Chapter 08: Life Insurance Premiums and Proceeds

What 1035 policy exchanges are allowed?

1. A life insurance policy for another life insurance policy, endowment, or annuity contract 2. An endowment policy for an annuity contract 3. An annuity contract for another annuity contract

Which two assumptions do insurers make with regard to interest?

1. A specific net rate of interest will be earned on all of its investments 2. That one full year's interest will be earned by each premium policyowners pay; therefore, it must be assumed that all premiums are paid at the beginning of the year.

Living Benefits

1. Accelerated Benefits 2. Viatical Settlements 3. Life Settlements

What are the general principles of taxation of life insurance proceeds?

1. Death benefits are usually not taxed 2. Interest paid is taxed (just like it would be by a bank) 3. Benefits paid in installments are taxed, because they include the interest earned 4. Same principle applies to insurance policy dividends- the dividends are generally free of tax but the interest is taxable

Settlement Options

1. Lump-sum 2. Interest Only 3. Fixed Period 4. Fixed Amount 5. Life Income

How are life insurance rates usually expressed?

Annual cost per $1000 of face amount. Ex- a $13.73 rate for a $50,000 participating straight life policy will end up being $686.50/yr (13.73 x 50)

What is the difference between "policy cash value" and "policy reserve"?

Cash value is the tangible amount that represents the additional funds paid in the early years of a whole life policy. The reserve is a more intangible amount, required by the state to be set aside by insurance companies to pay future claims.

Expense Factor

Each premium includes this small, proportionate charge to cover the various operating expenses of an insurance company. Also called a "loading charge"

How are Accelerated Death Benefits and Viatical Arrangements taxed?

For chronically ill policyholders there is a limit to the income they can use tax-free ($300/ day in 2011). This limit does not apply to terminally ill policyholders. Both terminally and chronically ill people can also assign or sell a policy to a viatical settlement provider, tax-free.

Transfer-for-Rule

If a policy is transferred for "valuable consideration" (i.e. sold) and the insured dies, the person who bought the policy will be taxed on the excess of the proceeds over the consideration (price) paid, including any premiums paid by the transferee.

Level Premium Funding

Method used by all regular life insurance companies; the insured pays more than the insurance protection requires in the policy's early years. In the policy's later years, when the increasing mortality charge would normally increase the premium to a very high level, the excess paid in the early years is used to help fund the additional cost now required.

What factor has the greatest impact in life insurance premiums and why?

Mortality, because while an insurer's interest and expense factors are generally the same for all policyholders, the mortality factor can vary greatly depending on personal characteristics.

What are the primary factors considered when computing the basic premium for life insurance?

Mortality, interest and expense

Rate-up in Age

No longer widely used; using rates assuming the proposed insured is a number of years older than they actually are for substandard cases that assumes there are a certain number of extra deaths per thousand.

Probability of Death

One of the two primary purposes of a mortality table; the average number of deaths for a group of persons in given years

Expectation of Life

One of the two primary purposes of a mortality table; the average number of years remaining (to live) for a group of persons the same age

How are surrendered policies taxed?

Only the excess of proceeds are taxable, i.e. a policyowner who receives the cash value must pay taxes on any gain.

How are endowment policies taxed?

Partially taxable under the rule of constructive receipt. The policyowner has 60 days to exercise an annuity option.

Viatical Settlement

Settlement in which individuals with a terminal or severe chronic illness sell their life insurance policies for 50-80% of face value and the viatical company becomes the policyholder and is responsible for paying the premiums and receives the death benefit when the insured dies. Under HIPAA, the proceeds from these sales are exempt from federal income tax.

Accelerated Benefits

Standard in most life insurance policies; allow people who are chronically or terminally ill to have tax-free access

Constructive Receipt

Tax term mandating that a policyholder can be taxed on income that hasn't actually been received but will become available in the future.

Fixed-Period Option

The company pays the beneficiary equal amounts of money at regular intervals over a specifies number of years. It pays out both the principal and the interest. The amount of each installment is determined by the length of the payments. The amount of the payments may be more but can never be less.

Policy Cash Value

The equity amount of a policy, the savings element of a whole life policy. These are the excess funds that are paid in the early years of a policy that are set aside but still belong to the policyholder.

What happens if a company's earnings are large enough to permit paying excess interest when a fixed-period option has been chosen?

The excess interest will be used to make each payment larger, it will NOT be used to extend the payment period.

What happens if excess interest is credited if a fixed-amount option is chosen?

The excess interest, IF credited, will be useed to extend the payment period but the amount of the payments remains the same.

Interest Only Option

The insurance company holds the death proceeds for a specified period of time and pays the interest earned on the proceeds at regular intervals. Since the interest is paid out rather than accumulated, the proceeds of the policy remain the same and intact. The interest rate can never be lower than the rate specified, but it can be higher.

When the death proceeds of a policy are paid out under the interest-only option, what happens (tax-wise)?

The interest payments are taxable as ordinary income. The principal (when it is finally paid out) is not taxed.

Settlement Options

The payment options available to the policyholder for how the death proceeds of a life insurance policy are paid out. The choice can be made by the policyholder as a right of ownership or they may leave the decision up to the beneficiary.

Fixed-Amount Option

The policy proceeds plus interest are used to pay out a specified amount at regular intervals for as long as the proceeds last. The amount of the payment is fixed- the duration varies based on the amount of the payment.

Dividend

The sum of money paid out regularly (typically quarterly) by a company to its policyowners out of its profits.

Life Income Option

There are many options, all of which guarantee the beneficiary an income for life. These are the same as annuity income options. Even if the principal is depleted, the payments will continue as long as the beneficiary lives.

Are accumulated dividends taxable?

These are not taxable because they are not properly classed as life insurance proceeds.

Policy Reserve

This is the fund required by each state's insurance laws to be set aside to ensure that money will be available to pay future claims.

Lump-sum Option

Traditionally how life insurance policy proceeds were paid out; this option is still available, though it is no longer used to the extent of others.

Are life insurance premiums generally tax deductible?

Unless premiums qualify as some other form of expense that is tax deductible (Ex- alimony payments or charitable contributions), premiums are not tax deductible.

Extra percentage tables

Varies somewhat from company to company but it is the one used most extensively to rate substandard risk; involves a numerical system for rating substandard cases that assumes there are a certain number of extra deaths per thousand so the premium charged, for example, may be from 125-500% of standard.

Rating

When an individual is a sub-standard risk, the premium is adjusted to reflect the increased

Is the value of life insurance taxable?

When an insured dies, the value of life insurance is included in the gross estate for federal tax purposes and is also subject to state death taxes. Any accumulated policy dividends, although exempt from income tax, are also included in the insured's gross estate for federal estate tax purposes.

Methods of Rating Substandard Risks

1. Extra percentage tables 2. Permanent flat extra premiums 3. Temporary flat extra premiums 4. Rate-up in age

What proceeds of a life insurance policy are exempt from federal income tax?

1. Lump-sum death benefit 2. The amount paid under a double indemnity provision 3. The benefits from any paid-up additions to a life insurance policy

Risk Classifications

1. Preferred 2. Standard 3. Sub-standard

Life Income Options

1. Straight life income option 2. Cash refund option 3. Installment refund option 4. Life with period certain option 5. Joint and survivor option 6. Period certain option

Permanent Flat Extra Premiums

A fixed charge of so many extra dollars per $1000 of face value for substandard cases that assumes there are a certain number of extra deaths per thousand. These extra premiums do not increase the policy's cash or nonforfeiture value and may be removed when the insured's condition is improved to a point where the risk is reduced.

Temporary Flat Extra Premiums

A fixed charge of so many extra dollars per $1000 of face value for substandard cases that assumes there are a certain number of extra deaths per thousand. This additional premium is charged for a specified number of years, such as the first few years after a surgery.

Annuity Rule

A fixed, unchanging fraction of each payment (fixed-amount, fixed-period, or life income options) is considered a return of principal and is excluded from gross income for tax purposes.

What is the spirit of the 1035 Policy Exchange?

Gains are generally considered ordinary income and are taxable, 1035 recognizes that if one policy is exchanged for another no gain (or loss) will be recognized.