Fundamentals of Insurance Chapter 10
annual exclusion
$14,000 2013-2017; exempt amount increases to $28000 for MFJ,
10. A client applies to life insurance and is placed in a substandard classification. He has a hazardous job, but is in great health. Explain to your client the rationale for substandard insurance.
A group that is rated substandard is expected to produce higher mortality rate than group of normal lives, if 1000 persons, each engaged in same hazardous occupation, granted insurance, it is certain that the death rate will be higher than those not engaged in the same occupation.
What provisions are generally included in a properly designed buy-sell agreement?
A properly designed buy-sell agreement includes provisions that state the purpose of the agreement , state the commitment of the parties, contain lifetime transfer restricitons, specify a purchase price for business or a method for determinign the purchase price, specify how the price will be funded.
Suzie feels b/c business is growing rapidly due to productive employees, wants to provide life insurance 2x their salary. Cost effective way to do this?
Company can provide group term life insurance to parcipating employees under Sec.70 benefit plan. Allows the employer a tax deduction for premium payments on behalf of participants,
Sophie Jones, single mother, manager on fast track, needs help to determine amount of additional life insurance she needs to provide support for her children should she die before they finish college. Support for her children including college, would require $300,000 lump sum needs. Present value of $200,000 to cover income support needs if Sophie were to die today. Sophie already has $200,000 in group life insurance and $50,000 in savings. How much additional life insurance would Sophie need if the principal will be liquidated to help meet the families needs?
Financial needs approach, which involves the liquidation of principal, calculates the amount of additional life insurance needed by computing the gap between the needs of the clients' dependents and the resources available to meet those needs. $50,000 of additional life insurance needed to meet lump sum needs (300,000-250,000 existing insurance and savings) Another $200,000 of life insurance needed to meet children's ongoing income needs after taking into account their SS benefits following their mother's death. Thus Sophie would need an additional $250,000 ($50,000 + $200,000).
Before gathering the amount the information required for determining the amount of life insurance your client needs, explain to your client the key steps involved and types of information required in the financial needs analysis approach.
First step- estimate the family's financial needs in the event of the client's death, both lump-sum and ongoing needs. Lump-sum needs encompass, for example, final medical expenses not covered by insurance, repayment of debt, estate taxes, final expenses, and an emergency fund. On-going needs must be estimated for 4 periods- readjustment, period following readjustment and until the youngest child becomes self-suffficient, the black-out period between the time the youngest child becomes self-sufficient and the surviving spouse becomes eligible for SS. Step two- identify sources of income to offset ongoing income needs, Step 3- determine amount of lump sum needs that cannot be met by liquid or near liquid assets
1035 exchange
IRS Code that permits a policyowner who exchanges one insurance contract for another in a like-kind exchange to receive certain tax advantages
What methods do life insurers use to handle substandard risk? Indicate types of substandard risk for which each method is commonly used.
Increase in age- applicant is assumed to be older than actual age, policy written accordingly, deals with substandard applicants when extra mortality is markedly increasing and will continue to increase extra percentage tables- applicant presents an increasing hazard, life insurer may charge premiums that reflect the appropriate increase in mortality flat extra premium- life insurer increases standard premium by specified dollar per thousand of insurance, flat extra premium is used with hazard it thought to be constant or decreasing, widely used for hazardous occupations and avocations liens- mortality expected from impairment or disease that is decreasing or temporary, policy issued at standard rates, with reduced benefit for specified period of time other methods- extra mortality is small or not well known, insurer may place all members of the group in a special class and adjust dividends in accordance with actual experience
Life insurance plays a key role in most clients' financial plans. What two basic tasks are involved in life insurance planning?
Life insurance planning includes a determination of how much insurance is needed and an evaluation of the proper type of insurance. The first of these tasks is usually based on an analysis of the client's needs. The second task begins with a decision between temporary versus permanent coverage and proceeds to the selection of a particular policy.
What are the general rules and key exceptions with regard to the federal income tax treatment of the following aspects of life insurance? g. loans and most other distributions from a policy that falls under the definition of a MEC
MEC policy is subject to an income first tax treatment; 10 percent penaly may also apply to taxable portion of any loan or withdrawal from a MEC, unless aged 59 1/2
What are the major elements of the NAIC model regulation that applies to to life insurance policy illustrations?
Major elements of NAIC are as follows: -new regulation applies to life insurance policies for more that $10,000 of death benefit -each illustration used in the sale of a life insurance policy covered by the new regulation must be clearly labeled life insurance illustration, and must include certain specified pieces of information about the company, the agent, the proposed insured, and the policy and its benefit features -NAIC model regulation prohibits insurers and their agents from misrepresenting various specified types of information to the client -the illustration must clearly indicate what elements are guaranteed and what elements are not -any amount illustrated as being available upon surrender will be the amount after deduction of surrender charges -each illustration must be accompanied by a narrative summary that describes the policy premiums and features and defines column headings used in the illustration -summary should also state that actual results may be more or less favorable than those shown in the illustration -regulation states that illustrations for universal life policies must comply with regulation requirements and that they insurance company must issue annual reports to policyowners after the policy is issued and it specifies the content of those annual reports -regulation further stipulates that policyowners have the right to request an in-force illustration annually without charge
A financial planning client receives a buyer's guide and policy summary from agent trying to sell him some additional life insurance. Your client asked the agent several different questions, but the agent said, Don't worry about the detail. Our policy is a good buy. Answer the following questions your client asked: c. Why is there so much concern with taking interest into account in these calculations? Why can't you just calculate the cost of a life insurance policy by adding the premiums for 20 years and subtracting the sum of the illustrated dividends for 20 years and the 20th year cash value?
The calculations must take into account the time value of money. The future value of all premium payments is compared to the eventual cash value plus the future of all premium payments is compared to the eventual cash value plus the future value of dividends accumulated. The net shortfall, or future value of net costs is then annuitized across the payment period.
A financial planning client receives a buyer's guide and policy summary from agent trying to sell him some additional life insurance. Your client asked the agent several different questions, but the agent said, Don't worry about the detail. Our policy is a good buy. Answer the following questions your client asked: b. How does the net payment cost index shown in the summary differ from the surrender cost?
The net payment cost index is useful when the main concern is the death benefit, rather than the cash value to be paid at some future point in time, such as the end of the 20th year. The procedure for calculating this index is identical to that for the surrender cost index, except that in step 3 there is no subtraction for the 20th year cash value.
A financial planning client receives a buyer's guide and policy summary from agent trying to sell him some additional life insurance. Your client asked the agent several different questions, but the agent said, Don't worry about the detail. Our policy is a good buy. Answer the following questions your client asked: a. The summary says the policy has a surrender cost index of $7.35 per $1000 of coverage. What does that number indicate and generally how was it calculated?
The surrender cost index indicates the cost of surrendering the policy and withdrawing the cash value at some point in the future. The result is the average amount of each annual premium--in this case, $7.35 per $1000 of coverage-- that is not returned if the policy is surrendered for its cash value. To compute the surrender cost index, the steps are as follows: 1. Assume each annual premium is placed in an account to accumulate at 5% interest until the end of a 20 year period. 2. Assume that each annual dividend is placed in an account to accumulate at 5% interest until end of 20 year period. 3. subtract the 20th year cash value and the result of step 2 from the result in step 1 4. Divide the result of step 3 by the future value of an annuity due factor for 20 years and 5 percent. This result represents the estimated level annual cost of the policy. 5. Divide the result of step 4 by the number of thousands of dollars in the policy's death benefit. Result is the level annual cost per $1000 of coverage.
Many clients have heard the buy term and invest the difference argument against the use of permanent insurance. This argument is based on the assumption that an individual can invest his or her surplus funds more wisely and with greater returns than a life insurance company can. Analyze this argument in terms of the following objectives of an investment program: safety of principal, yeild, and liquidity.
The use of permanent life insurance meets these three key objectives of an investment: Safety of principal: life insurance industry has compiled a solvency record over the years that is unmatched by any other type of business operation. It has survived war, depression, and inflation. Losses to policyowners have been relatively rare. yield: life insurance companies unquestionably obtain the highest possible yield commensurate with the standard of safety they have set for themselves and the regulatory contraints within which they operate. It is highly questionable that the typical policy owner can, over a long period, earn a consistently higher yield than a life insurance company without taking on a greater degree of speculative investment risk. liquidity: liquidity of a life insurance contract is unsurpassed. The policyowner's cash value can be tapped at any time, sometimes subject to surrender fees. This can be accomplished through surrender for cash, through policy loans, or through partial withdrawals
4. What are the steps in the capital needs analysis approach for determining the amount of additional life insurance your client needs, and how does that approach differ from the financial needs approach?
Unlike the capital liquidation approach in financial needs analysis, which assumes that the policy proceeds will provide a life income through orderly consumption of available funds, the capital needs analysis approach assumes that the income benefits can be provided from investment income only. First, family financial needs are determined in the same manner as in the capital liquidation approach. Then the client's personal balance sheet is prepared,. All the liabilities, immediate cash needs, and all assets that do not produce income are subtracted from the total assets. The remainder is the client's income-producing capital. Finally the additional capital needed to achieve the desired income objective, net of all other income sources is computed. The amount of additional capital needed to meet the desired objective is calculated by dividing additional income needed by the applicable interest rate that represents the after-tax investment return.
modified endowment contract (MEC)
a policy that fails the 7-pay test; test applied at the inception of the policy and again if it experiences a material change, designed to affect policies that take in too much premium in the first 7 years; or the 7 years after the change; designed to discourage a premium schedule that would result in a paid up policy before the end of a 7 year period.
illustration
a presentation or depiction that includes non-guaranteed elements of life insurance policy over a period years
multiple of income approach
a simplistic approach that determines life insurance needs based on the client's current annual income
gift
a transfer and acceptance of property, including money; a transfer for less than full and adequate consideration
You suggested to a financial planning client that she might want to consider replacing a life insurance policy she already owns with a new one. She quickly replied, "An agent told me at a cocktail party last week that you should never replace a life insurance policy. In fact, it's against the law." Advise her by answering the following questions; a. Why might replacement of an existing policy be advantageous to the client?
a. Due to increased competition and improved mortality experience, a policyowner may be able to substantially improve his or her situation by replacing an existing policy with a new one from either the same or a different company
Compare accelerated benefits, viatical agreements, and life settlements as alternatives for converting a life insurance policy to cash.
accelerated benefits, aka living benefits, are a provision in some life policies, permit policyowner to withdraw a part of death benefits under certain circumstances, vs. viatical settlement- in which policy on her/his life is sold to a viatical settlement provider for a portion of its face value, viatical settlement provider becomes beneficiary of policy and pays premium to keep policy in force,
capital needs analysis
an approach that determines how much life insurance is needed to provide a principal sum adequate to fund survivor's needs while preserving the principal
financial needs analysis
an approach that determines how much life insurance is needed to provide a principal sum that will be liquidated to meet survivor's lump sum and ongoing income needs
human life value approach
an approach that measures a person's human life value in terms of the present value of that portion of estimated future earnings which, if he or she lives long enough to achieve all the earnings, will be used to support support dependents
cash value accumulation test
applies to more traditional cash value policies, such as whole life policies, cash value accumulation test, cash value generally may not exceed the net single premium that would be needed to fund the policy's death benefit;
You suggested to a financial planning client that she might want to consider replacing a life insurance policy she already owns with a new one. She quickly replied, "An agent told me at a cocktail party last week that you should never replace a life insurance policy. In fact, it's against the law." Advise her by answering the following questions; b. If replacement itself is not illegal, what type of replacement is illegal?
b. the Unfair Trade Practices Act contains prohibitions against misrepresentation, including misrepresentations to induce the lapse, forfeiture, exchange, conversion or surrender of any life insurance policy
a. What can you suggest for Suzie's star sales person?
business can purchase life insurance on Betty as a key employee, to cover lost income and increased expenses in event of her death; term insurance if primary concern is key employees dollar value to the business, if retirement benefit for key employee is part of concern, permanent life insurance is purchased
buy-sell agreement
buy sell agreement ensures that the estate can sell its interest in a closely held business; binds the owner of a business interest to sell at his or her death, and a designated buyer to buy at that time, protects the business and the estate of the owner
b. two minority stockholders own 40% of voting stock and are also vice presidents, concerned because if Suzie dies her shares pass to dead beat son Lance. How to protect interests of Suzie's estate and minority stock holders in event of Suzie's death? How funded?
buy-sell agreement with two minor shareholders funded by life insurance and should indicate how life insurance will be structured and paid for. Entity agreement can be used, in which firm enters into and agreement with each owner specifying that on death of an owner the firm will buy and the deceased's estate will sell business interest of decesed. Firm carries life insurance on each owner to fund agreement. cross-purchase agreement- each stockholder is a buyer and a seller, on death of one owner decedent's estate will sell and other owners will buy deceased's interest. Each owner carries insurance on the others to fund agreement.
You suggested to a financial planning client that she might want to consider replacing a life insurance policy she already owns with a new one. She quickly replied, "An agent told me at a cocktail party last week that you should never replace a life insurance policy. In fact, it's against the law." Advise her by answering the following questions; c. What requirements are typically imposed on the replacing agent, the replacing insurer, and the existing insurer or agent by state law>
c. replacing agent must state whether the policy is a replacement at the time of application. For a replacement the agent must give the applicant a prescribed notice alerting the applicant to the need to compare the existing and the proposed benefits carefully,
extra percentage tables
classify applicants into groups based on the expected percentage of standard mortality and charge premiums that reflect the appropriate increase in mortality
rate-up age method
dealing with substandard applicants is often used when the extra mortality is decidedly increasing and will continue to increase indefinitely
What are the general rules and key exceptions with regard to the federal income tax treatment of the following aspects of life insurance? b. death proceeds distributed under a settlement option
death proceeds distributed as a series of payments under a settlement option generally include an element of interest earned, which is taxable, however, the portion of a settlement option payment hat represents principal qualifies for income tax exclusion
incident of ownership
element of ownership or degree of control over a policy; includes but not limited to the power to change beneficiary, assign the policy, borrow on the policy, surrender the policy, exercise any other essential rights or priviledges
transfer-for-value rule
exception to general rule of exclusion of life insurance death proceeds from federal taxation, rule provides that if a policy is transferred from one owner to another for valuable consideration, the income tax exclusion is lost; when insured dies, beneficiary only can recover tax free amounts the transferee owner paid for the policy plus any premiums subsequently paid
split-dollar life insurance
form of life insurance frequently used prior to 2003 as an executive compensation benefit; corporation and employee split a life insurance policy covering the life of the employee; The corporation contributes an amount equal to the annual increase in the cash surender value, while the executive pays the remainder of the annual premium; Sarbanes-Oxley Act 2002, prohibits a publicly traded company from using corporate funds to make personal loans to its directors or officers
Sec. 79 plan
group term life insurance plan, provided by an employer to a group of participating employees, designed to receive a favorable federal income tax treatment; allow the employer a tax deduction for premium payments on behalf of a participant
inside buildup
increase in the cash value of a permanent life insurance policy ; inside buildup not subject to taxation as long as it is left inside the policy; however amounts taken out during the insured's life may be subject to taxation as discussed in this section
surrender cost index
indicates the cost of surrendering the policy for the cash value at some future point in time, such as 20 years.
What are the general rules and key exceptions with regard to the federal income tax treatment of the following aspects of life insurance? d. inside buildup of a policy's cash value
inside buildup not subject to taxation as long as it is left inside the policy
net payment cost index
interest adjusted cost index, evaluates the cost of insurance protection based on the assumption that the insured dies a the end of the policy's 20th year.
viatical settlement
involves the sale of terminally ill insured's life insurance policy exchange for a percentage of the face amount, the viator receives a lump-sum cash settlement from the settlement providor; 40 to 80 percent of the death benefit
life settlement
involves transferring the ownership of life insurance policy to a third party investor, much like a viatical settlement, but in cases where the insured is not chronically or terminally ill; provide relatively new way for seniors to convert their life insurance policies into cash.
What distinguishing characteristics may make one type of permanent life insurance preferable over another type for a particular client?
length of planned premium-paying period emphasis on cash value vs protection- if client places heavy emphasis on cash value element, he or she should consider a very short premium paying period time when death benefits are needed- principal need for funds is at the death of the main income-earner, single life policy is appropriate. however, if principal need is estate liquidity when surviving spouse dies, joint survivorship policy is better desire for inflation protection- variable life, universal life, universal variable life, or equity-indexed insurance can provide increasing amounts of death benefits importance of yield vs safety- variable, universal, or variable universal life may provide increased yields unbundling of cost components- if client wants to know where premium dollars go- consider variable, universal, or variable universal life insurance premium payment flexibility- universal life or variable universal life
What are the benefits and pitfalls of a policyowner's viaticating an insurance policy?
major benefits- cash will be available to the policyowner to fund the insured's final needs pitfalls- surviving family will no longer be provided for by the policy, potential loss of social benefits based on need, lack of regulation regarding privacy, information re providers financial strength may be unavailable and fraud taints industry
flat extra premium
method of underwriting for substandard applicants; assess a flat extra free per $1000 of coverage
What are the general rules and key exceptions with regard to the federal income tax treatment of the following aspects of life insurance? f. policy loans
only taxable if policy is an MEC
What are the general rules and key exceptions with regard to the federal income tax treatment of the following aspects of life insurance? c. policy dividends
policy dividends are nontaxable return of premium and reduce the policyowner's basis, total dividends paid exceed total premiums, dividends become taxable by amount of excess, dividends used to reduce premiums , basis is reduced
What are the general rules and key exceptions with regard to the federal income tax treatment of the following aspects of life insurance? h. premium payments
premiums for individual life insurance policies not tax deductable,
lien
reduction in coverage for a period of time when an insured has a temporary and decreasing convalescence or serious illness from which they are expected to recover; allows a person to be insured despite poor health; policy issued at face value but specifies reduced benefits for a period of time
replacement
refers to the process of replacing an existing life insurance policy with a new policy, a move that might or might not be advantageous to the policy-owner; agents and insurers must avoid harm to policyowners
guideline premium and corridor test
second two-pronged test to determine if policy meets IRS definition of life insurance: limits the total premium that may be paid into the policy at a given time, limit varies with each life insurance agency, insurer's own interest assumptions; second prong is if the death benefit exceeds a specified multiple of its cash value at all times; multiple varies according to the insured's attained age
What are the general rules and key exceptions with regard to the federal income tax treatment of the following aspects of life insurance? a. death proceeds distributed in lump sum
some exceptions; lump-sum proceeds paid under life insurance due to insured's death are excludable from gross income taxes for federal tax purposes;
stranger-originated life insurance (STOLI)
speculators initiate coverage on an older person and fund the premium payments with intentions of profiting upon the death of the insured. speculators violate the intent behind the insurable interest laws,
gross estate
starting point in the federal estate tax calculation; property in the decedents estate, which is all the property that passes under the decedent's will or in the absence of a valid will, under the state intestancy law, also includes property transferable by the decedent at death or by other means
estate tax
tax imposed on transfer of property at death;
gift tax
tax imposed on transfers of property by gift during the donor's lifetime; taxes are levied on the donor, not the recipient
cross-purchase agreement
under such an agreement, each partner or stockholder is both a seller and a purchaser, provides that, on the death of one owner, his or her estate will sell the deceased's interest and the other owners will buy it. To fund the agreement, each owner is the beneficiary of a life insurance policy on the other owners
key employee life insurance
used by closely held businesses, inteneded to cover the losses to the business of the key employees expertise or the increased cost associated with hiring a replacement
entity agreement
used in partnerships or closely held corporations; firm itself enters into an agreement with each owner specifying that on the death of an owner the firm will buy the business interest of the deceased and the deceased's estate will sell it
What are the general rules and key exceptions with regard to the federal income tax treatment of the following aspects of life insurance? e. withdrawal of funds from a policy's cash value
withdrawal is first treated as a nontaxable return of premiums, excess amount withdrawn beyond policyowner's basis is taxable in the year of withdrawal, some excpeitons