2.1 Purpose and Need for Life Insurance
Key Takeaways
- Life insurance creates an immediate estate that replaces lost economic value at death.
- The Human Life Value (HLV) approach measures the present value of future earnings net of self-maintenance and taxes.
- The Needs Analysis approach totals immediate cash needs plus income replacement, then subtracts existing assets.
- Risk is the chance of loss; insurance transfers the financial consequences of premature death to the insurer.
- Insurable interest must exist at the time of application, not at the time of loss.
Life insurance exists to solve a single financial problem: the economic loss a family or business suffers when a person dies prematurely. Unlike property losses, the death of a wage earner is certain to happen eventually but uncertain as to timing, and that uncertainty is exactly what makes the risk insurable. The exam expects you to articulate both why coverage is purchased and how much is appropriate.
The Risk Being Insured
Risk is the uncertainty regarding financial loss. Life insurance transfers the financial consequences of premature death from an individual to an insurer in exchange for premium. The death itself is not what is insured; the economic value the person represents to others is.
- Pure risk (only loss or no loss) is insurable; speculative risk (loss, no loss, or gain) is not.
- Insurable interest must exist when the policy is applied for. In life insurance it is presumed to exist between spouses, parents and children, and a business and a key employee, and it need NOT still exist at the time of death.
Trap: In property insurance, insurable interest must exist at the time of loss. In LIFE insurance it must exist only at policy inception. The exam loves this distinction.
Primary Uses of Life Insurance
| Use | What It Funds |
|---|---|
| Income replacement | Replaces the breadwinner's lost paychecks |
| Final expenses | Funeral, burial, unpaid medical bills |
| Debt liquidation | Mortgage, car loans, credit cards |
| Estate creation/conservation | Creates an instant estate; pays estate taxes |
| Education funding | Replaces money a parent would have provided |
| Business continuation | Buy-sell agreements, key person coverage |
Life insurance creates an immediate estate the moment the first premium is paid. A 30-year-old who pays one $40 premium and dies the next day may leave a $500,000 estate that did not exist before. No other financial product produces this leverage.
The Human Life Value (HLV) Approach
The Human Life Value approach measures a person as an income-producing asset. It calculates the present value of the insured's future earnings that would have supported the family, after subtracting the portion the insured would have consumed personally and paid in taxes.
Steps in HLV:
- Estimate the insured's average annual income for the remaining working years.
- Subtract personal expenses (self-maintenance), taxes, and the insured's own consumption.
- The remainder is the annual amount available to the family.
- Multiply that net amount across the remaining working years, then discount to present value.
Worked example. A 40-year-old earns $80,000 per year and plans to work 25 more years. Personal consumption and taxes total $30,000, leaving $50,000 per year for the family. Ignoring discounting for simplicity, the raw HLV is $50,000 x 25 = $1,250,000. Applying a present-value factor reduces this to a smaller figure because future dollars are worth less today, but the unadjusted figure shows the magnitude of the economic loss.
Exam Tip: HLV is earnings-based. It asks, "What is this stream of future income worth today?" It does NOT count specific debts or existing assets.
The Needs Analysis (Needs) Approach
While HLV values the person, the Needs Analysis approach values the family's actual obligations. It asks, "What will this family actually need, and how much is already provided?" It is the more client-centered method and is the dominant approach used by producers today.
Needs Analysis has two halves.
Immediate (Lump-Sum) Cash Needs
These are one-time costs payable at death:
- Final expenses (funeral, last illness)
- Outstanding debts (mortgage, loans, credit cards)
- Estate settlement costs and taxes
- An emergency/readjustment fund
Ongoing Income Needs
The family also needs replacement income for several periods:
- Dependency period income while children are at home
- Blackout period income for the surviving spouse (the gap between the youngest child turning 16 and the spouse's own retirement, during which Social Security survivor benefits stop)
- Retirement income for the surviving spouse
The Calculation
Total needs minus existing resources equals the coverage gap.
| Step | Item | Amount |
|---|---|---|
| 1 | Final expenses | $15,000 |
| 2 | Mortgage payoff | $250,000 |
| 3 | Other debts | $35,000 |
| 4 | Education fund | $120,000 |
| 5 | Income replacement (capitalized) | $600,000 |
| 6 | Total needs | $1,020,000 |
| 7 | Less: existing life insurance | ($200,000) |
| 8 | Less: savings & investments | ($120,000) |
| 9 | Additional coverage needed | $700,000 |
The producer recommends roughly $700,000 of new coverage to close the gap.
Trap: Needs Analysis SUBTRACTS existing assets and in-force insurance; HLV does not. If a question lists current savings and existing policies and asks you to net them out, it is testing the Needs approach.
Choosing Between the Methods
Both methods are accepted, but they answer different questions. HLV is quick and emphasizes the economic worth of the earner; Needs Analysis is detailed and produces a more precise, client-specific figure. A producer documenting a recommendation will usually run a Needs Analysis because it ties the face amount to identifiable obligations and existing resources, which supports a suitability file. HLV is useful as a sanity check and in business settings such as valuing a key employee.
Exam Tip: If a question gives you debts, an education goal, current savings, and in-force insurance and asks for "additional coverage needed," you are doing Needs Analysis. If it gives only income, working years, and personal consumption, you are doing HLV.
Under the Human Life Value (HLV) approach, which factor is subtracted from the insured's projected earnings before the amount is multiplied across the remaining working years?
In life insurance, when must insurable interest exist?