1. 2 - 1 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 2 Tools & Techniques of Life Insurance Planning

2. 2 - 2 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

3. 2 - 3 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

4. 2 - 4 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

5. 2 - 5 How To Estimate The Insurance Need  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) Chapter 2 Tools & Techniques of Life Insurance Planning

6. 2 - 6 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

7. 2 - 7 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

8. 2 - 8 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning AVERAGE ANNUAL NOMINAL AND REAL COMPOUND RETURNS (1977-2006) NominalReal 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 Index4.27% Source: Based on data obtained from Global Financial Data, Los Angeles, CA, www.globalfindata.com.

9. 2 - 9 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

10. 2 - 10 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

11. 2 - 11 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

12. 2 - 12 How To Estimate The Insurance Need  The income replacement approach (cont'd) Chapter 2 Tools & Techniques of Life Insurance Planning

13. 2 - 13 How To Estimate The Insurance Need  The income replacement approach (cont'd)  Income replacement as a multiple of gross pay - Examples Chapter 2 Tools & Techniques of Life Insurance Planning

14. 2 - 14 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

15. 2 - 15 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

16. 2 - 16 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

17. 2 - 17 How To Estimate The Insurance Need  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? Chapter 2 Tools & Techniques of Life Insurance Planning

18. 2 - 18 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

19. 2 - 19 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

20. 2 - 20 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

21. 2 - 21 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

22. 2 - 22 How To Estimate The Insurance Need  Business Insurance Needs Analysis (cont'd)  Key employee valuation method Chapter 2 Tools & Techniques of Life Insurance Planning

23. 2 - 23 How To Estimate The Insurance Need  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) Chapter 2 Tools & Techniques of Life Insurance Planning

24. 2 - 24 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning

25. 2 - 25 How To Estimate The Insurance Need  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 Chapter 2 Tools & Techniques of Life Insurance Planning