The human-capital approach is a method of calculating the amount of insurance a family will need that is based on the financial loss the family would incur if the insured person were to pass away today.
It is calculated by taking into account a number of factors such as; insured individual’s age, gender, planned retirement age, occupation, annual wage, employment benefits, Centrelink benefit as well as expenses.
To calculate the necessary insurance using this method, a Net Present Value calculation is performed taking into consideration the after tax contribution of the insured individuals contribution year by year. This is achieved by implementing the following steps:
Step 1: Determine gross cashflow. Gross cashflow is defined as all gross salary, investment income, rental income, Centrelink benefit, business & trust income that is attributable to the insured individual.
Step 2: Determine tax payable.
Step 3: Adjust household expenses if necessary. For example:
Life insurance: In the event of death it may be assumed that overall household expenses will drop with 1 less person to support.
TPD: In the event of TPD it may be necessary to adjust for additional medical expenses.
Step 4: Calculate final after tax income. This is calculated by determining: Gross cashflow – Tax payable – Household expense adjustments
Step 5: Establish required growth rate for Net Present Value calculation. The adviser can set the required growth rate based on risk profile or alternatively specify an alternative rate if necessary.
Step 6: Calculate Net Present Value using the year by year final after tax income and the required growth rate.
Step 7: If we are also providing advice on income protection insurance, TPD recommendation will be adjusted accordingly so that the loss of human capital is net of income protection.
An example of how the human capital method is calculated is provided below:
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