3.1 Purpose and Uses of Life Insurance
Key Takeaways
- The core purpose of life insurance is replacing the economic value lost when an insured's income stops at death.
- The Human Life Value (HLV) approach measures the present value of an individual's future earnings net of self-maintenance.
- The Needs Analysis approach totals immediate cash needs plus ongoing income needs, then subtracts existing assets and coverage.
- Business uses include key person coverage, buy-sell funding, and creditor protection on business loans.
- Death proceeds paid in a lump sum to a named beneficiary are generally received income-tax-free under IRC Section 101(a).
Why Life Insurance Exists
Life insurance answers a single economic problem: a person's earning power can stop without warning, but the financial obligations that depend on that earning power do not stop. The contract transfers the financial consequences of premature death from the family or business to an insurer in exchange for premium.
A death benefit (also called the face amount) is the sum the insurer pays the beneficiary when the insured dies. Properly sized coverage lets survivors maintain their standard of living, retire debt, and meet future goals such as education. Exam questions frame this as the difference between an immediate cash need and an ongoing income need.
Personal Uses
Most individual policies are bought for one or more of these reasons:
- Income replacement for surviving dependents who relied on the insured's paycheck.
- Final expenses such as funeral costs, unpaid medical bills, and estate settlement fees.
- Debt liquidation including the mortgage, auto loans, and consumer debt so survivors are not forced to sell assets.
- Education funding to keep a child's college plan intact.
- Estate liquidity so heirs can pay settlement costs or federal estate tax without a forced sale of illiquid property.
A common rough guideline is coverage of 10 to 15 times annual income, but exam-correct sizing uses a formal method, covered below, rather than a multiplier.
Life insurance also creates value while the insured is alive. Permanent policies accumulate cash value that can supplement retirement income, fund an emergency, or collateralize a loan. Many policies add accelerated (living) benefit riders that advance part of the death benefit if the insured is diagnosed as terminally or chronically ill, turning the contract into a source of funds during a health crisis.
The Human Life Value (HLV) Approach
The Human Life Value (HLV) method treats a wage earner as an income-producing asset and measures the present value of future net earnings. "Net" means gross earnings minus the share the earner consumes on themselves (self-maintenance) and taxes, leaving the amount actually directed to the family.
Steps the exam expects:
- Estimate the earner's average annual income that benefits the family.
- Subtract self-maintenance, taxes, and personal expenses to get the annual amount available to dependents.
- Determine the number of working years remaining to retirement.
- Discount that stream to present value using an assumed interest rate.
Worked example
A 40-year-old earns $90,000. After taxes and self-maintenance, $55,000 per year supports the family. She has 25 working years left. The HLV is the present value of $55,000 per year for 25 years. At a 5% discount rate the present-value annuity factor for 25 years is about 14.09, so:
| Item | Value |
|---|---|
| Annual amount to family | $55,000 |
| Years to retirement | 25 |
| PV annuity factor (5%, 25 yr) | 14.09 |
| Human Life Value | $774,950 |
HLV is purely income-focused; it does not add final expenses or subtract existing assets. That is the job of the needs approach.
Because HLV ties the death benefit to earnings, the figure naturally falls as a person nears retirement and has fewer working years left to discount. It also rises with income and with a lower assumed discount rate. Underwriters use HLV as a sanity check on the amount applied for: a request far above the applicant's economically justified human life value can signal over-insurance or a lack of insurable interest.
The Needs Analysis Approach
The Needs Analysis (also called the Capital Needs or financial needs approach) builds the death benefit from the family's actual obligations rather than the earner's wage. It is generally the more thorough method and the one most exam questions favor for individual planning.
Formula: (Immediate cash needs + Ongoing income needs) − (Existing assets and in-force coverage) = Additional coverage required.
Worked example
| Category | Amount |
|---|---|
| Final expenses and debts (immediate) | $40,000 |
| Mortgage payoff (immediate) | $250,000 |
| Income fund: $48,000/yr for 18 years | $560,000 |
| College fund | $150,000 |
| Total need | $1,000,000 |
| Less: existing savings | ($120,000) |
| Less: in-force group life | ($150,000) |
| Additional coverage needed | $730,000 |
Key contrast for the exam: HLV starts with income and ignores assets; Needs Analysis starts with obligations and credits existing assets and coverage. Needs Analysis usually produces a more individualized figure.
Business and Estate Uses
Life insurance also solves problems that have nothing to do with a household budget.
| Use | How it works |
|---|---|
| Key person | The business owns the policy, pays premium, and is beneficiary on an essential employee; proceeds cushion lost revenue and replacement costs. |
| Cross-purchase buy-sell | Each owner insures the others; survivors use proceeds to buy a deceased owner's share. |
| Entity (stock-redemption) buy-sell | The business insures each owner and buys back the deceased owner's interest. |
| Business loan protection | A lender requires coverage equal to the loan so the debt is retired at death. |
| Estate liquidity | Proceeds pay estate settlement costs and federal estate tax, preserving illiquid assets. |
Tax note: A death benefit paid to a named beneficiary in a lump sum is generally income-tax-free under Internal Revenue Code (IRC) Section 101(a). If proceeds are left with the insurer and paid out in installments, the interest portion is taxable while the principal portion remains tax-free.
An applicant earns $80,000 per year, of which $50,000 supports his family after taxes and self-maintenance. He has 20 working years left. Which approach uses only this net-earnings stream, discounted to present value, to size the death benefit?
A beneficiary receives a $300,000 life insurance death benefit as a single lump sum. For federal income tax purposes, this payment is generally: