The main purpose of life insurance is to meet the financial needs that arise when a person dies, especially if the death is unexpected. Other personal uses of life insurance include creating 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 someone buys a $1,000,000 policy and dies prematurely after making only one premium payment. In that case, the value received (the death benefit) is far greater than the amount paid in premiums, so the person has effectively created a sizeable estate immediately.
Life insurance is also an important financial planning tool. It can provide savings through 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 pay estate taxes, conserving the estate, or to provide cash to more easily liquidate an estate.
Under a viatical settlement, a terminally ill insured (the viator) sells all rights to their life insurance policy to an investor for a percentage of the eventual death benefit. When the insured later dies, the investor receives the full death benefit. Proceeds from viatical settlements are not taxable as income. However, in most terminal cases, the insured will choose accelerated benefits instead of a viatical settlement. Accelerated benefits are living benefits paid by the insurance company that reduce the remaining death benefit that will ultimately be paid to the beneficiary.
Life insurance can also serve several strategic purposes in a business setting. It can fund buy-sell agreements to support smooth ownership transitions, protect the business from the loss of key employees, and support executive compensation or retention strategies through arrangements such as split dollar plans. These uses help businesses maintain stability and plan for unexpected events.
Business owners and partners need a plan to continue the business if an owner dies prematurely. A common solution is to ensure that funds will be available for the surviving partner(s) to 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 buy 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 the estate. This allows the business to continue under the surviving owners, and the family receives fair compensation for the decedent’s interest in the business.
Under an entity buy-sell agreement, the partnership itself owns a policy on the life of each partner. When a partner dies, the partnership uses the proceeds to purchase the deceased partner’s share of the business from the estate and then divides that share among the surviving partners.
The death of a key employee can have serious consequences for a company, especially a smaller one. A key employee is anyone whose role is essential to the company’s success, often someone at the executive level.
Key person insurance is designed 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 that would occur before a suitable replacement is found.
Key person life insurance policies are owned by the business, which is also the beneficiary.
A company may want to reward certain employees, and split dollar life insurance is one way to help an employee purchase life insurance.
Under a typical split dollar plan, the employer owns the policy, but the employee has the right to name the beneficiary. Premiums are split between the employer and the employee. 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 the employee’s estate to pay the employer an amount equal to the total premiums paid by the employer.
Two methods are commonly used to identify life insurance needs: the human life value approach and the needs approach. Both methods aim to estimate how much money would be needed at death to meet specific objectives.
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 needed is equal to the present value of those 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 before retirement. Under this approach, the person 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 money to compensate a plaintiff for a wrongful death.
A more common (and more subjective) method is to focus on the financial needs of the insured’s family or business. Examples of expenses that may be considered include:
Final expenses
Housing
Education
Retirement income
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 may provide savings opportunities on a tax-deferred basis.
The business uses of life insurance are buy-sell agreements and key person insurance:
To determine the appropriate amount of life insurance, there are two methods:
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