FP512: Module Three

Life Insurance

Pays the beneficiaries when the insured dies.

Annuities

Pay while the annuitant is alive.

Facts Relevant to Client in Evaluating Life Insurance

• Client Profile

• Client Goals and Objectives

• Survivors’ Needs

• Estate Liquidity

• Risk Tolerance

• Existing Insurance

• Amount of Insurance Needed

Steps for Determining Appropriateness of Life Insurance

• Identify essential facts about client

• Identify measurable goals

• Identify Resources

• Identify Economic Assumptions

• Consider Insurability

Term Life Insurance Uses

Useful for short-term temporary needs.

Annually Renewable Term Insurance

Policy that provides death protection for one year at a time. Policy renews each year with payment of premium. Lowest initial premium, and as mortality cost increases, cost increases each year.

Have a guaranteed maximum premium and are renewable for specified period of time.

Level Term Insurance

Initial premium is guaranteed for a period of time. The longer that period, the more expensive the premium.

Reentry Term Policies

Permit the insured to be underwritten every five years and get premium based on new condition.

Decreasing Term Life Insurance

The premium remans level, but the amount of death benefit decreases. Usually 15 or 30 years, as they are usually used for mortgages.

Term Insurance

• Guaranteed premium for the term

• Guaranteed death benefit

• No Cash value

Whole Life Insurance (Permanent Insurance) Types

• Whole Life

• Variable Life

• Limited-Pay Life

• Modified Whole Life

• Graded Premium Life

Whole Life Insurance

Most common type of permanent insurance.

Premiums remain same throughout the policy period.

Provides guaranteed death benefit for life of the insured.

Provide a guaranteed cash value.

Nonforfeiture Values

Provide a benefit payable to the policy owner of they discontinue premiums before death of the insured.

Nonparticipating Whole Life

Offered by stock companies, do NOT pay dividends.

Participating Whole Life

Offered mutual companies, sometimes pay dividends to policy owners.

Variable Life (VL)

Policy’s cash value is NOT guaranteed, but is invested in a separate account.

Premiums are fixed, and death benefit has guaranteed minimum.

Must use a prospectus when selling.

Limited-Pay Life

Whole life policy with shorter premium-paying period. Premiums cease at some point, but death benefit continues for life.

Single Premium Whole Life

Lump sum payment is made and no further premiums are required.

Treated as a Modified Endowment Contract (MEC)

Modified Whole Life

Whole life policy preceded by a period of term insurance. Have initial period of low, term-like premiums, then increase to whole life levels.

Graded Premium Life

Premiums start low and increase over some period before leveling and remaining same for rest of policy.

Endowment Policy

The death benefit and cash surrender value are equal at a specific date, and policy is said to have endowed. Face amount of policy is paid at endowment, with large tax consequences likely. Amount exceeding basis (premiums paid) is taxed as ordinary income.

Universal Life Insurance (UL)

Gives policy owners the ability to adjust the premium, death benefit and cash value.

Policy stays in force so long as cash surrender value can support the monthly deductions for mortality and administrative expenses. If insufficient, policy owner must deposit additional premiums.

Universal Life Option A (Level Death Benefit Option)

Pays a level death benefit. Net amount at risk (NAR) decreases as cash value increases to keep death benefit the same.

Universal Life Option B (Increasing Death Benefit Option)

Provides an increasing death benefit. NAR stays the same, so as cash value increase, death benefit does too.

Policy Features of Universal Life Policies

• Premiums

  • Minimum

  • Target

  • Maximum

• Credited Interest

  • Minimum guaranteed

    • Rate guaranteed to be credited to cash value

  • Current rate

    • Rate credited on the premium

  • Blended rates

    • Amounts from previous premiums are blended with pools of interest rates reflecting earlier economic conditions

  • Interest credited on loaned amounts

    • Dollar equivalent of a loan based on contract may receive current credited interest or some lower rate

  • Dividends

    • Very rare

• Mortality Charges

  • Guaranteed

    • Schedule of maximum charges provided with contract

  • Current

    • Current year’s charge against the contract. Based on company’s actual mortality experience.

  • Projected

    • Projection of company’s mortality experience

• Administrative Expenses

  • Guaranteed

    • Contract states maximum dollar or percentage

  • Current

    • Current charges against cash fund or each premium paid

  • Banded

    • Charges may vary according to face amount. Banding identifies a range of face amounts

  • Other Charges

    • Surrender charges

    • Policy fees

    • Premium fees

    • State premium tax

      • Company charges same for everyone and averages out each state’s actual tax

    • Withdrawal charge

      • Fees for taking money out of contract

Benefits of Universal Life Policy

• Flexible premium payments

• Adjustable death benefits

  • May increase or decrease face value

• Unbundled structure

  • Policyowner know which components premium is going toward

• Full disclosure

• Costs

  • Based on amount of risk plus expense charges

Variable Universal Life (VUL)

Guarantees only the mortality rate and that contract stays in force if policy owner pays premiums.

Very complex and policy owner assumes the risk.

No guaranteed death benefit, so all premiums go to investment sub accounts.

Equity-Indexed Universal Life (EIUL)

Provide a minimum fixed interest rate, but also allow policy owners to use an index option to earn a potentially better rate.

Tied to a specific market index.

Value remains unchanged during down markets.

Participation Rate

Dictates specific percentage of index gain credited to policy in Indexed Universal Life.

Rate Cap

Limits the interest Indexed Universal Life can earn by placing an upper limit on the credited rate.

Methods for Measuring Change in Index for Index Universal Life

• Percentage change

• Ratchet/ point-to-point method

• Spread method

• High (low) water mark method

Adjustable Life

Like whole life insurance, but provides option to make changes to policy as needs change.

Joint Life Policies

• First to Die

  • Pays face amount on death of first of two or more covered persons.

• Second to Die (Survivorship)

  • Pays when the last person dies.

Low-Load Life Insurance

Life insurance policies sold by individuals who do not earn a commission.

Private Placement Life Insurance (PPLI)

Specialized type of insurance that is not available to the general public.

Treated as unregistered securities, must be sold my agents with a securities license. May only be sold to accredited investors.

Tax Treatment of Death Benefit

Received income tax free by beneficiaries. It DOES face estate tax.

Earnings in Cash Value of Life Insurance

Grow tax-deferred.

Withdrawals of Cash Value

Basis is tax-free.

Modified Endowment Contract (MEC)

Policy becomes this if it fails a seven-pay test. Cannot deposit more than the total net annual premiums at any time in first seven years.

Withdrawals from an MEC are subject to ordinary income taxes and 10% penalty before age 59 1/2.

Once MEC, always an MEC.

Single premium life insurance is always an MEC.

Viatical Settlement

An arrangement in which a terminally ll person sells his life insurance policy at a discount rate from its face value for current cash.

Death benefit becomes subject to ordinary income tax.

Standard Provisions of Life Insurance Policy

• Entire Contract Clause

• Owners’ Rights

  • Owner may assign or transfer rights to another.

• Beneficiary Designation

  • If irrevocable designation, owner must get permission from bene to make changes.

• Premium Payment Section

• Automatic Premium Loan

• Grace Period

  • 30 or 31 days without penalty

• Reinstatement Clause

  • Once lapsed, owner may reinstate it by paying back all back premiums.

• Misstatement of Age Clause

  • Benefit adjusted to what would be received if correct age had been used on application.

• Contestable Clause

  • Company only has 2 years from issuance to find issues.

• Suicide Clause

  • For first two years of policy, if insured commits suicide, company only pays back premiums.

• Nonforfeiture Options

  • May receive cash value, purchase reduced paid-up insurance, or purchase term insurance.

• Policy Loans

  • Standard Policy Loans

  • APLs

  • May borrow entire cash value of policy.

• Settlement Options

  • Usually lump sum.

• Conversion Clause

  • May convert term to permanent.

• Common Disaster Clause

  • If insured and primary bene die in common disaster, even if actual death is up to 30 days apart, bene is assumed to have died first.

• Spendthrift Clause

  • Prevents a bene from assign any benefits they may eventually get.

Dividend Options for Participating Policies

• Cash

  • Not taxed bc treated as return of premium.

• Reduced Premium

• Accumulate at Interest

  • Interest earnings are taxable.

• Paid-Up Dividend Additions

• One-year Term

  • AKA Fifth Dividend Option

Insurance Riders for Life Policies

• Term Rider

• Cost of Living Rider

• Accidental Death Benefit Rider

• Guaranteed Insurability Option

• Spouse or Children’s Rider

• Disability Waiver of Premium Rider

• Presumptive Disability

• Universal Life Variations on Waivers of Premium

• Disability Income Rider

• Critical Illness Rider

• Long Term Care Rider

• Accelerated Death Benefit Rider

• Family Income Benefit Rider

• Return of Premium Rider

Term Rider

Rider that is added to permanent insurance for a certain period of time.

Cost of Living Rider (Increasing Death Benefit)

Increase death benefit by inflation.

Accidental Death Benefit Rider

May be less than face amount.

Guaranteed Insurability Option

Permits policy owners to purchase more life insurance on a younger insured at specified times and in specified amount WITHOUT providing evidence of insurability.

Spouse or Children’s Rider

Allow a spouse or child o be added to cash value of policy as insured for a specified amount.

Disability Waiver of Premium Rider

If policy owner is disabled, insurance company waives premium for base policy and riders.

Presumptive Disability

May result in waiver of premium without Toal liability of policy owner.

Disability Income Rider

Both a waiver of premium and a supplemental income if insured is totally disabled.

Critical Illness Rider

Allows client to accelerate a portion of death benefit on life insurance if facing specified illness.

Long-Term Care Rider

Allows for access to death benefit to pay for long-term-care related expenses. Death benefit is reduced by amount used.

Restoration of Benefits Rider

Pairs with LTC Rider to say that withdrawals for long term care do NOT reduce death benefit.

Accelerated Death Benefit Rider

Payments of death benefit trigger when insured is terminally ill.

Family income Benefit Rider

Benefit payout will automatically be spread out in monthly benefits, removing choice of payout options that bene has.

Return of Premium Rider

On term policies, if insured does not dies during term, they receive their premiums back.

In Life Insurance Needs Analysis

Assume insured will die tomorrow.

Methods for Analyzing Life Insurance Need

• Multiple of Salary Method

  • Multiple wage earner’s salary by a number that works for the client.

• Human Life Value Method

  • Accounts for income-earning ability of deceased over a lifetime, and discounts amount back to today’s dollars.

• Income Replacement

  • Capital Utilization

    • Uses all of the principal over a period of time so that noting remains.

  • Capital Retention

    • Preserves the principal and only interest is used to meet income needs.

Primary purposed of life insurance

• Replace earning power of a family’s income earner

• Ensuring liquidity for an estate to meet settlement costs

Common Pitfalls or Incorrect Assumptions

• Term insurance only because the client is young

• Variable products outperform non variable ones

• Buy term and invest the difference

• Diversification of insurance products is beneficial

• Not taking advantage of breakpoints

If insufficient resources to buy most appropriate type of insurance

• Client’s objectives are modified

• Choose appropriate type, but in lesser amount

Most important consideration in determining life insurance need

How much insurance, NOT type of insurance

Policy illustrations

Show how the policy is expected to perform over the life of the insured.

Dividend Scale used in a Policy Illustration

The scale used by company is changed from year to year, so only current one is used in a policy illustration.

Regulations on Life Insurance Policy Illustrations

Set by the model created by NAIC

Replacing an insurance policy

Often NOT in policy owner’s best interest.

Types of Life Insurance Policy Replacements

• Replacing one term policy with another

  • Least complex

• Replacing a term policy with a cash value policy

  • Usually done through term policy’s conversion clause

• Replacing a cash value police with another cash value policy

  • Usually not beneficial

• Replacing a cash value policy with a term policy

  • Usually unwise

Under 1035 Exchanges

One policy may be exchanged for another without triggering a taxable event.

May convert cash value policy to an annuity or longer term care.

Cost basis of new is same as cost basis of the old.