Purpose and Uses of Life Insurance
Life insurance serves as a critical financial tool that provides protection and security for individuals and families. Understanding the various purposes and applications of life insurance is fundamental to helping clients choose appropriate coverage.
The Fundamental Purpose
The primary purpose of life insurance is to provide financial protection against the economic consequences of death. When someone dies, their income stops—but the financial needs of dependents continue. Life insurance replaces lost income and provides funds to meet ongoing financial obligations.
Personal Uses of Life Insurance
Income Replacement
The most common reason people buy life insurance is to replace the income a breadwinner would have earned had they lived.
| Factor | Consideration |
|---|---|
| Current income | Annual earnings to be replaced |
| Years of income needed | Until dependents are self-sufficient |
| Inflation | Future purchasing power needs |
| Other income sources | Social Security, savings, spouse's income |
Rule of Thumb: Many financial advisors recommend coverage equal to 10-15 times annual income, though individual needs vary.
Final Expense Coverage
Final expenses include costs associated with death:
- Funeral and burial costs ($7,000-$15,000 average)
- Medical bills not covered by insurance
- Legal and estate settlement fees
- Outstanding debts
Debt Protection
Life insurance proceeds can pay off:
- Mortgage balance
- Auto loans
- Student loans
- Credit card debt
- Personal loans
This prevents survivors from inheriting debt obligations or losing the family home.
Education Funding
Parents often purchase life insurance to ensure their children's education will be funded even if they die prematurely. Proceeds can cover:
- Private school tuition
- College expenses
- Vocational training
Estate Planning Uses
Life insurance plays a critical role in estate planning for both modest and large estates.
Estate Liquidity
When someone dies, their estate may face immediate cash needs:
- Estate taxes (for taxable estates)
- Probate costs
- Administrative expenses
- Debts and final expenses
Life insurance provides instant liquidity—cash available immediately when other assets may take months to sell or liquidate.
Wealth Transfer
Life insurance allows wealth to transfer to heirs:
- Tax-efficiently: Death benefits are generally income tax-free
- Immediately: No waiting for probate
- Equitably: Can equalize inheritances among heirs
Estate Tax Payment
For large estates subject to federal estate taxes, life insurance can provide funds to pay these taxes without forcing the sale of illiquid assets like businesses or real estate.
| Estate Planning Use | Benefit |
|---|---|
| Liquidity | Immediate cash for estate expenses |
| Wealth transfer | Tax-free inheritance for beneficiaries |
| Estate equalization | Fair distribution among heirs |
| Estate tax funding | Preserve business/property assets |
Business Uses of Life Insurance
Life insurance is essential for business continuity and planning.
Key Person Insurance
Key person insurance (also called key man insurance) protects a business against the financial loss resulting from the death of an essential employee or owner.
How it works:
- The business purchases and owns the policy
- The business pays the premiums
- The business is the beneficiary
- Death proceeds help the business survive the loss
Key persons typically include:
- Owners and partners
- Top executives
- Employees with specialized skills
- Top salespeople
Buy-Sell Agreements
A buy-sell agreement is a legally binding contract that specifies what happens to a business interest when an owner dies, becomes disabled, or leaves the business. Life insurance funds these agreements.
| Type | How It Works |
|---|---|
| Cross-purchase | Each owner buys insurance on the other owners; survivors use proceeds to buy deceased's share |
| Entity purchase (Stock redemption) | The business buys insurance on each owner; business uses proceeds to buy back deceased's share |
| Hybrid | Combination of cross-purchase and entity purchase |
Business Loan Protection
Lenders often require business owners to carry life insurance equal to the loan amount. If the owner dies, the insurance pays off the debt.
Executive Bonus Plans (Section 162)
Employers can provide life insurance as a benefit to key executives. The employer pays the premium as a bonus, which is tax-deductible to the employer and taxable income to the employee.
Charitable Giving
Life insurance offers unique opportunities for charitable giving:
Methods of Charitable Giving with Life Insurance
| Method | Description |
|---|---|
| Name charity as beneficiary | Simple; donor retains ownership and control |
| Transfer ownership to charity | Premiums become tax-deductible donations |
| Create charitable trust | Complex planning for large gifts |
Benefits
- Make a larger gift than otherwise possible
- No reduction in current lifestyle
- Potential income tax deductions
- Create a lasting legacy
Key Takeaways
- Life insurance primarily provides income replacement and financial protection for dependents
- Final expenses including funeral costs and medical bills are immediate needs after death
- Estate planning uses include liquidity, wealth transfer, and estate tax payment
- Key person insurance protects businesses from the loss of essential employees
- Buy-sell agreements funded by life insurance ensure smooth business succession
- Life insurance can be used for charitable giving with potential tax benefits
The primary purpose of life insurance is to:
Key person insurance is designed to:
In a cross-purchase buy-sell agreement:
Which of the following is NOT considered a final expense?
4.2 How Life Insurance Works
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