The Human Capital approach used by RazorPlan and the traditional Insurance Needs Analysis approach advisors have used for years, have more in common than most would expect.
When compared directly, Human Capital and Insurance Needs Analysis have a strong correlation. They both calculate the value of a loss, but from different ends of the spectrum. Human Capital looks at the value of income earned, whereas Insurance Needs Analysis looks at the effect of earning an income.
Through an Insurance Needs Analysis approach we ask questions such as “How much is your mortgage?”, “What lifestyle do you need to maintain?”, or “What school will your kids go to?” Based on the answers provided, this approach will allow us to calculate various insurance needs for a client.
Where Human Capital is similar is that the answers to these questions will be based on how much income the clients earned in the first place. The client will go to work each day, earn a salary, and pay taxes. The amount they have left will allow them to qualify for a mortgage, save for retirement, and establish a lifestyle. If we then calculate the value required to replace their lost income in the event of death, disability, or critical illness, we will get a Human Capital value similar to the amount provided through the Insurance Needs Analysis approach.
The benefit to Human Capital is that it allows you to begin the discussion of insurance needs without a large data requirement. RazorPlan uses the information already gathered to analyze a client’s retirement and automatically calculate an optimal amount of coverage for Life, Disability, and Critical Illness needs.
Why Use Human Capital?
First of all, Human Capital should never be viewed as a replacement to Insurance Needs Analysis, but rather as a complement. Human Capital allows you to open the discussion around insurance and, when necessary, move the client into an Insurance Needs calculation. In the end it will help the client to better understand what issues exist before answering questions regarding their lifestyle and mortality.
This approach is the same one many of us already use in retirement planning. We outline the issues the client may have in funding their retirement goals, then transition the client into a fact-finding questionnaire and retirement calculation.
Human Capital Example
Bill is projecting to earn $100,000/year for the next 20 years. Assuming 3% inflation and an investment rate of return of 5%, Bill’s future earnings potential has a present value of $1,596,000; this is his Human Capital value.
Using a Traditional Insurance Needs approach we asked Bill for the following information:
This approach determined that Bill requires $1,438,000 of life insurance in the event of his death; alternatively, Human Capital calculated a need of $1,596,000. Human Capital will usually calculate a slightly higher need as it is based on a separate calculation. However, this will work to the benefit of the client as these approaches will provide an Upper Limit ($1,596,000) and Lower Limit ($1,438,000) insurance need. At this point it’s the discussion with the client that will determine the best approach to take and level of insurance required.
Another benefit to the use of Human Capital when calculating a client’s insurance needs, is the flexibility. In addition to Life Insurance needs, Human Capital can also be used to calculate Disability and Critical Illness needs. By altering the time frame and method of calculation, we can utilize the same information already gathered in the retirement analysis, to calculate all insurance needs. RazorPlan allows for full control of the assumptions used to calculate Human Capital. You can select between a 1, 3, 5, 10, Retirement, or Life Expectancy Human Capital value for each insurance type.
By default, RazorPlan calculates the following insurance needs as outlined below. Modify this information through Human Capital Settings:
Life Insurance: Human Capital calculated to life expectancy.
Disability Insurance: Human Capital to retirement, divided by the number of months remaining, multiplied by a factor (for example 60%).
Critical Illness Insurance: Human Capital for 3 years.
In the end, although Human Capital and Traditional Insurance Needs are calculated using differing methodologies, the results are very similar. When used in conjunction, these two insurance needs calculations can benefit any insurance practice through increased discussions and client understanding.
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