Applications of Life Insurance
Personal uses of life insurance
The most important use of life insurance is to meet the financial needs that arise when a person dies, especially if the death is untimely. Other personal uses of life insurance include the creation of an estate, cash accumulation, liquidity, estate conservation, and viatical settlements.
Life insurance is often described as the easiest way to create an estate. For example, suppose a person buys a $1,000,000 policy. If that person dies prematurely after making only one premium payment, the policy pays the death benefit. In that situation, the premium payment results in an immediate, substantial increase in value, and the deceased has effectively created a sizeable estate.
Life insurance is also an important financial planning tool. It can provide savings (cash accumulation) on a tax-deferred basis. This tax-deferred growth can be accessed tax-free through policy loan provisions.
Life insurance proceeds can also help with estate planning. They can be used to offset estate taxes, conserving the estate, or to provide cash that makes it easier to liquidate an estate.
Under a viatical settlement, a terminally ill insured (viator) sells all rights to his/her life insurance policy to an investor for a percentage of the eventual death benefit. The investor receives the full death benefit when the insured ultimately dies. Proceeds from viatical settlements are not taxable as income, but in most terminal cases the insured will choose accelerated benefits over a viatical settlement. Accelerated benefits are living benefits paid by the insurance company that reduce the remaining death benefit to ultimately be paid to the beneficiary.
Business uses of life insurance
Life insurance serves several strategic purposes in a business setting. It can fund buy-sell agreements to support smooth ownership transitions, protect the business against the loss of key employees, and support executive compensation or retention strategies through arrangements like split dollar plans. These uses help businesses maintain stability, reward valuable personnel, and prepare for unexpected events.
Buy-sell agreements
Business owners/partners need a plan for business continuation if an owner dies prematurely. A common goal is to make funds available so the surviving partner(s) can purchase the deceased partner’s business interest from the estate. A buy-sell agreement, drafted by an attorney and funded by insurance proceeds, may be established for this purpose.
Under a cross purchase buy-sell agreement, the partners purchase life insurance on each other in an amount equal to each partner’s share of the business. Each partner is the owner and beneficiary of the policy. When one partner dies, the policy proceeds are used to purchase the deceased partner’s share of the business from his/her estate. As a result, the business continues under the surviving partner(s), and the family receives fair compensation for the decedent’s interest in the business.
Under an entity buy-sell agreement, the partnership itself is the owner of a policy on the life of each partner. When any one partner dies, the partnership purchases his/her share of the business from the decedent’s estate and divides it among the surviving partners.
Key person insurance
The death of a key employee can have serious consequences for a company, especially a smaller one. A key employee is anyone whose role in the company is essential to its success, usually someone at the executive level.
Key person insurance is intended to indemnify a business for the economic hardship caused by the death of a key employee. One common way to estimate the amount of insurance needed is to project the loss of company profits expected before a suitable replacement is found.
Key person life insurance policies are owned by the business, which is also the beneficiary.
Split dollar life insurance
A company may want to reward certain employees. Split dollar life insurance (to assist that employee in the purchase of life insurance) is one way to do this.
Under a typical split dollar plan, the employer is the owner of the policy, but the employee has the right to name the beneficiary. Premiums are split between the employer and the employee, and the employer pays an amount of premium equal to that year’s increase in cash value.
As cash value increases over time, the employer’s share of the premium increases, while the employee’s share decreases. At the death (or termination) of the employee, a split dollar plan requires the employee or his/her estate to pay the employer a sum equal to the total amount of premiums paid by the employer.
Determining the appropriate amount of life insurance
There are two methods used to identify life insurance needs today: the human life value approach and the needs approach. Both methods try to place a dollar value on the amount of money needed at death to meet specific objectives.
Human life value
The human life value concept is based on the idea that life insurance should replace the insured’s income for the beneficiary after the insured’s death. This method estimates the present value of the future income that would be lost if the insured dies prematurely. The amount of life insurance required is equal to the present value of lost future earnings.
For example, if an individual earns $50,000 per year and has 10 years until retirement, that person can expect to earn $500,000 prior to retirement and should own life insurance equal to the present value of $500,000.
The human life value approach is commonly used in lawsuits where a jury is asked to award a sum of money to the plaintiff to compensate for a wrongful death.
Needs approach
A more common (and more subjective) method of calculating the amount of life insurance required is to look at the financial needs of the insured’s family or business. Examples of expenses that may be considered include:
Final expenses
- This includes funeral and burial expenses.
Housing
- Does the insured want the family’s home mortgage paid off? The cost of the remaining mortgage may be considered in calculating the insured’s financial needs.
Education
- If there are young children in the family, the future cost of education is an important consideration.
Retirement income
- A life insurance policy can offer an important supplement to any other retirement and Social Security benefits to which the survivors may be entitled.
Lesson summary
The personal uses of life insurance include financial needs following death, estate creation, cash accumulation, liquidity, estate conservation, and viatical settlements. Life insurance can create an estate quickly and can provide savings opportunities on a tax-deferred basis.
The business uses of life insurance are buy-sell agreements and key person insurance:
- Buy-sell agreements: Business owners plan for business continuation in case of a partner’s death. Funds are made available through insurance proceeds for surviving partners to purchase the deceased partner’s interest. There are cross purchase and entity buy-sell agreements.
- Key person insurance: Protects a business from financial loss due to the death of a key employee. The insurance indemnifies the company for the economic impact of losing a key individual.
To determine the appropriate amount of life insurance, there are two methods:
- Human life value: Calculates the present value of lost future earnings to determine the needed insurance amount.
- Needs approach: Examines the financial needs of the family or business, considering expenses such as final expenses, housing, education, and retirement income.