3.1 Purpose and Uses of Life Insurance

The Economic Purpose of Life Insurance

The fundamental purpose of life insurance is to create an immediate estate that replaces the economic loss a premature death imposes on others. When a wage earner dies, the income stream that supported a family, repaid a mortgage, or funded education ends abruptly. Life insurance substitutes a lump-sum (or income-stream) death benefit for that lost human earning capacity, transferring the financial consequence of death from the family to the insurer.

Life insurance solves a problem no savings plan can: the risk that death arrives before assets accumulate. A 30-year-old who intends to save $1 million over a career has nothing saved on day one - but a policy guarantees the full face amount from the first premium. This is why it is sometimes called 'the only asset that is fully funded the moment it is created.'

Insurable Interest - Timing Rule

For a life policy to be valid, the applicant must hold an insurable interest in the insured - a reasonable expectation of benefit from the insured's continued life, or of loss from the death. Critically, in life insurance insurable interest need exist only at policy inception, not at the time of death. A divorced ex-spouse who owned a valid policy on the former partner may still collect, because interest existed when the contract began.

Two Ways to Measure the Need

Producers determine how much coverage a client should buy using one of two recognized approaches.

Human Life Value (HLV)

HLV estimates the present value of future net income the insured would have earned and contributed to the family. The five steps are: (1) estimate annual income; (2) subtract taxes and the insured's own living costs to get the amount actually given to the family; (3) determine the years remaining to retirement; (4) select a discount rate; (5) compute the present value of that income stream.

Needs Approach

The needs approach totals the family's actual cash needs at death - final expenses, debt repayment, mortgage payoff, an income fund for survivors, and education funds - then subtracts existing resources such as savings, Social Security survivor benefits, and other policies. The gap is the recommended face amount. Because it credits assets the family already owns, the needs approach is generally more accurate and reduces the danger of over-insuring.

Worked Needs Example

Consider a household with the following figures:

Final expenses + debts        $40,000
Mortgage payoff              $300,000
Income fund for survivors    $500,000
Education fund               $160,000
= Total needs              $1,000,000
- Existing savings          ($90,000)
- Existing life insurance   ($150,000)
- Social Security lump fund  ($60,000)
= Additional coverage needed $700,000

The producer recommends roughly $700,000 of new coverage. Note how the needs approach nets out the $300,000 of resources the family already has - an HLV calculation that ignored those assets could have recommended close to $1,000,000, over-insuring the client and wasting premium dollars.

Exam trap: When a question stresses that existing assets and survivor benefits should be CREDITED against the amount of insurance, the answer is the needs approach. When it describes capitalizing future earnings into a present value, the answer is human life value.

Personal and Business Uses

Personal Uses

• Income replacement for dependents.
• Debt and mortgage cancellation so survivors keep the home.
• Estate liquidity to pay final expenses and estate taxes without forcing the sale of illiquid assets.
• Cash accumulation through the living values of permanent policies.
• Charitable giving by naming a charity as owner or beneficiary.

Business Uses

• Key person insurance - the business owns a policy on an essential employee and receives the proceeds to absorb the loss and fund a replacement search.
• Buy-sell funding - life insurance funds the purchase of a deceased owner's share. A cross-purchase plan has each owner insure the others; an entity (stock-redemption) plan has the business itself own one policy per owner.
• Executive bonus (Section 162) - the employer pays the premium on a policy the executive owns; the bonus is deductible to the employer and taxable to the executive.
• Deferred compensation - the employer informally funds a future benefit promise with life insurance.