insurance ch.9b

Chapter 9© 2007 DF Institute, Inc.
© 2007 DF Institute, Inc.
Individual Life Insurance Policies
Term insurance
Whole life insurance also known as cash value (CV) insurance
Universal life insurance
Variable universal life
Equity-indexed universal life
Term Insurance
Term insurance
“Pure” insurance – death protection for a TERM of time (e.g., X years, while employed) – with no cash value
Most is renewable – continue without proving insurability (can be expensive!)
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Term Insurance: Types
Annual renewable term (ART or YRT): no evidence of insurability, but annually increasing premium based on insured’s age (can get expensive fast).
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Term Insurance: Types
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Rider: Additional coverage for something not specifically covered within the primary policy.
Waiver of premium for disability
90 day to 6 month waiting periods apply before premium is waived.
Accidental death benefit (death within 90 days of accident, double indemnity – face value of policy * 2)
Accelerated death benefit, “living benefit,”Terminal/ Compromised life expectancy.
Return of premium – Returns premium to insured or bene (+ DB)
Spouse and Child insurance – Coverage for spouse/child
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Term Insurance
Affordable: Maximum coverage/amount of premium. Cost effective for early to mid portion of lifetime.
Fulfills temporary need (until achieving financial independence/accomplishing goals, like Ed funding)
Protects insurability – guaranteed renewable
Cost prohibitive at older ages (not viewed as lifetime protection)
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+ Protects insurability: guaranteed renewable or convertible
Prohibitively expensive with age
No savings ( if goal strategy, + low ROI for whole life)
Buy Term & Invest the Difference
No lifetime coverage, due to cost
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Can surrender for cash value
Can borrow against the cash value
Tax-deferred accumulation
Mortality charges – “death benefit”
Pre-pay future mortality costs.
Administrative costs and insurer profit
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Whole Life Insurance: Types
Ordinary life/continuous premium (until death or age 100 – living benefit paid at age 100 if insured living)
Limited-pay policy; paid up policy (premiums paid for limited # of years) – High initial premiums
Modified life (lower premium first 3-5 yrs.) – good if cf low early on
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Whole Life Insurance: Types
Current assumption (interest sensitive) – CAWL
New money interest rates (additions to CV) and current mortality assumptions (costs, subtractions from CVk) to determine cash values
Ins Co shares investment experience and profits with policy owner.
Interest rate floor (guaranteed minimum).
Variable life: fixed premium but face/cash values depend on investment performance; guaranteed face amount as minimum
Policy holder invests cash value in subaccounts and bears the investment risk.
Joint life: first- or last-to-die policies – underwriting based on one with longest life expectancy
Pays DB out at the first or second death.
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Whole Life: Dividend Options
Dividends held on deposit with insurance company and earn interest
Either added to DB at death or added to the CV if surrendered
Paid-up additions: no insurability required
Increases both DB and CV
Equal to what a single premium would purchase
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Whole Life: Nonforfeiture Options
Cost basis = tax-free return of basis.
Gain (above cost basis) = ordinary income
No longer need death benefit.
Reduced paid-up insurance
Use CV as a single premium to buy a paid up policy (uses current age to determine how much the premium will buy) –
Extended term insurance
Use CV as a single premium to buy term insurance equal to the original policy FV that lasts as long as the CV will support it.
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Accidental death benefit (typically death within 90 days)
Spouse and children’s riders (term)
Term insurance (later convert to permanent)
Living benefits (life expectancy 12 months or less)
Paid-up insurance additions (premiums purchase additional death benefit amounts)
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Inflexible premium – risk of policies lapse
Gradual/slow cash value -- Low IRR (unless a variable policy that is invested well)
* Consider M&E charges compared to the CV invested in an IRA or regular brokerage account.
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Ability to change death benefit amount
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NAR equals death benefit less cash value
Death benefit may increase in later years to prevent an “investment” instead of a life insurance policy – “DEFRA corridor”
Option B (Option 2)
NAR remains level throughout the policy
See Exhibit 9.4, page 314
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Typically a required target amount for a number of years
Possible to stop premium payments if policy CV is sufficient to cover M&E charges.
OR, could just pay the M&E charges.
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Flexible premiums and death benefits:
Premium, death benefit and cash value flexibility of universal life + investments and increasing/decreasing face value of a variable policy
Self-directed investments:
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Variable Universal Life Features
VUL policy structure:
Like a UL, mortality charges and admin expenses deducted from the cash value
InVestment earnings fund the cash value
Agents/brokers who sell VUL must have state life license and FINRA securities license – Series 6 or Series 7
Death benefits:
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UL and VUL Riders
Waiver of premium or monthly deductions:
Requires insured to be permanently/totally disabled before X age, typically 65 and meet waiting period
Two riders: waiver for mortality and expense charges OR waiver of the original target premium
Accidental death benefit: Requires death within 90 days of accident; double indemnity
Other insured: Level term for spouse/children; typically convertible
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UL and VUL: Pros/Cons
+ Flexible death benefit
- Flexible premiums, no fixed commitment: polices lapse. Many require min/max premiums or targets for X years
- Misleading rates of return and long-term illustrations may mean the target premium is NOT enough to keep policy in force and may be higher than a whole life policy
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+ Premium & investment flexibility, including changing sub-accounts without tax liability
+ Current assumptions (interest & M&E, can mean cheaper expenses than whole life)
- Premium flexibility
Relatively high fees, commissions, surrender charges + M&E + monthly administrative charges
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(MECs) (only policies sold after 6/20/88)
If cumulative premium payments exceed the net level premium (as defined by IRC) during the 1st 7 years, the policy is MEC.
7-pay test: Amount invested cannot exceed the net level premium for a 7-pay life policy, given the year 1 face amount, age & life expectancy of the insured; IRC calculation
OR…7 years following a material change (increase/decrease of cash or death benefit)
IF determined MEC, loans & withdrawals (above basis)
LIFO treatment (income/gains distributed and taxed first)
10% penalty (< age 59½)
Death benefits are not affected if policy determined MEC
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Group Life Insurance– Save $$
Group term
Cost of coverage >$50k: Section 79 income –subject to income tax & SS & Medicare
May have option to increase coverage
May have option to convert to whole life, if employment ends
Most common.
Group universal life
Employee paid supplement to term; no evidence of insurability to stated max of coverage
Group VUL
Low fees/surrender charges
Tax-favored investment vehicle
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Policy Selection & Cost Comparisons
Policy cost – budget available to pay the premium
Duration of the need – “term” or lifetime
Amount of coverage (life needs analysis)
Risk tolerance -- consider a variable product?
Policy Selection – consider the policy illustrations:
Illustrations are NOT guarantees of policy performance
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Policy Selection & Cost Comparisons
Interest-adjusted surrender cost index
Interest-adjusted net payment cost index
Surrender cost index (compares cash value and costs given a surrender date)
Net payment cost index (death benefit cost comparison in X (10 or 20) years)
CAREFULLY judge the accuracy/representativeness of policy illustrations
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Policy Replacement
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Life Insurance Health Ratings
Life Insurance Health Ratings:
Life Insurance Policy Provisions
Grace period (31 days to pay premium after due date)
Incontestability (insurer cannot cancel after in force for 2 years if discover material misrepresentation or concealment)
Entire contract clause (application part of the contract – statements made in contract can void/alter the contract)
Misstatement of age or gender (usually discovered at death upon receipt of death certificate – DB of policy can be adjusted due to this)
Assignment
Suicide (usually a 2 year window)
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Life Insurance Policy Provisions (cont.)
Reinstatement: 31 days (no insurability) to 5 years (insurability) after the grace period ends
Policy loans (borrow against cash value with interest)
Automatic premium loan: Pay premium with loan
Must request on application or later in writing
Beneficiary designations
Revocable (can change) and irrevocable (can’t change typically used with divorce settlements)
Primary and contingent (1st/2nd)
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Aviation exclusion: noncommercial only; premiums returned; not as common today
War exclusion: no pmt of DB, instead, premiums + interest returned to the beneficiary
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Life Insurance Settlement Options
Lump Sum OR…. Some alternatives*
Interest only (Ins co retains DB and pays the bene interest)
Fixed amount (Specific amount paid until depleted)
Fixed period (Maximum payment for period of time)
Life income (Specific amount for life)
Life income with period certain (Life or specific period, whichever is longer)
Life income with refund
Joint and last survivor income
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How are premiums paid?
Single premium (lump sum)
How is the payment determined?
Fixed annuity (specific interest rate)
Variable annuity – subaccounts, accumulation units
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What is the timing of the annuity payments or annuitization?
Straight life annuity
Life with period certain annuity (e.g., 10 or 20 years)
Guarantee of a specific period of time or life, whichever is greater.
Installment refund annuity (continued annuity to beneficiary refund after annuitant’s death) Refund based on amount paid out compared to purchase price of annuity.
Cash refund annuity (lump sum refund after annuitant’s death) Refund based on amount paid out compared to purchase price of annuity.
Joint and survivor annuity (provides for the annuitant and a survivor)
100%, 75%, 50%
Taxation of Life Insurance
No tax on policy proceeds paid to beneficiary
Dividends are not taxable unless withdrawn and in excess of premiums paid
Except for MECs, loans against the cash value are tax free
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Dividends as return of principal are not taxable unless they > premiums, then taxed as income
Withdrawals
FIFO treatment until all premiums paid out – Tax-free return of premiums
LIFO treatment for MECs + 10% on taxable gains before age 59 ½ - Gain out first
Policy surrender
Interest only payment is taxable
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Section 1035 exchanges: gains from the original contract are not taxed, but deferred, if applicable
2 life, 2 annuity, 2 endowment (restrictions apply) OR life for annuity or endowment OR endowment for annuity NOTE: no annuity for life or endowment
For transfers for “valuable consideration,” proceeds lose tax-free status if transfer is not a gift or a transfer to the insured’s business (partner, partnership, corporation). Otherwise included in gross income of transferee (i.e., the RECIPIENT), for amount proceeds exceed the basis
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Taxation of Death Benefits
Interest-only payments are taxable
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Taxation of Viatical Agreements
Viatical agreements – sell policy to 3rd party
Proceeds are tax free to insured (usually a lower amount than the DB)
Proceeds beyond purchase price and premiums paid taxable to purchaser (Difference between purchase price and DB)
Terminal illness: life expectancy of 2 years or less
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Inclusion/exclusion ratio to determine nontaxable portion of each payment
100% taxable after principal has been fully paid out
Unrecovered basis, in case of death, allows for a deduction on the decedent’s final 1040 form
Investment in the Contract
Expected Return = Exclusion ratio

insurance ch.9b

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