Loss of Life Chapter 16

1. Loss of LifeChapter 16 ©2005, Thomson/South-Western

2. Chapter Objectives • To distinguish among the insurer, the beneficiary, the insured, and the policyowner of the life insurance policy • Describe the major characteristics of term life, whole life, universal life, variable life, and other forms of life insurance and give examples of appropriate uses for each • List three general premium payment arrangements for whole life insurance and discuss the effects of each arrangement on the buildup of the policy’s cash value • Explain how life insurance premiums, death benefits, and cash values are treated for federal income tax purposes

3. Chapter Objectives • Explain the intent of the following contract provisions • Incontestability clause, suicide clause, misstatement-of-age clause, misstatement-of-sex clause, entire contract clause, provisions related to policy assignment clause, war hazard exclusion, aviation hazard exclusion, spendthrift trust clause, and grace period and reinstatement provisions • Explain the nature of policyowner dividends, nonforfeiture options, and settlement options and describe the choices available for each of these terms • Give examples of important considerations in wording the beneficiary designation in a life insurance policy • Explain the intent of the waiver of premium benefit, the accidental death benefit, and living benefit options

4. Introduction • For many people, the risk management tool most appropriate for dealing with the exposure of premature death is life insurance • The standard arrangement is a contract specifying that upon the death of a person whose life is insured • A stated sum of money (the policy’s face amount) is paid to the person or organization designated in the policy as the beneficiary • Many life insurance contracts also have benefits that may be payable due to circumstances other than death • One example is the savings element (called the cash value) that accumulates under some policies • The cash value can be refunded to the owner of the policy if the contract is terminated prior to death

5. Types of Life Insurance • In 2002 the face amount of new life insurance sold in the U.S. was $2.9 trillion • Total life insurance in force by the end of 2002 was $16.3 trillion • Three major types of life insurance • Term • Whole life • Universal life • Other types of life insurance exist • Some were more prevalent in past years but decreased in popularity as newer forms of life insurance were developed and marketed

6. Term Insurance • Designed to provide protection if the insured person dies during a specified period of time • Accounts for a substantial portion of the face amount of all life insurance purchased by individuals in the U.S. each year • In most cases it has no cash value and cannot be used to meet savings needs • Its exclusive focus on death protection means that, for a given amount of premium dollars • A person can usually buy a larger face amount of term insurance coverage than can be purchased with any other type of life insurance

7. Duration of Term Coverage • Term insurance contracts are issued for a specific period of time • Such as 1 year, 5 years, or 20 years • At the end of the period, the insurance protection ceases unless the coverage is renewed • Some term insurance is sold with the expectation that the coverage will be renewed several times • Straight term insurance is generally not renewable • Another way of stating the policy’s duration of coverage, instead of specifying an exact number of years • The contract remains in effect up to a particular age

8. Coverage Options and Guarantees • A legitimate concern regarding the purchase of term insurance would arise if there were no guarantees allowing insureds to renew their term insurance protection • A person’s health might deteriorate while the coverage was in effect • The individual could be considered uninsurable in the future • Thus, when the term period ended, the insurance protection would expire • And the former insured would be unable to obtain new coverage • Because many insureds want to protect their right to buy coverage in the future regardless of their health • Most insurance companies issue what is known as renewable term insurance

9. Coverage Options and Guarantees • Renewable term policies are written for a specified number of years • Are renewable for similar periods of time, regardless of the insured’s health • Each time the policy is renewed • The premium increases to reflect the insured’s current age • Changes in health status that may have taken place since the policy was issued are not reflected in future premiums

10. Coverage Options and Guarantees • Term insurance renewal rights usually are not completely unlimited • Due to insurers’ concerns about adverse selection • Without some limitation on the right to renew • Overall mortality rates among insureds would be higher due to these types of behaviors • Insurance premiums would have to be greater • Previously this concern about adverse selection caused many insurers to offer the renewability option only until about age 60 or 65 • However, with greater experience and in response to competitive pressures • It is now common for insurers to issue policies that can be renewed until more advanced ages

11. Coverage Options and Guarantees • Most term policies are convertible into a different form of life insurance • Standard conversion provision gives the insured the option to change the term policy into some form of permanent coverage to remain in effect for the person’s entire lifetime • Rather than expiring on a specified date • When term insurance is convertible, the right to change to permanent coverage is provided • Regardless of the insured’s health at the time of conversion • Some policies can be converted at any time before they expire • However, term insurance contracts that can be renewed up to very advanced ages often are more restrictive regarding conversion rights • It is not unusual for conversion rights to end after age 65 for 70 • Even though right to renew policy as term insurance extends to age 90 or beyond

12. Face Amount Variability • The majority of term policies have a face amount that does not change over time • Referred to as level term contracts • Term insurance can also be arranged so that the face amount either • Decreases over time (decreasing term insurance) • Usually purchased for specific purpose • Such as providing cash to pay off a mortgage or other debt if the insured dies with some of the loan still outstanding • Increases over time (increasing term insurance) • Face amount increases periodically on a predetermined basis • A more common approach for meeting an increasing need is through a cost-of-living rider or a guaranteed insurability rider • Both of these are endorsements to a basic level term or permanent insurance policy

13. Face Amount Variability • Cost-of-living rider • Automatically increases the amount of protection by the same percentage that the Consumer Price Index has increased since the basic policy was issued • As long as the insured accepts and pays for the additional amount of coverage each time it is offered, no evidence of insurability is required • Guaranteed insurability rider • Provides that the insured will be able to purchase additional amounts of insurance protection in the future • Regardless of health • Subject to stated maximums

14. Whole Life Insurance • May be kept in force for the insured’s entire lifetime • Has accounted for more than half of all life insurance policies sold in the U.S. in recent years • Lags behind term insurance with respect to the total face amount of coverage issued • Contains the savings elements called cash values • If the owner of the whole life policy decides to terminate it before the insured’s death, the cash value can be refunded

15. Whole Life Insurance • A straight life contract is arranged so that the premiums are payable as long as the insured lives • A limited-pay life policy requires that the premiums are payable for only a specified period of time • Such as 20 years or until age 65 • After that time, no further premiums are necessary, but the coverage remains in effect until the insured’s death • Is also possible to pay for a whole life policy with only one premium • Called a single-premium life

16. Whole Life Insurance • When a premium for whole life insurance is paid to the insurer • Part of that premium is used to help pay the policy’s fair share of death benefits for insureds who die that year • Part of the premium not needed to pay that year’s death benefits is used to pay current expenses of the insurer • Any remaining amounts are invested to earn interest • Life insurance premiums are calculated such that, when they are combined over time with the premiums and investment earnings from other similar policies • All mortality and expense costs can be paid as incurred until all insureds are dead

17. Whole Life Insurance • If insureds terminate their whole life contracts before death • They are entitled to refunds of the excess premiums that have accumulated for their policies to date • Called the policy’s cash value • The more premium dollars that are paid earlier in the life of the contract • The greater the cash value available on policy termination • Life insurers make various assumptions about mortality costs, interest earnings, and expenses • On the basis of these assumptions, it is possible to guarantee within the contract the cash values that will be generated by policy termination at various times

18. Universal Life Insurance • First introduced in the U.S. in 1979 • Offers more flexible premium payment options than do most other forms of life insurance • The minimum initial premium required to activate the policy is specified by the insurer • But the policyowner usually decides the timing and size of subsequent premiums • Policyowners can also periodically adjust the size of the death benefit in most universal life contracts • Although insurers may require proof of insurability if a request is made to increase the death benefit

19. Universal Life Insurance • The cash value of the universal life policy is established deliberately and varies regularly • Depending on such factors as • The insurer’s investment savings, mortality experience, and expenses • The amount and timing of premiums paid by the insured • Basic versions of life insurance contracts–differ only with respect to how the death benefit is designated • Type A universal life • Type B universal life

20. Universal Life Insurance • Type A universal life • The death benefit is an amount that remains the same while the policy is in force • The death benefit is the cash value plus whatever amount is necessary to bring the total to the specified amount • Type B universal life • Has fluctuating death benefits that are made up of a specified amount of death protection plus the policy’s cash value • Table 16-1 provides an illustration of the structure of the Type B universal life policy • As the cash value grows over time so does the death benefit • The actual rates credited correspond closely to money market rates • The interest rate credited is an especially crucial item in determining the size of the cash value and the death benefit for Type B contracts

21. Table 16-1: Illustration of Type B Universal Life Insurance Policy Structure (Male, age 25)

22. Universal Life Insurance • In the first several years following their introduction • Universal life cash values were credited with interest that substantially exceeded the minimum guarantees • Illustrations for selling policies were often based on the assumption that interest rates of 10 or 11% would continue throughout the life of the policy • However, in the early 1990s interest rates dipped to their lowest levels in decades • Insurers were forced to credit universal life cash values with much lower interest rates • Leading to dissatisfaction among many policyowners • For the policy illustrated in Table 16-1, a wide range of potential cash values may result at various ages • Depending on the interest rate assumption • Table 16-2 shows some of the possible results

23. Table 16-2: Interest Rate Sensitivity of Type B Universal Life Policy Cash Values (Initial Death Benefit of $100,000)

24. Variable Life • The death benefit and cash value fluctuate with the investment performance of one or more portfolios of securities • Policyholders can designate the types of investments that they want supporting their policies • If the selected investments increase in value • Both the face amount and the cash value of the variable life contract will also increase • Poor investment performance will result in decreasing coverage and cash values • Although a minimal face amount is usually guaranteed • Originally designed to provide an inflation hedge for both the death protection and savings elements of the policy

25. Variable Universal Life • Combines some of the features of both universal life and variable life insurance • Referred to as flexible premium variable life • Contract usually is designed similarly to a universal life policy with respect to death benefits and flexible premium arrangements • A primary difference is that policyowners are given a choice of investments to be used to support the contract • Rather than using only high-grade, short-term money market investments as in the standard universal life policy • Usually only the cash value of a variable universal policy varies with the performance of the underlying securities

26. Modified Life • Can describe many different policy structures • Usually the contract is a form of whole life insurance with premiums that are lower than usual for an initial period of time • After that time, the premiums are somewhat higher than they otherwise would be • Can be especially appropriate for insureds with limited incomes who want to own permanent life insurance they cannot currently afforded • Convertible term insurance can meet the same need • But many persons who plan to convert their term insurance do not actually do so because of the substantial premium increase • An advantage of modified life is that the policyowner does not have to initiate any type of positive action to obtain the permanent insurance

27. Endowment • The amount of endowment insurance sold in the U.S. is now negligible • Provides death benefits for a specified period time • Has a cash value, and the policyowners pay the contract’s face amount at the end of the protection period if the insured is still alive • While the policy does provide death protection • On a relative basis it emphasizes savings to a much greater degree than any policy discussed so far • Most insureds now seek other alternatives because of the adverse tax treatment now accorded to endowment policies

28. Industrial Life • Known variously as industrial life, home service life, or debit insurance • Type of cash value life insurance that is sold in very small amounts • Primarily to meet burial needs of low income insureds • The face amount is only a few thousand dollars • Premiums are only a few dollars each week and are usually collected personally at the insureds’ homes

29. Industrial Life • More expensive on a relative basis than other forms of life insurance because • Of the high cost of its premium collection method • Mortality rates tend to be higher for persons who purchase this form of coverage • Because the face amount is so small, underwriting standards are often fairly liberal • Medical exams are rarely required • Those who purchase industrial life insurance would be better served by regular term or whole life insurance • The low-income status of most of these insureds makes it unlikely that they will be approached by traditional life agents

30. Credit Life • Offered in connection with installment sales of consumer durables, such as automobiles • Decreasing term insurance issued without a medical examination • Will expire when the installment sales contract is paid off • Cost of protection is incorporated into the regular payment made by the purchaser • If the insured dies before the loan is repaid • Sufficient coverage exists to repay the balance of the debt • Protects the insured’s dependents as well as the lender

31. Income Tax Treatment of Life Insurance • Premiums • In most cases, individuals cannot deduct the premiums they pay for individual life insurance • The primary exception is for someone who is paying premiums on a life insurance policy owned by a charitable organization • Death benefits • As a general rule, when an insured dies and a death benefit is paid • The beneficiary does not have to report the death benefit as taxable income if the proceeds are paid in a lump sum • When settlement is made through a series of periodic payments from the insurer • The beneficiary generally can exclude only part of each payment from taxable income • The amount of each payment that represents a distribution of the original death benefit is not taxed • While the portion that is due to interest earnings is subject to taxation

32. Income Tax Treatment of Life Insurance • Cash values • If a life insurance policy with a cash value is terminated before death and the contract is surrendered for cash • It is likely that there will be taxable income that must be reported in the year of the surrender • The amount of taxable income is the difference between the cash received at termination and premiums that were paid during life of the contract • While a cash value policy is in force, the annual increments to the cash value (inside buildup) often escape immediate taxation • In many policies these increments are not taxed until the policy is surrendered for its cash value

33. Income Tax Treatment of Life Insurance • Cash Values • In some policies however, taxation of part of the inside buildup occurs every year • The determining factor depends on whether the policy meets the statutory definition of life insurance as specified in the IRC • Policies that meet this definition are not subject to immediate taxation of their inside buildup • Cash values of policies that cannot meet the requirements will be partially taxed each year • According to the IRC, a policy is considered to be life insurance for tax purposes of it meets at least one of two tests • The intent of both tests is to assure that the cash value in a particular policy is not excessive in relationship to the policy’s death benefit • Contracts that are primarily savings vehicles and have a only a nominal death benefit will be unable to pass these tests • Therefore, these contracts will not be granted an income tax advantage for the inside buildup

34. Life Insurance Contract Provisions • The contractual provisions of the life insurance policy are of special significance to the insured • Because it is through the wise use of these rights that some of the most valuable benefits of protection can be obtained

35. Incontestability Clause • If the policy has been in force for a given period and if the insured has not died during that time • The insurer may not afterward refuse to pay the proceeds, nor may it cancel or contest the contract, even due to fraud • Thus, if an insured is found to have lied about his or her physical condition at the time the application was made for life insurance • And this misrepresentation is not discovered until after the expiration of the incontestability clause • The insurer may neither cancel the policy nor refuse to pay the face amount if the insured has died from a cause not excluded under the basic terms of the policy • Serves as a time limit within which the insurer must discover any fraud or misrepresentation in the application or be barred thereafter from asserting what would otherwise be its legal right • The legal justification for this clause is protection of beneficiaries from doubtful claims by an insurer • That the deceased had made misrepresentations after it becomes impossible for the deceased to defend against or to deny the allegation

36. Suicide Clause • Partially protects the beneficiary from the financial consequences of suicide • States that if the insured does not commit suicide for at least a stated period (usually two years after issuance of the contract) • The insurer may not deny liability under the policy for subsequent suicide • If the suicide occurs within two years of the issuance of the policy • The insurer’s only obligation is to return without interest the premiums that have been paid

37. Misstatement of Age or Sex • Misrepresenting one’s age in life insurance is material to accepting the risk and normally would become a defense against payment of the proceeds • If it were not for the incontestability clause • Without some control over this possibility • It would become possible for people to understate their ages to obtain lower life insurance premiums • Proof of age is therefore required before proceeds are paid • Under the misstatement-of-age clause • If it is determined that the policyholder’s age has been misrepresented • The insurer adjusts the amount of proceeds payable rather than canceling the agreement altogether • Proceeds will be adjusted in a similar manner through the misstatement-of-sex clause • It is common for females to pay lower premiums than males of the same age when purchasing life insurance

38. Entire Contract Clause • Provides that the policy, together with the application, constitutes the entire contract between the parties • Desirable for the protection of the insured and the beneficiary because • Without the clause it might be possible to affect the rights of the respective parties through changes in the bylaws or in the charter of the insurer

39. Assignments • An insured may wish to assign the benefits of a life insurance policy • Often as collateral for a loan • Permission of the insurer is not necessary • But the insurer must be properly notified in writing of an assignment or else is not bound by it • If the insured dies, the insurer pays the holder of the assignment that part of the proceeds equal to the outstanding debt • Then pays the remainder to the named beneficiaries

40. Dividend Options • Some life insurance policies are participating • They pay the policyowner dividends • The dividend is not a distribution of profit but a partial return of the premium payment • Reflects the insurer’s experience with respect to mortality, investment income, and expenses • Dividends are not taxable to the recipient • Insurers are not required to pay dividends • However, dividends may be substantial

41. Cash or Payment of Premium • A policyowner may specify that all dividends are either to be paid to the policyowner in cash • Or be applied toward the payment of the next premium due

42. Accumulation at Interest • The insurer may retain the dividends and pay interest on the accumulated amount • A minimum guaranteed interest rate is stated in the policy • Although insurers often pay more than the guaranteed minimum • The dividends themselves are not taxable • But interest paid on them through this option is taxable to the policyowner in the year in which it is credited • When dividends are paid and are not withdrawn prior to the insured’s death • The accumulated dividends are added to the policy face amount and are paid to the beneficiary as part of the death benefit • Accumulated dividends distributed as part of the death benefit are not considered taxable income

43. Paid-Up Additions • Policyowners of whole life policies usually are offered the paid-up additions option • Each dividend is used to purchase as much single premium whole life insurance as possible • An economical way to buy additional life insurance • No commission or other acquisition expenses must be paid • No medical examination or other evidence of insurability is required • The insurance purchased under this option provides additional death protection and has a cash value

44. One-Year Term Option • Uses each year’s dividend to purchase as much one-year term insurance as possible • Insureds can increase their death protection to the maximum extent without additional premium payment • Sometimes the amount of term insurance may be limited to the size of the policy’s accumulated cash value or its face amount • Any remaining dividend can be taken under another dividend option

45. Nonforfeiture Options • Guarantee that the savings element in a policy will not be forfeited to the insurer under any circumstances • But will always accrue to the benefit of the insured • Required by law in all states • Prior to this requirement there were cases in which aged persons agreed to sell their policies to speculators when they could no longer afford to pay the premiums • The insured seldom fared well in these transactions

46. Cash Value Option • The policy may be surrendered for cash • A schedule of guaranteed minimum cash values is included in the policy • Although the actual cash value in policies may vary considerably from the minimums guaranteed • Before payment is made, any outstanding indebtedness is subtracted • The cash is usually paid immediately • Although the insurer has the right to delay payment for as long as six months • After 30 days the insurer is entitled to interest on the amount due

47. Paid-Up Insurance Option • The insurer uses the cash value to buy as much single-premium insurance as possible on the life of the insured • Given the size of the cash value • The same type of insurance is purchased as existed for the original policy • The only difference is that the new death benefit will be for lower now than before • And no more premiums will be required after the option is exercised

48. Extended-Term Option • If the insured does not select a nonforfeiture option and has not implemented the automatic premium loan provision • Most insurers automatically place a cash value policy on the extended-term option • If premiums remain unpaid after expiration of the grace period • The policy’s cash value is used to purchase term insurance for as many years and months as are allowed by the rates in effect for the insured’s age when the lapse occurs • Minimum guarantees regarding this option are included in the policy

49. Policy Loans • Sometimes the policyowner may need access to funds that are only available through the cash value of his or her life insurance policy • And it may not be desirable to terminate the policy • The cash value may be borrowed from the insurer with the insurance coverage remaining intact • If the insured dies with an outstanding policy loan • The amount of the loan is subtracted from the policy proceeds before payment is made to the beneficiary • Otherwise, there is no obligation to repay policy loans • However, because the insurer calculates premiums on the assumption that interest will be earned on the funds supporting the policy • Interest is charged to anyone--including the policyowner—who borrows some of these funds • Unpaid interest accumulates and is added to the total loan outstanding

50. Policy Loans • If the policyowner takes a policy loan but still wants to maintain the full amount of death protection • The one-year term dividend option can be helpful, assuming that the contract is participating • Because policies without flexible premium arrangements will lapse after expiration of the grace period if premiums are not paid when due • Many insurers encourage the use of an automatic premium loan provision • Automatically authorizes the insured to use cash values to pay unpaid premiums that are due • Policy loans from cash value life insurance contracts generally are not taxable as income