Chapter 4 - Life Policy Provisions & Options

Provisions

Benefits provide in policy as part of contract without additional charge. May be referred to as a clause.

Options

Provisions that provide choices which must be specified by policyowner.

Entire Contract Clause

• Provision describes parts of life insurance contract.

• Entire contract consists of policy, riders (or endorsements), amendments, and a copy of application.

• All statements made in application are, in absence of fraud, deemed to be representations and warranties.

• All parts to the contract must be attached and in writing.

• Nothing Can be incorporated by reference.

Incontestability Clause

• Within first two years of policy, insurer may contest a claim and void contract upon proof of a material misstatement or fraud.

• Material misstatement is one which insurer would not have issued policy if true info was known.

• Except for nonpayment of premiums, policy will be incontestable after it has been in force for, typically, 2 years from issue date, even in cases of fraud

Insuring Clause (Proof of Death)

• Found on first page of policy and is considered most important clause in policy.

• Identifies parties to contract & perils or conditions under which it will pay.

• This clause is insurance company’s promise to pay policy’s death benefit to named beneficiary, after receiving proof of death, as long as policy is still in force.

Consideration Clause

• Clause specifies amount and frequency of premium that will be paid by owner as something of value, in exchange for which company promises to pay, as necessary, in the future

• Particulars of payments insurer agrees to are found in insuring clause.

Changes (Modifications)

• Must be in writing, signed by executive officer of insurer, approved by policyowner, and made part of entire contract.

• Producer cannot alter, change, modify, or waive any policy provisions.

Suicide Clause

• If insured commits suicide, while sane or insane, typically 2 years from policy’s issue date, insurer’s liability is limited to a refund of premium.

• If insured commits self removal after clause has expired, insurer must pay out death benefit to beneficiary.

• Intent of this clause is to discourage individuals from purchasing an insurance policy while contemplating self removal.

Owner’s Rights (Ownership Provision)

• Policyowner retains all rights in policy; unless insured is also policyowner, insured does not have rights.

• Policyowner has right to name or change revocable beneficiaries, borrow against cash values, or access living values, receive dividends, select among the dividend options made available, and assign policy on a a collateral/absolute basis, etc.

• Also owner’s responsibility to make premium payments.

• Beneficiary does not have rights in policy.

Assignment

Transfer of ownership. There are two types:

• Absolute - Original owner (assignor) will name a new owner (assignee) of policy. Considered a permanent this since new owner is named. Amount of policy is assigned and referred to as transfer of ownership.

• Collateral- does not cause a permanent change in ownership. Rights of owner will be subject to assignment. Typically used when policy becomes collateral for a loan. This is a temporary assignment until debt is paid in full. Assignor is original owner & assignee is creditor. Takes precedence over any beneficiary. Can reduce dollar amount of claim at time of insured’s death because assignee has priority claim against policy and must be paid first. No assignment will be binding on insurer unless it is in writing and received at insurer’s home office. Insurer not responsible for determining validity.

Misstatement of Age/Gender

• If age/gender of insured has been misstated in policy, all benefits will be provided based on insured’s correct age/gender according to premium scale in effect at time policy was issued. Insurer can refund overpaid premiums if amount paid was greater than should have been; can reduce face amount when premium paid was less than should have been. Ex: if premium amount paid for policy was 50% less than what it should have been, then death benefit will be reduced by 50%.

• No time limit for discovery, and provision never cancels or voids policy. Incontestability clause does not apply. Age/gender are not considered material to policy issuance.

Free Look (Right to Examine Period)

• This allows policyowner a specified number of days following receipt of policy to look it over. If dissatisfied for any reason, owner has the right to return it for a full refund of any premiums paid.

• This period is usually 10 days, unless state law specifies otherwise. (Info presented in state law chapter)

• Period starts on the date when policy is delivered to owner. It is important for producer to collect delivery receipt when delivering policy.

Exclusions

• Aviation

• Status Clause

• Results Clause (War Clause)

• Hazardous Occupation

• Hazardous Hobbies or Avocation

• Suicide

Aviation (Exclusion)

Exclusion does not apply to fare-paying passengers on regularly scheduled commercial flights. Applies most specifically to student pilots, or those with a newly issued pilot’s license with a limited number of hours of flying experience.

Status Clause (Exclusion)

No coverage for individuals with military status, since these individuals are provided coverage through the government.

Results/War Clause (Exclusion)

No coverage if death is result of war, declared or undeclared. If death occurs during period of war, only premiums are refunded.

Hazardous Occupation (Exclusion)

No coverage if death is related to hazardous occupation as stated in policy, such as stunt drivers or auto racers.

Hazardous Hobbies/Avocation (Exclusion)

No coverage if death is related to hazardous hobby as stated in policy, such as sky diving or hot air ballooning.

Suicide (Exclusion)

Within fist 2 years, death due to self removal is excluded from coverage as stated in ‘self removal’ clause.

Mode of Premium (Premium Provisions)

• Provision addresses frequency of premium payments (monthly, quarterly, semiannually, annually) and to whom premiums are payable.

• More frequent payments, greater cost.

• Policyowner has right to change premium mode.

Grace Period (Premium Provisions)

• Time period provided after premium due date before policy lapses.

• If insured dies during this period, death benefit is payable minus any premiums/loans due.

• Typically 1 month (30-31 days)

• Coverage continues during this period, but if premium is not paid, policy lapses at end.

Automatic Premium Loans (APL) (Premium Provisions)

• Provision must be elected by policyowner and can be cancelled at any time.

• Enables insured to automatically borrow against cash value to cover a premium payment and prevent contract from lapsing unintentionally.

• Available on cash value policies only and does not require an additional premium.

• Becomes effective at end of a grace period. Loan is treated as all other loans. If used to pay premiums, loan accumulates on annual basis.

Reinstatement (Premium Provisions)

• In policy has lapsed unintentionally due to nonpayment, it can be re-upped by owner. Time period is typically 3 years from lapse, but can be as long as 5 years.

• In order to re-up, insured must provide evidence of insurability and owner must pay all late premiums from date of lapse, plus interest.

• Designed to put policy back in force as if lapse never occurred.

• When re-upped, a new incontestability period takes effect.

Policy Loans Provision

• Policy loan may be made from a cash value policy once there is sufficient cash value to borrow against. In most policies, cash value must be made available to borrow against after 3 years.

• Loan against cash value does not immediately reduce cash value in a policy. Cash value is used as collateral against loan. Interest will be charged annually, and if unpaid will be added to balance of unpaid loan. Interest charge may be fixed or variable.

• Insurer may defer granting a loan for up to 6 months unless loan was intended to repay any premium, such as an automatic premium loan. Failing to repay a loan or interest will not void policy until total amount of outstanding loan and unpaid interest equals or exceeds policy’s total cash surrender value.

• Any outstanding loans will be deducted from face amount at time of claim, or from cash values upon surrender, along with any interest due.

Policy Loan Rate Provisions

• Policy loans with fixed rates can have a max fixed interest rate of 8% or less as stated in policy. For policy loans with an adjustable (variable) interest rate, max rate is based on Moody’s corporate bond yield average and is stated in policy.

• Loan amount cannot exceed available cash surrender value.

Partial Withdrawals or Partial Surrenders

• Partial withdrawal of cash values upon surrender is permitted in Universal or Variable Universal Life policy.

• Partial withdrawal is considered a partial surrender of policy. Partial surrender is actually paid from policy value and either reduced amount of death benefit or amount of cash value in policy.

• Not considered a loan, so annual interest not charged.

• Taxation applies to any interest on cash value paid out as a withdrawal. Any amount paid in excess of premium is subject to taxation.

• When partial withdrawal is made, policy’s cash or account value will be reduced by amount of withdrawal.

• May be a surrender/withdrawal charge associated with withdrawal.

• Insurer may limit number of withdrawals that can be made annually or amount of withdrawal, specifying minimums and maximums.

Surrenders

• Owner of cash value policy may surrender entire policy. Action will cancel insurance coverage. Policyowner is entitled to receive cash surrender value in policy. UL and VUL policies may have a surrender charge schedule which lasts 10-20 years. Schedule must be given, which shows what percent of cash value is subject to surrender charge. Typically shows percentage charged, reducing on an annual basis.

• Ex: End of policy year 1, Surrender charge 10%, etc down to Year 10, Charge 1%.

• Difference between cash value & cash surrender value is surrender charge. Provides a means for insurer to recapture up front expenses involved in issuing policy.

Policy Provisions Prohibited by Law

Refer to state law for specific requirements. It is prohibited in most states to have a contract with a provision:

• Limiting time for any legal action to be taken against insurer to less than 1 year after the act (or lack of act) occurs. Statute of limitations cannot be less than 1 year.

• Allowing for backdating of policy more than 6 months. If backdating is allowed, insurer may only allow this for max 6 months.

• For any settlement at maturity of less value than amount insured by policy, plus dividend additions, less any outstanding policy loans, loan interest, and unpaid premium.

• For forfeiture of policy for failure to repay any loan on policy or to pay interest on loan while total indebtedness on policy is less than cash value of policy.

Revocable (Beneficiary)

Policyowner may change this type of beneficiary at any time. Beneficiary does not have vested interest in policy. Most named beneficiaries are this and have no rights.

Irrevocable (Beneficiary)

• Policyowner may not change this type of beneficiary unless beneficiary dies or provides written consent for change. If this type of beneficiary is named, owner may not make changes to policy that affect coverage or benefits without consent of beneficiary.

• Changes include: assigning policy, cancelling/surrendering policy, taking a policy loan.

• This beneficiary has vested interest in policy benefits. A divorced spouse with vested interest in policy is an example of this type of beneficiary.

Primary Beneficiary

First in line to receive death benefit upon death of insured.

Contingent/Secondary Beneficiary

Receives death benefit only if there is no primary beneficiary alive following death of insured. Benefit is only payable to this beneficiary if primary beneficiary predeceases insured.

Tertiary Beneficiary

• Receives policy proceeds if both primary and secondary beneficiaries predecease insured.

• If there is no surviving named beneficiary at time of insured’s death, proceeds are payable to policyowner, if living, or insured’s estate.

• May be multiple primary or secondary beneficiaries named.

• When naming multiple beneficiaries, it is important to indicate each beneficiary’s share of proceeds in percentages rather than dollar amounts unless they are to share in proceeds equally.

Beneficiary Designations

• Selected at time of application.

• Change of beneficiary will take effect on date request was signed by owner, whether or not insured is alive at time insurer receives the notice.

Individual/Named

• Very specific

• Individual is specified by name as beneficiary, such as Mary Doe (wife) or John Doe (husband).

• Prevents probate proceedings.

Class/Classification

• Used in instances where each beneficiary is not directly identified by name.

• Wording of each class designation must be specific & carefully worded to remove any doubt of owner’s/insured’s intentions.

• Ex: “any children of this marriage”, or “the insured’s spouse”

• Could cause complications if insured has step children or has been married more than once.

Per Capita

• Will pay surviving beneficiaries equally if named beneficiaries predecease insured.

• Ex: insured names their 3 children as beneficiaries and one predeceases insured, benefit will pay equally to surviving named beneficiaries. Each receives 50% of death benefit in this example.

Per Stirpes

• Will pay deceased beneficiary’s share to heirs of beneficiary who predecease insured.

• If insured names their 3 children as beneficiaries and one predeceases insured, deceases beneficiary’s share will be paid to their heirs. Beneficiaries will each receive 1/3 of benefit and remaining 1/3 will be paid to heirs in this example.

Estate

• May be tertiary beneficiary in case insured outlives all other beneficiaries.

• If insured outlives all beneficiaries, benefits are paid to insured’s estate.

• Death benefit increases estate value and may have tax implications.

Trust

• When recipient does not have direct access to death benefits, such as minor children, and proceeds are to be distributed as per insured’s directions set forth in this.

• This may also be used in estate tax planning strategies when using irrevocable life insurance this.

Minors

• If underage children are named as beneficiaries, but no trust as been established, funds are placed in a settlement option (held with interest), with insurer acting as trustee.

• Guardian/legally responsible adult may receive payments for benefit of child, until child receives lump sum at age of majority.

Creditor

• Designated by assignment, or named at application, to cover indebtedness.

• May either be named beneficiary or a ben assignee under collateral assignment.

• Can only receive amount of indebtedness.

• Benefit may be purchased as decreasing term insurance so benefit will decrease by amount of loan automatically.

Common Disaster Clause

• Provides that if an insured and primary beneficiary are in the same accident, primary beneficiary must survive insured by a specific number of days (usually 90) or insurance company will assume insured died last (primary beneficiary died first. Provision designed to pay benefits to either contingent beneficiary or insured/policyowner’s estate if no contingent has been designated.

• Ex: Mr. & Mrs. Smith each had an insurance policy naming each other as primary beneficiary to respective policies & their children from previous marriages as contingent. If they are both killed in a car accident at the same time, each insurer would assume that both died last to protect next named beneficiaries in policies.

• The Uniform Simultaneously Death Act has been adopted by all states & provides that when insured and primary beneficiary die as a result of same event and the order of death cannot be determined, is is assumed insured died last, protecting secondary beneficiary or heirs.

Spendthrift Trust Clause

• Denies beneficiary the right to assign their interest in policy proceeds.

• Purpose is to prevent creditors of beneficiary from claiming any benefits payable before they are actually received.

• Clause does not protect beneficiary if benefits are payable in a lump sum, only when proceeds are held by insurance company under a settlement option.

Change of Insured

• Typically a rider found in corporate-owned life insurance when executive moves to anther company or retires.

• Benefit allows owner to exchange insured covered by policy for new insured in which owner has incurable interest or to exchange policy for new policy covering new insured in which owner has insurable interest.

• Benefits are most often used in business insurance market to exchange insureds in case of personnel departures, without having to purchase an entirely new policy and without upfront loads & surrender charges.

• New insured must be insurable.

Facility of Payment Clause

• Provision allows insurer to pay relative or anyone it deems entitled to benefits in absence of properly designated beneficiary or in cases of no living beneficiaries.

• Can alleviate any lawsuits and can be used to reimburse someone who may have paid expenses on insured’s behalf, such as funeral costs.

Life Policy Settlement Options - Characteristics

• Life insurance benefits are paid in a lump sum unless another mode of settlement has been selected. A settlement option directs insurance company how to pay out death benefits.

• Settlement Options are used in place of receiving a lump sum death benefits or living benefit at time of maturity. Choice of settlement option may be made by policy owner if insured is living or by beneficiary if insured is not living and no option has been previously selected. If owner has selected a settlement option, beneficiary cannot change option.

• Principal payments of death benefit that are made after insured’s death are not taxable as income. Any interest received from settlement option distribution is taxed as ordinary income. Benefits paid in a lump sum are income tax free.

Interest Only (settlement option)

• Death benefit proceeds may be left with insurer while interest payments are paid annually or more frequently.

• Principal amount does not decrease, and interest generated is taxed as ordinary income when paid to beneficiary.

• This method of providing income is known as capital conservation. Principal (capital) is left with insurer at interest, conserving the capital.

• With this option, owner or beneficiary must direct insurer as to when principal will be paid as a benefit.

Fixed Amount (settlement option)

• Payments are for a specified dollar amount paid monthly until benefits & interest are exhausted.

• Ex: interest will extend time period in which benefits are paid.

• Only interest portion of benefit is taxable.

Fixed Period (settlement option)

• Payments are guaranteed for a specified period of time, such as 10-20 years, after which payments will cease.

• Proceeds and interest are used to make payments.

• Interest will increase amount of each payment, and interest is taxable.

Life Income Option (settlement option)

• Allows insurer to used death benefit to purchase an annuity on behalf of beneficiary. Any interest paid is taxed as income.

Straight Life (Pure/Life Income Only)

• Payments are guaranteed for lifetime of recipient. Upon death, payments will cease.

• Dollar amount of each payment will depend on age/gender of recipient.

• Example of single life option since payments will not be made to anyone other than recipient.

Life Income Period Certain

• Payments are guaranteed for lifetime of recipient or a specified period of time, whichever is longer.

• If recipient dies prior to end of period certain, payments continue to another person until end of payment certain.

Life Refund

• Payments are made for lifetime of recipient.

• If recipient has not received amount equal to total death benefit at their death, balance is refunded to beneficiary either in a lump sum called Cash Refund Option, or in installments, as in the Installment Refund Option.

Joint & Survivor Income Option

• Payments are guaranteed for lifetime of 2 or more recipients.

• Upon death of first recipient, payment continues to survivor(s) until death of survivor.

• Survivor’s payment may be full (100%), 2/3, or ½ of original payments.

• Payout option may be referred to as Joint & Full Survivor, Joint & 2/3 Survivor, or Joint & ½ Survivor, depending on which option is selected.

Joint Life Income Option

Payments are guaranteed to 2 or more recipients until first recipient dies, then all payments cease.

Nonforfeiture Options (Guaranteed Values) Characteristics

• These options are found in policies that accumulate cash values and protect policy owner against a total loss of benefits if policy lapses due to nonpayment of premium or is intentionally cancelled.

• Three nonforfeiture options add flexibility to a cash value policy:

  • Cash Surrender

  • Reduced Paid-Up

  • Extended Term

Cash Surrender (guaranteed values)

• Upon surrendering policy back to insurer, policyowner will receive cash surrender value stated in policy less any outstanding loans and accrued interest.

• Any amount that exceeds premiums paid into policy is taxable as income.

• Insured no longer has insurance coverage if this option is selected.

Reduced Paid-Up (guaranteed values)

• Present cash value is used to buy a single premium permanent policy with reduced face amount.

• Considered a paid-up policy since there are no additional premiums required.

• Provides longest period of coverage provided by a nonforfeiture option.

• Coverage, although reduced in face value, will continue to age 100.

Extended Term (guaranteed values)

• Present cash value is used to buy a single premium term policy of same face amount for as long a period as it will buy, expressed as a combination of years & days.

• Provides largest death benefit and is sometimes referred to as Automatic (or Default) Option if no other option has been selected.

• Insured no longer has rights to cash value under this option, and policy will expire prior to age 100.

Dividend Options - Characteristics

• Dividends represent favorable experience of insurer & result from excess investment earnings, favorable mortality, and expense savings.

• Dividends are available on participating policies issued by mutual insurers. Paid annually, and cannot be guaranteed.

• Since dividends are essentially a return of excess premiums paid, they are not taxable s income until all premiums paid-in have been recovered.

• Should total accumulation of dividends exceed total premiums paid, excess amount is taxable as income.

• Interest earned on dividends left to accumulate is taxable as income.

• Policyowner decides which dividend option is in effect and can change the election at any time

• If dividends are designated for any option other than cash and all current accumulations are withdrawn, option will begin again at next declared dividend.

Cash (dividend)

Policyowner receives declared dividends in the form of a check on or near each policy anniversary.

Premium Reduction (dividend)

• Dividends are applied toward the next premium due.

• The same could be accomplished if policyowner received the dividends in cash and remitted the full premium.

• If declared dividends equal or exceed the premium, premium payment may be suspended.

Accumulate at Interest (dividend)

Dividends are retained by insurer and interest rate paid to policyowner is compounded annually.

Paid-up Additions (dividend)

• Purchases single premium, additional permanent benefits at insured’s attained age.

• Additional insurance is paid out in addition to face amount if insured dies.

• While insured is living, it generates cash value and dividends as if paid-up additional benefit was part of original policy.

1-Year Term (dividend)

• Purchases a single premium, 1-year term benefit.

• Premiums are calculated at insured’s attained age; also referred to as fifth dividend option.

Paid-up Option (dividend)

Pays off policy more quickly than scheduled. If company’s overall performance declines, premiums may have to be resumed.