2.1 Purpose and Need for Life Insurance
Key Takeaways
- Human Life Value values the breadwinner's future earnings: (income minus self-maintenance) times working years remaining.
- Needs Analysis totals family needs (final expenses, debts, income replacement, education) and subtracts existing resources to find the coverage gap.
- A life policy protects against dying too soon; an annuity protects against living too long (outliving assets).
- Business uses include key-person coverage, buy-sell funding, and estate liquidity to pay settlement costs and estate taxes.
Life insurance exists to solve one problem: when an income earner dies, the paycheck stops but the bills do not. The policy converts the insured's future earning capacity into an immediate, income-tax-free pool of cash (the death benefit) payable to the named beneficiary. Producers must be able to quantify how much coverage a client needs, not just sell a round number, and the exam tests two formal methods: the Human Life Value approach and the Needs Analysis approach.
The Two Sides of Risk
Mortality risk has two faces. Dying too soon leaves dependents without income, which life insurance covers. Living too long risks outliving savings, which annuities cover. A life policy and an annuity are mirror images: a life policy creates an estate at death, an annuity liquidates an estate during life.
Human Life Value (HLV)
The Human Life Value approach measures the economic value of the breadwinner's future earnings to the family. It treats the insured as a wage-producing machine and asks: what is the present value of the income the survivors lose at death?
Steps for the HLV calculation:
- Start with gross annual income.
- Subtract the insured's own self-maintenance costs (food, clothing, taxes the insured used on themselves).
- Result is the annual income contributed to the family.
- Multiply by the number of working years remaining to retirement (or discount to present value).
Worked HLV Example
| Item | Amount |
|---|---|
| Gross annual income | $80,000 |
| Less self-maintenance (taxes, personal use) | $30,000 |
| Net annual contribution to family | $50,000 |
| Years to retirement (age 40 to 65) | 25 |
| Simple HLV (undiscounted) | $1,250,000 |
The simple version multiplies the $50,000 contribution by 25 years for $1,250,000. A present-value version discounts that stream at an assumed interest rate, producing a smaller figure because future dollars are worth less today. Trap: HLV ignores the family's actual needs and existing assets; it only values lost earnings.
Needs Analysis
The Needs Analysis (or needs approach) is the more thorough method preferred for personal planning. Instead of valuing the earner, it adds up what the surviving family will actually need and subtracts resources already available.
Common needs grouped as immediate (cash) needs and ongoing (income) needs:
- Final expenses (clean-up fund): funeral, medical bills, estate settlement costs.
- Debt liquidation: mortgage, car loans, credit cards.
- Emergency reserve: typically several months of expenses.
- Income replacement: monthly income for the surviving spouse and a dependency period for children.
- Special needs: college education fund, special-care dependents.
- Readjustment period: income during the months after death while the family adjusts.
From total needs, subtract existing resources: current savings, existing life insurance, Social Security survivor benefits, and the spouse's earning ability. The remainder is the insurance gap the new policy must fill.
Needs Analysis Worked Example
A client has the following picture. Compute the additional coverage required.
| Category | Amount |
|---|---|
| Final expenses | $15,000 |
| Mortgage payoff | $200,000 |
| Other debts | $25,000 |
| Education fund | $120,000 |
| Income replacement (lump sum) | $400,000 |
| Total needs | $760,000 |
| Less: existing life insurance | $100,000 |
| Less: liquid savings | $60,000 |
| Total resources | $160,000 |
| Coverage gap (need new policy for) | $600,000 |
The client needs $600,000 of new coverage. Note how the needs approach can produce a lower or higher figure than HLV depending on assets and obligations — the methods are not interchangeable.
Other Recognized Uses
Beyond family protection, life insurance funds business needs: key-person coverage (the business owns the policy on a vital employee), buy-sell agreements (funding the purchase of a deceased owner's share), and executive bonus plans. It also provides estate liquidity so heirs can pay estate taxes and settlement costs without forced sale of illiquid assets like real estate or a family business.
Comparing the Two Methods
Expect questions that force you to pick the right method for a fact pattern. The Human Life Value approach is fast and earnings-based; it is favored in litigation and wrongful-death valuations because it objectively capitalizes lost wages. The Needs Analysis approach is client-centered and produces a tailored figure, so it is the standard for personal financial planning. HLV can overstate coverage for a family with substantial assets and understate it for a family with heavy debts and young children; needs analysis self-corrects for those facts because it explicitly nets out resources and adds obligations.
The Time-Value Caveat
A discounted HLV is always smaller than the simple multiplication because future earnings are discounted to present value at an assumed interest rate. If a question supplies an interest rate or asks for present value, do not simply multiply income by years — that yields the undiscounted figure.
Conversely, when a needs analysis assumes survivors will invest the lump sum and live off the earnings (the interest-only method), the required principal is the annual income need divided by the assumed rate. For example, a $40,000 annual income need at a 5% assumed return requires $800,000 of principal ($40,000 / 0.05). These rate-driven calculations are common exam traps because candidates forget to divide or discount.
An applicant earns $80,000 per year, spends $30,000 on self-maintenance, and has 25 working years remaining. Using the simple (undiscounted) Human Life Value method, what is the value of his life?
Under the needs analysis approach, which of the following is SUBTRACTED from total family needs to find the amount of new insurance required?