Chapter 12- Life Insurance Contractual Provisions

Life Insurance Contractual Provisions

Learning Objectives

  • 12.1 Describe the following contractual provisions that appear in life insurance policies:

    • Ownership clause

    • Entire-contract clause

    • Incontestable clause

    • Suicide clause

    • Grace period provision

    • Reinstatement clause

    • Misstatement of age or sex clause

    • Beneficiary designation

    • Change of plan provision

    • Exclusions and limitations

    • Assignment of the contract

    • Policy loan

    • Automatic premium loan

  • 12.2 Identify the dividend options that typically appear in participating life insurance policies.

  • 12.3 Explain the cash-surrender options (nonforfeiture options) that appear in cash-value policies.

  • 12.4 Describe the various settlement options for the payment of life insurance death benefits and explain how they might be used when compared to a trust.

  • 12.5 Describe the following riders that can be added to a life insurance policy:

    • Waiver of premium rider

    • Term insurance rider

    • Guaranteed purchase option

    • Accidental death benefit rider

    • Cost-of-living rider

    • Accelerated benefits rider

Detailed Overview of Life Insurance Contractual Provisions

Ownership Clause

  • Under the ownership clause, the policyholder possesses all contractual rights in the policy while the insured is living.

    • Rights include:

    • Naming beneficiaries.

    • Surrendering the policy for its cash value.

    • The policyholder can designate a new owner by filing an appropriate form.

Entire-Contract Clause

  • The entire-contract clause states that the life insurance policy and any attached application constitute the entire contract between the parties.

    • This clause prevents the insurer from making amendments to the policy without the policyholder’s knowledge.

Incontestable Clause

  • The incontestable clause states that the insurer cannot contest the policy after it has been in force for two years during the insured’s lifetime.

    • Protects the beneficiary if the insurer tries to deny payment of the claim years after the policy was first issued.

    • The insurer has two years to detect fraud.

    • The insurer can contest a claim after the incontestable period in limited circumstances.

Suicide Clause

  • The suicide clause states that if the insured commits suicide within two years after the policy is issued, the face amount of insurance will not be paid; instead, there will only be a refund of the premiums paid.

Grace Period Provision

  • A life insurance policy contains a grace period during which the policyholder has a period of 31 days (or more) to pay an overdue premium.

    • The purpose of the grace period is to prevent the policy from lapsing if a payment is missed.

Reinstatement Clause

  • The reinstatement provision permits the owner to reinstate a lapsed policy.

    • Requirements for reinstatement include:

    • Evidence of insurability is required.

    • All overdue premiums plus interest must be paid.

    • Any policy loans must be repaid or reinstated.

    • The policy must not have been surrendered for its cash value.

  • The policy must be reinstated within a certain period to retain the benefits of original coverage.

    • Although it may require a large outlay of cash, it may be cheaper to reinstate a lapsed policy than to purchase a new one.

Misstatement of Age or Sex Clause

  • Under the misstatement of age or sex clause, if the insured’s age or sex is misstated, the amount payable upon death will be adjusted to reflect what the premiums paid would have purchased at the correct age and sex.

Beneficiary Designation

  • The beneficiary is the party named in the policy to receive the policy proceeds at the death of the insured.

    • Types of beneficiaries:

    • Primary Beneficiary: First entitled to receive the policy proceeds on the insured’s death.

    • Contingent Beneficiary: Entitled to the proceeds if the primary beneficiary dies before the insured.

    • Revocable Beneficiary: The policyholder reserves the right to change the beneficiary designation without the beneficiary’s consent.

    • Irrevocable Beneficiary: Cannot be changed without the beneficiary’s consent.

    • Specific Beneficiary: A specific individual identified in the policy, e.g., spouse or child.

    • Class Beneficiary: A member of a group, such as the children of the insured.

Change-of-Plan Provision

  • A change-of-plan provision allows policyholders to exchange their present policies for different contracts without penalties.

Exclusions and Limitations in Policies

  • Life insurance contracts do not contain many exclusions:

    • Suicide Exclusion: Generally applies for the first two years after the policy is issued.

    • War Clause: May exclude payment if the insured dies as a direct result of war.

    • Aviation Exclusions: Specific exclusions related to aircraft accidents.

    • Hobbies Exclusions: Some policies exclude risks associated with certain hobbies.

Assignment of the Contract

  • Premiums can be paid annually, semiannually, quarterly, or monthly.

  • A life insurance policy is freely assignable to another party:

    • Absolute Assignment: All ownership rights in the policy are transferred to a new owner.

    • Collateral Assignment: The policyholder temporarily assigns a life insurance policy to a creditor as collateral for a loan, but only certain rights are transferred to the creditor.

Policy Loan Provision

  • A policy loan provision allows the policyholder to borrow against the cash value of the policy.

    • The policyholder must pay interest on the loan to offset the loss of interest to the insurer.

    • The policy could lapse if the policyholder does not repay the loan and the total indebtedness exceeds the available cash value.

    • Major advantages:

    • Relatively low rate of interest paid on the loan.

    • Major disadvantages:

    • No legal requirement for the policyholder to repay the loan, which may lead to lapsing if indebtedness exceeds cash value.

Automatic Premium Loan Provision

  • Under the automatic premium loan provision, an overdue premium is automatically borrowed from the cash value after the grace period expires.

  • This provision prevents the policy from lapsing due to nonpayment of premiums.

    • It may be overused, which can exhaust the cash value, potentially leading to reduced proceeds if premium loans are not repaid by the time of death.

Dividend Options in Participating Life Insurance Policies

  • Policies that pay dividends are termed participating policies; those that do not pay dividends are called nonparticipating policies.

  • Sources of Dividends:

    • The difference between expected and actual mortality experience.

    • Excess interest earnings beyond what was anticipated.

    • The difference between expected and actual operating expenses.

Options for Taking Dividends

  • Policyholders have several options for taking dividends:

    • Take the cash directly.

    • Reduce the upcoming premium due.

    • Allow dividends to accumulate at interest and withdraw later.

    • Apply dividends toward the purchase of paid-up whole life insurance under the paid-up additions option.

    • Use dividends to purchase term insurance.

    • Convert the policy to a paid-up contract.

    • Mature a policy as an endowment.

Nonforfeiture Options in Cash-Value Policies

  • The payment to a withdrawing policyholder is known as a nonforfeiture value or cash surrender value.

    • A policyholder has the right to the policy’s accumulated cash value; all states possess standard nonforfeiture laws.

  • Nonforfeiture Options Include:

    • Cash Value: Policyholder withdraws the accumulated cash value.

    • Reduced Paid-Up Insurance: The policyholder can convert the policy to a reduced amount of whole life insurance that requires no further premiums.

    • Extended Term Insurance: Converts the cash value to a term policy for a set period.

Settlement Options for Life Insurance Death Benefits

  • The policyholder can choose among several options for paying the policy proceeds, which may be granted to the beneficiary:

    • Cash Option: Immediate payment in full.

    • Interest Option: The proceeds are retained by the insurer and interest is paid to the beneficiary.

    • Fixed-Period Option: Proceeds are paid to a beneficiary over a fixed period of time.

    • Fixed-Amount Option: A fixed amount is periodically paid to the beneficiary.

    • Life Income Option: Payments are made only while the beneficiary is alive and cease upon death.

Fixed-Period and Fixed-Amount Options

  • Fixed-Period Option: Payments are made for a predetermined fixed period.

  • Fixed-Amount Option: A set amount is paid periodically until the proceeds are exhausted.

Life Income Option Variants

  • Life income options consist of various forms:

    • Life Income with Guaranteed Period: Guarantees payments for a certain period even if the beneficiary dies.

    • Life Income with Guaranteed Total Amount: Guarantees a total sum to be paid regardless of lifespan.

    • Joint-and-Survivor Income: Payments continue until both beneficiaries (typically spouses) have passed away.

Additional Life Insurance Benefits

  • Other benefits may be added to a life insurance policy by using a rider, which generally incurs an additional premium.

  • Riders Include:

    • Waiver of Premium Rider: Waives premiums if the insured becomes totally disabled.

    • Term Insurance Rider: Adds term insurance to a cash-value policy for increased death benefit.

    • Family Rider: Provides additional insurance for family members at reduced rates.

    • Guaranteed Purchase Option: Allows for additional coverage without evidence of insurability during specified future times.

    • Accidental Death Benefit Rider: Doubles death benefit if death occurs due to an accident.

    • Cost-of-Living Rider: Permits the purchase of one-year term insurance equal to the percentage change in the Consumer Price Index with no evidence of insurability.

    • Accelerated Benefits Rider: Permits terminally ill insureds to access benefits prior to passing.

Viatical Settlements and Life Settlements

  • Viatical Settlement: Involves selling a life insurance policy due to terminal illness to investors who expect a profit upon the insured's death.

  • Life Settlement: The policyholder sells a policy to a third party for more than its cash value, often when the policyholder no longer wants to maintain the policy.

Concerns Around Secondary Life Insurance Market

  • The sale of life insurance in the secondary market might present challenges for insurers, particularly concerning Stranger-Owned Life Insurance (STOLI):

    • STOLI involves investors acquiring large policies with a focus on selling in the secondary market, often perceived as a wagering transaction.

    • Incidents of material misrepresentation or fraud regarding the intent of policy acquisition, taking advantage of vulnerable groups, such as the elderly, frequently arise.