Unit 15
According to federal law, an insurance company under the provisions of the Investment Company Act of 1940 must allow a variable life policyholder the option to convert the policy into a whole life contract for a period of
24 months Although state law may allow for periods longer than 24 months, federal law requires a 2-year conversion privilege.
John owns a nonqualified, tax-deferred annuity. When he retires, what will be the tax consequences of his annuity payments?
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.
Which of the following types of life insurance has premiums that increase each time the policy is renewed, and no cash value buildup?
Term A term policy provides life insurance only with no savings element. Upon renewal, the rates are higher as you age.
Which of the following is designed primarily as a retirement vehicle to help protect contract owners from a decline in purchasing power?
Variable annuities The tradeoff with lack of guarantees is the potential to keep pace with inflation.
Variable annuities
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.
All of the following are advantages of universal life insurance EXCEPT
the policy is guaranteed never to lapse A universal life policy may lapse if the accumulation fund drops below a specified level and an additional premium is not paid.
A client purchased an index annuity from you 3 years ago and made an initial deposit of $100,000. The contract calls for a 90% participation rate with a 15% cap. The index had a return of +20% in the 1st year, -5% the 2nd year, and +10% the 3rd year. The investor's current value is approximately
$125,350 In the 1st year, the index gained 20%. With a 90% participation rate, the investor might have earned 18%, but was limited by the 15% cap. So, after 1 year, the value was $115,000. In the 2nd year, the index lost money. However, with an index annuity there are never any reductions in a down market, so the account remained at $115,000. In the 3rd year, the investor received 90% of the 10% growth and that increased the account value to $125,350. This resulted in an overall gain of 25.35%, or an average return of almost 8.5% per year.
Alexander Wimpton purchased a variable life insurance policy 10 years ago. The policy has a $500,000 face amount which has grown to $525,000 due to the performance of the selected separate account subaccounts. Three years ago, Wimpton borrowed $50,000 against the policy which has never been repaid. The effect of this is that Wimpton's total death benefit today is
$475,000 The death benefit of a variable life insurance policy is the current face amount ($525,000) or the guaranteed minimum, whichever is greater, less any outstanding loans ($50,000).
In a scheduled premium variable life insurance policy, which of the following are guaranteed?
A minimum death benefit In a variable life insurance policy, a minimum death benefit is guaranteed, but no cash value is guaranteed. There is a contract exchange privilege during the first 24 months allowing the conversion of the variable policy to a comparable form of permanent insurance, but no physical is required. The 75% cash value loan is a minimum, not a maximum, and applies after the 3rd year of coverage.
Which of the following is NOT considered to be an annuity purchase option?
Periodic payment immediate annuity An immediate annuity is one in which the payout begins immediately (generally within 30-60 days). As such, the concept of making purchases while receiving payout is illogical and is, therefore, not offered as an option.
Which of the following would most likely put a limit on the amount of interest to be credited to an index annuity?
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.
An individual is deciding between a flexible premium variable life contract and a scheduled premium variable life contract. If she is concerned about maintaining a minimum death benefit for estate liquidity needs, she should choose
the scheduled premium policy because the contract is issued with a minimum guaranteed face amount A scheduled premium variable life contract is issued with a guaranteed minimum death benefit. If the individual is concerned about having the minimum guarantee, you should recommend the scheduled contract.
A client has purchased a nonqualified variable annuity from a commercial insurance company. Before the contract is annuitized, your client, currently age 60, withdraws some funds for personal purposes. What is the taxable consequence of this withdrawal to your client?
Ordinary income taxation on the earnings withdrawn until reaching the owner's cost basis Contributions to a nonqualified annuity are made with the owner's after-tax dollars. Distributions from such an annuity are computed on a LIFO basis with the income taxed first. Once the cost basis is reached, any further withdrawals are a nontaxable return of principal. Because the client is older than 59½ at the time of distribution, the additional 10% penalty tax is not incurred.
Which of the following is not a type of life insurance policy?
Variable annuity policy Although a variable annuity may have a death benefit provision, it is not considered a life insurance policy. One key to that is, among other things, there is no health questionnaire when purchasing an annuity. Perhaps you have never heard of an endowment policy (it is not mentioned in the LEM). This type of situation may come up on the actual exam where one of the choices is something unfamiliar to you. Don't let that cause you to lose your focus. Annuities are issued by life insurance companies, but they are not life insurance policies, so select the correct answer and move on.
Which of the following is indicative of the primary difference between variable life insurance and straight whole life insurance?
Way in which the cash values are invested Variable life insurance allows the policyowner to decide how the cash value is invested through a number of subaccounts.
You have a 70-year-old client who is in excellent health. Both parents lived into their late 90s and the client is concerned about outliving her money. One product that should be considered to alleviate this concern is
an annuity. One of the unique characteristics of an annuity (variable or fixed) is that it guarantees monthly payments for the life of the annuitant. Life insurance provides a death benefit, but not income. An index fund carries no guarantees.
In general, when describing the characteristics of equity index annuities and variable annuities, each of the following would be a true statement EXCEPT
both offer an opportunity for unlimited gain EIAs almost always come with a cap rate, a ceiling beyond which earnings cannot be credited to the investor's account. There is, theoretically, no limit as to how much one could earn with a variable annuity. Both are issued by life insurance companies, and only the EIA offers a guaranteed floor (minimum return). Based on court rulings in effect at this time, the equity index annuity is not considered a security
A customer purchased a variable annuity from an agent 5 years ago with an initial investment of $200,000. The annuity's surrender fee will expire in year 7, which coincides with the customer's anticipated need for the funds. In the 5th year of the contract, the value of the annuity increased from $300,000 to $375,000. The agent notices that the general market is on the decline and recommends she enter a 1035 exchange of the variable contract for another, thus increasing her death benefit and locking it in at a higher minimum. This recommendation is
unsuitable because of surrender fees Incurring the surrender fee for the 1035 exchange of one contract and initiating a new long-term contract is inappropriate for a customer, in general, and particularly for this customer, considering her need to access her funds only two years later.
An individual purchased a variable life insurance policy 10 years ago. The policy has a $500,000 face amount which has grown to $525,000 due to the performance of the selected separate account subaccounts. Three years ago, the insured borrowed $50,000 against the policy which has never been repaid. The effect of this is that the total death benefit today is
$475,000. The death benefit of a variable life insurance policy is the current face amount ($525,000) or the guaranteed minimum, whichever is greater, less any outstanding loans ($50,000).
Which of the following is a possible advantage of scheduled premium variable life insurance over whole life insurance?
Possible inflation protection for the death benefit Scheduled (fixed) premium variable life has fixed, not flexible, premium payments. The distinguishing factor is the variable death benefit. The insured assumes more risk, not less, in exchange for the possibility that the death benefit will provide protection from inflation.
In a scheduled premium variable life contract, which of the following has a guaranteed minimum?
The death benefit There is a guaranteed minimum death benefit. The cash value will vary according to the performance of the investments in the separate account. These policies to not have a maturity value and may have a guaranteed maximum expense, ratio, not a guaranteed minimum.
Which of the following is indicative of the primary difference between variable life insurance and straight whole life insurance?
Way in which the cash values are invested Variable life insurance allows the policy owner to decide how the cash value is invested through a number of subaccounts.
Surrender charges may cause a reduction to all of the following EXCEPT
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.
Larry purchased a deferred annuity and, on his 65th birthday, annuitized the product under a life with 15-year certain option. His spouse, Linda, is the beneficiary. Which of the following statements is CORRECT?
Payments would be made to Larry as long as he lives, but should he die prior to reaching age 80, Linda will receive payments until Larry's 80th birthday. Larry selected the life with 15-year certain option. This pays Larry for his life, regardless of how long, but continues to pay his beneficiary (Linda) if he dies before the end of 15 years. That is the 15-year certain part.
When discussing the purchase of a scheduled premium variable life insurance policy with a client, it would be CORRECT to state that
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.
The owner of a fixed annuity is protected against
longevity risk. Because a fixed annuity promises a fixed monthly payment for life, longevity risk is not a concern. However, the fixed payments are subject to purchasing power risk, also known as inflation risk. One other risk is that of dying after only receiving payments for several months after having chosen the life only option.
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?
$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.
A customer has invested a total of $10,000 in a nonqualified deferred annuity through a payroll deduction plan offered by the school system where he works. The annuity contract is currently valued at $16,000, and he plans to retire. On what amount will the customer be taxed if he chooses a lump-sum withdrawal?
$6,000.00 Payments into a nonqualified deferred annuity are made with after-tax money; taxes must only be paid on the earnings of $6,000.
An agent presenting a variable life insurance (VLI) policy proposal to a prospect must disclose which of the following about the insured's rights of exchange of the VLI policy?
Federal law requires the insurance company to allow the insured to exchange the VLI policy for a permanent form of life insurance policy, issued by the same company for 2 years with no additional evidence of insurability. Federal law requires that issuers of variable life insurance policies allow exchange of these policies for a permanent form of life insurance policy, issued by the same company for a period of no less than 2 years. The exchange must be made without additional evidence of insurability.
Which of the following statements are TRUE of a variable annuity? The number of annuity units is fixed when payout begins. The value of accumulation units is fixed at purchase. The monthly annuity payment is a variable amount. The annuity payments are not subject to income taxes.
I and III The number of annuity units is fixed when an annuitant starts the payout process, and the monthly payment will vary with the market value of the securities in the separate account portfolio. The value of accumulation units varies with the value of the portfolio, and the growth portion of the monthly payments is subject to income tax.
A client purchases a fixed annuity that will immediately begin paying $2,000 a month for life. What is the annuitant's greatest risk?
Inflation risk Also known as purchasing power risk, inflation risk is the effect of continually rising prices on investments. A client who annuitizes a fixed annuity, receiving $2,000 per month, will likely find the monthly check has less purchasing power as time goes on.
A 57 year-old client has $100,000 in a non-qualified variable annuity and $100,000 in a mutual fund with a dividend reinvestment plan. Coincidently, each was purchased 10 years ago with a deposit of $50,000. If the client needs $50,000 to use as a down payment for a vacation home, which would have the most severe tax consequences?
The mutual fund There are several differences involved here. First of all, withdrawals from a variable annuity are treated on a LIFO basis. That is, the earnings are considered to be withdrawn first. In that case, all $50,000 taken from the VA are taxed as ordinary income. In addition, because the client is not yet 59 ½, there is the 10% tax penalty tacked on. The mutual funds are part of a dividend reinvestment program which means that a good portion of the $50,000 in gain has already been taxed and, in any event, there is no early withdrawal tax penalty. Finally, profits from the sale of mutual fund shares held this long would be taxed at the long-term gains rate, always lower than ordinary income.
Which of the following best describes the death benefit provision of a variable annuity?
The principal amount at death is the greater of the total of premium payments or the current market value. The death benefit insures that the investor will never receive back less than the original amount contributed to the account. Unlike life insurance proceeds, with annuities, anything above the cost basis is taxed as ordinary income. Receiving the benefit as a lump sum is only one of the options available to a beneficiary of a variable annuity death benefit. There are others, such as annuitizing the benefit.
Life insurance is generally purchased to replace the lost income of the insured. A client wishing to purchase a policy with a level death benefit and level premium for as long as the premiums are paid would choose
a whole life policy. Whole life insurance is permanent insurance with a level premium and a level death benefit. The renewable term policy may have a level death benefit, but every 5 years, the premium will increase. Universal life has flexible premiums and, depending on the option chosen, the death benefit can increase.
An investor in a variable annuity will be purchasing
accumulation units Unlike a mutual fund, where the investment is into shares of the fund, when purchasing a variable annuity, the investor is acquiring accumulation units. Upon annuitization, those are converted into annuity units. The investor isn't directly purchasing shares in the underlying sub-account—the annuity company is doing that.
In general, when describing the characteristics of equity index annuities and variable annuities, each of the following would be a true statement EXCEPT
both offer an opportunity for unlimited gain EIAs almost always come with a cap rate, a ceiling beyond which earnings cannot be credited to the investor's account. There is, theoretically, no limit as to how much one could earn with a variable annuity. Both are issued by life insurance companies, and only the EIA offers a guaranteed floor (minimum return). Based on court rulings in effect at this time, the equity index annuity is not considered a security.
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
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. On the exam, all annuities are non-qualified unless the question states differently or there is a clue, such as being part of a 403(b) plan.
Among the reasons why deferred variable annuities might not be a suitable investment for seniors are all of the following EXCEPT
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.
A life insurance policy where the premium increases each time the policy is renewed while the face amount remains level is
renewable level term Level term insurance offers a fixed face amount over the life of the policy. If the policy is renewable, the owner has the ability to renew it for that same face amount and the new term, but at new, higher premiums as the insured's age increases.
When a client purchased an annuity with a 5% bonus, it means
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.
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
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.
A customer in his 20s, who is not risk averse, is in the market for life insurance. His main worry is that what looks like a generous death benefit today may not be sufficient for a beneficiary 40 or 50 years from now. An investment adviser representative might consider recommending
variable life insurance Variable life insurance has the advantage of offering possible inflation protection for the death benefit. The insured assumes investment risk for this benefit, but pays a fixed scheduled premium for the life of his contract.
