KEYWORDS: BASIC PRINCIPLES OF LIFE AND HEALTH INSURANCE

Prior to reading this chapter, please review the following keywords. An understanding of their basic definitions will improve your comprehension of the chapter content.

Actuarial Department: This is the department that calculates policy rates, reserves, and dividends.

Adjuster: This is the person who investigates claims and arranges for them to be settled or denied.

Alien Insurer: In the United States, this is an insurer whose principal office and domicile location is outside this country.

Admitted Insurer: This is an insurer who has received a certificate of authority from a state’s department of insurance which authorizes them to conduct insurance business in that state.

Agent: This is an individual or organization that’s authorized to solicit, sell, and transact (bind) coverage for specific insurance providers under the terms of one or more agent contracts.

Authorized Insurer: This is an admitted insurer.

Broker: This is a person who represents himself and the insured (i.e., the client or customer). A broker cannot bind coverage on behalf of an insurance carrier because a broker is not appointed as an agent.

Captive Insurer: This is an insurer that’s established and owned by a parent firm for the purpose of insuring the parent firm’s loss exposure.

Certificate of Authority: This is a license that’s issued to an insurer by an insurance department (or equivalent state agency) that authorizes that company to conduct insurance business in that particular state.

Claims Department: This is the department that’s responsible for processing, investigating, and paying claims.

Divisible Surplus: This is the amount of earnings that are paid to policy owners as dividends after the insurance company sets aside funds required to cover reserves, operating expenses, and general business purposes.

Domestic Insurer: This is an insurer with its principal or home office in the state in which it’s authorized.

Foreign Insurer: This is an insurer whose principal office or domicile location is in a state that’s different from the state in which it’s transacting insurance business.

Fraternal Benefit Society: This is a non-profit benevolent organization that provides insurance to its members.

Independent Insurance Agency: This is an agency that can represent any number of insurance companies through contractual agreements. Unlike a captive agency, they are not limited to one insurance company.

Insurance: This is the transfer of risk through the pooling or accumulation of funds.

Insured: This is the customer who receives insurance protection under an insurance policy.

Insurer: This is an insurance company.

Lloyds of London: This is NOT an insurer but a group of individuals and companies that underwrite unusual insurance policies.

Marketing Division: This is the division that’s responsible for acquiring prospective applicants through various advertising media.

Monoline Insurer: This is an insurance carrier that only sells one line of insurance.

Multi-Line Insurer: This is an insurance company or independent agent that provides a “one-stop-shop” for businesses or individuals who are seeking coverage for all of their insurance needs. For example, many large insurers offer individual policies for automobile, homeowner, long-term care, life, and health insurance needs.

Mutual Insurance Company: This is an insurance company that’s characterized by having no capital stock, being owned by their policy owners, and typically issuing participating insurance.

Non-Admitted (Unauthorized) Insurer: This is an insurer that has not received a certificate of authority from a state’s department of insurance which authorizes it to conduct insurance business in that state.

Nonparticipating Policy: This is a policy that’s typically issued by stock companies. This type of policy doesn’t allow policy owners to participate in dividends or to elect the board of directors.

Participating Policy: This is an insurance policy that pays policy dividends to policy owners. By receiving dividends, policy owners share in the company’s divisible surplus and also elect the company’s board of directors.

Personal Producing General Agency (PPGA): This is an agency that represents one or more specific insurers. A PPGA is a similar agency system, but PPGAs don’t recruit, train, or supervise career agents.

Policy owner: This is the person who’s responsible for the payment of premiums and who possesses all ownership rights of the contract. Typically, the policy owner is also the insured.

Private (Commercial) Insurer: This is an insurer that’s owned by private citizens or groups that offer one or more insurance lines. Commercial insurers are NOT government-owned.

Producer: This is an individual who’s licensed by one or more states to sell, solicit, or transact insurance in a given state.

Proposed Insured: This is the person whose life will be covered by an insurance policy. (See also: Insured).

Public Adjuster: This person acts on behalf of a consumer who’s settling an insurance claim.

Reciprocal Insurer: This is an unincorporated organization in which all members insure one another. An attorney-in-fact manages it.

Reinsurance: This is the acceptance by one or more insurers (referred to as reinsurers) of a portion of the risk being underwritten by another insurer that has contracted with a consumer to cover the entire risk.

Reinsurer: This is a company that provides financial protection to insurance companies. Reinsurers handle risks that are too large for insurance companies to cover on their own and make it possible for insurers to obtain more business than they would otherwise be able to obtain.

Risk Retention Group: This is a group-owned liability insurer that assumes and spreads product liability and other forms of commercial liability risks among its members.

Sales Department: This department acquires clients through one-on-one meetings in which consumers complete applications.

Self-Insurer: This is a company that establishes a self-funded plan to cover potential losses rather than transferring the risk to an insurance company.

Service Representatives: These are customer service employees. Service representatives are not required to obtain a license because they neither sell nor solicit coverage, and they don’t bind coverage.

Solicitors: These are the individuals who solicit and schedule sales meetings between consumers and the producers for whom they work. Some states separately license these individuals.

Stock Insurance Company: This is an insurance company that’s owned and controlled by a group of stockholders (or shareholders) whose investment in the company provides the safety margin necessary in the issuance of guaranteed, fixed premium, nonparticipating policies.

Surplus Lines Insurance: This is non-traditional insurance that’s only available from a surplus lines insurer. This type of insurance provides coverage for substandard or unusual risks and is not available through private or commercial carriers.

Unauthorized Insurer: This is a non-admitted insurer.

Underwriting Department: This is the department within an insurance company that’s responsible for reviewing applications, approving or declining applications, and assigning risk classifications.

INTRODUCTION

This chapter offers an overview of the insurance industry. It introduces basic insurance principles, how insurance is sold, the common types of insurance companies, and their important functional departments. Some regulatory principles and industry organizations that help govern the insurance industry across state lines will also be examined. The chapter provides a framework for studying a state’s specific definitions, regulations, rules, and obligations, which will be described in the state-specific supplement at the end of this course.

Some state exams test general principles and state law separately, while other states combine them into one exam. If your test integrates state law and general principles, please remember that state law supersedes the general content in the event of a conflict.

The content in this chapter is broken down into the following sections:

• The Concept of Insurance

• Types of Insurance Companies

• Insurer Classifications

• Departments Within an Insurance Company

• Key People Within an Insurance Company

• How Insurance is Sold

• Evolution of Industry Oversight

Reviewing this chapter will enable a person to:

• Better understand the broad purpose of insurance and its benefits to society

• Understand how insurance is sold

• Describe the difference between private and government insurance

• Differentiate between mutual and stock insurance companies

• Differentiate between participating and nonparticipating policies

• Understand the purpose of the industry’s state-based regulatory system

• Understand the various departments within an insurance company and their role

• Differentiate between career agency systems, personal producing general agency systems, and independent agency systems

• Understand the methods of selling insurance without a licensed agent

• Differentiate between domestic, foreign, and alien insurance companies

• Understand the role that rating services play within the insurance industry

· THE CONCEPT OF INSURANCE

· For more than a century, insurance has been recognized as an essential element in an individual’s or family’s financial planning program. Insurance helps to reduce the financial uncertainty of the policy owner with regard to possible future losses. A financial planning program should include the individual’s or family’s general and specific financial goals and a plan to achieve those objectives. This chapter will review the basic principles, nature, and legal concepts of insurance contracts.

· In generic terms, the concept of insurance may be defined as the transfer of risk from one party to another through a legal contract. When a person purchases insurance, that person (as identified in insurance transactions as the policy owner or applicant) transfers the possibility of suffering a large financial loss to an insurer in return for paying a relatively small, contractually defined premium. The insurer assumes the risk in exchange for the payment of premiums. Insurance spreads the risk of loss from one person to a large number of persons through the pooling of premiums. When the transfer of risk is accomplished by purchasing an insurance policy, the policy owner obtains a large quantity of coverage in return for a small fee (i.e., the premium).

· A Solution to Economic Uncertainties and Losses

· Insurance evolved as a practical solution to economic uncertainties and losses. Most insurance contracts pay off financial losses and reimburse the insured. Insurance contracts indemnify policyholders, which means the policies restore insureds to the financial position they experienced before the insured loss. The “principle of indemnity” states that the goal of an action is to “restore” an insured to the same financial position they were in prior to when the loss in question occurred. Insurance contracts indemnify insureds. Indemnification also holds to the principle that an insured shall not profit or gain from their loss. In other words, they will not receive more than they lost.

· Most accident, health, property and casualty insurance contracts are contracts of “indemnity.” Their purpose is to reimburse for a loss. In contrast, life insurance policies are “valued contracts” because they pay a predetermined amount regardless of the actual loss that was incurred.

· Death could potentially strike any person prematurely. When death takes a family provider (e.g., the family breadwinner), surviving family members suffer if they are left without adequate income. Life insurance pays death benefits and creates an instant estate, regardless of when death occurs. On the other hand, when people face the unpleasant prospect of outliving their income, annuities can generate a lifetime income stream to help solve or alleviate this problem.

· Eliminating the possibility of an unplanned expense is arguably the most significant advantage of insurance contracts. Insurance also lessens the chance of the person suffering loss will be required to pay entirely for a loss out of his funds, thereby allowing for the benefit of greater management of cash flow and providing for better loss control.

· TYPES OF INSURANCE COMPANIES

· There are many ways to classify organizations that provide insurance. Conventional methods of insurer classification include where the company is located, how the company is owned, or whether the company is authorized in a given state. In the broadest of terms, insurers can be classified as private (commercial) insurance companies or government providers. It is important to note that the company providing the insurance is considered the insurer, while the covered person is considered the insured.

· PRIVATE VERSUS GOVERNMENT INSURERS

· Private Insurance

· Private citizens or groups own commercial insurance companies, which may be proprietary or cooperative. An example of a proprietary insurer is a profit-motivated stock company. These private insurers offer individual, group, industrial, or blanket insurance policies.

· Government (Social Insurance)

· Government (Federal and state governments also offer a variety of coverage. Federal and state government provided insurance programs are commonly referred to as social insurance. Social insurance programs range from crop insurance to FDIC insurance on bank deposits.

· Self-Insurers

· Although self-insurance is not a method of transferring risk, it’s an important concept to understand. Rather than transfer risk to an insurance company, a self-insurer establishes a self-funded plan to cover potential losses. Large companies often use self-insurance for funding pension plans and some health insurance plans. A self-insurer will often utilize an insurance company to provide insurance above a specified maximum loss level, but the self-insurer will bear the amount of loss below that maximum amount.

SOCIAL INSURANCE

Government insurers are owned and operated by a federal or state entity. They are commonly referred to as Social Insurance.

Government insurers may either:

• Write insurance to cover catastrophic perils or losses that are not insurable by commercial insurers (e.g., war, flood, or nuclear reaction) or

• Write insurance on insurable risks in competition with commercial insurance or possibly instead of them. Such is the case with workers’ compensation.

Examples of social insurance programs include:

• Old-Age, Survivors, and Disability Insurance (OASDI), commonly referred to as Social Security

• Original Medicare (Medicare Parts A and B)

• Medicaid

• Serviceman’s Group Life Insurance (SGLI) and Veteran’s Group Life Insurance (VGLI)

  • SGLI is provided up to $400,000 for full-time members of the armed services (in $50,000 increments).

  • National Flood Insurance Program (NFIP)

  • Federal Crop Insurance Corporation (FCIC)

As the list above shows, the government plays a vital role in providing social insurance programs. These programs pay billions of dollars in benefits every year and affect millions of people.

PRIVATE (COMMERCIAL) INSURANCE COMPANIES

Commercial insurers are private companies that offer many lines of insurance. Some only sell life insurance and annuities, while others sell only accident and health insurance or strictly property and casualty insurance. Companies that sell more than one line of insurance are referred to as “multi-line insurers.” A company that only sells one line of insurance is considered a monoline insurer. Stock and mutual companies can both be considered commercial insurers, and as such, both can write life, health, property, and casualty insurance.

STOCK COMPANIES – NONPARTICIPATING

A stock insurance company is an insurance company that is owned by private investors. Typically, these companies are publicly traded commercial entities that are organized and incorporated under state laws to make a profit for their stockholders (shareholders).

The individual stockholders provide capital for the insurer. In return, they share in any profits or losses. Management control rests with the Board of Directors, selected by the stockholders. The Board of Directors elects the officers who conduct the daily operations of the business. If cash dividends are declared, stock insurers will make the payments to their stock/shareholders. Dividends paid to shareholders are subject to taxes that are similar to long-term capital gains tax.

Stock companies seek to grow their post-tax earnings (earned surplus or retained earnings) that are not paid out in the form of cash dividends. Earnings that are retained by a company are considered equity and are owned by the shareholders.

Stock insurance companies issue nonparticipating insurance policies. Nonparticipating policies don’t pay policy dividends because policy owners are not the owners of the insurance company. Also, the purchase of nonparticipating insurance policies doesn’t confer any other ownership privileges, such as electing the company’s board of directors.

MUTUAL COMPANIES – PARTICIPATING

Mutual insurance companies are also organized and incorporated under state laws, but they have no stockholders, therefore, ownership rests with the policy owners. Any person who purchases insurance from a mutual insurer is both a customer (i.e., policy owner) and an owner of the insurer. The policy owners vote for a Board of Directors, which in turn elects or appoints the officers to operate the company. Funds remaining after paying claims and operational costs may be returned to the policy owners, in the form of policy dividends. Dividends from a mutual company may never be guaranteed. Also, mutual company dividends are not taxable. These policies are known as participating or “par” contracts because the policy owners participate in the distribution of dividends.

Although stock insurance companies use some of these profits to pay stock dividends to their shareholders, mutual insurers hold their excess earnings as a divisible surplus, which they return to their policyholders. Mutual insurers return this surplus to their policy owners by issuing participating policies that pay policy dividends.

The divisible surplus is the amount of earnings paid to policy owners as dividends after the insurance company sets aside funds that are required to cover reserves, operating expenses, and general business purposes. Policy dividends represent a partial refund of the premiums remaining after the company has set aside the necessary reserves and has made deductions for claims and expenses. Mutual companies typically distribute policy dividends to policy owners on an annual basis.

Occasionally, a stock company may be converted into a mutual company through a process called “mutualization.” Likewise, mutual companies can convert to stock companies through a process called “demutualization.” Through demutualization, existing policyholders are provided with shares of stock in proportion to their gross insurance premiums. This is often used to raise funding through the sale of stock.

If an insurance company issues both participating and nonparticipating policies, it is referred to as using a “mixed plan.”

[EXAM TIP: Participating policies allow policyholders to participate in the company by electing the board of directors and receiving dividends from the divisible surplus. Nonparticipating policies do not allow policyholders to participate in elections or receive dividends.]

Assessment Mutual Insurers

Assessment mutual companies are classified by the manner in which they charge premiums. A pure assessment mutual company operates based on loss-sharing by group members, and no premium is payable in advance. Instead, each member is assessed a portion of the losses that occur.

An advance premium assessment mutual company charges a premium at the beginning of the policy period and, if the original premiums exceed the operating expenses and losses, the surplus is returned to the policy holders as dividends. However, if total premiums are not enough to meet losses, additional assessments are levied against the members. Typically, the maximum assessment amount that may be levied is limited either by state law or simply as a provision in the insurer’s by-laws.

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MUTUAL COMPANIES – PARTICIPATING

Mutual insurance companies are also organized and incorporated under state laws, but they have no stockholders, therefore, ownership rests with the policy owners. Any person who purchases insurance from a mutual insurer is both a customer (i.e., policy owner) and an owner of the insurer. The policy owners vote for a Board of Directors, which in turn elects or appoints the officers to operate the company. Funds remaining after paying claims and operational costs may be returned to the policy owners, in the form of policy dividends. Dividends from a mutual company may never be guaranteed. Also, mutual company dividends are not taxable. These policies are known as participating or “par” contracts because the policy owners participate in the distribution of dividends.

Although stock insurance companies use some of these profits to pay stock dividends to their shareholders, mutual insurers hold their excess earnings as a divisible surplus, which they return to their policyholders. Mutual insurers return this surplus to their policy owners by issuing participating policies that pay policy dividends.

The divisible surplus is the amount of earnings paid to policy owners as dividends after the insurance company sets aside funds that are required to cover reserves, operating expenses, and general business purposes. Policy dividends represent a partial refund of the premiums remaining after the company has set aside the necessary reserves and has made deductions for claims and expenses. Mutual companies typically distribute policy dividends to policy owners on an annual basis.

Occasionally, a stock company may be converted into a mutual company through a process called “mutualization.” Likewise, mutual companies can convert to stock companies through a process called “demutualization.” Through demutualization, existing policyholders are provided with shares of stock in proportion to their gross insurance premiums. This is often used to raise funding through the sale of stock.

If an insurance company issues both participating and nonparticipating policies, it is referred to as using a “mixed plan.”

[EXAM TIP: Participating policies allow policyholders to participate in the company by electing the board of directors and receiving dividends from the divisible surplus. Nonparticipating policies do not allow policyholders to participate in elections or receive dividends.]

Assessment Mutual Insurers

Assessment mutual companies are classified by the manner in which they charge premiums. A pure assessment mutual company operates based on loss-sharing by group members, and no premium is payable in advance. Instead, each member is assessed a portion of the losses that occur.

An advance premium assessment mutual company charges a premium at the beginning of the policy period and, if the original premiums exceed the operating expenses and losses, the surplus is returned to the policy holders as dividends. However, if total premiums are not enough to meet losses, additional assessments are levied against the members. Typically, the maximum assessment amount that may be levied is limited either by state law or simply as a provision in the insurer’s by-laws.

FRATERNAL BENEFIT SOCIETIES

Fraternal benefit societies are noted primarily for their social, charitable, and benevolent activities, but they also issue insurance to cover their members. These societies have memberships that may be based on religion, nationality, or ethnicity.

Fraternal benefit societies have existed in the United States for more than a century and first began offering insurance to meet the needs of their low-income members. Initially, they funded these benefits on a pure assessment basis. This allowed them to assess the policy owners in times of financial difficulty and payout non-taxable dividends in times of financial surplus. Today, few fraternal rely on an assessment system; instead, most have adopted the same advanced funding approach that other insurers use.

To be characterized as a fraternal benefit society, the organization must have the following characteristics:

• It must be a non-profit organization

• It must have a lodge system that includes ritualistic work and must maintain a representative government form with elected officers

• It must exist for reasons other than obtaining insurance

Today, most fraternal benefit societies issue group insurance and annuities with many of the same provisions that are found in commercial insurers’ policies. Fraternal benefit societies are more concerned about maintaining minimum reserves and surpluses for coverage than providing dividends or profits.

Examples of fraternal benefit societies include the Independent Order of Foresters or the Knights of Columbus.

RECIPROCAL INSURERS

A reciprocal insurer is an unincorporated organization that’s overseen by a board of governors or directors in which individual members (also referred to as subscribers) agree to insure one another. Unlike mutual or stock insurer policy holders, the reciprocal policy holders themselves insure each other’s risks. Policies don’t transfer these risks to a separate corporate entity. Instead, each policy holder individually assumes a share of the risk that’s brought to the company by the other individuals covered by the reciprocal insurer. This arrangement makes the reciprocal insurer a risk-sharing mechanism rather than a form of risk transfer.

As with policy holders who own participating contracts, policy holders of reciprocal insurers receive policy dividends and their share of the company surplus (capital) if they terminate their membership. An attorney-in-fact handles transactions for the reciprocal insurer and is authorized to conduct the day-to-day affairs of the insurer on behalf of the subscribers.

RISK RETENTION GROUPS (RRGS)

A risk retention group is a specialized insurance company that’s created under the terms of the Federal Liability Risk Retention Act (LRRA) of 1986 to provide liability insurance for individuals and entities with a common bond. Participating professionals and organizations in the same business, occupation, or profession (e.g., pharmacists, dentists, or engineers) become owners and policy holders. The primary purpose of an RRG is to retain or pool risks. These group-owned liability insurers assume and spread liability risks among their members, and, in doing so, they defend claims and pay awards.

Risk-retention groups are only licensed in the state in which they’re domiciled. Federal law requires them to follow the laws of their home state. However, in other jurisdictions, federal law prevails. They’re only required to be licensed in that one state, despite the fact that they may insure members throughout the United States. Although RRGs are a specialized form of mutual insurance company (owned by its members), the insurance exam treats them as a distinct and different class of carrier (which is how this program will treat them).

RISK PURCHASING GROUPS (RPGS)

A risk purchasing group shares some common characteristics with an RRG. Both operate under the auspices of the Federal Liability Risk Retention Act (LRRA) of 1986. Also, both types of organizations provide liability insurance for individuals and entities with a common bond.

RPGs differ from risk retention groups in that RPGs purchase insurance from an insurance company; they don’t act as insurers. Membership in an RPG allows for increased bargaining power and streamlined administration for individuals and businesses participating in the group. The risk purchasing group becomes a master policy holder, and its members receive certificates of insurance.

REINSURERS

Reinsurers are a specialized branch of the insurance industry because they insure other insurers. Reinsurance is an arrangement by which an insurance company transfers a portion of an assumed risk to another insurer. Reinsurance typically occurs to limit the loss that any single insurer would face if a significant claim became payable. Reinsurance can also enable a company to meet specific objectives, such as favorable underwriting or mortality results.

In a reinsurance agreement, the insurance company that transfers its loss exposure (risk) to another insurer is called the primary insurer. We also call it the ceding company. The company assuming the risk is the reinsurer, also called the assuming company. The portion of the risk that the ceding insurer retains is called the net retention (or net line). In other words, reinsurance is actually insurance from one insurance company to another insurance company.

A typical reinsurance contract between two insurance companies is referred to as treaty reinsurance. Treaty reinsurance involves an automatic sharing of the risks that are assumed based on previously established criteria. In some situations, a primary insurer will seek reinsurance that’s tailored to cover a specific risk or exposure without an ongoing agreement. This type of reinsurance is referred to as facultative reinsurance.

CAPTIVE INSURER

An insurer that’s established and owned by a parent firm or group of firms to insure the parent’s loss exposure is referred to as a captive insurer. A risk retention group can be established as a type of captive insurance company.

SURPLUS LINES INSURANCE

Surplus lines insurance refers to the non-traditional insurance market. Surplus carriers provide coverage for unusual risks or unique situations. Surplus lines insurance is available to those who need protection which is not available through the commercial insurance carriers that are authorized to do business in the applicant’s state.

A person will seek coverage through a producer that’s licensed as an excess or surplus lines broker to secure coverage for high, substandard, or unusual risks (e.g., hole-in-one insurance at a golf tournament or non-appearance coverage). Surplus lines carriers are not regulated in the same manner as traditional insurances carriers. Therefore, consumers purchasing surplus lines insurance are typically not offered the same legal protections as consumers purchasing traditional insurance. Consequently, many states require consumers to demonstrate that they have made an unsuccessful effort to secure coverage in the authorized market before seeking coverage through a surplus lines insurer. An individual may not attempt to secure coverage just because it may be less expensive.

SERVICE PROVIDERS

Service providers sell medical and hospital care services (not insurance) to their subscribers in return for a premium payment. Benefits are in the form of services that are provided by the hospitals and physicians who participate in the plan. These services are packaged into various plans, and those who purchase these plans are referred to as subscribers.

One type of service provider is a health maintenance organization (HMO). HMOs, offer a wide range of health care services to member subscribers. For a fixed periodic premium that’s paid in advance of any treatment, subscribers are entitled to the services of specific physicians and hospitals that are contracted to work with the HMO. Unlike commercial insurers, HMOs provide financing for health care plus the health care itself. HMOs are known for stressing preventive health care and early treatment programs.

Another type of service provider is the preferred provider organization (PPO). Under the typical PPO arrangement, a group that desires healthcare services (e.g., an employer or a union) will obtain price discounts or special services from certain select health care providers in exchange for referring its employees or members to them. PPOs can be organized by employers or by the health care providers themselves. The types of services provided are identified in the contract between the employer and the health care professional (i.e., a physician or a hospital). Insurance companies can also contract with PPOs to offer services to their insureds.

LLOYD’S OF LONDON

It’s important to note that Lloyd’s of London is not an insurer but rather a syndicate of individuals and companies that individually underwrite insurance. Lloyd’s of London can be compared to the New York Stock Exchange, which provides the arena and facilities for buying and selling stock publicly. The function of Lloyd’s of London is to gather and disseminate underwriting information, help its associates settle claims and disputes, and, through its member underwriters, provide coverages that may otherwise be unavailable in certain areas.

INDUSTRIAL INSURER

Home service or debit insurers specialize in a particular type of insurance that’s referred to as industrial insurance. Industrial insurance is characterized by relatively small face amounts (typically $1,000 to $2,000). Generally, the selling agent visits the policy owner’s home each week to collect premiums.

INSURERS CLASSIFIED BY AUTHORIZATION

Before an insurance company can conduct business, it must, by law, receive the authority to do so. Insurance statutes require a company to secure a license from the Department of Insurance to sell insurance in a particular state. An insurer that’s admitted or authorized to transact insurance business in a particular state is referred to as an authorized or admitted insurer in that state. The authorized company is issued a certificate of authority. Generally, an unauthorized (non-admitted) insurance company is prohibited from conducting insurance operations in that particular state.

In some cases, a non-admitted/unauthorized insurer may still offer surplus lines insurance without a certificate of authority if no authorized insurer in the market is available or willing to take the risk. The surplus insurance market is heavily regulated, requires additional licensing, and typically doesn’t provide the consumer with the same protections as the primary insurance market.

INSURER CLASSIFIED ACCORDING TO DOMICILE

Another method for classifying insurance carriers is by organizing them based on where they’re incorporated. Often this is the jurisdiction in which they have their corporate headquarters or domicile of incorporation. If an insurer is incorporated under the laws of the state in which it conducts insurance business, that insurer is considered a domestic insurer. When it is conducting insurance business in a state other than where its offices are located, it is considered a foreign insurer. If the insurer is incorporated in a country other than the United States, it is considered an alien insurer.

For example, let’s say that XYZ Insurance Company is incorporated in Oklahoma and is an authorized insurer in Oklahoma. In this case, XYZ Insurance Company is recognized as a domestic insurance company when writing insurance policies in Oklahoma. However, let’s say that XYZ Insurance Company also obtains a certificate of authority to offer insurance products in Texas. Texas will recognize XYZ Insurance company as a foreign insurer when it is conducting insurance business in Texas. Further, if RST Insurance Services of Toronto, Canada, receives a certificate of authority to transact insurance in Oklahoma, it transacts insurance as an alien company in Oklahoma and any other state in which it’s authorized.

[EXAM TIP: ABC Insurance Company of Puerto Rico operates as a domestic insurer in Puerto Rico; however, it’s also licensed or authorized in the State of Florida, which means that it operates throughout the State of Florida as a foreign insurer. Rising Sun Life of Tokyo, Japan, is authorized to transact insurance business in Florida and Puerto Rico as an alien insurer.]

DEPARTMENTS WITHIN AN INSURANCE COMPANY

Throughout this program, numerous references will be made to the different departments within an insurance company. Some of the most common departments are:

• Marketing or Sales – The marketing department is responsible for increasing the number of prospective applicants, thereby increasing the number of insureds through various advertising mediums. The sales department is typically responsible for completing the applications and face-to-face appointments with individual prospective buyers.

• Underwriting – This department is responsible for reviewing applications, conducting investigations to gain additional information about applicants, assigning risk classifications, and approving or declining an application.

• Claims – The claims department is responsible for processing, investigating, and paying claims for losses that are incurred by insureds.

• Actuarial – The actuarial department calculates policy rates, reserves, and dividends and makes other applicable statistical studies and reports that focus on morbidity and mortality tables.

PRODUCERS

The term “Producer” refers to the individuals who solicit the sale of insurance products to the public. Licensed producers are obligated to act in a fiduciary capacity on behalf of the insurers with which they place insurance business and the clients they represent in insurance transactions. Producers are typically considered to be part of the sales department. The various types of producers include:

• Agents – Agents represent one or more insurers under the terms of their appointment contract.

• Brokers – Brokers represent themselves and the insured (i.e., the client or customer).

• Solicitors – A solicitor is not licensed to sell insurance. Instead, a solicitor represents a producer and solicits prospective applicants to meet and discuss their insurance needs with that producer on their behalf.

• Service Representatives – Service representatives are insurance company employees who do not engage in sales activities that pay commissions. These individuals are not required to be licensed unless they receive commissions, solicit, countersign policies, or collect premiums from policy owners.

· UNDERWRITERS

· Underwriters identify, assess, examine, and classify the amount of risk represented by an applicant (proposed insured) to determine whether coverage should be provided and, if so, at what cost (premium). An underwriter approves or declines insurance applications and determines the cost to provide insurance.

· ACTUARIES

· Actuaries calculate policy rates, reserves, and dividends. They also make other applicable statistical studies and reports. Actuaries are concerned with the cost of insurance as a whole or the cost for a specific class of risk.

· ADJUSTER

· An insurance adjuster is a person who engages in investigative work to obtain information for adjusting, settling, or denying insurance claims. An insurance adjuster will primarily rely on completed claim forms but (depending on the claim) may also investigate an insured’s identity, habits, conduct, business, occupation, honesty, integrity, or credibility. The title “public adjuster” refers to a person who, for compensation, acts on behalf of insureds or aids them with insurance claim settlements.

· HOW INSURANCE IS SOLD

· Most consumers purchase insurance through licensed producers who market insurance products and services to the public. Typically, insurance producers are agents who have been appointed to represent one or more insurance companies or brokers and are not tied to any particular company. In most states, producers must be contracted and appointed with an insurer before taking an application for that insurer. An agent has an agent’s contract, while a broker has a broker’s contract. A contract and appointment with an insurance company will grant the agent the authority to bind an insurer to an insurance contract. In a sales transaction, agents represent the insurer, while brokers represent the buyer. In disputes between insureds or beneficiaries and the insurer, the agent who solicits an insurance application represents the insurer and not the insured or beneficiary.

· Agents are also classified as either captive/career agents or independent agents. A captive or career agent works for one insurance company and sells only that company’s insurance policies. An independent agent works for herself and sells the insurance products of many companies. In most states, an agent may represent as many insurers as will appoint her. The three most common types of agencies that support the sale of insurance are the career agency system, the personal producing general agency system, and the independent agency system.

· [EXAM TIP: Career agencies recruit, train, and supervise agents through managers or general agents. These agencies primarily build staff.

· Personal Producing General Agencies (PPGA) don’t recruit, train, or supervise agents. These agencies primarily sell insurance.

· Independent agents (American agency system) represent any number of insurance companies through contractual agreements.]

· TYPES OF AGENCY SYSTEMS

· CAREER AGENCY SYSTEM

· A career agency is often a branch of a major stock or mutual insurance company. Depending on the organization, the agency may represent the sponsoring insurer in a specific area. In career agencies, insurance agents are recruited, trained, and supervised by a general agent (GA) who has a vested right in any business that’s written by the agents who sell for the agency. General agents may operate strictly as managers, or they may devote a portion of their time to sales. The career agency system focuses on building sales staff.

· Managerial System The managerial system is a form of career agency. In the managerial system, the insurance company establishes branch offices in multiple locations. Rather than contracting with a general agent to run the agency, the insurer employs a salaried branch manager. The branch manager supervises agents who work out of that branch office. The insurer pays the branch manager’s salary and a bonus based on the amount and type of insurance sold and the number of new agents hired.

· PERSONAL PRODUCING GENERAL AGENCY SYSTEM

· Although the personal producing general agency (PPGA) system is similar to the career agency system, the PPGAs don’t recruit, train, or supervise career agents. Instead, they primarily sell insurance, but they may build a small sales force to assist them. PPGAs are generally responsible for maintaining their own offices and administrative staff. Agents who are hired by a PPGA are considered employees of the PPGA, not the insurance company, and are supervised by regional directors.

· INDEPENDENT AGENCY SYSTEM

· The independent agency system—which is a creation of the property and casualty industry—doesn’t commit a sales staff or agency to any one particular insurance company. Instead, independent agents represent any number of insurance companies through contractual agreements, and they’re compensated on a commission or fee basis for the business they produce. These independent agents own and control their book of business (i.e., the renewal or expiration of the business). This system is also referred to as the American agency system.

· Other Methods of Selling Insurance

· Although the agents or brokers who work in the systems that have been previously described sell most insurance, insurers also market a significant volume of business through direct selling and mass marketing methods. With the direct selling method, the insurer deals directly with consumers by selling its policies through vending machines, advertisements, or salaried sales representatives who are licensed.

· A large volume of insurance is also sold through mass marketing techniques, such as over the internet, newspaper, magazine, radio, and television ads. Mass marketing methods provide exposure to many consumers, often using direct selling methods with occasional follow-up by agents.

· EVOLUTION OF INDUSTRY OVERSIGHT

· The insurance industry is regulated by multiple authorities, including some that operate inside the industry itself. The primary purpose of this regulation is to promote public welfare by maintaining the solvency of insurance companies. Other objectives are to provide consumer protection and ensure fair trade practices and fair contracts at fair prices. Insurance agents must understand and obey these insurance laws and regulations.

FEDERAL COURT CASES AND LEGISLATION AFFECTING THE REGULATION OF THE INSURANCE INDUSTRY

A selective historical review of insurance regulations shows the interaction between state and federal efforts to regulate the insurance industry. Although a balance between these two bodies has been reached, it’s a dynamic balance that is subject to change as the industry evolves. Other line-specific laws are discussed in conjunction with the products they govern.

• 1868 – Paul v. Virginia. As decided by the U.S. Supreme Court, this case involved one state’s attempt to regulate an insurance company that was domiciled in another state. The Supreme Court sided against the insurance company, ruling that the sale and issuance of insurance is not interstate commerce, thereby upholding a state’s right to regulate insurance.

• 1944 – United States v. Southeastern Underwriters Association (SEUA). The Supreme Court revisited the issue of state versus federal regulation of the insurance industry. In the SEUA case, the Supreme Court ruled that the insurance industry is a form of interstate commerce that’s regulated by the federal government and subject to a series of federal laws which often conflict with existing state laws. Although this decision did not affect states’ power to regulate insurance, it did nullify state laws that conflicted with federal legislation.

• 1945 – The McCarran-Ferguson Act. The turmoil created by the SEUA case prompted Congress to enact Public Law 15, The McCarran-Ferguson Act. This law made it clear that the states’ continued participation in the regulation of insurance was in the public’s best interest. However, it also made possible the application of federal antitrust laws to the extent that the insurance business is not regulated by state law. This Act led each state to revise its insurance laws to conform to federal statutes. Today, the insurance industry is considered to be state-regulated. Any person who violates the McCarran-Ferguson Act faces a fine of $10,000 or up to one year in jail.

• 1958 – Intervention by the FTC. In the mid-1950s, the Federal Trade Commission (FTC) sought to control the health insurance industry’s advertising and sales literature. In 1958, the Supreme Court held that the McCarran-Ferguson Act disallowed such supervision by the FTC—a federal agency. Additional attempts have been made by the FTC to force further federal control, but none have been successful.

• 1959 – Intervention by the Securities and Exchange Commission (SEC). In this instance, the issue was whether variable annuities are an insurance product that should be regulated by the states or a securities product that should be regulated federally by the SEC. The Supreme Court ruled that federal securities laws applied to insurers that issued variable annuities and, therefore, required these insurers to conform to both SEC and state regulations. The SEC also regulates variable life insurance.

• 1970 – Passage of the Fair Credit Reporting Act. This Act attempts to protect an individual’s right to privacy. This law requires fair and accurate reporting of information about consumers, including insurance applications. Insurers must inform applicants about any investigations that are being conducted following the completion of the application. If any consumer report is used to deny coverage or charge higher rates, the insurer must provide the applicant with the name of the reporting agency that’s conducting the investigation.

  • Any insurance company that fails to comply with this Act is liable to the consumer for actual and punitive damages. The maximum penalty for obtaining Consumer Information Reports under false pretenses is $5,000 and one-year imprisonment.

• 1994 – United States Code (USC) Sections 1033 and 1034 Regarding Fraud and False Statements. According to these sections of the USC, it’s a criminal offense for an individual who’s convicted of a felony involving dishonesty or a breach of trust to participate in the insurance business without first obtaining a “Letter of Written Consent to Engage in the Business of Insurance” from the appropriate state regulator.

  • The Fraud and False Statements Act made it illegal to lie, falsify, or conceal information (orally or in writing) from a federal official. As it applies to insurance, any person involved in interstate insurance business who intentionally engages in unfair or deceptive insurance practices or overvalues an insurance product in a financial report or document presented to a regulatory official will violate federal law. Other violations include but are not limited to, embezzling money from an insurance company, misappropriating insurance premiums, and writing threatening letters to insurance offices.

  • Any violation of this federal law will subject an individual to a monetary fine of up to $50,000, or imprisonment for up to 10 years, or both. In addition, if the material misrepresentation jeopardized the safety and soundness of an insurer and was a significant cause of the insurer being placed in conservation, rehabilitation, insolvency, or liquidation, the agent making the false statements may be subject to imprisonment of not more than 15 years. In other words, if the insurer’s solvency is threatened due to the material misrepresentations of a licensee, a prison sentence of up to 15 years may be assessed on the guilty individual.

  • An individual who’s convicted of a felony involving dishonesty may engage in the insurance business ONLY after receiving written consent from the state insurance regulatory agency and a 1033 waiver.

• 1999 – Financial Services Modernization Act (also referred to as the Gramm-Leach-Bliley Act or GLBA). This Act allowed commercial banks, investment banks, retail brokerages, and insurance companies to engage in each other’s lines of business.

  • The Financial Services Modernization Act repealed The Glass-Steagall Act of 1933, which barred common ownership of banks, insurance companies, and securities firms and erected a regulatory wall between banks and non-financial companies.

  • This Act also requires financial institutions, including insurance companies, to protect the privacy of their customers’ personal information. GLBA also recommends that state insurance regulators create regulations regarding the protection of consumers’ personal information. The main components of the rule are that financial institutions must:

    • Notify consumers about their privacy policies

    • Provide consumers with the opportunity to prohibit the sharing of their protected financial information with non-affiliated third parties

    • Obtain affirmative consent from consumers before sharing protected health information with any other parties, affiliates, and non-affiliates

• 2001 – Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act (USA PATRIOT Act). The USA PATRIOT Act was adopted in response to the terrorist attacks on September 11, 2001. The law aims to detect, deter, and disrupt terrorist efforts and funding while prosecuting international money laundering. These anti-money laundering (AML) measures impact the financial services community.

• 2003 – Do Not Call Implementation Act. The Do Not Call Registry allows consumers to list their phones in a registry of numbers to whom telemarketers (including insurers) cannot legally make solicitation calls. Calls made on behalf of charities, political organizations, and surveys are exempt.

• 2003-CAN-SPAM Act. This Act creates rules for commercial emails and messages. Specifically, the regulation outlines the right for a consumer to request a business to stop sending emails, the requirements for businesses to honor such requests, and the penalties incurred for those who violate the Act. The Act covers all electronic mail messages with the primary purpose of advertisement or promotion of a product, service, or commercial website. The Act does not apply to transactional and relationship messages. According to the Federal Trade Commission, the main requirements of the CAN-SPAM Act include the following:

  • Don’t use false or misleading header information (i.e., “From,” “To,” “Reply-To,” etc.)

  • Don’t use deceptive subject lines (i.e., the subject line must accurately reflect the content of the message.

  • Identify the message as an advertisement.

  • Include the company's valid physical postal address in every email

  • Tell recipients how to opt out of receiving future emails (i.e., a return email address or another easy Internet-based way to allow people to communicate their choice to opt-out).

  • Honor opt-out requests promptly (i.e., within 10 business days.

  • Don’t charge a fee, require the recipient to give personally identifying information beyond an email address, or make overcomplicate the process.

NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS (NAIC)

All state insurance regulators (commissioners, superintendents, or directors) are members of the National Association of Insurance Commissioners. The NAIC brings together regulators and industry personnel on committees that regularly examine various aspects of the insurance industry and recommend applicable insurance laws and regulations.

The NAIC was formed shortly after the Supreme Court decision in Paul v. Virginia. The organization has four broad objectives:

• To encourage uniformity among the state insurance laws and regulations

• To assist in the administration of those laws and regulations by promoting efficiency

• To protect the interests of policy owners and consumers, and

• To preserve state regulation of the insurance business

The NAIC recognizes and supports the efforts of individual states to regulate an industry that’s both complex and essential. As a result, the actions of individuals who solicit insurance sales are strictly regulated on the state level. Laws regarding insurance marketing, trade practices, and regulation can vary from state to state, but overall, there are more similarities than differences.

Please note, the NAIC is not a regulatory organization; it neither enacts legislation nor enforces compliance with relevant laws. Instead, the NAIC creates “model acts” and “model regulations.” These models serve as legislative and regulatory templates that help streamline and standardize the “rules of the road” for those in the insurance industry.

It’s imperative for students to examine and understand their state’s specific laws, which this course covers in a separate chapter. This section will review some of the general principles that guide regulation at the state and territorial level and will consider some of the model acts developed by the National Association of Insurance Commissioners.

NAIC Unfair Trade Practices Act Most jurisdictions have adopted their own version of the NAIC model “Unfair Trade Practices Act.” Although individual states have adjusted the model to better reflect their laws and regulations, all states use this model to base their laws on a set of common standards.

This Act gives the head of each state insurance department power to investigate insurance companies and producers, but it also authorizes them to issue cease and desist orders and to impose penalties. The Act gives officers the authority to seek a court injunction to restrain insurers from using any methods that are believed to be unfair. The individual practices which are identified in the model as unfair include misrepresentation and false advertising, coercion and intimidation, unfair discrimination, and inequitable administration of claims settlements.

NAIC Advertising Code In the past, a principal problem for states was the regulation of misleading insurance advertising and direct mail solicitations. Many states now also subscribe to the Model Advertising Code, which was developed by the NAIC. The code specifies certain words and phrases that are considered misleading by their very nature. These words or phrases cannot be used in the advertising of any kind of insurance. The code also requires the complete disclosure of policy renewal, cancellation, and termination provisions.

THE NATIONAL CONFERENCE OF INSURANCE LEGISLATORS (NCOIL)

After the Supreme Court ruled that insurance was a form of interstate commerce and subject to federal regulation, the McCarran-Ferguson Act made it clear that the states’ continued regulation of insurance was in the public’s best interest. In 1969, the National Conference of Insurance Legislators (NCOIL) was formed. The NCOIL is a legislative organization that focuses on the insurance industry. The membership is principally comprised of state legislators from around the nation that serve on state insurance and financial institutions committees.

As with the NAIC, the NCOIL works to preserve state regulation of the industry and to educate public policymakers on related issues. The NCOIL also writes Model Laws for consideration and adoption by state legislatures. The NCOIL also helps legislators make informed decisions on insurance issues that affect their constituents and declares its opposition to any federal encroachment on state authority to oversee insurance business, as authorized under the McCarran-Ferguson Act of 1945.

FINANCIAL ADVISORS (NAIFA) AND THE NATIONAL ASSOCIATION OF HEALTH UNDERWRITERS (NAHU)

Members of the National Association of Insurance and Financial Advisors (NAIFA) and the National Association of Health Underwriters (NAHU) are life and health agents who are dedicated to supporting the industry and advancing the quality of service being provided by insurance professionals. These organizations created a Code of Ethics which details the expectations of agents in their duties toward clients.

Agent Marketing and Sales Practices The marketing and selling of financial products require a high level of professionalism and ethics. Some of the standards in various states include:

• Selling to needs: An ethical agent learns the client’s needs and determines the best way to address those needs.

• Suitability of recommended products: The ethical agent assesses the correlation between a recommended product and the client’s needs and capabilities.

• Full and accurate disclosure. The ethical agent makes it a practice to inform clients about all aspects of the products being recommended, including benefits and limitations.

• Documentation. The ethical agent documents each client’s meeting and transactions. He also uses fact-finding forms and obtains the client’s written agreement for the needs determined, the products recommended, and the decisions made.

• Client service. The ethical agent knows that a sale doesn’t mark the end of a relationship with a client but rather the beginning.

Producer Responsibilities A producer is a conduit between the company and the insurance-buying public. Therefore, a producer must ensure that his actions are always in compliance. A producer’s responsibilities include:

• Providing customers with the best service possible.

• Soliciting new business for his company by helping clients acquire products from application to policy delivery.

• Guiding customers to the right products that meet their needs and maintaining a relationship with them.

• Building a business by keeping current customers satisfied and also actively seeking referrals.

RATING SERVICES

While not technically insurer oversight, rating services help publicize the financial health of insurers. An insurance company’s financial strength (solvency) and stability are two factors that are crucial to potential insurance buyers and insurance companies. The primary purpose of a rating service company (e.g., A.M. Best, Fitch Ratings, Standard & Poor’s, and Moody’s) is to determine the rated insurance company’s (i.e., the insurer’s) financial strength. An insurer’s financial strength can be evaluated by examining the company’s reserves and liquidity.

• Reserves are the accounting measurement of an insurer’s future obligations to its policyholders. They are classified as liabilities on the insurance company’s accounting statements since they must be settled at a future date.

• Liquidity indicates a company’s ability to make unpredictable payouts to policy owners.

States require various minimum reserves and liquidity thresholds before issuing a certificate of authority. Thereafter, states will periodically verify these thresholds by examining insurer financial records.

CHAPTER SUMMARY - BASIC PRINCIPLES OF LIFE AND HEALTH INSURANCE

The Concept of Insurance

• Insurance is a legal contract that transfers an uncertain risk from one party to another. The insured transfers the possibility of suffering a large financial loss to an insurer in return for paying a relatively small, contractually defined premium.

• An insurance policy restores an insured to the financial position she experienced before an insured loss. Insurance companies indemnify their insureds when covered losses occur.

Types of Insurance Companies

• Stock Companies – Nonparticipating

  • Stockholders own a stock company.

  • Stockholders share in company profits, and, if these insurers declare stock dividends, they’re taxable.

  • Stock insurers issue nonparticipating insurance policies because policy owners are not stockholders and, therefore, are not owners.

• Mutual Companies – Participating

  • The policy holders own mutual insurance companies.

  • Mutual insurance companies sell “participating policies” because policy owners receive a share of surplus revenue in the form of policy dividends.

  • The revenue paid out in the form of policy dividends is referred to as the divisible surplus.

  • In the aggregate, policy dividends represent a refund of excess premium or that portion of premium remaining after a company has set aside the necessary reserves.

• Assessment Mutual Insurers

  • To pay for claims, assessment mutual insurance companies assess premiums at the time members experience losses.

  • Pure assessment mutual companies charge no premium in advance.

  • Advance premium assessment insurers levy assessments if the premium is insufficient.

• Fraternal Benefit Societies

  • Fraternal societies are not-for-profit organizations that are noted for their social, charitable, and benevolent activities.

  • Fraternal membership is based on a common bond, and these organizations may form around a common religion, nationality, ethnicity, charitable cause, or other affiliation.

  • The three defining characteristics of a fraternal organization are as follows:

    • It’s non-profit.

    • It has a lodge system, including ritualistic work and a representative form of government.

    • It was not formed simply to provide insurance

• Reciprocal Insurers

  • Each policy owner individually assumes a share of another’s risk, which makes reciprocal insurance contracts a form of risk sharing rather than risk transfer.

  • Policy holders receive policy dividends, and they own a share of the company surplus, which they can receive upon terminating their membership.

  • An attorney-in-fact is appointed to handle transactions for the reciprocal insurer.

• Risk Retention Groups (RRGs)

  • A risk retention group (RRG) is a specialized insurance company that provides liability insurance for individuals and entities with a common bond.

  • Risk retention groups retain risks (risk retention) and process claims.

• Risk Purchasing Groups (RPGs)

  • A risk purchasing group (RPG) buys coverage for its members, which must have a common bond.

  • The risk purchasing group becomes a master policy holder, and its members receive certificates of insurance.

• Reinsurers

  • Reinsurers provide insurance for other insurance companies.

  • The reinsurer assumes risk from a ceding insurer, which is also referred to as the primary insurer.

  • Primary insurance companies purchase reinsurance when they underwrite large risks that could result in claims exceeding the primary carrier’s risk retention limit. The risk retention limit is the maximum amount of exposure that the insurer can carry when insuring a single risk.

  • Treaty reinsurance exists when a reinsurer enters into a contract with a primary insurance company to automatically assume its excess exposure for risks that meet contractually defined criteria. This agreement is also referred to as automatic reinsurance.

  • When a primary insurer seeks reinsurance for a specific exposure without an ongoing agreement, it’s referred to as facultative reinsurance.

• A captive insurer is established to cover the loss exposure of the parent organization that owns it.

• Surplus Lines Insurance Carriers are unauthorized insurers that provide coverage when authorized insurers reject buyers or authorized insurers don’t offer the type of insurance being sought.

• Lloyd’s of London is a syndicate of individuals that individually underwrite special (unique) risks.

• Self-Insurers establish a self-funded plan to cover potential losses and often cap potential losses with a stop-loss insurance policy. “Self-insurance” does NOT EQUAL “no insurance.”

Insurers Classified by Authorization

• An authorized or admitted insurer describes an insurer that has been issued a certificate of authority from a state's insurance department authorizing the insurer to transact insurance in that state. Insurers must receive a certificate of authority from each state they wish to transact insurance.

• An unauthorized (non-admitted) insurance company is prohibited from conducting insurance operations in that particular state.

Insurer Classified According To Domicile

• A domestic insurer is organized and incorporated in the state in which it’s writing business.

• A foreign insurer is organized under the laws of a different state.

• An alien insurer is organized under the laws of a different nation.

Departments within an Insurance Company

• The marketing or sales division prospects for new business.

• The sales department meets with clients face-to-face and completes applications.

• The underwriting department reviews applications, selects risks to insure, and assigns risk classifications.

• The claims department administers claims.

• The actuarial department calculates policy parameters, such as risks and costs relative to promised benefits.

Key People Within an Insurance Company

• Producers

  • The term “Producer” describes an individual or organization that is licensed by a state to solicit, sell, or transact insurance in that state.

  • Licensed producers have a fiduciary responsibility to the companies they represent and the consumers they serve.

  • The terms “agent” and “broker” are used throughout the insurance industry to describe the legal relationship between a producer, an insurer, and a consumer.

  • Agents, represent one or more insurers under the terms of an appointment contract, which gives them limited authority to make binding commitments on the insurer’s behalf.

  • Brokers, represent themselves and the insured. The state licenses brokers, but they are not appointed by the insurer whose product is being considered by a consumer. Brokers cannot bind the insurer.

• Underwriters

  • Underwriters identify, examine, assess, and classify loss exposures.

  • Underwriters approve or decline applications and determine the cost of insurance.

• Actuaries calculate policy rates, reserves, and dividends.

• Adjusters investigate and settle claims.

How Insurance is Sold

• Most insurance purchased in the United States is sold through licensed insurance producers. Typically, these producers are agents who are appointed to represent one or more insurance companies.

• Agents represent the insurer during a sales transaction and can bind insurance. In other words, they can commit the insurers that they represent to cover a risk exposure—at least temporarily.

• Career Agency System

  • Major insurers (including direct writers) often establish career agencies, which recruit and train new agents. The agency is often a branch of a significant stock or mutual insurance company.

  • Some career agencies are contracted to represent an insurer in a specific geographical area or market.

  • A general agent typically runs a career agency.

  • The managerial system features career agencies that are run by a salaried branch manager.

• Personal Producing General Agency System

  • The personal producing general agency (PPGA) system is affiliated with one or more insurers, but a PPGA doesn’t recruit, train, or supervise career agents. Instead, a PPGA focuses on sales in its assigned market or territory.

  • PPGAs generally maintain their own offices and staff. The staff consists of employees of the PPGA rather than of the appointing insurer.

• Independent Agency System

  • Independent agents represent any number of insurance companies through contractual agreements.

• Other Methods of Selling Insurance

  • Insurance companies also sell coverage using mass marketing methods that expose their products to large groups of consumers, with occasional follow-up by agents.

  • Insurance companies that use these methods deal directly with consumers.

  • Direct sellers use vending machines, advertisements, or salaried producers.

Evolution of Industry Oversight

• Federal Court Cases and Legislation Affecting Insurance Industry Regulation

  • Paul v. Virginia (1868): The United States Supreme Court ruled that insurance is not interstate commerce, thereby upholding the states’ right to regulate it.

  • The United States v. Southeastern Underwriters Association (SEU) (1944): The United States Supreme Court reversed Paul v. Virginia and ruled that insurance is a form of interstate commerce and is subject to federal regulation.

  • The McCarran-Ferguson Act(1945): Congress responded to the SEU decision by delegating the regulation of insurance to the states while requiring compliance with federal antitrust standards – either directly or through comparable state laws. McCarran-Ferguson (also referred to a Public Law 15) also levied a maximum penalty of up to one year in jail and a fine of $10,000 for violators.

  • The Fair Credit Reporting Act (1970): This Act was established to protect privacy by requiring the fair and accurate reporting of consumer information.

  • Amendments to USC 1033 and 1034 regarding Fraud and False Statements (1994): This section of the United States Code (USC) prohibits felons (those guilty of crimes involving dishonesty or breach of trust) from participating in the insurance industry without a “Letter of Written Consent” from their state insurance regulator. Any person who engages in intentionally unfair or deceptive insurance practices is subject to a fine of up to $50,000, 15 years in prison, and license revocation.

  • The Financial Services Modernization Act (1999): This Act allowed banks to sell insurance and prompted states to create regulations for insurance companies to protect the privacy of consumer personal information.

  • The USA PATRIOT Act (2001): This Act focuses on the funding sources for terrorists and international money laundering in general.

  • The Do Not Call Implementation Act (2003) implemented the Do Not Call Registry, which allows consumers to opt-out of receiving calls from telemarketers, except for those on behalf of charities, political organizations, and surveys.

  • 2003-CAN-SPAM Act: This Act outlines the right for consumers to request a business to stop sending emails, the requirements for businesses to honor such requests, and the penalties incurred for those who violate the Act. The Act does not apply to transactional and relationship messages.

• National Association of Insurance Commissioners (NAIC)

  • The National Association of Insurance Commissioners (NAIC) is an industry association of state insurance regulators focused on establishing model acts and regulations that provide a common framework for state officials to address industry-wide issues. These regulatory models help streamline the legislative and administrative processes while encouraging uniform standards.

  • The NAIC lists four objectives: (1) To encourage regulatory uniformity among the states. (2) To promote efficient regulatory administration. (3) To protect policy owners and consumer interests. (4) To preserve state regulation of the insurance industry.

  • The NAIC’s Model Advertising Code labels certain words and phrases as inherently misleading and bans their use.

  • NAIC Unfair Trade Practices Act (Model) Act gives a state insurance department the power to:

    • Investigate insurance companies and producers.

    • Issue cease and desist orders.

    • Impose penalties.

    • Seek a court injunction to restrain unfair activities.

• The National Conference of Insurance Legislators (NCOIL) is an association of state legislators that serves on insurance and financial institutions committees to educate policymakers and preserve state regulation. NCOIL also writes model laws.

• The National Association of Insurance and Financial Advisors (NAIFA) and The National Association of Health Underwriters (NAHU) created a Code of Ethics for agents.

• Agent Marketing and Sales Practices standards include:

  • Selling to needs: Learning and addressing client needs

  • Suitability: Recommending products that address client needs and match client capabilities

  • Full and accurate disclosure of product information

  • Documentation of each client meeting and transaction

  • Client service after the sale

• Rating Services describe companies that determine an insurer’s financial strength. These services publicize the financial health of insurers after analyzing company reserves and liquidity.

Chapter 2

KEYWORDS: THE NATURE OF INSURANCE

Prior to reading this chapter, please review the following keywords. An understanding of their basic definitions will improve your comprehension of the chapter content.

Adverse Selection: This is broadly defined as selection against the company or the tendency of people with higher risks to seek/continue insurance to a greater extent than those with little or less risk. In other words, adverse selection occurs when the percentage of poor risks among those covered by issued policies exceeds the ratio predicted by the actuaries when they designed the policies. This also consists of the tendency of policy owners to take advantage of favorable options in insurance contracts.

Hazard: This is any factor, condition, or situation that creates an increased possibility that a peril (a cause of a loss) will actually occur.

Homogeneous Exposure Units: These are similar “objects of insurance” that are exposed to the same group of perils. An “object of insurance” can be a person, a business, or a piece of property. Each “unit” represents one of many similar risks that are undertaken to be insured by an insurance company.

Indemnify: This is the act of restoring insureds to the financial condition that existed prior to a loss.

Indemnity: This is the amount needed to restore an individual to the financial condition he was in before he suffered a loss. An indemnity can be a reimbursement or a fixed dollar amount.

Indemnity Contract: This is a contract that attempts to return the insured to her original financial position.

Law of Large Numbers: This is a fundamental principle of insurance. The larger the number of individual risks that are combined into a group, the more certainty there is in predicting the degree or amount of loss that will be incurred in any given period.

Loss: The insurance industry defines the word “loss” as the unintentional decrease in the monetary value of an asset due to a peril.

Loss Exposure: This is the risk of a possible loss.

Loss Exposure Unit: This refers to each individual, organization, or asset that’s exposed to the potential of financial loss due to a defined peril. When loss exposure units are aggregated together, the maximum potential loss expresses the overall loss exposure.

Moral Hazard: This is the type of hazard that exists because of the effect of an insured’s personal reputation, character, associates, personal living habits, or degree of financial responsibility. This also includes criminal activity.

Morale Hazard: This is a hazard that arises from an insured’s indifference to loss because of the existence of insurance. Morale hazards are often associated with having a careless attitude.

Peril: A peril is the immediate, specific event that causes loss and gives rise to risk.

Physical Hazard: This is a physical or tangible condition that exists in a manner which makes a loss more likely to occur.

Primary Insurance Company: This phrase has the following meanings:

• When more than one policy covers the same claim, the term “primary insurance company” refers to the first policy to pay.

• As it relates to reinsurance, the primary insurance company writes a policy to cover a risk in the marketplace. This primary insurer then surrenders a portion of the risk to a reinsurer and the reinsurer assumes the excess risk for a reinsurance premium.

Pure Risk: This is a type of risk that involves the chance of loss only; there’s no opportunity for gain. Pure risks are the only form of insurable risks.

Reinsurance: This is the acceptance by one or more insurers—referred to as reinsurers—of a portion of the risk underwritten by another insurer that has contracted with an insured to provide coverage for the total value of a loss exposure.

Reinsurer: This is an insurance company that assumes a portion of the risk underwritten by a primary insurance company.

Risk: This is the uncertainty regarding loss. Risk is the probability of a loss occurring for an insured or prospect.

Risk Avoidance: This occurs when individuals evade risk entirely. It’s the act of NOT participating in an activity that could possibly cause a loss.

Risk Management: This is the process of analyzing exposures that create risk and then designing programs to address them.

Risk Reduction: This is the risk management strategy that focuses on taking actions which decrease the chances of a loss occurring. It also refers to action taken to lessen the severity of a loss if one occurs.

Risk Retention: This is the act of analyzing the loss exposure presented by a risk and determining that the potential loss is acceptable. Risk retention is often associated with self-insurance.

Risk Selection: This is not a risk management technique that’s used by consumers. Instead, “risk selection” describes the insurance company’s process for determining whether to cover a new loss exposure. If done correctly, the ratio of losses to premium should reflect what actuaries predicted when they created the product, established the price, and set the underwriting criteria.

Risk Sharing (Risk Pooling or Loss Sharing): This is the risk management technique that manages an individual’s risk by sharing the possibility of loss with others and spreading the cost over a large number of individuals. This technique transfers risk from an individual to a group.

Risk Transfer: This is the act of exchanging the responsibility for a significant potential loss (risk) to another party in exchange for a smaller, preset cost or premium.

Self-Insurance: This is a risk retention process. A self-insuring individual or organization maintains monetary reserves to cover potential costs in the event of a financial loss occurring.

Speculative Risk: This is a type of risk that involves the chance of both loss and gain; it’s not insurable.

INTRODUCTION

This chapter will introduce the concept of insurance, which evolved from the need to minimize the adverse effects of risk associated with the probability of loss. This chapter will describe the different types of insurance perils, losses, hazards, and risks. It will also review how insurance companies use various tools and strategies to treat, manage, and deal with risks.

The chapter is broken into the following sections:

• The Nature of Insurance

• Perils, Loss, and Hazards

• Risk

Specific definitions, rules, regulations, and obligations pertaining to insurance in your particular state are discussed in detail in the state-specific chapter which is located at the end of the course. In the event of a conflict, state law will supersede the general content.

A review of this chapter will enable a person to:

• Understand the nature of insurance

• Understand the principle of indemnity

• Explain the law of large numbers and provide examples

• Understand and identify the concept of risk spreading

• Explain adverse selection and understand its importance in the insurance industry

• Differentiate between a loss and a peril

• Identify a loss and distinguish between the different types of losses

• Distinguish between an accident and an occurrence and provide examples

• Identify a hazard and distinguish between the different types of hazards

• Distinguish between the different types of risks

• List the elements of an insurable risk

• Understand how risk is managed and treated by implementing a variety of strategies

· THE NATURE OF INSURANCE

· In generic terms, the concept of insurance may be defined as the transfer of risk from one party to another through a legal contract. The insurer assumes the risk in exchange for the payment of premiums.

· Risk pooling (also referred to as loss sharing) distributes risk by spreading the cost of possible losses over a large number of people. It transfers risk from an individual to a group. Insurance companies function through the concept of pooling.

· Insurance spreads one person’s risk of loss among a large number of individuals through the pooling of premiums. In other words, insurance reduces financial risk by spreading one individual’s risk of loss among many. When the transfer of risk is accomplished by purchasing an insurance policy, the policy owner obtains a large quantity of coverage in return for a small fee (premium).

· PRINCIPLE OF INDEMNITY (INDEMNIFICATION)

· The “Principle of Indemnification” states that the goal of an action is to “restore” an insured to the same financial position that he was in prior to when the loss in question occurred. Insurance contracts indemnify insureds. Indemnification also holds to the principle that an insured shall not profit or gain from their loss. In other words, they will not receive more than they lost.

· Most accident, health, property, and casualty insurance contracts are contracts of indemnity. Their purpose is to reimburse for a loss. In contrast, life insurance policies are valued contracts because they pay a predetermined amount regardless of the actual loss that was incurred.

· LAW OF LARGE NUMBERS (SPREAD OF RISK)

· The ‘law of large numbers’ states that, based on experience, larger groups provide an increased degree of accuracy in loss predictions. The greater the number of homogenous loss exposures, the more likely it is that future losses can be accurately predicted. Predicting the level of future losses expected across a large group is also referred to as the “spread of risk,” or more commonly referred to as risk spreading.

· This principle of actuarial science states that the larger the number of risks insured in the same risk pool, the more predictable losses become—at least in the aggregate. Although an insurance company can use the Law of Large numbers to predict the total amount of expected loss in the risk pool, there’s no way to predict which specific individual will suffer financial loss.

· For example, let’s assume that an insurance company insures 100,000 homes (rather than only 100 homes) against fire and collects $1,000 in premiums from each homeowner. In this situation, the premiums should provide enough money so that the insurer can pay all losses to policy holders during the year while at the same time covering all overhead costs and still making a profit. Now, what if an insurer only insured 100 homes, and five of them were total losses in the same year? That type of loss could bankrupt the carrier, especially if an unexpected event increases the losses. Essentially, no matter what, there’s safety in larger numbers.

· ADVERSE SELECTION

· Insurers must minimize adverse selection, which is defined as the tendency for higher-than-average risks to seek out insurance. In the purest sense, adverse selection means that one party in a business transaction has superior accurate information over another party. Insurance underwriting is designed to ensure that insurance carriers are fairly compensated for the actual risks they undertake when issuing insurance contracts. Therefore, the premium for a high-risk person or property is greater than the premium for a lower risk. Some risks are avoided by an insurance carrier altogether because the company may choose not to select risks that run against its own best interest.

· Adverse selection occurs when a company takes on risk without being accurately compensated for the actual amount they must ultimately pay in claims. To be profitable and stay in business, companies must avoid adverse selection. A profitable distribution of exposure exists when the number of preferred risks is balanced with poor risks, and the number of average risks is in the middle. Sound, competent underwriting may reduce the chance of adverse selection. Insuring large groups of individuals (i.e., group life insurance) may also reduce this danger.

PERILS, LOSS, AND HAZARDS

PERILS (CAUSES OF LOSS)

A peril is the immediate, specific event that causes a loss. As noted in the following list, different lines of insurance cover different perils.

• Property insurance covers losses caused by such perils as fire, lightning, windstorm hail, earthquake, and vandalism.

• Liability insurance covers an insured’s legal responsibility to indemnify a third-party that’s harmed due to the insured’s negligence.

• Accident and health insurance covers losses caused by illnesses and accidents.

• For life insurance and annuities, the covered peril is mortality. Life insurance protects against premature death; however, annuities provide a measure of protection when death is delayed, and the insured would otherwise outlive his assets.

· Named Perils versus Special (Open) Perils

· Typically, insurance policies define the perils being protected against in one of two ways: Specified (Named) Perils and Special (Open) Perils.

· Insurance contracts that individually cover Specified or Named Perils list those specific perils that they cover. If a loss is caused by a peril that’s not listed within the insurance policy, then the loss is not covered.

· For example, a life insurance policy may specifically name coverage for only accidental death. A health insurance policy may explicitly only cover cancer. A property policy may explicitly cover only loss that’s caused by fire and lightning. Again, a named perils policy identifies the perils that are covered under the policy. By doing so, a named-peril policy defines the covered losses narrowly.

· Special or Open Peril insurance policies don’t name the perils that they cover. Instead, these policies begin by stating that they cover all direct causes of loss and then list all of the perils that they exclude from coverage. Since an open peril policy stipulates the causes of loss that are not covered under the policy, the policy will therefore cover any peril that’s not explicitly identified as being excluded from coverage.

· For example, comprehensive medical insurance and standard life insurance will typically cover medical bills and pay death claims related to perils other than those expressly excluded.

· LOSS

· A loss is defined as an unintended and unforeseen reduction or destruction of financial or economic value. In other words, a loss is an unintentional decrease in the value of an asset due to a peril.

· Losses can be further classified as being either Direct Losses or Indirect Losses. Direct losses occur when a person or property is damaged, destroyed, or killed by a peril without any intervening cause. The peril in question is the proximate cause of the direct loss. An indirect loss is also referred to as “Consequential Loss” because the loss is a consequence of, or results from, a direct loss. This distinction is most relevant for property and casualty insurance.

· A loss can also be defined as either an accident or an occurrence. An accident is an unforeseen, unexpected, unintended, and sudden event that occurs at a specific time and specific place. An occurrence can be any event that causes a loss. Occurrences include accidents, injuries, illnesses, as well as losses that are caused by repeated or continuous exposure to conditions over time.

· For example, if an individual needs a knee replacement from being involved in a car accident, there are likely some witnesses who saw the accident and, in theory, could provide the exact time and location of the accident that caused the injury.

· Now, let’s assume the individual needs a knee replacement due to years of intense physical activity. In this case, there are no witnesses who could provide the specific time and location of the occurrence that resulted in the need for the individual’s knee replacement.

· [EXAM TIP: Every accident is an occurrence, but not every occurrence is an accident.]

· Loss Exposure: Loss exposure is the risk of a possible loss. Basically, it’s any situation that presents the possibility of a loss.

· Homogeneous Exposure Units: Homogeneous exposure units are similar objects of insurance that are exposed to the same group of perils. The larger the number of homogeneous units (similar risks), the easier it becomes to predict loss. A loss exposure consists of loss exposure units.

· HAZARDS

· A hazard increases the possibility that a peril (a cause of a loss) will occur. Examples of hazards include icy roads, driving while intoxicated, and improperly stored toxic waste. There are three types of hazards—physical hazards, moral hazards, and morale hazards. All of these hazards result from conditions relating to the insured. For exam purposes, a person must be able to distinguish between these hazards.

· Physical Hazards Physical hazards are physical or tangible conditions that exist in a manner which makes a loss more likely to occur. Physical hazards can be seen, touched, tasted, smelled, or tripped over, thereby causing loss. Poor health and ice on roads are examples of physical hazards.

· For example, let’s assume that an individual leaves a full can of gasoline near the furnace in his basement. In this case, there’s a greater likelihood that an explosion will occur than if the individual had left the gas can in his garage.

· Moral Hazards Moral hazards make the loss more likely to occur due to the dishonest character of the insured, who may be more disposed to either engage in criminal activity or cause a loss because of negative habits. The chance of loss increases because of who the insured is. In other words, the chance of loss is greater due to the individual character of the insured. Properly defined, a moral hazard occurs when the insured is much more intentioned and conscious of participating in wrongdoing that’s more likely to lead to a loss.

· For example, a dishonest person is more likely to lie to an insurance company—both on an application and when submitting a claim for loss, thereby creating a higher likelihood of engaging in insurance fraud. Drug use and alcohol abuse are commonly associated with moral hazards.

· Morale Hazards Morale hazards result from the personal or subjective thought process of the insured. In other words, they arise from a state of mind that’s related to the indifference of an insured to whatever loss may occur. The insured unintentionally creates a loss situation on an unconscious level. In essence, they just don’t care about loss prevention since the property is insured.

· For example, Alex leaves his car running unattended and the doors unlocked to heat it on a cold winter morning. This act makes it more likely that his car will be easily stolen by a car thief who’s looking for such vehicles. On some unintentional mental level, the insured simply doesn’t care that this kind of loss may occur, probably because the vehicle is insured. Reckless driving, jumping off a cliff, stealing, racing motorcycles, and a careless lifestyle are often associated with morale hazards.

· RISK

·
Risk is defined as the potential for, or uncertainty of, loss.

· TYPES OF RISK

· Speculative Risk Speculative risk is a risk that presents the chance for both loss and gain. Speculative risks are not insurable.

· For example, investing in the stock market and gambling are speculative risks. Individuals can realize financial gains, or they can lose all of their money.

· Pure Risk Pure risks present a potential for loss only and no possibility of gain. Only pure risks are insurable.

· For example, injuries, illnesses, and death represent pure risks because an individual can only suffer a loss in the form of missed work and medical bills or burden survivors through the untimely loss of life.

ELEMENTS OF AN INSURABLE RISK

It’s impossible to insure every type of risk. For a pure risk to be insurable, it must involve a chance of accidental, measurable, and definable loss. General elements of insurable risk include:

• An insurable loss must be due to chance (accidental) – “Chance” means that it’s outside an insured’s control. In this sense, the individual insured (loss exposure unit) that suffers the loss is randomly selected. This characteristic helps insurers avoid adverse selection.

For example, an insured catches a cold.

• An insurable loss must be definite and measurable – “Definite and measurable” means that the time, place, amount, and whether the claim is payable can be documented.

For example, the insured’s automobile accident occurred at 2:00 p.m. on Friday and caused $2,000 in damage.

• An insurable loss must be predictable – The term “predictable” means that the (estimated) average frequency and severity of future losses can be calculated. There must be a sufficient number of homogeneous loss exposure units to effectively allow insurers to apply law of large numbers.

For example, 18% of accidents involve distracted driving.

• An insurable loss cannot be catastrophic – The term “catastrophic” is from the perspective of the insurer. This is meant to indicate that it’s too big and uncertain to be insured. The loss exposure must be reasonable.

For example, a war, a nuclear disaster, or a $1 trillion life insurance policy is not reasonable loss exposure.

• The number of loss exposures (units) to be insured must be substantial – The carrier’s actuaries must be able to apply the law of large numbers to help the insurance company predict loss.

• The premium cost must be economically feasible – A premium is “feasible” when it’s affordable. Also, the premium must be small in comparison to the loss exposure being insured.

For example, a healthy 45-year-old male could probably qualify for a 20-year term life insurance policy with a $250,000 face amount for less than $500 per year.

INSURANCE RISK CLASSIFICATIONS

As will be described later in this course, insurers use various underwriting techniques to evaluate risks and assign risk classifications. Typically, an insurer will place a risk exposure into one of the following three risk classifications:

1. Standard Risks: Standard risks are considered to have an average potential for loss. Standard risks are typically insured in return for a predetermined standard premium.

2. Substandard Risks: Substandard risks are judged to be a poor risk for an insurance company and have a higher-than-average potential for loss. Substandard risks may be insured for an increased premium, covered with a lower benefit, or declined altogether.

3. Preferred Risks: Preferred risks are judged to be a better than average risk for an insurance company. Preferred risks have a lower potential for loss. Insurers offer coverage to preferred risks for a lower-than-average premium.

RISK MANAGEMENT

The process of analyzing exposures that create risk and designing programs to handle them is referred to as risk management. Risk management may be accomplished by (1) detecting the potential loss exposure; (2) selecting a method or tool in order to reduce risk; (3) executing a course of action; and (4) periodically reviewing the measures taken. The risk may be reduced or managed by purchasing an insurance contract.

Methods of Handling Risk

Risk Sharing Risk-sharing spreads risk among multiple parties. Each party assumes a portion of the risks that are covered by the arrangement. Reciprocal insurance companies (e.g., USAA in San Antonio, TX)—also referred to as inter-insurance exchanges—are one type of risk sharing arrangement.

An example of risk-sharing is the use of co-insurance in a major medical insurance policy. If the co-insurance split is 80% / 20%, then the insurance company carries 80% of the risk, and the insured carries 20%. Often this risk-sharing mechanism is used in conjunction with the risk retention mechanism that’s referred to as a deductible.

Risk Transfer Risk transfer features a legal contract that transfers risk from one party to another. In general, insurance contracts are risk transfer arrangements. They transfer the risk of loss defined in the policy to the insurer in exchange for a known fee or premium.

Buying insurance is the best way to transfer risk. Additional examples include incorporation and hold-harmless clauses in contracts.

Reinsurance One method that insurers use to prevent a catastrophic loss is through reinsurance, which is defined as transferring risk from one insurer to one or more other insurers. Many insurers can minimize exposure to substantial loss by reinsuring risks.

Risk Avoidance Risk avoidance means that risk can be avoided by eliminating an activity or condition that exposes a person to a type of loss or specific perils.

For example, if a person doesn’t go skydiving, she has no risk of dying in a skydiving accident.

Risk Reduction Risk reduction is the process by which a person takes deliberate actions to reduce the likelihood of a loss, or the severity of a loss if it should occur.

For example, installing smoke alarms and a sprinkler system reduces the risk of death and will reduce the amount of property loss in a building fire.

Risk Retention Risk retention is a conscious strategy in which a person maintains a certain amount of reserves to address unexpected expenses that are caused by insurable losses. Some forms of risk retention are limited, such as the deductibles in a health insurance plan or personal automobile insurance. Some large companies that have highly predictable patterns of loss also self-insure.

For example, a person with a $1,000 deductible on her automobile insurance policy retains $1,000 of any risk if her car is damaged in an accident.

It’s essential to know that “self-insurance” is much different than “no insurance.” The former is a planned strategy that’s based on holding reserves and self-financing losses. The latter is simply a refusal to acknowledge the reality of risk and the possibility of financial loss.

[EXAM TIP: One way to remember these methods of handling risk is to use the acronym STARR (shared, transferred, avoided, reduction, and retention).]

Loss Prevention

Another risk management tool available is loss prevention. Loss prevention involves taking actions to eliminate damage or loss. In fact, it’s a method used to identify and analyze risk and to control losses.

For example, constructing a building using masonry materials rather than wood, removing flammable materials from a premise, or de-icing the wings of an aircraft before takeoff are loss prevention steps.

CHAPTER SUMMARY

The Nature of Insurance

• An insurance policy is the transfer of risk from one party to another in exchange for a fee (premium) using a legal contract.

• Insurance companies take one person’s risk of loss and spread it among all parties who are participating in the insurer’s risk pool, as evidenced by the payment of premiums.

• The “Principle of Indemnification” is financial. Any insurance contract that’s based on this principle intends to restore insureds to their original financial position after they suffer losses.

  • The same principle stipulates that insureds will not profit or gain from their loss. In other words, they will not receive more than they lost.

  • The amount needed to restore the insured’s financial status can be referred to as an indemnity. The act of restoring is considered indemnifying.

  • The ‘law of large numbers’ states that the greater the number of homogenous loss exposures, the more accurate the prediction of the aggregate risk within an insurance pool.

  • Adverse selection is the tendency for higher-than-average risks to seek out insurance more frequently than lower risks.

Perils, Loss, and Hazards

• A peril is the immediate and specific cause of a loss.

  • Insurance policies that cover Specified or Named Perils will individually list the perils that they cover. If the peril that causes a loss is not listed, then the loss is not covered.

  • Insurance policies that use a Special or Open Peril definition of covered perils will cover losses that result from any cause (peril) which is not explicitly excluded in the policy.

  • A loss is an unintended (by the insured) loss of financial or monetary value.

  • The event that causes a loss is referred to as an Occurrence. An occurrence takes place at a specific time or place or develops over time before it makes itself known.

  • An accident is a type of occurrence but is unexpected and unintended. An accident happens at a specific time and place and causes a measurable loss.

    • Other occurrences such as illnesses, repetitive motion injuries, or exposure to toxins may cause an identifiable loss, but it’s not possible to determine the exact moment that the loss occurred.

    • A direct loss occurs when people are harmed, or a covered peril damages property.

    • An Indirect Loss or “Consequential Loss” results from a direct loss, such as the loss of revenue when a business shuts down to rebuild after a fire. Disability insurance also covers a consequential loss—the loss of income when a person cannot work because of an illness or injury (direct loss).

    • Loss exposure is the risk of a possible loss. Basically, any situation that presents the possibility of a loss. In some cases, the term is used to refer to a loss exposure unit.

    • Homogeneous exposure units are individual entities that are exposed to the same group of perils. Their similarities allow them to be grouped together so that the same actuarial assumptions can be applied when pricing coverage.

    • A hazard is a physical condition, a way of acting, or a way of thinking that increases the likelihood that a loss will occur.

      • Physical hazards are physical or tangible conditions that make a loss more likely to occur, such as the increased risk of disability if a person has chronic back problems.

      • Moral hazards make the loss more likely to occur due to the dishonest character of the insured or harmful acts that are done intentionally. Cigarette smoking is an example of a legal action that’s considered a moral hazard. Falsifying the circumstances of an automobile insurance claim to avoid paying a deductible or being held liable is both illegal and evidence of a moral hazard.

      • Morale hazards arise from a state of mind that’s indifferent to the possibility of loss because of the existence of insurance.

Risk

• Risk is the uncertainty regarding the occurrence of a loss.

  • Speculative risks are not insurable as they result in financial gains as well as losses.

  • Pure risks are insurable because there’s only the potential for loss.

  • In general, insurable risk must include all of the following elements:

    • An insurable loss must be due to chance (accidental), which means the cause must be outside an insured’s control.

    • An insurable loss must be definite and measurable, which means the time, place, and amount are known.

    • An insurable loss must be predictable (calculable). There must be a sufficient number of homogeneous loss exposures.

    • An insurable loss cannot be catastrophic. If the potential loss is too large or unpredictable, an insurer cannot financially survive after paying a claim.

    • An insured consumer must have a substantial loss exposure to make the option of buying insurance economically reasonable.

    • The premium cost must be affordable.

    • The following are the three basic risk classifications:

      • Standard risks have an average potential for loss.

      • Substandard risks have a higher-than-average potential for loss.

      • Preferred risks have a lower-than-average potential for loss.

      • Risk managers analyze existing loss exposures and create programs that manage the risk using one or more of the following risk management tools:

        • Risk avoidance eliminates situations that expose a person to risk.

        • Risk reduction accepts the existence of a risk but takes actions to reduce the likelihood or severity of a loss.

          • Loss prevention is a form of risk reduction. The insured takes actions that eliminate damage or loss.

• Risk retention occurs when a person accepts a degree of risk and creates a reserve to pay for it if needed.

• Risk transfer is the practice of transferring risk from one party to another and is the basis of insurance.

• Risk-sharing spreads risk among multiple parties that each assumes a portion of the covered losses.

• Risk pooling spreads risk by distributing the anticipated cost of future losses among many individuals.

  • Risk pooling transfers the risk of loss from an individual to a group.

• Reinsurance is a form of risk transfer between insurance companies.

  • The ceding primary insurer transfers excess risk (risk in excess of its retention limit for a single exposure) to a reinsurance carrier that assumes the risk after receiving a premium from the primary carrier.

Chapter 3

KEYWORDS: LEGAL CONCEPTS OF INSURANCE

Prior to reading this chapter, please review the following keywords. An understanding of their basic definitions will improve your comprehension of the chapter content.

Adhesion: A contract of adhesion is one that has been prepared by one party (the insurance company) with no negotiation between the applicant and insurer. The applicant adheres to the contract terms on a “take it or leave it” basis when accepted. (See Rule Regarding Ambiguities)

Agent: This is the person who represents the insurer during an insurance transaction and has been authorized to act on the insurance company’s behalf. Agents have a fiduciary responsibility to both parties—the insurer and the policy owner.

Aleatory: This is a legal arrangement in which there’s the potential for an unequal exchange of value or consideration between both parties. The insured may never file a claim in an insurance contract, or a claim may be filed after only one or two premiums.

Ambiguities: This refers to terms or conditions that are not clearly defined in an insurance contract. (See Adhesion)

Apparent Authority: This is the appearance of the insurer providing the agent authority to perform unspecified tasks based on the agent-insurer relationship. This perception of authority must stem from the insurer’s actions, even if the perception is unintended and the perception is in error.

Broker: This is a licensed producer who represents himself and the insured (i.e., the client or customer) during an insurance transaction. However, a broker is different from an agent. A broker doesn’t hold an appointment with the insurer in question, and a broker cannot bind coverage on behalf of the insurer.

Competent Party: This is a person who’s able to understand the contract to which two parties are agreeing. All parties must be of legal competence, which means that they must be of legal age, mentally capable of understanding the contract terms, and not under the influence of drugs or alcohol.

Concealment: This is the failure of an applicant to disclose a known material fact when applying for insurance.

Conditional: This is an agreement that remains in force if certain conditions are met. The insurer’s promise to pay benefits is dependent on the occurrence of an event that’s covered by the contract.

Consideration: This is the legal description of the items of value that each party to the contract provides to the other. In the case of an insurance policy, the applicant provides material information and the premium. In return, the insurance company agrees to pay the cost of claims that are covered by the policy.

Consideration Clause: This clause is part of an insurance contract and sets forth the initial and renewal premiums and frequency of future payments.

Doctrine of Reasonable Expectations: This doctrine states that an insurance contract will be interpreted to mean what a reasonable individual would think it means, even if the insurer must pay additional benefits that are not intended by the contract.

Estoppel: This is the legal impediment to one party’s ability to deny the consequences of its own actions or deeds if such actions or deeds result in another party acting in a specific manner or if certain conclusions are drawn.

Express Authority: This is the explicit authority that’s granted to the agent by the insurer, as written in the agency contract.

Fiduciary: A fiduciary is a person to whom property or power is entrusted for the benefit of another person. A producer is a fiduciary that’s in a position of trust regarding the funds of its clients and the insurer. It’s the responsibility of an insurance producer to account for all of the premiums collected and to provide sound financial advice to clients.

Fraud: An individual commits fraud when he engages in intentional deceit to gain a benefit. Fraud includes having deliberate knowledge of false statements that are made or intended as well as the act of a person making such statements herself.

Implied Authority: This is an authority that’s not explicitly granted to the agent in the contract of agency, but which common sense dictates the agent has. This authority enables the agent to carry out routine responsibilities.

Indemnity Contract: This type of contract attempts to return the insured to his original financial position.

Insurable Interest: This is the financial, economic, and emotional impact that’s experienced by a person who suffers a covered loss. A person has an insurable interest if she has more to gain by not experiencing the loss.

Insurance Policy: This is a written contract in which one party promises to indemnify another against a loss that arises from an unknown event.

Legal Purpose: This means that an insurance contract must be legal in nature and not in opposition to public policy.

Material Misrepresentation: This is a false statement being made by an applicant that influences either an insurer’s decision to accept the risk, or the classification and pricing of a risk that’s accepted by the insurer.

Misrepresentation: This is a statement being made as a legal representation that’s factually incorrect, either totally or in part.

Parole Evidence Rule: This rule states that, when the parties agree in writing, all previous verbal statements come together. A written contract cannot be changed or modified by parole (oral) evidence.

Policy Rider or Endorsement: This is an amendment which is added to an insurance contract that overrides terms in the original policy. Riders may add or remove coverages, change deductibles, or revise any other policy feature. In general, a policy owner must pay an additional premium to add a policy rider that enhances policy benefits.

Reasonable Expectations: This indicates that the insured is entitled to coverage under a policy that any sensible and prudent person would expect it to provide.

Representations: These are statements made by the applicant that he considers true and accurate to the best of his belief.

Rule Regarding Ambiguities: This rule applies to contracts of adhesion. Courts will interpret the terms of an insurance contract in favor of the insured if there’s a legal dispute and the court holds the terms of the contract to be ambiguous. The insurer is responsible for ensuring that the contract is clear since it creates the policy terms as a contract of adhesion.

Subrogation: This is the right for an insurer to pursue a third party that caused an insurance loss to the insured.

Unilateral: This is a type of contract in which only one party—the insurer—makes any kind of enforceable promise. The promises remain in force for as long as the insured pays the required premium.

Utmost Good Faith: This statement is based on the belief that both the policy owner and the insurer must know all of the material facts and relevant information. As such, they will provide each other with all material facts and relevant information.

Valued Contract: This type of contract pays a stated sum regardless of the actual loss incurred. Life insurance contracts are valued contracts.

Void Contract: This contract is an agreement that has never really been in force because it lacks one of the essential elements of a contract. For example, if a third party (rather than the applicant for insurance) provides a urine sample for analysis, this act of impersonation deprives the insurer of the information it needs. In effect, the applicant is withholding necessary consideration; therefore, any policy is void from the day it’s issued. In other words, it never really goes into effect. (See Voidable Contract for contrast.)

Voidable Contract: This type of contract is an agreement that may be set aside by one of the parties in the contract for a reason that’s satisfactory to the court. (See Void Contract for contrast.)

Waiver: This is the voluntary giving up of a legal, given right.

Warranty: This is a statement made by the applicant that’s guaranteed to be true in every respect and also becomes a part of the contract. The discovery that a warranty is untrue can be grounds for revoking the agreement. In general, all statements that are made by an applicant are representations, rather than warranty

INTRODUCTION

This chapter will introduce the general law of contract and the unique features of an insurance contract, including aleatory contracts, contracts of adhesion, unilateral, personal, and conditional contracts. The chapter will also review the concepts of indemnity, valued contracts, insurable interest, and legal concepts that are essential to negotiating and issuing new contracts. It will also examine other critical legal concepts that underlie the process of soliciting and selling insurance. Finally, the chapter concludes with a description of the losses that are covered under an errors and omissions (E&O) policy.

The chapter is broken down into the following sections:

• General Law of Contracts

• Special Features of Insurance Contracts

• Negotiating and Issuing Insurance Policies

• The Law of Agency

• Other Legal Concepts Related to Insurance

Specific definitions, rules, regulations, and obligations pertaining to insurance in your specific state are discussed in detail in the state-specific chapter that’s located at the end of the course. In the event of a conflict, state law will supersede this general content.

A review of this chapter will enable a person to:

• Understand the basic terminology that’s used in insurance contracts

• Identify the parties of an insurance contract

• Understand and list the essential elements that are contained in legal and binding contracts

• Distinguish the unique characteristics of insurance contracts

• Distinguish between a warranty, representation, and material representation

• Understand concealment and rescission

• Distinguish between void and voidable contracts

• Understand and list the three types of agent authority

• Distinguish between agents and brokers

• Distinguish between agent and solicitor authority

• Understand the concept of errors and omissions

GENERAL LAW OF CONTRACTS

Contracts of insurance are binding legal agreements and are enforceable by law. There are two parties to an insurance contract—the policy owner (or applicant) and the insurer. In most cases, the policy owner is also the insured; however, third parties own some life insurance policies. The insurer (or insurance company) makes a promise to pay benefits to the policy owner (the insured) under certain circumstances that are dictated in the contract.

For a contract to be legally valid and binding (enforceable), the following four essential elements must be included:

• Competent parties

• Legal purpose

• Offer and acceptance (agreement)

• Consideration

Use the mnemonic device “C, L, O, C” to remember the four elements.

COMPETENT PARTIES

The parties (i.e., the applicant and insurer) that arrive at an agreement must be competent parties and they must possess the capacity to enter into the contract. In other words, the parties involved in the agreement must be competent. For a person to be considered competent, he must possess such a capacity. This requirement may also be referred to as legal capacity. The insurer is considered competent if it has been licensed or authorized by the state(s) in which it conducts business. Most people are considered competent to enter into a contract; however, the following list represents those who are not competent:

• Minors are not considered competent, except those who are entering into agreements for necessities (e.g., food). State laws will vary as far as determining the “age of majority” or the age at which a person may enter into an insurance agreement.

• Insane or mentally incompetent individuals

• Individuals who are under the influence of alcohol or drugs at the time of application

• Persons who are forced or coerced into a contract

• Enemy aliens

• Convicts (based on state law)

[EXAM TIP: An insurance contract consists of two parties—the policy owner (applicant) and the insurer (company). The beneficiary and insured (if different from the policy owner) are not parties of an insurance contract and don’t have legal capacity.

If an insurance exam question asks about identifying the party who enters a contract with an insurer, the proper answer is “the policy owner,” even if “the insured” is also given as a choice. The policy owner (regardless of whether he’s also the insured) has committed to pay the premium. It’s also the policy owner who has the right to make changes or exercise policy options.]

LEGAL PURPOSE

Contractual arrangements cannot be contrary to public policy and must be created in the public’s best interest. For a contract to be enforceable, the contract must have a legal purpose. The object of the contract and the reason for the parties to be entering into the agreement must be lawful. Therefore, an organized crime “hit” contract is neither valid, nor is it in the public’s best interest because the object or purpose of the contract is not legal. Insurance contracts are always considered to possess a lawful purpose.

OFFER AND ACCEPTANCE (AGREEMENT)

A valid offer and unconditional acceptance must be present for a contract to be enforceable. The offer and acceptance are often referred to as the agreement. An offer is a proposal by one party that will create an agreement if accepted by another.

In an insurance contract, the applicant for insurance generally makes the “offer” by submitting a completed application and paying the initial premium. If an applicant applies without an initial premium, she’s making an invitation. The offer is not complete unless the premium is included. The insurer either accepts or declines (rejects) the offer based on its underwriting criteria.

If the insurer accepts the offer, it will issue the requested policy, and the producer will deliver it. At that point, the parties have arrived at an agreement. Therefore, the acceptance can be demonstrated by the insurer issuing, or the producer delivering, the policy. There must be a genuine agreement between the parties, which means that neither party must be under duress or any undue influence.

If the insurer makes a counteroffer, the original offer that was made by the applicant has been rejected by the insurer and that initial offer is void. No contract will exist unless the applicant accepts the insurer’s counteroffer, usually by paying an additional premium or agreeing to benefit limitations.

CONSIDERATION

For any agreement to be binding, both parties must provide each other with some item of value. Or, put another way, there must be an exchange of valuables between the parties to make the agreement binding. The applicant’s consideration is the premium paid and the representations (statements) she makes on the completed application. The insurer’s consideration is the promise to pay legitimate claims for the coverage that’s provided during the policy period. In some cases, consideration is referred to as a bargained-for exchange. Regardless of what it’s called, consideration is the binding force of any insurance policy.

The coverage remains in effect if the policy owner complies with the premium payment schedule. The insurer’s promise to pay exists as long as the insured pays the prescribed premium. For coverage to remain in effect, the consideration must be perpetual. Therefore, the consideration clause also contains information related to the schedule and amount of premium payments.

[EXAM TIP: In an insurance contract, consideration (completed application and premium payments) is given by the applicant in exchange for the insurer’s promise to pay benefits.]

SPECIAL FEATURES OF INSURANCE CONTRACTS

There are many legal concepts and interpretations that affect all types of contracts, including insurance contracts. Insurance policies also possess additional features and characteristics which distinguish them in the “world of contract law.” This section will take a closer look at some of these distinctions.

ALEATORY CONTRACT

An insurance contract is an aleatory contract because one party may recover more in value than she has paid. This disparity between the amount each party to the contract realizes in the way of benefits occurs because benefits are based on an uncertain future event (e.g., an illness or the timing of a person’s death). In other words, an aleatory contract is characterized by an unequal payment or consideration. The value of the policy owner’s potential benefit (i.e., the claim payment) is generally higher than the value (i.e., the premium) that’s received by the insurer.

Although this aleatory feature of insurance means that a policy owner gets a large amount of coverage by paying a relatively small premium, there’s no guarantee that the insured will receive a benefit. A covered loss must occur for any benefit to be paid, and the policy must be in force when it does. Performance is based on an uncertain future event involving unequal bargaining value. Both insurance and gambling contracts are typically considered aleatory contracts.

For example, an individual who has a disability insurance policy will collect benefits if she becomes disabled. However, if she suffers no disability, benefits are not paid.

Another example which illustrates the aleatory nature of insurance contracts is a life insurance policy that pays out a $20,000 death benefit after the insurance company collects only $100 in premiums.

CONTRACT OF ADHESION

Insurance policies are contracts of adhesion because these contracts are prepared by only one of the parties—the insurance company. The applicant and the insurer don’t negotiate the terms of the contract. Instead, the applicant adheres to the insurance company’s contract terms on a “take it or leave it” basis when accepted. A policy of adhesion can also be described as one which can only be modified by the insurance company.

Ambiguities in a Contract of Adhesion

Ambiguities or confusing language in a contract can result in differing legal interpretations and conflicts. In any contract of adhesion, the party that dictates the contract terms has the responsibility to ensure that all of the contract terms are clear and free of ambiguities. The insurance company has this responsibility when it comes to its insurance policies.

If a legal question arises regarding an insurance policy, it often involves an ambiguous definition, description, or policy provision. In such cases, courts will rule in favor of the insured because the insurance company is responsible for making the policy terms clear. After all, the insurer has total control of the contract language.

Doctrine of Reasonable Expectations

A conventional legal interpretation of this situation entails the doctrine of reasonable expectations. According to this doctrine, a court will generally interpret an insurance contract to mean what a “reasonable” consumer would expect. Reasonable expectations may be based on what the producer or insurer has indicated or what the consumer interpreted or expected it to mean. The purpose is to correct any advantage that’ s gained by the party who prepared the contract.

The insurance carrier is responsible for assembling the policy forms for the insured person(s). However, the insurer is typically required to obtain approval from the state’s insurance department before using or modifying any policy forms.

[EXAM TIP: The reasonable expectation is a legal principle that reinforces the rule
that ambiguities in insurance contracts should be interpreted in favor of the policy holder. It also states that an insured is entitled to coverage under a policy that a sensible and prudent person would expect it to provide.]

UNILATERAL CONTRACT

Insurance policies are also unilateral contracts. A unilateral contract is one in which only one party (the insurer) makes any enforceable promise. Therefore, it’s often considered to be a one-sided contract. Insurers promise to pay benefits upon the occurrence of a specific event (e.g., death or disability); however, the applicant makes no such promise. In fact, the applicant doesn’t even promise to pay premiums. The insurer cannot require the policy owner to pay premiums; instead, the insurer has the right to cancel the contract if premiums are not paid. The payment of premiums is a necessary condition for keeping the insurer’s promise in force.

PERSONAL CONTRACT

Most forms of insurance are personal contracts. In other words, they’re personal agreements between the insurer and the insured. By referring to an insurance policy as a personal contract, it’s understood that a policy insures the owner (person) of the property, and not the property itself. As such, most types of insurance cannot be transferred to another person.

For example, an individual typically carries auto insurance on his car and homeowner’s or renter’s insurance on his home. The coverage is specific to the individual. When he sells his house or his car, he cannot transfer those insurance policies to the new owner.

Life insurance is an exception to this rule. Life insurance policies are NOT personal contracts because they allow for the transfer of ownership through assignments. For this reason, people who buy life insurance policies are typically referred to as policy owners rather than policy holders. If a policy owner wants to assign a life insurance policy, he simply notifies the insurer in writing. The company will accept the validity of the transfer without question, and the new policy owner is granted all of the rights of policy ownership. Therefore, contracts of life insurance are NOT personal contracts.

CONDITIONAL CONTRACT

A condition is a requirement that’s specified in the contract, which limits the rights provided by the contract. An insurance contract is conditional. The contract includes conditions that must be upheld by the insured to qualify for indemnification. The insurer’s promise to pay a benefit is dependent on the occurrence of an event that’s covered by the contract. If the event doesn’t materialize, no benefits are paid. Additionally, the insurer’s obligations under the contract are conditioned on the performance of specific acts by the insured or the beneficiary.

For example, the timely payment of premiums is a condition for keeping the contract in force. If premiums are not paid, the company is relieved of its obligation to pay a benefit. The requirement to notify the insurer of a loss is another necessary condition, as is the insured’s need to provide “proof of loss.”. An insurer will not pay the benefits if the insured doesn’t notify the company of the loss or cannot prove that the loss occurred.

VALUED CONTRACT OR INDEMNITY CONTRACT

Life and health insurance policies fall into one of two categories—they’re either valued contracts or indemnity contracts. Valued contracts set a value on certain losses independent of a specific loss, while indemnity contracts replace identified economic losses.

Valued Contracts

A valued contract pays a stated sum regardless of the actual loss incurred. Life insurance contracts are valued contracts. There’s no attempt to calculate a death benefit at the time of death; instead, the parties established the death benefit when the policy was first issued. Accidental death and dismemberment policies, which are a form of health insurance, also fall into this category.

For example, if an individual acquires a life insurance policy to insure her life for $500,000, that’s the amount payable at death.

Indemnity Contracts

An indemnity contract pays an amount that’s equal to a loss. A contract of indemnity specifies that insurance should restore an individual to the same or a similar financial position in which he existed prior to the loss. Some contracts of indemnity are reimbursement policies. These contracts reimburse the insured for the exact amount of covered costs minus any required cost-sharing amounts, such as policy deductibles.

For example, let’s assume that an individual is covered by a reimbursement type of plan with a maximum hospital benefit of $500,000. She’s hospitalized due to an illness and the bill is $25,000. The policy will pay or reimburse her or the hospital for the amount equal to the expenses incurred (i.e., $25,000).

Other indemnity contracts define their benefits as a certain amount of money per day, week, or month to offset a loss of revenue as in a disability policy.

For example, an individual earns $600 per week and has a disability insurance policy that pays $400 per week. When he becomes disabled, the policy pays the stated benefits, which replaces two-thirds of his lost income while he’s disabled. Although the policy doesn’t reimburse the insured for specific expenses, it does restore his income to the extent that’s defined in the policy.

INSURABLE INTEREST

Another element of a valid insurance contract, and a component of legal purpose, is the concept of insurable interest. Insurable interest can be defined as the type of financial interest that a person must have in themselves or another person to purchase legally enforceable insurance coverage. To have “an insurable interest” in oneself or another person, an individual must have a reasonable expectation of benefiting from the other person’s continued life and well-being. It’s this relationship between parties that justifies one person owning an insurance policy on the other. For a person other than the insured to be the policy owner, she must have an insurable interest in the insured.

Conversely, the individual will suffer a loss (financial or economic) if the other person becomes ill, suffers an injury, or dies. Life and health insurance policies assume that insureds have an “insurable interest” in themselves. This assumption is necessary and explains the need for suicide exclusions and exclusions for intentionally self-inflicted injuries. Ultimately, a policy obtained by a person who doesn’t having an insurable interest in the insured is a type of wager. Such a policy is not valid and cannot be enforced. Life insurance contracts originated without an insurable interest are known as Stranger Originated Life Insurance (STOLI). They are formed without a legal purpose and are therefore not enforceable.

Any person who purchases life insurance on his own life possesses an unrestricted or unlimited insurable interest in himself. Insurable interest also exists automatically in marital relationships, between parents and children, in a business situation between a business and a key employee, or in a debtor-creditor relationship.

For example, it’s assumed that a husband and wife have an insurable interest in each other’s life as there are financial and emotional benefits to the continuation of each life. An individual even possesses an insurable interest in a nephew or niece if either lived in the individual’s household or was their guardian. A person does not have an insurable interest in the life of his mail carrier since there’s no expectation of benefiting from the mail carrier’s continued life.

It’s important to note that, for a life or health insurance contract, insurable interest is only required at the time of the application. Insurable interest doesn’t need to continue throughout the duration of the policy, and it doesn’t need to exist at the time of claim.

For example, two individuals are married and take out an insurance policy on each other’s life. There’s no issue if the individuals later get divorced but keep the life insurance policies they own on each other. Although insurable interest no longer exists, the policies remain valid because insurable interest existed when the policies were bought.

For property and casualty insurance, an insured must prove that she has a legitimate interest in preserving the property she seeks to insure when the insurance is purchased and when a loss occurs.

For example, Bob owns the house next door to Tiffany, who also owns her house. Bob can purchase a homeowner’s policy on his home, and Tiffany can buy a homeowner’s policy on her house. However, they’re not allowed to purchase a homeowner’s policy on each other’s property because they each only have an insurable interest in their own home.

NEGOTIATING AND ISSUING INSURANCE POLICIES

To reiterate, an insurance policy is a written contract in which one party promises to compensate another against loss from an unknown event. Therefore, an insurance policy is also referred to as an insurance contract. The term can refer to the overall agreement between the insurer and insured, as well as to a basic policy form without any optional provisions added. A policy rider or endorsement is a legal attachment which amends a policy. The rider often incorporates additional benefits into a policy. Some riders limit policy benefits to allow coverage for high-risk situations. An insurance policy (contract) will include the policy form, any riders or endorsements, and a copy of the completed application. Therefore, the application is a part of the insurance contract.

UTMOST GOOD FAITH

Insurance is a contract of utmost good faith, which means that both the policy owner and the insurer must know all material facts and relevant information. There can be no attempt by either party to conceal, disguise, or deceive.

A consumer purchases a policy mainly based on the insurer’s or agent’s explanation of the policy’s features, benefits, and advantages, as well as the “faith” that the company will be able to pay the claim in the event of a loss. Insurance applicants must make a full, fair, and honest disclosure of the risk to the agent and insurer.

The insurer issues the policies on the “faith” that the applicant was truthful. Concepts related to utmost good faith include warranties, representations, and concealment. These represent grounds through which an insurer may seek to avoid payment under a contract.

Warranty

A warranty is a statement that’s guaranteed to be true in every respect. It becomes part of the contract and can be grounds for revoking the agreement if it’s found to be untrue. Warranties are presumed to be material because they affect the insurer’s decision to accept or reject an applicant. A warranty can be expressed or implied and may relate to the past, present, future, or any combination. Generally, applicant statements that are treated as warranties appear in some lines of property and casualty coverage rather than life and health insurance applications.

Representation

A representation is a statement that’s made by the applicant and considered to be true and accurate to the best of the applicant’s belief. The insurer uses the representation to evaluate whether to issue a policy. Unlike warranties, representations are not a part of a contract and need to be true only to the extent that they’re material and related to the risk. Statements that are made by applicants for insurance are representations and not warranties. A representation cannot qualify an express provision in a contract of insurance, but it may qualify as an implied warranty. A false statement that’s made by an applicant which would influence an insurer in determining whether to accept the risk is considered a material misrepresentation.

Concealment

Concealment is defined as the failure or neglect by the applicant to disclose a known, material fact when applying for insurance. If the purpose of concealment is to defraud the insurer (i.e., obtain a policy that may not otherwise be issued if the information were revealed), the insurer may have grounds for voiding the policy. Regardless of whether concealment is intentional, the injured party has the right to rescind the insurance contract. Rescission means that the contract is made null and void.

The insurer must prove concealment and materiality. Materiality means that the insurer would not have issued the same policy with the exact same terms had the insurer known the concealed facts at the time of application. In most cases, insurers have only a limited period to uncover misrepresentations or concealment. After that period passes (normally two or three years from policy issue depending on state law), the contract cannot be voided or revoked for these reasons.

VOID VERSUS VOIDABLE CONTRACTS

The terms void and voidable are often incorrectly used interchangeably. In one case, a valid contract may be terminated, while in the other case, a valid contract may never be in force.

Void Contract

A void contract is simply an agreement without legal effect. In essence, it’s not a contract at all because it lacks one of the elements that are specified by law for a valid contract. Neither party can enforce the terms of a void contract.

For example, a contract that has an illegal purpose is void, and neither party to the contract can enforce it.

An insurer may void an insurance policy if a misrepresentation on the application is proven to be material.

Voidable Contract

A voidable contract is an agreement that may be set aside by one party to the contract for reasons that are satisfactory to the court. It’s binding unless the party with the right to reject it chooses to do so.

For example, a policy holder fails to comply with a condition of the contract when he stops paying his insurance premium. As a result, the contract is now voidable, and the insurance company has the right to cancel the contract and revoke the coverage.

CANCELLATION

The voluntary act of terminating an insurance contract is referred to as cancellation. The policy owner may voluntarily cancel an insurance contract for any reason at any time. A policy will lapse if the premiums are not paid before the end of the grace period. As with other financial commitments, insurance policies have a due date on which the required premium is paid, but also a grace period (after the due date) during which the payment may be made without penalty.

FRAUD

Fraud involves deliberate or intentional deceit with the objective of making false statements in order to be compensated by an insurance contract (e.g., filing a false claim). Contracts may be rescinded if one or more of the parties engages in fraudulent activities. Under most types of contracts (other than life and health insurance), fraud is a reason to void a contract. With insurance contracts, an insurer may only have a limited period to challenge the validity of a contract.

In most states, insurers cannot void life insurance contracts after they have been in force for two years. Guaranteed renewable health insurance policies typically have two or three years, depending on state law. After this period of two or three years, life and health insurers cannot contest the policy or deny benefits based on application errors resulting in material misrepresentations or concealment. The ability of insurers to void other health insurance policies due to fraud is not necessarily limited. This will be examined later in this chapter in the section titled “Time Limit on Certain Defenses.”

PAROLE EVIDENCE RULE

Parole evidence is oral or verbal evidence or that which is given verbally in a court of law. The legal principle of the parole evidence rule limits a contract to its written terms. This rule minimizes the use of oral or written documents that are outside of the written policy. In general, oral statements cannot be used to counteract or nullify insurance contract provisions. In other words, if a litigious dispute arises, oral statements that are made before the formation of a contract, if not made a part of the written contract, will not be admitted in court in the future. Additionally, only that which is written in the contract is enforceable.

For example, once an insurance producer delivers the insurance policy to the insured, the written contract (policy) supersedes any issues that were discussed verbally during the application or sales process.

WAIVER

A waiver is the voluntary surrendering (giving up) of a known right. A waiver is also defined as “the deliberate, voluntary, or intentional abandonment of a known right by the insurer.” It usually involves the conduct of an insurer or its sales representative, which intentionally relinquishes a defense against a claim. If an insurer fails to enforce (waives) a contract provision, it cannot later deny a claim based on a violation of that provision.

For example, let’s assume that a life insurer issues a policy which states the policy is void if the insured enters the military. The insured joins the army and is killed during a battle. A company officer informs the insured’s beneficiary that, since the insured died in defense of his country, the insurance company will waive its defense of military service death. Later, the insurer denies the claim. However, the company will need to pay the claim since the company officer’s communication (written or verbal) constitutes a waiver and prevents the insurer from denying the claim.

Another example of a waiver could involve an insurer that mistakenly accepts an incomplete application and issues a policy. Later, the insurer attempts to rescind the policy or deny a claim because the application was incomplete. In this case, the insurer will be prevented from doing so since it has engaged in a waiver. The company’s mistake prevents it from denying the claim or attempting to take back or rescind the policy. A waiver can also occur if an insurer fails to enforce a provision in the policy. After an insurer issues a policy, if it discovers that an individual lied about her health and the insurer doesn’t inform her within a reasonable time that the contract will be void or rescinded, it has engaged in a “waiver by silence.”

ESTOPPEL

The legal principle of estoppel involves a broken promise. Estoppel prohibits an insurer from denying a claim due to specific actions (or inactions) by the insurer or its representatives. Typically, estoppel applies when an agent makes a false or misleading representation to a consumer. The consumer bases his decision to purchase or alter coverage based on the agent’s representation. When a situation arises that tests the validity of the inaccurate representation, the insurance company denies the consumer’s claim based on the actual policy language. The insured consumer then experiences financial harm. If the consumer challenges the decision in court, the law will stop the insurer from relying on the contract language to deny the claim. The insurer’s agent made a representation, and an act of the agent is legally considered an act of the insurer. Therefore, the insurance company must honor its agent’s representation and pay the claim.

This legal doctrine of estoppel applies when ALL of the following elements are present:

• An agent or legal representative, who’s acting within their authority, makes an inaccurate representation on behalf of the insurance company.

• A consumer relies on the veracity of the information that’s provided to make legally binding decisions.

• When a circumstance arises that tests the validity of the questionable representation, the insurance company refuses to honor it by citing the terms of the contract as written.

• The decision of the insurer causes financial harm to the consumer.

If all four conditions are present, the insurer will be estopped or prevented from denying the claim and is legally bound to honor the promise rather than abide by the written contract.

THE LAW OF AGENCY

As noted earlier, an insurance agent is authorized to sell, solicit, negotiate, and effect contracts of insurance on behalf of an insurer through a contractual arrangement. An agent’s role involves the following duties:

• Describing the company’s insurance policies to prospective buyers

• Soliciting applications for insurance

• Collecting premiums from policy owners

• Rendering service to prospects and currently insured consumers

Insurers grant agents the authority to undertake these functions in their contract of agency with the company. This agreement may also be referred to as an agent appointment or agency agreement. This contract clearly defines the scope of an agent’s authority to act for an insurer. When acting within the scope of the authority granted, an agent is considered to be the insurance company. The relationship between an agent and the company being represented is governed by agency law.

PRINCIPLES OF AGENCY LAW

By legal definition, an agent is a person or entity that acts on behalf of another person (i.e., the principal). For insurance purposes, the insurer is referred to as the principal. The agent represents the principal in dealings with third parties that concern contractual arrangements. Authorized agents have the power to bind the principal to contracts (and to the rights and responsibilities of those contracts). From this description, the four essential principles of agency law can be identified:

1. The acts of an agent (within the scope of his authority) are the acts of the principal.

2. A contract that’s completed by an agent on behalf of the principal is a contract of the principal.

3. Payments received by an agent on behalf of the principal are payments made to the principal.

4. An agent’s knowledge regarding a business matter of concern to the principal is presumed to be known by the principal.

AGENT AUTHORITY

The scope of agent authority is another important concept of agency law. “Authority” is what an insurer grants a licensee for this person to transact insurance on its behalf. Technically, only authorized actions can bind a principal. In reality, an agent’s authority can be quite broad.

There are three types of agent authority—express, implied, and apparent. The significance of this authority (whether express, implied, or apparent) is that it ties the company to the acts and deeds of its agents. The law will view the agent and company as identical when the agent acts within the scope of his authority. Additionally, an insurer may be liable to an insured for unauthorized acts of its agent when the agency contract is unclear about the authority granted.

Express Authority

Express authority is the authority a principal deliberately gives to its agent. This authority is granted by means of the agent’s contract, which is the principal’s appointment of the agent to act on its behalf. Express authority refers to those activities that are expressly stated in writing under the terms of the agent’s contract.

For example, an agent has the express authority to solicit applications for insurance on behalf of the company.

Implied Authority

Implied authority is the unwritten authority that’s not expressly granted in writing; instead, it’s the authority that can be assumed an agent needs to transact the principal’s business as expressed in the contract. Implied authority is incidental to express authority because not every single detail of an agent’s authority can be spelled out in the agent’s contract.

For example, an agent’s contract may not explicitly state that he can print business cards which contain the company’s name, but the authority to do so is implied.

Apparent Authority

Apparent authority is the appearance authority based on the actions, words, or deeds of the principal. Consumers assume the agent has certain types of authority based on the appearances or circumstances that the principal has created—regardless of whether such authority exists.

For example, if an insurer provides an individual with a rate book, application forms, and sales literature, the insurance company has created the impression that an agency relationship exists between itself and the individual. The law will not allow the company to later deny that such a relationship existed, even if no signed agency agreement is in force.

Please note, apparent authority relies on company actions. If the agent stole the items described in the above example, then it would be a case of fraud since the insurance company had no role in providing or not reclaiming the material in question.

BROKERS VERSUS AGENTS

As described previously, insurance producers may be agents or brokers. Although an agent has an agent’s contract, and a broker has a broker’s contract, the same Law of Agency governs both parties. The most significant difference between the two types of contracts is that, in a sales transaction, agents represent the insurer, while brokers represent the buyer (or applicant). A broker solicits and accepts insurance applications and then places the coverage with an insurer. A broker cannot bind coverage. However, an agent’s contract and appointment with one or more insurance companies grants that agent the authority to bind an insurer to an insurance contract. A broker must work with an agent or company representative who can bind an insurer.

AGENT VERSUS SOLICITOR AUTHORITY

An insurance producer who’s working as an agent has the authority to seek out applicants, present product solutions to meet insurance needs, complete applications, and bind coverage. Some states also allow for licensed solicitors. Solicitors have the authority to seek out insurance applicants for a company, but don’t have any authority to bind coverage on behalf of a company. Solicitors arrange for prospective clients to meet with agents who can sell and bind insurance coverage that meets the clients’ needs.

AGENT AS A FIDUCIARY

The concept of fiduciary responsibility is another legal concept that governs the activity of an agent. A fiduciary is a person who holds a position of financial trust and confidence. Agents act in a fiduciary capacity when they accept premiums on behalf of the insurer or offer advice that affects a person’s financial security.

OTHER LEGAL CONCEPTS RELATED TO INSURANCE

SUBROGATION

Subrogation represents the right for an insurer to pursue action against a third party that caused an insurance loss to the insured. Subrogation is used to recover the amount of the claim paid to the insured for the loss. Generally, in most subrogation cases, an individual’s insurance company pays its client’s claim for losses directly, then seeks reimbursement from the other party’s insurance company.

TORT LAW

Remember, contract law deals explicitly with contracts—whether written, oral, express, or implied. Issues related to the validity of a contract (including an insurance policy) are handled through contract law. On the other hand, Tort law involves private wrongs that are independent of contracts. By definition, a tort is a private wrong that occurs when one individual wrongs another by failing to act in a reasonable or prudent manner. Tort law is different from criminal law because people commit crimes against society, even if the victim is an individual. Criminal courts have jurisdiction over crimes, while civil courts preside over torts.

Lawsuits involving contracts fall under contract law; however, most civil court claims fall under tort law. The concept of tort law is to provide compensation for proven harms, or put another way, to right a wrong that’s been done to a person and provide relief from the wrongful acts of others by awarding monetary damages as compensation.

Negligent acts that result in a loss or damage can create a tort. There are several types of negligence, including:

• Simple negligence is a failure to act (or not act) in a reasonable or prudent manner.

• Gross negligence results from a reckless disregard for the need to act in a reasonable manner, regardless of the potential for harm.

• Willful and wanton negligence occurs when a person recklessly disregards reasonable care standards and is aware that bodily injury or property damage will probably occur. This borders on being an intentional act, which liability insurance doesn’t cover.

INSURANCE AGENT ERRORS AND OMISSIONS (E&O) PROFESSIONAL LIABILITY INSURANCE

Just as doctors should have malpractice insurance to protect against legal liability arising from their professional services, insurance agents need errors and omissions (E&O) professional liability insurance. Under this insurance, the insurer agrees to pay sums that the agent is legally obligated to pay for injuries resulting from professional services that he rendered or failed to render. The coverage available includes liability protection that will pay for defense costs and damages awarded to an injured party if the insurance professional is negligent while performing professional services.

Typical Losses Covered

A professional is obligated to deliver a level of service that’s standard for the industry. In some cases, an insurance producer can make a mistake or fail to do something she was supposed to do. Typical losses that are covered for the producer under an E&O policy include:

• Not effecting insurance coverage when requested

• Creating an administrative error

• Premium calculation errors

• Misstating insurance coverages

• Not effecting a policy change as requested by the customer

• Not properly explaining policy provisions

• Incorrect identification of client loss exposures

• Forwarding inaccurate or incomplete information about a client to a carrier

• Failing to recommend coverage

• Improperly handling a claim

Typical E&O Exclusions

Intentionally harming another person is always excluded in any liability insurance policy. This exclusion includes:

• Criminal acts

• Illegal acts

• Dishonest acts

• Malicious acts

• Libel and slander

• Intentional violation of any law, regulation, statute, or ordinance

CHAPTER SUMMARY

Key points to remember from this chapter include:

General Law of Contracts

• Insurance contracts are binding legal agreements between two parties—the policy owner and the insurer.

  • If offered a choice of parties contracting with an insurer, choose the policy owner rather than the insured.

  • The only time “insured” is the correct answer is when “policy owner” (or “policy holder”) is not given as a possible answer.

  • The beneficiary is not a party to the contract.

  • The Four Essential Elements of Every Contract (C.L.O.C.)

    • Competent Parties

      • The parties to a contract must be legally competent, which means mature, mentally sound, and sober.

      • State law may bar certain other categories of individuals (unlikely to be tested).

• Legal Purpose

  • The object of the contract and the reason for the parties to enter into an agreement must be legal.

• Offer and Acceptance (Agreement)

  • Both parties must agree to the contract terms. The first party to ratify the contract terms makes an offer, while the second party to ratify the terms provides her acceptance.

  • OFFER + ACCEPTANCE = AGREEMENT

• Consideration

  • For an agreement to be binding, each party must provide the other with some item of value or “consideration.”

  • An insurance applicant provides the premium and information on the completed application.

  • The insurer promises to pay legitimate claims.

Special Features of Insurance Contracts

• An insurance contract is an aleatory contract because one party may recover more in value than she has paid.

  • The value of the policy owner’s potential benefit (i.e., claim payment) is generally higher than the value (i.e., premium) that’s received by the insurer.

  • There’s no guarantee that the insured will receive a benefit. Performance is based on an uncertain future event involving unequal bargaining value.

  • Insurance policies are contracts of adhesion because they’re prepared by only one of the parties—the insurance company and offered on a “take it or leave it” basis.

    • When the terms in a contract of adhesion are ambiguous (unclear), courts rule in favor of the party that did NOT create the contract (i.e., the insured).

    • The doctrine of reasonable expectations interprets contract terms that may be interpreted more than one way by ascertaining what a “reasonable” consumer would interpret them to mean.

    • Insurance policies are unilateral contracts because only one party (the insurer) makes an enforceable promise, which is contingent on the policy owner paying the premium.

    • Most forms of insurance are personal contracts because they’re non-transferable, and they insure named individuals as owners, potential defendants (torts), or healthcare consumers.

      • Life insurance is an exception to this rule. Life insurance is NOT a personal contract since it can be borrowed against or sold like a transferable asset.

      • Insurance policies are conditional because the insurer’s promise to pay is contingent on the occurrence of uncertain future events. It also requires the insured or beneficiary to take certain actions.

      • Valued contracts pay a stated sum regardless of the actual loss that’s incurred.

      • Indemnity contracts pay an amount that’s equal to a loss identified in the policy.

      • To have “an insurable interest” in oneself or another person, an individual must have a reasonable expectation of benefiting from the other person’s continued life, and conversely, will suffer a financial loss if the insured party becomes ill, is injured, or dies.

        • Insurable interest must exist at the time of application but does not need to exist at the time of a claim payment (i.e., the death of the insured).

Negotiating and Issuing Insurance Policies

• Utmost good faith means that the policy owner and the insurer disclose material information.

• Reasonable expectations are the basis for interpreting ambiguous contract terms.

  • A warranty is a statement that’s guaranteed to be true in every respect and becomes a part of the contract.

  • A representation is a statement made by the applicant which he considers to be true and accurate to the best of his belief. Statements made on an insurance application by the applicant are considered to representations.

  • Concealment is defined as the failure or neglect by the applicant to disclose a known material fact.

  • A void contract is one that has never really gone into effect because it lacks one of the four essential elements of a contract.

  • A voidable contract is an in-force agreement that may be terminated because one of the parties violates a condition of the policy.

  • Fraud is an intentional misrepresentation regarding a claim or policy application that a consumer makes to obtain benefit payments or policy coverage under false pretenses.

  • The parole evidence rule limits a contract to its written terms.

  • A waiver is the voluntary surrendering (giving up) of a known right.

  • Estoppel requires an insurer to abide by misleading or incorrect statements that are made by one of its agents, even if it can demonstrate that the governing policy form contradicts the agent.

    • Estoppel applies when ALL of the following elements are present:

      • An agent is acting within their authority.

      • The agent makes an inaccurate representation on behalf of the insurance company.

      • A consumer relies on the information being correct.

      • When a circumstance arises that tests the validity of the questionable representation, the insurance company refuses to honor the agent’s words.

      • The insurer’s decision causes financial harm to the consumer.

The Law of Agency

• The insurer is considered the principal of an agent contract.

  • Acts of an agent are considered acts of the principal.

  • Payments received by an agent are received by the principal.

  • If an agent knows something, the principal (insurer) knows it as well.

  • Express authority is the agent’s authority expressly granted in his agency contract.

  • Implied authority is the ancillary authority which is assumed that an agent needs to carry out the tasks covered by the express authority conferred by his agent’s contract.

  • Apparent authority is the appearance of authority based on the actions, words, or deeds of the principal. It can exist even if no written agreement exists.

  • Insurance producers may be agents or brokers.

    • Agents are appointed by insurers, represent insurers, and can bind coverage on their behalf.

    • Brokers represent the consumer and cannot bind coverage.

    • Some states license solicitors and provide them with the authority to seek out insurance applicants and arrange for prospective clients to meet with a licensed agent.

    • An agent is a fiduciary because they hold a position of financial trust and confidence with both consumers and insurers.

Other Legal Concepts Related to Insurance

• Subrogation is an insurer’s right to pursue liable third parties for amounts that are paid out in claims made by the insured.

• Torts are private wrongs which mostly involve negligence and are adjudicated in civil court. Civil courts also decide cases involving contract law.

• Insurance agents need errors and omissions (E&O) liability insurance, which covers injuries resulting from mistakes that are made rendering or failing to render professional services.

Chapter 4

KEYWORDS: LIFE INSURANCE POLICY TYPES

Prior to reading this chapter, please review the following keywords. An understanding of their basic definitions will improve your comprehension of the chapter content.

Accidental Death and Dismemberment Insurance (AD&D): This is a form of insurance that provides benefits in the event of accidental death; the accidental loss of sight, speech, or hearing; loss of use of limbs (i.e., paralysis); or loss of a member(s), such as the loss of an arm or a leg.

Accidental Death Benefit (ADB): The ADB provides a lump-sum payment for loss of life due to an accident that was the direct cause of death. The cause of the death must be accidental for a benefit to be payable under the policy.

Additional Premium: This provision is used in Universal Life Policies. Additional premiums can be paid into the policy account in an amount above the target premium. Current tax laws limit the amount of excess cash value that can be accumulated in a life insurance policy. The insurance company may not accept the additional premium if it nears this limit without increasing the limit of life insurance (subject to underwriting).

Attained Age: This is the age that a person or an insured has attained as of a given date. For life insurance purposes, the age is based on either the nearest birthday or the last birthday, depending on the practices of the insurance company involved. Attained age is also referred to as “current age.”

Adjustable Life Insurance: This is a type of policy that combines permanent, whole life, and temporary term life into a single plan that provides the policy owner with the flexibility to adjust premiums throughout the life of the policy.

Cash Surrender Value: This is the amount that’s available in cash upon the surrender of a policy by the owner before or after the policy matures (as a death claim or otherwise). This value is also simply referred to as surrender value.

Cash Value: This is the equity portion of a whole life policy that increases with each subsequent premium payment. The insurer pays interest on the cash value, which is tax-deferred. In a whole life policy, the cash value is designed to equal the policy’s death benefit at age 100. Traditional whole life insurance policies are considered to mature when the insured attains the age of 100.

Credit Insurance: This is insurance that’s designed to pay the balance of a loan if the insured dies or becomes permanently disabled before the loan has been repaid in full. Generally, credit insurance is sold by a lender or finance company.

Convertible Term Life Insurance: This is temporary life insurance that provides the policy owner with the right to exchange an existing policy for other policies that are offered by the insurance company. This conversion may be the conversion of individual term insurance to an individual permanent plan that a company sells or the conversion of group disability, life, or health to an individual plan.

Decreasing Term Insurance: This is a type of temporary or pure protection that’s characterized by a reducing face amount each year and the cost of this coverage remains constant. Decreasing term insurance may be referred to as mortgage redemption or mortgage protection insurance since it’s primarily used in conjunction with a debt or loan.

Endowment Contract: This contract pays a face amount after a fixed time period, at a specific age, or upon the death of the insured if it occurs before the end of the period.

Evidence of Insurability: This involves an insurance applicant establishing the fact that they meet the insurance company’s health requirements. Statements of good health, attending physician statements, health history, and an applicant’s current health can all be used as evidence of insurability.

Extended Term Insurance: This is a non-forfeiture option that’s available when a policy is surrendered and the same face amount of the policy is continued in force for a specified additional period; however, the coverage has changed from permanent to level term protection. Extended term insurance is the non-forfeiture option that provides the policy owner with the highest face amount of coverage.

Face Amount: This is another name for the death benefit of a life insurance policy.

Family Income Policy: This is a policy that combines a whole life policy with a decreasing term rider to provide a death benefit together with monthly income payments to the beneficiary. Monthly income payments are made only from the date of death until the maturity date of the contract. Thereafter, the lump sum part of the whole life coverage is paid.

Family Maintenance Policy: This is a type of policy that combines whole life insurance and a level term rider. It provides for the payment of a monthly income during a stated period of years once the insured dies. The monthly income is payable from the date of death to the end of the pre-selected period. The payment of the face amount of the policy is payable at the end of the pre-selected period.

Family Policy: This is a policy that covers an entire family. Whole life insurance covers the primary insured (i.e., breadwinner) with varying amounts of level term insurance on the remainder of the family.

Guideline Premium: This represents the maximum premium that can be paid into universal life policies and still have the benefit qualify as life insurance under federal tax laws. If a guideline premium is paid regularly, there may be little margin for any additional premium payments into a universal life insurance policy account.

Indexed Contracts: These are contracts in which the policy holder can share in a percentage of the growth of an indexed investment (e.g., a mutual fund tied to the Standard & Poor’s Index). The principle (benefit) is guaranteed, and in many cases, a minimum interest is guaranteed. These products are not considered securities.

Increasing Term Life Insurance: This is term life insurance that provides an increasing face amount over time based on specific amounts or a percentage of the original face amount.

Industrial Life Insurance: This is insurance under which premiums are paid monthly or more often (i.e., weekly). Additionally, the face amount of the policy doesn’t exceed a stated amount, and the words “industrial policy” are printed in prominent type on the face of the policy. Industrial life insurance is also referred to as “debit insurance.”

Joint Life Insurance (First to Die Insurance): This is a life insurance policy that covers the lives of two or more persons. The policy pays a death benefit and ends when the first insured dies. This type of policy is also referred to as “first to die” insurance.

Joint Life Survivor (Last to Die Insurance): This is a life insurance policy that covers the lives of two or more persons. The policy pays a death benefit and ends when the last insured dies. This type of policy is also referred to as “last to die” insurance.

Juvenile Life Insurance: This is a life insurance policy that’s owned by an adult and written on the lives of children.

Level Premium: This describes a premium that remains constant, fixed, or predetermined throughout the life of a policy.

Life Insurance: This represents insurance on the lives of human beings that creates an immediate and guaranteed estate upon the death of an insured or at the end of a predetermined period (in whole life insurance, this is age 100).

Limited Pay Life Insurance: This is a life insurance plan under which the premiums are payable for a specified number of years, after which the policy remains in effect for life without any additional payments. However, the policy still doesn’t mature until age 100.

Maturity Date: This is the date on which a life insurance policy becomes payable due to the death of the insured or as a result of an insured’s living to the end of a specified period (i.e., age 100). In whole life insurance, the cash value is designed to equal the face amount at maturity.

Maturity Value: This is the amount that’s paid under a whole life insurance contract if the insured reaches the age of the mortality table on which the contract was based. If it’s an endowment contract, it represents the cash value amount at the end of the endowment period.

Modified Endowment Contract (MEC): This is a whole life insurance policy under which the amount a policy owner pays in premium during the early years exceeds the sum of premiums required for the first seven years of insurance. The IRS views MECs as the policy owner’s attempt to use the policy as a short-term investment vehicle, and as such, the policy will be designated for tax purposes as an MEC.

Modified Life Policy: This is a whole life plan that’s characterized by a lower premium during the initial years of the contract to make it more affordable for the policy owner. The premium then increases after this introductory period and remains level for the life of the contract.

Mortgage Redemption Plan: This is another name for a decreasing term life insurance policy. This type of plan is used to provide funds for a survivor to pay off a debt. This type of plan is also referred to as mortgage protection coverage or reducing term insurance.

Mutual Insurance Company: This is an insurance company that’s owned and controlled by its policy holders. Mutual insurance companies issue participating policies that may pay dividends to policy holders.

Non-Forfeiture Values: These are benefits that are required by law to be made available to the policy owner if she surrenders the policy by discontinuing premium payments. These values state that the owner will not forfeit or lose all that she has invested in the policy. Also referred to as non-forfeiture options, they include surrender for cash, extended term insurance, and reduced paid-up insurance.

Non-Medical Life Insurance: This is issued without requiring the applicant to submit to a medical examination. The insurer relies on the applicant’s answers to the questions regarding his physical condition, personal references, and inspection reports. However, the insurance company retains the right to require a medical examination if an investigation indicates a need for one.

Non-Participating Insurance: This is a type of insurance policy that’s issued by a stock insurer. This form of insurance contract doesn’t pay dividends to the policy holders.

Ordinary Life Insurance: This is most often described as an insurance policy that’s issued by commercial insurers with face values of $1,000, or multiples thereof.

Paid-Up Insurance: This is life insurance on which future premium payments are not required. Frequently, the term is used to identify a 10, 20, or 30 payment life insurance policy on which 10, 20, or 30 annual premium payments have been paid. Although the policy is “paid-up” at the end of the payment period, the contract doesn’t mature until the age of 100.

Participating Insurance: This is a type of insurance policy that entitles the policy holder to share in the divisible surplus of the insurer through dividends.

Permanent Life Insurance: This is any plan of life insurance that’s designed to last throughout the life of the insured. Level premium, cash value, and non-forfeiture options characterize permanent life insurance.

Policy Proceeds: This refers to the amount that’s paid as a death, surrender, or maturity benefit. In the case of a death benefit, it includes the face value, plus any earned dividends, minus any outstanding loans and interest. If paid as a surrender benefit, the amount includes any cash value, minus surrender charges, outstanding loans, and interest. If the benefit is paid at maturity, the benefit includes the cash value, minus any outstanding loans and interest.

Policy Term: Typically expressed in years, this is the time for which a policy remains in existence.

Renewable Term Life Insurance: This is temporary life insurance that may be renewed at the end of the policy term without evidence of insurability. The premium is based on the attained age of the insured and, as such, increases at each renewal.

Single-Premium Insurance: This form of insurance involves the payment of one premium that’s large enough to cover the cost of a life or annuity contract for life. This is also referred to as a lump-sum premium.

Straight Life Insurance: This is a type of whole life insurance that provides coverage for the entire life of the insured and for which the premiums are payable until death. This is also referred to as continuous premium life.

Stock Insurance Company: This is an insurance company that’s owned and controlled by its stockholders who share in its divisible surplus. Generally, stock insurance companies issue non-participating life insurance; however, some also issue participating life insurance policies.

Target Premium: This represents the suggested premium that’s used in universal life insurance policies; however, there’s no guarantee that there will be adequate funds to maintain the policy. Instead, it may indicate what will be needed (under conservative estimates) to maintain the policy. The validity of a target premium is based on an individual insurance company’s marketing stance, investment performance, and cost control.

Term Life Insurance: This is temporary life insurance that’s generally designed to afford coverage for a limited number of years. The policy includes no cash value and can be described as pure protection.

Universal Life Insurance: This is adjustable life insurance under which premiums and coverage are adjustable. For a universal policy, company expenses are not explicitly disclosed to the insured, but a financial report is provided to policy holders annually.

Variable Life Insurance: This is life insurance whose face value or duration varies depending on the value of underlying securities.

Variable Universal Life Insurance: This form of insurance combines the flexible premium features of universal life with the component of variable life in which excess credited to the cash value of the account depends on investment results of separate accounts. The policy holder selects the accounts into which the premium payments are to be made.

Whole Life Insurance: This is the form of life insurance that may be kept in force for a person’s entire life, and that pays a benefit upon the person’s death.

INTRODUCTION

This chapter will introduce the general concepts of life insurance policy contracts and the various types of life insurance products. Determining the best type of life insurance for a person depends on (among several other factors) how long the person wants the policy to last and how much he wants to pay. This chapter will examine the various types of life insurance policies that are available, their benefits, and how each policy is funded.

The chapter is broken into the following sections:

• General Concepts of Life Insurance

• Temporary Life Insurance Products

• Permanent Life Insurance Products

• Alternative Non-Traditional Life Insurance Products

• Securities and Exchange Commission (SEC) Regulated Life Insurance Policies

• Special Use Life Insurance Products

• Other Life Insurance Products

The state-specific portion of this course (located at the end) will detail the specific insurance definitions, rules, regulations, and statutes for your state. In the event of a conflict, state law will supersede the general content.

Review of this chapter will enable a person to:

• Understand the general concepts that are used in life insurance contracts

• Become familiar with life insurance policies

• Identify the different types of term life insurance

• Identify the advantages and disadvantages of term life insurance

• Understand the general concepts of whole life insurance

• Identify the features of whole life insurance

• Identify the different types of whole life insurance policies

• Become familiar with the types of non-traditional whole life insurance policies

• Distinguish between low premium type and high premium type

• Understand the concept of modified endowment contracts

• Identify and distinguish between the different types of special-use life insurance products

• Distinguish between family plan policies and family income policies

• Distinguish between joint life policies and joint life and survivor policies

• Identify the most notable non-traditional life insurance products

• Identify universal life death benefit options

• Distinguish between participating versus non-participating policies

GENERAL CONCEPTS OF LIFE INSURANCE

For more than a century, life insurance has been recognized as an essential element in an individual’s or family’s financial planning program. Life insurance involves the transfer of the risk of premature death from one party (i.e., the policy owner/insured) to another party (i.e., the insurer). When a life insurance contract is payable upon the death of the insured, it instantly creates funds for a named beneficiary. In other words, a life insurance contract creates an immediate estate.

Unlike other lines of insurance (e.g., property and casualty), there are no “standard life insurance policies.” Today’s life insurance policies are typically defined by the benefit options available, the intended length of coverage, and how the policy benefits will be paid for or funded. Broadly speaking, all life insurance policies fall into the following categories:

• Permanent (whole life or ordinary) or temporary (term life)

• Group or individual

• Fixed or variable

• Industrial, Burial, or Debt insurance

A life insurance company may choose to specialize in any of these types, or just specialize in one or two. These basic coverage types are distinguished by the type of customers, amounts of insurance written, underwriting standards, and marketing practices. Group life insurance will be described later in the course.

TEMPORARY LIFE INSURANCE PRODUCTS

TERM LIFE INSURANCE

Term life insurance provides pure or temporary protection and is the simplest form of life insurance coverage; essentially, it provides the maximum amount of life insurance at the lowest initial outlay of funds. Term life provides low-cost insurance protection for a specified, limited period and pays a benefit only if the insured dies during that period. Term life is often referred to as temporary life insurance since it provides protection for a temporary period. The period (or TERM) for which these policies are issued can be defined by years (e.g., one-year term, five-year term, or 20-year term) or age (e.g., term to age 65, term to age 70). Term policies that are issued for a specified number of years provide coverage from their issue date until the end of the years specified. Term policies that are issued until a certain age provide coverage from their date of issue until the insured reaches the specified age. Term insurance provides the insured with peace of mind against the financial loss that an early death may cause. However, if the insured survives, there’s no loss and therefore no benefits are paid.

For example, Steve purchases a 20-year $75,000 level term policy on his life and names his sister, Amy, as the beneficiary. If Steve dies at any time within the policy’s 20-year period, Amy will receive the $75,000 death benefit. If Steve lives beyond that period, the policy expires, and nothing is payable to either Steve or Amy. Additionally, if Steve cancels or lapses the policy during the 20-year term, nothing is payable.

Term life policies are able to offer fixed, or constant, level premiums because the premiums are averaged over the term of the policy. Term life insurance provides the greatest amount of death benefit per dollar of initial cash outlay.

The primary advantage of term life insurance is that the premium or cost of the policy is substantially lower than the premium or cost of a permanent, whole life insurance policy that’s issued for the same face value amount. However, unlike permanent (whole) life insurance, term life insurance policies don’t build cash value.

An insurer may offer a selection of several different types of term life insurance policies. The various types of term life insurance policies that are available are primarily distinguished by the characteristics of their face value (death benefit). Basic types of term life insurance policies include level term insurance, decreasing term insurance, and increasing term insurance.

LEVEL TERM LIFE INSURANCE

The most common form of term life insurance—level term life insurance—provides a constant or fixed amount of coverage for as long as the policy remains in force. This form is characterized by a level face amount (death benefit) for a specified period. A level term policy expires at the end of the policy period. Remember, the “level” part of the name is really referring to the death benefit. The premium payments are fixed (or level) for the term of the policy as a standard characteristic of term insurance.

For example, a 10-year level term policy with a $100,000 face value provides a flat, level $100,000 of coverage protection for a period of 10 years. If the insured dies at any point within those 10 years, the insured’s beneficiaries will receive the policy’s $100,000 death benefit (or face value). If the insured lives beyond the 10-year term, the life insurance policy will expire, and no benefits will be paid.

A term to age 65 life insurance policy with a face value (or death benefit) of $250,000 provides a level $250,000 of coverage until the insured reaches the age of 65. If the insured dies at any point before age 65, the insured’s beneficiaries will receive the policy’s $250,000 death benefit (or face value). If the insured lives beyond age 65, the life insurance policy will expire, and no benefits will be paid.

[EXAM TIP: Assume an exam question is referring to a level term life insurance policy if the question doesn’t specify the type of term policy and simply indicates, “a term policy.”]

INCREASING TERM LIFE INSURANCE

Increasing term life insurance is term life insurance that provides a death benefit which increases at periodic intervals over the policy’s term. The amount of the increase is typically stated as specific amounts or as a percentage of the original amount. The amount may also be tied to a cost-of-living index, such as the Consumer Price Index (CPI). Increasing term insurance may be sold as a separate policy but is generally purchased as part of a package or cost of living rider attached to a policy. Increasing term life insurance is often used to account for anticipated income growth as individuals advance in their careers. Increasing term life insurance may also be referred to as incremental term life insurance.

For example, a 30-year-old physician may choose to take out a term to age 65 life insurance policy with a $100,000 face value that increases by $100,000 every five years to account for growth in his income. This will allow for a maximum of six, $100,000 increases throughout the life of the policy. The face value or death benefit of the insurance policy would increase to $200,000 at age 35, $300,000 at age 40, $400,000 at age 45, $500,000 at age 50, $600,000 at age 55, and $700,000 at age 60.

If the physician dies before the age of 65, the life insurance policy will pay the insured’s beneficiaries the face amount associated with the insured’s current (attained) age. At age 65, if the physician has not yet died, the policy will terminate, and no death benefit will be paid.

DECREASING TERM LIFE INSURANCE

Decreasing term life insurance policies are characterized by benefit amounts that decrease gradually over the term of protection and have level premiums. Decreasing term life insurance is commonly used to pay off the insured’s debt in the event of her death.

For example, a 20-year $50,000 decreasing term policy will pay a death benefit of $50,000 at the beginning of the policy term. That amount gradually declines over the 20-year term and reaches $0 at the end of the term.

Mortgage Redemption Insurance

Mortgage Redemption Insurance is a type of decreasing term life insurance policy, and its purpose is to provide policy holders with a way to have their mortgages paid off if they die before they’re fully paid. Mortgage protection prevents the full burden of paying the mortgage from falling on the shoulders of the surviving family members. With this design, the face value decreases as the balance remaining on the mortgage decreases.

Credit Life Insurance

Credit Life Insurance is a limited benefit (term) policy that’s designed to cover the life of a debtor and pay the amount due on a loan if the debtor dies before the loan is repaid. The beneficiary of this type of policy is typically the lender. The type of insurance used is decreasing term, with the term matched to the length of the loan period (which is generally limited to 10 years or less) and the decreasing insurance amount matched to the outstanding loan balance. Credit life may be issued to individuals as single policies; however, most often, it’s sold to a bank or other lending institution as group insurance that covers all of the institution’s borrowers. The cost of group credit life (or actually any credit life) insurance is typically paid entirely by the borrower.

The maximum benefit for a credit life insurance policy (regardless of individual or group) is the value of the loan. The lender only has an insurable interest in the insured up to the value of the indebtedness. The life insurance policy is not a legal contract if it allows the lender to profit from the death of a debtor.

While credit life or mortgage insurance may be required as a condition of a loan, the creditor cannot require the borrower to purchase the insurance from the organization that’s granting the loan or another specific organization. A lender that requires a borrower to purchase insurance from a specific company as a condition of providing a loan is considered coercion, which is an illegal practice.

CONVERTIBLE TERM LIFE INSURANCE

By definition, term insurance is designed to terminate after a specified period; however, some term policies may contain an option which allows the policy owner to convert the temporary protection to permanent protection. The option to convert must be included in the contract when the policy is purchased and, depending on the insurance company, may specify a time limit for converting (e.g., three years prior to policy expiration) or an age limit for converting (e.g., before the insured reaches the age of 55). Policies that contain the option to convert are named accordingly and are easy to identify.

For example, a term policy that provides life insurance protection for 15 years and also has a conversion privilege is referred to as a 15-year convertible term policy.

The option to convert gives the insured the privilege to convert or exchange the term policy for a whole life (or permanent) policy without evidence of insurability. In other words, the insured is not required to pass a medical exam or demonstrate good health since that requirement was already satisfied before the policy was initially issued.

For example, let’s assume that Steve purchased a 15-year term policy and suffers a massive heart attack 10 years into the policy term. Steve’s heart attack negatively impacts his insurability and due to his increased health risk, it’s unlikely that an insurance company will allow him to purchase a life insurance policy. When his 15-year policy expires, he will be without life insurance and possibly unable to obtain life insurance due to his increased risk. If Steve purchased a 15-year convertible term policy, he would have the option to convert the policy to permanent protection without the need to prove insurability.

Depending on the conversion method, the premium rate for the new whole life policy will reflect the insured’s age at either the time of the conversion (the attained age method) or at the time when the original term policy was taken out (the original age method). The cost of insurance is the most important factor to consider when determining whether to convert term life insurance at the insured’s original age or the insured’s attained age. The method that insurance companies use to develop the premium amount will be examined later in the course, but one of the most significant impacts of the cost of insurance is the insured’s age. The older the insured, the more likely he is to die, and as such, the higher risk he poses to the insurer. While it may seem obvious for the insured to use his original age for conversion, the decision is typically made by the insurance company and is outlined in the provisions of the original term life insurance policy.

When the attained age is used, the policy owner is effectively terminating the pure, term insurance protection and purchasing a new whole life insurance policy without providing any health history information. As described, the insured’s age is one of the largest premium factors, and as such, this method results in higher premiums. Despite this, most conversions are accomplished in this manner.

When the original age is used, the insurer will determine what the appropriate premium would have been had the owner purchased a whole life policy at the “original age” when life insurance was initially purchased. Premiums will be lower using the original age than the attained age. However, if this method is selected, the owner must fund or deposit an amount equal to the difference between what he would have spent on the policy had he started with whole life and what he actually spent on term life the policy so far, plus interest. This deposit guarantees lower premiums and also results in higher cash values. The premium and cash value deposit characterizes the retroactive conversion that exists if this method is selected.

[EXAM TIP: Assume an exam question is referring to the attained age method if the question doesn’t specify the method of conversion.]

Interim Term Life Insurance

Interim term life insurance is a type of convertible term insurance that’s written on a person who wants protection immediately, but who’s not able to afford permanent protection immediately. It provides interim coverage between now with the eventual conversion to permanent protection.

Interim term life insurance is typically written to automatically convert to permanent protection at some point within the first year. While insurability is guaranteed, the premium for the temporary protection is based on the original application age. Whereas the premium for permanent protection is based on the age at the time permanent protection begins (the attained age).

RENEWABLE TERM LIFE INSURANCE

Some term life insurance policies may contain an option which allows the policy owner to renew the term policy before its expiration date without being required to provide evidence of insurability. As with the option to convert, the option to renew must be included in the contract at the time the policy is purchased; it cannot be added later. Term life insurance policies are renewed using the insured’s attained age. The premiums for each renewal period will be higher than the initial period, reflecting the insured’s increased age and increased risk. This steady increase in premium is often referred to as a step-up premium (since the insured climbs up another “step” when he renews the policy). The advantage of the renewal option is that it allows the insured to continue insurance protection, even if he has become uninsurable due to a change in health. However, as the premiums increase each renewal, the cost of the policy typically becomes cost-prohibitive, forcing those who are older, and more likely to need the protection, to terminate or not renew the coverage.

Renewal options typically provide for several renewal periods or for renewals until a specified age. The renewal privilege often expires by the time the insured reaches the age of 65. The option to convert and the option to renew may be combined into a single term policy.

For example, a $25,000, 10-year renewable, and convertible to age 65 term life insurance policy provides a death benefit (face value) of $25,000 for 10 years. Additionally, it allows the policy owner the privilege of renewing the policy every 10 years until the insured reaches the age of 65. Furthermore, the policy allows the policy owner the privilege of converting the temporary, term insurance to permanent, whole life protection, as long as that conversion happens before the insured reaches the age of 65. The insured is not required to prove insurability if he exercises his privilege to renew or convert. However, the premium will definitely increase each time either of those options is exercised.

Annually/Yearly Renewable Term (A/YRT) Life Insurance

Annually renewable term (ART) or yearly renewable term (YRT) life insurance provides coverage for one year and allows the policy owner to renew coverage each year, without evidence of insurability. Annually renewable term and yearly renewable term life insurance represent the most basic form of life insurance. This renewal is typically automatic and renews with an increased premium cost each renewal period. This type of term life insurance policy provides an insured with two sets of premium rates—a current or scheduled premium (based on the insurer’s current cost of insurance) and a guaranteed maximum premium (based on the maximum the insurer agrees to increase the cost of insurance). For this reason, the premium is said to be a non-guaranteed level.

Re-Entry Term Insurance

Some term life insurance policies include a re-entry feature, which states that the premium can change at renewal based on insurability. The insured has the option of taking the standard renewal rate without proving insurability. However, to maintain the lowest premium rate (or a discount from standard), the insured may be required to prove insurability again upon renewal. If there’s an insurability problem (i.e., the insured fails the medical exam), coverage may be maintained but at a higher premium rate. Re-entry term life insurance is also referred to as revertible term life insurance.

[EXAM TIP: If an exam question references renewing a life insurance policy, the new premium will ALWAYS be higher than the previous or original premium. The cost of insurance will never stay the same or decrease. Additionally, only temporary coverage can be renewed. There’s no need to renew permanent coverage.]

POLICY CHARACTERISTICS

Policy

Death
Benefit

Premium

Cash Value

Policy
Loans

Partial Withdrawals
of Cash Value

Surrender Charges

Level Term

Level

Fixed

No

NO

NO

NO

Renewable Term

Level

Fixed per term. Increases each renewal.

No

NO

NO

NO

Convertible Term

Level

Fixed until converted. Converted premiums increase if the attained age is used or remain fixed if the original age is used.

No, until converted

No, until converted

NO

NO

Increasing Term

Increases on a schedule.

Fixed

NO

NO

NO

NO

Decreasing Term

Decreases on a schedule.

Fixed

NO

NO

NO

NO

USES OF TERM INSURANCE

Although temporary life insurance protection may not seem ideal at first, it’s essential to note that there’s no such thing as “bad life insurance.” However, every type of insurance is uniquely designed to fill a specific purpose or goal. For term insurance, that goal is typically to provide temporary financial protection in case the insured dies too soon. As with any other type of insurance, there are many uses, advantages, and disadvantages of term life insurance.

Advantages of term life insurance policies include:

• Term life insurance is less expensive than permanent insurance.

• Term life insurance may protect the insured’s insurability if the policy is renewable and/or convertible.

• Term life insurance may be used in conjunction with debts, mortgages, or as a supplement to whole life insurance.

• Term life insurance provides the most substantial amount of protection for the lowest cost.

Disadvantages of term life insurance include:

• The protection provided by term life insurance policies terminates with the policy terminates. No protection is in effect once the term protection ends.

• If the term life insurance policy is renewable or convertible, premium rates rise as the insured ages. This premium increase often leads to policy cancellation prior to the policy terminating.

• Due to the temporary nature of term insurance, few death claims are actually paid under term life insurance policies.

• Term life insurance policies don’t contain any cash savings or equity elements (i.e., cash value). Since it has no cash value, it doesn’t mature like a whole life policy.

· PERMANENT LIFE INSURANCE PRODUCTS

·
GENERAL CONCEPTS OF WHOLE LIFE INSURANCE

· Whole life insurance provides for the payment of a death benefit or face amount of coverage upon the death of the insured, regardless of when the death occurs. This type of policy will provide permanent protection for the insured’s entire (whole) lifetime, from the date of issue to the date of the insured’s death. Whole life policies may also be referred to as straight life, continuous premium life, permanent life, or ordinary life insurance.

· A whole life policy is generally described as a fixed death benefit, fixed premium life insurance contract. In other words, it’s characterized by a level death benefit, a cash savings value (i.e., equity build-up), permanent protection, and a fixed, level, or predetermined premium. The death benefit, premium payment, and the interest rate paid on the cash value are all predetermined for the insured’s “whole life.” Also, a whole life policy protects an insured permanently for the remainder of her life. This form of life insurance policy never needs to be converted or renewed, since it remains in force for as long as all premiums are paid in a timely fashion.

· FEATURES OF WHOLE LIFE INSURANCE

· Generally speaking, there are certain features that are shared by all types of whole life insurance. A traditional whole life insurance policy combines pure death protection with a cash value feature. Additionally, the death benefit (face amount) of the policy remains constant or level throughout the life of the insurance policy. Premiums are set at the time of policy issuance, and they too remain fixed for the policy’s life. Whole life policies are based on the assumption that premiums will be paid by the policy owner throughout the insured’s lifetime or to age 100, whichever occurs first. This means that the whole life policies are designed to “mature” or “endow” at age 100. “Mature” or “endow” means that the cash value accumulations are equal to the face amount. The cash value and endowment (or maturity) are the main features which distinguish whole life insurance from term life insurance and combine to produce additional living benefits for the policy owner.

· [EXAM TIP: While term life is designed to provide temporary protection IF the insured dies too soon, whole life insurance is designed to provide permanent protection WHEN the insured dies.]

· Cash Values

· Unlike term insurance, which only provides death protection, permanent life insurance combines insurance protection with a savings element. This savings accumulation is commonly referred to as the policy’s cash value and builds over the life of the policy. Although it’s an essential part of funding the policy, the cash value is often regarded as a savings element because it represents the amount of money the policy owner will receive if the policy is ever surrendered or voluntarily terminated.

· When a policy owner pays the premium for a whole life insurance policy, a portion of that premium is used to pay for the death benefit. This portion of the premium is referred to as the “term” insurance cost or cost of insurance.

· Another portion of the premium is used to cover the costs associated with the insurance company that issued the policy, commissioners, underwriting, medical exams, etc. and the costs of maintaining the policy. After the contract has been in effect for an initial period, the insurer begins depositing a portion of the premium into the policy’s cash value. Some states may have specific requirements as to when the accumulation begins. Still, in most traditional whole life policies, the cash savings value begins to build within two to three years after the policy is issued. Once cash value begins to accumulate, this savings account or “equity’ increases with each subsequent premium payment and continues to build during the life of the contract. The cash value accumulates from the premiums paid plus a guaranteed fixed interest rate. This interest is added to the savings account and allows the cash value to grow exponentially each policy year.

·

· In the policy’s early years, more of the premium money paid goes towards providing the actual insurance protection, but as the cash value grows larger and begins to offset the death benefit, the funds needed to purchase the actual insurance protection decreases. With less money being used for actual insurance protection, more of the premium can go toward growing the cash value during the later policy years. Whole life insurance policies were traditionally designed so that their cash value buildup would equal the policy’s face amount by the time the insured reaches the age of 100. Therefore, if a person purchases a whole life policy today and lives to age 100, she will receive all of her premiums back plus some interest. The premiums paid plus interest equal the total cash value at age 100, which also matches the policy’s face value or death benefit.

·

·

Cash Values

Over the past few decades, the mortality tables that are used to determine premiums and maturity have been modified by many insurers. Although some continue to base maturity on the age of 100, many are using age 115, up to age 121.

It’s important to understand that, traditionally, the cash value buildup is not paid to a beneficiary in addition to the death benefit when the insured dies. The policy’s cash value is available to the policy owner at any time. The policy owner may surrender the policy, thereby canceling coverage and receive the amount of the cash value. This is why the cash value is also referred to as the cash surrender value or non-forfeiture value. In other words, it’s the dollar amount that the policy owner will receive if she chooses to surrender or forfeit the life insurance policy. The cash value accumulation also provides the policy owner with the opportunity to borrow some of the policy’s equity funds to borrow against while keeping the policy in force. The borrowing of a policy’s cash value is considered a loan and, as such, interest is charged for it.

For example, let’s assume that John purchased a $100,000 whole life policy at 30 years old, which costs $1,000/year. It will likely take about three years for the policy to begin to build cash value. As with all whole life policies, the cash value equals the face value (in this case, $100,000) at age 100. For this example, let’s say the policy’s cash value is scheduled to be $15,000 after 10 years and $50,000 after 35 years. During the initial three-year period, the insurance company needs to provide the full $100,000 of protection. After John has made payments for 10 years (and did not take out any policy loans), the cash value now equals $15,000. The insurance company can use this $15,000 to offset the death benefit, meaning they only need to worry about providing $85,000 of protection. After the policy has been in force for 35 years (provided John did not take out any policy loans against his cash value), the cash value now equals $50,000. In turn, the insurance company only needs to worry about providing $50,000 worth of protection. Again, this means more of John’s premium can be diverted to growing the cash value. Once John reaches the age of 100, the policy endows or matures, the insurance company no longer needs to worry about providing any protection. At this point, John’s protection ends, and the insurance company will issue John (or the policy owner) a check for $100,000.

The amount of a policy’s cash value depends on a variety of factors, including:

• The face amount of the policy; the higher the face amount of the policy, the larger the cash values.

• The duration and amount of the premium payments; the shorter the premium-payment period, the quicker the cash values grow. The higher the premium amount paid by the policy owner, the quicker the cash values grow.

• The length of time that the policy has been in force; the longer the policy has been in force, the faster the build-up in cash values.

[EXAM TIP: There’s a specific “return of cash value” benefit rider that can be added to a whole life policy. If an exam question doesn’t explicitly mention an insurance policy having a return of cash value rider or endorsement, it should be assumed that the policy in question doesn’t include that rider.]

Maturity at Age 100

Whole life insurance was originally designed to mature at the age of 100. From an actuarial standpoint, it’s assumed that every insured will be deceased by the time they would have reached the age of 100. Although some individuals live beyond the age of 100, the number of individuals who do live that long is not a statistically significant portion of the population.

Consequently, the premium rate for whole life insurance is based on the assumption that the policy owner (usually the insured) will be paying premiums for the insured’s whole life. As previously described, the policy is designed in such a way that when the insured attains the age of 100, the cash value of the policy has accumulated to the point that it equals the face amount of the policy.

At that point, the policy has matured or endowed, and no more premiums are owed. In turn, the insurance company will issue a check for the full face value of the policy, minus any policy loans that have not been repaid. Practically speaking, very few individuals live to the age of 100. In fact, it’s far more likely that a whole life policy will be cashed in for its surrender value or that its face amount will be paid out as a death benefit before the policy matures.

Whole Life Insurance Premiums

As noted earlier, whole life is designed with the belief that the insured will live to the age of 100. Accordingly, the amount of premium for a whole life policy is calculated, in part, based on the number of years between the insured’s age at issue and the age of 100. The shorter the payment period, the higher the premium. This span of years represents the full premium-paying period, with the amount of the premium spread equally over that period. This is referred to as the level premium approach. As is also the case with level premium term insurance, the level premium whole life approach allows whole life insurance premiums to remain level rather than increase each year with the insured’s age.

Whole life premiums are referred to as “bundled premiums.” Bundled premiums mean that the insurer is not required to explain to the policy owner how the premium paid is ultimately distributed (i.e., for death protection, commissions, and other expenses). Premium rates are based on a dollar amount per $1,000 of coverage and are typically expressed annually.

For example, an insurance producer may explain to a potential applicant that the whole life insurance policy costs $9 per $1,000 of coverage. If the applicant wants a policy with a $100,000 face value, the cost will be $900 per year ($9 x 100).

BASIC FORMS OF WHOLE LIFE INSURANCE

Remember, whole life insurance provides a fixed, level death benefit or permanent protection with a cash savings feature. It’s characterized by a fixed, level, or predetermined premium for life (or up to the age of 100).

The policy’s cash value increases with every premium payment, and a fixed interest rate is paid on the cash value that’s also fixed for the life of the policy. Therefore, the cash value buildup of a whole life policy equals the face amount at age 100. The contract also includes non-forfeiture options or values in the event the policy owner wants to surrender the policy.

Although it’s been presented that whole life premiums are calculated as if they were payable to the age of 100, they don’t necessarily need to be paid this way. There are actually several different whole life insurance policy types to accommodate different premium-paying periods. The three most common types of whole life insurance are straight whole life, limited pay whole life, and single premium whole life.

Straight Whole Life Insurance Policies

The most basic form of whole life insurance is straight whole life, which may also be referred to as ordinary whole life insurance. Straight whole life insurance is basically the standard definition of whole life as has been described up to this point.

It’s whole life insurance that provides permanent level protection with level premiums from the time the policy is issued until the insured’s death (or age 100). This continuous premium or whole life plan is characterized by level or fixed premiums as long as the contract remains in force.

[EXAM TIP: Unless explicitly specified otherwise, it should be assumed that any exam reference to whole life insurance is referring to straight, whole life insurance.]

Limited Pay Whole Life Insurance Policies

The advantage of this type of whole life insurance policy is to permit the policy owner to cease paying premiums after the limited payment period. At this point, the policy is entirely paid-up for life and no future premiums are required. However, as with a straight life plan, the policy is designed to mature or “endow” at the age of 100. A limited payment whole life policy is characterized by a predetermined, level premium for a limited payment period. There are several types of limited payment policies in existence, such as 10-pay life, 20-pay life, 30-pay life, and life paid-up at the insured’s age 65.

For example, a 20-pay life policy is a whole life insurance policy in which premiums are payable for 20 years from the policy’s inception, after which no more premiums are owed. A life paid-up at 65 policy is a whole life policy in which the premiums are payable to the insured’s age 65, after which no more premiums are owed.

Premiums paid for these policies are initially higher than a straight life policy since they’re only paid for a limited period (i.e., 10 years rather than to the age of 100). Once the payments are finished, the policy is paid-up for life, which means that no additional premiums are due. Whenever the insured dies, the death benefit will be paid to the designated beneficiary. Although the policy is paid-up earlier than a traditional straight whole life policy, it will still not “mature” until age 100 since the contract has been predetermined. Since the initial premiums for these policies are higher than a traditional straight whole life policy, it’s often said that they possess a more substantial savings element or a greater emphasis on savings than the traditional straight whole life contracts.

Since the insurance company is receiving their money in larger premium payments, the cash value builds quicker in a limited pay policy than in a straight life policy. Additionally, cash values build up even faster during the premium paying years than during the non-premium paying years. After the premium paying period, the cash values continue to grow, but more slowly, until the policy matures and the cash value equals the face amount, again, at the age of 100.

It’s important to remember that, despite the fact that the premium payments are limited to a certain period (as with all other types of whole life insurance), the insurance protection is in force until the insured’s death, or to the age of 100.

[EXAM TIP: A limited pay life insurance policy will best suit a prospective insured who’s seeking permanent insurance but doesn’t want to pay premiums indefinitely.]

Single Premium Whole Life Insurance Policies

Single premium whole life insurance is the extreme form of a limited payment policy and is characterized by a lump-sum or single premium payment. Therefore, the policy is fully paid-up upon the payment of a lump-sum premium. Some single premium plans are in existence, which consists of two premium payments, such as a “dual premium” policy. Single premium plans may possess tax advantages and the ability to borrow against the cash value at below-market interest rates.

A single premium whole policy is the most expensive whole life policy initially. The higher up-front cost should be evident due to its single lump-sum premium. However, when compared to a straight life policy over the life of the contract, the single premium life is the least expensive.

For example, let’s assume that an insured is 30 years of age and purchases a $10,000 traditional straight whole life policy with an annual premium of $120. If the insured lives for 40 years, he will have paid $4,800 in traditional straight whole life premiums ($120 per year x 40 years). For a single premium life policy of the same face amount, the lump-sum single premium may only be $3,800.

Therefore, in most cases, during the life of the policy, straight whole life policies are more expensive than the single premium life plan. However, again, the single premium policy requires a significant initial premium, typically making it cost-prohibitive for most people.

Common traits of a single premium whole life policy include:

• An immediate non-forfeiture value (cash value) is created.

• A large part of the premium is used to set up the policy’s reserve.

• The advantage offered by a single premium policy is that the policy owner will pay less for the policy than if the premiums were stretched over several years.

POLICY CHARACTERISTICS

Policy

Death
Benefit

Premium

Cash Value

Policy
Loans

Partial Withdrawals
of Cash Value

Surrender Charges

Straight Whole Life

Level for life

Predetermined -Fixed for the life of the policy (age 100)

YES. Predetermined,

tax-deferred and guaranteed

YES

NO. To receive cash, it must

be borrowed.

NO

Limited Pay Whole Life

Level for life

Predetermined -Fixed for the period selected. Then premiums cease.

YES. Predetermined,

tax-deferred and guaranteed

YES

NO. To receive cash, it must

be borrowed.

NO

Single Premium Whole Life

Level for life

Predetermined single, lump-sum premium paid
at issue

YES. Predetermined,

tax-deferred and guaranteed

YES

NO. To receive cash, it must

be borrowed.

YES

NON-TRADITIONAL WHOLE LIFE INSURANCE

Again, additional types of whole life plans alter the method by which premiums are paid. The premium charged for these plans is less than that for a straight life insurance policy in the first few years of the policy. Cash values also accumulate with each premium payment. Insureds who need permanent protection but cannot afford the higher traditional whole life premiums required, will buy this type of policy.

Modified Whole Life Insurance Policies

Modified whole life insurance is a type of whole life insurance policy that’s characterized by an initial premium which is lower than straight whole life insurance for an introductory period. The policy owner will pay a lower initial premium, as compared to the straight life premium, for the first few years. After this time, the premium will increase to an amount that’s higher than what the initial straight whole life premium would have been.

Once the premium “jumps” following the initial period, it will remain level or constant for the life of the policy. Therefore, modified whole life premium is characterized by two fixed premiums —a lower initial premium for five years that increases in the sixth year to an amount higher than the traditional straight whole life premium would have been and then remains level for life.

Again, modified whole life insurance policies alter the method by which premiums are paid. The premium charged for these plans is less than that for a straight life insurance policy in the first few years of the policy. As with all other types of whole life insurance, the life insurance protection is in force until the insured’s death, or to the age of 100. Also, cash values accumulate with each subsequent premium payment.

The purpose of modified whole life policies is to make the initial purchase of permanent insurance more accessible and more attractive, especially for individuals who have limited financial resources, but also the promise of an improved financial position in the future. Any individuals who are seeking permanent protection but cannot afford the higher traditional straight whole life premiums required, will buy this type of policy.

Graded Premium Whole Life

A graded premium whole life plan is a contract that’s characterized, like modified life, by a lower premium than whole life in the early years of the contract. However, premiums increase annually or every year for the initial period. Thereafter, it jumps to an amount that’s higher than the whole life premium and remains fixed for life. The premiums for these policies are predetermined, but are not level in the traditional sense, as they would be in the traditional straight whole life or limited pay whole life plans.

POLICY CHARACTERISTICS

Policy

Death
Benefit

Premium

Cash Value

Policy
Loans

Partial Withdrawals
of Cash Value

Surrender Charges

Modified Whole Life

Level for life

Predetermined – Two fixed premium periods

YES. Predetermined,

tax-deferred and guaranteed

YES

NO. To receive cash, it must

be borrowed.

NO

Graded Whole Life

Level for life

Predetermined – more than two fixed premium periods

YES. Predetermined,

tax-deferred and guaranteed

YES

NO. To receive cash, it must

be borrowed.

NO

Enhanced Whole Life Insurance (Economatic / Extraordinary Life)

An enhanced whole life insurance policy (also referred to as economatic life or extraordinary life) is a low premium based participating permanent insurance policy. The contract’s face amount is reduced each year. Any dividends that are paid are set aside and used to purchase either paid-up additions or one-year term insurance which is equal to the reduction of death coverage. This policy provides a guaranteed death benefit in the early years of the policy, even if dividends are insufficient to maintain level coverage.

Indeterminate Premium Whole Life Insurance

Indeterminate premium whole life insurance is a type of whole life policy that provides low initial premium costs for a specified period. After that period, the insurer may then increase premiums. The characteristics of and benefits provided by this policy are similar to other contracts. However, an indeterminate premium whole life policy allows for a change of premium due to a change in the investment income of the insurer. Therefore, future premium adjustments are based on the insurer’s investment performance, mortality experience, and expenses.

Premiums may be raised or lowered by the company, but they can never exceed the guaranteed maximum. Insurers adopted this innovative type of policy in an attempt to offer lower-cost life insurance. Today, term insurance may also be written with indeterminate premiums.

Current Assumption Whole Life (CAWL) / Interest Sensitive Whole Life

Current assumption whole life, also referred to as interest-sensitive whole life and excess interest whole life, is characterized by premiums that vary to reflect the insurer’s changing assumptions concerning its death, investment, and expense factors. However, interest-sensitive products also provide that the cash values may be higher than the guaranteed levels. If the company’s underlying death, investment, and expense assumptions are more favorable than expected, policy owners will have two options—lower premiums or higher cash values. Underlying assumptions could also turn out to be less favorable than anticipated, which would call for a higher premium than that at policy issue.

The policy owner may then either pay the higher premium or choose to reduce the policy’s face amount and continue to pay the same premium. An interest-sensitive life insurance policy owner may be able to withdraw the policy’s cash value interest-free. The provision that allows this is referred to as the partial surrender provision.

CAWL policies are either of the low premium or high premium variety. Both possess several characteristics, including but not limited to:

• The use of an accumulation account which is made up of the premium, less expense and mortality charges, and credited with interest based on current rates

• Minimum guaranteed cash value and rate of return

• Maximum annual premium

• Use of a surrender charge, fixed at issue, which is deducted from the accumulation account to derive the policy’s surrender value, and

• Use of a fixed death benefit and maximum premium level at the time of issue

Low Premium Type - The low premium type includes an indeterminate premium that’s initially lo

Indexed Whole Life Insurance

This policy offers a face amount that increases along with rises in the Consumer Price Index (CPI). These policies are classified according to whether the policy owner or the insurer assumes the inflation risk. If the policy owner assumes the inflation risk, the death benefit increases each year in accordance with the CPI and the insurer will bill the policy owner each year for the new, higher amount of insurance. The insurer agrees not to require the insured to demonstrate insurability for any increase in protection as long as the policy owner accepts each year’s increase in the coverage amount.

If the insurer assumes the inflation risk, it’s similar to the previously mentioned approach, except that the premium being charged initially by the insurer is loaded in anticipation of future face amount increases. These increases in face amount don’t alter the premium level paid. These policies possess a cap as to the maximum total permitted.

Equity Index Whole Life Insurance

Another type of indexed life insurance product is equity indexed life insurance. This type of policy combines most of the features, benefits, and security of traditional life insurance with the potential of earned interest based on the upward movement of an equity index. Rather than the policy including a specific interest rate (as in a traditional whole life plan), interest earnings are credited based on increases in the specific equity index (e.g., the S&P 500 Index) to which the policy is linked. Therefore, credited interest is linked to an index without the downside risk connected with directly investing in the stock market. These policies are characterized by a guaranteed minimum interest rate, tax deferral of interest accumulations, and policy loan access. The equity index returns are designed to keep pace with or beat inflation, which protects the policy holder against downside market risk. Equity indexed life insurance contracts combine term life insurance with an investment feature, similar to a universal life plan (described later). Death benefit amounts are based on the coverage amount selected by the contract owner plus the account value.

ALTERNATIVE NON-TRADITIONAL LIFE INSURANCE PRODUCTS

Most whole life insurance policies are characterized by a fixed or level premium. As such, traditional whole life policies are referred to as level death benefit, level (or fixed) premium life insurance. During the 1970s, insurers developed a new type of policy that provided greater flexibility for the policy owner. These “non-traditional” policies are characterized by flexible coverage amounts and premiums. The following are other types of more modern and newer life insurance plans in existence that are characterized by a flexible, adjustable, or variable death benefit or premium. They function a bit differently than traditional whole life policies in several ways.

ADJUSTABLE LIFE

This type of permanent insurance product combines elements of traditional fixed premium whole life insurance with the potential to adjust the coverage or face amount based on the policy owner’s changing needs. The best description of adjustable life is Prentice-Hall, 1985:

“At any point in time, adjustable life is a level-premium, level-death benefit policy that may assume the form of any traditional type of life insurance.”

Characteristics

Adjustable life provides an adjustable death benefit and cash value, while also possessing all of the features of traditional whole life policies. Its distinguishing characteristic is a provision that’s referred to as the adjustment provision. The advantage of this policy is that it permits the policy owner to make prospective adjustments (i.e., in the future) to the policy’s coverage amount. The policy premium is fixed for the policy year if an adjustment in coverage is made (obviously, if more coverage is purchased, then the consumer pays more).

An individual whose income has been fluctuating during the past several years or a couple who plans to have children over the next several years are examples of prospective clients who may purchase an adjustable life policy so that they possess flexibility to satisfy their “changing needs.” Therefore, this is the type of life insurance policy that’s available to an individual who wants to have the opportunity to make changes or alterations to her contract each year.

There may be some confusion regarding premiums for adjustable life. Although the policy owner may pay more or less per year in the future than the original premium, the premium is adjustable. However, remember the original definition. At any point in time adjustable life insurance is a level-premium, level-death benefit policy. This means that whenever a coverage amount is increased, the premium that’s due is level for the upcoming policy year. If the policy owner decides to increase the coverage amount, the insured party must always prove insurability. To simplify, an adjustable life policy is a traditional whole life policy with an adjustable death benefit. This type of policy is characterized by prospective (i.e., future) adjustments only.

UNIVERSAL LIFE

As with adjustable life, universal life insurance provides its owner with more flexibility than a traditional whole life plan. It may be referred to as an adjustable form of life insurance since it allows the contract owner to change the coverage amount at his discretion. This type of policy may be characterized as an interest sensitive life product since it utilizes changing interest rates (or rate of return) to determine cash values. These changing interest rates are not used to determine death benefits or future premiums.

Universal life premiums pay for pure protection (i.e., term insurance), and a portion is deposited into its cash value. In this policy, the cash value may be referred to as: (1) a cash value fund; (2) a cash savings plan; (3) policy equity; or (4) a savings feature. As with traditional whole life policies, a fixed interest rate is paid on the cash savings plans as it accumulates. The minimum fixed interest rate paid on the cash value of a universal life contract is equal to the maximum paid (3% to 4%) on the cash value of most traditional whole life policies. This interest rate that’s paid on the cash savings plan will vary (i.e., interest sensitive) depending on market conditions and is responsible for the yearly increase in the cash savings.

Therefore, the interest rate is guaranteed for the policy year. If the contract owner pays a monthly premium, each month the insurer subtracts mortality charges and other applicable expenses from the cash savings plan. If the premium is paid annually, this deduction occurs once per year.

Most importantly, universal life is also characterized by a flexible premium. Therefore, the policy owner may pay whatever amount of premium she wants to pay each year. This flexibility could be a disadvantage for the owner of the policy if it’s not appropriately managed. For example, if premiums are not paid following the first year to keep coverage in force, the cost of death protection will be withdrawn from the cash savings plan. In this manner, the policy can pay for itself for as long as there are sufficient cash savings. If no additional premiums are paid, the policy uses the cash value to keep coverage in force. However, in the future, if there’s not enough cash to pay for death protection, the policy could lapse.

If only a small amount of cash value remains, the owner can use the cash available to purchase as much protection as the cash will buy. Therefore, in a universal life policy, the death benefit may not be guaranteed and, in some cases, may be dependent on the amount of cash value available (if the contract owner is not funding the policy by paying premiums).

When considering a universal life policy, a person must remember:

• The death benefit may not be guaranteed (i.e., if not appropriately managed).

• The interest rate paid on the cash value is guaranteed (i.e., for the policy year).

• At times, the amount of coverage provided for the year will be dependent on the amount of cash value available.

· Unique Characteristics of Universal Life

· In a universal life insurance policy, the premiums, cash value, and the face amount can be adjusted. However, it’s neither identical to adjustable life nor is it backed by equities as in variable life products. Let’s closely examine the characteristics that make universal life insurance policies unique.

· Unbundled Premium

· Universal life policies are transparent since they’re characterized by unbundled or decoupled premiums. This means that the contract owner is provided with information describing where the policy costs are allocated. In other words, the contract owner receives a breakdown of premiums, death benefits, mortality charges, expenses, and cash values. This breakdown shows the contract owner the disposition of the policy funds.

· Some insurers offer a target premium to allow contract owners to plan premium payments regularly. Since the premium is flexible, many contract owners who don’t manage the plan may see their coverage lapse. To avoid possible tax problems, premium allocations to a universal life policy’s cash value must comply with tax law (IRS) guidelines.

· Cash Value

· Funds that are withdrawn from the cash savings plan may not be subject to interest payments when they’re used to pay premiums. As premiums are paid, and as cash values accumulate, interest is credited to the contract’s equity. The interest credited may be a current rate based on current market conditions or on a guaranteed minimum rate that’s listed in the policy.

· Fixed interest rates that are paid on the cash value traditionally include a guaranteed minimum of 2% to 4%; however, this will vary based on market conditions (although some have included rates as high as 7%, recently they’ve been in the lower single digits). Therefore, interest may be paid at either the contract’s guaranteed minimum rate or at the current interest rate as declared by the insurer. The fixed interest rate may change each year based on money instruments (i.e., Treasury bill rates, money-market rates, etc.).

· Since the interest rate paid on the cash value changes each year and the amount of cash value changes, an annual statement must be provided to the contract owner each year by the insurer. This annual statement identifies the upcoming interest rate for the coming year, the cost of coverage, the current cash value amount, other applicable expenses, and additional relevant information. Also, contract owners may utilize a partial withdrawal from the cash value, unlike a traditional whole life policy, which requires the owner to borrow against the cash value (i.e., a loan) to access funds in the cash value.

· Death Benefit

· Universal life policies offer two death benefit patterns by including Option A and Option B. Under Option A (also referred to as Option One), a level death benefit is provided. The net amount at risk (NAR) is adjusted after each month. As such, a mortality charge is deducted from the policy’s cash savings plan monthly. Therefore, the cash value and NAR (benefit) together provide a fixed death benefit. Option B (also referred to as Option Two) provides an increasing death benefit as the cash value increases. As such, the death benefit equals the face amount plus the cash value at the time of death.

· Tax Considerations

· The amount of pure insurance protection above the cash value is often referred to as a corridor. In order for a contract to qualify as life insurance for tax purposes, there must be “space” between the total death benefit and the cash value of the policy. An automatic increase in the death benefit results when the cash value approaches the initial face amount under Option A.

· Again, if this space is not present, the policy will lose its favorable tax treatment since it will not meet the Internal Revenue Code’s definition of life insurance. In addition, for cash value accumulations to receive favorable tax treatment (i.e., tax deferral), a specific percentage of universal life premiums must be used to purchase the death benefit amount.

· Universal Life Riders

· Waiver of Monthly Deduction Rider (Waiver of the Cost of Insurance)

· Some insurers offer a “waiver of monthly deduction” rider to be added to a universal life policy. This rider waives the monthly portion of the premium that pays for the expenses of the policy (e.g., contract expenses and mortality charge), but not the portion that’s allocated to the cash value.

· No Lapse Guarantee Rider

· A no lapse guarantee rider may be added to a universal life policy. Universal life insurance offers the contract owner with premium flexibility that could result in insufficient premiums being paid to support the policy. As previously described, paying insufficient premiums could cause the policy to lapse. The no lapse guarantee benefit rider prevents a lapse by imposing a premium payment schedule, which requires minimum premiums on a regular payment schedule. In other words, the no lapse guarantee rider guarantees that the policy will not terminate before a determined date if specified amounts of premium are paid, and any policy loan plus accrued loan interest don’t exceed the cash surrender value. The length of the policy’s guarantee period generally ranges from five to 40 years, depending on the age of the insured when the policy was issued. Some (but not all) insurers charge an extra premium for this rider.

· Indexed Universal Life

· Universal life insurance comes in many different models, from fixed rate models to variable ones. In a variable model, a person may select various equity accounts in which to invest. An indexed universal life (IUL) allows the owner to allocate cash value amounts to either a fixed account or an equity index account. Policies offer a variety of indices, such as the S&P 500. These policies are more volatile than fixed account plans, but less risky than variable life policies since no funds are invested in equities.

· Indexed universal life plans also offer tax-deferral of cash accumulation while maintaining a death benefit. Individuals who seek permanent protection but want to take advantage of an equity index may use these plans to fund various programs such as key-person insurance for business owners or estate planning. These plans are considered advanced life insurance products since they may be difficult for the average consumer to comprehend.

· Guaranteed / No-Lapse Guarantee Universal Life

· Guaranteed universal life insurance—which is also referred to as no-lapse guaranteed universal life or guaranteed death benefit universal life—is a type of life insurance that provides a policy owner with a guaranteed death benefit, as long as the required premiums are paid. Therefore, even if there’s insufficient cash value within the contract to support the death benefit, the policy will continue to remain in force due to the coverage protection guarantee. For this guarantee to be provided, the contract stipulates that minimum premiums must be met and paid on time. As such, a guaranteed universal life insurance contract will still pay out a death benefit even if the accumulated cash value decreases or goes to zero.

· As with most types of universal life insurance, guaranteed universal life offers flexible premium options that can vary based on an individual’s ever-changing financial situation. However, a minimum premium (or premium target) must still be met to prevent the policy from lapsing. Also, any variation in premium amounts will affect the interest rate within the contract, which will affect the cash value accumulations. The focal point of this type of product is the guaranteed death benefit rather than the cash value accumulations.

· Most insurers allow a policy owner to select a guaranteed coverage period (e.g., age 90 or age 120). In effect, this means that the contract provides permanent protection with the flexible premium structure of a traditional universal life insurance plan. Additionally, some insurers provide the policy owners with the flexibility to change the coverage period as their needs or situations change.

· Survivorship Guaranteed Universal Life

· As with a survivorship life insurance policy, a survivorship universal life insurance contract is often referred to as second-to-die insurance. The contract covers two people and pays a benefit only after both covered individuals have died. Since it costs less than two individual permanent policies, it’s an affordable option for a person who wants to leave a larger nest egg for his heirs or a favorite charity. First-to-die versus second-to-die life insurance is reviewed more extensively later in this chapter.

POLICY CHARACTERISTICS

Policy

Death
Benefit

Premium

Cash Value

Policy
Loans

Partial Withdrawals
of Cash Value

Surrender Charges

Adjustable Life

Level, but changeable by request

Level, but the level may change when the policy change is requested

Predetermined and tax-deferred, but new schedule needed after each negotiated policy change

YES, if there’s cash value

NO. To receive cash, it must

be borrowed.

NO

Universal
Life

Flexible; original DB cannot be guaranteed if

the owner is not funding the plan with premiums.

A flexible premium insurance plan.

Flexible premium. Required first year target (i.e., suggested level premium), and then the owner may pay flexible premiums each year or nothing

at all.

Guaranteed minimum interest rate (e.g., 4%). The interest rate will vary each year based on the money market index. Interest is tax-deferred.

YES. Loans affect the interest rate credited to the cash value.

YES

YES

SECURITIES AND EXCHANGE COMMISSION (SEC) REGULATED LIFE INSURANCE POLICIES

The Securities and Exchange Commission (SEC) regulates securities transactions, which include the trading of stocks, bonds, and variable insurance products. The Financial Industry Regulatory Authority (FINRA) is the entity that oversees securities firms in the United States. Formerly, the National Association of Securities Dealers (NASD), this regulatory body governs securities activities, administers securities exams, and issues licenses. Therefore, producers who want to solicit variable products must hold a life insurance license as well as a securities license.

VARIABLE LIFE

Variable life insurance (VL) combines the protection and savings features of whole life insurance with the growth potential of securities, such as common and preferred stocks, bonds, and other similar investments. Variable life insurance is a type of permanent (i.e., whole life) insurance that’s characterized by fixed (level) premiums and a guaranteed minimum death benefit. Part of the premium paid is placed into a separate account, which is invested in a stock, bond, or money market fund. Although the death benefit is guaranteed, the cash value of the benefit can vary considerably based on the rise and fall of the stock market.

The policy’s death benefit can also increase if the earnings of that separate fund increase. Variable insurance products don’t guarantee contract cash values, and it’s the policy owner who assumes the investment risk.

Variable life insurance contracts don’t provide guarantees as to either interest rates or minimum cash values. Instead, these products offer the potential to realize investment gains which exceed those that are available with traditional life insurance policies. The potential for more significant investment gains is offered by allowing policy owners to direct the investment of the funds that back their variable contracts through separate account options.

By placing their policy values into separate accounts, policy owners can participate directly in the account’s investment performance, which will earn a variable (as opposed to a fixed) return. The cash value and the death benefit of this policy may increase if investment performance is good. If the cash value increases, the face amount also increases, thereby evidencing the variable nature of the coverage limit. In other words, the cash value of a VL policy is deposited into a separate account which, in turn, is invested in securities. Therefore, the cash value is not guaranteed.

This presents a means of transferring the investment risk from the insurer to the policy owner. The insurer can offer policy owners the possibility (but not the guarantee) of competitively high returns without facing the investment risk that’s posed by its guaranteed fixed policies. This policy may be advantageous for a person who wants to experience a potentially higher rate of return or degree of growth of the cash savings value. It also provides a policy owner with flexibility and control over the investment portion of the contract.

In order to sell this product, a producer or agent must possess a life insurance license (i.e., state-regulated) AND a securities license that’s issued by the Financial Industry Regulatory Authority, or FINRA (i.e., federally regulated). The amount of death protection can increase based on good investment performance, but the cash value and death benefit may also decline based on poor investment performance.

However, the coverage amount will never fall lower than its guaranteed minimum death benefit. The guaranteed minimum death benefit is the amount of coverage that’s initially purchased by the policy holder. Therefore, the death benefit possesses a type of guarantee, which is the guaranteed minimum death benefit. There’s no guaranteed rate of return on the cash value since the funds are invested in securities.

Keep in mind, although these policies involve investment management and offer the potential for investment gains, they’re primarily life insurance policies and not investment contracts. As with any life insurance plan, the primary purpose of these plans is to provide financial protection in the event of the insured’s death.

VARIABLE UNIVERSAL LIFE (VUL)

Variable universal life insurance policies combine some of the characteristics of variable whole life insurance and universal life insurance. Let’s revisit some of the critical differences between variable life and universal life:

• A universal life policy’s death benefit may not be guaranteed since the amount of coverage in any particular year may be based on how much cash value is available if the owner is not funding the policy. Variable life policies do possess a guaranteed minimum death benefit.

• Universal life policies do pay a minimum fixed interest rate (i.e., guarantee) on the cash value in a particular policy year, while there’s no guaranteed rate of return on the cash value of the variable life policy.

• Variable life insurance policies provide the policy owner with flexibility and control over the investment portion of the policy. Universal life insurance provides the policy owner with options regarding the cash value, but not regarding the underlying investments.

Variable universal (whole) life insurance products offer the policy owner a combination of investment options with a flexible premium payment, flexible expense deduction method, and a guaranteed minimum death benefit. These policies can also be described as the equivalent of variable whole life insurance with the added benefit of flexible premium payments. It also possesses a guaranteed minimum coverage amount. Variable universal life insurance may also be referred to as universal/variable whole life.

POLICY CHARACTERISTICS

Policy

Death
Benefit

Premium

Cash Value

Policy
Loans

Partial Withdrawals
of Cash Value

Surrender Charges

Variable

Life

Guaranteed minimum but may increase based on investment performance.

Fixed, level, or predetermined. A security (i.e., investment) and insurance plan with a fixed premium.

May increase or decrease based on investment performance, tax deferred. Owner control of CV investment.

YES

NO. To receive cash, it must

be borrowed.

YES

Variable Universal

Life

Guaranteed minimum but may increase based on investment performance.

Flexible premium. Required first year target (suggested level premium). A securities and insurance plan with a flexible premium.

Depends on investment performance, tax deferred. Policy owner controls CV investment.

YES

YES

YES

SPECIAL USE LIFE INSURANCE PRODUCTS

In addition to the basic types of life insurance policies, there are a number of “special use” policies that are offered by insurers. Many of these are a combination or packaging of different types of policies that are designed to serve a variety of needs.

FAMILY PLAN POLICIES

The family plan policy is designed to insure all family members under one policy. Coverage is sold in units. Whole life coverage is purchased on the life of the primary insured (i.e., breadwinner). The coverage on the spouse and children is level term insurance in the form of a rider. The children’s coverage is typically convertible (to whole life insurance) without evidence of insurability, and new (or future) children are automatically included at no extra cost. Therefore, this policy is a combination of whole life and level term insurance. This type of contract is also known as a family protection policy or family plan.

For example, a typical plan could insure the head of the family (main earner) with $20,000 whole life insurance and $10,000 of level term life insurance on the spouse and children.

Family Income Policies

A family income policy consists of both whole life and decreasing term insurance. This policy will provide monthly income to a beneficiary if death occurs during a specified period beginning after the date of purchase. A decreasing term policy supplies the family income portion of this type of coverage. Income payments to the beneficiary begin when the insured dies and continue for the period specified in the policy, which is usually 10, 15, or 20 years from the date of policy issue, and not from the date of the insured’s death. If the insured dies after the specified period, only the face value (whole life) is paid to the beneficiary since the decreasing term insurance expired.

Family Maintenance Policy

A family maintenance policy consists of both whole life and level term insurance, which provides income for a specific period beginning on the date of death of the insured. If the insured dies before a predetermined time, this policy provides income to a beneficiary for a stated number of years from the date of the insured’s death. In addition, the beneficiary will receive the entire face amount of the whole life insurance component of the policy at the end of the income-paying period. However, if the insured dies after the selected coverage period, the beneficiary receives only the face amount of the whole life insurance component of the policy.

JOINT LIFE POLICIES

A joint life policy covers two or more people. Using some type of permanent insurance (as opposed to term), it pays the death benefit at the death of the first insured. The survivors then have the option of purchasing a single individual policy without evidence of insurability. The premium for a joint life policy is less than the premium for separate, multiple policies. The ages of the insureds are averaged, and a single premium is charged for each life. Joint life policies may also be referred to as “first to die policies” because the death benefit is paid upon the first death.

Joint Life and Survivor Policies

A variation of the joint life policy is the last survivor policy, also referred to as a “second to die policy.” This plan also covers two (or more) lives, but the benefit is paid upon the death of the last surviving insured. This type of coverage can also be considered a “survivorship life insurance policy” and will typically cover two lives. As with a joint life policy, the premium for a survivorship life policy is lower than the combined premium for separate life insurance policies on two married individuals. Survivorship life insurance policies are useful in estate planning because they can provide money to pay taxes on assets.

JUVENILE INSURANCE

A juvenile life insurance policy is any type of ordinary life insurance policy that insures the life of a minor. Applications for insurance and ownership of the policy rests with an adult (e.g., a parent or guardian) and don’t require the minor’s consent. As such, juvenile insurance utilizes the concept of third-party policy ownership. Additionally, the adult applicant is typically the premium payor, at least until the child comes of age and can take over the payments.

For life insurance purposes, an applicant is generally considered a juvenile if they are under the age of 15. However, some states use the age of 16 as the age of maturity. The applicable age of maturity will be discussed further in the laws and rules chapter at the end of this course.

The owner and payor of the policy will not change automatically. In this case, the current owner (i.e., the parent or guardian) must request the change (typically in writing) with the insurance company. Since insurable interest is only required at the time of the application, the parent or guardian will never be required to relinquish ownership of a child’s policy.

Jumping Juvenile Insurance (Estate Builder)

In addition to purchasing insurance on a child for burial expenses, insurance may also be purchased to protect the child’s insurability. Some parents purchase these plans to begin a savings plan for their child. The face amount of this policy can be as low as $1,000 to start. The coverage amount “jumps up” (typically five times the initial amount) when the child reaches the age of majority or a specified age (i.e., age 21). This benefit increase comes without any evidence of insurability and no premium increase. Some insurers may also refer to a jumping juvenile insurance policy as a junior estate builder plan.

ENDOWMENTS

An endowment policy is characterized by cash values that grow at a rapid pace so that the policy matures or endows at a specified date (that is, before the age of 100). Endowment life insurance contracts pay a death benefit to a named beneficiary upon the death of an insured during a specified “endowment” period. If the insured doesn’t die during the endowment period, the policy pays the policy owner/insured a cash value that’s equal to the face amount of the policy at the end of the endowment period (when the contract matures or “endows”) if the insured is still living. Endowments don’t pay the cash value upon death. Therefore, an endowment pays a stated benefit at the earlier of the insured’s death or the end of a specified period (i.e., at the end of the endowment period).

Endowment policies can be compared to whole life policies with accelerated maturity dates. While a whole life policy “matures” or “endows” at the age of 100, an endowment matures or endows at the end of a specified period. At the maturity date, the cash value has grown to match the face amount, which is identical to what occurs at the age of 100 with a whole life policy. For example, a $50,000 whole life policy endows at age 100. A $50,000, 20-year endowment endows at the end of the 20 years.

Endowment policies are typically purchased to provide a living benefit for a specified future time (e.g., for retirement) or to fund a child’s college education. Due to their rapid cash value build-ups to provide early policy maturity, endowment policies have comparatively high premiums. Remember, the shorter the policy term, the higher the premiums.

• Semi-endowment policies are plans that pay 100% of the benefit in the event of the death of the insured during the specified period, but only 50% of the benefit if the insured survives.

• Pure endowment policies pay nothing if the insured dies during the endowment period. Instead, they only pay if the insured survives.

• Juvenile endowments are those which cover children and mature when the child reaches a specified age. These plans are typically used to help meet the educational goals of the policy owner.

Endowment policies have been on the decline for several years because they no longer meet the income tax definition of life insurance. Consequently, they no longer qualify for the favorable tax treatment that life insurance is given. The Tax Reform Act of 1984 states that “any policy issued after 1/1/1985 that endows before age 95 no longer qualifies as life insurance.”

MODIFIED ENDOWMENT CONTRACTS

In 1988, Congress enacted the Technical and Miscellaneous Revenue Act, commonly referred to as TAMRA. Among other things, this act revised the tax law definition of a life insurance contract. The primary reason for it being passed was to discourage the sale and purchase of life insurance for investment purposes or as a tax shelter. A modified endowment contract (MEC) is a whole life insurance policy that’s considered to be overfunded according to IRS tables and, as such, is not truly a life insurance policy.

Any life insurance policy that’s been purchased after June 20, 1988, is considered by the IRS to be an MEC if it doesn’t satisfy the seven-pay test. The seven-pay test is a limitation on the total amount a person can pay into a policy in the first seven years of its existence. A whole life insurance policy is considered to be a modified endowment contract if the total amount of premiums paid during the first seven years of the contract exceeds the total amount of premiums required for the same insurance policy to be paid up in seven years. The purpose of the test is to discourage premium schedules that could result in a paid-up policy before the end of a seven-year period. By definition, all single premium whole life policies are modified endowment contracts. Once a contract is declared an MEC, it can never revert back to ordinary insurance. However, if there’s a material change in the contract, the seven pay test applies again.

The following are illustrations of the tax treatment of benefit distributions from an MEC:

• Taxation only occurs when any cash is distributed to the contract owner or money is withdrawn, whether by surrender, loan, or dividends.

• The gain (i.e., interest or appreciation) is taxable first when a distribution is made (i.e., LIFO).

• The first dollars received by the contract owner are considered “earning first,” or excess amounts of cash value beyond premiums and are taxable.

• If a policy is an MEC and cash is withdrawn, appropriate amounts are still taxable, even if it will be used for a legitimate reason such as financial hardship or to pay medical expenses.

• If cash is withdrawn prior to age 59 1/2, a 10% penalty tax will be assessed.

· INDUSTRIAL (HOME SERVICE) LIFE INSURANCE

· Industrial life insurance is characterized by comparatively small issue amounts, such as $1,000, with premiums collected by the agent on a weekly or monthly basis at the policy owner’s home. This insurance is often marketed and purchased as burial insurance but may also include dismemberment benefits or a benefit multiplier (indemnity) for accidental deaths.

· Although the more common and modern term is home service companies, companies that sell industrial life insurance may also refer to themselves as combination or debit companies. Home service companies typically sell other combinations of insurance in addition to industrial life insurance. These additional policies allow the company to assign agents to specific geographic locations (referred to as debits) within a city to collect premiums.

· Some home service companies now offer a product that’s termed monthly debit ordinary life insurance. Monthly debit ordinary life insurance is a combination of the previously offered industrial life insurance and ordinary life insurance. The hybrid nature of these policies allows for higher face amounts and higher premiums. These policies are typically paid for on a monthly basis via mail or bank draft, but they may also be collected at the policy owner’s home.

· At one time, industrial life policies made up a substantial portion of the life insurance market. However, due to rising wages, increased awareness of the need for adequate life insurance, and the expansion of employer-provided group life insurance, interest in industrial life insurance has now become a very marginal portion of the market.

· OTHER LIFE INSURANCE PRODUCTS

· FACE AMOUNT PLUS CASH VALUE

· A face amount plus cash value policy is a contract that promises to pay the policy’s face amount plus the policy’s cash value upon the death of the insured. This type of insurance policy requires a substantially higher premium than its traditional counterpart and, because of that, the policy is not common within the insurance industry.

· ACCIDENTAL DEATH AND DISMEMBERMENT (AD&D)

· This policy can provide financial benefits if an insured is killed, loses a limb, suffers blindness, or is paralyzed in a covered accident.

· NON-MEDICAL LIFE INSURANCE

· Non-medical life insurance doesn’t typically require a medical exam and tends to be more expensive than medically underwritten policies. The insurer will average out everyone’s risk and charge accordingly. Although insurers typically will not require a medical exam, they will still inquire about the applicant’s medical history and lifestyle.

· MINIMUM DEPOSIT

· Minimum deposit life insurance is more of a method to finance life insurance than an actual type of policy. This type of policy is best suited for individuals in high marginal tax brackets. It allows the policy owner to use policy loans to pay the premiums that are due each year. For example, each year, the policy owner is allowed to borrow, (subject to certain tax restrictions) that year’s cash value increase and use it to pay the premium. The policy owner only pays the difference between the premium due and the amount borrowed (plus interest on the policy loan).

· PARTICIPATING VERSUS NON-PARTICIPATING

· A participating life insurance policy is a policy that has dividend payments from the life insurance company. It’s referred to as participating because it’s permitted to share or “participate” in the excess earnings of the life insurance company. A non-participating policy doesn’t have the right to share in excess earnings and consequently doesn’t receive dividend payments. Typically, a mutual insurance company issues a participating policy.

· STRANGER / INVESTOR-OWNED LIFE INSURANCE (STOLI) / (IOLI)

· Stranger-owned life insurance (STOLI) is essentially a scheme whereby strangers to the insured — those without any true insurable interest — originate a policy for their own financial gain. Simply put, these schemes are wagers on human life and are prohibited in most states. To legally purchase life insurance on another person, the purchaser must have an insurable interest in that person’s life. STOLI policies were a way to circumvent the insurable interest requirement when purchasing a life insurance policy.

· Investor-Owned Life Insurance (IOLI) is a life insurance policy that covers the life of an individual who’s unrelated to the policy owner by either familial relationship or economic relationship. The investor pays the person’s premiums in exchange for the person’s life insurance benefits. An IOLI transaction is very closely related to a STOLI transaction. The primary difference between the two is that an investor always initiates an IOLI.

· Both STOLIs and IOLIs are considered fraudulent. STOLIs and IOLIs do not include lawful life settlement contracts, provided that such contracts or practices are not for the purpose of evading regulation.

CHAPTER SUMMARY

Key points to remember from this chapter include:

General Concepts of Life Insurance

• Life insurance involves the transfer of the risk of premature death from one party to another party.

• Life insurance contracts create an immediate estate.

• Unlike other lines of insurance (e.g., property and casualty), there are no “standard life insurance policies.”

Temporary Life Insurance Products

• Term lifeinsurance provides pure or temporary protection and is the simplest form of life insurance coverage

  • It provides the maximum amount of life insurance at the lowest initial premium.

  • Temporary or limited protection

  • No cash value / no equity

  • Protects the insured against the financial loss that an early death may cause.

  • Level term life insurance provides a level amount of protection for a specified period, after which the policy expires.

  • Increasing term life insurance provides a death benefit that increases at periodic intervals over the policy’s term.

  • Decreasing term life insurance provides a death benefit amount that decreases gradually over the term of protection.

    • Mortgage redemption insurance is a type of decreasing term life insurance policy.

    • Credit life insurance is a limited benefit (term) policy that’s designed to cover the life of a debtor and pay the amount due on a loan if the debtor dies before the loan is repaid. The maximum benefit for a credit life insurance policy, regardless of individual or group, is the value of the loan.

    • The option to convertgives the insured the ability to convert or exchange the term policy for a whole-life or permanent policy without evidence of insurability.

      • The cost of insurance is the most important factor to consider when determining whether to convert term life insurance at the insured’s original age or the insured’s attained age

      • Interim term life insurance is a type of convertible term insurance that’s written on a person who wants protection immediately, but who’s not able to afford permanent protection immediately. The premium for the temporary protection is based on the original application age. The premium for permanent protection is based on the age when permanent protection begins (the attained age).

      • The option to renewallows the policy owner to renew the term policy before its expiration date without being required to provide evidence of insurability.

        • Step-up premium is a steady increase in premium.

        • Annually renewable term (ART) or yearly renewable term (YRT) life insurance provides coverage for one year and allows the policy owner to renew coverage each year, without evidence of insurability.

        • Advantages of term life insurance policies include:

          • Term life insurance is less expensive than permanent insurance.

          • Term life insurance may protect the insured’s insurability if the policy is renewable and or convertible.

          • Term life insurance may be used in conjunction with debts, mortgages, or as a supplement to whole life insurance.

          • Term life insurance provides the most substantial amount of protection for the lowest cost.

          • Disadvantages of term life insurance include:

            • The protection provided by term life insurance policies terminates when the policy terminates. No protection is in effect once the term protection ends.

            • If the term life insurance policy is renewable or convertible, premium rates rise as the insured ages, which often leads to policy cancellation prior to the policy terminating.

            • Due to the temporary nature of term insurance, few death claims are actually paid under term life insurance policies.

            • Term life insurance policies don’t contain any cash savings or equity elements (i.e., cash value). Since it has no cash value, it doesn’t mature as does a whole life policy.

Permanent Life Insurance Products

• Whole lifeinsurance provides for the payment of a death benefit or face amount of coverage upon the death of the insured, regardless of when the death occurs.

  • It’s a form of permanent insurance.

  • Level, fixed, or predetermined death benefit

  • Level, fixed, or predetermined premium

    • The shorter the payment period, the higher the premium.

• Tax-deferred cash value (i.e., equity or savings)

• Whole life insurance is designed to mature (cash value = face value) at the age of 100.

• Ordinary Whole Life / Straight Life / Continuous Premium Lifeis the most basic form of whole life insurance.

  • Premiums are payable as long as the insured is alive.

  • Limited Payment Whole Life

    • Predetermined premium for a limited payment period

    • A single premiumwhole life policy is the most expensive whole life policy initially.

      • An immediate non-forfeiture value (cash value) is created.

      • A large part of the premium is used to set up the policy’s reserve.

      • The advantage offered by a single premium policy is that the policy owner will pay less for the policy than if the premiums were stretched over several years.

      • Modified whole life insurance is a type of whole life insurance policy that’s characterized by an initial premium that’s lower than straight whole life insurance for an introductory period (e.g., five years). After the introductory period, the premium jumps to a rate higher than a straight life policy would have cost if it were taken out originally.

      • A graded premium whole life plan is a contract that’s characterized, like modified life, by a lower premium than straight whole life in the early years of the contract. However, premiums increase annually or every year for the initial period. Thereafter, it jumps to an amount that’s higher than the whole life premium and remains fixed for life.

      • Enhanced Whole Life Insurance, also referred to as economatic life or extraordinary life, is a low premium based participating permanent insurance policy.

      • Indexed Whole Life Insurance offers a face amount (death benefit) that increases in line with rises in the Consumer Price Index (CPI) without requiring evidence of insurability.

      • Equity Indexed Whole Life Insurance includes contracts where the policyholder can share in a percentage of the growth of an indexed investment (e.g., a Mutual Fund tied to the Standard & Poor’s Index). The minimum interest and death benefit are guaranteed. These products are not considered securities.

Alternative Non-Traditional Life Insurance Products

• Adjustable whole life insurance policies, also referred to as blended or combination policies, are distinguished by their flexibility from combining term and permanent insurance into a single plan.

  • Permanent insurance in which the face amount and premium may change

  • Looks to the future (i.e., prospective)

  • Flexible / adjustable death benefit based on changing needs

  • Universal Life (UL)insurance is essentially a term policy with cash value (savings), flexible premiums, and an adjustable death benefit.

    • Tax-deferred cash value (money market rates) has a guarantee (i.e., interest rate).

    • Universal Life Insurance is considered permanent insurance. Coverage remains in place for the life of the insured as long as the cost of insurance can be paid by the cash value or increasing premium payments.

    • The policy owner may surrender the universal life policy for its entire cash value at any time.

    • Target premium is a suggested premium that’s used in universal life policies.

    • Universal life insurance offers two death benefit options:

      • Option A: the death benefit equals the cash values plus the remaining pure insurance (decreasing term plus increasing cash values).

      • Option B: the death benefit equals the face amount (pure insurance) plus the cash values (level term plus increasing cash values).

      • Equity Index Universal Life Insurance combines most of the features, benefits, and security of traditional life insurance with the potential of earned interest based on the upward movement of an equity index.

Securities and Exchange Commission (SEC) Regulated Life Insurance Policies

• Variable Life (VL)

  • Guaranteed minimum death benefit

  • The death benefit and cash value will vary based on investment performance

  • Tax-deferred cash value is deposited in a separate account and then invested in securities

  • Permanent insurance in which the owner has control over the investment portion

  • Fixed premium

  • Universal Variable Whole Life (or Variable Universal Life)

    • Hybrid of UL and VWL

    • Flexible premiums and death benefit with control over investment aspect

    • Combines an investment feature and a flexible premium

Special Use Life Insurance Products

• The family plan policyis designed to insure all family members under one policy.

  • A family maintenance policy consists of both whole life and level term insurance, which provides income for a specific period beginning on the date of death of the insured.

  • A joint life policycovers two or more people and pays a benefit upon the first death of a covered person.

    • The last to die (survivor) policy covers two or more people and pays a benefit upon the death of the last covered person.

    • A juvenile life insurance policy is any type of ordinary life insurance policy that insures the life of a minor.

    • An endowment policyis characterized by cash values that grow at a rapid pace so that the policy matures or endows at a specified date (i.e., before the age of 100).

      • Higher premiums than WL.

      • Quickest or accelerated cash value build-up.

      • Pays if the insured dies or if the insured survives the endowment (i.e., specified) period (e.g., 10-year; 20-year; 30-year, endowment at the age of 65).

      • A modified endowment contract is (according to IRS tables) considered to be a policy that’s overfunded. As such, MECs don’t technically meet the IRS definition of a life insurance policy. “Failed the 7-pay test;” Premiums paid in the first 7 years exceed the total amount of premiums required for the same insurance policy to be paid up in seven years.

      • Industrial life insuranceis characterized by comparatively small issue amounts, such as $1,000, with premiums collected on a weekly or monthly basis.

        • Monthly debit ordinary life insurance is a combination of industrial life insurance and ordinary life insurance.

Other Life Insurance Policy Concepts

• A face amount plus cash value policy is a contract that promises to pay the policy’s face amount plus the policy’s cash value upon the death of the insured.

• Stranger-Owned Life Insurance (STOLI) is when a person purchases life insurance only to sell to a third-party with no insurable interest, who would, therefore, be unable to legally purchase the original policy.

• Non-medical life insurance typically doesn’t require a medical exam and tends to be more expensive than medically underwritten policies.

• A participating life insurance policy is a policy that has dividend payments from the life insurance company.

• A non-participating policy does not have the right to share in excess earnings and consequently doesn’t receive dividend payments.

Please take a look at the tables below to gain a better understanding of the various types of life insurance products:

Traditional Life Insurance Policies

Death Benefit

Cash Value

Premium

Policy
Loans

Partial Withdrawals of Cash Value

Surrender Charges

Term

Level or decreasing

None

Level increases at each renewal.

Decreasing is fixed.

NO

NO

NO

Whole Life

Fixed, level or predetermined

Predetermined,

tax-deferred and guaranteed

Level for the period selected

YES

NO. To receive cash, it must
be borrowed.

NO

Single Premium Whole Life

Fixed, level, and predetermined

Predetermined, tax-deferred, and guaranteed

Lump-sum premium paid
at issue

YES

Generally, not available

YES

Non-Traditional Life Insurance Policies

Death Benefit

Cash Value

Premium

Policy
Loans

Partial Withdrawals
of Cash Value

Surrender Charges

Interest Sensitive/
Current Assumption
Whole Life

Fixed or level

Scheduled and guaranteed plus accumulation fund from excess interest

May vary based on experience.

Guaranteed maximum level

YES

YES

YES

Adjustable
Life

Level, but changeable by request

Predetermined and tax-deferred, but new schedule needed after each negotiated policy change

Level, but the level may change when the policy change is requested

YES, if there’s cash value

NO. To receive cash, it must
be borrowed.

NO

Universal
Life

Flexible. Original DB cannot be guaranteed if
the owner is not funding the plan with premiums.
A flex premium insurance plan.

Guaranteed minimum interest rate (e.g., 4%). The interest rate will vary each year based on the money market index. Interest is tax-deferred.

Flexible premium. Required first year target (i.e., suggested level premium), and then the owner may pay flexible premiums each year or nothing
at all.

YES. Loans affect the interest rate credited to the cash value.

YES

YES

Variable Life Insurance Policies

Death Benefit

Cash Value

Premium

Policy
Loans

Partial Withdrawals
of Cash Value

Surrender Charges

Variable Life

Guaranteed minimum but may increase based on investment performance.

May increase or decrease based on investment performance, tax deferred. Owner control of CV investment.

Fixed, level, or predetermined. A security (i.e., investment) and

insurance plan with a fixed premium.

YES

NO. To receive cash, it must
be borrowed.

YES

Variable Universal Life

Guaranteed minimum but may increase based on investment performance.

Depends on investment performance, tax deferred. Policy owner controls CV investment.

Flexible premium. Required first year target (suggested level premium). A securities and insurance plan with a flexible premium.

YES

YES

YES

Combination Plans and Variations

Family Income

Family Policy

Joint Life

Last-Survivor Life

WL and decreasing term

A family maintenance policy that combines whole life and level term

WL and level term

Doesn’t terminate when
the primary insured dies

Covers two or more lives
and pays when the first insured dies. Thereafter,
the policy terminates.

Covers two lives only and pays when the last insured dies. Thereafter, the policy ends.

Also referred to as “second to die” insurance.

Chapter 5

KEYWORDS: LIFE INSURANCE POLICY PROVISIONS, OPTIONS, AND RIDERS

Please review the following keywords prior to beginning this chapter. The understanding of their basic definition will improve comprehension of the chapter content.

Absolute Assignment: This is a policy assignment under which the assignee (person to whom the policy is assigned) receives full control over the policy and also full rights to its benefits. Generally, when a policy is assigned to secure a debt, the owner retains all of the rights in the policy in excess of the debt, despite the fact that the assignment is absolute in form.

Accidental Death Benefit (Multiple Indemnity) Rider: This rider pays an additional sum to the beneficiary if the insured dies due to a covered accident. The amount paid is a multiple of the policy face amount, such as double or triple the original benefit. Accident death life insurance provides the cheapest way to add a significant amount of coverage for a limited period.

Accelerated Benefits Rider: This rider allows the insured to receive a portion of the death benefit before death if the insured has a terminal illness and is expected to die within one-to-two years. Regardless of the amount that’s withdrawn in an accelerated death benefit, it will decrease the death benefit when death occurs.

Accumulate Interest Option: The “accumulate interest” dividend option allows the policy owner to leave dividends with the insurer to accumulate interest. In turn, the policy owner is required to pay taxes on any interest (profit) that’s generated by the dividend.

Assignment Clause: This clause allows for the right to transfer policy rights to another person or entity.

Automatic Premium Loan Provision (or Rider): This provision allows the insurance company to deduct the overdue premium from an insured’s cash value by the end of the grace period if a payment is missed on a life policy. The insurance company can AUTOMATICALLY take out a LOAN for the insured against her CASH VALUE to cover her PREMIUM if it doesn’t receive payment when due. This automatic premium loan can continue until the policy owner resumes making payments, or the policy runs out of cash value. Once all of a policy owner’s cash value is gone, if she doesn’t start paying, her policy will lapse.

Cash Option: The “cash” dividend option allows policy owners to cash out the dividends they receive.

Cash Surrender Option: The “cash surrender” non-forfeiture option allows the policy owner to receive the policy’s cash value. If this option is exercised, at this point, the policy owner no longer has coverage. Typically, the maximum period that a life insurance company may legally defer paying the cash value of a surrendered policy is six months (Delayed Payment provision).

Collateral Assignment: This is an assignment of a policy to a creditor as security for a debt. The creditor is entitled to be reimbursed out of policy proceeds for the amount that’s owed. Any proceeds above the amount that’s due at the insured’s time of death will be paid to a beneficiary who’s designated by the policy owner.

Consideration Clause: This clause states a policy owner must pay a premium in exchange for the insurer’s promise to pay benefits. A policy owner’s consideration consists of completing the application and paying the initial premium. The amount and frequency of premium payments are contained in the consideration clause. An example of the clause is, “Please CONSIDER me for insurance. Here is my COMPLETED APPLICATION, INITIAL PREMIUM, including how much and how often I agree to pay. Please consider me.”

Dependent Riders (Other Insureds Rider): Dependents may be added as additional (other) insureds through the use of a dependent rider. Other insured riders are typically used for spouses and children.

Dividend Options: These are the options that a policy owner has when receiving dividend payments from an insurance policy.

Entire Contract Provision: This provision (or clause) states the insurance policy itself, including any riders, endorsements/amendments, and the application comprises the entire contract between all parties.

Exclusions: These are features of an insurance policy which states that the policy will not cover certain risks.

Extended Term Option: This non-forfeiture option permits the policy owner to use the policy’s cash value to buy level, extended term insurance for a specified period. No further premium payments are made.

Free-Look Period: This period states that the policy owner is permitted a certain number of days once the policy is delivered to examine the policy and return it for a refund of all premiums paid.

Grace Period: This is a period after the due date of a premium during which the policy remains in force without penalty. If an insured dies during the grace period of a life insurance policy before paying the required annual premium, the beneficiary will receive the face amount of the policy minus any required premiums. For life insurance, the grace period is typically one month.

Guaranteed Insurability Rider (Future Increase Option): This rider permits the policy owner to buy additional permanent life insurance coverage, at the insured’s attained age, at predetermined intervals without submitting proof of insurability. It also includes specific events, such as marriage and births, without requiring proof of insurability. Typically, the benefit is allowed every three years, up to the original face amount of the policy.

Incontestable Provision (Period): This provision states that the insurance company cannot challenge the validity of the policy once the policy has been in force for a specific period (generally two years). Over the years, case law has established precedence that the incontestable clause applies to cases of fraud.

Insuring Clause (or Insuring Agreement): This agreement is the insurer’s basic promise to pay specified benefits to a designated person in the event of a covered loss. The agreement stipulates the scope and limits of coverage, and states, “We ensure to INSURE you for...”

Misstatement of Age or Sex Provision: This provision allows the insurer to adjust the policy benefits if the insured’s age or sex is misstated on the policy application. The misstatement of age provision allows the insurer to adjust the benefits payable if the age of the insured was misstated when the application for the policy was made. At the time of application, if the insured was older than what’s shown in the policy, benefits would be reduced accordingly. The reverse is true if the insured was younger than listed in the application.

Non-Forfeiture Options: These are the options an insured has for her cash value if she terminates a policy that has a cash value. For example, “you are closing your account (surrendering your policy); what do you want us to do with your cash (so you don’t forfeit it)?” When a policy owner decides she doesn’t want her insurance policy any longer, she has the option to surrender her policy.

One-Year Term Option: This dividend option allows the policy owner to exchange the dividend for additional coverage in the form of a one-year term policy.

Paid-Up Additions Option: This dividend option allows the policy owner to exchange the dividend for an additional single payment whole life policy.

Payor Provision (Rider or Clause): This provision waives future premiums for a juvenile life insurance policy if the person who’s responsible for paying the premiums dies or becomes disabled.

Policy Loan (Cash Withdrawal) Provisions: These provisions apply to policies that have cash value, as well as policy loan and withdrawal provisions. These policies must begin to build cash value after a certain number of years which, in most states, is three years. These loans, with interest, cannot exceed the guaranteed cash value. If the loan exceeds the guaranteed cash value, the policy is no longer in force. The policy owner has the right to the policy’s cash value.

Reduced Paid-Up Option: This non-forfeiture option allows the policy owner to reduce the policy’s benefit amount and, in turn, cease making premium payments.

Reduced Premiums Option: This dividend option allows the policy owner to return the dividend payment to the insurer in exchange for a reduction in the following year’s premium payments.

Reinstatement Provision: This provision allows an insured to put a lapsed policy back in force by producing satisfactory evidence of insurability and paying any required past-due premiums. It permits the policy owner to reinstate a policy that has lapsed as long as the policy owner can provide proof of insurability and pays all back premiums, outstanding loans, and interest.

Return of Premium Rider: This rider pays the total amount of premiums paid into the policy in addition to the face value, as long as the insured dies within a specific period that’s identified in the policy. It may also return premiums to the policy owner at the end of a specified period, if the insured is still alive.

Suicide Clause: This clause states that the policy will be voided, and no benefit will be paid, if the insured commits suicide within two years from policy issuance. The primary purpose of a suicide provision is to protect the insurer from applicants who are contemplating suicide.

Waiver of Premium Rider: This rider allows the policy owner to waive premium payments during a disability and keeps the policy in force. The waiver of premium rider is not a loan and doesn’t provide cash payments to the policy owner. The insurance company is “waiving” the premiums.” In other words, it’s just as if the policy owner made the premiums every month.

INTRODUCTION

Unlike other lines of insurance, there’s not a standard Life Insurance Policy form that all insurance companies use. Despite efforts by insurance companies to offer products that are different from their competitors, insurance policies are more notable for their many similarities than their differences. The foundation of the uniformity is rooted in the state-level regulation of the industry and the adoption of NAIC guidelines.

Regulators in each state protect consumers by establishing strict guidelines as to what must and must not be included in an insurance policy. Furthermore, in an effort to promote state-by-state uniformity of insurance industry regulation, most states have adopted the standard wording of NAIC Model Regulations. As such, this standard wording is similar among the many different life insurance contracts that are available to consumers.

This chapter will begin with a discussion of the standard provisions that appear in most life insurance contracts. Thereafter, we’ll examine some of the standard exclusions and additional policy options. This chapter will introduce life insurance policy provisions, riders, and exclusions. Overall, this chapter will consider the rights and obligations of insurance contracts and how insurers can modify already existing provisions to increase or decrease policy benefits and premiums to meet an individual’s specific needs.

The chapter is broken into the following sections:

• General Life Insurance Policy Provisions

• Provisions and Options Related to Cash Value

• Provisions and Options Related to Policy Proceeds

• Options Related to Dividends

• Life Insurance Policy Riders

• Life Insurance Policy Exclusions

The state-specific portion of this course (located at the end) will detail the specific insurance definitions, rules, regulations, and statutes for your state. If a conflict exists, state law will supersede the general content.

Review of this chapter will enable a person to:

• Identify the standard provisions that are included in all life insurance contracts

• Understand the structure of a policy loan

• Identify the provisions and options that impact policy cash values

• Understand the taxation structure for insurance policy loans

• Understand provisions and options that impact policy proceeds

• Distinguish between revocable and irrevocable beneficiary designations

• Understand the concept of dividends and their taxation structure

• Distinguish between the different types of life insurance policy riders

• Distinguish between the different types of dividend options

• Distinguish between the principal sum and the capital sum

• Distinguish between level, decreasing, and increasing term riders

• Identify the common exclusions of life insurance contracts

· GENERAL LIFE INSURANCE POLICY PROVISIONS

· Most states require the same set of provisions to be included in all life insurance contracts. These standard or usual provisions are almost identical in verbiage regardless of the insurance company or the locale in which the policy is issued.

· These “standard provisions” that are found in all life insurance policies identify the duties, obligations, and rights of the parties to the contract. A provision may also be referred to as a policy clause. In general, provisions are intended to protect the owner of the policy.

· ENTIRE CONTRACT PROVISION

· The entire contract clause or provision is found at the beginning of the policy and states that the entire contract consists of all included policy documents, the attached photocopy of the original application, and any attached riders or endorsements. Nothing may be incorporated by reference, meaning that the policy cannot refer to any outside documents as being part of the contract. Therefore, the insurer cannot deny a claim in the future by stating that it did not provide the policy owner with the entire contract.

· Additionally, the entire contract provision prohibits the insurer (including the agent) from making any changes to the policy, either through policy revisions or changes in the company’s bylaws, after the policy has been issued. Naturally, the policy owner or insured is also prohibited from making any changes to the policy.

· The following is an example of an actual “entire contract” provision that may appear in a life insurance policy:

· “The insurer has issued the policy in consideration of the application and payment of the premium. A copy of the application is attached and is part of the policy. The policy with the application makes up the entire contract. All statements made by or for the insured will be considered representations and not warranties. This insurer will not use any statements in defense of a claim unless it is made in the application, and a copy of the application is attached to the policy when issued.”

· This clause doesn’t prevent a mutually agreeable change from being made to the policy if the policy expressly provides a means for modifying the contract after it has been issued. Changes or additions to a life insurance contract are referred to as endorsements, riders, or amendments. Only authorized company officers are permitted to modify or amend an insurance contract and, again, the changes must be agreed upon by the policy owners before taking effect.

· Examples of mutually agreeable changes may include the policy owner changing the face amount of an adjustable life policy or adding additional coverage through a rider.

· EXECUTION CLAUSE

· The execution clause states that the insurance contract will be executed when both parties (the insurer and the policy owner) have satisfied the conditions of the contract. In other words, when both parties have fulfilled their responsibilities, the contract will be executed.

· MODIFICATION PROVISION

· This provision may be listed separately from the entire contract provisions and states that any changes made to the contract must be in writing and endorsed or attached to the policy. It also states that only an executive officer of the insurer or authorized home office personnel possess the authority to make any changes or modifications or waive a policy provision. A producer or agent is not required to countersign any such modification.

· PRIVILEGE OF CHANGE CLAUSE (POLICY CHANGE PROVISION)

· The privilege of change clause—also referred to as the policy change provision or conversion option—outlines the conditions under which the company will allow the policy owner to change the policy’s coverage. If the premium is increasing, but the face value remains the same, the insured will not be required to prove insurability. However, the insured is required to prove insurability if the premiums are decreasing or the face value is increasing, since it could result in adverse selection.

· For example, this clause may allow you to exchange a higher-premium whole life policy for a cheaper term life policy with the same face amount. This option may seem attractive to an insured who recently found out they have a terminal illness. However, the insured will have to prove their insurability (i.e., that they don’t have a terminal illness) to ensure the insurer isn’t taking on greater risk for lower premium.

· INSURING CLAUSE PROVISION

· The insuring clause or agreement sets forth the company’s fundamental promise to pay benefits upon the insured’s death. This provision appears on the first page of the policy, which is also referred to as the policy face or cover page. This provision identifies the insurer’s promise, as well as the scope and limits of coverage provided by the policy. In other words, it specifies the death benefit or face amount. Additionally, the insuring clause identifies the amount of the annual premium, the frequency with which the premium is paid, and the name of the beneficiary.

· An insuring clause may state that the promise to pay is subject to a policy’s provisions, exclusions, and conditions. Typically, the insuring clause is undersigned by the president and secretary of the insurance company.

· One company’s insuring clause reads:

· “This agreement has been made between the policy owner and the insurer. It provides a coverage limit of $100,000 payable to the primary or other beneficiaries in the event of the insured’s death. The annual premium is $400 to be paid in the method or mode selected by the policy owner. Further, the Company agrees to pay the surrender value to the policy owner if the insured is alive on the maturity date.”

· CONSIDERATION CLAUSE

· As previously described, there must be an exchange of value between the two parties for the contract to be legally enforceable. Consideration is the value that’s given in exchange for a contractual promise. In an insurance policy, the consideration clause states that the policy owner’s consideration consists of completing the application and paying the initial premium. The consideration clause or provision in an insurance policy also specifies the amount and frequency of premium payments that the policy owner must make to keep the insurance in force. The material statements of the applicant must be true. Therefore, the policy owner’s consideration in a life insurance contract is the premium paid and his representations regarding health history which appear in the application. Again, the insurer’s consideration in this life insurance agreement is its promise to pay a legitimate death claim once it receives a completed proof of loss (i.e., claim form) accompanied by a notarized death certificate.

· If, for some reason, the consideration is not complete on the part of the policy owner, the contract will be void. Void means that there was never a valid contract and coverage was never in effect.

· For example, if the policy owner’s check bounces or is returned for insufficient funds, there’s no coverage because there’s no consideration. If the check clears the bank, but the insurer later finds that the applicant engaged in material misrepresentations concerning his health, again, there will be no coverage since there’s no valid consideration. In this latter instance, the insurer will void or cancel the policy and return the premiums to the policy owner.

INCONTESTABLE CLAUSE

The incontestable clause or provision specifies that, after a certain period of time has elapsed (usually two years from the issue date), the insurer no longer has the right to contest the validity of the insurance policy as long as the contract continues in force. Therefore, after the policy has been in force for the specified term, the company cannot contest a death claim or refuse payment of the proceeds even on the basis of fraud, a material misstatement, or concealment.

The incontestable clause applies to the policy face amount plus any additional riders that are payable at death. Although the incontestable clause applies to death benefits, it generally doesn’t apply to accidental death benefits or disability provisions if they’re part of the policy. Because conditions relating to accidents vary and are often uncertain, the right to investigate them is typically reserved by the company.

The insurance company may only challenge (contest) a claim during the policy’s contestable period. Therefore, claims outside of the contestable period are generally incontestable. It should be noted that there are three situations to which the incontestable clause doesn’t apply. A policy that’s issued under any of the following circumstances will not be considered a valid contract and the insurer will therefore have the right to contest and possibly void the policy at any time:

• Impersonation or Identity For example, if the insurer discovers that one person completed the insurance application, but a different person signed the application or completed the medical exam, the insurer can contest the policy and its claim.

• Lack of Insurable Interest at the Time of Application If no insurable interest existed between the applicant and the insured at the inception of the policy, the contract is not valid. As such, the insurer can contest the policy at any time.

• Intent to Murder If it’s proven that the applicant applied for the policy with the intent of murdering the insured for the proceeds, the insurance company can contest the policy and its claim. Since the policy did not have a legal purpose from the start, the insurance company may simply deny coverage. The policy owner is powerless to fight such a claim since no court of law will force an insurer to provide coverage under these circumstances.

A company can always void or cancel a policy for non-payment of premiums. Additionally, statements related to age, sex, or gender can be contested at any time.

MISSTATEMENT OF AGE OR SEX (GENDER) PROVISION

This provision states that if the age of the insured is “misstated” on the application, the policy will not be void or canceled. However, the amount of insurance will be adjusted to be that which would have been purchased by the premium had the correct age been known. In other words, the amount of death proceeds will be adjusted (up or down) to reflect the appropriate benefit that the premium paid would have purchased at the correct age.

A death benefit adjustment is involved whether the age was misstated higher or lower. This means that, even if the applicant lied intentionally about his age to save premium dollars, the insurer will not cancel or void the policy and will not deny a death claim when it discovers the incorrect age. Instead, it will simply adjust the death benefit or the death claim amount. Therefore, if the age of the insured is understated on the application, the insurer will pay a lower death benefit amount at death, and if the age of the insured is overstated, the insurer will pay a higher or additional face amount at death. If the sex of the insured is misstated, the insurer will take the same action of adjusting the face amount. Again, the insurer will not cancel the policy due to these inaccuracies but will adjust the policy benefit.

For instance, let’s assume that a 35-year-old insured purchased a $10,000 policy for $100 and, at his death, it’s determined that the actual age of the insured at the time of application was 40. The premium should have been $125. Therefore, since his age was misstated, the insurer will adjust the death benefit or pay 100/125 or 4/5ths of the original death benefit (i.e., $8,000).

SUICIDE CLAUSE OR PROVISION

For many years, insurers did not cover death as a result of suicide. Today, an insurer continues to protect itself against this contingency of a person taking his own life. Therefore, a suicide provision is inserted in most life insurance contracts. The provision or clause stipulates that death which is caused by suicide is excluded during an initial period after the policy becomes effective. The provision or clause stipulates that death which is caused by suicide is excluded during the initial two years after the policy becomes effective. Therefore, if the insured dies as a result of suicide during the first two years of the policy’s existence, the insurer will deny the claim and refund all premiums paid up to that point to the beneficiary. After the initial two-year period, if the insured dies as the result of suicide, coverage is provided, and the coverage limit will be paid to the beneficiary.

For example, John is covered by a life insurance policy and, six months after he purchases the policy, he commits suicide. Will the insurer pay the death benefit amount to the beneficiary? No, it will not because suicide is not a covered cause of death in the initial two years. If John commits suicide in the first two years, will anything be paid to the beneficiary? Yes, a return of the premium paid will be provided to the beneficiary.

OWNER’S PROVISION (RIGHTS OF POLICY OWNERSHIP)

This provision states that the policy owner possesses all of the rights contained in the policy. In any insurance policy or contract, the policy owner may name or change the beneficiary, borrow against the cash value (if applicable), and select the frequency with which premiums are paid (i.e., the premium mode, such as annual, monthly, etc.). The owner may also choose to transfer one, some, or all of these rights to another party. The transfer of policy ownership rights is referred to as “policy assignment.” Additionally, if the contract is participating, the policy owner possesses the right to receive any dividends (also referred to as excess interest credits) that are payable and vote to elect the company’s board of directors.

More often than not, the policy owner, the policy payor, the applicant, and the insured are all the same person. However, as described previously, this is not always the case.

For example, in the case of a juvenile policy, the parent or guardian is the owner, the payor, and the applicant, whereas the child is the insured. The child doesn’t possess any ownership rights until ownership is transferred to her.

An additional example could involve a divorce where, as part of an alimony judgment, a spouse is required to be the insured and payor of an insurance policy with the other (ex)spouse being listed as the policy owner.

Again, the primary rights of a policy owner include:

▪ The right to assign and change the policy’s beneficiaries

▪ The right to determine how proceeds will be paid (i.e., settlement options)

▪ The right to terminate the policy and select a non-forfeiture option

▪ The right to determine and change the premium payment schedule (not necessarily the amount of the premium, but whether the premium is paid monthly, quarterly, annually, etc.)

▪ The right to assign ownership of the policy to another person

▪ The right to decide what happens with dividends that are paid out from a participating policy

▪ The right to convert or renew a term policy if such option exists within the contract

▪ The right to exercise any other applicable policy options (i.e., guaranteed insurability option, policy loans, etc.)

APPLICANT CONTROL OR OWNERSHIP CLAUSE

If a proposed insured is under the age of majority (i.e., a minor), a parent or guardian is typically the applicant and the policy owner. When this occurs, the parent may have a provision inserted into the contract that provides him with full control of the policy until the minor reaches a specific age. Since the applicant is designated as the person in control of the policy, the provision is most often named, “the applicant control clause.”

ASSIGNMENT PROVISION

Individuals who purchase life insurance policies are commonly referred to as policy owners, rather than policy holders because they own their insurance policies and may do with them as they wish. The assignment provision reiterates one of the policy owner’s rights, as stated in the contract. It enables the policy owner to transfer any or all of their policy rights to another person. This transfer of rights or ownership is referred to as policy assignment. The previous owner is considered the assignor, and the new owner is considered the assignee.

Although the policy owner doesn’t need the insurer’s permission to assign a policy, the assignment provision will lay out the procedure required for the policy owner to transfer or assign his ownership rights. Generally, the policy owner must provide the insurance company with written notification of any assignment. The company will then accept the validity of the transfer without question. Additionally, insurable interest is not required to exist between the insured and the assignee.

The following is a description from the assignment provision of an actual policy: “The policy owner may assign this policy. The insurer will not be responsible for the validity of an assignment. The insurer will not be liable for any payments it makes or any actions it takes before notice of the assignment is provided to it from the policy owner.”

Absolute versus Conditional or Collateral Assignment

An absolute or complete assignment occurs when the policy owner transfers all of her policy (ownership) rights. In this case, the entire contract has been transferred to another party. An absolute assignment involves a complete transfer of the policy to another person. The assignor (original policy owner) is typically not able to recover an absolute assignment. An absolute assignment may also be referred to as a voluntary or complete assignment.

Collateral or conditional assignment occurs when the policy owner assigns one or some of the ownership rights to another party but doesn’t assign all of the policy ownership rights. As such, a collateral (or conditional) assignment is a partial and temporary transfer of policy rights to another person.

In a conditional assignment, the policy owner or assignor transfers a policy right to an assignee. Most conditional assignments involve the use by the assignor of a whole life policy’s cash value as collateral to secure a loan from a financial institution. When the cash value or a portion of it is “assigned” to a bank or “assignee,” the assignee becomes the primary beneficiary with regard to its interest (the amount of money owed). The assignee is only entitled to be reimbursed out of the policy proceeds for the amount of the outstanding loan (i.e., credit) balance. If the insured dies before the assignee is repaid, the death benefit is divided between the assignee and the stated primary beneficiary according to each person’s interest in the policy proceeds. In other words, under a conditional assignment, policy proceeds in excess of the “collateral” amount (i.e., the amount owed to the lender), pass to the insured’s primary beneficiary. Therefore, pledging the cash value of a whole life policy as security for a loan involves a “collateral” assignment.

Policy Assignment and Beneficiaries

Although a more detailed review of beneficiaries will be provided in a later chapter, let’s now focus on examining the provisions that are related to this topic.

The inclusion of the revocable beneficiary provision means that the policy owner may modify, alter, or change the beneficiary at any time and at her discretion. This is one of the owner rights as provided by the policy. If the owner wants to change the beneficiary, she may simply request a “change of beneficiary form,” complete it, and return it to the insurer.

With an irrevocable beneficiary provision, the policy owner or a court of law may designate an irrevocable beneficiary. In this case, the beneficiary designation cannot be changed or modified without the permission or consent of the named beneficiary. If a policy owner names an irrevocable beneficiary, the policy owner must obtain the irrevocable beneficiary’s agreement prior to any assignment. Furthermore, an assignee typically doesn’t have the ability to change an irrevocable beneficiary designation. However, the assignee could change a revocable beneficiary.

An irrevocable beneficiary may be able to assign a portion (or all) of the proceeds in a similar fashion as the policy owner. However, in general, if the beneficiary dies prior to the insured, any assignments that are made by that beneficiary are no longer valid unless the policy owner also agreed to the assignment in writing.

FREE-LOOK PROVISION

When a policy is delivered, this provision allows the new owner to review the contract for a specified number of days. If the new policy owner decides not to keep the policy, she may return it to the insurer as long as this is accomplished within a specified number of days from the delivery date. If the new policy owner decides to take this course of action and return the policy to the insurer, she will receive a full return of premium. The free-look provision may also be referred to as the “right to examine” provision. This provision allows the policy owner to return the policy for a full premium refund without giving the insurer a reason. A free-look provision must be included in all forms of life insurance, with the exception of flight or aviation insurance.

Mandatory free-look periods vary in each state, but they’re generally within 10 days of the delivery date. Depending on the state, there may be additional requirements for variable policies or senior applicants. The free-look period begins when the policy owner receives the policy. Most insurers require their policy owners to sign a dated delivery receipt when they receive their policy, and this receipt triggers the start of the free-look period. For the applicant to receive a premium refund, the policy must be returned within the specified number of days from the date she received it.

For example, if a policy is delivered to the new owner on January 25, the 10-day free look period begins on January 25 and will end 10 days later. In this case, the free-look period will end on February 4. To arrive at the correct answer, the day after the policy is delivered (January 26) should be counted as day one.

MODE OF PREMIUM (PREMIUM PAYMENT) PROVISION

The “mode of premium” provision states that premiums must be paid to an insurer or its representative in order for coverage to be provided and allows the policy owner to select the mode of premium. Insurers vary with regard to the payment modes that are made available. Some policy owners may choose to pay on an annual basis. The policy owner will save the most money (i.e., have lower premiums) if she pays annually, since annual premium payments result in lower administrative and maintenance costs for the insurer. This savings is typically passed to the policy owner. The other methods that are available for the payment of premiums include quarterly, semiannually, or monthly. Since insurers experience substantially higher administrative and maintenance costs when the premium is paid monthly, it’s considered the most costly method.

GRACE PERIOD PROVISION

Grace periods are standard in many other financial products, such as consumer loans, mortgages, credit card payments, etc. In a life insurance policy, the grace period is meant to protect the policy owner against the unintentional lapse of the policy. Grace period describes the period of time following the premium due date, that coverage doesn’t lapse despite the fact that the premium has not been paid. This period is generally 31 days (for some states, it’s 30 days) and coverage remains in effect during the days following the due date. Although it’s no longer a common practice, industrial policies have been known to define their grace period as four weeks. Additionally, some states may have specific laws for grace periods when the policy owner is a senior.

The insurer offers this grace period because it wants to keep business “on the books.” If the insured dies during the grace period and before a premium has been paid, the death benefit will be paid less a pro-rata share of the owed premium. A primary purpose of the grace period, as well as the reinstatement and automatic premium loan provision, is to keep a life insurance policy in force even when a premium payment is late. Keeping the policy in force prevents the life insurance company from requiring the insured to prove their insurability again and prevents the insurer from charging a higher rate for the insured’s increased age.

REINSTATEMENT PROVISION

If a policy lapses because premiums are not paid, many life contracts allow reinstatement as long as it’s requested within three years (for some states, it’s five or seven years) after the policy lapses. However, the request is not the predominant factor. The insurer will require proof of insurability or good health and all back premiums (plus interest) that are owed must be paid to the insurer before reinstatement is granted. Once a reinstatement application (along with proof of insurability and owed premiums) is sent to the insurer, coverage will automatically be reinstated within 45 days unless the insurer rejects the request.

A principal reason for a policy being reinstated is that the contract owner wants to “reinstate” the initial premium rate as well as the coverage limit. Other than an insured’s coverage being reinstated, the most crucial advantage to the reinstatement of an insurance policy is that the premium of the policy will continue to be based on the insured’s age at the time of the initial application (i.e., the applicant’s original age).

Whenever a policy is reinstated, a new two-year contestable period goes into effect for the statements that are made on the reinstatement application. However, there’s no new suicide exclusion. A policy cannot be reinstated if it was surrendered (i.e., given up by the policy owner).

PROVISIONS AND OPTIONS RELATED TO CASH VALUE

The following provisions are associated with the cash value of a whole life insurance policy. There are two primary types of cash value provisions—those involving policy loans and those involving policy surrender. Provisions involving a policy loan give a policy holder the ability to utilize the cash value of a life insurance policy without surrendering it. Provisions involving policy surrender give the policy owner the ability to surrender the policy without losing all of its equity.

EXCESS INTEREST PROVISION

The excess interest provision in life insurance means that the cash value will increase faster than the guaranteed rate if the insurer earns a return that’s greater than the guaranteed rate. Therefore, the excess interest provision allows interest that’s more than the policy’s guaranteed rate of interest to be credited to the cash value account. The following two methods are used for the excess interest provision:

Index-linked Method: The index-linked method credits the excess interest from earnings tied to an economic indicator (e.g., the Consumer Price Index).

Portfolio Method: The portfolio method credits the excess interest in direct relation to the insurance company’s earnings on its investments.

NON-FORFEITURE CASH VALUES

There was a point in time in the life insurance industry that, if a person did not pay her premium and failed to pay it by the end of the grace period, the policy would lapse, and she would forfeit any equity held in the policy. In response to this problem, many states adopted the standard non-forfeiture law. This law requires the policy owner to be given access to any cash value accumulation if she stops paying the policy. In simple terms, this means that a person is allowed to stop paying premiums and not forfeit any of the equity in the policy. The amount of cash value and rate of accumulation will vary by both policy type and company. Additionally, prior to the execution of any non-forfeiture option, the cash value is reduced by any loans that have been taken out.

Insurers are typically required to make cash surrender values available for ordinary whole life insurance after the first three policy years. However, most policies begin to generate cash values in as little as one year.

There are three non-forfeiture options that are available to a policy owner who decides to surrender a whole life policy—surrender for cash, reduced paid-up permanent insurance, and extended term insurance. If this scenario arises, the policy owner can stop paying premiums, and she will not “forfeit” the cash value or equity that has been built up in the policy.

In other words, when a policy owner decides to terminate the policy, she has the “option” of using the cash surrender value in one of three ways. However, none of these options is available if there’s no cash value present. These non-forfeiture options prevent the loss of cash value or equity if the policy owner surrenders the policy. Generally, an option will be selected by the owner; however, in one instance, an option will go into effect automatically.

Furthermore, once a policy is surrendered, it cannot be reinstated. Non-forfeiture options may also be referred to as non-forfeiture benefits or non-forfeiture values since they provide guaranteed values. Generally speaking, a policy cannot lapse as long as there’s cash value present. Non-forfeiture options recognize the equity build up in a whole life policy.

Cash Surrender Option

Policy owners may request an immediate cash payment of their cash values when their policies are surrendered. Any outstanding policy loans or debts reduce the amount of cash value that the policy owner will receive.

The cost recovery rule states that when a life policy is surrendered for its cash value, the cost basis (total premiums paid) is exempt from taxation. If the amount received in a cash surrender is greater than the total of premiums paid (minus dividends paid), the excess is taxable as ordinary income. A partial surrender will allow the policy owner to withdraw the policy’s cash value on an interest-free basis.

Reduced Paid-Up Option

A second non-forfeiture option is to accept a paid-up policy for a reduced face amount of insurance. By doing this, the policy owner uses the policy’s cash value as the premium for a single-premium whole life policy at a lesser face amount than the original policy. When this option is exercised, the paid-up policy is the same kind as the original, but for a lesser amount of coverage. This means that if the original policy was a participating policy, the new policy will also be a participating policy. Once the paid-up policy has been issued, the new face value remains the same for the life of the policy. Additionally, as with all whole life policies, the new policy will also build cash value.

The insured’s current attained age is used for premium calculation, but proof of insurability is not required since the benefit is being reduced. Additionally, riders and accidental death benefits from the original policy are excluded from the premium calculation and are dropped from the new policy.

When an insured selects this option, she has recognized the need for some type of permanent life insurance, but no longer wants to continue premium payments. Therefore, this is the option that provides the policy holder/insured with life insurance coverage for the greatest period (i.e., permanent whole life protection).

Extended Term Option

The extended term option permits the policy owner to surrender the policy and exchange the cash value for a paid-up level term insurance policy. Unless a policy loan is present at the time of surrender, the coverage amount of the new paid-up extended-term life policy will be identical to the face amount of the surrendered whole life policy. Again, since all of the elements in a traditional whole life policy is predetermined, the policy holder will know precisely what the cash value will be in subsequent years. When this option is exercised, the non-forfeiture table will inform the policy owner of the period during which coverage is provided (i.e., 11 years and 165 days). Generally, when a policy lapse occurs with cash value present and the insurer is unable to contact the policy owner, this non-forfeiture option is activated automatically. This fact is also stated in the policy.

If there’s an outstanding policy loan when the policy is surrendered, the balance of the loan is deducted from the cash value amount and the policy’s face value amount. In this situation, loans are deducted from both the face value and the cash value to prevent terminally ill policy owners from taking out large loans before changing to a policy that they know they will not outlive.

The extended term option is typically the default non-forfeiture option for a standard risk insured. If a whole life policy lapses because the policy owner fails to pay the premium and there’s still an amount of cash value present, the extended term option will routinely or automatically be activated if the insurer is unable to make contact with the policy owner.

The extended term insurance option provides the insured with the most life insurance protection (i.e., greatest face amount) in the event of a voluntary policy surrender or non-payment of premium. It also provides an insured with the greatest amount of coverage in the event of non-payment of premium (i.e., as long as the cash value is present).

POLICY LOAN PROVISION

Permanent or whole life insurance is characterized by a buildup of cash value. The policy loan provision, which is required in all whole life policies, outlines that the policy owner has the right to access this equity at his discretion. This provision, which is supported by the previously reviewed owner’s rights provision, permits the owner to receive an advance against the cash value build-up of the whole life policy.

Structure of a Policy Loan

This advance against the cash value should be considered more of an advance of policy proceeds as opposed to an actual bank loan. A policy “loan” cannot be “called” by the insurance company and is able to be repaid at any time by the policy owner. Additionally, policy loans don’t require credit checks, proof of income, or other things that are commonly associated with taking out a loan. Remember, the policy owner is essentially getting the policy proceeds advanced and using the cash value as collateral. Typically, the only qualification for a policy owner to be able to take out a policy loan is that the policy must have accumulated cash value which is available to secure the loan (i.e., act as collateral). However, if the policy contains an irrevocable beneficiary, the policy owner must secure permission from the irrevocable beneficiary in order to borrow against the cash value.

The maximum loan value of a whole life policy is generally its cash value, less any projected interest. Therefore, policy owners may make withdrawals or partial surrenders in amounts that don’t exceed the cash value, less the interest. Although the loan doesn’t need to be repaid, any outstanding policy loans or interest at the time of the insured’s death will reduce the policy’s face amount. Additionally, if the policy owner later chooses to surrender the policy for cash, the cash value available to the policy owner is reduced by the amount of any outstanding loan, plus interest. Other surrender options (i.e., extended term or reduced paid-up) would also take any outstanding policy loans into account when determining the term period or reduced face value. Taking a loan permits the person to keep the whole life policy in force and use the borrowed funds when cash is needed.

Policy Loan Interest

Keep in mind, while a policy owner may be borrowing “his money,” the insurance company planned on using that money as an investment to return an estimated amount of interest. This estimated interest is a crucial component for an insurance company to fulfill its obligations.

Policy loans reduce the amount of funds that an insurer has to invest and, accordingly, reduce the interest that the insurance company can accumulate. Policy owners are required to pay interest on these loans to offset the interest that the insurance company is missing by not having the funds invested.

Interest rates on policy loans can vary by company. The method for calculating the rate and any rate minimums or maximums must be specified in the policy when it’s issued. Most states stipulate that the maximum allowable fixed rate can be no more than 8%, but some states charge between 5 and10%, or a variable interest rate that’s tied to the Moody’s Corporate Bond Index. If the interest rate is variable, the company may set a new rate each policy year.

The policy owner may pay off the interest each year on the anniversary date of the policy (not the anniversary date of the loan). If the policy owner doesn’t make a scheduled interest payment on a policy loan, the amount of interest due will be added to the loan balance. If policy loan balance (plus interest) ever exceeds the life insurance policy’s cash value, the policy will lapse (no longer be in force).

Uses of a Policy Loan

Individual Uses The primary advantage of a policy loan is that it provides ready cash for the policy owner without needing to apply or qualify for the loan. Whether it’s to pay debts, pay for emergencies, pay for education expenses, or to be used for a business purpose, a policy owner may use the cash value for any reason when he needs cash. The cash value may also be used as collateral in order to secure another type of loan with a lending institution.

Business Uses Businesses may take out life insurance to safeguard a number of different risks. As the policy’s cash value grows, the company has the option of taking a policy loan for any reason that it deems necessary. Business policy loans encounter the same rules as loans on individual policies with regard to structure, interest, and repayment. The original purpose for the company taking out the policy may be significantly impacted if the policy proceeds are reduced due to an outstanding loan.

Taxation

In general, policy loans may be taken out of an individual whole life policy without any tax implications as long as the policy remains active. However, this changes if the policy lapses or is surrendered and there’s an outstanding loan that’s greater than the total premiums paid. When a policy with an outstanding loan is lapsed or surrendered (before the insured’s death), any gains (i.e., the amount received via policy loan that exceeds the premiums paid) will be immediately taxed as ordinary income. Additionally, interest that’s paid to the insurer on a policy loan is not tax-deductible. Tax implications for policy loans that are taken on business-owned life insurance are beyond the scope of this course.

Right to Defer Loan

While not often utilized, insurers typically have the right to defer a policy loan or the payment of the cash value (in most states, this can be for up to six months after its request). This right to defer is designed to protect an insurer if a large number of policy holders decide to make withdrawals at the same time. However, this right to defer doesn’t apply to death benefit claims or automatic premium loan payments.

Even if the policy doesn’t contain an automatic premium loan provision, if the policy owner informs the insurer that he wants to borrow against his policy’s available cash value to pay his premium, the company cannot defer the loan.

AUTOMATIC PREMIUM (OR POLICY) LOAN PROVISION

The automatic premium loan provision offers another way for the policy owner to avoid or guard against the unintentional lapse of his policy, as long as there’s sufficient cash value present in the policy. The automatic premium loan provision allows the insurance company to automatically take a loan against the policy’s cash value to pay the premium due if the required premium is not paid by the end of the grace period.

For example, if the policy owner’s premium due date is the first of the month and he forgets to pay the premium, coverage could lapse following the grace period. However, if this provision has been inserted in the policy and if there’s enough cash value present, once the grace period elapses, the insurer “automatically” withdraws an amount from the cash value in order to pay the premium.

If elected, this provision provides a means by which the policy will pay for itself if the owner inadvertently forgets to pay the premium within the grace period. In other words, if included in a whole life policy, this provision will ensure that coverage continues beyond the grace period by preventing a premium default.

The automatic premium loan provision is NOT automatically included in a policy and must be elected by the policy owner, typically at the time of application. However, there’s generally no charge to add this provision. This provision is only available on policies that offer cash value (i.e., permanent, whole life) and cannot be added to any type of temporary or term insurance. Since the provision is elected (either at the time of application or after policy issue), it may also be referred to as a rider (i.e., the automatic premium loan rider).

The funds that are taken from the cash value constitute a loan and are used to pay the premium. For this provision to work, there must be sufficient cash value present in the policy. In other words, the automatic premium loan provision prevents a policy from lapsing due to the non-payment of premium as long as there’s enough equity in the policy to pay the overdue premium. However, the cash value will eventually reduce to zero and cause the policy to lapse if the policy owner allows the automatic premium loan provision to pay the premiums for an extended period.

Automatic premium loans are added to, and treated the same as, any other policy loans from the standpoint of the maximum loan amount, the interest charged, and the impact to proceeds and surrender values. Although this option is typically elected at the time of application, some insurers may allow for it to be added after the policy is issued. Additionally, insurers may place a limit on the number of consecutive premium payments it will make under the automatic premium loan provision.

PROVISIONS AND OPTIONS RELATED TO POLICY PROCEEDS

When applying for life insurance, the policy owner must understand the purpose of the policy she wants to purchase. Who’s the policy designed to protect (i.e., a child, a spouse, a charity)? What’s the policy’s intended purpose (i.e., income replacement, debt reduction, estate creation)?

One of the important elements that a policy owner should consider when she purchases life insurance is the settlement options or the manner in which death proceeds are paid at the time of the insured’s death. In most cases, the selection is made by the beneficiary at the time of the insured’s death. However, a settlement option may be selected by the policy owner at the time of application. Failure to arrange for the proper payment of proceeds may defeat the very purpose for which the insurance was intended.

Living benefits allow a policy owner to receive a portion of the policy proceeds while the insured is still alive. The insurer will typically require the policy owner to have a physician certify that the insured has a qualifying condition (i.e., terminal illness) before providing access to living benefits.

BENEFICIARY DESIGNATION PROVISIONS

The policy owner has the option to designate who will receive any policy proceeds at the time of the insured’s death (i.e., the beneficiary). The beneficiary designation is part of the entire contract. Later in this course, there will be a closer examination of the types of beneficiary designations and unique circumstances that can arise. Beneficiaries are not required to sign the application or be notified of their designation. The policy owner may change the beneficiary at any time as long as the beneficiary is not irrevocable.

SETTLEMENT OPTIONS PROVISION

The settlement options provision outlines the various ways that the policy’s death benefit may be paid to the beneficiary, as well as who has the authority to decide how the funds will be distributed.

All life insurance policies include a variety of settlement options that are available to a beneficiary when an insured dies. The settlement options provide the beneficiary with more flexibility with which to receive proceeds. The principal method used to pay death proceeds is a lump-sum. In this manner, the beneficiary receives policy proceeds income tax-free in one payment.

Following the death of the insured, if any settlement option other than the lump-sum option is used, the proceeds will remain with the insurer to be paid out in installments. The insurance company must pay interest on the proceeds that remain with them. The interest that’s credited to or paid to the beneficiary is taxable as ordinary income.

The various settlement options available and when they may be used will be examined later in the course.

The spendthrift clause stipulates that the policy owner may select a settlement option at the time of application. However, in most cases, the settlement selection is made by the beneficiary following the insured’s death.

WITHDRAWAL PROVISION

The withdrawal provision is often used when the policy proceeds are held by the insurer and earn interest. This provision outlines the any steps and requirements for withdrawing any funds left on deposit with the insurer. The beneficiary may have the option to withdraw all of the funds or only a limited amount each year.

ACCELERATED (DEATH) BENEFITS PROVISION (RIDER)

The accelerated benefits provision allows an insured to “accelerate” the death benefit of a life insurance policy while still living as long as a physician diagnoses and verifies that the insured is suffering from a terminal illness and is likely to die within 12 to 24 months or less. The accelerated benefits provision is typically added to a policy through an accelerated benefits rider or terminal illness rider. Specific conditions for payment must be satisfied in order for a benefit to be paid. The insured may receive up to a specific percentage (which varies by company) of the death benefit. Any amount that’s paid out under the accelerated benefits provisions will be subtracted from the face value at the time of the insured’s death. This is referred to as the effect on the death benefit.

For example, a $100,000 policy that provides for a 75% accelerated benefit will pay up to $75,000 to the terminally ill insured. The remaining $25,000 is payable as a death benefit to the beneficiary when the insured dies.

Accelerated payment can be made in a lump-sum or through monthly installments over a particular period (e.g., one year), and are received tax-free as long as the insured is terminally ill.

This provision or rider is typically given without an increase in premium. However, companies may deduct an interest charge from the proceeds that are paid out to make up for what the company would have made had the funds not been withdrawn.

Disclosures

When applying for a policy that includes an accelerated benefits provision, the customer must receive a summary of coverage which includes a brief summary of the accelerated benefit, the conditions or occurrences that trigger payment of the benefit, and an explanation of the effect exercising payment under the provisions may have on the cash value, accumulation account, death benefit, premium payments, and policy loans.

If the accelerated benefit option is exercised, the insurer must provide the policy holder and any irrevocable beneficiary with an illustration that:

▪ Demonstrates any effect the payment of the benefit will have on the cash value, accumulation account, death benefit, premium payments, policy loans

▪ Includes a statement that receipt of accelerated benefit payments may adversely affect the recipient’s eligibility for Medicaid or other government benefits or entitlements

▪ Includes a statement that benefits may be taxable, and

▪ Includes a statement that assistance should be sought from a personal tax advisor

Variations

Another type of accelerated benefit is the catastrophic, chronic, or critical illness coverage rider (i.e., dread disease coverage). The terms of this coverage are similar to the terminal illness rider except that the covered disease must be identified or listed in the policy (e.g., cancer, heart disease, renal failure, stroke, cancer, AIDS, etc.).

Additionally, the rider may provide benefits for those who are unable to perform at least two activities of daily living (e.g., eating, bathing, toileting, dressing, transferring, and continence).

Long-Term Care Rider

Some accelerated benefits are available by adding a long-term care rider to a life insurance policy. If an insured is permanently confined to a nursing home and requires long term care, the policy rider will pay a benefit. A long-term care rider can help safeguard against the financial burden of long-term care. These riders may be added to individual or group policies. For the insured to qualify for an accelerated benefit under a long-term care rider, the (long-term) confinement must be covered by the rider, or additional requirements must be satisfied.

The long-term care rider, similar to an individual long-term care policy, will generally pay benefits when the insured is unable to perform at least two activities of daily living (ADLs). Activities of daily living include eating, dressing, bathing, toileting/continence, walking/ambulation, transferring, or taking medication. As with the accelerated benefits rider, the long-term care benefits that are received will typically be paid out income tax-free.

There are two different ways that a long-term care rider may be designed. When designed using the generalized or independent approach, the long-term care rider is recognized as independent from the base life insurance policy. As such, the base policy’s face amount or cash value is not impacted by any benefits that are paid out. When designed using the integrated approach, the base policy’s death benefit and/or cash value amounts will be reduced by any long-term care benefits that are paid out.

For example, if the life insurance policy has a death benefit of $100,000 and the long-term care rider pays out $20,000 before the death of the insured, the final death benefit paid will be $80,000.

OPTIONS RELATED TO POLICY DIVIDENDS

POLICY DIVIDENDS

As described previously, mutual insurers issue participating or par insurance policies and, as such, provide their policy owners with the opportunity to receive dividends. Although stock companies typically only issue non-participating or non-par policies, in rare cases, they may also issue participating policies, which include the potential for policy owner dividends. A stock insurance company that offers both par and non-par policies is operating on a mixed plan. Mutual companies can issue only participating policies.

An insurance dividend is not considered taxable income since it’s actually a return of an overpayment of premium. Therefore, insurance dividends are tax-exempt. During the sale of insurance, producers cannot inform an applicant that dividends are guaranteed. In fact, most states require a policy that provides a choice of dividend options to include a statement that dividends are not guaranteed. A producer is allowed to provide illustrations or documentation to an applicant that verifies the payment of dividends in previous years by the insurer.

The source of funds from which policy dividends are paid includes mortality, interest, and expenses. At the end of each year, the insurance company will review the money it received (premium payments), the gain (interest) generated by that money, the annual operating costs (loading expenses), and the claim expenses paid out (mortality). The mutual insurer that experiences excess surplus after paying claims and other operating expenses pays dividends to its policy holders.

Dividends typically become payable after the first or second policy year and are generally paid on policy anniversary dates. The policy holder may inform the insurer as to what dividend option she selects. This option will remain the same until the policy holder requests another option.

DIVIDEND OPTIONS

If a policy owner is entitled to a dividend, she can choose how to receive it in any of the five ways identified below. An easy way to remember these options is by using the acronym CRAPO.

1. Cash: If the policy owner is entitled to a $50 dividend, she may request for the insurer to send payment directly to her. Again, insurance dividends that are received are tax-exempt.

2. Reduced, Reduction, or Suspension of Premiums: If the policy owner’s annual premium is $250 and he discovers that he’s entitled to a $50 dividend, he may choose to direct the insurer to retain the dividend and subtract that amount from the upcoming premium. The policy owner then pays $200 for the year’s premium. This dividend option assists the policy owner whose primary objective is to conserve cash since the policy owner is not required to remit the entire annual premium. The premium reduction option is the dividend option that’s utilized by the policy owner when the policy owner wants to minimize his current outlay of funds.

3. Accumulate At Interest: Under this option, the policy owner directs the insurer to retain the $50 dividend in a designated account. When this occurs, the insurer must pay interest on the dividend(s) it holds. Although the dividend is tax-exempt (not taxable), any interest earned on dividends that are left with the insurer is taxable as ordinary income in the year in which the interest is credited, regardless of whether the policy owner actually receives it. As related to life insurance, if death occurs, the face amount is paid plus any dividend accumulations. In the event of a policy surrender, the cash value and dividend accumulations will be paid to the policy owner.

Although it’s not common, a policy dividend may be utilized to pay up a policy earlier than expected by suspending or terminating premium payments. If the situation arises in which the policy’s cash surrender value plus dividends payable or accumulated (if previously left with the insurance company) equals or exceeds what the single premium at the attained age of the insured would be for a coverage amount that’s equal to the current face amount of the policy, the policy will be “paid-up” for life.

[EXAM TIP: Don’t confuse paying a policy up using dividends with the reduced paid-up non-forfeiture option. Using dividends, the policy (including the original face value) remains fully intact. With a reduced paid-up option, the face value is REDUCED to the amount that the policy’s present cash value could afford if it’s used to purchase a single-premium policy.]

4. Paid-Up Permanent Additions: Often referred to simply as paid-up additions (PUA), the policy owner may elect to use the $50 dividend to purchase additional permanent whole life insurance. The amount that can be purchased will be based on two criteria:

• The current age of the insured, and

• The amount of the dividend

The insured is not required to prove insurability. Since there’s no investigation conducted to determine the insured’s health and there’s no agent to whom commissions are paid, the operating expenses or load charge that’s associated with issuing paid-up additions is substantially lower than that which is associated with issuing other insurance coverages. The dividend amount is the premium that will be used to purchase a small amount of permanent paid-up life insurance. In other words, the dividend is being spent on purchasing a small face amount of single premium life insurance. This paid-up addition has its own cash value. Therefore, this option provides for an increase in cash value for the policy owner. If this option is used, it increases the total death coverage to its greatest amount possible.

5. One-Year Term Insurance: The $50 dividend can be used to simply purchase any type of term insurance that the insurer offers. The one-year term option is the dividend option that provides the policy owner with a different type of life insurance (i.e., term life insurance) than that which is provided by the primary policy (i.e., whole life) paying the dividend.

This option may be used to purchase as much term insurance as possible up to the base policy’s cash value. Any excess dividend portions may be applied to any of the other dividend options. It may also be used to provide a face amount of life insurance that’s equal to the amount of a policy loan taken against the cash value of the whole life policy.

For example, the policy owner who has an outstanding loan can use this option to buy more life insurance just in case the insured dies before the loan is repaid.

The one-year term insurance dividend option requires a specific application and the issuance of a separate rider. If this option had been selected since the policy’s inception, proof of insurability is typically not required. However, if the policy has been in force for several years with a different dividend option, the insurer may require evidence of insurability.

LIFE INSURANCE POLICY RIDERS

One of the unique features of a life insurance contract is the ability for the policy owner (typically the applicant and insured) to customize the policy to meet his specific needs through policy add-ons (also referred to as riders or endorsements). Riders are special policy provisions that provide benefits that are not found in the original contract, or that make adjustments to the policy.

Since many of these riders provide an additional benefit for the policy owner, their inclusion will typically result in an increase in the cost of the policy (i.e., an added premium).

Policy options and riders are a similar concept to customizing a new vehicle, such as adding leather seats, a sunroof, or even an extended warranty. All of these customizations cost additional money.

Riders are generally added at the time of application; however, in some circumstances, the policy owner may add a rider after the policy is issued. If the policy owner allows their policy to lapse, any additional riders that have been added to the policy will cease, even if the lapsed policy is automatically converted to another type of coverage as provided in the original policy.

WAIVER OF PREMIUM RIDER

When added to an insurance policy, the waiver of premium rider prevents the policy from lapsing if the insured becomes totally disabled. If an insured becomes totally disabled for six consecutive months, the insurer promises to waive any future premium payments until she returns to work. When this rider is in use, the insurer is technically making the premium payments for the insured. Therefore, in a whole life policy, the cash value accumulates as it normally would, and the policy owner can still borrow against the cash value. Also, if the policy is participating, the policy owner will continue to receive any owed dividend payments while the premiums are being waived. The policy owner resumes premium payments if the insured recovers and can return to work. However, the premiums that were paid by the insurer are NOT required to be repaid.

This rider is not automatically included in a life insurance policy and, although it requires an extra premium, it’s actually quite inexpensive. This is considered an additional rider that must be requested by the applicant. This rider may be added to both term and permanent life insurance. Adding the waiver of premium rider to a policy requires an additional charge added to the policy’s premium since the rider provides additional protection to the policy owner and additional risk to the insurance company.

The additional fee required for this rider only covers the protection that’s provided by the rider; it doesn’t have any impact on the cost of insurance or cash values. The rider typically “falls off” once the insured reaches a specified age—which most often ranges from age 60 to 65. Once the rider falls off, the premiums for the policy will be reduced by the additional amount that was required for the rider.

If the insured becomes disabled after the rider falls off, the premiums will not be waived since the coverage is no longer in force. However, the premiums will continue to be waived beyond the limiting age as long as the disability occurred prior to the rider falling off the policy. This benefit applies even if the waiting period (generally six months after the disability occurs) extends past the cutoff age (age 60 to 65).

In addition to making the full premium payments during the waiting period, for the premiums to be waived under this rider, the insured typically must be under the care of a physician and be totally disabled as defined by the policy. Some insurers may also describe the disability requirement as “total and permanent.” Note, there’s not a universal definition of totally and permanently disabled. Depending on the policy, totally disabled may mean that the insured is not able to perform her normal job (own occupation) or is unable to engage in any gainful employment (any occupation). Some policies will even use a combination which applies the “own occupation” definition for a specific period (e.g., the first two years of the disability) and then applying the broader “any occupation” definition if the insured is still disabled. The insured doesn’t need to be hospitalized or collecting Social Security benefits to receive the waiver of premium benefits.

Any premiums that are paid within the initial six months of the disability will be refunded to the policy owner from the first day of disability. The waiver of premium rider waives the required premium payments to keep the policy in force; however, it doesn’t provide any income or modify the coverage provided under the policy in any way. This rider typically excludes disabilities which are the result of acts of war, self-inflicted injuries, or injuries sustained while committing a crime.

WAIVER OF COST OF INSURANCE RIDER

The waiver of cost of insurance rider—also referred to as the waiver of monthly deductions—is typically reserved for universal life policies. Premiums for a universal life policy can fluctuate. For this reason, insurers generally only offer to waive the monthly cost of the insurance, not the total premium that was being paid by the insured. In this case, the cash value will remain level and continue to collect interest, but it will not grow to the extent that it would have had the full premiums been paid.

In some cases, a company may write the rider to waive the guaranteed minimum annual premium instead of the monthly cost of insurance. In this case, the policy’s cash value will grow by the amount of the additional premium payment minus the actual cost of insurance. The cash value will also continue to collect interest.

DISABILITY INCOME BENEFIT RIDER

The disability income benefit rider provides an income benefit if the insured is totally and permanently disabled as defined by the policy. Most disability income benefit riders provide for a small, stated benefit, such as 1% of the face amount of the policy, that is payable if the insured is totally disabled. The monthly income paid is generally limited to no more than $1,000 per month. Income benefits begin after the six-month waiting period as previously described.

For example, if Jim owns a $20,000 life insurance policy with this rider included and becomes totally disabled, he will be paid $200 per month (1% of $20,000).

As a whole, the disability income benefit rider contains the same type of qualifications and structure as the waiver of premium rider. In fact, most disability income benefit riders waive the premium in addition to including a disability income benefit.

In the event of an insured’s total and permanent disability:

▪ The waiver of premium rider states that the company will pay the premiums. Therefore, the amount paid depends on the amount of the policy’s premium.

▪ The disability income rider states that the company will pay the insured policy owner a monthly income. Therefore, the amount paid is based on the face amount of the policy.

ACCIDENTAL DEATH BENEFIT (ADB) RIDER (DOUBLE INDEMNITY)

This type of rider may also be attached to a life insurance policy for an additional premium. This benefit provides a multiple indemnity and an additional death benefit if the cause of death on a death certificate is listed as “accidental.” Policies that pay a multiple of two times the policy face amount are referred to as double indemnity, while those that pay three times the death benefit for death due to accidents are referred to as triple indemnity, and so forth.

This rider often includes a restriction that the insured must die within 90 days of the accident in order for the additional death benefit to be paid. Therefore, the rider typically doesn’t provide any coverage if the insured dies more than 90 days after the accident. Statistically, in such cases, the cause of death is not accidental, but more likely due to heart failure, kidney or liver failure, pneumonia, or some other type of “non-accidental” cause.

Remember, the cause of death that appears on the death certificate will indicate whether the insurer pays the claim.

For example, if the insured suffers a fatal heart attack or stroke while driving a car and the car crashes into a tree, the policy will not pay the rider benefit.

Additionally, the definition of “accidental death” doesn’t include accidents resulting, directly or indirectly, from an ailment or physical disability relating to the insured. Accidental deaths resulting from self-inflicted injury, war, riot, insurrection, or private aviation activities are also excluded.

This rider provides the least expensive form of life insurance available today. The primary reason that accidental death insurance is cheaper than other life insurance is that it’s limited in scope since it only covers death due to an accident and stipulates that death must occur within 90 days of the accident. Therefore, under this rider, coverage is less expensive than whole life insurance or any type of individual term life insurance, regardless of whether it’s characterized by a level or decreasing face amount.

An accidental death rider provides an additional death benefit for a limited period of time at the lowest possible cost. Typically, the insured must be under the age of 55 or 60 to add the rider, and the extra protection generally expires after the insured reaches the age of 60 or 65. As with the other riders that have age limits, the premium for this benefit is not payable beyond the date on which the additional benefit expires. The benefit also drops off if the policy owner surrenders the policy and selects one of the non-forfeiture options.

The addition of an accidental death benefit rider to a whole life policy doesn’t impact the policy’s cash value. Any policy loans are subtracted from the policy’s face amount and not from the accidental death riders. Additionally, the benefit doesn’t apply to paid up additions or extended term that is purchased with policy dividends.

ACCIDENTAL DEATH AND DISMEMBERMENT (AD&D) RIDER

Some accidental death benefit riders may include dismemberment benefits as well. The death benefit that’s paid under accidental death coverage is referred to as the principal sum. The severance (dismemberment) benefit that’s paid under accidental dismemberment is referred to as the capital sum and is most often one-half of the principal sum.

A dismemberment involves the loss of a limb as a result of an accident. The loss of use of a limb (i.e., paralysis) may also qualify as a dismemberment loss under some policies. However, the loss of a toe or finger doesn’t qualify. Most policies also pay dismemberment benefits for presumptive types of disability, such as the loss of sight or hearing. The principal sum may be paid when an insured loses any combination of limbs, such as a hand and a foot, an arm and a foot, or both eyes.

For example, if an accidental death benefit of $20,000 was purchased and the insured suffers a loss of hearing, the policy will pay (a capital) sum of $10,000 (i.e., 50% of the principal sum).

GUARANTEED INSURABILITY OPTION

This rider allows a policy owner to purchase additional life insurance coverage at specified dates without providing evidence of insurability (i.e., no medical exam required). Since this rider provides specific dates on which additional life insurance policies can be bought, the policy owner can only transact purchases using this option on these days, or within a short window (generally 90 days). Typically, the older the insured gets, the fewer dates the policy owner has to purchase more life insurance. The rider may also allow the policy owner to purchase additional coverage at various milestones (e.g., marriage or the birth of a child). For the birth of a child, it’s often referred to as the stork provision.

The option amount is the maximum life insurance that a policy owner can buy on the specified date (option date). The policy owner can buy the option amount or less on the option date, or none at all. However, the option amounts cannot be added from one option to another if the earlier option date was not exercised. Premium costs for new coverages being purchased under this rider are calculated using the standard premium rates for the insured’s attained age.

Although the concept is the same from company to company, the official name may vary. Other names used to refer to the same type of rider include the insurance protection rider (IPR) or future increase option (FIO).

COST OF LIVING (ADJUSTMENT) RIDER

This rider automatically increases the face amount of the policy at specified intervals based on increases in the Consumer Price Index (CPI). The CPI measures the inflation rate each year. For example, if there’s a 2% rise in this index, the policy owner’s face amount will increase by 2% for the next year. However, a decrease in the index will not result in the lowering of the policy’s death benefit.

The cost of living (COL) rider or cost of living adjustment (COLA) rider can provide increases in the amount of insurance protection without requiring the insured to provide evidence of insurability. Of course, an increase in the death benefit will mean that there’s an increase in premiums. Additionally, a policy owner is not required to add the increased benefit; instead, she may simply request to keep the existing premium and benefit amounts.

These riders can take many different forms depending on the type of policy to which it’s attached. With adjustable life policies, the COL is more of an agreement than a rider. The policy owner already has limited freedom to change the policy’s face value amount. A COL agreement simply waives the need for the insured to prove insurability if the face amount increase is intended to match the increases in the CPI. With whole and term life insurance, a COL typically takes the form of an increasing term rider that’s attached to the base policy. Since universal life insurance policies already have such a high degree of flexibility, the addition of a COL is not sensible.

PAYOR RIDER

The payor rider—also referred to as the payor benefit provision or payor clause—is only added to a policy that an adult purchases to cover the life of a child or juvenile. This rider provides that premiums will be waived until the child reaches age 21 (some policies use the age of 18 or 25) if the premium payor (i.e., parent or guardian) dies or becomes totally disabled. The rider solely covers the premium payments for the policy; it doesn’t provide any income or death benefit to the child.

[EXAM TIP: Don’t confuse the payor rider with the guaranteed insurability rider. The guaranteed insurability rider may be added to a policy that covers an adult or child and allows the insured to buy more insurance without a medical exam. The payor rider waives premiums or the cost of a policy that covers a child.]

EXCHANGE PRIVILEGE RIDER (SUBSTITUTE OR CHANGE OF INSURED RIDER)

The exchange privilege rider—also referred to as the substitute or change of insured rider—outlines the conditions and processes for changing the insured of an insurance policy. This rider is typically limited to a business policy that covers a key employee or executive. The goal is to simplify updating the insurance policy when such an insured is no longer employed with the business. Although the exchange privilege rider allows for the policy to continue with the same face amount, the premiums are recalculated based on the new insured’s age, sex, insurability, etc.

TERM INSURANCE RIDERS

Many people like the peace of mind that comes with permanent insurance policies and the large, inexpensive face values that are typically associated with term insurance. Term insurance riders were created to give insureds an inexpensive option to add additional temporary coverage to a permanent policy. These riders allow for an additional death benefit (above the permanent face value) if the insured dies during a specified term. Although there’s an additional expense for the extra protection, it’s nominal compared to the cost for the permanent protection and less than if the insured were to take out a separate term policy.

Additionally, if the insured is still alive at the end of the term, the rider will fall off the policy (i.e., the extra coverage terminates) and the cost associated with the rider will fall off of future premium costs. However, the premium and face value that are associated with the permanent protection for which the rider was attached will remain intact.

This additional insurance doesn’t have any impact on cash values or dividends and is typically dropped if the insured exercises a non-forfeiture option or allows the policy to lapse. In addition to only being attached to a permanent policy (a term rider cannot be added to a term policy), the coverage period for a term rider cannot extend past the premium paying period for the permanent policy to which it’s attached.

For example, if a 35-year-old individual is applying for a 20-pay whole life policy, he could also add a $100,000 10-year or even 20-year term rider for a small additional fee. However, he cannot add a 30-year term rider because the policy to which he’s attaching it will be paid-up in 20 years.

As with a standard term life insurance contract, term riders are a common way for an insured to have excess coverage during a specific phase of life (e.g., while raising children). There are many different term riders from which a policy owner may choose, most of which resemble the term life policies described earlier.

Level Term Rider

A level term rider adds an additional fixed, level death benefit for a predetermined period at a predetermined cost to the existing face value of a permanent policy.

For example, an individual has been issued a $50,000 whole life insurance policy with a $100,000 10-year term rider. If she dies in five years (or at any point in the next 10 years), her beneficiary will receive $150,000 ($50,000 for the whole life + $100,000 for the term rider). If the individual dies in 15 years (or at any point after the 10-year term), her beneficiary will only receive the $50,000 face value of the whole life insurance.

Decreasing Term Rider

A decreasing term rider adds an additional decreasing death benefit to the existing face value of a permanent policy for a predetermined period and at a predetermined cost. The cost of a decreasing term rider is lower than the cost of a level term rider because the benefit amount decreases each year. To discourage policy owners from canceling the rider later in the term (when the benefit is scheduled to decrease to a low amount), some insurers may design the premium schedule to end earlier than the protection period. Other insurers may design the benefit to only decrease for a portion of the protection period.

For example, Mary wants to add a 20-year decreasing term policy to her whole life insurance to cover the $100,000 balance of her mortgage. The insurance company may design the rider to start with a face value of $100,000 and decrease by $5,000 per year for a fixed additional premium of $20/month, which is in addition to the premium for the permanent whole life policy.

However, to discourage Mary from canceling the rider as the coverage decreases, the insurer may design the premiums so that they’re complete after 15 of the 20 years. Or the insurer may design the policy so that the face value stops decreasing after 15 years and remains at a fixed $25,000 for the final five years.

Increasing Term Rider

An increasing term rider will allow for an increasing amount of coverage each year. Increasing term riders provide an additional term insurance face amount at death that’s equal to either all premiums paid or the amount of cash value. Increasing term riders may also be referred to as increasing benefit riders and they always increase the cost of the insurance policy.

Return of Premium Rider

The return of premium rider is a type of increasing term insurance that’s added to a whole life policy. When the insured dies, the beneficiary receives the face amount plus an additional (term insurance) death benefit that’s equal to the cumulative total of all premiums paid during the life of the policy. Therefore, under this rider, the amount of coverage increases each year based on the cumulative total of all premiums paid. The policy owner is simply purchasing term insurance that increases as the total amount of premiums paid increases.

Insurers may also offer a return of premium (ROP) term life insurance policy, which returns 100% of the premiums paid over the life of the policy to the policy owner if the insured is still alive at the end of the policy term. Any return of premium is received tax-free. Some policies may allow for premiums to be returned on a sliding scale if the return of premium term life policy is surrendered. If the insured dies during the term, the beneficiary will receive the policy’s face value only, without any premium return.

For example, at the age of 70, an insurer may return all premiums paid over the life of the policy back to a living insured if he carries such a rider.

Return of Cash Value Rider

The return of cash value rider is another type of increasing term rider that provides an increasing amount of term insurance that equals the cash value as it accumulates in a whole life policy. This rider allows the cash value to be paid in addition to the face amount. Again, the rider provides an additional term insurance benefit that’s equal to the cash value amount at the time of death.

RIDERS COVERING ADDITIONAL INSUREDS

At this point, the riders described are added to the insured’s policy and provide the insured (or policy owner) with additional benefits. Riders may also be added to a life insurance policy that provides term insurance coverage for a spouse, children, or entire family. The actual name of the rider may or may not include the word “term.” Whenever the insured adds a rider to their individual policy that covers the life of another person, the insurance provided by the rider will always be term insurance..

As a whole, these riders are referred to as other insured or dependent (term) riders.

▪ The family (term) rider – When added to an insured’s individual policy, this rider covers the rest of the family, but not the primary insured who’s protected by the individual policy.

▪ The spousal (term) rider – This rider may be added to a primary policy to cover a spouse.

▪ The child or children’s (term) rider – This rider may be added to an insured’s policy to cover children or adopted children.

For example, a potential client of an agent or producer wants to purchase a life insurance policy covering her life, but also wants to cover her husband by adding a rider to her policy if he dies in an accident. To meet her policy needs, what type of rider should be suggested? The reference “if he dies in an accident” gives the impression that the accidental death rider should be added to the policy to satisfy this need. However, this is a dependent rider that would be added to cover the spouse. The accidental death rider is added to the primary insured’s policy to cover the primary insured; it doesn’t cover her spouse.

LIFE INSURANCE POLICY EXCLUSIONS

Insurance policies may contain an exclusion provision which provides the insurer with the right to deny a death claim if death is caused by any of the listed exclusions. Exclusions may be listed in the policy itself or attached as riders and referred to as optional provisions or clauses. Today, many exclusions (with the exception of suicide) are being replaced with additional premium requirements (also referred to as a rate-up). Listed below are the most common types of exclusions.

WAR (MILITARY SERVICE)

The war or military service exclusion prevents an insurer’s financial catastrophe and typically applies to declared and undeclared wars. Most life insurance policies will contain one of two common war exclusions clauses. The status war clause is a restrictive type of clause which states that the insured will not possess coverage under an individual life insurance policy while he’s in the military even if he’s killed while away on furlough. The results clause states that an individual policy doesn’t provide coverage if the insured dies while participating in military activities or during military maneuvers of some sort. If the insured was killed while on furlough, he would be covered under an individual policy

[EXAM TIP: It’s safe to assume that an exam question is referring to the “results clause” unless the exam question explicitly uses the “status war clause.”]

AVIATION

Although it was common years ago, current life insurance policies are unlikely to exclude death for passengers, crew members, or pilots aboard commercial aircraft. However, most life insurance policies will exclude deaths resulting from certain types of high-risk aviation activities.

For example, the activities of a stunt, test, or student pilot, a flight instructor, and aircraft used for agricultural purposes (i.e., crop dusting) are typically excluded.

COMMISSION OF A FELONY (ILLEGAL ACTIVITY)

Some insurance contracts exclude death or injury when it results from the insured committing a felony or doing something illegal. If included in the policy, the exclusion only applies to persons committing the crime since victims or innocent bystanders are always covered.

ILLEGAL OCCUPATION

The illegal occupation provision specifies that the insurer is not liable for losses which are attributed to the insured being connected with a felony or participating in any illegal occupation.

INTOXICANTS AND NARCOTICS

The insurer will typically deny a claim if the insured is intoxicated or under the influence of narcotics at the time of the loss.

SUICIDE

As previously described, all policies exclude the payment of the benefit if the insured commits suicide during the specified period. Again, in the case of suicide during that period, the beneficiary will only receive the premiums paid for the policy up to the time of death, minus any outstanding loans. The suicide exclusion is the only exclusion that “falls off” after a specified period. Any other policy exclusions remain for the life of the policy unless the policy is amended.

HAZARDOUS OCCUPATIONS, HOBBIES, OR AVOCATIONS

Insurers can choose to exclude coverage for deaths resulting from an individual’s dangerous occupation, hobbies, or avocations. In the past, excluding occupations (e.g., a high-rise window washer), hobbies (e.g., scuba diving), and avocations (e.g., a doctor who’s traveling to a third world country to provide care) was a common practice. However, today, most insurers forgo the exclusion and instead offer the coverage if an extra premium is collected (rate-up). If a specific cause of loss is excluded in the policy, it’s excluded forever. If a cause of loss is not excluded in the policy, the cause of loss is covered forever. Hazardous hobbies or occupations may result in the exclusion of certain causes of death by endorsement, resulting in a refund of premiums paid.

For example, let’s assume that Robert has been scuba diving for 10 years when he applies for life insurance. The insurance company may tell Robert that, due to the risky nature of scuba diving, death resulting from a scuba-related accident is excluded from his policy (i.e., it’s not covered). As such, his policy will contain a scuba diving exclusion form, which becomes part of his entire contract. While on vacation, Robert convinces Carol to go scuba diving. Carol obtained life insurance five years ago, but since she has never been scuba diving, the insurer did not include a scuba diving exclusion in her life insurance policy. Unfortunately, Robert and Carol suffer a tragic accident during their scuba excursion and, as a result, both die. Robert’s beneficiary will not receive his policy’s death benefit since scuba-related deaths were excluded. However, Carol’s beneficiary will receive her policy’s death benefit (minus any outstanding policy loans) because scuba-related deaths were not excluded. The insurer cannot change her policy and exclude Carol’s death after the fact (post-claim underwriting) since the exclusion form is not a part of the entire contract.

What if Robert failed to tell his insurer that he frequently scuba dives and, as such, the scuba exclusion form was not included in his entire contract? Would his death then be covered? In reality, it depends. If the policy was inside the contestable period, the insurer could do more research on Robert’s scuba diving history. After finding out that Robert was an avid scuba diver, the insurer may determine that had Robert been untruthful on the application and will exclude the loss. However, if the policy is not inside the contestable period, the incontestable clause forces the insurance company to cover the loss.

The change of occupation provision allows the insurer to reduce the maximum benefit payable under the policy if the insured switches to a more hazardous occupation or to reduce the premium rate charged if the insured changes to a less hazardous occupation.

CHAPTER SUMMARY – LIFE INSURANCE POLICY PROVISIONS, OPTIONS, AND RIDERS

Standard Life Insurance Provisions

Key points to remember from this chapter include:

▪ The entire contract clause or provision is found at the beginning of the policy.

▪ The privilege of change clause (or policy change provision) outlines the conditions under which the company will allow the policy owner to change the policy’s coverage.

▪ The insuring clause or agreement sets forth the company’s basic promise to pay benefits upon the insured’s death and specifies the amount and frequency of premium payments.

▪ The execution clause or provision specifies that, after a certain period has elapsed (typically two years from the issue date), the insurer no longer has the right to contest the validity of the insurance policy so long as the contract continues in force.

▪ The incontestable clause allows an insurer to contest a claim during the contestable period. However, statements related to age, sex, or gender can be contested at any time. The company reserves the right to adjust the premium if the age of the insured is misstated.

▪ Death caused by suicide is excluded during the initial period after the policy becomes effective.

▪ Owner’s Provision or Rights of Policy Ownership states that the policy owner possesses all of the rights contained in the policy. The primary rights of a policy owner include:

‒ The right to assign and change the policy’s beneficiaries

‒ The right to determine how proceeds will be paid (settlement options)

‒ The right to terminate the policy and select a non-forfeiture option

‒ The right to determine and change the premium payment schedule (not necessarily the amount of the premium, but whether the premium is paid monthly, quarterly, annually, etc.)

‒ The right to assign ownership of the policy to another person

‒ The right to decide what happens with dividends that are paid out from a participating policy

‒ The right to convert or renew a term policy if such option exists within the contract

▪ Absolute assignment of an insurance policy involves a complete transfer of the policy to another.

▪ Beneficiaries and assignees are entitled to the proceeds upon the death of the insured before any claims of the insured’s creditors.

▪ Irrevocable beneficiary means that the beneficiary cannot be changed.

▪ The two types of assignments are absolute and collateral.

▪ Mode of Premium states that premiums must be paid to an insurer or its representative in order for coverage to be provided and allows the policy owner to select the mode of premium.

▪ Free-look Provision allows the policy owner to return the policy for a full premium refund without providing the issuer with a reason.

▪ The grace period in a life insurance policy is meant to protect the policy owner against the unintentional lapse of the policy.

▪ The reinstatement period allows an insured to reinstate a lapsed insurance policy. Typically, this must be done within three years of the policy lapse. However, in some states, reinstatement may be allowed for as long as seven years. If the insurer doesn’t accept or reject the reinstatement within 45 days, coverage will be automatically reinstated as if it had never lapsed.

▪ Non-forfeiture options prevent the policy owner from forfeiting a policy’s cash value if he decides to terminate the policy. The three non-forfeiture options are:

1. Cash Surrender

2. Reduced Paid-Up Option

3. Extended Term Option

▪ The cost recovery rule states that, when a life policy is surrendered for its cash value, the cost basis (total premiums paid) is exempt from taxation.

▪ The extended term insurance option provides the insured with the most life insurance protection in the event of a voluntary policy surrender or non-payment of premium.

▪ The primary advantage of a policy loan is that it provides ready cash for the policy owner without needing to apply or qualify for the loan.

▪ The automatic premium loan provision allows the insurance company to automatically take a loan against the policy’s cash value to pay the premium due if the required premium is not paid by the end of the grace period.

▪ The spendthrift clause stipulates that a settlement option may be selected by the policy owner at the time of application. Additionally, it protects the monies, left on account with the insurer to the named beneficiary from creditors.

▪ The accelerated benefits provisions, also referred to as the living benefits or terminal illness rider, allows a policy owner to “accelerate” the death benefit of a life insurance policy if certain conditions are met.

▪ Catastrophic illness coverage covers only identified or listed diseases in the policy, such as cancer, heart disease, renal failure, stroke, etc.

▪ The long-term care rider will generally pay benefits when the insured cannot perform at least two activities of daily living (ADLs).

▪ Activities of daily living (ADLs) include:

‒ Eating

‒ Dressing

‒ Bathing

‒ Toileting/continence

‒ Walking/ambulation

‒ Transferring or

‒ Taking medication

▪ There are two different ways that a long-term care rider can be designed:

‒ Generalized or independent approach

‒ Integrated approach

▪ An insurance dividend is not considered taxable income.

▪ A policy that provides a choice of dividend options must include the statement that dividends are not guaranteed.

▪ Dividend options include:

‒ Cash

‒ Reduced, reduction, or suspension of premiums

‒ Paid-up permanent additions

‒ One-year term insurance

‒ Accumulate at interest

▪ One of the unique features of a life insurance contract is the ability for the applicant (typically the policy owner) to customize the policy to meet her specific needs through policy add-ons, which are referred to as riders.

▪ The waiver of cost of insurance rider, also referred to as the waiver of monthly deductions, is typically reserved for universal whole life policies.

▪ The disability income benefit rider provides an income benefit if the insured is totally and permanently disabled as defined by the policy.

▪ Policies that pay a multiple of two times the policy face amount are referred to as double indemnity, while those that pay three times the death benefit for death due to accidents are referred to as triple indemnity, and so forth.

▪ The death benefit that’s paid under accidental death coverage is referred to as the principal sum.

▪ The severance (dismemberment) benefit that’s paid under accidental dismemberment is referred to as the capital sum and is generally one-half of the principal sum.

▪ The guaranteed insurability option allows a policy owner to purchase additional life insurance coverage at specified dates without providing evidence of insurability.

▪ The payor rider—also referred to as the payor benefit provision or payor clause—is only added to a policy that an adult purchases to cover the life of a child.

▪ Term insurance riders were created to give an insured an inexpensive option to add additional temporary coverage to a permanent policy.

▪ A level term rider adds an additional fixed, level death benefit to the existing face value of a permanent policy for a predetermined period and at a predetermined cost.

▪ A decreasing term rider adds an additional decreasing death benefit to the existing face value of a permanent policy for a predetermined period and at a predetermined cost.

▪ An increasing term rider will allow for a greater amount of coverage each year. Increasing term riders provide an additional term insurance face amount at death that’s equal to either all of the premiums paid or the amount of cash value.

▪ The cost of living rider automatically increases the face amount of the policy at specified intervals based on increases in the Consumer Price Index (CPI).

▪ Additional insured riders can be added to a life insurance policy to provide term insurance coverage for a spouse, children, or an entire family.

▪ The exchange privilege rider—also referred to as the substitute or change of insured rider—outlines the conditions and processes for changing the insured of an insurance policy.

▪ The war exclusion prevents an insurer’s financial catastrophe and typically applies to declared and undeclared wars.

▪ The status war clause is a restrictive-type clause which states that the insured will not possess coverage under an individual life insurance policy while he’s in the military even if he’s killed while away on furlough.

▪ The results clause states that an individual policy doesn’t provide coverage if the insured dies while participating in military activities or during military maneuvers of some sort.

▪ Most life insurance policies will exclude deaths that result from certain types of high-risk aviation activities.

Chapter 6

KEYWORDS: LIFE INSURANCE PREMIUMS, PROCEEDS, AND BENEFICIARIES

Prior to reading the chapter, please review the following keywords. An understanding of their basic definitions will improve comprehension of the chapter content.

Accelerated Benefit (Option) Rider: This rider allows the insured to receive a portion of the death benefit prior to death if the insured has a terminal illness that’s certified by a physician and is expected to die within one to two years.

Beneficiary: This is the person (or entity) who’s designated in a life insurance policy to receive the death proceeds.

Cash Value: This is the equity or savings element of whole life insurance policies.

Class Designation: This is a beneficiary group designation (e.g., all of a person’s children), opposed to specifying one or more beneficiaries by name.

Common Disaster Provision: This is a provision of the Uniform Simultaneous Death Act, which ensures a policy owner that death benefits will be paid to the contingent beneficiary if both the insured and the primary beneficiary die within a short period of time of one another. It also states that the primary beneficiary must outlive the insured by a specified period in order to receive the proceeds.

Contingent (Secondary) Beneficiary: This is the beneficiary who’s second in line to receive death benefit proceeds if the primary beneficiary dies before the insured.

Earned Premium: This is the amount of premium that’s paid by the policy owner for policy coverage or insurance protection up to a specific point.

Expense Factor: Also referred to as the loading charge, this is a measure of what it costs an insurance company to continue to operate.

Excess Interest: In life insurance, this provision means that the cash value will increase faster than the guaranteed rate if the insurer earns a greater return than the guaranteed rate.

Fixed Amount Installment Option: This option pays a fixed death benefit in specified installment amounts until the principal and interest are exhausted.

Fixed/Level Premium: This is a concept which averages what the total single premium would be for a policy over periodic payments. More periodic payments = higher total premium.

Fixed Period or Period Certain Option: This payment option pays the death benefit proceeds in equal installments over a set number of years. The dollar amount of each installment is dependent on the total number of installments.

Graded Premium: This premium funding option is characterized by a lower premium in the early years of the contract, with premiums increasing annually for an introductory period. After the introductory period, the premium increases to an amount that’s higher than what the initial level premium would have been. Thereafter, it remains fixed or constant for the life of the policy.

Gross (Annual) Premium: An insurer’s gross premium consists of the net premium for insurance PLUS commissions, operating and miscellaneous expenses, and dividends.

Interest Factor: This is the calculation for determining the amount of interest an insurance company can expect to earn from investing insurance premiums.

Interest Only Option: This is a death settlement option in which the insurance company holds the death benefit for a period and pays only the interest that’s earned to the named beneficiary. A minimum rate of interest is guaranteed, and the interest must be paid at least annually.

Irrevocable Beneficiary: This is a beneficiary that cannot be changed by the policy owner without the written consent of the beneficiary.

Joint and Survivor Option: This is a settlement option which guarantees that benefits will be paid on a life-long basis to two or more people. This option may include a period certain, and the amount payable is based on the ages of the beneficiaries.

Life Income Option: This is a death benefit settlement option which provides the beneficiary with an income that she cannot outlive. Installment payments are guaranteed for as long as the recipient is alive. The amount of each installment is based on the recipient’s life expectancy and the amount of principal.

Life Settlement: This is an agreement in which a policy owner sells or transfers ownership in all or part of a life insurance policy to a third party for compensation that’s less than the expected death benefit of the policy.

Lump-Sum Option: This is a death settlement option in which the death benefit is paid in a single payment, minus any outstanding policy loan balances and overdue premiums. The lump-sum option is considered the automatic (or “default”) option for most life insurance contracts.

Modified Premium: This is a premium funding option which is characterized by an initial premium that’s lower than it should be during an introductory period (typically the first three to five years). After this period, the premium will increase to an amount that’s greater than what the initial level premium would have been and then remain level or constant for the life of the policy.

Morbidity Rate: This rate demonstrates the incidence and extent of disability that may be expected from a given group of people.

Mortality Rate: This rate is the measure of the number of deaths (in general or due to a specific cause) in some population, scaled to the size of that population, per unit time.

Net Payment Cost Index: This is a formula that’s used to determine the actual cost of a policy for a policy owner. It helps the consumer compare costs of death protection between policies that will be held for 10 to 20 years.

Net (Single) Premium: This is a premium calculation that’s used to calculate an insurer’s policy reserves factoring in interest and mortality.

Per Capita (By the Head): This form evenly distributes benefits among all named living beneficiaries (i.e., all living children).

Per Stirpes (By the Bloodline): This form evenly distributes benefits among an insured’s beneficiaries according to the family line, branch, or root (i.e., children and grandchildren).

Premium Mode: This is the frequency in which a policy owner elects to pay premiums.

Primary Beneficiary: This is the first beneficiary in line to receive benefit proceeds upon the death of an insured.

Policy Proceeds: This is the amount actually paid as a death, surrender, or maturity benefit. In the case of a death benefit, it includes the face value, plus any earned dividends, less any outstanding loans and interest. In the case of a surrender benefit, the amount includes any cash value, minus surrender charges, outstanding loans, and interest. In the case of maturity, the benefit amount includes the cash value, less any outstanding loans and interest.

Reserves: This is the money an insurer sets aside (as required by the state’s insurance laws) to pay future claims.

Revocable Beneficiary: This is a beneficiary that the policy owner may change at any time without notifying or getting permission from the beneficiary.

Settlement Options: These are optional modes of settlement that are provided by most life insurance policies. Options include lump-sum cash, interest only, fixed-period, fixed-amount, and life income.

Single Premium Funding: This is a policy funding option in which the policy owner pays a single premium that provides protection for life as a paid-up policy.

Spendthrift Clause: This clause prevents creditors from obtaining any portion of policy proceeds upon an insured’s death. Additionally, the clause can be selected by the policy owner to prevent a beneficiary from recklessly spending benefits by requiring the benefits to be paid in fixed amounts or installments over a certain period.

Surrender Cost Index: This is a cost comparison calculation formula which is used to determine the average cost-per-thousand for a policy that’s surrendered for its cash value. It aids in cost comparisons if the policy owner plans to surrender the policy for its cash value in 10 or 20 years.

Tertiary Beneficiary: This is the third beneficiary in line to receive death benefit proceeds. The tertiary beneficiary will only receive the death benefit if both the primary and contingent beneficiaries die before the insured.

Underwriting Department: This is the department within an insurance company that’s responsible for reviewing applications, approving or declining applications, and assigning risk classifications.

Unearned Premium: This includes the premium that has been paid by a policy owner for insurance coverage which has not yet been provided.

Uniform Simultaneous Death Act: This act states that if the insured and the primary beneficiary die in a common accident at approximately the same time, with no clear evidence as to who died first, the law will assume that the primary died first. Therefore, the death benefit proceeds are paid to the contingent beneficiaries.

Viatical Settlement: This settlement involves a person with a terminal illness selling his existing life insurance policy to a third party for a percentage of the death benefit.

Viatical (Viatee): This is the new third-party owner in a viatical settlement.

Viator: This is the original policy owner in a viatical settlement.

INTRODUCTION

When individuals buy life insurance, they’re trading their money (in the form of premium payment) for future financial security (typically in the form of a death benefit). Upon the insured’s death, policy proceeds (the death benefit) are payable to the beneficiary in any one of a variety of methods, depending on the unique situation and needs of the beneficiary. Additionally, many policies include living benefits to address an insured’s pre-death needs. This chapter will examine how premiums are determined and collected, how and to whom benefits are paid, and the various tax consequences that are related to life insurance premiums and benefits.

This chapter will introduce the primary factors in premium calculations, policy proceeds, settlement options, the tax treatment of proceeds, the types of beneficiary designations, and the distribution of death benefits.

The chapter is broken down into the following sections:

▪ Life Insurance Premiums

▪ Comparing Life Insurance Policy Costs

▪ Viatical Settlements

▪ Life Insurance Death Benefits

▪ Benefit Distributions

▪ Special Situations

▪ Tax Consequences of Life Insurance

The state-specific portion of this course (located at the end) will detail the specific insurance definitions, rules, regulations, and statutes for your state. In the event of a conflict, state law will supersede the general content.

Review of this chapter will enable a person to:

▪ Understand the purpose of premiums in life insurance policies

▪ Identify the different factors in premium calculations

▪ Distinguish between mortality factor and mortality rate

▪ Identify the different options that a policy owner has to pay for the insurance policy

▪ Distinguish between level, modified, flexible, and graded premium funding

▪ Distinguish between earned and unearned premium

▪ Understand the costs associated with life insurance contracts

▪ Understand death benefit settlement options and payment of claims

▪ List and distinguish between the different types of beneficiary designations

▪ Understand the different methods of benefit distribution

▪ Distinguish between the Uniform Simultaneous Death Act and the Common Disaster Provision

▪ Understand the tax consequences of life insurance

LIFE INSURANCE PREMIUMS

PURPOSE OF PREMIUMS

Once an insurance company determines that an applicant is insurable, it needs to establish the payment (premium) for the insurance policy. The premium is both an exchange for insurance protection and a portion of the policy owner’s consideration. The consideration is the “binding force” in the contract, which solidifies the agreement between the insurer and policy owner.

As previously described, the policy owner is expected to remit premiums by the due date. However, as with most bills, insurance companies allow for a grace period (a time after the due date) during which payment may be made without penalty. The effect of non-payment of premium before the expiration of a grace period will cause a policy lapse.

FACTORS IN PREMIUM CALCULATION

Life insurance premiums are calculated per $1,000 of coverage. There are three primary factors or elements that are utilized in determining what an insurer will charge for its life insurance product. The three factors that influence the gross premiums charged for life insurance are:

Mortality

Interest and

Expenses

Mortality Factor or Mortality Rate

The mortality factor has the greatest effect on premium calculations or rate-making since it can vary greatly based on the personal characteristics of an individual to be insured. The mortality factor is determined from a mortality table which provides an indication of the “probability of death” of an individual at a particular age. In other words, the mortality table provides the death rate (i.e., the average number of deaths that will occur each year in each age group). For a mortality table to be accurate, it must be based on a large cross-section of individuals and time. This mortality factor originates from the Commissioners Standard Ordinary (CSO) Mortality Table. Today, this is the generic table that’s used by most insurers; however, some insurance companies utilize mortality factors that are derived from their own experience (i.e., death claims paid).

The number of deaths in a group of people is typically expressed as deaths per thousand. Insurance companies use mortality tables to help predict the life expectancy and probability of death for a given group.

For example, when determining the premium amount per $1,000 of coverage for a standard risk 35-year-old male, the company will consult the mortality table to view the average number of deaths per thousand for standard risk 35-year-old males.

Interest/Investment Factor

Insurance companies invest the premiums they receive in an effort to earn interest. This interest is one of the ways an insurance company can lower the premium rates. Premium calculations are made with the expectation that the company will earn an assumed rate of interest. A higher assumed (predicted) rate will lead to lower premiums. However, the actual interest earned may be higher or lower than the assumed rate.

The interest factor is a reflection of an insurer’s return on its investments. An insurer invests the premiums it collects in multiple different investment vehicles. The wiser its investment decisions, the better return it will realize.

Expense Factor

The expense factor—also referred to as the loading charge or factor—is derived from operating expenses, or funds that the insurer “pays out.” These expenses include, but are not limited to, death benefits paid, commissions or salaries to producers and other employees, and other administrative costs (i.e., rent). As described previously, each state sets a minimum reserve (or funds) that the insurer must set aside to pay future claims. Additionally, companies need to build in profit, also referred to as surplus. If a company is not generating a profit, it will likely need to raise premiums; however, if a company is generating a profit, it will likely maintain premiums or possibly lower them.

Additional factors that may influence the premium cost include:

▪ Age of the Proposed Insured – The older the person, the higher probability of death and disability.

▪ Sex / Gender – Women tend to live longer than men; therefore, their premiums are typically lower.

▪ Health History of Proposed Insured – Poor health increases the probability of death and disability.

▪ Occupation – Having a hazardous job can increase the risk of loss.

▪ Personal Activities and Hobbies – High-risk activities or hobbies (e.g., parachuting) also increase the risk of loss.

▪ Personal Habits – Tobacco use, DWI, or DUI presents a higher risk.

▪ Travel Outside the United States – This travel can expose a proposed insured to additional risks and/or illnesses.

NET VERSUS GROSS PREMIUMS

The net (single) premium is a premium that makes provision for mortality cost (death benefit) and interest. The “net single premium” is influenced by the assumed interest rate, the proposed insured’s gender, the benefits to be provided, and the mortality rate (death benefit).

Net single premium = Mortality cost – Interest

The net level annual premium allows for a small adjustment to the interest rate to account for the fact that most people don’t pay the policy’s required premium in a single payment; instead, they typically pay over a period of years.

The gross premium is the premium charged by an insurer that is comprised of, or influenced by, the factors described previously of mortality, interest, and expenses. This represents the actual premium that’s paid by the policy owner for life insurance coverage.

Gross premium = Net premium + Insurer expenses.

The gross annual premium is the gross premium that’s adjusted for the fact that most people don’t pay the policy’s required premium in a single payment; instead, they typically pay over a period of years.

The mortality rate refers to the frequency of deaths, while the morbidity rate refers to the occurrence of diseases in a defined population at a specific time interval.

Higher morbidity and mortality rates equate to higher insurance premiums.

The term “premium mode” refers to the policy feature that permits the policy owner to select the timing of premium payments. Insurance policy rates are based on the assumption that the premium will be paid annually at the beginning of the policy year and that the company will have the premium to invest (interest factor) for a full year. If the policy owner chooses to pay the premium more than once per year (e.g., monthly, quarterly, semi-annually), there normally will be an additional charge because the company will incur additional charges in billing and collecting the premium payments. This may be referred to as the Mode of Premium provision. The effect of non-payment of premium before the expiration of a grace period will cause a policy lapse.

The higher the frequency of payments, the higher the premiums. This is because the interest earned to the insurer is decreased while the administrative costs are increased.

FUNDING INSURANCE PREMIUMS

Whole life policies may be purchased by paying a single premium or by paying periodically. With single premium funding, the policy owner pays a single premium that provides protection for the life of the policy. Single premium funding is generally associated with “single pay whole life insurance.” Since a single premium is generally too expensive for the average person, alternative periodic options were developed to be more cost-effective or affordable for the purchaser.

Fixed/level premium funding averages the “single premium” over the policy period. The policy owner pays more than the actual cost of insurance in the early years to help cover the cost of insurance in later years. This allows the premiums to remain level throughout the life of the policy.

Modified premium funding is characterized by an initial premium that’s lower than it should be during an introductory period. After this time, the premium will increase to an amount that’s greater than what the initial level premium would have been and then remain level or constant for the life of the policy. Some customers may find this advantageous as it allows them to purchase permanent insurance for a more manageable initial price with a higher percentage of the cost added to a later period when the policy owner’s income is expected to be higher.

Graded premium funding is a contract that’s characterized (like modified) by a lower premium in the early years of the contract. However, premiums increase annually for the initial period. Thereafter, it increases to an amount that’s higher than what the initial level premium would have been, and then remains level or constant for the life of the policy. The premiums for these policies are predetermined, but are not level in the traditional sense.

Flexible Premium Funding allows the policy owner to adjust the premiums throughout the life of the contract.

PAYING PREMIUMS FROM POLICY VALUES

Depending on the type of policy, a policy owner may be able to use the policy’s cash value and dividends to pay the premium. With dividends, a policy owner could choose to pay down premiums on the existing policy or buy additional coverage in the form of paid-up whole life additions or one-year term.

While using the policy (cash) value to pay premiums is an option, this funding method also decreases the value of the policy. The policy will lapse if the policy’s value becomes insufficient, and the policy owner fails to pay the required premium.

MINIMUM DEPOSIT (FINANCED) INSURANCE

Although it’s occasionally grouped with “types of whole life insurance,” minimum deposit or financed insurance is not an actual policy type. Minimum deposit financing is a method of financing life insurance that’s best suited for individuals who are in high marginal tax brackets. It allows the policy owner to use policy loans to pay premiums that are due each year.

For example, each year, the policy owner is allowed to borrow (subject to certain tax restrictions) that year’s cash value increase and use it to pay the premium.

The policy owner only pays the difference between the premium due and the amount borrowed (plus interest on the policy loan). For this payment method to work, the policy owner must make two to three initial premium payments to build up the cash value. Additionally, under IRS rules, at least four of the initial seven annual premiums must be paid from funds other than policy loans to avoid classification as an MEC.

PREMIUM COLLECTION AND RESERVES

Producers generally collect the initial premium from the applicant at the time of application. The insurer will bill all future premiums to the insured who will then remit the payments to the company. Policy owners who are unable to pay their premiums may potentially use a premium financing organization that will function similar to an entity that provides installment loans.

Earned versus Unearned Premium

Earned premium is the amount to which an insurer is entitled since it’s providing coverage for a specific period.

Unearned premium is an amount of premium for which the policy owner has made a payment to the insurance company, but coverage has not yet been provided. Unearned premium typically becomes earned premium as an insurance contract progresses, but represents the amount that an insurer will return to an insured if the policy is canceled.

For example, let’s assume that an individual’s insurance policy costs $120 per year, and she pays the full amount on January 1. On April 1, the insurance company only earned $30 ($120 ÷12 months x three months of coverage). If the individual cancels her policy with an effective cancellation date of 7/1, the insurance company owes her a refund of $60 for unearned premium ($10/month x six months remaining of the amount paid in advance).

The earned and unearned premiums make up the insurer’s total premium.

Reserves

As required by law, reserves (also referred to as unpaid claim reserves) are the funds that are set aside by an insurer to pay current and future claims. This is a fixed liability of an insurer and represents the amount that’s expected to be available to pay future benefits under a policy. An insurer’s reserve supports its promise to pay as identified in the policy’s insuring provision.

Each state has its own requirement with regard to the amount of funds that make up the reserve. Reserves also demonstrate the solvency of an insurer. The reserves are funded through future premium payments from policy owners and the interest (investment return) earned on those premiums.

A legal reserve is the amount of funds an insurance commissioner (or director/superintendent) requires an insurer to maintain based on the CSO mortality table and the assumed rate that’s designated by the state’s commissioner or state insurance law.

COMPARING LIFE INSURANCE POLICY COSTS

The cost of a policy may be defined as the difference between what a person pays and what the person receives back. If a person pays a premium for life insurance and receives nothing back, the cost for the death protection is the premium. If a person pays a premium and receives something in return (e.g., a dividend or cash value), the true cost is less than the premiums paid. Therefore, a lower premium doesn’t automatically mean a lower-cost policy. Cost comparative methods are designed to evaluate the true cost of a policy against this standard.

INTEREST ADJUSTED NET COST METHOD

Interest adjusted cost indexes are designed to provide information on the following four items:

1. Premiums

2. Death benefits

3. Cash value

4. Dividends

These are the variables that must be considered when evaluating cost, and they’re the basis for the life insurance policy cost comparison methods.

The index numbers are designed to give consumers a means of comparing the cost of policies of the same generic type. The indexes also factor the insured’s age and the amount of coverage desired. Each insurer and its producers must use the same computation formulas to determine the index numbers or the purpose would be defeated. Due to the increasing complexity of life insurance policy structures, premium payment methods, benefits, and dividend configurations, the average consumer would not be able to make cost comparisons without these index figures.

The NAIC Model Life Insurance Solicitation Regulation requires two interest-adjusted cost indexes for policy illustrations—a surrender cost index and a net payment cost index. These indexes show average annual costs and payments per $1,000 of insurance, while also recognizing that $1.00 payable today is worth more than $1.00 payable in the future (i.e., the time value of money).

LIFE INSURANCE SURRENDER COST INDEX

The surrender cost index uses a calculation formula in which the net cost is averaged over the number of years that the policy was in force to arrive at the average cost-per-thousand for a policy that’s surrendered for its cash value at the end of the period. The surrender cost index is important to the consumer who places a high priority on the growth of cash value in the policy. It aids in cost comparisons if the policy owner plans to surrender the policy for its cash value in 10 or 20 years.

NET PAYMENT COST INDEX

The net payment cost index uses a similar formula, but it doesn’t assume that the policy is surrendered at the end of the period. As such, the cash value element is omitted. The net payment cost index provides the policy owner with an estimate of her average annual premium outlay, adjusted for the time value of money.

The net payment cost index is useful if an insured’s primary concern is the amount of death benefit provided in the policy and is not as concerned with the build-up of cash value. It helps compare future costs, such as in 10 to 20 years, if the insured continues to pay premiums and doesn’t take the policy’s cash value.

COMPARATIVE INTEREST RATE METHOD

The comparative interest rate method determines the rate of return that’s required on an investment account to yield the same return as a life insurance policy that has cash value. This method may also be referred to as the “buy term and invest the rest” strategy.

The amount spent on the term insurance plus the hypothetical investment account must be the same as the required premiums for permanent insurance. The face value of the temporary and permanent insurance products being compared must also be the same.

For example, let’s assume that a 30-year-old man wants $150,000 in permanent insurance coverage. One insurance agent shows the man a $150,000 whole life insurance policy that requires annual premiums of $2,000 per year for 30 years. A second insurance agent shows the man a $150,000 decreasing term life insurance policy that costs $500 per year. The second agent further explains that the man could place the $1,500 premium difference in an investment account to grow. This second account can be used to offset the decreasing term policy or replace it entirely when it expires. This combination will essentially allow him to have permanent coverage.

The comparative interest rate is the rate of return required on the investment account, so that the value of the investment is equal to the surrender value of the higher premium policy at a specific point (i.e., 30 years or death). The higher the comparative interest rate (CIR), the less expensive the higher-premium permanent policy is compared to the alternative plan.

VIATICAL SETTLEMENTS

A viatical settlement allows a person with a chronic or terminal illness to sell his existing life insurance policy to a third party for a percentage of the face value. The new owner continues to make the premium payments and eventually collects the full death benefit when the original owner dies. The original policy owner is referred to as the viator, while the new third party owner is referred to as the viatical or the viatee.

Due to the nature of the contract, most states require a special license for viatical settlement providers and, at a minimum, require a viatical company to recommend that the client consult a tax adviser as the proceeds could be taxable in certain situations. Tax laws require viators to be chronically or terminally ill to receive payments from viatical settlements on a tax-free basis.

▪ Chronically ill – This is a person who needs considerable supervision due to cognitive impairment or is unable to perform at least two activities of daily living (eating, toileting, transferring, bathing, dressing, or continence).

▪ Terminally ill – This is a person who’s not expected to survive a medical condition for more than 24 months.

LIFE SETTLEMENT

In many states, viatical settlements are being replaced by life settlements. A life settlement is the sale of an existing life insurance policy to a third party for more than its cash surrender value, but less than its net death benefit. Unlike viatical settlements, life settlements don’t require the insured to be suffering from a chronic or terminal illness to sell and transfer the policy. With a life settlement, the policy owner may sell the policy to a life settlement firm for any reason. As with viatical settlements, a life settlement broker represents the policy owner and must hold an appropriate life settlement license. Disclosure requirements (e.g., right of rescission within 15 days) are also similar.

Life settlement contracts don’t include the following alternatives:

▪ An assignment of a policy as collateral for a loan

▪ The making of a policy loan, or the paying of surrender benefits or other benefits, by the issuer of a policy with respect to that policy

▪ A 1035 exchange of a life insurance policy as described by the Internal Revenue Code

▪ An agreement in which all of the parties are closely related to the insured by blood, law, or have a lawful substantial economic interest in the continued life, health, and bodily safety of the person insured, or are trusts that are established primarily for the benefit of such parties

▪ Legitimate corporate or pension benefit plans

LIFE INSURANCE DEATH BENEFITS

DEATH BENEFIT SETTLEMENT OPTIONS AND PAYMENT OF CLAIMS

Life insurance policies contain a provision that settlement shall be made on receipt of proof of death (death certificate). Most states require insurers to pay interest on any proceeds that are not paid within a specific period. Death benefits can be paid out in a variety of methods which are referred to as settlement options.

The policy owner may select a settlement option at the time of the application and may change the option at any time during the life of the insured. If the policy owner selects a settlement option, it cannot be changed by the beneficiary. However, in most cases, the settlement selection is made by the beneficiary at the time of the insured’s death.

Unless the policy owner specifies an irrevocable settlement option, the beneficiary always possesses the right to withdraw proceeds at any time in the future. Under any option selected in which the policy proceeds are left “at interest” with the insurer, the beneficiary is protected against the claims of creditors.

Death benefit settlement options include the following:

Lump-Sum (Cash Payment)

Under this option, the death benefit is paid in a single payment, minus any outstanding policy loan balances and overdue premiums. The lump-sum option is the most common option used and is considered the automatic (or “default”) option for most life insurance contracts. The lump-sum option is used when the policy owner wants funds to be paid in one single disbursement.

Interest Only

Under this option, the insurance company holds the death benefit for a period and pays only the interest that’s earned to the named beneficiary. A minimum rate of interest is guaranteed, and the interest must be paid at least annually. This option provides the beneficiary with flexibility since the proceeds may be left with the insurer, which eliminates her investment concerns while guaranteeing both principal and a minimum rate of return (i.e., interest).

As always, interest that’s paid by an insurer on policy proceeds is taxable. Again, even when the policy proceeds are left with the insurer and the beneficiary selects this option, she continues to possess the right to withdraw the proceeds in the future at her discretion unless the policy owner explicitly listed restrictions.

For example, if a policy owner selects the interest only settlement option, she could choose for the beneficiary to have the option to pull out 100% of the principal at any time or to be unable to withdraw any of the principal until after a preset age or number of years.

The next three settlement options available are simplified versions of an annuity.

Fixed Amount

The fixed amount installment option permits the death proceeds to be left “at interest” with the insurer and used to pay a fixed death benefit in specified installment amounts until the principal and interest are exhausted. The amount of monthly income selected by the beneficiary, the amount of proceeds, and the interest rate paid by the insurer will all determine the length of time during which the beneficiary receives the monthly income. The larger the installment payment, the shorter the payout period. Under this option, the amount of income is the primary consideration rather than the period over which the proceeds and interest are to be liquidated.

The fixed amount option allows the beneficiary to designate an amount of income to be replaced (e.g., $1,200 per month). These payments continue until the principal and interest are exhausted.

Fixed Period

When either the fixed period or period certain option is chosen, the death benefit proceeds are paid in equal installments over a set period of years. The fixed period option is one of the two options that’s based on the concept of systematically liquidating principal and interest over a period of years without references to life contingencies.

Under this option, the beneficiary leaves the death proceeds with the insurer. Interest is paid on the proceeds (i.e., principal) by the insurer. Monthly income is then paid to the beneficiary for a specified period as selected by the beneficiary (e.g., 10 years). Part of the installments that are paid to a beneficiary consists of interest which is calculated on the proceeds of the policy. This option provides for the payment of proceeds in installments over a definite number of years. The amount of each installment is determined by the amount of proceeds, the selected period (total number of installments), the guaranteed rate of interest, and the frequency of payments.

The fixed period option is valuable when the most crucial consideration is to provide income for a definite period (e.g., until all children graduate from high school).

The face amount and the length of time during which payments will be made are the primary factors that determine the monthly income amount that’s paid to the beneficiary.

Life Income

The life income settlement option liquidates policy proceeds (i.e., principal) and interest with regard to life contingencies. Installment payments are guaranteed for as long as the recipient lives. Therefore, the life income option provides the beneficiary with an income that she cannot outlive. The amount of each installment is based on the recipient’s life expectancy and the amount of principal. Using the recipient’s life expectancy gives the potential for a greater return, or the potential for greater loss, based on how long the insured lives. The life income option is used to ensure that the beneficiary receives a payment for as long as she’s alive.

There are several life income options available from which the beneficiary may select, including:

Single, Pure, or Straight Life Income Option

Under the single, pure or straight life income option (as with a straight life annuity), monthly installments are paid to the beneficiary for as long as she lives. In other words, income payments end upon the death of the recipient (i.e., the beneficiary). No refund or any other payments are made once the beneficiary dies. This option potentially provides the most significant amount of income per $1,000 of proceeds. However, it also possesses the most significant amount of risk since there’s no survivorship.

Refund Life Income Option

The refund life income option—also referred to as the joint life option—guarantees the return of an amount that’s equal to the principal less any payments which have already been made. In other words, it provides a minimum guaranteed return. Once the primary beneficiary dies, his survivors may receive the refund on an installment basis (referred to as the installment refund) or in a lump-sum (which is referred to as a cash refund).

Life Income Option with a Period Certain

The life income option with a period certain pays a monthly income for as long as the beneficiary lives. However, if the beneficiary dies before a predetermined number of years have elapsed, the insurer will continue monthly payments to a second beneficiary for the remainder of the designated period certain (e.g., 10 years).

For example, let’s assume that the settlement option is designated as life income with a 20-year period certain. If the primary beneficiary dies after 15 years, the insurer will continue monthly payments to the second beneficiary for the remaining five years.

Joint and Survivor Option

The joint and survivor option guarantees that benefits will be paid on a life-long basis to two or more people. This option may include a period certain with a reduction in benefits after the death of the first beneficiary. The amount payable is based on the ages of both beneficiaries.

BENEFICIARY QUALIFICATIONS

The beneficiary of a life insurance policy is the person or entity who’s been designated in the policy to receive the death proceeds. The owner of the policy is the ultimate decision-maker and is responsible for handling, naming, or changing a beneficiary. There are few restrictions on who may be named a beneficiary of a life insurance policy. However, in the underwriting process, the underwriter may consider the issue of insurable interest. When the policy owner (other than the insured) lists themselves as the beneficiary, they will require proof of insurable interest.

Although not a full list, examples of acceptable beneficiaries include:

▪ Individuals – a person who’s identified by name and relationship (e.g., spouse, daughter)

▪ Class designations – a group of individuals (e.g., children of the insured, all siblings)

▪ Businesses – businesses often hold life insurance policies on the owner or key personnel to help mitigate the expense involved in finding a replacement

▪ Charities – as a lump-sum donation or to create continued funding (e.g., a scholarship fund)

▪ Trust – provides management of the proceeds

▪ Estate – although a policy owner may choose to list an estate as a beneficiary, it’s typically not advisable

CHANGING A BENEFICIARY

If a policy owner wants to change the beneficiary, there are two standard methods:

1. Filing (recording) method and

2. Endorsement method

The filing method is the predominant method used and requires the policyholder to notify the insurer in writing of the desired change. The effective date of the change is the date of the request. Some insurers require a witness to sign the request.

When the endorsement method is utilized, the policy is returned to the insurer so that the new beneficiary designation can be added to the policy. The effective date of the change is the date that the new policy is printed.

A revocable beneficiary may be changed or removed by the policy owner at any time without notifying or obtaining the beneficiary’s permission.

An irrevocable beneficiary cannot be changed without the beneficiary’s written consent. The irrevocable beneficiary has a vested interest in the policy; therefore, the policy owner cannot exercise certain rights (e.g., assignment, policy loans, surrender, etc.) without the beneficiary’s consent. In addition, an irrevocable beneficiary has the right to receive a copy of the policy.

BENEFIT DISTRIBUTION

DISTRIBUTION BY DESCENT

Per Capita

Per capita (i.e., per person or per head) evenly distributes benefits among all named living beneficiaries; typically the surviving children.

Per Stirpes

Per stirpes (i.e., by the bloodline) makes distributions according to a family line, branch, or root (children and grandchildren). If a beneficiary dies before the insured and no changes are made to the policy, benefits from that policy will be paid to that deceased beneficiary’s heirs.

DISTRIBUTION BY ORDER OF SUCCESSION

Primary Beneficiary

The primary beneficiary is the first or principal person in line to receive the policy proceeds income tax-free. A policy owner may designate multiple primary beneficiaries and choose different or equal amounts for each beneficiary (e.g., 50% to a son, 25% to a grandson, and 25% to a granddaughter). If one of the primary beneficiaries dies prior to the insured, the face amount is paid to the surviving primary beneficiary(s). Unless specifically requested as part of the contract (per stirpes) or required by law, the estate or heirs of a deceased beneficiary will not receive any payment in this case.

Secondary or Contingent Beneficiary

The secondary or contingent beneficiary is the second individual(s) in line to receive the death benefit and will only receive the death benefit only if the (or all) primary beneficiary(s) has died prior to the insured. The primary beneficiary must predecease the insured in order for this secondary beneficiary to receive any proceeds.

Tertiary Beneficiary

A tertiary beneficiary is third in line to receive policy proceeds when the insured dies (assuming the insured outlived both the primary and contingent beneficiaries). Technically, the policy owner may continue the succession by listing a fourth in line, fifth in line, etc. In other words, there’s no limit as to the depth of the succession.

DISTRIBUTION TO AN ESTATE

It’s important for a policy owner to list all desired beneficiaries and keep the designations updated as needed. The policy proceeds will be paid to the estate of the insured if none of the listed beneficiaries are still alive at the time of the insured’s death. Benefits that are paid to an estate are subject to possible federal and state estate (death) taxes, as well as probate fees, prior to being passed on to any other person. Additionally, creditors may have a right to funds in an estate and, therefore, a right to the proceeds of a life insurance policy that’s paid to an estate.

For example, let’s assume that an individual purchases a $100,000 life insurance policy covering his life and he designates his spouse as the primary beneficiary. His only daughter is designated as the contingent beneficiary. However, the individual fails to designate any of his four sons as beneficiaries. If his spouse and daughter are killed in an auto accident and, five years later, the individual dies and had not made any alterations to the life insurance contract, the death benefit or policy proceeds will be paid to his estate, not to the sons.

DISTRIBUTION TO A MINOR

A life insurance company typically will NOT pay policy proceeds directly to a minor beneficiary. Although any entity can be named as a beneficiary, many states don’t permit proceeds to be paid to a minor since she lacks “legal capacity.” In addition to a minor potentially not being competent to handle a large sum of money, a minor may not be able to receive the payment and return a receipt legitimately. For these reasons, a guardian or trustee will typically need to be appointed. In some cases, the insurance company may hold the proceeds and pay interest on them until the beneficiary reaches legal age.

DISTRIBUTION TO A TRUST

Trusts may be named as the beneficiary of a life insurance policy and manage the proceeds upon the insured’s death. Naming a trust as beneficiary is the most advantageous designation to use if a policy owner wants to leave policy proceeds to a “minor” child. In this case, a trustee will manage the trust for the benefit of the child (or children). However, trust administration fees may reduce policy proceeds. Two forms of trust are testamentary and inter vivos trusts. A testamentary trust is created at the time of the insured’s death according to a will. An inter vivos (living) trust is created during the life of the insured.

FACILITY OF PAYMENT

The facility of payment provision permits an insurer to pay a portion (or all) of the policy proceeds to ANY individual who appears to be equitably entitled. Such payment may be provided to a party who paid for the medical or final expenses of the insured who has died. Typically, the facility of payment provision arises when a death claim is not filed within two months following the death of the insured. Additionally, this provision may be triggered to assist a guardian when a minor is listed as the beneficiary.

SPECIAL SITUATIONS

UNIFORM SIMULTANEOUS DEATH ACT AND COMMON DISASTER PROVISION

How a policy responds to common disaster deaths is governed by the Uniform Simultaneous Death Act. The act states that if the insured and primary beneficiary both die in a common disaster (e.g., a plane crash) and it cannot be determined who died first, the insured will be considered to have survived the primary beneficiary (or died last). In other words, the primary beneficiary will be considered to have died before the insured. Therefore, the face amount is paid to the contingent beneficiary.

The problem with the Uniform Simultaneous Death Act is that it only applies to situations in which it cannot be definitively determined whether the insured died before the beneficiary. If it can clearly be determined who died first, even if the difference is only a few minutes or hours, the insurance company will follow the normal succession process that’s outlined in the policy:

▪ If the primary beneficiary clearly died first, and then the insured died, the benefits are payable directly to the contingent beneficiary.

▪ If the insured died first, the death benefit is payable to the primary beneficiary. If the primary beneficiary then dies shortly thereafter, the face amount will be paid to the estate of the primary beneficiary and not directly to a contingent beneficiary. Again, possible death taxes and probate charges may be assessed before the heirs receive the remainder.

The common disaster provision further clarifies these complicated situations by adding a survivorship clause. This clause requires that the primary beneficiary not just survive longer, but also outlive the insured for a specified period (typically 14 to 30 days). The common disaster provision ensures a policy owner that, if both the insured and the primary beneficiary die within a short period, the death benefits will be paid to the contingent beneficiary. Benefits will only be paid to the primary beneficiary’s estate if the primary beneficiary lives past the minimum period.

The goal of both the Uniform Simultaneous Death Act and the common disaster provision is to protect the contingent beneficiary by not paying the proceeds to the primary beneficiary’s estate. Paying the benefits to the beneficiary’s estate will likely defeat the purpose of the insurance policy. Furthermore, it potentially causes undesired death taxes and probate charges to be assessed, which significantly reduce the benefit before the heirs receive the remainder. If there’s no contingent beneficiary listed, the benefits will be paid to the insured’s estate, just as if the primary beneficiary had died before the insured.

For example, let’s assume that John has a life insurance policy covering his life. He designates his wife, Mary, as the primary beneficiary and all of his children equally as the contingent beneficiaries. While traveling for business, John and Mary are involved in a plane crash. When the paramedics arrive, John is found dead at the scene of the crash, but Mary is found alive and is rushed to the hospital. Unfortunately, Mary succumbs to her injuries and dies on the way to the hospital.

In this case, Mary definitively outlived John. Under the Uniform Simultaneous Death Act, since John technically died first, the proceeds of John’s life insurance policy will be paid to Mary’s estate, potentially creating both probate and tax issues, but also possibly being subject to creditors. However, since John’s policy also contained the common disaster provision, the insurance company will act as if Mary died first and pay John’s death benefit directly to his children.

SPENDTHRIFT CLAUSE

This provision protects a beneficiary from creditors with regard to life insurance proceeds. When the death benefit is left with the insurer, no creditors can attach a lien of any kind to the proceeds. The spendthrift clause also protects a beneficiary by minimizing or restricting the use of proceeds as long as the insurer holds them. Only after proceeds have been distributed can the beneficiary assign or transfer the benefits to a creditor. Additionally, under the spendthrift clause, a beneficiary cannot take the present value of future payments in a lump-sum (commuting) or use future payments as collateral for a loan (encumbering).

The spendthrift clause is most often used to prevent a beneficiary from recklessly spending benefits by requiring the benefits to be paid in fixed amounts or installments over a certain period. Beyond preventing distribution directly to the insured’s creditors, this clause doesn’t have any effect if the beneficiary receives the proceeds as one lump-sum payment. Additionally, once the beneficiary receives the payment, creditors may be able to take steps to collect on any money owed.

TAX CONSEQUENCES OF LIFE INSURANCE

TAX TREATMENT OF INDIVIDUAL LIFE INSURANCE

According to the Internal Revenue Code, premiums that are paid for individual life insurance policies are considered a personal expense and, as such, are not tax-deductible. Just because a premium is used to purchase life insurance on a spouse or in a third-party ownership situation doesn’t mean that the premiums will be tax-deductible.

Premiums paid on life insurance may be tax-deductible:

▪ To an employer if the insurance is used as an employee benefit

▪ To provide for charitable contributions

▪ To benefit an ex-spouse as court-ordered alimony

TAXATION OF PROCEEDS PAID AT DEATH

Since the premiums paid are not tax-deductible (they’re paid after-tax), the proceeds (death benefit) from the life insurance policy are generally paid to the named beneficiary on a tax-free basis if paid out as a lump-sum. The exception to this rule is the transfer for value rule, which applies when a life insurance policy is sold to another party before the insured’s death. The value of a life insurance policy (death benefit) is included in the policy owner’s estate, despite the fact that the face amount is paid to the beneficiary income tax free. If death benefits are paid in installments rather than as a lump-sum, the principal is received tax-free and any interest that’s received is taxable.

ECONOMIC BENEFIT DOCTRINE

According to the Economic Benefit Doctrine, if any benefit is granted to an individual that has an economic or financial value, it must be included as compensation for income tax purposes in the year in which the benefit is granted. The key to avoiding the imposition of the Economic Benefit Doctrine is the existence of a substantial risk of forfeiture. Therefore, individual life insurance avoids this doctrine since premature death can cause a substantial risk to a surviving family.

TAXATION OF CASH VALUES

The equity that builds within a whole life policy is referred to as the cash value. As the cash value increases or accumulates, the interest paid on it is tax-deferred. The total of the premiums paid into the policy, MINUS the total dividends received in cash or used to offset premiums, is referred to as the cost basis. According to the cost recovery rule, if the policy is surrendered for its cash value, the portion that exceeds the cost basis (or premiums paid) is considered ordinary income and taxable. As long as the cash value remains in the policy, taxes will never be imposed on any portion (not even the amount that exceeds the cost basis).

TAXATION OF POLICY LOANS

In most situations, if a contract owner borrows against the cash value in the contract (i.e., takes a policy loan), there are no tax consequences. However, if a policy is an MEC, distributions are subject to the interest first rule, which states that they’re taxable as income if the cash value of the contract immediately prior to the payment exceeds the cost basis in the contract.

Borrowing against the cash value may be referred to as a partial surrender. This action on the part of the owner, while not resulting in a taxable event, does lower the owner’s equity in the policy. If a total surrender occurs, the cash value received is not taxable as long as it doesn’t exceed the total of premiums paid by the owner (i.e., the cost basis). Additionally, when a contract owner borrows against the cash value of a whole life policy, the interest paid to the insurer is not tax-deductible.

For example, let’s assume that Bob is the owner of a $100,000 whole life insurance policy on his own life and the cash surrender value is $45,000. He has paid $35,000 in premiums over the years. If Bob borrows $40,000 against the policy, he will not be subjected to tax consequences as long as the policy remains active. Bob is obligated to repay the loan received from the insurer plus interest, but the interest is not tax-deductible.

If Bob surrenders the policy, he will realize a taxable gain of $10,000 (the difference between his $35,000 cost basis and $45,000 in surrender value) which must be reported as taxable ordinary income.

TAXATION OF ACCELERATED DEATH BENEFIT

Under a life insurance policy, when benefits are paid to a terminally ill person, the benefits are received on a tax-free basis. To be considered terminally ill, a physician must certify that the person has a condition or illness that will result in death within two years.

TAXATION OF POLICY DIVIDENDS

Dividends that are paid on a whole life policy are tax-exempt since they’re considered a return of overpaid or excess premiums. Although it’s unlikely to happen, any dividends that are received in excess of the premiums paid are taxable as ordinary income. If dividends are left with the insurer to accumulate interest, the interest earned will be taxable as ordinary income in the year in which it’s received. If the life insurance policy is determined by the IRS to be a Modified Endowment Contract (MEC), dividends will be taxable unless they’re used to purchase paid-up additional insurance. In addition, dividends payable under an MEC may be subject to a 10% penalty tax (applying to premature distributions before age 59 1/2).

MODIFIED ENDOWMENT CONTRACT

Recall from earlier that a Modified Endowment Contract is not a life insurance policy. It is an IRS classification or category of insurance contract if certain conditions are not satisfied with regard to the funding of the contract. Any life insurance policy purchased after 6/20/88 is considered by the IRS to be a MEC if it does not satisfy the seven-pay test.

The following are illustrations of the tax treatment of benefit distributions from an MEC:

• Taxation only occurs when any cash is distributed to the contract owner or money is withdrawn, whether by surrender, loan, or dividends.

• The gain (i.e., interest or appreciation) is taxable first when a distribution is made (i.e., LIFO).

• The first dollars received by the contract owner are considered "earning first," or excess amounts of cash value beyond premiums and are taxable.

• If a policy is an MEC and cash is withdrawn, appropriate amounts are still taxable, even if it will be used for a legitimate reason such as financial hardship or to pay medical expenses.

• If cash is withdrawn prior to age 59 ½, a 10% penalty tax will be assessed.

· 1035 EXCHANGE

· The Internal Revenue Code (IRC) permits an individual to trade or exchange a life insurance policy, endowment, or annuity contract for another of like kind. Since a life insurance policy is a form of property, exchanges of policies are allowed. When a less competitive policy is being replaced or exchanged with a more competitive policy, a Section 1035 exchange may be utilized which allows for the postponement of tax consequences. In other words, the IRC allows a tax-free exchange if it is done from insurer to insurer where the policy owner never receives any cash. This regulation allows the policy owner to move cash value from one contract to another without current tax considerations. As long as the transfer is transacted within or between insurance companies and the policy owner receives no money, the exchange is permitted (without tax ramifications). This means that, theoretically, the cost basis remains the same.

· Therefore, the following types of exchanges are allowed under this section of the IRC;

· (1) a life insurance policy for another life insurance policy, endowment, or annuity;

· (2) an endowment policy for another endowment or an annuity; or

· (3) an annuity contract for another annuity contract.

· It is not permissible to exchange an annuity for a life insurance policy. The reason for this is that the IRS is not willing to allow a policy owner to exchange policies which will improve the income tax treatment of the benefits. If this were permitted, the policy owner could transfer funds from the annuity, which incurs income taxation on at least a portion of the benefits (i.e., tax deferral means that the annuitant will be taxed on interest sometime in the future), to a life insurance policy which pays a death benefit free of income taxation. If this were allowed, an annuity to life insurance exchange would move a tax-deferred characteristic to a tax-free characteristic.

· With regard to a whole life insurance policy, a 1035 exchange involves the vesting of cash value from one permanent insurance plan to another. Some of the reasons why an individual considers such a transfer include: (1) the financial condition or rating of the current insurer; (2) the enhancement of benefits in newer policies; (3) higher interest rates being offered in the newer policies; or (4) the desire for additional investment alternatives not available under the older contract. When a policy owner decides to make a permitted exchange, the transfer, assignment or surrender of the policy to the insurer and the subsequent replacement with the new contract must be completed within sixty days. To ensure that there are no tax considerations because of the exchange, the policy owner should receive no cash proceeds.

· CHAPTER SUMMARY: LIFE INSURANCE PREMIUMS, PROCEEDS, AND BENEFICIARIES

· Life Insurance Premiums

· The key points to remember from this chapter include:

· ▪ The premium is both an exchange for insurance protection and a portion of the policy owner’s consideration.

· ▪ Factors in premium calculations include:

· ‒ Mortality factor or mortality rate

· ‒ Interest factor

· ‒ Expense factor

· ▪ The mortality rate refers to the frequency of deaths in a defined population at a specific time interval.

· ▪ The morbidity rate refers to the occurrence of diseases in a defined population at a specific time interval.

· ▪ Interest is one of the ways an insurance company can lower the premium rates.

· ▪ The expense factor—also referred to as the loading charge or factor—is derived from operating expenses or funds that the insurer “pays out.”

· ▪ Net (single) premium is a premium that makes provisions for mortality (death benefit) losses only while being influenced by the interest rate assumed, gender, the benefit to be provided, and the mortality rate.

· ▪ Gross (annual) premium is the premium that’s charged by an insurer which is comprised of (or influenced by) the mortality, interest, and expenses.

· ▪ Additional factors that may influence the premium amount include:

· ‒ Age

· ‒ Sex/gender

· ‒ Health

· ‒ Occupation

· ‒ Hobbies

· ‒ Habits

· ‒ Benefits

· ‒ Options and riders

· ‒ Premium mode

· ▪ Premium mode refers to the policy feature that permits the policy owner to select the timing (frequency) of premium payments.

· ▪ With single premium funding, the policy owner pays a single premium that provides protection for the life of the policy.

· ▪ Fixed/Level premium funding averages the “single premium” over the policy period.

· ▪ Modified premium funding is characterized by an initial premium that’s lower than it should be during an introductory period (typically the first three to five years).

· ▪ Graded premium funding is a contract (like modified) that’s characterized by a lower premium in the early years of the contract.

· ▪ Flexible premium funding allows the policy owner to adjust the premiums throughout the life of the contract.

· ▪ Earned premium is the amount to which an insurer is entitled since it provided coverage for a specific period.

· ▪ Unearned premium is an amount of premium that the policyholder has paid to the insurance company, but coverage has not yet been provided.

· ▪ As required by law, reserves are the funds that are set aside by an insurer and used to pay current and future claims.

· ▪ A legal reserve is the amount of funds that an insurance commissioner (or director/superintendent) requires an insurer to maintain based on the mortality table and an assumed rate that’s designated by the state’s commissioner or state insurance law.

· Comparing Life Insurance Policy Costs

· ▪ Surrender Cost Index uses a calculation formula in which the net cost is averaged over the number of years that the policy was in force to arrive at the average cost-per-thousand for a policy that is surrendered for its cash value at the end of that period.

· ▪ Net Payment Cost Index uses the same formula as the Surrender Cost Index; however, it doesn’t assume that the policy will be surrendered at the end of the period.

· ▪ During the life of the policy, the primary living benefit that a whole life (permanent life) insurance plan possesses is its cash value build-up.

· Viatical Settlements

· ▪ The accelerated benefit—also referred to as the terminal illness rider—allows the policy owner to access a portion of the death benefit if a physician certifies that the insured is terminally ill.

· ▪ A viatical settlement allows a person with a chronic or terminal illness to sell his existing life insurance policy to a third party for a percentage of the face value.

· ‒ The original policy owner is referred to as the viator.

· ‒ The new third party owner is referred to as the viatical or the viatee.

· ▪ Chronically ill means a person who needs considerable supervision due to cognitive impairment or a person who cannot perform at least two activities of daily living.

· ▪ Terminally ill means a person who’s not expected to survive a medical condition for more than 24 months.

· Life Insurance Death Benefits

· ▪ If a policy owner chooses to select a settlement option, it cannot be changed by the beneficiary.

· ▪ In a lump-sum settlement option, the death benefit is paid in a single payment, minus any outstanding policy loan balances and overdue premiums.

· ▪ Under the interest only settlement option, the insurance company holds the death benefit for a period and pays only the interest that’s earned to the named beneficiary.

· ▪ The fixed amount installment option permits the death proceeds to be left “at interest” with the insurer and to pay a fixed death benefit in specified installment amounts until the principal and interest are exhausted.

· ▪ The fixed period (period certain) option pays the death benefit proceeds in equal installments over a set period of years.

· ▪ The life income option provides the beneficiary with an income that she cannot outlive.

· ▪ Under the single, pure or straight life income option (as with a straight life annuity), monthly installments are paid to the beneficiary for as long as she lives.

· ▪ The refund life income option—also referred to as the joint life option—guarantees the return of an amount which is equal to the principal less any payments already made.

· ▪ The life income option with a period certain pays a monthly income for as long as the beneficiary lives. However, if the beneficiary dies before a predetermined number of years have elapsed, the insurer will continue monthly payments to a second beneficiary for the remainder of the designated period.

· ▪ The joint and survivor option guarantees that benefits will be paid on a life-long basis to two or more people.

· ▪ A revocable beneficiary may be changed or removed by the policy owner at any time without notifying or obtaining the beneficiary’s permission.

· ▪ An irrevocable beneficiary may not be changed without the beneficiary’s written consent.

· Benefit Distribution

· ▪ Per capita means by the person or by the head.

· ▪ Per stirpes means by the bloodline.

· ▪ The primary beneficiary is the individual who receives the death benefit when the insured dies.

· ▪ The secondary or contingent beneficiary is the second individual(s) in line to receive the death benefit.

· ▪ A tertiary beneficiary is third in line to receive policy proceeds when the insured dies and this person survived both the primary and contingent beneficiaries.

· ▪ Testamentary trusts are created at the insured’s death according to a will.

· ▪ Inter vivos trusts or living trusts are created during the insured’s lifetime.

· ▪ The Uniform Simultaneous Death Act states that, if the insured and primary beneficiary both die in a common disaster and it cannot be determined who died first, the insured will be considered to have survived the primary beneficiary (or died last).

· ▪ The spendthrift clause provision protects a beneficiary from creditors with regard to life insurance proceeds.

· ▪ Dividends that are paid on a whole life policy are tax-exempt since they’re considered a return of overpaid or excess premiums.

· ▪ A Section 1035 exchange enables the postponement of tax consequences.

Chapter 7

KEYWORDS: LIFE INSURANCE UNDERWRITING AND POLICY ISSUE

Prior to reading this chapter, please review the following keywords. An understanding of their basic definitions will improve your comprehension of the chapter content.

Adverse Selection: This represents the tendency of a disproportionate number of poor risks to seek or buy insurance or to maintain existing insurance in force (i.e., the selection against the insurance company). Sound underwriting reduces adverse selection.

Age Change: This is the date halfway between birthdays when the applicant’s age changes to the next higher age. For some insurers, the age is based on the applicant’s age at his nearest birthday, while for others, it’s based on the applicant’s age as of his last birthday.

Applicant: The applicant is the person who’s completing an application with an insurance company for the insurance policy. In most cases, the applicant is also the proposed insured, but this is not always the case.

Application: The application is the statement of information that’s given when a person applies for life, health, or disability insurance. The insurance company’s underwriter uses this information as a basis in determining whether the applicant qualifies for acceptance under the company’s guidelines. Applications are attached to, and made a part of, all individual contracts.

Attending Physician Statement (APS): An APS is used when the application or medical examiner’s report reveals conditions or situations, past or present, about which more information is desired. Due to physician/patient confidentiality guidelines, the applicant must sign an authorization for a physician is allowed to release information to the insurance company underwriter.

Backdating: This is the practice of making the effective date of a policy earlier than the application date. Backdating is used to make the issue age lower than an applicant’s real age in order to obtain a lower premium. State laws typically limit the time to which policies can be backdated to six months. Due to the nature of the investment, backdating is not allowed in variable contracts.

Binding Receipt (Unconditional Receipt): This is one of the types of receipts that’s given by an insurance company upon the completion of an insurance application if the initial premium is collected with the application. Insurance becomes effective on the receipt date and continues for a specified period or until the insurer declines the application.

Buyer's Guide: This is a pamphlet which describes and compares various forms of life or health insurance. This guide must be provided to a consumer by the producer when the producer is attempting to solicit insurance. This guide provides the consumer with information so that she can make an informed decision when purchasing insurance coverage.

Conditional Receipt: This is a form that’s customarily required to be signed by the agent and given to the prospective owner at the time a new application is completed. The issuing of a receipt is subject to rules of the individual company. Most companies require the agent to collect an initial premium and, in turn, grant some level of limited coverage under special conditions before issuing the policy. Without a valid conditional receipt, no coverage is in force until the policy is issued, delivered, and accepted with the initial premium paid.

Consumer Report (Investigative Consumer Report): This report is a detailed background investigation that may include an interview with co-workers, friends, and neighbors about an applicant’s character, reputation, lifestyle, etc. Insurers are allowed to conduct a consumer report to obtain additional information as long there’s no invasion of privacy. A common type of consumer report is a credit report.

Credit Report: This is a summary of an insurance applicant’s credit history (i.e., credit score, debt levels, repayment history, assumed creditworthiness, etc.) that’s completed by an independent organization which has investigated the applicant’s credit standing. Credit reports are typically obtained from one of the three major credit bureaus (Experian, Equifax, and TransUnion).

Declined Risk: This describes an individual whose application for coverage was rejected by an insurance company.

Disclosure Form: As required by various state regulatory agencies, this is a comparison form that must be given to every policy owner who chooses to replace an existing policy with another.

Evidence of Insurability: This describes a statement or proof of a person’s health history and current health status which qualifies that person for coverage.

Fair Credit Reporting Act: Passed in 1970, this is a federal law that provides an insurer with the right to receive additional information regarding applicants for insurance coverage. This law permits an insurer to conduct a consumer report on both applicants and proposed insureds. An applicant for insurance must be informed of the purpose of the report. If coverage is declined due to the information in the report, the insurer must provide the name and address of the reporting agency so that the applicant can secure a copy of the information in the report.

Field Underwriter: This is the agent or producer who completes the applicant’s application for insurance.

Free-Look Period: All life insurance policies must include at least a 10-day free-look period. This period begins when the producer delivers the insurance policy. During this period, if the policy owner decides to return the contract to the insurer, he will receive a full premium refund. Mail order or direct response insurers must include a free-look period of at least 30 days.

Inspection Report: This is a report that contains general information regarding the health, habits, finances, and reputation of an applicant. This report is developed by a firm that specializes in rendering this type of service.

Insurable Interest: This describes the financial or emotional relationship between two or more parties which justifies one owning a life insurance policy on the other. A person is considered to have an unlimited insurable interest in her own life.

Insurable interest may exist in another person’s life if there’s a chance of a financial or emotional loss due to that person’s death. The insurable interest must exist at the time of policy issue.

Medical Information Bureau: This is a service organization that collects medical data on life and health insurance applicants for member insurance companies.

Policy Summary: This summarizes the basic terms of an insurance policy, including the conditions, coverage limitations, and premiums. Policy summaries are often used with life insurance, long-term care insurance, and annuities.

Preferred Risk: This describes an applicant who represents the likelihood of risk that’s lower than that of the standard applicant. This is typically due to better than average physical condition, occupation, mode of living, and other characteristics as compared to other applicants of the same age.

Proposed Insured: This is the person who’s requesting that her life be insured. This is also typically the applicant (but not always).

Rated Policy (Rating Up): A rated policy is the basis for an additional charge to the standard premium because the person insured is classified as a higher-than-average risk. The higher risk level is typically the result of impaired health or a hazardous occupation.

Replacement: This is a permitted activity in which a producer convinces a prospective client to lapse or surrender a life or health policy and purchase a new one. If this activity occurs, producers must provide a “Notice Regarding Replacement” to the consumer. The producer must also notify the insurer that a replacement is occurring.

Representations: Most state laws specify that an applicant’s statements on an application are considered representations and not warranties. A representation is only required to be substantially accurate to the best of the applicant’s knowledge. Generally, a representation is considered to be fraudulent if it relates to a situation that would be material to the risk and that the applicant made with fraudulent intent.

Risk Classification: This describes the underwriting category into which risk is placed depending on the applicant’s susceptibility to injury, illness, or death.

Special Class: This describes an applicant who cannot qualify for a standard policy but may secure one with a rider that waives the payment for a loss involving certain existing health impairments. The applicant may be required to pay a higher premium or to accept a type of policy that’s different from the one for which he applied.

Standard Risk: This describes a person who, according to a company’s underwriting standards, is considered an average risk and insurable at standard rates. High-risk or low-risk candidates may qualify for increased or discounted rates based on their deviation from the standard.

Substandard Risk (Impaired Risk): This describes an applicant whose physical condition doesn’t meet the usual minimum standards. If the substandard classification is due to adverse health, the application may be declined or written with a “rated-up” premium. An applicant may be in excellent health, but considered substandard due to her activities, hobbies, or avocations (e.g., scuba diving, skydiving, etc.).

Underwriter: This is a person who identifies, examines, and classifies the degree of risk represented by a proposed insured in order to determine whether coverage should be provided and, if so, at what rate.

Underwriting: This involves the analysis of information that’s obtained from various sources pertaining to an applicant for insurance and the determination of whether the insurance should be issued as requested, offered at a higher premium, or declined.

Warranties: Most state laws specify that an applicant’s statements on the application are considered representations and not warranties. A warranty must be absolutely and literally true. A breach of warranty may be sufficient to void the policy regardless of whether the warranty is material and whether such breach of warranty had contributed to the loss.

INTRODUCTION

Underwriting is the delicate insurance function which involves the research and evaluation of potential insureds to determine whether they’re acceptable to the company as insureds. This chapter will introduce the basic principles with regard to underwriting and agent responsibilities. The application information, including its required signatures, will be reviewed along with an applicant’s responsibility for providing truthful responses to an insurance producer. The types of premium receipts, insurable interest, risk classification, and policy delivery information will also be examined.

This chapter is broken into the following sections:

▪ Purpose and Characteristics of Underwriting

▪ The Application

▪ Initial Premium and Receipts

▪ Additional Sources of Underwriting Information

▪ Classification of Applicants

▪ Policy Issue and Delivery

The state-specific portion of this course (located at the end) will detail the specific insurance definitions, rules, regulations, and statutes for your state. If a conflict exists, state law will supersede the general content.

Review of this chapter will enable a person to:

▪ Understand the concept of underwriting and the responsibilities of an underwriter to reduce the probability of adverse selection

▪ Understand the importance of insurable interest in life insurance contracts and the measures to be taken to determine whether insurable interest exists

▪ Identify what constitutes an insurable risk

▪ Identify the parties involved in underwriting and their role

▪ Distinguish between an applicant, a proposed insured, and policy owner

▪ List and identify the most common sources of underwriting information

▪ Distinguish between medical and non-medical applications

▪ Identify and understand the three essential parts of a life insurance application

▪ Distinguish between the terms representation, misrepresentation, and warranties

▪ Identify situations and examples of material misrepresentation that are made with fraudulent intent

▪ Understand the process of completing an application and making necessary corrections

▪ Understand the concept of a trial application

▪ Distinguish between the different types of premiums and how they may determine when coverage will be in force

▪ Understand the different types of insurance receipts

▪ Understand and list the three applicant ratings

THE PURPOSE AND CHARACTERISTICS OF UNDERWRITING LIFE INSURANCE

Insurance companies are interested in nothing more than selling their policies to any persons who want to buy them. However, they need to exercise caution when deciding who’s qualified to purchase insurance. Issuing a policy to a person who’s uninsurable is an unwise business decision that can easily result in a company’s financial loss. One of the primary responsibilities of an underwriter is to protect the insurer against adverse selection.

Remember, adverse selection is the underwriting concept that involves the tendency of poorer risks to seek insurance coverage or the chance that an insurer will accept applicants who are bad risks (i.e., those in poor health, are moral hazards, etc.). Simply put, those who are most likely to experience a loss are also most likely to seek insurance. Sound and competent individual or group underwriting will reduce the probability or chance of adverse selection.

For example, a person with a life-threatening disease is typically more concerned or eager to obtain insurance coverage due to the probability of imminent death than an individual who’s in good health.

Just as each insurer determines the premium rates it will charge its policy owners, each insurer also sets its own standards as to what constitutes an insurable risk versus an uninsurable risk. Every applicant for insurance is individually reviewed by a company underwriter to determine whether the applicant meets the company’s standards to qualify for its life insurance coverage.

Underwriting—another term for risk selection—is the process of reviewing the many characteristics that make up the risk profile of an applicant to determine whether the applicant is insurable and, if so, at standard or substandard rates. The two fundamental questions that underwriters seek to answer about an applicant are:

1. If the applicant and insured are two different people, does an insurable interest exist between the two?

2. Is the applicant insurable?

Therefore, the purpose of underwriting is to avoid adverse selection, properly classify risk, and to differentiate between preferred, standard, and substandard risk classifications.

AGENT RESPONSIBILITY

As noted earlier, an agent plays an essential role in the underwriting process. Any producer is required to act in a fiduciary capacity when collecting premiums and/or dealing with the public. As such, all producers possess a fiduciary responsibility when engaging in insurance transactions. A producer who has made an unintentional error or honest mistake has committed a tort which is referred to as an error and omission. Therefore, it’s recommended that insurers purchase Errors and Omissions (E&O) insurance to cover the malpractice or negligence of producers. In some cases, agents may be required to obtain their own Errors and Omissions coverage.

As a field underwriter, the agent initiates the process and is responsible for many crucial tasks, including proper solicitation, completing the application thoroughly and accurately, obtaining appropriate signatures, collecting the initial premium, and issuing a receipt. Each of these tasks is vitally important to the underwriting process and policy issue.

PROPER SOLICITATION

As a representative of the insurer, an agent has the duty and responsibility to solicit good (i.e., profitable) business. Therefore, an agent’s solicitation and prospecting efforts should focus on cases that fall within the insurer’s underwriting guidelines and represent profitable business to the insurer. At the same time, the agent has a responsibility to the insurance-buying public to observe the highest professional standards when conducting insurance business.

DOES INSURABLE INTEREST EXIST?

Insurable interest is vital in life insurance. Without this requirement, a person could purchase life insurance on another party and the policy would represent nothing more than a wagering contract. As established previously, an insurable interest exists when the insured’s death will have a clear financial impact on the policy owner. Therefore, when the applicant and proposed insured are the same person, there’s no question that insurable interest exists. However, questions are raised with third-party contracts (those in which the applicant is not the insured). Some relationships are automatically presumed to qualify as insurable interest, such as spouses, parents, children, and specific business relationships. Insurable interest cannot be established sufficiently by sentimental attachment alone.

The following is a list of situations in which insurable interest automatically exists:

▪ An individual has an insurable interest in his life.

▪ A husband and/or wife has an insurable interest in a spouse.

▪ Parents have an insurable interest in their children.

▪ A child has an insurable interest in a parent or grandparent.

▪ A business has an insurable interest in the lives of its officers, directors, and key employees, including an employee who produces high volume sales.

▪ Business partners have an insurable interest in each other.

▪ A creditor has an insurable interest in the life of a debtor (but only to the extent of the debt).

It bears repeating that, with life insurance, an insurable interest must exist only at the time of application or policy inception. It doesn’t need to exist at the time of loss (when the policy proceeds are paid at death). Therefore, a policy owner could assign a life policy to a person who has no insurable interest in the insured, and the assignment will nonetheless be valid. Also, with a few exceptions (e.g., buying insurance on a minor), a person cannot purchase life insurance on another person without her consent.

AMOUNT OF INSURABLE INTEREST

Based on the principle of indemnity, a person’s insurable interest should be limited to the amount required to “return an insured to whole” after suffering a loss. The insured should be returned to the same financial condition that existed before the loss—no better and no worse. Indemnity is a simple concept for property insurance; the insured should be “made financially whole again” when the damaged or destroyed property is repaired or replaced.

For example, if an individual purchases a home that has a replacement cost of $250,000, she could purchase a homeowner’s insurance policy for up to $250,000 to replace the home if she experiences a total loss.

The principle of indemnity, and therefore the amount of insurable interest, is less clear when dealing with life insurance. With life insurance, once insurable interest is generally established, the amount of that interest is typically limited by the amount of insurance that the insurer is willing to issue and the amount of premium that the policy owner can afford. However, there are some general guidelines to remember. Individuals are typically presumed to have an unlimited insurable interest in themselves. Additionally, life insurance proceeds that are collected by a creditor-beneficiary are generally limited to the amount of the debt PLUS interest.

Some insurance companies may have limits that are based on the relationship between the insured and the beneficiary. For example, a parent will have a more insurable interest in her child than a grandparent to a grandchild. Furthermore, an insurer may limit the coverage amount that’s available on a child due to the parent’s amount of (or lack of) coverage. For example, a parent with less than $50,000 of life insurance coverage may be limited to purchasing no more than $25,000 worth of coverage on her child.

IS THE PROPOSED INSURED INSURABLE?

Once the underwriter determines that insurable interest exists, the next question is, “Is the proposed insured insurable?” The answer to this question lies in the underwriting process. The underwriting process is accomplished by reviewing and evaluating information about a proposed insured and applying what’s known of the individual against the insurer’s standards and guidelines for insurability and premium rates.

As examined previously, the most common way to manage risk is when an individual transfers risk to an insurer by purchasing an insurance policy. An insurer cannot insure every type of risk presented. In order for a pure risk to be insurable, it must involve a chance of loss that’s accidental, measurable, and definable, and cannot involve a change for financial gain. The law of large numbers must also apply. This mathematical law of probability states that the larger the number of occurrences (i.e., the number of lives covered), the more predictable losses will be. As the number of exposures increases, the more the actual results will approach the results expected for a specific event. In other words, the larger the number of homogeneous units (i.e., similar risks), the loss predictability will increase. Other elements of insurable risk include:

▪ The loss must be significant enough to cause financial hardship (e.g., death).

▪ The loss must not be catastrophic (e.g., loss due to war).

▪ The cost for coverage (i.e., the premium) must not be unreasonable.

▪ The loss must be unpredictable or fortuitous.

Underwriting evaluates the proposed risk (or insured) and determines whether the elements of insurable risk have been met. If the risk is insurable, underwriting then determines the amount of premium required based on the net risk (likelihood of needing to pay a claim).

PARTIES INVOLVED IN UNDERWRITING

An agent cannot complete an application, underwrite, and issue a policy all on his own. While the process of acquiring insurance is typically pretty straightforward, there are technically many people involved from start to finish. For the state exam, a person needs to understand the parties involved in the underwriting process to be able to answer questions accurately.

A producer needs to understand who he or she needs to speak with to complete and sign insurance applications. Also, producers need to know who to reach out to if questions arise regarding insurance applications or insurability.

When taking applications for potential insureds on behalf of the insurer, a producer performs the extremely important initial step in the underwriting process which is referred to as field underwriting. During this process, the producer determines which risks are desirable and submits those to the underwriting department for approval. The producer also possesses some additional duties with regard to the application process. A field underwriter or producer may solicit appointments, complete applications, collect premiums, and submit applications to the home office underwriter; however, the producer doesn’t issue the policy. The producer is also responsible for providing any required disclosure of information practices to an applicant, such as a notice regarding replacement, a life insurance buyer’s guide, an outline of coverage, or a policy summary.

The applicant is simply the person who’s requesting the insurance and completing the application, typically with the help of a licensed producer. In many cases (but not always), the applicant is also the proposed insured. The proposed insured is the person whose life is to be insured (if approved). The policy owner is the person who, if the application is approved, will retain all of the policy’s rights and options. The policy owner will also typically serve as the payor (i.e., the person who’s ultimately responsible for ensuring that the premiums are paid when due. The underwriter is the person who reviews the insurance application, examines any additional information about the applicant, and classifies the degree of risk posed by the proposed insured to determine whether coverage should be offered and, if so, at what premium rate.

For example, Frannie works with an insurance producer to complete an application for a $20,000 insurance policy on her life. In this situation, Frannie is the applicant, the proposed insured, the policy owner, and the payor. After completing her application, Frannie informs the insurance producer that she also wants to obtain insurance for her five-year-old son. In this case, Frannie is the applicant, policy owner, and payor, but her son is the proposed insured.

[EXAM TIP: Although the parties of an insurance contract can be very complicated, the vast majority involve only one party. Typically, the policy owner, payor, applicant, and proposed insured are all the same person. For the exam, assume that this is the case unless a question specifically suggests otherwise.]

With a few exceptions (e.g., buying insurance on a minor), an individual CANNOT purchase life insurance on another person without that person’s consent.

For example, Luke wants to purchase a life insurance policy on his wife, Gina. Gina agrees and signs the application; therefore, she has provided her consent. However, it’s doubtful (and for good reason) that an insurer would approve an application if Luke were to apply for a $500,000 accidental death insurance policy covering Gina’s life without her consent.

THE UNDERWRITING PROCESS

An underwriter’s primary duties are to assess risks (i.e., applications), approve or decline applications, determine premiums, and protect the insurer against adverse selection. Underwriters have several sources of underwriting information available so that they’re able to develop an applicant’s risk profile. The number of sources that are checked will typically depend on several factors, most notably the requested policy’s size (i.e., face value) and the risk profile that’s developed after an initial review of the application. The larger the policy, the more comprehensive and diligent the underwriting research.

Regardless of the policy size, if the application raises questions in the underwriter’s mind, that can also trigger a review of other sources of information. The most common underwriting information sources include the application, the medical report, an attending physician’s statement, the Medical Information Bureau, special questionnaires, inspection reports, and credit reports.

Mortality tables show the rate of deaths occurring in a defined population during a selected period, or survival rates from birth to death. These tables also indicate that the older an individual is, the higher the probability of death. This is the reason that age affects insurance costs. Mortality information also indicates that women statistically live longer than men. Therefore, for an insurer, the risk when providing coverage for a female is lower than it is for a male and, as such, the cost is lower (all things being equal).

The field underwriting that’s performed by the producer will also assist the home office underwriters. The agent should complete the application by providing as much detail as possible. Once the application is forwarded to the insurer, the underwriter may require additional information from the applicant’s doctor to assess the risk. However, such action is only permitted if the applicant signs a disclosure statement. In some instances, insurers utilize a non-medical application which requires no additional information other than the application. This type of application is most often used when the proposed insured is seeking a low amount of coverage and she’s young (e.g., in her 20s or 30s).

Pre-Selection Underwriting Activities

This involves the process by which an agent / producer completes the initial application prior to submission to the underwriting department. Appropriate activities include:

(1) obtaining complete and detailed answers to all policy application questions, including personal physician information;

(2) providing insight with regard to possible underwriting rating services; and

(3) stressing the importance of answering all questions honestly.

An agent may not legally guarantee or bind coverage.

Post-Selection Activities

These involve the activities that are conducted by the underwriting department once the application has been received including:

(1) evaluating the risk by utilizing all of the appropriate sources of information; or

(2) determining the acceptability of the risk and whether the applicant will be classified as a preferred, standard, or substandard risk (a substandard risk may be uninsurable or may be written with a higher (rated) premium).

Underwriting Outcomes

Underwriting outcomes affect the insurer and the business it writes. It also affects an insured as to whether he can secure desired insurance coverage. Lastly, agents or producers are also affected as a result of underwriting decisions since positive decisions allow the issuance of policies and the payment of commissions.

DISCLOSURES

If required by state law, the agent also must sign a form attesting to the fact that a disclosure statement has been given to the applicant. Moreover, a form which authorizes the insurance company to obtain investigative consumer reports or medical information from investigative agencies, physicians, hospitals, or other sources generally must be signed by the proposed insured and the agent as a witness. The insurance company’s name and the agent’s name and license identification number must appear on the application. This information may be printed, typed, stamped, or handwritten (if legible).

In many states, an agent is required to deliver both a Life Insurance Buyer’s Guide and a policy summary to the applicant. These documents are generally delivered before the agent accepts the applicant’s initial premium.

The Buyer’s Guide is often a generic publication that explains life insurance in a way that average consumers can understand. It speaks of the concept in general terms and doesn’t address the specific product or policy being considered. The policy summary addresses the specific product being presented for sale and identifies the agent, the insurer, the policy, and each rider. It includes information about premiums, dividends, benefit amounts, cash surrender values, policy loan interest rates, and life insurance cost indexes of the specific policy being considered.

THE APPLICATION

For an insurer, the insurance application is its underwriting department’s principal source or tool to determine whether a potential insured (the applicant) is eligible for insurance coverage. Regardless of what other sources of information from which the underwriter may draw, the application is the first source of information to be reviewed and evaluated thoroughly. Since the application provides a variety of important information to the insurer, it’s the agent’s responsibility to ensure that an applicant’s answers to the application’s questions are thoroughly and accurately recorded. There are three essential parts to a typical life insurance application:

▪ Part I: General Applicant Information

▪ Part II: Medical and Health History

▪ Part III: The Agent’s Report or Statement

An underwriter is provided with the application and will review the information in all three sections to determine whether the proposed insured is insurable. All of the fact-finding information that appears on an application will help the underwriting department determine the individual premiums to be charged.

[EXAM TIP: As described previously, the application also serves as the applicant’s formal request for insurance. Together with the initial premium, a completed application is the applicant’s consideration.]

PARTS OF THE APPLICATION

Part I: General Applicant Information

Part I of the application includes general questions about the proposed insured, including name, age, address, birth date, sex, income, marital status, and occupation. Details about the requested insurance coverage are also included in Part I, such as:

▪ Type of policy

▪ Amount of insurance

▪ Name and relationship of the beneficiary

▪ Other insurance owned by the proposed insured

▪ Additional insurance applications that are pending for the proposed insured

Other information that’s sought may indicate possible exposure to a hazardous hobby (e.g., scuba diving), foreign travel, aviation activity, or military service. Part I of the application also indicates whether the proposed insured is a tobacco user.

Part II: Medical and Health History

Part II focuses on the proposed insured’s health and includes several questions about the person’s health history, not only of the proposed insured, but also of the proposed insured’s family. This medical section must be completed in its entirety for every application.

Depending on the proposed policy face amount, this section may not be all that’s required by way of medical information. The individual to be insured may be required to take a medical exam or provide a blood test or urine specimen. If requested by the insurer, physical exams are performed at the expense of the insurer.

Part III: The Agent's Report (or Statement)

Part III of the application is referred to as the agent’s report or agent’s statement. The agent’s statement is where the agent indicates his personal observations of the proposed insured. Since the agent represents the insurance company’s interests, the agent is expected to complete this part of the application thoroughly and truthfully.

In Part III, the agent provides additional information about the applicant’s financial condition and character, the background and purpose of the sale, and how long the agent has known the applicant. The agent’s report will also typically indicate whether the proposed insurance will replace an existing policy. If it is a replacement, most states require specific procedures to be followed to protect consumers’ rights when policy replacement is involved.

COMPLETING THE APPLICATION

The application is one of the most critical sources of underwriting information and it’s the agent’s responsibility to ensure that the application is completed fully and accurately. There may be several consequences of a producer submitting an incomplete application, including a delay in underwriting, policy issuance, policy delivery, and commissions payment to the producer. The applicant may also choose to do business elsewhere as a result of such delays. An insurance company will return the application to the agent if the agent submits an incomplete application.

Statements that are made in the application are used by insurers to evaluate risks and decide whether to insure the proposed insured (applicant). All of the applicant’s replies to specific questions on the application regarding health history are considered representations.

Representations are statements made by an applicant that are deemed substantially true to the best of the applicant’s knowledge and belief, but which are not warranted to be exact in every detail. Representations must be accurate only to the extent that they’re material to the risk. If the applicant lies about her health status, material misrepresentation is present, which may void the policy or cause it to be canceled by the insurer. Typically, the premium is refunded to the policy owner or applicant whenever the insurer cancels or declines an insurance policy.

If an applicant makes any statements that are guaranteed to be true, she has made a warranty. A warranty that’s not literally true in every detail (even if made in error), is sufficient to render a policy void. Therefore, the statements that are made by an applicant and recorded on the application are considered to be representations and not warranties.

If an insurer rejects a claim based on a representation, it bears the burden of proving materiality. Representations are considered fraudulent only when they relate to a matter that’s material to the risk and when they were made with fraudulent intent.

APPLICATION SIGNATURES

When a producer completes an application, he must include at least two required signatures—that of the applicant and the producer. If third party ownership is present (when the applicant and proposed insured are different parties), the application requires three signatures—the applicant, the proposed insured, and the producer.

All insurers require the producer to sign the application as well, or it will not be underwritten. The applicant’s signature is required on a life insurance application to indicate that the application’s statements are true to the best of the applicant’s knowledge. Therefore, the applicant’s signature attests to the accuracy of the information in the application. By reading and signing the insurance application, the applicant should realize that any false statements on the application could lead to loss of coverage.

[Exam Tip: Each application requires the signatures of the proposed adult insured, the policy owner (if different from the insured), and the agent who solicits the application. The beneficiary does not sign the application.]

MINOR APPLICANTS AND PROPOSED INSUREDS

Any person who’s under the age of majority is considered a minor (for most states, the age of majority is the age of 18). In general, this principle also applies to legal contracts, which means that minors can usually void any contracts that they signed before reaching 18 years of age. However, life insurance is an exception to this principle. With life insurance contracts, most states consider any person who’s under the age of 15 to be a minor. Typically, proposed insureds who are age 15 or older (age 14 1/2 in New York and age 16 in Indiana) can sign and enter into a contract for life insurance. In reality, many companies still require a parent or guardian’s signature if the proposed insured is under the age of 18.

CHANGES TO THE APPLICATION

The insurance application must be completed accurately, honestly, and thoroughly, and it must be signed by the insured and witnessed. When an applicant makes a mistake regarding the information that’s given to an agent who’s completing the application, the applicant can have the agent correct the information, but the applicant must initial the correction. If the producer alters or changes the application information in any way without informing the applicant or insurer, he may be engaging in fraud. Therefore, any changes that are made to an application by a producer must be initiated by both the applicant and the producer before the application is submitted to underwriting. If the company discovers a mistake, it typically returns the application to the agent. The agent then corrects the mistake with the applicant and has the applicant initial the change.

If the insurer discovers that the information on an application is incomplete or incorrect after a policy is issued, the company may rescind or cancel the contract. However, the company may only rescind or cancel the contract during the policy’s contestable period. Once the policy’s incontestable clause takes effect, the insurer can no longer rescind or cancel the contract.

Remember, the application becomes part of the legal contract between the insurer and the insured when it’s attached to the insurance policy. Consequently, the general rule is that no alterations of any written application can be made by any person (other than the applicant) without the applicant’s written permission.

INITIAL PREMIUM AND RECEIPTS

PREMIUMS PAID WITH THE APPLICATION

It’s generally in the best interests of both the proposed insured and the agent to have the initial premium paid at the same time that the application is forwarded to the insurer. For the agent, this will typically help solidify the sale and may even accelerate the payment of commissions on the sale. The proposed insured also benefits by having insurance protection become effective immediately, with some significant restrictions.

The premium is generally forwarded with the application to the underwriting department. However, if a premium is not paid with the application, the agent should submit the application to the insurance company without the premium. Even if the policy is approved and issued, it will not become effective until the initial premium is collected. An application submitted without an initial premium is typically referred to as a trial application.

Remember, an applicant’s consideration is one of the requirements for a valid contract. In the case of an insurance contract, the consideration is the first full premium payment plus the application. An insurer will not allow an applicant to possess a policy without receipt of the initial premium.

PREMIUM RECEIPTS

Whenever a premium is collected at the time of application, the producer must provide a premium receipt to the applicant. This receipt is proof that an initial premium was paid with the application. The type of receipt that’s given may determine precisely when and under what conditions an applicant’s coverage begins.

There are two types of receipts in existence that may be provided to an applicant when the producer collects a premium—a conditional receipt and a binding receipt. Conditional receipts generally provide coverage as of the date of the receipt as long as one or more specific conditions are satisfied. Coverage may be provided if the proposed insured demonstrates insurability. Insurability may be accomplished simply by submitting the application to the underwriting department at which point it may be approved or declined on its own merits without any other information required. However, in other cases, information may be obtained from other sources, such as the Medical Information Bureau, a consumer report, an attending physician’s statement, a medical exam, or other tests (e.g., a blood test).

For example, the insurer may want to receive more information before it approves the application or agrees that the proposed insured is, in fact, insurable.

These receipts identify the amount of premium collected and may indicate when coverage is in effect. Today, the conditional receipt is predominantly utilized, whereas the binding receipt is used in a limited fashion. The date that appears on a conditional receipt always reflects a date earlier than the policy’s issue date.

Temporary Insurance Agreement

This is life insurance terminology that’s used to describe the amount of insurance provided by the insurer between the period when the application is taken and the first premium is paid, and the time when the policy is issued. The limit of insurance on the temporary agreement may be less than the policy limit for which has been applied. Most often the temporary insurance agreement is designed to pay if the insured dies before the policy is issued only if that company would have issued the policy except for the prior death of the insured. Therefore, a death benefit will not be paid if the company determines, through its standard underwriting practices, that the applicant was not insurable.

Conditional Receipts

A conditional receipt is also referred to as a temporary receipt and is the most common type of premium receipt used today. A conditional receipt outlines certain conditions that must be met for the insurance coverage to go into effect. The conditional receipt provides that, when the applicant pays the initial premium, coverage is effective on the condition that the applicant proves to be insurable either on the date that the application was signed or the date of the medical exam. However, if the applicant proves to be uninsurable as of the date of application or the date of the medical exam, no coverage takes effect, and the premium is refunded.

For example, an applicant dies between the date on which she completed her application or medical exam and the date on which the insurer approved the application. In this case, the coverage is retroactively effective, as long as the applicant proves to be insurable as of the date of the application or completion of the medical exam.

Insurability Type Conditional Receipt

In an insurability type of conditional receipt, the language indicates that the insurer has made an offer that’s conditional upon the proposed insured’s insurability, and the applicant accepts the conditional offer by paying the premium. Therefore, coverage becomes effective as of the date of the application or the date of the medical exam (if one is requested) as long as the proposed insured is found to be insurable. Policy delivery is not required for coverage to be provided.

For example, let’s assume that Edwin signs an application for coverage on August 2 and takes a required medical exam on August 4. In this case, protection begins on August 4 because the medical exam was required for coverage to be provided. If Edwin dies before the application is underwritten, the insurer must still proceed with the underwriting phase and determine insurability according to its usual underwriting standards. If the application is approved, the claim will be paid even after the insured died because insurance was in effect. However, if it turns out that Edwin did not meet the insurer’s approval guidelines, the application would be declined. In this situation, the death benefit would not be paid. However, the initial premium is refunded to the applicant or beneficiary.

Approval Language in a Conditional Receipt

This type of receipt indicates that coverage is effective only after the application has been approved by the insurer. Therefore, if the producer collects the premium and application on June 15, and the application is approved by underwriting on June 29, coverage is effective as of June 29.

Binding Receipts

With a binding receipt, also referred to as an unconditional receipt, coverage become effective as soon as the premium is collected. The policy is guaranteed under a binding receipt until the insurer formally rejects the application. Even if the proposed insured is ultimately found to be uninsurable, coverage is still guaranteed until rejection of the application. Therefore, the insurer must pay the claim if the applicant dies before the insurance company formally rejects the insurance application.

Since the underwriting process can often take several weeks or longer, this can place the company at considerable risk. Accordingly, binding receipts are often reserved only for a company’s most experienced agents. As with the conditional receipt, a binding receipt typically stipulates a maximum amount that’s payable during the particular protection period. Binding receipts are far more common for auto or homeowners insurance than they are for life or health insurance.

ADDTIONAL SOURCES OF UNDERWRITING INFORMATION

Although the primary source of information available to an underwriter is the application, additional information may be required if an application reveals certain health conditions or other risk exposures. The underwriter will also base a final decision on an assortment of other information, including the producer or agent’s report, an attending physician statement (APS), MIB, consumer (e.g., credit) or inspection reports, medical or physical exam results (e.g., medical report), laboratory tests (e.g., blood tests or HIV) or a motor vehicle/DMV report. Many insurers require an applicant to complete a hazardous activity questionnaire to determine whether the proposed insured engages in scuba diving, sky diving, any type of racing activities (auto, motorcycle, boats), aviation activities, hang gliding, or mountain climbing.

THE MEDICAL REPORT

A policy is often issued based on only the information that’s provided in the application. Most companies have set non-medical limits, which means that applications for policies below a certain face amount (e.g., $50,000, or even $100,000) will not require any additional medical information other than what’s provided by the application. However, for policies with a more substantial face value, a medical report may be required to provide further underwriting information. If the medical section of a person’s application raises questions that are specific to a particular medical condition, the underwriter may also request an attending physician’s statement (APS) from the physician who has treated the applicant. A copy of the signed authorization must accompany an insurer’s request for an attending physician’s report.

The statement will provide details about the medical condition in question. Medical reports must be completed by a qualified person, but that person doesn’t necessarily need to be a physician. Many companies accept reports that are completed by a paramedic or a registered nurse. When completed, the medical report is forwarded to the insurance company so that it can be reviewed by the company’s medical director or a designated associate.

When a medical examination, physical examination, electrocardiogram (EKG), treadmill examination, or medical report is required by the insurer, it will pay for the examination and use a physician or medical professional of its choice.

THE MEDICAL INFORMATION BUREAU

Another source of underwriting information that focuses explicitly on an applicant’s medical history is the Medical Information Bureau (MIB), which was formed by more than 700 member insurance companies. Essentially, the MIB is a clearinghouse of health information that’s supplied by insurers from information on applications. The MIB contains information about an applicant’s previous health history and helps to detect any adverse health conditions that the potential insured may experience. The MIB report will also identify life insurance in force with other carriers and lifestyle habits, such as drug use.

The purpose of the MIB is to serve as a reliable source of medical information concerning applicants and to help disclose cases in which an applicant either forgets or conceals pertinent underwriting information or submits erroneous or misleading medical information with fraudulent intent. A Medical Information Bureau report may disclose lifestyle habits such as drugs, drinking, overeating, and smoking. The MIB operations help to minimize the cost of life insurance for all policy owners by preventing misrepresentation and fraud. Information that’s received from the Medical Information Bureau (MIB) about a proposed insured may be released to the proposed insured’s physician. One of the primary purposes of the MIB report is to allow an insurer to avoid high-risk applicants.

The following is a summary of how the Medical Information Bureau works:

If a company finds that one of its applicants has a physical ailment or impairment that’s listed by the MIB, the company is required to report the information to the MIB in the form of a code number. By having this information, home office underwriters will know that a past problem existed if the same applicant later applies for life insurance with another member company. The information is available to member companies only and may be used only for underwriting and claims purposes. Information that’s received from the Medical Information Bureau (MIB) regarding a proposed insured may be released to the proposed insured’s physician.

PRIVACY NOTICE

The Health Insurance Portability and Accountability Act of 1996 (HIPAA) is a federal law that requires the creation of national standards to protect sensitive patient health information from being disclosed without the patient’s consent or knowledge and gives patients an array of rights concerning individually identifiable health information. According to HIPAA, when an agent submits an application that reveals personal information regarding the applicant, the agent is responsible for providing the insurance applicant with a privacy notice. In applicable situations, producers must also secure an HIV consent form from the applicant and communicate that blood tests may be a required underwriting practice. In other words, despite the fact that the insurer requires a blood test as part of its regular underwriting activity, it must still secure a signed consent form which indicates to the applicant that any blood taken will be screened for HIV and that he’s providing permission for such testing to be completed.

SPECIAL QUESTIONNAIRES

When necessary, special questionnaires may be required for underwriting purposes to provide more detailed information about aviation or avocation, foreign residence, finances, military service, or occupation. For example, let’s assume that an applicant has a hobby of skydiving. In this case, the insurance company needs detailed information about the extent of the applicant’s participation to determine whether the insurance risk is acceptable. Of these special questionnaires, the most common is the aviation questionnaire which is required of any applicant who spends a significant amount of time flying.

INSPECTION REPORTS

Inspection reports are generally obtained by insurance companies on applicants who apply for large amounts of life and health insurance but are generally not requested for applicants who apply for smaller policies. However, company rules vary as to the sizes of policies that require a report by an outside agency. These reports contain information about prospective insureds and are reviewed to determine their insurability. Insurance companies often obtain inspection reports from national investigative agencies or firms, and they may include credit reports for the proposed insureds.

The purpose of these reports is to provide a picture of an applicant’s general character and reputation, mode of living, finances, and any exposure to abnormal hazards. Investigators or inspectors may interview employees, neighbors, associates of the applicant, as well as the applicant. When an investigative consumer report is used in connection with an insurance application, the applicant has the right to receive a copy of the report. An insurer’s obligation involving the disclosure of an insured’s non-public information is to give notice, explain, and allow the process of opting out.

In fact, if an insurance company obtains an inspection report on a prospective insured, it must inform the prospect that it’s permitted to do so under The Fair Credit Reporting Act (FCRA). The FCRA established procedures for collecting and disclosing information that was obtained on consumers through investigation and credit reports. The law is intended to ensure fairness concerning confidentiality, accuracy, and disclosure.

CREDIT REPORTS

Based on information that was obtained before a policy is issued, some applicants may prove to be higher credit risks. Therefore, credit reports that are obtained from retail merchants’ associations or other sources are often valuable underwriting tools.

Applicants who have questionable credit ratings could ultimately cause an insurance company to lose money. Applicants with low credit standings are likely to allow their policies to lapse within a short time, perhaps even before a second premium is paid. This results in an insurance company losing because the insurer’s expenses to acquire the policy cannot be recovered in such a short period. The home office underwriters may refuse to insure persons who have failed to pay their bills or who appear to be applying for more life insurance than they can reasonably afford.

THE FAIR CREDIT REPORTING ACT OF 1970

In 1970, Congress enacted the Fair Credit Reporting Act to protect consumers’ rights when an inspection or credit report has been requested. As previously described, this federal law applies to financial institutions that request these types of consumer reports, which includes insurance companies. A life insurance applicant must be informed of her rights that fall under the Fair Credit Reporting Act upon completing the application.

USA PATRIOT ACT

The USA PATRIOT Act was enacted in 2001 to deter and detect terrorism. Under the act, insurance companies are required to establish formal anti-money laundering (AML) programs. A life insurance policy that can be cash surrendered is an attractive money-laundering vehicle because it allows criminals or terrorists to put dirty money in and take clean money out in the form of an insurance company check.

This act increased the ability of the law enforcement agencies to search telephone and e-mail communications, as well as medical, financial, and other records in order to thwart and prevent terrorist activities. The act also expanded the Secretary of the Treasury’s authority to regulate financial transactions, particularly those involving foreign and individual entities, in order to protect the United States and its interests. Insurance companies are required to implement written AML programs which include designating a compliance officer for updating the program, ensuring that the appropriate persons are educated and trained on the use of the program, and conducting on-going AML training.

CLASSIFICATION OF APPLICANTS

APPLICANT RATINGS

Once all of the information about a given applicant has been reviewed, the underwriter will seek to classify the applicant’s risk to the insurer. This evaluation is referred to as risk classification. In some cases, an applicant represents a risk so significant that the applicant is considered uninsurable, and the application will be rejected. However, most insurance applicants fall within an insurer’s underwriting guidelines and will accordingly be classified as a preferred risk, standard risk, or substandard risk.

Preferred Risk

Many insurers reward good (low) risks by assigning them to preferred risk classification. Companies issue preferred risk policies with reduced premiums due to the expectation of a better than average mortality or morbidity experience. Some of the characteristics that contribute to a preferred risk rating include being a non-smoker, being a non-drinker, and maintaining weight within an ideal range.

Standard Risk

Standard risk is the term that’s used for individuals who fit the insurer’s guidelines for issuing the policy without special restrictions or an additional rating. These individuals meet the same conditions as the tabular risks on which the insurer’s premium rates are based.

Substandard Risk

A substandard risk is one below the insurer’s standard or average risk guidelines. An individual can be rated as substandard for many reasons, including poor health, a dangerous occupation, or attributes and habits that could be hazardous. Some substandard applicants are rejected outright, while others are accepted for coverage with an increase in their policy premium.

UNFAIR DISCRIMINATION

An insurer is not permitted to engage in any unfair discrimination regarding applicants for life insurance. Sexual orientation, religious preference, or geographical location are prohibited life insurance underwriting factors because they’re unfairly discriminatory.

POLICY ISSUE AND DELIVERY

POLICY EFFECTIVE DATE

In any life insurance sale, an essential question is, “when does the policy become effective?” The effective date is important for two reasons—not only does it identify when the coverage is effective, but it also establishes the date by which future annual premiums must be paid. Let’s assume that a receipt (either conditional or binding) is issued in exchange for the initial premium payment. In this case, the receipt’s date will generally be noted as the policy effective date in the contract. If a premium deposit is not given with the application, the policy effective date is typically left to the insurer’s discretion. Often, it will be the date that the insurance company issues the policy. However, the policy will not be truly effective until it’s delivered to the applicant, the first premium is paid, and a Statement of Continued Good Health is obtained.

BACKDATING

Keep in mind, the premiums required to support a life insurance policy are determined, in part, by the insured’s age. If the insurance company can treat an applicant as being a year younger, the result can be a lifetime of slightly lower premiums. The purpose of backdating a life insurance policy is to use premiums based on an earlier age. Therefore, it’s understandable that applicants may want to backdate a policy and make it effective earlier than the present.

Many insurers are willing to let an applicant backdate (or “save age”) a policy. However, some conditions must be met before this step can be taken. First of all, the insurer must allow backdating. Second, the company will typically impose a time limit on how far back a policy can be backdated (generally six months). More importantly, the next premium is due at the backdated anniversary date.

After the underwriting is complete and the policy is issued, the insurance contract is sent to the sales agent for delivery to the applicant. The policy is not typically sent directly to the policy owner since, as an important legal document, it should be explained to the policy owner by the agent who’s delivering the policy. The agent must also secure a signed document from the policy owner identifying the date on which the policy was delivered. The free-look period commences on the date of delivery.

CONSTRUCTIVE DELIVERY

By law, the approved policy must be delivered to the policy owner. However, this doesn’t mean that the policy must be in the physical hands of the policy owner to be considered “delivered.” When the insurer gives the policy to the agent for delivery to the policy owner, this is considered to be “constructive delivery.”

Mailing the policy to the agent for unconditional delivery to the policy owner also constitutes constructive delivery, even if the agent never personally delivers the policy. On the other hand, if the company instructs the agent to not deliver the policy unless the applicant is in good health, there’s no constructive delivery.

A client merely being in possession of a policy doesn’t actually establish delivery if all conditions have not been met. For example, a policy may be left with an applicant for inspection in a case where an initial premium has not been paid. An inspection receipt may be obtained to indicate that the policy is neither in force during the inspection period nor will it be in force until the initial premium has been paid.

EXPLAINING THE POLICY AND RATINGS TO CLIENTS

Most applicants will not remember all of the essential details about their policies after they have signed the application. This is another reason that agents should deliver policies in person. Only by personally delivering a policy does the agent have a timely opportunity to review the contract, along with its provisions, exclusions, and riders. In fact, some states (and most insurers) insist that policies be delivered in person for this very reason. The agent’s review is incredibly useful to reinforce the sale and to prevent a potential lapse. It can also lead to future sales by building the client’s trust and confidence in the agent’s abilities. Explaining the policy and how it meets the policy owner’s specific objectives helps avert misunderstandings, policy returns, and potential lapses.

In some cases, agents may have a chance to prepare applicants in advance when it appears that their policies may be rated-up as substandard, which generally requires an extra premium. Occasionally, both the agent and policy owner may be surprised when the policy is issued at an increased premium rate. In either case, the agent should stress that the insured has an even greater need for insurance protection because of the impairment or condition that resulted in the higher premium. It may be the policy owner’s last chance to purchase such coverage because of a worsening condition that could render the insured uninsurable in the future.

OBTAINING A STATEMENT OF INSURED'S CONTINUED GOOD HEALTH

It’s possible that the initial premium will not be paid until the agent delivers the policy. In such cases, common company practice requires that, before delivering the policy, the agent must collect the insured’s premium and obtain a signed statement attesting to the insured’s continued good health.

The agent will then submit the premium with the signed statement to the insurance company. Since there can be no contract until the premium is paid, the company has a right to determine whether the proposed insured has remained in reasonably good health from the time that the applicant/policy owner signed the application until she received the policy. In other words, the company has the right to know if the policy owner represents the same risk to the company as when the application was first signed.

CHAPTER SUMMARY: LIFE INSURANCE UNDERWRITING AND POLICY ISSUE

Key points to remember from this chapter include:

▪ Adverse selection is the underwriting concept that involves the tendency of higher risks to seek insurance coverage.

▪ In life insurance contracts, an insurable interest must exist only at the time of policy inception.

▪ The law of large numbers is a mathematical law of probability which states that the larger the number of occurrences, the more predictable losses will be.

▪ A field underwriter or producer may solicit appointments, complete applications, collect premiums, and submit applications to the home office underwriter, but it doesn’t issue the policy.

▪ The applicant is the person who’s requesting the insurance and completes the application (and later becomes the policy owner).

▪ The proposed insured is the person who’s requesting to be insured.

▪ The policy owner is the person who, if the application is approved, will retain all of the ownership rights and options of the policy.

▪ The underwriter is the person who reviews the application for insurance.

▪ A non-medical application requires no additional information other than the application.

▪ The three essential parts to a typical life insurance application are:

‒ Part I of the application includes general questions about the proposed insured, including name, age, address, birth date, sex, income, marital status, and occupation.

‒ Part II focuses on the proposed insured’s health and includes several questions about the health history of the family.

‒ Part III includes additional information about the applicant’s financial condition and character, the background and purpose of the sale, and how long the agent has known the applicant.

▪ Incomplete applications are to be returned to the agent.

▪ Representations are statements that an applicant makes as being substantially true to the best of her knowledge and belief.

▪ Warranties are statements that are guaranteed to be true.

▪ Life insurance applications must be signed by all parties involved (i.e., the insured, policy owner, and the agent).

▪ For life insurance contracts, any person who’s under the age of 15 is considered a minor.

▪ The applicant must initial any changes that are made to a contract.

▪ The date that appears on a conditional receipt always reflects a date that’s earlier than the issue date of the policy.

▪ Under a binding receipt, coverage is guaranteed until the insurer formally rejects the application.

▪ The Medical Information Bureau (MIB) is a clearinghouse of health information that’s supplied by insurers from information on insurance applications.

▪ The purpose of the USA PATRIOT Act is to detect and deter terrorism.

▪ Insurance companies obtain inspection reports for life and health insurance contracts with high benefit amounts.

▪ The three different risk classifications are:

1. Preferred risk

2. Standard risk

3. Substandard risk

▪ Agents must provide all life insurance applicants with a life insurance Buyer’s Guide and a policy summary.

▪ The purpose of backdating a life insurance policy is to use premiums based on an earlier age.

▪ Policy delivery may be accomplished without physically delivering the policy into the policy owner’s possession.

Chapter 8

KEYWORDS: GROUP LIFE INSURANCE

Prior to reading this chapter, please review the following keywords. An understanding of their basic definitions will improve your comprehension of the chapter content.

Blanket Health Policies: These policies are issued to cover a group that may be exposed to the same risks, but the composition of the group (i.e., the individuals within the group) are continually changing. A blanket health plan may be issued to an airline or a bus company to cover its passengers or to a school to cover its students. As compared to group insurance, no certificates of coverage are issued in a blanket health plan.

Certificate of Insurance: This is a document that’s issued by an insurance company/broker and used to verify the existence of insurance coverage granted to individuals under specific conditions. With group insurance, the group (typically the employer) is the policy owner and maintains a master policy. The insureds (typically the employees) receive a certificate of insurance rather than a policy.

Contributory Plan: This is a group insurance plan that’s issued to an employer under which both the employer and employees contribute to the cost of the plan. Generally, 75% of the eligible employees must be insured in most states. The employees must contribute to the cost of the plan.

Conversion Privilege: Before an original insurance policy expires, this privilege allows a policy owner to elect to have a new policy issued which will continue the insurance coverage. Conversion may be effected at attained age (premiums based on the age attained at the time of conversion) or at original age (premiums based on the age of the insured at the time of original issue). Conversion is a common privilege for term life insurance and all group insurance. The insured is not required to prove insurability (good health) when converting a policy.

Credit Policies: These policies are designed to help the insured pay off a loan in the event she’s disabled due to an accident or sickness, or she dies. If the insured becomes disabled, the policy provides for monthly benefit payments that are equal to the monthly loan payments due. If the insured dies, the policy will pay a lump-sum to the creditor to pay off the loan. Credit policies typically cannot exceed the amount of the loan since that’s the limit of the creditor’s insurable interest in the insured(s).

Franchise Insurance: This is a life or health insurance plan for covering groups of persons with individual policies that are uniform in provisions, but perhaps different in benefits. Solicitation typically takes place in an employer’s business with the employer’s consent. Franchise insurance is generally written for groups that are too small to qualify for regular group coverage. This policy may be referred to as wholesale insurance when the policy is life insurance.

Master Policy: This policy is issued to the employer under a group plan and contains all of the insuring clauses which define employee benefits. Individual employees who participate in the group plan receive individual certificates that outline the highlights of the coverage.

Non-Contributory Plan: This is an employee benefit plan under which the employer bears the full cost of the employees’ benefits. In most states, the plan must cover 100% of eligible employees. The employees do NOT contribute to the cost of the plan.

Persistency: As it pertains to insurance, persistency is the percentage of policies that an insurer has in force after a specified period. Persistency is negatively impacted by policies that are replaced by other insurers, that are canceled by the policy owner, or that lapse due to non-payment. Companies with higher persistency are more stable and profitable than those with lower persistency. In general, companies aim for 80% persistency after three-years, and 60% persistency after five years. This means that 60% of the policies that were written five years ago should still be active.

INTRODUCTION

Group life insurance covers a group of people under a single policy contract. Group life insurance is most often comprised of annual renewable term life insurance and is typically offered by a large association or entity for its workers. Depending on the type of policy, the workers may contribute to the cost of the policy through weekly or monthly paycheck deductions (premium payments). Group life insurance policies contain many features and conditions that are different from those that are covered in an individual life insurance policy.

This chapter will introduce the basic concept of group life insurance, terms, and conditions of group life insurance, eligibility, types, and features. We’ll also examine the process of underwriting group insurance and the many advantages of group life insurance.

The chapter is broken into the following sections:

• Principles and Characteristics of Group Life Insurance

• Underwriting Requirements for Group Life Insurance

• Other Forms of Group Life Insurance

• Taxation of Group Life Insurance Plans

The state-specific portion of this course (located at the end) will detail the specific insurance definitions, rules, regulations, and statutes for your state. If a conflict exists, state law will supersede the general content.

Review of this chapter will enable a person to:

• Differentiate between individual and group life insurance contracts

• Understand the underwriting process of group life insurance contracts

• Determine who’s eligible under a group life insurance contract

• List the features of group insurance contracts

• Understand the difference between contributory and non-contributory group plans

• Determine the eligibility of employee group members

• Understand the concepts of adverse selection and the law of large numbers

• Understand the conversion privilege under group life policies

• Understand the rating classification system that’s used in life insurance contracts

• Provide examples of different types of risks

• Determine which risks are insurable or declined

• Understand taxation of group life insurance plans

· PRINCIPLES AND CHARACTERISTICS OF GROUP LIFE INSURANCE

· Group insurance is a way to provide life insurance, health insurance, or both kinds of coverage for a number of people under one contract. Typically, group insurance is provided by an employer for its employees; however, it’s also available to other kinds of groups. As opposed to individual life insurance (which is written on a single life), group life insurance is written on more than one life. Group life insurance is typically written for employee-employer groups and is most often written as an annually renewable term policy.

· Group life insurance differs from individual life insurance contracts in several ways. One of the differences between the two is that group insurance is most often comprised of annual renewable term life insurance. In contrast, individual insurance contracts may be either term life or whole life insurance. Underwriting is handled differently, and varying types of policy provisions appear in a group life policy. Group term life insurance, as with all insurance contracts that were previously mentioned, is a two-party contract between the policy holder and the insurer (identical to an individual contract). However, unlike an individual insurance policy, the insured is almost never the policy owner of group life insurance. Instead, the employer is generally the policy owner.

· The employer or group that provides the group life coverage pays all or a portion of the premium and is the policy owner. The employer or plan sponsor receives the master policy/contract. In contrast, the covered employees or plan participants receive a certificate of coverage or a booklet which describes the benefits, the coverage provided, and how long the insurance coverage will last. The covered employee or plan participant is also referred to as the certificate holder. Types of groups that are eligible include employees of a single employer, credit groups, labor unions, and multiple employer groups.

· EMPLOYER RESPONSIBILITIES

· The employer is responsible for the selection of group coverages, recordkeeping, and employee enrollment. The employer is not permitted to discriminate, especially when the plan is non-contributory.

GROUP INSURANCE VERSUS INDIVIDUAL INSURANCE

Features that separate group insurance from individual insurance include:

1. Underwriting

   • In an individual policy, the insured must prove that he’s insurable.

   • In group insurance, the group must meet various criteria, but the insureds are not individually underwritten.

2. Policy Ownership

   • With individual insurance, the insured is traditionally also the policy owner. In instances of third party ownership, the policy owner and the insured are different parties (e.g., husband covering wife, wife covering husband, parent covering child, etc.)

   • With group insurance, the insured is rarely the policy owner. There’s one master policy that’s owned by the employer or plan sponsor.

‒ The employer or plan sponsor receives the master policy and, as such, is the policy owner or contract holder.

‒ Employees or plan participants receive the certificates of insurance (not individual policies), and as such, are certificate holders.

1. Policy Type

   • Group life insurance is always considered temporary insurance. Annually, renewable term is typically used, which provides a fixed amount of coverage throughout the contract.

   • Individual insurance can be any of the previously discussed temporary or permanent insurance products.

   • Whenever a person converts his group insurance to individual insurance, he’s always converting temporary protection to permanent protection.

2. Cost

   • Individual insurance policies are considerably more expensive for the insurer to issue (underwrite, commission, billing, maintenance, etc.). As described previously, these administrative costs are passed on to the customer, thereby making individual policies more expensive to purchase.

   • Group insurance policies are substantially less expensive for the insurer to underwrite, issue, and maintain. As such, group insurance is much cheaper for the customer to purchase.

   • In some cases, the employer or sponsor may pay a substantial portion or all of the premium cost for the group insurance policy. With individual insurance, the customer (policy owner) is always responsible for all of the premium cost.

[EXAM TIP: Since the individual doesn’t own or control the policy, he’s issued a certificate of insurance (often referred to as the certificate of coverage and benefits) to serve as evidence of an employee’s coverage. The actual policy, which is referred to as the master policy, is issued to the employer and the employer becomes the policy owner.]

CONTRIBUTORY AND NON-CONTRIBUTORY PLANS

Non-Contributory Plan

With this plan, the employer pays the entire cost of the plan. The insurance company requires that 100% of all eligible employees participate. The most significant benefit of a non-contributory insurance plan is that it helps the insurer avoid adverse selection.

With a non-contributory group insurance plan, the employees or plan participants do NOT contribute to the premium payments.

Contributory Plan

With this form of employee group insurance plan, the employees share the cost. The insurance company requires that at least 75% of all eligible employees chose to be covered/participate. For example, if a company has 1,000 eligible employees, at least 750 of them must choose to be covered. If not, the insurer will not write the policy.

With a contributory group insurance plan, the employees or plan participants contribute to the premium payments.

ELIGIBLE GROUPS

People cannot form a group for the sole purpose of securing group insurance coverage. The securing of such coverage must be incidental to the group’s formation. In other words, a group of people cannot form an organization whose primary purpose is to secure insurance coverage for the group.

Businesses are operated in order to produce a product or provide a service and earn a profit; therefore, they’re eligible to purchase group insurance. A group of persons who are engaged in occupations of a common industry may form an association (e.g., all hat manufacturers) and then later purchase group coverage.

Remember, for groups to offer group insurance, the primary requirement is that the group is formed for a purpose other than acquiring insurance. Offering group insurance products should be a benefit of the group, not the purpose of the group. States may impose additional requirements. For example, states may require the group to have existed for more than two years or have a minimum of two members.

Although there’s generally an employment or professional relationship present in order for group coverage to be secured, this is not always the case. Examples of some of the groups that are eligible to participate in group insurance include:

• Single employee groups (employer)

• Multiple employee groups (employment-related)

• Labor unions

• Trade associations

• Credit/debit groups

• Fraternal organizations

• Customer groups (e.g., credit union members)

• Trustee groups (established by two or more employers or labor unions)

ELIGIBILITY OF GROUP MEMBERS (EMPLOYEES)

• An employee must be full time and actively working.

• If the plan is contributory, employees must approve of automatic payroll deduction.

• The new employee probationary period is typically one to six months.

• During the enrollment period, an employee has 31 days to sign up. Otherwise, she may need to provide evidence of insurability.

· UNDERWRITING REQUIREMENTS FOR GROUP LIFE INSURANCE

· Sound group underwriting can be profitable to an insurer, since it primarily reduces adverse selection. Adverse selection or anti-selection is the tendency or danger of an insurer to write (i.e., approve) more bad risks than acceptable risks. People with more significant risk tend to seek insurance coverage more often than those with little risk. Since more individuals are covered under group policies, there’s a higher probability that a “bad” risk will be included. However, the insurer may continue to earn a profit if the acceptable risks far outweigh the bad. This offset of high versus low risk is what an insurer is depending on when it writes group life coverage. Writing large groups of individuals also helps to reduce adverse selection based on the law of large numbers.

· Proof of insurability may not be required of larger groups, but insurers may require some type of insurability for smaller groups. As explained previously, the smaller the group, the greater the potential for adverse selection.

· For example, if an insurer writes a group life insurance policy for 500 employees, the law of large numbers indicates that some of those employees will be of high risk, some will be low risk, but the majority should be of standard risk. Throughout the year, the insurance company will hardly notice if it needs to pay out one or two death claims out of the group of 500 insureds. However, if the insurer writes a group life insurance policy for 10 insureds, the law of large numbers no longer applies and the risk is far less predictable. Paying out one or two death claims out of the group of 10 insureds could have a significant impact.

· Group life plans will not exclude employees who have a physical impairment (e.g., paralysis) from the group life plan.

· Underwriters take policy persistency into account. As it pertains to insurance, persistency is the percentage of active policies in force, without them lapsing or being replaced by policies of other insurers. Insurers may measure policy persistency in various periods, such as one year, three years, or five years from policy issue. Due to the expenses involved in acquiring and issuing a new policy, persistency can be a vital factor in the stability and success of an insurer. The insurer may avoid groups that change insurers regularly because it may believe that writing such groups doesn’t represent an acceptable risk.

CLASSIFICATION OF RISK

In order to minimize adverse selection, insurers require a minimum number of group members/employees to participate in a group insurance plan. After all of the necessary information is collected on an applicant, the underwriter will classify the applicant based on the degree of risk assumed.

The following rating classification system is used to categorize the favorability of a given risk:

• Preferred: Low risk and lower premiums

• Standard: Average risk, with no extra ratings or restrictions

• Substandard: High risk (rated up) with higher premiums

  • Declined: Not insurable since the potential of loss to the insurance company is too high

[EXAM TIP: Lower risks tend to have lower premiums. If an applicant is too risky, the insurer will decline coverage.]

ADDITIONAL FEATURES OF GROUP TERM LIFE INSURANCE

Conversion to Individual Policy

All group policies contain a conversion privilege which gives a covered employee the option of converting his group term life coverage to his own individual plan upon termination from the company. Termination of employment includes an employee who’s laid-off or who leaves a job voluntarily. In most cases, when an employee leaves an employer, he may take advantage of the conversion privilege. However, most insurers only allow the terminated employee to convert the group coverage to an individual whole life policy.

Conversion Period

The period during which the terminated employee may convert to an individual plan of insurance without proof of insurability is within 31 days after termination. If death occurs during the conversion period (31 days after termination), even if the employee doesn’t intend on converting to an individual policy, the death claim will be paid by the group policy. An individual is covered under the group policy during the conversion period.

No medical exam or other proof of insurability is required to convert coverage to an individual policy. In other words, an insured employee may exercise the conversion privilege regardless of his insurability.

If a member’s coverage is terminated, the member and his dependents may convert their group coverage to individual permanent (whole life) coverage without being required to show proof of insurability. If conversion occurs, the premium is based on the insured’s (employee’s/dependent’s) current or attained age.

Group Policy Termination

If the master policy is terminated, each individual member who has been insured for at least five years is permitted to convert to an individual policy which will provide coverage up to the face value of the group policy.

Incident of Ownership – Beneficiary Selection

Although the employer is the contract owner in a group life policy, it retains all of the rights of ownership with the exception of the right to name or change the beneficiary. Therefore, the covered employee or “certificate holder” possesses an “incident of ownership” in the group plan. In other words, it’s the “certificate holder” (insured employee) who names the beneficiary, not the policy owner (employer). The employee may name the employer as a beneficiary of the group life policy, but only if the employer has an insurable interest in the employee.

For example, an employer may have an insurable interest in a key executive who has 20 years of experience. However, the employer is not likely to have an insurable interest in a part-time clerk.

In recent years, based on modifications of state laws, many insurers have been permitted to include an assignment provision in group life policies. Of course, any assignment must be in writing and must be filed with the insurer.

OTHER FORMS OF GROUP LIFE INSURANCE

The following are different types of life insurance that are issued as group plans.

GROUP CREDIT LIFE INSURANCE

Group credit life policies are established by organizations (e.g., banks and finance companies) and stipulate that, if the insured dies before a loan is repaid, the policy benefits will be used to settle the loan balance. Premiums for group credit life insurance are based on claims experience and expense factors, not necessarily the borrower’s age. The premiums are typically paid by the insured. A decreasing term policy is commonly used.

BLANKET LIFE INSURANCE

Blanket life insurance covers groups of individuals who are exposed to the same hazard. For example, passengers on an airplane or students and faculty of schools. No one person is named on the policy, and certificates of coverage are not given out. Individuals are only covered for the specified common hazard.

LIFE INSURANCE FOR MEMBERS OF THE ARMED FORCES AND FEDERAL EMPLOYEES

The federal government provides life insurance coverage for those in the armed services and other federal employees.

Servicemembers’ Group Life Insurance (SGLI)

SGLI is provided up to $400,000 (in $50,000 increments) for full-time members of the armed services. The coverage provided is group term life insurance and all active servicemembers are covered unless they choose otherwise.

Family Servicemembers’ Group Life Insurance Coverage (FSGLI)

FSGLI is a component of the Servicemembers’ Group Life Insurance program. FSGLI provides coverage for spouses and children of servicemembers who are insured under SGLI. Non-military spouses are covered automatically for $100,000 or the amount of the member’s coverage, whichever is less. Premiums for spousal coverage are based on the spouse’s age and the amount of coverage. Dependent children are covered for $10,000 each at no cost to the member.

Veterans’ Group Life Insurance (VGLI)

VGLI provides for the conversion of Servicemembers’ Group Life Insurance coverage to a renewable term policy of insurance protection after a servicemember’s separation from service.

Servicemembers and their spouse may be able to convert their SGLI or VGLI to permanent insurance through a commercial insurer without proving insurability.

Federal Employees Group Life Insurance (FEGLI)

FEGLI provides group term life insurance for all other federal employees or civil service workers.

TAXATION OF GROUP LIFE INSURANCE PLANS

For a group life insurance plan to receive favorable tax treatment, there are specific requirements. These requirements ensure that the average employee is not discriminated against in favor of higher-level employees.

Proceeds For Group Life Insurance

Proceeds from a group life policy are tax-free if they’re taken in a lump-sum. Proceeds taken in installments will be subject to taxes on the interest portion of the installments.

Retired Lives Reserve and Qualified Plans

Retired Lives Reserve (RLR) is a group life insurance product with the objective of providing continuing life insurance protection beyond retirement. RLR provides annual renewable term insurance and a reserve account that accumulates funds before retirement, which will be used to pay premiums on the term insurance after a person’s retirement. Under this plan, an employer can make a tax-deductible contribution to the fund (i.e., reserve account) on behalf of employees, and the contributions are not tax-deductible to employees. A life insurance company or trust can administer this fund or reserve account.

A qualified retirement plan may purchase life insurance to provide death benefits under very limited circumstances. The plan document must authorize such a purchase, but the decision to buy a policy may be made by either the plan administrator (employer) or the participant. In a defined contribution plan, the policy is part of the participant’s account; however, in a defined benefit plan, the death benefit is part of the definite determinable benefit provided to the participant by the plan. Most importantly, the purchase of life insurance must be incidental to the primary purpose of providing retirement benefits under the plan.

CHAPTER SUMMARY: GROUP LIFE INSURANCE

Key points to remember from this chapter include:

• Group insurance provides both life and health insurance policies.

• Group insurance is comprised of annual renewable term life insurance.

• Group insurance is a two-party contract and is usually between an employer and an employee.

• Employees are referred to as certificate holders.

• Employers are referred to as contract holders.

• In group life insurance, individuals are NOT required to provide evidence of insurability.

• In a non-contributory plan, the employer pays the entire cost.

• In a contributory plan, the employees share the cost with the employer.

• People cannot form a group for the sole purpose of securing group insurance coverage.

• For new employees, the probationary period is one to six months.

• For group life insurance, the enrollment period is 31 days.

• Under a group life policy, individuals are offered a conversion privilege upon their employment termination.

• The conversion period is valid for 31 days after the group coverage termination date.

• A group life insurance uses the following rating classification system to categorize risks:

‒ Preferred risk is a low risk that offers lower premiums.

‒ Standard risk is an average risk with no extra ratings or restrictions.

‒ Substandard risk is high risk (rated up) that has higher premiums.

‒ Declined means not insurable because the potential of loss to the insurance company is too high.

• Group Credit Life Insurance is set-up by banks and finance companies to pay off a creditor’s outstanding debts.

Group versus Individual Insurance

GROUP

INDIVIDUAL

One master policy is issued to the group

Each covered person possesses her own policy

Covered members have the same benefits/coverages

Each person selects her benefits /coverages

Only eligible group members can apply

Any individual can apply

Group underwriting

Individual underwriting

Coverage ceases when the member leaves the group

Coverage continues as long as the premium is paid

Less expensive with few restrictions

More expensive with more restrictions

The essentials of group versus individual forms of insurance apply to life and health insurance.

Chapter 9

KEYWORDS: ANNUITIES

Prior to reading this chapter, please review the following keywords. An understanding of their basic definitions will improve your comprehension of the chapter content.

403(b) Plan: As defined in Section 403(b) of the IRS tax code, this is a retirement plan for certain employees of public schools, employees of specific tax-exempt organizations, and certain ministers.

1035 Contract Exchange: This provision states that if an annuity is exchanged for another annuity, a “gain” (for tax purposes) is not realized. This is also true if a life insurance policy or endowment contract is exchanged for an annuity. However, an annuity cannot be exchanged for a life insurance policy. This provision in the tax code allows a policy holder to transfer funds from a life insurance, endowment, or annuity to a new annuity policy without being required to pay taxes.

Accumulation Period: During this period, the premiums that an annuitant pays into an annuity are credited as accumulation units. The accumulation period may continue during the period between when the premium payments have ceased, and the payout has not yet begun. At the end of the accumulation period, accumulation units are converted to annuity units.

Accumulation Units: These units represent the value of contributions that are made by the annuitant LESS a deduction for expenses. The value of each accumulation unit is a credit to the individual’s account and varies depending on the value of the underlying stock investment.

Annuitant: This is one to whom an annuity is payable or a person upon whose continued life future payments are dependent.

Annuity Units: These units are used to make payments to the annuitant. Annuity units are received once the accumulation units are converted to begin the pay-out period. At the time of the initial payout, the annuity unit calculation is made and, from then on, the number of annuity units will remain the same for the life of the contract.

Cash Refund Option: Upon the death of an annuitant, this option provides that, before payments totaling the purchase price have been made, the excess of the amount paid by the purchaser over the total annuity payments received will be paid in one lump-sum to designated beneficiaries.

Deferred Annuity: These annuities provide for the postponement of the payment of an annuity until after a specified period or until the annuitant attains a specified age. A deferred annuity may be purchased on either a single-premium or flexible premium basis. Deferred annuities typically don’t begin making income payments for at least one year after the date of purchase.

Equity Indexed Annuity (EIA): This is a fixed deferred annuity that offers the traditional guaranteed minimum interest rate as well as an excess interest feature that’s based on the performance of an external equities market index.

Exclusion Ratio: This is a fraction which is used to determine the amount of annual annuity income that’s exempt from federal income tax. The exclusion ratio is calculated by taking the total contribution or investment in the annuity divided by the expected ratio.

Fixed Annuity: This is an annuity that provides a guaranteed rate of return. The interest payable for any given year is declared in advance by the insurer and is guaranteed to be no less than a minimum that’s specified in the contract. With fixed annuities, the investment risk is assumed by the insurer.

Immediate Annuity: This type of annuity can only be purchased with a single payment and typically begins paying income within one month of purchase.

Joint Life and Survivor Option: This annuity payout option provides for payments to two people. If either person dies, the income payments continue to the survivor for life. When the surviving annuitant dies, no further payments are made to any person. A full survivor option pays the same (i.e., full) benefit amount to the survivor. A two-thirds survivor option pays two-thirds of the original joint benefit to the survivor. A one-half survivor option pays one-half of the original joint benefit to the survivor.

Life with Period Certain (or Life Income with Term-Certain) Option: This payout option is designed to pay the annuitant an income for life, but guarantees a definite minimum period of payments. Therefore, if the annuitant dies during the specified period, benefit payments will continue to the beneficiary for the remainder of that period.

Market Value Adjustment: This adjustment can be attached to a deferred annuity and features fixed interest rate guarantees combined with an interest rate adjustment factor that can cause the actual crediting rates to increase or decrease in response to market conditions. Rather than having the annuity’s interest rate linked to an index (as with the equity-indexed annuity), an MVA annuity’s interest rate is guaranteed to be fixed if the contract is held for the period that’s specified in the policy. The market-value adjustment feature applies only if the contract is surrendered before the contract period expires. If it’s not surrendered, the annuity functions in the same manner as a fixed annuity.

Period Certain Annuity: This is an annuity income option that guarantees a definite minimum period of payments (e.g., 10 years).

Periodic Payment Annuity (Flexible Premium): This refers to an annuity owner making multiple premium payments to accumulate principal. Typically, after the initial premium, these payments are flexible in regard to both frequency and amount.

Principal: This is the original sum of money that’s paid into an annuity through premium(s).

Single Premium Annuity: This is an annuity for which the entire premium is paid in one lump-sum at the beginning of the contract period. This can be a deferred or immediate single premium annuity.

Straight Life Annuity: This is an annuity income option that pays a guaranteed income for the annuitant’s lifetime, but payments cease upon the annuitant’s death.

Variable Annuity: This annuity shifts the investment risk from the insurer to the contract owner. Variable annuities are similar to a traditional, fixed annuity in that retirement payments will be made periodically to the annuitants, usually over the remaining years of their lives. However, with the variable annuity, there’s no guarantee of the dollar amount of the payments. The payments actually fluctuate according to the value of the securities in the account (primarily the value of common stocks). A variable annuity invests deferred annuity payments in an insurer’s separate account rather than the insurer’s general account (which allows the insurer to guarantee interest in a fixed annuity). Since variable annuities are based on non-guaranteed equity investments (e.g., common stock), a sales representative who wants to sell these contracts must be registered with the Financial Industry Regulatory Authority (FINRA) and must hold a state insurance license.

INTRODUCTION

An annuity is a series of periodic benefits or payments that are made to an annuitant and is considered an insurance contract between a contract owner and insurer. The contract owner funds the contracts, while the insurer (at some future date) promises to pay a series of periodic payments for either a fixed period or for the remainder of the annuitant’s life. The state insurance departments regulate traditional, fixed annuity products. Like variable life insurance, variable annuities are regulated at the state level, by the department of insurance, and at the federal level, through the Securities Exchange Commission (SEC), and the Financial Industry Regulatory Authority. This chapter will focus on a description of the various classifications of the annuity product.

This chapter is broken into the following sections:

• Purpose and Function

• Classification Based on Premium Payments

• Classification Based on When Benefits Begin

• Classification Based on Source of Income

• Classification Based on Disposition of Proceeds (Annuity Payment/Settlement Options)

• Classification Based on the Number of Lives Covered

• Additional Annuity Characteristics and Aspects

• New Types of Annuities

• Uses of Annuities

• Suitability in Annuity Investments

• Annuities and Taxation

The state-specific portion of this course (located at the end) will detail the specific insurance definitions, rules, regulations, and statutes for your state. If a conflict exists, state law will supersede the general content.

Review of this chapter will enable a person to:

• Understand the concept and structure of an annuity

• Differentiate between an annuity contract and a life insurance contract

• Differentiate between a fixed annuity and a variable annuity

• Understand how an annuity is funded

• Understand how annuities are taxed

• Differentiate between the different types of annuities based on their payment options

• Be familiar with the many uses of annuities

• Be familiar with the standards and procedures for recommendations that are made to senior consumers relating to annuities

· PURPOSE AND FUNCTION

· An annuity is a product which is only sold by a life insurance company and designed to protect an individual against outliving her income. Primarily, an annuity is a savings-type vehicle that’s used to set aside funds for the future. An annuity can be defined as the liquidation of an estate. This definition is the opposite of life insurance, which involves the immediate creation of an estate. Policy issuance and pricing of both term and whole life insurance is based, in part, on a mortality risk (i.e., mortality factor). However, an annuity is generally an investment product and does not require proof of insurability. The payment made to fund an annuity can be referred to as either a contribution or premium. If an annuity contract owner dies before income commences, there’s a payment made to a beneficiary. This payment is limited to the amount paid into the contract plus any interest credited.

· The essential function of an annuity is the systematic reimbursement or liquidation of funds (i.e., savings) for a specified period or for life. Therefore, an annuity is a systematic approach to liquidating an estate (i.e., funds). An individual deposits or makes contributions to an annuity during the annuity’s pay-in or accumulation period. During this phase, the individual is also referred to the policy or contract owner. The policy owner possesses contractual rights in the annuity contract when the contract is purchased.

· The annuity period begins once the contract owner starts receiving income. As soon as the insurer makes the first periodic payment, the contract owner is now referred to as the annuitant. Therefore, the annuitant is the person who receives monthly income from the annuity contract. The owner must also designate a beneficiary who will have access to the accumulated funds if the contract owner dies. Unlike the funds paid to beneficiaries of term or whole life insurance policies, this amount is not actually a death benefit since it only includes the amount contributed and accumulated due to any interest that’s credited. This indicates that an annuity possesses an insurance aspect. During the accumulation phase, the principal grows at interest. In fact, the interest that’s earned as the principal grows is tax-deferred. When a periodic payment is received at some point in the future, it’s considered to represent a combination of principal plus interest. Therefore, an annuity contract provides peace of mind to those who are concerned with receiving income for life.

·

· For tax purposes, annuities are classified as either qualified or non-qualified. With a non-qualified annuity, the contributions are made in after-tax dollars. The contract owner receives the tax deferral of interest and growth earned, but there’s no tax deduction of premiums (or yearly tax savings through a salary reduction). Annuities that are purchased outside of qualified pension plans don’t receive tax-favored treatment of premium payments. In other words, premiums are not tax-deductible. Non-qualified annuities may be purchased by any individual or entity, but again, the premium payments or contributions are not tax-deductible.

· A qualified annuity is one that’s purchased as part of a tax-qualified retirement plan. If the premium paid for a qualified annuity is in the form of a contribution by an employer to a qualified retirement plan, the premium is tax-deductible. Some qualified annuities also permit employees to fund the plan through a salary reduction (e.g., a tax-sheltered annuity or TSA). In this case, the plan is funded with pre-tax dollars, which lowers the employee’s yearly taxable income. An important note is that, regardless of whether the annuity is qualified or non-qualified, accumulations (i.e., interest earned) are tax-deferred.

· A significant reason for a person to purchase an annuity is to provide income at retirement. An annuity does this by guaranteeing income to the recipient. As examined later, an annuity protects an individual against outliving her income. Only a life insurer can guarantee income for the life of an annuitant. An annuity is attractive to investors since insurers generally pay higher interest rates than other traditional savings vehicles (e.g., certificates of deposit or money market funds). If a contract owner withdraws funds prior to a stated period, withdrawal penalties may be assessed. However, if the contract owner dies or becomes disabled, funds may be withdrawn without penalty.

The parties involved in an annuity contract include the insurer, the contract owner, the annuitant, and the beneficiary. The contract owner has the right to name a beneficiary who will have access to the funds in the event of the owner’s death prior to annuitization (i.e., the annuity or pay-out phase). An annuity possesses some insurance aspects in that a mortality factor is used to determine periodic payments, but it’s not the same mortality factor that’s used in term or whole life insurance. In addition, as described previously, a beneficiary must be named in the event that the contract owner dies prior to the annuity phase. If no beneficiary is listed on an annuity contract and the owner dies before annuitization (payout), the proceeds are paid to the owner’s estate.

Annuities can be classified in several categories, including:

(1) based on how the premiums are paid,

(2) based on when benefits begin,

(3) based on the source of income,

(4) based on the disposition of proceeds, and

(5) based on the number of lives covered.

CLASSIFICATION BASED ON PREMIUM PAYMENTS

ANNUITY PREMIUMS

Annuities possess their own mortality tables, which are different from those used for life insurance. Items that are taken into consideration include the interest rate paid, the amount of total contributions or accumulations, and the settlement option selected. An annuitant’s occupation or hobbies don’t influence an annuity since they will not affect the liquidation of funds. Annuities may be funded with either a single premium or periodic premiums. There are two classifications of periodic premium plans.

Single Premium Annuities

Single premium annuities are characterized by a lump-sum (single) premium payment. In other words, the annuity is entirely funded with one premium payment. Monthly income payments that are made to the annuitant may begin immediately (i.e., 30 days following the single premium) or may begin at some point in the future (i.e., deferred). When an annuity is funded with a single, lump-sum payment, the principal is created immediately. Generally, this type of annuity doesn’t permit the contract holder to make any additional deposits into the contract. This means that the contract is fully funded with one lump-sum payment.

Periodic Premium Annuities

Periodic premium annuities are characterized by multiple premium payments over a set period of time. Periodic premium annuities are broken into two classifications, level premium and flexible premium.

• A level premium annuity is characterized by level or constant annual payments to fund the annuity. For example, a 35-year-old purchases a level premium annuity with an annual premium of $1,200. The contract owner will pay that level amount each year until retirement at age 65. At that time, he will begin to receive monthly income payments. This type of annuity is also referred to as an annual premium annuity.

• A flexible premium annuity is characterized by periodic premiums that may be in variable amounts each year. In this case, the contract owner will contribute an amount with which he’s comfortable each year. These premiums are paid until the contract owner wants to begin receiving income after retirement. As long as a minimum payment is made, the contract owner is permitted to determine the amount he can afford to contribute each year. The future income benefit will be based on the total amount of funds saved once the plan is annuitized (i.e., when income payments begin).

· CLASSIFICATION ACCORDING TO WHEN BENEFITS BEGIN

· Annuities may be described according to when the payout or distribution phase commences. In other words, they may be characterized as either immediate or deferred annuities.

· IMMEDIATE ANNUITY

· This class of annuity is designed to generate an income stream to the annuitant soon after it’s purchased. The first installment payment to an annuitant will typically begin 30 days after the annuity is funded or purchased. An insurer will only accept a lump-sum premium for this type of plan. This means that there’s no accumulation period since only a single payment is made. No income will be paid to the annuitant until the lump-sum has been provided to the insurer. The income payments that are made to the annuitant consist of both principal and interest. In addition, the first payment from a single premium immediate annuity must be made within 12 months of the contract date.

· As with any annuity, the period during which the annuity generates income for the annuitant will depend on

· (1) the total amount contributed to the account; and

· (2) the settlement or distribution option selected by the owner.

· The longer the period of desired income payments to the annuitant and the more guarantees provided (e.g., period certain), the lower the amount of each installment. The income from the annuity may either be a fixed dollar amount each month or a variable sum. An immediate annuity is best suited for a person who needs “immediate” income (i.e., a person who’s totally disabled or who’s ready to retire).

DEFERRED ANNUITY

This class of annuity may be funded with any type of premium payment plan (single or deferred/flexible). However, this classification is different from the immediate annuity because it includes an accumulation period. This means that there’s a lengthy period between the time of the contract’s purchase and when the income or annuity phase begins. A deferred annuity emphasizes the safety of principal, asset accumulation, and tax deferral of interest. Therefore, a deferred annuity is useful for any person who wants to defer income until the future (e.g., retirement). Contributions may accumulate over time, and every year the insurer credits the funds with a specific rate of interest, which is tax-deferred. When the owner decides to receive cash from the fund in the future, she has three options:

• A lump-sum distribution, of which the interest portion that’s credited is taxable

• Systematic or periodic withdrawals

• Convert the fund to the annuity phase and begin to receive an income stream per month.

For example, a new physician is just beginning her practice and wants to set aside funds for the future. However, if her current expenses are high, she may choose to achieve this objective by purchasing a flexible premium deferred annuity.

CLASSIFICATION ACCORDING TO THE SOURCE OF INCOME

Some annuities may be classified by their investment configuration or the source of income payments that are provided. The investment configuration affects the income benefits paid. For this type of classification there are two types of annuities—fixed annuities and variable annuities.

FIXED ANNUITIES

A fixed annuity guarantees a predetermined income or level benefit payment amount, which is paid each month for the life of the annuitant. The recipient (i.e., the annuitant) will receive this monthly income or fixed dollar amount each month for the remainder of his life. Fixed annuities are derived from the insurer’s general account assets since it’s this account that provides an interest rate guarantee as well as the fixed dollar or income guarantee. The general account of an insurance company is used for the deposits of the premiums that are collected for both insurance and annuity contracts (i.e., this account holds the assets of the insurance company).

As long as the insurer remains solvent, a fixed annuity also guarantees the safety of the principal. In comparison to a variable annuity, this type of annuity is a conservative product. Since it’s characterized by a predetermined amount of income, its purchasing power will be most affected by inflation. Once the predetermined income payments begin for a fixed annuity, the beneficiary receives a guaranteed refund when the annuitant dies (if a period certain has been selected). With a fixed annuity, the investment risk is assumed by the insurance company. This means that the insurer invests the funds in safe and conservative investments so that it’s able to guarantee the annuity benefit. As required under the terms of the contract, the insurer is required to provide the promised benefit regardless of whether it earns its assumed interest rate.

To summarize, a fixed annuity guarantees a minimum amount of interest to be credited to the purchase payment. Income payments don’t vary from one payment to the next. For a fixed annuity, the insurer can afford to make guarantees because the money is placed in the general account of the insurer and this account is part of the insurer’s investment portfolio.

VARIABLE ANNUITIES

A variable annuity is a contract that’s issued by an insurer which provides the contract owner with the option of having premiums invested and managed differently than they are in a fixed annuity. This type of annuity generally consists of two investment accounts—both the general account and a separate account. A guaranteed return is provided when funds are invested in the general account; however, for funds that are invested in a “separate account,” they’re invested in equity products (e.g., common and preferred stocks), bonds, and other investment vehicles.

With a variable annuity, there’s a more significant potential for higher returns from the separate account, but (unlike in the general account) there’s no return guarantee. The separate account holds all of the variable account options of the insurer and allows the contract holder to control the investment of his premiums. This means that the contract owner assumes the investment risk when funds are directed to a separate account. The separate account feature is unique to variable products. As the name implies, the assets in an insurance company’s separate account are segregated from the insurance company’s general account (which is used for fixed annuities). All of the income and capital gains that are generated by the investments in the separate account are credited to the account. Also, any capital losses that are incurred by the separate account are then charged to the account.

Keep in mind, the separate account is not affected by any other gains or losses that are incurred by the insurance company. If the insurance company becomes insolvent, its creditors cannot make claims against the assets in the separate account, but they can make claims against the assets in the general account. The separate accounts of variable products are generally required to be registered as investment companies under the Investment Company Act of 1940.

A variable annuity provides more flexibility since the contract owner is able to determine how much risk he’s willing to assume. The benefits that are ultimately paid by the contract will be determined by the performance of the separate account (i.e., performance of the securities portfolio). If an equity fund (i.e., mutual fund) performs well, the monthly income amount being paid to the annuitant will increase. On the other hand, if the fund does poorly, the monthly installment payment will decrease. Similar to the cash value in a variable whole life insurance policy, the separate account value of a variable annuity contract is not guaranteed.

To be qualified to sell a variable annuity, a FINRA Series 6 or Series 7 securities registration and a life insurance license are required. Variable annuities are considered securities and are subject to SEC, FINRA, and state insurance regulation. As is the case with all variable products, a prospectus must be delivered prior to completing the sale of any variable annuity.

Variable annuities were created to provide investors with greater protection against inflation than what traditional, fixed annuities can offer. The contract owner is also given a level of control over how her contributions are invested. A variable annuity is characterized by variable rates of return, and its performance advances or declines based on the value of the investments that are chosen by the annuitant. During the accumulation period of a variable annuity, contributions that are made by the contract owner (minus expenses) are used to purchase accumulation units.

Variable Annuity Subaccounts

For variable annuities, the separate accounts typically contain a variety of different underlying portfolios or subaccounts (which are similar to the mutual fund choices that investment companies offer to their investors). The contract owners are able to allocate their payments among these different subaccounts based on their investment objectives. Additionally, contract owners are generally allowed to transfer their money from one subaccount to another as their investment goals change. Each of the subaccounts typically corresponds to a different underlying mutual fund, such as a large-cap stock fund, a long-term bond fund, or a money-market fund. The value of these subaccounts will fluctuate based on the changing market conditions for the underlying securities. Another subaccount may have a fixed rate of return which is guaranteed by the insurance company.

During the annuity’s accumulation (pay-in) period, the contract holder is permitted to surrender the annuity in exchange for its current value. However, once a person decides to annuitize (begin receiving income payments from the annuity), she may no longer surrender the annuity or freely withdraw money from it. Instead, she’s receiving payments based on the performance of the assets in the separate account.

At annuitization, the insurance company converts all of the accumulation units that have been purchased into annuity units. Annuity units represent the accounting measurement that’s used to determine the dollar amount of each payment that will be made to the annuitant. At this time, the number of annuity units represented in each payment is fixed. However, going forward, the value of each payment that’s made to the annuitant is based on a fixed number of annuity units which is then multiplied by a fluctuating unit value.

CLASSIFICATION ACCORDING TO DISPOSITION OF PROCEEDS (ANNUITY PAYMENT/SETTLEMENT OPTIONS)

Unlike a term life or whole life insurance policy, an annuity is not a contract that pays a guaranteed death benefit. When determining the income to be paid to the annuitant, the insurer utilizes a mortality table with an extra element which is referred to as a survivorship factor. An annuity may also be described according to the life payout period or life contingency settlement option selected. Let’s analyze the various options.

STRAIGHT LIFE ANNUITY

This contingency option—also referred to as a pure life annuity or “life” annuity—is classified according to the period during which the annuitant will receive income. If a straight life settlement option is chosen, once it commences making payments, the recipient will continue to receive payments for her life with no refund paid to her family or any beneficiary upon her death. This settlement option exposes the annuitant to the most significant amount of risk since there’s no survivorship (i.e., no refund), but it also provides the annuitant with the highest payout of all options. The purpose of a straight life annuity is to protect against an annuitant outliving her income. This means that a straight life annuity protects against superannuation. (i.e., using up income due to longevity).

Insurers that pay out under life annuities may suffer adversely if there’s a sudden decrease in the mortality rate. In other words, people are living longer and, therefore, insurers are paying life incomes longer. In addition, since women have a longer life expectancy than men, monthly payments would be smaller to a female if all other things are equal.

For example, Joe and Joan are twins and inherit an equal amount of money from their favorite aunt. If they both purchase an annuity with the funds and each contract includes the same life income option, Joe’s monthly income payments from the annuity contract will be higher since his life expectancy is shorter than Joan’s.

ANNUITY (PERIOD) CERTAIN

An annuity certain or period certain is a description of income or installments for a fixed period as decided upon by the owner. This means that the monthly income will be paid for a specified period only (i.e., not for life). Payments will cease after the specified period, even if the annuitant is still alive. However, if the annuitant dies prior to the end of that period, payments continue to the designated beneficiary for the remainder of the specified period.

For example, let’s say at age 60 Joe purchases an annuity period certain for 20 years. Joe’s annuity payments will cease at age 80 (20 years later), even if he is still alive. However, if Joe dies at age 70 (after 10 years), his family (or designated beneficiary) will continue to receive his payments for 10 more years.

LIFE WITH REFUND OPTION

With a life with refund annuity option, the contract owner makes premium payments to the insurer throughout his life, but the contract also assures the return of the original amount paid into the annuity contract (i.e., the principal). If the annuitant dies before the principal is distributed, the beneficiary receives the remaining amount. Due to this guarantee, the premium for a refund annuity plan is generally higher than other annuity plans. There are two life with refund options available, the installment refund option and the cash refund option.

Installment Refund Option

The installment refund option will pay the beneficiary the same monthly income benefit that the annuitant was receiving until the remaining principal is depleted.

Cash Refund Option

The cash refund option will pay the remaining principal to the beneficiary in one lump sum.

Exam Tip: Remember an annuity certain guarantees payments will be made for at least a certain period of time. A refund annuity guarantees the entire principal will be depleted.

CLASSIFICATION ACCORDING TO THE NUMBER OF LIVES

Annuities may also be classified according to the number of lives covered, whether single or multiple life types. Let’s examine the three basic types.

INDIVIDUAL OR SINGLE LIFE ANNUITY

An individual or single life annuity is the most common form of an annuity. It is are pure life annuity, covering one life, with no survivorship (beneficiary). It provides income to the recipient, once it commences, for life with no refund paid to the annuitant's family upon his or her death. This settlement option possesses the most significant amount of risk to the annuitant as well since there is no survivorship (i.e., no refund). The purpose of a straight life annuity is to protect against outliving one's income.

JOINT LIFE ANNUITY

A joint life annuity is a type of multiple life contract that’s designed to pay benefits to two or more annuitants at the same time. However, all benefits will end once the first annuitant dies. In this manner, it’s similar to a joint life insurance policy.

JOINT AND SURVIVOR ANNUITY

A joint and survivor annuity is another form of a multiple life contract. With this type of annuity, the benefits are paid throughout the lifetime of one or more annuitants. Therefore, payments continue until the last annuitant dies. In other words, joint and survivor annuities guarantees income payments for the duration of two lives.

ADDITIONAL ANNUITY CHARACTERISTICS AND ASPECTS

ACCUMULATION PERIOD

During the pay-in (accumulation) phase, the insurer is obligated to return all (or a portion) of the annuity’s value if the contract owner dies. This value will be equal to the amount of any contributions (minus withdrawals or other expenses), plus interest. Although the contract doesn’t identify the proceeds available at death as a death benefit, the owner must name a beneficiary who’s entitled to proceeds if the owner dies during the accumulation period. Again, the amount or appreciation earned during the accumulation phase is tax-deferred. However, additional surrender charges may also be assessed at withdrawal. The accumulation period will cease when any of the following occur:

• The contract owner dies

• The annuity or “pay-out” phase begins

• The policy is surrendered.

This period will not cease if a premium payment has not been made.

ANNUITY PERIOD

The annuity period, which may also be referred to as “annuitization,” is the period that begins when the contract owner gives up the right to the funds in the contract and, in return, receives a promise of monthly income.

PARTIES OF ANNUITIES

The parties involved in an annuity contract include the insurer, the contract/policy owner, the annuitant, and the beneficiary.

• The insurer is the party (insurance company) issuing the annuity.

• The contract owner purchases and pays for the annuity, can surrender the annuity and execute nonforfeiture options, and has the right to name a beneficiary who will have access to the funds in the event of the owner’s death prior to annuitization (i.e., the annuity or pay-out phase).

• The annuitant is the individual (natural person) who receives the benefits or payments from the annuity.

• The beneficiary is the recipient of the annuity assets in the event the annuitant dies during the accumulation period, or a balance of annuity benefit needs to be paid out.

· SURRENDER CHARGES

· Surrender charges—also referred to as back-end loads—are assessed if the contract owner cancels an annuity. A surrender charge (i.e., penalty) is assessed whenever a cash withdrawal is made in excess of a specified percentage (e.g., 10%), in any policy year. If the total annuity is surrendered, the surrender charges are subtracted from the annuity value. However, for any withdrawals of less than the specified percentage, no surrender charge is assessed. The surrender charge will generally decrease each year. For example, an insurer may assess a surrender charge of 8% if any withdrawals in excess of 10% of the account balance are taken in the first year. This penalty will decrease by 1% per year for the next eight years. In year nine, there will be no surrender charge for excess withdrawals. In other words, after this time period expires, the insurer effects a waiver of surrender charges.

· NON-FORFEITURE VALUES

· Annuity contracts also identify the non-forfeiture value of a fund. This represents the value of the fund less any surrender charges if the funds are being withdrawn. As is the case for certain types of qualified retirement plans that are available today, funds may be withdrawn without surrender charges being assessed if the owner dies, becomes disabled, or requires specific types of extended medical care in a skilled nursing or extended care facility. Surrender charges are designed to make moving money out of an annuity less attractive to the contract owner. Surrender charges that are assessed by an insurer are different from the 10% federal tax penalty that’s assessed for a premature withdrawal. Therefore, a withdrawal from an annuity may be subject to both a surrender charge and a tax penalty.

· EXAM TIP: Before annuitization, the non-forfeiture value of an annuity equals all premiums paid, plus interest, minus any withdrawals and surrender charges. If the annuitant dies before the annuity period start date, the beneficiary receives the premiums paid plus interest earned.

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· FLEXIBLE PREMIUM DEFERRED ANNUITY (FPDA)

· Today, the most popular annuity product being sold is the flexible premium deferred annuity. An FPDA provides for flexible payments and allows for the future supply of income to an annuitant. Any interest earned is tax-deferred. This type of annuity has virtually replaced the annual premium retirement annuity contract, which has a fixed schedule of annual premiums (including bundled premiums) and high expenses. Today’s FPDAs have little or no front-end loads due to the tremendous competition between insurers. However, many FPDAs do assess back-end or surrender charges.

· SINGLE PREMIUM ANNUITY

· Single premium annuity types may provide either immediate income (SPIA) or deferred income (SPDA). Single premium immediate income annuities are paid for with a lump-sum payment, with income then beginning 30 days later. Single premium deferred annuities are paid for with a lump-sum, with income being paid in the future. At times, SPDAs include a bailout provision which allows the owner to withdraw funds without a penalty if the interest rate falls below a specified rate.

· ANNUAL PREMIUM RETIREMENT ANNUITIES

· An annual premium retirement annuity is a vehicle that provides tax-deferred income to the owner. Although the amounts deposited into the account are not tax-deductible (i.e., the premiums are paid after-tax), the income earned on the annual premium paid into the contract will not be taxed until it’s removed from the account. In other words, the interest or earnings paid on the principal is tax-deferred. As described earlier, these older types of contracts were characterized by high loads.

· FIXED AND VARIABLE ANNUITIES

· The following is a review of details regarding fixed and variable annuities.

· A fixed annuity pays a guaranteed, predetermined, or level benefit payment amount during the annuity phase. Premiums are placed in the insurer’s general account with other non-variable product premiums. These premiums are invested in fixed-rate products (e.g., CDs, money market, etc.) to provide a “fixed” return based on interest rate guarantees. These contracts include minimum interest rate guarantees and may pay higher rates based on current economic market conditions.

· For a variable annuity, premiums are placed in a separate account. These funds are invested in securities, such as equities (i.e., common stock or preferred stock) or debt securities (i.e., bonds). This type of annuity provides the potential for increasing income if the securities perform well. To solicit a variable product, a person must obtain a life insurance license and a FINRA securities registration (i.e., Series 6 or Series 7).

· LONG-TERM CARE RIDERS

· Long-term care riders may be attached to an annuity or a life insurance policy and they allow for the payment of a percentage of the death benefit if an individual requires long-term care but is not terminally ill.

· GUARANTEED MINIMUM WITHDRAWAL BENEFIT (GMWB)

· A guaranteed minimum withdrawal benefit is a rider that may be included in an annuity contract. The GMWB guarantees the policy holder a steady stream of retirement income regardless of market volatility. During market downturns, the annuitant can withdraw a maximum percentage of his entire investment in the annuity. Annual maximum percentages that are available for withdrawal vary with contracts, but are generally between 5% and 10% of the initial investment amount until the depletion of the total initial investment is reached. During the withdrawal period, the annuitant may continue to receive income.

· GUARANTEED MINIMUM INCOME BENEFIT (GMIB)

· This feature assures a guaranteed amount of income after the assets of the contract are annuitized, regardless of investment performance. The guaranteed amount of income is the higher of (1) the account value at annuitization that’s applied to the current annuity purchase rates, or (2) the GMIB benefit base. (The GMIB benefit base is the equivalent of net premiums paid in and compounded at an annual fixed rate, which is then applied to the current annuity purchase rates that are in force at annuitization.) The account must be annuitized for this benefit to be triggered, regardless of the fees that have been paid by the owner to fund the benefit. Regardless of how the market performs while the annuity contract is in force, this feature offers a guaranteed amount of income.

· GUARANTEED MINIMUM ACCUMULATION BENEFIT (GMAB)

· The GMAB is a feature which guarantees that the premiums paid into the contract by the owner will have a minimum accumulation value after a multi-year waiting period. The net premiums are typically multiplied by a value of one to three to determine this minimum. The contract doesn’t need to be annuitized for this benefit to be triggered.

· NEWER TYPES OF ANNUITIES

· Insurers also offer equity-indexed annuities and market value adjusted annuities. An equity-indexed annuity (EIA) is a fixed (non-variable) annuity that offers a rate of interest that’s linked to (but the funds are not directly invested in) a stock market-related index (e.g., the Standard & Poor’s 500 Index). This form of annuity may also be referred to as simply an indexed annuity. Index annuities provide the contract owner with the safety of principal (since the principal is guaranteed), and a guaranteed minimum return (e.g., 3%) since a high percentage of the contract owner’s premium is invested in high-grade government bonds. This provides a downside guarantee if the market performs poorly. In other words, this type of contract allows the owner to participate in market gains without assuming the risk of a market decline. An EIA also provides the opportunity for appreciation (i.e., upside potential) in the stock market. Generally, the contract owner is obligated to remain in the contract for a minimum period (e.g., three years) and will receive a return of a percentage of the appreciation (e.g., 10%) in the selected equity index over that period. This “percentage of the appreciation” may also be referred to as the participation rate.

· A market value-adjusted annuity (MVA)—also referred to as a modified guaranteed annuity—shifts some (but not all) of the investment risk from the insurer to the contract owner since the annuity account value will fluctuate with the changes in market interest rates. In other words, it’s a type of single premium-deferred annuity that allows contract owners to lock in a guaranteed interest rate over a specified maturity period of typically two to 10 years.

· An MVA functions in a manner that’s similar to a bond in times of fluctuating interest rate (i.e., when interest rates fall, bond prices rise, etc.). MVAs generally provide higher interest rates than traditional annuities and also possess lower reserve requirements and pass on more risk to the contract owner. When surrendered, there will generally be both a market value adjustment and a surrender penalty assessed to the owner.