Life Insurance Basics

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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

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