Applications of Life Insurance

Personal Uses of Life Insurance

The most important use of life insurance is to meet the financial needs that accompany a person’s death, especially an untimely death. Other personal uses of life insurance include the creation of an estate, cash accumulation, liquidity, estate conservation, and viatical settlements.

It is said that life insurance is the easiest way to create an estate. Consider the person who takes out a $1,000,000 policy. If that person suffers a premature death after making only one premium payment, it’s obvious that a tremendous increase in the value of that investment (the premium payment) will be realized and that the deceased will have instantly created a sizeable estate.

Life insurance is recognized as an important financial planning tool. It provides the opportunity for savings (cash accumulation) on a tax deferred basis; the tax deferred growth can be accessed tax free through policy loan provisions.

Life insurance proceeds can offset estate taxes, conserving one’s estate, or can be used to more readily 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

Buy-Sell Agreements

Business owners/partners must plan for business continuation in the event of their premature death. The best approach is to make funds available for the surviving partner(s) to purchase the business interest from the deceased partner’s 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 is continued by competent person(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 may have adverse consequences on 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 brought on by the death of a key employee. A common method of determining the amount of insurance required is to estimate the loss of company profits that would result 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

Often a company will want to reward certain employees. Split dollar life insurance (to assist that employee in the purchase of life insurance) is one means of doing so.

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 attempt to place a dollar value on the amount of money needed at death to meet certain objectives.

Human Life Value

The human life value concept is based on the premise that life insurance is intended to act for the beneficiary as an income replacement upon death of the insured. This method attempts to determine the present value of future income that will be lost if the insured dies prematurely. The amount of life insurance required is equal to the present value of lost future earnings.

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 is a way to create an estate quickly, providing 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.

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