A 38-year-old engineer with $360,000 in group term thinks he has "enough" life insurance, but his mortgage alone exceeds that amount. The gap between perceived and actual coverage is why needs analysis exists.
Each method answers the same question (how much money must be available at the insured's death?) but they differ in precision.
Income replacement approach (multiple-of-income). Multiply annual income by 10 to 12. A person earning $150,000 at 10x needs $1,500,000. Fast, easy to communicate, useful as a sanity check. Its weakness: it ignores specific obligations, dependents' ages, existing assets, and the time value of money. If a question asks which method is "quickest but least precise," this is the answer.
Human life value (HLV) approach. Calculate the present value of the insured's future earnings stream lost to dependents. Start with annual income, subtract personal consumption (the portion the insured spends on himself that dependents would not need to replace) then discount the remainder over remaining working years.
Common mistakes
- Using the standard annuity when two rates are given. The presence of both a discount rate and a growth/inflation rate is a deliberate signal to use the growing annuity formula. The standard formula understates the need. Trap: $1,404,000 (standard) vs. the correct $1,764,000 (growing).
- Forgetting to subtract all available resources. Capital needs analysis requires netting out savings, existing insurance, retirement assets, and the PV of Social Security benefits. Missing any offset inflates the gap. A common miss: subtracting group term but forgetting 529 savings or Social Security.
- Confusing capital retention with capital liquidation. Capital retention = perpetuity = larger number. Capital liquidation = PV annuity = smaller number. Trap: $100,000/year at 5% = $2,000,000 (retention) vs. ~$1,246,000 for 20 years (liquidation). The wrong method produces a wrong answer that always appears as a choice.
Bottom line
- Three methods: income replacement (10-12x, rough), human life value (earnings minus personal consumption, discounted), capital needs analysis (all needs minus all resources = gap)
- Two rates in the fact pattern signal the growing annuity formula; one rate uses the standard annuity
- Capital retention (perpetuity, larger number) preserves principal; capital liquidation (PV annuity, smaller number) exhausts the fund
- HLV's defining adjustment is personal consumption; it does NOT subtract existing assets
Exam shortcut
Two rates in the fact pattern = growing annuity. One rate = standard annuity. This single check prevents the most common calculation error. For HLV, personal consumption is always the answer to "what most reduces the value." For disability, 60, 70% of gross replaces ~100% of after-tax pay. "NEEDS minus RESOURCES = GAP" (the capital needs framework).
The full lesson (about 2,700 words, 18 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- C.25
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