3.1 Purpose and Uses of Life Insurance (Needs Analysis, Human Life Value)

Why Life Insurance Exists

Life insurance is a contract in which an insurer promises to pay a death benefit (the face amount) to a named beneficiary when the insured dies, in exchange for premium. Its core economic job is to transfer the financial loss caused by a premature death from a family or business to a pool of policyowners. The exam frames every product around one question: what need does the death benefit solve?

Life insurance addresses income replacement, final expenses (funeral, medical bills, estate settlement), debt liquidation (mortgage, loans), education funding, and estate liquidity so heirs are not forced to sell assets to pay estate taxes.

Personal Uses vs. Business Uses

Personal uses center on the household: replacing a breadwinner's income, paying off a mortgage, or leaving a legacy. Business uses are tested heavily:

• Key person insurance — the business owns the policy on a critical employee and is the beneficiary; it offsets lost revenue and recruiting costs if that person dies.
• Buy-sell agreements — funded with life insurance so surviving owners can buy a deceased owner's share. A cross-purchase plan has owners insure each other; an entity (stock-redemption) plan has the business own all policies.
• Executive bonus (Section 162) plans — the employer pays a bonus equal to the premium on a policy the employee owns; the bonus is deductible to the employer and taxable to the employee.

Human Life Value Approach

The Human Life Value (HLV) approach measures the present value of the insured's future earnings that would be lost to the family if the insured died. It treats the person as an economic asset.

Steps the exam expects:

1. Start with gross annual income.
2. Subtract the insured's own self-maintenance costs (food, clothing, personal taxes) to get the amount the family actually depends on.
3. Multiply that net contribution by the number of remaining working years.
4. Discount the total to present value using an assumed interest rate.

Worked example: Insured earns $80,000, spends $30,000 on self-maintenance, leaving a $50,000 net family contribution, with 20 working years remaining. The undiscounted HLV is $50,000 x 20 = $1,000,000. Discounting at a chosen rate produces a smaller present-value figure, but exam questions often accept the undiscounted product when no rate is supplied.

Needs Analysis Approach

The needs analysis (needs approach) is more granular than HLV. Instead of valuing the person, it adds up the dollars the survivors will actually need and subtracts the resources they already have. The gap is the recommended coverage.

The two often-tested survivor periods inside income replacement are the dependency (readjustment and blackout) period and the Social Security blackout period — the gap after the youngest child turns 16 (when the surviving spouse's Social Security benefit stops) and before the spouse reaches retirement age.

Risk, Insurable Interest, and Adverse Selection

For a policy to be valid, the applicant must have insurable interest in the insured at the time of application — a reasonable expectation of financial loss or a close family/economic relationship. Unlike property insurance, life insurance does not require insurable interest to continue at the time of the claim.

Adverse selection is the tendency of higher-risk individuals to seek insurance more aggressively. Insurers counter it with underwriting, medical exams, and rate classes. Confusing adverse selection with anti-selection is a common trap: they are the same concept.

Matching purpose to need, and the two valuation methods

Life insurance exists to transfer the financial loss of premature death. Its purpose in any case is matched to a specific need: income replacement, final expenses, debt payoff, education funding, or estate liquidity (paying taxes/costs so heirs need not sell assets). Two methods size the coverage:

Worked HLV example: A 40-year-old earns $80,000, consumes $25,000 on self-maintenance/taxes, leaving a $55,000 net family contribution. With 25 working years remaining (ignoring discounting for simplicity), the gross HLV is $1,375,000 — the present-value discount then lowers the final figure.

Insurable interest and business uses

Insurable interest for life insurance must exist at the time of application but need not exist at the time of claim — distinguishing it from property insurance. Individuals have unlimited insurable interest in their own lives and a recognized interest in spouses, certain family members, business partners, key employees, and debtors.

Key business uses the exam tests:

• Key person insurance: The business owns and is beneficiary of a policy on a vital employee, offsetting the loss of that person's contribution.
• Buy-sell agreements: Cross-purchase (owners each buy on the others) or entity (the business buys on each owner) — life insurance funds the purchase of a deceased owner's interest.
• Executive bonus (Section 162) plan: The employer pays a tax-deductible bonus that the executive uses to fund a personally owned life policy; the bonus is taxable income to the executive.

Trap: With insurable interest, the timing rule (application, not claim) explains why a divorced spouse can still collect as a named beneficiary on a policy bought during the marriage.