Unit 15. Insurance-Based products

variable life insurance policy

-scheduled premiums -minimum guaranteed plus variable death benefit -premiums to general and separate account -no guaranteed cash value

Whole life policy

-scheduled premiums -fixed death benefit -premiums to general account -guaranteed cash values

The main benefit that variable life insurance has over whole life insurance is A) an adjustable premium B) a lower sales charge C) the potential for a higher cash value and death benefit D) the availability of policy loans

C) the potential for a higher cash value and death benefit Premiums of variable life insurance policyholders are invested in the insurer's separate account. This allows the policyholder the opportunity (though there are no guarantees) to enjoy significant returns and substantially higher cash values than are obtainable through a whole life policy. U15LO7

Variable life separate account valuation

Unit values are computed daily and cash values are computed monthly.

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) $9,000 is taxable; $6,000 is nontaxable. B) The entire amount is nontaxable. C) $6,500 is nontaxable; $8,500 is taxable. D) The entire amount is taxable.

A) $9,000 is taxable; $6,000 is nontaxable. Because this is a nonqualified plan, 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 Under the Tax Code, the taxable portion is considered to be withdrawn first in any lump-sum distribution. Therefore, the first dollars withdrawn are all taxable until the amount of withdrawal meets or exceeds the growth in the account.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. U15LO5

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) variable annuity with an extended death benefit C) a 20-pay life policy 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. U15LO6

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. Death benefit is adjusted annually. U15LO7

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 sub-account 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. U15LO2

When a client purchased an annuity with a 5% bonus, it means A) the bonus is added to the initial payment B) the bonus is included every payment period C) the bonus is added to the death benefit D) the bonus is added at the last payment

A) 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. U15LO4

One of your customers owns an index annuity. The percentage of the index's return the insurance company credits to the annuity is determined by A) the participation rate B) the CDSC C) the annuity reset rate D) the cap rate

A) the participation rate Virtually all index annuities have a specified participation rate, the percentage of the index's earnings that will be credited to the account. For example, if the index returned 8% and the participation rate is 80%, the customer's account will be credited with 6.4%. Not all index annuities have a cap rate, but even then, the cap rate only takes effect when the credited earnings exceed the cap. For example, if the cap in our example was 5%, that is what the customer would receive. It is important to read the questions carefully. The cap rate puts an upper limit on the amount credited, but it is the participation rate that specifies the percentage of the return that will be credited. U15LO3

Variable annuities A) may invest only in money market mutual funds B) may have 20 or more subaccount investment options C) generally provide more security of principal than fixed annuities D) provide a guaranteed minimum annuity payout

B) 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. U15LO1

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 annuity reset rate C) The cap rate D) The CDSC

C) 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, but, 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. U15LO3

A client of an 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) a product very similar to a mutual fund, but with lower costs and expenses B) the insurance company's backing of the annuity' performance C) the opportunity to invest in equity securities on a tax-deferred basis D) lifetime income guaranteed never to drop below the initial rate

C) 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 sub-accounts 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 VA is annuitized. U15LO1

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 cease at age 78. B) monthly payments will continue to the beneficiary(s) for 10 years after the annuitant's death. C) monthly payments will continue until death. D) monthly payments will remain fixed until age 78 and then reduce until death.

D) monthly payments will remain fixed until age 78 and then reduce 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. U15LO4

Surrender charges may cause a reduction to all of the following EXCEPT A) the liquidation value of a variable annuity B) the redemption value of Class B mutual fund shares C) the cash value of a variable life insurance policy D) the death benefit of a variable life insurance policy

D) 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. U15LO4

straight life, fixed, single-premium immediate annuity

-payments do not increase with inflation. -payments stop when the annuitant dies. -the annuitant may die before a return of the principal is realized.

universal life insurance policy

-premiums are flexibile -variable death benefit -premiums to separate account -no guaranteed cash value

A client has been contributing to a periodic payment annuity for 20 years. The M&E charge is 1.25% per year. What happens to that charge when the client annuitizes at attained age 68? A) It continues B) It ceases C) It increases because the client's mortality risk is higher at the older age D) It continues but at a reduced rate

B) It ceases The M&E charge is for mortality and expenses. Once an annuity contract, fixed or variable, is annuitized, that charge no longer applies to the account. There may be an internally computed charge, but unlike the accumulation period, the charge is not broken out separately. U15LO4

Investment Company Act of 1940 conversion privilege

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.

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) $4,480.00 B) $2,520.00 C) $3,420.00 D) $0.00

C) $3,420.00 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 non-qualified annuity are subject to the 10% penalty; it is only the principal that escapes the tax and penalty. The remaining $7,000 withdrawn is considered a withdrawal of principal and is therefore nontaxable. U15LO5

You have a 37-year-old client whose wife has just given birth to triplets. Because of the added responsibilities, he wants to maximize the amount of life insurance he can acquire. Which of the following types of insurance will give him the greatest amount of coverage for the lowest initial premium? A) Universal life B) Variable life C) Annual renewable term D) Whole life

C) Annual renewable term At any given age, term insurance always carries the lowest premium and, of the term policies available, annual renewable term always has the lowest initial premium. Of course, because the premium tends to increase each year the policy is renewed, at older ages it can become unaffordable. But, remember, this question is only asking about initial cost. U15LO6

A popular vehicle for saving for retirement is the variable annuity. An agent explaining the benefits of this product would probably be in violation of the NASAA Statement of Policy on Dishonest or Unethical Business Practices of Broker-Dealers and Agents by claiming that variable annuities offer A) the choice of a large number of different subaccounts with varying objectives B) tax deferral on earnings until withdrawn from the account C) lower overall expenses than a mutual fund with similar investment objectives D) the ability to exchange funds between subaccounts without incurring a tax liability under IRS Code Section 1035

C) lower overall expenses than a mutual fund with similar investment objectives In general, variable annuity expenses are higher than those of a mutual fund with similar objectives. That doesn't mean the fund is good and the VA bad, it is that there are guarantees and other features offered by the VA that a fund does not have and they have to be paid for. U15LO2

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) capital gains tax on $125,000. B) partly ordinary income and partly capital gains depending on the length of time the variable annuity was in force. C) ordinary income tax on $125,000. D) ordinary income tax on $125,000 with a 10% tax penalty.

C) 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. You can safely assume that any annuity is non-qualified unless something in the question says it is. U15LO5

Juliette, a math teacher in the local high school, owns a qualified, tax-deferred annuity. When she retires, what will be the tax consequences of her annuity payments? A) Her annuity payments are partly taxable and partly tax-free return of capital. B) Her annuity payments are partly taxable as capital gain and partly taxable as ordinary income. C) Her annuity payments are tax free. D) Her annuity payments are all taxable as ordinary income.

D) Her annuity payments are all taxable as ordinary income. The key word here is qualified! The investment Juliette made was with pre-tax dollars, the money grows tax-deferred, and everything is taxed at distribution at ordinary income rates. No annuity payment is ever treated as a distribution of capital gains. Note: On the exam, all contributions to retirement plans are fully -deductible unless something in the question specifies otherwise. U15LO5

John owns a nonqualified, tax-deferred annuity. When he retires, what will be the tax consequences of his annuity payments? A) His annuity payments are tax free. B) His annuity payments are all taxable as ordinary income. C) His annuity payments are partly taxable as capital gain and partly taxable as ordinary income. D) His annuity payments are partly taxable and partly tax-free return of capital.

D) His annuity payments are partly taxable and partly tax-free return of capital. The key word here is nonqualified! The investment John made was with after-tax dollars, the money grows tax-deferred, and only the earnings are taxed at distribution. A computation will be made at John's retirement called the exclusion ratio to determine how much of each retirement payment will be treated as a return of cost basis and how much as taxable ordinary income. No annuity payment is ever treated as a distribution of capital gains. U15LO5

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) a guaranteed death benefit for death before annuitization C) avoiding probate upon the death of the investor D) capital gains treatment on any realized gains upon withdrawal

D) 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. U15LO5

High water crediting method

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.