Term insurance. Nothing new here, right? It’s straightforward life insurance coverage, and it helps protect families and businesses in the event of early death. Advisors and insurance providers have simple formulas to help clients understand their coverage needs. “Seven times income” or “mortgage value plus other debts” – we’ve all heard them.
But we have to ask how useful such formulas are today. They lead clients to a better outcome than “no coverage at all,” but they might not reveal one’s total insurance need. In a culture of “more is more,” people often move up the property ladder. Having enough to cover the mortgage for their starter home may leave them underinsured in the future or needing additional term coverage at higher ages and rates. And what about clients who don’t own homes, have children or own a business? How do we account for the financial capital that they can build through smart investments or their careers?
Rethinking the conversation: the value of human capital
A way to rethink this discussion is to speak to clients about their human capital and about how it leads to future financial capital. Everyone who earns income has human capital, and the concept offers an easy way to understand insurance need. The simplest way to explain human capital is as the sum of all the income a client will earn over their working years. You take their take-home pay and multiply it by the number of years they plan to work.1
$45K x 30 years = $1.35 million
How many clients would estimate their value so high? In fact, human capital is often a client’s greatest asset. And that makes it important to protect.
Building financial capital through human capital
It can be hard to demonstrate the immediate value of protecting human capital. After all, living expenses will consume a large portion of the income a client will earn.
It’s important to connect the value of human capital to the ability to create wealth. Clients can think of their working years as a transition from human capital to financial capital. When they begin their working years, they likely have high human capital and low financial capital. Over time, with fewer years left to work, their human capital lowers. As it does, they are able to invest their income and grow financial capital, supplementing the human capital they are losing.
Projections of financial capital can help clients connect significant value to their human capital, and to the need to protect it. Let’s take a conservative example [tweet this]: A 35-year-old client makes $60,000 per year, leaving them with $45,000 after taxes and deductions. They also expect a small annual salary increase of 2%. Of this income, they devote 30% to growing assets, including a house, retirement savings, TFSAs and investments. These assets return a rate of 5%. When this client retires at age 65, they will have grown a financial capital of over $1.2 million.2
How many 35-year-olds think about the future value they can build with the money they will earn?
Thinking bigger: modernizing term conversations
Term is a cost-effective way to help protect human capital. And because values for human capital are high, especially for younger people, strategies to protect it often rely on term policies with larger face amounts. Of course, the idea of buying term at a higher face amount can seem daunting, especially to younger clients. But the design of term products can actually benefit using them as part of such a strategy.
It’s a smart move to purchase term insurance at a younger age. Not only are premiums lower, but a client’s human capital is at its highest value when they’re young. Term insurance is also a better deal when purchased at larger face amounts. Life insurance, like so many other things, can be a better deal when purchased in bulk. While annual premiums are higher for higher face amounts, the unit costs are actually lower. For a 35-year old, a term 30 for $1 million can be more than 40% cheaper per $1,000 of coverage than a policy for $250,000.
Male non-smoker, 35
Female non-smoker, 35
Sample rates for SunTerm 10, effective July 22, 2019
When working through a client’s insurance need, it can be helpful to introduce human capital, and to connect the concept to financial capital [tweet this]. It can also help facilitate a fuller discussion of what a client might want to protect. And while we don’t often think of insurance as a bulk deal, it’s important to keep that in mind when including it in solutions for human capital protection.
Disclaimers: Sun Life Assurance Company of Canada has not been engaged for the purposes of providing legal, accounting, taxation, or other professional advice. No one should act upon the examples/information presented here without a thorough examination of the legal/tax situation with their own professional advisors, after the facts of their specific case are considered. Unless specifically stated, the values and rates presented are not guaranteed.
1 For simplicity, we have assumed that the discount rate used to calculate the time value of money in PV calculation would be cancelled out with the annual inflationary increase one may earn on their salary. For this reason, we are calculating human capital as salary multiplied by working years.
2 This example calculates a gross total for financial capital, and doesn’t calculate present value of the assets invested, nor account for the tax incurred in accessing them.