Introduction to Life Insurance and Annuities

Transcription

1 Module 5 Introduction to Life Insurance and Annuities David Mannaioni CPCU, CLU, ChFC, CFP 7485

2 1982, 1985, 1991, 1996, , College for Financial Planning, all rights reserved. This publication may not be duplicated in any way without the express written consent of the publisher. The information contained herein is for the personal use of the reader and may not be incorporated in any commercial programs, other books, databases, or any kind of software or any kind of electronic media including, but not limited to, any type of digital storage mechanism without written consent of the publisher or authors. Making copies of this material or any portion for any purpose other than your own is a violation of United States copyright laws. The College for Financial Planning does not certify individuals to use the CFP, CERTIFIED FINANCIAL PLANNER, and CFP (with flame logo) marks. CFP certification is granted solely by Certified Financial Planner Board of Standards Inc. to individuals who, in addition to completing an educational requirement such as this CFP Board-Registered Program, have met its ethics, experience, and examination requirements. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP, CERTIFIED FINANCIAL PLANNER, and federally registered CFP (with flame logo), which it awards to individuals who successfully complete initial and ongoing certification requirements. At the College s discretion, news, updates, and information regarding changes/updates to courses or programs may be posted to the College s website at or you may call the Student Services Center at

3 Table of Contents Study Plan/Syllabus... 1 Learning Activities... 3 Chapter 1: Financial Risk Exposures at Death... 5 Life Exposures... 5 Personal Obligations or Desires... 5 Family Needs... 8 Business Needs Chapter 2: Life Insurance: Types Pricing Fundamentals Traditional Forms of Life Insurance Term Life Insurance Permanent Life Insurance Interest-Sensitive Life Insurance Other Forms of Life Insurance Tax Treatment Chapter 3: Contract Clauses The Declarations Page Inside the Policy Standard Provisions Chapter 4: Life Insurance Policies: Dividend Options and Riders Dividends Life Insurance Riders Chapter 5: Illustrations and Choosing a Policy Illustrations Choosing the Right Policy Insurability... 76

4 Chapter 6: Managing a Policy Nonforfeiture Options Viatical Agreements Exchanges Settlement Options Chapter 7: Annuities Definitions Income Taxation of Annuities Estate Taxation of Annuities Single Premium Immediate Annuity (SPIA) Deferred Annuities: Single Premium (SPDA) or Flexible Premium (FPDA) Summary Module Review Questions Answers References About the Author Index

5 Study Plan/Syllabus Life insurance should be an essential part of any client s financial portfolio. If the client were to die too soon, life insurance can provide much-needed resources for the surviving family members. For clients who beat the longevity odds, annuities can also be an integral part of a financial and risk management plan to create a secure base income that will last their entire life. The primary purposes of life insurance and annuities are, in fact, two sides of the same coin. Life insurance pays the beneficiaries when the insured dies. Annuities pay while the annuitant is alive. Module 6 will cover how to define the life insurance needs, but first you will learn about the various products and their structure. Many clients will already have some coverage which must be understood before an accurate analysis can occur. A financial planner first identifies financial risk exposures facing a client upon their death, then analyzes the client s present coverage and resources. This analysis allows the planner to also determine how well the existing coverage fits into the risk management plan. To acquire the skills necessary to accomplish this task, a planner must learn basic life insurance policy and annuity features, provisions, and riders. Planners will need to help clients decide on dividend options, choose appropriate riders, and guide beneficiaries through their options upon death of the insured. Part of this module gives you pointers on how to evaluate insurance proposals. This is more important than ever because of changes that have been made in insurance products in the last several decades. Products, because of heightened consumer awareness, have become more responsive to the economic climate. However, many of these products do not have the guarantees they once had. A thorough grasp of insurance illustrations is essential. Related to this understanding of illustrations is a clear comprehension of life insurance pricing factors. This module also introduces these factors and explains how they interact with one another. Finally, there are times when an individual will need to change or utilize their policy differently than their original intent. A terminally ill person may need Study Plan/Syllabus 1

6 extra money to pay medical bills or simply to maintain their dignity in the face of the inevitable and unrelenting advance of their illness. Many companies have added accelerated death benefit options, but if this is not available and other options are exhausted, viatication may be an answer. If someone who is terminally ill owns a life insurance policy, he or she may be able to sell it at a discount to policy face value. The concept of viatication is introduced and examined in this module. Finally, annuities have exploded in the marketplace as longevity is increasing and people look to create more certainty that they will not outlive their money. A high-level overview of annuities is provided. The chapters in this module are: Financial Risk Exposures at Death Life Insurance: Types Contract Clauses Life Insurance Policies: Dividend Options and Riders Illustrations and Choosing a Policy Managing a Policy Annuities Upon successful completion of this module, you will be able to identify and compare the unique set of characteristics of each form of life insurance and annuity contracts in order to make recommendations to clients. Additionally, you will be able to explain policy riders, and critical clauses in policies including as dividend, nonforfeiture, and settlement options. Finally, you will be able to explain options relating to alternate uses and terminating policies. Remember, exam questions for this course are based on the learning objectives in each module. 2 Introduction to Life Insurance & Annuities

7 Learning Activities Learning Objective Readings Learning Activities Module Review Questions 5 1 Identify areas of financial risk exposures at death. Chapter 1: Financial Risk Exposures at Death Identify types, uses, and limitations of various types of individual life insurance policies. 5 3 Compare the purposes of the general provisions of a life insurance policy. 5 4 Identify appropriate dividend options available under participating life insurance policies. 5 5 Analyze the application of a given optional provision (rider) available in a life insurance policy. 5 6 Distinguish between policy illustration factors to select the most appropriate insurance product. 5 7 Recommend an appropriate type of insurance policy. Chapter 2: Life Insurance: Types Chapter 3: Contract Clauses Chapter 4: Life Insurance Policies: Dividend Options and Riders Chapter 4: Life Insurance Policies: Dividend Options and Riders Chapter 5: Illustrations and Choosing a Policy Chapter 5: Illustrations and Choosing a Policy Calculate the value of a given nonforfeiture option in a life insurance policy at a specific point in time. 5 9 Analyze and compare settlement options available under a life insurance for specific situations. Chapter 6: Managing a Policy Chapter 6: Managing a Policy Study Plan/Syllabus 3

8 Learning Objective Readings Learning Activities Module Review Questions 5 10 Distinguish between types, uses, and limitations of various types of annuities. Chapter 7: Annuities The question of why one should buy life insurance is answered by determining whether any adverse financial consequences will be faced upon the death of the person in question. Learning objective 5-1 addresses these life exposures. This topic will be covered in much more detail in the Module 6, The Life Insurance Selection Process. Before determining the appropriate policy to use, you need a good understanding of the various products available. Learning objective 5-2 directs you to examine the many products available and determine each one s unique characteristics. Learning objectives 5-3, 5-4, and 5-5 focus on understanding the various general clauses of life insurance policies, dividend options in whole life, and the available riders so you will be able to guide clients effectively. Most life insurance purchases are made following the presentation of some type of illustration. Being able to understand policy illustrations is an integral part of providing financial planning advice, which can help you in the selection of the appropriate policy. Learning objectives 5-6 and 5-7 cover this process. Learning objectives 5-8 and 5-9 discuss the management of a policy from annual reviews to alternatives in light of terminal illnesses, or termination. Often called the flip side of life insurance, annuities are unique in that they have the primary purpose of guaranteeing that the income they provide will not run out during the lifetime of the annuitant. Learning objective 5-10 involves understanding what annuities are, how they can be used, and their limitations. 4 Introduction to Life Insurance & Annuities

9 Chapter 1: Financial Risk Exposures at Death Reading this chapter will enable you: 5 1 Identify areas of financial risk exposures at death. Life Exposures The financial planner is called upon to recognize and address financial exposures related to the death of the client, the consequences to the client s family members, and others with whom the client may have interactions. Further, clients may have objectives that they wish to have funded upon their death. In addressing such objectives, life insurance should be considered as a possible funding alternative. Recognizing these exposures and the funding requirements they create is essential to assuring adequate protection, and recommending the most appropriate type(s) of insurance for the client. This chapter addresses some of the risk exposures for which life insurance would be utilized. A different module addresses selecting the proper amount and type of insurance based on needs uncovered here. Life exposures, predicated on the client s own goals and objectives fall into three main categories: 1. Personal obligations or desires 2. Family or survivor needs 3. Business needs Personal Obligations or Desires Clients may feel a moral obligation or desire to make sure that certain things happen independent of the potential impact to their families. A client could wish to make a major charitable gift to an organization that impacted their life. They Chapter 1: Financial Risk Exposures at Death 5

10 could have a buy-sell agreement that even though their partner would be financially fine, they feel a moral obligation to complete the transaction. A spouse could come from a very wealthy family that will leave him or her a trust fund, but could the client may consider it a matter of personal integrity to provide for their spouse s retirement or leave a legacy for a child or any number of other things. It is important that you find out what is important to an individual and not just make the assumption that meeting family needs is all there is to the insurance equation. Below are some examples that may be needed for family security or could be a personal obligation or desire. Finance Risk exposure death before loan repayment is finished. It is not uncommon for banks to require that a customer maintain a certain amount of insurance in force, collaterally assigned to the bank, to assure it will receive money owed in the event of the customer s death. Clients who do not often borrow money can probably be adequately protected with temporary insurance. If your client is very active financially and borrows frequently, it often makes more sense to cover this need with some form of cash value insurance. The idea is that while one particular loan may be paid off, there are likely to be other loans in the future, and the bank is likely to continue to require insurance to cover them. Collaterally assigned life insurance is appropriate when there is no other collateral for a loan. Life insurance purchased to pay off a mortgage would not be assigned to the lending institution since the property itself is collateral for the loan. Continuation of Retirement for Spouse Risk exposure spouse outliving pure life annuitant. Often a client will have a pension plan through an employer or other business entity that provides for a lifetime retirement income. Even though a lump-sum distribution may be available, there are income tax and practical reasons why this may not be the most desirable option. Among the lifetime payment options available to the client will be options that pay income only during the life of the client or during the lives of the client and/or his or her spouse (a joint and survivor payout). Because of the longer payout period facing the plan when a joint and survivor payout is 6 Introduction to Life Insurance & Annuities

11 chosen, the benefit under such an option can be substantially less than the benefit under a life-only option, in which payments cease upon the death of the client. For example, the client may have the following options: Payout Form Monthly Benefit Life only $2,000 Joint and full survivor $1,500 If the client has life insurance that can replace the $1,500 of monthly income for the client s spouse at the client s death, the client may choose to take a $2,000 monthly benefit and enjoy an additional $500 of monthly income for life. Of course, the additional monthly benefit to be received must be weighed against the additional expense represented by the insurance premium. If the premium is $200, then the net gain is $300. If the pension has a cost of living adjustment, then the cost of living adjustment is on the higher amount and the income will be substantially higher. Because the policy must be in force at the death of the insured, whole life is generally utilized. The economics of this transaction must be examined on a case-by-case basis. Risk exposure the person responsible for paying your retirement income may die before you do or become disabled, causing default. Sometimes, the intrinsic nature of a client s assets causes them to be poorly diversified. A client who owns a small business illustrates this situation. The small business owner frequently has to invest most of his or her assets in the business. One result is that the business must be sold in order for the owner to be able to retire. A cash sale usually is safest, but circumstances and other issues may make this undesirable or impractical. Tax considerations, difficulties in finding a buyer, having a buyer who has trouble obtaining credit, or considerations arising when the buyer is a son or daughter may entice the owner to sell over a period of time. This puts the owner at risk of default by the buyer. Assuming the client has selected a buyer capable of running the business and has built sufficient legal safeguards into the installment sale (or private annuity) contract, the two primary reasons for default are the death or the disability of the buyer. To safeguard against such a default, appropriate life and disability insurance should be placed on the life of the buyer. Chapter 1: Financial Risk Exposures at Death 7

12 In addition to life insurance policies that pay lump-sum benefits to meet such obligations, there also are disability income policies specifically designed for such business situations that pay a lump-sum benefit. A business owner who sold the business to a family member may want to keep the insurance on his own life in force until the loan is paid so that the rest of the family receives their share immediately, thus creating less family stress. Personal Goals Risk exposure death before accomplishment or when insurance is the best funding vehicle. Not everyone can be a Bill Gates and create an impact through charitable giving while they are alive, but many can do so at their death by utilizing insurance to fund a legacy. Chairs at universities, scholarships, charitable foundations, etc., are all designed to accomplish a vision. Generally, this includes charitable giving objectives, although it could include any goal the client wants funded. Some clients have funded specific family vacations for their children and grandchildren for the next 10 years as a way of reinforcing the family. Some people choose to create college funding for their grandchildren and great-grandchildren. Life insurance is an obvious way to fund such objectives. Further, life insurance provides a way to multiply a client s gift. For example, a few thousand dollars in annual premium can ultimately result in a $1 million endowment for a charity or family from the death benefit. Family Needs Final expenses. These are obligations that must be paid before probate of the estate can be completed. They include expenses of the last illness, burial expenses, legal fees, accounting fees and appraisal costs (where necessary), death notice costs, and outstanding debts of the deceased. Note that some debts were listed under personal obligations or desires. Other debts may be joint debts that do not have to be paid off but the family or insured wishes them to be paid such as a mortgage, home equity line, or car loans. If the estate is large enough, various estate taxes may be levied. There is a federal estate tax that must be paid if more than a specified amount is transferred by a decedent (except in the case of assets passing to a surviving spouse, which qualify 8 Introduction to Life Insurance & Annuities

13 for an unlimited marital deduction). Further, most states levy a death tax. To the extent these costs exceed liquid assets in the estate, insurance can provide a good source of funds. Assets that are illiquid in nature are poor choices for funding these needs, because rapidly liquidating such assets may result in significant financial losses. Note: Care should be taken to uncover contingent liabilities as well, such as notes on which the client has co-signed. An example that occurs frequently is the business liabilities the client personally guaranteed. It is not uncommon for banks to require such personal guarantees from the owners of a closely held business as a condition for extending credit to the business. (A closely held business is one that is owned by just a few stockholders or partners.) These contingent liabilities could subject the owners and/or their estates to hundreds of thousands of dollars of personal liability. Dependent income. Most individuals want to, and need to, provide for their dependents. Even two-income families can seldom lose one of their sources of income without serious economic repercussions for the family. In most situations, both income earners should have life insurance to cover the potential loss of income. The retirement needs of the surviving spouse are also taken into account in calculating coverage requirements. This calculation can be complex. It is easy to cut expenses from the budget, such as the house and car payments that were paid off by insurance. It is harder is to identify new expenses such as unsubsidized health insurance, or young children growing up to be teenagers and needing cars and expensive insurance. Care must be taken in analyzing the needs, both now and in the future, over the stages of life for the remaining family. Note: In years past, the automatic assumption was that the husband would be the major wage earner, and therefore would require the most life insurance. This should no longer be an automatic assumption. A husband may stay at home to take care of the children, while the wife works outside of the home. Or, the wife may have a higher-paying job than the husband, and therefore require the most life insurance. The best solution is to enter the fact-finding period with an open mind, and allow each client s individual situation to determine the best recommendations. Chapter 1: Financial Risk Exposures at Death 9

14 One-income families also generally have substantial economic repercussions in the event of the non-wage-earning spouse s death. Children living at home must have proper child care, which is often quite expensive. The loss of the ability to file a joint income tax return generally results in additional income taxes and a reduction in disposable income. Any other services that must be replaced increase the income needed; therefore, a spouse not earning an income generally needs life insurance as well. While an expense would be incurred for the burial of a child, it generally is not considered a serious enough threat to the finances of a family to require significant insurance coverage. Some individuals do purchase insurance on minor children to guarantee future insurability and to establish what can become an exceptional asset when the child grows up. However, adequate insurance on the parents always takes priority. Education. Dependents educational goals must also be taken into account when determining life insurance needs. Children, a surviving spouse, and possibly grandchildren may be among those about whom the client is concerned. If the spouse plans to return to work after a long absence from the workforce, skills may need updating and funds should be planned for this purpose. Adjustment fund. An often forgotten expense is an adjustment fund. Survivors may want to pay for family members who don t have the funds to come to the funeral or for visits afterward. The spouse may need to fix up the house and sell it and move someplace closer to family support. When an individual dies, the surviving spouse s emotional strain can be exceptional. Survivors often deal with this strain in different ways. Some want to travel, to run from the loss. Others find solace in shopping or dining out. Some survivors may take a trip to stay with other family members for support. The unusual spending may last for days or months, and should be considered when discussing life insurance needs. Family goals. The family may be working together toward certain goals, and the client may want the surviving family members to enjoy the fulfillment of these goals. Since loss of the decedent s income might endanger the achievement of these goals, the client may wish to plan for their funding through life insurance. Examples of family goals might include owning a certain home, taking a dream vacation, or establishing a business. 10 Introduction to Life Insurance & Annuities

15 Parents. As life expectancy continues to improve, more and more people find themselves caring for aging parents. Many people who work in the field of longterm care report that a large number of families care for aging parents at home as long as possible. In fact, many families care for aging parents until the strain of doing so precipitates either a serious illness in the caregiver or, in some instances, upheaval in the caregiver s own family. Given the concern and devotion many people exhibit toward their parents, it makes sense to explore the client s feelings in this area. Clients, especially those in poor health with aging parents, may want to make specific arrangements for assuring sufficient income to care for their parents. In addition to life insurance, long-term care insurance on the parents may be a part of the solution. (Long-term care policies are covered in a different module.) Note: The death benefits of life insurance generally are received by the beneficiary income-tax-free. If the insured had any ownership rights in a policy at the time of death, or within three years prior to death, the proceeds of the policy will generally be included in the decedent s estate. In certain circumstances this might subject the proceeds to federal and/or state death taxes with possible negative repercussions. This will be discussed further in other CFP Certification Professional Education Program courses. Business Needs The business uses of life insurance are dealt with more completely in the Estate Planning modules. They are mentioned and examined briefly in this module to provide students with an idea of the wide range of uses for life insurance in the risk management area of the financial planning process. Closely Held Business Risk exposure death of a partner or co-shareholder. When others are involved in the client s ownership of a closely held business, both the client s and the partner s mortality must be taken into consideration during the planning stages. If a partner dies in the absence of a properly drawn buy-sell agreement, the client may eventually be in partnership with the heirs of the deceased co-owner or be forced to liquidate the business. If the relatives are not already involved in the Chapter 1: Financial Risk Exposures at Death 11

16 day-to-day operations of the business, misunderstandings are almost certain to occur. If the client wants to buy the partner s share of the business from the family (assuming a price and terms can be arranged), there still is a problem of funding. Life insurance is frequently the best answer here. If proper funding is not available, the result may be that the business is liquidated, in which case both the decedent s family and the client are adversely affected. It is important to remember that, technically, when a partner in a partnership dies, in the absence of a written agreement, surviving partners are obliged to close the business, liquidate the partnership, and distribute the proceeds. Planning techniques using life insurance are presented in other modules. Buy-sell agreements. A buy-sell agreement is often used to transfer the ownership interest of a deceased business owner. Buy-sell agreements have many variations, and normally require the services of an attorney to properly set up. Simply put, a buy-sell agreement allows the business (corporation or partnership) to purchase the deceased owner s (or shareholder s) share of the business from the estate. This provides money for the deceased s family, and all but eliminates the need for a surviving spouse to remain involved in the business. The agreement allows the business to continue operating as planned, and eliminates any ongoing obligation to the deceased s family. Buy-sell agreements have many forms. In all cases it is a very good idea to get an accurate business valuation (or stock valuation) as part of the process, in order to determine the selling price of the ownership interest. Types of buy-sell agreements include: Stock redemption. The business agrees to buy the deceased shareholder s stock (i.e., entity plan). Cross purchase. Each business owner agrees to buy out the interest of the deceased business owner. Other, often less favorable non-buy-sell methods of dealing with business continuity issues include: Wait and see. Upon the death of a business owner, the remaining owners decide the best way to proceed. 12 Introduction to Life Insurance & Annuities

17 Third-party buyout. A nonrelated party agrees to purchase the deceased owner s interest. Life insurance is often used as the funding vehicle for buy-sell agreements. One example of a policy used for this purpose would be a participating whole life policy, using the paid-up dividend addition option. Universal life and first-to-die policies are other examples of policies used to fund buy-sell agreements. Depending on the plan, one or several policies may be necessary. Care must be exercised to limit any potential income tax liability on the sale/purchase of a deceased owner s interest. Disability or retirement can also be triggering events, and require different funding vehicles. Generally, the death benefits of life insurance are received free of income tax. If a cash value type of policy is surrendered prior to death and the cash surrender value exceeds the cumulative premiums paid in (basis), the gain is taxed as ordinary income. However, planners should be aware that life insurance proceeds payable to a C corporation may give rise to alternative minimum taxable income. In addition, if insurance policies are transferred from one owner to another in order to fund a cross-purchase agreement, there is a possibility that most of the death benefits may be taxed as ordinary income under the transfer for value rule. This contingency is addressed in greater detail in the Estate Planning and Income Tax Planning courses. Risk exposure death of a key employee. A key employee is defined as a person who, if lost, would have a material effect on the earnings of the business. If an employee can be replaced within a reasonable time with minimal effect on the earnings of the business, there is no reason to insure against the loss of that person. The business may be able to take steps that make an otherwise key employee less critical to the business. Steps such as cross-training current employees, writing procedures manuals, or installing specialized accounting systems can prepare for an employee s absence. If, on the other hand, such measures cannot be applied to the unique talents the employee brings to the business, life insurance may be required to cover the very real economic risks faced by the business in the event of the death of the employee. Life insurance can provide for the loss of potential business income as well as the cost of searching for a replacement. Chapter 1: Financial Risk Exposures at Death 13

18 Risk exposure loss of a key employee. Related to the above concern is that of retaining key employees. Frequently this is accomplished through benefit programs aimed specifically at the key employee. These often use life insurance as the funding vehicle. Such programs include deferred compensation and splitdollar programs. These programs are more thoroughly explained in other modules. If your client is the owner of the business, you may assist him or her in designing such programs. If your client is a key employee, there may be opportunities for bringing such programs to the attention of the business owner or board of directors for your client s benefit. Note: Recent legislative changes have created some concern regarding the use of at least some split-dollar programs. The legislation does not appear to have invalidated split-dollar arrangements, but it does bring the use of some arrangements into question. It is important to remember, when implementing any creative use of a financial tool (life insurance, in this case) to stay alert for any tax or legislative events that may impact the use of such a tool. This does not mean that you should not try to make creative use of the available financial tools. It does mean, however, that you must be alert for potential problems. This seems to be especially true where potential tax savings (as in the case of split-dollar plans) are involved. Risk exposure death of an owner/estate liquidity. It is not uncommon for the owner of a closely held business to plan for meeting estate settlement costs through a partial redemption of corporate stock. There are statutory requirements that must be met for such a redemption to receive favorable tax treatment (Section 303 of the Internal Revenue Code). Where it is anticipated that these requirements can be met, the redemption generally is funded by having the corporation purchase insurance on the life of the owner of the stock. Risk exposure special situations. There are special situations where insurance may be called for; read contracts carefully and consider the implications of what they require. For example, life insurance is sometimes worked into plans for stock repurchases under employee stock ownership plans (ESOPs) or is used to provide death benefits under a qualified retirement plan. Estate plans may utilize insurance to move assets outside of a taxable estate to transfer wealth more efficiently. This will be covered in the Estate Planning course. 14 Introduction to Life Insurance & Annuities

19 Chapter 2: Life Insurance: Types Reading this chapter will enable you to: 5 2 Identify types, uses, and limitations of various types of individual life insurance policies. There are many forms of life insurance, and all of them can be put into two general categories: cash value and term. Some forms of life insurance have been around a long time and some are relatively new. Additionally, there have been some changes to the older forms that are quite significant. Pricing Fundamentals Two concepts mortality and morbidity are the cornerstones of the actuarial basis of life and health policies. Mortality deals with death. Morbidity deals with the incidence of losing one s health through illness or injury. Mortality and Morbidity Mortality rates are statistical figures that show an average of how long a group of people will live. They are rates of life expectancy. Life insurance policy premiums are based on three factors mortality rates, investment income, and expenses. Insurance companies currently use the 1980 or the 2001 Commissioners Standard Ordinary mortality tables (1980 CSO or 2001 CSO), as well as tables the companies produce themselves. The CSO tables are used to determine the reserves required of a company in relation to all policies sold. Premiums generally are affected as much by the actual experience of the company as by the CSO tables, since the CSO rates the entire population, including those who are uninsurable because of poor health. The insurance company s own experience may give it somewhat of a better base on which to determine premiums. Chapter 2: Life Insurance: Types 15

20 Morbidity, on the other hand, is a measure of the rate of disability. Tables exist that predict what portion of a group may become disabled over a specific period of time. Morbidity rates affect the cost of premium waiver riders on life insurance as well as the premiums for disability income insurance. Traditional Forms of Life Insurance Most of what are considered the traditional forms of insurance have been around for more than a century. These include whole life, limited pay life, endowments, annually renewable term, and decreasing term. In the early years of life insurance, only term-like policies were available. As is true today, the cost of the insurance increased as each insured aged. When the premium increased too much, many people dropped their policies and died uninsured. Eventually the public demanded and received level premium policies. These were designed so that the policyowner paid excess premiums in the early years. The additional premium amounts were put into a cash account from which the insurer could draw needed funds as actual costs increased in later years. Using this plan, the insurance didn t become prohibitively expensive as the insured aged. Whole life was born the first consumer-demanded form of insurance. The cash account of a traditional whole life policy is invested in the company s general account. While the conservative nature of the general account does not provide much in the way of investment earnings, it does help to assure that the life insurance will be around when needed. Alternatives exist with regard to how the cash account is invested, and those alternatives have helped create several additional forms of life insurance (discussed below). Today, term insurance is generally considered useful for short-term needs, and cash value insurance is normally used for long-term needs. 16 Introduction to Life Insurance & Annuities

21 Term Life Insurance Annually Renewable Term Insurance Term insurance is also known as temporary insurance. An annually renewable term (ART) policy, also known as yearly renewable term (YRT), provides death protection for one year at a time. The policy renews each year with the payment of the premiums due. This form of insurance almost always has the lowest initial premium since the risk of death the mortality rate is relatively low when insurance is first sold, and the risk is priced for one year at a time. Term insurance premiums are based on the estimated cost of insuring the individual for one year at a time. The cost of insuring a person the mortality cost increases each year, so everyone s mortality costs are lower today than they will be in one year. The mortality rates below provide an example of this. Age (Male) Table 1: Male Mortality Rate Comparison % increase from prior number Mortality Rate per thousand , , ,015 % increase from age 25 It is easy to see from this table, which is based on the 2001 Commissioner s Standard Ordinary (CSO) Mortality Table, that the risk of dying not only increases as we get older, it generally increases at an increasing rate. While the table shows that a $101 mortality cost at age 25 goes up to $124 at age 35, by the time this insured reaches age 65, the same amount of insurance will cost $1,765; and if the insurance is kept to age 85, it will be $12,236. (Note: You will not be required to do any mortality calculations for the exam.) These numbers are based on a mortality table that reflects the entire population, including those who are uninsurable. Since insurance companies evaluate the insurability of applicants, this table, in the early years, does not reflect the Chapter 2: Life Insurance: Types 17

22 insurance companies actual mortality experience. As time goes on, the table more closely reflects the mortality experience of the companies. What this means is that in the early years of a term policy, the actual mortality costs are lower, and the company can sell the policy for a very low premium. It also means that the increases in later years will be greater since the underwriting that took place at the inception of the policy means very little as the years pass. ART/YRT policies generally have a guaranteed maximum premium and are renewable for some period of time. Most insurance companies permit a term life insurance policyowner to keep the policy in force up to age 70 or so, or sometimes even longer. Some states limit the age to which term insurance may be renewed. In today s marketplace, term policies often have the initial premium guaranteed for some period of time. This may be from five to 30 years, for example. Many of these policies project a level premium but only guarantee the first five years. The longer the guarantee for the level premium, the higher the premium will be. A policy that has a guaranteed level premium to age 100 or 120 will have a premium approaching that of a whole life policy. While some insurance companies permit a policyowner to renew a term policy by merely paying the premium, some companies offer a significant incentive for insureds to requalify for coverage. These policies, called reentry term policies, permit the insured to be underwritten every five years or so. If he or she is still insurable in the same classification, the premium for ART may actually drop in the sixth year, and for other policies the premium won t go up very much. Unfortunately, if the insured is not in the same physical condition, the premium will increase significantly. At some ages it might triple or quadruple. The National Association of Insurance Commissioners created and approved model law, Regulation XXX, which addresses long-term guarantees for term insurance premiums. Because term insurance rates are exceptionally low, the commissioners are concerned that if insurance companies do not collect adequate premiums for term insurance, many of them will become bankrupt as their insured population ages. Regulation XXX requires higher reserve requirements for term policies that guarantee premiums for more than five years. This is an 18 Introduction to Life Insurance & Annuities

23 effort to assure the solvency of insurance companies in the future. The high reserve requirements continue to have a significant financial impact on insurers, as well as reinsurers. Decreasing Term Life Insurance Decreasing term insurance is a form of term life insurance where the premium remains level, but the amount of death benefit decreases. These policies have generally been sold to cover home mortgages. One problem with the early forms of decreasing term was that they all used straight-line depreciation. The amount of coverage decreased by the same dollar amount every year. Unfortunately, the principal of home loans doesn t decrease in this manner. In the late 1970s, insurance companies began to offer decreasing term policies using various interest rates and an amortization table to have the coverage decrease at the same rate as the mortgage. However, although this answered one problem of the policies, it didn t correct the major problem that these policies cannot address. Most people do not live in one home until it is paid off. When they move, they often obtain a larger mortgage. If they do stay in the home for many years, they may borrow against the equity in the home. With either scenario, the decreasing term insurance becomes inadequate to cover the outstanding debt associated with the home. For these reasons very few companies sell these policies now. Insurance experts generally recommend that if term insurance is used to cover a mortgage, that one of two approaches be used. The first is to purchase a level death benefit policy. If some years down the road the insured needs less insurance, that policy may be able to be reduced. This way, the reduction happens when the policyowner wants it to happen, and not before. The preferred method is to incorporate the mortgage need into an overall life insurance needs analysis. Insurance used to cover a mortgage should not necessarily be tied to the home or the mortgage. It should be payable to a named beneficiary, who then has the option of choosing whether to pay off the mortgage or not. The time to determine which option is better should be made at the time of death, taking into consideration the survivor s situation, desire to maintain the same home (or not), and the state of the economy at that time. Chapter 2: Life Insurance: Types 19

24 Death Benefits of Term Insurance It is important when discussing term insurance to recognize some basic facts regarding the payment of death benefits. It was during the 1950s that an MDRT (Million Dollar Round Table) life insurance member once said, The best life insurance policy is the one that is in force when you die. In the mid-1990s, nearly one-third of all life insurance policies were term insurance. These policies provided nearly half of the life insurance dollars in force. However, relatively few of the proceeds from death claims paid (possibly as low as 1% to 2% according to some studies) were from term insurance policies. From this, we can draw a number of conclusions. Term insurance in all of its forms provides most of the death protection at any given point in time. Most term insurance policies are allowed to lapse prior to the insured s death; the majority of all death claims are paid on cash value forms of insurance. Term policies are generally larger in amount (death benefit) than cash value policies. Because of the pricing of term, the highest premiums are going to be toward the end of life when the insured is retired and may be facing concerns over sustaining their income. Within the insurance industry, it is generally understood that term insurance policies are usually either converted to cash value policies or allowed to lapse prior to death. Permanent Life Insurance Endowments An endowment policy is one in which the death benefit and cash surrender value are the same at a specific date (e.g., 20 years from date of issue). These policies used to be popular in the United States for funding future needs, such as college education, weddings, and retirement, because the cash accumulation could be predetermined and targeted for a specific date. U.S. tax law changes effective after 1984 eliminated most new sales of policies that endowed before age 95. However, you may still encounter some clients who own these contracts. 20 Introduction to Life Insurance & Annuities

25 It is important to recognize that an endowment policy is not the same as a modified endowment contract, or MEC. The MEC is an insurance policy that has failed the seven-pay test created by Congress. Non-death-benefit withdrawals from a MEC are generally taxable, and there are additional adverse tax consequences. The MEC is examined in this module, while the more detailed tax ramifications are discussed in the Income Tax Planning course of this program. Whole Life Whole life is the most common form of permanent insurance. It has a fixed premium, a guaranteed cash value, a guaranteed death benefit, and includes a minimum guaranteed interest rate to hold the entire product together. Premiums are initially higher than those for term insurance. However, a portion of the premium is placed in an account so premiums remain the same throughout the policy period. The account, commonly known as a cash value account, has additional uses that are available to the policy owner. These are discussed later in this module. Whole life policies have a reserve maintained by the insurance companies so that the benefits of the policies can be paid. Companies selling whole life must provide nonforfeiture values with their whole life policies. These values provided a benefit payable to the policyowner if he or she quit paying premiums before the death of the insured. These are covered in detail in a later chapter. Insurance companies can be structured as stock companies or mutual companies. Companies capitalized by common stock are owned by shareholders and trade on the financial markets. Stock companies do not normally pay dividends to policyowners. They are referred to as non-participating whole life. Companies known as mutual companies are owned by policyowners. Mutual companies, when they pay dividends, pay them to their policyowners. A policy that receives dividends is said to be participating. These dividends are considered a return of excess premium. Here s why: Policy reserves are based on a very conservative interest rate (e.g., 3.5% per year). Since companies can generally earn more than this, they return at least a portion of the excess in the form of dividends. Until the cumulative dividends exceed the cumulative premiums paid, Chapter 2: Life Insurance: Types 21

26 dividends are treated as an income-tax-free return of the unneeded premium. Ways in which dividends can be used will be discussed later in this module. Actuaries determine that the premium and reserve requirements are based, in part, on an assumed life expectancy (e.g., age 100 under the 1980 CSO or age 120 under the 2001 CSO). Since it is presumed that people die at a given age (based on current mortality tables), the actuaries calculate the premiums, taking into consideration the guaranteed minimum interest rate, so that the reserves equal the death benefit at the assumed age of mortality. With most whole life policies, beginning in about the 10th policy year, the nonforfeiture value, also known as the cash surrender value, is equal to the policy s reserves. When the insured reaches the age of mortality (e.g., age 100 or 120), the reserves equal the death benefit, and the policy is said to have endowed. Older whole life policies would then consider the policy endowed and the accumulation sent to the policyholder. Endowment of a whole life policy may create an unfavorable tax situation for an insured where face value is paid out, exceeding the policy s basis (premium paid). It is important to check this feature when examining old policies that are still in force. Most policies now allow the funds to remain with the insurance company and be accessed through loans rather than create a tax consequence. The standard form of whole life insurance provides a guaranteed death benefit for the life of the insured, and requires premium payments to be made until death or policy maturity. Options allowing shorter premium payment periods, but continuing coverage for life, are discussed below. Limited Pay Policies Somewhere in between whole life and endowment policies are limited pay policies, also known as limited pay life policies. These are essentially whole life policies with a shortened premium-paying period. A whole life policy is generally designed to have the premium paid for the life of the insured or to age 100 (120 under the 2001 CSO), whichever comes first. With a limited pay policy, the death benefit continues to age 100/120 when the policy matures or endows, but the premiums stop earlier. 22 Introduction to Life Insurance & Annuities

27 Some limited pay policies are designed to be paid up when the insured reaches a specific age such as 65 or 95, where premiums are paid to that age and then cease. Other plans include 10-pay, 20-pay, or 30-pay life policies. With these policies, premiums are paid for 10, 20, or 30 years, respectively. As a result of the shorter payment period, the premiums for these policies are higher than for regular whole life. Single premium whole life is a policy in which a lump-sum payment is made and no further premiums are required. There are substantial surrender charges if the policy is cashed in within the first few years. Special tax rules (MEC) apply to these policies. Generally there are very specific planning strategies that utilize this type of policy that are beyond the scope of this material. Variations Modified whole life. Modified whole life is a whole life policy preceded by a period of term insurance. These policies have low, term-like premiums for a number of years, then premiums automatically increase to whole life levels. Many of these policies have an ultimate premium that is lower than it would be if the insured waited until the age at which the premium automatically increased to purchase the insurance. Another type of modified whole life is sold on the lives of children. The policy provides term insurance until the insured reaches a specified age, typically from 18 to 25. When the child reaches this age, the policy converts to a whole life or limited pay life policy with a lower premium than if the insured had waited until that age to obtain the insurance. Such protection can sometimes be added very inexpensively as a children s level term rider. Graded premium life. Graded premium life was designed to ease people into a whole life premium. Its premium per thousand dollars of insurance is fairly low the first year, and increases each year for five to seven years, at which time it reaches its ultimate premium. The ultimate premium is level for the life of the insured. The ultimate premium is typically the premium for a whole life policy purchased a year or two before the ultimate premium is reached. Chapter 2: Life Insurance: Types 23