Chapter 4 - Life Policy Provisions and Options

Beneficiary Designations

A beneficiary designation is selected at the time of application. A change of beneficiary will take effect on the date the request was signed by the owner, whether or not the insured is alive at the time the insurer actually receives the notice.

Policy Loans Provision

A policy loan may be made in a cash value policy once there is sufficient cash value to borrow against. In most policies, cash value must be made available to borrow against after 3 years. A loan against the cash value does not immediately reduce the cash value in a policy. Rather the cash value is used as collateral against the loan. Interest will be charged annually, and if unpaid will be added to the balance of the unpaid loan. Interest charged may be fixed or variable. The insurer may defer granting a loan for up to 6 months unless the loan was intended to repay any premium, such as an automatic premium loan. Failing to repay a loan or interest will not void the policy until the total amount of the outstanding loan and unpaid interest equals or exceeds the policy's total cash surrender value. Any outstanding loans will be deducted from the face amount at time of claim or from the cash values upon surrender along with any interest due.

Assignment

Assignment is the transfer of ownership. There are two types of assignments: absolute assignment, and collateral assignment

Policy Changes (Modifications)

Changes or modifications must be in writing, signed by an executive officer of the insurer, approved by the policyowner and made part of the entire contract. A producer cannot alter, change, modify or waive any policy provisions.

Standard Provisions (Individual Policies Only)

Contractual provisions explain what the contract consists of, what duties and responsibilities the parties to the contract have, how the policy works, and basically spells out the agreement between the policyowner and the insurance company. Provisions and clauses, unlike riders, are included in the contract for no additional charge.

Exclusions

Exclusions are conditions stipulated in the contract for which the insurer will not provide coverage. The insurer cannot add or alter any of the exclusions after the policy has been issued.

Payment of Premium Provisions: Reinstatement

If a policy has lapsed unintentionally due to nonpayment, it can be reinstated by the owner. The reinstatement time period is typically 3 years from lapse (but can be as long as 5 years). In order to reinstate, the insured must provide evidence of insurability and the owner must pay all back premiums from the date of lapse plus interest. Reinstatements are designed to put a policy back in force as if the lapse never occurred. Upon reinstatement, a new incontestability period takes effect.

Types of Beneficiary Designations: Minors

If minors are named as beneficiaries, but no trust has been established, the funds are placed in a settlement option (held with interest), with the insurer acting as trustee. The guardian or legally responsible adult may receive payments for the benefit of the child, until the child receives the lump sum at the age of majority.

Exclusion: Status Clause

No coverage for individuals with military status, since these individuals are provided coverage through the government.

Exclusion: Hazardous Hobbies or Avocation

No coverage if death is related to a hazardous hobby as stated in the policy, such as sky diving or hot air ballooning.

Exclusion: Results Clause (War Clause)

No coverage if death is the result of war declared or undeclared. If death occurs during the period of war, only the premiums are refunded.

Settlement Options: Fixed Amount

Payments are for a specified dollar amount paid monthly until the benefits along with interest are exhausted. In this example, the interest will extend the time period in which the benefits are paid. Only the interest portion of the benefit is taxable.

Life Income Options: Joint and Survivor Income Option

Payments are guaranteed for the lifetime of 2 or more recipients. Upon the death of the first recipient, payment continues to the survivor(s) until death of the survivor. The survivor's payment may be full (100%), 2/3, or 1/2 of the original payments. This payout option may be referred to as Joint and Full Survivor, Joint and 2/3 Survivor, or Joint and ½ Survivor, depending on which option is selected.

Life Income Options: Life Income Period Certain

Payments are guaranteed for the lifetime of the recipient or a specified period of time, whichever is longer. If the recipient dies prior to the end of the period certain, the payments continue to another person until the end of the period certain.

Life Income Options: Joint Life Income Option

Payments are guaranteed to 2 or more recipients until the first recipient dies, then all payments cease.

Life Income Options: Life Refund

Payments are made for the lifetime of the recipient. Upon death, if a recipient has not received an amount equal to the total death benefit, the balance is refunded to the beneficiary either in a lump sum (Cash Refund), or in installments, (Installment Refund).

Policy Loan Rate Provisions

Policy loans with fixed rates can have a maximum fixed interest rate of 8% or less as stated in the policy. For policy loans with an adjustable (variable) interest rate, the maximum rate is based upon Moody's corporate bond yield average and is stated in the policy. The policy loan amount cannot exceed the available cash surrender value.

Life Income Options: Single Life

Provides guaranteed lifetime income to the recipient. Once the recipient dies, payments cease.

Dividend Options: 1-Year Term

Purchases a single premium, 1-year term benefit. Premiums are calculated at the insured's attained age; also referred to as the fifth dividend option

Dividend Options: Paid-up Additions

Purchases single premium, additional permanent benefits at the insured's attained age. The additional insurance is paid out in addition to the face amount if the insured dies. While the insured is living, it generates cash value and dividends as if the paid-up additional benefit was part of the original policy.

Owner's Rights (Ownership Provision)

The Policyowner retains all rights in the policy. Unless the insured is also the policyowner, the insured does not have rights. The policyowner has the right to name or change revocable beneficiaries, borrow against the cash values or access living values, receive dividends and to select among the dividend options made available, and to assign the policy on a collateral basis or an absolute basis, to name a few. It is also the owner's responsibility to make the premium payments. The beneficiary does not have rights in the policy.

Spendthrift Trust Clause

The Spendthrift Clause denies the beneficiary the right to assign his/her interest in the policy proceeds. The purpose is to prevent creditors of a beneficiary from claiming any benefits payable to the beneficiary before they are actually received. This clause does not protect the beneficiary if the benefits are payable in a lump sum, only when the proceeds are held by the insurance company under a settlement option.

Consideration Clause

The consideration clause specifies the amount and frequency of premium paid by the owner as something of value provided in exchange for the company's promise to pay (the insuring clause).

Contingent or secondary beneficiary

The contingent beneficiary receives the death benefit only if there is no primary beneficiary alive following the death of the insured. In other words, the benefit is payable to the contingent beneficiary only if the primary beneficiary predeceases the insured.

Surrender Charge

The difference between the cash value and the cash surrender value is the surrender charge. This provides a means for the insurer to recapture the upfront expenses involved in issuing the policy.

Absolute Assignment

The original owner, the assignor, will name a new owner, the assignee, of the policy. Since a new owner is named, this is considered a permanent assignment. The full amount of the policy is assigned, and this is referred to as a transfer of ownership.

Dividend Options: Cash

The policyowner receives the declared dividends in the form of a check on or near each policy anniversary.

Primary beneficiary

The primary beneficiary is the first in line to receive the death benefit upon the death of the insured.

Nonforfeiture Options (Guaranteed Values)

These options are found in policies that accumulate cash values and protect the policyowner against total loss of benefits if the policy should lapse due to nonpayment of premium or is intentionally cancelled. Three nonforfeiture options add flexibility to a cash value policy: Cash Surrender, Reduced Paid-Up , and Extended Term. If any of these options are selected the owner cannot reinstate the policy

Settlement Options: Life Income Option

This option allows the insurer to use the death benefit to purchase an annuity on behalf of the beneficiary. As with other settlement options, any interest paid is taxed as ordinary income. This comes with several additional options

Payment of Premium Provisions: Mode of Premium

This provision addresses the frequency of premium payments (monthly, quarterly, semiannually or annually), and to whom the premiums are payable. The more frequent the payment, the greater the cost. The policyowner has the right to change the premium mode.

Facility of Payment Clause

This provision allows the insurer to pay a relative or anyone it deems entitled to the benefits in the absence of a properly designated beneficiary or in cases of no living beneficiaries. This can alleviate any lawsuits and can be used to reimburse someone who may have paid expenses on the insured's behalf, such as funeral costs.

Entire Contract Clause

This provision describes the parts of the life insurance contract. The entire contract consists of the policy, riders (or endorsements), amendments, and a copy of the application. All statements made in the application are, in the absence of fraud, deemed to be representations and not warranties. All parts to the contract must be attached and in writing. Nothing can be incorporated by reference.

Types of Beneficiary Designations: Trust

When a recipient is not to have direct access to the death benefits, such as in the case of minor children, and the proceeds are to be distributed as per the insured's directions set forth in a trust. A trust beneficiary may also be used in estate tax planning strategies when using an irrevocable life insurance trust.

Exclusion: Suicide

Within the first 2 years, death due to suicide is excluded from coverage as stated in the suicide clause.

Change of Insured Benefit

allows the owner to exchange the insured covered by the policy for a new insured in which the owner has an insurable interest or to exchange the policy for a new policy covering a new insured in which the owner has an insurable interest. Change of insured benefits are most often used in the business insurance market to exchange insureds in the case of personnel departures, without having to purchase an entirely new policy and without upfront loads and surrender charges. The new insured must be insurable. This is typically a rider found in corporate owned life insurance when an executive moves to another company or retires.

Common Disaster Clause

provides that if an insured and primary beneficiary are in the same accident, the primary beneficiary must survive the insured by a specific number of days (usually 90 days) or the insurance company will assume the insured died last (the primary beneficiary died first). This provision is designed to pay the benefits to either the contingent beneficiary or the insured/policyowner's estate if no contingent beneficiary has been designated.

Partial Withdrawals or Partial Surrenders

A partial withdrawal is considered a partial surrender of the policy. A partial surrender is actually paid from the policy value and either reduces the amount of the death benefit or the amount of cash value in the policy. Since this is not considered a loan, annual interest is not charged. Taxation applies to any interest on the cash value paid out as a withdrawal. So any amount paid in excess of the premium is subject to taxation. When a partial withdrawal is made, the policy's cash or account value will be reduced by the amount of the withdrawal. There may be a surrender or withdrawal charge associated with the withdrawal. The insurer may also limit the number of withdrawals that can be made annually or the amount of the withdrawal specifying minimums and maximums.

Types of Beneficiary Designations: Creditor

Designated by assignment or named at application to cover indebtedness. The creditor may either be the named beneficiary or can be the assignee under a collateral assignment. The creditor can only receive the amount of the indebtedness. The benefit may be purchased as decreasing term insurance so the benefit will decrease by the amount of the loan automatically.

Dividend Options: Premium Reduction

Dividends are applied toward the next premium due. The same could be accomplished if the policyowner received the dividends in cash and remitted the full premium. If the declared dividends equal or exceed the premium, the premium payment may be suspended.

Free Look (Right to Examine Period) Provision

The free look allows the policyowner a specified number of days following receipt of the policy to look it over. If dissatisfied for any reason, the owner has the right to return it for a full refund of any premiums paid. The free look period is usually 10 days, unless state law specifies otherwise. The free look period starts on the date when the policy is delivered to the owner of the policy. For this reason, it is important for a producer to collect a delivery receipt when delivering the policy.

Dividend Options: Accumulate at Interest

The dividends are retained by the insurer and the interest rate paid the policyowner is compounded annually.

Types of Beneficiary Designations: Estate

The estate may be the tertiary beneficiary in case the insured outlives all other beneficiaries. By default, if the insured outlives all other beneficiaries, benefits are paid to the insured's estate. The death benefit increases the estate value and may have tax implications.

Payment of Premium Provisions: Grace Period

The grace period is the time period provided after the premium due date before a policy lapses. If the insured dies during this period, the death benefit is payable minus any premiums or loans due. The typical grace period is a month (30 or 31 days) unless state law specifies otherwise. Coverage continues during the grace period, but if the premium is not paid, the policy lapses at the end of the grace period.

Types of Beneficiaries: Revocable

The policyowner may change a revocable beneficiary at any time. This beneficiary does not have a vested interest in the policy. Most named beneficiaries are revocable and have no rights.

Incontestability Clause

Within the first 2 years of a policy, the insurer may contest a claim and void the contract upon proof of a material misstatement or fraud. A material misstatement is one in which the insurer would not have issued the policy had they known the true information. Except for nonpayment of premiums, the policy will be incontestable after it has been in force for typically 2 years from the policy issue date, even in cases of fraud.

Dividend Options

Dividends are available on participating policies issued by mutual insurers. They are paid annually, if declared, and cannot be guaranteed. Since dividends essentially are a return of excess premiums paid, they are not taxable as income until all of the premiums paid in have been recovered. Should the total accumulation of dividends exceed the total premiums paid, the excess amount is taxable as ordinary income. Interest earned on dividends left to accumulate is taxable as ordinary income. The policyowner decides which dividend option is in effect and can change the election at any time. If dividends are designated for any option other than cash and all current accumulations are withdrawn, the option will begin again at the next declared dividend.

Exclusion: Hazardous Occupation

No coverage if death is related to a hazardous occupation as stated in the policy, such as stunt drivers or auto racers.

Options

Provisions that provide choices that must be specified by the policy owner

Tertiary beneficiary

The tertiary beneficiary receives policy proceeds if both the primary and the contingent beneficiaries predecease the insured. If there is no surviving named beneficiary at the time of the insured's death, the proceeds are payable to the policyowner if living or to the insured's estate.

Types of Beneficiary Designations: Class or classification

This designation is used in instances where each beneficiary is not directly identified by name. The wording of the class designation must be specific and carefully worded to remove any doubt of the owner's/insured's intentions. For example, "any children of this marriage", or "the insured's spouse" may be classified as beneficiaries. This could cause complications if the insured has step children or has been married more than once.

Types of Beneficiary Designations: Individual/Named

This designation is very specific. An individual is specified by name as the beneficiary, such as Mary Doe (wife) or John Doe (husband). This prevents probate proceedings.

Exclusion: Aviation

This exclusion applies most specifically to student pilots or those with a newly issued pilot's license with a limited number of hours of flying experience.

Types of Beneficiary Designations: Per stirpes

This is a designation that will pay a deceased beneficiary's share to the heirs of the beneficiary who predecease the insured. If an insured names his/her 3 children as beneficiaries and one of the children predeceases the insured, the deceased beneficiary's share will be paid to their heirs. The surviving beneficiaries will each receive 1/3 of the benefit and the remaining 1/3 will be paid to the deceased beneficiary's heirs in this example.

Payment of Premium Provisions: Automatic Premium Loans (APL)

This provision must be elected by the policyowner and can be cancelled at any time. It enables the insurer to automatically borrow against the cash value to cover a premium payment to prevent the contract from lapsing unintentionally. APL is available on cash value policies only and does not require an additional premium. It becomes effective at the end of a grace period. The APL loan is treated as all other loans. If it is used to pay premiums, interest on the loan accumulates annually.

Collateral Assignment

Does not cause a permanent change in ownership. However, the rights of the owner will be subject to the assignment. This typically used when an insurance policy is used as collateral for a loan. It is a temporary assignment until the debt is paid in full. In this case, the assignor is the original owner and the assignee is the creditor. This assignment takes precedence over any beneficiary designation, and can reduce the dollar amount of the beneficiary's claim at the time of the insured's death because the assignee has a priority claim against the policy and must be paid first. No assignment of the policy will be binding on the insurer unless it is in writing and received at the insurer's home office. The insurer is not responsible for determining the validity of the assignment.

Suicide Clause

If the insured commits suicide, while sane or insane, within typically 2 years from the issue date, the insurer's liability is limited to a refund of premium. If the insured commits suicide after the suicide clause has expired, the insurer must pay out the death benefit to the named beneficiary. The intent of this clause is to discourage individuals from purchasing an insurance policy while contemplating suicide.

Life Policy Settlement Options

Life insurance benefits are paid in a lump sum, unless another mode of settlement has been selected. A settlement option directs the insurance company how to pay out the death benefits. The choice of a settlement option may be made by the policyowner if the insured is living or by the beneficiary if the insured is not living and if no option has been previously selected. It is important to note that if the owner has selected a settlement option, a beneficiary cannot change that option. Principal payments of the death benefit made after an insured's death are not taxable as income. However, any interest received from a settlement option distribution is taxed as ordinary income. Benefits paid in a lump sum are income tax free.

Settlement Options: Fixed Period

Payments are guaranteed for a specified period of time, such as 10 or 20 years after which time payments will cease. The proceeds and interest are used to make the payments. The interest will increase the amount of each payment, and the interest is taxable.

Life Income Options: Straight Life (Pure or Life Income Only)

Payments are guaranteed for the lifetime of the recipient. Upon death, payments will cease. The dollar amount of each payment will depend upon the age and gender of the recipient.

Dividend Options: Paid-up Option

Pays off the policy more quickly than scheduled. If the company's overall performance declines, premiums may have to be resumed.

Nonforfeiture Options: Extended Term

Present cash value is used to buy a single premium term policy of the same face amount for as long a period as it will buy, expressed as a combination of years and days. This option provides the largest death benefit and is sometimes referred to as the Automatic (or Default) Option if no other option has been selected. The insured no longer has rights to the cash value under this option, and the policy will expire prior to age 100.

Nonforfeiture Options: Reduced Paid-Up

Present cash value is used to buy a single premium, permanent paid-up policy of a reduced face amount. This option provides the longest period of coverage provided by a nonforfeiture option. Coverage, although reduced in face value, will continue to age 100.

Insuring Clause

Specifically, the insuring clause is found on the first page of the policy and is considered the most important clause in the policy. It identifies the parties to the contract and the perils or conditions in which it will pay. The insuring clause is the insurance company's promise to pay the policy's death benefit to the named beneficiary, after receiving due proof of death of the insured, as long as the policy is in-force.

Uniform Simultaneous Death Act

The act has been adopted by all states and provides that when the insured and primary beneficiary die as the result of the same event and the order of death cannot be determined, it is assumed the insured died last, protecting their secondary beneficiary or heirs.

Settlement Options: Interest Only

The death benefit proceeds may be left with the insurer while interest payments are paid at least annually or more frequently. The principal amount does not decrease, and the interest generated is taxed as ordinary income when paid to the beneficiary. This method of providing income is known as capital conservation. The principal (capital) is left with the insurer at interest, conserving the capital. When this option is selected, the owner or beneficiary must direct the insurer as to when the principal will be paid as a benefit.

Surrenders

The owner of a cash value policy may surrender the entire policy. This action will cancel the insurance coverage. The policyowner is entitled to receive the cash surrender value in the policy. Universal life and variable universal life policies may have a surrender charge schedule which might last 10-20 years. The schedule would show what percent of the cash value is subject to a surrender charge. The surrender charge schedule typically shows the percentage charged, reducing on an annual basis.

Types of Beneficiaries: Irrevocable

The policyowner may not change an irrevocable beneficiary unless the beneficiary dies or provides written consent for the change. If an irrevocable beneficiary is named, the owner may not make changes to the policy that affect the coverage or benefits without consent of the beneficiary. These changes include assigning the policy, canceling or surrendering the policy, or taking a policy loan. An irrevocable beneficiary has a vested interest in the policy benefits.

Types of Beneficiary Designations: Per capita

This is a designation that will pay to surviving beneficiaries equally if a named beneficiary predeceases the insured. For example, if an insured names his/her 3 children as beneficiaries and one of the children predeceases the insured, the benefit will pay equally to the surviving named beneficiaries. Each beneficiary receives 50% of the death benefit in this example.

Nonforfeiture Options: Cash Surrender

Upon surrendering the policy back to the insurer, the policy owner will receive the cash surrender value stated in the policy less any outstanding loans and accrued interest. Any amount that exceeds the premiums paid into the policy will be taxable as ordinary income. The insured no longer has insurance coverage if this option is selected