BUSI 687 Week 5 DB Forum 4 Example

Discussion Board Forum 4: Thread and Replies

BUSI 687 Insurance & Risk Management, Discussion Board Forum 4 (thread and two replies)

Thread by [Student Name]

The forum topic, the family, the premium quotes and the classmates are composites standing in for the course's own; the calculation is illustrative, and the textbook and research cited are real; the requirements follow Liberty's public course guide for BUSI 687.

Thread

The topic describes a composite family: a 36-year-old main earner making $95,000, a spouse working part time, two children ages 3 and 6, a $310,000 mortgage, $80,000 in savings and a group life policy at work worth one year's salary. They ask how much coverage they need and whether to buy term or whole life.

Dalton et al. (2018) describe a needs approach that totals what the survivors would require and subtracts what they already have. For this family:

The 16 years run until the younger child turns 19. The $60,000 figure assumes the surviving spouse keeps working part time and that household spending falls modestly without the main earner. A 4 percent discount rate reflects what a family could earn on the proceeds in safe investments, not what stocks have returned historically. A $1 million policy covers the gap.

The product choice follows from the purpose. The need is large and temporary: it shrinks as the mortgage is paid, the children grow and savings build. Quotes the family received for a healthy 36-year-old were about $50 a month for 20-year level term and about $900 a month for whole life with the same face amount. At that difference, term covers the need at a cost they can sustain, and the $850 monthly difference could go to retirement saving. Whole life earns its cost when the need never ends, which is not this family's situation.

Why does this analysis matter? Bernheim et al. (2003) examined older households in the Health and Retirement Study and found that life insurance holdings were only loosely related to the financial vulnerability a death would create, leaving many spouses exposed to large drops in living standards. People tend to own the life insurance someone sold them, not the amount a calculation would give them. A close friend of mine lost her husband at 41. He had only his employer's group policy, and she sold their house within a year. A needs analysis would have shown the gap in an afternoon. I would also recommend that this family rerun the analysis at each milestone, such as a new child, a bigger mortgage or a job change, and at least twice a decade otherwise, since the right amount will fall as the years of dependence pass and their savings grow. If they later find they need less, a term policy can simply be reduced or allowed to lapse.

Reply to Sophie

Sophie, your needs analysis for your own family was thorough, and I liked that you included child care costs for the surviving spouse, which many analyses miss. I did want to recheck one assumption. You discounted the survivors' income need at 8 percent, the long-run stock return you cited, which lowers the present value considerably. Dalton et al. (2018) explain that the discount rate in a needs analysis should reflect what the survivors can realistically earn on the proceeds with little risk, since a grieving family is unlikely to invest a death benefit aggressively. At 4 percent, your $55,000 annual need over 18 years has a present value of about $696,000; at 8 percent it is about $515,000, a gap of more than $180,000 in coverage. A lower rate is the safer assumption, because an analysis that overstates future returns leaves the family underinsured in exactly the years it can least afford a shortfall. Lin and Grace (2007), using the Survey of Consumer Finances, found that term and total life insurance holdings do rise with a household's financial vulnerability, but that older consumers protect a given level of vulnerability with less coverage than younger ones, which suggests many families settle for less than their exposure warrants. Because term coverage of a few hundred thousand dollars more would add only a few dollars a month for someone your age, erring on the side of the lower discount rate costs little. Your inclusion of child care already shows the kind of care this analysis deserves. Would you consider rerunning the analysis at 4 or 5 percent to see how much the face amount changes?

Reply to Devon

Devon, you recommended whole life for the family because it builds cash value and never expires, and you mentioned that your parents' whole life policy paid for your father's funeral when he died at 79. Your father's policy did its job, and it is clear the experience shaped how your family thinks about insurance. Dalton et al. (2018) describe permanent insurance as fitting obligations with no end date, such as burial costs, taxes due at death or support for an adult child with a disability. The difficulty is the size and timing of this family's need. Their $1 million gap lasts about 16 years and then shrinks sharply, as the mortgage falls and the children become independent. Buying $1 million of whole life would cost roughly $900 a month in the quotes we discussed, which this family cannot sustain alongside retirement and college saving, and a policy that lapses after a few years because the premium was too high protects no one. In older households, Bernheim et al. (2003) saw coverage track need only loosely, and a family stretching to afford an expensive policy might end up buying too little coverage in total. A combination could address your concern: $1 million of 20-year term for the years of greatest need, plus a small permanent policy, perhaps $50,000, to cover final expenses at any age. That would cost a fraction of the all-whole-life plan while honoring the lesson of your father's policy. Your family's experience shows why the permanent piece matters, and this plan keeps it while protecting the years when the children depend on the paycheck. Would that combination meet the purpose you had in mind?

References

Bernheim, B. D., Forni, L., Gokhale, J., & Kotlikoff, L. J. (2003). The mismatch between life insurance holdings and financial vulnerabilities: Evidence from the Health and Retirement Study. American Economic Review, 93(1), 354-365. https://doi.org/10.1257/000282803321455340

Dalton, M. A., Dalton, J. F., & Langdon, T. P. (2018). Insurance planning. Money Education.

Lin, Y., & Grace, M. F. (2007). Household life cycle protection: Life insurance holdings, financial vulnerability, and portfolio implications. Journal of Risk and Insurance, 74(1), 141-173. https://doi.org/10.1111/j.1539-6975.2007.00205.x