3.1 Purpose and Uses of Life Insurance
Key Takeaways
- The core function of life insurance is to replace the economic value lost when an income earner dies.
- The needs analysis approach totals specific cash needs and ongoing income needs, then subtracts existing resources.
- The human life value approach capitalizes future net earnings to estimate an economic worth.
- Personal uses include income replacement, final expenses, debt and mortgage payoff, and education funding.
- Business uses include key person coverage, buy-sell funding, and Section 162 executive bonus plans.
Why Life Insurance Exists
Life insurance answers a single economic problem: a person's earning power can vanish in an instant, but the people and obligations that depend on it do not disappear. The policy converts the uncertain risk of premature death into a certain, manageable cost (the premium) and delivers a lump sum exactly when survivors need it most.
Unlike most assets, the death benefit is created the moment the first premium is paid. A 30-year-old who buys a $500,000 policy and dies after one $40 monthly payment leaves a half-million-dollar estate. No other financial product produces that leverage on day one.
Two Ways to Measure the Need
Producers size coverage two ways. The exam expects you to know the logic of each and when each applies.
The Needs Analysis (Needs Approach)
The needs analysis adds up the specific dollars a family will require, then subtracts what already exists. It separates one-time cash needs from ongoing income needs.
| Category | Examples |
|---|---|
| Immediate cash needs | Funeral and burial, final medical bills, probate and legal fees |
| Debt elimination | Mortgage balance, auto loans, credit cards, student loans |
| Income replacement | Monthly support for dependents until self-sufficient |
| Special needs | College funding, emergency fund, care for a disabled child |
Worked example. A client wants $15,000 for final expenses, $250,000 to retire a mortgage, $150,000 for college, and $600,000 to fund 15 years of income. Total need = $1,015,000. Existing resources are $200,000 in savings and a $100,000 group policy. Coverage gap = $1,015,000 minus $300,000 = $715,000 of additional insurance.
The Human Life Value (HLV) Approach
The human life value approach treats a worker as an income-producing asset and estimates the present value of future earnings the family would lose.
The four steps are:
- Estimate average annual net earnings (gross pay minus taxes and the worker's own living costs).
- Determine the number of working years remaining to retirement.
- Select a reasonable discount (interest) rate.
- Capitalize the income stream into one present-value lump sum.
Worked example. A 40-year-old nets $50,000 a year after taxes and self-maintenance, with 25 years to retirement. Ignoring discounting for a rough estimate, $50,000 multiplied by 25 = $1,250,000 of human life value. Discounting future dollars to present value lowers that figure, but the method shows the asset's order of magnitude.
Exam contrast: Needs analysis starts from what survivors must spend; human life value starts from what the breadwinner would have earned. Needs analysis is generally considered more precise for an individual family.
Personal and Family Uses
| Use | What the proceeds accomplish |
|---|---|
| Income replacement | Maintains the family's standard of living after a wage earner dies |
| Final expenses | Pays funeral costs and unreimbursed medical bills, often $7,000 to $15,000 |
| Debt and mortgage payoff | Keeps survivors in the home and free of inherited debt |
| Education funding | Guarantees college dollars even if a parent dies early |
| Survivor income | Bridges the gap until Social Security or a spouse's earnings cover needs |
A common rule of thumb is coverage equal to 10 to 15 times annual income, but the exam treats rules of thumb as starting points, not substitutes for an analysis.
Business Uses
Key Person Insurance
Key person (key employee) insurance protects a firm against the loss of an essential owner or employee. The business applies for, owns, pays for, and is the beneficiary of the policy. Proceeds offset lost revenue and the cost of recruiting a replacement. Premiums are not tax-deductible, but the death benefit is generally received income-tax-free.
Buy-Sell Funding
A buy-sell agreement binds owners to transfer a deceased owner's share at a set price; life insurance supplies the cash.
| Structure | Who owns the policies |
|---|---|
| Cross-purchase | Each owner insures the other owners individually |
| Entity (stock redemption) | The business owns one policy on each owner |
With four owners, a cross-purchase plan needs 12 policies; an entity plan needs only 4. That contrast is a frequent exam point.
Executive Bonus (Section 162) Plans
Under a Section 162 executive bonus plan, the employer pays a bonus that funds a personally owned policy on a key executive. The bonus is tax-deductible to the employer and taxable income to the executive, who owns the policy and names the beneficiary.
Estate Uses
Death benefits create liquidity so heirs can pay estate settlement costs and any federal estate tax without a forced sale of a home, farm, or business. Properly structured (often through an irrevocable trust), the proceeds transfer wealth quickly, outside probate, and free of income tax.
An applicant nets $60,000 per year after taxes and personal expenses and has 20 working years remaining. Using a simple, non-discounted human life value estimate, how much economic value would the family lose at death?
Four equal owners want a buy-sell plan in which each owner personally owns a policy on every other owner. How many policies does this cross-purchase arrangement require?