Life Insurance Basics An Introductory Guide
DISCLAIMER The content contained in this document is designed to help you understand the ideas discussed. Any examples are hypothetical and are used only to help you understand the ideas. They may not reflect your client(s)’ particular circumstances. Your clients should carefully read their contract, policy, and prospectus(es), when applicable. What we say about legal or tax matters is our understanding of current law; but we are not offering legal or tax advice. Tax laws and IRS administrative positions may change. This material is not for use in avoiding any IRS penalty and neither you nor your clients may use it for that purpose. Your clients should ask their independent tax and legal advisors for advice based on their particular circumstances.
If this material states or implies that it was prepared or distributed to promote, market or recommend an investment plan or arrangement within the meaning of IRS guidance, or such use may be reasonably expected, then, as required by the IRS, the following also applies:
The tax information in this material was written to support the promotion or marketing of the transaction(s) or matter(s) addressed in this material.
Changes to tax laws may require changes to the contents of this material from time to time. Once distributed, we cannot be responsible for the continued accuracy of the material.
Any examples or excerpts from illustrations are for training purposes only and are not intended to represent any specific product. These examples or illustrations are not valid for use in a sales setting with consumers.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC.
Table of Contents
Module 1 – Introduction to Life Insurance 1
Why People Buy Life Insurance 1
Income Replacement 2
Personal Uses of Life Insurance 2
Business Uses of Life Insurance 2
Estate Planning Uses of Life Insurance 3
Charitable Giving Uses of Life Insurance 3
Living Benefit Uses of Life Insurance – Accessing Cash Value 4
Living Benefit Uses of Life Insurance – “Death Benefits” During Lifetime 4
The New Business and Underwriting Process 4
Retention and Reinsurance 5
Insurable Interest 6
Financial Underwriting 7
Parties to the Application 7
Drafting Beneficiary Designations 8
Overview of Types of Life Insurance 8
Term Life Insurance 8
Whole Life Insurance 9
Fixed Universal Life Insurance 10
Variable Life and Variable Universal Life Insurance 11
Survivorship Universal Life Insurance 11
Module 2 – Fixed Universal Life Insurance 12
Death Benefits 12
Corridor 14
Premiums 14
Minimum and Maximum Premiums 14
Target Premium 15
Policy Fees And Other Policy Charges 15 Cash Value 16 Premiums are the Primary Driver of Cash Value 16 Cash Surrender Value and Surrender Penalties 17 Policy Loans 17 Withrawals 17 Grace Period 18
FOR BROKER/DEALER USE ONLY. NOT TO B E REPRODUCED OR SHOWN TO THE PUBLIC.
Module 3 – Basic Illustrations 19
Compliant Illustrations 19
Parts of A Life Insurance Illustration 19
Current Assumptions Versus Guaranteed Features 20
Module 4 - Fixed UL with “Secondary Guarantees” – Lifetime Guarantee UL 23 Catch-Up Provisions 25
Grace Period And Secondary Death Benefit Guarantees 26
Summary 26
Module 5 – Basics of Life Insurance Taxation 27
Federal Income Taxation of Death Benefits 27
Life Insurance Owned by And Payable to Employer 27
Transfers for Valuable Consideration 28
Federal Income Taxation of Cash Value 28
Modified Endowment Contracts (MEC) 29
IRC Section 1035 Exchanges 30
FOR BROKER/DEALER USE ONLY. NOT TO B E REPRODUCED OR SHOWN TO THE PUBLIC.
Module 1 – Introduction to Life Insurance
People who live in financially developed societies use insurance to help reduce the risk of suffering a financial loss. A common example is the purchase of auto insurance. Auto insurance policies provide liability coverage to protect us from financial loss if we are held liable for an accident as well as collision coverage to pay for repair to a damaged car and medical coverage to reimburse for the treatment of injuries.
Life insurance is also a risk management tool, but a unique type. It is unique because its primary purpose is to create a pool of cash that is payable at the death of the insured person.
To meet diverse needs and to enhance the value of life insurance, different types of policies and features have been designed. While some life insurance policies focus exclusively on providing a death benefit, others also build cash value amounts within the policy that the owner of the policy may access to meet emergencies, help purchase a home, or pay for a college education.
Finally, to encourage people to buy life insurance, these products have certain income tax benefits. The death benefit paid to the beneficiary is usually income tax free. And any cash value growth inside the policy is not subject to income tax unless it is removed from the life insurance policy.
Why People Buy Life Insurance
Income Replacement
People use life insurance for many reasons. But, the most important reason, by far, is to protect the family from the financial loss that occurs when a wage earner dies. The death benefit paid to the beneficiaries can be used to replace lost income, ensure that the family can stay in their home, purchase food, clothing and other necessities, pay funeral expenses, as well as create a fund to meet future expenses or education costs. Let’s look at an example.
Joseph and Marie Alvarez are both hard working individuals who place high value on the family. Joseph is a pharmaceutical salesperson, with the same employer for 8 years. He makes about $85,000 per year. Marie works as an x- ray technician at the hospital, earning about $50,000 per year. She went back to work when their youngest started pre-school. Their son, Michael, is 11 and their daughter, Kelly, is 9.
With Marie back to work, they were able to qualify for a bigger mortgage and three years ago they bought their dream house in a new suburb that isn’t far from her parents.
They have all settled comfortably into the community. Michael plays both Little League and soccer. Kelly takes ballet and also plays soccer. And, Marie’s job is only a few miles away – her short commute means she’s able to spend more time with her family and get the kids to their soccer games on time – especially important since Joseph’s job often takes him out of town. Everything is perfect.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 1
Fast forward a few years… Joseph was coming home from a week of sales calls when he was in a serious traffic accident. Unfortunately, Joseph was pronounced dead at the hospital.
This story could have two endings depending on the amount of life insurance that Joseph had on his life.
• Joseph had no life insurance: Marie is devastated by the loss of her best friend and husband. After she got through the ordeal of the funeral, she realized she couldn’t afford the mortgage payments on her salary. She was forced to sell the house and rent an apartment that was more within her means. Unfortunately, the apartment isn’t in the same neighborhood as the old house. The kids had to change schools and make new friends. For the kids, the devastating loss of their father was compounded by this upheaval in their lives. Marie has a longer commute and her parents aren’t nearby if she is late getting home. Worse, the dreams that she and Joseph had for their children’s college education and for their own comfortable life through retirement seem far off and unobtainable now.
• Joseph had life insurance: Marie is devastated by the loss of her best friend and husband. But she and the kids have managed to move on with their lives. Thanks to Joseph’s deep sense of responsibility, there was enough life insurance to pay off the mortgage and to set aside money for both kids’ college educations and other future needs. The kids are still active in sports and Kelly has started acting in school plays. Marie’s parents are still nearby and drop by to help out when needed. She wonders what she and the kids would have done had Joseph not insisted on buying enough life insurance to offset his income in the event of his death. She can only imagine how difficult it would have been.
This story can’t capture the pain of losing a loved one, but it does demonstrate the important role life insurance can play in the lives of real people.
Personal Uses of Life Insurance
Life insurance death benefits can help in many ways including, but not limited to the following:
• Replace the income of a deceased wage earner;
• Pay off the mortgage and other debts (including funeral expenses);
• Provide funds for the education of the surviving spouse or the children;
• Fulfill the obligations of a divorce decree or child support agreement;
• Benefit charitable organizations, churches or schools (such as one’s alma mater);
• Equalize the inheritance heirs receive.
Business Uses of Life Insurance
Life insurance is a valuable tool in the business setting as well. For example, it is common for businesses – large and small – to purchase life insurance on the lives of those key people in the business who are responsible for its success.
The business owns the policy and also receives any death benefits paid. If the insured key
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 2
person dies, then the business can use the cash it receives to help offset the associated business losses such as:
• Make up for any lost profits
• Settle business debt; or
• Use the funds to recruit, hire and train a replacement.
Small, closely held businesses often use life insurance to fund plans that help the business continue if the business owner(s) die, retire or leave the business. These plans are commonly referred to as buy-sell arrangements. These arrangements are contracts between the business and its owners or between the owners themselves. In the contract, the owners promise to sell their share of the business if they die, retire or leave the business and the other owners, or the business, promise to buy it. The party that has promised to buy the business may choose to buy life insurance on the seller. Then, if the seller dies, the death benefit will help the buyer fulfill the terms of the buy-sell contract by providing cash to help purchase the deceased owner’s share.
Other ways the business may use life insurance include:
• Provide extra benefits for key executives of the business as an inducement to stay with the business;
• Paying for group life insurance for all the employees;
• Allowing the employees to purchase personal life insurance through a payroll deduction program; or
• Including life insurance in the company retirement plan to provide a death benefit to a deceased employee’s family.
Estate Planning Uses of Life Insurance
For affluent people, life insurance assists with transferring wealth to their heirs or to charitable organizations. The most common use is purchasing life insurance within a trust to provide cash to pay the costs associated with settling a large estate. These costs might include the expenses connected with probating the will or estate transfer taxes that may be payable to federal or state governments. In addition, life insurance may be used to:
• Pay off business or personal debts;
• Equalize the estate among heirs;
• Fund estate planning and charitable planning techniques such as charitable remainder trusts, wealth replacement trusts, and grantor retained annuity trusts or unitrusts.
Charitable Giving Uses of Life Insurance
Charitable organizations can benefit from life insurance that insures the lives of their key donors. Typically, the charitable organization is both the policyowner and beneficiary of the policy. The donor makes yearly donations to the charity that are tax-deductible and the charity uses these funds to pay the policy’s premium. At the donor’s death, the charity can use the death benefit funds to help fulfill their obligations.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 3
Living Benefit Uses of Life Insurance – Accessing Cash Value
While most people are familiar with the importance of the death benefit protection, many aren’t aware of the living benefits of life insurance.
If the policy builds cash value, the policyowner may access these values to meet emergencies or take advantage of opportunities. There are two ways that policyowners can access cash value.
• Policy loans – all types of cash value life insurance provide the ability to borrow against the cash surrender value in the policy. Loans are typically provided at interest (e.g., 8%) although in some policies the interest charged on the loaned portion may be partially or wholly offset by interest credited to the cash value. Policy loans that are not repaid are deducted from the death benefit at death or from the cash value if the policy is surrendered.
• Withdrawals – many types of cash value life insurance allow the policyowner to withdraw funds from the policy cash surrender value. Usually there is a fee associated with each withdrawal and there may be limits on the number of withdrawals that may be made in any policy year (e.g., one withdrawal per year). Unlike policy loans that can be repaid, withdrawals permanently remove funds from the policy and as such, are not subject to interest charges like policy loans. Withdrawals may reduce the death benefit.
Living Benefit Uses of Life Insurance – “Death Benefits” During Lifetime
If the insured becomes seriously ill and that illness is anticipated to end in death, most life insurance policies today will pay part of the death benefit amount to the policyowner while the insured is still living. These benefits are known as accelerated death benefits. The amount of the death benefit that will be paid is limited by formula or percentage of the death benefit. To receive this money, the policyowner must provide proof that the insured’s life expectancy will not exceed some period of time. The law permits the anticipated life expectancy to be as long as 2 years, but most insurance carriers limit the period to no more than six months.
The New Business and Underwriting Process
Purchasing life insurance transfers the risk of financial loss that results from the insured’s death from the policyowner to the life insurance company. To be profitable, the insurance company must be able to determine how much it has to charge for a certain life insurance policy to ensure it has sufficient funds to cover the costs of issuing the policy, its ongoing expenses and overhead, as well as pay future claims. The individuals trained to do this type of analysis are known as actuaries.
In addition to the ability to price the products correctly, the insurance company must be able to evaluate each person that applies for insurance to determine if it wants to offer insurance coverage to that person. This is done through a process known as underwriting. With the proposed insured’s approval, the company’s underwriters gather and evaluate medical information on the proposed insured, as well as some family medical history and information on hobbies and the proposed insured’s occupation.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 4
Information about the proposed insured’s health and other factors influencing the decision to offer insurance coverage comes from a variety of sources which may include:
• The insurance application and any supplemental forms.
• An exam conducted by a paramedical or a doctor. The size of the policy, as well as the age of the insured, may determine whether an exam is needed and what information will be gathered. Most exams are done by paramedical personnel who gather information about the proposed insured’s medical history, family history, height and weight. They also often collect a blood and urine sample. For higher death benefit amounts or when other circumstances dictate, an exam by a medical doctor as well as additional tests (e.g., stress EKG) may be required.
• An attending physician’s statement (APS) may be requested from the proposed insured’s doctor to get more detailed information about a specific medical condition.
• Inspection reports are often requested to check for any criminal activity or other high- risk behavior.
• Driving records are also checked for high-risk behavior such as an unusually high number of traffic violations or arrests for driving while under the influence of drugs or alcohol.
• Medical Information Board (MIB) information is routinely collected by life insurance companies. The MIB is an association of life insurance companies that provides information to protect companies from attempts to conceal or omit health information that is necessary to make an underwriting decision. As part of the application process, proposed insureds and policyowners are made aware of the information sources companies use.
The underwriter uses all this information to evaluate the risk and then approve or decline to issue the policy. For those approved for coverage, the underwriter also determines the rate that needs to be charged to adequately cover the risk.
Rates are set on a cost per $1,000 of death benefit. The rates fall into classes such as Custom, Standard, Select, Preferred and Preferred Best. The healthiest individuals would fall into the preferred best categories. These rate classes are also split into nicotine and non-nicotine users. In addition, individuals with more serious health issues may be charged a higher rate per thousand, known as a table rating. Or, sometimes a flat extra premium is charged. The ratings may last for the life of the policy or may be charged only for a specified period of time.
Retention and Reinsurance
Insurance companies are in business to manage risk. However, on large life insurance cases, insurance companies typically share the risk with another insurance company known as a reinsurer. Reinsurance companies don’t sell insurance directly. They only underwrite the excess risk of the primary insurance carrier – the distributors of the product.
The amount of insurance that the primary insurance carrier does not reinsure is known as its retention limit.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 5
o For example, life insurance Company A has a retention limit of $1,000,000 for all individual applicants under the age of 70 and life insurance Company B has a retention limit of $5,000,000 for the same group. If both receive applications for $3,000,000 of life insurance coverage on similar individuals age 50, Company A will retain only $1,000,000 of the risk on their own books and pay a reinsurer to take the other $2,000,000. Company B will retain the entire amount because it is less than its retention limit.
o The amount that each company retains would be reduced by other insurance they have in force on the proposed insured.
On much larger cases, even the reinsurer may choose not to take all of the excess risk. It may, in turn, choose to reinsure some part of its share of the death benefit risk to yet another reinsurance company. The company that takes the excess risk from a reinsurance company is known as the retrocessionaire.
Many people with a high net worth may find it advisable to carry large amounts of insurance. However, the reinsurance marketplace limits the total amount of insurance that it will carry on a single individual. This is known as the Jumbo Limit. The Jumbo Limit takes into account all pending applications and in-force life insurance (including amounts being replaced) on the applicant. The Jumbo Limit is currently about $65,000,000.
Insurable Interest
Life insurance is meant to protect those who would suffer financially if the insured individual died. This is known as having an insurable interest. Just as one person cannot purchase insurance on someone else’s car, someone with no financial stake in the insured’s continued life cannot buy life insurance on that person.
State law determines whether an insurable interest exists. Insureds who own their own policy, can name any beneficiary. Insurable interest issues arise when the owner and insured are not the same. In the absence of a blood relationship, all states require that the policyowner have a greater interest in the insured’s continued life than in the insured’s death at the time the policy is issued. Some states require that both the owner and the beneficiary hold an insurable interest. This usually means that both would suffer a financial loss if the insured died.
Even if a financial loss is not apparent, certain family members are assumed to have an insurable interest in the insured based on love and affection. These include the insured’s: • Spouse • Children • Parents
The following may also have an insurable interest (documentation supporting insurable interest may be required): • Brothers and sisters of insured • Grandparents • Fiancé of the insured
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 6
• Domestic partner of the insured • Business owned by insured • Business partner or co-shareholder • Trust established by the insured, or a trust in which the insured is a beneficiary (provided the grantor and the trust beneficiaries have an insurable interest in the insured at the time the policy is issued) • Employer, but only if the insured is a key employee, officer or owner of the company • Creditors of the insured • Insured’s estate • A charitable organization to which the insured makes donations
Financial Underwriting
Assuming the applicant for insurance has an insurable interest in the insured, it is also necessary to determine if the amount of insurance being applied for, plus the sum of all life insurance currently in force on the insured, is reasonable. This is because no one should be insured for more than the amount of financial loss that would occur if the insured died.
Financial underwriting isn’t an exact science. Rather, it is an evaluation based on many factors such as the individual’s future earnings capacity or net worth. Sometimes the amount of coverage is tied to a contractual agreement such as a buy-sell arrangement. In that situation, the value of the share of the business owned by the insured helps to determine the amount of life insurance that may be purchased. Other times, the amount might be tied to anticipated estate tax liability that will be due when the individual dies.
Company published guidelines will provide information on acceptable limits. If the total amount of insurance in force plus the amount being applied for exceeds these limits, it is important to provide additional information for the underwriter. A cover letter is a good place to explain the reason for the coverage amount. Additional documentation such as financial statements, estate tax analyses, businesses’ financial statements or balance sheets, or any other pertinent information helps the underwriter reach an informed decision.
Parties to the Application
There are generally four parties to a life insurance policy: the insured individual, the insurance carrier, the policyowner, and the beneficiary. Many times the policyowner is also the insured.
The insured is the person whose death will trigger the payment of the death benefit. Some policies will cover more than one insured under the same policy.
The policyowner is the person or entity that will own the life insurance policy and who will have all the rights under the policy. These rights include the right to name and change the beneficiary (unless named irrevocably), the right to access any policy cash value, and the right to surrender the policy for cash. If the policyowner is not the insured, then the policyowner must have an insurable interest in the insured’s life (see the sections on Financial Underwriting and Insurable Interest above). There may be both a primary policyowner and a contingent policyowner. If a contingent owner has been named, ownership of the policy will pass to the contingent owner if the primary owner dies.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 7
The beneficiary is the person or legal entity who is entitled to receive the death benefits paid under a life insurance policy. A beneficiary can be a primary beneficiary or a contingent beneficiary. There may be more than one beneficiary to a life insurance policy. The primary beneficiary receives the death benefit if he or she is alive at the time of the insured’s death. The contingent beneficiary doesn’t receive any death benefit unless the primary beneficiary is deceased (or if a legal entity, no longer exists).
Drafting Beneficiary Designations
A well-drafted beneficiary designation for a life insurance policy provides a description that both:
• Clearly identifies the beneficiaries; and
• Fulfills the policyowner’s intent with respect to how the death benefit is to be paid. Below are general guidelines for drafting beneficiary designations. • Include both the name of the beneficiary and identifying information about the beneficiary such as the beneficiary’s relationship to the insured, date of birth or Social Security number.
• If a trust is the beneficiary, the names of the trust and trustee, and the trust’s date, are required.
• If a business is the beneficiary, you are not required to provide the name of the officers of the corporation or partners of the partnership. These individuals can change over time.
• When there are two or more beneficiaries, define how the benefit should be split. If unequal shares are requested, use only percentages to establish portions.
• Avoid situations where the insured, the policyowner and the beneficiary are all different. This can result in adverse gift or income tax consequences.
• If appropriate, use beneficiary wording that can accommodate future changes to the policyowner’s situation (such as the expectation that the insured will have more children). Use class designations if there are multiple beneficiaries when the designation is made, but membership in the class is not yet known.
• Policyowner Services or Advanced Marketing can provide assistance on specific beneficiary wording, if needed.
Overview of Types of Life Insurance
Life insurance generally falls into one of two broad categories – term life insurance or cash value life insurance. Cash value life insurance polices can be further divided into two general types – whole life insurance and universal life insurance.
Term Life Insurance
Term insurance is a death benefit in exchange for a premium payment. It does not build cash value although some policies sold today now offer return of premium benefits or cash value riders.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 8
Typically the premium on term insurance is level for a certain number of years (e.g., 10, 20, 25 or 30 years – the specified period). These premiums are usually guaranteed not to increase during the level period selected. At the end of the level period, the premium increases each year. See the chart below.
Example of 20-Year Term Life Premium Paying Period Pattern
t 20000
oun 15000
m
A 10000
m
u
i
m 5000
re
P 0 1 6 11 16 21 26 31 36 41 46 Years to Pay Premium
After the level premium period, the premiums that the insurance company plans to charge are not guaranteed. The insurance company has the right to charge higher amounts provided those amounts don’t exceed a maximum premium level.
Term insurance provides an affordable initial cost way to purchase life insurance. However, the increasing premium in later years makes term insurance impractical for meeting long-term life insurance needs. For needs that will last a longer period of time, whole life or universal life insurance should be considered.
If the required premium is not paid by the due date, or within the allowable grace period, the policy lapses without value. The grace period for paying premiums is usually 31 days from the due date.
Whole Life Insurance
Whole life policies were the primary type of insurance sold before universal life insurance policies were developed in the late 1970’s. The distinguishing features of whole life are that it has guaranteed premiums for the life of the policy, a guaranteed death benefit and guaranteed cash value.
Example of Whole Life Insurance Policy
100,000 80,000
s r 60,000
a
l
l
o 40,000
D 20,000 0 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 Ye ars
Death Benefit Net Policy Value
In most policies the death benefit remains level throughout the life of the policy, although some polices may offer the option to pay a higher premium to limit the premium-paying period (e.g., to age 65).
The guaranteed cash value is expected to “endow” at a certain age, usually 95 or 100. This generally means that if the insured is still living at this point, the policy terminates
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 9
and the cash value is paid to the policyowner. Most whole life policies are designed so that the guaranteed cash value at the time the policy terminates is equal to the death benefit.
Whole life policies are of two basic types, nonparticipating and participating:
Participating policies pay dividends back to the policyowners. The dividends are a return of part of the premiums that the policyowner previously paid but which were not needed by the insurance company to pay expenses or meet claim obligations. The dividends can be taken in cash, used to reduce future premium payments or used to purchase additional insurance, known as paid-up additions.
Paid-up additions increase the total amount of death benefit and also have cash value. But no premium payments are required to keep them in force. In later years, the policyowner may choose to surrender the additional coverage and use their cash value to pay premiums on the original policy.
Nonparticipating policies do not pay dividends to the policyowners. However, most nonparticipating policies sold today credit cash value with an interest that exceeds the guaranteed interest rate. The non-guaranteed interest rate fluctuates with the investment results of the insurance company’s general investment portfolio. But it is guaranteed never to drop below a certain level.
The grace period for paying premiums on a whole life policy is usually 31 days from the due date. If the required premium is not paid by the due date, or within the allowable grace period, the policyowner is permitted to borrow from any policy cash value to make the premium payments. If the policy is a participating policy, dividends or the surrender of the paid-up additions may be available to help pay the premiums.
In addition, whole life policies have certain other non-forfeiture options. Policyowners can surrender the policy for any cash value. They can also use the cash value to continue the death benefit as term insurance for a limited period of time or purchase a completely paid-up policy with a reduced death benefit.
Fixed Universal Life Insurance
Universal life insurance – commonly referred to as “UL” – was a new type of life insurance introduced in the late 1970’s. These policies were unique because they offered significant flexibility in both the premiums paid and in death benefit options. Unlike whole life that offered a guaranteed death benefit with guaranteed cash value for a guaranteed premium, UL allowed policyowners to choose the premium to pay (within certain limits), when to pay it, and gave them the option to increase or decrease the death benefit, or even select a death benefit that could increase each year. These early UL policies were all based on “current assumptions.” This means that the performance of the policy depends on the interest rate credited to the policy as well as the current charges assessed against the policy.
Today, there are different types of UL products on the market. Current assumption type UL policies are still offered, but now there are also policies that offer death benefits that are guaranteed regardless of the interest rate credited or the policy charges assessed, provided a required premium is paid. In addition, policies are now designed to meet different market needs. Some are designed to focus on affordable death benefit protection while others may focus on accumulating cash value. Details on different types of UL policies are covered in the modules below.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 10
Variable Life And Variable Universal Life Insurance
With the fixed whole life and universal life policies discussed above, the insurance company invests the part of the premiums not used to pay claims and expenses. The policy cash value is part of this general investment account. But, in a variable life (VL) or variable universal life (VUL), the premiums that are not needed to support the policy are invested in “subaccounts” selected by the policyowner.
Subaccounts are typically special mutual fund accounts designed to be used in variable life and annuity products. Just like regular mutual funds, these investment vehicles have specific investment objectives (e.g., growth or income) and different risk profiles. This means that some of the subaccounts may offer higher potential growth, but correspondingly higher risk, while others may be less risky but have lower growth potential. The policyowner controls how to allocate premium payments among the subaccount choices. This means that if the accounts perform well, the policyowner may have relatively high cash value, but if the accounts don’t perform well, the policyowner may have low, or even no, cash value. Thus, the payment of a premium generally does not guarantee that the death benefit will be there when needed. These products are also evolving. Today some variable policies are offering certain guarantees even if the subaccounts have performed poorly. There may be a separate cost for this guarantee feature.
Survivorship Universal Life Insurance
In some situations, primarily estate planning, it is desirable to have the death benefit paid at the second death of two people. Survivorship life insurance was created for this purpose. Because it insures two lives but only pays one death benefit at the second death, these policies are often known as “second-to-die” life insurance policies. Universal life is the most common type of survivorship policy but some whole life versions also are sold.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 11
Module 2 – Fixed Universal Life Insurance
Universal life insurance first came to the market place in the late 1970’s. It offered more flexibility than whole life insurance polices – flexibility in both death benefit options and premium payments. However, to accomplish this increased flexibility, the policy design was significantly more complicated than whole life insurance.
Unlike someone who owns a whole life policy, the owner of UL has the option to:
• Increase or decrease the initial specified amount. The specified amount is the amount of death benefit applied for. Increases in the death benefit are generally subject to new underwriting requirements.
• Increase or decrease the amount of premium paid, and under certain circumstances, skip premium payments.
• Vary the frequency of premium payments.
• Change the type of death benefit option (level or increasing) provided under the policy. Increases in the death benefit are generally subject to new underwriting requirements.
UL will be explored in detail in this module. At the end of the module you should have an understanding of the product design and functionality as well as its features.
Death Benefits
Universal life death benefits are very flexible. The policyowner has different options to select from and may also increase and decrease the specified amount of insurance. Increases in the specified amount require additional underwriting, however.
In general, most UL products offer at least 2 death benefit options – a level death benefit and an increasing death benefit.
The level death benefit is called either Option 1 or Option A. The increasing death benefit is called either Option 2 or Option B.
UL Level Death Benefit UL Increasing Death Benefit Option 1 or A Option 2 or B 150000
t
i
f t 150000
i
e
f
n
e
e n 100000
e
B
B
h
t 50000
h
a 50000
t
e a
e
D
0 D 0 0 5 10 15 20 Year 5 10 15 Years Years
Death Benefit Net Cash Surr Value Death Benefit Net Cash Surr Value
The first diagram is the level death benefit option. Notice that the total death benefit includes the cash value in the policy and that the “pure” death benefit amount at risk decreases as the cash value increases.
However, in the second diagram, the total death benefit includes the original specified amount of death benefit (e.g., $100,000) plus an amount that equals the cash value in the policy. So the death benefit in the second example equals $100,000 plus any cash
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 12
value that exists at the time of death. Since there is an increasing death benefit, this option will cost the policyowner more to maintain.
The policyowner may also change options after the policy is issued. The diagram below shows a policy that started out as an Option 1 or A and was changed to Option 2 or B.
Change in UL Death Benefit Options Option 1 to Option 2
150000
t
i
f
e
n 100000
e
B
h
t 50000
ea
D 0 0 5 10 15 Year
Below are excerpts from UL illustrations showing Option 1, Option 2 and a change from Option 1 to Option 2. We will discuss illustrations in more detail in a later module.
Option 1 or A Option 2 or B Change from Option 1 to 2
5.40% Interest Rate 5.40% Interest Rate 5.40% Interest Rate Nonguaranteed Basis** Nonguaranteed Basis** Nonguaranteed Basis**
Total Annual Total Annual Total Annual Net Cash Net Cash Net Cash Premium Net Policy Death Premium Net Policy Death Premium Net Policy Death Surrender Surrender Surrender Outlay Paid Value Benefit Outlay Paid Value Benefit Outlay Paid Value Benefit Value Value Value Annually Annually Annually 1,100.00 972 564 100,000 1,100.00 972 564 100,972 1,100.00 972 564 100,000 1,100.00 1,985 1,169 100,000 1,100.00 1,983 1,167 101,983 1,100.00 1,985 1,169 100,000 1,100.00 3,042 1,818 100,000 1,100.00 3,038 1,814 103,038 1,100.00 3,042 1,818 100,000 1,100.00 4,156 2,514 100,000 1,100.00 4,149 2,517 104,149 1,100.00 4,156 2,514 100,000 1,100.00 5,308 3,528 105,308 1,100.00 5,320 3,540 100,000 1,100.00 5,320 3,540 100,000 1,100.00 6,529 4,838 106,529 1,100.00 6,547 4,856 100,000 1,100.00 6,547 4,856 100,000 1,100.00 7,816 6,217 107,816 1,100.00 7,842 6,243 100,000 1,100.00 7,842 6,243 100,000 1,100.00 9,161 7,657 109,161 1,100.00 9,197 7,693 100,000 1,100.00 9,197 7,693 100,000 1,100.00 10,578 9,173 110,578 1,100.00 10,627 9,222 100,000 1,100.00 10,627 9,222 100,000 1,100.00 12,059 10,758 112,059 1,100.00 12,124 10,823 100,000 1,100.00 12,124 10,823 100,000 1,100.00 13,621 12,427 113,621 1,100.00 13,702 12,508 101,578 1,100.00 13,703 12,509 100,000 1,100.00 15,266 14,184 115,266 1,100.00 15,366 14,284 103,242 1,100.00 15,370 14,288 100,000 1,100.00 17,001 16,036 117,001 1,100.00 17,119 16,154 104,995 1,100.00 17,129 16,164 100,000 1,100.00 18,829 17,985 118,829 1,100.00 18,967 18,123 106,843 1,100.00 18,985 18,141 100,000 1,100.00 20,756 20,038 120,756 1,100.00 20,915 20,197 108,791 1,100.00 20,943 20,225 100,000 1,100.00 22,787 22,201 122,787 1,100.00 22,968 22,382 110,844 1,100.00 23,009 22,423 100,000
Some policies have a third option (3 or C). This is also an increasing death benefit. It increases the death benefit by an amount equal to the total premiums paid rather than increasing by an amount equal to any increase in cash value. Not all UL policies offer Options 2 or 3. Some only offer Option 1, the level death benefit option.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 13
Corridor
Sometimes in later years the cash value grows to within a certain percentage of the death benefit. If this occurs, the death benefit must grow as the cash value grows to maintain a corridor between the two, even if option 1 (level death benefit) was chosen. The amount by which the death benefit must exceed the cash value decreases as the policyowner gets older and is permitted to be zero percent at age 100. That is, the death benefit and the cash value can be equal at age 100. The death benefit corridor typically occurs in policies where high premiums have been paid resulting in high cash value. The images below show what this looks like numerically as well as graphically.
5.40% Interest Rate Nonguaranteed Basis** Total Annual Net Cash Premium Net Policy Death Surrender Outlay Paid Value Benefit Value Death Benefit Corridor Annually 3,000.00 2,835 2,427 100,000 3,000.00 5,814 4,998 100,000 500,000 3,000.00 8,944 7,720 100,000 3,000.00 12,245 10,613 100,000 400,000 3,000.00 15,717 13,937 100,000
3,000.00 19,379 17,688 100,000 300,000 3,000.00 23,242 21,643 100,000 3,000.00 27,303 25,799 105,994 200,000 Corridor 3,000.00 31,575 30,170 118,543 3,000.00 36,059 34,758 130,926 100,000
3,000.00 40,776 39,582 143,194 Cash Value 3,000.00 45,740 44,658 155,404 0 3,000.00 50,964 49,999 167,525 1 3 5 7 9 11 13 15 17 19 21 23 25 3,000.00 56,463 55,619 179,612 3,000.00 62,252 61,534 191,678 Cash Value Death Benefit 3,000.00 68,348 67,762 203,733 3,000.00 74,766 74,317 215,785 3,000.00 81,524 81,218 227,843 3,000.00 88,642 88,486 239,962 3,000.00 96,140 96,140 252,150
3,000.00 104,037 104,037 264,413 3,000.00 112,336 112,336 276,755 3,000.00 121,057 121,057 289,180 3,000.00 130,224 130,224 301,740 3,000.00 139,860 139,860 314,438
Premiums
Unlike term or whole life insurance where a specific premium must be paid by a certain date or the policy may terminate, UL policies have a flexible premium structure. But, while premiums are flexible, the amount of premium paid will impact both the amount of cash value in the policy and how long the policy lasts (the point at which the policy lapses).
Minimum And Maximum Premiums
The law restricts the amount of premium that can be paid into a universal life insurance policy. These maximum limits may vary by policy type and design.
In addition to the maximum premiums established by law, the insurance company may restrict the amount of additional premium that may be paid into a policy that is already issued. Therefore, before large sums are sent to the insurance carrier for deposit into a UL policy, the carrier should be contact to find out what limits may apply.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 14
While universal life insurance policies do have maximum premium levels, there really isn’t a minimum premium for a universal life policy. The company needs to receive sufficient premium to put the policy in force. But, after that, the policyowner has a certain degree of flexibility as to when and how much premium to pay. Within certain limits, the policyowner may increase, decrease and even skip premium payments.
Sound simple? Well, it isn’t simple at all. As will be explained, if the policyowner doesn’t pay sufficient premiums to cover the fees and other charges in the policy, the policy may lapse.
And if the policy has a death benefit guarantee, a specified premium paid by a specified date is required to keep the guarantee. The policyowner can pay more than the required premium for the guarantee, but paying less may shorten or void the guarantee. Premium requirements for secondary death benefit guarantees will be discussed later.
Target Premium
Insurance brokers and agents are compensated for their sales efforts by receiving commissions. The commission on a UL policy is usually a flat percentage of the premium up to a certain level known as the target premium. The target premium is different for different products and carriers. For first year premium amounts in excess of the target premium, a smaller commission percentage is paid.
Some insurance companies pay commissions based on a rolling target premium. This means that if the first year premium does not equal or exceed the target premium, the agent will receive the balance of the first year target commission when the premium is paid in the second year until the target premium is reached.
Policy Fees And Other Policy Charges
All fees and charges are spelled out in the policy. The fees are necessary to cover the cost of issuing the policy, to support the policy administration and to cover the risk that the insured may die (mortality costs).
Most fees are fixed and guaranteed for a specific period or for the life of the policy and will not change. They may take the form of:
• Flat monthly deductions for the life of the policy;
• Percentage of premiums paid;
• Fee for a limited period of time.
Fees associated with mortality are known as “cost of insurance” charges (COI). These are based on the age, gender and risk class of the insured and will increase as the insured gets older. The COI charges and the amount by which they will increase is not guaranteed. That means the amount currently charged at each age and for each risk class could go up in the future. The charges are based on the mortality assumptions used when the product was designed. If future mortality is much worse than assumed, the insurance company reserves the right to increase these costs. However, the insurer can only increase them up to a certain maximum which is stated in the policy. And, any increase must apply to all policies using the same policy form; no individual policyowner can be singled out for this type of increase.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 15
COI charges are assessed monthly against the net amount at risk. This is the amount of the total death benefit that exceeds any cash value.
Cost of Insurance $100,000 For example, assume that a $100,000 policy
$75,000 has $27,500 of cash value and the monthly Net Amount At Risk = $72,500 policy charge for this insurance is $.36 per $50,000 COI = .36 x 72.5 = $26.10 thousand of death benefit. The net amount $25,000 at risk is:
$0 $100,000 – 27,5000 = $72,500 0 5 10 15 20 Years The cost of insurance charge deducted that Death Benefit Net Cash Surr Value month will be $26.10 (72.5 x .36).
Cash Value
Premiums Are The Primary Driver of Cash Value
A UL policy can have cash value. To have cash value, the accumulated premiums paid by the policyowner must be greater than the deductions for fees and cost of insurance. Think of it as a bucket. The premium goes into the bucket and the monthly policy fees and COI charges come out of the bucket. If the premiums paid, plus interest credited to the cash value, are greater than the monthly deductions, there will be cash value in the bucket. If monthly deductions are greater than the premium paid plus any interest credited, then the excess amount will be deducted from any policy cash value.
Premiums Fees/COI
If there is cash value in the policy, the company will credit it with interest. The policy guarantees that the interest credited to the policy cash value will never drop below a certain amount, such as 3% (depending on the policy form). But, the actual interest credited may be higher and will vary over time based on the results of the company’s own investment portfolio.
The bottom line – if the policyowner only pays low (minimal) premiums into the policy, eventually the COI charges, plus other fees, will be likely exceed the premium levels and credited interest. Over time, cash value will be depleted. If the policyowner doesn’t increase the premium levels to cover these increasing charges, the policy will eventually lapse.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 16
On the other extreme, if a policyowner pays in premiums much higher than needed to cover the policy charges, the cash values plus accruing interest may grow significantly. In later years, if cash value is sufficient, the policyowner may be able to skip or even stop making out of pocket premium payments without lapsing the policy.
Cash Surrender Value and Surrender Penalties
The policyowner can access cash value either through policy surrender, policy loans or withdrawals. The amount that the policyowner may receive is limited to the total cash value less a surrender penalty.
The surrender penalty is designed to discourage the early surrender of the policy and, in the case of early surrender, to help the insurance carrier recoup some of the initial costs associated with underwriting and issuing the policy. The surrender penalty will vary by product. But, generally, the penalty is highest in the early years and declines until it reaches zero. The length of the surrender penalty period will also vary from product to product, but 15 to 20 years is not unusual.
Policy Loans
With policy loans, the policyowner can access policy values when needed. The policy values become the collateral for the loan. When the insured dies, any outstanding loan balance is paid out of the death proceeds and the remaining balance is then paid to the policyowner’s beneficiary.
The insurance company charges interest on the policy loans. The interest is specified in the life insurance policy. 8% is a typical interest rate. Some products credit interest to the policy cash values that equal the outstanding policy loan. This makes the net cost of the loan less.
For example, let’s assume that a life insurance policy charges 8% on policy loans, but continues to credit the cash values associated with that loan with the guaranteed interest rate of 3%. The “net” impact would be that the loan is costing the policyowner 5%.
Policy loans are different than loans from lending institutions. Banks require borrowers to make regular cash payments to reduce the amount of their loan. However life insurance policy loans can remain outstanding until the policy is either surrendered or the insured dies. In addition interest charged on a policy loan does not have to be paid in cash, although the policyowner may choose to do this. Rather, the interest can continue to accumulate and add to the outstanding loan balance (and increase the interest due). However, if the policy loan, plus accumulated interest, ever exceeds the policy cash surrender value, the policy may lapse. Also the outstanding loan will be deducted from the death benefit, reducing the amount received by the beneficiaries.
Withdrawals
A policyowner in need of money may choose to withdraw money from the cash surrender value. This money reduces the cash value in the policy, but does not have to be paid back and no interest is charged on this amount. Withdrawals from the policy cash value will reduce the death benefit in most cases. Withdrawals can also impact whether or not the policy will remain in force in the future. If the policyowner makes significant withdrawals, the level of premium payments may need to be increased to ensure sufficient dollars are in the policy to cover the monthly fees and charges.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 17
Grace Period
If at any point the cash surrender value, plus interest, is insufficient to cover the monthly deductions for fees and cost of insurance, then the policy will enter the grace period. Once in the grace period, the policyowner has 61 or 62 days (depending on the policy) to send the company sufficient money to cover these charges or the policy will lapse. So, although the policyowner has flexibility in the amount and timing of the premium payments, if too little premium is paid into the policy, if too many premiums are skipped, or if interest rates drop significantly from what was assumed, the policy will not have sufficient cash value to cover the monthly charges and the policy will eventually lapse.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 18
Module 3 – Basic Illustrations
Because of the complexity and flexibility of universal life insurance, computer illustrations of policy values and assumptions have become commonplace. This module will take you through the requirements for illustrations used to sell universal life insurance.
Compliant Illustrations
Most states have adopted some form of the NAIC (National Association of Insurance Commissioners) model regulation on life insurance illustrations. These laws require that fixed universal life insurance policies be sold using an illustration that meets certain state requirements.
These illustrations must be signed by the policyowner and the broker and submitted with the application. Alternatively, a broker may use a “no illustration certificate” that the policyowner signs stating that no illustration was used in the sales process. If the “no illustration certificate” is used, then a signed illustration must be part of the policy delivery requirements.
Even if an illustration was signed when the application was taken, a new illustration may be required any time the issued policy doesn’t match the original illustration. This could happen if: • The policy is issued other than as applied for (e.g., a different rate class due to a health condition); or • The policyowner requests to change the amount or type of coverage during the underwriting process
The purpose of the illustration laws is to make sure that the consumer has all the necessary information to make an informed purchasing decision, including the ability to see how the policy will perform under certain conditions. For this reason, we require signed illustrations even if the policy is being applied for in a state that has not adopted some version of the model illustration legislation.
For the company, the illustrations serve another purpose. They help the new business and underwriting departments understand what the client is applying for and how much and how often the client expects to pay premiums (the premium pattern).
Parts of a Life Insurance Illustration
There are three basic parts to the illustration – the Narrative Summary, the Numeric Summary and the Tabular Detail.
The narrative summary describes the life insurance policy and discusses various features of the policy. It also explains certain premium levels.
The numeric summary shows how the planned premium will impact the guaranteed and non-guaranteed elements of the policy and estimates how long the policy will stay in force using the assumptions shown. This is the page that the applicant and broker are required to sign.
The tabular detail provides a year-by-year look at the policy premiums, cash values and death benefit on both a current assumption and guaranteed basis and shows any resulting changes in premium payments, cash value and death benefit.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 19
Current Assumptions Versus Guaranteed Features
A basic UL policy has very few guarantees. In fact, the guarantees that exist do not guarantee that the policy will have cash value or a death benefit. The only guarantees in the policy are the: • Stated policy fees; • Maximum Cost of Insurance (COI) charges; and • Minimum interest crediting rate on any cash value that does exist
Yet, UL policies are often illustrated based on “current assumptions” – that is, the illustration assumes that the current (not guaranteed) interest rate is credited and the current COI charges (not the possible maximum) are deducted.
However, the model illustration regulations require that illustrations also show what would happen to policy value and death benefit if only the minimum interest rate was credited and the maximum COI charge was deducted. Below is an example of a numeric summary highlighting the differences between current assumptions and guarantees. You should note that this page shows three different scenarios; fully guaranteed, midpoint assumptions (non-guaranteed) and current assumptions (non-guaranteed). The last row of the chart shows the estimated year of lapse under these various assumptions.
Assumes current non-
guaranteed interest is credited
Male, Age 30 and current non- guaranteed COI Preferred Best No Nicotine Use charges are assessed throughout
Initial Assumptions: the life of the policy. Initial Specified Amount: $100,000 Death Benefit Option: 1 Assumes Initial Planned Premium Outlay: $443.00 Annually minimum guaranteed 3.00% Interest Rate 4.20% Interest Rate 5.40% Interest Rate interest is Guaranteed Basis Nonguaranteed Midpoint Basis Nonguaranteed Basis credited and Cumulative Net Cash Cumulative Net Cash Cumulative Net Cash Death Death Death Year Premium Surrender Premium Surrender Premium Surrender maximum Benefit Benefit Benefit COI charges Outlay Value Outlay Value Outlay Value 5 2,500 0 100,000 2,500 0 100,000 2,500 256 100,000 are assessed. 10 5,000 1,602 100,000 5,000 2,383 100,000 5,000 3,246 100,000 20 10,000 5,145 100,000 10,000 8,250 100,000 10,000 11,932 100,000 Age 70 17,000 0 0 20,000 10,769 100,000 20,000 42,122 100,000 Age 100 17,000 0 0 23,000 0 100,000 35,000 199,213 199,213 Age Policy 64 76 Not prior to age 100 Lapses*
* The policy will end during this policy year unless a higher premium is paid
Assumes that a non-guaranteed interest rate that is half way between the guaranteed and current is credited to the policy. Also, assumes that a COI charge half way between the guaranteed maximum and the current COI is assessed.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 20
After the Numeric Summary in the illustration is the Tabular Detail showing the fully guaranteed and the current assumption for all years.
Flexible Premium Adjustable Life Insurance Basic Illustration for: John Doe - Age 30, Male, Preferred Best No Nicotine Use, $100,000 (Prepared by: Joe Agent)
Tabular Basis Detail - Yearly Values and Benefits>> 3.00% Interest Rate 5.40% Interest Rate Guaranteed Basis Nonguaranteed Basis**
Total Annual Total Annual Net Cash Net Cash Premium Net Policy Premium Net Policy Death Year Age Surrender Death Benefit Surrender Outlay Paid Value Outlay Paid Value Benefit Value Value Annually Annually 26 56 500.00 5,024 5,024 100,000 500.00 18,511 18,511 100,000 27 57 500.00 4,766 4,766 100,000 500.00 19,775 19,775 100,000 28 58 500.00 4,416 4,416 100,000 500.00 21,090 21,090 100,000 29 59 500.00 3,959 3,959 100,000 500.00 22,460 22,460 100,000 30 60 500.00 3,378 3,378 100,000 500.00 23,889 23,889 100,000
31 61 500.00 2,653 2,653 100,000 500.00 25,381 25,381 100,000 32 62 500.00 1,766 1,766 100,000 500.00 26,940 26,940 100,000 33 63 500.00 694 694 100,000 500.00 28,562 28,562 100,000 34 64 0.00 * 0 + 0 + 0 + 500.00 30,252 30,252 100,000 35 65 0.00 * 0 0 0 500.00 32,023 32,023 100,000
36 66 0.00 * 0 0 0 500.00 33,865 33,865 100,000 37 67 0.00 * 0 0 0 500.00 35,791 35,791 100,000 38 68 0.00 * 0 0 0 500.00 37,808 37,808 100,000 39 69 0.00 * 0 0 0 500.00 39,916 39,916 100,000 40 70 0.00 * 0 0 0 500.00 42,122 42,122 100,000
41 71 0.00 * 0 0 0 500.00 44,420 44,420 100,000 42 72 0.00 * 0 0 0 500.00 46,812 46,812 100,000 43 73 0.00 * 0 0 0 500.00 49,316 49,316 100,000 44 74 0.00 * 0 0 0 500.00 51,935 51,935 100,000 45 75 0.00 * 0 0 0 500.00 54,682 54,682 100,000
46 76 0.00 * 0 0 0 500.00 57,558 57,558 100,000 47 77 0.00 * 0 0 0 500.00 60,580 60,580 100,000 48 78 0.00 * 0 0 0 500.00 63,763 63,763 100,000 49 79 0.00 * 0 0 0 500.00 67,112 67,112 100,000 50 80 0.00 * 0 0 0 500.00 70,650 70,650 100,000 ** Actual results may be more or less favorable than those illustrated.
Below is the numeric summary, again. Note that this time we have lowered the current crediting rate to 3% to match the guarantee rate. This allows us to independently show how charging the maximum COI impacts policy values.
Male, Age 30 Preferred Best No Nicotine Use
Initial Assumptions: Initial Specified Amount: $100,000 Death Benefit Option: 1 Initial Planned Premium Outlay: $443.00 Annually
3.00% Interest Rate 3.00% Interest Rate 3.00% Interest Rate Guaranteed Basis Nonguaranteed Midpoint Basis Nonguaranteed Basis Cumulative Net Cash Cumulative Net Cash Cumulative Net Cash Death Death Death Year Premium Surrender Premium Surrender Premium Surrender Benefit Benefit Benefit Outlay Value Outlay Value Outlay Value 5 2,500 0 100,000 2,500 0 100,000 2,500 107 100,000 10 5,000 1,602 100,000 5,000 2,124 100,000 5,000 2,643 100,000 20 10,000 5,145 100,000 10,000 7,072 100,000 10,000 8,967 100,000 Age 70 17,000 0 0 20,000 4,078 100,000 20,000 20,943 100,000 Age Policy 64 73 94 Lapses*
* The policy will end during this policy year unless a higher premium is paid
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 21
Notice that when we drop the crediting rate to the guaranteed level while continuing to show the current COIs, we get quite a different picture. Charging current COIs added 30 years to the point where the policy lapses. Conversely, this clearly shows the impact on the policy if the guaranteed COI charges were assessed from policy inception.
Remember that although an insurance company can raise the COI charges above what it is currently charging, it should not need to do this if it maintains a solid risk management discipline by ensuring that underwriting practices match up with its product pricing. And, if a company does decide to raise its COI rates, it may not find it necessary to raise them to the maximum. However, even a modest increase in the COI rates can impact policy performance.
Prospective policyowners who are concerned about possible increases in COI charges or reductions in crediting interest rates should consider a universal life insurance policy that has a guaranteed death benefit feature. These types of UL policies are covered in the next module.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 22
Module 4 – Fixed UL with “Secondary Guarantees”
Lifetime Guarantee* Universal Life This module assumes the reader has completed Module 2 – Fixed Universal Life Insurance
As we have seen in the previous modules, the flexibility of universal life insurance policies comes with some risks. Policyowners may choose to pay different premium levels for the same death benefit, or stop and start premiums as their financial situation changes. But, if at any time, the cash value in these policies is insufficient to pay the monthly deductions, the policy may lapse unless the policyowner sends in additional money. Therefore, although the policy has premium flexibility, paying consistently low premiums may not be sufficient to keep the policy in force or to counter the impact of fluctuating interest rates or possible increases in charges for the cost of insurance (COI).
To counter these risks, many of today’s UL polices offer a guaranteed death benefit for some specified period of time or for life. These guaranteed death benefits are known as “secondary guarantees.” They are also referred to as no-lapse guarantees or lifetime guarantees.
This feature guarantees the existence of a death benefit even if the cash value in the policy is not sufficient to cover the monthly deductions, provided certain conditions are met. [NOTE: This is different than a pure current assumption policy that requires cash value (or additional premium) to keep the policy in force.] To keep the guarantee, the policyowner must pay a specific premium and pay it by the premium due date. If premiums are missed or paid late, the length of the death benefit guarantee period may be shortened. In some cases, the guarantee may actually terminate. Using the withdrawal or policy loan features may also shorten or terminate the guarantee.
NOTE: Some companies allow 30 days from the due date to receive premiums with no impact on the lifetime guarantee.
* Lifetime guarantee is a long-term conditional guarantee that can keep the policy in force when policy values are too small to do so. Certain policy rights, if exercised by the Owner, will end this guarantee. In addition, an unpaid loan may terminate coverage.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 23
In the illustration excerpt below, notice how the death benefit continues on the guaranteed side even though there is no cash value to pay the monthly deductions. This is true even though the maximum COI is being charged and the minimum interest rate is being credited.
Flexible Premium Adjustable Life Insurance Basic Illustration for: John Doe - Age 30, Male, Preferred Best No Nicotine Use, $100,000 (Prepared by: Joe Agent)
Tabular Basis Detail - Yearly Values and Benefits>> 3.00% Interest Rate 5.2% Interest Rate Guaranteed Basis Nonguaranteed Basis**
Total Annual Total Annual Net Cash Net Cash Premium Net Policy Death Premium Net Policy Death Year Age Surrender Surrender Outlay Paid Value Benefit Outlay Paid Value Benefit Value Value Annually Annually 26 56 443.00 1,986 1,986 100,000 443.00 13,441 13,441 100,000 27 57 443.00 1,543 1,543 100,000 443.00 16,360 16,360 100,000 28 58 443.00 999 999 100,000 443.00 15,308 15,308 100,000 29 59 443.00 335 335 100,000 443.00 16,285 16,285 100,000 30 60 443.00 0 0 100,000 443.00 17,295 17,295 100,000
31 61 443.00 0 0 100,000 443.00 18,338 18,338 100,000 32 62 443.00 0 0 100,000 443.00 19,419 19,419 100,000 33 63 443.00 0 0 100,000 443.00 20,528 20,528 100,000 34 64 443.00 0 0 100,000 443.00 21,680 21,680 100,000 35 65 443.00 0 0 100,000 443.00 22,865 22,865 100,000
36 66 443.00 0 0 100,000 443.00 24,089 24,089 100,000 37 67 443.00 0 0 100,000 443.00 25,353 25,353 100,000 38 68 443.00 0 0 100,000 443.00 26,661 26,661 100,000 39 69 443.00 0 0 100,000 443.00 28,016 28,016 100,000 40 70 443.00 0 0 100,000 443.00 29,404 29,404 100,000
The corresponding excerpt from the numeric summary shows that the death benefit is guaranteed to last for life under the illustrated premium pattern.
Initial Assumptions: Initial Specified Amount: $100,000 Death Benefit Option: 1 Initial Planned Premium Outlay: $443.00 Annually
3.00% Interest Rate 4.075% Interest Rate 5.20% Interest Rate Guaranteed Basis Nonguaranteed Midpoint Basis Nonguaranteed Basis Cumulative Net Cash Cumulative Net Cash Cumulative Net Cash Death Death Death Year Premium Surrender Premium Surrender Premium Surrender Benefit Benefit Benefit Outlay Value Outlay Value Outlay Value 5 2,215 0 100,000 2,215 0 100,000 2,215 228 100,000 10 4,430 1,948 100,000 4,430 2,461 100,000 4,430 3,235 100,000 20 8,860 3,046 100,000 8,860 5,636 100,000 8,860 8,641 100,000 Age 70 17,720 0 100,000 17,720 1,734 100,000 17,720 29,404 100,000 Age 100 31,010 0 100,000 31,010 0 100,000 31,010 81,214 100,000 Age 120 31,010 0 100,000 31,010 0 100,000 31,010 221,727 210,867 Age Policy Not prior to age 120 Not prior to age 120 Not prior to age 120 Lapses
Let’s change the premium just a little and see what happens to the guarantee. We dropped the premium only $43 per year. The impact is clear – the death benefit is guaranteed to last until the insured is only 69, rather than for life as above. This emphasizes the importance of paying the specific premium in order to maintain the
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 24
guaranteed death benefit. A lower premium results in a lapse in the death benefit (on a guaranteed basis) in year 40 when the insured is only 69.
Initial Assumptions: Initial Specified Amount: $100,000 Death Benefit Option: 1 Initial Planned Premium Outlay: $400.00 Annually
3.00% Interest Rate 4.075% Interest Rate 5.20% Interest Rate Guaranteed Basis Nonguaranteed Midpoint Basis Nonguaranteed Basis
Cumulative Net Cash Cumulative Net Cash Cumulative Net Cash Death Death Death Year Premium Surrender Premium Surrender Premium Surrender Benefit Benefit Benefit Outlay Value Outlay Value Outlay Value 5 2,000 0 100,000 2,000 0 100,000 2,000 0 100,000 10 4,000 1,471 100,000 4,000 2,056 100,000 4,000 699 100,000 20 8,000 1,901 100,000 8,000 4,358 100,000 8,000 7,210 100,000 Age 70 15,600 0 100,000 15,600 0 100,000 15,600 23,806 100,000 Age Policy 69 69 99 Lapses
This raises a critical question. Since UL is a flexible premium policy, what happens to the guaranteed death benefit if the policyowner varies the amount and timing of his premium payments?
A policyowner still has the flexibility to vary the premium and the amount. But, if premiums are less than required for the lifetime guarantee, or if premiums are paid late, the policyowner may jeopardize the length of the guaranteed period. And, in some cases, the guarantee may actually terminate. It is very important for the policyowner to understand this point.
Catch-Up Provisions
If a lifetime guarantee is shortened because payments are inadequate or late, catch-up provisions in the policy allow the policyowner to pay back premiums, plus interest, to bring the lifetime guarantee back. Depending on the policy language, this catch-up feature may last for the life of the policy or only for a limited number of years.
In other words, if the catch-up feature is available for three years, policyowners have only three years from the time they fell behind, to pay the back premiums. However, if the catch- up feature is for the life of the policy, policyowners can pay the back premiums, plus interest, throughout the life of the policy to restore the lifetime guarantee.
Note that the catch-up provision cannot be used if the policy’s death benefit guarantee has actually terminated. The death benefit guarantee may terminate if the:
• Loan balance exceeds the policy’s cash surrender value;
• Policyowner increases the specified amount of death benefit;
• Policyowner changes the level death benefit option to an increasing option
• If the policy lapses (reinstating the policy will not reinstate the death benefit guarantee)
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 25
Grace Period And Secondary Death Benefit Guarantees
As noted in an earlier module, the grace period on a UL policy is not tied to the premium payments. Rather, it starts when the cash surrender value of the policy is insufficient to pay the monthly fees and charges.
However, when the UL policy also has a secondary death benefit guarantee, then the grace period doesn’t start until BOTH:
• The cash surrender value is insufficient to pay the monthly fees and charges; AND
• The secondary death benefit guarantee is no longer active.
Flexible Premium Adjustable Life Insurance Basic Illustration for: John Doe - Age 45, Male, Preferred Best No Nicotine Use, $100,000 (Prepared by: Joe Agent)
Tabular Basis Detail - Yearly Values and Benefits>>
3.00% Interest Rate 4.50% Interest Rate Guaranteed Basis Nonguaranteed Basis**
Total Annual Total Annual Net Cash Net Cash Premium Net Policy Death Premium Net Policy Death Year Age Surrender Surrender Outlay Paid Value Benefit Outlay Paid Value Benefit Value Value Annually Annually
26 71 0.00 0 0 100,000 0.00 10,811 10,811 100,000 27 72 0.00 0 0 100,000 0.00 10,584 10,584 100,000 28 73 0.00 0 0 100,000 0.00 10,278 10,278 100,000 29 74 0.00 0 0 100,000 0.00 9,890 9,890 100,000 30 75 0.00 0 0 100,000 0.00 9,393 9,393 100,000
31 76 0.00 0 0 100,000 0.00 8,778 8,778 100,000 32 77 0.00 0 0 100,000 0.00 8,039 8,039 100,000 Grace Period 33 78 0.00 0 0 100,000 0.00 7,155 7,155 100,000 doesn’t start 34 79 0.00 0 0 100,000 0.00 6,104 6,104 100,000 35 80 0.00 0 0 100,000 0.00 4,851 4,851 100,000 here.
36 81 0.00 0 0 100,000 0.00 3,380 3,380 100,000 37 82 0.00 0 0 100,000 0.00 1,635 1,635 100,000 38 83 0.00 0 0 100,000 0.00 0 0 100,000 39 84 0.00 0 0 100,000 0.00 0 0 100,000 40 85 0.00 0 0 100,000 0.00 0 0 100,000
41 86 0.00 0 0 100,000 0.00 0 + 0 100,000 Grace Period + The policy will, end during this policy year unless a higher premium is paid. ** Actual results may be more or less favorable than those illustrated. The benefits and values are not guaranteed. The assumptions on which they are based starts here. are subject to change by the insurer. >> Premiums shown are paid during the policy year, at the beginning of each payment period. Cash surrender values show are end-of-year values. Death Benefits shown are beginning-of-year values.
In the example above, you can clearly see that the death benefit continued even though the cash value was exhausted. This shows that the lifetime guarantee was still active on this policy. But, in policy year 41, the lifetime guarantee ended. Since there is no cash value to cover the monthly deductions and the lifetime guarantee has ended, the policy will enter the grace period. If additional premiums sufficient to cover the monthly deductions are not paid, the policy will lapse at the end of the grace period.
Summary
Lifetime guarantee policies provide long-term death benefit protection at a guaranteed premium. They remove the risks associated with current assumption policies where policy values can be adversely impacted by declines in interest crediting rates and increases in cost of insurance charges. However, these policies require the policyowner to pay the specified premium and pay it on time. Failure to meet this requirement, as well as taking policy loans or withdrawals, can adversely impact the lifetime guarantee on the policy.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 26
Module 5 – Basics of Life Insurance Taxation
This module will cover some basic information on the income, estate and gift taxation of life insurance. This topic is extensive and can’t possibly be covered in depth in this module. However, at the end of the module, you should have a basic working knowledge of life insurance taxation.
Federal Income Taxation of Death Benefits
One of the key benefits of life insurance is that the death benefits are generally received by the beneficiary income tax free. This is a significant benefit that enhances the value of purchasing life insurance. While most death benefits are income tax free, there are exceptions that will be covered later.
In addition to the benefits paid when the insured dies, some life insurance policies will allow the policyowner to take a portion of death benefits before the insured has died if the insured is either terminally ill or chronically ill. For these early benefits to be received income tax free, they must meet certain requirements.
• Benefits for the terminally ill are defined in the Internal Revenue Code as those paid to an insured when death is expected within 24 months. Most life insurance policies that provide accelerated death benefits for the terminally ill will only pay these benefits if death is expected within 6 or 12 months.
• To meet the definition of chronically ill the Internal Revenue Code says that the insured must be certified by a doctor as unable to perform two or more activities of daily living (which include eating, toileting, transferring, bathing, dressing and continence) and these limitations are expected to continue for at least 90 days. Benefits are also payable if the insured suffers from a severe cognitive impairment.
Life Insurance Owned by And Payable to Employer
Death benefits paid under a life insurance policy that is owned by and payable to an employer will be received income tax free by the business only if the employer complies with certain requirements. The first requirement is that the employee must be notified that the employer intends to purchase insurance on the employee’s life and the employee must consent to be insured. In addition, the death benefits will remain income tax free only if the policy falls within one of four categories, known as “safe harbors.” Finally, the employer must comply with certain annual reporting requirements.
The safe harbors are:
1. The insured must have been employed by the employer at any time during the 12 months preceding the insured’s death;
2. At the time of issue, the insured either:
• Earned $95,000 or more, or
• Was a director, a 5% or greater owner, one of the 5 highest-paid officers, or one of the highest-paid 35% of employees of the business;
3. The death benefit proceeds are paid to a spouse, parent, grandparent, child, grandchild, brother, sister, an individual other than the business named by the insured, a trust set up for any such person, or the insured’s estate; or
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 27
4. The business uses the death benefit proceeds to purchase an interest in the business from one of the people listed above.
Transfers for Valuable Consideration
There are other times when the death benefit may not be paid income tax free. These situations generally fall under a provision known as the Transfer for Value Rule. These complex rules are covered only briefly here.
The transfer for value rule states that death benefits paid will not be income tax free if some interest in the policy is transferred for valuable consideration, unless the transfer meets a series of exceptions. A transfer of an interest in a policy can take many forms, but the most common is the transfer of the policy’s ownership. But, the transfer of the interest in the policy alone is not sufficient to cause the death benefits to be taxed. The transfer must be accompanied by some valuable consideration. That is, the transferor must receive something of value in exchange for making the transfer.
For example: Joe, the insured, has a life insurance policy with a death benefit of $250,000 and a cash value of $55,000. Joe changes the ownership of the policy to Mike in exchange for $55,000. Both a transfer and the receipt of something of value occurred. Therefore, when the insured dies, the death benefit paid will not be entirely income tax free. Assume that Mike paid 2 additional premiums of $2,000 (total of $4,000) before the insured died. An amount equal to the total premiums paid by Mike plus the amount he paid to Joe will be received income tax free. The balance of the death benefit, $191,000 ($250,000 – [$4,000 + $55,000]) will be subject to income tax.
There are some exceptions to the transfer for value rule. The four main exceptions state that if a transfer is made in exchange for something of value, the death benefit will remain income tax free if the transfer is made to:
• The insured;
• A partner of the insured;
• A partnership where the insured is a partner; or
• A corporation where the insured is an officer or shareholder.
Another exception, known as the basis exception, is used when someone wants to transfer a policy that is a part gift and a part sale. Discussion of this exception is beyond the scope of this material.
Federal Income Taxation of Cash Value
Life insurance policy cash value provides a source of funds for the policyowner if money is needed to meet an emergency or an opportunity. These cash values also have the added benefit of being income tax deferred. That is, any interest credited to the cash value in the policy is not taxed unless the cash value is removed from the policy. The following summary of the taxation of cash value applies only to policies that are not modified endowments (see section on modified endowments below).
If the policyowner surrenders the policy, the cash received will be included in the policyowner’s taxable income to the extent that the amount of the cash exceeds the policyowner’s basis in the policy. Basis is generally the sum of the premiums paid,
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 28
reduced by the cost of any riders and any prior withdrawals or policy loans (NOTE: other adjustments to basis may be required for dividend paying policies).
For example: Kathy has a universal life insurance policy with an annual premium of $2,000. She has had the policy for 10 years. The policy has no riders and she has never borrowed from the policy or made a withdrawal of any of the cash value. She decides to surrender the policy when the cash value equals $30,000. Kathy’s basis in the policy is the sum of the premiums paid, $20,000 (10 x $2,000). She will have to pay income tax on $10,000 ($30,000 - $20,000).
If the policyowner makes a withdrawal from the policy, there will be no income tax payable until the amount of the withdrawal exceeds the amount of the basis. That is, the policyowner is permitted to withdraw the basis first before taking out the taxable gain.
Example: Kathy decides not to surrender the policy. Instead, she takes a $15,000 withdrawal from the cash value. Because Kathy’s basis, $20,000, is greater than the withdrawal, Kathy will not have to pay taxes on any of the $15,000. But, her basis will now be reduced to $5,000.
If the policyowner borrows money from the life insurance policy, the amount of the loan will not generate any taxable income while the policy remains in force. If the policy lapses or is surrendered, the total amount of the loan will be repaid from the cash value in the policy. The policyowner will be subject to income tax to the extent the total loan, plus cash received, exceeds the policyowner’s basis in the policy.
Example: Kathy decides to borrow from her policy instead of taking a withdrawal. She borrows $12,000. The interest rate on her policy is 8%. Rather than pay the interest, she allows the interest to accrue, creating additional loans. Five years later (after paying five more premiums), the outstanding loan is now $17,632. The total cash value in the policy is now worth $42,000. Kathy then surrenders the policy. The loan is repaid from the cash value leaving a net amount paid to Kathy in cash of $18,368. Her basis is $30,000. $12,000 of the $18,368 that she receives will be subject to income tax. This is calculated by subtracting her basis from the total cash value ($42,000 - $30,000 = $12,000).
Modified Endowment Contracts (MEC)
Some life insurance polices are known as Modified Endowment Contracts (MEC) and are taxed a little differently than non-MEC policies. A MEC is a regular life insurance policy to which very high premiums have been paid during the first seven years of the policy, or the seven years following a material change to the policy. The premium level at which the policy will become a MEC may be different for different policies. You can find this premium amount by reading the narrative summary part of the illustration. This premium level is often referred to as the seven-pay test premium. Once a policy becomes a MEC, it will always be a MEC.
Withdrawals from MEC policies are treated as coming from the growth on the policy first.
Example: Pete has a life insurance policy with $75,000 in cash value. His basis in the policy is $55,000. If Pete takes a withdrawal of $25,000, $20,000 will be subject to income tax and only $5,000 will be tax free as return of basis.
In addition, loans on MEC policies are taxed as withdrawals to the amount of the gain in the policy.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 29
IRC Section 1035 Exchanges
The Internal Revenue Codes (IRC) allows a policyowner to exchange an older policy for a new policy and move the cash value from the older policy to the new policy. The primary advantage of doing this is that it postpones the payment of income taxes on any gain in the cash values and carries over the tax basis from the old policy to the new policy.
Here is an example:
John owns a universal life insurance policy on his own life. He has paid $2,000 per year for 15 years and the cash value in the policy is now worth $40,000. If John surrenders the policy he will have to pay income tax on the amount of the cash value that exceeds his basis (total premiums) in the policy.
$40,000
- 30,000 ($2,000 x 15)
$10,000 of taxable income
However, since John is still healthy and still needs the coverage, he might decide to purchase a new life insurance policy with a more favorable design and have the cash value transferred. By doing this, John doesn’t have to pay any income tax on the growth in the cash value as long as it stays in the new policy. And the $40,000 can be used to offset premiums that would otherwise be paid out-of-pocket on the new policy.
To make use of IRC Section 1035, the policyowner must follow certain steps.
1. Apply for new life insurance
2. Assign the old life insurance policy to the new insurance company
After John has been approved for the new life insurance, the insurance company will surrender the old policy and have the old insurance company send the money to them to put toward John’s new policy.
FOR BROKER/DEALER USE ONLY. NOT TO BE REPRODUCED OR SHOWN TO THE PUBLIC. 30