The Capital Needs Approach/ Capital Retention Approach is based on an end-needs analysis first, followed by an analysis to determine if current assets are sufficient to meet current and future income requirements.
It begins by putting a value on the assets of the individual's estate at death or determine whether needs can be met from existing resources, then obligations are determined i.e. meeting income needs with the earnings on a principal sum without liquidating that sum. It is appropriate for a client who wishes to meet the financial needs of surviving family members without the capital sum being depleted, and to leave an estate for heirs or charity.
This is much like the needs approach, but provides the surviving family with capital that earns income over time. This generally requires much more life insurance. If the owner of the policy cannot afford the capital retention approach, then it makes more sense to pay off debt, since debt usually incurs greater interest than can be safely earned from investments. In fact, paying off debt is like earning the interest that would otherwise be paid tax free.
Obligations are of two types:
final Expenses - Funeral, Legal Fees, Taxes, Debts, Mortgage.
Continuing Expenses for Dependents - Food, Medical and Dental Costs, Education Funding.
This approach relies on meeting with the earnings on a principal sum without liquidating that sum.
Appropriate only for those who wish to meet the financial needs of surviving family members without the capital sum being depleted and to leave an estate for heirs or charity.
Can also use a combination approach, liquidating some of the capital and retaining some of it.
Unlike the Needs Approach, which assumes liquidation of the life insurance proceeds, this approach preserves the capital needed to provide income to the family!
Prepare a personal balance sheet
Determine the amount of income-producing capital
Determine the amount of additional capital needed (if any)
The formula for the capital retention approach is a four-step process :
* C (cash needs) may show a positive number that indicates that assets exceed expenses, or a negative number indicating expenses exceed assets. If the cash needs are a positive number (a surplus), they are subtracted from the capitalized value. This is because cash is available to help meet costs on death. If there is a negative number (a deficit), they are added to the capitalized value. This is because there is not enough cash to help meet costs so this shortfall must also be accommodated by the life insurance.
The agent must consider all sources of funds when determining need. Group life coverage of the proposed life insured must be taken into consideration as an asset. The agent must ask if the policy includes a survivor income plan that pays a monthly income to survivors if the group member dies.
Similarly, if income needs are a negative number, then the shortfall forms the capitalized value of the life of the proposed insured. If there are no income needs, because continuing income exceeds continuing expanses, then insurance requirements will be based on cash needs at death.
Preserving capital requires a substantially larger capital sum than consuming it during the survivor's remaining lifetime, thus requiring a much higher insurance recommendation than the capital needs analysis approach.
for example; If Rs.1,00,000 per year of additional income is desired and the capital sum generating those income payments can realistically be expected to generate a 5 % return after taxes, Rs. 2 million fund will be at least required (Rs.100,000 ÷ 5 % = Rs. 20,00,000).
Refer exhibit 3, which is mentioning the steps for need analysis calculations in order to get the clarity of the approach.
Exhibit 3 : Steps for need analysis calculations
S.No.
Follow the steps for doing the Need Analysis
Step 1
You may use a combination of the two approaches, liquidating some of your client's capital and retaining some of it.
Step 2
with the capital-needs method, determine the amount of life insurance proceeds.
Step 3
Prepare a personal balance sheet.
Step 4
All the liabilities, immediate cash needs and assets that do not produce income, such as, residence are subtracted from total assets.
Step 5
The remainder is the present income-producing capital.
Step 6
Determine the amount of additional capital needed to meet the income objective by dividing the amount of additional income desired by the applicable rate representing the after-tax rate of investment return anticipated on the capital sum.
Estate Planning with Life Insurance
Life insurance is frequently used to provide cash for an estate.
Most large estates have most of their worth in the form of land, buildings, art, collectibles and so on-items that are not easily converted into cash.
However, any federal estate taxes must be paid within 9 months of someone's death and the decedent may have wished to make cash bequests, and to cover the expenses associated with the estate without liquidating any assets.
Frequently, the proceeds of the life insurance are paid into a trust. This Life Insurance Trust then purchases the assets in the estate, providing the estate with cash to pay expenses and provide for heirs, while maintaining the assets within the trust so that it can continue to earn income.
Another form of life insurance used in estate planning is the Survivor Life Insurance Policy (Second-To-Die Life Insurance) which insures both spouses, but pays the estate of the last spouse to die, since no estate tax is due when an estate transfers from the 1st spouse to the 2nd.
Taxation of Life Insurance
Generally, the payment of a life insurance policy to a beneficiary is not taxable.
However, if the beneficiary takes the proceeds as an annuity and the money not paid continues to earn interest, then the interest is taxable.
If a life insurance policy is sold by the owner for immediate cash-transferred for value-then, for the buyer, the difference between the cash value of the policy and the purchase amount is taxable when the policy is finally paid.
Dividends, Savings and accelerated Death Benefits
Participating life insurance policies pay dividends, which is not taxed. This is because the IRS (Internal Revenue Service) treats the dividends as a return of premium rather than earned income.
Many life insurance policies have a savings value that the owner of the policy can withdraw.
These policies have an adjusted cost basis which is equal to the sum of all premiums paid minus the sum of all dividends received.
If the amount of money withdrawn is greater than the adjusted cost basis, then the income is taxed as ordinary income.
Many policies also have an accelerated death benefit, which allows the insured to withdraw some of the death benefits when the insured is terminally ill.
Accelerated death benefits are fully excludable from income if the insured is a terminally ill individual, which is a person who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death within 24 months from the date of the certification.
Exhibit 4 : Needs Analysis Tools Available
According to a LIMRA (Life Insurance and Market Research Association) study, too many people today are under insured and life insurance ownership continues to decline. Nearly 1/3 of all women and more than 1/4 of all men have no life insurance at all.
To support our strong advocacy for meeting the need for life insurance among the middle market, certain websites provide a fundamental needs analysis tool for brokers. Online calculator is available asking, "How Much Life Insurance Do You Need?". In addition to the calculation tool, they also offer a corresponding fact finder that helps you gather the important and necessary information about the client to help estimate their life insurance needs. The fact finder can be emailed as a PDF document and printed for easy use. Each section of the fact finder has been structured to match the input fields on the calculator tool, providing for easy transfer of the data.
The end result is a printable, consumer friendly report summarizing the client's current assets, estimated expenses at the death of the breadwinner, and their potential life insurance shortfall.
Points to Ponder
The amount of life insurance needed depends on the family and their situation.
There are various methods at estimating the amount of life insurance to purchase.
The Human Life Value method simply calculates the present value of all earnings of the breadwinner that would have gone to the dependents.
The amount of these earnings would be the estimated amount earned from work or other sources, minus the amount that would be paid in taxes, and minus the amount that the breadwinner would keep for himself.
While the human life value method is one way to calculate the amount of life insurance needed, it is not very valuable. It makes more sense to calculate the amount that the financial dependents will need rather than what they would have gotten if the breadwinner had lived.
The needs calculation would involve estimating and providing a fund for all known expenses, and paying off all debt; then determine the amount of financial need after all debts have been paid off. It can be paid as a lump sum, or as income using a "Capital Retention Approach".
Some needs are temporary; others are permanent. As temporary needs are eliminated, the total amount of life insurance can be reduced.
Final Expenses, which include funeral expenses and unpaid medical bills.
A Debt Retirement Fund to retire all debt, including mortgages, credit card bills, and auto loans. Being debt-free will allow a family to live with less income.
An Income Fund provides an income to the surviving members of the family, which would be especially helpful if the surviving spouse would have to stay at home to care for children, or to pay for their care while the surviving spouse works.
An Education Fund to pay for the future education of children. The cost for a 4 year college education can easily be more than Rs.1,00,000, and this will no doubt continue to increase, probably faster than inflation as it has in the past.
An Estate Preservation Fund may be desirable for those which substantial estates that may incur high attorney fees, court costs, and taxes.
Once the needs have been determined, then other sources of income should be considered that would reduce the amount of life insurance needed. These would include social security benefits; benefits from other insurance policies, such as from work; investment income; and other possible sources of income, such as from a business that the deceased had an ownership interest.
The choice between capital liquidation and capital retention is not necessarily an all-or-nothing decision. You may use a combination of the two approaches, liquidating some of your client's capital and retaining some of it, as a compromise approach to filling the gap between the income needs of the survivors and the other available sources of income.
When we think of life insurance, people generally take the shotgun approach and randomly pick an amount of insurance they believe to be sufficient to support their dependents in the event of their death. However, choosing the correct amount of insurance requires an approach that determines exactly what needs should be met. By understanding what our needs are and how insurance can fill those needs, we can better determine how much insurance is coverage is sufficient.
When shopping for life insurance, the majority of people only considers their earnings and look to life insurance to replace their income should they die unexpectedly. In order to calculate the necessary life insurance required, a person should approach the life insurance selection process from a total needs approach. By utilizing the total needs application, the primary income provider in the household meets the needs of the family immediately upon death and needs in the future.
Immediate needs are those needs required to meet daily expenses such as the monthly mortgage, car payments, clothing and food. Transitional need are funds made available to beneficiaries for life changes in the absence of the breadwinner such as moving expenses should the family need to move to another location. The amount of debt owed is another consideration when determining the amount of life insurance needed. Debt elimination in many cases will be a major concern for the remaining spouse and life insurance should provide a way to eliminate all or a large portion of outstanding debt.
One of the most important applications of life insurance is spousal income over the life of the remaining spouse. In many cases one spouse earns many times more than the other spouse and maintaining their level of daily living is a considerable concern. Life insurance can be utilized as income replacement; however, careful consideration is needed when determining how much insurance is required to meet this individual need along with other needs and what is affordable to the family budget.
If a primary breadwinner has children, educational issues are another need to be considered when determining the total amount of life insurance needed. A college education is important and expensive. In this area when approaching needs, some people consider purchasing a separate life insurance policy to meet educational needs for their children. However, this need can also be met with one individual policy if careful planning is used to meet all needs.
But determining your life insurance needs by utilizing a total needs approach rather than just an income replacement approach. You can better protect your family in the event of death and help them remove unnecessary financial strain.
SELECTED REFERENCES
QUESTIONS FOR REVIEW AND DISCUSSION
Explain how the risk of disability differs from the risk of premature death.
Discuss the factors influencing the need to partially or fully replace a deceased's income for his or her surviving children and/ or spouse.
Describe the financial impact of premature death on different types of families.
Explain the relationship between the risk of premature death and superannuation.
What reasons can you suggest for providing a lifetime income to a spouse after any children have been raised ?
Establish a relation between the stages of life insurance of a person and calculation of insurance needs.
"The effect of the income loss occasioned by premature death depends on the circumstances". Describe a combination of circumstances in which the effect of income loss occasioned by premature death is insignificant.
"On first consideration, it might seem that the risk of income loss resulting from premature death is universal. After all, no one lives forever. But death does not automatically result in financial loss ". Explain why do you agree or disagree with this statement.
It is often stated that one of the most neglected areas in the life insurance field is that of insurance on the homemaker spouse. In facing the risk-management decision regarding life insurance for the family, where do you think that life insurance on a spouse who is not employed outside the home should fit ?
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