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Topic 19: Life Insurance Risk factors

Lifestyle Occupation Medical condition Family history

High risk individuals Denied coverage Increased premiums Exclusion of certain risks: skydivers

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Topic 19: Life Insurance

Concepts Mortality: death rates Morbidity: rates of disability

Expenses: greatest in early years Commissions

Insurable interest Required at time of policy inception Not at the time benefits are paid

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Topic 19: Life Insurance Term insurance: temporary

Renewable: to age 70 Convertible: to whole life

Whole life: permanent/forced savings Variable: separate account invested based on policy holder’s

allocation Whole life funds go into general account of company Can increase death benefits/cash value based on investment

performance Universal: can change

Premiums: can skip payments Death benefit

Cash value separated from death benefit Variable universal: combine features Survivorship: second to die policy

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Topic 19: Life Insurance Contract provisions

All language contained in contract Backdating: can be done up to six months Owner may not be insured One month grace period for premium payments Misstate age: adjust death benefit Loans: amount borrowed subtracted from death

benefits Assignment: generally policies may be assigned Common disaster: primary beneficiary must outlive

insured by 60 – 90 days

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Topic 19: Life Insurance Contract provisions

Incontestable: insurer has two years to challenge validity of policy

Exclusions: suicide (one to two years) and war

Settlement options Lump sum Annuity

Single or joint life; term certain Interest only

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Topic 19: Life Insurance Dividends

Cash Accumulate Reduce premiums Buy additional coverage

Interest credits Portfolio method: based on insurer’s

earnings of overall portfolio New money method: based on insurer’s

earnings on money invested that year

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Topic 19: Life Insurance

Riders Accelerated death benefits: pay benefits if expected

to die within year; in nursing home permanently Long-term care: benefits rider can be added to life

insurance policy Waiver of premiums: if disabled Guaranteed insurability: can buy more coverage

without showing insurability Double indemnity: twice policy amount if death

accidental

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Topic 19: Life Insurance Nonforfeiture options

After policy has cash surrender value, Can get cash within six months Can get a paid-up policy with a reduced

face amount Can get a term policy with the same face

amount

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Topic 19: Life Insurance Illustrations

Projection of financial results Incorporate present value or just nominal values? Optimistic assumptions? Clearly label what is guaranteed? NAIC model does not apply to variable

life/annuities Policy replacement

Regulated by many states High commissions May make sense due to reduced mortality charges

and in higher interest rate periods

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Topic 19: Life Insurance Accelerated death benefits

Allow terminally ill insured to obtain funds prior to death tax-free Pay for custodial care Preferable to viatical due to discounts on viatical

Viatical settlements Terminally ill insured transfers policy for lump sum

payment Benefits tax-free to insured if:

expected to die within two years can’t perform two activities of daily living

Life settlement Sell life insurance policy

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Topic 20: Income Taxation of Life Insurance Dividends: whole life policies

Not taxable unless total dividends > premiums paid on policy

Loans: whole life policies Not taxable

Withdrawal of cash value Not taxable unless withdrawals > basis If taxable, ordinary income

Surrender Not taxable unless proceeds > basis If taxable, ordinary income

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Topic 20: Income Taxation of Life Insurance Death benefit: not taxable MECs: premiums higher than necessary for insurance.

Often single premium policy Then take cash value prior to death Test during first seven years of policy

Is it paid up in seven years? If policy is MEC,

Death benefit is still not taxable Withdrawals and loans taxed as ordinary

income with penalty if under 59 ½

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Topic 20: Income Taxation of Life Insurance

Transfer for value Sell policy to someone other than related

party (business, co-owner, family member) Seller not taxed if viatical settlement

Expected to die within two years Buyer will be taxed on death benefits if

greater than basis (ordinary income) Including premiums paid and purchase price

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Topic 20: Income Taxation of Life Insurance Section 1035 exchange

Trade an existing policy for a new policy Good idea??? Mortality/interest rate assumptions

Trade a life insurance policy for an annuity Makes IRS happy

Can also trade life insurance or annuity policy for long-term care policy

Can not trade an annuity for an insurance policy Would make the IRS sad

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Topic 21: Business Uses of Insurance

Buy-Sell Agreements Provides for the sale of business interest

on death of owner Allows heirs to cash out of business Keeps heirs from becoming co-owners Keeps ownership with existing owners Value generally based on formula

Valid for estate tax valuation

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Topic21: Business Uses of Insurance

Buy-Sell Agreements Cross purchase

Owners buy policies on each other Number of policies? Older owner Premiums not deductible

Entity Company buys policy on each owner

Premiums not deductible

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Topic 21: Business Uses of Insurance

Key Person Life Insurance Insures life of valued employee:

LeBron Janitor

Business is beneficiary Premiums not deductible Benefits tax-free

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Topic 21: Business Uses of Insurance Split Dollar Life Insurance

Employer and employee share cost of premiums Employer pays cash value portion Employee pays pure life insurance cost

If employer pays entire premium, coverage above $50,000 taxable

Endorsement method Employer owns policy

Receives reimbursement for premiums paid Employee gets balance Employer paid premiums income to employee

Collateral assignment method Employee owns policy

Again must reimburse business for premiums paid Premiums treated as loans: employee must pay interest

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Topic 22:Insurance Needs Analysis

Life insurance Anyone financially sad??? Financial needs approach: determine

cash needs, income needs, special needs and then subtract net worth Income replacement Debt elimination College education Less assets available to meet these needs

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Topic 22:Insurance Needs Analysis

Life insurance Human life value approach:

Present value of insured’s future income Does not consider assets, liabilities, other

sources of income Capital retention approach:

Not only provide present value of future income but capital is maintained also

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Topic 22:Insurance Needs Analysis

Life insurance Income retention approach:

Based on income needs of survivor rather than income generated by insured

How soon until surviving spouse will accidentally fall in love?

Income multiplier approach: five to fifteen times annual income

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Topic 23:Insurance Policy and Company Selection

Life insurance Temporary needs: term Permanent needs: whole life

Participating: pays dividends when premiums were “too large”

Cost analysis Net cost method per $1,000 of coverage =

(total premiums – cash value) / number of years policy held Ignores time value of money

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Topic 23:Insurance Policy and Company Selection Life insurance

Cost analysis Surrender cost index =

(future value of premiums – dividends – cash value)/fv factor for $1 for n years at i rate)

/$1,000 units of coverage Net payment cost index =

Same as surrender cost index but cash value is not subtracted

Benchmarks: Age 30: $2 cost per $1,000 Age 60: $25 cost per $1,000 Age 80: $125 cost per $1,000

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Topic 23:Insurance Policy and Company Selection Life insurance

Company selection: financial ratings Companies rated based on financial strength

A.M. Best, S&P, Moody’s Best: insurance companies only “A+” rating has different meanings

Variable products provide security of subaccounts

Company selection: underwriting Some companies only want certain types of risk

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Topic 18: Annuities Types

Immediate: payments begin now Deferred: payments begin later Single premium: one payment

Purchase annuity with 401(k) proceeds Periodic premium Single vs. joint and survivor Period certain: benefits continue for a

minimum number of years Even if die before period ends

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Topic 18: Annuities

Types Fixed: periodic payment known

Turn defined contribution plan into defined benefit plan

Variable: periodic payments based on investment performance Considered securities: must hold Series 6

and insurance license to sell Oversold/undersold????

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Topic 18: Annuities

Structured settlements Receive periodic payments instead of

lump sum For auto accident, medical malpractice, etc. Payments are tax-free if compensatory

including pain/suffering/wrongful death/loss of goodwill Effectively makes interest tax-free Punitive, non-physical damages are taxable

Companies buying structured settlements

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Topic 18: Annuities Taxation of annuities

Noncontributory-qualified plan All payments ordinary income

Contributory-qualified plan Basis / total expected payments = percent of each

payment not taxed Remainder of payment ordinary income

Subject to 10% penalty if not age 59 1/2 After recover entire basis, all taxable

If die before deferred annuity payments begin Refund of premiums paid generally not taxable

since payment equals basis No step-up in basis for annuities

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Topic 18: Annuities Taxation of annuities

Commercial annuity Ordinary income and return of capital based on expected

payments Corporate annuities

Must recognize income immediately on increase in value of annuity; no deferral

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Topic 19: Group Term Life Insurance

Must be nondiscriminatory Amount of coverage usually multiple

of salary Cost of coverage above $50,000 is

taxable

No evidence of insurability required Even if leave company and convert to

individual cash value policy Inexpensive form of life insurance

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Topic 19: Group Permanent Insurance Premiums

Deductible by employer Taxable to employee GULPs: employees pay for universal life coverage

Advantage Group underwriting Can continue as individual policy after leaving

employment No evidence of insurability required Must convert to permanent insurance

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Topic 19: Group Permanent Insurance

Carve Out Insurance Cover top dogs only

Employer’s cost deductible Top dogs taxed on premiums paid

Pay bonus to top dogs so they can pay taxes on premiums so they won’t be sad

Employer paid death benefit Taxable

Not funded by life insurance policy