Life Insurance Basics

Transcription

1 Producer Training I Life Insurance Life Insurance Basics An Introductory Guide Life Insurance Underwritten by Genworth Life and Annuity Insurance Company Genworth Life Insurance Company Richmond, Virginia Genworth Life Insurance Company of New York, New York, New York Only Genworth Life Insurance Company of New York is admitted in and conducts business in New York /22/11 For Agent/Producer/Broker/Dealer Use Only. Not to be reproduced or shown to the public.

2 Table of Contents Module 1 Introduction to Life Insurance Why People Buy Life Insurance: The Financial Risk of Dying...4 Personal Uses of Life Insurance...4 Income Replacement Case Study...5 Business Uses of Life Insurance...6 Key Employee Life Insurance...6 Buy-Sell Arrangements...7 Estate Planning Uses of Life Insurance...9 Charitable Giving Uses of Life Insurance...9 Retirement Planning and Life Insurance...1 Insurable Interest...1 The New Business and Underwriting Process...12 Retention and Reinsurance...13 Financial Underwriting Parties to the Application...15 Drafting Beneficiary Designations...15 Overview of Life Insurance Products and Features...16 Term Life Insurance...16 Whole Life Insurance...17 Nonparticipating Whole Life...17 Participating Whole Life...18 Fixed Universal Life Insurance...18 Variable Life and Variable Universal Life Insurance...19 Survivorship Universal Life Insurance...19 Living Benefits of Life Insurance Accessing Cash Surrender Value...19 Policy Loans...19 Withdrawals...19 Accessing Death Benefits During Lifetime...2 Accelerated Death Benefits for the Terminally Ill...2 Accelerated Death Benefits for the Chronically Ill...2 Additional Benefits Provided Through Riders...2 Waiver of Premium...2 Waiver of Monthly Deductions...21 Waiver of Specified Amount...21 Child Rider...21 Accidental Death Benefit

3 Module 2 Fixed Universal Life Insurance (Current Assumption) Definition of Life Insurance...23 Death Benefits...24 Corridor...25 Premiums...26 Minimum and Maximum Premiums...26 Target Premium...26 Policy Fees And Other Policy Charges...26 Cost of Insurance (COI) Charges Policy Value...28 Premiums, Interest Rates and COLI Charges Drive Policy Value...28 Cash Surrender Value and Surrender Penalties...28 Access to Policy Values through Loans...29 Access to Policy Values through Withdrawals...29 Grace Period... 3 Module 3 Life Insurance Illustrations Compliant Illustrations...31 Parts of a Life Insurance Illustration...31 Current Assumptions Versus Guaranteed Features...32 Module 4 Death-Benefit Guarantee Universal Life (UL) Insurance Death-Benefit Guarantee Universal Life...35 Specified Premium Account Method...37 Shadow Account Method...37 When the Grace Period Begins Catch-Up Provisions...39 Summary...39 Module 5 Basics of Federal Life Insurance Taxation Federal Income Taxation of Death Benefits... 4 Transfers for Valuable Consideration... 4 Life Insurance Owned by and Payable to an Employer Notice and Consent Exceptions Reporting Federal Income Taxation of Cash Value Modified Endowment Contracts (MEC)...45 Tax Implications of MEC Status Internal Revenue Code (IRC) 135 Exchanges Exchange of Life Insurance Policies with Outstanding Loans Advantages of Genworth Policies

4 Module 1 Introduction to Life Insurance Life insurance is a unique risk management tool. Unlike car or medical insurance, which reimburse for specific expenses associated with an accident or illness, life insurance pays a pre-determined dollar amount at the death of the insured person, usually unrelated to a specific monetary loss. However, as discussed here, the amount of life insurance a carrier will issue on a specific individual s life is limited to an estimate of the potential losses that may result from that individual s death. A life insurance policy is a contract between the insurance company and the policyowner. It generally stipulates that in exchange for the payment of either a set premium at a set time or sufficient amounts to pay the policy s fees and charges, a specified death benefit amount will be paid to the policy s beneficiary when the insured dies. To meet diverse needs and enhance the value of life insurance, today s policies come in different types and offer a variety of features. While some life insurance policies focus exclusively on providing a death benefit, others also build policy value amounts within the policy that the policyowner may access through withdrawals, if permitted, or policy loans. How withdrawals and loans impact life insurance policies will be discussed more fully later. Finally, to encourage people to buy life insurance, these products have certain income tax benefits. The death benefit paid to the beneficiary is usually income tax free. Moreover, any policy value growth inside the policy is generally not subject to income tax unless removed from the life insurance policy. Why People Buy Life Insurance: The Financial Risk of Dying People buy life insurance for many reasons, but insurable interest laws and financial underwriting principles provide guidance on who can buy the insurance and for how much. As a lead into a discussion of insurable interest, let s look at some of the reasons individuals might consider buying life insurance. Personal Uses of Life Insurance Life insurance death benefits can help in many ways, including, but not limited to, the following: Replace the income of a deceased wage earner; Pay off mortgages and other debts (including funeral expenses); Provide funds for home maintenance, emergencies or opportunities; Supplement retirement income of a surviving spouse; Provide funds for the education of the surviving spouse or children; Fulfill the obligations of a divorce decree or child support agreement; Benefit charitable organizations, churches or schools (like an alma mater); Equalize the inheritance heirs receive. While people use life insurance for many reasons, the most important reason, by far, is to protect their families from the financial loss that occurs when a wage earner dies. The death benefit paid to beneficiaries can be used to replace lost income; ensure the family can stay in their home; purchase food, clothing and other necessities; pay funeral expenses or create a fund to meet future expenses or education costs. Let s look at an example on the next page. 4

5 Example: Joseph and Marie Alvarez Joseph and Marie Alvarez are both hard-working individuals who place a high value on family. Joseph is a pharmaceutical salesperson who has been with the same employer for eight years. He makes about $95, per year. Marie works as an x-ray technician, earning about $55, annually. She went back to work when their youngest started pre-school. Their son, Michael, is 11, and their daughter, Kelly, is 9. With Marie back to work, they qualified for a bigger mortgage, and three years ago, they bought their dream house in a new suburb that isn t far from Marie s parents. They have all settled comfortably into the community. Michael plays both baseball and soccer. Kelly takes ballet and also plays soccer. Marie s job is only a few miles away, and her short commute provides her more time to spend with her family and get the kids to their soccer games on time. Her parents live nearby and are able to help with the kids when needed. This is especially helpful since Joseph s job often takes him out of town. Things are good. Fast-forward a few years. Joseph was coming home from a week of sales calls when he was { } in a serious traffic accident. He passed away as a result of the accident. This story has two possible endings: Joseph did not have life insurance: Marie is devastated by the loss of her best friend and husband. Very quickly after the funeral, she realizes that she cannot afford the mortgage payments on her salary alone. She has to sell the house and rent an apartment that fits her budget. Unfortunately, the apartment isn t in the same neighborhood as the old house, so the kids have to change schools and make new friends. For the kids, the distressing loss of their father is compounded by the upheaval in their lives. After the move, Marie has a longer commute, and her parents aren t as close by and available to help if she is late getting home. The dreams that she and Joseph had for their children s college education and for their own comfortable retirement seem unobtainable now. Joseph had life insurance: Marie is devastated by the loss of her best friend and husband. After the funeral, she has to help her kids and herself move on with their lives. She knows it will never be the same for any of them, but thanks to Joseph s thoughtful planning, there was enough life insurance to pay off the mortgage and to set aside money for both kids college education and other future needs. She and the kids are able to stay in the home she and Joseph worked so hard to obtain, in the same neighborhood, with friends and school nearby. The kids have resumed their involvement in sports and school activities. Marie s parents are still nearby to support her and the kids. She wonders what she and the kids would have done had Joseph not bought enough life insurance to offset his income in the event of his death. She can only imagine how difficult it would have been. This story can t capture the pain of losing a loved one, but it does demonstrate the important role life insurance can play in the lives of real people. 5

6 Business Uses of Life Insurance Life insurance is also common in the business setting. Examples include: Insuring a key person to help protect the business from potential losses resulting from the insured s death Funding a buy-sell arrangement for the transfer of a business interest at an owner s death Insuring owners or key employees to cover the repayment of a business loan Providing extra benefits for key executives of the business as an inducement to join or remain with the business Providing group life insurance for all employees Allowing employees to purchase personal life insurance through a payroll deduction program Including life insurance in the company retirement plan to provide a death benefit to a deceased employees families Let s explore a couple of these in more detail. Key Employee Life Insurance It is common for businesses large and small to purchase life insurance on the lives of key employees who are responsible for their success. In this arrangement, the business owns the policy and receives any death benefits paid. Life insurance death benefits help offset potential financial losses triggered when a key person dies, such as: Paying to recruit, hire and train a replacement with similar skills Offsetting any lost profits or decreased cash flow that occurs as a result of the death Repaying business debt(s) Figure 1: During Lifetime... Life insurance death benefits help offset potential business financial losses triggered when a key person dies. Business Premium $ Genworth Life Insurance Policy Insuring Key Employee When Key Employee Dies... Business Death Benefit $ Genworth 6

7 Buy-Sell Arrangements Small, closely held businesses often use life insurance to fund plans that will help the business continue if a business owner dies. These plans are commonly referred to as buy-sell arrangements. Written agreements spell out the terms of arrangements between the business and its owners or between the owners themselves. The owners agree to sell their share of the business if they die, retire or leave the business, and the other owners, or the business, agrees to buy it. The buyer may choose to purchase life insurance on the seller as part of this arrangement in the event an owner dies. Then, if the seller dies, the death benefit will help the buyer fulfill the terms of the buy-sell contract by providing cash to help purchase the deceased owner s share. The ownership of the policies depends on the type of buy-sell agreement established. If the business is to be the buyer of a decedent s interest an entity purchase arrangement then the business should be the owner and beneficiary of the life insurance policy. 1 Figure 2: Entity Purchase Arrangement Life insurance death benefits can be used to fund business continuity plans and take care of the owner s family. Owner A Business Owner B Owners enter into an agreement with the business. Business applies for, owns and pays the life insurance premium on each owner. When one owner dies... Business uses the proceeds to purchase the deceased s business interest Heirs receive an agreed-upon price for their business interest Genworth $ Business $ Deceased s Business Interest 1 Note that employer-owned life insurance must comply with the requirements of IRC section 11(j) in order for the death benefit to maintain its tax-free status. See the section on Employer-Owned Life Insurance in the chapter titled Basics of Federal Life Insurance Taxation. 7

8 If a co-owner is the purchasing party a cross purchase arrangement then the co-owner should be the owner and beneficiary of the insurance policy on the seller s life. Occasionally, other types of arrangements are established to meet other business continuation needs. Figure 3: Cross Purchase Arrangement Life insurance death benefits can be used to fund business continuity plans and take care of the co-owner and the deceased owner s family. Owner A Agreement Between Owners Each owner owns (and pays the premiums for) a life insurance policy on the other owner(s). The policy provides a death benefit equal to the amount needed to buy their partner's business interest upon death. Owner A is the owner and beneficiary of a policy on Owner B. Genworth Owner B is the owner and beneficiary of a policy on Owner A. Owner B At the Death of One Owner Genworth $ $ Surviving Business Owner Deceased Owner s Estate Deceased s Business Interests 8

9 Estate Planning Uses of Life Insurance For high-net-worth individuals, life insurance assists with transferring wealth to their heirs. The most common use is to provide cash to pay the costs associated with settling a large estate. These costs might include expenses connected with probating the will or estate transfer taxes that may be payable to federal or state governments. In addition, life insurance may be used to: Pay off business or personal debts; Equalize the estate among heirs; Fund estate planning and charitable planning techniques such as charitable remainder trusts, wealth replacement trusts, or grantor-retained annuity trusts or unitrusts. Insureds with large estates should not own life insurance on their own life. This is because assets owned by a deceased are included in their gross estate at death and may be subject to estate taxes (in general, estates in excess of $5,, in are subject to estate taxes). Therefore, many attorneys will recommend that their highnet-worth clients set up irrevocable trusts to own the life insurance. These trusts are often referred to as irrevocable life insurance trusts (ILIT). When set up and administered properly, the assets in the ILIT will not be included in the decedent s gross estate and will not be subject to estate taxes. Life insurance death benefits payable to the ILIT can be used to provide for the trust beneficiaries in accordance with the provisions of the trust document. In addition, the trustee may be empowered to loan money to the estate or purchase assets from the estate, so that the estate has sufficient cash to pay any estate taxes it owes. Charitable Giving Uses of Life Insurance Charitable organizations can benefit from life insurance that insures the lives of their key donors. Typically, the charitable organization is both the policyowner and beneficiary of the policy. The donor makes yearly tax-deductible donations to the charity, and the charity uses these funds to pay the policy s premium. At the donor s death, the charity can use the death benefit to help fund its activities. Client Makes Tax-Deductible Donation Life Insurance on Donor s Life Figure 4: Charitable Purchase Plan Life insurance death benefits can be used to leave a legacy gift to a charity. Charitable Organization $ $ Premium Death Benefit at Donor s Death Genworth 9

10 Retirement Planning and Life Insurance For many couples, serious planning for retirement may not begin until the kids are grown and on their own. As empty nesters, they may now have the time to start planning for retirement and the resources to begin building a retirement fund. For couples with two incomes, the death of one spouse and the corresponding loss of their income can seriously impact the surviving spouse s ability to fund for retirement. Dependent now on a single income, the surviving spouse may use or drastically spend down any discretionary funds, making it difficult to meet retirement goals. Having life insurance on both wage earners can ensure that if either dies, the survivor will still be able to enjoy the comfortable retirement originally planned. Additionally, if cash value life insurance policies are used, they can serve double duty. The death benefit can provide funds if one dies early, and, if they both live to retirement, any cash surrender value in the policy can be used to supplement retirement income. Some employer-provided pension or profit-sharing plans include life insurance on the lives of the plan participants. If the participant dies before retirement and before the plan has accumulated enough to provide for retirement the life insurance death benefit can infuse the retirement account with cash and help make up for some or all of the loss resulting from the employee s premature death. Insurable Interest Life insurance is designed to protect those who would suffer financially if the insured individual died. This is known as having an insurable interest. Just as one person cannot purchase insurance on someone else s car, someone with no financial stake in the insured s continued life cannot buy life insurance on that person. State law determines whether an insurable interest exists. Insurable interest issues may arise when the owner and insured are not the same. In the absence of a blood relationship, all states require that the policyowner have a greater interest in the insured s continued life than in the insured s death at the time the policy is issued. A few states require that both the owner and the beneficiary hold an insurable interest. This usually means that both would suffer a financial loss if the insured died. Outside of these few states, insureds who own their own policies can generally name any beneficiary. 1

11 This excerpt is from the Virginia statute regarding insurable interest: Insurable interest required; life, accident and sickness insurance. A. Any individual of lawful age may take out an insurance contract upon himself for the benefit of any person. No person shall knowingly procure or cause to be procured any insurance contract upon another individual unless the benefits under the contract are payable to (i) the insured or his personal representative or (ii) a person having an insurable interest in the insured at the time when the contract was made. B. As used in this section and , insurable interest means: 1. In the case of individuals related closely by blood or by law, a substantial interest engendered by love and affection; 2. In the case of other persons, a lawful and substantial economic interest in the life, health, and bodily safety of the insured. Insurable interest shall not include an interest which arises only or is enhanced by the death, disability or injury of the insured; Even if a financial loss is not apparent, certain family members are assumed to have an insurable interest in the insured, based on love and affection. These include the insured s: Spouse Children Parents The following may also have an insurable interest (documentation supporting insurable interest may be required): Brothers and sisters Grandparents Fiancé/Fiancée Domestic partner Business owned by the insured Business partner or co-shareholder Trust established by the insured, or a trust in which the insured is a beneficiary (provided the grantor or the trust beneficiaries (as applicable) have an insurable interest in the insured at the time the policy is issued) Employer, but only if the insured is a key employee, officer or owner of the company Creditors Insured s estate A charitable organization to which the insured makes donations While most states require only that the policyowner have insurable interest in the insured, many insurance companies require the beneficiary to have insurable interest, as well. 11

12 The New Business and Underwriting Process underwriting practices of the company that will drive future mortality. If the underwriting practices aren t consistent and predictable, the mortality assumptions used by the actuary to price the product may be wrong leading to more, or fewer, deaths than predicted during the pricing process. Purchasing life insurance transfers a portion of the risk of financial loss due to an insured s death from the policyowner to the life insurance company. The insurance company must be able to determine how much to charge for the policies it issues to ensure it has sufficient funds to cover the costs of selling and issuing new policies, ongoing administration of the polices and payment of future claims. Individuals who are trained to do this type of pricing analysis are known as actuaries. Either situation can lead to an undesirable outcome. If the underwriting practices are stricter than the actuary assumed during pricing, the product may be priced higher than it needs to be. This leads to a less competitive position for the company and fewer sales. Conversely, if the underwriting practices are more liberal than assumed during pricing, future mortality may be higher than expected, resulting in lower returns for the company or even insufficient premium dollars to meet future obligations. Along with pricing the products correctly, the insurance company must be able to evaluate each person who applies for insurance to determine if it wants to approve them for insurance coverage. This process is known as underwriting. There is a direct correlation between product pricing and the underwriting standards and principles used by an insurance company. In order for an actuary to accurately price a product, he or she must be able to reasonably predict future mortality (as well as expenses, etc.). These predictions are based on past mortality experience as well as the current It is the responsibility of the company s underwriting department to conduct a thorough evaluation of each proposed insured by applying the carrier s underwriting standards. With the proposed insured s approval, the company s underwriters gather and evaluate medical information on them, 12

13 as well as information on family medical history, hobbies and occupations. Information about the proposed insured s health and other factors influencing the decision to offer insurance coverage comes from a variety of sources, which may include: The insurance application and any supplemental forms An exam conducted by a paramedical or a doctor. The size of the policy, as well as the age of the insured, may determine the need for a medical examination and what information will be required. Paramedical personnel gather information about the proposed insured s medical history, family history, height and weight and often collect blood and urine samples. For higher death benefit amounts, or when other circumstances dictate, an exam by a medical doctor or additional tests (e.g., stress EKG) may be required. Attending Physicians Statements (APSs) requested from the proposed insured s doctors to obtain more detailed information about specific medical conditions Inspection reports, which provide other information like any criminal activity or other high-risk behaviors Driving records to check for an unusually high number of traffic violations or any arrests for driving while under the influence of drugs or alcohol Medical Information Bureau (MIB) reports. The MIB, an association of life insurance companies, provides medical information to help protect companies from attempts to conceal or omit health information that is necessary to make an underwriting decision. The underwriter uses all of this information to evaluate the risk before approving or declining to issue a policy. For those approved for coverage, the underwriter also determines the appropriate premium rate needed to adequately cover the risk. The rates fall into classes, like Standard, Select, Preferred and Preferred Best. (The names of rate classes may vary among carriers.) The healthiest individuals would fall into the Preferred Best category. Rate classes are further split into nicotine and non-nicotine users. Individuals with more serious health issues are charged a higher rate per thousand dollars of death benefit, known as a table rating. Sometimes a flat extra premium is charged. The ratings may last for the life of the policy or, as in the case of many flat extra premiums, for only a specified period of time. Retention and Reinsurance Insurance companies are in business to manage risk. However, on large life insurance cases, insurance companies typically share the risk with another insurance company known as a reinsurer. Reinsurance companies don t sell insurance directly. They only underwrite the excess risk of the primary insurance carrier the issuers of the policy. An insurance company s retention limit is the amount of insurance the carrier does not reinsure. For example: Life insurance Company A has a retention limit of $1,, for all individual applicants under the age of 75. Life insurance Company B has a retention limit of $5,, for the same group. If both receive applications for $3,, of life insurance coverage on similar individuals age 5, Company A will retain only $1,, of the risk on their own books and pay a reinsurer to take the other $2,,. Company B will retain the entire amount because the amount is less than its retention limit. 13

14 The amount that each company retains is reduced by other insurance it already has in force on the proposed insured. Additionally, the retention limit generally decreases at older ages (e.g., over age 75). For reinsurance purposes, the carriers have autobind limits the amount of death benefit risk they may issue, and commit the reinsurer to, without individual case approval by the reinsurer. Linked to the autobind limits are the jumbo limits. The jumbo limit currently $65,, takes into account all insurance being applied for and existing on the proposed insured from all insurance companies, including life insurance being replaced. If either of these limits is exceeded, the carrier must send the entire underwriting file to the reinsurer(s) for approval. Facultative reinsurance is the term used to describe a case that is sent to reinsurers for review and approval, like cases that exceed the autobind or jumbo limits. In facultative reinsurance, the carrier sends the entire underwriting file to the reinsurer s underwriters for review and an underwriting decision or offer. Despite autobind and jumbo limits, a carrier may choose to send a specific, sometimes problematic, case to reinsurance facultatively. Once a case goes facultative, the carrier loses its ability to autobind that particular case. On large cases, even the reinsurer may choose not to take all of the excess risk. It may, in turn, choose to reinsure part of its share of the death benefit risk to yet another reinsurance company. A retrocessionaire is a company that takes the excess risk from a reinsurance company. Financial Underwriting Assuming the applicant for insurance has an insurable interest in the insured, it is also necessary to determine if the amount of insurance applied for, plus the sum of all life insurance currently in force on the insured, is reasonable. This is because the amount of insurance on a person s life should not exceed the amount of financial loss that would occur if the insured died. Financial underwriting is an evaluation based on many factors, like the individual s future earnings capacity or net worth. Sometimes the amount of coverage is tied to a contractual agreement such as a buy-sell arrangement in which the amount of insurance approximates the value of the proposed insured s ownership in a business. For high-networth clients, the amount might approximate the anticipated estate tax liability that will be due when the individual dies. Company-published guidelines provide information on acceptable limits. If the total amount of insurance in force plus the amount being applied for exceeds these limits, the underwriter will need additional documentation demonstrating why the higher amount is justified. A cover letter is a good place to explain the reason for the coverage amount. Additional documentation such as financial statements, estate tax analyses, businesses financial statements or balance sheets, charitable giving history or any other pertinent information can help the underwriter reach an informed decision. Failing to provide this documentation often results in a delay in reaching an underwriting decision. 14

15 Parties to the Application There are generally four parties to a life insurance policy: the insured individual, the insurance carrier, the policyowner and the beneficiary. Many times, the policyowner is also the insured. The insured is the person whose death will trigger the payment of the death benefit. Some policies will cover more than one insured under the same policy. The policyowner is the person or entity that will own the life insurance policy and have all the rights under the policy, which include the rights to: Name and change the beneficiary (unless named irrevocably) Access any policy cash surrender value Surrender the policy for its cash surrender value If the policyowner is not the insured, then the policyowner must have an insurable interest in the insured s life (see the sections on Financial Underwriting and Insurable Interest). There may be both a primary owner and a contingent owner. If a contingent owner is named, ownership of the policy will pass to the contingent owner if the primary owner dies before the insured. A contingent owner must also have insurable interest in the insured s life. The beneficiary is the person or legal entity who is entitled to receive the death benefits under a life insurance policy. Life insurance policies may have more than one beneficiary. The primary beneficiary or beneficiaries receive the death benefit if they are alive at the time of the insured s death. The contingent beneficiary does not receive any death benefit unless the primary beneficiary is deceased (or, in the case of a legal entity, no longer exists). Drafting Beneficiary Designations A well-drafted beneficiary designation for a life insurance policy provides a description that: Clearly identifies the beneficiaries AND Fulfills the policyowner s intent with respect to how the death benefit is to be paid. These are general guidelines for drafting beneficiary designations: Include both the name of the beneficiary and identifying information about the beneficiary, such as the beneficiary s relationship to the insured, date of birth or Social Security number (a few states require the beneficiary s address). If a trust is the beneficiary, the names of the trust and trustee and the trust s date are required. If a business is the beneficiary, you are not required to provide the name of the officers of the corporation or partners of the partnership. These individuals can change over time. When there are two or more beneficiaries, define how the benefit should be split. If unequal shares are requested, use only percentages to establish portions, and not dollar amounts. Avoid situations in which the insured, the policyowner and the beneficiary are all different. This can result in adverse gift or income tax consequences. If appropriate, use beneficiary wording that can accommodate future changes to the policyowner s situation (such as the expectation that the insured will have more children). Use class designations if there are multiple beneficiaries when the designation is made, but membership in the class is not yet known. Genworth Policyowner Services or Advanced Marketing can provide assistance on specific beneficiary wording, if needed. 15

16 Overview of Life Insurance Products and Features Life insurance policies generally fall into two broad categories: those that are designed to meet life insurance needs of a relatively short duration (3 years or less) and those that meet life insurance needs that are anticipated to last much longer, perhaps a lifetime. This overview will introduce you to products available in the marketplace today. Term Life Insurance Term life insurance provides a death benefit in exchange for a premium payment. It generally does not build policy value, though some policies sold offer return-of-premium benefits or cash value riders. Designed to meet short-term needs, most term life insurance sold today features a premium that is level for a certain number of years (e.g., 1, 15, 2, 25 or 3 years). This premium is usually guaranteed not to increase during the period selected. At the end of this period, the premium increases each year, and, as the insured ages, the increase can be substantial. 2-Year Term, Male, Age 45, Preferred No Nicotine Use $1,, Death Benefit; Premium for First 2 Years: $1,49 7, 6, 5, 4, 3, 2, After the level premium period, the premiums the insurance company plans to charge begin to increase and are not guaranteed. The insurance carrier has the right to charge higher amounts, as long as those amounts don t exceed a maximum premium level as stated in the policy. (See Figure 5.) If the required premium is not paid by the due date, or within the allowable grace period, the policy lapses without value. The grace period for paying premiums for term life insurance is usually 31 days from the due date. Term life insurance is the traditional option for shortterm coverage generally, 3 years or less. It can be used to pay off a mortgage or provide income for a family during child-rearing years. The increasing premiums in later years make term insurance impractical for meeting long-term life insurance needs. Today, some universal life insurance policies offering premiums comparable to term life insurance are also available for short-term needs. For needs lasting more than 3 years, a client may want to consider using whole life or universal life insurance, which is designed for this purpose. Figure 5: Term life insurance features a premium that is level for a certain number of years. At the end of the period (2 years), the premium increases each year as the insured ages. 1, Guaranteed Maximum Annual Premium Currently Charged Annual Premium 16

17 Whole Life Insurance Whole life insurance policies were the primary type of insurance sold before universal life insurance policies hit the market in the late 197s. The distinguishing features of whole life are that it has guaranteed premiums generally for the life of the policy a guaranteed death benefit and guaranteed policy value. In most policies, the premium remains level throughout the life of the policy, although some policies provide for paying a higher premium for a shorter premium-paying period (e.g., to age 65) with no further premiums due from that point on. Whole life policies have a 31-day grace period from the premium due date. However, failing to pay the premium by the end of the grace period doesn t necessarily result in lapse. Whole life policies have nonforfeiture options, which include: Surrendering the policy for its cash surrender value Applying the cash surrender value to purchase extended-term insurance, which maintains the death benefit for a limited amount of time determined by the insured s age and risk class, as well as the amount of cash surrender value available Applying the cash surrender value to purchase a reduced amount of death benefit on a completely paid-up basis (reduced paid-up insurance) The policyowner may also be permitted to borrow from any policy cash surrender value to make premium payments. If the policy is a participating policy (see below), dividends or the surrender of the paid-up additions may be available to help pay the premiums. There are two basic types of whole life policies: nonparticipating and participating. Nonparticipating Whole Life These policies are purchased with a guaranteed premium for a specific death benefit that is guaranteed to last to age 121. Although the death benefit lasts for life, policies may offer guaranteed premium payments for a specific number of years (e.g., 2 years) or to a certain age (e.g., to age 1). Depending on the policy, the policy values may: Be a guaranteed amount that increases each year OR Grow based on a fluctuating, interest-crediting rate guaranteed to not drop below a certain level (e.g., 2.5%). Additionally, some whole life insurance policies promise that the policy value will equal the death benefit by age 12. Figure 6 is an example of a whole life policy with policy values guaranteed to equal the death benefit at age 12. This typically means that if the insured is still living at this point, the policy terminates and the policyowner receives the policy value. Figure 6: Guaranteed Policy Value Relative to Death Benefit $12, $1, $8, $6, $4, $2, Age DeathBenefit Guaranteed Policy Value 17

18 Participating Whole Life Participating whole life policies are generally more expensive than nonparticipating whole life policies. To the extent the insurance company doesn t need the extra premium it collects to meet its obligations, it credits the excess back to the policyowner in the form of dividends. Dividends are not guaranteed, but, when declared, the policyowner may use them in several ways: Take them in cash Use them to reduce future premium payments Leave them on deposit with the insurance company to earn interest Apply them to the purchase of additional whole life insurance (paid-up additional life insurance) Apply them to the purchase of one-year term insurance Use them to repay any outstanding policy loans Paid-up additions are the most popular option, as they increase the total death-benefit amount and also have policy value. Figure 7 shows an example of a participating whole life policy with the (nonguaranteed) dividends applied to purchase paid-up additions. Other than the initial dividend, no premium payments are required to keep the paid-up additions in force. In later years, the policyowner may choose to surrender the additional coverage and use the policy value to pay premiums on the base policy. Fixed Universal Life Insurance Universal life insurance commonly referred to as UL was introduced in the late 197s. These policies were unique because they offered policyowners significant flexibility in premium payments and how death-benefit options were structured. In addition, policy values in the policy could earn current interest, backed by a base guaranteed rate. This contrasts with whole life insurance policies that offered a guaranteed death benefit with guaranteed policy value for a guaranteed premium and little or no flexibility beyond how to apply any credited dividends. 18 Figure 7: Policy Value and Death Benefit Including Paid-Up Additions 4, 35, 3, 25, 2, 15, 1, 5, Age Total Death Benefit Total Policy Value Current assumptions form the basis for the projected performance of some UL policies. In other words, the performance of the policy depends on the current non-guaranteed interest rate credited to the policy as well as the current non-guaranteed charges assessed against the policy. If interest rates drop or charges increase, the premium amount the policyowner pays may not be sufficient to keep the policy in force. Current assumption UL policies are still available, but now there are policies that offer guaranteed death benefits, regardless of the interest rate credited or the policy charges assessed, provided the amount and timing of premiums are sufficient to maintain the death-benefit guarantee. Policies are also designed to meet different market needs. Some focus on affordable death-benefit protection and may allow planned premiums comparable to term life insurance premiums for a similar coverage period. Others may focus on accumulating policy value on a non-guaranteed basis. A more detailed discussion of UL insurance policies is provided in the following sections.

19 Variable Life and Variable Universal Life Insurance With the fixed whole life and universal life policies discussed above, the insurance company invests the part of the premiums not used to pay claims and expenses. The policy value is part of this general investment account. But in a variable life (VL) or variable universal life (VUL) policy, the premiums not needed to support the policy are invested in subaccounts selected by the policyowner. Subaccounts are typically special types of mutual fund accounts designed to be used in variable life and annuity products. Just like regular mutual funds, these investment vehicles have specific investment objectives (e.g., growth or income) and different risk profiles. This means that some of the subaccounts may offer higher potential growth, but corresponding higher risk, while others may be less risky but have lower growth potential. The policyowner controls how to allocate premium payments among the subaccount choices. The performance of the policy is based on the performance of the subaccounts. If the selected accounts perform well, the policyowner may have relatively high policy value, but if the accounts don t perform well, the policyowner may have low or even no policy value. And, if subaccounts don t perform well, the policyowner may have to increase premium payments in order to keep the policy in force. Like other types of life insurance policies, these products are evolving. Today, some variable policies offer certain guarantees even if the subaccounts perform poorly. There may be a separate cost for this guarantee feature. Survivorship Universal Life Insurance In some situations, primarily estate planning, it is desirable to have the death benefit paid at the second death of two people. Survivorship life insurance was created for this purpose. Because it insures two lives but pays only one death benefit at the second death, these policies are also known as second-to-die life insurance policies. Second-to-die policies can be universal life (either fixed or variable) or whole life insurance. Living Benefits of Life Insurance Accessing Cash Surrender Value While most people are familiar with the importance of the death-benefit protection, many aren t aware of the living benefits of life insurance. If the policy has cash surrender value, the policyowner may access these values to cover emergencies or take advantage of opportunities. There are two ways policyowners can access cash surrender value: Policy Loans All types of cash surrender value life insurance offer the ability to borrow against the cash surrender value in the policy. While interest is charged on the loans (e.g., 8%), in some policies, the interest on the loans is partially or wholly offset by interest credited to the policy value. The policyowner can repay all or part of the loan, pay only the interest or allow both to accrue. However, unpaid policy loans, including accumulated unpaid interest, reduce both the death benefit payable at death and available cash surrender value if the policy is surrendered. Also, if the total amount of an outstanding loan and interest exceeds the cash surrender value, this may result in the termination of the policy. If a policy terminates, the outstanding loan is income taxable to the extent there was gain in the policy cash surrender value. Withdrawals Many types of cash value life insurance allow the policyowner to withdraw funds from the policy cash surrender value. There is usually a fee associated with each withdrawal, and there may be limits on the number of permitted withdrawals in any policy year (e.g., one withdrawal per year). Unlike policy loans, withdrawals permanently remove funds from the policy and are not subject to interest charges like policy loans. Withdrawals reduce the death benefit in most policies. 19

20 Accessing Death Benefits During Lifetime Accelerated Death Benefits for the Terminally Ill If the insured becomes seriously ill and that illness is anticipated to end in death, most life insurance policies today will pay part of the death benefit amount to the policyowner while the insured is still living. This is known as an accelerated death benefit, and the amount available to the policyowner is limited by formula or to a percentage of the death benefit. To receive this money, the policyowner must provide evidence that the insured s life expectancy will not exceed some period of time. The law permits the anticipated life expectancy to be as long as 24 months for the payments to remain income tax free, but most insurance carriers limit the estimated period until death to no more than six months (depending on the policy and state law). On policies insuring two people, the accelerated death benefit is generally not applicable unless one of the insureds has died and the surviving insured is applying for benefits under this rider. Accelerated Death Benefits for the Chronically Ill Some companies offer accelerated death benefit payments payment of some portion of the death benefit while the insured is still living that can be triggered by a chronic illness and are generally paid on a tax-free basis. Under the law, a chronically ill individual is someone who is certified by a licensed health care practitioner as: Unable to perform at least two activities of daily living (eating, toileting, transferring, bathing, dressing or continence) for a period of at least 9 days OR Requiring substantial supervision to protect the insured individual from threats to health and safety resulting from a severe cognitive impairment. The law requires the above minimum standards for benefits to be paid income tax free, but actual requirements under individual policies offered by carriers may be more restrictive. Additional Benefits Provided Through Riders Optional features or benefits are frequently provided through riders to the base life insurance policy. Some of the most common riders are discussed below. Waiver of Premium For an additional premium, this rider waives the required premium in the event the insured becomes totally disabled. This type of waiver is used with term and whole life insurance policies. Generally: The entire premium is waived if the insured meets the definition of total disability under the rider. It waives the premium only if the disability is continuous for at least six months. Premiums paid during those six months might be reimbursed to the policyowner or the premium may continue to be waived for six months following the end of the disability. The disability must begin after a certain age, such as age 15. The disability must begin before the insured reaches a specific age, such as 6. The rider may terminate when the insured attains a specific age, such as 6, unless the insured has a covered disability that began before the rider terminated. 2

21 Waiver of Monthly Deductions This type of waiver is used primarily with current assumption universal life insurance policies those that don t offer a death-benefit guarantee. Rather than waive a specific premium amount in the event of a covered total disability, the rider covers only the fees and other charges that are deducted each month from the policy values. This amount is sufficient to keep the death benefit in force, but will not enhance the policy value. It waives the monthly deduction only if the disability is continuous for at least six months. The disability must begin after a certain age, such as age 15. The disability must begin before the insured reaches a specific age, such as 6. The rider may terminate when the insured attains a specific age, such as 6, unless the insured has a covered disability that began before the rider terminated. Waiver of Specified Amount Used with universal life insurance policies that provide a death-benefit guarantee, this option usually adds a specified premium amount if the insured becomes disabled. However, because of the flexible nature of UL premiums, it adds only a specified amount of premium as purchased by the policyowner. Generally, this amount cannot exceed the planned premium necessary to keep the death-benefit guarantee in effect. The specified premium is added if the insured meets the definition of disability under the rider. It adds the specified premium only if the disability is continuous for at least six months. The disability must begin after a certain age, such as age 15. The disability must begin before the insured reaches a specific age, such as 6. The rider may terminate when the insured attains a specific age, such as 6, unless the insured has a covered disability that began before the rider terminated. Child Rider A Child Rider (or Children s Rider) adds term life insurance on the life of each covered child. It is generally sold in $1, face amount units, up to a maximum of ten units. Subject to underwriting approval, eligible children include: Any child of the insured who falls within a certain age range (e.g., at least 15 days old but not more than 23 years old) on the rider effective date A stepchild of the insured or a legally adopted child who becomes eligible after the rider becomes effective (within the same age range as biological children) Additionally, children born after the rider takes effect are automatically covered once they reach the minimum age specified in the rider (e.g., 15 days). Coverage on a child usually lasts until the child reaches a certain age, such as 25. A child is permitted to convert the coverage at that point (or an earlier point, if provided under the rider) without evidence of insurability for some multiple of the coverage under the rider. For example, if a rider is purchased with 1 units of coverage, each child has $1, of death benefit while the rider is in force. If the same rider provides for a conversion up to five times the amount in force, the child will be permitted to purchase up to $5, of whole life or universal life coverage, depending on the product used by the carrier. Premiums will be based on the insured s attained age. 21

22 Accidental Death Benefit Accidental death benefit riders provide additional death benefit if the death of the insured is the result of an accident. The amount of the additional death benefit is usually limited to the base death benefit, up to a certain amount. Policies often include restrictions that prevent payment of the accidental death benefit if the death occurs under certain circumstances. Figure 8 shows a sample of rider wording outlining typical restrictions. Figure 8: The Company will not pay the accidental death benefit if the Insured s death is a direct or indirect result of: any bodily or mental disease or sickness; medical or surgical treatment for bodily or mental disease or sickness; bacterial infection, except infection resulting from accidental bodily injury; intentionally self-inflicted injury, while sane or insane; the Insured s commission of, or attempt to commit, an assault or felony; participation in a riot or insurrection; war, declared or undeclared, or any act of war; travel or flight in, or descent from, any aircraft, unless the Insured is a fare-paying passenger on a scheduled commercial passenger flight; any intoxicant or drug taken, absorbed or inhaled, unless such drug was used on the advice of a licensed physician and in the dosage prescribed; any gas taken, absorbed or inhaled, except in the case of an occupational accident resulting from a hazard incidental to the Insured s occupation; or any poison taken, absorbed or inhaled. 22

23 Module 2 Fixed Universal Life Insurance (Current Assumption) Universal life insurance first came to the marketplace in the late 197s. It offered more flexibility than whole life insurance policies flexibility in both death-benefit options and premium payments. However, in order to provide this increased flexibility, the policy design was more complicated than whole life insurance. Unlike someone who owns a whole life policy, the owner of UL has the option to: Increase or decrease the initial specified amount. The specified amount is the amount of death benefit applied for on the application. Increases in the death benefit are generally subject to new underwriting requirements. Increase or decrease the amount of premium paid and, under certain circumstances, skip premium payments. Vary the frequency of premium payments. Change the death benefit option (level or increasing), if provided under the policy. Changes to an increasing death benefit option typically require additional underwriting. This module will discuss what is commonly referred to as current assumption universal life insurance. These are UL policies that do not have a death-benefit guarantee feature. An understanding of current assumption UL is the basis of an understanding of death-benefit guarantee UL. Definition of Life Insurance To be considered life insurance under federal law, a life insurance contract must pass one of two tests set out in Internal Revenue Code (IRC) 772: The cash value accumulation test OR The guideline premium test and the cash value corridor test. The maximum premium that can be paid into a universal life insurance policy is determined by law. These tests limit the amount of premium that can be paid into a specific type of UL policy. The test used to build the product determines the maximum premium limits in a policy. Finally, under both tests, the policy s death benefit will always exceed the cash values by some amount, commonly referred to as a corridor. This corridor prevents the cash value from ever exceeding the death benefit amount. The policyowner of a life insurance product that fails to meet the definition of life insurance will be taxed annually on the increase in any cash value. However, the death benefit paid in excess of the net cash surrender value will remain income tax free. At the end of the module, you should have an understanding of the product design and functionality, as well as its features. 23

24 Death Benefits Universal life death benefits can be very flexible, depending on the policy design. The policyowner can select from different options and may also increase and decrease the specified amount of insurance. Increases in the specified amount require additional underwriting. Many UL products offer at least two death benefit options a level death benefit and an increasing death benefit. The level death benefit is called either Option 1 or Option A (Figure 9). The increasing death benefit is called either Option 2 or Option B (Figure 1). In Figure 9, notice that the total death benefit includes the policy value and that the pure death benefit (net amount at risk) decreases as the policy increases. Despite the existence of policy value, the total death benefit paid during these years would be only the initial specified amount, $5,. Figure 9: UL Level Death Benefit, Option 1 8, 7, 6, 5, 4, 3, 2, 1, Years Death Benefit Policy Value However, in Figure 1, the total death benefit includes the original specified amount of death benefit (e.g., $5,) plus an amount equal to the policy value in the policy. Therefore, the death benefit in Option 2 will be equal to $5, plus any policy value that exists at the time of death. Since there is an increasing death benefit, this option will cost the policyowner more to maintain. Figure 1: UL Increasing Death Benefit, Option 2 8, 7, 6, 5, 4, 3, 2, 1, Years Figure 11: UL Change from Option 1 to Option 2 8, 7, 6, 5, 4, 3, 2, 1, Death Benefit Years Death Benefit Policy Value Policy Value Subject to restrictions in the policy, the policyowner may be able to change death benefit options after the policy is issued. Figure 11 shows a policy that started out as an Option 1 and was changed to Option 2. The amount of increase is based on the policy value growth occurring in the policy from that point on, and not the total policy value in the policy. A change from Option 1 to Option 2 requires underwriting approval. A change from Option 2 to Option 1 generally does not. 24

25 Some policies have a third option (3 or C). This is also an increasing death benefit, but the amount of increase is based on the amount of total premiums paid rather than on any increase in policy value. Not all UL policies offer Options 2 or 3. Corridor As noted above, the death benefit must generally remain higher than the policy value by some amount (e.g., the death benefit factor). If a death benefit Option 1 is selected, this requirement does not come into play until the policy value growth exceeds a certain point. This is easiest to see on a life insurance illustration. Figure 12 shows what this looks like numerically as well as graphically. In this example, the policy value is assumed to reach a level sufficient to begin pushing up the death benefit at age 72. This would vary depending on premium paid, actual interest credited, cost of insurance charges and other factors. Figure 12: 4.15% Interest Rate Non-Guaranteed Basis Age Policy Value Death Benefit 65 26,742 5, ,58 5, ,74 5, ,2 5, 69 27,5 5, 7 287,433 5, 71 35,624 5, ,639 5, ,47 519, , , , , , , , , ,252 62, ,64 642, , , ,57 689, , , ,34 74, , , ,64 795, ,23 825, ,13 856, , , , ,687 UL Death Benefit Option 1, Demonstration of Corridor $1,2, $1,, $8, $6, $4, $2, Age Death Benefit Policy Value At age 72, the policy value is assumed to reach a level sufficient to begin increasing the death benefit. 25

26 Premiums UL policies have a flexible premium structure. This flexibility enables the policyowners to pay premiums in nearly any amount and at any time, as long as the paid premium amount is sufficient to keep the policy in force. While premiums are flexible, the amount of premium paid will impact both the amount of policy value in the policy and how long the policy lasts (the point at which the policy lapses). Minimum and Maximum Premiums In addition to maximum allowable premiums under the definition of life insurance, insurance companies may restrict the amount of additional premium that may be paid into an already-issued policy. Therefore, before large sums are sent to the insurance carrier for payment into a UL policy, the carrier should be contacted to find out what limits may apply. A UL policy doesn t have a specific minimum premium, but the insurance carrier does need to receive sufficient premium to put the policy in force. After that, the policyowner has a significant degree of flexibility as to when and how much premium to pay. Within certain limits, the policyowner may increase, decrease and even skip premium payments. As will be explained, if the policyowner doesn t pay sufficient premiums to cover the fees and other charges in the policy, the policy may lapse. Plus, if the UL policy has a death-benefit guarantee feature, the guarantee may be shortened or lost if sufficient premiums are not paid. Premium requirements for secondary death-benefit guarantees are discussed later. Target Premium Insurance brokers and agents are compensated for their sales efforts by receiving commissions. The commission on a UL policy is usually a flat percentage of the premium, up to a certain level known as the target premium. The target premium is different for different products and carriers. First-year premium amounts that exceed the target premium are generally a smaller commission percentage. Some insurance companies pay commissions based on a rolling target premium. This means that if the first year premium does not equal or exceed the target premium, the agent will receive the balance of the first-year target commission when the premium is paid in the second year until the target premium is reached. Policy Fees and Other Policy Charges Unlike whole life insurance policies, universal life has an open architecture that is, all fees and charges are spelled out in the policy. These fees are necessary to cover the cost of issuing the policy, support the policy administration and cover the risk that the insured may die (mortality costs). Most fees are fixed and guaranteed for a period stated in the policy or for the life of the policy and will not change. They may take the form of: A fixed dollar amount deduction for the life of the policy A percentage of premiums paid A fee for a limited period of time Figure 12 shows a hypothetical example of how this might appear in a policy. Figure 12: Sample policy fees and charges Fees and Charges Monthly Administrative Fee: Monthly Expense Charge for Initial Specified Amount: Premium Expense: $8.28 per Policy Month $55. per Policy Month for First 2 Policy Years; $ Thereafter Rate is.22/$1, of Initial Specified Amount 8.% of all Premium Received 26

27 Cost of Insurance (COI) Charges Cost of insurance charges may include charges for mortality, persistency, taxes and investment earnings. Charges vary based on the age, gender and risk class of the insured and will increase as the insured gets older. Figure 13: COI charges are applied to the net amount at risk, the amount of the total death benefit that exceeds any policy value. UL Level Death Benefit, Option 1 The COI charges and the amount by which they will increase are not guaranteed. That means the amount currently charged at each age and for each risk class could increase in the future. The current charges are based on the assumptions when the policy is issued. The insurance company reserves the right to increase these charges if these assumptions change. However, the insurer can only increase them up to a certain maximum as stated in the policy. Additionally, any increase must apply to all policies using the same policy form; individual policyowners cannot be singled out for this type of increase. 8, 7, 6, 5, 4, 3, 2, 1, Net Amount at Risk = $35, COI =.12 x 35. = $42. COI charges are assessed monthly against the net amount at risk. This is the amount of the total death benefit that exceeds any policy value. Years Death Benefit Policy Value For example, assume that a $5, policy has $15, of policy value and that the monthly policy charge for this insurance is $.12 per thousand dollars of death benefit. The net amount at risk is: $5, 15, = $35, The cost of insurance charge deducted that month will be $42. (35 x.12). 27

28 Policy Value Premiums, Interest Rates and COLI Charges Drive Policy Value A UL policy can have policy value. To have policy value, the accumulated premiums paid must be greater than the deductions for fees and cost of insurance. Think of it as a bucket. The premium goes into the bucket and the monthly policy fees and COI charges (not guaranteed) come out of the bucket. If the premiums paid, plus interest credited to the policy value, are greater than the monthly deductions, there will be policy value in the bucket. If monthly deductions are greater than the premium paid plus any interest credited, then the excess amount will be deducted from any policy value. Figure 14: Premiums Paid + Interest Credited Policy Value Policy Fees/COI Deducted On the other extreme, if a policyowner pays premiums much higher than needed to cover the policy charges, the policy values plus accruing interest may grow significantly. In later years, if policy value is sufficient to cover monthly deductions, the policyowner may be able to skip or even stop making out-of-pocket premium payments without the policy lapsing. Cash Surrender Value and Surrender Penalties The policyowner can access policy value either through policy surrender, policy loans or withdrawals. The amount the policyowner may receive is limited to the total policy value minus a surrender penalty. The surrender penalty is designed to discourage the early surrender of the policy and, in the case of early surrender, to help the insurance carrier recoup some of the initial costs associated with underwriting and issuing the policy. The surrender penalty will vary by product. Generally, the penalty is highest in the early years and declines until it reaches zero. The length of the surrender penalty period will vary from product to product, but 15 to 2 years is not unusual. (Premiums + Interest) (Fees + COI) = Policy Value If there is policy value, the company will credit it with interest. The policy guarantees that the interest credited to the policy value will never drop below a certain guaranteed amount, such as 3% (depending on the policy form). However, the actual interest credited may be higher and will vary over time based on the results of the company s own investment portfolio. Bottom line: if the policyowner pays only low (minimal) premium amounts into the policy, eventually the COI charges and other fees will likely exceed the premium levels and credited interest. Over time, policy value will be depleted. If the policyowner doesn t increase the premium levels to cover these increasing charges, the policy will eventually lapse. 28

29 Access to Policy Values through Loans Whole life and universal life insurance policies allow the policyowner to use the policy values as security for a loan from the insurance carrier. The carrier charges interest on the loan which the insured may repay or accrue as an additional loan. The accumulated loan balance reduces the death benefit before the beneficiary is paid. The policyowner may borrow an amount that doesn t exceed the policy s cash surrender value, minus any unpaid interest and prior loans. An over-loan situation the point where the total outstanding loan balance, including interest, exceeds the cash surrender value of the policy may result in the policy s termination. Some policies offer over-loan protection. If a policy lapses with an outstanding loan balance, the balance will be income taxable to the policyowner to the extent there is gain in the policy. The interest charged on the loan is contractual and generally ranges from 7% to 8%. However, some policies offer preferred loans. The definition of a preferred loan varies from carrier to carrier and even policy to policy. For some policies, it is a portion of the outstanding loan equal to the policy value at the time the loan is made, reduced by prior loans and withdrawals, minus the accumulated premiums paid. Access to Policy Values through Withdrawals A policyowner who needs money may choose to withdraw money from the policy value. This money reduces the policy value in the policy, but does not have to be paid back, and no interest is charged on this amount. Withdrawals from the policy value may reduce the specified amount of death benefit. However, the amount of the reduction in death benefit varies by policy. Some policies are designed so that a withdrawal reduces the death benefit proportionately, while others have a dollar-for dollar reduction. It is important to note that the withdrawn money usually can t be repaid, but, if permitted, repayment does not restore the death benefit. Withdrawals can also impact whether the policy remains in force in the future. If the policyowner makes significant withdrawals, the level of premium payments may need to increase to ensure sufficient dollars are in the policy to cover the monthly fees and charges. Preferred loans pay a preferred interest rate. This preferred rate also varies by policy and carrier. It might be based on the difference between the policy s guaranteed crediting rate and the non-preferred interest rate or tied to some market index and recalculated periodically. 29

30 Grace Period Premiums for term life or whole life insurance must be paid by the premium due date or when the policy enters the grace period. The grace period is 31 days for these types of policies, and if the premium is not received before the end of the grace period, the policy will lapse. However, universal life insurance policies are flexible premium contracts. They do not have a premium due date. The result is that the grace period begins at the point where the net cash surrender value, plus interest, is insufficient to cover the monthly deductions for fees, charges and cost of insurance. Once in the grace period, the policyowner has 61 or 62 days (depending on the policy and state of issue) to send the company sufficient money to cover these charges. Failure to remit sufficient funds will result in the policy s lapse. The following can all impact the policy value in a current assumption policy: Reducing the interest crediting rate Increasing the Cost of Insurance (COI) charges Paying too little premium Timing of premium payments Four important takeaways: Current interest and COI charges are not guaranteed UL policies don t have a premium due date Grace period is not tied to the payment of a specific premium Grace period begins when there are insufficient values to cover the monthly deductions Figure 15: Grace Period (Premiums + Interest) (Fees + COI) = Negative Policy Value Premiums + Interest Fees/COI Policy Value Depleted Crediting rate is lower and/or COI is higher than original assumptions 3

31 Module 3 Illustrating Current Assumption UL One of the best ways to learn about current assumption UL is by running illustrations. The more you compare the results of the input, the more you ll understand the impact of the guaranteed and non-guaranteed components. Because of the flexibility of universal life insurance, standardized illustrations of policy values and assumptions have become commonplace. Here, we will look at the illustration requirements and use the illustration examples to demonstrate how current assumption UL works. Compliant Illustrations Most states have adopted some form of the NAIC (National Association of Insurance Commissioners) model regulation on life insurance illustrations. The law essentially says that if non-guaranteed values, like current crediting interest rates and policy values, are shown, the illustration must comply with the regulation requirements of the state in which the policy is sold. The illustration, signed by the policyowner and the broker, must be submitted with the application. Alternatively, a broker may use a no-illustration certificate that the policyowner signs stating that no illustration was used in the sales process. If the no-illustration certificate is used, then a signed illustration must be part of the policy delivery requirements. Even when a signed illustration was part of the application process, a new illustration is required any time the issued policy doesn t match the original illustration. This happens when: The policy is issued other than as applied for (e.g., a different rate class due to a health condition) OR The amount or type of coverage changes during the underwriting process. The purpose of the illustration law is to ensure the consumer has all the necessary information to make an informed purchasing decision. This includes seeing how the policy will perform under certain conditions. For this reason, the Genworth Financial companies require signed illustrations for sales occurring in states that have not adopted the illustration regulations. For the insurance carrier, the illustrations serve another purpose. They help new business and underwriting understand what the client is applying for and how much and how often the client expects to pay premiums (the premium pattern). Parts of a Life Insurance Illustration Three basic parts make up a compliant illustration: The Narrative Summary describes the life insurance policy and discusses various features of the policy. It also explains certain premium levels. The Numeric Summary shows how the planned premium impacts the guaranteed and nonguaranteed elements of the policy and estimates how long the policy will stay in force using the assumptions shown. This is the page the applicant and broker are required to sign. The Tabular Detail provides a year-by-year look at the policy premiums, policy values and death benefit on both a current assumption and guaranteed basis, including changes that may occur over time. 31

32 Current Assumptions Versus Guaranteed Features A current assumption UL policy has very few guarantees. The only guarantees in the policy are the: Stated policy fees Maximum Cost of Insurance (COI) charges (not the current charges) Minimum interest crediting rate on any policy value that exists Figure 16: Numeric Summary Male, Age 35 Preferred Best No Nicotine Use Yet UL policies are often illustrated based on current assumptions. That is, the illustration assumes that the current (not guaranteed) interest rate is credited and the current COI charges (not the maximum possible) are deducted and assume these do not change for the life of the policy. However, the model illustration regulations require that illustrations also show what would happen to policy value and death benefit if only the minimum interest rate was credited and the maximum COI charge was deducted. Figure 16 shows an example of a numeric summary highlighting the differences between current assumptions and guarantees. You should note that this page shows three different scenarios: fully guaranteed, midpoint assumptions (non-guaranteed) and current assumptions (non-guaranteed). The last row of the chart shows the estimated year of lapse under these various assumptions. Initial Assumptions Initial Specified Amount: $1, Death Benefit Option: 1 Initial Planned Premium Outlay: $65.73 Annually Year Age 7 Age 1 Age 12 Age Policy Lapses* Cumulative Premium Outlay 3,254 6,57 13,15 22,776 22,776 22,776 3.% Interest Rate Guaranteed Basis Net Cash Surrender Value 2,436 6,957 Death Benefit 1, 1, 1, 1, 3.575% Interest Rate Non-Guaranteed Midpoint Basis** Cumulative Premium Outlay 3,254 6,57 13,15 22,776 29,283 29,283 Net Cash Surrender Value 3,162 9,658 13,126 Death Benefit 1, 1, 1, 1, 4.15% Interest Rate Non-Guaranteed Basis** Cumulative Premium Outlay 3,254 6,57 13,15 22,776 42,297 55,963 Net Cash Surrender Value 172 3,92 12,57 28,33 78,181 5, Not prior to age 12 Death Benefit 1, 1, 1, 1, 1, 1, Assumes minimum guaranteed interest is credited and maximum COI charges are assessed. Assumes a crediting interest rate that is halfway between the guaranteed and current interest rates. Also, assumes that a COI charge halfway between the guaranteed maximum and the current COI is assessed. Assumes current non-guaranteed interest is credited and non-guaranteed COI charges are assessed throughout the life of the policy. * The policy will end during this policy year unless a higher premium is paid. ** Benefits and values are not guaranteed, the assumptions on which they are based are subject to change by the insurer, and actual results may be more or less favorable. 32

33 The Tabular Detail, shown in Figure 17, shows the fully guaranteed and the current assumption figures for all years. The first set of numbers assumes that only 3% interest is credited and maximum COI charges are assessed from the day the policy is put into effect. Under this worst-case scenario, the policy lapses at age 7. Figure 17: The second set of numbers is also unlikely to occur. These assume a constant crediting rate of 4.15%. In reality, the actual crediting rate may go up or down several times a year. The second set of numbers also assume non-guaranteed COI charges, which can also change. For these reasons, the actual performance of the policy may be worse or better than what is shown. Flexible Premium Adjustable Life Insurance Basic Illustration for: Male, Age 35 Preferred Best No Nicotine Use $1, (Prepared by: Joe Agent) Tabular Basis Detail Yearly Values and Benefits * 3.% Interest Rate Guaranteed Basis 4.15% Interest Rate Non-Guaranteed Basis** Year Age Total Annual Premium Outlay Paid Annually Policy Value 7,26 6,982 6,636 6,15 5,54 Net Cash Surrender Value 7,26 6,982 6,636 6,15 5,54 Death Benefit 1, Total Annual Premium Outlay Paid Annually Policy Value 18,161 19,176 2,22 21,293 22,388 Net Cash Surrender Value 18,161 19,176 2,22 21,293 22,388 Death Benefit 1, ,68 3,664 2,446 1, + 4,68 3,664 2,446 1, ,58 24,664 25,857 27,81 28,33 23,58 24,664 25,857 27,81 28, ,598 3,896 32,217 33,574 34,961 29,598 3,896 32,217 33,574 34, ,373 37,815 39,297 4,89 42,355 36,373 37,815 39,297 4,89 42, The point when the net cash surrender value is insufficient to cover the monthly deductions and the policy enters the grace period. + The policy will end during this policy year unless a higher premium is paid * Premiums shown are paid during the policy year, at the beginning of each payment period. Cash surrender values shown are end-of-year values. Death benefits shown are end-of-year values. ** Benefits and values are not guaranteed, the assumptions on which they are based are subject to change by the insurer, and actual results may be more or less favorable. 33

34 Figure 18 shows the numeric summary again. This time, we have lowered the current crediting rate to 3% to match the guarantee rate. This allows us to independently show how charging the maximum COI impacts policy values. Prospective policyowners who are concerned about possible increases in COI charges or reductions in crediting interest rates should consider a UL policy with a guaranteed death benefit feature. These types of UL policies are covered in the next module. Although changes in COIs are less common than changes in interest rates, current COI charges can still change. Even a modest increase in COI rates can impact policy performance. Figure 18: Numeric Summary Male, Age 35 Preferred Best No Nicotine Use Initial Assumptions Initial Specified Amount: $1, Death Benefit Option: 1 Initial Planned Premium Outlay: $65.73 Annually Shows the impact of maximum COI charges on the policy assessed from policy issue. Year Cumulative Premium Outlay 3,254 6,57 13,15 3.% Interest Rate Guaranteed Basis Net Cash Surrender Value 2,436 6,957 Death Benefit 1, 1, 1, 3.% Interest Rate Non-Guaranteed Midpoint Basis** Cumulative Premium Outlay 3,254 6,57 13,15 Net Cash Surrender Value 3,16 8,988 Death Benefit 1, 1, 1, 3.% Interest Rate Non-Guaranteed Basis** Cumulative Premium Outlay 3,254 6,57 13,15 Net Cash Surrender Value 91 3,593 1,983 Death Benefit 1, 1, 1, Age 7 22,776 1, 22,776 1,525 1, 22,776 2,721 1, Age Policy Lapses* * The policy will end during this policy year unless a higher premium is paid. ** Benefits and values are not guaranteed, the assumptions on which they are based are subject to change by the insurer, and actual results may be more or less favorable. 34

35 Module 4 Death-Benefit Guarantee Universal Life (UL) Insurance Death-Benefit Guarantee* Universal Life A solid understanding of current assumption UL provides the necessary foundation to study death-benefit guarantee UL. As discussed, current assumption UL policies come with some risks. Although policyowners may choose to pay flexible premiums, make withdrawals or take policy loans, if, at any time, the net cash surrender value in these policies is insufficient to pay the monthly deductions, the policy will enter the grace period and may lapse unless the policyowner pays additional money. Even when a regular planned premium is paid, changes in the interest crediting rate or COI charges can result in insufficient net cash surrender value to maintain the policy. To counter these risks, many of today s UL policies offer a death-benefit guarantee that is guaranteed to last for a specified period of time, or for life, provided all the conditions for the death-benefit guarantee are met. These guarantees are sometimes called secondary guarantees, no-lapse guarantees or lifetime guarantees. Unlike current assumption policies, UL policies with death-benefit guarantees offer policyowners a guarantee that can keep the policy in effect even if there are changes in interest crediting rates or increases in COI charges. In other words, this feature guarantees the existence of a death benefit even if the underlying policy would have lapsed in the absence of the guarantee provided certain conditions are met. Generally, these conditions include: Paying enough premiums at the right time to maintain the death-benefit guarantee (see discussion of Specified Premium and Shadow Accounts below) AND Refraining from taking withdrawals and policy loans, and avoiding policy changes such as increasing the specified amount. For the purposes of this workbook, the deathbenefit guarantee is called active and in effect if these conditions are met. As will be discussed here, keeping the policy in force is not always the same as keeping the death-benefit guarantee active. This distinction is important. In Figure 19, notice how the death benefit continues on the guaranteed side even though there is no cash surrender value to cover the monthly deductions. This is true even though the maximum COI charges apply and the minimum interest rate is being credited. This shows that a death-benefit guarantee is in effect on this policy. * Death-benefit guarantee is a long-term conditional guarantee that can keep the policy in force when policy values are too small to do so. Certain policy rights, if exercised by the owner, will end this guarantee. In addition, an unpaid loan may terminate coverage. 35

36 Figure 19: Flexible Premium Adjustable Life Insurance Basic Illustration for: Male, Age 35 Preferred Best No Nicotine Use $1, (Prepared by: Joe Agent) Tabular Basis Detail Yearly Values and Benefits* 3.% Interest Rate Guaranteed Basis 4.15% Interest Rate Non-Guaranteed Basis** Year Age Total Premium Outlay During Policy Year (Paid Annually) Policy Value Net Cash Surrender Value Death Benefit Total Premium Outlay During Policy Year (Paid Annually) Policy Value Net Cash Surrender Value Death Benefit ,258 4,198 4,65 3,87 3,596 4,258 4,198 4,65 3,87 3,596 1, ,445 7,975 8,53 9,41 9,579 7,445 7,975 8,53 9,41 9,579 1, ,242 2,766 2,153 1, ,242 2,766 2,153 1, ,116 1,652 11,178 11,74 12,218 1,116 1,652 11,178 11,74 12, ,723 13,216 13,698 14,17 14,69 12,723 13,216 13,698 14,17 14, * Premiums shown are paid during the policy year, at the beginning of each payment period. Cash surrender values shown are end-of-year values. Death benefits shown are end-of-year values. ** Benefits and values are not guaranteed, the assumptions on which they are based are subject to change by the insurer, and actual results may be more or less favorable. The easiest way to make sure the death-benefit guarantee remains in effect is to pay a planned premium in a consistent and timely manner and to avoid taking withdrawals or policy loans. If policyowners vary from their planned premiums, the death-benefit guarantee will stay in effect as long as the conditions of the guarantee are met. Insurance carriers typically use one of two methods: Specified premium method Shadow account method Both of these methods exist solely to determine if the policy will remain in effect even if the policy value is not sufficient to keep it in effect. 36

37 Specified Premium Method While designs vary, this method typically has specified premiums that are required to maintain the death-benefit guarantee. These premiums are accumulated using an assumed interest rate that has no bearing on actual policy value. Under this method, the actual accumulated premiums paid are compared with the accumulated specified premiums. If the actual accumulated premiums (including any assumed interest) are equal to or greater than the accumulated specified premiums, then the death-benefit guarantee is active. If they are less, then the death-benefit guarantee is not in effect. Both the actual accumulated premiums and the accumulated specified premiums are reduced by policy loans and withdrawals. It is important to understand that the death-benefit guarantee no longer being active does not mean that the life insurance policy will enter the grace period. It only means that there is no death-benefit guarantee to keep the policy in force if the cash surrender values are insufficient to pay the monthly deductions. If the net cash surrender value is sufficient to cover the monthly deductions, the policy will remain in force. Otherwise, the grace period will begin. Shadow Account Method A shadow account is similar to life insurance policy values but it has no real monetary value for the customer. It serves only as a reference point for determining if the death-benefit guarantee is still in effect. At Genworth, the shadow account is referred to as Coverage Protection Amount. As premiums are paid to the universal life insurance policy, they are credited to the policy value account and credited with interest each month. Policy fees and charges are also deducted from the policy value each month. However, many UL policies with death-benefit guarantees will generate little or no policy value. The actual premiums paid are also credited to the shadow account a reference account used only to determine if the death-benefit guarantee still exists. Interest is credited to this shadow account, and charges are deducted. The interest credited and the charges deducted will be different from those credited and deducted from the policy s actual policy value. Unlike in the specified premium method, which compares the accumulated premiums paid with the accumulated specified premiums, no comparison is made in the shadow account method. Instead, the death-benefit guarantee (Genworth s Coverage Protection Benefit) is considered in effect if the shadow account value (Genworth s Coverage Protection Amount) is zero or greater. Most policyowners structure their planned premiums so that, if they are paid at planned intervals, the policy s shadow account will stay at zero or better for the selected planned coverage period. If the policyowner pays more than the planned premium in the early years, such as in a limitedpay situation or with a 135 exchange, the shadow account builds a reserve. Over time, interest is credited and charges are deducted from the shadow account. If no additional premium is paid, the shadow account balance will gradually shrink to zero or less. However, if sums paid in the early years are large enough, the shadow account may remain at zero or better for many years, successfully keeping the death-benefit guarantee in effect. However, once the shadow account balance goes below zero, the death-benefit guarantee is no longer in effect, unless sufficient premiums are paid to restore a shadow account balance of zero or greater. 37

38 When the Grace Period Begins Because of the flexible nature of UL, the grace period isn t tied to a premium due date as it is with term or whole life insurance policies. Current assumption UL (one without a deathbenefit guarantee): the grace period is triggered when the net cash surrender value is insufficient to cover the monthly deductions. Figure 2: Flexible Premium Adjustable Life Insurance Basic Illustration for: Male, Age 35 Preferred Best No Nicotine Use $1, (Prepared by: Joe Agent) Tabular Basis Detail Yearly Values and Benefits* Death-Benefit Guarantee UL using the specified premium method: the grace period is triggered when the net cash surrender value is insufficient to cover the monthly deductions AND the accumulated premiums paid are less than the accumulated specified premiums. Death-Benefit Guarantee UL using a shadow account: the grace period is triggered when the net cash surrender value is insufficient to cover the monthly deductions AND the shadow account balance is less than zero. Figure 2 shows a portion of an illustration. It clearly demonstrates that the death benefit continues beyond the end of the projected net cash surrender value. This shows that the shadow account is still active until policy year 56. The grace period would begin at that point. 3.% Interest Rate Guaranteed Basis 3.75% Interest Rate Non-Guaranteed Basis** Year Age Total Annual Premium Outlay Paid Annually Policy Value Net Cash Surrender Value Death Benefit Total Annual Premium Outlay Paid Annually Policy Value Net Cash Surrender Value Death Benefit , ,284 14,77 14,136 13,365 12,424 15,284 14,77 14,136 13,365 12,424 1, ,34 9,957 8,388 6,544 4,39 11,34 9,957 8,388 6,544 4, ,898 1, Net cash surrender value exhausted, but grace period does not begin because the death-benefit guarantee is still in effect. Grace period begins at this point. +The policy will end during this policy year unless a higher premium is paid. * Premiums shown are paid during the policy year, at the beginning of each payment period. Net cash surrender values shown are end-of-year values. ** Benefits and values are not guaranteed, the assumptions on which they are based are subject to change by the insurer, and actual results may be more or less favorable. Death benefits shown are end-of-year values. 38

39 Carriers will test each policy monthly to determine if they need to send a grace period notice. Figure 21 provides a typical view of the process to determine the start of the grace period. If a grace period notice is triggered, the policyowner will have 61 or 62 days to submit premium sufficient to keep the policy in force. Catch-Up Provisions If the death-benefit guarantee is no longer in effect, the policyowner may restore the guarantee. However, the sum of money necessary to reinstate the guarantee is generally greater than the sum of the back premiums. Depending on age, risk class and other factors, the additional cost can be significant. For this reason, policyowners should be encouraged to maintain premium levels to keep the death-benefit guarantee active. The policy may contain provisions that limit the opportunity to restore the guarantee. These limitations will vary with carrier and product design, so individual policy provisions should be reviewed to identify any limits for a specific policy. Examples of situations where catch-up provisions may not be present include: Loan balance exceeds the policy s cash surrender value Policyowner increases the specified amount of death benefit Policyowner changes the level death-benefit option to an increasing option Policy lapses (reinstating the policy will not necessarily reinstate the death-benefit guarantee) Summary Lifetime guarantee policies help protect against the risks associated with current assumption policies, declines in interest rates and increases in COI that can adversely impact policy values. However, deathbenefit guarantee policies require the policyowner to pay premiums that are sufficient in amount and timing to maintain the death-benefit guarantee. Failure to pay sufficient premiums or exercising certain policy rights, such as taking withdrawals or policy loans, can terminate the death-benefit guarantee on the policy. Figure 21: Grace Period Test Performed at the End of Each Policy Month NCSV* Sufficient to Cover Monthly Fees/ Deductions NO Shadow Account Balance Greater Than or Equal to Zero NO Grace Period Begins YES YES Policy Remains in Force Death-Benefit Guarantee Active, Policy Remains in Force *Net Cash Surrender Value 39

40 Module 5 Basics of Federal Life Insurance Taxation This module will cover some basic information on the income, estate and gift taxation of life insurance. Such an extensive topic cannot be exhaustively addressed here, but by the end of the module, you should have a working knowledge of life insurance taxation. Federal Income Taxation of Death Benefits The income taxation of life insurance death benefits is governed primarily by Internal Revenue Code (IRC) 11 and related regulations and rulings. IRC 11(a) states that, with certain exceptions, a death-benefit payment is not included in the beneficiary s taxable income. Covered in depth here are two key exceptions when the death benefit can lose its tax-free status. These include: When an interest in a life insurance policy has been transferred for valuable consideration (IRC 11(a)(2)) and an exception doesn t apply If an employer owns life insurance on an employee s life and the purchase does not comply with the requirements of, or meet the exceptions identified in, IRC 11(j) Additionally, IRC 11(g) addresses the taxation of accelerated death benefits paid when the insured meets the definition of either terminally or chronically ill. For these early benefits to be received income tax free, they must meet certain requirements. Benefits for the terminally ill are defined in the IRC as those paid to an insured when death is expected within 24 months. Most accelerated death benefits riders on life insurance policies are more restrictive and require that death be anticipated within six or 12 months. Chronically ill means that the insured is unable to perform two or more activities of daily living (eating, toileting, transferring, bathing, dressing and continence) and these limitations are expected to continue for at least 9 days or suffers from a severe cognitive impairment requiring substantial supervision to protect the health and safety of the insured. Transfers for Valuable Consideration The transfer-for-value rule states that death benefits paid will not be fully income tax free if some interest in the policy is transferred for valuable consideration, unless the transfer meets one of a series of exceptions. The transfer-for-value rule seems complex, but the analysis is actually fairly straightforward. It begins with an understanding of the key terms and how they are applied. A transfer of an interest in a policy can take many forms and is not limited to just ownership changes. Examples of a transfer of an interest in the policy may include: Changing the beneficiary on the policy Naming an irrevocable beneficiary Giving someone (other than the policyowner) the right to borrow or withdraw from policy values The transfer of a right or interest in the policy alone is not sufficient to tax the death benefits. For the transfer-for-value rule to apply, some valuable consideration must accompany the transfer essentially a payment of some type. It can be money or property, a contract to perform some service, paying off the transferor s debt or anything else of financial value. 4

41 Example: Policy transfer with a taxable death benefit Joe owns a life insurance policy on his own life with a death benefit of $25, and a cash surrender value of $55,. Joe changes the ownership of the policy to his brother Mike in exchange for $55,. Mike names himself as beneficiary. Both a transfer and the receipt of something of value occurred. Therefore, when the insured dies, the death benefit paid will not be entirely income tax free. Assume that Mike made two additional premium payments of $2, before Joe died. Mike will receive the amount he paid for the policy $59, income tax free. The balance of the death benefit, $191, ($25,-$59,) will be included in Mike s taxable income (unless one of the exceptions below applies). Even if a policy is transferred for something of value, the death benefit will remain fully income tax free if the transfer is to an eligible party. Eligible parties include transfers to: The insured A partner of the insured A co-member of the insured in a limited liability company (LLC) taxed as a partnership (owners of LLCs are called members) A partnership in which the insured is a partner An LLC taxed as a partnership in which the insured is a member A corporation in which the insured is an officer or shareholder. NOTE: transfer to a co-shareholder is not an exception. The spouse of the insured, but only if the transfer was made by the insured An ex-spouse of the insured, as long as the transfer is made in accordance with a divorce decree or separation agreement and occurs within one year of the divorce decision. A transferee whose basis in the life insurance policy is determined by reference to the transferor s basis. A transferred policy will also remain income tax free if it is part of a tax-free corporate reorganization. Example: Policy transfer to an eligible party Mary owns a life insurance policy on her life that she no longer needs. Mary is the president of a corporation that wants to maintain key person insurance on her to protect the company in the event of her death. Mary sells the policy to the corporation. Although there was a transfer of the policy in exchange for valuable consideration, the death benefit will remain income tax free because the transfer was to a corporation in which the insured was an officer. 41

42 The final exception is the basis rule. This rule says that the death benefit will remain income tax free if, after the transfer, the transferee s basis in the life insurance policy is determined by reference to the basis that the transferor had in the policy before the transfer. Generally, this exception comes into play when the transfer is part gift and part sale, and requires some knowledge of how basis is established in either situation. If property is transferred by gift, the recipient of the gift acquires the basis of the person making the gift. If property is sold for full fair-market value, the purchaser s basis in the newly acquired property is what the purchaser paid for it. If Ginny sells a policy to Ali for less than full fair-market value, the transaction would be a part gift, part sale. If, after the transfer, Ali surrenders the policy, her basis will be the greater of Ginny s basis in the policy or the price Ali paid for the policy. Example 1: Property is transferred as a gift Ginny owns a life insurance policy on her life. She has paid a total of $18, in premiums. This is her basis in the policy for income tax purposes. Ginny makes a gift of the policy to her sister, Ali. Ali pays no further premiums and surrenders the policy when the cash surrender value is $3,. Because it was a gift, Ali s basis in the policy for tax reporting purposes is the same as Ginny s basis, $18,. Ali reports a gain of $12, ($3, - $18,) on surrender. In other words, Ali determined her basis by reference to Ginny s basis. Example 2: Property is sold for full fair-market value Ginny owns a life insurance policy on her own life. She has paid a total of $18, in premiums. This is her basis in the policy for income tax purposes. Ginny sells the policy to her sister, Ali, for its current surrender value of $3, (the example assumes that the cash surrender value is the full fair-market value of the policy). Ali keeps the policy for a few years, paying no more premiums, and then surrenders it when the cash surrender value is $33,. Ali s basis in the policy for tax reporting purposes is $3, because that is what she paid for it. Ali reports a gain on surrender of $3, ($33, - $3,). Ali did not determine her basis by reference to Ginny s basis, but rather from her purchase price. Example 3: Property is sold for less than full fair-market value Ginny sells a policy worth $3, (the example assumes that the cash surrender value is the full fair-market value of the policy) to Ali for $6, when the surrender value is $3,. Ginny s basis (total premiums paid) in the policy is $18,. Since Ginny s basis is higher than the purchase price, Ali s basis in the life insurance policy is determined by reference to Ginny s basis. Therefore, even though this is a transfer for valuable consideration, it meets the basis exception, and the death benefit will remain fully income tax free. 42

43 In summary, the analysis of whether or not a transfer will cause the death benefit to be taxable involves a determination: Was an interest in the policy transferred? Was something of value exchanged for the transfer? If the answer is yes to both of these questions, does the transfer for value fall within one of the allowable exceptions? If yes, then the death benefit remains income tax free. Life Insurance Owned by and Payable to an Employer Under a provision added to the tax code in 26, life insurance issued to an employer (as owner and beneficiary) after August 17, 26, (or materially changed after that date) does not automatically qualify for tax-free status. IRC section 11(j) states that any death benefit paid to an employer from an employer-owned life insurance policy (EOLI) will be taxable to the extent the death benefit exceeds the sum of the premiums and other amounts paid by the employer unless the employer complies with certain requirements. To protect the tax-free status of the death benefit, the employer must: 1. Comply with Notice and Consent requirements BEFORE a policy s effective date 2. Meet one of the four exceptions In addition, the employer is required to file IRS Form 8925 every year the policy is in effect Notice and Consent To meet the Notice and Consent requirements, the employer must notify the proposed insured in writing of the maximum amount of life insurance the employer reasonably expects to buy on the employee during the term of employment AND that the employer will be both the policyowner and the beneficiary. The insured must also consent to: Being insured Allowing the policy to continue after employment ends The employer being the beneficiary Exceptions: One of these exceptions must be met: 1. Insured must have been an employee during the 12-month period prior to his/her death 2. Insured is a key employee who satisfies at least one of these criteria: Is a director of the employer Is one of the five highest paid officers Was paid greater than $11, (211, as indexed) in the preceding year Is one of the top 35% highest paid employees Owns 5% or more of the employer the year the policy is issued or the year before 3. Death benefit is used to purchase an equity interest in the employer (buy-sell agreement) 4. Death benefit must be paid to a member of the insured s family, a personal beneficiary of the insured (not the employer), or a trust established for the insured s family or the insured s estate. Reporting Employers must report information about their EOLI policies to the IRS annually. IRS Form 8925 reports: The total number of employees employed by the business at the end of the year How many of those employees are covered by EOLI policies at the end of the year The total amount of EOLI in force at the end of the year The business address, taxpayer identification number and business type That you have a valid consent form from each insured employee and the number of insured employees from whom consent was not obtained For purposes of 11(j), an employee includes common law employees, self-employed individuals, directors (in their capacity as directors), officers and highly compensated employees. 43

44 Federal Income Taxation of Cash Value Life insurance policy value can provide a source of funds for the policyowner if money is needed to meet an emergency or opportunity. These policy values also have the added benefit of being income tax deferred while in the policy. That is, any interest credited to the policy value in the policy is not taxable unless the policy value is removed from the policy. The following summary of the taxation of policy value applies only to policies that are not Modified Endowments (see the section on Modified Endowments below). If the policyowner surrenders the policy, the cash received will be included in the policyowner s taxable income to the extent that the amount of the cash exceeds the policyowner s basis in the policy. Basis is generally the sum of the premiums paid, reduced by the cost of any riders and any prior nontaxable withdrawals or (if surrendered) outstanding policy loans. (NOTE: Other adjustments to basis may be required for dividend-paying policies.) If the policyowner makes a withdrawal from the policy, no income tax is payable until the amount of the withdrawal exceeds the amount of the basis. The policyowner is permitted to withdraw the basis first before taking out the taxable gain. Example 1: Policyowner surrenders the policy Kathy has a universal life insurance policy with an annual premium of $2,. She has had the policy for 12 years. The policy has no riders, and she has never borrowed from the policy or made a withdrawal of any of the cash surrender value. She decides to surrender the policy when the cash surrender value equals $3,. Kathy s basis in the policy is the sum of the premiums paid, $24, (12 x $2,). She will have to pay income tax on $6, ($3, - $24,). Example 2: Policyowner makes a withdrawal from the policy Kathy decides not to surrender the policy. Instead, she withdraws $15, a from the cash surrender value. Because Kathy s basis, $24,, is greater than the withdrawal, Kathy will not have to pay taxes on any of the $15,. Her basis is now $9,. Example 3: Policyowner borrows from the policy Kathy decides to borrow from her policy instead of taking a withdrawal. She borrows $26,. The interest rate on her policy is 8%. Rather than pay the interest, she allows the interest to accrue, creating additional loans. Five years later (after paying five more premiums), the outstanding loan is now $38,23. The gross cash surrender value in the policy is $4, and the basis is $34, (17 years x $2,). Kathy then surrenders the policy. The cash surrender value is used to repay the outstanding loan, and the remaining balance of $1,797 ($4, - 38,23) is paid to Kathy. The taxable gain on the policy is $6, ($4, - $34,). Although Kathy receives only $1,797 in cash, she has $6, of taxable income. 44

45 If the policyowner borrows money from the life insurance policy (not a Modified Endowment Contract), the amount of the loan doesn t generate any taxable income while the policy remains in force. If the policy lapses or is surrendered, the total amount of the loan will be repaid from the cash surrender value in the policy. The policyowner will be subject to income tax to the extent the total loan, plus cash received, exceeds the policyowner s basis in the policy. Modified Endowment Contracts (MEC) Some life insurance policies are known as Modified Endowment Contracts (MEC) and are taxed differently from non-mec policies. A policy becomes a MEC if the premiums paid during the first seven years of the policy, or the seven years following a material change to the policy, exceed a certain level commonly referred to as the seven-pay test. Maggie s cumulative premiums exceeded the MEC cumulative premium in year five. At that point, the policy became a MEC. Even though her cumulative premiums for the next two years are below the cumulative MEC premium, the policy will remain a MEC. Once a policy becomes a MEC, it will always be a MEC. The premium level at which the policy will become a MEC may be different for different policies and companies. You can usually find the seven-pay test premium amount by reading the narrative summary part of the illustration. Example: MEC Policies Maggie buys a flexible premium UL policy with an annual seven-pay test premium of $1,. Maggie, who is self-employed, has income that varies from year to year and likes the idea of being able to adjust her annual premium payments. Below is Maggie s premium-paying history through the first seven years. Year Modified Endowment Contracts (MEC) Maggie s Annual Premium Maggie s Cumulative Premium Cumulative Seven-Pay Premium 1 8, 8, 1, 2 11, 19, 2, 3 9, 28, 3, 4 11, 39, 4, 5 12, 51, 5, 6 8, 59, 6, 7 8, 67, 7, Policy Becomes a MEC. 45

46 Tax Implications of MEC Status MEC policies are not taxed the same as non-mec policies. Withdrawals from MEC policies are treated as coming from any growth on the policy first. In addition, loans on MEC policies are taxed as withdrawals up to the amount of the gain in the policy. This also applies to the collateralized part of a policy pledged as security for a loan from another source (e.g., a bank). In addition to the regular income tax, the taxable portion of any withdrawal or loan is subject to an additional 1% tax penalty. The penalty does not apply to distributions or if one of these exceptions applies: Made after the taxpayer attains age 59½ Made after the death of the policyowner Attributed to the policyowner becoming disabled (under the IRC definition) Considered part of a series of substantially equal periodic payments over the policyowner s life expectancy (or joint lives of the policyowner and a beneficiary) The death benefit of a MEC policy is taxed the same as a non-mec policy. It will generally be income tax free (see sections on Transfer for Value and Employer-Owned Life Insurance). Example: Accessing cash surrender value in a MEC Pete has a life insurance policy that is a MEC and has $75, in cash surrender value. His basis in the policy is $55,. Withdrawal If Pete takes a withdrawal of $25,, $2, ($75, - $55,) will be subject to income tax in the year he takes the withdrawal, and only $5, will be tax free as return of basis. Loan If Pete takes a loan of $25,, $2, ($75, - $55,) will be subject to income tax in the year he takes the loan, and only $5, will be tax free as return of basis. Comparison Chart Year Modified Endowment Contract Non-Modified Endowment Contract Withdrawals Loans Taxable to the extent there is gain in the contract Taxable to the extent there is gain in the contract Non-taxable until basis has been withdrawn, then taxed on gain Not taxable unless the policy lapses or is surrendered Death Benefit Generally income tax free* Generally income tax free* Tax Penalty on Withdrawals and Loans 1%, unless over age 59½ or other exception applies None * A life insurance policy that has been subject to a transfer for valuable consideration that does not fall within one of the allowable exceptions or that is employer-owned where the employer has not complied with the provisions of IRC 11(j) may lose its tax-exempt status. 46

47 IRC 135 Exchanges IRC 135 says that certain exchanges of policy values will not result in current income taxation of any gain that exists at the time of the transfer both the gain (if any) and the basis are carried to the new policy. Allowable transfers under 135 include: Life insurance to another life insurance policy Life insurance to an annuity contract Life insurance to a qualified long term care insurance policy Endowment insurance to an annuity contract Endowment insurance to a qualified long term care insurance policy Annuity contract to another annuity contract Annuity contract to a qualified long term care insurance policy Qualified long term care insurance policy to qualified long term care insurance policy To make use of IRC Section 135, the policyowner must follow certain steps: 1. Apply for new life insurance 2. Assign the old life insurance policy to the new insurance company After approval of the new life insurance policy, the insurance company requests the surrender of the policy and the transfer of the cash surrender value and basis to the new policy. To be a valid exchange that qualifies for this favorable tax treatment, the policyowner and the insured must be the same on the new policy as on the old policy. The old insurance carrier will issue a Form 199 with a code 6 to indicate that the transfer was not taxable under 135. Example: Allowable 135 Exchange John owns a universal life insurance policy on his own life. He has paid $2, per year for 15 years, and the cash surrender value in the policy is now worth $4,. If John surrenders the policy, he will have to pay income tax on the amount of the cash surrender value that exceeds his basis in the policy assumed to be total premiums. $4, - 3, ($2, x 15) $1, of taxable income Since John is still healthy and still needs the coverage, he might decide to purchase a new life insurance policy with a more favorable design and have the cash surrender value transferred. By doing this, the $4, can be used to offset premiums that would otherwise be paid out of pocket on the new policy. Additionally, the gain that John would have realized on surrender is carried to the new policy without incurring income tax. The new policy will start out with a tax basis of $3,. 47

48 135 Exchange of Life Insurance Policies with Outstanding Loans Care must be taken when a policy with an outstanding loan is exchanged for a new life insurance policy. If the loan is paid off from the policy values prior to the balance being sent to the new policy, it is treated as the receipt of boot. The amount of the loan repaid is taxable to the policyowner to the extent there was gain in the replaced policy. Advantages of Genworth Policies Our life insurance policies provide some advantages over our competitors in a 135 situation. The 135 form that assigns the old policy to a Genworth Financial company is usually sufficient consideration to put the new policy in effect. The effective date of the new policy will be the date we request the funds from the old insurance carrier. (Funds received within one year of issue apply toward the maintenance of any deathbenefit guarantee but do not get credited to cash surrender value until actually received.) Some policies issued will accept a 135 exchange with a loan carryover. Example: 135 Exchange Policy with an Outstanding Loan Kathy has a life insurance policy to which she has paid a total of $4, in premiums (basis). The policy has gross cash surrender values of $55, and has an outstanding policy loan of $3,, leaving net cash surrender value of $25,. Kathy applies for a new policy and asks the new carrier to bring over the cash surrender value from the old policy as a 135 exchange. The old carrier uses the cash surrender value to pay off the loan and sends the remaining $25, to the new carrier. The old carrier sends Kathy a Form 199 showing an income tax liability of $15, ($55, - $4,). Life insurance is one of the most efficient and effective ways people can help protect the things they value most, from their families financial security to their businesses continued success. Having a basic understanding of how the product works and the benefits it offers will help financial professionals fully explain the advantages of adding this product to clients portfolios. If you have questions about any of the information presented here, please contact your Genworth representative. 48

49 Genworth Financial Advanced Marketing DISCLAIMER The Genworth Financial companies wrote this content to help you understand the ideas discussed. Any examples are hypothetical and are used only to help you understand the ideas. They may not reflect your client(s) particular circumstances. Your clients should carefully read their contract, policy, and prospectus(es), when applicable. What we say about legal or tax matters is our understanding of current law; but we are not offering legal or tax advice. Tax laws and IRS administrative positions may change. We did not write this material for use in avoiding any IRS penalty and neither you nor your clients may use it for that purpose. Your clients should ask their independent tax and legal advisors for advice based on their particular circumstances. If this material states or implies that it was prepared or distributed to promote, market or recommend an investment plan or arrangement within the meaning of IRS guidance, or such use may be reasonably expected, then, as required by the IRS, the following also applies: The tax information in this material was written to support the promotion or marketing of the transaction(s) or matter(s) addressed in this material. Changes to tax laws may require changes to the contents of this material from time to time. Once distributed, Genworth cannot be responsible for the continued accuracy of the material. Therefore, you should contact Genworth or refer to the Genworth Advanced Marketing website to ensure access to the most recent changes. Any examples or excerpts from illustrations are for training purposes only and are not intended to represent any specific product. These examples or illustrations are not valid for use in a sales setting with consumers Genworth Financial, Inc. All rights reserved.