Steve Drummond, 35, currently earns $40,000 per year.

He expects that his

income will increase at the rate of inflation, which is expected to be 5% each
year. He intends to retire in 30 years at age 65. Assume that the real rate of
interest is expected to be 3% for the next 30 years.

Using the income approach, estimate the amount of life insurance that Steve
should buy.

PVA = Annual earnings (PVIFA n, k)

If Annual earnings = $40,000

n = 30 = years in the work force from now until retirement
k = 3% = real rate of interest
PVA = $784,018 = amount of insurance to buy
2) Suppose Steve dies and his beneficiary elects to receive the insurance
payout (of the face value determined in your answer to the previous
question) in the form of an annuity spread over 40 years
a) How much would annual payment of beneficiary be?
PVA = $548,812
n = 40 years = 40 periods
I = 3.00% / p.a.
k = 3.00% / period
PMT = [PVA/(PVIFAn,k)]
PMT = [$548,812/(PVIFA40, 3.00%)]
PMT = $23,743
b) What portion of each payment would be taxable to beneficiary?
Total payout over 40 years = $23,743 x 40 = $949,720
Face value of the policy (non-taxable) = $548,812
Term = 40 years

Taxable amount per year = [Total payout - Face value of the policy (nontaxable)]/Term
Taxable amount = ($949,720 - $548,812) / 40
Taxable amount = $10,023

3) What is the present discount rate of the insureds exoected future income?
Max Brownlie, 35, is currently earning $30,000 per year. He expects his
income will increase at the rate of infla-tion, which is expected to be 5%
every year. He intends to retire at the age of 65, 30 years from now. We want
to use the income approach to estimate the face-value amount of the life
insurance that Max should buy.
$30,000 x [1/0.03 - 1/.03(1.03)^ 30] or $588,000 after rounding . .

4 ) We can illustrate this effect with the Max Brownlie example again. Max
would have included the entire $30,000 in his calculation of taxable income.
His benefi-ciary will not include the $588,000 lump sum in income, but will
declare the inter-est on it each year. Suppose the beneficiary lives for 50
years more and uses the $588,000 to buy an annuity. The annual payment, in
real dollars, using a 3% real rate of interest, would be $22,853. The payments
the beneficiary will receive over the 50 years total 50 x $22,853 =
$1,142,650. The beneficiary thus receives ($1,142,650 -$588,000) =
$554,650 of taxable interest. To simplify matters, assume away the usual
declining balance factor of higher interest payments in the early years. The
beneficiary receives on average $554,650 +50 = $11,093 of income that has
to be reported for tax purposes. This amount will attract a lot less tax than
the $30,000 p.a. that Max was receiving. If the death benefit provides most of
the ben-eficiary's future income, the income taxes will be very low or zero.
5 )Billy Stieger, 35, is a mmmg engineer earning $60,000 per year. His wife
Nellie, also 35, works part-time as a secretary in an insurance company,
earning $20,000 per year. The current family expenditure is $45,000; but if
one of them dies, it is expected that the family expenses will fall to $35,000
per year. They expect their income and expenses will increase at the rate of
inflation. They want to buy enough life insurance so that in the event of
premature death, the surviving spouse will not suffer from a drop in the
standard of living
(a) What is the annual income shortfall if Billy or Nellie dies?

(b) Using the real rate of interest of 3% as the dis-count rate, what is the
amount of life insurance under the Expense Approach that the Stieger fam-ily
needs?
(a) The easiest way to deal with inflation is to use real dollars to measure
income and expenditure. If Billy dies, Nellie will still earn $20,000 in real dollars per year until she retires at, say, 65, and the family expenses will be
$35,000 in real dollars per year. Therefore, there will be an annual income
shortfall of ($35,000 -$20,000) or $15,000 in real dollars per year until age
65. If Nellie dies, Billy's income of $60,000 is more than enough to cover his
expected expenses of $35,000, so the annual income shortfall is zero.
(b) The Expense Approach assumes that the purpose of buying life
insurance is that in the event of pre-mature death, the surviving family does
not suffer from a fall in the standard of living. The amount of life insurance
coverage for Billy is the present value of $15,000 real dollars per year for (6535) or 30 years. This is equal to: $15,000 x [( ~3) -1 30] or $294,007 . .
03(1.03) If Nellie dies, there is no income shortfall, so the amount of life
insurance coverage for Nellie is zero.
in practice, many insurance advisors and financial planners adopt an approximate method to estimate the amount of life insurance under the expense
approach. This is done by dividing the average annual income shortfall by the
discount rate, and then multiplying the answer by an adjustment factor of
70% to 80%, say 75%. In Example 10.2, the amount of life insurance that
Billy should buy for himself is [($15,000) + (.03)](.75), which is equal to
$375,000.
6) Pure premium
Let us illustrate how the premium of annual term insur-ance would be
calculated. Suppose a male aged 35 wants to buy $200,000 of term
insurance for a year. The mor-tality rate of this specific group of people-35year-old males-is .108% (see Appendix B2).
In that case, the life insurance company expects to pay to the beneficiaries
on average an amount of: $200,000 X .00108 = $216
Premiums are paid at the beginning of the year, but benefits are paid
through-out the year. The insurance payout must be discounted for this
period. Let us assume that all benefits are paid at year end. If the appropriate
discount rate is 5%, the pure premium that must be charged is equal to ($216
+ 1.05) or $205.71. Finally, service costs (including profits) will be added to
the pure premium. If servicing costs are $35, then the final premium is equal
to ($205.71 + $35.00) or $240.71

What is the probability of a 35-year-old woman surviving to age 65? Answer:

At age 35 there are 98,695 women surviving out of the original 100,000. At
age 65 there are 90,899. The proba-bility of survival, given that the woman
has already reached 35, is: 90,899 + 98,695 = 92.1 %
We need this probability to calculate the present value of the expected future
payouts. We will not derive it formally, but use the following notation:
M the face amount of the insurance policy, i.e., the death benefit xP; the
probability that an individual aged x will survive i more years : on pic