Sam and Susan Scully have come to financial planner Lissa Cardenas to ask about the adequacy of their life insurance coverage. They have two children ages 4 and 2. They are each 35 years old. Sam works full-time in a management position in a manufacturing company. He earns $95,000 p.a. and does not expect further promotions, but does expect his salary will keep pace with inflation. His take home pay is $70,000 after all deductions. Susan spends much of her time as a homemaker, but she earns $15,000 p.a. in part-time jobs, which is also her take home pay. She expects she will continue to do that in the future. They plan to retire when Sam reaches age 65.
They would like to continue to support the children for the first few years after high school; they are saving a small amount every year in an RESP for them. The balance in the RESP is now $10,000. They live in Wawanesa, Manitoba. They also have $40,000 in TFSAs, $10,000 in bank accounts and $4,000 in an RRSP. Sam will get a reasonably good employer pension, but Susan will get only CPP when she retires. If Sam predeceases her, she would get a top-up of CPP that would take her to the maximum CPP. They own their own home in Wawanesa, Manitoba, with a mortgage of $200,000 and an estimated market value of $400,000. They pay off the credit cards completely every month and have no other debts. Their budget is balanced, but after paying normal living expenses, the mortgage and small contributions to the RESP and $5,000 to the TFSA, they will not have money for much else. They are in excellent health and do not smoke.
Susan gets no benefits from her work, other than the mandatory employer contributions to CPP. In addition to the pension plan, Sam has good extended health care insurance and life insurance worth two times his salary, from the employer. His employer has a long-term disability plan and Sam pays the premiums for a benefit of 65% of his salary if he is unable to perform his existing job. They would have to pay $10,000 p.a. to replace the employer benefits. Sam also has a whole life insurance policy with a face value of $100,000 and a cash surrender value of $6,000.
They own only one car because Sam doesnât need a car for his work. It is insured for $200,000 liability, collision, theft and accident, with a deductible of $100. The house is insured for $100,000. The insurance company estimates that the land is worth $80,000 of $250,000 market value. The deductible is $100.
Required:
a)Estimate their requirement for additional life insurance using the income method and the expense method. Recommend how much additional insurance they need and what kind they need. Use a discount rate of 3% and assume all the expenses and income are constant.
b)Analyse their other insurance needs, keeping in mind the basic risk management process. Recommend other additional insurance coverage they need or can reduce or cancel, and estimate how much they need.
Sample Solution
a) Estimating the Scully’s life insurance coverage:
Income method: The first step is to estimate the total income needed by the family if one of the earners were to die prematurely. Sam earns $95,000 p.a., and Susan earns $15,000 p.a., for a total family income of $110,000 p.a. Sam and Susan plan to retire when Sam reaches age 65, so they have 30 years until retirement. Using a discount rate of 3%, the present value of 30 years of lost income is:
PV of lost income = $110,000 x (1-0.30) x ((1-(1/1.03^30))/0.03) = $2,613,645
To this, we add the present value of Susan’s CPP top-up, which is the difference between the maximum CPP benefit and her expected CPP benefit. According to the Service Canada website, the maximum CPP benefit in 2023 is $1,203.75 per month. Assuming Susan’s expected CPP benefit at retirement is $700 per month, the present value of the top-up is:
PV of CPP top-up = ($1,203.75 – $700) x ((1-(1/1.03^30))/0.03) = $70,876
The total present value of the Scully’s lost income and CPP top-up is $2,684,521.
Expense method: The second step is to estimate the total expenses that the family will incur after one of the earners dies prematurely. The family’s current budget is balanced, but after paying normal living expenses, the mortgage, and small contributions to the RESP and TFSA, they will not have money for much else. Assuming that the family will continue to live at their current standard of living, we estimate their annual expenses at $70,000.
To estimate the present value of the Scully’s future expenses, we need to account for inflation. Assuming a 2% inflation rate, we discount the future expenses at a rate of 1%. Using the formula for the present value of a perpetuity, we get:
PV of expenses = $70,000 x (1+0.02)^30 x (1-(1/1.01^30))/0.01 = $1,706,942
Total life insurance coverage needed: The total life insurance coverage needed by the Scullys is the sum of the present value of their lost income and the present value of their future expenses, minus the present value of their current assets. Their current assets consist of their TFSA, bank accounts, and RRSP, which total $54,000. Therefore, the total life insurance coverage needed is:
$2,684,521 + $1,706,942 – $54,000 = $4,337,463
They should consider purchasing a term life insurance policy to cover this amount of coverage.
b) Analyzing the Scully’s other insurance needs:
Auto insurance: The Scully’s auto insurance policy provides coverage for $200,000 in liability, collision, theft, and accident, with a $100 deductible. This seems like adequate coverage for their needs, but they should check if they qualify for any discounts that could reduce their premiums.
Home insurance: The Scully’s home insurance policy provides coverage for $100,000 in building and contents, with an $80,000 valuation on the land. Given that the estimated market value of the house is $400,000, they should consider increasing the coverage for the building to reflect the replacement cost of the house in case of a total loss. They should also consider increasing the liability coverage to protect against potential lawsuits.
Disability insurance: Sam has good extended health care insurance and life insurance
