present financial position, forecasting future financial obligations, and determining the proper life insurance to meet future obligations.
Programming creates a plan for purchasing life insurance. You should focus on all members of your family when creating this plan because it will not be complete until all members of your family are insured. A spouse that is not formally employed will still require life insurance because they provide financial value in other ways, such as maintaining the home and providing childcare.
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Capital Retention Method
The capital retention method is a method of determining the amount of life insurance needed by using an interest-only model to support your family. Under this method, the original principal that you save will still remain at the end of the income period. However, this method does not take into account inflation.
Human Life Value Method
The human life value method forecasts the income of the insurance-seeking individual, taking into account the remaining work-life expectancy and any raises. Afterward, using a discount rate, the present value of your life is determined.
The cash flows can be adjusted for what you might have consumed or paid in taxes. In addition, the percentage of consumption and taxation can be applied to the present value in order to reflect the total present value of all income that can be provided to dependents.
Financial Needs Analysis Method
The financial needs analysis method examines all expenses that are recurring for dependents, and any expenditures that might come as a result of the death of the insured. Factors that are considered in this method include marital status, the role of spouses, size of the family, and the dependents’ ability to work.
The different lifestyle that a family has may result in different outcomes. A person that is single and has no dependents has little need for life insurance. They may only need to repay their debt and any expenses that result from their death.
On the other hand, a single parent who supports dependents will need life insurance to continue the flow of income towards their children if they die. Childless couples may also need life insurance, but only to the extent of covering the amount necessary for debts, final expenses, and maintaining their lifestyle. Children and dependents increase the need for life insurance to guarantee the current standard of living. If only one parent is employed, then the primary insurance emphasis should be on the income-producing parent. If both are employed, then both should be insured.
The needs of a family can be classified as the following:
A fund for final expenses— last medical costs and funeral costs
A fund for readjustment—covers the period immediately following the death and includes nonrecurring costs of two years
The dependency period income fund— income for current living and other routine costs to maintain a household for dependents
The mortgage payment fund—ability to pay off the mortgage and other debts at the death of an income producer
The education fund—establishing a lump sum for education
Life income for the surviving spouse—If the spouse is not employed, then this is necessary
All the needs should be inflated using the Consumer Price Index (CPI), and if appropriate, each cash flow should then be discounted back to the present.
The financial needs analysis can be calculated in two different ways: the annuity approach and the purchasing power preservation model.
The Annuity Approach
Using this approach, the expected pay is just enough to meet the needs of dependents through the life expectancy period of those dependents. Both the death benefit and the interest from the death proceeds are all consumed by the survivors
The Purchasing Power Preservation Model
This approach provides for annuity income and capital preservation on an inflated basis. As a result, there is no loss in purchasing power at the end of the life expectancy. With this method, only part of the interest of the invested death benefit is consumed by the survivors. The rest of the interest is then used to preserve the purchasing power of the death benefit.
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Make Sure You Are Covered With an Appropriate Amount of Life Insurance
To protect your loved ones, you will want to make sure that you and your spouse, if applicable, have enough life insurance coverage. This will help those who depend on you to cover costs if you pass away. There are many different ways to calculate how much life insurance you need, but ultimately, you will want to decide if you want it for your whole life or just a specific term. Make sure that you are covered appropriately by reviewing your existing policy and reaching out to a professional for assistance.