2.1 Purpose and Need for Life Insurance
Key Takeaways
- Life insurance creates an immediate estate to replace the economic value a person provides to dependents.
- The Human Life Value (HLV) approach values the insured as an income-producing asset.
- The Needs Analysis approach totals specific obligations and subtracts existing resources.
- Common uses include income replacement, debt payoff, final expenses, estate liquidity, and business continuation.
- Death proceeds paid in a lump sum are generally received income-tax-free under IRC Section 101(a).
Life insurance answers a single economic question: when an income earner dies, where does the money come from to replace what that person would have provided? Death stops income, but it does not stop the mortgage, the grocery bill, or a child's tuition. Life insurance solves this by creating an immediate estate—a guaranteed sum payable the moment the insured dies, regardless of how few premiums were paid.
Why People Need Life Insurance
The exam tests several recurring personal and business uses. You must recognize each by its description:
| Use | What it covers |
|---|---|
| Income replacement | Wages the breadwinner would have earned |
| Final expenses | Funeral, burial, unpaid medical bills (often $7,000–$15,000) |
| Debt liquidation | Mortgage, auto loans, student loans, credit cards |
| Education funding | College or vocational costs for survivors |
| Estate liquidity | Cash to pay estate taxes and settlement costs without selling assets |
| Mortgage protection | Decreasing coverage tied to a loan balance |
A key tested fact: lump-sum death proceeds are income-tax-free to the beneficiary under IRC Section 101(a). The proceeds may, however, be included in the insured's gross estate for federal estate-tax purposes if the insured held any incidents of ownership at death.
Approach 1: Human Life Value (HLV)
The Human Life Value approach treats the insured as a depreciating income-producing asset. It estimates the present value of the income the insured would earn over the remaining working years, after deducting amounts the insured consumes personally (taxes, self-maintenance). The remainder—the dollars actually available to the family—is capitalized.
The four steps:
- Estimate average annual earnings to retirement.
- Deduct self-maintenance: income taxes, life/health premiums, and personal living costs.
- Determine the number of earning years remaining.
- Discount the net annual contribution to present value.
Worked example. A 40-year-old earns $80,000 a year and will work 25 more years. Personal taxes and self-maintenance consume $30,000, leaving $50,000 per year dedicated to the family. Ignoring discounting for a simplified exam figure, the family loses 25 × $50,000 = $1,250,000 of future support. That undiscounted figure is the Human Life Value. (When a discount rate is applied, the present value is lower—HLV always discounts future earnings to today's dollars.)
HLV's strength is objectivity; its weakness is that it ignores specific family needs and existing assets.
Insurable Interest and Consideration
Before coverage is issued, two legal threshold concepts apply. Insurable interest must exist between the policyowner and the insured at the time of application (unlike property insurance, where it must exist at the time of loss). A person always has insurable interest in their own life; spouses, dependents, business partners, and creditors (up to the amount owed) qualify as well. The applicant must also provide consideration—the first premium plus the statements in the application—for the contract to be valid.
Approach 2: Needs Analysis (Needs Approach)
The Needs Analysis approach is the more common method in practice and the one most tested for application. Instead of valuing the person, it totals the family's actual cash needs at death, then subtracts existing resources. The gap is the amount of insurance to buy.
Needs fall into two buckets:
- Immediate (lump-sum) needs: final expenses, an emergency/readjustment fund, debt payoff, mortgage retirement, education fund.
- Ongoing income needs: monthly support during the dependency period, the spouse's blackout period (the gap after Social Security child benefits end and before retirement survivor benefits begin), and retirement income.
From total needs you subtract existing assets: current savings and investments, existing life insurance, and Social Security survivor benefits.
Worked example.
| Item | Amount |
|---|---|
| Final expenses | $15,000 |
| Mortgage payoff | $250,000 |
| Other debts | $35,000 |
| Education fund | $120,000 |
| Income fund (capitalized) | $400,000 |
| Total needs | $820,000 |
| Less: existing savings | ($60,000) |
| Less: existing life insurance | ($150,000) |
| Less: Social Security survivor benefit value | ($110,000) |
| Additional insurance needed | $500,000 |
The family needs $500,000 of new coverage. Memorize the logic: Total Needs − Existing Resources = Coverage Gap.
HLV vs. Needs Analysis
| Feature | Human Life Value | Needs Analysis |
|---|---|---|
| Focus | The insured as an asset | The survivors' obligations |
| Inputs | Earnings, years, self-maintenance | Specific cash needs minus resources |
| Subtracts existing assets? | No | Yes |
| Best for | Quick estimate, litigation | Tailored, practical planning |
Common trap. HLV does not deduct existing assets or other insurance—Needs Analysis does. If a question subtracts current savings or Social Security, it is describing the Needs approach.
Business Uses of Life Insurance
The purpose-and-need topic also tests three business applications. Key person insurance protects a firm against the death of an essential employee: the business owns the policy, pays the premium, and is the beneficiary. A buy-sell agreement is funded with life insurance so surviving owners (cross-purchase) or the business itself (entity/stock-redemption) can buy a deceased owner's interest at a pre-agreed price. An executive bonus (Section 162) plan lets the employer pay deductible premiums on a policy the executive owns, treated as taxable compensation to the executive.
Exam Tip: In key person insurance the business—not the employee's family—is the beneficiary, because the business suffers the financial loss.
Under the Needs Analysis approach, after totaling all family financial needs the producer should:
A 45-year-old earns $70,000 per year, will work 20 more years, and consumes $30,000 annually in taxes and self-maintenance. Ignoring discounting, what is the simplified Human Life Value?