Insurance Test Two: Chapter 4

Watson, Inc. has four equal partners. All four partners are interested in entering into a buy-sell arrangement. How many life insurance policies would be purchased to properly fund using a crosspurchase agreement?

12. Each partner purchases a policy on the other

Life Insurance Nonforfeiture Options: cash surrender values, reduced paid-up insurance, extended term insurance

- Cash surrender values: Insured receives accumulated cash value when terminating the life insurance policy; surrender charges may be imposed - Reduced paid-up insurance: recives the cash value in the form of a paid-up policy with a smaller face amount - Extended Term Insurance: recieves the cash value in the form of a paid-up term policy for a specified duratoin, with the same face value amount as the orignal policy

Accelerated death benefits

- Accelerated death benefits provision entitles a qualified insured to recieve a lifetime benefit deemed nontaxable. - A rule similar to vatical settelment and follows the same rules expect the only parties involved are the originally insured and original insurer

Group Whole Life Insurance

- Allows employee to accumulate savings for retirement through cash value of policy - Not widely offered by employers - Generally, premiums paid by the employer are taxable income to the employee

Three types of term insurable: 1. Annual Renewable term

- Allows policyholder to purhase term insurance in subsequnet years without evidence of insurability - Premiums increase each year to account for the increasing mortality risk. - Most companines will limit the renewal period to a specified number of years or not a specific age - Most will limit the renewal period to a specified number of years or to a specific age, at which time they would have to provide further evidence of insurability in order to obtain a new policy. The limitation on renewal protects the insurer from anti-selction risk

Appropriate Use of Whole Life Insurance

- Anyone with permanent life insurance needs - Estate planning purposes: provide lqiuity at death for taxes and debt

Cross purchase agreements

- Arrangement between inidivudals to purchase an interest of a deceased owner - They all purchase life insurance on each other - Advantage: the ability to increase the survivng owner's basis in their share of the business entiity - Typically preferred from a tax standpoint because they permit surving owners to increase their basis in the business, the death benefit on life insuracne owned by individuals is not subject to the possible imposition of the alternative minimum tax; life insurance owned by business onwers outside of a corporaiton does not trigger any accumlated tax earnings

Disadvantages of buy-sale agreement

- Buy-sale agreement will increase their taxable gain upon the sale of their interest - Using life insuance to fund a buy-sale agreement may present tax problems

Dividend policies for whole life insurance

- Cash - Paid-up additions: an addtional amount of paid-up insurance protection is purchased, which increases the death benefit on the policy. Often attractive for uninsurable individuals who want addtional death benefit protection. - Increased cash value - Reduced premiums - One year term (5th dividend)

Whole Insurance: cash values; participating

- Cash value may be received for loans or may be recieved if the policy is surrendered. If surrendered, then the insured recieves the cash surrender value. This is the cash value - cash surrender charges - Cash values usally have a minmum gaurnteed rate of interest - Whole life polices may be participating (recieve dividends from insurer) or non-participating (do not recieve dividend from insurer

Taxation of benefits recieved during lifetime: Transfer of policy for value of a life insurance contract

- Death benefits become taxable to the transferee to the extent proceeds exceed basis - Exceptions to the transfer for value rule: 1. When policy is transferred to the insured 2. Transferred to business partner of insured 3. Trasnferred to a partnersnuip of insured 3. Trasnferred to corporation in whcih the insured is a shareholder 4. Transfer that results in a carryover basis from trasnferor to transferee - Ex. Joe owes Mike 100K. Joe gives Mike a policy for 1 million with a cash value of 40,000. Mike could cash it in and take a 60,000 loss. Mike could collect if Joe dies and have a taxable gain of 900,000.

Taxation of life insurance benefits: death benefits,

- Death benefits generally excluded from taxable income - dividends on earned on cash surrender values are generally not taxable until withdrawn - Cash value is not taxable if withdrawn at death - Death benefit wil be included in gross estate and possibly subject to estate tax

Limitations of term insurance (4)

- Exponential increasing premiums for older age or renewal; (mortaility cost of the premium increases each year) - Most term policies are lapsed without collection by the insured - No savings componet - Term policy may not meet permenant insurance needs

Customized Whole Life Policies: first to die;

- First to Die: Provides death benefits when the first insured dies...first to die life expectancy is less than either single life expectancy. Typically best for young couples with a mortage. Two term polices would be less expensive than one fist to die policy. - 2nd to die: Provides death benefits when 2nd or last insured dies. 2nd to die life expenctancy is greater than either individual life expectancy. Primairly for estte planning purposes. Mostly found in an ILLIT. To pay estate taxes and/or create liquity.

Life Insurance Policy provisions: Grace period, incontestability; Mistatement of gender or age

- Grace period: typically 31-61 days after the premium due date in which the policy remains in force. If insured dies during grace period, insurer assumes they would have renewed. Insurer pays the benefit and deducts the premium. - Incontestability: States that once the policy has been in force for a period of time (typially two years), the insurer may not cancel the policy if they later discover a material misrepersentation, omission, or ommission - Misstatement of gender or age: younger persons and women may pay less for life insurance; misstatement of age on applicaton will not void the contract; the benefit is paid but adjusted up or down for what age would hav ebeen if accurately said

Life Insurance Policy Provisions: Reinstatement; Policy loan

- If a life insurance policy lapses due to non-payment of premium and expiration of grace period, the policy may permit reinstatement provided requires specified in policy are met. Policy will specify the reinstatement wihtout evidence of inusrability is avaliable for a short time after grace period ends (ex. 31 days) - Policy loan provisons: when a policy loan is issued, there are no income tax consequences for the policy-owner (provided its not a Modified Endowment contract) and the interest rate on the loan is typically a low rate specified in the contract. Any loan outstanding at the death of the insured, plus accrued interest on the loan is deducted from the death benefit paid to the policy beneficary.

Parties to a Life Insurance Contract: insured, beneficiary, owner of policy

- Insured=individual whose life is covered by the policy - Owner=the person who can excercise the economic right in the policy. Typically pays the premiums - Beneficary= person who recieves the death benefit

Surrender Charges

- Insurer incurs several costs when issuing a whole life insurance policy that often exceeds first premium payment made by the insured - To prevent incurring losses when policy owners purchase and then quickly cancel their insurance contracts , they typically issue a surrender charge

Taxation of loans against life insurance

- Loans against life insurance are generally tax free, not inlcuding a MEC - Exchanges of one life insurance policy for another or for an annuity does not create a taxable event. Exchanging an annuity for an annuity is tax freee....exchanging an annuity for life insuance is taxable

Settlement Options for Life Insurance: Lump-Sum payment;

- Lump-sum payment - Interest only - Annuity payments: 1. Fixed amount: policy death benefit will be desposited with the inusrance company, and the beneficary will recieve a fixed payment each year until the proceeds are deplered 2. Life income: Portion of the payments representing the return of the death benefit paid under the life insurace policy will be recivied income tax free. Since payments stop at death, no need for contingent benefitcar ylike with fixed amount 3. Fixed period: need for a contingent benefiaary in case they die during teh perido 4. Life income with period certain: treated as a life ananuity contract based on the age and health of the beneficary, with a number of specified payments promised. If dies early, a contingent benficary recieves 5. Joint and last surivor income: annuity payments made over the joint lives of two invidiauls, and when one dies, the sruvivor recieves a reduced payment for the rest of their lives.

Why Purhcase Life Insurance: Estate preservation

- Medical expenses prior to death; may incur siginficant expenses to fight an illness or prolong life. - Disposal and ceremonines - Probate expenses: attorney's fees and court cost to proving a will, taxes assocatied with probate process, paying off any remaining debt, cash to pay for estate taxes

Taxation of life insurance benefits received during life: dividends,

- Not taxable...considered a return of premiums; if dividends exceed premiums they are taxable Withdrawls - If a Modified Endowment Contract, then withdrawls taxed on a LIFO basis. Taxed as ordinary income until cash value=accumulated premiums. Subject ot 10% penealty if withdrawn before 59.5 - If not a MEC, taxed as FIFO -

When utilizing the needs approach in the determination of the amount of life insurance, which factors should be considered? 1. The family expenses that will remain after the wage earner dies. 2. The value of the wage earner's life in the event he or she dies. 3. The income that can be generated by the surviving spouse. 4. Number of dependents

1.3.4

Type of Whole Life Insurance: ordinary, limited, variable

- Ordinary life: pay premiums until age 100 or death - Limited pay life: preimums are hgiher than ordinary life, only pay premiums until a specified number of years or until a specific age. - Variable: cash value is invested in stock, bond, and money market mutual funds. There is an oppounrity for hgiher returns on cash value. Death benefit and cash value fluctuate based on investment perforamnce.

Life Insurance Policy Provisions: Assignment (absolute, collateral); Suicide

- Owner assigns rights to someone else 1. Absolute assignment: owner transfers all ownership rights, typically the result of divorce 2. Collateral assignment: used for collaterl on debt, only assings limited ownership rights. Automatically terminates when debt is satisified. For example, assignment is to payoff debt with remainder to beneficares. - Coverge is excluded if suicide committed within 1-2 years of purchasing policy. If suicide is commited within exlcusion period, premiums are returned. Same is true for deaths as a result of war.

Level Term

- Premiums are level for a period of time - No cash value build up in the policy - Death benefit is fixed - Prepay some of the mortality cost early so you can hold the premium constant at later ages - When a level-term policy is purchased, the preimums paid by the owner are larger than the premiums on annual renewable term insurance in the early years but will be less than the preimums on an annual renewable in later years

Decreasing Term

- Premiums are level throughout the policy - No cash value build up within the policy. - Death benefit decreases over time - Mortage insuance is essentially decreasing term

Taxation of life insurance premiums

- Premiums are not tax deductible by the individual - Group insurance premiums paid by the employer are deductible to the employer - Premiums paid by the employer are taxable income to the employee in excess of 50,000 in coverage (first 50,000 of coverage is not taxable to the employee; must impute taxable income for benefits in excess of 50,000)

Whole Insurance

- Provide lifetime protection if premiums are paid as agreed - all polices are pre-fund future higher mortality costs using present value analysis - Cash value: increases to FV as age 100 or 120; insured can recieve the cash value of teh policy, which is equal to the FV of the policy at age 100 or 120 - Death benefit: level throughout the term of the policy - Premium: typically level throughout the term of the policy. Can vary widely from single premium to increasing premiums. - These policies have a savings or investment componet with earnings accuring on the residual of the premium less the cost for the year + any savings balance. Ex. Premium is 2,000 and mortality cost if 1,200. Overhead/profit is 300. Savings componet is 500. 2000-1,200-300=500 savings componet

Term Insurance Provisions

- Renewable: Most can be renewed without evidence of insurability - Covertible: most have a provision to convert to whole life without evidence of insruability for a particular period (may be less than full term) - Waiver of premium: if the premium becomes totally disabled, the premiums are waived during the period of disability

Entity Agreements:

- Simplest form of buy-sale agreements - Obligates the business entity to purhcase an owner's interest upon a triggering event - To fund the pruchase obligation, they can aquire life insureance on the owner's life with a death benefit sufficent to cover the purchase amount

Variable Life Insurance Nonforfture options:

- Structure of a variable life insurance policy is much like a universal policy with one major expection...variable univesal policies permit the owner of the life insurance policy to direct the investment of the policy's cash value - VULs are often used by young individuals who can weather market downturnd

Beneficiary Designations

- The individual or organization that will receive the death benefit upon the death of the insured is referred to as the primary beneficary - Contingent beneficaries will reiceve if the primary beneficary isn't avaliable

Fred is 30 years old and recently began a job with a salary of $60,000. He is single but has been dating Lisa for 3 years. He expects to marry her within the next 5 years. Fred lives with his parents. What is the amount of life insurance that Fred currently needs

0 because he has no dependents

Betty owns a $150,000 whole life participating insurance policy that she purchased ten years ago. She has paid premiums of $4,000 each year since she bought the policy, and the current cash surrender value is $60,000. Betty has received $10,000 in paid dividends since the policy inception. Which of the following statement(s) is/are correct regarding Betty's policy? 1. If Betty surrenders the policy now, she will have a taxable gain of $30,000 taxed as ordinary income. 2. The dividends that were paid on Betty's policy were subject to ordinary income tax treatment.

1 only. Ordinary taxable gain on surrender policy is 30,000. Premium payments of 40,000-10,000 paid dividends=30,000 adjusted basis. Taxable gain=60,000-30,000=30,000

Which of the following is needed to calculate the client's human-life value? 1. Average annual earnings to the age of retirement. 2. Estimated annual Social Security benefits after retirement. 3. Costs of self-maintenance. 4. Number of years from the client's present age to the contemplated age of retirement.

1,3,4

Steps in calculating the Human Life value

1. Determine client's annual earnings 2. Subtract personal expenses and taxes they would have incurred 3. Determine their WLE (work life expectancy)....number of years they would have contiued to earn income 4. Calculate the future value of the lost earnings for the family, taking into consideration the expected growth rate 5. Calculate the PV of the family's at the inflation rate to determine the human life value

Types of Universal Life Insurance polices

1. Type A: flexible premium, adjustable death benefit unbundled life insurance contract; beneficary recieves the cash value or death benefit 2. Type B: Same as A expect death benefits vary directly with the cash value. B is more expensive than A because death benefit is equal to the specified amount of insurance + cash value. Death benefit increases with cash value. Beneficary recieves cash value and death benefit 3. Variable: product with investment options and no minmium gaurenteed return or interest. The insured directs investment of the cash value into stock bonds and money market mutual funds.

Which of the following statement(s) is/are correct regarding buy-sell arrangements?1. Entity purchase arrangements increase the income tax basis for some survivors upon the death of another owner. 2. Cross-purchase arrangements increase the income tax basis for all survivors upon the death of another owner.

2 only

Marsha, age 35, is a single mother of one daughter, Skyler, age 9. Marsha is a secretary with annual income of $35,000 and a negative net worth. Marsha has two objectives: (1) to protect Skyler in the event of her untimely death and (2) to save for her own retirement. Which of the following life insurance policies should she buy

20 year term policy

Capitalized Earnings Approach

A modification of the human life approach 1. There is no need to determine WLE 2. Investment returns on the life insruance are presumed to be at the long term riskless rate - Very efficent method to determine the approximate amount of life insurance needed for one who has dependents and life insurance needs - Ex. Earnings are 100,000. Inflaiton is 3% and riskless rate is 6%. Consumption by the insured is 25%. Federal and state taxes are 25%. - 100,000-25,000-25,000=50,000/(1.06/1.03)-1=50,000/0.0291262=1,716,667

Advantages (4) and Disadvantages (3) of Level and Decreasing Term insurance

Advantages 1. Premiums remain level throughout the term or policy 2. Pure death benefit protection (inexpensive) 3. Maximum death benefit for each dollar in preimums 4. Can be converted to a permenant policy without evidence of insurability Disadvantages 1. "overpay" premiums initally compared with annual renewal 2. Policy is prefunded in the early years, which results in lower premiums later, when compared to an annual renewal 3. No savings componet

Advantages (2) and Disadvantages (3) of Whole Life Insurance

Advantages: - tax deferred growth of cash value (earnings portion of cash value is not taxed each year) - policy offers permenant protection until age 100 Disadvantages - policy is expensive and inflexible preimums - there is gradual cash value growth - insured may not be able to purchase as much proteciton

Advantages (3) and disadvantages (3) of annual renewal term

Advantages: 1. Pure death benefit protection....inexpensive 2. Provides the maximum death benefit for each dollar in preimums 3. Can be converted into a permenant policy without evidence of insurability Disadvantages: 1. Becomes costly at older ages 2. No savings componet 3. Premiums increase each year

Advantages (2) and Disadvatnages (1) of Universal Life Insurance

Advantages: 1. policy owner determines the frequency and amount of each preimum 2. death benefit may increase Disadvantages: 1. Death benefit may decrease

Buy-Sale Agreements

Arrangements that require the sale and purchase of securities owned by one individaul to another upon the happening of a specific event. - The plan for the orderly tranfer and control of a business interest - Creates a market for stock that is not traded - to plan for liqudity in the estate of a deceased business owner - Triggering events: death of business owner, disability, divorce, retirement, withdraw from business

Taxation of group term benefits received during lifetime: Ex. Frank, age 40, earns 75,000 per year and has group term life insurance throguh his employer equal to twice his salary. How does his income need to be imputed?

Based on some IRS table, the monthly cost in excess of coverage is 0.1 per 1,000 in excess of coverage. Therefore... - 75,000 X 2=150,000 death benefit - 150,000-50,000 esclusion= 100,000 in excess of coverage - (100.000/1,000)*0.1 *12=120 imputed income

Terry has been advised by his insurance agent to purchase a variable universal life insurance policy. He has sought your advice regarding this purchase. All of the following are characteristics of a variable universal policy, except: A) The policy features increasing or decreasing death benefits and flexibility of variable premium payments. B) The policy owner has exclusive investment control over the cash value of the policy. C) The death benefit is guaranteed to be equal to the face value. D) The cash value of a variable universal life policy is dependent on premiums and investment returns.

C

Why Purchase Life Insurance: income replacement

Changes as a person moves through the life cycle. 1. Income replacement: - income for readjustment period: family may have to adjust their standard of living. family member must recocile greif and resume their life - Financial support for dependents: children with educational needs and elderly parents - Other personal financial plans: paying off the mortage or other debts; providing income for suriving spouse

An individual has decided to purchase life insurance and comes to you as his agent. In order to propose a plan of life insurance to meet his individual needs, your first step would be to:

Conduct a needs analysis

Which one of the following statements concerning universal life insurance is false? A) The insured has the flexibility to adjust premiums, face value and cash value of the policy. B) The insured has flexibility without the investment responsibility of the cash value. C) The cash value of the policy can be used to pay the premiums. D) The death benefit of a universal life insurance policy is fixed.

D. Depends on investment performance and premiums paid

Measuring Life Insurance Need: Human Value Approach and Needs Approach

Determines amount of insurance based on: - Human value approach: present amount of income earned-amount consumed by insured. - Needs approach: determines amount of insurance based on income during the readjustment period, life income to surviving spouse, education for children, and retirement for suriving spouse

Olivia, age 52, purchased a life insurance policy on her own life. All the necessary legal elements of a contract including, (1) offer and acceptance, (2) consideration, (3) competent parties, and (4) legal purpose were met. However, Olivia lied that her age was 42 on the insurance application, and is receiving a premium commensurate with that age. Olivia died two years later in an automobile accident. Her certified death certificate indicated that she was 54 at the time of her death, and that she was 52 when she purchased the policy. Which of the following statement(s) is/are correct regarding this scenario?

Her beneficiary will receive a reduced death benefit to reflct her actual age

Wait and See Buy-Sale Agreements

Hybrid between entity and cross-purchase buy-sale agreements. - Using this approach, the business has the first option to purchase the interest of a deceased owner. IF they choose not to, the survivng owners are given the option to purchase the deceased's interest in proporiton ot their own interest. If they don't excercise, any interest remaining is purchased by the business.

Vatical Settlements

If the owner-insured of a life insurance policy is terminally ill at the time the policy is sold, the gain in the policy will not be subject to income tax. - Terminal illness= life expectancy less than 24 months.

Taxation of life insurance surrender benefits received during life

If they surrender the policy prior to death, the insured may take the cash value as a - lump-sum: amount above premiums is ordinary income - Interest only: interest is taxable as ordinary income - Installment payments: portion is a return of principal and interest; interest portoin taxed as ordinary income

Unholey Trinity

Inured=one parent. Policy owner=parent two; beneficary=child.

Joe, age 33, is married and has a newborn son. Joe is concerned about providing for his family in the event of his premature death. He is concerned about the long-term affordability of life insurance but is able to budget a fixed amount for a period of time. Which of the following policies would you recommend?

Level Premium term

Which of the following method(s) is/are appropriate to evaluate a person's life insurance needs? 1. The human life approach to evaluate life insurance needs takes into consideration the income replacement needs of a person's survivors including income during the readjustment period, income to widow(er), and educational funds for dependents. 2. The needs approach evaluates the estimated present value of income generated over a person's work-life expectancy that is needed and then adjusts for the expected consumption of the person and for taxes.

Neither (definitions reversed)

Universal Life Insurance: what can the insured adjust?

Offers flexibility because the insured may adjust... - Premiums - Face Value - Cash Value - Insured does NOT direct the investment portion - Cash value can be used to pay the premiums

Appropriate uses of term life insurance

Only for temporary insurance needs, such as... - education funding - expenses during grieving process Decreasing term is approrpatei for... - paying off a mortage - benefit decreases while preimum stays level

Taxation of Whole Life Insurance

Owners who wish to receive lifetime benefits from whole life insurance policy without triggering income ta conseunces can do so in two ways: 1. Withdraw their basis in the policy 2. Take loans against the cash value in the policy. Provided the policy is in force at the date of the insured's death, loans outstanding at policy cash value will be free of fedral income tax but will reduce the death benefit by the amount of the outstanding loan

Individual Life Insurance Type: Term

Pays a predetermined sum if the insured dies during a specified period of time. - Protection ceases at the end of the term unless removed - Premium pattern may be increasing at an annual or set period basis - Face amount may be level or decreasing - Generally no cash value, savings, or investing componet - Very inexpensive at young ages - Most of the time it is the answer for young clients, epeiclaly with children.

Life insurance and mortality risk

Risk exposures from dying early - As individuals age, their mortality risk (risk that they will die during the year) increases.

Which of the following life insurance policies provides the highest benefit for the lowest premium and is simply a pure death benefit policy

Term

The blackout period is:

The period of time when the dependents have reached age 18 and the spouse's Social Security retirement benefits have not started.

Which of the following life insurance policies has a fixed premium, a cash value and a death benefit that can fluctuate based on investment performance?

Variable Whole Life

Which of the following life insurance policies contains a cash-value savings component that reaches the face value of the policy at age 100 -120?

Whole

Which one of the following statements concerning whole life insurance is false?

Whole life insurance can be participating, which means the insured must participate in self-directed investments for the cash value.