Unit 24 - Insurance-Based Products
A customer has invested a total of $10,000 in a nonqualified deferred annuity through a payroll deduction plan offered by the school system where he works. The annuity contract is currently valued at $16,000, and he plans to retire. On what amount will the customer be taxed if he chooses a lump-sum withdrawal? A) $6,000.00 B) $10,000.00 C) He will not owe taxes because the annuity was nonqualified. D) $16,000.00
A) $6,000.00 Payments into a nonqualified deferred annuity are made with after-tax money; taxes must only be paid on the earnings of $6,000. LO 24.e
If an index annuity has a participation rate of 80%, it means A) the investor's account will be credited with 80% of the growth of the index. B) the investor's account will never be less than 80% of the initial investment. C) the investor's account will participate in 80% of the gains and losses of the index. D) the investor's account will be charged with 80% of the amount lost by the index.
A) the investor's account will be credited with 80% of the growth of the index. The participation rate of an index annuity is the percentage of the growth of the index credited to the investor's account. For example, if the index had a return of 10% and the participation rate is 80%, the investor's account is credited with 8% growth. This may be limited by a cap (a maximum), but unless a cap rate is stated in the question, there isn't one. One of the benefits of an index annuity is that it only shares in the growth, never any losses. LO 24.c
In a scheduled premium variable life contract, which of the following has a guaranteed minimum? A) The cash value B) The death benefit C) The maturity value D) The expense ratio
B) The death benefit There is a guaranteed minimum death benefit. The cash value will vary according to the performance of the investments in the separate account. These policies do not have a maturity value and may have a guaranteed maximum expense ratio, not a guaranteed minimum. LO 24.f
Which of the following is indicative of the primary difference between variable life insurance and straight whole life insurance? A) Amount of insurance that can be issued B) The way in which the cash values are invested C) Cost of the insurance D) Tax treatment of the death proceeds
B) The way in which the cash values are invested Variable life insurance allows the policyowner to decide how the cash value is invested through a number of subaccounts. Death benefits from life insurance policies are always free of income tax regardless of the type of policy. LO 24.f
An investor in a variable annuity will be purchasing A) shares of the underlying subaccount. B) accumulation units. C) participation units. D) annuity units.
B) accumulation units. Unlike a mutual fund, where the investment is into shares of the fund, when purchasing a variable annuity, the investor is acquiring accumulation units. Upon annuitization, those are converted into annuity units. The investor isn't directly purchasing shares in the underlying subaccount; the annuity company is doing that. LO 24.b
Variable annuities A) may invest only in money market mutual funds. B) provide a guaranteed minimum annuity payout. C) may have 20 or more subaccount investment options. D) generally provide more security of principal than fixed annuities.
C) may have 20 or more subaccount investment options. Some variable annuity separate accounts have 50 or more subaccounts to choose from. There are no guarantees as far as the amount of payout; that is why it is called a variable annuity. LO 24.a
A life insurance policy where the premium increases each time the policy is renewed while the face amount remains level is A) variable universal B) renewable level term C) decreasing term D) increasing term
B) renewable level term Level term insurance offers a fixed face amount over the life of the policy. If the policy is renewable, the owner has the ability to renew it for that same face amount and the new term, but at new, higher premiums as the insured's age increases. LO 24.f
A client needs funds for an unexpected medical emergency. If the client takes out a loan against the cash value of his life insurance policy and does not pay it back, the insurance company can do which of the following? A) Increase the premium amortized over the life of the policy B) Cancel the policy C) Reduce the death benefit when the client dies D) Reduce the cash value at the next anniversary
C) Reduce the death benefit when the client dies Unpaid cash value loans reduce the death benefit. LO 24.f
Which of the following statements is true concerning variable life separate account valuation? A) Unit values are computed daily and cash values are computed monthly. B) Unit values are computed weekly and cash values are computed monthly. C) Unit values are computed monthly and cash values are computed weekly. D) Unit values are computed monthly and cash values are computed daily.
A) Unit values are computed daily and cash values are computed monthly. Unit values are computed each day. Policy cash values are a monthly computation. The death benefit is computed annually. LO 24.f
If a customer assumes the risk involved with her variable annuity, what does this mean? I She is not assured of the return of her invested principal. II The underlying portfolio of the selected subaccount is primarily common stocks, which have no guaranteed return. III As an investor, she can be held liable for the debts incurred by the insurance company. A) I and II B) II and III C) III only D) I, II, and III
A) I and II B) II and III C) III only D) I, II, and III Explanation The annuitant bears the investment risk in a variable annuity. This means that the portfolio is not guaranteed to return a specified rate, and the principal invested will also fluctuate in value according to the securities held in the separate account portfolio. LO 24.a
A 35 year-old client indicates that he needs $500,000 of life insurance coverage for the next 20 years. The lowest out-of-pocket cost would be if he purchased A) a 20-year level term policy B) a 20-pay life policy C) variable annuity with an extended death benefit D) a whole life policy
A) a 20-year level term policy In almost all circumstances, certainly for short-to-immediate time periods, term life will be the least expensive form of insurance. A 20-pay life is a permanent policy where the premiums are paid in a 20-year period rather than until death. Variable annuities are not life insurance policies, even though they are issued by life insurance companies. LO 24.f
A 68-year-old individual, who purchased a single premium immediate fixed annuity, elected monthly payments for life with a 10-year certain settlement option. If the individual lives to the age of 80, A) monthly payments will continue until death. B) monthly payments will remain fixed until age 78 and then reduce until death. C) monthly payments will continue to the beneficiary(s) for 10 years after the annuitant's death. D) monthly payments will cease at age 78.
A) monthly payments will continue until death. When choosing the settlement option, life with 10 years certain, the annuitant will receive payments until the later of death or 10 years. LO 24.d
A client has invested $25,000 into a variable annuity which has grown to $150,000 over the accumulation period. At age 60, the account is liquidated. The tax treatment of the withdrawal would be A) ordinary income tax on $125,000. B) ordinary income tax on $125,000 with a 10% tax penalty. C) partly ordinary income and partly capital gains depending on the length of time the variable annuity was in force. D) capital gains tax on $125,000.
A) ordinary income tax on $125,000. Any increase in the value of a variable annuity is taxed as ordinary income, never capital gain. In this case, there is no 10% penalty tax because the client is over 59½ years old. On the exam, all annuities are non-qualified unless the question says it is qualified or there is a clue, such as being part of a 403(b) plan. LO 24.e
Surrender charges may cause a reduction to all of the following except A) the redemption value of Class B mutual fund shares B) the death benefit of a variable life insurance policy C) the cash value of a variable life insurance policy D) the liquidation value of a variable annuity
B) the death benefit of a variable life insurance policy Surrender charges never apply in the case of a death benefit. There may be a surrender charge in the case of early surrender of a variable annuity, taking out the cash value of a variable life policy, or redemption of Class B (back-end load) mutual fund shares. LO 24.d
Which of the following is not an annuity purchase option? A) Single premium deferred annuity B) Single premium immediate annuity C) Periodic payment immediate annuity D) Periodic payment deferred annuity
C) Periodic payment immediate annuity With an immediate annuity, payout begins immediately (generally within 30-60 days). As such, the concept of making purchases while receiving payout is illogical and is, therefore, not permitted as an option. LO 24.d
Marianne has a fixed-premium variable life policy in which the separate account has been performing extremely well, and the face value has been increasing as a result of the investment performance. However, recently the separate account performance has been negative. If this continues, the face value could decrease A) to the original face value minus any future negative performance B) to 50% of the original face value C) to the original face value D) to 0
C) to the original face value The face value in an insurance policy is the death benefit. In a variable life policy, the face value will fluctuate with the separate account's performance, but it will never decrease below the original minimum face value. LO 24.f
A customer purchased a variable annuity from an agent 5 years ago with an initial investment of $200,000. The annuity's surrender fee will expire in year 7, which coincides with the customer's anticipated need for the funds. In the 5th year of the contract, the value of the annuity increased from $300,000 to $375,000. The agent notices that the general market is on the decline and recommends she enter a 1035 exchange of the variable contract for another, thus increasing her death benefit and locking it in at a higher minimum. This recommendation is A) unsuitable unless the customer agrees with the recommendation B) suitable because of the increased death benefit C) suitable because 1035 exchanges have no adverse tax consequences D) unsuitable because of surrender fees
D) unsuitable because of surrender fees Incurring the surrender fee for the 1035 exchange of one contract and initiating a new long-term contract is inappropriate for a customer, in general, and particularly for this customer, considering her need to access her funds only two years later. LO 24.d
On a scheduled premium variable life insurance policy, the insured is guaranteed: A) nothing. B) at least 100% of the stated cash value. C) at least 100% of the stated death benefit. D) that premiums may be reduced due to better than projected performance in the separate account.
C) at least 100% of the stated death benefit. Scheduled, or fixed, premium variable life insurance has a minimum guaranteed death benefit equal to 100% of the original face amount. There are no guarantees to the cash value and, as a fixed premium policy, no changes are made as a result of performance of the separate account. LO 24.f
All of the following terms are found in a typical equity index contract except A) inflation rate. B) settlement options. C) cap rate. D) participation rate.
A) inflation rate. Equity-indexed annuities (EIAs), or just plain index annuities, have a participation rate and a cap rate. They, like all annuities, offer different settlement options. However, there is no such thing as an inflation rate. LO 24.c
The owner of a fixed annuity is protected against A) inflation risk. B) longevity risk. C) loss of money due to early death. D) purchasing power risk.
B) longevity risk. Because a fixed annuity promises a fixed monthly payment for life, longevity risk is not a concern. However, the fixed payments are subject to purchasing power risk, also known as inflation risk. One other risk is that of dying after only receiving payments for several months after having chosen the life only option. LO 24.b
All of the following statements regarding universal life insurance are correct except A) it may include a minimum guaranteed interest rate. B) it offers the policyowner exceptional flexibility in adjusting the premiums, cash value, and death benefit. C) it offers two death benefit options. D) its premiums are fixed for the life of the policy.
D) its premiums are fixed for the life of the policy. The single most distinguishing characteristic of universal life is the fact that premiums are flexible and not fixed. LO 24.f
A terminally ill client wishing to access a portion of the cash value in his whole life insurance policy while still providing a death benefit for his beneficiaries could do so by A) selling the policy in a viatical settlement B) surrendering the policy for its cash value C) converting it into a term policy D) taking out a policy loan
D) taking out a policy loan One of the benefits of whole life insurance is the ability to borrow against the guaranteed cash value in the policy. At death, the amount of the loan is paid off from the death benefit, but the remainder is then paid to the beneficiaries of the policy. Surrendering the policy cancels the death benefit, and the purchaser of the viatical is now the one who determines the beneficiaries. You can't convert permanent insurance to term (and the exam will not consider the situation of leaving the cash value to purchase extended term insurance, which wouldn't work here anyway). LO 24.f
A 54-year-old individual invests $25,000 into a nonqualified single premium deferred variable annuity. Five years later, with an account value of $35,000, the investor engages in a Section 1035 exchange into a variable annuity issued by a different insurance company. Four years later, with an account value of $50,000, the investor withdraws $20,000. The tax consequence of the withdrawal is A) $20,000 of ordinary income. B) $15,000 of ordinary income, $5,000 nontaxable return of principal. C) $15,000 of ordinary income, $5,000 of long-term capital gain. D) $20,000 of ordinary income plus a 10% penalty tax.
A) $20,000 of ordinary income. A partial withdrawal from a nonqualified annuity is taxed on a LIFO basis. That is, the last money in (assumed to be earnings), is the first money out. The cost basis is the original $25,000. The 1035 exchange merely carried that cost basis over and resulted in no current tax on the $10,000 of earnings. When $20,000 is withdrawn, all of it represents the earnings and that is taxed as ordinary income. There is never capital gains taxation on an annuity and there is no 10% penalty tax because this investor is older than 59½ at the time of the withdrawal. LO 24.e
In a scheduled premium variable life insurance policy, which of the following are guaranteed? A) A minimum death benefit B) A minimum cash value C) The ability to borrow a maximum of 75% of the cash value once the policy has been in force at least 3 years D) The right to exchange the policy for a permanent form of insurance with comparable benefits within the first 24 months of issue, as long as the insured passes a new physical examination
A) A minimum death benefit In a variable life insurance policy, a minimum death benefit is guaranteed, but no cash value is guaranteed. There is a contract exchange privilege during the first 24 months allowing the conversion of the variable policy to a comparable form of permanent insurance, but no physical is required. The 75% cash value loan is a minimum, not a maximum, and applies after the 3rd year of coverage. LO 24.g
An owner of an equity index annuity would be wise to use the high-water crediting method if the underlying index was expected to A) be volatile. B) remain steady. C) decline. D) change its objective.
A) be volatile. An advantage of the high-water crediting method is that the interest is calculated using the highest value of the index during the term. Therefore, in a volatile market, where prices are going up and down, it picks up the highest price. LO 24.c
Among the reasons why deferred variable annuities might not be a suitable investment for seniors are all of the following except A) potential inflation protection. B) potential capital fluctuation. C) improper subaccount selection. D) surrender charges.
A) potential inflation protection. Variable annuities do offer potential inflation protection due to their participation in the equity market. The tradeoff is potential capital fluctuation, particularly if the portfolio selected is too aggressive. In addition, unlike mutual funds, they typically carry high surrender charges. LO 24.b
All of the following are advantages of universal life insurance except A) the policy is guaranteed never to lapse. B) the ability to change the death benefit amount. C) the ability to adjust the amount of premium payments. D) when the cash value is sufficient, no premium payment is required.
A) the policy is guaranteed never to lapse. A universal life policy may lapse if the accumulation fund drops below a specified level and an additional premium is not paid. LO 24.f
Bob, age 60, has invested $17,000 in his nonqualified variable annuity over the years. The total value has reached $26,000. He wishes to withdraw $15,000 to send his son to college. What is his tax consequence on the withdrawal? A) The entire amount is nontaxable. B) $9,000 is taxable; $6,000 is nontaxable. C) $6,500 is nontaxable; $8,500 is taxable. D) The entire amount is taxable.
B) $9,000 is taxable; $6,000 is nontaxable. Because this is a nonqualified annuity, the $17,000 invested is after-tax dollars. Under the tax code, the taxable portion is considered to be withdrawn first in any lump-sum distribution. Therefore, the first dollars withdrawn are all taxable until the amount of withdrawal meets or exceeds the growth in the account. Because Bob is over 59½, there is no 10% tax penalty on his withdrawals. LO 24.e
The difference between a fixed annuity and a variable annuity is that the variable annuity I offers a guaranteed return II offers a payment that may vary in amount III will always pay out more money than the fixed annuity IV attempts to offer protection to the annuitant from inflation A) I and III B) II and IV C) I and IV D) II and III
B) II and IV Variable annuities differ from fixed annuities because the payments vary and are designed to offer the annuitant protection against inflation. LO 24.a
A client has purchased a nonqualified variable annuity from a commercial insurance company. Before the contract is annuitized, your client, currently age 60, withdraws some funds for personal purposes. What is the taxable consequence of this withdrawal to your client? A) A 10% penalty plus the payment of ordinary income tax on funds withdrawn in excess of the owner's basis B) Ordinary income taxation on the earnings withdrawn until reaching the owner's cost basis C) A 10% penalty plus the payment of ordinary income tax on all of the funds withdrawn D) Capital gains taxation on the earnings withdrawn in excess of the owner's basis
B) Ordinary income taxation on the earnings withdrawn until reaching the owner's cost basis Contributions to a nonqualified annuity are made with the owner's after-tax dollars. Distributions from such an annuity are computed on a LIFO basis with the income taxed first. Once the cost basis is reached, any further withdrawals are a nontaxable return of principal. Because the client is older than 59½ at the time of distribution, the additional 10% penalty tax is not incurred. LO 24.e
Which of the following would most likely put a limit on the amount of interest to be credited to an index annuity? A) The participation rate B) The cap rate C) The annuity reset rate D) The CDSC
B) The cap rate Many index annuities have a cap rate. That represents the maximum return that can be credited to the annuity, regardless of the performance of the index. It is what limits the amount credited. Yes, the participation rate does affect how much can be credited. However, if there is no cap, there is theoretically no limit on the earnings. This is an example where you have to select the answer that best matches the question. A cap is a limit. LO 24.c
A terminally ill client wishing to access a portion of the cash value in his whole life insurance policy while still providing a death benefit for his beneficiaries could do so by A) converting it into a term policy B) taking out a policy loan C) surrendering the policy for its cash value D) selling the policy in a viatical settlement
B) taking out a policy loan One of the benefits of whole life insurance is the ability to borrow against the guaranteed cash value in the policy. At death, the amount of the loan is paid off from the death benefit, but the remainder is then paid to the beneficiaries of the policy. Surrendering the policy cancels the death benefit, and the purchaser of the viatical is now the one who determines the beneficiaries. You can't convert permanent insurance to term (and the exam will not consider the situation of leaving the cash value to purchase extended term insurance, which wouldn't work here anyway). LO 24.f
A client of an investment adviser representative (IAR) mentions that he has received a prospectus for a variable annuity but does not really understand the product. It would be reasonable for the IAR to explain that a variable annuity offers an investor A) lifetime income guaranteed never to drop below the initial rate. B) the opportunity to invest in equity securities on a tax-deferred basis. C) the insurance company's backing of the annuity' performance. D) a product very similar to a mutual fund but with lower costs and expenses.
B) the opportunity to invest in equity securities on a tax-deferred basis. One of the most attractive features of variable annuities is that all earnings are tax-deferred until withdrawal. The subaccounts are usually invested in equities (although there are some with fixed income as the primary component of the portfolio), but the expenses are generally higher than for a mutual fund with similar goals. There are no guarantees on the amount of income when the variable annuity is annuitized. LO 24.a
A widowed customer with no children has a portfolio invested in mutual funds valued at $250,000. The portfolio generates a monthly income of $1,600, an amount that exceeds her living expenses by $300. The investment portfolio is her sole source of income. Her agent recommends she sell $30,000 worth of her mutual funds and purchase a deferred variable annuity to take advantage of the tax deferral and death benefit features. This recommendation is A) suitable because it provides diversification B) unsuitable C) suitable because it offers a growth opportunity with a death benefit for a portion of her holdings D) suitable because it provides tax deferral features
B) unsuitable The customer has no need for the death benefit (she has no immediate survivors) or tax deferral features (with $19,200 in annual income, there are virtually no income taxes due) of a variable annuity, so this transaction is unsuitable. Finally, she would be replacing income generating assets with one that does not offer immediate income and that could reduce her income cushion to an uncomfortable margin of safety. LO 24.b
A client purchases a fixed annuity that will immediately begin paying $2,000 a month for life. What is the annuitant's greatest risk? A) Market risk B) Interest rate risk C) Inflation risk D) Capital risk
C) Inflation risk Also known as purchasing power risk, inflation risk is the effect of continually rising prices on investments. A client who annuitizes a fixed annuity, receiving $2,000 per month, will likely find the monthly check has less purchasing power as time goes on. LO 24.a
Which of the following is not considered to be an annuity purchase option? A) Periodic payment deferred annuity B) Single-premium immediate annuity C) Periodic payment immediate annuity D) Single-premium deferred annuity
C) Periodic payment immediate annuity An immediate annuity is one in which the payout begins immediately (generally within 30-60 days). As such, the concept of making purchases while receiving payout is illogical and is, therefore, not offered as an option. LO 24.d
When discussing the purchase of a scheduled premium variable life insurance policy with a client, it would be correct to state that A) you will receive a statement of your death benefit no less frequently than semiannually. B) if a policy loan exceeds the policy cash value, the deficiency must be remedied within 10 business days to keep the policy from lapsing. C) by surrendering the policy, its cash value may be obtained. D) premiums will vary based on performance of the separate account.
C) by surrendering the policy, its cash value may be obtained. Surrender of the contract requires the insurance company to pay out its cash value. The death benefit is adjusted annually. The cash value and perhaps the death benefit will vary based on the performance of the selected separate account subaccount, but the fact that this is a scheduled premium policy means the premiums are fixed. LO 24.g
A client purchased an index annuity from you three years ago and made an initial deposit of $100,000. The contract calls for a 90% participation rate with a 15% cap. The index had a return of +20% in the first year, -5% the second year, and +10% the third year. The investor's current value is approximately A) $128,620. B) $117,829. C) $126,500. D) $125,350.
D) $125,350. In the first year, the index gained 20%. With a 90% participation rate, the investor might have earned 18% but was limited by the 15% cap. So after one year, the value was $115,000. In the second year, the index lost money. However, with an index annuity, there are never any reductions in a down market. So the account remained at $115,000. In the third year, the investor received 90% of the 10% growth, and that increased the account value to $125,350. This resulted in an overall gain of 25.35%, or an average return of almost 8.5% per year. LO 24.c
A 54-year-old individual invests $25,000 into a nonqualified single premium deferred variable annuity. Five years later, with an account value of $35,000, the investor engages in a Section 1035 exchange into a variable annuity issued by a different insurance company. Four years later, with an account value of $50,000, the investor withdraws $20,000. The tax consequence of the withdrawal is A) $15,000 of ordinary income, $5,000 nontaxable return of principal. B) $15,000 of ordinary income, $5,000 of long-term capital gain. C) $20,000 of ordinary income plus a 10% penalty tax. D) $20,000 of ordinary income.
D) $20,000 of ordinary income. A partial withdrawal from a nonqualified annuity is taxed on a LIFO basis. That is, the last money in (assumed to be earnings), is the first money out. The cost basis is the original $25,000. The 1035 exchange merely carried that cost basis over and resulted in no current tax on the $10,000 of earnings. When $20,000 is withdrawn, all of it represents the earnings and that is taxed as ordinary income. There is never capital gains taxation on an annuity and there is no 10% penalty tax because this investor is older than 59½ at the time of the withdrawal. LO 24.e
In the past 20 years, 55-year-old James has put $27,000 into accumulation units in his nonqualified variable annuity. The current value of his units is $36,000. He wishes to withdraw $16,000 to assist with his grandchild's college education. If he is in the 28% tax bracket, what is his tax consequence on the withdrawal? A) $2,520 B) $4,480 C) $0 D) $3,420
D) $3,420 Because this is nonqualified, the investments are in after-tax dollars. Therefore, any value of the account over the investment is growth. Withdrawals from tax-deferred plans treat the growth as ordinary income for tax purposes. The portion attributable to growth is considered to be withdrawn first under the Tax Code. Here, we have $9,000 worth of growth taxable at 38% (28% + 10% penalty) because James is younger than 59½. Yes, the earnings on a nonqualified annuity are subject to the 10% penalty; only the principal escapes the tax and penalty. The remaining $7,000 withdrawn is considered a withdrawal of principal and is therefore nontaxable. LO 24.e
Which of the following is true with an annuity? I Taxes on earned dividends, interest, and capital gains are paid annually until the owner withdraws money from the contract. II Tandom withdrawals are taxed on a LIFO basis. III Money invested in a nonqualified annuity represents the investor's cost basis. IV Upon withdrawal, the amount exceeding the investor's cost basis is taxed as ordinary income. A) I, II, and IV B) I only C) IV only D) II, III, and IV
D) II, III, and IV Money randomly withdrawn (not annuitized) is handled under last-in, first-out (LIFO) tax rules. Money invested in an annuity represents the investor's cost basis, and on withdrawal, the amount exceeding the investor's cost basis is taxed as ordinary income. Taxes on earned dividends, interest, and capital gains are not paid annually. They are deferred and paid later, when the owner withdraws money from the contract. LO 24.e
A 35 year-old client indicates that he needs $500,000 of life insurance coverage for the next 20 years. The lowest out-of-pocket cost would be if he purchased A) variable annuity with an extended death benefit B) a 20-pay life policy C) a whole life policy D) a 20-year level term policy
D) a 20-year level term policy In almost all circumstances, certainly for short-to-immediate time periods, term life will be the least expensive form of insurance. A 20-pay life is a permanent policy where the premiums are paid in a 20-year period rather than until death. Variable annuities are not life insurance policies, even though they are issued by life insurance companies. LO 24.f
Larry purchased a deferred annuity and, on his 65th birthday, annuitized the product under a life with 15-year certain option. His spouse, Linda, is the beneficiary. Which of the following statements is correct? A) Payments will be made to Larry until his death and then to Linda for another 15 years. B) Payments will be made to Larry as long as he lives, but should he die prior to reaching age 80, Linda will receive payments until Larry's 80th birthday. C) Payments will be made to Larry until he is 80 and then to Linda for the remainder of her life. D) Payments will be made to Larry until he is 80 and then cease.
B) Payments will be made to Larry as long as he lives, but should he die prior to reaching age 80, Linda will receive payments until Larry's 80th birthday. Larry selected the life with 15-year certain option. This pays Larry for his life, regardless of how long, but continues to pay his beneficiary (Linda) if he dies before the end of 15 years. That is the 15-year certain part. LO 24.d
A married couple, both age 28, are considering the purchase of an annuity to help them save monthly for their retirement at age 65. They want an annuity that will allow them to participate in the equities market, and because of their long-term investment horizon, they are not particularly concerned about safety of principal. Which of the following annuity products best meets their needs? A) Single premium deferred fixed annuity B) Periodic payment deferred variable annuity C) Periodic payment deferred fixed annuity D) Single premium deferred variable annuity
B) Periodic payment deferred variable annuity A variable annuity will allow the couple to participate in the equities market. Fixed annuities are more suited for investors who are concerned with safety of principal. Because the couple plans to save monthly, a single premium deferred annuity, fixed or variable, does not meet their requirements. LO 24.d
In a scheduled premium variable life insurance policy, all of the following are guaranteed except A) the ability to borrow at least 75% of the cash value after the policy has been in force at least 3 years B) a minimum cash value C) the right to exchange the policy for a permanent form of insurance, regardless of health, within the first 24 months D) a minimum death benefit
B) a minimum cash value In a variable life insurance policy, a minimum death benefit is guaranteed, but no cash value is guaranteed. There is a contract exchange privilege during the first 24 months allowing the conversion of the variable policy to a comparable form of permanent insurance and the 75% cash value loan minimum applies after the 3rd year of coverage. LO 24.g
Alexander Wimpton purchased a variable life insurance policy 10 years ago. The policy has a $500,000 face amount that has grown to $525,000 due to the performance of the selected separate account subaccounts. Three years ago, Wimpton borrowed $50,000 against the policy that has never been repaid. The effect of this is that Wimpton's total death benefit today is A) $500,000. B) $525,000. C) $450,000. D) $475,000.
D) $475,000. The death benefit of a variable life insurance policy is the current face amount ($525,000) or the guaranteed minimum, whichever is greater, less any outstanding loans ($50,000). LO 24.g
Concerning index annuities and their method of crediting interest, which of the following is true? A) On average, annual reset has a higher participation rate than point to point. B) Annual reset offers the best return regardless of market fluctuations. C) Point to point offers the best return when the market has had a single drastic decline during the period. D) High-water mark with look back offers the best return during periods of high volatility
D) High-water mark with look back offers the best return during periods of high volatility. Using the annual high-water mark with look back will generally result in the highest return during periods of high volatility. The reason is because under this method, the highest anniversary value is used to determine the gain. In a volatile market, there is likely to be a high spike sometime during the period and that is the value used. The problem with point to point when there is a single drastic decline during the period is that the decline might occur at or just prior to the annual crediting computation. Annual reset does ignore the daily market fluctuations, but if the index is lower at the end of the year, there is nothing credited. In reality, annual reset has a lower participation rate than point to point. LO 24.c
Annuity companies offer a variety of purchase options to owners. Which of the following definitions regarding these annuity options is not true? A) An accumulation annuity allows the investor to accumulate funds in a separate account prior to investment in an annuity. B) A single premium deferred annuity is a lump sum investment, with payment of benefits deferred until the annuitant elects to receive them. C) An immediate annuity allows an investor to deposit a lump sum with the insurance company; payout of the annuitant's benefits starts immediately (usually within 60 days). D) A periodic payment deferred annuity allows a person to make periodic payments over time; the contract holder can invest money on a monthly, quarterly, or annual basis.
A) An accumulation annuity allows the investor to accumulate funds in a separate account prior to investment in an annuity. Accumulation does not refer to a purchase option. The pay-in period for an annuity is known as the accumulation stage. A single premium deferred annuity is an annuity with a lump-sum investment, with payment of benefits deferred until the annuitant elects to receive them. Periodic payment deferred annuities allow a person to make periodic payments over time. Immediate annuities allow an investor to deposit a lump sum, with the insurance company payout of the annuitant's benefits starting immediately (usually within 60 days). LO 24.a
A client who purchased a variable life insurance policy 15 months ago has suffered a stroke. In addition, he has developed adult onset diabetes. When receiving treatment for the stroke, he was diagnosed with lung cancer. He has decided to convert his variable policy to a whole life policy. Which of the following statements is correct? I He will not be able to convert to a whole life insurance policy because his health has deteriorated to such a severe level. II The new policy will bear the same issue date and age as the original policy. III The face amount must remain the same. IV The premium will be rated because his health has taken a marked turn for the worse. A) II and III B) I, II, III, and IV C) II, III, and IV D) I and IV
A) II and III Variable life insurance offers a unique conversion policy. Anytime during the first 24 months after policy issue, the policy may be exchanged for a whole life policy (or some similar form of permanent insurance if the company doesn't offer whole life) using the age and medical condition at issue, regardless of the insured's current health. However, the face amount cannot be changed from its original amount. LO 24.g
When discussing the purchase of a scheduled premium variable life insurance policy with a client, it would be correct to state that A) by surrendering the policy, its cash value may be obtained B) if a policy loan exceeds the policy cash value, the deficiency must be remedied within 10 business days to keep the policy from lapsing C) premiums will vary based upon performance of the separate account D) you will receive a statement of your death benefit no less frequently than semiannually
A) by surrendering the policy, its cash value may be obtained Surrender of the contract requires the insurance company to pay out its cash value. The death benefit is calculated annually (not semiannually) with the cash value being figured monthly. There is no time requirement to remedy a cash value deficiency. Scheduled premium means fixed premium, one that does not change. It is the cash value and the death benefit that will be affected by the performance of the separate account. LO 24.f
Among the reasons to consider investing in a variable annuity would be all of the following except A) basically, no limit on the amount that can be contributed B) capital gains treatment on any realized gains upon withdrawal C) a guaranteed death benefit for death before annuitization D) avoiding probate upon the death of the investor
B) capital gains treatment on any realized gains upon withdrawal In return for granting tax deferral on all gains in the account, the IRS taxes everything over the investor's cost basis as ordinary income. There is never a capital gain with a variable annuity. Some insurance companies will place a limit on the amount that may be invested, especially for older clients, but unlike IRS rules on retirement plans, this is strictly a company-by-company decision, not a law. Variable annuities are generally sold with a death benefit provision guaranteeing that the beneficiary will receive the higher of the amount invested or the current value of the account. Because there is a specifically named beneficiary, annuities do not go through the probate process. LO 24.e
A variable annuity has A) fixed payments once it has been annuitized. B) different investment options known as subaccounts. C) a high degree of liquidity. D) a guaranteed rate of return.
B) different investment options known as subaccounts. Variable annuities pay variable payments once annuitized; they do not guarantee a rate of return. That is why the term variable is used to describe them. Although a variable annuity may be surrendered and the cash value paid out similar to the redemption of mutual fund shares, they are not considered liquid investments because of the surrender charges that can run for 10 years or longer. They do offer multiple investment options through the subaccounts. LO 24.a
An agent presenting a VLI policy proposal to a prospect must disclose WOTF about the insured's rights of exchange of the VLI policy? A)The insured may request that the ins comp exchange the VLI policy for a permanent form of LI policy, issued by the same comp, w/in 2 yrs. The ins comp retains the right to have med examinations for underwriting purposes B)The ins comp will allow the insured to exchange the VLI policy for a permanent form of LI policy w/in 45 days from the date of the application or 10 days from policy delivery, whichever is longer C)Federal law requires the ins comp to allow the insured to exchange the VLI policy for a permanent form of LI policy, issued by the same comp, for 2 yrs w no add evidence of insurability D)W/in the 1st 18 mo, the insured may exchange the VLI policy for either a permanent form of LI or a uni variable policy, issued by the same comp, w no additional evidence of insurability
C) Federal law requires the insurance company to allow the insured to exchange the VLI policy for a permanent form of life insurance policy, issued by the same company, for two years with no additional evidence of insurability. Federal law requires that issuers of variable life insurance policies allow the exchange of these policies for a permanent form of life insurance policy, issued by the same company, for a period of no less than two years. The exchange must be made without additional evidence of insurability. LO 24.g
Which of the following would be a difference between a universal life insurance policy and a scheduled premium variable life insurance policy? A) The universal life policy will generally outperform the variable life policy during a period of falling interest rates and rising stock prices. B) There is a greater choice of separate account subaccounts in the universal life policy. C) Premiums on a scheduled premium variable life policy are fixed, while those on a universal life policy are flexible. D) There is a minimum guaranteed return on the variable life, while there is no guaranteed return on the universal.
C) Premiums on a scheduled premium variable life policy are fixed, while those on a universal life policy are flexible. A major difference between these two insurance programs is the payment of premiums. Scheduled premium is just another way of saying fixed premium. In a universal life policy, including universal variable life, the premiums are flexible. There is no choice of separate account subaccounts for universal life. Universal life is designed to benefit from periods of high interest rates, not falling ones. Finally, universal life policies have a minimum guaranteed interest rate; no such guarantee applies to variable life. LO 24.f
A 57-year-old client has $100,000 in a nonqualified variable annuity and $100,000 in a mutual fund with a dividend reinvestment plan. Coincidently, each was purchased 10 years ago with a deposit of $50,000. If the client needs $50,000 to use as a down payment for a vacation home, which would have the most severe tax consequences? A) The mutual fund B) The same tax consequences for both C) The variable annuity D) Not enough information to tell
C) The variable annuity There are several differences involved here. First of all, withdrawals from a variable annuity are treated on a last-in, first-out (LIFO) basis. That is, the earnings are considered to be withdrawn first. In that case, all $50,000 taken from the variable annuity are taxed as ordinary income. In addition, because the client is not yet 59½, the 10% tax penalty is tacked on. The mutual funds are part of a dividend reinvestment program, which means that a good portion of the $50,000 in gain has already been taxed; in any event, there is no early-withdrawal tax penalty. Finally, profits from the sale of mutual fund shares held this long would be taxed at the long-term gains rate, which is always lower than the rate for ordinary income. LO 24.b
A 47-year-old investor purchases a single premium deferred variable annuity from the ABC Insurance Company with an initial premium payment of $25,000. Six years later, a 1035 exchange is made to an annuity offered by the XYZ Insurance Company when the value of the account is $35,000. Seven years later, the account has a current value of $50,000 and the investor withdraws $20,000. The tax consequence of this withdrawal is A) no tax until the withdrawal exceeds $25,000. B) ordinary income tax on $20,000 plus a 10% penalty. C) ordinary income tax on $20,000. D) ordinary income tax on $15,000.
C) ordinary income tax on $20,000. Withdrawals from nonqualified annuities (all annuities on the exam are nonqualified unless otherwise specified) are taxed on a LIFO basis. That is, the last money in (the earnings) is considered the first money withdrawn. The investor's cost is $25,000. The 1035 exchange doesn't affect the cost basis because it is nontaxable. Therefore, with the account currently valued at $50,000, the first $25,000 withdrawn is from the earnings. That makes all of the $20,000 in this question taxable as ordinary income. What about the 10% tax penalty for early withdrawal? If you add the years together (47 + 6 + 7), the investor is 60 and, once reaching 59½, there no longer is the tax penalty. LO 24.e
All of the following statements are features of a straight life, fixed, single-premium immediate annuity except A) the annuitant may die before a return of the principal is realized. B) payments stop when the annuitant dies. C) the income level may drop if the underlying investments go down in value. D) payments do not increase with inflation.
C) the income level may drop if the underlying investments go down in value. Payments from a straight life, fixed, single-premium immediate annuity are fixed and are not dependent on underlying investments. However, as fixed payments, they do not offer inflation protection. As a straight life annuity, payments cease at the death of the annuitant. Because there is no minimum payout period, early death could result in total payments being less than the amount of the invested principal. LO 24.d
If a client wishes to purchase a life insurance policy that doesn't invest in the market, but allows the holder to pay additional premium if desired, the recommendation is A) index annuity. B) variable life. C) universal life. D) term life.
C) universal life. Universal life (not universal variable life) does not invest in the market through a separate account. That is only true of life insurance policies using the word "variable." These policies are frequently overfunded (premium over the required amount is paid-in by the policyowner). Term life cannot be overfunded and annuities of any type are not life insurance policies. LO 24.f
An agent has 4 clients who have purchased variable annuities, all of who are about to enter the annuitization phase. Client 1 purchased a single premium deferred annuity 20 years ago with a premium of $30,000. Client 2 purchased a single premium deferred annuity 10 years ago with a premium of $50,000. Client 3 purchased a periodic payment annuity 15 years ago and has made monthly premium payments totaling $60,000. Each of these 3 annuities has a current surrender value of $100,000. Client 4 just purchased an immediate annuity with a premium of $100,000. Assuming that all of these clients are of the same sex and the same age, when the annuity payout begins, which of the clients will receive the lowest amount of taxable income? A) Client 3 B) Client 1 C) Client 2 D) Client 4
D) Client 4 When it comes to taxation on annuitization, each payment consists of a combination of income and return of principal, how much of which depends on the exclusion ratio. In the case of Client 4, with an immediate annuity, it is unlikely that there is much in the way of income - almost all of the monthly payout will represent a nontaxable return of principal. Each of the other clients has tax-deferred income ranging from Client 1's $70,000 to Client 3's $40,000. When using the exclusion ratio to determine how much is income and how much is return of principal, Client 1 will have the greatest amount of taxable income followed by Client 2 and then Client 3. LO 24.e
Which of the following is a possible advantage of scheduled premium variable life insurance over whole life insurance? A) Greater guaranteed cash value B) Less risk in the underlying investment instruments C) Flexibility of premium payments D) Possible inflation protection for the death benefit
D) Possible inflation protection for the death benefit Scheduled (fixed) premium variable life has fixed, not flexible, premium payments. The distinguishing factor is the variable death benefit. The insured assumes more risk, not less, in exchange for the possibility that the death benefit will provide protection from inflation. LO 24.f
All of the following statements regarding scheduled premium variable life insurance are correct except A) premiums are determined based on age and sex of the insured B) the policyowner has the right to change the selection of subaccounts C) once selected, the policyowner may change payment modes D) better than anticipated results in the separate account could lead to a reduction in annual premium
D) better than anticipated results in the separate account could lead to a reduction in annual premium Scheduled (fixed) premium variable life premiums are fixed. It is universal life that has flexible premiums. LO 24.g
A customer has a nonqualified variable annuity. Once the contract is annuitized, monthly payments to the customer are A) 100% taxable. B) 100% tax-deferred. C) 100% tax free. D) partially a tax-free return of capital and partially taxable.
D) partially a tax-free return of capital and partially taxable. The investor has already paid tax on the contributions, but the earnings have grown tax-deferred. When the annuitization option is selected, each payment represents both capital and earnings. The money paid in will be returned tax free, but the earnings portion will be taxed as ordinary income. LO 24.e
When a client purchases an annuity with a 5% bonus, it means A) the bonus is added to the death benefit. B) the bonus is added at the last payment. C) the bonus is included every payment period. D) the bonus is added to the initial payment.
D) the bonus is added to the initial payment. A bonus annuity is one in which the specified bonus is added to the initial payment. For example, a client invests $100,000 into a 5% bonus annuity. The initial account balance will show as $105,000. In general, all earnings are based on the $105,000 amount. Bonus annuities tend to have longer surrender periods to compensate. LO 24.d
