3.1 Purpose and Uses of Life Insurance

Life insurance answers a single economic question: what happens to the people and obligations that depend on a person's income when that income suddenly stops at death? The policy converts a stream of small premium payments into a large, generally income-tax-free death benefit paid to the beneficiary.

Why People Buy Life Insurance

At death, income ends but financial obligations continue. Life insurance creates an immediate estate — a sum of money available the moment the insured dies, regardless of how little has been paid in premiums.

The core personal needs it funds are:

• Income replacement — covering the wages a surviving family loses.
• Final expenses — funeral costs, medical bills, and small debts due at death.
• Mortgage and debt protection — paying off the home loan and consumer debt.
• Education funding — money set aside so children can finish school.
• Survivor income — ongoing support for a spouse or dependents.

The Human Life Value (HLV) Approach

The Human Life Value (HLV) method estimates the present economic worth of a wage earner's future net earnings to the family. It treats a person as an income-producing asset and asks how much capital would be needed to replace those earnings.

The four steps are:

1. Estimate average annual income the family loses.
2. Subtract taxes and the insured's own self-maintenance costs to get the net contribution to the household.
3. Determine the number of working years remaining until retirement.
4. Discount that future income stream to its present value using an assumed interest rate.

Worked HLV Example

Because future dollars are worth less than today's dollars, an actuary discounts the $50,000 per year for 25 years. At roughly a 5% discount rate, the present value is about $705,000 — the HLV-indicated amount of coverage. The discount always makes HLV lower than the simple multiplication.

The Needs Analysis Approach

The Needs Analysis (or needs-based) approach is more detailed and is the method most exams favor for accuracy. Instead of valuing the person, it totals the specific dollar amounts the family will actually need, then subtracts assets already available.

Needs are usually grouped as immediate (cash) needs and ongoing (income) needs:

The formula is: Total needs − Existing resources = Additional life insurance required. Existing resources include current savings, group life from work, and Social Security survivor benefits. If a family needs $900,000 and already has $250,000 in assets and group coverage, the recommended new policy is $650,000.

Business and Estate Uses

Businesses rely on life insurance to survive the loss of important people:

• Key person (key employee) coverage — the business owns the policy on a vital employee and is the beneficiary, replacing lost profits and recruiting costs.
• Buy-sell agreements — funded with life insurance so surviving owners can buy a deceased owner's share at a pre-agreed price. A cross-purchase plan has owners insure each other; an entity (stock-redemption) plan has the business own all the policies.
• Executive bonus (Section 162) plans — the employer pays a bonus equal to the premium on a policy the executive owns; the bonus is deductible to the employer and taxable to the executive.

In estate planning, life insurance supplies liquidity so heirs can pay federal estate taxes, probate costs, and debts without a forced sale of illiquid assets such as a farm or business. It also enables charitable giving and equalizes inheritances among heirs.

Insurable Interest — The Threshold Requirement

No life policy is valid without insurable interest: the applicant must stand to suffer a genuine loss if the insured dies. A person always has unlimited insurable interest in their own life. In others, it arises from close family relationships or a financial/business connection (a creditor, employer, or business partner).

Exam trap: In life insurance, insurable interest must exist only at the time of application, not at the time of the claim. This differs from property insurance, where insurable interest must exist at the time of loss. A man who insures his wife retains a valid policy even after divorce, as long as interest existed when the policy was issued.

Comparing the Two Need Methods

Producers should know when each method fits:

A frequent exam point: HLV does not subtract existing assets or group coverage, so it can overstate the gap. Needs Analysis subtracts resources and is therefore considered more accurate.

Producers often calculate both and reconcile the results, because clients are reassured when an income-based number and a needs-based number land near each other before a policy is recommended.