According to this concept, an individual's net worth is the present value of that person's future income stream that will be allocated to others. Present Value tells you what your money will be worth in a given number of years while earning a specific rate of interest.
A variation of this method is used in wrongful death litigation to compute the present value of the decedent's anticipated future income, minus personal expenses, to compensate the survivors for lost net earnings.
Like the earnings-multiple method, the Capital Needs Analysis projects the income the insured will earn between now and retirement and discounts these flows. But this procedure goes further: It calculates the net contribution of the insured to the family's living standard by subtracting the insured's present value of future tax payments and living expenses from his or her present earnings. The net contribution is then compared with the pending needs of potential survivors, including mortgage payments, household expenses and special expenditures.
To use this method:
1- Estimate the individual's average annual earned income from the person's present age to the age of retirement.
2- Deduct the amount that is not allocated to others. Money spent for income taxes, life and health insurance premiums, and all other self-maintenance expenses should be deducted in this step.
Typically this is a percentage of salary. A good starting point is the Consumer Expenditures Survey by the Bureau of Labor Statistics. Examples of the percentage of income required after taxes and expenses are:
Annual Gross Income Percentage of Gross Income Required
Under $48,000 70%
$48,000 to $53,000 66%
$53,000 to $59,000 63%
$59,000 to $65,000 60%
Over $65,000 57%
All Two Income Families 70%
3- Using a reasonable rate of interest, determine the present value of the amounts allocated to others for the working period used in step 1. Most financial calculators can perform this equation for you.
Note that he Capital Needs Analysis method raises several concerns:
- If the household sets a spending target too high for survivors, the method will generate a larger amount of life insurance than is appropriate. This will cost the household too much in life insurance premiums. If the spending target is set too low, the recommended amount will leave the household underinsured.
- It does not take into account what your beneficiary's needs will be.
- The percentage of gross income required is an average, not exact.
- It assumes that educational expenses are taken care of separately and the mortgage is paid for.
- It does not integrate with Social Security or other sources of income.
- This method only factors in the replacement of income and does not take into account any lump sum needs at death.
- Decisions about buying insurance, spending and saving money are interrelated and need to be jointly determined. The amount of life insurance purchased affects the amount of premiums paid, which impacts the household's living standard, which in turn influences how much life insurance the household needs. A complex mathematical formula is needed to account for all these factors, which this method does not employ.
- Unless future tax payments are calculated accurately on a year-by-year basis, they can easily be overstated or understated, which will throw off the calculation of the amount of life insurance needed.
- For married couples, tax payments are generally made via a joint return. This makes distinguishing each spouse's individual taxes difficult to determine. Again, without an accurate calculation of future tax responsibility, the life insurance needs analysis will not be reliable.
HUMAN LIFE VALUE CONCEPT
The human life value concept deals with human capital. Human capital is a person's income potential. We all have a human life value, and insuring human life value is the primary purpose of life insurance.
The human life value concept goes beyond numbers and into considering the entire impact caused by the loss of a human being. Here are some questions to give you a start:
If you had been killed in a car accident last week, and someone else had been responsible for your death, how much money would your family sue the responsible party for?
If had been killed in a car accident last week, and you had been responsible, how much money would you want your family to receive?
If you died of cancer last week, how much money would you want your family to receive?
How much are your tomorrows worth? What is your Potential Earning Power (PEP)?
How much insurance is there on your life?
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