Module 5

Introduction to Life
Insurance and
Annuities

David Mannaioni CPCU, CLU, ChFC, CFP®

7485
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Table of Contents
Study Plan/Syllabus ................................................................ 1
Learning Activities ............................................................. 3
Chapter 1: Financial Risk Exposures at Death ...................... 5
Life Exposures .................................................................... 5
Personal Obligations or Desires .......................................... 5
Family Needs ...................................................................... 8
Business Needs ................................................................. 11
Chapter 2: Life Insurance: Types ........................................ 15
Pricing Fundamentals........................................................ 15
“Traditional” Forms of Life Insurance .............................. 16
Term Life Insurance.......................................................... 17
Permanent Life Insurance ................................................. 20
Interest-Sensitive Life Insurance ....................................... 25
Other Forms of Life Insurance .......................................... 39
Tax Treatment .................................................................. 42
Chapter 3: Contract Clauses ................................................ 46
The Declarations Page ...................................................... 46
Inside the Policy—Standard Provisions ............................. 47
Chapter 4: Life Insurance Policies: Dividend Options
and Riders ........................................................................ 55
Dividends ......................................................................... 55
Life Insurance Riders ........................................................ 58
Chapter 5: Illustrations and Choosing a Policy ................... 67
Illustrations ...................................................................... 67
Choosing the Right Policy ................................................ 76
Insurability ....................................................................... 76
Chapter 6: Managing a Policy ............................................... 78
Nonforfeiture Options ........................................................ 78
Viatical Agreements .......................................................... 81
1035 Exchanges ................................................................. 82
Settlement Options ............................................................ 83
Chapter 7: Annuities ............................................................. 89
Definitions ........................................................................ 90
Income Taxation of Annuities ............................................ 92
Estate Taxation of Annuities .............................................. 96
Single Premium Immediate Annuity (SPIA) ....................... 96
Deferred Annuities: Single Premium (SPDA) or
Flexible Premium (FPDA) ................................................. 98
Summary .............................................................................. 108
Module Review .................................................................... 110
Questions ........................................................................ 110
Answers .......................................................................... 121
References ............................................................................ 145
About the Author ................................................................. 146
Index .................................................................................... 147
Study Plan/Syllabus

L
ife insurance should be an essential part of any client’s financial
portfolio. If the client were to die too soon, life insurance can provide
much-needed resources for the surviving family members. For clients
who beat the longevity odds, annuities can also be an integral part of a financial
and risk management plan to create a secure base income that will last their entire
life.
The primary purposes of life insurance and annuities are, in fact, two sides of the
same coin. Life insurance pays the beneficiaries when the insured dies. Annuities
pay while the annuitant is alive. Module 6 will cover how to define the life
insurance needs, but first you will learn about the various products and their
structure. Many clients will already have some coverage which must be
understood before an accurate analysis can occur. A financial planner first
identifies financial risk exposures facing a client upon their death, then analyzes
the client’s present coverage and resources. This analysis allows the planner to
also determine how well the existing coverage fits into the risk management plan.
To acquire the skills necessary to accomplish this task, a planner must learn basic
life insurance policy and annuity features, provisions, and riders. Planners will
need to help clients decide on dividend options, choose appropriate riders, and
guide beneficiaries through their options upon death of the insured.
Part of this module gives you pointers on how to evaluate insurance proposals.
This is more important than ever because of changes that have been made in
insurance products in the last several decades. Products, because of heightened
consumer awareness, have become more responsive to the economic climate.
However, many of these products do not have the guarantees they once had. A
thorough grasp of insurance illustrations is essential. Related to this
understanding of illustrations is a clear comprehension of life insurance pricing
factors. This module also introduces these factors and explains how they interact
with one another.
Finally, there are times when an individual will need to change or utilize their
policy differently than their original intent. A terminally ill person may need

Study Plan/Syllabus  1
© 1982, 1985, 1991, 1996, 2002–2015, College for Financial Planning, all rights reserved
extra money to pay medical bills or simply to maintain their dignity in the face of
the inevitable and unrelenting advance of their illness. Many companies have
added accelerated death benefit options, but if this is not available and other
options are exhausted, “viatication” may be an answer. If someone who is
terminally ill owns a life insurance policy, he or she may be able to sell it at a
discount to policy face value. The concept of viatication is introduced and
examined in this module. Finally, annuities have exploded in the marketplace as
longevity is increasing and people look to create more certainty that they will not
outlive their money. A high-level overview of annuities is provided.
The chapters in this module are:
Financial Risk Exposures at Death
Life Insurance: Types
Contract Clauses
Life Insurance Policies: Dividend Options and Riders
Illustrations and Choosing a Policy
Managing a Policy
Annuities

Upon successful completion of this module, you will be able to identify and
compare the unique set of characteristics of each form of life insurance and
annuity contracts in order to make recommendations to clients. Additionally,
you will be able to explain policy riders, and critical clauses in policies
including as dividend, nonforfeiture, and settlement options. Finally, you will
be able to explain options relating to alternate uses and terminating policies.
Remember, exam questions for this course are based on the learning
objectives in each module.

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Learning Activities
Learning Activities
Module
Review
Learning Objective Readings Questions

5–1 Identify areas of financial risk Chapter 1: Financial 1–4

exposures at death. Risk Exposures at Death

5–2 Identify types, uses, and Chapter 2: Life 5–16

limitations of various types of Insurance: Types
individual life insurance
policies.

5–3 Compare the purposes of the Chapter 3: Contract 17–22

general provisions of a life Clauses
insurance policy.

5–4 Identify appropriate dividend Chapter 4: Life 23–26

options available under Insurance Policies:
participating life insurance Dividend Options and
policies. Riders

5–5 Analyze the application of a Chapter 4: Life 27–28

given optional provision (rider) Insurance Policies:
available in a life insurance Dividend Options and
policy. Riders

5–6 Distinguish between policy Chapter 5: Illustrations 29–31

illustration factors to select the and Choosing a Policy
most appropriate insurance
product.
5–7 Recommend an appropriate Chapter 5: Illustrations 32–33
type of insurance policy. and Choosing a Policy

5–8 Calculate the value of a given Chapter 6: Managing a 34–39

nonforfeiture option in a life Policy
insurance policy at a specific
point in time.
5–9 Analyze and compare Chapter 6: Managing a 40–43
settlement options available Policy
under a life insurance for
specific situations.

Study Plan/Syllabus  3
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 Learning Activities
Module
Review
Learning Objective Readings Questions

5–10 Distinguish between types, Chapter 7: Annuities 44–54

uses, and limitations of various
types of annuities.

The question of why one should buy life insurance is answered by determining
whether any adverse financial consequences will be faced upon the death of the
person in question. Learning objective 5-1 addresses these “life exposures.” This
topic will be covered in much more detail in the Module 6, The Life Insurance
Selection Process.
Before determining the appropriate policy to use, you need a good understanding
of the various products available. Learning objective 5-2 directs you to examine
the many products available and determine each one’s unique characteristics.
Learning objectives 5-3, 5-4, and 5-5 focus on understanding the various general
clauses of life insurance policies, dividend options in whole life, and the
available riders so you will be able to guide clients effectively.
Most life insurance purchases are made following the presentation of some type
of illustration. Being able to understand policy illustrations is an integral part of
providing financial planning advice, which can help you in the selection of the
appropriate policy. Learning objectives 5-6 and 5-7 cover this process.
Learning objectives 5-8 and 5-9 discuss the management of a policy from annual
reviews to alternatives in light of terminal illnesses, or termination.
Often called the flip side of life insurance, annuities are unique in that they have
the primary purpose of guaranteeing that the income they provide will not run out
during the lifetime of the annuitant. Learning objective 5-10 involves
understanding what annuities are, how they can be used, and their limitations.

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Chapter 1: Financial Risk
Exposures at Death
Reading this chapter will enable you:

5–1 Identify areas of financial risk exposures at death.

Life Exposures

T
he financial planner is called upon to recognize and address financial
exposures related to the death of the client, the consequences to the
client’s family members, and others with whom the client may have
interactions. Further, clients may have objectives that they wish to have funded
upon their death. In addressing such objectives, life insurance should be
considered as a possible funding alternative.
Recognizing these exposures and the funding requirements they create is
essential to assuring adequate protection, and recommending the most
appropriate type(s) of insurance for the client. This chapter addresses some of the
risk exposures for which life insurance would be utilized. A different module
addresses selecting the proper amount and type of insurance based on needs
uncovered here.
Life exposures, predicated on the client’s own goals and objectives fall into three
main categories:
1. Personal obligations or desires
2. Family or survivor needs
3. Business needs

Personal Obligations or Desires

Clients may feel a moral obligation or desire to make sure that certain things
happen independent of the potential impact to their families. A client could wish
to make a major charitable gift to an organization that impacted their life. They

Chapter 1: Financial Risk Exposures at Death  5

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could have a buy-sell agreement that even though their partner would be
financially fine, they feel a moral obligation to complete the transaction. A
spouse could come from a very wealthy family that will leave him or her a trust
fund, but could the client may consider it a matter of personal integrity to provide
for their spouse’s retirement or leave a legacy for a child or any number of other
things. It is important that you find out what is important to an individual and not
just make the assumption that meeting family needs is all there is to the insurance
equation. Below are some examples that may be needed for family security or
could be a personal obligation or desire.

Finance
Risk exposure—death before loan repayment is finished. It is not uncommon
for banks to require that a customer maintain a certain amount of insurance in
force, collaterally assigned to the bank, to assure it will receive money owed in
the event of the customer’s death. Clients who do not often borrow money can
probably be adequately protected with temporary insurance. If your client is very
active financially and borrows frequently, it often makes more sense to cover this
need with some form of cash value insurance. The idea is that while one
particular loan may be paid off, there are likely to be other loans in the future,
and the bank is likely to continue to require insurance to cover them. Collaterally
assigned life insurance is appropriate when there is no other collateral for a loan.
Life insurance purchased to pay off a mortgage would not be assigned to the
lending institution since the property itself is collateral for the loan.

Continuation of Retirement for Spouse

Risk exposure—spouse outliving pure life annuitant. Often a client will have a
pension plan through an employer or other business entity that provides for a
lifetime retirement income. Even though a lump-sum distribution may be
available, there are income tax and practical reasons why this may not be the
most desirable option. Among the lifetime payment options available to the client
will be options that pay income only during the life of the client or during the
lives of the client and/or his or her spouse (a joint and survivor payout). Because
of the longer payout period facing the plan when a joint and survivor payout is

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chosen, the benefit under such an option can be substantially less than the benefit
under a life-only option, in which payments cease upon the death of the client.
For example, the client may have the following options:

Payout Form Monthly Benefit

Life only $2,000

Joint and full survivor $1,500

If the client has life insurance that can replace the $1,500 of monthly income for
the client’s spouse at the client’s death, the client may choose to take a $2,000
monthly benefit and enjoy an additional $500 of monthly income for life. Of
course, the additional monthly benefit to be received must be weighed against the
additional expense represented by the insurance premium. If the premium is
$200, then the net gain is $300. If the pension has a cost of living adjustment,
then the cost of living adjustment is on the higher amount and the income will be
substantially higher. Because the policy must be in force at the death of the
insured, whole life is generally utilized. The economics of this transaction must
be examined on a case-by-case basis.
Risk exposure—the person responsible for paying your retirement income may
die before you do or become disabled, causing default. Sometimes, the intrinsic
nature of a client’s assets causes them to be poorly diversified. A client who
owns a small business illustrates this situation. The small business owner
frequently has to invest most of his or her assets in the business. One result is that
the business must be sold in order for the owner to be able to retire. A cash sale
usually is safest, but circumstances and other issues may make this undesirable or
impractical. Tax considerations, difficulties in finding a buyer, having a buyer
who has trouble obtaining credit, or considerations arising when the buyer is a
son or daughter may entice the owner to sell over a period of time. This puts the
owner at risk of default by the buyer. Assuming the client has selected a buyer
capable of running the business and has built sufficient legal safeguards into the
installment sale (or private annuity) contract, the two primary reasons for default
are the death or the disability of the buyer. To safeguard against such a default,
appropriate life and disability insurance should be placed on the life of the buyer.

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In addition to life insurance policies that pay lump-sum benefits to meet such
obligations, there also are disability income policies specifically designed for
such business situations that pay a lump-sum benefit. A business owner who sold
the business to a family member may want to keep the insurance on his own life
in force until the loan is paid so that the rest of the family receives their share
immediately, thus creating less family stress.

Personal Goals
Risk exposure—death before accomplishment or when insurance is the best
funding vehicle. Not everyone can be a Bill Gates and create an impact through
charitable giving while they are alive, but many can do so at their death by
utilizing insurance to fund a legacy. Chairs at universities, scholarships,
charitable foundations, etc., are all designed to accomplish a vision. Generally,
this includes charitable giving objectives, although it could include any goal the
client wants funded. Some clients have funded specific family vacations for their
children and grandchildren for the next 10 years as a way of reinforcing the
family. Some people choose to create college funding for their grandchildren and
great-grandchildren. Life insurance is an obvious way to fund such objectives.
Further, life insurance provides a way to multiply a client’s gift. For example, a
few thousand dollars in annual premium can ultimately result in a $1 million
endowment for a charity or family from the death benefit.

Family Needs
Final expenses. These are obligations that must be paid before probate of the
estate can be completed. They include expenses of the last illness, burial
expenses, legal fees, accounting fees and appraisal costs (where necessary), death
notice costs, and outstanding debts of the deceased. Note that some debts were
listed under personal obligations or desires. Other debts may be joint debts that
do not have to be paid off but the family or insured wishes them to be paid such
as a mortgage, home equity line, or car loans.
If the estate is large enough, various estate taxes may be levied. There is a federal
estate tax that must be paid if more than a specified amount is transferred by a
decedent (except in the case of assets passing to a surviving spouse, which qualify

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for an unlimited marital deduction). Further, most states levy a death tax. To the
extent these costs exceed liquid assets in the estate, insurance can provide a good
source of funds. Assets that are illiquid in nature are poor choices for funding these
needs, because rapidly liquidating such assets may result in significant financial
losses.
Note: Care should be taken to uncover contingent liabilities as well, such as
notes on which the client has co-signed. An example that occurs frequently is the
business liabilities the client personally guaranteed. It is not uncommon for banks
to require such personal guarantees from the owners of a closely held business as
a condition for extending credit to the business. (A closely held business is one
that is owned by just a few stockholders or partners.) These contingent liabilities
could subject the owners and/or their estates to hundreds of thousands of dollars
of personal liability.
Dependent income. Most individuals want to, and need to, provide for their
dependents. Even two-income families can seldom lose one of their sources of
income without serious economic repercussions for the family. In most
situations, both income earners should have life insurance to cover the potential
loss of income. The retirement needs of the surviving spouse are also taken into
account in calculating coverage requirements. This calculation can be complex. It
is easy to cut expenses from the budget, such as the house and car payments that
were paid off by insurance. It is harder is to identify new expenses such as
unsubsidized health insurance, or young children growing up to be teenagers and
needing cars and expensive insurance. Care must be taken in analyzing the needs,
both now and in the future, over the stages of life for the remaining family.
Note: In years past, the automatic assumption was that the husband would be the
major wage earner, and therefore would require the most life insurance. This
should no longer be an automatic assumption. A husband may stay at home to
take care of the children, while the wife works outside of the home. Or, the wife
may have a higher-paying job than the husband, and therefore require the most
life insurance. The best solution is to enter the fact-finding period with an open
mind, and allow each client’s individual situation to determine the best
recommendations.

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One-income families also generally have substantial economic repercussions in the
event of the non-wage-earning spouse’s death. Children living at home must have
proper child care, which is often quite expensive. The loss of the ability to file a joint
income tax return generally results in additional income taxes and a reduction in
disposable income. Any other services that must be replaced increase the income
needed; therefore, a spouse not earning an income generally needs life insurance
as well.
While an expense would be incurred for the burial of a child, it generally is not
considered a serious enough threat to the finances of a family to require
significant insurance coverage. Some individuals do purchase insurance on minor
children to guarantee future insurability and to establish what can become an
exceptional asset when the child grows up. However, adequate insurance on the
parents always takes priority.
Education. Dependents’ educational goals must also be taken into account when
determining life insurance needs. Children, a surviving spouse, and possibly
grandchildren may be among those about whom the client is concerned. If the
spouse plans to return to work after a long absence from the workforce, skills
may need updating and funds should be planned for this purpose.
Adjustment fund. An often forgotten expense is an adjustment fund. Survivors
may want to pay for family members who don’t have the funds to come to the
funeral or for visits afterward. The spouse may need to fix up the house and sell
it and move someplace closer to family support. When an individual dies, the
surviving spouse’s emotional strain can be exceptional. Survivors often deal with
this strain in different ways. Some want to travel, to run from the loss. Others
find solace in shopping or dining out. Some survivors may take a trip to stay with
other family members for support. The unusual spending may last for days or
months, and should be considered when discussing life insurance needs.
Family goals. The family may be working together toward certain goals, and the
client may want the surviving family members to enjoy the fulfillment of these
goals. Since loss of the decedent’s income might endanger the achievement of
these goals, the client may wish to plan for their funding through life insurance.
Examples of family goals might include owning a certain home, taking a dream
vacation, or establishing a business.

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Parents. As life expectancy continues to improve, more and more people find
themselves caring for aging parents. Many people who work in the field of long-
term care report that a large number of families care for aging parents at home as
long as possible. In fact, many families care for aging parents until the strain of
doing so precipitates either a serious illness in the caregiver or, in some
instances, upheaval in the caregiver’s own family. Given the concern and
devotion many people exhibit toward their parents, it makes sense to explore the
client’s feelings in this area. Clients, especially those in poor health with aging
parents, may want to make specific arrangements for assuring sufficient income
to care for their parents. In addition to life insurance, long-term care insurance on
the parents may be a part of the solution. (Long-term care policies are covered in
a different module.)
Note: The death benefits of life insurance generally are received by the
beneficiary income-tax-free. If the insured had any ownership rights in a policy
at the time of death, or within three years prior to death, the proceeds of the
policy will generally be included in the decedent’s estate. In certain
circumstances this might subject the proceeds to federal and/or state death taxes
with possible negative repercussions. This will be discussed further in other CFP
Certification Professional Education Program courses.

Business Needs
The business uses of life insurance are dealt with more completely in the Estate
Planning modules. They are mentioned and examined briefly in this module to
provide students with an idea of the wide range of uses for life insurance in the
risk management area of the financial planning process.

Closely Held Business

Risk exposure—death of a partner or co-shareholder. When others are involved
in the client’s ownership of a closely held business, both the client’s and the
partner’s mortality must be taken into consideration during the planning stages. If
a partner dies in the absence of a properly drawn buy-sell agreement, the client
may eventually be in partnership with the heirs of the deceased co-owner or be
forced to liquidate the business. If the relatives are not already involved in the

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day-to-day operations of the business, misunderstandings are almost certain to
occur. If the client wants to buy the partner’s share of the business from the
family (assuming a price and terms can be arranged), there still is a problem of
funding. Life insurance is frequently the best answer here. If proper funding is
not available, the result may be that the business is liquidated, in which case both
the decedent’s family and the client are adversely affected. It is important to
remember that, technically, when a partner in a partnership dies, in the absence of
a written agreement, surviving partners are obliged to close the business,
liquidate the partnership, and distribute the proceeds. Planning techniques using
life insurance are presented in other modules.
Buy-sell agreements. A buy-sell agreement is often used to transfer the
ownership interest of a deceased business owner. Buy-sell agreements have many
variations, and normally require the services of an attorney to properly set up.
Simply put, a buy-sell agreement allows the business (corporation or partnership)
to purchase the deceased owner’s (or shareholder’s) share of the business from
the estate. This provides money for the deceased’s family, and all but eliminates
the need for a surviving spouse to remain involved in the business. The
agreement allows the business to continue operating as planned, and eliminates
any ongoing obligation to the deceased’s family.
Buy-sell agreements have many forms. In all cases it is a very good idea to get an
accurate business valuation (or stock valuation) as part of the process, in order to
determine the selling price of the ownership interest. Types of buy-sell
agreements include:
 Stock redemption. The business agrees to buy the deceased shareholder’s
stock (i.e., entity plan).
 Cross purchase. Each business owner agrees to buy out the interest of the
deceased business owner.
Other, often less favorable non-buy-sell methods of dealing with business
continuity issues include:
 Wait and see. Upon the death of a business owner, the remaining owners
decide the best way to proceed.

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 Third-party buyout. A nonrelated party agrees to purchase the deceased
owner’s interest.
Life insurance is often used as the funding vehicle for buy-sell agreements. One
example of a policy used for this purpose would be a participating whole life
policy, using the paid-up dividend addition option. Universal life and first-to-die
policies are other examples of policies used to fund buy-sell agreements.
Depending on the plan, one or several policies may be necessary. Care must be
exercised to limit any potential income tax liability on the sale/purchase of a
deceased owner’s interest. Disability or retirement can also be triggering events,
and require different funding vehicles.
Generally, the death benefits of life insurance are received free of income tax. If
a cash value type of policy is surrendered prior to death and the cash surrender
value exceeds the cumulative premiums paid in (basis), the gain is taxed as
ordinary income. However, planners should be aware that life insurance proceeds
payable to a C corporation may give rise to alternative minimum taxable income.
In addition, if insurance policies are transferred from one owner to another in
order to fund a cross-purchase agreement, there is a possibility that most of the
death benefits may be taxed as ordinary income under the transfer for value rule.
This contingency is addressed in greater detail in the Estate Planning and Income
Tax Planning courses.
Risk exposure—death of a key employee. A key employee is defined as a person
who, if lost, would have a material effect on the earnings of the business. If an
employee can be replaced within a reasonable time with minimal effect on the
earnings of the business, there is no reason to insure against the loss of that
person. The business may be able to take steps that make an otherwise key
employee less critical to the business. Steps such as cross-training current
employees, writing procedures manuals, or installing specialized accounting
systems can prepare for an employee’s absence. If, on the other hand, such
measures cannot be applied to the unique talents the employee brings to the
business, life insurance may be required to cover the very real economic risks
faced by the business in the event of the death of the employee. Life insurance
can provide for the loss of potential business income as well as the cost of
searching for a replacement.

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Risk exposure—loss of a key employee. Related to the above concern is that of
retaining key employees. Frequently this is accomplished through benefit
programs aimed specifically at the key employee. These often use life insurance
as the funding vehicle. Such programs include deferred compensation and split-
dollar programs. These programs are more thoroughly explained in other
modules. If your client is the owner of the business, you may assist him or her in
designing such programs. If your client is a key employee, there may be
opportunities for bringing such programs to the attention of the business owner or
board of directors for your client’s benefit.
Note: Recent legislative changes have created some concern regarding the use of
at least some split-dollar programs. The legislation does not appear to have
invalidated split-dollar arrangements, but it does bring the use of some
arrangements into question. It is important to remember, when implementing any
creative use of a financial tool (life insurance, in this case) to stay alert for any
tax or legislative events that may impact the use of such a tool. This does not
mean that you should not try to make creative use of the available financial tools.
It does mean, however, that you must be alert for potential problems. This seems
to be especially true where potential tax savings (as in the case of split-dollar
plans) are involved.
Risk exposure—death of an owner/estate liquidity. It is not uncommon for the
owner of a closely held business to plan for meeting estate settlement costs
through a partial redemption of corporate stock. There are statutory requirements
that must be met for such a redemption to receive favorable tax treatment
(Section 303 of the Internal Revenue Code). Where it is anticipated that these
requirements can be met, the redemption generally is funded by having the
corporation purchase insurance on the life of the owner of the stock.
Risk exposure—special situations. There are special situations where insurance
may be called for; read contracts carefully and consider the implications of what
they require. For example, life insurance is sometimes worked into plans for
stock repurchases under employee stock ownership plans (ESOPs) or is used to
provide death benefits under a qualified retirement plan. Estate plans may utilize
insurance to move assets outside of a taxable estate to transfer wealth more
efficiently. This will be covered in the Estate Planning course.

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Chapter 2: Life Insurance: Types
Reading this chapter will enable you to:

5–2 Identify types, uses, and limitations of various types of individual life
insurance policies.

T
here are many forms of life insurance, and all of them can be put into
two general categories: cash value and term. Some forms of life
insurance have been around a long time and some are relatively new.
Additionally, there have been some changes to the older forms that are quite
significant.

Pricing Fundamentals
Two concepts—mortality and morbidity—are the cornerstones of the actuarial
basis of life and health policies. Mortality deals with death. Morbidity deals with
the incidence of losing one’s health through illness or injury.

Mortality and Morbidity

Mortality rates are statistical figures that show an average of how long a group of
people will live. They are rates of life expectancy. Life insurance policy
premiums are based on three factors—mortality rates, investment income, and
expenses. Insurance companies currently use the 1980 or the 2001
Commissioners Standard Ordinary mortality tables (1980 CSO or 2001 CSO), as
well as tables the companies produce themselves. The CSO tables are used to
determine the reserves required of a company in relation to all policies sold.
Premiums generally are affected as much by the actual experience of the
company as by the CSO tables, since the CSO rates the entire population,
including those who are uninsurable because of poor health. The insurance
company’s own experience may give it somewhat of a better base on which to
determine premiums.

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Morbidity, on the other hand, is a measure of the rate of disability. Tables exist
that predict what portion of a group may become disabled over a specific period
of time. Morbidity rates affect the cost of premium waiver riders on life
insurance as well as the premiums for disability income insurance.

“Traditional” Forms of Life Insurance

Most of what are considered the traditional forms of insurance have been around
for more than a century. These include whole life, limited pay life, endowments,
annually renewable term, and decreasing term.

In the early years of life insurance, only term-like policies were available. As is
true today, the cost of the insurance increased as each insured aged. When the
premium increased too much, many people dropped their policies and died
uninsured. Eventually the public demanded and received level premium policies.
These were designed so that the policyowner paid excess premiums in the early
years. The additional premium amounts were put into a cash account from which
the insurer could draw needed funds as actual costs increased in later years.
Using this plan, the insurance didn’t become prohibitively expensive as the
insured aged. Whole life was born—the first consumer-demanded form of
insurance.

The cash account of a traditional whole life policy is invested in the company’s
general account. While the conservative nature of the general account does not
provide much in the way of investment earnings, it does help to assure that the
life insurance will be around when needed. Alternatives exist with regard to how
the cash account is invested, and those alternatives have helped create several
additional forms of life insurance (discussed below). Today, term insurance is
generally considered useful for short-term needs, and cash value insurance is
normally used for long-term needs.

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Term Life Insurance
Annually Renewable Term Insurance
Term insurance is also known as temporary insurance. An annually renewable
term (ART) policy, also known as yearly renewable term (YRT), provides death
protection for one year at a time. The policy renews each year with the payment
of the premiums due. This form of insurance almost always has the lowest initial
premium since the risk of death—the mortality rate—is relatively low when
insurance is first sold, and the risk is priced for one year at a time. Term
insurance premiums are based on the estimated cost of insuring the individual for
one year at a time. The cost of insuring a person—the mortality cost—increases
each year, so everyone’s mortality costs are lower today than they will be in one
year. The mortality rates below provide an example of this.

Table 1: Male Mortality Rate Comparison

% increase
Mortality Rate from prior % increase
Age (Male) per thousand number from age 25
25 1.01
35 1.24 23 23
45 2.77 123 174
55 6.52 135 546
65 17.65 171 1,648
75 43.95 149 4,252
85 122.36 178 12,015

It is easy to see from this table, which is based on the 2001 Commissioner’s
Standard Ordinary (CSO) Mortality Table, that the risk of dying not only
increases as we get older, it generally increases at an increasing rate. While the
table shows that a $101 mortality cost at age 25 goes up to $124 at age 35, by the
time this insured reaches age 65, the same amount of insurance will cost $1,765;
and if the insurance is kept to age 85, it will be $12,236. (Note: You will not be
required to do any mortality calculations for the exam.)

These numbers are based on a mortality table that reflects the entire population,
including those who are uninsurable. Since insurance companies evaluate the
insurability of applicants, this table, in the early years, does not reflect the

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insurance companies’ actual mortality experience. As time goes on, the table
more closely reflects the mortality experience of the companies. What this means
is that in the early years of a term policy, the actual mortality costs are lower, and
the company can sell the policy for a very low premium. It also means that the
increases in later years will be greater since the underwriting that took place at
the inception of the policy means very little as the years pass.

ART/YRT policies generally have a guaranteed maximum premium and are

renewable for some period of time. Most insurance companies permit a term life
insurance policyowner to keep the policy in force up to age 70 or so, or
sometimes even longer. Some states limit the age to which term insurance may
be renewed.

In today’s marketplace, term policies often have the initial premium guaranteed
for some period of time. This may be from five to 30 years, for example. Many
of these policies project a level premium but only guarantee the first five years.
The longer the guarantee for the level premium, the higher the premium will be.
A policy that has a guaranteed level premium to age 100 or 120 will have a
premium approaching that of a whole life policy.

While some insurance companies permit a policyowner to renew a term policy by

merely paying the premium, some companies offer a significant incentive for
insureds to requalify for coverage. These policies, called reentry term policies,
permit the insured to be underwritten every five years or so. If he or she is still
insurable in the same classification, the premium for ART may actually drop in
the sixth year, and for other policies the premium won’t go up very much.
Unfortunately, if the insured is not in the same physical condition, the premium
will increase significantly. At some ages it might triple or quadruple.

The National Association of Insurance Commissioners created and approved

model law, Regulation XXX, which addresses long-term guarantees for term
insurance premiums. Because term insurance rates are exceptionally low, the
commissioners are concerned that if insurance companies do not collect adequate
premiums for term insurance, many of them will become bankrupt as their
insured population ages. Regulation XXX requires higher reserve requirements
for term policies that guarantee premiums for more than five years. This is an

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effort to assure the solvency of insurance companies in the future. The high
reserve requirements continue to have a significant financial impact on insurers,
as well as reinsurers.

Decreasing Term Life Insurance

Decreasing term insurance is a form of term life insurance where the premium
remains level, but the amount of death benefit decreases. These policies have
generally been sold to cover home mortgages. One problem with the early forms
of decreasing term was that they all used straight-line depreciation. The amount
of coverage decreased by the same dollar amount every year. Unfortunately, the
principal of home loans doesn’t decrease in this manner.
In the late 1970s, insurance companies began to offer decreasing term policies
using various interest rates and an amortization table to have the coverage
decrease at the same rate as the mortgage. However, although this answered one
problem of the policies, it didn’t correct the major problem that these policies
cannot address. Most people do not live in one home until it is paid off. When
they move, they often obtain a larger mortgage. If they do stay in the home for
many years, they may borrow against the equity in the home. With either
scenario, the decreasing term insurance becomes inadequate to cover the
outstanding debt associated with the home. For these reasons very few companies
sell these policies now.
Insurance experts generally recommend that if term insurance is used to cover a
mortgage, that one of two approaches be used. The first is to purchase a level
death benefit policy. If some years down the road the insured needs less
insurance, that policy may be able to be reduced. This way, the reduction
happens when the policyowner wants it to happen, and not before. The preferred
method is to incorporate the mortgage need into an overall life insurance needs
analysis.
Insurance used to cover a mortgage should not necessarily be tied to the home or
the mortgage. It should be payable to a named beneficiary, who then has the
option of choosing whether to pay off the mortgage or not. The time to determine
which option is better should be made at the time of death, taking into
consideration the survivor’s situation, desire to maintain the same home (or not),
and the state of the economy at that time.

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Death Benefits of Term Insurance
It is important when discussing term insurance to recognize some basic facts
regarding the payment of death benefits. It was during the 1950s that an MDRT
(Million Dollar Round Table) life insurance member once said, “The best life
insurance policy is the one that is in force when you die.” In the mid-1990s,
nearly one-third of all life insurance policies were term insurance. These policies
provided nearly half of the life insurance dollars in force. However, relatively
few of the proceeds from death claims paid (possibly as low as 1% to 2%
according to some studies) were from term insurance policies.
From this, we can draw a number of conclusions. Term insurance in all of its
forms provides most of the death protection at any given point in time. Most term
insurance policies are allowed to lapse prior to the insured’s death; the majority
of all death claims are paid on cash value forms of insurance. Term policies are
generally larger in amount (death benefit) than cash value policies. Because of
the pricing of term, the highest premiums are going to be toward the end of life
when the insured is retired and may be facing concerns over sustaining their
income. Within the insurance industry, it is generally understood that term
insurance policies are usually either converted to cash value policies or allowed
to lapse prior to death.

Permanent Life Insurance

Endowments
An endowment policy is one in which the death benefit and cash surrender value
are the same at a specific date (e.g., 20 years from date of issue). These policies
used to be popular in the United States for funding future needs, such as college
education, weddings, and retirement, because the cash accumulation could be
predetermined and targeted for a specific date. U.S. tax law changes effective
after 1984 eliminated most new sales of policies that endowed before age 95.
However, you may still encounter some clients who own these contracts.

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It is important to recognize that an endowment policy is not the same as a
modified endowment contract, or MEC. The MEC is an insurance policy that has
failed the “seven-pay test” created by Congress. Non-death-benefit withdrawals
from a MEC are generally taxable, and there are additional adverse tax
consequences. The MEC is examined in this module, while the more detailed tax
ramifications are discussed in the Income Tax Planning course of this program.

Whole Life
Whole life is the most common form of permanent insurance. It has a fixed
premium, a guaranteed cash value, a guaranteed death benefit, and includes a
minimum guaranteed interest rate to hold the entire product together. Premiums
are initially higher than those for term insurance. However, a portion of the
premium is placed in an account so premiums remain the same throughout the
policy period. The account, commonly known as a cash value account, has
additional uses that are available to the policy owner. These are discussed later in
this module.
Whole life policies have a reserve maintained by the insurance companies so that
the benefits of the policies can be paid. Companies selling whole life must
provide nonforfeiture values with their whole life policies. These values provided
a benefit payable to the policyowner if he or she quit paying premiums before the
death of the insured. These are covered in detail in a later chapter.
Insurance companies can be structured as stock companies or mutual companies.
Companies capitalized by common stock are owned by shareholders and trade on
the financial markets. Stock companies do not normally pay dividends to
policyowners. They are referred to as non-participating whole life.
Companies known as mutual companies are owned by policyowners. Mutual
companies, when they pay dividends, pay them to their policyowners. A policy
that receives dividends is said to be participating. These dividends are considered
a return of excess premium. Here’s why: Policy reserves are based on a very
conservative interest rate (e.g., 3.5% per year). Since companies can generally
earn more than this, they return at least a portion of the excess in the form of
dividends. Until the cumulative dividends exceed the cumulative premiums paid,

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dividends are treated as an income-tax-free return of the unneeded premium.
Ways in which dividends can be used will be discussed later in this module.
Actuaries determine that the premium and reserve requirements are based, in
part, on an assumed life expectancy (e.g., age 100 under the 1980 CSO or age
120 under the 2001 CSO). Since it is presumed that people die at a given age
(based on current mortality tables), the actuaries calculate the premiums, taking
into consideration the guaranteed minimum interest rate, so that the reserves
equal the death benefit at the assumed age of mortality. With most whole life
policies, beginning in about the 10th policy year, the nonforfeiture value, also
known as the cash surrender value, is equal to the policy’s reserves. When the
insured reaches the age of mortality (e.g., age 100 or 120), the reserves equal the
death benefit, and the policy is said to have “endowed.” Older whole life policies
would then consider the policy “endowed” and the accumulation sent to the
policyholder. Endowment of a whole life policy may create an unfavorable tax
situation for an insured where face value is paid out, exceeding the policy’s basis
(premium paid). It is important to check this feature when examining old policies
that are still in force. Most policies now allow the funds to remain with the
insurance company and be accessed through loans rather than create a tax
consequence.
The standard form of whole life insurance provides a guaranteed death benefit for
the life of the insured, and requires premium payments to be made until death or
policy maturity. Options allowing shorter premium payment periods, but
continuing coverage for life, are discussed below.

Limited Pay Policies

Somewhere in between whole life and endowment policies are limited pay
policies, also known as limited pay life policies. These are essentially whole life
policies with a shortened premium-paying period. A whole life policy is
generally designed to have the premium paid for the life of the insured or to age
100 (120 under the 2001 CSO), whichever comes first. With a limited pay policy,
the death benefit continues to age 100/120 when the policy matures or endows,
but the premiums stop earlier.

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Some limited pay policies are designed to be paid up when the insured reaches a
specific age such as 65 or 95, where premiums are paid to that age and then
cease. Other plans include 10-pay, 20-pay, or 30-pay life policies. With these
policies, premiums are paid for 10, 20, or 30 years, respectively. As a result of
the shorter payment period, the premiums for these policies are higher than for
regular whole life.
Single premium whole life is a policy in which a lump-sum payment is made and
no further premiums are required. There are substantial surrender charges if the
policy is cashed in within the first few years. Special tax rules (MEC) apply to
these policies. Generally there are very specific planning strategies that utilize
this type of policy that are beyond the scope of this material.

Variations
Modified whole life. Modified whole life is a whole life policy preceded by a
period of term insurance. These policies have low, term-like premiums for a
number of years, then premiums automatically increase to whole life levels.
Many of these policies have an ultimate premium that is lower than it would be if
the insured waited until the age at which the premium automatically increased to
purchase the insurance.

Another type of modified whole life is sold on the lives of children. The policy
provides term insurance until the insured reaches a specified age, typically from
18 to 25. When the child reaches this age, the policy converts to a whole life or
limited pay life policy with a lower premium than if the insured had waited until
that age to obtain the insurance. Such protection can sometimes be added very
inexpensively as a children’s level term rider.
Graded premium life. Graded premium life was designed to ease people into a
whole life premium. Its premium per thousand dollars of insurance is fairly low
the first year, and increases each year for five to seven years, at which time it
reaches its ultimate premium. The ultimate premium is level for the life of the
insured. The ultimate premium is typically the premium for a whole life policy
purchased a year or two before the ultimate premium is reached.

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Adjustable Life
Adjustable life is a unique product encompassing aspects of whole life, term, and
universal life, or, in the comparative lexicon, built on the whole life insurance
chassis. Adjustable life provides policyowners the option of making various and
significant adjustments to the policy as their circumstances and needs change.
Structure of adjustable life. One way to describe adjustable life is that it is a
combination of term and whole life; another is that it is a whole life policy with
adjustable cash value and death benefit guarantees; and a third is to call it
“changeable life.” When the policy is first issued, the face amount and premium
are chosen. From those choices comes a guarantee period. This period is the
number of years the death benefit is guaranteed to be in place. Since the premium
can be changed at will, within minimum and maximum range limitations, the
guarantee period can be lengthened or shortened.
Dividends paid on adjustable life policies are most commonly used to extend the
guarantee period and increase the cash value. This dividend option is unlike any
other in the industry. Often the agent will work with the client to determine a
premium that will show the death benefit extended to an age chosen by the client,
based on the current dividend scale. Over the years, as the economy and
dividends change, the premium may be adjusted to keep the coverage in force
until the target age. If the premium chosen is based on a high cash value
accumulation, then other dividend options, such as paid-up additions, are also
available.
The policyowner may increase or decrease the face amount, premiums, and
length of coverage. Additional, unscheduled premium contributions, as well as
partial withdrawals, may be made. An unusual decision involves two choices for
the waiver of premium rider. The policyowner may choose a disability waiver of
premium rider that waives the premium that has been scheduled or one that will
waive a whole life equivalent premium. This second option is usually more
expensive, but it may substantially increase the value of the policy. Most other
traditional riders are available. An interesting variation is a cost-of-living (COL)
rider. This rider, with no premium of its own, allows the policyowner to increase
the policy once every three years by the same percentage as the increase in the
CPI. The additional premium is based on the same rate classification as the base

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policy, but at the current age of the insured. If in any year the policyowner
declines to accept the increase, all future increases are forfeited. Typically, any
policyowner-initiated increase in the death benefit requires evidence of
insurability.
Advantages and disadvantages of adjustable life. The exceptional flexibility of
adjustable life is its greatest advantage. The nature of the policy also lets the
policyowner know how long the benefits are guaranteed, unlike universal life.
The disadvantages of adjustable life are similar to those for universal life. An
adjustable life policy may end up being an exorbitantly expensive term policy if
only the minimum premium is paid and if dividends are not adequate to continue
the policy at the initial premium rate. The flexibility may give a poorly motivated
or careless policyowner too many ways to inadvertently lapse the policy.
However, this is less likely to happen with adjustable life than it is with UL. The
flexibility and uniqueness of each adjustable life policy also makes it more
expensive than a traditional whole life policy, and its minimum term premium is
generally higher than normal term insurance premiums.

Interest-Sensitive Life Insurance

A number of products have entered the American life insurance market since the
mid-1970s. Adjustable life, universal life, variable products, and policies that
stock insurance companies designed as a response to participating policies added
to the tool kit of insurance agents and companies.

Universal Life Insurance

Universal life (UL), sometimes referred to on policies as flexible premium
adjustable life, is composed of some of the same components as whole life
products, though the undercarriage of the universal product is unique. The
primary difference is that these components making up the universal life product
have been “unbundled.” With most other products, these elements—mortality,
the risk charge (also called the term charge, or cost of insurance), expense
charges, administrative fees, and credited interest—are visible only to the actuary
who designed the product. The actuary takes them all into account but determines
one composite premium rate for the product. The company then assumes both the
potential profit and potential loss if the expected assumptions are incorrect. Since

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our mortality tables have been extending, companies have benefited. If the
reverse were to occur, the company would lose. This is why whole life is
described as the insurer taking the mortality and interest rate risks.
With universal life, these components are not combined (U for universal; U for
unbundled). Instead, they are kept separate and shown in the contract and/or each
policy’s annual statement. This does have some marketing advantages. It creates
the impression that the ultimate performance of the product is more predictable.
It also makes the product more marketable from an investment point of view.
However, this unbundling can be confusing. For example, some have made the
argument that a person should buy UL instead of whole life if he or she is young
because the term insurance element in the UL will be inexpensive. This is
irrelevant. The term insurance element (or mortality charge) would also be
inexpensive in all cash value products. It simply is less visible since the risk
charge is not unbundled in more traditional products. There is flexibility on the
part of the company. Generally there are current rates and guaranteed rates for
mortality, so the company may be able to raise the rates on the policies if
mortality costs increase, but only to the guaranteed maximum.
Once the concept of unbundling is understood, it is apparent that the real
distinction of UL is its flexibility. Premiums are flexible and can be varied. Any
monies that are not used to pay the expense and mortality charges can
accumulate in the cash value of the product. This affects such policy
characteristics as the dollar amount of premium payments and the policy’s ability
to become paid up.
The operating mechanism of a UL policy is such that from the initial premium
paid, the company deducts certain expenses and the cost of the first month’s risk
premium, with the balance going into the cash value. Each month thereafter,
premiums received plus interest are added to the cash value fund, while the cost
of an additional month’s risk premium and expenses are deducted. Note that the
risk premium (or term premium) is the cost of providing insurance to cover the
net amount at risk. Generally, the net amount at risk is the difference between the
death benefit and the cash value. UL policies operating in this manner are
identified as “Option 1” or “Option A.” Thus, the policyowner, as with any cash
value product, is actually buying a tax-deferred cash value fund and a decreasing
amount of term insurance.

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Understanding this concept makes it clear why the death benefit does not consist
of the initial face amount of the policy plus the cash value. Universal life does
offer the option of a death benefit equal to the initial face amount plus the cash
value, and this selection is referred to as “Option 2” or “Option B.” If this option
is elected, what actually happens is that the policyowner is buying term insurance
in an amount equal to the original death benefit. It should be noted that if the
death benefit equals the initial face amount plus the cash value, the net amount at
risk never changes. The policy effectively consists of a level term policy with an
increasing cash value. Since the cost of a constant amount of term insurance
increases each year with the insured’s increasing age, over the life of the contract
a substantially larger amount of premium is spent on the term element. In a
contract with the level death benefit option, while the mortality cost per thousand
increases with age, the amount of term protection decreases each year as the cash
value increases. Policyholders typically have an option to switch from one to the
other, which leads to some planning opportunities.
Policy features. Each of the following components can vary depending upon how
the contract is designed. When a financial planner is comparing two or more
universal life policies, these components should be watched carefully so that the
policies are compared on an equal basis.

Premiums
 Minimum. Premiums large enough to cover expenses and mortality.
 Target premium. It is based on an interest rate that may be expected to
remain relatively the same over the life of the contract. (Note: This term
often has other meanings.)
 Maximum. The most money the contract can accept without violating Internal
Revenue Code restrictions on life insurance.

Credited Interest
 Minimum guaranteed. Economic conditions aside, this is the rate guaranteed
in the contract to be credited to the cash value (e.g., 3.5% or 5%). The UL
product is built on a term chassis, but this cash value feature is what
distinguishes it from its term insurance predecessor.

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 Current rate. This is the interest credited on this deposit/premium. The
current rate usually is set by the insurance company, frequently indexed to T-
bills or some other current money market-type rate. It usually is guaranteed
for one year, but it may be shorter.
 Blended rates. Last year’s premium (or an older premium) may receive a
different rate than current premiums. Amounts from prior premiums are
blended with pools of interest rates reflecting those earlier economic
conditions. For example, current premiums will be credited with 6% until
December 31; effective each January 1, all previous monies will receive
5.25% for the next calendar year, while the current rate for new calendar-
year premiums will be 5.75%. There is no consistent method of calculating
blended rates.
 Interest credited on loaned amounts. The dollar equivalent of a loan based on
the contract may receive the current credited interest or some other lower rate
as defined in the contract.
Some policies credit one interest rate on a specified level of cash
accumulation, perhaps $1,500, and a higher rate on cash accumulations
above that amount.
 Dividends. Since UL policies have the ability to adjust the credited interest
rate, it is rare for a company to pay dividends on a UL policy. Even those
mutual company policies that state that the policy may share in the divisible
surplus (the term used to identify dividends) seldom make those payments.
Some mutual companies go so far as to set up stock subsidiaries to sell their
UL products.

Mortality Charges
 Guaranteed. A schedule of mortality charges is included in the contract,
which states the maximum charge against the contract at each particular age
(usually based on the 1980 or the newer 2001 Commissioners Standard
Ordinary Mortality (CSO) table). The rates are the monthly charge per
thousand dollars net amount at risk.

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 Current. This is the current year’s charge against the contract, which is usually
lower than the guaranteed rate and is usually the rate used in the policy
illustration. The current rate is based on the company’s actual experience. It is
important to recognize the difference between current rates used in an illustration
and guaranteed minimum interest rates.
 Projected. Some universal life contract illustrations use a projection of the
company’s mortality experience rather than the current rates.

Administrative Expenses
 Guaranteed. The contract states the maximum dollar or percentage amount
that will be withdrawn from the contract in the first year and in all
subsequent years. It may be a flat amount per month or per year, or a
percentage of the premium. It may also be a cost per thousand of face amount
or net amount at risk.
 Current. Current charges against the cash fund or each premium paid,
depending on how payment is made (monthly, annually, or as a single
premium).
 Banded. Charges may vary according to face amount. Banding identifies a
range of face amounts (e.g., $10,000 to $99,000). Death benefits in a lower
band may have one charge, while death benefits in a higher band may have a
different charge.

Other Charges
 Surrender charges. If the contract is terminated before the insured dies, then
a charge may be made against the contract cash values. The variations of
back-end charges range from 5-year to 15-year sliding scales (e.g., 10% after
one year, 7% after two, 6% after three, 5% after four, 0% after five) to rolling
surrender charges (disappearing charges on old premiums, but each new
year’s premium carries its own sliding scale of surrender charges). The
annual statement will often show both a surrender value and an accumulation
value.
 Policy fees. May be for the first year only or annual.

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 Premium fees. Either a percentage of all premiums paid (e.g., 3%) or a fixed
dollar amount per premium payment.
 State premium tax. Generally 2% to 3% of any premium paid. Some
companies charge the same amount of premium tax in all states regardless of
the state’s actual tax. This is an averaged amount, and high-tax states are
subsidized by low- and no-tax states. When an average amount is used, the
tax is not specifically identified, but is included in general expense charges.
Some companies charge a premium tax that is specific for a given state.
 Withdrawal charges. Fees for taking money out of the contract.
A Closer Look at Selected Policy Benefits
Although tax-deferred accumulation is a major attraction of universal life
policies, UL policies also have other benefits that add to their appeal. These
benefits include flexible premium payments, adjustable death benefits, unbundled
structure, full disclosure, and cost advantages. The flexibility of the UL policy in
responding to the policyowner’s ever-changing needs may allow this one policy
to satisfy life insurance requirements throughout the insured’s lifetime.
Flexible premium payments. Flexible premium payments allow the policyowner
to determine when and in what amounts payments are to be made. The
policyowner can choose to pay for the cost of a lifetime of insurance with
whatever payment schedule he or she chooses. Premiums may be made at
differing intervals of time or may be stopped temporarily and then resumed later.
This type of payment pattern does not initiate a policy loan. The only limitation
placed on these flexible payments is that the cash value be enough to allow the
next month’s policy reserve to cover the cost of the next month’s charges. The
first year’s premium generally has a minimum required level.
This flexibility is both a distinct advantage and a distinct disadvantage of
universal life. When a policyowner realizes that he or she doesn’t have to put
money into a policy in a given year, the tendency may be to use the money for
something else. If this continues too long, the cash account of the policy will be
depleted and the policyowner will receive a notice from the insurance company
stating that a minimum amount of premium must be paid to keep the policy in
force. At this point, the policy becomes relatively expensive term insurance.

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Unless additional premium is put into the policy to build up the cash value, the
required minimum will increase every year. Additionally, because of the
transparency, an insured will see the cash value in his or her policy depleting
rapidly in retirement years. If enough funds have not been put in the policy to
maintain funding until age 120 and the insured lives a long time, the policy may
not be sustained because the insured is taking the mortality risk rather than the
company.
Adjustable benefits. The policyowner can increase or decrease the face amount of
the policy according to his or her changing needs. For example, a family with
children generally needs more insurance when the children are young. (To
increase the amount of coverage, the insured will be required to show evidence of
insurability.) However, after the children have left home, the family’s insurance
needs may decrease. Some traditional policies would require a new policy to
meet the new coverage requirements; however, some now allow policies to be
reduced. Multiple policies generally mean increased costs, because most
insurance policies have an individual policy fee. This fee is usually the same
regardless of the size of the policy. If a company has a $30 annual fee per policy,
and an individual has to purchase four policies over the years to meet his or her
needs, the annual fees come to $120. If only one UL policy is used to meet the
insured’s changing requirements, the annual fee stays at $30, and the
policyowner saves money as a result.
Unbundled structure. Unbundling means that the insurance contract is broken
down into its components. Thus, the policyowner knows exactly where premium
dollars are going. The effect of the interest rate on the policy’s cash value can
also be determined.
Full disclosure. One unique feature of the UL policy is its transparency—the
policyowner is shown exactly how the policy cash values are developed. The
policy outlines and explains its different components. Policyowners also receive
annual reports providing information concerning policy activity during the past
year, including cash value accumulations, loans, partial withdrawals, and
premium payments. All charges are stated in the report, and each policyowner
knows where his or her money is going. This full disclosure of UL policies is a
major step in responding to consumer demand for readable and understandable

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policies. From the planner’s perspective, it is important to realize that the
expenses and charges can vary widely. Careful reading of the specific parts of the
contract and study of illustrations is important.
Costs. The cost of UL is based on net amount at risk plus expense charges.
Expense charges may consist of several components: a fixed dollar amount, a
level percentage of all premiums received, a policy origination fee, and/or an
additional first-year load that may be fixed or may depend on the face amount of
the policy. These charges may be deducted from the cash value account or
directly from the monthly premium.
Since each UL policy is unique, it can be argued that they cost more to
administer than more traditional policies. All traditional policies issued to the
same classification of insured, of a given sex and at a given age, have the same
cash value per thousand dollars of insurance. UL policies, however, are all
different, and their expenses can reflect those differences.
Disadvantages of universal life. UL’s chief disadvantage is that, since the
product is a single package, the UL policyowner may end up with neither the
most competitive insurance coverage nor the most competitive savings vehicle. It
is possible that as the policy matures and if insufficient premiums have been paid
into the contract, the cost of the insurance protection may outstrip the reserves of
the cash value account, forcing the policyowner to increase premiums, or drop or
reduce the coverage. Secondly, as with virtually all modern products, rates of
return will vary in the future since they are based on current economic
conditions. The uncertainty of future yield potential is best illustrated by history.
In the early 1980s, current UL interest rates were often between 9% and 15%.
Illustrations created with the assumption that those interest rates would continue
were impressive. By the mid-1990s, money market rates had dropped to around
2%, and UL policies seldom paid more than 5.5% in current interest. The
precipitous drop in interest rates resulted in insurers having to face innumerable
lawsuits.
As mentioned previously, the flexibility of UL can also be viewed as its greatest
disadvantage. With the flexible premium, the compulsory form of savings that
traditional whole life policies generate for policyowners is reduced. Clients who
are likely to pay premiums consistently are the best prospects for UL.

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Inconsistent premium payments, or attempts to pay only enough to meet
minimum requirements, generally lead to the policy becoming an expensive term
product.
Universal life policies’ annual reports can create problems for some
policyowners as well. The reports show current accumulated cash values and
often current surrender values. This information is available for other cash value
plans, but it is not presented in such an obvious manner. A problem can arise
when people see these values and either decide themselves or are encouraged by
others to take those funds and do something else with them. The buildup of cash
values is an important part of the successful operation of UL policies. To invade
the cash values compromises the long-term success of the policy (success being
defined as the policy being in force when the insured dies).
Most UL policies provide a return based on short-term interest rates. Thus, they
react faster in a rising interest rate economy than do whole life policies. This is
the primary reason UL was so popular in the late 1970s and early 1980s.
Unfortunately, the converse is true as well; when interest rates come down, rates
of return come down faster for UL policies than for whole life. The lower interest
rates of the early 1990s through the present have resulted in a reduction in the
popularity of UL. Even so, UL policies are still some of the most popular ever
purchased, making up 20% to 25% of all insurance in force today.
One interesting result of unbundling universal life premiums is that it demystifies
the product. Once it is understood that cash value products are, in effect,
composed of an increasing cash value and a decreasing term element, there is a
tendency to assume that there is no reason to purchase a cash value product. It
seems to be accepted as axiomatic that anyone can “do better” with his or her
money than an insurance company, and therefore, the virtue of buying term and
investing the difference is self-evident. There are, however, a number of reasons
why this may not necessarily be true.

Why not buy term and invest the difference?

 The tax treatment of a life insurance contract generally is more favorable
than that of buying term and investing the difference. The internal growth of
the cash value is generally tax-deferred.

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 Many of the comparisons purporting to prove the superiority of the “buy
term and invest the difference” approach are inaccurate because they
compare the return on a relatively safe universal life product with riskier
equity investments. Because the equity investment returns used are historical,
the impression given is one of a far greater certainty of return than is
justified.
 People have a tendency to think they are more daring than they really are
when it comes to investments. In fact, many who say they intend to invest in
equities end up with large amounts of money in CDs or other similarly
conservative investments. The cash value of a whole life or universal life
insurance product often has a return similar to CDs.
 The very fact that both the cash value and the term element are in one
contractual package gives the program flexibility.
 Waiver of premium provisions, which pay the premium or at least the
monthly charges in the event of the policyowner’s disability, enable the
policyowner to be sure that the cash value element will grow even if he or
she is disabled. Some annuities offer similar protection, but no other
investment does.
 It is human nature to pay a bill. Receiving a bill from the insurance company
may result in the completion of a savings program that otherwise would
never be funded.
 The perceived difficulty of getting at the money in a cash value contract
discourages the client from accessing the funds for frivolous purposes and
makes it more likely they will be there for the long term.
 Unfortunately, rather than buying term and investing the difference, the client
often buys term and spends the difference. If the majority of policyowners
actually invested the difference, planners would find more people with
adequate emergency funds and substantial investment portfolios.
This is not to say that term products should not be used (or that “investing the
difference” may not be a good idea). In many situations, term is the best choice.
(Remember that the primary focus in life insurance planning is to cover the risk or

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need. In many cases, term’s lower premiums are the only way for an individual to
cover the entire life insurance need. Even when funds are available to pay for a
cash value life policy, it may not make sense to do so.) The purpose here is simply
to show that there are valid reasons for using cash value products in the right
situation and that they should not automatically be rejected as unsuitable.

Joint Life Policies

Most life insurance is structured to cover one life, but some policies cover more
than one life. These can be either first-to-die or second-to-die policies, also
known as survivorship policies. These policies traditionally have been whole life
contracts, but other products, such as current assumption whole life and universal
life, have also expanded into the multiple-lives arena. Because they are used
typically in complex estate planning situations, this is one type of insurance that
needs to remain in force until the death of the insureds, therefore variable life is
not used.
First-to-die policies. A first-to-die policy may be used in either a personal or a
business situation. It promises to pay the face amount on the death of the first of
two or more covered persons. This type of policy arrangement may be used to
fund buy-sell agreements. For example, if one of three covered business partners
dies before retirement, the business is provided with enough cash to purchase his
or her share of the business without invading current assets.
If the policy is written on a husband and wife, the policy pays on the death of the
first and may be terminated at that time. Instead of two policies covering the risk
of either dying first, this policy covers that risk in one contract. The survivor,
then, may be without coverage, or the joint life contract may provide the survivor
with the right to purchase another policy without evidence of insurability or to
continue with the same or a lesser amount of coverage. A first-to-die policy
might be used to cover a mortgage or an education fund.
Premiums for a first-to-die policy are generally more than the cost of insurance
on any one of the people insured, but they are less than the combined premium of
individual policies on each of insureds. These life insurance policies have not
been among the best-selling types, and as such, they can be hard to find in the
marketplace.

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Second-to-die policies. The survivorship life (or second-to-die or last-to-die)
policy pays when the last person dies, not at the first death. This policy is
especially attractive in estate planning situations when the unlimited marital
deduction is used. For example, after the husband dies, his entire estate passes
estate-tax-free to his wife; when she dies, a well-structured policy will provide
the liquidity necessary for the wife’s estate taxes. With proper estate planning,
the insurance benefits may avoid estate taxes while being available to pay taxes
arising from the transfer of other assets. Details of estate planning issues are
covered in the Estate Planning course of the College’s CFP Certification
Professional Education Program.
Premiums for a second-to-die contract generally are lower than the cost of two
separate policies. This type of policy is particularly advantageous in situations
where one insured is highly rated and older, since the underwriting will
concentrate on the person who is likely to be the second to die.
Traditionally, some form of cash value life insurance, such as whole life, is the
policy type used. However, some companies now offer term policies in the
survivorship life category. More commonly, a number of survivorship life plans
may use a combination of term and cash value life insurance. The cash value
component would most likely be some form of whole life or universal life
insurance.

Variable Life
Variable life (VL) emerged in the United States in the 1970s. Variable life is a
variation built on the whole life model. Here the policyowner invests the policy’s
cash value in the equivalent of mutual funds (sub-accounts).
Traditional variable life. Traditional variable life (as opposed to variable
universal life), hereafter called variable life, is discussed first. It has some whole
life features, namely a guaranteed premium and a guaranteed death benefit
(normally).
Structure of variable life. Variable life is designed to combine the protection and
savings functions of traditional life insurance with the growth potential of
mutual-fund type investments. The policy’s cash value is not guaranteed, and is
invested in a separate account (not in the insurer’s general account). Premiums

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are fixed, but the face amount and cash values vary in relation to the contract’s
earnings. A variable life policy normally includes a guarantee that the death
benefit in any year will never be less than the initial face amount. Premiums are
typically higher than for an equal amount of whole life insurance. A prospectus,
which will include all the information usually found in a mutual fund prospectus
(including the charges for fund management and administration), must be used
when selling variable life products.
Inherent risk of variable life. The buyer of variable life must be willing to give
up the guarantee of a stated cash value in exchange for the possibility of
enhanced death benefits and cash values. Many people are not willing to take
such a risk with respect to their death protection. All of the investment risk falls
to the policyowner.

Variable Universal Life

Variable life insurance is built on a whole life platform. Variable universal life
(VUL) insurance is built on a universal life platform, unbundled. VUL is also
known as flexible premium variable life. Basically, VUL marries the flexibility
of universal life with the investment selection aspect of variable life. Unlike
variable life, VUL guarantees only the mortality rate and the right to keep the
policy in force. This type of product requires that the owner be familiar with
investing and be willing to bear the expense and risk of this type of policy.
Following is a list of typical items in a VUL policy that you, as a planner, should
fully understand. This information should be readily available for your interested
clients.
Typical Items in a VUL Policy
Death Benefit Determination Renewal Expense
Effect on policy account value Premium load
Mortality Charges Policy fee
Current State premium tax
Guaranteed Administrative fees
Projected Expense charge maximum
Basis of guarantee/projection Investment Manager
First-Year Expense Charges Who
Premium load Experience
Policy fee Fund choices

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 State premium tax Policy Loan Rate
Administrative fees/percentage Fixed
Investment Account Charges Adjustable
Fixed amount Loan Credit Rate
Percentage of account Fixed
Volume discounts Adjustable
Transfer fees Maximum Loan
Surrender Charges Partial Withdrawals
Number of years Additional Benefits/Riders
Percentages of account value
Rolling, continual percentage of
each new deposit

Some of these items warrant additional discussion.

Investment account charges. Few companies offer a volume discount on VUL
investment accounts since VUL policies are generally subject to contingent
deferred sales charges.
Policy loan effect. It is important to understand what happens when a
policyowner takes out a policy loan. Many companies automatically move the
cash value that is collateral for the policy loan into the policy’s guaranteed return
account. Once the loan is paid off, these accounts often have strict limits on how
much may be moved out of them in a given year. The guaranteed interest
accounts are generally considered to be a very conservative investment, and those
who believe in variable products usually don’t want their cash values in them.
This works against the general purpose of using variable products.
Obviously, VUL policies are not simple, and they can be expensive. If the client
does not understand how this policy works, he or she should not buy it.
Essentially all of the risk, other than the mortality risk, belongs to the
policyowner.

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Other Forms of Life Insurance
Group Life Insurance
There are a number of ways an individual may augment his or her personal life
insurance through an employer. Group life is the most common. In fact, group
life insurance accounts for a large portion of all life insurance in force in the
United States. Because of this, a planner cannot ignore group life coverage.
Companies may offer a set amount such as $50,000 or a multiple of salary. Some
companies allow employees to sign up for additional coverage at open
enrollment and even offer spousal and child insurance coverage with no
underwriting requirements. It is important to check a client’s opportunities at
work, especially if there are health issues.
The primary advantage of group life is that it is generally paid for by the
employer and may have no underwriting requirements (subject to predetermined
limits). The major disadvantage is the ability of the employer or the insurance
company to cancel the policy, and the fact that, unless the employee can afford to
convert the group term insurance to whole life upon separation from the
employer, the protection is tied to the job. Because of this, it is important to
emphasize that all of an individual’s insurance should not be tied to his or her
employment.
When an employer provides group life insurance, there are some unique benefits
that arise. The employer may deduct the insurance premiums as long as the plan
is for the benefit of employees. Employees do not have to report as income any
premiums paid for up to $50,000 of group term life (premiums paid for amounts
larger than $50,000 are taxable to the employee). The death benefits remain
income-tax-free to the named beneficiary.

Franchise or Payroll Deduction Life Insurance

Franchise or payroll deduction life insurance is basically the offering of
individual insurance products (it can be universal life or some form of whole life)
to people who work for the same employer. Employees who elect to purchase the
life insurance receive an individual contract from the insurer, just as they would

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if they had purchased an individual life policy. The premium is deducted
automatically from wages by the employer and forwarded, together with other
participants’ premiums, to the insurance company on a monthly basis. There are
two primary considerations in the design and marketing of this product. The first
consideration is the product, premium, and billing structure that will be used. The
second is the underwriting that will be required.
The product is similar to any other individual life product. The principal
differences are related to the insurer’s ability to meet the administrative demands
and special underwriting concessions generally expected in such a product.
Pricing will be based on the insurer’s expectations for (or experience with) the
amount of product sold, administrative time required, lapse ratios, adverse
selection due to underwriting concessions, increased expense associated with a
lower average policy size, and decreased expenses associated with group billing.
Company estimates of how these factors will interact and vary from their general
book of business will affect whether the product offered is more or less
expensive than other products offered to the general public.
Generally, there are fewer underwriting requirements for payroll deduction or
franchise insurance. The degree to which the requirements are relaxed is based
on the size of a group and the percentage of that group purchasing insurance
under the program. As is the case with group insurance, the larger the group and
the larger the percentage of people enrolled, the smaller the chance of substantial
adverse selection. Generally, upon leaving the employer, the employee may
simply notify the insurer, which changes the billing on the product so that the
former employee is billed directly.
Advantages associated with the product are convenience, relaxed underwriting
requirements, minimum face amounts that are often reduced, and whatever
pricing advantages are extended. Employers often prefer such programs since
they are perceived as a benefit by employees who participate, yet they cost the
employer nothing except the administrative expense of making the payroll
deduction.

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Low-Load Life Insurance
In the past several years there has been a great deal of interest in life insurance
policies that are sold by individuals who do not earn commissions. These policies
are generally known as low-load, or no-load policies. This refers to the low, or
lack of, commission costs being incorporated in the premium of the insurance.
Low-load life insurance can be found in the form of any product, including term,
survivorship life, whole life, universal life, and variable life. The principal
difference between low-load life insurance and traditional life insurance is that
low-load life insurance reduces the acquisition costs. This often results in lower
premiums and higher immediate cash surrender values.
Low-load life insurance is usually marketed through alternate distribution
systems—either directly to the consumer or through a fee-only financial advisor.
The wholesale approach (direct to the consumer) is appropriate for people who
know what they want and don’t need advice. Consumers can either buy direct
from insurance companies or they can contact a large wholesale “clearinghouse”
that offers several different low-load life insurance products from several
different companies (many of these organizations offer quotes on the Internet,
and consumers may also be able to initiate the purchase of some policies online).

Private Placement Life Insurance

Private placement life insurance policies (PPLI) are offered through both
domestic and foreign insurers to high net worth individuals. These policies are
anything but “off-the-shelf.” They are highly customizable, and in many ways
structured as much (or more) to be investment vehicles as to be typical life
insurance policies.
Much of the flexibility in PPLI policies is in where (how) the cash account is
invested. Policyowners can use mutual funds, hedge funds, various equity and
fixed-income instruments, and even direct investments in businesses. Owners can
transfer assets into PPLI policies with potentially positive tax consequences.
Rapidly appreciating assets may be a particularly good choice for transfer into a
PPLI policy. Policyowners can also choose (and change) investment advisors. As
you might suppose, the premium dollar amounts involved are high—typically in

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the millions of dollars (usually paid over a period of years to avoid status as a
MEC—see below). Separate accounts must remain diversified to stay within
legal guidelines. PPLI policies are typically structured as VUL policies, and
retain all the tax benefits of non-PPLI policies (e.g., tax-deferred growth, tax-free
death benefit, etc.). Potential PPLI owners need to realize that, in order to satisfy
legal guidelines, they have to give up a great deal of control over assets placed
within the PPLI. There is still a large amount of flexibility, but this loss of
control should be considered.
PPLI policyowners should be aware of two potential problems of overfunding.
The first is the most crucial: if the policy fails the guideline premium test and the
cash value accumulation test (under IRC Section 7702), the policy may lose its
full status as a life insurance policy. If this happens, one of the primary
advantages of life insurance—tax-deferred growth—will be eliminated, and the
policyowner must report the annual gain as taxable income. It is also possible
that some of the death benefit may become taxable. To avoid this potential, be
careful how much money is deposited into the policy, and structure the policy to
have an increasing death benefit. In this way, the required “corridor” between the
cash value and the death benefit will be maintained. The second problem is
avoiding being classified as a modified endowment contract (MEC)

Tax Treatment
One of the draws of life insurance is that the death benefit is received income-
tax-free by beneficiaries. Imagine how much more life insurance individuals
would need to purchase if their heirs had to pay income tax on life insurance
proceeds. Because it is generally received in a lump sum, it would be taxed at the
highest rate. You can begin to see what a harmful effect it would have on society
if death benefits were taxed as income. There are circumstances, described
below, in which death benefits will be considered taxable as income. Do not
confuse this with being estate tax exempt. Life insurance is included in the estate
of the owner so in most situations, it will increase the value of the estate and if
the client will exceed the current thresholds for estate taxation, there could be
estate tax due. Planning strategies to address this issue are covered in the Estate
Planning course of this program. It is important to remember this fact, however
in planning with clients for large insurance amounts.

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Another benefit of cash value life insurance is that the earnings grow tax-
deferred. Again, if taxes had to be paid on the money accumulating to support a
whole life policy in later years, it would require substantially higher premiums
and affordability would lessen. Withdrawals from cash value policies are tax-free
up to the basis in the policy. The basis is the amount paid minus any prior
dividends paid and/or prior withdrawals. For example, if I had paid in $20,000 in
premiums, if I withdraw $15,000, I will pay no tax but my basis is now $5,000. If
the policy is then surrendered and I receive $28,000, I will pay ordinary income
on the $13,000 above my basis. Because I have paid taxes on the money I put
into the policy, that amount is not taxed. Because the dividends were considered
return of premium, they were not taxed, but reduced my basis. The balance is
gain and that is taxed as ordinary income, not capital gains.
In order to ensure that these benefits are used as intended versus manipulated for
gain, there are a multitude of laws related to when these two factors will apply
and when they will be voided.
Recent years have seen substantial federal activity in the area of the tax treatment
of life insurance. Laws have been enacted to limit the use of life insurance
primarily for investment purposes. The result has been that there are now
substantial tax implications regarding the way in which an insurance product is
designed by the company and paid for by the policyowner. Under the 1984 tax
law changes, the government created a definition for life insurance that related
the cash values to the death benefit. If the cash values of a policy become too
large relative to the death benefit, the policy ceases to qualify as life insurance
for some purposes. The growth in cash values is no longer tax-deferred, and the
policyowner must report the annual gain as taxable income (whether or not the
gain is taken from the policy). However, the policy death benefit, when paid,
normally remains income-tax-free. These policies are called MECs.

Modified Endowment Contract (MEC)

In 1979 when UL policies debuted in the United States, savvy investors realized
they had the best of both worlds. Drop in huge amounts of cash to a small life
policy, let it grow, then pull it out under first-in, first-out (FIFO) rules and
borrow the rest—investments with no taxation. However, in 1988, Congress

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passed legislation—the Technical and Miscellaneous Revenue Act of 1988
(TAMRA)—creating modified endowment contracts (MECs). If a policy fails the
seven-pay test, policy loans and withdrawals are then subject to taxes and
penalties. Without going into great detail, a policy is classified as a MEC if the
policyowner deposits the equivalent of more than total net annual premium
payments at any time during the first seven years. For example, if a policy’s
annual premium is $2,000, the total maximum in deposits in year three cannot
exceed $6,000. But if deposits were $1,000 each in years one and two, then the
maximum amount that can be deposited in year three, and still avoid MEC
classification, is $4,000. Also, once a MEC, always a MEC. Once a policy is
classified as a MEC, it remains so for its life (there is no way to change the
status, other than to lapse the entire policy).
MEC status means that any withdrawals from the policy (e.g., loans, partial cash
withdrawals, pledging as collateral, etc.) will be taxable as ordinary income (on a
LIFO basis). It will be subject to a 10% early withdrawal penalty if accessed
prior to the policyowner reaching age 59½. This is only a problem if the owner
wishes to make withdrawals from the policy, so it is important to pay attention to
his or her goals when deciding the best way to proceed.
It should also be noted that even if a policy avoids MEC status during its first
seven years, it may still be subject to MEC rules should there be any material
change such as a change of amount, addition of riders, or increase of coverage
amount. At this time a new seven-year premium limit is instituted. Finally, it
should be understood, that by their very nature, all single-premium life policies
are considered to be MECs.
The other set of laws addressed using life insurance death benefits as an
investment. When an individual buys a policy on another’s life, at the time of
underwriting, they must have an insurable interest. If a policy is sold to someone
without an insurable interest, such as in viatical settlements, the death benefit
becomes subject to ordinary income tax and the new owner does not receive the
favorable tax treatment. Policies can be transferred for value to select individuals,
such as the insured, or partners of the insured without triggering this rule. This
will also be covered more in the Income Tax Planning and Estate Planning
courses, but due care must be paid when life insurance policies are transferred or
surrendered because tax consequences do exist.

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Tax legislation in 1996 addressed accelerated death benefits. Accelerated death
benefits are defined as those benefits paid by a life insurance company to a
terminally or chronically ill person. The 1996 legislation made these payments,
including payments made under a viatical agreement (discussed later), income-
tax-free (with some limitations). Details of the various tax laws are beyond the
scope of this module.

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Chapter 3: Contract Clauses
Reading this chapter will enable you to:

5–3 Compare the purposes of the general provisions of a life insurance

policy.

The Declarations Page

W henever evaluating a client’s life insurance, the front page of the

policy and the declarations page are the windows to the contract.
Some companies combine the two pages. The cover page of the
policy generally states what type of insurance it is: term, whole life, flexible
premium adjustable life, etc. It will generally name the company, often name the
insured, and show the policy number.

This is a good time to point out that the only important information from the
policy that is needed at time of claim is the insured’s name and policy number. It
is not a good idea to keep life insurance policies in a safe-deposit box because, in
most jurisdictions, death of a box owner results in denial of access to others, even
a co-owner of the same box. Thus, beneficiaries may not be given access to the
box immediately following the owner’s death. However, it is a good idea to keep
a list of insurance policies and their numbers in a safe-deposit box in case family
members are unaware of older policies. Possession of a policy is not required to
file a claim. A policy may or may not show the current beneficiary. The
insurance company keeps track of beneficiary changes, and no change is
complete until the company acknowledges receipt of a written request for a
change. For a claim to be filed, a certified copy of a death certificate and a claim
form signed by the beneficiary are all that are required.

When undertaking construction of a financial plan for a client, regardless of

whether it is the front page of a policy or the first inside page that is the
declarations page, this is where an analysis begins. The information found here
includes the name of the insured, the name of the owner (if different), the name
of the policy given by the insurance company, the amount of insurance, the

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policy date, the date of issue (usually the same as the policy date), any riders, and
a premium schedule.

Inside the Policy—Standard Provisions

Because an insurance policy is a legal contract, it contains the rights and duties of
each party in the contract. Most states have certain provisions, which are referred
to as standard provisions, that they require policies in their states to address.
Below are the most common provisions.
Entire contract clause. This clause states that the policy, along with the attached
application, constitutes the entire contract. Further, this clause states that changes
to the contract must be made in writing and must be signed by an officer of the
company. Students may recognize this last statement, also known as the waiver
clause.
Owners’ rights. The owner of the policy is generally stated on the declarations
page and on the application, which is made part of the policy. The ownership
clause states that the owner of the policy has the right to assign or transfer all or
some of the rights pertaining to the policy. No transfer of ownership will be
completed until the company has received and acknowledged a written copy of
the change. A change of ownership is done with an absolute assignment of the
policy.
A temporary transfer of ownership may be made by use of a collateral
assignment, which must also be in writing. A collateral assignment is generally
made when a policyowner wants to borrow money, and the lending institution
wants to be sure it gets paid back if the insured dies. A collateral assignment
provides that at the death of the insured, the lending institution has first claim on
the proceeds of the policy up to the amount owed. Once the debt is paid, the
lender signs a release of assignment that must be sent to the insurance company.
It is possible for a policyowner to assign some, but not all, of the rights of a
policy. One example is that the owner retains all policy rights, but may give a
person or organization the right to name the beneficiary. This might be done for
estate or income tax planning purposes or due to a legal proceeding. Rights can
include changes that can be made to the policy, such as dropping riders or

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switching from Option A to Option B in universal life. It can allow the owner to
predetermine settlement options, borrow from the policy, or exercise any of the
nonforfeiture options.
Beneficiary designations. The beneficiary clause in a policy generally identifies
that the beneficiary is as stated in the application or as changed, in writing,
subsequent to issue of the policy. The standard provision states that any
beneficiaries in the primary beneficiary class receive death benefits before any
other beneficiaries. There is no limit to the number of beneficiaries that can be in
one class. There are various methods of establishing beneficiaries. A standard
beneficiary arrangement, known as the per capita provision, states that any
proceeds of the policy will be paid to anyone in the class of primary beneficiaries. All
beneficiaries in a class share equally in the proceeds. If the insured wants something
other than this to happen, then provisions must be made.
The most common beneficiary arrangement lists the insured’s spouse as primary
beneficiary with the children as secondary beneficiaries. The next-most common
arrangement is the same, but adds grandchildren as tertiary beneficiaries. Certain
problems can arise with both of these typical arrangements. First, if the children
are minors, the courts will not let them have the money directly. However, after
the courts set up a trustee for the children’s funds (if the parents didn’t establish
trusts to take care of it), the children will receive their shares at age 18 in most
states. Many children of this age are not mature enough to handle such large
amounts of money wisely.
Per capita vs. per stirpes. The policyowner/insured/decedent may inadvertently
cause an undesired distribution among beneficiaries (not that they will really care
at that point). However, as a planner working with a client, beneficiary
designations really do matter. Assume the policyowner has named his children as
primary beneficiaries and his grandchildren as secondary beneficiaries. Without
proper wording, if one of the policyowner’s children dies before the
policyowner/insured were to die, the deceased child’s children (i.e.,
policyowner’s grandchildren) may share equally with any remaining primary
beneficiaries. This is the result of a per capita distribution. To avoid this, the
policyowner must provide that multiple beneficiaries in a single class (e.g.,
grandchildren as secondary beneficiaries) are to receive their portion per stirpes

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(“by line of descent” or “by right of representation”). If this is done, the children
of a deceased child will each receive an equal share of their parent’s share.

Example. Assume three children (children A, B, and C), each of whom has two
children (grandchildren X and Y). Children A, B, and C are to share policy
proceeds equally (i.e., 33.33% each).
In one form of per capita (by head) distribution, if child A dies before the insured
parent, grandchildren X and Y will receive nothing until children B and C are
also gone. In yet another permutation of per capita distribution, if child A dies,
grandchildren X and Y will both become primary beneficiaries and share the
death benefit equally with children B and C (or 25% for each) and a dilution of
benefits occurs. And in yet one additional form of per capita arrangement, known
as per capita at each generation, assume both children A and B were to die (A
with grandchildren X and Y, and B having only one child, grandchild Z), then
child C would retain a one-third interest, and each grandchild would receive 22%
or one-third of the remaining two-thirds of the death benefit. Be sure to examine
the per capita benefit to ascertain what a firm’s policy entails.
To avoid this, the policyowner can stipulate per stirpes (by branch) distribution.
In this case, children B and C will each receive 33.33% of the policy proceeds.
Grandchildren X and Y will divide child A’s (their parent’s) share of 33.33%
equally—each getting 16.66%. This avoids any dilution of benefits to children B
and C, and most likely reflects the policyowner’s original intent.

Revocable vs. irrevocable. Most beneficiary designations are revocable. This

means that the policyowner may change the beneficiaries of the policy at any
time and include or exclude anyone. An irrevocable beneficiary designation
changes everything. Once a beneficiary is designated as irrevocable, the owner
must get written permission from that beneficiary if the owner wants to do
anything with the policy other than stop premium payments (and in some cases
of divorce, if continued premium payments are court ordered, even this cannot be
done). The owner may not change beneficiaries, borrow against the policy,
surrender the policy, or assign it absolutely or collaterally without the irrevocable
beneficiary’s written permission.

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Premium payment section. In addition to defining the acceptable modes of
payment such as annual, semiannual, or monthly and addressing level or flexible
payments in UL or VL policies, this section will cover automatic premium loans
and grace periods.
Automatic premium loan. With most life insurance policies, if a premium is not
paid by the due date, and is also not paid by the end of the grace period, the
policy will lapse. Many whole-life-type policies have an automatic premium loan
(APL) provision in the contract that can prevent a lapse from occurring. At the
time the policy normally would lapse, if adequate cash value exists, a policy loan
is created to cover the premium due. An APL can be somewhat of a safety valve.
The benefit of this is that if a client is hospitalized or traveling or simply misses
making the payment, the policy will stay in force after the grace period.

While a policyowner may realize that premium payments have ceased, he or she
may believe the policy has lapsed, when in fact, some policies will last for years
using the APL provision to keep them in force. When the APL provision is in
effect, it essentially negates the automatic implementation of an extended term
insurance nonforfeiture option upon policy lapse. Interest on the APL is due on
the policy anniversary, and if it isn’t paid, the loan amount increases to include
the interest due.
Grace period. This provides that premiums received within 30 (or 31) days after
the due date are treated as though received on time. This clause also states that if
premiums are not received in that time frame, the policy will lapse.
Reinstatement clause. The reinstatement clause normally follows the grace
period clause. With most companies this clause provides that once the policy has
lapsed, the owner may reinstate it by paying all back premiums, paying off or
reinstating any policy loans that existed at the time of lapse, and by providing
proof of insurability satisfactory to the company. However, no insurance
coverage will have been in place from the date of lapse to the date all
reinstatement requirements are submitted, assuming the reinstatement is granted.
Upon lapse, and following reinstatement, some companies begin a new, full-term
contestable period.

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With some companies, the reinstatement clause extends the grace period to some
extent. For these companies, there is no requirement to provide proof of
insurability if the request is made within 31 days of the lapse date. Many
companies allow an application for reinstatement to be made as long as seven
years after lapse. No company will allow reinstatement if a policy has been
surrendered for its cash value. Unless otherwise requested, lapse of a whole life
policy lapses to extended term insurance. This is one of the nonforfeiture options
discussed later in this module.
Misstatement of age clause. This provides that if at death the insured turns out to
be older or younger than indicated on the application, the benefit will be adjusted
to provide the amount the premium would have provided at the correct age. This
is outside the realm of contract law since the age of the insured is a material fact
in issuing life insurance. Contract law is overridden in this case because there is a
specific clause in the contract to deal with this factual error.
Contestable clause. Once a life insurance policy is issued, the insurance
company has no more than two years (some states specify one year) during the
life of the insured to determine if there is any reason that it should not have
issued the policy. If the insured dies within the one- or two-year limit, the clock
stops, and the insurance company can take any reasonable amount of time
required to investigate and determine if there was any material misrepresentation
or concealment in the application. Blatant fraud may have no statute of
limitations, and in some cases a fraudulent application allows the insurance
company to avoid payment of a death claim even beyond the two-year
contestable period. This is handled on a case-by-case and state-by-state basis in
the courts. Likewise, purely fraudulent claims are likely to be contestable at any
time (e.g., submitting a death claim for someone who is still alive).
Suicide clause. Most policies will pay a death benefit if the insured commits
suicide. This clause generally provides that if the insured commits suicide within
one or two years (again, varies by state) after the policy was issued, the insurance
company need only return the cumulative premiums minus any indebtedness
(some companies also pay interest). Once the two years pass, suicide is treated as
any other death. Some states have a one-year suicide clause, and one state has no
suicide clause. In jurisdictions where there is no suicide clause (such as

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Missouri), the state essentially requires the insurance company to prove that the
insured intended to commit suicide before purchasing the policy.
Nonforfeiture options. When a person owns a whole-life-type insurance policy
and decides that he or she doesn’t want to continue to pay premiums on it, he or
she has a number of options. Over the years of ownership, the policy builds
reserves. Since the owner contributed to the reserves, it is the intent of the law
governing insurance that he or she should not forfeit those reserves, thus the term
nonforfeiture options.

Every whole-life-type of life insurance includes a nonforfeiture table. This table

has four columns. The first is the number of years the policy has been in force.
The second is the cash surrender value, listed as an amount per thousand dollars
of death benefit. The third column is the reduced paid-up insurance column, also
shown as an amount per thousand dollars of insurance. And finally there is the
extended term insurance column, stated in years and days. These nonforfeiture
options will be further discussed in Chapter 4 of this module.
Policy loans. Two types of policy loans can be made against cash-value-type
policies: standard policy loans and automatic premium loans. Before discussing
the loans themselves, it is important for the planner to understand what a policy
loan is and what it is not.
A policy loan is made by the insurance company using the policy as collateral. It
is very much like an equity loan taken out against the equity in one’s home. The
cash value of a life insurance policy is the equity the policyowner has in the
policy. If the owner wants to access the equity, he or she must borrow against it
or sell the asset.
Standard policy loans. A policyowner generally may borrow the entire cash
value of a policy, less an amount that is equal to the interest due on the next
policy anniversary. Most insurance companies charge interest in arrears (after the
time has passed for which interest is due), but some companies charge interest in
advance. Companies that charge interest in advance may state that they have a
lower interest rate, but since it is charged in advance, it is often equivalent to a
higher interest rate. For example, if someone borrows $1,000 at 8% for one year,
the interest due, if charged in arrears, will be $80 at the end of the year. The
present value of $80 due in one year, at 8%, is $74.07. If another company

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charges any rate of interest in excess of 7.407% in advance, its interest rate is
actually higher than 8% in arrears. This can be an important and somewhat
expensive distinction.
The interest rate may be fixed or variable. Participating policies generally use a
variable rate. A participating policy that has a fixed interest rate, such as 8%,
generally includes a provision called “direct recognition.” This provision
recognizes that the insurance company can earn either more or less than the 8%
being charged for policy loans. If it can earn more, the dividends for the policy
may be reduced when borrowing takes place. If the insurance company cannot
earn as much as the 8%, dividends may be increased. When a variable interest
rate is used for borrowing, the dividends are generally the same whether or not
borrowing takes place.
When a policy loan is taken from a variable product, an amount of the cash value
equal to the amount borrowed is generally moved to a guaranteed interest rate
account within the policy. The insurance company is accepting the policy values
as collateral for the loan, and as any good business would, it wants those values
in a secure investment, not one where the values may fluctuate.
Settlement options. When the proceeds of a life insurance policy are paid out as a
death benefit, or when the cash values are paid out, a lump-sum payment is the
most commonly used method of distribution. Sometimes, however, some other
method of distribution is better suited to the needs of the recipient. Policies offer
many distribution options. All of the proceeds may be distributed using any given
option, or several options may be used with different portions of the proceeds.
Annuities and life insurance policies offer the same settlement options.
Settlement options are covered in detail in Chapter 4 of this module.
Dividends. Policies issued by mutual life insurance companies must include a
provision that addresses dividends. When a mutual life insurance company has
revenues in excess of expenses, it has a surplus. Some of the surplus is used for
contingency reserves, some for working capital, and some is given back to the
policyowners. Each year, a mutual company’s board of directors declares a
dividend scale, and the policyowners share in what is called the divisible surplus.
Policies on which dividends are paid are said to be participating. Policyowners
may choose how to receive these payments, called dividends.

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There are five basic dividend options: cash, reduced premium, accumulate at
interest, paid-up dividend additions, and one-year term insurance (also known as
the fifth dividend option). Adjustable life policies have an additional option, but
it is beyond the scope of this introductory module. These options will be
discussed in detail in Chapter 4 of this module.
Conversion clause. Term insurance policies generally include a provision that
permits the policyowner to convert the term insurance into a cash value form of
insurance. Individuals often purchase term insurance to meet their long-term
needs because they can’t afford to purchase cash value insurance. Once their
income increases, they may be able to replace all or part of the term insurance
with a policy that more appropriately addresses their long-term needs. This
clause often limits conversion to specific forms of cash value insurance, and
usually permits conversion only up to the policy anniversary nearest the insured’s
age 65. Some low-cost term insurance policies further limit the conversion right
or exclude it altogether. When the conversion right is restricted, it is often limited
to the first five years or so after the issue date of the original term policy.
Common disaster clause. This is sometimes called a payment delay clause.
Simply stated, if the insured and the primary beneficiary die in a common
disaster, even if the deaths occur as much as 30 days apart, the beneficiary is
presumed to have died first. This automatically gives the proceeds to the
secondary beneficiaries. This can be a good clause to include in order to prevent
children from being inadvertently disinherited, especially in the case of a second
marriage.
Spendthrift clause. The spendthrift clause also may be attached to the
beneficiary agreement. This clause essentially prevents a beneficiary (who may
be presumed to be a spendthrift or otherwise unable to handle money well) from
assigning any benefits he or she may eventually get from the insurance company.
It prevents this only while the insurer has the money. Once it is in the hands of
the beneficiary, there are no restrictions on how he or she may use the money.

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Chapter 4: Life Insurance Policies:
Dividend Options and Riders

A
fter reading this chapter on options you will be able to recognize,
understand, and differentiate between dividend options and various
available riders.
At the time of the policy selection, dividend options and riders are selected.
Changing dividend options is generally one of the rights of the owner, but
restrictions may be placed during the underwriting process or if the policy is a
conversion. Riders can always be dropped but may require underwriting or may
not be allowed to be added after a policy is purchased.
Reading this chapter will enable you to:

5–4 Identify appropriate dividend options available under participating

life insurance policies.

Dividends
When a whole life participating policy is purchased, there are five common
dividend options from which the insured can choose.
1. cash
2. reduced premium
3. accumulate at interest
4. paid-up dividend additions
5. one-year term (also known as the fifth dividend option)
It may seem like a very minor choice at the time but the dividend choice can have
a huge impact on the policy in later years. In the early years of a participating
policy, the dividends are fairly small. Some companies don’t pay a dividend the
first policy year. Not all dividend options are available for all policies at all
times, as will be described later. An accelerated endowment option is an
additional option that may be offered (discussed in the paid-up additions section).

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Cash
The cash option is exactly what it appears to be. On the policy anniversary, if
there is any divisible surplus credited to a policy, the insurance company sends a
check to the policyowner. It is considered a return of premium so it is not taxed.

Reduced Premium
Likewise, on the policy anniversary, if a premium notice is being sent to the
policyowner, the premium will be reduced by any dividend paid. Most
companies that permit premiums to be paid by an automatic draft against a
checking account do not allow for dividends to reduce the automatic draft.
Whenever the dividend exceeds the premium due, one of the other dividend
options is used with the balance. Some companies permit dividends to be used to
pay any policy loan interest due or to reduce any outstanding loan balance but the
policyholder must call the company or complete paperwork each year for this to
happen.

Accumulate at Interest
This option operates like a savings account. The insurance company holds the
dividends in a separate account and pays a current rate of interest on the
accumulated dividends. At death or on surrender, this fund is paid out in addition
to the other policy proceeds. While dividends on participating policies are
generally not taxable as income because they are considered a return of premium,
the interest earned on accumulated dividends is taxable.

Paid-Up Additions Dividend Option

When a dividend is applied to this option, a small amount of insurance is
purchased that has a cash value equal to the dividend without any medical or
other underwriting required. This small amount of insurance is fully paid-up;
there are no premiums due to keep it in force. As with the cash value of the basic
policy, the cash value of this additional paid-up insurance increases at the
guaranteed interest rate credited to the rest of the policy. Additionally, these paid-
up additions generate more dividends. All of the growth of these additions is
fully tax-deferred.

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This is one of the most popular choices of all dividend options. With most
companies, the use of paid-up dividend additions provides for the greatest long-
term increase in death benefit and cash accumulation. The extra cash value
created by using paid-up additions usually exceeds that created by accumulating
the dividends at interest.
A variant of the paid-up dividend additions options may be offered. Some
policies will offer an option to convert the policy into an endowment, before its
normal or set maturity date, by using the accumulated policy dividends for this
purpose. This option is known as the accelerated endowment option, or just the
accelerated option.

One-Year Term
Also known as the fifth dividend option, this permits a beneficiary to receive
both the basic policy death benefit and an amount equal to the guaranteed cash
value. Each year all or a portion of the dividend is used to purchase one-year
term insurance in an amount equal to the guaranteed cash value. In the early
years the dividend is usually more than enough. In later years the policyowner
has the right to pay an additional amount to make sure the entire guaranteed cash
value is insured. Since only part of the dividend is used in the early years, this
dividend option must be used with one of the other options.
On or before the policy anniversary nearest an insured’s 65th birthday, many
companies permit a policyowner to convert one-year term to a whole life policy.

Paying Premiums with Dividends

The most obvious way premiums are paid with dividends is choosing the reduced
premium dividend option. If a policy is kept long enough, it may very well have
dividends that completely pay the premium. However, there are other methods
that have been used that permit the policyowner to have a whole life policy, but
not have to pay the premium for life. Mistakenly, in years past, some companies
used the term “vanishing premium.” The problem was that the premium doesn’t
vanish, it was just paid from a different, “nontraditional” cash source, the
dividends.

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The first step is to have a participating whole-life-type policy with either paid-up
additions or accumulating dividends. A policyowner pays the full premium for a
number of years. If dividend scales are high, illustrations may show payment of
only seven or eight years of premiums required. With lower interest rates, hence
low dividend scales, illustrations may show 14 or 15 years’ worth of premiums
must be paid. If dividends are adequate, the policyowner may change the
dividend option to reduce premium. Then, part of the paid-up additions is
surrendered, or part of the accumulated dividends is used to pay the balance of
premium.

As long as the dividend scale is adequate and illustrations using that dividend
scale are followed, a policy should continue without further out-of-pocket
premiums required. This premium-paying strategy was used extensively in the
early 1980s when interest rates and dividends were high. When interest and
dividends plummeted in the 1990s, illustrations originally showing only seven
required premium payments for this option to work became useless. Updated
illustrations at the new dividend scales often changed 7-pay policies to 13- or 14-
pay (or longer) policies.

Life Insurance Riders

Reading this rest of this chapter will enable you to:

5–5 Analyze the application of a given optional provision (rider)

available in a life insurance policy.

Unlike some forms of insurance, life insurance is generally not automatically

packaged with benefits beyond the basic death benefit. While most agents and
planners include a disability waiver of premium as a matter of course, different
clients have different needs, and the various riders, or additional benefits,
available allow the planner and agent to design a package that meets the client’s
particular needs. To adequately analyze a client’s coverage and make
comprehensive recommendations, it is important for you as a planner to
understand these riders. Innovations are occurring routinely with riders and each

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company has different definitions and details, so it is important to read the actual
language and not just rely on the name of the rider. Following are selected riders
you may encounter.
The first group of riders are concerned with providing additional death benefit in
one form or another.

Term Rider
Some companies will allow a purchaser of whole life to add a term rider for a
specific period of time. Because the underwriting, acquisition, and marketing
costs are already covered, the term rider may cost less than a separate term
policy. Generally they will be for terms such as 10 or 20 years designed to cover
a mortgage or other needs that are anticipated to disappear at a certain time
period.

Cost of Living Rider

Some companies will allow a rider to be added to policies that will increase the
benefit by inflation each year. The insurer requires no evidence of insurability.
Some companies require that the insured accept the increase and if he or she
rejects it at any time, either the rider ends or insurability proof may be required.
It can either be a term rider or, in the case of whole life insurance, an increase in
the base policy. In universal policies, the face amount may increase but the
premium may not adjust until the policy values are insufficient to support the
higher death benefit.

Accidental Death Benefit

Another common rider is the accidental death benefit. The accidental death
benefit (ADB) is often no longer synonymous with the term double indemnity. In
years past, the amount of ADB was nearly always double the amount of the basic
policy, so the term double indemnity was appropriate. Over the last 20 years or
so, the amount of ADB has often been limited in amount, and may be much
lower than the death benefit of the basic policy. In today’s world, where million-
dollar policies are not uncommon, the maximum amount of ADB offered by an
insurance company is often substantially less than the face amount.

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In general, ADB gives a false sense of security. Relatively few people actually
die as a result of accidents. Those who do seldom leave their families in a
financial condition that is worse than if they had died of a heart attack, stroke, or
fatal disease. If an employer provides ADB in conjunction with group life
insurance, that’s wonderful. It is a nice thing to have, but insurance planning
should never assume these benefits will be paid. There is a reason ADB is so
inexpensive. ADB pays only if an accident is the immediate cause of death. So,
for example, if a person dies as a result of an accident, but does so after 90 days
of being hooked up to machines, the benefit is not likely to be paid. The time
requirements can vary so, once again, it is important to read the policy. Likewise,
if an individual develops a fatal infection while being treated for accidental
injuries, benefits normally will be denied.
These denials of coverage come from the wording of the ADB clause. Generally,
an ADB payment is made only if the insured dies as the direct “result of bodily
injury effected solely through external, violent, and accidental means,
independently and exclusively of all other cause,” and the death occurs within 90
days of the accident. Because the chances of death from an accident that falls
within the parameters of the policy are small, most planners discourage use of
this and encourage any additional funds be put toward other riders or the base
premium.

Guaranteed Insurability Option

The guaranteed insurability option, also known as a purchase option, permits
younger policy owners to purchase more life insurance on the insured at specified
times and in specified amounts regardless of the insured’s occupation,
avocations, or health at that time. It is typically offered to purchasers of cash
value policies. Further, it provides that the policies purchased under the rider will
be the same classification as the original policy. A new version of this has started
occurring for business buy-sell agreements so that future value of the business
can be protected.

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Underwriting classifications usually differentiate between smokers and
nonsmokers, since smokers have a significantly shorter life expectancy than
nonsmokers. Additionally, many companies have standard and preferred
classifications, with preferred premiums being lower than standard premiums.
The typical purchase option permits the policyowner to obtain policies every
three years, starting at a given age (generally age 25) and normally ending at age
40. If the individual gets married or has a child, the next option can usually be
changed so that it can be exercised on the date of marriage or the date a child is
born or adopted.

Example. Bill just got married. The next normal option date on his guaranteed
insurability rider is two-and-a-half years away. However, because of his marriage
Bill was able to exercise that next option and purchase the insurance now.

Spouse or Children’s Rider

Some insurance companies will allow a spouse or child to be added as an insured
for a specified amount to the cash value policy. The amounts are typically small,
such as $10,000 or $25,000 of coverage. It is generally a level term rider and may
permit conversion to cash value coverage without evidence of insurability prior
to termination or at the death of the insured. The life insurance needs of both
spouses are often similar, and frequently are better served with individual
policies, but a rider with fewer or no underwriting requirements is an excellent
tool when insurability issues may exist.
A children’s rider has a number of significant benefits. The first is that insurance
on children can prevent a financial problem in the event a child dies. The second
is the provision that the child normally can convert the rider into a cash value
policy when he or she becomes an adult. This conversion benefit may be for an
amount three to five times larger than the amount of the rider. This conversion
can usually include a guaranteed insurability rider as well. The third benefit is the
insurability of uninsurable children. If the rider is in place prior to the birth of a
child (generally this must be the second child), as soon as the infant is 15 days
old, he or she is insured, regardless of any birth defects.

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This next group of riders address benefits other than increasing death benefits.
They are riders designed to address such issues as disability, critical illnesses,
long-term care, and terminal illness. If a client cannot afford to continue the life
insurance premium because of a medical problem, the chances are this is when
their family most needs the coverage to stay in force. These riders are frequently
referred to as extension of benefits riders. You may see them referred to as
accelerated benefits, long-term care, critical care, or any other number of terms
that mean the insured can access some form of the death benefit prior to death.
Prior to these being developed, the only options available were viatical
settlements and cashing in policies. The following riders are designed to address
these and other needs.

Disability Waiver of Premium

General
The most common rider included with life insurance policies is the disability
waiver of premium rider. With most policies, this rider provides that if the
policyowner is disabled, under the definitions in the contract, the insurance
company will waive the premium for the base policy and generally all riders.
Any loan interest will still be required to be paid so if there are large loans, the
policy may still lapse if the client cannot cover the cost of the loans. Otherwise,
the policy will continue as if the premiums were being paid. At no time will the
policyowner be required to repay any premiums waived on account of a
qualifying disability. How long the waiver lasts may be related to the age of the
onset of disability. For example, some policies say if the disability occurs after
age 60, benefits will only be paid to age 65. Others may extend for the life of the
policy. Some companies will automatically make the waiver of premium
permanent if the insured was disabled prior to age 60 or the disability lasted over
five years. This can be especially valuable on term insurance policies or universal
life. Read the policy carefully. Many planners will drop the waiver of premium
rider at age 60 based on the language in the contract, thus reducing premiums.
With most companies a qualifying disability must last six months before the
premium is waived. Often, once qualification has been determined, premiums
that were paid subsequent to the date of disability will be refunded.

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The definition of total disability varies widely. Frequently there will be split
definitions such as inability to perform one’s own job for two years, then any job
reasonably suited by education, training, and experience. Older policies may
have a fairly restrictive definition, such as one that prevents the policyowner
from working. Under this definition, if the policyowner is able to work, even for
a substantially reduced income, the premium is generally not waived.
Note that while the policyowner is generally responsible for payment of the
policy premium, he or she may not be the individual insured under the life
insurance provision. It is possible that a person other than the insured (for the
death benefit) will be insured for purposes of the waiver of premium rider. This
frequently happens when the purchaser and owner of a policy is a parent of an
insured child. In some cases, the disability waiver of premium provision covers
both the insured and the premium payor.

Presumptive Disability
Presumptive disability is a provision that may result in the waiver of premium
being effective without a total disability of the policyowner. Most companies
include this provision, and it is the same provision that is found in most disability
income insurance policies.
Presumptive loss can be either “loss of use” or a more restrictive definition loss
of eyes, both hands, both feet, or one of each, etc., and is very specific. If one of
these events occur, the disability will be presumed to be total and the premium
will be waived generally under the same terms as the waiver of premium. A few
companies add loss of speech as a qualifying disability. Some companies are
very restrictive with this clause, and others are fairly generous. The most
restrictive companies require any loss to be total and permanent. They also
require the loss of hands to be by severance at or above the wrist, with a similar
requirement for the loss of feet. The most generous companies require the loss to
be total, but only as long as the loss persists (i.e., the loss doesn’t have to be
permanent). There may be no requirement for extremities to be severed, merely a
loss of use of hands and/or feet, and again, only as long as the loss persists.
Again, to understand the value and compare policies, the language of the riders
must be reviewed.

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Universal Life Variations on Waivers of Premium
This rider changes its nature as it applies to universal life. Most UL policies will
waive only the monthly charges for mortality, riders, and expenses under the
rider. While the rider does not add any funds to the cash value build-up side of
the policy, it does allow the existing cash value to grow undisturbed. Some
waiver of premium riders on universal life policies waive the entire planned
premium, thus adding to the cash value in the policy. It is very important to
carefully read the description of exactly what is waived should the policyowner
be qualified for benefits.
The assumptions used in establishing a UL policy will dictate which option may
be best. If the UL was established to have a relatively low premium, assuming
that interest rates would increase or the premium would be increased in the
future, waiving the monthly charges will be the best option. If the policy is
established with a relatively high premium with the intent of building substantial
values for some future need, waiver of the planned periodic premium would be
better. A few companies give the purchaser the choice at inception of the policy,
but most companies offer only one method or the other.
Variable life policies generally follow the format of the policy form they take. A
variable life policy patterned after a whole life policy will have a waiver of
premium provision similar to a whole life policy. A variable UL will have
options similar to UL.
As with most insurance products, a planner cannot assume that the existence of a
specific rider means the same thing when comparing policies. It is important to
read each contract. Some riders will require disability to be total and permanent.
Others will pay as long as the disability lasts. A six-month wait is by far the most
common time period encountered, but others also may be encountered.

Disability Income Rider

Some companies offer a disability income rider (DIR), which provides both a
waiver of premium and a supplemental income if the insured is totally disabled
under the same definitions for waiver of premium. It is generally written as a
percentage of the amount paid monthly. A common percentage is 1%, so a

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$100,000 policy would pay $1,000 per month. There may also be restrictions as
to the maximum monthly benefit and coordination of benefits with other
disability policies or benefits to avoid creating moral hazard. Generally,
individual disability benefit policies are more appropriate but underwriting may
be less strict, so it may be a viable option for those clients who may have
difficulty acquiring the coverage they need.

Critical Illness Rider

This rider allows a client to accelerate a portion of the death benefit on a life
insurance policy. The policies will provide specified illnesses such as terminal
diseases or chronic illnesses that will require continuous care over an extended
period. The diseases will be listed and many policies include items such as heart
attacks, strokes, and cancer. The amount of the accelerated benefit made
available will be dependent on diagnosis and life expectancy at the time of
diagnosis. Obviously, this reduces the death benefit that the family will receive.
The insured may choose to take all of the benefit or only some, leaving the
balance for the family. There may be other requirements such as the policy must
be in effect for a certain number of years.

Long-Term Care Rider

Premiums can be made in lump sums or by periodic payments. This allows the
policyowner to access the death benefit to pay for long-term-care-related
expenses. The amount of death benefit and long term care allowance are based on
the insured’s age, gender, and health at the time of purchase. The death benefit is
reduced by the amount used for long-term care expenses plus a service charge.
Requirements to qualify are typically the same as for long-term care policies and
generally have an elimination period. The policy may be more restrictive than
stand-alone policies in that it may not cover home health care or inflation riders.
The long-term care benefit is limited to a portion of the face amount, so it may
not be enough by itself. There are also potential tax consequences if it is not a
qualified long-term care rider. The planner must carefully analyze the death
benefit needs and the potential long-term care needs so that both needs are
adequately addressed.

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Accelerated Death Benefit Rider
In response to viatical settlements and other issues, this rider was developed to
trigger accelerated payments of the death benefit. Many policies require the
individual to meet the definition of terminally ill, but the advent of critical care
and long-term care riders have caused some companies to create a single, broad
rider that defines a variety of situations where a portion between 25% and 98% of
the death benefit may be accessed. Insurers reduce the advanced death benefit
through actuarial computations. The insured may elect to take all or only a
portion of the death benefit. IRS law changes were made so that terminally ill
patients accessing the cash benefit would not be taxed and the cash treated as if it
were a death benefit. The wider availability of the accelerated death benefit riders
has reduced the need for the viatical market. Planners should, however, compare
this option to viatical settlements if the client is facing this need. An illustration
of the impact on death benefits should always be required.

Family Income Benefit Rider

This rider provides that the benefit payout will automatically be spread out in
monthly benefits, removing the choice of payout options from the beneficiary.
This can be beneficial for minors, spouses who have difficulty managing money,
special needs children, or anyone else who is concerned about the beneficiary
managing the money. There may or may not be a charge for this rider.

Return of Premium Rider

Some clients will purchase term insurance and prefer to pay a premium so if they
do not die within the time frame, they will receive their premiums back.
Requirements are that the policy must be kept the entire time and can cost 20%–
40% more than a policy without it. It may make sense for short, level term
policies such as 10 or 15 years designed to cover specific items such as buy-sell
agreements or a specific loan. Completing an opportunity cost calculation will
help answer the question, and that will be highly based on the expected rate of
return an alternate investment can earn.

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Chapter 5: Illustrations and
Choosing a Policy

O
ne of the sources of information you will use when helping clients
evaluate new or existing policies are illustrations from the insurance
company. Illustrations show how the policy is expected to perform over
the life of the insured. Two universal life policies with the same benefit and same
selected options and riders may look very different in 20 years. It might be easy
to just say “pick the best one,” but it is not as simple as that. There are a number
of factors that enter into understanding illustrations and comparing policies.
Understanding them will help you better explain insurance to your clients.

Reading the next part of this chapter will enable you to:

5–6 Distinguish between policy illustration factors to select the most

appropriate insurance product.

Illustrations
The financial planner is often asked to make qualitative as well as quantitative
judgments about various insurance illustrations when a client is considering life
insurance. The evaluation process is often incorrectly called due diligence. It is
more appropriately called due care.
Due diligence is actually a defense. It is used to show that a significant level of
conscientiousness and concern was taken in the preparation of the registration
statement and prospectus used in the sale of a security. Its meaning has been
expanded so that it provides a defense for anyone, other than the issuer of these
documents, who can prove he or she carried out a reasonable investigation and
examination to determine the accuracy of the disclosure in the offering
documents. Insurance itself is not a security (variable products aside, for the time
being). Since there are no offering documents, the due diligence process becomes
quite difficult.

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Due care, on the other hand, is the process of obtaining what information there is
and passing it along to the client with an analysis that is as objective as the
planner is capable of providing. Policy illustrations will be evaluated both for
existing in-force policies and policies being considered for purchase.
As a starting place, the planner should remember that an illustration is limited to
current information. Only the guaranteed columns (with some exceptions) can be
counted on to provide absolutely accurate information. A complete illustration
will clearly state that dividends are shown at the current scale and are not
projections for the future. Universal life and variable life interest rates may or
may not be guaranteed for any period of time. As is the case when considering
any financial statements, footnotes should be evaluated as an integral part of the
illustration.
The first step is to check the specifications to assure that the illustration pertains
to the client. The most obvious items to check include the age and sex of the
client, risk classification, inclusion or reference to requested riders, use of
dividends, use of tobacco, type of policy, and date of the illustration.
The illustration may show the age of the client as of the last birthday or the
nearest birthday. Backdating a policy to use a younger age may be a good way to
save on the premium, especially on whole life policies. If the nearest birthday is
used and the client is nearing the midpoint between birthdays, it might make
sense to apply for the insurance quickly to be able to use the younger age. Most
companies will allow backdating of a life insurance policy to use the younger
age; however, premiums will have to be paid from the birth date used.
Unless your client lives in a state that uses unisex rates to determine premiums,
the incorrect sex on the illustration will lead to incorrect premiums, dividends,
and/or cash values being shown.
Most illustrations will be calculated at a standard rate, based on certain
assumptions about the client. The underwriting process will determine if those
assumptions remain valid. If the company has a preferred or special rate, ask
what the terms mean and whether it is likely the client will qualify. Prior to
acceptance of a policy after the underwriting, it is best to acquire an illustration
for the specific policy being issued.

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Check to see if premiums are included for any requested riders, such as a
disability waiver of premium or an accidental death benefit. If it was requested
that dividends purchase paid-up dividend additions, are they illustrated that way?
If your client uses tobacco, is that shown on the illustration? Some people who
run illustrations have defaults set on the computer to show rates for those who
don’t use tobacco. A tobacco user’s premiums may be significantly higher than
those of a nonuser. Dividend scales change, so you need to make sure the
illustrated rates are current and valid (or biased on the conservative side).
Earlier it was stated that there are exceptions to the guaranteed columns on an
illustration. Some universal and variable life columns may show a column as
guaranteed when it actually is not. The guaranteed column may be calculated
using current mortality rates rather than the maximum guaranteed rates.
With the expanding capabilities of personal computers and PC-based illustration
systems, there has been a significant increase in the ability of the person running
an illustration to customize it. If the planner intends to do a mathematical
comparison of illustrations, he or she may be frustrated by the multitude of
assumptions used to create them. If one company or agent provides a
conservative illustration showing a lower-than-current dividend scale, comparing
it to another illustration using the current dividend scale is invalid. Dividend
history and company stability are probably better indicators of future
performance.
Some of this frustration with all the variations can be controlled by asking for
very specific illustrations. It can be especially helpful to ask for several different
illustrations when evaluating an existing policy. Looking at multiple illustrations
in which a single variable is changed can help you understand how that variable
will impact the policy and help you make a more informed decision.

Dividend Scale
It is important to understand what the term current dividend scale means as used
on an illustration. Each year a dividend scale is adopted by the board of directors
of every insurance company that sells participating policies. This scale, based on
the profits and surplus of the insurance company, is used to determine how much
money can be paid to policyowners. Companies generally want to maintain a

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dividend scale from year to year so that their illustrations provide a reasonable
representation of what actually may happen with a given policy. No illustration is
complete if it does not include a statement similar to the following: “Dividends
are shown at the current scale and are neither guarantees nor projections of the
future.” A planner reviewing illustrations must look for a statement that indicates
whether the illustration is using the current scale or a lower one.
The law prevents an insurance company from guaranteeing dividends. For most
of this century, virtually every insurance company met or exceeded the dividend
scale shown on earlier illustrations. Beginning in the mid-1980s this trend ended,
primarily as a result of the downward slide of interest rates from more than 15%
to below 3%.

Individual Product Illustrations

Whole life. This is one of the few products that will illustrate truly guaranteed
values. The basic policy has guaranteed premiums, a guaranteed death benefit,
and guaranteed cash values. The classic participating whole life policy from a
mutual company generally will show dividend values on any illustration. Until
the late 1980s, when interest rates began to fall from their high levels, few mutual
companies had even reduced dividend scales. Today it may be reasonable to
question any company that has not lowered them in the last few years.
Interest-sensitive and indeterminate premium whole life policies also will show
guaranteed values. These products were initially created by stock companies as
an answer to the dividend-paying participating policies of mutual companies.
Adjustable life, sold by only a few companies, will show guaranteed values that
may change as time goes on. The policy design will affect the guarantees.
Most illustrations can display values that deviate up or down from real company
returns or expenses. This can be done in a number of ways.
To illustrate other than guaranteed values, the company may assume mortality
costs will decrease at a rate greater than company history would indicate. This
would produce a reduction in costs that could be passed on to policyowners. In
order to look better, a company may assume life expectancy will increase in the
next 50 years, as it did in the last 50.

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Assuming a greater lapse rate can allow a company to show significantly higher
dividends in later years. Generally, until a policy has been in force 10 years or
more, there is, in effect, a surrender charge. Part of the company’s assets have
been set aside to cover the future obligations of the policy. If a policy is
surrendered in the early years, part of this money is freed up and can be used for
the benefit of remaining policyowners.

A company also might assume an unreasonable increase in investment returns.

Some companies readily admit that they will not be able to pay illustrated
dividends or interest payments. Other companies may use surplus to pay
dividends in order to look better on illustrations and to impress potential
policyowners, but this works to the financial detriment of the company.

If a company’s dividend scale is based on a gross 9% return, but the company is

earning 7.68% on its invested assets, what is the likelihood the dividends will be
maintained? If they are, what chance does the company have of surviving? Some
companies do base their dividend scale on a given block of business. If a given
policy has its dividend scale based on 9% and its invested assets are segregated
by blocks of business that were purchased when interest rates were high, higher
illustrated interest rates may be reasonable.

Variable life (traditional). The traditional form of variable life (VL) looks much
like a whole life policy. It has a guaranteed premium and a guaranteed death
benefit. The death benefit can increase based on the return of the equity portion
of the policy. However, because it is an equity product, unless a guaranteed fund
is used as the investment there are no guaranteed cash values. Illustrated rates of
return should reflect historical averages. Comparing the illustrated returns to
historical returns is one of the things a planner can do to evaluate an illustration.
Another is to analyze expense charges as would be done for a mutual fund. Since
VL is an equity product, due diligence is appropriate.

Universal life. The unbundled structure of universal life (UL) lends itself far too
easily to manipulation for illustrative purposes. UL is one of the products that can
show guaranteed values on the illustration that are not truly guaranteed.

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This is accomplished in a few simple ways. Most UL policies have current and
guaranteed mortality rates, interest rates, and expense charges. A truly
guaranteed set of numbers on an illustration will use only the guaranteed
maximum mortality and expense rates and the guaranteed interest rate. Some
companies have been known to use the guaranteed interest rate and expense rate
with current mortality charges. They argue that they never actually use the
maximum mortality charges because they underwrite applications and do not
accept bad risks; therefore, a lower mortality rate is justified. This is not bad
reasoning, but the fact remains that guaranteed numbers on an illustration may
not actually be guaranteed.
All too often, the credited interest rate is used to compare two UL policies. This
is a mistake, and is often compounded by asking for illustrations from a number
of companies using the same interest rate. For comparison purposes, a planner
should always request UL illustrations showing each company’s current credited
interest rate. Other illustrations, such as one using the same interest rate, can be
requested, but it only highlights one factor of the policy and should not be the
only factor considered.
Assume the following information for Company A and Company B:

Surrender
First After After Value After
Year 4 Years 9 Years 10 Years
Company A 12.00% 9.00% 7.00% $15,489
Company B 11.00% 8.75% 6.65% $17,260

Since Company B had lower interest rates in every identified period, it would be
expected that the surrender/accumulation value after 10 years would be less than
for Company A. There are several possible reasons why Company B’s values
were higher than Company A’s.

Some policies pay only the guaranteed rate of interest on the first $500 or $1,000
of cash accumulation value. In this case, the current interest rate may not even
apply to the first year’s cash value. Other policies have a fixed per-premium
charge or a percentage of premium charge before any money is put into the cash

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accumulation fund. Higher monthly expenses or mortality charges can easily
offset higher current interest rates. A company may tout its exceptionally low
mortality charges while increasing fees or charges elsewhere in the policy. A
careful analysis of the illustration may make some of these actions apparent.

Variable universal life. As an equity product, due diligence is appropriate for

variable universal life (VUL). Most of the same variables as used with standard
UL policy illustrations apply, with the addition of illustrated returns versus
historical returns for the various investment accounts. The various policy fees are
shown in the VUL prospectus, and often are more easily identified than they are
with a standard UL policy.

Joint life. There are two types of joint life policies—first to die and last to die.
Compare these in the same way as you compare the basic policies they emulate.
In addition, there is one very important factor to keep in mind. Generally, last-to-
die policies are purchased for estate liquidity; thus they tend to have a lower
lapse rate than individual policies. High future dividends may not be realized if a
company uses an accelerated lapse rate to support future dividends or interest
assumptions in its policies.
Joint life policies often combine a base policy with term insurance. The term
portion of the premium usually is not guaranteed at the current rates. As insureds
get older, the term portion of the cost increases. Many illustrations show this
increasing cost to be covered by dividends or excess interest. However, if interest
rates remain low or decrease, the term cost at life expectancy may be greater than
the actual dividends or excess interest. For this reason, the term portion should be
kept as small as possible. If there is an option to convert it to the same type of
policy as the base policy, that may be a good alternative as the insureds age.

Model Illustration
The National Association of Insurance Commissioners (NAIC) developed the
Life Insurance Disclosure Model Regulation, which sets guidelines for life
insurance policy illustrations. The model regulation includes requirements that
must be included in any illustration, along with an additional requirement that a
Buyer’s Guide be delivered before a sales presentation or at least five days before
delivery of a policy. There are many details to the regulation, including one

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identifying that an agent must make clear before beginning any sales presentation
that he or she is an agent and represents a specific company. A financial planner
may not allow a client to believe that he or she is merely acting in an advisory
capacity if there is any intent to sell life insurance.
The model regulation, as adopted by the various states, makes the process of
comparing illustrations somewhat easier. However, any comparison still requires
careful evaluation on the part of the planner.

Using the Illustrations

The American Society of CLU and ChFC (now, the Society of Financial Services
Professionals) developed an Insurance Questionnaire, which is in use (in some
form) by most of the large insurance companies. A trained individual can read
the responses to these questionnaires and learn a great deal about the long-term
accuracy of the illustrations from each of the companies. A planner or insurance
agent should be able to obtain one by requesting it from any company with which
he or she might place insurance business. If a company declines to provide the
information, the planner and agent may choose not to place business with it. Be
aware, though, that many companies consider the NAIC’s disclosure information
to be more than adequate. This is a fair position. If you wish to become more
familiar with companies and their practices, however, the questionnaires are
excellent sources.
The process of illustration analysis is not a simple task. Part of the process can be
eliminated if the planner initially establishes basic parameters of acceptance for
insurance companies. These can be based on ratings, company size, product mix,
or any other criteria. This step alone will often reduce the number of illustrations
to be analyzed. If a number of agents have submitted proposals, the completeness
of the illustrations and an agent’s responses to questions, or lack of response,
may further reduce the field.
An illustration is best used as an initial screen. Since an illustration is primarily
made up of nonguaranteed figures, the company behind the figures is of primary
importance. The best use of an illustration is in viewing it as a presentation of a
concept, rather than as the absolute operation of the policy under consideration.

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Once that approach is established, there are a few items the planner should keep
in mind when evaluating an illustration:

Is the information on the policy correct?

 company name

 client age and sex

 type of insurance

 amount of insurance

 underwriting classification

 health rating

 tobacco use status

How does the dividend scale or the current interest rate compare to the
company’s investment return?

How does the company’s actual dividend history compare to the illustrated
version?

For UL and VUL, how long is a surrender charge effective?

Are current mortality charges reasonable?

Is improvement assumed?

How do policy charges compare to those of similar policies?

Are dividends or interest rates based on increased lapse rates?

Is there a term rider on a second-to-die policy?

Will the company provide a copy of its answers to the Insurance Questionnaire?

Does the agent respond in a timely manner with adequate information to any
questions asked?

While this list alone does not cover all possibilities, it will give you, as a planner,
a basis for beginning a professional evaluation of the illustrations available.

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Reading the next part of this chapter should allow you to:

5–7 Recommend an appropriate type of insurance policy.

Recommending the right insurance policy is not a simple task, but it is an

important one.

Choosing the Right Policy

How do you know which policy is right for a given client? The process is as
much art as science. There seldom will be a situation where a single life
insurance or annuity product clearly will be the best one for your client. In many
circumstances, more than one contract may be called for.
Clients will often need insurance to cover both short- and long-term needs. Most
of the time, clients need more life insurance than they imagine they need.
Disposable income often is inadequate to meet all the insurance needs with a
cash value product (which may not be desirable even with adequate disposable
income). A combination of term and cash value often is the best alternative.
Long-range planning also is important. Evaluation of expected needs in 20 or 30
years should be considered in addition to today’s needs. Needs and life insurance
uses change over time. For example, insurance used for funding college when
children are young may become insurance that can permit maximization of
retirement income in later years or provide liquidity for estate settlement
expenses. The next module will cover this in more detail.

Insurability
The problem of insurability is real. Everyone has a line of insurability in front of
him or her. When one crosses that line of insurability, he or she will no longer be
able to purchase life insurance. That line may be crossed today, tomorrow, or not
until death. The planner should express a sense of urgency when establishing a
client’s life insurance program. Most agents who have been in the business 10 or
more years have experienced a prospect‘s or client’s death before insurance was
in place or shortly after the insurance was put in place. Many also have had
clients become uninsurable shortly after putting a life insurance program in place,
and more than a few have had the insurance physical uncover signs of a serious,

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previously undiagnosed problem that ultimately saved the insured’s life. To wait
until insurance is needed may make it impossible to buy for the same reason that
you can’t call your insurance agent while your house burns to purchase additional
homeowners insurance. After all, sick people wanting health insurance, and
deathbed breadwinners wishing for more life insurance are examples of adverse
selection, a topic discussed previously, but illustrated and hopefully understood
very clearly here in this discussion of insurability.

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Chapter 6: Managing a Policy

A
fter a policy is purchased, your role has not ended. Monitoring of
financial assets and a financial plan includes life insurance policies. On
a routine basis, illustrations and beneficiary designations should be
reviewed. Decisions on dividend options and riders will need to be made.
Sometimes, the point comes where the insurance is no longer needed as a death
benefit or there are more pressing needs for the cash than maintaining the death
benefit. At this time, the planner may become involved in helping policyowners
understand their options and the best choice to accomplish a goal. The first area
to explore is what are called nonforfeiture options. A call to the insurance
company by the policy owner can result in specific calculations being sent to the
insured.
Reading the first part of this chapter will enable you to:

5–8 Calculate the value of a given nonforfeiture option in a life insurance

policy at a specific point in time.

Nonforfeiture Options
Reduced Paid-Up Insurance
The reduced paid-up insurance option (not to be confused with the “paid-up
additions” dividend option) is for those individuals who want to stop paying
premiums, but also want whatever insurance they can keep for life. The policy is
treated as though it were a smaller limited pay life policy. An example might be
where a $100,000 policy with a $13,800 cash surrender value showed a reduced
paid-up value of $447 (again, a “per thousand” figure). Here, rather than taking
the $13,800 cash value, the owner would leave the cash with the company and
have a $44,700 ($447 × 100) paid-up policy using the $13,800 as a single
premium. Again, if it were a participating policy, the dividends would play a role
as well as any loans on the policy. Many individuals when their children are
grown and are entering retirement appreciate this option. The coverage becomes
a “burial” plan and the reduction in premiums can increase the probability of
their money lasting their entire lifetime.

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Extended Term
The owner of this same hypothetical policy may decide that he or she doesn’t
want to pay any more premiums, but wants to have the full $100,000 death
benefit for a set number of years. The extended term option could be the best
choice. In this case, the $13,800 cash value is given to the insurance company in
exchange for having the full $100,000 of coverage for the next 15 years and 37
days. It is more or less a single premium term policy. If the time period the client
needs will be covered, then this can be an excellent shift. Sometimes clients will
want to cancel cash value coverage and buy term instead. This option will
prevent a taxable event from occurring and cover part of the term coverage the
client desires.
While not common, it is possible to use more than one nonforfeiture option with
portions of the cash value. If a policy lapses with a cash value, the automatic
nonforfeiture option is the extended term option. If any other option is desired, a
request for it must be included in the application or submitted in writing to the
insurance company.

Sample Nonforfeiture Table

Amounts per $1,000 of Policy Face Amount
Nonforfeiture Values
Extended Term Insurance
End of
Policy Cash or Paid-up
Year Loan Value Insurance Years Days
1 $ 0.00 $ 0 0 0

2 10.55 48 3 154

3 21.82 97 6 107

4 31.52 138 8 199

5 44.96 179 10 244

6 57.03 220 11 346

7 71.18 264 13 298

8 85.98 299 15 222

9 100.47 340 18 11

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 Extended Term Insurance
End of
Policy Cash or Paid-up
Year Loan Value Insurance Years Days
10 116.72 375 19 277

15 203.93 522 21 86

20 301.33 644 22 11

Cash
Surrendering a policy for the cash value is the most common nonforfeiture
option. The guaranteed values are included in each whole life policy includes in
the policy. The amount received by the policyowner would be this amount times
the number of thousands of dollars of life insurance, plus any dividend values,
minus any outstanding policy loans or premiums due. For example, a
nonforfeiture table may show a cash value of $138 for the 12th year of a policy.
If a policy had a $100,000 death benefit, the $138 would be multiplied by 100
(i.e., per thousand of insurance face value) to arrive at a $13,800 cash surrender
value. If the policy had been a participating policy, there may be another $15,000
in value from the dividends. On the other hand, if the policyowner had taken
loans or allowed the cash value of the policy to pay the premiums, the cash
surrender value may be less than the $13,800.
The nonforfeiture calculation is the starting point. It is important to ascertain the
reason the client wants the cash before determining to surrender a cash value
participating policy. When a policy is surrendered, the gain over the basis is
taxed at ordinary income rates. Remember that dividends are a return of premium
so they have reduced the basis in the contract. A loan will reduce the cash but not
the basis, so a fully loaned out policy may have no cash to surrender but still
cause a hefty taxable consequence. In these cases, other options may be more
appropriate.
Some of the reasons clients want cash can be related to critical illnesses or
terminal situations. If the policy has either of these riders, the client can take
advantage of the accelerated death benefit to avoid taxation and receive more
than the cash value. If the policy is an old one that does not include accelerated
death benefits, a viatical agreement may be beneficial.

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Viatical Agreements
A viatical agreement states that one or more persons will purchase the life
insurance on another person. This is generally done when a person is terminally
or chronically ill. However, recently, some viatical companies have been
approaching senior citizens with an eye on buying their policies for more than the
cash value but less than the death benefit.
While more and more life insurance policies now sold include a provision for
accelerated death benefits, not all policies have these provisions. Provisions for
accelerated death benefits generally state that if an insured becomes terminally
ill, the insurance company will pay a portion of the death benefit prior to death. It
makes little sense for a terminally ill person to surrender a life insurance policy,
especially if the cash value is only 20% or 30% of the death benefit.
The need created out of these situations is addressed by viatical agreements. The
buyer (often a viatication company, but sometimes an individual) will generally
pay 60% to 80% of the death benefit, depending on the assumed life expectancy
of the insured. The policyowner receives needed dollars right away, and on the
death of the insured, the buyer receives 100% of the death benefit.
The price paid for the policy is based to some extent on the National Association
of Insurance Commissioners Viatical Settlements Model Act and Regulations, if
it has been adopted in the state where the agreement takes place. The general
approach is to estimate the present value of the death benefit, based on the life
expectancy of the insured. From that amount, the buyers subtract the estimated
present value of any premiums that will have to be paid until the date of death.
Once the policy is sold, the buyer, typically a viatical company, must continue to
pay any premiums that come due.
The sale of the policy is a transfer for value, which means that any gain by the buyer
will be treated as investment gain and will not receive the favorable tax treatment life
insurance death benefits normally receive. The buyer may make a very good profit or a
poor profit. Changes in treatment for various diseases may drastically change the life
expectancy of an insured after the viatication of his or her policy. Extending a life by
one year would substantially reduce the gain to the buyer.

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The tax ramifications to policyowners selling their policy, regarding the viatical
payments received, are now similar to those for death benefits paid. The Health
Insurance Portability and Accountability Act of 1996 (HIPAA) provided that the
proceeds from the sale or assignment of all or part of a life insurance policy on a
terminally ill person to a viatical settlement provider will be free from income
tax. To qualify, the insured person must be diagnosed and certified by a
physician as terminally ill with a life expectancy of two years or less (some
current variations extend the qualification guidelines to allow for longer life
expectancies; e.g., seven years).
Some individuals have undertaken viatication, but more and more organized
businesses that represent investors have been purchasing policies under viatical
agreements. By operating this way, businesses working with viaticated policies
can spread out the risk associated with the inability to accurately estimate a
person’s life expectancy.
Senior or life settlements. An outgrowth of viatical settlements allows seniors
whose life expectancy exceeds two years to sell their life insurance policies.
Generally, the biggest difference between a viatical settlement and a life (or
senior) settlement is the insured’s age and life expectancy. Life settlements
usually require the insured to be at least 65 years old, and have poor health.
However, they allow the insured to have a much longer life expectancy than with
viatical settlements (e.g., 10 years or even longer). Settlements usually will be
taxable to the policyowner to the extent that proceeds exceed the policy’s basis.
However, if the insured is terminally ill and expected to die within 24 months,
the HIPAA viatication guidelines will come into play.

1035 Exchanges
The final area to look at is when the insured has decided that the type of cash
value coverage is no longer needed or that they would be better served by a
different policy. Rather than simply surrendering the policy, the tax codes allow
exchanges into other policies without creating a taxable event. This is referred to
as 1035 exchanges. The following exchanges can be made without taxable gain:

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 a contract of life insurance for another contract of life insurance or for an
endowment or annuity or qualified long-term care insurance contract;
 an endowment contract for another endowment contract in which the
beginning date for regular payments is no later than the original contract, an
annuity contract, or qualified long-term care contract;
 an annuity contract for another annuity contract or a qualified long-term care
contract; and
 a qualified long-term care contract for another qualified long-term care
contract.

Notice that you cannot go from annuity or long-term care to life insurance, but
you can go from life insurance to those contracts. This provides a great
opportunity to avoid gain and solve problems for clients whose needs have
changed. This rule makes cash value policies even more attractive for younger
buyers because they can accumulate the money in the life insurance and then
convert it to an annuity or long-term care if the insurance is no longer needed. All
of these options should be considered if a policy is going to create a taxable
event.

Settlement Options
If a policy remains in force until the death of the insured, the family will need to
determine how they want the proceeds paid out. Many times, they are not ready
to make such momentous decisions quickly and will rely on the planner to help
guide them through their choices.

Reading the next part of this chapter will enable you to:

5–9 Analyze and compare settlement options available under a life

insurance for specific situations.

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Interest Only
Most people normally think of death benefits being paid in a lump sum. This is
the most common method of settlement, but a number of settlement options exist.
The first settlement option examined is interest only or accumulate at interest.
The insurance company holds onto the funds and pays the beneficiary interest on
those funds, no less often than quarterly (normally). This is the only option that
keeps all other options open. However, the interest only option is generally a
temporary parking place until the beneficiary gets his or her bearings and decides
how and where to make a move with the proceeds. Eventually (i.e., within a year
or two), another option is usually chosen. Some insurers may allow this option to
continue for a longer period of time (however, it is not to be considered a life
income option). As was the case with dividend taxation, while the death benefit
usually is not taxable to the beneficiary, the interest paid on the proceeds while
using this option is taxable.

Installments for a Fixed Period

With this option, the beneficiary chooses the period of time over which payments
are to be received. The insurance company then uses its current interest rate
assumption to identify the amount of each payment.

Installments of a Fixed Amount

A different beneficiary may want to make sure that a specific amount is received
each month for as long as the proceeds will last. With this option, the beneficiary
specifies the amount of desired income, and the company uses its current
assumed interest rate to determine how long the payments will last.

Life Income Options

Many beneficiaries are less concerned about the level of their income than they
are about it running out. There are a number of options that will guarantee an
income for life. These should be compared with purchasing other immediate
annuities available at that time, as benefits can be significantly different.

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Straight life income. A straight life income option provides that the proceeds are
paid out in equal payments over the lifetime of the recipient. Actuarial tables are
used to determine the life expectancy of the recipient, and an earned interest rate
is also assumed. In most cases, once this option is chosen it cannot be changed. A
few companies have made some changes that permit an individual to change his
or her mind after starting this option. Generally, if allowed, the change must be made
within a specified number of months or years of the start date. Payments stop the day
the recipient dies, whether it is six months after the start date or 60 years.
Life income with a period certain. The harshness of the straight life income
option can be tempered by adding a period certain. The period certain is the
minimum number of years that the payments will be made, even if the recipient
dies. If the recipient is still alive at the end of the 10 years, the payments continue
for the balance of his or her life. These options may be referred to as 10 c&c or
20 c&c. These would be read as 10 years certain and continuous or 20 years
certain and continuous.
Life income with refund. This is another way to reduce the potential loss if a
recipient dies before receiving a total payout of the original proceeds. With this
option, the monthly income is paid during the life of the recipient. If he or she
dies before receiving cumulative payments equaling the original death benefit or
cash surrender value, the balance is paid to his or her heirs in one of two ways.
The most common way is a lump sum. A second payment method is to have
payments continue until the original lump sum has been paid out.
Joint and survivor life. The beneficiary of a life insurance policy or the
policyowner may want to take the proceeds as a lifetime income, but may also
want the income to last as long as either one of two people is alive. Joint and
survivor options provide that choice. A straight joint and survivor option will pay
one amount as long as either person is alive. A joint and two-thirds survivor
option will pay one amount as long as both people are alive, with two-thirds of
the original payment continuing for the survivor’s life after one of them dies. A
joint and one-half survivor option will pay one amount as long as both people are
alive with one-half of the original payment continuing for the survivor’s life after
one of them dies.

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Joint life. This is a rather uncommon option. A joint life option pays one amount
only while both people are alive. When one dies, income stops. Sometimes this is
chosen with a spouse and child, and it is common if a special needs adult child is
involved.
Which life income option pays the most? A straight (pure) life income option
pays the highest income. However, this option is rarely used because of the total
loss of principal when the recipient dies. The pure life option makes sense if the
client has no living relatives or has taken care of all possible family, wants the
highest possible life payout, and wants none of the proceeds to accrue to his or
her estate upon death. The refund option or a period certain are second highest,
depending on the age of the recipient. Of the joint and survivor options, the more
that is guaranteed after the first death, the lower the income while both are alive.

Recommending Settlement Options

When should a given settlement option be used? Identification of the various
settlement options is important, but determining when each might be most
beneficial is the practical skill needed by a planner.
An important first step is to recognize that all proceeds of a policy, either annuity
or life insurance, do not have to be applied to the same settlement option.
Assume David Weems died and left life insurance proceeds to his wife in the
amount of $350,000. Widow Weems may need $20,000 immediately to cover
funeral costs and other related expenses. Being a prudent person, she does not
believe she should make any rash decisions regarding the balance of the death
benefits. She is considering taking a lump sum of $20,000 now and leaving the
balance with the insurance company for a while.
If she leaves all or a portion of the funds with the insurance company, she will be
using the interest only option. This gives her the most flexibility in that she not
only maintains the right to take it all as a lump sum at a later date, but she has
also reserved the right to use any of the other settlement options without
incurring additional costs. As previously mentioned, most insurance companies
will not allow funds to remain in the interest option indefinitely. Limits may be
stated in months or years. The planner should contact the insurance company
involved when a client is in this type of situation.

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Assume that a month later Mrs. Weems determines that with her income and the
Social Security benefits being paid for the benefit of her dependent children, she
needs an additional $3,500 per month for the next five years. The insurance agent
tells her that the company will require approximately $180,000 of the remaining
funds to provide this income. She agrees and is now using a part of the proceeds
under a combination of the options of income for a fixed period and installments
of a fixed amount. In this case, she did not ask the insurance company how much
she would get if she applied all of the remaining proceeds to provide an income
for five years. She also did not tell them to pay her $3,500 per month for as long
as the proceeds lasted. Separately, these requests would have been the traditional
way of using these options, but there is nothing preventing a beneficiary from
combining them.
At this point, Mrs. Weems would have about $150,000 remaining with the
insurance company. She could choose to take a lump sum and invest it for the
children’s education or for augmenting her income later. The insurance company
may allow her to roll it into a deferred annuity, or she could purchase a deferred
annuity. If that were done, the growth of the funds would be tax-deferred, and
she could later choose to take one of the life income options.
A life income only option, sometimes called the straight life or pure life option,
provides her the maximum income that would be guaranteed not to run out as
long as she lives. Additionally, it would prevent any portion of the remaining
proceeds from being included in her estate. The benefit of this option is discussed
in the Estate Planning course of the CFP Certification Professional Education
Program. If she were to choose a life income with period certain option, the
present value of any payments due after her death would be included as part of
her estate. The same would be true if she were to choose a life income with
refund option.
When would a person want these options? The life income with period certain
option provides a guarantee of a specified payout regardless of how long the
recipient lives. The life income only option has a downside of the possibility that
only a few payments will be made before the recipient dies, resulting in a
substantial loss of potential benefits. The difference in income levels between the
life income only option and the option of life income with 10 years certain is
typically not very much until the person is quite old. The reason for this is that

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the vast majority of those reaching age 65 will also make it to age 75. A person
age 65, for example, has a life expectancy approaching 20 years. An option with
a period certain of 20 years would cause a more substantial difference in income
levels between the two options.
The life income with refund option has an effect similar to that of the life income
with period certain option. Rather than specifying a time frame for payments, the
life income with refund option guarantees that, while the benefits may last a
lifetime, if the recipient dies prior to receiving an amount equal to the original
amount applied to the option, the balance of that option will be paid to a named
beneficiary.
The life income with refund option and the life income with period certain option
are generally used by those who want a lifetime of guaranteed income but do not
want to take the chance that they or their beneficiaries might not receive at least
the principal in payments. Additionally, these options enhance the ability to plan.
If client A takes an option of life income with 10 years certain from his or her
pension plan, there is a guarantee that payments will be made for at least 10
years. If insurance is purchased to ensure that a spouse will continue to have
income after the death of the retiree, the amount of insurance required can be
based on a period beginning 10 years after retirement, at the earliest.
A joint and survivor option is used when income is required for two lives. The
joint and full survivor option is generally used when an income stream is needed
and there is no other income source for either person. Unfortunately, this option
provides the lowest possible income level from a given sum of money. If some
insurance money will be available at the death of one of two people receiving a
joint income, a different mix may be more appropriate. A joint and two-thirds
option or a joint and one-half option increases the income level while both people
are alive. However, the income level will still be substantially less than the life
only option

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Chapter 7: Annuities

A
nnuities were created to address concerns individuals had about
outliving their money and managing their money in later years.
Initially, annuities were simple products that were easy to understand.
Today, they are complex products that are easily misunderstood, misrepresented,
and misused. Consequently, they have received a significant amount of bad press
and are heavily regulated by state departments of insurance, and, for variable
annuities, by FINRA.

Reading this chapter will enable you to:

5–10 Distinguish between types, uses, and limitations of various types of

annuities.

A number of descriptive terms may be used to classify annuities. The first term
used in this section requiring definition is nonqualified annuity. This discussion
focuses on annuities where payment has been made with after-tax funds outside
of a qualified, employer-sponsored plan. These are nonqualified annuities.
Annuities can be held inside of qualified plans, in which case they are referred to
as qualified annuities. Annuities are structured based on life expectancy of a
specific individual or two individuals who are referred to as annuitants. It is
important to understand that an annuity can be owned by someone other than the
annuitant. Most annuities have the owner, annuitant, and beneficiary as the same
individual, but that is not required. The owner has rights in the contract such as
naming the beneficiary who is to receive the payment.

Other important terms, such as those listed below in Table 2, identify how
premiums are paid, when benefits begin, who is the annuitant, how long benefits
will be paid, and what method of payment/accumulation is to be utilized in the
annuity policy.

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 Table 2: Descriptive Terms Relating to Annuities
Single premium
HOW are premiums paid? Fixed premium
Flexible premium
Immediate
WHEN do benefits begin? Deferred
Longevity
Individual
WHO is the annuitant?
Joint Life
Fixed interest
WHAT is the
Variable earnings
accumulation structure?
Indexed earnings
WHAT is the method Fixed payment
determining the benefit Fixed with COLA
payment amount? Variable
Period certain
Pure life
HOW LONG are the Joint life
benefits paid? Life and period certain (5, 10, or 20
years)
Life with refund

Definitions
Single premium: One, up-front, lump-sum payment only.
Fixed premium: A predetermined premium, stated in the contract, which is to be
paid on each scheduled premium due date. The annuity owner can stop making
contributions at any time, but the amount allowed to be contributed is fixed.
Flexible premium: The premium deposit can be changed by the annuity owner at
any time, generally within specified limits.
Immediate annuity: Income payments to the named beneficiary start within a
year after a single payment is made.
Deferred annuity: Income payments will not start until a later date, usually a
year or more into the future.
Longevity annuity: Product designed to address the fear of running out of money
but delaying an annuity payment many years from the purchase, such as starting
at age 85.

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Individual annuitant: Income payments are made based on one person’s lifespan.
Typically, the annuitant is also the owner, but this is not always the case.
Joint lives: The contract is based on life expectancy of two lives.
Fixed interest annuity: The interest rate on invested dollars has a guaranteed
minimum rate. The current rate may be increased if insurance company general
account investments experience a higher rate of return.
Variable annuity: The internal value of the annuity is invested, at the direction of
the annuity holder, in various separate accounts that are similar to mutual funds.
Equity indexed annuity: A guaranteed minimum interest rate is given but offers
the potential for market-based return typically guaranteeing that the contract
value will not decline below the credited account as of the last policy anniversary
or other identified point in the life of the contract.
Fixed payment: At the annuitization of the contract, the monthly payment is
determined and remains at that level for the balance of the payout period chosen.
Fixed payment with COLA: The fixed amount of the payment increases based on
the contracted amount each year for the balance of the payout period chosen. A
few are tied to indexes but most are set at specific rate such as 3%.
Variable payment: At annuitization, the contract is converted to a specified
number of units based on amount in the contract minus contract fees and state
premium taxes along with age, sex, and assumed investment rate (AIR). Annuity
payments then increase or decrease in proportion to the extent that the net
investment performance exceeds or lags the AIR. Market risk and returns are
built into the payout structure that is based on the original amount invested. The
principal is not depleted by the payments and payments continue for the balance
of the payout period chosen.
Period certain annuity: A pure period certain annuity makes a payment for a
specified number of years and then ends. These are sometimes used for business
purchases, alimony payments, or any other situation where the funds are set aside
to provide income for a specified number of years. The payment is made to the
primary beneficiary (usually the annuitant) and if their death occurs, the
payments continue to the named beneficiary until the end of the specified period.

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Pure life annuity: Income payments last for the lifetime of the annuitant. This
option leaves no residual estate value, so it effectively removes the amount
invested from the estate.
Joint and survivor: An amount determined on two lives is paid out to the
beneficiary prior to either death. At the death of one of the annuitants, the
contract may continue either in full or for a reduced amount to the beneficiary (in
most cases this is the survivor) after the death of the other annuitant.
Joint life: Income payments last only as long as both annuitants live. When the
first annuitant dies, payments stop. This option is seldom used but could be used
when the remaining needs of a survivor will be covered by life insurance or some
other contract tied to a death.
Life and period certain: Income payments last for the lifetime of the annuitant,
with payments guaranteed to continue for a minimum specified payment period
(typically from 5–20 years) to a beneficiary the annuitant has named.
Life with refund annuity: If the value of the income payments over the life of
the annuitant do not equal the value of the annuity at the date of annuitization, the
balance is paid to a beneficiary either as continued payments or, more commonly,
as a lump sum.

Income Taxation of Annuities

One of the reasons annuities are popular is their deferred taxation aspect.
Contributions to nonqualified annuities are made with after-tax dollars that have
already been taxed. This becomes the basis in the contract. The primary rule of
taxation is that when income is both earned and accessible, it is taxed. Annuities
take advantage of this rule by restricting access to earnings, thereby creating
deferral of taxation. Earnings are not taxed immediately but are taxable upon
receipt. Receipt can occur in many ways, as described below. It is important to
note that annuity contracts held by entities that are not a natural person are not
treated as annuities exceptions, such as:
 Those held under qualified plans, stock bonus plans, 402(b) or IRAs, or
qualified funding assets

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 An estate that becomes the owner by reason of death
 Those purchased by an employer at termination of a qualified plan being held
until distribution to the employee
 Immediate annuities
 Those held in trust for a living person
If a company or trust owns an annuity that is not covered by one of these
exceptions, then the earnings are taxed as they are credited. Gifting an annuity to
a charity has complex rules where the gift is fully deductible but the gain must be
recognized. The full rules on trust ownership, gifting, and transferring annuities
are more fully covered in the Income Tax Planning course and are beyond the
scope of this module.
During the ownership of an annuity, tax is deferred. Taxation can be triggered by
withdrawals, surrender, pledging the annuity, sale or gifting, or annuitization. It
is important to note that utilizing 1035 exchanges does not create a taxable event.
A life insurance policy or an annuity can be exchanged for an annuity contract. If
the entire amount of the contract transfers to the new annuity, there is no
taxation. If the owner receives cash or reduction of debt in addition to the new
contract, then the amount received (referred to as boot) will be taxable. For
example, if an insurance contract held a loan and the policy was converted to an
annuity, the loan amount will be taxed as ordinary income if it exceeds the basis
in the contract.
Annuities can be converted under 1035 exchanges into multiple annuities. The
requirement for 1035 exchanges is that the funds transfer directly from one
insurer to another—the policyholder cannot have control of the funds at any time.
Due to the new hybrid annuities and life insurance contracts allowing values to
be accessed for long-term care and the importance of long-term care, Congress
now allows annuities to be converted into these policies or single premium long-
term care policies under 1035 exchanges. The one drawback is that there will be
no tax deduction for the long-term care premium for money converted. This
brings interesting possibilities for planners to create long-term strategies for cash
value life policies and annuities for addressing changing life needs. It is easy to
see a situation where a cash value policy is created to meet insurance needs and

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then converted when not needed into annuities and/or long-term care coverage.
Deferred annuities can be created with the intention of ultimately addressing
long-term care issues when the client is in his late 50s or early 60s. If other
solutions have been found, then funds are there to supplement retirement.
When addressing taxation, it is helpful to understand that tax treatment varies
between withdrawals and annuitization. Taxation of withdrawals (nonperiodic
distributions) is somewhat different than the taxation of annuity payments.
Withdrawals can be direct withdrawals, surrender, or pledging the asset for
collateral.
For an annuity contract purchased after August 13, 1982, all money withdrawn
on or after the annuity starting date (if such a withdrawal is allowed) will
normally be taxable as ordinary income. Withdrawals made before the annuity
starting date will normally be taxable as ordinary income until all the earnings
have been withdrawn (LIFO rules—last in, first out). After the earnings have
been withdrawn, additional withdrawals will be considered a nontaxable return of
principal/original investment. For example, an annuity with $100,000 deposited
is now worth $150,000. Withdrawals of any amount up to $50,000 will be
considered earnings, fully taxable as ordinary income. Any withdrawals
exceeding $50,000 will be considered a return of principal, which is not taxable.
Additionally, in most cases, any taxable withdrawals made prior to age 59½ will
be subject to a 10% tax penalty, or as the IRS refers to it, “a 10% excise tax.”
(Remember that only the interest/earnings are taxable, not the principal when you
are calculating the penalty!)
For an annuity contract purchased prior to August 14, 1982, withdrawals are
considered a return of principal first and earnings second, so amounts up to the
investment in the contract could be withdrawn before any tax would be paid.
These contracts are taxed under FIFO (first in, first out).
Once a contract is annuitized, Internal Revenue Code Section 72 determines the
income taxation of annuity payments (periodic distributions). Basically, each
periodic payment from a nonqualified annuity (one that is not part of a qualified
retirement plan) is considered one part return of principal (tax-excluded) and one
part return of interest (taxable). Each payment will be adjusted by the exclusion
ratio, which is the ratio that the total investment in the contract bears to the total
expected return under the contract.

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For example, assume Mrs. Smith purchased a $100,000 annuity, and expects 20
years of payments at $750 per month. Part of each $750 will be taxable, and part
will be a nontaxable return of capital. The nontaxable amount is determined as
follows:

$100,000
$750 × = $750 × .5556 = $416.67
($750 × 12 × 20)
So, for each $750 payment, $416.67 will be a nontaxable return of capital and
$333.33 will be taxable. Variable payout annuities are taxed in a similar manner;
however, the formula is a bit different.

For contracts purchased after December 31, 1986, the exclusion ratio applies
until the initial investment in the contract is returned; then the entire payment is
considered taxable (i.e., all additional payments will be from interest/investment
earnings only).

The tax advantage of fixed annuities is obvious. Fixed accounts create ordinary
income and are taxable each year. Putting money into a fixed annuity maintains
the same risk level and delays the tax until withdrawal. If a client believes she
will be in a lower tax bracket in retirement, this becomes a tax advantage. If she
believes she will be in a higher bracket, it may not be a wise move.

The tax deferral under variable annuities has different considerations. Tax on
long-term capital gains receive favorable rates compared to ordinary income. It is
true that variable annuities defer the income tax, but all distributions are taxed at
ordinary income rates, which are typically 10% or more higher than the long-
term capital gains rate. Buying a deferred variable annuity to avoid income tax
only may not be in the client’s best interest and needs to be analyzed carefully. A
tax-efficient fund or individual stock portfolio with a buy and hold strategy may
be more efficient. Many articles concerning the research on this issue and the
characteristics that impact the success of the strategy are available and should be
read by those employing annuities as a tool.

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Estate Taxation of Annuities
Part of the job of a planner is to understand the consequences of an action on
other components of a client’s plan. Utilization of annuities and the impact on
estate planning is a good example. You will get a more in-depth coverage of this
topic in the Estate Planning course. A critical point to know, however, is that
annuities typically avoid probate because they pass by contract to a beneficiary.
If the contract is a pure life annuity on one life, there will be no residual value,
therefore there will be nothing to include in the estate. If there is a continued
stream of income, the present value of that stream will be included in the estate.
It can become a very complex issue if the owner and the beneficiaries are
different. There is no step up in basis for annuity contracts, therefore the amount
will also be income taxable to the beneficiary. There are many advanced
planning concepts and strategies that utilize annuities, such as using a variable
deferred annuity to provide death benefit for an uninsurable estate owner, using
annuities to maintain control from beyond the grave for beneficiaries with money
management issues, etc., that are beyond the scope of this module.
This next section will review various types of annuities in more detail.

Single Premium Immediate Annuity (SPIA)

This type of annuity provides a guarantee of income for the life of the annuitant.
In its purest form, monthly payments begin one month after purchase and
continue for the life of the annuitant, whether one benefit payment is made or
hundreds are made. Many deferred annuities are exchanged for SPIAs because
the payouts available through shopping may be higher than the guaranteed
payouts in the deferred annuity contract. This is also a common purchase from
401(k)s and sometimes used for negotiated settlements. Divorce cases may
utilize these to create income streams for child support or annuity. Companies
wishing to remove themselves from liability for contracted payments and other
business transactions where the payments need to be spread over years find these
to be very useful tools. It is important to shop these carefully based on company
strength and current rates, as payouts can range substantially. Another planning
component is the conversion of a lump sum into income for creditor protection.
Medicaid planning, divorce planning, high risk of lawsuit, etc., can all be reasons

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that an individual would want to convert lump sums into income streams. The
income may be attached by creditors but the principal is not. Courts treat income
streams differently and put more limits on how much can be attached. The full
scope of this discussion is beyond the scope of this course, but note that once
understood, it is a powerful tool for planners.

Advantages
 Ensures a lifetime of income, without fear of outliving the principal
 Protects principal from creditors
 May include COLA
 The guaranteed income allows remaining portfolio to accept higher risk and
still retain acceptable probability of sustainable income distribution
 Income tax is predictable
 Investment risk is transferred to insurer
 Requires no time or skill in management, which can be important in senior
years or where fear of manipulation or fraud exists
 Longevity risk is transferred to the insurer so if major medical breakthroughs
occur and life expectancy increases, the risk is addressed

Disadvantages
 Most benefits are fixed and will not increase with inflation
 Adding riders such as period certain may be higher cost than separate
insurance contract.
 Principal is not available for emergencies
 Inflation riders may not match inflation and periods of high inflation can
erode the intention
 The prevailing assumptions and thus rate of return assumptions at the time of
purchase may be low compared to future periods, so timing of purchase
incorporates risk

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 If the insured dies before life expectancy, neither the heirs nor the annuitant
will have benefited compared to maintaining the original investment
Some immediate annuities are variable. The annuitant is credited with units of
annuity. These units vary in value with the underlying investments. As the value
varies, so do the payments. Here the disadvantage is that the income level may
drop if the underlying investments go down in value (of course, income may
increase as the investment value increases). In this situation, the insured is
retaining market risk and reward, but all decisions are made at time of
annuitization so no further management is required.

Rate of Return
Since the benefit is based on the annuitant’s life expectancy, there is no exact
method of determining the rate of return on a pure life annuity (i.e., how
competitive this product is versus the return on another investment). Multiple
company quotes will let you compare one SPIA to another, but comparing it to a
bond portfolio of similar risk is much harder. However, by looking at the
monthly payment, the initial investment (less policy fees, mortality charges, and
other expenses), and the annuitant’s life expectancy (based on gender), an annual
rate of return can be estimated. For example, assume that the initial investment is
$100,000, the monthly payment is $650, and the life expectancy is 20 years.
Using the financial functions on a calculator (begin mode), the annual rate of
return based on a 20-year life expectancy is 4.8671%. This estimate must be
tempered by either the annuitant’s premature death (which significantly lowers
the rate of return) or unexpected longevity (which increases it). This simple
calculation does not work if there is an inflation adjustment or other riders.
Typically, rates are very conservative because the insurance company must
assess their anticipated earnings and costs for many years.

Deferred Annuities: Single Premium (SPDA)

or Flexible Premium (FPDA)
A deferred annuity contract is based on the accumulation of funds of more than
one year rather than the immediate payment of benefits. Currently, these products
come in three basic forms: fixed, variable, and indexed.

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Fixed Annuities
Fixed annuities can be funded by either a single premium (SPDA) or an ongoing
series of payments (FPDA). Basic fixed annuities are fairly simple to explain to
consumers and have few moving parts. The contract is fixed in that there is a
guaranteed fixed interest rate minimum that will be credited on the account
value. The account value is the sum of all premiums plus earnings credited minus
withdrawals and expenses. In addition to the basic guaranteed rate (e.g., typically
low 2%–4%) the company generally will pay an excess current rate (based on
market conditions). The excess current rate usually will be guaranteed for a
period of time extending from one month to ten years, depending on the contract.
When considering the rate, explore the following:

 How the excess interest rate is determined: Is the rate linked to company
investments or indexed to an outside source?
 How new deposits (FPDA) are credited with excess interest
 Bailout interest rate provisions: If the excess rate fails to remain competitive,
is it possible to surrender the contract without a penalty?
 History of credited interest rates after the guarantee period has ended and
how often they have changed
 Bonus interest rates applied to deposits that are immediately vested
(important to check relationship of surrender charges to bonus rates)
 Bonus at annuitization that credits policy owner additional interest at
annuitization.
In addition to rates, expenses and potential charges must be examined:

 Annual contract fees can exist, such as a $25 annual fee or a charge if an
amount is below a certain value
 Surrender charges can range from just a couple of years through the entire
contract and impact the benefits potentially gained in some riders and under
what circumstances charges are waived. It is especially important to consider
if the company has a history of high initial guaranteed rate and then
substandard rates following.

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 Rights for penalty-free withdrawals (typically 10%)
 Circumstances in which surrender charges are waived such as death,
annuitization, or long-term care expenses
 Market value adjustments: These charges are made against the contract value
because the insurance company must cash out early from its underlying
investments at either surrender or partial withdrawal.
Finally, what are the guarantees related to annuitization, riders, options, transfer
or use of funds for LTC, and specific contract provisions?

 Guaranteed immediate annuity rates compared to immediate annuities and

impact on the contract at anticipated annuitization date
 Restrictions to guarantees if exchanged or surrendered
 Optional riders, etc.
The choice of the issuing company is significant, and evaluation should include
the company’s ratings from A.M. Best, Moody’s, and/or Standard & Poor’s; the
reasonableness of rates as compared to the current market conditions; the renewal
rate history; level of service; and communications.

Advantages
(General annuity advantages and disadvantages apply. These are specific to
FIXED interest rate annuities.)
 May allow the individual to receive a better fixed return than managing fixed
investments on their own or utilization of CDs
 Contract accelerates savings growth because of its tax-deferred nature and
the fact that comparable investments are also taxed at ordinary income rates,
not capital gains rates
 Investment risk is transferred to the insurance company
 Minimum floor rate
 Emotional security

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Disadvantages
 Contract may fail to remain competitive or underperform
 Surrender penalties and charges may create false expectations about growth
rate
 Company strength or policies over many years may shift

Variable Annuities
The variable annuity contract was created on the theory that in the long run, the
equities market will outperform inflation and fixed-interest-rate investments.
Each payment into the contract purchases units of a subaccount similar to buying
shares of a mutual fund. The units accumulate in a separate account and may
carry unit value that reflects this investment’s market performance. Investment
choices are as varied as in any mutual fund account; some annuity contracts will
allow liberal transferring, but most will charge for and/or restrict frequent
transfers.
Do not confuse subaccounts with the mutual funds that they may be based upon.
Management of the account may be different due to tax advantage of annuities
and the costs of managing the funds may be higher, therefore returns will not be
the same as the mutual fund. Questions on the investments include the same
types of questions you would ask of any equity investment portfolio:

 What are the asset classes available?

 What are the specific investments available?
 What are the risk return/characteristics of the subaccounts?
 How does the company determine when to change out investments and how
active are they in addressing underperforming investments?
 Are there both active and passive funds?
 How much support is provided in selecting, monitoring, and rebalancing?
In addition to rates, expenses and potential charges must be examined.

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 Annuity fees in variable products can contain insurance charges,
administrative charges, and fund expenses. Average variable annuity
expenses in 2012 were 2.35%. This can be a hefty cost to overcome.
 Annual contract fees can exist, such as $25 annual fee or a charge if an
amount is below a certain value.
 Surrender charges work the same as in fixed annuities. They can range from
just a couple of years through the entire contract and impact the benefits
potentially gained in some riders.
 Rights for penalty-free withdrawals (typically 10%)
 Circumstances in which surrender charges are waived such as death,
annuitization, or long-term care expenses.
Finally, what are the guarantees related to annuitization, riders, options, transfers,
use of funds for LTC, and other specific contract provisions?

 Similar to fixed annuities, guaranteed annuity rates must be examined.

 Guaranteed death benefits provided by contract can vary widely. Options
include: no guarantee, amount originally invested less any withdrawals, cash
value at time of death, highest cash value as of certain policy anniversaries,
total contributions made less withdrawals, accumulated as a specified
interest.
 Impact of withdrawals to death benefits or guarantees
 Which living benefit riders must be added at purchase and which living
benefit riders can be added at a later date?
 Guaranteed minimum income benefit (GMIB) guarantees a minimum income
to the annuitant, regardless of adverse investment performance. It only
applies to annuitization of the contract and has many restrictions and moving
parts that must be explored. Restrictions on timing, specific annuity tables,
required annuitization, adjusted age, etc., can make these riders very complex
and difficult to analyze accurately. It can provide important protection, but
the assumption that the rate of return stated is locked in can be misleading.

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 Guaranteed minimum accumulation benefit (GMAB) guarantees that there
will be a minimum account value at the end of a specified guaranteed date.
Variations can include a step up with a new guarantee period. There may be
restrictions on asset allocation that, if not followed, could void the
agreement. Withdrawals may or may not be allowed and annuitization is
generally not required. Based on the specific guarantees, costs can vary
substantially ranging anywhere from 25 basis points to 100 basis points.
 Guaranteed minimum withdrawal benefit (GMWB) guarantees that either a
return of principal or a protected amount through systematic withdrawals
over a specified time period in years (not covering a life expectancy). The
insurer must permit withdrawals not to exceed a specified percentage
independent of adverse investment performance. The amount protected may
be reset if the withdrawal exceeds the limit or occurs prior to a specified time
negating the value of the rider. There may be restrictions on the investment
choices or election of a diversified model portfolio may be required. There
may be reset options similar to step-ups. Costs can range from 60 to150 basis
points, and most insurers have the right to change the rider cost to a specified
maximum. Again, the devil is in the details in understanding and evaluating
the appropriate use and value of this rider.
 Guaranteed lifetime withdrawal benefit (GLWB) is the most popular rider
currently with almost 70% of buyers opting to purchase it. It guarantees the
right to withdraw up to the specified percentage each year for life. The
guaranteed compounding ceases at the first withdrawal or at the expiration of
the specified period, frequently 10 years. It may have step-up options.
Because the cost of the rider can be a 1% annual fee on top of the other fees,
the underlying portfolio must achieve a fairly high return in order to
overcome the fees. Annuity owners may not be aware of the date by which
they must act in order to utilize this benefit, in which case they will have paid
significant premiums for no benefit. It is one thing to not need the guarantee
because the underlying investments have performed well, but it is another to
have been able to utilize the provision yet failed to act in a timely matter due
to lack of knowledge. Careful evaluation of pros and cons and discussion
with the purchaser are necessary for all of these living benefits.

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Advantages
(General advantages and disadvantages of annuities apply. These are specific to
variable annuities.)
 Diversification
 Professional management
 Advantage of dollar cost averaging
 A supplemental retirement plan
 Death benefit guarantees
 Riders that can provide protection from downside loss

Disadvantages
 Contract owner may be adding insurance company expenses he or she may
not need
 Tax penalties for early withdrawals apply to variable annuities
 Lack of liquidity
 Fees can range from low load to over 3%
 Loss of long-term capital gains rates
 Complex and difficult for purchasers to understand

Equity-Indexed Annuities
Equity-indexed annuities (EIAs) offer some of the growth potential of the stock
market with the downside protection of a guaranteed annuity. These products are
fairly sophisticated, so both financial advisors and their clients should have a
firm understanding of these annuities before adding them to an investment
portfolio. Further, there are many variables in these products, which can make
comparisons difficult. The living benefit riders of the variable annuities are used
in variations for indexed annuities.
EIAs have characteristics of both fixed and variable annuities. EIAs usually
provide a guaranteed minimum interest rate and an interest rate tied to a market

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index. They typically are linked to a benchmark (such as the S&P 500), which
provides the growth potential in these accounts. The participation rate
determines how much of the underlying index’s gain will be applied to the
account value. For example, if the participation rate is 90%, and the S&P
increases by 10% in a period of time (called the index interval, which can be 1, 5,
7, or even 10 years), the annuity’s account value would increase by 9% (90% of
the 10% increase). Some annuities also may have a rate cap, which will limit the
amount of growth that can be applied to the account value for a given interval.
There are different methods of measuring the change in the underlying index.
The percentage change method measures the percentage change in the index
from the beginning to the end of the index interval. Only the index’s starting and
ending points matter; market fluctuations in between are ignored. In those
intervals when the index declines, no gain is credited to the account. The ratchet
or point-to-point method locks in the gain credited to the account each policy
year. The index value at the end of one policy year becomes the starting value for
the next policy year. The spread method subtracts a fixed percentage (such as 2%
or 3%) from the index’s percentage change in a given interval. So if the index
grew by 30% over a three-year interval and the insurance company used a 2%
spread, the account would be credited with a 28% increase in value.
In terms of downside protection, assume the S&P 500 declined 10% over a given
index interval. In this case, the annuity’s account value would remain unchanged
from its starting point for that interval. While the annuity owner did not earn any
interest or have any gain during this period, neither did the account lose money
due to the market’s drop. This downside protection can be very appealing to a
client who wants to participate in the market’s gains (to a limited degree) while
avoiding market losses.
The idea is that the account value in an equity indexed annuity will not decline
unless the owner takes a withdrawal. In particular, the timing of a withdrawal can
have a significant impact on the participation rate. The ideal situation would be
for the annuity owner to only take withdrawals immediately after the
participation rate (for a given interval) has been credited to the account. Once the
participation rate has been credited to the account, the increase in account value
is locked in and guaranteed into the next index interval. So you can see that a

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withdrawal in the middle of a participation rate interval could minimize the
growth potential of the account for that period of time.

Surrender charges and expenses tend to be higher in indexed annuities. Another

variation may be that instead of a surrender charge, the interest credited is
reduced based on withdrawal rates. Partial withdrawals can end or cause
forfeiture of any accumulated equity-linked interest. Finally, some index
annuities require the contract to be annuitized or provide lower levels of benefits
for contracts that are surrendered even if held to the end of the required term. It is
very important that an advisor dive into the impact various scenarios would have
on a contract and review these with clients. If a client is anticipating market
returns with no risk and access to their cash for emergencies, they are going to
find they have an entirely different result than the one anticipated.
One final note: Regulators are giving EIAs extra scrutiny. They are concerned
that these products may be too complex, that EIAs are not being adequately
described (with adequate disclosures) to potential clients, and that there is too
much opportunity for abuse.

Private Annuities
Private annuities are generally used as part of estate planning and are similar to
PPLI, except they have no pure insurance component. Income-producing assets
and/or cash are put (sold) into a private annuity structure (e.g., LLC or other). By
doing so, the donor can remove assets from his or her estate, thereby potentially
eliminating future gift or estate tax liabilities, and the donor can get a stream of
income from the annuity while alive. If the current income stream is equal to the
value of the original assets, it should keep the donor from having to pay gift taxes
on the transfer (which is usually made for the benefit of a child or other family
member). Payments received by the donor are usually taxable as ordinary income
based on recovery of basis, gain, and interest. It should be noted that the IRS
tends to closely scrutinize private annuities. In fact, private annuities tend to have
pretty complex tax and estate planning requirements and ramifications, so care
should be taken in setting up and maintaining them. Additional discussion of
private annuities is beyond the scope of this course, and will be covered in the
Estate Planning course.

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Structured Settlements, the Non-Annuities
Structured settlements often look like annuities, although they are not annuities.
Payments are generally made by an insurance company, in compliance with a
settlement arising from legal liability. Rather than a single payment, a series of
payments are made to the injured party. Actuarial considerations are involved in
determining the amount of each payment, but in other respects, structured
settlements are not annuities in the traditional sense.
IRC Section 130 covers tax-exempt structured settlements. The most common
method of compliance with the IRC Section 130 requirements is to work through
an insurance company. However, another viable option is to use a U.S. Treasury
Bond Structured Settlement Trust (TBSS). A TBSS will be set up through a
national bank and funded using U.S. Treasury bonds. This approach is safe and
meets IRS requirements. Additional information on TBSSs and other structured
settlement alternatives is beyond the scope of this course.

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Summary

T
his module introduced life insurance and annuity contracts. This
information will not make you an expert in insurance, but it provides a
sound base of knowledge so that you can intelligently discuss insurance
products and their differences with your clients and their insurance agents.
Having read the material in this module, you should be able to:

5–1 Identify areas of financial risk exposures at death.

5–2 Identify types, uses, and limitations of various types of individual life
insurance policies.

5–3 Compare the purposes of the general provisions of a life insurance

policy.

5–4 Identify appropriate dividend options available under participating

life insurance policies.

5–5 Analyze the application of a given optional provision (rider)

available in a life insurance policy.

5–6 Distinguish between policy illustration factors to select the most

appropriate insurance product.

5–7 Recommend an appropriate type of insurance policy.

5–8 Calculate the value of a given nonforfeiture option in a life insurance

policy at a specific point in time.

5–9 Analyze and compare settlement options available under a life

insurance for specific situations.

5–10 Distinguish between types, uses, and limitations of various types of

annuities.

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Before moving on to the next module, answer the Module Review
Questions that follow, and check your answers with those provided
(following the questions). Review the module text to help you master any
learning objective areas where you are not able to adequately answer
questions.

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Module Review
Questions
5–1 Identify areas of financial risk exposures at death.

1. List four personal risk exposures that may indicate a need for life insurance.
Go to answer.
2. List family risk exposures related to the death of a primary income earner
that may indicate a need for life insurance.
Go to answer.
3. List four closely held business risk exposures that may indicate a need for
life insurance.
Go to answer.

4. What is the general purpose of a buy-sell agreement, and how may life
insurance be used in a buy-sell agreement?
Go to answer.

5–2 Identify types, uses, and limitations of various types of individual life
insurance policies.

5. What is term insurance?

Go to answer.

6. What are the advantages and disadvantages of using term insurance?

Go to answer.
7. What is whole life insurance?
Go to answer.
8. What are the advantages and disadvantages of using whole life insurance?
Go to answer.

9. What is limited pay whole life insurance?

Go to answer.

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10. What is universal life insurance?
Go to answer.
11. What are the advantages and disadvantages of using universal life insurance?
Go to answer.
12. What is variable life insurance?
Go to answer.
13. What are the advantages and disadvantages of using variable life insurance?
Go to answer.

14. What is variable universal life insurance (VUL)?

Go to answer.

15. What is adjustable life insurance?

Go to answer.

16. Participating and nonparticipating life insurance differ in their approach to

dividends. Briefly describe the differences.
Go to answer.

5–3 Compare the purposes of the general provisions of a life insurance

policy.

17. What is meant by the designation primary beneficiary on a life insurance

policy?
Go to answer.

18. What is meant by the designation contingent beneficiary on a life insurance

policy?
Go to answer.

19. What is the difference between a revocable beneficiary on a life insurance

policy and an irrevocable beneficiary?
Go to answer.
20. Sally Hansen owns a whole life insurance policy on her own life and has
designated her husband, John, as irrevocable beneficiary. What rights does
John have concerning the policy and policy proceeds?
Go to answer.

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21. Joan Ryan owns a whole life insurance policy on her own life and has
designated her sister, Cindy, as revocable beneficiary. What rights does
Cindy have concerning the policy and policy proceeds?
Go to answer.
22. Define the purpose of the following clauses in a life insurance policy.
a. entire contract
Go to answer.
b. ownership
Go to answer.
c. incontestable
Go to answer.
d. misstatement of age
Go to answer.
e. grace period
Go to answer.
f. reinstatement
Go to answer.
g. conversion provision
Go to answer.
h. common disaster clause
Go to answer.
i. spendthrift clause
Go to answer.
j. renewability provision
Go to answer.

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 5–4 Identify appropriate dividend options available under participating
life insurance policies.

23. List and explain the advantages of the following dividend options available
for a participating life insurance policy.
a. cash
Go to answer.
b. paid-up dividend additions
Go to answer.
c. reduced premium
Go to answer.
d. accumulate at interest
Go to answer.
e. one-year term (fifth dividend option)
Go to answer.

24. Identify which dividend option provides the greatest combination of

increased death benefit and cash value, and explain your answer.
Go to answer.

25. Identify which dividend option provides the least beneficial current tax
consequences, and explain your answer.
Go to answer.

26. David Walder wants to maximize the income-tax-deferred accumulation in

his participating whole life policy. Which dividend option will appropriately
accomplish this, and why?
Go to answer.

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 5–5 Analyze the application of a given optional provision (rider)
available in a life insurance policy.

27. Explain the following optional provisions (riders) available in a life

insurance policy.
a. disability waiver of premium
Go to answer.
b. accidental death benefit
Go to answer.
c. guaranteed insurability
Go to answer.

28. Jeremy Potter decided to take up flying lessons. Unfortunately, he was

having such a good time on his first solo flight that he failed to see the
mountain he flew into. He managed to survive the crash, but died four
months later after being on life support equipment the whole time. Will the
accidental death benefit rider on his life insurance policy pay off? Explain
your answer.
Go to answer.

5–6 Distinguish between policy illustration factors to select the most

appropriate insurance product.

29. What points should be checked before the planner proceeds to evaluate the
numbers on a policy illustration?
Go to answer.

30. Why should the company’s actual investment yield be compared with the
interest rate underlying the dividend scale?
Go to answer.

31. Why should the company’s actual dividend history be compared with past
projections?
Go to answer.

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 5–7 Recommend an appropriate type of insurance policy.

32. For each of the following types of insurance, give a description that would
reflect a client’s needs that would be met by that type of policy.
a. whole life
Go to answer.
b. 20-year level term
Go to answer.
c. annually renewable term
Go to answer.
d. life paid up at 65
Go to answer.
e. modified whole life
Go to answer.
f. variable universal
Go to answer.

33. Penny Franklin realizes that her insurance needs will change over time.
Currently she considers her primary need to be providing for her children’s
well-being. She can afford any type of life insurance, but wants to be able to
change her premiums and death benefits as time goes on. She’s not looking
to her insurance as a risk-taking purchase. Which type of policy is most
likely to meet all of her needs?
Go to answer.

5–8 Calculate the value of a given nonforfeiture option in a life insurance

policy at a specific point in time.

34. Define each of the following items that appear on a nonforfeiture table.
a. cash or loan value
Go to answer.

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 b. reduced paid-up insurance
Go to answer.
c. extended term insurance
Go to answer.
Refer to the following table for questions 35 and 36.

Nonforfeiture Values
Extended Term Insurance
End of
Policy Cash or Paid-up
Year Loan Value Insurance Years Days
1 $ 0.00 $ 0 0 0

2 10.55 48 3 154

3 21.82 97 6 107

4 31.52 138 8 199

5 44.96 179 10 244

6 57.03 220 11 346

7 71.18 264 13 298

8 85.98 299 15 222

9 100.47 340 18 11

10 116.72 375 19 277

15 203.93 522 21 86

20 301.33 644 22 11

35. Annie Leonard purchased a $10,000 whole life policy three years ago.
Provide the appropriate nonforfeiture value for each option. (Remember to
multiply the dollar amounts by the number of thousands, in this case, 10.)
Nonforfeiture Option Nonforfeiture Value
Surrender Value

Paid-up Insurance

Extended Term Insurance

Go to answer.

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36. Jack Bryant purchased a $50,000 whole life policy 10 years ago. What are the
nonforfeiture values for Jack for each option? (Remember to multiply the dollar
amounts by the number of thousands, in this case, 50.)
Nonforfeiture Option Nonforfeiture Value
Surrender Value

Paid-up Insurance

Extended Term Insurance

Go to answer.

37. Susan Arnolt wants to stop paying for the whole life policy she purchased 12
years ago, but she wants to maintain the full amount of insurance. What is an
appropriate option? Explain your answer.
Go to answer.

38. Describe the basic structure of a viatical agreement.

Go to answer.

39. David Smith has terminal cancer, and his physician has given him three
months to live. His adult children own an insurance policy on his life. Briefly
describe the viatication process as it relates to David and his children.
Go to answer.

5–9 Analyze and compare settlement options available under a life

insurance for specific situations.

40. List and describe the settlement options available for life insurance policies.
Go to answer.

41. List and describe the four basic categories of life income settlement options.
Go to answer.

42. Mac Dahrr wants to use a settlement option with the life insurance proceeds
he is receiving from a policy on his father. He can’t decide between a 10 c&c
or a 20 c&c payout. Which one will provide him with the most monthly
income, and why?
Go to answer.

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43. Pat Zeit’s grandfather died. He left Pat the proceeds of a life insurance
policy. Rather than take the lump sum, she wants to have the proceeds paid
out quarterly from now until her youngest child, now age 11, turns 21. She
also wants to receive the largest guaranteed payment available. What is an
appropriate option? Explain.

Go to answer.

5–10 Distinguish between types, uses, and limitations of various types of

annuities.

44. Identify the five ways annuities may be classified and list the annuities that
fit each classification.
Go to answer.

45. Describe the following annuity terms.

a. single premium
Go to answer.
b. flexible premium:
Go to answer.
c. immediate
Go to answer.
d. deferred
Go to answer.
e. longevity
Go to answer.
f. fixed interest accumulation
Go to answer.
g. variable accumulation
Go to answer.
h. indexed earnings
Go to answer.

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 i. period certain
Go to answer.
j. pure life/straight life
Go to answer.
k. joint and survivor
Go to answer.
l. life and period certain
Go to answer.
m. life with period certain
Go to answer.
n. life with refund certain
Go to answer.

46. What tax rate is applied to withdrawals from annuities?

Go to answer.

47. What 1035 exchanges are allowed for annuities?

Go to answer.

48. What are the advantages and disadvantages of a pure life immediate fixed
annuity?
a. advantages
Go to answer.
b. disadvantages
Go to answer.

49. What are the advantages and disadvantages of fixed annuities?

a. advantages
Go to answer.

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 b. disadvantages
Go to answer.

50. What are the characteristics that should be examined in a fixed annuity?
Go to answer.

51. What are the advantages and disadvantages of variable annuities?

a. advantages
Go to answer.
b. disadvantages
Go to answer.

52. What characteristics should be examined when evaluating variable annuities?

Go to answer.

53. What are the four types of living benefit riders?

Go to answer.

54. What are indexed annuities?

Go to answer.

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Answers
5–1 Identify areas of financial risk exposures at death.

1. List four personal risk exposures that may indicate a need for life insurance.
 death before debt repayment
 spouse outliving pension plan pure life annuitant
 debtor’s death before having repaid the client money owed
(insurance would be required on the debtor)
 death before reaching personal goals the client wants funded,
regardless of whether he or she lives to see them fulfilled
Return to question.
2. List family risk exposures related to the death of a primary income earner
that may indicate a need for life insurance.
 final expenses
 contingent liabilities
 dependent income
 education
 family goals
 support of parents
Return to question.
3. List four closely held business risk exposures that may indicate a need for
life insurance.
 death of a partner or co-shareholder
 death of a key employee
 loss of a key employee to a competitor
 illiquidity of the business in the event of an owner’s (probably the
client’s) death
 special situations
Return to question.

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4. What is the general purpose of a buy-sell agreement, and how may life
insurance be used in a buy-sell agreement?
A buy-sell agreement is often used to transfer the ownership interest
of a deceased business owner to the remaining owners (or corporate
entity).
Buy-sell agreements have many forms, including
 Stock redemption
 Cross purchase
 Wait and see
 Third party buy-out
Life insurance is often used as a funding vehicle to provide the money
required to purchase the deceased owner’s share (often from the
deceased’s estate).
Return to question.

5–2 Identify types, uses, and limitations of various types of individual life
insurance policies.

5. What is term insurance?

It protects against financial loss resulting from death during a
specified period of time. It may have an annually increasing premium
or a premium that is level from 5–20 years.
Return to question.

6. What are the advantages and disadvantages of using term insurance?

Advantages of Term Insurance Disadvantages of Term Insurance
Initial premium is lower than It does not develop cash values
for whole life. and has no savings element.
It initially provides more The premium cost increases as
insurance protection per the policyowner gets older.
premium dollar than cash
value forms of insurance.
It may often be reduced to At the end of the specified term,
meet changing needs. policyowner may be declined for
renewed coverage.
Return to question.

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7. What is whole life insurance?
 provides guaranteed insurance protection for entire lifetime of
insured
 provides guaranteed nonforfeiture values that can be used as
forced savings
 has a guaranteed level premium
Return to question.
8. What are the advantages and disadvantages of using whole life insurance?
Disadvantages of Whole Life
Advantages of Whole Life Insurance Insurance
It provides a guaranteed cash value It has a higher initial premium
that can be: than term.
1. used as a savings plan
2. used for financial emergencies
3. borrowed against
The premium is level for the life of the In the early years, it is not
insured. flexible to meet changing
needs.
The death benefit is guaranteed for life.
Return to question.

9. What is limited pay whole life insurance?

 protection and guarantees are like whole life (e.g., extend to age
100)
 premium payments are made for shorter period of time than whole
life
 during the payment period, premiums are high enough to prepay
policy
Return to question.

10. What is universal life insurance?

 Its technical name is flexible premium adjustable life.
 It is an unbundled life insurance product with a cash value fund
that accumulates tax-deferred. The cash value earns at least a
minimum guaranteed rate of interest.

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  It includes flexible premium payments, adjustable death benefits,
unbundled structure, and full disclosure.
 It may be set up as a level death benefit policy, termed Type A or
Type 1, or as an increasing death benefit policy, termed Type B or
Type 2.
Return to question.
11. What are the advantages and disadvantages of using universal life insurance?
Advantages of Universal Life Disadvantages of Universal Life
It has flexible premium The policyowner may receive neither
payments. the most competitive insurance
coverage nor the most competitive
savings vehicle.
It has an adjustable death The future yield is uncertain.
benefit.
It provides full disclosure The compulsory form of savings is
annually. reduced due to flexible premium
payments.
It has an unbundled structure. There is no assurance that a given
premium will be adequate.
Return to question.
12. What is variable life insurance?
 It is designed to combine traditional protection and savings
functions of life insurance with growth potential of equities or fixed
income investments.
 It includes investments similar to mutual funds, called separate
accounts or sub-accounts.
 It has a guaranteed premium and often a guaranteed death
benefit, but no guaranteed cash value.
Return to question.

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13. What are the advantages and disadvantages of using variable life insurance?
Advantages of Variable Life Disadvantages of Variable Life
The policy has a higher yield potential The buyer must be willing to
because of use of equities. give up guaranteed cash
value in exchange for the
possibility of enhanced cash
value and death benefit.
The owner generally chooses from The owner must choose from
among investment options. among investment options.
The policy has a guaranteed premium
and death benefit (usually).
Return to question.

14. What is variable universal life insurance (VUL)?

 combines all the features of universal life with variable life
 flexible premium
 investment choices for cash fund
 adjustable death benefit
 no guarantees beyond ability to keep coverage in force
Return to question.

15. What is adjustable life insurance?

 It is a combination of term and whole life where the mix is dictated
by the face amount of insurance combined with the chosen
premium.
 The premium and face amount are adjustable at any monthly
policy anniversary.
 Policy can change from term to whole life or vice versa.
Return to question.

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16. Participating and nonparticipating life insurance differ in their approach to
dividends. Briefly describe the differences.
 Participating policy: It is a policy on which annual dividends may
be paid to the policyowner; for tax purposes, the dividend is
generally treated as a tax-free return of excess premium.
 Nonparticipating policy: No dividends are paid, although the policy
may have provisions for excess interest or current interest to be
paid on the cash value.
Return to question.

5–3 Compare the purposes of the general provisions of a life insurance

policy.

17. What is meant by the designation primary beneficiary on a life insurance

policy?
It is the person(s) or entity first entitled to proceeds of the policy
following the death of the insured.
Return to question.

18. What is meant by the designation contingent beneficiary on a life insurance

policy?
It is the person(s) or entity entitled to policy benefits if the primary (or
direct) beneficiary predeceased the insured or is ineligible to receive
the proceeds.
Return to question.

19. What is the difference between a revocable beneficiary on a life insurance

policy and an irrevocable beneficiary?
With a revocable beneficiary, the policyowner reserves the right to
change the beneficiary designation at any time, without the consent or
notification of the beneficiary.
With an irrevocable beneficiary designation, the policyowner cannot
change the designation of the beneficiary without the latter’s consent.
Additionally, a policy loan or assignment of contract requires the
written permission of the beneficiary.
Return to question.

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20. Sally Hansen owns a whole life insurance policy on her own life and has
designated her husband, John, as irrevocable beneficiary. What rights does
John have concerning the policy and policy proceeds?
John’s written consent is necessary for Sally to change beneficiary
designation, acquire a policy loan, assign the contract, or surrender it;
however, he has only a contingent vested interest in the death
benefits.
Return to question.
21. Joan Ryan owns a whole life insurance policy on her own life and has
designated her sister, Cindy, as revocable beneficiary. What rights does
Cindy have concerning the policy and policy proceeds?
 She has nothing more than a mere expectation, subject to all
rights and privileges that Joan may exercise in the contract.
 She receives a legal interest in the contract only at Joan’s death.
Return to question.
22. Define the purpose of the following clauses in a life insurance policy.
a. entire contract
The policy and the application constitute entire contract between
the insurer and the policyowner/insured. It declares that
statements of the insured are representations and not warranties,
so the insurer must prove materiality of any misrepresentations by
the insured.
Return to question.
b. ownership
A life insurance policy is personal property. The designated owner
has vested privileges of ownership, including the rights to assign
or transfer the policy, name a beneficiary, receive the cash value
and dividends, and borrow against the cash value.
Return to question.
c. incontestable
After the policy has been in force for two years, the validity of the
contract cannot be questioned, except in most cases of fraud.
Return to question.

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 d. misstatement of age
It provides that, if the insured has misstated his or her age, the
policy face amount will be adjusted to the amount of insurance
that the premium paid would have purchased at the correct age.
The incontestability clause is not applicable to a misstatement of
age by the insured.
Return to question.
e. grace period
A specified number of days are allowed for payment of a premium
beyond the due date, usually 30 or 31. The grace period prevents
a policy from lapsing during this time period.
Return to question.
f. reinstatement
 It comes into play after the end of the grace period.
 It provides for a policy to be reinstated within a specified time
period after the date of premium default if the policy is not
surrendered for its cash value.

It usually requires evidence of insurability and payment of all
overdue premiums with interest
Return to question.
g. conversion provision
The policyowner is granted an option to exchange a term contract
for some type of cash value insurance, without having to prove
evidence of insurability.
Return to question.
h. common disaster clause
A settlement of policy proceeds is withheld for a designated
number of days after the insured’s death. Any beneficiary
surviving the insured, but dying within that period, is considered to
have predeceased the insured.
Return to question.

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 i. spendthrift clause
It denies the beneficiary the right to commute, alienate, or assign
interest in the policy proceeds paid under an installment
settlement option. It must be requested in writing.
Return to question.
j. renewability provision
It guarantees the policyowner the right to renew a policy for a
specified number of additional periods (in renewable term
insurance).
Return to question.

5–4 Identify appropriate dividend options available under participating

life insurance policies.

23. List and explain the advantages of the following dividend options available
for a participating life insurance policy.
a. cash
The client can handle and invest or spend the money.
Return to question.
b. paid-up dividend additions
It allows for the purchase of additional net cost whole life
insurance. It can be added each year, regardless of the insured’s
health or occupation. No further premiums are due on it, and it
pays dividends. Maximizes tax-deferred accumulation.
Return to question.
c. reduced premium
It decreases out-of-pocket expenses.
Return to question.
d. accumulate at interest
It allows for professional management of money, and a minimum
rate is guaranteed. Dividends are tax-free up to the taxpayer’s
basis in the policy, but interest earned on the accumulated
dividends is not tax-free.
Return to question.

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 e. one-year term (fifth dividend option)
It allows the acquisition of inexpensive insurance that is equal to
the guaranteed cash value. It is added to each year, regardless of
health or occupation, and it usually is used in addition to another
option.
Return to question.

24. Identify which dividend option provides the greatest combination of

increased death benefit and cash value, and explain your answer.
Paid-up additions (PUAs) add to the death benefit and, in doing so,
increase the cash value.
Return to question.

25. Identify which dividend option provides the least beneficial current tax
consequences, and explain your answer.
When dividends are left to accumulate at interest, the interest is
currently taxable. Other dividend options do not increase current tax
liabilities.
Return to question.
26. David Walder wants to maximize the income-tax-deferred accumulation in
his participating whole life policy. Which dividend option will appropriately
accomplish this, and why?
Dividends used to purchase paid-up dividend additions will provide
the greatest tax-deferred accumulation. Until the cumulative dividends
exceed the cumulative premiums paid, they are income-tax-free. The
dividends purchase small amounts of life insurance that are paid up
and have a cash value approximately the same as the amount of the
dividend. These paid-up additions also earn dividends.
Return to question.

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 5–5 Analyze the application of a given optional provision (rider)
available in a life insurance policy.

27. Explain the following optional provisions (riders) available in a life

insurance policy.
a. disability waiver of premium
The company agrees to waive the entire premium or the monthly
charges, whichever applies, if the policyowner becomes totally
disabled in accordance with the provisions in the contract.
Return to question.
b. accidental death benefit
If the death of the insured is caused by an accident, and death is
within 90 days of the accident, an additional sum equal to the
amount of the rider will be paid.
Return to question.
c. guaranteed insurability
The policyowner may purchase additional specified amounts of
insurance at stated intervals without providing evidence of
insurability.
Return to question.
28. Jeremy Potter decided to take up flying lessons. Unfortunately, he was
having such a good time on his first solo flight that he failed to see the
mountain he flew into. He managed to survive the crash, but died four
months later after being on life support equipment the whole time. Will the
accidental death benefit rider on his life insurance policy pay off? Explain
your answer.
If Jeremy had died within 90 days of the crash, the accidental death
benefit would probably have paid. Since he survived more than 90
days, the rider will not likely result in a benefit being paid.
Return to question.

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 5–6 Distinguish between policy illustration factors to select the most
appropriate insurance product.

29. What points should be checked before the planner proceeds to evaluate the
numbers on a policy illustration?
 Does the illustration go out to age 95 or beyond?
 Is the insurer the one intended?
 Is the illustration recent?
 Is the information for age, tobacco user status, and rating
accurate?
 Does the illustration correspond correctly to the contract under
consideration?
Return to question.

30. Why should the company’s actual investment yield be compared with the
interest rate underlying the dividend scale?
If the interest rate underlying the dividend scale is too close to, or
significantly higher than, the rate of return actually being earned by
the company, there is a reasonable question as to whether the
company can actually pay the dividends shown on the illustration.
Return to question.

31. Why should the company’s actual dividend history be compared with past
projections?
The comparison can give the planner an idea of whether the company
over-projects expected results.
It should be noted that a number of companies have gone to a direct
recognition dividend scale, which is generally used to provide equity
among policyowners. The dividends paid on a policy recognize when
a loan is taken against the policy, taking into consideration whether
the loan interest rate is fixed or variable.
Return to question.

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 5–7 Recommend an appropriate type of insurance policy.

32. For each of the following types of insurance, give a description that would
reflect a client’s needs that would be met by that type of policy.
a. whole life
Client wants predictability and guarantees regarding cost, death
benefit, and cash accumulation. Client may recognize lifetime
insurance needs or needs lasting well beyond 10 years and wants
lowest net cost over time.
Return to question.
b. 20-year level term
Client wants predictable cost with a finite need. Currently displays
good saving and investing habits.
Return to question.
c. annually renewable term
Client has substantial need with limited funds or a relatively short-
term need and wants to minimize cash flow to insurance.
Return to question.
d. life paid up at 65
Client wants lifetime coverage and wants assurance that
premiums will stop by the date of retirement.
Return to question.
e. modified whole life
Client needs to minimize cash flow now but wants predictability of
premium, death benefit, and cash accumulation for long-term
needs. Also expects income and cash flow limitations to be
reduced substantially within three to five years.
Return to question.
f. variable universal
Client is not risk averse, likes the idea of buying term and
investing the difference, but needs long-term insurance coverage.
Income fluctuates. Has very good history of saving and investing.
Return to question.

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33. Penny Franklin realizes that her insurance needs will change over time.
Currently she considers her primary need to be providing for her children’s
well-being. She can afford any type of life insurance, but wants to be able to
change her premiums and death benefits as time goes on. She’s not looking
to her insurance as a risk-taking purchase. Which type of policy is most
likely to meet all of her needs?
A universal life policy provides the flexibility required. It is a form of
cash value insurance she can keep as long as she wants. By using a
reasonable premium, she can assure its presence throughout her life.
Return to question.

5–8 Calculate the value of a given nonforfeiture option in a life insurance

policy at a specific point in time.

34. Define each of the following items that appear on a nonforfeiture table.
a. cash or loan value
This value, also known as the surrender value, is shown as the
number of dollars per thousand dollars of insurance that can be
obtained by the policyowner if he or she surrenders the policy. It
also represents the gross amount against which the policyowner
may borrow from the insurance company.
Return to question.
b. reduced paid-up insurance
This value represents the amount of insurance, per thousand
dollars of the policy face amount, that the cash or loan value
would purchase if the policyowner wanted to stop paying
premiums but wanted to keep insurance in force as long as the
insured lives.
Return to question.
c. extended term insurance
This value represents the number of years and days that a term
insurance policy will remain in force if the policyowner wants to
stop paying premiums, but wants the original face amount of

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© 1982, 1985, 1991, 1996, 2002–2015, College for Financial Planning, all rights reserved
 insurance to continue for as long as the cash or loan value will
permit. The cash or loan value is essentially a single premium for
this term insurance.
Return to question.
Refer to the Questions section for the table to answer questions 35 and 36.

35. Annie Leonard purchased a $10,000 whole life policy three years ago.
Provide the appropriate nonforfeiture value for each option. (Remember to
multiply the dollar amounts by the number of thousands, in this case, 10.)
Nonforfeiture Option Nonforfeiture Value
Surrender Value $218.20
Paid-up Insurance 970
Extended Term Insurance 6 years and 107 days
Return to question.

36. Jack Bryant purchased a $50,000 whole life policy 10 years ago. What are the
nonforfeiture values for Jack for each option? (Remember to multiply the dollar
amounts by the number of thousands, in this case, 50.)
Nonforfeiture Option Nonforfeiture Value
Surrender Value $5,836.00
Paid-up Insurance $18,750
Extended Term Insurance 19 years and 277 days
Return to question.

37. Susan Arnolt wants to stop paying for the whole life policy she purchased 12
years ago, but she wants to maintain the full amount of insurance. What is an
appropriate option? Explain your answer.
Susan should choose the nonforfeiture option of extended term
insurance. This option trades her surrender value for a term insurance
policy in the same amount as her original policy (less any policy
loans) for a specified number of years and days as found in the
nonforfeiture table printed in the policy.
Return to question.

Module Review  135

© 1982, 1985, 1991, 1996, 2002–2015, College for Financial Planning, all rights reserved
38. Describe the basic structure of a viatical agreement.
It is a contract between a life insurance policyowner and another
person or entity. The policy is sold for a price that is determined by
calculating the estimated present value of the future death benefit and
subtracting the estimated present value of the premiums that will have
to be paid through the death of the insured.
Return to question.

39. David Smith has terminal cancer, and his physician has given him three
months to live. His adult children own an insurance policy on his life. Briefly
describe the viatication process as it relates to David and his children.

David’s children may sell the policy to a viatical company. The

company would verify David’s life expectancy and make an offer to
purchase the policy from the children. Even though David is the
insured, he does not have to approve the transaction.
Return to question.

5–9 Analyze and compare settlement options available under a life

insurance for specific situations.

40. List and describe the settlement options available for life insurance policies.
 Lump sum: It is a single payment in cash.
 Interest option: The proceeds of a policy are left with the
insurance company to be paid out at a later time, in which case
only interest on the principal amount is paid to the beneficiary
(with a minimum rate of interest guaranteed).
 Installments for a fixed period: The policyowner may specify (or
beneficiary may elect) to have the proceeds paid out over some
specified period.
 Installments of a fixed amount: The policyowner (or beneficiary)
may elect to have policy proceeds paid out as some fixed amount
per month for as long as principal and interest on the unpaid
portion of principal lasts.

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  Life income options: The proceeds are paid out in the form of an
annuity over the life of the recipient. However, payments may be
received by a person other than the one whose life determines the
payout period.
Return to question.

41. List and describe the four basic categories of life income settlement options.
a. Straight life income: The proceeds are paid to a beneficiary on
the basis of life expectancy.
b. Life income with period certain: The beneficiary is paid a life
income for as long as he or she lives, with a minimum number of
payments guaranteed.
c. Life income with refund: A beneficiary is paid a life income for as
long as he or she lives; if the original proceeds are not paid out
when the beneficiary dies, the remainder is paid to a contingent
beneficiary.
d. Joint and survivor income: It provides income to two payees, with
payments continuing to the survivor after the death of the first
payee.
Return to question.

42. Mac Dahrr wants to use a settlement option with the life insurance proceeds
he is receiving from a policy on his father. He can’t decide between a 10 c&c
or a 20 c&c payout. Which one will provide him with the most monthly
income, and why?
The 10 c&c payout will provide the highest income. Even though he may
live for 30 years or more, the insurance company would have to guarantee
payments for at least 20 years under the 20 c&c settlement option. That is
a much greater certain obligation than a certain 10-year obligation.
Return to question.

Module Review  137

© 1982, 1985, 1991, 1996, 2002–2015, College for Financial Planning, all rights reserved
43. Pat Zeit’s grandfather died. He left Pat the proceeds of a life insurance
policy. Rather than take the lump sum, she wants to have the proceeds paid
out quarterly from now until her youngest child, now age 11, turns 21. She
also wants to receive the largest guaranteed payment available. What is an
appropriate option? Explain.

Ten-year quarterly payout. This option accomplishes exactly what Pat

wants done. The proceeds will be paid out in equal installments for 10
years. If she had chosen a life income with 10 years certain, her
payments would have been substantially less.
Return to question.

5–10 Distinguish between types, uses, and limitations of various types of

annuities.

44. Identify the five ways annuities may be classified and list the annuities that
fit each classification.
 Method of premium payment: single premium, fixed or flexible
basis over a period of years.

 When payments are to commence: immediate versus deferred

annuities.
 Number of lives are covered: single life (paid for duration of a
single life) or joint and survivor annuities (paid for duration of two
or more lives).
 Methods of payment/accumulation: fixed, variable or indexed.

 Method of determining benefit payment amount: fixed, fixed with

COLA or variable
 Length of insurer’s obligation: period certain, pure life annuity, joint
life, life and period certain, or life with refund.
Return to question.

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45. Describe the following annuity terms.
a. single premium
Annuity purchased with single premium rather than on installment
basis.
Return to question.
b. flexible premium:
Owner has right to vary contributions on an installment basis.
Return to question.
c. immediate
Benefits payable to begin within one year of purchase.
Return to question.
d. deferred
Benefits deferred to begin more than one year after purchase.
Return to question.
e. longevity
Annuity designed to address living beyond life expectancy with
benefits generally starting a long deferred period after purchase.
Typically pure life annuity with no refund certain.
Return to question.
f. fixed interest accumulation
There is a minimum guaranteed interest rate and a current interest
rate that is paid on the contract value. The value is contributions
plus prior earnings, minus withdrawals and expenses.
Return to question.
g. variable accumulation
The contributions are invested in sub-accounts similar to mutual
funds. The account value is based on the value of the units which
varies based on market returns.
Return to question.

Module Review  139

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 h. indexed earnings
Similar to a fixed account, a minimum interest rate is guaranteed
and the contract holder receives a percentage of the value that an
index receives above the minimum rate. There are many
requirements to receive the additional interest.
Return to question.
i. period certain
The annuity is paid for a specific number of years independent of
life expectancy.
Return to question.
j. pure life/straight life
 Payments made only for balance of annuitant’s lifetime,
regardless of how long.
 Considered fully liquidated at annuitant’s death, with nothing
payable to his or her estate.
 Provides maximum income per dollar of principal sum.
Return to question.
k. joint and survivor
Covers two or more annuitants with payments continuing until
death of last survivor.
Return to question.
l. life and period certain
Payments made for life of annuitant, but guaranteed a certain
number of years (5, 10, 15, 20), regardless of whether the
annuitant lives to end of period. If the period certain is not
reached, payments continue to named beneficiary.
Return to question.
m. life with period certain
Guarantees that a number of payments will be made to either the
annuitant or the beneficiary.
Return to question.

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 n. life with refund certain
Contract guarantees that either the principal or a specified amount
at date of annuitization is returned in payments or either a lump
sum or payments will continue to a beneficiary.
Return to question.

46. What tax rate is applied to withdrawals from annuities?

Ordinary income tax rates plus penalties if withdrawn before 59½.
Return to question.

47. What 1035 exchanges are allowed for annuities?

Annuity to annuity and annuity to long-term care.
Return to question.

48. What are the advantages and disadvantages of a pure life immediate fixed
annuity?
a. advantages

 Guaranteed stream of income.

 Annuitant cannot outlive principal.

 No residual value at death that would be subject to estate

taxes.
Return to question.
b. disadvantages

 Does not increase with inflation.

 Access to principal in case of emergencies either nonexistent

or limited based on whether there are living benefit riders such
as long term care.
 Annuitant may die before return of principal is realized; nothing
left for beneficiaries.
Return to question.

Module Review  141

© 1982, 1985, 1991, 1996, 2002–2015, College for Financial Planning, all rights reserved
49. What are the advantages and disadvantages of fixed annuities?
a. advantages

 Credited interest rate that may be above what an investor

would achieve on their own
 Easy to manage

 Tax deferral of ordinary income

 Insurance company takes the investment risk

 Guarantee rate provides security

Return to question.
b. disadvantages

 Income will not keep pace with inflation unless a rider is

purchased
 The company rate may drop below market rates at some point
in the future and surrender penalties may make it impossible
to shift

 Surrender penalties and contract requirements may result in a

less than expected return
Return to question.

50. What are the characteristics that should be examined in a fixed annuity?
Rates, fees, and contract provisions along with rating of the insurance
company and past behaviors compared to marketing promotions
Return to question.

51. What are the advantages and disadvantages of variable annuities?

a. advantages
 Diversification
 Professional management
 Advantage of dollar cost averaging
 A supplemental retirement plan

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  Death benefit guarantees
 Riders that can provide protection from downside loss
 Tax-deferred growth on market returns
Return to question.
b. disadvantages
 Earnings will be taxed at ordinary income tax vs. long term
capital gains rates for other equity investments.
 Contract owner may be adding insurance company expenses
he or she may not need
 Tax penalties for early withdrawals apply to variable annuities
 Lack of liquidity
 Fees can range from low load to over 3%
 Loss of long term capital gains rates
 Complex and difficult for purchasers to understand
 High expense ratios
 Surrender penalties and contract requirements may result in a
less than expected return.
Return to question.

52. What characteristics should be examined when evaluating variable annuities?

Investment characteristics and options within the annuity, expenses,
surrender charges, and specific contract language related to
annuitization, riders, withdrawals and other factors that could impact
actual results.
Return to question.

53. What are the four types of living benefit riders?

 Guaranteed minimum income benefit (GMIB) guarantees a
minimum income to the annuitant, regardless of adverse
investment performance.
 Guaranteed minimum accumulation benefit (GMAB) guarantees
that there will be a minimum account value at the end of a
specified guaranteed date.

Module Review  143

© 1982, 1985, 1991, 1996, 2002–2015, College for Financial Planning, all rights reserved
  Guaranteed minimum withdrawal benefit (GMWB) guarantees that
either a return of principal or a protected amount through
systematic withdrawals over a specified time period in years (not
covering a life expectancy).

 Guaranteed lifetime withdrawal benefit (GLWB) guarantees the

right to withdraw up to the specified percentage each year for life
at a specified time.
Return to question.

54. What are indexed annuities?

Indexed annuities are a fixed annuity which provides the annuitant an
opportunity to participate in a portion of the gain tied to a specific
above the minimum guaranteed rate.
Return to question.

144  Introduction to Life Insurance & Annuities

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References
Black, Kenneth, and Harold D. Skipper, Life & Health Insurance, 14th edition.
Upper Saddle River, NJ: Prentice Hall, 2013.
Leimberg, Stephan, [Link]., Tools & Techniques of Life Insurance Planning, 4th
edition. Cincinnati: The National Underwriter Company, 2007.
Olson, John, and Michael Kitces, The Advisor’s Guide to Annuities, 3rd edition.
Erlanger, KY: The National Underwriter Company, 2012.
Rejda, George E., Principles of Risk Management and Insurance, 11th edition.
Upper Saddle River, NJ: Pearson Education, 2010.
Trieschmann, James S., Robert E. Hoyt, and David Sommers, Risk Management
and Insurance, 12th edition. Cincinnati: South-Western College Publishing,
2004.
Vaughan, Emmett J and Therese Vaughan, Fundamentals of Risk and Insurance.
10th edition. New York: John Wiley & Sons, 2008.

References  145
© 1982, 1985, 1991, 1996, 2002–2015, College for Financial Planning, all rights reserved
About the Author
David Mannaioni, CFP®, CLU, ChFC, CPCU is an associate
professor at the College for Financial Planning. Utilizing his 30+
years of experience in the financial services industry, David also
maintains a financial planning practice where he works with his
clients in all areas of financial planning. In addition to his
certifications, David holds Life and Health insurance licenses in
several states, as well as the Series 6, Series 7, Series 63, and Series 24
registrations with FINRA. You can contact David at [Link]@[Link].

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Index
A master index covering all modules of this course can be found in the Self-Study
Examination book.

1035 exchanges, 82 per stirpes, 48

Accidental death benefit, 59 revocable, 49
Adjustable life, 24 Choosing the right policy, 76
Annuities, 89 Commissioner’s Standard Ordinary
deferred annuities, 98 (CSO) Mortality table, 17
deferred annuity, 90 Deferred annuities, 98
equity indexed annuities, 104 fixed, 99
equity indexed annuity, 91 variable, 101
estate taxation, 96 Disability waiver of premium, 62
fixed annuity, 91 Dividends, 55
fixed payout, 91 accumulate at interest, 56
fixed payout with COLA, 91 cash, 56
fixed premium, 90 one-year term, 57
flexible premium, 90, 98 paid-up dividend additions, 56
immediate annuity, 90, 96 reduced premium, 56
income taxation of annuities, 92 Financial risk exposures at death
(personal), 5
individual annuitant, 91
death before loan repayment, 6
joint and survivor, 91, 92
final expenses, 8
joint life, 92
outliving pure life annuitant, 6
life and period certain, 92
Franchise life insurance, 39
longevity annuity, 90
Grace period, 50
period certain annuity, 91
Group life insurance, 39
private annuities, 106
Guaranteed insurability, 60
pure life annuity, 92
Illustrations, 67
refund annuity, 92
dividend scale, 69
single premium, 98
NAIC model, 73
variable annuity, 91, 101
using the illustrations, 74
variable payment, 91
Insurability, 76
Beneficiary clause, 48
Insurance policy, standard provisions,
irrevocable, 49
47
per capita, 48
automatic premium loan, 50

Index  147
© 1982, 1985, 1991, 1996, 2002–2015, College for Financial Planning, all rights reserved
 contestable clause, 51 Life insurance tax treatment, 42
conversion clause, 54 Life risk exposure (business), 11, 14
dividends, 53 death of a key employee, 13
entire contract clause, 47 death of a partner, 11
misstatement of age clause, 51 death of an owner, 14
nonforfeiture options, 52 loss of a key employee, 14
policy loans, 52 Life risk exposures (personal), 11
reinstatement clause, 50 aging parents, 11
settlement options, 53 death before accomplishment, 8
suicide clause, 51 dependent income, 9
Insurance Questionnaire, 74 education, 10
Joint life insurance, 35 family goals, 10
first-to-die policies, 35 retirement income default, 7
second-to-die policies, 36 Low-load life insurance, 41
Life income options, 84 Mortality tables, 17
joint and survivor life, 85 Nonforfeiture options, 78
joint life, 86 cash, 80
period certain, 85 extended term, 79
refund, 85 reduced paid-up insurance, 78
straight life, 85 Ownership clause, 47
Life insurance policies, franchise or Payroll deduction life insurance, 39
payroll deduction, 39 Presumptive disability, 63
Life insurance policies, joint life, 35 Pricing fundamentals, 15
first-to-die policies, 35 morbidity, 15
second-to-die policies, 36 mortality, 15
Life insurance policies, low-load, 41 Private annuities, 106
Life insurance policies, nontraditional, Private placement life insurance, 41, 43
25
Settlement options, 83
adjustable, 24
installments for a fixed period, 84
universal life insurance, 25
installments of a fixed amount, 84,
variable, 36 87
variable universal life, 37 installments of a fixed period, 87
Life insurance policies, private interest only, 84, 86
placement, 41, 43
life income, 87
Life insurance policies, traditional, 16
life income options, 84
term life, 17
recommending settlement options,
whole life, 21 86

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Single premium immediate annuity, 96 Variable universal life, 37
Structured settlements, 107 Viatical agreements, 81
Tax treatment, annuities, 94 senior or life settlements, 82
Tax treatment, life insurance, 42 Waiver of premium, 62
Term life insurance, 17 Whole life insurance, 21
annually renewable, 17 endowments, 20
death benefits, 20 graded premium life, 23
decreasing, 19 limited pay policies, 22
Universal life insurance, 25 modified whole life, 23
Variable life insurance, 36

Index  149
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