CFP 102 Unit 4 Key Terms Life Insurance (Individual)—Part 2

Transfer-for-value

A transfer of an asset by means of a sale, exchange or any transfer which includes valuable consideration. If a life insurance policy is transferred for value, the death benefit in excess of the transferor's adjusted basis will be subject to income tax, meaning that the income tax exclusion of the death benefit is lost. There are five instances when transfer of a policy will not result in loss of exclusion treatment. These include transfers to: ■ the insured; ■ a partner of the insured; ■ a partnership in which the insured is a partner; ■ a corporation in which the insured is an officer or shareholder; ■ a transferee whose basis in the policy is determined by reference to the transferor's basis (tax-free exchange or a gift that may be eligible for the gift tax annual exclusion of $15,000 for 2018* ).

Seven-pay test

Determines whether a life insurance policy is a modified endowment contract, which it is if cumulative amounts paid under the contract at any time during the first seven contract years exceeds the cumulative amount that would have been paid had the policy's annual premium equaled the net level premium for a seven-pay life policy of the same type, using certain required assumptions

Adjustable life insurance

This form of life insurance operates somewhat like universal life insurance and somewhat like whole life. That is, on the initial application date, the applicant chooses the death benefit and premium amount. After determining the amounts for these two options, the nonforfeiture values are then calculated. As the years pass, the policy owner may elect to increase or reduce (adjust) the death benefit, change the premium amount, or both. However, any changes result in new computations and new nonforfeiture values being calculated. Typically, the policy has a cost-of-living rider that permits the owner to increase the death benefit once every three years in the same percentage amount as the Consumer Price Index (without having to prove insurability).

Accelerated death benefit

This rider typically provides that, if an individual is terminally ill, usually with a life expectancy of 24 months or less, the insurance company will pay out a portion of the death benefit. The most common amount paid is 50% of the face amount. The other 50% is paid out as an income tax-free death benefit to the insured's named beneficiary. Benefits are fully excludable if the insured is terminally ill. If the insured is chronically ill, benefits paid on the basis of costs incurred for qualified long-term care services are fully excludable. Benefits paid on a per diem or other periodic basis are excludable up to a limit. The main advantage of the accelerated death benefit rider is that terminally or chronically ill insureds may obtain advances of death benefits and use them for a variety of personal needs. On the other hand, the receipt of the advance reduces the face amount of the insured's life insurance policy, which may pose a problem to surviving dependent

First-to-die life insurance

Unlike second-to-die life, an insurance policy may be structured to pay out at the death of the first spouse or individual to die. This arrangement is commonly used in a buy-sell or business continuation agreement to provide liquidity for one business owner to buy out the family of the second owner.

Traditional net cost method

Used to compare the cost of life insurance policies. This method bases calculations on projected premiums, dividends, and cash values over a selected term. The net cost per $1,000 of insurance per year is calculated by dividing the net cost per year by the face amount of the policy in thousands. One weakness of this method is that it does not consider the time value of money.

IRR on yield method

Used to compare the cost of life insurance policies. This method is used to determine the internal rate of return (IRR) on the cash value of a permanent policy that is held for a particular term.

Interest-adjusted methods

Used to compare the cost of life insurance policies. Two interest-adjusted methods may be used for comparing the cost of life insurance policies: the surrender cost method and the net payment method. Each method accounts for the time value of money and, as a result, is more useful than the traditional net cost method.

Modified endowment contract (MEC)

are subject to last in, first out (LIFO) characterization for the life of the policy with a 10% tax penalty for withdrawals or loans (excluding the basis or the amount of premiums paid into the policy) made before the owner attains age 591⁄2. MECs happen when the seven pay test is failed. One of the most common examples of a MEC is a single-premium life insurance policy. All withdrawals or loans are taxed first to the extent of taxable earnings as ordinary income and the basis is considered as returned to the taxpayer only when earnings have been exhausted. MECs are also subject to a 10% penalty on the taxable portion of these withdrawals or loans if they are made before the policyholder attains age 591⁄2. However, the death benefit remains tax-free to the beneficiary and is not affected by the MEC rules. Also, there is never any tax consequence or tax penalty on the portion of the withdrawal that includes the basis.

Variable universal life (VUL) insurance

combines the policy owner investment direction element of variable life with the flexible premium, cash value, and death benefit elements of universal life. Accordingly, the attributes of a VUL policy include an increasing or decreasing death benefit and a flexible premium payment schedule. Like universal life, the policy's cash value is not guaranteed. However, unlike universal life and like variable life, the cash value in a VUL policy is held in sub-accounts and is not part of the insurance company's general account. Therefore, if the policy owner is at all concerned about the future financial ability of the insurance company to pay the cash value, he should consider a VUL (or variable life) policy instead of a whole life or universal life contract. Because securities are used as VUL cash value sub-account investment options, the policy must be offered by prospectus, along with a computer-generated policy illustration.

Universal life insurance

gives policy owners the ability to adjust the premium, death benefit, and cash value to meet their financial goals. Unlike whole life insurance, universal life does not have a structured premium requirement. The policy will remain in force as long as the cash surrender value can support the monthly deductions for mortality and administrative expenses. If the cash surrender value is insufficient to support the deductions, the policy owner is required to deposit additional premium to avoid a policy lapse. While flexible premiums are a distinguishing feature of universal life, caution should be used in applying this flexibility. Unlike variable life, the universal life policy owner does not have the ability to direct the investment of the policy's cash value.

Second-to-die (survivorship) life insurance

not so much a type of insurance policy as a time of payment of the policy's benefits—specifically, it pays at the death of the second of two spouses. The underlying policy, which can be either term or permanent, pays out at the survivor's death and is usually used to pay any estate settlement costs including federal estate or transfer taxes. The most common use of this type of policy is to provide liquidity to pay the estate taxes due on the death of the second spouse.

Variable life insurance

the policy owner directs the investment of the policy's cash values among variable sub-accounts (also referred to as separate accounts) and bears all investment risk. Therefore, a person who is interested in this policy should have a higher-than-average risk tolerance compared with owners of universal and whole life policies. Although a variable life policy does not have a guaranteed minimum cash value or interest rate, it does guarantee that if the fixed and level premiums are continuously paid, the policy will not lapse.

Viatical settlement

the sale of a life insurance policy by a terminally ill person to an investor or investment group. The terminally ill insured needs the cash received in the settlement to pay ongoing medical expenses. Typically, the insured receives a lump-sum payment ranging from 50% to 80% of the policy's face value; the third-party purchaser (often another insurance company) then names itself as the beneficiary of the policy, continues to pay any required premiums, and collects the policy's death benefit upon the death of the insured. Because the transfer-for-value rule applies, the death benefit received by the purchaser, less the sales price and the basis, is taxable to the purchaser as ordinary income. However, generally, there is no taxable consequence to the terminally ill insured. Investors typically use the following rules in deciding whether to enter into a viatical settlement or agreement. ■ The insured must have owned the policy for at least two years to ensure that the contestability period has expired. ■ The insured must be terminally ill, with a remaining life expectancy of no more than two years from the date of entering into the agreement. ■ The insured must sign a release permitting the investor to access any medical records. ■ The insured must sign a waiver releasing the investor from any liability associated with changing existing beneficiary designations.

Endowment life insurance

these policies traditionally endowed at age 100, however newer polices may endow at higher ages such as 120, due to increased life expectancy. However, traditional endowment policies endowed much earlier—for example, at age 65 when an individual was entering retirement. Endowment policies were initially sold as a savings vehicle with 10-or 20-year maturities with others going to a certain age, such as 65 as mentioned. Pure endowment policies, which are not sold in the United States, pay the face amount of the policy only if the insured survives the endowment period. Regular endowment polices pay the face amount of the policy if the insured dies within the endowment period or survives beyond the endowment period. Endowment policies are rarely used now because legislation enacted in 1984 provides that endowment policies no longer enjoy all of the tax benefits associated with other life insurance policies.

Guaranteed values

those for which the insurer bears the risk, such as the interest rate on permanent life insurance policies with guaranteed cash value.

Nonguaranteed values

those for which the risk is borne by the policy owner, such as investment returns under a variable life insurance policy.

factors that an agent or producer should consider when evaluating an existing insurance policy for replacement

■ The existing policy's relative value (in determining this value, such methods as the Belth price of protection model may be useful) ■ The issuing company's A.M. Best and other company ratings ■ The appropriateness of the policy for the client's needs ■ Any possible (or intervening) changes in the client's insurability ■ The client's risk tolerance level ■ The financial cost of starting over with a new policy The client should be sure not to let the existing policy lapse before the new policy is in effect, or the client may be without any life insurance protection