2.1 Purpose and Need for Life Insurance (Human Life Value, Needs Analysis)
Key Takeaways
- Life insurance creates an immediate estate that replaces the economic value lost when a breadwinner dies.
- The Human Life Value (HLV) approach measures the present value of an insured's future net earnings to survivors.
- The Needs Analysis approach totals specific survivor obligations, then subtracts existing assets and in-force coverage.
- Insurable interest in a life policy must exist at the time of application, not at the time of death.
- Common business uses include key person coverage, buy-sell funding, and executive bonus (Section 162) plans.
Why Life Insurance Exists
Life insurance solves a single economic problem: the premature death of a person whose earnings, services, or capital others depend on. When that person dies the income stream stops, but the obligations do not. Life insurance converts a stream of small premium payments into an immediate estate — a lump sum available the moment a claim is paid, regardless of how few premiums were made.
The contract pools the risk of many insureds. Most policyowners pay premiums for years; a few die early and receive far more than they paid. This is the principle of pooling: the losses of the few are paid by the contributions of the many. Because the death benefit is generally received income-tax-free by the beneficiary, life insurance is one of the most efficient ways to move wealth to the next generation.
Personal Uses
- Income replacement — replacing the paycheck a family loses at the breadwinner's death.
- Debt and final-expense coverage — paying off a mortgage and car loans and covering burial/funeral costs (often $10,000–$15,000).
- Estate creation and conservation — providing liquidity so heirs are not forced to sell illiquid assets to pay estate taxes or debts.
- Education funding — ensuring children can attend college if a parent dies.
- Cash accumulation — permanent policies build cash value usable for emergencies or supplemental retirement income.
Business Uses and Insurable Interest
Business Uses
- Key person insurance — the business is owner, premium payer, and beneficiary on a critical employee; proceeds offset lost revenue and recruiting costs.
- Buy-sell agreements — life insurance funds a binding agreement so surviving owners can buy a deceased owner's share at a pre-set price.
- Executive bonus (Section 162) plans — the employer pays a bonus equal to the premium on a policy the executive personally owns; the bonus is deductible to the employer and taxable to the executive.
Insurable Interest
For a life policy to be valid, the applicant must have an insurable interest in the insured at the time of application — a reasonable expectation of benefit from the insured's continued life, or financial loss from the death. People are presumed to have unlimited insurable interest in their own lives; a business has insurable interest in a key employee; spouses and close family members have it in each other.
Trap: Unlike property insurance, insurable interest in a life policy need NOT exist at the time of loss. Once a valid policy is issued it stays valid even if the relationship later ends — for example, a divorced spouse who keeps paying premiums can still collect. The purpose of the rule is to prevent wagering and to deter the moral hazard of insuring a stranger.
The Human Life Value (HLV) Approach
HLV estimates the dollar value of a person's future earnings to their dependents — the present value of the income survivors would have received. Five steps:
- Estimate the insured's average annual income to retirement.
- Subtract taxes and the insured's self-maintenance (food, clothing, personal costs).
- The remainder is the net annual contribution to the family.
- Determine the number of years to retirement.
- Discount that stream to its present value using an assumed interest rate.
Worked example. Maria earns $80,000. Taxes and self-maintenance consume $30,000, leaving a $50,000 annual contribution. She is 35 with 30 years to retirement. A simple (undiscounted) HLV is $50,000 × 30 = $1,500,000. After discounting future dollars to present value the figure is lower — but exam questions usually use the undiscounted multiplication unless a discount rate is given.
| HLV Input | Maria |
|---|---|
| Gross income | $80,000 |
| Less taxes + self-maintenance | $30,000 |
| Net annual contribution | $50,000 |
| Years to retirement | 30 |
| Simple HLV | $1,500,000 |
Trap: HLV measures earnings replacement only. It ignores final expenses, debts, and existing assets — those are exactly what the Needs Analysis adds.
The Needs Analysis Approach
Needs Analysis is more thorough: it totals the survivors' actual cash needs and subtracts the assets already available. Memorize the categories:
- Cleanup (final-expense) fund — funeral, medical bills, estate settlement.
- Mortgage / debt fund — pay off the home and other loans.
- Income (readjustment + dependency) period — income while the family adjusts and while children are dependent.
- Education fund — college costs.
- Emergency reserve.
Then subtract existing resources: current savings, retirement accounts, Social Security survivor benefits, and life insurance already in force.
Worked example.
| Need | Amount |
|---|---|
| Final expenses | $15,000 |
| Mortgage payoff | $250,000 |
| Income (10 yrs × $40,000) | $400,000 |
| Education | $120,000 |
| Total needs | $785,000 |
| Less: existing savings | ($85,000) |
| Less: current life insurance | ($100,000) |
| Additional coverage needed | $600,000 |
The answer ($600,000) is the gap to fill with a new policy. Trap: forgetting to subtract existing coverage and assets overstates the recommendation — a classic exam distractor that produces $785,000 instead of $600,000.
An applicant earns $90,000, pays $35,000 in taxes and self-maintenance, and has 25 years to retirement. Using the simple (undiscounted) Human Life Value method, what is the HLV?
When must insurable interest exist for a life insurance policy to be valid?