Insurance Planning - Required Sum Insured Calculation

Sum insured is calculated in order to tabulate your scheduled premium payment. Three methods are discussed here.

1) Rule of Thumb method:
It provides a brief idea of sum insured: 5-10 times annual income
This method is used by insurance agent to close the deal fast, too rough, not accurate as different individual has different expense/income ratio). 5 to 10 times of annual income may be very subjective.

Example 1: Let's take 8 times. Amy earns 10,000/month. Thus, annual income is 120,000/month.

Rule of thumb's sum insured = 8*10k*12 = 960k.
Current life insurance coverage = 100k
The shortfall shall be 860k.

Then insurance agent will recommend her to buy another 860k sum insured.
It will be very funny if Amy's dependence expenses is said 40k which the agent do not consider her net worth that can be off set for the high sum insured. It is baseless to make the assumption that causes a big gap between 5 times and 10 times sum insured.

Further more, higher earner will end up with higher sum insured.

2) Human Life Value or Economic Life Value method:
Another slightly improved method but flaw is still exist. As my lecturer said, if a person is symbolized as a money printing machine, will you protect this machine? Human has a value. SS Huebner first expounded the concept of a human value. The economic value of a human being may be taken to be the present value or discounted value of anticipated net earning of the individual during the productivity year. But, it is a good method for those who do not has a fix income, not yet perfect approximately.
To get the highest commission or promising commission, agent uses the method wont be very-wrong or commission-guaranty. It is due to no matter how high or low of a person's income, it will sure work out with a sum insured that higher that income replacement method. Thus, over insured might be exist if you view it from the method 3. However, the advantage of this method would be the most secured way to calculate the sum insured...because it wont be the scenario that expense more than income. Thus, the failure rate is low but might be a burden to the insured.

Example 2: 33-year-old Amy earns 10,000/month. Her commitment to her dependence is 25 years. What would be the sum insured that she required if the policy has ROI of 5%?

Answer:
PV(.05,25,-120000,0,0) =$1,691,273.35 without salary increment.

Growth adjusted rate of return, I,adj = (r-g)/(1+g)
I,adj = (0.05-0.04)/(1+0.04) = 0.009615385, or 0.9615%

PV((0.05-0.04)/(1+0.04),25,-120000,0,0)/(1+0.04)

= $2,553,253.71 with 4% salary increment.

Remember that premium has to be paid first before u enjoy the coverage. so, it is divided by (1+.04).

which one is realistic? $2,553,253.71.

Net worth statement from CFP step 2/3 will be used to offset the sum insured requirement, said 350k.

Current life policy (validity till 25 years) = Current bought life policy#1 + Current bought life policy#2 + Current bought life policy#3 + Current bought life policy#4 + Company group policy till retire
= 32k + 100k + 10k + 115k + 3*120K = 617k

shortfall = $2,553,253.7- (350k + 617k)
= $1,586,253.71.

Conclusion: She requires 1.6 million sum insured.

For this method you would always notice that you need to have a high net worth in order to have a zero shortfall.

3) Income replacement method:
Insurance agent wants to close the deal fast, they most likely wont spend mush time for this method. To understand this, you will lost your patient if your agent tell you so.

Two approaches for your requirement for your principal, A) Principal Liquidation method and B) Principal Intact Method. In mathematics, A means FV=0 at the targeted period while B means n=infinity,9999 with FV=constant.

Example 3: 33-year-old Amy earns 10,000/month. 40k expenses per year. Her commitment to her dependence is 25 years. What would be the sum insured that she required if the policy has ROI of 5%?

Answer:
Principal Liquidation = PV(0.05,25,-40000,0,1)
= $591,945.67 without considering Inflation.
Principal Intact = PV(0.05,9999,-40000,0,1) = $840,000.00, or (40000/.05)+40000
=840,000 without considering inflation

Figure 1: Malaysian 30-years historical fixed deposit rate and consumer price index

Inflation adjusted rate of return, I,adj = (r-i)/(1+i)
I,adj = (0.05-0.04)/(1+0.04) = 0.009615385, or 0.9615%

Now, it become more realistic if we consider the inflation.
Principal Liquidation = PV((0.05-0.04)/(1+0.04),25,-40000,0,1)
= $893,638.80 with considering Inflation 4%.
Principal Intact = PV((0.05-0.04)/(1+0.04),9999,-40000,0,1)
= $4,200,000.00 or (40000/((0.05-0.04)/(1+0.04)))+40000 =4200000 with considering inflation 4%.

Which one is more realistic and practical among the four figures?
$893,638.80

Net worth statement from CFP step 2/3 will be used to offset the sum insured requirement, said 350k.

Current life policy (validity till 25 years) = Current bought life policy#1 + Current bought life policy#2 + Current bought life policy#3 + Current bought life policy#4 + Company group policy till retire = 32k + 100k + 10k + 115k + 3*120K = 617k

shortfall = $893,638.80 - (350k + 617k)
= (73,361)

Conclusion: No need to buy insurance because no short fall.

Quit Job Scenario:
Amy quits the current company and join another new company. The new company has no life insurance provided.

Then, the sum insured to be revised as below:

shortfall = (73,361) + 3*120k = 286,638. In order to protect her family expenses, she need to buy additional 286 k life insurance because there is a short fall.

As a conclusion, changing a job might seriously affect your insurance planning. The premium of the additional 286k is, 0.005*286000 = 1500 per annual for non-participating insurance.

Diverted original posting from my facebook note dated 4-Nov-09.