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Life Insurance Principles

10 Hour California Insurance

Continuing Education Course

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TABLE OF CONTENTS

PART I: THE BASICS OF LIFE INSURANCE 1

CHAPTER 1: THE CONCEPT OF LIFE INSURANCE 1

THE NEED FOR LIFE INSURANCE ..................................................................................... 2 LIFE INSURANCE BENEFITS FOR THE LIVING .................................................................. 2

CHAPTER 2: THE LIFE INSURANCE POLICY 4

THE USES OF LIFE INSURANCE ......................................................................................... 4 LIFE INSURANCE AS A PROPERTY ................................................................................... 4 THE LIFE INSURANCE APPLICATION ............................................................................... 4

THREE PARTIES TO AN APPLICATION .............................................................................. 4 DEFINITION OF AN APPLICATION................................................................................... 5 MINOR APPLICATIONS .................................................................................................... 5 CORRECTING APPLICATIONS ........................................................................................ 5 INCORRECT/INCOMPLETE APPLICATIONS ................................................................... 5 REPRESENTATIONS/WARRANTIES .................................................................................... 5 FRAUD ................................................................................................................................ 6 CONCEALMENT ............................................................................................................... 6 CONDITIONAL RECEIPT ................................................................................................... 6 SHOULD THE INSURED DIE ............................................................................................... 6 POLICY EFFECTIVE DATE ................................................................................................. 6 BACKDATING POLICIES ................................................................................................... 6

HOW MUCH LIFE INSURANCE DO I NEED? .................................................................. 6 USING THE NEEDS APPROACH TO LIFE INSURANCE .................................................... 6

CHAPTER 3: TYPES OF LIFE INSURANCE 8

TYPES OF LIFE INSURANCE AND WHAT IS AVAILABLE ................................................. 8 TERM INSURANCE............................................................................................................. 8 WHOLE LIFE ....................................................................................................................... 9 UNIVERSAL LIFE ................................................................................................................. 9 VARIABLE LIFE ................................................................................................................... 9 ADJUSTABLE LIFE............................................................................................................... 9 MODIFIED LIFE ................................................................................................................ 10 FAMILY LIFE ..................................................................................................................... 10

CHAPTER 4: CHARACTERISTICS OF POLICIES 11

WHOLE LIFE INSURANCE ............................................................................................... 11 INTEREST SENSITIVE WHOLE LIFE POLICIES .................................................................. 11

UNIVERSAL LIFE INSURANCE ......................................................................................... 13 VARIABLE UNIVERSAL LIFE ............................................................................................. 14 PRE-REQUISITES OF SELLING VARIABLE UNIVERSAL LIFE ........................................... 16 VARIABLE UNIVERSAL LIFE AND THE MARKET PLACE ................................................ 17

CHAPTER 5: LIFE INSURANCE COMPANIES 20

FINANCIAL STATUS OF INSURERS .................................................................................. 22

CHAPTER 6: POLICY PROVISIONS OF LIFE POLICIES 23

OWNERSHIP CLAUSE...................................................................................................... 24 ENTIRE CONTRACT CLAUSE .......................................................................................... 24 INCONTESTABLE CLAUSE ............................................................................................... 24 SUICIDE CLAUSE ............................................................................................................. 24 GRACE PERIOD .............................................................................................................. 24 REINSTATEMENT CLAUSE ................................................................................................ 24 MISSTATEMENT OF AGE ................................................................................................. 25 BENEFICIARY DESIGNATION ......................................................................................... 25 CHANGE OF PLAN PROVISION .................................................................................... 25

CHAPTER 7: PREMIUMS 26

SINGLE AND PERIOD PREMIUMS .................................................................................. 26

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PARTS OF THE PREMIUM ................................................................................................ 26 NET AND GROSS PREMIUM ........................................................................................... 27 MORTALITY AND INTEREST FACTORS ........................................................................... 27 LEVEL PREMIUM CONCEPT RESERVES ......................................................................... 27 INSURANCE AGE ............................................................................................................ 28

CHAPTER 8: EXCLUSIONS AND RESTRICTIONS 29

PAYMENT OF PREMIUMS ............................................................................................... 29

CHAPTER 9: SETTLEMENT OPTIONS 29

LUMP SUM SETTLEMENT ................................................................................................. 29 PROCEEDS AND INTEREST ............................................................................................. 29 FIXED YEARS INSTALLMENTS .......................................................................................... 29 LIFE INCOME................................................................................................................... 30 JOINT LIFE INCOME ....................................................................................................... 30 FIXED AMOUNT INSTALLMENTS ..................................................................................... 30 OTHER MUTUALLY AGREED METHOD .......................................................................... 30

CHAPTER 10: NON-FORFEITURE OPTIONS 31

CASH SURRENDER VALUE ............................................................................................. 31 REDUCED PAID-UP INSURANCE ................................................................................... 31 EXTENDED TERM INSURANCE ....................................................................................... 32 AUTOMATIC PREMIUM PROVISION ............................................................................. 32 DIVIDEND ACCUMULATIONS TO AVOID LAPSE ......................................................... 32

CHAPTER 11: DIVIDEND OPTIONS 33

CASH PAYMENT .............................................................................................................. 33 REDUCTION OF PREMIUM ............................................................................................ 33 ACCUMULATION OF INTEREST ...................................................................................... 33 PAID-UP ADDITIONS ....................................................................................................... 33 ONE-YEAR TERM ............................................................................................................. 33

CHAPTER 12: LIFE INSURANCE POLICY RIDERS 34

WAIVER OF PREMIUM .................................................................................................... 34 ACCIDENTAL DEATH AND DISMEMBERMENT ............................................................. 34 GUARANTEED PURCHASE OPTION .............................................................................. 34

CHAPTER 13: LIFE INSURANCE UNDERWRITING 35

UNDERWRITING FACTORS FOR INDIVIDUAL COVERAGE ........................................ 35 AGE .................................................................................................................................. 35 SEX ................................................................................................................................... 35 HEALTH ............................................................................................................................. 36 OCCUPATION AND AVOCATION ................................................................................ 36 PERSONAL HABITS .......................................................................................................... 36 FOREIGN TRAVEL OR RECENT IMMIGRATION ............................................................ 36

UNDERWRITING ACTIONS ............................................................................................. 36

CHAPTER 14: DELIVERING THE POLICY 37

POLICY EFFECTIVE DATE ............................................................................................... 37 AGENTS RESPONSIBILITIES ............................................................................................. 38

CHAPTER 15: SUMMING UP THE APPLICATION 39

INSURABLE INTEREST ....................................................................................................... 39 POLICY OWNER AND CREDITOR ................................................................................. 39

COMPLETING THE APPLICATION ................................................................................. 40 CONCEALMENT, REPRESENTATIONS, AND WARRANTIES .......................................... 40 OBTAINING NECESSARY SIGNATURES ......................................................................... 41 MINORS ........................................................................................................................... 41 PREMIUM RECEIPT .......................................................................................................... 41

CHAPTER 16: RISK SELECTION & CLASSIFICATION 43

UNDERWRITING FACTORS ............................................................................................. 43

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PHYSICAL CONDITION: ................................................................................................. 43 OCCUPATION: ............................................................................................................... 44

SOURCES OF INFORMATION ........................................................................................ 44 AGENT'S REPORT ............................................................................................................ 44 MEDICAL EXAMINATION ............................................................................................... 44 ATTENDING PHYSICIAN'S STATEMENT .......................................................................... 44 MEDICAL INFORMATION BUREAU ............................................................................... 44 INSPECTION REPORTS .................................................................................................... 45

TYPES OF RISK.................................................................................................................. 45 RATED POLICIES.............................................................................................................. 46 REINSURANCE ................................................................................................................. 46

CHAPTER 17: TERMINOLOGY OF LIFE INSURANCE 48

PART II: LIFE INSURANCE IN THE BUSINESS MARKET 52

CHAPTER 1: EXECUTIVE BENEFITS FINANCED WITH LIFE INSURANCE 52

A MULTITUDE OF OPTIONS ............................................................................................ 52 THE EXECUTIVE COMPENSATION MARKETPLACE ..................................................... 53

NON-QUALIFIED DEFERRED COMPENSATION AFTER THE 1986 TAX ACT ................ 53 EXAMINING THE VARIABLES ......................................................................................... 53

DECISION MODEL .......................................................................................................... 54 CORPORATE-OWNED LIFE INSURANCE AS A FINANCING TOOL ............................ 54

LOANS ............................................................................................................................. 55 ALTERNATIVES TO LOANS .............................................................................................. 55 LIFE INSURANCE FINANCING EXECUTIVE BENEFITS — SOME EXCEPTIONS ............ 55

ALTERNATIVE MINIMUM TAX ON CORPORATE-OWNED LIFE INSURANCE ............. 55 SPLIT DOLLAR LIFE INSURANCE ..................................................................................... 56

A MODIFIED APPROACH TO SPLIT DOLLAR PROGRAMS ......................................... 56 POLICY ILLUSTRATIONS .................................................................................................. 57

EVALUATING ALTERNATIVE PROPOSALS ..................................................................... 58 THE FUTURE FOR LIFE INSURANCE AS A BENEFIT FINANCING TOOL ........................ 59 THE NEED FOR SUPPLEMENTAL PLANS ........................................................................ 59 THE FUTURE FOR LIFE INSURANCE AS A BENEFIT FINANCING TOOL ........................ 60 THE NEED FOR SUPPLEMENTAL PLANS ........................................................................ 60 TRUSTS .............................................................................................................................. 62

RABBI TRUST ..................................................................................................................... 62 SECULAR TRUST ............................................................................................................... 62

FISCAL RESPONSIBILITY .................................................................................................. 62 GENERAL FINANCING OBSERVATIONS ....................................................................... 62 A CAVEAT ........................................................................................................................ 64 PRESENT VALUE ANALYSIS ............................................................................................. 64

COST RECOVERY LIFE INSURANCE .............................................................................. 65 TAX CONSIDERATIONS .................................................................................................. 66

ALTERNATIVE MINIMUM TAX (AMT) ............................................................................. 66 ACCOUNTING FOR THE SUPPLEMENTAL PLANS ........................................................ 67

TEMPORARY TAX DIFFERENCES .................................................................................... 68 ACCOUNTING FOR INSURANCE .................................................................................. 69

REPORTING REQUIREMENTS ......................................................................................... 70 EXECUTIVE BENEFIT PLANNING PROCESS ................................................................... 70

PLAN DESIGN AND ANALYSIS ....................................................................................... 70 CASH FLOW ANALYSIS ................................................................................................... 71 PROFIT & LOSS ANALYSIS .............................................................................................. 71 INSURANCE COMPANY ................................................................................................ 72 SIZE AND FINANCIAL STRENGTH ................................................................................... 72 INTEGRITY ........................................................................................................................ 73 INVESTMENT PERFORMANCE/PHILOSOPHY ............................................................... 73 COMPETITIVENESS .......................................................................................................... 73 RATING ............................................................................................................................ 73 RETENTION LEVELS ......................................................................................................... 73 SUMMARY AND CONCLUSION .................................................................................... 73

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CHAPTER 2: PURCHASING INSURANCE USING A PROFIT SHARING ACCOUNT 74

FINDING THE MONEY..................................................................................................... 74 UTILIZING A PROFIT SHARING FOR SURVIVORSHIP INSURANCE .............................. 75 USING A PROFIT SHARING FOR THE MAXIMUM PURCHASE OF LIFE INSURANCE .. 76

TAX CONSIDERATIONS FOR QUALIFIED PROFIT SHARING PLAN DISTRIBUTIONS ... 77 ALTERNATIVES TO INDEFINITE TAX DEFERRAL ............................................................. 78

DIRECTING FUTURE DEFERRALS TO A LIFE INSURANCE POLICY ............................... 78 SELECTING THE PLAN BENEFICIARY ............................................................................. 78

THE ROLE OF LIFE INSURANCE IN ADVANCED FINANCIAL PLANNING .................. 78 ADVANCED PLANNING —A NEEDS APPROACH ...................................................... 79 AGENTS SALES PRESENTATIONS .................................................................................... 80

POLICY ILLUSTRATIONS .................................................................................................. 80 ILLUSTRATION ISSUES ...................................................................................................... 81

THE FUTURE OF LIFE INSURANCE................................................................................... 82 AN INFORMAL PENSION UTILIZING TAX-DEDUCTIBLE LIFE INSURANCE .................. 82 EXECUTIVE RETIREMENT BONUS PLAN ......................................................................... 82

UNREASONABLE COMPENSATION............................................................................... 84 USING AN EXECUTIVE RETIREMENT BONUS PLAN ...................................................... 84 PARTICIPATING DIVIDEND PAYING CONTRACT ........................................................ 85 ERBP, IRAS AND 401(K) PLANS ...................................................................................... 86

LOANS AND BORROWING............................................................................................ 86 EXCESS ACCUMULATION AND EXCESS DISTRIBUTION INCOME TAXES .................. 86 HIGHLIGHTS FOR ERBP PLAN PARTICIPANTS .............................................................. 86

CHAPTER 3: TRANSFERRING DISCOUNTED DOLLARS 86

VALUATION DISCOUNTS ................................................................................................ 86 GOVERNMENT REGULATION ........................................................................................ 87 PROFESSIONAL APPRAISAL ........................................................................................... 87 LEVERAGING .................................................................................................................. 88 PLANNING DEVICES ...................................................................................................... 89 ADDITIONAL DISCOUNTS .............................................................................................. 90

CHAPTER 4: LIMITED LIABILITY COMPANIES AND LIMITED LIABILITY PARTNERSHIPS 91

NEW VEHICLES FOR BUSINESS LIFE ............................................................................... 91 WHAT IS AN LLC? ........................................................................................................... 91 WHAT IS AN LLP? ............................................................................................................ 92 STATE REQUIREMENTS .................................................................................................... 92

INSURED BUY/SELL AGREEMENTS FOR LLCS ............................................................... 92 BUY/SELL AGREEMENTS FOR LLPS ................................................................................ 94

LIFE INSURANCE IN AN LLC OR LLP AS AN EMPLOYEE BENEFIT .............................. 94 SOLVING THE PROBLEMS CAUSED BY INSURANCE STOCK REDEMPTION PLANS .. 95

A LIFE INSURANCE LLC OR LLP IN THE ESTATE PLAN .................................................. 97 GIFT TAX CONSIDERATIONS .......................................................................................... 97 ESTATE TAX CONSIDERATIONS ...................................................................................... 97

IMPORTANT TERMINOLOGY ......................................................................................... 98

CHAPTER 5: ETHICS ISSUES FOR LIFE AGENTS 98

I. PERCEPTIONS OF ETHICS ................................................................................. 99 II. ETHICS FOR INSURANCE AGENTS ................................................................... 99 III. ETHICS FOR INSURANCE BROKERS ................................................................. 99 IV. CHARACTERISTICS OF A PROFESSIONAL .................................................... 100 FIDUCIARY RESPONSIBILITIES ...................................................................................... 100

THE CONCEPT OF AGENCY ........................................................................................ 100 THE AGENT AS A FIDUCIARY ....................................................................................... 101

RESPONSIBILITIES TO CONSUMERS & CLIENTS .......................................................... 102 RESPONSIBILITIES TO THE GENERAL PUBLIC .............................................................. 103 THE ENFORCEMENT OF ETHICS .................................................................................. 104 MAKING DECISIONS ETHICALLY ................................................................................ 104

END OF COURSE WC60319 ........................................................................................ 105

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PART I: THE BASICS OF LIFE INSURANCE

CHAPTER 1: THE CONCEPT OF LIFE INSURANCE

The concept of life insurance is a means of spreading financial loss among many individuals so that the cost to anyone

individual is small compared to the actual loss.

Younger individuals in the pool contribute more because normally they will live longer than older individuals in the pool.

The advantage of a younger person participating in the pool is that in the event he or she were to die before the

anticipated age, that individual would be assured that the remaining family members would have the security of financial

coverage as provided for in the insurance policy.

Thus life insurance is a way of spreading among many individuals financial loss resulting from an individual‘s death.

An insurance company is the entity that coordinates the administration and details of selling the life insurance program,

collecting the money required to make the ―pool‖ effective, and paying out the benefits to the designated individuals as

desired by the insured.

Life insurance is a contract, and as in any other contract, is a promise between two or more parties promising a certain

performance in exchange for some form of consideration.

In order for a contract to be legal certain requirements must be met under the law. All parties to the contract must be of

sound mind and legal age. A contract can be either verbal or written. Most contracts, including insurance contracts, are

written.

A life insurance policy is a unilateral contract wherein the insurance company promises to perform in accordance to the

terms of the policy and it‘s riders in exchange for a premium.

As long as the owner of the policy continues to pay the premium the insurance company must perform on its‘ contractual

obligation.

Besides competence of mind and legal age in order for a contract to be valid it must also have offer and acceptance and

consideration.

Consideration occurs when the policy owner promises to pay the insurance company a premium in exchange for the

insurance.

Offer occurs when the potential policyholder applies for insurance and proceeds to submit the first premium.

Acceptance occurs when the insurance company accepts the application, the first premium and issues the policy.

Insurance contracts have certain characteristics with which you should be familiar.

The term waiver is a voluntary relinquishing of a right or privilege, and the term estoppel

Is used to refer to that individual‘s inability to enforce a right that the individual has previously relinquished.

Insurance contracts are ALEATORY in nature. This means that the parties to the contract may not necessarily receive equal

value. An example might be an individual dying very early in the stage of the contract thus having paid less premium than

the benefit received by the beneficiary.

Insurance contracts are also contracts of ADHESION. This means that the contract is drawn up by one party, and the other

party ―adheres‖ to its terms. In the event of dispute over interpretation courts, normally, rule on behalf of the policy owner or

the beneficiary.

Because insurance contracts rely on ―GOOD FAITH‖ performance, there is a duty by the parties to disclose all material facts.

Failure to do this usually gives the other party grounds to void the contract

Insurance contracts are both EXECUTORY and CONDITIONAL. Conditional in the sense that the policy owner must perform

certain acts such as provide proof of claim and pay the premiums. Executory in that something in the future must occur in

order to complete the contract, such as the payment of a death benefit upon the demise of the insured.

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Mortality Tables provide insurance companies the guide that helps to set insurance premiums. Together with the Mortality

Rate insurance companies evaluate the risk involved in insuring life policies.

THE NEED FOR LIFE INSURANCE The chief function of life insurance is to create a sum of money under the conditions outlined in the insurance policy. This is

known as creating an estate.

The life insurance estate is created for many different reasons. The money is usually paid to a beneficiary to take care of the

debt caused by the death of the insured such as funeral expenses; to take care of debt left by the deceased; or perhaps

as a gift to the beneficiary; or maybe to take care of future needs of the beneficiaries.

Thus life insurance either becomes survivor protection need or a total needs protection.

Some of the considerations that an individual might take into account in planning for the estate might be:

Medical bills left behind after death

General bills left behind, such as, credit cards, mortgages owed

Future education for children

Estate taxes

A revenue stream of future income for the survivors

A person who wants to make sure that all obligations of the family are well taken care of will plan an estate that is sufficient

to cover all needs. An estate large enough to cancel all debt, provide liquidity to pay taxes, and enough money to support

the beneficiaries.

An individual can choose many options in creating an estate, but only life insurance creates an immediate estate.

A saving account requires years of deposits or a very large deposit earning interest immediately before it represents an

―estate‖ for the survivors.

Investment in the stock market is no guarantee of an estate.

But, life insurance can create an estate of any value simply by paying a small premium. It takes only one premium

payment to establish the security of a large or predefined amount granting the beneficiaries immediate security even if the

insured were to die the next day.

LIFE INSURANCE BENEFITS FOR THE LIVING

In addition to death benefits, life insurance can also provide benefits during the life of the insured.

As premiums are paid into a life policy, they accumulate and the policy develops a ―cash value‖ enabling the individual to

take advantage of the available cash, use the value to establish collateral for a loan, or perhaps set up a scheduled pay

out benefit.

In addition to financial security a properly planned life insurance program provides mental tranquility for the survivors who

are able to carry on with every day life without having to deal with the financial stress that might have burdened them.

There are two methods used to calculate the required amount of insurance needed by a family should the wage earner

die early in life.

Capital Retention or Capital Conservation is a method used that does not draw on the principal but simply uses the interest

to generate income for the family. This method guarantees income forever and ever regardless of how long the beneficiary

lives.

The funds can also outlive the beneficiary and be given away to loved ones or charity.

The second method is the Capital Utilization or Capital liquidation method. This method draws on both the interest and

principal. Thus at some point in time the fund will be depleted and the beneficiary may out live the benefit.

Wise planning should be used in deciding the goal of the policy and its benefit to the beneficiary.

o FOCUS POINTS

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1.o Life insurance is a means of spreading financial loss amongst many individuals.

2.o Younger individuals who live out their life expectancy contribute more to the financial pool than older individuals

3.o The advantage of life insurance to a younger individual is the benefit acquired if the individual were to die early.

4.o Life insurance is a way of spreading financial loss in the event of some ones death.

5.o An insurance company is the entity that coordinates the balances required to make life insurance work as a

business.

6.o Life insurance is a contract

7.o A contract is a promise by two individuals or entities to perform in a certain manner in exchange for consideration.

8.o Parties to a contract must be of sound mind and legal age

9.o A contract can be either verbal or oral

10.o Insurance contracts are written agreements.

11.o A life insurance contract is unilateral.

o Unilateral means as long as the premium is paid the insurance company must perform.

13.o A valid contract must have offer, acceptance and consideration.

14.o Consideration occurs when the premium is paid in exchange for the insurance.

15.o Offer occurs by application and payment of premium.

16.o Acceptance occurs by acceptance of application, acceptance of premium and issuing of policy.

17.o A waiver is the voluntary relinquishing of a right or privilege

18.o Estoppel is the inability to enforce a right previously relinquished.

19.o Insurance contracts are Aleatory.

20.o Aleatory means both parties do not receive equal rights.

21.o Insurance contracts are Adhesion contracts.

22.o Adhesion is a contract drawn up by one party.

23.o ―Good Faith‖ performance requires both parties to disclose material facts.

24.o Insurance contracts are both Executory and Conditional.

25.o Executory means something in the future must occur in order to complete the contract.

26.o Conditional means the policy owner must perform certain acts.

27.o Mortality Tables and Mortality rates help insurance companies evaluate the risk involved insuring life

policies.

28.o The chief function of life insurance is to create an estate.

29.o Estates are created to take care of the future needs of the beneficiaries.

30.o Life insurance can provide benefits during the life of the insured.

31.o Cash value establishes benefits during the life of the insured.

Formatted: Bullets and Numbering






























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32.o Cash value can be used as collateral.

33.o Cash value can be borrowed against.

34.o Capital Retention draws on the interest not the principal.

o Capital Utilization can deplete an account prior to the death of a beneficiary.

CHAPTER 2: THE LIFE INSURANCE POLICY

Life insurance is a contract between an individual and an insurance company. In this contract, the insurance company

agrees to pay a stated amount of money to a beneficiary, under certain conditions, in exchange for a sum of money

called the premium. It is important to note that a life insurance policy is in fact a legal contract. It is an agreement

between two parties to do something in exchange for the premium that is paid to the company.

THE USES OF LIFE INSURANCE

Life insurance is primarily used to function in personal and family situations. As a rule a person's death creates an

immediate need for money. The following is a list of some of the needs that might be created from an individual's death.

Expenses created by final illness.

Burial and funeral expenses.

Debts due at time of death.

Costs to administer the estate.

Federal and state death taxes.

Inheritance taxes.

Money may also be needed to provide for the following:

Payoff mortgage or purchase a new home.

Provide an education for children.

Meet unexpected financial needs.

Life insurance can also provide benefits for business situations. Here are a few examples:

Loss caused by death of a key employee.

Collateral for loans.

A business insurance fund.

Buy-out business interest of a deceased owner.

Fringe benefits for employees.

Fund qualified retirement plans.

LIFE INSURANCE AS A PROPERTY

Few people consider life insurance as property. Is it possible for a premium payment of $100.00 to create an immediate

estate or property valued at $250,000.00? That is possible with life insurance. Here are some advantages of life insurance

as property:

As an asset it is very secure.

There is no managerial care.

It can be purchased in any desired amount.

It provides a reasonable rate of return.

Proceeds are payable immediately.

Policy owner chooses the method of payment for premiums.

THE LIFE INSURANCE APPLICATION

Three Parties to an Application

A life insurance application contains three parties:




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The proposed insured.

The applicant.

The policy owner.

THE PROPOSED INSURED

The person whose life is being insured with the life insurance policy.

THE APPLICANT

The person that is making application to the insurance company for the life insurance and may or may not be the

proposed insured.

THE POLICY OWNER

The person that usually pays the premiums and the person who retains all rights to any values or options contained in the

policy.

Definition of an Application In order for a person to purchase life insurance they must make a request to the insurance company of their choice. The

form on which this request is made is known as an application.

Most companies now require that the proposed insured be physically present in front of the agent while the questions on

the application are being filled out. The application is crucial in that it provides the data that the underwriters and

insurance company will use to determine if a policy will be issued.

When the proposed insured signs the application he is making a formal request to the company that a policy be issued on

his life. In addition, the signature on the application indicates that the information is true and correct to the best of his

knowledge.

Minor Applications In most states a person is not considered an adult until 18 years of age. As a rule, minors are not permitted to enter into

contracts. However life insurance is the exception in that a person is a minor only until age 15. In the event that the

proposed insured is younger than age 15 one of the following persons must sign the application on behalf of that child:

The mother or father of the minor child.

A court appointed safeguard for the well being of the minor.

The grandparents of the minor child.

Correcting Applications Should it be necessary to correct a mistake regarding information given on the application, the proposed insured must

initial any and all changes on that application.

Mistakes on the application can be costly, especially when the company is paying an outside reporting service to conduct

an inspection. Any changes that are made on a completed application must have the approval of the proposed insured.

The normal procedure is to return the incorrect application to the agent who in turn will take it to the insured to have the

errors initialed.

Incorrect/Incomplete Applications Should an application contain incorrect or incomplete information it should not be taken lightly. In the event that the

company has already made a decision on a risk, based on these inaccuracies, it could result in a serious loss.

Should the error be discovered after the issuance of a policy the company can cancel or rescind the entire contract from

the date of issue. Of course this must take place before the incontestability clause of the contract takes effect.

Representations/Warranties All statements on applications are regarded as representations. When an individual makes a statement he believes to be

true, he is making a representation of the truth. While it is possible that a representation may be found to be untrue, a

person who makes a representation believes it to be true.

A warranty on the other hand is a statement made with such absolute certainty that it is guaranteed to be true. No

statement on an application is considered a warranty.

Misrepresentation - A false representation can be defined as a misrepresentation.

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Fraud There are three elements necessary to constitute fraud:

A person makes an intentional misrepresentation of what is known to be a material fact.

The person has intent to gain advantage.

A person relies upon a second party that suffers a loss.

There can be no fraud unless there is intent.

Concealment Concealment is close to misrepresentation when it comes to information included on a policy application.

While misrepresentation, as stated earlier, is something known to be untrue, concealment is withholding of facts that the

applicant should have given to the insurance carrier at the time of application.

Conditional Receipt Always collect the first full premium from the applicant at the time of application. The receipt that is located at the bottom

of the application is called a conditional receipt. The word "conditional" is very important because the agent is not

guaranteeing that the policy will be issued. Issuance of the policy is subject to the full approval of the insurance carrier.

The conditional receipt serves two functions:

It acknowledges the first full premium.

It states in very clear terms that the policy acceptance is subject to the approval of the carrier.

Should the Insured Die In the event the proposed insured dies before the policy is issued, according to the conditional receipt, the following will

take place:

If the insurance carrier had issued the policy to the proposed insured, had they still been living, then the

proceeds would be paid to the beneficiary.

Should the above not be the case and the claim is denied the premium will be returned to the beneficiary.

Policy Effective Date Full protection takes effect as of the policy effective date. The policy effective date also begins the date on which the

contestable period begins to run. The policy effective date also is the date on which the suicide clause begins to run.

There are three reasons why the policy effective date is important:

Insurance begins on this date.

The contestable period begins on this date.

The suicide clause begins on this date.

Backdating Policies Policies can be backdated, as a rule, a maximum of six months. Most companies allow backdating for several reasons:

Ten-times backdating can save an age by one year of the proposed insured and this can result in a lower

premium for the proposed insured.

Backdating is useful to assist the policy-owner in coordinating dates to fit their income pattern. Perhaps the

backdating may change the policy to closely match paydays.

Occasionally some policy forms have minimum and maximum age limits and backdating may be able to

put the applicant's age into the window of acceptable age limits.

HOW MUCH LIFE INSURANCE DO I NEED?

The majority of families in America are inadequately insured. As a rule individuals should carry life insurance equal to five or

six times annual earnings.

Using the Needs Approach to Life Insurance The following are a few of the more popular applications for life insurance to provide for a need that occurs as a result of a

death.

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ESTATE SETTLEMENT NEEDS

Cash is needed for burial expenses, installment debt, administration expense, estate tax and in some cases expense for the

last illness.

READJUSTMENT PERIOD

Following the death of a head of family there is usually a one to two year period in which the family needs to continue to

receive the same amount of income it would have received had the head of the family lived.

DEPENDENCY PERIOD

This period usually follows the readjustment period in that it lasts until the youngest child of the family reaches age 18.

BLACKOUT PERIOD

This is the period when social security benefits to a surviving spouse are temporarily terminated. This occurs when the

youngest child reaches age 16 and will not resume until the surviving spouse reaches age 60.

SPECIAL NEEDS

Special needs may consist of a fund to pay off the mortgage, education fund for the children's education or an

emergency fund for unexpected expenses.

RETIREMENT FUND

In this instance the head of a family may also wish to provide the surviving spouse with funds for retirement.

o FOCUS POINTS

1.o A life insurance policy is a legal contract.

2.o Life insurance is primarily used to function in personal and family situations.

3.o Needs that might be created from an individual‘s death include expenses from illness, burial, funeral, debts owed,

taxes, and administration of the estate.

4.o Other needs one might encounter include paying off a mortgage, childrens‘ education, unexpected expenses.

5.o A life insurance application involves three parties the proposed insured, the applicant, and the policy owner.

6.o The application provides crucial information to an underwriter.

7.o The application is a formal request to be insured.

8.o The signatures on an application certify the ―good faith‖ performance of the applicant.

9.o Any changes made on a completed application must be initialed and approved by the proposed insured.

10.o Should an error be discovered in the application the insurance company can cancel the policy.

11.o All statements on the application are regarded as representations.

12.o Fraud is created by intentional misrepresentation, intent to gain advantage, a second party suffers a loss.

13.o Concealment is withholding of facts the applicant should have revealed.

14.o The initial receipt for premiums is called a ―conditional receipt‖.

15.o A conditional receipt does not guarantee acceptability of the applicant.

16.o Should a proposed insured die during the period of conditional receipt and policy issuance, the claim

would be paid if there were no reason to have denied the application.

17.o The policy effective date is important in determining the insurability date, the contestable period date, and

suicide clause date.

18.o Backdating of policies is permitted by most insurance companies.



















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19.o Individuals should carry life insurance equal to five or six times their annual earnings.

20.o Life insurance is valuable in settling estate needs.

21.o Life insurance can assist a family during the ―re-adjustment period ― after a death.

22.o Life insurance can be beneficial for a child during the dependency period.

23.o Life insurance can fill the gap during a ―black-out‖ of income period.

24.o Life insurance can come in handy in resolving special needs.

o Life insurance can provide retirement funds for the survivor.

CHAPTER 3: TYPES OF LIFE INSURANCE

TYPES OF LIFE INSURANCE AND WHAT IS AVAILABLE

Term Insurance.

Whole Life.

Universal Life.

Variable Life.

Adjustable Life.

Modified Life.

Family Life.

Term Insurance

Term Insurance is the most basic type of life insurance. Some of its characteristics:

Term Insurance provides only temporary protection from one to 20 years or until the insured reaches a specified

age. Should the insured be alive at the end of the term period the protection expires.

Term Insurance has no cash value or savings element. It is strictly pure protection.

Term Insurance can be renewable and convertible. Renewable means that you can continue the coverage for

additional periods without proof of insurability. As a rule the premium increases each time the policy is renewed

based on the age of the insured at the time of renewal. Convertible means that the term policy can be

exchanged for some type of cash value insurance without proof of insurability.

Term Insurance comes in a variety of policies. They are:

A. YEARLY RENEWABLE TERM - This is issued for a one year period and the policy owner has the right to renew coverage

for successive one-year periods.

B. FIVE, TEN, FIFTEEN, OR TWENTY YEAR TERM - Term insurance can be purchased for a specific period such as five, ten,

fifteen or twenty years, and in some instances even longer periods. The premium remains level during the policy

term and should the policy be renewed at the end of the term the premium will increase.

C. TERM TO AGE SIXTY-FIVE OR SEVENTY - In this instance the term insurance is provided to a stated age. The premium

remains level during the policy term and the insurance expires when the stated age is attained. As a rule the

insured has the right to convert this term insurance to a cash value policy; however the policy must be converted

sometime prior to the expiration date.

D. DECREASING TERM - With a decreasing term policy although the premiums remain level during the policy term the

face amount of insurance gradually decreases over time. For example a $100,000.00 policy issued for a

decreasing term of 30 years could decline to $50,000.00 by the end of the twentieth year and zero by the end of

the thirtieth year.







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E. REENTRY TERM - This is a new type of term insurance that some companies make available. With this policy the

premiums are based on a low-rate schedule. Under the terms of this policy the insured must demonstrate evidence

of insurability, usually every one to five years.

Whole Life Whole Life Insurance has level premiums and will provide protection until age 100.

Some examples of Whole Life Insurance are:

A. ORDINARY LIFE INSURANCE - Ordinary Life Insurance is a form of Whole Life. Lifetime protection is provided until

age 100 and the premiums remain level. In the event the insured is still alive at age 100 the full-face amount will

be paid without death having to occur.

B. LIMITED-PAYMENT LIFE INSURANCE - This is another form of Whole Life Insurance. Although the premiums are

level they are only paid for a certain number of years. After this payment period, the policy becomes paid up.

Limited-Payment policies can be issued for ten, twenty or thirty years. A policy that is paid up at age sixty-five

or seventy is still available. The premiums for a Limited-Payment policy are higher than an ordinary life insurance

policy but the cash value is also higher.

C. ENDOWMENT INSURANCE - This is the third basic type of Whole Life Insurance. An endowment pays policy

proceeds to the named beneficiary if the insured dies within a certain period. Should the insured survive to

the end of the stated period, the policy proceeds are paid to the policy owner.

Universal Life

Universal policies are sold as investments that combine insurance protection with savings. Actually, a Universal Life Policy

can be defined as a flexible premium deposit fund that is combined with monthly renewable term insurance.

Here's how it works:

First, an initial specific premium is paid. Then expenses are deducted from the gross premium and the

balance is credited to the policy's initial cash value.

Second, a monthly mortality charge is conducted from the cash value to pay for the pure insurance

protection.

Finally, the remaining cash value is then credited with interest at a specified rate.

Universal Life has the following basic characteristics:

There are two forms available.

Protection, savings, and expense components are separated.

There is a stated investment return.

Considerable flexibility.

Cash withdrawals are permitted.

Variable Life With a Variable Life Insurance policy, the face amount of insurance varies according to the investment experience of a

separate account that is maintained by the insurer. This is the perfect solution to the fact that inflation can quickly erode

the real purchasing power of life insurance. Under the Variable Life Insurance policy the premiums are invested in equities

or other investments. Should the investment experience be favorable the face amount of insurance is increased.

However, should the experience be unfavorable the amount of insurance is reduced. In no event can the amount of

insurance be reduced below the original face amount. The Variable Life Insurance policy was designed to maintain the

real purchasing power of the death benefit.

Adjustable Life This type of Whole Life policy permits changes to be made in the following areas:

Amount of life insurance.

Period of protection.

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Amount of premium.

Duration of premium-paying period.

This type of insurance is frequently called "Life Cycle" insurance because policy changes may be made to conform to

different periods in the insured‘s life. Within certain limits, the policy owner can make the following adjustments as the

situations warrants:

Reduce or increase the amount of insurance.

Shorten or lengthen the period of protection.

Increase or decrease the premiums paid.

Lengthen or shorten the period for paying of premiums.

A cost of living provision can also be attached to the Adjustable Life Policy and this will in fact maintain the real purchasing

power of the insurance.

Modified Life This is a type of Whole Life Policy in which the premiums are reduced for an initial period of three to five years and then the

premiums increase thereafter. The initial or reduced premium as paid in the beginning is slightly higher than Term Insurance

rates but substantially lower than the premium paid for an ordinary Life Policy issued at the same age.

There are different types of Modified Life Insurance:

One version of Term Insurance is used for the first three to five years and then automatically converts into an

ordinary life policy at a premium that will be higher than what would have been paid for a regular ordinary Life

Policy issued at the same age.

In another version of Term Insurance, the approach is to redistribute the premiums by charging lower premiums

during the early years of the policy but higher premiums thereafter.

Modified Life Insurance can be attractive to individuals expecting increases in income.

Family Life Family Life is a Whole Life Policy designed to insure all family members in one policy. This policy is sold in units that state the

amount and types of life insurance on the family members. One unit for example may consist of the following:

$5,000.00 of Ordinary Life on the head of the family.

$2,000.00 of Term to sixty-five on the spouse.

$1,000.00 of Term Insurance on each child up to stated age.

As a rule, Term Insurance under the Family Life Policy can be converted to some form of permanent insurance, typically the

children's protection can be converted up to five times the face amount without proof of insurability.

Finally, there is no additional premium if another child is born and newborn children are usually automatically covered after

a fifteen-day waiting period.

o FOCUS POINTS

1.o Term insurance is the most basic type of life insurance.

2.o Term insurance provides only temporary protection until the insured reaches a specified age.

3.o Term insurance has no cash value or savings element.

4.o Term insurance can be renewable and convertible.

5.o Term insurance comes in the formats of yearly renewable; five, ten fifteen, or twenty year term, term to age sixty

five or seventy, decreasing term, and reentry term.

6.o Whole life insurance has level premiums and will provide protection until age 100.







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7.o Ordinary life insurance has death benefits or full face pay out at age 100.

8.o Limited payment life insurance features level payments for a specified number of years and then it becomes fully

paid up.

9.o Endowment policy pays policy proceeds to the named beneficiary if the insured dies within a certain period of

time. Should the insured outlive the period the proceeds are paid to the policy owner.

10.o Universal Life policies are sold as investments that combine insurance protection with savings.

11.o In a Universal Life policy protection, savings, and expense components are separated.

12.o A Universal Life policy has a stated investment return.

13.o A Universal Life policy has considerable flexibility and cash withdrawal privilege.

14.o In a Variable Life policy the face amount of insurance varies depending on investment performance of the

policy.

15.o Adjustable Life policies permit changes to be made in the areas face amount, period of protection,

amount of premium, and duration of premium.

16.o Adjustable Life is often called ―Life Cycle‖ insurance because policy changes may be made to conform to

different periods in the insured‘s life.

17.o A cost of living provision can be attached to an Adjustaable Life Policy.

18.o Modified Life offers reduced premiums in the first three to five years and then premiums increase

thereafter.

19.o There are several formats of Modified Life Insurance.

o Family Life is a Whole Life Policy designed to insure all family members in one policy.

CHAPTER 4: CHARACTERISTICS OF POLICIES

WHOLE LIFE INSURANCE

This type of insurance most characteristically has a cash value accumulation.

It is a simple process wherein an individual pays a premium for their entire life in exchange for coverage in the event they

die early. As the premiums build up the risk by the insurance company decreases.

If one were a gambling person, one might say that the insurance company is betting that the individual will live out their life;

whereas, the insured is betting that they may die early.

In a Whole Life policy when the insured dies the beneficiary receives the face amount of the policy.

Because many individuals enjoy the protection offered by a Whole Life policy but do not want to pay a premium for their

entire life, a policy called a Limited Life policy is made available. In this policy an individual pays for a specified number of

years and then stops, but the insurance protection continues for life.

One of the most common type of Limited Life policy is the paid up at age 65 policy.

A variety of blended policies are offered that incorporate whole life features and term insurance to create a choice to

meet every consumer‘s need.

Single Premium Whole Life insurance is a format wherein the policy owner pays one lump sum premium up front for the face

amount of protection.

The advantages that one might have with this form of payment is that it is less costly and allows the purchaser to begin

accumulating tax free rewards that are not payable until the money is withdrawn.

INTEREST SENSITIVE WHOLE LIFE POLICIES














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Interest sensitive whole life provides a level death benefit, requires a fixed schedule of premium payments and uses current

interest and mortality assumptions to determine policy cash values.

Interest sensitive whole life combines features of whole life and universal life.

The main attractions of this product are a fixed premium payment, guaranteed death benefits, and a minimum guarantee

of cash value.

One approach to an interest sensitive policy is the Low Premium approach. This approach normally offers premiums lower

than a whole life policy but guaranteed cash values are generally lower.

This policy has a recalculation feature after an established period of time. The recalculated premium, depending on the

policy‘s interest and mortality experience, can be higher or lower than the initial premium.

If the recalculated premium is lower than the initial premium the policy owner can pay the new lower premium or can

continue to pay the higher premium with the difference being credited to the accumulated value.

For both options the death benefit remains the same.

If the recalculated premium is higher than the original premium, the policy owner may pay the new higher premium and

maintain the original death benefit or continue to pay the lower premium and reduce the death benefit amount.

Another format of interest sensitive whole life is the higher initial premium method.

It usually has more substantial guaranteed cash values, a premium guaranteed not to increase, and an option to pay the

premium from the accumulated value of the policy.

These types of policy usually are scheduled to terminate premium payments within a span of 5 to 12 years while at the same

time continuing the death benefit beyond this point.

An individual can chose to continue paying premiums after the so-called ―vanishing‖ period and ad to the cash value of

the policy.

Some policies have riders providing for lump sum premiums to be deposited within the first year of the policy.

The death benefit in interest sensitive whole life policies is a level benefit equivalent to the face amount of the policy.

Like other life products the interest sensitive whole life policy must meet the definition of life insurance as contained in the

Tax Equity and Fiscal responsibility Act of 1982 (TEFRA).

The policy cash surrender value may at no time exceed the net single premium, which would be required to fund future

benefits.

In addition under the ―corridor‖ provision, the cash value of a life policy must not account for more than a certain

percentage of the total death benefit.

If the policy fails to meet one of these two tests it is disqualified to be a life product fot tax purposes.

Provisions are made part of interest sensitive whole life policies to automatically raise the death benefits to maintain the

policy‘s life insurance qualification.

Interest sensitive whole life policies come with a guaranteed minimum cash value.

Some companies determine the cash values monthly and others yearly. The process for determining valuation of interest

sensitive whole life policies is:

Accumulated value determined as of the previous valuation date

Plus interest for the period since the last valuation date

Plus any net premium credited to the policy since the last valuation date

Minus the cost of providing insurance protection until the next valuation date

The interest rate used in crediting the interest credit is determined differently by different companies.

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The most common methods are the Declared Rate and the Indexed Rate.

The Declared Rate is a method wherein an insurance company declares a current interest rate and this becomes the

established rate for the policy.

In the Indexed Rate method the rate is determined by an outside index, such as the yield on Treasury notes.

How money is credited also differs and some companies use the Portfolio Rate and others use the New Money/Old Money

Rate.

The Portfolio Rate credits one rate to the entire policy value regardless of when the premium was paid.

On the other hand the New Money/ Old Money method applies different interest rates to different premium payments

depending on when the premium was paid into the policy. As declared rates change so will the computation on

additional paid in premiums change.

In many cases there is no guarantee on how long a given rate will be guaranteed. The rate and the frequency of change

are left entirely to the determination of the insurance company. In interest sensitive whole life policies there is a

Guaranteed Minimum usually based on an outside index.

Computed charges for mortality rates may go up or down, but may not rise above the guaranteed maximum. These rates

vary from company to company.

Surrender charges are another factor in interest sensitive whole life policies.

Surrender charges vary from company to company and are usually deducted from the accumulated value of the policy to

arrive at the actual cash value on surrender.

Most commonly surrender charges are based on a percentage of the annual premium, a fee per $1000 of coverage, a

percentage of the cash value or perhaps a combination of all these factors.

Surrender charges are usually imposed within the first 20 years of a policy and in some cases no longer than the first five

years. The surrender charges usually decline as the policy gains maturity.

Front-End Loads and Policy fees are another element of interest sensitive whole life policies.

Front-end loads refers to a percentage that is deducted out front from every premium before the balance is credited to the

accumulation amount. This fee usually is in the 2% to 7.5% range.

A few interest sensitive whole life policies offer partial surrender features. In the case of partial surrenders the cash surrender

and the death benefit are reduced by the amount of the surrender.

In addition to the standard policy some additional riders are available. These riders include a Term rider for a spouse and or

children; Disability waiver of premium; accidental death benefit; cost of living adjustment, guaranteed insurability; and a

death benefit advance pay for a terminally individual.

At the end of each policy year, the owner of the policy receives a report detailing the activity of the policy.

UNIVERSAL LIFE INSURANCE

In a Universal life policy the policyholder can adjust the premium payments and death benefit without having to obtain a

new policy. In addition to the death benefit a universal policy also accumulates cash value.

A universal life policy offers both a level and an increasing death benefit option.

When an individual chooses a level benefit option this pretty much functions as any traditional life policy might function.

The cash value of a universal life is tax deferred until the individual surrenders the policy and never subject to income tax if

the policy is held until the death of the insured.

Depending on the policy, universal life policies can have front end and back end sales loads, or a combination of the two.

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VARIABLE UNIVERSAL LIFE

Variable life insurance provides equity based cash values and life insurance protection. In this type of policy the consumer

takes the investment risk not the insurer. Because the policy owner takes the investment risk, variable life is regulated as a

security. This means that besides meeting state insurance requirements, variable life must also meet state and federal

security requirements.

Universal life provides the consumer the ability to change the death benefit and the premium contribution.

Variable universal life incorporates the flexibility of universal life, the investment features of variable life and the tax

advantages of all life insurance products.

The variable universal life is policy is not dependent on the payment of a specific premium by a given date. The policy

owner can add money to the cash value account on whatever basis is convenient within the top limit set by legislation and

within the low limit set by the insurance company.

Variable universal life can have front-end loads, back-end loads or a combination of the two. A flat fee may also be

deducted.

Once the fees are deducted policy owners can allocate premium payments amongst the available investment options.

Every business day, the market value of the securities held in the investment is determined, thus creating the cash value of a

variable universal life policy. The cash value of a variable universal life can change on a daily basis.

The grace period involved in a universal life is not determined by when a premium is not made, but is based on maintaining

a cash value in the account. Because this is an investment product, a bad decision could cause the cash value to be

depleted thus creating the need for an influx of premiums to maintain the policy. Should this occur the policy owner is

notified and has 61 days grace in which to replenish the cash value to maintain the policy.

The cash value of a variable universal life policy is maintained in a separate account, apart from the general assets of the

company. From this account two types of deductions are made: monthly deductions for the cost of insurance, riders and

policy expenses, and a daily mortality expense risk charge.

The monthly deductions may also consist of certain administrative charges.

When a policy owner takes out a loan against a variable universal life policy, the interest charged is part of the cost of the

loan. The amount of the cash value for the loan is credited with a rate of interest that is generally lower than the investment

return earned on the rest of the cash value in the account.

Policy owners may withdraw money from their policies; the death benefit of the policy is usually reduced by the amount of

the withdrawal.

A Level Death Benefit Option permits the policy owner to specify the total death benefit they want in the policy. This

amount stays the same until the policy owner decides to change it. The ratio of cash value to death benefit must stay

within the specified limits to meet the definition of life insurance for tax purposes.

The sum of cash value and insurance protection must always equal the total death benefit specified in the policy.

A Variable Death Benefit Option permits the policy owner to specify the amount of pure insurance coverage, and this

remains constant. While the death benefit varies.

A policy owner has the option of switching back and forth between the level death benefit option and the Variable death

benefit option.

Additionally, as a policy owners needs change, coverage can be either increased or decreased as the need arises.

Because the investment side of the policy can suffer negative effects, insurance companies offer either as part of the

policy or as an optional rider, a guaranteed death benefit provision.

The Settlement options offered under a variable universal life policy include:

Joint and Survivor option-payments are made on the lives of two beneficiaries with payments continuing to

the second beneficiary after the death of the first.

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Fixed period option-equal payments are made to the beneficiary over a specified period of years.

Fixed amount option-fixed payments are made to the beneficiary until all policy proceeds are exhausted.

Life income option-equal payments are made for the life of the beneficiary.

Interest option-the insurer retains the policy proceeds and pays the beneficiary the interest earned.

Variable Universal Life Policies offer the policy owner a variety of investment options. Policy owners are permitted to make

transfers or exchanges amongst these options. Rules regulating these transfers vary from company to company.

Some general guidelines include the following:

Limits on the timing and amount of transfers from fixed accounts

Limits on the number of transfers that can be made within a one year period

Fees for transfers made in excess of a certain limit

A limit on the minimum dollar amount or percentage of account value being transferred

A limit on a minimum dollar amount or percentage of value that remains in the account

A limit on the frequency of transfers

A limit on the interval period between transfers.

Asset allocation is part of the formula used in managing a variable universal life policy.

To meet a policy owner‘s end goal, different investment options must be exercised and re-arranged on a continues basis.

Adjusting the percentage of assets devoted to each investment option increases the chances that the policy owner‘s goals

will be met.

Some variable universal life polocies offer asset allocation services that automatically move the policy owner‘s money

according to a professional asset manager‘s assessment of the outlook of the markets. With this type of policy, this is

accomplished by allowing the asset manager to make the appropriate transfers between accounts.

Some policies offer asset allocation that change the mix of investments on an on going basis to maximize the return for the

policy owner.

Some variable UNIVERSAL LIFE POLICIES OFFER A PORTFOLIO REBALANCING FEATURE.

This allows the policy owner to establish target percentages for various investment options and usually quarterly, transfers

are automatically made among the options to bring the mix in line with the policy owner‘s objectives.

Dollar cost averaging is another method of managing a variable universal life account.

This method permits an individual to invest the same dollar amount in the same securities at regular intervals, over a period

of time, regardless of whether the price of the security is going up or down.

Dollar cost averaging allows an individual to automatically buy more shares when the market is down and fewer shares

when the market is up. Thus the average cost per share will always be less than the average market price.

Transfers from one account to another in a variable universal life policy are not taxed at the time of transfer. Annually,

policy owners receive detailed reports that summarize policy activity and values on a month to month basis. Semiannually

they receive reports that list the securities held by the separate investment accounts.

Certain considerations should be taken into account if one is to use the single premium method in purchasing a variable

universal life policy.

As the name implies a single premium policy is purchased with a single premium and no additional premium need ever be

paid to keep the policy in force.

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The single premium is based on the policy‘s death benefit amount, the insurer‘s expected rate of return and the life

expectancy of the insured. With a variable universal life the policy‘s cash value must always be sufficient to pay the cost of

maintaining the insurance protection and the policy‘s death benefit.

Since the policy‘s cash value can rise or fall based on investment experience, it then becomes possible that a variable

universal life policy with a bad investment experience could lapse, unless additional premiums are paid into the policy.

Because of this, a variable life policy requires an initial premium that is of a substantial nature.

In some cases, a single premium variable universal life policy may have a schedule of additional premium payments. The

policy owner is not obligated to adhere to these payments unless the cash value is not sufficient to meet the requirements.

Since a variable universal life is considered both a life product and a security, it is subject to regulation by the state

insurance department and by state and federal securities commissions.

Who are these regulators and what role do they play?

The Securities and Exchange Commission or the SEC is the agency of the federal government, which

regulates the offering of securities to the public. It enforces the securities laws enacted by congress. The

SEC also issues its own regulations.

The National Association of Securities Dealers or NASD is a self-regulatory organization whose members

are from the securities industry. NASD keeps a watchful eye on its‘ members activities, to make sure that

they are in compliance with federal laws and regulations. NASD also issues its own rules, which are binding

upon its members.

A broker/dealer is an individual or a firm registered with the SEC to buy and sell securities either for its own

account or for the account of others. Most variable universal life companies establish a broker/dealership

to distribute their product.

A registered representative is an agent for a broker/dealer. This individual represents the broker/dealer in

a transaction with the public.

PRE-REQUISITES OF SELLING VARIABLE UNIVERSAL LIFE

In addition to having a life license, one must have become a registered representative of one‘s company broker/dealer. In

order to become a registered representative, you must pass either the Series 6 or Series 7 examination covering the Uniform

Securities Act. Some states also require an additional examination to sell registered contracts.

Sales activities in this area must be strictly supervised by the broker/dealer, and strict compliance to NASD rules and

regulations are mandatory.

The necessity of these rules is for the purpose of providing prospects with accurate information before making a buying

decision that involves risk.

Some of the most important rules to remember follow.

A prospectus must be provided to each prospective consumer prior to the time of decision-making. A prospectus

summarizes the detailed statement previously filed with the Securities Exchange Commission.

Any and all solicitations must be either preceded or accompanied by a prospectus.

The prospect should be encouraged to read the prospectus and formulate his or her own decision.

Because of the strict sales rules, companies often times prepare brochures, pamphlets, and sales presentation folders that

are provided to the sales agent as an assurance that all NASD rules have been followed.

An agent must use the highest ethics in presenting this type of product. It is important that no statements are made in

regard to predicting losses or gain.

It is critical that a prospect not be made to believe that the product is sanctioned or approved by the Securities Exchange

Commission. Your statement to the client must not go any further than to acknowledge that both the statement and the

prospectus has been filed with the Securities Exchange Commission.



17

NASD places strict rules on the rate of return that may be illustrated to a prospect.

Hypothetical illustrations cannot show a rate of return exceeding 12% and must also show examples of 0% return illustrations.

Illustrations must show maximum guaranteed mortality and expense charges at each rate of return. Preceding any

illustrations a statement must prominently be made that the underlying investment accounts may affect the policy‘s cash

value and death benefit. It must also be stated the illustration is hypothetical and is not meant to project or predict

investment results.

NAIC (National Association of Insurance Commissioners) also has issued guidelines that must be used in illustrations dealing

with variable universal life products.

The NAIC guidelines states that all illustrations should provide accurate representations of what a policy owner might expect

from an actual variable life policy.

Statements made to prospects must not be misleading, must not exaggerate or make unreasonable claims. No assurances

should be made of either potential losses or gains.

The recommendation of a variable universal life must be suitable for the prospects needs.

Does it meet client‘s tolerance for risk?

Does the prospect already own any equity-based product?

What is the client's expectation of return on the investment?

Can the prospect afford additional premiums if the cash value were to drop?

Is the prospect been made aware of the potential of additional premiums should the cash value drop?

Some variable universal life policies offer a refund privilege or ―free look‖ period. This period will vary from 10 days after

receipt of policy to 45 days from the signing of the application.

Some policies also permit the exchange of the policy for a different life product within the first 24 months of the policy.

Regardless of the living benefits of life insurance, life products are mainly sold as protection against early or unexpected

death.

Replacement of life insurance policies must address the need for replacement. Ethical issues are a constant consideration

in making these decisions with the client.

Life insurance policies are considered to be property; therefore, gain or loss on an exchange of such policies would be

subject to federal income tax. Under section 1035 of the IRS, no gain or loss is recognized when one life insurance policy is

exchanged for another.

VARIABLE UNIVERSAL LIFE AND THE MARKET PLACE

Variable universal life can serve as a hedge on inflation because it can be adjusted to keep pace with erosion in

purchasing power.

If investment experience is favorable funds will be available in the cash value to pay for increases in coverage.

For those who do not want to leave their future welfare in the hands of Social Security, variable universal life provides a

vehicle to maintain control of their future. Through variable universal life they manage the death benefit, the premium,

flow, and the investments made with the cash value.

Variable universal life deals effectively with a policy owner‘s personal needs and changes in market conditions and the

economy.

Variable universal life can effectively meet the need of the young single consumer because it never becomes obsolete. It

serves to provide insurance protection and at the same time permits the building of cash values at a very low cost due to

age and health positioning. As a young consumer‘s needs change a variable universal life policy will never get out of step

with his or her needs.

As a consumer gets married and has children variable universal life can serve the needs of the growing family. The cash

values offer both a potential for growth and a choice of options depending on how much risk they want to assume.

Accumulated funds can be withdrawn through partial surrender, or borrow against cash values.

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Other advantages include:

Putting in more money as their income increases

Reduce the amount paid in should their expenses increase

Put in an scheduled amounts should additional monies become available

Skip payments without losing the insurance coverage

Increase coverage without increasing the premium

As one gets older and reaches retirement the variable universal life once again is flexible enough to meet the consumers

new needs.

With proper management the variable universal life can:

Offer tax advantages to the policy owner and beneficiary

Offer a form of estate planning

Set up a distribution which receives favorable annuity tax treatment

Provide access to cash values through partial surrender.

Create borrowing power against cash values, if more advantages

Be purchased with pre tax dollars

Provide income protection as an income stream

Provide income protection in a lump sum

Provide income in a second to die situation

o FOCUS POINTS

1.o Whole life insurance most characteristically has a cash value accumulation.

2.o In whole life insurance the insured is buying protection in the event he or she dies early.

3.o As a premiums build up the risk by the insurance company decreases.

4.o In a Whole Life policy when the insured dies the beneficiary receives the face amount of the policy.

5.o The premium in a Whole Life policy is paid for life.

6.o In a Limited Life policy an individual pays for a limited amount of years but the insurance protection continues for

life.

7.o One of the most common Life Policy is the paid up at age 65 policy.

8.o In a single premium Whole life policy the owner pays one lump sum premium up front for the face amount of

protection.

9.o A single premium policy is less costly and allows the purchaser to accumulate tax-free rewards that are not payable

until the money is withdrawn.

10.o Interest Sensitive Whole Life provides a level death benefit.

11.o Interest Sensitive Whole Life requires a fixed schedule of premium payments.


























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12.o Interest Sensitive Whole Life uses current interest and mortality assumptions to determine policy cash values.

13.o Interest Sensitive Whole Life combines features of whole life and universal life.

14.o A fixed premium payment, guaranteed death benefit and minimum guarantee of cash values are all

attractive features of Interest Sensitive Whole Life.

15.o An interest sensitive policy offers a Low Premium approach which offers premiums lower than a whole life

policy, but guaranteed cash values are generally lower.

16.o Interest Sensitive Whole Life policies have a recalculation feature.

17.o A recalculated premium can be higher or lower than the initial premium.

18.o An Interest Sensitive Whole Life policy using a higher initial premium method has a substantial cash value, a

premium guaranteed not to increase, and an option to pay the premium from the accumulated value.

19.o Policies using a higher initial premium method usually terminate the premium payments within a 5 to 12

year span.

20.o The death benefit in Interest Sensitive Whole life policies is a level benefit equivalent to the face amount of

the policy.

21.o In an Interest Sensitive Whole Life policy the cash surrender value can at no time exceed the net single

premium, which would be required to fund future benefits.

22.o Under the ―corridor‖ provision, the cash value of a life policy must not account for more than a certain

percentage of the total death benefit.

23.o Interest Sensitive Whole Life policies come with a guaranteed minimum cash value.

24.o Some companies determine cash values monthly and others yearly.

25.o The interest rate used in crediting the interest credit is determined differently by different companies.

26.o The most common methods of crediting interest rates are the Declared Rate and the Indexed Rate.

27.o In the Declared Rate the insurance company ―declares ― a rate.

28.o The Indexed Rate is determined by an outside index, such as the yield on Treasury notes.

29.o Money is credited in two fashions, the Portfolio Rate and the Old Money/New Money Rate.

30.o Portfolio Rate credits one rate to the entire policy value.

31.o The New/Money Old Money method applies different interest rates to different premium payments

depending on when the premium was paid.

32.o In interest rate sensitive whole life policies there is a Guaranteed minimum rate based on an outside index.

o Surrender charges vary from company to company.

34.o Surrender charges are usually imposed within the first 20 years of a policy.

35.o In some cases surrender charges are only applied for the first five years.

36.o Front-End Loads and Policy fees are another element of interest sensitive whole life policies.

37.o In addition to the death benefit a Universal policy also accumulates cash value.

38.o A Universal policy offers both a level and increasing benefit option.



























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39.o The cash value of a Universal Life is tax deferred.

40.o Depending on the policy, Universal Life policies can have front and back end sales loads.

41.o Variable life insurance provides equity-based cash values and life insurance protection.

42.o In A variable Life insurance the consumer takes the investment risk not the insurer.

43.o Because the policy owner takes the risk Variable Life is regulated as a security.

44.o Variable Universal Life incorporates the flexibility of Universal Life, the investment features of Variable Life

and the tax advantages of all life products.

45.o The cash value of a Variable Universal Life can change on a daily basis.

46.o The grace period in a Universal Life is based on maintaining a cash value in the account.

47.o A policy owner has sixty-one days grace in which replenish the cash value of a Variable Universal Life.

48.o The cash value of a Variable Universal Life policy is maintained in a separate account, apart from the

general assets of the company.

49.o When a policy owner withdraws money from their Variable Universal policy, the death benefit is reduced

by the amount of the withdrawal.

50.o A level death benefit option permits the policy owner to specify the total death benefit they want in the

policy.

51.o The sum of cash value and insurance protection must always equal the total death benefit specified in the

policy.

52.o A policy owner has the option of switching back and forth between the level death benefit option and the

variable death benefit option.

53.o Settlement options include joint and survivor, fixed period, life income, interest option.

54.o Variable Universal policies offer the policy owner a variety of investment options.

55.o Rules that vary from company to company regulate the transfers and exchanges.

56.o Asset allocation is part of the formula used in managing a Variable Universal Life.

57.o Some Variable Universal Life Policies offer a portfolio-rebalancing feature.

58.o Dollar cost averaging is a method of managing a Variable Life account.

59.o When selling a Variable Universal Life account a prospectus must be provided to each prospective

consumer.

60.o NASD places strict rules on the rate of return that may be illustrated to a prospect.

o Hypothetical illustrations cannot show a rate of return exceeding 12% and must show examples of 0% return

illustrations.

CHAPTER 5: LIFE INSURANCE COMPANIES

Life insurance companies can be organized in several ways; however, most are organized either as stock companies or as

mutual companies.























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A STOCK LIFE INSURANCE COMPANY gets its name from its basic ownership characteristic. Its stockholders - people, who

have bought stock in the company, own a stock company. The stockholders may or may not also be policy owners. The

sole function of the stockholders is to elect a board of directors who in turn will guide the operation of the company.

If the company is successful financially, the stockholders will receive dividends that are paid for each share of stock owned.

A stock life insurance company, like all other corporations, is in business to make a profit for the stockholders.

A MUTUAL INSURANCE COMPANY is also a corporation, and it also derives its name from its basic ownership characteristic.

Unlike a stock company that is owned by its stockholders, a mutual company has no stockholders. Control in a mutual

company rests with the policy owners who "mutually" own the company.

The policy owners elect a board of directors, and any "profits" are returned as dividends to the policy owners in the form of

reduced costs for insurance. It should be mentioned here that dividends from a mutual company are not profits in the

mercantile or commercial sense but rather the return of an "overcharge" of premium.

For example, a mutual life insurance company might sell life insurance at one specific age for $20 per $1,000 of face

amount. Once a dividend has been declared, each policy owner might then receive credit on the premium statement in

the amount of $2 per $1,000. Thus, the resultant cost for the insurance is $18 per $1,000 of face amount.

While not true in every case, mutual insurance companies usually issue "participating" life insurance policies. The term

participating means that if the company realizes a savings in death claims due to a lower mortality rate, or an increase in

the interest earned, or if it realizes some efficiency in its operation, which reduces expenses, these savings or "profits", is

passed along to the policy owner in the form of policy dividends.

Thus, the policy owner in a mutual life insurance participates in any savings or "profits" enjoyed by the company.

Never imply to a client that a stock company is better from an organizational standpoint than a mutual company, or vice

versa, or that participating policies are better than non-participating ones. Both types of companies and both policies

have merit.

Before any life insurance company can sell insurance in any state, it must be licensed to sell insurance or, as it is called,

admitted to that state. An insurer that is admitted to a state is authorized to do business in that state. If an insurer is not

admitted to a state, it is unauthorized to do business in that state.

Another type of insurer with which you should be familiar is the fraternal benefit society, also known as a "fraternal". A

fraternal insurer is a social and benevolent organization that provides, among other services, life insurance benefits for

members. Membership in such an organization is often based on factors such as a person's nationality, religion, or

occupation, but whatever the criterion for membership, keep in mind that fraternals have functions other than providing

insurance.

Each state defines and provides for the regulation of fraternal benefit societies in its insurance laws. But, although the exact

definition of a fraternal may differ from state to state, an organization usually must have certain characteristics to qualify as

a fraternal benefit society. First, the organization generally must exist only for the benefit of its members and of their

beneficiaries and be non-profit. Second, it must be organized without capital stock.

A third characteristic is that the society usually is organized on a lodge system. This means that the organization must have

local lodges or chapters that hold regular meetings to carry on the activities of the society. Ritualistic ceremonies are often

a part of those activities.

Finally, the organization must have a representative form of government. There must be a governing body chosen by the

members directly or by delegates, in accordance with the organization's bylaws or constitution.

GOVERNMENT INSURANCE PROGRAMS have been established for a variety of reasons throughout history. Social insurance

programs have been created to allow the government to make compulsory a program lacking equity in order to cover

fundamental risks and to redistribute income. Government insurance programs have been created when private insurers

would have been subjected to adverse selection or were incapable of meeting society's needs.

By its administration of various Federal insurance programs, the U.S. government has become the largest insurer in the world.

These various programs include Social Security, Medicare, and the Railroad Retirement, Disability, and Unemployment

Programs.

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RECIPROCALS are groups of individuals (called "subscribers") who are insured under an arrangement where each subscriber

is both an insured and an insurer. In other words, the other members of the group insure each subscriber. However, the

liability of each subscriber is limited.

The administrator of the reciprocal is the "attorney-in-fact". He or she is granted this power by the subscribers through a

broad power of attorney, and receives a percentage of the gross premiums paid by the subscribers. Other than this

payment to the attorney-in-fact and administrative expenses, the cost to the reciprocal is limited to the amount of the

losses that occur. Any unused premiums are returned to the subscribers.

LLOYD'S OF LONDON is a name familiar to many in the insurance industry. However, perhaps the most interesting fact about

Lloyd's of London is that it is not an insurer nor does it issue policies. Rather, Lloyd's of London is an association of members

who write insurance for their own accounts. The New York Stock Exchange bears the same relationship to stock purchases

as Lloyd's bears to the purchase of insurance.

Like the Stock Exchange, Lloyd's provides quarters for its members as well as procedures for business transactions. Though

neither organization engages in trade, both provide facilities and rules that govern how its members will pursue trade. In

addition, Lloyd's maintains worldwide underwriting information and a complete record of losses. It also aids in loss

settlements and supervises salvage and repairs throughout the world.

At Lloyd's, an insurance transaction begins when a proposal is placed before the underwriting members, or their agents, by

a licensed broker. The broker prepares the policy and submits it to the Policy Signing Office where the policy is examined.

If the policy conforms to agreed-upon rules, it is submitted to the underwriters. Those underwriters who wish to participate in

the policy affix their signatures or "underwrite" the risk. American Lloyd's associations operate under the same principles and

methods as Lloyd's of London.

Financial Status of Insurers Changing economic conditions and highly publicized failures of financial institutions (from savings and loan companies to

insurance companies) have focused much attention on the financial status of private insurers. Independent rating services

provide ratings consumers can use to measure the status of a company and compare it to others.

The two most popular rating services are A.M. Best Company and Standard and Poors. A.M. Best Company looks at

profitability, leverage, and liquidity and assigns ratings from A++ (Superior) to C and C- (Fair) and below. Standard and

Poor's focuses on the claims paying ability of an insurer and offers ratings from AAA (Superior) to D (Insurers placed under an

order of liquidation).

In most cases, insurance companies pay a fee to be rated by a rating service. Other rating services include Moody's

Investors Service (measuring financial strength), and Duff and Phelps (measuring claims paying ability and managerial

soundness).

In addition to private rating services the National Association of Insurance Commissioners measures company performance

and prepares analytical reports as part of the Insurance Regulatory Information System (IRIS). Agents have access to IRIS

ratios that serve as indicators of a company's financial condition in various areas.

FOCUS POINTS

1.o Most life insurance companies are organized as either stock or mutual company

2.o The sole function of stockholders is to elect a board of directors who will guide the operation of the company.

3.o Stockholders may or may not also be policy holders

4.o A stock life company is in business to make a profit for the stockholders.

5.o The policy owners who ―mutually‖ own the company control a mutual company.

6.o Profits in a mutual company are returned as dividends to policy owners

7.o Dividends or Profit in a mutual company are returned as an ―overage‖ of premiums.

8.o Before any life insurance company can sell insurance in a state it must be ―admitted‖ or licensed by the state.









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9.o A fraternal insurer is a social and benevolent organization that provides life insurance benefits to its members.

10.o Fraternal insurers have functions other than providing insurance.

11.o Each state defines and provides for the regulation of fraternal benefit societies in its insurance laws.

12.o Although the definition of fraternal differs from state to state, a fraternal must exist only for the benefit of its

members and their beneficiaries.

13.o A fraternal must be non-profit and be organized without capital stock.

14.o Fraternals must be organized under a lodge or chapter system and hold regular meetings of the society.

15.o Fraternals must have a representative form of government in accordance with the organization bylaws

and constitution.

16.o Government insurance programs have been created to allow the government to make compulsory a

program lacking equity in order to cover the fundemental risks and redistribute income.

17.o The federal government is the largest insurer in the world.

18.o Reciprocals are groups of individuals (called ―subscribers‖) who are insured under an arrangement where

each subscriber is both an insured and an insurer.

19.o In reciprocals the liability of each subscriber is limited.

20.o The administrator of a reciprocal is the ―attorney-in-fact‖.

21.o Other than a percentage of the gross premium fee paid the ―attorney in fact‖ and administrative

expenses, any unused premiums are returned to the subscribers.

22.o Lloyd‘s of London is not an insurer nor does it issue policies.

23.o Lloyd‘s of London is an association of members who write insurance for their own accounts

24.o Lloyds of London provides facilities and rules that govern how its members will pursue trade.

25.o Lloyd‘s maintains worldwide underwriting information and a complete record of losses.

26.o Lloyd‘s aids in loss settlements and supervises salvage and repairs throughout the world.

27.o Independent rating services provide ratings consumers can use to measure the status of a company and

compare it to others.

28.o The two most popular rating services are A.M. Best Company and Standard and Poors.

CHAPTER 6: POLICY PROVISIONS OF LIFE POLICIES

Most agents have never read the required policy provisions that are contained in every policy sold. It is important to note

that policy provisions are in fact contractual provisions and govern what the policy owner can and cannot do with the

policy.

Here is an overview of some of the policy provisions:

Ownership Clause.

Entire Contract Clause.

Incontestable Clause.

Suicide Clause.

Grace Period.

Reinstatement Clause.

Misstatement of Age.




















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Beneficiary Designation.

Change of Plan Provision.

Ownership Clause The owner of a Life Insurance Policy can be the applicant, the insured, or the beneficiary. In most cases, the applicant and

insured are the same person. Under the Ownership Clause, the policy owner possesses all contractual rights in the policy

while the insured is still alive.

These rights include the selection of a settlement option, naming and changing the beneficiary designation, election of

dividend options, and other rights. These contractual rights typically can be exercised without the beneficiary's consent.

In addition, the Ownership Clause provides for a change in ownership. The policy owner can designate a new owner by

filling out an appropriate form with the company. The insurer may require that the Life Insurance Policy be endorsed to

show the name of the new owner.

Entire Contract Clause The Entire Contract Clause states that the Life Insurance Policy and attached application constitute the complete contract

between the insurer and policy owner. The insurer to void the policy unless the statement is a material misrepresentation

and is part of the application can use no statement. In addition, any officer of the company cannot change the terms of

the policy unless the policy owner agrees to the change.

Incontestable Clause Under the Incontestable Clause, the company cannot contest the policy after the policy has been in force two years

during the insured's lifetime. The insurance company has two years to discover any irregularities in the contract, such as a

material misrepresentation or concealment. If the insured dies after that time, the death claim must be paid.

For example, if John conceals a cancer operation when the application is filled out and dies after expiration of the

incontestable period, the death claim WILL be paid.

The purpose of the incontestable clause is to protect the beneficiary if the insurance company tries to deny payment of the

death claim years after the policy is issued. Since the insured is dead, allegations by the insurer concerning statements

made in connection with the application cannot be easily refuted. After the incontestable period has expired, with few

exceptions, the company must pay the death claim.

Suicide Clause A typical Suicide Clause states that the face amount of the policy will not be paid if the insured commits suicide within two

years after the policy is issued. The only payment is a refund of the premiums. The purpose of the Suicide Clause is to

reduce adverse selection against the insurer by providing the insurer some protection against an individual who purchases

a Life Insurance Policy with the intention of committing suicide.

Grace Period A Grace Period is another important contractual provision. A typical Grace Period gives the policy owner thirty-one days to

pay an overdue premium. The life insurance remains in force during the Grace Period. If death occurs during the Grace

Period, the overdue premium usually is deducted from the policy proceeds.

Reinstatement Clause If the premium is not paid during the grace period, a life insurance policy may lapse for nonpayment of premiums.

The Reinstatement Clause allows the policy owner the right to reinstatement of a lapsed policy under certain conditions:

The insured must provide evidence of insurability, a condition that insurers often waive for lapses of less

than two months.

All overdue premiums plus interest must be paid.

A policy loan must be repaid or reinstated.

The policy has not been surrendered for its cash value.

The lapsed policy must be reinstated within five years.

If the policy owner wishes to continue the same type of life insurance coverage, it usually is more economical to reinstate a

policy than to buy a new one. This is because a new policy is likely to have a higher premium, since it will be issued when

the insured is older.

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Misstatement of Age The insured's age may be misstated in the application. Under the Misstatement Clause, the amount paid is the amount of

life insurance that the premium would have purchased at the insured's correct age.

Example:

Assume that Mary's correct age is thirty but is incorrectly recorded in the application as age twenty-nine

and the premium for an ordinary life application at age twenty-nine is $20.00 per $1,000.00 and $21.00 per

$1,000.00 at age thirty. If Jane has $15,000.00 of Ordinary Life Insurance and dies, only 14/15ths of the

proceeds will be paid, or $14,000.00.

Beneficiary Designation The beneficiary is the person or party named in the policy to receive the policy proceeds. There are numerous Beneficiary

Designations in life insurance such as:

The Primary Beneficiary is the first party who is entitled to receive the proceeds at the insured's death.

The Contingent Beneficiary is the beneficiary entitled to proceeds if the primary beneficiary is not alive.

A Revocable Beneficiary designation means that the policy owner has the right to change the Beneficiary

Designation without the beneficiary's consent.

An Irrevocable Beneficiary designation means that the policy owner cannot change the beneficiary

without the irrevocable beneficiary's consent.

A Specific Beneficiary designation means that the beneficiary is named and can be identified. For

example, Martha Smith may be specifically named to receive the policy proceeds if her husband should

die.

A Class Beneficiary designation means that a specific individual is not named but is a member of a group

to whom the proceeds are paid. One example of a class Beneficiary Designation would be "children of the

insured."

Change of Plan Provision The Change of Plan Provision allows the policy owner to exchange the present policy for a different one. If the change is to

a higher premium plan, such as exchanging an ordinary life policy for an endowment at age sixty-five, the policy owner

must pay the difference in cash values between the two contracts plus interest at a stipulated rate. Since the net amount

at risk is reduced, evidence of insurability is not required. Some insurers also allow the policy owner to change to a lower

premium policy, such as exchanging an endowment contract for an ordinary life contract. The insurer refunds the

difference in cash values to the policy owner. However, evidence of insurability is required since the net amount at risk is

increased.

FOCUS POINTS

1.o Policy provisions are contractual provisions that govern what a policy owner can and cannot do with the policy.

2.o The owner of a life insurance policy can be the applicant, the insured, or the beneficiary.

3.o In most cases the applicant and the insured are the same person.

4.o Under an OWNERSHIP CLAUSE the policy owner possesses all contractual rights in the policy while the insured is still

alive.

5.o Contractual rights typically can be exercised without the beneficiary‘s consent.

6.o A policy owner designating a new owner and filing out the appropriate forms can implement changes in

ownership.

7.o The ENTIRE CONTRACT CLAUSE states that the life policy and the attached application constitute the complete

contract between the insurer and the policy owner.

8.o Any officer of the company cannot change the terms of a life policy unless the policy owner agrees.









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9.o The INCONTESTABLE CLAUSE prevents the company from contesting the policy after it has been in force for two

years.

10.o An insurance company has two years to discover any irregularities in the contract such as a material

misrepresentation or concealment.

11.o A typical SUICIDE CLAUSE states that the face amount of the policy will not be paid if the insured commits

suicide within two years after the policy is issued.

12.o The GRACE PERIOD of a policy gives the policy owner thirty-one days to pay an overdue premium.

13.o If death occurs during the grace period the overdue premium is usually deducted from the policy

proceeds.

14.o The REINSTATEMENT CLAUSE allows the policy owner the right to reinstate the policy under certain

conditions.

15.o A lapsed policy must be reinstated within five years.

16.o It is usually more economical to re-instate a policy than to buy a new one.

17.o The MISSTATEMENT OF AGE Clause specifies that the amount of death benefit paid is the amount that the

premium would have purchased at the insured‘s correct age.

18.o The Beneficiary is the person or party named in the policy to receive the policy proceeds.

19.o A CONTINGENT beneficiary will only receive benefits if the Primary beneficiary is not alive.

20.o A revocable beneficiary can be changed without the permission of the beneficiary.

21.o A CLASE beneficiary means that a specific individual is not named but is a member of a group to whom

proceeds are paid.

o A CHANGE OF PLAN PROVISION allows the policy owner to exchange the present policy for a different one.

CHAPTER 7: PREMIUMS

SINGLE AND PERIOD PREMIUMS

There are two basic ways to purchase a life insurance policy. The first is by paying the entire cost in one lump-sum

payment. This is the "single premium" method. The second method of purchasing a policy is by the payment of periodic

premiums. Rather than making a single payment for the insurance, the policyholder makes annual, semi-annual, or more

frequent payments.

A single premium policy is seldom purchased because of the large lump-sum payment that is generally required. The

typical policyholder finds the periodic payments much easier to make.

A second reason why single premium policies are seldom purchased concerns the cost of the policy if the insured dies in

the early years of the contract. In this situation, the amount paid for the insurance under the periodic method will be less

than the single premium amount.

Parts of the Premium There are three basic factors that affect the premium charged for a life insurance policy. The first is "mortality". Mortality

refers to how many people within a given age group will die each year. The second factor is interest. Interest refers to the

earnings the company receives on the premiums dollars it invests. The third factor is expenses. Expenses are, of course, all

of the costs the company incurs in selling, issuing, and servicing its policies.

As an individual grows older, the cost of insurance increases, since growing older increases the chance of death.

Insurance companies use mortality tables and other statistics to determine the number of insureds, within each age group,

who will die each year. What happens if more people died in a year than the company predicted? The company will pay

out more for death claims than was anticipated.














27

Another factor that influences the cost of insurance is the interest income that the company earns from its investments.

Insurance companies receive millions of dollars each month in premium dollars. And, while each company has death

claims and other expenses, the costs for these claims and expenses should be less than the total premiums received.

By law, a life insurance company is permitted to invest this extra money to obtain additional revenue in the form of interest.

Most life insurance companies invest in stocks, bonds, construction projects, and in a variety of other ventures designed to

provide a return on their investment. The principal, as well as the interest earned, on these investments establishes a fund to

pay all death claims as they occur and also helps to offset the cost of insurance.

In addition to savings which may result from lower than anticipated mortality, an insurance company may also realize

income from investments. Naturally, the insurance company is not permitted to keep all the money it receives. Expenses,

of course, have to be paid. And, in addition to death claims, expenses include such items as:

Agent's commissions.

Salaries.

Advertising.

Physical examinations.

Legal costs.

Policy issue costs.

Here is a very simple formula that indicates how these factors affect premium costs:

Death claims + other expenses - interest earned = premium to be charged.

Keep in mind that no company determines the premium to be charged by the simple method we have described above.

This simplified approach merely describes the important relationship between these factors.

Net and Gross Premium The premium that a company charges for a life insurance policy is called the "gross" premium. When a company is

calculating the premium for a policy, it begins by determining the "net" premium. Once the net premium has been

computed, the company then adds the expense factor, or "loading", to this net premium to arrive at the gross premium.

Mortality and Interest Factors Two basic factors go into the calculation of the net premium—the mortality and interest factors.

An insurance company cannot predict when a particular insured will die. However, by using the mathematical concept of

probability, the company can predict, with a great deal of accuracy, the number of insureds that will die each year.

This prediction of future mortality is made on the basis of past mortality experience and assumes that future experience will

parallel past experience. But, if past mortality is to be a reliable basis for prediction, accurate data must be kept on a large

group of representative individuals for a sufficiently long period of time.

Information on past mortality is analyzed and arranged in a table, called the "mortality table" which shows probable death

or mortality rate at a specific age. Beginning with a given number of individuals at a given age, the mortality table shows

the number of people out of the group who probably will die at each age and the number who will survive.

Even if the mortality rates and the mortality table are accurate, a company that wants a reliable estimate of future

mortality must apply the rates to a large enough group of individuals for the "law of averages" to operate.

Level Premium Concept Reserves Once the net single premiums are computed, the company then converts that premium into a ―net level premium‖ since

few policies is purchased by the single premium method

The early renewable term premium, also called a "natural or step-rate" premium, increases each year as the insured ages

and the risks of mortality increases. The premium rises rather gradually during the younger ages, but increases sharply for

the older ages. As a result, the premiums can become prohibitively expensive for most insureds at the older ages.

To overcome the problem of annually increasing premiums, companies develop the level premium plan. With this plan, the

premium remains the same during the premium payment period rather than increasing as the probability of death

increases. This level premium is higher than the natural, or yearly renewable term; premium in the early years of the policy

but is lower than the natural premium in the later years.

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Under the natural premium plan, the net premium charged policy owners each year is just sufficient to pay the expected

claims for the year. This is not true for the level premium plan. The net level premium payments made in the early years of

the contract are greater than the amount needed to pay the policy claims during those years.

By investing the excess part of the premium in the early years, the company accumulates funds to cover the deficiency

that occurs in the latter years. These funds, which the company holds to meet future policy obligations, constitute the

policy reserve or simply the "reserve". The reserve is the amount that, together with future premiums and interest earnings,

will be sufficient for the company to pay all future policy claims, based on the company's mortality and interest

assumptions.

Thus, the reserve is a liability - future obligation to the company. Because a company's ability to fulfill its contract

obligations depends upon sufficient policy reserves, the state requires a company to maintain certain minimum reserves.

Most states now require that the insurance company become part of the legal reserve pool.

State laws specify the mortality table and the assumed rate of interest to be used in calculation of the legal minimum

reserves. Because of these state regulations, reserves are often called "legal reserves".

Insurance Age Premiums charged for life insurance depend upon the insured's age. The mortality factor is one of the three basic elements

of the premium and the mortality factor varies with an insureds age.

However, the age used to determine the premium is the insured's insurance age. The insured's insurance age may, or may

not, be the same as his actual or chronological age.

A company may use one of two methods of determining an insurance age.

In the first method, an insured's insurance age is his age at the insured's nearest birthday. If the insured turned age 30 less

than 6 months ago, the insured's age would be 30. However, if the insured's 30th birthday was more than 6 months ago, the

insurance age would be 31 since the next birthday would be nearer than the last.

Although the nearest birthday is the more commonly used method, some companies may use the insured's last birthday to

determine the insurance age. The insurance age under this method is the same as the insured's actual age, regardless of

the number of months since his or her last birthday.

FOCUS POINTS

1.o The two basic methods of purchasing life insurance is the ―single premium‖ or periodic premium‖ method.

2.o A lump sum or single premium policy creates a higher cost to the policy owner in the event of an early death.

3.o The three basic factors that affect the premiums charged are ―mortality‖, Interest earnings on investments and

expenses of company.

4.o Mortality tables and other statistics are used by insurance companies to determine the number of insured, within

each age group, that will die each year.

5.o Most insurance companies create interest revenue by investing in stocks, bonds and construction projects.

6.o Death claims plus other expenses minus interest earned equals premiums charged.

7.o The premium that an insurance company charges for a life insurance policy is called a gross premium.

8.o A gross premium is determined by adding the net premium plus ―loading charges‖ (expenses) to arrive at the gross

premium.

9.o The mortality and the interest factor are the two basic elements that go into the calculation of the net premium.

10.o Once the net single premiums are computed, the company converts that premium into a ― net level

premium‖.

11.o A ― natural or step rate premium‖ increases each year as the insured ages and the risks of mortality

increases.












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12.o To overcome the problem of annually increasing premiums, companies offer a ―level premium‖ plan.

13.o The ‗reserve‖ is the amount that, together with future premiums and interest earnings, will be sufficient for

the company to pay all future policy claims.

o States require that a company maintain certain minimum reserves or be part of the legal reserve pool.

CHAPTER 8: EXCLUSIONS AND RESTRICTIONS

Although few exclusions or restrictions are placed on Life insurance policies the more common ones are:

Certain activities that are considered dangerous such as flying, hang-gliding, auto racing or skydiving may

either be excluded or covered if an additional premium has been paid.

A Suicide Clause excludes payment of the face amount in the event of suicide within two years

of the issue date.

An Aviation Exclusion may be present in the policy and would exclude death coverage from an aviation

accident other than as a passenger on a regularly scheduled airline.

The War Exclusion is designed to control adverse selection during times of war and may be inserted to

exclude payment if death occurs as a result of war.

Payment of Premiums The policyholder of a life insurance contract has a choice as to how they may pay premiums. Premiums can be paid

annually, semiannually, quarterly, monthly direct or monthly bank draft.

The company usually offers a discount for paying the premiums annually. The most popular method of payment is monthly

bank draft.

The method that causes the most lapses is quarterly followed by monthly direct billing.

The method that best suits persistency is monthly bank draft followed by annually.

CHAPTER 9: SETTLEMENT OPTIONS

When benefits are paid following the death of the insured the payments of benefits is referred to as Settlement of the Policy.

The following is an overview of the settlement options and then we will review them one at a time. They are:

Lump sum settlement.

Proceeds and interest.

Fixed years installments.

Life income.

Joint life income.

Fixed amount installments.

Other mutually agreed methods.

Lump Sum Settlement This is when the beneficiary receives the policy proceeds in a single payment following the death of the insured.

Proceeds and Interest Under this option, the insurance company will hold the policy proceeds and make interest payments to the beneficiary.

The minimum interest rate is spelled out in the policy and the company may at its discretion to pay a higher rate. The

beneficiary still has the right to withdraw all or part of the proceeds of the policy at any time.

Fixed Years Installments With this option, the insurance company pays the proceeds in equal monthly payments. The recipient of the proceeds

chooses the number of years for which payments will be made.



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The amount received monthly depends on three factors:

Policy proceeds.

Number of years payments are to be made.

Interest rate paid by the insurance company.

Again, under this settlement option, the beneficiary still has the right to withdraw all or part of the proceeds at any time.

Life Income Under this settlement option, the beneficiary will receive equal monthly payments for the life of the beneficiary. The

amount of monthly payments depends on four factors:

Policy proceeds.

Beneficiary's sex.

Beneficiary's age at time payments begin.

Period certain for which payments are guaranteed.

Should payments be guaranteed for a period certain, such as ten years, payments will be made for the specified number

of years regardless or whether the beneficiary lives to the end of that period. Should the beneficiary die during the period

certain payments will continue to the beneficiary's designated successor.

Example:

A beneficiary is going to receive $500.00 a month for 10 years certain. This means that should the

beneficiary live the entire ten years he will receive $500.00 a month. After ten years there are no more

benefits paid. However; if the beneficiary die in the sixth year, the remaining four years of $500.00 per

month will go to his designated successor.

Joint Life Income When this option is chosen equal monthly payments will be made so long as either one or two payees is alive. This option

may be used when a policy owner/insured contributes to the support of his or her parents. In the event of the insured's

death, the parents, as beneficiaries, would receive monthly income for the rest of their lives.

The amount of the monthly benefits would depend on two factors that are:

The policy proceeds.

Parents' ages at the time they begin to receive benefits. However; under this option, the beneficiaries

typically do not have the right to discontinue the monthly payments and receive the balance in a one-sum

settlement.

Fixed Amount Installments Using this settlement option, the insurance company makes equal payments per month, or at longer intervals, in an amount

chosen by the policy owner or beneficiary.

All proceeds held by the insurance company will earn interest. If the monthly payment is greater than the monthly interest

earned, the balance of the proceeds held by the insurance company decreases each month until the total proceeds and

interest due are paid out.

Under this option, the beneficiary may withdraw the unpaid balance at any time. If the beneficiary dies before the

installment payments are completed, the unpaid balance is paid to the beneficiary's estate.

Other Mutually Agreed Method On occasion, a life insurance company may allow the policy owner to designate other payments methods if the insurance

company agrees to them.

An example of this may be that the proceeds at interest are to be paid to the insured's spouse for the spouse's lifetime and,

upon the spouse's death, a one-sum settlement is to be made to the insured's children.

FOCUS POINTS

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1.o Lump sum settlement is when the beneficiary receives the policy proceeds in a single payment following the death

of the insured.

o Under the proceeds and Interest option, the insurance company holds the policy proceeds and makes interest

payments to the beneficiary.

o Under proceeds and interest a minimum interest rate is spelled out in the policy.

4.o Under proceeds and interest the beneficiary still has the right to withdraw all or part of the proceeds at any time.

5.o Fixed years installment pays proceeds in equal monthly payments over a period of time as outlined by the

recipient.

6.o Under fixed year installments the beneficiary has the right to withdraw all or part of the proceeds at any time.

7.o Life income provides the beneficiary equal monthly payments for the life of the beneficiary.

8.o Under period certain guarantee, should the beneficiary die, the proceeds would be paid to the beneficiary‘s

designated successor for the remaining period.

9.o Under joint life income equal monthly payments will be made so long as either one or two payees is alive.

10.o Under fixed amount installments, the insurance company makes equal payments per month, or at longer

intervals, in amount chosen by the policy owner or beneficiary.

o Under fixed amount installments, the beneficiary may withdraw the unpaid balance at any time.

CHAPTER 10: NON-FORFEITURE OPTIONS

Life insurance policies contain non-forfeiture options.

They are designed to give the insured ways in which he or she may gain continued value from a policy in the event the

insured is unable to continue premium payments.

The five non-forfeiture options are as follows:

1. Cash Surrender Value

2. Reduced Paid-Up Insurance.

3. Extended Term Insurance.

4. Automatic Loan Provision.

5. Dividend Accumulations to Avoid Lapse.

Cash Surrender Value A policy owner may surrender the policy and request that the company pays the cash surrender value of the policy, if any.

As a rule most policies have no cash value whatsoever for the first two to three years.

The Cash Surrender Value usually consists of the following:

The policy cash value.

Cash value of paid up additions.

Dividends.

The Cash Surrender Value can be reduced by any outstanding policy loans and accrued loan interest on outstanding

policy loans.

It is important to know that all coverage ceases when the policy is cash surrendered. Payment is usually made in one lump

sum and in some cases in accordance with one of the other policy settlement options already discussed.

Reduced Paid-Up Insurance Under this option the policy owner may request that the cash value of the policy be used to keep a reduced amount of

paid-up insurance in force under the same policy.









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Usually the policy has a table contained in it that shows the amount of reduced insurance in any given year that the cash

value that same year would purchase.

Although the policy has had its face reduced the policy will continue to earn cash value and pay dividends if applicable.

Extended Term Insurance This option allows the same face amount of the policy to remain in effect for a specified number of years and days.

As with reduced paid-up insurance, the policy will contain a table showing how long in years and days the original face

amount will remain in force during any given surrender year.

The length of time in years and days is calculated by taking the policy's cash surrender value, the insured's age and sex at

the time premiums were discontinued and using that cash surrender value to purchase term insurance for a specified

amount of years and days.

Under this option the policy does not continue to earn cash value or pay dividends if applicable.

Automatic Premium Provision It is possible for the insured to authorize the insurance company to make an automatic loan from the policy's cash value to

pay any premium not paid by the grace period.

Dividend Accumulations to Avoid Lapse Should the policy pay a dividend, the dividend accumulations may be applied to any premium not paid by the end of the

grace period. In the event the amount of accumulated dividends is not enough to pay the entire premium, coverage will

then be extended in proportion with the amount of premium paid by the accumulated dividends. As a result of this a new

grace period will start at the end of extension coverage.

FOCUS POINTS

1.o Life insurance non-forfeiture options give the insured ways in which he or she may gain continued value from a

policy in the event the insured is unable to continue premium payments.

2.o There are 5 non-forfeiture options.

3.o Cash Surrender Value permits the policy owner to surrender the policy in exchange for its cash surrender value.

4.o Cash Surrender Value is made up of policy cash value, cash value of paid up additions, and dividends.

5.o Cash Surrender value is reduced by any outstanding loans.

6.o Reduced Paid up Option permits the policy owner to use the cash value to keep a reduced amount of paid-up

insurance in force under the same policy.

7.o A reduced policy will continue to earn cash value and pay dividends.

8.o Extended Term Option allows the same face amount of the policy to remain in effect for a specified number of

years and days.

9.o Under Extended Term Option the policy does not continue to earn cash value or pay dividends.

10.o Automatic Premium Provision permits the insurance company to make an automatic loan from the policy‘s

cash value to pay any premium not paid by the grace period.

11.o Should a policy pay a dividend, the dividend accumulation may be applied to any premium not paid by

the end of the grace period.

o When accumulated dividends are not enough to pay an entire premium, coverage is extended in proportion with

the amount of premium paid












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CHAPTER 11: DIVIDEND OPTIONS

If a life insurance contract is a participating policy that means that the policy owner is entitled to an annual dividend paid

by the insurance carrier. Participating policies affords the policy owner the opportunity to participate in the earnings of the

insurance company through dividend payments.

The following are the ways in which a policy owner may use his or her dividends:

Cash Payment.

Reduction of Premium.

Accumulation at Interest.

Paid-up Additions.

One-year Term.

Cash Payment Under this dividend option the insurance company sends the insured a check equal to the amount of the declared

dividend payment.

Reduction of Premium The premium due on the policy for the upcoming year will be reduced by the amount of the current year's declared

dividend and the balance becomes the new premium due for the upcoming year.

Accumulation of Interest The dividend may be held by the insurance company to accumulate with interest paid at the rate that is specified in the

contract.

The insured has the right to withdraw the accumulated dividends at any time.

Should the accumulated interest and dividend be on deposit with the company at the time of the insured's death, the

accumulated interest and dividend will be paid along with the policy proceeds.

Paid-Up Additions This option enables the insured to receive additional amounts of life insurance by using the dividend to purchase paid-up

additions. The additional insurance will be the same kind and subject to the same provisions as the original policy. Again, on

the insured's death paid-up additions of insurance will be paid up along with the policy proceeds.

One-Year Term Some policies permit dividends to purchase one-year term coverage. The amount of the one-year term coverage would

be added to the face amount of the base policy in the event of the insured's death.

FOCUS POINTS

1.o Some life insurance policies are participating contracts.

2.o Participating policies permit the policy owner to participate in the earnings of the insurance company.

3.o Policy owners participate in the earnings of an insurance company through dividend payments.

4.o Dividends can be used through cash payment, reduction of premium, accumulation of interest, paid up additions,

one year term.

5.o Under Cash Payment the insurance company pays the dividends directly to the insured.

6.o Reduction of Premium applies dividends to the upcoming premium payment.

7.o Accumulation of interest applies the dividends that are held by the company to accumulate interest for the benefit

of the insured.

8.o The insured has a right to withdraw the accumulated dividends at any time.

9.o At the time of the insured‘s death the accumulated interest and dividends would be paid in addition to the policy

proceeds.

10.o Dividends may be used to buy up additional insurance under a Paid Up Additions option.











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o Some policies permit dividends to purchase one-year term coverage, which would be added to the face amount

of the base policy in the vent of the insured‘s death.

CHAPTER 12: LIFE INSURANCE POLICY RIDERS

In life and health insurance the word "rider" is used in lieu of endorsement. The effect is the same in that riders modify the

coverage of the basic policy the same as an endorsement would.

The most commonly used riders in life insurance policies are:

Waiver of Premium.

Accidental Death and Dismemberment.

Guaranteed Purchase Option.

Waiver of Premium This rider protects the insured in the event he becomes totally disabled. The waiting period usually is six months, and if the

insured continues to be disabled after the six-month waiting period the premium payments on the policy will be waived.

Many policies will also refund the premium that was paid by the insured during the six-month waiting period. The cost for

this coverage is a bargain to say the least and no policy should be sold without this rider.

Accidental Death and Dismemberment The amount paid in the event of accidental death of the insured is usually the same as the policy's regular face amount.

Therefore, if death occurs as the result of an accident the beneficiary receives twice the amount of the face value of the

policy. Some agents may better recognize this benefit when it is referred to as "double indemnity."

As a rule, the accidental death rider is very carefully worded to define exactly under what circumstances this benefit will be

paid. The most liberal of the definitions is "accidental bodily injury." The less favorable wording would be that death must

occur "by accidental means."

For example using "by accidental means" if an insured died from a broken neck after intentionally diving into the shallow

end of a swimming pool the policy would not pay the accidental death benefit because the action of diving into this pool

wasn't accidental. However, if the insured accidentally fell into the pool and drowned the benefit would be paid. Under

the "accidental bodily injury" definition the intentional diving into the pool would have been paid.

Normally, the death caused by the accident must consummate itself within 90 to 180 days of the incident. Under the

dismemberment rider payment is made to the insured rather than the beneficiary.

Benefits typically are paid for:

Loss of Sight.

Loss of Hand or Hands.

Loss of Foot or Feet.

Regarding the loss of hand or foot, the loss typically must involve "complete severance through or above the wrist or ankle

joint.‖ Loss caused by amputation is excluded unless medically necessary and as the result of an accidental injury.

Guaranteed Purchase Option This option is used most frequently with whole life insurance rather than term insurance. Under this option the company

guarantees the insured that he or she may purchase additional amounts of coverage without evidence of insurability.

These additional purchases usually are made at specific time intervals or events that change your family status.

For example some policies permit additional purchases of life insurance under the following circumstances:

Every fourth policy anniversary year.

The insured purchases a new home.

The insured gets married.

The birth of a new child.

The premium charge for the additional coverage is typically based on:

The type of insurance purchased.

The insured's age at time of exercising option.

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FOCUS POINTS

1.o In life and health insurance the word ―rider‖ is used in lieu of endorsement.

2.o ―Riders modify the coverage of the basic policy.

3.o The most common riders in life insurance are waiver of premium, accidental death and dismemberment, and guaranteed

purchase option.

4.o Waiver of Premium protects the insured should he or she become totally disabled.

5.o There is usually a six-month waiting period on a Waiver of Premium rider.

6.o Under some Waiver of Premium policies the insured is refunded the premium paid during the 6-month waiting period.

7.o Under Accidental death and Dismemberment in the event of accidental death the policy pays twice the amount of the face

value.

8.o The benefit under Accidental death and Dismemberment is often referred to as ―double indemnity.‖

9.o Under most policies death caused by an accident must consummate itself within 90 to 180 days of the accident.

10.o Under Dismemberment Rider the loss of a hand or foot must involve the ―complete severance‖ through or above the

wrist or ankle joint.

11.o Loss caused by amputation is excluded unless medically necessary and as the result of an accidental injury.

12.o Guaranteed Purchase Option is used frequently with whole life insurance rather than term insurance.

13.o Guaranteed Purchase Option permits the insured to purchase additional amounts of insurance without evidence of

insurability.

14.o Additional purchases are usually made at specific time intervals or as a result of certain events.

o Premium charged, under a Guaranteed Option, is typically based on type of insurance purchased and the insured‘s age.

CHAPTER 13: LIFE INSURANCE UNDERWRITING

The purpose of life insurance underwriting is to develop a profitable book of business for the insurance company.

In order to accomplish this goal the life insurance underwriter attempts to provide coverage for a diversified group of

insureds where the expected death rate is the same or lower than what is expected of the population as a whole.

UNDERWRITING FACTORS FOR INDIVIDUAL COVERAGE

Life insurance is priced on a class basis. Perspective clients of the insurance company are classed on the basis of a number

of factors that help to predict expected mortality rates.

The principal rating factors are:

Age.

Sex.

Health.

Occupation and Avocation.

Personal Habits.

Foreign Travel or Recent Immigration.

Age Mortality rates are measured in terms of deaths per one thousand persons and this of course increases with age. Thus, the

older you are, the more life insurance costs because you are closer to death than a younger person.

Sex Women in the United States live seven years longer than men. Therefore, cost for life insurance on a woman is lower, based

on a three-year age difference, than on a man of the same age. For example, a thirty-year old male would pay the same

premium as that of a 33-year-old female.















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Health The health of an individual as well as the health history of their family helps the underwriter to determine if the applicant

presents an average or better than average risk to the insurance company.

In evaluating an insured's health the company will consider whether the applicant or family members have had any of the

following illnesses:

Cancer.

Heart Disease.

Hypertension.

Diabetes.

As a rule, persons whose health history include the above diseases will likely have a higher than normal mortality rate. Most

insurance companies are now offering discounted rates to non-smokers due to the link between smoking and lung and

heart disease.

Occupation and Avocation Since certain occupations pose hazards such as flying and scuba-diving, applicants who engage in these hobbies are likely

to have a higher than normal mortality rate.

Personal Habits If a life policy exceeds $100,000.00 in coverage the insurance company will more than likely investigate the personal

circumstances of the insured's life. For example, areas such as alcohol or drug use, poor driving record or financial

problems may be taken into consideration.

Foreign Travel or Recent Immigration People who travel or reside outside the United States may be exposed to diseases not commonly found in this country.

Additionally, mortality rates vary from country to country. Therefore if a person is applying for life insurance shortly before

leaving the country special medical tests or a postponement of coverage may take place.

UNDERWRITING ACTIONS

Based on the information that the underwriter receives from the applicant one of following three actions may be taken:

Rate the applicant standard and charge the normal premium.

Rate the applicant substandard and charge a higher premium.

Decline the coverage.

In addition to the above three actions many insurance companies recognize preferred risks and they will actually reduce

premiums.

FOCUS POINTS

1.o The purpose of insurance underwriting is to develop a profitable book of business for the company

2.o In order to accomplish the goal of profitability for the company an underwriter attempts to provide coverage for a

diversified group of insureds.

3.o Profitability is accomplished by insuring a group of insureds where the expected death rate is the same or lower

than what is expected of the population as a whole.

4.o Life insurance is priced on a class basis.

5.o Perspective clients are classed on the basis of a number of factors that help to predict expected mortality rates.

6.o The principal rating factors are age, sex, health, occupation and avocation, personal habits, and foreign travel or

recent immigration.

7.o Mortality rates are measured in terms of deaths per one thousand.

8.o Mortality increases with age, thus causing insurance premiums to be higher with age.









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9.o Because women in the United States live longer then men, insurance for a woman at any specific age is lower than

a man at the same age.

10.o The health of an individual helps the underwriter to determine if the applicant presents an average or

better than average risk.

11.o The health history of an individual‘s family helps an underwriter further evaluate risk.

12.o Individuals that either have hobbies or occupations that pose hazard are likely to have a higher mortality

rate.

13.o An underwriter takes alcohol, drug use, and poor driving record or financial problems into consideration.

14.o Because people traveling or residing outside the United States may be exposed to diseases not commonly

found in the U.S., an underwriter analysis the risk as part of the consideration.

15.o Mortality rates vary from country to country

o Some insurance companies recognize preferred risks and reduce the actual premium.

CHAPTER 14: DELIVERING THE POLICY

POLICY EFFECTIVE DATE

The effective date of a life insurance policy is very important since this is the date on which coverage begins. The policy

effective date may also have additional significance with regard to the incontestable and suicide clauses.

The incontestable clause gives the insurer, usually two years, that amount of time to contest the policy on the basis of

material misrepresentation, fraud, or concealment in the application.

The suicide clause excludes coverage for death by suicide during the first two years of the policy.

To determine the effective date of the policy, we must examine the principal of contract law known as "offer and

acceptance".

If a proposed insured signs the application and submits it with the first premium to the company, an offer to buy insurance

has been made by the proposed insured.

If the insurance company issues the policy, as applied for, then the fundamental of offer and acceptance occurs. That is,

the proposed insured has made an offer to purchase a life insurance contract, and the insurance company has accepted

that offer.

It is assumed that the premium was submitted with the application. However, there are two other possibilities to consider

regarding the effective date of the policy.

The first occurs when an application is submitted without the premium. In this case, the applicant has made no offer. The

applicant has only extended an invitation to the company to make an offer.

The insurance company makes the offer when it issues a policy as applied for and delivers it to the applicant. Further, the

offer is accepted when the applicant pays the premium, assuming any other conditions have been fulfilled and this date

becomes the effective date of the policy.

In situations where the initial premium does not accompany the completed application, most companies state in the

application that the proposed insured must be in good health at the time of policy delivery before coverage becomes

effective.

So, before accepting the initial premium and leaving the policy, the agent must obtain a signed statement of the

prospective insureds continued good health. This statement and the initial premium are then transmitted to the company.

The final possibility occurs when the premium is submitted with the application but no receipt is given. If this is the case,

then the policy's effective date is generally date that the policy is issued and delivered.

Delivery of the policy constitutes the company's acceptance of the applicant's offer - the application and initial premium.








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A policy is considered delivered when:

The policy is actually handed over in person.

It is mailed to the policyholder.

It is mailed to the agent for unconditional delivery to the policyholder.

Delivery, then, does not usually have to be accomplished by the manual transfer of the policy to the policyholder. Delivery

accomplished by means other than a manual transfer is called "constructive delivery".

If a policy is not, or cannot, be delivered as defined previously, then the policy is not in effect, as policy delivery has not

been accomplished. Two other situations need to be addressed.

Inspection Receipt. When the applicant wants to examine the policy for a time before paying the initial premium,

and the policy is left with the applicant for inspection, he or she should sign a receipt for the policy referred to as

an "inspection receipt". This acknowledges that the policy is in the insured's possession for inspection purposes only

and that the initial premium has not been paid and that the insurance is not in effect.

Backdating. An applicant may ask the company to give the policy for which they are applying a date earlier than

the application date. The reason for backdating is usually to obtain a lower premium. Premium paid for life

insurance depends, among other factors, on the insured's age. So, in order to obtain a lower insurance age, and,

as a result a lower premium, backdating is used.

AGENTS RESPONSIBILITIES

The agent should deliver the policy to the client as soon a possible after the policy is issued. This is especially important

when no premium was submitted with the application because the coverage will not become effective until the policy is

delivered and the first premium paid during the continued good health of the proposed insured.

The agent also has a responsibility to explain the policy's provisions, riders, and exclusions. If the policy is rated, the agent

should explain why the policy was issued that way.

FOCUS POINTS

1.o The effective date of an insurance policy is the date on which coverage begins.

2.o The incontestable clause gives the insurer, usually two years, to contest the policy on the basis of material

misrepresentation.

3.o A suicide clause excludes coverage for suicide during the first two years of a policy.

4.o A signed application together with the submission of the first premium constitutes an offer to buy insurance by the

proposed insured.

5.o When an insurance company issues a policy, as applied for, acceptance occurs.

6.o If an application is submitted without a premium, the applicant has only extended an invitation to the company to

make an offer.

7.o Offer and acceptance occur when the applicant pays the premium.

8.o When the initial premium is paid at delivery, the proposed insured must be in good health at the time of policy

delivery before coverage becomes effective.

9.o Delivery of the policy constitutes the company‘s acceptance of the applicant‘s offer, application and premium.

10.o A policy is considered delivered when the policy is hand delivered, mailed to the policyholder or mailed to

the agent for unconditional delivery to the policyholder.

11.o Delivery accomplished by means other than manual delivery is called ―constructive delivery.‖












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12.o An ―inspection‖ receipt should be signed by the applicant when the individual wants to examine a policy

for a time before paying the initial premium.

13.o Backdating of a policy is permitted.

14.o The reason for backdating a policy is usually to obtain a lower premium.

15.o An agent has a responsibility to explain the policy‘s provisions, riders, and exclusions.

CHAPTER 15: SUMMING UP THE APPLICATION

Three terms with which an agent should become familiar are: Applicant, Insured, and Policy owner. The applicant is the

person applying to the company for insurance, either on the applicant's own life of the life of another; the insured is the

person whose life is covered by the policy; and the policy owner is the person who has the ownership rights in the insurance

policy. The majority of policies are issued on the application of the person to be insured, who is also the owner of the

policy.

In the typical situation, the policy owner, the applicant, and the insured will be the same person. There are, however, many

policies issued where someone other than the insured applies for and owns the policy. The situation in which someone

other than the insured is the policy owner is called "Third party ownership."

This type of arrangement is often found in family situations where, for example, a wife will insure her husband, or vice versa,

or a parent will insure children. Third-party ownership is also often found in business situations, where a business insures the

life of a key employee, for example. Another common third-party ownership arrangement is where a creditor owns a policy

on the life of a debtor.

Insurable Interest For a life insurance policy to be issued, an "insurable interest" between the insured and the policy owner must be present. In

this regard, it is necessary to examine insurable interest from two standpoints. Look at the situation in which a person

applies for insurance on the life of another; look at insurable interest when a person applies for insurance on his or her own

life, and examine the conditions that must be present to satisfy the insurable interest requirements in each of these

situations.

To purchase life insurance on the life of another, an insurable interest in the life of the proposed insured must exist. This

means the policy owner must benefit, either emotionally or financially, by the insured continuing to live. Generally for an

insurable interest to exist, the potential emotional loss must arise from love and affection that grows from a close blood

relationship, or marriage. And, of course, where ones' own life is concerned, each person has an unlimited insurable

interest in his or her own life.

Suppose that a life insurance policy could be sold when no insurable interest requirements existed. If a person could apply

for insurance on the life of another without this interest, then the policy owner would stand to gain, and suffer no emotional

loss, by the insured's death. As such, a life insurance policy would constitute a mere wager which would be clearly against

public policy, and therefore illegal.

Remember, an insurable interest arises out of a close blood relationship. While this is basically true, being the relative of a

potential policy owner does not automatically establish an insurable interest. For example, under most circumstances a

person would probably find it difficult to establish an insurable interest in an aunt, uncle, or cousin unless the policy owner

could show that a significant financial or emotional loss would result upon the death of the relative.

Example:

Assume George has loaned a substantial amount of money to his cousin. George wants to

purchase a life insurance policy on his cousin's life. George will be the policy owner, and his

cousin will be the insured.

Policy owner and Creditor Another important aspect of insurable interest is the relationship between a policy owner and a creditor. This relationship

brings about another type of insurable interest.

Example:

A creditor can establish an insurable interest with a debtor. For instance, assume a bank loans $5,000 to an

individual. Obviously, the bank will suffer financially if the debtor dies before the loan is repaid.





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This fact establishes the insurable interest between the bank and the debtor. For this reason, the bank can

purchase life insurance on the life of the debtor and receive the death benefit of the life insurance policy,

but only in an amount which reflects the balance of the unpaid loan should the debtor die prior to

repaying the loan.

Insurance purchased by a creditor on the life of a debtor must be in an amount that approximates the size

of the debt. So, if a debtor owes a creditor $1,000, it is unlikely that the creditor could purchase a $10,000

life insurance policy on the life of the debtor.

For this reason, most credit life insurance purchased on the life of a debtor has a reducing death benefit which keeps pace

with the diminishing loan balance. Therefore, if a debtor owes $5,000 to be repaid over a period of five years, the death

benefit might begin at $5,000 to match the original amount of the loan. However, this policy would eventually reduce to $0

at the end of five years when the loan has been repaid.

COMPLETING THE APPLICATION

The application is a life insurance company document containing questions and information, which the company uses in

evaluating the insurance risk and in properly preparing the policy, if one is issued. The agent completes the application by

asking the applicant the questions.

The information requested on the application generally includes items such as the applicant's full name and address, age,

sex, marital status, occupation, medical and family histories, present physical condition, and a description of the type and

the amount of insurance applied for. It also includes the name of the person who is the beneficiary of the insurance along

with data on other insurance owned and applied for, as well as whether or not the applicant was ever refused life

insurance.

In view of the importance of the application, it is essential that the application be completed fully and accurately. If the

application is incomplete, the underwriting process and policy issue will be delayed until the necessary information is

obtained. And the company depends upon accurate information to make a proper evaluation of the proposed insured.

Sometimes an agent will need to correct an application. There may be a mistake in completing the form, or the applicant

may remember some fact that requires an addition to or change in the information already recorded. In such a situation,

erasures, additions, or alterations of any kind MUST BE INITIALED BY THE APPLICANT.

Concealment, Representations, and Warranties As noted previously, the application is intended to reveal facts about the proposed insured that the company feels will be

pertinent to making a decision about whether or not to insure the applicant. The insurance company uses the information

supplied on the application, in large part, to make the decision about whether or not to issue the policy.

If the information submitted by the applicant is incorrect or incomplete, the insurance company may be forced to void the

contract later on the grounds of a concealment, material misrepresentation, or warranty violation.

CONCEALMENT occurs when an applicant conceals or fails to disclose known facts. To void a contract in most states, the

concealment of facts by the proposed insured must be material to the selection of the risk, and it must be done with the

intent to defraud. If knowledge of the concealed fact would have influenced the company to accept or reject the risk,

concealment has occurred and the contract may be voided.

MISREPRESENTATION is just what it implies. Any material misrepresentation made by the applicant can also provide grounds

for the company to void the policy.

Assume that an applicant tells the insurance company that she visited the doctor for the treatment of a cold. Instead, she

visited the doctor for a heart condition. Assume also that her condition was serious enough for the company to have

refused to issue the policy if all the facts had been known. Since she failed to correctly inform the company about the true

reason for visits to her doctor, and since the misrepresentation is material, material misrepresentation has occurred.

There is a close relationship between the terms material misrepresentation and concealment. An easy way to distinguish

them is to remember, if a material fact is omitted, that is concealment. If a material fact is not presented truthfully, that is

material misrepresentation. And, for concealment and misrepresentation to exist, there must be generally be intent to

defraud the insurance company.

Because of the harsh consequences of warranty rule enforcement, nearly all states now have statutes providing that all

statements made by the applicant for life insurance are representations and NOT WARRANTIES. In simple terms, a

representation is a statement that is true to the best of the applicant's knowledge.

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Obtaining Necessary Signatures After the application has been fully and accurately completed, the agent must obtain the necessary signatures on the

application. The applicant must sign and so must the proposed insured, if someone other than the applicant. The

proposed insured's signature in a third-party ownership situation is required to show his or her consent to being insured

under the policy. The agent will also sign as witness to the applicant's (and proposed insured's) signature.

Minors A life insurance contract between a minor applicant and the life insurance company is binding on the company, but the

minor can back out of the contract at his or her option and receive back at least part of the premiums paid for the

insurance.

Because of this problem, many states have adopted statutes that provide that a minor of a certain age or older has the

legal capacity to enter into a life insurance contract that is binding on both the minor and the company. The age limit can

be as low as age 14. Generally, the special age limit applies only to insurance on the minor applicant's life. Also, the

beneficiary usually must be a close relative.

In addition to the signatures on the application, other signatures will usually be required. The applicant generally must sign

an authorization form allowing the company to obtain medical information from physicians, hospitals, etc.

Because of the confidential nature of such information and possible legal restrictions on giving out unauthorized medical

information, a signed authorization is necessary before the company can have access to the data.

The rules of the Medical Information Bureau (MIB) and the Fair Credit Reporting Act require written notification to the

applicant. The agent should explain these notifications. The applicant will be asked to sign receipts acknowledging that

the notices were received. Depending on company practice, these receipts may be combined with the medical

authorization.

In addition to signing as witness to the applicant's signatures, the agent will be required to complete and sign the agent's

report which is commonly part of the application form. Also, if the initial premium is paid, the agent will generally issue a

premium receipt to the applicant. The agent should complete and sign this receipt, carefully explaining its provisions to the

applicant.

Premium Receipt When the applicant pays an initial premium at the time the application is completed, it is customary for the agent to give

the applicant a premium receipt to show that the money was received. The premium receipt is significant because it is

intended to provide coverage, under certain circumstances, before the policy is issued and delivered. The coverage

provided by the premium receipt is, therefore, an incentive for the applicant to pay the initial premium when the

application is completed, rather than waiting until policy delivery.

When the premium receipt is issued, the agent should explain its effect to the applicant. However, there are several

different types of premium receipts, so it's important to understand each type and to recognize how the consequences of

each of the receipts differ.

There are two major types of premium receipts: (1), the conditional receipt, and, (2), the binding receipt, which is also

called a temporary insurance agreement. Conditional receipts may be further divided into two types: (1) insurability, and

(2) approval.

THE INSURABILITY CONDITIONAL RECEIPT provides that insurance will become effective as of the date the receipt is issue, IF

the applicant is found to be insurable as of that date.

EXAMPLE:

The application for insurance is made on January 14th. The application and a check for the initial

premium is submitted on that date. The insurance company subsequently determines that the applicant is

insurable as applied for, and issues the policy on February 14th. The effective date for this policy is January

14th, the date the application and check were originally submitted because the applicant was insurable

on that date. Most companies use the insurability type of conditional receipt.

The APPROVAL type of conditional receipt also provides that the policy will become effective on the date of the receipt.

However, it becomes effective only if the application is actually approved.

EXAMPLE:

42

An application is submitted on July 19, together with the initial premium. The applicant is given an

approval type of conditional receipt on that date. If the applicant dies on July 23rd as a result of an

accident, and the company had not approved the application by that date, the applicant would not be

insured, even though he or she was insurable on the date of the application. The applicant has no life

insurance protection during the period of time the company is determining insurability the approval type of

receipt.

THE BINDING RECEIPT, also called a temporary insurance agreement. The temporary insurance agreement is given by the

agent to the applicant when the initial premium is paid. However, the temporary insurance agreement provides life

insurance coverage IMMEDIATELY, even though the company's underwriters have not as yet determined the insurability of

the proposed insured.

If the proposed insured dies while the temporary coverage is in effect, the company will be liable for the full amount of the

death benefit applied for, subject to any limitations as to maximum amount specified in the receipt.

FOCUS POINTS

1.o The Applicant is the person applying for insurance.

2.o An Applicant can insure his or her own life or the life of someone else.

3.o The insured is the individual whose life is covered by the policy.

4.o The policy owner has the ownership rights to the policy.

5.o In the majority of policies the applicant, the insured, and the owner are the same individual.

6.o ―Third Party Ownership‖ is when someone other than the insured is the policy owner.

7.o One form of ―third Party‖ ownership is a business insuring the life of a key employee.

8.o Another form of ―Third Party‖ ownership is a creditor insuring the life of the debtor.

9.o For a life policy to be issued, an ―insurable interest‖ between the insured and the policy owner must be present.

10.o Insurable interest is defined in that the policy owner must benefit, either emotionally or financially, by the

insured continuing to live.

11.o Insurable interest arises out of a close blood relationship.

12.o Insurance purchased by a creditor on the life of a debtor must be in an amount that approximates the size

of the debt.

13.o Most credit life insurance policies have a reducing death benefit to keep pace with the diminishing loan

balance.

14.o An application is an insurance company document, which the company uses in evaluating the insurance

risk.

15.o The applicant must initial corrections made to a loan application.

16.o If the information submitted on an application is incorrect, an insurance company can void the contract

later on the grounds of concealment, material misrepresentation, or warranty violation.

17.o Concealment occurs when an applicant conceals or fails to disclose known facts.

18.o If knowledge of the concealed fact would have influenced the company to accept or reject the risk,

concealment has occurred and the contract may be voided.

19.o The concealment of facts by the proposed insured must be material to the selection of the risk and done

with intent to defraud.




















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20.o A material fact not presented truthfully, with the intention to defraud, is called material misrepresentation.

21.o Both the applicant and the proposed insured must sign an insurance application.

22.o A life insurance contract between a minor and an insurance company is binding on the company, but not

the minor.

23.o In some states statutes permit individuals as young as 14 years old to be of legal age to enter into an

insurance contract.

24.o Applicants normally sign an authorization form allowing the company to obtain medical records.

25.o An agent‘s signature as witness to the applicant‘s signature is required on the insurance application form.

26.o A premium receipt is significant because it is intended to provide coverage, under certain circumstances,

before the policy is issued and delivered.

27.o An Insurability Conditional Receipt provides that insurance will become effective as of the date the receipt

is issued, if the applicant is found to be insurable.

28.o A Binding Receipt, also called a temporary insurance agreement, is given by the agent to the applicant

when the initial premium is paid.

29.o Under a Binding Receipt life insurance coverage is effective immediately, even though the policy has not

yet been underwritten.

30.o If the insured dies while the Temporary Coverage is in effect, the company will be liable for the full death

benefit minus the limitations.

CHAPTER 16: RISK SELECTION & CLASSIFICATION

Once the agent submits the completed application to the life insurance company, the company must evaluate the

proposed insured's acceptability for life insurance. If he is acceptable, the company must then decide if the insurance will

be issued at the normal premium or, because of some increased risk of death, at a higher than normal premium.

It is important to keep in mind that risk selection begins before the application reaches the company. The process actually

begins with the agent when the company instructs its soliciting agents on the classes of people it is willing to insure. If the

prospective insured obviously does not meet the standards, no application should be completed.

The agent is very important in the selection process since the agent is often the only person connected with the company

with any personal knowledge of the proposed insured.

UNDERWRITING FACTORS

The first factor, closely related to mortality is AGE. As age increases, the chance of death increases. The SEX of the

proposed insured is also a factor that affects longevity. Statistics show that women live longer than men do generally

speaking.

PHYSICAL CONDITION: The proposed insured's health also affects life expectancy. Actually, there are several health-related factors that a

company will examine. One of these is the person's physical condition. Diseases such as heart disease, high blood

pressure, liver disease of cancer can obviously affect life expectancy.

A person's height, weight, and weight distribution can also be a health related factor in underwriting. Generally,

overweight has a more serious impact on underwriting than underweight. Overweight people have a higher than normal

mortality rate and excess weight can also increase the dangers from conditions such as heart disease and high blood

pressure.

Knowledge of the proposed insured's family history is another factor that is useful in selecting and classifying the risk.

Statistical evidence indicates that longevity is linked to heredity. If the proposed insured's parents have lived to an old age,

then there is and increased probability that the proposed insured will also have a long life.












44

On the other hand, if the family history shows a pattern of early deaths from heart disease, for example, and if the proposed

insured suffers from some impairment that increases the danger of heart disease, such as excess weight or high blood

pressure, the underwriters are going to carefully consider the potential for an early death

OCCUPATION: A number of years ago, occupation was a primary factor in selection. With the advent of automation, industrial safety

programs, and improved working conditions, the impact of occupation on mortality has decreased. And relatively few

occupations today are listed by insurers as requiring an extra premium.

Even today, certain occupations with a high accident hazard, such as explosives handling, are associated with a greater

than normal mortality. A second major group of occupations shows an additional hazard because of exposure to dust,

poison, or radiation. The occupation of crop duster is one that is very dangerous.

Thus, the insurance company generally has two choices available to it if a crop duster applies for life insurance. Issue the

policy at an increased premium or decline to issue the coverage all together.

The proposed insured's hobbies can also affect the risk. Activities such as sky diving, skin diving or auto racing obviously

have a bearing on insurability. The habits and morals of the proposed insured are also important in risk selection. Misuse of

alcohol or drugs, for example, may cause the company to decline the coverage. The individual's personal reputation,

character, and personal habits are also considered in evaluating the risk.

The financial situation of the proposed insured is also a factor. The company will examine not only the relationship between

income and the amount of insurance to guard against the danger of over insurance, but also to assess the proposed

insured's ability to pay for the insurance requested.

SOURCES OF INFORMATION

The application processed has been reviewed several times in this course, and it's importance in determining the

acceptability of the proposed insured for life insurance has been discussed. The application is a primary source of

information about the proposed insured's age, sex, marital status, occupation, and other items.

Agent's Report Another source of information is the agent's report. Most companies require the agent who completes the application to fill

out such a report. The agent's report is usually on the back of the application. The report generally contains questions

about the agent's personal knowledge of the proposed insured and about the proposed insured's financial position.

Information about the purpose of the insurance and whether or not the insurance is intended to replace other coverage is

commonly requested. The agent's report is obviously important in view of the fact, as mentioned, that the agent may be

the only person connected with the company with any personal knowledge of the proposed insured.

Medical Examination Another source of information is the medical examination, which affects underwriting when an examination is required as a

part of the selection process. A urine sample and/or blood test may also be required. The medical examiner will record the

proposed insured's answers to questions about medical and family histories and otherwise report the findings of the physical

examination.

In cases where a medical examination is not required under the company's underwriting rules, the policy is issued non-

medical" and the agent will ask the questions about the proposed insured's medical and family histories.

Attending Physician's Statement If the company wants more detail about medical information revealed in the application or medical examination, it may

obtain and attending physician's report or statement from the proposed insured's physician. The attending physician's

report is only requested when elaboration on medical information is desired. This report is another insurability information

source.

Medical Information Bureau The "Medical Information Bureau" is another source of information. The MIB is a nonprofit organization that was established

by life insurance companies to make possible the exchange of pertinent underwriting information among life insurance

companies. The information is composed chiefly of medical facts, both favorable and unfavorable, about applicants for

life insurance. A member company must report to the MIB if it finds certain specified impairments in the individual during

the selection process.

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In underwriting a policy, MIB information may be used only as an alert signal. Every member company is also required to

make its own independent underwriting investigation. In addition, insurance cannot be denied nor can an extra premium

be charged solely on the basis of information supplied by MIB.

MIB rules require that every applicant be given a written notice that (1) the company may make a brief report of

information to the MIB, (2) if the applicant applies for insurance with another MIB member company or makes a claim to

such a company, the MIB will furnish information on the applicant to the company upon request, and (3) if requested by

the applicant, the MIB will arrange disclosure of any information on the applicant in its files. However, medical information

will be disclosed only to the applicant's physician.

If the applicant questions the accuracy of any information, he or she can seek a correction through the MIB. Further, the

applicant must sign an authorization permitting MIB information to be disclosed to member companies.

Inspection Reports Inspection reports come from various consumer-reporting agencies. These are another source of underwriting information.

These reports, called consumer investigative reports, cover credit information, as well as information about an applicant's

personal habits, lifestyle, reputation, health, occupation, and so forth. Although company practice varies, these reports are

often only obtained when larger amounts of coverage are involved. The information for the report is obtained through

personal interviews with the individual's friends, neighbors, and associates.

The "Fair Credit Reporting Act" requires that the proposed insured be informed in writing that such an investigation may be

made. The notice must also inform the person that, upon a written request, the company will furnish information

concerning the nature and scope of the investigative consumer report.

If coverage is denied or a higher premium charged as a result of such information, the proposed insured must be so notified

and given the name of the consumer-reporting agency.

TYPES OF RISK

Based on the insurability information obtained from the various sources, a company will usually classify a proposed insured

in one of three ways; (1) standard risk, (2) a substandard risk (also called a special class, impaired, or under average risk), or

(3) an unacceptable or uninsurable risk.

The great majority of proposed insureds are STANDARD risks. This means that they are exposed to a "normal" risk of death

and are charged the regular or standard premium for the coverage. About 90% of proposed insureds are acceptable on a

standard basis.

Some individuals who do not qualify as standard under a company's underwriting rules are declined coverage by the

company because they have an unacceptable high probability of death. These are the UNINSURABLE risks.

Other proposed insureds are subject to higher than normal mortality rates but are still acceptable risks. These are the

SUBSTANDARD risks. Because of the greater mortality risk, members of the substandard group are charged a premium that is

higher than the standard premium.

The individual is charged extra premiums for the coverage because of the hazards applicable to that person. A hazard is a

condition that increases the chance of loss. Among the factors that may cause an individual to be classified as a

substandard risk are:

An existing medical condition, such as a heart murmur or hypertension.

Past medical history of a condition that may recur or may have adversely affected life expectancy. An occupation that involves an increased risk of accidents or subjects the workers to an unhealthy

environment.

The moral hazard, the existence of morals or habits, such as misuse of alcohol or drugs that increase the

chance of loss.

Some companies also use a "preferred risk" classification. A preferred risk might qualify for an even lower premium than a

standard risk. Other companies, however, use the term "preferred" in reference to their standard risks. Agents must know

the risk classification systems of the companies they represent.

46

RATED POLICIES

Consider the factors that impact an applicant's life span and how these factors are evaluated by life insurance

underwriters to determine if a life insurance policy should be issued at standard rates. So long as an applicant is a standard

risk, the company will issue the policy and charge a premium that is standard for others in the applicant's group.

If, because of health, age, occupation, or some other factor, the applicant is not a standard risk, then the company can

choose one of two alternatives available. First, it can decline to issue the policy, or second, it can charge an increased

amount for the insurance. A policy on which the company charges an increased amount is called substandard or RATED

policy.

Although not as popular as it once was, another system for increasing the premium for a rated policy is called the "rate-up

in age". Under this system, if an insured's true age is 40, the company might use the premiums based upon age 45. This

increase in age requires the insured to pay more for insurance than those standard risks charged the usual amount for his

age.

One final method of determining a premium for a substandard risk is the lien system. Under this method, the insured pays

the standard premium for the age and plan, but the amount of insurance purchased by that premium is reduced.

The policy has a lien against it, and the lien is deducted in case of death. The lien system, also called the graded death

benefit, is seldom used in the United States except for money purchase pension plans. This method is used because, under

the pension formula, the premium for a participant cannot vary.

REINSURANCE

Reinsurance is insurance for insurers. Insurance companies use reinsurance to protect themselves against the catastrophe

of a large single loss or a large number of small losses caused by the same occurrence. In reinsurance, and insurer "cedes"

part of a risk to a second insurer. The first insurer is known as the "direct writer" or "ceding company," while the second

insurer is called the "reinsurer."

There are two types of reinsurance treaties:

FACULTATIVE:

Under the facultative treaty, initially both parties consider the risks, with the direct writer carrying the entire risk. Each risk is

submitted to the reinsurer on the option of the direct writer, and the risk is either accepted or rejected. The terms under

which reinsurance will occur are enumerated, and once the risk is accepted, those terms apply.

AUTOMATIC:

Under the terms of the automatic treaty, the reinsurer agrees to accept a portion of the direct line or of certain risks in

advance. The direct writer is then obligated to cede the portion to which the treaty applies.

There are two important purposes that are served by reinsurance. First, reinsurance spreads the risk, allowing companies to

protect themselves from catastrophic losses. Second, reinsurance serves a financial function by allowing the direct writer to

be relieved of the obligation to maintain the unearned policy reserves of those policies reinsured. In essence, the excess

capacity of the direct writer is transferred to the reinsurer.

FOCUS POINTS

1.o Risk selection begins when the company instructs its soliciting agents on the classes of people it is willing to insure

2.o If the prospective insured does not meet the standards, no application should be completed.

3.o Because of the personal knowledge of the proposed insured, the agent is a very important element in the process

of selection of risk.

4.o Age, sex and physical condition are important considerations in the underwriting process.

5.o Overweight people have a higher than normal mortality rate.

6.o Statistical evidence indicates that longevity is linked to heredity.

7.o With the advent of automation, industrial safety programs and improved working conditions, the impact of

occupation on mortality has decreased.








47

8.o Occupations that have exposure to dust, poison, or radiation represent a higher than normal mortality rate.

9.o Individuals with higher than normal risk will either be denied insuring or charged a higher premium.

10.o An individual‘s hobby has an effect on insurability.

11.o Persons having activities such as sky diving, skin diving or auto racing represent a higher risk to insure.

12.o Misuse of alcohol or drugs can effect insurability.

13.o An individual‘s reputation, character, and personal habits are a consideration in evaluating risk.

14.o The financial situation of a proposed insured effect insurability.

15.o Besides the application, an agent‘s report is another source of information for the underwriter.

16.o An agent‘s report generally contains questions about the agent‘s personal knowledge of the proposed

insured and proposed insured‘s financial position.

17.o An agent‘s report also states the purpose of the insurance and is it intended to replace other coverage.

18.o In some cases medical examinations become part of the underwriting requirements.

19.o When a medical examination is required usually a blood test and /or a urine specimen is also required, as

well as, answers to medical information.

20.o When a policy is issued on a ―non-medical‖ basis, the agent will ask the questions about the proposed

insured‘s medical and family history.

21.o In some cases an attending physician‘s report is also required.

22.o A ―Medical Information Bureau‖ is another source of information.

23.o The ―Medical Information Bureau‖ is a non-profit organization that was established by insurance

companies to create an exchange of pertinent underwriting information among life insurance companies.

24.o MIB is an information center of medical facts about applicants for life insurance.

25.o Member companies provide information to the MIB to create a central ral data source.

26.o Insurance cannot be denied or an additional premium charged only on the basis of an MIB report.

27.o MIB rules require that every applicant be given written notice that information is being provided to MIB.

28.o An applicant must sign an authorization permitting MIB information to be disclosed to member companies.

29.o Another source of underwriting is inspection reports that come from various consumer-reporting agencies.

30.o Consumer reports normally cover personal habits, lifestyle, reputation, health, occupation, etc.

31.o Consumer Reports generate from personal interviews with individual‘s friends, neighbors, and associates.

32.o The ―Fair Credit Reporting Act‖ requires that the proposed insured be informed in writing that an

investigative report may be made on him or her.

33.o There are three classes of risk- standard risk, substandard risk, and unacceptable or uninsurable risk.

34.o The great majority of proposed insured are standard risk

35.o A substandard risk is a proposed insured with a greater mortality risk.

36.o Substandard risks are usually charged a higher premium.






























48

37.o An existing medical condition such hypertension can cause an individual to be considered a substandard

risk.

38.o Some companies also use a preferred risk category which might qualify an individual for a lower premium.

39.o Some companies use the term ―preferred risk‖ to reference individuals in the standard risk category.

40.o A policy on which the company charges an increased amount is called substandard or RATED policy.

41.o A Lien Policy is applied to a substandard insured and reduces the death benefit in situations where a

higher premium cannot be charged.

42.o A lien Policy is also called a Graded Benefit Policy.

43.o Reinsurance is insurance for insurers.

44.o Reinsurance is used by companies to protect themselves against the catastrophe of a large single loss or a

large number of small losses.

45.o The first insurer is known as the ―direct writer‖ or ―ceding Company,‖ while the second insurer is called the

―reinsurer.‖

46.o The two types of reinsurance treaties are Faculative and Automatic.

47.o Reinsurance spreads the risk, allowing companies to protect themselves from catastrophic loses.

Reinsurance allows the direct writer to be relieved of the obligation to maintain the unearned policy reserves of those

policies reinsured.

CHAPTER 17: TERMINOLOGY OF LIFE INSURANCE

AGE CHANGE –

The point in the 12 months between natural birthdays at which the individual is considered to be of the next higher age for

the purpose of insurance rates. Most life insurers consider that point as halfway between birthdays. Health insurers

frequently use the age at last birthday until the next birthday is actually reached.

AGE LIMITS –

The ages below or above which an insurer will not issue a given policy.

AGENT –

An individual appointed by an insurer to solicit, negotiate, effect or countersign insurance contracts on its behalf. (See also

Producer)

ALIEN COMPANY OR INSURER –

An insurer organized and domiciled in a country other than the United States.

APPLICANT –

The party submitting an application to an insurer for an insurance policy.

ATTAINED AGE –

The age an insured has reached on a given date.

BENEFICIARY –

A person, who may become eligible to receive, or is receiving, benefits under an insurance plan, other than as an insured.

BENEFICIARY CHANGE –

A change in the policy which alters the previous beneficiary designation. Must be made by formal application to the

insurer. Compare to Beneficiary, Irrevocable.

BENEFICIARY, IRREVOCABLE –












49

A named beneficiary whose status as beneficiary cannot be changed without his or her permission.

BENEFICIARY, PRIMARY –

The person first designated to receive the proceeds of a policy, as named in the policy.

CANCELLATION –

Termination of the insurance contract by voluntary act of the insurer or insured, effected in accordance with provisions in

the contract or by mutual agreement.

CARRIER –

The insurance company that ―carries‖ 11 the insurance. The term ―insurer‖ is preferred.

CASH SURRENDER VALUE –

In life insurance, the value in a policy that is the legal property of the policyowner, and which the policyowner may receive

if the policy is surrendered for cash. Synonymous with cash value.

CLAIM –

The demand of an insured or his or her representative or beneficiary for benefits as provided by an insurance policy.

COMMISSION –

The portion of the premium stipulated in the agency contract to be retained by the agent as compensation for sales,

service, and distribution of insurance policies.

CONCEALMENT –

The withholding, by an applicant for insurance, of facts that materially affect an insurance risk or loss.

CONDITIONAL RECEIPT –

Provides that if the premium accompanies the application, the coverage is in force from the date of the application

(whether the policy has yet been issued or not) provided the insurer would have issued the coverage on the basis of facts

as revealed by the application and other usual sources of underwriting information.

CONTINGENT BENEFICIARY –

Person or persons named to receive benefits if the primary beneficiary is not alive at the time the insured dies.

DEATH BENEFIT –

The policy proceeds to be paid upon the death of the insured.

DEATH CLAIM –

A formal request for payment of policy benefits occasioned by the death of the insured. Should be made through the

agent, but may be made directly to the home office. Requires a copy of the death certificate as proof of death and is

made by the beneficiary.

DECLARATION PAGE –

The portion of an insurance policy containing the information regarding the risk.

DECREASING TERM INSURANCE –

Term insurance for which the initial amount gradually decreases until the expiration date of the policy, at which time it

reaches zero.

DEFERRED ANNUITY –

An annuity on which payments to the annuitant are delayed until a specified future date.

DOMESTIC COMPANY –

An insurer formed under the laws of the state in which the insurance is written.

DOUBLE INDEMNITY –

Payment of twice the basic benefit in event of loss resulting from specified causes or under specified circumstances

EFFECTIVE DATE –

The date on which an insurance policy goes into effect.

ENDORSEMENT –

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Technically, a change made directly on the policy form by writing, printing, stamping or typewriting and approved by an

executive officer of the insurer. In general use, also may refer to a change made by means of a form attached to the

policy.

ESTATE –

Assets of an individual comprising total worth. Includes any life insurance in force.

EXCLUSIONS –

Stated exceptions to prior provisions in a policy. Common exclusions in health policies include pre-existing conditions,

suicide, self-inflicted injuries, and many others. In life policies, common exclusions are death through flying in a private

airplane, riot, or state of war.

EXPIRATION -

The date upon which a policy's coverage ceases.

FACE AMOUNT -

The amount indicated on the face of a life policy that will be paid at death or when the policy matures.

FAMILY PLAN POLICY –

An all-family plan, usually with permanent insurance on the father‘s life, with mother and children automatically covered for

lesser amount -usually term -- all paid by a single premium.

FOREIGN COMPANY –

An insurer organized under the laws of a state other than the one where the insurance is written.

FRAUD –

An intentional misrepresentation made by a person with the intent to gain an advantage and relied upon by a second

party that suffers a loss as a result.

GRACE PERIOD –

A period of time after the premium due date during which a policy remains in force without penalty even though the

premium due has not been paid. Commonly 30 or 31 days in life insurance policies; seven, 10, or 31 days in various health

insurance policies.

HOME OFFICE –

The place where an insurance company maintains its chief executives and general supervisory departments.

INSURABILITY –

The condition of the proposed insured as to age, occupation, physical condition, medical history, moral fitness, financial

condition and other factors that makes the individual an acceptable risk to an insurance company.

INSURABLE INTEREST –

In life and health insurance, the interest of one party in the possible death or disability of an insured that would result in a

significant emotional or financial loss. Such an interest must exist in order for the party to purchase insurance on the life or

health of another. In property-casualty insurance, a financial interest is property.

INSURANCE DEPARTMENT –

A governmental bureau in each state of territory (and federal government in Canada) charged with administration of the

insurance laws, including licensing, examination, and regulation of agents and insurers. In some jurisdictions, the

department is a division of some other state departments or bureau.

INSURED –

The party to an insurance contract to whom, or on behalf of whom, the insurer agrees to indemnify for losses, provide

benefits, or render service.

INSURER –

The party to an insurance contract that undertakes to indemnify for losses provides other pecuniary benefits, or render

service. Also called insurance company and sometimes-insurance carrier.

LAPSED POLICY –

A policy for which the policyholder has f ailed to make the premium payment during the grace period, causing the

coverage to be terminated.

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LICENSE, AGENTS –

A state-conferred license that enables an insurance agent to do business in the conferring state. Renewable annually.

Subject to an initial written examination and to suspension or revocation for certain offenses.

LIFE EXPECTANCY –

Average number of years of life remaining for persons at any given age.

LIFE INSURANCE –

Insurance pays a specified amount upon the death of the insured to the insured's estate or to a beneficiary.

LOAN VALUE –

The amount of cash value reposing in a policy which may be borrowed by the insured.

MISREPRESENTATION –

On the part of an insurer or its agent, falsely representing the terms, benefits, or privileges of a policy. On the part of an

applicant, falsely representing the health or other condition of the proposed insured.

MORTALITY RATE –

The average number of people who die each year.

NON-FORFEITURE OPTION –

A legal provision whereby the life insurance policyowner may take the accumulated values in a policy as (1) paid-up

insurance for a lesser amount (2) extended term insurance; or (3) lump-sum payment of cash value, less any unpaid

premiums, or outstanding loans.

NON-PARTICIPATING POLICY –

A policy that does not provide for the policyowner to share in dividends. Also called a nonpar policy.

NON-RESIDENT AGENT –

An agent licensed in a state in which he or she is not a resident.

ORDINARY AGENT –

An agent selling ordinary life insurance.

ORDINARY LIFE INSURANCE –

Life insurance other than group life. Ordinary life may be either permanent or temporary term.

PAID-UP INSURANCE –

A non-forfeiture option in life insurance policies under which insurance exists and no further premium payments are

required.

PARTICIPATING POLICY –

A policy in which the policyowner receives a share of policy dividends. Also called par policy.

PERMANENT INSURANCE –

Life insurance with some type of cash value accumulation.

POLICY LOAN –

A loan to the policyholder from the insurer using the insurance cash value as collateral.

PRE-AUTHORIZED CHECK PLAN –

An arrangement under which the policyowner authorizes the insurer to draft his or her bank accounts for the (usually

monthly) premium.

PRIMARY BENEFICIARY –

The beneficiary named first to receive proceeds or benefits of a policy that provides death benefits.

PROOF OF DEATH –

A usual requirement before paying a death claim is that a formal proof of death form of some type be submitted to the

insurer.

REBATE –

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Giving or offering to give something of value other than the benefits of a policy as an inducement to buy insurance, a

practice illegal in all states except Florida.

REINSTATEMENT –

(1) Putting a lapsed policy back in force, sometimes requiring the payment of back premiums and evidence of

insurability, (2) In some health policies, reinstating or restoring the amount of benefits available when the payment

of claims has reduced the principal amount of the policy by the amount of the claims. Provision is usually made for

a method of reinstating the policy to its original amount. This may be done automatically either with or without

premium consideration or at the request of the insured. Often found in-group health contracts and may be called

restoration of benefits.

RIDER –

An amendment attached to a policy that modifies the conditions of the policy by expanding or decreasing its benefits or

excluding certain conditions from coverage.

SETTLEMENT OPTION –

A method of receiving life insurance proceeds other than a lump sum.

STANDARD RISK –

A risk that meets the same conditions of health, physical condition and morals as the tabular risks on which the rate is based

without extra rating or special restrictions.

SUICIDE CLAUSE –

In a life insurance policy, states that if the insured commits suicide within a specified period of time, the policy will be

voided. Paid premiums are usually refunded. The time limit is generally one or two years.

TERM INSURANCE –

Life insurance that normally does not have cash accumulations and is issued to remain in force for a specified period of

time,, following which it is subject to renewal or termination.

UNIFORM POLICY PROVISIONS –

A set of standardized provisions used in health insurance policies, of which 12 are required and 11 are optional. All states

use these provisions, although they are permitted to revise the wording as long as it is at least as beneficial to the insured as

the original wording.

WAIVER OF PREMIUM PROVISION –

When included, provides that premiums are waived and the policy remains in force if the insured becomes totally and

permanently disabled.

WHOLE LIFE –

Permanent life insurance on which premiums are paid for the entire life of the insured.

XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX

X

PART II: LIFE INSURANCE IN THE BUSINESS MARKET

CHAPTER 1: EXECUTIVE BENEFITS FINANCED WITH LIFE INSURANCE

A MULTITUDE OF OPTIONS

Agents need to be proactive and bring appropriate life insurance concepts to a client's attention. Ideally, an agent is

involved with a client from the time life insurance is first considered. The agent is then able to help the client focus on the

objectives for his benefit plans, and examine alternative plan structures.

There are numerous options:

1. Group term life insurance;

2. Executive bonus plans;

3. Split dollar insurance;

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4. Buy/sell agreements financed with life insurance;

5. Life insurance financing of executive benefits;

6. Life insurance applications in personal financial planning; and 7. Estate planning issues involving life insurance.

If a client decides life insurance is an appropriate financing vehicle, an agent helps the client examine the financial and

tax aspects of various financing alternatives, and identify products that meet the client‘s needs. Although an agent

identifies criteria for policy selection, the client makes the final decision.

Clients should select an agents based on the client‘s perception of the agent‘s service capability, rather than on the basis

of a proposal war, where several agents are simultaneously offering to the same client. Proposal wars are not in anyone‘s

best interest, and do not allow the agent to bring his best efforts to the client.

THE EXECUTIVE COMPENSATION MARKETPLACE

Items to consider when structuring options and financial planning for the executive compensation marketplace:

The use of deferred compensation after the 1986 Tax Act;

The impact of the act on using life insurance to finance executive benefits;

Split dollar considerations;

Life insurance policy illustrations; and

The future of life insurance in compensation planning.

Non-Qualified Deferred Compensation After the 1986 Tax Act

After the 1986 Tax Act, many practitioners believed that deferred compensation was much less attractive. Tax brackets

were lower and tax deferral appeared much less valuable. In addition, there was always the threat that tax rates might

increase. It seemed logical for the prudent executive to "take the money and run."

When the tax law is analyzed in more detail, however, note that in many ways the 1986 Tax Act generated an increased

need for nonqualified deferred compensation plans. Qualified retirement plan benefits were significantly cut back in many

situations, and included a $7,000 limitation imposed on contributions to 401(k) plans.

Add to that the imposed 15 percent luxury tax on the privilege of having excess qualified retirement plan benefits.

Legislative changes negated many of the tax favored investment opportunities that had been utilized by clients prior to the

act.

In light of these changes, a more studied, analytical approach to the deferral decision is needed. Executive clients need to

explore the variables of participating in a nonqualified deferred compensation plan.

EXAMINING THE VARIABLES

In a deferred compensation plan, the employee is an unsecured creditor of the corporation. Nothing in the 1986 Tax Act

changes this fact, although the use of a Rabbi trust can reduce an executive‘s risk in the event of a corporate takeover.

Deferred compensation remains a tool appropriate only for a relatively stable ongoing corporate entity.

Given that a client is comfortable with the stability of his employer, there are factors to consider while evaluating the

economics of deferred compensation:

Executive's marginal tax rate marginal tax rate in the year of deferral: The higher the tax rate, the more attractive a

deferral appears because more taxes are being deferred.

Marginal tax rate during the deferral period: A higher rate makes deferral more attractive, not because it impacts

the accumulation of the deferred funds, but rather because it makes the alternative of taking compensation in

cash and investing it less attractive, since the after tax rate of return on funds outside the plan is reduced.

Marginal tax rate in the year of withdrawal: Here, a lower rate makes deferral more attractive. In the past,

deferred compensation could be justified simply on the basis that the executive could defer income in high

marginal tax rate years and have the funds paid out in lower marginal tax rate years during retirement.

Relationship between the earnings rate being paid on funds inside the deferral plan vs. the earnings available on

investment opportunities outside the plan: Deferral is more attractive where the earnings rate on deferred funds is

favorable when compared to outside investment opportunities. This point is often overlooked. Many executive

clients do not have the time to actively manage investments. In many cases, deferred compensation plans,

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especially those financed with life insurance, have earnings rates substantially in excess of the rate the executives

would be likely to earn investing on their own.

The period of deferral: Since the primary benefits of deferred compensation are deferral of current taxation and

accumulation of assets on a tax deferred basis, the longer the deferral, the more attractive deferred compensation

appears.

Evaluating the impact of these five different factors is very difficult. In order to analyze the interrelationship of these factors,

it is necessary to structure a decision model for illustration to the client.

Decision Model Make assumptions concerning the variables identified above, and ask the client to identify the key risks

perceived in those assumptions.

Generally, clients are most concerned about the potential that marginal tax rates could rise in the future. In

other words, compute how high marginal tax rates must go before a deferral becomes uneconomical.

CORPORATE-OWNED LIFE INSURANCE AS A FINANCING TOOL

The 1986 Tax Act had a significant impact on the use of leveraged corporate-owned life insurance. The act eliminates the

interest deduction for loans in excess of $50,000 on the life of any one individual for contracts purchased after June 20,

1986.

In addition, generally lower marginal corporate tax rates make any interest deductions obtained less beneficial. As a result,

some clients question whether corporate-owned life insurance is still appropriate as a benefit-financing vehicle.

Life insurance still is a very viable financing tool after the 1986 Tax Act, however, it needs to be structured in a slightly

different manner.

Clients adopting nonqualified benefit plans must consider a number of financing approaches. If life insurance is suggested

as a possible financing vehicle, a typical question is—―Why life insurance?‖

In the marketplace terms such as internal rate of return, full cost recover, mortality adjusted present value gains and, of

course, tax leverage are bandied about. Detailed computer projections illustrate the economic, tax and financial

statements results obtained by providing nonqualified benefits financed with life insurance.

But what does all this terminology and analysis tell the client? An agent needs to explain special characteristics of

corporate-owned life insurance that make it appropriate as an employee benefit-financing vehicle.

The key to the attractiveness of corporate-owned life insurance (COLI) financing is relatively simple. Properly structured,

COLI can provide an attractive after tax rate of return when the policy is held until death.

Three factors allow life insurance policies to generate these rates of return:

First, insurance companies typically invest in a widely diversified portfolio that generally has a relatively competitive

rate of return.

Second, when the employee dies there is a pure death benefit that enhances the rate of return.

Third, life insurance death proceeds are tax favored. Proceeds are received tax free by the employer upon death

of the insured, unless the company is subject to the alternative minimum tax. Consequently, policy earnings

permanently escape taxation unless the employer is subject to the alternative minimum tax.

Assuming that the life insurance policy can generate an attractive rate return, it is important to note how is it used to

finance executive benefits. Corporate-owned life insurance is used as a benefit-financing vehicle due to the fact that the

rate of return on the life insurance policy exceeds the employer‘s cost of funds, from whatever source. In addition, the

policy has the added benefit of providing an immediate source of funds if the covered employee should die prematurely.

Example: A corporation lends funds and recovers the funds plus a six percent after tax earnings rate. The

executive receives a return of contributed funds plus 10 percent earnings, along with the four-percent

excess earnings on the employer‘s contribution. It is important to realize that driving this plan is the fact

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that the life insurance policy generates after tax earnings in excess of the rate of return available to the

employer and the employee.

Loans The two major forms of deferred compensation, noncontributory and contributory, should be evaluated when considering

the use of policy loans. Assume that the after-tax cost of loan interest is six percent. Loans are simply another source of

funds that can be used in lieu of cash to fund the policy.

Note that the overall economics of the transaction are similar whether the policy is financed with employer funds or

borrowed funds, as long as the interest is deductible. In either case, the employer must recover funds placed in the policy,

plus after tax interest of six percent. The remainder of the policy earnings is used to provide benefits for the executive.

Alternatives to Loans For many employers, cash flow is a real concern, and policy loans are a simple way of providing the required cash flow.

Employers must be reeducated about the concept of using sources other than policy loans to pay premiums.

In addition, consider the impact, positive or negative, that a direct recognition loan provision might have on the policy

earnings. Borrowing from sources other than the policy may have a detrimental impact on certain financial statement

ratios.

The economics of life insurance as a benefit-financing vehicle have not changed—what has changed is the source of

funds used to put the policy in force. In the past, the focus has been on the use of tax leverage generated by borrowing

from the policy.

The same leverage exists whether borrowing from the policy, use other sources of borrowing or pay premiums in full using

corporate funds otherwise generating taxable earnings. The economics of financing premiums with corporate assets

earning six percent after tax is no different than borrowing from the policy at six percent after tax. The leverage is the same,

though the cash flow is admittedly different.

Life Insurance Financing Executive Benefits — Some Exceptions Life insurance as a method financing of executive benefits is not appropriate in every instance. Some company managers

believe they are able to consistently earn 15 percent or 20 percent after tax on invested cash over an extended period of

time.

In these situations, life insurance financing of executive benefits may not be appropriate. However, for the majority of

clients, life insurance financing of executive benefits is a concept that clearly warrants serious consideration.

ALTERNATIVE MINIMUM TAX ON CORPORATE-OWNED LIFE INSURANCE

There is a significant advantage of the life insurance financing approach—increases in life insurance policy cash values

and death benefits paid from a life insurance contract are normally received free of income taxes. However, the Tax

Reform Act of 1986 created an exception to this rule in the case of corporations that are subject to the alternative

minimum tax (AMT).

The AMT is a separate tax calculation that is paid if it exceeds the regular income tax. The tax is equal to 20 percent of

alternative minimum taxable income (AMTI), which consists of regular taxable income, adjusted to reflect different AMT

treatment of certain items, plus certain preference items.

Under the Tax Reform Act of 1986, a new book-income adjustment was created. This adjustment is equal to one-half the

amount by which an employer‘s book-income exceeds its alternative minimum taxable income before the book-income

adjustments.

The definition of book-income for this purpose is a complex, technical tax concept. However, income reported to creditors,

shareholders or the Securities Exchange Commission (SEC) will generally control.

Since life insurance cash surrender value increases (net of premiums) and death benefits (in excess of cash-surrender value)

are part of book but are not taxable income, they potentially can be subject to the AMT. Small employers receiving

substantial policy death benefits in a particular tax year could become subject to the AMT for that year.

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While AMT considerations

should be discussed with

clients, it is difficult to assess

the impact of the AMT on a

specific insurance plan.

Where a corporation is subject to AMT due to the book-income adjustment,

an AMT credit is generated. This credit can be carried forward to offset future

regular tax liabilities.

As a result, in many cases, the AMT imposed on policy cash surrender value

increases and death benefits will be recovered in future years. After 1989,

earnings and profits replace book-income in this calculation, and it produces

no AMT credit.

Assessing the impact of the AMT on a specific insurance plan is very difficult because most corporations have no way of

predicting either the tax situation in future years or the year their executives will pass away.

SPLIT DOLLAR LIFE INSURANCE

Split dollar life insurance continues to be an attractive executive compensation tool. However, the 1986 Tax Act forced a

rethinking of the mechanics of most existing and proposed split dollar programs.

Prior to the 1986 Tax Act, a typical split dollar plan might be structured as follows:

A life insurance policy would be purchased and owned by an executive under the collateral assignment method,

with the executive owning the policy and assigning a right to an amount equal to cumulative policy premiums paid

to the corporation.

The corporation would pay most or all of the policy premiums, and would tax qualify the policy by paying four out

of the first seven premiums in cash, with the remainder being paid by policy loan.

After the policy had been tax qualified under the four-out-of-seven rule, a policy loan would be taken to reimburse

the corporation for the premiums it had paid. The executive would then own a life insurance policy, subject to a

large policy loan.

In future years, the tax arbitrage generated by the policy would be sufficient to support the policy without future

premium payments.

This technique worked very effectively until the 1986 Tax Act. However, the 1986 Tax Act phases out the deduction of policy

loan interest by individuals unless the loan proceeds can be traced directly to an investment.

As a result, the split dollar rollout approach is no longer appropriate for most executives, because policy loan interest is no

longer deductible and therefore the policy will not support itself without premium payments by the executive. Many

executives consider split dollar plans a fringe benefit and do not contribute to the policies.

A Modified Approach to Split Dollar Programs

In response to the 1986 Tax Act, many clients continue to use split dollar programs, but with a slightly modified the

approach. The policies are purchased on a collateral assignment basis, with the corporation being entitled to a recovery

of premiums paid.

However, the corporations now plan to pay premiums for a period of 10 to 15 years. At the end of that period, the policy is

projected to have sufficient cash value to allow the corporation to recover its premium investment in the policy, while

leaving enough cash value remaining in the policy to support the death benefit without future premium contributions.

If using this approach, clients should be aware of several issues:

Taxation of the split dollar plan at the time of rollout is currently unclear.

Example: Assume a corporation pays an annual premium of $10,000 per year for a period of 15

years. At the end of that time, the policy has a cash value of $250,000, and a cost basis

(cumulative premiums paid) of $150,000. The corporation is reimbursed for its $150,000 contribution

to the policy, and the collateral assignment is terminated, leaving the executive with a $100,000

cash value policy. What is the tax treatment of the rollout to the executive?

One school of thought would argue that subject to Rule 83 of the Internal Revenue Code (IRC), whenever property

is transferred to an employee in compensation for services, the value of the property transferred is subject to tax.

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The regulations under IRC 83 provide that when a life insurance policy is transferred, the value of the asset is defined as the

policy cash surrender value.

Therefore, this school would argue that a taxable transfer takes place in these plans either at the time the collateral

assignment is terminated, or perhaps earlier on an annual basis as the executive begins to develop a net equity in the

policy.

The other school of thought would argue that IRC 83 is not applicable to this situation because no transfer has taken place.

The policy is, initially, owned by the policyholder, and the only policy right not maintained by the policyowner is the

corporation‘s right to recover its premium payments at the executive‘s death or termination of employment.

As a result, they would argue that under IRC 72 the internal build-up of a life insurance policy is tax free, and since no

transfer takes place the $100,000 of equity build-up is not taxable to the executive.

The issue is gray, and both sides are supportable.

While the IRC 83 argument for taxation of the equity build-up is slightly stronger than the IRC 72 argument against it, it is still

appropriate for clients to take the position that no taxable event occurs in these plans.

However, it is essential that the client be clearly advised that this risk exists, and that at some point in the future he may be

challenged on treatment of these policies by the Internal Revenue Service.

Cash flow. While the 10 to 15 year pay-in approach allows the corporation to eventually recover its entire premium

contributions, both from a cash flow standpoint and from a time value of money perspective, the new approach is

clearly more expensive for the corporation. However, many corporations want to provide this benefit to their

executives, and are willing to pay the additional price to provide it.

Conversion from the old minimum deposit approach to the post-1986 Tax Act full pay approach. Specifically,

corporations must address the following equity issues when converting from the old approach to the new

approach for existing plans:

Treatment of executives who terminated their split dollar arrangements and decided to surrender the policies prior to

adoption of the new split dollar plan; and

Treatment of executives who have terminated their split dollar agreements and reimbursed the corporation for its

premium payments prior to adopting the new approach.

Does the corporation ignore those policies, or does it make additional compensatory payments to the executive to

assist in paying the additional cash into the contract, which will now be required, because the policy loan interest is no

longer deductible?

To answer that question consider the fact that the older, senior executives are most likely to have terminated their split

dollar arrangements, since they may have been under the plan longer.

These, of course, are issues that cannot be resolved by the advisors, but must be handled internally by the corporation. Of

course, it is important to raise these issues for consideration by management. Overall, split dollar remains an attractive

planning tool.

POLICY ILLUSTRATIONS

A few years ago, policy illustrations were really fairly straightforward. For nonparticipating contracts, the numbers shown

were exactly what was received. All of the policy values were contained in the policy and were not subject to change. As

a result, illustrations were not an issue.

For participating contracts, companies generally illustrated policies based on current dividend scales that changed very

slowly and positively, due to slowly increasing interest rates and mortality improvements.

On a relative basis, the projections gave a fairly accurate picture of how policies would actually perform in the

marketplace. And, of course, projections were produced entirely by the home office actuaries and could not be modified

by the field force.

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Situations have changed, and insurance professionals are concerned about the projections that are now being presented

to policyholders. In addition, agents are often frustrated by the proposal wars, in which agents battle to illustrate the best

projected values, regardless of the significant likelihood that the projections will not be achieved.

Too often clients focus on projected figures, failing to consider the likelihood that projected performance will be achieved.

The current policy projection issues seem fall into a few major categories:

1. Inappropriately stated assumptions. Under this category fall illustrations containing assumptions which are not

reasonably attainable by the insurance company in the current economic environment.

Example: Assume an insurance company priced a product to make a reasonable profit at a given interest

rate. For purposes of this example, use an eight percent rate.

Company administrators know that, given current investment yields, if an earnings rate in excess of eight

percent is credited, the product will not be profitable.

However, the policy is offered with a first year crediting rate of nine percent, and projections are illustrated

for a period of several decades using the nine percent interest rate.

Company management intends to decrease the interest down to eight percent after the first year, unless

economic conditions change. Indeed, the company must drop the interest rate if it is to survive. Clearly, in

this situation the nine percent interest rate projection is simply not appropriate.

2. Inappropriate unstated assumptions. Some policy illustrations assume that mortality experience will improve over time.

This fact is never disclosed in the illustration, and is questionable at best. Likewise, some life insurance companies not

currently subject to income taxation assume this state of affairs will extend forever.

3. This is an unlikely assumption unless the insurance company is headed for liquidation. Another unstated factor is the

basis upon which the insurance company will determine policy values.

Some policies credit earnings based on linkage to an outside index, others by linking to actual life insurance company

experience, and still others credit earnings based entirely on the discretion of the insurance company.

Some policies are based on a short-term investment philosophy, while others rely on a portfolio-based approach. All of

these factors can have a dramatic impact on the long-term performance of the policy, yet are seldom disclosed in a

meaningful manner, if at all.

4. Lack of comparability among illustrations. It is very difficult to compare policy illustrations on a meaningful basis. For

example, to compare two policy illustrations fairly, it would seem appropriate to run both illustrations at the same

interest rate. However, this is not always the case. When actuaries design life insurance products, the expense charges

can be taken from a variety of sources. They can be stated as a separate charge, they can flow through as an

increased mortality charge, or they can be taken out of investment earnings.

Example: Consider two products, one of which has a stated expense charge, and the other has no

expense charge, but covers expenses by reducing credited investment earnings by half a point.

If the first company can afford to credit 10 percent earnings on the policy, the second company can

afford to pay only 9.5 percent. Therefore, to compare these policies using a 10 percent crediting

assumption on both actually biases the evaluation in favor of the second product.

Consider the fact that one product may be structured as a current assumption product, while another may

be structured on a portfolio basis. It is unfair to project both of these policies at the same interest rate.

These issues point to the risks inherent in attempting to draw meaningful conclusions from analysis of policy illustrations. In

industry circles there is a lot of discussion regarding regulating the use of illustrations, and several industry groups are

addressing this issue.

Evaluating Alternative Proposals Illustrations can be very helpful in understanding the structure of a proposed transaction. In addition, illustrations are useful

in addressing financial and tax aspects of proposed plan designs.

However, while projections are useful in structuring a transaction and in developing a rough idea of how the plan will

perform in practice, they are not particularly helpful in attempting to project future values or in comparing projected

policy performance.

Sophisticated financial analysis and comparisons of illustrations generally are not beneficial in the decision-making process.

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Clients should carefully

consider the historic

performance of the issuing

insurance company.

When evaluating any investment, the starting point should be historic cost

performance. Life insurance is no different on that score than any other type

of investment. A proven track record of efficient performance indicates the

company has the ability to deliver value to policyholders.

In addition, clients should note that to a great extent, a life insurance contract is a contract of faith between the

policyholder and the insurance company. In most life insurance policies, the insurance company has a wide degree of

discretion in determining what the policyholder will receive.

As a result, an insurance company‘s track record of treating all its policyholders fairly is extremely important. One basic rule

is that today‘s new policyholders become tomorrow‘s ―old block of business.‖ Therefore, suggest that clients focus not just

on what companies are illustrating today, but also on how they are treating their policyholders from 10 and 20 years ago.

The client does not want to be known as ―that old profitable block of business‖ 10 years from now. These are not

quantifiable values, but rather issues in which a qualified life insurance agent‘s input can be extremely helpful.

Overall, today‘s life insurance policy illustrations present substantial challenges in working with clients to structure insurance

transactions. Competent insurance advisors can be very helpful to policyholders in understanding the significance and

limitations of policy illustrations.

THE FUTURE FOR LIFE INSURANCE AS A BENEFIT FINANCING TOOL

Overall, barring major adverse tax legislation, the future of life insurance in compensation planning is very bright, because:

The well-publicized limits imposed by the Tax Reform Act of 1986 on qualified plan contributions are leading to a

continued proliferation of nonqualified plans, including nonqualified deferred compensation plans;

The imposition of nondiscrimination rules for group term life insurance plans has increased the need for nonqualified

death benefit protection;

For high-income individuals, the 15 percent excise tax on excessive distributions from qualified plans will also reduce

the attractiveness of those plans;

Many companies recognize the magnitude of liabilities for deferred benefit plans. Life insurance is a logical

financing alternative in many instances; and

Freezing of the estate tax rate at 55 percent and phase-out of the unified credit will increase the attractiveness of

life insurance in planning for estate taxes. Wealthy individuals find life insurance to be an excellent device for

minimizing the generation skipping tax which, when added to regular transfer taxes, is the highest government-

imposed tax.

Overall, there is an increasing need for a flexible, tax favored financial too—life insurance.

Financial planners and consultants such as CPAs and accountants often receive policies for review from their clients. The

planners are responsible for the analysis of many of the qualified and nonqualified plans considered by the clients, as well

as answering specific tax and accounting questions concerning the use of insurance products.

Frequently, as part of an executive compensation consulting engagement with a client, financial planners are actively

proposing, designing and assisting in the selection of financing for nonqualified supplemental benefit plans. Since financial

planners and analysts do not sell products, they usually work with an agent of the client.

THE NEED FOR SUPPLEMENTAL PLANS

Tax legislation has severely restricted the amount of money that may be set aside by, or accumulated for, highly

compensated executives for their retirement. Restrictions on such qualified plan contributions and payouts continue to

arise.

Many large and small corporations (and nonprofits as well) calculate how much executives will lose under the various

pension and group insurance provisions of recent law changes and seek ways to replace those benefits.

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Companies continue to attract, retain and reward valuable executives. Employers continue to look for competitive (within

the industry and labor market), cost effective and tax efficient ways to do so.

When a senior executive joins a company after walking away from 15 years of credit toward a pension somewhere else,

the new company must design a plan to make the executive compensation package whole.

Executives continue to seek ways to accumulate wealth (preferably tax-advantaged), to be assured of income security for

themselves and their families at retirement, death or disability. Executives want to know that they have incentive and

benefit plans that are competitive with other companies and other executives in the marketplace.

In addition, clients should note that to a great extent, a life insurance contract is a contract of faith between the

policyholder and the insurance company. In most life insurance policies, the insurance company has a wide degree of

discretion in determining what the policyholder will receive.

As a result, an insurance company‘s track record of treating all its policyholders fairly is extremely important. One basic rule

is that today‘s new policyholders become tomorrow‘s ―old block of business.‖ Therefore, suggest that clients focus not just

on what companies are illustrating today, but also on how they are treating their policyholders from 10 and 20 years ago.

The client does not want to be known as ―that old profitable block of business‖ 10 years from now. These are not

quantifiable values, but rather issues in which a qualified life insurance agent‘s input can be extremely helpful.

Overall, today‘s life insurance policy illustrations present substantial challenges in working with clients to structure insurance

transactions. Competent insurance advisors can be very helpful to policyholders in understanding the significance and

limitations of policy illustrations.

THE FUTURE FOR LIFE INSURANCE AS A BENEFIT FINANCING TOOL

Overall, barring major adverse tax legislation, the future of life insurance in compensation planning is very bright, because:

The well-publicized limits imposed by the Tax Reform Act of 1986 on qualified plan contributions are leading to a

continued proliferation of nonqualified plans, including nonqualified deferred compensation plans;

The imposition of nondiscrimination rules for group term life insurance plans has increased the need for nonqualified

death benefit protection;

For high-income individuals, the 15 percent excise tax on excessive distributions from qualified plans will also reduce

the attractiveness of those plans;

Many companies recognize the magnitude of liabilities for deferred benefit plans. Life insurance is a logical

financing alternative in many instances; and

Freezing of the estate tax rate at 55 percent and phase-out of the unified credit will increase the attractiveness of

life insurance in planning for estate taxes.

Wealthy individuals find life insurance to be an excellent device for minimizing the generation skipping tax which,

when added to regular transfer taxes, is the highest government-imposed tax.

Overall, there is an increasing need for a flexible, tax favored financial too—life insurance.

Financial planners and consultants such as CPAs and accountants often receive policies for review from their clients. The

planners are responsible for the analysis of many of the qualified and nonqualified plans considered by the clients, as well

as answering specific tax and accounting questions concerning the use of insurance products.

Frequently, as part of an executive compensation consulting engagement with a client, financial planners are actively

proposing, designing and assisting in the selection of financing for nonqualified supplemental benefit plans. Since financial

planners and analysts do not sell products, they usually work with an agent of the client.

THE NEED FOR SUPPLEMENTAL PLANS

Tax legislation has severely restricted the amount of money that may be set aside by, or accumulated for, highly

compensated executives for their retirement. Restrictions on such qualified plan contributions and payouts continue to

arise.

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Many large and small corporations (and nonprofits as well) calculate how much executives will lose under the various

pension and group insurance provisions of recent law changes and seek ways to replace those benefits.

Companies continue to attract, retain and reward valuable executives. Employers continue to look for competitive (within

the industry and labor market), cost effective and tax efficient ways to do so.

When a senior executive joins a company after walking away from 15 years of credit toward a pension somewhere else,

the new company must design a plan to make the executive compensation package whole.

Executives continue to seek ways to accumulate wealth (preferably tax-advantaged), to be assured of income security for

themselves and their families at retirement, death or disability. Executives want to know that they have incentive and

benefit plans that are competitive with other companies and other executives in the marketplace.

Use 'The Rule of 72': at nine

percent, money doubles in

eight years.

Theoretically, dramatic tax reduction should diminish the willingness of

executives to defer income (and possibly invoke higher rates).

The loss of consumer interest and net investment interest will remove the tax

subsidy for executives who borrow to replace deferred compensation cash

flow.

However, the tax-free compounding of untaxed money results in the

doubling of money within only a few years using the Rule of 72.

And, many companies pay higher rates on deferred income than the

executive can obtain individually. In fact, companies that incur the 20

percent corporate alternative minimum tax may encourage deferral by

offering even higher rates because deferred income could reduce their

taxes.

This is so because under the new AMT, pretax book income in excess of

taxable income contributes to the AMT. Deferred compensation, while an

expense for book, is not a deduction in arriving at taxable income.

The reverse is true of companies that do not incur the AMT. These companies must pay taxes at a higher percentage on

deferred income; the executive pays less on the same income if he takes it.

Example: Consider a financial planning company that conducted a survey of executives and deferred

income opportunities. In this survey, 46 percent of all firms surveyed offered their executives the

opportunity to defer income.

If the companies were categorized by size, only 36 percent of the companies with fewer than 500

employees—compared with 75 percent of the companies with 10,000 or more employees—offered

deferrals. The results also differ by industry.

There is a trend to use nonqualified deferred compensation plans as 401(k) excess plans which allow executives to defer

salary in excess of the cap and often credit executives with the same company match that is used for the tax-qualified

plan.

In fact, new restrictions on qualified plans—401(k) and defined benefit pension plans as well—have significantly increased

the popularity of excess benefit plans. In the same survey previously mentioned, 44 percent of the large companies and

23 percent of the small companies surveyed had modified or added a Supplemental Executive Retirement Plan (SERP) to

keep executive compensation packages whole.

Continued shifting of significant liabilities from tax-qualified plans to nonqualified supplemental plans increases executives

growing concern over benefit security. Many executives, because of concern over takeover activity or bankruptcy,

seriously question the security of these promises. This concern leads increasingly to an interest in financing or securing these

arrangements.

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Corporate-owned life insurance (COLI) is the most popular financing arrangement because it is, in most cases, still more

attractive than the alternatives. The Tax Reform Act of 1986 reduced the after-tax rate of return on these policies by limiting

the tax leveraging possibilities of these policies in two ways:

The $50,000 limit on deductibility of loan interest per insured; and

The inclusion of the inside build-up and death proceeds in the AMT.

These two changes and a reduced corporate income tax rate caused many plans financed with COLI, to become under

funded. The reduction of the corporate tax rate combined with the loss of loan deductions and the taxability of some of

the inside build-up and death proceeds (under AMT) could cause earlier projections to be outdated. It is important,

therefore, for corporations with existing plans to reforecast the insurance financing.

COLI is a hedge against a company‘s liabilities. While it can be used in combination with a security arrangement, it is not a

security device in itself.

Future payments of supplemental retirement benefits and deferred compensation amounts can be made more secure,

and the funds to allow the corporation to make such future benefits can be accumulated in an irrevocable trust with an

independent trustee.

The funding requirements can be estimated by an actuary, similar to pension funding.

TRUSTS

There are essentially two kinds of trusts being used today, the 'Rabbi Trust', and the Secular Trust.

Rabbi TrusT A Rabbi Trust is a grantor trust, the assets of which remain company property that can be reached by company creditors in

the event of insolvency or bankruptcy. Executives are not taxed until they receive payments from the trust.

The company is not allowed a tax deduction for contributions to the Rabbi Trust until payments are actually made to the

executive; also, trust income is currently taxed to the company.

Secular Trust The assets in a Secular Trust are truly separate property and cannot be reached by company creditors. Unfortunately,

executives are taxed currently on their non-forfeitable, vested interests as contributions are made to the trust, and on trust

income. For this reason, secular trusts are not very popular.

However, the corporation or the trust could make annual payments to the executive to cover the increased tax liability.

The company is allowed a current tax deduction for contributions to the trust when the amount is includable in the

executive‘s income, and it pays no tax on trust income.

Since the corporation now has a higher tax bracket than the executives, this approach should be explored in many

situations to provide security against the company‘s future financial instability, as well as future management‘s change of

heart.

FISCAL RESPONSIBILITY

Anyone reviewing proxy statements and calculating the benefit liabilities under these plans for a Fortune 500 company, or

analyzing a similar plan for a small closely held corporation, has to think that it is good business practice to be certain that

funds are available to fulfill these obligations.

This is particularly applicable in a corporation that may not have the necessary cash flow to meet these obligations when

they become payable.

The corporation that provides such benefits has several financing options:

Self-funding. Pay all benefits out of cash flow at the time they come due.

Sinking fund. Earmark some investments as the source of funds for benefit payments when due.

Insurance. Purchase cash value life insurance to finance benefits and associated plan costs; and

Annuities. In a non-taxable situation, the purchase of an annuity may still make sense.

General Financing Observations

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Corporate-owned life insurance has some unique advantages under current law that makes it the method of choice for a

growing number of firms. Both large and small companies can use the concept of using cost recovery life insurance

products to finance selective benefits for top executives.

Technically, the benefit plans and the insurance financing are separate. Nonqualified plans must be unfunded (in contrast

to the required and tax deductible funding of qualified plans) to avoid bringing the plans under the provisions of ERISA.

Since unfunded nonqualified plans are for the benefit of a select management group, they are exempt from ERISA‘s rules

on participation, vesting, funding and termination.

Because these are unfunded nonqualified plans, the executives are unsecured creditors of the corporation.

Any substantial attempt to give the employee security in the benefits generally will cause the employee to recognize

income. An employee‘s interest in a Rabbi Trust arrangement established by the employer still must be that of an

unsecured creditor.

The benefits paid under a nonqualified plan are specified in formal documents that govern the specific plan benefits,

conditions under which they are paid, and the class of employees who qualify for each benefit.

The benefits provided in this manner can range from supplemental retirement benefits that are entirely corporate-funded

to deferred compensation benefits that are financed entirely with employee salary deferrals and many variations in

between.

Plans that are financed with corporate-owned life insurance often provide a substantial pre-retirement death benefit as

well as post-retirement income benefits. It is not unusual to have a disability benefit as well.

The life insurance financing consists of key person life insurance policies owned by and payable to the corporation upon

the death of the executive.

It is important to understand that usually, for large companies, cost recovery life insurance is not designed to accumulate

cash values to pay benefits, but to allow the corporation to recover all costs at the executive‘s ultimate death.

The benefits paid to an executive, or to the family, actually are paid from corporate cash flow. This is true whether the

benefit is from a supplemental corporate-paid plan or a true deferred compensation plan. The amount of life insurance

financing necessary in any case is the face amount necessary at the executive‘s ultimate death.

This usually is assumed, in a small group, to be at age 80. In a group over 100-300 lives, it is best to use a mortality-adjusted

life expectancy to make the corporation whole for all premiums paid, all benefits paid from cash flow, and the loss of using

of money after adjusting for tax effects.1

The Tax Reform Act of 1986

amended the law to deny

the deduction for interest

expense for loans in excess

of $50,000 (per insured)

from corporate-owned life

insurance policies. The

amendment is effective for

policies purchased after

June 20, 1986.

Cost recovery life insurance financing for executive benefit programs is

attractive because of the interplay of several different tax rules. Although the

premium is not deductible, the cash values accumulate tax-free (unless the

corporation is subject to alternative minimum tax).

Most of these plans use whole life insurance and, until the June 20, 1986 tax

law amendment limiting interest deductions, most of the policies were

minimum financed.

In essence, pre-Tax Reform Act of 1986, the cash flow commitment to the

insurance funding was only to the extent of four premium payments.

The premiums were payable for the life of the policies, but the majority of the

premiums were paid via loans from the policies‘ cash values.

If four of the first seven premiums were paid other than by borrowing, then the

interest paid on subsequent policy loans was deductible.

1 The tax effects include deduction loss on deferred compensation, tax deduction for interest paid on loans from

grandfathered policies, and on new policies up to $50,000 per insured executive.

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The cash values accumulate in the policy tax-free (except for AMT) even though loans far in excess of premiums paid are

being extracted from the contracts. The policy proceeds, when paid as death benefits, are received by the corporation

income tax free (again, unless the corporation is subject to AMT).

Benefits when paid to the executive are tax deductible to the corporation, whether they are paid while the executive is

living or at death. These benefits are taxable as compensation to the executive as income, or income in respect of a

decedent to his/her heirs.

A Caveat A word of caution is in order. If the policies are canceled or surrendered for their cash values, the excess of the cash

received upon surrender plus the policies‘ loan balance forgiven over the cash premiums paid (minus cash dividends

received) is taxable as ordinary income to the corporation in the year of surrender. This could result in a large amount of

phantom income.

Thus, surrender or lapse of the policies is to be avoided.

This tax arbitrage, pre-Tax Reform Act of 1986, meant that previously some policies could earn an internal rate of return as

high as 25 to 28 percent. It also meant that there was, at times, more focus on the return than on the prudent financing of

liabilities.

By limiting the interest deduction, Congress removed one part of the tax arbitrage, and now there is evidence of internal

rates of return closer to other market rates, but still quite appealing.

Present Value Analysis The best method of analyzing these financed plans is to prepare a present value analysis of the entire transaction. A

present value analysis solves for the net present value of cash inflows less cash outflows.

The timing of both inflows and outflows are discounted, usually at the corporation‘s cost of money. A specific face amount

of insurance will produce a positive net present value at the end of the transaction.

However, since these programs are long-term (i.e., in a given group of executives the youngest is age 35, the transaction

being analyzed will not be complete until he dies, perhaps 45 to 55 years later), an additional factor to be considered is the

cash outflow in any given year.

However, in deferred income plans with insurance financing, the internal rate of return for the transaction often is used to

establish the maximum rate of return the corporation safely can credit deferred monies. In non-borrowed illustrations, some

returns are projected as high as 13 to 15 percent. With loans up to $50,000 per insured, the rate can exceed 14 to 18

percent with products currently on the market.

The interest rate promised to executives should be associated, however, to some unrelated outside indicator; for example,

many companies use Moody’s, plus two to four points. The interest rate promised also should be reasonable. Extremely

high rates promised on executives‘ deferred funds and disclosed in a proxy may cause problems with the stockholders.

There is also the "janitor insurance" scenario, where it is proposed that the corporation insure almost everyone in the

company for smaller amounts to achieve a larger loan interest deduction ($50,000 per insured). This proposal should be

carefully evaluated for insurable interest problems in some states, and its ethical value.

The nonqualified plans outlined above are most frequently seen in large, publicly held corporations. Industry figures

indicate that:

Approximately 63 percent of the largest industrial and financial organizations have nonqualified deferred

compensation plans;

Approximately 67 percent of the Fortune 100 companies have nonqualified supplemental benefit plans;

Approximately 44 percent of the Fortune 100 have pre-retirement supplemental death benefit plans, and

39 percent have post-retirement supplemental death benefit plans.

Those plans are large and lend themselves detailed analysis. In concept, they are mini-pension and 401(k) plans with

different tax rules, but the same funding complexities of qualified plans. They are also administratively complex and there is

scrutiny on the ability of the insurance agent, his firm or his carrier to administer the plan for years to come.

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The existence of a formal

deferral plan for a new

company can be very

useful in defending an

unreasonable

compensation in later,

cash-rich years.)

There are fewer situations in which nonqualified deferred compensation

plans will be beneficial to small businesses, but such plans can often be

valuable.

They may be useful in the start-up phase of a new company when cash is

scarce.

Nonqualified supplemental benefit plans are more frequently encountered in the smaller company for a number of

reasons. In general, the advantages to a small company of a nonqualified supplemental benefit plan include:

Simple to adopt

Discrimination is possible;

Latitude in vesting;

No 415 limits;

No minimum funding rules; and

Exempt from ERISA.

The main disadvantages include:

No current deduction;

Lack of security for the employee; and

Potential accumulated earnings problem.

The security issue can be partially addressed by a Rabbi Trust, which can protect key employees if the company is sold.

However, employees will have to have absolute confidence in the long-term viability of the company to perceive the

promise of supplemental retirement funds as a benefit.

If the individuals covered by the supplemental plan are truly key people, one of the standard defenses against an

accumulated earnings attack is key person insurance.

If there is any concern that the corporation may cease to exist (or thrive) after the exit of a key executive, then split dollar

insurance may be more appropriate. Countless design decisions need to be made—

Endorsement or collateral assignment?

Is the insured a major stockholder?

Is this an S corporation?

How, after the demise of personal interest deductions and the adoption of the $50,000 corporate loan interest

deduction cap, is the split dollar arrangement settled?

In the analysis of the financing alternatives for these plans, it is important to ascertain whether the corporation will have

difficulty making benefit payments out of cash flow.

If so, it will be important to factor in policy loans to pay benefits or to look at short pay or limited payment policies to allow

for available cash flow for benefits at a later period. It is also possible to design the plan so that the cash value at

retirement approximately equals the present value of benefit payments to be made.

COST RECOVERY LIFE INSURANCE

As regulations increase regarding available deferral, accumulation and distribution rules for qualified plans, more

companies will seek to provide tax-advantaged compensation via nonqualified plans for their top executives.

The financing of these plans with key person life insurance policies is, undeniably, less attractive from an investment

viewpoint without the tax leveraging possibilities made possible by unlimited deduction for policy loan interest payments.

Such financing, however, remains attractive (even necessary) for the following reasons:

1. There is almost no other way to get long-term tax-free accumulation outside of a qualified trust.

2. The rates of return are highly competitive even without the interest deduction and exceed the interest assumptions

used by most actuaries in funding for pension benefits and the other financing alternatives.

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3. Current financing of these benefits avoids a situation where current management makes promises for which future

management must pay.

4. Current financing closely parallels what FASB soon may require on corporate balance sheets.

5. Current financing is in accordance with the corporate (and congressional) philosophy of funding for benefits over the

active working life of an employee.

Tax Considerations

Since the employer is the beneficiary of the insurance policy, the premium is not deductible to the corporation. The policy

proceeds at the executive‘s death, however, are received income tax free by the corporation, unless the corporation is

subject to the new alternative minimum tax (AMT).

The key person insurance results in no reportable income to the insured executive since he has no rights in the policy. The

executive is taxed on the benefits provided under the various benefit plans according to the tax rules applicable to that

plan whether or not there is insurance financing. For FICA and FUTA, for example, the executive will be taxed currently on

all vested benefits (such as deferred compensation in which he is fully vested).

Amounts subject to forfeiture (such as supplemental retirement benefits that are usually forfeitable if the executive leaves

prior to retirement) are taxable for FICA and FUTA when all risk of forfeiture has lapsed.

For federal income tax purposes, neither the deferred compensation (if deferred before it is earned) nor the supplemental

retirement benefits are currently taxable to the executive. The deferred compensation is not subject to withholding

currently, but will be when paid to the executive.

Since all benefits, when received, are taxable as ordinary income to the executive as compensation or includable in his

estate as income in respect of a decedent, there may be some estate planning problems for the executive.

At the very least, these benefits should be qualified for the full marital deduction and other funds freed to pass without

estate tax (via the use of irrevocable trusts or other estate transfer techniques).

These nonqualified benefit plans are effective in retaining top executives in that, unlike qualified plans, the executive

generally is not vested in a benefit unless he stays with the company until retirement or some other date advantageous to

the corporation.

An employee who may get 20 to 50 percent of his total retirement benefit from one or more of these supplemental plans

will be less likely to seek employment with another company.

ALTERNATIVE MINIMUM TAX (AMT)

The Tax Reform Act of 1986 amended the corporate alternative minimum tax provisions to assure that fewer corporations

with substantial economic income could report little or no taxable income and escape all tax liability.

This was achieved by starting with a broader income base, known as the alternative minimum taxable income (AMTI),

which includes taxable income plus tax preferences and adjustments and a book income adjustment, reduced by an

exemption of $40,000 (phased out from $150,000 to $300,000 of AMTI).

Tax preferences, which must be added to taxable income, include such items as the excess of accelerated depreciation

deductions on real property over straight-line depreciation, and the excess of percentage depletion deductions over the

adjusted basis of depleted property.

Adjustments are items of income or deduction, which must be recomputed for AMT purposes consisting primarily of

depreciation deductions, net losses from passive investment activities, and amortization schedules.

Book income adjustments adds to AMTI one-half of the amount by which adjusted net book income exceeds regular

taxable income, increased by the preferences and adjustments already discussed.

In general, adjusted net book income is the income or loss as shown on the company‘s financial statements, but with

modifications.

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For example, adjusted net book income includes the income of companies that are included in the consolidated return,

and excludes the income of those that are not, such as foreign subsidiaries.

Corporate earnings that are not included in the consolidated return are taken into account only to the extent of dividends

received.

Additional adjustments are made to remove the effect of federal and foreign income taxes.

Book income is generally defined as the net income or loss of the corporation as shown on its applicable financial

statements. These are, in order of priority:

Statements required to be filed with the SEC;

Statements audited by a certified public accountant for reporting to creditors, shareholders, etc.;

Statements required to be provided to the federal government or its agencies (other than the SEC), a state

government or its agencies, etc.; and

Statements used for reporting to creditors, shareholders, etc.

It is important to understand the effect of these items on the analysis of the cost/benefit of corporate-owned life insurance

policies to note that, in effect, AMTI taxes the inside build-up of cash values and life insurance proceeds.

Since life insurance cash values (net of premiums and loans) and life insurance proceeds are shown on the corporate

books as income, and 50 percent of the amount by which the corporation‘s book income exceeds its taxable income is

subject to AMT, the maximum liability on these amounts alone is 10 percent.

It may be less as there may be other offsetting book losses or negative adjustments to AMTI.

In 1990, the book income adjustment was replaced by a measurement of current earnings and profits and AMTI was

increased by 75 percent of the amount by which earnings and profits exceed AMTI. The effective tax on the cash

surrender value and death proceeds at that point was up to 15 percent.

There are some considerations to review:

First, it should be noted that AMT does not apply to S corporations.

Second, the net effect of the AMT, in these example analyses, means that most regular corporations will simply

purchase 10 to 15 percent more insurance, or decide to under fund by that amount if they are or expect to be

affected by the AMT.

More important, however, the cash flow analysis and explanation of corporate-owned insurance became more

complicated, and Financial Accounting Standard 96 (FAS-96) made the profit and loss analysis and explanation

more complicated, as well.

It follows that agents in this marketplace need to be very technically inclined, financially-educated, and have substantial

technical and computer backup.

ACCOUNTING FOR THE SUPPLEMENTAL PLANS

Certain accounting principles for deferred compensation and survivor income plans have been prescribed by the

Accounting Principles Board (APB) of the American Institute of Certified Public Accountants, predecessor to the present

Financial Accounting Standards Board (FASB).

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These benefit costs must be

accrued annually even if

payment is subject to a

vesting schedule or is

conditioned upon other

requirements, such as

retainer of the executive as

a consultant after

retirement or non-compete

plans with the employer.

APB Opinion 12 would apply generally to executive supplemental retirement

plans.

Under this APB Opinion, the cost of the expected retirement and survivor

benefit payments under the plan must be accrued in a systematic and

rational manner over the executive‘s period of active service—from the time

participation in the plan commences—so that the amount accrued at the

executive‘s retirement is not less than the present value of the estimated

retirement and survivor benefit payments to be paid.

Unless the plan qualifies as a pension plan, it will be accounted for per APB-12. APB-12 allows straight-line or interest method

allocation of the expense over the service period. FASB-87 has generally, but not exclusively, replaced APB-8, governing

the accounting for pension plans.

Under APB Opinion 12, the retirement and survivor benefit cost accrued in each year is charged against the employer‘s

earnings for that year.

Because the cost of an executive‘s benefits will have been fully accrued and expensed by retirement, however, there

should be no further charge against the employer‘s earnings for post-retirement benefit payments other than the accrual of

interest between the retirement date and the date the benefits are paid.

Temporary Tax Differences FAS 96: Accounting for Income Taxes (which is effective for corporate years beginning on or after December 15, 1988,

unless adopted earlier) effects the way companies account for income tax effects for financial reporting.

In December 1987 the Financial Accounting Standards Board issued its Statement of Financial Accounting Standards No.

96. Before the issuance of FAS 96, accounting and reporting requirements for income taxes were largely contained in

Accounting Principles Board Opinion No. 11 (APB Opinion 11), which was issued 20 years earlier.

Under FAS 96, deferred taxes generally represent the future income tax effect of existing differences between the book and

tax bases of a company‘s assets and liabilities, assuming they will be realized and settled, respectively, at the amounts

reported in the company‘s financial statements. Those book/tax differences are defined in FAS 96 as temporary

differences. These differences occur because tax laws and financial accounting differ in their recognition and

measurement of assets, liabilities, revenues and expenses.

Cumulative temporary differences at year-end are scheduled by the years they would be expected to result in taxable or

deductible amounts, assuming no other taxable or deductible amounts will occur in those years.

Tax rates and tax laws enacted as of the balance date are then applied to each year‘s scheduled net taxable or

deductible amounts to compute the deferred tax, after giving effect to tax loss and credits that were carried forward.

The tax benefit of an existing temporary difference that will result in a future tax deduction can be recognized under FAS 96

only to the extent it can be offset:

in a future year against another existing temporary difference that will result in taxable income (i.e., by reducing a

deferred tax liability), or

against taxable income of the current or prior years through carry back (i.e., by claiming a refund of taxes that

have been paid).

The tax benefit of an operating loss that is carried forward can be recognized under FAS 96 only to the extent of the tax

effect of offsetting it against an existing temporary difference that will result in taxable income in the carry forward period.

Under APB Opinion 11, deferred taxes generally represented the past income tax effects attributed only to items reported in

different periods for book and tax purposes, i.e., timing differences. Deferred taxes represented the reduction or increase in

taxes that occurred when the timing differences arose.

FAS 96 will affect the accounting impact for supplemental plans. Prior to FAS 96, companies were generally allowed to

record a tax benefit for the expected future tax deductions resulting from current book expense.

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Under FAS 96, the circumstances under which the deferred tax benefit may be recognized have become more restrictive.

The tax effect may be recognized only if realizable as a reduction of deferred tax liabilities in the same time period or by

carry back to a prior year when taxes were paid.

ACCOUNTING FOR INSURANCE

Accounting for insurance policies purchased by the employer in connection with a deferred compensation plan is

governed by means of generally accepted accounting principles.

he insurance policies are treated separately for accounting purposes, as investments, and the annual premiums payable

are expenses that, net of any increases in cash surrender value, should be charged against the employer‘s current

earnings, whether or not the employer effects a policy loan to pay the premium. Since the premium expense on the life

insurance policy is not tax deductible by the current employer, this cost is charged dollar-for-dollar against earnings.

Since the employer borrows against the policy (now largely for grandfathered policies), the interest on policy loans will

constitute an additional expense that also should be charged against the employer‘s earnings.

This interest expense will grow at an increasing rate in each succeeding year as additional amounts are borrowed not only

to pay each year‘s policy premium, but also to pay interest on amounts borrowed in prior years.

The charge against earnings for interest expense is applied on an after tax basis, so that the tax deductible nature of the

expense will serve to reduce its charge against earnings. For example, every dollar of interest expense would result in a

charge of 66 cents against earnings (for an employer in a 34 percent bracket).

The huge interest deductions for these plans ceased to be such an issue as more policies were added after June 20, 1986.

Since the employer is the owner of the life insurance policies, the cash surrender value net of loans for each policy should

be reflected as an asset on the employer‘s balance sheet.

Unfortunately, insurance consultants have sometimes recommended the use of the ratable charge method rather than the

GAAP method to account for the life insurance expense incurred during the first few years so as to offset the expense by

the income expected on the policy in later years.

Under that approach, a straight-line expense is calculated by taking the sum of the annual expense and income amounts

for a period of years and then dividing by the number of years.

This ratable charge method has been rejected by FASB since the employer is under no obligation to hold the contracts for

any period of time (even though intent and business exchange riders might be present), so there is no assurance of

obtaining the income (from death proceeds) in the later years.

This position was stated in FASB Technical Bulletin 85-4. The Emerging Issues Task Force (EITF) considering Emerging Issue 88-5,

stated that death proceeds cannot be anticipated or actuarially adjusted; instead, they must be recognized when an

individual insured dies.

As a second topic in EITF 88-5, the insurance industry has also requested that a "net loan value" rather than cash surrender

value be used for accounting purposes in order to mitigate the effects of FAS-96 income tax accounting for otherwise

temporary differences. No consensus was reached on this issue; the FASB staff agreed to further consider this question.

Because the asset recorded for an insurance policy is its cash surrender value, FAS 96 requires that the gain, which would

be taxable upon surrender of the policies, be considered a temporary difference in making deferred tax calculations.

Thus in any given year, a tax liability is recognized (for FAS 96), in the amount by which the net cash surrender value of the

policies exceeds the basis, as though all of the policies were cancelled that year.

For most public companies, the accounting issue is a major consideration in the adoption and financing of these plans. In

recent years, the insurance industry has developed products with substantial first year cash values and external fees to

reduce the book effect for the insurance to the smallest amount possible in the first few years. As a result of AMT and FAS-

96, there is impetus to design products with lower cash surrender values in the accumulation phase.

It is, however, the accrual for benefit obligations, rather than insurance expense, that creates the major book effect.

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Many small companies can safely ignore the technical accounting rules because they need not explain their expenses

and accruals to largely unknown public stockholders. However, the new corporate alternative minimum tax (AMT) will be of

concern to both large and small companies.

Reporting Requirements In order for a nonqualified plan to maintain its exemption from ERISA (and all its reporting and other requirements), a one-

page notice MUST be filed with the Department of Labor within 120 days of the plan‘s effective date.

The Department of Labor requires only that notice be given that such a plan exists, including the number of employees it

covers and the employer‘s name, address and identification number.

The Department of Labor seeks to confine the definition of management to upper-echelon employees, in the belief that all

other employees are entitled to the protection of ERISA.

EXECUTIVE BENEFIT PLANNING PROCESS

The process of executive benefit planning can be outlined as follows:

1. Analysis of existing corporate benefit plans;

2. Survey of competitive benefit plans;

3. Understanding of corporate goals and objectives;

4. Understanding of executives‘ needs and desires;

5. Understanding of corporate priorities;

6. Analysis of available alternatives;

7. Selection of optimum plan;

8. Design of specific plan;

9. Selection of financing method;

10. Implementation and communication of plan; and

11. Administration of plan.

Every corporate environment and every small business is different, and no single plan fits every environment. It is important

to understand the client‘s needs and desires before proceeding.

Properly designed plans—qualified and nonqualified—should be appropriate to the corporate environment and be no

more complicated than necessary. They should be cost-effective and competitive, and dovetail properly with each other

and with other fringe benefits. Proper plans take a considerable amount of time to develop, implement, communicate and

administer.

Plan Design and Analysis Focus specifically on the approach to these plans as they require complex analysis:

To verify the advantages;

To point out the problem

To examine the financing alternatives;

To select a competitive product (when insurance is to be used);

To test for mortality, interest rate and corporate tax rate sensitivity; and

On an ongoing basis, to adjust for changes in any of the above.

Before proceeding, evaluate the level of benefits the corporation should provide (considering reasonableness,

competitiveness, etc.) and complete an unbiased analysis of the benefits being offered under all excess plans (an

assessment of the liability).

A model of the financing with the ability to change assumptions (corporate tax bracket, deductibility of interest payments,

cost of corporate funds, etc.) should be created. The discount rate ordinarily used is the corporation‘s cost of money. All of

the assumptions used must be reasonable for the long-term, since these plans may last 50 years or more, assuming no new

entrants (almost never true).

Sophisticated computer capability also is necessary to do the multitude of projections with varying assumptions. Where

insurance financing is to be used, quotations should be secured from various carriers since the insurance carriers with a

substantial presence in this marketplace are highly competitive.

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Since these plans are administratively complex and long-term, it is important that the firm that designs and administers them

have knowledgeable employees and is likely to be in business many years.

Once designed and installed, these plans require annual reporting (benefits and insurance), employee communication,

corporate reporting to stockholders, and re-forecasting at any point where substantial tax or business assumptions have

changed (or every three years in any case).

There are new entrants, salary increases, dividend and face amount changes, etc., to be recognized.

Cash Flow Analysis

There are several steps involved in cash flow analysis for a supplemental retirement plan. All of the cash flow components

are reviewed separately, then the individual components are combined to form a composite cash flow statement.

Track, year by year, the expected after tax benefit payments to be made to each plan participant;

Track the cash flows for the insurance premiums, loans, interest expenses and fees, if applicable. This will result in a

net corporate outlay for insurance; and

Track the insurance proceeds that the corporation expects to receive during the year.

Combine these three elements to arrive at the expected annual cash flow without considering the corporate cost of

money:

To arrive at the Total Expected Cash Flow for year N, calculate the Expected Cash Flow, as above, and add

Expected Cash Flow (year N-1) multiplied by the corporate cost of money;

For Total Expected Cash Flows, have the computer solve for a positive cash flow at the completion of the program

and test to see what effect changes in assumptions will have on the cash flow. A model of the plan, designed on a

spreadsheet, will allow the flexibility to vary the plan assumption almost infinitely; and

A present value analysis can be prepared using various corporate costs of money on all expected cash inflows

and outflows. We would expect to see a positive present value for a reasonable spread of interest rates and

assumptions.

Profit & Loss Analysis

Profit & Loss (P&L) analysis is similar to a cash flow analysis—the elements are tracked separately as they are expected to be

reflected on the corporate books, and then are combined on a present value basis. In sum, the steps are:

1. Track the P&L effect of the supplemental benefit payments to be made to the plan participants. Take the

supplemental benefits paid, plus an accrual for future benefit payments, less a credit for deferred taxes, to

arrive at a net, after tax, annual P&L for benefit payments;

2. Track the P&L effect of the insurance premiums and cash values by tracking the cumulative gross insurance

premiums net of cash value increases;

3. Track the P&L effect of the insurance death proceeds by taking the insurance death proceeds during the year,

subtract the cash value (after reduction for premiums and loans) and arrive at the P&L gain at death from the

insurance proceeds;

4. Track the P&L effect of the insurance (while living) by taking the after tax policy loan interest, minus the cash

value increase in excess of the annual premium, to arrive at the net P&L charge for insurance (while living). This

is then mortality adjusted to get the expected P&L (living) charge for insurance. (Note that GAAP requires the

recognition of proceeds upon actual death of an insured not on a mortality adjusted basis; the mortality

adjusted death proceeds is used for illustrative purposes only.);

5. Take the P&L Gain at Death from Insurance Proceeds and mortality adjust it to arrive at the Expected P&L Gain

from Insurance Proceeds. The validity of this step has recently been challenged.

The FASB, in EITF 88-5, has stated that it is not appropriate for the purchaser of life insurance to recognize

income from death benefits on an actuarially expected basis. For projection purposes, this is still a valid

procedure; however, for actual book entries, only death proceeds actually realized can be booked;

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6. Combine all of the individual insurance P&L items with the after tax cost of fees, if applicable, to arrive at the

Expected P&L Charge (Gain) from Insurance;

7. Bring the pieces together (benefit payments and insurance related amounts) to arrive at the final P&L effects;

and

8. The final step is to list, on a year by year basis, the annual and cumulative expected increase (decrease) in

annual P&L charges.

Insurance Company

The following items should be considered when analyzing the performance of an insurance company:

Size

Financial strength

Integrity

Investment performance

Investment philosophy

Competitiveness

Best’s rating / Moody’s/ Standard & Poor's

Retention levels

Product Choice

Determine what type of policy is required for a particular program. Evaluate if the outcome desired is higher early cash

values, or lower premiums because of going in cost considerations. Determine if these policies will be borrowed against,

and note the policy loan rate. Consider also:

Is this a direct recognition product?

Whole life or a universal life product?

What is the mortality charge?

What is the expense load?

What is the dividend history?

Investigate the insurance carrier‘s historical return on its portfolio. If policy values are determined by reference to outside

indicators, review fluctuation in those indicators. Investigate how the carrier treated old policyowners, especially in difficult

times.

There is good reason to believe that the lack of any significant interest deduction will cause some refocusing on the

integrity of the underlying product and the carrier.

What is the carrier’s investment and product philosophy?

How suitable is its investment philosophy to its products for this market?

Without tax leveraging to produce a higher rate of return, focus on solid investment strength. For a company with a sizable

investment in these programs and some risk tolerance, equity-based life insurance products may be appropriate, as the

structure is similar to the funding of pension benefits.

Some insurance companies introduce products (on larger cases) that are issued with either no commission or a minimal

commission. In lieu of the traditional commission, the agent charges a fee for service. In many cases this is preferable to

the client because the fee is deductible to a client while the traditional life insurance commission is not deductible.

On many of the larger cases covering multiple lives, ongoing plan administration is very important. A fee-based structure

can be used to pay for the ongoing administrative function.

On occasion, we encounter a product that may not fit the definition of a life insurance contract under 7702. Since this

would cause serious tax problems, consider this possibility when examining a proposal.

Size and Financial Strength

The most important consideration is the financial strength of the insurance carrier. The size of the carrier is important since

many of these programs involve sizable face amounts of insurance.

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What guaranteed issue limits are available (for a large group of top executives)?

What are the carrier’s reinsurance limits? Has the company shown a net operating gain for at least the last few

years?

Are the company’s admitted assets increasing?

Is surplus increasing?

What has been their mortality experience?

Are their expenses of operation reasonable? Is their lapse ratio on the rise? Is the company being operated by an

experienced management team?

Integrity Most insurance companies establish a certain reputation in the industry. Some companies are known for low cost term;

others are known for easy underwriting, etc.

Look for companies that have a proven track record of delivering on their promises.

Seek a company that will underwrite fairly, pay their projected dividends if a participating company, make realistic

projections of future performance, and realistically pay any claims due.

Investment Performance/Philosophy To be sure that a company is earning a reasonable rate of return while not risking their assets unnecessarily, ask a few

questions:

What is the current rate of return on assets?

Where are the assets invested?

What is the quality of the investment portfolio?

How is their liquidity position?

Are they invested heavily in potentially volatile investments?

Do they have a good mix of assets?

Competitiveness

Make sure the cost of a proposed program compares favorably with the industry norm. The program does not have to be

the most competitive program available, competitive.

The insurance company should be historically competitive in this marketplace, meeting projections over the years, either in

the form of dividend projections or interest assumptions. Programs of this duration cannot be judged on entry costs alone.

Rating Best’s independently rates insurance companies based upon their sworn financial statements as filed with the insurance

commissions of the states in which the companies are licensed to do business.

Best’s provides information about company operations, development, assets, asset distribution, management and history,

as well as profitability and liquidity figures. Discourage clients from purchasing a program with a carrier that does not

maintain at least an 'A' rating.

Enough carriers with an 'A' or better rating exist to almost rule out the use of the lower-rated company.

Retention Levels

Most companies reinsure a portion of their risk with a reinsurer. This is just another aspect of the total financial position of a

company and it is important that the quality of the reinsurer and the philosophy regarding retention levels is in line with the

other goals of the company.

Summary and Conclusion

The art of compensating executives today, with constant tax and accounting changes, not to mention

occasional economic trauma, is just that—an art. Fortunately for most agents, it is an art that is likely to

continue to provide rewards, as long as the time and energy necessary to master all of the techniques

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CHAPTER 2: PURCHASING INSURANCE USING A PROFIT SHARING ACCOUNT

FINDING THE MONEY

It is a good sales strategy to help clients 'find the money' when recommending a life insurance purchase. Since a

traditional or 401(k) profit sharing (P/S) account can be a welcome source of premium funds, be aware of the incidental

death benefit rules. Incidental death benefit rules permit a plan participant to apply up to 49 percent of his share of

aggregate employer contributions to buy whole life insurance (25 percent, if term) on his life.

Example: Consider a client who wants to use a profit sharing account for premiums on the life of someone

else—a family member or possibly a business associate. Perhaps the policy will also insure the last survivor

of two or more insureds, or it may be that projected premiums will exceed the 49 percent or 25 percent

limits.

What can be done? Can the account fulfill these and other out-of-the-ordinary objectives?

Utilizing a Profit Sharing Account for Insurance on the Life of a Family Member

There is a creative way to use a profit sharing account for insurance on the life of a family member. Although regulations

do not require a participant-insured connection, it appears the IRS will not approve profit sharing plan prototypes that

permit insurance coverage on the life of someone other than the participant.

Nonetheless, in a 1984 Private Letter Ruling the IRS concluded it was possible for a profit sharing plan participant in a 401(k)

plan to direct some of his account for premiums on the lives of his spouse and children. Premiums are limited to the support

of incidental death benefits and PS-58, or alternative term rates based on the age of the non-participant insured, are

taxable to the participant.

The 1984 Ruling permitted a plan account at the death of the insured to immediately distribute a sum representing the

amount at risk as income tax free insurance proceeds under 101(a) of the Internal Revenue Code.

The client gains two ways:

The plan participant at the insured‘s death would receive a cash payment without the necessity of a triggering

event; and

The distribution would be exempt from excise taxes otherwise due on pre-age 59½ amounts—10 percent, or for

sums exceeding $150,000, 15 percent.

Use of the Profit Sharing Account for Insurance on the Life of a Business Associate

Consider a corporate client with a profit sharing plan that has a buy/sell objective. His current planning options may

include a typical stock redemption program with corporate-owned insurance. However, there are concerns about the

alternative minimum taxes (AMT) on corporate-owned insurance.

Since a post-death liquidation or a sale of stock by survivors are real life possibilities which may cause significant income

taxes, a second plan design, a cross-purchase agreement with crisscrossed insurance, could be used to create a basis

step-up in the acquired shares.

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This option is sometimes

called the 'mixmaster' or

'wait-and-see' plan and

is an effective use of

insurance premium

dollars.

A third option, a stock redemption plan coupled with crisscrossed insurance,

could be selected.

Here, the policyowner/beneficiary gets a choice to (1) purchase shares

outright or

(2) loan funds to the corporation to effect a stock redemption.

The former would achieve a basis step-up and the latter would enable the

policyowner/beneficiary to obtain a subsequent pay back of the loan on a

tax-free basis

Sometimes there is an added feature, a split dollar agreement where the

corporation lends its financial assistance.

But, with all its technical worthiness, even a mixmaster plan may meet with

sales resistance because premiums are paid from taxable funds and a

personal checkbook will be required.

Improve the mixmaster design by using profit sharing accounts (which will not be a party to any buy/sell agreement) to own

the crisscrossed policies. Here, someone else, the plan trustee, will be writing premium checks and using soft, tax-

deductible dollars targeted for the distant future.

This plan design can be psychologically appealing.

In a 1981 Private Letter Ruling, the IRS indicated a profit sharing account might apply its funds to insurance on the life of a

co-shareholder. The taxpayer requesting the ruling stated that the proceeds would not be distributed until approximately

two years after the insured‘s death.

Therefore, this ruling is supportive only where it is affordable for insurance proceeds to remain in the plan for a considerable

length of time following death. Applying current law, the at-risk part of the proceeds would be paid out income and excise

tax-free.

Whenever a profit sharing account acquires crisscrossed buy/sell insurance, it is best to structure permissive plan language

and the purchase as follows:

(1) The Plan Trustee for the appropriate account would acquire, at the participant‘s election and direction, coverage on

the life of a co-shareholder;

(2) PS-58 or applicable term rates and incidental death benefit rules would apply;

(3) There would be an immediate post death distribution limited to the at risk amount (the cash value portion will remain in

the account for reinvestment and later distribution at the participant‘s retirement); and

(4) This distribution would be income and excise tax-free.

This structure could provide the optimum buy/sell design2. The profit sharing account will be the liquid and attractive

premium source for tax-free insurance proceeds. When the funds are distributed, the participant can either purchase

shares, make a loan to his/her corporation so it can redeem shares, or both.

Utilizing a Profit Sharing for Survivorship Insurance Survivorship insurance on spouses is popular where there is a desire to defer estate taxes until the second death. Similarly,

three or more business owners with plenty of corporate cash may opt to self-insure a first death, while using survivorship

crisscrossed policies for key person loss or buy/sell obligations at a second death; or, perhaps a child wants to insure parents

to acquire their shares at the second death. In these situations, a profit sharing account can acquire a joint/survivor policy

as it would a single life policy.

If the plan participant becomes the survivor of two spouses and then dies, the at-risk amount will be distributed as income

and excise tax-free insurance proceeds. However, the first to die should create an irrevocable family-type trust and

2 Caution: with rewards so great, it may be wise to seek a specific IRS ruling that a proposed design meets IRS guidelines.

76

designate it as the beneficiary of the policy to prevent inclusion of the ultimate death proceeds in the estate of the

surviving spouse.

There is no contemplation of death or transfer for value problems when the policy is transferred in this manner. Of course,

the cash value amount initially paid to the trust will be income taxable and if it exceeds $600,000, there will be an estate tax

due at the participant‘s death.

If the plan participant‘s account acquires a survivorship policy to fund a crisscrossed buy/sell plan and he survives the

death of the last insured, the at-risk amount could then immediately be distributed as tax-free insurance proceeds. If the

participant predeceases the last insured to die, the cash value will become part of his plan account for payment to his

beneficiary.

In a spousal setting, if the participant predeceases his spouse, arrangements should be made to continue the policy. For

example, the plan could purchase and distribute a nontransferable annuity policy sufficient in amount to provide the

recipient after tax income targeted for premium payments.

In a buy/sell setting, a new buyer by separate agreement might purchase the policy from the designated beneficiary of the

account balance. Here, care is advisable because the sale will be a transfer for value. Consequently, the most convenient

purchaser usually will be the corporation for which the value is being insured.

A survivorship policy is of special value when acquired by a profit sharing account. The annual allocable term insurance

charge during the lifetimes of the joint insureds is quite low because it is based on the likelihood all insureds will die within

the same policy year. Since cash values are usually small in relation to the at risk portion, a significant share of the death

proceeds will be paid income and excise tax-free.

Using a Profit Sharing for the Maximum Purchase of Life Insurance Analysis of a profit sharing account as a source of premiums should base the purchase on a seasoned funds technique.

There are two:

Account balances to the extent they exceed, in amount, the last two annual allocations of employer contributions

to the account are deemed seasoned funds and may be used for premiums; or

If the participant has been in the plan for five years, all of his account will qualify as aged funds and may be used

for premiums.

Seasoned funds are rooted in the premise that a profit sharing plan may permit in-service withdrawals to the extent the

funds have actually remained in the account for at least two years.

The premiums are deemed distributions although the cash values remain in the participant‘s account and are permitted as

if they were an in-service withdrawal. Note that participant deferrals within a 401(k) profit-sharing plan may not be

withdrawn except in hardship, and logically should not be available as seasoned funds for premiums.

Once a premium is paid, only PS-58 or alternative term rates and not the actual premium are the measure of current

taxable income.

Extreme care is necessary

when applying seasoned

funds to premiums under

the two-year test. Do not

use contributions made by

the employer during the

past two years.

When considering insurance on other than the life of the participant, be

aware of the 1984 Letter Ruling that limited within a 401(k) plan premiums on

spouse and children to amounts permitted under the incidental death benefit

rules. The participant must direct the plan trustee to make the insurance

purchase.

Since a prototype plan will not permit seasoned funds for premiums, an

amendment may be necessary.

There are numerous advantages to applying seasoned funds to premiums. A larger amount of insurance will be possible.

Since the incidental rules (which require at a participant‘s termination of employment distribution of a policy or conversion

to cash) do not apply, it is arguable the policy can remain in the account past the retirement date.

This may be a special blessing where the policy is targeted for continuous ownership within a plan subtrust designed to

safeguard the insurance proceeds from death taxes at the insured‘s death. The regular premium limits of 49 percent if

whole life, or 25 percent if term, will not apply. To this extent, it will make no difference what kind of insurance is purchased

with the seasoned funds.

77

The insurance provisions of a profit sharing plan typically will connect a named insured only with his plan account and limit

premiums to somewhere within the 49 percent test. Nevertheless, it may be possible to expand the profit sharing account

to do a much bigger job. And, when the stakes indicate a need for assurances, be prepared to encourage clients to seek

a Private Letter Ruling from the IRS.

TAX CONSIDERATIONS FOR QUALIFIED PROFIT SHARING PLAN DISTRIBUTIONS

Back in the 1960's and 1970's, a profit sharing plan participant was entitled to special tax benefits:

1. Non income-taxed employer contributions could accumulate on a tax deferred basis,

2. Accumulations were exempt from federal estate tax when paid as plan benefits and could remain in the plan post

age 70½ until termination of employment;

3. There were no excise taxes on plan payments; and

4. Income tax free loans could be made available without a $50,000 limit.

Congress enacted laws eroding most of these earlier tax advantages: (1) above is still true, but the rules surrounding (2), (3),

and (4) have been modified.

The subjection of plan benefits to federal estate taxes, a major tax on distributions, has significantly diminished the value of

a retirement fund to a beneficiary. The participant also faces some special problems.

If funds are withdrawn too soon, before age 59½, there is a ten percent excise tax. If the participant waits past age 70½,

he must pay a 50 percent excise tax on the shortfall and, if more than $150,000 is taken annually, he may be subject to a 15

percent excise tax.

There is need for a well-conceived payout scheme and advance planning is a necessity.

Example: George Grimes, a widower with children, has accumulated $2 million in a profit sharing plan by

the time of his death at age 72. He leaves the $2 million in trust for his grandchildren.

George had received minimum distributions since age 70½, and his remaining grandfathered amount is $1

million, which was greater than the present value of his $112,500 threshold, which had increased by then

to $912,607 ($175,000 x 5.2149 = $912,607).

Further, federal and state income tax rates had increased. George‘s estate is sufficient to place him and

his family in the highest income, estate, generation skipping, etc., tax brackets after applying all available

exemptions, exclusions, deductions and credits. (No additional surcharges or local income taxes are

added.

TOTALS

VALUE OF GEORGE GRIMES' PLAN $2,000,000.00 $2,000,000.00

LESS EXCESS ACCUMULATION TAX

(15 PERCENT X $1,000,000)

- 150,000.00 1,850,000.00

LESS FEDERAL ESTATE TAX

(55 PERCENT X $1,850,000)

- 1,017,500.00 832,500.00

LESS GENERATION SKIPPING TAX (GST)

(55 PERCENT X $ 633,871)3

- 348,629.00 433,871.00

LESS FEDERAL & STATE INCOME TAXES

(50 PERCENT X $633,871)4

- 316,935.00 166,936.00

BALANCE TO GRANDCHILDREN 8.3 CENTS PER DOLLAR

166,936.005

3 The direct transfer to grandchildren which 'skips' children for GST purposes is $982,500 since the excess accumulations tax is

not deductible when calculating the GST. 4 $633,871=$483,871 plus $150,000 -- the excess accumulation tax is not deductible for purposes of calculating income taxes

due.

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George‘s planning problems are not unique. Clients who accumulate sizeable plan retirement funds are faced with many

choices, traps and pitfalls. Since profit sharing accounts can grow to unlimited size, tax considerations are paramount.

In a nutshell, all retirement plan distributions are fully exposed to income taxes, estate taxes and a variety of punishing

excise taxes. If a participant wants to preserve the integrity of retirement accumulations for self and family, there is a

serious need for planning and liquidity. This is where the creative life agent can be of assistance.

ALTERNATIVES TO INDEFINITE TAX DEFERRAL

At some point, an optimum account balance may exist. If an existing capital sum will accumulate to $1.1 million or more by

a desired retirement age, it may be time to cease plan contributions.

Example: Harry Hogan, age 50, has a profit sharing account balance of $275,000 (the employer is

contributing $15,000 annually to the account). He plans to begin payout as late as possible at age 70½

when at least minimum distributions are required.

At eight percent interest compounded annually on $275,000, over $1.1 million will be available when Harry

starts receiving payments from the plan. Using current annuity rates, his lifetime income would then

exceed $150,000 annually. Thus, a modest $275,000 present fund value will likely expand with the simple

passage of time into a fund exposed to the taxes previously mentioned.

What happens if, in lieu of continuing to receive a plan contribution, Harry freezes his plan participation

and takes a $15,000 executive bonus dedicated to premiums on a personally-owned life insurance policy

premium?

Policy values and proceeds can be income and excise tax sheltered. If a third party correctly owns the

contract, there will also be an estate tax advantage. And, consider split dollar, death benefit only or

nonqualified plan designs which, depending on Harry‘s circumstances, as alternatives to the executive

bonus arrangement.

A qualified retirement plan is a government-sponsored tax shelter. There is a tendency to continue plan contributions

beyond a common sense level when alternatives may be indicated.

Directing Future Deferrals to a Life Insurance Policy It may not be psychologically or financially wise to suspend plan contributions. The participant can benefit from the

creditor-proof shelter of a retirement plan. Or, he may need the forced savings element of regular plan contributions.

When a continuing pattern of contributions is indicated, consider applying a portion of these amounts to a life insurance

policy owned by the plan account. At risk amounts will be income and excise tax-free. If a sub-trust holds the policy, death

proceeds should also be estate tax free.

Selecting the Plan Beneficiary It is very important to select the correct plan beneficiary in the event of death. Typically, participants will choose as

recipients of remaining plan funds a marital trust, a surviving spouse or (if there is no spouse) a family trust for children. If a

marital trust becomes the beneficiary, it will pay any income and excise taxes due.

Conversely, a spouse as direct beneficiary may elect to defer income taxes on payout till age 70½ and, in some cases, may

defer excise taxes until his death.

Because of these tax (and other personal planning) differences, caution must be used before electing or changing a

beneficiary designation.

Agents may find a niche as plan distributions consultants. Many clients participate in qualified retirement plans, and profit

sharing plans offer exciting insurance options. However, the overly successful plan account can generate significant tax

and financial problems for clients. Life insurance and annuities, with their strengthened tax positions can be the alternative

to the problem, and provide numerous sales opportunities for the savvy financial planner.

THE ROLE OF LIFE INSURANCE IN ADVANCED FINANCIAL PLANNING

5 If George had designated his children as beneficiaries and the GST were not an issue, the balance to children would be

$341,250 , or 17 cents per $1.00.

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It has been said that people don‘t buy life insurance; they buy the way life insurance makes them feel. Life insurance is a

tool to help clients accomplish individual or corporate objectives. It is not an end in itself. The focus must always remain on

the client‘s objectives.

Example: Consider a benefits manager soliciting advice from an agent. The benefits manager asks if a

Section 162 bonus plan, a group universal life plan, a split dollar plan, a death-benefit-only plan or a SERP is

the best plan. Without knowing the corporate objectives, and what the company will accomplish with the

chosen plan, an agent cannot provide the answer.

In this situation the desired benefit was a pre- and post-retirement death benefit, with no additional

retirement income. Once the company had a clear view of its objective, design and implementation of

the plan became a simple mechanical process. It is important to focus on the corporate objectives for the

plan.

Life insurance is not always the best solution to a client‘s needs. To accomplish objectives, both insured and noninsured

solutions should be considered. Short-term needs for life insurance seldom exist.

If clients are successful, they generally will need coverage for liquidity. If they are not as successful, they will need

coverage for dependents. Therefore, virtually all planning should involve permanent insurance.

Life insurance has several attributes that make it a unique planning tool:

It is the only asset that can create instant wealth if death occurs prematurely.

Life insurance is a tax-favored investment that can have a very attractive after-tax rate of return.

Life insurance is systematic—once implemented, it tends to stay implemented. While this is often a positive, it can also

be a negative. Some plans stay in place long after the policyholder‘s need has disappeared or changed.

Due to tax law changes, life insurance is one of the few tools that allows families to move substantial assets between

generations without prohibitive transfer tax consequences.

A quality life insurance contract is a contract of faith between the insured and the insurance company. Subject to

minimum guarantees and state regulation, an insurer has broad latitude concerning how the policyholder will be

treated in future years.

Items such as equity between old and new policyholders and update programs are not contractual rights under the

policy. This structure is necessary in a contract that potentially will remain in place for nearly a century.

Life insurance is often misunderstood as a financial instrument. It is complex, confusing and virtually impossible for even the

most sophisticated buyers to evaluate without outside assistance. However, properly used, life insurance can be immensely

valuable.

ADVANCED PLANNING —A NEEDS APPROACH

The market is filled with agents who find a great solution and go out looking for prospects with the right problem. The

planning process should instead focus primarily on determining the prospect‘s real needs, and serving those needs.

Life underwriters have five basic benefits (not products) to provide to clients:

Pre-retirement death benefit;

Post-retirement death benefit;

Supplemental retirement income;

Voluntary deferral opportunity; and

Disability income.

Seven tools are available to provide those benefits:

Direct policy ownership;

Executive bonus (Section 162) plan;

Split dollar plan;

Death-benefit-only plan;

Supplemental executive retirement plan (SERP);

Disability income plan.

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In many cases, a client‘s needs can be satisfied by using one or several of the tools noted above. The challenge is to

determine which tool best solves the client‘s problem.

Example: Consider a corporate client with a president that feels his group term life insurance plan was

very expensive for the benefits being provided. The president wants to provide a more extensive death

benefit for his executive group without increasing the present value cost of the plan.

An executive bonus plan, a split dollar plan, or a death-benefit-only plan financed with life insurance could

provide the desired benefit. Once the tools that could accomplish the client's objectives are identified,

there are a number of key questions to be answered.

Is it necessary to keep life insurance proceeds out of the insured‘s estate? If this is an important issue, split

dollar insurance (or perhaps a bonus plan) is indicated, but a death-benefit-only plan probably is not

appropriate. If security of the benefit is important, the death-benefit-option is not appropriate unless a

rabbi trust was used.

If current cash flow is an issue, split dollar is less desirable due to its higher front-end premium.

Ask questions and identify a plan design that meets the needs of the client. Once the best solution has been identified,

communicate to the client how the plan solves the problem rather than focusing on the numbers. Following this type of

systematic approach places the focus on solving the client‘s real problems, rather than simply searching for attractive

illustrations.

AGENTS SALES PRESENTATIONS

It has been noted that there are two basic rules to remember when preparing sales presentations:

Rule 1: Keep it simple. Clients understand very little about life insurance.

Rule 2: Never forget Rule 1.

Example: A large Fortune 500 manufacturing company client had a split dollar plan for 15 years. The client

and his life insurance agent decide to restructure the split dollar life insurance plan.

As a result of tax changes, leveraged rollouts no longer made sense. The agent proposes that the plan be

changed to a 15-year pay-in with a partial surrender rollout, and it is agreed upon.

During the meeting to restructure the plan, the client‘s personnel officer has administered this plan for over

10 years but is confused by one term. He wants to know exactly what split dollar is.

He is told by the agent that split dollar life insurance works as a split ownership arrangement of a

permanent life insurance policy. He comments that it is the first time in 15 years that he understands what

the plan was all about—and he administered it for ten years.

People understand much less about life insurance than agents realize.

Policy Illustrations Computers give the insurance agent the opportunity to generate enormous quantities of totally unintelligible data in a

remarkable short period of time. Contrary to popular belief, a pile of computer printouts does not constitute a presentation.

Simple illustrations for two or three sample individuals provide much more meaningful information than composite

illustrations. Composite illustrations and detailed support materials may be useful for advisors, but do not rely on the

numbers to sell the concept.

If the presentation includes a lot of life insurance jargon, the client will not be able to understand the proposal. Even terms

such as cash surrender value and mortality cost are completely foreign to most buyers. And, most life insurance buyers will

never admit that they have absolutely no idea what an agent is talking about.

Provide a truly balanced view of the technical issues related to the proposed plan. This increases credibility. Do not just

identify issues—explain them and document them in writing. Be precise. When showing illustrations of values that are not

guaranteed, make sure the client understands this.

In sum:

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Provide a detailed description of the client‘s need being addressed.

Provide a simple description of potential solutions, both insured and noninsured, and the rationale for choosing the

solution or solutions you are recommending.

Provide a detailed description of the solution being recommended, with simple illustrations. Use older individuals in

illustrations; it makes the illustration shorter.

Provide a statement of benefits to be gained from implementing the suggested solution.

Provide the numerical support for the concept presented; however, if the rest of the presentation is effective, clients will

seldom feel the need to delve into that detail.

Illustration Issues In the past there were two kinds of life insurance—nonparticipating and participating. In nonparticipating policies, all the

policy values were fixed in the contract. As a result, illustrations were not an issue.

In participating contracts, dividends were projected based on the current dividend scale. The projections were generally

prepared on a conservative basis by the home office, and the life insurance agent had no ability to modify the illustrations.

In practice, due to rising interest rates and favorable mortality experience, virtually every life insurance company managed

to outperform its illustrations.

Interestingly, on a relative basis, most companies performed roughly the way their illustrations said they would.

Today's market is much more complex—universal life, microcomputers, and creative actuarial science. As a result of these

advancements, illustrations have lost much of their value, for a variety of reasons:

Inappropriately stated assumptions. This relates to companies that project interest rates in excess of what their

investment portfolio can support. It is fairly easy for life insurance companies to pay high interest rates on new policies,

there is no money in the contract. The concern is not what interest rate is going to be credited on the policy at issue,

but rather what will be paid 20 years later.

Inappropriately unstated assumptions. Some companies project annual improvements in mortality. An industry rumor is

that one companies project five percent annual improvement in mortality. If that premise is followed, by year 20 no

one dies, and insureds start rising from the dead every year thereafter!

Taxation of the life insurance company. Some companies currently are not paying income taxes, and they therefore

assume they will never pay taxes in the future. The only way this is likely to occur is if the insurance company goes

bankrupt.

Variables. Illustrations have been created where the cash surrender value increases by as much or more than the

stated interest rate, multiplied by the beginning cash value, and adding the premium payment. If the cash value rises

by the amount of the entire investment earnings, where does the insurance company find the money to pay mortality

costs and expenses?

There are a number of policies that are designed to perform especially well at certain

ages or for a certain duration. For example, some policies seem to perform much

better assuming death at age 80 than at earlier or later ages.

In many policies, it is unclear what basis will be used for computing policy values. There are many variables to be

determined:

Will value be based on actual company experience, linkage to an outside index, or based on pure company

discretion?

Will investment earnings be based on a current money or portfolio approach?

Are investment earnings presented gross or net of expenses?

None of these approaches are necessarily wrong, but it is difficult to compare policies that use two different

approaches. Likewise, if one policy has separately stated expenses, and the other policy takes expenses out of

investment earnings, it is unfair to compare these two policies using the same interest assumption.

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Illustrations to life expectancy. Illustrations that stop prior to self-destruction of the policy are also a problem. Today, it

seems essential to illustrate policies at least to life expectancy, and preferably to age 95 or 100.

Projected values are not guaranteed. Finally, and most important, many illustrations do not clearly explain that

projected values, number of vanish years, etc. are not guaranteed and are subject to change.

Illustrations can be very useful in understanding life insurance proposals. Illustrations can show how the ownership and

premium flows of the plan are structured, as well as the economics of the rollout transactions. However, illustrations are

invalid to project future values or to compare contracts from different companies.

Life insurance is just like any other investment. An analysis must start with the history and track record of the insurer,

company operating statistics and the company‘s commitment to its existing policyholders. In the final analysis, life

insurance is simply a contract of faith between the insurance company and the policyholder.

A key issue to address when analyzing life insurance providers is to seek a company with a demonstrated willingness to

take care of its old policyholders. The new policyholder of today becomes the old policyholder of tomorrow.

THE FUTURE OF LIFE INSURANCE

The market for properly structured quality life insurance is very strong. Market trends are moving back to basics: executive

bonus plans, group term carve-out, split dollar insurance, buy-sell agreements, financing of executive benefits and estate

liquidity—all the needs agents have talked about for years. Public perception of permanent life insurance has greatly

improved.

Today, quality life insurance products are very competitive in the current financial marketplace and generally are well

received.

However, there are other issues to consider:

Future legislation could have a negative impact on life insurance.

There may be a backlash against illustrations that are not actually achieved.

Reappearing vanished premiums, increasing level premiums and death benefits that do not grow as projected will

certainly cause many agents and companies to incur the wrath of their policyholders.

Corporate disenchantment with large cases that are not being properly administered will continue to grow.

If the current economic environment continues, expect to see many policyholders disappointed with current

assumption life insurance contracts. Short-term investment philosophy is not consistent with a long term life insurance

investment.

There are number of emerging issues:

Negotiated commissions are becoming more common in the larger cases.

More and more policyholders that buy large amounts of insurance are diversifying among several insurers.

As the tax and economic environment continues to become more complex, specialization will become essential to

properly serve policyholders in the advanced markets.

The market dictates the need to design flexibility into plans. Agents should expect potentially retroactive changes to tax

laws, and volatility in the economic marketplace.

AN INFORMAL PENSION UTILIZING TAX-DEDUCTIBLE LIFE INSURANCE

The Executive Retirement Bonus Plan (ERBP) also commonly referred to as the Section 162 Bonus Plan or Selective Executive

Retirement Plan (SERP) is one of the premier life insurance concepts available today.

With Executive Retirement Bonus Plans clients get leverage. Due to the Tax Reform Act of 1986, bonus plans took on new

power.

EXECUTIVE RETIREMENT BONUS PLAN

An Executive Retirement Bonus Plan is an informal pension plan using life insurance. It‘s a perfect vehicle for setting up a

stand-alone or supplemental retirement plan for the executives of most small, closely held corporations.

The client does not have to be a corporation to take advantage of an ERBP, though there are more advantages for

corporations than there are for sole proprietors and partnerships. In short, Executive Retirement Bonus Plans are a tool to set

aside dollars for long-term retirement needs.

Most executives would structure their own retirement program to:

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Be tax deductible to the corporation;

Allow the corporation to select individuals to be included;

Allow the corporation (rather than the government) to decide how much money it would contribute to each person;

Have limited government regulations;

Be tax-deductible;

Accumulate money under the plan as tax-sheltered funds; and

Provide tax-free retirement income to those key individuals covered by the plan.

The executive objective of creating a retirement plan that is tax-deductible, tax-sheltered while it is accumulating, and tax-

free at retirement is possible. The funding vehicle for the plan is life insurance. Life insurance has many advantages over

other investments in this form of retirement plan. Insurance offers tax-sheltered growth, tax-free income, disability waiver of

premiums, tax-free death benefits, favorable rate of return, liquidity, safety, tax-free dividends and more.

There is no other funding vehicle that provides as much leverage and power. Compared to virtually all other retirement

plans, the executive receives more income and other benefits with an Executive Retirement Bonus Plan.

Highlight for the executive the features of an Executive Retirement Bonus Plan:

1. IRS approval of the program is not required.

2. Deposits are tax-deductible under Section 162 of the Internal Revenue Code covering ordinary and necessary

business expenses.

3. Unlike a deferred compensation agreement or salary continuation program, the employee controls the assets.

4. The employer does not carry these assets on the corporation books.

5. The employee carries these assets on his personal financial statement.

Employee control of the

assets is a key point. Unlike

a deferred compensation

agreement, the corporation

with an ERBP takes a tax

deduction when monies are

deposited for the executive.

The corporation realizes the

tax deduction immediately

instead of upon retirement

of the executive.

The cost to the corporation is the same as it would be under a qualified

pension or profit sharing plan contribution to the executive.

The major difference between the two plans is that under a nonqualified

deferred compensation arrangement, whether it‘s a salary reduction or salary

continuation arrangement, the corporation defers the tax deduction now

because it owns the assets.

In essence, the corporation holds the assets for the executive‘s retirement. At

retirement of the executive the corporation realizes the deduction, and the

executive then pays his income tax on that money.

Employees understand this type of bonus plan. There are many benefits of the Executive Retirement Bonus Plan—it

improves employee morale, lowers turnover, enhances employee loyalty and improves employee productivity. It builds

equity tax-free, provides funds for emergencies through loans, retirement funds are tax-free, post-retirement benefits are

income tax-free and pre-retirement death benefits are income tax-free.

And, with a waiver of premium provision, it is possible to complete and fund the program in event of a disability.

Example: Consider that a corporation pays Major Executive a bonus. Major then turns this bonus over to

pay annual premiums on a life insurance policy.

he bonus is taxable. Dividends and/or gross up bonuses are used to pay the taxes.

At retirement, Major receives tax-free income and at death, Major‘s family receives tax-free death benefits.

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Most employers look at the lists of benefits and find them hard to believe. Not only does the Executive Retirement Bonus

Plan offer more, it costs no more than current programs. In fact, compared to a qualified plan, it costs less. There are low

administrative costs, due to the fact that little paperwork requires processing.

When comparing the ERBP to a qualified pension or profit sharing plan, there are points to consider. Companies that have

in excess of 100 employees typically structure a qualified pension or profit sharing plan. Most of the companies that are

attracted to the Executive Retirement Bonus Plan are small, closely held, and employ under 25 employees. These company

administrators desire a plan structured for just a few key people.

A company administrator or president is interested in cost savings for the company and increased return for the key

employees, such as himself. Government regulations and tax considerations drain the income that is designed for the key

employee.

When an agent illustrates that an ERBP allows tax deductions for its funding, uses corporation money, uses the corporate

checkbook to fund it, sets up the retirement plan outside the corporation, gives the corporate executive complete control

over the assets, and allows money to be moved out of the corporation in a favorable way, most executives want to know

where to sign.

The timing is right for this type of product. The Tax Reform Act of 1986 was probably the single best thing that has ever

happened to this industry as it relates to marketing this concept. Executives generally are in a lower tax bracket, with their

companies in a higher tax bracket.

This tax differential makes this type of program even more enticing to the corporation. It makes good business sense for the

corporation to take the deduction now, rather than have the business executive—who is in the lower bracket already—tax

the deduction now. However, tax brackets are not the key. The key is using the corporate checkbook. The executive tax

effect is minimal because those taxes are covered with dividends, loans, or bonuses.

Unreasonable Compensation

When structuring an Executive Retirement Bonus Plan, there are problems that may arise, such as encountering:

An individual who is uninsurable, and/or

An individual whose compensation is technically unreasonable and who cannot be bonused any additional dollars.

In this case, use a salary reduction arrangement that effectively does the same thing by having the executive reduce his

income by depositing it into this program. However, few individuals fit the requirement for unreasonable compensation

and this is not a major issue in structuring an Executive Retirement Bonus Plan.

USING AN EXECUTIVE RETIREMENT BONUS PLAN

For illustration purposes, review the situation below:

Example: Consider the corporate executive Mr. Major Executive. Major Executive is a valued 33-year-old

Silicon Valley executive whom the corporation has rewarded with a $30,000 bonus.

Major, already in the 35 percent tax bracket, will have to pay taxes of $10,500 on this bonus.

However, with an Executive Retirement Bonus Plan, Major will receive tax-free dividends that will lower his

tax cost over time. In the early years, the corporation could gross up the bonus to even cover these few

dollars until dividends exceed the tax.

By retirement time, Major will have made $780,000 in deposits to the plan and will have a post-retirement

pool of $1,976,630. Project that at age 60, he will begin borrowing $160,000 from the policy each year after

recovering his cost basis through use of dividend withdrawals.

There is enough cash value in the policy to do this for 20 years, at which time there is $1,916,089 of cash

value left in the policy at age 80. Projected cash values at age 92 still show $229,714. If death occurs prior

to 92, there will be no phantom income tax problem. During the 26-year period of contributions, he will

have had to pay $63,336 out of pocket in personal taxes or slightly more than eight percent of the total

bonuses received.

To carry the illustration further than age 92, by taking a slight retirement income reduction, the values at

age 100 would show $135,000 annual income and a residual cash value at age 100 of $1,306,683.

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Also, if there is concern about the fact that loans are involved in this transaction, then an alternative

retirement payout option could be presented in the form of a single premium immediate annuity (SPIA).

The annual payout starting at age 60, using a joint and one-half to survivor option, would be $198,788.

This approach would provide partially tax-sheltered income. In addition, the SPIA approach locks in the

payout, which eliminates adjustments to income to meet the changing needs of the client. Combinations

of both loans, withdrawals, and a portion of the values under an SPIA payout arrangement are another

possibility.

It should be apparent that the choices are many. Another advantage in the scenarios outlined above—Major Executive

will have significant funds available should he wish to borrow for any reason prior to normal retirement and will not have any

pre-retirement withdrawal penalties as in qualified plans.

PARTICIPATING DIVIDEND PAYING CONTRACT

There are a number of reasons for using the participating dividend paying contract. The tax-free dividend used to cover

the tax generally exceeds the premium between five and eight years (for most companies). In fact, most companies will

actually pay out more in dividends than projected.

The following illustration is based upon a $30,000 annual contribution for a period of 26 years at an interest rate of nine

percent:

Typical Pension and Profit Sharing

Plan

Executive Retirement Bonus Plan

Tax deferred deposits $ 780,000.00 $ 780,000.00

Balance at Age 60 $2,949,970.006 $1,976,630.00

Total for sole use of executive? NO. Distributed among plan

participants

YES

Death benefit at age 80 Actual amount employee has

contributed.

Continues to compound from

balance at age 60 if plan is not

borrowed against.

Restrictions on withdrawals? YES. Withdrawals cannot be

made later than age 70½

NO

EBRP Illustration

The government requires the executive to deposit no greater percentage of his compensation than the rest of his

employees to a qualified plan. Major Executive has determined that $30,000 is all that his company can comfortably

allocate this year to a retirement plan. Since Major‘s salary, as a percentage of total payroll, is 31 percent of the company

payroll, then 31 percent of $30,000—or $9,300—is all that Major will receive for his share of the $30,000 deposit.

With an Executive Retirement Bonus Plan, Major could receive all $30,000. In 20 years, Major would receive $2,093,140 more

tax-free income through use of the Executive Retirement Bonus Plan

A major concern for most executives considering structuring an Executive Retirement Bonus Plan is the initial amount of

taxes to be paid. It is important to look at the rate of return.

Example: As noted in the ERBP Illustration, investing $63,336 over eight years, Major Executive will generate

a 14.58 percent internal rate of return that will yield $1,976,630 by age 60.

In addition, his tax-free death benefit, at age 60, will be $4,144,356. Of course, it is also possible that the

dividends could be greater than projected.

It is even more advantageous to the executive if he does not use the dividend to offset this tax liability.

Rather, he should continue paying the taxes until age 60 because his retirement account will have grown

to $2,577,231, which would provide an additional $40,000 of annual tax-free income. His cash-on-cash rate

of return would be 13.43 percent.

Of course, the company could pay his taxes for him, in addition to the bonus. In that case, his return would

be infinite and his tax-free retirement value would be $2,577,231.

6 After plan administration fees are deducted.

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ERBP, IRAS AND 401(K) PLANS

It is important to evaluate how the Executive Retirement Bonus Plan compares with IRAs and 401(k) plans. Many individuals

believed they were secure because they had opened IRAs or other retirement accounts. But tax laws put restrictions on

how much tax-deferred income can be put away. The government also taxes the income accumulated at retirement.

There is a very important

difference with Executive

Retirement Bonus Plan—

unlike company plans that

have fund or trust

managers, the executive

controls the asset.

Unlike most pension and profit-sharing plans, the Executive Retirement Bonus

Plan does not require special accounting or approval from the IRS. As long as

the money contributed to the plan is not unreasonable compensation, there is

no concern about how much is deposited.

Loans and Borrowing With an Executive Retirement Bonus Plan, cash values are also available to the executive for loans. The executive can

always borrow money out of the equity for emergencies, education, or other opportunities.

Unlike the typical corporate pension or profit-sharing plan that limits borrowing up to $50,000 with a tightly controlled

repayment schedule, the Executive Retirement Bonus Plan places no restriction on borrowing. There is no repayment

schedule, and the loan interest can be added to the outstanding loan balance. The executive can borrow at a current

fixed interest rate and not have to repay the loan.

Excess Accumulation and Excess Distribution Income Taxes Consider the impact of excess accumulation and excess distribution income taxes, commonly referred to as the "success

tax" (Internal Revenue Code Sec. 4981 A). Penalties may be assessed for accumulating retirement funds in excess of

current IRS specifications, and these penalties are assessed in addition to the normal income tax. Penalties and taxes may

amount to 50 percent of the funds accumulated.

Highlights for ERBP Plan Participants

Can include only the covered participant.

Contributions to the plan are tax deductible to the company.

Contributions accumulate tax-free.

Contribution amounts are not affected by other retirement plans such as profit-sharing, pension, 401(k) and IRAs.

Retirement income could be received under preferential tax law.

Funds are available before age 59½ without penalty.

Participant owns and controls the assets outside the company.

The Executive Retirement Bonus Plan is one of the best plans available today for business owners and corporation

executives.

CHAPTER 3: TRANSFERRING DISCOUNTED DOLLARS

VALUATION DISCOUNTS

Most people overpay gift and estate taxes. There are several valuation discounts available to taxpayers that are regularly

ignored when determining the fair market value of assets transferred during lifetime or at death: fractional interests, lack of

marketability, minority, and non-voting discounts can be combined.

In addition, family corporations, partnerships and limited liability companies (LLCs), created to hold assets being transferred

within the family group, can be used to "manufacture" discounts for transfer tax purposes while achieving important non-tax

goals for family members. Further discounts are inherent in the very nature of tax-motivated arrangements such as Grantor

Retained Annuity Trusts (GRATs) and Grantor Retained Income Trusts (GRITs).

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The all too common over-valuation of business interests in buy/sell agreements also requires attention.

Government Regulation Extensive tax changes over the years have eliminated many of the effective tools that were available to preserve family

businesses and protect other illiquid assets from tax liability. Estate and GRIT taxes are paid by the wealthiest strata of

Americans. There are, however, several techniques available to taxpayers that permit substantial asset holdings to pass to

younger generation family members without invoking the full brunt of these taxes.

Real estate values are no longer at the levels achieved in the boom times of the late 1980s. IRS field examiners reviewing

gift and estate tax returns recognize this and are accepting aggressive lower appraisals of realty.

Family businesses must consider the price-to-earnings rations being paid by purchasers when seeking an appraisal. Note

that appraisers are asked to give an opinion of what a willing buyer would pay for the property or business under

consideration: no options, no seller financing, no earn-outs; cash on the barrel-head.

Professional Appraisal It is very important to obtain a professional appraisal of assets being transferred. A proper appraisal is required for gift or

estate tax reporting purposes. Even if the gift does not require current reporting (because it is sheltered with the annual gift

tax exclusion), it is important to obtain a professional appraisal to substantiate the exclusion being claimed.

The IRS can re-value all of an individual‘s lifetime gifts when auditing his estate tax return (even if the statute of limitations

has run out on the gift tax liability).

Although spoken of—and accounted for—separately, most discounts really are for only one thing: lack of marketability. It is

the inability to readily dispose of the interest being gifted or inherited which has the greatest impact upon its value to a

willing buyer. No willing buyer would purchase a non-marketable asset for the same price that he would purchase an

equally valuable asset, which he could sell at any time and realize its full value.

It is important that the

appraiser of the non-

marketable interest being

transferred include

appropriate empirical

evidence to justify the

discount claimed.

The lack of a public market in which these family assets are regularly bought

and sold significantly decreases their fair market value. Studies by the

Securities and Exchange Commission review discounts in connection with

securities whose transfers are restricted by Rule 144.

Discounts of 23-24 percent are reported in those analyses. Of course, the

discount for interests in closely held businesses should be greater than those

for publicly traded securities, which were the basis of those studies.

This same discount for a lack of marketability is available when determining the value of a fractional interest in property. For

example, the fair market value of an undivided one-half interest in a $100,000 parcel of realty should not be $50,000 but

some lesser amount to take account of the unwillingness of any right-minded buyer purchasing such an interest and not

being able to easily dispose of it without having to go through the expense and delay of a judicial partition proceeding.

In a private letter ruling, the IRS accepted the cost of the partition action as the appropriate discount for lack of

marketability of a factional interest in property. However, that ruling ignores the long delays incident to this type of court

case and assumes that fractional interests in the property are immediately marketable just by paying a legal fee.

Some additional discount was surely warranted for the fact that it can take two or three years for the partition suit to work its

way through the courts before the owner of the fractional interest has anything he can easily sell. Discounts for fractional

interests in property often fall in the 15-20 percent range, but have been noted to go as high as 40-50 percent. This

discount should be incorporated by the professional appraiser in his valuation report.

Although it often appears

to overlap with the lack of

marketability discount, a

minority interest discount

has long been recognized

as appropriate in valuing

an interest in a business.

Since the owner of less than a majority interest in a business cannot control

the day-to-day or long-range managerial decisions, establish executive

compensation, control efforts designed to promote growth or force a

liquidation to reach the corporate assets, the fair market value of that interest

is less than its proportionate share of the entire business enterprise.

This discounted interest may be worth less than its ―liquidation‖ value. This

discount is also based upon the specific facts and circumstances applicable

to the minority interest being valued.

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The appraiser must look at the entire rights possessed by the holder of the minority interest. These rights are based upon

applicable state law, the business entity‘s articles and by-laws or partnership agreement and any restrictions on

shareholders‘/partners‘ rights contained in related agreements.

Obviously related to the minority discount, but often treated separately by the courts when determining value for tax

purposes, is the discount inherent in the nonvoting nature of the asset transferred if the transferred interest has no right to

vote on any of the day-to-day and long-term management issues, etc.

Although state laws may give nonvoting shareholders the right to vote on a very limited number of actions (such as the

liquidation of the company), they do not allow the nonvoting shareholders to cause that liquidation. Thus, an additional

discount is often allowed when the asset being transferred is nonvoting stock, a limited partnership interest or a nonvoting

membership interest in an LLC.

Previously the IRS regularly asserted a family attribution principle, holding that minority discounts should not be available for

intra-family transfers if the collective ownership of the members of the family represented control of the company. The

courts have squarely rejected this interpretation requiring that the identity of the ―willing buyer and willing seller‖ be known

to be family members. In Revenue Ruling 93-12, the Service abandoned its application of family attribution principles in the

area of minority discounts.

Transferring an asset to a corporation with voting and nonvoting shares, a similarly structured LLC or a limited partnership

effectively can 'manufacture' discounts for intra-family gifts. Instead of giving an interest in realty to family members, it may

be more appropriate to transfer the property to a family limited partnership in which the older generation retains a one

percent general partnership interest (thereby holding onto the exclusive control over the business activities of the

partnership) while making gifts of the nonvoting limited partnership interests to younger generation members or a trust for

their benefit.

These gifts of limited interests in the partnership will qualify for discounts for lack of marketability, minority interest and the

nonvoting nature of the assets transferred. The funding of this type of two-tiered business entity with fractional interests in

property allows a double dipping of discounts when valuing the business before the application of the other mentioned

discounts.

Leveraging Leveraging of benefits to taxpayers—the ability to give more real value in the guise of a discounted valuation—encourages

tax-efficient arrangements involved in lifetime gifting programs. The gift tax annual exclusion of $10,000 per donee (which

can be double to $20,000 with a spouse‘s consent) is a renewable resource in that it is available each calendar year. The

utilization of Crummey trusts allows inclusion of many more donees for tax purposes than actually will receive substantial

benefits from the gift.

The tax court‘s Cristafani decision emphatically rejected the IRS attacks on "naked" or "dummy" Crummey powers.

Taxpayers have the potential for shifting significant wealth from the top estate tax bracket (which approaches 65-70

percent in some states) to a zero percent bracket. Some industry leaders indicate that an appropriate reform would be to

limit annual exclusion gifts to no more than three donees and prohibit their use for any gifts to trusts.

Utilization of the $600,000 unified credit exemption equivalent should also warrant consideration. The ability to move so

much wealth at depressed asset values represents an extraordinary opportunity for estate planning. Gift splitting allows up

to $1.2 million to be shifted down to younger generations without the current payment of any federal gift tax.

And, this unified credit is in addition to the annual exclusion gifts. Rather than saving unified credits to reduce estate taxes

when he dies, a client should be advised to use those credits to the fullest extent during his lifetime. Not only are the

currently depressed values used as the measure of the tax base but all post-gift appreciation and income earned on the

gifted property will be excluded from the donor‘s taxable estate.

Older generation members should be more willing to transfer value to younger family members if control over the gifted

asset or business enterprise can be retained through the continued retention of the voting shares or general partnership

interest. With these retained powers the older generation member can still control the day-to-day operations of the

business, fix salaries of employees (including himself and other family members) and make the ultimate decisions regarding

the sale/liquidation of the business.

The transfer of equity often gives younger family members a feeling of truly being an integral economic part of the business;

they are transferred from employees to owners.

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Planning Devices

In addition to these discounts in valuing transferred assets, certain planning devices are useful for tax discounting. For

example, Grantor Retained Annuity Trusts (GRATs) are irrevocable trusts in which the grantor retains an annuity interest; that

is, the right to receive a fixed sum for a certain number of years. At the end of the fixed number of years, the trust properly

passes to younger generation family members.

The longer the term and/or

the greater the amount of

the annuity retained by the

grantor, the smaller the

taxable gift.

This arrangement provides significant gift tax leverage in that the amount of

the current gift is measured by the value of the property transferred to the

trust, reduced by the actuarial value of the retained annuity payments due to

the grantor.

These retained annuity payments are valued according to IRS tables. If the

grantor dies within the trust‘s fixed term, the full date of death value of the

trust property will be included in his taxable estate; any gift tax paid when the

GRAT was established will be credited and any unified credit will be returned

to reduce the estate tax liability.

Conversely, if the grantor survives the trust‘s fixed term, then the trust assets will

belong to the younger generation members and all appreciation in value

during the trust term will avoid estate and gift taxation.

With the ability to have assets valued at a low level, the annuity which those assets can generate for the grantor is greatly

increased. It is not unusual to see GRATs structured for annuity payments of 12 percent or 15 percent of the initial value of

the trust‘s property. Given the low applicable federal rates which are used by the IRS tables to determine the discount for

the retained interest of the grantor, these arrangements can produce gift tax discounts of 80 percent or 90 percent of the

trust‘s value without having to extend the GRAT‘s fixed term beyond eight or ten years.

Similar arrangements to the

annuity trust, or GRAT, are

available for a donor's

personal residence. This

funding vehicle is known as

a Grantor Retained Income

Trust, or GRIT.

Instead of retaining an annuity interest the grantor retains the rent-free use of

his house for a fixed term of years. This right to use the trust property is valued

as if the grantor had retained the income from the property. The discount for

a five-year term is about 32 percent, for a 10-year term about 56 percent and

for a 15-year term about 73 percent. If a client transferred a $1 million home

into a 10-year GRIT, the amount of the gift made to the trust‘s remaining

beneficiaries would be only $438,000.

If the donor doesn‘t survive the 10-year term, he is no worse off than if he had

done nothing. If outlives the ten-year term, the house and all appreciation in

its value since the GRIT was established will be exempt from his taxable estate.

At the end of the GRIT‘s term if the donor wants to continue living in the home,

he must pay fair market rent to his children or grandchildren. This is a hidden

advantage that many estate planners ignore: each rent payment from the

older generation to the younger reduces the potential gross estate subject to

taxation when the donor dies.

Although the landlord will have to pay a current income tax on the net rental

income (after depreciation, maintenance expenses, etc.) income tax rates

are significantly lower than gift/estate tax rates and thus additional funds are

being siphoned off to the younger generation at a reduced over-all tax cost.

Another alternative to having to pay rent on his own house is for the donor to purchase the house back from the GRIT right

before the end of its fixed term. That transaction can be accomplished without any recognition of capital gains by the

trust; the donor can have his house back (together with all of the tax advantages available only for principal residences

such as the overage 55 exclusion and tax-free roll-overs); and the trust has money or the donor‘s promissory note secured

with a mortgage on the house for distribution to the younger generation members.

It is not recommended to transfer an entire business residence to only one GRAT or GRIT. It is more prudent to spread the

mortality risk and have one-third of the property transferred to each of three separate, layered trusts.

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Example: A 60-year-old donor could transfer one-third of his house to GRITs for 5, 10 and 15 years

respectively and still enjoy a 54 percent gift tax discount. If he dies 6 years out, the family circumvents IRS

taxes on one-third of the estate.

The mortality risk can be further reduced by transferring one-third of the house into the name of the donor‘s

spouse and then having each of them set up three layered GRITs. Also, the donor can claim an additional

discount for the fractional interests in property with which he is funding the trusts.

Additional Discounts Over-Priced Buy/Sell Agreements

Over-priced relates to the price set by the agreement for the purchase of a deceased shareholder‘s or partner‘s interest in

the business. This arrangement is not uncommon because the parties to the agreement want a particular price for their

interest in the business upon their deaths.

Fully funding the buy/sell agreement with insurance so that each shareholder can feel comfortable that his family will get

that inflated amount of insurance as payment for his share in the business. It is more efficient to get the insurance to a

shareholder's family in a more tax-efficient manner—through an irrevocable trust, for example—and give his interest in the

business to his fellow shareholders. At least that way there can be some discussion of the true value of the business. The

estate‘s representative will then fight for the lowest possible value for the decedent‘s shares (including appropriate

discounts for the loss of this key man to the ongoing business).

Liquidation

The second discount is really an adjustment to the value of a corporation for the income tax cost of liquidating the entity. If

a corporation holds assets whose cost bases are significantly less than their fair market value, then the sale of those assets

upon the liquidation of the company will cause a capital gains taxable event at the corporate level.

Obviously any willing buyer of the shares would adjust his offering price to take account of this not-so-hidden liability. The

IRS does not readily acknowledge the validity of this adjustment.

Any business broker can testify to the difference in value between a sale of a company‘s stock and the sale of its

underlying assets.

No matter how well implemented gifting programs are leveraged with these several discounting techniques, they rarely

solve the whole problem. The net result of the leveraging is simply that the problem has not been getting worse as quickly

as it would have been if no leverage had been structured.

Adequate insurance protection continues to play a critical role in the over-all structure of a properly crafted estate plan.

Consider the various funding and leveraging options:

There are many uses for life insurance in planning for the orderly succession in the ownership and management of

family-owned businesses.

There is tremendous value added to a family‘s total wealth when illiquid assets do not have to be sacrificed at a forced

sale.

There are ways to structure funds for a GRAT or GRIT donor who will miss the opportunity to save significant tax dollars by

dying sooner than expected.

The need to equalize the shares of a parent‘s estate passing to the children is not solved just by shifting the family

business to the one child who is active in its day-to-day operations, no matter how efficiently that business transfer has

been structured.

New money still has to be added in order to achieve the kind of equality of treatment for the business and non-business

children which most parents desire.

Life insurance is still the only way to make sure that there is enough cash to achieve these important goals.

And there is no amount of advance planning to correct the surprises in estates—new-found spouses and/or children of the

decedent who come out of the woodwork. An executor can best deal with these surprises if extra cash is available to

make these problems go away.

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In Sum

Don‘t pay more taxes than required.

Use annual exclusions and the $600,000 unified credit while available.

Use them efficiently: take full advantage of valuation discounts for fractional interests in property, lack of marketability,

minority and nonvoting interests and built-in capital gains tax liability. Don‘t forget tax-driven trust structures like GRATs

and house GRITs.

Don‘t over-price and over-fund buy/sell agreements.

Don‘t ignore the continuing role which life insurance plays in protecting family wealth and achieving long-term family

financial goals.

CHAPTER 4: LIMITED LIABILITY COMPANIES AND LIMITED LIABILITY PARTNERSHIPS

NEW VEHICLES FOR BUSINESS LIFE

Both the Limited Liability Company (LLC) and Limited Liability Partnership (LLP) are fast growing forms of business enterprise

in the United States. The driving force behind these enterprises is the protection of the owners from personal liability in a tax-

advantaged enterprise.

LLCs are currently approved in nearly every state and statutes are pending in the states that have yet to enact LLC laws.

The LLP got off to a later start than the LLC and LLP statutes have been enacted in less than one-half of the states. In many

ways, the LLP is more attractive than the LLC, and professional partnerships, like law firms and accounting firms, will wait for

approval to reorganize as LLPs.

LLCs and LLPS encompass many of the traditional business insurance issues and also have some unique implications that

need to be examined for clients. Despite all of the enthusiasm about LLCs and LLPs, little discussion has occurred to date

concerning the life insurance opportunities provided by these organizations.

What is an LLC? An LLC is a limited liability company. The LLC provides an attractive hybrid of other organizational forms. The greatest

attraction is the limited liability granted to all owners, otherwise available only in corporations. Properly structured, an LLC

provides the advantages of partnership pass-through income taxation.

Note that LLCs have become important even though S corporations also provide limited liability and pass-through taxation.

However, partnership pass-through tax treatment has significant advantages over S corporations.

The owners of an LLC, known as members, receive a statement of business income, deductions, credits, and other tax items

that can be used on individual income tax returns. The members will not, on the other hand, have liability for business

operations passed through to them. It is important to remember that the LLC, itself, is liable and individual members who

personally perform or supervise employees in negligent acts will also retain responsibility for their own actions.

LLCs are authorized by and organized under various state's laws. The laws contain complex details and the flexibility of the

members to choose their organizational formalities will vary from state-to-state. Virtually all LLCs are formed with the goal of

realizing advantages of partnership taxation.

The members must organize and operate within certain guidelines to achieve this goal. The IRS has provided a Revenue

Procedure that provides safe harbor rules to receive a favorable ruling on the taxation of an LLC. These guidelines provide

a unique business insurance opportunity: more or less a mandatory buy/sell agreement.

An LLC can be suitable for a number of different business and service activities. It can be used for a start-up business or an

existing business could be converted to an LLC. Note that this can result in significant legal costs and, in the case of

converting a corporation, significant capital-gains taxes. The LLC may also be used as the vehicle for an estate freeze of

family business or investment assets.

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What is an LLP? An LLP is a limited liability partnership. The LLP has been authorized in a growing number of states and its main purpose is to

allow all partners in a general partnership to receive liability protection. The assets of the partnership, itself, remain at risk.

One advantage of the LLP

over the LLC is the fact that

existing general

partnerships can be

changed to an LLP with a

simple amendment of their

current partnership

agreement and the

required state filing without

changing most

characteristics of how the

business is operated.

Forming an LLC requires a new operating agreement and may result in

significant structural and operating changes within the firm.

Many law firms are waiting for state approval of the LLP to avoid the

significant structural changes required by reforming as an LLC.

Typically, the business owner who sets up an LLP as an estate-freeze vehicle

will be in his late 40s to mid 50s or older, married, have several children and/or

grandchildren, a sizable estate that will ultimately be subject to federal estate

taxes and has business or real estate holdings that are appreciating in value.

The client probably will be a professional (CPA, physician, attorney) or an

entrepreneur in business with one or more active investors (including family

members). The client may also be an investor in a high technology business,

real estate or oil and gas investment, or other risky joint venture.

The LLP allows this client to transfer wealth using the valuation discounts available to family partnerships and will protect

family members from personal liability for business or investment ventures that present a liability risk.

State Requirements There are some state-specific aspects of LLCs and LLPs, and it is important to know where a client‘s LLC or LLP is registered.

Some states have a greater concern than others for protecting liability claimants.

In some states, liability insurance or certain minimum capitalization is required. For example, Pennsylvania requires LLPs to

carry liability insurance on each general partner of $100,000 up to a maximum of $1 million. It may be necessary to work

with a specialist in this area to design the complete business insurance plan.

Some states exempt the general partners of LLPs from all liabilities. Most provide a liability shelter for personal injury claims,

but do not extend the protection to business debts or contractual liability. This may not be the hindrance it appears,

however, since most lenders will not make financing available to a closely held business, regardless of its organization,

without the personal guarantees of the deep pocket owners.

Some states provide extra requirements or restrict the liability protection extended to professional practices. For example,

the bar authorities of the various states may get into the action by regulating the use of liability shelters by lawyers licensed

to practice in the state. A good example of this is the state of California where attorneys are not permitted to operate in

LLC status.

INSURED BUY/SELL AGREEMENTS FOR LLCS

LLCs are closely held enterprises. The reasons buy/sell agreements work for closely held businesses are well known, and

those reasons apply to LLCs as well as the traditional entities. A key to success in forming LLCs is the opportunity for

partnership federal income taxation. The IRS released a procedure for receiving favorable rulings on this status and this

procedure provides requirements that create unique opportunities for buy/sell agreements.

One of the possible requirements for a favorable ruling is the lack of continuity of LLCs at the death, disability, or retirement

of a member. Another requirement is the restriction on the free transferability of an LLC ownership interest.

These characteristics are specific to partnerships and not corporations, and ensure partnership tax treatment. Some state

statutes specifically impose these requirements while other states permit flexibility in these key operational characteristics.

However, in either event, buy/sell agreements must be made to ensure continuity of the LLC at the death or disability of a

member.

This appears to be a mandatory buy/sell agreement for the LLC. The business has to terminate by the agreement. This

means that the departing member or the deceased member‘s estate must be given fair value for the ownership interest or

a costly fight could result.

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The restrictions on transfer

will cause problems any

time a member dies, or

wishes to withdraw. Like

many closely-held

businesses, the lack of free

transferability will result in

no outside market for an

LLC interest.

The interest must be sold to the remaining members or be liquidated by the

LLC. Without a planned buy-out, the remaining members and the departing

member must rely on an ad hoc purchase and sale agreement.

They may be bargaining on a non-level playing field. For example, the

executor of a deceased member‘s estate may be bargaining with surviving

members who have exclusive knowledge of the LLC‘s value.

Or, the departing member may be disabled and in need of cash. From the

standpoint of the remaining members, there will be no funding in place to

cash out the departing member.

The LLC may have difficulty financing the purchase price since lenders will be

wary of the limited liability of the owners. The members may have to

personally guarantee the LLC loans. This sort of defeats the basic purpose of

the LLC.

If the buy-out collapses the remaining members, who have unanimously consented to continuing the LLC after a

termination event, may be forced to liquidate the LLC. This adds up to is a buy/sell agreement fully funded with life

insurance—a win-win scenario.

All departing members or their estates will receive a fair price for their membership interest. The remaining members can

agree to continue the business as a going concern without the threat of liquidation or burdensome debt obligations.

LLC clients can be guaranteed their goal of favorable partnership taxation since the operating agreement will provide for

the requisite termination events and transfer restrictions to preserve the closely held ownership and the control of the

current members.

Structuring the LLC Buy/Sell.

Clients can use either the traditional cross-purchase or entity purchase means of buying a membership interest in an LLC at

a member‘s death, disability, retirement, or termination of employment. An entity purchase will in essence be a liquidation

of the interest of a member.

The partnership tax treatment creates some complex issues that will affect the design choice. These issues never have

been understood well by the general public, even though partnership taxation has been largely unchanged for many

years. The insurance funding design will be successful only if these issues are addressed.

The agreement should be properly structured with appropriate life insurance funding regardless of the chosen design. One

frequent problem in designing the agreement is the failure of the planning team and the client to work together.

Remember, the planning team is greater than the sum of the individual parts. All members of the team will make more

compensation in commissions and fees if the process is completed and followed up with necessary periodic reviews. There

is more personal satisfaction that the client‘s interests were served.

Someone must lead the process, such as life underwriters who drive the process from beginning to end7. The American Bar

Association once found that 90 percent of buy/sell agreements were initiated by life underwriters.

The Entity Buy/Sell in an LLC.

Most traditional types of buy/sell agreements can be used. An entity buy/sell will involve the LLC as the purchaser

(technically the liquidator), of a departing member‘s interest. The LLC should be the owner and beneficiary of all life

insurance funding the entity buy/sell. Only one policy with a face amount equal to the purchase price will be required per

member.

7 A caveat: Although very rewarding, this can be a time-consuming and labor-intensive process. The agent is often

responsible for pushing the other advisors, not just the client, when they procrastinate. The agent will have to answer tough

questions about the life insurance product. These are questions the attorney or other advisors must ask if they are serving

the client‘s interest, and the agent will have to stand aside and let the other advisors resolve complex tax issues and draft

the documents. If an agent suspects that any of the client‘s current advisers lack the expertise for their role in the plan, the

agent must recognize this and either get the client the support he needs or refer him to a new adviser.

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The highly specialized and complex partnership tax treatment is one of the goals of the client in forming an LLC. This tax

treatment provides a unique advantage in an LLC (or partnership) entity buy/sell approach when comparing entity

purchase agreements of LLCs to corporate stock redemption agreements. The advantage is lower capital-gain taxes if the

members choose an appropriately designed entity buy/sell agreement funded with life insurance.

When an LLC receives the proceeds of life insurance, for example, when a member dies and the death benefits from the

policy funding the entity-purchase are paid to the LLC, its members are allowed a pro rata increase in their cost bases in

the LLC. The members can provide in their operating agreement that the basis will be allocated only to surviving members.

This is known as a special allocation and requires appropriate language in the LLC operating agreement. This special

allocation gives the remaining members a higher cost basis and will reduce the capital gains tax they will have to pay if

they sell their LLC interests in the future.

Cross-Purchase Buy/Sell Agreements for LLCs

The traditional cross-purchase approach is also available for the design of the LLC buy/sell agreement. This agreement

should be funded by having the members purchase, own and be the designated beneficiary of life insurance on the lives

of other LLC members that they will be required to buy-out on a termination event.

As an alternative, a trusteed buy/sell approach could be used where the trustee will hold all the policies and see that the

cross-purchase is carried out. The trusteed approach can be designed to limit the number of life insurance policies to one

per owner and will be more attractive if the LLC has many members. The benefit of the cross-purchase approach is that all

purchasers will receive a full purchase price cost basis for any LLC interest that they purchase.

The buy/sell agreement potential for this marketplace is largely untapped. Most practitioners have just begun to

understand what the LLC is and how it fits in the business and estate planning arena. However, clients appreciate the

advantages of the LLC, which has become a fast-growing form of enterprise.

The unique termination requirements and transfer restrictions that most LLCs impose provide a natural buy/sell agreement

market. It is recommended that an agent focus marketing efforts on these organizations, use knowledge about the insured

buy/sell agreements and apply it to the unique circumstances of LLCs.

These businesses should have a designator, ―LLC,‖ in their business title. All LLCs will be required to do some mandatory filing

with the state agency with jurisdiction over new business filings. These filings are public information and list the names of the

organizers of the business.

BUY/SELL AGREEMENTS FOR LLPS

Many of the details about buy/sell agreements for LLCs apply to LLPs. The LLP is a general partnership with unique liability

protection for the partners. It qualifies for partnership tax treatment unless the design and operation of the LLP is unusually

misguided.

An LLP is a closely-held enterprise and the lack of continuity and restrictions on the transfer of a partnership interest are

included in the partnership agreement. Without a buy/sell agreement fully funded with life insurance:

A withdrawing partner or the estate of a deceased partner cannot be guaranteed a market for the partnership interest

at a predictable price;

The remaining partners or the partnership will not have the necessary funds to provide the purchase price; and

The business itself may be in jeopardy as a going concern. The buy/sell agreement for an LLP can be structured as an

entity purchase or with a cross-purchase approach.

The life insurance funding and tax considerations should be identical to the LLC approach discussed previously.

Life Insurance in an LLC or LLP as an Employee Benefit Tax-advantaged employee benefits generally do not work for the owners of an organization that has pass-through taxation.

Members of an LLC or partners in an LLP will be treated as self-employed for the purposes of employee benefits.

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They are not able to participate in group term life insurance with the usual tax advantage. Members of an LLC or partners

in an LLP typically do not find split dollar or nonqualified deferred compensation plans appealing from a tax standpoint. As

owners of an entity with pass-through tax treatment they are taxed on premiums paid by the business without the additional

cash to pay the tax.

However, these life insurance compensation plans can be used to help recruit and retain key employees other than

members or partners. For instance, LLC will often be formed and operate under the direction of one or more non-member

managers.

Premiums for Section 79 group term life insurance plans covering non-owner employees of an LLC or LLP will be deductible

by the business. Note that a Section 79 group term life insurance plan may be important for one or more owners—even

without tax advantages—if they are otherwise unable to obtain individual insurance due to impaired health.

Premiums paid by the LLC or LLP on life insurance funding split dollar or nonqualified deferred compensation plans for non-

owner employees will still be nondeductible and taxed to members of the LLC, or partners of an LLP, in proportion to their

ownership interests.

If a significant life insurance employee benefit should be provided to a key non-owner employee of an LLC or LLP, a

Section 162 bonus life insurance plan should be considered. All of the premium bonuses should be deductible by the

business and will not cause adverse tax consequences to the members or partners.

Of course, the Section 162 bonus plan will not provide the restrictions of a split dollar or nonqualified deferred

compensation plan and will be less effective if an important goal is to retain the key non-owner employee.

Solving the Problems Caused by Insurance Stock Redemption Plans

Agents working with buy/sell agreements are aware of the significant problems associated with stock redemption buy/sell

agreements. First, stock redemption agreements generally are a tax problem for a family corporation.

If the corporation is a regular (not an S) corporation, a stock redemption may result in a dividend if the family members of

the redeemed shareholder hold stock in the corporation. Family members are spouses, parents, children, and

grandchildren. A dividend is subject to double tax if the corporation making the redemption has accumulated earnings

and profits.

This result could also occur in a family S corporation if the corporation used to be a regular corporation and has retained

earnings and profits left over from its pre-S days. The same result will occur if the estate of deceased stockholder is

redeemed if family members who also hold stock are beneficiaries of the estate.

Example: Familyco, Inc. is owned by Mr. Jones and his three children in the following shares: 70 percent by Mr.

Jones and 10 percent each by his three children. If the corporation is worth $1 million, let‘s assume that Mr. Jones‘

share is worth $700,000. A stock redemption buy/sell agreement is in place and fully funded with life insurance.

At Mr. Jones‘ death, his estate is left to his three children in equal shares. When Mr. Jones dies, the insurance

proceeds are payable to Familyco, which is required to redeem his stock for $700,000. If Familyco has $700,000 of

current and accumulated earnings and profits, the estate will receive the $700,000 as ordinary income and pay

$277,200 in income taxes.

The normal basis step-up for Mr. Jones‘s stock does the estate no good because this dividend is ordinary, not

capital gain income. The rules that apply to the tax treatment of corporate stock redemptions are highly technical

and the facts should be examined by the client‘s tax advisor.

Note, however, that this negative result generally occurs only in a family corporation. Another problem is the corporate

alternative minimum tax or (AMT). The AMT can cause a problem when the life insurance death benefits are paid to a

regular (not an S) corporation.

hese proceeds are treated as a tax preference in the AMT rules. Again, the rules are very technical and will cause extra

work for the client‘s CPA since a separate set of books will be needed to maintain records of the AMT tax basis of

corporate-owned life insurance.

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Example: Use Mr. Jones from the previous example and assume Mr. Jones‘s stock redemption agreement was

funded with $700,000 of term life insurance. (This is not a normal recommendation, but it simplifies the calculation.)

At Mr. Jones‘s death, the corporation receives the $700,000 death benefit free of ordinary income tax as we all

know.

However, 75 percent of the proceeds become a preference against the corporate AMT. At a 20 percent AMT rate,

Familyco may have to pay as much as $105,000 in extra tax as a result of the receipt of the death benefits. This

leaves Mr. Jones‘s stock redemption 15 percent underfunded. Combined with the dividend discussed earlier, this

would make the Jones family very upset with their advisors.

These scenarios illustrate that LLCs and LLPs can be used as a vehicle to relieve insured stock redemption agreements from

tax complications. First, there may be many stock redemption agreements formed under prior tax law when the design

made good sense. Second, a stock redemption agreement may still have advantages if structured to benefit from the

effect of the redemption and the life insurance outside of the corporation. This is where the LLC and LLP fit in.

Converting the stock redemption agreement

One method involves converting the stock redemption agreement to the traditional cross-purchase buy/sell agreement.

The problem here has to do with another tax problem known as the Transfer-for-Value Rule. To convert a stock redemption

to a cross-purchase agreement, the life insurance funding the agreement would have to be transferred out to the

appropriate shareholders.

his could be a taxable dividend, but that is only part of the problem. The transfer of life insurance for valuable

consideration could result in the death benefits becoming taxable. That is, the purchaser will get cost basis equal to the

purchase price and additional premiums paid. The IRS requires an additional reduction in basis for the annual cost of

insurance and this basis adjustment is not favorable or reasonable.

Although there are exceptions to the Transfer-for-Value Rule, none of these exceptions would be useful in directly

converting a corporate stock redemption agreement to a corporate cross-purchase arrangement.

The exceptions are as follows; no adverse income tax result will occur if a life insurance policy is transferred for valuable

consideration to:

The insured individual;

A partner of the insured;

A partnership in which the insured is a partner;

A corporation in which the insured is an officer or shareholder; and

A grantor trust (basically a trust where the grantor is treated as the owner for income tax purposes).

The exceptions make it clear that life insurance can be transferred for valuable consideration to a partnership or the

insured‘s partners. Since an LLC is a tax partnership an LLC or LLP can be used as a transfer vehicle for a life insurance

policy.

To extricate a client out of insured stock redemption agreements, the stockholders of the closely held corporation need to

be in a partnership to avail themselves of this opportunity. The partnership can either be in existence before this plan is

implemented or can be formed specifically for this purpose.

Don't summarily recommend a partnership formed merely to hold the life insurance as an asset, for a couple of reasons.

Thus far, there is only one private letter ruling approving this naked life insurance partnership approach and the taxpayer‘s

attorney made the claim that it was a valid partnership under state law and the IRS merely accepted, without examining,

this claim.

Another problem with the unfunded partnership approach is that the partnership has no cash flow to make required

premium payments.

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If the partnership that will be used is an operating business or real estate investment, an LLC or LLP is the obvious choice

where liability is a concern. There are many ways to design the structure of this plan. Numerous private rulings have been

issued approving the various approaches that have captured the imaginations of the business owners and their advisers.

In one approach, the life insurance funding the stock redemption agreement is transferred from the corporation to the LLC

or LLP. This life insurance can be used by the LLC or LLP to purchase the stock from the estate of a deceased stockholder.

A new agreement will also be needed to terminate the stockholder‘s LLC or LLP interest.

The LLC or LLP can be used to match the design of a stock redemption agreement. Once stock is purchased by the LLC or

LLP, it can be distributed to the remaining members or partners since distributions from LLCs or LLPs are much easier and less

costly to make from a tax standpoint than they would be from a corporation.

In another approach, distributions of the life insurance policies are made directly to the members or partners of the LLC or

LLP. These policies are then used to fund a cross-purchase agreement of the closely held corporate stock and the LLC or

LLP interests. Of course, the policies have to be distributed properly.

The shareholder/members/partners receive the policies on the lives of the parties that they are required to buy-out. Some

of the private rulings take this a step further. To limit the number of policies to one per owner (or the same number that

would exist in a stock redemption agreement) the partners contribute the policies to a grantor trust. This trust is designed to

carry out a trusteed cross-purchase arrangement.

A LIFE INSURANCE LLC OR LLP IN THE ESTATE PLAN

Many industry leaders have trumpeted the demise of the irrevocable life insurance trust. There is a growing trend, driven by

the need for flexibility, to place life insurance in a family partnership rather than a trust. How then does the LLC or LLP fit in?

These vehicles become important when an active business or risky investment assets are placed in the LLC or LLP with the

life insurance coverage on the senior generation family member or members.

This is the usual recommendation. The active business or investment assets will fund the premium payments. If the LLC or

LLP is properly designed, the business or investment assets will be transferred through valuation discounts to the junior

generation family members. The life insurance can be included with minimal estate tax consequences to the insured.

A major concern with the irrevocable life insurance trust is the loss of control by the insured; the gift is truly irrevocable, and

the terms cannot be changed by the insured without adverse tax consequences. This concern over control is solved by a

life insurance LLC or LLP. An LLC or LLP will be formed and active business or investment assets will be placed in the entity.

A senior generation family member who is contemplating a life insurance purchase retains the managing member or

partner status. The LLC or LLP ownership interest is held by the insured parent (or grandparent) and the family heirs (the

children and/or grandchildren). The LLC or LLP applies for, owns, and is the beneficiary of the policy on the parent's or

grandparent‘s life.

The policy premiums are paid for out of LLC or LLP assets, or the insured makes additional contributions to the partnership

when premiums are due. At the death of the insured, the LLC or LLP can continue or be determined. The proceeds are

distributed or allocated to the capital accounts of the partners based on the provisions of the partnership agreement.

Gift Tax Considerations

The heirs receive their LLC or LLP interests as a gift from their parent or grandparent. The gifts of the partnership interest

qualify for annual gift tax exclusion to the amount of $10,000 per donee, because the LLC or LLP interests are current

transfers of property creating a present-interest gift.

Any value of the gifted interest that exceeds the annual exclusions can be sheltered from tax by the donor‘s unified credit.

Properly structured, these gifts should be discounted significantly for lack of marketability and inability of the donees to

control the LLC or LLP. Estate Tax Considerations Since the parent or grandparent makes gifts of the partnership interests (and maybe some subsequent gifts of premium

payments), he or she reduces the gross estate by the amount of the gifts. In addition, the full death benefit from the policy

is not included in the gross estate.

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Provided the policy is payable to, or for the benefit of, the LLC or LLP, the insured‘s estate includes only the estate‘s

percentage of ownership interest in the business. The insured‘s ownership interest can be kept to a minimum by making the

children the majority interest members or partners. Of course, the managing control will be retained by the senior

generation to preserve the flexibility the client requires.

IMPORTANT TERMINOLOGY

AMT -Alternative Minimum Tax.

AMTI-Alternative Minimum Taxable Income.

APB-Accounting Principles Board.

Carry Back-Claiming of refund of taxes that have been paid.

COLI-Corporate Owned Life Insurance.

Donee- Recipient of a gift.

EITF-Emerging Issues Task Force.

FASB-Financial Accounting Standards Board.

GRATs-Grantor Retained Annuity Trusts.

GRIT-Grantor Retained Income Trust.

LLC-Limited Liability Company.

LLP-Limited Liability Partnership.

P&L- Profit and Loss.

Profit & Loss Analysis-Profit & Loss (P&L) analysis is similar to a cash flow analysis-the elements are tracked separately as they

are expected to be reflected on the corporate books, and then are combined on a present value basis

Sinking fund-Earmark investments as the source of funds for benefit payments when due.

Rabbi Trust- A Rabbi Trust is a grantor trust, the assets of which remain company property that can be reached by company

creditors in the event of insolvency or bankruptcy. Executives are not taxed until they receive payments from the trust. The

company is not allowed a tax deduction for contributions to the Rabbi Trust until payments are actually made to the

executive; also, trust income is currently taxed to the company.

Secular Trust- The assets in a Secular Trust are truly separate property and cannot be reached by company creditors.

Unfortunately, executives are taxed currently on their non-forfeitable, vested interests as contributions are made to the trust,

and on trust income. For this reason, secular trusts are not very popular. However, the corporation or the trust could make

annual payments to the executive to cover the increased tax liability. The company is allowed a current tax deduction for

contributions to the trust when the amount is includable in the executive's income, and it pays no tax on trust income.

Self-funding - Pay all benefits out of cash flow at the time they come due.

SERP- Supplemental Executive Retirement Plan.

Sinking Fund- Earmark some investments as the source of funds for benefit payments when due.

CHAPTER 5: ETHICS ISSUES FOR LIFE AGENTS

Whether you are a Life and Health Agent or a Property and Casualty Agent, the ethics you employee in your sales

approach reflects not only on you but also the companies you represent.

Although some ethical issues are personal issues of conduct or level of integrity, other issues become violation of state laws.

In selling annuities it is critical that the highest standard of ethics be adhered to in making recommendations for products.

Are you properly outlining the risk factors involved in some choices the client may make?

Are you properly explaining the sales and administrative charges or are they being buried away in the fine

print.

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Do you know enough about the products that you are marketing not to misrepresent to the consumer?

Are you adhering to all Security Exchange Commission Rules regarding variable products?

Are you making sure that a prospectus is being delivered, when required by law, to the consumer prior to

him or her making a decision?

Are you adhering to all NASDA rules and regulations?

In this chapter we will be reviewing the ethical issues that face all agents in the conflict of earning a living verses serving the

customer‘s needs.

I. PERCEPTIONS OF ETHICS

A. Ethics is "the discipline that deals with what is good and bad or right and wrong or with moral duty

and obligation."

B. Ethics can be approached from two levels:

1. The philosophical level-dealing with the possibilities

2. The practical level - dealing with the reality of every day experiences

C. Ethics is a person's perceptions or convictions about what is right or wrong.

D. Living by the Golden Rule is often the role model for sound religious ethics.

E. Society, through laws and accepted behavior patterns, imposes guidelines on how to deal with other

people.

II. ETHICS FOR INSURANCE AGENTS

An insurance agent is anyone who solicits insurance or who aids in the placing of risks, delivery of policies or collection of

premiums on behalf of an insurance company.

There are four areas of ethical responsibility for an insurance agent:

Responsibilities to the agent's insurer are covered under the concept of agency. The agent owes his or her insurer

the duties of good faith, honesty and loyalty.

The agent's day-to-day activities are a direct reflection of the insurer's ―image‖ within the

community.

Responsibilities to policy owners require the agent to meet the needs of the client, provide quality

service, maintain loyalty, confidentiality, timely submission of applications and prompt policy

delivery.

Responsibilities to the public require the agent to maintain the highest level of professional

conduct and integrity in all public contact in order to maintain a strong positive image of the

industry.

Responsibilities to the state require the agent to adhere to the ethical standards mandated by his

or her state.

III. ETHICS FOR INSURANCE BROKERS

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A broker's primary responsibility is to his or her client, meaning that, the broker is charged with

the responsibility of finding the appropriate insurance coverage and markets to meet a

client's needs.

Brokers are held to the same standards of care as agents in terms of their responsibilities to the general public and

the state.

IV. CHARACTERISTICS OF A PROFESSIONAL

The word "profession" means an open or public declaration, but has come to mean any calling requiring academic

training and specialized knowledge.

Insurance agents and real estate agents are considered professionals because their business meets the following

six commonly accepted characteristics of a profession:

1. Commitment to high ethical standards;

2. Concern for the welfare of others;

3. Mandatory licensing and training;

4. Formal participation in an association or society;

5. Acting with integrity and objectivity; and

6. Public acknowledgement as a profession.

FIDUCIARY RESPONSIBILITIES

The two fundamental principals of an agency relationship are power and authority and the high standards of conduct

expected of the agent as a fiduciary

The concept of Agency Agency is a legal term used to describe the relationship between two parties, in which the principal authorizes the agent-

to, perform certain legally binding acts on the principal's behalf.

The main components of an agency relationship are:

1. An agent is an agent of the principal, not the third party with whom the agent deals.

2. An agent has the power to bind the principal to a legal contract and its terms.

3. The acts of the agent, within the scope of authority, are the acts of the principal.

Agency can be created by:

Appointment or Explicit contract;

Estoppel is the principal allows someone to act in a way that would induce a third party to believe that a

person was an agent of the principal;

Ratification-the principal later sanctions the actions of an authorized principal.

Before an individual can act as an agent he or she must have the power and authority to take action. There are three

types of agency authority:

Express authority is the authority the principal intentionally and expressly gives the agent.

Implied authority is the authority that the principal intends for the agent to have, but does not expressly

give.

Apparent authority arises when principal permits an agent to perform acts neither expressly nor implicitly

authorized.

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The limits to an insurance agent's authority are usually defined in his or her agency agreement and the agent must work

within those perimeters.

The ethical significance of these limits to an insurance agent's authority is that an agent must serve the needs of the insurer,

live up to the contract and operate within the scope of his or her authority. By entering into this contractual relationship

with the insurer, the agent becomes a fiduciary of the insurer.

The Agent as a Fiduciary An individual whose position and responsibilities involve a high degree of trust and confidence is known as a fiduciary. An

insurance producer has a fiduciary relationship with his or her insurer with regard to the following:

Loyalty to the insurer-A producer must at all times act in the insurer's best interest, not his or her interests of

personal gain.

Skill and performance-An agent has the duty to carry out his or her actions with the care and skill because

an agent represents the company to the public and must act in such a manner as not to create a

tarnished image for the company.

Full disclosure

An agent is obligated to fully disclose all information he or she has that may affect the insurer and

its ability to do business. Full disclosure is critical during the application and claims handling processes.

Follow up

An agent has the obligation to act promptly in all matters regarding the insurer's business, including the

duties to forward completed applications as quickly as possible.

Handling of premiums

By law, payment to an agent is payment to the insurer. The agent has a fiduciary duty to turn over all funds

given to him or her as specified in the agency agreement.

Avoiding conflicts of interest

An insurance agent cannot serve two principals at the same time. An agent has the ethical duty to make

full disclosure to an insurer in regard to any other related service he or she provides and receives

compensation.

Responsible solicitation

An agent has the duty to solicit only business that appears to be good and profitable to his employer.

Competitive integrity

An agent cannot misrepresent or in any way defame a competitive agent or insurer. An agent must

compete only on the basis of products and services he or she can provide.

The principal is responsible for the acts of its agents and owes the agent three duties:

1. Payment of compensation in the form of commissions or fees

2. Employment in return for meeting production responsibilities.

3. Indemnification or reimbursement for damages or expenses incurred in defending claims for which the

agent may be liable.

Legally, a broker acts as an agent and representative of the applicant. However, when an insurer gives a policy for

delivery to an insured, the broker becomes the agent for the insurer. Should payment of a premium be involved, payment

to the broker is considered payment to the insurer.

Although, the broker technically represents the client, the ethical and fiduciary standards that apply to an agent also apply

to a broker.

Employing sound ethics principles permits producers to serve both the insurer and client may consider serving both the

insurer and the client without creating a conflict of interest.


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RESPONSIBILITIES TO CONSUMERS & CLIENTS

Agents fulfill their ethical responsibilities to their insurers by providing the appropriate Products to meet their consumer‘s

needs, as well as, quality service. Making sure that the consumer understands both the products and underwriting process is

a critical responsibility of the agent.

The insurance agent can serve the needs of the prospect by providing the prospect with the types of policies that best fit

his or her needs, in the amounts he or she can afford. In order to accomplish these goals, the agent should:

1. Obtain the required knowledge and skills to accomplish the needed objectives.

2. Educate the prospect or policy owner about the products and plans being recommended by the

agent.

Additionally, the agent should be committed to, not only selling the product, but to quality service both before, during and

after the sale.

This means:

1. Educating the prospect about insurance products and the underwriting process;

2. Treating all information obtained with confidentiality;

3. Disclosing all necessary information so that both the insurer and the prospect can make an

informed decision.

4. Keeping the prospect informed through out his application.

5. Showing loyalty to prospects, clients and insurer

Service begins with the application.

1. It is the agent's duty to see to it that the application is completed both accurately and completely.

2. To properly explain why required information is necessary.

3. How the underwriter will evaluate the information.

4. That accuracy and honesty are imperative in the application.

5. A prospect should be informed that failure to disclose information could result in denial of claims or

policy cancellation.

6. It should be explained that a binder provides temporary protection while the policy is being

underwritten and is not a guarantee that the policy will be issued

The agent or broker is responsible for service before and after the sale, which includes:

1. Maintaining accurate client records;

2. Maintaining complete and accurate records of all business transactions;

3. Knowledge of new coverage and products.

4. Availability and changes in products offered in the marketplace;

5. Assistance with claims processing;

6. Reviewing clients' existing policies;

7. Suggestions on updating coverage on existing policies;

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Ethically an agent or broker must respect the confidential information provided by the client and must assist the client in the

following areas:

1. Selecting the most appropriate policy;

2. Understanding the basic features of the policy; and

3. Evaluating the costs and features of similar plans.

Ethical standards must be used in evaluating risk management.

Risk management is the process of decision making that protects assets and income against accidental or

unintended loss by identifying, measuring, controlling and treating the elements that contribute to the risk.

Two basic risk management rules are:

1. The size of the potential loss must be within the scope of the resources available

to the insurer.

2. The possible benefit must exceed the costs of the potential loss.

The risk manager, agent or broker should:

1. Identify and measure the loss exposures and hazard.

2. Determine the amount of money available to pay for the potential loss; and

3. Identify various risk management techniques to deal with potential losses.

Risk management techniques include:

1. Avoidance-averting a loss by refusing to take part in something that could cause a loss.

2. Transfer- shifting risk to another entity through a contract or hold-harmless agreement;

3. Loss control-reducing the frequency or probability of loss through loss prevention or lowering the

severity of loss through loss reduction.

4. Retention-holding part of the risk through deductibles or all of the risk through self-insurance.

5. Insurance-transferring risk to an insurance company.

RESPONSIBILITIES TO THE GENERAL PUBLIC

Because unethical behavior by agents and brokers can effect the whole industry, the integrity and professionalism of their

conduct is of utmost concern to all.

The public‘s perception of the insurance industry is gagged by the behavior of both insurance agents and brokers and their

commitment to professionalism is the key to the public‘s trust of the industry.

Insurance is something that is used by many, but yet, many are unaware of how insurance works and benefits them.

The ethical agent has a duty to provide the consumer with fair and honest information of the policies and services he or she

has to offer.

The Insurance Industry is regulated by both the state and federal governments with the state departments of insurance

issuing rules and regulations, licensing insurers, agents and brokers, suggesting laws to legislators, examining insurers'

financial operations, approving policy forms and overseeing marketing practices.

A code of ethics is employed by the industry to guide corporations, agents and brokers.

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Insurance producers continuously face complex issues dealing with skill, competence, and levels of knowledge required of

professionals.

Professional conduct often dictates that the client‘s need be put ahead of the agent‘s needs, be dedicated to the

insurance industry and offer quality plans from quality insurance companies. The agent should develop high ethical

standards, adhere to integrity and serve the interests of the client.

The public's perception of the activities of an individual agent or broker shapes the perception of the industry as a whole.

Skill, competence, professionalism and moral integrity shape public perceptions.

THE ENFORCEMENT OF ETHICS

Each state regulates the ethical conduct of insurance producers by creating rules, regulations and legislation to protect the

consumer.

States through an Insurance Commissioner or Director to oversee the marketing activities of agents regulates the Insurance

industry.

The National Association of Insurance Commissioners (NAIC) proposes model legislation to:

Encourage uniformity in state insurance laws and regulations; assist officials in administering laws and regulations,

help protect the interest of policy owners; and preserve state regulation of insurance.

Most states have laws that protect consumers against unfair trade practices such as:

Mis-representation and/or false advertising, coercion, improper placement, or rebating.

States also prohibit unfair claims methods and practices, such as:

1. Misrepresenting policy provisions to claimants or insureds;

2. Failing to deliver a determination on a claim within a reasonable time;

3. Failing to settle claims promptly and fairly;

4. Attempting to settle a claim for less than could be reasonably expected;

5. Engaging in activities that result in a disproportionate number of complaints;

6. Failing to provide necessary claims forms; or

7. Unfair claims practices.

Insurers are prohibited from engaging in underwriting or rating that is based on race, religion, and national origin or redlined

areas.

In most states the punishment for unethical practices ranges from fines to license suspension and revocation.

Once a license is revoked, normally a one-year waiting period is required for re-application. And in most states a bond will

also be required.

People who set high personal and professional goals of honesty, integrity, loyalty, fairness and truthfulness will never have to

deal with the penalties set by state governing bodies.

MAKING DECISIONS ETHICALLY

When trying to make decisions ethically, ask yourself the following questions:

1. To whom do I have obligations?

2. Whose rights must I protect?

3. What rules apply to this situation and should be observed?

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4. Would I be proud of my decision and advocate this action again?

Even the most ethical producers are often time confronted with unhappy clients who feel their claim was improperly

handled. Producers can help to protect themselves by:

1. Maintaining high standards of personal ethics;

2. Having errors and omissions insurance;

3. Being diligent when recommending policies and placing business;

and

4. Being committed to continuing education.

Competition and production quotas often encourage producers to look to an increased bottom line, regardless of what it

takes.

An agent‘s moral values and standards should help to resolve this inner conflict and guide them to the right decision.

END OF COURSE WC60319

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