Life Insurance Basics
Purpose and amount
Life insurance replaces the economic value of a person's future earnings. Need is estimated two ways: human life value (present value of future earnings) and needs analysis (income replacement, debts, education, final expenses, minus existing resources). The DIME formula - Debt, Income, Mortgage, Education - is a quick shorthand.
Parties and insurable interest
The policyowner holds all rights (naming beneficiaries, borrowing, surrendering, assigning); the insured's life is covered; the beneficiary receives proceeds. Insurable interest must exist at application or policy issue - not at death. A person may insure their own life and, generally, a spouse, dependent, business partner, or key employee.
Premiums
Premium reflects mortality, reduced by assumed interest and increased by expenses, then loaded for contingencies and profit. Mortality is the probability of death at a given age. Risk classes run preferred, standard, substandard (rated), and declined.
Taxation
Death proceeds are generally income-tax-free to the beneficiary, but are included in the insured's estate if the insured held incidents of ownership. Cash value grows tax-deferred, and policy loans are not taxable while the policy remains in force. A policy that fails the 7-pay test becomes a modified endowment contract (MEC): distributions are then taxed LIFO with a 10% penalty before age 59 1/2. The transfer-for-value rule makes proceeds taxable to a purchaser unless an exception applies (for example, the insured, a partner, or the insured's corporation).
Worked example: an insured dies owning the policy on his own life. The $500,000 death benefit is income-tax-free to his spouse but is counted in his gross estate.