The Human-Life Approach is a method used to calculate the adequate amount of life insurance coverage a family requires by estimating the financial loss they would incur if the insured individual were to pass away. This approach takes into account various factors such as the insured person’s income, expenses, and the number of working years remaining.
Value Calculation in the Human-Life Approach
Key Steps in Calculation
Estimate the Insured’s Future Earnings:
$$ \text{Future Earnings} = \sum_{t=1}^{n} E_t (1 + g)^t $$where \(E_t\) is the earnings at time \(t\), \(g\) is the growth rate of earnings, and \(n\) is the number of years until retirement.Deduct Personal Expenses: Non-family related personal expenses and taxes need to be subtracted from the future earnings.
Calculate the Present Value:
$$ \text{Present Value} = \sum_{t=1}^{n} \frac{E_t - \text{Expenses}}{(1 + r)^t} $$where \(r\) is the discount rate.
Example Calculation
Consider an individual with the following details:
- Annual income: $50,000
- Expected growth rate: 3%
- Personal expenses excluding taxes: $15,000 annually
- Years until retirement: 25
- Discount rate: 5%
Future Earnings:
Personal Expenses Deducted:
Present Value Calculation:
This present value would represent the total life insurance coverage needed to replace the insured’s income for their family.
Special Considerations
Inflation and Earning Growth Rate
The choice of inflation and earning growth rates significantly impacts the calculation. It is crucial to use realistic and current data for these rates to ensure the accuracy of the insurance amount.
Changes in Financial Conditions
Life events such as marriage, childbirth, or a significant career change necessitate a reassessment of the life insurance needs using the Human-Life Approach.
Applicability
The Human-Life Approach is applicable for:
- Financial planners advising clients on life insurance
- Individuals seeking to estimate their life insurance needs
- Insurance companies designing life insurance products
Comparison with Other Methods
Needs Approach
Unlike the Human-Life Approach, the Needs Approach calculates the life insurance requirement based on the family’s specific financial needs and obligations, such as mortgage payments, education costs, and living expenses, rather than the income replacement philosophy.
Capital Retention Approach
This method ensures that the capital remains intact and only the investment returns are used to support the family. It typically requires a higher insurance amount compared to the Human-Life Approach.
Related Terms
- Term Insurance: Life insurance coverage for a specific term, requiring lower premiums.
- Whole Life Insurance: Permanent life insurance that provides coverage throughout the insured’s life and includes a savings component.
- Income Replacement: The concept of compensating for lost income due to unforeseen circumstances like death or disability.
Frequently Asked Questions (FAQs)
Why is the Human-Life Approach important?
The Human-Life Approach ensures that a family can maintain their standard of living and meet financial obligations if the primary earner passes away, providing a sense of financial security.
How often should the Human-Life Approach be revisited?
It should be revisited upon significant life changes such as marriage, the birth of a child, a career change, or substantial financial shifts.
References
- Black, K. Jr., & Skipper, H. D. Jr. (2000). Life Insurance. Prentice Hall.
- Rejda, G. E., & McNamara, M. J. (2014). Principles of Risk Management and Insurance. Pearson.
- Schmit, J. T., & Roth, K. L. (1990). “Human-Life Approach Calculation: Theory and Practice.” Journal of Insurance Issues, 13(2), 67-85.
Summary
The Human-Life Approach is a fundamental method for determining life insurance needs based on future income replacement, ensuring financial stability for the insured’s family. It involves a comprehensive calculation considering future earnings, expenses, and present value discounting. Regular reassessment and consideration of life changes ensure adequate coverage over time.
