What Is the Needs Approach?
The needs approach is a way of determining the appropriate amount of life insurance coverage an individual should purchase. This approach is based on a budgeting of expenses and costs that the individual will incur for burial expenses, settling their estate, and then replacing a portion of future income to sustain the household for some years.
Understanding the Needs Approach
The needs approach is a function of two variables:
- How much will be needed at death to meet obligations.
- How much future income is needed to sustain the household.
When calculating your expenses, it is best to overestimate your needs a little. If you underestimate, you might realize your mistake until it's too late. For instance, the needs approach will consider any outstanding debts and obligations, such as a mortgage or car payments, that the insurance benefit should cover as well as costs such as funeral and burial expenses. The needs approach also recognizes that future income needs will be curtailed if and when children living at home finish college and move away, or if a spouse re-marries and income is thus replaced through their work.
The needs approach contrasts with the human-life approach. The human-life approach calculates the amount of life insurance a family will need, based on the financial loss the family would incur if the insured person were to pass away today. The human life approach usually takes into account factors such as the insured individual's age, gender, planned retirement age, occupation, annual wage, employment benefits, as well as the personal and financial information of the spouse and/or dependent children.
- The needs approach to life insurance planning is used to estimate the proper amount of insurance coverage an individual needs.
- The needs approach considers the amount of money needed to cover burial expenses as well as debts and obligations, such as mortgages or college expenses, that will need to be covered.
- The needs approach also considers lost income, but can be contrasted with the human-life approach which is more comprehensive in determining the future value of an individual's employment potential.
Needs Approach and a Primer on Life Insurance
Life insurance provides financial protection to surviving dependents in case of or after the death of an insured. As with other forms of insurance, life insurance is a contract between an insurer and a policyholder. In life insurance, the insurer guarantees payment of a death benefit to named beneficiaries. Various types of life insurance approaches exist, including the needs approach and human life approach. Whole life, term life, universal life, and variable universal life (VUL) policies are separate types of plans available to individuals and their families. Whole life (also known as traditional or permanent life) covers the full duration of the life of the insured.
In addition to providing a death benefit, whole life also contains a savings component where cash value may accumulate. Term life guarantees payment of a death benefit during a specified term. Unlike whole life, after the term expires, the policyholder can renew for another term, convert to permanent (whole life) coverage, or let the policy to terminate.
Universal life is similar to whole life insurance yet it provides an additional investment savings element and low premiums like term life insurance. Most universal life insurance policies contain a flexible premium option although some require a single premium (single lump-sum premium) or fixed premiums (scheduled fixed premiums). Finally, variable universal life or VUL is a permanent life policy with a built-in savings component, which allows for the investment of the cash value. Like standard universal life, the VUL premium is flexible.