3.1 Purpose and Uses of Life Insurance
Key Takeaways
- The human life value approach measures the present value of the insured's lost future contribution to the family, net of personal consumption.
- The needs analysis approach itemizes survivor obligations (final expenses, debts, income, education) and subtracts existing resources.
- Always subtract existing resources in needs analysis and personal consumption in HLV; failing to do so overstates the coverage figure.
- Key person insurance protects a business from an employee's death; buy-sell agreements fund ownership transfer (cross-purchase vs. entity).
- Life insurance also provides estate liquidity and can fund charitable gifts.
Life insurance exists to solve a single financial problem: the premature death of a person whose income or services others depend on. When the insured dies, the policy pays a death benefit (also called the face amount) to the named beneficiary, replacing lost economic value with cash. On the national licensing exam, you must be able to identify why a client needs coverage before recommending how much.
The two foundational methods for quantifying need are the human life value approach and the needs analysis approach. Memorize the distinction: human life value measures the insured's economic worth, while needs analysis measures the survivors' cash requirements.
Human Life Value Approach (HLV)
The human life value (HLV) approach estimates the present value of the income a wage earner would have produced over a working lifetime, then deducts amounts the earner would have spent on themselves (taxes, personal consumption, the earner's own insurance premiums). What remains is the economic contribution the family loses at death.
Four factors drive HLV:
- Current and projected annual earnings
- Years remaining until retirement
- Estimated personal consumption (subtracted out)
- A discount/interest rate used to find present value
Worked HLV Example
A 40-year-old earns $80,000 per year. After taxes and personal expenses, she contributes $50,000 annually to her family. She plans to work 25 more years. Ignoring the time-value discount for a simple gross estimate:
| Item | Value |
|---|---|
| Annual contribution to family | $50,000 |
| Years to retirement | 25 |
| Gross human life value | $1,250,000 |
The exam may ask for the contribution figure (net of personal consumption), not gross salary. Trap: candidates multiply the full $80,000 by 25 ($2,000,000) and get it wrong. HLV uses the amount the survivors actually lose, after the insured's own consumption is removed.
Needs Analysis Approach
The needs analysis (also called needs approach) method adds up the specific dollar obligations survivors face and subtracts existing resources. It is generally considered more accurate than HLV because it is itemized rather than formula-driven.
Common categories tested:
- Final expenses — funeral, burial, and unpaid medical bills (an immediate, lump-sum need)
- Debt liquidation — credit cards, auto loans, the mortgage
- Income replacement — ongoing support for dependents until self-sufficient
- Education fund — college costs for children
- Emergency/readjustment fund — cushion during the transition period
Needs Analysis Worked Example
A family lists the following needs and resources at the breadwinner's death:
| Needs | Amount |
|---|---|
| Final expenses | $15,000 |
| Mortgage payoff | $250,000 |
| Education fund | $120,000 |
| Income replacement (10 yrs) | $400,000 |
| Total needs | $785,000 |
| Existing resources | Amount |
|---|---|
| Savings | $40,000 |
| Existing group life | $100,000 |
| Social Security survivor benefit (PV) | $145,000 |
| Total resources | $285,000 |
Additional coverage needed = $785,000 − $285,000 = $500,000. The exam rewards subtracting existing resources; forgetting to do so overstates the recommendation.
Business and Estate Uses
Beyond personal protection, life insurance funds business continuity and estate liquidity:
- Key person (key employee) insurance — the business owns the policy and is the beneficiary, protecting against the loss of an employee whose death would reduce profits.
- Buy-sell agreements — premiums fund the purchase of a deceased owner's interest. A cross-purchase plan has owners insure each other; an entity (stock-redemption) plan has the business own the policies.
- Estate liquidity — proceeds pay estate taxes and settlement costs so heirs need not sell illiquid assets like real estate or a family business.
- Charitable giving — naming a charity as owner/beneficiary creates a future gift, sometimes with current tax advantages.
A client earns $90,000 annually but spends $30,000 on personal taxes and consumption. She will work 20 more years. Using a simplified human life value calculation that ignores discounting, what is her gross human life value?
When a corporation purchases life insurance on a top executive, names itself as both owner and beneficiary, and intends to use any proceeds to offset lost profits and recruiting costs, this arrangement is BEST described as:
Personal, Business, and Survivor Uses Summarized
Beyond income replacement, the exam expects you to match a fact pattern to the correct use of life insurance:
| Use | What the death benefit accomplishes |
|---|---|
| Final expenses | Funeral, medical, and estate-settlement costs |
| Mortgage / debt protection | Pays off a home loan or other debt so survivors keep the asset |
| Education funding | Replaces a parent's contribution to children's schooling |
| Estate liquidity | Cash to pay estate taxes and avoid forced sale of illiquid assets |
| Key person | Reimburses a business for losing a vital employee |
| Buy-sell funding | Provides cash for surviving owners to buy a deceased owner's share |
Survivor-needs scenario: A widow has immediate needs (the cleanup/blackout fund for final bills and the readjustment period), ongoing dependency-period income until children are grown, and a later retirement gap once Social Security survivor benefits stop and her own retirement begins. A complete needs analysis prices each phase separately, then subtracts existing assets and other coverage to reach the recommended face amount.
Trap: Human Life Value measures the economic worth of the wage-earner; needs analysis measures the family's actual cash requirements. The two methods can produce very different figures for the same client.