FIN 4320: Chapter 11 - Life Insurance Notes

Chapter 11: Life Insurance

This chapter from FIN 4320 Risk Management & Insurance, presented by The Stumbaugh School of Risk Management & Insurance at Faulkner, focuses on determining the appropriate amount of life insurance.

How Much Life Insurance? Two Primary Approaches

There are two main methodologies to determine the sufficient amount of life insurance:

1. Human Life Value Approach
  • Definition: This approach calculates the present value of a deceased person's future earnings.
  • Calculation Steps:
    • Estimate the breadwinner's earnings for the remainder of their working life.
    • Deduct taxes and self-maintenance needs from these estimated earnings.
    • Determine the present value of the resulting income stream.
  • Limitations:
    • Ignores crucial financial resources such as Social Security survivor benefits and retirement income/benefits.
    • It is challenging to accurately account for dynamic financial factors like changing salaries, fluctuating expenses, and evolving employee benefits.
    • Family changes, such as divorce or the birth of a new child, significantly impact financial needs but are difficult to incorporate into this static calculation.
    • The choice of the discount rate for determining the present value is critical and can drastically alter the outcome.
    • Does not consider the impact of inflation over time, which can erode the purchasing power of the determined value.
  • Better Tool: For a more dynamic assessment, the resource www.lifehappens.org is suggested.
2. Needs Approach
  • Definition: This method precisely analyzes the specific financial needs of the surviving family and determines the exact amount of money required to meet those needs.
  • Most Important Needs for Most Families:
    • Estate Clearance Fund: Covers immediate post-death expenses such as burial costs, outstanding medical bills, installment debts, and various estate expenses.
    • Income during the Readjustment Period: Provides a stable income for approximately a 22-year period immediately following the death, allowing the family time to adjust without immediate financial stress. This period provides crucial time for emotional and financial reorganization.
    • Income during the Dependency Period: Covers the time after the readjustment period until the youngest child reaches a specific age, typically 1818. During this time, the children are financially dependent.
    • Life Income to the Surviving Spouse: Addresses the financial needs of the surviving spouse after the dependency period. This is particularly important concerning the "blackout period" where Social Security benefits for a surviving spouse (who is not caring for a minor child) are unavailable—typically from when the youngest child turns 1616, 1717, or 1818 until the spouse reaches age 6060. This supplemental income is necessary after these blackout periods.
    • Special Needs: Category for specific, often lump-sum, financial requirements:
      • Mortgage Redemption Fund: Ensures the family home can be paid off.
      • Educational Fund: Provides for future educational expenses, such as college tuition.
      • Emergency Fund: A reserve for unexpected financial emergencies.
      • Special Needs Family Members: Funds dedicated to the ongoing care or support of family members with chronic health conditions or disabilities.
    • Retirement Needs: Ensures the surviving spouse can maintain a comfortable lifestyle in retirement.
  • Calculation Flow of the Needs Approach (as illustrated in PPT-05):
    • What Dependents Will Need (comprising Cash Needs, Income Needs, and Special Needs)
    • SUBTRACT What Breadwinner Has Today (including Cash, Investments, Personal Retirement Accounts, and Current Life Insurance)
    • EQUALS Life Insurance Needed

Americans' Management of Premature Death (2016 Statistics)

  • Prevalence of Coverage: Approximately 6060% of U.S. households had some form of life insurance.
  • Type of Coverage: Less than 3030% of these households held individual life insurance policies, suggesting a reliance on group or employer-provided coverage.
  • Adequacy of Coverage: The typical coverage was sufficient to replace only about 33 years of income before deductions for final expenses, indicating potential under-insurance.
  • Reasons for Under-Insurance:
    • Perceived Cost: Consumers often believe life insurance is too expensive.
    • Decision Difficulty: Many consumers find it challenging to make informed purchasing decisions regarding life insurance.
    • Procrastination: A common human tendency to delay important decisions, including life insurance purchases.
    • Opportunity Cost: The financial trade-off where discretionary income might be allocated to other immediate needs or desires rather than life insurance premiums.
  • Issues: A significant contributing factor to under-insurance is the limited amount of discretionary income available to many households, making it difficult to prioritize what is perceived as a long-term expense.