Table of Contents
Life Insurance Fundamentals
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Contents
Page
Part I Life Insurance Products, Riders & Benefits
1
Part II The Application, Underwriting & Policy Delivery
27
Part III Standard Policy Provisions & Policy Options
36
Part IV Group Life Insurance
55
Part V Life Insurance and Taxation
63
Part V Glossary of Terms
71
Table of Contents
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Part I
Life Insurance Products, Riders & Benefits
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Introduction
When you are thinking of any insurance product, you are thinking of indemnity. Look at the definition of
indemnity: it means to compensate or reimburse. You insure your home, apartment or car against a loss.
Should a loss occur, you look to your insurance company for reimbursement or compensation. With life
insurance, a named beneficiary is reimbursed or compensated for the loss of income or increased expenses
caused by the death of the insured. This is a somewhat liberal example of indemnity.
What Does Life Insurance Do?
Life insurance creates an immediate estate, and it also provides economic security against two kinds of
losses:
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Losses that occur from physical death, and;
Loss of income that can occur at retirement.
Life Insurance satisfies two very basic "needs":
1. Personal Needs - Life insurance is used to create a specific sum of money that is payable to a named
beneficiary when the insured dies.
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Living values of life insurance - created through cash accumulations in a policy or policies that can
satisfy "living needs" -- i.e.: collateral for a loan, supplement retirement income, pay tuition for
college, etc.
2. Business Needs - Life insurance is used in various business entities, sole proprietorships, partnerships,
and corporations to satisfy:
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Funding of Buy-Sell Agreements - An agreement by business principals (sole proprietors,
partnerships or corporations) to purchase another business principal's interest in that business
upon his/her death, disability or retirement. This agreement is usually funded with life insurance.
Key Man Life Insurance - The concept of insuring a key man in a business organization, which if he
were to die would cause financial hardship to the business. Various forms of life insurance are
used. For example: Whole Life, Term, Universal Life, or Variable Life.
Business debt obligation
Keeping business intact
Deferred Compensation - An "executive incentive" to provide him compensation at some future
date, usually at retirement.
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Tax Treatment of Life Insurance
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Premiums - Are not tax deductible unless paying for employee benefits such as group insurance.
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Proceeds - Are the death benefit of a life policy and are not income taxable to the beneficiary.
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Dividends - Are not taxable, but the interest on the dividends is taxable. Dividends are considered
an overcharge of premium and are generally paid by mutual insurance companies.
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Withdrawals - Are not taxable (usually associated with universal life and annuities).
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Group Life Insurance - Proceeds are nontaxable like those of an individual life policy. The company,
not the employee, may deduct the premiums as a business expense. The premiums paid on behalf
of the employee are not considered income to him for tax purposes.
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Federal Estate Tax - Life insurance proceeds are included in an individual's gross estate and may be
subject to tax if the estate exceeds a certain amount.
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Gifting Life Insurance - The charity (donee) is made the beneficiary and owner. The donor
(insured) pays the premium and receives an income tax deduction. The charity is given all rights of
ownership in the policy, and for a tax deduction, the donor must not have any control of the
policy. A person can gift a policy to someone other than a charity. To avoid a gift tax, the annual
values must not exceed $10,000 per donee or a total of $20,000 for him and his spouse. A person
may gift a policy which has cash value or can elect to pay the premium up to the above limits to
pay for a policy. The gift is received tax free by the donee regardless of the proceeds.
The taxation of life insurance will be explored in greater detail later in this text.
Types of Life Insurance
There are four (4) basic types of life insurance, each having its own characteristics. Each will be discussed
in greater detail later in this text.
1. Term Life Insurance
Tern life is sometimes referred to as Temporary Insurance. It provides temporary protection for a
specified term of years. For Example: one year, five year, thirty years, etc. The policyholder must die during
the term of the policy for any benefit to be paid. Mortgage Life is a form of term insurance and it usually
provides a reducing death benefit, reducing to "0" at the end of a specified period of time.
2. Whole Life (Ordinary Life Insurance)
Also referred to as ordinary or permanent insurance. As implied by its name, affords coverage for life, or
up to age 100. At age 100 the policy endows and the insured receives the face amount of the policy in cash.
Note: All whole life policies endow at age 100.
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3. Industrial Life Insurance
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Policies are written in small death benefits amounts; usually less than $5,000
Usually purchased by low income workers' including their family members
Usually no medical examination is required
Policies are sold house to house by debit agent (also known as home service agents)
The premiums are collected weekly or monthly by the debit or home service agent
The grace period is four weeks or 28 days
Death benefit settlement is paid in a lump sum
Contains Facility of Payment Clause - Permits the company to pay the death benefit to any relative
or anyone they deem entitled to the benefits when there is no beneficiary to facilitate funeral
arrangements;
Contains accidental death & dismemberment coverage
Does not have a suicide clause
Has a one-year incontestability clause
The premiums quoted at age of next birthday
Non-forfeiture values are provided in Industrial Life Insurance after premiums have been paid for at
least three years. The term non-forfeiture values will be discussed in more detail later.
4. Group Life Insurance
This coverage is written on members of a common group, and the group must have been formed for a
purpose other than that of obtaining insurance. The coverage can be offered as term or whole life.
Characteristics of group life insurance will be discussed in this text.
Term Life
Characteristics of term life:
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Temporary protection. (Specified number of years)
Face Value paid only at death.
Usually, there is no cash value build-up
No Permanent Values.
Low Premium outlay initially.
Options – Not all companies provide the following options:
(a) Renewability - Right to renew the policy on a renewal date without evidence of insurability.
The premium usually is increased on renewal date.
(b) Convertibility - Right to convert to a permanent policy without evidence of insurability.
Note: To help you remember and understand this life insurance product, think of its name. Term
insurance is insuring a life for a defined “term of time.” Options included in the product are included in the
name of the product. Example: Five Year Renewable and Convertible Term.
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Types of Term Life
May be defined by the way the face amount of the policy changes throughout the life of the policy.
Level Term - The face amount of the policy remains constant over the life of the policy.
Decreasing Term - The face amount decreases throughout the life of the policy.
Whole Life
Characteristics of whole life:
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The policy provides permanent protection for the whole life of the insured. Also referred to as
permanent life insurance.
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The policy has cash or loan value, and non-forfeiture values (or simply stated - equity buildup).
Policy equity (loan value) must begin after 2 years.
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The policy will endow at age 100; at maturity (age 100) the Cash Value = Face Amount.
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The policy provides level premiums and has a 30 day grace period.
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The policy has a constant face amount of more than $1,000.
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With any life insurance product, the policyowner pays the premium in advance. Money is paid for
future protection. This premium is earned by the insurance company each day the insured lives.
Therefore, when a claim occurs, the insurance company keeps that portion of the premium it has
earned and refunds the unearned premium to the beneficiary.
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May be issued as an endowment. This form of life insurance has rapidly building cash value, the
amount of which will ultimately equal the death benefit of the policy. Such policies are usually
issued with a specific time period in mind -- 10 year endowment, 20 year endowment, or
endowment at age 65. This form of insurance is not as popular in today's environment as it once
was. The emphasis of this type of policy is in its cash accumulation more than death benefit and is
the most expensive policy that can be purchased.
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Has a two (2) year incontestability clause and a two (2) year suicide clause.
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When issued a permanent insurance, all policies shall have non-forfeiture values after premiums
have been paid for two (2) years. The non-forfeiture values must be illustrated in the policy
annually for no less than twenty (20) years.
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Death benefit may be paid in a lump sum, or paid under a settlement option other than lump sum
to the beneficiary.
Whole life insurance products contain equity build up that is called “cash value.” This equity (cash value)
results from the fact that an overcharge of premium is made by the insurer in the early years of the life of
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the policy. This “overcharge” is held in an interest bearing reserve that is drawn upon by the insurance
company in later years as the insured ages. The billed level premium plus the funds drawn from the
reserve, supports the death benefit and maintains the consistent level premium to the maturity age of the
insured at age 100. The credited guaranteed rate of interest in the reserve is the cash value or equity in
the policy.
The policyowner (who is not always the life insured) owns and therefore, has access to the cash value.
The cash value can be borrowed for whatever use the policyowner desires. You need to understand and
keep in mind that, if a loan exists at the death of the insured, the claim will be paid as follows:
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Death benefit amount
Minus outstanding loan
Minus any outstanding interest on loan
Equals death benefit payable
An additional point to remember and understand is that the insurance company has the right to take up to
six months to honor a request for a policy loan from the policy cash value. Also, insurance company can
charge interest on a variable loan rate not to exceed 1 ½ % per month (18% APR).
Lastly, we referenced a 30-day grace period as one of the characteristics of the policy. The 30-day grace
period also applies to term insurance. The importance of the grace period is it is the period of time after
the premium due date the policyowner has to pay his/her premium without losing their coverage (policy
lapses for non-payment of premium). If the insured dies during the grace period, you must understand two
important points:
1. The death claim will be paid, because
2. The coverage is still in force.
The death claim will be paid as follows:
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Death benefit payable
Minus the outstanding premium (monthly, quarterly, semi-annual or annual premium)
Minus any outstanding loan
Minus any outstanding interest on loan
Equals death benefit payable
If an accidental death benefit (double indemnity benefit) is included on the policy, and the insured dies from
an accident during the grace period, the accidental death benefit is included in the calculation of the total
death benefit. Note the following example:
Death Benefit: $25,000
Accidental Death Benefit: $25,000
Quarterly Premium: $70.00
If the insured dies in an accident during the grace period the total death benefit payable is:
Total Death Benefit:
$50,000
Minus outstanding premium:
70.00
Minus outstanding loan:
0
Death Benefit Payable:
$49,930
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Types of Whole Life
(As defined by the methods of premium payment):
Continuous Premium Whole Life Policies - Spreads the premium payments over the whole life of the
insured (age 100). It is sometime referred to as straight life insurance.
Limited Payment Whole Life Policy – Another member of the whole life family is the limited payment
whole life policy. Again, note the name of the policy. Limited payment (of premiums) with whole life
(protection to age 100). Limited payment whole life policies limit the number of premium payments to a
specified number of years (10 years, 20 years, or to age 65), but provides coverage (death benefit) for the
whole life of the insured (to maturity at age 100). A limited payment life policy will accumulate more cash
value more quickly than the lower premium paid continuously to age 100 simply because the limited
premium payment is higher.
Single Premium Whole Life Policy - This policy provides for the payment of one premium payment
covering the entire term of the insurance contract rather than installments. All other facts being equal, this
is the least expensive product as far as the total premiums paid is concerned, and therefore is considered
to be the most efficient.
Endowment Policy – An endowment policy is a form of whole life insurance, and is usually purchased to
accumulate funds for specified purposes such as retirement, etc. An endowment policy is a savings
program with protection against dying before the savings goal is reached.
Characteristics of Endowment Policies:
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Is considered a whole life policy and has an early maturity period
Has cash, loan and nonforfeiture values
Endows before age 100; i.e. in 10 years, 20 years or at age 65
Specialized Policies
There are various policy forms that have evolved from the three basic forms (whole life, term, and
endowment) to meet various needs. The following are samples of specialized policies all of which begin
with an underlying whole life policy.
Combination Policies (Written on Breadwinner) Family Income Policy:
The family income policy combines whole life and decreasing term coverages to provide income protection
during child-rearing years. Under the terms of this policy, if the insured dies during the policy period
(typically 20 years), a monthly income is provided to the beneficiary for the remaining period of the policy
(through the decreasing term coverage). After this time period is completed, the beneficiary receives only
the face amount of the policy (from the whole life coverage). For example, the insured purchases a 20year family income policy with a face amount of $50,000. If the insured died after the policy had been in
effect for four years, the insured's beneficiary would receive $100/month for the remaining 16 years. After
that time, the beneficiary would receive a lump sum check in the amount of $50,000 (the face amount of
the policy). Characteristics of the Family Income Policy include:
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1. Whole Life Policy
2. Decreasing Term Rider
3. Pays monthly income from date of death until end of term. The income time period begins with
the issue date of the policy.
4. Whole life death benefits are usually paid at the end of the term.
The Family Policy
The family or family protection policy provides coverage on all members of the insured's family from a
specified time period after birth (normally 15 days) up to a specified age (18 or 21). Whole life insurance is
written on the breadwinner; term insurance is usually written on the spouse and children. Minimal
amounts of insurance are written on all members of the family by a rider known as the “other insureds
rider.” The family policy usually provides the following features:
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Death of the head of the household will result in paid up term coverage on the children
Permanent disability of the head of the household will result in a waiver of premium
Additional children born to the family insured are covered for no extra premium
Most companies require no insurability requirement for newborns; however, some companies will
underwrite newborns
5. Dependents may convert their term coverage into permanent insurance without the evidence of
insurability
Initially, all persons to be insured under the family policy must be insurable. If either husband or wife is not
insurable, the policy cannot be issued.
Again, as you study the characteristics of these two products, consider their names. The Family Income
Policy is designed and sold to provide income to the family if the primary breadwinner dies; thus the name
of the product. The Family Policy is designed to insure the family; thus the name.
Joint Life Policies
These products are normally issued on a whole life basis, and two or more lives are insured under one
policy for the same death benefit.
Joint First Death
This policy insures one or more persons on one policy, and each person insured is insured for the same
death benefit. This policy will pay the insured death benefit at the death of the first insured to die. A
common policy is issued insuring two lives, however, some companies will issue with more than two lives.
Under a two-life joint first death policy, the survivor is usually granted a 90 day conversion privilege
permitting him/her to convert to an individual policy at his/her current age without medical evidence.
Another feature usually available with this product is the ability to exchange to separate policies. If a joint
policy is used in a business situation and the need for coverage is gone, the insureds may exchange to single
life policies for the same death benefit issued under the joint life product. The premium is usually adjusted
to reflect current ages, and this exchange privilege usually is made without evidence of insurability. Any
cash value in the joint life product is refunded, with the new single life policies, to the original policyowner.
If benefits such as waiver of premium or accidental death are desired under the joint life product, the
benefits applied for must cover all insureds. No insured can be excluded for benefits.
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Joint Second Death (also known as Survivorship Life)
This policy form insures two lives and pays the policy face amount at the second death of the two insureds
(a one life deductible type policy). This policy is a very popular policy among the estate planners, and is
usually issued on husband/wife combinations. The underwriting is usually liberal in the sense that it is
common to find one of the two insureds having a medical problem. In some cases, one of the insured may
be totally uninsurable, on traditional individual policy, but insurable under this policy. Usually, no benefits
such as waiver of premium or accident death are available for issue under this policy. Most companies
issuing this product do not provide for a "split exchange" (issue two single life policies) without complete
underwriting including medical evidence on both named insureds.
Juvenile Policies
As the name suggests, juvenile insurance is written to address the specific needs of "juveniles" (written on
children under age 15) for:
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the funeral expenses of juveniles upon their untimely deaths
future education needs.
Very often, juvenile insurance takes the form of an endowment policy payable upon the insured juvenile
reaching age 18. The amount of the endowment would address projected college expenses at the time the
insured reaches college age. As previously noted, endowments provide for accumulating a specific sum of
money over a specific period of time with this savings program protected against premature death.
A payor benefits rider can be included in insurance on children. It states that in the event of the death or
permanent disability of the payor (hence, the name) of the policy (usually a parent, grandparent or some
other close relative), future premiums will be waived until the child reaches a specified age (usually age 21
or 25). The payor in question must provide evidence of insurability (e.g., submit to a physical examination)
and pay an additional premium for this coverage.
Jumping Juvenile insurance is an insurance contract on a juvenile which promises to provide a multiple
(usually five times) of the face amount of the policy coverage once the juvenile attains age 21. In this way,
the policy "jumps" from the lower original figure to a greater amount. Such contracts provide the
advantage of guaranteeing the insurability of a child at age 21 for a given amount of insurance (the initial
face amount times the multiple). This contract may also be referred to as the “Estate Builder.”
Modified and Graded Premium Whole Life
Modified and graded premium life policies address a market which needs permanent life protection
immediately but cannot afford the level premium payments needed to purchase the coverage required.
A modified whole life policy is actually a combination of term coverage and whole life; the term policy
initiates coverage then automatically converts into whole life after a relatively short amount of time
(typically three to five years). With this configuration, the policy offers the advantage of low premium
payments for high coverage amounts for the first three to five years. Once the term converts into whole
life, the premium payments radically rise from a level lower payment to a level higher payment.
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As a contrast, a graded premium whole life policy, provides a "graded premium" for the initial period
(typically five years) then levels off at the end of that period. The rise from the initial payment to the level
premium payment of the sixth year is a gradual one, not a radical jump like a modified whole life policy.
In conclusion, the premium payment "profile" of a modified life policy represents "one huge step" from a
level lower payment to a level higher payment. In contrast, a graded premium whole life's payment profile
represents a series of small steps at the outset of the policy which level off after five years or so.
Adjustable Life
Adjustable Life is a "flexible premium, adjustable death benefit" type of permanent cash value insurance.
Adjustable life, within limits, allows the policyowner to change the premium (lengthen or shorten the
premium payment period), and/or the level of death benefit. In general the policyowner may:
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Increase or decrease the premium
Increase or decrease the face amount
Lengthen or shorten the protection period
Lengthen or shorten the premium payment period
Similar to other traditional forms of insurance, various options or riders are available including:
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Waiver of premium,
Guaranteed insurability
Accidental death benefit, and
Cost-of-living adjustments
Although the policyowner has flexibility in selecting the plan of insurance, changes are generally permitted
only at specified intervals and with advance notice to the insurer. Between adjustment periods, the policy
is a level-premium, level-death-benefit policy. Depending on the particular premium and death benefit
levels chosen, the policy can assume the form of almost any traditional term or whole life policy from lowpremium term through ordinary whole life to high-premium limited-pay whole life.
Universal Life
Although similar in approach, universal life varies dramatically from adjustable life and other traditional
whole products by providing a "vehicle" for allowing internal cash values to build at variable current
interest rates as opposed to conservative, guaranteed rates. Premiums paid for universal life are divided
into two "accounts" (a process also known as "unbundling the cash value"):
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expense account
cash value account
The expense account addresses the costs of the agent commission, administrative costs incurred by the
company in creating and maintaining the individual policy, etc.
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The cash value account is the aforementioned "vehicle" which provides the funding for three separate
operations:
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The monthly premium payment for the insurance protection (mortality costs)
A small cash value fund which provides a guaranteed, conservative long-term amount of interest
(5% or under)
A larger cash value fund which reflects the actual investment earnings of the insurer during a given
period (e.g., 10%). The extra earnings are commonly known as “excess interest”.
At the inception of the policy, the insured must pay an annual premium to initiate the two accounts and set
them in motion. This premium is based on the face amount of the policy desired and the age of the
insured. The insured then has the option of choosing a “target premium”(a premium amount the insured
can afford or is willing to pay) and a mode of payment (annual, quarterly, monthly, etc.). These premiums
are directed into the expense and cash value accounts as needed.
Since premiums are paid directly from the cash value account, the insured may “skip” a premium payment
as long as there are sufficient funds in the cash value account to pay the premium payment. If insureds
wish to invest extra money into their cash value accounts, they may do so, subject to certain limits
prescribed by the company involved and federal tax law. The death benefit under most universal life
policies provides two options:
1. Option A - This option, which is similar to a traditional whole life policy, offers a fixed (level) death
benefit. As cash values grow larger, the net amount at risk (or pure insurance) is reduced to keep
the total death benefit constant (unless the cash value grows to an amount where the death benefit
must be increased to avoid classification as a modified endowment contract).
2. Option B - This option operates in a manner similar to the death benefit one would receive from a
traditional whole life policy with a term insurance rider that is equal to the current cash value.
Under option B, the death benefit at any time is equal to a specified level of pure insurance plus the
policy's cash value at the time of death. Therefore, the death benefit increases as the cash value
grows.
Unlike traditional whole life policies, universal life policies allow partial withdrawals of money from the cash
value account. Traditional whole life policies allow full cash surrenders only (whereby the insured
"surrenders" his/her policy in return for any cash value that has accumulated at the time).
An annual load may be made against the cash accumulation of a universal life policy. The annual load is
generally the difference between the guaranteed rate and current rate of the first $1,000 in accumulated
value. For example: 9% current - 4% guaranteed X 1,000 = $50 load. In summary, universal life offers:
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A fixed conservative return on a small portion of cash values with the possibility of a larger rate of
return based on the insurer's investment experience
Flexible premium arrangements
Flexible, optional death benefits
Partial as well as full withdrawals
Note of caution: Interest credited to the cash accumulation inside universal life products, variable life
products, and traditional whole life products accumulate free of income tax. However, given this "tax
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shelter" our Government taxing agencies have attempted to close this "tax free / deferred" feature of life
insurance. When universal life insurance and other interest sensitive products were first introduced into
the market, double digit interest rates began occurring and many field underwriters (agents) sold these
products with heavy emphasis on the then current interest rates and tax free cash accumulations in the
products. At that point in time, the government recognized the impact of losing the tax dollars they would
have received from other forms of investing. Therefore, the Deficit Equity Fiscal Responsibility Act
(DEFRA) and the Tax Equity Fiscal Responsibility Act (TEFRA) set forth guidelines establishing the criteria
to maintain life insurance as life insurance and retain the continued tax-free accumulation of cash value
within a life insurance policy. Violations of the established guidelines will convert the policy into a
"modified endowment policy." If this occurs distributions from the policy are adversely taxed. Such
distributions are subject to a 10% penalty if they occur before the policyowner attains the age of 59 1/2,
dies, or becomes disabled. The guidelines established by DEFRA and TEFRA define to all insurance
companies the required cash value levels and the necessary "corridors" of cash value to death benefit to
remain a life insurance policy. Whenever either of these areas of concern shows signs of being violated,
most insurance companies will notify you as the agent, and your client of the potential problem and how it
can be corrected. Further, the illustration process addresses the possible problems whenever large sums of
money are "dumped" into an interest sensitive product.
Annual Report to Universal Life Policyholders
1. Policyholder receives an annual statement disclosing death benefit and cash value status. Also, all
policy transactions are a part of this statement. For example: All expense charges, insurance cost
and interest credited.
2. Loads - (front end or rear end loads) - Some universal contracts have gone from a front end load
to a rear end load contract. The result is a reduced or replaced front end fixed charge. In a rear
end load, there is generally a surrender charge against the cash value for policies surrendered
before a fixed period. This period will usually vary from 10 to 20 years from date of issue.
Universal Life Waiver of Monthly Deduction - Since premiums on a Universal Life Policy may fluctuate
considerably, most companies provide a waiver of premium rider on a Universal Life Policy that will
guarantee only the monthly cost of insurance, not the total premium the insured was paying. The policy's
cash value will remain intact and continue to earn interest.
TEFRA 1982 (Tax Equity and Fiscal Responsibility Act of 1982) - TEFRA allows universal life the same
tax treatment as traditional whole life:
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Interest on cash value accumulates tax free
Death proceeds are income tax free, and
Cash value withdrawals, up to the amount of premium paid in, are income tax free
Variable Whole Life
The purpose of variable whole life is to protect the insured from the ravages of inflation. Specifically,
traditional whole life policies are written on a fixed dollar value (such as $100,000) which will be paid to
the beneficiary upon the death of the insured. The true purchasing power of this amount changes with the
inflation rate of the times. In response, variable whole life provides death benefits which "vary" (hence, the
name) according to the insured's investment choices which, in turn, vary with inflation.
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Variable life insurance combines traditional whole life insurance with mutual-fund type investments.
Basically, it is a whole life policy where the policyowner may direct the investment of cash values among a
variety of different investments. Variable life has a guaranteed minimum face amount and a level premium
like traditional life insurance, but it differs in three respects:
1. The policyowner's funds are placed in separate accounts that are distinct and separate from the
company's general investment fund.
2. There is no guaranteed minimum cash value. The cash value at any point in time is based on the
market value of the assets in the separate account. Variable life policyowners bear all the
investment risk associated with the policy.
3. The death benefit is variable. The face value may increase or decrease, but not below the
guaranteed minimum.
Similar to other traditional forms of insurance, various options or riders are available including waiver of
premium, guaranteed purchase or insurability, and accidental death benefits. Insurers that market variable
life often offer a number of premium payment plans including single premium, limited pay (for a specified
number of years or until a specified age), and lifetime-pay plans. In summary, variable whole life insurance
is characterized as follows:
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The face amount of the policy "varies" with the fortunes of the insured's investment choices
This face amount never decreases below an initial specified amount
Premium payments are level
Investment risks are taken by the insured based upon a prospectus prepared by the insurer
Agents need a securities license (NASD) in order to sell variable life
Variable Universal Life
Variable universal life, which is also called flexible premium variable life, is a combination of universal life
and variable life. It offers policyowners the flexibility of universal life with respect to premium payments
and death benefits. Specifically, variable universal life owners can:
•
•
•
•
•
Determine the timing and amount of premium payments (within limits).
Skip a premium payment if the cash value is sufficient to cover the mortality and expense charges.
Adjust the amount of the death benefit in response to inflation or changing needs (subject,
generally, to policy minimums and, with respect to increases, evidence of insurability
requirements).
Withdraw money without creating a policy loan and without an interest charge if there is sufficient
cash value to cover mortality and expense charges.
Choose between two death benefit options similar to options A and B for universal life policies.
Under option A, the death benefit remains level, similar to a traditional policy. Under option B,
the death benefit is equal to a level pure insurance amount plus the cash value.
The death benefit of a variable universal life policy is not "variable" in the same sense as the death benefit of
a variable life policy. Under option B, the death benefit will vary directly with changes in the cash value.
Under option A, the death benefit is level. However, the death benefit of variable universal life policies is
flexible or adjustable, within limits and subject to insurability requirements, at the discretion of the insured.
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Variable universal life policyowners receive periodic reports that explicitly show mortality and expense
charges and changes in the investment value of their accounts. Since variable life products are considered
securities, prospective purchasers must be given a prospectus. The prospectus contains the identity and
nature of the insurer's business, the use to which the insurer will put the premiums, financial information
on the insurer, the investment characteristics of the product, expenses, fees, loads, and policyowner rights.
In addition, the agent must be properly licensed to sell securities products.
Interest-Sensitive Whole Life
Similar to continuous pay whole life contracts, interest-sensitive whole life insurance guarantees that the
policy's cash values will receive interest over a period of time. The rate of interest varies to reflect the
economic conditions of the time; however, it will never fall below a certain rate specified in the contract.
Because of the interest-sensitive nature of the policy, the policy's cash values accrue more rapidly than
under traditional whole life contracts. Typically, insurers encourage policyowners to assume a relatively
high premium payment in conjunction with a provision to utilize cash value buildups toward premium
payment with the objective of paying the policy premium in full over a shorter than anticipated period.
This process is known as a "vanishing premium" payment. This is another incentive to purchasing interestsensitive whole life insurance. Life insurers typically invest in fixed-income investments for interestsensitive whole life products. Fixed-income investments generally are loans made to large corporations on
one of three basis:
•
•
•
Short-term - several weeks up to two years
Intermediate-term - two to ten years
Long-term - 10 years or more
Usually, the longer the term, the higher the interest rate received. The investment strategy for interestsensitive whole life usually involves intermediate-term fixed-income investments. Guaranteed interest and
any excess interest amounts are applied to the policy's cash values.
Policy Riders and Benefits
A rider is a form which, when added to an underlying life insurance policy, amends coverage by:
•
•
•
Increasing benefits
Decreasing benefits
Waiving a condition
Waiver of Premium Benefit
The disability waiver of premium rider provides that the insurance company will "waiver" (voluntarily
relinquish) all premiums due on a life insurance policy of an insured who has become totally disabled,
usually for a 6 month period and before a certain, specified age (usually 60 or 65). Policy premiums will be
waived for the duration of the illness or injury. The insured does not have to "pay back" the insurer for
paying the policy premium during a disability.
Total disability is usually defined as a disability which will preclude the individual in engaging in any gainful
employment. Included within this definition are the loss of both arms, both legs, or the loss of sight as well
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as other very serious injuries. In practice, the "yardstick" of total disability is used with respect to the
insured's present occupation during the first two years of disability; any occupation for which he/she is
qualified, thereafter. As a result, if an insured artist could no longer paint pictures for a living as a result of
losing a hand, the artist would be considered "totally disabled" even though he/she could still teach art for
the first two years of disability, but not thereafter.
Permanent disability is usually declared once an insured has been disabled for a period of six consecutive
months. The "disability" itself may be caused by an injury or sickness that began after the inception date of
the policy. Just about any cause for the disability is covered, but there are typical exclusions for the cause
of the injury or sickness such as:
•
•
•
War
Self-inflicted injuries
Violation of the law
Guaranteed Insurability Rider
Guaranteed insurability is a rider in a policy which permits purchase of additional amounts of insurance at
stated intervals without evidence of insurability. Since evidence of insurability is not required, insurability is
"guaranteed." Usually, the option of purchasing additional amounts of insurance is limited to a maximum
amount of insurance (e.g., $10,000 and $25,000 are typical amounts) and to a maximum specified age (e.g.,
age 40) at specified intervals (e.g., 3-year intervals). In addition, the insured has a time limit (e.g., 90 days)
in which to decide if more insurance is needed through this rider. This rider usually requires an additional
premium. It is only available under whole life and endowment contracts.
Payor Benefits
The payor benefits rider pertains to insurance on children. It states that in the event of the death or
permanent disability of the payor (hence the name) of the policy, subsequent premiums will be waived until
the child reaches a specified age (usually 21 or 25). The "payor" in question must provide evidence of
insurability (e.g., submit to a physical examination) and pay an additional premium for this coverage. As
noted, this rider is usually written on juvenile contracts but it may also be used with endowments.
Accidental Death Benefit
The accidental death rider, as its name suggests, provides that if the death of the insured is caused by an
accident, a multiple of the face amount of the policy will be paid to the beneficiary. For years, this rider
was referred to as "double indemnity" because it provided for payment of twice the face amount of the
policy in the event of the accidental death of the insured. In practice, some companies provide triple or
quadruple indemnity as well. In order for this rider to provide its multiple payment, the death itself must:
•
•
•
Be purely accidental
Occur within 90 days of the accident
Occur before age 70
If an insured is hit by a car, and dies at the scene of the accident, he/she obviously would be the victim of
an accidental death. If this same auto accident resulted in injuries that caused the insured's death shortly
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after the accident (but within 90 days), this death would be considered accidental. The 90 day "expiration"
period is imposed upon the accidental death definition to provide some necessary parameters to the
definition. Realizing that everyone must die some day and most people become involved in accidents, one
could argue a case of accidental death for every living human eventually without this 90 day maximum.
Finally, an age limit of 70 is further imposed on this rider because of the frequency of deaths in the post-70
age group. To further underscore the required accidental, unplanned, unforeseen nature of death, this
rider usually excludes death by:
•
•
•
•
•
•
•
Any disease or illness of any kind, physical or mental infirmity or medical/surgical treatment of
these
Suicide, while sane or insane
War or military conflict
Committing a felony
Drugs, unless prescribed by a physician
Poisonous gas (except from an occupational accident)
Acting in any capacity, other than as a passenger, on an aircraft
Cost-of-Living Rider
With the cost of living rider, the policyowner has the option to increase the death benefit of his or her
policy to match any increase in the cost-of-living index (usually the CPI-U the Consumer Price Index - All
Urban). Any increase in the death benefit, of course, will mean an increase in premium. Any subsequent
decrease in the index will not result in lowering the policy's death benefit.
Waiver of Monthly Deduction (Universal Life)
Since premiums on a universal life policy may fluctuate considerably, most companies provide a waiver of
premium rider on a Universal Life Policy that will guarantee only the monthly cost of insurance, not the
total premium the insured was paying. The policy's cash value will remain intact and continue to earn
interest.
Accelerated (Living) Benefit Rider
Many insurers make living benefit riders available which, when attached to a life insurance policy, pay
benefits during the lifetime of an insured who is seriously or terminally ill. Accelerated benefits are
benefits payable under a policy that meets all of the following criteria:
•
•
•
The benefits are payable to the policyholder or certificate holder during the lifetime of the insured
upon the occurrence of a "qualifying event."
The benefits are payable in amounts that are fixed at the time of the acceleration of benefits.
The benefits reduce the death benefit otherwise payable under the policy.
A qualifying event is the occurrence of any of the following:
•
A medical condition that drastically reduces the potential life span of the insured to a period of
time that is within the period of time specified in the policy.
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•
•
•
A medical condition that requires the use of extensive or extraordinary medical care or treatment,
including major organ transplant or the continuous use of artificial life support systems, without
which the insured would likely die.
A condition that normally results in continuous confinement in an eligible institution, as defined in
the policy, if the insured is expected to remain in the institution for the remainder of his or her life.
A medical condition that, in the absence of extensive or extraordinary medical care or treatment,
would drastically reduce the potential life span of the insured.
Other Insured Rider
Individuals other than the named insured can be insured under most insurance policies through the use of
specific riders such as:
•
•
Spouse and children insurance rider
Second insured rider
As its name suggests, the spouse and children rider is designed to be added to a whole life insurance
contract to provide coverage on the insured's spouse and children. The coverage provided by this rider is
term insurance and is usually subject to certain specified maximums.
The term coverage on the spouse usually is written for a much greater amount (e.g., a multiple of five) than
the amount written on the children. Furthermore, the amount of insurance written on the children is a
stated, flat amount that does not change with the addition or deletion of any one child. Once a child
reaches a certain specified age, he/she is eliminated from coverage. A spouse and children insurance rider
typically provides:
•
•
A conversion privilege, allowing a child reaching the "stated age" to contract for permanent
insurance without evidence of insurability.
Paid-up term riders on the spouse and children if the named insured dies
The second insured rider is a rider that adds a second insured to a life insurance policy, but usually for an
amount different from the amount written on the "first" or named insured. A single mother or single
father wishing to insure a child under his/her coverage would be an ideal market for a second insured
rider.
Miscellaneous Life Insurance Concepts
Keyman Life Insurance - Businesses often insure persons who vitally contribute to the success of the
business. The death benefit indemnifies (insures) the business against losses that could occur if the key
person were to die. Funds received by the business would help solidify the continuity of the business and
provide funds to seek a capable replacement. These funds would also help the business with any
interruption in business due to the loss of the key employee.
Buy-Sell Agreement - is a formal written arrangement specifying the terms and conditions for the
retirement of, or passing of, a business interest. Characteristics of a buy-sell agreement include:
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•
•
•
•
•
It is a contractual agreement and not a life insurance policy. Life insurance is used for the
purpose of "funding" a written agreement and providing funds for the retirement of the
business interest caused by death.
The agreement establishes a price for the business interest removing the need to negotiate
with heirs.
The agreement binds all parties mandating that, due to a death, the survivor(s) must buy
and the decedent's estate (executor/administrator) must sell the business interest for the
price stipulated in the agreement.
A properly written buy-sell agreement will not only address the issue of death, but will also
define how, when and the term under which a business interest will be retired due to a
total and permanent disability or the retirement of a partner or stockholder.
Parties to a buy-sell agreement may be a partner or partners, stockholder or stockholders,
a trust or a corporation.
There are two types of buy-sell agreements:
1. Cross Purchase – The parties to a cross purchase agreement are the owners of the business and
the insurance funding this agreement is owned by the business owners.
2. Entity Purchase – With this agreement, the business is the entity agreeing to retire the owner’s
interest in the business. Any insurance funding in this agreement is owned by the business (the
entity).
Split-Dollar Plan - is an arrangement where a designated employee and his/her employer split the cost of
a life insurance purchase for the benefit of the employee. Under such an arrangement, a policy is
purchased on the life of the designated employee and the employer pays a portion of the premium each
year so that at any time the total employer contributions to date do not exceed the sum of the policy cash
value at the end of the current policy year. Each year, the employee pays the remaining portion of the
premium. Such an arrangement is usually used as a reward to a valued employee without risk or cost to
the employer. This arrangement enables the designated employee to purchase life insurance for much less
than he otherwise would pay for such protection.
If the employee dies while the split-dollar plan is in effect, the employer receives from the proceeds an
amount equal to the cash value of the policy or his premium payments and the employee's beneficiary
receives the balance of the proceeds. In a much broader sense a "split-dollar life insurance plan" has come
to mean any plan of life insurance under which the right to benefits and/or the obligation to pay premiums
is split between two individuals or entities, one of whom has a need for life insurance protection, and the
other a reason to assist financially in providing such protection.
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Summary – Types of Policies
I.
Whole Life
A.
Types of Policies
1.
2.
3.
4.
B.
II.
Continuous Premium (Straight Life)
Limited Pay
Single Premium
Endowment
Characteristics
1.
2.
3.
4.
5.
6.
7.
8.
Builds Cash Value
Endows (matures) at age 100
Level Premiums
Permanent Protection
Mode - monthly; quarterly; semi-annually; annually
Loans - Yes, generally at a guaranteed interest rate stated in policy
Partial Surrender - No. Only a full policy surrender
Non-forfeiture Values
a.
Loan or cash surrender value
b.
Reduced paid-up
c.
Extended term
9.
Dividends
a.
Participating policies only
b.
Cannot be guaranteed
c.
Return of over-charge of premium
d.
Non-taxable; interest is taxable
Term
A.
Types of Policies
1.
2.
3.
B.
Level Term
Decreasing Term
Increasing Term
Characteristics
1.
2.
3.
4.
5.
No cash value
Temporary - must die within term of policy for death benefits to be paid
Mode monthly; quarterly; semi-annually; annually
Term varies from 1 year to 30 years
Premium - lower cost per $1,000 because there is not CV buildup
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a.
b.
Can be level for the term.
Can be step-rate; ranging from 1 year to every 5 years; 10 years, etc.
6.
Renewable
a.
May be written in policy provisions or by rider
b.
Allows insured to renew policy without evidence of insurability
c.
Premium usually increases at renewal
7.
Convertible
a.
May be written in policy provisions or by rider
b.
Allows insured to convert without evidence of insurability. Conversion is
to a permanent policy which builds cash value
c.
Conversion date varies by company
d.
Conversion either at original age:
1. Must pay difference between lower cost term and higher cost WL, plus
interest, in lump sum
2. Advantage - builds some CV immediately
3. Disadvantage - must pay lump sum
e.
8.
Uses
a.
b.
III.
Conversion at attained age (present or current age at conversion)
Can fill the need where greatest amount of protection for lowest cost is
appropriate
Decreasing term - protect mortgage, installment loan, business loan, time
period children in college
Specialized Policies
A.
Family Income
1.
2.
3.
4.
5.
B.
Combination of WL and decreasing term policies
Provides monthly income from date of death for remaining years of term.
Counting of term years begins at issue date of policy.
Term usually varies from 10 years to 20 years
Most companies pay the WL benefits after final term payments
No monthly income if insured out lives term
Example: Insured is age 30 when policy is purchased with 20 year term. Dies 5
years into term. Company pays income for remaining 15 years of term. If
insured lives beyond age 50, no income paid - only WL benefits
Family Policy
1.
2.
3.
4.
Combo of level term and WL
No monthly income
Permanent insurance on breadwinner; term on spouse and children
Term insurance provided for each child born or adopted after policy issued at no
additional premium
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5.
C.
D.
Juvenile Insurance
1.
2.
3.
Written on children under age 15
Can be any type policy - WL, limited pay, 10 year term, etc.
Uses:
a.
Take advantage of younger age - lower premium
b.
Assured of having coverage if child becomes uninsurable before reaching
adulthood
c.
Build CV in order to help provide for education
4.
“Jumping Juvenile”
a.
Face amount jumps at age 21(25) - usually 5 times
b.
Premium does not increase
c.
If child becomes uninsurable before age 21 (or 25) policy still automatically
increases
Joint Life
1.
2.
3.
E.
Covers 2 or more persons
Pays at first death
Commonly called Joint First to Die
Survivorship Policy
1.
2.
3.
4.
5.
6.
7.
8.
9.
F.
Coverage expires on children when they reach a specified age - 18, 21 or even 25.
Usually convertible to any permanent insurance with no evidence of insurability.
Covers two lives
Pays only at second death
Commonly called Joint Second to Die
Premiums usually payable until second death
Useful in estate planning
When surviving spouse dies, policy proceeds can pay taxes on assets that may
have been sheltered by the marital deduction
Can be used in certain business situations
Since it pays only at second death, underwriting is liberal. Can allow one person
to be unhealthy and/or uninsurable.
Premiums can be significantly less than if two lives insured separately.
Universal Life
1.
2.
Flexible premium, adjustable benefit contract that accumulates cash value
Two adjustments made to CV account, usually on a monthly basis
a.
Charge against account to pay cost of insurance at current rates for term
insurance
b.
Credit account for current interest (Equal to guaranteed interest plus
excess interest) Not all of CV account receives interest at current rate
c.
Additional annual load (sales charge) on first $1,000 of CV account (So no
excess interest is paid on amount)
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d.
e.
f.
g.
Current interest rate commonly set once each year and guaranteed for
that entire policy year. However, some companies choose a shorter
period - such as 3 months
Current interest is sum of guaranteed interest and excess interest
Guaranteed interest is rate fixed for life of policy
Death Benefit Options:
1.
Option A - Level death benefit
a.
Made up of CV and pure insurance. The longer policy is in
effect, the greater the proportion of the death benefit is
made up of accumulated cash value and the smaller is
made up of the amount of risk.
b.
There is a limit as to how far replacement of amount at
risk by cash value accumulation can be carried
c.
Under law - to qualify as a life insurance contract and
exclude the death benefit from federal income tax. The UL
policy must always include an amount at risk until age 95,
when the death benefit may equal the cash value (CV =
FA). If CV approaches the FA, the death benefit must
increase so as to provide for this amount at risk. The IRS
determines guidelines to be used
Example - Option A:
$45,000 Cash Value
$50,000 Level Death Benefit in Policy
$55,000 Minimum death benefit to qualify as life insurance
under IRS rules.
$10,000 is the amount at risk.
The initial face amount has increased because there must
be at least a minimum level of insurance protection for
proceeds to qualify as life insurance proceeds for tax
purposes.
2.
Option B - Increasing Death Benefit
a.
Made up of policy face amount PLUS the CV account.
Amount at risk is a level amount equal to the policy face
amount.
Example - Option B:
$50,000 Face Amount
$12,000 CV Account
$62,000 Death Benefit
$50,000 Amount at risk
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b.
G.
Variable Life
1.
2.
3.
4.
5.
6.
7.
H.
Securities-based whole life insurance
Requires dual licenses - resident life agent and NASD registered representative
Death benefit may increase with success of investment experience (May also
decrease!)
Must never fall below guaranteed minimum (same as face amount of policy)
Fixed premium payments
CV determined on a daily basis
Characteristics a.
Whole life policy
b.
Death benefit varies with investment experience of separate account, as
specified in policy
c.
Guarantees a minimum death benefit
d.
May be surrendered for cash
e.
May be sold only by NASD licensed agents
f.
Usually has level premiums
Variable Universal Life
a.
b.
c.
d.
I.
At any specific age, policyowner buying more pure
insurance protection under Option B than under Option
A. Therefore, greater cost incurred under Option B than
Option A.
Combination of universal life and variable life
Offers flexibility of universal life
Prospective purchasers must be given a prospectus
Agent must be licensed to sell securities
Interest-Sensitive Whole Life
a.
b.
Guarantees cash value will receive interest over a period of time
Utilizes “vanishing premium” process
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Review Quiz
1. The following statements are true about term insurance except:
A.
B.
C.
D.
low premium outlay.
face value is paid only if you die during the term period.
builds cash value.
temporary protection.
2. An insurance company will grant an advance from the cash value of a life insurance policy when the
policyowner requests which of the following:
A. a low-interest dividend loan.
B. a policy loan.
C. a loan from extended term insurance.
D. an automatic premium loan.
3. A 10 year renewable term policy is characterized by which of the following statements:
A.
B.
C.
D.
can be converted to whole life after 10 years.
automatically converts to whole life after 10 years.
can be renewed for 10 years without proof of insurability.
converts to decreasing term automatically after the initial term period.
4. When an insured reaches age 100, a whole life policy:
A.
B.
C.
D.
pays the face amount to insured if living.
pays face amount to insured as endowment for retirement.
get installments for a fixed period as a settlement option.
is renewed for a fixed period.
5. Which of the following is not correct about life insurance policy types?
A.
B.
C.
D.
term insurance is useful to meet a temporary need.
term insurance pays only if the insured dies during the protection period.
whole life insurance pays the face amount when the insured reaches age 65.
whole life insurance combines nonforfeiture values and protection under a single contract.
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6. Joint life policies are commonly written to cover two or more lives and are usually whole life type
policies. In a situation insuring only two lives, the death of one of the insureds provides the survivor
with the following:
A. The survivor would be required to prove insurability if he/she desired to continuing the coverage.
B. May request an individual policy be issued at his/her current age within 90 days of the first insureds
death.
C. The survivor has no options under this type of policy because no policy exists after a claim is paid.
D. None of the above.
7. A policy form that insures two lives and pays a death benefit at the second death of the two insureds:
A. Requires the applicant/owners to specify who, of the two insureds, is to be the last to die.
B. Will experience a premium increase after the first death.
C. Is commonly known as survivorship insurance and is widely used in estate planning.
D. Will experience a premium reduction after the first death if the survivor is a female.
8. What is a limited payment life insurance contract:
A. The premiums are limited to a specific amount of money.
B. It is whole life contract that is in force for the whole life but the premiums are limited to a specific
number of years.
C. It is a whole life contract that is not in force for the whole of life but the premiums are limited to a
specific number of years.
D. None of the above.
9. Which of the following policies would cost the most at any given age?
A.
B.
C.
D.
20 year term
whole life
20 year endowment
20 payment life
10. If a 35-year old man purchased one of the following policies, which one would provide the highest cash
value at age 65:
A.
B.
C.
D.
whole life policy
endowment at 65 policy
life paid up at 65 policy
twenty payment life policy
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11. If a policy contains a guaranteed insurability rider, the insured has the right to purchase:
A. additional coverage when the insured reaches retirement age.
B. additional coverage whenever the insured changes careers.
C. additional coverage at specified ages.
D. coverage on the insured's children within 31 days of their birth.
12. The "family insurance policy" usually consists of:
A.
B.
C.
D.
whole life insurance on the family head and term insurance on other family members.
whole life insurance on the entire family.
term insurance on the entire family.
term insurance on the family head and whole life insurance on the other family members.
13. Which policy provides term protection for a certain period and then converts to permanent coverage:
A.
B.
C.
D.
mortgage redemption
modified whole life
family policy
family income
14. A jumping juvenile policy:
A.
B.
C.
D.
Pays proceeds to juvenile if the insured dies.
Automatically increases the face amount at a given age.
Endows at age 18.
Waivers premium if juvenile is disabled.
15. Term insurance may be convertible. This means that during the term period:
A.
B.
C.
D.
Cash value insurance may be purchased without proving insurability.
The same coverage may be renewed for another term.
If the insured meets underwriting requirements, permanent insurance will be issued.
An extra large dividend is paid.
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Answer Key
1. C
2. B
3. C
4. A
5. C
6. B
7. C
8. B
9. C
10. B
11. C
12. A
13. B
14. B
15. A
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Part II
The Application, Underwriting & Policy
Delivery
________________________________________________________________________
Completing the Application
Agent's Responsibilities
The following are considered an agent's responsibilities regarding the underwriting process:
•
•
•
•
•
•
•
•
The honest, complete and accurate completion of the application for insurance as well as
any relative comments concerning the applicant
Administration of any necessary Fair Credit Reporting Act forms or inspection report
requests
Issuance of a conditional receipt upon the applicant's payment of premium
Submission of the completed application and any other pertinent information to the
insurer for its underwriting evaluation
Delivery of the policy (once issued by the insurer) to the insured, complete with an
explanation of coverage and the collection of any additional premium not collected at time
of application
Sign policy delivery receipt, leaving a copy with the insured and submitting original to
insurer
Prompt submission to the insurer of any premiums received
On-going contact with the insured
The life insurance policy has a provision that addresses the "entire contract." This provision means that
the policy with all of its provisions, riders, exclusions and a photo copy of the original, completed and
signed application constitute the entire contract of life insurance. A typical life insurance application
includes:
•
•
•
•
•
•
The name, address, age, sex and occupation of the insured
The type of insurance desired
The mode of premium payment
Information concerning beneficiaries (primary and contingent)
Information concerning other life insurance in force
A health questionnaire and examining physician's statement if required
A life insurance application must be signed by the insured and the agent: The insured's signature attests to
the accuracy of the statements made in the application; the agent's signature acts as witness to the
transaction. In addition, if the insured is not the applicant for the policy, the applicant (policyowner) must
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sign as well. Finally, if an examining physician's statement is required, the physician must sign the
application to attest to the accuracy of his/her remarks.
Since a copy of the application becomes part of the "entire contract" along with the life policy itself, any
changes in the application must be signed by the insured and agent. In addition, the agent must remind the
insured of the importance of completing the application fully and accurately. The consequence of
incomplete applications is rejection by the company's underwriters.
As previously noted, representations are statement of fact. Warranties are guarantees that a condition exists.
Warranties become part of an insurance contract; representations do not. In life insurance, statements made
in the application are considered representations, not warranties.
Finally, once the application has been completed by the applicant, the agent usually collects the initial
premium and issues a "conditional receipt." The initial premium payment demonstrates the applicant's
seriousness in purchasing insurance. The use of a conditional receipt demonstrates the ability of life
insurance agents to make coverage effective on one of the following dates:
•
•
Date of application, or
Date of the medical examination.
A properly completed application is obviously important to the insurer, applicant and the agent. Some
possible consequences of an incomplete application are:
•
•
•
•
•
•
Possible inaccurate decisions may be made by the underwriter.
Policy issue delays due to a return of the application to the agent for proper completion in
the presence of the applicant.
Possible loss of trust and credibility of the agent by applicant.
Delays may occur with the request of an attending physician statement (APS) and initiation
of investigation reports.
Claim processing and payment of claims could be delayed.
Possible contestability of a claim.
Underwriting
As mentioned earlier the theory of insurance involves the pooling of a large number of similar pure risks,
thereby transferring the uncertainty related to the risk from the individual to the insurance company, in
return for payment of the insurance premium. Insurers find "similar pure risks" and pool them through
underwriting.
Underwriting is the process by which prospective insureds are reviewed or examined for their
acceptability as insureds. Prospects are either accepted or rejected as a result of the underwriting process.
Accepted risks are classified as to their potential for loss: the true nature of risk.
The purpose of underwriting is to ensure an insurance company that it is pooling similar pure risks, not
dissimilar ones. In this way, losses can be predicted with some accuracy; premiums can be determined
accordingly. As a result, insurers can make a reasonable profit and insureds can be billed equitably.
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The initial consideration in underwriting is selection of acceptable risks. The end product of the
underwriting process is the development of a company's rate structure. The underwriting process
demands adherence to certain guidelines or underwriting rules by which an insurer must abide in order to
prevent adverse selection: the selection of risks which have a greater than average exposure to loss.
Adverse selection has a negative impact on an insurance company's rates. All of the following are factors in
the underwriting of a life insurance policy:
•
•
•
•
Fair Credit Reporting Act
Insurable interest
Risk classification
Medical information and consumer reports
Insurable interest must exist at the time of the application for life insurance. An individual has unlimited
insurable interest in his/her own life. One individual has an insurable interest in another individual's life due
to marriage, a close blood relationship, business relationship, creditor relationship, etc.
Medical information on an applicant can determine through a direct physical examination and the use of the
Medical Information Bureau (MIB), an organization which accumulates medical data on individuals from
member insurers.
The Fair Credit Reporting Act mandates confidential, fair and accurate reporting of information on consumers
by reporting organizations as well as organizations (such as insurers) which use the services of reporting
organizations. Under the Fair Credit Reporting Act, applicants for insurance must be informed if a credit
report is needed in order to underwrite an application. This procedure must be made a part of a written
disclosure statement given to a prospective insured by the insurer before the report is made. If an
applicant is denied coverage based on information contained in a consumer report, the applicant has the
right to obtain:
•
•
A summary of the substance of the information from the consumer reporting agency
The names of the other individuals/companies who have obtained consumer reports on
the applicant within the previous six (6) months from that reporting agency.
Reporting agencies cannot report on adverse information involving the applicant which predates the report
request by seven (7) years except in the case of bankruptcy a (10 year period is allowed).
Once life underwriters have gathered information on a prospective insured's medical, character and credit
background, they can classify these risks in one of the following categories:
•
•
•
Preferred - Usually non-smokers/non-tobacco users with no health or occupational
problems
Standard – No health or occupational problems but may use tobacco products
High Risk – Those with health problems, occupational hazards or avocation risks
Selection Criteria
The selection criteria for individual life insurance depends on a particular company's underwriting
philosophy as well as the specifics of the insurance contract in question. A physical examination might be
required. A credit report ordered. The insurer then determines if it wants to write the individual.
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Sometimes, special circumstances may require use of a "trial application." The trial application provides the
agent with a procedure to focus specifically on an applicants medical history (heart problem, diabetic
condition, etc.), specific background information, or avocation history without initial utilization of a formal
application. The underwriter can focus specifically on the purpose of the trial application submission and
provide the agent with a strong indication of the underwriting approach to the problem. The underwriter
will outline any special medical tests or questionnaires and may offer a rate based on the anticipated
findings.
Premium Determination
Since death is the eventual ending to life, life insurance policies are written with the assumption that they
will be called upon to pay, in full, eventually. Since a life insurance contract anticipates the eventual
payment of its policy limits, it also anticipates the development of a fund - known as a policy reserve - that
will address this payment. Based on its mortality table and its use of the "law of large numbers" to predict
numbers living and dying in a particular age group, a company can establish a rate for life insurance
protection at each chronological age.
In addition to the actuarial basis of its mortality table, companies base the needs of their loss reserve funds
on the basis of interest that they will make on the premiums which they collect and this interest will help
defray the cost of future losses.
Finally, a loading factor is added to address the costs connected with the marketing, sale and administration
of insurance. In summary, life insurance rate-making is based on three major factors:
 Mortality tables
 Interest income
 Loading factors
Combining the rate-making process with the classification process, we can understand that:
 Standard risks pay "standard rates" for their risk exposure to the company
 Preferred risks (e.g., non-smokers), pay "preferred rates" which are cheaper than standard rates
 High risks or substandard risks (e.g., overweight individuals), pay "substandard rates" which are
more expensive than standard rates.
Delivering the Policy
As noted, if the initial premium is paid at the time of application, the applicant is issued a conditional
receipt. This conditional receipt makes coverage effective on one of the following dates:
•
•
Date of application, or
Date of the medical examination if required by the insurer.
If the initial premium is not paid at the time of the application, the policy goes into effect when it is
delivered to the applicant (who must be in good health at the time) and premium is paid.
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Finally, if the premium had been paid at the time of application, but no conditional receipt had been issued,
the policy would become effective upon the delivery of the policy.
Remember, coverage does not begin until the policy is delivered to the insured by the agent unless
conditional receipts are used. When a conditional receipt is used, coverage begins either on the date of
the application or the date of a medical examination (if required), depending on the particular receipt.
When the agent delivers the policy to the insured, he/she must explain the policy and its provisions, riders,
exclusions and ratings to the client. When the insurer mails the policy to the agent, this is considered
"constructive delivery."
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Review Quiz
1. ___________ are guarantees that certain conditions exist.
A.
B.
C.
D.
Representations
Concealment
Misrepresentations
Warranties
2. ___________ are statements of fact believed to be true.
A.
B.
C.
D.
Representations
Concealment
Misrepresentations
Warranties
3. Statements made in an application are:
A.
B.
C.
D.
Representations
Concealment
Misrepresentations
Warranties
4. Who must sign an application for insurance?
A.
B.
C.
D.
Insured/Owner
The insurance agent
Both A and B
Only the policyowner
5. All of the following are factors in underwriting a life insurance policy except:
A.
B.
C.
D.
Insurable Interest
Risk Classification
MIB/Consumer Reports
Premium
6. Life insurance rate making is based on three major factors: mortality tables, interest income and:
A.
B.
C.
D.
The applicant's marital status
The applicant's state of residence
The applicant's warranty of answers on the application
Loading factors
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7. Agent Jones submitted an application for life insurance on John L. Smith. Agent Jones did not collect
any money from Mr. Smith. When will this policy become effective?
A.
B.
C.
D.
When the underwriting process is complete.
On the date the policy issued.
When the 10 day free look has ended.
When the policy has been delivered to the client and the premium paid.
8. If a premium has been paid with an application and the agent failed to give a conditional receipt, when
will the policy become effective?
A.
B.
C.
D.
When the underwriting process is complete.
On the date the policy issued.
Upon delivery of the policy to the insured.
When the 10 day free look expires.
9. If the initial premium is paid at the time of application and the applicant is issued a conditional receipt,
coverage will become effective:
A.
B.
C.
D.
On the date the policy is issued.
Date of application or date of medical exam.
When the policy is delivered to the insured
When the 10 day free look expires.
10. Reinstatement of a life insurance policy requires an insured to take all of the following actions except:
A.
B.
C.
D.
Provide evidence of insurability
Make collateral assignment to the insurance company
Repay any outstanding policy loans plus interest
Repay all past due premiums
11. Bill Insured is the supervising computer programmer for I.M. Big Client. The president of I.M. Big
Client wants to insure Bill as a key person in the business. Who is required to sign the application?
A.
B.
C.
D.
Bill Insured
Bill Insured and the agent
Bill Insured, the agent and the president of I.M. Big Client
None of the above need to sign
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12. John Agent did not receive a premium at the time of application on Bill Insured. After the
underwriting process, but prior to policy issue, Bill had a very slight heart attack. John Agent learns of
this episode when he delivers the policy to Bill Insured who just happens to be working in his garden.
What should John Agent do?
A. Collect the premium due and give Bill the policy.
B. Keep the policy, take the premium and get a current medical report from Bill's physician for the
company.
C. Keep the policy, take the premium and notify his company about what he learned about Bill.
D. Keep the policy and notify his company.
13. If, in question 12 above, John Agent had collected the first premium at the time of application and
learned of Bill's very slight heart attack at the time of policy placement, what should John Agent do?
A.
B.
C.
D.
Keep the policy and notify his company.
Give Bill the policy and notify his company
Notify his company and then give the policy to Bill.
Any of the above are acceptable answers.
14. John Agent is completing an application on Bill Insured and Bill lights a cigarette as John asks Bill to sign
the application. Bill told John that he didn't smoke when asked if he smoked. At this moment, John
Agent refers back to the smoking section of the application and is told by Bill that he does not want to
pay a higher rate because he smokes and that he will not sign the application if the answer is changed.
What should John do?
A.
B.
C.
D.
Leave the answer as is and have Bill sign the application because Bill is responsible for his answers.
Have Bill sign the application and change the answer at the office.
Ask his company to issue two policies; one at smoker rates and the other with non-smoker rates.
Try and explain to Bill his responsibility to his company and Bill holds fast to his position, terminate
the interview.
15. Your client tells you that earlier in the year he had been significantly overweight and had elevated blood
pressure. He has now lost most of the excess weight and now has normal blood pressure and does
not take any medication. How should you handle this situation when taking an application?
A.
B.
C.
D.
Record the facts as they exist today and submit the application to your company.
Defer taking the application for at least one year.
Record the facts as they exist today and arrange for a medical exam.
Record the facts as they exist today and give a report of the history to your company's
underwriting department and await direction from the underwriter.
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Answer Key
1. D
11. C
2. A
12. D
3. A
13. B
4. C
14. D
5. D
15. D
6. D
7. D
8. C
9. B
10. B
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Part III
Standard Policy Provisions & Policy
Options
_______________________________________________________________________
Standard Policy Provisions
An insurance policy is a legal contract and therefore contains the rights and duties of the parties to the
contract. Although there is no uniform life insurance contract where the exact wording is mandated, the
validity of the contract has been established by the courts for over 150 years. Most states, however, have
certain provisions (known as standard provisions) that must be addressed. Exact wording is not necessary,
but must comply with the law in substance. The following are the most common provisions that must be
addressed. This list of standard provisions is important to understand.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
Entire Contract
Insuring Clause
Free Look
Consideration
Owner's Rights
a. assigning and transferring
b. changes that can be made
c. settlement options
d. borrowing policy cash value, etc.
Beneficiary Designations
a. primary
b. contingent
c. tertiary
d. revocable and irrevocable
e. changes
f. common disaster, etc.
Premium Payment
a. modes
b. grace period
c. automatic premium loan
d. level or flexible
Reinstatement
Policy Loans, Withdrawals, Partial Surrenders
Incontestability (two year clause)
Assignments
a. absolute
b. collateral
Suicide Clause (two year clause)
Misstatement of Age
Claim Provision
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The Entire Contract
The life insurance policy and a photocopy of the original application for insurance constitute the "entire
contract." The entire contract" provision states that "no statement shall void this policy or be used in
defense of a claim under it unless contained in the application." This reinforces the idea that the policy
itself (whatever kind of life insurance it may be) constitutes the entire contract along with a copy of the
original application for insurance.
The Insurance Clause
(The heart of the contract) - States that for a consideration of premium, the company will pay a stated
amount to the beneficiary or the insured if the policy endows. Includes name of the insured. (You pay us we pay you.)
Free Look Provision
This provision provides the insured with a 10-day period, following the actual delivery of the policy, to
either keep the policy or return it to the insurance company and receive a full refund of the premium paid.
This 10-day free look period begins when the policy is actually delivered to the insured, any outstanding
premium is collected and a delivery receipt is dated and signed by the insured and witnessed by the agent.
Once this process has been completed, the 10-day free look period begins. Obviously, the policy does
provide coverage on the life of the insured during this time because all premium has been paid and a “live”
contract now exists.
Consideration Clause
Premium Payment - Includes the cost of the policy, premium duration, and when future premiums are due.
Consideration always refers to money or premium.
Owner’s Rights
The owner of the policy may exercise all policy rights and privileges without the consent of any beneficiary
including the right to:
•
•
•
•
•
•
•
•
Assign or transfer the policy
Select and change the payment schedule
Choose and subsequently change a beneficiary (as long as the beneficiary is not an
irrevocable beneficiary)
Select settlement options, conversion options or any nonforfeiture options
Receive or borrow any cash values and/or dividends that have accumulated
Exercise a dividend option providing the policy is a participating policy
Cancel the policy
Receive the policy proceeds upon maturity or endowment
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Ownership
The owner of a life insurance policy can be any of the following:
 The insured
 The beneficiary
 A third party
Usually, the applicant for life insurance is the insured and the owner. However, this need not be the case.
With life insurance, the insured or subject of the policy in question may not be the owner nor the
beneficiary. The policy itself may be owned by someone other than the named insured or beneficiary due
to certain circumstances.
The following statements are true regarding life insurance policies:
•
The "insured" is the subject of coverage in a life insurance policy: if he/she dies, the policy
pays the "beneficiary."
•
The owner of a life insurance policy need not be the insured or beneficiary. An example of
this would be the case of a divorced woman who owns an insurance policy on her exspouse as a result of a divorce decree and who names their son as beneficiary.
•
Ownership of a life insurance policy may be transferred to anyone with an insurable
interest in the life of the insured.
•
With life insurance, insurable interest must exist at the time of the contract (or transfer)
not at the time of the loss (death).
Conversion of an Individual Policy
Under an individual term policy, the insured usually has the option to "convert" the term policy into some
form of permanent life insurance, such as whole life or endowment, without evidence of insurability during
a specified "conversion period" (e.g., the first five years of the term period prior to age 70). Furthermore,
the insured has the option to convert the policy in one of two ways:
•
•
Attained age basis
Original age
If the insured decides to convert the policy at his/her attained age (his/her age at that moment in time) a
premium is developed for the new policy and the insured begins paying that premium. If the insured
decides to convert the policy at the age at which he/she "originally" purchased the term coverage, he/she
will be forced to pay back premiums in the form of a lump sum to the company, plus interest.
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Beneficiary Designations
Primary and Contingent Beneficiaries
A beneficiary is defined as a "person or interest" to whom payment of life insurance policy proceeds will be
made upon the death of the insured.
A primary beneficiary has primary or first claim to the policy proceeds upon the death of the insured. A
primary beneficiary can be multiple parties.
A contingent beneficiary has contingent claim to the policy proceeds upon the death of the insured. This
contingency is based upon the act of the primary beneficiary predeceasing the insured. Therefore, if the
primary beneficiary dies before the insured, the contingent beneficiary will be paid in the event of the death
of the insured.
Contingent beneficiaries may be listed as secondary beneficiaries (making them second in line to the policy
proceeds upon the death of the insured) or tertiary beneficiaries (making them third in line to the policy
proceeds upon the death of the insured).
Tertiary
A tertiary beneficiary is designated as third in line to receive proceeds or benefits if the primary and
secondary beneficiary do not survive. For example: "Beneficiary Mary Jones, wife of the insured if living,
otherwise Sally Jones, mother of the insured if living, otherwise Jim Jones, father of the insured.
Individual and Class Beneficiaries
An individual or a class of persons can be named beneficiary. If a class membership ("all my sisters and
brothers," or "all my surviving children," etc) is altered by births or deaths, for example, it is not necessary
to make a specific policy change each time. Each type must have an insurable interest in the insured when
the policy is originally purchased.
Per Capita / Per Stirpes
When used as part of a beneficiary designation naming more than one person as a primary beneficiary, the
expression "per capita," or person, means that the beneficiaries will divide the proceeds equally among
themselves. For example: If a man insured for $15,000 names his three sons as beneficiaries on a per
capita basis, each of the sons would receive $5,000 at the death of the insured.
However, under a per capita beneficiary designation, if one of the sons had died before the insured died,
the other two sons would divide the $15,000 policy proceeds between the two of them, each receiving
$7,500. Note that the heirs (relatives) of the deceased son would not receive anything.
Under a per stirpes designation, the proceeds which would have gone to the deceased son, had he lived,
would now pass to his heirs. The $15,000 policy proceeds would be divided on the basis of $5,000 to each
of the living beneficiaries and $5,000 to be divided among the heirs (relatives) of the deceased son.
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Child Guardianship and Minors as Beneficiary
Paying the proceeds to a trustee or guardian who is legally entitled to receive and manage such funds on
behalf of the minor is a valid beneficiary arrangement. However, the insurer may be instructed to hold the
death proceeds and credit interest until the minor attains legal/majority age.
Estates
Estates can be designated as beneficiary. There are five disadvantages to naming an estate, rather than a
person, as the beneficiary of a life insurance policy:
1. If no will exists, there's no way of knowing for sure to whom the court will award the proceeds of
the policy.
2. Adding the proceeds to the estate will increase the cost of settling the estate, since estate
settlement costs are usually based on the size of the estate.
3. Once the proceeds have entered the estate, they are paid out in the form of cash, which means
the heirs have no settlement options.
4. Proceeds paid into an estate lose the favorable income tax status of proceeds paid to a named
beneficiary or beneficiaries.
5. Money paid in cash to an heir from an estate is more difficult to protect from the beneficiary's
creditors than proceeds paid directly to a named beneficiary.
Trusts
Trusts may be named as a beneficiary. Many persons create life insurance trusts that are a beneficiary of
various life insurance policies and activated with the death of the insured.
Inter-Vivos Trust
This is a trust (also known as a living trust) created during the lifetime of the settler (creator of the trust),
and become effective during his lifetime, as contrasted with an insurance trust which takes effect at death
of the settler or testator. Assets are put into the inter-vivos trust during the settler’s lifetime.
Revocable and Irrevocable Beneficiaries
In addition to being classified as primary and contingent, beneficiaries are also classified as revocable and
irrevocable.
When the insured is the owner of the insurance contract, he/she has the right to name anyone as his/her
beneficiary, even if the person named has no insurable interest in the insured's life. In fact, the insured has
the right to change this beneficiary at any time and any number of times if the beneficiary is a revocable
beneficiary.
In contrast, an irrevocable beneficiary is one that cannot be changed without the consent of the
beneficiary. An irrevocable beneficiary might be named in a divorce matter where the husband is the
insured and the ex-wife becomes an irrevocable beneficiary of an insurance policy under a divorce decree.
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As such, in light of the presence of an irrevocable beneficiary, the policy is jointly owned by the insured and
the irrevocable beneficiary. The insured cannot exercise any policy option with respect to borrowing
against cash values, etc., without the irrevocable beneficiary's permission. If the irrevocable beneficiary
predeceases the insured, the complete policy ownership usually reverts to the insured. An irrevocable
beneficiary designation may be changed with the consent of the irrevocable beneficiary or at the death of
the irrevocable beneficiary.
Change of Beneficiary Provision
The beneficiaries section of any policy describes the process of the designation and change of beneficiaries.
In general, the following may be said of the changing of beneficiaries in ordinary life policies:
 The owner of the policy may designate and change primary and contingent beneficiaries, as often as
desired, during the lifetime of the insured.
 Usually the owner of the policy is the insured as well.
 Beneficiaries are described as primary and contingent as well as revocable and irrevocable as just
described.
 A transfer of ownership of a policy will not change the interest of any beneficiary automatically.
The new owner has to change the beneficiary in order for a change to take place.
 Unless otherwise permitted by law, no amount payable under a life policy is subject to the claims
of creditors of the payee.
Spendthrift Clause
A spendthrift clause may be included in a life insurance policy requiring that the policy proceeds be paid to
the beneficiary in installments of a defined amount and at set intervals. The beneficiary has no right to
elect a different settlement. Furthermore, the beneficiary is not allowed to borrow from the policy
proceeds nor assign any of the proceeds. In this way, the insured is assured that the beneficiary will not
spend money foolishly as a "spendthrift" (hence the name) upon the insured's death. In addition to
monitoring the spending habits of the beneficiary, this clause acts to prevent creditors from attaching the
policy proceeds upon the insured's death.
The Uniform Simultaneous Death Act
The uniform simultaneous death act is a law that has been enacted in most states to address a situation
where the insured and the primary beneficiary die within a short amount of time of each other (e.g., while
occupants in a car involved in an auto accident). In the event it cannot be determined who died first, the
uniform simultaneous death act presumes that the insured survived the beneficiary named in the policy or
to the insured's estate.
Common Disaster Clause
When included in a policy, the common disaster clause states that in the event the insured and his/her
beneficiary die in or as a result of a common disaster, the insured is presumed to have survived the
beneficiary. As a result, this clause enables the policy proceeds to be paid to the insured's estate or some
contingent beneficiary, and precludes payment of the policy proceeds to the primary beneficiary's estate.
Obviously, this provision in a life insurance policy addresses the same situation as the uniform simultaneous
death act addresses in individual state laws. This common disaster provision expands on the intent of the
uniform simultaneous death act by providing the policyowner with an opportunity to pick a time period by
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which the primary beneficiary must outlive the insured in order for the primary beneficiary to collect. For
example, if the policyowner chooses a 60-day time period connected with the common disaster clause, the
insured can die on March 1st and the primary beneficiary die on April 15th and the insured will be
considered to have "outlived" the primary beneficiary.
Premium Payment
The mode of premium payment is the frequency of premium payment. Modes of premium payment are
annually, semi-annually, quarterly or monthly. Premium payment amounts are either:




Level (as with ordinary life insurance)
Single payment (as with single premium whole life)
Graded premium (as with graded premium whole life)
Flexible premium (as with universal life)
Level Premium Payment
Level premium payment is a provision whereby the insured pays a set premium for the entire span of the
policy. Some term policies allow for a level premium payment for the term of the policy. However, at
policy renewal, the premium level is adjusted to coincide with the insured's age.
Single Premium Payment
With this provision, a one time payment (single premium) is made at the time the contract is activated.
No additional premiums are paid throughout the life of the contract.
Graded Premium Payment
This provision is used in some modified or whole life contracts, allowing for premiums to increase over a
period of time, until a specific level is reached. For example, a young college graduate just entering the
business world might better afford life insurance with lower premiums. As his/her career (and salary)
accelerate, he/she can withstand the higher premiums.
Flexible Premium Payment
Flexible premium is an indeterminate premium provision, and is referred to as a flexible premium life policy
or a variable premium life policy. It allows the insured to vary the amount of premium paid and the timing
of the payments. Whenever the change in payments is adjusted the amount of insurance in force will also
be modified.
Back Dating
Back dating is an option (not a standard provision) permitting the issue of a life insurance policy with a date
earlier than the current date. For example: Assume that a life insurance company establishes and issues
life insurance policies based on the applicant’s age last birthday. An applicant has a birthday on September
15 making him age 35. He applies for a life insurance policy on October 1. With the back dating option,
the agent can request that the policy be issued with a policy date of September 14 to save the applicant’s
age 34. The younger age obviously provides the insured with a lower premium and, with a whole life
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policy, the insured will get higher cash value accumulations. Some states do not allow back dating or allow
back dating for only a set period of time (six months for example).
Grace Period
We have described how policy premiums are paid annually, semiannually, quarterly, monthly and are due
on or before the date prescribed. However, if the insured does not pay the premium on that date, he/she
has a "grace period" during which premium payment is allowed without terminating the contract. The
grace period lasts for thirty (30) days and after this period, the policy terminates unless the required
premium is paid. During the grace period, the full policy provisions apply. If the insured dies during the
grace period, the face amount of the policy will be paid to the beneficiary minus the amount of the
premium due the insurer. The insurer may also deduct any outstanding premium loan plus the interest on
the premium loan. The intent of the grace period is to prevent the unintentional lapse of coverage by an
insured.
Automatic Premium Loan Option
Reinforcing the grace period provision is the automatic premium loan provision that states that a premium
loan will be granted automatically to pay a premium in default. When this provision is included in a policy,
the company will pay the premium due and charge it against the cash value of the policy at a rate used for
other policy loans. Therefore, the insured's policy will not lapse as long as there are cash value buildups in
the policy. This option is usually selected by the insured at the time of application and is available in
policies having cash value.
Reinstatement
Reinstatement is the restoration of a lapsed policy as originally purchased. Permanent life insurance
contracts permit reinstatement of lapsed policies in nearly all cases. Reinstatement of a policy is done
because the old policy would have a more favorable rate as it was purchased at a younger age. Unless the
policy has been surrendered for cash, it may be reinstated within three years (in most policies) after
payment of the last premium (the premium last paid before default). The insured will receive the
protection of the original policy if he/she does the following:
 Provides satisfactory evidence of insurability (medical examination)
 Pays back premiums owed plus interest
 Pays any other debt owed the company plus interest
A reinstated policy usually starts a new contestable period (two years); however, it does not require a new
suicide period.
Policy Loans, Withdrawals and Partial Surrenders
After premiums have been paid for a sufficient time (usually 2-3 years) to build up cash values, an insured
may withdraw a portion (e.g., up to 80%) of the cash surrender value of the policy as a loan. The amount
of this loan, plus any existing indebtedness to the policy, may not exceed the cash surrender value. The
policy itself is used as collateral for the loan. The insurer may take up to six months to honor a loan
request and may charge interest of as much as 1.5% per month (18% APR).
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The term withdrawal simply means that the insured is exercising the right to extract available funds from
the life insurance policy cash value.
The term partial surrender simply refers to the fact that the insured chooses to extract only a portion of
the available cash value.
The interest on the loan is specified in the policy, subject to individual state law. The loan may be paid at
any time: there is no set schedule for repaying the loan nor set payment amount. If the interest is not paid
and the loan amount increases to an amount greater than the cash value, the policy will terminate. If the
insured dies after having made a loan against the policy, the loan amount plus any applicable interest will be
subtracted from the policy proceeds. If the interest on the loan is not paid, the interest due will be
subtracted from the policy's remaining cash value. Once this cash value is exhausted, the policy will
terminate after the insured has received proper notification.
Universal life policies and similar interest-sensitive products often contain a policy withdrawal provision
(also known as a "partial surrender provision") which allows the policyowner to withdraw the policy's cash
value interest free. However, the face amount of the policy is reduced by the same amount as the
withdrawal. Most universal life and similar policies limit the amount of a withdrawal and the number of
withdrawals permitted each year. In addition, an administrative fee is usually charged per withdrawal.
Incontestability
The incontestable clause is provided to protect the insured. It states that after a life insurance policy has
been in effect for two years the company cannot claim that a statement made in the application for
insurance was meant to defraud the insurer. As a result, once a life policy has been in effect for two years,
an insurer cannot try to suspend coverage based on concealment or fraud made by an insured in the
application. Without this incontestable clause, insureds might be required to substantiate statements in
applications made many years before. The first two years are known as the "contestable period." As previously
stated, a lapse of the policy and subsequent reinstatement will usually initiate a new contestable period.
Finally, the death of the insured during the contestable period will suspend the clause. As a result, if the
insured did attempt to defraud the insurer through statements made in the application, these statements
could be used against the insured's beneficiary if he/she died before the two year period had elapsed. In
other words, the insurer could invoke this clause during this two year period for material
misrepresentation.
Assignments
Assignment of life insurance is a transfer of the owner's rights in a policy, in whole or in part, to another
individual. There are two types of assignment: absolute assignment and collateral assignment.
An absolute assignment (total assignment) is the assignment of the entire policy, complete with all of its
rights.
A collateral assignment is made, as its name suggests, to serve as collateral for a debt. As a result, the
person receiving the collateral assignment only receives the rights in the policy necessary to create
collateral for the indebtedness. In other words, if a policy is used as collateral for a $5,000 debt, the
creditor is entitled to $5,000 only, not one dollar more (referred to as a partial assignment).
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When a policy is assigned to another person (the assignee), the other person becomes the owner of the
policy to the extent assigned, not the beneficiary. If the assignment is absolute, the assignee is entitled to
receive repayment of the debt invoked from the proceeds of the policy or the cash values. The right of
assignment reflects the fact that a life insurance policy is viewed by the law as property.
The concept of assignment becomes complicated in light of the beneficiary provision. If the policy names
an irrevocable beneficiary (a beneficiary who cannot be changed without his/her consent), the policyowner
cannot assign the policy without the irrevocable beneficiary's permission. However, if the policy names a
revocable beneficiary (a beneficiary who can be changed by the policyowner), the policyowner need not
consult with the revocable beneficiary before assigning the policy.
Suicide Clause
The suicide clause states that if an insured, whether sane or insane, commits suicide during the first two
years after a life insurance contract has been issued, the company will pay only the premium paid by the
insured, not the face amount of the policy. Once the policy has been in effect for two years, an insured's
suicide will result in payment of the full face amount of the policy. A suicide will not result in the multiple
payment of an accidental death claim.
Misstatement of Age
The incontestability clause previously discussed does not pertain to an insured's misstatement regarding
age. If a deceased insured misrepresented his/her age, the face amount of the policy will be adjusted to an
amount the premium would have purchased at the insured's correct age, at the time of purchase of the
policy. For example, if an insured claimed to be 30 years old when in fact he/she was 40 years old, the
$50,000 policy purchased would be adjusted to a lower face amount in the event of his/her death. If the
insured claimed to be 30 years old when in fact he//she was 20 years old, the $50,000 policy purchased
would be adjusted to a higher face amount.
If a misstatement of age is discovered while the insured is alive, this mistake will be rectified usually at the
insured's option. An understatement of age will result in the original policy being reissued for a reduced
amount or the original policy amount retained after the payment of the premium difference (with interest).
An overstatement of age will usually result in a refund of premium payment.
Claim Provision
The insurance company is generally required to pay a death claim within 60 days (two months)
after receiving notification of the claim. If the claim payment is made more than 60 days after
notification of the claim, interest must be paid.
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Policy Options
In addition to the above standard policy provisions, it is important to understand the options listed below
because they are an integral part of life insurance policies. A detailed explanation of each of these options
will follow:
1. Nonforfeiture Options
a. Cash or loan value
b. Reduced paid up insurance
c. Extended term insurance
2. Dividends and Dividend Options
3. Settlement Options
a. Lump sum option
b. Income options
Nonforfeiture Options
Permanent insurance contracts provide nonforfeiture options. Literally, nonforfeiture options are
privileges that cannot be forfeited or lost to the insurer by the insured if the insured can or will no longer
pay the premium payments.
As previously discussed, to achieve level premiums in a whole life policy, a company overcharges in
premium in the early years. The company must by law, provide a fair and equitable return on these
premiums paid in advance. This return builds, and is known as the policy's cash value. The value is not
forfeited if a policy lapses or is surrendered, and the insured has the following required standard nonforfeiture options:
1. Cash Surrender Value - Surrender policy, withdraw cash. Amount in excess of premium is taxable.
2. Reduced Paid-up Value - Cash value is used to buy a permanent paid-up policy of reduced face
amount.
3. Extended Term - Cash value is used to buy a term policy of same face value, for as long a period as it
will buy. Also known as the "automatic option" if no choice is made.
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$25,000 Whole Life Nonforfeiture Table (20 Years)
End Of
Policy Year
1
2
3
4
5
Reduced
Paid-Up
Insurance
Cash Or
Loan Value
$
Extended Term
Insurance
Years Days
0.00
0.00
50.00
275.00
475.00
0.00
0.00
325.00
1,700.00
2,800.00
0
0
1
5
8
0
0
10
64
7
6
7
8
9
10
700.00
925.00
1,175.00
1,400.00
1,675.00
3,950.00
5,000.00
6,075.00
6,950.00
7,975.00
10
12
14
15
17
216
239
197
274
34
11
12
13
14
15
1,925.00
2,200.00
2,475.00
2,775.00
3,075.00
8,800.00
9,650.00
10,400.00
11,200.00
11,925.00
17
18
19
19
20
348
284
141
350
130
16
17
18
19
20
3,375.00
3,700.00
4,025.00
4,375.00
4,725.00
12,575.00
13,275.00
13,875.00
14,500.00
15,075.00
20
20
21
21
21
223
316
1
52
64
By law the policy must show 20 years of nonforfeiture options.
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Dividends and Dividend Options
Life insurance premiums are developed to address two distinct rating plans:
 Participating
 Nonparticipating
Under a participating plan, the company develops a rate with a "generous" margin for error in the areas of
mortality, interest, and operating expenses. If the full annual premium is not needed, the overcharge is
refunded to the insured in the form of a dividend. However, if the full premium is needed, no dividend is
provided to the insured. In other words, dividends are not guaranteed.
Under a nonparticipating plan, the company's rate has a less generous margin for error. If actual costs
exceed the projected rate, the company and its stockholders bear the loss. If the costs do not exceed the
projected rate, a profit is declared. However, under a nonparticipating plan, the insured receives no
dividends in any event.
As noted, dividends are refunds of an initial overcharge to the insured. The insured has the following
options by which dividends can be received (known as dividend options):





Cash
Premium reduction
Paid-up additions
Accumulation at interest
One-year term option
The first dividend option is very simple. The insured may take dividends in cash. If the insured desires this
option, he/she will receive a check for dividends annually.
If the insured chooses the second option, the dividend amount will be subtracted from the annual premium
of the policy. The insured will pay the remainder which is known as the "net premium."
The paid-up additions option utilizes the dividend to purchase as much paid-up additional insurance as
possible. This additional insurance is the same type as the original coverage producing the dividends.
The dividends may be allowed simply to "accumulate at interest," meaning they are left with the company
to accumulate interest in the name of the insured.
In addition to the "traditional" dividend options listed above, a fifth option has been included which
provides the insured with the opportunity to purchase a one-year term policy in an amount the dividend
will purchase.
Keep in mind that dividends and dividend options only apply to participating life insurance policies.
Dividend projections may be included in a proposal for life insurance when this proposal clearly states that
payment of future dividends is not guaranteed.
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Settlement Options
The following are standard settlement options in the event a policy is required to pay its face amount:
1. Lump Sum Cash Settlement - Under a lump sum cash settlement, the beneficiary receives the face
amount of the policy, plus any cash buildups if applicable, in the form of one check.
2. Interest Only - Under the interest only settlement option, the company retains the face amount of
the policy (which will be paid at some later agreed upon date) and pays the beneficiary an interest
income at certain specified intervals. This option might appeal to someone who does not need the face
amount of the policy at the time of the insured's death.
3. Fixed Period Installments - The fixed period installment option divides the face amount of the policy plus
any cash buildup and interest by the desired fixed payout period (e.g., 10 years) and arrives at a monthly
payment amount.
4. Fixed Amount Installments - The fixed amount installment option divides the face amount of the policy
plus any cash buildups and interest by the desired fixed installment amount and arrives at the number of
monthly payments to be paid.
5. Life Income Options - The life income options provide the beneficiary with the opportunity to receive
the policy proceeds in the form of an annuity:




Straight life income
Life income with period certain
Life income with refund
Joint and survivor income
Under the straight life income, the life policy proceeds are used to fund an annuity that will pay a
specified amount of money for the remainder of the individual's life. The amount of the annuity itself is
based on the attained age of the individual, his/her life expectancy and the amount of lump sum premium
(from the original life policy) to fund the annuity. Once the annuitant dies, even if this annuity is in its first
year of operation, payments cease and the insurer keeps the full lump sum premium that funded the
annuity originally.
Under the life income with period certain option, the annuity is paid for the lifetime of the beneficiary
(as with the straight life option), but a minimum number of payments are guaranteed. As a result, if the
annuitant dies, even in the first year of operation, the annuitant's beneficiary receives the balance of the
payments for the certain period (e.g., 5 years, 10 years, etc.).
Under the life income with refund option, the annuity is paid for the lifetime of the beneficiary (as with
the preceding two options), then a refund is made to the beneficiary of any remaining balance.
Finally, the joint and survivor income option provides an income over the lives of two individuals, usually
husband and wife; payment stops upon the death of the second individual (the "survivor" of the pair).
Usually, the annuity is arranged in such a way that more money is provided while the two individuals are
alive and less money (because of the lesser need) upon the death of one of the individuals. For example,
the joint and two-thirds option, provides that the initial income will be reduced following the death of one
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of the two individuals to an amount equal to two-thirds of the original sum. Similarly, the joint and onehalf option provides that the initial income will be reduced to one half of the original sum.
Policy Exclusions
Many life insurance policies have certain exclusions and will not pay a death benefit if death occurs as a
result of:
•
Certain aviation activities
•
Suicide, if a suicide is committed while sane or insane during the period cited under the
suicide provision
•
War-like activities. This exclusion is included in the policy to avoid catastrophic
consequences of numerous deaths not anticipated with the company's mortality tables.
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Review Quiz
1. All of the following are standard life insurance provisions except:
A.
B.
C.
D.
Assignment
Misstatement of Age
Incontestability
Policy Back-Dating
2. To reinstate a lapsed policy, the applicant must:
A.
B.
C.
D.
Pay all back premiums with interest.
Notify agent and pay all premiums which are due.
Submit a new application.
Pay all back premiums with interest and prove insurability.
3. The uniform standard policy provision law requires all of the following life insurance provisions except:
A.
B.
C.
D.
Suicide
Incontestability
Assessment
Reinstatement
4. A transfer of the right to receive benefits of a policy to another for a particular claim is known as:
A.
B.
C.
D.
Level indemnity
Level benefits
Rebating
Assignment
5. A provision that states the contract and the application together form the entire contract between the
policyowner and the company is called the:
A.
B.
C.
D.
Whole Contract
Contingent Contract
Entire Contract
Exception of the Contract
6. In a ____________ assignment of a life insurance policy, when the debt is paid off the assignee will
transfer back to the insured all rights of the policy.
A.
B.
C.
D.
Collateral
Absolute
Combined
Transfer
7. The mode of premium payment:
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A.
B.
C.
D.
Is defined as the frequency and the amount of the premium payment.
Is the factor which determines the amount of dividends in a policy.
Is the method used to compute the cash surrender value of the policy.
All of the above.
8. Mr. Smith names his wife as the primary beneficiary of his universal life policy on a revocable basis. He
also names his three children as his secondary beneficiaries and his estate as his tertiary beneficiary. If
Mr. Smith's wife predeceases him and then he dies, who will receive the policy proceeds?
A.
B.
C.
D.
The children
Mr. Smith's estate
The primary beneficiary's estate
The tertiary beneficiary
9. A life insurance company may contest a policy during the contestable period for which of the following
reasons:
A.
B.
C.
D.
Nonpayment of Premiums
Material Misrepresentation
Change of Occupation
Misstatement of Age
10. A life insurance policyowner normally has the right to do all of the following except:
A.
B.
C.
D.
To assign the policy.
To borrow the loan value.
To establish and change the premium payment schedule.
To determine the premium for the policy.
11. The insuring clause in a life policy states which of the following:
I. The insurer will pay the insured/policyowner a stated sum when the policy matures.
II. The promise that the insurance company will pay a stated amount to the beneficiary upon receipt of
proof of death of the insured.
A.
B.
C.
D.
I only
II only
Both I and II
Neither I nor II
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12. Which of the following policy provisions state that the application is part of the policy?
A. Entire contract
B. Ownership clause
C. Nonforfeiture option
D. Assignment clause
13. A (an) _______is a single-premium amount of additional insurance purchased by a policy dividend.
A. Extended Term Option
B. Term Option
C. Paid-Up Addition Option
D. Annuity Certain Option
14. A prospect's statement made in the application for insurance constitute a part of which of the
following:
A. Consideration Clause
B. Incontestability Clause
C. Subrogation Clause
D. Coinsurance Clause
15. Which of the following statements about the reinstatement provision is correct:
A. It provides for reinstatement of a policy regardless of the insured's health.
B. It guarantees the reinstatement of a policy that has been surrendered for cash.
C. It permits reinstatement within 10 years after a policy has lapsed.
D. It requires the policyowner to pay, with interest, all premiums that are in arrears in order for the
policy to be reinstated.
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Answer Key
1. D
2. D
3. C
4. D
5. C
6. A
7. A
8. A
9. B
10. D
11. C
12. A
13. C
14. B
15. D
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Part IV Group Life Insurance
________________________________________________________________________
Group life insurance provides coverage to a group of individuals under one master policy. Any group must
be a "natural group" formed for a reason other than solely to obtain group insurance coverage. The
insurance must be incidental to the purpose of the formation of the group. Group life insurance is
characterized by:
 Usually specifies the minimum number of individuals that can be written (ten persons is referred to
as a "true group"; less than 10 is referred to as a baby group)
 Provides a "master policy" to the administrator of the group and a "certificate of insurance" to each
member
 Usually not requiring evidence of insurability from individuals within the group
 Written on a contributory basis (e.g., employer and employee pay for the premium) or noncontributory basis (only the employer pays; the employee does not contribute)
 Requires 100% participation by employees for noncontributory plans and 75% participation by
employees for contributory plans
 Individual underwriting usually not required and coverage usually guaranteed issue
 Usually has a grace period of 31 days
 Premium based on average age of group
 Has a two year incontestability period applicable to the sponsor (employer, association, union,
etc.)
 Plan of insurance is usually one year renewable and convertible term insurance
Eligible Groups
Group life insurance can be issued to the following eligible groups:





Employee groups (10 persons at date of issue)
Labor union groups (require 25 or more covered members)
Employer and labor union group combinations
Public employee groups
Professional associations and trusts (100 or more covered members)
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Legal Requirements of a Group
In keeping with NAIC Model Group Life Insurance Bill, the legal requirements of group insurance are
uniform throughout the majority of states and include the following six basic characteristics:
1.
All states define a "true" group as having at least 10 people covered under one master contract.
2.
Coverage is generally available without individual medical examinations.
3.
The master group policy is issued to the employer, trust, union, or the association. Certificates
of insurance are issued to the individual insureds.
4.
The insurance cannot be obtained to benefit the employer, trust, union, or other association. It
must be for the benefit of the covered employee or member, and their dependents.
5.
Premiums are based on the age of the group as a whole. Premium may be paid entirely by the
policyowner or, paid jointly by the policyowner and the insured. If premium is paid entirely by
the policyowner it is a "noncontributory plan," and all eligible employees or members must be
covered. If premium is paid by both policyowner and insured the plan is a "contributory plan,"
and at least 75% of all eligible employees or members must be covered. The employer or
association is always required to pay some portion of the premium. Insureds are, by law, not
permitted to contribute more than a specified amount.
6.
Individuals covered under the plan are classified in such a way (usually by salary, or time on the
job) that they do not choose the benefit levels.
Contributory vs. Noncontributory Plans
In group life insurance, under a contributory plan, the insured's employees "contribute" to the plan
financially.
Most all states require employers in an employer-employee group to pay a percentage of group life
insurance in a contributory plan. Group life coverage must be offered to all eligible employees, but all need
not carry it under a contributory plan. Most states require participation by 75% of eligible employees in
order for a group to be eligible for coverage.
In contrast, under a noncontributory plan, the employer pays the full amount of the policy premium; the
employee pays nothing. All eligible employees must be covered under a noncontributory plan. This is
known as 100% participation. From an underwriting standpoint, 100% participation helps to preclude
adverse selection.
Group Conversion Privilege
Group life insurance policies allow terminating employees to "convert" to individual life coverage without
evidence of insurability. An individual policy will be issued:
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 Upon payment of the first premium and completion of an application within 31 days of termination
of group membership
 If a master group policy is in force on the date of the individual's termination, providing the
individual has been insured for at least 3 years
 In an amount equal to the group amount applicable to the insured upon termination minus any
applicable amount of group insurance for which the insured becomes eligible upon termination
from the first group
Premium rates for these conversion policies must be based on the insurer's individual premium rates for an
individual at the prospective insured's attained age.
Finally, the NAIC model legislation provides that a conversion privilege must be available upon termination
of the master group policy. The maximum amount of coverage available under this model bill is the lesser
of:
 $10,000; or
 The amount of coverage in force under the group plan minus the amount of group
coverage for which the insured becomes entitled to receive (e.g., under a new group
policy) within 31 days of termination or $2,000.
Dependent coverage is sometimes provided under employer sponsored group plans in amounts less than
provided the covered employee. Typically, the spousal coverage is $5,000 or less with a conversion right
of $2,000.
Standard Provisions of a Group Policy
Group insurance policies have special provisions that are unique to group insurance. Most states have
enacted, or adopted the standard provisions found in the NAIC model bill for group life insurance. Group
policies must contain provisions relating to the following:
 Grace period - usually 31 days
 Incontestability - usually one or two years after the policy becomes effective; usually two years
from the insured's effective date of coverage
 Entire contract - the application must be attached to and made part of the master contract
 Representations - statements regarding the individual's health are representations not warranties
 Evidence of insurability - individual insurability must be proven if the employee or member joins
the plan after the enrollment period
 Misstatement of age - premium is adjusted to the correct age to average of group; under individual
insurance benefits are adjusted
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 Facility of payment - allows payment of policy proceeds to a close relative or friend if no
beneficiary is named, or living
 Conversion - the right to convert to an individual policy when the insured's coverage is terminated
because of termination of employment, or the elimination of a class of insureds
 Termination of master policy - the right to convert to an individual policy because the master
policy has been terminated usually allows 90 days in this case
 Individual certificates - issued as evidence of coverage under a master policy
In addition to the rights of conversion, an insured who dies after coverage has terminated, but before the
end of the 31-day conversion period, the beneficiary will receive the group life policy benefit.
Group Credit Life Insurance
Group credit life insurance is offered to persons borrowing money from a bank, finance company or some
other lending institution who may be financing such items as automobiles, furniture, etc. The purpose of
such coverage is to cover the unexpected death of an individual who has obligated himself/herself to time
payment obligations.
As we have seen with employer/employee group life arrangements, the insurance company will issue a
master policy to the lending institution and the lending institution issues a certificate to the borrower to
the extent of the loan. If the borrower dies, the loan is paid (decreasing term insurance is used).
Usually, credit disability is also offered by the lender to provide coverage of the installment payments
should the borrower become disabled. Such payments begin after a "waiting period" that can range from 7
days, 14 days or 30 days. The renewal provision of the master policy may require a specified number of
new insureds annually.
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Review Quiz
1. Under group insurance practices, the original policy is called:
A.
B.
C.
D.
Master Policy
Controlling Policy
Comprehensive Outline
Representative Policy
2. The premium in group life may be based on:
I. Medical records of individuals in group
II. Group experience
III. Age distribution of individuals in group
A.
B.
C.
D.
I
II
III
All of the above
3. The minimum grace period in a group life policy gives the:
A.
B.
C.
D.
Policyholder 30 days for payment of any premium due except the first.
Insurer 31 days in which to inform the policyholder that his policy will lapse.
Policyholder has 31 days for payment of any premium due except the first.
Insurer 30 days in which to inform the policyholder that his policy will lapse.
4. An employee covered under a group life insurance would have ________ days of coverage after
termination of employment:
A. 60
B. 7
C. 31
D. 15
5. Which of the following items are included in the conversion privilege provision of a group life insurance
policy?
I. Conversion on termination of employment.
II. Conversion in the event that the group policy is terminated.
III. Conversion to an individual policy if an insured dies within the convertible period provided by the
policy.
A.
B.
C.
D.
I
II
III
All of the above
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6. Under contributory group life insurance policies, the minimum percentage of employees required to
participate is:
A.
B.
C.
D.
No minimum required
50%
75%
100%
7. Under a non-contributory group plan, what percentage of employees must be eligible:
A.
B.
C.
D.
100%
75%
50%
35%
8. Group credit life insurance:
A.
B.
C.
D.
Is a major segment of the insurance business.
Enjoys level prices from company to company.
Provides protection for creditors.
Requires financial institutions to collect on unsecured obligations from the estate of debtors.
9. An employee covered by group life insurance receives:
A. A Master Policy
B. An Individual Policy
C. A Certificate
D. A Subscription
10. A spouse's conversion privileges under a group policy are the same as the group member's except:
A. Insurability need not be proven.
B. Conversion must be applied for within one month.
C. Premiums are based on attained age.
D. The amount of conversion is less.
11. The amount of coverage on the spouse of a group life policy member that may be provided without tax
consequences to the member:
A. Is limited to $2,000.
B. Is limited to one-half of the member's coverage.
C. Is limited only by the member's ability to pay.
D. May be any amount that does not exceed the member's coverage.
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12. All of the following are true about group life insurance except:
A. Premiums are based on the average age of the group.
B. Coverage is usually available without a medical exam.
C. Group policy provisions include a grace period.
D. Each individual insured receives an insurance policy.
13. When writing group insurance, companies use the following as underwriting guides to guard against
adverse risk, except:
A. Medical examination for prospective insureds who are borderline risks.
B. Minimum participation rules.
C. Benefits determined for formula.
D. Careful group selection.
14. Generally, an employee is taxed on the cost of employer-provided group insurance above:
A. $50,000
B. $30,000
C. $100,000
D. $5,000
15. All of the following are true about the group life insurance conversion option except:
A. No benefits are paid if a terminated employee dies before converting.
B. The option is available upon termination of employment.
C. Evidence of insurability is not required for conversion.
D. The option must be exercised during a specified period of time.
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Answer Key
1. A
2. C
3. C
4. C
5. D
6. C
7. A
8. C
9. C
10. D
11. A
12. D
13. A
14. A
15. A
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Part V
Life Insurance and Taxation
The taxation of life insurance is a complex issue, because the product may be affected by federal
income, corporate, gift and estate taxes. State taxes are usually limited to premium taxes,
calculated into the gross premium paid by the consumer, and have relatively little direct impact.
Of course, Congress is always altering the Internal Revenue Code, so federal tax rules are always
subject to change.
The "Life Insurance" Tests
The most important factor in determining the tax effect on a life insurance product is its status as
"life insurance" within the Internal Revenue Code. In reaction to abuses 20 years ago, Congress
created two tests that all products must pass—the cash value accumulation test and the guideline
premium and corridor test. A policy qualifies as life insurance if it meets either one.
The testing is done by the issuing company, and all approved products from admitted
companies pass one test or the other.
The cash value accumulation test, most usually applied to whole-life type policies, limits the cash
value to the single net premium necessary to fund the actuarial death benefit.
The guideline premium and corridor test, a 2-pronged test applied to universal life-type
policies, limits the total premium that can be paid in at any one time and establishes a
minimum ratio of death benefit to cash value at all times.
These rules are contained in Section 7702 of the IRC and are also known as the Section 7702 tests.
Basis and Individual Life Insurance
Assuming a product qualifies as "life insurance" under the law, the key element in reviewing the
taxation of individual life insurance is the concept of “basis.”
Basis in taxation is, in effect, the total costs attributable to an investment or purchase. With life
insurance tax basis is the sum of all premiums paid plus all dividends received in cash. "Premiums
paid", however, does not include any premiums paid for any additional benefits, such as waiver
of premium, if these can be calculated separately.
Keep the concept of basis in mind. It appears frequently in tax issues.
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Individual Life Insurance
PremiumsPremiums paid for individual life insurance products, including premiums for additional
benefits, are not deductible items for the federal income tax, whether the taxpayer itemizes
or not. There are two common exceptions, however. Premiums paid for life policies gifted
to or absolutely assigned to a qualifying charitable organization are deductible for taxpayers
who itemize. And premiums paid as part of a court-approved alimony settlement are also
deductible (and taxable as income to the receiving ex-spouse.)
Death BenefitsSince premiums aren't deductible, death benefits aren't taxable as income, either. And this
principal also applies to the newer concept of accelerated benefits. Insureds may receive up
to two per cent of the face amount of their policy a month as tax-free income if they are
terminally ill, or one per cent a month if they are in a long-term care situation, up to a total
of 50 per cent of the death benefit.
But there is an important exception to the principal that death benefits are not taxable. If the
policy violates the "transfer for value" rule, proceeds will be taxable as income. A transfer for
value occurs whenever a policy is sold or transferred from one owner to another (not one
insured to another) for any valuable consideration. Fortunately, there are five acceptable
exceptions to the transfer for value rule. Any policy sold or transferred within one of these
exceptions will not lose its tax-free death benefit.
The five exceptions are:
•
•
•
•
•
transfers in which the transferee-owner is the insured.
transfers to a partner of the insured (but not a fellow shareholder).
transfers to a partnership in which the insured is a partner.
transfers to a corporation when the insured is a shareholder or officer.
transfers in which the transferee's tax basis is determined by the basis of the transferor.
Given these exceptions, it is difficult to violate the transfer for value rule. But one situation
where violations can occur is when shareholders in a corporation assign or transfer individual
policies to their fellow shareholders as a means to guaranty a cross-purchase buy-sell
agreement.
Settlement OptionsWhile life insurance proceeds are generally not taxable to the recipient, the interest portion
of settlement options is. These payments are taxed as if they were annuities, with the
portion attributable to the insurance principal received tax-free and the remainder taxable as
income.
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Additional BenefitsThe premiums for additional benefits are also not deductible and do not count toward basis,
while the benefits themselves are not taxable. Most importantly, premiums waived while
disabled under a waiver of premium benefit do not trigger taxable income and any dividends
received during that period are taxed as if the premium were being paid.
DividendsThe tax code considers policy dividends to be refunds of overcharges and thus not taxable,
but there are two exceptions to this general rule. First, when the total of all dividends paid in
cash exceeds the total premiums paid, the excess becomes taxable income (this rarely
happens). Second, when dividends are accumulated at interest, the interest becomes taxable
as if the account were passbook savings.
But dividends used to reduce premiums do not trigger either of these tax issues and
dividends used to purchase one-year term or buy paid-up additions remain tax-free benefits.
Policy Loans and WithdrawalsPolicy loans and withdrawals are not taxable income, unless the policy is surrendered with an
unforgiven (unpaid) loan. Then the loan is reported as taxable income by the insurer. This
phenomenon is known as "phantom income."
Interest on policy loans, even if paid, is considered consumer interest and is no longer
deductible, even for taxpayers who itemize.
Consequently, the "inside buildup" of cash value is also not taxable, even if taken as loans,
until the policy is surrendered. However, Congress periodically reconsiders its opinion on
this particular tax advantage for the product and it is possible it could change someday.
Policy SurrendersSurrendering a policy for cash does trigger a taxable event. If the cash value received,
including unpaid loans exceeds the basis, then the excess is taxable income in the year
received. Most surrenders, however, result in a loss, although there is no provision in the
Tax Code for deducting any losses.
The potential surrender penalty does not apply to the election of the other two nonforfeiture values–extended term insurance or reduced paid-up insurance. The remaining death
benefits remain tax-free and the cash value (in reduced paid-up) may be borrowed on a taxfree basis. The surrender of a reduced paid-up policy is treated just like the surrender of an
active policy.
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Section 1035 Exchanges
Another important tax advantage for life insurance is the tax-free exchange provision
contained in Section 1035 of the Tax Code.
A 1035 exchange permits a policyowner to exchange one life policy for another without
penalty, provided that the entire cash value is transferred from the old policy to the new one.
In effect, the policyowner is permitted to rollover his basis to the new policy.
Also, a life policy may be exchanged for an endowment contract or an annuity under the
same Section 1035 rules. (An endowment may be exchanged for another endowment or an
annuity, but not a life policy. And an annuity may only be exchanged for another annuity.)
Modified Endowment Contracts
Some of these tax advantages are lost if the life policy is determined to be a Modified
Endowment Contract (MEC), although the term is misleading because a MEC has nothing to
do with a contractual endowment.
A MEC is a life insurance policy that has failed the 7-pay test, meaning that too much
premium was paid in during the policy's first seven years. Congress wrote these rules to
protect against another of a series of tax-avoidance abuses. By definition all single-premium life
products are MECs.
A MEC can never lose its status. Once a MEC, always a MEC. MEC status is not necessarily a
bad thing. The tax-free death benefit is unaffected, as is the tax treatment upon surrender.
What are affected are policy loans and withdrawals. In a MEC these lose their FIFO accounting
status (first-in, first-out) and are treated on a LIFO basis (last-in, first-out), meaning that loans
and withdrawals trigger taxable income until the total taken equals the basis. In effect, MECs
are taxed as if they were annuities in these transactions.
Corporate-Owned Life Insurance
Corporate-owned life insurance (COLT) is, for the most part, taxed as if it were individuallyowned. That is, premiums are not deductible and proceeds are not taxable. This is especially
true for policies used to fund key person benefits and buy-sell agreements. Remember,
however, that using individual policies to fund a cross-purchase agreement may trigger the
transfer-for-value tax trap.
Likewise, the tax rules regarding settlement options, policy loans, dividends, surrenders and
MEC status are the same for COLI as for individual policies, with one important exception.
Loans and death benefits for certain large policies are preference items and may trigger the
corporate alternative minimum tax. The rules governing this are complex, and frequently
changed, but it is an issue that practitioners must be alert to.
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Split Dollar
Split dollar plans are almost impossibly complex, but the general rule is that as long as the
corporation owns the policy, then the employee is subject to taxation only on the imputed
value of the premium, called the Table 2001 cost (formerly the P.S. 59 cost). In effect the
employee pays income tax on the equivalent to the premium for a 1-year renewable term
policy. With tax rates so low, this tax treatment makes split dollar very attractive. It creates
insurance at a discount.
Reverse and equity split dollar, where the employee owns the policy, is a much more
problematic issue and should be researched thoroughly.
Deferred Compensation
Although life insurance is commonly used to assure a participant in a deferred compensation
plan that benefits truly will be paid, great care must be taken so that the plan remains
"unfunded." (Funding deferred compensation with COLI creates an unfunded plan.)
As long as the plan is unfunded, the participant does not generate imputed income upon the
payment of the premium. In other words, the plan does not trigger any tax effects until the
benefits are actually paid. At that time those benefits will represent taxable income. (In the
typical deferred compensation arrangement the corporation owns the policy and names itself
beneficiary. Upon the death of the plan participant the corporation receives the proceeds and
pays an equivalent amount—usually in annual installments—to the participant's beneficiary. It is
those corporate payments that are subject to income tax.)
Estate and Gift Taxes
The unified federal estate and gift tax law has been much modified in recent years and may
eventually disappear.
But for now the impact of the estate tax upon life insurance is quite clear. A policy is
included in the estate of whoever possessed "incidents of ownership" at the time of the
death of the insured.
Policyownership itself is, obviously, an incident of ownership, but so are many forms of
limited ownership, including the right to name a beneficiary. This latter ruling affects split
dollar plans.
Generally, if you enjoy any right of ownership, you are likely to have the policy's death benefit
included in your estate for purposes of calculating your gross estate. And the size of your
gross estate determines whether an estate tax may be due.
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Policies intended as gifts, and thus qualifying for the annual gift tax exclusion (currently $12,000 per
recipient), must be "gifts of the present interest", meaning that nothing may prevent or delay a
policy beneficiary from full enjoyment of the proceeds upon the death of the insured. (The gift, of
course, is the premium payment, not the proceeds.)
Paying proceeds into a trust does not violate this principal, since the trust, in the guise of the trustee,
is the policy beneficiary and may act immediately. (The beneficiaries of the trust are indirect to the
policy.) But imposing spendthrift clauses on a direct beneficiary could cause a life policy to be rules as
something other than a gift of the present interest. Remember, though, that this determination only
applies to policies seeking to qualify under the annual gift tax exclusion.
Group Life Insurance
The taxation of group life insurance is rather simple, on the premise that the vast majority of group
life plans are group term insurance and almost all are sponsored by an employer for its employees.
Also, to earn its tax status a group life plan must meet all the tests for a qualifying health and welfare
benefits plan, meaning that it must not discriminate improperly and must be established for the
benefit of the participants (usually employees).
Group Premiums
Premiums for qualifying group life plans, whether term or not, are deductible to the
employer and not taxable to the employee, with one important exception.
The premium for group life benefits for amounts in excess of $50,000 paid by an employer creates
imputed income for the employee and require the employee to pay tax on that amount. Since this is
annoying to the employees, and a real burden on employers, very few group plans have employerpaid premiums for amounts greater than $50,000. (There is no penalty if the employee pays that
portion of the premium.)
Furthermore, this tax-free threshold is reduced to just $2,000, if the employer-paid group life benefit
also covers dependents. Thus, few plans do. Again, the employee can pay for that coverage without
penalty.
Cafeteria Plans
Finally, voluntary group life plans (those elected by and paid for by the employee) may be included in
popular cafeteria plans under Section 125 of the Tax Code, but they may not be provided on a pretax basis. In other words, group life is eligible for payroll deduction but all employee-paid premiums
are always made with after-tax dollars.
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Review Quiz
1. This section of the tax code permits a policyowner to exchange one life policy for another without
penalty.
A.
B.
C.
D.
Section 401(k)
Section 1035
Section 1077
Section 501
2. Employees are required to pay tax on the premium for group life insurance benefits in excess of:
A.
B.
C.
D.
$2,000
$5,000
$25,000
$50,000
3. A life insurance policy wherein too much premium was paid in during the policy's first seven years
is known as:
A.
B.
C.
D.
An HMO
A PPO
A MEC
A COLT
4. Which of the following statements is not true?
A. Death benefits are not taxable as income.
B. Premiums paid for individual life insurance products are not deductible items the federal
income tax.
C. The premiums for additional life insurance benefits are deductible items for federal income tax.
D. Policy loans and withdrawals are not taxable income, unless the policy is surrendered with an
unpaid loan.
5. With life insurance tax basis is the sum of all premiums paid plus:
A.
B.
C.
D.
All dividends received in cash.
The premiums paid for additional benefits.
Any policy loans received.
The cash value received as the result of a surrender.
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Answer Key
1. B
2. D
3. C
4. C
5. A
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Part VI Glossary of Terms
_______________________________________________________________________________
This glossary of terms pertaining to life insurance and life insurance products will help you to better
understand the material presented in this text.
Absolute Assignment - Assignment by the policyowner of all control and rights to a third party.
Adjustable Life - A form of life insurance which allows changes on the policy face amount, the amount of
premium, period of protection, and the length of the premium payment period.
Age Change - The point in the 12 months between natural birthdays that the individual is considered
being of the next higher age for the purposes of insurance rates. Most life insurance companies consider
that point as half-way between birthdays. Health insurance companies frequently use age last birthday until
the next birthday is actually reached. Age change can be last birthday, nearer birthday, depending on the
way the rate was constructed.
Assignee - The person to whom policy rights are assigned in whole or in part by the original policyowner.
Assignment - Transfer of rights in a policy to other than the policyowner.
Association Group - Technically, group insurance issued to an association in contrast to an employer or
a union.
Automatic Premium Loan - A provision in a life policy authorizing the insurance company to use the
loan value to pay any premium not paid by the end of the grace period.
Collateral Assignment - Assignment of a life insurance policy as security for a loan, the creditor to
receive the proceeds or values to the extent of his interest.
Conditional Receipt - The more exact term for what is often called a "binding receipt" in life and health
insurance. It provides that if premium settlement accompanies the application, the coverage shall be in
force from the date of application (whether the policy has yet been issued or not) provided the insurance
company would have issued the coverage on the basis of facts as revealed by the application and other
usual sources of underwriting information.
Debit - The collectible premium accounts assigned to one industrial or combination agent.
Decreasing Term - A form of Life Insurance that provides a death benefit which declines throughout the
term of the contract, reaching zero at the end of the term.
Deferred Annuity - An annuity contract that provides for the initiation of payments at some designated
future date in contrast to one in which payment begins immediately on purchase.
Direct Selling System - A distribution system within which the insurance company deals with the
insureds through employees rather than insurance agents.
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Dismemberment - Loss, or loss of use of specified members of the body, resulting from accidental
bodily injury.
Dividend - The return of part of the premium paid for a participating policy.
Dividend Addition - Paid up life insurance purchased with policy dividends.
Endowment Insurance - A form of life insurance where the face amount is payable to the insured at the
end of the contract period or to a beneficiary if the insured dies before that. An example would be an
insured purchasing an endowment payable at age 65. If he reaches that age, the proceeds would be payable
to him. If he dies prior to that age, the proceeds would be payable to the designated beneficiary and a Life
Insurance benefit.
Face Amount - In a life insurance policy, the death benefit stated on the first page of the policy.
Facility of Payment - A provision permitting the insurance company to pay a portion of the proceeds of
a policy to any relative or person who has possession of the policy and appears entitled to such payment.
Fair Credit Reporting Act - Public Law 91-508 requires that an applicant be advised that a consumer
report may be requested, if such be the case, and the scope of the investigation which may be requested
and the name and address of the reporting agency, should the request for insurance be declined, because
of information contained in that report.
Family Income Policy - A life insurance policy that pays an income after the death of the insured for a
stated number of years from date of issue of the policy, and then pays the face amount.
Family Maintenance Policy - A policy that pays a stated income for a selected number of years
beginning with the date of death of the insured. The face amount is usually paid immediately following
death.
Fixed Dollar Annuity - Guarantees a fixed, minimum dollar payout, during each payout period.
Flexible Premium Annuity - An annuity that allows the contract holder to vary the amount of the
premium payment, or stop payments and resume payments at will. A flexible premium annuity is used to
fund IRA and Keogh retirement plans because it allows the amount of premium to change as wages change.
General Agent (GA) - An individual appointed by a life or health insurer to administer its business in a
given territory. He is responsible for building his own agency and service force and is compensated on a
commission basis, although he may have some additional expense allowances.
Grace Period - A period of time (commonly 30-31 days) after premium the due date during which a
policy remains in force without penalty even though the premium due has not been paid.
Guaranteed Insurability - An option in life or health Insurance contracts that permits the insured to
buy additional prescribed amounts of insurance at prescribed future time intervals without evidence of
insurability.
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Industrial Insurance - Insurance, usually in small amounts or low benefits, the premium for which is
collected at the door by an agent on a weekly or monthly bases. In the life insurance business, many large
insurance companies have replaced industrial with weekly or monthly premium ordinary life.
Inspection - Independent checking on facts about an applicant or claimant, usually by a commercial
inspection agency.
Installment Refund Annuity - Promises to continue the periodic payments after the death of the
annuitant, until the combined benefits paid to the annuitant and his beneficiary have equaled the purchases
price of the annuity.
Installment Settlement - Payment of the proceeds of a life insurance policy (or of the cash value) in
installments in contrast to lump sum. Any of the income settlement options in a policy.
Insurability - Acceptability of an applicant for insurance to the insurance company.
Insurable Interest - Any interest in a subject of insurance or any legal relation to it of such a nature that
a certain happening might cause monetary loss to the insured.
Joint Life Policy - Pays the benefit when the first of two or more covered persons die.
Joint and Survivor Life Annuity - Income is payable through the joint lifetimes of two or more
annuitants and continues throughout the lifetime of the last survivor.
Juvenile Policies - In life insurance, policies modified to meet the needs of young children (usually under
age 15).
Key Man (Key Employee) Insurance Policy - An insurance policy on the life of a key employee whose
death would cause the employer financial loss, owned by and payable to the employer. In health insurance,
the term Key Employee A&H policy is also used to designate salary continuation insurance payable to a key
employee or to a medical benefits plan, payable to that employee paying all or part of the premium.
Lapse - Termination of a policy because of failure to pay the premium. In life insurance, this term is
sometimes confined to non-payment before the policy has developed any non-forfeiture value, known as
termination if premium failure is after non-forfeiture values develop or surrender if cash value is
withdrawn.
Level Premium Insurance - Life insurance, the premium for which remains at the same level (amount)
throughout the life of the policy (except as reduced by any policy dividends.)
Level Term Policy or Rider - Provides a stated or constant amount of insurance throughout a specific
period of time.
Life Annuity - A contract that provides a stated income for life, payable annually or more frequently.
Life Expectancy - Average number of years remaining for a person of a given age to live as shown on the
mortality or annuity table being used as a reference.
Limited Pay Life Policy - A whole life contract with premium limited until the expiration of a stated
(limited) period.
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Life Insurance Fundamentals
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Loading - The amount added to the pure insurance cost to cover the cost of the operations of an insurer,
the possibility that losses will be greater than statistically expected, and fluctuating interest rates on the
insurer's investments. The "pure" insurance cost is that portion of the premium estimated to be necessary
for losses.
Lump Sum – Payment of the entire proceeds of a life insurance policy at one time. This is the method of
settlement provided by most policies, unless an alternate settlement is elected by the policyowner before
the insured’s death or thereafter by the beneficiary before receiving the payment.
MIB - Medical Information Bureau - An organization serving as a clearing house of medical
information on impaired risks reported to it by insurance companies which are members of the service and
reported to them as a source of underwriting information on applicants.
Mode Premium - The premium paid according to the mode of payment selected by the policyowner;
this is, monthly, quarterly, semi-annually, or annually (or any other mode acceptable to the insurance
company).
Non-Participating - Insurance that does not pay policy dividends.
Paid-Up Life Insurance - Life insurance on which all premium have been paid but that has not yet
matured by death or endowment, such as a limited payment policy on which the premium-paying period
has been completed or the insurance paid for by using cash value under the paid-up non-forfeiture option.
Paid-Up Additions – The dividend option that provides additional single premium life insurance paid for
by policy dividends and added to the face amount.
Participating - (1) Insurance that pays policy dividends. (2) Insurance or reinsurance which contributes
proportionately with other insurance on the same risk.
Payor Benefit - A rider or provision, usually in juvenile policies, under which premiums are waived if the
payor (usually parent) of the premium becomes disabled or dies while the child is still a minor.
Permanent Life Insurance - A term loosely applied to life insurance policy forms other than group and
term, is usually cash value life insurance including endowment as well as whole life.
Persistency - The staying quality of insurance policies, that is, the renewal quality. "High" persistency
means that a high number of policies stay in force; "low" persistency means that many lapse for
nonpayment of premium.
Policy Dividend - The return of the overcharge in a participating premium. It represents the difference
between the premium charged and actual experience.
Policy Fee - A small annual charge (sometimes a one-time charge) to the policyowner, in addition to the
premium, to cover the costs of policy administration (premium collections, etc.)
Policy Loan - A loan made by the insurance company to the policyowner with the cash value of the policy
as security or collateral. One of the nonforfeiture options.
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Life Insurance Fundamentals
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Policyowner - The person who has the right to exercise the rights and privileges in the policy contract.
Such person may or may not be the insured, depending on policy ownership and assignment, if any.
Premium - (1) Part of the consideration for the insurance, by whatever name called. (2) The periodic
payment made to keep a policy in force. Premium and rate are sometimes incorrectly used
interchangeably. Technically, rate is the amount charged for a given unit of insurance coverage, and
premium is the sum of the unit rates for a given policy. (3) In annuities, the purchase payment.
Premium Loan - A loan made by the insurance company to the insured, with the cash value of the policy
as security, to pay a premium due.
Premium Notice - A notice from the insurance company to the policyowner that a premium is (or will
be) due on a given date.
Preauthorized Check Plan - An arrangement under which the policyowner authorizes the insurance
company to draft his bank account for the (usually monthly) premium.
Preexisting Condition - A condition of health or physical condition (and sometimes moral condition)
that existed before the policy was issued.
Primary Beneficiary - The beneficiary named first to receive proceeds or benefits of a death claim.
Principal Sum - The amount payable in one sum in the event of accidental death or certain accidental
dismemberments. When a contract provides benefits for both accidental death and accidental
dismemberment, each dismemberment benefit is an amount equal to the principal sum or some fraction
thereof. Examples would be half the principal sum for loss on one arm, half the principal sum for the loss
of one leg, etc.
Reduced Paid-up Insurance - A form of insurance available as a non-forfeiture option that provides that
the cash value of the policy may be used as the single premium for paid-up insurance in whatever amount it
will provide (which will be a lesser or reduced amount than the policy face amount in most cases).
Refund Life Annuity - An annuity paying installments as long as the insured lives and installments after
death to the beneficiary until the amount paid equals the principal sum of insurance.
Reinstatement - (1) Putting a lapsed policy back in force. (2) The payment of a claim under some forms
of insurance reduces the principal amount of the policy by the amount of the claim. Provision is usually
made for a method of reinstating the policy to its original amount. This may be done automatically with or
without premium consideration or at the request of the insured.
Reinsurance - (1) A contract of indemnity against liability by which the insurance company procures
another insurance to insure it against loss or liability by reason of the original insurance. (2) Insurance by
one insurance company of all or part of a risk accepted by it with another insurance company which agrees
to reimburse the insurance company for the portion of the claim reinsured. The insurance company
obtaining the reinsurance is called the "ceding insurance company;" the insurance company issuing the
reinsurance is called the "reinsurer." A reinsurer may, in turn, seek reinsurance on some portion of the
risk it has reinsured, a process known as "retrocession."
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Life Insurance Fundamentals
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Secondary Beneficiary - The second person named to receive benefits upon the death of the insured if
the first named (primary) beneficiary is not living or does not collect the benefit before his or her own
death.
Settlement Options - The various methods of settlement of the proceeds or values of a life insurance
policy that the insured or beneficiary may choose in lieu of immediate lump sum.
Underwriter - (1) A person trained in evaluating risks and determining the rates and coverages that will
be used for them. (2) An agent, especially a life insurance agent, who might qualify as a "field underwriter."
In theory, the agent is supposed to do some underwriting before submitting the case to the home office
underwriter; i.e., to make a decision on the basis of facts known to him on whether or not the risk is
sound and to report all facts known to him that might affect the risk.
Underwriting - The process of evaluating a risk for the purpose of issuing insurance coverage on that
risk.
Universal Life - A combination flexible premium, adjustable life insurance policy. The premium payor
may select the amount of premium he or she can pay and the policy benefits are those which the premium
will purchase. Or, the premium payor may change the amount of insurance and pay premium accordingly.
Many believe this is the only true solution to the "buy term invest the difference" problem.
Variable Annuity - An annuity contract in which the amount of the periodic benefit varies, usually in
relation to security market values, a cost-of-living index, or some other variable factor in contrast to a
fixed or guaranteed return annuity.
Variable Life Insurance – Life insurance that provides a guaranteed minimum death benefit, but the
actual benefit paid by be more, depending on the fluctuating market value of investments in the separate
account backing the contract at the time of the insured’s death.
Variable Universal Life – The generic name for a flexible premium universal life insurance policy,
distinguished by a flexible premium and separate cash value investment accounts.
War Clause – A clause in an insurance contract limiting the insurance company’s liability for specified loss
caused by war.
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Copyright © Insurance Schools, Inc.
Copying any part of this text is strictly prohibited. Violators will be prosecuted.