Ch.4 Life Insurance Premiums, Proceeds and Beneficiaries | NOTES

Cash Value

For policies that are not surrendered, the cash value grows tax-free. If cash value is surrendered, the portion that exceeds the premiums paid is taxable. As long as the cash value stays in the policy taxes will never be imposed on any portion, not even the amount that exceeds the cost basis. Proceeds from a policy loan do not count as taxable income, according to the IRS. However, if you surrender your policy or if your policy lapses, the IRS is notified of the taxable event and taxes may be required.

Occupation:

Hazardous job increases the risk of loss.

Hobbies:

High risk hobbies also increase the risk of loss. Remember these are typically only important at time of application. If you tell them you never went sky diving (and that is true) then 5 years later you go sky diving for the first time and die, they will pay.

Distribution by Descent

Per Stirpes: (meaning by the bloodline) In the event that a beneficiary dies before the insured, benefits from that policy will be paid to that beneficiary's heirs. Per Capita: (meaning by the head) Evenly distributes benefits among all named living beneficiaries.

Health:

Poor health increases probability of death and disability.

Life Insurance and Taxes

Premiums paid on individual life insurance policies and premiums paid for life insurance used for business purposes (the company's benefit) are generally not tax-deductible. Exceptions to the rule includes: Premiums on an insurance policy to benefit a charity are tax-deductible. Premiums on an insurance policy to benefit an ex-spouse as court-ordered alimony are tax-deductible. Employer-paid premiums used to fund group insurance for the benefit of employees are tax-deductible for the employer and neither tax-deductible nor taxable to the employee.

Spendthrift Clause:

Prevents the decease's creditors from obtaining the death benefit and prevents a beneficiary from recklessly spending benefits by requiring the benefits to be paid in fixed amounts or installments over a certain period of time.

By Order of Succession:

Primary: First in line to receive death benefit proceeds Secondary (contingent): Second in line to receive death benefit proceeds if primary beneficiary dies first Tertiary: Third in line to receive death benefit proceeds. If no one named, death benefit will go to insured's estate.

Premium Mode:

refers to the premium payment schedule and permits the policyowner to select the timing of premium payments. Options include: annual, semi-annual, quarterly, monthly. The more payments you make, the more it is going to cost you overall. Ideally, if you could make 1 payment in a lump sum to start and "Pay up" the policy, you would save the most amount of money. Also, your cash value would begin accumulating right away. The higher your premium payments are, the quicker you accumulate cash value. The higher the frequency of payments = higher premiums.

Modified Premium Funding

is characterized by an initial premium that is lower than it should be during an introductory period of time (normally the first three to five years). After this time, the premium will increase to an amount greater than what the initial level premium would have been, and then remains level or constant for the life of the policy. For example, John can buy that same $100,000 whole life policy for 36 initial fixed premiums(monthly for 3 years) for $50 each ($1,800 total introductory) and then an additional 804 fixed premiums (monthly for 67 years) for $110 each ($88,440 total remainder). ($1,800 introductory + $88,440 for reminder = $90,240 total).

Gross Premium

is the premium charged by an insurer that is comprised of or influenced by all factors of mortality, interest and expenses. It is the actual premium paid by the policyowner for life insurance coverage. Gross Premium = Net Premium + insurer expenses.

Transfer-for-Value Rule

The transfer for value rule applies when a life insurance policy is sold to another party before the insured's death. For this reason, most states require a Viatical Settlement Company or Life Settlement Company to inform the client that the proceeds could be taxable in certain situations and recommend they consult a tax advisor.

Policy Dividends:

Dividends are a refund of part of the premium under a mutual insurer's participating policy. Dividends may be used by the policyowner for cash payments, to pay the insurance premium, to purchase additional paid-up whole life insurance, to purchase one year term insurance, or as an investment to accumulate interest. While not directly tied to the policy proceeds, dividends are still considered a living benefit.

Other factors that impact the premium amount

*Age *Sex / Gender *Health *Occupation *Hobbies *Habits *Benefits, options, and riders *Premium Mode

Purpose of Premiums

*The insurer receives premium from a policyowner in exchange for insurance protection. *The premium is part of the policyowner's consideration, or the "binding force" in the contract which cements the agreement between the insurer and policyholder.

Life Settlement:

A life settlement is the sale of an existing life insurance policy to a third party for more than its cash surrender value, but less than its net death benefit. An insured does not have to have a terminal illness to participate in a life settlement.

Living Benefits

A living benefit is the option to use some of the future death benefit proceeds before death. Living Benefit Options include: Cash Value Accelerated Benefit Viatical Settlement Life Settlement Policy Dividends

Mortality Factor:

A measure of the number of deaths in a given population. Mortality is based on a large risk pool of people and time. Insurance companies use mortality tables to help predict the life expectancy and probability of death for a given group.

Accelerated Benefit:

Allows someone that a physician certifies as terminally ill to access the death benefit. To be considered terminally ill, a physician must certify that the person has a condition or illness that will result in death in two years. Since your doctor has certified you are going to die soon the insurance company feels confident you aren't going to stop paying your insurance premiums now. Since the insurance company also now knows they are going to have to pay out the benefit soon, they will give YOU some of the proceeds NOW and deduct it from what would go to your beneficiary.

Viatical Settlement:

Allows someone with a terminal illness to sell their existing life insurance policy to a third party for a percentage of the death benefit. The new owner continues to make the premium payments and will eventually collect the entire death benefit. The original policyowner is called the Viator and the new third-party owner is called the Viatical, or sometimes referred to as the Viatee.

Joint and Survivor

Benefits will be paid on a life-long basis to two or more people. This option may include a period certain and the amount payable is based on the ages of the beneficiaries.

Lump Sum

Death benefit is paid in a single payment, minus any outstanding policy loan balances and overdue premiums. The lump sum option is considered the automatic (or "default") option for most life insurance contracts.

Simultaneous Death:

If the insured and the primary beneficiary die at approximately the same time for a common accident with no clear evidence as to who died first, the Uniform Simultaneous Death Act will assume that the primary died first, this allows the death benefit proceeds to be paid to the contingent beneficiaries.

Expense Factor

Insurance companies are just like any other business. They have operating expenses which need to be factored into the premiums. The expense factor is also known as the loading charge.

Interest Factor

Insurance companies invest the premiums they receive in an effort to earn interest. The rate of earnings on investments is one of the ways an insurance company can reduce premium rates.

Interest Only

Insurance company holds death benefit for a period of time and pays only the interest earned to beneficiaries. A minimum rate of interest is guaranteed and the interest must be paid at least annually.

Policy Proceeds

Living Benefits Death Benefit settlement options:

REMEMBER: Living Benefits have tax ...

Living benefits have can have tax implications depending on the situation.

Reserves:

Money that together with future premiums, interest, and survivorship benefits will fulfill an insurance company's obligations to pay future claims. Each state has its own reserve requirements.

Primary Factors in Premium Calculation

Mortality Factor Interest Factor Expense Factor

Premium Terms and Funding

Reserves The earned premiums and unearned premiums Cost basis Net Premium Gross Premium Single Premium Funding Level (fixed) Premium Funding Modified Premium Funding Graded Premium Funding Flexible Premium Funding Minimum deposit financing

Changing a Beneficiary

Revocable Beneficiary - The policyowner may change the beneficiary at any time without notifying or getting permission from the beneficiary. Irrevocable Beneficiary - An irrevocable designation may not be changed without the written consent of the beneficiary. The irrevocable beneficiary has a vested interest in the policy, therefore the policyowner may not exercise certain rights (such as taking out a policy loan) without the consent of the beneficiary.

Special Situations

Simultaneous Death Common Disaster Provision Spendthrift Clause Facility of Payment

Economic Benefit Doctrine

The Economic Benefit Doctrine requires that any benefit granted to an individual that has economic or financial value be included as compensation for income tax purposes in the year the benefit is granted. Individual life insurance generally avoids this doctrine since premature death can cause a substantial risk to a surviving family. *Life insurance proceeds paid to a beneficiary as a lump sum are generally received tax free. Additionally, Proceeds pass directly to the beneficiary and are not subject to attachment by the insured's creditors. *If death benefits are paid to a beneficiary in installments, as opposed to a lump sum, the principal is received tax free and any interest received is taxable. *Another tax cost typically associated with death is the Federal estate tax (although most relatively simple estates do not require the filing of an estate tax return).

Cash Value

The cash (equity) that accumulates may be borrowed against, used as collateral, utilized as supplemental retirement income, or may be withdrawn for emergencies or other situations where cash is needed.

Comparing life insurance policy costs

The cost of life insurance depends largely upon an individual's specific circumstances and requirements, however, cost estimates are useful so that the consumer has the opportunity to consider every factor when making a buying decision. A lower premium does not automatically mean a lower-cost policy. To that extent, cost indexes have been developed to help in the process of measuring an insurance policy's actual cost.

The earned premiums and unearned premiums

The earned premiums (the amount an insurer is entitled for coverage provided)and unearned premiums(the premium collected from the policyholder for future coverage) make up the insurer's total premium.

Fixed Amount

The fixed amount installment option pays a fixed death benefit in specified installment amounts until the proceeds are exhausted. The larger the installment payment the shorter the payout period.

Fixed Period (Period Certain)

The fixed period option is when the insurer pays proceeds (including interest and principal) in minimum guaranteed dollar payments over a specified number of years.

The interest adjusted cost method

The interest adjusted cost method calculates the cost of life insurance, taking into account the time value of money (i.e., the investment return on sums placed in premium dollars had these sums been invested elsewhere).

Life Income

The life income option provides the beneficiary with an income that they cannot outlive. Installment payments are guaranteed for as long as the recipient lives, the amount of each installment is based on the recipient's life expectancy and the amount of principal.

Benefits, options, and riders:

The number and kinds of benefits provided by a policy affect the premium rate. The greater the benefits, the higher the premium. To state it another way, the greater the risk to the company, the higher the premium.

Age:

The older the person, the higher probability of death and disability.

Single Premium Funding:

The policyowner pays a single premium that provides protection for life as a paid- up policy. This provides for the lowest total premium and fastest build up of cash value. For example, John, a 30-year old nonsmoker buys a $100,000 whole life policy for one single premium of $70,000.

Level (fixed) Premium Funding:

The policyowner pays more in the early years for protection to help cover the cost in later years, which allows the premiums to remain level throughout the life of the policy. The shorter the premium-paying period, the higher the periodic premiums BUT, the lower the total premium paid and quicker cash value builds. For example, John can buy that same $100,000 whole life policy for 10 (annual) level premiums of $8,000 each ($80,000 total premiums); or John can buy that same $100,000 whole life policy for 840 level premiums (monthly for 70 years) for $105 each ($88,200 total).

Cost basis:

The total of the premiums paid into the policy minus total dividends received in cash or used to offset premiums.

The traditional net cost method

The traditional net cost method adds a policy's premiums and subtracts dividends, if any, and cash value.

Beneficiaries

There are very few restrictions on who may be named a beneficiary of a life insurance policy. A beneficiary can be either specific (a person identified by name and relationship), or a class designation (a group of individuals such as the "children of the insured"). If no one named, or if all beneficiaries die before the insured dies, death benefit will go to insured's estate. The policyowner is the ultimate decision maker. However, in the underwriting process, the underwriter may consider the issue of insurable interest. Examples of who can be beneficiaries include: *Individuals *Businesses *Trust *Estates *Charities *Minors *Class (having a group named as the beneficiary instead, such as the children of the insured)

Habits:

Tobacco use presents a higher risk than non-smokers

Surrender Cost Index:

Uses a complicated calculation formula where the net cost is averaged over the number of years the policy was in force to arrive at the average cost-per-thousand for a policy that is surrendered for its cash value at the end of that period.

Net Payment Cost Index:

Uses the same formula as the Surrender Cost Index with the exception that it doesn't assume that the policy will be surrendered at the end of the period. The net payment cost index is useful if one's primary concern is the amount of death benefits provided in the policy. It is helpful in comparing future costs, such as in 10 to 20 years, if one will continue to pay premiums and does not take the policy's cash value.

Graded Premium Funding

is a contract characterized, like modified, by a lower premium in the early years of the contract. However, premiums increase annually or every year for the initial period. It then jumps to an amount higher than what the initial level premium would have been, and then remains level or constant for the life of the policy. For example, John can buy that same $100,000 whole life policy for monthly payments of $20 each year 1, $40 each year 2, $50 each year 3, $75 each year 4 ($2,220 total introductory) and then an additional 792 fixed premiums (monthly for 66 years) for $120 each ($95,040 total remainder). ($2,220 introductory + $95,040 for reminder = $97,260 total).

Net Premium

is a premium that makes provision for mortality (death benefit) losses only, while being influenced by the interest rate assumed, gender, benefit to be provided and the mortality rate.

1035 Exchange:

When an existing life insurance policy is assigned to another insurer for a new contract, the transaction may be treated for tax purposes as a Section 1035 exchange. Policy exchanges that qualify as a 1035 exchange are not taxable.

Accelerated Death Benefit:

When benefits are paid under a life insurance policy to a terminally ill person, the benefits are received tax-free.

Death Benefit settlement options:

While normally selected by the beneficiary, the policyowner may select a settlement option at the time of the application and may change the option at anytime during the life of the insured. If selected by the policyowner, the settlement option cannot be changed by the beneficiary. Death benefit settlement options include: Lump Sum Interest Only Fixed Period (Period Certain) Fixed Amount Life Income Joint and Survivor

Common Disaster Provision:

With a common disaster provision, a policyowner can be sure that if both the insured and the primary beneficiary die within a short period of time, the death benefits will be paid to the contingent beneficiary.

Sex / Gender:

Women tend to live longer than men, so their premiums are usually lower.

Facility of Payment:

allows the insurance company to pay all or part of proceeds to someone not named in the policy that has a valid right. This is usually done on behalf of a minor or when the named beneficiary is deceased.

Flexible Premium Funding

allows the policyowner to adjust the premiums throughout the life of the contract.

Minimum deposit financing

allows the policyowner to use policy loans to pay premiums due each year. The policyowner only pays the difference between the premium due and the amount borrowed (plus interest on the policy loan). Depending on the type of policy, a policyowner may be able to use the policy's cash value and dividends to pay premium.

Dividends

are received tax free however, if the policyowner chooses to leave the dividends with the insurance company as an investment, any interest which accumulates will be subject ordinary income tax.