When Insuring Against the Risk of Permanent Loss of Income

Life insurance provides protection from the permanent loss of income that arises from premature death. Income, for the purposes of a life insurance needs analysis, can be identified in terms of cash flow and income-in-kind (e.g., a spouse providing child care at home). The loss of income means dependents — the spouse and children — are faced with immediate, ongoing, and future expenses.

It is important to take income-in-kind into consideration when assessing need. If a stay-at-home mom can no longer provide child care, then costs of day care or nanny services will be a cost for the survivor to pay.

For the Financial Dependency of Survivors

The three phases of financial dependency and the costs that survivors will face during these phases are:

• readjustment/last expenses
• dependency/ongoing expenses
• survivor life income needs/future expenses

The readjustment period/last expenses: The bills that must be paid immediately after death are known as last expenses. They include funeral costs, probate fees, payments of debts such as loans, credit cards, and the mortgage since it is assumed that survivors will want to continue to live in their home without mortgage costs. It is also essential to immediately establish an emergency fund
for survivors.

The two years that follow the death of the life insured will be a period of readjustment for survivors. Financial support will be needed by dependents while they cope with the emotional trauma of death and, in cases where needs have not been adequately planned, dependents may have to adjust to a new standard of living.

Why is life insurance so important to Canadian families?

A the cash values of most insurance policies are secure from the demands of creditors;
B sufficient policy face values can provide capital and income relief due to death of family breadwinners;
C not only can the lives of principal income earners be insured, but all forms of debt can be insured;
D all of the above.

The dependency period/ongoing expenses. During this time the surviving spouse must have sufficient income to provide care for the himself or herself and children until the youngest reaches the age of 18, or 25 if attending school on a full-time basis.

Ongoing expenses include all the daily costs of living such as food, clothing, holidays, and saving for post-secondary education.

Survivor life income needs/future needs: This is a period of time that may be life long for the surviving spouse. This spouse may never have worked, or may not have worked for many years. If so, financial support for the duration of his or her life may be needed.

Also, providing a retirement income for the spouse may be required if he or she has limited employment opportunities.

Emergency fund
Financial planners advise clients to have the equivalent of three months’ income available in case of emergency

A surviving spouse who has been out of the work force for many years may have to take a lower level job than he or she needs from an income point of view just to try and reestablish skills.

Life insurance has other principal functions besides making a cash payment on death of a life insured. What are they?

A insurance can provide an emergency cash reserve;
B it can provide capital to pay “last expenses” and operating capital during a family’s readjustment period;
C life insurance proceeds generate a financial lump sum that can be used to cover a family’s current and long-term operating expenses;
D all of the above.

How Much?

In order to estimate the amount of life insurance that is required an agent must be able to assess with the client which costs would be faced by the survivors resulting from the premature death of the proposed life insured, and how much it would cost to maintain the same or similar standard of living. A fact-finding interview with the client will begin by establishing qualitative goals . Once quality of life has been planned then a dollar figure can be assigned to meet the those objectives. These dollar figures are called quantitative goals.

Qualitative goals
Qualitative goals are “quality of life” goals. They reveal lifestyle choices that have a direct bearing on expenses, risk tolerance, and investment choices. For example, a family chooses to vacation each year in England for a month has made a qualitative decision.

Quantitative goals
Quantitative goals are the dollar figures assigned to qualitative goals. For example, the family who vacations in England for a month needs $22,000 to pay for their holiday.

Driving a convertible is a qualitative choice. Such a choice is quantified by the higher cost of the vehicle and higher auto insurance rates.

A needs analysis provides the quantitative answers to the quantitative goals. In other words: how much.

One way to answer this question is called the personal income needs approach. This approach identifies the needs of dependents and family members that must be met in the event of the loss of a major income stream. These needs include income throughout the three phases identified previously: the readjustment period, the dependency period, and survivor life income needs.

This method is based on the objectives and needs of the family and dependents and considers all financial assets when determining the amount of insurance needed. Its disadvantages include the need for regular re-evaluation, it may ignore inflation, and it does not incorporate estate creation or preservation. It is not widely used.

The two most commonly-used methods to determine the amount of life insurance for a client are:

• the capitalization of income approach (or human life value approach)
• the capital retention approach (or capital needs approach

Capital
Capital is cash and assets that can be invested or used for financial gain.
For example, capital can include stocks, bonds, real property, mutual funds, etc.

Both approaches are based on the principle that a life has economic value. This value is called the capitalized value of life. Capitalized value may be represented by the sum earned as salary by an income-earner who dies during the prime of his or her life. Capitalized value may also be represented by the loss of income-in-kind such as the cost of having to provide daycare for children who can no longer be cared for by their mother.

The objective of insurance is to replace the capitalized value of the life insured with a sum of money that - when invested at the interest rate in effect at the time of the needs analysis - will provide an annual income stream equivalent to the annual lost earning power of the life insured.

This can be expressed as: annual income need ÷ interest rate = lump sum.

Capitalization of income determines the amount of insurance needed to replace that lost income. Capital retention determines the amount of insurance needed to pay capital costs of survivors by providing a lump sum—the interest earned on the lump sum provides the income.

For example, if today’s interest rate is 4%, the capitalized value of a life insured who earns $60,000 annually is $60,000 ¸ 4% = $1,500,000. This means $1.5 million would have to be invested at 4% so that $60,000 could be used annually for expenses that would have been paid by the income earner.

How do you calculate “capitalized value?” Choose the correct answer from the following.

A lump sum + current interest rate = annual income need;
B desired amount of insurance ÷ interest rate;
C annual income need ÷ prevailing interest rate = lump sum insurance required;
A total net worth ÷ interest rate = lump sum insurance required.

If the rate of interest is higher, the capitalized value is less. That is, $60,000 at 6% is $1,000,000. This is because less must be invested to yield the same annual amount (in this case $60,000). It is possible to take inflation into account by using the real rate of return instead of the nominal interest rate. This is easily done by subtracting the rate of inflation from the interest rate. For instance, if the interest rate is 5% and the rate of inflation is 3%, the real rate of return is 2%.

When the real rate of return is taken into consideration, the capitalized value is greater: $60,000 ¸ 2% = $3 million.

How do you calculate “inflation-adjusted capitalized value?”  

A it is not possible to do so;
B use the capitalized value and multiply the answer by the prevailing inflation rate (core CPI only);
C use the capitalized value and multiply the answer by the prevailing interest rate (nominal CPI only);
D take the prevailing interest or investment rate, deduct the nominal inflation rate, and complete the formula calculations.

Note that the principal is not diminished in these models. Only the interest is used. The principal forms a tidy sum that can supplement annual income, form a source of retirement income, or create an estate for heirs.

Nominal Interest Rate
Also called the nominal rate of return the nominal interest rate is the named rate of return for an investment. For example, a GIC that pays 4% interest has a nominal rate of return of 4%.

Capitalization of Income Approach (Human Life Value Approach)

This approach to determining how much insurance is needed is based simply on how much income the proposed insured earns.

As we have discussed above t he formula is annual income ÷ interest rate = lump sum (the human life value).

For example: if the annual income of the primary wage-earner is $30,000, the total amount of insurance needed would be (assuming a nominal rate of interest of 8% and a long-term inflation rate of 3%, the real rate of interest is 5%):

$30,000 ÷ .05 = $600,000 (human life value = amount of insurance required)  

If $600,000 is invested at 5%, the return will be $30,000 annually. Thus, the family of the insured has, in economic terms, would replace the income-earning value of the life lost through a policy with a $600,000 death benefit.

This approach has a number of drawbacks: it fails to consider other sources of income (e.g., business earnings), it is calculated by using a constant income stream over the life of the insured since it is difficult to know what increase in income is probable, and it ignores the number of years that income will be required: a person aged 25 and a person aged 65 would appear to require the same amount of coverage.

An insured makes $42,000 a year and the current interest rate is 3.4%. She has a generous A&S policy plus disability benefits that pay 70% of her salary. How much life insurance does she need based on capitalization of income?

A $1,428;

B $12,352.94;

C $142,800;

D $1,235,294.10.

Capital Retention Approach (Capital Needs Approach)

The capital retention approach (also known as the capital needs approach) begins by putting a value on the assets of the individual’s estate at death to determine whether needs can be met from existing resources, then obligations are determined. Obligations are of two types: final expenses including funeral, legal fees, taxes, debts, and the mortgage and continuing expenses for dependents including food, medical and dental costs, and education funding.

Funding post-secondary education is a significant future expense to include in the needs analysis.

A true picture of assets is best revealed by preparing a net worth statement of the proposed life insured that adds together all assets and subtracts all liabilities to arrive at “net worth”. Then a needs analysis is prepared that uses some information from the net worth statement and additional information that pertains to the death of the proposed insured. This information determines financial position to see whether the client needs a term insurance or permanent insurance solution.

The needs analysis will consider the mortgage as a final expense—but it does not include the underlying value of the real estate (usually the family home) as an asset. This is because when dependents are to be provided for, it is assumed that they will want to continue to live in the home. Therefore the objective of the life coverage is to pay off the mortgage while ensuring the family home exists for the
family to live in mortgage-free.

In your opinion, is the “capital needs approach” the best insurance amount calculation option? Choose the correct answer.

A yes, the capital needs approach is based on an end-needs analysis first, followed by an analysis to determine if current assets are sufficient to meet current and future income requirements;

B no, it is too complicated for the average client to comprehend, it is difficult to calculate, and it can lead to financial errors that could end in a financial shortfall for the insured;

C no, the CNA is not available to insurance agents because of its complexity—it is a tool available to and applied by insurance company auditors to insure that the correct amount of insurance has been applied for;

D none of the above.

The formula for the capital retention approach is a four-step process:

Step 1: A (assets) - B (final expenses) = C (cash needs)

Step 2: D (continuing income) - E (continuing expenses) = F (income needs)

Step 3: F (income needs) ÷ interest rate = G (capitalized value)

Step 4: G (capitalized value) +/- C (cash needs)* = H (insurance needs)

* C (cash needs) may show a positive number that indicates that assets exceed expenses, or a negative number indicating expenses exceed assets. If the cash needs are a positive number (a surplus), they are subtracted from the capitalized value. This is because cash is available to help meet costs on death. If there is a negative number (a deficit), they are added to the capitalized value. This is because there is not enough cash to help meet costs so this shortfall must also be accommodated by the life insurance.

The agent must consider all sources of funds when determining need.

Group life coverage of the proposed life insured must be taken into consideration as an asset. The agent must ask if the policy includes a survivor income plan that pays a monthly income to survivors if the group member dies.

Similarly, if income needs are a negative number, then the shortfall forms the capitalized value of the life of the proposed insured. If there are no income needs, because continuing income exceeds continuing expenses, then insurance requirements will be based on cash needs at death.

A System to Help You Remember

The capitalized retention formula is one that must be memorized. Try this to help:

Step 1: A (Assets) — B (Bills) = C (Cash needs)

Step 2: D (Dollars in) — E (Expenses) = F (Funds required)

Step 3: F (Funds required) ÷ interest rate = G (Gross value of life)

Step 4: G (Gross value of life) +/— C (Cash needs)* = H (How much insurance)

Write out what the letters stand for to help you remember:

A :

B :

C :  

D :  

E :

F :  

G :   

H :   

Now, write out the steps using the letters given:

Step 1:

Step 2:

Step 3:

Step 4:

Got it? If not, repeat until you do!