There are many different approaches to determining the amount of life insurance appropriate for any given client. Just trying to sort through them can be very time consuming and confusing. Financial journalists tend to prefer simplistic rules of thumb, such as some multiple of annual income, because it�s short and easy to explain. However, there is a trap in this seductive simplicity.

An attempt to determine life insurance needs that does not rely upon a fair amount of client information is of questionable worth. The rule-of-thumb approach ignores information about how much the client has already accumulated and any existing external sources of finance such as trusts and inheritances. The simplistic rule-of-thumb approach can err in either direction; that is, it can either overinsure or underinsure the client.

Simplistic rules of thumb may perform a positive function if they are the only approach or logic that motivates the client to purchase needed insurance. Sometimes clients do resist providing the information necessary for an appropriate and thorough analysis of their needs.

In this chapter it is assumed that clients are serious about their financial future and that the financial services professional has established enough trust for the information-gathering and analysis process to proceed. Problem solving in this arena requires complete and accurate information about current income, potential future income, accumulated assets, investments, pensions, and other qualified plan holdings. In addition, it is important to develop a profile of the client�s priorities and goals or objectives. A fair amount of time and energy is often spent in gathering the necessary information before any steps can even be taken toward analysis and recommendation.

The conceptual approach to determining needs is very easily explained. The client�s desires must be translated into estimated costs, and then those costs must be evaluated to determine how much of the funding is already in place. Any deficit between the intended goals and objectives and current financial sources is usually a candidate for life insurance. Life insurance provides a means of completing the financing of family goals and objectives that individuals work toward during their lifetime. In essence, life insurance can be a personally arranged and collectively financed means of replacing lost income, and in some ways it is analogous to trusts and inheritances in wealthy families.

Postdeath financial needs are conveniently separated into two main categories: (1) lump-sum needs at death and (2) ongoing income. The cash needs at death include such items as final costs not covered by insurance; repayment of outstanding debt that becomes due and payable upon death; estate taxes, if applicable; the expenses of the funeral, burial, and cremation, if applicable; the costs of probate court to prove the validity of the will; attorneys� fees; and operational expenses to cover the ongoing costs of the survivors� household. The surviving family members need funds to pay for the mortgage or rent, utility bills, property insurance premiums, property taxes, food, clothing, transportation costs, and costs of child care and/or education. The amounts associated with each of these categories vary widely from one individual to another and from one family to another. Each case must be evaluated individually. Reliance on general guidelines rather than on individual evaluation increases the likelihood that important and potentially costly needs may be overlooked or ignored.

The lump-sum needs at death should also include an emergency fund. This is a form of safety net or shock absorber to help the survivors cope with unexpected emergencies that could otherwise devastate an already strained cash-flow budget. This kind of planning can prevent the necessity of trading off essential expenditures against funding for emergencies.

There is no general consensus on the appropriate amount for an emergency fund. Estimating the needs for this purpose should be based on a realistic assessment of the survivors� finances. The need for an emergency fund may be even greater in families where the finances are already stretched even before death than in families where disposable income is high enough to spend a significant proportion on relatively frivolous discretionary items. A household where nearly all the major appliances and automobiles are operating on borrowed time can look forward to more failures and earlier expenditures on these items than households where these items are relatively new and well maintained.

Another important factor in setting the level of the emergency fund is whether the family has other liquid or near-liquid assets that could easily be used to cover such emergencies. Money market accounts and listed security holdings may be acceptable sources of funds to cover all or part of any potential emergency, thus reducing or eliminating the amount of funds from life insurance death proceeds needed to cover emergencies.

Many financial planners suggest that prefunding of children�s educational needs be classified under the lump-sum category rather than being provided for out of income. Obviously the amount needed to prefund children�s education is a function of the current ages of those children, the costs associated with the intended educational institutions, the number of years for which educational support is intended to be provided, and the proportion of financing for education that the parents intend to prefund. For some families the intent will be to provide nothing more than a public school education through high school, while at the other end of the spectrum a family may provide full funding for private preparatory schools and an Ivy League education up to the completion of a professional degree such as a JD or MD or even a PhD program. Each family will have its own target somewhere along that continuum of possibilities.

The ongoing income needs of the surviving dependent family members already exist at the instant of death. These needs for income will continue until those dependents can become self-supporting. In some families that can be a relatively short time and in others it may take decades. In some families the dependent spouse will never become self-sufficient, and there is no intent that he or she attempt to do so. At the other end of the spectrum is the family where all family members are expected to become self-sufficient shortly after the head of the household dies. In some cases such an extreme expectation may be unrealistic and even constitute neglect on the part of the deceased. In most families there is both a desire and the financial ability to prefund the survivors� income needs at least until the youngest child becomes self-sufficient, often when he or she completes formal education. This type of evaluation becomes more difficult when there are children with special needs that will keep them from ever becoming self-sufficient. Such special children may actually have ongoing income needs many years beyond the death of the surviving parent.

It is common to classify the survivors� ongoing income needs in four categories:

Since the purpose of life insurance is to fund the unfunded portion of these objectives, it is important to consider any and all existing funds that can provide part or all of these needs. For simplicity and efficiency, most planners suggest using some target percentage of the insured�s current income as the target income level rather than calculating a composite of each individual anticipated need component. It is often suggested that the survivor(s) will need about 70 percent of the predeath income to carry on after death.

Once the desired income goal has been set, the deficits in each future period can be estimated by deducting the existing sources at their anticipated benefit or income levels.

The most commonly available source of income is social security benefits. The surviving parent and each child will be eligible for benefits as long as the children are under 16 and living with the surviving spouse. The children�s benefits will actually continue until they are 18, but the surviving spouse�s benefit will stop when the youngest child reaches 16. Other potential sources of income include employer-provided plan benefits such as deferred compensation, death-benefit-only plans, and any qualified plan participation funds that are not forfeited or terminated upon the employee�s death.

Projecting future cash flow and deducting the existing sources of income are the first steps in determining the income deficit. The next step is to find the present value of all those future income needs. This calculation can be done in many different ways and with many different levels of specificity. Often it is broken up into component segments so that the income deficit will be the same throughout that particular component period. If the calculation is done that way, the final calculation of the total income need is the sum of the present values of each of the separate, individually calculated segments.

Most financial advisers suggest that these components be kept at a minimum and that simplifying assumptions be made whenever possible or appropriate in order to keep this estimation process from becoming too cumbersome and time consuming. It is important to remember that this is still an estimation process intended to simulate unknown future occurrences. The estimates are made without the benefit of knowing what future inflation rates and investment returns will be. Financial advisers and insurance agents are no more omniscient than economists when it comes to estimating future investment income and inflation rates.

In fact, some advisers suggest that all values should be done in current dollar amounts and no discounting applied to future income periods. They maintain that such discounting merely complicates an imprecise estimation process and that ignoring inflation as well will probably make the estimates somewhere near what will ultimately happen. There is much merit in these suggestions. An inordinate amount of time and resources can be spent trying to estimate to the penny future income flows. Computers make it possible to estimate every last detail in fractions of a cent. However, just because a computer spits out numbers with four-decimal-place accuracy or more does not mean that those numbers will really be anywhere near the numbers that will actually unfold in the future.

After future income needs have been estimated and combined into a total, there is another important step that must be completed to translate this need into a stated funding objective. Future income payments can be comprised solely of investment earnings on a capital sum, or they can be a combination of investment earnings and liquidation of part of the capital sum. The advantage of using investment earnings only to supply such income streams is that the capital sum is not being depleted, and consequently a termination date on the income stream is not necessary. This means that individuals relying upon the income will not outlive their income stream. The disadvantage of this strategy is that it takes more money in the capital fund to fully fund this approach than it takes to fund a program that relies on liquidation of part of the principal.

A serious shortcoming of the liquidating approach is that the fund will eventually be totally dissipated. The strategy requires estimating the insured�s likely maximum age at death and planning liquidation for that date or later. Any liquidation planning predicated on the beneficiary�s death at an early age runs a high risk of liquidating the proceeds while the beneficiary is still dependent on them. As one famous agent likes to put it, they run out of money before they run out of time. Financial advisers are well advised to plan for a liquidation in such a way that the beneficiary is likely to run out of time before he or she runs out of money.

There are essentially two ways of eliminating this potential problem associated with liquidating the principal sum over the beneficiary�s lifetime. One approach is to use policy proceeds at death to provide a life income through policy settlement options or separate annuity contracts. These arrangements guarantee lifelong income payments regardless of how long the recipient lives. The other approach (nonliquidating) is the previously mentioned capitalization at a high enough level that all the income benefits can be provided from the investment income only.

Within the life insurance industry the liquidating approach is often referred to as the financial needs analysis, and a nonliquidating approach is often referred to as the capital needs analysis.

Another advantage of the nonliquidating approach is the simplicity of calculating the needed capital fund. The desired income level is easily capitalized by dividing that income amount by the applicable interest rate representing the aftertax investment return anticipated on the capital sum. For example, if $100,000 per year is desired, and the capital sum generating those income payments can realistically expect to generate a 5 percent return after taxes, a $2 million fund is sufficient. This is determined by taking the desired income amount and dividing into that the realistic estimate of the aftertax investment return rate. In our example it was .05, or 5 percent. That division yields the $2 million capital fund amount needed. Obviously the lower the aftertax investment return rate, the higher the capital fund needed to throw off the same amount of income. Similarly higher marginal tax rates will lower the aftertax return rate and increase the size of the fund needed to generate the income.

To see how one successful, well-known agent and American College trustee approaches needs analysis, see the appendix, "How Much Life Insurance Is Enough?"