3.1 Purpose and Uses of Life Insurance
Key Takeaways
- Life insurance transfers the financial risk of premature death from the family to the insurer in exchange for premium.
- The Human Life Value (HLV) approach values the insured's future earnings; the Needs Approach totals specific obligations and subtracts existing resources.
- Personal uses include income replacement, final expenses, debt and mortgage payoff, and education funding.
- Business uses include key-person coverage, buy-sell funding, and executive bonus (Section 162) plans.
- Estate uses center on liquidity to pay taxes and costs so heirs need not sell illiquid assets at a loss.
Life insurance exists to solve a single problem: when a person who supports others dies, the income and economic value that person produced stops, but the financial needs of survivors continue. A life insurance policy is a risk transfer contract. For a relatively small, certain payment called the premium, the insurer assumes the large, uncertain financial loss caused by the insured's death and pays a death benefit (the face amount) to the beneficiary.
The Fundamental Purpose
The central purpose is financial protection against the economic consequences of dying too soon. Unlike most property coverage, life insurance does not restore a person, so it cannot truly indemnify (make whole) a survivor. Instead it pays a stated sum that the beneficiary uses to replace lost support, retire debts, and fund future goals.
Two Ways to Measure the Right Amount
Producers use two recognized methods to determine how much coverage a client needs. The exam tests the distinction sharply.
Human Life Value (HLV) Approach
Human Life Value estimates the present value of the insured's future earnings devoted to the family. The steps are:
- Start with annual earnings (for example, $80,000).
- Subtract the insured's own consumption, taxes, and the premium (say $30,000), leaving $50,000 of support each year.
- Multiply by the number of working years remaining (assume 25), then discount to present value.
A simplified, undiscounted estimate is $50,000 x 25 = $1,250,000. HLV treats the insured as an economic asset and is the basis for the "10-15 times income" rule of thumb.
Needs Approach
The Needs Approach (also called the needs analysis) adds up specific cash needs the death would create, then subtracts assets already available. The shortfall is the amount of insurance to buy.
| Step | Example |
|---|---|
| Final expenses (funeral, medical) | $20,000 |
| Debts + mortgage payoff | $250,000 |
| Education fund | $150,000 |
| Income replacement (capitalized) | $600,000 |
| Total needs | $1,020,000 |
| Less existing assets/insurance | ($220,000) |
| Additional coverage needed | $800,000 |
Trap: HLV focuses on the value of the person's earnings; the Needs Approach focuses on the obligations the death creates. Confusing the two is a common exam error.
Personal Uses of Life Insurance
- Income replacement keeps a household running after a wage earner dies and is the most common reason for purchase.
- Final expense coverage pays funeral, burial, and uncovered medical bills (often $7,000-$15,000).
- Debt and mortgage protection retires loans so survivors keep the home and do not inherit obligations.
- Education funding ensures children's tuition is paid even if a parent dies prematurely.
Business Uses of Life Insurance
- Key-person (key-employee) insurance: the business owns the policy, pays the premium, and is the beneficiary on a vital employee. Proceeds offset lost revenue and recruiting costs. Premiums are not tax-deductible, but the death benefit is generally received income-tax-free.
- Buy-sell agreement funding: life insurance provides cash so surviving owners can buy a deceased owner's share at a price fixed in advance. A cross-purchase plan has each owner insure the others; an entity (stock-redemption) plan has the business own the policies.
A third common business arrangement rewards a valued executive directly.
- Executive bonus (Section 162) plan: the employer pays a bonus the executive uses to fund a personally owned policy. The bonus is deductible to the employer and taxable income to the executive.
Estate Planning Uses
When someone dies, the estate often needs cash quickly for estate taxes, probate costs, and final debts, while the largest assets (a home, a business, land) may take months to sell. Life insurance supplies instant liquidity so heirs are not forced to sell illiquid property at a discount. Death benefits also transfer wealth income-tax-free and can equalize inheritances among children when one child receives an indivisible asset such as a family business.
Scenario: A farmer's estate is worth $4 million, almost all in land. Estate settlement costs and taxes total $400,000 due within nine months. Rather than sell acreage, the family uses a $400,000 life policy held in an irrevocable trust to pay the bill and keep the farm intact.
A producer values a client by estimating the present value of the income the client would have devoted to the family over a remaining 25-year career. Which approach is being used?
Under a key-person life insurance arrangement, which statement is correct?
Worked Numeric: Human Life Value vs. Needs Approach
The two methods for sizing coverage produce different numbers and the exam tests the logic of each.
Human Life Value (HLV) capitalizes future income lost to premature death. Example: a worker earns $80,000, spends $20,000 on self, leaving $60,000/year supporting the family for 20 remaining work years. A simplified HLV is roughly $60,000 x 20 = $1,200,000 (a present-value calculation lowers this somewhat).
Needs approach totals actual obligations instead of income. Example - add final expenses ($15,000) + mortgage payoff ($250,000) + education fund ($120,000) + income replacement ($600,000) = $985,000, then subtract existing resources (savings, group life, Social Security survivor benefits).
HLV answers 'what is this earner's economic value?'; the needs approach answers 'what specific gaps must be filled?' Business and estate uses (key-person, buy-sell funding, estate liquidity) build on the same sizing logic.