Definition and Purpose
The Needs Approach is a method used to determine the appropriate amount of life insurance coverage an individual or family requires. The primary goal is to ensure that, in the event of the policyholder’s death, the financial needs of the dependents are met, covering expenses such as living costs, education, and outstanding debts.
Key Components
The calculation involves assessing various financial needs, such as:
- Immediate Expenses: Funeral costs, medical bills, and any immediate debts.
- Debt Repayment: Mortgage, car loans, credit card debt, etc.
- Living Expenses: Daily living costs for dependents.
- Education Costs: Future education expenses for children.
- Retirement Funds: Contributions to retirement plans for the surviving spouse.
How the Needs Approach Works
Step-by-Step Process
The Needs Approach involves several steps to accurately calculate the required life insurance coverage:
1. Estimate Immediate Expenses
Identify and estimate immediate expenses that will occur upon the policyholder’s death. This includes funeral costs, medical bills, and any unpaid debts.
2. Assess Long-term Financial Needs
Calculate the long-term financial needs of the dependents. This includes daily living expenses, education costs, and any ongoing debt repayments.
3. Account for Existing Resources
Evaluate any existing financial resources that can help cover these expenses, such as savings, current life insurance policies, and Social Security benefits.
4. Calculate the Required Life Insurance
Subtract existing resources from the total identified financial needs to determine the required life insurance coverage.
Example Calculation
Let’s consider an example to illustrate this process.
- Immediate Expenses: $15,000 (funeral and medical costs)
- Long-term Financial Needs: $4,000 per month for 15 years (180 months), totaling $720,000
- Existing Resources: $200,000 (savings, current policies, benefits)
Therefore, the required life insurance coverage is $535,000.
Historical Context
The concept of the Needs Approach has evolved alongside modern financial planning strategies. It emerged as a structured method for life insurance calculation in response to increasing complexity in family financial needs and the availability of various insurance products.
Applicability
The Needs Approach is particularly valuable for individuals and families looking to ensure comprehensive financial protection. It applies to:
- Breadwinners: Ensuring family members’ financial security in case of unforeseen events.
- Financial Planners: Providing structured advice to clients on adequate life insurance coverage.
- Insurance Agents: Offering tailored life insurance solutions based on clients’ unique financial needs.
Comparing Different Approaches
There are other methods for calculating life insurance, such as the Human Life Value Approach. Below is a comparison:
- Needs Approach: Focuses on specific financial needs of dependents.
- Human Life Value Approach: Based on the economic value of the insured’s future earnings.
Each approach has its merits and can be chosen based on the policyholder’s specific situation and financial goals.
Related Terms
- Term Life Insurance: A policy that provides coverage for a specified term.
- Whole Life Insurance: Permanent life insurance with an investment component.
- Universal Life Insurance: A flexible premium life insurance policy.
- Beneficiary: The individual(s) designated to receive the benefits from a life insurance policy.
Frequently Asked Questions (FAQs)
What is the main advantage of the Needs Approach?
The main advantage is its precision in calculating life insurance requirements, ensuring that all anticipated expenses and financial needs are covered.
How often should the Needs Approach be revisited?
It should be revisited periodically or upon significant life events such as marriage, birth of a child, or major financial changes.
Can the Needs Approach be used for other types of insurance?
While primarily used for life insurance, the principles can be adapted for other insurance types by identifying and assessing specific financial risks and needs.
References
- Life Insurance Handbook by Lewis L. Altfest (2016)
- Financial Planning Standards Board’s Guide to Risk Management (2020)
- The American College of Financial Services, Insurance Planning
Summary
The Needs Approach is a vital tool in financial planning, ensuring that an individual’s or family’s life insurance coverage is sufficient to meet all financial obligations and needs. By systematically assessing immediate expenses, long-term needs, and existing resources, this method provides a tailored and effective insurance solution.
