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home / study / questions and answers / business / finance / your friend john asks you for advice concerning ... Question Your friend John asks you for advice concerning life insurance. John is 40 years old and graduated from law school last year. He currently earn $43,000 per year as a first year attorney. John is married and has two children, Billy, age 12, and Sarah, age 4. John's wife, Mary, is a professor who currently earn $56,000 per year. Mary is 38 years old. John and Mary pay $1,700 per month for their home mortgage, which will be paid off in 15 years. The interest rate on their mortgage is 3.5%. (Their current equity in the home is $50,000) The couple owns two cars, both 8 years old, and personal property( such as cloths, electronic, furniture, etc) valued $35,000. Their investments have been used up paying for John's law school education, so they currently have only $1,000 in savings and checking accounts, and $2,000 in a mutual fund. John has no life insurance. Mary has $125,000 of life insurance provided by her employer. Mary' pension plus social security are expected to total $65,000 per year, beginning when she is 67 years old. If John should die, Mary would receive approximately $12,000 per year from social security until Billy reaches age 18, and $6,000 per year after that until Sarah reaches age 18. Mary'semployer subsidizes 75% of family' healthcare costs, so the family only pays about $3,000 per year out of pocket. John and Mary spend most of their current income, although they do try to save about $50 per month. Their investments earn approximately 4% per year. Inflation is currently rather low at about 2% per year, but John wonders if it will increase after the Federal Reserve stops their expansive monetary policy. In addition to their home mortgage, John makes student loan payment of $400 per month. He plans to pay back the loan in 4 years and the loan' interest rate is 6% per year. Given that Mary enjoys a flexible work schedule, and because Mary' mother lives close by and watches the kids two days per week, they currently are not paying any child care expenses. John is worried about what may happen to his family is he should die. He is considering the purchase of life insurance and asks your advice. question: Assuming neither John nor Mary will receive large inheritance, how much life insurance do you think John needs on his life? (Use the needs approach.) Show all calculation and explain your answer. Make any assumptions you believe are reasonable, and make sure your assumptions are clearly stated. Also indicate the type of insurance you would recommend, whole life or term, and explain why. If you select term insurance, indicate the number of years of coverage to purchase
Explanation / Answer
Insurance requirements
Family’s Liabilities
Mortgage Loan = $ 237,801
Student Loan = $ 17,032
Child Care Expenses = $ 3,600
Children Education = $ 332,100
Medical Expenses = $ 30,000
Reserve Fund = $ 100,000 (assumed for home repairs, unforeseen exp., funeral expenses etc.)
Net Loss of John’s Income = $ 170,000
Total Liabilities & Future value of payments of the Family = $ 890,533 or $ 890,000 (rounded off)
Total Assets
Home Equity = $ 50,000
Value of investments = $ 3,000
Wife’s Insurance Policy = $ 125,000
Personal Property = $ 35,000
Amount receivable from social security = $ 95000
Total Assets & Present Value of receivables = $ 308,000
Net Difference = $ 890,000 - $ 308,000 = $ 582,000
This the amount for which John should take insurance ie., for $ 582,000.
As there will be social security payments for the wife after her retirement at the age of 67, it is better he take only a term policy for a period of 15 years as by that time both his children will complete their education, his home mortgage will be paid off and possibly both his children will start earning and does not need any support from the family.
In addition as the family currently does not have any savings, it is better if John take a policy with an element of savings involved instead of pure term policy.
Working and assumptions
Monthly payment = $ 1700
Rate of interest = 3.5% pa or 0.2916667% per month
Period remaining in mortgage = 15 years or 15*12 = 180 months
1700 = Loan amount * [((0.002916667) * (1+0.002916667)^180)) /((1+0.002916667)^180) -1)]
1700 = Loan amount * [((0.002916667) * (1.6891675)) /(1.6891675 -1)]
1700 = Loan amount * (0.004926738876/0.6891675)
Loan amount = 1700 /0.0071488264 = $ 237,801.26 or $ 237,801 (rounded off)
Student Loan
Monthly Payment = $ 400
Rate of interest = 6% pa or 0.5% per month
Expected repayment period = 4 years or 48 months
$ 400 = Loan amount * [((0.005)*(1+0.005)^48)/(1+0.005)^48 – 1)]
$ 400 = Loan amount * [(0.005 * 1.270489)/(1.270489-1)]
$ 400 = Loan amount * [0.0063524458/0.270489]
Loan Amount = $ 400 /0.023485 = $ 17032.116 or $ 17032 (rounded off)
Let us assume inflation rate will be 2.5% per annum after one year and continues at the same level throughout.
Let us assume per month child care expenses at $ 50 per child till they reach the age of 10
Child care expenses for Son = 0
Child care expenses for daughter = (10-4)*12 * $50 = $ 3600
Let us assume the educational needs of children are to be taken care upto an age of 20
Total number of years of education remaining for son = 20-12 = 8 years
Total number of years of education remaining for daughter = 20-4 = 16 years
Let us assume the average cost of education per annum is $ 10000 per child
Let us assume the educational expenses go up by 5% every year
Total expected education expenses of Son = $ 10000 * [(1+0.05)^8 – 1)/0.05]
= $ 10000 * [(1.477455-1)/0.05]
= $ 10000 * 9.5491
= $ 95,491 or $ 95,500 (rounded off)
Total expected education expenses of Daughter = $ 10000 * [(1+0.05)^16 – 1)/0.05]
= $ 10000 * [(2.182874-1)/0.05]
= $ 10000 * 23.65749
= $ 236,574.91 or $ 236,600 (rounded off)
Total Educational Expenses = $ 95500 + $ 236600 = $ 332100
Medical Expenses paid out of pocket = $ 3000 per annum
Number of years required is assumed till son gets an employment which covers the medical expenses of the family. Let us assume he gets employment one year after his education. That is out of pocket medical expenses are required for 8 years education + 1 year of unemployment =9 years at expected inflation rate of 2.5%
Total medical expenses for 9 years = 3000 * [(1+0.025)^9 – 1/0.025] = 3000 * (1.2488629-1)/0.025
= 3000 * 9.9545 = $ 29,863.55 or $ 30,000 rounded off
Amount receivable by Mary in case of John’s death till son attains 18 years = $12000
Number of years of receipt = 18- son’s current age = 18-12 = 6 years
Amount receivable after son attained 18 and till daughter attain 18 = $ 6000 per annum
Number of years for which $ 6000 received after son attains 18 = 18 - (daughter current age+number of years higher amount is received)
= 18-(4+6) = 18-10 = 8 years
Let us assume the investment rate of 4% for discounting the expected flows
Present value of $ 6000 annuity at the end of 6th years = $ 6000 * {(1-(1/(1+0.04)^8)/0.04]
= $ 6000 *{(1-(1/1.368569))/0.04]
= $ 6000 * [(1-0.73069)/0.04]
= $ 6000 * 6.73274
= $ 40,396.47 or $ 40,400 (rounded off)
Present value of cash flow for son and daughter = $ 12000*{(1-(1/(1+0.04)^6)/0.04] + $40400/(1.04)^6
Present Value of cash flow = $ 12000 * [(1-(1/1.265319)/0.04 + $ 40,400/1.265319
= $ 12000 * (1-0.7903145/0.04) + $ 40400 * 0.7903145
= $ 12000 * 5.2421 + $ 40400 * 0.7903145
= $ 62905 + $ 31929
= $ 94834 or $ 95000
Net Loss of John’s Income = $ 43000 (his current earnings) - $ 12000 (receiable from social security)
= $ 31000
Let assume that his salary increase by 2.5% which is expected inflation rate. Thus the net loss of income from John till his son gets a job (assuming he gets a similar paying job) would be
Present Value of Loss of Income = $ 31000 * {(1-(1/(1+0.0275)^6)/0.0275]
= $ 31000 * [(1-(1/1.1767684)/0.0275]
= $ 31000 * [1-0.8497849]/0.0275
= $ 31000 * 5.4623
= $ 169,333.37 or $ 170,000
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