2.1 Purpose and Need for Life Insurance
Key Takeaways
- Human Life Value measures the present value of an insured's future earnings lost to dependents.
- The needs approach totals survivor obligations (debts, income, education, final expenses) and subtracts existing resources.
- HLV ignores debts and final expenses; the needs approach is generally more accurate.
- The blackout period is the gap when a surviving spouse receives no Social Security survivor income.
- Business uses include key person, buy-sell funding, and estate liquidity.
Life insurance exists to replace the economic value a person provides to others. When the insured dies, the policy delivers a lump-sum death benefit (the face amount) to named beneficiaries, converting an unpredictable financial catastrophe into a predictable, funded outcome. The exam tests why coverage is needed and how much is appropriate, using two standard quantification methods: the Human Life Value (HLV) approach and the Needs Analysis (needs approach) method.
Human Life Value (HLV)
The Human Life Value approach measures the present value of an individual's future earnings that would be lost to the family if the insured died today. It treats the wage earner as an income-producing asset.
The simplified calculation:
- Start with annual income the insured contributes to the family.
- Subtract the insured's self-maintenance costs (taxes, personal expenses) to isolate the amount actually supporting dependents.
- Multiply the net annual contribution by the number of working years remaining until retirement.
- Discount the result to present value (because a dollar received in the future is worth less than a dollar today).
Worked HLV Example
A 40-year-old earns $90,000 per year and plans to work 25 more years. Personal expenses and taxes consume $30,000, leaving $60,000 contributed annually to the family.
| Step | Figure |
|---|---|
| Gross income | $90,000 |
| Less self-maintenance | -$30,000 |
| Net annual contribution | $60,000 |
| Years to retirement | 25 |
| Undiscounted value | $1,500,000 |
A simple (undiscounted) HLV is $60,000 x 25 = $1,500,000. When discounted to present value at an assumed rate, the figure is lower, but exam questions often use the undiscounted multiplication to test the concept.
Trap: HLV ignores debts, final expenses, and survivor goals. It values only lost income, not the family's actual needs. That is why most planners prefer needs analysis.
The Needs Analysis (Needs Approach)
The needs approach calculates the actual dollar amount survivors require, then subtracts assets already available. It is more precise than HLV because it counts obligations the income-replacement method ignores.
Common needs (cash and income)
- Final expenses (the "clean-up fund"): funeral, burial, medical bills, estate-settlement costs.
- Debt liquidation: mortgage, auto loans, credit cards.
- Income replacement: ongoing support for the dependency period (until children are self-supporting) and the surviving spouse's blackout period (the gap between when Social Security survivor benefits stop and when the spouse's own retirement benefits begin).
- Education fund: projected college costs.
- Emergency reserve: typically several months of household expenses.
Existing resources subtracted
- Current life insurance in force
- Savings, investments, and retirement accounts
- Social Security survivor benefits
- Spouse's earning capacity
Worked Needs-Analysis Example
| Need | Amount |
|---|---|
| Final expenses | $15,000 |
| Mortgage payoff | $250,000 |
| Other debts | $35,000 |
| Income replacement (10 yrs x $50,000) | $500,000 |
| Education fund | $120,000 |
| Total needs | $920,000 |
| Less existing insurance | -$200,000 |
| Less savings/investments | -$120,000 |
| Additional coverage needed | $600,000 |
The recommended new policy is $600,000. Notice the method nets out resources the family already controls, producing a tighter recommendation than HLV.
Personal vs. Business Uses
Life insurance funds several business needs. Key person coverage is owned by and payable to the company on a vital employee, cushioning lost revenue and recruiting costs at that person's death.
Buy-sell agreements use insurance to fund the purchase of a deceased owner's share. In a cross-purchase plan each owner insures the others; in an entity (stock-redemption) plan the business owns policies on each owner. Executive bonus (Section 162) plans let an employer pay premiums on a personally owned policy as taxable compensation.
On the personal side, life insurance provides estate liquidity so heirs can pay estate taxes, debts, and settlement costs without forced sales of illiquid assets such as a home or a closely held business.
Factors Affecting the Amount of Coverage
When recommending a face amount, producers weigh income level and stability, number and ages of dependents, outstanding debt (especially a mortgage), existing coverage and assets, and the client's budget. A young family with a new mortgage and small children needs far more income-replacement coverage than an empty-nester whose primary goal is final expenses and estate liquidity. Reassessing coverage after marriage, a birth, a home purchase, or a major raise keeps the plan aligned with actual need.
How the Death Benefit Is Funded
Life insurance works by pooling risk and the law of large numbers. Many insureds pay premiums; the relatively few who die in a given year are paid claims from the pool. Each premium is built from the mortality cost (the pure cost of insurance based on the probability of death at the insured's age), expense loading (administration, commissions), and an interest assumption that credits the insurer's investment earnings.
Principle of Indemnity Does Not Apply
Unlike property insurance, life insurance is valued (not indemnity) coverage. A human life has no objective market value, so the policy pays a stated face amount rather than reimbursing a measured loss.
Insurable interest must exist at the time of application. A person has unlimited insurable interest in their own life; others (a spouse, a creditor, a business partner) must show a financial or close-family relationship. Unlike property insurance, insurable interest need not exist at the time of the claim.
An insured earns $80,000 annually, spends $20,000 on personal expenses and taxes, and plans to work 20 more years. Using the simple (undiscounted) Human Life Value method, what is the approximate human life value?
Which factor is considered by the needs approach but NOT by the human life value approach?