APPENDIX 3 - CALCULATING INSURANCE REQUIREMENTS

Topics in this section include:

1.0

Life-Insurance-Needs Calculations
1.1
Capitalization of income
1.2
Capital-needs approach
1.3
Ongoing retention approach
1.4
Capital Depletion approach

1.0

Life-Insurance-Needs Calculations

1.1

Capitalization of income
The primary reason most people purchase insurance is to provide some income
to their family in the event of their death, so that the family can continue to
enjoy the lifestyle they have been living until then. For determining the amount
of insurance that a person must have in order to leave a certain annual income
for his survivors, we use a capital-retention or preservation approach. For
example if the person wants to leave $20,000 per year for his or her family in the
event of death, and assuming the real interest rate in the economy is 4%, they
would need to insure themself for an amount of $500,000, calculated as
($20,000 per year 4%). In the event of the persons death, the family would
receive $500,000, invest it at 4%, and receive $20,000 per year perpetually. The
assumption behind this approach is that the principal of $500,000 will not be
touched by the family, and that it will always remain invested. Using this
approach, we have found the capital required to generate an income of $20,000
per year at 4%. This is called the capitalization-of-income approach.

1.2

Capital-needs approach
While this approach determines the amount of insurance required to take care
of the ongoing needs of the survivors, it does not take into account the other
needs that a person may use insurance to cover. For example, it does not cover a
cash shortfall on death. To determine the amount of insurance, we add any cash
shortfall to the amount required to provide income to the family (see previous
paragraph). Let us assume that you are an agent and you wish to determine the
amount of insurance each one of a couple should have.

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Capital-Retention Approach or Capital-Needs Approach

Final Expenses Statement
Cash Needs
A. Assets
Investments

200,000

Real Estate
Home
Cottage
Cash and cash equivalents
Total Assets

82,500
282,500 (A)

B. Final Expenses
Funeral

20,000

Legal & Accounting Fees

10,000

Taxes

150,000

Home
Cottage
Mortgage
Debts
Total Final Expenses
Total Cash Need (A B)

500,000
30,000
710,000 (B)
427,500 (C)

The above is an example of a final-expenses statement. To prepare a finalexpenses statement, one assumes that the person to be insured dies today, and
the final-expenses statement is a snapshot of his/her financial standing as of that
point. You will observe that this is not the net-worth statement of the couple. If
a net-worth statement were being prepared, one would add the FMV of the
home and the cottage in the assets section. Assuming that the cottage and home
together are worth $1-million dollars, we can conclude that the couple has a net
worth of $572,500. But when we make the final-expenses statement for
insurance purposes, we include only such assets as can be disposed of on the
death of the insured. For example, the home of the insured is rarely considered
an asset for determining insurance needs, because the surviving family is very
likely to need the home to live in. A second property, such as a cottage, may or
Copyright 2011 Oliver Publishing Inc. All rights reserved

may not be included, depending upon the requirements of the insured. In the
above example, if we assume that the couple wants to bequeath the cottage to
their daughter, the cottage cannot be sold on death to meet the bills.
The final-expense part of the statement lists all the expenses to be incurred by
the insured on death. Typically, these would include funeral expenses,
mortgages, loans, bills due, etc.
We note that the couple has a cash shortfall of $427,500 in the event that one of
them dies.

1.3

Ongoing-retention approach
The next step is to assess the ongoing needs of the surviving family. If the
husband dies, we assume that the wifes income will continue. Any shortfall in
the wifes income will have to be met by insurance on the husbands life, and
vice versa.

The Ongoing Expenses Needs

Income Needs

Husband
Dies

Wife dies

Continuing Income Sources

Survivors Income
Rental Income
Total Cont. Annual Income

45,000

100,000

8,400

8,400

53,400 (D)

108,400

61,000 (E)

61,000

7,600 (F)

47,400

Continuing Expenses
Total Cont. Expenses
Total Income Need (D E)

Per Year

Per Year

4%

4%

Insurance Need Calculation

Assume Real Interest Rate

Capitalized value of Total Income Need = (Total Income Need/ Interest Rate)
(F)/Int Rate

190,000 (G)

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The idea behind the ongoing-expenses needs of the survivors is to determine the
annual income shortfall that will be faced by the family in the event of death of
one of the spouses. In the example above, if the husband dies, we note that the
wife makes an income of $45,000 per year, which will be a source of continuing
income for the family. We also assume that the couple is making a rental income
of $8,400 per year by renting out their cottage during weeks when they are not
using it. Therefore, the continuing income from all sources in the event of the
husbands death is $53,400 ($45,000 wifes salary, plus $8,400 rental income).
We then look at the continuing expenses of the family. Let us assume that the
family requires $61,000 per year to maintain a certain lifestyle. This implies that
the family will be short $7,600 per year in income. The income need of the family
is therefore $7,600 per year in the event of the husbands death. The husband
will need to insure himself for the capital amount required to provide $7,600 per
year to the family. If we assume that the real interest rate is 4%, the husband
would have to insure himself for $7,600 4%, or $190,000.
Therefore, the total insurance that the husband must carry on himself is
calculated as the income need of $190,000, plus the cash shortfall of $427,500,
which is $617,500.
If the husband dies, the family will receive the benefit of $617,500. Of this,
$427,500 will be used to meet the cash shortfall and the balance, $190,000, will
be invested at 4% to provide an annual income of $7,600 to the family to meet
their ongoing needs.
Let us determine the amount of insurance that the wife must carry on herself.
We find from the table above that the husband makes $100,000 per year, which
will continue in the event of the wifes death. The husband will also continue to
receive the rental income of $8,400 per year, bringing the total continuing
income of the family to $108,400. Assume that the family requires $61,000 per
year to maintain a certain lifestyle. Clearly, the husband makes more money
than is required to meet the continuing expenses of $61,000 per year. Therefore
the wife does not need to provide any income to the family in the event of her
death. The husbands income is sufficient.
In this case, it might make financial sense for the wife to insure herself for the
amount of cash shortfall of $427,500, so that, in case she dies, the insurance
benefit can be used to clear the debts of the family.
Clearly the husband must insure himself for $617,500, whereas for insurance for
the wife is not compulsory, because the husband earns a good annual income.

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1.4

Capital-depletion approach
It is also possible that a person wants to deplete the capital during his/her
lifetime, and does not want to use the capital-retention approach. In that case,
we use the capital-depletion approach to determine the amount of insurance
required. For example, let us assume that a person expects that his wife will
outlive him by 20 years at the most, and let us assume that he wants to provide
his wife $20,000 per year for 20 years. In this case an annuity that pays $20,000
per year may be purchased with the proceeds of insurance. The calculation in
this case boils down to figuring out the present value of an annuity that pays an
annuitant $20,000 per year for 20 years at a given interest rate. Let us assume
the interest rate to be 4%. The present value (PV) of an annuity that pays at the
end of each period can be arrived at by using the formula:

(END)

= $271,806.53
Using the capital-retention approach, we determine that the amount of
insurance required would be $20,000 per 0.04, or $500,000. Using the capitaldepletion approach, we find that the insured requires just $271,806.53 to
provide an income of $20,000 per year. In the capital-retention approach, the
insured will have the capital of $500,000 intact at the end of 20 years, whereas,
in the capital-depletion approach there will be no capital left at the end of 20
years.
In the LLQP exam, you will be allowed to use only an ordinary (not financial)
calculator. So how do we do this calculation with an ordinary calculator? Follow
these steps:

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Step 1

Calculate:
(1.04)20

Result
Enter 1.04 into an ordinary
calculator.
Press the times button (X).
The press the equal to button (=) 19
times that is 1 less than the number
of years

2.1911231

Step 2

Store Result in
Memory

M+

Step 3

I/MR

Divide 1 by Memory recall

1 MR =

Step 4

Step 5

interest rate

0.04

13.5903263

Step 6

X Payment

x 20,000

271806.529

Subtract 1 from result. This will give

a
Negative number. IT DOES NOT
MATTER.
1 =

0.4563869

0.5436130

Ignore the negative sign

Answer

271,806.53

This procedure works for end-of-period payments from an annuity. If the

calculation is to be done for payments received at the beginning of each period,
we need to modify the procedure slightly. Do the end-of-term payment annuity
for one year less than the number of years that payments are required, and add
one payment to the result. That would provide the result for a beginning-of-term
payment annuity.

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For example, if we required the annuity in our example to pay $20,000 per year
at the beginning of each year, considering an interest rate of 4%:
(Beginning)

= $282,679.79
Step 1

Calculate:
(1.04)19

Result
Enter 1.04 into an ordinary
calculator.
Press the times button (X).
The press the equal to button (=) 18
times that is 1 less than the number
of years

Step 2

Store Result in
Memory

M+

Step 3

I/MR

Divide 1 by Memory recall

1 MR =
Subtract 1 from result. This will give
a Negative number.
IT DOES NOT MATTER.
1 =

2.1068491

0.4746424

Step 4

0.5253575

Step 5

interest rate

0.04

13.1339394

Step 6

X Payment

x 20,000

262678.79
Ignore the negative sign
262678.79

Step 7

+Payment

+20,000

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282,678.79