Pat estimates that $60,000 is seen as sufficient wealth to meet his family’s needs after his death.  Currently, the family has $800,000 total assets, including bank saving, securities investment, house, cars, etc. The family currently has $220,000 total liability (e.g., mortgage payoff, auto loan, credit card balance), $135,000 cash needs (e.g., emergency fund, educational fund, and final expenses), and $145,000 non-income-producing capital. Ignore any other potential capital resources or needs, e.g., Social Security benefits. Assuming a 5% rate of return, how much life insurance does the Capital Retention Approach suggest?

QUESTION

at estimates that $60,000 is seen as sufficient wealth to meet his family’s needs after his death.  Currently, the family has $800,000 total assets, including bank saving, securities investment, house, cars, etc. The family currently has $220,000 total liability (e.g., mortgage payoff, auto loan, credit card balance), $135,000 cash needs (e.g., emergency fund, educational fund, and final expenses), and $145,000 non-income-producing capital. Ignore any other potential capital resources or needs, e.g., Social Security benefits.

Assuming a 5% rate of return, how much life insurance does the Capital Retention Approach suggest?

ANSWER

Calculating Life Insurance Needs Using the Capital Retention Approach

Introduction

Determining the appropriate amount of life insurance coverage is crucial to ensure the financial security of your loved ones after your passing. One popular method for estimating life insurance needs is the Capital Retention Approach. In this essay, we will apply this approach to the case of Pat, who aims to determine the optimal amount of life insurance coverage for his family, taking into account their current assets, liabilities, cash needs, and non-income-producing capital. Considering a 5% rate of return, we will calculate the recommended amount of life insurance using this approach.

Understanding the Capital Retention Approach

The Capital Retention Approach focuses on preserving the capital required to generate sufficient income to meet the family’s ongoing financial needs after the policyholder’s death. It considers the existing assets, liabilities, and future cash needs of the family to determine the desired amount of life insurance coverage. By ensuring the preservation of capital, this approach aims to generate income that can sustain the family’s lifestyle in the absence of the deceased’s financial contributions.

Analysis of Pat’s Situation

In Pat’s case, his family’s current assets amount to $800,000, which includes various holdings such as bank savings, securities investments, and property. On the other hand, they have a total liability of $220,000, encompassing mortgage payments, auto loans, and credit card balances. Additionally, the family has identified cash needs of $135,000 for emergency funds, educational expenses, and final expenses. Furthermore, they have $145,000 in non-income-producing capital.

Calculating the Recommended Life Insurance Coverage

To determine the appropriate life insurance coverage using the Capital Retention Approach, we need to consider the rate of return on investment. Assuming a 5% rate of return, we can estimate the amount of capital needed to generate the required income to meet the family’s needs.

First, we subtract the total liability of $220,000 from the current assets of $800,000, resulting in a net asset value of $580,000 ($800,000 – $220,000).

Next, we subtract the identified cash needs of $135,000 and the non-income-producing capital of $145,000 from the net asset value, yielding $300,000 ($580,000 – $135,000 – $145,000). This remaining amount represents the capital that needs to be retained to generate income.

Now, using the assumed rate of return of 5%, we can calculate the annual income generated by this capital. Multiplying the retained capital by the rate of return, we get $15,000 ($300,000 * 0.05) as the annual income.

To determine the recommended life insurance coverage, we divide the annual income by the rate of return. Dividing $15,000 by 0.05, we find that the Capital Retention Approach suggests life insurance coverage of $300,000 ($15,000 / 0.05).

Conclusion

Based on the Capital Retention Approach, taking into account Pat’s family’s current assets, liabilities, cash needs, and non-income-producing capital, a life insurance coverage of $300,000 is recommended. This coverage aims to preserve the necessary capital to generate income equivalent to the family’s ongoing financial needs, assuming a 5% rate of return on investment. However, it is essential to review and update the life insurance coverage periodically as circumstances and financial situations change. Seeking advice from a financial professional can provide further guidance to ensure the adequacy of the life insurance coverage to meet the family’s evolving needs.