Pat and Mandy are married and have a son, Steve, age 8.  Mandy, age 29, earns $40,000 annually from her job.  Pat, age 31, earns $50,000 annually from his job.  Assume that Pat will die before Mandy.  The family wants to ensure that they have adequate life insurance on Pat to cover their cash and income needs if Pat dies.  Hence, they want to determine if they should purchase additional life insurance on Pat to cover these needs using Needs Approach.

QUESTION

The correct answers are based on the set of facts and tables provided below.  All the data you need to perform the necessary calculations are contained in the tables following the three paragraphs below. Show all your calculations so you can receive partial credit even if you make a mistake.

Pat and Mandy are married and have a son, Steve, age 8.  Mandy, age 29, earns $40,000 annually from her job.  Pat, age 31, earns $50,000 annually from his job.  Assume that Pat will die before Mandy.  The family wants to ensure that they have adequate life insurance on Pat to cover their cash and income needs if Pat dies.  Hence, they want to determine if they should purchase additional life insurance on Pat to cover these needs using Needs Approach.

The tables below provide figures on their: 1) cash needs; 2) present insurance and financial assets; 3) income needs; and 4) income that the family will receive if no additional life insurance is purchased.  Use the values in these tables to determine how much, if any, additional life insurance the family should purchase on Pat to cover their needs.  In your answer, calculate and show the components of any additional life insurance needed in terms of cash needs and income needs and the total amount of additional life insurance needed.

This exercise assumes that 1) Pat dies immediately; 2) Mandy continues to work if Pat dies. However, her earnings are not enough to meet their needs. So, the numbers provided in the table are net of her earnings; 3) Mandy plans to retire at age 65; and 4) the life insurance proceeds are invested at an interest rate equal to the rate of inflation (so, you do not have to worry about time-value of money issues).

ANSWER

To determine the additional life insurance needed by the family to cover their needs, we need to calculate the cash needs and income needs separately and then add them together.

Cash Needs:
– Estate Clearance: $15,000
– Mortgage Redemption: $150,000
– Emergency Fund: $20,000
– Educational Fund: $100,000

Total Cash Needs: $15,000 + $150,000 + $20,000 + $100,000 = $285,000

Present Insurance and Financial Assets:
– Whole Life Insurance: $150,000
– Investments/Savings: $10,000

Total Present Insurance and Financial Assets: $150,000 + $10,000 = $160,000

Additional life insurance needed for cash needs: $285,000 – $160,000 = $125,000

Income Needs:
– Readjustment Period: $5,000 monthly for 2 years
– Dependency Period: $5,000 monthly for 8 years
– Blackout Period: $3,500 monthly for 28 years
– Mandy’s Retirement Period: $3,500 monthly for 25 years

Expected Income from Sources Other than Life Insurance:
– Readjustment Period: $3,500 monthly for 2 years
– Dependency Period: $3,500 monthly for 8 years
– Blackout Period: $3,000 monthly for 28 years
– Mandy’s Retirement Period: $2,000 monthly for 25 years

Total Income Needs:
($5,000 – $3,500) * 12 months * 2 years +
($5,000 – $3,500) * 12 months * 8 years +
($3,500 – $3,000) * 12 months * 28 years +
($3,500 – $2,000) * 12 months * 25 years

= ($1,500 * 24) + ($1,500 * 96) + ($500 * 336) + ($1,500 * 300)
= $36,000 + $144,000 + $168,000 + $450,000
= $798,000

Total Expected Income from Sources Other than Life Insurance:
($3,500 * 12 months * 2 years) +
($3,500 * 12 months * 8 years) +
($3,000 * 12 months * 28 years) +
($2,000 * 12 months * 25 years)

= ($3,500 * 24) + ($3,500 * 96) + ($3,000 * 336) + ($2,000 * 300)
= $84,000 + $336,000 + $1,008,000 + $600,000
= $2,028,000

Additional life insurance needed for income needs: $798,000 – $2,028,000 = -$1,230,000 (negative value indicates no additional insurance needed)

Therefore, based on the given information and calculations, the family does not need to purchase any additional life insurance on Pat to cover their needs.