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THE SPECTER OF PREMATURE DEATH
Two things in life, we are told, are certain and
unavoidable: death and taxes. It is not surprising that
people, being the stubborn creatures that they are, have
developed a tool to help handle these unpleasant realities.
That tool is life insurance.
Unfortunately life insurance, much like death and taxes,
can be bewildering and difficult to explain. To begin with,
it is a product that is euphemistically named. Certainly,
"death insurance" is a more accurate term. What we would
gain in precision, however, we would no doubt lose in the
offense of our sensibilities.
A dictionary definition will describe life insurance as
protection against the premature death of an individual.
"Protection" here refers not to stopping the death, but to
a payment of a beneficiary. Again, the confusing nature of
life insurance rears its ugly head: this is a product that
one buys for the peace of mind it engenders while
contemplating death. The inevitable has not been avoided,
but one's loved dependents are at least provided for.
Another of life insurance's perplexing qualities arises out
of how the government views the product. While the
consumer, more often than not, sees this insurance purchase
as a vehicle to save his or her dependents from financial
need, Uncle Sam sees only death's ugly twin-- taxes.
Indeed, for the government, life insurance is defined
through the manner in which it is taxed. This definition is
found in the Internal Revenue Code Section 7702 of the
Deficit Reduction Act of 1984, also known as DEFRA. It is
important at this time to keep in mind that cash value
insurance policies are best thought of as containing a dual
nature regarding money. First, there is the money that
belongs to the policy-owner _ the cash value. In addition
to this, there is also money paid into the policy that goes
to pay for the insurance costs. It is money from this
account that is paid-out if the insured dies. This is the
insurance company's money.
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Internal Revenue Code Section 7702 insists that life
insurance contain a certain net amount of money at risk.
Three tests exist to determine if the net amount at risk
meets the government’s standards. (Should the government’s
standards not be met, the insurance becomes endowment
insurance, and loses its tax advantages.)
First, there is the so-called cash value accumulation test.
This test states that the policy-owner's current cash
value, or the "net cash surrender value," cannot be greater
than the value of the net single premium that could
Compound to the face amount of the policy at age 95 (with a
net single premium discount factor of either 4% or the
contract's minimum guaranteed rate).
A second test is the cash corridor test. The corridor test
is simply relationship expressed as a percentage difference
between the policy's cash value and the policy's face
value. This ratio is found in the Internal Revenue Code
Section 7702(d)(2).
Finally, there is the guideline premium test. This method
can take the form of a guideline single premium or
guideline level premium test. The guideline single premium
test simply means that the policy-owner may not invest more
into his or her policy than the current net value of the
benefits to be paid out at age 95, less a discounted 6%
rate that assumes the stated mortality charges and expenses
of the contract. The guideline level premium, on the other
hand, states the level annual amount necessary to fund
future benefits to age 95, while assuming the contract's
mortality and expense charges, plus 4% interest.
Even to the professional in the field, such aspects of life
insurance as the government's income tax definitions can
seem inarticulate, unwieldy, and simply unclear. To the
consumer, such details about life insurance are more often
than not cryptic, complicated, and simply confusing.
Nevertheless, the total amount of life insurance in force
continues to grow. This should not be surprising, however,
when we reflect upon the needs that life insurance seeks to
address: premature death, payment of estate taxes, an
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income
readjustment
fund,
emergency
monies,
college
funding, and a mortgage fund, to name a few. Confusing or
not, these concerns are real, apparent, and pressing to
most people.
These needs can be broken into two categories, the first
constant, and the second fluctuating. Constant needs
include a death fund to handle premature death, emergency
savings, and estate planning. Fluctuating needs are those
that change as one ages, and include such financial
planning issues as funding a college education, buying out
a business partner, or handling a mortgage after the death
of one's spouse.
While not all of these needs are created by death, death
remains the dominant factor in the life insurance equation.
While life expectancy has increased -- it is currently 73
for a male and 79 for a female in the United States,
according to the U.S. Bureau of the Census -- no one
seriously believes that they can avoid the inevitable. It
is this inevitability that creates many (though not all) of
the constant and fluctuating needs that life insurance is
designed to meet.
Moreover, while actuaries can gain a surprisingly accurate
picture of when one will die, death at an age earlier than
expected is not so rare as to be overlooked. Indeed,
premature death is a more likely event than most persons
believe. Since the time of death is uncertain, it is a form
of risk. It is the temporal uncertainty of this event that
is covered by the life insurance's valued policy contract.
While we have named some of the concerns that life
insurance attempts to address, the real-life consumer's
needs are as unique as only individuals can be. One aspect
of life insurance is, however, uniform: the underlying
reason for its purchase, premature death, is a risk that
touches everyone. Also, at least one cost of death is
familiar to everyone: the loss of a loved one that can
never be replaced. The emotional impact of death can be as
heavy as the event is final.
In
addition
companionship,
to
the
loss
of
another's
love
there are also multiple, difficult
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realities that premature death can create. Foremost, of
course, is the loss of financial support. Should the
principal "breadwinner" die without a life insurance policy
in place, it is quite possible that his or her dependents
will face desperate financial straits.
It is vital to underscore his or her dependents here, as
demographic and cultural changes in the United States have
helped turn life insurance into more than a "man's
product."
Indeed,
with
the
growth
of
female-headed
households, life insurance is needed by a more diverse
public than ever before.
In addition to the changes in heads of households,
dependents are becoming more diverse as well. When the
responsibility of an aged parent, for example, or the
children of a divorced and remarried spouse are added to
one's responsibilities, the need for coverage expands. The
soaring divorce rates that this country has experienced in
recent years, as well as our aging population, make both of
these situations less than unusual, and can dramatically
alter a family's financial planning.
Furthermore,
premature
death
can
have
costs
beyond
emotional bereavement and financial ruin. For many twoincome households, for example, the death of a spouse
causes financial juggling and insecurity rather than
complete destitution. Life insurance in this case plays the
role of a readjustment fund.
The need for a readjustment is also not limited to a twoincome household. Many "traditional" households that lose a
spouse who is not the principal supporter of the family
still face the loss of the skills and services which that
person provided while living. A readjustment fund can play
an invaluable in this situation as well.
Even the single person with no children often "needs" life
insurance. This is because one may not carry any other
insurance coverages that pay for funeral costs, which can
run as high as $10,000. Furthermore, unforeseen and unpaid
expenses can occur, such as bills relating to an extended
final illness. In addition, unpaid bills may also be
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present at the time of death. Life insurance is also an
acknowledgment and assumption of personal responsibility.
Lastly, life insurance is an acceptance of another
unpleasant reality in addition to death and taxes: we
generally do not save enough money. We generally think
primarily about today, and depend upon our earning capacity
to
meet
both
our
current
and
future
obligations.
Ultimately, though, that all-important earning power will
end.
While pursuing a life insurance policy does not mean one no
longer needs to save, it is an important tool with a vital
roll. Along with savings, Social Security, and pension
benefits, it helps provide peace of mind -- and financial
security -- for the inevitability of tomorrow. Fortunately,
unlike death and taxes, financial insecurity can be avoided
through proper planning and the effective use of such
instruments as life insurance.
•
Why People Purchase Life Insurance
The primary purpose of life insurance is to provide a sum
of money to a beneficiary at the death of an insured. The
uses of this money, however, can be quite varied. Also, not
all life insurance policies function equally well for all
goals. The specific purpose of the policy will help
determine the type of life insurance policy that one will
purchase. The following is a list of the most common uses
of life insurance for individuals.
1.
Creation of an Estate
For the majority of persons purchasing life insurance, the
life insurance policy is used to “create an estate.” The
estate in this instance is the sum of money paid to the
beneficiary at the death of the insured. Through life
insurance, the insured determines the exact size of the
estate by selecting the face amount of the policy.
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2.
Protection of an Estate
Some individuals already possess sizeable assets. These
assets may be in a variety of forms, such as property,
investments, collectibles, etc. Depending on the valuation
of the estate, their heirs may face substantial costs at
the time of death. Without proper planning, the estate’s
heirs can be forced to sell assets in order to meet their
tax obligations. Life insurance can be used to provide
available cash to meet necessary estate costs.
3.
Final Expense Fund
When a person dies, a number of expenses will invariably
come due. These can include, but are not limited to, the
following: state and federal death taxes, outstanding
debts, funeral costs, unpaid hospital and medical bills,
and potential host of legal fees (e.g. executor’s fees).
4.
Mortgage or Rental Fund
In a household with only one wage-earner, the premature
death of the wage-earner can force the sale of a home or a
relocation from an apartment due to the loss of income.
Even as the American economy has moved to a two-wage-earner
model, the death of a spouse usually causes serious cash
flow problems for the survivor. A life insurance policy can
provide the liquidity necessary in order to give the
survivor the flexibility to pay off the mortgage or
continue mortgage or rent payments.
5.
Monthly Income Supplementation
When a wage-earning spouse dies, his or her monthly income
is subtracted from the family budget. However, the monthly
income needs and expectations of the surviving family
members remain. Generally, the most pressing need is
maintaining an adequate income stream for housing (as
discussed above). In addition to housing, the remaining
income needs include all the items typical for a household
budget: food and clothing, utilities, entertainment, etc.
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The insurance industry classifies two specific “needs
periods” that follow the death of a wage-earner: the
dependency period and the blackout period.
The dependency period is that flexible time-frame when
dependent children are still living at home. This timeframe is when a family’s income need is the usually the
most significant.
The blackout period occurs when no Social Security benefits
are available for the surviving spouse. If the family has
no children, the blackout period begins immediately, and
continues until age 60.1
6.
Education Fund
Post-secondary
education
is
important
for
enhancing
economic
opportunities.
The
costs
of
post-secondary
education are significant, and their annual increases
continue to outpace inflation. Life insurance can play an
important
role
in
guaranteeing
the
availability
of
education funds.
7.
Emergency Fund
Because of its guaranteed nature, insurance is
valuable as an emergency fund for unforeseen expenses.
8.
also
Retirement Income Supplement
Depending on the type of policy, life insurance can play a
role in supplementing retirement income.
9.
Business Uses
Life insurance is able to deliver a guaranteed amount at a
specific time, and can enjoy a range of tax benefits. For
these reasons, life insurance is often used for a variety
of business purposes.
1
If the family has children, Social Security benefits can be available upon the death of a primary wageearning spouse. However, these benefits will usually expire as soon as the child turns 16.
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REVIEW QUESTIONS
1.
Life insurance is needed by many people, in no small part because
premature death is often more common than realized.
a. true
b. false
2.
The life insurance product is very easily understood. One generally
does not even need an agent to explain it.
a. true
b. false
3.
A definition of life insurance for income tax purposes is found in the
Internal Revenue Code Section 7702 of the Deficit Reduction Act of
1984.
a. true
b. false
4.
In order to be classified as insurance and receive the tax benefits of
the product, a certain net amount at risk must be present.
a. true
b. false
5.
The cash value accumulation test for life insurance states that the
policy-owner's current cash value cannot be greater than the value of
the net single premium that would compound to the face value of the
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policy at age 95 (with a single premium discount factor of 4% or the
contract's minimum rate).
a. true
b. false
6.
The percentage ratio needed to determine the cash value corridor of a
policy is found in the Internal Revenue Code Section 7702(d)(2).
a. true
b. false
7.
Confusion over the product has resulted in a continual shrinkage of
the total amount of life insurance in force over the years.
a. true
b. false
8.
Life insurance can be used to meet both constant and fluctuating
needs that are caused by premature death.
a. true
b. false
9.
As opposed to a valued contract, life insurance is an indemnity
contract.
a. true
b. false
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10.
As a result of the changing demographics and economy of the United
States, life insurance has ceased to be an exclusively "male product.”
a. true
b. false
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ANSWERS TO THE REVIEW QUESTIONS
1. a
2. b
3. a
4. a
5. a
6. a
7. b
8. a
9. b
10. a
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ESTATE PLANNING
•
Determining How Much Life Insurance One Needs2
Life insurance needs fall into three broad categories:
individual and family income needs, business needs and,
estate preservation and liquidity needs. Especially in
relation to estate planning, it is important that a
sufficient sum is available, and that it is directed in the
proper manner.
Today, a wide variety of resources are available to help
one calculate the “correct” amount of life insurance, from
computer software programs to Internet websites. However,
relative ease of calculation is not sufficient for proper
life insurance planning. One must also adopt an approach
that supplies a rationale for the coverage proposed.
For example, a common “rule of thumb” for individual life
insurance is the following: most people require at least 6
to 8 times their annual gross income for adequate coverage.
Thus, a person earning $38,000 per year would require an
approximate
range
of
$225,000
to
$300,000
of
life
insurance. Naturally, this model can break down fairly
quickly. For example, what if the spouse also works, and
makes $50,000? Is all of the income from the
$38,000 per
year earner vital to the family’s financial needs and
objectives? Does the household carry significant debt? If
so, what kind of debt (i.e., mortgage, student loan,
consumer loan, etc.)? Obviously, this general rule of thumb
is only a basic starting point for assessing life insurance
needs.
Many life insurance companies employ one of two specific
needs approaches for determining life insurance needs—the
human life value approach and the human needs approach.
Neither is demonstrably superior to the other,
but the
needs approach has gained ascendancy among the majority of
today’s insurance practitioners.
2
Determining life insurance needs is a very complex process, and different companies use different
approaches and different models. Furthermore, each insurance case is unique, and subject to a wide array of
influencing factors. This section is only a broad overview of the process.
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Human Value Approach
The human value approach was developed by the late Dr. S.S.
Huebner. This is an income replacement reproach. It offers
a method for expressing the economic value a human life.
The “economic value” that this approach uses is a dollar
valuation.
In its most basic outline, the human life value approach
makes use of several assumptions for its calculations: the
current annual after-tax earnings, the number of working
years prior to retirement, and a reasonable after-tax
discount rate.
A weakness of the human life value approach is that it does
not factor inflation and salary increases into its
estimates. The human life value approach tends to produce a
static analysis of insurance needs. As such, it can
overstate or understate the amount of life insurance
needed.
Needs Analysis Approach
The needs approach determines the appropriate level of life
insurance coverage through analyzing specific needs. The
second step in this approach is to measure the family’s
ability to meet these needs in the event that a wage-earner
should die.
Needs are categorized as immediate and multi-period.
Immediate needs can include, but are not limited to, the
following:
1.
2.
3.
4.
Final expenses
Estate settlement expenses
Tax liabilities
Debt liquidation
Multi-period needs include, but are not limited to,
temporary
adjustment
income
for
the
household,
the
children’s and spouse’s income needs, and the spouse’s
retirement needs.
To meet the immediate and multi-period needs, this approach
includes the family’s existing capital (i.e. savings,
investments, pensions, etc.), Social Security, and the
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spouse’s income in its calculations. Usually, the total
dollar amount for needs will exceed the total dollar amount
available from existing capital. This difference will be
addressed by the appropriate amount of insurance.
REVIEW QUESTIONS
1.
The human value approach for determining life insurance needs is an
income replacement strategy. This approach uses the estimated aftertax earnings plus the total number of years worked to find an
appropriate amount of life insurance.
a) true
b) false
2.
All of the following are usually classified as immediate needs under the
needs analysis approach except:
a)
b)
c)
d)
final expenses
estate settlement expenses
spouse’s retirement needs
debt liquidation
ANSWERS TO THE REVIEW QUESTIONS
1.
a
2.
c
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NOTES
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•
Life Insurance and Estate Planning
Estate planning is no more than a plan to accumulate and
then distribute wealth to named heirs. At the death of the
owner, a well-conceived estate plan will experience only
the necessary minimum loss in taxes and expenses.
The legal nature of our society has turned estate planning
into a science, and many professionals need to play a role
in its development. In addition to a qualified life
insurance agent, a lawyer, a banker, and an accountant may
all serve in formulating an effective estate plan.
The life insurance product itself typically plays one of
two parts in the estate "game."
First of all, it can be
used to create an estate. The money that the death benefit
from a high value life insurance policy creates instantly
upon the death of the insured would take many years of
shrewd investing for the average consumer to amass.
Moreover, the benefits from a life insurance policy are not
subject to probate costs. You will remember of course that
probate is nothing more than that legal process by which
money and property is transferred to the deceased's heirs.
In cases where the proceeds of the policy's death benefit
are not the sole estate, life insurance performs a
different function. Here, the monies generated by life
insurance serve the purpose of liquidity. Non-liquid assets
are preserved that in other circumstances might have been
sold for death taxes, funeral costs, and estate clearance
costs.
When the named insured in the policy has any "incidents of
ownership" at the time of death, the paid out death benefit
can and will be taxed according to the federal estate tax.
Furthermore, the monies paid out by the policy are attached
to the insured's gross estate when their payment is
directed to the estate.
"Incidents of ownership" are those powers that are typical
to ownership of a policy. Such powers might include policy
loans and partial surrenders, optional modes of settlement,
and the right to change a beneficiary.
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Should an absolute assignment be made, however, these
incidents of ownership are waived, the death benefit's
monies are potentially separated from the gross estate. We
say potentially because the assignment must be made three
years prior to the insured's death in order to avoid
federal estate taxes.
At this point, the consumer will wonder what has happened
to his or her tax benefits. We must emphasize that it is
the federal income tax that is waived for the death benefit
in a life insurance policy, not all taxes. The wishful
thinking of consumers often lulls them into believing that
every financial aspect of their life insurance contract is
tax-sheltered.
Again, the lump sum payment of a life insurance death
benefit is free of federal income tax. Alternative modes of
settlement, however, may not escape federal income tax. For
example, periodic distribution of an insurance policy's
death benefit are subject to tax on the interest income
(the principal remains tax free).
Lastly, life insurance is a way to provide an estate that
is fair to all one's heirs. In cases where one's assets are
tied up in property, a life insurance death benefit
provides a method to keep ownership of property in the
hands of one heir, with an equal value in cash proceeds
from the policy going to other heirs.
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REVIEW QUESTIONS
1.
Estate planning is really no more than commonsense, and is a matter
that one can easily take into their own hands without the counsel of
professionals.
a. true
b. false
2.
Life insurance proceeds avoid all taxes when disbursed to the
beneficiary in a lump sum.
a. true
b. false
3.
One benefit of life insurance is that it can help provide fair and equal
transferring of an estate to one's heirs.
a. true
b. false
4.
Life insurance is often used as a way of providing liquidity in estate
planning, as it avoids probate and provides immediate cash.
a. true
b. false
5.
Federal estate tax, death taxes, and funeral expenses are some of the
expenses associated with estate planning.
a. true
b. false
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6.
Generally, when an insured has some form of incidents of ownership
in a policy, he or she can expect that the death benefit will be attached
to the gross estate.
a. true
b. false
7.
One device to avoid attaching a life insurance's proceeds to the gross
estate is to make an absolute assignment at least three years prior to
an insured's death.
a. true
b. false
8.
For the typical consumer, life insurance is often used to actually
create an estate at death.
a. true
b. false
9.
Incidents of ownership simply means that one has rights to make
policy loans, partial surrenders, choose a beneficiary, and decide
upon the mode of settlement.
a. true
b. false
10.
Probate is nothing more than a legal process through which money
and property is transferred to one's heirs.
a. true
b. false
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ANSWERS TO THE REVIEW QUESTIONS
1. b
2. b
3. a
4. a
5. a
6. a
7. a
8. a
9. a
10. a
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THE ROLE OF LIFE INSURANCE IN THE FINANCIAL
PLANNING PROCESS
Obviously, a death fund which pays for final expenses is a
part of one's financial planning. Providing for dependents
is also within the domain of financial planning, whether in
delivering a specific lump-sum that avoids federal income
tax and "creates" an estate, or in efficiently disbursing
an estate.
All of these elements of financial planning focus on life's
end. As such, they are permanent needs. Life insurance can
play an additional role in financial planning, however, and
as such is indeed a tool for the living, and not just one's
heirs.
Foremost, life insurance can form an effective savings
vehicle that can either serve as an account geared to a
specific goal, an emergency cash fund, or both. Life
insurance is effective in such a capacity because of a
unique tax advantage of this product. Like an IRA, or an
annuity, its account can grow tax-deferred. Unlike the IRA
or annuity, however, many cash value life insurance
policies retain a level of penalty-free liquidity that make
them the envy of these other investments. Even with the
expense fees and loads of the insurance policy, the taxdeferred build-up of interest over time is a powerful tool
for financial planning, and an effective method for many
families searching for a tax-advantaged tool to meet
changing goals.
In addition to providing an emergency savings account, life
insurance can be used as a mortgage fund. In this capacity,
life insurance is designed to protect a survivor from the
burden of mortgage payments. This feature allows one to
remain in a home that under other circumstances would have
to be sold or rented out.
Life insurance can also be a means of saving for a college
fund. The cash value universal variable insurance is
perhaps the best vehicle for this task, as the flexibility
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of this product with its aggressive investment portfolio
allows for an attractive build-up of tax-deferred, liquid
funds.
Finally, life insurance can play a useful role for
continuing business operations. For example, the policy can
be used to hire a replacement for the owner in event of his
or her death, it can repay business loan obligations, or
buy-out a partner.
The Strengths of the Life Insurance Product
Life insurance is a form of valued property, and is in many
ways unique. It offers numerous advantages over other types
of property for meeting specific financial planning needs.
• Favorable Tax Treatment
Cash values in a whole life policy will grow tax-free. The
proceeds from any life insurance policy, whether whole life
or term, are exempt from federal income tax when paid in a
lump sum.
•
Guaranteed Values
The majority of life insurance policies will guarantee the
face value of the death benefit. Depending on the type of
policies, other guarantees may be available. These can
include cash values, minimum interest rates, and premium
rates. Guaranteed sums and expenses are very valuable for
the financial planning process.
•
Appreciation
The payment of a death claim represents a significant
appreciation in value over the total of premiums paid into
the policy.
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•
Direct Payment to Beneficiaries
The proceeds from a life policy are payable directly to the
beneficiary. In most cases, an insurance company will issue
payment for a death claim within 24 hours after the claim
work has been completed.
•
Flexible Income Options
Death benefits are available to the beneficiary in a
variety of formats, called “settlement options.” Settlement
options are the choices presented to a beneficiary for
collecting the death benefit. These can include a lump sum
payment, an interest option, a fixed amount option, a fixed
period option, and a life income option.
With an interest option, the death benefit is left on
deposit with the insurance company with earnings paid the
beneficiary annually. A fixed amount option is a death
benefit paid in a series of fixed installments until the
proceeds are exhausted. A fixed period option occurs when
the death benefit proceeds are left on deposit with the
insurance company and paid out in equal payments for a
specified period of time. A life income option is a life
annuity; with this option, payments occur for the life of
the insured.
If the insured possess a cash value life insurance policy,
he or she will also have access to the policy’s cash value
in the form of loans, surrender values, and, in some cases,
partial surrenders.
•
Protection from Creditors
A life insurance policy is valued property, however, unlike
most forms of property, proceeds from a death benefit
receive protection from creditors in the majority of
instances.
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REVIEW QUESTIONS
1.
Clarence is single, but has a sizeable amount of debt. Some of these
loans have been co-signed by his girlfriend. One definite use that
Clarence could make of a life insurance policy is
a)
b)
c)
d)
2.
Life insurance is often used to provide a monthly income stream to
dependents when a wage-earning spouse dies. The insurance industry
classifies two specific “needs periods” following the death of a
household wage-earned. These two periods are:
a)
b)
c)
d)
e)
f)
3.
an education fund
an estate conservation tool
a final expense fund
none of the above
the dependency period
the secondary period
the blackout period
the Social Security
a&e
a&c
The proceeds from a life insurance policy, when paid in a lump sum, are
exempt from federal income taxes.
a) true
b) false
4.
In most cases, the death benefit proceeds from a life insurance policy
cannot be attached by creditors.
a) true
b) false
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ANSWERS TO THE REVIEW QUESTIONS
1.
c
2.
f
3.
a
4.
a
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Chapter Two
Traditional Life Insurance
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FUNDAMENTAL ELEMENTS OF LIFE INSURANCE
All life insurance agreements have fundamental elements
that make the policy workable. Simply put, in order to
provide their service, which is essentially a disbursement
of monies, they must first somehow accumulate money. The
most obvious payment of money to the consumer by the
insurance company comes through the death benefit, or face
value of the policy. However, money can flow from the
insurance company to the consumer in other ways. Two
examples of payment to the insured are survivorship
benefits, and the treatment of cash values.
The survivorship benefit is a feature of cash value
insurance policies that allows insureds who do not die or
surrender their policy to receive the face value of the
policy. The accumulated cash value is not paid out to the
insured, but remains with the company.
Another possibility of cash flow from the insurance company
to the insured occurs in the case of dividends. In a
participating policy, the insurance company will credit the
insured with gains made from the company's investment
accounts.
Money flows into the insurance company through a number of
paths. These are various charges to the insured. First,
there is the "cost of insurance" itself, the so-called
mortality charge. This charge is based upon mathematical
principles used by the company's actuary to calculate the
probability of an insured's death. The actuary uses what
are termed mortality tables that factor an insured's age,
sex, state of health and habits in order to provide a
statistical snapshot. The underwriter then classifies the
applicant into risk categories based upon the actuarial
information.
This information allows the insurance company to have a
good sense of its expected losses. Knowing this allows the
company to charge the insured proper rates so that each is
bearing his or her proper amount of cost. The actual cost
of the premium is derived by a use of a rate that assumes a
cost per thousand dollars of insurance. That rate times one
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thousand dollars of coverage equals the premium that the
insured will need to pay for coverage.
The insurance company carries still other costs for doing
business which it will pass on to the insured. One such
area of cost it that of general administration. The state
premium tax and overhead office costs are both a part of
this charge. The cost of managing the investments,
distributing the dividends, and collecting premiums also
play a large part in this expense.
Insurance also needs to pay for what is termed its
acquisition expenses in order to function efficiently. This
is the cost of getting the product out before the consumer
and processing the applicant. General sales costs such as
advertising,
promotions,
and
the
printing
of
sales
literature all play a part in this expense. In addition,
the
payment
of
agent's
commission
comes
under
the
acquisition expense heading, as does the printing of the
policies and application forms. Lastly, the services which
the insurance company uses to guard itself against adverse
selection also fall under this rubric.
In short, it is not useful to think of the premium as the
cost of insurance. The premium is more than this. It
reflects the cost of pure insurance by covering the
mortality costs of the insured, but it also pays for the
insurance company's operations. In addition to this, a
portion of the premium is credited to the general or
separate accounts of the company. This portion of the
premium generates the cash value of the insured.
Traditionally,
premiums
were
paid
annually,
but
the
emergence of flexible premium policies such as universal
and variable universal life have altered this situation.
Even though the newer, flexible policies offer more choices
on how the premium can be paid, the cost of insurance must
still ultimately be paid. Should the premiums paid into the
policy
be
insufficient
for
insurance
coverage,
the
accumulated cash value will be tapped to meet the insurance
company's costs.
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REVIEW QUESTIONS
1.
A survivorship benefit is a way in which the insured who has neither
died nor surrendered his or her policy can receive the death benefit's
face amount.
a. true
b. false
2.
The insured can receive a credit from the insurance company if the
company's investment account earned a profit. This credit can come in
the form of a dividend.
a. true
b. false
3.
The mortality charge is the actual cost of pure insurance protection.
a. true
b. false
4.
The mortality cost is arrived at by the sales agent assessing the health,
age, and habits of the insurance applicant.
a. true
b. false
5.
The information provided by the applicant and used by the actuary and
underwriter provide a statistical picture that allows the company to
adequately classify the risk and charge an appropriate premium.
a. true
b. false
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6.
The cost of general business administration is another charge that the
insured will assume in order to receive coverage.
a. true
b. false
7.
Acquisition expenses pay for general overhead, the cost of managing
investment accounts, collection of premiums, and the state premium
tax.
a. true
b. false
8.
Advertising, sales promotions, and the printing of sales literature are
all elements of the insurance company's acquisition costs.
a. true
b. false
9.
Premiums include more that the cost of pure insurance coverage.
a. true
b. false
10.
Premiums must always be paid on an annual basis.
a. true
b. false
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ANSWERS TO THE REVIEW QUESTIONS
1. a
2. a
3. a
4. b
5. a
6. a
7. b
8. a
9. a
10. b
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THE CONCEPT OF CASH VALUE
Cash value is the concept that is often the most confusing
concept of insurance to consumers, and the most decisive
feature that distinguishes whole life and its various
innovations from term insurance. While the cash value
element of the whole life family has many qualities which
make it potentially more attractive than term insurance,
ironically the mysterious functioning of this policy
feature sometimes drives customers away. Simply put, it is
challenging to sell a product in which the most exciting
benefit is not always readily comprehended.
While the mathematical computations and financial prognoses
that support cash values accounts are rather mind-boggling,
the basic concept is not. In his or her role as educator,
the insurance agent needs to be able to explain effectively
the cash value idea to the consumer.
Cash value in a whole life policy is the result of the
overpayment of the premium. Initially, these premiums do no
more than cover the insurance company's cost of doing
business with the insured. Subsequently, the cash surrender
value of the policy is little or nothing in the contract's
early stages. The passage of time, however, has a powerful
effect on the money wisely handled. In other words, the
cash value in the policy grows.
This growth occurs because the vehicle in which it is
invested grows. In the broadest terms, this investment
vehicle will take the form of either a general account or a
separate account.
A general account in life insurance is the investment
account of the life insurance company. That it is not a
single account should not be surprising, because an insurer
bases its risk assessments upon calculations derived from
the law of large numbers and the pooling of risks.
Individual accounts in such a scheme are not useful.
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The insurance company's general account, or investment
account, is geared toward conservative vehicles. This is at
least partially due to the fact that insurance companies
face
oversight
and
regulation
from
the
Insurance
Commissioner in their state (or states) of operation. The
state regulator will usually set a ratio of what percentage
of the insurance company's policy-owner's surplus, or
admitted assets, can be in any one form of investment.
The investments that comprise the equity of the insurance
company's general account may include stocks, bonds,
mortgage accounts and speculative real estate. Typically,
the State will limit an insurance company's holdings in
preferred stocks to 20% of a single company, with not more
than a 2% holding of a company's admitted assets, while
common stock holdings cannot be larger than 1% of admitted
assets.
Bonds
tend
to
be
debentures
rather
than
convertibles. Speculative real estate holdings are limited
to 10% of the company's admitted assets.
Both traditional whole life and universal life insurance
make use of the insuring company's general account for the
investment purposes of the excess premium. While this can
provide a safe rate of return (providing the insuring
company is stable and well-funded), many consumers desire
to forego a certain amount of safety in order to reap
higher returns. To this end, variable and variable
universal life insurance were formed.
Unlike traditional whole life and universal life insurance,
variable and variable universal products make use of a
separate account. The separate account for these products
is an investment portfolio (or portfolios) maintained or
attached to the insurance company. These portfolios are
essentially mutual funds, and like mutual funds, they can
follow a specified investment strategy.
As
mutual
fund
vehicles,
these
portfolios
are
professionally managed, and can be matched in order to
provide diversification. Also, the cash value can be moved
through the various portfolio options in order to take
advantage of market shifts. The policy owner can make these
decisions, or control can be handed to an asset allocation
service. The investment possibilities in this arrangement
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are numerous, and can include such strategies as listed
below.
Income Funds
Income funds invest in dividend-paying stocks, bonds, and
money-markets. Their goal is not growth of capital, but the
payment of income through dividends and interest earnings.
Growth Funds
Growth funds are the opposite of income funds. They invest
in common stocks with the goal of capital appreciation. The
emphasis might be on sustained, stable growth, with
investments geared toward established companies. Another
approach would be to target emerging companies for a more
volatile – and hopefully, more aggressive -- rate of
return.
Money Market Funds
A money market fund is one that invests in short term
securities characterized by a high level of liquidity and
security. These funds produce comparatively low rates of
return because of the short duration of the investment
vehicles, but are valued for their low degree of risk.
Bond Funds
Bond funds aiM to produce income. They invest in debt
securities, and possess long term rates. They are riskier
than growth and stock funds, but the risk level can be
raised or lowered in accordance with the type and grade of
bonds in which the fund invests.
As the monies in separate accounts are securities, they
must be handled and regulated as securities. In order to
sell
variable
life
insurance
policies
(or
variable
annuities), an agent needs to be licensed by the National
Association of Securities Dealers. The NASD is a group of
brokers and dealers that operates under the umbrella of the
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Securities and Exchange Commission. The exams to sell this
product line are taken in addition to the Life and Health
Examination.
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REVIEW QUESTIONS
1.
Along with the duration of the insuring agreement, the cash value
accumulation in the policy is a decisive difference between whole life
and term insurance.
a. true
b. false
2.
The general account is the investment account of the life insurance
company.
a. true
b. false
3.
The investment account of the insurance company is subject to little
or no regulation by the State Insurance Bureau.
a. true
b. false
4.
While an insurance company's investment account may include
speculative real estate in addition to bonds and long term mortgages,
the real estate investments usually make up no more than 10% of the
company's admitted assets.
a. true
b. false
5.
"Admitted assets" is a term that describes the policy owners' surplus
in the insurance company's account.
a. true
b. false
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6.
Traditional whole life invests policy owner surplus in the general
account. Universal life and all the other variations of whole life invest
in separate accounts.
a. true
b. false
7.
A separate account operates like a mutual fund.
a. true
b. false
8.
Variable and variable universal are insurance policies that make use of
separate accounts to attain a higher rate of return.
a. true
b. false
9.
Separate accounts, like pure mutual funds, are professionally
managed and have a targeted investment strategy.
a. true
b. false
10.
Separate accounts are essentially securities, and are regulated as
such by the SEC.
a. true
b. false
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ANSWERS TO THE REVIEW QUESTIONS
1. a
2. a
3. b
4. a
5. a
6. b
7. a
8. a
9. a
10. a
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CASH VALUE VERSUS TERM
The title of this part is perhaps misnamed, as it generates
a sense of controversy and antagonism by the use of
"versus." That is not our intent, but we thought it
appropriate to try and capture a feel for the content of
the plethora of pop financial planning books and magazine
articles current in the market.
To read some of today's popular financial planning
literature targeted to the general consumer, one would
think that the purchase of life insurance is best achieved
by following some magic formula. Depending on the prejudice
of the writer, this all-purpose template would lead the
consumer to invariably buy either term or some form of
whole life.
The problem with such an approach is obvious to the
professional in the field. Appropriate insurance coverage
is completely dependent upon the consumer's unique needs.
Obviously, not all consumers have the same needs (or
lifestyles, spending habits, expectations, etc.)
Indeed, we approach the problem entirely off-center when we
think in terms of cash value "versus" term insurance. The
comparison is without meaning when an understanding of the
consumer's specific needs and desires is lacking.
Naturally, we can speak in some broad generalities. Term
insurance, for example, does tend to be cheaper. Again,
however, so much of this can change when we apply the
generalities to a specific case. Furthermore, cheaper is
not always better. While this may sound quaint in a cost
conscious world, it is nevertheless a maxim which often
holds true. In addition, "cheaper" may be a temporary
condition, especially as the insured ages.
One of the recent rallying cries for term insurance is BTID
-- "buy term, invest the difference". While this tragedy
can have definite merits, it simply will not suffice as an
axiom.
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Especially in the case of a policy replacement, it is vital
that the insurance agent be keenly aware of the consumer's
needs, desires and expectations. To avoid a situation of
twisting, it is imperative that the new policy will clearly
present
a
gain
for
the
insured.
Typically,
policy
replacement can present a new two year contestable period
and higher premium rates. The insured must know what he or
she is getting into when replacing a policy, and should be
pursuing some recognizable and coherent financial planning
strategy rather than the cant of the pop financial media.
Another general rule is that it seldom makes sense to
replace a cash value policy that an insured has held for a
long period.
Finally,
products.
can be
specifics
cash value and term insurance are complementary
Each can play a role in life insurance, and each
appropriate or inappropriate based upon the
of the situation.
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REVIEW QUESTIONS
1.
Term insurance is always more appropriate than cash value whole
life, and should always replace such outmoded contracts.
a. true
b. false
2.
The concept "cash value versus term insurance" is really
inappropriate. Instead of an antagonistic relationship, a
complementary one exists, as each product serves specific needs.
a. true
b. false
3.
While term insurance does tend to be less expensive than whole
life and its Innovations, it is not necessarily the best choice for the
consumer.
a. true
b. false
4.
BTID, or "buy term and invest the difference" is a strategy that is
never appropriate for life insurance consumers.
a. true
b. false
5.
Policy replacement can present a number of risks for a consumer,
such as a higher premium and new two year contestable period.
a. true
b. false
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ANSWERS TO THE REVIEW QUESTIONS
1. b
2. a
3. a
4. b
5. a
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Chapter Three
The Traditional Products -Term Insurance
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TERM INSURANCE FUNDAMENTALS
Term Life Insurance provides life insurance coverage for a
specified period of time, or “term.” Term life is the most
basic form of life insurance. Often, term life is thought
of as “pure” insurance because it offers only a death
benefit. Because term life is a temporary, “no-frills”
policy, it is generally used for limited, time-sensitive
periods—for example, a young couple may carry term
insurance until their children can earn their own incomes.
The duration of the policy depends on the design offered by
the insuring company. Typical terms include 1, 5, 10, and
20 years.
Another method of specifying the policy’s time period is to
define the age at which the policy will expire. Usually
age-based expirations include 60, 65, or 70. Such policies
are referred to as “term to age” plans, such as “term to
age 65.”
The primary advantage of term life insurance is based on
cost. One can usually acquire the largest death benefit
through the smallest premium with this policy design. * This
is an attractive feature for young people who have
insurance needs but are just entering the workforce or have
limited financial means. Because of its initial low cost,
term life insurance coverage finds enthusiastic proponents
among those who believe life insurance should be no more
than pure insurance coverage.
The primary disadvantages of term life are fivefold: 1) the
policy does not provide life insurance coverage for the
insured’s entire life; 2) the policy does not provide taxfree accumulation of cash value; 3) since no cash value can
accumulate, the policy cannot provide living benefits; 4)
the policy’s premiums become progressively more expensive
at later ages; 5) it is generally not available to persons
in extremely poor health, while persons in moderately poor
health (termed “substandard”) often can find ordinary whole
life policies easier than term life policies.
*
This does NOT mean that term insurance is always the most affordable or least expensive form of life
insurance over the entire duration of needed coverage. Since term premiums increase with each renewal as
the insured grows older, the premium cost for term insurance will ultimately exceed the level premium
charged for a whole life policy.
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• Characteristics of Term Life
All term life insurance has these three characteristics:
•
Death benefit3
•
Protection for a specified time period
•
Decreasing, level, or increasing face amount
Decreasing Term Insurance
Decreasing term life insurance provides death benefit
protection in decreasing increments for a specified period
of time. At the end of the specified time period, the death
protection is $0.
TABLE 1-1
$100,000
$100,000 Ten Year Decreasing
Term Policy
$75,000
$50,000
$25,000
$5,000
$0
Premium
1
5
10
$100
$100
$100
Policy
Year
$0
In Table 1-1, the decreasing term concept is visually
described. In this example, a $100,000 decreasing term
policy with a ten-year term period has been purchased. The
features of the policy are the following:
3
A death benefit is a sum, stated in the life insurance contract, that is to be paid upon the death of the
insured. The death benefit equals the face value of the policy, less any outstanding loans.
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•
•
•
The duration of the policy is ten-years
Available
amount
of
insurance
protection
decreases yearly
The amount and frequency of the premium remain
the same, or level, throughout the ten-year life
of the policy—thus, the same premium is buying
increasingly
smaller
amounts
of
insurance
protection
Uses of the product
Decreasing term is used when a need for life insurance
decreases on a regular, predictable basis. A commonly
shared decreasing need is a mortgage balance. Because it is
used so frequently in this capacity, decreasing term is
often called mortgage cancellation insurance. Although a
mortgage is the most typical situation met with decreasing
term, any large loan that is paid in installments could
create a need for this type of term coverage.
An example of decreasing term providing mortgage protection
functions as follows: Kerry purchases a home with a
$100,000 30-year fixed-rate mortgage. Kerry’s wife does not
work, and he is concerned that she could not meet the house
payments if he were to die. Kerry reviews the amortization
schedule of his mortgage and purchases a decreasing term
policy that keeps pace with the declining balance of the
mortgage.
NOTES
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PRACTICE QUESTIONS
1.
Morrie Monie and his wife, Penny, have just purchased a 20-year
decreasing term policy to pay off their mortgage in case Moose passes
away. Which of the following statement(s) is/are correct?
a)
b)
c)
d)
2.
The Monie’s have purchased a mortgage cancellation policy.
The Monie’s premiums will decrease each year because the level
of insurance protection will decrease.
While the premium will remain the same over the policy’s life, the
Monie’s will annually be buying less insurance .
The Monie’s purchased their policy in 1980. Morrie passes away
in 2002. Unfortunately, their policy will have expired and Penny
will not receive any proceeds.
Which of these two cases is the better choice for a decreasing term
policy?
a)
b)
Sammy has just taken out a 15-year mortgage. Because his wife’s
job would not allow her to meet the house payments if he were to
die, he wants to purchase a policy that will pay the mortgage for
her.
Eddie wants to purchase a policy that will last his entire life and
provide a supplement to his retirement fund.
ANSWERS TO THE REVIEW QUESTIONS
1.
a, c, d
2.
a
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Level Term Insurance
Like all term policies, level term life provides pure
insurance protection for a specified period of time. Level
term also provides a level death benefit and a level
premium for the duration of the policy.
TABLE 2-1
$100,000 Ten
Year Level Term
Policy
$100,000
(End of
Term)
$0
Policy
Year
Premium
1
5
$100 …
$100 …
10
$100
(End of
Term)
$0
In Table 2 – 1, the level term concept is visually
described. In this example, a ten-year level term policy
has been purchased. The death benefit remains $100,000
throughout the ten years that the policy is in effect. The
premium of $100 also remains the same for each year of the
policy. After the tenth year, the policy expires—no more
premium is due, and no death benefit is forthcoming. If the
insured were to reapply for a new policy, the premium would
be more expensive, because the insured was now ten years
older.
An example of a level policy in action is as follows: Gerry
and his wife, Corrine, have two children, aged 8 and 6,
plus a new mortgage. Gerry is an electrician and Corrine
works part-time as a teacher’s aide. Gerry wants to make
sure that the following needs would be met if he were to
die: one, that enough income would be generated so that
Corrine could continue to work part-time and still meet all
the household bills, including the mortgage, and two, that
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enough money would be available to help fund the children’s
college education. Gerry’s agent reviews Gerry’s household
income, debt, and assets. The agent suggests a 20-year
level term policy with a $300,000 face value as a low-cost,
temporary insurance solution.
Uses of the Product
Level term insurance is called for when one has a specific,
time-sensitive need for life insurance protection. Level
term is popular among younger persons who can purchase a
relatively large face amount for a specific premium. Often
this type of policy is used to meet the life insurance
needs of a family during the time when the children are
dependent.
NOTES
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REVIEW QUESTIONS
1.
Jose has a wife and one twelve-year old child. Even though his wife,
Gertrude, has a good job, Jose is worried that she and their child, Marie,
will be hard put to enjoy the lifestyle they are accustomed to should he
die. Jose’s agent suggests he purchase insurance that will pay Marie
$250,000 if Jose dies at anytime in the course of the next ten years. Jose
is also told that the premium for this insurance will be the same each
year for the ten years that the policy is in force. Which of the following
most completely describes the kind of policy has Jose purchased?
a)
b)
c)
d)
2.
term life insurance
decreasing life insurance
level term life insurance
ten-year level term life insurance
Steve believes he is a shrewd insurance buyer. Five years ago, he
purchased a five-year level term policy because “the price was right.”
The policy has just expired, and he wishes to purchase the same policy
again. He is surprised to find that, even though the policy is for the
same face value and same duration of time, the premium has gone up.
This increase is because of:
a)
b)
c)
d)
inflation
unscrupulous agent practices
Steve is now five years older
none of the above
ANSWERS TO THE REVIEW QUESTIONS
1.
d
2.
c
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Increasing Term Insurance
Increasing term life insurance is essentially the opposite
of decreasing term insurance. Increasing term insurance
provides an increase in the amount of death benefit on an
annual basis. Unlike decreasing term, however, increasing
term insurance is usually not sold as a self-standing
policy. Instead, increasing term is usually a rider to an
existing policy.4 As a rider, increasing term acts as an
additional benefit to the base policy. A common example of
increasing term is a return of premium policy in which the
sum paid at death is the face amount plus an amount that is
equal to all or a portion of the premium paid.
• Major Features of Most Term Products
Option to Renew and Varieties of Renewable Term Life
In most cases, a term life insurance policy offers the
policy owner the option to renew the contract without
showing
evidence
of
insurability.
This
means
that,
regardless of the physical health of the insured, the
insured must be allowed to renew the contract and the
premium cannot be increased in response to any physical
condition. However, the renewed premium will be higher to
reflect the insured’s new age.
To control its risk level, the insurance company will set
parameters when a policy may be renewed. These parameters
could be a set number of times, or specified ages. On a
practical level, whatever the parameters of renewal, a term
policy will only be renewed while it is cost effective to
do so. Ultimately, the premium will become prohibited based
on the insured’s attained age and life expectancy.
A policy that is renewable will cost more than a
nonrenewable policy because the insurance company assumes
more risk. A nonrenewable term policy is the most basic
form of life insurance. It provides a level death benefit
with a level premium. At the end of the term, the policy
expires.
4
A rider is an endorsement to a life insurance policy that adds additional features and benefits to the contract.
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Renewable policies, however, give the policy owner choices
based on the policy design. For example, annually renewable
term, or ART, provides coverage for one year with the
option to renew (without evidence of insurability) at the
end of the policy.5 Because the premium increases, or “steps
up” each year, an ART’s premium is called a “step-rate.”
Most designs of this product limit the number of times the
policy can be renewed, and the final age at which can be
insured under the policy.6
Another renewable term policy design is called re-entry
term. A re-entry policy offers the insured the option to
renew, without evidence of insurability and at a specified
premium rate. Usually, the renewal occurs every five years.
The insured agrees to submit evidence of insurability at
specified periods. If the insured is in good health, the
renewal premium rate will be lower than the guaranteed
rate. If the insured’s health is not good, he or she may
still renew, but at the contract’s guaranteed rate.
Option to Convert
It is not uncommon for a term insurance policy to be
“convertible.” This means that an insured may convert their
current term contract into a permanent, or whole life,
insurance contract.7 Usually, a time-limit is stated in the
policy for converting.
The option to convert is a valuable privilege in the term
contract because it allows the insured to replace a
temporary insurance coverage with a permanent coverage
without evidence of insurability. Thus, an insured who
purchased a ten-year level policy could convert his policy
into a permanent policy without having to provide any
information about his health history and current physical
condition, let alone undergo a physical. Even if one
developed a physical condition that would create a greater
risk for the insurance company, this information does not
have to be revealed to the company, and the company cannot
refuse coverage.
5
Annually renewable term is also called yearly renewable term, or YRT, by some companies.
6
Again, these limits are based on the insurance company’s design choices. However, while a policy may be
renewable to ages beyond 65, it becomes less and less cost-effective for the insured to pursue this option.
7
A term policy that does not possess the option to convert is called a nonconvertible policy.
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Naturally, this does not mean that the insured will pay the
same premium for his new, converted policy that he paid for
his original policy. When an insured converts a policy, the
conversion will be based on either the attained age or
original age of the insured.
An attained age is the insured’s age at a particular point
in time. An original age is the insured’s age at the date
that a term policy was issued. A conversion based on
attained age raises a premium to reflect the insured’s
current age and reduced life expectancy. A conversion based
on
original
age
is
sometimes
called
a
retroactive
conversion. The premium in this type of conversion is
lower, but the policy owner must pay an additional sum to
make up for the difference between the term and whole life
insurance from the date of the term policy’s original issue
to the time of conversion.
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REVIEW QUESTIONS I
1.
Clara is 26, divorced, with two children. In talking with her agent, she
believes a $500,000 face amount would be adequate. She would like to
purchase a whole life policy, but is feeling strapped for cash while she
finishes law school. The insurance strategy her agent could suggest
that would make the most sense is:
a) A non-convertible ART policy with a face amount of $1,000,000.
b) A non-convertible ten-year level term policy with a face amount of
$750,000.
c) A $500,000 decreasing term policy with a ten-year term period.
d) A ten-year convertible term policy with a face amount of $500,000.
2.
Duke purchased a 20-year renewable term policy with an option to
convert within five years of the policy’s expiration date. It is now ten
years since the policy’s inception, and Duke has developed high blood
pressure and diabetes. Will he be able to convert his policy to
permanent insurance?
a) Yes, provided the conversion occurs within five years of the policy’s
expiration.
b) Yes, provided he passes a physical examination.
c) No, because his health situation has changed dramatically.
3.
Graham has an ART policy that is renewable to age 70. Graham is now
40, and has renewed for five years in a row. Which statement is true?
a) Graham’s premiums have increased with each renewal.
b) Graham’s premiums have stayed the same, because the policy has
the option to renew until age 70.
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4.
Trent has a renewable term policy with a re-entry option. Trent’s policy
requires that he take a physical at specific times. Trent is in excellent
physical condition, and continues to be insurable. When he renews his
policy, his rates are:
a)
b)
c)
d)
lower than the policy’s guaranteed rates
the rate guaranteed by the policy
higher than the policy’s guaranteed rate
none of the above
ANSWERS TO THE REVIEW QUESTIONS I
1.
d
2.
a
3.
a
4.
a
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REVIEW QUESTIONS II
1.
Term insurance has only a small slice of today's life insurance market.
a. true
b. false
2.
Term insurance is pure insurance protection.
a. true
b. false
3.
Because it does not possess a cash value component and exists for
only a limited, time frame, term insurance tends to be relatively
inexpensive.
a. true
b. false
4.
While it may begin as a good buy, term insurance does become
progressively more expensive as the insured grows older and
becomes more of a risk.
a. true
b. false
5.
Term insurance is best suited to meet specific, temporary needs.
a. true
b. false
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ANSWERS TO THE REVIEW QUESTIONS II
1. b
2. a
3. a
4. a
5. a
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Chapter Four
The Traditional Products (B) -- Whole Life
Insurance
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WHOLE LIFE INSURANCE FUNDAMENTALS
Whole life insurance is the direct opposite of term
insurance.8 While term insurance is designed to expire after
the end of a specified period, whole life insurance is
designed to be “permanent.” Permanent in this context means
for the whole life of the insured, or until the age of 100.9
Whole life insurance can be represented visually by the
following chart:
TABLE 3 – 1
The Policy’s Duration
Issue Age
Age 100
The Policy’s Premium
$1500
$1500
$1500
$1500
$1500
The Policy’s Face Amount
$100,000
$100,000
The Policy’s Cash Value
$100,000
$0
A whole life policy has premiums that are payable to age
100. The premiums are level, so unlike term insurance, a
whole life policy does not become prohibitively expensive
as the insured ages.
8
Other terms for whole life are “straight life,” “ordinary level-premium whole life,” and “traditional whole
life.”
9
The use of the age 100 as a “cut off” is an actuarial device. While some persons obviously do live to 100,
the number is statistically insignificant; it is presumed that by age 100 that the insured will be dead.
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A whole life policy can offer level premiums because
initially overcharges the insured for the cost of
chosen face amount. The excess amount is invested by
insurance company, and credited to the cash value in
insured’s policy. This cash value accumulates tax-free,
earns interest. Cash value provides a savings element,
is a major source of the policy’s living benefits.10
it
the
the
the
and
and
The living benefits from a life insurance policy can
include
loans
against
the
accumulated
cash
value.
Typically, insurance companies will allow up to 98% of the
cash value in form of a loan with simple interest. The loan
does not have to be repaid, but an unpaid loan plus its
accumulated interest will be subtracted from the face
amount before it is paid as a death benefit or an
endowment.
Typical uses for a whole life policy’s cash values are the
following:
•
•
•
•
•
Providing collateral for a loan
Paying off a mortgage
Supplementing retirement income
Providing an emergency cash fund
Establishing a college fund
A whole life policy provides insurance protection until age
100, when the policy reaches maturity. At maturity, the
whole life policy endows. This means that the cash value in
the policy has accumulated to equal the face amount of the
policy. If the insured is still living, he or she will
receive the face amount as an endowment. When a whole life
policy reaches maturity and endows, the contract is
completed and expires. The insured no longer owes premiums,
and the company no longer provides insurance coverage.
Just like term insurance, whole life insurance possesses
relative strengths and weaknesses. The primary advantages
of whole life insurance are the following:
•
A whole life policy provides guaranteed cash values.
10
Living benefits are benefits provided by a whole life policy that the policy owner can access while alive.
In addition to cash value, they can include disability income and waiver of premium.
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•
•
•
•
The cash values are not subject to the market risk
associated with other conservative investments such as
longer-term municipal bonds.
Cash value interest accumulates tax-free or tax-deferred,
depending on whether the gains are distributed during
lifetime or at death.
A whole life policy can be used as collateral for
personal loans.
A fixed and known premium for lifetime life insurance
coverage.
The primary disadvantages of whole life insurance are the
following:
•
•
•
•
The premium may be too expensive for the level of
coverage needed.
The rate of return on the cash value may not be
competitive with higher-risk investments.
Cash values are subject to inflation.
If the policy is surrendered within the early years of
the contract (typically up to five to ten years from the
policy’s inception), the insured can face a considerable
loss.
Uses of the Product
For most consumers, the essential purpose of the whole life
product is very similar to term life. Like term insurance,
whole life can provide an immediate estate. Typically, this
estate is used to provide income for dependents. Whole life
can also be used for specific goals such as funding a
college education, funding a charity, or providing cash for
federal estate and state inheritance tax purposes. Other
uses include providing cash for business debts, mortgages,
and funeral expenses.
Like term insurance, whole life insurance helps preserve
the confidentiality of one’s financial affairs. Proceeds
from an insurance policy’s death benefit payable to someone
other than the deceased’s estate avoid probate and are not
part of the public record.
Term insurance focuses on providing an insurance solution
for short term needs. Whole life, on the other hand, is
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best suited for long term needs. Because whole life
provides a series of “knowns” (fixed premium, guaranteed
ceiling on mortality and expense and guaranteed cash
value), it meets the financial and psychological security
needs inherent in long term planning.
Whole life, however, is a more complex product than term
insurance, and is often more useful for meeting more
diverse needs. Whole life tends to be an excellent product
for meeting various business life insurance needs. Some
examples include split dollar and nonqualified deferred
compensation arrangements, funding buy-sell agreements, and
key person insurance.
NOTES
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REVIEW QUESTIONS
1.
Ira has a $100,000 level premium whole policy. Ira has a massive heart
attack and unexpectedly dies at 57. Ira had recently borrowed $5000
from his policy’s cash value. How much will his beneficiary receive?
a)
b)
c)
d)
2.
Which of the following are not (a) feature(s) of whole life insurance?
a)
b)
c)
e)
3.
$100,000
$0
$95,000 plus the interest
$95,000 less any unpaid interest
temporary protection
cash values
maturity at age 100
initial low cost, with escalating
premiums as one grows older
Otto has a whole life policy with a $25,000 face value. Otto has just
turned 100, and is as healthy as ever. He has never missed a premium
payment, and has never borrowed from his policy. Based on this profile,
Otto will soon receive a check from the insurance company to the
amount of:
a) $25,000 plus interest
b) $25,000
4.
Which of the following can be counted part of a whole life policy’s living
benefits?
a) loans from the policy
b) the policy’s face amount
c) disability income
d) waiver of premium
f) a & b only
g) a, c, d
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ANSWERS TO THE PRACTICE QUESTIONS
1.
d
2.
a
3.
b
4.
f
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Traditional Whole Life Variations
In addition to traditional whole life with level premiums
to age 100, the whole life product exists in a range of
variations. These modifications have been introduced by the
insurance industry over time in order to better meet the
specific needs of consumers. Some of these product
variations include limited pay whole life, modified whole
life, indexed whole life, graded premium whole life, and
indeterminate premium whole life.
Limited pay whole life is a whole life policy that provides
the same benefits as a traditional whole life policy, but
with pre-defined limit on the number of required premium
payments. Typical limited pay whole life policy designs
include 15, 20 and 30 pay plans. The number of “pays”
equals the number of years that the insured must pay a
premium. Thus, a 15-pay whole life policy requires premium
payments for 15 years.11
Another variation on the limited pay policy design is to
state an age, short of 100, to which an insured must pay
premiums. A typical age-based limited pay life policy is
“to age 65.” This type of policy is usually referred to as
“life paid up at age 65 (LP65).”
Still another form of limited pay whole life is 1-pay whole
life, which is also known as single premium whole life.
Because a 1-pay policy funds the entire contract with one
premium, the premium must be very large. However, the real
cost of this premium is actually less than what the total
of premiums spread over a 15, 20, 30, or 100 year period
would be. This reduction in premium occurs because of the
interest that the lump sum payment will accrue and the
minimized expenses realized by the company.
Single premium whole life policies are rarely purchased in
today’s environment. Current tax legislation defines single
11
Limited pay policies are subject to a 7-pay test for determining the tax status of a policy loan or partial
surrender. If the total premiums paid into the policy during its first year exceed the total amount of
premiums that would have been payable to provide a paid-up policy in seven years, the policy is classified
a modified endowment contract.
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premium policies as modified endowment contracts, which are
discussed in the following sections.12
Because the premium payment period is reduced in a limited
pay policy, the required dollar amount is higher than in a
comparable traditional whole life contract. Within this
structure, a higher percentage of the limited pay premium
dollar is credited to the policy’s cash value. The shorter
the premium-paying period, the faster the growth in cash
value. After the premium paying period, the cash value
growth slows down, as it is driven solely by interest
earnings. At this point, the policy functions like a
traditional whole policy, in that the cash value increases
until it matches the face amount and the policy matures.
TABLE 4 – 1
COMPARISON OF 20-PAY AND TRADITIONAL WHOLE LIFE POLICIES
WITH $100,000 FACE AMOUNTS
GROWTH IN CASH VALUE
$ 0
AGE
$100,000
28 …
48 …
100
12
In most cases, single premium life insurance contracts issued on or after June 21, 1988 are modified
endowment contracts.
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Lifetime Protection
PREMIUM
PERIOD –
20-PAY
LIFE
Lifetime Protection
PREMIUM
PERIOD –
TRAD.
WHOLE
LIFE
Another example of a whole life variation is modified whole
life. This product offers a low period at the start of the
contract, and then increases once. The new premium rate
remains level for the duration of the policy period (age
100). The initial low-premium period usually lasts from
three to five years.
During the initial period, the premium is only slightly
more than for a term policy. When the premium increases, it
is higher than the whole life rate at the age of issue, but
lower than the term rate for the insured’s attained age at
the time of the transition.
TABLE 5 – 1
$50,000 MODIFIED WHOLE LIFE
Age 30
100
Age 35
Age
Initial low premium
Subsequent premium
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Graded premium whole life is similar to modified whole
life, but adds an additional “spin.” Like a modified whole
life policy, a graded premium plan will offer an initial
period of lower premiums that ultimately level off to a
level rate for the remainder of the contract (age 100).
The difference between the graded and modified whole life
is in the duration and format of the initial premium
period. First, the lower premium period lasts longer –
usually ten years. Second, the lower premium period has a
step-rate design. This means that the premium gradually
increases each year until the level premium period is
reached.
Both the modified and graded whole life policy are designed
for consumers who want to lock in the benefits of a whole
life design, but are initially “cash challenged.” While
their premium structure helps meet one of the primary
disadvantages of whole life insurance – the cost of the
policy – they can only function if the insured is in a
position to eventually pay a higher premium. These policies
are ultimately not more or less expensive than level
premium whole life. Actuarially, the premium rates are
equivalent to traditional whole life.
Indeterminate premium whole life is another whole life
design that seeks to meet the premium price objection. This
variety of whole life insurance has a premium rate that is
adjustable based upon the company’s anticipated future
experience. In this form of whole life, a maximum premium
is stated, with an initial rate that is both lower and
fixed for a guaranteed short-term (typically two to three
years.)
When the guaranteed short-term expires, the premium rate is
reviewed in light of the insurance company’s expected and
realized earnings and expenses. If the situation is
favorable, the premium may be adjusted down. If the
situation is unchanged, the premium may remain level. If
the company’s situation is worse, the premium may be
increased. Some of the factors the company reviews are:
mortality
experience,
administrative
expense,
and
investment returns.
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Whole life variations all possess a number of advantages
for the consumer. First, limited pay plans help the
consumer with financial planning by providing a known
dollar amount for the premium outlay. By providing a
limited time-frame during which premiums must be paid, a
limited pay policy also reduces the chances that the policy
might lapse. The major reason that the limited pay design
is popular, however, is that the cash values build faster
than a traditional whole life policy.
The main disadvantage of any limited pay whole life policy
is that it will be even more expensive than traditional
whole life coverage. By compressing the payment period,
these types of policies are often unaffordable for
consumers with limited means.13
Modified whole life plans make whole life insurance more
affordable for consumers that are just beginning their
careers or returning to the workforce and have yet to
experience significant earning power. These policies seek
to meet the major obstacle many consumers find when trying
to purchase whole life coverage – the cost of the premium.
Using modified whole life policies requires good planning.
If the insured does not manage their expenses properly,
they will be in a difficult position when the premium
increases.
Uses of the Product
Limited pay policies are effective instruments for a number
of cases. These policies are often used to provide
insurance protection after retirement without the need of
paying premiums. Limited pay policies are also good choices
for persons with a brief working lifetime, such as
professional athletes.
Another use of limited pay policies funding insurance is
for
juveniles.
Parents
can
purchase
basic
insurance
protection for their children, and have the policy paid-up
before they leave the household to begin their own lives.
13
From an asset allocation standpoint, it can also be argued that limited pay plans suffer a major defect in
the early years of the contract. This is because the amount of life insurance protection – the difference
between the face amount and the cash value – is lower relative to the premium than with traditional whole
life or term.
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Modified whole life policies, as we have already mentioned,
are geared to consumers that recognize the value of whole
life insurance, but lack the means to comfortably meet the
premium required for adequate protection. These policy
designs can be very valuable for persons in training
programs or defined pay structures who are confident about
future salary increases.
While the modified plan will ultimately provide the same
coverage as a traditional whole life plan, the insured will
be “stuck” with little to no cash value in the policy for a
longer time than in a traditional whole life policy.
Furthermore, the insured will have some period of higher
premiums than would have been paid with a level premium
policy.
NOTES
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REVIEW QUESTIONS
1.
Hank has a 20-pay limited life policy. His twin brother Skippy has a
traditional whole life policy. Both policies were purchased at the same
time and for the same face amount.
Which brother pays the higher premium?
Whose policy will earn cash value quickest?
2.
Most single premium whole life policies are :
a)
b)
c)
d)
3.
Which of the following are true for limited pay whole life policies?
a)
b)
c)
d)
4.
sold to low- to middle-income consumers
modified endowment contracts
slightly more expensive than whole life policies
all of the above
they provide lifetime protection until age 100
they endow at age 100
their premiums are payable for limited, stated time period
all of the above
Cosmo has a LP65 policy. This means:
a) he will be finished with premiums at age 65
b) he has lifetime protection with a face amount of 65,000
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5.
Renaldo has just graduated from McDonald College and taken a
position as management trainee. He has a wife and child, and would like
to purchase life insurance. Renaldo wants a policy that, should he die,
can help provide income to his wife and child plus pay all final
expenses. Renaldo’s training period lasts two years, after which he will
earn a sizable pay increase. Of the following options, Renaldo is a good
candidate for:
a)
b)
c)
d)
6.
Declining term life
Graded premium whole life
Single premium whole life
Re-entry term life
Louie has purchased an indeterminate premium whole life policy. Which
of the following is probably true about his coverage:
a) his premium will be higher for the first years of the contract, and
then decline to a constant lower level
b) his policy will state a maximum premium that can be charged
c) his premium will be fixed for the initial few years, and then raised,
lowered, or kept the same, based upon the company’s expected
mortality, expense, and investment projections
d) a & b
e) b & c
ANSWERS TO THE PRACTICE QUESTIONS
1.
Hank; Hank
2.
b
3.
d
4.
a
5.
b
6.
e
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Endowment Policies and MECs
Endowment policies are yet another type of ordinary life
insurance. Unlike a traditional whole life policy, however,
an endowment policy does not mature at age 100; the
endowment policy does not provide lifetime insurance
protection.
An endowment policy offers life insurance for a specific
period of time. Typical time periods include 10 years, 20
years, and “endowment at age 65.” The premium during the
time that the policy is in force is level,
just like a
traditional whole life policy. Should the insured die at
any point during the premium paying period, the endowment
policy will pay the face of the policy as a death benefit
to the beneficiary.14
At the maturity date, an endowment policy will pay the face
amount as an endowment. Like a whole life policy, the
endowment is paid to the policy owner.
Endowment policies increase their cash value extremely
quickly. Because of their abbreviated accumulation period,
endowment policies have very expensive premiums.
TABLE 6 - 1
Policy Comparison – Endowment and Traditional Whole Life
Endowment
Traditional
Whole
Life
Policy Begins
Age 35
14
Endowment Matures
Age 65
WL Matures
Age 100
The premium paying period is called the endowment period.
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The modified endowment concept originated from changes in
the tax code. The United States Congress enacted the
Technical and Miscellaneous Revenue Act (TAMRA) in 1988.
TAMRA determined that all life insurance policies issued on
or after June 21, 1988 must meet the 7-pay test or be
classified as modified endowment contracts (MECs).
As an MEC, any amount that is withdrawn in the form of a
loan or partial surrender is taxed as ordinary income and
return of premium (if there is any gain in the contract
over premiums paid). In addition, there is a 10 percent
penalty tax on withdrawals if they occur before the policyowner reaches age 59 ½ .
MECs can potentially occur with single pay and limited pay
policies. Avoiding an MEC situation is the responsibility
of the insurance company home office, but the agent needs
to be aware of the concept and how it can affect consumers.
NOTES
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REVIEW QUESTIONS
1.
Endowment contracts are known as (circle one) expensive / inexpensive
policies.
2.
Endowment contracts share all of the following characteristics as
traditional whole life polices except for:
a)
b)
c)
d)
level premium
level death benefit
matures at age 100
builds cash value
ANSWERS TO THE PRACTICE QUESTIONS
1.
expensive
2.
c
NOTES
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Chapter Five
New Worlds of Life Insurance
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WHOLE LIFE INSURANCE VARIATIONS
A variety of forces emerged that challenged the life
insurance industry to develop alternatives to product
designs that had received little more than “fine tuning”
for nearly 100 years. First, the consumer movement led to
a greater demand from consumers for knowing how their
premium dollars would be invested. Second, the weakening of
the “endowment” ethos and the growth of the “lifestyle”
ethos, coupled with the increase in life expectancies, has
greatly altered the perceived need for--as well as the
anticipated uses of—life insurance.15
Some of these forces have been driven by the post-World War II
Baby Boomer generation that numbers more than 78 million. Because
of the influence that their sizeable numbers and affluence
command, their tastes and demands have forced the insurance
industry to develop products to meet such needs as college
planning,
retirement
income
supplementation,
and
estate
16
planning.
In addition to demographics, the volatility of the economy
has exerted a
powerful influence upon life insurance
innovation. Such factors as the experience of hyperinflation in the 1970s, “stagflation,” the subsequent
changes
in
the
interest-rate
environment,
and
the
“irrational exuberance” of the Bull Markets of the late
1980s and 1990s all have affected the product designs
offered by life insurance companies.
Universal Life
Universal life insurance emerged out of the hyper-inflation
and high interest rates of the late 1970s. As consumers
were able to earn 10% or more on cash in bank and money
market accounts, the insurance industry witnessed a massive
withdrawal of funds from traditional whole life policies.
As these policies were built upon the assumption of low,
stable interest rates, the 3 to 4% returns they were
generating looked meager to many policy owners.
15
An “endowment” ethos is a value system that places primacy on furthering the economic position of
one’s offspring; a “lifestyle” ethos focuses on one’s own well-being throughout the various stages of life.
16
The Baby-Boomer generation will represent the largest transfer of assets in history.
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Universal life (UL) was created to meet this challenge.
While UL operates like a whole life policy, and enjoys the
same tax advantages as whole life, it is essentially a
level or decreasing term life insurance policy with an
investment account. Following this design, universal life
is an unbundled policy. As an unbundled policy, the
investment, mortality, and cost features are all separated
and reported annually in a yearly statement.
The universal life policy is unique among life policies.
This is because universal life is based upon current,
available cash value rather than regularly scheduled
premiums. In a term or traditional whole life policy, the
insurance company determines a premium based upon a series
of assumptions and underwriting information. The policy is
dependent upon regular, scheduled premium payments by the
policy owner.
With universal life, however, the policy owner possesses
wide latitude as to the frequency and level of premiums. As
long as the cash value within the investment account is
sufficient to pay the monthly mortality expenses for the
insurance coverage and the necessary policy expenses, the
policy stays in force. The policy owner may occasionally
skip premium payments, make partial payments, or increase
premium payments. With universal life, the policy may be
funded in pattern that can be continually revised. In this
type of policy, the policy owner has significant control
over the amount and frequency of the premium payments.17
In addition to being able to skip payments, the policy
owner may also increase or decrease coverage. If the policy
owner desires, the death benefit can be decreased to a
level at which the existing cash value would carry the
policy to maturity. In this type of policy, the policy
owner has significant control over the level of death
benefit.
The universal life policy also possesses a variety of other
flexibility features that benefit the policy owner. For
example, the policy owner may let the cash values
accumulate, make partial surrenders, or surrender the
policy for the entire cash value. In addition, various
17
While the policy owner possesses wide latitude for making decisions, the company sets guidelines by
which the policy owner must abide. These guidelines conform to company policy and statutory
requirements. In addition, loans from the company’s cash values are capped, typically at 90% of the current
cash value. Policy loans do not decrease the death benefit.
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riders can be added to a policy to further shape it to the
policy owner’s specific needs. Riders that are commonly
added to a universal life policy include the following:
cost-of-living, additional insureds, children’s, guaranteed
insurability, and waiver of premium.
The reason that the universal life policy can offer these
flexibility options is because the cash values in the
investment account reflect “current interest rates.” For
universal life policies, “current interest rates” are
determined by the company’s own investment earnings return
rate, the sale of 90-day U.S. Treasury bills, or a bond
index. In a high-interest rate environment, the monies in
the investment account can grow tax-deferred at a rate
faster than many traditional whole life policies.
Because the performance of the universal life policy is
tied to current interest rates, the policy owner is exposed
to a measure of volatility.18 When interest rates are high,
the policy performs well and the flexibility options
described above can be employed by the policy owner. When
interest rates fall, however, the universal life design is
presented with some challenges.
First of all, low interest rates can cause a funding
problem for the universal life policy. Even though the
policy design allows the policy owner to skip payments,
make partial payments, etc., the assumption is always that
the cash value in the investment account is sufficient to
allow for a monthly withdrawal that will meet both the
mortality charge (the cost of the insurance) and the
policy’s operating expenses. A sustained period of lowerthan-expected interest rates can destroy the policy’s
flexibility, as the target premium specified by the company
will have to be met on a monthly basis in order to keep the
insurance protection in force.
Secondly, low and/or declining interest rates and the
increasing age of the insured will increase the cost of
pure death protection. The result is that the amount of
cash value allocated to the mortality charge will increase
and the amount entering the investment account will
decrease.
18
While possessing an element of volatility, universal life policies are nevertheless typically guaranteed
policies. They provide a minimum guaranteed interest rate and death rate.
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On a more positive note, however, universal life policies
use a back-end load rather than the front-end load typical
of most traditional whole life policies.19 Because of the
back-end load structure of the universal life policy, a
larger portion of the policy owner’s initial premiums go
into the cash value account. This means that the cash
values in the universal life’s investment account will grow
quicker than a traditional whole life policy.
Universal Life Death Benefit Options
Option 1 (or A)
The Option 1 (or A) death benefit is similar to a
traditional whole life policy. As the cash value in the
investment account grows, the net amount at risk decreases.
The total death benefit remains constant. Option 1 is thus
a level death benefit policy.
However, if the cash value growth approaches the face
amount before the policy matures, the universal policy
automatically provides an increased death benefit. This
additional insurance is called the “corridor.” It is
maintained in addition to the cash values, and is done to
avoid negative tax consequences.
Death Benefit
Age 40
Age 100
Cash Value
Option 2 ( or B)
The Option 2 (or B) death benefit equals the face amount plus the
cash values in the investment account. This makes the Option 2
19
A load refers to the sales charge imposed by an insurance company to recover its initial policy expenses.
“Front” and “back” refer to when the policy expenses are paid.
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death benefit similar to that found in a traditional whole life
policy with a term insurance rider that equals the current cash
value. The result is that the death benefit grows along with the
cash values.
Age 40
Age 100
The primary advantages of the universal life policy are the
following:
•
•
•
•
•
The policy owner has flexibility in premium payments
The policy owner has flexibility in changing the death
benefit, and may select from two design options
Most universal life policies are back-end loaded, with
the result that cash values tend to build faster than in
traditional whole life policies
The unbundled design provides the policy owner with a
clear presentation of the policy’s performance on an
annual basis
Universal life policies offer the cash value advantages
typical of traditional whole life: tax-deferred build-up
of the cash value and low-interest policy loans
The primary disadvantages of the universal life policy are
the following:
•
•
The policy owner is exposed to a greater deal of risk
than a traditional whole life policy, as sustained low
interest rates can cancel the policy’s flexibility
features
The flexibility of the policy can create unforeseen
circumstances. For example, the policy can inadvertently
become a MEC through over-funding. The ability to skip
premium payments takes away the “forced savings” element
of traditional whole life and can encourage under-funding
and/or policy lapses
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Uses of the Product
The flexibility of universal life makes it suitable for
many insurance needs. However, the cash value element of
this policy design generally makes it more appropriate for
long-term needs.
A universal life policy can be designed to change with a
person’s developing needs. For example, the initial phase
of the policy can emphasize insurance protection, with
lower premiums and a high death benefit. As insurance needs
change, the emphasis can switch to build-up of cash value
with an increase in premiums.
NOTES
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REVIEW QUESTIONS
1.
Theo would like a cash value policy that allows him to easily change the
death benefit level because of life-events like the birth of a child. His
best option is:
a)
b)
c)
d)
2.
Increasing term life
Traditional whole life
Universal life
Industrial life
Melissa is 46, and has a universal life policy with a $100,000 face value.
When she purchased the policy, current interest rates were 8%. Interest
rates have been falling steadily since she purchased the policy. Which
of the following statement(s) reflect Melissa’s situation:
a) The policy’s features—death benefit, rate of cash value
accumulation, target premium—will be unaffected
b) The death benefit will most likely be unaffected, but the cash value
will not grow as fast
c) The death benefit and cash values will most likely decrease
d) None of the above
3.
Felipe quits his job to start up an internet-service company. As his
income stream is temporarily interrupted and his business start-up
costs are high, he would like to not make life insurance premium
payments for a brief period -- without surrendering his policy. Is this
possible with a universal life policy?
a) No
b) Yes, if the policy has sufficient
4.
The universal life policy possesses
death benefit options.
different designs of
a) Two
b) Three
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ANSWERS TO THE PRACTICE QUESTIONS
1.
c
2.
b
3.
b; cash values
4.
a
Adjustable Life
Adjustable life, or ALI, is a flexible premium policy with
an adjustable death benefit. Adjustable life is a whole
life variation that has features similar to universal life
and traditional whole life. Adjustable life is an example
of a hybrid policy. As such, the adjustable life policy
allows the policy owner the following options:
•
•
•
•
Increase
Increase
Increase
Increase
or
or
or
or
decrease
decrease
decrease
decrease
the
the
the
the
premium20
premium payment period
death benefit
protection period
These features mirror the flexible nature of the universal
life policy. However, unlike the universal life design, an
adjustable life policy is bundled. This means that the
death protection and cash value components are not
segregated. Unlike a universal life policy, withdrawals
from the cash values are not permitted without a partial
surrender of the policy.
Other features of the adjustable life policy that are
consistent with a traditional whole life design include the
following:
20
Increases in the policy’s premium naturally require that the policy’s face amount state within statutory
guidelines. Increases in premium typically require evidence of insurability.
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•
•
•
•
•
•
•
Guaranteed maximum mortality charges
Cash values
Guaranteed minimum interest
Nonforfeiture options
Settlement options
Dividend options
Policy loan provisions
In addition, a variety of riders typical for traditional
whole life may be attached to the adjustable life policy.
These commonly include waiver of premium, cost-of-living,
and accidental death & dismemberment.
Another element that differentiates the adjustable life
policy from a true universal life policy is how the death
benefit and premium level may be adjusted. Unlike the
universal life design, changes in death benefit and premium
level can only occur at specific intervals. All changes
must occur with advanced notice to the insurer. The
schedule of cash values, which is based upon the current
program of premiums, face value, and duration of coverage,
is recomputed each time the death benefit or premium
payment is adjusted. During the time period between
changes, the adjustable life policy functions like a
traditional whole life level death benefit and level
premium policy.
Adjustable life is simply another policy design created by
the insurance industry to meet the public’s demand for
greater flexibility. It is appropriate for a wide range of
life insurance needs. However, because of its cash value
component, adjustable life is typically better for longterm insurance needs.
Adjustable life is often sold on a money purchase basis.
This means that a specific premium dollar figure is
selected, and this figure is matched with an appropriate
whole life policy.
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NOTES
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Current-Assumption Whole Life
Current-assumption whole life (CAWL) is also known as
interest-sensitive whole life or fixed premium universal
life.21 Current-assumption whole life is another hybrid of
universal life and traditional whole life.
The current-assumption whole life policy is usually issued
with a level (i.e. fixed) premium and death benefit.
The
premiums, however, will reflect changing conditions in two
broad categories: the insurer’s assumptions and actual
experience with mortality and/or expenses, and current
interest rates.22 The company will usually tie the policy’s
performance to a specified index or yield.
The result is that premiums for a current-assumption policy
can become higher or lower than those stated at the
policy’s issue. High interest rates will tend to produce
lower premiums, while lower interest rates will produce
higher premiums. Typically, the current-assumption policy
presents a guaranteed minimum interest rate as well as a
maximum charge for mortality expenses.
The current-assumption policy is similar to traditional
whole life in the following features. Most currentassumption policies possesses such elements as guaranteed
maximum mortality charges, minimum guaranteed cash values,
nonforfeiture options, settlement options, policy loan
provisions, and a guaranteed minimum interest level.
Between determination periods, the policy functions as a
level premium, level death benefit policy.
Current-assumption whole life resembles universal life
through the following two major features. First, the policy
is unbundled. Second, the current-assumption policy is
generally back-end loaded.
21
The other terms for current-assumption whole life are problematic. “Fixed premium universal life” is
only partially accurate, as the premium and death benefit levels are only fixed for a limited period, based
upon anticipated interest, mortality, and expenses. “Interest sensitive” is also incomplete, as the policy is
not only sensitive to interest rates but also to the company’s mortality and expense experience. Some
current-assumption policies, however, are exclusively interest-sensitive.
22
Some current-assumption policies do not have stand-alone expense charges. Instead, the policy’s
expenses are folded into the mortality charge, or they may be included as “adjustments” to the current rate
credited to the cash values.
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Like adjustable life, current-assumption whole life blends
aspects of the traditional whole life and universal life
designs. The strengths of the policy include the following:
•
•
•
•
•
•
Cash values that grow tax deferred
An
interest
rate
that
is
often
higher
than
traditional whole life
Low-interest policy loans
Annual reports on the policy’s performance
Back-end loads
Withdrawal of the excess cash value accumulations
The weaknesses of this policy design are in the following:
•
•
•
The policy owner is exposed to a level of risk in
the form of volatile interest rates that can create
higher premiums
The policy only guarantees maximum mortality and/or
expense rates
Unlike a universal policy, the current-assumption
policy will ultimately lapse if the scheduled
premium payments are not paid, regardless of the
accumulated cash values
Because of its cash-value features, the current-assumption
whole life policy is best for long-term life insurance
needs. It is well suited for the client who wishes to make
use of the “forced savings” aspect of traditional whole
life policy, but still wants an annual report detailing the
policy’s performance as well as the potential for higher
interest rates on the cash values.
NOTES
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REVIEW QUESTIONS
1.
Another term for current-assumption whole life is interest sensitive
whole life.
a) true
b) false
2.
Jack has a current-assumption whole life policy. Since he purchased
the policy, interest rates have increased several times and are now 5%
higher than when the policy originated. It is reasonable to believe that
Jack’s premiums are
than (as) before.
a) higher
b) lower
c) the same
3.
Samson has an adjustable life policy. He has recently taken a new sales
job for a major wig manufacturer. With the costs of relocation and
establishing a new territory, he believes his cash flow will be strained
for a temporary period. Can he decrease his premiums with this type of
policy design?
a) yes
b) no
4.
Adjustable life and current-assumption whole life are both unbundled
policies.
a) true
b) false
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ANSWERS TO THE PRACTICE QUESTIONS
1.
a
2.
b
3.
a
4.
b
VARIABLE LIFE INSURANCE PRODUCTS
Variable life (VL) and variable universal life (VUL) are
policy designs derivative of traditional whole life that,
like universal life, evolved out of the economic conditions
of the late 1970s and early 1980s. December of 1976 the SEC
issued Rule 6E-2, which provided a limited exception from
sections of the Investment Company Act of 1940. This rule
requires that insurance companies provide an accounting to
contract holders, imposes limitations on sales charges, and
requires that the insurers offer refunds or exchanges to
variable life purchasers under certain circumstances,
including an option of returning to a traditional whole
life policy.23 Rule 6E-2 defines variable life as a contract
in which the life insurance element is predominant, the
cash values are funded by separate accounts of a life
insurance company, and death benefits and cash values vary
in response to investment experience.
The first variable life policy was issued in the United
States in 1976. The growth of the product was initially
slow. In 1981, only ten companies sold the product. In
1992, variable products only accounted for nine percent of
total life insurance market share. However, with the strong
bull market of the nineties, variable and variable
universal life have grown steadily in popularity. In 1998,
23
There are no SEC limitations applicable in whole life or universal life sales charges.
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the sale of variable life insurance products surpassed
traditional whole life sales for the first time in history.
• Variable Life
Variable life is also referred to as scheduled premium
variable life. It is characterized by three main features.
First, the policy owner’s cash values are placed in a
separate account (or accounts) that is (or are) different
from the company’s general account. These separate accounts
are investment vehicles that mirror mutual funds.24 The
variety of separate accounts dependent upon the company’s
choices and policies. They can essentially include any form
and style of mutual fund, such as a stock fund and its
relevant variations (e.g. growth stock, foreign stock,
small cap stock, etc.).
Policy owners may choose the initial mix of funds, and can
switch funding options one or more times per year. Other
policies allow for a managed account, in which an
investment manager is in charge of the asset allocation of
the cash values. Today’s products offer not only the money
markets and common stock accounts typical of the earliest
variable policies, but also aggressive growth accounts,
global and international equity accounts, and various bond
accounts.
Like a traditional whole life policy, cash values grow tax
deferred. However, the investments that are allowed in a
variable
life’s
separate
account
can
be
much
more
aggressive than those that fund an insurance company’s
general account. Thus, the opportunity for returns that are
significantly better than a traditional whole life policy
are possible.
In addition, since the policy owner may invest in a mix of
separate accounts, a level of diversification can be
achieved. Furthermore, since switching funding options is
not considered a taxable event, the policy owner may
periodically alter the mix in reaction to the changing
economic climate.
24
The separate account that backs a variable life insurance contract is usually classified as an investment
company and registered as such with the appropriate government regulatory bodies.
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The second defining feature of the variable life policy is
its lack of guarantees. Unlike a traditional whole life
policy, the variable life policy does not guarantee the
cash value in the separate account. The policy owner, not
the company, will bear the risk of the separate account’s
performance.
The third defining feature of the variable life policy is
the functioning of the death benefit. The variable life
policy requires the payment of a level, scheduled premium,
and this supports a guaranteed minimum death benefit.
However, the realized face amount of the death benefit is
flexible. If the investment performance of the separate
account is positive, the death benefit can increase.
Conversely, it can also decrease if the investment
performance is negative (but the death benefit will never
be lower than the stated guaranteed minimums).25
In most other respects, variable life is like a traditional
whole life policy. It has fixed and guaranteed mortality
charges, does not allow partial surrenders from the policy,
and has a “forced savings” element in its scheduled level
premium. In addition, the variable policy will allow for
low interest policy loans, nonforfeiture and settlement
options, and a reinstatement period.
• Variable Universal Life
Variable universal life is also called universal variable
life, flexible-premium variable life, and universal life
II.
The
first
variable
universal
life
product
was
introduced in 1985.
This policy blends the features of universal life and
variable life for a whole life hybrid that offers
flexibility and the possibility for aggressive growth of
cash value. The key concept of variable universal life is
policy owner control. The policy owner selects, within the
guidelines of the company, the face amount, the premium
allocation, and the investment vehicle.
25
There are two methods of determining the death benefit level in a variable life policy. The corridor
percentage approach periodically adjusts the death benefit so it is at least equal to a specified percentage of
the cash value. The net single premium approach periodically adjusts the death benefit so that it matches
the amount of insurance that could be purchased with a single premium equal to the cash value, assuming
guaranteed mortality rates and a stated rate of return.
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Variable universal is like regular variable life in that
the policy owner’s premiums are invested in separate
accounts that are (usually) registered as mutual funds. The
policy owner will usually have a choice of separate
accounts, each representing a different investment style or
objective. As with a variable policy, these accounts can be
equity or bond accounts with such objectives as aggressive
growth, growth and income, international growth, etc.
Furthermore, the policy owner will be periodically able to
alter the mix of separate account monies. The benefit of
the variable life features is that they offer the
possibility of aggressive cash value growth.
Variable universal life is like regular universal life in
the following:
•
•
•
•
•
Premium
payments
are
flexible
within
limits
specified by the company
The policy owner can choose from two death benefit
options: Option 1 (or A) with a level death benefit
and Option 2 (or B) with a death benefit that is
equal to a specified level of pure insurance and the
current cash value in the separate account(s)
The face amount of the death benefit is adjustable
by the policy owner (within limits specified by the
company and statutory law)
The policy owner may make partial withdrawals of the
cash value without a policy loan
The policy is unbundled, and provides an annual
report on performance and expenses
Because of the blending of variable and universal life, the
variable universal life product is considered a “second
generation” product. As a relatively new product, it is
often poorly understood. In addition, by combining the best
features of two products, it is subject to a variety of
expenses that have received a great deal of attention in
the financial and consumer-oriented press. It is vital to
understand what these expenses are to properly explain this
type of product.
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Expenses in Variable Universal Life Insurance
Variable universal life expenses are found at two levels:
the policy level and the investment account level. At the
policy level, expenses have to do with the policy owner’s
premium dollar before it reaches the sub-account(s) or
separate account(s). Expenses at the policy level are what
the company charges in order to cover its costs of doing
business. Expenses at the investment account level include
the cost of life insurance and the management of the
underlying funds.
Expenses at the Policy Level
Front-End Sales Load
This expense is charged against the policy owner’s going
into the policy. Some companies charge a front-end sales
load, others do not. The legal limit for a front-end sales
load is 8.5 percent.
Back-End Sales Loads
The back-end sales load is the amount the policy owner
forfeits when he or she surrenders the policy. A back-end
load can be in force for the life of the contract, or it
may have an expiration period. When a back-end load phases
out after a period of time, it is referred to as a
contingent deferred sales charge.
State Premium Taxes
State premium taxes are mandatory expenses levied by the
state government. In most cases, when there is a front-end
sales load, the state premium tax is taken from there.
Administration Fees
Administration fees can take two forms—first year and
ongoing. First year administration fees cover the costs of
setting
up
the
policy
and
any
costs
incurred
in
underwriting. The ongoing administration fees go to company
services such as mailing confirmation notices, periodic
reports, and production of such materials as the prospectus
and annual report.
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Other service fees can also exist with this type of policy.
For example, even though a policy owner may move his or her
funds between accounts without incurring a taxable event,
the company may or may not allow such changes to be made
free of charge. Typically, companies allow a certain number
of fund shifts per year free of charge; any number above
this amount requires a fee.
Expenses at the Investment Account Level
Cost of Insurance
The cost of insurance is referred to as the mortality cost.
This cost is a monthly expense, and is based upon age, sex,
health, use or non-use of smoking products, occupation, and
avocation.
Once
the
applicant’s
mortality
status
is
determined, it usually remains constant for the life of the
policy. Future changes in health cannot increase the
insured’s rates. However, the costs for insurance increase
naturally during the life of the policy as the insured
ages.
Mortality and Expense Charges
The insurance company will provide a number of guarantees
within the policy; the cost of these guarantees are
reflected in the mortality and expense (M&E) charges.
Typical guarantees include maximum monthly administrative
charges, maximum monthly cost of life insurance charges,
guaranteed
annuity
factors
within
the
contract,
and
continuing lifetime service.
Investment Management and Fee Advisory
This is the fee that is charged for the overall management
of the underlying mutual funds. This fee is derived daily
from the funds’ daily net assets. It varies from fund to
fund, and can decline as the size of funds under management
grows.
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Policy Loans and Withdrawals in Variable Universal Life
Insurance
In most cases, policy owners are permitted to borrow up to
ninety percent of the cash surrender value of the policy
(the cash surrender value is the gross value of money in
the policy less the surrender charge.) Loans are typically
available for a stated percentage of interest. While the
policy owner is not forced to pay the accumulated interest
(or the loan principle) back within a certain time, if the
sum owed is not repaid during the policy owner’s life, it
will ultimately be taken from the death benefit.
Partial withdrawals are also possible with the variable
universal policy. Depending on the company’s operating
guidelines and policy design, there may be a minimum and
maximum on the amounts that can be withdrawn. In addition,
withdrawals normally carry a service fee to complete the
transaction. Even though partial withdrawals are usually
contractually possible in variable universal policies,
current tax legislation has made partial withdrawals less
attractive than loans in many cases.
Death Benefit Options in Variable Universal
Life Insurance
The variable universal life death benefit is a combination
of the policy’s cash value and some portion of pure
insurance coverage. The pure insurance coverage represents
the company’s amount at risk.
Like universal life, the variable universal has two death
benefit options, usually termed option one and option two
(or “A” and “B”). The choice of death benefit is not
irrevocable; the policy owner may switch death benefit
option as life circumstances change.
Option One – Level Death Benefit
Under
total
level
alter
the level death benefit option, the insured selects a
death benefit amount. This face amount will remain
until one of two events: the policy owner decides to
it, or the growth of cash value forces the death
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benefit to increase to maintain the legally required ration
of cash value to death benefit.
Option Two – Variable Death Benefit
With the variable death benefit option, the policy owner
selects the amount of pure insurance coverage desired
rather than the total death benefit. The amount of pure
insurance remains constant; as the cash value of the policy
increases or decreases, the total death benefit varies.
This option most closely represents the increasing death
benefit option in universal life.
LEVEL DEATH BENEFIT OPTION
$
DEATH BENEFIT
----------------PURE INSURANCE
CASH VALUE
Age 30
35
40
45
50
VARIABLE DEATH BENEFIT OPTION
$
DEATH BENEFIT
CASH VALUE
Age 30
35
40
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Sales and Regulatory Aspects of Variable
Insurance Products
Because of the nature of their separate accounts, variable
life and variable universal life are classified as
securities as well as insurance products. As such, they are
regulated by both the state insurance department and state
securities commissions.
Securities products are also subject to federal regulation.
The federal agency charged with regulating all securities
offered to the public is the Securities and Exchange
Commission (SEC). This five-member commission was created
by the Securities Exchange Act of 1934 for the purpose of
enforcing the Securities Act of 1933. The SEC also sets
disclosure and accounting rules for most issuers of
corporate
securities,
and
oversees
the
actions
of
securities firms, investment companies, and investment
advisers. The SEC has authority to issue its own rules and
regulations.
Along
with
state
and
federal
regulation,
securities
products are self-regulated by the securities industry.
This self-regulation is managed by the National Association
of Securities Dealers (NASD), which is a not-for-profit
membership organization of securities firm authorized by
Congress in 1939. Membership in the NASD entitles firms to
participate in the investment banking and over-the-counter
securities
business
for
distributing
new
issues
underwritten by NASD members and to distribute shares of
investment companies sponsored by NASD members.
The NASD was created to promote the investment banking and
securities
industry,
standardize
its
principles
and
practices, promote high ethical standards, and help its
members achieve maximum compliance with applicable state
and federal securities laws and regulations. The NASD can
issue rulings that are binding on its members.
In order to sell variable insurance products, an agent must
be a registered representative for a broker/dealer. The
broker/dealer is a firm (or individual) registered with the
SEC to buy and sell securities. Generally, insurance
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companies that sell variable life products establish
broker/dealership for distribution of their product.26
a
In order to become a registered representative, an agent
must maintain an active life insurance license and pass
either the NASD Series 6 or NASD Series 7 exam and the NASD
Series 63 exam. All applicants for these NASD tests must be
thoroughly investigated to determine that he or she has not
violated any federal or state law or any NASD exchange rule
that would prohibit him or her from entering the securities
business. As part of the background check, the applicant is
finger-printed by the local police department.
The NASD Series 6 exam is titled the Investment Company
Products/Variable
Contracts
Representative
Examination.
This is the exam most insurance agents selling variable
life products opt to take. Unlike the life insurance
license, there is no mandatory education component required
to sit for the exam. However, as the exam is very rigorous,
most agents choose to take an exam preparation course
before sitting for the test. This exam only qualifies the
individual for sales of mutual funds and variable products.
The exam consists of 100 questions with a 2 hour and 15
minute testing time.
The NASD Series 7 exam, titled the General Securities
Representative Examination, is an even more extensive exam.
In addition to qualifying the applicant to sell mutual
funds and variable products, successful completion also
allows one to sell stocks, municipals, options, and direct
purchase programs. This exam consists of 250 questions,
administered in two equal parts of 125 questions each. The
allowed testing time is 3 hours for each part.
The NASD Series 63 exam is titled the Uniform Securities
Agent State Law Examination. It is also referred to as the
“Blue Sky Laws Exam.” This exam consists of 50 questions
with a one hour testing time.
It is vital to understand that until one has passed the
appropriate exams and been appointed as a registered
26
To sell variable life insurance products, an agent must also have a variable contracts license. This license
qualification can be earned at the same time that one sits for the life insurance exam. Should the agent
successfully pass this section of the exam, the variable contracts qualification will appear on his or her
license. Thus, one exam can potentially yield two qualifications for the life insurance agent.
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representative of a broker/dealer, one cannot even approach
prospects about variable life insurance products
Just as the sale of life insurance is subject to specific
trade practice regulation, the sale of securities must meet
certain regulatory requirements. Two of the most important
regulatory requirements for the sale of any securities
product are the prospectus and suitability.
A prospectus is a document summarizing the information
contained in a security’s SEC registration statement. It is
important to understand that, with the exception of
certain, limited advertisements and direct mail pieces that
meet NASD and SEC requirements, contact with a prospect
regarding
variable
life
insurance
products
must
be
accompanied with a prospectus. This means that sales
literature,
illustrations,
mailers,
and
face-to-face
meetings must include a prospectus.
Suitability means that when an agent recommends a variable
insurance product to a prospect, it must be suitable for
the prospect’s specific financial needs, circumstances, and
objectives.
Suitability
for
a
variable
life
policy
includes, but is not necessarily limited to, such elements
as a need for permanent life insurance protection, the
willingness to be exposed to a risk level greater than
traditional whole life, the financial capacity to assume
this risk, and the ability to afford the required premium.
Uses of the Product
Variable life products are best suited to persons with a
long-term life insurance need and an understanding of basic
investments. Since variable products present an element of
risk, and it is possible for the death benefit and cash
values to decline, it is imperative that the prospect
understand the volatility that these products possess.
Because of the element of risk inherent in variable life
products,
these
policy
designs
are
often
used
as
supplements to existing life insurance policies that
provide the minimum base level of coverage that prudent
planning would recommend.
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NOTES
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REVIEW QUESTIONS
1.
Amory has a sound basic life insurance package from his employer. He
is currently enjoying high earnings at work would like to boost his
insurance coverage AND see his cash value account grow as
aggressively as possible. Amory is a good candidate for:
a)
b)
c)
d)
2.
traditional whole life
current-assumption whole life
interest sensitive whole life
variable life
The variable life policy presents no guarantees: mortality expenses,
cash values, and death benefit are all variable.
a) true
b) false
3.
Earl would like to start selling variable life products. Which of the
following must Earl secure before he can sell these products?
a)
b)
c)
d)
e)
f)
4.
Life insurance license
NASD Series 6 license
Variable contracts license
NASD Series 63 license
All of the above
a, b, and d
A life insurance agent without the appropriate NASD license can still
solicit clients for variable life products as long as he or she provides a
prospectus.
a) true
b) false
5.
Variable universal life possesses all of the following features except:
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a)
b)
c)
d)
two benefit options
guaranteed cash values
flexible premium
partial surrenders
ANSWERS TO THE REVIEW QUESTIONS
1.
d
2.
b
3.
e
4.
b
5.
b
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Chapter Six
The Life Insurance Contract
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BASIC CONTRACT ELEMENTS FOR LIFE INSURANCE
For a life insurance contract to be valid, five conditions
must be present. The contract must possess an offer and
acceptance, a consideration, competent parties, and a
legally acceptable form. The power of the contract to be
binding is conditional upon the existence of these
elements. The absence of even one eliminates the contract's
power to bind the parties to the agreement. When a contract
is without legal power, it is termed void, and is
essentially a worthless piece of paper.
Legal Capacity to Enter a Contract
The first element that must be present for a contract to be
valid is the existence of legally competent parties. The
law attempts to protect the vulnerable from the actions of
the unscrupulous by this provision. Generally, in the area
of contract law, the term "competent parties" refers to
adults who have the mental capacity to understand the terms
and conditions of a legal agreement. Thus, the mentally
infirm, retarded, and insane are not generally deemed
competent parties. Furthermore, minors typically are not
held competent to engage in a legal contract. We have
hedged our statements with such words as "typically" and
"generally" because the world of law is so complex and
fraught with exceptions. As always, we are best advised to
leave law to the lawyers, and keep to the plain of
generalities rather than risk getting mired in the swamp of
exceptions.
Consideration
The consideration is the second element that is vital to
the legal power of a contract. A consideration should be
thought of that which make the whole agreement worthwhile.
A consideration is simply something with real value that
the two parties exchange. What is exchanged could be a
service, an amount of money, or the promise to meet a
specified obligation. For example, an insured agrees to pay
a certain premium in exchange for the insurer's agreement
to perform all the duties outlined in the contract should a
loss occur. Thus, in a life insurance contract, an
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insured's premiums lead to the beneficiary's receiving a
named death benefit following a premature death -- the paid
premium, or consideration, secures the valued contract.
Offer and Acceptance
If legally competent parties and a consideration are
present, the third essential element of the legal contract
can be approached -- an offer and acceptance. The offer and
acceptance is, remarkably for the world of law, just what
it sounds to be, one party making an offer and the other
party accepting it. The reason it is stated is that the
offer must be clear, definite, and free of qualifications.
Again, the intent of this condition is to protect honest
business persons and the consumer from those who are less
than honest and attempt to do business by "scams."
Also,
it is important to note that in life insurance, an offer
and acceptance cannot be oral.
Legal Purpose
Another layer of protection to the consumer supplied by
contract law is that an activity must be legal in order to
be insurable. In this case, a contract's power is
irrevocably bound to the legality of the goods, services,
or obligations stipulated in the agreement. The general
welfare is obviously protected by this legal provision, and
absurd situations avoided.
Insurable Interest
An insurable interest exists when there is the expectation
of a monetary loss that can be covered by insurance. For
life insurance, an insurable interest must exist at the
outset of the contract. Individuals are considered to
automatically have an insurable interest in their own
lives. An insurable interest also exists between a parent
and his or her child, and between spouses.
Other
forms
of
insurable
interest
relationship between a creditor and
employer and a key employee.
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Acceptable Form
Another element of a contract's power has to do with its
legally acceptable form. Both the format and language of
life insurance contracts must meet specific parameters
outlined by the State Insurance Bureau. Furthermore, if a
state government requires filing and approval of a contract
form, then any issued contract must be filed and accepted
by the state following the appropriate legal procedures.
Often in life insurance, a contract is not immediately
signed. Rather, a conditional receipt is used instead. This
conditional receipt is analogous to a binder in the
Property and Casualty line of insurance. Like a binder, the
conditional receipt is a temporary contract that makes the
insurance company provide some agreed-upon coverage while
the application is processed. A conditional receipt is
issued with an application and initial premium payment, but
it is not a guarantee of acceptance. Still, it must follow
acceptable
legal
form,
just
like
a
contract,
and
temporarily obligates the insurer, just like a contract.
Beyond these basics, the life insurance contract possesses
some additional fundamental features that make it different
from contracts particular to their types of business. For
example,
most
commercial
contracts
are
commutative
contracts. A commutative contract simply means that an
agreement has been made that follows acceptable legal
format, and specifies conditions for an exchange of moreor-less equal value.
An insurance contract, on the other hand, is an aleatory
contract. Here, "aleatory" is really no more than a fiftycent adjective meaning that the result of a contractual
agreement is dependent upon an uncertain outcome or event.
Also, in an aleatory contract, the conditions of the
transaction may or may not be an equal exchange of value.
The "uncertain event" of a life insurance contract concerns
the specific age at which the insured dies. The potentially
unequal exchange pertains to the level of benefits paid out
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in relation to the total value of premiums paid in to the
policy.
It is worthwhile to point out that an aleatory contract is
not just an elaborate game of chance. First of all, as we
have previously mentioned, a contract's legal validity
rests in no small part upon it handling a legal activity.
In addition, we should not focus overly much on the element
of chance alone. Certainly, chance is at the basis of the
aleatory contract, but this is not surprising or unusual
when we think about the situation. Insurance as we have
defined it is a method of handling risk, and risk is no
more than uncertainty regarding a loss. What we should
realize is that while all gambling arrangements must be
aleatory, not all aleatory arrangements are gambling.
The difference here has to do with intent. Pure gambling is
done to realize a gain, and has nothing to do with the
general
welfare.
An
aleatory
contract
for
insurance
purposes, on the other hand, is designed to guard against
loss. It is a frank and rational acknowledgment of the risk
that is a part of normal life, not the willful seeking-out
of additional risk for the possibility of profit.
A further feature of life insurance contracts is that they
are characterized by the principle of adhesion. This
concept is significant, as it is yet another facet of the
insuring contract that make it different from other legal
agreements.
All that is meant by a contract of adhesion is that the
legal agreement is not built from scratch in equal giveand-take between parties. Instead, in a contract of
adhesion, the party which makes the offer to deliver
services or meet obligations accepts
the entire contract,
or refuses it.
Obviously, the offering party in the contract of adhesion
has a great deal of power in this arrangement. Everything
seems to be formed according to the offerer's terms. In
reality, however, the situation is not necessarily so onesided. For example, areas of ambiguity in the contract that
are contested tend to be decided in favor of the party
accepting services, in our case, the insured. (Of course,
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this favoritism has its limits: a failure to understand or
properly interpret the contract on the part of the insured
does not necessitate that the court rule in the insured's
favor.)
Furthermore, as a general rule, all arrangements are
subject to compromise. The same is true of the contract of
adhesion. Thus, while the substantive elements and overall
nature of the contract in life insurance cannot be altered,
a wide range of features can be amended by the use of
riders. Even though the language and terms of these riders
are controlled by the insuring party, the contract is not
without flexibility.
Along with being an aleatory contract characterized by the
principle of adhesion, the life insurance contract is a
unilateral
contract. This is yet another feature which
separates the life insurance contract from most commercial
business contracts. Typically, business contracts are
bilateral, meaning that both parties to the contract
exchange something of value along specific terms. In the
unilateral life insurance contract, on the other hand, only
the insurer promises to provide a service. The insured's
premium payment is not seen in this case as a service or
payment of a claim, but only as part of the consideration
of the contract.
The life insurance contract, is also characterized by a
conditional nature. This means that it is a contract in
which the provisions of the agreement need only be
fulfilled if the insured has met certain, specific
conditions. In this sense, conditions may be seen as a set
of duties. The insured is not legally bound to meet the
agreed upon conditions, but the insurer need not meet its
obligations if the contract's conditions have not been
realized.
Finally, it should be stated that unlike property insurance
contracts, life insurance contracts are not characterized
by the principle of indemnity. Simply put, a property
insurance contract attempts to return an insured to his or
her approximate position before a loss. With property loss,
a dollar figure can be arrived at to determine how much was
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at risk. Human life, on the other hand, is not so easily
measured.
Life insurance contracts do not attempt to put a dollar
value on human life. While various methods do exist to
determine the "right" amount of life insurance, these
methods are not in any way a form of indemnification.
Rather, the life insurance contract is a valued contract.
This means that a stated amount of money is paid contingent
upon the death of the insured.
It is also worthwhile to note that since the life insurance
contract is not an indemnity contract, the principle of
subrogation does not apply. You will remember that
subrogation is a legal principle by which the insuring
party attains rights to pursue damage losses from the
negligent party.
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REVIEW QUESTIONS
1.
Life insurance contracts, like all insurance contracts, are
characterized by the principle of indemnity.
a. true
b. false
2.
In life insurance, the temporary contract tool that is analogous to the
binder in property insurance is called the______________.
a. conditional contract
b. conditional receipt
c. temporary receipt
d. life binder
3.
Since the insurance contract is an aleatory contract, it is essentially a
sophisticated and legal form of gambling.
a. true
b. false
4.
Life insurance contracts are termed valued contracts, meaning that
the insuring party will pay a stated amount of money if an agreed
upon event -- in this case, premature death -- occurs.
a. true
b. false
5.
For any contract in the insurance field to be legally valid, it is vital
that it follows a form acceptable to the State Insurance Bureau.
a. true
b. false
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6.
If it can be demonstrated that one of the parties to a contract was not
mentally competent when he or she entered the agreement, it is held
that the contract is void due to the lack of legal capacity.
a. true
b. false
7.
Since life insurance contracts are contracts of adhesion, entirely new
contracts are not crafted out of equal give-and-take between the two
signing parties. Rather, a contract is offered by the insurer, and it is
accepted or rejected by the customer.
a. true
b. false
8.
The conditions in a life insurance contract legally bind the insured to
a specific set of duties. The insurer can not only withhold payment of
obligations and services, but can even bring suit against the insured
if the contract's conditions have been violated.
a. true
b. false
9.
For a life insurance contract to be valid, there must be some
consideration, meaning a monetary amount exchanged for a
promised value to be paid out at the event of an agreed upon
contingency.
a. true
b. false
10.
Life insurance contract, like most business contracts, are bilateral,
because both parties agree to perform a certain set of duties.
a. true
b. false
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ANSWERS TO THE REVIEW QUESTIONS
1. b
2. b
3. b
4. a
5. a
6. a
7. a
8. b
9. a
10. b
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CONTRACT PROVISIONS IN LIFE INSURANCE
The insured's rights, as well as the duties of the insurer,
are outlined in the life insurance contract. These rights
and duties are termed the policy's contract provisions.
These provisions operate in conjunction with contract law,
and provide the operative parameters of the insuring
agreement.
It is important to note that life insurance policy's
contract provisions are not universal. Varying from state
to state, they are subject to the jurisdiction of the state
legislature and the State Insurance Bureau. Nevertheless,
there are standard elements to the common contract
provisions in the life insurance contract, and this makes a
general discussion of them possible.
As the life insurance contract's provisions serve such
functions as demonstrating ownership of the contract,
availability of policy loans, entitlement of the death
benefit, etc., it obviously benefits one to possess a
thorough understanding of them. Now, as the typical
consumer
of
life
insurance
products
has
rarely
distinguished him or herself by making a strong effort to
read and master these provisions, it is vital that the
insurance professional be able to succinctly explain them
to his or her clients.
For life insurance, there are seven provisions that are
absolutely vital for the operation of the contract. We will
briefly go over each in turn.
Entire-Contract Clause
The entire-contract clause is essentially a device to
protect the consumer. The way that the entire-contract
clause protects the consumer is to block any incorporation
by reference.
The incorporation by reference concept is actually a device
to make contractual agreements less cumbersome by including
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other stipulations and agreements that are based upon the
language of other legal documents. This is accomplished
simply by reference to those documents.
The potential problem with the incorporation by reference
device is that limitations which negatively affect the
insured can be effectively hidden. Thus, the entirecontract clause guarantees that the policy is the entire
contract between the insurer and the insured. Any changes
and
attachments
made
to
the
policy
are
considered
modifications.
We should note here that the entire-contract clause
pertains to the actual policy application as well as the
contract. Therefore, all of the pertinent underwriting and
medical information supplied by the insured is included.
Generally speaking, the information in the application is
treated as representation rather than warranty, and most
states do not allow the insurer to contest the contract on
the basis of statements in the application which are not
attached to the actual policy. This helps protect the
insurance consumer, as the insurer cannot deny a claim to a
beneficiary based upon information in the application
(unless,
of
course,
the
statement
is
a
material
misrepresentation).
Ownership Clause
The clause in the life insurance policy that states who
owns the contract is the ownership clause. But this clause
does still more than list the name of the owner. The
ownership clause is in many ways the most significant
clause in the contract as it details the owners rights in
the insuring agreement. Such rights include the naming of
the beneficiary, the changing of the named beneficiary,
accessing
the
policy's
accumulated
cash
value,
and
selection of an optional mode of payment. In addition, the
policy-owner can transfer ownership of the policy, which
can be done by simply filing a form with the insurer that
creates an "absolute assignment," or a change of policy
ownership free of conditions. The owner of the policy is
free to exercise any of these powers unless he or she is
constricted by the right of irrevocable beneficiary.
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Incontestable Clause
Although life insurance contracts are supposedly contracts
of utmost good faith, fraud and dishonesty do occur. In
order to protect themselves from unscrupulous consumers,
insurers employ an incontestable clause. Simply put, the
incontestable clause gives the insurance company a two year
time-frame in which to discover fraudulent activities or
statements of an insured.
The intent of this clause is to provide a deterrent to
fraud. It is reasoned that if a dishonest consumer knows
that the insuring company is vigilantly searching for fraud
for a full two years, the person will seek some other angle
to earn a dishonest dollar.
But the incontestable clause also protects the consumer.
Through
this
provision,
the
insuring
company
cannot
challenge a contract after a reasonable period of time. The
beneficiary is spared the corroding sense of insecurity and
potential hardship that would occur if an insurer could
contest and void a policy years after the underwriting
information should have been made plain.
Lastly, the incontestable clause is designed to promote the
general welfare. By providing a guard to the rights of the
consumer and the insurer, both benefit. Also, actions that
are grossly immoral, such as insurance contracts taken out
for the intent of collecting a death benefit from the
murder victim are of course not extended protection by the
incontestable clause.
Grace Period
The grace period can literally by like an act of grace.
This important provision is that stated period of time that
the policy remains in force even though the premium has not
been paid. This allows the insured to keep his or her
insurance protection and avoids the complications of having
to reapply for a policy. This device helps guard against
tragedies that could occur out of mistakes, failures to
communicate, or temporary financial short falls.
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When a policy is operating during the grace period, all the
rights and privileges contained in the contract are in
effect. Should benefits need to be paid out, they would be
paid less the amount of the "missing" premium. After the
grace period has elapsed, the policy is no longer valid.
The normal period for a grace period is 31 days, but
because of the nature of such flexible policies as
universal life, the grace period may well be longer.
Reinstatement Clause
The reinstatement clause allows for the return of a lapsed
contact to its original terms within a specified period of
time. This normally occurs after an insured has opted for a
non-forfeiture option, such as paid-up conversion or an
extended term conversion.
For an insured to be reinstated, evidence of insurability
is generally expected. Also, the insured can expect to pay
any overdue premiums from the previous due date with an
additional interest charge.
Some states legally demand that insurance contracts carry a
reinstatement clause. Whether required by law or not,
however, most insurance companies carry a reinstatement
clause in order to retain customers.
Misstatement-of-Age Clause
The most significant information used for life insurance
underwriting is the age of the prospective insured. If an
inaccurate age is used to compute the insured's premium, it
stands to reason that the result will not be adequate for
the risk-level of the prospect. Here, an inaccurate premium
means potential danger for an insurer, as the actuarial
basis for the company's financial decisions depends on
statistical precision.
Lacking some means to guarantee that the correct age be
stated in life insurance contracts, it is reasonable to
assume that understatement of age would by quite common in
the field. The result of lower than necessary premiums on a
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mass scale could prove ruinous to the industry when the
belated claims started coming due.
What then occurs when an insured has misstated his or her
age in the policy application?
This depends primarily on
the time when the error is discovered. For if the correct
age is found before the incontestable clause comes into
effect, the policy may simply be voided. The insurance
company can correctly state that the prospect is not one
with whom it cares to conduct business, and send him or her
on their way.
The situation is somewhat different if the waiting period
of the incontestable clause has elapsed. As mentioned
above, the contract is now considered incontestable, and
the insurance company cannot cancel it, even though it has
discovered fraud.
Still, the company need not remain victimized simply
because it was not able to discover the misstatement until
some time after the waiting period expired. Rather, the
policy remains in force, but the premiums are altered so
that they reflect the correct and truthful age of the
insured. If the insured has died, benefits are still paid
out, but they are paid out at an adjusted level that
reflects the correct amount of insurance.
Suicide Clause
The suicide clause mirrors the incontestable clause, in
that a two-year window exists during which a claim can be
legally denied by the insurer. However, after the two years
has expired, the insurer must pay out benefits to the
beneficiary even if the cause of death was suicide. (Even
in the event of suicide, the named beneficiary does receive
back the equivalent of the premiums paid into the policy,
without interest.)
The suicide clause provides a dual purpose. Foremost, it is
a shield for the insurer against adverse selection.
Obviously, an insurer has no desire to sell life insurance
coverage to a prospect who intends, for whatever reason, to
commit suicide. Furthermore, it is certainly difficult to
screen for potential suicides.
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The suicide clause also protects the named beneficiary as
well. By returning the paid premiums before the expiration
of the waiting period and the full benefits afterwards, the
best possible situation is made out of a tragedy.
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REVIEW QUESTIONS
1.
The purpose of the entire-contract clause is to protect the consumer
from the potentially adverse elements of incorporation by reference.
a. true
b. false
2.
The entire-contract clause only pertains to the contract, it does not
encompass the actual policy application.
a. true
b. false
3.
The ownership clause outlines the policy owner's rights and privileges
in the contract.
a. true
b. false
4.
A policy owner's powers are constricted if there is an irrevocable
beneficiary.
a. true
b. false
5.
The incontestable clause states that a policy cannot be dropped by the
insurer after the expiration of a two year waiting period.
a. true
b. false
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6.
The incontestable clause protects the consumer by guaranteeing that
the insurer cannot challenge a contract after a reasonable amount of
time.
a. true
b. false
7.
The grace period normally lasts for 31 days, and allows the policy to
stay in force even if the last premium has not been paid.
a. true
b. false
8.
Because of the flexible nature of universal life policies, the grace
period is often shorter than 31 days.
a. true
b. false
9.
The ____________ allows for the return of a lapsed contract to its
original terms within a specified period of time.
a. replacement clause
b. reinstatement clause
c. reinforcement clause
d. retro clause
10.
If a misstatement of age is found in an insured's policy after the waiting
period has elapse, the policy stays active, but the premium is
recalculated to reflect the accurate level.
a. true
b. false
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ANSWERS TO THE REVIEW QUESTIONS
1. a
2. b
3. a
4. a
5. a
6. a
7. a
8. b
9. b
10. a
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OTHER FEATURES OF THE LIFE CONTRACT
Beneficiary Status
A significant aspect of the life insurance contract
concerns how the beneficiary is named. The beneficiary is
that party who is named in the contract to receive the
death benefit in event of the death of the insured. There
are generally few limits on who or what can be named as the
beneficiary to a life insurance contract. A pet, a charity,
a partnership, or a trustee are just some of the more
unusual
potential
beneficiaries
of
a
life
insurance
contract. As would be expected, however, most often named
beneficiary is a relative of the insured, usually a child
or a spouse.
In regards to children, a couple of situations can occur.
When the child is still that, a minor, then the death
benefit cannot be received directly. In this case, a
trustee or guardian should be named as the beneficiary.
When the insured has many children, another situation
arises if no one specific is named as the beneficiary, but
rather the "children" are to receive the policy's proceeds.
In this case, the monies are divided equally among the
multiple beneficiaries. This is termed the payment of a
class beneficiary.
The class beneficiary is different from the two more
typical
varieties
in
life
insurance:
primary
and
contingent beneficiaries. The primary beneficiary is first
in line for the death benefit. The contingent beneficiary
is the secondary beneficiary. He or she is next in line, or
is entitled to the death benefit proceeds should the
primary beneficiary die before the insured.
Generally speaking, the named beneficiary can be changed.
This is a policy with a revocable beneficiary status. The
tricky (and dangerous) element here is that the beneficiary
need not be informed that they have been dropped from the
policy.
A life insurance policy with an irrevocable beneficiary, on
the other hand, constricts the freedom of the insured to
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exercise his or her ownership. To begin with, the named
beneficiary of this form of policy cannot be changed
without his or her written consent. Secondly, when an
irrevocable beneficiary is named, the policy is effectively
placed outside the estate of the insured, who subsequently
surrenders incidences of ownership as they relate to the
federal estate tax.
Change Of Plan Provision
Another example of the life insurance contract's ability to
change in order to adapt to new needs and conditions is the
change of plan provision. Simply put, this provision is a
feature that allows for the insured to change his or her
contract. Should the exchange go for the policy with a
lower premium than the policy it replaces, and if the
insured has an amount of cash value built up in the former
policy, he or she will have that amount refunded.
Conversely, should a higher premium policy be desired, the
difference in cash value would be corrected in favor of the
insurance company.
Assignment
An insurance policy is also modified when it is assigned.
Two varieties of assignment exist, absolute assignment and
collateral assignment. This is a feature that is not
available to the property insurance contract, and can have
important business ramifications for the life insurance
policy-owner.
When an absolute assignment is made, a situation is formed
in which all ownership is transferred to the named party. A
collateral assignment, on the other hand, is partial and
temporary. In this situation, a part or all of a life
insurance's death benefit is assigned to another party as
collateral. An example of this is a bank making a loan to a
policy-owner. This is a common enough practice that many
banks possess assignment forms on file.
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REVIEW QUESTIONS
1.
Who can be named a beneficiary of a life insurance policy is limited to
living persons. Pets, partnerships, and charities are excluded.
a. true
b. false
2.
Generally, the named beneficiary in a life insurance policy is the
insured's spouse or children.
a. true
b. false
3.
Should the named beneficiary be a minor at the time of the insured's
death, the proceeds from the policy are paid out in a lump sum and
placed into a account. A trustee or guardian are useful, but not
required.
a. true
b. false
4.
A policy with an insured's children listed as the beneficiary has a class
beneficiary. The proceeds in this case are split into equal portions and
disbursed.
a. true
b. false
5.
Should both the primary and contingent beneficiary be deceased
before the death of the insured, the monies from the death benefit are
attached to the insured's estate.
a. true
b. false
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6.
A life insurance policy with a revocable beneficiary provision allows for
the insured to change his or her beneficiary without gaining their
consent or informing them or the change in status.
a. true
b. false
7.
The reason for the change of plan provision is to aid in the practice of
twisting.
a. true
b. false
8.
An absolute assignment is a fairly common practice in both life and
property insurance.
a. true
b. false
9.
A collateral assignment is a procedure by which the holder of a life
insurance policy may obtain a loan from a bank by assigning all or part
of the death benefit to the bank as collateral.
a. true
b. false
10.
When a policy possesses an irrevocable beneficiary, the insured is
said to have surrendered all incidences of ownership as they relate to
the federal estate tax.
a. true
b.false
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ANSWERS TO THE REVIEW QUESTIONS
1. b
2. a
3. b
4. a
5. a
6. a
7. b
8. b
9. a
10. a
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LOANS AND OPTIONS
Policy Loans
One
of the outstanding features of the cash value life
insurance contract is that it builds monies that the
contract holder can access. The methods of accessing these
funds are diverse. One of the most popular is the policy
loan.
The life insurance loan will be at interest rates that are
much lower than those available from traditional lenders.
The interest rate to be charged is stated in the policy
loan provision section. It is possible that some contracts
will have variable interest rates that are tied to a bond
index. Most important, gaining a policy loan is much easier
than loaning money from a banking institution. One is not
subjected to the necessary but inconvenient hassle of a
credit check. Also, the repayment schedule is set by the
contract holder.
If the interest on a policy loan is not paid at the year's
end, it is rolled into the outstanding loan. The loan
amount should of course be paid in full before a death
benefit is distributed. If it is not paid, then the death
benefit is reduced by the amount necessary to pay the loan
back in full.
Dividend Options
When we speak of a "participating policy" we are referring
to a policy that pays dividends to its owner. A dividend is
nothing more than a surplus that the insuring company
receives when there is a positive difference between
expected and actual expenses. This difference could arise
from operating expenses, or mortality experience. As the
consumer expects a dividend, even though it is not
guaranteed, calculations of predicted losses and investment
returns are made sufficiently low to make a dividend easy
to generate. The money that arises in form of a dividend
needs to take some form of pay-out. There are five methods
of dividend pay-out.
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One method of paying the dividend is to apply it to the
next premium. Using this method, the contract holder
receives a notice when there is a dividend stating the
dividend's value. He or she then need only pay the
difference between their premium and the dividend to
continue coverage.
Also, a dividend can be paid out in cash. Naturally, this
is a popular form of pay-out structure at first glance.
Upon examination, however, cash payments tend not to be
taken because the recipient must pay tax on these sums.
The cash option is generally paid out on the anniversary
date of the policy.
Dividends may also be used to buy increments of paid-up
insurance. This can be used in a single premium whole life
policy.
Using
a
paid-up
insurance
dividend
option
circumvents the policy's load, effectively purchasing
insurance at net rates.
Another option with dividends is to let them stay with the
insuring
company
and
accumulate
at
interest.
These
dividends may be withdrawn at any time by the insured, or
they may be left in the account with the purpose of being
ultimately added to the death benefit pay-out. It is
interesting to note that the interest that accumulates
under this system of dividend option is taxable, and must
be reported.
Lastly, there is the so-called Fifth Dividend Option. This
is a form of term insurance. The dividend in this option
buys an annual, renewable term insurance, or a one year
term contract that is equal to the cash value of the
underlying policy. If a difference is left over under the
second option, it is usually left in the insuring company's
account to accumulate at interest.
While dividend options are generally the province of life
insurance contracts, some health insurance contracts also
present dividend options. All in all, a dividend option can
be thought of as a refund of some portion of the contract's
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gross premium whenever
favorable year.
the
insurance
company
has
had
a
Nonforfeiture Options
Nonforfeiture options are applicable to cash value life
insurance policies. These options are a form of policy
provision that protects the policy-owner from losing the
cash value that has accumulated in the account. This option
provides four methods of protecting the policy-owner's
equity.
First, the policy can be surrendered for its cash value.
This surrender will be for the full amount of the cash
value account, less any outstanding loans and interest on
the loans. It is technically feasible that an insurance
company can reserve the right to withhold the cash value
for up to six months. This is, however, a left-over from
the Depression era, when devices were needed to slow the
draw of cash from insurers. Today, this is rarely if ever
used.
Another nonforfeiture option takes the form of extended
term insurance. The cash value buys a paid-up term policy
for a specified period of time under this strategy.
Also possible is a paid-up insurance option. This option
uses the cash value to buy a reduced, paid-up policy with a
net single premium. This creates a policy that is
essentially the same as the policy that was replaced, but
with a smaller death benefit -- and the absence of any
future payments!
Lastly, there is the loan value option. This option allows
the insured to borrow from the company, with the cash value
used as collateral for the loan.
Settlement Options
Sometimes, an insured may not want to receive the life
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insurance's proceeds in a single payment. When this occurs,
we say that an optional mode of settlement has been decided
upon. Optional modes of settlement have four main forms,
with the fourth posing a number of variations within its
own structure.
When a sizable amount of money is not needed immediately,
the beneficiary may elect an interest option as the mode of
settlement. This is a highly flexible form of pay-out. The
benefit proceeds are left with the insurance company, and
gain interest. The accumulated interest is paid-out to the
beneficiary monthly, quarterly, or annually. Also, the
principal can be accessed at any time. In addition, the
beneficiary can alter this settlement to another form at
any time. This option provides a small, regular cash flow.
Another type of flexible settlement option is the fixed
amount option. As the name would indicate, the death
benefit is paid out in installments until the monies are
exhausted.
This
strategy
allows
the
beneficiary
considerable room to tailor the plan to his or her changing
needs. For example, the fixed amount can be raised or
lowered at any point. Withdrawals from the benefit proceeds
above and beyond the fixed amount can be made, and this
mode of settlement can be changed at any time.
A mode of settlement which is not flexible is the fixed
period option, and is not to be confused with the fixed
amount option. This strategy allows for the disbursement of
the death benefit proceeds over a specific, fixed period of
time. The structure is not adjustable, and withdrawals are
rarely permitted.
Lastly, there are the life income options. Life income
options are methods of disbursement through an annuity, and
as such they mirror an annuity's structure.
Thus, a pure life income option is a pay-out format in
which the proceeds are paid out only when the beneficiary
is alive. When the beneficiary dies, proceeds cease and are
kept by the insuring company.
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On the other hand, a life income with period certain option
allows for a secondary beneficiary to receive payments for
some stated period after the death of the primary, named
beneficiary. This provides a guarantee that someone will
receive the benefit proceeds in the event of the primary
name beneficiary's death, but the payments are smaller than
under that of the life income option.
A married couple, however, would probably choose a jointand-survivor option. This structure allows for the payment
of the benefit to two persons, and payments continue when
one of the two dies.
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REVIEW QUESTIONS
1.
A loan from a cash value insurance policy really presents no
advantage over a loan from a bank. One must still be approved, a credit
check is run, etc.
a. true
b. false
2.
Dividend options are a feature of insurance contracts in nonparticipating policies.
a. true
b. false
3.
Essentially, a dividend payment is a type of refund that an insurance
company offers to the policy holder because expenses or mortality
were less than anticipated.
a. true
b. false
4.
The Fifth Dividend Option is a method of purchasing annually
renewable term insurance with the dividend.
a. true
b. false
5.
Nonforfeiture options are policy provisions designed to protect the
contract holder's equity in a cash value insurance policy.
a. true
b. false
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6.
Perhaps the most common nonforfeiture option is the surrender of the
policy's cash value, less any outstanding loans or interest payments
due the insuring company.
a. true
b. false
7.
Settlement options are policy provisions that allowed for a mode of
distributing a policy's proceeds in a manner other than a single, lump
sum payment.
a. true
b. false
8.
Interest option and fixed amount option are two types of settlement
options that are characterized by a high degree of flexibility.
a. true
b. false
9.
A life income option is a settlement option that turns the policy
proceeds into a type of annuity.
a. true
b. false
10.
The interest rate for a policy loan is stated in the contract's loan
provision section. It is not uncommon for the rate to be tied to an
index.
a. true
b. false
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ANSWERS TO REVIEW QUESTIONS
1. b
2. b
3. a
4. a
5. a
6. a
7. a
8. a
9. a
10. a
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THE COST-OF-LIVING AND DOUBLE INDEMNITY
RIDERS
Cost-of Living Rider
The cost-of-living rider, or cost of living increase, is
just that -- an increase in benefit level designed to ward
off the corroding effects of inflation. This is a policy
provision that is typically added to life insurance
policies at the demand of an extremely inflation-conscious
public.
In short, the cost-of-living rider allows the insured to
buy a year's worth of term insurance that is equal to the
percentage change in the Consumer Price Index (CPI). This
additional insurance can be had without the insured's
providing evidence of insurability.
The level of this additional term insurance is linked to
the CPI, and will vary on a constant basis, just as does
the CPI. Theoretically, this adjusted amount can go up or
down. The rider is not designed to handle hyper-inflation,
however, as the adjusted increase is generally capped to
reflect some percentage of the policy's face amount.
Double Indemnity Rider
Double-indemnity is also known as the accidental death
clause. It provides an additional (double) death benefit
should the insured die from an accident. There is also a
triple indemnity, in which case three times the face value
of the contract is paid out in event of accidental death.
The double-indemnity rider can be had for a relatively
small charge. Even though it is affordable, however, it is
not usually as valuable as it is popular. Foremost, it
provides an illusion of expanded coverage. The increase in
benefits are accessible only after having met a number of
exclusionary
objections.
Secondly,
disease
and
not
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accidental
injury
is
the
killer
of
most
insureds.
Nonetheless, the double-indemnity rider remains in demand.
In order to be eligible for the added benefits of a doubleindemnity claim, it must be demonstrated that the insured
died as a direct result of an accidental injury. Next, the
death has to occur soon after the accidental injury.
Typically, the insured must die within 90 days of the
injury. And finally, the rider will state the high-end age
at which the benefit will be paid out.
As with so many insuring agreements, the double-indemnity
rider outlines a list of exclusions to prevent abuses of
this provision. For example, as the rider is limited to
accidents, deaths from disease or insanity are not eligible
for benefits. Suicide is also an excluded death, as is any
death that occurs while committing a crime. Finally, death
that arises out of the inhalation of poison fumes, flying
in a non-commercial airplane, or during an act of war
cannot receive benefits from this rider.
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REVIEW QUESTIONS
1.
The cost-of-living rider is a provision that will increase or decrease the
face amount of a policy in conjunction with shifts in the Consumer
Price Index.
a. true
b. false
2.
The additional protection of the cost-of-living rider comes through the
purchase of additional term insurance.
a. true
b. false
3.
The primary goal of the cost-of-living rider to protect the insured from
the negative effects of inflation by keeping his or her face value in tune
with current prices.
a. true
b. false
4.
The adjusted level of insurance in the cost-of-living rider is usually
capped to reflect a stated percentage of the policy's face amount.
a. true
b. false
5.
The double-indemnity rider is a valuable contract provision for most
consumers, but is often not purchased because it is so expensive.
a. true
b. false
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6.
The double-indemnity rider is generally a good deal for most
consumers because most people today die of accidents rather than
disease.
a. true
b. false
7.
In order for an insured to claim benefits through a double-indemnity
rider, it must be shown that the death occurred as the direct result of
an accidental injury.
a. true
b. false
8.
The double-indemnity rider usually covers accidental death caused by
inhalation of poisonous fumes.
a. true
b. false
9.
If an insured with a double-indemnity rider dies exactly one year after
an accidental injury, his or her policy will probably not pay double the
face amount of the policy.
a. true
b. false
10.
The double-indemnity rider is not subject to any exclusions.
a. true
b. false
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ANSWERS TO THE REVIEW QUESTIONS
1. a
2. a
3. a
4. a
5. b
6. b
7. a
8. b
9. a
10. b
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