Insurance needs analysis - CFP Risk Management and Insurance Planning

Insurance needs analysis

Computing life insurance need by the human life value, needs (capital needs) and capital retention approaches, and disability or long-term care need from income replacement and cost figures, then reconciling the result with existing coverage and the client's budget.

Life insurance needs analysis

Practice question for this objective

Free sampleRisk Management and Insurance Planninghard

Daniel, aged 52, has asked his planner to size the capital his wife Ruth would need if he died this year. After allowing for Ruth's own earnings and the household costs that would stop at his death, the shortfall she would have to fund is 58,500 dollars a year in today's money, needed for 30 years and drawn at the BEGINNING of each year. The portfolio is expected to earn 7 percent a year in nominal terms, inflation is assumed at 3 percent, and the planner instructs that a real rate of 4 percent a year be used for all discounting. Daniel has told the planner that the capital sum must be left intact for their disabled son at the end of the 30 years. On that instruction, what capital sum is required at the start of the income period?

A1,052,047 dollars
B1,011,584 dollars
C835,714 dollars
D1,462,500 dollars Correct

Capital retention capitalises the income need at the real rate and preserves principal; capital liquidation spends principal and needs less capital. The two capital needs variants answer different questions. Capital liquidation asks what sum, drawn down to zero over the period, funds the income; capital retention asks what sum funds the income from earnings alone so the principal survives. Daniel's instruction that the capital pass to his son forces retention. Capitalising at the real rate gives 58,500 divided by 0.04, which is 1,462,500 dollars: the fund earns 4 percent in real terms, that 4 percent is withdrawn, and the principal keeps its purchasing power. The liquidation figure is smaller because the principal is being eaten: the ordinary annuity factor for 30 years at 4 percent is (1 minus 1.04 to the power of minus 30) divided by 0.04, which is 17.292033, and multiplying by 1.04 for beginning of year withdrawals gives 17.983715, so 58,500 times 17.983715 equals 1,052,047 dollars. The end of year version is 58,500 times 17.292033, or 1,011,584 dollars. Capitalising at the nominal 7 percent gives 58,500 divided by 0.07, or 835,714 dollars, which fails because the 3 percent inflation component of the return has to be retained rather than spent.

Why A is wrong: This is the capital liquidation answer, a 30 year annuity due at 4 percent. It is the correct method for a client happy to see the fund exhausted, but it leaves nothing at the end and so contradicts Daniel's instruction that the capital pass to his son.

Why B is wrong: This applies capital liquidation and also treats the withdrawals as arriving at the end of each year. It carries two errors: the fund is consumed rather than retained, and the stem states the withdrawals are taken at the beginning of each year.

Why C is wrong: This retains the capital but capitalises the income at the 7 percent nominal return rather than the 4 percent real rate. Drawing the full nominal return leaves nothing to reinvest for inflation, so the real value of both the income and the capital falls every year.

Why D is correct: Preserving the capital for the son means the income must be drawn from the return alone, which is the capital retention approach: 58,500 divided by the 4 percent real rate gives 1,462,500 dollars, and the principal survives the 30 years untouched.

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Exam traps in Risk Management and Insurance Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

Approximately 1,654,249 dollars
Why it is wrong: This is the right cash flow of 95,000 dollars a year discounted as an ordinary annuity, with the first payment assumed to arrive at the end of year one. The stem specifies payments at the beginning of each year, so the whole stream must be shifted forward one year by multiplying the ordinary annuity factor by 1.03.
The human life value method, because it works from the goals the survivors identify and so ties the sum insured to the amounts the family says it would actually spend after a death.
Why it is wrong: The method named is the one that fits this couple, but the reasoning describes the needs approach. Human life value is driven by the earner's income stream, not by an itemised list of survivor goals, so this option mislabels the mechanics it is recommending.

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