# 17.7: Appendix - How Much Life Insurance to Buy?

$$\newcommand{\vecs}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} }$$

$$\newcommand{\vecd}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash {#1}}}$$

$$\newcommand{\id}{\mathrm{id}}$$ $$\newcommand{\Span}{\mathrm{span}}$$

( \newcommand{\kernel}{\mathrm{null}\,}\) $$\newcommand{\range}{\mathrm{range}\,}$$

$$\newcommand{\RealPart}{\mathrm{Re}}$$ $$\newcommand{\ImaginaryPart}{\mathrm{Im}}$$

$$\newcommand{\Argument}{\mathrm{Arg}}$$ $$\newcommand{\norm}[1]{\| #1 \|}$$

$$\newcommand{\inner}[2]{\langle #1, #2 \rangle}$$

$$\newcommand{\Span}{\mathrm{span}}$$

$$\newcommand{\id}{\mathrm{id}}$$

$$\newcommand{\Span}{\mathrm{span}}$$

$$\newcommand{\kernel}{\mathrm{null}\,}$$

$$\newcommand{\range}{\mathrm{range}\,}$$

$$\newcommand{\RealPart}{\mathrm{Re}}$$

$$\newcommand{\ImaginaryPart}{\mathrm{Im}}$$

$$\newcommand{\Argument}{\mathrm{Arg}}$$

$$\newcommand{\norm}[1]{\| #1 \|}$$

$$\newcommand{\inner}[2]{\langle #1, #2 \rangle}$$

$$\newcommand{\Span}{\mathrm{span}}$$ $$\newcommand{\AA}{\unicode[.8,0]{x212B}}$$

$$\newcommand{\vectorA}[1]{\vec{#1}} % arrow$$

$$\newcommand{\vectorAt}[1]{\vec{\text{#1}}} % arrow$$

$$\newcommand{\vectorB}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} }$$

$$\newcommand{\vectorC}[1]{\textbf{#1}}$$

$$\newcommand{\vectorD}[1]{\overrightarrow{#1}}$$

$$\newcommand{\vectorDt}[1]{\overrightarrow{\text{#1}}}$$

$$\newcommand{\vectE}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash{\mathbf {#1}}}}$$

$$\newcommand{\vecs}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} }$$

$$\newcommand{\vecd}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash {#1}}}$$

In this section, the income continuation needs for a single-parent family, the Dowds, will be evaluated to see how much life insurance is necessary. Although the various types of life insurance products will be discussed at length in "19: Mortality Risk Management - Individual Life Insurance and Group Life Insurance", this exercise is intended to satisfy the needs analysis approach to dealing with mortality risk. The risk management component of the financial planning process will be used to look at the family’s present resources, income needs, and insurance needs in the event of the wage earner’s death. Coverages for property and casualty, health, disability, and retirement are covered in Case 1 of "23: Cases in Holistic Risk Management".

## Data Collection

The Dowd family has three members:

• Sharon, age thirty-five
• Liz, age six
• Bob, age four

Liz and Bob see a pediatrician at least once a year. Sharon had a routine checkup about six months ago. All three are apparently healthy.

## Financial Situation

Sharon is a branch bank manager whose gross yearly income is $50,000. Her former husband lives in another state and does not pay alimony or contribute to child support. A balance sheet and cash flow statement are important in evaluating Sharon’s current ability to meet her needs and in establishing postloss objectives. Sharon has constructed Table 17.7 and Table 17.8. On the balance sheet, you may wonder why the value of furniture and other personal property is only$10,000. The sums listed are liquidation values; these items probably have a replacement value between $30,000 and$40,000. But our concern, in the event of Sharon’s death, is how much the items would sell for if they had to be liquidated to meet family income needs. Unlike houses and automobiles, limited demand exists for used furniture and clothing.

## Objectives

### In Case of Death

In the event of her premature death, Sharon would like her children to live with her sister, Kay, and Kay’s husband, Robert, who have expressed a willingness to assume these responsibilities. However, Sharon has not formally created a legal document expressing this wish. Kay and Robert have three small children of their own, and Sharon would not want her children to be a financial burden to them. Taking care of her children’s nonfinancial needs is all that Sharon expects from Kay and Robert.

Sharon’s values influence her objectives. Her parents paid almost all her expenses, including the upkeep of a car while she earned a bachelor’s degree. Sharon recognizes that her children are currently benefiting from her above-average income. When they reach college, she wants them to concentrate on their studies and enjoy extracurricular activities without having to work during the academic year. They would be expected to work during the summers to earn part of their spending money for school. Sharon decides that, if she dies prematurely, she wants to provide $12,000 per year before taxes for each child through age seventeen, when they will graduate from high school, both having been born in August. During their four years of college, Sharon wants$18,000 per year available for each child. She realizes that inflation can devastate a given level of income in only a few years. Thus, she wants her expressed objectives to be fulfilled in real (uninflated) dollars. We will present a simple planning solution to this problem.

## Alternative Solutions/Exposure Evaluation

The next step in the financial planning process requires determining the following:

• The amount of money required to meet Sharon’s objectives
• Any gaps that exist between what is desired and Sharon’s current financial resources
• Alternatives available to fill the gaps

### Money Required for Death

Determination of the amount of money required to meet Sharon’s objectives for her children in the event of her premature death is complicated by the following:

• We do not know when Sharon will die.
• The family’s income needs extend into the future possibly eighteen years (assuming Sharon dies now and income is provided until her younger child is age twenty-two).
• Social Security will make its payments monthly over fourteen of the eighteen years.
• Sharon’s two life insurance policies (and any new policies) would most likely make lump-sum payments at the time of her death, although her objective calls for the provision of support over many years.
• Lump sums may be liquidated over the period of income need, but we need to be sure the money does not run out before the period ends.
• The effects of inflation must be recognized.

### Life Insurance Planning and Need Analysis

With some simplifying assumptions, these problems can be solved by a technique that we will call life insurance planning. The technique is static in the sense that it considers only the worst possible scenario: Sharon dies this year. Also, the technique does not recognize various changes (e.g., remarriage and a third child) that could occur at some point during the planning period.

Figure $$\PageIndex{1}$$ reflects the assumption that Sharon dies today by showing Liz’s and Bob’s current ages on the left, on the horizontal axis. The figure continues until Sharon’s objectives are met when Bob is assumed to complete college at age twenty-two.

The vertical axis in Figure $$\PageIndex{1}$$ shows Sharon’s real income objective of $12,000 per year, per child, prior to age eighteen. Sharon plans for much of this money to be spent by her sister and brother-in-law for her children’s food, utilities, transportation, child care, school expenses, and other basic needs. She does not plan for her children to have excessive amounts of spending money. During college, each child has$18,000 per year, which will provide financial access to modestly priced private colleges and out-of-state universities. The maximum annual need of $36,000 per year, depicted in Figure $$\PageIndex{1}$$, occurs during the last two years of Liz’s planned college period, when it is assumed that Bob will have begun college. Social Security benefits begin at$14,400 and remain at this level (in real terms) until Liz’s benefit terminates at age eighteen. Bob’s benefit of $7,200 continues until he is age eighteen. Looking at the differences (gaps A through D in Figure $$\PageIndex{1}$$) between Sharon’s objectives and the income expected from Social Security, we see an increase in the size of the gaps as Social Security payments decline and then stop when Bob’s college years begin. The simplest way to summarize the amount of the gaps is to add the following:  ($24,000 – 14,400) × (12 years) $115,200 ($30,000 – 7,200) × (2 years) $45,600 ($36,000) × (2 years) $72,000 ($18,000) × (2 years) $36,000 Total$268,800

This period while the children remain dependent is called the family dependency period. A subsequent period during which support might be provided to a spouse is not depicted because Sharon is not married. Such a period may be called a spousal dependency period.

What are the problems with saying that $268,800 is needed to fulfill Sharon’s objectives, assuming she dies now? Reviewing our list of seven complications, we can recognize two major problems. First, inflation is likely to increase her nominal (inflated dollar) needs. Current Social Security legislation provides for annual benefit increases to reflect the lesser of either inflation or wage increases over time. Thus, we can assume that real-dollar Social Security benefits will increase approximately at the rate of inflation. Our concern becomes the effect of inflation on the gap between total income needs and Social Security. In the first year, we know this gap is$9,600. If there is 4 percent inflation, the gap in nominal dollars would be $13,664 by the beginning of the tenth year and$64,834 by the beginning of the sixteenth year, the second year when both Liz and Bob are expected to be in college. Our $268,800 total understates the nominal dollar need substantially. Second, we have ignored the opportunity to invest the lump-sum insurance benefits (existing and yet to be purchased) and net worth. With such an opportunity, investment earnings would provide part of the future cash flow needs. Unlike the possibility of inflation, the failure to recognize this time value of money overstates the size of the gaps. Sharon may use the$268,800 figure depicted above if she is willing to assume that the net return on investments will be just sufficient to cover the rate of expected inflation. This is not an unrealistic assumption for the conservative investor, who would make low-to-medium risk/low-to-medium expected return investments. Relatively conservative investments may be suitable when the purpose is the safety of the principal that is invested with the objective of supporting two children following the death of the person who is their sole financial support (other than Social Security). The static life insurance planning technique produces approximate, rather than exact, estimates of death needs.

At this point, we have only estimated Sharon’s gross death needs for the family dependency period.

## Total Needs

Total death needs for most situations can be grouped into four categories:

• Final expenses
• Family dependency period
• Spousal dependency period
• Special needs

We have looked only at the family dependency period. To complete Sharon’s financial planning for death, assume that her final expenses consist of funeral costs of $4,500,$1,500 to pay her current bills, and $3,000 for an executor to settle her estate. Nothing is required to fund a spousal dependency period in Sharon’s case. The special needs category could include college expenses that we have placed in the family dependency period, care of a dependent parent, or other expenses that do not fit neatly in the other three categories. Sharon’s total needs above Social Security are the following:  Final expenses$9,000 Family dependency period $268,800 Total needs$277,800

## Net Needs

Life insurance is a substitute for other assets that, for one reason or another, at the current time have not been accumulated. Thus, the need for new life insurance as a result of the life insurance planning process consists of the following:

Net Needs = Gross Death Needs – Resources

## Consideration of Existing Resources

Are Sharon’s current net worth and life insurance adequate to meet her objectives if she dies now? From the balance sheet provided earlier, we know that she has a net worth of $39,500.It is feasible that all furniture, jewelry, and so on would be liquidated. In a two-parent family, the surviving spouse might want to retain the house and all furnishings. This is a liquidation value that is the net of sales commissions, depreciation, and other value-reducing factors. Her current life insurance consists of a$100,000 term policy through her employer and a $15,000 individual policy. The proceeds from the individual policy will be$11,000 after the insurer deducts the $4,000 loan. Her automobile loan will be paid by credit life insurance. We show this loan repayment below as a life insurance resource. Sharon’s net needs after recognizing existing resources are as follows:  Total needs$277,800 Resources (minus): Net worth $39,500 Group life insurance$100,000 Individual life insurance $11,000 Credit life insurance$8,000 $158,500 Net needs$119,300

## Solutions

Sharon could resolve this $119,300 shortage in one of three ways. First, she could reevaluate her objectives, decide to lower the amount of financial support for Liz and Bob, and calculate a lower total. Second, she could decide to tighten her budget and increase her savings/investment program. Third, she could buy an additional life insurance policy in the amount of, let’s say,$125,000. Life insurance premiums would vary upward from approximately \$175 for next year for an annual renewable term policy to higher amounts for other types of insurance. Buying additional life insurance is probably Sharon’s best option. Savings as an alternative to life insurance is not a good solution because she could die before contributing much to her savings program. Nevertheless, she should continue to save.

## Other Life Insurance Planning Issues

Sharon’s situation certainly does not cover all planning possibilities. For example, a person with a disabled child might want to extend the family dependency period far beyond age twenty-two. Another person might want to contribute to a spouse’s support for the remainder of his or her life. In this case, a good option is using the life insurance planning technique to quantify the need up to an advanced age, such as sixty-five, and getting price quotations on a life annuity for the remainder of the person’s lifetime.

17.7: Appendix - How Much Life Insurance to Buy? is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.