There are many applications of insurance, but the most basic one is still protection of survivors, especially those who are financially dependent on the insured person’s income.
There are various methods for calculating the insurance needs of a family. Some agents prefer quite detailed and complicated ones, and you can do such calculations yourself on a sheet of paper or even on-line. A general problem with many of those approaches that you can easily get lost in the details. Furthermore, they may give the false impression that anyone can deal with these issues with extreme precision and certainty, while in fact the most anyone can do is sketch with broad brush various future scenarios. We can, and should, examine various realistic, or even extreme, assumptions and chances, and try to build as much fix points into our life as seem necessary and possible. The strength of the method I present here is in its simplicity and the ability to make anyone more conscious of his or her situation. Of course, when the needs analysis is part of a detailed comprehensive financial plan, then there is more sense in striving for more elaborate and specific analysis.
Let's suppose Mark (35 years old) has a gross annual income of $45,000, and that of his wife, Angela (33), is $30,000. They have two kids, aged 6 and 2.
What would be the financial consequence of Mark's sudden death? If the family wants to keep its standard of living, they would need a large part of his lost salary for many years. How large a part, and for how many years are the questions we have to seek answer to first. What is the share of Mark's income that is spent on himself now? No outsider can tell this exactly, perhaps not even Mark; an estimate of 20 to 30 percent seems to be quite generous. His food, clothing, and personal pastimes probably do not take more, since the majority of his income is spent on the individual and common needs of his family. So, we can say that about 75 percent of his income is needed after his death, as long as the kids are not financially independent, at least. Since parents usually recognize the importance of education to the future of their kids, we can probably assume that Angela would need that additional income until her youngest child is at least 21 or so. (One can argue that the family can survive on much less income than what we calculate here, and that the kids can earn their living much earlier, ... or even that Angela may remarry and then she wouldn't miss Mark's income. Yes, all these things may happen. The question is, does Mark want such things to happen as of necessity, or does he want leave them the best chances to arrange their life with the most freedom possible. We can even suppose that the substitution of Mark's non-financial contribution to the family will have to be paid for, needing extra income, but let's forget that item now.)
How much will she get from group and government plans for the kids, as a widow? Probably not more than $5,000 or 6,000 annually. Let's say it is $6,000. 75% of Mark's $45,000 gross income is $33,750, less the $6,000 makes the annual income needed as $27,750.
If Angela is to receive the proceeds in the next 19 years (that is while her youngest child is under the age of 21), does she need 19 times $27,750? Not really, since the money not yet used can be invested. On the other hand, will she need really $27,750 every year, to keep their standard of living? No, she will need increasingly more, nominally, because of inflation. If we come up with a realistic estimate of inflation and that of the interest she can expect from her investments, then we can calculate a lump sum of money (the insurance need) that can provide Angela and her three children with the income discussed above. This kind of calculation can be called as Income from Capital Analysis. What would be a realistic assumption for inflation? It's better not to be misled by its current low level; the assumption of 3% as an annual average on the long run is quite modest. The assumption for the long term level of interest should be somewhat conservative too. One can read a lot about returns of 15-20 percent in various funds, but it's far from being typical, and especially not on the long run. Historically, interests are about 3% higher than inflation, so we can estimate it for our calculation as that of 6%.
Punching our estimates into the appropriate program, the computer gives us the lump sum of $412,244.79 as the insurance need, together with the following details:
Year Age Investment Income Capital to Interest
Capital Required Earn Interest
1 35 412,244.79 27,750.00 384,494.79 23,069.69
In the first year, Angela would take $27,750 from the lump sum to live on, and would invest the remaining $384,494.79. The investment would yield $23,069.69 at 6% interest.
2 36 407,564.48 28,582.50 378,981.98 22,738.92
In the second year, Angela would start the second year with slightly less money then the first year. However, she would now need $28,582.50 to buy the same amount of goods and services than what she bought in the first year, because of the inflation. She would reinvest the remaining $378,981.98, and the interest earning would decrease a bit to $22,738.92.
3 37 401,720.89 29,439.98 372,280.92 22,336.86
The same simple calculations can be done in every year. The remaining part of the initial lump sum will shrink increasingly ...
4 38 394,617.77 30,323.17 364,294.60 21,857.68
5 39 386,152.28 31,232.87 354,919.41 21,295.16
6 40 376,214.57 32,169.86 344,044.72 20,642.68
7 41 364,687.40 33,134.95 331,552.45 19,893.15
8 42 351,445.59 34,129.00 317,316.59 19,039.00
9 43 336,355.59 35,152.87 301,202.72 18,072.16
10 44 319,274.88 36,207.46 283,067.43 16,984.05
11 45 300,051.47 37,293.68 262,757.79 15,765.47
12 46 278,523.26 38,412.49 240,110.77 14,406.65
13 47 254,517.42 39,564.86 214,952.55 12,897.15
14 48 227,849.71 40,751.81 187,097.90 11,225.87
15 49 198,323.77 41,974.36 156,349.40 9,380.96
16 50 165,730.37 43,233.60 122,496.77 7,349.81
17 51 129,846.58 44,530.60 85,315.98 5,118.96
18 52 90,434.93 45,866.52 44,568.41 2,674.10
... and in year 18 she will have only $44,568.41 to invest.
19 53 47,242.52 47,242.52 0.00 0.00
In year 19 she will have to spend all the available $47,242.52 on the same amount of goods and services she paid only $27,750 for in the first year. At the and of year 19 she will have used up all the initial $407,564.
Does this calculation indicate that Mark has to buy a $407,000 insurance policy? No, it doesn't. What it says is that he shouldn't buy much less and still think that he ensured the financial security of his family. Risk tolerance of people is naturally different, and also their financial means and discipline. Angela and Mark have to decide on the amount of insurance they want, and no-one else can interfere with that. A broker's professional duty is not more, but not less either, than to help Mark and Angela to make an informed decision. Such kind of transparent calculations are indispensable in this regard.
With the same assumptions of inflation and interest, the calculation would yield that the family also has a need for insurance on Angela's life in the amount of $ 245,118.52. That amount would complement Mark's income with $16,500 annually (on a first year level of prices), in case Angela dies.
We have made some important assumptions, therefore, to deal with the numbers with extreme precision is aimless, of course. The big picture is: they need insurance on Mark for about $400,000, and on Angela for about $250,000. These amounts can change if different assumptions are applied; the important thing is to ensure that those assumptions be realistic and something Mark and Angela are comfortable with. One of the nice things about using a computer is that it makes playing around with those possible various assumptions easy. The point of the whole calculation is not to find out how much insurance would serve the agent's purposes best, anyway; this is their plan, to solve their problems.
You can go through the detailed calculation for Angela below:
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If Angela is a housewife and the family lives solely on Mark's income, they may decide that the income protection is needed not until their kids graduate from school, but even after that. Angela may not be willing or able to join the workforce at that time, therefore she will need some income from a lump sum remaining from Mark's insurance. Let's say they think her need for income will be less than what it was while the kids were around, and make some calculation with the assumption of about half of Mark's current income. How long would she need that? Probably not later than when Mark would retire if living. By that time they were supposed to save enough for their retirement years, and she should and could do that as a widow as well. If we modify the calculations on the need for insurance on Mark's life above according to this (that is additional need for $22,500 income for eleven more years after the youngest child has reached age 21), we can calculate that they need $130 thousands more, that is altogether $537,016 insurance on Mark's life.
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