John Wilson is a 42-year-old computer programmer, husband, and father of four. He wants to use the capital retention approach to determine how much life insurance he should purchase. Because of his $105,000 salary and their four children, his wife does not work outside the home. The family’s current annual living expenses are approximately $75,000, including $8,000 in annual IRA contributions. He prefers to use the capital retention approach (CRA) so that he can be reasonably assured that his family will not exhaust the proceeds of his policy. However, he also wants to consider the possible reduction in expenses and apply a 70% replacement ratio to the calculation.
a. Calculate John’s insurance need using the capital retention approach, an after-tax discount rate of 5.5%, and assume end-of period payment of benefits.
b. Calculate John’s insurance need using the human life value approach (HLV), an after-tax discount rate of 5.5%, a remaining working life of 25 years, and assume end-of period payment of benefits.
After your presentation, John was bewildered about why the HLV and CRA calculations resulted in significantly different insurance needs. Using the two formulas as a guide, explain to John why this result occurred.
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