There is some consensus on what constitutes adequate life insurance coverage. There are numerous methods to determine the adequate amount of life insurance a person should have - it can be scientific or simplistic. There are four classic methods to determine the adequacy of life insurance need or coverage. According to Jerry D. Todd (2004) many different names are given to these method on which he refer to; A) the multiple-earnings rule of thumb method, 2) the capital needs analysis method, 3) the human life value method, and 4) the needs analysis method. All the method have advantages and disadvantages and suitable to certain or specific case. We will examine on the surface and briefly discuss advantages and disadvantages of the method according to the Jerry D. Todd (2004) below.
1) The Multiple-Earnings Method
This method is extremely simple to use and understand, and it relates the need directly to the person's salary or income. It typically measures the appropriate amount of life insurance as some multiple of annual earnings-usually somewhere between 4 and 7 times. But its crudeness also weakens its accuracy and appropriateness when considering factors other than pure income-for example, size of family, living expenses, and stage of life.
2) The Capital Needs Analysis Method
This method purports to measure the amount of capital, at some appropriate rate of return, that will produce the amount of income and cash needed to replace the deceased's income contribution to the family. It assumes 1) no dissolution of the principal amount (and has been called the capital conservation strategy), 2) that the survivors will forever have the principal on which to earn income, and 3) that they will pass the principal amount on to their heirs. A primary criticism of this method is that it definition puts great importance on the estate value; by doing so it overstates the amount of lire insurance otherwise needed to replace lost income.
3) The Human Life Value Method
The HLV approach has great theoretical accuracy and is perhaps the most used of these approaches (at least in general concept) in wrongful death court cases. It seeks to measure the present value of the lost income stream to dependents caused by the death of the insured. As modified by expert witnesses in court cases, it also incorporates inflation and even mortality probabilities. If lifestyle expectations are considered, perhaps it is the most appropriate to use. However, it does tend to overstate the amount of life insurance needed based on current lifestyle. The reason is the simple fact that most people have the greatest incomes later in life when their needs are less because of grown children, matured mortgages, etc. The HLV approach measures life insurance need based on assumptions of ever-growing salaries and increasing standards of living regardless of actual needs based on current and projected expenses. The needs analysis method instead bases the appropriate amount of life insurance on expense needs that change depending on age and number of children and other lifestyle changes.
4) The Needs Analysis Method
This method has been the most touted in personal finance and insurance textbooks. It is easier to understand in general and involves more practical and fewer theoretical applications. It incorporates cash needs caused by death, which arc ignored in the HLV approach. It is easily adaptable to different stages of the life cycle and different demographics of the insured. It is more intuitive and understandable.
Therefore, the more scientific methods to determine the appropriate amount of life insurance are the needs analysis and the human life value. According to Scarbrough and Norris (1999), the most commonly used sales tool is the needs analysis; and the human life value is the most agreed academic expression for the purpose of life insurance. However, there are some weaknesses of using both methods that would leave a person underinsured or over insured. For example, both methods do not explicitly take account of other financial elements such as income taxes and retirement benefits (Daily, 2000). Hence, we think it is possible to establish meaningful benchmarks and a method to evaluate the adequacy of life insurance. According to Bernheim et al. (1999), life insurance is deemed inadequate if it does not allow individuals and their children to sustain their standard of living, in financial terms, upon the death of the breadwinner. A severe underinsurance refers to a situation where the dependents would face a drop in living standards of 40-percent or more, while significant underinsurance refers to a decline of 20-percent or more. For the purposes of this study, we adopt the same benchmark as Bernheim et al. (1999) and also Auerbach and Kotlikoff (1987), which defined the adequacy of life insurance as the dependent's highest sustainable standard of living after the death of a breadwinner is equal to or greater than the breadwinner or couple's (if married couple) highest sustainable standard of living if both survive. We equate standard of living with consumption, adjusted for household demographic composition. Much of the world's population is underinsured. A new study by Life Insurance Marketing and Research Association (2009) shows that forty-eight million United States household (44-percent) are underinsured. Mitchel (2007) who studied the adequacy of life insurance coverage in the United States showed that the most underinsured group are those with the largest need - married parents and single parents. These groups have 20- percent or less of the needed coverage. The cost of insurance is not a factor of underinsurance in the United States because the life insurance industry is highly competitive and insurance premiums are generally quite reasonable. Insurance agents and financial advisors, and the unpleasantness of thinking carefully about a person's death are the likely factor of life insurance inadequacy (Kotlikoff and Gokhale, 2002). In Australia, a research commissioned by AXA Australia and carried out by DEXX&R (Investment and Financial Services Association, 2005) has revealed that many Australians have less life insurance coverage that they need to protect their income and families. Life insurance cover of the average Australian is just 30-percent of that required equating to a massive 70-percent underinsured. Other alarming research conducted by Rice Walker Actuaries in 2005 on behalf of the Investment and Financial Services Association (2005) found that a staggering 60-percent of insured families in Australia have not got enough life insurance to look after their dependents for more than a year if they were to die. The research also showed that only 4-percent of Australian families with dependent children have an adequate level of life insurance cover. Most Singaporeans are also woefully underinsured. A study by Life Insurance Association of Singapore (2007) showed that the average Singaporean working adult is underinsured by 75-percent. This shows that while Singaporeans are purchasing savings and investment products, they are failing to get adequate protection coverage. They see insurance as expensive and believe there are more urgent necessities such as a car and credit card loans. Those were the key findings of the study commissioned by the Life Insurance Association of Singapore (LIA) to find out consumers' attitudes on insurance protection, and to determine the extent of underinsurance for death cover among working Singaporeans. According to James O Mitchel (2003), the amount of coverage carried by U.S. households is inadequate when compared to a human life value and a life insurance needs calculator. Households with dependents are particularly underinsured. Several reasons are suggested as a cause of the underinsurance. Cost is a common reason given for not owning adequate insurance, but analysis of actual premiums shows that it is a misperception. Lack of consumer education or inappropriate assumptions are more likely causes for being underinsured. John F. Elger (2003) on his study argue, few calculations made in the financial planning process are done as frequently and misunderstood as frequently as the determination of how much life insurance a person needs. Yet few financial planning steps can have as dire consequences for clients and so risk the reputation of the financial adviser as this one. Technology has both simplified this calculation and seemingly decreased the understanding of the theories behind it. Ways in which an adviser might use or misuse technology to improve the quality of the advice he provides are considered. There are at least 3 recognized conceptual bases for determining life insurance need. The most simplistic (and least supportable) is the multiple earnings approach. Of the remaining 2 approaches - the needs approach and the human life value approach - the needs approach is by far the more popular. The life insurance needs and calculations for a family of 5 are examined using electronic spreadsheets and online calculators. The penetration rate of life insurance in Malaysia is rather low, with only 18-percent of the population aged 18 and above owning some form of life insurance (Johnraj and Rohaizat, 2007). Even among these life insurance owners, it is not known how sufficient their coverage is or how large the shortfall of their existing coverage from their protection needs; and this becomes motivation of this study.
OBJECTIVES OF RESEARCH
3.1 By using current methods of scientific method (needs analysis and human life value) in estimating the amount of life insurance a person should carry, it would leave a person underinsured or over insured. This research will look into both methods and combine both concept of needs analysis and human life value to create a powerful methodology that provide adequate life insurance protection.
4.0 METHODOLOGY
4.1 Data
In order to realizing the method, we need breadwinner or insured's financial statement consists of his or her current assets and liabilities that provide net worth. Furthermore, his or her monthly and annual income and expenses data should be available. In addition, we need to know any other life insurance that he or her purchase including group insurance if available, any other college savings program, he or her social security program. The financial statement criteria will refer to Table 1: The Thomases' Financial Statement as Jerry D. Todd (2004) use in his study and we need only one reality data in Malaysia to be use in our study. So, we need to choose one suitable prospects and interview him to collect such information. The standard data such taxes (investment, income, goods and etc), inflation rate, house market value, dividend receive from investments, autos current market value, salary increment rate, retirement age or any others data will receive from statistics department, general banks, security commission, banks, utilities companies such Tenaga Nasional Berhad, Syarikat Bekalan Air Selangor, Astro and etc. After all, these standard data will be forecast for the next few years by using stochastic method. Some special data such dependent's age, number of dependent, type of current dependent whether normal or disable, dependent's health level ( smoker or non-smoker), or other should be gather upon interview. We need to know standard age to support children education fund until their tertiary level in Malaysia.
4.2 The Concept
We adopt the same benchmark as Bernheim et al. (1999) and also Auerbach and Kotlikoff (1987), which defined the adequacy of life insurance as the dependent's highest sustainable standard of living after the death of a breadwinner is equal to, or greater than the breadwinner highest sustainable standard of living if both survive. In order to measure life insurance adequacy, it is important to set benchmarks to which help us to know the range of adequacy. Therefore, we will set two benchmarks whether in lifetime predictions or present value. The two benchmarks call as floor and ceiling. Ceiling benchmark will indicate the highest dependent's sustainable standard of living equate to total household income if insured or breadwinner survive for certain period of time. Floor benchmark will indicate the lowest dependent's sustainable standard of living equate to household expenses and liabilities for certain period. The amount sum assured suggest to the policy owner should be between these ceiling and floor benchmark if he or she decide to maintain dependent's standard of living after the death of insured or breadwinner. If their sum assured less than floor benchmark, underinsured will occur where the dependents cannot maintain their standard of living after the death of insured or breadwinner under expenses and liability perspectives. If their sum assured more than ceiling benchmark, over insured occur. In other words, there is too much coverage if they plan to maintain their current standard of living even after the death of insured or breadwinner.
If the amount of sum assured in between floor and ceiling benchmarks, the life insurance needs are in adequate range. This will let dependents to maintain their standard of living under both perspective (total household income and expenses and liability). Previous studies have done many things to estimating life insurance adequacy around the world. Whether it is simplistic, scientific, theoretical, or practical to implement. A lot of study use present value in their methodology. Few forecast future tax rate, taxes, and other rates. We will examine scientific method done by Jerry D. Todd (2004): Integrative Life Insurance Need Analysis where we will include the idea to consider individual saving program and social security program, salary increment and household income (for working spouse). Now we need to consider the time constraints available. The time constrains would be what current age of insured and spouse (if she working) and other dependents in order to predict lifetime household income expenses and liability then discounted back to present value. We should consider other time constraint that is how long dependents will survive. Let say, we consider duration of money need to cover income replacement, expenses and liability 20 years from now but how about if dependents are predicted to survive until 2 years, why we need consider 18 years remaining in our calculation? It will let over insured or even underinsured (if the duration not tally with expected lifetime of dependents). Therefore, the core addition concept to previous studies, must under actuarial point of view should consider the probability of dependents survive for specific term. The reason for this purpose is given example below.
C
B
A
C
D
The above diagram indicates the concept of adequacy. Let A, B, C and D is beaker some filled with water. If water in A and B mixed up, the beaker C will indicate the total amount of water A and B. Now we want to fill beaker D from beaker C. Several questions regarding factors to influence the adequacy of water in beaker D come along, what amount of water in beaker C can be transfer to beaker D? What size of beaker D? What type of shape beaker D should be use? Is there any hole in beaker D that will make water lose out? Moreover, are there any time constraints to transfer the water from beaker C to beaker D? The perfect adequacy must satisfy these questions. If not, the even of inadequacy or over adequate (over load) will occur. Now let we interpret and translate the example to life insurance adequacy case below.
Let;
Beaker A = Indicate breadwinner income
Beaker B = Indicate spouse income
Beaker C = Indicate the total amount of household income
Beaker D = Fund need after the death of insured (breadwinner)
Let translating the questions;
1) What amount of water in beaker C can be transfer to beaker D? = How much fund need to cover dependents highest sustainable standard of living after breadwinner death?
2) What size of beaker D? = How many dependents involve?
3) What type of shape beaker D should be use? = What type of dependents to cover whether term or whole life purpose?
4) Is there any hole in beaker D that will make water leaking? = Is there any human factor such in improper fund management to control the fund?
5) Are there any time constraints to transfer the water from beaker C to beaker D? = Is it tally between duration of income that discounted back (present value) for specific time with duration of the income to be use by the dependents?
Since question number four is subjective and cannot control by us, we are only refer the remaining four questions for our study in order to the develop powerful method measuring adequacy of life insurance.
EXPECTED RESULT OR BENEFITS
5.1 New Scientific Method
This research contributes to a development of a scientific method to estimate the adequate amount of life insurance coverage especially in Malaysia.
Research Publications
The developed method in this project will be shared academically in the local and international conferences and will be submitted to journals for publication.
6.0 References
Auerbach, A.J. and Kotlikoff, L.J. (1987), Life Insurance of the Elderly: Adequacy and Determinants, NBER Working Papers 1737,National Bureau of Economic Research, Inc.
Bernheim, B. D., Forni, L., Gokhale, J. and Kotlikoff, L.J. (1999), The Adequacy of Life Insurance: Evidence from the Health and Retirement Survey, NBER Working Papers 7372, National Bureau of Economic Research, Inc.
Daily, G. S. (2000), Life Insurance Perspectives for Consumers. A paper presented at the Capital Strategies Conference in New York.
Investment and Financial Services Association (2005), Analysis of Life Insurance Needs. Cost of Underinsurance Project, Sydney.
Johnraj, D. And Rohaizat, Y. (2007), Status of the Private Health Insurance in Malaysia: A Nationwide Two-staged Stratified Random Sampling. A paper presented at the 3rd International Casemix Conference, Kuala Lumpur on the 14th November 2007.
Kotlikoff, L.J. and Gokhale, J. (2002), The Adequacy of Life Insurance, Working Paper No. RD72, TIAA-CREF Institute.
Life Insurance Marketing and Research Association (2009), The Facts of Life and Annuities. LIMRA International.
Mitchel, J. O. (2003), The Adequacy of Life Insurance Coverage in U.S. Households. Journal of Financial Service Professionals, 57(3), pp. 54-63.
Scarbrough, J.E. and Norris, G.A (1999), Balance of Life. Advisor Today, 94(1), pp. 68-77.
Jerry D. Todd (2004), Integrative Life Insurance Need Analysis, Vol. 58, Iss. 2; pg. 57, 10 pgs
