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  • What is the life-cycle model of consumption and savings?
  • June 29, 2013
  • Tony Steuer

    By Tony Steuer, CLU, LA

    A new approach to calculating life insurance needs is the life-cycle model of consumption and savings, which is based on the life-cycle model.

    Professor Franco Modigliani, and his colleagues at Massachusetts Institute of Technology developed this model in the 1950s and 1960s. Modigliani won the Noble Peace Price in 1985 for the development of this model, which was built of the early work of Irving Fisher, a Yale economist, in the 1920s.

    In this model, it is assumed that the goals of the insured are to secure both the living standards of the household and his or her survivors.

    According to the economic approach, spending targets are derived from calculating how much the household can afford to consume in the present, while still preserving the same living standards for the future.

    A life insurance policy preserves the standard of living for a household in the event of a premature death.

    Under the Capital Needs Analysis, spending targets can be adjusted to approximate those derived under the economic approach, which has practical limits. This is particularly true in the case of a household who is experiencing changing demographics or facing borrowing constraints.

    An approach like this is based on the fundamental goal of saving money and having insurance, while avoiding major disruptions in a household’s standard of living.

    This method uses advanced mathematical techniques to calculate the savings and life insurance needed to balance consumption in the present with future consumption, to help preserve a household’s living standard for survivors. It also describes how life insurance holdings are adjusted, as life insurance needs change.

    All economic resources, tax liabilities and benefits – Social Security retirement benefits, and survivor benefits, etc. – are taken into account in the calculation, along with family demographics, tax-deferring saving, housing plans, special expenditures, estate plans, capacity to borrow, and lifestyle preferences.

    This type of modeling includes contingent planning, which recognizes that survivors may have special needs and different incomes. Key variables – age of retirement, Social Security benefits, and tax-deferred assets withdrawals, for example – can be changed to determine how theses factors alter the maximum sustainable living standard.

    The insurance recommendations are substantially different from those of the conventional methods. This type of approach (in theory) would allow the agent/representative to use a more comprehensive base to determine life insurance needs rather than the historical guessing/estimated theory. Without economic modeling process, there is no mathematical ability for determining an appropriate amount of insurance.

    A benefit of this approach is that it incorporates the fact that as other assets grows; the need for life insurance to replace income will diminish.

    The downside of this approach is that it depends on a large number of assumptions and the more assumptions that are relied upon, the greater the chance that the calculation will be further off. The other issue is the complexity of this type of model.

    The Life Foundation and ESPlanner have both developed a simple, easy-to-use program, which can calculate an individual’s life insurance needs. Both of these programs are based off this mathematical approach.

About Tony Steuer

Noted insurance author Tony Steuer has spent over 25 years in the life insurance industry. Steuer’s leadership roles include serving on the California Department of Insurance Curriculum board and the National Financial Educator's Council Curriculum Advisory Panel as well as having served as President of the San Francisco Chapter of the American Society of CLU & ChFC, President of the leading Life Insurance Producers of Northern California, and as a board member of the San Francisco Life Underwriters Association. Mr. Steuer is the author of Questions and Answers on Life Insurance: The Life Insurance Toolbook, The Questions and Answers on Life Insurance Workbook and The Questions and Answers on Disability Insurance Workbook - the first two were awarded the “Excellence in Financial Literacy (EIFLE) Award from the Institute of Financial Literacy. Steuer holds a Chartered Life Underwriter (CLU) designation and also holds the Life and Disability Insurance Analyst License, a designation that is held by less than thirty people in California.

Creative Commons License
Questions & Answers on Life Insurance by Tony Steuer, CLU, LA, CPFFE is licensed under a Creative Commons Attribution 3.0 Unported License.

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