How Life Insurance Agents Should Determine Family Needs and Income Replacement

The chart above presents a worksheet that summarizes the nine basic steps in using the income replacement approach to determine insurance need. 

For example, in the case of the Mike Fox family, the analysis would proceed as follows. Assume Mike’s after-income-and FICA tax take-home pay is $50,000. Assume also that Mike expects his income to grow at 4 percent [about 1 percent more than the rate of inflation, which is assumed to be 3 percent (to be consistent with assumptions regarding Social Security benefits)]. Also assume, that a 2 percent after-tax return in excess of inflation is reasonable, or about 5 percent. In this case, then, the earnings-adjusted discount rate for computing the present value of Mike’s future earnings is about 1 percent (5 percent less 4 percent). Further assume Mike’s employer provides an insurance benefit equal to one and one-half times Mike’s gross pay of $60,000, or $90,000 and that he has $30,000 in marketable assets and cash available to help fund the family’s income need. Assume further that Mike’s current mortgage balance is $110,000, which he would like paid off in the event of his death and that final death expenses are expected to be about $15,000. Finally, assume about 75 percent of Mike’s after-tax income would be necessary to support the family’s current standard of living should he die. 

Based on these assumptions and using equation 2.1, the present value of Mike’s twenty years of future after-tax earnings is about $892,186, which is entered in Step 1 of the worksheet. Multiplying this present value by the 75 percent family support ratio determines the present value of the family support obligation, which is $669,140. As described above, the present value of the survivorship benefits under Social Security is $527,000. This amount, together with the $90,000 of employer-provided life insurance and $30,000 of available assets, reduces the present value of the family support obligation by $647,000 to just $22,140. When the special funding needs totaling $125,000 are added, the amount of insurance required is determined to be about $147,140. This amount represents just about 2.5 times Mike’s current gross income of $60,000. 

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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