MODERN LIFE INSURANCE – ( 8/11)
TABLE OF CONTENTS
CHAPTER ONE - BASICS OF LIFE INSURANCE .................................................... 1
UPDATED TEXT ........................................................................................................... 1
DEFINITION OF LIFE INSURANCE .......................................................................... 1
ACCUMULATING A FUND FOR PAYMENT OF CLAIMS ..................................... 2
UNCERTAINTY CHANGES INTO CERTAINTY ....................................................... 3
DEFINITION
.............................................................................................. 3
POOLING OF THE RISK ........................................................................................... 4
ASSESSMENT INSURANCE ...................................................................................... 5
POLICY PROVISIONS.................................................................................................. 6
THE CONTRACTUAL BASIS ..................................................................................... 6
POLICY FACE PAGE................................................................................................. 7
STANDARD POLICY PROVISIONS .......................................................................... 8
REQUIRED PROVISIONS ......................................................................................... 8
Grace Period........................................................................................................ 8
LATE PREMIUM PAYMENT ..................................................................................... 9
POLICY LOANS.......................................................................................................... 9
INCONTESTABLE CLAUSE .................................................................................... 10
DIVISIBLE SURPLUS PROVISION ......................................................................... 10
ENTIRE CONTRACT PROVISION .......................................................................... 10
REINSTATEMENT .................................................................................................... 10
MISSTATEMENT OF AGE OR SEX......................................................................... 11
NONFORFEITURE PROVISIONS ........................................................................... 11
SETTLEMENT OPTIONS ......................................................................................... 12
PROHIBITED PROVISIONS .................................................................................... 12
OPTIONAL PROVISIONS ........................................................................................ 13
SUICIDE PROVISION ........................................................................................ 13
OWNERSHIP PROVISION ................................................................................... 1
ASSIGNMENT PROVISION .............................................................................. 13
PLAN CHANGE .................................................................................................. 13
ACCELERATION OF BENEFITS ...................................................................... 14
NAIC MODEL ACCELERATED DEATH BENEFIT REGULATION ............. 14
ADDITIONAL COMMON PROVISIONS ................................................................. 15
ACCIDENTAL DEATH BENEFITS ................................................................... 15
DEFINITION OF ACCIDENTAL DEATH ......................................................... 15
GUARANTEED PURCHASE OPTION (GPO) ........................................................ 16
WAIVER OF PREMIUM........................................................................................... 16
CHAPTER TWO - TERM INSURANCE .................................................................... 19
BASICS OF TERM INSURANCE .............................................................................. 19
Renewing a Term Policy....................................................................................... 19
Convertibility .................................................................................................... 20
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Original Age Conversion .................................................................................. 21
When to Convert ............................................................................................... 22
RE-ENTRY TERM ..................................................................................................... 22
LONG-TERM TERM INSURANCE .......................................................................... 24
INCREASING AND DECREASING TERM INSURANCE ....................................... 24
THE PLACE OF TERM INSURANCE IN TODAY’S MARKET ............................. 25
WHEN TERM INSURANCE SHOULD BE USED ................................................... 25
Temporary Protection Needs ............................................................................ 26
Supplement to Group Insurance........................................................................ 26
OBJECTIONS TO OTHER FORMS OF INSURANCE ............................................ 24
BUY TERM - INVEST THE DIFFERENCE .............................................................. 28
What Kind of Investments? .............................................................................. 28
Safety of Principal............................................................................................. 28
Yield .................................................................................................................. 28
Liquidity............................................................................................................ 29
Otherwise .......................................................................................................... 29
Summary ........................................................................................................... 29
CHAPTER THREE - WHOLE LIFE INSURANCE .................................................. 31
PRINCIPAL TYPES OF WHOLE LIFE INSURANCE .............................................. 31
ORDINARY LIFE INSURANCE ............................................................................... 31
Permanent Protection ............................................................................................... 31
Lowest Premium Outlay ............................................................................................ 31
Cash Value or Accumulation Element ...................................................................... 32
Policy Loans.............................................................................................................. 32
Nonforfeiture or Surrender Options. ........................................................................ 34
Cash Value. ....................................................................................................... 34
Reduced Amount of Paid-Up Whole Life. ....................................................... 34
Paid-Up Term.................................................................................................... 34
Annuity or Retirement Income. ........................................................................ 35
Conversion. ....................................................................................................... 35
Participating versus Nonparticipating ............................................................... 36
Dividends and taxes .................................................................................................. 36
Limited-Payment Life Insurance ............................................................................... 37
The Face Amount .............................................................................................. 37
Life Income ....................................................................................................... 37
Fixed Period Income ......................................................................................... 37
Fixed Amount Income ...................................................................................... 37
Interest Option .................................................................................................. 37
JOINT LIFE INSURANCE ........................................................................................ 38
SPECIAL LIFE INSURANCE POLICIES .................................................................. 39
PREFERRED RISK POLICIES ................................................................................... 39
ENDOWMENT POLICIES .......................................................................................... 40
ADJUSTABLE LIFE INSURANCE ............................................................................ 41
CURRENT ASSUMPTION WHOLE LIFE INSURANCE......................................... 42
CAWL Low-premium Plan............................................................................... 42
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CAWL High-premium Plan .............................................................................. 43
DEBIT INSURANCE ................................................................................................. 44
FAMILY POLICY ...................................................................................................... 44
JUVENILE INSURANCE .......................................................................................... 45
BURIAL INSURANCE .............................................................................................. 45
GROUP LIFE INSURANCE ........................................................................................ 45
GROUP INSURANCE REQUIREMENTS ................................................................ 46
Participants ........................................................................................................ 46
Probationary Period .......................................................................................... 46
Coverage Period ................................................................................................ 46
Benefit Amount ................................................................................................. 46
Convertibility .................................................................................................... 46
Waiver of Premium ........................................................................................... 47
Type of Insurance ............................................................................................. 47
Employee Contributions ................................................................................... 47
Supplemental Life Insurance ............................................................................ 47
Credit Group Life Insurance ............................................................................. 47
Accelerated Death Benefit ................................................................................ 47
Taxation of Employee ....................................................................................... 47
Group Paid-up Insurance .................................................................................. 48
Group Ordinary Insurance ................................................................................ 48
Group Universal Life ........................................................................................ 48
Retired Life Reserves ........................................................................................ 48
Supplemental Coverages ................................................................................... 49
CHAPTER FOUR - VARIABLE INSURANCE POLICIES ..................................... 51
VARIABLE LIFE INSURANCE ................................................................................. 51
SEC Objections to Variable Life ............................................................................... 51
VOLATILITY OF VARIABLE PRODUCTS .............................................................. 52
NOT EXCLUSIVELY INVESTMENTS...................................................................... 52
INCREASING INSURANCE PROTECTION FROM
Investment
Performance .............................................................................................................. 53
Level Additions ................................................................................................. 53
Constant Ratio................................................................................................... 54
Increased Number of Investment Fund Options ............................................... 54
POLICY CASH VALUES ............................................................................................ 55
THE PROSPECTUS.................................................................................................. 56
EXPENSE INFORMATION ............................................................................ 56
INVESTMENT PORTFOLIO INFORMATION ........................................................ 57
POLICYOWNER ASSUMED RISKS......................................................................... 57
VARIABLE ADJUSTABLE LIFE INSURANCE ....................................................... 58
UNIVERSAL LIFE INSURANCE............................................................................... 58
DISINTERMEDIATION .............................................................................................. 59
FLEXIBLE PREMIUMS ........................................................................................... 60
FUNDING CHOICES ............................................................................................... 60
FUND WITHDRAWAL ............................................................................................. 62
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TARGET PREMIUM ................................................................................................. 62
ADDITIONAL PREMIUM PAYMENTS ................................................................... 63
NO OR INSUFFICIENT PAYMENTS ...................................................................... 64
PAYING AN INADEQUATE PREMIUM.................................................................. 64
TYPE OF DEATH BENEFIT ...................................................................................... 64
POLICY LOANS........................................................................................................ 65
LIFETIME FLEXIBILITY ......................................................................................... 68
INDEXED UNIVERSAL LIFE .................................................................................... 69
VARIABLE UNIVERSAL LIFE INSURANCE ......................................................... 71
FLEXIBILITY ............................................................................................................ 72
INCOME TAX WHEN THE POLICY IS EXHAUSTED EARLY ............................... 73
COMPARING LIFE INSURANCE POLICY COSTS ................................................ 74
NET COST ................................................................................................................ 74
INTEREST-ADJUSTED INDEXS ............................................................................. 75
USING A FINANCIAL CALCULATOR .................................................................... 75
CASH ACCUMULATION METHOD OF COMPARISON ....................................... 76
AN EQUAL OUTLAY METHOD .............................................................................. 76
THE COMPARATIVE INTEREST RATE METHOD ................................................ 76
CHAPTER FIVE - POLICY PROVISIONS & RELATION TO DEATH
BENEFITS. ...................................................................................................................... 79
POLICY PROVISIONS OF VARIABLE CONTRACTS ........................................... 79
Guaranteed Minimum Death Benefit ................................................................ 79
Separate Accounts ............................................................................................. 79
Redetermination of the Death Benefit .............................................................. 79
Revaluation of the Cash Value ......................................................................... 79
Entire Contract .................................................................................................. 79
Free Look Provision .......................................................................................... 79
Incontestability.................................................................................................. 80
Misstatement of Age or Gender ........................................................................ 80
Assignment ....................................................................................................... 80
Reinstatement .................................................................................................... 80
Grace Period...................................................................................................... 80
Exchange ........................................................................................................... 81
Policy Loans...................................................................................................... 81
Description of Benefits ..................................................................................... 82
Investment Objective Provision ........................................................................ 82
Reinstatement .................................................................................................... 82
Free-Look Provision ......................................................................................... 82
Conversion Privilege ......................................................................................... 82
Annual Report ................................................................................................... 82
Riders & Options Available .............................................................................. 83
TAXATION AND REGULATION ............................................................................. 83
1. Cash Value Accumulation Test .................................................................... 84
2. The Corridor Test .......................................................................................... 84
3. The Seven-pay Test ................................................................................... 85
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CORRIDOR RATIO .................................................................................................. 86
NASD CONDUCT RULES ........................................................................................ 87
ILLUSTRATIONS...................................................................................................... 87
SPECIAL NASD VARIABLE CONTRACT RULES .................................................. 87
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CHAPTER ONE - BASICS OF LIFE INSURANCE
This text is furnished solel y by C.E.I.S. as a reference to be used in Continuing
Education. It is to be used as educational material onl y and it is not intended to
provide advice—legal or professional. The re aders of this text must consult their own
legal advisor for legal advice on any information contained herein.
(NOTE: The use of the male gender, i.e. “he,” “his,” “him” etc., is used in this text
to designate a person of either sex for simplicit y purposes , as having to refer to
“he/she,” “him/her,” is rather clumsy and it certainl y is not intended in any way to
denigrate the important contributions those of the female gender make to the life
insurance industry.)
UPDATED TEXT
This text is updated from “Mo dern Life Insurance” and discusses products and
policy forms that are in use in 2011. Whereas many of the fundamental policies, such
as Whole Life, Term Life, etc., are basicall y the same, there has been much more
interest recentl y in interest -sensitive life insurance policies. A generation ago, there
was a problem with standard life insurance policies that onl y used a growth factor for
cash values at around 3%. It soon led to innovations whereby the policyowner could
realize a faster growth as the econo m y improved and interest rates for commercial
transactions increased. In recent years, this has become less of a factor as commercial
interest has fallen sharpl y to the point where guaranteed investments, such as
Certificates of Deposit, are generating le ss than 2% in most cases.
As this is being written, the Federal Trade Commission has indicated that present
low interest rates will continue for at least two years. However, little is “cast in
stone” these days as the nation’s credit rating has sunk to AA+ from a normal AAA.
Next year is an election year, and with the nation’s high unemployment rate and the
roller-coaster ride of the Stock Market, plus financial uncertaint y in most other
countries, indicates that there is a possibilit y that life insuran ce policies that
determine benefits as accrued by a separate fund(s) may suffer from low investment
returns. On the other hand, it is possible that the public may look more favorabl y to
investing in an insurance product where the results are guaranteed by the insurance
company.
Nonetheless, this text will discuss many interest -sensitive products that have arisen
and/or become more popular in recent years.
DEFINITION OF LIFE INSURANCE
Solomon Huebner, the grand old man of the life insurance industry, st ated in “Life
Insurance, a Textbook” written in 1914: “Mankind is exposed to may serious hazards
such as fire, disability and premature death, the happening of which, from the
standpoint of the individual, it is impossible to foretell or prevent, but the e ffect of
which, such as the loss of propert y or earning, it is highl y important to provide
against. It is the function of insurance in its numerous forms to enable individuals to
safeguard themselves against such misfortunes by having the losses of the un fortunate
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few paid by the contributions of the many who are exposed to the same risk. If the
hazard under consideration is that of premature death, the loss suffered is indemnified
through life insurance. From the communit y standpoint, life insurance may be defined
as “that social device for making accumulations to meet uncertain losses through
premature death which is carried out through the transfer of the risks of many
individuals to one person or a group of persons.” From the standpoint of the
individual however, life insurance may be defined as consisting of a contract, whereby
for a stipulated compensation, called the premium, one part y (the insurer) agrees to
pay the other (the insured) or his beneficiary, a fixed sum upon the happening of death
or some other specified event.”
ACCUMULATING A FUND FOR PAYMENT OF CLAIMS
While all forms of insurance are alike in that they required for their successful
operation a combination of many risks in a group, they are vitall y different as regards
the nature o f the risks covered. In this respect, the chief difference between life and
other forms of insurance is that in the latter the contingency insured against may or
may not happen, and as regards the great majorit y of policies written, does not happen,
while in life insurance the event against which protection is granted, namel y death, is
a “hazard converging into certaint y.” It is necessary, therefore, if a life insurance
policy is to protect the insured during the whole of life, to provide not onl y against
the risk of death each year, but also to accumulate an adequate fund for the purpose of
meeting at the ultimate limit of human life and absolutel y certain claim if one has up
to that been escaped.
It was a failure to see the necessit y for providing for an increasing hazard,
converging into certaint y, which has caused many serious errors in the fundamental
plans of some institutions formed to furnish life insurance, and the thing which
separates plans of insurance into sound and unsound is precisel y wheth er intelligent
regard for this principle has guided the company in determining its rates of premium
and the management and disposition of its funds.
In accumulating such a fund, it is important for the companies to take into account
several other character istics that differentiate life insurance from other forms of
insurance. To start, the persons combining for life insurance are not of the same age,
and it is clear that on the average those insuring at the younger ages will life much
longer before receivin g payment on their policies than those who insure at the older
ages. Justice, therefore, required that the premium payments should be graded
according to the age when the policy is issued. In addition, the rates for the various
types of policies must be determined not onl y with reference to the age of the insured
at entry, but also according to the protection promised.
Therefore, companies must follow scientific principles in determining their rates.
Since life insurance policies promise a definite sum i n the event of death, and in some
instances in the event of survival at a stated time, it is essential that there be an
accurate determination of the liabilit y involved and that an adequate premium be
charged which is just as between ages and t ypes of poli cies. This is important also
because life insurance policies can be written for one or more years and are subject to
cancellation at the option of the insured part y and are unilateral as against the
company and usuall y extend throughout the life or for lo ng periods of time.
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In addition to this, life insurance presents a further problem as regards the
accumulation of the fund necessary to pay policy claims. A workable plan of life
insurance required the charge of a uniform annual premium during the premium -paying
period. Simpl y put, a life insurance policy is composed of a series of one -year
renewable term (annual renewable term) and each year’s premium just covers the cost
of the protection. Under this simple plan, however, as each person ages, the premiu ms
soon become prohibitive with the result that the healthy members of the group will
withdraw rather than continue to pay the greatl y increased rates.
In order to overcome a problem —the premium must be increased with age —during
the earl y years, the compan y accumulates sufficient funds over and above the cost of
current insurance. This “overcharge” does not belong to the company but is held in
trust with the insurer for the benefit of the insured at an assumed rate of interest for
this purpose. When this is applied to a large number of policies, this overcharge —
unearned premium—is considered as the reserve and which, together with future
premiums paid by the policyholder will just enable the company to meet its claims
according to the mortalit y tables in u se.
This is the very basic and fundamental method to any sound plan of life insurance.
Reserves—defined as the present value of future claims —comprise the greater amount
of the insurers admitted assets.
UNCERTAINTY CHANGES INTO CERTAINTY
The direct economic function of a life insurance company is to change uncertaint y
into certaint y; therefore, they enable the insured to transfer the hazard of premature
death to the insurer at the lowest possible cost. The larger the number of separate
risks (insured’s) increases the size of the group for the purpose of substituting certain
for uncertain loss.
The larger the number of separate risks comprising a group, the less certaint y there
will be as to the amount of loss, the less uncertaint y of loss the smaller wi ll be the
premium that the company needs to collect annuall y from the insured. This is known
as “pooling the risks.”
DEFINITION
 Insurance transfers an existing exposure and, through the pooling of similar loss
exposures, reduces risk.
Another definition widel y accepted:
 Life insurance is a device to spread the cost of financial loss resulting from
death from an individual t o a group through an insurance company by
transferring the cost so the financial loss to any one individual is small.
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POOLING OF THE RISK
There are many other definitions of Life Insurance but the “spreading of risk” and
the “transfer of risk” are the two most common and most accurate in discussing life
insurance in today’s societ y.
The very basic element of these definitions is the pooling of risks, the sharing of
losses by members of a group. There are various ways to share the risk in Life
Insurance, but principall y it is an arrangement where the members of the group
“insure” each other, or the risk is transferred to an organization that assumes the risk
and pays the losses of the group. For this purpose of this discussion, the very heart,
the “essence, ” of life insurance—indeed, all insurance plans —is the pooling of the
risks and losses.
Textbooks often use the example of a fire insurance policy, as it is the easiest to
understand when describing the pooling concept. If —for example, obviousl y—there
are 1,000 individual homes in the communit y, each is worth $100,000 (for simplicity
purposes as few communities would have houses this cheap…) and they are all built
the same with the same loss exposures, ergo, the same probabilit y of being destroyed
by fire. The probabilit y of a loss of a home would be remote, probabl y near 1 in 1,000
each year. However, to the owner of the house, a loss of $100,000 would be
disastrous. Using these assumptions, if each homeowner paid an annual contribution
of $100, there would be large enough fund to reimburse the homeowner suffering the
loss. Actuall y, each homeowner is assuming a loss of $100 in order to eliminating the
risk of losing $100,000. Even though each homeowner contributes a “premium” of
$100, and pays it year after year, it would still be a small sum when related to the
possible loss.
Appl ying this basic principle to life insurance, if there were a group of persons in
equal health, same age and each having the same prospect for longevit y, the members
of this group could agree that the group would pay $100,000 to the beneficiaries of
each person who dies during each year. Simpl y (very simpl y) put, it could be in the
form of an assessment paid by each member in the group as the death occurs.
What are the chances of an individual member of the group dying in any one year?
To determine the probabilit y of death, if all members were 35 years old, 21 of them
could be expected to die, taking the information from the Commissioners 1980
Standard Ordinary Mortalit y Tabl e (referred to as the “1980 CSO Table”). Therefore,
ignoring expenses, cumulative assessments of $210 per person would provide the
funds for payment of $100,000 to the beneficiary of each of the 21 deceased persons.
Obviousl y, if the death benefit were t o be twice as large, the assessment would be
twice as much.
Please note that the actual premium within a group would be a much more complex
calculation of premium, for many reasons, which will be discussed later in more
detail. One important factor is tha t the 1980 CSO Table is a sex -divided table, i.e.,
the mortalit y of males and females are different. For example, using the same Table, a
female at age 35 would pay an assessment of $165 (compared to the $210 for the
male).
It is important to be aware t hat the CSO Tables (yes, there are many, such as male female, smoker -nonsmoker, etc.) are used as guidelines for the smaller companies.
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The larger insurers will have developed their own mortalit y tables based upon their
insured losses, which would reflect the type of business sold by this insurer, the
geographical location of their insured’s, etc.
ASSESSMENT INSURANCE
Before one can understand the complexities of today’s life insurance plans, the
starting point must be the simplest and most easil y under stood t ype of life insurance,
such as the “Assessment Insurance” plans. Actuall y, this is probabl y the oldest form
of life insurance, as the Ancient Order of United Workmen “way back” in 1868, levied
an assessment of $1 per member in order to pay a death benefit of $2,000 upon the
death of the union member. Originall y, the assessment was levied after the payment
of each death claim, thereby making sure that there would be enough funds to pay
future death claims. Later, the assessments made were on an ann ual basis.
In the very earl y years, the assessments were the same on all members, regardless of
age as they felt that there would be a “flow” of new members at the younger ages,
which would offset the aging of existing members. Before long it became appar ent
that this theory did not hold water as with age the older members died “quicker,” i.e.,
deaths do not occur evenl y at each age as death increases more rapidl y the older the
person. For instance, if a group were made up of 20 -year olds, and 50 -year olds, the
average age would be 35. However, the mortalit y tables show that males who have a
death rate of 3.02 per thousand at age 40, this would increase to 6.71 at age 50. The
fact that the average age will continue to increase as everyone gets older and the
average age would increase as the number of new entrants could not compensate for
the increase in mortalit y of existing members must be taken into consideration.
Combining these problems would lead to an increasing in assessments just to cover
present mortalit y.
Another problem was created by the fact that as the assessments increased in
amount (and sometimes, frequency); young and healthy persons had a tendency to
withdraw from the societ y. This happens even today, where the young and healthy
seem to feel that they are indestructible and immortal. Therefore, the average age
increased with the comparable increase in assessments to the point to where it was
impossible to attract new members. This is known as “anti -selection” or “adverse
selection,” which is in realit y the process in life insurance when an applicant who is
uninsurable—or, at least, a greater than average risk —attempts to purchase a policy at
a standard premium. This is the principal reason that insurers soon discovered that
they needed qualified persons to screen applications, a practice now known as
“underwriting.”
The first change many societies imposed on their members was the grading of the
assessment depending upon the age of the member at time of entry. The problem with
this is that the assessment remained level as the member grew older and the mortality
risk increased, working a hardship upon the younger members.
Next, the assessments were increased, as the member got older. While this may
seem to be the perfect solution —the older paying more because the risk of loss is
greater at the older ages —over the horizon, the problem comes, riding on a galloping
black horse, called “ adverse selection.” Healthy member withdrew from the plan,
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which created an abnormall y high assessment fo r the older members. The assessments
would become so high that the older members could not afford to pay them, but at
their age, they were the ones who needed the plan, as they were the ones that would be
using the benefits the most.
The final attempt by some societies was to reduce benefits with advancing age but
the assessments would remain level. While this then created a block of “ insured’s”
who were progressivel y getting older, their benefits were decreasing at the age, again,
where the benefits were the most needed as they were the most likel y to die. This is
not totall y a bad idea, as it is found today in some forms of group insurance.
These plans are not important today, in the field of life insurance, and those old
assessment plans have become insolvent or they have reorganized using more modern
principles of life insurance.
POLICY PROVISIONS
THE CONTRACTUAL BASIS
It should be noted that this text discusses policy provisions in two separate areas.
This section pertains to life insurance p olicies, per se, whereas a later discussion
pertains onl y to Variable, Flexible, and Universal Life insurance. The latter variety of
life insurance policies are heavil y involved with the accounting for, distribution of,
and reimbursement of fluctuating fu nds. An example of the different treatment of the
two t ypes of policies is apparent in the treatment of policy grace periods. There will
be some duplication as it is better to cover the subject separatel y, rather than in a
comparative manner.
First, it should be understood that a life insurance policy is a legal contract, and as
such, legal terminology is the most correct way to address the subject. A life
insurance contract is a contract of adhesion. The usual and t ypical definition of a
contract invol ves two negotiating parties. However, a contract of adhesion means that
one part y presents the terms of the contract and the other party accepts or rejects the
contract. What this means primaril y is that in case of ambiguities or
misinterpretations, the law will always rule in favor of the accepting part y and the
part y that prepared the contract must abide by the terms it has chosen. Onl y fair, when
it is seriousl y considered.
The terms of the contract are drawn up by the insurer, and the policyholder ei ther
accepts the terms or not —in which case the cont4ract would normall y be ruled void ab
initio, i.e., at inception.
Be this as it may, this is not totall y accurate as the applicant fills out an application
form requesting insurance. However, the applic ant may not qualify for the policy
because of occupation, financial or health reasons. Then, there may be reasons as to
why the applicant cannot qualify for the policy they requested, and even though the
applicant may have paid for the policy in advance, the insurer may not issue the
policy.
If the applicant accepts the terms of the application and is approved for coverage
under the issuing guidelines of the insurer, the policy is issued and the applicant is
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now an insured. If a partial premium has been p aid and a premium receipt has been
issued by the insurer's agent, onl y temporary coverage under the terms of the receipt is
in effect. The contract is accepted by the applicant and binding on the insurer under
the particular terms of the receipt and the p olicy.
The applicant rejects the offered contract by refusing delivery of the policy. Even
after the applicant accepts the insurer's offer of coverage and a contract is binding on
the insurer, the policyowner may, in effect, reject the contract and get a full refund
based on the 10 -day free look provision —as explained later. This provision is
included in the vast majorit y of life insurance contracts. There can be situation, also
discussed later, whereby premiums are immediatel y deposited into an investmen t
vehicle and if the insured does not accept the contract after the designated period of
time, it will be handled differentl y for obvious reasons, as discussed later.
A t ypical application informs the applicant that the agent cannot alter the wording
or an y provision in the policy. For the applicant, it is a take -it or leave-it proposition.
Life insurance is a contract of adhesion which means that the applicant must accept
the contract as-is without change or modification. Again, this means that the insure r is
restricted as to what it can offer according to law which also means that, as stated
earlier, if there is an ambiguit y, the applicant will have the benefit of the doubt.
The wording of the contracts in nearl y all jurisdictions is that the contract mus t be
easil y understood, even by those with limited education. So, again, the insurer is at
some disadvantage as this places restrictions on attorneys to make sure that the
contract is worded exactl y as the drafter (the insurer) intended.
Ever since the fi rst insurance contract, of any kind, was offered, there are
standardized meanings to certain terms and phrases out of necessit y. Even the old
maritime agreements where cargoes were “insured” it became necessary to interpret
and understand certain terminol ogy and to assign the actions certain terms that have
literall y existed for centuries. Over many years, courts have given certain legal terms
specific meanings as it provides legal certaint y upon which lawyers have come to rel y
in drafting contracts. For new terms, lawyers must rel y upon current and future cases
to develop new “standard meanings” accepted by the courts.
POLICY FACE PAGE
Although the placement of the provisions may vary from company to company, the
face pages of most life insurance contra cts are similar and will show specific
identification information.
The policy page traditionall y shows the name of the insurance company, the name
of the policyowner, the amount payable under the contract provisions (e.g., face
amount). The policy identif ying number and the policy date and/or issue date.
This information is followed by a general description of the t ype of insurance
provided by that policy contract. For example, the face page of a traditional
participating whole life policy might read as fo llows:
Whole Life—Level Face Amount Plan. Insurance payable upon death. Premiums
payable for life. Policy participates in dividends. Dividends, dividend credits, and
policy loans may be used to help pay premiums.
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As mentioned above, a “free -look” period, usuall y 10 days, allows the policyowner
to return the policy with (no questions asked) and for a total refund.
Then there is the “Promise to Pay” statement, the insurer's promise to pay. This is
the heart of the insurance contract.
The signatures of the o fficers (usuall y the president and the secretary) of the
company, which binds the company to the terms of the contract .
STANDARD POLICY PROVISIONS
The standard policy provisions laws of the various states require that life insurance
policies include certain provisions but allow the insurance companies to select the
actual wording with the proviso that the wording is approved to the State Department
of Insurance. The majorit y of the wording is rather standard and would not appl y to
group life insurance. For certain contracts, such as term insurance, single premium
insurance and nonparticipating policies, there may be a variance from the “standard
wording.”
Term life insurance does not have policy loan and/or nonforfeiture wording as they
are not applicable.
Policy language has had a rather colorful past, as in the earl y 1900’s, as a result of
the Armstrong Investigation, and the resulting policy language was detailed, precise,
non-arguable, and soon it was appealed. The country followed the New York
Department, changed where they required onl y certain kinds of wording to be in the
contract, and the wording was subject to State approval in all states.
The language the insurers selected was subject to state approval, which would be
granted as long as (1) t he minimum intent of the required statutory provision was
obtained or (2) the insurer's language was more favorable to the policyowner than the
statutory intent.
The majorit y of the states require that unless specificall y exempted from the law,
all life insurance policies delivered or issued for delivery in the state must contain
language substantially the same as certain specified provisions. However, the insurers
are usuall y to provide other wording if the insurer’s wording is more favorable to the
insured, as determined by the Insurance Department.
REQUIRED PROVISIONS
Grace Period
The grace period clause grants the policyowner an additional period of time to pay
any premium after it was due. The policy that would otherwise have lapsed for
nonpayment of premium will continue in force during the grace period. Still, the
premium is due the insurer, but if the insured dies during the grace period, the insurer
can deduct one month’s premium from the death benefit.
If the insured survives the grace period bu t the premium remains unpaid, the policy
lapses (except for any nonforfeiture options).
One might consider that the policyowner gets “free” insurance for a month, which
would appl y onl y if the insured did not die during the grace period. The standard
8
length of the grace period is 31 days. If the last day of the grace period falls on a
nonbusiness day, the period is normall y extended to the next business day.
LATE PREMIUM PAYMENT
There generall y is no provision in a policy that allows for a late premium pa yment,
but insurers will usuall y honor such a request at their discretion. Note that is different
than a payment made during the grace period.
Sometimes insurers may make a late remittance offer to a policyowner whose
coverage has lapsed after the grace p eriod has expired such action is not a
requirement, but is offered so as to encourage the policyowner to reinstate the policy.
Sometimes there are reasonable and/or legitimate reasons for late payment, and
insurers, as a general rule, will jump on any suc h remittance. However, this is not an
extension of the grace period and coverage is not continues because of the offer. The
insurer simpl y agrees to that the policy can be reinstated without evidence of
insurabilit y. Normally, the onl y requirement is th at the insured must have been alive
when the late payment was submitted.
POLICY LOANS
An insurer is required by law to allow policy loans if the policy provides for cash
values. A loan on the policy simpl y transfers money to the policyowner with the
obligation that it is simpl y an advance to the policyowner from the cash value of the
policy.
Interest is accrued on the loan amount, even though there is no particular required
time frame in which the loan must be repaid —indeed, if not repaid the loan amount
plus interest will be deducted from the cash value in case of a policy surrender. If the
insured dies before the amount is repaid, the amount of the loan plus interest is
subtracted from the death benefit.
Technicall y, “advancement” is money or propert y t ransferred to the policyowner
prior to the anticipated time of payment or delivery. It should be noted that a policy
“loan” is actuall y an advancement against the cash value and not, technicall y, a loan
because there is no obligation on the part of the po licyowner to repay the “loan.”
A question that often arises is where the policyowner asks why is there interest
charged on the cash value as the cash value belongs to the policyowner. This may be a
little difficult to explain satisfactoril y sometimes, bu t the money that is withdrawn is a
withdrawal from the assets of the insurance company that are intended to provide the
insurer with assets that draws interest so that the premium can be maintained at the
agreed amount. It is onl y fair that the policyowne r that withdraws these funds the
policyowner should pay an interest rate that would approximate what the insurer might
earn if the money was kept in the assets of the insurer.
Another form of loan is the automatic premium loans that are advances that the
insurer makes to the policyowner from the policy cash value to pay the unpaid
premiums.
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INCONTESTABLE CLAUSE
The National Association of Insurance Commissioners Standard Policy Provisions
Model Act and the state laws based upon the Model, require that the p olicy contain an
incontestable clause, a provision that makes the life insurance policy incontestable by
the insurer after it has been in force for a certain time period. This time period is
usuall y 2 years, but there are exceptions but no state required the clause to be
effective for MORE than two years.
After a policy has been in effect for the period of time prescribed by the
incontestable clause (normall y 2 years), the insurance company cannot have the policy
declared invalid. The courts have generall y recognized three exceptions to this rule. If
(1) there was no insurable interest at the inception of the policy, if (2) the policy had
been purchased with the intent to murder the insured, or if (3) there had been a
fraudulent impersonation of the insure d by another person (for example, for purposes
of taking the medical exam), then the incontestable clause is deemed not to appl y
because the contract, which includes the incontestable clause, was void from its
inception (void ab initio).
DIVISIBLE SURPLUS PROVISION
The divisible surplus provision applies only to participating policies, which It
requires the insurer to determine and apportion any divisible surplus among the
insurer's participating policies at frequent intervals.
A t ypical divisible surplus provision from an insurance contract reads as follows:
ENTIRE CONTRACT PROVISION
This provision may seem excessive as, of course, what you have is what you get.
Sometimes, in the past, there were references in an insurance policy that is derived
from another policy or contract. This was good for attorneys, but was terribl y
confusing to the policyholders even though it was called the innocuous title of
“incorporation by reference.” Needless to say, Commissioners do not like this, and the
policy will say that the application constitutes the entire contract —or other states may
simpl y provide that the contract and the application actuall y are the “contract”
regardless of any other wording or reference in the contract.
REINSTATEMENT
Reinstatement provisions allow a policyowner to reacquire coverage under a policy
that has lapsed. This right is valuable to both the policyowner and the insurer. The
various state laws and the insurance contracts impose certain requirements that the
policyowner must meet to rein state the policy. A t ypical reinstatement statement
requires the insurer to reinstate within a specified period (usuall y three years) and the
policy has value and the policyowner applies and provides evidence of insurabilit y,
and pays back premiums and in terest, etc. If the policy had been surrendered for its
cash value, evidence of insurabilit y is required along with overdue premiums plus
interest (usuall y 6%) and the policy loan must be repaid or reinstated.
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Typicall y, reinstatement of a policy surrende red for cash value cannot be
reinstated.
MISSTATEMENT OF AGE OR SEX
Obviousl y, since life insurance premiums are based upon the age of the insured, and
in many cases the sex of the insured, if these factors are inaccurate, it would be a
material misrepres entation. The insurer would t ypicall y adjust the premiums and
benefits to reflect the correct age and sex.
Adjustments to the policy’s premiums and/or benefits are usuall y the actions taken
by the insurer. Adjustments of premium or benefits for misstatem ents are not
prohibited because of the incontestabilit y clause, as that clause disallows contesting
the validit y of the policy, therefore, a misstatement or age or sex would be an attempt
to enforce the contract terms (and not prohibit them).
If the insured is alive when it is discovered that age or sex has been
misrepresentative, the parties may elect to adjust the premium to the correct amount
rather than adjust benefits. State laws generall y limit the amount payable or benefit
accruing will be what the premium would by at the correct age. A few states also
include misstatement of sex also.
NONFORFEITURE PROVISIONS
When insurers developed the concept of level premium insurance policies, the goal
was to make life insurance affordable to elderl y policyhol ders. This was accomplished
through the introduction of the lifetime level premium whereby the risk premium was
level, making the cost higher at the younger ages than annual term insurance or
policies that increased premium according to age, but lower at the older ages. The
purpose was to make the insurance more affordable to older policyowners by way of
charging a level premium for lifetime.
The “excess” premium at the younger years built up a reserve that was used to pay
the mortalit y costs at older a ges. The question arose as to the ownership of these
reserves if the policy lapsed in the earl y years. The quick answer was that the reserves
were forfeited by the policyowners, however that was considered inequitable and
nonforfeiture benefits were crea ted which pay back a portion of the increase in cash
value, i.e., Standard Nonforfeiture laws.
This law is not specific as to surrender values except that the surrender values are
at least as large as those that would be produced by the methods used.
These laws require that after a cash value policy has been in effect for a minimum
number of years—usuall y three—the insurer must use part of the reserved excess
premium to create a guaranteed minimum cash value. In addition, the insurer must
make that value a vailable to the policyowner in cash as a surrender value and must
give the policyowner a choice of two nonforfeiture options: (1) extended term
insurance for the net face amount of the policy or (2) paid -up insurance at a reduced
death benefit amount. If no election has been made by the policyholder, one of these
options will automaticall y become effective.
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SETTLEMENT OPTIONS
The standard policy provisions of the various states require that a life insurance
policy must include certain settlement options ta bles if the settlement options include
installment payments or annuities. These tables must show the amounts of the
applicable installment or annuit y payments.
PROHIBITED PROVISIONS
State laws vary among states, and insurers within the states; however, th ere are
several provisions that are prohibited by law, because it is felt by the courts that they
violate “public policy.”
 The insurance producer agent or “producer” of the insurance, and who is the
agent of the insurance company, cannot be made the agent of the insured for
purposes of filling out the application for insurance. The reasoning is that if the
producer could be made the insured's agent (rather than the company's agent),
then the insurance company could not be charged with knowing facts presented
to the agent but not communicated to the insurance company by the agent. This
restriction onl y pertains to the taking of the application as in some cases, few to
be sure, the producer could be held to be the agent of the insured for other
purposes once the policy is in force.
 Nonpayment of a loan cannot cause a forfeiture of the policy, i.e. as long as the
cash value of the policy exceeds the total indebtedness on the policy, the
policyowner's failure to repay the loan or to pay interest on the loan cannot
cause a forfeiture of the policy.
 Less-value statutes prevent an insurer from promising something on the face of
the policy and taking it away in the fine print. These laws are called less value
statutes because the insurer is prohibited from providing a settlement option of
less value than the death benefit of the policy.
 All states have statutes of limitation that control how long a person may wait
before bringing a lawsuit of any t ype against another part y. These statutes appl y
to many t ypes of legal documents and ac tions. They are designed to force people
to sue in a timel y fashion rather than waiting in the hope that evidence favorable
to the other side will be lost. The court will not hear a suit if the statute has
expired. The statutes of limitation have differe nt lengths for different t ypes of
lawsuits. Ordinaril y, the time period during which a lawsuit based on a contract
must be brought can be as long as ten years, but can be onl y 4 years or less for
medical malpractice. Most states prohibit insurers from is suing policies that
greatl y reduce the length of the statute of limitations on contract actions. These
statutes permit insurers to shorten the period to a reasonable length but not to
eliminate it entirel y. The permissibl y shorter periods range from one to 6 years.
Some states do not permit insurers to reduce the statute of limitations period at
all.
 These laws may seem inequitable at times —particularl y where the injured part y
was not aware of the limitations of the statute and/or was not aware of the harm
until after the statute expired. Otherwise, insurers are protected because the
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laws allow them to impose shorter limitation periods than otherwise permitted in
the state. This benefits insurers because it requires plaintiffs to sue while
information relevant to the insurance policy is still easy to obtain. The public is
protected because the statu tes do not allow insurers to shorten the limitation
period so much that the public does not have sufficient time to determine
whether a lawsuit is worthwhile.
 A common practice is backdating to save age (issuing the policy as if the insured
was younger when the policy was issued). If this is used within reason, it could
be advantageous to the insurer (they get new business) and to the applicant (his
premiums, if based on age, are lower). For various reasons, statutes generall y
limit backdating to no more than six months.
OPTIONAL PROVISIONS
In addition to the required provisions, there are numerous other provisions that are
not required nor are they prohibit ed.
SUICIDE PROVISION
Typicall y, a death by suicide is not covered for a specified period —usuall y two
years, sometimes one year. This is to protect the insurer from an insured purchasing
the policy for the purpose of committing suicide so that the benefic iaries will receive
funds immediatel y. A t ypical provision reads:
Suicide of the insured, while sane or insane, within 2 years of the issue date, is not
covered by this policy. In that event, we will pay onl y the premiums paid to us less
any unpaid policy loans.
OWNERSHIP PROVISION
Ordinaril y the insured is the applicant and owner of the policy and certain rights
are necessaril y spelled out. Typicall y, the policy states that the owner of the policy is
the insured unless the application states otherwise. The provision also usuall y states
that the policyowner may change the beneficiary, assign the policy to another part y,
and exercise other ownership rights. If these powers are described, the provision will
also define these powers and how they can be lega ll y exercised.
ASSIGNMENT PROVISION
In keeping with normal rights of property owner, the policyowner may transfer
some or all of his or her rights to another person. Legall y, this is the right to assign.
The right to assign an ownership interest in an ins urance policy exists even without an
assignment provision in the contract but most contracts have an assignment clause
outlining conditions upon which an assignment can be made.
PLAN CHANGE
This provision simply states that the parties may agree to change the terms of the
contract-plan change. It allows for addition of riders or endorsements, and other
changes if mutuall y agreed.
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ACCELERATION OF BENEFITS
The AIDS epidemic was the catal yst for this provision, plus public concern about
other terminal illness es. This provision permits the insured to withdraw death benefits
under certain specific conditions. This also applies to situations where the insured is
terminall y ill whereby the policyowner can withdraw part of the death benefit.
The Model legislatio n states that funds may be withdrawn during the lifetime of the
insured under a life insurance contract to a policyowner (or certificate holder for
group insurance) upon the occurrence of life -threatening or catastrophic conditions
that are specified in th e policy. To qualify as accelerated benefits, the lifetime
payments must reduce the death benefit otherwise payable under the contract.
The model regulation prescribes that the condition that permits the payment of the
accelerated benefits must be a medica l condition that drastically limits the insured's
normal life span expectation (for example, to 2 years or less). The regulation also lists
several diseases as examples of a qualifying medical condition: acute coronary artery
disease, a permanent neurolog ical deficit resulting from a cerebral vascular accident,
end-stage renal failure, HIV (AIDS), or such other medical condition as the
commissioner may approve.
NAIC MODEL ACCELERATED DEATH BENEFIT
REGULATION
The majorit y of the states have adopted the NAIC Model and other states may have
some variation thereof. According to the Model, the purpose “is to regulate
accelerated benefit provisions of individual and group life insurance policies and to
provide required standards of disclosure. This regulation sh all appl y to all accelerated
benefits provisions of individual and group life insurance policies except those subject
to the Long-Term Care Insurance Model Act, issued or delivered in this state, on or
after the effective date of this regulation.
The Model definitions state (1) "Accelerated benefits" covered under this regulation
are benefits payable under a life insurance contract:
a. To a policyowner or certificate holder , during the lifetime of the insured, in
anticipation of death or upon the occurrence of specified life -threatening or
catastrophic conditions as defined by the policy or rider; and
b. Which reduce the death benefit otherwise payable under the life insurance
contract; and
c. Which are payable upon the occurrence of a single qualifying even t that results
in the payment of a benefit amount fixed at the time of acceleration.
2. "Qualifying event" shall mean one or more of the following:
a.
A medical condition which would result in a drasticall y limited life span as
specified in the contract, for example, twent y-four (24) months or less; or
b.
A medical condition which has required or requires extraordinary
medical intervention, such as, but not limited to, major organ trans plant or
continuous artificial life support, without which the i nsured would die; or
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c.
d.
(1)
(2)
(3)
(4)
(5)
e.
Any condition which usuall y requires continuous confinement in an
eligible institution as defined in th e contract if the insured is ex pected to
remain there for the rest of his or her life; or
A medical condition that would, in the absence of extensive or
extraordinary medical treatment, result in a drasticall y limited life pan.
Such conditions may include, BUT ARE NOT LIMITED TO, one or more of
the following:
Coronary artery disease resulting in an acute infarction or req uiring
surgery;
Permanent neurological deficit resulting from cerebral vascular accident;
End stage renal failure;
Acquired Immune Deficiency S yndrome; or
Other medical conditions which the commissioner shall approve for any
particular filing; or
Other qualifying events that the commissioner shall approve for any
particular filing.
ADDITIONAL COMMON PROVISIONS
Other common policy provisions are those concerning accidental death benefits, the
guaranteed purchase option (a lso known as the guaranteed insurabilit y option), and the
waiver of premium in the event of the insured's disabilit y.
ACCIDENTAL DEATH BENEFITS
This optional policy provision is added to some insurance contracts in the form of a
rider, or amendment, to the policy and is also known as the double indemnit y provision
because it normall y doubles the standard death benefit if the insured dies accidentall y.
DEFINITION OF ACCIDENTAL DEATH
Because this benefit is payable onl y in the event of the insured's accidental death,
many policies define “accident,” and “accidental death.” In the absence of a specific
definition in the rider, the word accident means an unintentional event that is sudden
and unexpected. An accidental death is one that is caused by an accident .
There have been cases where an insured dies and the method or cause of death is
questioned as to whether the policy covers death by that particular cause. One
qualifying incident is that if the accident was the cause of death —for instance, often a
heart attack is the cause of an accident that the insured did not survive, in which case
the accident benefit will be payable onl y if it can be proven that the accident caused
the heart attack. Court cases on such factors abound and make for interesting readi ng.
The problems caused by cases in which there is potentiall y more than one cause of
death are lessened somewhat by putting a time limit in the accidental death benefit
provision, such as (commonl y used) the death must occur within 90 days of the
accident that is said to have caused the injury.
There are two t ypes of accidental death clauses: (1) the accidental result t ype and
(2) the accidental means t ype. The most common t ype of provision in life insurance
15
policies is the accidental result category. This is more favorable to the consumer,
further, most courts have recognized that the difference between the two clauses is too
difficult for many consumers to understand and have therefore ceased to recognize a
distinction between the two t ypes of clauses.
The distinction can be explained as follows: under an accidental means clause both
the cause (means) of the death and the result must be unintentional. Under an
accidental result clause, onl y the result must be unintentional. For example, assume
that an insured is participating in an obstacle course race at a famil y reunion, and the
race requires the racers to dive over a barrel, do a somersault, and run to the next
event. The insured breaks her neck dies as a result of doing a somersault. Because she
was doing exactl y what she intended to do, the means was not accidental although the
result was certainl y an accident. The accidental means clause would not require the
payment of the benefit, but the accidental result clause would.
Another and more strict provi sion requires that, in addition to being accidental, the
means (cause) of death must also be violent and caused by an external agency. Courts
have been liberal in their interpretation of these limitations in favor of the public.
Most accidental death bene fit clauses do not provide coverage in the event of the
insured's death by suicide as it would entail an examination of the insured's mental
state at the time of the suicide, is avoided. If the insured is sane at the time of the
suicide, then it is an intentional act that would not qualify as an accident. If the
insured is insane, the suicide may be classified as unintentional because the insured
may be presumed not to have been able to intend the consequences of his or her act.
Courts have gone around an d around on that one.
GUARANTEED PURCHASE OPTION (GPO)
The guaranteed purchase option is quite popular – also known as the guaranteed
purchase option. This is a relativel y new provision. It protects policyowners against
the possibilit y that they might b ecome uninsurable, right when they need and want to
purchase added coverage. The GPO give the policyowner the right to acquire
additional insurance in specified amounts at specified times or ages —such as allowing
additional purchases every 3 years and aft er the birth of a child —provided the events
occur before the insured reaches a specified maximum age (often 45). The right to
purchase additional insurance can be very valuable because the insured does not have
to provide evidence of insurabilit y to exerci se the option. In addition, the new
coverage is normall y not subject to a new suicide provision or a new incontestability
clause.
There is a ceiling on the maximum amount of insurance available under the
guaranteed purchase option and a maximum age at whi ch the option may be exercised.
Once the insured passes an age or event that triggers the right to purchase, additional
insurance but he or she does not exercise that option, the option lapses.
WAIVER OF PREMIUM
A waiver-of-premium provision waives the p remium in case of disabilit y of the
insured; such disabilit y requires the insured to be totall y disabled (the policy provides
16
a definition of “totally disabled) in which case the insured will not have to pay any
premiums as long as the disabilit y continues .
This provision has its limitation, such as an age limit for the inception of the
disabilit y, or for the usual exception of self -infliction or as an act of war. Premiums
are waived at the interval of payment in effect when the total disabilit y started, a nd
while waived, the insurance continues as if premiums had been paid, and further, a
waived premium will not be subtracted from the policy proceeds.
Basicall y, for disabilit y policies in particular, there are two definitions of
“disabilit y” using “occupat ion” as the defining element. Total disabilit y can mean the
inabilit y for one to perform the duties of “his occupation,” or the duties of “any
occupation.”
For the Waiver of Premium purposes, a contract most frequentl y uses the definition
that “because of disease or bodil y injury, the Insured cannot do any of the essential
acts and duties of his or her job or of any other job for which he or she is suited based
on schooling, training, or experience. If the Insured can do some but not all of these
acts and duties, disabilit y is not total and premiums will not be waived.” If the
Insured is a minor and is required by law to go to school, "Total Disabilit y" means
that, because of disease or bodil y injury, he or she is not able to go school.
"Total Disabilit y" also means the Insured's total loss, starting while this rider is in
effect, of the sight of both eyes or the use of both hands, both feet, or one hand and
one foot.
The insurer uses certain standard conditions, such as information in respect to the
physical condition while the Insured is living and totall y disabled, or as soon as it can
reasonabl y be done, proof may be required “from time to time,” and the insured may
be required to be examined by doctors appointed by the insurer.
Payment of Premiums. Premiums must be paid when due, and if a total disabilit y
starts during a grace period, the overdue premium must be paid before the claim is
approved.
Refunds of Premiums. If total disabilit y starts after a premium is paid, and if it
goes on for at least 6 consecutive months the insurer will refund the part of that
premium paid for the period after the policy month when the disabilit y started. Any
other premium paid and then waived will be full y refunded.
Values. This rider does not have cash or loan values.
Contract. This rider, when paid for, becomes part of the policy, based on the
application for the rider.
Incontestability of Rider. The insurer cannot contest this rider after it has been in
force during the lifetime of the insured for 2 years from its da te of issue, unless the
Insured is totall y disabled at some time within 2 years of the date of issue.
Dates and Amounts. The effective dates of the policy and the Rider, when issued
simultaneousl y, will both have the same date of issue.
When this rider is added to a policy that is already in force, the rider will be
considered as part of the policy and will show the date of issue.
Cancellation - Termination. This rider can be cancelled as of the due date of a
premium by returning the policy and signed noti ce to the insurer within 31 days of that
17
date. If this rider is still in effect on the anniversary on which the Insured is age 65, it
will end on that date.
This rider ends if the policy ends or is surrendered. In addition, this rider will not
be in effect if the policy lapses or is in force as extended or paid -up insurance.
STUDY QUESTIONS
1. The direct economic function of a life insurance company is
A. to change uncertainty into certainty.
B. the accumulation of funds for retirement at older ages.
C. to provide assets to the general population for investment in real estate, etc.
D. to provide jobs for those who are mentally handicapped.
2. The basic definitions of insurance will refer to
A. creating competition for investments.
B. stabilizing the economy.
C. the ownership of insurers—stock or mutual.
D. the pooling of risks and losses.
3. Basically, a life insurance policy is
A. a gambling arrangement.
B. a governmental function.
C. a legal contract.
D. used only for accumulation of retirement funds.
4. After a policy has been in force for a stipulated period of time, the insurer must use part of the excess
premium for guaranteed minimum cash value, in accordance with
A. settlement options.
B. the suicide clause.
C. the nonforfeiture provision.
D. a prospectus.
5. An accidental death rider on a life insurance policy defines “accident” as
A. where one party has violated a law.
B. unintentional event that is sudden and unexpected.
C. damage caused by a collision.
D. personal injury in violation of a specific and not-excluded law.
ANSWERS TO STUDY QUESTIONS
1A 2D 3C 4C 5B
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CHAPTER TWO - TERM INSURANCE
BASICS OF TERM INSURANCE
Term insurance provides protection for only a specified and limited period, and if the
insured dies during the period while the insurance is in force the beneficiary will receive the
death benefit amount. If, however, the insured survives to the end of the insured period, the
policy terminates and there is nothing paid to the insured. The length of these policies varies,
and can run from one year to 20 years, or to age 65 or above. Basically, these policies insure
for the time stated only, or they may give the insured the option of renewing the policy for
successive terms without providing evidence of insurability.
Term insurance is carefully underwritten and restrictions can be imposed on the amount of
insurance and/or on the minimum age of issue, the length of the renewal period, etc. The
principal reason that it is so carefully underwritten is simply that there is considerable
exposure for little premium. If, for instance, a person discovers that he has a terminal disease
that he believes he can hide from an insurance company, he would apply for t erm insurance as
he feels he would “get more bang for the buck.” There would be little reason for him to apply
for a cash value or permanent policy that would demand a higher premium outlay. This does
create an underwriting problem by its very nature, as often the insurance company does not
receive enough premiums on the policy to enable it to require additional underwriting
information.
Term insurance is, obviously, temporary insurance, and in many ways is comparable to
types of property and casualty insurance. In auto and homeowners insurance, for example,
premiums paid for the protection are considered as fully earned (at the end of the policy year)
whether there is a loss or not, and the policy has no further value once the policy term has
been completed. With term insurance, the same situation applies and there is no obligation on
the part of the insurer unless the insured dies during the policy term.
Following the conception voiced previously, that term insurance insures only against a
contingency. The term premiums is relatively low, even though it carries a high expense
loading and allowance for adverse selection—which is possible because term insurance
contracts, as a general rule, do not cover the older ages when death is most likely to occur and
when the cost of insurance is high.
Renewing a Term Policy
Many, if not most, term insurance policies have an option to renew for a specified period or
periods of time, which generally are all the same length of time. The YRT policy is renewable
for successive one-year periods. Term policies for longer periods of time—10-20 years
typically—usually are renewable under certain stipulations. Primarily, the renewal may occur
without evidence of insurability or medical examination if the premium has not lap sed and the
insured so notified the home office of the insurer of his intention to renew prior to the
expiration of the policy and by the payment of the premium for the new (attained) age. These
premiums are usually stated in the policy.
The unique feature of this type of term policy is, of course, the right to renew without
additional medical information being required. Otherwise, if evidence of insurability were
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required with renewal, any changes in the health status of the insured would create a non renewal. Such changes that would not be acceptable to the insurer for renewal purposes, might
be caused not only by ill health, but also by change of occupation or geographical location, or
some other reason—and if this would happen, the chances are very slim that the insured would
be successful in obtaining like coverage elsewhere. Therefore, it is apparent that the renewal
feature of a term policy is designed to protect the insurability of the insured.
With the renewable term policy, the premium increases with each renewal because it is
based upon the attained age of the insured, and we all know what happens to mortality at older
ages. Interestingly, at age 50, the term insurance premium would be higher than the premium
for a whole life contract that was acquired when the insured was 35 or younger. Each term
policy renewal renews at the attained age, so they will increase rather substantially at the older
ages. The schedule of renewal premiums will be part of the insurance policy and the company
cannot change them while the policy is still in force.
The evidence of insurability is usually provided in the form of a certificate or similar form
that is to be attached to the insurance policy; however, some insurers may issue a new policy
with each renewal.
There are insurance companies that specialize in term insurance —not as many now as there
used to be years ago when insurers engaged in a “term war—but life insurers as a whole seem
to have mixed feelings about the product. It does fulfill a real need fo r many persons who
otherwise would have no life insurance at all.
The major concern of the insurers is the possibility of selection against the company at
time of renewal, and the selection becomes greater the older the insured becomes. It is the
“old story” of anti-selection (or adverse selection). Because the premium rises so rapidly at
the older ages, those in better health or with fewer infirmities may drop the insurance, while
those who are in poor health will pay the premiums, often no matter how high they may be.
This leaves a block of business of poorer risks, and since the premiums are based upon the
average health of a person at that particular age, this would mean that the premiums are, then,
inadequate. Because those of poor health will often (sometime must) renew, while those who
in good health will not (generally, they will purchase other coverage at a lower price), the
mortality experience among the surviving policyholders will deteriorate faster than expected.
The result is that every dollar that is used for protection on a term policy has a tendency to
cost middle-aged or older policyholders more than under any other type of policy.
Because of this, companies usually do not allow renewals to be available over a certain
specified age—such as 65, 70 or 75—plus limitations on YRT policies are even more stringent
as coverage is restricted to 10 or 15 years, or to age 65, whichever is earlier.
As a general rule, renewable term insurance is acceptable to both the insured and the
insurer as long as it does not extend into the older ages.
Convertibility
Besides offering renewability, most term policies are also convertible —permitting a
policyowner to exchange the term policy to a permanent type of insurance without evidence of
insurability. Many term policies are both, renewable and convertible.
Convertibility is important to those who want permanent insurance but presently are unable
to afford the higher premiums for the permanent insurance. Still they need immediate
protection. There are situations where a policyowner just simply wants to postpone
purchasing permanent insurance until a later date, for whatever reason. With some of the
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interest-sensitive permanent insurance plans available, the individual may want present
protection but wants to wait and see what the “market” does, for example. Then, if the
policyowner becomes uninsurable for some reason, he still can purchase permanent insurance
at a later date (albeit at a higher price which at the younger ages is not particularly
significant).
Actually, convertibility is more important that renewability as it guarantees access to a
permanent plan, not just to coverage or continuation of temporary protection.
There are two types of convertibility: attained age and original age. With the attained age
conversion, the premiums for the permanent plan would be based upon the age of the
policyowner at which the conversion occurs. The original age conversion (also called
“retroactive conversion”) uses the original date of the term policy and pr emiums on the
permanent insurance would be based upon the age of the policyowner when he was first
insured under the term policy.
Original Age Conversion
Some insurers allow conversion on a retroactive basis (Original Age) at any time within a
specified number of years after issue. When the conversion is effective, the premium is that
which would have been paid had the policyholder taken out the permanent plan originally.
Because of this, there usually is strong motivation for a policyowner to convert r etroactively.
Additionally, there can be better features in a policy that is issued at the original age.
However, it may not be as advantageous as there must be a financial adjustment of a
payment by the insured—which can be substantial if the term policy has been in force for
several years. After all, an insurance company is not an eleemosynary (charitable) institution.
There are a variety of methods used to compute this adjustment, but the most popular method
is that the payment will be the greater of (a) the difference in cash surrender values under the
exchanged policies, or (b) the difference in the premiums paid on the term policy and those
that would have been paid on the permanent plan, plus interest on the difference at some
specified rate. These methods are not uniform, and some companies require a payment that is
equal to the reserves difference in the two policies, plus a charge (as high as 8%) to
compensate for the investment loss on the difference.
These arrangements may seem complicated—and they can be—but the message is that the
insurer simply wants to be in the same financial situation that it would have been if it had
issued the permanent policy first.
So, what is the advantage to the policyowner to convert retroactively? Actually, ver y little,
as while the insured will pay a smaller premium, they will, in effect, pay it over a longer
period of time. On an actuarial basis, the two sets of premiums are equivalent. Do not forget
that the insured pays the company the interest it would have earned had the larger premium
been paid from the beginning.
Which is the preferred method of conversion? The insured should strongly consider the
state of his health. The insured would not be wise to convert retroactively (which entails
paying a substantial sum to the insurer) if his health was impaired. The sum that the insured
would pay would become part of the reserve under the contract and would not increase the
amount of death benefits in case the insured succumbs to an early death. All the addi tional
payment would do is to reduce the effective amount of insurance.
If this seems confusing, it is actually a simple matter of continuing the death benefit at the
term premiums (lower than with a permanent plan) and because of health problems, there is a
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greater chance that the insured will not outlive the term period. So, why pay more for the
same death benefit?
Occasionally, the “dream” client may appear—someone who has surplus funds to invest in
insurance, in which case the insured would probably be better off if he bought additional
insurance, or prepaid premiums on existing policies. This is accomplished by prepaying fixed
premiums by the use of premium deposits, or by discounting future premiums. In either case,
the funds deposited with the insurer are credited with interest (at some designated rate) and
sometimes, the deposited funds are credited with interest earned by the company in excess of
the designated rate. When the insured dies, the balance of such deposits is returned to the
estate or designated beneficiaries (in addition to the policy’s death benefits). Companies vary
as to allowing withdrawals of these funds on the policy anniversary or premium due dates.
Some allow withdrawals only in case or surrender or death, and some do not credit interest and
may even penalize the insured if the funds are withdrawn —but these companies are in the
minority.
When to Convert
A retroactive conversion must take place within a certain number of years after the policy
has been issued. If the policy is no more than a 10-year term, for instance, a conversion can
usually be accomplished according to the wishes of the policyholder. If the policy term is
longer than 10 years, then the policy will usually state when the conversion can take place —
always prior to the end of the policy term.
The reason for the time limit is the old bugaboo of adverse selection. There always is some
sort of adverse selection in most conversions as those in poor health at the time of conversion
are more likely to convert and pay the higher premiums, than would those who are in good
health. Therefore, it can be reasonably assumed that since conversion must be made some
time before policy expiration, a higher number (percentage) of policyowners will elect to
convert, as they may not be too sure of their future health. Not surprisingly, statistics indicate
that the death rate of those who convert are higher than normal (expected). Therefore,
premiums for convertible term insurance are higher than those for term policies that do not
allow conversion.
If the term policy is only renewable, the time limitation may be that it must be renewed
before age 60 or 65. Sometimes the policy will state that the policy must be converted within
a specified period prior to the latest date that it can be renewed.
It should be noted that conversion might be allowed after the time limit, but only with
evidence of insurability.
There are some term policies that automatically convert at the expiration of the term
period, to a specified permanent plan. However, there is a question as to whether this
effectively reduces adverse selection because those policyholders who are healthy will
probably decline to continue the insurance.
RE-ENTRY TERM
Because the element of adverse selection is so troublesome, insurance companies invented
a term insurance policy that charges higher premiums to those of poor health when they renew
their term insurance, ergo; the degree of adverse selection is reduced.
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A discussion of re-entry term can become complicated, but it is a policy that is subject to
two different premium schedules. One, the lowest, rate is based upon mortality tables that
apply to those individuals who have recently given evidence that they were in good health
(“Select” mortality). These rates are available just as long as the insured can provide new
evidence of insurability at renewal dates (and/or other dates as specified by the policy).
The other, higher, premium schedule is based on rates that apply to insured’s that have not
produced evidence of insurability for 15 or 20 years after the initial evidence (“Ultimate”
mortality). Therefore, if the insured cannot provide evidence of insurability at the renewal
date, then they will have to pay the higher premium immediately and into the future, unless, of
course, they can show that there has been an improvement in their health.
On the face of it, this seems to be a logical choice—in order to get lower premiums, the
insured must be healthy and the insured should be willing to pay higher premiums if/when h is
health deteriorates. However, there is always the question as to whether the insured fully
understands what can happen if they purchase re-entry term. As anyone with teen-age children
knows, young people believe they are immortal so they would never h ave to pay the higher
rates. However, if their health does deteriorate, they will then have to pay the higher
(ultimate) rates and (in all probability) they will not be able to buy insurance from another
insurer. Looking back at that point, they could see that the single premium schedule term
insurance was a real bargain, but by then, it is too late.
Do not feel that re-entry term is a “rip-off” as for those who actually do remain healthy
into their retirement years; this can be a very economical way to b uy insurance. However, if
their health deteriorates at the expected rate, i.e., that of the population in general, insurance
can be costly. Statistics indicate that with most person’s health starts to decline around ages
45 to 50 and if they live their normal life expectancy (50% of them will, statistically) they
could live 40 or 50 years with impaired health—and they would be paying the higher term
rates for more years than they paid the lower rates.
As a general rule, re-entry term initial premiums are about 10% lower than those for a
regular renewable term policy (with guaranteed future rates). If, however, the insured suffers
an illness or injury and his health deteriorates, the new premium may be as much as twice,
what the renewal premium would have been under the traditional renewable term policy.
Therefore, they could easily end up paying much more premiums for many more years than
they would have if they had just purchased a renewable term.
A professional approach to marketing re-entry term could involve comparison of the high
rates of various insurers for similar coverage. Once the insured cannot provide the necessary
evidence of insurability, however, the lower premium schedule is meaningless. Comparisons
may be made by making pro-forma cash flow simulations of both the high and the low
premiums, for each policy under consideration, and at a range of dates that the premiums
would increase. Practically, however, this is rarely performed. Those who have absolute faith
in their good health extending into the distant future—and there are many of them, nearly all
young—look upon re-entry term as a real “bargain” and they are really not too interested in
comparisons of anything that suggests that they may not be as healthy as they would wish in
the future.
One other important aspect is whether the insurer considers the new policy issued if the
insured can no longer qualify for the re-entry lower premiums, as a new policy. If they do,
there is a possibility that the new policy may have a new contesta ble period of one or two
years. In any event, as any good agent knows and would communicate to his client, 23
if the insured should die while the policy is contestable, the claim will be
investigated much more thoroughly; plus it will take longer to sett le than for an
incontestable claim.
LONG-TERM TERM INSURANCE
Most of the discussion of term insurance so far has been generally in the area of short -term
policies, or with renewability features. However, there are some very popular term policies
that are written for a longer period of time and have distinct features different from those of
shorter duration. These policies usually allow the insured to purchase waiver -of-premium and
accidental death benefits, similar to that offered with permanent plans.
A term-to-age-65 policy, for instance, provides protection on a level premium basis from
the age at issue to attained age 65. The length of the policy is somewhat shorter than the life
expectancy of the insured, but the termination date is usually that o f the date of retirement;
therefore, it covers primarily the period of time that the insured is earning a living. Since the
term is shorter, the premium is less, than a comparable permanent plan. It is customary
(indeed, in many states it is required) for there to be a cash value and surrender values. There
may be a conversion privilege that has to be exercised (usually) prior to a specified
termination date—typically at age 60.
INCREASING AND DECREASING TERM INSURANCE
This discussion has centered on level death benefits throughout the term of the policy.
However, as anyone who has ever purchased a car or home or borrowed a large sum of money
can attest, there are policies with decreasing amounts of insurance. For instance, when used in
credit life situations, decreasing term policies decrease either uniformly or according to some
schedule. “Mortgage Redemption Life Insurance,” for instance, is a form of decreasing term
insurance where the face amount decreases periodically to reflect the amount of t he mortgage
remaining after each mortgage payment. Some specialty policies mirror the decrease in debt
exactly; while others simply decrease the policy in approximate amounts so as to closely
reflect the debt decrease.
This type of coverage can be issued as a policy, as a rider to a policy or as a combination
with another policy.
Increasing term insurance, which is actually a rather-old product, has taken on a new life
in recent years, particularly with arrangements such as split -dollar plans that may consider
borrowing or encumbering the cash value of the underlying policy. This type of plan can be
used to provide a uniform death benefit for the benefit of the beneficiaries by making a
provision that there will be an automatic additional amount of ter m insurance purchased each
year in the same (or approximate) amount that the cash value increases.
Increasing term insurance can be issued on a year-to-year basis through the fifth dividend
option. This dividend option makes available the use of the divid end to purchase one-year
term insurance. There are a couple of forms of this, one of which applies the dividend as a net
single premium to purchase as much one year term insurance protection that the dividend can
buy. Another form purchases one-year term insurance in an amount equal to the policy’s cash
value with the excess dividend portion applied tone of the other dividend option —often used
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with split-dollar insurance plans . The purpose is to assure the beneficiary payment of an
amount equal to the policy’s face amount if the insured dies, even though the cash value may
be totally pledged—hence the use of increasing term insurance.
THE PLACE OF TERM INSURANCE IN TODAY’S MARKET
Even though term insurance may be the oldest form of life insurance, excep t possibly the
assessment plans, it still has a place in today’s societies. There are those who maintain that all
life insurance should be term insurance as it fills all life insurance needs. This theory gained
some traction in the marketplace 20-30 years ago when it became fashionable to market yearly
renewable term with the slogan of “buy term and invest the difference.” This led to several
insurers entering the additional field of “investment” by either forming their own mutual funds
or contract with various mutual funds. At that period in time, the typical cash value of whole
life policies were only credited with 3% growth each year, while other investments were
producing investment returns of around 10%—sometimes even higher. This required that life
insurance agents become dually licensed—securities and insurance licenses—and this also
meant dual regulation with the SEC concerned with the securities and the Insurance
Departments concerned with the life insurance. This dual regulation will be discus sed in more
detail when the Variable Life Insurance plans are explored later in this text.
To this day, there are agents who will encourage a whole life policyholder to cash in their
policies and replace them with term insurance. Insurance companies disco urage this type of
indiscriminate use of term insurance which /has led to an impression by the general public that
life insurance companies want to sell only permanent insurance so that they can receive more
premiums, thereby increasing their assets and income. Regardless of public perception, there
are certainly valuable uses for this product.
WHEN TERM INSURANCE SHOULD BE USED
From the previous discussion, it is obvious that there are two areas where term insurance
may be or should be used. Since term insurance provides temporary protection, then that is
one of the areas where it should be used—to provide temporary protection.
The second area where term insurance is suitable is when the need for insurance may be
permanent, but the insured simply cannot afford permanent insurance to provide the coverage
needed. As an example, if an insured wants insurance to pay off a large debt in case of his
untimely passing, it might be nice to have permanent insurance as then when the debt is paid
off, he will still have life insurance regardless of his state of health at that time. However,
often the insured can only afford the term insurance premiums. As a corollary, consider that
driving to work every day behind the wheel of the large Lexus, many people can only afford a
Corolla that will get them to work just as well as a Lexus or any luxury car. There are times
when one cannot afford what he would like or even what would be best for him, so he will
have to find another way that he can afford.
It is certainly advisable, if term insurance is purchased, to makes sure that it is convertible.
This can be the best of both worlds as the insured may later be able to convert the term
insurance to a permanent plan when they can better afford to do so. The basic premium
between convertible term and non-convertible term is so slight that rarely will an applicant
refuse this feature.
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The policy should be renewable as well, as the financial status of the insured may remain
the same in the future. Renewability and convertibility features serve different functions, but
they work together well and should be used in all term policies.
Temporary Protection Needs
As mentioned above, a person might only need temporary protection, particularly when
insurance is needed to “hedge” a loan. A term policy in the amount of an obligation serves a
dual purpose: (1) it protects the lender or lending institution against the possible loss of the
principal, therefore the loan is easier to obtain (often on better terms) if the loan is protect ed
against loss by premature death of the debtor; (2) it protects the estate of the insured against
having to repay a loan if the insured should die before the obligation has been fulfilled.
There is actually a plethora of situations where temporary protec tion is not only desirable,
but also needed. Most people are familiar with mortgage redemption insurance where the
mortgage is paid off if the mortgagee dies while there still is a mortgage, but there are other
uses that can include corporations purchasing a form of key-man insurance when they are
engaged in experimental products that would provide funds to reimburse the corporation for
any losses they may suffer if there is a death of an employee who is heavily involved in the
experiments. Movie studios will cover their principal actors—and sometimes their directors or
producers—for the period of time that the movie is in production.
A perhaps more mundane type of temporary protection is needed by parents who need the
protection while the children are still dependent, but not so much when they are “all grown up.” This can be accomplished by term insurance on the parents or a larger amount on the
breadwinner during the child-rearing years, or sometimes it is better accomplished by the use
of decreasing term being superimposed on a permanent insurance plan.
Younger persons who fully expect their financial situation to improve in the future often
use term. While young professionals are getting established, it is often wise for them to
purchase insurance that will provide funds to cover their debts and other expenses, in addition
to family needs (particularly if there are children), at the lowest premium available, with the
ability to convert at a later time to more permanent type of insurance. Term insuran ce can be
used in the same manner for young persons who are entering the business world, especially if
they have executive possibilities and ability.
Supplement to Group Insurance
Many employees that covered by group life insurance, as part of an employee benefit plan
are hesitant to purchase individual life insurance. In many cases, the employee that has a good
benefit program has the attitude that the employer is “taking care of him” whether he is injured
or becomes ill, or unable to work, and will provide adequate life insurance for the protection
of his family. Unfortunately, in most cases, the group life insurance is only for $50,000 or
less, and while that seems like a lot of money for many young working persons, an individual
could not even leave a mortgage-free house to his family if he should die early.
Employees should be aware of how much of the group life insurance they can convert after
an involuntary termination of employment—strike, lay-offs, plant closing, work reduction, etc.
They should purchase term insurance in at least the amount of their group life insurance plan
while they are still employed.
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OBJECTIONS TO OTHER FORMS OF INSURANCE
Anyone who has been in the life insurance field for any length of time has heard some of
the objections to whole life and other forms of permanent insurance—some may have used
these arguments in attempts to sell permanent insurance.
The most often used—and the easiest to explain to a prospect—reason not to buy
permanent plans is that it is more expensive. A person buys life insurance so as to leave
money to his beneficiaries in case he dies early or during his income -producing years and that
should be the only purpose of life insurance. That is what term insurance covers and why
should anyone pay more so that the life insurance company can invest his funds along with a
jillion other insured’s premiums, when the prospect can invest it himself and get a better
return without having to pay an intermediary? In addition, if he needs the money for a good
reason, he will not have to invest the savings in the premium —it can be spent for whatever he
wishes.
The basic argument is that why should anyone pay in advance for something that they may
not need or live to enjoy? Term insurance, however, is a method of “ paying as you go and you
get what you paid for.”
OK, there is a lot to the argument that the insured’s would be better off with term
insurance, if they are sure that they are going to die within a short period of time. However,
what if they get “lucky” and they live to a ripe old age? As they get older, the health
deteriorates, and they will probably not be able to get life insurance after the end of the term
life period, and they can use funds for estate purposes, future debt settlement in case of death,
even burial costs. The possibility of living so long that the premiums paid in exceed the total
premiums paid under a level premium plan is relatively high.
The factual argument is that with a level premium plan, the insured is protected against
living too long and having to pay extravagant premiums. Since, in reality no one knows when
they are going to die, the level premium plan shifts some of the premium burdens of living too
long to those who die early and who have a very large return on their premiu m outlay.
The old story, worth repeating, is where an agent attempting to sell life insurance, was
asked by his prospect, “Exactly how much life insurance should I buy?” The agent replied, “I
can tell you exactly what you need, and I only need to know tw o things — your date of birth
and your date of death!”
Perhaps the most intellectual (?) argument against permanent insurance is that
policyowners are overcharged because the reserve under permanent plans of insurance is
“forfeited” to the insurance company when the insured dies. Therefore, it is contended, the
death benefit should be increased by the amount of this reserve.
If, as suggested, the reserve is paid to the policyowner in the event of death, in addition to
the death benefit, this destroys the level premium concept, the heart of which is the reduction
in the net amount at risk as the reserve increases. If the reserves were paid in addition to the
death benefit, premiums will obviously be inadequate as they are calculated on the assumption
that the death risk is a decreasing risk.
OK, you may know of a policy that will return the reserves in addition to the death benefit,
however check the premium—it will be increased accordingly. Remember,
Life insurance companies are not eleemosynary institutions.
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BUY TERM - INVEST THE DIFFERENCE
The “buy term and invest the difference” philosophy as extolled by some, needs further
consideration and discussion as it is based upon the proposition that in dividuals can invest
their funds as efficiently and profitably as can the insurer, and usually at a higher rate of
return. There are some arguments for this as an individual can “play the market” and if he is
knowledgeable (and lucky), he can probably “beat” the investment return for the insurer as the
insurer is restricted as to where it can invest its assets. Their restrictions are tightly regulated
by insurance regulations and they are rather conservative for the protection of the
policyholder. The Departments of Insurance do not want to see insurance companies go into
receivership or bankruptcy because of risky investments. Therefore, there is some truth to the
claim that an individual may do better than insurers in their return on investments.
Those who preach the “buy-term-and-invest-the-difference” philosophy use this argument,
and therefore they recommend that an individual buy term insurance and the difference in what
they would have paid for level premiums, they can invest in a separate program. Some
recommend that all such investments be in government bonds, some recommend investing in
investment trusts or mutual funds, or even in common stocks —whatever they can sell that day.
What Kind of Investments?
It may be necessary to determine what kind of investment program best serves those that
ascribe to the term-and-investment philosophy. Textbooks (quoting experts) maintain that any
investment program should have safety of principal, yield and liquidity. Each of these should
be discussed separately.
Safety of Principal
This is, so to speak, a ballgame in the insurer’s ballpark! Throughout the years, the life
insurance business has a solvency record that is better than any other type of business
organization. True, there have been insolvencies but in every case, the Insurance Departments
have been able to either find a buyer for the company or its business, or have assigned blocks
of businesses to other companies. Even when Baldwin United Life Insurance Company was
taken over by the Department of Insurance many years ago, leaving thousands of annuity
owners fearing for their own investments in annuities, the worse that any annuity owners
suffered was that there was no increase in annuity assets for a year or so, and then the
annuities were taken over by other companies (such as Metropolitan Life) and the annuity
owners lost no more investment income. Few, if any, industries could perform as well.
The insurers are required to concentrate on quality investments and government bonds
(federal, state and local), high-grade corporate bonds and real estate mortgages, and there must
be diversification by regulation. Investments are diversified as to type of industry,
distribution, maturity, etc. The individual policyowner’s reserve is commingled with all of the
other policyowner reserves; therefore, each policyowner has a pro -rata share of each
investment unit in the insurer’s portfolio. This affords the maximum of security of
investments and they are collectively beyond the reach of any individual inves tor. The only
way that an individual investor could match the safety of principal of the insurance companies,
would be if they could invest in federal and state government bonds, which would sacrifice
yield in deference to safety, and few investors would want to do that, even if they could.
Yield
Life insurers measure their investment yield by a percentage of their mean ledger assets —
the net investment income without capital gains or losses, and after deducting investment
28
expenses but prior to deducting federal income taxes—and they earned over 9% during the
past 10 years. So, it is possible for an individual investor to do as well as an insurance
company by investing in common stocks or other equity investments, particularly if unrealized
capital appreciation is considered—and many investors have done as well. Still, it is rather
unlikely that the typical life insurance policyowner can do as well as insurance companies
over a long period of time. Plus, a very important factor,
annual increases in cash values are not subject to federal income taxes as they
accrue, while the earnings from a separate investment account would be taxed to the owner as
ordinary income.
Liquidity
This is where the life insurance policy “shines.” Simply, the policyowner’s investment can
be withdrawn at any time without losing any of the principal through surrender for cash or
through a policy loan. This means that the insured never has to worry about liquidating assets
during a market downturn—and the policy loans cannot be “called” because there is
inadequate collateral.
True, there are some types of investments that are liquid, but no market -value investment
can come close to the liquidity of the obligations of the life insurance contract.
Otherwise
One more, but important, point. As anyone who knows anything about life insurance can
attest, one of the most important reasons to buy life insurance is the “forced savings.” This is
what many, many have discovered when they bought term and “invest ed” the difference—the
difference just was not invested. For life insurance, when the savings feature is combined
with the protection feature, there is a considerable incentive for the insured to save.
Contrast the situations where if an individual purchased, say, bonds for investment on a
regular basis, they may skip a month, or two, or three, if they either feel that they need the
money to buy something else or some other disposition of money is more important at that
time. Conversely, if they set aside a predetermined amount each month to a savings account
that if not paid, could mean that they would lose valuable protection that might be
irreplaceable (particularly if there are health problems)—they are much more likely to put the
amount into the “savings account” each month, like clockwork. With forced savings, if the
insured did not save, they would have no other way to preserve their protection.
Summary
All investments have their place in an individual’s financial and/or estate planning
programs but life insurance is normally the very foundation of such a program or plan, and
rightfully so.
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STUDY QUESTIONS
1. If the insured dies while insured under a term policy
A. the beneficiary will receive the death benefit amount.
B. the beneficiary will receive the difference between the reserve and net amount at
risk.
C. the death benefit is always a pro-rata share of the face amount decreased by a
factor involving the number of years that the policy has been in force.
D. the beneficiary will receive the face amount plus any cash value.
2. The renewability of a term policy is designed
A. to keep premiums down.
B. to provide continuing commissions.
C. to protect the insurability of the insured.
D. to provide nonforfeiture values.
3. A term policy that is subject to two different premium schedules would be
A. a re-entry term policy.
B. a limited term policy.
C. a yearly renewable term policy.
D. an adjustable term policy.
4. “Mortgage Redemption Life Insurance” is a fo rm of
A. decreasing term.
B. increasing term.
C. level term.
D. adjustable term.
5. Earnings to an individual from a separate investment account is taxed to the owner as
ordinary income; annual increases in cash values are
A. taxed at capital gains rates.
B. not subject to federal income taxes.
C. are subject to federal income taxes.
D. taxed as ordinary income every five years only.
ANSWERS TO STUDY QUESTIONS
1A 2C 3B 4A 5B
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CHAPTER THREE - WHOLE LIFE INSURANCE
PRINCIPAL TYPES OF WHOLE LIFE INSURANCE
ORDINARY LIFE INSURANCE
Ordinary life insurance (also called continuous premium whole life) is a t ype of
whole life insurance that requires premiums for the entire life of the insured. While
this is categorized a s “Whole Life” per se, many times there is no intention of the
policyholder to pay premiums for his entire life. For instance, it is often used where
insurance is purchased as part of a program that contemplates the use of dividends to
pay up the insurance by the end of a period shorter than the life expectancy of the
insured. In other cases, the plan may be to eventuall y surrender insurance for an
annuit y—or for a reduced amount of insurance. One should not consider that ordinary
life insurance must be paid for the entire life of the insured, but in actualit y, it is a
type of insurance that provides maximum protection for the lowest financial outlay.
This, obviousl y, provides considerable flexibilit y to meet unexpected situations and
circumstances, regardless of how long the insured lives. This is the basic life
insurance policy and is the one is purchased the most, particularl y since it can provide
the t ype of financial foundation for most estate planning programs.
Permanent Protection
Basicall y, the term of insurance is always there so that policy does not have to be
renewed or converted. Just as long as the policyholder pays the premium, the
coverage is there for as long as premiums are paid. Most people will need some
insurance during their lifet ime, even if it is just for paying final expenses or last illness expenses.
An Ordinary life policy is equivalent to an endowment contract that pays the face
amount as a death claim if the insured dies before age 100 or as a matured endowment
if he or she survives to age 100. ‘Back in the day” mortalit y tables upon which
premiums are based, this policy was referred to as “Endowment at 96” (the mortality
table assumed that everyone would be dead by the age 96.) (Some insurers today call
their ordinary life policy as “Endowment at Age 95.)
Lowest Premium Outlay
The premiums are the lowest of this t ype of policy, since the premium rate for an
ordinary life contract is calculated on the assumption that premiums will be payable
throughout the whole of life. T he net single premium for a whole life policy is
computed with taking into consideration the premium payment schedule, but the longer
the period over which the single -sum payment is spread, the lower each periodic
payment will be.
Limited-payment insurance contracts provide benefits that justify the higher
premium rates. If, however, the insured's objective is to secure the maximum amount
of permanent insurance protection per dollar of premium outlay, then his purposes will
31
be best served by an ordinary li fe contract. It is the “best buy” in respect to cost —
except at the older ages.
Cash Value or Accumulation Element
As level premium permanent insurance, ordinary life accumulates a reserve that
graduall y reaches a substantial level and eventuall y equals t he face amount of the
policy. As is to be expected, however, the reserve at all durations are lower than that
of the other forms of permanent insurance. The dollar amount of protection is a little
higher than similar other t ypes of insurance coverage’s . Still, the policy offers the
maximum combination of protection and savings as it accumulates a cash value that
may be used for whatever purpose of the policyowner.
The cash values that accumulate under an ordinary life contract can be utilized as
surrender values, paid-up insurance, or extended term insurance (as discussed in more
detail later). Cash values are not generally available during the first couple of years
because of the administrative cost of policy issuance and sales cost (such as agent’s
commission)—except for some single -premium policies and some duration of limited payment whole life policies whose first -year premiums are large enough to exceed all
first-year expenses incurred to create the policy and maintain policy reserves.
Policy Loans
Policyowners have cash values at their disposal for all level premium life insurance
policies such as whole life, universal life, adjustable life, variable life, variable
universal life, and current assumption whole life —all have provisions for policy lo ans.
Policy loans simpl y provide a cash value access to the policyholder without having to
terminate the policy. Policy loans are kept confidential and the policy specifically
states what portion of the cash value is available for loans and how interest will be
determined on the loan. As a general rule, 90 percent of the cash value is available
for 92 percent of the cash value in recognition of an 8 percent policy loan interest
rate—and any part of the cash value can be borrowed. Policyholders are allow ed more
than one policy loan as long as the aggregate amount of all outstanding loans and
accrued interest applicable to those loans does not exceed the policy cash value.
Policy loans require interest to be charged on the borrowed funds, which generall y
are either a fixed rate as specified in the policy (commonl y 8 percent), or a variable
interest rate tied by formula to some specified index. The index can be Standard and
Poor’s, Moody’s, some other known index. There is another approach whereas the
interest rate may be credited to the cash value plus a specified spread.
State laws impose changing upper limits on variable policy loan interest rates .
These laws require that the rate be lowered whenever the upper limit drops to more
than half of 1 percent below the rate being charged and such rate may be changed up
to four times each year.
The policyowner has the option of paying the policy loan interest in cash or having
the unpaid interest charge added to the balance of the outstanding loan(s) so that
additional interest charges can be applied to the unpaid interest amount. The
policyowner has the abilit y to pay any part of the interest charge as there is no
32
repayment schedule or requirement to repay. Conversel y, the policyowner is not
required to pay th e interest or repay the policy loan in cash. If any repayment is
made, the policyowner determines both timing and amount.
When the loan and/or accrued interest are not paid to the insurer in cash, the
insurer can withhold such funds from the death benefit s if the insured dies or from the
cash surrender value if the policy is terminated. Obviousl y, the policy will
automaticall y terminate if the policy loan balance plus unpaid interest exceeds the
policy cash value.
However, some whole life policies give po licyowners an automatic premium loan
option and when it is selected any outstanding premium will be paid automaticall y by
a new policy loan, which means that the policy will stay in force as long as there is
adequate cash value to cover each delinquent pre mium. However, once the cash value
reaches zero, the policy terminates. An exception is where the policy is a flexible
premium policy, in which case the insurer automaticall y deducts mortalit y charges
(plus other expenses, if any) from the cash value, re ndering interest charges as non applicable.
It must be kept in mind that a policy loan, per se, is simpl y an advance against the
death benefit, therefore the death benefit is adjusted to reflect the previous
disbursement. Further, a policy loan has negati ve consequences on benefits and may
reduce the amount credited to the cash value and/or the level of policyowner
dividends. When the insured dies, the death benefit is reduced by the full amount of
outstanding policy loans and accrued interest under most t ypes of policies. If the
beneficiary is an irrevocable beneficiary, the irrevocable beneficiary's consent may be
required to obtain a policy loan. A policy loan is reall y an advance against the death
benefit; thus, the death benefit is adjusted to refle ct the prior disbursement.
It is often asked by policyholders why there are interest charges on money that they
(the policyholder) have “earned” under the policy. Policy loans result in the life
insurer's release of funds it would otherwise invest to earn investment income. If the
rate of investment return on the insurer's portfolio is greater than the rate being
applied to the policy loan, the insurer experiences a reduction in earnings. The
insurer then offsets the reduction in earnings so as to maintai n a “level playing field”
between the policyowner who allows the cash value to be invested and those who leave
their entire cash value with the insurer who has calculated the investment income to
include the interest earned on the cash value amount that ha s been loaned and is no
longer under the custody of the insurer.
Normall y, with standard participating whole life policies, policyowner dividends
are not affected by policy loans, but most participating whole life policies being sold
today use what is called "direct recognition" to reduce dividends on policies with
outstanding loans. Basicall y, this not only adjusts for the differential in earnings, but
also discourages policy loans.
For universal life policies and other non -participating plans, designs , there are no
dividends to adjust so insurers compensate for lost earnings by reducing the earnings
rate being credited directl y to the cash value. If there are no policy loans, the insurer
credits its normal crediting rate to the full cash value. Never theless, if there are
policy loans, the insurer t ypicall y credits the normal rate to the part of the cash value
that has not been loaned, and a lower (e.g., 2%) unloaned portion of the cash value
33
equal to the loan indebtedness. Once the loan is repaid, th e insurer resumes crediting
the higher rate to the full cash value. Insurers do not allow a retroactive payment to
eliminate the past differential.
Since outstanding policy loans reduce both death benefits and nonforfeiture
benefits, the amount of the cas h value available to provide either extended term
insurance or reduced paid -up insurance is reduced by the loan amount. Further, if the
insurance is extended term, the amount of term insurance is also reduced from the
original amount of coverage by the am ount of loan debt.
States allow life insurers to delay lending funds for up to 6 months after requested
under the theory that that this would be a form of emergency protection in case
policyowners' demand for loans accelerates to the point that the insurer is forced to
liquidate other assets at significant losses to satisfy the loan demands. Practicall y
speaking, delaying access to funds is an indication of financial weakness or lack of
policyowner confidence that insurers want to avoid. Regardless, the f ew life insurers
that have failed in recent years chose not to invoke their right to delay policy loan
disbursements. However, once the insurance commissioner seized control of the
company, the quick access to cash values was terminated.
Nonforfeiture or Surrender Options.
One of the most important contract provisions with whole life is the nonforfeiture
options—also known as surrender options. Basicall y there are three surrender
options—cash, reduced amount of paid -up whole life insurance, or paid -up life
insurance.
Cash Value.
Standard wording states that the policy may be surrendered at any time for its cash
value, then the protection terminates and the company has no further obligation under
the policy. Surrendering for cash value must be done with care as that action would
prett y much take care of the policy. It is often used for a business opportunit y,
college fund, or other emergencies. Once the policy has been “cashed out”, it cannot
be reinstated without specific evidence of insurabilit y that would satisfy issuing a new
policy for a first -time applicant.
Reduced Amount of Paid-Up Whole Life.
Another option allows the insured to receive a reduced amount of paid -up whole
life insurance. The amount of the policy is the amount that could be purch ased at the
attained age of the insured which would be the net cash value —cash value less any
policy indebtedness (such as policy loans and interest) plus any dividend accumulation
as the original policy. Since the paid -up insurance is at net rates, there can be a
considerable savings to the purchaser. This reduced amount of protection continues
until either the policy is surrendered or the insured dies.
Paid-Up Term.
Another (the third) option provides paid -up term insurance in an amount equal to
the original face amount of the policy, plus dividend additions or deposits and reduced
by any policy indebtedness. The length of the contract would be what can be
purchased at the insured's attained age with the net cash value applied as a net single
34
premium. If the insured fails to elect an option within a specified period after
premiums are due, then the paid -up term option automaticall y goes into effect.
If the policyholder can no longer afford the premiums, or if the need for the policy
changes, a policyow ner can select one of the surrender options. Frequentl y surrender
options are exercised after dependents become self -supporting and the policyowner
wants to reduce the premiums for a particular period of time. When the policyowner
retires, he may want to exercise one of the options. Retirement is often a time to use
surrender options as the income of the policyowner is reduced.
Annuity or Retirement Income.
Another use of surrender values is in estate planning —for instance, purchasing an
annuit y or retirement income with the cash value proceeds. Often insured’s purchase
ordinary life insurance to protect their families during the child -raising period, and
then using the cash value for retirement purposes. For example, the cash value of an
ordinary life insurance policy purchased at age 35, would be in the range of 40 percent
to 55 percent. An ordinary life policy for $50,000 face amount, the insured would
have around $24,000 in cash value, which could provide a life income around $140 $165 per month. This amount in addition to Social Securit y and other retirement
benefits, this could provide adequate retirement income.
A unique and important vale of life insurance is to provide protection when the
need arises, and if the payment of premium creates financ ial difficulties, the
difficulties can be lessened when the need for protection becomes the foremost
requirement.
Conversion.
The insured is permitted the abilit y to convert to other forms of insurance, usuall y
subject to specified conditions. Even if th e right not specificall y stated, it usuall y can
be negotiated. As a general rule the policy can be converted to another form of
insurance without requiring evidence of insurabilit y, provided the new policy requires
a higher premium.
Conversel y, companies will rarel y allow a conversion to a contract for a lower
premium unless the insured can produce evidence of insurability. This restriction
applies primaril y because the company would be returning future premiums to the
policyholder, which means returning part of the reserve, thereby creating an increase
in the actual amount at risk. A practical reason is that the insurer suspects the insured
to have impaired health, whereas with a higher premium, the net amount at risk will
decrease more rapidly and the co mpany does not have to fear adverse selection.
The abilit y of ordinary life insurance to convert without evidence of insurabilit y
allows those whose savings program calls for substantial amounts of permanent
insurance but currently the funds are not availa ble to pursue this program, can start his
program with ordinary life insurance with the intention of converting it later to a plan
with higher premium. The beaut y of this is that if the policyowner does not realize
the abilit y to purchase more insurance, the insured still has permanent protection with
a modest amount of cash value.
Still, there are insurers who may allow a conversion to a lower premium plan
without evidence of insurabilit y if the insurance amount is increased to where the
35
insurer is relie ved of the obligation to refund a portion of the reserve and suffers no
reduction in premium income.
Participating versus Nonparticipating
In many cases, whole life insurance can be issued on a nonparticipating basis with
fixed and guaranteed premiums, i.e . there are no policyholder “dividends.”
Historicall y, nonparticipating policies were issued by stock life insurance companies
(i.e., owned by the stockholders).
Conversel y, whole life policies that are participating and they usuall y charge a
small extra premium with the intent to return part of the premium in the form of
policyowner dividends. It is a widel y known fact that, years ago, the U.S. Supreme
court ruled that “participating” policies that paid dividends, were actuall y returning an
“overpayment ” of premium.
Those who own whole life and universal life insurance policies may receive
dividends, while people who own term life insurance policies will not. That is because
the cash value in a whole or universal life insurance policy is a fixed rate gua ranteed
by the insurer and funded through money in the company's reserves. In turn, the
investment return on its reserves is one factor that determines whether the insurer will
pay a dividend. Term life insurance policyholders do not receive dividends beca use
there is no underl ying cash value that earns interest.
Variable life and variable universal life insurance policyholders may receive
dividends if there are a lower -than-expected number of death claims in their rating
class and the insurer managed to k eep down its expenses. However, these
policyholders are less likel y to receive dividends than whole or universal life
insurance policyholders because earnings on the cash value (one factor life insurers
use to determine whether they will pay a dividend) a re not fixed or guaranteed.
Instead, the cash values in Variable policies are based on the performance of
subaccounts, which are investment options that may include mutual funds.
Dividends and taxes
If the insurer issues a dividend, the policyowner can ta ke it in cash, buy additional
insurance coverage, or appl y the money toward his premium. For life insurance
policies, the dividend may be used to pay off loans the policyholder has taken against
the whole life policy.
Life insurance policy dividends are ta xable onl y when the amount received in cash
exceeds the amount of premiums paid. The dividends are taxable onl y if taken in
cash. If dividends are used to buy paid -up additions to the policy, they are not
taxable. Dividends also may be taxable if the li fe insurance policy is a modified
endowment contract, which is a policy that is overfunded in order to build up greater
cash value. Dividends on modified endowment contracts are taxable unless the money
is used to buy paid -up additions to the policy.
36
Limited-Payment Life Insurance
Limited payment life insurance , sometimes referred to simply as limited pay life
insurance, is reall y a way of having the best of all worlds using a whole life policy.
The policyholder pays a premium for a predetermined number of years and he keeps
his policy for the rest of his life.
The Face Amount
This policy has a death benefit that is guaranteed to stay level for as long as the
policyowner owns it, even up to age 100. The face amount is usuall y paid out income
tax free to the beneficiary. It can be paid in one lump sum or in the form of a monthl y
income. If the policyowner chooses to receive payment made in income form, there
are several options.
Life Income
Limited payment life insurance policy proceeds used life income is one of the
many choices. With this choice, the life insurance company will pay this income to
the beneficiary for life. Upon the death of this beneficiary there is no more income
paid even if payment has onl y been paid for onl y one month. Simpl y put, if the
beneficiary lived a long life the insurer would be on the hook for a lot more than the
face amount of the policy. On the other hand, a short life would m ean the heirs would
lose. In most situations, a life income payment with no income-certain may not be a
very good choice, all things being equal.
Another choice would be a life income with a certain period . The proceeds of the
limited payment life insura nce can be paid out in life income form with, for example,
5 years certain, 10 years certain or 20 years certain. If the policyowner chooses a life
income with 20 years certain his beneficiary would be paid a lesser income for his
life but upon death, if, for example, death occurred after one year the income will
continue for another 19 years —the income must be paid for a minimum of 20 years.
Fixed Period Income
This is simpl y an instruction for the insurance company to pay the proceeds of the
limited pa yment life insurance policy to the beneficiary in equal amounts over a
period of X years (such as 10 years) 10 years, for example, upon death. The amount
paid out would be more than the lump sum insurance amount.
Fixed Amount Income
The proceeds of a li mited payment life insurance policy can be paid to the
beneficiary in fixed amounts. The insurer is instructed to pay a certain amount to the
beneficiary until the proceeds are exhausted. This always amounts to considerabl y
more than if the payments were made in a lump sum.
Interest Option
The insured can choose to have the lump sum that would be paid upon his death
held by the insurance company and onl y the interest paid out each year. At a given
time in the future, the entire lump sum will have been paid.
The limited payment life insurance policy is a whole life policy that has cash
values that accumulate at a guaranteed minimal rate of interest. If the policyowner is
in need of cash the policyowner may take a loan from his policy, usuall y limited to
37
about 80% of the cash value. If the policyowner is unable to pay the premiums, the
automatic premium loan provision will be effective and a portion of the cash value i s
used to keep the policy in force, in effect, using a portion of the cash value to keep the
policy in force.
The limited payment life insurance policy also accrues dividends, which, h owever,
are not guaranteed and depend on the performance of the life ins urance company.
 If a dividend is earned on a limited payment life insurance policy, it can be paid
to the policyowner in cash and the life insurance company will mail the
policyowner a check.
 Dividends may be applied to the reduction of premiums . The amount necessary
to keep the policy in force would be less than the premium contracted for in that
year.
 Dividends can be used to purchase paid up additions . Paid up additions are
single premium policies of the same t ype as the base policy. They have cash
values and participate in dividends if any dividends are declared.
JOINT LIFE INSURANCE
The joint life insurance policy is simpl y a life insurance policy written on more
than one life, and is often called the “first -to-die” joint life policy. There are similar
policies written on two lives and if benefits are paid upon the death of the second
person, then it is a “second -to-die” policy, more often known as a “survivorship”
policy. These policies are often used to fund federal estate taxes of wealthy couples
where their Wills are constructed so that they make maximum use of tax deferrals at
the first death. Joint life policies may also be used for funding business buy -sell
agreements.
Actuall y, joint life insurance policies can cover two or as many as twelve lives, but
because of the expense and the administrative headaches, most companies limit the
policies to three or four individuals. Some companies will issue insurance on more
lives if they have a related business interest. Generall y, the policies are either
ordinary life, limited pay life, or under a Universal Life policy. Rarel y are they
written on a term basis as the separate term policies could cost more than a joint
policy and the ordinary life, limited pay or UL would offer protecti on to survivor(s).
The premiums is usuall y larger than the combined premiums on separate policies
that provides an equivalent amount of insurance —the premium for $200,000 coverage
on two lives is larger than the combined premiums for two $100,000 policies. The
reason is that the joint policy will pay $200,000 upon the death of the first to die, but
under the two -policy format, they would onl y pay $100,000 upon the death of the first
to die. Besides, a joint life policy costs less than two separate policie s with half of
the benefits.
The joint life policies offer conversion to single -life policies on separate lives if
the conversion is on the same plan as that of the joint policies and the conversion is
the result of divorce or dissolution of a business; or conversion by dividing the
amount of insurance among the insured lives (equall y or unequall y); and dating the
new policies as of the original date of issue of the joint policy.
38
Business partners or stockholders in a closel y held corporation often use thes e
policies. A problem that could arise in these cases is that since the insurance usually
terminates upon the first death of the partner or stockholder, the remaining members
of the firm may not onl y be without insurance, their health may be so that they cannot
become insured.
However, some insurers have special joint life policies designed for buy -sell
funding, some offering a short period of extended coverage for the surviving partners
or shareholder, and further, they guarantee their insurabilit y under a new joint life
policy much like the previous one. Some offer joint life policies that allow uneven
allocations of death benefits to coincide with the unequal ownership interests.
While joint life policies are sometimes offered to husband -and-wife jointl y,
(especiall y if there is going to be a need for funds upon the first to die, such as for
death taxes), the problem of the survivor losing insurance coverage under the policy
can cause problems.
SPECIAL LIFE INSURANCE POLICIES
One of the most controversia l recent developments in the life insurance industry is
the widespread introduction and vigorous promotion of "special" policies. Usuall y on
the ordinary life plan, these policies carry a premium rate lower than those of the
regular forms. Such policies ha ve long been offered by many companies, but in recent
years many more companies have begun to offer them to meet the growing price
competition.
PREFERRED RISK POLICIES
Life insurers are continuall y on a search for policies that will offer policies at a
lower cost to the consumer, and in certain situations a “preferred risk” policy (or with
a similar name) is offered with more protection or at a lower cost —or both. These
policies are justified because they are limited to either a specified minimum amount o r
to a certain market —in either case, those insured’s should have a lower mortalit y rate
either because of the company’s experience, tougher underwriting requirements, or
perhaps, a breakthrough in medicine. For instance, a company that takes onl y
nonsmokers and nondrinkers will have a better mortalit y.
The “cheaper by the dozen” theory is in use when the policy must be of a certain
face amount as the expense rate per $1,000 of insurance is reduced. There are many
expenses borne by the insurer that have little, if any, relationship to the amount of
insurance, such as medical examiners fees, inspection reports, accounting and issue
costs, general overhead, etc.
If the average size of the policy is increased, this will mean that the expense rate
per $1,000 will be lower. A class of policies in which the minimum face amount is
$50,000 can be expected to develop an average face amount double that of the regular
classes in which the minimum is $10,000, therefore some companies do not offer their
special poli cy in less than a specified amount ($50,000, $100,000, $250,000,
$500,000, or$1 million, for example). For the agent marketing the plans, the average
39
commission per thousand would t ypicall y be less and with many companies the
commission rate on special po licies is lower than that on other whole life policies.
Underwriting and other “superior” selection procedures contribute to the
profitabilit y, which basicall y is mortalit y experience. These policies are almost
always issued on a minimum amount basis, whi ch creates expense savings for the
insurer.
There are arguments against the “bargain” policies that basically question the way
that the premiums are created, such as the contention that premium rates per $1,000
should decrease as the size of the policy inc reases. While this sounds reasonable, it
would cause added administrative costs, and further, if this is such a good deal for
whole life policies, why limit it to onl y those policies?
While not considered as a viable argument against these special policie s by
textbooks writers, in actual practice, actuaries are concerned for a very practical
reason. By placing larger policies or superior risks in a separate class with a lower
premium rate, this creates a perfect instance of anti -selection. Imagine 10,000
superior risks (such as healthy individuals who vigorousl y exercise, watch their
weight, and have no famil y health problems) out of a “pool” of 100,000 lives, are
offered “bargain” rates per thousand to change to the special policies. That would
leave 90,000 policyowners paying the same rates while the overall mortalit y of the
remaining policyowners would show an increased mortalit y risk —those “superior”
risks have now left thereby diluting the pool experience. Therefore, the remaining
policyowners are pa ying too little for their insurance as those who have exceptional
risk experience are no longer in that group. The onl y practical way to create a “super”
class with lower rates, etc., would be to increase the premiums for the remaining
policyholders. Thi s practice of creating “super -insured’s” without compensating for
the now-substandard risks that are left has created havoc in, for instance, the health
insurance industry. Careful consideration might lead one to believe that creating such
“super-risk pools” entail an offsetting increase in losses with the remainder.
ENDOWMENT POLICIES
As mentioned previousl y, level premium term insurance to age 100 is identical to
whole life insurance, but there also is another t ype of life insurance that is identical
to whole life insurance —endowment at age 100. Rarel y do endowment contracts
mature at ages less than 100, and at earl y maturit y dates, they are not identical to
whole life policies.
One can consider Endowment policies as another variet y of whole life insur ance
that provides level death benefits and cash values that increase with the duration of
the policy. However, they allow the policyowner to specify the maturit y date of the
policy.
Technicall y, a whole life contract provides a survivorship benefit at ag e 100 (the
maximum age of mortalit y tables, except it now is 120 years under the 2001 CSO
table….yep, people are living longer) — that is equal to the death benefit that would
have been payable prior to the insured's age 100. One can say that endowment
contracts simpl y merel y make the same full survivorship benefit payable at younger
ages. Endowment contracts offer a plethora of lengths, such as 10 -, 15-, 20-, 25-, 30-,
40
35-, and 40-year endowments (or longer); or the maturit y date can be a specific age of
the insured, such as 55, 65, 70, or older.
Simpl y put, this policy provides a death benefit during an accumulation period that
is equal to the target (i.e., desired) accumulation amount. This allows the policyowner
to make sure that funds will be availabl e regardless of whether the insured survives
the target date. The purpose of this plan was to appeal to purchasers who were in the
later years of their careers and they wanted some insured accumulation for retirement,
or other such purposes.
With the advent of double-digit inflation rates during the late 1970s and earl y
1980s, most consumers were moving away from long -term fixed-dollar policies that,
unfortunatel y, include most forms of life insurance and endowment policies. They
were, in particular paint ed with this brush because tax -sheltered investments in real
estate had overtaken good business sense, but regardless, consumers turned to shorter
maturit y contracts and investments. As much as this hurt the insurance industry,
factuall y it was rather a r easonable answer to runaway inflationary expectations.
Although endowment contracts were readily available, sales were declining in the
United States even before the federal income tax law changed in 1984 that eliminated
the tax-free buildup of flexible -premium endowment policies' cash value. The federal
government was concerned that forms of life insurance, i.e., endowment and universal
life policies in particular, were being used as a tax -advantaged accumulation vehicle
by the “wealthy.” For political re asons, Congress developed a dislike for any form of
real or perceived tax shelter. Congress, venturing into previous unknown waters,
developed a test for flexible -premium life insurance —the corridor test —Sec. 101 (f)
of the Internal Revenue Code —which took away the tax preference that flexible
premium endowments previousl y enjoyed, although it exempt policies in force before
1985. Later, adding Sec. 7702 to the Internal Revenue Code extended the corridor test
to all life insurance policies (repealing Sec. 101 (f)), including fixed -premium
endowments, entered into after October 22, 1986.
As desired by Congress, sales of new endowment contracts have been very limited,
such as where new sales are for policies used in tax -qualified plans where the tax
treatment is controlled by other factors.
ADJUSTABLE LIFE INSURANCE
As young families looked toward the future, particularl y their children’s
educational needs, it was apparent that a famil y’s financial needs varied throughout
their lifetime. Life insurers were p articularl y sensitive to this need —after all,
providing funds for the future is what they do —and they introduced whole life
insurance that can be adjusted when needed during the life of the policy, hence, the
Adjustable Life Insurance policy was born.
Adjustable Life policies can be shaped to provide anywhere from short term
insurance to single premium whole life insurance, but most importantl y, the
policyowner has the right to reconfigure the policy at specified times, and to do so
without the policyowne r having to assume any of the mortalit y or investment risk.
Adjustable Life policies have the same guarantees as cash value, mortalit y and
expenses as regular whole life, but the premiums, face amount and cash value are
41
subject to change. In most cases, the changes can be made without evidence of
insurabilit y, however if the amount at risk increases, evidence may be required, such
as a substantial increase in the death benefit or a substantial decrease in premium for
the same face amount.
Situations that can trigger adjustments to the policy include increased children’s
educations costs (private school or college), losing employment, starting a new
business (or having a business fail), a career change, or retirement. The largest
number of adjustments wou ld involve lowering the premium so as to lower the cash
flow during a period of time when income has been reduced, expenses have been
increased, or both. Once the children are grown, oftentimes the policyholder will
direct that the premium be increased in order to have more funds for retirement.
Adjustable life was introduced in the mid -1970s, prior to the introduction of
Universal Life in the 1980s. Since that time, Universal Life is a recognized superior
product to Adjustable Life, particularl y because of the investment feature during a
period of increased interest earnings. Adjustable Life has basicall y disappeared from
the scene and the name has become synonymous with Universal Life Insurance.
CURRENT ASSUMPTION WHOLE LIFE INSURANCE
A current assum ption whole life (CAWL) provides a “bridge” between traditional
insurance and interest sensitive “new generation” products. In effect, a CAWL is
called “interest sensitive whole life” by some, and called “indeterminate -premium
whole life” by others. The CAW L provides non -par whole life insurance under a more
modern “transparent” format. Generall y, the policy will use interest rates that reflect
the new-money rates and will also use the current mortalit y charges in determining the
cash value. While more traditional whole life policies use dividends as a means of
passing to the policyowner any changes in assumptions used in the pricing of the
original policy, CAWL uses changes in the cash value and premiums to reflect the
changes in the company expense and interest criteria from that guaranteed inside the
contract.
Because CAW L policies are “unbundled,” much like Universal Life, there is a
stated allocation of premium payments and interest earnings to the mortalit y charges,
expenses and cash values. Cont rast this with the traditional whole life policy, where
the policyowner has no idea as to how these funds are allocated.
To be specific, the premiums paid are designated expense charges, and the
remainder is a (net) addition to the policy fund that is adde d to the previous policy
fund balance and any interest (at the current rate) that has accumulated on the fund.
From this fund total, a mortalit y charge is levied, and the remaining amount is the
year-end fund balance. This balance, less any stipulated su rrender charges, would be
the net surrender value if the policy were to be surrendered.
The CAW L can be either a low -premium plan, or a high -premium plan.
CAWL Low-premium Plan
The initial indeterminate premium is lower than that of a traditional ordinar y life
policy and the policy has a provision that allows the company to “redetermine the
premium using either the same or other (new) assumptions for future mortalit y and/or
interest, within the guaranteed assumptions in the policy.” When the premium is
42
redetermined, it, combined with the existing account value, will be sufficient to
maintain a level death benefit for the life of the policy (if the new assumptions are
correct). If these new assumptions are higher or lower than those used at the time of
issue, the premiums will be either higher or lower – if they are the same, the premium
will remain the same.
If the new premiums are lower than the previous premium, there are three options
available to the policyowner:
1. The policyowner may pay the new (lower) premium and keep the previous death
benefit. (The usual choice).
2. The policyowner may elect to continue to pay the previous premium, maintain
the same death benefit, and pay the difference into the fund.
3. The policyowner may continue to pay the previous premium, but use the
difference to purchase an increased death benefit. If this option is used, the
insured may be subject to evidence of insurabilit y.
CAWL High-premium Plan
If the premium is higher than the previous premium:
1. The policyowner may pay the new (higher) premium and keep the previous
death benefit;
2. The policyowner may elect to continue to pay the previous premium, but accept
a lower death benefit that can be paid -for by the new higher premium; or
3. The policyowner may continue to pay the previous premium and keep the same
death benefit, using some of the cash value to pay the additional premium. This
option is usuall y available onl y if the account is at a determined level for at
least 5 years in the future.
The high premium plan is, as the name implies, relativel y high, however, there is a
guarantee that the premium will not exceed a stated amount. Some of the policies
offer a vanishing premium concept which states that the “vanish” will continue as long
as it is greater than the minimum cash value. Policyowners have been known to
confuse the “may vanish” in this option, with a paid -up life policy where the policy
has matured and there are no more premiums to be paid.
There are many variations of this pol icy, some of short -lived duration. The
principal difference between the CAWL and Universal Life is that the CAWL has a
required premium, making it easier for companies to administer, and the company has
a greater control over the cash value buildup. One of the principal advantages in the
mind of many is that it “forces” the payment of an established premium amount. One
of the well -established advantages of life insurance as a savings or investment vehicle
is that many people do not consider themselves (a nd probabl y rightfull y so) as having
the personal discipline to pay flexible premiums.
In the CAW L policy, current interest rates are used to enhance the accumulation
account; however, the CAWL does not have the flexibilit y of premium of Universal
Life policies. The insured/policyowner assumes some of the investment risk and a
small amount of the mortalit y risk. Moreover, as indicated above, if the experience
does not turn out as well as expected, the policy can be periodicall y downgraded on
each redetermination date. Conversel y, if the experience is positive, the policyowner
43
then participates in the positive effect (one might say that it was earned because the
policyowner assumed these risks, or a part thereof, so it is only fair that he is
rewarded). If the experience is favorable, costs can be much less in the end, than the
original projections.
DEBIT INSURANCE
Dating back to England in the 17 t h century, debit insurance was the major t ype of
life insurance sold in the U.S. until the beginning of th e 20 t h century. Also called
Industrial insurance, it was sold in small amounts, usuall y no more than $2,000, and
was sold door -to-door by “debit” agents who had their own territory – called a “debit”
because the insurance agent would accept the payment (u sually weekl y, then later
monthl y) and then “debit” the insured’s record for the premium payment. In today’s
market, debit insurance usuall y applies to any t ype of insurance sold through home
marketing.
Debit insurance has lost its appeal as $2,000 does not go far today and the
premiums are relativel y high compared to other permanent insurance. Debit insurers
have received bad publicit y because their premiums are so high; however, the
principle reason that premiums are high is that the persistency is no t good, as the
lapse rate is very high. Many debit customers drop the insurance for a month or so if
finances become tight, and then start again when they have a few dollars available.
Today most of the former -debit companies are called home service life insurance
companies (an appropriate name) and most of their “debit” insurance is monthl y debit
ordinary which are ordinary life policies written for amounts of $5,000 to $25,000,
usuall y with premiums collected monthly at the policyowner’s home, although some
policyowners make monthl y payments regularl y at the local insurance office, or they
mail the premiums monthl y.
It is expected that debit insurance will continue to decrease as group insurance has
replaced much of the debit insurance. Statistics not f orthcoming, but high unemployment may have caused a new interest in Debit insurance as it is inexpensive
(relativel y) and those without employment no longer have group life insurance. There
has also been considerable legislation restricting the marketing and provisions of debit
insurance, with the result that much of the profit of this business has been reduced.
FAMILY POLICY
A Family policy is a policy or a rider on a contract that provides for whole life
insurance for the father or mother and with term insurance for the other famil y
members. The coverage on the spouse and children can be a specified amount of
insurance, or it can vary by age. The amount of life insurance is often measured by a
“unit,” t ypicall y $1,000 of coverage per unit for spouse an d children, and $5,000 per
unit for the principal insured.
The premium for a famil y policy t ypicall y will remain level, regardless if there are
additional children, and premium is based upon an average number of children. This
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could prove inexpensive co verage if there are several children or expensive if there is
onl y one child.
JUVENILE INSURANCE
Typicall y, Juvenile Insurance is a whole life policy issued on the application of
the parent or other responsible person, on the life of a juvenile. Most juv enile
policies insure children who are at least one month old and the applicant controls the
policy until the child reaches the age of 18 (usuall y) or upon the death of the
applicant, whichever comes first.
The purposes of juvenile insurance are many, but the principal use is for
guaranteeing a college fund if the applicant should die prior to the child entering
college, or at least there will be a cash value that can be used for college purposes. It
is also frequentl y used to guarantee that there will be some life insurance for the child
even if the child becomes uninsurable later.
Many agents and financial planners insist that it is better to use the funds that
would go to pay the premiums on a child, for the purchase of additional coverage on
the “breadwinner” under the theory that there is little “financial” loss that will occur
in the death of the child, and onl y the death of the breadwinner will cause a financial
hardship.
BURIAL INSURANCE
Burial insurance is also called “ Pre-need Funeral Insurance” by some of those in
the business, as it is felt that “burial” is a small part of the final expense of the
insured (undoubtedl y true). This policy provides that a fund will be made available
for final expenses, and in most cases, it is used to fund a prear ranged funeral. The
funeral provider (usuall y a funeral home) agrees to furnish certain services and
articles for the funeral, including casket and in many cases, even a burial plat, for the
amount of the policy.
These policies are usuall y sold to persons between ages 65 and 70, and provide
$2,500 to $10,000 of coverage –frequentl y a single premium whole life policy.
There were considerable concerns about these policies as some consumer advocates
believe that the funeral companies were taking advantage of older persons because
they were easil y confused and did not understand that they were dealing with a life
insurance agent. The NAIC has since changed its advertising and disclosure model
regulations to include funeral insurance, with the result that comp laints have
diminished significantl y.
GROUP LIFE INSURANCE
Group life insurance is an important part of the life insurance industry, accounting
for about 40% of all life insurance in force by amount with an average certificate of
$32,000.
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GROUP INSURANCE REQUIREMENTS
While the minimum size of a group was t ypicall y 50 lives a few years ago, it is now
usual for states and insurers to require a minimum of 10 lives. The larger the group,
the less expense per person is incurred.
While groups eligible for insurance coverage can cover a wide variet y of
professions, industries, etc., there are, at times, questions as whether loosel y joined
groups of people qualify as a “group” for insurance purposes.
It is “etched in stone” that a group cannot be qualified for group insurance if
the group was been formed for the purpose of obtaining insurance.
Participants
Generall y, onl y active, full -time employees are eligible for group coverage, usually
specified by occupation classification of those that must be include d in the group,
such as “salaried employees” or “all hourly employees.” The employee must be
activel y at work for a normal number of hours per week (usuall y 30 hours) at the
employee’s regular job at the date the employee becomes eligible for coverage.
Probationary Period
Employees usuall y have a probationary period, usuall y one to six months, during
which they are not eligible for coverage. After this period, under a contributory plan
(the employee pays part of the premium) the employee has an eligibil it y period in
which they must apply for insurance without submitting evidence of insurabilit y. This
period is usuall y for 30, 31 or 45 days. If the plan is noncontributory, then there is no
eligibilit y period as all employees automaticall y go on the plan when they have
completed the probationary period.
Coverage Period
The coverage period is usuall y the length of time that the employee remains with
the employer (assuming the plan stays in force with the employer and the employee
pays their share of the pr emium, if any). The employer has the right to continue
coverage for an employee temporaril y off the job and upon termination; coverage is
usuall y provided for 31 days.
Benefit Amount
Typicall y, the employee does not specify the benefit amount and the amount is
usuall y (1) a set amount for all employees, (2) a percentage of the employee’s income
with the employer, (3) an amount that is designated for the position the employee
holds (job title), or (4) a function of the employees length of service. Insurer s do not
usuall y write insurance for less than $2,000 on an employee, most companies require
$5,000 or $10,000, or more. Most companies allow for additional insurance over the
normal maximum with evidence of insurability.
Convertibility
Employees usuall y have the option to convert their group life policy into an
individual cash value policy within 31 days after termination of employment or after
the employee ceases to be a member of an eligible position. The death benefit is paid
under the group policy wi thin 31 days after the insured has withdrawn from the
eligible group.
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Waiver of Premium
A t ypical waiver of premium is used with group life insurance plans, and the
premium will be waived as long as the insured can prove disabilit y periodicall y.
Type of Insurance
Group life insurance is basicall y yearly renewable term insurance. Group
premiums are paid monthl y, except with some small groups when premiums may be
paid quarterl y. Premiums are usuall y guaranteed for one year onl y, but often for
competitive purposes, the premiums are guaranteed for a longer period of time.
Employee Contributions
For contributory plans, employee contributions are usuall y at a set rate per $1,000
of coverage at all ages. In most states, employers are required to pay at least a
portion of the premium, and some states restrict the amounts that can be paid by any
one employee, commonl y 60 cents per month per $1,000 of coverage, or 75% of the
total premium for that employee.
Supplemental Life Insurance
Supplemental life insurance may be provided to employees, normall y contributory
and the amounts of insurance available are banded. Generall y, the maximum is a
multiple of the employee’s salary.
Credit Group Life Insurance
A common form of group insurance is Credit Life insurance, which provides a
benefit that is equal to the unpaid amount owed to the institution by the consumer.
The creditor, which is usuall y a bank or a finance company, is both the policyowner
and beneficiary of the policy. The debtor usuall y pays premiums, but i f there are
dividends, they are paid to the creditor. Needless to say, group credit life can be very
profitable to the lender and there has been considerable abuse. States have reacted,
most states now have maximum rates that can be charged, and most, if not all, states
do not allow the purchase of credit life insurance to be a prerequisite for obtaining a
loan.
Accelerated Death Benefit
Group life insurance often includes an accelerated death benefit , which pays a
portion of the face amount of the policy in case of the terminal illness of the
employee.
Taxation of Employee
Under U.S. law, the value of the first $50,000 of employer-provided group term life
insurance is non-taxable as income to the employee, but amounts over $50,000 may be
taxable. If the employee contributes towards the plan, then the amount of the
contributions are allocated to the excess coverage. The formula for determining the
taxable amount to an employee is as follows:
1. The total amount of group term life insurance for the emp loyee in each month of
the taxable year.
2. The $50,000 is subtracted from each month’s coverage.
3. The IRS furnishes a Uniform Premium Table and the appropriate rate is applied
to any balance for each month.
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4.
Then from the sum of the monthl y cost, the total employee contributions for the
year are subtracted.
When a group has less than 10 lives, IRS Regulation 1.70 -1(c) requires that all
full-time employees who provide adequate evidence of insurabilit y, must be included
unless they “opt” out.
Under the U.S. Tax Equit y and Fiscal Responsibilit y Act of 1982 (TEFRA), the
$50,000 tax exemption is not available to key employees if the plans discriminates in
their favor, either in eligibilit y or t ype and amount of the benefit; but are not
discriminatory if all benefits to the key employees are also available to all group
members. Plans will not be discriminatory if they have a uniform relationship to the
total compensation of the group members, or the basic rate of compensation of each
employee.
For those retired employees, they may be provided group life insurance coverage if
the plan continues a portion of the term life insurance or cash -value life insurance is
provided, or a retired lives reserve is established.
Group cash-value life insurance i s the simplest method of providing coverage
for retirees, and is usuall y expressed as either a flat amount or a percentage of
the previous group coverage.
Group Paid-up Insurance
Group paid-up insurance has been popular and is a combination of
accumulating “units” of single-premium whole life and decreasing units of
group term life. Usuall y this is on a contributory plan and the employees
contributions go toward units of single premium whole life insurance. The
employer’s contributions provides an amount of decreasing term insurance,
when added with the amount the employee pays for, equals the total amount for
which the employee is eligible. Then at retirement, the term insurance portion
is discontinued and the paid -up insurance remains in force on the em ployee for
the remainder of his/her life.
Group Ordinary Insurance
Group ordinary insurance can be any traditional plan (except group paid-up) that
provides the cash value life insurance to employees, where the employer pays the cost of the
term portion, and the employee (which the employee may refuse to accept) pays the cash value
portion.
Group Universal Life
Group Universal Life has the typical guaranteed interest rate, a fixed death benefit and
loan option, plus the flexibility and added returns of the newer life insurance products. Group
Universal Life (UL) is the same as individual UL, except that Group UL is generally issued (up
to a certain amount) without evidence of insurability and is usually high enough to meet the
needs of most employees. Group UL products usually pay low, or no, commission, plus
administrative charges is lower than individual plans. Generally, these plans are 100%
contributory; therefore, the plans are very portable. (See later Discussion of the Universal Life
products.)
Retired Life Reserves
Retired life reserves (RLR) is a group reserve accumulated before retirement
in order to pay premiums on term insurance after retirement. The employer can
48
make tax-deductible contributions to this reserve on behalf of the employees,
and these contributions are not taxed as income to the employees. RLRs can be
administered through a trust or by a life insurance company and as long as there
are employees participating in the plan, the reserve cannot be recaptured by the
employer. If an employee dies (or resigns) prior to retirement, the individual’s
reserve value is used to fund the RLR for others in the plan. The plan must be
nondiscriminatory and limits the amounts to $50,000.
Supplemental Coverage’s
Supplemental coverage’s are generally available, through the insurer of the
group, or by another insurer, that offers supplemental benefits, such as
accidental death, or accidental death & dismemberment .
Some plans also offer Survivor Income Benefits where proceeds are payable
in monthl y income benefits onl y. Beneficiaries are not named but are covered
by specified beneficiaries in the policy, and benefits usuall y continue as long as
there is a surviving beneficiary and sometimes are discontinued if the survivor
remarries.
Dependent Life insurance may be offered whereby the spouse and/or
unmarried dependent children are insured for usuall y a small amount of life
insurance.
STUDY QUESTIONS
1. “Special policies” are “special” inasmuch as
A. they are guaranteed issue.
B. they pay no commissions.
C. they have a lower premium than regular forms.
D. they are cash value term insurance policies
2. A policy that can be shaped to provide anywhere from short term insurance to single
premium insurance, and the policyowner has the right to reconfigure the policy without
having to assume any of the mortality or investment risk, is
A. an adjustable life insurance policy.
B. a Variable life insurance policy.
C. a Variable endowment policy.
D. a current assumption whole life policy.
3. With group life insurance, a typical plan will have eligibility requirements, which include
limiting insurance to
A. executives of a company only.
B. active, full-time employees.
C. any employees, regardless of status.
D. only those employees who can pass a stringent physical examination.
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4. Employers may offer life insurance for some amount, for example $10,000, but if an
employee wants more coverage
A. the employer must pay 100% of the additional premium.
B. the employee cannot, for any reason, be insured for more than $25,000.
C. usually they can obtain it with evidence of insurability.
D. an employee may obtain as much as $100,000 with no further action.
5. Under the law, employer-provided life insurance is non-taxable as income to the employee,
A. up to a maximum of $50,000, unless the employee contributes to the premium,
and then taxes are determined by a formula.
B. up to a maximum of $10,000 coverage per employee.
C. with a maximum premium for each certificate holder of not more than 25% of
the employee’s annual income.
D. but the employer must not pay for any of the premium.
ANSWERS TO STUDY QUESTIONS
1C 2A 3B 4C 5A
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CHAPTER FOUR - VARIABLE INSURANCE POLICIES
VARIABLE LIFE INSURANCE
A predecessor to Universal Life Insurance is Variable Life Insurance, introduced in
1976, which shifts the investment risk to the policyholders.
A variable life insurance policy provides no guarantees of either interest rate or
minimum cash value. Theoreticall y, the cash value can go down to zero, and if so, the
policy will terminate. As the SEC pointed out, in order for policyowners to gain the
additional benefit of better -than-expected investment returns, they also have to assume
all of the downside investment risk. Consequentl y, the SEC required variable life
policies to be registered with the SEC and all sales to be subject to the requirements
applicable to other registered securities. In other words, policy sales can be made
onl y after the prospective purchaser has a chance to read the policy prospectus. The
SEC also requires that the insurance company be registered as an investment company
and that all sales agents be registered with the SEC for the specific purpose of
variable life in surance policy sales. Agents who sell variable life insurance policies
must be licensed as both life insurance agents and securities agents.
SEC Objections to Variable Life
There were two main obstacles in gaining SEC approval of variable life products.
The first one was the maximum compensation to agents for the sale of this product as
the SEC wanted the sales load not to exceed 8 percent of the sale price, which keeps
it within the range for investment products. A big problem was the that SEC was used
to a different t ype of marketing compensation as the majorit y of investment products
are sold on a cash -sale basis rather than on an installment -sale basis and this presented
some serious drawbacks from the insurance companies' standpoint. After consider able
negotiation there was a compromise whereby there would be a 20 percent load on the
first year's premiums, which was thought to be the equivalent of an 8 percent load
over the lifetime of the policy. Another problem was whether insurance companies
would be permitted to allow flexible -premium payments under these policies. In the
beginning, the SEC stalled on this issue. Therefore the first generation of variable life
insurance products was fixed -premium products. The onl y real innovation was the
variable investment part that did allow the policyowner to select among a limited
number of investment portfolio choices, with the death benefit amount varying as a
function of the portfolio's investment performance.
In the beginning, variable life insurance policies gave the purchaser (insured) three
investment options into which the funds could be directed —whether all or a
distribution in whatever portions desired among the options. Typicall y, there was a
minimum requirement of at least 5 or 10 percent of i ncoming funds had to be allocated
to any investment option the policyowner selected. The minimum requirement was
51
supposed to eliminate the chance that administrative costs would exceed the amount of
money being directed into a particular option.
The options were usuall y a stock fund, a bond fund, and either a treasury fund or a
money market fund. Not surprisingl y, the funds were primarily mutual funds run by
the insurer and earmarked as separate accounts per SEC requirements with the assets
beyond the claims of its general creditors. This was to be expected as many insurers
already had mutual funds that they managed, which was a profit center with its
business coming from policyholders who were looking for a higher return on their
investments than afforde d them by the life insurance cash value fund. During this
time, the t ypical cash value accumulated at 3% per annum, whereas investment funds
grew at a rate three times that.
These separate funds were reported as separate items on the insurance company's
financial statements for both statutory purposes and generall y accepted accounting
purposes.
This was, the policyowner becomes the portfolio director with limitations. The
policyholder still has no control over what assets are purchased and sold by the
selected funds as that prerogative is retained by the insurance company's portfolio
management team. Of importance is the fact that policyowner plays a participative
role in portfolio management and consequentl y can benefit directl y from better -thanexpected results or suffer from poor investment performance. Importantl y, the results
of the investment performance are credited directl y to the policy cash values.
VOLATILITY OF VARIABLE PRODUCTS
Those who are experienced in equit y investments may be comfortabl e with the
variable life insurance policy. For those without such experience, the dail y portfolio
fluctuations can provoke great anxiet y in individuals who are not used to or
comfortable with such market value fluctuations. This uncertaint y creates probl ems,
as many life insurance agents are reluctant to try to sell any policy whose success
depends on the investment decisions of the policyowner —particularl y since for
generations they have been taught that life insurance is not designed to create wealth
through investments, primaril y with outside (not cash value) investments. Many are
afraid that they can be accused of giving investment advice and they could lose their
license (or they may have to use their Errors and Omissions policies).
The popularit y of a variable life policy depends almost entirely upon general
investment market conditions. In the early 1990s when interest rates dropped to very
low levels, people used to higher yields on bonds and other investment instruments
turned to variable life in surance contracts as an alternative to reinvesting in
certificates of deposit. In 2011, CDs give a whopping 1 ½ to 2 ½ percent return over
several months.
NOT EXCLUSIVELY INVESTMENTS
All things being equal (which rarel y is the case) if the right investme nt choices are
made, variable life insurance allows the policyowner's money to work better for him.
However, one must remember that variable life insurance contracts are not exclusivel y
52
investments —even if marketed by insurance professionals such as Chart ered Life
Underwriters. Also since they are still life insurance policies, they must provide death
benefits as provided for within the policy. This is the reason that a variable insurance
contract will never equal that of a separate investment fund that does not provide
death benefits but that invests in assets of a similar t ype and qualit y.
Variable life insurance should not be purchased as a short -term investment vehicle.
The combination of sales load, mortalit y charges, and surrender charges will
significantl y reduce any potential gains in the policy's earl y years.
INCREASING INSURANCE PROTECTION FROM
Investment Performance
Yes, the raison d’ ȃ tre of life insurance is to provide benefits in case of death of
the policyowner. Therefore, one might believe that superior investment performance
should accompany increases in the death benefit, primaril y as a method to keep up
with inflation. In actualit y, such situation would increase equal or more than the effect
of inflation. BUT (a big “bu t”) while investment performance in equities equal or
exceed inflation, such is not the case in the short term. It is possible for inflation to
exceed investment increases over a short period of time —such as 2-3 years. In
today’s (2011) market, investmen t returns are all over the spectrum, but still life
insurance should be considered as a long -term financial security purchase and not a
short-term investment.
There are more ways to connect the death benefit to the associated portfolio’s
investment returns, and the insurance industry earl y came up with two different
approaches—level additions or constant ratio method.
Regardless of that choice, earl y contracts had the purchaser select a “target” level
of investment performance as a “benchmark” from which ac tual investment
performance would be measured. Performance in excess of the target level would be
used to fund incremental increases in the death benefit; performance below the target
amount would require downward adjustments in the death benefits to make up for the
deficit.
Level Additions
The level additions type uses excess investment returns (returns in excess of the
target rate) to purchase a level single -premium addition to the base policy. The face
amount or death benefit will increase just as long as investment performance equals or
exceeds the target rate. Using level additions does not increase of decrease as the
constant ratio method, which links the death benefit to investment returns. However,
the level additional does not require an ever -increasing investment return to support
incremental increases in death benefits. It is true that this method causes additional
coverage to be added more slowl y, but once it is added, it is more easil y supported.
The reverse is true also, however, policies using the level additions design provide a
minimum base value guarantee equal to the amount of coverage when the policy was
first purchased.
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Constant Ratio
The constant ratio method also uses the excess investment earnings as a net single
premium to purchase a paid -up additional amount of coverage. However, under this
method, the paid-up additional coverage is not a level benefit amount but a decreasing
benefit amount because it is designed to maintain a ratio between the death benefit and
the policy reserve that satisfies the corridor test. More volatile increments are added
to or subtracted from the contract as investment performance differs from the target
amount.
Similar to the level addition t ype it has a minimum death benefit guarantee equal to
the initial face amount of the policy. Therefore, if the initial stage of the contract has
lower returns than the target level, the policy reserves will drop below the level
necessary to sustain the guaranteed death benefit amount. The policy will have to
remain in force long enough for the investment returns to exceed the target rate to
bring the reserve back up to a level capable of supporting incremental increases in
coverage before the policyowner will see increases in the death benefit.
Variable Life insurance policies generally have positive excess investment earnings
in the earl y years of the contract in order to provide incremental increases in the death
benefit before the investment earnings drop below the target rate. Experience has
shown that over a period of 30+ years, most policies have experienced investment
earnings over the target rate more frequentl y and for longer durations than they have
experienced investment earnings below the target rate. One should not present this as
de facto as there is no guarantee that this will always be true, but the expectation is
that overall investment earnings will exceed the target amount over the bulk of the
policy duration. Many variable life policyowners have been pleasantl y surprised at
how well their poli cies have done over two decades. One can onl y wonder what the
present turmoil in investments and the market will bring in the future…
Over several years, regardless of the policy design, the excess investment earnings
over the target level must support an y incremental additions to the policy. If
investment earnings are negative (the actual earnings are lower than the target rate),
then the adjustments will have to be downward from any previousl y attained levels
above the policies initial face value, conve rsel y, if investment earnings are positive
(the actual earnings are above the target rate), the adjustments will be upward.
Increased Number of Investment Fund Options
It should not be surprising that variable life insurance policy designs have not been
static since their introduction with the result that life insurance companies are now
offering many more investment fund options made available in the earl y stages of this
product's development. Some insurance companies have more than 4 dozen funds to
choose from in their current product offering, consisting of a wide variet y of stock
funds, including growth stock funds, income stock funds, balanced stock funds, and
international stock funds. Bond fund offerings are also vigorous with a variet y of
durations and t ypes of issuers (large corporations, small corporations, state
governments, and the federal government).
Many insurance companies offer a managed fund as one of the portfolio choices.
The policyowner can put all of the policy funds in a managed portf olio fund and have
the investment allocation decisions made by a professional money manager working
for the insurance company. This appeals in particular to policyowners who do not
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want to spend a lot of time studying the market and making investment deci sions.
This leaves the policyholder with little investment functions required.
For years, smaller insurance company have contracted with large mutual fund
groups that make their entire range of mutual funds available by offering the same, or
nearl y the same, funds to the insurer which makes it possible for those smaller life
insurance companies to gain access to the administrative services already in place in
these large mutual fund famil y groups. (Separate account funds cannot be available
directl y to the public.)
POLICY CASH VALUES
Policy premiums paid under variable life insurance contract may be subject to
and added to an administrative charge whereas the balance of the premium payment
goes directl y to the cash value. The determination of the cash is the net asset value of
the separate account funds in the policy portfolio. The cash value of the variable life
insurance policy fluctuates dail y and each day’s net asset value is based on the closing
price for the issues in the portfolio on that tradin g day. Cash value accounts are
diminished by mortalit y charges to support the death benefits.
Just like traditional life insurance, the policyowner has access to the cash value
through the process of policy loans. Variable life insurance policies usuall y limit the
maximum policy loans to pay a little less percentage of the total cash value then is
usuall y available in whole life policies
The earnings on the cash value are affected by any outstanding policy loans and the
policyowner accrues indebtedness at the stated policy loan interest rate, which is
applicable to the assets that are associated with a portion of the cash value minus the
outstanding loan. Whenever the policy loan interest rate is lower than the portfolio
earnings rate, the insurer experie nces a lower effective investment return. An
insurance company shows a financial gain from policy loans onl y when the interest
rate of the policy loan is more than that earned by the portfolio that backs up the
policies. Policy loans can be repaid at any time in part or in full but there is no
requirement for the policy loans to be repaid in cash at any time during the existence
of a life insurance contract. For any portion of the loan not repaid, interest accrues on
a compound basis. Just as in any oth er form of whole life policy, outstanding policy
loans under a variable life insurance policy reduce the death benefit payable. The
policy loan is always full y secured by the remaining cash value in the policy, and
when the outstanding loan’s accrued inte rest equals the remaining cash value, then the
next cash value becomes zero and the policy is terminated.
The net cash value in the contract is also closel y related to the nonforfeiture
options available under the policy. Variable life insurance contract provide the same
range of nonforfeiture options as do the more traditional whole life policy. The net
cash surrender value can be obtained by surrendering the contract to the insurance
company, or the net cash value can be applied as a single premium to p urchase either
reduced amount paid -up insurance or the same amount of extended term insurance.
The duration of the extended term insurance will be the longest. Coverage for the
same death benefit is equal to the policies’ net cash value.
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Variable life insurance policies have the usual form of reinstatement provisions,
specificall y prohibiting reinvestments where the policy has been surrendered for the
cash value. Standard waiver of premium options are the same as with any insurance
contract—the policy will lapse if they are not paid.
THE PROSPECTUS
Variable life insurance policies cannot be sold without providing a prospectus
similar to that required by stock issues. The prospectus is a full disclosure of all of
the provisions of the contract including expenses, investment options, benefit
provisions, the policyowner rights under the contract. Purchasers should take the time
to read the entire document even if it is rather lengthy and they should be aware that it
contains information that they could no t receive elsewhere.
As usual, the focus of the SEC is on providing thorough and accurate information,
so the prospectus for a new stock issue from a stock life insurance company would
provide more information about the company to potential investors then would ever be
available to purchasers of life insurance products.
EXPENSE INFORMATION
The prospectus contains very complete information about all of the expenses
charges levied by the insurance company against the variable life insurance policy —
including commissions, state premium taxes, administrative charges, and even,
possibl y, fees for specific future transactions.
Administrative charges usuall y differ between the first year and renewal years.
Commonl y, first year charges run in the neighborhood of $15 -$50 a month. In the
second and later years these charges were dropped to a lower level such as $5 -$10 a
month. In addition, the prospectus indicates whether or not there is any maximum
guarantee on those administrative fees over the duration of the cont ract.
Also, the prospectus reiterates the manner in which charges were made against the
asset account to cover the cost of insurance under the contract —usuall y referred to in
the prospectus as the cost -of–insurance charge. The prospectus specificall y stat es
what rate will be used to determine the cost –of–insurance charges and if there is any
maximum rate against the intended rate. The prospective will explain how the charges
were levied against the separate account itself and that part of that charge is a lways
some specified percentage of the assets available in the separate account. There may
be specific charges to establish and maintain the trust necessary to managing these
assets–similar to charges levied by mutual fund administrators on investors in t heir
funds.
Surrender charges to the prospectus particularl y spells out information that must be
considered when purchasing any insurance policy, in particular the surrender charge
applicable to policy surrenders. Usuall y this information is provided in a tabular
form, showing the policy year in the applicable percentage for the surrender for that
particular user. Some contracts show the surrender charge in terms of percentage of
premiums, whereas other contracts specify in terms of the aggregate account balance
in the separate funds. Surrender charges appl y onl y if the policy is surrendered for its
cash value, lapsed, or under some contracts if the policies are adjusted to provide a
56
lower death benefit. Surrender charges are commonl y levied the first 10 to 15 years of
the contract the actual number of years and rates are always set forth.
The maximum duration of surrender charges is usuall y a good indicator of how long
the insurance company intends to amortize excessive first year acquisition cost. The
surrender charges applicable onl y to the policy surrender before the insurance
company's front -end expenses have been recovered. The surrender charges are often
called contingent deferred sales charges.
INVESTMENT PORTFOLIO INFORMATION
The prospectus set s forth the investment objectives of each of the available
investment funds and a record of their performance. They also show detailed
information on the current holdings of each of the available portfolios, usuall y
accompanied by information about purchas es and sales of individual equities or debt
instruments by the fund in the previous year. Further information is given about
earnings during that same period and usuall y for longer interval of poor performance
if the portfolio funds have been in existence long enough to give investment results
for trades of 5 to 10 years. Investment restrictions applicable to portfolios are also
shown.
There are also projections of anticipated performance provided the portfolio funds
generate a fixed level of investment e arnings over the projected time period. Under
SEC C regulations the rates of return projected must be the gross annual rates after -tax
charges but before any other deductions (zero, four, six, eight, 10, or 12%). The
insurer determines which rate they ch oose to project.
There is also detailed information in the prospectus in respect to ownership and
voting rights regarding procedures to change any of the trust documents restrictions.
POLICYOWNER ASSUMED RISKS
As stated earlier, fixed premium variable li fe insurance contracts are very similar
to whole life insurance contracts – the principal difference is the policyowner assumes
reinvestment risk and therefore can participate in favorable investment returns. This
provision does not allow the policyowner t o increase or decrease the death benefits by
negotiated adjustment – if results are favorable, it is automaticall y translated into
increased death benefits amounts.
The policy does guarantee a minimum death benefit level that is equal to the
original face amount of the contract, regardless of the investment performance. If all
the premiums are paid, the insurer guarantees that the death benefit is equal to the
original face amount of the policy and said amount will be paid even if the investment
funds themselves are unable to support the policy. Therefore, the variable feature of
this policy can provide additional coverage if investment experience warrants, but the
policyowner will never be required to pay more or permitted to pay less the guaranteed
premium.
A fixed premium variable life insurance policy provides more guarantee to the
policyowner than its more recentl y developed cousins’ maturely flexible provision,
such as Universal Life and variable Universal Life.
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VARIABLE ADJUSTABLE LIFE INSURANCE
Companies that first marketed adjustable life policies later developed a variable
adjustable life policy, which coverage is an adjustable life insurance policy that can
be negotiated to change the death benefit up or down, or to increase/decrease premium
amounts to a new fixed level – which can shorten or lengthen the premium paying
period. The policyowner makes a choice of the investment portfolio within specified
limits. This policy corrects a problem with the fixed – premium variable life insurance
policy because it allows the policyowner to negotiate with the insurance company a
change-policy configuration that more closel y follows the individual’s changed
circumstances.
Still, the policyowner does not have the right to skip premium payments or vary the
amount of any one-premium payment without previous association with the insurer and
as with the “old" variable life policies, the death benefit is determined by the
investment performance but will never be less than the original amount of coverage
under the policy. Many, if not most, of the insurers that market variable life, chose
not to market Universal Life. In fact, they introduced variable adjustable life
insurance as a defensive move for competitive reasons after the success of the
Universal Life with its flexible– premium plan had succeeded.
UNIVERSAL LIFE INSURANCE
Universal Life insurance was introduced in the 1970s and had been sold in Europe.
Companies in the United States were desperate to have such a plan. The big problem
was with the problem of non-forfeiture laws that are regulated so as to eliminate such
a plan unless it is sold as a noninsurance product that would then bring the SEC into
the marketing and accounting of life insurance.
Not widel y known is the fact that actuaries had been wo rking on this problem for
years. In the late 70’s three well -known and respected actuaries met at an
insurance/reinsurance forum in Monaco and were able to discover an acceptable
solution—hence Universal Life was born. It was the first variation of whole life
insurance that could offer trul y flexible premiums and also include adjustment
provisions similar those contained in Adjustable Life. The policy shifted some of the
possibilit y of investment fluctuation to the policyowner because the cash value can be
increased by crediting interest rates in excess of the guaranteed interest rate. They did
not give the policyowner any option in respect to the investment portfolio. There are
two prominent features of Universal Life policies: the policyowner's abilit y to
withdraw part of the cash value without having the withdrawal treated as a policy loan
and the choice of either a level death benefit design or an increasing death benefit
design.
The timing could not have been better for such a product as in the earl y 1980s, the
econom y was suffering extremel y high inflation rates and very high rates of
investment return. The real rate of return – defined as the rate of return minus
inflation rate – was quite low. Inflationary expectations were so widespread that
investors were avoiding long – term investments and the demand for short -term
investments was actuall y outstripping the suppl y of funds. This in turn led to a
58
problem called "reverse yield curve" whereas the cost of borrowing short -term funds is
higher than the cost of borrowing for long – term mortgages. It should be evident that
when economic conditions are normal, higher rates for borrowing are available for
longer-term investments, and lower rates are associated with the shortest investment
durations.
DISINTERMEDIATION
The problems of short – term investments returns and inflation had been climbing
rapidl y to nearl y 20% annuall y. Therefore, as could be expected, many policyowners
with traditional life insurance contracts elected to take the cash value o ut of their
existing life insurance contracts by policy loans or policy surrenders, and then invest
these funds directl y into the high -yield investors. This process is referred to as
DIS INTERMEDIATION. Whenever the short -term investment yields exceed bot h
policy loan interest rates and long -term investment yields, life insurers suffer from
disintermediation. Policyowners withdraw funds from policy loans or surrenders,
which prevent the insurers from investing in the current high -yield, and extreme cases
can force liquidation of investments at a loss in order to payout funds.
Life insurance companies were desperately looking for ways to stop this draining
of funds. Many of them had to liquidate some of their long – term investments at a
loss in order to p rovide for the policyowner request. Needless to say, in this
environment, traditional fixed – dollar life insurance policies were not particularl y
appealing.
Stock insurance companies were the first companies to introduce Universal Life
policies because m utual insurance companies were concerned that federal income tax
law would not allow them to offer Universal Life insurance policies. Mutual
insurance companies that did introduce Universal Life generally formed a downstream
subsidiary stock insurance com pany with a parent mutual insurance company
controlling the subsidiary. The real advantage was that nearl y every insurance
company was able to introduce Universal Life policies and to do so through a new
company that invested all of its assets into a new money portfolio—earning very high
short-term investment yields. These yields seemed extremel y high when compared
with yields being earned by traditional life insurance companies with their long – term
investment portfolios. Although there was a tremendous immediate advantage of
higher yields, they could not persist over the entire duration of the life insurance
policy, the policy did exploit the marketplace for a few years while it lasted.
As one would expect, normal investment conditions eventually return ed and the
yields dropped to lower levels creating a decrease in popularity of Universal Life.
Insurers selling Universal Life insurance start investing in longer -term assets to
increase their returns and their total portfolios associated with Universal L ife policies
would then be very similar to those of older insurance companies that still had large
blocks of traditional whole life policies in force.
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FLEXIBLE PREMIUMS
The trul y unusual feature of Universal Life was the completely flexible premiums
after the first policy year —the onl y time a minimum level of premium payments for
Universal Life insurance policy is required. Therefore, the first year’s premium can
be arraigned on a monthl y, quarterl y, semiannual or annual basis. The insurance
company requires that minimum specified level year premium payments be equaled or
exceeded. After the first policy year it is up to the policyholder as to how much
premium to pay and even whether or not pay premiums.
But, when one thinks about it, if onl y one -year premium is needed to be paid and
the policyowner can forget all other premium payments, life insurance would be free
for all years after the first. However, the aggregate premiums paid regardless of the
timing, must be adequate to cover the costs of mai ntaining the policy. Onl y makes
sense. A Universal Life insurance policy, if the policy cash value is allowed to drop
too low, then the policy will lapse. If an additional premium payment is made soon
enough the policy can be restarted without going thro ugh the reinstatement process.
However, if an injection of additional funds comes after the end of the grace period,
the insurance company may force the policyowner to request a formal reinstatement
before accepting any further premium payments.
FUNDING CHOICES
With the introduction of Universal Life insurance, the investment risk to the
policyowner was shifted to the policyowner and as such they had to make
determination of the amount, if any, of pre -funding. One choice is to pay minimum
premiums and maintain a very high cash value, or, on the other hand, the policyowner
can pay minimum premiums, which just barel y will cover mortalit y and expense
charges because there is so little up front or no pre -funding.
The higher the amount or share of pre -funding, the more investment earnings are
available for the insurer to cover policy expenses. When the insured put money into
the policy earl y, the earl y-paid money itself starts earning money, which reduces the
amount of premium payments needed for later policy durations. The maximum
situation would be a single premium approach where the initial fund is sufficient to
cover all future costs. Normall y there is a level premium basis wherein partial pre funding creates the cash value but continuall y increases and t hat, in turn, generates
increasing investment returns to help offset mortalit y and administrative cost.
It is necessary for the insurer to pay the premium on some assumed level of
investment earnings. The policyowner bears the risk that actual investment earnings
will be less than that necessary to support this original premium. Investment earnings
cannot go below the guaranteed rate, however, a long – term shortfall may require
either increase in premiums or reduction in coverage at some time in the futu re.
Conversel y, the minimum – premium approach (reminds one of annual renewable
term insurance) there is little, if any, prefunding. When the policies are participating,
dividends could exceed the premiums with the policy developing large enough cash
value to pre-fund all future policy elements.
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Most people trying to understand life insurance are confused about the investment
component of pre-funding of the policy. Suffice it to say a 1/2% increase in
investment earnings at each annual renewable point, wo uld produce a meaningful
lower gross premium. Therefore, the problem is predicting what level of investment
earnings will actually be there, as it is highl y unlikel y that investment earnings rates
will always increase. Therefore, the onl y safe thing is t o realize that future
investment earnings will always change.
Universal Life provides for minimum pre -funding premium payments that barel y
covers the current mortalit y and expense charges. Therefore the premiums must
increase as the insured ages since mor tality rates increase with the age of the insured.
Premiums increase rapidl y at advanced ages because there is still the maximum
amount at risk – cash value is very low with the mortalit y rate must be applied to
nearl y the full death benefit amount. Und er a partial pre -funding approach, cash
value increases result in an amount of risk decreasing as the insured ages, and
increasing mortalit y rates are applied to an alternate risk amount.
With a traditional whole life policy, insurers have a wide range of level premium
contracts with a different level of fixed premiums for each t ype. Policies that have a
higher-level premium can develop larger cash values of earlier policy durations –
nothing new about this. Once the cash value is adequate to pre -fund the total policy,
the policy could be converted to a guaranteed paid up status. If the policy is
participating, dividends could actuall y exceed premiums where the policy development
was large enough cash value to pre -fund all future policy benefits.
The investment component of insurance policies in the matter of pre -funding is
rather confusing to most of the public. A 1/2% increase in investment earnings at the
end of each policy year provides a somewhat lower gross premium. The problem
occurs when they try to predict what level of investment earnings will actuall y occur.
One cannot assume that investment earnings will always increase, so the onl y safe
thing to predict is that future investment rates will change. Some the changes will be
down, some will go up, and no one knows for sure what the actual pattern will be.
As a general rule, policies have generall y done much better than the guaranteed
amount. The general public is not reall y aware of how much actual performance
exceeded guaranteed or expected l evels because, for instance, life insurance is rarely
discussed with friends —much less the expectation of guaranteed or expected levels of
return. There have been reports that, for instance, the 50th policy year of a whole life
policy where premiums are r elativel y high but policy generates high earl y cash values,
it was observed that the policy now provides more than five times the original death
benefit, cash value of more than four times the value of all premium paid over the 50
years, plus, since the po licy is participating, the dividends are now greater than 13
times the annual premium. While this is certainl y interesting for this discussion, the
first question the public would have is that they have no idea what will happen,
therefore, since there's b een so much competition with premium reductions in recent
years, the cash value build -up in earl y policy years will undoubtedl y not show such
progress.
Even though insurance companies must predict with some amount of accuracy
future interest rates investme nt returns, their very future depends upon policies’ cash
values if they are going to return part of the premium to policyholders. If they are
61
not, the insurer then may need to keep all the investment returns, and might still have
difficult y meeting the p roblems in the contract. Therefore, it just makes good sense to
have more premium money collected upfront, further delaying the collection of funds,
in the hope that economic conditions will be better in the future. At the present time,
in 2011, the stock market is on a roller coaster ride, the country’s investment rating
has been downgraded, and everything is so highl y political that insurance companies
might be wondering why they got into the business at all —then they take a look at the
assets the insurers have built up over the years and they are more optimistic.
Traditionall y, policies were funded in the earl y years from the creation of
policyholder dividends. But with Universal Life, policy accumulations from pre funding are credited to the policies cu rrent value and therefore quite well known to the
policyowner as the earning rates are applied to these accumulations. Contrary to what
many may think at first blush, actuall y the open disclosure for Universal Life policies
eliminate some of the doubts ab out fair treatment often directed by the public in
respect to whole life insurance.
FUND WITHDRAWAL
Universal Life policies, as indicated, are unique because the policyholder has the
abilit y to make partial withdrawals from the cash value from the policy without
incurring any indebtedness. Money can be taken out of the cash in the policy (like
taking money out of the bank) and there is no obligation to repay the funds and there
is no interest on the amount taken out. Withdrawals do affect the policies fu ture
earnings because the fund still remains to earn interest for future crediting periods is
thereby reduced by the amount that's been withdrawn. Further, its effect on the death
benefit depends on the t ype of death benefit in force – discussed later.
TARGET PREMIUM
Almost all universal policies are issued with a target premium amount. The usage
of the "target premium" originall y caused considerable confusion, however, many
people now understand the term … but just in case, it is defined as a suggested
premium to be paid on a level basis throughout the duration of the contract or for
shorter periods of time. It is a limited pay approach that was intended to fund the
policy. The "target premium" amount is simpl y a suggestion. There is no liabilit y in
respect of its inadequacy to maintain the contract for any duration, or even to the end
of life.
With some insurers, the target premium is enough to keep the policy in force under
typicall y conservative investment return assumptions to age 95 or100 with a ca sh
value equivalent to the death benefit amount. Conversel y, some companies in the
more aggressive marketing positions choose lower target premiums that are not
adequate to carry the policy-in-force to advanced ages even under more generous
assumptions of higher investment returns over future policy years . The assumptions,
correctl y, question the legitimacy of these amounts, and if the investment return
credits or the policy cash value is less than the amount assumed in obtaining a target
premium, the policyowner may receive a dispiriting letter from the insurer in respect
to the changing of policy provisions, or the necessary addition of more premiums.
62
This occurred in many cases just a few years ago with policyholders screaming that
their “agent had told them” that they would not have to put any more (or much more)
money into their policy.
If the policyowner elects to increase the level of premium, or reduce the death
benefit amount, such decisions are not particularly desirable but they are the only
acceptable way under the contract to correct for the untrue but optimistic
assumptions about investment returns in the contracts early years.
There are those professionals who believe that this statement should appear on the
stationery head of any agent that sells Universal Life, or some variation of it.
Some insurers use a secondary guarantee with the target premium wherein the
contract will keep the policy in force for a specified period of time —15 or 20 years–
and to pay the full death benefit as long as th e premium inventory in an amount equal
to or greater than the target premium amount at each suggested premium payment
interval—which is reall y not as complicated as it may seem at first blush. Regardless,
these guarantees do not extend to the maximum cont ract date but they are, at least, a
guarantee that the suggested premium, suggested as a target, will be adequate to
provide coverage for at least as long as a guarantee. In determining whether not the
target premium is adequate for the policy in force up through the maximum contract
age, one would have to compare it with the premiums for a traditional whole life
policy with the similar face amount at issue age. Universal Life policy target
premiums that are less than the premium for a comparable whole li fe policy should
wave a red flag. They may be low by design because the insurance company does not
expect the policy to remain in force until the very end of life in most of the cases.
The onl y people who will ever reall y find out whether not the policy’ s target
premiums are adequate are those who pay the premiums religiousl y throughout the
duration of the contract and lived to an age old enough to test the target premium.
Persistency is always an extremel y important part of premium calculation. It would
appear on the surface, that some insurers so believed in the validit y of Universal Life,
they assumed unrealistic persistency charges. If that is the case, there is not much an
insurance company can do about it except be extremel y careful in the future ab out
changing established persistency calculations.
ADDITIONAL PREMIUM PAYMENTS
Policyowners may make additional premium payments above the target premium
amount at any time they desire without any prior negotiation agreement with the
insurer. There is, however, a limitation on paying excess premiums associated with
the income tax definition of life insurance. One simpl y cannot put massive amounts of
money into a Universal Life policy and try to use it as a tax shelter…the IRS picked
up on that ploy earl y in the development of the product. However, the insurer reserves
the right to refuse additional premium payments under a Universal Life policy if the
cash value is large enough to intrude upon the upper limit for cash values relative to
the level of death benefit granted in the policy, in which case, Uncle Sam is satisfied.
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NO OR INSUFFICIENT PAYMENTS
The flexibilit y of Universal Life allows policyholders to omit premium payments
without knowledge and without notification, or they may pay lower premiums than the
target premium suggested at the time of purchase. The lower limitations on premium
payments have a couple of problems. Nearl y every company specificall y indicates a
minimum acceptable amount for any single payment –and thereby that they will not
process a minimum payment that would be lower than their administrative costs of
putting it on the books.
The other situation depends upon whether there is enough cash value in the contract
to meet mortalit y and administrative charges for the next 60 days. This could include
potential surrender charges in the earl y policy years —which should be easil y
explained and justifiable.
PAYING AN INADEQUATE PREMIUM
Since a Universal Life policy increases the risk that the policy may terminate due
to insufficient p remiums, there are now guarantees that the coverage will stay in force
provided the actual premiums paid equally amount specified in the no -lapse guarantee
provision. This provision guarantees coverage will continue as long as this
requirement is been met .
Generall y, the provision requires that at least the target premium amount must be
paid on time for every month or other specified interval. The payments can be delayed
into the grace period, or even be less than the target amount and such delay or
underpayment will eliminate the no -lapse guarantee. Essentially, this removes the
flexibilit y to completel y skip the premium payment or to make a payment for any
amount less the target amount if the no –lapse guarantee is to be preserved. Still, the
guarantee continues coverage even if the cash value account dropped to zero, because
the target premium turns out to be inadequate under this approach.
Another approach to the no –lapse guarantee allows the flexibilit y of skipping a
premium or paying smaller than target premiums, provided that the cash value must
equal or exceed a particular schedule of accumulation. The required schedules are
often called a “shadow case value amount.” In order to be able to skip premiums and
maintain the guarantee, adequate larg e prior premiums must be paid to build up the
cash value in excess of the required schedule. Failure to maintain a cash value that
equals or exceeds the required schedule will render the guarantee inoperable…Bang!
It is gone!
TYPE OF DEATH BENEFIT
Universal Life gives policyholders a choice of level death benefits and that of
increasing the benefits. Level death benefit is much like a traditional whole life
policy so that when the death benefit stays constant in the cash value increases over
the duration of the contract, the amount at risk or the protection element decreases.
There is a new aspect of the level death benefit under Universal Life policies, which is
basicall y a function of its tax law definition of life insurance after the introduction of
the Universal Life policy, wherein it requires that the specified portion of the death
64
benefit be derived from the amount of risk. Therefore, whenever the cash value in the
contract gets high enough that this proportion is no longer satisfied, the Univer sal Life
policy starts increasing the death benefit (even though the contract is called a level
death benefit contract). This unusual situation rarel y occurs and onl y then at ages
beyond normal retirement and even though it sounds good, it is actuall y not significant
to the insurer or the insured.
The increasing death benefit design modifies Universal Life policies so that it
specifies that there is always a constant amount risk superimposed over the policy’s
cash value–whatever that is. When the cash va lue increases, so does the total death
benefit payable under the contract. Conversel y, a reduction in cash value will reduce
the death benefit. This pays both the policy’s stated face amount and its cash value as
benefits at the death of the insured. Pol icies with this increasing death benefit
revision overcome a criticism of whole life policies that the death benefit is made up
partiall y by the contract cash value portion. When increasing the death benefit option
is selected under a Universal Life polic y the policyholder is ensuring that the death
benefit will be composed of the cash value and an “at -risk” portion equal to the
original face value of the contract.
Mortalit y charges for increasing death benefits pertain to a constant amount risk.
There are similarities between increasing death benefits for Universal Life and the
paid up additions option under a participating whole life policy. With a whole life
policy, dividends are used to purchase single -pay premium additions to the base
policy. In both t ypes of policies the excess investment earnings are used to increase
the cash value and also the death benefit.
Since the technicalities of the two death benefit designs and Universal Life policies
are slightl y different, the effective partial withdrawa ls on the mortalit y charge is
different even though the death benefit is reduced by the amount of the partial
withdrawal under both plans. On the level death benefit plan, partial withdrawals
reduce the death benefit by the amount of the withdrawal and de crease the amount of
the policy’s cash value, thereby increasing proportionatel y the charge for mortalit y.
Under this t ype of plan, partial withdrawals reduce the death benefit payable as the
withdrawal decreases the cash value that constitute part of the death benefit amount.
However, these withdrawals will not increase mortalit y charges because the amount of
risk still is the same. Cash value decreases has a negative impact on the amount of
investment earnings credited to the cash value after withdrawa l.
POLICY LOANS
There is a differential crediting rate on the cash value of Universal Life policy,
which depends on whether or not there are policy loans outstanding. Most Universal
Life policies credit current interest rates on the cash value as long as there are no
outstanding policy loans in arrears. If the policyowner borrows funds from the cash
value, then the insurer credits a lower interest rate or earnings rate to the portion of
the cash value associated with the policy loan. This is another e ffort to curb
disintermediation.
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Any outstanding policy loans when the insured dies reduces the death benefit by
the amount of the loan plus any unpaid interest of the loan —the same for Universal
Life policies and for any life insurance policy that has pol icy loans.
Earlier designs of Universal Life policies had various bands with different
crediting rates. For instance, the first $500 (or $1000) of policy loan interest may
have been credited with one interest rate and every successively loan would be
charged a higher rate. A higher policy loan interest rate structure still exist in a few
Universal Life policies offered in the marketplace today but generall y most insurance
companies have dropped the multiple -rate approach and adopted the system of
premium loan interest-charged. One the reasons, and a good reason, are that it was so
complex it was hard to explain to policyholders plus it required very complex
computer software to track it. Many Universal Life policies seen on the market today
credit the cash value with the current rate for non -borrowed funds at a lower rate —
often 2% (1200 basis points) lower than the current rate —from borrowed funds.
Although Universal Life in today's market seems rather" old hat," some of the
policies are already in their eighth and ninth generation series from the original policy
introduced by the company. Policy designs evolve in response to three factors:
econom y, competitive pressures, and innovative zeal. Most of the first generation of
Universal Life policies were v ery heavil y front – end loaded policies. What they did
was to take a significant portion of each premium dollar as administrative expenses
and then credit the remaining portion to the policy cash value.
Then, after the funds reached the policy cash value a ccount, they were subject to
charges for current death benefits (mortalit y charge) based on the amount of risk.
Generall y the mortalit y rate actuall y charged was often around 50% of the guaranteed
maximum mortalit y set forth in the policy contract for eac h attained age of the
insured. The difference in the mortalit y rate being charged and the maximum
permitted mortalit y rate published in the policy, represented the safet y margin the life
insurance company held in reserve. If the future mortalit y cost for the block of
policies turned out to be more expensive than the initial assumption, the insurance
companies are allowed to increase the mortalit y rate as long as it did not exceed
guaranteed maximum rates specified in the contract itself. After deductions for
expenses and mortality, the Universal Life cash value account is increased by the
current crediting rate to reflect investment earnings on the cash value. What this does
is to reduce the policyholder's current and future out -of-pocket premium expenses.
The actual rate credited this decision of the insurance company, actuarial supported,
and it tends to fluctuate freel y which reflects current economic conditions. Not
surprising reall y, sometimes insurers in the past were reluctant to credit the curre nt
interest rate to the policies cash value. As interest rates are dropping graduall y and
steadil y over the last decade, many insurance companies were hesitant to allow their
current interest -crediting rate to drop to below 10% —the interest -crediting rate seems
to remain at that level. Eventuall y this rather ridiculous system of crediting interest
rates in excess of annual earnings on invested assets became apparent, and single -digit
interest rates replaced double -digit rates in the crediting formula.
As of this writing, the federal government has determined that in an effort to avoid
hyperinflation, and other such results in today's econom y, the interest rates for
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mortgages, etc., would remain at extremely low rates for least two years. It will be
interesting to see at that time what interest rates are credited by insurance companies.
Competition always has a strong stand in determining the rates and provisions of
insurance policies and since Universal Life insurance is a relativel y new product,
interest -crediting rates seem to be something that can be used for competition among
other companies selling similar products. There seems to have been very little
emphasis on mortality rate charge or expense charges leveled against the premium
income—while actuall y interest rates, mortalit y charges and expense charges all
constitute the total cost of insurance. When consumers choose to focus on onl y one of
the three elements, it is not surprising that the marketing efforts zero -in “like a laser”
on interest crediting rates. This is unfortunate, as the assessment of overall policy
efficiency must consider all of the factors working together.
After the initial introduction of Universal Life, many Universal Life insurers
moved to a back -end loading design. What the y did was to lower and eliminate the
upfront charges levied against incoming premium amounts, and instead, impose new or
increased surrender charges applicable to the cash value policies surrendered during
the contracts during the first 7 to 15 years. Sur render charges are usuall y highest
during the first policy year than the decrease on the straight -line basis over the
remaining years until the year that the insurer expects first year charges to have been
amortized. At that point the surrender charge red uces to zero and will not be
applicable for later policy durations. The actual surrender charge itself can be based
on the cash value or on the target premium, including some that have a cross pollination deal that depends upon both approaches in order to generate the full
surrender charge. Surrender charges usuall y decrease by the same percentage on each
policy anniversary until this charge reaches zero. The amount payable for surrendered
policies is determined by deducting any applicable surrender char ge on that specific
contract which is the policy cash value minus any unpaid policy loans and interest.
Basicall y, this is a marketing decision, as the average person is uninformed in
respect to insurance, particularl y into the rather complicated workings of a Universal
Life policy. However, they can feel comfortable if they are presented with a plan that
has competitive investment features.
Companies that have the highest surrender charges usuall y have little or no front end expenses charged against the p remiums. Some “middle -of-the-road” companies
combine a moderate front -end loading and moderate surrender charges. Not
surprisingl y, there is a discernible preference for higher surrender charges and little
for no-front-end loading in most Universal Life policies being marketed today.
The actual front–end loading can be a flat annual charge per policy, plus a small
percentage of premium dollar actuall y received and a charge of a few cents per each
thousand dollars of coverage enforcement of the policy. Th e charges applicable to the
premium and the automatic coverage are usuall y deducted monthl y from the policy
cash value account. The current interest crediting rate is also usuall y applied
monthl y.
Again, because of competition, there are companies who hav e eliminated charges
based on the amount of coverage in force. Front -end loadings are sometimes even
minimized due to competitive pressure in order to emphasize that nearl y all premium
dollars go directl y into the cash value account. The actual expenses are still being
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deducted internall y. The way in which they are handled is not easil y discernible by
the public—for example, expenses can be part of the spread between actual mortality
cost and actual mortalit y charges or in the spread between investment e arnings and the
interest rate credited to the cash value accounts.
It should not be any surprise that an insurance company is not able to operate
without generating legitimate costs of operations above the amount needed to pay the
death benefits onl y (lik e saying your new car won’t run if it doesn’t have fuel). These
expenses must be covered in the method of allocating them and which is nothing more or-less than a cost–accounting approach. The allocation formula is, unbelievabl y,
always arbitrary, and to some extent guided by the philosophy of the insurance
company's management team –or more pertinentl y, the profitabilit y of the policies. It
is obviousl y necessary to consider equit y among short -term or long-term
policyowners, the appropriate duration for amortizing excess first year expenses (here
is that persistency gremlin again) and how much investment operations gain can be
kept for the growth of the company plus safet y margins, and how much to distribute to
policyowners.
LIFETIME FLEXIBILITY
Probabl y the most attractive feature of Universal Life policies, when you come
down to it, is not necessaril y the fact that the policyowner now has the abilit y to share
in excessive interest earnings but primarily the flexibilit y of premiums that have to be
paid under the policies. Life insurance policies now can keep pace with the needs of
the policyowners without "programming" various assumptions. The policy can be
funded heavil y when premium dollars are available and conversel y, they can be
suspended when the budget gets tight or new expenses arise (such as tuition).
The death benefit can be increased –sometimes requiring evidence of insurabilit y –
when the policyowner needs to do so —and once any temporary needs are over with,
then the policy can be adjusted down ward to provide lower death benefits (if that's
what the policyowner wants). A Universal Life insurance policy can be designed to
take care of changing policyowner needs and conditions to the degree that there are
those who have been known to subsequentl y call this plan "irreplaceable life
insurance." It is heavil y touted because it may be the onl y policy needed throughout
the life of the individual.
Still it is a life insurance policy and people do not stand in line to purchase it. (An
example of the ge neral public thinks about life insurance was illustrated when this
writer used to travel frequentl y and if I wanted to read or do some work (or nap), and
the seatmate in the plane wanted to talk, I would just ask him what he did for a living,
and then when he would ask me what “I did for a living,” I would repl y, “I am in the
life insurance business.” That shut him up every time! – except when I sat next to a
Million Dollar Roundtable Agent…)
Those that market Universal Life attempt to convince their prosp ect that their own
version of Universal Life is better than that offered by the guy -down–the-street (or the
brother-in-law). To be truthful, all Universal Life policies are quite similar and only
future investment performance will reall y determine which t he “best” policy is. The
consumer, per se, would be better off buying a policy that does well over the long haul
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instead of looking for a policy that wins every short -term investing contest, for the
obvious reason that no policy can be best in all areas a nd durations. Sometimes,
though, focusing on a single competitive advantage makes insurance companies spend
valuable adjustment time and money that may not be in their or the policyowner's best
interest in the long -term.
It is undeniable that Universal Li fe is very, very flexible:
In order to get this illustration inserted here, the wording contained in the
illustration is rather small. Therefore, to better explain: At age 30, the insured
purchases a Universal Life death benefit of $100,000 for a $500 an nual premium. This
coincides with the birth of a child. At $500 per year, the cash value grows
moderatel y. When the insured is age 33, the policyowner receives a $1,000 windfall,
which is deposited into the cash value account with the usual premium. At a ge 36, the
policyowner withdraws $500, but continues to make level $500 payments and the death
benefit remains at $100,000 .
At age 40, the insured increases the death benefit to $150,000 and begins making
$900 premium paym ents. At age 42, the insured skip s one premium payment, then
resumes paying at age 43. At age 44, the policyowner increases the premium payment
to $1,500 per year, retaining the $150,000 death benefit.
At the insured's age 48, the child enters college. The insured withdraws $4,000
that year and the next year, while continuing premium payments (must be an unusuall y
inexpensive school!). At ages 50 and 51, the policyowner withdraws $4,500 each
year. At 52, after the child graduates from college the insured continues paying
premiums and k eeps the $150,000 death benefit, making no further withdrawals. At
age 55, the insured lowers the premium payment in anticipation of retirement and
drops the death benefit to $100,000. At age 60, the insured makes no more premium
payments, and lowers the death benefit to $50,000. At that time, the cash value is
sufficient so that no further premiums are required.
INDEXED UNIVERSAL LIFE
The indexed product first started with fixed annuities —called Equit y Indexed
Annuit y— then spread to the Universal Lif e insurance policy, and they are now
holding hands as they tried to make inroads to a whole life policy. The indexed
Universal Life policies have basicall y all the features of a non –indexed Universal Life
policy but it also has a minimum interest creditin g rate guarantee, therefore they are
classified as fixed rather than variable life insurance contracts by the SEC and
therefore, are not subject to securities regulation by the federal government.
The indexed feature adds the possibility of enhanced cred iting rates linked to
the performance of a specific stock index such as Standard & Poor's 500.
The contract specifies which particular composite index applies in all of the
indexes major stock market performance. Whichever indexes used, any increases are
applied to the formula as stated in the policy to see if there will be an increase in the
crediting rate for the measured time interval. It is important to realize that the
formulae are designed to reduce the interest enhancement to significantl y less th an the
change in the stock index. The formulae vary considerabl y from one company to
another and frequently consist of many components. Often there is a cap for any one
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single performance period that effectivel y puts an upper limit on the amount of
interest enhancement permitted. Some formulae utilize a participation rate applicable
to the index, which can further dampen the results if the rate is less than 100%. There
are many different approaches to determining the high and low point for the indexed
during the measurement interval.
Basicall y this is a life insurance product copying an equit y indexed annuit y (EIA)
that has become quite popular in the annuit y market – geared normall y toward
retirement plans. It has the features of being a life insurance contract, hence no
federal license requirements, but still offers the flexibilit y of investment earnings.
There are several variations on the market today but an important feature to the public
in this time of trials and tribulations in the investment worl d, the contract guarantees
a minimum “floor” on the investment portion guaranteed by the assets of the life
insurance company. And everyone knows that the insurance companies have more
money than even the government!
Universal Life policy is a fixed contra ct and therefore the majorit y – 90% – of
investments in the portfolios must be in bonds and mortgages. This is a fact that is
overlooked by the general public who do not understand why insurance companies
cannot consistentl y make the high rates of return that other investments, such as
mutual fund companies, make. One of the most important reasons is that because
insurance companies provide long -range protection, their own investment portfolio
must be constructed so that there will always be enough money to pay claims, hence
legal requirements for the insurer to invest their own assets and those of their
policyholders into the safest investments possible. Makes sense, but amazing how
many insurance representatives neglect to so inform a prospect.
In keeping with the solidit y of regulations, insurance regulations limit life
insurance company investment portfolio to less than 10% in stocks and equities.
Therefore, the interest enhancement component is derived from a very small part of
the overall invested funds of the insurer. The applicable form must keep the
enhancements in line with what can actuall y be delivered by the relativel y small
proportion of the equit y portfolio. None of the formulas recognized dividend income
from the stock portfolio. In 2008, the New York insurance Department mandated that
indexed insurance product sales must be accompanied by a report showing the
difference between the index -worth performance when dividends are and are not
included. Agents are also required emphasize that th e index policy does not include
dividends.
Taking another look at the equit y indexed annuities, annuit y agents must be
extremel y careful never to represent their product as an investment. This is
required so that the product will not be regulated by the fe deral government as a
securit y, and this is currentl y enforced strictl y and sternl y by the insurers. It would
be assumed that those selling a similar life insurance product would also be cognizant
of this requirement as it has been reported that the SEC h as recentl y questioned this
feature and exclusivity from securities laws and regulations. Indexed annuities have
already created dissatisfied contract owners who expected more than the contract was
able to deliver. The SEC is arguing that these contracts should be regulated as an
investment contract because the enhancements are based on stock market performance.
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The same argument could be made relative to indexed Universal Life policy. Time will
tell if such is the case.
Insurance companies usuall y provid e a lower guaranteed interest rate under the
index universal policy than their standard Universal Life policies, and the reduction
can range from 50 to 150 basis points. Therefore the indexed feature must overcome
this reduction before the policyholder re ceives a positive net benefit from the contract.
During periods of poor stock market performance, the indexed Universal Life
policy will most likely underperform the standard Universal Life policy.
Marketing promotions for the indexed products emphasize interest guarantee plus
potential enhancement of the crediting rate from stock index increases. This may
seem to be, and is often stated, the best of both worlds as there is a guaranteed
minimum performance but still the chance to participate when the sto ck market goes
up. This t ype of promotion usuall y creates an expectation that usuall y exceeds the
maximum possible performance from these contracts and those marketing these
contracts may be accused of exhibiting exuberant expectations. A truism, rarel y
voiced, is that in a strong bull market, indexed Universal Life policies will provide
interest income onl y slightl y above guaranteed rate. Still, every little bit helps.
VARIABLE UNIVERSAL LIFE INSURANCE
This is one of the most recentl y developed t ypes of whole life policies as it
incorporates all of the flexibilit y and policy adjustment features of Universal Life
with the policyowner directing the investments of variable life insurance. Fixed
premium features of the variable life insurance contract ar e not present in this policy.
One the different features of variable Universal Life and Universal Life insurance
is that variable Universal Life eliminates the connection between the performance of
the investment above or below some stated target level and the related formula –
directed adjustment in death benefits. Instead variable Universal Life insurance
carriers adopt the death benefit provisions that appl y to Universal Life, either a level
death benefit plan or increasing death benefit design, and whe re a constant amount of
risk is paid in addition to the cash accumulation account. The death benefit does not
change regardless of the investment performance of the contract. If it is decided that
the owner wants to have the death benefit vary with the p erformance of the
investments of the contract, then the policyholder must choose the increasing death
benefit. All of the increases or decreases of the cash value is a direct result of the
accumulation account balance –rather than the result of producing p aid-up additions as
is the case under fixed premium variable life insurance.
Variable Universal Life offers policyholder a choice among a particular group of
mutual funds management of separate accounts, usuall y created and maintained by the
insurance comp any. Some insurance companies have made arrangements with other
investment companies to use separate account portfolios that have been created and
maintained by these investment management firms. Basicall y, many of the separate
funds are simpl y copies of popular mutual funds available to other investors.
Variable Universal Life insurance, like variable life insurance, are technicall y
classified as securities, meaning that they are subject to regulation by the SEC which
requires registration of agents mark eting the product, the separate accounts connected
71
to the contract, and the contract themselves. Besides, policies must conform to the
SEC requirements that the investment funds are separate accounts segregated from
insurance company’s general investment portfolio, and not subject to creditor's claims
to the insurer’s general portfolios in times of financial difficulties. Variable
Universal Life policies are also regulated by state insurance departments, and nearly
80% of the states of adopted the NAIC mo del variable life insurance regulation in a
modified form.
Since this is a regulated product, prospectuses must be provided as with variable
life policies, such documents providing necessary information so that the policyowner
can have a meaningful evaluat ion and have abilit y to compare policies.
FLEXIBILITY
Variable Universal Life insurance is simply a Universal Life insurance policy with
the additional feature that allows the policyowner to choose investors, just like a fixed
premium variable life insur ance contract. Variable Universal Life offers the maximum
in both flexibilit y with the policyholder and the amount of the risk has been shifted to
the policyowner. Further, there are no interest rates or cash credit guarantees and
specificall y, very limi ted guarantees on the maximum mortalit y rates applicable.
Policyowners have maximum premium flexibilit y as they can choose to fund it at
whatever level they like as long it is at least high enough to create coverage similar to
yearl y renewal term —it is not in excess of the amount that would drive the cash
accumulation account above the maximum threshold set forth in tax laws. It is not
required for policyowners to negotiate with the insurance company or even to inform
the insurer in advance of any premium modification or stopping a premium payment.
These contracts allow partial withdrawals just like those under Universal Life
policies. Earl y partial withdrawals may be subject to surrender charges, and surrender
charges appl y to total surrenders in the earl y years of the policy when the insurance
company is still "recovering" excess first year acquisition costs. The surrender charges
vanish at a particular policy duration.
Variable Universal Life can be pre -funded so that the policy can completel y
support itself independent of its cash value. If the premiums are adequate that are
contributed to the contract, this may be performed in a relativel y short number of
years. Variable Universal Life policies have no guarantee that once the cash value is
large enough to carry the policy it will always be able to do so –as with Universal Life
and current assumption whole life policy. The risk of investment return is on the
shoulders of the policyholder, to a certain amount, along with some of the risk of
mortalit y rat e charges. Therefore, certain adjustments by the policyholder must be
made so that he must either pay more premiums or reduce the death benefit at a
specified future time if in fact the cash value dips below the level needed to
completel y pre-fund the rem aining contract years.
Policyholders can provide a hedge against inflation by choosing the increasing
death benefit option under the contract —but it is subject to a timing “mismatch.” On
the other hand, if the primary objective for purchasing the contrac t is for the
policyowner to use the cash values prior to the death of the insured, then a more
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aggressive growth plan is preferable —usuall y when this occurs, the policyholder
would probabl y be the beneficiary and the risk bearer.
INCOME TAX WHEN THE POLICY IS EXHAUSTED EARLY
Variable Universal Life policies are not designed to be and should never be used as
short-term investment vehicles. There are two “tax traps” when policyowners exhaust
the policies’ cash values significantl y at various times during th e first 15 policy years.
WARNING: These income tax penalties are in addition to any surrender charges but
are within the policy itself.
One “trap” is called a "modified endowment (MEW) contract provision of the tax
code" which effectivel y treats all cash value distributions as taxable income until all
the returns on investments have been taxed before the remainder of the distribution is
treated as recovery of basis. This treatment can be used whenever material policy
changes are made in the policy so that it failed the seven day test (reaching the cash
value amount for policy paid -up after seven years). If the policy does failed the
seven-year a test, in addition to the distributed amounts being subject to income tax up
to the total amount of the gain, th ere may also be a 10% penalty tax applicable to
those taxable gains if the policyowner is younger than 59 1/2 years of age. High cash
values with high premium t ypes of variable Universal Life policies are the one most
likel y to suffer from this taxation. One should always make sure that the cash value
before and after any "material" change is lower than what it would be when the policy
is full y paid up after seven years, in which case that potential problem is avoided.
The second problem regards high leve ls of cash value approaching the upper limits
permitted under the tax code. If the reduction in the death benefit level forces cash
value to be distributed in order to retain life insurance status under the tax code, these
distributions may be taxable inc ome to the extent where they represent gain in the
policy. The strictest rules appl y to withdrawals during the first five years of the
policies existence, but there are less binding constraints for policy years 6 -through-15.
Therefore, any policyowner th inking about making a switch from the increasing death
benefit to the level benefit provision during the first 15 years of the policies
existence, should seriousl y consider these tax rules before making the change.
Actuall y, as long as there is no distrib ution or simultaneous request by the
policyowner for discretionary distribution of cash value funds, there should be no
problem.
On the other hand, if the increasing death benefit under the policy has been
refunded close to the maximum amount allowed, ther e is still the possibilit y that some
cash value could be forced out so as to compl y with the tax code requirements on life
insurance policies.
Neither of these tax code requirements is of any significance if there are no gains
in the contract where premium s paid exceed the cash value when distributions are
made. Under the modified endowment contract provisions taxation will be applicable
onl y if there are distributions of the cash value. So if funds are left in the contract
and allowed to remain there as part of the cash value, there will be some taxation even
though the potential still exists for any distribution once the policy is been classified
as a modified endowment contract.
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Variable Universal Life contracts are not designed for or should be even de sirable
for policyowners who do not want to assume the risk of investments under the
contract. The policyowner who says they want to assume the investment risk would
become very anxious over any short -term fall in the value in the particular investment
portfolio they have selected, and they would be wise to exercise caution. Perhaps the
best prospects for variable life in variable Universal Life policies are those who do
have a continuing interest in the performance of investments such as in the stock
market as they are more used to the dail y fluctuations of the value of the fund. The
separate account requirements of the SEC force most insurance companies to use funds
not available to the general public. It is difficult to track the investment record of
these funds as they are very rarel y publicly traded and they are not included in the
Wall Street Journal funds reports.
Variable Universal Life insurance has become a good policy for corporate -owned
life insurance because the flexibilit y works well with th e continuall y changing needs
of the corporation that owns the policy. The corporate management is usuall y fairly
sophisticated and understanding in respect to the process of investments and the short term upward and downward fluctuations in investment hol dings.
COMPARING LIFE INSURANCE POLICY COSTS
NET COST
There are a wide variet y of methods used to compare life insurance policies and
usuall y, the net cost method is the most understood and used. The way that works is
rather simple, easy-to-understand and actuall y even easy to calculate. The steps are to
determine a starting point that is a specification of the duration of coverage to be
evaluated–usuall y 10 or 20 years of coverage. Then the actual mechanics of this
process involves taking all the net premiums paid under the policy, adding them
altogether, subtracting the cash surrender value for the time -frame being considered,
and all dividends paid over that period. One of the reasons this method is so easy to
understand is that it does not take int o account the time value of money, e.g., it
ignores interest.
Under the net cost method, the final cost is primaril y the return to the insurance
company. The problem of this system is that after 20 years the net cost is usuall y
negative. Simpl y put (as m uch as possible) the cash value amounts at the end of the
time plus dividends paid over the specified interval exceed the aggregate of premiums
paid. This would indicate that the policyowner has reall y a “good deal” inasmuch as
they received insurance fre e of charge. The fallacy of using this method is that it
gives equal weight to payment amounts that may be separated by 10 or 20 years and
therefore totall y ignoring the opportunity cost of earnings offered because the funds
are not invested in an investm ent account.
The net cost method is actuall y not appropriate for comparing policies where they
are the same or different t ype. It is not accepted under state statutes and regulations
for purposes of making replacement evaluations. As one might suspect, u nder some
state regulations, insurance agents are not allowed to use the net cost method.
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INTEREST-ADJUSTED INDEXS
The purpose of using interest adjusted indexes is very similar to that of the
traditional net cost approach, except that interest adjusted i ndexes do not take into
account the time value of money. The National Association of Insurance
Commissioners (NAIC) developed the interest – adjusted cost indices and provided
model laws requiring their use. Such statutes were drafted and adopted during the
1970s prior to the high interest and inflation rates of the late 70s and earl y 80s.
Almost all states mandate the rate of interest used to be 5% annuall y.
The interest–adjusted method basicall y takes all payments for premiums and treats
them as if the y were put into interest –bearing accounts where they would accumulate
interest until the end of this specified time for evaluation. Similarl y, all dividend
payments are considered as being deposited in an interest – bearing account, and that
account balan ce is calculated to the end of the interval for evaluation.
Next, one would take the future net cost divided by the future value of an annuit y
due, based on a specific interest rate at the time being evaluated. Using 5% interest,
the factor to use for te n-year evaluation is 13.2068. Similarl y, the factor used to
divide the future value amount over a 20 -year interval, assuming 5% interest rate, is
34.7193. This result is the level annual cost for the policy. Still, this would be an
aggregate amount that must be converted to a per -thousand amount, which is
accomplished by dividing the level annual cost amount by the number of thousands of
dollars of policy death benefits. For example, if the aggregate level annual cost for
$50,000 policy is 50 times grea ter than it would be for a $40,000 policy, then one
would simpl y divide the level annual policy cost by 50 to determine the level annual
cost per thousand dollars of coverage. The future values are used in most sales
presentation materials used by insuran ce agents and therefore reason there is usually
no need calculate them independentl y. The numbers presented will be based on 5%
mandated interest rate in the methodologies described in the statute, and the same
methodology works for any other interest rat e that could be considered as appropriate.
USING A FINANCIAL CALCULATOR
The future value factor for an annuit y due can be obtained using a financial
calculator using the beginning -of-period-mode. One would merel y determine the
number of periods in the ev aluation interval (such as 10 or 20) on the “N” key and
enter the interest rate on the “I” key and payment amount of $1.00 on the “PMT” key.
Press the “FV” key to solve for the future value. The resulting factor is then divided
into the net future value of the accumulated premium amounts in excess of the
accumulated dividends and end -of-period cash value. If there are terminal dividends
available at the end of the time interval, they would be subtracted from accumulated
premiums prior to dividing the ann uit y-due factor in order to determine the surrender
coast index. Or, more practicall y, these calculations can be made by the actuarial
department, which is probabl y the more accurate way to accomplish the needed result.
In any event, the financial calcul ators are important tools if one knows how to operate
them.
75
CASH ACCUMULATION METHOD OF COMPARISON
The cash accumulation method comparison method is much more complex and
requires a rather large amount of data entered into a computer program in order to
calculate results accuratel y. Its flexibility allows it to compare permanent insurance
policies with term policies, and it can also be used for evaluating replacement
proposals.
The methodology is beyond the purpose of this text and in nearl y all cases wil l be
handled by the home office of the insurer, however the technique is simpl y to
accumulate the premium differences between the policies they have been comparing
while holding the death benefits of both policies constant and equal. After the
calculation is been performed generall y the policy with a greater accumulation in the
comparison interval is considered the preferable contract.
While these calculations are quite impressive and of great value in marketing a
product, one reall y requires a computer in order to be efficient. By using a computer,
once a spreadsheet uses the available logic to make the necessary comparisons it is
just a matter of plugging in new values for premiums, cash value, and accumulation
account amounts.
AN EQUAL OUTLAY METHOD
The equal outlay method is similar to the cash accumulation method. The same
amount of premium dollars on one hand is spent for a cash value contract and on the
other for a term policy. The amount by which a cash value contract premium exceeds
the term premium is then deposited into a side fund. Then the difference in the
premium amounts accumulated at a specified interest rate and the death benefits of the
term insurance plus the accumulated side funds are compared with the death benefit
under the cash val ue contract in which dividends, if any, have been used to purchase
data benefit amounts in the value of these paid -up additions.
This method and the cash accumulation method are both extremel y sensitive to the
interest rate used for the purposes of the sid e-fund accumulation. Manipulating
interest rates can change the comparison results. The higher the interest rate used, the
more the equal outlay method returns favor the lower premium policy with a side fund
combination.
THE COMPARATIVE INTEREST RATE METHOD
There are other comparison methods that utilize and assume a cost of coverage.
Creating an interest rate for comparison purposes will also illustrate the problems of
comparing any life insurance policy because there are degrees of freedom in the
parameters involved. The comparative method looks for the interest rate that would
make the buy-term-and-invest-the-difference comparison exactl y equivalent in the
provided death benefits. The onl y way that can be accomplished would be for the
premiums and side funds to be exactl y equal to the death benefit. The problem with
this method is that it requires a large amount of data input and a sophisticated
computer program in order to accuratel y determine the interest rate needed.
76
Another problem with this met hod is that each comparison must use the same
assumed term premium rates to derive the interest rate. Otherwise, there have been
manipulation whether intentional or not, of the interest rates as a result of the
calculations. The policy generating the hig hest comparative interest rate is assumed is
the preferable policy making comparisons by this method.
These are onl y a quick summary of cost comparison approaches. There are other
methods developed by a former insurance professor and even though his met hods are
often used by various actuaries in developing cost comparisons, he insists that there is
no perfect comparison method because of the wide range of objectives that are
involved in insurance policies require that different priorities in respect to t he death
benefit and cash values in different situations. Therefore, any comparison method will
place its priorities on the elements that are considered to be of highest priorit y.
STUDY QUESTIONS
1. The SEC requires that an insurance company that sells Variable Life Insurance products
A. post a $250,000 bond.
B. license all employees as security dealers.
C. have all variable life insurance agents be registered with the SEC.
D. must appoint one actuary as the “registered” company actuary.
2. The popularity of a variable life policy depends upon
A. the reputation of the insurance company.
B. the general investment market conditions.
C. upon the company getting investment income on their investments at least 2
percent higher than the average.
D. the number of rural agents marketing the product .
3. The cash value of the variable life insurance policy fluctuates daily and each day’s net asset value is
A. based on Standard and Poor’s evaluation of that month.
B. solid and immovable, always remains constant.
C. determined by actuarial studies.
D. based on the closing price for the issued in the portfolio on that trading day.
4. A prospectus
A. provides full disclosure of the entire contract, including expenses, etc.
B. states the anticipated returns on investments.
C. is used for advertising for the insurance product.
D. cannot be used if the plan is registered with the SEC.
77
5 Fixed premium variable life insurance contracts are similar to whole life insurance except
A. premiums must be paid annually on a variable product.
B. with variable life the policyholder assumes reinvestment risk.
C. they can be sold only by mutual insurance companies.
D. there are no commissions or other compensation paid on variable products.
ANSWERS TO STUDY QUESTIONS
1C 2B 3D 4A 5B
78
CHAPTER FIVE - POLICY PROVISIONS & RELATION TO
DEATH BENEFITS.
POLICY PROVISIONS OF VARIABLE CONTRACTS
Certain mandatory provisions are part o f a variable contract. Some of the t ypical
provisions that appl y to both variable and traditional insurance have been discussed,
but there are other important variable provisions that need to be understood.
Guaranteed Minimum Death Benefit
Variable life policies provide that the death benefit must be equal to the initial face
amount as a minimum. While the cash value of the policy is not guaranteed, the initial
death benefit is guaranteed and this provides a sense of security to the policyholder.
Separate Accounts
This states that the cash value of the policy will be determined by the separate
account(s) activit y of the funds that are held in one or more separate accounts. This is
the “heart” of the policy and it allows the policyowner to participate in a bove-average
investment returns and still have the protection of life insurance.
Redetermination of the Death Benefit
The policy’s face amount —death benefit —must be calculated annuall y and the
method of recalculation is provided (paid -up additions/surrende rs, or the cash value
increase/decrease method).
While this is a flexible feature, it offers some permanency to the policyowner as
the death benefit will remain constant for a year —until the amount has been
redetermined. It should be pointed out, though , that this may not always show an
increase as if the market drops significantl y at the time of redetermination, or shortl y
before, the death benefit could be lower for that year.
Revaluation of the Cash Value
The separate accounts change dail y according t o the investment value increase or
decrease, however the cash values supporting the policy are onl y determined
(revalued) on a monthl y basis.
This also can be a risk factor, as changes in the direction of the market can affect
the cash value, but in this case, it would onl y be for a month. This could work for or
against the policyholder.
Entire Contract
This provision is part of every life insurance policy and it means that the policy
itself, including a copy of the application, is the entire contract a nd if it is not stated
in the contract, it does not exist.
Free Look Provision
Except for short-term nonrenewable policies, such as temporary policies and travel
insurance, life insurance policies have a provision that allows the policyowner to
examine the policy and provides for a full refund of premiums if the policy is returned
79
to the insurer, usually within 10 days after delivery or within 45 days after the
application was completed.
Incontestability
Variable life has the same two -year contestabilit y period as traditional life
insurance. Misrepresentations discovered on the application are grounds for voiding
the contract and the insurer must then return the premium. Once the contestabilit y
period expires, the policy cannot be voided by the insurer.
Misstatement of Age or Gender
If there is a misstatement of age or gender, the premiums will be adjusted to reflect
what they should have been —identical to all life insurance products.
Assignment
As with all life insurance plans, variable contracts can be as signed to another
part y, either on a temporary basis, as collateral for a loan, or assigned permanently
and completel y. Insurance interest does not need to be established between the
insured and the new owner.
Assignment can be used for personal or busine ss reasons, such as a gift to a friend
or relative, or as the transfer of key -man insurance for a business after the person
retires or is terminated.
Reinstatement
The policyowner may seek to reinstate a policy, particularl y if the policy has been
surrendered by mistake and the policyowner wants to keep the benefits of the original
policy. To qualify for reinstatement, the original policy must not have been
surrendered—if the original policy was canceled and the cash value distributed to the
owner, reinstatement cannot, of course, be accomplished.
Reinstatement may be possible if the request is made within a certain time frame
(usuall y three years) after the original policy’s default. A written request for
reinstatement is submitted, evidence of insurabili t y is furnished and a reinstatement
premium is paid with the application. The reinstatement premium usuall y consists of
all past-owed premiums (plus interest usuall y), unless the company agrees to some
other premium.
As a rule, Variable life insurance rei nstatements will allocate the premium
according to the original separate accounts allocation request, unless it is modified.
Grace Period
The same 31-day grace period as with traditional life insurance is used with
variable insurance. Note, however, that Variable Universal Life has a different t ype
of grace period. Since the VUL is an “unbundled” policy, there reall y is no connection
between the payment of the premium and the continuation of the coverage, but whether
the policy continues is a function of the cash value. If the cash value is insufficient to
maintain the cost of insurance, the policyowner will be so notified that a premium
must be paid. From that date –date of notification –the required premium to keep the
policy in force must be paid within 61 days or the policy will lapse. Full coverage
remains in force during the 61 days.
80
Exchange
Unique to Variable life insurance policies, the insurer must allow for the exchange
of the policy for a fixed benefit policy at any time within the first 24 m onths of the
policy’s life, provided premiums are full y and timel y paid. The new fixed benefit
policy must:
 have the same initial death benefit as the variable policy;
 have the same issue date and age at issue as the original variable policy;
 be issued with a permanent plan of insurance that is substantiall y comparable, that
is offered by the insurer in the residence state of the insured;
 be issued with premium rates that were in effect at the time the original Variable
life policy was issued;
 include all riders and incidental insurance benefits that were included with the
original policy; and
 be issued with the same cash value as would have existed is the actual premiums
had been paid into the new, fixed policy.
Note: The 24 -month minimum time for conversion is determined by federal law;
although individual States have the right to establish a longer minimum period.
This provision provides a prospective purchaser of a Variable life plan a sense of
securit y, particularl y if they do not know if t he variable plan is right for them.
Policy Loans
Adjustable Policy Loan Interest Rate provisions are required to target the maximum
interest rate to be not more than the greater of Moody’s Corporate Bond Yield Average
as of two months earlier, or the interest rate that is used to calculate the cash value,
plus one percent. Variable rates must be redetermined a minimum of once a year, but
not more than once every three months.
Life insurers are required by law to notify policyowners requesting a loan of the
initial loan rate, and they must also notify them with “reasonable” advance notice of
any increase in the loan rate on outstanding loans.
Further, insurers that use the variable rate method must also offer the fixed interest
rate method as an alternative.
Under the laws of most states, policy loans must be available after the policy has
been in force for three years, and they must permit loans of at least 75% of the cash
value. Insurers can base the policy loan interest rate on a fixed interest basis, but it
cannot exceed 8 percent annuall y, or on a variable interest basis as discussed above.
Policy loans are often used in estate planning situations and policyowners must
understand that there are certain criteria involved, such as outstanding loan
indebtedness wherein interest will be deducted from the death benefit at death. In
case of surrender or election of a nonforfeiture option, the indebtedness plus interest
will be deducted from the cash value. If, for whatever reason, the outstanding loan
balance exceeds the cash surrender value, the policy will be cancelled if the excess
indebtedness is not repaid within 31 days of the notice. The policy may stipulate that
the loans must be greater than a certain amount, and particularl y applicable to variable
plans, loan amounts will be withdrawn from a separate account and loan repayments
will be deposited into a separate account.
81
Description of Benefits
The cover page of a life insurance policy contains descriptions of the policy.
With variable insurance, the variable nature of the product itself must be not onl y
printed on the cover page, but the differences between the conventional whole life and
Variable life must be highlighted, including the death benefit, cash value, methods of
determining benefits, and the guaranteed interest rate credited to funds allocated to the
company’s general account.
Investment Objective Provision
Variable life insurance policies must contain a provision that states that a separate
account’s investment objective cannot be changed without the approval of the state
Insurance Commissioner (or Department of Insurance).
Reinstatement
If a VUL policy should lapse, it may be reinstated at any time within a stated
period of time (usually 2 years), subject to specified requirements and conditions:
 An application for reinstatement must be sent to the company, signed by the
policyowner.
 The policy must not have been totall y surrendered, i.e. it must not have been
surrendered for its net cash surrender value.
 The company may require e vidence of insurabilit y, and if so, it must be provided to
the company.
 Premiums must be paid, which, with interest, are sufficient to keep the policy in
force for a stipulated period of time (3 months usuall y).
Free-Look Provision
As required by law, af ter the policy is issued, the policyowner has a stipulated
period of time (usually 10 days after receipt of the policy by the policyowner, or 45
days after the application has been signed) to return the policy to the insurer and
receive a full refund of al l premiums paid, no questions asked. In some states, the
refund will reflect earnings or losses in the cash value accounts, due to investment(s)
performance, for the period of time that the money was in the control of the insurer.
Conversion Privilege
Unique to VUL policies, the VUL allows policyowners to exchange the VUL for a
comparable non -variable plan, or they may transfer all values in the subaccounts of
the VUL to the general and fixed account within 24 months after issue of the VUL.
The new policy, if the VUL is exchanged, will have the same effective date, same
issue age and the same underwriting classification as the VUL.
Annual Report
At the time the policy is issued, it is impossible to project what the cash values
will actuall y be because of t he fluctuations of the investment accounts. The SEC also
requires “full -disclosure,” so for these reasons, the policyowner is sent an annual
report that explains the current status of the policy, in full detail. The annual report
will contain the followi ng information:
 death benefit;
 total cash value, by account and by percentage allocated to each account;
82





net cash surrender value;
total premiums that were paid since the previous report;
policy loans and interest charged on loans made during the previous year, if any;
partial surrenders made since the last report; and
the transfers of funds among the accounts.
Semiannual reports are also sent to the policyowner, which show the 6 -month
performance of the cash value accounts in which the funds of the policyown er has
invested and a complete listing of all investments in the policy.
Riders & Options Available
The same options that are available for Universal Life and some traditional
products are generally available for VUL policies. Following is a list of those that
may be included:
 Waiver of Premium in case of disability;
 Cost of Living Riders (COLA) which may be either a rider or part of the policy and
may or may not have a separate premium;
 Accidental Death Benefit;
 Accelerated Death Benefit;
 Term insurance rider;
 Famil y Insurance rider; and
 Guaranteed Insurabilit y Rider (GIR), or option, which allows the increasing of the
specified amount on each option date, without evidence of insurabilit y and at
standard rates.
TAXATION AND REGULATION
 The separate accounts withi n a VUL policy builds cash value within a life
insurance policy, therefore a VUL receives the same favorable tax treatment as
other cash value life insurance policies.
Even though it is regulated as a Securit y, it still retains its originalit y as a life
insurance policy for taxation purposes.
Obviousl y, premiums are not tax deductible. Cash values accumulate free of
current income taxes (but the legal guideline corridor ratio between cash value and
death benefit must be maintained within the policy).
Death benefit proceeds are tax -free, and lump-sum benefits paid to a beneficiary
are excluded from the beneficiary’s gross income for tax purposes.
Policy loans are viewed as a debt of the policyowner, and not as income or a
taxable distribution. Interest paid on a loan (for non -business purposes) is not tax
deductible. Also, if a policy fails the “7 -pay test” it then becomes an “MEC” and
loans and withdrawals are then subject to current income taxes plus a 10% penalt y if
the policyowner is under age 59 ½. (See discussions of modified endowment contracts,
MECs.)
83
In some cases, surrenders, withdrawals, and the right to change death benefits
options, can have tax consequences. For instance, upon total surrender, any amount
received by the policyowner in exces s of the total premiums paid into the policy, is
treated as ordinary income and is taxed as such.
In total, taxation of the VUL benefits has created a very appealing product too
many persons, particularl y those who are in a higher tax bracket. This was cer tainly
one of the reasons that while individual life insurance doubled from 1986 to 1996,
over the same period of time, Variable life insurance (including VUL) grew from
approximatel y $65 billion, to $591 billion.
In order for a VUL policy to meet the defi nition of an insurance contract and obtain
the favorable tax treatment, three tests must be met:
1. Cash Value Accumulation Test
When the cash value of a permanent life insurance policy exceeds the single
premium that would pay for all future benefits, at that point the policy no longer
meets the IRS definition of life insurance. If a policy does not meet this cash value
accumulation test, the policy is “disqualified,” with the disqualification retroactive
to the policy issue date. All income credited to that policy becomes taxable to the
policyowner.
Since the insured or the insurance company’s producers do not have access to the
mortalit y tables and the present value tables necessary to make this “test,” the
insurance company’s home office will provide the necessary expertise to make sure
that the policy meets the test and is considered as life insurance.
2. The Corridor Test
All VUL contracts contain a provision that defines the minimum of pure insurance
protection in comparison to the cash value amount . This minimum amount,
technicall y referred to as the guideline minimum sum insured, is the amount that
is necessary to prevent the policy from violating the IRS Corridor rules.
To further make this complicated, the IRS considers the minimum sum insured b y
using a published ratio between the face amount of the policy and its cash value.
(See table below) For example, for those under age 40, the death benefit must be
250 percent as great as the cash value at that age. The ratio decreases each year,
eventuall y reaching 100 percent around age 95, at which time it is said to “mature.”
In the previous discussion of Universal Life, the illustrations shows how the face
amount increases after the cash value grows to a certain point, and after that point,
the “amount at risk” continues to grow, with the “corridor” between the cash value
and the death benefit. The reason for the corridor is that if a policy matures before
age 95, under the IRS Code it is no longer considered as life insurance. Therefore,
in order to maintain this ratio, insurance companies reserve the right to refuse
additional payments of premium if they would cause the cash value to increase
beyond the upper limits relative to the death benefit. If the policy fails to meet the
corridor test in a ny year, the policy is disqualified from inception and all income
credited to that policy becomes taxable income to the policyowner.
84
CORRIDOR TEST FOR
LIFE INSURANCE CASH VALUE
Death Benefit must exceed
cash value by this multiple
Age
0-4041
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75-90
91
92
93
94
95
2.50
2.43
2.36
2.29
2.22
2.15
2.09
2.03
1.97`
1.91
1.85
1.78
1.71
1.64
1.57
1.50
1.46
1.42
1.38
1.34
1.30
1.28
1.26
1.24
1.22
1.20
1.19
1.18
1.17
1.16
1.15
1.13
1.11
1.09
1.07
1.05
1.04
1.03
1.02
1.01
1.00
Cash Value may not exceed
this % of death benefit
.
.40
.41
.42
.44
.45
.47
.48
.49
.51
.52
.54
.56
.58
.61
.64
.67
.68
.70
.72
.75
.77
.78
.79
.81
.82
.83
.84
.85
.85
.86
.87
.88
.90
.92
.93
.95
.96
.97
.98
.99
1.00
3. The Seven-pay Test
Another test! However, if a policy fails the 7-pay test, it still remains as a life insurance
policy, even though it loses the tax advantages of policy loans and withdrawals. Thi s has
been mentioned previously, during the discussion of MECs.
Basically, the test considers that if the total amount a policyowner pays into a life
insurance policy during its first years, exceeds the sum of the net level premiums that
would have been payable to provide paid-up future benefits in 7 years, then the policy is a
MEC. Once a policy is an MEC, it will always be an MEC. Moreover, to repeat the earlier
85
discussion of MECs, if the policyowner receives any amount from a loan or withdrawal,
that amount is taxed first as ordinary income, then as return of premium. In addition, the
10% penalty if the policyowner is under age 59 ½.
One other point on taxation of VULs. If interest accrues after a date of death because of a
delay in settlement, the interest may be taxable. If the interest-only settlement option is
chosen, the tax exclusion does not apply, and it does not apply to any option selected by the
beneficiary.
CORRIDOR RATIO
Ratio of Face Amount to Cash Value in order to meet the Corridor Test
Age
Percentage
Age
Percentage
Through 40
250%
60
130%
41
243%
61
128%
42
236%
62
126%
43
229%
63
124%
44
222%
64
122%
45
215%
65
120%
46
209%
66
119%
47
203%
67
118%
48
197%
68
117%
49
191%
69
116%
50
185%
70
115%
51
178%
71
113%
52
171%
72
111%
53
164%
73
109%
54
157%
74
107%
55
150%
75 thru 90
105%
56
146%
91
104%
57
142%
92
103%
58
138%
93
102%
59
134%
94
101%
95
100%
86
NASD CONDUCT RULES
An outline of the NASD Conduct Rules was indicated earlier. At this point, it
would be advantageous to discuss some of those rules in a little mor e detail as they are
very important to the marketing of Variable Universal Life.
 Advertisements and all sales literature must not attempt to mislead investors, in any
fashion or in any way, and must be filed with the proper department of the NASD.
 Any discussions or communications with customers or potential customers regarding
securities must be done in good faith, which means that there must not be any
misleading information, omission of key information, exaggeration or other such
guarantees, particul ar when comparing funds or accounts.
 Any recommendation given must be reasonable, and if the representative has an
interest in any security or product’s success, this interest must be full y disclosed.
 The firm or the individual representative may not advertise in any other identit y or
name, or anonymously, and the firm must display their name prominentl y on all
advertising and sales literature.
 If the product’s name does not adequatel y identify it as a Variable life insurance
product, the representative must full y describe what the produ ct is. Further, an
agent should never suggest that VUL policies or their separate accounts are mutual
funds.
 As explained earlier, every prospect must be furnished a prospectus, either at the
time of the first presentation, or mailed to the prospect in advance.
 Under no circumstances should the agent suggest, or even impl y that the any
variable product, including VUL, is a “short -term” or “liquid” investment.
 Obviousl y, the agent must be extremel y careful about representing as to what is
“guaranteed” and as to what is not, under a VUL or other variable product.
 Even though separate accounts are, for the most part, patterned after mutual funds –
an agent must not represent or indicate that the separate accounts are mutual funds.
However, it is deemed proper to use the experience of a mutual fund invested in the
same products as the separate account so as to be shown what did occur with the
mutual fund.
ILLUSTRATIONS
Because the variable products are rather complex and the outcomes are not readily
and accuratel y forecast without considerable explanation and assumptions, it is rather
difficult to describe to the average consumer exactl y how a VUL functions. The life
insurance industry has a checkered past in using illustrations as a sales tool, so the
insurer’s representative or agent must be extremel y careful and must always tell the
prospect that all illustrations are hypothetical and based on assumptions, and are
certainl y not a guarantee of cash value accumulations. A statement to the effect that
the prospect understands that the illustrations are not guarantees, etc., is required to
be signed by the prospect by some insurers as a precaution.
Illustrations may use any combination of returns up to a maximum gross rate of 12
percent, but onl y if the present market conditions warrant such expectations and an
87
illustration with a “0” return is also provided. The major difficult y suffered by
insurers today with existing blocks of Universal and other interest -sensitive life
products is that the interest rates have declined recentl y, to levels beyond the
comprehension of most people just a few years ago. Unfortunatel y, in the past many
illustrations were shown with an investment return of a level 10% interest rate.
All illustrations must show that separ ate account returns are what determines the
cash values as well as the death benefits, and they must show maximum mortality and
expense charges.
It is NOT appropriate to compare one policy to another based on hypothetical
performances. Further, a hypoth etical illustration can onl y show the relationship
between the cash value and the death benefit value, not whether it is “better” than
another policy. Illustrations comparing VUL to the “buy term and invest the
difference” strategy is considered as approp riate, if the hypothetical returns are
identical and other such stipulations are met.
SPECIAL NASD VARIABLE CONTRACT RULES
Variable contracts have special rules as part of the NASD rules and they appl y
mostl y to the construction of the policy and not spec ificall y to agent’s conduct.
Obviousl y, when the values of a contract can change dail y, it is necessary that the
value must be determined at a specific time, in this case when the payments have been
received—they are considered to have been received when t he application has been
received. This further emphasizes that all applications and premiums must be
submitted to the insurance company’s home office promptl y.
A representative may not sell contracts through another broker -dealer unless the
other broker-dealer is also a member of the NASD. This also means that an agent
cannot sell a product that his broker -dealer is not licensed to sell or does not have a
valid sales agreement.
Sales charges may not be excessive and the NASD Rules set forth what is
considered as “excessive.”
When a sales charge has multiple payments, they cannot exceed 8.5% of the total
payments due in the first 12 years of the contract or for total length if the contract
length is less than 12 years.
If the contract has a single paymen t of the sales charge, the maximums are 8.5% of
the first $25,000 (of the purchase payment); 7.5% of the next $25,000; and 6.5%
for any amount over $50,000.
Section 2300 of the Conduct Rules addresses “suitabilit y” which is the
recommending of products for customers onl y when the product suits the customer’s
needs.
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STUDY QUESTIONS
1. With a variable contract, the “heart” of the policy is
A. competitive premiums.
B. level death benefit.
C. separate accounts.
D. high commissions.
2. The separate accounts of a variable contract change dail y, and the cash value
supporting the policy
A. never changes.
B. changes weekl y.
C. is determined on a monthl y basis.
D. is calculated only at death of the insured.
3. Once the contestabilit y period of a variable policy expires
A. it cannot be voided by the insurer,
B. premiums automaticall y increase by a predetermined factor.
C. the insurer may void the policy for a period of 2 years following a claim.
D. the cash value automaticall y increases by 25%.
4. With variable life policies, the differences between the variable life policy and a
whole life policy
A. are miniscule.
B. must be printed on the cover page and highlighted.
C. may be discussed onl y on an attached Exhibit.
D. must be filed with the SEC within 24 hours of issue.
5. For tax purposes, a variable life insurance policy
A. receives the same favorable tax treatment as other cash value policies.
B. is specificall y excluded from an y taxation at any time.
C. must be shown on the policyowners tax return on the growth of the cash value.
D. must consider all growth in cash value as a 1099 must be filed.
ANSWERS TO STUDY QUESTIONS
1 C
2 C
3 A
4 B
5 A
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