2 - 1 how to estimate the insurance need introduction principal planning areas income replacement...

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How To Estimate The Insurance Need

Introduction Principal planning areas

Income replacement and family needs analysis

Business insurance needs analysis

Estate preservation and liquidity needs analysis

Begin and end with the objectives and goals of the client Even if they do not conform to what advisor’s considers proper or appropriate

Advisor should “educate” client about uses and abuses of insurance

Ethics and prudence require that the insurance plan satisfy the client’s objectives

Chapter 2Tools & Techniques of Life

Insurance Planning

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Income replacement and family needs analysis Rule of thumb approach

Estimate amount of insurance required as roughly six to eight time annual gross income

Another estimate take five rimes gross income, plus mortgage, debts, final expenses, and any other special funding needs

Another estimate says that 6% of breadwinner’s gross income, plus 1% for each dependent, should be spent on premiums for life insurance

Example – Person with nonworking spouse and three children should spend 10% of gross income on insurance premiums

These methods are easy to understand, but limited Individuals needs vary widely Age of insured or dependents not taken into account


Insurance Planning

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Income replacement and family needs analysis Multiples of salary method

Hybrid method combining rules of thumb approach with elements of income replacement and needs analysis


Insurance Planning

Your Clients

Present Gross

Earnings 75% 60% 75% 60% 75% 60% 75% 60%

7,500$ 4.0 3.0 5.5 4.0 7.5 5.5 6.5 4.5

9,000 4.0 3.0 5.5 4.0 7.5 5.5 6.5 4.5

15,000 4.5 3.0 6.5 4.5 8.0 6.0 7.0 5.5

23,500 6.5 4.5 8.0 5.5 8.5 6.5 7.5 5.5

30,000 7.5 5.0 8.0 6.0 8.5 6.5 7.0 5.5

40,000 7.5 5.0 8.0 6.0 8.0 6.0 7.0 5.0

65,000 7.5 5.5 7.5 6.0 7.5 6.0 6.5 5.0

Present Age of Your Clients Spouse

Source: Cady, Field Guide To Estate Planning, Business Planning and Employee Benefits, (National Underwriter Company 2007)

Multiples-of-Salary Chart

25 years 35 years 45 years 45 years

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Income replacement and family needs analysis (cont'd) Multiples of salary method (cont'd)

Adjusts for spouse’s age

Does not take into account age of insured, premium costs or number of dependents

Not a suitable method when both spouses work

Does not take into account difference in tax rates or investment rates of return that may apply in difference family situations


Insurance Planning

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The income replacement approach Based on human life value concept

Present value of earnings potential of that person

Basic objective of life insurance is to replace some or all of the earnings lost if an income- producing family member should die

Human life value Factors used to determine human life value

Current annual after tax earnings (C)

Projected growth rate of earnings (g)

Future working lifetime (n)

An after tax discount rate (r)


Insurance Planning

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The income replacement approach (cont'd) Equation

Basic assumptions Present value is very sensitive to changes in the underlying earnings growth and discount

rate assumptions

Earnings rate growth Dependent on inflation rates, tax rates, and career opportunities

U.S. compound growth rate of inflation-adjusted disposable after tax income – just over 2%

Inflation has averaged just over 4% in the long run

1 1+i

1 - 1+in x 1+ r/2i

C x PV Future Earnings =


Insurance Planning

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The income replacement approach (cont'd) Basic assumptions (cont'd)

Earnings rate growth (cont’d) Not necessarily a good estimate for a particular individual

Every individual is unique

Many advance faster or slower than others within their occupation

Earnings growth rates vary among industries and occupations

After-tax discount rates Also problematic

Depends on the risk one is willing to assume, tax rates, and inflation rates


Insurance Planning

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The income replacement approach (cont'd) After-tax discount rates

Discuss alternative assumptions with client and let client be your guide on selecting the appropriate discount rate

Selected return must be adjusted for taxes


Insurance Planning

AVERAGE ANNUAL NOMINAL AND REAL COMPOUND RETURNS

(1977-2006)

Nominal Real

Large Stocks (S&P 500) 13.75% 7.91%

Corporate Bonds (Moody’s AAA) 10.04% 5.23%

Government Bonds (10 Years) 9.12% 5.77%

Treasury Bills (3 Month) 6.22% 1.86%

Inflation (Consumer Price Index 4.27% 4.27%

Source: Based on data obtained from Global Financial Data, Los Angeles, CA, www.globalfindata.com.

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The income replacement approach (cont'd) Family support ratio

Portion of after-tax income spent on self-maintenance not available for the family

25% after-tax income spent for self-maintenance, 75% for family support Ratio may vary widely from family to family

Once estimate of breadwinner’s human life value is determined, the amount should be multiplied by the family support ratio

Example – Present value of future earnings determined to be $1,000,000

Assume 70% of breadwinner’s after-tax income used to support the family

Then amount needed to support the breadwinner’s family is $700,000


Insurance Planning

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The income replacement approach (cont'd) Other adjustments

Reduce by other assets currently available to fund survivor’s income needs Marketable securities

Pension and profit-sharing balances

Tax-deferred annuity plans

IRAs

Simplified employee pension plans

Reduce by other life insurance currently in force

Increase by any outstanding debts Mortgages Personal loans Final death expenses


Insurance Planning

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The income replacement approach (cont'd) Adjustments for social security

survivor benefits Benefits for surviving

spouses with dependant children (% of PIA)

Benefits for surviving spouse alone

Fig. 2.2 can be used to estimate social security survivor benefits


Insurance Planning

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The income replacement approach (cont'd)


Insurance Planning

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The income replacement approach (cont'd) Income replacement as a multiple of gross pay - Examples


Insurance Planning

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Needs analysis Estimates the family income need directly

Lump sum cash needs Administrative / final expenses

Estate settlement costs

Debt liquidation

Tax liabilities

Education fund

Emergency fund

Other special needs funding needs


Insurance Planning

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Needs analysis (cont'd) Multi-period income needs

Adjustment period income

Surviving spouse’s income needs

Children’s income needs

Spouse’s retirement income needs

Mortgage repayment policy Current amount of risk and how long risk needs to be covered

Other major debt repayment policies Nonmortgage long-term debt


Insurance Planning

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Needs analysis (cont'd) Education fund accumulation policy

Pays for projected education costs

Estate tax liability policy For estates above $2,000,000 (in 2008) or $4,000,000 with a spouse

Income needs are met from various sources Social security survivor’s income

Spouse’s earnings

Annuity payments

Employer provided pension survivor benefits

Investment income


Insurance Planning

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Needs analysis (cont'd) Excess of income needs over expected income

Covered by income from re-investing insurance proceeds or

Taking an annuity settlement from insurance company

Lump sum required to generate a monthly income Capital preservation method

Interest income from proceeds without consuming principal Conservative method Requires greater insurance principal

Capital consumption method Calculate income assuming liquidation of both interest and principal What happens if spouse outlives income?


Insurance Planning

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Needs analysis (cont'd) Needs analysis worksheet (Figure 2.9)

Current cash needs are estimated

Capital necessary to fund lifetime income needs estimated

Total value of assets subtracted from current cash needs and capital needs

Interest rate assumption critical Use an after-tax rate Adjust for inflation

Income needs of children based on a capital liquidation approach Needs will end when they graduate college & support themselves

Adjustment period One to two years


Insurance Planning

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Business Insurance Needs Analysis For business insurance applications

Key employee

Split dollar

Nonqualified deferred compensation agreements

Executive bonus plans

Funding of Buy-Sell agreements

Amounts depend on insurance needs particular to each situation


Insurance Planning

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Business Insurance Needs Analysis (cont'd) Key employee insurance (cont'd)

Premature death or disability, or untimely resignation, will severely impact the business’s profitability

Managing the risk Non-compete clauses

Employment severance agreements

Cross training among employees

Management philosophy of mentoring subordinates

Attractive and properly designed compensation packages

Properly designed insurance plan can provide funds during the transition period


Insurance Planning

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Business Insurance Needs Analysis (cont'd) Basic principles of key employee valuation approaches

measure financial loss based in what employee would have contributed to future success of the firm

Adjust financial consequences for the timing of those lost contributions

Account for trends in employee’s contributions

Realize employee’s contributions will terminate (resignation, death, disability, retirement)

Key employee’s contributions will be recovered over time


Insurance Planning

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Business Insurance Needs Analysis (cont'd) Key employee valuation method


Insurance Planning

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Business Insurance Needs Analysis (cont'd) Key employee valuation method – Required inputs

Number of years required to locate, hire, train, and develop replacement

Estimated gross revenue each year of transition (line 1)

Estimate of percentage of gross revenues attributable to key employee (line 2)

Expected total compensation each year over the transition period (Line 4)

Direct and indirect costs of locating, recruiting, hiring, installing, compensating, and training a replacement each year during the transition (Line 8)

Estimate of contribution of replacement (Line 6)


Insurance Planning

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Business Insurance Needs Analysis (cont'd) Remaining parts of worksheet

Line 3 – Total projected revenues attributable to key employee

Line 5 – Key employee’s net contribution

Line 7 – Replacement employee’s contribution

Line 9 - Replacement employee’s net contribution

Line 10 – Difference between contributions of key employee and replacement

Line 11 – Discount factor

Line 12 – Net present value of each year’s loss

Line 13 – Cumulative present value of the loss in net contributions


Insurance Planning

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Estate preservation and liquidity needs analysis Planning to minimize estate taxes and to assure adequate liquidity

Techniques Lifetime gifts

Optimal use of the marital deduction

Various marital and family trust arrangements

Charitable gifts

Life Insurance


Insurance Planning

2 - 1 how to estimate the insurance need introduction principal planning areas income replacement...

Documents

insurance needchapter

tax income

elements of income replacement

good estimate

rimes gross income

breadwinners gross income

tax rates

limitedindividuals needs