2.1 Purpose and Need for Life Insurance (Human Life Value, Needs Analysis)

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:

1. Estimate the insured's average annual income to retirement.
2. Subtract taxes and the insured's self-maintenance (food, clothing, personal costs).
3. The remainder is the net annual contribution to the family.
4. Determine the number of years to retirement.
5. 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.

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.

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.