Life insurance how much cover is needed? Fact Sheet - October 2014

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1 Life insurance how much cover is needed? Fact Sheet - October 2014 This fact sheet examines various methods of estimating the level of personal life insurance to be taken by an individual. The calculation methods do not take account of any tax that may apply to the receipt of insurance proceeds, earnings or income. The role of the adviser is to estimate the amount of money a family or dependant would need to replace the financial loss if the insured dies or suffers disability or critical illness and was unable to produce an income. There are various methods used to calculate the level of cover, however all have limitations. Being aware of the limitations is important and will assist you to advise your client. Ultimately the appropriate amount of insurance is the level that provides reassurance to your client, replaces their immediate and longer term losses and satisfies industry limits and life office s underwriting guidelines. The three methods we examine here are: 1. Capitalisation of current income stream and estimate of the years the lump sum will last 2. Using expected years to calculate a lump sum 3. Applying a rule-of-thumb. Scenario Ernie, a marketing manager with a toy company receives an annual salary of $100,000. His family would need $60,000 per annum (60% of $100,000) in the event of his premature death. The estimated earnings rate of an insurance lump sum is 7% per annum and inflation is expected to be 3% per annum. Ernie s funeral expenses are expected to be $8,000. His personal debts are $50,000 and the expected education costs of his children are $100,000. He has cashable investments of $50,000 and his superannuation is currently valued at $150,000. Any lump sum would need to support his dependants for at least 20 years. The examples that follow use this information to illustrate the alternative methods of estimating the life insurance that Ernie requires. 1. Capitalisation of current income stream This method produces an estimate by capitalising the income required using an assumed earnings rate for the lump sum. The estimate of lump sum needed is calculated as follows: Lump sum needed = Gross annual salary x % required on death of life insured assumed earnings rate of lump sum Asteron Life 1

2 Example Lump sum needed = $100,000 x 60% 7% Lump sum needed = $857,143 Capital needed to produce income (deduced above) $857,143 Suggested life insurance $815,143 Life insurance shortfall $815,143 The method assumes that investment earnings rate will be stable. The lump sum calculated is completely dependent on the assumptions of the investment earnings rate and the annual income required. The method does not tell the adviser how long the lump sum will last if income required needs to increase to keep up with inflation. How long will the lump sum last? In the method above we capitalised the annual income required by the earnings rate. However we do not know how long this lump sum may last. If we estimate the inflation rate we can calculate how long the lump sum will be able to pay an inflation-adjusted income stream. The formula is: Year Capital start of year + Earnings - Income Year1 Capital needed to produce income Capital needed to produce income x earnings rate Income in year 1 Year2 Year 2 Capital Year 2 Capital x earnings rate Income in year 1 x (1+inflation rate) Year3 Year 3 Capital Year 3 Capital x earnings rate Income in year 2 x (1+inflation rate) and so on Asteron Life 2

3 Example The table below demonstrates the formula applied to a lump sum of $857,143 at the beginning of Year 1, earning 7% per annum, and paying an income of $60,000 in Year 1, indexed at 3% per annum. Year Capital start of year + Earnings - Income 1 $857,143 $60,000 $60,000 2 $857,143 $60,000 $61,800 3 $855,343 $59,874 $63,654 4 $851,563 $58,609 $65,564 5 $845,609 $59,193 $67,531 6 $837,271 $58,609 $69,556 7 $826,323 $57,843 $71,643 8 $812,523 $56,877 $73,792 9 $795,607 $55,962 $76, $775,293 $54,271 $78, $751,277 $52,589 $80, $723,232 $50,626 $83, $690,804 $48,356 $85, $653,614 $45,753 $88, $611,255 $42,788 $90, $563,288 $39,430 $93, $509,240 $35,647 $96, $448,605 $31,402 $99, $380,636 $26,659 $102, $305,349 $21,374 $105, $221,513 $15,506 $108, $128,652 $9,006 $111, $26,040 $1,823 $27, $0 The income of $60,000 in year 1, indexed at 3% per annum will last for 22 years. We can alter the variables including earnings rate, annual income and the inflation rate to estimate how long a lump sum will last under various assumptions. 2. Estimate of lump sum using expected years and amount In this method the amount required per annum is calculated and multiplied by the years required. The estimate of the lump sum is calculated as follows: Lump sum needed = gross annual salary x % required on death of life insured x years required Example Lump sum needed = $100,000 x 60% x 20 Lump sum needed = $1,200,000 Asteron Life 3

4 Capital needed to produce income (deduced above) $1,200,000 Suggested life insurance $1,158,000 The method does not include an inflation multiplier. There is no consideration of the reinvestment of earnings. Life insurance shortfall $1,158,000 The method assumes the cost of living will remain the same and does not rise in nominal terms. The years required may be an under or overestimate leading to under or over insurance particularly if the insured dies many years after taking out insurance. 3. Estimate using a rule-of-thumb In this method the annual income of the life insured is multiplied by a pre-determined factor to arrive at a lump sum. The estimate of the lump sum is calculated as follows: Lump sum needed = gross annual salary x pre-determined factor Example Lump sum needed = $100,000 x 10 Lump sum needed = $1,000,000 Capital needed to produce income (deduced above) $1,000,000 Suggested life insurance $958,000 Life insurance shortfall $958,000 A rule-of-thumb uses a multiple, 10 being common. The multiple can be an overestimate for an older person or an underestimate for a younger person. The method does not include an inflation multiplier. There is no consideration of the reinvestment of earnings. The method does not estimate the present value of annual income that may be required. Asteron Life 4

5 Contact Details Technical Services Suncorp Portfolio Services Limited ABN AFS Licence No For more information on Asteron product solutions, please contact the Sales Manager in your State. NSW/ACT Level Kent Street Sydney NSW 2000 T NSW callers outside Sydney: VIC/TAS Level Collins Street Melbourne VIC 3000 T VIC callers outside Melbourne: QLD Level Wickham Terrace Brisbane QLD 4000 T QLD callers outside Brisbane: SA/NT Level Grenfell Street Adelaide SA 5000 T SA callers outside Adelaide: WA Level William Street Perth WA 6000 T WA callers outside Perth: Important note The information contained in this publication is of a general nature only and is intended for use by financial advisers or other licensed professionals only. it must not be handed to clients for their keeping nor can any copies of sections of this publication be given to clients. The information has been compiled based on regulatory policy at the time of writing. We recommend that your client refer to their professional tax or legal adviser prior to implementing any recommendations you may make based on the information contained in the publication. 10/2014