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 the creation of a budget of expenses that will be incurred, including funeral expenses, estate settlement costs, and replacement of a portion of future income to sustain the spouse or dependants.
Key Takeaways
- The needs approach to life insurance planning is used to estimate the 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.
- This approach stands in contrast with the human-life approach, which is more comprehensive in determining the value of an individual's future earnings potential or an individual's future earnings.
Understanding the Needs Approach
The needs approach is a function of two variables:
- The amount that will be needed at death to meet immediate obligations.
- The future income that will be needed to sustain the household.
When calculating your expenses, it is best to overestimate your needs a little. For instance, the needs approach will consider any outstanding debts and obligations that should be covered, such as a mortgage or car payments. The needs approach also recognizes that the need for income replacement may gradually decline as children living at home move away, or if a spouse remarries.
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, and employment benefits, as well as the personal and financial information of the spouse and any dependent children.
Types of Life Insurance
Life insurance provides financial protection to surviving dependents in case of 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 the 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 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 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.
