United States
Hong KongHow much life insurance: two methods, and when each applies
Human life value capitalizes the insured's future earnings. The needs approach totals the specific obligations survivors face and subtracts existing resources. The needs approach is the one the exam generally expects.
Two methods, different logic, and different answers for the same client.
Human life value
The present value of the insured's future earnings, net of taxes and their own consumption, over their working life.
It answers "what is this person's economic contribution worth?" and it is a time value of money calculation. It ignores what survivors actually need, which is both its weakness and the reason it produces large numbers.
The needs approach
Add up what survivors require. Subtract what already exists. Insure the gap.
| Needs | Resources |
|---|---|
| Final expenses and funeral costs | Existing life insurance |
| Debt repayment, including the mortgage | Liquid savings and investments |
| Emergency fund for survivors | Retirement accounts |
| Income replacement for a defined period | Social Security survivor benefits |
| Education funding | The surviving spouse's earning capacity |
| Retirement funding for the survivor | Other assets that could be sold |
The Social Security row is the one candidates forget, and it is frequently material - survivor benefits for a spouse caring for young children can be substantial.
Usually the needs approach, because it produces a defensible recommendation for a specific client. Human life value appears as a comparison, or where a question explicitly names it. Read for the method being asked about.
Common shortcuts and their limits
Multiples of income - ten to twelve times - are quick and crude. They ignore existing assets, the number and age of dependants, and the surviving spouse's earnings.
They are useful as a sanity check on a needs calculation, and a question offering a multiple as the recommendation for a specific client is generally not the answer.
Who else needs cover
- A non-earning spouse, because childcare and household services have a replacement cost.
- A business owner, for buy-sell funding and key person exposure.
- Anyone with an estate tax liability and illiquid assets.
- A parent of a special needs child, where the need is permanent.
The non-earning spouse is the one questions use, because the instinct is to insure income and the correct answer is to insure the economic function.
Reviewing it
Needs fall over time as debts amortize, children age out and assets accumulate. A recommendation made at thirty-five is usually wrong at fifty-five, and monitoring is the seventh step of the planning process for a reason.
Dollar limits here are indexed annually and several were changed by recent legislation. Confirm the current figure before relying on it, and expect the exam to test the rule rather than the number.
Common questions
What is the human life value approach?
The present value of the insured's future earnings, net of taxes and their own consumption, over their working life. It measures economic contribution rather than survivor need.
What is the needs approach?
Totaling what survivors require - final expenses, debt, income replacement, education, retirement funding - and subtracting existing resources including Social Security survivor benefits. The gap is the insurance need.
Which method does the CFP exam expect?
Usually the needs approach, because it produces a defensible recommendation for a specific client. Human life value appears as a comparison or where a question names it explicitly.
Are income multiples acceptable?
As a sanity check only. Ten to twelve times income ignores existing assets, dependants and the surviving spouse's earnings, so it is rarely the correct recommendation for a specific client.
Should a non-earning spouse be insured?
Usually yes. Childcare and household services have a real replacement cost, and the instinct to insure only income is what the question is testing.