Chapter 6: Life Insurance Premiums, Proceeds and Beneficiaries
Lump Sum
Death benefit is paid in a single payment, minus any outstanding policy loan balances and overdue premiums. Usually known as the (default or automatic) choice for most life insurance contracts
Reserves
Money set aside to pay future claims
Qualifications
The beneficiary of a life insurance policy is the person or entity designated in the policy to receive the death proceeds
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.
Viatical Settlement
Allows someone with a terminal illness to sell their existing life insurance policy to a third party for a percentage of the face value. The new owner continues to make the premium payments and will eventually collect the entire death benefit. (The original policy owner is called the aviator and the new party owner is called the Viatical, sometimes called the Viatee.
Premium Mode
Refers to the policy feature that permits the policy owner to select the timing of premium payments.
Changing the Beneficiary
Revocable Beneficiary: The policy owner 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 policy owner may not exercise certain rights without the consent of the beneficiary.
Mode of Premium Provision
When the policy owner chooses to pay the premium more than once a year, there usually is an additional charge because the company will have additional charges in billing and collecting the premium payments.
Death Benefit Settlement Options
- Lump Sum - Interest only - Fixed period - fixed amount - Life Income - Joint and survivor
Primary Factors In Premium Calculations
1. Mortality Factor 2. Interest Factor 3. Expense Factor
Other Factors that impact the premium amount include:
Age: The older the person, the higher probability of death of disability. Sex/Gender: Women tend to live longer than men, so their premiums are usually lower Health: Poor Health increases probability of death and disability Occupation: Hazardous job increases the risk of loss Hobbies: High risk hobbies also increase the risk of loss Habits: Tobacco use presents a higher risk than non-smokers
Taxation of Proceeds Paid at Death
Life insurance proceeds paid to a beneficiary are usually tax free if taken as a lump sum. The exception to this rule is the transfer for value rule, which applies when a life insurance policy is sold to another party before the insured's death.
Special Situations
Simultaneous Death Common Disaster Provision Spendthrift Clause
Facility of Payment
Typically found in industrial policies, it allows the insurance company to pay all or part of the proceeds to someone not named in the policy that has a valid right. This is usually done on behalf of a minor.
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.
Morality 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.
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 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
Death Benefits
Settlement options: the policy owner may select a settlement option at the time of the application and may change the option at anytime during the life of the insured. Once selected, the settlement option cannot be changed by the beneficiary.
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.
Net Payment Cost Index
Uses the same formula as the Surrender Cost Index with the exception that if doesn't assume that the policy will be surrendered at the end of the period. The net payment cost index is useful if ones 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.
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. (A section 1035 exchange enables the postponement of tax sequences)
Premium Payment Options
annual, semi-annual, quarterly, monthly The higher the frequency of payments, the higher the premiums. This is because the interest earned to the insurer is decreased while the administrate costs are increased.
Who can be a beneficiary?
- Individuals - Businesses - Trusts - Estates - Charities - Minors
Spendthrift Clause
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. A Spendthrift clause in a life insurance policy would have no effect if the beneficiary receives the proceeds as one lump of sump payment. The spend thirst clause is elected at the time of the application
Type of Beneficiaries
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 name, or if all beneficiaries die before the insured dies, death benefit will go to insured's estate. By order of succession: Primary: First in line to receive death benefit proceeds Secondary: (contingent) Second in line to receive death benefit proceeds Tertiary: Third in line to receive death benefit proceeds. If no one is named, death benefit will go to insured's estate.
Living Benefit Options
Accelerated Benefit Viatical Settlement Life Settlement
Accelerated Benefits
Allows someone that a physician certifies as terminally ill to access the death benefit. The amount of benefit received will be tax free
Tax Treatment of Cash Values
If cash value is surrendered, the portion that exceeds the premiums paid is taxable. For policies that are not surrendered, the cash value grows tax-free. 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. The total of the premiums paid into the policy minus dividends received in cash or used to offset premiums is referred to as the cost basis.
Single Premium Funding
The policyowner pays a single premium that provides protection for life as a paid-up policy. Normally associated with whole life insurance.
Tax Treatment of Proceeds
• Premiums: Not tax deductible • Death Benefit: Tax- free if taken as a lump sum to a named beneficiary. Subject to federal estate tax under certain circumstances and normally included in the policy owners gross estate • Death Benefit Installments: Principal is tax- free - interest is taxable
Life Income
This life income option provides the beneficiary with an income that they cannot out live. 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. This gives life the potential for a greater return, or the potential for greater loss, based on how long the insured lives. A joint and survivor option guarantees that benefits will be payed 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. Living benefits is the option to use some of the future death benefit proceeds when they may be most needed, before their death, when the insured has a terminal illness.
Interest Factor
Insurance companies invest the premiums they receive in an effort to earn interest. This interest is one of the ways an insurance company can lower the premium rates.
Level Premium Funding
Policies that have a level premium average premiums over the policy period. 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.
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. It also states that the primary beneficiary of the policy must survive the insured by a certain number of days (usually from 60 to 90) to qualify to receive the policy's benefits. Otherwise the benefits will be paid to the insureds estate as if the primary beneficiary died before the insured
Comparing Life Insurance Policy Costs
Life insurance cost comparison methods are used to evaluate the cost of one life insurance policy in relation to another so that consumers can be better informed when shopping for the most competitively priced offering for their particular needs. Although the the cost of life insurance depends largely upon an individual law specific circumstances and requirements, cost estimates are nonetheless useful so that the consumer has the opportunity to consider every factor when making a buying decision. When evaluating different policies, it's not enough to simply compare premiums. 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.
Taxation of Proceeds Paid During the Insured's Lifetime
Policy Surrender: When a policy is surrendered for the cash value, some of the cash value received may be taxable, if the value was more than the amount of the premiums paid for the policy. Accelerated Death Benefit: When benefits are paid under a life insurance policy to a terminally ill person, the benefits are received tax free. Note: Most states still require a viatical company to inform the client that under a viatical arrangement, then proceeds could be taxable in certain situations and recommended they consult a tax advisor.
Tax Treatment of Premiums
Premiums paid on individual life insurance policies are generally not deductible. Premiums for life insurance used for business purposes are generally not tax-deductible. Here are the exceptions to these rules: • Premiums used for a charity are tax-deductible. • Life insurance premiums paid by an ex-spouse as court-ordered alimony are tax- deductible. • Employer-paid premiums used to fund group life insurance for the benefit of employees are tax-deductible.
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.
Fixed Period
Also called period certain, the death benefit proceed is paid in equal installments over a set period of years. Part of the installments paid to a beneficiary consists of interest calculated on the proceeds of the policy. The dollar amount of each installment depends upon the total number of installments.
Cash Value
Cash value applies to the savings element of whole life insurance policies that are payable before death. The cash value of a whole life insurance policy during the early policy years typically will be less than the premiums paid.
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 law will assume that the primary died first, this allows the death benefit proceeds to be paid to the contingent beneficiaries.