The human life value approach involves estimating an individual’s personal earnings each year to retirement, from which the costs of self-maintenance, Life Insurance premiums, and income taxes are deducted to produce residual income. The residual income stream is then discounted to its present value. The present value of that residual income stream is the value of that human life. Life Insurance is concerned with the economic value of a human life.
That economic value results from these two factors:
As we can see, an individual’s earning capacity alone does not create the economic value that serves as the basis of Life Insurance. The fact that earning capacity must be relied upon by others also factors into economic value.
There are some obvious relationships in which we would be likely to encounter both of those factors: earning capacity and dependence. Specifically, in both families and businesses we find an individual’s earning capacity that is relied upon by others.
Most reasonable people would probably agree that an individual should protect his or her earning capacity for the benefit of dependents by owning the appropriate amount of life insurance. The problem lies in how to determine just how much is appropriate. In other words, how do you measure your economic value?
We just reviewed the human life value approach, which will help you to better understand the importance of needs analysis. However, moving on to the actual calculation of the Life Insurance you will need under the human life value approach, understand that this approach is based on the idea that you should own an amount of life insurance equal to the capitalized value of your net earnings.
How much capital would be needed to replace earnings? It is the present value of that stream of net earnings.
Capitalizing the value of your net earnings requires five steps:
(1 – 2) × present value of $1 [based on 3 and 4] = human life value
Let’s briefly examine each of these 5 steps.
Step 1, estimate your average annual earnings from personal efforts over the remaining years of his or her income producing lifetime. That is, until your retirement age.
There are certain rules of thumb that can assist you with this calculation. Estimate your average annual earnings, factor in the following facts.
Step 2 of the human life value calculation, deduct the following from your annual average earnings:
By deducting these amounts from the average annual earnings, the human life value approach arrives at the earnings used to support your family.
Step 3, determine how long your family can expect to receive your income. For most families, that means until your retirement at age 65 or 70.
Step 4, determine the rate of interest to use in discounting those future earnings to derive a present value. The present value is the current value of a future sum discounted at some interest rate, also known as a discount rate. The discount rate used in determining present value is the annual rate of return that could be earned currently on an investment. Because life insurance companies are appropriately conservative in their assumptions, the rate of interest chosen as the discount rate should low.
Step 5, we use the information that resulted from the first four steps of the human life value calculation to determine your human life value. In other words, you calculate the present value of the future stream of net income that you would produce for your family if you were to continue working until retirement. That is the amount under this system of determining life insurance need.
A Human Life Value Case Study
Dr. Joseph Smith’s Life Insurance Need with the Human Life Value Approach
In estimating Dr. Joseph Smith’s Life Insurance need using the human life value approach, his average income to retirement is estimated. In this case, it is estimated at $500,000. At Dr. Smith’s current income of $400,000, it is likely that two-thirds of his income is used to maintain his family. So, the family’s claim on the average family income is $333,330.
The task is to determine the present value of that 30 years of family maintenance that the family would lose if Dr. Smith were to die today. Because the current investments return approximately 5 percent, we can determine the present value at 5 percent of that stream of income over the next 30 years by using the following formula:
($500,000 × .66666) × 15.3725 = $5,124,115.42
* One dollar due ten years from today is worth less than one dollar due today. A compound discount table enables you to determine the value today i.e., the present value of that dollar due in the future.