Chapter 1

Prior to reading this chapter, please review the following keywords. An understanding of their basic definitions
will improve your comprehension of the chapter content.
Agent: An individual authorized to solicit, sell, and transact coverage for specific insurance providers under an
agent contract.
Broker: A person who represents the insured (client) rather than the insurance company and cannot bind
coverage.
Claims Department: The department responsible for processing, investigating, and paying claims.
Insurance: The transfer of risk through the pooling or accumulation of funds.
Insured: The customer who receives insurance protection under an insurance policy.
Insurer: An insurance company that provides coverage and assumes risk.
Mutual Insurance Company: An insurer owned by policyholders that typically issues participating insurance
policies with potential dividends.
Nonparticipating Policy: A policy that doesn't provide dividends or voting rights to policy owners.
Participating Policy: A policy that allows policy owners to receive dividends and elect the board of directors.
Producer: An individual licensed to sell, solicit, or transact insurance, including both agents and brokers.
Stock Insurance Company: An insurer owned by stockholders that typically issues nonparticipating policies.
Underwriting Department: The department responsible for reviewing applications, approving or declining
coverage, and assigning risk classifications.

Insurance is the transfer of risk from one party to another in exchange for the payment of premiums.
Most accident, health, property, and casualty insurance contracts are contracts of "indemnity." Their purpose is
to reimburse for a loss. In contrast, life insurance policies are "valued contracts" because they pay a
predetermined amount regardless of the actual incurred loss.
Participating policies allow policyholders to participate in the company by electing the board of directors and
receiving dividends from the divisible surplus. Mutual companies issue participating polices.
• Nonparticipating policies do not allow policyholders to participate in elections or receive dividends.
Stock companies issue nonparticipating policies.
• A company that issues both participating and nonparticipating policies operates under a mixed plan.

In a reinsurance agreement, the insurance company that transfers its loss exposure (risk) to another insurer is
called the primary insurer, or ceding company.
Reinsurance is "insurance for insurance companies."
Treaty reinsurance is broader and automatic.
Facultative reinsurance is tailored to specific risks on a case-by-case basis.
The ceding (original) insurer remains responsible to the client.

Quiz:
Primary insurer/ceding company = Insurance company that transfers its loss exposure (risk) to another insurer
Reinsurer/assuming company = Company assuming the risk
Net retention/net line = Portion of the risk that the ceding insurer retains
Treaty reinsurance = Automatic sharing of the risks assumed based on previously established criteria
Facultative reinsurance = Reinsurance tailored to cover a specific risk or exposure without an ongoing agreement
Stock company = Owned by private investors who receive stock dividends
Mutual company = Owned by policyholders who receive policy dividends
Risk retention group (RRG) = Created under federal law for liability insurance among similar professionals
Fraternal benefit society = Must have a lodge system and ritualistic work
Learning Objective 1: Define basic insurance concepts, including risk transfer, indemnification, and
premium pooling
Key Concepts:
• Insurance is a legal contract that transfers risk from the policyholder to the insurer
• Premium pooling spreads risk across many policyholders
• Indemnification means restoring an insured to their pre-loss financial position
• Key difference: Life insurance uses valued contracts (predetermined amount), while most other
insurance uses indemnity contracts
Important Terms:
• Insured: Person receiving insurance protection
• Insurer: Company providing coverage and assuming risk
• Premium: Payment made for insurance coverage
• Policy owner: Person who transfers risk to insurer
Learning Objective 2: Distinguish between major types of insurance companies
Stock Insurance Companies:
• Owned by shareholders
• Issue nonparticipating policies
• Profits go to stockholders
• Publicly traded entities
Mutual Insurance Companies:
• Owned by policyholders
• Issue participating policies
• Policyholders receive dividends
• Policyholders elect the board of directors
Fraternal Benefit Societies:
• Non-profit organizations
• Must have a lodge system
• Must have ritualistic work
• Exist for reasons beyond insurance
Other Important Types:
• Reciprocal insurers: Members insure each other
• Risk retention groups (RRGs): Created under federal law for liability insurance
• Captive insurers: Owned by a parent company to insure its risks
Learning Objective 3: Identify key departments and roles within an insurance company
Essential Departments:
• Marketing/Sales: Increases prospective applicants
• Underwriting: Reviews applications, assigns risk classifications
• Claims: Processes and pay claims
• Actuarial: Calculates rates, reserves, dividends
Key Personnel:
• Producers (agents/brokers): Sell insurance products
• Underwriters: Assess and classify risks
• Actuaries: Calculate rates and reserves
• Adjusters: Investigate and settle claims
Learning Objective 4: Compare different insurance distribution systems
Distribution Systems:
• Career agency system: Agents work exclusively for one company
• Independent agency system (American agency): Represents multiple companies
• Personal producing general agency (PPGA): Focuses on sales
• Direct selling: The company deals directly with consumers
Important Distinctions:
 • Captive agents: Work for one company
• Independent agents: Represent multiple companies
• Brokers: Represent the buyer
• Solicitors: Not licensed to sell, only refer
Learning Objective 5: Explain the evolution of insurance industry oversight
Key Legislation:
• Paul v. Virginia (1868): Established state regulation
• McCarran-Ferguson Act (1945): Returned regulation to states
• Gramm-Leach-Bliley Act (1999): Privacy requirements
• Fair Credit Reporting Act (1970): Consumer protection
Regulatory Organizations:
• NAIC: Creates model laws and regulations
• NCOIL: Legislative organization focusing on insurance
• State insurance departments: Primary regulators
Learning Objective 6: Describe the roles of major insurance industry organizations
NAIC Functions:
• Promotes uniform state laws
• Creates model regulations
• Protects consumer interests
• Preserves state regulation
Other Organizations:
• NAIFA: Professional association for agents
• Rating services (A.M. Best, etc.): Evaluate insurer financial strength
• State insurance departments: Issue licenses, enforce regulations
Exam Tips:
• Focus on differences between company types
• Know key legislation dates and purposes
• Understand distribution system characteristics
• Memorize department functions
• Know regulatory organization roles
• Understand the difference between participating and nonparticipating policies
Remember:
• Terms must be used precisely
• Dates of major legislation are important
• Company classifications affect operations
• Distribution systems have distinct characteristics
• The regulatory framework is state-based
• Consumer protection is a primary focus

Which of these describe a participating life insurance policy?

A. Policyowners are not entitled to vote for members of the board of directors
B. Policyowners may be entitled to receive dividends
C. Stock companies allow their policyowners to share in any company earnings
D. Policyowners pay assessments for company losses

At what point must a life insurance applicant be informed of their rights that fall under the Fair Credit Reporting
Act?
A. Upon completion of the application
A(n) ________ agent is an insurance agent who represents only ONE insurance company.
 A. captive
A reciprocal insurer typically has an administrator who manages the premiums collected from the group's
members. This administrator is called a(n)
A. attorney-in-fact
Which of the following is NOT an objective of the National Association of Insurance Commissioners?
A. Promote efficiency in the administration of state insurance laws
B. Encourage uniformity in state insurance laws
C. Regulate state insurance commissioners
D. Protect the interest of policyowners and consumers

Mutual insurers pay dividends to participating policyowners if the insurer has which of the following?
A. Certificate of Authority
B. Participating clause
C. Reciprocal Dividend Agreement
D. Divisible surplus

Which of the following types of insurers limits the exposures it writes to those of its owners?
A. Restricted insurer
B. Limited insurer
C. Confined insurer
D. Captive insurer

Who regulates an insurer's claim settlement practices?

A. State insurance departments
B. National Association of Claim Adjusters
C. State attorney general
D. National Association of Insurance Commissioners

The State Guaranty Association guarantees

A. that a policy will be issued
B. the rate of return on a policy
C. that a claim will be paid if an admitted insurer becomes insolvent
D. that dividends will be paid

Dividends from a stock company are paid to stockholders, whereas in a mutual company, dividends are
A. paid to both the policyowners and shareholders
B. paid to the policyowners
C. reinvested as capital gains, used to reduce rates for policyowners
D. paid quarterly to corporate officers in the form of a bonus

Insurance is NOT characterized as which of the following?

A. Method of risk management
B. Transference of risk
C. Pooling of premium dollars
D. As the number of insureds increase the number of losses decrease

Which of the following outlines the authority given to the producer on behalf of the insurer?
A. Producer contract
B. Rebating arrangement
 C. Commingling contract
D. Controlled business clause

The main role of accident and health and disability insurance is to

A. protect against the premature death of the insured
B. protect against accidents
C. protect against on-the-job injuries and illnesses
D. protect against medical care costs and the loss of earning power

Dividends from a stock insurance company are normally sent to

A. shareholders
B. beneficiaries
C. insureds
D. policyowners

What is the accounting measurement of an insurance company's future obligations to its policyowners?
A. Credits
B. Reserves
C. Retention fund
D. Surplus account
A group-owned insurance company that is formed to assume and spread the liability risks of its members is
known as a
A. treaty insurer
B. captive insurer
C. risk retention group
D. risk assumption group

Which of the following is a syndicate established by a group of insurers to share underwriting duties?
A. Multi-line insurers
B. Lloyd's organization
C. Reinsurer
D. NAIC
 Chapter two
Adverse Selection: The tendency of higher-risk individuals to seek insurance coverage more frequently
than lower-risk individuals.
Hazard: A condition that increases the likelihood of a loss occurring.
Law of Large Numbers: The principle that the larger the number of similar risks insured, the more
accurately future losses can be predicted.
Loss: An unintentional decrease in value due to a covered peril.
Peril: The specific event or cause that results in a loss.
Pure Risk: A risk that involves only the possibility of loss, with no chance of gain; the only type of risk that
is insurable.
Risk: The uncertainty regarding the possibility of loss.
Speculative Risk: A risk that involves the possibility of both loss and gain; not insurable.

Risk pooling transfers risk from an individual to a group

The exposure units in the pool must be similar (homogeneous)
Insurance companies use risk pooling, along with the law of large numbers, to predict losses and calculate
appropriate premiums

Remember the following key points about adverse selection:

• Adverse selection increases the insurance company's risk
• It results in higher claims costs than the company anticipated
• Insurance companies use underwriting to help prevent adverse selection
• Concealing material information on an insurance application is a form of adverse selection

The law of large numbers helps insurance companies predict losses more accurately
Both the number AND independence of exposure units are crucial
This principle works together with risk pooling to make insurance operations possible
Without the law of large numbers, insurance companies couldn't accurately price their products
• Don't confuse "large numbers" alone with accurate predictions. The exposure units must be both
numerous AND independent. A large group of homes in a single neighborhood might not provide accurate
predictions because a single event (like a flood) could affect many units simultaneously.

Physical hazards: Think "can be measured or observed"

Moral hazards: Think "intentional and dishonest" (like insurance fraud)
Morale hazards: Think "unintentional/careless because insured" (like skipping preventive care)

Most state exam questions about risk types focus on identifying whether a scenario represents a pure or
speculative risk. When answering questions about risk types, first ask yourself: "Can this situation result in a
gain?" If yes, it's speculative and not insurable. If no, it's pure risk and potentially insurable.
Insurance companies only insure pure risks.
[4.1] ELEMENTS OF AN INSURABLE RISK
It’s impossible to insure every type of risk. For a pure risk to be insurable, it must involve a chance of accidental,
measurable, and definable loss. General elements of insurable risk include:
An insurable loss must be due to chance (accidental) – “Chance” means that it’s outside an insured’s control. In
this sense, the individual insured (loss exposure unit) that suffers the loss is randomly selected. This
characteristic helps insurers avoid adverse selection.
For example, an insured catches a cold.
An insurable loss must be definite and measurable “Definite and measurable” means that the time, place,
amount, and whether the claim is payable can be documented.
For example, the insured’s automobile accident occurred at 2:00 p.m. on Friday and caused $2,000 in damage.
An insurable loss must be predictable The term “predictable” means that the (estimated) average frequency and
severity of future losses can be calculated. There must be a sufficient number of homogeneous loss exposure
units to effectively allow insurers to apply law of large numbers.
For example, 18% of accidents involve distracted driving.
An insurable loss cannot be catastrophic – The term “catastrophic” is from the perspective of the insurer. This is
meant to indicate that it’s too big and uncertain to be insured. The loss exposure must be reasonable.
For example, a war, a nuclear disaster, or a $1 trillion life insurance policy is not reasonable loss exposure.
The number of loss exposures (units) to be insured must be substantial – The carrier’s actuaries must be able to
apply the law of large numbers to help the insurance company predict loss.
The premium cost must be economically feasible – A premium is “feasible” when it’s affordable. Also, the
premium must be small in comparison to the loss exposure being insured.
For example, a healthy 45-year-old male could probably qualify for a 20-year term life insurance policy with a
$250,000 face amount for less than $500 per year.
[4.2] INSURANCE RISK CLASSIFICATIONS
As will be described later in this course, insurers use various underwriting techniques to evaluate risks and
assign risk classifications. Insurers place risk exposures into one of three risk classifications: standard risk,
substandard risk, or preferred risk.
Standard risks are considered to have an average potential for loss. Standard risks are typically insured in return
for a predetermined standard premium.
Substandard risks are judged to be a poor risk for an insurance company and have a higher-than-average
potential for loss. Substandard risks may be insured for an increased premium, covered with a lower benefit, or
declined altogether.
Preferred risks are judged to be better than average risks for an insurance company. Preferred risks have a lower
potential for loss. Insurers offer coverage to preferred risks for a lower-than-average premium.
[4.3] RISK MANAGEMENT
The process of analyzing exposures that create risk and designing programs to handle them is referred to as risk
management. Risk management may be accomplished by:
• Detecting the potential loss exposure;
• Selecting a method or tool in order to reduce risk;
• Executing a course of action; and
• Periodically reviewing the measures taken.
The risk may be reduced or managed by purchasing an insurance contract, known as risk transfer. In addition to
risk transfer, we will next explore other ways to manage risk.
[4.3.1] METHODS OF HANDLING RISK QUICK REFERENCE CHART

Exam Tip!
One way to remember these risk-handling methods is to use the acronym STARR (Sharing, Transfer, Avoidance,
Reduction, and Retention).
[4.3.2] METHODS OF HANDLING RISK
Risk sharing spreads risk among multiple parties. Each party assumes a portion of the risks that are covered by
the arrangement. Reciprocal insurance companies (e.g., USAA in San Antonio, Texas)—also referred to
as inter-insurance exchanges—are one type of risk sharing arrangement.
An example of risk-sharing is the use of coinsurance in a major medical insurance policy. If the coinsurance split
is 80% / 20%, then the insurance company carries 80% of the risk, and the insured carries 20%. Often, this risk-
sharing mechanism is used in conjunction with the risk retention mechanism that’s referred to as a deductible.
Risk transfer features a legal contract that transfers risk from one party to another. In general, insurance
contracts are risk transfer arrangements. They transfer the risk of loss defined in the policy to the insurer in
exchange for a known fee or premium.
Buying insurance is the best way to transfer risk. Additional examples include incorporation and hold-harmless
clauses in contracts.
• Reinsurance is one method that insurers use to prevent a catastrophic loss. Reinsurance, which is
defined as transferring risk from one insurer to one or more other insurers. Many insurers can minimize
exposure to substantial loss by reinsuring risks.
Risk avoidance means that risk can be avoided by eliminating an activity or condition that exposes a person to a
type of loss or specific perils. Avoidance is the most complete form of risk management.
For example, a company decides not to build in a flood zone and completely eliminates the risk of flood loss.
Risk reduction is the process by which a person takes deliberate actions to reduce the likelihood or frequency of
a loss, or the severity of a loss if it should occur. This is different from risk avoidance since the risk is not
completely eliminated.
For example, installing smoke alarms and a sprinkler system reduces the risk of death and will reduce the
amount of property loss in a building fire.
Risk retention is a conscious strategy in which a person maintains a certain amount of reserves to address
unexpected expenses that are caused by insurable losses. Some forms of risk retention are limited, such as the
deductibles in a health insurance plan or personal automobile insurance. Some large companies that have highly
predictable patterns of loss also self-insure. Choosing not to purchase insurance at all is also a form of risk
retention.
For example, a person with a $1,000 deductible on their automobile insurance policy retains $1,000 of any risk if
their car is damaged in an accident.
It’s essential to know that “self-insurance” is much different from “no insurance.” The former is a planned
strategy that’s based on holding reserves and self-financing losses. The latter is simply a refusal to acknowledge
the reality of risk and the possibility of financial loss.
[4.4] LOSS PREVENTION
Another risk management tool available is loss prevention. Loss prevention involves taking actions to eliminate
damage or loss. In fact, it’s a method used to identify and analyze risk and to control losses.
For example, constructing a building with masonry rather than wood, removing flammable materials from a
premise, or de-icing an aircraft's wings before takeoff are loss-prevention steps.
[5] CHAPTER SUMMARY
In this chapter, we explored the fundamental concepts that make insurance work. We learned that insurance is
essentially a method of transferring risk from individuals to a larger group through risk pooling, which makes
uncertain losses more predictable and manageable.
We discovered that only pure risks (those with potential for loss only) are insurable, while speculative risks
(those with potential for both loss and gain) are not. We examined how different types of hazards – physical,
moral, and morale – can increase the likelihood of loss, and how insurance companies work to manage these
risks.
The law of large numbers emerged as a crucial principle, showing how insurance companies can predict losses
more accurately when they insure many similar risks. We also learned about adverse selection and the various
methods insurance companies use to combat it, including underwriting and waiting periods.
The chapter covered the six primary methods of handling risk: sharing, transfer, avoidance, reduction, retention,
and prevention. Each method serves specific purposes in risk management, with insurance being a prime
example of risk transfer.
Finally, we explored the principle of indemnity, which ensures that insurance serves its intended purpose of
restoring insureds to their pre-loss financial position without allowing for profit from losses.
These foundational concepts will serve as building blocks as you continue your insurance studies and prepare for
your licensing exam. Remember, understanding these basics is crucial not only for passing your exam but also for
serving your future clients effectively.
[5.2 ]REVIEW NOTES – THE NATURE OF INSURANCE
Learning Objective 1: Explain how risk pooling works in insurance operations
• Risk pooling (loss sharing) fundamentals:
o Combines a large number of exposure units
o Units must face similar risks (homogeneous)
o Losses must be accidental/unintentional
o Exposure units must be independent
• Benefits:
o Policyholders: Transfer financial uncertainty for a known premium
o Insurers: Use statistics to predict losses and set premiums
Learning Objective 2: Explain how adverse selection affects insurance operations and methods to control it
• Adverse selection definition: Selection against the insurance company by higher-risk individuals
• Warning signs:
o Unusual urgency in the application
o Incomplete information
o Early or pattern of claims
o Coverage amounts exceeding needs
• Control methods:
o Medical underwriting
o Waiting periods
o Preexisting condition limitations
o Complete health information requirements
o Risk classification
Learning Objective 3: Describe how the law of large numbers enables insurance companies to predict
losses
• Key requirements:
o Independence: Each exposure unit is independent of the others
o Similarity: Units face similar risks
o Large number: Sufficient quantity of exposure units
• Application:
o More accurate loss predictions with larger groups
o Enables proper premium calculations
o Works with risk pooling for viable insurance operations
Learning Objective 4: Apply the principle of indemnity to insurance situations
• Definition: Restoring the insured to the same financial position before the loss
• Key points:
o Prevents profit from insurance
o Applies to most property, casualty, and health insurance
 o Exception: Life insurance (valued contract)
• Purpose:
o Maintain insurance as financial protection
o Prevent insurance from being a source of profit
Learning Objective 5: Define and differentiate between perils, hazards, and losses in insurance contexts
• Perils (cause of loss):
o Specific events causing loss
o Examples: fire, accident, illness, death
• Hazards (conditions increasing loss likelihood):
o Physical: Tangible conditions
o Moral: Dishonest character/intentional
o Morale: Careless attitude due to insurance
• Losses:
o Direct: Immediate damage from peril
o Indirect: Consequential losses
o Must be definite and measurable
Learning Objective 6: Identify three types of hazards and their impact on insurance
• Physical hazards:
o Tangible/observable conditions
o Examples: poor health, dangerous occupation
o Can often be measured or documented
• Moral hazards:
o Involve dishonesty/intentional acts
o Examples: insurance fraud, application lies
o Increases the likelihood of intentional losses
• Morale hazards:
o Carelessness due to insurance
o Examples: skipping preventive care
o Unintentional risk increase
Learning Objective 7: Distinguish between pure and speculative risks in insurance contexts
• Pure risks (insurable):
o Only the possibility of loss
o No chance of gain
o Examples: death, illness, injury
• Speculative risks (not insurable):
o Possibility of loss or gain
o Examples: investments, gambling
o Cannot be insured
Learning Objective 8: Explain methods of handling risk in insurance
• Risk sharing: Spreading among multiple parties
• Risk transfer: Moving risk to another party (insurance)
• Risk avoidance: Eliminating risk-causing activity
• Risk reduction: Decreasing loss likelihood/severity
• Risk retention: Keeping risk (deductibles, self-insurance)
• Risk prevention: Actions to eliminate loss potential
Exam Tips
• Pay special attention to distinguishing between:
o Moral vs. morale hazards
▪ Moral = Intentional/dishonest
 ▪ Morale = Careless/unintentional
o Pure vs. speculative risks
▪ Pure = loss only (insurable)
▪ Speculative = loss or gain (not insurable)
o Direct vs. indirect losses
▪ Direct = Immediate from peril
▪ Indirect = Consequential
• Common trick questions involve:
o Life insurance is a valued contract (not indemnity)
o Identifying correct hazard types in scenarios
o Distinguishing between accidents (sudden/specific) and occurrences (can be gradual)
o Recognizing proper risk management methods
• When answering questions about:
o Adverse selection: Look for intentional concealment or urgency
o Law of large numbers: All three conditions must be met (independence, similarity, large number)
o Risk pooling: Focus on homogeneous exposure units
o Methods of handling risk: Remember STARR (Sharing, Transfer, Avoidance, Reduction, Retention)
Remember
• Essential definitions:
o Risk = Uncertainty of loss
o Peril = Cause of loss
o Hazard = Condition increasing the likelihood of loss
o Loss = Unintentional decrease in value
• Key principles:
o Insurance only covers pure risks
o Every accident is an occurrence, but not every occurrence is an accident
o Self-insurance is different from no insurance (planned vs. unplanned)
o Adverse selection works against the insurance company
• Critical concepts:
o Risk pooling requires similar risks
o The law of large numbers enables accurate predictions
o Indemnity prevents profit from insurance
o Physical hazards can be observed
o Moral hazards involve dishonesty
o Morale hazards stem from carelessness
• For the exam:
o Read questions carefully for key terms
o Look for qualifying words such as "EXCEPT" or "NOT"
o Consider all elements of a concept before answering
o When in doubt about risk type, ask: "Can this result in a gain?"
o Remember that insurance is based on uncertainty and chance
A hazard is a condition that increases the possibility of loss. A peril is the cause of a loss.
[1] INTRODUCTION: LEGAL CONCEPTS OF INSURANCE
Imagine you've just started your dream job as an insurance agent. On your first day, a client walks in wanting to
purchase life insurance for their neighbor without the neighbor's knowledge. Can they do this? Why or why not?
What if they ask, "Why do I need to fill out all these forms? Can't we just shake hands on it?" These questions get
to the heart of what makes insurance contracts unique in the business world. Insurance is more than just an
agreement between two parties. It's a legal relationship with rules to protect both the insurance company and
the customer.
In this chapter, we’ll delve into the legal framework that supports how insurance operates. You'll learn why
certain questions must be asked, why specific procedures must be followed, and, most importantly, how these
legal concepts protect both insurance professionals and their clients.
Think of legal concepts as the "rules of the game" in insurance. Just as you need to understand what constitutes
a foul to play basketball, you need to understand fundamental legal principles to serve insurance clients
properly. Whether you're helping a family protect their home, assisting a business owner with liability coverage,
or advising someone about life insurance, these concepts will guide every transaction you handle.
We'll break down complex legal terms into practical, real-world applications. You'll learn:
• What makes an insurance contract valid and enforceable
• Who can legally buy insurance on whom or what
• How insurance agents get their authority to represent insurance companies
• What protections exist for both insurance professionals and their clients
By the end of this chapter, you'll have a solid foundation in insurance law that will serve you throughout your
career and help you pass your licensing exam.
This chapter is broken into the following sections:
• General Law of Contracts
• Characteristics of Insurance Contracts
• Negotiating and Issuing Insurance Policies
• The Law of Agency
• Other Legal Concepts
[1.1] CHAPTER LEARNING OBJECTIVES
After completing this chapter, you will be able to:
• Define the four essential elements (CLOC) required for a valid insurance contract
• Distinguish between the unique features of insurance contracts, including aleatory, adhesion, unilateral,
and personal contracts
• Explain the concept of insurable interest and when it must exist for different types of insurance
• Compare and contrast valued contracts versus indemnity contracts in insurance
• Differentiate between warranties, representations, and concealment in insurance contracts
• Identify the three types of agent authority and their implications in insurance transactions
• Explain how the principles of waiver and estoppel affect insurance relationships
• Describe the basic concepts of tort law and the purpose of errors and omissions (E&O) insurance for
insurance professionals
Chapter 3:
[1.3] KEYWORDS: LEGAL CONCEPTS OF INSURANCE
Prior to reading this chapter, please review the following keywords. An understanding of their basic definitions
will improve your comprehension of the chapter content.
Agent: A person who represents the insurer during an insurance transaction and has been authorized to act on
the insurance company's behalf. Agents have a fiduciary responsibility to both the insurer and the policy owner.
Broker: A licensed producer who represents the insured (client) during an insurance transaction. Unlike agents,
brokers don't hold appointments with insurers and cannot bind coverage.
Contract of Adhesion: An insurance contract prepared by the insurance company with no negotiation between
the applicant and insurer. The applicant must accept the contract terms on a "take it or leave it" basis.
Consideration: The items of value that each party provides in a contract. The applicant provides material
information and premiums; the insurer promises to pay covered claims.
Insurable Interest: The financial or economic interest that a person must have in the subject of insurance to
purchase legally enforceable coverage. A person has an insurable interest if they would suffer a financial loss
from damage to or loss of the insured person or property.
Material Misrepresentation: A false statement made by an applicant that influences either the insurer's
decision to accept the risk or the classification and pricing of an accepted risk.
Utmost Good Faith: The principle that both the policy owner and insurer must disclose all material facts and
relevant information, with no attempt to conceal or deceive.
Void Contract: A contract that has never been legally in force because it lacks one of the essential elements of a
contract.
Voidable Contract: A contract that may be set aside by one of the parties for a reason satisfactory to the court.
Waiver: The voluntary giving up of a known legal right.

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[2] GENERAL LAW OF CONTRACTS
Before we dive into the specific legal features of insurance contracts, we must first understand their foundation –
the four essential elements that make any insurance contract valid and enforceable. Just as a building needs a
solid foundation, every insurance contract must have these four core elements, known by the mnemonic
"CLOC." Let's examine each one in detail.
Insurance contracts establish binding legal agreements that are enforceable by law. There are two parties to an
insurance contract – the policy owner (or applicant) and the insurer. In most cases, the policy owner is also
the insured; however, third parties own some life insurance policies. The insurer (or insurance company) makes
a promise to pay benefits to the policy owner (the insured) under certain circumstances dictated in the contract.
Every valid insurance contract needs four basic parts:
• Competent parties
• Legal purpose
• Offer and acceptance (agreement)
• Consideration
Use the mnemonic device "C, L, O, C" to remember the four elements.
Exam Tip:
An insurance contract consists of two parties – the policy owner (applicant) and the insurer (company). The
beneficiary and insured (if different from the policy owner) are not parties to an insurance contract and don’t
have legal capacity.
If an insurance exam question asks about identifying the party who enters a contract with an insurer, the proper
answer is “the policy owner,” even if “the insured” is also given as a choice. The policy owner (regardless of
whether they’re also the insured) has committed to paying the premium. It’s also the policy owner who has the
right to make changes or exercise policy options.
[2.1] COMPETENT PARTIES
Both the person buying insurance and the insurance company must be legally able to make decisions. We call
this being “competent.” For a person to be considered competent, they must possess such a capacity. This
requirement may also be referred to as legal capacity. The insurer is considered competent if it has been
licensed or authorized by the state(s) in which it conducts business. Most people are considered competent to
enter into a contract; however, the following list represents those who are not competent:
• Minors are not considered competent, except those entering into agreements for necessities (e.g., food).
State laws vary in determining the “age of majority,” or the age at which a person may enter into an
insurance agreement.
• Insane or mentally incompetent individuals
• Individuals under the influence of alcohol or drugs at the time of application
• Persons forced or coerced into a contract
• Enemy aliens
• Convicts (based on state law)
Exam Tip:
Questions about competency often appear as scenarios. Remember: BOTH parties must be competent. Even if
the insurance company is competent, if the other party is a minor or mentally incompetent, the entire contract is
void from the beginning—not voidable!

[2.2] LEGAL PURPOSE

Contractual arrangements cannot be contrary to public policy and must be created in the public interest. For a
contract to be enforceable, the contract must have a legal purpose. The purpose of the contract and the reason
both parties are entering into the agreement must be lawful. Therefore, an organized crime “hit” contract is
neither valid nor is it in the public’s best interest because the object or purpose of the contract is not legal.
Insurance contracts are always considered to possess a lawful purpose.
[2.3] OFFER AND ACCEPTANCE (AGREEMENT)
A valid offer and unconditional acceptance must be present for a contract to be enforceable. The offer and
acceptance together constitute the agreement. An offer is a proposal by one party that creates an agreement if
accepted by the other party.
In an insurance contract, the applicant for insurance makes the “offer” by submitting a completed application
and paying the initial premium. If an applicant applies without an initial premium, they are making an invitation.
The offer is not complete without the premium. The insurer either accepts or declines (rejects) the offer based on
its underwriting criteria.
For example, if an applicant only saves a completed online application but does not submit an electronic
premium payment to the insurer, no offer has been made. An application MUST be accompanied by a
premium payment to be considered a legal offer.
If the insurer accepts the offer, it will issue the requested policy, and the producer will deliver it. At that point, the
parties have arrived at an agreement. Therefore, acceptance can be demonstrated by the insurer issuing the
policy or the producer delivering it. There must be a genuine agreement between the parties, meaning neither
party is under duress or undue influence.
If the insurer makes a counteroffer, the applicant's original offer has been rejected, and that initial offer is void.
No contract will exist unless the applicant accepts the insurer’s counteroffer, usually by paying an additional
premium or agreeing to benefit limitations.
[2.4] CONSIDERATION
Insurance contracts need both sides to give something of value:
• The insured gives: Money (premiums) and honest application information
• The insurance company gives: A promise to pay claims
The value each side provides is known as consideration. In some cases, consideration is referred to as a
bargained-for exchange. Regardless of what it’s called, consideration is the binding force of any insurance policy.
The policy owner keeps coverage active by paying premiums on schedule. The insurer’s promise to pay exists as
long as the insured pays the prescribed premium. For coverage to remain in effect, the consideration must be
perpetual. Therefore, the consideration clause also contains information related to the schedule and amount of
premium payments.
Exam Tip:
Remember, in an insurance contract, consideration (completed application and premium payments) is given by
the applicant in exchange for the insurer’s promise to pay benefits.
[3.1] ALEATORY CONTRACT
An insurance contract is an aleatory contract because one party may recover more in value than has been paid.
This difference in benefits occurs because they depend on uncertain future events, such as illness or death. In
other words, aleatory contracts involve unequal exchanges. The value of the policy owner's potential benefit (a
claim payment) is usually higher than the premium paid to the insurer. Both insurance and gambling contracts
are typically considered aleatory contracts.
Think of an aleatory contract like a "what if" agreement. Here's how it works:
Step 1: What You Pay
 • You pay a set amount (premium) regularly
• Example: $100 per month for car insurance
Step 2: What You Might Get
• You might get nothing if nothing goes wrong
• You might get a lot more than you paid if something does go wrong
• Example: After paying $1,200 in premiums, you could get $25,000 for car repairs
Why It's Called "Aleatory"
• "Aleatory" means depending on chance
• You don't know if you'll need to use the insurance
• The insurance company doesn't know if they'll need to pay
Consider these three real-world examples of aleatory contracts:
A policyholder pays $1,200 annually for a $500,000 life insurance policy but dies after paying only two premiums
($2,400 total). The beneficiary receives the full $500,000.
For 20 years, a person pays $800 annually for disability insurance ($16,000 total) but never becomes disabled
and receives no benefits.
A homeowner pays $1,500 annually for homeowners' insurance for 15 years ($22,500 total) and files one claim
for $75,000 after a major fire.
These examples show how either party might receive more or less value than they give, depending on whether
the uncertain event occurs.
[3.2] CONTRACT OF ADHESION
Insurance policies are contracts of adhesion because they are prepared by only one party—the insurance
company. When buying insurance, the applicant can't change what the policy says. The insurance company
writes all the rules. The applicant can either take the policy as it is or leave it and choose something else. A
policy can also be described as a contract of adhesion because it can only be modified by the insurance
company.
[3.2.1] AMBIGUITIES IN A CONTRACT OF ADHESION
Ambiguities or confusing language in a contract can result in differing legal interpretations and conflicts. In any
contract of adhesion, the party that dictates the contract terms is responsible for ensuring that all terms are clear
and free of ambiguity. The insurance company has this responsibility when it comes to its insurance
policies. When policy language is unclear:
• The court looks at the disputed terms
• The insurance company is responsible for clarity
• The court typically favors the policyholder
Here's why ambiguities matter:
• An auto policy states, “coverage excludes damage from acts of nature” without defining “acts of nature.”
• A fallen branch damages the insured's car during a storm.
• The insurer claims this is an act of nature and denies coverage.
• The insured argues that damage from fallen branches should be covered since “acts of nature” is not
clearly defined.
The court would likely rule in favor of the insured because:
• The insurer wrote the contract
• The term is ambiguous because reasonable people might interpret it differently
[3.2.2] DOCTRINE OF REASONABLE EXPECTATIONS
The doctrine of reasonable expectations means courts look at what an average person would expect from the
policy. If the policy promises something different from what it delivers, the court supports the consumer's
reasonable understanding.
Reasonable expectations may be based on what the producer or insurer has indicated, or on what the customer
has interpreted or expected it to mean. The purpose is to correct any advantage gained by the party that prepared
the contract.
The insurance company creates and assembles all policy forms. However, the insurer is typically required to
obtain approval from the state’s insurance department before using or modifying any policy forms.
Exam Tip:
The reasonable expectation is a legal principle that reinforces the rule that ambiguities in insurance contracts
should be interpreted in favor of the policyholder. It also states that an insured is entitled to coverage under a
policy that a sensible and prudent person would expect it to provide.
[3.3] UNILATERAL CONTRACT
Insurance policies are also unilateral contracts. A unilateral contract is one in which only one party (the insurer)
makes any enforceable promise. Therefore, it’s often considered to be a one-sided contract. Insurers promise to
pay benefits upon the occurrence of a specific event (e.g., death or disability); however, the applicant makes no
such promise. In fact, the applicant doesn’t even promise to pay premiums. The insurer cannot require the policy
owner to pay premiums; instead, the insurer has the right to cancel the contract if premiums are not paid. The
payment of premiums is a necessary condition for keeping the insurer’s promise in force.
[3.4] CONDITIONAL CONTRACT
A condition is a requirement specified in the contract that limits the rights it grants. An insurance contract is
conditional. The contract includes conditions that the insured must meet to qualify for indemnification. The
insurer’s promise to pay a benefit is dependent on the occurrence of an event covered by the contract. If the
event doesn’t materialize, no benefits are paid. The insurer will pay claims when:
• The insured follows all policy requirements
• The insured provides proof of loss
• All conditions in the policy are met
For example, the timely payment of premiums is a condition for keeping the contract in force. If premiums are not
paid, the company is relieved of its obligation to pay a benefit. The requirement to notify the insurer of a loss is
another necessary condition, as is the insured’s need to provide “proof of loss.” An insurer will not pay the
benefits if the insured doesn’t notify the company of the loss or cannot prove that the loss occurred.
[3.5] PERSONAL CONTRACT
Most forms of insurance are personal contracts. In other words, there are personal agreements between the
insurer and the insured. By referring to an insurance policy as a personal contract, it’s understood that a policy
insures the owner (person) of the property, and not the property itself. As such, most types of insurance cannot
be transferred to another person.
For example, an individual typically carries auto insurance on their car and homeowners or renters insurance on
their home. The coverage is specific to the individual. When they sell their house or car, they cannot transfer
those insurance policies to the new owner.
Life insurance is an exception to this rule. Life insurance policies are NOT personal contracts because they allow
ownership to be transferred through assignments. For this reason, people who buy life insurance policies are
typically referred to as policy owners rather than policyholders. If a policy owner wants to assign a life insurance
policy, they simply notify the insurer in writing. The company will accept the transfer's validity without question,
and the new policy owner will be granted all the rights of policy ownership. Therefore, life insurance contracts are
NOT personal contracts.
[3.7] VALUED CONTRACTS OR INDEMNITY CONTRACTS CHART
Life and health insurance policies fall into two categories: valued contracts or indemnity contracts. Valued
contracts assign a value to certain losses independent of specific losses, while indemnity contracts replace
identified economic losses.
[3.7.1] VALUED CONTRACTS
A valued contract pays a stated sum regardless of the actual loss incurred. Life insurance contracts are valued
contracts. There’s no attempt to calculate a death benefit at the time of death; instead, the parties established
the death benefit when the policy was first issued. Accidental death and dismemberment policies, which are a
form of health insurance, also fall into this category.
For example, if an individual acquires a life insurance policy to insure their life for $500,000, that’s the amount
payable at death.
[3.7.2] INDEMNITY CONTRACTS
An indemnity contract pays an amount equal to a loss. An indemnity contract has one simple goal: to return you
to the same financial position you had before the loss occurred. For example, if your car sustains $5,000 in
damage, an indemnity contract pays you $5,000 for repairs. Some contracts of indemnity are reimbursement
policies. These contracts reimburse the insured for the exact amount of covered costs minus any required cost-
sharing amounts, such as policy deductibles.
For example, let us assume that a type of reimbursement plan covers an individual with a maximum hospital
benefit of $500,000. If the insured is hospitalized due to an illness and the bill is $25,000, the policy will pay or
reimburse the insured or the hospital for the amount of the expenses incurred (i.e., $25,000).
Other indemnity contracts define their benefits as a fixed amount per day, week, or month to offset a loss of
revenue, as in a disability policy.
For example, an individual earns $600 per week and has a disability insurance policy that pays $400 per week. If
the individual becomes disabled, the policy will pay the stated benefits, which will replace two-thirds of
the income lost during the disability. Although the policy doesn’t reimburse the insured for specific expenses, it
does restore their income to the extent defined in the policy.
Exam Tip!
Remember: Valued contracts pay a predetermined amount (like a $500,000 life insurance policy), while
indemnity contracts pay based on actual loss (like a $25,000 hospital bill). Life insurance is ALWAYS a valued
contract – you can't calculate the "actual loss" of a life.
[3.8] INSURABLE INTEREST
Among all the special features we have discussed, the concept of insurable interest stands out as particularly
crucial. It serves as the cornerstone that distinguishes legitimate insurance contracts from mere wagers.
Understanding insurable interest is essential because it determines who can purchase insurance and what or
whom can be insured. As such, it directly affects the validity of insurance contracts.
The simple rule is this: "You can only insure what you could lose money on." You CAN insure those things that
would cost you money if they were damaged or lost, such as the following:
• Your own stuff, including your house, car, or phone
• Your own life, because your family depends on your income
• Your spouse’s life, because you depend on his or her contributions to the family (income, childcare, or
homemaker responsibilities)
• Your dependent children, because you are responsible, should something happen to them
• Your business, including your building, inventory, or key employees
You CANNOT insure Things that don't affect you financially, such as the following:
• Your neighbor’s house, because you don’t lose money if it burns down
• Your mail carrier’s life, because there is no meaningful impact on you
• A stranger's life, because you do not depend on their income or contributions
• A car you do not own, because it is not your financial loss if it is damaged
Time matters.
• For life insurance, you only need an insurable interest when you buy the policy.
• For property insurance, you need an insurable interest both when you buy the policy AND when you file a
claim

[3.8] INSURABLE INTEREST (CONTINUED)

Ask yourself: "Would I lose money if this were damaged or lost?"
• If YES = You probably have insurable interest
• If NO = You probably do not have an insurable interest
Any person who purchases life insurance on their own life possesses an unrestricted or unlimited insurable
interest in themself. Insurable interest also exists automatically in marital relationships, between parents and
children, in a business situation between a business and a key employee, or in a debtor-creditor relationship.
For example, it is assumed that spouses have an insurable interest in each other’s lives, as there are financial and
emotional benefits to the continuation of each life. An individual even possesses an insurable interest in a
nephew or niece if either lived in the individual’s household or was their guardian. A person does not have an
insurable interest in the life of their mail carrier since there’s no expectation of benefiting from the mail carrier’s
continued life.
For a person other than the insured to be the policy owner, they must have an insurable interest in the insured.
Life insurance contracts originated without an insurable interest are known as stranger-originated life insurance
(STOLI). They are formed without a legal purpose and are therefore not enforceable.
It’s important to note that, for a life or health insurance contract, insurable interest is only required at the time of
the application. Insurable interest doesn’t need to continue throughout the duration of the policy, and it does not
need to exist at the time of the claim.
For example, two individuals are married and take out an insurance policy on each other’s lives. There’s no issue
if the individuals later get divorced, but keep the life insurance policies they own on each other. Although
insurable interest no longer exists, the policies remain valid because insurable interest existed when the policies
were bought. However, they would no longer be able to purchase additional insurance on the other’s life since
insurable interest no longer exists.
For property and casualty insurance, an insured must prove that they have a legitimate interest in preserving the
property they seek to insure when the insurance is purchased and when a loss occurs.
For example, Bob owns the house next door to Tiffany, who also owns her house. Bob can purchase a
homeowners policy on his home, and Tiffany can buy a homeowners policy on her house. However, they’re not
allowed to purchase homeowners insurance on each other’s property because each has only an insurable
interest in their own home.
[4] NEGOTIATING AND ISSUING INSURANCE POLICIES
To reiterate, an insurance policy is a written contract in which one party promises to compensate another
against loss from an unknown event. Therefore, an insurance policy is also referred to as an insurance
contract. The term can refer to the overall agreement between the insurer and the insured, as well as to a basic
policy form without any optional provisions. A policy rider or endorsement is a legal attachment that amends a
policy. The rider often incorporates additional benefits into a policy. Some riders limit policy benefits to allow
coverage for high-risk situations. An insurance policy (contract) will include the policy form, any riders or
endorsements, and a copy of the completed application. Therefore, the application is a part of the insurance
contract.

[4.1] UTMOST GOOD FAITH

Insurance is a contract of utmost good faith, meaning both the policyholder and the insurer must know all
material facts and relevant information. There can be no attempt by either party to conceal, disguise, or deceive.
A consumer purchases a policy mainly based on the insurer’s or agent’s explanation of the policy’s features,
benefits, and advantages, as well as the “faith” that the company will be able to pay the claim in the event of a
loss. Insurance applicants must make a full, fair, and honest disclosure of the risk to the agent and insurer.
The insurer issues the policies on the “faith” that the applicant was truthful. Concepts related to utmost good
faith include warranties, representations, and concealment. These represent grounds through which an insurer
may seek to avoid payment under a contract.
[4.2] WARRANTIES AND REPRESENTATIONS IN COMPARISON
[4.2.1] WARRANTY
A warranty is a statement guaranteed to be true. It becomes part of the insurance contract. If the statement isn't
true, the insurance company can cancel the whole contract. Warranties are presumed to be material because
they affect the insurer’s decision to accept or reject an applicant. A warranty can be expressed or implied and
may relate to the past, present, future, or any combination. Generally, applicant statements that are treated as
warranties appear in some lines of property and casualty coverage rather than life and health insurance
applications.
[4.2.2] REPRESENTATION
A representation is a statement made by the applicant and considered to be true and accurate to the best of the
applicant’s belief. The insurer uses the representation to evaluate whether to issue a policy. Unlike warranties,
representations are not a part of a contract and need to be true only to the extent that they’re material and
related to the risk. Statements made by applicants for insurance are representations and not warranties. A
representation cannot qualify as an express provision in a contract of insurance, but it may qualify as an implied
warranty. A false statement made by an applicant that would influence an insurer in determining whether to
accept the risk is considered a material misrepresentation.
Exam Tip!
Questions often present a scenario and ask whether a policy is automatically void (warranty) or potentially
voidable (representation). Focus on whether the statement must be exactly true throughout the policy period
(warranty) or merely substantially true when made (representation).
[4.3] CONCEALMENT
Concealment is defined as the failure or neglect by the applicant to disclose a known, material fact when
applying for insurance. If the purpose of concealment is to defraud the insurer (i.e., obtain a policy that may not
otherwise be issued if the information were revealed), the insurer may have grounds for voiding the policy.
Regardless of whether concealment is intentional, the injured party has the right to rescind the insurance
contract. Rescission means that the contract is made null and void.
Let's compare two scenarios:
• Material misrepresentation: Sarah applies for life insurance and states she has never had cancer, when in
fact she had breast cancer five years ago. This false statement influences the insurer's decision to issue
the policy.
• Concealment: John applies for life insurance and doesn't mention his recent heart attack diagnosis when
asked about his medical history. He knew about the condition but chose not to disclose it.
The insurer must prove concealment and materiality. Materiality means that the insurer would not have issued
the same policy with the exact same terms had the insurer known the concealed facts at the time of application.
In most cases, insurers have only a limited period to uncover misrepresentations or concealment. After that
period passes (normally two or three years from policy issue, depending on state law), the contract cannot be
voided or revoked for these reasons.
For example, if an applicant uses online quote comparison tools and intentionally omits information about
previous claims when entering their information, or uses website autofill features without correcting outdated
information about their driving record, this constitutes concealment.
[5] VOID CONTRACTS VS. VOIDABLE CONTRACTS
The terms void and voidable are often incorrectly used interchangeably. In one case, a valid contract may be
terminated; in the other, it may never be in force.
[5.1] VOID CONTRACT
A void contract is simply an agreement without legal effect. It’s not a contract at all because it lacks one of the
elements specified by law for a valid contract. Neither party can enforce the terms of a void contract.
For example, a contract with an illegal purpose is void, and neither party to the contract can enforce it.
An insurer may void an insurance policy if a misrepresentation on the application is proven to be material.

[5.2] VOIDABLE CONTRACT

A voidable contract is an agreement that may be set aside by one party to the contract for reasons that are
satisfactory to the court. It’s binding unless the party with the right to reject it chooses to do so.
Consider the following two cases that distinguish between “void” and “voidable” contracts:
 • Void contract: Tom, age 16, purchases a life insurance policy without parental consent. The contract is
void from the outset because Tom lacks the legal capacity to enter into it.
• Voidable contract: Lisa's health insurance policy is voidable because she stopped paying premiums after
three months. The contract was valid but can be terminated by the insurer.
[6] CANCELLATION AND FRAUD
[6.1] CANCELLATION
The voluntary act of terminating an insurance contract is referred to as cancellation. The policy owner may
voluntarily cancel an insurance contract for any reason at any time. A policy will lapse if the premiums are not
paid before the end of the grace period. As with other financial commitments, insurance policies have a due date
on which the required premium is paid, but also a grace period (after the due date) during which the payment
may be made without penalty.
[6.2] FRAUD
Fraud involves deliberate or intentional deceit with the objective of making false statements to be compensated
by an insurance contract (e.g., filing a false claim). Contracts may be rescinded if any party engages in fraudulent
conduct. Under most types of contracts (other than life and health insurance), fraud is grounds for voiding a
contract. In insurance contracts, an insurer may have only a limited time to challenge the validity of a contract.
In most states, insurers cannot void a life insurance contract after it has been in force for two years. Guaranteed
renewable health insurance policies typically allow two or three years, depending on state law. After this period
of two or three years, life and health insurers cannot contest the policy or deny benefits based on application
errors resulting in material misrepresentations or concealment. The ability of insurers to void other health
insurance policies due to fraud is not necessarily limited. This will be examined later in this course.
[7] WAIVER, PAROLE EVIDENCE RULE, AND ESTOPPEL
[7.1] WAIVER
A waiver is the voluntary surrendering (giving up) of a known right. A waiver is also defined as “the deliberate,
voluntary, or intentional abandonment of a known right by the insurer.” It usually involves the conduct of an
insurer or its sales representative, which intentionally relinquishes a defense against a claim. If an insurer fails to
enforce (waives) a contract provision, it cannot later deny a claim based on a violation of that provision.
For example, let’s assume that a life insurer issues a policy that states it is void if the insured enters the military.
The insured joins the army and is killed during a battle. A company officer informs the insured’s beneficiary that,
since the insured died in defense of their country, the insurance company will waive its defense of military
service death. Later, the insurer denies the claim. However, the company will need to pay the claim since the
company officer’s communication (written or verbal) constitutes a waiver and prevents the insurer from denying
the claim.
Another example of a waiver could involve an insurer that mistakenly accepts an incomplete application and
issues a policy. Later, the insurer attempts to rescind the policy or deny a claim because the application was
incomplete. In this case, the insurer will be prevented from doing so since it has engaged in a waiver. The
company’s mistake prevents it from denying the claim or attempting to take back or rescind the policy. A waiver
can also occur if an insurer fails to enforce a provision in the policy. After an insurer issues a policy, if it discovers
that an individual lied about their health, and the insurer doesn’t inform them within a reasonable time that the
contract will be void or rescinded, it has engaged in a “waiver by silence.”
[7.2] PAROLE EVIDENCE RULE
"Parole" in this context means "verbal" or "spoken" – it has nothing to do with the criminal justice system. The
parole evidence rule states that only the written terms of an insurance contract are legally binding. This means:
• Verbal statements or promises made before the contract was signed cannot override what's written in
the policy
• Conversations between the agent and client about coverage cannot change the actual policy terms
• If there's a dispute, the court will only consider what's written in the policy
• Any changes to the policy must be made in writing through proper endorsements
Think of the insurance policy as the "final word" on what is and isn't covered. Even if an agent or company
representative made promises or statements about coverage before the policy was issued, these verbal
statements cannot change or override what the actual policy says.
Here's how the parole evidence rule works in practice:
• An agent verbally tells a client during the sales meeting that their homeowners policy covers all water
damage
• The written policy clearly states it excludes flood damage
• The client's home is later damaged by a flood
• The client tries to claim coverage based on the agent's verbal statement
• The parole evidence rule means:
o The written policy terms prevail
o The verbal promise cannot override the written exclusion
o The client cannot use the agent's verbal statement as evidence in court
This demonstrates why it's critical for both agents and clients to:
• Read the written policy carefully
• Not relying on verbal explanations that differ from policy language
• Get any policy modifications in writing through endorsements
7.3] ESTOPPEL
Estoppel is a legal principle that protects consumers when they rely on incorrect information from an insurance
agent. In simple terms, if an agent tells a client something about their coverage and the client acts on that
information, the insurance company must honor what the agent said – even if it differs from the actual policy
language.
For estoppel to apply, four conditions must ALL be met:
• The Agent's Statement
o An insurance agent makes an incorrect statement about coverage
o The agent must be acting within their authority when making the statement
• The Client's Action
o The client believes the agent's statement
o The client takes some action based on what the agent said
Example: A client changes their coverage because the agent states certain items will now be covered
• The Company's Denial
o A claim situation occurs that relates to the agent's incorrect statement
o The insurance company tries to deny the claim based on the actual policy language
o The company refuses to honor what their agent told the client
• Financial Impact
o The client loses money because they relied on what the agent said
o The denial of coverage causes financial harm to the client
If all these conditions are met, the law prevents (estops) the insurance company from denying the claim. The
company must honor what its agent told the client, even if it differs from the written policy.
Remember: An agent represents the insurance company, so the company is responsible for what its agents tell
clients.
Exam Tip!
Questions about estoppel often test whether all four conditions are present in a given scenario. Make sure all
four conditions are met before concluding that estoppel applies.
[7.4] PAROLE EVIDENCE RULE, AND ESTOPPEL – TYING IT ALL TOGETHER
Consider the following scenario:
• An agent emails a client stating their auto policy covers business use
• The client starts using their car for food delivery based on this email
• The client has an accident while delivering food
 • The written policy actually excludes business use
• Due to estoppel, the insurer must honor the agent's email representation because:
o The agent made the representation
o The client relied on it
o The client suffered financial harm
o The representation was within the agent's apparent authority
If all four conditions are present, the insurer is estopped (prevented) from denying the claim and is legally bound
to honor the promise rather than abide by the written contract.
The concepts of the parole evidence rule and estoppel are similar, but distinct in important ways. The primary
distinction between the parole evidence rule and estoppel can be summarized by TIMING and PURPOSE
[7.4.1] PAROLE EVIDENCE RULE - TIMING: BEFORE or DURING CONTRACT FORMATION
The parole evidence rule deals with statements/promises made before the policy is issued. It protects the
written contract from being modified by prior verbal agreements. For example:
1. The agent promises coverage during the sales process.
2. The written policy says otherwise.
3. The written policy wins.
Verbal promises before policy issuance cannot override written terms.
[7.4.2] ESTOPPEL - TIMING: AFTER THE CONTRACT IS IN FORCE
Estoppel concerns representations made after the policy is in effect. This doctrine protects the insured from
harmful reliance on post-contract representations. For example:
1. The agent tells an existing policyholder that something is covered.
2. The policyholder takes action based on the agent's statement.
3. A loss occurs.
The insurer must honor the agent's representation if all the following elements are present: representation,
reliance, harm, and authority.
Exam Tip!
Here is a simple memory aid to remember the difference between the parole evidence rule and estoppel:
• Parole evidence = PAST (before policy)
• Estoppel = EXISTING policy (after policy is in force)
8] THE LAW OF AGENCY
While understanding who can purchase insurance is crucial, equally important is understanding how insurance is
sold. This brings us to the law of agency, which governs the relationship between insurance companies and the
professionals who represent them. The insurance industry relies on a complex network of relationships between
companies, agents, brokers, and clients. Let's examine how these relationships work and the legal principles that
govern them.
As noted earlier, an insurance agent is authorized to sell, solicit, negotiate, and effect contracts of insurance on
behalf of an insurer through a contractual arrangement. An agent’s role involves the following duties:
• Describing the company’s insurance policies to prospective buyers
• Soliciting applications for insurance
• Collecting premiums from policy owners
• Rendering service to prospects and currently insured consumers
Insurers grant agents the authority to undertake these functions in their contract of agency with the company.
This agreement may also be referred to as an agent appointment or agency agreement. This contract clearly
defines the scope of an agent’s authority to act for an insurer. When acting within the scope of the authority
granted, an agent is considered to be the insurance company. The relationship between an agent and the
company being represented is governed by agency law.
[8.1] PRINCIPLES OF AGENCY LAW
By legal definition, an agent is a person or entity that acts on behalf of another person (i.e., the principal). For
insurance purposes, the insurer is referred to as the principal. The agent represents the principal in dealings with
third parties that concern contractual arrangements. Authorized agents can create binding contracts for the
principal. These contracts include both rights and responsibilities. From this description, the four essential
principles of agency law can be identified:
• The acts of an agent (within the scope of their authority) are the acts of the principal.
• A contract completed by an agent on behalf of the principal is a contract of the principal.
• Payments received by an agent on behalf of the principal are payments made to the principal.
• An agent’s knowledge regarding a business matter of concern to the principal is presumed to be known by
the principal.
[8.2] AGENT AUTHORITY
The scope of agent authority is another important concept of agency law. “Authority” is what an insurer grants a
licensee for this person to transact insurance on its behalf. Technically, only authorized actions can bind a
principal. In reality, an agent’s authority can be quite broad.
There are three types of agent authority: express, implied, and apparent. When agents act with authority, the
company becomes legally responsible for their actions. Under the law, the agent and the company are treated as
identical when the agent acts within the scope of their authority. This is why it’s important for the insurance
company to clearly define the authority it grants its agents, because the company might have to pay for the
agent's mistakes.
Now, let’s take a closer look at each of the three types of agent authority.
[8.2.1] EXPRESS AUTHORITY
Express authority is the authority a principal deliberately gives to its agent. This authority is granted by means of
the agent’s contract, which is the principal’s appointment of the agent to act on its behalf. Express authority
refers to those activities that are expressly stated in writing under the terms of the agent’s contract.
For example, an agent has the express authority to solicit applications for insurance on behalf of the company,
whether through face-to-face meetings, video consultations, or by helping clients navigate the company's digital
application platforms. This includes the authority to send secure electronic documents for e-signature and
process digital payments.
[8.2.2] IMPLIED AUTHORITY
Implied authority is the unwritten authority not expressly granted in writing; instead, it’s the authority that an
agent is assumed to have to transact the principal’s business. Implied authority is incidental to express authority
because not every single detail of an agent’s authority can be spelled out in the agent’s contract.
For example, an agent’s contract may not explicitly state that they can print business cards containing the
company’s name, but the authority to do so is implied.
[8.2.3] APPARENT AUTHORITY
Apparent authority is the appearance of authority based on the actions, words, or deeds of the principal.
Consumers assume the agent has certain types of authority based on the appearances or circumstances that
the principal has created – regardless of whether such authority exists.
For example, if an insurer provides an individual with access to its agent portal, digital quoting tools, and an
official company email address, the insurer has created the impression that an agency relationship exists
between itself and the individual. The law will not allow the company to later deny that such a relationship
existed, even if no signed agency agreement is in force.
Please note that apparent authority relies on a company's actions. If the agent stole the items described in the
above example, it would constitute fraud, since the company neither provided the material nor failed to reclaim
it.
Exam Tip!
Licensing exams frequently present scenarios asking you to identify which type of authority is being
demonstrated.
• Express = specifically written in the contract
• Implied = necessary to do the job
 • Apparent = would customers assume that an agent could do something? Most agent mistakes that lead
to company liability fall under apparent authority!
[8.2.4] AGENT AUTHORITY – TYING IT ALL TOGETHER
Consider Agent Maria:
• Express Authority: Her contract explicitly states she can sell auto insurance policies
• Implied Authority: She orders office supplies with the company credit card (not explicitly stated but
necessary for business)
• Apparent Authority: She has a company email address and business cards stating she is a licensed
agent, leading clients to reasonably believe she can bind coverage
This scenario shows how all three types of authority can exist simultaneously for a single agent.
[9] BROKERS, AGENTS, SOLICITORS, AND FIDUCIARIES
[9.1] BROKERS VERSUS AGENTS
As described previously, insurance producers may be agents or brokers. Although an agent has an agent’s
contract, and a broker has a broker’s contract, the same Law of Agency governs both parties. The most
significant difference between the two types of contracts is that, in a sales transaction, agents represent the
insurer, while brokers represent the buyer (or applicant). A broker solicits and accepts insurance applications
and then places the coverage with an insurer. A broker cannot bind coverage. However, an agent’s contract and
appointment with one or more insurance companies grants that agent the authority to bind an insurer to an
insurance contract. A broker must work with an agent or company representative who can bind an insurer.
[9.2] AGENT VERSUS SOLICITOR AUTHORITY
An insurance producer who’s working as an agent has the authority to seek out applicants, present product
solutions to meet insurance needs, complete applications, and bind coverage. Some states also allow for
licensed solicitors. Solicitors have the authority to seek out insurance applicants for a company, but don’t have
any authority to bind coverage on behalf of a company. Solicitors arrange for prospective clients to meet with
agents who can sell and bind insurance coverage that meets the clients’ needs.
[9.3] AGENT AS A FIDUCIARY
A fiduciary is someone who must put their client's interests first. Insurance agents are fiduciaries because they
handle money and make decisions that affect their clients' financial security. A fiduciary is a person who holds a
position of financial trust and confidence. Agents act in a fiduciary capacity when they accept premiums on
behalf of the insurer or offer advice that affects a person’s financial security.
[10] OTHER LEGAL CONCEPTS RELATED TO INSURANCE
While the previous sections covered the fundamental principles of insurance contracts and agency
relationships, there are several other important legal concepts that insurance professionals must understand.
These concepts affect how insurance claims are handled, how disputes are resolved, and how insurance
professionals protect themselves from liability.
In this section, we will examine:
• Subrogation and how insurance companies recover claim payments from responsible parties
• Tort law and its impact on insurance claims and liability
• Professional liability coverage (E&O insurance) for insurance agents
Understanding these concepts is crucial because they:
• Affect how claims are processed and settled
• Influence how insurance companies manage risk and recover losses
• Impact how insurance professionals protect themselves from liability
Are frequently tested on insurance licensing exams
[10.1] SUBROGATION
Subrogation means 'stepping into someone else's shoes.' When an insurance company pays your claim, they
gain the right to recover that money from whoever caused the loss. In most subrogation cases, an individual’s
insurance company pays its client’s claim for losses directly, then seeks reimbursement from the other party’s
insurance company.
For example,
1.
1.
1. Your car is damaged by another driver.
2. Your insurance company pays you $5,000 for repairs.
3. Your insurer then pursues the at-fault driver's insurance company to recover the $5,000.
This is subrogation – your insurer "steps into your shoes" to recover its payment.
[10.2] TORT LAW
While contract law governs the insurance agreement itself, insurance professionals must also understand
another crucial area of law: tort law. Many insurance claims arise from torts (civil wrongs), and understanding
tort law is essential for properly evaluating and handling these claims. Moreover, insurance professionals
themselves can be subject to tort claims if they fail to meet their professional obligations.
Tort law involves private wrongs that are independent of contracts. By definition, a tort is a private wrong that
occurs when one individual wrongs another by failing to act in a reasonable or prudent manner. Tort law is
different from criminal law because people commit crimes against society, even if the victim is an individual.
Criminal courts have jurisdiction over crimes, while civil courts preside over torts.
Lawsuits involving contracts fall under contract law; most civil court claims, however, fall under tort law. Tort law
helps people get money when someone else's actions harm them. It fixes wrongs by making the person who
caused harm pay the person who was harmed.
Negligent acts that result in loss or damage may give rise to a tort. There are several types of negligence,
including:
• Simple negligence is a failure to act (or not act) in a reasonable or prudent manner
• Gross negligence results from a reckless disregard for the need to act in a reasonable manner,
regardless of the potential for harm
• Willful and wanton negligence occurs when a person recklessly disregards reasonable care standards
and is aware that bodily injury or property damage will probably occur. This borders on being an
intentional act, which liability insurance doesn’t cover.
An example of each type is as follows:
•
o Simple negligence: The agent forgets to submit a client's application
o Gross negligence: The agent consistently fails to maintain proper client records
o Willful and wanton negligence: The agent knowingly processes a fraudulent claim
[10.3] INSURANCE AGENT ERRORS AND OMISSIONS PROFESSIONAL LIABILITY INSURANCE
Given the complex legal responsibilities we've discussed and the potential for professional liability under tort
law, insurance professionals need their own protection. This is where errors and omissions (E&O) insurance
comes in. Just as insurance professionals help their clients manage risk, E&O insurance helps professionals
manage their own liability risks.
E&O insurance helps protect insurance agents when they make mistakes. It pays for:
• Legal costs if someone sues the agent
• Money to fix problems caused by the agent's mistakes
For example, an agent forgets to add flood coverage to your home policy after you request it. A flood damages
your house. E&O insurance helps to pay for the agent's mistakes.
The coverage available includes liability protection that will pay for defense costs and damages awarded to an
injured party if the insurance professional is negligent in the performance of professional services.
[10.3.1] TYPICAL LOSSES COVERED
A professional is obligated to deliver a level of service that meets industry standards. In some cases, an
insurance producer can make a mistake or fail to do something they were supposed to do. Typical losses covered
under an E&O policy include:
• Not putting into effect insurance coverage when requested
 • Mistakes in processing electronic signatures or digital authorizations
• Creating an administrative error
• Premium calculation errors
• Misstating insurance coverages
• Not putting into effect a policy change as requested by the customer
• Not properly explaining policy provisions
• Incorrect identification of client loss exposures
• Forwarding inaccurate or incomplete information about a client to a carrier
• Failing to recommend coverage
• Improperly handling a claim
[10.3.2] TYPICAL E&O EXCLUSIONS
Intentionally harming another person is always excluded from any liability insurance policy. This exclusion
includes:
• Criminal acts
• Illegal acts
• Dishonest acts
• Malicious acts
• Libel and slander
• Intentional violation of any law, regulation, statute, or ordinance
[11] CHAPTER SUMMARY
In this chapter, we've explored the essential legal concepts that form the foundation of insurance practice. We
began with the four fundamental elements of any valid insurance contract – Competent parties, Legal purpose,
Offer and acceptance, and Consideration (CLOC). These elements ensure that insurance contracts are legally
binding and enforceable.
We examined what makes insurance contracts unique, including their status as aleatory contracts (in which
benefits depend on uncertain events) and contracts of adhesion (written by one party). We learned how valued
contracts differ from indemnity contracts, with life insurance being a prime example of a valued contract that
pays a predetermined amount.
The concept of insurable interest proved crucial in understanding who can purchase insurance on whom or what.
We saw how this requirement differs between life/health insurance (needed only at policy issue) and
property/casualty insurance (required at both policy issue and time of loss).
We clarified important distinctions between warranties (statements guaranteed to be true), representations
(statements believed to be true), and concealment (failure to disclose material facts). We also explored how
agent authority – whether express, implied, or apparent – affects insurance transactions.
Finally, we covered tort law and the importance of E&O insurance, understanding how these concepts protect
both insurance professionals and their clients.
Remember, these legal concepts aren't just theoretical requirements – they're practical tools that help you serve
clients effectively while staying within legal and ethical boundaries. As you move forward in your insurance
career, these principles will guide your daily decisions and help you protect both your clients and yourself.
[11.2] REVIEW NOTES
Learning Objective 1: Identify and explain the four essential elements of a valid insurance contract (CLOC)
Key Concepts:
• All insurance contracts must have four essential elements to be valid
• Use mnemonic "CLOC" to remember elements
• Missing any element makes a contract void from the beginning
Essential Elements:
• Competent Parties
o Both insurer and applicant must have legal capacity
o The insurer must be licensed in the state
 o Incompetent parties include minors, mentally incompetent persons, and intoxicated persons
• Legal Purpose
o Contract must serve a lawful purpose
o Must align with public policy
o Insurance contracts inherently have a legal purpose
• Offer and Acceptance
o Offer: Application plus premium payment
o An application without a premium is just an invitation
o Acceptance shown by policy issuance or delivery
• Consideration
o Applicant: Premiums + truthful statements
o Insurer: Promise to pay claims
o Must be perpetual (ongoing premium payments)
Learning Objective 2: Describe key features that make insurance contracts unique, including valued vs.
indemnity contracts
Special Features:
• Aleatory Contract
o Unequal exchange possible
o Benefits based on an uncertain event
o Example: Pay $1,200/year for $500,000 coverage
• • Contract of adhesion
o Written by the insurer only
o Take-it-or-leave-it basis
o Ambiguities favor the insured
• Unilateral Contract
o Only insurer makes enforceable promise
o Policyholders don’t promise to pay premiums
o The insurer can cancel if premiums are unpaid
• Personal Contract
o Between the insurer and a specific person
o Cannot be transferred to another person
o Exception: Life insurance allows assignment
• Conditional Contract
o Benefits depend on specific conditions
o Example: Premium payment, proof of loss
Valued vs. Indemnity:
• Valued Contracts
o Pay a predetermined amount
o Used in life insurance
o Death benefit fixed at policy issue
• Indemnity Contracts
o Pay based on actual loss
o Used in property/health insurance
o Restore to pre-loss position
Learning Objective 3: Explain the concept of insurable interest and when it must exist for different types of
insurance
Key Concepts:
• Insurable interest means financial/economic interest in the subject of insurance
• Must suffer financial loss if the insured person/property is damaged
 • Timing requirements differ by insurance type
Life/Health Insurance:
• Required only at the time of application
• Automatically exists for:
o Self
o Spouse
o Parent-child relationships
o Business-key employee
o Debtor-creditor relationships
• Does not need to continue after the policy is issued
o Example: Divorced couples can keep existing policies
Property/Casualty Insurance:
• Required at both the time of application and the time of loss
• Must have a financial interest in the property
• Cannot insure neighbor's property
• Ends when ownership transfers
Important Points:
• Stranger-originated life insurance (STOLI) is illegal
• Cannot have an insurable interest in a mail carrier
• Business partners have an insurable interest in each other
• Amount of coverage must align with financial interest
Learning Objective 4: Compare and contrast the roles and authorities of insurance representatives
Types of Authority:
• Express Authority
o Specifically written in the agent's contract
o Clearly stated powers
o Example: Authority to collect premiums
• Implied Authority
o Necessary to do the job
o Not explicitly stated
o Example: Ordering business cards
• Apparent Authority
o Created by the company's actions
o What the public reasonably believes
o Example: Agent using company email
Representative Types:
• Agents
o Represent insurer
o Can bind coverage
o Have fiduciary responsibility
• Brokers
o Represent client
o Cannot bind coverage
o Must work with an agent/company
• Solicitors
o Can only seek applicants
o Cannot bind coverage
o Limited authority
Learning Objective 5: Distinguish between key legal principles that affect insurance contracts and claims
Void vs. Voidable:
• Void Contracts
o Never legally in force
o Missing essential element
o Cannot be enforced by either party
o Example: Contract with a minor
• Voidable Contracts
o Valid but can be terminated
o One party can reject
o Example: Any policy when premiums are unpaid
Waiver vs. Estoppel:
• Waiver
o Voluntary giving up of a known right
o Intentionally done by the insurer
o Example: Accepting a late premium
• Estoppel
o Based on reliance on statements
o Requires all four conditions:
▪ The agent makes a statement
▪ The client believes the statement
▪ The clientacts on the statement
▪ The client suffers financial harm
Other Key Principles:
• Warranties
o Statements guaranteed true
o Part of the contract
o Material to risk
• Representations
o Statements believed true
o Not part of the contract
o Must be material to void policy
• Concealment
o Failure to disclose material facts
o Can void policy
o Must be proven by the insurer
• Subrogation
o Insurer's right to recover from the party responsible for a loss
o Applies after a claimis paid
o Common in property, health and accident, and Workers’ Compensation insurance
Learning Objective 6: Explain basic tort law concepts and the purpose of E&O insurance
Tort Law Basics:
• Definition: Private wrongs independent of contracts
• Different from criminal law
• Handled in civil courts
• Purpose: Provide compensation for harm
Types of Negligence:
• Simple Negligence
o Failure to act reasonably
o Example: Forgetting to submit an application
 • Gross Negligence
o Reckless disregard
o Example: Never maintaining records
• Willful and Wanton
o Knowing harm will occur
o Not covered by insurance
E&O Insurance:
• Purpose
o Protects against professional liability
o Covers defense costs
o Pays damages if negligent
• Typical Covered Losses
o Administrative errors
o Premium calculation mistakes
o Coverage misstatements
o Failure to recommend coverage
• Common Exclusions
o Criminal acts
o Intentional harm
o Dishonest acts
o Illegal activities
Common Exam Focus Areas
Key Distinctions
• Void vs. voidable contracts
• Agent vs. broker roles
• Warranties vs. representations
• Waiver vs. estoppel
Critical Timing Requirements
• When insurable interest must exist
• When warranties must be true
• When representations must be true
• Contestability periods
Remember
• All CLOC elements required
• Life insurance is always valued contract
• Ambiguities favor the insured
• E&O excludes intentional acts
Exam Tips
Watch for scenarios testing:
• Type of agent authority
• All four estoppel conditions
• Void vs. voidable situations
• Insurable interest timing
Key terms must be precise
• Use exact legal terminology
• Don't confuse similar concepts
• Know exceptions to rules
• Understand practical applications
Chapter 4
[1.3] KEYWORDS
Prior to reading this chapter, please review the following keywords. An understanding of their basic definitions
will improve your comprehension of the chapter content.
Accidental Death Benefit (ADB): A type of policy that provides benefits in the event of accidental death; the
accidental loss of sight, speech, or hearing; loss of use of limbs (i.e., paralysis); or loss of a member(s), such as
the loss of an arm or a leg.
Adjustable Life Insurance: A permanent life policy offering the policyowner flexibility in premium payment
amounts and an adjustable death benefit. Unlike Universal Life, the cash value grows at a guaranteed fixed rate.
Attained Age: The age that an insured has attained as of a given date. For life insurance purposes, the age is
based on either the nearest birthday or the last birthday, depending on the practices of the insurance company
involved. Attained age is also referred to as “current age.”
Cash Surrender Value: The amount available in cash upon the surrender of a policy by the owner before or after
the policy matures.
Convertible Term Life Insurance: Temporary life insurance allowing the policy owner to convert the term policy
for a permanent whole life policy offered by the insurance company without evidence of insurability.
Decreasing Term Insurance: A type of temporary protection characterized by a reducing face amount each year,
often used in conjunction with a debt or loan.
Endowment Contract: A contract that pays a face amount after a fixed period (10, 20 years, or at age 65), or
upon the insured's death if it occurs before the end of the period.
Extended Term Insurance: A nonforfeiture option available when a policy is surrendered, continuing the same
face amount of the policy in force for a specified period.
Family Income Policy: A policy that combines a whole life policy with a decreasing term rider to provide a death
benefit and monthly income payments to the beneficiary.
Joint Life Insurance: A policy that covers the lives of two or more persons, paying a death benefit and ending
when the first insured dies.
Universal Life Insurance: The most flexible life insurance policy with flexible premiums and adjustable death
benefits. The accumulation account grows at a guaranteed rate, but the insurer often credits a higher rate.
[2] GENERAL CONCEPTS OF LIFE INSURANCE
Life insurance involves the transfer of the risk of death from one party (i.e., the policy owner/insured) to another
party (i.e., the insurer). When a life insurance contract is payable upon the death of the insured, it instantly
creates funds for a named beneficiary. In other words, a life insurance contract creates an immediate estate.
Unlike other lines of insurance (e.g., property and casualty), there are no “standard life insurance policies.”
Today’s life insurance policies are typically defined by the benefit options available, the intended length of
coverage, and how the policy benefits will be paid for or funded. Broadly speaking, all life insurance policies fall
into the following categories:
• Permanent (whole life or ordinary) or temporary (term life)
• Group or individual
• Fixed or variable
• Industrial, burial, or debt insurance
A life insurance company may choose to specialize in any of these types, or in just one or two. These basic
coverage types are distinguished by customer type, amount of insurance written, underwriting standards, and
marketing practices. Group life insurance will be described later in the course.
[2.1] TERM LIFE INSURANCE, PERMANENT LIFE, AND THE RISK OF DYING
Everyone dies, but the age at which we die remains uncertain; therefore, we need life insurance. We do know
that, statistically, we are more likely to die when we are older. Insurance companies also know the risk of death in
any given time increases each year as we age, and price their policies accordingly. The older we get, the more we
pay for life insurance.
[2.1.1] TERM LIFE INSURANCE
Term insurance premiums cover the risk of death for a limited period, which may be as short as one year. Term
policies that last more than one year charge a fixed, average premium rate. For the first few years, this average
premium rate is more than the actual cost based on the real risk of death for those years, and less than the actual
cost would be in the last years.
For example, if Alfred buys a 10-year term policy at age 20, his premium will be higher than the premium one
would pay for a 20-year-old man for the first several years. However, his premium will be lower than that of a 27-
or 28-year-old man seeking the same coverage for a single year.
[2.1.2] PERMANENT LIFE INSURANCE
Permanent life insurance uses the same concept of an average premium, but the time period covered is a
person’s entire lifespan, right up to the point where the risk of death is statistically 100%. When the risk of dying
gets close to being a certainty, the only way to extend coverage for life is to pay in advance for coverage in those
later years.
[3] TEMPORARY LIFE INSURANCE PRODUCTS
Term life insurance provides pure or temporary protection and is the simplest form of life insurance coverage; it
essentially offers the maximum amount of life insurance at the lowest initial outlay. Term life provides low-cost
insurance protection for a specified period and pays a benefit only if the insured dies during that period. Term life
insurance is often called temporary life insurance because it provides protection for a limited period.
The period (or TERM) for which these policies are issued can be defined by years (e.g., one-year term, five-year
term, or 20-year term) or age (e.g., term to age 65, term to age 70). Term policies issued for a specified number of
years provide coverage from their issue date through the end of the period specified. Term policies issued until a
certain age provide coverage from their date of issue until the insured reaches the specified age.
Term insurance provides the insured with peace of mind against financial loss that an early death may cause.
However, if the insured outlives the coverage period, the policy expires, and no benefits are paid.
Scenario Application
Steve purchases a 20-year, $75,000 level-term life insurance policy and names his sister, Amy, as the
beneficiary. If Steve dies at any time during the 20-year term, Amy will receive the $75,000 death benefit. If Steve
lives beyond the term, the policy expires, and no benefit is payable to either Steve or Amy. Additionally, if Steve
cancels or allows the policy to lapse during the 20-year term, no benefit will be paid.
Term life policies can offer fixed, or constant, level premiums because premiums are averaged over the policy
term. Term life insurance provides the greatest amount of death benefit per dollar of initial cash outlay.
The primary advantage of term life insurance is that the premium or cost of the policy is substantially lower than
the premium or cost of a permanent, whole life insurance policy that’s issued for the same face value amount.
However, unlike permanent (whole) life insurance, term life insurance policies don’t build cash value.
An insurer may offer several different types of term life insurance policies. The available types of term life
insurance policies are primarily distinguished by the characteristics of their face value (death benefit). The basic
types of term life insurance policies include level term, decreasing term, and increasing term.
[3.1] DECREASING TERM LIFE INSURANCE
Decreasing term life insurance policies have benefit amounts that decrease gradually over the term of protection
and level premiums. Decreasing term life insurance is commonly used to pay off the insured’s debt in the event
of death.
For example, a 20-year $50,000 decreasing term policy will pay a death benefit of $50,000 at the beginning of the
policy term. That amount gradually declines over the 20-year term and reaches $0 at the end of the term. The
premium for these policies, in this case $350, remains level.
[3.1] DECREASING TERM LIFE INSURANCE (continued)
[3.1.1] MORTGAGE REDEMPTION INSURANCE
Mortgage redemption insurance is a decreasing term life insurance policy, and its purpose is to provide policy
holders with a way to have their mortgages paid off if they die before they’re fully paid. Mortgage protection
prevents the full burden of paying the mortgage from falling on the shoulders of the surviving family members.
With this design, the face value decreases as the balance remaining on the mortgage decreases
[3.1.2] CREDIT LIFE INSURANCE
Credit life insurance is a limited benefit (term) policy designed to cover the life of a debtor and pay the amount
due on a loan if the debtor dies before the loan is repaid. The beneficiary of this type of policy is typically the
lender. The type of insurance used is decreasing term, with the term matched to the length of the loan period
(generally limited to 10 years or less) and the decreasing insurance amount matched to the outstanding loan
balance. Credit life may be issued to individuals as single policies; however, it is most often sold to a bank or
other lending institution as group insurance that covers all of the institution’s borrowers. The cost of group credit
life insurance (or any credit life insurance) is typically paid entirely by the borrower.
The maximum benefit for a credit life insurance policy (regardless of whether it is an individual or group policy) is
the loan amount. The lender has insurable interest in the insured only up to the value of the indebtedness. A life
insurance policy is not a legal contract if it allows the lender to profit from the debtor's death.
While credit life or mortgage insurance may be required as a condition of a loan, the creditor cannot require the
borrower to purchase the insurance from the organization granting the loan or another specific organization. A
lender that requires a borrower to purchase insurance from a specific company as a condition of providing a loan
is considered coercion, which is an illegal practice.
[3.2] INCREASING LIFE INSURANCE
Increasing term life insurance is term life insurance that provides a death benefit that increases at periodic
intervals over the policy’s term. The increase is typically stated as a specific amount or as a percentage of the
original amount. The amount may also be tied to a cost-of-living index, such as the Consumer Price Index (CPI).
Increasing term insurance may be sold as a separate policy, but is generally purchased as part of a package or
cost-of-living rider attached to a policy. Increasing term life insurance is often used to account for anticipated
income growth as individuals advance in their careers. Increasing term life insurance may also be referred to as
incremental term life insurance.
In this example, the face amount increases from $0 to $50,000 over 30 years. The premium, in this case $250,
remains level for the life of the policy. Let us look at another example. A 30-year-old physician may choose to
take out a term-to-age-65 life insurance policy with a $100,000 face value, which increases by $100,000 every
five years to account for growth in income. This allows for a maximum of six $100,000 increases over the life of
the policy. The face value, or death benefit, of the insurance policy would increase to $200,000 at age 35,
$300,000 at age 40, $400,000 at age 45, $500,000 at age 50, $600,000 at age 55, and $700,000 at age 60.
If the physician dies before the age of 65, the life insurance policy will pay the insured’s beneficiaries the face
amount associated with the insured’s current (attained) age. At age 65, if the physician is still alive, the policy will
terminate, and no death benefit will be paid.
[3.3] LEVEL TERM INSURANCE

The most common form of term life insurance—level term life insurance—provides a constant or fixed amount of
coverage for as long as the policy remains in force. This form is characterized by a level face amount (death
benefit) for a specified period. A level term policy expires at the end of the policy period. Remember, the “level”
part of the name refers to the death benefit. The premium payments are fixed (or level) for the term of the policy
as a standard characteristic of term insurance.
This 10-year Level term insurance policy has a $100,000 Face Amount and a $350 level premium as well
EXAM TIP!
Assume an exam question is referring to a level term life insurance policy if the question doesn’t specify the type
of term policy and simply indicates “a term policy.”
3.4] RENEWABLE TERM LIFE INSURANCE
Some level term life insurance policies may include an option that allows the policy owner to renew the policy
before its expiration date without having to provide evidence of insurability. As with the option to convert, the
option to renew must be included in the contract when the policy is purchased; it cannot be added later.
Term life insurance policies are renewed using the insured’s attained age. The premiums for each renewal period
will be higher than those for the initial period, reflecting the insured’s increased age and risk. This steady increase
in premium is often referred to as a step-up premium (since the insured climbs up another “step” when
renewing the policy). The advantage of the renewal option is that it allows the insured to continue insurance
protection, even if they have become uninsurable due to a change in health.
Renewal options typically provide for several renewal periods or for renewals until a specified age. However, as
premiums increase with each renewal, the policy's cost typically becomes prohibitive, forcing older individuals
who are more likely to need the protection to either terminate or not renew the coverage.
The option to renew is often combined with the option to convert, in the same term insurance policy. An
uninsurable insured may also consider converting the coverage to a permanent plan.
[3.4.1] RENEWABLE TERM APPLICATION SCENARIO
Maria, a 45-year-old marketing executive, decides to purchase a 20-year term life insurance policy to ensure her
family is financially protected in case of her untimely death. The policy includes a renewable option, which
means that when the 20-year term ends, Maria can renew her policy without having to undergo a medical
examination, even if her health has deteriorated.
As Maria approaches the end of her policy term at age 65, she considers her options. She has developed a
chronic health condition that would make it difficult to qualify for a new policy. Fortunately, because she opted
for a renewable term policy, she can continue her coverage without proving insurability. However, Maria notices
that the premium for the renewed policy is significantly higher than what she initially paid, reflecting her
increased age and health risks. This increase is known as a step-up premium.
Maria must now decide whether to renew her policy at the higher cost or explore other financial planning options.
The renewal privilege allows her to maintain coverage, but the rising premiums may strain her budget.
This scenario highlights the importance of understanding the implications of renewable term life insurance,
including the benefits of guaranteed coverage and the potential financial burden of increasing premiums as one
ages.
[3.4.2] ANNUAL (YEARLY) RENEWABLE TERM (ART/YRT) INSURANCE
Annual renewable term (ART) or yearly renewable term (YRT) life insurance provides coverage for one year and
allows the policy owner to renew each year without evidence of insurability. This renewal is typically automatic
and increases the premium each renewal period. Annual renewable term life insurance represents the most
basic form of life insurance.
[3.4.3] RE-ENTRY TERM INSURANCE
Re-entry term insurance policies are named for their re-entry feature that offers policyholders two options at
renewal time. The first option allows insureds to automatically renew at a standard premium rate without proving
insurability. Alternatively, to qualify for the lowest premium rates or receive discounts, an insured can undergo a
medical examination to demonstrate their insurability. However, the insured could fail this medical exam or
exhibit health issues. In such a case, the insured will not necessarily lose coverage — the insured might still be
able to retain the coverage, but only at a higher premium rate.
Exam Tip!
If an exam question references renewing a life insurance policy, the new premium will ALWAYS be higher than
the previous or original premium. The cost of insurance will never stay the same or decrease. Additionally, only
temporary coverage can be renewed. There’s no need to renew permanent coverage.
[3.5] CONVERTIBLE TERM LIFE INSURANCE
Term insurance is designed to terminate after a specified period; however, some level term policies may contain
an option that allows the policy owner to convert the term protection to permanent protection. The option to
convert must be included in the contract when the policy is purchased and, depending on the insurance
company, may specify a time limit for converting (e.g., three years prior to policy expiration) or an age limit for
converting (e.g., before the insured reaches the age of 55). Policies that contain the option to convert are named
accordingly and are easy to identify.
For example, a term policy that provides life insurance protection for 10 years and also has a conversion privilege
is referred to as a 10-year convertible term policy.
The option to convert gives the insured the privilege to convert or exchange the term policy for a whole life (or
permanent) policy without evidence of insurability. In other words, the insured is not required to pass a medical
exam or demonstrate good health since that requirement was already satisfied before the policy was initially
issued.
Application Scenario:
Let us assume Steve purchased a 15-year term life insurance policy and suffered a massive heart attack 10
years into the policy term. The heart attack negatively impacted his insurability, and due to his increased health
risk, it is unlikely that an insurance company would allow him to purchase a new life insurance policy. When his
15-year policy expires, he will be without life insurance and possibly unable to obtain coverage due to his
elevated risk.
However, if Steve had purchased a 15-year convertible term policy, he would have had the option to convert the
policy to permanent protection without needing to prove insurability.
[3.5.1] INTERIM TERM LIFE INSURANCE
Interim term life insurance is a form of convertible term insurance designed for individuals seeking immediate
coverage but unable to afford permanent insurance right away. It offers temporary protection with the intention of
transitioning to permanent coverage later. Typically, this type of insurance is set up to automatically convert to
permanent coverage within the first year. Insurability is assured, with the premium for the temporary coverage
calculated based on the original application age, while the premium for the permanent coverage is determined by
the age at which the permanent protection starts (the attained age).
[3.5.2] ATTAINED VS ORIGINAL AGE CONVERSION
Depending on the conversion method, the premium rate for the new whole life policy will reflect the insured’s age
at either the time of the conversion (the attained age method) or at the time when the original term policy was
taken out (the original age method). Attained-age conversion is the usual method for converting term insurance
to permanent insurance. When the attained age is used, the policy owner effectively terminates the pure term
insurance protection and purchases a new whole life insurance policy without providing any health history
information. The new premium is based on the insured’s age at the time of conversion.
The insured’s age is one of the largest premium factors, so this method results in higher premiums. Most
conversions use attained because when the “original age” is used, the policy owner must pay an amount equal to
the difference between the original term cost and the new original-age whole life for the number of years that
have passed. Premiums will be lower, but the upfront cost is high. Using the original age method would be more
attractive if conversion is requested in the policy’s earliest years
The new original-age policy will not automatically have cash value, but may generate more cash value than the
attained age method in a comparable time frame.
Exam Tip!
Assume an exam question is referring to the attained age method if the question doesn’t specify the method of
conversion.
[3.7] USES OF TERM INSURANCE
Application Scenario
Imagine you are advising a client named Stacy, who is considering purchasing life insurance. Stacy is 35 years
old, has two young children, and is the primary breadwinner in her family. She is trying to decide between
permanent (whole life) insurance and term life insurance.
Stacy is particularly interested in ensuring her family is financially protected if something happens to her
unexpectedly. She has heard about the cash value component of whole life insurance, but she is unsure if it is the
right choice for her current financial situation.
To help Stacy understand the concept of term life insurance, consider the following points:
Purpose and duration: Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years. It
is designed to offer financial protection during the years when Stacy's children are dependent on her income.
Unlike permanent life insurance, term life does not accumulate cash value.
Cost-effectiveness: Term life insurance is generally more affordable than whole life insurance because it does
not include a savings component. This could be beneficial for Stacy, who wants to maximize her coverage while
managing her budget.
Flexibility: Since term life insurance is temporary, Stacy can choose a term that aligns with her financial goals,
such as covering her children's education expenses or paying off the mortgage. Once the term ends, she can
reassess her insurance needs based on her family's situation.
Focus on protection: Term life insurance focuses solely on providing a death benefit to Stacy's beneficiaries if
she passes away during the term. This aligns with her primary goal of ensuring her family's financial security.
By considering these aspects, Stacy can critically evaluate whether term life insurance is a suitable option for
her, given her current priorities and financial circumstances. This scenario helps illustrate the differences
between term and permanent life insurance, emphasizing the importance of aligning insurance choices with
personal financial goals.
While term insurance might initially appear less than perfect, it is important to recognize that all life insurance
serves a valuable purpose. Each type of insurance is crafted to meet specific needs or objectives. Term
insurance aims to offer short-term financial security if the insured passes away unexpectedly. Like other
insurance types, term life insurance comes with its own set of uses, benefits, and drawbacks.
Advantages of term life insurance policies include:
• Term life insurance is less expensive than permanent insurance for a given period
• Term life insurance may protect the insured’s insurability if the policy is renewable and/or convertible
• Term life insurance may be used in conjunction with debts, mortgages, or as a supplement to whole life
insurance
• Term life insurance provides the greatest amount of protection for the lowest cost
Disadvantages of term life insurance include:
• The protection provided by term life insurance policies terminates with the policy terminates. No
protection is in effect once the term of protection ends.
• If the term life insurance policy is renewable, premiums rise as the insured ages. This premium increase
often leads to policy cancellation before the policy terminates.
• Due to the temporary nature of term insurance, few death claims are paid under term life insurance
policies
• Term life insurance policies don’t contain cash savings or equity elements (i.e., cash value). Since it has
no cash value, it doesn’t mature like a whole life policy.
[4] PERMANENT LIFE INSURANCE PRODUCTS
Permanent life insurance policies are designed to provide lifelong protection. The basis for permanent insurance
contracts is whole life insurance.
Whole life insurance ensures a death benefit or face amount is paid upon the insured's death, no matter when it
happens. This policy offers lifelong protection, covering the insured from its start date until their passing. Whole
life policies are also known as straight life, continuous premium life, permanent life, or ordinary life insurance.
A whole life policy is generally described as a fixed death benefit, fixed premium life insurance contract. In other
words, it’s characterized by a level death benefit, a cash savings value (i.e., equity build-up), permanent
protection, and a fixed, level, or predetermined premium. The death benefit, premium payment, and the interest
rate paid on the cash value are all predetermined for the insured’s “whole life.” Also, a whole life policy protects
an insured permanently for the remainder of their life. This life insurance policy never needs to be converted or
renewed, since it remains in force as long as all premiums are paid on time.
[4.1] FEATURES OF WHOLE LIFE INSURANCE
Exam Tip!
While term life is designed to provide temporary protection IF the insured dies too soon, whole life insurance is
designed to provide permanent protection WHEN the insured dies.
All types of whole life insurance share certain features. A traditional whole life insurance policy combines pure
death protection with a cash value feature. Additionally, the policy's death benefit (face amount) remains
constant or level throughout the policy's life. Premiums are set at the time of policy issuance and remain fixed for
the policy’s life. Whole life policies are based on the assumption that premiums will be paid by the policy owner
throughout the insured’s lifetime or to age 100, whichever occurs first. This means that whole-life policies are
designed to “mature” or “endow” at age 100. Many newer whole life policies now endow at older ages (105 or
110). “Mature” or “endow” means that the cash value accumulations equal the face amount. Cash value and
endowment (or maturity) are the main features that distinguish whole life insurance from term life insurance, and
they combine to produce additional living benefits for the policy owner.
[4.1.1] CASH VALUES
Unlike term insurance, which only provides death protection, permanent life insurance combines insurance
protection with a savings element. This accumulation of funds or equity, commonly referred to as the
policy’s cash value, builds over the life of the policy. Although it is an essential part of funding the policy, the cash
value is often considered a living benefit because it represents the amount the policy owner will receive if the
policy is ever surrendered or voluntarily terminated.
When a policy owner pays the premium for a whole life insurance policy, a portion of that premium is used to pay
for the death benefit. This portion of the premium is referred to as the “term” insurance cost or the mortality cost
of insurance.
Another portion of the premium is used to cover the costs associated with the insurance company that issued
the policy —commissions, underwriting, medical exams, etc.—and the costs of maintaining the policy. After the
contract has been in effect for an initial period, the insurer begins depositing a portion of the premium into the
policy’s cash value. Some states may have specific requirements as to when the accumulation begins. Still, in
most traditional whole life policies, the cash value begins two to three years after the policy is issued. Once the
cash value begins to accumulate, it increases with each subsequent premium payment and continues to build
during the life of the contract. The cash value accumulates from the premiums paid plus a guaranteed fixed
interest rate. This interest is added annually and allows the cash value to grow each policy year.
[4.1.1] CASH VALUES (continued)
In the policy’s early years, more of the premium money goes toward providing the actual insurance protection,
but as the cash value grows and begins to offset the death benefit, the funds needed to purchase the actual
insurance protection decrease. With less money being used for actual insurance protection, more of the
premium can go toward growing the cash value during the later policy years. Whole life insurance policies were
traditionally designed so that their cash value buildup would equal the policy’s face amount by the time the
insured reaches the age of 100. Therefore, if a person purchases a whole life policy today and lives to age 100,
they will receive all their premiums back, plus some interest. The premiums paid plus interest equal the total
cash value at age 100, which also matches the policy’s face value or death benefit.
Over the past few decades, many insurers have modified the mortality tables used to determine premiums and
maturity. Although some continue to base maturity on age 100, many are using age 115 or 120.
It is important to understand that, traditionally, the cash value buildup is not paid to a beneficiary in addition to
the death benefit when the insured dies. The policy’s cash value is available to the policy owners at any time.
Policyowners always have the right to a policy’s cash value. The policy owner can surrender the policy, cancel
coverage, and receive the cash value. This is why the cash value is also referred to as the cash surrender value or
nonforfeiture value. In other words, it is the amount the policy owners will receive if they choose to surrender or
forfeit the policy. The cash value accumulation also provides policy owners with the opportunity to borrow
against the policy’s equity while keeping the policy in force. The borrowing of a policy’s cash value is considered a
loan and, as such, interest is charged for it.
[4.1.2] APPLICATION SCENARIO
At age 30, John buys a $100,000 whole life policy for $1,200/year. It takes about 3 years to start building cash
value. By year 10, the policy has $9,000 in cash value, reducing the insurer’s risk to $91,000. After 35 years, the
cash value grows to $40,000, lowering the insurer’s risk to $60,000. At age 100, the policy matures with a full
$100,000 cash value, and no further protection is needed.
Understanding the Whole Life Insurance Scenario
At Policy Start (Age 30): John’s policy has no cash value yet. The insurer is responsible for the full $100,000
death benefit.
After 10 Years (Age 40): The policy accumulates $9,000 in cash value. This reduces the insurer’s risk to
$91,000, since the cash value offsets part of the death benefit.
After 35 Years (Age 65): The cash value grows to $40,000, further reducing the insurer’s risk to $60,000.
At Maturity (Age 100): The policy endows with a full $100,000 cash value. The insurer no longer bears any risk,
as the policyholder now owns the full amount.
The cash value of a policy is influenced by several factors: a higher face amount leads to larger cash values,
shorter and higher premium payments accelerate cash value growth, and the longer the policy is active, the
quicker the cash values accumulate.
Exam Tip!
There’s a specific “return of cash value” benefit rider that can be added to a whole life policy. If an exam question
doesn’t explicitly mention an insurance policy having a return of cash value rider or endorsement, it should be
assumed that the policy in question doesn’t include that rider.

[4.1.3] MATURITY AT AGE 100

Whole life insurance was originally designed to mature at the age of 100. From an actuarial standpoint, it’s
assumed that every insured will be deceased by the time they would have reached the age of 100. Although
some individuals live beyond the age of 100, the number who do is statistically insignificant in the population.
Consequently, the premium rate for whole life insurance is based on the assumption that the policy owner
(usually the insured) will be paying premiums for the insured’s whole life. The policy is designed in so that when
the insured attains the age of 100, the cash value of the policy is equal to the face amount of the policy.
At that point, the policy has matured or endowed, and no more premiums are owed. In turn, the insurance
company issues a check for the policy's face value, minus any outstanding policy loans. Practically speaking,
very few individuals live to the age of 100. In fact, it’s far more likely that a whole life policy will be cashed in for
its surrender value or that its face amount will be paid out as a death benefit before the policy matures.
[4.1.4] WHOLE LIFE INSURANCE PREMIUMS
As noted earlier, whole life is designed with the belief that the insured will live to the age of 100. Accordingly, the
amount of premium for a whole life policy is calculated, in part, based on the number of years between the
insured’s age at issue and the age of 100. The shorter the payment period, the higher the premium. This span of
years represents the full premium-paying period, with the amount of the premium spread equally over that
period. This is referred to as the level premium approach. As with level premium term insurance, the level
premium whole life approach keeps premiums level rather than increasing each year with the insured’s age.
Whole life premiums are referred to as “bundled premiums.” Bundled premiums mean the insurer is not required
to explain to the policy owner how the premium paid is ultimately distributed (i.e., for death protection,
commissions, and other expenses). Premium rates are based on a per-$1,000-of-coverage rate and are typically
expressed annually.
For example, an insurance producer might explain to a potential applicant that a whole life insurance policy
costs $9 per $1,000 of coverage. If the applicant wants a policy with a $100,000 face value, the annual cost
would be $900 ($9 × 100).
[4.2] BASIC FORMS OF WHOLE LIFE INSURANCE
Remember, whole life insurance provides a fixed, level death benefit or permanent protection with a cash
accumulation feature. It’s characterized by a fixed, level, or predetermined premium for life (or up to the age of
100).
The policy’s cash value increases with each premium payment. A fixed interest rate is paid on the cash value,
which, in a traditional policy, is also fixed for the life of the policy. Therefore, the cash value buildup of a whole life
policy equals the face amount at age 100. The contract also includes nonforfeiture options or values if the policy
owner wants to surrender the policy.
Although it’s been presented that whole life premiums are calculated as if they were payable to the age of 100,
they don’t necessarily need to be paid this way. There are several different whole life insurance policy types to
accommodate different premium-paying periods. The three most common types of whole life insurance are
straight whole life, limited-pay whole life, and single-premium whole life.
[4.2.1] STRAIGHT WHOLE LIFE INSURANCE POLICIES
The most basic form of whole life insurance is straight whole life, also known as ordinary whole life. Straight
whole life insurance is the standard definition of whole life insurance as described up to this point.
It’s whole life insurance that provides permanent level protection with level premiums from the time the policy is
issued until the insured’s death (or age 100). This continuous premium, or whole life, plan is characterized by
level, or fixed, premiums as long as the contract remains in force.
Exam Tip!
Unless explicitly specified otherwise, it should be assumed that any exam reference to whole life insurance is
referring to straight, whole life insurance.
[4.2.2] LIMITED PAY WHOLE LIFE INSURANCE POLICIES
The advantage of this type of whole life insurance policy is that it allows the policy owner to cease paying
premiums after the limited payment period. At this point, the policy is entirely paid-up for life, and no future
premiums are required. However, as with a straight life plan, the policy matures or “endows” at age 100. A
predetermined, level premium for a limited payment period characterizes a limited payment whole life policy.
There are several types of limited-payment policies, such as 10-pay life, 20-pay life, 30-pay life, and life paid-up
at age 65.
For example, a 20-pay life policy is a whole life insurance policy in which premiums are payable for 20 years from
the policy’s inception, after which no more premiums are owed.
A life paid-up at 65 policy is a whole life policy in which the premiums are payable to the insured’s age 65, after
which no more premiums are owed.
Premiums for these policies are higher than for a straight life policy because they are paid for only a limited
period (i.e., 10 years rather than to age 100). Once payments are complete, the policy is paid-up for life, meaning
no additional premiums are due. Upon the insured's death, the death benefit will be paid to the designated
beneficiary. Although the policy is paid-up earlier than a traditional straight whole life policy, it will still not
“mature” until age 100 since the contract has been predetermined. Since the premiums for these policies are
higher than those for a traditional straight whole life policy, they are often said to have a more substantial savings
element or a greater emphasis on savings than traditional straight whole life contracts.
Since the insurance company is receiving its money in larger premium payments, the cash value builds more
quickly than in a straight life policy. Additionally, cash values build up even faster during the premium-paying
years than during the non-premium-paying years. After the premium-paying period, the cash value continues to
grow, but more slowly, until the policy matures and the cash value equals the face amount again at age 100.
It is important to remember that, despite the fact that the premium payments are limited to a certain period (as
with all other types of whole life insurance), the insurance protection is in force until the insured’s death, or to the
age of 100.
Exam Tip!
A limited-pay life insurance policy will best suit a prospective insured who seeks permanent insurance but
doesn’t want to pay premiums indefinitely.
[4.2.3] SINGLE PREMIUM WHOLE LIFE INSURANCE POLICIES
Single premium whole life insurance is the most extreme form of a limited-payment policy. The policy is
characterized by a lump-sum or single premium payment. The policy is fully paid up upon the payment of a lump-
sum premium. Some single premium plans exist, which require two premium payments, such as a “dual
premium” policy.
Common traits of a single premium whole life policy include:
 • An immediate cash value is created
• Part of the premium is used to set up the policy’s reserve
• Over time, the policy owner will pay less for the policy than if the premiums were paid annually
• Single premium life is defined as a modified endowment contract by the IRS.
A single premium whole policy is initially the most expensive whole life policy. However, over the life of the
contract, the single premium life policy is the least expensive compared to a straight life policy.
It should be noted that the IRS considers single premium policies to be a hybrid of a living investment and life
insurance, known as a modified endowment contract (MEC). While these policies offer a tax-free death benefit
like other cash value policies, some of the living benefits are restricted. For example, the IRS treats policy loans
differently. Unlike loans against other whole life policy cash values, loans against a MEC’s cash value are
considered taxable distributions. This reflects the IRS's tendency to treat the living benefits of a MEC as a
retirement plan asset. We will discuss taxation in more detail in a later chapter.
[[Link]] APPLICATION SCENARIO
Meet Pam, a 45-year-old successful entrepreneur who recently sold her tech startup. With a significant amount
of liquid assets, Pam is looking for a way to ensure her family's financial security while also making a smart
investment. She decides to purchase a single premium whole life insurance policy.
Pam opts for a policy with a face amount of $500,000. The insurance company calculates the lump-sum
premium required for this policy is $150,000. Although this is a substantial upfront cost, Pam appreciates the
benefits it offers:
Immediate cash value: Upon purchasing the policy, Pam's policy immediately has a nonforfeiture cash value,
Tax advantages: The cash value grows on a tax-deferred basis. s.
Cost efficiency over time: Compared to a traditional straight whole life policy, which would require ongoing
premium payments, Pam’s single premium policy is less expensive over the life of the contract. If she had chosen
a straight life policy, she would have paid more in total premiums over the years.
Financial security: The policy ensures Pam’s family will receive a $500,000 death benefit, providing them with
financial security in the event of her passing.
Pam’s decision to invest in a single premium whole life insurance policy aligns with her financial goals, offering
her peace of mind and a strategic use of her capital.
Therefore, in most cases, during the life of the policy, straight whole life policies are more expensive than the
single premium life plan. However, the single premium policy requires a significant initial premium, which
typically makes it cost-prohibitive for most people.
[4.3] NONTRADITIONAL WHOLE LIFE INSURANCE
There are other whole life plans that alter how premiums are paid to meet unique needs. Premiums charged for
these plans are less than for a straight life insurance policy in the early years of the policy. Cash values
accumulate with each premium payment. Insureds who need permanent protection but cannot afford the higher
traditional whole life premiums required may buy these types of policies.
[4.3.1] MODIFIED WHOLE LIFE INSURANCE
Modified whole life insurance is a whole life insurance policy characterized by an initial premium that is lower
than that of straight whole life insurance for an introductory period. The policy owner will pay a lower, flat initial
premium for the first few years, compared to the straight life premium. After this time, the premium will increase
to an amount higher than what the initial straight whole life premium would have been.
The premium increases following the initial period. The premium changes once and then remains level for the life
of the policy. Therefore, the modified whole life premium is characterized by two fixed premiums — a lower initial
premium (3-10 years) that increases to an amount higher than the traditional straight whole life premium would
have been, then remains level for life.
Again, modified whole life insurance policies alter the method by which premiums are paid. The premium
charged for these plans is less than that for a straight life insurance policy in the first few years of the policy. As
with all other types of whole life insurance, the life insurance protection is in force until the insured’s death, or to
the age of 100. Also, cash values accumulate with each subsequent premium payment.
The purpose of modified whole life policies is to make the initial purchase of permanent insurance more
accessible and more attractive, especially for individuals who have limited financial resources, but also the
promise of an improved financial position in the future. As mentioned previously, any individuals who are seeking
permanent protection but cannot afford the higher traditional straight whole life premiums required, will buy this
type of policy.
[4.3.2] GRADED PREMIUM WHOLE LIFE
A graded premium whole life plan is a contract characterized, like modified life, by a lower premium than whole
life in the early years of the contract. However, premiums increase annually or every year during the initial period.
Thereafter, it once it has increased to its final premium, an amount higher than the whole life premium, it remains
fixed for life. The premiums for these policies are predetermined, but are not level in the traditional sense, as they
would be in the traditional straight whole life or limited pay whole life plans.
[4.3.4] ENHANCED WHOLE LIFE INSURANCE (ECONOMATIC / EXTRAORDINARY LIFE)
An enhanced whole life insurance policy (also referred to as economatic life or extraordinary life) is a low–
premium, participating, permanent life insurance policy. The contract’s face amount is reduced each year. Any
dividends paid are set aside and used to purchase either paid-up additions or one-year term insurance, which is
equal to the reduction of death coverage. This policy provides a guaranteed death benefit in the early years of the
policy, even if dividends are insufficient to maintain level coverage.
[4.3.5] INDETERMINATE PREMIUM WHOLE LIFE INSURANCE
Indeterminate premium whole life insurance is a type of whole life policy that offers a low initial premium for a
specified period. After that period, the insurer may then increase premiums. The characteristics and benefits of
this policy are similar to those of other contracts. However, an indeterminate premium whole life policy allows
the premium to change due to changes in the insurer's investment income. Therefore, future premium
adjustments are based on the insurer’s investment performance, mortality experience, and expenses.
The company may raise or lower premiums, but they can never exceed the guaranteed maximum. Insurers
adopted this innovative policy type to offer lower-cost life insurance. Today, term insurance may also be written
with indeterminate premiums.
[4.3.6] CURRENT ASSUMPTION WHOLE LIFE (CAWL) / INTEREST SENSITIVE WHOLE LIFE
Current assumption whole life, also referred to as interest-sensitive whole life and excess interest whole life, is
characterized by premiums that vary to reflect the insurer’s changing assumptions concerning its death,
investment, and expense factors. However, interest-sensitive products also provide that the cash values may be
higher than the guaranteed levels
If the company’s underlying death, investment, and expense assumptions are more favorable than expected,
policy owners will have two options: lower premiums or higher cash values, which could result in a higher death
benefit in later years
Underlying assumptions could also turn out to be less favorable than anticipated, which would call for a higher
premium than that at policy issue.
The policy owner may then either pay the higher premium or reduce the policy’s face amount and continue
paying the same premium.
CAWL policies are either low-premium or high-premium. Both possess several characteristics, including but not
limited to:
• The use of an accumulation account, which is made up of the premium, less expense and mortality
charges, and credited with interest based on current rates
• Minimum guaranteed cash value and rate of return
• Maximum annual premium
• Use of a surrender charge, fixed at issue, which is deducted from the accumulation account to derive the
policy’s surrender value, and
• Use of a fixed death benefit and maximum premium level at the time of issue
Low premium type: The low premium type includes an indeterminate premium that’s initially low. It also
contains a redetermination provision that allows the insurance company to refigure the premium after a
specified period.
High-premium type: With the high-premium type, the initial premium is relatively high. It includes an optional
pay-up provision that allows the policy owner to cease paying premiums once the policy’s values are sufficient to
pay up the contract.
[4.3.7] EQUITY-INDEXED (INDEXED) WHOLE LIFE INSURANCE
Equity-indexed whole life insurance offers the security of traditional life insurance while allowing interest
earnings tied to an equity index (S&P 500), without direct stock market risks. The policy guarantees a minimum
interest rate, defers taxes on interest, and provides access to policy loans. Designed to outpace inflation, these
policies blend term life insurance with investment features, akin to universal life plans, with death benefits based
on chosen coverage and account value
[5] ALTERNATIVE NONTRADITIONAL LIFE INSURANCE PRODUCTS
In contrast to traditional whole life insurance policies—which feature fixed, level premiums and are often
referred to as level death benefit, level premium life insurance—modern alternatives offer greater flexibility for
policyholders. These nontraditional life insurance products include Universal Life Insurance, Variable Life
Insurance, Indexed Universal Life Insurance, Variable Universal Life Insurance, Current Assumption Whole Life
(CAWL), Yearly Renewable Term (YRT), and Annually Renewable Term (ART). Developed primarily in the 1970s
and beyond, these plans are characterized by adjustable or variable death benefits and premiums, allowing for
more personalized coverage and financial planning. The pages that follow will explore each of these alternatives
in detail, highlighting how they differ from traditional whole life policies in structure and function.
[5.1] ADJUSTABLE LIFE
This type of permanent insurance product combines elements of traditional fixed premium whole life insurance
with the potential to adjust the coverage or face amount based on the policy owner’s changing needs.
Adjustable life provides an adjustable death benefit and cash value, while also possessing all of the features of
traditional whole life policies. Its distinguishing characteristic is a provision referred to as the adjustment
provision. The advantage of this policy is that it permits the policy owner to make prospective adjustments (i.e., in
the future) to the policy’s coverage amount. The policy premium is fixed for the policy year. If an adjustment in
coverage is made (obviously, if more coverage is purchased, then the consumer pays more). The policyowner
cannot waive premiums.
An individual whose income has been fluctuating over the past several years, or a couple who plans to have
children over the next several years, are examples of prospective clients who may purchase an adjustable life
policy to provide flexibility to meet their “changing needs.” Therefore, this is the type of life insurance policy
available to an individual who wants to have the opportunity to make changes or alterations to their contract
each year.
There may be some confusion regarding premiums for adjustable life. In the future, the policy owner may pay
more or less per year than the original premium, because the premium is adjustable. However, remember the
original definition. At any point in time, adjustable life insurance is a level-premium, level-death benefit policy.
This means that whenever a coverage amount is increased, the premium that is due is level for the upcoming
policy year. If the policy owner decides to increase the coverage amount, the insured party must always prove
insurability. To simplify, an adjustable life policy is a traditional whole life policy with an adjustable death benefit.
This type of policy is characterized by prospective (i.e., future) adjustments only.
[5.2] UNIVERSAL LIFE
Universal life insurance provides its owner with the most flexibility compared to a traditional whole life plan. It
may be referred to as an adjustable form of life insurance (flexible premium adjustable life) since it allows
contract owners to change the coverage amount at their discretion. This type of policy may be characterized as
interest-sensitive as it utilizes changing interest rates (or rate of return) to determine cash values. These changing
interest rates are not used to determine death benefits or future premiums.
Universal life premiums pay for pure protection (i.e., YRT term insurance), plus a portion is deposited into the
Accumulation Account. The cash value may also be referred to as: (1) a cash value fund, (2) a cash savings plan,
(3) policy equity, or (4) a savings feature. As with traditional whole life policies, a fixed interest rate is paid on the
cash savings as it accumulates. The minimum fixed interest rate paid on the cash value of a universal life
contract is equal to the maximum interest rate paid (3.5% to 4.5%) on traditional whole life policies. This interest
rate paid on the cash savings plan may be higher (i.e., interest-sensitive), depending on the insurer’s investments.
Like traditional whole life policies, the insurer is responsible for the growth of the cash values.
Therefore, the interest rate is guaranteed for the policy year. If the contract owner pays a monthly premium, the
insurer subtracts mortality charges and other applicable expenses from the cash savings plan each month. If the
premium is paid annually, this deduction occurs once per year.
A flexible premium also characterizes universal life. The policyowner may pay any amount of premium they wish
each year or no premium at all if there is sufficient money in the accumulation account. This flexibility can be a
disadvantage for an undisciplined policyowner. The only required premium is the first year’s. If premiums are not
paid following the first year to keep coverage in force, the cost of death protection will be withdrawn from the
cash savings plan. The policy can pay for itself if there are sufficient cash savings. If no additional premiums are
paid, the policy uses the cash value to keep coverage in force. However, if there is not enough cash to pay for
death protection, the policy lapses.
When considering a universal life policy, a person must remember:
• The death benefit may not be guaranteed if not appropriately managed
• A minimum interest rate is guaranteed, which never changes
• The interest rate may be higher depending on the company’s performance (current rate), and rates may
be adjusted quarterly
• At times, the amount of coverage provided for the year will depend on the cash value available
[5.2.1] UNIQUE CHARACTERISTICS OF UNIVERSAL LIFE
In a universal life insurance policy, the premiums, cash value, and the face amount can be adjusted. However, it
is neither identical to adjustable life nor is it backed by equities, as in variable life products. Let us closely
examine the characteristics that make universal life insurance policies unique.
[[Link]] UNBUNDLED PREMIUM
Universal life policies are transparent since they’re characterized by unbundled premiums. This means the
contract owner is provided with information describing where the policy costs are allocated. In other words, the
contract owner receives a breakdown of premiums, death benefits, mortality charges, expenses, and cash
values. This breakdown shows the contract owner the disposition of the policy funds.
Some insurers offer a target premium, allowing contract owners to plan their premium payments regularly. Since
premiums are flexible, many contract owners may see their coverage lapse if they don’t manage the plan. To
avoid possible tax problems, premium allocations to a universal life policy’s cash value must comply with tax law
(IRS) guidelines
[[Link]] CASH VALUE
Funds withdrawn from the policy's cash value may not be subject to interest when used to pay premiums. As
premiums are paid, and as cash values accumulate, interest is credited to the contract’s equity. Companies pay
a guaranteed rate but may also pay a higher (current) rate depending on the company’s investment performance.
They will never pay less than the guaranteed rate. The company may adjust the rate quarterly.
Fixed interest rates paid on the cash value traditionally include a guaranteed minimum of 2% to 4%; however,
this will vary based on market conditions. Therefore, interest may be paid at either the contract’s guaranteed
minimum rate or at the current interest rate as declared by the insurer.
Since the current interest rate paid on the cash value changes each year and the amount of cash value changes,
the insurer must provide an annual statement to the contract owner. This annual statement identifies the
upcoming interest rate for the coming year, the cost of coverage, the current cash value amount, other applicable
expenses, and additional relevant information. Also, contract owners may make partial withdrawals from their
cash value, unlike a traditional whole life policies, which require the owner to borrow against the cash value (i.e.,
taking a loan) to access funds.
Since universal life is an unbundled product, the different factors that affect cash value are considered
individually, including surrender charges. Insurers apply a surrender charge against the existing cash value if a
policy is cancelled by the insured during the first 10 to 15 years of the policy. Surrender charges may also be
applied to partial withdrawals in some cases, depending on the size of the withdrawal as a percentage of the
total available cash.
[[Link]] DEATH BENEFIT
Universal life policies offer two death benefit choices: Option A and Option B. Under Option A (also referred to as
Option One), a level death benefit is provided. The net amount at risk (NAR) is adjusted after each month. As
such, a mortality charge is deducted from the policy’s cash value monthly. Therefore, the cash value and NAR
(benefit) together provide a fixed death benefit. Option B (also referred to as Option Two) provides an increasing
death benefit as the cash value increases. As such, the death benefit equals the face amount plus the cash value
at the time of death.
[5.2.2] TAX CONSIDERATIONS
The amount of pure insurance protection above the cash value is often referred to as a corridor. In order for a
contract to qualify as life insurance for tax purposes, there must be “space” between the total death benefit and
the cash value of the policy. An automatic increase in the death benefit results when the cash value approaches
the initial face amount under Option A.
Again, if this space is not present, the policy will lose its favorable tax treatment and become a modified
endowment contract (MEC) since it will not meet the Internal Revenue Code’s definition of life insurance. In
addition, for cash value accumulations to receive favorable tax treatment (i.e., tax deferral), a specific percentage
of universal life premiums must be used to purchase the death benefit amount.
[5.2.3] UNIVERSAL LIFE RIDERS
[[Link]] WAIVER OF MONTHLY DEDUCTION RIDER (WAIVER OF THE COST OF INSURANCE)
Some insurers offer a “waiver of monthly deduction” rider to be added to a universal life policy. Much like the
waiver of premium rider used on term and traditional whole life policies, the waiver of cost of insurance rider
waives premiums when the policyowner is permanently disabled; however, it does not waive the total premium.
This rider waives only the cost of the pure protection (mortality, interest, and expenses), not the portion allocated
to the cash value.
[[Link]] NO-LAPSE GUARANTEE RIDER
A no lapse guarantee rider may be added to a universal life policy. Universal life insurance offers the contract
owner premium flexibility that could result in insufficient premiums being paid to support the policy. As
previously described, paying insufficient premiums could cause the policy to lapse. The no-lapse guarantee
benefit rider prevents a lapse by imposing a premium payment schedule that requires minimum premiums to be
paid on a regular basis. In other words, the no lapse guarantee rider guarantees that the policy will not terminate
before a determined date if specified amounts of premium are paid, and any policy loan plus accrued loan
interest does not exceed the cash surrender value. The length of the policy’s guarantee period generally ranges
from five to 40 years, depending on the age of the insured when the policy was issued. Some (but not all) insurers
charge an extra premium for this rider.
[5.2.4] INDEXED UNIVERSAL LIFE
Universal life insurance comes in several forms, including fixed-rate policies controlled by the insurer and
variable policies in which the policy owner can allocate premium dollars in separate accounts that invest in
equities. Fixed-rate policies offer a degree of security. Variable policies offer the potential for higher returns if the
policy owner accepts the risk of losing cash value in a market downturn.
Indexed universal life, also known as equity-indexed universal life, is a fixed (non-variable) product that offers
policy owners a third option, one that offers some potential for higher returns, but also ensures that policy
owners will not lose money in a stock market downturn.
Indexed policies link their rate of return to a stock market index, such as the S&P 500, but the funds are not
directly invested in it. Instead, insurers determine their rate of return based on the market index's value at two
specific points in time. If the index is higher at the end of the period, policy owners receive a percentage of the
gain, usually capped at a stated maximum. If the index has declined, the policy owner is protected; no cash value
is lost. However, no interest will be earned.
[5.2.5] GUARANTEED / NO LAPSE GUARANTEE UNIVERSAL LIFE
Guaranteed universal life insurance — which is also referred to as no-lapse guaranteed universal life or
guaranteed death benefit universal life — is a type of life insurance that provides a policy owner with a
guaranteed death benefit, as long as the required premiums are paid. Therefore, even if there’s insufficient cash
value in the contract to support the death benefit, the policy will remain in force due to the coverage protection
guarantee. For this guarantee to be provided, the contract stipulates that minimum premiums must be met and
paid on time. As such, a guaranteed universal life insurance contract will still pay out a death benefit even if the
accumulated cash value decreases or goes to zero.
As with most types of universal life insurance, guaranteed universal life offers flexible premium options that can
vary based on an individual’s ever-changing financial situation. However, a minimum premium (or premium
target) must still be met to prevent the policy from lapsing. Also, any variation in premium amounts will affect the
interest rate within the contract, which will affect the cash value accumulations. The focal point of this type of
product is the guaranteed death benefit rather than the cash value accumulation.
Most insurers allow a policy owner to select a guaranteed coverage period (e.g., age 90 or age 120). In effect, this
means that the contract provides permanent protection with the flexible premium structure of a traditional
universal life insurance plan. Additionally, some insurers provide the policy owners with the flexibility to change
the coverage period as their needs or situations change.
[5.2.6] SURVIVORSHIP GUARANTEED UNIVERSAL LIFE
A survivorship universal life insurance contract is often referred to as second-to-die insurance. The contract
covers two people and pays a benefit only after both covered individuals have died. Since it costs less than two
individual permanent policies, it’s an affordable option for a person who wants to leave a larger nest egg for their
heirs or a favorite charity.
First-to-die versus second-to-die life insurance is reviewed more extensively later in this chapter.
6] VARIABLE INSURANCE POLICIES - REGULATED BY THE SECURITIES AND EXCHANGE COMMISSION
The Securities and Exchange Commission (SEC) regulates securities transactions, which include the trading of
stocks, bonds, and variable insurance products. The Financial Industry Regulatory Authority (FINRA) is the entity
that oversees securities firms in the United States. This regulatory body governs securities activities, administers
securities exams, and issues licenses. Therefore, producers who want to sell variable products must hold both a
life insurance license and a securities license.
[6.1] VARIABLE LIFE (VARIABLE WHOLE LIFE)
Variable life insurance (VL) combines life insurance protection with investment opportunities in securities, such
as stocks and bonds. It features fixed premiums and a guaranteed minimum death benefit. After deducting the
cost of protection, the balance of the premium is placed in a separate account, where the owner chooses from a
family of pooled investments resembling mutual funds, consisting of stocks, bonds, or money market funds
selected by the policyowner. The owner may change the mix of funds at any time.
While the death benefit is guaranteed, the cash value may fluctuate with market performance. The policy owner,
not the insurer, assumes all investment risk. Unlike traditional life insurance, VL doesn't guarantee interest rates
or minimum cash values, but it offers the potential for higher investment returns through separate account
options.
The cash value and death benefit can increase with good investment performance but may also decline with
poor performance. There is always a guaranteed minimum death benefit, but all of the cash value is at risk of
total loss. To sell VL insurance, agents must have both a state life insurance license and a FINRA securities
license.
Although VL policies involve investment management, they remain primarily life insurance products designed to
provide financial protection upon the policyholder's death.
[6.2] VARIABLE UNIVERSAL LIFE (VUL)
Variable universal life (VUL) insurance policies combine elements of variable whole life insurance and universal
life insurance. Let’s revisit some of the critical differences between variable life and universal life:
A VUL’s death benefit is designed like a regular universal life policy’s death benefit in that it may not be
guaranteed because the death benefit depends on there being sufficient cash value.
A VUL’s cash value is structured like a variable life insurance policy in that the amount of cash value in the policy
depends on the performance of the chosen investments. Policy owners have an opportunity for greater growth,
but there is no guaranteed rate of return on the policy’s cash value.
Variable universal life insurance offers the policy owner a combination of investment options, flexible premium
payment options, and a flexible expense deduction method. These policies can also be described as a
combination of variable life insurance with the added benefit of flexible premium payments.
[7.1] FAMILY PLANS, FAMILY INCOME, FAMILY MAINTENANCE
[7.1.1] FAMILY PLAN POLICIES
The family plan policy is designed to cover all family members under one policy. Coverage is sold in units. Whole
life coverage is purchased on the life of the primary insured (i.e., breadwinner). The coverage for spouses and
children is level term insurance in the form of a rider. Sometimes, the spouse’s amount is 50% of the primary
insured, and then 20% for all of the children. The spouse and children’s coverage is typically convertible (to
whole life insurance) without evidence of insurability, and new (or future) children are automatically included at
no extra cost. Therefore, this policy combines whole life and level term insurance. This type of contract is also
known as a family protection policy or family plan.
For example, a typical plan could insure the head of the family (main earner) with $20,000 whole life insurance
and $10,000 of level term life insurance on the spouse and children.
[7.1.2] FAMILY INCOME POLICY
A family income policy consists of whole life and decreasing term insurance. This policy will provide monthly
income to a beneficiary if death occurs during a specified period beginning after the date of purchase. A
decreasing term policy supplies the family income portion of this type of coverage. Income payments to the
beneficiary begin when the insured dies and continue for the period specified in the policy, which is usually 10,
15, or 20 years from the date of policy issue, and not from the date of the insured’s death. If the insured dies after
the specified period, only the face value (whole life) is paid to the beneficiary, as the decreasing term insurance
has expired.
[7.1.3] FAMILY MAINTENANCE POLICY
A family maintenance policy consists of whole life and level term insurance, which provides income for a specific
period beginning on the date of the insured's death. If the insured dies before a predetermined time, this policy
provides income to a beneficiary for a stated number of years from the date of the insured’s death. Additionally,
the beneficiary will receive the entire face amount of the whole life insurance component of the policy upon
completion of the income-paying period. However, if the insured dies after the selected coverage period, the
beneficiary receives only the face amount of the whole life insurance component of the policy.
[7.2] JOINT LIFE POLICIES
[7.2.1] JOINT LIFE
A joint life policy covers two or more people. Using some type of permanent insurance (as opposed to term), it
pays the death benefit at the death of the first insured. The survivors then have the option of purchasing a new
policy. The premium for a joint life policy is lower than the combined premiums for separate, multiple policies.
The ages of the insureds are averaged, and a single premium is charged for each life. Joint life policies may also
be referred to as “first-to-die policies” because the death benefit is paid upon the first death.
[7.2] JOINT LIFE AND SURVIVOR POLICIES (SURVIVORSHIP LIFE)
A variation of the joint life policy is the last survivor policy, also referred to as a “second-to-die policy.” This plan
also covers two (or more) lives, but the benefit is paid upon the death of the last surviving insured. This type of
coverage can also be considered a “survivorship life insurance policy” and will typically cover two lives. As with a
joint life policy, the premium for a survivorship life policy is lower than the combined premium for separate life
insurance policies on two married individuals. Survivorship life insurance policies are useful in estate planning
because they can provide money to pay taxes on assets
[7.3] JUVENILE INSURANCE
A juvenile life insurance policy is any type of ordinary life insurance policy that insures the life of a minor.
Applications for insurance and ownership of the policy rest with an adult (e.g., a parent or guardian) and don’t
require the minor’s consent. As such, juvenile insurance utilizes the concept of third-party ownership.
Additionally, the adult applicant is typically the premium payor, at least until the child comes of age and can take
over the payments.
For life insurance purposes, an applicant is generally considered a juvenile if they are under the age of 15.
However, some states use 16 as the age of maturity. The applicable age of maturity will be discussed further in
the laws and rules chapter at the end of this course.
[7.3.1] JUMPING JUVENILE INSURANCE (ESTATE BUILDER)
In addition to purchasing insurance for a child's burial expenses, insurance may also be purchased to protect the
child’s insurability. Some parents purchase these plans to begin a savings plan for their child. The face amount of
this policy can start as low as $1,000. The coverage amount “jumps up” (typically five times the initial amount)
when the child reaches the age of majority or a specified age (i.e., age 21). This benefit increase comes without
any evidence of insurability and no premium increase. Some insurers may also refer to a jumping juvenile
insurance policy as a junior estate builder plan.
The owner and payor of the policy will not change automatically. In this case, the current owner (i.e., the parent or
guardian) must request the change (typically in writing) with the insurance company. Since insurable interest is
only required at the time of the application, the parent or guardian will never be required to relinquish ownership
of a child’s policy.
[7.3.2] APPLICATION SCENARIO
Tina and Michael decide to purchase a jumping juvenile insurance policy for their 5-year-old daughter, Emma.
Initial Policy Details:
• Initial face amount: $20,000
• Monthly premium: $25 (fixed)
• Policy purchase age: 5 years old
• Jump age: 21 years old
• Jump multiplier: 5x
What happens at age 21:
• Face amount automatically increases from $20,000 to $100,000 ($20,000 × 5)
• Monthly premium remains at $25
• No medical exam or proof of insurability required
• Guaranteed insurability regardless of Emma's health at age 21
Benefits:
• Protection: Provides immediate coverage for burial expenses if needed
• Guaranteed insurability: Ensures Emma can have substantial coverage in adulthood regardless of future
health issues
• Fixed premium: The $25 monthly premium remains constant even after the coverage increases
• Cash value: The Policy builds cash value that Emma can access later in life
• Financial head start: Creates a foundation for Emma's financial future
This example illustrates how the policy safeguards the child while also offering substantial future benefits
without incurring additional costs or medical requirements. When Emma turns 21, she automatically receives
$100,000 in coverage while still paying the same premium established when she was 5 years old.
[7.4] INDUSTRIAL (HOME SERVICE) LIFE INSURANCE
Industrial life insurance is characterized by comparatively small issue amounts, such as $1,000, with
premiums collected by the agent on a weekly or monthly basis at the policy owner’s home. This insurance is
often marketed and purchased as burial insurance, but may also include dismemberment benefits or a benefit
multiplier (indemnity) for accidental deaths.
Home service companies typically sell other insurance products in addition to industrial life insurance. These
additional policies allow the company to assign agents to specific geographic locations (referred to as debits)
within a city to collect premiums.
Some home service companies now offer a product that’s termed, “monthly debit ordinary life insurance.”
Monthly debit ordinary life insurance is a combination of the previously offered industrial life insurance and
ordinary life insurance. The hybrid nature of these policies allows for higher face amounts and higher premiums.
These policies are typically paid for on a monthly basis via mail or bank draft, but they may also be collected at
the policy owner’s home.
[8] ENDOWMENTS
[8.1] ENDOWMENT POLICIES
An endowment policy is a type of life insurance that provides two potential benefits:
• A death benefit if the insured dies during the policy term; or
• A maturity benefit equal to the face amount if the insured survives to the end of the term.
Endowment policies resemble whole life insurance but mature sooner. While whole life policies mature at age
100, endowment policies mature at a specified earlier date.
For example, a $50,000 20-year endowment pays out (matures) after 20 years, versus a whole life policy that
pays at age 100. Both policies pay the face value if the insured dies before the policy matures.
Key features of endowment policies include:
• Rapid cash value growth
• Higher premiums due to shorter term
• Typically used for:
o Retirement planning
o College funding
o Other specific future financial needs
[8.1.1] TYPES OF ENDOWMENT POLICIES
•
o Standard endowment: Pays full benefit either at death or maturity
o Semi-endowment: Pays 100% at death, 50% if insured survives
o Pure endowment: Pays only if the insured survives
o Juvenile endowment: Specifically designed for children's education

[8.1.2] TAXATION OF ENDOWMENT POLICIES

Due to the Tax Reform Act of 1984, policies that endow before age 95 no longer qualify as life insurance for tax
purposes. This has led to a decline in their popularity since they no longer receive favorable tax treatment.
[8.2] MODIFIED ENDOWMENT CONTRACTS
In 1988, Congress enacted the Technical and Miscellaneous Revenue Act, commonly referred to as TAMRA.
Among other things, this act revised the tax law definition of a life insurance contract. The primary reason for its
passage was to discourage the sale and purchase of life insurance for investment purposes or as a tax shelter. A
modified endowment contract (MEC) is a whole life insurance policy that, according to IRS tables, is considered
overfunded and, as such, is not truly a life insurance policy.
Any life insurance policy that’s purchased after June 20, 1988, is considered by the IRS to be an MEC if it doesn’t
satisfy the seven-pay test. The seven-pay test is a limitation on the total amount a person can pay into a policy in
the first seven years of its existence. A whole life insurance policy is a modified endowment contract if the total
amount of premiums paid during the first seven years of the contract exceeds the total amount of premiums
required for the same insurance policy to be paid up in seven years. The purpose of the test is to discourage
premium schedules that could result in a paid-up policy before the end of a seven-year period. All single-
premium whole life policies are modified endowment contracts. Once a contract is declared an MEC, it can
never revert to ordinary insurance. However, if there’s a material change in the contract, the seven-pay test
applies again.
The following are illustrations of the tax treatment of benefit distributions from an MEC:
• Taxation only occurs when any cash is distributed to the contract owner or money is withdrawn, whether
by surrender, loan, or dividends
• The gain (i.e., interest or appreciation) is taxable first when a distribution is made (i.e., LIFO)
• The first dollars received by the contract owner are considered “earnings first,” or excess amounts of cash
value beyond premiums, and are taxable
• If a policy is an MEC and cash is withdrawn, appropriate amounts are still taxable, even if it will be used
for a legitimate reason, such as financial hardship or to pay medical expenses.
• If cash is withdrawn prior to age 59 1/2, a 10% penalty tax will be assessed
[8.2.1] MODIFIED ENDOWMENT CONTRACTS SCENARIO
Meet Robert, a 45-year-old successful software engineer who recently received a substantial bonus of
$200,000. Concerned about his family's financial future and attracted by the tax-advantaged growth potential of
life insurance, Robert consults with his insurance agent, Sarah.
Sarah presents two whole life insurance options:
Option 1: Traditional whole life policy
• Death benefit: $500,000
• Annual premium: $12,000
• Seven-year total premiums: $84,000
• Meets seven-pay test requirements
Option 2: Accelerated premium policy
• Death benefit: $500,000
• Proposed premium structure:
• Year 1: $100,000
• Years 2-7: $5,000 annually
• Seven-year total premiums: $130,000
• Exceeds seven-pay test limits
Robert, eager to maximize his investment and minimize his future premium obligations, initially leans toward
Option 2. However, Sarah explains that this choice would trigger MEC status because the premium schedule
exceeds the seven-pay test limits.
Five Years Later...
Let's examine two different scenarios based on Robert's choice:
Scenario A: If Robert chose Option 1 (traditional policy)
Robert needs $30,000 for his daughter's college tuition. He takes a policy loan:
• No immediate tax consequences
• Loan can be repaid at his convenience
• No early withdrawal penalty
• Cash value continues to grow
Scenario B: If Robert chose Option 2 (MEC policy)
Robert takes the same $30,000 loan:
• Immediate taxation on any gain in the policy
• Additional 10% penalty tax (since he's under 59½)
• Less favorable tax treatment on future withdrawals
• Reduced flexibility in accessing funds
This scenario illustrates how MECs can substantially affect a policyholder's ability to access funds tax-efficiently
and underscores the importance of understanding the seven-pay test when structuring life insurance policies.
[9] OTHER LIFE INSURANCE PRODUCTS
[9.1] FACE AMOUNT PLUS CASH VALUE
A face amount plus cash value policy is a contract that promises to pay the policy’s face amount plus the policy’s
cash value upon the death of the insured. This type of insurance policy requires a substantially higher premium
than its traditional counterpart, and as a result, the policy is not standard within the insurance industry.
[9.2] ACCIDENTAL DEATH AND DISMEMBERMENT (AD&D)
This policy can provide financial benefits if an insured is killed, loses a limb, suffers blindness, or is paralyzed in a
covered accident.
[9.3] NONMEDICAL LIFE INSURANCE
Nonmedical life insurance doesn’t require a medical exam and tends to be more expensive than medically
underwritten policies. The insurer will average out everyone’s risk and charge accordingly. Although insurers
typically will not require a medical exam, they will still inquire about the applicant’s medical history and lifestyle.
[9.4] PARTICIPATING VERSUS NONPARTICIPATING
A participating life insurance policy is a type of life insurance policy that receives dividend payments from a
mutual life insurance company. It is referred to as participating because the policyowner is permitted to share or
“participate” in the excess earnings of the life insurance company. A nonparticipating policy does not share
excess earnings, and consequently, policyowners do not receive dividend payments. Stock insurers issue
nonparticipating policies.
[10] STRANGER / INVESTOR-OWNED LIFE INSURANCE (STOLI) / (IOLI)
Stranger-owned life insurance (STOLI) is essentially a scheme whereby strangers to the insured – those without
any true insurable interest – originate a policy for their own financial gain. Simply put, these schemes are wagers
on human life and are prohibited in most states. To legally purchase life insurance on another person, the
purchaser must have an insurable interest in that person’s life. STOLI policies were a way to circumvent the
insurable interest requirement when purchasing a life insurance policy.
Investor-owned life insurance (IOLI) is a life insurance policy that covers the life of an individual who is unrelated
to the policy owner, either by familial or economic relationship. The investor pays the person’s premiums in
exchange for the person’s life insurance benefits. An IOLI transaction is very closely related to a STOLI
transaction. The primary difference between the two is that an investor always initiates an IOLI.
Both STOLIs and IOLIs are considered fraudulent. STOLIs and IOLIs do not include lawful life settlement
contracts, provided that such contracts or practices are not for the purpose of evading regulation.
[11] CHAPTER SUMMARY
[11.1] REVIEW NOTES
Key points to remember from this chapter include:
GENERAL CONCEPTS OF LIFE INSURANCE
• Life insurance involves transferring the risk of premature death from one party to another
• Life insurance contracts create an immediate estate
• Unlike other lines of insurance (e.g., property and casualty), there are no “standard” life insurance policies
TEMPORARY LIFE INSURANCE PRODUCTS
• Term life insurance provides pure or temporary protection and is the simplest form of life insurance
coverage
o It provides the most amount of life insurance at the lowest initial premium
o Temporary or limited protection
o No cash value / no equity
o Protects the insured against the financial loss that an early death may cause
• Decreasing term life insurance provides a death benefit amount that decreases gradually over the term
of protection
o Mortgage redemption insurance is a type of decreasing term life insurance policy
 o Credit life insurance is a limited benefit (term) policy designed to cover the life of a debtor and
pay the amount due on a loan if the debtor dies before the loan is repaid. The maximum
benefit for a credit life insurance policy, regardless of individual or group, is the value of the loan
• Level term life insurance provides a level amount of protection for a specified period, after which the
policy expires
• The option to renew allows the policy owner to renew the term policy before its expiration date without
being required to provide evidence of insurability
• Step-up premium is a steady increase in the premium
• Annually renewable term (ART) or yearly renewable term (YRT) life insurance provides coverage for
one year and allows the policy owner to renew coverage each year, without evidence of insurability
• Increasing term life insurance provides a death benefit that increases at periodic intervals over the
policy’s term
• The option to convert gives the insured the ability to convert or exchange the term policy for a whole-life
or permanent policy without evidence of insurability
• The cost of insurance is the key factor to consider when determining whether to convert term life
insurance at the insured’s original age or the insured’s attained age
• Interim term life insurance is a type of convertible term insurance written on a person who wants
protection immediately, but who is not able to afford permanent protection immediately.
The premium for the temporary protection is based on the original application age.
The premium for permanent protection is based on the age when permanent protection begins (the
attained age).
• Advantages of term life insurance policies include:
o Less expensive than permanent insurance
o May protect the insured’s insurability if the policy is renewable and/or convertible
o May be used in conjunction with debts, mortgages, or as a supplement to whole life insurance
o Provides the most substantial amount of protection for the lowest cost
• Disadvantages of term life insurance include:
o The protection provided by term life insurance policies terminates when the policy terminates. No
protection is in effect once the term of protection ends.
o If the term life insurance policy is renewable or convertible, premium rates rise as the insured
ages, which often leads to policy cancellation before the policy terminates.
o Due to the temporary nature of term insurance, few death claims are paid under term life
insurance policies.
o Term life insurance policies don’t contain any cash accumulation elements (i.e., cash value).
Since it has no cash value, it doesn’t mature as a whole life policy does.
PERMANENT LIFE INSURANCE PRODUCTS
• Whole life insurance provides for the payment of a death benefit or face amount of coverage upon the
death of the insured, regardless of when the death occurs
o It’s a form of permanent insurance
o Level, fixed, or predetermined death benefit
o Level, fixed, or predetermined premium
▪ The shorter the payment period, the higher the premium
• Tax-deferred cash value (i.e., equity or savings)
• Whole life insurance is designed to mature (cash value = face value) at age 100
• Ordinary whole life / straight life / continuous premium life is the most basic form of whole life
insurance
o Premiums are payable as long as the insured is alive
• Limited payment whole life
o Predetermined premium for a limited payment period
 • A single-premium whole life policy is the most expensive whole life policy initially
o An immediate nonforfeiture value (cash value) is created
o A part of the premium is used to set up the policy’s reserve
o The advantage offered by a single premium policy is that the policy owner will pay less for the
policy than if the premiums were stretched over several years
• Modified whole life insurance is a type of whole life insurance policy characterized by an initial premium
lower than that of straight whole life insurance for an introductory period (e.g., 5 years). After the
introductory period, the premium jumps to a rate higher than a straight life policy would have cost if it
were taken out initially.
• A graded premium whole life plan is a contract characterized, like modified life, by a lower premium
than straight whole life in the early years of the contract. However, premiums increase annually for the
initial period. Thereafter, it increases to an amount higher than the whole life premium and remains fixed
for the remainder of the policyholder's life.
• Enhanced whole life insurance, also referred to as economatic life or extraordinary life, is a low–
premium, participating, permanent life insurance policy
• Indexed Equity-indexed (Indexed) whole life insurance includes contracts where the policyholder can
share in a percentage of the growth of an indexed investment (e.g., a mutual fund tied to the S&P 500).
The minimum interest and death benefit are guaranteed. These products are not considered securities.
ALTERNATIVE NONTRADITIONAL LIFE INSURANCE PRODUCTS
• Adjustable life insurance policies are distinguished by combining flexibility and permanent insurance
into a single plan.

oPolicies can offer permanent insurance,

oThe adjustment provisions look to the future (i.e., prospective)
oThe premium may change with one’s financial condition
oThe death benefit is adjustable based on changing needs
• Universal life insurance is essentially a term policy with cash value (savings), flexible premiums, and an
adjustable death benefit
o Tax-deferred cash value (money market rates) has a guarantee (i.e., interest rate)
o Universal life insurance is considered a type of permanent insurance. Coverage remains in place
for the life of the insured as long as the cost of insurance can be paid by the cash value or
increasing premium payments.
o The policy owner may surrender the universal life policy for its entire cash value at any time
o Target premium is a suggested premium used in universal life policies
o Universal life insurance offers two death benefit options:
▪ Option A: the death benefit equals the cash values plus the remaining pure insurance
(decreasing term plus increasing cash values)
▪ Option B: the death benefit equals the face amount (pure insurance) plus the cash values
(level term plus increasing cash values)
• Indexed universal life insurance combines most of the features, benefits, and security of traditional life
insurance with the potential of earned interest based on the upward movement of an equity index
SECURITIES AND EXCHANGE COMMISSION (SEC) REGULATED LIFE INSURANCE POLICIES
• Variable life
o Guaranteed minimum death benefit
o The death benefit and cash value will vary based on investment performance
o Tax-deferred cash value is deposited in a separate account and then invested in securities
o Permanent insurance, in which the owner has control over the investment portion
o Fixed premium
• Variable Universal Life
 o A hybrid of universal life and variable whole life
o Flexible premiums and a death benefit with control over the investment aspect
o Combines an investment feature and a flexible premium
SPECIAL USE LIFE INSURANCE PRODUCTS
• The family plan policy is designed to cover all family members under one policy
• A family maintenance policy consists of both whole life and level term insurance, which provides
income for a specific period beginning on the date of death of the insured
• A joint life policy covers two or more people and pays a benefit upon the first death of a covered person
• The second-to-die (survivor) policy covers two or more people and pays a benefit upon the death of the
last covered person
• A juvenile life insurance policy is any type of ordinary life insurance policy that insures the life of a minor
• An endowment policy is characterized by cash values that grow at a rapid pace so that the policy
matures or endows at a specified date (i.e., before the age of 100)
• Higher premiums than a whole life policy
• Quickest or accelerated cash value build-up
• Pays if the insured dies or if the insured survives the endowment (i.e., specified) period (e.g., 10-year, 20-
year, 30-year, endowment at the age of 65)
• A modified endowment contract is (according to IRS tables) considered to be a policy that’s
overfunded. As such, MECs don’t technically meet the IRS definition of a life insurance policy: “failed the
seven-pay test.” Premiums paid in the first seven years exceed the total amount of premiums required for
the same insurance policy to be paid up in seven years.
• Industrial life insurance is characterized by comparatively small issue amounts, such as $1,000, with
premiums collected on a weekly or monthly basis
• Monthly debit ordinary life insurance is a combination of industrial life insurance and ordinary life
insurance
OTHER LIFE INSURANCE POLICY CONCEPTS
• A face amount plus cash value policy is a contract that promises to pay the policy’s face amount plus
the policy’s cash value upon the death of the insured
• Stranger-owned life insurance (STOLI) is when a person purchases life insurance only to sell it to a third
party with no insurable interest, who would be unable, therefore, to purchase the original policy legally
• Nonmedical life insurance typically doesn’t require a medical exam and tends to be more expensive
than medically underwritten policies
• A participating life insurance policy is a policy that has dividend payments from the life insurance
company
• A nonparticipating policy does not have the right to share in excess earnings and consequently doesn’t
receive dividend payments
Chapter 5
[1.2] KEYWORDS
Please review the following keywords before beginning this chapter. The understanding of their basic definition
will improve comprehension of the chapter content.
Absolute Assignment: This is a policy assignment under which the assignee (person to whom the policy is
assigned) receives full control over the policy and full rights to its benefits. Generally, when a policy is assigned to
secure a debt, the owner retains all the rights in the policy over the debt, although the assignment is absolute in
form.
Accidental Death Benefit Rider: This rider pays an additional sum to the beneficiary if the insured dies due to a
covered accident. The amount paid is a multiple of the policy face amount, such as double or triple the original
benefit. Accident death life insurance provides the cheapest way to add a significant amount of coverage for a
limited period.
Accelerated Benefits Rider: This rider allows the insured to receive a portion of the death benefit before death if
the insured has a terminal illness and is expected to die within one-to-two years. Regardless of the amount that's
withdrawn in an accelerated death benefit, it will decrease the death benefit when death occurs.
Automatic Premium Loan Provision: This provision allows the insurance company to deduct the overdue
premium from an insured's cash value by the end of the grace period if a payment is missed on a life policy. The
insurance company can automatically take out a loan for the insured against cash value to cover premiums if it
does not receive payment when due.
Cash Surrender Option: This non-forfeiture option allows the policy owner to receive the policy's cash value. If
this option is exercised, the policy owner no longer has coverage. Typically, the maximum period that a life
insurance company may legally defer paying the cash value of a surrendered policy is six months (delayed
payment provision).
Collateral Assignment: This is an assignment of a policy to a creditor as security for a debt. The creditor is
entitled to be reimbursed out of policy proceeds for the amount owed. Any proceeds above the amount due at
the insured's time of death will be paid to a beneficiary designated by the policy owner.
Consideration Clause: This clause states a policy owner must pay a premium in exchange for the insurer's
promise to pay benefits. A policy owner's consideration consists of completing the application and paying the
initial premium. The amount and frequency of premium payments are contained in the consideration clause.
Dependent Riders: Dependents may be added as additional (other) insureds through the use of a dependent
rider. Other insured riders are typically used for spouses and children.
Dividend Options: These are the options that a policy owner has when receiving dividend payments from an
insurance policy. Options include cash, reduced premiums, accumulated interest, paid-up additions, and one-
year term insurance.
Entire Contract Provision: This provision states the insurance policy itself, including any riders,
endorsements/amendments, and the application comprises the entire contract between all parties.
Free-Look Period: This period states that the policy owner is permitted a certain number of days once the policy
is delivered to examine the policy and return it for a refund of all premiums paid.
Grace Period: This is a period after the due date of a premium during which the policy remains in force without
penalty. Suppose an insured dies during the grace period of a life insurance policy before paying the required
annual premium. In that case, the beneficiary will receive the face amount of the policy minus any outstanding
premiums. For life insurance, the grace period is typically one month.
[2] GENERAL POLICY PROVISIONS:
Most states require the same set of provisions to be included in all life insurance contracts. These standard or
usual provisions are almost identical in wording regardless of the insurance company or the locale where the
policy is issued.
These "standard provisions" found in all life insurance policies identify the duties, obligations, and rights of the
parties to the contract. A provision may also be referred to as a policy clause. In general, provisions are intended
to protect the policy owner.
[2.1] ENTIRE CONTRACT PROVISION
The entire contract clause or provision is found at the beginning of the policy and states that the entire contract
consists of all included policy documents, the attached photocopy of the original application, and any attached
riders or endorsements. Nothing may be incorporated by reference, meaning that the policy cannot refer to any
outside documents as being part of the contract. Therefore, the insurer cannot deny a claim in the future by
stating that it did not provide the policy owner with the entire contract.
Additionally, the entire contract provision prohibits the insurer (including the agent) from making any changes to
the policy, either through policy revisions or changes in the company's bylaws, after the policy has been issued.
Naturally, the policy owner or insured is also prohibited from making any changes to the policy.
The following is an example of an actual "entire contract" provision that may appear in a life insurance policy:
"The insurer has issued the policy in consideration of the application and payment of the premium. A copy of the
application is attached and is part of the policy. The policy with the application makes up the entire contract. All
statements made by or for the insured will be considered representations, rather than warranties. This insurer
will not use any statements in defense of a claim unless it is made in the application, and a copy of the
application is attached to the policy when issued."
This clause does not prevent a mutually agreed change to the policy if it expressly provides a mechanism for
modifying the contract after it has been issued. Changes or additions to a life insurance contract are referred to
as endorsements, riders, or amendments. Only authorized company officers may modify or amend an insurance
contract, and the policy owners must agree to any changes before they take effect.
Examples of mutually agreeable changes may include the policy owner changing the face amount of an
adjustable life policy or adding additional coverage through a rider.
[2.2] EXECUTION CLAUSE
The execution clause states that the insurance contract will be executed when both parties (the insurer and the
policy owner) have satisfied the conditions of the contract. In other words, when both parties have fulfilled their
responsibilities, the contract will be executed.
[2.3] MODIFICATION PROVISION
This provision, which may be listed separately from the entire contract provision, states that any changes made
to the contract must be in writing and endorsed or attached to the policy. It also states that only an executive
officer of the insurer or authorized home office personnel has the authority to make any changes or
modifications, or to waive a policy provision. A producer or agent is not required to countersign any such
modification.
[2.4] PRIVILEGE OF CHANGE CLAUSE (POLICY CHANGE PROVISION)
The privilege of change clause – also known as the policy change provision or conversion option – outlines the
conditions under which the company allows the policy owner to change the policy's coverage. If the premium is
increasing, but the face value remains the same, the insured will not be required to prove insurability. However,
the insured must prove insurability if premiums are decreasing or the face value is increasing, as this could lead
to adverse selection.
[2.5] INSURING AGREEMENT CLAUSE PROVISION
The insuring agreement, sometimes called a provision or clause, sets forth the company's fundamental promise
to pay the policy benefits upon the insured's death or as otherwise defined in the insurance contract. This
provision appears on the first page of the policy, which is also referred to as the policy face or cover page.
Typically, the president and secretary of the insurance company undersign the insuring clause.
One company's insuring clause reads:
"This agreement has been made between the policy owner and the insurer. It provides a coverage limit of
$100,000 payable to the primary or other beneficiaries in the event of the insured's death. The annual premium is
$400 to be paid in the method or mode selected by the policy owner. Further, the Company agrees to pay the
surrender value to the policy owner if the insured is alive on the maturity date."
[2.6] CONSIDERATION CLAUSE
As previously described, there must be an exchange of value between the two parties for the contract to be
legally enforceable. Consideration is the value given in exchange for a contractual promise. In an insurance
policy, the consideration clause states that the policy owner's consideration consists of completing the
application and paying the initial premium. The consideration clause or provision in an insurance policy also
specifies the amount and frequency of premium payments that the policy owner must make to keep the
insurance in force. The material statements of the applicant must be true. Therefore, the policy owner's
consideration in a life insurance contract is the premium paid and their representations regarding health history
which appear in the application. Again, the insurer's consideration in this life insurance agreement is its promise
to pay a legitimate death claim once it receives a completed proof of loss (i.e., claim form) accompanied by a
notarized death certificate.
If, for some reason, the consideration is not complete on the part of the policy owner, the contract will be void.
Void means that there was never a valid contract and coverage was never in effect.
For example, if the policy owner's check bounces or is returned for insufficient funds, there's no coverage
because there's no consideration. If the check clears the bank, but the insurer later discovers that the applicant
engaged in material misrepresentations concerning their health, there will still be no coverage since there's no
valid consideration. In this latter instance, the insurer will void or cancel the policy and return the premiums to
the policy owner.
[3] INCONTESTABILITY AND MISSTATEMENTS OF AGE
The concept of incontestability limits insurance companies' ability to void policies based on misstatements
made by the insured on an application. The statements in question misrepresent the underlying level of risk
involved in providing coverage to the insured. Misstatements of age, on the other hand, misstate the cost of
coverage without misstating the underlying level of risk. The two types of misstatements affect the policy in
unrelated ways.
[3.1] INCONTESTABLE CLAUSE
The incontestable clause or provision specifies that, after a certain period has elapsed (usually two years from
the issue date), the insurer no longer has the right to contest the validity of the insurance policy as long as the
contract continues in force. Therefore, after the policy has been in force for the specified term, the company
cannot contest a death claim or refuse payment of the proceeds even based on fraud, a material misstatement,
or concealment.
The incontestable clause applies to the policy face amount plus any additional riders that are payable at death.
Although the incontestable clause applies to death benefits, it generally doesn't apply to accidental death
benefits or disability provisions if they're part of the policy. Because conditions relating to accidents vary and are
often uncertain, the right to investigate them is typically reserved by the company.
The insurance company can only contest a claim during the policy's contestable period. Claims outside this
period are generally incontestable. However, there are three exceptions where the incontestable clause does not
apply, allowing the insurer to void the policy at any time:
• Impersonation or Identity: If someone other than the applicant signed the application or completed the
medical exam, the insurer can contest the policy.
• Lack of Insurable Interest: If there was no insurable interest between the applicant and the insured at
the time of application, the contract is invalid, and the insurer can contest it.
• Intent to Murder: If the policy was taken out with the intent to murder the insured for the proceeds, the
insurer can deny coverage as the policy lacks a legal purpose.
A company can always void or cancel a policy for non-payment of premiums.
[3.2] MISSTATEMENT OF AGE OR SEX (GENDER) PROVISION
This provision states that if the insured's age is "misstated" on the application, the policy will not be voided or
canceled. However, the amount of insurance will be adjusted to the amount that would have been purchased at
the premium paid had the correct age been known. In other words, the amount of death proceeds will be
adjusted (up or down) to reflect the appropriate benefit that the premium paid would have purchased at the
correct age.
A death benefit adjustment is involved, whether the age was misstated higher or lower. This means that, even if
applicants lie intentionally about their age to save premium dollars, the insurer would not cancel or void the
policy and would not deny death claims when it discovers an incorrect age. Instead, it will simply adjust the
death benefit or the death claim amount. Therefore, if the insured's age is understated on the application, the
insurer will pay a lower death benefit; if the insured's age is overstated, the insurer will pay a higher or additional
face amount at death. If the insured's sex is misstated, the insurer will adjust the face amount as well. Again, the
insurer will not cancel the policy due to these inaccuracies but will adjust the policy benefit.
For instance, let us assume that Dave, a 35-year-old insured, purchased a $10,000 policy for $100 and, at his
death, it's determined that his actual age of the insured at the time of application was 40. The premium should
have been $125. Therefore, since his age was misstated, the insurer will adjust the death benefit or pay 100/125
or 4/5 of the original death benefit (i.e., $8,000).
[4] RIGHTS OF POLICY OWNERSHIP: OWNER'S PROVISION
[4.1] OWNER'S PROVISION
The owner's provision states that the policy owner possesses all of the rights contained in the policy. In any
insurance policy or contract, the policy owner may name or change the beneficiary, borrow against the cash
value (if applicable), and select the frequency of premium payments (i.e., the premium mode, such as annual,
monthly, etc.). The owner may also choose to transfer one or more of these rights to another party. The transfer of
policy ownership rights is referred to as "policy assignment." Additionally, if the contract is participating, the
policy owner has the right to receive any dividends (also referred to as excess interest credits) payable and to
vote to elect the company's board of directors.
More often than not, the policy owner, the policy payor, the applicant, and the insured are all the same person.
However, as described previously, this is not always the case.
For example, in the case of a juvenile policy, the parent or guardian is the owner, the payor, and the applicant,
whereas the child is the insured. Children do not possess any ownership rights until ownership is transferred to
them.
An additional example could involve a divorce in which, as part of an alimony judgment, a spouse is required to
be the insured and payor of an insurance policy, with the other (ex)spouse listed as the policy owner.
[4.1.1] APPLICANT CONTROL OR OWNERSHIP CLAUSE
If a proposed insured is under the age of majority (i.e., a minor), a parent or guardian is typically the applicant and
the policy owner. When this occurs, the parent may have a provision inserted into the contract that provides
them with full control of the policy until the minor reaches a specific age. Since the applicant is designated as the
person in control of the policy, the provision is most often named "the applicant control clause."
[4.2] ASSIGNMENT PROVISION
Individuals who purchase life insurance policies are commonly referred to as policy owners, rather than
policyholders, because they own their insurance policies and may do with them as they wish. The assignment
provision reiterates one of the policy owner's rights, as stated in the contract. It enables the policy owner to
transfer any or all of their policy rights to another person. This transfer of rights or ownership is referred to as
policy assignment. The previous owner is considered the assignor, and the new owner is considered the
assignee.
Although the policy owner doesn't need the insurer's permission to assign a policy, the assignment provision
outlines the procedure required for the policy owner to transfer or assign ownership rights. Generally, the policy
owner must provide the insurance company with written notification of any assignment. The company will then
accept the transfer's validity without question. Additionally, insurable interest is not required to exist between the
insured and the assignee.
The following is a description from the assignment provision of an actual policy: "The policy owner may assign
this policy. The insurer will not be responsible for the validity of an assignment. The insurer will not be liable for
any payments it makes or any actions it takes before notice of the assignment is provided to it from the policy
owner."
[4.2.1] ABSOLUTE VERSUS CONDITIONAL OR COLLATERAL ASSIGNMENT
An absolute or complete assignment occurs when the policy owner transfers all policy (ownership) rights. In this
case, the entire contract has been transferred to another party. An absolute assignment involves a complete
transfer of the policy to another person. The assignor (original policy owner) typically cannot recover an absolute
assignment. An absolute assignment may also be referred to as a voluntary or complete assignment.
Collateral or conditional assignment occurs when the policy owner assigns one or some of the ownership rights
to another party but doesn't assign all of the policy ownership rights. As such, a collateral (or conditional)
assignment is a partial and temporary transfer of policy rights to another person.
A conditional assignment in life insurance occurs when a policyholder uses their whole life policy's cash value as
loan collateral. The assignee (typically a bank) becomes a primary beneficiary only to the extent of the
outstanding loan amount. Upon the insured's death, the death benefit is proportionally distributed between the
assignee (for the remaining loan balance) and the original primary beneficiary (for the excess amount). This
arrangement, known as a collateral assignment, effectively protects both the lender's financial interest and the
beneficiary's right to the remaining proceeds.
Key critical insights:
• This structure balances the interests of three parties: lender, policyholder, and beneficiary
• The assignment is "conditional" because it's limited to the loan amount
• The arrangement provides financial flexibility while preserving the policy's primary purpose
• It's a secure lending mechanism since life insurance policies have guaranteed death benefits
• [4.2.2] POLICY ASSIGNMENT AND BENEFICIARIES
• Although a more detailed review of beneficiaries will be provided in a later chapter, let's now focus on
examining the provisions related to this topic.
• The inclusion of the revocable beneficiary provision means that policy owners may modify, alter, or
change the beneficiary at any time and at their discretion. This is one of the owner's rights as provided
by the policy. If the owner wants to change the beneficiary, the owner may simply request a "change
of beneficiary form," complete it, and return it to the insurer.
• With an irrevocable beneficiary provision, the policy owner or a court of law may designate an
irrevocable beneficiary. In this case, the beneficiary designation cannot be changed or modified
without the permission or consent of the named beneficiary. If a policy owner names an irrevocable
beneficiary, the policy owner must obtain the irrevocable beneficiary's agreement prior to any
assignment. Furthermore, an assignee typically does not have the ability to change an irrevocable
beneficiary designation. However, the assignee could change a revocable beneficiary.
• An irrevocable beneficiary may be able to assign a portion (or all) of the proceeds in a similar fashion
as the policy owner. However, in general, if the beneficiary dies prior to the insured, any assignments
made by that beneficiary are no longer valid unless the policy owner also agreed to the assignment in
writing.
[4.3] FREE-LOOK PROVISION
When a policy is delivered, the Free-look (also called “Right to Examine”) provision allows the new owner to
review the contract for a specified number of days. If the new policy owner decides not to keep the policy, they
may return it to the insurer as long as this is accomplished within a specified number of days from the delivery
date. If the new policy owner decides to take this course of action and return the policy to the insurer, they will
receive a full return of premium. The free-look provision is also known as the "right to examine" provision. This
provision allows the policy owner to return the policy for a full premium refund without providing a reason. A free-
look provision must be included in all forms of life insurance, except for flight or aviation insurance.
Mandatory free-look periods vary in each state, but they're generally within 10 days of the delivery date.
Depending on the state, additional requirements may apply for variable policies or senior applicants. The free-
look period begins when the policy owner receives the policy. Most insurers require policy owners to sign a dated
delivery receipt upon receiving their policy, and this receipt triggers the start of the free-look period. To receive a
premium refund, the policy must be returned within the specified number of days from the date it is received.
For example, if a policy is delivered to the new owner on January 25, the 10-day free-look period begins on
January 25 and ends 10 days later. In this case, the free-look period ends on February 4. To arrive at the correct
answer, the day after the policy is delivered (January 26) should be counted as day one.
[4.4] MODE OF PREMIUM (PREMIUM PAYMENT) PROVISION
The "mode of premium" provision states that premiums must be paid to an insurer or its representative for
coverage to be provided and allows policy owners to select the mode (frequency) of premium. Insurers vary in
the payment modes they offer. Policy owners can choose from the available options.
Some policy owners may choose to pay annually. Those who do will save the most money (i.e., have lower
premiums) because annual premium payments result in lower administrative and maintenance costs for the
insurer. These savings are typically passed to policy owners. The other methods for paying premiums include
quarterly, semiannual, or monthly. Since insurers incur substantially higher administrative and maintenance
costs when premiums are paid monthly, it is considered the costliest method.
[4.5] GRACE PERIOD PROVISION
Grace periods are standard in many other financial products, such as consumer loans, mortgages, and credit
card payments. In a life insurance policy, the grace period is meant to protect the policy owner from an
unintentional policy lapse. A grace period is the time following the premium due date during which coverage does
not lapse even if the premium has not been paid. This period is generally 30 days, or one month, unless
otherwise required by state law. Coverage remains in effect for the days following the due date. Additionally,
some states may have specific laws governing grace periods for senior policy owners.
The insurer offers this grace period because it wants to keep business "on the books." If the insured dies during
the grace period and before a premium has been paid, the death benefit will be paid less a pro rata share of the
owed premium. A primary purpose of the grace period, as well as the reinstatement and automatic premium loan
provision, is to keep a life insurance policy in force even when a premium payment is late. Keeping the policy in
force prevents the life insurance company from requiring the insured to prove their insurability again and prevents
the insurer from charging a higher rate for the insured's increased age.
[4.6] REINSTATEMENT PROVISION
If a policy lapses because premiums are not paid, many life contracts allow reinstatement, generally provided it
is requested within three years of the lapse. However, the request is not the predominant factor. The insurer will
require proof of insurability or good health, and all outstanding back premiums (plus interest) must be paid to the
insurer before reinstatement is granted.
A principal reason for a policy being reinstated is that the contract owner wants to "reinstate" the initial premium
rate as well as the coverage limit. Other than an insured's coverage being reinstated, the most crucial advantage
of reinstating an insurance policy is that the policy's premium will continue to be based on the insured's age at
the time of the initial application (i.e., the applicant's original age).
Whenever a policy is reinstated, a new two-year contestable period begins for statements made on the
reinstatement application. However, there's no new suicide exclusion. A policy cannot be reinstated if it was
surrendered (i.e., given up by the policy owner).
[5] PROVISIONS AND OPTIONS RELATED TO CASH VALUE
The following provisions are associated with the cash value of a whole life insurance policy. There are two
primary types of cash value provisions – those involving policy loans and those involving policy surrender.
Provisions for a policy loan allow a policy owner to use the cash value of a life insurance policy without
surrendering the policy. Provisions for policy surrender allow the policy owner to surrender the policy without
losing all of its equity.
[5.1] EXCESS INTEREST PROVISION
The excess interest provision in life insurance means that the cash value will increase faster than the guaranteed
rate if the insurer earns a greater return than the guaranteed rate. Therefore, the excess interest provision allows
interest that exceeds the policy's guaranteed rate of interest to be credited to the cash value account.
Excess interest can be applied using either the index-linked method or the portfolio method.
• Index-linked method: Credits the excess interest from earnings tied to an economic indicator (e.g., the
Consumer Price Index).
• Portfolio method: Credits the excess interest in direct relation to the insurance company's earnings on
its investments.
[5.2] POLICY LOAN PROVISION
Permanent or whole life insurance builds cash value. The policy loan provision, which is required in all whole life
policies, states that the policy owner has the right to access their equity at their discretion. This provision, which
is supported by the previously reviewed owner's rights provision, permits the owner to receive an advance
against the cash value buildup of the whole life policy.

[5.2.1] STRUCTURE OF A POLICY LOAN

A policy "loan" cannot be "called" by the insurance company and can be repaid at any time by the policy owner.
Additionally, policy loans don't require credit checks, proof of income, or other things commonly associated with
taking out a loan. Remember, the policy owner is essentially borrowing funds from the insurer and using the cash
value as collateral. Technically, the policy owner is making a collateral assignment of cash value that equals the
amount borrowed. Typically, the only qualification for a policy owner to take out a policy loan is that the policy
must have accumulated cash value available to secure the loan (i.e., act as collateral). However, if the policy
contains an irrevocable beneficiary, the policy owner must secure permission from the irrevocable beneficiary to
borrow against the cash value.
The maximum loan value of a whole life policy is generally its cash value, less any projected interest. Therefore,
policy owners may make withdrawals or partial surrenders in amounts that don't exceed the cash value, less the
interest. Although the loan doesn't need to be repaid, any outstanding policy loans or interest at the time of the
insured's death will reduce the policy's face amount. Additionally, if the policy owner later chooses to surrender
the policy for cash, the cash value available to the policy owner is reduced by the amount of any outstanding
loan, plus interest. Other surrender options (i.e., extended term or reduced paid-up) would also take any
outstanding policy loans into account when determining the term period or reduced face value. Taking a loan
permits the person to keep the whole life policy in force and use the borrowed funds when cash is needed.

[5.2.2] POLICY LOAN INTEREST

Keep in mind that while policy owners may be borrowing "their money," the insurance companies planned to use
that money as an investment to return an estimated amount of interest. This estimated interest is a crucial
component for an insurance company to fulfill its obligations.
Policy loans reduce the amount of funds that an insurer has to invest and, accordingly, reduce the interest that
the insurance company can accumulate. Policy owners are required to pay interest on these loans to offset the
interest the insurance company would have earned if the funds were invested.
Interest rates on policy loans can vary by company. Most states set the maximum allowable fixed interest rate at
8%-10%. If the interest rate is variable, the company may set a new rate each policy year. Variable interest rates
are usually tied to a market index, such as the Moody’s Corporate Bond Index.
The policy owner may pay off the interest each year. If the policy owner does not make a scheduled interest
payment on a policy loan, the unpaid interest will be added to the loan balance. If the policy loan balance (plus
interest) ever exceeds the life insurance policy's cash value, the policy will lapse (no longer be in force).
[5.2.3] AUTOMATIC PREMIUM (OR POLICY) LOAN PROVISION
The automatic premium loan (APL) provision is an optional financial safety mechanism in permanent life
insurance policies, designed to prevent unintentional policy lapses. Think of it as an automated backup system
that kicks in when traditional premium payments fail.
When a policyholder misses a premium payment and the grace period expires, the APL automatically initiates a
loan against the policy's cash value to cover the missed premium. This mechanism offers a critical advantage to
policy owners by preventing an accidental policy lapse without active intervention. It provides peace of mind at
no additional charge. Of course, an APL provision only works if there is sufficient cash value. Also, it creates a
policy loan and, over time, could deplete the policy’s cash, ultimately leading to a policy lapse.
[5.2.4] USES OF A POLICY LOAN
Individual Uses: The primary advantage of a policy loan is that it provides the policy owner with ready cash
without having to apply for or qualify for a loan. Whether it’s to pay debts, pay for emergencies, pay for education
expenses, or to be used for a business purpose, a policy owner may use the cash value for any reason when they
need cash. The cash value may also be used as collateral to secure another loan with a lending institution.
Business Uses: Businesses may take out life insurance to safeguard against a number of different risks. As the
policy’s cash value grows, the company may take a policy loan for any reason it deems necessary. Business
policy loans are subject to the same rules as individual policy loans regarding structure, interest, and repayment.
The original purpose for the company's decision to take out the policy may be significantly impacted if the policy
proceeds are reduced due to an outstanding loan.
[5.2.5] TAXATION
In general, policy loans may be taken out of an individual whole life policy without any tax implications as long as
the policy remains active. However, this changes if the policy lapses or is surrendered, and there is an
outstanding loan greater than the total premiums paid. When a policy with an outstanding loan is lapsed or
surrendered (before the insured's death), any gains (i.e., the amount received via policy loan that exceeds the
premiums paid) will be taxed as ordinary income. Additionally, interest paid to the insurer on a policy loan is not
tax-deductible. Tax implications for policy loans that are taken on business-owned life insurance are beyond the
scope of this course.
[5.2.6] RIGHT TO DEFER LOAN
While not often used, insurers typically have the right to defer a policy loan or the payment of the cash value (in
most states, this can be for up to six months after its request). This right to defer is designed to protect an insurer
if a large number of policy owners decide to make withdrawals at the same time. However, this right to defer
doesn't apply to death benefit claims or automatic premium loan payments.
Even if the policy doesn't contain an automatic premium loan provision, if the policy owner informs the insurer
that they want to borrow against the policy's available cash value to pay the premium, the company cannot defer
the loan.
[5.3] NON-FORFEITURE CASH VALUES
In the past, if a policyholder missed a premium payment and the grace period ended, the policy would lapse, and
they would lose any accumulated equity. To address this, many states adopted the standard non-forfeiture law,
allowing policyholders to access their cash value even if they stop paying premiums. The cash value and its
growth rate depend on the policy type and company, and any loans taken out will reduce the cash value.
Insurers must offer cash surrender values for whole life insurance after three years, though some policies
generate cash values within a year. There are three non-forfeiture options for policyholders who surrender their
whole life policy: surrender for cash, reduced paid-up insurance, and extended term insurance. These options
ensure that policyholders do not lose their accumulated cash value or equity. Once a policy is surrendered, it
cannot be reinstated. Non-forfeiture options guarantee that a policy with cash value will not lapse, recognizing
the equity built up in the policy.
[5.3.1] CASH SURRENDER OPTION
Policy owners may request an immediate cash payment of their cash values when their policies are surrendered.
Any outstanding policy loans or debts reduce the amount of cash value that the policy owner will receive.
The cost recovery rule states that when a life policy is surrendered for its cash value, the cost basis (total
premiums paid) is exempt from taxation. If the amount received in a cash surrender is greater than the total of
premiums paid (minus dividends paid), the excess is taxable as ordinary income. A partial surrender will allow
the policy owner to withdraw the policy's cash value interest-free.
[5.3.2] REDUCED PAID-UP OPTION
A second non-forfeiture option is to accept a paid-up policy for a reduced face amount of insurance. By doing
this, the policy owner uses the policy's cash value as the premium for a single-premium whole life policy at a
lesser face amount than the original policy. When this option is exercised, the paid-up policy is a cash value
policy like the original, but for a lesser amount of coverage. This means that if the original policy was a
participating policy, the new policy will also be a participating policy. Once the paid-up policy has been issued,
the new face value remains the same for the life of the policy. Additionally, as with all whole life policies, the new
policy will also build cash value.
The insured's current attained age is used for premium calculation, but proof of insurability is not required since
the benefit is being reduced. Additionally, riders and accidental death benefits from the original policy are
excluded from the premium calculation and are dropped from the new policy.
When an insured selects this option, they have recognized the need for permanent life insurance but no longer
want to continue making premium payments. Therefore, this is the option that provides the policyholder/insured
with life insurance coverage for the longest period (i.e., permanent whole life protection).
[5.3.3] EXTENDED TERM OPTION
The extended term option permits the policy owner to surrender the policy and use the cash value to purchase a
paid-up level term insurance policy. Unless a policy loan is outstanding, the face amount of extended term
coverage is identical to the original whole life policy's face amount. No more premium payments are made once
the Extended Term option is activated.
Since all elements in a traditional whole life policy are predetermined, the policy owner knows precisely what the
cash value will be in any given year. When this option is exercised, the policy’s non-forfeiture table shows how
long the coverage will last with the given cash value (i.e., 11 years and 165 days).
Extended Term is the default option when a whole life policy lapses, and it is automatically activated.
If there is an outstanding policy loan when the policy is surrendered, the loan balance is deducted from the cash
value, and the net cash value buys a paid-up extended term policy with a shorter period.
The extended term insurance option provides the insured with the most life insurance protection (i.e., the highest
face amount) in the event of a voluntary policy surrender or non-payment of premium.
[6] PROVISIONS AND OPTIONS RELATED TO POLICY PROCEEDS
When applying for life insurance, policy owners must understand the purpose of the policy they want to
purchase. Who's the policy designed to protect (i.e., a child, a spouse, a charity)? What's the policy's intended
purpose (i.e., income replacement, debt reduction, estate creation)?
One important element policy owners should consider when purchasing life insurance is the availability of
settlement options—the ways death proceeds are paid at the time of an insured's death. In most cases, the
selection is made by the beneficiary at the time of the insured's death. However, the policy owner may select a
settlement option at the time of application. Failure to arrange for the proper payment of proceeds may defeat
the very purpose for which the insurance was intended.
Living benefits allow a policy owner to receive a portion of the policy proceeds while the insured is still alive. The
insurer will typically require the policy owner to have a physician certify that the insured has a qualifying
condition (i.e., terminal illness) before providing access to living benefits.
[6.1] BENEFICIARY DESIGNATION PROVISIONS
The policy owner has the right to designate who will receive any policy proceeds upon the insured's death (i.e.,
the beneficiary). The beneficiary designation is part of the entire contract. Later in this course, there will be a
closer examination of the types of beneficiary designations and unique circumstances that can arise.
Beneficiaries are not required to sign the application or be notified of their designation. The policy owner may
change the beneficiary at any time, provided the beneficiary is not irrevocable.
[6.2] SETTLEMENT OPTIONS PROVISION
The settlement options provision outlines the various ways that the policy's death benefit may be paid to the
beneficiary, as well as who has the authority to decide how the funds will be distributed.
All life insurance policies include a variety of settlement options that are available to a beneficiary when an
insured dies. The settlement options provide the beneficiary with greater flexibility in receiving proceeds. The
principal method of paying death proceeds is a lump sum. In this manner, the beneficiary receives the policy
proceeds income tax-free in a single payment.
Following the insured's death, if any settlement option other than the lump-sum option is used, the proceeds will
remain with the insurer and be paid in installments. The insurance company must pay interest on the proceeds
that remain with them. The interest credited to or paid to the beneficiary is taxable as ordinary income.
The various settlement options available and when they may be used will be examined later in the course.
The spendthrift clause protects a death benefit against the claims of a beneficiary’s creditors as well as the
beneficiary’s own poor financial decisions. It prevents creditors from claiming a right to death benefit funds yet to
be paid by the insurer in the form of a settlement option over time. The clause only applies to non-lump-sum
settlement options.
[6.3] WITHDRAWAL PROVISION
The withdrawal provision is often used when the policy proceeds are held by the insurer and earn interest. This
provision outlines the steps and requirements for withdrawing any funds left on deposit with the insurer. The
beneficiary may have the option to withdraw all of the funds or only a limited amount each year.
[6.4] ACCELERATED DEATH BENEFITS PROVISION (TERMINAL ILLNESS RIDER)
The accelerated death benefits provision allows an insured to "accelerate" the death benefit of a life insurance
policy while still living if a physician diagnoses and verifies that the insured is suffering from a terminal illness and
is likely to die within 12 to 24 months or less. The accelerated benefits provision is typically added to a policy
through an accelerated benefits rider or terminal illness rider. Specific conditions for payment must be satisfied
for a benefit to be paid. This provision, or rider, is typically offered without a premium increase.
The insured may receive up to a specific percentage (which varies by company) of the death benefit. Any amount
paid out under the accelerated benefits provisions will be subtracted from the face value at the time of the
insured's death. This is referred to as the effect on the death benefit. Accelerated payment can be made in a
lump sum or in monthly installments over a specified period (e.g., one year) and is received tax-free if the insured
is terminally ill.
For example, a $100,000 policy providing a 75% accelerated benefit will pay up to $75,000 to the terminally ill
insured. The remaining $25,000 is payable as a death benefit to the beneficiary when the insured dies.
[6.4.1] DISCLOSURES
When applying for a policy with accelerated benefits, customers must receive a summary of coverage detailing
the benefit, the triggers for payment, and the effects on the cash value, accumulation account, death benefit,
premiums, and policy loans.
If the benefit is exercised, the insurer must illustrate the impact on the policy, including:
• Effect on cash value, accumulation account, death benefit, premiums, and policy loans
• Statement on potential adverse effects on Medicaid or other government benefits
• Statement on possible tax implications
• Advice to consult a tax adviser
[6.4.2] VARIATIONS
Another type of accelerated benefit is the catastrophic, chronic, or critical illness coverage rider (i.e., dread
disease coverage). The terms of this coverage are similar to the terminal illness rider except that the covered
disease must be identified or listed in the policy (e.g., cancer, heart disease, renal failure, stroke, cancer, AIDS,
etc.).
Additionally, the rider may provide benefits for those unable to perform at least two activities of daily living
(ADLs), such as eating, bathing, toileting, dressing, transferring, and continence.
[6.5] LONG-TERM CARE RIDER
Some accelerated benefits are available by adding a long-term care rider to a life insurance policy. If an insured is
permanently confined to a nursing home and requires long-term care, the policy rider will pay a benefit. A long-
term care rider can help safeguard against the financial burden of long-term care. These riders may be added to
individual or group policies. For the insured to qualify for an accelerated benefit under a long-term care rider, the
(long-term) confinement must be covered by the rider, or additional requirements must be satisfied.
The long-term care rider, similar to an individual long-term care policy, will generally pay benefits when the
insured is unable to perform at least two of the basic activities of daily living (ADLs): eating, dressing, bathing,
toileting/continence, walking/ambulation, transferring, or taking medication.
There are two different ways that a long-term care rider may be designed. When designed using the generalized
or independent approach, the long-term care rider is recognized as independent from the base life insurance
policy. As such, the base policy's face amount or cash value is not impacted by any paid-out benefits. When
designed using the integrated approach, the base policy's death benefit and/or cash value will be reduced by any
long-term care benefits paid out.
Suppose Alex purchases a life insurance policy with a $200,000 death benefit and adds a long-term care rider.
o Generalized (Independent) Approach: If Alex triggers the long-term care rider due to illness,
they receive long-term care benefits, say $40,000, without reducing the life insurance policy’s
face amount. After receiving these benefits, if Alex passes away, their beneficiaries would still
receive the full $200,000 death benefit, because the rider’s payments are independent and do not
impact the core policy value.
 o Integrated Approach: In contrast, if Alex’s policy uses the integrated design and they claim
$40,000 in long-term care benefits, the policy’s death benefit is reduced accordingly. So, if Alex
passes away after using the rider, the beneficiaries would receive only $160,000, reflecting the
amount already paid out for care.
This example highlights how the two designs affect both the insured’s access to long-term care funds and the
ultimate payout to beneficiaries.
[7] POLICY DIVIDENDS AND DIVIDEND OPTIONS
As described previously, mutual insurers issue participating or par insurance policies and, as such, provide their
policy owners the opportunity to receive dividends. Mutual companies can issue only participating policies.
An insurance dividend is not considered taxable income because it's a return of an overpayment of
premium. Therefore, insurance dividends are tax-exempt. During the sale of insurance, producers cannot inform
an applicant that dividends are guaranteed. Most states require a policy that provides a choice of dividend
options to include a statement that dividends are not guaranteed. A producer is allowed to provide illustrations or
documentation to an applicant that verifies the payment of dividends in previous years by the insurer.
The source of funds from which policy dividends are paid includes mortality, interest, and expenses. At the end of
each year, the insurance company will review the money it received (premium payments), the gain (interest)
generated by that money, the annual operating costs (loading expenses), and the claim expenses paid out
(mortality). The mutual insurer that experiences excess surplus after paying claims and other operating expenses
pays dividends to its policy owners.
Dividends typically become payable after the first or second policy year and are generally paid on policy
anniversary dates. The policy owner may inform the insurer of the dividend option they select. This option will
remain the same until the policy owner requests another option.
[7.1] DIVIDEND OPTIONS
If a policy owner is entitled to a dividend, they can choose to receive the dividend as Cash, Reduction of
Premiums, Accumulation at Interest, Paid-Up Permanent Additions, Paid-up Policy, or One-Year Term. An easy
way to remember these options is the acronym CRAPPO.
[7.1.1] CASH
Cash: If the policy owner is entitled to a $50 dividend, they may request that the insurer send the payment
directly to them. Again, received insurance dividends are tax-exempt.
[7.1.2] REDUCTION OF PREMIUM
Reduced, Reduction, or Suspension of Premiums: If the policy owner's annual premium is $250, and they
discover they're entitled to a $50 dividend, they may choose to direct the insurer to retain the dividend and
subtract that amount from the upcoming premium. The policy owner then pays $200 for the year's premium. This
dividend option assists the policy owner whose primary objective is to conserve cash, since the policy owner is
not required to remit the entire annual premium. The premium reduction option may be the dividend option used
by the policy owner to minimize their current outlay of funds.
[7.1.3] ACCUMULATE AT INTEREST
Accumulate at Interest: Under this option, the policy owner directs the insurer to retain the $50 dividend in a
designated account. When this occurs, the insurer must pay interest on the dividend(s) it holds. Although the
dividend is tax-exempt (not taxable), any interest earned on dividends left with the insurer is taxable as ordinary
income in the year in which the interest is credited, regardless of whether the policy owner receives it. When
death occurs, the life insurance policy pays out the face amount plus any dividend accumulations. In the event of
a policy surrender, the cash value and accumulated dividends will be paid to the policy owner.
[7.1] DIVIDEND OPTIONS (continued)
[7.4] PAID-UP ADDITIONS
Paid-Up Additions (PUAs): Also known simply as paid-up permanent additions , the policy owner may elect to
use the $50 dividend to purchase additional permanent whole life insurance. The amount that can be purchased
will be based on two criteria:
• The current age of the insured, and
 • The dividend amount
The insured is not required to prove insurability. Since there's no investigation to determine the insured's health
and no agent to whom commissions are paid, the operating expenses or load charge for issuing PUAs is
substantially lower than for issuing other insurance coverages. The dividend amount is the premium used to
purchase a small amount of permanent paid-up life insurance. In other words, the dividend is used to purchase a
small face amount of single-premium life insurance. Each paid-up addition also has cash value. Therefore, this
option provides an increase in the policy owner's cash value. If this option is used, it increases the total death
coverage to its maximum.
EXAM TIP
Do not confuse the dividend option, "Paid-up Additions," with the non-forfeiture option, "Reduced paid-up
Insurance." Paid-up additions increase the death benefit rather than reduce it. With a reduced paid-up option,
the face value is REDUCED to the amount that the policy's present cash value could afford if it's used to
purchase a single-premium policy.
[7.5] PAID-UP POLICY
Although uncommon, a policy dividend may be used to pay up a policy earlier than expected or as originally
planned. In such cases, policy owners continue to pay their normal premium and use the dividends as additional
payments toward the overall cost of their insurance. The option was designed for use with adjustable life
insurance contracts. The option is analogous to making additional mortgage payments to pay off their mortgage
early.
EXAM TIP
Don't confuse paying a policy up using dividends with the reduced paid-up non-forfeiture option. With this
dividend option, the policy (including the original face value) remains fully intact. With a reduced paid-up option,
the face value is REDUCED to the amount that the policy's present cash value could afford if it's used to
purchase a single-premium policy.
[7.1.6] ONE-YEAR TERM
One-Year Term Insurance: The $50 dividend can be used to simply purchase any type of term insurance that the
insurer offers. The one-year term option is the dividend option that provides the policy owner with a different type
of life insurance (i.e., term life insurance) than that which is provided by the primary policy (i.e., whole life), paying
the dividend.
This option may be used to purchase as much term insurance as possible up to the base policy's cash value. Any
excess dividend portions may be applied to any of the other dividend options. It may also be used to provide a
face amount of life insurance equal to the amount of a policy loan taken against the cash value of the whole life
policy.
For example, the policy owner with an outstanding loan can use this option to buy more life insurance just in case
the insured dies before the loan is repaid.
The one-year term insurance dividend option requires a specific application and the issuance of a separate rider.
If this option had been selected since the policy's inception, proof of insurability is typically not required.
However, if the policy has been in force for several years with a different dividend option, the insurer may require
evidence of insurability.
[8] LIFE INSURANCE POLICY RIDERS
One of the unique features of a life insurance contract is the ability for the policy owner (typically the applicant
and insured) to customize the policy to meet their specific needs through policy add-ons (also referred to as
riders or endorsements). Riders are special policy provisions that provide benefits not found in the original
contract or that make adjustments to the policy.
Since many of these riders provide additional benefits to the policy owner, their inclusion typically increases the
policy's cost (i.e., an additional premium).
Adding policy riders, like customizing a new vehicle with leather seats, a sunroof, or an extended warranty, all
cost additional money.
Riders are generally added at the time of application; however, in some circumstances, the policy owner may add
a rider after the policy is issued. If the policy owner allows the policy to lapse, any additional riders added to the
policy will cease, even if the lapsed policy is automatically converted to another type of coverage as provided in
the original policy.
[8.1] PREMIUM WAIVERS
[8.1.1] WAIVER OF PREMIUM RIDER
The waiver of premium rider ensures that an insurance policy remains active if the insured becomes totally
disabled. After the waiting period stated in the contract—usually six consecutive months of total disability— the
insurer waives future premium payments until the insured returns to work. During this period, the insurer
effectively makes premium payments, allowing the policy's cash value to accumulate and dividends, if
applicable, to be paid as usual. Some companies will reimburse premiums paid during the waiting period. If the
insured recovers, they resume premium payments without repaying the premiums that were waived.
This rider is optional and requires an additional but generally affordable premium. It can be added to both term
and permanent life insurance policies. The rider typically expires when the insured reaches a specified age,
usually between 60 and 65. If the insured becomes disabled before the rider expires, premiums will continue to
be waived even if the waiting period extends past the cutoff age.
To qualify for the waiver, the insured must be under a physician's care and meet the policy's definition of total
disability, which can vary. Some policies define total disability as the inability to perform one's own occupation,
while others use a broader definition, such as the inability to engage in any gainful employment. Some policies
may combine these definitions, applying the "own occupation" standard for an initial period and then switching
to the "any occupation" standard.
The rider does not provide income or alter the policy's coverage. It typically excludes disabilities resulting from
acts of war, self-inflicted injuries, or criminal activities. If premiums are paid during the initial six months of
disability, they will be refunded from the first day of disability.
[8.1.2] WAIVER OF COST-OF-INSURANCE RIDER
The waiver of cost-of-insurance rider – also referred to as the waiver of monthly deductions – is typically
reserved for universal life policies. Premiums for a universal life policy can fluctuate. For this reason, insurers
generally only offer to waive the monthly cost of the insurance, not the total premium paid by the insured. In this
case, the cash value will remain level and continue to collect interest, but it will not grow to the extent that it
would have had the full premiums been paid.
In some cases, a company may write the rider to waive the guaranteed minimum annual premium instead of the
monthly cost of insurance. In this case, the policy's cash value will grow by the additional premium payment
minus the actual cost of insurance. The cash value will also continue to collect interest.
[8.2] PAYOR BENEFIT RIDER
The payor rider, also known as the payor benefit provision or payor clause, is added only to a policy an adult
purchases to cover the life of a child or juvenile. This rider waives premiums until the child reaches a specified
age (usually 18, 21, or 25) if the premium payor (i.e., parent or guardian) dies or becomes totally disabled.
• The insurer, not the policyowner, now pays every scheduled premium that would have been due on the
base policy and all riders included at issue.
• No late-payment notices or policy-lapse danger while the waiver is in force.
• Whole-life or universal-life cash values, dividends, or interest credits accrue as though every premium
were being paid in full and on time.
• Any benefits tied to cash value—e.g., loan availability or paid-up insurance options—remain intact.
• Supplemental riders such as the guaranteed-insurability options, accidental-death benefits, and term
riders, e all remain in force because the premiums that support them are being waived.
• If the payor recovers from disability before that terminal age, most contracts still keep the waiver in place;
a few may restart premiums after a recovery period.
• The original owner (often the surviving parent or a trust) still controls beneficiary designations, policy
loans, and other contractual rights.
The face amount stays exactly the same; the waiver does not convert the coverage to paid-up or reduce
it. Waived premiums are not considered taxable income to the policyowner. Also, the insurer cannot “claw back”
the premiums later; the waiver is a contractual benefit, not a loan.
The rider covers only the policy's premium payments; it does not provide any income or death benefit to the
child.
Exam Tip!
Don't confuse the payor rider with the guaranteed insurability rider. The guaranteed insurability rider may be
added to a policy that covers an adult or child and allows the insured to buy more insurance (as an adult) without
a medical exam. The payor rider waives the premiums required for a child’s life insurance policy when they payor
dies or becomes disabled.
[8.2.1] PAYOR BENEFIT RIDER SCENARIO
The example timeline below highlights a payor benefit rider scenario:
• Mom and Dad purchase a $50,000 whole-life insurance policy on newborn Ava. Mom is the payor; Dad is
the owner. The payor benefit provision states that premiums will be waived up to the insured reaching age
21, if the policy’s payor dies or becomes totally disabled before the insured child reaches age 21.
Year 4:
• Mom suffers a qualifying total disability.
• The rider activates and the company begins paying the $480 annual premium.
Years 5-20:
• The policy’s cash value, dividends, and any riders remain fully active and build exactly as if Mom had paid
$480 every year.
Ava’s 21st birthday:
• Waiver ends. Premiums resume and Dad (or Ava, if ownership is transferred) is now responsible for future
payments—or can choose to use dividends/cash value to keep the policy paid-up.
Bottom Line
Once executed, a payer rider turns the life insurer into the premium payer for the rest of the rider period.
Coverage continues undiminished, cash values grow normally, and all other riders remain effective, relieving the
family of the financial burden at precisely the time they are coping with the loss or disability of the premium-
paying parent or guardian.
[8.3] DISABILITY INCOME BENEFIT RIDER
The disability income benefit rider provides an income benefit if the insured is totally and permanently disabled
as defined by the policy. Most disability income benefit riders provide for a small, stated benefit, such as 1% of
the face amount of the policy, that is payable if the insured is totally disabled. The monthly income paid is
generally limited to no more than $1,000 per month. Income benefits begin after the stated waiting period
previously described.
For example, if Jim owns a $20,000 life insurance policy with this rider included and becomes totally disabled, he
will be paid $200 per month (1% of $20,000).
The disability income benefit rider contains the same type of qualifications and structure as the waiver of
premium rider. In fact, most disability income benefit riders waive the premium in addition to including a disability
income benefit.
Exam Tip!
In the event of an insured's total and permanent disability:
• The waiver of premium rider covers the policy's premiums during total and permanent disability
• The disability income rider provides the insured with a monthly income based on the policy's face amount
during a period of total disability
[8.4] ACCIDENTAL DEATH BENEFITS
[8.4.1] ACCIDENTAL DEATH BENEFIT RIDER (DOUBLE INDEMNITY)
The accidental death benefit (ADB) rider may also be attached to a life insurance policy for an additional
premium. This rider provides an additional death benefit by multiplying the face policy’s amount when the cause
of death is an accident. Policies that pay a multiple of two times the policy face amount are referred to as double
indemnity, while those that pay three times the death benefit for death due to accidents are referred to as triple
indemnity, and so forth.
This rider often includes a restriction that the insured must die within 90 days of the accident for the ADB to be
paid. Therefore, the rider typically doesn't provide any coverage if the insured dies more than 90 days after the
accident. Statistically, in such cases, the cause of death is not accidental, but more likely due to heart, kidney, or
liver failure, pneumonia, or some other type of "non-accidental" cause.
For example, if the insured suffers a fatal heart attack or stroke while driving a car, and the car crashes into a tree,
the policy will not pay the rider benefit.
Exam Tip
The accidental death benefit will not be paid if the death is due to “complications.” This is a potential test point.
Remember, the cause of death that appears on the death certificate indicates whether the insurer pays the
claim.
Additionally, the definition of "accidental death" doesn't include accidents resulting, directly or indirectly, from
an ailment or physical disability relating to the insured. Accidental deaths resulting from self-inflicted injury, war,
riot, insurrection, or private aviation activities are also excluded.
An accidental death rider provides an additional death benefit for a limited period at the lowest possible cost.
Typically, the extra protection generally expires after the insured reaches the age of 60 or 65. The benefit also
drops off if the policy owner surrenders the policy and selects one of the non-forfeiture options.
[8.4.2] ACCIDENTAL DEATH AND DISMEMBERMENT (AD&D) RIDER
Some accidental death riders may include dismemberment benefits as well. The death benefit paid under
accidental death coverage is referred to as the principal sum. The dismemberment (severance) benefit paid
under the accidental death and dismemberment rider is referred to as the capital sum and is most often one-
half of the principal sum.
Dismemberment is usually defined as the loss of an arm or hand, or the loss of a leg or foot. Most policies also
pay dismemberment benefits for presumptive types of disability, such as the loss of sight or hearing. The
principal sum may be paid when an insured suffers more than one dismemberment.
For example, if a $50,000 AD&D benefit is purchased, and the insured suffers a loss of hearing, the policy will
pay a (capital) sum of $25,000 (i.e., 50% of the principal sum).
[8.5] GUARANTEED INSURABILITY OPTION RIDER
The guaranteed insurability option (GIO) allows a policy owner to purchase additional life insurance coverage at
specified dates without providing evidence of insurability (i.e., no medical exam required). Insurers offer this
option on a "use it or lose it" basis. The rider expires if the insured declines to exercise the option, so as to
reduce the risk of adverse selection.
Since this rider specifies specific dates on which additional life insurance policies can be purchased, the policy
owner can only make purchases using this option on those days or within a short window (generally 90 days).
Typically, the older the insured gets, the fewer opportunities the policy owner has to purchase more life
insurance. The rider may also allow the policy owner to purchase additional coverage at various milestones (e.g.,
marriage or the birth of a child). The birth of a child is often referred to as the stork provision.
The option amount is the maximum life insurance that a policy owner can buy on the specified date (option date).
The policy owner can buy the option amount or less on the option date, or none at all. However, the option
amounts cannot be added from one option to another if the earlier option date was not exercised. Premiums for
new coverage purchased under this rider are calculated using the standard premium rates for the insured's
attained age. The cost for the new coverage purchased under this rider is calculated on the basis of the insured’s
attained age.
Although the concept is the same from company to company, the official name may vary. Other names used to
refer to the same type of rider include the guaranteed purchase option (GPO), the insurance protection rider
(IPR), or the future increase option (FIO).
[8.5.1] GUARANTEED INSURABILITY OPTION SCENARIO
For example, let us say Maria and Daniel purchase a $25,000 whole-life policy on their newborn son, Leo. For an
extra $3 per month, they add the Guaranteed Insurability Option (GIO) rider.
How the rider works in Leo’s case:
• Issue date (Age 21)
• Base coverage: $25,000
• GIO rider: Gives Leo the contractual right to buy up to $25,000 of NEW permanent coverage (called an
“option amount”) at each future option date—no questions about health, hobbies, or occupation, and at
the smoker/nonsmoker rate class he already has.
• Guaranteed option milestones written into the rider include Leo reaching age 24, 27, 30, 33, 36, and 39.
• Loe can also substitute one of the age milestones for a life-event trigger, such as marriage, the birth or
adoption of a child, or the purchase of a first home.
NOTE: If Leo exercises every option, he can add $25,000 × 6 = $150,000 of additional insurance, bringing his
total lifetime coverage to $175,000. The premium required for these increases will be based on Leo’s age at the
time of the increase.
[8.5.1] GUARANTEED INSURABILITY OPTION SCENARIO (CONTINUED)
How the story may unfold
Age 24 – First full-time job with aviation hobby: Leo is now a recreational pilot. Traditional life insurers would rate
him up or decline him, but the GIO rider lets him buy $25,000 of new whole-life coverage at the standard non-
smoker rate. He sends in the short option form and the first premium.
Age 26 – Marriage (event option): Rather than wait until 27, Leo files to “advance” the next option because Leo is
getting married. Another $25,000 is issued.
Age 29 – Birth of twins: The event replaces the 30-year-old birthday option. Leo buys a third $25,000 block.
Age 33 – Startup business loan requires collateral: Leo exercises the regular age-33 option, adding $25,000
more. Now total coverage = $125,000.
Age 36 & 39: By age 39, Leo has taken every remaining option, using 6 of the 8 available increases, to obtain
$150,000 of whole life insurance coverage (plus the original $25,000 base coverage), total allotment without
ever completing a medical exam—even though he picked up type-1 diabetes at 34.
Key takeaways shown by the scenario:
• Availability windows are locked in at issue; Leo cannot “miss” an option and make it up later.
• Each option typically must be exercised within 30–60 days of the milestone date/event.
• Premiums for each new block are based only on Leo’s attained age and rate class, never on new medical
evidence.
• The GIO rider ends automatically (usually at age 40 or once all options are used).
• In short, the Guaranteed Insurability Option rider in a life policy acts like a series of prepaid “tickets” that
allow the insured to step up coverage at specific milestones—24, 27, 30, 33, 36, 39 (or equivalent life
events)—with no health questions asked.
[8.6] COST-OF-LIVING (ADJUSTMENT) RIDER
This rider automatically increases the face amount of the policy at specified intervals based on increases in the
Consumer Price Index (CPI). Decreases in the CPI do not impact the face amount. The CPI measures the
inflation rate each year.
For example, if there's a 2% rise in this index, the policy owner's face amount will increase by 2% for the next
year. However, a decrease in the index will not result in the lowering of the policy's death benefit.
The cost-of-living (COL) rider or cost-of-living adjustment (COLA) rider can provide increases in the amount of
insurance protection without requiring the insured to provide evidence of insurability. Of course, an increase in
the death benefit will result in an increase in premiums. Additionally, a policy owner is not required to add the
increased benefit; instead, they may simply request to keep the existing premium and benefit amounts.
These riders can take many different forms depending on the type of policy to which they are attached. With
adjustable life policies, the COL is more of an agreement than a rider. The policy owner already has limited
freedom to change the policy's face value amount. A COL agreement simply waives the need for the insured to
prove insurability if the face amount increase is intended to match the increases in the CPI. With whole and term
life insurance, a COL typically takes the form of an increasing term rider attached to the base policy. Since
universal life insurance policies already have such a high degree of flexibility, the addition of a COL is not
sensible.
[8.7] TERM INSURANCE RIDERS
Many people like the peace of mind that comes with permanent insurance policies and the large, inexpensive
face values typically associated with term insurance. Term insurance riders were created to give insureds an
inexpensive option to add additional temporary coverage to a permanent policy. These riders allow for an
additional death benefit (above the permanent face value) if the insured dies during a specified term. Although
there's an additional expense for the extra protection, it's nominal compared to the cost for the permanent
protection and less than if the insured were to take out a separate term policy.
Additionally, if the insured is still alive at the end of the term, the rider will fall off the policy (i.e., the extra
coverage terminates) and the cost associated with the rider will fall off of future premium costs. However, the
premium and face value associated with the permanent protection for which the rider was attached will remain
intact.
This additional insurance does not have any impact on cash values or dividends and is typically dropped if the
insured exercises a non-forfeiture option or allows the policy to lapse. In addition to only being attached to a
permanent policy (a term rider cannot be added to a term policy), the coverage period for a term rider cannot
extend past the premium paying period for the permanent policy to which it's attached.
As with a standard term life insurance contract, term riders are a common way for an insured to have excess
coverage during a specific phase of life (e.g., while raising children). There are many different term riders from
which a policy owner may choose, most of which resemble the term life policies described earlier.
[8.7.1] APPLICATION SCENARIO
John, a 35-year-old software engineer, is planning for his family's financial future. He decides to purchase a 20-
pay whole life insurance policy with a face value of $200,000. John is aware that his family will have significant
financial needs over the next decade, especially with his two young children, Emma and Liam, who will be
starting college in the coming years.
To ensure his family has additional financial protection during this critical period, John opts to add a $100,000
10-year term rider to his whole life policy. This rider provides an extra death benefit if John were to pass away
within the next 10 years, giving his family a total of $300,000 in coverage ($200,000 from the whole life policy
and $100,000 from the term rider).
The cost of adding this term rider is minimal compared to taking out a separate term policy, making it an
affordable way for John to temporarily increase his coverage. If John is still alive at the end of the 10-year term,
the rider will expire, and the additional cost will no longer be included in his premium payments. However, the
$200,000 face value of his whole life policy will remain intact, continuing to provide permanent protection for his
family.
This setup gives John peace of mind, knowing his family is well-protected during a crucial phase of their lives,
without significantly increasing his insurance costs.
[8.7.2] LEVEL TERM RIDER
A level term rider adds an additional fixed, level death benefit for a predetermined period at a predetermined
cost to the existing face value of a permanent policy.
For example, an individual has been issued a $50,000 whole life insurance policy with a $100,000, 10-year term
rider. If they die in five years (or at any point in the next 10 years), their beneficiary will receive $150,000 ($50,000
for the whole life + $100,000 for the term rider). If the individual dies in 15 years (or at any point after the 10-year
term), their beneficiary will only receive the $50,000 face value of the whole life insurance.
[8.7.3] DECREASING TERM RIDER
A decreasing term rider adds a decreasing death benefit to the existing face value of a permanent policy for a
predetermined period and at a predetermined cost. The cost of a decreasing term rider is lower than the cost of a
level term rider because the benefit amount decreases each year. To discourage policy owners from canceling
the rider later in the term (when the benefit is scheduled to decrease to a low amount), some insurers may
design the premium schedule to end earlier than the protection period. Other insurers may design the benefit to
only decrease for a portion of the protection period.
For example, Mary wants to add a 20-year decreasing term policy to her whole life insurance to cover the
$100,000 balance of her mortgage. The insurance company may design the rider to start with a face value of
$100,000 and decrease by $5,000 per year for a fixed additional premium of $20 per month, which is in addition
to the premium for the permanent whole life policy.
However, to discourage Mary from canceling the rider as the coverage decreases, the insurer may design the
premiums so they're complete after 15 of the 20 years. Or the insurer may design the policy so that the face
value stops decreasing after 15 years and remains at a fixed $25,000 for the final five years.
[8.7.4] INCREASING TERM RIDER
An increasing term rider allows for an increasing amount of coverage each year. Increasing term riders provide
an additional term insurance face amount at death equal to either all premiums paid or the amount of cash value.
Increasing term riders may also be referred to as increasing benefit ridersand always increase the cost of the
insurance policy.
[[Link]] RETURN OF PREMIUM RIDER
The return of premium rider is a type of increasing term insurance added to a whole life policy. When the insured
dies, the beneficiary receives the face amount plus an additional (term insurance) death benefit equal to the
cumulative total of all premiums paid during the life of the policy. Therefore, under this rider, the amount of
coverage increases each year based on the cumulative total of all premiums paid. The policy owner is simply
purchasing term insurance that increases as the total amount of premiums paid increases.
Insurers may also offer a return of premium (ROP) term life insurance policy, which returns 100% of the
premiums paid over the life of the policy to the policy owner if the insured is still alive at the end of the policy
term. Any ROP is received tax free. Some policies may allow for premiums to be returned on a sliding scale if the
ROP term life policy is surrendered. If the insured dies during the term, the beneficiary will receive the policy's
face value only, without any premium return.
For example, at age 70, an insurer may return all premiums paid over the life of the policy to a living insured if the
policy carries this rider.
[[Link]] RETURN OF CASH VALUE RIDER
The return of cash value rider is another type of increasing term rider that provides an increasing amount of term
insurance equaling the cash value as it accumulates in a whole life policy. This rider allows the cash value to be
paid in addition to the face amount. Again, the rider provides an additional term insurance benefit equal to the
cash value amount at the time of death.
[8.8] RIDERS COVERING ADDITIONAL INSUREDS
At this point, the riders described are added to the insured's policy and provide the insured (or policy owner) with
additional benefits. Riders may also be added to a life insurance policy that provides term insurance coverage for
a spouse, children, or entire family. As a whole, these riders are referred to as other insured or dependent (term)
riders. The actual name of the rider may or may not include the word "term." Whenever the insured adds a rider
to their individual policy that covers the life of another person, the rider's coverage will always be term insurance.
For example, a potential client of an agent or producer wants to purchase a life insurance policy covering their
life, but also wants to cover their spouse by adding a rider to their policy if the spouse dies in an accident. To
meet their policy needs, what type of rider should be suggested? The reference "if the spouse dies in an
accident" gives the impression that the accidental death rider should be added to the policy to satisfy this need.
However, this is a dependent rider that would be added to cover the spouse. The accidental death rider is added
to the primary insured's policy to cover the primary insured; it does not cover the primary insured's spouse.
Other insured riders generally use convertible level term insurance to cover the other insured or
spouse. Children's term covers all the children of the family as a class of insured at a set amount per
child. Family insurance riders combine these two coverages into a single rider.
[8.9] EXCHANGE PRIVILEGE RIDER (SUBSTITUTE OR CHANGE OF INSURED RIDER)
The exchange privilege rider – also referred to as the substitute or change of insured rider – outlines the
conditions and processes for changing the insured of an insurance policy. This rider is typically limited to a
business policy that covers a key employee or executive. The goal is to simplify updating the insurance policy
when the insured is no longer employed by the business. Although the exchange privilege rider allows for the
policy to continue with the same face amount, the premiums are recalculated based on the new insured’s age,
sex, insurability, etc.
[9] LIFE INSURANCE POLICY EXCLUSIONS
Insurance policies may contain an exclusion provision that provides the insurer with the right to deny a death
claim if death is caused by any of the listed exclusions. Exclusions may be listed in the policy itself or attached as
riders and referred to as optional provisions or clauses. Today, many exclusions (with the exception of suicide)
are being replaced with additional premium requirements (also referred to as a rate-up). Listed below are the
most common types of exclusions.
[9.1] WAR (MILITARY SERVICE)
The war or military service exclusion prevents an insurer's financial catastrophe and typically applies to declared
and undeclared wars. Most life insurance policies will contain one of two common war exclusions clauses. The
status war clause is a restrictive type of clause stating that the insured will not possess coverage under an
individual life insurance policy while they are in the military, even if they are killed while away on furlough. The
results clause states that an individual policy doesn't provide coverage if the insured dies while participating in
military activities or during military maneuvers. If the insured were killed while on furlough, they would be
covered under an individual policy
Exam Tip!
It's safe to assume that an exam question is referring to the "results clause" unless the exam question explicitly
uses the "status war clause.
[9.2.] AVIATION
Although it was common years ago, current life insurance policies are unlikely to exclude death for passengers,
crew members, or pilots aboard commercial aircraft. However, most life insurance policies exclude deaths
resulting from certain types of high-risk aviation activities.
For example, the activities of a stunt, test, or student pilot, a flight instructor, and aircraft used for agricultural
purposes (i.e., crop dusting) are typically excluded.
[9.3] COMMISSION OF A FELONY (ILLEGAL ACTIVITY)
Some insurance contracts exclude death or injury when it results from the insured committing a felony or doing
something illegal. If included in the policy, the exclusion only applies to persons committing the crime since
victims or innocent bystanders are always covered.
[9.4] ILLEGAL OCCUPATION
The illegal occupation provision specifies that the insurer is not liable for losses that are attributed to the insured
being connected with a felony or participating in any illegal occupation.
[9.5] INTOXICANTS AND NARCOTICS
The insurer will typically deny a claim if the insured is intoxicated or under the influence of narcotics at the time
of the loss
[9.6] HAZARDOUS OCCUPATIONS, HOBBIES, OR AVOCATIONS
Insurers can choose to exclude coverage for deaths resulting from an individual's dangerous occupation,
hobbies, or avocations. In the past, excluding occupations (e.g., a high-rise window washer), hobbies (e.g., scuba
diving), and avocations (e.g., a doctor who's traveling to a developing country to provide care) was a common
practice. However, today, most insurers forgo the exclusion and instead offer the coverage if an extra premium is
collected (rate-up). If a specific cause of loss is excluded in the policy, it's excluded forever. If a cause of loss is
not excluded in the policy, the cause of loss is covered forever. Hazardous hobbies or occupations may result in
the exclusion of certain causes of death by endorsement, resulting in a refund of premiums paid.
For example, let us assume that Robert has been scuba diving for 10 years when he applies for life insurance. The
insurance company may tell Robert that, due to the risky nature of scuba diving, death resulting from a scuba-
related accident is excluded from his policy (i.e., it's not covered). As such, his policy will contain a scuba diving
exclusion form, which becomes part of his entire contract. While on vacation, Robert convinces Carol to go
scuba diving. Carol obtained life insurance five years ago, but since she has never been scuba diving, the insurer
did not include a scuba diving exclusion in her life insurance policy. Unfortunately, Robert and Carol suffer a
tragic accident during their scuba excursion and, as a result, both die. Robert's beneficiary will not receive his
policy's death benefit since scuba-related deaths were excluded. However, Carol's beneficiary will receive her
policy's death benefit (minus any outstanding policy loans) because scuba-related deaths were not excluded.
The insurer cannot change her policy and exclude Carol's death after the fact (post-claim underwriting) since the
exclusion form is not a part of the entire contract.
What if Robert failed to tell his insurer that he frequently scuba dives and, as such, the scuba exclusion form was
not included in his entire contract? Would his death then be covered? In reality, it depends. If the policy were
within the contestable period, the insurer could conduct further research into Robert's scuba-diving history. After
learning that Robert was an avid scuba diver, the insurer may determine that Robert was untruthful on the
application and exclude the loss. However, if the policy is not inside the contestable period, the incontestable
clause forces the insurance company to cover the loss.
[9.7] SUICIDE CLAUSE OR PROVISION
For many years, insurers did not cover death as a result of suicide. Today, an insurer continues to protect itself
against the contingency of a person taking their own life. Therefore, a suicide provision is inserted in most life
insurance contracts. The provision or clause stipulates that death which is caused by suicide is excluded during
an initial period after the policy becomes effective. The provision or clause stipulates that death which is caused
by suicide is excluded during the initial two years after the policy becomes effective.
The exclusion protects the insured from individuals who may be considering suicide, even as they apply for
insurance. Someone in such a position may be said to lack an insurable interest in their own life because they are
considering the possibility of ending it. Therefore, if the insured dies as a result of suicide during the first two
years of the policy's existence, the insurer will deny the claim and refund all premiums paid up to that point to the
estate of the insured, or the policy owner if a third party owns the contract.
If the insured dies as a result of suicide after the initial two-year period, coverage is provided, and the face value
will be paid to the beneficiary. In this case, insurable interest existed at the time of application, even if it was lost
later. Therefore, the policy is valid and the loss is covered. Furthermore, if an insured reinstates a lapsed policy,
there is no suicide exclusion. The two-year period is calculated from the date the policy originally went into
effect, not the date of reinstatement.
As previously described, all policies exclude the payment of the benefit if the insured commits suicide during the
specified period. Again, in the case of suicide during that period, the beneficiary will only receive the premiums
paid for the policy up to the time of death, minus any outstanding loans. The suicide exclusion is the only
exclusion that "falls off" after a specified period (2 years). Any other policy exclusions remain for the life of the
policy unless it is amended.
For example, John is covered by a life insurance policy and, six months after he purchases the policy, he commits
suicide. Will the insurer pay the death benefit amount to the beneficiary? No, it will not because suicide is not a
covered cause of death in the initial two years. If John commits suicide in the first two years, will anything be paid
by the insurer? Yes, a return of the premium paid will be paid to the policy owner’s (typically the insured) estate.
[10] CHAPTER SUMMARY
Throughout this chapter, we've explored the essential components that make up life insurance contracts and
how they work together to create a balanced agreement between insurers and policyholders.
We began by examining standard provisions that form the foundation of all life insurance policies. The entire
contract provision establishes what documents constitute the complete agreement, while the incontestable
clause provides crucial protection for beneficiaries after a policy has been in force for a specified period. We also
explored how provisions like the misstatement of age clause and suicide provision create fair solutions to
potentially problematic situations.
The chapter highlighted the significant rights that policy owners possess—from changing beneficiaries to
borrowing against cash value. We saw how these rights can be transferred through policy assignments, either
absolutely or conditionally, and the implications of each type of assignment.
For policies with cash value, we examined the three non-forfeiture options that prevent policyholders from losing
their accumulated equity: cash surrender, reduced paid-up insurance, and extended term insurance. We also
explored how policy loans work and their potential impact on death benefits and policy values.
Participating policies offer additional flexibility through dividend options, allowing policyholders to receive cash,
reduce premiums, accumulate interest, purchase paid-up additions, or buy one-year term insurance. Each
option serves different financial objectives and life situations.
The various riders we discussed demonstrate how life insurance can be customized to address specific needs.
Whether waiving premiums during disability, guaranteeing future insurability, or providing coverage for family
members, these riders transform basic policies into comprehensive financial protection tools.
Finally, we examined common policy exclusions that limit coverage in specific circumstances, understanding
that these limitations help keep insurance affordable while protecting insurers from excessive risk.
By mastering these provisions, options, and riders, you're now better equipped to understand how life insurance
policies function and how they can be tailored to meet diverse client needs—essential knowledge for both your
licensing exam and your future insurance career.
[10.2] REVIEW NOTES
Learning Objective 1: Identify the standard provisions found in life insurance contracts and explain their purpose.

KEY PROVISIONS:

Insuring Clause: Company's promise to pay benefits upon the insured's death; appears on the first page
Consideration Clause: Policy owner's consideration is the application, the premium, and truthful statements
Incontestable Clause: After two years, the insurer cannot contest policy validity except for specific exceptions
Misstatement of Age/Sex: Policy not voided, but death benefit adjusted to reflect correct age/sex
Owner's Provision: The policy owner has all rights contained in the policy
Assignment Provision: Owner can transfer policy rights to another person
Free-Look Provision: Owner can return the policy within the specified period (usually 10 days) for a full refund
Premium Mode: Defines premium frequency; the annual mode is least costly, and the monthly one most costly
Grace Period: Usually 30 days after the premium due date; coverage continues during this period
Reinstatement: Allows policy to be reinstated within three years if lapsed; requires proof of insurability
Learning Objective 2: Explain the provisions and options related to cash value in life insurance policies.

CASH VALUE PROVISIONS:

Excess Interest Provision: Cash value increases faster if the insurer's returns exceed the guaranteed rate
Non-Forfeiture Options: Allow access to cash value if premiums stop; required after three years
Cash Surrender Option: Immediate cash payment of the policy's cash value minus any loans
Reduced Paid-Up Option: Uses cash value to buy a smaller permanent policy with no more premiums
Extended Term Option: Uses cash value to buy term equal to the original face amount; (default option)
Policy Loan Provision: Owner can borrow against cash value; the loan reduces the death benefit if not repaid
Automatic Premium Loan: An optional provision that uses cash value to pay premiums if they're missed
Learning Objective 3: Describe the provisions and options related to policy proceeds.

POLICY PROCEEDS PROVISIONS:

Beneficiary Designation: The Owner designates who receives the death benefit; it is part of the entire contract
Settlement Options: Ways death benefits can be paid; a lump sum is the principal method
Spendthrift Clause: Protects the death benefit from a beneficiary's creditors; applies to non-lump sum options
Accelerated Death Benefits: Allows a terminally ill insured to receive a portion of the death benefit while living
Long-Term Care Rider: Provides benefits if the insured requires long-term care; may reduce the death benefit
Learning Objective 4: Compare the dividend options available to owners of participating policies.

DIVIDEND OPTIONS (CRAPPO):

Cash: Direct payment to policy owner; tax-exempt

Reduction of Premium: Dividend applied to reduce the next premium payment
Accumulate at Interest: Dividend held by insurer in separate account; interest is taxable
Paid-Up Additions: Purchase additional permanent insurance without proving insurability
Paid-Up Policy: Dividends are used to make additional premium payments and pay up the policy sooner
One-Year Term: Purchase term insurance; can cover policy loan amount
Learning Objective 5: Evaluate common life insurance riders and determine appropriate situations for their use.

COMMON RIDERS:

Waiver of Premium: Waives premiums if an insured becomes totally disabled; it has a 6-month waiting period
Disability Income Benefit: Pays a monthly income (usually 1% of face amount) if an insured becomes disabled
Accidental Death Benefit (Double Indemnity): Pays an additional death benefit if death is accidental
Accidental Death & Dismemberment: Adds dismemberment benefits to accidental death coverage
Guaranteed Insurability Option: Allows purchase of additional insurance without evidence of insurability
Cost of Living Adjustment: Automatically increases the face amount based on the Consumer Price Index
Payor Benefit: Waives premiums on juvenile policy if the adult payor dies or becomes disabled
Exchange Privilege: Allows changing the insured on business policies
Term Insurance Riders: Add temporary coverage to permanent policies (level, decreasing, increasing)
Return of Premium/Cash Value: Adds a death benefit equal to premiums paid or cash value
Family/Spousal/Children's Riders: Provide term coverage for family members
Learning Objective 6: Recognize standard policy exclusions and their implications for coverage.

COMMON EXCLUSIONS:

War/Military Service: Two types - status clause (excludes while in military) and results clause (excludes death
during military activities)
Aviation: Typically excludes high-risk aviation activities, not commercial flights
Commission of Felony: Excludes death resulting from the insured committing a crime
Illegal Occupation: Excludes losses from participation in illegal occupations
Intoxicants and Narcotics: May exclude death while under the influence
Suicide: Excluded first two years; the only exclusion that "falls off" after a specified period
Hazardous Activities: May exclude or charge an extra premium for dangerous occupations/hobbies
EXAM TIPS:

Know an incontestable clause three exceptions: impersonation, no insurable interest, and intent to murder
Understand differences between absolute and conditional assignments
Remember that the extended term option is the default non-forfeiture option
Know that policy loans reduce the death benefit if not repaid
Memorize the dividend options using the acronym CRAPPO
Distinguish between waiver of premium (waives premiums) and disability income (provides income)
Remember that riders covering other people always provide term insurance
Know that suicide exclusion is the only one that expires (after two years)
REMEMBER:

Standard provisions protect both insurer and policy owner

Cash value provisions allow access to policy equity
Policy loans are not "called" but reduce the death benefit if unpaid
Dividends are a return of premium and therefore tax-exempt
Interest on dividends held in the accumulate at interest dividend option are taxable.
Riders customize policies, but typically increase premiums
Most exclusions remain for the life of the policy; the suicide exclusion expires after two years
Reinstatement starts a new contestable period but not a new suicide period
Chapter 6
[1.2] KEYWORDS
Before reading the chapter, please review the following keywords. Understanding the basic definitions will
enhance comprehension of the chapter content.
Grace Period: The time after the premium due date during which payment can be made without penalty.
Policy Lapse: The termination of a policy due to non-payment of premiums.
Loading Charge: Another term for the expense factor in premium calculations.
Mortality Table: A table showing the probability of death at each age.
Surrender Value: The amount available in cash upon voluntary termination of a policy before it becomes payable
by death or maturity.
Policy Loan: A loan issued by the insurance company using the policy's cash value as collateral.
Settlement Option: The method used to distribute the policy proceeds.
Contingent Beneficiary: The person or entity designated to receive the death benefit if the primary beneficiary
predeceases the insured.
Spendthrift Clause: A provision that prevents creditors from claiming any portion of the policy proceeds.
Common Disaster Clause: A provision that specifies how proceeds are distributed if the insured and
primary beneficiary die in the same accident.
Policy Reserves: Funds that an insurer sets aside to pay future claims.
Premium Mode: The frequency with which a policy owner elects to pay premiums (e.g., monthly, quarterly,
annually).
[2] LIFE INSURANCE PREMIUMS
Once an insurance company determines that an applicant is insurable, it must establish the payment (premium)
for the insurance policy. The premium serves as payment for insurance coverage and constitutes part of the
policyholder's consideration. The consideration is the "binding force" in the contract, which solidifies the
agreement between the insurer and policy owner.
As previously described, the policy owner is expected to remit premiums by the due date. However, as with most
bills, insurance companies allow for a grace period (a time after the due date) during which payment may be
made without penalty. If the premium is not paid before the end of the grace period, the policy will lapse.
[2.1] FACTORS IN PREMIUM CALCULATION
Life insurance premiums are calculated per $1,000 of coverage. Three primary factors are used to determine
what an insurer will charge for its life insurance product. The three factors that influence the gross premiums
charged for life insurance are: Mortality, Interest, Expenses
2.1.1] THE ROLE OF MORTALITY FACTOR IN INSURANCE PREMIUMS
The mortality factor has the greatest impact on premium calculations and rate-making, as it can vary
substantially based on the insured's characteristics. The mortality factor is determined from a mortality table,
which indicates the "probability of death" of an individual at a particular age. In other words, the mortality table
provides the death rate (i.e., the average number of deaths per year in each age group). For a mortality table to be
accurate, it must be based on a large cross-section of individuals over a long period. This mortality factor
originates from the Commissioners Standard Ordinary (CSO) Mortality Table. Today, this is the generic table
used by most insurers; however, some insurance companies use mortality factors derived from their own
experience (i.e., death claims paid).
The number of deaths in a group of people is typically expressed as deaths per thousand. Insurance companies
use mortality tables to estimate life expectancy and the probability of death for a given group.
For example, when determining the premium per $1,000 of coverage for a standard-risk 35-year-old male, the
company will consult the mortality table to find the average number of deaths per thousand for standard-risk 35-
year-old males.
[2.1.2] UNDERSTANDING THE INTEREST/INVESTMENT FACTOR IN INSURANCE PREMIUMS
Insurance companies invest the premiums they receive to earn interest. This interest is one way an insurance
company can lower its premium rates. Premium calculations are based on the assumption that the company will
earn an assumed rate of interest. A higher assumed (or predicted) rate will result in lower premiums. However,
the actual interest earned may be higher or lower than the assumed rate.
The interest factor reflects an insurer's return on its investments. An insurer invests the premiums it collects in
multiple investment vehicles. The wiser its investment decisions, the better return it will realize.
[2.1.3] EXPENSE FACTOR
The expense factor – also referred to as the loading charge or factor – is derived from operating expenses, or
funds the insurer "pays out." These expenses include death benefits paid, commissions or salaries to producers
and other employees, as well as other administrative costs (e.g., rent). As described previously, each state sets a
minimum reserve (or funds) that the insurer must set aside to pay future claims. Additionally, companies need to
build in profit, also referred to as surplus. If a company is not generating a profit, it will likely need to raise
premiums; however, if a company is generating a profit, it will likely maintain premiums or possibly lower them.
Additional factors that may influence the premium cost include:
o Age of the Proposed Insured
o Sex / Gender
o Health History of Proposed Insured
o Occupation
o Personal Activities and Hobbies
o Personal Habits
[2.2] LIFE INSURANCE PREMIUM CALCULATIONS AND PAYMENT OPTIONS
The net (single) premium is a premium that makes provision for mortality cost (death benefit) and interest. The
"net single premium" is influenced by the assumed interest rate, the proposed insured's gender, the benefits to
be provided, and the mortality rate (i.e., the death benefit).
Net single premium = Mortality cost - Interest
The net level annual premium is the premium calculated to cover the present value of future benefits.
For example, suppose an insurance policy promises to pay $300,000 in 25 years. In that case, the net level
annual premium is the amount required annually to ensure that $300,000 is available at the end of 25 years. The
calculation assumes the premium will not be paid in a lump sum but over a period of years.
The gross premium is the premium charged by an insurer, comprised of or influenced by the factors described
previously: mortality, interest, and expenses. This represents the actual premium paid by the policy owner for life
insurance coverage.
Gross premium = Net premium + Insurer expenses
The gross annual premium is the gross premium adjusted for the fact that most people don't pay the policy's
required premium in a single payment; instead, they typically pay for years.
The mortality rate refers to the frequency of deaths, while the morbidity rate refers to the incidence of disease in
a defined population over a specific time interval. Higher morbidity and mortality rates equate to higher insurance
premiums.
The term "premium mode" refers to a policy feature that allows the policyholder to select the timing of premium
payments. Insurance policy rates assume that the premium will be paid annually at the beginning of the policy
year and that the company will have the premium to invest (interest factor) for a full year. Suppose the
policyowner chooses to pay the premium more than once per year (e.g., monthly, quarterly, semiannually). In that
case, they will usually incur an additional charge because the company incurs additional costs in billing and
collecting the premium payments. This may be referred to as the Mode of Premium provision. Non-payment of
the premium before the grace period expires will cause a policy to lapse.
The more frequent the payments, the higher the premiums will be. This is because the insurer's earned interest
decreases while the administrative costs increase.
[2.3] FUNDING INSURANCE PREMIUMS
Whole life policies can be funded through various premium payment methods, including single premium funding,
fixed level premium funding, modified premium funding, graded premium funding, and flexible premium funding.
Let us take a closer look at how each funding method works.
Single Premium Funding: The policy owner pays a one-time lump sum that covers the entire policy. This method
is often too costly for most people.
Fixed/Level Premium Funding: Premiums are spread evenly over the policy period. The policy owner pays more
than the actual cost in the early years to offset higher costs later, keeping premiums level throughout the policy's
life.
Modified Premium Funding: Starts with a lower initial premium for a set period, after which the premium
increases to a higher amount and remains constant. This option is beneficial for those expecting a higher income
in the future.
Graded Premium Funding: Begins with lower premiums that increase annually for a specified period. After this
period, the premium increases to a higher amount and remains stable for the remainder of the policy.
Flexible Premium Funding: Allows the policy owner to adjust premium payments throughout the policy's life,
offering flexibility based on financial circumstances.
[2.4] PAYING PREMIUMS FROM POLICY VALUES
Depending on the type of policy, a policy owner may be able to use the policy's cash value and dividends to pay
the premium. With dividends, a policy owner can choose to pay down premiums on the existing policy or
purchase additional coverage in the form of paid-up whole life additions or a one-year term.
While using the policy’s cash value to pay premiums is an option, it also reduces the policy's value. The policy
will lapse if its value becomes insufficient, and the policyowner fails to pay the required premium.
[2.5] MINIMUM DEPOSIT (FINANCED) INSURANCE
Although it's occasionally grouped with "types of whole life insurance," minimum deposit or financed insurance is
not an actual policy type. Minimum deposit financing is best suited for individuals in high marginal tax brackets
who are considering life insurance. It allows the policy owner to use policy loans to pay premiums due each year.
For example, each year the policy owner may borrow the cash value increase for that year (subject to certain tax
restrictions) and use it to pay the premium.
The policy owner only pays the difference between the premium due and the amount borrowed (plus interest on
the policy loan). For this payment method to work, the policy owner must make two to three initial premium
payments to build up the cash value. Additionally, under IRS rules, at least four of the initial seven annual
premiums must be paid from funds other than policy loans to avoid classification as a modified endowment
contract (MEC).
[2.6] PREMIUM COLLECTION AND RESERVES
Producers generally collect the initial premium from the applicant at the application. The insurer will bill all future
premiums to the insured, who will then remit the payments to the company. Policy owners who cannot pay their
premiums may use a premium financing organization that operates like an installment loan provider.
[2.6.1] EARNED VERSUS UNEARNED PREMIUMS
The insurer’s “total premium” is made up of both “earned” and “unearned” premiums.
Earned premium is the amount to which an insurer is entitled for providing coverage over a specific period.
Unearned premium is the amount of premium the policy owner has paid to the insurance company for coverage
that has not yet been provided. Unearned premium typically becomes earned premium as an insurance contract
progresses, but represents the amount that an insurer will return to an insured if the policy is canceled.
Imagine Alex purchases an insurance policy for $240 annually, paying the full premium upfront on January 1. By
April 1, three months have passed, meaning the insurer has earned $60 of the premium ($240 ÷ 12 months x 3
months). If Alex decides to cancel the policy effective July 1, the insurance company must refund $120 for the
unearned premium ($20/month x 6 months remaining).
[2.6.2] RESERVES
As required by law, reserves (also referred to as unpaid claim reserves) are the funds an insurer sets aside to pay
current and future claims. This is an insurer's fixed liability, representing the amount expected to be available to
pay future benefits under a policy. An insurer's reserve guarantees its promise to pay as identified in the policy's
insuring provision.
Each state has its own requirement regarding the amount of funds that make up the reserve. Reserves also
demonstrate an insurer's solvency. The reserves are funded through future premium payments from policy
owners and the interest (investment return) earned on those premiums.
A legal reserve is the amount of funds an insurance commissioner (or director/superintendent) requires an
insurer to maintain based on the CSO mortality table and the assumed rate designated by the state's
commissioner or state insurance law.
[3] COMPARING LIFE INSURANCE POLICY COSTS
The cost of a policy is the difference between what a person pays and what they receive in return. If a person
pays a life insurance premium and receives nothing back, the cost of the death protection is the premium. If a
person pays a premium and receives something in return (e.g., a dividend or cash value), the actual cost is less
than the premiums paid. Therefore, a lower premium doesn't automatically mean a lower-cost policy. Cost-
comparative methods evaluate the actual cost of a policy against this standard.
[3.1] INTEREST-ADJUSTED NET COST METHOD
Interest-adjusted cost indexes are designed to provide information on the following four items:
1. Premiums
2. Death Benefits
3. Cash Value
4. Dividends
These variables must be considered when evaluating costs, and they form the basis for the life insurance policy
cost comparison methods.
The index numbers are designed to provide consumers with a means of comparing the costs of policies of the
same generic type. The indexes also take into account the insured's age and the desired coverage amount. Each
insurer and its producers must use the same computation formulas to determine the index numbers. Due to the
increasing complexity of life insurance policy structures, premium payment methods, benefits, and dividend
configurations, the average consumer would struggle to make cost comparisons without these index figures.
The NAIC Model Life Insurance Solicitation Regulation requires two interest-adjusted cost indexes for policy
illustrations – a surrender cost index and a net payment cost index. These indexes show average annual costs
and payments per $1,000 of insurance, while also recognizing that $1 payable today is worth more than $1
payable in the future (i.e., the time value of money).
[3.2] LIFE INSURANCE SURRENDER COST INDEX
The surrender cost index uses a calculation formula to determine the average cost per thousand for a policy
surrendered for its cash value at the end of the period. It averages the net cost over the number of years the
policy was in force. The surrender cost index is crucial for consumers who place a high priority on the policy's
cash value growth. It aids in cost comparisons if the policyowner plans to surrender the policy for its cash value
within 10 to 20 years.
[3.3] NET PAYMENT COST INDEX
The net payment cost index uses a similar formula but does not assume the policy is surrendered at the end of
the period. As such, the cash value element is omitted. The net payment cost index provides the policyowner
with an estimate of the average annual premium outlay, adjusted for the time value of money.
The net payment cost index is helpful if an insured's primary concern is the amount of the death benefit provided
by the policy and is less concerned with the buildup of cash value. It helps compare future costs —such as in 10
to 20 years —assuming the insured continues to pay premiums and doesn't take the policy's cash value.
[3.4] COMPARATIVE INTEREST RATE METHOD
The comparative interest rate method determines the rate of return required on an investment account to yield
the same return as a life insurance policy with cash value. This method is also known as the "buy term and invest
the rest" strategy.
The amount spent on term insurance, plus the hypothetical investment account, must equal the required
premiums for permanent insurance. The face value of the temporary and permanent insurance products being
compared must also be the same.
Application Example
For example, let’s assume that a 30-year-old man wants $150,000 of life insurance coverage.
One insurance agent shows the man a $150,000 whole-life insurance policy that requires annual premiums of
$2,000 for life.
A second insurance agent shows the man a $150,000 35-year term life insurance policy that costs $500 per
year. The term policy provides coverage into the retirement years, at which point the man’s insurance needs
should be less, assuming mortgages and other “large debts” are paid off or close enough to be immaterial. The
second agent further explains that the man could place the $1,500 premium difference in an investment account
to grow, and if designed correctly, this second account can provide retirement income and funds for final
expenses when the term policy expires.
The comparative interest rate is the rate of return required on the investment account, ensuring that the
investment's value equals the surrender value of the higher-premium policy at a specific point (e.g., 30 years or
at death). The higher the comparative interest rate (CIR), the less expensive the higher-premium permanent
policy is compared to the alternative plan.
[4] VIATICAL SETTLEMENTS AND LIFE SETTLEMENTS
[4.1] VIATICAL SETTLEMENTS
A viatical settlement enables an individual with a chronic or terminal illness to sell their existing life insurance
policy to a third party for a percentage of the policy's face value. The new owner continues to make the premium
payments and eventually collects the full death benefit upon the original owner's death. The original policy owner
is referred to as the viator, while the new third-party owner is referred to as the viatical or viatee.
Due to the nature of the contract, most states require a special license for viatical settlement providers and, at a
minimum, require a viatical company to recommend that the client consult a tax adviser, as the proceeds could
be taxable in certain situations. Tax laws require viators to be chronically or terminally ill to receive tax-free
payments from viatical settlements.
[4.2] LIFE SETTLEMENTS
In many states, viatical settlements are being replaced by life settlements. A life settlement is the sale of an
existing life insurance policy to a third party for more than its cash surrender value, but less than its net death
benefit. Unlike viatical settlements, life settlements don't require the insured to be suffering from a chronic or
terminal illness to sell and transfer the policy. With a life settlement, the policy owner may sell the policy to a life
settlement firm for any reason. As with viatical settlements, a life settlement broker represents the policy owner
and must hold an appropriate life settlement license. Disclosure requirements (e.g., right of rescission within 15
days) are also similar.
Life settlement contracts don’t include the following alternatives:
• An assignment of a policy as collateral for a loan
• The making of a policy loan, or the paying of surrender benefits or other benefits, by the issuer of a policy
with respect to that policy
 • A 1035 exchange of a life insurance policy as described by the Internal Revenue Code
• An agreement in which all of the parties are closely related to the insured by blood, law, or have a lawful
substantial economic interest in the continued life, health, and bodily safety of the person insured, or are
trusts that are established primarily for the benefit of such parties
• Legitimate corporate or pension benefit plans
[4.2.1] LIFE SETTLEMENTS CHART

[5] LIFE INSURANCE DEATH BENEFITS

Life insurance policies contain a provision that the settlement will be paid upon receipt of proof of death (a death
certificate). Most states require insurers to pay interest on any unpaid proceeds within a specific period. Death
benefits can be paid out in various methods, referred to as settlement options.
The policy owner may select a settlement option at the time of application and can change it at any time during
the insured's lifetime. If the policy owner selects a settlement option, the beneficiary cannot change it. However,
in most cases, the beneficiary makes the settlement selection at the time of the insured's death.
Unless the policy owner specifies an irrevocable settlement option, the beneficiary always retains the right to
withdraw proceeds at any time in the future. Any option selected in which the policy proceeds are left "at
interest" with the insurer protects the beneficiary against creditors' claims.
[5.1] DEATH BENEFIT SETTLEMENT OPTIONS
Life insurance proceeds (the death benefit) can be paid out (settled) in various ways. The policyowner may
choose any of the five settlement options. The five settlement options are: (1) lump-sum, (2) interest only, (3)
fixed period, (4) fixed amount, and (5) life income. This next section will take a closer look at the features and
uses of each settlement option.
[5.1.1] LUMP-SUM (CASH PAYMENT)
Under this option, the death benefit is paid in a single payment, minus any outstanding policy loan balances and
overdue premiums. The lump-sum option is the most common option used and is considered the "default"
option for most life insurance contracts. Policy owners select the lump-sum option to receive their funds in a
single disbursement.
[5.1.2] INTEREST ONLY
Under this option, the insurance company holds the death benefit for a period and pays only the interest that's
earned to the named beneficiary. A minimum interest rate is guaranteed, and the interest must be paid at least
once a year. This option provides the beneficiary with flexibility, as the proceeds may be left with the insurer,
which eliminates her investment concerns while guaranteeing both the principal and a minimum rate of return
(i.e., interest).
As previously stated, interest paid by an insurer on policy proceeds is taxable. Even when policy proceeds are left
with the insurer and the beneficiary selects this option, the beneficiary retains the right to withdraw the proceeds
in the future at their discretion, unless the policyowner has explicitly listed restrictions.
For example, suppose a policy owner selects the interest-only settlement option. In that case, they can choose
whether the beneficiary has the option to withdraw 100% of the principal at any time or is unable to withdraw
any of the principal until after a preset age or number of years.
[5.1.3] FIXED AMOUNT
The fixed amount installment option allows the death proceeds to remain at interest with the insurer and to be
used to pay a fixed death benefit in specified installment amounts until the principal and interest are fully paid.
The amount of monthly income selected by the beneficiary, the amount of proceeds, and the interest rate paid by
the insurer all determine the duration of the beneficiary's monthly income. The larger the installment payment,
the shorter the payout period. Under this option, the amount of income is the primary consideration rather than
the period over which the proceeds and interest are to be liquidated.
The fixed amount option allows the beneficiary to designate an amount of income to be replaced (e.g., $1,200
per month). These payments continue until the principal and interest are exhausted.
[5.1.4] FIXED PERIOD
When either the fixed period or period certain option is chosen, the death benefit proceeds are paid in equal
installments over a set period of years. The fixed period option is one of the two options based on systematically
liquidating principal and interest over a specified period of years, without reference to life contingencies.
Under this option, the beneficiary leaves the death proceeds with the insurer. The insurer pays interest on the
proceeds (i.e., principal) and then pays a monthly income to the beneficiary for a specified period, as selected by
the beneficiary (e.g., 10 years). Part of the installments paid to a beneficiary consists of interest calculated on the
policy proceeds. This option provides for the payment of proceeds in installments over a definite number of
years. The proceeds determine the amount of each installment, the selected period (i.e., the total number of
installments), the guaranteed interest rate, and the payment frequency.
The fixed period option is valuable when the primary consideration is to provide income for a definite period (e.g.,
until all children graduate from high school).
The face amount and the length of time during which payments will be made are the primary factors that
determine the monthly income paid to the beneficiary.
EXAM TIP
While the proceeds of a Life Insurance policy left to a beneficiary are not subject to income tax, the interest
earned is income taxable in the year earned, even if not paid out in the year earned.
[5.1.5] LIFE INCOME
The life income settlement option liquidates policy proceeds and interest while also providing for life
contingencies. Selecting this option guarantees that the recipient receives install payments for as long as they
are alive, even after all the proceeds are paid out. Therefore, the life income option provides the beneficiary with
an income that they cannot outlive.
This option is funded by the insurance company using the death benefit to purchase a single payment immediate
annuity (SPIA). By electing the life income option, the company would immediately begin paying monthly
payments to the beneficiary. The amount of each installment is based on the principal amount and the age, sex,
and life expectancy of the beneficiary. Using the recipient's life expectancy gives the potential for a greater return
or a greater loss, based on how long the insured lives.
Beneficiaries who select the life income settlement can customize their settlement options to better align with
their income concerns. These refined options include the straight life income option, life income with period
certain option, life income with (cash or installment) refund, and joint life income. Regardless of the life income
settlement option selected, the beneficiary receives a guaranteed income for the rest of their life, through an
annuity.
We will take a deep dive into annuities and the income options they can provide in the Annuities chapter of this
course. The following section highlights how these options relate to the life income settlement option.
[[Link]] SINGLE, PURE, OR STRAIGHT LIFE INCOME OPTION
Under the single, pure, or straight life income option, monthly installments are paid to the beneficiaries for as
long as they live. In other words, income payments end upon the death of the recipient. No refund or any other
payments are made once the beneficiary dies.
This option poses the greatest risk, as any remaining proceeds are forfeited to the company—even if the
beneficiary dies after receiving only a single payment. However, this option also provides the highest income per
$1,000 of proceeds because the company does not guarantee that any minimum portion of the policy proceeds
will be paid out.
While beneficiaries receive larger installment payments under the straight life income option than under the
other life income options, the latter offer various contingent benefits if the beneficiary dies before all the
proceeds have been paid out.
Let us look at a specific example to help compare the different life-income options.
Suppose Patricia insures her life for $100,000 and names her husband, Mark, as the beneficiary.
When Patricia dies, Mark is 65 years old. He chooses the straight life income option as his settlement option. As
shown on the policy’s Table of Installments, with the straight life income option, the insurance company will pay
Mark $560 per month for the rest of his life. We'll return to this example as we discuss the other life income
options, so that you can get an idea of how each option affects the income payment amount.
[[Link]] JOINT AND SURVIVOR OPTION
The joint and survivor option guarantees that benefits will be paid on a life-long basis to two or more people. This
option may include a period certain with a reduction in benefits after the death of the first beneficiary. The
amount payable is based on the ages of both beneficiaries.
Scenario: David and Sarah, ages 72 and 68, are the recent recipients of a life insurance payout from their favorite
uncle. They want income that will continue regardless of who dies first. The joint option offers $2,600 per month
while both live, reducing to $1,950 after the first death.
[[Link]] LIFE INCOME OPTION WITH A PERIOD CERTAIN
The life income option with a period certain pays a monthly income for as long as the beneficiary lives. However,
suppose the beneficiary dies before a predetermined number of years have elapsed. In that case, the insurer will
continue monthly payments to a stated beneficiary for the remainder of the designated period certain (e.g., 10
years).
Returning to our example, suppose that when Patricia dies, leaving a $100,000 policy with her husband Mark as
the beneficiary, Mark chooses lifetime income with period certain as the settlement option.
He specifies ten years as the "period certain." He must also designate a secondary payee (contingent
beneficiary) for the policy proceeds, and he chooses his granddaughter Lorraine.
Under this option, Mark's lifetime benefit--the installment amount generated by the policy proceeds, plus
interest--is $544 per month. (Compare that to the $560 payments he would have received under the straight life
income option.)
Mark will receive $544 per month for the rest of his life, even if he lives to be 120 years old. However, if Mark dies
after receiving payments for only four years, then the secondary payee--Mark's granddaughter Lorraine--will
continue to receive the $544 per month for the next six years. After that, the payments will cease. If Mark dies
after receiving payments for ten years or more, then Lorraine will receive nothing.
The longer the period for which the insurance company is asked to guarantee the payments, the lower the
payment amount will be. If Mark had chosen twenty years instead of ten years, the monthly payment may have
been only $499, instead of $544.
[[Link]] REFUND LIFE INCOME OPTION
The refund life income option guarantees payment of the remaining death benefit to a stated beneficiary if the
original beneficiary dies without receiving the full benefit amount. In other words, it provides a guaranteed
disbursement of the original death benefit to one or more persons. If the original beneficiary dies, their stated
beneficiary will receive the balance on an installment basis or in a lump sum.
Let us look at our earlier example again. This time, suppose that upon Patricia's death, Mark chose the lifetime
income with refund option and named his granddaughter Lorraine as the secondary payee.
According to the Table of Installments, the monthly income to be paid to Mark under this option was $522. The
company sent Mark a check for that amount each month.
Seven years after Patricia's death, Mark is killed in a car accident. Lorraine, the granddaughter, is 25 years old. At
this point, the amount in the policy fund is still $57,000.
Under the installment refund option, the company is now obligated to pay $522 per month to Lorraine, the
secondary payee, until the money in the fund is exhausted. While the company would have been required to pay
Mark an income for the rest of his life, Lorraine can expect to receive the payments only for another 8 years or so.
Under the cash refund option, the company is obligated to pay Lorraine, the secondary payee, a lump-sum
payment of the remaining $57,000.
The company will not pay the secondary payee (Lorraine in this example) an income for the rest of their life.
[5.2] THE SPENDTHRIFT CLAUSE
The spendthrift clause protects a beneficiary's life insurance proceeds against creditors. When the death
benefit is left with the insurer, no creditors can attach a lien of any kind to the proceeds. The spendthrift clause
also protects a beneficiary by minimizing or restricting the use of proceeds if the insurer holds them. Only after
proceeds have been distributed can the beneficiary assign or transfer the benefits to a creditor. Additionally,
under the spendthrift clause, a beneficiary cannot take the present value of future payments in a lump
sum (commuting) or use future payments as collateral for a loan (encumbering).
The spendthrift clause is most often used to prevent a beneficiary from recklessly spending benefits by requiring
the benefits to be paid in fixed amounts or installments over a certain period. Beyond preventing distribution
directly to the insured's creditors, this clause has no effect if the beneficiary receives the proceeds as a lump
sum payment. Additionally, once the beneficiary receives the payment, creditors may take steps to collect any
outstanding amounts owed to them.
[6] BENEFICIARIES AND DEATH BENEFIT DISTRIBUTION
The designation of a beneficiary is perhaps the single most important aspect of a Life Insurance contract. Who
receives the death proceeds when the insured dies? What is the purpose of those proceeds?
[6.1] BENEFICIARY QUALIFICATIONS
The beneficiary of a life insurance policy is the person or entity designated to receive the death proceeds. The
policy owner is the ultimate decision-maker and is responsible for naming or changing a beneficiary. There are a
few restrictions on naming a beneficiary of a life insurance policy. However, during the underwriting process, the
underwriter will consider the issue of insurable interest. When the policy owner (other than the insured) lists
themselves as the beneficiary, they will require proof of insurable interest. While not a full list, acceptable
beneficiary types include individuals, minors, trusts, estates, charities, businesses, class designations, and
more. The chart below provides examples of some beneficiary types.
[6.2] CHANGING A BENEFICIARY
If a policy owner wants to change the beneficiary, there are two standard methods:
• The Filing (recording) method
• The Endorsement method
The filing method is the predominant method used, requiring the policyholder to notify the insurer in writing of
the desired change. The effective date for the change is the date the request is submitted. Some insurers require
a witness to sign the request.
[6.3] REVOCABLE AND IRREVOCABLE BENEFICIARIES
In most cases, the beneficiary is a revocable beneficiary, meaning the policy owner may change the beneficiary
at any time by notifying the insurer. A revocable beneficiary may be changed or removed by the policy owner at
any time without notifying or obtaining the beneficiary's permission.
An irrevocable beneficiary cannot be changed without the beneficiary's written consent. The irrevocable
beneficiary has a vested interest in the policy; therefore, the policy owner cannot exercise certain rights (e.g.,
assignment, policy loans, surrender) without the beneficiary's consent. In addition, an irrevocable beneficiary
has the right to receive a copy of the policy. However, the owner may still collect dividends, choose dividend
options, and choose the premium mode.
When the endorsement method is used, the policy may be returned to the insurer so the new beneficiary
designation can be endorsed to the policy. The effective date for the change is the date that the endorsement is
approved and signed by an officer of the company. The endorsement (and policy if returned to the insurer) is
mailed to the policy owner.
[6.4] DISTRIBUTION BY ORDER OF SUCCESSION
The policy owner may list a primary beneficiary, a secondary beneficiary (also called a contingent beneficiary),
and a tertiary beneficiary. Each level (primary, contingent, etc.) may include one or more persons. Each level will
split proceeds according to percentages designated by the policy owner. Technically, the policy owner may
continue the succession by listing a fourth-in-line, a fifth-in-line, and so on. In other words, there is no limit on the
depth of succession. Let us take a closer look at the most common beneficiary levels: primary, contingent, and
tertiary.
[6.4.1] PRIMARY BENEFICIARY
The primary beneficiary is the first or principal person in line to receive the policy proceeds, income tax-free. A
policy owner may designate multiple primary beneficiaries and choose different or equal amounts for each
beneficiary. If one of the primary beneficiaries dies before the insured, the face amount is paid to the surviving
primary beneficiary(s). Unless specifically requested as part of the contract (per stirpes) or required by law, the
estate or heirs of a deceased beneficiary will not receive any payment in this case.
[6.4.2] SECONDARY OR CONTINGENT BENEFICIARY
The secondary or contingent beneficiary is the second individual(s) in line to receive the death benefit and will
only receive the death benefit if all primary beneficiary(s) have died before the insured. The primary beneficiary
must predecease the insured for this secondary beneficiary to receive any proceeds.
[6.4.3] TERTIARY BENEFICIARY
A tertiary beneficiary is third in line to receive policy proceeds when the insured dies (assuming the insured
outlived both the primary and contingent beneficiaries).
[6.4.4] DISTRIBUTION BY ORDER OF SUCCESSION SCENARIO
For example, Mary elects to name her husband, Brad, as a primary beneficiary for 50% of the policy proceeds.
She also names their son, Duke, as a primary beneficiary for 25% of the proceeds, and their daughter, Taylor, as
another primary beneficiary for the remaining 25%. Additionally, Mary names each of Duke’s 4 children (Joe,
Jack, Jane, and Janet) as a secondary beneficiary for 25% of the proceeds. Finally, Mary names her favorite local
charity as the tertiary beneficiary. Let us look at the following situations that could arise, assuming Mary does not
update her policy.
Exam Tip
When dealing with order-of-succession questions, always assume the policy owner has not updated or made
any changes to the beneficiaries unless those changes are explicitly included in the question. You will face
questions with answers that are “almost correct,” “correct if/except,” and “the most correct based on the
included information.” The best way to ensure you’re picking the “most correct” answer is to avoid interpreting or
adding information to the question that was not included.
[6.6] OTHER DISTRIBUTION METHODS
[6.6.1] DISTRIBUTION TO AN ESTATE
A policy owner must list all desired beneficiaries and update the designations as needed. The policy proceeds
will be paid to the insured's estate if none of the listed beneficiaries are still alive at the time of the insured's
death. Benefits paid to an estate are subject to possible federal and state estate (death) taxes, as well as probate
fees, before being passed on to any other person. Additionally, creditors may have a right to funds in an estate
and, therefore, a right to the proceeds of a life insurance policy paid to an estate.
For instance, consider an individual who purchases a $100,000 life insurance policy on their own life, naming
their spouse as the primary beneficiary and only daughter as the contingent beneficiary. The individual does not
designate any of their four sons as beneficiaries. If both their spouse and daughter are killed in an automobile
accident, and the individual subsequently dies five years later without having made any amendments to the life
insurance contract, the death benefit or policy proceeds would be allocated to their estate rather than to their
sons.
[6.6.2] DISTRIBUTION TO A MINOR
A life insurance company typically will NOT pay policy proceeds directly to a minor beneficiary. Although any
entity can be named as a beneficiary, many states don't permit proceeds to be paid to a minor because they lack
"legal capacity." In addition to a minor potentially not being competent to handle a large sum of money, a minor
may not be able to receive the payment and return a receipt in a legitimate manner. For these reasons, a guardian
or trustee is typically appointed to manage the estate. In some cases, the insurance company may hold the
proceeds and pay interest on them until the beneficiary reaches the age of majority.
[6.6.3] DISTRIBUTION TO A TRUST
Trusts may be named as the beneficiary of a life insurance policy and manage the proceeds upon the insured's
death. Naming a trust as the beneficiary is the most advantageous designation to use if a policyowner wants to
leave policy proceeds to a "minor" child. In this case, a trustee will manage the trust for the benefit of the child
(or children). However, trust administration fees may reduce policy proceeds. Two forms of trusts are
testamentary and inter vivos trusts. A testamentary trust is created at the time of the insured's death, as
specified in their will. An inter vivos (living) trust is created during the life of the insured.
[6.6.4] THE FACILITY OF PAYMENT PROVISION
The facility of payment provision permits an insurer to pay a portion (or all) of the policy proceeds to ANY
individual who appears to be equitably entitled. Such payment may be provided to a party who paid for the
medical or final expenses of the insured who has died. Typically, this provision arises when a death claim is not
filed within two months of the insured's death. Additionally, it may be triggered to assist a guardian when a minor
is listed as the beneficiary.
[6.7] UNIFORM SIMULTANEOUS DEATH ACT AND COMMON DISASTER PROVISION
How a policy responds to common disaster deaths is governed by the Uniform Simultaneous Death Act. It states
that if the insured and primary beneficiary both die in a common disaster (e.g., a plane crash) and it cannot be
determined who died first, the insured will be considered to have survived the primary beneficiary (or died last).
In other words, the primary beneficiary will be considered to have died before the insured. Therefore, the face
amount is paid to the contingent beneficiary.
The problem with the Uniform Simultaneous Death Act is that it only applies to situations in which it cannot be
definitively determined whether the insured died before the beneficiary. If it can be determined who died first,
even if the difference is only a few minutes or hours, the insurance company will follow the normal succession
process outlined in the policy:
If the primary beneficiary clearly died first, and then the insured died, the benefits are payable directly to the
contingent beneficiary.
If the insured died first, the death benefit is payable to the primary beneficiary. If the primary beneficiary dies
shortly thereafter, the face amount will be paid to the primary beneficiary's estate rather than to a contingent
beneficiary. Again, possible death taxes and probate charges may be assessed before the heirs receive the
remainder.
The common disaster provision further clarifies these complex situations by adding a survivorship clause (a
time-delay feature). This clause requires that the primary beneficiary not only survive longer but also outlive the
insured for a specified period (typically 14 to 30 days). The common disaster provision guarantees that if both the
insured and the primary beneficiary die within a stated period, the death benefits will be paid to the contingent
beneficiary. Benefits will only be paid to the primary beneficiary's estate if the primary beneficiary lives past the
required period.
The goal of both the Uniform Simultaneous Death Act and the common disaster provision is to protect the
contingent beneficiary by not paying the proceeds to the primary beneficiary's estate. Paying the benefits to the
beneficiary's estate will likely defeat the purpose of the insurance policy. Furthermore, it potentially causes
undesired death taxes and probate charges to be assessed, which significantly reduce the benefit before the
heirs receive the remainder. If no contingent beneficiary is listed, the benefits will be paid to the insured's estate,
just as if the primary beneficiary had predeceased the insured.
[6.7] UNIFORM SIMULTANEOUS DEATH ACT AND COMMON DISASTER PROVISION (continued)
For example, let's assume John has a life insurance policy that covers his life. He designates his wife, Mary, as
the primary beneficiary and all his children equally as the contingent beneficiaries. While traveling for business,
John and Mary are involved in a plane crash. When the paramedics arrive, John is found dead at the scene of the
crash, but Mary is found alive and is rushed to the hospital. Unfortunately, Mary succumbs to her injuries and
dies on the way to the hospital.
In this case, Mary outlived John. Under the Uniform Simultaneous Death Act, since John technically died first, the
proceeds of John's life insurance policy will be paid to Mary's estate, potentially creating both probate and tax
issues, as well as exposing the estate to creditors. However, since John's policy also contained the common
disaster provision, the insurance company will act as if Mary died first and pay John's death benefit directly to his
children.
[7.1] TAX TREATMENT OF INDIVIDUAL LIFE INSURANCE PREMIUMS
According to the Internal Revenue Code, premiums paid for individual life insurance policies are considered a
personal expense and, as such, are not tax-deductible. Just because a premium is used to purchase life
insurance on a spouse or in a third-party ownership situation doesn't mean that the premiums will be tax-
deductible.
Premiums paid on life insurance may be tax-deductible:
• For life insurance owned by a qualified charity to provide contributions to the charity.
• For life insurance taken out as a court order to benefit an ex-spouse as part of an alimony decree.
• To an employer if the insurance is used as an employee benefit.
[7.2] TAXATION OF PROCEEDS PAID AT DEATH
Since the premiums paid are not tax-deductible (they're paid after tax), the proceeds (death benefit) from the life
insurance policy are paid to the named beneficiary on a tax-free basis if disbursed as a lump sum. An exception
to this rule is the transfer-for-value rule, which applies when a life insurance policy is sold to another party before
the insured's death. The value of a life insurance policy (death benefit) is included in the policy owner's estate,
even though the face amount is paid to the beneficiary income tax-free. If death benefits are paid in installments
rather than as a lump sum, the principal is received tax-free, while any interest is taxable.
[7.2.1] ECONOMIC BENEFIT DOCTRINE
According to the Economic Benefit Doctrine, if any benefit with economic or financial value is granted to an
individual, it must be included as compensation for income tax purposes in the year in which the benefit is
granted. The key to avoiding the imposition of the Economic Benefit Doctrine is the existence of a substantial risk
of forfeiture. Therefore, individual life insurance avoids this doctrine since premature death can cause a
substantial risk to a surviving family.
[7.3] TAXATION OF PROCEEDS PAID WHILE THE INSURED IS ALIVE
[7.3.1] TAXATION OF CASH VALUES
The equity that builds up in a whole life policy is called the cash value. As the cash value increases, the interest
paid on it is tax-deferred. The total of the premiums paid into the policy, MINUS the total dividends received in
cash or used to offset premiums, is referred to as the cost basis. Under the cost recovery rule, if the policy is
surrendered for its cash value, the portion that exceeds the cost basis (or premiums paid) is treated as ordinary
income and taxable. If the cash value remains in the policy, taxes will never be imposed on any portion (not even
the amount that exceeds the cost basis).
[7.3.2 TAXATION OF POLICY LOANS
In most situations, if a contract owner borrows against the cash value in the contract (i.e., takes a policy loan),
there are no tax consequences. However, if a policy is a modified endowment contract (MEC), distributions are
subject to the interest-first rule, which treats them as taxable income to the extent that the contract's cash value
exceeds the contract's cost basis.
Borrowing against the cash value may be referred to as a partial surrender. This action on the part of the owner,
while not resulting in a taxable event, does lower the owner's equity in the policy. If a total surrender occurs, the
cash value received is not taxable, provided it doesn't exceed the total of premiums paid by the owner (i.e., the
cost basis). Additionally, when a contract owner borrows against the cash value of a whole life policy, the
interest paid to the insurer is not tax-deductible.
[[Link]] INSURANCE POLICY SCENARIO: TAX IMPLICATIONS OF POLICY LOANS
John owns a whole life insurance policy with a $100,000 cash value. His total premium payments (cost basis)
are $75,000. He's considering borrowing $30,000 from the policy to fund his daughter's college tuition.
If John's policy is a standard whole life policy:
• The $30,000 loan won't trigger taxes
• The loan reduces his equity in the policy
• The interest he pays isn't tax-deductible
If John's policy is an MEC:
• The $30,000 would be taxable as income since his cash
[7.3.3] TAXATION OF ACCELERATED DEATH BENEFIT
Under a life insurance policy, when benefits are paid to a terminally ill person, the benefits are received tax-free.
To be considered terminally ill, a physician must certify that the person has a condition or illness that will result in
death within two years.
[7.3.4] TAXATION OF POLICY DIVIDENDS
Dividends paid on a whole life policy are tax-exempt because they're considered a return of overpaid or excess
premiums. Although unlikely, any dividends received in excess of the premiums paid are taxable as ordinary
income. If dividends are left with the insurer to accumulate interest, the interest earned will be taxable as
ordinary income in the year in which it's received. If the IRS determines the life insurance policy to be an MEC,
dividends will be taxable unless they're used to purchase additional paid-up insurance. In addition, dividends
payable under an MEC may be subject to a 10% penalty tax if they are distributed before the age of 59
1/[Link]
[7.4] MODIFIED ENDOWMENT CONTRACTS
Recall from earlier that an MEC is not a life insurance policy. It is an IRS classification or category for an
insurance contract if certain conditions regarding its funding are not met. Any life insurance policy purchased
after June 20, 1988, is considered by the IRS to be an MEC if it does not satisfy the seven-pay test.
The following illustrates the tax treatment of MEC benefit distributions:
• Taxation occurs only when cash is distributed to the contract owner or money is withdrawn, whether
through surrender, a loan, or dividends.
• The gain (i.e., interest or appreciation) is taxable first when a distribution is made (i.e., LIFO).
• The first dollars received by the contract owner are considered "earnings first," or excess amounts of cash
value beyond premiums, and are taxable.
• If a policy is an MEC and cash is withdrawn, the amounts are still taxable, even if they are used for
legitimate reasons such as financial hardship or medical expenses.
• If cash is withdrawn prior to age 59 ½, a 10% penalty tax will be assessed.
[7.5] 1035 EXCHANGES
The Internal Revenue Code (IRC) permits an individual to trade or exchange a life insurance policy, endowment,
or annuity contract for another of like kind. Since a life insurance policy is a form of property, exchanges of
policies are allowed. When a less competitive policy is being replaced or exchanged for a more competitive
policy, a Section 1035 exchange may allow for the postponement of tax consequences. In other words, the IRC
allows a tax-free exchange if it is made from insurer to insurer, in which the policy owner never receives any cash.
This regulation allows the policyowner to transfer cash value from one contract to another without incurring
current tax consequences. If the transfer is transacted within or between insurance companies and the
policyowner receives no money, the exchange is permitted (without tax ramifications). This means that,
theoretically, the cost basis remains the same.
An annuity cannot be exchanged for a life insurance policy because the IRS prohibits policyowners from
exchanging policies that would improve the income tax treatment of the benefits. If this were permitted, the
policyowner could transfer funds from the annuity, which incurs income taxation on at least a portion of the
benefits (i.e., tax deferral means that the annuitant will be taxed on interest sometime in the future), to a life
insurance policy, which pays a death benefit free of income taxation. If this were allowed, an annuity-to-life
insurance exchange would move a tax-deferred characteristic to a tax-free characteristic.
Regarding a whole life insurance policy, a 1035 exchange involves the vesting of cash value from one permanent
insurance plan to another. Some of the reasons why an individual considers such a transfer include:
The financial condition or rating of the current insurer;
The enhancement of benefits in newer policies;
Higher interest rates are being offered in the newer policies; or
The desire for additional investment alternatives not available under the older contract.
When a policyowner decides to make a permitted exchange, the transfer, assignment, or surrender of the policy
to the insurer, along with the subsequent replacement with a new contract, must be completed within 60 days.
The policyowner should receive no cash proceeds to avoid tax considerations from the exchange.
Therefore, the following types of exchanges are allowed under this section of the IRC;
A life insurance policy for another life insurance policy, endowment, or annuity;
An endowment policy for another endowment or an annuity; or
An annuity contract for another annuity contract.
[8] CHAPTER SUMMARY
In this chapter, we've explored the fundamental relationship between life insurance premiums, proceeds, and
beneficiaries—the core elements that make life insurance work as a financial protection tool.
We began by examining how premiums serve as the consideration that binds the insurance contract, and how
insurers calculate these premiums using mortality, interest, and expense factors. You learned that personal
characteristics like age, gender, health history, and lifestyle significantly impact premium costs. We also explored
various premium payment methods, from single premium funding to flexible premium options, each designed to
meet different financial situations.
The chapter then shifted to policy proceeds and how they're distributed. You now understand the five settlement
options—lump-sum, interest-only, fixed period, fixed amount, and life income—and how each serves different
beneficiary needs. We examined the importance of proper beneficiary designation and the differences between
primary, contingent, and tertiary beneficiaries, as well as per capita versus per stirpes distribution methods.
Special provisions like the common disaster clause and spendthrift clause were discussed as important policy
features that protect beneficiaries in challenging circumstances. Finally, we explored the tax implications of life
insurance, including the tax-free nature of death benefits and the potential tax consequences of policy loans,
dividends, and surrenders.
As you prepare for your licensing exam, remember that these concepts aren't just academic—they represent real
decisions that affect people's financial security. Understanding how premiums fund benefits, how proceeds are
distributed, and how taxes impact these transactions will help you guide clients through some of their most
important financial decisions.
[8.2] REVIEW NOTES
Learning Objective 1: Explain the purpose of premiums in life insurance policies and identify the key
factors that influence premium calculations.
Key Concepts:
 • Premiums serve as payment for insurance coverage and constitute part of the policyholder's
consideration
• The consideration is the "binding force" in the contract between insurer and policy owner
• If the premium is not paid before the end of the grace period, the policy will lapse
• Life insurance premiums are calculated per $1,000 of coverage
Factors in Premium Calculation:
• Mortality factor: Based on mortality tables showing the probability of death at each age
• Interest/Investment factor: Reflects insurer's return on investments of premiums
• Expense factor (loading charge): Derived from operating expenses, including death benefits,
commissions, and administrative costs
Additional Factors Influencing Premium Cost:
• Age of the proposed insured: Older individuals pay higher premiums
• Sex/Gender: Women typically pay lower premiums due to longer life expectancy
• Health history: Poor health increases the probability of death and disability
• Occupation: Hazardous jobs increase risk of loss
• Personal activities and hobbies: High-risk activities increase risk of loss
• Personal habits: Tobacco use, DWI/DUI present a higher risk
Premium Types:
• Net (single) premium: Covers mortality cost and interest
• Net level annual premium: Amount required annually to ensure future benefits
• Gross premium: Actual premium paid (net premium + insurer expenses)
• Gross annual premium: Adjusted for payment over years rather than a single payment
Learning Objective 2: Distinguish between different premium payment methods, including level, modified,
flexible, and graded premium funding.
Premium Funding Methods:
• Single Premium Funding: One-time lump sum payment covering the entire policy
• Fixed/Level Premium Funding: Premiums are spread evenly over the policy period
• Modified Premium Funding: Lower initial premium for a set period, then increases to a higher constant
amount
• Graded Premium Funding: Begins with lower premiums that increase annually for a specified period, then
stabilizes
• Flexible Premium Funding: Allows adjustable payments throughout the policy's life
Other Premium Concepts:
• Premium mode: Frequency of payments (monthly, quarterly, annually)
• Higher frequency of payments results in higher total premiums
• Policy owners may use cash value and dividends to pay premiums
• Minimum deposit (financed) insurance: Uses policy loans to pay premiums
• Earned premium: The amount an insurer is entitled to for providing coverage
• Unearned premium: Amount paid but coverage not yet provided
• Reserves: Funds insurer sets aside to pay current and future claims
Learning Objective 3: Compare life insurance policy costs using various cost comparison methods.
Cost Comparison Methods:
• Interest-Adjusted Net Cost Method: Considers premiums, death benefits, cash value, and dividends
• Surrender Cost Index: Determines the average cost per thousand for a policy surrendered for cash value
• Net Payment Cost Index: Estimates average annual premium outlay without assuming surrender
• Comparative Interest Rate Method: Determines the rate of return required on an investment to yield the
same return as a cash value policy
Learning Objective 4: Describe viatical and life settlements and their role in the insurance marketplace.
Viatical Settlements:
 • Enables an individual with a chronic/terminal illness to sell their existing policy to a third party
• Original policy owner (viator) receives a percentage of the face value
• The new owner continues premium payments and collects the death benefit
• Special license required for viatical settlement providers in most states
• Tax-free payments require viator to be chronically or terminally ill
Life Settlements:
• Sale of existing policy to a third party for more than the surrender value but less than the death benefit
• No requirement for the insured to be chronically/terminally ill
• Life settlement brokers must hold the appropriate license
• Disclosure requirements include the right of rescission within 15 days
• Not considered life settlements: policy loans, 1035 exchanges, assignments as collateral
Learning Objective 5: Identify the different death benefit settlement options and explain how each works.
Death Benefit Settlement Options:
• Lump-Sum (Cash Payment): Entire death benefit paid at once; most common and default option
• Interest Only: Insurer holds the death benefit and pays only the earned interest to the beneficiary
• Fixed Amount: Proceeds paid in specified installment amounts until principal and interest are exhausted
• Fixed Period: Equal installments paid over a set period of years
• Life Income: Guarantees payments to the beneficiary for the beneficiary's lifetime. Life income
settlement options include:
o Single/Pure/Straight Life Income: Payments end upon beneficiary's death with no refund
o Life Income with Period Certain: Payments continue to the secondary beneficiary if the primary
dies before the period ends
o Refund Life Income: Guarantees payment of the remaining death benefit if the beneficiary dies
prematurely
o Joint and Survivor: Guarantees benefits to two or more people on a life-long basis
Learning Objective 6: Differentiate between types of beneficiary designations and methods of benefit
distribution.
Beneficiary Types:
• Primary beneficiary: First in line to receive policy proceeds
• Secondary/Contingent beneficiary: Receives proceeds if the primary beneficiary predeceases the
insured
• Tertiary beneficiary: Third in line to receive proceeds
• Revocable beneficiary: Can be changed by the policy owner without notifying the beneficiary
• Irrevocable beneficiary: Cannot be changed without the beneficiary's written consent
Distribution Methods:
• Per Capita: Evenly distributes benefits among all named living beneficiaries
• Per Stirpes: Distributes according to family line; deceased beneficiary's share goes to their heirs
• Distribution to Estate: Proceeds subject to estate taxes, probate fees, and creditor claims
• Distribution to Minor: Typically requires a guardian or trustee
• Distribution to Trust: Trust manages proceeds; advantageous for minor beneficiaries
Learning Objective 7: Explain how special provisions like the common disaster clause and spendthrift
clause protect beneficiaries.
Special Provisions:
• Uniform Simultaneous Death Act: If the insured and the beneficiary die together and the order cannot be
determined, the insured is considered to have survived
• Common Disaster Provision: Requires the beneficiary to survive insured by a specified period (14-30
days)
• Spendthrift Clause: Protects proceeds against creditors when left with the insurer
• Facility of Payment: Permits insurer to pay a portion of proceeds to anyone equitably entitled
Learning Objective 8: Analyze the tax consequences of life insurance premiums, proceeds, and
distributions.
Tax Consequences of Premiums:
• Individual life insurance premiums are personal expenses and not tax-deductible
• Exceptions: Premiums may be deductible for qualified charity-owned policies, court-ordered alimony, or
as an employee benefit
Tax Consequences of Proceeds:
• Death benefits paid as a lump sum are income tax-free to the beneficiary
• Exception: Transfer-for-value rule when policy sold before insured's death
• Policy values are included the in owner's estate for estate tax purposes
• Installment payments: Principal received tax-free, interest is taxable
Tax Consequences During Insured's Life:
• Cash value interest accumulates tax-deferred
• Policy surrender: Amount exceeding cost basis is taxable as ordinary income
• Policy loans: Generally, there are no tax consequences unless the policy is a MEC
• Accelerated death benefits: Tax-free for terminally ill (death expected within 2 years)
• Dividends: Generally tax-exempt as return of excess premiums
• Modified Endowment Contract (MEC): Subject to different tax treatment
• 1035 Exchange: Tax-free exchange of like-kind insurance products
Exam Tips:
• Know the three factors in premium calculation: mortality, interest, and expenses
• Understand differences between premium funding methods
• Memorize the five settlement options and their characteristics
• Know the difference between per capita and per stirpes distribution
• Understand how the common disaster provision protects contingent beneficiaries
• Remember the tax treatment of premiums, proceeds, and distributions
• Know the definition and tax implications of Modified Endowment Contracts
• Understand permitted 1035 exchanges and their tax consequences
Chapter 7
[1] LIFE INSURANCE UNDERWRITING: INTRODUCTION
Have you ever wondered how insurance companies decide who to insure and at what cost? When Maria applies
for life insurance to protect her family, what determines whether she'll be approved, and how much she'll pay?
The answers lie in a process called underwriting—the foundation of the insurance industry. Underwriting is the
backbone of the insurance industry, balancing insurers' need to manage risk with consumers' need for fair
access to protection.
Imagine you're helping a client complete a life insurance application. They ask, "Why do they need to know so
much about me?" This chapter will help you answer that question with confidence. You'll learn how insurance
companies evaluate applicants like your client, balancing the need to offer fair coverage while protecting
themselves from excessive risk.
Underwriting might seem mysterious at first, but it follows logical principles that you can easily understand and
explain to others. From the moment you help a client complete an application to the day you deliver their policy,
you play a crucial role in this process. You will learn about the information underwriters collect, how they classify
applicants into different risk categories, and what happens when the premium is collected.
For example, when your client Mark mentions his weekend skydiving hobby on his application, you will
understand why the underwriter requests additional information and how this might affect his premium. Or when
Sarah asks why she needs to sign a medical release form, you'll be able to explain how her health information
helps ensure she receives the appropriate coverage at a fair price.
In this chapter, you will learn the step-by-step process that underwriters follow to evaluate applicants like Sarah.
You will discover how they assess health conditions, lifestyle factors, and financial situations to make fair and
accurate decisions. What factors do you think might influence your own insurability? By the end of this
chapter, you will be able to explain the underwriting process to your clients and help them navigate their
insurance journey with confidence.
This chapter is broken into the following sections:
• Agent Responsibility and Proper Solicitation;
• The Purpose and Characteristics of Life Insurance Underwriting;
• The Application;
• Additional Sources of Underwriting Information;
• Initial Premium and Receipts; and
• Policy Issue and Delivery.
As we explore the underwriting journey together, remember that each concept connects directly to real-world
situations you'll encounter as an insurance professional. Let us begin by examining your responsibilities as an
agent in this important process.
[1.1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
• Explain the agent's role and responsibilities in the life insurance solicitation and underwriting process
• Define insurable interest and identify when it must exist in life insurance contracts
• Describe the purpose of underwriting and how it helps prevent adverse selection
• Identify the key parties involved in the underwriting process and their specific responsibilities
• Outline the three parts of a life insurance application and explain the importance of accurate completion
• Compare the different sources of underwriting information and explain how each contributes to risk
assessment
• Differentiate between preferred, standard, and substandard risk classifications
• Explain how premium receipts affect when coverage begins and the conditions that must be met
• Describe the policy issuance and delivery process, including the concept of constructive delivery
• Identify the consumer protections in the underwriting process, including disclosure requirements and the
free-look period
[1.2] KEYWORDS
Prior to reading this chapter, please review the following keywords. An understanding of their basic definitions
will improve your comprehension of the chapter content.
Adverse Selection: The tendency of higher-risk individuals to seek insurance coverage. Sound underwriting
practices help insurers identify and manage this risk to maintain fair premiums for all policyholders.
Attending Physician Statement (APS): A report from an applicant's doctor providing detailed medical information
requested by underwriters when the application reveals conditions requiring further investigation.
Conditional Receipt: A document provided when premium is collected with an application that establishes when
coverage begins, subject to the applicant proving insurability. Coverage is typically effective as of the application
date or medical exam date.
Field Underwriter: The agent or producer who initiates the underwriting process by completing the application,
collecting information, and submitting it to the home office underwriter.
Fiduciary Capacity/Responsibility: The legal obligation of insurance producers to act in the best interest of their
clients when collecting premiums and providing advice. This trust relationship requires producers to place client
interests above their own and exercise care, loyalty, and good faith in all insurance transactions.
Free-Look Period: A minimum 10-day period (30 days for mail-order policies) after policy delivery during which
the owner can return the contract for a full premium refund if dissatisfied.
Insurable Interest: A financial or emotional relationship between parties that justifies one owning life insurance
on another. Insurable interest must exist at policy issue and is automatically presumed in certain relationships
(spouses, parents, children, business partners).
Medical Information Bureau (MIB): A service organization that collects and shares medical data on insurance
applicants among member companies to help detect undisclosed health conditions and prevent fraud.
Representations: Statements made by applicants on insurance applications that are considered substantially
true to the best of their knowledge. Unlike warranties, representations must only be materially accurate, not
absolutely true in every detail.
Risk Classification: The categorization of applicants based on their risk profile, typically as preferred, standard, or
substandard risks. Classification determines premium rates and insurability.
Underwriting: The process of evaluating applicants to determine insurability and appropriate risk classification.
Underwriting involves analyzing information from various sources to decide whether to issue coverage and at
what premium rate.
[2] AGENT RESPONSIBILITY AND PROPER SOLICITATION
Your role as an insurance agent carries significant legal and ethical responsibilities. When you represent an
insurance company and advise clients, you're not just selling a product – you're acting in a position of trust.
Understanding these responsibilities will help you avoid common pitfalls while building a reputation for
professionalism and integrity.
[2.1] AGENT RESPONSIBILITY
An agent plays an essential role in the underwriting process. Any producer is required to act in a fiduciary
capacity when collecting premiums and dealing with the public. As such, all producers possess a fiduciary
responsibility when engaging in insurance transactions. A producer who has made an unintentional error or
honest mistake has committed a tort, known as an error and omission. Therefore, it’s recommended that
insurers purchase Errors and Omissions (E&O) insurance to cover the malpractice or negligence of producers. In
some cases, agents may be required to obtain their own Errors and Omissions coverage.
As a field underwriter, the agent initiates the process and is responsible for many crucial tasks, including proper
solicitation, completing the application thoroughly and accurately, obtaining appropriate signatures, collecting
the initial premium, and issuing a receipt. Each of these tasks is vitally important to the underwriting process and
policy issue.
[2.2] PROPER SOLICITATION
As a representative of the insurer, an agent has the duty and responsibility to solicit good (i.e., profitable)
business. Therefore, an agent’s solicitation and prospecting efforts should focus on cases that fall within the
insurer’s underwriting guidelines and represent profitable business to the insurer. At the same time, the agent has
a responsibility to the insurance-buying public to observe the highest professional standards when conducting
insurance business.
[2.3] INSURABLE INTEREST
[2.3.1] DOES INSURABLE INTEREST EXIST?
Insurable interest is vital in life insurance. Without this requirement, a person could purchase life insurance on
another party and the policy would represent nothing more than a wagering contract. As established previously,
an insurable interest exists when the insured’s death will have a clear financial impact on the policy owner.
Therefore, when the applicant and proposed insured are the same person, there’s no question that insurable
interest exists. However, questions are raised with third-party contracts (those in which the applicant is not the
insured). Some relationships are automatically presumed to qualify as insurable interest, such as spouses,
parents, children, and specific business relationships. Insurable interest cannot be established sufficiently by
sentimental attachment alone.
The following is a list of situations in which insurable interest automatically exists:
• An individual has an insurable interest in their own life.
• A husband or wife has an insurable interest in their spouse.
• Parents have an insurable interest in their children.
• A child has an insurable interest in a parent or grandparent.
• A business has an insurable interest in the lives of its officers, directors, and key employees, including an
employee who produces high-volume sales.
• Business partners have an insurable interest in each other.
• A creditor has an insurable interest in the life of a debtor (but only to the extent of the debt).
It bears repeating that, with life insurance, an insurable interest must exist only at the time of application or policy
inception. It doesn’t need to exist at the time of loss (when the policy proceeds are paid at death). Therefore, a
policy owner could assign a life policy to a person with no insurable interest in the insured, and the assignment
will still be valid. Also, with a few exceptions (e.g., buying insurance on a minor), a person cannot purchase life
insurance on another person without their consent.
[2.3.2] AMOUNT OF INSURABLE INTEREST
Based on the principle of indemnity, a person’s insurable interest should be limited to the amount required to
“return an insured to whole” after suffering a loss. The insured should be returned to the same financial condition
that existed before the loss – no better and no worse. Indemnity is a simple concept for property insurance; the
insured should be “made financially whole again” when the damaged or destroyed property is repaired or
replaced.
For example, if an individual purchases a home that has a replacement cost of $250,000, they could purchase a
homeowners insurance policy for up to $250,000 to replace the home if they experience a total loss.
With life insurance, once insurable interest is generally established, the amount of that interest is typically
limited by the amount of insurance that the insurer is willing to issue and the amount of premium that the policy
owner can afford. However, there are some general guidelines to remember. Individuals are typically presumed
to have an unlimited insurable interest in themselves. Additionally, life insurance proceeds collected by a
creditor-beneficiary are generally limited to the amount of the debt PLUS interest.
Some insurance companies may have limits based on the relationship between the insured and the beneficiary.
For example, a parent may have a more insurable interest in their child than a grandparent to a grandchild.
Furthermore, an insurer may limit the coverage amount available on a child due to the parent’s amount of (or lack
of) coverage. For example, a parent with less than $50,000 of life insurance coverage may be limited to
purchasing no more than $25,000 worth of coverage on their child.
[2.4] DISCLOSURES: BUYER'S GUIDE AND POLICY SUMMARY
If required by state law, the agent must sign a form confirming that a disclosure statement has been given to the
applicant. Moreover, the proposed insured and the agent (as a witness) must sign a form authorizing the
insurance company to obtain investigative consumer reports or medical information from investigative agencies,
physicians, hospitals, or other sources. The insurance company’s name and the agent’s name and license
identification number must appear on the application. This information may be printed, typed, stamped, or
handwritten (if legible).
In many states, an agent must deliver both a life insurance buyer’s guide and a policy summary to the applicant.
These documents are generally delivered before the agent accepts the applicant’s initial premium.
• The Buyer’s Guide is a generic publication that explains life insurance in a way that average consumers
can understand. It describes the basic types of insurance including whole life, term insurance, universal
life, and the differences between them. It is a compliance document. It addresses general concepts, not
the specific product or policy under consideration.
• The Policy Summary describes the specific product being presented for sale and identifies the agent,
insurer, policy, and each rider. It includes information about premiums, dividends, benefit amounts, cash
surrender values, policy loan interest rates, and life insurance cost indexes of the specific policy being
considered.
Exam Tip!
Agents must provide required disclosures before collecting the first premium. Failure to do so can lead to
regulatory non-compliance – a detail that appears frequently on exam questions about ethical and legal
responsibilities in insurance sales.
[3] THE PURPOSE AND CHARACTERISTICS OF LIFE INSURANCE UNDERWRITING
Insurance companies aim to provide coverage to qualified applicants while managing risk. However, they need to
exercise caution when deciding who’s qualified to purchase insurance. Issuing a policy to an uninsurable person
is an unwise business decision that can easily result in a company’s financial loss. One of the primary
responsibilities of an underwriter is to protect the insurer against adverse selection.
Remember, adverse selection is the underwriting concept that involves the tendency of poorer risks to seek
insurance coverage or the chance that an insurer will accept applicants who are bad risks (i.e., those in poor
health, who are moral hazards, etc.). Simply put, those who are most likely to experience a loss are also most
likely to seek insurance. Sound, competent individual or group underwriting will reduce the probability of adverse
selection.
For example, a person with a life-threatening disease is typically more concerned or eager to obtain insurance
coverage due to the probability of imminent death than a healthy individual.
Just as each insurer determines the premium rates it will charge its policy owners, each insurer also sets its own
standards of what constitutes an insurable risk versus an uninsurable risk. A company underwriter individually
reviews every insurance applicant to determine whether the applicant meets the company’s standards to qualify
for its life insurance coverage.
Underwriting – another term for risk selection – is the process of reviewing the many characteristics that make up
the risk profile of an applicant to determine whether the applicant is insurable and, if so, at standard or
substandard rates. The two fundamental questions that underwriters seek to answer about an applicant are:
• If the applicant and the insured are two different people, does an insurable interest exist between them?
• Is the applicant insurable?
As you begin your insurance career, understanding why underwriting exists is essential. Underwriting is more
than just paperwork – it's the process that protects both insurance companies and policyholders from financial
harm. When your clients ask why they need to answer so many personal questions, you'll need to explain how
underwriting helps create a fair system where everyone pays premiums appropriate to their risk level. Let's
explore the fundamental principles that guide this critical process.
[3.1] IS THE PROPOSED INSURED INSURABLE?
Once it is determined that insurable interest exists, the next question is whether the proposed insured is
insurable. The answer to this question lies in the underwriting process. The underwriting process involves
reviewing and evaluating information about a proposed insured and applying what is known about the individual
against the insurer’s standards and guidelines for insurability and premium rates.
As previously examined, the most common way to manage risk is for an individual to transfer it to an insurer by
purchasing an insurance policy. An insurer cannot insure every type of risk presented. For a pure risk to be
insurable, it must involve a chance of loss that is accidental, measurable, and definable, and cannot involve a
chance for financial gain. The law of large numbers must also apply. This mathematical law of probability states
that the larger the number of occurrences (i.e., the number of lives covered), the more predictable the losses will
be. As the number of exposures increases, the actual results will more closely approach the expected results for
a specific event. In other words, the larger the number of homogeneous units (i.e., similar risks), the better our
ability will be to predict aggregate losses. Other elements of insurable risk include:
• The loss must be significant enough to cause financial hardship (e.g., death).
• The loss must not be catastrophic (e.g., loss due to war).
• The cost for coverage (i.e., the premium) must not be unreasonable.
• The loss must be unpredictable or fortuitous.
Underwriting evaluates the proposed risk (or insured) and determines whether the elements of insurable risk
have been met. If the risk is insurable, underwriting then determines the premium amount based on the net risk
(the likelihood of having to pay a claim).
[3.2] PARTIES INVOLVED IN UNDERWRITING
Underwriting is a collaborative process involving several key players with distinct responsibilities. As a new
insurance professional, you'll need to understand not only your role in this process but also how you'll interact
with others. When your clients ask who will be reviewing their application, you should be able to explain each
person's contribution to the final decision.
For the state exam, a person needs to understand the parties involved in the underwriting process to answer
questions accurately. A producer needs to understand who they need to speak with to complete and sign
insurance applications. Also, producers need to know who to reach out to if questions arise regarding insurance
applications or insurability.
When taking applications for potential insureds on behalf of the insurer, a producer performs the extremely
important initial step in the underwriting process, referred to as field underwriting. During this process, the
producer determines which risks are desirable and submits those to the underwriting department for approval.
The producer also possesses some additional duties for the application process. A field underwriter or
producer may solicit appointments, complete applications, collect premiums, and submit applications to the
home office underwriter; however, the producer doesn’t issue the policy. The producer is also responsible for
providing any required disclosure of information practices to an applicant, such as a notice regarding
replacement, a life insurance buyer’s guide, an outline of coverage, or a policy summary.
The applicant is simply the person requesting the insurance and completing the application, typically with the
help of a licensed producer. In many cases (but not always), the applicant is also the proposed insured.
The proposed insured is the person whose life is to be insured (if approved). The policy owner retains all of the
policy’s rights and options if the application is approved. The policy owner also typically serves as the payor (i.e.,
the person ultimately responsible for ensuring that the premiums are paid when due). The underwriter reviews
the insurance application, examines any additional applicant information, and classifies the degree of risk posed
by the proposed insured to determine whether coverage should be offered and, if so, at what premium rate.
For example, Frannie works with an insurance producer to complete an application for a $20,000 insurance
policy on her life. In this situation, Frannie is the applicant, the proposed insured, the policy owner, and the payor.
After completing her application, Frannie informs the insurance producer that she also wants to obtain insurance
for her five-year-old son. In this case, Frannie is the applicant, policy owner, and payor, but her son is the
proposed insured.
Exam Tip!
Although the parties of an insurance contract can be very complicated, the vast majority involve only one party.
Typically, the policy owner, payor, applicant, and proposed insured are all the same person. For the exam,
assume that this is the case unless a question specifically suggests otherwise.
With a few exceptions (e.g., buying insurance on a minor), an individual CANNOT purchase life insurance on
another person without that person’s consent.
For example, Luke wants to purchase a life insurance policy on his wife, Gina. Gina agrees and signs the
application; therefore, she has provided her consent. However, it’s doubtful (and for good reason) that an insurer
would approve an application if Luke were to apply for a $500,000 accidental death insurance policy covering
Gina’s life without her consent.
[3.3] INSURABILITY AND THE UNDERWRITING PROCESS
An underwriter’s primary duties are to assess risks (i.e., applications), approve or decline applications, determine
premiums, and protect the insurer against adverse selection. Underwriters have several sources of underwriting
information available to develop an applicant’s risk profile. The number of sources that underwriters check
typically depends on several factors, most notably the requested policy’s size (i.e., face value) and the risk profile
that’s developed after an initial review of the application. The larger the policy, the more comprehensive and
diligent the underwriting research.
Regardless of the policy size, an application that raises questions in the underwriter’s mind can also trigger a
review of other information sources. The most common underwriting information sources include the
application, medical report, an Attending Physician's Statement (APS), the Medical Information Bureau (MIB),
special questionnaires, inspection reports, and credit reports.
Mortality tables show the rates of death in a defined population over a selected period, or survival rates from
birth to death. The tables also show that the likelihood of death increases with age. This is why age affects
insurance costs. Mortality information also indicates that women statistically live longer than men. Therefore, for
an insurer, the risk when providing coverage for a female is lower than it is for a male and, as such, the cost is
lower (all things being equal).
The producer's field underwriting also assists the home office underwriters. The agent should complete the
application by providing as much detail as possible. Once the application is forwarded to the insurer, the
underwriter may require additional information from the applicant’s doctor to assess the risk; however, this is
only permitted if the applicant signs a disclosure statement. In some instances, insurers use a non-medical
application, which requires no additional information other than the application. This type of application is most
often used for younger proposed insureds (e.g., in their 20s and 30s) seeking a limited amount of coverage.
[3.3.1] PRE-SELECTION UNDERWRITING ACTIVITIES
This involves the process by which an agent or producer completes the initial application prior to submission to
the underwriting department. Appropriate activities include:
• Obtaining complete and detailed answers to all policy application questions, including personal
physician information
• Providing insight with regard to possible underwriting rating services
• Stressing the importance of answering all questions honestly
An agent may not legally guarantee or bind coverage.
[3.3.2] POST-SELECTION ACTIVITIES
These involve the activities conducted by the underwriting department once the application has been received,
including:
• Evaluating the risk by using all appropriate sources of information
• Determining the acceptability of the risk and whether the applicant will be classified as a preferred,
standard, or substandard risk (a substandard risk may be uninsurable or may be written with a higher
[rated] premium)
[3.3.3] UNDERWRITING OUTCOMES
Underwriting outcomes affect the insurer and the business it writes. It also affects an insured's ability to secure
desired insurance coverage. Lastly, agents or producers are also affected by underwriting decisions, as positive
decisions lead to policy issuance and commission payments.
[3.4] PRIVACY NOTICE
The Health Insurance Portability and Accountability Act of 1996 (HIPAA) is a federal law that establishes national
standards to protect sensitive patient health information from disclosure without the patient’s consent or
knowledge, and grants patients an array of rights concerning individually identifiable health information. Under
HIPAA, when an agent submits an application that reveals an applicant's personal information, the agent must
provide the applicant with a privacy notice. In applicable situations, producers must also secure an HIV consent
form from the applicant and inform the applicant that blood tests may be a required underwriting practice. In
other words, despite the insurer requiring a blood test as part of its regular underwriting, it must still secure a
signed consent form indicating to the applicant that any blood taken will be screened for HIV and that they're
providing permission for such testing.
Exam Tip!
HIPAA mandates that applicants must receive a privacy notice outlining how their personal health information
will be handled. Exams often test your understanding of when and how privacy notices are required.
[4] THE APPLICATION
For an insurer, the insurance application is its underwriting department’s principal source or tool to determine
whether a potential insured (the applicant) is eligible for insurance coverage. Regardless of what other sources of
information from which the underwriter may draw, the application is the first source of information to be
reviewed and evaluated thoroughly. Since the application provides a variety of important information to the
insurer, it’s the agent’s responsibility to ensure that an applicant’s answers to the application’s questions are
thoroughly and accurately recorded. There are three essential parts to a typical life insurance application:
• Part I: General Applicant Information
• Part II: Medical and Health History
• Part III: The Agent’s Report or Statement
An underwriter is provided with the application and will review the information in all three sections to determine
whether the proposed insured is insurable. All of the fact-finding information that appears on an application will
help the underwriting department determine the individual premiums to be charged.
Exam Tip!
As described previously, the application also serves as the applicant’s formal request for insurance. Together
with the initial premium, a completed application is the applicant’s consideration.
[4.1] PART I: GENERAL APPLICATION INFORMATION
Part I of the application includes general questions about the proposed insured, including name, age, address,
birth date, sex, income, marital status, and occupation. Details about the requested insurance coverage are also
included in Part I, such as:
• Type of policy
• Amount of insurance
• Name and relationship of the beneficiary
• Other insurance owned by the proposed insured
• Any additional insurance applications that are pending for the proposed insured
Other information being sought may indicate possible exposure to hazardous hobbies (e.g., scuba diving), foreign
travel, aviation activities, or military service. Part I of the application also indicates whether the proposed insured
is a tobacco user.
The application will also typically include a question asking whether the proposed insurance will replace an
existing policy. If a policy replacement is indicated, each state will require agents to provide specific disclosure
and follow codified procedures to protect consumers’ rights.
[4.2] PART II: MEDICAL AND HEALTH HISTORY
Part II focuses on the proposed insured’s health and includes several questions about the person’s health history,
not only of the proposed insured, but also of the proposed insured’s family. This medical section must be
completed in its entirety for every application.
Depending on the proposed policy face amount, additional medical information may be required beyond what is
outlined in this section. The proposed insured may be required to take a medical exam, provide a blood test, or
provide a urine specimen. If requested by the insurer, physical exams are performed at the insurer's expense.
[4.3] PART III: THE AGENT’S REPORT (OR STATEMENT)
The agent’s report or agent’s statement is often described as Part III of the application. Actually, the agent’s report
is a confidential communication between the agent, as a field underwriter, and the insurance company. The
agent’s statement is where the agent indicates their personal observations of the proposed insured. Since the
agent represents the insurance company’s interests, the agent is expected to complete this part of the
application thoroughly and truthfully.
The nature of the agent’s report allows a producer to provide additional information about the applicant’s
financial condition and character, the background and purpose of the sale, and how long the agent has known the
applicant.
Exam Tip!
The application is a critical document. Incomplete or inaccurate applications can result in delayed underwriting
or coverage denial. Watch out for exam questions that test your knowledge of the consequences of
misrepresentation!
[4.5] COMPLETING THE APPLICATION
The application is one of the most critical sources of underwriting information, and it’s the agent’s responsibility
to ensure that the application is completed fully and accurately. There may be several consequences of a
producer submitting an incomplete application, including a delay in underwriting, policy issuance, policy delivery,
and commission payment to the producer. The applicant may also choose to do business elsewhere due to such
delays. An insurance company will return the application to the agent if the agent submits an incomplete
application.
Insurers use statements made in the application to evaluate risks and decide whether to insure the proposed
insured (applicant). All of the applicant’s replies to specific questions on the application regarding health history
are considered representations.
Representations are statements made by an applicant that are deemed substantially true to the best of the
applicant’s knowledge and belief; however, they are not warranted to be exact in every detail. Representations
must be accurate only to the extent that they’re material to the risk. If the applicant lies about their health status,
it is a material misrepresentation that may void the policy or lead the insurer to cancel it. Typically, the premium
is refunded to the policy owner or applicant whenever the insurer cancels or declines an insurance policy.
If an applicant makes any statements that are guaranteed to be true, they have made a warranty. A warranty that
is not literally true in every detail (even if made in error) is sufficient to render a policy void. Therefore, the
statements made by an applicant and recorded on the application are considered to be representations and not
warranties.
If an insurer rejects a claim based on a representation, it bears the burden of proving materiality. Representations
are considered fraudulent only when they relate to a matter that’s material to the risk and when they were made
with fraudulent intent.
[4.5.1] SCENARIO – MATERIAL MISREPRESENTATION
Carlos applied for a $750,000 life insurance policy. When completing the application with his agent, he
answered "No" to questions about tobacco use, though he had been smoking a pack of cigarettes daily for 15
years. He also denied having any respiratory conditions, despite being treated for chronic bronchitis twice in the
past year.
The policy was issued at preferred non-smoker rates. Thirteen months later, Carlos died from pneumonia
complications. During the claims investigation, the insurer obtained medical records revealing his smoking
history and previous bronchitis treatments.
Despite the policy being beyond the one-year contestable period, the insurer denied the claim on the grounds of
material misrepresentation. Carlos's beneficiary sued, but the court upheld the denial, finding that:
1. The misrepresentations were material to the risk.
2. The insurer would have either declined coverage or issued a policy at smoker rates with higher premiums.
3. The incontestability clause does not protect against fraudulent misrepresentation in most states.
This case demonstrates why truthful disclosure on applications is essential, even after the contestable period
has passed.
[4.6] APPLICATION SIGNATURES
When a producer completes an application, they must include at least two required signatures: the applicant's
and the producer's. If third-party ownership is present (when the applicant and proposed insured are different
parties), the application requires three signatures: the applicant, the proposed insured, and the producer.
All insurers require the producer to sign the application as well, or it will not be underwritten. The applicant’s
signature is required on a life insurance application to indicate that the application’s statements are true to the
best of the applicant’s knowledge. Therefore, the applicant’s signature attests to the accuracy of the information
in the application. By reading and signing the insurance application, the applicant should understand that any
false statements on the application could result in loss of coverage.
Exam Tip!
Both the applicant and the agent must sign the insurance application. When the proposed insured is not the
policy owner, all parties’ signatures (except the beneficiary) are required. This detail is a common exam trap!
[4.6.1] MINOR APPLICANTS AND PROPOSED INSUREDS
Any person younger than the age of majority is considered a minor (for most states, the age of majority is 18). In
general, this principle also applies to legal contracts, meaning minors can usually void any contracts they signed
before reaching 18 years of age. However, life insurance is an exception to this principle. In life insurance
contracts, most states consider anyone under 15 a minor. Typically, proposed insureds aged 15 or older (14 1/2
in New York and 16 in Indiana) can sign and enter into a life insurance contract. In reality, many companies still
require a parent or guardian’s signature if the proposed insured is under 18.
[4.6.2] CHANGES TO THE APPLICATION
The insurance application must be completed accurately, honestly, and thoroughly, and it must be signed by the
insured and witnessed. When an applicant makes a mistake regarding the information given to an agent
completing the application, the applicant can have the agent correct the information, but the applicant must
initial the correction. If the producer alters or changes the application information in any way without informing
the applicant or insurer, they may be engaging in fraud. Therefore, any changes made to an application by a
producer must be initiated by both the applicant and the producer before the application is submitted to
underwriting. If the company discovers a mistake, it typically returns the application to the agent. The agent must
then have the applicant correct the mistake and initial the change.
If the insurer discovers that the information on an application is incomplete or incorrect after a policy is issued,
the company may rescind or cancel the contract. However, the company may only rescind or cancel the contract
during the policy’s contestable period. Once the policy’s incontestable clause takes effect, the insurer can no
longer rescind or cancel the contract.
Remember, the application becomes part of the legal contract between the insurer and the insured when it’s
attached to the insurance policy. Consequently, the general rule is that no alterations of any written application
can be made by any person (other than the applicant) without the applicant’s written permission.
With this foundation in mind, let's explore how insurers categorize applicants into different risk classes.
[5] ADDITIONAL SOURCES OF UNDERWRITING INFORMATION
When clients ask why insurance companies need so much information, they're often surprised by the variety of
sources underwriters consult. Beyond the application itself, underwriters have access to specialized databases,
such as those of the Medical Information Bureau, and to reports that help create a complete picture of each
applicant. Understanding these information sources will help you prepare clients for the underwriting process
and explain why certain questions or requirements exist.
Although the primary source of information for an underwriter is the application, additional information may be
required if the application reveals certain health conditions or other risk exposures. The underwriter will also
base a final decision on an assortment of other information, including the producer or agent’s report, an APS,
MIB, consumer (e.g., credit) or inspection reports, medical or physical exam results (e.g., medical report),
laboratory tests (e.g., blood tests or HIV), or a motor vehicle DMV report. Many insurers require an applicant to
complete a hazardous activity questionnaire to determine whether the proposed insured engages in scuba
diving, skydiving, any type of racing (auto, motorcycle, boat), aviation activities, hang gliding, or mountain
climbing.
By understanding these information sources, you will be better equipped to guide your clients through the
application process, set appropriate expectations, and help them present their case in the most favorable light.
[5.1] THE MEDICAL INFORMATION BUREAU
Another source of underwriting information that focuses explicitly on an applicant’s medical history is
the Medical Information Bureau (MIB), which was formed by more than 700 member insurance companies.
Think of the MIB as the insurance industry's shared memory. When your client mentions they've applied for
insurance before, the underwriter will check the MIB to see what health information was previously reported. The
MIB contains information about an applicant’s health history and helps identify any adverse health conditions the
potential insured may experience. The MIB report will also identify life insurance in force with other carriers and
lifestyle habits, such as drug use.
For example, if your client disclosed diabetes on a previous application but omitted it on the current one, this
discrepancy will be flagged by an MIB check. You should explain to clients that this helps keep premiums fair for
everyone by preventing information gaps.
The purpose of the MIB is to serve as a reliable source of medical information concerning applicants and to help
disclose cases in which an applicant either forgets or conceals pertinent underwriting information or submits
erroneous or misleading medical information with fraudulent intent. An MIB report may disclose lifestyle habits
such as drugs, drinking, overeating, and smoking. The MIB operations help to minimize the cost of life insurance
for all policy owners by preventing misrepresentation and fraud. Information received from the MIB about a
proposed insured may be released to the proposed insured’s physician. One of the primary purposes of an MIB
report is to help insurers avoid high-risk applicants.
The MIB also identifies situations in which multiple applications are placed with different insurers
simultaneously. Such situations potentially result in overinsurance or a planned replacement.
The following is a summary of how the MIB works:
If a company discovers that one of its applicants has a physical ailment or impairment listed by the MIB, it must
report the information to the MIB using a code number. By having this information, home office underwriters will
know that a past problem existed if the same applicant later applies for life insurance with another member
company. The information is available to member companies only and may be used only for underwriting and
claims purposes. Information received from the MIB regarding a proposed insured may be released to the
proposed insured’s physician. An applicant may request a free copy of their MIB report from the MIB.
[5.1.1] SCENARIO – MEDICAL INFORMATION BUREAU
Jennifer applied for a $1 million life insurance policy with Company A. During underwriting, the company
discovered through medical records that she had been treated for depression and prescribed medication, which
she hadn't disclosed in her application. Company A declined her application and reported the undisclosed
depression to the MIB using appropriate codes.
Three months later, Jennifer applied with Company B, again omitting her depression history. When Company B
checked the MIB database, they found the code indicating undisclosed depression. The underwriter requested
an APS, which confirmed the condition. Rather than declining coverage, Company B offered Jennifer a standard
policy with a mental health exclusion rider.
Six months later, Jennifer applied with Company C and fully disclosed her depression history, current treatment,
and previous declination. Because of her honesty and evidence that her condition was well-managed, Company
C offered her a standard policy without exclusions, though at a slightly higher premium than would be offered to
someone without depression.
This scenario demonstrates how the MIB helps insurers detect undisclosed conditions while still allowing
applicants with managed health conditions to obtain appropriate coverage when they provide full disclosure.
[5.2] MEDICAL REPORTS
A policy is often issued based on only the medical information provided in the application. Most companies have
set non-medical limits, meaning that applications for policies below a certain face amount (e.g., $50,000, or
even $100,000) will not require any additional medical information other than what’s provided by the application.
However, for policies with a higher face value, a medical report may be required to provide additional
underwriting information.
Following the application review, medical examinations provide objective verification of the applicant's health
status. Medical reports must be completed by a qualified person, but that person doesn’t necessarily need to be
a physician. Many companies accept reports completed by paramedics or registered nurses. When completed,
the medical report is forwarded to the insurance company for review by the company’s medical director or a
designated associate.
When an insurer requires a medical examination, physical examination, electrocardiogram (EKG), treadmill
examination, or medical report, the insurer will pay for the examination and use a physician or medical
professional of its choice.
[5.2.1] ATTENDING PHYSICIAN’S STATEMENT
If the medical section of a person’s application raises questions specific to a particular medical condition, the
underwriter may also request an APS from the physician who has treated the applicant. A copy of the signed
authorization must accompany an insurer’s request for an attending physician’s report.
For example, when Jason disclosed his Type 2 diabetes on his application, the underwriter requested his A1C
levels from the past two years. With well-controlled readings consistently below 7.0, Jason qualified for standard
rates rather than being rated or declined.
The statement will provide details about the medical condition in question. Moreover, attending physician
statements offer detailed insights that standardized exams might miss.
[5.2.2] PRESCRIPTION DRUG DATABASE
These databases reveal your client's medication history, which can tell underwriters a lot about their health.
For example, if records show your client has been taking blood pressure medication for five years, this indicates a
managed but ongoing condition. Prepare your clients by advising them to disclose all the medications they take
regularly, even if they consider them "not important."
[5.3] SPECIAL QUESTIONNAIRES
When necessary, special questionnaires may be required for underwriting purposes to provide more detailed
information about aviation or avocation, foreign residence, finances, military service, or occupation.
For example, let us assume that an applicant has a hobby of skydiving. In this case, the insurance company
needs detailed information about the extent of the applicant’s participation to determine whether the insurance
risk is acceptable. Among these special questionnaires, the most common is the aviation questionnaire, which is
required of any applicant who spends a significant amount of time flying.
[5.3.1] MOTOR VEHICLE REPORTS (MVR)
Driving records provide insights into risk-taking behavior. A client with multiple speeding tickets or a DUI may
face higher premiums or even declined coverage. When discussing this with clients, you might explain:
"Insurance companies have found that how we drive often reflects how we approach other risks in life."
[5.4] FINANCIAL DISCLOSURES
Have you considered how your financial situation relates to the amount of insurance you might qualify for?
Beyond health considerations, financial factors play an equally important role in the underwriting process. While
medical underwriting assesses mortality risk, financial underwriting ensures the coverage amount is appropriate
and justified. If your 30-year-old client earning $50,000 annually applies for a $10 million policy, underwriters will
investigate this financial mismatch. Help your clients understand that insurance is designed for financial
protection, not wealth creation.
For example, Alex, earning $75,000 annually, applied for $5 million in coverage – far exceeding typical income-to-
coverage ratios. The underwriter investigated and found that Alex was a key person in a growing business, which
justified the higher coverage amount.
[5.4.1] CREDIT REPORTS
Based on information obtained before a policy is issued, some applicants may be higher credit risks. Therefore,
credit reports obtained from retail merchants’ associations or other sources are often valuable underwriting
tools.
Applicants who have questionable credit ratings could ultimately cause an insurance company to lose money.
Applicants with low credit standings are likely to allow their policies to lapse within a short time, perhaps even
before a second premium is paid. This results in an insurance company losing money because the insurer’s
acquisition costs for the policy cannot be recovered in such a short period. The home office underwriters may
refuse to insure people who have failed to pay their bills or who appear to be applying for more life insurance than
they can reasonably afford.
[5.4.2] INSPECTION REPORTS
Insurance companies generally obtain inspection reports for applicants seeking large amounts of life and health
insurance, but do not typically request them for applicants seeking smaller policies. However, company rules
vary regarding the size of policies that require a report by an outside agency. These reports contain information
about prospective insureds and are reviewed to determine their insurability. Insurance companies often obtain
inspection reports from national investigative agencies or firms, and they may include credit reports for the
proposed insureds.
The purpose of these reports is to provide a picture of an applicant’s general character and reputation, mode of
living, finances, and any exposure to abnormal hazards. Investigators or inspectors may interview employees,
neighbors, associates, and the applicant. When an investigative consumer report is used with an insurance
application, the applicant has the right to receive a copy of the report. An insurer’s obligation involving the
disclosure of an insured’s non-public information is to give notice, explain, and allow the process of opting out.
In fact, if an insurance company obtains a prospective insured's inspection report, it must inform the prospect
that it’s permitted to do so under the Fair Credit Reporting Act (FCRA). The FCRA established procedures for
collecting and disclosing information obtained from consumer investigations and credit reports. The law is
intended to ensure fairness concerning confidentiality, accuracy, and disclosure.
5.4.3] THE FAIR CREDIT REPORTING ACT OF 1970
In 1970, Congress enacted the FCRA to protect consumers’ rights when an inspection or a credit report is
requested. As previously described, the act established procedures for the collection and disclosure of
information obtained from consumer investigations and credit reports. This federal law applies to financial
institutions that request these types of consumer reports, including insurance companies. A life insurance
applicant must be informed of their rights that fall under the FCRA upon completing the application.
[5.4.4] USA PATRIOT ACT
The USA PATRIOT Act was enacted in 2001 to deter and detect terrorism. Under the act, insurance companies
are required to establish formal anti-money laundering (AML) programs. A life insurance policy that can be
surrendered for cash is an attractive money laundering vehicle because it allows criminals or terrorists to put
dirty money in and take clean money out by using an insurance company check.
This act increased the ability of law enforcement agencies to search telephone and email communications, as
well as medical, financial, and other records, to thwart terrorist activities. The act also expanded the Secretary of
the Treasury’s authority to regulate financial transactions, particularly those involving foreign and individual
entities, to protect the United States and its interests. Insurance companies must implement written AML
programs that include designating a compliance officer to update the program, ensure that appropriate
personnel are educated and trained on the program, and conduct ongoing AML training.
[6] INITIAL PREMIUMS AND PREMIUM RECEIPTS
The moment an agent collects an applicant’s first premium payment is a critical point in the insurance process.
This transaction can determine exactly when coverage begins as well as any conditions that must be met.
Properly handling initial premiums and issuing the correct receipts helps ensure a smooth underwriting process
while providing appropriate protection for the client during the application review period.
[6.1] PREMIUMS PAID WITH THE APPLICATION
It is generally in the best interests of both the proposed insured and the agent to have the initial premium paid
when the application is completed. For the agent, this typically helps solidify the sale and may even accelerate
the payment of commissions on the sale. The proposed insured also benefits by having insurance protection
become effective immediately, with some significant restrictions.
The premium is generally forwarded with the application to the underwriting department. However, if a premium
is not paid with the application, the agent should submit the application to the insurance company without the
premium. Even if the policy is approved and issued, it will not become effective until the initial premium is
collected. An application submitted without an initial premium is typically referred to as a trial application.
Remember, an applicant’s consideration is a requirement for a valid contract. In the case of an insurance
contract, the consideration is the first full premium payment plus the application. An insurer will not allow an
applicant to possess a policy without receipt of the initial premium.
6.2] PREMIUM RECEIPTS
Whenever a premium is collected at the time of application, the producer must provide a premium receipt to
the applicant. This receipt is proof that an initial premium was paid with the application. The type of receipt given
may determine precisely when and under what conditions an applicant’s coverage begins.
These receipts identify the amount of premium collected and indicate a date when coverage is in effect. The
dates on these receipts are always earlier than the policy’s issue date. Sometimes, these receipts are referred to
as temporary insurance agreements. This life insurance terminology is used to describe the amount of
insurance provided by the insurer between the period when the application is taken and the first premium is paid,
and the time when the policy is issued, which may be limited and depend on whether the applicant is ultimately
found to be insurable as a standard risk.
There are two types of receipts that may be provided to an applicant when the producer collects a premium:
a conditional receipt and a binding receipt.
• Conditional receipts generally provide coverage as of the date of the receipt as long as one or more
specific conditions are satisfied. Today, the conditional receipt is predominantly used in life and health
insurance.
• Binding receipts are used sparingly, primarily in property and casualty insurance. They provide temporary
coverage until coverage is issued as requested or denied. Binding receipts may also be referred to
as temporary insurance agreements. The terminology reflects the fact that the binding receipt is a
guarantee of temporary coverage until an underwriting decision is made.
[6.2.1] CONDITIONAL RECEIPTS
• A conditional receipt outlines certain conditions that must be met for the insurance coverage to go
into effect. The conditional receipt provides that, upon payment of the initial premium, coverage is
effective on the condition that the applicant proves insurable as of either the date the application was
signed or the date of a medical exam, if required, whichever is later.
• However, if the applicant is found to be uninsurable based on the information gathered through the
application process or during a required medical exam, then the coverage is void. No coverage takes
effect or was ever in effect, and the premium is refunded.
• For example, an applicant dies between the date on which they completed their application or
medical exam and the date on which the insurer approved the application. In this case, the coverage
is retroactively effective, as long as the applicant proves to be insurable as of the date of the
application or completion of the medical exam.
• It should be noted that insurance carriers must approve the coverage as it was applied for. On an
insurance licensing exam, we assume the applicant is applying for standard coverage. If the insurer
approves the applicant as standard or preferred, then coverage is effective retroactively back to the
later of the application or medical exam. If the insurer declines the application or makes a
counteroffer to insure the applicant as a high risk for a higher [rated] premium, then the coverage is
void and not in effect until the applicant pays the additional premium.
• For example, Edwin signs an application for coverage on August 2 and takes a required medical exam
on August 4. In this case, protection begins on August 4 because the medical exam was required for
coverage to be provided. If Edwin dies before the application is underwritten, the insurer must still
proceed with underwriting and determine insurability in accordance with its usual underwriting
standards. If the application is approved, the claim will be paid even after the insured died because
insurance was in effect. However, if it turns out that Edwin did not meet the insurer’s approval
guidelines, the application would be declined. In this situation, the death benefit would not be paid.
However, the initial premium is refunded to the applicant or beneficiary.
[[Link]] SCENARIO – CONDITIONAL RECEIPT
On March 10, Elena applied for a $500,000 life insurance policy and paid the first premium of $650. Her
agent provided a conditional receipt stating that coverage would begin on the application date if she was
found insurable under the company's underwriting standards.
On March 15, Elena completed her medical exam, which showed normal results. On March 28, before the
underwriting was complete, Elena was seriously injured in a car accident. She died from her injuries on April
2. When Elena's husband filed the claim, the insurance company continued with the underwriting process as
if Elena were still alive. Based on her application, medical exam, and other information, they determined she
would have qualified for coverage at standard rates. Even though the policy had not ye t been issued, the
company paid the $500,000 death benefit because:
Elena had paid the initial premium
She had received a conditional receipt
She was deemed insurable as of the application date
Had the underwriting revealed an undisclosed medical condition that would have made Elena uninsurable,
the claim would have been denied, and the premium refunded.
[6.2.2] BINDING RECEIPTS
With a binding receipt, also known as an unconditional receipt, coverage becomes effective upon receipt of the
premium. The policy is guaranteed under a binding receipt until the insurer either approves or formally rejects the
application. Even if the proposed insured is ultimately found to be uninsurable, coverage remains guaranteed
until the application is rejected. Therefore, the insurer must pay the claim if the applicant dies before the insurer
formally rejects the application.
Since the underwriting process can often take several weeks or longer, this can place the company at
considerable risk. Accordingly, binding receipts are often reserved only for a company’s most experienced
agents. As with the conditional receipt, a binding receipt typically stipulates a maximum amount payable during
the particular protection period. Binding receipts are far more common for auto or homeowners insurance than
for life or health insurance.
Exam Tip!
You can expect to see 2-4 questions on your state exam regarding conditional and binding receipts. Remember:
A conditional receipt provides coverage only if subsequent underwriting confirms insurability based on the
application date or medical exam date.
A binding receipt grants immediate coverage until the insurer makes a final decision.
[6.2.3] TEMPORARY INSURANCE AGREEMENTS
This is life insurance terminology that is used to describe the amount of insurance provided by the insurer
between the period when the application is taken and the first premium is paid, and the time when the policy is
issued. The amount of insurance provided by the temporary agreement may be less than the policy applied for by
the applicant. Most often, the temporary insurance agreement is designed to pay if the insured dies before the
policy is issued, only if that company would have issued the policy except for the insured's prior death. Therefore,
a death benefit will not be paid if the company determines, through its standard underwriting practices, that the
applicant was not insurable.
[7] POLICY ISSUE AND DELIVERY
The final steps in establishing insurance coverage – policy issue and delivery – are often overlooked but are
critically important. These steps transform the application and underwriting decision into an active contract that
provides protection. How you handle policy delivery can affect not only when coverage begins but also your
client's understanding of their benefits and your future business opportunities.
This section examines how policies become effective, the importance of proper delivery procedures, and the
producer's responsibilities during this critical phase. You'll learn about policy effective dates, the practice of
backdating, constructive delivery concepts, and the requirements for explaining policy provisions to clients.
Understanding these elements is essential for producers because errors in the delivery process can affect when
coverage begins, create compliance issues, or lead to client misunderstandings about their coverage. Proper
policy delivery not only fulfills legal requirements but also provides an opportunity to strengthen client
relationships and ensure policyholders fully understand their coverage.
[7.1] CLASSIFICATION OF APPLICANTS
Once the information about a given applicant has been reviewed, the underwriter will seek to classify the
applicant’s risk to the insurer. This evaluation is referred to as risk classification. Why do you think insurance
companies need to classify applicants into different risk categories?
In some cases, applicants pose a risk so significant that they are considered uninsurable, and their application
will be rejected. However, most insurance applicants fall within an insurer’s underwriting guidelines and are
accordingly classified as preferred, standard, or substandard risks.
For example, consider Maria, a 35-year-old marathon runner with excellent health metrics but a family history of
heart disease. Her underwriter must weigh these competing factors when determining her risk classification.
[7.1.1] PREFERRED RISK
Additionally, many insurers reward good (low) risks by assigning them to preferred risk classification. Companies
issue preferred risk policies with reduced premiums due to the expectation of a better-than-average mortality or
morbidity experience. Some characteristics that contribute to a preferred risk rating include being a non-smoker,
a non-drinker, and maintaining a healthy weight.
[7.1.2] STANDARD RISK
First, it's important to recognize that standard rates serve as the baseline for all underwriting decisions. Standard
risk is the term used for individuals who fit the insurer’s guidelines for issuing the policy without special
restrictions or an additional rating. These individuals meet the same conditions as the tabular risks on which the
insurer’s premium rates are based.
[7.1.3] SUBSTANDARD (RATED) RISK
In contrast, a substandard or "rated' risk is one below the insurer’s standard or average risk guidelines. An
individual can be rated as substandard for many reasons, including poor health, a dangerous occupation, or
attributes and habits that could be hazardous. Substandard applicants are accepted for coverage with increased
policy premiums.
[7.1.4] DECLINED RISKS (UNINSURABLE)
Some applicants cannot be approved because the risk of a premature loss is too great. In such cases,
underwriters must decline the application.
[7.2] UNFAIR DISCRIMINATION
An insurer is not permitted to engage in any unfair discrimination regarding applicants for life insurance. Sexual
orientation, religious preference, or geographical location are prohibited life insurance underwriting factors
because they’re unfairly discriminatory. On the other hand, smoking is a legitimate basis for what might be
described as “legitimate discrimination”, because it impacts one’s health and rate of mortality. Smokers are
statistically more likely to die at a younger age than non-smokers, which is a key consideration in the life
insurance underwriting process.
It is important to recognize that not all forms of discrimination in insurance are considered unfair or illegal.
Insurance companies are permitted—and indeed required—to classify applicants based on risk factors that
affect the likelihood of a claim. These classifications, such as age, medical history, occupation, and lifestyle
habits, are designed to ensure that premium rates accurately reflect the level of risk associated with each group
(sometimes referred to as a “class” of insureds). Such legal discrimination allows insurers to remain financially
sound while offering fair premiums to all policyholders. Distinguishing between legal and unfair discrimination
helps clarify why certain questions and ratings are standard practice in the underwriting process.
For example, charging higher premiums to smokers or those in hazardous occupations is permitted because
statistical evidence shows these groups present increased risk.
Exam Tip!
We often hear “discrimination against protected classes is illegal” related to employment, housing, education,
etc. Most of this holds true for insurance. However, not every “class” is a protected class. Be careful not to
immediately apply the negative emotion tied to discrimination to exam questions. Considerations around
tobacco use, age, gender, etc. and their impact to mortality rates are examples of fair and legal discrimination
that is permitted and necessary throughout the insurance industry.
[7.3] SCENARIO – RISK CLASSIFICATION
Let's follow three applicants through the classification process: Applicant 1: James (Preferred Risk)
James, 42, is a non-smoker with excellent health metrics. His BMI is 23, blood pressure 118/75, and cholesterol
levels well within normal ranges. He exercises regularly, has no family history of early cardiac death or cancer,
and works in a low-risk occupation. The underwriter classified James as a preferred risk, resulting in premiums
15% lower than standard rates.
Applicant 2: Diane (Standard Risk)
Diane, 39, has generally good health with a few minor concerns. Her BMI is 27 (slightly overweight), and she
takes medication for mild hypertension that keeps her blood pressure controlled at 135/85. She doesn't smoke
and has no hazardous hobbies. The underwriter classified Diane as a standard risk, qualifying her for normal
premium rates.
Applicant 3: Marcus (Substandard Risk)
Marcus, 45, is a smoker with a BMI of 33 (obese). He has Type 2 diabetes with inconsistent A1C readings
between 8.0–9.5 over the past year. His father died of heart disease at age 52. Marcus works as an electrical
lineman, an occupation with elevated risk. The underwriter classified Marcus as a substandard risk with a Table 3
rating, increasing his premium by 75% above standard rates.
[7.5] POLICY EFFECTIVE DATE
In any life insurance sale, an essential question is, "When does the policy become effective?" The effective date
is important for two reasons – not only does it identify when the coverage is effective, but it also establishes the
date by which future annual premiums must be paid. Let’s assume that a receipt (either conditional or binding) is
issued in exchange for the initial premium payment. In this case, the receipt’s date will generally be noted as the
policy's effective date in the contract. If a premium deposit is not given with the application, the policy effective
date is the date it is delivered to the applicant, and the first premium is collected, along with a statement of
continued good health.
Exam Tip!
You may see a question that asks about the effective date of a life insurance policy. Ironically, the effective date
of a life insurance policy (unlike for other types of insurance) is NEVER the date the policy is issued.
• If the premium was paid with the application, the policy is effective as of the date of the receipt or
medical exam.
• If NO premium was paid, then the policy will not be effective until the first premium is collected, which
will be after the policy's issue date.
[7.6] BACKDATING
Keep in mind, the premiums required to support a life insurance policy are determined, in part, by the insured’s
age. If the insurance company can treat an applicant as being a year younger, the result can be a lifetime of
slightly lower premiums. The purpose of backdating a life insurance policy is to use premiums based on an earlier
age. Therefore, it’s understandable that applicants may want to backdate a policy and make it effective earlier
than its current effective date.
Many insurers are willing to let an applicant backdate (or save age) a policy. However, some conditions must be
met before this step can be taken. First, the insurer must allow backdating. Second, the company typically
imposes a time limit on how far back a policy can be backdated (generally six months). More importantly, the
next premium is due at the backdated anniversary date.
After the underwriting is complete and the policy is issued, the insurance contract is sent to the sales agent for
delivery to the applicant. The policy is not typically sent directly to the policy owner, since, as an important legal
document, it should be explained to the policy owner by the agent delivering it. The agent must also secure a
signed document from the policy owner that identifies the date the policy was delivered. The free-look period
commences on the date of delivery.
Exam Tip!
Remember that the free-look period typically lasts 10 days (30 days for mail-order policies), during which the
policy owner may return the policy for a full refund. This rule is a core concept and is often tested in exam
scenarios about when coverage becomes effective.
Some questions on the exam might ask about the length of the free-look period in your specific state, which may
be different (state-specific rules are covered in a later chapter). Don’t fall for this common trap! Determine if the
question refers to your state’s specific rule or the general rule covered here first, then answer accordingly.
[7.7] POLICY DELIVERY
[7.7.1] CONSTRUCTIVE DELIVERY
By law, the approved policy must be delivered to the policy owner. However, this doesn’t mean the policy must
be in the policy owner's physical possession to be considered “delivered.” "Constructive delivery" occurs when
the insurer gives the policy to the agent for delivery to the policy owner.
Mailing the policy to the agent for unconditional delivery to the policy owner also constitutes constructive
delivery, even if the agent never personally delivers the policy. On the other hand, there is no constructive
delivery if the company instructs the agent not to deliver the policy unless the applicant is in good health.
A client's mere possession of a policy does not establish delivery if all conditions haven't been met. For example,
a policy may be left with an applicant for inspection if an initial premium has not been paid. An inspection receipt
may be obtained to indicate that the policy is neither in force during the inspection period nor will it be in force
until the initial premium has been paid.
[7.7.2] EXPLAINING THE POLICY AND RATINGS TO CLIENTS
Most applicants will not remember all the essential details of their policies after they sign the application. This is
another reason that agents should deliver policies in person. Only by personally delivering a policy does the
agent have a timely opportunity to review the contract, along with its provisions, exclusions, and riders. In fact,
some states (and most insurers) require policies to be delivered in person for this very reason. The agent’s review
is incredibly useful for reinforcing the sale and preventing a potential lapse. It can also lead to future sales by
building the client’s trust and confidence in the agent’s abilities. Explaining the policy and how it meets the policy
owner’s specific objectives helps avert misunderstandings, policy returns, and potential lapses.
In some cases, agents may have a chance to prepare applicants in advance when it appears their policies may
be rated up as substandard, which generally requires an extra premium. Occasionally, both the agent and the
policy owner may be surprised when the policy is issued at a higher premium rate. In either case, the agent
should stress that the insured has an even greater need for insurance protection due to the impairment or
condition that led to the higher premium. It may be the policy owner’s last chance to purchase such coverage
because of a worsening condition that could render the insured uninsurable in the future.
[7.7.3] OBTAINING A STATEMENT OF THE INSURED’S CONTINUED GOOD HEALTH
It’s possible that the initial premium will not be paid until the agent delivers the policy. In such cases, common
company practice requires that, before delivering the policy, the agent must collect the insured’s premium and
obtain a signed statement attesting to the insured’s continued good health.
The agent will then submit the premium, along with the signed statement, to the insurance company. Since there
can be no contract until the premium is paid, the company has the right to determine whether the proposed
insured has remained in reasonably good health from the time that the applicant/policy owner signed the
application until they receive the policy. In other words, the company has the right to know whether the policy
owner continues to represent the same risk to the company as when the application was first signed.
[8] CHAPTER SUMMARY
In this chapter, we've explored the essential process of life insurance underwriting—the system that allows
insurers to evaluate applicants, classify risks, and issue policies at appropriate rates.
We began by examining the agent's critical role as a field underwriter, including your responsibility to act in a
fiduciary capacity, properly complete applications, and ensure insurable interest exists between parties. You
learned that insurable interest must exist at policy inception but not necessarily at the time of loss, and that
certain relationships automatically establish this interest.
The chapter explained how underwriting protects insurers from adverse selection while ensuring fair treatment
of applicants. You discovered that underwriting involves multiple parties—the applicant, proposed insured,
policy owner, agent, and underwriter—each with specific responsibilities in the process.
We explored the three parts of a life insurance application and the importance of completing them accurately,
emphasizing that statements on applications are representations rather than warranties. You learned about the
various sources of underwriting information beyond the application itself, including medical exams, the Medical
Information Bureau, attending physician statements, and inspection reports.
The chapter also covered how underwriters classify applicants as preferred, standard, or substandard risks
based on their evaluation, and how these classifications affect premium rates. You now understand the
difference between conditional and binding receipts and how they determine when coverage begins.
Finally, we examined the policy issuance and delivery process, including the concept of constructive delivery, the
importance of explaining policy provisions to clients, and consumer protections like the free-look period.
As you begin your insurance career, this knowledge will help you guide clients through what can sometimes feel
like a complex process. You'll be able to explain why certain information is required, set appropriate expectations
about underwriting decisions, and ensure that policies are properly issued and delivered. Most importantly, you'll
understand how underwriting creates a fair system where each policyholder pays a premium appropriate to their
level of risk—the foundation of a sustainable insurance marketplace.
[8.2] REVIEW NOTES
Learning Objective 1: Explain the agent's role and responsibilities in the life insurance solicitation and
underwriting process
Key Concepts:
• Agents act as field underwriters, initiating the underwriting process
• Producers must act in a fiduciary capacity when collecting premiums and dealing with the public
• Agents have legal and ethical responsibilities to both insurers and clients
• Proper solicitation focuses on cases within the insurer's underwriting guidelines
Important Terms:
• Field Underwriter: Agent who initiates underwriting by completing application and collecting information
• Fiduciary Responsibility: Legal obligation to act in client's best interest
• Errors and Omissions: Unintentional errors or honest mistakes (torts) made by producers
Learning Objective 2: Define insurable interest and identify when it must exist in life insurance contracts
Key Concepts:
• Insurable interest must exist at policy inception (not at time of loss)
• Without insurable interest, life insurance would be a wagering contract
• Insurable interest exists when the insured's death would have a financial impact on the policy owner
• Amount of insurable interest is typically limited by insurer's guidelines and premium affordability
Automatic Insurable Interest Relationships:
• Individual in their own life
• Spouses in each other
• Parents in their children
• Children in parents or grandparents
• Businesses in officers, directors, and key employees
• Business partners in each other
• Creditors in debtors (limited to debt amount)
Learning Objective 3: Describe the purpose of underwriting and how it helps prevent adverse selection
Key Concepts:
• Underwriting is the process of reviewing risk profiles to determine insurability and appropriate rates
• Primary purpose is to protect insurers against adverse selection
• Adverse selection occurs when poorer risks seek insurance or insurers accept bad risks
• Sound underwriting reduces the probability of adverse selection
Elements of Insurable Risk:
• Loss must be significant enough to cause financial hardship
• Loss must not be catastrophic (e.g., war)
• Premium cost must be reasonable
• Loss must be unpredictable or fortuitous
• The law of large numbers must apply
Learning Objective 4: Identify the key parties involved in the underwriting process and their specific
responsibilities
Key Parties:
• Applicant: Person requesting insurance and completing application
 • Proposed Insured: Person whose life is to be insured
• Policy Owner: Person who retains policy rights and options
• Payor: Person responsible for premium payments
• Producer/Agent: Completes application, collects premium, delivers policy
• Underwriter: Reviews application, classifies risk, determines premium rates
Agent Responsibilities:
• Complete applications thoroughly and accurately
• Collect the initial premium and issue receipt
• Provide required disclosures before collecting premium
• Deliver policy and explain provisions
• Obtain statement of continued good health when needed
Learning Objective 5: Outline the three parts of a life insurance application and explain the importance of
accurate completion
Application Parts:
• Part I: General applicant information (name, age, address, policy details, etc.)
• Part II: Medical and health history of proposed insured and family
• Part III: Agent's report/statement (confidential communication with insurer)
Important Application Concepts:
• Statements on applications are representations, not warranties
• Representations must be materially accurate, not absolutely true in every detail
• Material misrepresentation may void the policy
• Application must be signed by applicant and agent (and proposed insured if different from applicant)
• Changes to application must be initialed by applicant
Learning Objective 6: Compare the different sources of underwriting information and explain how each
contributes to risk assessment
Primary Information Sources:
• Application: Primary source for personal, medical, and financial information
• Medical Information Bureau (MIB): Shared database of medical information to detect undisclosed
conditions
• Attending Physician Statement (APS): Detailed medical information from applicant's doctor
• Medical examination: Objective verification of health status (for higher face amounts)
• Special questionnaires: Details on aviation, avocation, foreign residence, etc.
• Inspection reports: Information on character, finances, and lifestyle
• Credit reports: Financial stability and responsibility
• Motor vehicle reports: Driving history and risk behaviors
• Prescription drug database: Medication history
Regulatory Considerations:
• Fair Credit Reporting Act (FCRA): Establishes procedures for collecting and disclosing consumer
information
• HIPAA: Requires privacy notices when collecting personal health information
• USA PATRIOT Act: Requires anti-money laundering programs
Learning Objective 7: Differentiate between preferred, standard, and substandard risk classifications
Risk Classifications:
• Preferred Risk: Better than average mortality expectation, lower premiums
• Standard Risk: Meets insurer's guidelines without special restrictions
• Substandard Risk: Below standard guidelines, may require higher premiums
• Declined Risk: Uninsurable due to excessive risk
Classification Factors:
• Health status and medical history
 • Family medical history
• Tobacco/alcohol use
• Occupation and hobbies
• Driving record
• Financial status
Unfair Discrimination:
• Sexual orientation, religion, and geographical location are prohibited underwriting factors
• Legal discrimination based on risk factors (age, health, occupation) is permitted
Learning Objective 8: Explain how premium receipts affect when coverage begins and the conditions that
must be met
Types of Receipts:
• Conditional Receipt: Coverage effective as of application date or medical exam date if applicant proves
insurable
• Binding Receipt: Coverage effective immediately when premium is collected, until formal rejection
• Temporary Insurance Agreement: Limited coverage between application and policy issue
Key Conditions:
• With conditional receipt, applicant must be insurable as of receipt date
• If applicant proves uninsurable, premium is refunded
• The maximum coverage amount is typically specified on the receipt
• Coverage begins only when all conditions are met
Learning Objective 9: Describe the policy issuance and delivery process, including the concept of
constructive delivery
Policy Issuance Process:
• Underwriting completed and risk classified
• Policy prepared and sent to the agent
• The agent delivers policy to owner
• Initial premium collected (if not paid with application)
• Statement of continued good health obtained if needed
Delivery Concepts:
• Constructive delivery occurs when insurer gives policy to agent for delivery
• Physical possession doesn't establish delivery if conditions aren't met
• Agent should explain policy provisions, exclusions, and riders
• Backdating may be permitted (typically up to 6 months) to save age
Learning Objective 10: Identify the consumer protections in the underwriting process, including disclosure
requirements and the free-look period
Consumer Protections:
• Free-look period: Minimum 10 days (30 days for mail-order policies) to return policy for full refund
• Required disclosures: Life insurance buyer's guide, policy summary
• HIPAA privacy notice
• Fair Credit Reporting Act protections
• Prohibition against unfair discrimination
Exam Tips:
• Know the difference between representations and warranties
• Understand when an insurable interest must exist
• Remember the three parts of the application
• Know the different types of premium receipts and when coverage begins
• Understand the concept of constructive delivery
• Remember the standard free-look period duration
Chapter 8
[1.2] KEYWORDS
Prior to reading this chapter, please review the following keywords. Understanding their basic definitions will
improve your comprehension of the chapter content.
Blanket Health Policies: These policies are issued to cover a group that may be exposed to the same risks, but
whose composition (i.e., the individuals within the group) is continually changing. A blanket health plan may be
issued to an airline or a bus company to cover its passengers or to a school to cover its students. Unlike group
insurance, no certificates of coverage are issued in a blanket health plan.
Certificate of Insurance: This is a document issued by an insurance company or broker that verifies insurance
coverage granted to individuals under specific conditions. With group insurance, the group (typically the
employer) is the policy owner and maintains a master policy. The insureds (typically the employees) receive a
certificate of insurance rather than a policy.
Contributory Plan: This is a group insurance plan issued to an employer, under which both the employer and
employees contribute to the plan's cost. Generally, at least 75% of eligible employees must be covered by
insurance in most states. The employees must contribute to the cost of the plan.
Conversion Privilege: Before an original group insurance policy expires, this privilege enables the policy owner
to convert the expiring group coverage (usually group term) to an individual whole life policy. The insured is not
required to prove insurability (good health) when converting a policy.
Credit Policies: These policies are designed to help the insured pay off a loan in the event the insured passes
away. The policy will pay a lump sum to the creditor to pay off the loan. Credit policies typically cannot exceed
the amount of the loan since that’s the limit of the creditor’s insurable interest in the insured(s).
Franchise Insurance: This is a life or health insurance plan that covers groups of individuals with uniform
policies, though the benefits may vary. Solicitation typically takes place in an employer’s business with the
employer’s consent. Franchise insurance is generally written for groups that are too small to qualify for regular
group coverage. This policy may be referred to as wholesale insurance when it involves life insurance.
Master Policy: This policy is issued to the employer under a group plan and contains all the insuring clauses that
define employee benefits. Individual employees who participate in the group plan receive personalized
certificates that outline the key highlights of their coverage, including their beneficiary designation.
Noncontributory Plan: This is an employee benefit plan under which the employer bears the full cost of the
employees’ benefits. The plan must cover 100% of eligible employees. Employees do not contribute to the plan's
cost.
Persistency: As it pertains to insurance, persistency is the percentage of an insurer's policies that remain in
force after a specified period. Persistency is negatively impacted by policies that are replaced by other insurers,
cancelled, or that lapse due to nonpayment. Companies with higher persistency tend to be more stable and
profitable than those with lower persistency.
[2] PRINCIPLES AND CHARACTERISTICS OF GROUP LIFE INSURANCE
Group insurance is a way to provide life insurance coverage for multiple individuals under a single contract.
Typically, group insurance is provided by an employer for its employees; however, it is also available to other
kinds of groups as well. In contrast to individual life insurance (written on a single life), group life insurance is
written on the lives of more than one person. Group life insurance is typically written for employer-employee
groups and is most often written as an annual renewable term policy.
Group life insurance differs from individual life insurance contracts in several ways. One of the differences
between the two is that group insurance is most often comprised of annual renewable term life insurance. In
contrast, individual insurance contracts may be either term life or whole life insurance. Underwriting is handled
differently, and various types of policy provisions are included in a group life policy. Group term life insurance, like
all previously mentioned insurance contracts, is a two-party contract between the policyholder and the
insurer (identical to an individual contract). However, unlike individual insurance, the insured is never the
policyowner. The employer is the policyowner.
The employer or group that provides the group life coverage pays all or a portion of the premium and is the policy
owner. The employer or plan sponsor receives the master policy contract. In contrast, covered employees or
plan participants receive a certificate of coverage that contains their unique information (including
beneficiaries), the coverage provided, and the duration of the insurance coverage. The covered employee or plan
participant is also referred to as the certificate holder. Eligible groups include employees of a single employer,
credit unions, labor unions, and multiple-employer groups.
[2.1] EMPLOYER RESPONSIBILITIES
The employer is accountable for selecting group coverages, maintaining records, and managing employee
enrollment. The employer must not engage in discriminatory practices, particularly when the plan is
noncontributory.
[2.1.1] BENEFIT SCHEDULES
Most employers will establish benefit schedules based on a flat benefit amount, earnings (salary), or
employment position.
For example, some employers provide $50,000 of coverage for all employees. Many tie the amount of coverage
to one’s income, while others might tie the amount of coverage to one’s position, especially if compensation is
highly variable.
[2.1.2] INCIDENT OF OWNERSHIP – EMPLOYEE'S BENEFICIARY SELECTION
The employer is the contract owner of a group life policy and retains all rights of ownership, except the right to
name or change the beneficiary. The covered employee, or “certificate holder,” has an “incident of ownership”
because it is the “certificate holder” (insured employee) who names the beneficiary, not the policy owner
(employer).
The employee may name the employer as a beneficiary of the group life policy, provided the employer has an
insurable interest in the employee.
For example, an employer may have an insurable interest in a key executive who has 20 years of experience.
However, the employer is not likely to have an insurable interest in a part-time clerk.
EXAM TIP!
In recent years, due to modifications of state laws, many insurers have been permitted to include an assignment
provision in group life insurance policies. Of course, any assignment must be submitted in writing to the insurer.
[2.2] GROUP INSURANCE VERSUS INDIVIDUAL INSURANCE
Features that separate group insurance from individual insurance include underwriting, policy ownership, policy
type, and cost.
Underwriting
In an individual policy, the insured must provide evidence of insurability.
In group insurance, the group must meet various criteria, but the insureds are not individually underwritten.
Policy Ownership
With individual insurance, the insured is traditionally also the policy owner. In instances of third-party ownership,
the policy owner and the insured are different parties (e.g., husband covering wife, wife covering husband, parent
covering child, etc.)
The insured does not own the group policy. There is one master policy, which the plan sponsor owns. The plan
sponsor receives the master policy as the policy owner or contract holder.
Employees or plan participants receive certificates of insurance (not individual policies and are certificate
holders.
Policy Type
Individual insurance can be any of the previously discussed temporary or permanent insurance products.
Annual renewable term is the most common form of group coverage.
Converting group insurance to individual insurance always requires a conversion to a permanent policy.
Cost
Individual insurance policies are more expensive for the insurer to issue (underwrite, commission, billing,
maintenance, etc.). These administrative costs are passed on to the customer, thereby increasing their cost.
Group insurance policies are less expensive for the insurer to underwrite, issue, and maintain. As such, group
insurance is more affordable for customers to purchase.
In some cases, the employer or sponsor may pay most or all of the premium cost for the group policy. With
individual insurance, the customer (policy owner) is always responsible for paying the entire premium cost.
EXAM TIP!
Since individual insureds do not own or control the policy, they are issued a certificate of insurance (often
referred to as the certificate of coverage and benefits) to serve as evidence of their coverage. The actual policy,
referred to as the master policy, is issued to the employer, who becomes the policy owner.
[2.3] CONTRIBUTORY AND NONCONTRIBUTORY PLANS
[2.3.1] NONCONTRIBUTORY PLAN
Under this plan, the employer pays the entire cost. The insurance company requires that 100% of all eligible
employees participate. The most significant benefit of a noncontributory insurance plan is that it helps the
insurer avoid adverse selection. With a noncontributory group insurance plan, the employees or plan participants
do NOT contribute to the premium payments.
[2.3.2] CONTRIBUTORY PLAN
With this form of employee group insurance plan, employees share the cost. The insurance company requires
that at least 75% of all eligible employees choose to be covered/participate. With a contributory group insurance
plan, the employees or plan participants contribute to the premium payments.
For example, if a company has 1,000 eligible employees, at least 750 of them must choose to be covered. If not,
the insurer will not write the policy.
[2.4] ELIGIBLE GROUPS AND GROUP MEMBERS
Only a natural group can be eligible for a group insurance policy; that is, the availability of group insurance must
be an additional benefit of group membership, not the group's purpose for existing.
Insurers will not issue group life insurance policies to groups whose primary organizational purpose is to
purchase group life insurance. Securing such coverage must be incidental to the formation of the group. In other
words, a group of people cannot form an organization just to buy insurance.
Groups that purchase group life must also meet minimum size requirements. Generally, a group must have at
least 10 members to qualify for group life insurance, though states may impose additional standards. (It should
be noted that this standard for group life differs from the standards used in group medical insurance.)
Examples of groups eligible to participate in group insurance include: employers, other employment-based
groups, labor unions, trade associations, financial and customer groups such as credit unions, affinity and
organizational groups, fraternal organizations, and trustee groups (established by two or more employers or labor
unions).
[2.4.1] ELIGIBILITY OF GROUP MEMBERS (EMPLOYEES)
Employers can define eligible employees according to shared characteristics, that is, by class. If the plan is
contributory, employees must approve of automatic payroll deduction. Examples of eligible class definitions
might be as follows:
• An employee must be full-time rather than part-time
• An employee must be actively working
The new employee's probationary period is typically one to six months before they become eligible for coverage.
Once eligible, there is an initial enrollment period for contributory plans. During the enrollment period, an
employee has 31 days to enroll; otherwise, the employee may need to provide evidence of insurability later.
If the plan is non-contributory (employer pays the entire cost), all eligible employees are automatically enrolled.
[2.5] UNDERWRITING REQUIREMENTS FOR GROUP LIFE INSURANCE
Sound group underwriting can be profitable for an insurer, as it primarily reduces adverse selection. Adverse
selection is the tendency or danger of an insurer to write (i.e., approve) more bad risks than acceptable risks.
People with a higher risk tend to seek insurance coverage more often than those with a lower risk.
Since more individuals are covered under group policies, there’s a higher probability that a “bad” risk will be
included. For example, a group life plan will not exclude an employee with a physical impairment (e.g.,
paralysis). However, the insurer may continue to earn a profit if acceptable risks far outweigh the bad ones. This
offset of high versus low risk is what an insurer relies on when writing group life coverage. Writing large groups of
individuals also helps reduce adverse selection by leveraging the law of large numbers.
Group insurers avoid adverse selection by setting a participation requirement. For non-contributory
plans, 100% of all eligible group members must be enrolled. For contributory plans, 75% participation is
required.
Underwriters take policy persistency into account. In insurance, persistency refers to the percentage of active
policies in force that do not lapse or are not replaced by policies from other insurers. Insurers may measure
policy persistency over various periods, such as one year, three years, or five years from the policy issue date.
Due to the costs of acquiring and issuing a new policy, persistency can be a vital factor in an insurer's stability
and success. The insurer may avoid groups that change insurers regularly because it may believe that writing
such groups does not represent an acceptable risk.
[2.6] CONVERSION TO AN INDIVIDUAL POLICY
All group policies include a conversion privilege, which allows covered employees to convert their group term life
coverage to individual insurance contracts upon termination of employment with the company. Termination of
employment includes employees who are laid off or leave their jobs voluntarily. In most cases, employees who
leave an employer are eligible to exercise the conversion privilege. However, most insurers only allow terminated
employees to convert their group coverage to an individual whole life policy.
[2.6.1] CONVERSION PERIOD
Terminated employees have up to 31 days following termination to convert their group life insurance to individual
policies without proof of insurability. If a member’s coverage is terminated, the member’s dependents may also
convert their group coverage to individual permanent (whole life) coverage without being required to show proof
of insurability. If conversion occurs, the premium is based on the insured’s (employee/dependent) current or
attained age.
Terminated individuals remain covered under the group policy during the conversion period. If death occurs
during this conversion period, prior to either converting the coverage or qualifying for a new group plan, the
existing group policy will pay a death claim.
Key Points:
• Day 1: Termination occurs — coverage continues under the group policy.
• Day 15: During this period, the employee can convert to an individual plan without providing proof of
insurability.
• Day 31: Final day to convert to an individual policy without proof of insurability.
• During the 31 days: If death occurs before conversion or joining a new group plan, the group policy pays
the death claim.
• Dependents may also convert to permanent (whole life) coverage without proof of insurability if
applicable.
• Premiums are based on the insured’s current (attained) age at the time of conversion.
[2.6.3] GROUP POLICY TERMINATION AND CONVERSION RIGHTS
In the event that the master group life insurance policy is terminated, any insured member who has maintained
coverage under the policy for at least five consecutive years is eligible to convert their group coverage to
an individual whole life insurance policy.
• The converted policy may provide coverage up to the face amount of the group policy, subject to the
insurer's maximum limits (e.g., $10,000).
• No medical examination or proof of insurability is required for conversion.
• The premium for the individual policy will be based on the insured’s age at the time of conversion and
will probably be higher than the group rates.
• The insured must apply for conversion within 31 to 60 days following the termination of the group policy.
[3] OTHER FORMS OF GROUP LIFE INSURANCE
The following are different types of life insurance that are issued as group plans.
[3.1] GROUP CREDIT LIFE INSURANCE
Group credit life policies are established by organizations (e.g., banks and finance companies) and stipulate that,
if the insured dies before a loan is repaid, the policy benefits will be used to settle the loan balance. Premiums for
group credit life insurance are based on claims experience and expense factors, not necessarily the borrower’s
age. The premiums are typically paid by the insured. A decreasing term policy is commonly used.
[3.2] BLANKET LIFE INSURANCE
Blanket life insurance covers groups of individuals who are exposed to the same hazard, such as airplane
passengers or students and faculty at schools. No individual is named on the policy, and certificates of coverage
are not issued. Individuals are only covered for the specified common hazard.
[3.3] RETIRED LIVES RESERVE AND QUALIFIED PLANS
Retired Lives Reserve (RLR) is a group life insurance product designed to provide continued life insurance
protection for former employees. RLR offers annual renewable term insurance and a reserve account that
accumulates funds until retirement. Once a covered employee retires, the account funds in the reserve account
are used to pay the premiums needed to keep the term insurance in force during their retirement.
This plan allows employers to make tax-deductible contributions to the reserve account on behalf of employees.
These contributions are not taxable to employees at the time they are made, but are taxable only when finally
used in retirement. A life insurance company or trust can administer this fund or reserve account.
A qualified retirement plan may purchase life insurance to provide death benefits under minimal circumstances.
The plan document must authorize such a purchase; however, the decision to buy a policy may be made by
either the plan administrator (the employer) or the participant. Most importantly, the purchase of life insurance
must be incidental to the plan's primary purpose of providing retirement benefits.
[3.4] LIFE INSURANCE FOR MEMBERS OF THE ARMED FORCES AND FEDERAL EMPLOYEES
The federal government provides life insurance coverage for those in the armed services and other federal
employees.
[3.4.1] SERVICEMEMBERS’ GROUP LIFE INSURANCE COVERAGE
Servicemembers’ Group Life Insurance (SGLI) provides up to $500,000 (in $50,000 increments) to full-time
members of the armed services. The coverage provided is group-term life insurance, and all active
servicemembers are automatically covered unless they opt out.
[3.4.2] FAMILY SERVICEMEMBERS’ GROUP LIFE INSURANCE COVERAGE
Family Servicemembers’ Group Life Insurance Coverage (FSGLI) is a component of the Servicemembers’ Group
Life Insurance program. FSGLI provides coverage for the spouses and children of insured servicemembers. Non-
military spouses are automatically covered for $100,000 or the amount of the member’s coverage, whichever is
less. Premiums for spousal coverage are based on the spouse’s age and the amount of coverage. Dependent
children are covered for $10,000 each at no cost to the member.
[3.4.3] VETERANS’ GROUP LIFE INSURANCE COVERAGE
Veterans’ Group Life Insurance (VGLI) provides for the conversion of Servicemembers’ Group Life Insurance
Coverage to a renewable term policy of insurance protection after a servicemember’s separation from
service. Servicemembers and their spouses may be able to convert their SGLI or VGLI to permanent insurance
through a commercial insurer without having to prove insurability.
[3.4.4] FEDERAL EMPLOYEES GROUP LIFE INSURANCE COVERAGE
Federal Employees Group Life Insurance (FEGLI) provides group term life insurance for all other federal
employees or civil service workers. Eligible employees automatically receive basic coverage—unless waived—
usually equal to their annual salary plus $2,000.
[4] TAXATION OF GROUP LIFE INSURANCE PLANS
For a group life insurance plan to receive favorable tax treatment, specific requirements must be met. These
requirements ensure that the average employee is not discriminated against in favor of higher-level employees.
[4.1] PREMIUMS FOR GROUP LIFE INSURANCE
Premiums that employees pay for their group life insurance are not tax-deductible. On the other hand, premiums
paid by employers for group life insurance are tax-deductible as a legitimate business expense, provided specific
requirements are met. However, sole proprietors or partners cannot deduct premiums for group life insurance on
their own lives, as they are not considered employees.
The premium on the first $50,000 of group term life coverage that an employer provides is not included in an
employee’s taxable income (i.e., it’s tax-exempt to an employee). The cost of coverage exceeding $50,000 is
taxable as ordinary income to the employee and reported on the employee’s W-2 as imputed income, even
though the employee does not receive it as a cash benefit.
[4.2] PROCEEDS FOR GROUP LIFE INSURANCE
Proceeds from a group life policy are tax-free if they are taken in a lump sum. As with other forms of life
insurance, proceeds received in installments will be subject to tax on the interest portion of those installments.
[5] CHAPTER SUMMARY
In this chapter, we explored the world of group life insurance and how it differs from individual coverage. We have
seen that group life insurance provides protection for multiple people under a single contract, offering employers
a cost-effective way to provide valuable benefits to their employees.
We began by examining the key differences between individual and group life insurance. Unlike individual
policies, in which the insured is typically the policy owner, in group insurance, the employer or organization holds
the master policy, while employees receive certificates of insurance. We learned that group coverage is almost
always annual renewable term insurance, which is more affordable but temporary.
We explored the two primary funding methods for group plans: contributory plans where employees share in the
premium costs (requiring at least 75% participation), and noncontributory plans where employers pay the entire
premium (requiring 100% participation). These participation requirements help insurers manage adverse
selection and maintain affordable rates.
The chapter clarified which types of groups can qualify for coverage—emphasizing that groups must be formed
for purposes other than obtaining insurance. We also examined the eligibility requirements for individual group
members, including employment status and waiting periods.
We discussed how group underwriting differs from individual underwriting, with insurers focusing on the
characteristics of the group rather than individual health conditions. This approach leverages the law of large
numbers to balance risk across the group, though smaller groups may face more stringent requirements.
An important feature we covered is the conversion privilege, which allows employees to convert their group term
coverage to individual permanent insurance when they leave employment, without proving insurability. This
valuable right must be exercised within 31 days of termination, during which time the group coverage remains in
effect.
We also explored specialized forms of group life insurance, including credit life insurance that protects lenders,
blanket life insurance for specific hazards, and the comprehensive coverage programs available to military
personnel and federal employees.
Finally, we examined the tax implications of group life insurance, noting that employer-provided coverage up to
$50,000 is tax-free to employees, while the cost of coverage above that amount is considered taxable income.
Understanding group life insurance is essential for insurance professionals, as it represents a significant portion
of the life insurance market and provides crucial financial protection for millions of workers and their families.
The concepts we've covered—from eligibility requirements to conversion privileges to tax considerations—form
the foundation for advising clients about their group coverage options and helping them make informed decisions
about their insurance needs.
[5.3] REVIEW NOTES
Learning Objective 1: Explain the fundamental differences between individual and group life insurance contracts
Key Concepts:
Group life insurance covers multiple individuals under a single contract
Group insurance is typically provided by employers for employees
Group life is most often written as annual renewable term insurance
The employer is the policy owner and receives the master policy
Employees receive certificates of insurance rather than individual policies
Important Terms:
Master Policy: Contract issued to the employer containing all insuring clauses
Certificate of Insurance: The document issued to employees outlining their coverage
Certificate Holder: The covered employee or plan participant
Policy Owner: The employer or group sponsor who holds the master policy
Learning Objective 2: Distinguish between contributory and noncontributory group insurance plans
Contributory Plans:
Employees share in the cost of premiums
Requires at least 75% of eligible employees to participate
Employees must approve automatic payroll deduction
Noncontributory Plans:
Employer pays the entire cost of the plan
Requires 100% of eligible employees to participate
Help insurers avoid adverse selection
Learning Objective 3: Describe the eligibility requirements for groups and group members
Group Eligibility Requirements:
A group must be a "natural group," one formed for a purpose other than purchasing insurance
Securing coverage must be incidental to the formation of the group
States may require groups to have existed for more than two years
States may require a minimum number of members
Eligible Group Types:
Employment-based groups (single employer, multiple employer)
Labor unions and trade associations
Financial and customer groups (credit unions, customer groups)
Fraternal organizations and trustee groups
Employee Eligibility Requirements:
Must be full-time and actively working
New employee probationary period typically 1-6 months
Enrollment period of 31 days to sign up without evidence of insurability
Learning Objective 4: Explain how underwriting for group life insurance differs from individual life insurance
Group Underwriting Concepts:
Focuses on characteristics of the group rather than individuals
Leverages the law of large numbers to balance risk
Reduces adverse selection through minimum participation requirements
Smaller groups may face more stringent underwriting requirements
Group life plans cannot exclude employees with physical impairments
Important Terms:
Adverse Selection: Tendency for higher-risk individuals to seek insurance
Persistency: Percentage of policies that remain in force over time
Law of Large Numbers: A statistical principle that allows insurers to predict losses more accurately with larger
groups
Learning Objective 5: Outline the conversion privileges available to employees when they leave a group plan
Conversion Privilege Features:
Allow employees to convert group term coverage to individual insurance upon termination
Conversion must occur within 31 days following termination
No proof of insurability required during the conversion period
Coverage continues under the group policy during the 31-day conversion period
Death during the conversion period results in payment under the group policy
Dependents may also convert their coverage without proof of insurability
Premiums based on the insured's attained age at conversion
Group Policy Termination Conversion Rights:
Available to members covered for at least five consecutive years
Converted policy may provide coverage up to face value (subject to limits)
Must apply within 31-60 days following group policy termination
Learning Objective 6: Compare different types of group life insurance
Group Credit Life Insurance:
Established by banks and finance companies
Pays off the loan balance if a borrower dies before the loan is repaid
Premiums based on claims experience, not necessarily the borrower's age
Typically uses decreasing term insurance
Blanket Life Insurance:
Covers groups exposed to the same hazard (airline passengers, students)
No individuals are named on the policy
No certificates of coverage issued
Coverage is limited to the specified common hazards
Retired Lives Reserve:
Provides continuing life insurance protection after retirement
Combines annual renewable term with a reserve account
Employer contributions are tax-deductible
Funds in reserve are used to pay premiums during retirement
Learning Objective 7: Describe group life insurance for military personnel and federal employees
Servicemembers' Group Life Insurance (SGLI):
Provides up to $500,000 coverage in $50,000 increments
Available to full-time members of the armed services
Automatic coverage unless member opts out
Group term life insurance
Family Servicemembers' Group Life Insurance (FSGLI):
Covers spouses and children of servicemembers insured under SGLI
Spouses are automatically covered for up to $100,000
Dependent children are covered for $10,000 at no cost
Spousal premiums based on age and coverage amount
Veterans' Group Life Insurance (VGLI):
Conversion of SGLI after separation from service
Renewable term policy
No proof of insurability required
Federal Employees Group Life Insurance (FEGLI):
Provides group term life for federal employees/civil service workers
Basic coverage equals annual salary plus $2,000
Automatic enrollment unless waived
Learning Objective 8: Explain the tax treatment of group life insurance
Premium Taxation:
Employee-paid premiums are not tax-deductible
Employer-paid premiums are tax-deductible as a business expense
The first $50,000 of employer-provided coverage is tax-exempt to the employee
Cost of coverage exceeding $50,000 is taxable as ordinary income (imputed income)
Sole proprietors/partners cannot deduct premiums on their own lives
Proceeds Taxation:
Proceeds are tax-free if taken as a lump sum
Installment proceeds are taxable on the interest portion as with other types of insurance settlement options
Exam Tips:
Know the differences between individual and group insurance contracts
Understand the participation requirements for contributory (75%) and noncontributory (100%) plans
Remember that groups must be formed for purposes other than obtaining insurance
Know the 31-day conversion period for terminated employees
Understand that the employee (certificate holder) names the beneficiary, not the employer
Remember the tax treatment: first $50,000 of employer-provided coverage is tax-exempt
Know the different types of federal insurance programs (SGLI, FSGLI, VGLI, FEGLI)
Remember:
Group insurance is always temporary (term) insurance
Master policy goes to the employer; certificates of insurance go to the employees
Conversion always changes temporary protection to permanent protection
Group underwriting focuses on the group, not individuals
The employer has all ownership rights except the right to name beneficiaries, which the employee retains
Group insurance is less expensive with fewer restrictions than individual insurance
[1] ANNUITIES INTRODUCTION
Imagine reaching retirement with a substantial nest egg, but facing an uncertain future: How long will you live?
Will your money last? This fundamental concern—outliving one's assets—is precisely what annuities are
designed to address.
An annuity represents a unique financial partnership between you and a life insurance company. Unlike life
insurance, which creates an estate upon death, an annuity systematically liquidates an estate by providing
guaranteed income streams. It transfers the risk of longevity from you to the insurance company.
Consider Sarah, a 65-year-old retired teacher who has saved diligently throughout her career. While she has
accumulated significant assets, she worries about market volatility and whether her savings will sustain her
through retirement. By purchasing an annuity, Sarah can convert a portion of her savings into predictable income
that she cannot outlive, regardless of market performance or how long she lives.
In this chapter, we'll explore the various types of annuities available in today's market—from immediate to
deferred, fixed to variable, and single to joint life options. We'll examine how annuities are funded, how they grow,
and how they ultimately provide income. We'll also address important considerations like taxation, suitability for
different clients, and the evolving landscape of annuity products.
Whether you're preparing to advise clients on retirement planning or simply expanding your insurance
knowledge, understanding annuities is essential in today's financial landscape where traditional pension plans
have largely disappeared and individuals bear greater responsibility for their retirement security.
This chapter is broken into the following sections:
• Purpose and Function
• Classification Based on Premium Payments
• Classification Based on When Benefits Begin
• Classification Based on Source of Income
• Classification Based on Disposition of Proceeds (Annuity Payment/Settlement Options)
• Classification Based on the Number of Lives Covered
• Additional Annuity Characteristics and Aspects
• New Types of Annuities
• Uses of Annuities
• Suitability in Annuity Investments
• Annuities and Taxation
The state-specific portion of this course (located at the end) will detail the specific insurance definitions, rules,
regulations, and statutes for your state. If a conflict exists, state law will supersede the general content.
[1.1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
• Define what an annuity is and explain how it differs from life insurance
• Distinguish between the various types of annuities based on premium payments (single, level, and
flexible)
• Compare immediate annuities and deferred annuities and identify appropriate uses for each
• Differentiate between fixed, variable, and indexed annuities and their investment characteristics
• Identify the different annuity settlement options and explain how each affects payment structures
• Analyze how annuities are taxed during the accumulation and distribution phases
• Evaluate the suitability of annuity products for different client situations
• Recognize the parties involved in an annuity contract and their respective roles
• Explain the purpose of surrender charges and how they affect annuity withdrawals
• Describe the business and individual applications of annuities in financial planning
[1.3] KEYWORDS
Before reading this chapter, please review the following keywords. An understanding of their basic definitions
will improve your comprehension of the chapter content.
403(b) Plan: A retirement plan for certain employees of public schools, tax-exempt organizations, and ministers.
1035 Contract Exchange: A provision allowing tax-free exchanges of annuities, life insurance policies, or
endowment contracts.
Accumulation Period: The phase during which premiums are credited as accumulation units before payout
begins.
Annuity Units: Units used to make payments to the annuitant once accumulation units are converted.
Deferred Annuity: An annuity that postpones payments until after a specified period or age.
Equity-Indexed Annuity (EIA): A fixed deferred annuity with interest linked to an equity market index.
Fixed Annuity: An annuity providing a guaranteed rate of return with investment risk assumed by the insurer.
Immediate Annuity: An annuity purchased with a single payment that begins paying income within one month.
Joint Life and Survivor Option: An annuity payout option providing payments to two people, continuing to the
survivor for life.
Life with Period-Certain Option: A payout option providing income for life with a guaranteed minimum period of
payments.
Market Value Adjustment: An adjustment in deferred annuities affecting crediting rates based on market
conditions.
Variable Annuity: An annuity where investment risk is shifted to the contract owner, with payments fluctuating
based on securities value.
[2] PURPOSE AND FUNCTION
An annuity is a financial product designed to provide a steady income stream and is offered exclusively by life
insurance companies. Its central purpose is to protect individuals from the risk of outliving their assets by
guaranteeing regular payments over time. Unlike life insurance—which creates an estate upon the death of the
insured—an annuity serves to systematically liquidate an estate by gradually distributing the funds that have
been accumulated.
The process begins with contributions, also known as premiums, made by the contract owner. These funds
accumulate and earn interest. This is the accumulation phase of an annuity.
At some mutually agreed-upon time, the annuity contract owner can annuitize the contract by exchanging the
accumulation fund for a guaranteed income stream. Once a contract has been annuitized, it cannot be undone.
The insurer takes possession of the accumulation account and promises to pay a series of periodic payments (at
a future date) for either a fixed period or for the remainder of the annuitant's life.
If the contract owner passes away before the annuity income phase begins, the designated beneficiary receives
the total contributions plus any accumulated interest—though this is not considered a traditional death benefit.
Annuities are similar to life insurance contracts because their premiums and payments are based on mortality
calculations. An annuity is a risk-sharing contract because premature death could financially benefit the insurer,
while living longer than anticipated would financially benefit the annuitant.
One of the defining characteristics of an annuity is that the exact amount to be paid out is unknown at the
contract’s initiation, as it depends on future factors such as longevity and investment performance. However, the
insurer guarantees a series of periodic payments for either a specified time or for the remainder of the annuitant’s
life, beginning at a future date chosen by the contract owner.
Annuities are regulated as insurance contracts by state insurance departments when they are traditional fixed
annuity products. However, variable annuities—like variable life insurance—are subject to both state regulation
and federal oversight by the Securities Exchange Commission (SEC) and the Financial Industry Regulatory
Authority (FINRA).
In summary, an annuity offers individuals a way to convert their savings into a predictable income stream,
transferring the risk of longevity and market performance to the insurer.
[2.1] HOW ANNUITIES WORK
An annuity protects an individual against outliving income. Only a life insurer can guarantee income for the life of
an annuitant. An annuity is attractive to investors since insurers generally pay higher interest rates than other
traditional savings vehicles (e.g., certificates of deposit or money market funds). If a contract owner withdraws
funds before a stated period, withdrawal penalties may be assessed. However, if the contract owner dies or
becomes disabled, funds may be withdrawn without penalty.
An annuity operates in two phases:
• Accumulation Period (Pay-in Phase): Contributions are made, and the principal grows tax-deferred
through interest. The contract owner holds rights to the annuity during this period.
• Annuitization (Annuity) Period (Payout Phase): Once income distribution begins, the annuitant receives
regular payments composed of both principal and interest.
A beneficiary must be designated to receive any remaining funds if the contract owner passes away before full
payout.
[2.1.1] ACCUMULATION PERIOD
During the accumulation (pay-in) phase, the insurer must return all (or a portion) of the annuity's value if the
contract owner dies. This value equals the amount of any contributions (minus withdrawals or other expenses),
plus interest. Although the contract doesn't identify the proceeds available at death as a death benefit, the owner
must name a beneficiary to receive proceeds if the owner dies during the accumulation period. Again, the
amount of appreciation earned during the accumulation phase is tax-deferred. However, additional surrender
charges may also be assessed at the time of withdrawal. The accumulation period ends when any of the
following occur:
• The contract owner dies
• The annuity or "payout" phase begins
• The policy is surrendered
This period will not end if a premium payment is not made.
[2.1.2] THE ANNUITY PERIOD
The annuity period, also referred to as the "annuitization phase," begins when the contract owner chooses to
start receiving regular income payments. At that point, the insurer assumes ownership of the funds in the
accumulation account, and the annuitant owns the income promised under the contract terms. This annuitant
who receives the funds may be the contract owner or another individual designated by the owner.
[2.1.3] THE ANNUITY TIMELINE
Accumulation Period (Pay-in phase): When the individual contributes to the annuity.
• Contract Owner: Holds the rights during accumulation.
• Tax-Deferred Growth: Interest earned is not taxed until withdrawal.
• Designation of Beneficiary: Ensures funds are passed on if the owner dies.
Annuitization Period (Pay-out) Begins: Starts when income payments commence.
 • First Periodic Payment: Marks the transition to the annuitant role.
• Annuitant Receives Income: Regular payments begin.
• Income = Principal + Interest: Payments include both components.
• Peace of Mind: Provides financial security for a stated time or life.
[2.2] THE PARTIES OF AN ANNUITY
The four parties involved in an annuity contract include the insurer, contract owner, annuitant, and beneficiary.
The insurance company is the legal entity that underwrites and issues the annuity. Remember, only a life insurer
can guarantee income for the life of an annuitant.
The contract owner is the person who typically buys the annuity. As the owner, they can control many aspects of
the contract, including when the annuity is annuitized, naming and changing beneficiaries, cash distributions, and
transfer of ownership.
The annuitant is the person named in the annuity who receives the income benefit when it is annuitized. When an
annuity contract is annuitized, the age of the annuitant is taken into consideration. Therefore, it is the annuitant,
and not the owner, whose life expectancy the benefits are based upon. It is important to remember that the
annuitant and owner can be the same person or different individuals.
The beneficiary is the party specified in the annuity who receives funds from the annuity if there are any left to be
paid out at death. A beneficiary should be named in case the contract owner dies before the annuity phase. If no
beneficiary is listed on an annuity contract and the owner dies before annuitization (payout), the proceeds are
paid to the contract owner's estate.
EXAM TIP!
An annuity is considered an insurance contract between the contract owner and the insurer.
[2.3] ANNUITY CLASSIFICATIONS
Annuities can be classified in several categories, including:
1. Based on How the Premiums Are Paid
Annuities can be funded through:
Single Premium: One-time lump-sum payment
Flexible Premium: Multiple payments over time
2. Based on When Benefits Begin
This refers to the timing of income payouts:
Immediate Annuities: Payments begin shortly after purchase (30 days up to one year)
Deferred Annuities: Payments begin at a future date (more than one year)
3. Based on the Source of Income
Income can be derived from:
Fixed Annuities: Guaranteed payouts
Variable Annuities: Payments vary based on investment performance
Indexed Annuities: Linked to a market index
4. Based on the Disposition of Proceeds
This determines how benefits are distributed:
Life Annuity: Payments continue for the annuitant's lifetime
Period-certain: Payments for a fixed period
Refund Options: Remaining value paid to beneficiaries
5. Based on the Number of Lives Covered
Coverage can include:
Single Life: One annuitant
Joint Life: Two or more annuitants, often spouses
[3] CLASSIFICATION BASED ON PREMIUM PAYMENTS
Annuities have their mortality tables that differ from those used in life insurance. Considered items include the
interest rate paid, the total amount of contributions and accumulations, and the selected settlement option. An
annuitant's occupation or hobbies don't influence an annuity because they won't affect the liquidation of funds.
Like we discussed with life insurance, the amount a client pays for an annuity is called the premium. Annuities
may be funded with either a single premium or periodic premiums. Periodic premium plans can be further
classified into level or flexible plans.
[3.1] SINGLE PREMIUM ANNUITIES
Single premium annuities are characterized by a lump-sum (single) premium payment. In other words, the
annuity is fully funded with a single premium payment. Monthly income payments to the annuitant may begin
immediately (i.e., 30 days after the single premium) or at some point in the future (deferred).
Single premium annuities are either single premium immediate income (SPIA) or deferred income (SPDA). SPIAs
are paid in a lump sum, with income often beginning 30 days later. SPDAs are funded with a lump sum, with
income being paid in the future. At times, SPDAs include a bailout provision that allows the owner to withdraw
funds without penalty if the interest rate falls below a specified rate.
When an annuity is funded with a single, lump-sum payment, the principal is created immediately. Generally, this
type of annuity does not permit the contract holder to make any additional deposits into the contract. This means
the contract is fully funded with a single lump-sum payment.
For example, Jordan, age 50, won the lottery and received a $5,000,000 payout. After consulting with a financial
advisor, Jordan decides to use $1,000,000 to build a house and pay off existing debt, while investing the
remaining $4,000,000 in a single premium annuity. Jordan now needs to decide whether to begin receiving
income payments from the annuity immediately or defer them until a later date.
[3.2] PERIODIC PREMIUM ANNUITIES
Multiple premium payments over a set period characterize periodic premium annuities. Periodic premium
annuities are broken into two classifications: level premium and flexible premium.
[3.2.1] Level Premium Annuities
A level premium annuity is characterized by constant payments to fund the annuity. This type of annuity is also
called an annual premium annuity; however, many insurers allow premiums to be paid monthly, quarterly, or
semi-annually. Regardless of the premium frequency, the premium remains the same across all payment modes.
For instance, consider Debbie, a 35-year-old store manager who purchases a level premium annuity with an
annual payment of $1,200. The individual intends to commence income payments upon reaching the age of 65.
As the contract holder, they will remit the fixed premium amount of $1,200 each year until electing to transition
from premium payments to receiving income. In this scenario, monthly income disbursements will begin at age
65.
Although the amounts deposited into an annual premium retirement annuity are not tax-deductible (i.e., the
premiums are paid after tax), the income earned on the annual premium paid into the contract will not be taxed
until it's removed from the account. In other words, the interest or earnings paid on the principal are tax-
deferred. These older contract types were characterized by high front-end loads; that is, expense charges
deducted from deposits.
[3.2.2] Flexible Premium Deferred Annuities
A flexible premium annuity is characterized by periodic premiums that may vary in amount. The contract owner
determines the amount they can afford to contribute each year. In this case, the owner will contribute an amount
of their choosing with each payment and can even skip premium payments. They will pay premiums until they
want to begin receiving income after retirement. The future income benefit will be based on the total amount of
funds saved once the plan is annuitized (i.e., when income payments begin). While the contract owner can skip
premium payments, the lack of payment discipline will negatively impact their future income payments.
For example, Chris, a 40-year-old insurance agency owner, decides to allocate 10% of their annual commissions
over the next 20 years to purchase a flexible premium annuity. The amount of each premium payment will
fluctuate based on the commission earned. The future income payments from the annuity will reflect the total
contributions made over the 20 years. At age 60, the plan is annuitized, and monthly income payments begin.
Today, the most popular annuity product sold is the flexible premium deferred annuity (FPDA). An FPDA provides
for flexible payments and future income to an annuitant. Any interest earned is tax-deferred. This type of annuity
has virtually replaced the annual premium retirement annuity contract, which has a fixed schedule of annual
premiums (including bundled premiums) and high expenses. Today's FPDAs have little or no front-end loads due
to intense competition among insurers. However, many FPDAs do assess back-end or surrender charges.
EXAM TIP!
Notice that neither Debbie nor Chris had the option to start receiving income payments immediately. They do not
have the option to receive income payments immediately since they are still paying into the Annuity. The option
for immediate income is available only when the premium is paid at once (single-premium).
[4] CLASSIFICATION ACCORDING TO WHEN BENEFITS BEGIN
Annuities may be described according to when the payout or distribution phase begins. In other words, they may
be characterized as either immediate or deferred annuities. Immediate annuities begin paying benefits within 30
days to one year. Deferred annuities begin paying benefits more than one year in the future.
[4.1] IMMEDIATE ANNUITY
An immediate annuity is designed to generate an income stream to the annuitant soon after it’s purchased. The
first installment payment to an annuitant can begin as soon as 30 days after the annuity is funded or purchased.
The first income payment from a single premium immediate annuity must be made within 12 months of the
contract date.
An immediate annuity can only be funded with a single (lump-sum) premium. This means that there's no
accumulation period since only a single payment is made. No income will be paid to the annuitant until they have
paid the lump sum to the insurer. The income payments made to the annuitant consist of both principal and
interest.
As with any annuity, the period during which the annuity generates income for the annuitant depends on:
The total amount contributed to the account; and
The settlement or distribution option selected by the owner.
The longer the period of desired income payments to the annuitant and the more guarantees provided (e.g.,
period-certain), the lower the amount of each installment. The income from the annuity may either be a fixed
dollar amount each month or a variable sum. An immediate annuity is best suited for a person who needs
"immediate" income (i.e., a person who's disabled or ready to retire).
EXAM TIP!
These are often called Single Premium Immediate Annuities (SPIA) because they can only be funded with a
single premium and must begin paying benefits immediately (within 12 months). Be careful not to
overcomplicate exam questions. Immediate annuity = single premium. Income begins within the first year =
immediate annuity.
[4.2] DEFERRED ANNUITIES
Unlike immediate annuities, deferred annuities may be funded with any premium payment plan (single premium,
level premium, or flexible premium).
This classification also differs from an immediate annuity because it includes an accumulation period. This
means that there's a lengthy period between the contract's purchase and the start of the income or annuity
phase.
A deferred annuity emphasizes the safety of principal, asset accumulation, and tax-deferred interest. Therefore,
a deferred annuity is helpful for any person seeking to defer income until the future (e.g., retirement).
Contributions may accumulate over time, and each year the insurer credits the funds at a specific tax-deferred
rate of interest. When the owner decides to receive cash from the fund in the future, they have three options:
A lump-sum distribution, of which the credited interest portion is taxable
Systematic or periodic withdrawals taken from the accumulation account
Annuitization, the conversion of the accumulation fund into an irrevocable structured income stream so as to
receive guaranteed monthly payments.
For example, a new physician is just beginning their practice and wants to set aside funds for the future.
However, if their current expenses are high, they may achieve this objective by purchasing a flexible premium
deferred annuity.
EXAM TIP!
Get comfortable pulling apart the product name to answer exam questions.
A single premium deferred annuity = 1 premium payment and future income payments (at least 1 year later).
A flexible premium deferred annuity = periodic flexible premiums and future income payments after premium
payments cease.
[5] CLASSIFICATION ACCORDING TO THE SOURCE OF INCOME
Some annuities are classified by their investment configuration or the source of provided income payments. The
investment configuration affects the income benefits paid. For this type of classification, there are two types of
annuities: fixed and variable.
• A fixed annuity pays a guaranteed, predetermined, or level benefit payment amount during the annuity
phase. Premiums are placed in the insurer's general account with other non-variable product premiums.
These premiums are invested in fixed-rate products (e.g., CDs, Bonds, etc.) to provide a "fixed" return
based on interest rate guarantees. These contracts include minimum interest rate guarantees and may
pay higher rates based on current economic market conditions.
• For a variable annuity, premiums are placed into its separate account. These funds are invested in
securities, such as equities (i.e., common stock or preferred stock) or debt securities (i.e., bonds). This
type of annuity provides the potential for increasing income if the securities perform well. To solicit a
variable product, a person must obtain a life insurance license and a FINRA securities registration (i.e.,
Series 6 or Series 7).
[5.1] FIXED ANNUITIES
A fixed annuity guarantees a predetermined income or level benefit payment amount, which is paid each month
for the annuitant's life. The recipient (i.e., the annuitant) receives this monthly income or fixed dollar amount for
the remainder of their life. Fixed annuities are derived from the insurer's general account since it is this account
that provides an interest rate guarantee and the fixed dollar or income guarantee. An insurance company's
general account holds the deposits of premiums collected for fixed insurance and annuity contracts (i.e., this
account holds the insurance company's assets).
If the insurer remains solvent, a fixed annuity also guarantees the principal's safety. Compared with a variable
annuity, this type of annuity is a conservative product. Since a fixed annuity is characterized by a predetermined
income amount, its purchasing power is most affected by inflation. Once predetermined income payments begin
for a fixed period-certain annuity, the beneficiary receives a guaranteed refund if the annuitant dies within the
period chosen. With a fixed annuity, the insurance company assumes the investment risk. This means the insurer
invests the funds in safe, conservative assets to guarantee the annuity benefit. As required under the contract
terms, the insurer must provide the promised benefit regardless of its investments’ earnings.
To summarize, a fixed annuity guarantees a minimum interest rate on the purchase premium. Income payments
don't vary from one payment to the next. For a fixed annuity, the insurer can guarantee future payments because
investments are from the general investment portfolio (GIP), which invests in conservative, long-term,
government-backed treasuries.
[5.2] VARIABLE ANNUITIES
A variable annuity is a contract issued by an insurer that allows the contract owner to invest premiums in various
investment options, unlike a fixed annuity. It typically includes two investment accounts: a general account and a
separate account. General accounts provide a guaranteed return. Separate accounts invest in equity products
with no guaranteed return but higher potential for gains.
[5.2.1] SEPARATE ACCOUNT
The separate account is unique to variable annuities. It holds all variable investment options and allows the
contract holder to control their investments, assuming the investment risk. The assets in the separate account
are segregated from the insurer's general account.
[5.2.2] INSOLVENCY PROTECTION
If the insurance company becomes insolvent, creditors cannot claim assets in the separate account, but they
can claim assets in the general account. Separate accounts are generally registered with the Securities and
Exchange Commission under the Investment Company Act of 1940.
[5.2.3] FLEXIBILITY AND RISK
Variable annuities offer flexibility, allowing the contract owner to determine their risk level. The benefits paid by
the contract depend on the performance of the separate account – its value is not guaranteed. If the investments
perform well, the monthly income increases; if they perform poorly, the income decreases.
[5.2.4] QUALIFICATION AND REGULATION
To sell a variable annuity, a FINRA Series 6 or Series 7 securities registration and a life insurance license are
required. Variable annuities are considered securities and are subject to SEC, FINRA, and state insurance
regulation. A prospectus must be delivered before the sale is completed.
[5.2.5] PURPOSE AND PERFORMANCE
Variable annuities were created to provide better protection against inflation than fixed annuities. They offer
control over how contributions are invested and are characterized by variable rates of return. During the
accumulation period, contributions (minus expenses) are used to purchase accumulation units.
[5.2.6] VARIABLE ANNUITY SUBACCOUNTS
For variable annuities, the separate accounts typically contain a variety of different underlying portfolios or
subaccounts, which are like the mutual fund choices that investment companies offer to their investors.
Contract owners can allocate their payments across these subaccounts based on their investment objectives.
Additionally, contract owners are generally allowed to transfer their money from one subaccount to another as
their investment goals change. Each subaccount typically corresponds to a different underlying mutual fund,
such as a large-cap stock fund, a long-term bond fund, or a money market fund. The value of these subaccounts
fluctuates with changes in market conditions for the underlying securities. Another subaccount may have a fixed
rate of return, which the insurance company guarantees.
During the annuity's accumulation period, the contract holder may surrender the annuity for its current value.
However, once a person decides to annuitize (begin receiving income payments from the annuity), they may no
longer surrender the annuity or freely withdraw money from it. Instead, they're receiving payments based on the
performance of the assets in the separate account.
At annuitization, the insurance company converts all the purchased accumulation units into annuity units.
Annuity units represent the accounting measurement used to determine the dollar amount of each annuitant
payment. At this time, the number of annuity units represented in each payment is fixed. However, in the future,
the value of each payment to the annuitant is based on a fixed number of annuity units, multiplied by a fluctuating
unit value.
[5.3] EQUITY-INDEXED ANNUITIES
An equity-indexed annuity is a fixed (non-variable) annuity that offers a rate of interest linked to (but the funds
are not directly invested in) a stock-market-related index (e.g., the Standard & Poor's 500 Index). This form of
annuity may also be referred to as an indexed annuity.
Indexed annuities provide the contract owner with the safety of principal (since principal is guaranteed) and a
guaranteed minimum return (e.g., 0%), since a high percentage of the contract owner's premium is invested in
high-grade government bonds. This provides a downside guarantee if the market performs poorly. In other words,
this type of contract allows the owner to participate in market gains without assuming the risk of a market
decline. An EIA also provides the opportunity for appreciation (i.e., upside potential) in the stock market.
Generally, the contract owner is obligated to remain in the contract for a minimum period (e.g., three years) and
will receive a return equal to a percentage of the appreciation in the selected equity index over that period (e.g.,
10%). This "percentage of the appreciation" may also be referred to as the participation rate. This is similar to
the strategy used in indexed life insurance policies.
[5.4] MARKET VALUE-ADJUSTED ANNUITIES
A market-value-adjusted annuity (MVA), also referred to as a modified guaranteed annuity, shifts some (but
not all) of the investment risk from the insurer to the contract owner, since the annuity account value will
fluctuate with changes in market interest rates. In other words, it's a type of single-premium deferred annuity that
allows contract owners to lock in a guaranteed interest rate over a specified maturity period of typically 2 to 10
years.
An MVA functions similarly to a bond in times of fluctuating interest rates (i.e., when interest rates fall, bond
prices rise, etc.). MVAs generally offer higher interest rates than traditional annuities, have lower reserve
requirements, and transfer more risk to the contract owner. When surrendered, the owner will generally be
assessed both a market value adjustment and a surrender penalty.
[6] CLASSIFICATION ACCORDING TO DISPOSITION OF PROCEEDS (ANNUITY PAYMENT/SETTLEMENT
OPTIONS)
Unlike a term or whole life insurance policy, an annuity is not a contract that pays a guaranteed death benefit.
When determining the income to be paid to the annuitant, the insurer uses a different mortality table with an
extra element, which is referred to as a survivorship factor. An annuity may also be described by the life payout
period or the life contingency settlement option selected. Let's analyze the various options.
[6.1] STRAIGHT LIFE ANNUITY
This contingency option, also referred to as a pure life annuity or "life" annuity, is classified according to the
period during which the annuitant will receive income. If a straight life settlement option is chosen, the recipient
will receive monthly payments for life, with no refund to their family or any beneficiary. This settlement option
exposes the annuitant to the greatest risk because it lacks survivorship benefits (i.e., no refund) but also provides
the annuitant with the highest monthly amount of all options. Its purpose is to protect against an annuitant
outliving their income. This means that a straight life annuity protects against a future lack of money.
Insurers that pay out under life annuities may suffer if mortality rates decline suddenly. In other words, people are
living longer and, therefore, insurers are paying longer life incomes. In addition, since women have a longer life
expectancy than men, monthly payments would be smaller for a female if all other things are equal.
For example, Joe and Joan are twins and inherit an equal amount of money from their favorite aunt. Suppose they
both purchase an annuity with the funds, and each contract includes the same life income option. In that case,
Joe's monthly income payments from the annuity contract will be higher since his life expectancy is shorter than
Joan's.
[6.2] ANNUITY (PERIOD) CERTAIN
An annuity certain or period-certain is a description of income or installments for a fixed period chosen by the
owner. This means that the monthly income will be paid for a specified period only (i.e., not for life). Payments
cease after the specified period, even if the annuitant is still alive. However, if the annuitant dies before the end of
that period, payments continue to the designated beneficiary for the remainder of the specified period.
For example, let's say at age 60 Joe purchases an annuity with a period-certain term for 20 years. Joe's annuity
payments will cease at age 80 (20 years later), even if he is still alive. However, if Joe dies at age 70 (after 10
years), his family (or designated beneficiary) will continue to receive his payments for 10 more years.
[6.3] LIFE ANNUITY WITH PERIOD-CERTAIN
A life annuity with a period-certain pays a guaranteed minimum benefit (i.e., income) for the annuitant's life or a
specified period, whichever is longer. This means that the contract pays a survivor benefit if the annuitant dies
before the end of the period-certain (e.g., 10 years). In other words, the annuitant or survivors are entitled to a
guaranteed income for at least a specified number of years.
For example, let's say at age 60 Joe purchases a life annuity with a period-certain for 20 years. Joe will continue
to receive annuity payments for as long as he is alive. He cannot outlive his payments. If Joe dies at age 70 (after
10 years), his family (or designated beneficiary) will continue to receive his payments for 10 more years.
However, if Joe dies at age 85 (after 25 years), payments will cease, and his family (or designated beneficiary) will
not receive any of the proceeds.
[6.4] LIFE WITH REFUND OPTION
With a life-with-refund annuity option, the contract owner makes premium payments to the insurer throughout
their life. Still, the contract also assures the return of the original amount paid into the annuity contract (i.e., the
principal). If the annuitant dies before the principal is distributed, the beneficiary receives the remaining amount.
Due to this guarantee, the premium for a refund annuity plan is generally higher than that of other annuity plans.
Two life insurance options with refund options are available: installment and cash.
Option Description
Installment Refund Will pay the beneficiary the same monthly income benefit that the annuitant was receiving
Option until the remaining principal is depleted.
Cash Refund Option Will pay the remaining principal to the beneficiary in one lump sum.
EXAM TIP!
Remember, an annuity certain guarantees payments for a specified period. A refund annuity guarantees the
entire principal will be paid, either to the annuitant or to a beneficiary.
[7] CLASSIFICATION ACCORDING TO THE NUMBER OF LIVES
Annuities may also be classified according to the number of lives covered: single or multiple. Let's examine the
three basic types.
[7.1] INDIVIDUAL OR SINGLE LIFE ANNUITY
An individual or single life annuity is the most common annuity. It is a pure life annuity, covering one life, with no
survivorship (beneficiary). Once started, it provides the recipient with income for life, with no refund paid to
anyone upon their death. While this option pays the highest benefit amount, it has the greatest risk to the
annuitant, since there is no survivorship (i.e., no refund). Its purpose is to protect against outliving one's income.
[7.2] JOINT LIFE ANNUITY
A joint life annuity is a type of multiple-life contract that pays benefits to two or more annuitants simultaneously.
However, all benefits will end upon the first annuitant's death. In this manner, it's like a joint life insurance policy.
[7.3] JOINT AND SURVIVOR ANNUITY
A joint and survivor annuity is another multiple life contract. With this type of annuity, the benefits are paid
throughout the lifetime of one or more annuitants. Therefore, payments continue until the last annuitant dies. In
other words, joint and survivor annuities guarantee income payments for the duration of two lives.
[8] ADDITIONAL ANNUITY CHARACTERISTICS AND ASPECTS
[8.1] SURRENDER CHARGES
Surrender charges, also known as back-end loads, are assessed when the contract owner cancels an annuity. A
surrender charge (i.e., penalty) is assessed whenever a cash withdrawal is made more than a specified
percentage (e.g., 10%), in any policy year. If the total annuity is surrendered, the surrender charges are
subtracted from the annuity value. However, for any withdrawals of less than the specified percentage, no
surrender charge is assessed. The surrender charge generally decreases each year. For example, an insurer may
assess a surrender charge of 8% if any withdrawals over 10% of the account balance are taken in the first year.
This penalty decreases by 1% per year for the next eight years. Year nine will not have a surrender charge for
excess withdrawals. In other words, after this period expires, the insurer waives surrender charges.
[8.2] NON-FORFEITURE VALUES
Annuity contracts also identify a fund's non-forfeiture value, which represents the fund's value less any surrender
charges if the funds are being withdrawn. As is the case for certain types of qualified retirement plans available
today, funds may be withdrawn without assessing surrender charges if the owner dies, becomes disabled, or
requires specific types of extended medical care in a skilled nursing or extended care facility. Surrender charges
are designed to make moving money out of an annuity less attractive to the contract owner. They are different
from the 10% federal tax penalty for a premature (before age 59½) withdrawal. Therefore, a withdrawal from an
annuity may be subject to both a surrender charge and a tax penalty.
EXAM TIP!
Before annuitization, the non-forfeiture value of an annuity equals all premiums paid, plus interest, minus any
withdrawals and surrender charges. If the annuitant dies before the annuity period starts, the beneficiary
receives the premiums paid plus interest earned.
[8.3] GUARANTEED MINIMUM WITHDRAWAL BENEFIT
A guaranteed minimum withdrawal benefit (GMWB) is a rider that may be included in a variable annuity contract.
The GMWB guarantees the policyholder a steady stream of retirement income regardless of market volatility.
During market downturns, the annuitant can withdraw a fixed percentage of their entire annuity investment.
Annual maximum withdrawal percentages vary by contract but are generally between 5% and 10% of the initial
investment until the total initial investment is depleted. During the withdrawal period, the annuitant may
continue to receive income.
[8.4] GUARANTEED MINIMUM INCOME BENEFIT
Guaranteed minimum income benefit (GMIB) guarantees a minimum income amount at annuitization, regardless
of market performance. The payout is based on the greater of two values: the account's actual value or the GMIB
benefit base, net premiums compounded at a fixed rate. To activate this benefit, the contract must be annuitized,
even if fees have already been paid. What does this mean for investors? It shifts the focus from market returns to
strategic timing and commitment.
[8.5] GUARANTEED MINIMUM ACCUMULATION BENEFIT
The guaranteed minimum accumulation benefit (GMAB) guarantees that the owner's premiums paid into the
contract will have a minimum accumulation value after a set waiting period. The net premiums are typically
multiplied by a factor of one to three to determine this minimum. The contract does not need to be annuitized for
this benefit to be triggered.
[8.6] LONG-TERM CARE RIDERS
Long-term care riders may be attached to an annuity or a life insurance policy, allowing for the payment of a
percentage of the death benefit if an individual requires long-term care but is not terminally ill.
[9] USES OF ANNUITIES
An annuity is a type of insurance contract that may be used for any purpose where the accumulation of cash is
the goal, but it's primarily used to provide income at retirement. Annuities provide a structured and systematic
way to liquidate principal. While life insurance is intended to create an estate, annuities are intended to liquidate
an estate. This section examines some common uses of annuities.
For example, Alex is 45 and wants to ensure a stable income after retiring at 65. Alex invests in an annuity today
and contributes monthly. Over 20 years, the annuity grows. At 65, Alex starts receiving monthly payments,
replacing a paycheck and covering living expenses. Unlike life insurance, which would pay out upon death, Alex's
annuity helps spend down savings in a structured way, ensuring financial security during retirement.
[9.1] HOW ANNUITIES WORK AND WHY THEY MATTER
[9.2] QUALIFIED VERSUS NON-QUALIFIED ANNUITIES
For tax purposes, annuities are classified as either qualified or non-qualified. With a non-qualified annuity, the
contributions are made with after-tax dollars. The contract owner receives the tax deferral of interest and growth
earned, but there's no tax deduction of premiums (or yearly tax savings through a salary reduction). Annuities
purchased outside of qualified pension plans don't receive tax-favored treatment of premium payments. In other
words, premiums are not tax-deductible. Any individual or entity may purchase non-qualified annuities, but,
again, the premium payments or contributions are not tax-deductible.
A qualified annuity is one that's purchased as part of a tax-qualified retirement plan. If the premium paid for a
qualified annuity is in the form of a contribution by an employer to a qualified retirement plan, the premium is tax-
deductible to the employer. Some qualified annuities also permit employees to fund the plan through a salary
reduction (e.g., a tax-sheltered annuity or TSA). In this case, the plan is funded with pre-tax dollars, which lowers
the employee's yearly taxable income. An important note is that, regardless of whether the annuity is qualified or
non-qualified, accumulations of earned interest are tax-deferred.
[9.3] INDIVIDUAL USES OF ANNUITIES
Again, an annuity is an insurance product that offers the annuitant tax-deferred growth. Contract owners may
elect to receive a lump-sum payout (i.e., settlement) when the annuity phase begins. However, receiving a lump-
sum settlement can lead to significant tax liability for the recipient.
By design, an annuity will liquidate principal in a structured, systematic way, guaranteeing it will last a lifetime.
Since they may be used to fund individual retirement accounts (IRAs), they are also referred to as individual
retirement annuities. Annuities may also fund non-qualified retirement plans; however, such plans don't receive
the same tax-advantaged treatment as a qualified plan. Some annuities are used to fund a child's education or to
pay out lottery winnings.
Keep in mind, for most individuals, the primary use of an annuity is to set aside funds for retirement while
receiving tax-deferred growth.
Scenario Application:
Jordan, a 58-year-old educator, has been contributing to an FPDA for over a decade. As retirement nears, Jordan
considers taking a lump-sum payout to fund a dream vacation and pay off a mortgage. However, a financial
advisor warns that doing so could trigger a significant tax bill, since the annuity's growth has been tax-deferred.
Instead, the advisor suggests annuitizing the contract, turning it into a stream of guaranteed income for life. This
approach spreads out the tax burden and ensures Jordan doesn't outlive the savings.
[9.3.1] QUALIFIED ANNUITY PLANS
Although retirement plans are covered in detail in a later chapter, the following information describes annuities
related to them. As mentioned above, annuities may be used to fund qualified retirement plans on either an
individual or group basis. In some cases, the plans receive tax deferrals and tax deductions. Such plans include
Keogh plans, simplified employee pensions (SEPs), 401(k) plans, pension plans, and profit-sharing plans.
Pension and profit-sharing plans may be established as defined contribution or defined benefit plans. A defined
contribution plan specifies the amount each employee contributes to the plan. In contrast, a defined benefit plan
specifies the benefit amount the (retired) employee will receive in the future. Ultimately, annuities may be used
for employees on a group or individual basis.
During the accumulation (pay-in) phase, a qualified deferred annuity may be used to fund an IRA, and continued
contributions are permitted within the applicable IRS limits. Any IRA funds that have been annuitized will no
longer permit contributions.
[9.3.2] TAX-SHELTERED ANNUITY 403(B) OR 501(C)(3) PLANS
A tax-sheltered annuity (TSA) is a special type of annuity plan reserved for non-profit organizations and their
employees. Such a plan is also referred to as a 403(b) plan or 501(c)(3) plan because it was made possible by
those sections of the IRS tax code. For many years, the federal government, through its tax laws, has encouraged
specified non-profit charitable, educational, and religious organizations to set aside funds for their employees'
retirement.
Regardless of whether the employers of these organizations set aside the money or the funds are contributed by
the employees through a salary reduction, the money being placed in TSAs can be excluded from the employees'
current taxable income.
Upon retirement, payments received by employees from the accumulated savings in tax-sheltered annuities are
treated as ordinary income. However, since the total annual income of an employee is likely to be less after
retirement, the tax paid by a retiree is likely to be less than while working. Additionally, the benefits can be spread
out over a specified period or the employee's remaining lifetime. This generally allows smaller amounts of tax
owed on the benefits in any one year.
EXAM TIP!
In addition to TSAs and IRAs, annuities are an acceptable funding mechanism for other qualified plans, including
pensions and 401(k) plans.
[9.3.3] STRUCTURED SETTLEMENTS
Annuities are also used to distribute funds from the settlement of lawsuits or the winnings of lotteries and other
contests. Such arrangements are referred to as structured settlements. Court settlements of lawsuits often
require the payment of large sums of money throughout the rest of the injured party's life. For these settlements,
annuities are perfect vehicles because they can be tailored to meet the claimant's needs. Annuities are also
suitable for distributing significant state lottery awards. These awards are often paid out over several years,
usually 10 or 20 years. Because of the extended payout period, the state can advertise significant awards and
then provide for the distribution of the award by purchasing a structured settlement from an insurance company
at a discount. The state can get the discounted price because a $1 million award distributed over 20 years is not
worth $1 million today. Trends indicate that significant growth can be expected from both these markets for
annuities.
[9.3.4] EDUCATION FUNDS
An annuity provides a steady stream of income, typically used for retirement, but can also be used to fund
education for children or family members.
[9.4] BUSINESS USES OF ANNUITIES
Businesses primarily use annuities to manage financial obligations, provide employee benefits, and create tax-
efficient strategies for long-term planning. Common business uses for annuities include:
• Executive compensation - Deferred compensation plans using annuities to reward key employees
• Business succession planning - Funding buy-sell agreements between partners
• Key person insurance - Protecting against the financial impact of losing essential employees
• Corporate pension plans - Providing guaranteed retirement income for employees
• Funding future obligations - Setting aside money for known future liabilities
• Cash management - Storing excess capital with potential tax advantages
• Employee retention - Offering retirement benefits to attract and keep talent
• Asset protection - Shielding business assets from potential creditors
[9.4.1] INDIVIDUAL VERSUS GROUP ANNUITIES
Individual and group annuities are both financial products designed to provide income, typically during
retirement, but they differ in structure, purpose, and how they’re purchased. Here's a comparison across key
dimensions:
INDIVIDUAL
Purchased by a single person directly from an insurance company
Customizable to the individual's specific needs
Underwriting based on personal factors like age, health, and lifestyle
Generally, higher fees and administrative costs
No employer involvement required
Funded with after-tax dollars (unless qualified)
Portable and stays with the individual regardless of employment
GROUP
Purchased by an organization (typically an employer) for multiple people
Standardized features for all members of the group
Underwritten based on group demographics.
Lower administrative costs due to economies of scale
Often part of employer-sponsored retirement plans
May offer pre-tax contribution options
Usually tied to employment with the sponsoring organization
[10] SUITABILITY IN ANNUITY INVESTMENTS
Insurers and insurance producers must have reasonable standards for determining whether an agent's
recommended transactions meet the consumers' insurance needs and financial objectives. A producer cannot
recommend the purchase, sale, or exchange of any annuity contract unless the producer has reasonable grounds
to believe that the transaction or recommendation IS suitable for the person to whom it's recommended.
Suitability is based on the producer conducting a reasonable inquiry regarding the applicant's insurance
objectives, current financial situation, insurance needs, and risk tolerance.
Suitability information is considered information that is reasonably appropriate to determine the suitability of a
recommendation and includes:
• The age of the applicant and spouse
• Annual household income
• Financial situation and needs, including the financial resources used for the funding of the annuity
• Financial experience of the person
• Financial objectives of the prospective purchaser
• The intended use of the annuity
• Financial time horizon
Any existing assets, including investment and life insurance holdings of the prospective buyer
The producer should also consider the consumer's liquidity needs, liquid net worth, risk tolerance, and tax status
(e.g., tax bracket).
State legislatures have established standards and procedures for recommendations to senior consumers
regarding annuities. A senior consumer is defined as any person who is age 65 or older. In situations where more
than one party is making a joint purchase, a purchaser is a senior consumer if any party is age 65 or older. An
agent must make reasonable efforts to obtain information regarding the senior's financial status, tax status, and
risk tolerance, among other specified information relevant to determining suitability.
[11] ANNUITIES AND TAXATION
As mentioned earlier, contributions (i.e., premiums) to a qualified individual (or employer-sponsored) annuity are
generally tax-deductible. However, contributions to or premiums paid for a non-qualified individual annuity are
not tax-deductible. Annuity benefit payments are a combination of principal repayment and growth (interest,
dividends, and capital gains). Since the earnings (i.e., accumulations) in annuities are tax-deferred, the IRS will
tax the amount withdrawn above the amount invested as ordinary income (subject to the highest tax rates).
However, the portion of the benefit payments that represent a return of principal (i.e., the annuitant's
contributions) is not taxed. In other words, the result is a tax-free return on the annuitant's investment and
taxation of the growth.
[11.1] THE EXCLUSION RATIO
Although a detailed discussion of how to compute the taxable portion of an annuity payment is beyond the scope
of this text, the basics are not difficult to understand. A simple formula, known as the exclusion ratio, is used to
determine the annual annuity income exempt from federal income taxes. The formula is: the total investment in
the contract divided by the expected return.
The owner's investment (cost basis) in the contract is the amount of money paid into the annuity (the premium).
The expected return is the annual guaranteed benefit that the annuitant receives multiplied by the number of
years of the annuitant's life expectancy. The resulting ratio is applied to the benefit payments, allowing the
annuitant to exclude from income a like percentage from income tax.
For example, suppose $120,000 is invested in an annuity. The expected return each year is $6,000, and the life
expectancy is 25 years.
• Total expected return = $6,000 × 25 = $150,000
• Exclusion ratio = $120,000 ÷ $150,000 = 80%
• Tax-free portion of each payment = 80% of $6,000 = $4,800
• Taxable portion of each payment = $6,000 – $4,800 = $1,200
So, each year, $4,800 of the annuity payment is excluded from taxes, and $1,200 is taxable.
[11.2] EARLY / PARTIAL WITHDRAWAL / CASH SURRENDER
Deferred annuities accumulate interest earnings on a tax-deferred basis. Although no taxes are imposed on the
annuity during the accumulation phase, taxes are imposed when the contract begins to pay its benefits. To
discourage the use of deferred annuities as short-term investments, the Internal Revenue Code imposes a
penalty (as well as taxes) on early withdrawals and loans from annuities.
Prematurely withdrawn amounts are generally taxed on a last-in, first-out (LIFO) basis, which means that
accumulations or interest earned are considered withdrawn first when distributions are made. The exception to
this rule is that annuities purchased before August 14, 1982, are taxed on a first-in, first-out (FIFO) basis, which
means that the premium paid is considered withdrawn first. These taxes are in addition to, not inclusive of, the
federal age-based tax penalty.
For withdrawals from a deferred annuity taken before the age of 59 1/2, a 10% penalty tax is imposed on the
amount withdrawn. Withdrawals taken after the age of 59 1/2 are not subject to the 10% penalty tax, but they are
still taxable as ordinary income.
Penalties are not assessed on premature distributions if:
• The owner becomes disabled;
• The owner has reached the age of 59½;
• The owner has died;
 • An immediate annuity was purchased, or
• Funds are received under a qualified pension plan.
Like early withdrawals, partial withdrawals (i.e., loans) and cash surrenders are treated first as earned income
and are therefore taxable as ordinary income. Only after all earnings have been taxed are withdrawals considered
a return of principal.
[11.3] DISTRIBUTIONS AT DEATH
If the owner dies during the accumulation phase and before the annuity phase, the beneficiary will receive the
greater of the accumulated value of the annuity or the amount of contributions (i.e., premium payments). Any
amount received in excess of premiums paid is taxable as ordinary income to the recipient (i.e., the beneficiary).
If the beneficiary chooses to minimize their tax liability, they may select a life-income or installment option.
However, this option must be selected within 60 days of the annuitant's death. The amount paid to the
beneficiary upon an annuity owner's death is the accumulated amount (i.e., contributions plus interest). A life
insurance policy’s paid death benefit is the face amount, regardless of the number of premiums paid.
Since an annuity is an asset, if the policy owner or annuitant dies during the accumulation period, its proceeds
may be included in the deceased's estate if no beneficiary was named. Any unpaid annuity benefits following the
death of the annuitant are paid to the beneficiary and are taxable.
[11.4] 1035 CONTRACT EXCHANGES
The concept of Section 1035 exchanges was covered when the tax implications related to insurance policies
were described. Section 1035 of the Internal Revenue Code also allows for the tax-free exchanges of other types
of financial products, including annuity contracts. Remember, no gain will be recognized (and therefore no gain
will be taxed) if an annuity contract is exchanged for another annuity contract. The same applies when a life
insurance or endowment policy is exchanged for an annuity contract. However, under Section 1035, an annuity
contract cannot be exchanged on a tax-free basis for a life insurance contract.
This regulation allows the contract owner to move the cash value from one contract to another without incurring
current tax implications if the transfer is transacted within (i.e., intracompany) or between insurance companies,
and the policy owner receives no money, the exchange is permitted (without tax consequences). Theoretically,
this means that the cost basis remains the same. The result is that taxes are not avoided; instead, they're
postponed to a later date.
[11.5] CORPORATE-OWNED ANNUITIES
Contributions to a corporate annuity are taxed differently from individually owned annuities. If a non-natural
entity is named the annuitant (e.g., the corporation), the interest earned is taxable as ordinary income in the year
in which it’s credited.
Under current tax law, a corporation that owns an annuity must designate a natural person as the annuitant. At
times, this natural person is referred to as the “measurable life.” If a non-natural entity, such as the company
itself, is named as the annuitant, then the interest earned is taxable as ordinary income in the year it is credited.
In contrast, if a natural person is named as the annuitant, the interest credited to the annuity each year may be
tax-deferred. This natural person is sometimes referred to as a measurable life.
There is an exception to this non-natural person rule. If the annuity is held by a trust, corporation, or another non-
natural person as an agent for a natural person, the interest earned continues to be tax-deferred. Other
exceptions to this rule include:
• An annuity contract acquired by a person's estate following the death of that person
• An annuity contract held under a qualified retirement plan, such as a tax-sheltered annuity (TSA) or an
IRA
• An immediate annuity contract purchased with a single premium, with periodic payments to commence
within one year
Corporate-owned life insurance, as an employee benefit, is a deductible corporate business expense, and the
proceeds are paid to an employee’s beneficiary on a tax-free basis up to a certain level ($50,000). If more than
this amount is provided to an employee, the excess premium paid is reported on the employee’s W-2 as taxable
income. An annuity could also be owned by a non-living entity (e.g., a trust), and the tax considerations will be
based on whether it's qualified or non-qualified. Additionally, an annuity can be owned by a 501(c) non-profit
entity if there is a named annuitant.
[12] CHAPTER SUMMARY
Throughout this chapter, we've explored annuities as unique insurance contracts designed to provide income
security and protect against the risk of outliving one's assets.
We began by distinguishing annuities from life insurance—while life insurance creates an estate, annuities
systematically liquidate one. We identified the key parties involved: the insurer who guarantees the payments,
the contract owner who purchases the annuity, the annuitant whose life determines the payment schedule, and
the beneficiary who receives any remaining benefits.
We examined how annuities are classified based on premium structure (single, level, or flexible), timing of
benefits (immediate or deferred), source of income (fixed, variable, or indexed), disposition of proceeds (straight
life, period-certain, or refund options), and number of lives covered (individual or joint).
The chapter highlighted important annuity characteristics including accumulation and annuitization phases,
surrender charges, and non-forfeiture values. We also explored newer annuity types like equity-indexed and
market value-adjusted annuities that offer innovative features to address specific client needs.
We discussed the various applications of annuities—from individual retirement planning to business succession
strategies—and emphasized the importance of suitability assessment, particularly for senior consumers. Finally,
we covered the tax implications of annuities, including the exclusion ratio, early withdrawal penalties, and 1035
exchanges.
As you apply this knowledge in your insurance practice, remember that annuities serve a fundamental purpose:
providing financial security through guaranteed income. While product features may evolve, this core benefit
remains the foundation of annuity value for clients seeking protection against outliving their assets in retirement.
[12.2] REVIEW NOTES
Learning Objective 1: Define what an annuity is and explain how it differs from life insurance
Key Concepts:
• An annuity is a financial product designed to provide a steady income stream
• Only life insurance companies can offer annuities
• The primary purpose is to protect against outliving assets through guaranteed payments
• Unlike life insurance (which creates an estate), annuities systematically liquidate an estate
Important Terms:
• Accumulation phase: Period when premiums are paid and funds grow tax-deferred
• Annuitization: Converting accumulated funds into a guaranteed income stream (irreversible)
• Risk sharing contract: Premature death benefits insurer; longevity benefits annuitant
Learning Objective 2: Distinguish between the various types of annuities based on premium payments
Single premium annuities:
• Funded with one lump-sum payment
• Principal created immediately
• No additional deposits permitted
• Can be immediate or deferred
Periodic premium annuities:
• Level premium: Constant payment amounts (fixed schedule)
• Flexible premium: Variable payment amounts determined by the owner
• Cannot provide immediate income (must complete pay-in phase first)
Learning Objective 3: Compare immediate annuities and deferred annuities
Immediate Annuities:
• Begin paying benefits within 30 days to 12 months of purchase
• Must be funded with a single premium only
• No accumulation period
• Payments consist of both principal and interest
 • Best for those needing immediate income (retirees, disabled)
Deferred Annuities:
• Begin paying benefits more than one year in the future
• Can be funded with any premium payment plan
• Include an accumulation period
• Emphasize the safety of principal and tax-deferred growth
• Future distribution options include:
o Lump-sum distribution
o Systematic withdrawals
o Annuitization
Learning Objective 4: Differentiate between fixed, variable, and indexed annuities
Fixed Annuities:
• Guarantee a predetermined income amount
• Insurance company assumes investment risk
• Funds held in insurer's general account
• Conservative product with guaranteed principal
• Most affected by inflation due to the fixed payment amount
Variable Annuities:
• Payments fluctuate based on investment performance
• Contract owner assumes investment risk
• Includes a separate account for investments
• Requires a securities license (Series 6 or 7) to sell
• Better inflation protection potential
• Uses accumulation units (during pay-in) and annuity units (during payout)
Equity-Indexed Annuities:
• Fixed annuities with interest linked to a market index
• Principal guaranteed with minimum return
• Participation in market gains without risk of market decline
• Participation rate limits the percentage of index gains credited
Learning Objective 5: Identify the different annuity settlement options
Straight life annuity (pure life):
• Payments for the annuitant's lifetime only
• No refund or survivorship benefits
• Highest monthly payment amount
• Payments cease upon death
Annuity (period) certain:
• Payments for the specified period only
• Payments continue to a beneficiary if the annuitant dies before the period ends
• Payments stop after the period, even if the annuitantis still alive
Life annuity with period-certain:
• Guaranteed payments for life or a specified period, whichever is longer
• Beneficiary receives remaining payments if annuitant dies during period-certain
• No payments to beneficiary if annuitant outlives period-certain
Life with refund option:
• Guarantees the return of principal
• Two types:
o Installment refund: Continues the same monthly payments to the beneficiary
o Cash refund: Pays the remaining principal in a lump sum
Learning Objective 6: Recognize the parties involved in an annuity contract
Key Parties:
• Insurer: Company that issues the annuity
• Annuity Contract owner: Person who purchases the annuity and controls contract rights
• Annuitant: Person whose life expectancy determines benefit payments
• Beneficiary: Person who receives funds if owner dies before full payout
Important Distinctions:
• The owner and annuitant can be the same or different people
• If no beneficiary is named, proceeds go to the owner's estate
• Only the annuitant's age is considered for payment calculations
Learning Objective 7: Explain the purpose of surrender charges and how they affect annuity withdrawals
Surrender Charges:
• Also called back-end loads
• Assessed when the contract owner cancels the annuity or withdraws excess funds
• Typically decrease over time (e.g., 8% first year, decreasing 1% annually)
• Free withdrawals are usually permitted up to a specified percentage (e.g., 10%)
• Designed to discourage early withdrawals
• Different from the 10% federal tax penalty for premature withdrawals
• May be waived for death, disability, or extended medical care
Non-Forfeiture Values:
• Represents fund value minus surrender charges
• Before annuitization equals premiums paid plus interest minus withdrawals/charges
Learning Objective 8: Analyze how annuities are taxed during the accumulation and distribution phases
Tax Treatment:
• Qualified annuities: Premiums may be tax-deductible (part of a qualified plan)
• Non-qualified annuities: Premiums not tax-deductible (after-tax dollars)
• All annuities: Interest accumulates tax-deferred regardless of qualification
Taxation of Distributions:
• Exclusion ratio determines the tax-free portion of payments
o Formula: Investment in contract ÷ Expected return
• Early withdrawals (before 59½): Subject to 10% penalty plus ordinary income tax
• Withdrawals taxed on LIFO basis (earnings first) for post-1982 contracts
• Exceptions to early withdrawal penalty:
o Disability
o Death
o Age 59½ or older
o Immediate annuity
o Qualified pension plan
1035 Exchanges:
• Tax-free exchange of an annuity for another annuity
• Life insurance can be exchanged for an annuity tax-free
• An annuity cannot be exchanged for life insurance tax-free
Learning Objective 9: Describe the business and individual applications of annuities
Individual Uses:
• Retirement income planning
• Tax-deferred growth
• Funding IRAs and qualified plans
• Education funding
• Structured settlements for legal awards
• Lottery winnings distribution
Business Uses:
• Executive compensation
• Business succession planning
• Key person protection
• Corporate pension plans
• Funding future obligations
• Employee retention
Learning Objective 10: Evaluate the suitability of annuity products for different client situations
Suitability Factors:
• Age of applicant and spouse
• Annual household income
• Financial situation and needs
• Financial experience
• Financial objectives
• Intended use of annuity
• Financial time horizon
• Existing assets and investments
• Liquidity needs and risk tolerance
Special Considerations:
• Senior consumers (65+) require an additional suitability assessment
• Producers must have reasonable grounds for recommendations
• State regulations establish standards for senior consumer recommendations
Exam Tips!
• Immediate annuity = single premium, payments within 12 months
• Only single premium annuities can be immediate
• Variable annuities require a securities license to sell
• A straight life annuity has the highest payment, but no survivor benefit
• Exclusion ratio determines the tax-free portion of payments
• LIFO taxation applies to post-1982 annuities
• Corporate-owned annuities must name a natural person as annuitant
• Flexible Premium Deferred Annuity (FPDA) is the most popular annuity product
Chapter 10
[1] INTRODUCTION
Life insurance serves as a powerful financial tool that extends far beyond simply providing a death benefit. As
you progress through this material, you'll gain practical knowledge about how life insurance functions as a
versatile financial planning tool that creates immediate estates, provides liquidity, and offers protection in both
personal and business contexts.
Imagine a young family where both parents work to support their children's education and future. What happens
if one parent dies unexpectedly? Or consider a small business with three partners who've built their company
from the ground up. How would the business continue if one partner suddenly passed away? These scenarios
highlight why understanding the uses of life insurance is essential for anyone entering the insurance field.
In this chapter, we'll explore how to determine appropriate coverage amounts using structured approaches,
examine how individuals use life insurance to protect their families and build financial security, and investigate
how businesses leverage life insurance to ensure continuity and protect their interests. We'll also look at
employee benefit plans that incorporate life insurance to provide valuable protection for workers and their
families.
The chapter is broken into the following sections:
Determining the Proper Amount of Life Insurance
Personal Uses for Life Insurance
Business Uses of Life Insurance
Employee Benefit Plans
The state-specific portion of this course (located at the end) will detail the specific insurance definitions, rules,
regulations, and statutes for your state. In the event of a conflict, state law will supersede the general content.
[1.1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
Compare the human life value approach and needs approach for determining appropriate life insurance coverage
Calculate the proper amount of life insurance using various methods
Identify the personal uses of life insurance for individuals and families
Explain how life insurance functions in business continuation planning
Differentiate between entity plans and cross-purchase plans in buy-sell agreements
Describe the purpose and structure of key employee life insurance
Recognize how life insurance is utilized in various employee benefit plans
[1.3] KEYWORDS
Before reading this chapter, please review the following keywords. An understanding of their basic definitions will
improve your comprehension of the chapter content.
Cross-Purchase Plan: This is a plan that, upon a business owner’s death, surviving owners will purchase the
deceased’s interest, often with funds from life insurance policies owned by each principal on the lives of all the
other principals.
Entity Plan: This is an agreement whereby a business assumes the obligation of purchasing a deceased owner’s
interest in the business, which proportionately increases the interests of the surviving owners.
Human Life Value Approach: This is a method of determining an individual’s economic worth as measured by
the sum of the individual’s future earnings that is devoted to the individual’s family.
Key Person Insurance: This insurance protects a business against financial loss caused by the death or disability
of a vital member of the company, often individuals who possess special managerial or technical skills or other
expertise.
Needs Approach: This is a method for determining how much insurance protection a person should have by
analyzing a family’s or business’s needs and objectives if the insured were to die, become disabled, or retire.
[2] DETERMINING THE PROPER AMOUNT OF LIFE INSURANCE
Planning for the income needs of one's survivors is essential. The planning process includes the following steps:
STEPS ACTIONS
1. Gathering information • Personal: ages, health history
• Financial: wages, assets, investments, earnings, pensions,
savings
2. Identifying and prioritizing objectives • Understand what matters most to the client and their
family

3. Analyzing the client's current financial • Evaluating existing resources and gaps
condition
4. Developing and implementing a plan • Create a tailored strategy and put it into action
5. Reviewing the plan periodically • Adjust as life circumstances and goals evolve
Life insurance proceeds can be used to replace the salary or services lost due to the insured’s death. The
producer must assist the client in determining the appropriate amount of life insurance, considering the capital
that should be available at death and whether these funds will be sufficient to prevent the forced liquidation of
property. One approach, the “interest-only method,” determines how much insurance is needed to maintain
after-tax family consumption levels if the insurer maintains the principal for future payments.
Some producers have made recommendations based on a pre-determined multiple of their prospective clients'
earnings. This multiple-of-earnings method provides a rough estimate of one's insurance needs. Practitioners
often use five or seven times one's current earnings as the basis for calculating need. Though the estimate of
needs may be rough, it is better than the so-called "seat of the pants" method, in which the amount considered
is arbitrarily selected.
Traditionally, there are two primary methods to determine how much life insurance a person or family needs:
the human life value approach and the needs approach. While both methods can be effective, the human life
value approach focuses on calculating and replacing the amount of future income that would be due to the
insured's premature death, whereas the needs approach focuses on the insured's final goals for those who
would remain after his death.
[2.1] HUMAN LIFE VALUE APPROACH
The human life value (HLV) approach is a method for determining the capitalized value of an individual’s net
future earnings. In other words, it considers a person's potential lost earnings as a measure of how much
insurance to purchase. A person’s future earning capacity ends upon death. To determine how much life
insurance is needed to protect an individual’s dependents, the projected income earned per year must be
multiplied by the number of years until retirement. The present value of the individual’s projected earnings minus
expenses (i.e., income taxes and cost of living) is multiplied by the years until retirement age. This formula
provides an approximate amount of coverage that is needed. This process essentially determines the value of an
individual’s future earning potential based on current circumstances.
EXAM TIP!
The human life value approach calculates the appropriate face amount of life insurance by expressing a person's
life as a dollar value, based on discounted estimates of future net earnings used for family contributions, at a
reasonable interest rate. The calculation only accounts for potential lost income; it does not account for a
family’s needs, goals, etc.
[2.1] HUMAN LIFE VALUE APPROACH (CONTINUED)
The calculation steps look like this:
• Calculate remaining income-earning years
o Planned retirement age – current age = remaining income-earning years
• Calculate the proposed insured’s family contributions
o Gross income – taxes = net income
o Net income – personal expenses = family contribution
• Calculate to total potential loss if the insured dies today
o remaining income-earning years X family contribution = total potential loss
• Calculate the amount of capital needed to discount the potential loss by a reasonable interest rate
EXAM TIP!
Charts and tables are available to help with these calculations. Your state exam will test the concepts related to
determining the proper amount of insurance. You will need to understand what is considered for each approach
and its related advantages or disadvantages. You do not need to memorize the formulas.
[2.1] HUMAN LIFE VALUE APPROACH (CONTINUED)
This chart illustrates the substantial capital needed to replace different annual income amounts over various
time periods, assuming a 4% interest rate. For example, to provide $50,000 annually for 30 years, approximately
$864,602 in capital would be needed at a 4% interest rate.

Years $25,000 $50,000 $75,000 $100,000

 20 $339,758 $679,516 $1,019,274 $1,359,033

25 $390,552 $781,104 $1,171,656 $1,562,208

30 $432,301 $864,602 $1,296,902 $1,729,203

35 $466,615 $933,231 $1,399,846 $1,866,461

40 $494,819 $989,639 $1,484,458 $1,979,277

[2.2] NEEDS APPROACH

The needs approach determines the amount of life insurance an individual needs based on the insured's
personal (or family) financial goals and objectives, as well as those of the insured's survivors. Therefore, factors
such as eliminating funeral expenses, probate costs, personal debt, paying off a mortgage, funding education
goals, emergency funds, bequests, charitable gifting, and a surviving spouse's income and retirement needs can
influence the coverage needed. When used to address multiple needs, this formula suggests that all family
members’ ages, wages, and health histories may need to be reviewed.
The needs approach focuses on determining lump-sum needs. It will use all the costs associated with death (i.e.,
postmortem costs) plus financial objectives to determine a person’s (or family’s) total capital needs. Then, the
person's liquid assets are calculated. Liquid assets include savings, pension or profit-sharing benefits, life
insurance proceeds, Social Security retirement income, interest from bonds, dividends from mutual funds or
stocks, rental income, and any other income to which the person is entitled. It’s essential to consider Social
Security since no retirement income is provided to survivors during any applicable “blackout period.” The
blackout period is the time from the insured’s death until the surviving spouse is entitled to receive retirement
income benefits. However, benefits are provided for other dependents (i.e., children) during the blackout period
until the youngest child reaches age 18.
There are two exceptions under which a child may receive a benefit past age 18:
• The child remains a full-time student in high school. The student can continue receiving a benefit until
graduation or age 19 and two months, whichever comes first; or
• The child has a disability. At 18, Social Security will reevaluate whether the child qualifies under SSI
under different criteria and may continue benefits. Currently, more than one million minors receive
benefits under SSI.
By subtracting liquid assets from total capital needs, the individual will determine the approximate amount of life
insurance “needed.”
One approach is called the “capital needs analysis.” This method determines both future income requirements
and lump-sum needs for immediate cash expenditures, such as final expenses, death taxes, and mortgage
redemption, as well as reserve funds designated as emergency funds or for education.
Funds set aside for income needs are often used or liquidated as part of the future income stream. In some
more ambitious cases, clients might wish to employ a capital retention rather than a capital liquidation
approach. A capital retention plan would provide enough funds for immediate lump-sum needs as well as
sufficient funds to generate future income without further depleting the principal.
Alternatively, some consumers may be focused on a single need based on their priorities or a sense of urgency.
This often occurs when funds are insufficient to implement a plan that aims to address multiple needs
simultaneously.
Finally, some individuals may buy life insurance as part of a charitable giving program. Purchasing life insurance
as a charitable gift has its tax advantages. For instance, if the owner of a life insurance policy transfers all or a
part of an existing whole life policy to a charitable organization, they will receive an income tax deduction that’s
based on the cash value of the policy at the time of the transfer. Additionally, if a new policy is purchased and the
charity is named both owner and beneficiary, the purchaser’s future premium payments are tax-deductible (i.e.,
tax-deductible gift).
CHART: APPROACHES FOR DETERMINING THE PROPER AMOUNT OF LIFE INSURANCE
Approach Description Examples
Calculates the insurance needed by expressing the
To provide $50,000 annually for 30 years,
Human Life human life as a dollar valuation that is determining
approximately $864,602 in capital (via
Value the economic value of a person by discounting
insurance) would be needed at a 4%
Approach estimated future net earnings used for family
interest rate
contributions at a reasonable interest rate
Funeral costs and legal fees, estate and gift
Calculates the amount of life insurance needs based
Needs taxes and probate fees, the survivors’
on survivor expenses, personal (or family) financial
Approach mortgage or rent, debts, child education
goals, and objectives
costs.
Multiple
Select several years to replace the insured’s annual
earnings Five times a person’s annual salary
salary
method
Interest- Determines how much insurance is needed to
Maintains the principal for future payments
only method maintain after-tax family consumption levels
Single needs Identifies the amount of insurance needed based on a Loan or debt, education fund, and death
method specific need taxes
Final expenses, medical expenses, probate
Capital costs, cost of living expenses, debt
Determines the immediate cash needs of an
needs elimination, emergency fund, education
individual or family
analysis funds, federal and state death taxes,
continuing income needs
Seat-of-the-
Arbitrarily selects the amount of insurance that’s
pants None
necessary
method
[3] USES FOR LIFE INSURANCE
[3.1] LIFE INSURANCE AS PROPERTY
Among the various forms of insurance, life insurance is unique in that it serves as both an asset and a form of
protection against loss. Life insurance, unlike other insurance contracts, can be bought and sold. Though the
initial purchase requires the buyer to have an insurable interest in the insured's life, that "insurable interest" need
not persist for the policy to be valid. For example, a wife might own a life insurance policy covering her husband.
If the couple were to divorce, that life insurance policy would remain valid and in force as long as the premiums
were paid. The same would not hold true for health insurance policies or home insurance policies once the home
has been sold.
As insurance, life insurance can help meet immediate lump sum needs like covering final expenses, retiring
personal debts, and paying off a mortgage. I can also provide an estate that can be tapped for ongoing income
needs.
In addition to providing a tax-free death benefit to survivors in their time of greatest need, life insurance can also
provide living benefits to the policy owner. Policies can be used a collateral for loans. Policies with cash value
allow owners to borrow against that cash value at a low net interest rate. Cash value contracts also provide for
tax-free access to accumulated cash values up to the total amount of premiums paid. Such withdrawals are not
subject to qualified plan restrictions and receive more favorable treatment in terms of taxes compared to other
non-qualified tax-deferred instruments.
[3.2] PERSONAL USES FOR LIFE INSURANCE
Life insurance ensures immediate financial support for beneficiaries upon the insured's death. Common reasons
for purchasing include:
• Lump-Sum (immediate cash) Needs: These are lump sum amounts needed or desired for immediate
cash needs, payable shortly after the insured's death
o Final expenses: Funeral and burial costs, final medical expenses, burial, and related costs
o Debt repayment: Pay off medical bills or other personal debts (sometimes included in final
expenses)
o Emergency funds: Provide a financial cushion for unexpected events.
o Mortgage redemption: Pay the remaining mortgage balance to assure housing for survivors.
o Estate protection and conservation: Preserve wealth and manage estate taxes.
o Charitable contributions: Leave a legacy to a cause you care about.
• Income Needs: These are future income needs used to calculate the amount of insurance required to
provide the desired income during the period in which it is needed.
o Survivor protection and security: Provide a monthly income for dependents.
o Education expenses: Fund children’s or dependents’ schooling.
o Retirement income supplement: Add to retirement savings for later years.
o Cash accumulation and liquidity: Build accessible funds for future needs.
These personal uses of life insurance are examples of the costs associated with death that were previously
described. Therefore, a life insurance producer should consider all of these uses when working with a client.
A life insurance policy is an asset. Therefore, the asset’s value must be included in the owner’s estate at death
and is taxable if the estate is greater than the current exemption limit (2025 - $13.99 million per individual). The
most significant advantage of life insurance is that it creates an immediate estate when the insured dies.
Individuals with a life insurance policy that builds cash value may access it under the policy loan provision for
personal use. Details about how that works are covered elsewhere.
[3.3] BUSINESS USES OF LIFE INSURANCE
Life insurance is used in business in a variety of ways. Three popular uses are: (1) as a funding method, (2) as a
form of business interruption insurance, and (3) as an employee benefit. Policy loans can be utilized to meet
various business needs, such as funding buy-sell agreements, deferred compensation for key employees, or
split-dollar arrangements.
Business Continuation Plans (Funding Medium): Life insurance can be used to fund a business continuation
agreement, a transfer of ownership between business partners or stockholders, or a deferred compensation
plan.
Corporate-Owned Life Insurance (Business Interruption Insurance): Although life insurance cannot prevent
business interruptions caused by death or disability, it can help indemnify the business for losses resulting from
these interruptions.
Employee Benefit Plans: Life insurance can protect employees and their families from financial difficulties that
can arise upon death.
[3.3.1] BUSINESS CONTINUATION PLANS
Life insurance can be utilized to fund a business continuation agreement. The most common form of agreement
is an insured buy-sell agreement. This agreement guarantees that cash will be available upon the business
owner’s death to purchase the deceased’s interest in the business.
Sole proprietorships, corporations, or partnerships may face challenges in maintaining business stability and
continuity following the death of one or more owners or partners. The deceased individual’s surviving family also
has a personal and economic interest in the business, specifically the deceased’s share of the firm. The business
partners may want to ensure that their survivors receive funds equal to their financial interests in the firm if one
of them dies. Therefore, partners or members of a corporation, sole proprietors, or key employees will enter into
a formal business continuation agreement that’s referred to as a buy-sell agreement. Buy-sell agreements can be
funded for use in a sole proprietorship, partnership, or closely held corporation. A buy-sell agreement is a legal
agreement that provides for:
• An orderly continuation or transfer of the business, and
• An amount of money to be paid to the deceased’s survivors
Funds to be paid to the surviving family may be provided by a life insurance policy. Life insurance may be
purchased to fund a buy-sell agreement.
[[Link]] BUY-SELL FUNDING FOR SOLE PROPRIETORS
If a sole proprietor dies, there’s a two-step business continuation plan to keep the business running, in which the
employee takes over management.
Buy-sell plan: An attorney drafts a buy-sell plan, which states the employee’s agreement to purchase the
business and directs the proprietor’s estate to sell the business interest at a previously agreed-upon price.
Insurance policy: The employee purchases a life insurance policy on the life of the proprietor. The employee is
the policy owner, beneficiary, and pays the premiums. Upon the proprietor’s death, the funds from the policy are
used to purchase the business.
[3.3.1] BUSINESS CONTINUATION PLANS (continued)
[[Link]] BUY-SELL FUNDING FOR PARTNERSHIPS
Under the law, any change in a partnership's membership will cause its dissolution. Therefore, if a partner dies,
the partnership ends, and the remaining partners must now wind up the business and pay the deceased
partner’s estate an amount that’s equal to the deceased’s fair share of the liquidated value of the business. If a
forced sale results in assets being sold for less than their fair value, the fair share of the business may be less
than anticipated. For that reason, life insurance (which funds the buy-sell agreement) will help maintain the
business’s value. A buy-sell agreement used in a partnership binds the surviving partners to purchase the
deceased partner’s partnership interest at a prearranged price that’s identified in the agreement. The agreement
obligates the deceased partner’s estate to sell its interest to the surviving partner(s) and permits the surviving
partners, officers, or stockholders to maintain control of the business. This agreement, which is supported by life
insurance, is designed to protect the business or firm.
There are two types of buy-sell agreements used for partnerships. They are entity plans, which are funded by
insurance policies purchased by the company on the life of each partner, and cross-purchase plans, in which
the partners individually buy policies on each other to provide the required funds. We will describe how each one
works in more detail following our overview of relevant company types.
[[Link]] BUY-SELL FUNDING FOR CLOSELY HELD CORPORATIONS
Unlike a partnership, a closely held corporation (e.g., an incorporated family business) is legally separate from its
owners. It exists after one or more owners die. Buy-sell agreements used by corporations may also be funded by
life insurance. An entity plan funded by life insurance and used for a corporation is called a stock redemption
plan. The corporation is obligated to purchase the stock of the deceased stockholder at a prearranged price. If
funded by life insurance, the corporation purchases a policy on each stockholder's life.
A cross-purchase plan that’s financed by life policies involves each stockholder purchasing policies on each of
the other stockholders. Both corporate plans function similarly to agreements that are available to partners and
partnerships. An estate that is comprised mainly of stock and possesses potential estate tax problems (i.e.,
forced sale) may utilize a 303-redemption plan funded by life insurance. The stock’s value must represent at
least 35% of the deceased’s adjusted gross estate to qualify for this type of plan.
Small corporations often purchase life insurance on the lives of significant stockholders to fund a buy-sell
agreement.
[3.3.1] BUSINESS CONTINUATION PLANS (continued)
[[Link]] ENTITY BUY-SELL PLANS
These plans specify that the partnership must buy out the deceased partner’s ownership interest. In other words,
the agreement is made between the partnership and each partner. Therefore, if the partnership consists of three
partners, the partnership will purchase, own, and pay for a life insurance policy covering each of the three
partners (i.e., three policies will be purchased to fund the agreement). If a partner dies, policy proceeds will be
paid to the partnership, which will then be used to purchase the deceased partner’s interest.
Buy-Sell Entity Plan Scenario:
XYZ Financial Partners is a successful financial consulting firm with three equal partners. To ensure business
continuity and protect each partner’s interest, they establish an entity-purchase buy-sell agreement.
• The partnership agrees to buy out any deceased partner’s ownership interest
• The partnership purchases three life insurance policies, one on each partner
• The partnership is both the owner and beneficiary of each policy
What Happens if Partner A Dies:
• The life insurance policy on Partner A pays out to the partnership
• The partnership uses the proceeds to buy Partner A’s ownership interest from their estate
• The remaining partners retain complete control of the business
• Partner A’s family receives fair compensation—without disrupting the business

[3.3.1] BUSINESS CONTINUATION PLANS (continued)

[[Link]] CROSS-PURCHASE BUY-SELL PLANS
Unlike an entity plan, this plan specifies that the agreement will exist between the partners, rather than between
the partnership and the partners. When there is a minimal number of partners, a cross-purchase plan may be
preferred. As the number of partners or shareholders increases, this type of policy becomes challenging to
manage. Remember, shareholders or partners purchase policies under a cross-purchase plan, whereas the
company purchases policies under an entity buy-sell plan.
This plan is ideal for small partnerships where:
• Each partner wants direct control over the buyout
• The number of partners is manageable (since the number of policies increases rapidly with more
partners)
Cross-Purchase Buy-Sell Plan Scenario
Going back to our last example, let’s say the remaining 3 partners at XYZ Financial Partners decide to use a
cross-purchase plan to plan for business continuity in the event that one of them dies.
• The plan will require 6 life insurance policies, because each of the three partners will need to buy a policy
on the other two.
• Each partner will purchase, own, and be the beneficiary of an insurance policy on the other two partners.
What Happens if Partner B Dies:
 • The life insurance policy on Partner B pays out to Partner A and Partner C
• Partners A and C use the proceeds to buy Partner B’s ownership interest from their estate
• The remaining partners retain complete control of the business
• Partner P’s family receives fair compensation—without disrupting the business

BUSINESS CONTINUATION PLANS CHART

Plan Description Key Points
Buy-Sell Plan: An agreement for the employee to purchase the
Buy-Sell
A two-step plan to ensure business at a pre-agreed price.
Funding for
business continuity after Insurance Policy: The employee buys a life insurance policy on
Sole
the death of a sole proprietor. the proprietor's life to fund the purchase. The employee is the
Proprietors
policy owner, payor, and beneficiary.
The partnership purchases, owns, and pays for life insurance
An agreement where the
policies on each partner.
Entity Plan partnership buys out the
The partnership uses the proceeds from the policy to buy the
deceased partner's interest.
deceased partner's interest.
Each partner buys, owns, and is the beneficiary of life insurance
Cross- An agreement between partners
policies on the other partners.
Purchase to buy out the deceased
Each partner uses the proceeds from the policies to buy the
Plan partner's interest.
deceased partner's interest.
Buy-Sell Stock Redemption Plan: The corporation buys life insurance
A plan for corporations to buy
Funding for policies on each stockholder. Proceeds from the policy are used
out a deceased stockholder's
Closely Held to buy the deceased stockholder's interest.
interest.
Corporations Similar to entity.

[3.3.2] CORPORATE-OWNED LIFE INSURANCE

Corporate-owned life insurance (COLI) involves a company purchasing and owning a life insurance policy on a
key employee. The corporation is the primary beneficiary, and generally, premiums are not tax-deductible as a
business expense when the company is the policyowner and beneficiary. In return, the proceeds are paid tax-
free.
For business purposes, some insurers now include a “change of insured provision,” which allows for a change of
insureds. This provision applies primarily to COLI policies. When an employee who’s covered by the policy either
retires or their employment is terminated, the employer may change the name of the insured to that of a new or
replacement employee, subject to insurability requirements. The availability of this provision eliminates the need
to write a completely new policy, which would result in additional policy fees, commissions, or other expenses
incurred when purchasing new life insurance.
[3.3.3] KEY EMPLOYEE LIFE INSURANCE
The principal reason key employee insurance was developed was to compensate a business for the loss of
earnings (or increase in expenses) resulting from the death or disability of a key employee. This type of plan is
also referred to as key person insurance.
[[Link]] PURPOSE
A firm is often dependent on a key person whose management skills, technical knowledge, and experience make
them an invaluable asset to the business. In a sense, the company is dependent on this key person for its
success. The proceeds from a life insurance policy covering a key employee will provide the business with the
funds to find and train a new employee and continue operations without further interruption. Key employee
insurance serves the following four primary purposes: (1) business indemnification, (2) a reserve fund, (3)
business credit, and (4) favorable tax treatment.
1. Business indemnification: To compensate a business for the financial loss brought on by the death of a key
employee.
2. Reserve fund: This fund provides a business with a living benefit. When a business purchases key-person
insurance, it acquires an asset that can provide valuable services to the business while the key person is still
alive.
For example, the cash value in the policy provides for a cash reserve fund. In addition, the cash values are carried
as an asset on the company’s balance sheet.
3. Business credit: Key-person life insurance can offset the danger of business disruption caused by the death
of a business’s key person in two ways: (1) tangible evidence of business character and (2) as a guarantee of loan
repayment at the death of the key person.
4. Favorable tax treatment: Key-person life insurance receives favorable tax treatment. The death proceeds
received by the business are not taxable. The premiums are not deductible for income purposes, but the
proceeds may be used in whatever manner the company chooses.
[[Link]] THIRD-PARTY OWNERSHIP
Key employee insurance is a typical example of third-party ownership. Because the business has an economic
and financial interest in its key employee, an insurable interest exists in this relationship. The business can
protect against potential economic loss resulting from a key employee’s death by being named the beneficiary of
the life insurance policy. Consequently, the policy will compensate the business for financial losses incurred due
to the death of the covered key employee. The business will receive indemnity for the loss of a key manager,
director, or officer, and the policy proceeds will help sustain operations while a replacement is found. The
employer or business is the policy owner, while the employee is the insured.
[[Link]] OWNERSHIP
Key employee insurance is a typical example of third-party ownership. Because the business has an economic
and financial interest in its key employee, an insurable interest exists in this relationship. The business can
protect against potential economic loss resulting from a key employee’s death by being named the beneficiary of
the life insurance policy. Consequently, the policy will compensate the business for financial losses incurred due
to the death of the covered key employee. The business will receive indemnity for the loss of a key manager,
director, or officer, and the policy proceeds will help sustain operations while a replacement is found. The
employer or business is the policy owner, while the employee is the insured.
The corporation, firm, partnership, or sole proprietorship will be the applicant, policyowner, premium payor, and
the beneficiary (i.e., third-party ownership). Therefore, the business possesses the owner’s rights under the
policy, such as naming or changing the beneficiary, borrowing from the cash value, receiving dividends, or
assigning benefits. Whole life or universal life contracts are commonly used to fund a key employee life
insurance plan, while term life insurance may be used for short-term needs.
The premiums a business pays for key employee life insurance are generally not tax-deductible. In addition, none
of the death benefits that are paid when a key employee dies are taxable. The death proceeds will not be
included in the deceased employee’s estate if the employee has no ownership interest in the contract.
Remember, a key employee or key person life insurance policy does not provide coverage on the employer’s life.
Instead, it covers the key person’s life and indemnifies the employer (i.e., the business) if the key employee dies.
[3.3.4] EMPLOYEE BENEFIT PLANS
Companies can also use life insurance to benefit employees by providing deferred compensation, salary
continuation, executive bonuses, and split-dollar plans.
[[Link]] DEFERRED COMPENSATION FUNDING
Deferred compensation is an executive benefit that an employer can use to pay a highly paid employee later,
such as upon disability, retirement, or death. Deferred compensation funding generally refers to non-qualified
retirement plans. In other words, the plans do not receive the same tax advantages as qualified plans under the
Internal Revenue Code. These arrangements are generally between an employer and an employee, in which
compensation is paid to the employee at a later date. Some employers use cash value life insurance or annuity
products to provide promised funds.
[[Link]] SALARY CONTINUATION PLANS
A salary continuation plan is a corporate-sponsored benefit that’s generally designed to replace an executive's
income in the event of death, retirement, or disability. The benefit plan may be exempt from ERISA (Employee
Retirement Income Security Act of 1974) if it meets specific criteria and must be confined to a select group of
highly compensated individuals. Unlike a deferred compensation plan, this plan is funded by the employer, not
the employee. Such a plan begins with a written agreement that outlines its provisions, including how the
participating executive qualifies for a benefit.
[[Link]] EXECUTIVE BONUS PLAN
An executive bonus plan—also referred to as a Section 162 bonus plan—is a non-qualified employee benefit
arrangement. An employer pays a compensation bonus to a selected employee who uses the bonus payment to
pay the premiums on a life insurance policy that covers their life. Ultimately, the employee personally owns the
policy.
The employer may use the amount of the bonus as a tax deduction, and regardless of whether the employee
uses it to buy insurance, they must include the amount of the bonus in their gross income. In the event of the
employee/insured’s death, the policy’s proceeds are paid to the designated beneficiary income tax-free. Any
policy withdrawals, surrenders, or loans that the employee takes are taxed as if the employee had purchased the
policy without the benefit of the bonus arrangement.
[[Link]] SPLIT-DOLLAR PLANS (SDP)
This plan is a funding method involving an employer-employee arrangement, funded with whole life, cash value,
or continuous-premium life insurance. The death benefit and cash value are split, and sometimes the premium,
too. Split-dollar plans combine the employee's need for life insurance with the employer's ability to pay
premiums. This allows employees to obtain life insurance that they might not be able to afford independently.
Employers can provide these plans selectively, without offering them to all employees.
[4.0] CHAPTER SUMMARY
In this chapter, we've explored the multifaceted uses of life insurance for both individuals and businesses. We
began by examining methods for determining appropriate coverage amounts, comparing the human life value
approach, which calculates insurance needs based on future earning potential, with the needs approach, which
focuses on specific financial goals and obligations.
We discovered that personal uses of life insurance extend beyond providing death benefits to include funding
final expenses, protecting estates, securing survivors' financial futures, funding education, paying off debts,
supplementing retirement income, making charitable contributions, and building accessible cash reserves.
In the business context, we learned how life insurance serves as a funding mechanism for business continuation
through buy-sell agreements. We distinguished between entity plans, where the business purchases the
deceased owner's interest, and cross-purchase plans, where surviving owners buy the deceased's share. We
also examined how key employee insurance protects businesses against the financial impact of losing vital team
members.
Finally, we explored how life insurance functions within employee benefit plans, including deferred
compensation, salary continuation, executive bonus plans, and split-dollar arrangements.
Understanding these various applications of life insurance prepares you to help clients identify appropriate
coverage based on their unique circumstances, whether they're protecting their families or safeguarding their
business interests. As you move forward in your insurance career, you'll find that life insurance is one of the most
versatile and valuable tools in financial planning.
[4.2] REVIEW NOTES
Learning Objective 1: Compare the human life value approach and needs approach for determining
appropriate life insurance coverage
Human Life Value Approach:
• Calculates the capitalized value of an individual's net future earnings
• Considers potential lost earnings as a measure of insurance needed
• Formula: Present value of (projected earnings - expenses) × years until retirement
 • Focuses only on income replacement, not specific family needs
• Example: To provide $50,000 annually for 30 years requires approximately $864,602 at 4% interest
Needs Approach:
• Determines insurance amount based on personal/family financial goals and objectives
• Considers debt elimination, education goals, emergency funds, bequests, and charitable giving
• Focuses on determining lump-sum needs at death
• Formula: Total capital needs - liquid assets = insurance needed
• Accounts for Social Security benefits and "blackout period" considerations
• Single needs method: Based on specific needs (loans, education, taxes)
• Capital needs analysis: Determines immediate cash needs (final expenses, taxes, income)
Other Approaches:
• Multiple earnings method: Selects the number of years to replace the annual salary (e.g., 5× salary)
• Interest-only method: Maintains principal for future payments
• Seat-of-the-pants method: Arbitrarily selects an amount of insurance
Learning Objective 2: Identify the personal uses of life insurance for individuals and families
Personal Uses:
• Life insurance is both an asset and a form of protection against loss.
• Unlike other insurance contracts, Life insurance can be bought and sold. Though the initial purchase
requires the buyer to have an insurable interest in the insured's life, that "insurable interest" need not
persist for the policy to be valid.
• Lump-Sum (immediate cash) Needs:
o Final expenses: Funeral costs, final medical expenses, burial, and related costs
o Debt repayment: Pay off medical bills or other personal debts (sometimes included in final
expenses)
o Emergency funds: Provide a financial cushion for unexpected events.
o Mortgage redemption: Pay the remaining mortgage balance to assure housing for survivors.
o Estate protection and conservation: Preserve wealth and manage estate taxes.
o Charitable contributions: Leave a legacy to a cause you care about.
• Income Needs: These are future income needs used to calculate the amount of insurance required to
provide the desired income during the period in which it is needed.
o Survivor protection and security: Provide a monthly income for dependents.
o Education expenses: Fund children’s or dependents’ schooling.
o Retirement income supplement: Add to retirement savings for later years.
o Cash accumulation and liquidity: Build accessible funds for future needs.
Key Points:
• Life insurance creates an immediate estate at death
• Policy is an asset included in the owner's estate (taxable if the estate exceeds the exemption limit)
• Cash value policies allow access to funds through policy loans
Learning Objective 3: Explain how life insurance functions in business continuation planning
Business Uses of Life Insurance:
• Funding method: For business continuation agreements or ownership transfers
• Business interruption insurance: Indemnifies the business for losses from death/disability
• Employee benefit: Protects employees and families from financial problems
Buy-Sell Agreements:
• Legal agreement providing for orderly business continuation and payment to the deceased's survivors
• Guarantees cash availability to purchase the deceased owner's interest
• Can be funded with life insurance for sole proprietorships, partnerships, or corporations
Types of Buy-Sell Agreements:
• For sole proprietors: Two-step plan where the employee takes over management
 • For partnerships: Entity plan or cross-purchase plan
• For closely held corporations: Stock redemption plan (entity) or cross-purchase plan
Learning Objective 4: Differentiate between entity plans and cross-purchase plans in buy-sell agreements
Entity Plan:
• Agreement between the partnership/corporation and each partner/stockholder
• Business is obligated to buy the deceased owner's interest
• Business purchases, owns, and pays for policies on each owner
• Business receives proceeds and purchases the deceased's interest
• Simpler with many partners (requires fewer policies)
Cross-Purchase Plan:
• Agreement between partners/stockholders themselves
• Each partner/stockholder purchases policies on other partners/stockholders
• Each receives proceeds to buy the deceased's interest
• Preferred with a minimal number of partners
• The number of policies increases rapidly with more partners (n × (n-1))
Learning Objective 5: Describe the purpose and structure of key employee life insurance
Key Employee Insurance:
• Compensates the business for the loss of earnings due to the death/disability of a key employee
• Covers individuals with special managerial/technical skills or expertise
• Provides funds to find and train replacement employees
Four Primary Purposes:
• Business indemnification: Compensates for financial loss
• Reserve fund: Provides a living benefit through cash value
• Business credit: Evidence of business character and a loan repayment guarantee
• Favorable tax treatment: Death proceeds are not taxable to the business
Ownership Structure:
• Third-party ownership: Businesses have an insurable interest in their key employees
• The business is the applicant, policyowner, premium payor, and beneficiary
• Commonly funded with whole life or universal life (term for short-term needs)
• Premiums are not tax-deductible, but proceeds received are tax-free
• Death proceeds are not included in the employee's estate (if no ownership interest)
Learning Objective 6: Recognize how life insurance is utilized in various employee benefit plans
Corporate-Owned Life Insurance (COLI):
• The company purchases and owns a policy on key employees
• The corporation is the primary beneficiary
• May include "change of insured provision" for employee replacement
• Premiums are generally not tax-deductible, but proceeds are paid tax-free
Employee Benefit Plans:
• Deferred compensation: Non-qualified retirement plans for highly paid employees
• Salary continuation: Corporate-sponsored benefit replacing executive income
• Executive bonus plan (Section 162): Employer pays bonus used for insurance premiums
• Split-dollar plans: Employer-employee arrangement splitting the death benefit and cash value
Key Distinctions:
• Deferred compensation: Paid to employee later (disability, retirement, death)
• Salary continuation: Funded by the employer, not the employee
• Executive bonus: Tax-deductible to employer, taxable to employee
• Split-dollar: Combines the employee's need with the employer's ability to pay
Exam Tips:
• Know the calculation steps for the human life value approach
 • Understand the differences between the needs approach and the human life value approach
• Memorize the various personal and business uses of life insurance
• Know the structure and purpose of buy-sell agreements for different business types
• Understand the tax implications of corporate-owned policies
• Be able to distinguish between different employee benefit plans
Chapter 11
[1] INTRODUCTION TO RETIREMENT PLANS
Planning for retirement is one of the most important financial decisions individuals make during their working
years. Whether retirement is decades away or just around the corner, understanding the various retirement plans
available can significantly impact financial security in later years.
Imagine Sarah, a 35-year-old marketing professional who just started a new job. During orientation, she's
presented with retirement plan options but feels overwhelmed by unfamiliar terms like "401(k)," "vesting
schedule," and "catch-up contributions." Like many Americans, Sarah recognizes the importance of saving for
retirement but finds the landscape of retirement plans complex and confusing.
This chapter demystifies retirement planning by exploring the various qualified and non-qualified retirement
plans available to individuals and employers. We'll examine how the federal government encourages retirement
savings through tax incentives and how the Employee Retirement Income Security Act (ERISA) protects
participants' rights. From employer-sponsored plans to individual retirement accounts, you'll gain a
comprehensive understanding of retirement planning options and how they can be tailored to meet diverse
financial needs.
Life insurance companies play a significant role in the retirement planning arena. As an insurance professional,
your knowledge of these retirement vehicles will be invaluable to clients seeking guidance on securing their
financial future. Let's begin our exploration of retirement plans and the critical role they play in comprehensive
financial planning.
The chapter is divided into the following sections:
• Qualified Plans versus Non-Qualified Plans
• Qualified Employer Plans
• Qualified Defined Contribution Plans
• Qualified Defined Benefit Plans
• Qualified Salary Reduction Plans
• Qualified Plans for Small Employers
• Qualified Individual Retirement Plans
• Qualified Educational Savings Plans
• Non-Qualified Retirement Plans
The state-specific portion of this course (located at the end) will detail the specific insurance definitions, rules,
regulations, and statutes for your state. In the event of a conflict, state law will supersede the general content.
[1.1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
• Distinguish between qualified and non-qualified retirement plans based on their tax treatment and
eligibility requirements
• Identify the key characteristics of qualified employer plans established under ERISA
• Compare the features of defined contribution plans, including money purchase, profit-sharing, stock
bonus, and employee stock ownership plans
• Explain how defined benefit plans calculate guaranteed retirement benefits
• Describe the structure and benefits of salary reduction plans such as 401(k), 403(b), and Section 457
plans
• Recognize retirement plan options designed specifically for small employers and self-employed
individuals
 • Differentiate between traditional IRAs and Roth IRAs regarding contribution rules, tax treatment, and
distribution requirements
• Analyze the rules governing rollovers, spousal IRAs, and early withdrawals from retirement accounts
• Identify educational savings options, including Coverdell Education Savings Accounts and Section 529
plans
[1.3] KEYWORDS
Before reading this chapter, please review the following keywords. An understanding of the basic definitions will
improve your comprehension of the chapter content.
401(k) Plan: A retirement savings plan sponsored by an employer, allowing employees to save and invest a
portion of their paycheck before taxes are taken out.
403(b) Plan: A retirement plan for employees of public schools, specific tax-exempt organizations, and religious
organizations.
Defined Benefit Plan: This is a pension plan under which a specific future benefit is determined by a formula that
typically incorporates an employee’s years of service and compensation level.
Defined Contribution Plan: A retirement plan where a formula determines annual contributions, and benefits vary
based on contributions and service length.
Employee Retirement Income Security Act of 1974 (ERISA): A federal law setting minimum standards for
pension and health plans in private industry.
Employee Stock Ownership Plans (ESOP): Employee stock ownership plans provide employees with an
ownership interest in the company via shares held in an ESOP trust until the employee retires or leaves the
company.
Exclusive Benefit Rule: This rule states that assets held in a company's qualified retirement plan must be
maintained for the exclusive benefit of the employees and their beneficiaries
Keogh Plan: A retirement plan for self-employed individuals offering favorable tax treatment.
Money Purchase Plan: A money purchase plan is a type of qualified defined contribution retirement plan in which
the employer MUST contribute a predetermined, fixed percentage of each employee's salary, regardless of
company profits.
Non-Qualified Retirement Plan: A retirement or employee compensation plan that does not meet the
requirements set forth by the federal government and is therefore not eligible for favorable tax treatment.
Non-Qualified Withdrawal: Withdrawals exceeding contributions are taxable as ordinary income.
Profit-Sharing Plan: A plan where a portion of a company's profits is distributed to qualifying employees.
Qualified Plan: A retirement plan that meets IRS rules for favorable tax treatment.
Qualified Withdrawal: Tax-free distribution of earnings from a Roth IRA under specific conditions.
Required Minimum Distributions (RMDs): Mandatory withdrawals from retirement accounts imposed by the IRS
to ensure retirement funds don't grow tax-deferred forever.
Rollovers: When an individual retirement account (IRA) is established or expanded with funds transferred from
another IRA or a qualified retirement plan that the owner had terminated.
Roth Individual Retirement Account (Roth IRA): An individual retirement account allowing after-tax contributions
with tax-free earnings and withdrawals.
Savings Incentive Match Plan for Employees (SIMPLE): A qualified, tax-favored, employer retirement plan that a
small employer (less than 100 employees) can make available to its employees.
Section 457 Plan: A deferred compensation plan specifically designed for state and local government
employees and specific nonprofit organizations.
Simplified Employee Pension (SEP) Plan: A qualified retirement plan where employers contribute to employees'
IRAs.
Stock Bonus Plan: A plan that distributes company stock to eligible employees.
Traditional Individual Retirement Account (IRA): A traditional IRA is an individually qualified retirement account
into which an eligible individual can accumulate tax-deferred income up to a certain amount each year,
depending on the individual’s tax bracket.
Vesting: The schedule under which employees’ rights to receive the funds contributed to a plan by their
employers gradually become guaranteed based on their years of service.
[2] QUALIFIED PLANS VERSUS NON-QUALIFIED PLANS
There are many forms of retirement plans, each designed to fulfill specific needs. The products and contracts
they offer provide ideal funding or financing vehicles for both individual plans and employer-sponsored plans. In
general, retirement plans can be divided into two categories—qualified plans and non-qualified plans. Qualified
plans are those that meet federal requirements and receive favorable tax treatment.
Employer contributions to a qualified retirement plan are deductible business expenses, reducing the business’s
income taxes. Employer contributions to a qualified plan are not currently taxable to the employee in the year in
which the contribution is made. However, they become taxable when paid as a benefit (typically when the
employee is retired and in a lower tax bracket).
Put another way, under certain conditions, contributions to a qualified plan (e.g., an individual retirement account
or annuity) may be deductible from income. Also, the earnings of a qualified plan are tax-deferred until they’re
withdrawn.
[3] QUALIFIED EMPLOYER PLANS
An employer retirement plan is one that a business offers to its employees. The employees are not taxed on the
contributions made on their behalf, nor are they taxed on the accumulated earnings until those funds are paid
out. Additionally, an individual employee’s contributions to a qualified employer retirement plan are not included
in their ordinary income and are therefore not taxable.
For example, Jordan works for a mid-sized tech company that offers a 401(k) plan, a type of qualified employer
retirement plan.
How it applies:
• Jordan contributes a portion of his own salary to the plan. These contributions are excluded from income
tax when made, reducing Jordan’s current tax bill.
• Jordan’s employer will match Jordan’s contributions to his 401(k) plan each year, up to 5% of his salary.
These employer contributions are also not taxable at the time they are made.
• Both Jordan’s contributions and those of his employer are tax-deferred until Jordan withdraws them in
retirement.
• The investment earnings (interest, dividends, capital gains) within the plan are also tax-deferred until
withdrawn.
Result:
Jordan receives tax savings immediately, as well as compounded tax-deferred growth over time, which are key
features of a qualified employer plan.
[3.1] EMPLOYEE RETIREMENT INCOME SECURITY ACT OF 1974 (ERISA)
The federal government encourages businesses to set aside retirement funds for their employees and provides
incentives for individuals to do the same. To further encourage retirement planning, Congress passed the
Employee Retirement Income Security Act (ERISA) in 1974 to protect individuals' rights under retirement plans.
Many of the basic concepts associated with qualified employer plans can be traced to the Employee Retirement
Income Security Act of 1974 (ERISA). The purpose of ERISA is to protect the rights of workers covered by an
employer-sponsored plan.
ERISA imposes several requirements that retirement plans must follow to obtain IRS approval as a qualified plan
and be eligible for favorable tax treatment. This law sets forth standards for participation, coverage, and vesting.
To receive “tax-qualified” treatment, the employer plan must meet several criteria:
• It must be a formal, written document communicated to all employees.
• The plan must be established solely for the benefit of employees and their beneficiaries, with the
intention of being ongoing.
• It must satisfy minimum age and service standards (e.g., age 21 and at least one year of service).
• The plan may not discriminate in favor of highly compensated employees.
 o If key employee account balances equal more than 60% of the total accrued value of the plan,
then the plan is considered to be “top heavy”. Such plans must satisfy top-heavy plan rules to
ameliorate this imbalance by making minimum employer contributions for all non-key employees.
• Contributions to the plan must be actuarially determined.
• Plans must provide survivor benefits.
• Minimum vesting standards must be met
• Plan assets must be legally segregated from the sponsoring organization's assets.
[3.1.1] PARTICIPATION STANDARDS
All qualified employer plans must comply with ERISA minimum participation standards that are designed to
determine employee eligibility. In general, employees who are at least 21 years old and have completed one year
of service must be allowed to enroll in a qualified plan. If the plan provides 100% vesting upon participation, the
employees cannot be required to complete more than two years of service before enrolling. New employees
must receive a copy of their plan sponsor’s latest Summary Plan Description within 90 days after becoming
covered by the plan. Church, governmental, and collectively bargained plans are specifically exempt from ERISA
regulations.
[3.1.2] COVERAGE REQUIREMENTS
Under the IRS “minimum coverage” rules, a qualified retirement plan must benefit a broad cross-section of
employees. The purpose of coverage requirements is to prevent a plan from discriminating against the common
employees in favor of the “elite” employees (officers and highly compensated employees). The positions of these
elite employees often enable them to make basic policy decisions regarding the plan. The IRS will subject
qualified employer plans to coverage tests to determine whether they’re discriminatory. A qualified plan cannot
discriminate in favor of highly paid employees in its coverage provisions or in its contributions and benefits
provisions.
Form 5500 is a disclosure document that employee benefit plans use to satisfy annual reporting requirements
under ERISA.
[3.1.3] VESTING SCHEDULES
Vesting is the schedule under which employees’ rights to own the funds contributed to a plan by their employers
gradually become guaranteed based on their years of service. At a minimum, all participants must be either fully
vested after five years or 20% vested after three years (with full vesting after seven years of service). However,
employees are always 100% vested in the contributions they have made to a plan on their own behalf.
[4] QUALIFIED DEFINED CONTRIBUTION PLANS
Defined contribution plans may be funded by employers, employees, or both. Employer-funded plans may use
employer-selected investments or allow some flexibility. Employers must exercise due diligence in selecting
investment vehicles and incur administrative costs.
Plans funded with employee contributions are vested; that is, the amount contributed by the employee
represents the participant’s vested (nonforfeitable) amount. Participants can elect to defer a portion of their
gross salary through a pre-tax payroll deduction to the plan, and the company may match the contribution up to a
specified limit.
As the employer has no obligation regarding the performance of an account’s investments, these plans require
little work, cost less to administer, and are low risk to the employer. The employee is responsible for making the
contributions and choosing investments offered by the plan. Contributions are typically invested in select mutual
funds, which hold a basket of stocks or other securities, and in money market funds. Still, the investment menu
may also include annuities and individual stocks.
Investments in a defined contribution plan grow tax-deferred until funds are withdrawn in retirement. The final
amount that’s available to a participant depends on the total contribution amount, plus interest and dividends.
Under IRS provisions, there’s an inflation-adjusted limit to how much employees can contribute each year.
The primary types of defined contribution plans are money purchase plans, profit-sharing plans, stock bonus
plans, and employee stock ownership plans.
[4.1] MONEY PURCHASE PLANS
Money purchase plans provide for fixed (defined) contributions with future benefits to be determined based on
funds in the account upon retirement. Money purchase plans most closely resemble an actual defined
contribution plan. Contributions and earnings must be allocated to participants in accordance with a defined
formula. The employer MUST contribute a fixed percentage of each employee's salary. This percentage is set in
advance and doesn't change based on company profits.
For example, if the plan sets 5% contributions, a company must contribute $2,500 for an employee making
$50,000.
[4.2] PROFIT-SHARING PLANS
Profit-sharing plans are established and maintained by an employer, allowing employees to participate in the
company’s profits. These plans set aside a portion of the company’s net profit for distributions to employees who
qualify under the plan. Since contributions depend on company profits, employers are not required to contribute
every year or maintain consistent amounts. To maintain tax benefits, the IRS requires "recurring and substantial"
contributions. Withdrawals before age 59½ may result in a 10% IRS penalty plus income taxes.
Profit-sharing plans can provide flexible and rewarding incentives for employees, aligning their interests with the
company's success while also accommodating the company’s financial reality year to year.
For instance, imagine a company called GreenTech Solutions has established a profit-sharing plan for its
employees. Each year, the company’s board reviews the annual profits after all expenses are accounted for and
considers the following:
• One year, GreenTech earns $1 million in net profit, and the board decides to contribute 10% of the
profits—$100,000—into the profit-sharing plan. The $100,000 is allocated among eligible employees
based on a formula stated in the plan document. It could be a percentage of each employee's salary or
years of service.
• If GreenTech’s profits were to drop by 50% the following year, the board could decide not to contribute,
and employees would not receive additional allocations for that year, but all previous vested
contributions would remain theirs.
[4.3] STOCK BONUS PLANS
A stock bonus plan is similar to a profit-sharing plan. However, the employer’s contributions are not based on
profits, and benefits are given in the form of company stock. This equity-based pay gives employees partial
ownership in the company, allowing them to share in potential profits and losses (depending on stock price
changes) and to receive dividend payments (if applicable). This arrangement not only provides a valuable
retirement benefit but also encourages employees to contribute to the company’s ongoing success, aligning their
interests with those of the business and its shareholders.
For example, suppose a company called BlueRiver Technologies implements a stock bonus plan for its
employees. At the end of the fiscal year, the company decides to reward its workforce for their hard work and
dedication by allocating shares of company stock.
The plan’s formula might allocate enough shares so that each eligible employee receives shares equivalent to
5% of their annual salary.
The shares are placed in each employee’s retirement account, where their value will grow or decline based on
the company’s stock market performance.
If BlueRiver Technologies pays dividends, employees are also eligible to receive them as additional income or to
reinvest in their accounts.
When the employee retires or leaves the company, they can take ownership of the shares, either holding onto
them for further growth or selling them on the open market.
[4.4] EMPLOYEE STOCK OWNERSHIP PLANS
Employee stock ownership plans (ESOPs) are employee-owner programs that provide a company's workforce
with an ownership interest in the company. Shares are allocated to employees and may be held in the ESOP trust
until they retire or leave the company.
[5] QUALIFIED DEFINED BENEFIT PLANS
Unlike a defined contribution plan that sets up predetermined contributions, a defined benefit plan establishes a
definite future benefit that’s predetermined by a specific formula. Defined benefit plans provide eligible
employees with guaranteed income for a period of years (usually for life) upon retirement. Employers guarantee a
specific retirement benefit amount for each participant, based on factors such as the employee’s salary and
years of service. When the term 'pension' is used, it typically refers to a defined benefit plan.

Employees have little control over the funds until they are received in retirement. The company takes
responsibility for the investment and for its distribution to the retired employee. That means the employer
assumes the risk if the investment returns do not cover the defined benefit amount due to a retired employee.

To qualify for federal tax purposes, a defined benefit plan must meet the following basic requirements:

It must provide for definitely determinable benefits, either by a formula that’s specified in the plan or by actuarial
computation.
It must provide for systematic payment of benefits to employees over a period of years (typically for life) after
retirement. Therefore, the plan must detail the conditions under which benefits are payable and the options
under which benefits are paid.
[5.1] APPLICATION SCENARIO
Employee: Maria has worked at B Corporation for 30 years. Her average salary over the last five years of
employment is $80,000.
B Corporation’s Defined Benefit Plan Formula: 1.5% × Years of Service × Final Average Salary paid for life.
When Maria retires, her pension benefit is calculated as: 1.5% × 30 years × $80,000 = $36,000 per year
This means Maria will receive $36,000 annually for life after retirement, regardless of market performance or
how long she lives.
This guaranteed income stream provides Maria with financial security and predictability in retirement, unlike a
defined contribution plan, where the retirement benefit depends on investment returns and contributions.
Maria’s benefit is predetermined and backed by her employer.
[6.1] CASH OR DEFERRED ARRANGEMENTS (401(K) PLANS)
Another form of qualified employer retirement plan is referred to as the 401(k) plan. Employees can elect to
reduce their current salaries by deferring amounts into a retirement plan. These plans are considered a cash or a
salary deferral option because employees cannot be forced to participate. Instead, they may currently take their
income as cash or defer a portion of it until retirement with favorable tax advantages. The amounts deferred are
not included in the employees’ yearly gross income, and earnings credited to the deferrals grow tax-deferred until
distribution. Typically, 401(k) plans include matching employer contributions. The contributions are made pre-tax
(deductible), and the earnings grow on a tax-deferred basis
The maximum annual contribution is an inflation-adjusted amount determined by the IRS. However, employees
who are age 50 or older are allowed an additional “catch-up contribution” amount that may be contributed
annually.
For example, let us assume an individual contributes $250 per month to a 401(k) and invests the entire amount
in an index fund that mirrors the S&P 500 index. Based on the average growth rate of slightly more than 10% over
the last 30 years, those funds would grow to about $500,000 if compounded annually.
[6.2] TAX-SHELTERED ANNUITIES [403(B) PLANS]
A tax-sheltered annuity, or 403(b) plan, is a unique tax-favored retirement plan that’s available only to specific
groups of employees. Tax-sheltered annuities may be established for the employees of specified nonprofit
charitable, educational, religious, and other 501(c)(3) organizations, including teachers in public school systems.
These plans are generally not available to other types of employees.
Funds are contributed to tax-sheltered annuities by the employer or by the employees through payroll
deductions. The funds are excluded from the employees’ current taxable income.
[6.3] SECTION 457 DEFERRED COMPENSATION PLANS
Deferred compensation plans for employees of state and local governments and nonprofit organizations became
popular in the 1970s. Congress enacted Internal Revenue Code Section 457 to allow participants in these plans
to defer their compensation without current taxation as long as certain conditions are met.
If a plan is eligible under Section 457, the amounts deferred will not be included in gross income until they are
actually received or made available. Life insurance and annuities are authorized investments for these plans. The
annual amounts that an employee may defer under a Section 457 plan are similar to those available for 401(k)
plans.
[7] QUALIFIED PLANS FOR SMALL EMPLOYERS
For many years, small business owners found that their employees could participate in and benefit from a
qualified retirement plan, but the owners themselves could not. Self-employed individuals were in the same
predicament. The reason was that qualified plans were required to benefit employees. Because business owners
were considered employers, they were excluded from participating in a qualified plan.
The Self-Employed Individuals Retirement Act, enacted in 1962, addressed previous limitations by categorizing
small business owners and self-employed individuals as employees. This legislation allowed them to participate
in qualified retirement plans similar to those of their employees. As a result, the Keogh (HR-10) retirement plan
was established, followed by the Simplified Employee Pension SEP plan.
[7.1] KEOGH PLANS (HR-10)
A Keogh plan is a qualified retirement plan designed for unincorporated businesses (self-employed) and allows
the business owner (or a partner in a business) to participate as an employee, as long as the business’s
employees are included. These plans may be established as either defined-contribution or defined-benefit
plans.
In the first years following the Keogh bill’s enactment, there was a great deal of disparity between the rules for
Keogh plans and those for corporate plans. However, various laws have eliminated most of the rules that are
unique to Keogh plans, thereby establishing parity between qualified corporate employer retirement plans and
noncorporate plans.
Some important points to consider:
• Keogh plans are subject to the same maximum contribution and benefit limits as qualified corporate
plans.
• Keogh plans must comply with the same participation and coverage requirements as qualified corporate
plans.
• Keogh plans are subject to the same nondiscrimination rules as qualified corporate plans.
[7.2] SIMPLIFIED EMPLOYEE PENSIONS
Another type of qualified plan that’s suited for the small employer is the Simplified Employee Pension (SEP) plan.
Due to the many administrative burdens and the costs involved with establishing a qualified defined contribution
or defined benefit plan, as well as maintaining compliance with ERISA, many small businesses have been
reluctant to set up retirement plans for their employees. In 1978, SEPs were explicitly introduced for small
businesses to overcome these cost, compliance, and administrative issues.
Basically, SEPs are arrangements whereby an employee (including a self-employed individual) establishes and
maintains an IRA to which the employer contributes. These employer contributions are not included in the
employee’s gross income.
A primary difference between a SEP and an IRA is the fact that considerably more can be contributed each year
to a SEP. In accordance with the rules that govern other qualified plans, SEPs must not discriminate in favor of
highly compensated employees regarding contributions or participation.
[7.3] SIMPLE PLANS
A Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) is an employer-sponsored
retirement plan that, in some ways, is similar to 401(k) and 403(b) plans. SIMPLE IRAs are simpler and have
lower start-up and administrative costs than many other retirement plans. The employer will not be subject to
filing requirements with a SIMPLE IRA. These arrangements allow eligible employers to set up tax-favored
retirement savings plans for their employees without having to address many of the usual (and burdensome)
qualification requirements.
SIMPLE plans are available to small businesses (including tax-exempt and government entities) that employ no
more than 100 employees. The employees must have received at least $5,000 in compensation from the
employer during the previous year.
To establish a SIMPLE plan, the employer must not have a qualified plan in place. SIMPLE plans may be
structured as an IRA or as a 401(k) cash or deferral arrangement. All contributions to a SIMPLE IRA or SIMPLE
401(k) plan are nonforfeitable, and the employee is immediately and fully vested. Taxation of contributions and
their earnings is tax-deferred until the funds are withdrawn or distributed.
SIMPLE plans also allow participants to make additional “catch-up” contributions if they’re at least 50 years of
age by the end of the plan year.
[8.1] TRADITIONAL INDIVIDUAL RETIREMENT ACCOUNTS
An Individual Retirement Account (IRA) is a way for individuals to save for retirement and receive a current tax
break, regardless of whether they have another retirement plan. Essentially, the amount contributed to an IRA
accumulates and grows on a tax-deferred basis. IRA funds are not taxed until they’re taken out at retirement.
Depending on the individual’s earnings and whether an employer-sponsored retirement plan covers the
individual, the amount the individual contributes to a traditional IRA may be fully or partially deducted from
current income, which results in lower current income taxes.
[8.1.1] TRADITIONAL IRA PARTICIPATION AND CONTRIBUTIONS
Any person (of any age) who has earned income may open a traditional IRA and contribute up to the contribution
limit or 100% of annual compensation, whichever is less. Currently, the maximum annual contribution that an
individual can make is $7,000. An IRA may also be opened for a non-wage-earning spouse, up to the maximum
annual contribution limit.
[8.1.2] CATCH-UP CONTRIBUTIONS
Since 2002, individuals aged 50 and older have been allowed to make additional $1,000 “catch-up”
contributions to their IRAs. In other words, a person who is 50 or older can contribute a maximum of $8,000
annually. These extra contributions allow them to save even more for retirement and can be either deductible or
made to a Roth IRA.
[8.1.3] DEDUCTION OF TRADITIONAL IRA CONTRIBUTIONS
In many cases, the amount that an individual contributes to a traditional IRA can be deducted from that person’s
income in the year that it’s contributed. An IRA participant’s ability to take a deduction for her contribution is
dependent on the following two factors:
Whether an employer-sponsored retirement plan covers the participant
The amount of income the participant earns
Individuals who are not covered by an employer-sponsored plan may contribute (up to the annual limit) to a
traditional IRA and deduct the full amount of the contribution from their current income, regardless of their
income level. Also, married couples who both work and have no employer-sponsored plan can each contribute
and deduct up to the maximum each year.
However, individuals who are covered by an employer-sponsored plan are subject to different rules regarding the
deductibility of traditional IRA contributions. For these individuals, income level is the determining factor—the
more they earn, the less they can deduct from their IRA.
EXAM TIP:
Don’t confuse the deductibility of contributions with the ability to make contributions. Any person (of any age)
who has earned income (as well as a non-wage-earning spouse) can contribute to a traditional IRA. However, the
level of income and participation in an employer plan may affect the traditional IRA owner’s ability to deduct the
contributions.
[8.1.4] TRADITIONAL IRA FUNDING
An ideal funding vehicle for IRAs is a flexible premium, fixed, deferred annuity. Other acceptable IRA funding
vehicles include bank time deposit open accounts, bank certificates of deposit, insured credit union accounts,
mutual fund shares, face amount certificates, real estate investment trust units, and particular U.S. gold and
silver minted coins.
[8.1.5] TRADITIONAL IRA WITHDRAWALS
Since the purpose of an IRA is to help accumulate retirement funds, several rules discourage traditional IRA
owners from withdrawing those funds before retirement. Traditional IRA owners are also discouraged from
perpetually sheltering their accounts from taxes by rules that mandate when the funds must be withdrawn.
Traditional IRA owners must begin receiving payments from their accounts by no later than April 1 of the year
following the year in which they reach age 73 (per the SECURE Act 2.0). The law specifies a minimum amount
that must be withdrawn every year. These mandatory withdrawals are called required minimum distributions, or
RMD. Failure to withdraw the minimum amount can result in a 25% excise tax that will be assessed on the
amount that should have been withdrawn. The penalty is reduced to 10% if the error is corrected within two
years.
With few exceptions, any distribution from a traditional IRA before the age of 59 1/2 will incur adverse tax
consequences. In addition to income tax, the withdrawal will be subject to a 10% penalty (similar to that
imposed on early withdrawals from deferred annuities).
Early distributions that are taken for any of the following reasons or circumstances will not be assessed the 10%
penalty:
• Owner dies or becomes disabled
• Qualifying medical expenses
• Higher education expenses
• First-time home purchase expenses
• Health insurance premiums while unemployed
• Correct or reduce an excess contribution
At retirement, or at any time after the age of 59 1/2, IRA owners may choose to receive either a lump-sum
payment or periodic installment payments from their account. Traditional IRA distributions are taxed in much the
same way as annuity benefit payments are taxed. In other words, the portion of an IRA distribution that is
attributed to nondeductible contributions is received tax-free, while the portion attributed to interest earnings or
deductible contributions is taxable. The result is a tax-free return of the IRA owner’s cost basis and taxation of
the balance (interest). If an IRA owner dies before receiving full payment, the remaining funds in the deceased’s
IRA will be paid to the named beneficiary.
[8.2] ROTH INDIVIDUAL RETIREMENT ACCOUNTS
The Taxpayer Relief Act of 1997 introduced a new type of IRA—the Roth IRA. Roth IRAs are unique in that they
provide for back-end benefits. The contributions that are made to a Roth IRA are nondeductible (after-tax), but
the earnings on those contributions are entirely tax-free when they’re withdrawn. An amount up to the annual
contribution limit can be contributed to a Roth IRA for any eligible individual. In fact, active participant status in
an employer-sponsored retirement plan is irrelevant.
Individuals can open and contribute to a Roth IRA regardless of whether their employer’s plan covers them. They
may also maintain and contribute to other IRA accounts; however, no more than the maximum amount can be
contributed in any one year to any single account or combination of accounts.
As with traditional IRAs, the maximum annual contribution is $7,000, and individuals age 50 or older may make
an additional $1,000 contribution each year.
Roth IRAs don’t impose age limits. At any age, an individual with earned income can establish a Roth IRA and
make contributions. However, unlike traditional IRA participants, Roth IRA participants are subject to earnings
(income) limitations. High-income earners may not be able to contribute to a Roth IRA, as the maximum annual
contribution begins to phase out for individuals with modified adjusted gross income above certain levels. Above
these limits, Roth IRA contributions are NOT allowed.
[8.2.1] QUALIFIED ROTH IRA WITHDRAWALS
Withdrawals from Roth IRAs are either qualified or non-qualified. A qualified withdrawal provides for the full tax
advantage that Roth IRAs offer (tax-free distribution of earnings). To be a qualified withdrawal, the following two
requirements must be met:
• The funds must have been held in the account for a minimum of five years; and
• The withdrawal must occur because the owner has reached the age of 59 1/2, the owner dies, the owner
becomes disabled, or the distribution is used to purchase the owner's first home.
[8.2.2] NON-QUALIFIED ROTH WITHDRAWALS
A non-qualified withdrawal does not meet the previously discussed criteria. The result is that distributed Roth
IRA earnings are subject to tax. This occurs when a withdrawal is taken without meeting the above requirements
and the amount exceeds the total amount contributed.
Since Roth contributions are made with after-tax dollars, they are not subject to taxation again upon withdrawal.
The only portion of a Roth withdrawal that is subject to taxation is earnings, and only when those earnings are
removed from the account without having met the above requirements. If the owner of the Roth IRA is younger
than the age of 59 1/2 when the withdrawal is taken, it is considered premature, and the earnings portion will
also be assessed a 10% penalty
[8.2.3] NO REQUIRED DISTRIBUTIONS
Unlike traditional IRAs, Roth IRAs do not require mandatory distributions. In other words, there is no required
minimum distribution for the account owner. The funds can remain in the account for as long as the owner
desires. In fact, the account can be left intact and passed on to heirs or beneficiaries.
For example, Sarah, 35, opened a Roth IRA three years ago and has contributed $18,000 total. Her account has
grown to $22,000 (with $4,000 in earnings). She is facing unexpected home repairs costing $20,000 and decides
to withdraw $20,000 from her Roth IRA.
Since Sarah is under 59½ and her account is less than five years old, this is a non-qualified withdrawal. The first
$18,000 (her contributions) comes out tax-free, but the remaining $2,000 (earnings) will be:
• Subject to income tax; and
• Hit with a 10% early withdrawal penalty ($200).
Sarah may want to consider alternatives such as home equity loans or withdrawing only her contributions to
avoid these tax consequences.
[8.3] SPOUSAL INDIVIDUAL RETIREMENT ACCOUNT
People who are eligible to establish IRAs for themselves may also create a separate spousal IRA for a non-
working spouse and may contribute up to the annual maximum of $7,000 to the spousal account (or $8,000 if
the non-working spouse is age 50 or older). This can be done even if the working spouse is participating in an
employer-sponsored plan.
[8.3.1] APPLICATION SCENARIO
Tina, age 52, is a full-time graphic designer earning $60,000/year
Mark, age 54, is Tina’s spouse. He recently retired and is not currently earning income
Tina wants to maximize their retirement savings. Here’s how they apply the IRA rules:
Tina’s IRA Contribution
• Since she is over 50, she qualifies for the $1,000 catch-up contribution.
• She contributes the maximum $8,000 to her traditional IRA.
Spousal IRA for Mark
• Even though Mark has no earned income, Tina’s income allows her to contribute on his behalf.
• Mark is also over 50, so he qualifies for the $8,000 maximum contribution to a spousal IRA.
Together, Tina and Mark contribute $16,000 to their IRAs for the year, taking full advantage of the catch-up
provision and spousal IRA rules. These contributions may be tax-deductible, depending on their income and filing
status. Alternatively, they could choose to contribute to Roth IRAs for tax-free withdrawals in retirement.
[8.4] ROLLOVER INDIVIDUAL RETIREMENT ACCOUNTS
Benefits that are withdrawn from any qualified retirement plan are typically taxable in the year in which they’re
received. However, specific tax-free “rollover” provisions of the tax law provide some degree of portability when
an individual transfers funds from one plan to another, specifically to a rollover IRA.
Essentially, rollover IRAs allow individuals who have received a distribution from a qualified plan to reinvest the
funds in a new tax-deferred account and continue to shelter those funds and their earnings from current
taxes. Rollover contributions to an IRA are unlimited by dollar amount.
For example, rollover IRAs are used by individuals who have left one employer for another and have received a
complete distribution from their previous employer’s plan. Another example is an individual who invests funds in
an IRA of one type and wants to roll over those funds into another IRA for a higher rate of return.
A distribution received from an employer-sponsored retirement plan (or from an IRA) is eligible for a tax-free
rollover if it is reinvested in an IRA within 60 days following receipt of the distribution and if the plan participant
does not actually take physical receipt of the distribution. The entire amount does not need to be rolled over; in
fact, a partial distribution may be rolled over from one IRA or eligible plan to another IRA. However, if a partial
rollover is executed, the portion retained will be taxed as ordinary income and subject to a 10% early distribution
penalty.
Only the person who established an IRA is eligible to benefit from the rollover treatment; however, there’s one
exception to this provision. A surviving spouse who inherits IRA benefits or benefits from the deceased spouse’s
qualified plan is eligible to establish a rollover IRA in the surviving spouse’s own name. Assets that pass to a
surviving spouse are generally not subject to estate taxes at the time of death due to the unlimited marital
deduction.
Any rollover must be made directly from one IRA to another IRA, or it will be subject to a 20% withholding. This is
true even if the rollover occurs within the 60-day limit. The key here is the word “directly.” To avoid the
withholding rate, the rollover must occur without the plan’s funds being in the recipient’s control for even an
instant.
Let’s assume that such control does occur, and 20% is withheld. In this case, the recipient must make up this
amount out of other funds, or the amount withheld will be subject to income taxation and possibly a penalty for
premature distribution. Of course, the amount withheld is applied toward the tax liability (if any) of the money
distributed from the fund. The withholding rule also applies to a trustee-to-trustee transfer of rollover funds.
[8.4.1] IRA ONE-ROLLOVER-PER-YEAR-RULE
IRS regulations only allow one rollover from an IRA within one year. The limit applies as an aggregate when an
individual owns more than one IRA. Regulations also disallow a rollover from the IRA to which a rollover was
deposited for the same one-year period. As with any regulation, there are exceptions. The one-year limitation
does not apply to:
• Rollovers from traditional IRAs to Roth IRAs
• Trustee-to-trustee transfers to another IRA
• IRA-to-plan rollovers
• Plan-to-IRA rollovers
• Plan-to-plan rollovers
An individual may rollover any partial or full distribution from an IRA, except:
• Required Minimum Distributions (RMD)
• A distribution of excess contributions and related earnings
[9] QUALIFIED EDUCATIONAL SAVINGS PLANS
[9.1] EDUCATION IRA
Education IRAs (also referred to as Coverdell Education Savings Accounts) are also available. The funds being
saved can be used for primary and secondary school expenses (e.g., tuition and books) as well as higher
education fees (e.g., college expenses). Any funds remaining (i.e., if a child doesn’t attend college or receives a
scholarship) may be rolled over into another Education IRA before the beneficiary turns the age of 30.
[9.2] SECTION 529 PLANS
Section 529 plans are state-operated investment plans that give families a federal tax-free way to save for
college and other qualified higher education expenses, such as vocational, graduate, or trade school.
There are two types of 529 plans:
• A college savings plan allows parents to use their plan funds for college expenses at any college.
• A prepaid tuition plan allows parents to “lock in” future tuition at in-state public colleges at current prices.
As with a Roth IRA, earnings from a 529 plan are exempt from federal taxes, as are any withdrawals, as long as
they are used for qualified education expenses.
[10] NON-QUALIFIED RETIREMENT PLANS
If a plan does not meet the specific requirements that the federal government sets forth, it’s termed a non-
qualified plan and is therefore not eligible for favorable tax treatment.
For example, a 42-year-old man decides he wants to start a retirement fund. He opens a new savings account at
his local bank, begins depositing $150 per month into it, and vows not to touch the money until he reaches age
65. Although his intentions are good, they will not serve to “qualify” his plan. The income he deposits and the
interest he earns are still taxable every year.
Employers generally provide non-qualified retirement plans to highly paid (key) employees, directors, and
officers of the firm. Contributions to such plans are not tax-deductible because the employer is legally
discriminating in favor of higher-paid employees. In other words, the employer makes no effort to satisfy the
qualification requirements either under the Internal Revenue Code or ERISA for tax-favored treatment of qualified
plan costs or benefits. Providing this type of additional compensation to an employee allows the firm to attract
and retain key employees’ services.
Common types of non-qualified plans include non-qualified deferred compensation plans, supplemental
executive retirement plans, and incentive compensation plans.
For instance, in a non-qualified deferred compensation plan, a portion of the compensation for an employee’s
services is postponed until retirement.
Generally, the employee will not pay taxes on the deferred amounts until they’re received. The employer cannot
deduct the deferred payments until they are actually received by the employee, generally at retirement. Non-
qualified plans may be either funded or unfunded. A funded plan is one in which the employer maintains assets
in a trust or escrow account as security for promised future benefit payments. An unfunded plan exists when no
funds or assets have been designated to fund the plan. With an unfunded plan, the employee relies on the
employer's unsecured promise.
[11] RETIREMENT PLANS SUMMARY
Throughout this chapter, we've explored the diverse landscape of retirement plans designed to help individuals
secure their financial future. We began by distinguishing between qualified plans, which receive favorable tax
treatment, and non-qualified plans, which don't meet federal requirements for such benefits.
We examined qualified employer plans established under ERISA, which protect employees' rights while
providing tax advantages for both employers and participants. These plans fall into two main categories: defined
contribution plans (like money purchase, profit-sharing, and stock bonus plans) where future benefits depend on
investment performance, and defined benefit plans that guarantee specific retirement income based on salary
and years of service.
We also explored salary reduction plans such as 401(k)s, 403(b)s, and Section 457 plans, which allow
employees to defer current income for retirement while enjoying tax advantages. For small business owners and
self-employed individuals, we discussed specialized options, including Keogh plans, SEPs, and SIMPLE plans,
which provide similar benefits with less administrative burden.
Individual retirement options, including traditional IRAs with their tax-deductible contributions and Roth IRAs
with their tax-free withdrawals, offer flexibility for personal retirement planning. We covered important rules
governing contributions, rollovers, spousal provisions, and required minimum distributions for these accounts.
Finally, we touched on educational savings vehicles such as Coverdell Education Savings Accounts and Section
529 plans, which offer tax advantages for funding educational expenses.
Understanding these retirement options is essential for insurance professionals who guide clients through the
complex process of retirement planning. By helping clients select appropriate retirement vehicles, you play a
crucial role in ensuring their financial security in retirement.
[11.2] REVIEW NOTES
The key points to remember from this chapter include:
Learning Objective 1: Distinguish between qualified and non-qualified retirement plans based on their tax
treatment and eligibility requirements.
Key Concepts:
• Qualified plans meet federal requirements and receive favorable tax treatment
• Employer contributions to qualified plans are tax-deductible business expenses
• Employee contributions and earnings in qualified plans grow tax-deferred
• Non-qualified plans don't meet federal requirements and lack tax advantages
• Non-qualified plans are often used for highly compensated employees
Learning Objective 2: Identify the key characteristics of qualified employer plans established under ERISA.
ERISA Requirements:
• Plans must be formal, written documents communicated to all employees
• Plans must be established solely for employees' benefit, with the intention of being ongoing
• Minimum age (21) and service (1 year) standards must be satisfied
• Plans cannot discriminate in favor of highly compensated employees
• Plans must provide survivor benefits and meet minimum vesting standards
• Plan assets must be legally segregated from the sponsoring organization's funds
Vesting Schedules:
• Full vesting after 5 years, OR 20% vesting after 3 years, with full vesting after 7 years
• Employees are always 100% vested in their own contributions
Learning Objective 3: Compare the features of defined contribution plans.
Types of Defined Contribution Plans:
• Money Purchase Plans: Employer MUST contribute a fixed percentage of the employees' salary
• Profit-Sharing Plans: Contributions based on company profits; not required every year
• Stock Bonus Plans: Benefits are given in the form of company stock, not based on profits
• Employee Stock Ownership Plans (ESOPs): Provide employees ownership interest in the company
Key Features:
• The employer defines their contribution
• Employee contributions are always fully vested
• Investments grow tax-deferred until withdrawal
• Final benefit depends on contribution amounts plus investment returns
• Annual contribution limits are adjusted for inflation by the IRS
Learning Objective 4: Explain how defined benefit plans calculate guaranteed retirement benefits.
Defined Benefit Plan Characteristics:
• Establishes a predetermined future benefit using a specific formula
• Typically based on salary history and years of service
• Provides guaranteed income for life after retirement
• Employer bears investment risk
• Must provide definitely determinable benefits
• Must provide systematic payment over a period of years after retirement
Learning Objective 5: Describe the structure and benefits of salary reduction plans.
401(k) Plans:
• Employees elect to reduce their current salary by deferring amounts into retirement
• Contributions are not included in the employee's yearly gross income
• Earnings grow tax-deferred until distribution
 • Plans often include matching employer contributions
• Additional "catch-up contributions" allowed for employees age 50+
403(b) Plans:
• Available only to employees of nonprofit, educational, religious, and 501(c)(3) organizations
• Contributions are excluded from employees' current taxable income
Section 457 Plans:
• For employees of state/local governments and nonprofit organizations
• Deferred amounts are not included in gross income until received
Learning Objective 6: Recognize retirement plan options for small employers and self-employed
individuals.
Small Employer Plans:
• Keogh (HR-10) Plans: For unincorporated businesses; can be defined contribution or benefit
• Simplified Employee Pension (SEP): Employer contributes to employee's IRA
• SIMPLE Plans: Available to businesses with 100 or fewer employees
o Lower administrative costs than other retirement plans
o Can be structured as an IRA or a 401(k)
o All contributions are immediately vested
o Available to businesses with no other qualified plan in place
Learning Objective 7: Differentiate between traditional IRAs and Roth IRAs.
Traditional IRAs:
• Contributions may be tax-deductible depending on income and employer plan coverage
• Earnings grow tax-deferred until withdrawal
• Required Minimum Distributions (RMDs) begin at age 73
• Early withdrawals before age 59½ are subject to a 10% penalty tax plus income tax
• Maximum annual contribution: $7,000 ($8,000 if age 50+)
Roth IRAs:
• Contributions are after-tax (not deductible)
• Qualified withdrawals (including earnings) are completely tax-free
• No Required Minimum Distributions during the owner's lifetime
• Subject to income limitations for contributions
• Early withdrawal of earnings is subject to taxes and penalties
• Qualified withdrawals require a 5-year holding period and a qualifying event
Learning Objective 8: Analyze the rules governing rollovers, spousal IRAs, and early withdrawals.
Rollovers:
• Allow tax-free transfer between qualified plans
• Must be completed within 60 days of distribution
• Direct rollovers avoid 20% mandatory withholding
• One-rollover-per-year rule applies (with exceptions)
Spousal IRAs:
• Available for non-working spouses
• Working spouse must have sufficient earned income
• Same contribution limits apply ($7,000 or $8,000 if age 50+)
Early Withdrawal Exceptions (10% penalty waived):
• Death or disability
• Qualifying medical expenses
• Higher education expenses
• First-time home purchase
• Health insurance premiums while unemployed
Learning Objective 9: Identify educational savings options.
Education Savings Plans:
• Coverdell Education Savings Accounts (Education IRAs):
• Can be used for primary, secondary, and higher education expenses
• Unused funds can be rolled over to another beneficiary before age 30
Section 529 Plans:
• State-operated investment plans
• Two types: college savings plans and prepaid tuition plans
• Earnings and qualified withdrawals are federal tax-free
• Must be used for qualified education expenses
Exam Tips:
• Know the differences between qualified and non-qualified plans
• Understand ERISA requirements for qualified plans
• Distinguish between defined contribution and defined benefit plans
• Remember the key differences between traditional and Roth IRAs
• Know rollover rules and exceptions to early withdrawal penalties
• Understand the special provisions for small employer plans
• Understand contribution limits and catch-up provisions
Chapter 12
[1] SOCIAL SECURITY INTRODUCTION
Social Security touches the lives of nearly every American, yet many misconceptions exist about how this vital
program actually works. As an insurance professional, you'll frequently encounter clients who need guidance on
how Social Security fits into their broader financial planning strategy.
Imagine meeting with a couple in their late 50s who believe Social Security will fully fund their retirement, or a
young family who hasn't considered what would happen if a breadwinner became disabled. These scenarios
highlight why understanding Social Security is essential to providing comprehensive financial advice.
This chapter explores the Old-Age, Survivors, and Disability Insurance (OASDI) program—commonly known as
Social Security. We'll examine how the system is funded through FICA payroll taxes, who qualifies for benefits,
and the various types of protection the program provides. You'll learn about retirement benefits, disability
coverage, and survivor protections that form America's most comprehensive social insurance program.
Remember that while Social Security provides valuable protection, it was never designed to be a complete
financial solution. Understanding these fundamentals will prepare you for your licensing exam. It will also help
you serve your future clients by showing them how Social Security works alongside private insurance products.
This chapter is broken into the following sections:
• Social Security Characteristics;
• Social Security Coverages and Eligibility; and
• Types of Social Security Benefits
[1.1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
• Explain the purpose and fundamental characteristics of the Social Security system
• Describe how Social Security is funded through FICA payroll taxes
• Differentiate between "fully insured" and "currently insured" status and their eligibility requirements
• Calculate how retirement benefits are affected by claiming age (early, full, or delayed retirement)
• Identify the eligibility requirements and waiting periods for Social Security disability benefits
• Explain the types of survivor benefits available and who qualifies for each
• Recognize situations where the Social Security blackout period applies to surviving spouses
• Describe the key features and eligibility requirements of Social Security's major benefit programs
(retirement, disability, and survivors' benefits)
[1.3] KEYWORDS
Before reading this chapter, please review the following keywords. Understanding their basic definitions will
improve your comprehension of the chapter content.
Average Indexed Monthly Earnings (AIME): The calculation used to determine Social Security benefits, based on
a worker's highest indexed 35 years of earnings adjusted for inflation. This forms the basis for calculating the
Primary Insurance Amount (PIA).
Benefit Period: A specific time frame used to track Medicare hospital benefits. Unlike annual insurance policies,
a new benefit period begins with each hospital admission and ends when no hospital or skilled nursing care has
been received for 60 consecutive days.
Credits (Quarters of Coverage): Units that determine Social Security eligibility. Workers can earn up to four
credits annually, with 40 credits (10 years of work) typically required for full benefits. These credits determine
whether someone is fully or currently insured.
Currently Insured: Having earned at least six credits in the last 13 quarters, qualifying for limited survivor benefits
Federal Insurance Contributions Act (FICA): The law requiring payroll tax contributions that fund Social Security
and Medicare programs. Both employers and employees contribute 7.65% (6.2% for Social Security + 1.45% for
Medicare), while self-employed individuals pay 15.3%.
Full Retirement Age (FRA): The age at which a person becomes eligible for 100% of their Social Security
retirement benefits. For those born in 1960 or later, the FRA is 67. Benefits can be claimed earlier (with a
reduction) or later (with an increase).
Fully Insured: Having earned 40 credits (quarters), qualifying for retirement, survivor benefits, and Medicare
Old Age, Survivors, and Disability Insurance (OASDI): The official name for Social Security. This federal insurance
program provides retirement, disability, and survivor benefits to eligible workers and their dependents.
Primary Insurance Amount (PIA): The basic benefit amount a person receives at FRA, before any adjustments for
early or delayed retirement. This serves as the foundation for calculating all Social Security benefits.
Social Security Disability Insurance (SSDI): Benefits paid to workers who meet Social Security's strict definition
of disability – being unable to engage in substantial gainful activity due to a medical condition expected to last at
least 12 months or result in death.
Survivor Benefits: Benefits paid to eligible family members of a deceased worker, including a one-time death
benefit of $255 and monthly benefits for surviving spouses, dependent children, and, in some cases, dependent
parents
[2] SOCIAL SECURITY CHARACTERISTICS
As we begin our exploration of Social Security, it is important to understand its fundamental characteristics and
how the system operates. This section lays the groundwork for everything that follows by examining the basic
structure, purpose, and funding of America's most comprehensive social insurance program.
You will learn about the program's origins during the Great Depression, its evolution into the current Old-Age,
Survivors, and Disability Insurance (OASDI) system, and how it is funded through FICA payroll taxes.
Understanding these foundational elements is crucial because they directly influence who receives benefits and
how much they receive. Please pay particular attention to the FICA tax structure, because it is not only frequently
tested on licensing exams but also helps explain to clients why their Social Security benefits are calculated the
way they are.
Remember that while Social Security provides valuable protection, it was never designed to be a complete
financial solution. As you study this section, keep in mind that your future clients will need guidance on how
Social Security fits within their broader financial planning strategy.
[2.1] THE PURPOSE OF SOCIAL SECURITY
The Social Security Act created Social Security. Social Security is also known as OASDI (Old-Age, Survivors, and
Disability Insurance). The program was enacted in 1935 under President Roosevelt. The post-depression
program was established to assist citizens who could not afford to maintain their lifestyle without employment
or other financial resources. People who were unable to work due to disability, illness, or age also needed help.
Social Security is "funded" by payroll taxes collected from employees, employers, and the self-employed. Social
Security provides several benefits to eligible individuals, including retirement income, disability income, a lump-
sum death benefit, and income benefits for survivors.
[2.2] SOCIAL SECURITY FUNDING
Funding for Social Security and Medicare is accomplished through the Federal Insurance Contributions Act
(FICA) payroll taxes.
FICA Tax Contributions:
Employers: 7.65% total
Social Security: 6.2%
Medicare: 1.45%
Employees: 7.65% total
Social Security: 6.2%
Medicare: 1.45%
Self-employed: 15.3% total
Social Security: 12.4%
Medicare: 2.9%
Therefore, employers, employees, and self-employed individuals share the responsibility of funding social
insurance programs.
FICA tax is applied to an employee’s income up to a certain income amount. This amount is referred to as the
taxable wage base. There is a maximum amount of earnings that can be subject to Social Security tax each year.
This amount is indexed each year to the national average wage index. This maximum applies to employers,
employees, and self-employed individuals. However, Medicare Part A taxes are not subject to a maximum
taxable wage cap.
Exam Tip!
FICA Tax Breakdown – Frequently Tested!
Employee pays: 7.65% (6.2% SS + 1.45% Medicare)
Employer pays: 7.65% (6.2% SS + 1.45% Medicare)
Self-employed person pays: 15.3% (Both portions)
Key Point: The Medicare portion has no wage cap, while the Social Security portion does.
[2.3] SOCIAL SECURITY TAXATION
Social Security benefits may be subject to federal income taxation. For beneficiaries who file individual (single)
tax returns, a portion of their Social Security benefit will be taxed when their adjusted gross income exceeds
$25,000. For beneficiaries who file joint tax returns, a portion of their Social Security benefit will be taxed when
their adjusted gross income exceeds $32,000. Regardless of income, 15% of all Social Security benefits received
will always be 100% income tax-free.
[3] SOCIAL SECURITY COVERAGE AND ELIGIBILITY
Now that you understand the basic structure and funding of Social Security, we will examine who is covered by
the program and how they become eligible for benefits. This section introduces two critical concepts that
determine benefit eligibility: "fully insured" and "currently insured" status.
Think of these insurance statuses as keys that unlock different Social Security benefits. Just as different keys
open different doors, each status type provides access to specific benefits. Understanding these distinctions is
crucial because many clients assume that any work history qualifies them for all Social Security benefits – a
misconception you will need to address in your professional role.
We will also explore how Social Security calculates benefit amounts using factors such as lifetime earnings and
retirement age. The information is crucial because it affects every benefit calculation that follows, from
retirement benefits to survivor payments. Pay special attention to how the timing of benefits claims can
significantly impact the amount a person receives – knowledge that will prove invaluable when helping clients
make informed decisions about their Social Security benefits.
[3.1] INSURED STATUS
Social Security establishes benefit eligibility based on one’s status as an "insured". Two distinct categories of
individuals qualify for Social Security benefits: those who are fully insured and those who are currently insured.
Most Social Security benefits are only paid to individuals who qualify as fully insured.
Fully Insured and Currently Insured: A worker becomes fully insured after earning 40 quarters of coverage
(equivalent to 10 years of employment). A fully insured worker is entitled to retirement benefits, and his survivors
are eligible for retirement benefits when that worker dies.
Fully insured status is required to receive disability benefits. Disability benefits are provided to workers who are
fully insured and meet the definition of disability. Younger workers can qualify for disability benefits by meeting
the “20/40” rule. According to this rule, a worker age 31 or older must earn 20 quarters (5 years) of work credits
within the 40 calendar quarters (10 years) ending with the quarter in which the person becomes disabled.
Individuals under age 31 have even less restrictive qualification requirements. Younger workers who are
classified as fully insured under these conditions are entitled to disability benefits and survivor benefits.
A worker is currently insured if they have earned at least six quarters of coverage within the 13 quarters (three
years) ending in the quarter they die, are entitled to disability benefits, or qualify for retirement benefits. A quarter
of coverage is any three months ending on March 21, June 30, September 30, or December 31. The status is
essential for certain survivor and disability benefits.
To obtain fully insured status, a covered worker must accrue 40 quarters of credit, which is approximately 10
years of work. To be considered currently insured and eligible for limited survivor benefits, a worker must have
earned six credits during the last 13-quarter period.
Exam Tip!
To receive maximum benefits, the eligible individual must be "fully insured." This means that the eligible person
must have 40 quarters of coverage. In other words, a person must have worked for 10 years to be fully insured.
The minimum requirement for workers under age 24 to obtain "currently insured" status is six credits in the last
three years.
Beginning at age 24, additional credits are required to obtain "currently insured" status based on the worker’s age
at the time of disability.
Forty credits (fully insured status) are required to obtain disability, retirement, premium-free Medicare Part A
benefits, and eligibility for Medicare Part B.
[4] CALCULATING SOCIAL SECURITY BENEFITS
Social Security benefits are designed to provide financial support based on a worker's lifetime contributions to
the system. Before understanding how benefits are calculated, it is essential to know that a person must be
"insured" under the program to receive any benefits.
Once insured status is established, the Social Security Administration (SSA) uses a three-step process to
determine benefit amounts:
1. Average Indexed Monthly Earnings (AIME)
• Calculated based on lifetime earnings during working years
• Earnings are indexed for inflation to reflect current economic standards
• Higher lifetime earnings result in higher benefits
2. Primary Insurance Amount (PIA)
• This is the basic benefit amount before any adjustments
• Based on the worker's AIME
• Represents the benefit amount at full retirement age (FRA)
3. Benefit Adjustment Based on Claiming Age, or when a person starts receiving benefits:
• Early Retirement (ages 62-66):
o Can claim as early as age 62
o Benefits are permanently reduced based on the months before FRA
o Maximum reduction at age 62 is 30% of PIA
• Full Retirement Age (age 67):
o Receives 100% of PIA
 o No reduction or increase in benefits
o Benefits begin on the first day of the month reaching FRA
• Delayed Retirement (ages 67-70):
o Benefits increase 8% per year (2/3 of 1% monthly)
o Maximum benefit at age 70 is 124% of PIA
o No additional increases after age 70
[4.1] SOCIAL SECURITY BENEFITS BASED ON AGE
Age Reduction Receives
62 30% 70% of PIA
63 25% 75% of PIA
64 20% 80% of PIA
65 13.3% 86.7% of PIA
66 6.7% 93.3% of PIA
67 (FRA) No reduction 100% of PIA
68 8% increase 108% of PIA
69 16% increase 116% of PIA
70 24% increase 124% of PIA
It is worth noting that the system was not always like it is today. Social Security has evolved since its
inception, with one of the most significant changes being the gradual increase in the full retirement
age (FRA), which was initially set at 65. FRA remains at 65 for anyone born before 1938. One’s FRA gradually
increases depending on the year of one’s birth until 1960. Anyone born in 1960 or later has an FRA of 67. This
change reflects increasing life expectancies and the program's need to remain financially sustainable.
The decision on when to begin benefits is highly personal and depends on factors such as health, financial
needs, retirement plans, and estimated life expectancy. While starting early provides income sooner, the
permanent reduction in benefits means significantly lower monthly payments throughout retirement.
Conversely, delaying benefits requires waiting, but rewards patience with substantially higher monthly
payments for life.
[4.1.1] A SOCIAL SECURITY BENEFITS SCENARIO: EARLY VS. DELAYED RETIREMENT
David and James Thompson are identical twins turning 62 this year, with a full retirement age of 67. Both ave
similar work histories and PIAs of $2,000, but they're making different retirement choices.
David's Decision:
Plans to retire at 62
Reasons: Health concerns and desire to spend time with grandchildren
Monthly benefit: $1,400 (30% reduction)
Considerations:
Permanent reduction in benefits
Still subject to earnings test if working
James's Decision:
Plans to work until 70
Reasons: Enjoys his job and wants maximum benefits. No current health concerns.
Monthly benefit: $2,480 (24% increase) – Considerations:
Higher monthly income for life
No earnings test concerns
Larger survivor benefit for spouse
Key Learning: This scenario illustrates how personal circumstances influence retirement timing and the long -
term impact of benefit claiming decisions.
[4.2] THOSE WHO ARE NOT ELIGIBLE
Social Security offers coverage to virtually every American who is employed or self-employed, with a few
exceptions. Those who are not offered coverage include:
• Most federal employees who were hired before 1984 and are covered by Civil Service Retirement or
another similar plan
• Approximately 25% of state and local government employees who are covered by a state pension
program and elect not to participate in the Social Security Program
• Railroad workers who are covered under a separate federal program, the Railroad Retirement
program
Individuals who are actively contributing to the Social Security program through FICA taxes are considered
covered. Coverage does NOT guarantee benefit eligibility. Each Social Security benefit has requirements that
must be met to receive benefits.
[5] TYPES OF SOCIAL SECURITY BENEFITS
With a solid understanding of who qualifies for Social Security and how benefits are calculated, we can now
explore the specific types of benefits available through the program. This section examines the three primary
categories of Social Security benefits—retirement, disability, and survivors' benefits—as well as Medicare
coverage.
Each benefit type serves a distinct purpose in providing financial security, but they are interconnected
through the concepts we have already discussed. For instance, the PIA serves as the basis for calculating all
benefits, while insured status determines eligibility for each type.
As you study this section, you will notice that each benefit has its own unique eligibility requirements, waiting
periods, and calculation methods. Understanding these distinctions is crucial because your future clients
will often be eligible for multiple benefits but may only be able to receive one. You'll need to help them
navigate these choices and understand how factors such as age, disability onset, or death of a wage earner
affect their benefit options.
[5.1] SOCIAL SECURITY RETIREMENT BENEFITS
Retirement benefits provide a monthly retirement income to covered retired workers, their spouses, and
other eligible dependents. Fully-insured workers who reach their FRA are entitled to a monthly retirement
income for the remainder of their lives.
As previously discussed, the retirement income paid to a person who retires at their FRA is based on their
PIA. The retirement income paid by Social Security begins on the first day of the month in which an eligible
individual reaches their FRA, or their chosen retirement age if claiming early or delayed benefits.
One’s retirement income is not paid automatically when a retiree reaches their FRA. The recipient must apply
to receive the monthly income. It is recommended that one apply three months before the date one desires
benefits to begin. All other OASDI/Social Security benefits are also based on the PIA amount.
Age % of PIA Special Notes
62 70% Permanent reduction (30% less than the FRA benefit)
67 (FRA) 100% Full benefits for those born in 1960 or later
70 124% Delayed retirement credits (8% per year increase)
[5.1.1] RETIREMENT EARNING LIMIT
When someone reaches retirement age, there is no limitation or restriction on the amount of income they can
earn from any employment. Suppose an individual decides to begin receiving retirement income before
reaching FRA. In that case, there is a cap on how much that person can earn without reducing the retirement
benefit to which they are entitled. This limit is referred to as the earnings test. The earnings cap is adjusted
annually.
• Individuals who are below the FRA for the entire year are assessed a benefit reduction of $1 for every
$2 they earn above the annual limit.
 • Individuals who reach FRA during the year are assessed a benefit reduction of $1 for every $3 they
earn above a different limit. Only earnings up to the month before they reach FRA count, not earnings
for the entire year.
• An individual collecting retirement benefits at FRA is still allowed to work, and there is no longer any
reduction or offset of Social Security benefits.
[5.1.2] DUAL BENEFIT LIABILITY
In some cases, an individual is eligible for two retirement income benefits; however, they’re only allowed to
collect one. For example, if a surviving spouse reaches their full retirement age, they’re now eligible for a
retirement income benefit. However, they’re also entitled to their deceased spouse’s benefit. Since both
cannot be collected, the surviving spouse will select the greater of the two.
[5.2] SOCIAL SECURITY DISABILITY BENEFITS
Individuals are eligible for Social Security disability benefits based on their employment history. Benefits are
only available to workers who are fully insured, as defined by Social Security, at the time of their disability.
There is a five-month waiting period. Benefits begin after the eligible individual has been disabled for five
months. Benefits begin to accrue in the sixth month and are paid after the end of that month. A worker
disabled at the beginning of March would complete their waiting period at the end of July and receive their
first check in August.
[5.2.1] DEFINITION OF DISABILITY
Under Social Security, disability means an employee cannot engage in any occupation due to a condition that
either:
Is expected to result in death, or
Will last continuously for at least 12 months
The impairment must be severe enough to prevent the individual from performing any substantial gainful work
available in the national economy, regardless of local job availability.
Once a worker is eligible, the five-month waiting period must be satisfied before benefits are payable.
Therefore, monthly benefit payments begin at the end of the sixth month.
Remember, the minimum requirement for workers under age 24 to obtain "currently insured" status is six
credits in the last three years. Beginning at age 24, additional credits are required to obtain "currently
insured" status based on the worker’s age at the time of disability.
Exam Tip!
Key Disability Requirements – Commonly Tested!
Must be fully insured
Must have 20 of 40 quarters immediately before disability
Five-month waiting period
Must be total disability (not partial)
Must last 12 months or result in death
[5.2.2] SCENARIO: DISABILITY BENEFITS IN ACTION
Maria's Journey
Maria, age 45, is diagnosed with a severe medical condition:
• Previously earned $60,000 annually as an accountant
• Has 25 years of work history (100 quarters)
• Cannot perform any substantial work
Timeline of Events:
• January 1: Stops working due to a condition
• January 15: Files disability claim
• June 1: Completes five-month waiting period
• June 15: First benefit payment received
Lessons Illustrated:
• Importance of meeting both fully insured and recent work requirements
 • How the waiting period works in practice
• Value of having private disability insurance for the waiting period
[5.3] SOCIAL SECURITY DEATH AND SURVIVOR BENEFITS
Social Security survivor benefits or death benefits consist of two parts: a one-time lump-sum death benefit
and, in qualifying cases, monthly income payments to survivors of deceased covered workers. To qualify for
full benefits, a worker must be "fully insured." For limited benefits, a worker must be "currently insured" and
have earned at least 6 credits in the 13 quarters before death. Also, it should be noted that the family
maximum benefit limit may reduce individual payments when multiple beneficiaries are receiving benefits on
the same worker's record.
[5.3.1] LUMP-SUM DEATH BENEFIT
The lump-sum death benefit of $255 is paid only to:
A surviving spouse who was living with the deceased at the time of death, or
A surviving spouse or child who is eligible for monthly benefits based on the deceased's record
Exam Tip!
The $255 lump-sum death benefit amount and its specific eligibility requirements are frequently tested.
In addition to the lump-sum death benefit, Social Security provides eligible survivors with a monthly income
based on the deceased worker's PIA.
[5.3.2] SURVIVOR BENEFITS
The benefit amounts vary by beneficiary type:
Surviving Spouse: A surviving spouse can begin receiving reduced benefits as early as age 60. The following
benefit provisions apply:
Benefits are reduced if taken before full retirement age (age 67 for those born in 1960 or later)
Surviving spouses receive 100% of the deceased worker's PIA if benefits start at FRA
Surviving spouses only receive approximately 71.5% of PIA if benefits start at age 60
Surviving spouses can receive benefits at any age if they are caring for children of the deceased who are
under the age of 16
Children: Children of a deceased worker receive 75% of the worker’s PIA if the children are:
Under age 18, or
Under age 19 if a full-time high school student, or
Any age if disabled before age 22 and remains disabled
Dependent Parents: Dependent parents of a deceased worker may be eligible under the following
conditions:
The parents must be age 62 or older
They must have received at least 50% support from the deceased worker
Each eligible parent receives 75% of the worker’s PIA
If only one parent is eligible, the benefit increases to 82.5% of PIA
[5.3.3] MAXIMUM FAMILY BENEFIT
There’s a limitation when several family members are eligible for Social Security benefits. Similar to the PIA,
Social Security establishes a maximum family benefit for every level of average earnings.

[5.3.4] SURVIVOR BENEFIT BLACKOUT PERIOD

The Social Security blackout period describes that period following an insured’s death during which a
surviving spouse is ineligible for survivor benefits. Spousal survivor benefits are paid when a surviving spouse
is caring for minor children. Spousal benefits during the dependency period end when the youngest child
turns 16 years of age. The blackout period begins at this time, and ends when a surviving spouse reaches at
least 60 years of age and can apply for their own monthly survivor benefit.
Please note that the blackout period does consider any survivor benefits paid directly to surviving dependent
children. These benefits paid to children continue until age 18. They extend to age 19 if the surviving child is
still in high school.
Exam Tip!
Blackout Period Timeline – Frequently Tested!
• Starts: When the youngest child turns 16
• Ends: When the surviving spouse reaches 60
Remember: Children continue receiving benefits until age 18
[5.3.5] SCENARIO: FAMILY BENEFITS AFTER LOSS
The Martinez Family Situation
Robert Martinez passed away at the age of 50:
• PIA: $2,200
• Survivors:
o Wife Elena (age 48)
o Daughter Sofia (age 14)
o Son Miguel (age 16)
Benefit Distribution:
• Elena: Eligible for mother's benefits while caring for children under 16
• Sofia: Eligible for benefits until age 18 (or 19 if still in high school)
• Miguel: Benefits stop at age 18 unless disabled
• Family maximum applies
Timeline of Changes:
• Initial benefits begin
• Miguel's benefits end at 18
• Elena enters a blackout period when Sofia turns 16
• Sofia’s benefits end at 18
• Elena becomes eligible again at age 60 for widow's benefits, and the blackout period ends.
[6] CHAPTER SUMMARY
In this chapter, we've explored the Social Security system and its role in providing financial protection to
American workers and their families. We began by examining the program's fundamental characteristics,
including its purpose as a supplement to personal financial planning rather than a complete solution, and
how it's funded through FICA payroll taxes shared by employers and employees.
We then explored the critical concepts of "fully insured" and "currently insured" status, which determine
eligibility for different benefits. You learned that fully insured status (requiring 40 quarters of coverage)
unlocks retirement, disability, and full survivor benefits, while currently insured status (requiring six quarters
in the last 13) provides limited survivor benefits.
The chapter detailed how Social Security calculates benefits using the Primary Insurance Amount (PIA) and
how claiming age significantly impacts retirement benefits—with early retirement reducing benefits by up to
30% and delayed retirement increasing them by up to 24%. We examined the strict definition of disability
under Social Security and the five-month waiting period before benefits begin.
Finally, we covered survivor benefits, including the $255 lump-sum death benefit and monthly payments to
eligible family members. We also discussed the blackout period—that challenging time when a surviving
spouse may be ineligible for benefits after their youngest child turns 16 until they reach age 60.
Understanding these Social Security provisions is essential for helping clients integrate this government
program into their broader financial planning strategy. While Social Security provides valuable protection, it
works best when complemented by personal savings, investments, and appropriate insurance coverage.
[6.2] REVIEW NOTES – SOCIAL SECURITY
Learning Objective 1: Explain the purpose and fundamental characteristics of the Social Security
system
Key Concepts:
• Provides basic protection against financial problems from death, disability, and aging
• Social Security supplements, but does NOT replace personal financial and insurance programs
 • Many Americans mistakenly believe Social Security will cover all financial needs
Important Terms:
• OASDI: Old Age, Survivors, and Disability Insurance (official name for Social Security)
• Social Security Act: Created the Social Security program
• PIA: Primary Insurance Amount (basic benefit amount at full retirement age)
Learning Objective 2: Describe how Social Security is funded through FICA payroll taxes FICA
Tax Contributions:
• Employers pay: 7.65% (6.2% Social Security + 1.45% Medicare)
• Employees pay: 7.65% (6.2% Social Security + 1.45% Medicare)
• Self-employed pay: 15.3% (12.4% Social Security + 2.9% Medicare)
Key Points:
• The Social Security portion of FICA taxes has a taxable wage base (maximum cap)
• The Medicare portion of FICA has no wage cap
• Benefits may be subject to federal income taxation
• 15% of all Social Security benefits are always 100% income tax-free
Learning Objective 3: Differentiate between "fully insured" and "currently insured" status and their
eligibility requirements
Insured Status Types:
• Fully Insured: 40 quarters of coverage (10 years of work)
• Eligible for retirement, disability, Medicare, and survivor benefits
• Required for most Social Security benefits
• Currently Insured: Six quarters of coverage earned in the last 13 quarters (3 years)
• Eligible for limited survivor benefits only
Special Rules:
• "20/40 rule" for disability: Workers age 31+ need 20 quarters in the last 40 quarters
• Workers under age 31 have less restrictive disability qualification rules
• Quarter of coverage: Any three months ending March 31, June 30, September 30, or December 31
Learning Objective 4: Calculate how retirement benefits are affected by claiming age
Benefit Calculation Process:
• Average Indexed Monthly Earnings (AIME): Based on the highest 35 years of earnings
• Primary Insurance Amount (PIA): Basic benefit amount at full retirement age
• Benefit adjustment based on claiming age
Retirement Age Options:
• Early Retirement (age 62): 70% of PIA (30% reduction)
• Full Retirement Age (age 67 for those born 1960 or later): 100% of PIA
• Delayed Retirement (up to age 70): 124% of PIA (8% annual increase)
Earnings Test:
• Below FRA: $1 reduction for every $2 earned above the annual limit
• Year reaching FRA: $1 reduction for every $3 earned above a different limit
• At or above FRA: No earnings limitation
Learning Objective 5: Identify the eligibility requirements and waiting periods for Social Security
disability benefits
Disability Requirements:
• Must be fully insured
• Must have 20 of 40 quarters immediately before disability
• Five-month waiting period (benefits begin in the sixth month)
• Must be total disability (not partial)
• The condition must last 12 months or result in death
Definition of Disability:
 • Unable to engage in any substantial gainful activity
• Medical condition expected to last at least 12 months or result in death
• Impairment prevents performing any work in the national economy
Learning Objective 6: Explain the types of survivor benefits available and who qualifies for each
Death Benefits:
• Lump-sum death benefit: $255 (paid to surviving spouse living with deceased or eligible child)
• Monthly survivor benefits based on the deceased worker's PIA
Benefit Amounts by Beneficiary:
• Surviving Spouse:
o 00% of PIA if benefits start at FRA
o 71.5% of PIA if benefits start at age 60
o Any age if caring for a deceased's child under 16
• Children: 75% of PIA if under 18 (19 if a full-time student) or disabled before 22
• Dependent Parents (age 62+): 75% each or 82.5% if only one parent
Eligibility Requirements:
• Full benefits: Workers must be fully insured
• Limited benefits: Workers must be currently insured
Learning Objective 7: Recognize situations where the Social Security blackout period applies to
surviving spouses
Blackout Period:
• Starts: When the youngest child turns 16
• Ends: When the surviving spouse reaches age 60
• Children's benefits continue until age 18 (19 if still in high school)
Other Important Concepts:
• Maximum Family Benefit: Limits total benefits paid to a family
• Dual Benefit Liability: Eligible individuals can only collect one benefit (the greater amount)
Exam Tips:
• Know FICA tax percentages (7.65% each for employer/employee, 15.3% for self-employed)
• Remember the $255 lump-sum death benefit amount
• Understand the difference between fully insured (40 quarters) and currently insured (6 in the last 13)
• Know disability requirements (5-month waiting period, total disability, 12+ months)
• Memorize benefit percentages at different retirement ages (70% at 62, 100% at 67, 124% at 70)
• Know blackout period timing (starts at child's age 16, ends at spouse's age 60)
Remember:
• Social Security supplements, but does not replace personal financial planning
• The timing of benefit claims significantly impacts monthly payment amounts
• Each benefit type has unique eligibility requirements and calculation methods
• Family maximum benefit may reduce individual payments when multiple beneficiaries exist
Chapter 13
[1] HEALTH AND ACCIDENT INSURANCE INTRODUCTION
Imagine waking up with severe abdominal pain that requires immediate medical attention, or spraining your
ankle during a weekend hike. Without proper insurance coverage, these unexpected events could lead to
significant financial strain. Health and accident insurance serves as your financial safety net when life's
unpredictable health challenges arise.
In this chapter, we'll explore the diverse world of health and accident insurance —a field that encompasses
far more than just medical expense coverage. You'll discover how these policies protect individuals from the
economic impact of illness and injury through various coverage types, from disability income to dental care.
Whether you're new to insurance concepts or building on existing knowledge, understanding the
fundamentals of health and accident insurance is essential for anyone preparing for a career in insurance.
The policies we'll examine represent crucial financial tools that help people maintain their quality of life
when facing health challenges. As we navigate through different policy types, coverage structures, and
limitations, you'll gain the knowledge needed to recognize how these insurance products address specific
client needs and circumstances.
This chapter is broken into the following sections:
• Health and Accident Insurance Overview
• Covered Perils
• Covered Losses
• Classes of Health Insurance
• Limited Insurance Policy Types
• Dental Insurance
[1.1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
• Distinguish between the key perils covered by health and accident insurance (accidents and
sickness)
• Identify the five major types of losses addressed by health and accident insurance
• Compare individual versus group health insurance contracts and their key differences
• Differentiate between private insurance and government insurance programs
• Explain the distinction between comprehensive and limited health insurance policies
• Categorize various types of limited insurance policies and their specific purposes
• Describe the structure, coverage levels, and specialties within dental insurance plans
[1.3] KEYWORDS: HEALTH AND ACCIDENT INSURANCE
Accidental Bodily Injury (Accidental Result): This is another way to say, “accidental result." It stipulates that
if an action results in an injury, that injury must be unexpected and unintended for any claim to be covered,
even if the act that caused the injury was intended, even though the result was not.
Accidental Means: This is a more restrictive definition of an accident, requiring the cause to be unforeseen,
unexpected, and unintended, as well as any resulting loss or harm.
Capital Sum: The capital sum is the amount payable (lump-sum) for accidental loss of sight or accidental
dismemberment, under the terms of an accidental death and dismemberment (AD&D) policy.
Decreasing (Term) Disability Insurance: In the disability market, this type of insurance is described as
disability credit insurance. The contract's end date is fixed, and in the event of disability, the policy pays the
monthly premium due. The insurer’s exposure decreases as the total amount due to the creditor decreases
with each loan payment.
Elimination Period: This is the waiting period that starts at the beginning of a covered disability or long -term
care claim. Benefits begin after the elimination period ends. This period functions similarly to a deductible,
expressed in time rather than money.
Endodontics: This dental specialty performs root canals and treats the diseases affecting a tooth’s pulp.
Formulary: This is the list of specific medications covered by a prescription drug plan.
Morbidity: Morbidity is the probability or risk of becoming ill or disabled.
Oral Surgery: This dental specialty includes tooth extraction and other surgical treatments.
Orthodontics: This dental specialty corrects teeth alignment with devices such as braces and retainers.
Periodontics: This is a dental specialty focused on the diagnosis, treatment, and prevention of gum diseases.
Predetermination of Benefits: This is a review process conducted to determine whether proposed services
are medically necessary and covered under the policy. It also determines the approved amount and the
patient’s financial responsibility, but it does not authorize the procedure.
Prosthodontics: This dental specialty provides dentures to replace missing teeth and other artificial dental
devices.
Principal Sum: This is the death benefit payable under the terms of an AD&D policy.
[2] HEALTH AND ACCIDENT INSURANCE OVERVIEW
The term "health insurance" encompasses a wide variety of insurance types designed to protect insureds
against various risks. The phrase "health and accident insurance" refers to a broad range of policies that
cover the economic costs of various losses affecting an individual’s physical and mental health, well-being,
and ability to perform effectively. In short, accident and health insurance indemnifies individuals for losses
resulting from injuries and illnesses.
"Health and accident insurance" can be referred to as health insurance, accident and health insurance,
accident and sickness insurance, or sickness insurance. We sometimes refer to it as medical insurance, but
medical expense and hospital insurance are only one type of coverage. The wid e variety of health and
accident coverages includes disability income insurance, accident-only insurance, dental expenses, long-
term care, home health care, vision care, and a range of limited or specialized health exposures (e.g., a
cancer-only policy).
The goal of all health and accident policies is to indemnify the insured. Given the variety of policies
categorized as "accident and health insurance," the term "indemnity" can and does take on more than one
technical meaning. Depending on the type of insurance being described, the term can be used in two
different ways:
When describing medical and dental insurance, the term "indemnity plan" refers to a traditional contract that
reimburses the policyholder for covered expenses.
When describing disability insurance, long-term care insurance policies, and hospital (income) indemnity
plans, the phrase refers to a flat dollar amount paid periodically. In the case of hospital indemnity and long -
term care policies, this flat dollar amount is paid regardless of costs.
EXAM TIP!
When answering exam questions, pay attention to context to correctly apply technical definitions.
Health insurance can be classified by who is covered, who provides the coverage, and the extent of the
coverage provided. Policies may cover individuals, families, or groups, and vary in terms of their scope and
specificity. The government is a significant source of coverage, alongside private insurers.
[2.1] COVERED PERILS
Regardless of the losses they cover, all health and accident policies address the same, broadly defined
causes of loss or perils, accidents and sickness. The risk of loss due to illnesses or accidents is commonly
referred to as morbidity.
[2.1.1] ILLNESS (SICKNESS OR DISEASE)
The probability or risk of getting an illness or becoming disabled (whether due to an accident or disease) is
morbidity. Although a sickness (or illness) can be considered an internal occurrence, it becomes obvious. It
may have a sudden onset or develop over time. Illnesses include both acute infections and chronic
conditions. In some cases, an illness results from ongoing exposure to substances or conditions at a
person’s place of employment, which are considered occupational diseases.
[2.1.2] ACCIDENTS
An accident is an unintended occurrence caused by an external source that results in a loss or harm. An
accident is fixed in time and space. To be covered, an accident (i.e., the resulting loss) must be unintended.
The definition of a covered loss excludes a loss intentionally caused by a deliberate act.
[[Link]] ACCIDENTAL BODILY INJURY OR ACCIDENTAL RESULTS
Most policies use the less restrictive definition of an accident, which is based on accidental bodily injury (or
accidental result), requiring only that the injury resulting from an accident be unintentional. This is the
commonly accepted, legally valid definition currently in use.
[[Link]] ACCIDENTAL MEANS
Policies that base their benefit payments on the accidental means definition of an accident require that both
the cause and the result of an accident be unintentional.
For example, let us assume Robert is covered by an accident policy, voluntarily jumps to the ground from a
questionable but reasonable height, and suffers an injury. The insured’s policy will pay the requisite benefit if
his contract uses the "results" definition of an accident because the act that caused the injury was voluntary,
but the injury was not intentional. If the insured’s coverage had used the "accidental means" definition, it
would pay no benefit because he voluntarily performed the action (i.e., made the jump) that resulted in the
injury. The accidental means restriction holds regardless of whether the insured intended to hurt himself.
[2.2] COVERED LOSSES
At least five distinct categories of loss are covered among the various health insurance types: medical
expense, disability, dental expense, accidental injury, and long-term care.
Type of Coverage Losses Covered
Insurance
• Hospital, surgical, and physician
Medical Expense Reimbursement insurance expenses
• Outpatient care
• Income lost due to a disabling
Disability Income replacement insurance
disease or injury
• Diagnostic and preventive treatment
Dental Insurance Health expense coverage • Regular dental care
• Care necessitated by accidents
• Physical loss of function
Care for individuals who have lost the ability
Long-Term Care • Senile dementia, Alzheimer's, or
to complete daily tasks
Parkinson's disease
Accident • Accidental death and
Benefits for injuries in accidents
Insurance dismemberment (AD&D)

[2.2.1] MEDICAL EXPENSE INSURANCE

Medical expense insurance provides coverage for the costs of medical care by reimbursing the insured,
either fully or partially. These contracts are a form of reimbursement insurance that covers one or more types
of loss.
It is challenging to assess the relative importance of different types of insurance; however, it is reasonable to
consider that a health insurance program should begin with sufficient medical expense insurance. Even basic
medical care can significantly deplete an individual's savings without adequate coverage for potential
medical costs.
Currently, most Americans have coverage through a major medical policy or a service plan (e.g., an HMO).
Policyholders are often concerned about the cost of their health insurance and may need to adjust their
finances.
For example, a major medical plan with a $500 individual deductible will cost more than comparable
coverage with a $2,500 individual deductible. A policy with an 80/20 coinsurance provision will cost more
than a similar plan with a 75/25 coinsurance provision. Ultimately, the policy owner must answer this
question: "How willing am I to assume more of the cost of future claims in exchange for the definite cost
savings offered by a plan with a higher deductible or coinsurance limit?"
[2.2.2] DISABILITY INSURANCE
Effective financial planning must include the risk of income disability. Disability insurance, also known as
income replacement insurance, covers the loss of one’s ability to earn an income due to illness or injury. It
provides guaranteed weekly or monthly payments when wages are lost.
Many individuals mistakenly rely on Social Security to replace their income in case of a disability.
Unfortunately, Social Security has a narrow and strict definition of "disability," for which many do not qualify.
Additionally, it often fails to meet all needs. Because of these considerations, Social Security should be
considered a secondary source; personal disability insurance plans, whether group or individual policies,
should be the primary source of income in the event of disability.
Policy owners can manage premium costs by accepting a longer elimination (waiting) period before
benefits begin. These elimination periods act as a “time-deductible” rather than a monetary one.
Due to the favorable tax treatment given to individually funded disability income policies (benefits are
income-tax-free), a plan provides only a percentage of a person’s pre-disability gross earnings. Policies
typically cap benefits at 60% to 70% of gross earnings. Policies provide enough for essentials without
eliminating one’s incentive to return to work.
For example, an individual who earns $3,000 per month may only take home $2,000 after taxes.
Consequently, a disability plan may provide a monthly benefit, tax-free from federal income tax, equal to
$1,800. Such an amount could be sufficient.
[2.2.3] OTHER LOSSES
[[Link]] LONG-TERM CARE
Long-term care insurance covers the cost of caring for individuals who lose the ability to perform daily tasks
necessary for independent living. The loss may be physical or cognitive, but it is always the result of an
organic cause; therefore, long-term care insurance covers senile dementia, Alzheimer’s disease, and
Parkinson’s disease, but not anxiety or depression, which are considered psychological conditions.
Insurance policies help cover the cost of supportive services that help the insured achieve the best possible
quality of life while coping with a chronic condition that may have no cure.
[[Link]] DENTAL INSURANCE
Dental insurance is specialized health insurance that covers diagnostic and preventive treatments. It pays for
regular dental care and care necessitated by accidents. It is generally written on a group basis and subject to
a deductible and coinsurance. Many dental plans provide preventive care, for which there is often no
deductible. Coverage limitations and exclusions for certain types of treatment are also included, as is an
annual benefit limit that is often less than $2,000.
[[Link]] ACCIDENT INSURANCE
Accident insurance provides a benefit when an insured is injured in an accident, whether on or off the job.
Accidental death and dismemberment (AD&D) insurance is a common type of accident insurance. It is
offered as a standalone plan, part of a group plan, or as a rider added to other types of insurance. AD&D
policies pay lump-sum benefits in the event of accidental death or accidental dismemberment.
[[Link]] OTHER LIMITED COVERAGES
Other limited policies may address the cost of hospital care or the financial impact of certain diseases.
3] CLASSES OF HEALTH INSURANCE
The "class" of insurance is another way to categorize various health insurance policies. Different policies
have varying requirements, depending on how they define risk and the structure of the contract. Let’s
examine the following sets of class distinctions:
• Individual versus group contracts
• Private versus government insurance
• Limited risk versus comprehensive policies
[3.1] INDIVIDUAL VERSUS GROUP CONTRACTS
Commercial insurers and service organizations issue individual health insurance policies as contracts
between an insured and the company. Although all companies have standard policies for the coverages they
offer, most allow individuals to select various options or benefit levels that best meet their needs. Individual
health contracts require an application, and the proposed insured must typically provide evidence of
insurability. Once issued, the policy has an "effective date," which is the start date of the health insurance
coverage.
Group insurance differs from individual plans in terms of contract structure, costs, premium payments, and
eligibility requirements. They are accessible to employers, trade and professional associations, labor unions,
credit unions, and other organizations. The contract is between the insurer and the group, with standardized
coverage options for individuals. Premiums depend on the group's risk, which may be assessed using the
group's claim history (known as experience rating and used for large groups) or the risk level in the
surrounding community (known as community rating and used for small group plans).
Additionally, group insurers must comply with supplementary state and federal regulations, such as the
Consolidated Omnibus Budget Reconciliation Act (COBRA). COBRA provides employees and their families
with extended but duration-limited coverage following employment termination. Due to the single monthly
billing per group sponsor, administrative charges for group policies are lower than those for individual
policies.
[3.2] PRIVATE VERSUS GOVERNMENT INSURANCE
Consumers purchase most forms of accident and health insurance through private insurers, including
commercial insurance companies, service providers, and provider groups. Private insurance sources also
include self-insured employers and associations.
Consumers purchase most forms of accident and health insurance through private insurers, including
commercial insurance companies, service providers, and provider groups. Private insurance sources also
include self-insured employers and associations.
Health insurance is also provided through state and federal government programs, often referred to as social
insurance. Medicare, Medicaid, and Social Security are the three primary government health programs:
• The federal government created Medicare to provide medical expense coverage for seniors and those
with severe disabilities
• Medicaid, jointly funded by states and the federal government, provides services to low-income
individuals who meet financial eligibility requirements. The federal government defines the Medicaid
program standards, and states administer these standards with approved state-specific variations
• Social Security provides disability insurance for those unable to be gainfully employed
In addition, the Affordable Care Act (ACA) created state-based and state-administered health insurance
exchanges (marketplaces) for the individual and small group market. Only qualified health benefit plans that
meet specific criteria can be sold in the exchange.
[3.3] COMPREHENSIVE VERSUS LIMITED POLICIES
Although the word "comprehensive" has several meanings, it is used here to describe the breadth of
coverage that is provided. Comprehensive policies tend to be "open-peril" policies. In other words, they
cover a broad range of losses and exclude only those expressly excluded by the policy. Comprehensive
policies also cover a wide range of services.
For example, a private disability income policy covers loss of income resulting from an accident or illness. It
covers losses that occur both at work and at home. Major medical insurance covers most recognized
medical treatments unless they’re expressly excluded. Major medical doesn’t distinguish between accidents
and illness, nor does it restrict reimbursements to those services provided by certain classes of health
practitioners.
Limited policies often cover only a few or only one type of loss. Some limited contracts only cover specific
perils, such as accident policies or cancer insurance. Other policies limit coverage by the benefit amount
(e.g., basic medical expense insurance). Policies such as basic surgical contracts and prescription drug
plans define benefits in terms of specific procedures or particular needs. Still, other contracts limit insurance
protection to particular circumstances such as hospital indemnity plans and blanket insurance.
For example, an aviation policy provides benefits for accidental death or dismemberment if death or injury
results from an aviation accident during a specified trip. Travel accident insurance covers most travel
accidents on airplanes or bus lines, but only for a specified period.
A common thread runs through all these types of insurance; they cover a specified set of perils, losses, or
circumstances. Each policy form lists what it covers. If a potential cause or type of loss is not enumerated on
a given limited insurance policy, then the item is NOT covered by that policy. Limited policies often fill in
specific coverage gaps or address exceptional circumstances. The next section of this chapter provides a
detailed discussion of some relevant limited contracts.
Since limited insurance policies restrict coverage to specific perils or limited amounts, state insurance
departments require these policies to provide policyholders with a "Notice to Insured." This notice states
that the contract is a limited benefit policy.
[3.3] COMPREHENSIVE VERSUS LIMITED POLICIES
Although the word "comprehensive" has several meanings, it is used here to describe the breadth of
coverage that is provided. Comprehensive policies tend to be "open-peril" policies. In other words, they
cover a broad range of losses and exclude only those expressly excluded by the policy. Comprehensive
policies also cover a wide range of services.
For example, a private disability income policy covers loss of income resulting from an accident or illness. It
covers losses that occur both at work and at home. Major medical insurance covers most recognized
medical treatments unless they’re expressly excluded. Major medical doesn’t distinguish between accidents
and illness, nor does it restrict reimbursements to those services provided by certain classes of health
practitioners.
Limited policies often cover only a few or only one type of loss. Some limited contracts only cover specific
perils, such as accident policies or cancer insurance. Other policies limit coverage by the benefit amount
(e.g., basic medical expense insurance). Policies such as basic surgical contracts and prescription drug
plans define benefits in terms of specific procedures or particular needs. Still, other contracts limit insurance
protection to particular circumstances such as hospital indemnity plans and blanket insurance.
For example, an aviation policy provides benefits for accidental death or dismemberment if death or injury
results from an aviation accident during a specified trip. Travel accident insurance covers most travel
accidents on airplanes or bus lines, but only for a specified period.
A common thread runs through all these types of insurance; they cover a specified set of perils, losses, or
circumstances. Each policy form lists what it covers. If a potential cause or type of loss is not enumerated on
a given limited insurance policy, then the item is NOT covered by that policy. Limited policies often fill in
specific coverage gaps or address exceptional circumstances. The next section of this chapter provides a
detailed discussion of some relevant limited contracts.
Since limited insurance policies restrict coverage to specific perils or limited amounts, state insurance
departments require these policies to provide policyholders with a "Notice to Insured." This notice states
that the contract is a limited benefit policy.
[4] LIMITED INSURANCE POLICY TYPES
Limited benefit policies can be described as:
• Policies that provide benefits for expenses incurred for an accidental injury only
• Policies that pay fixed-dollar amounts for specified diseases or impairments
• Policies that provide benefits for specified, limited services
• Indemnity and other policies that pay a fixed-dollar amount per day (excluding long-term care
policies)
It is essential to distinguish between limited risk and special risk policies.
• Limited policies cover specific common risks
• Special risk policies cover unusual hazards typically excluded or ignored by ordinary insurance
contracts
For example, a ballet dancer who insures her legs for $1 million and a test pilot who flies an experimental
airplane and obtains a policy covering his life while flying that plane are both purchasing special risk policies.
On the other hand, a traveler who purchases an accident policy at the airport to provide coverage while she is
a passenger on a commercial airline flight is purchasing a limited risk policy.
Each of the following limited insurance policy types addresses a specific set of perils, losses, or
circumstances.
[4.1] ACCIDENT-ONLY
Accidental Death and Dismemberment (AD&D) insurance pays the insured a lump-sum benefit if an
accident results in death or dismemberment. These policies require that an accident must be the sole cause
of the loss for a benefit to be paid. Policies often include a restriction on death benefits that the insured must
die within 90 days of the accident.
In addition, the loss cannot be due to the insured being under the influence of alcohol or narcotics. Some
states may allow the payment of a death benefit even after the 90-day period has elapsed if the insured
suffered from total and continuous disability between the time of the accident and death.
[4.1.1] PRINCIPAL SUM
Under the terms of an AD&D policy, the principal sum refers to the death benefit payable if one’s death
results from an accident. The principal sum is the face amount of insurance purchased and represents the
maximum amount the policy will pay.
[4.1.2] CAPITAL SUM
The capital sum is the amount payable if an insured suffers an accident resulting in permanent loss of
hearing, speech, sight, or a limb. The benefit is a specified amount and is typically expressed as a percentage
of the principal sum (e.g., 50%), but it varies according to the severity of the injury.
For example, the benefit for the loss of one foot or one hand is typically 50% of the principal sum. The benefit
for the loss of one arm or one leg is typically two-thirds of the principal sum. The most extreme losses (e.g.,
both feet or the sight in both eyes) generally qualify for payment of the full benefit, which is 100% of the
principal sum.
Let us assume that an individual has an AD&D policy that pays $50,000 for accidental loss of life and the
same for accidental loss of two limbs or the sight in both eyes. Therefore, $50,000 is the policy’s principal
sum. The same policy pays $25,000 for accidental loss of vision in one eye or dismemberment of one limb.
Therefore, $25,000 is the policy’s capital sum.
EXAM TIPS!
1. When answering exam questions regarding accident insurance policies, assume that losses
that result from complications are excluded.
2. If a test question asks for a time frame within which an accidental loss must occur, assume 90
days.
3. The standard percentage used for the capital sum on an exam is 50%
4. Some policies might award a capital sum for partial loss of a foot or hand
[4.2] LIMITED ILLNESS ONLY
[4.2.1] SPECIFIED (DREAD) DISEASE
Dread disease policies provide limited benefits for a specific disease, such as cancer or heart disease. Policy
benefits are a scheduled, fixed-dollar amount for specified perils or medical procedures, such as hospital
confinement or chemotherapy.
[4.2.2] CRITICAL ILLNESS (SPECIFIED CONDITIONS)
Critical illness contracts pay a lump sum to the insured upon the diagnosis and survival of a critical illness.
Carriers pay these benefits directly to the insured. Insureds can use the benefits to cover non -medical
expenses that often accompany such events or fill gaps in their medical insurance coverage.
Covered conditions typically include heart attacks, strokes, organ transplants, and end -stage renal failure.
Policies may cover other conditions (e.g., Alzheimer’s disease) and conditions that result in the permanent
loss of a person’s eyesight. Some policies require the insured to survive the illness for a specific period (e.g.,
30 days).
[4.3] HOSPITAL INDEMNITY (INCOME)
Hospital indemnity insuranceprovides a steady income from the day an insured is confined to a hospital
until the day they are discharged. While the insured is confined to a hospital, these policies pay a specified
amount on a daily, weekly, or monthly basis directly to the insured (not the hospital). Under the terms of this
policy type, payment is unrelated to the incurred medical expenses and is based solely on the number of
days spent in a hospital. Benefit limits, pre-existing conditions, and elimination periods may be applied
depending on the policy.
[4.4] CREDIT DISABILITY
Credit disability insurance plans protect the lender. If a borrower becomes disabled before their debt is paid
off, credit disability insurance pays the monthly debt payments while the insured is disabled. This type of
coverage is available through banks, finance companies, retailers, or other creditors to cover loans or time-
payment purchases.
The lender or creditor is both the policy owner and the beneficiary. The insured is the debtor, who typically
pays the premiums. A creditor cannot purchase insurance on a debtor without permission. Once
indebtedness is incurred, a certificate of insurance must be issued within 30 days.
If a disability occurs, the policy makes benefits payments directly to the insured’s creditor. Payments will
continue until the insured debtor no longer meets the policy’s definition of disability or the covered debt is
paid in full, whichever comes first.
Credit insurance can be written as an individual insurance policy or under a group plan. Individual and group
credit insurance contracts are similar to individual and group health policies in terms of underwriting,
selection, and proof of insurability. However, group credit insurance requires a minimum number of debtors
each year, and this number varies by state law.
This policy is sometimes referred to as a decreasing or reducing term disability insurance policy.
[4.5] BLANKET INSURANCE (E.G., TEAMS AND PASSENGERS)
Insurance carriers issue blanket health insurance policies to cover group or association members exposed
to the same risks but at different times. The circumstances remain constant, but the group’s composition
(i.e., the individuals within the group) continually changes.
Situations in which blanket health insurance is used include the following:
• A common carrier (e.g., an airline, railroad, or bus company) that covers its passengers,
• A college, school, or other learning institution that covers its students or sports teams, and
• An employer that covers its employees who have exceptionally hazardous working conditions (e.g., a
volunteer fire department covering its firefighters)
As with other group insurance, the group or association is the policy owner, group members (employees,
passengers, or students) are those insured, and individual underwriting is not required. Unlike other types of
group insurance, individuals are not required to enroll, and insurers do not issue certificates of coverage.
Under blanket insurance policies, benefits are paid to insureds, their designated beneficiaries, or their estate.
However, benefits for insured minors may be payable to their parents, guardians, or other individuals who
support them.
[4.6] SHORT-TERM MEDICAL
Short-term medical insurance policies may provide up to 90 days of coverage. They cannot be renewed.
Short-term plans have always been scaled-down versions of major medical insurance policies. Traditionally,
consumers used these plans as interim coverage to bridge gaps between more robust forms of protection.
Today, individuals also use these plans as lower-cost alternatives to individual major medical contracts sold
online through state and federal insurance marketplace exchanges (i.e., plans that comply w ith ACA
standards). In return for a lower premium, insurance buyers must cope with many of the restrictions
eliminated by the ACA in major medical policies..
For example, short-term policies typically place dollar limits on covered benefits and may not cover
outpatient prescription medications. Policies covering prescriptions may also be limited. Some services are
excluded entirely, such as maternity care or treatment for substance abuse and other mental health
ailments.
Finally, these policies may be medically underwritten and may exclude current pre-existing conditions.
Policies that are not medically underwritten may include a pre-existing condition exclusion for unnamed
conditions. The extent to which insurance companies can restrict benefits depends on state law.
[4.7] PRESCRIPTION DRUGS
Prescription drug policies cover the cost of prescription drugs not dispensed in a hospital or extended care
facility. Each plan has a formulary, or a list of specific medications it covers. Formularies categorize drugs by
price class, drug family, and clinical purpose. Typical pharmaceutical classes include generic, brand -name,
and specialty medications.
These plans typically do not cover non-prescription drugs.
Prescription drug plans also exclude appliances, hypodermic needles, or the cost of having a third -party
administer drugs. These plans often exclude medications used to treat sexual dysfunction or infertility unless
state law requires them to do so. Most prescription drug plans require a copayment when a prescription is
filled.
[4.8] HEARING AND VISION PLANS
[4.8.1] HEARING AID COVERAGE
Some private healthcare plans cover the costs of audiological tests and hearing aid evaluations, offering
partial or full coverage for hearing aids.
[4.8.2] VISION CARE
Vision care coverage generally pays for reasonable and customary charges incurred from ophthalmologists
and optometrists during eye exams. Expenses for fitting, other corrective items, or contact lenses or
eyeglasses are often partially covered by insurance. Many plans limit coverage, often allowing for new lenses
annually and eyeglass frames once every two years.
Vision care coverage plans typically exclude safety lenses, cosmetic enhancements, plastic lenses, and
frame upgrades. LASIK surgery is often partially covered, but other necessary eye surgeries and the
treatment for eye diseases are excluded and covered by medical expense plans instead.
[5] DENTAL INSURANCE
Dental insurance is a specialized form of health expense coverage that focuses on diagnostic and
preventive treatment, designed to pay for routine dental care and care necessitated by accidents. It’s
generally written on a group basis and is subject to a deductible and coinsurance.
Though dental insurance is a relatively limited test topic, it receives more attention in many states.
Approximately half of all state exams include one to four questions on this topic, so we will spend a little
more time discussing it.
Many dental plans offer preventive care, as evidenced by the absence of a deductible for routine dental
examinations. Coverage limitations and exclusions for certain types of treatment are also included. Most
dental plans are purchased through groups.
Group dental plans typically operate similarly to individual dental insurance policies, with the added
characteristics of group health underwriting. It’s important to note that group dental policies generally do not
include a conversion privilege, although such policies are subject to COBRA’s continuation rules.
[5.1] TYPES OF DENTAL PLANS
Dental insurance can be divided into three categories: integrated, standalone, or combination plans.
• Standalone plans may be used with any provider. They have separate deductibles and benefit limits,
even if offered as part of an employer group benefit package.
• Integrated plans are offered in conjunction with medical expense coverage. They share the same
provider network and deductible structure. This may result in lower premiums for participants, but
also higher deductibles and out-of-pocket costs.
• Combination plans combine characteristics of standalone and integrated plans. They often have
their own benefit and deductible structures, similar to standalone plans, but may share a network of
providers covered to perform the required services. Basic services may be covered based on what is
usual and customary in a market area, while major services may have a scheduled maximum benefit.
[5.2] TYPES OF PLAN BENEFITS
Dental plans are generally written on an indemnity basis (i.e., reimbursement) and provide consumers with a
choice of providers (i.e., dentists, specialists, etc.). Insureds can assign benefits directly to their providers.
Dental plans define benefits in one of two ways.
[5.2.1] SCHEDULED (BASIC) PLANS
Scheduled plans offer benefits for specific services according to a published schedule. They pay the actual
cost of each listed service up to a stated maximum. The insured is responsible for any amount over the
published maximum benefit. These plans contain no deductibles or coinsurance and provide first-dollar
coverage.
[5.2.2] NON-SCHEDULED (COMPREHENSIVE) PLANS
Non-scheduled plans are the most common type of dental coverage. Unlike scheduled plans, these plans
include deductibles and coinsurance, which vary depending on the level of care provided: preventive,
restorative, or major service.
[5.3] LEVELS OF DENTAL TREATMENT
Non-scheduled plans pay benefits on a usual, customary, and reasonable basis (UCR). These plans generally
divide services into three categories: preventive, basic, and major services.
• Preventive services include periodic teeth cleaning, periodic examinations, and annual X-rays. These
services are usually covered at 100%, often without a deductible.
• Basic services are minor restorative procedures, such as filling of cavities, extracting teeth, and
performing root canals. It can also include treatments for gum disease. Insurers usually cover 80% of
their usual and customary costs up to an annual maximum. Benefits are also subject to a deductible.
• Major services, such as oral surgery and crowns, are also subject to a deductible and an annual
maximum. The insured’s financial responsibility (coinsurance) for such services is typically 50%.
[5.4] DENTAL SPECIALTIES
The following dental specialties may appear on your final exam.
• Oral Surgery – Surgery includes tooth extraction and surgical treatment of injuries, diseases, or jaw
defects.
• Endodontics – Endodontics involves performing root canal treatment and treating dental pulp
diseases within each tooth.
• Periodontics – Periodontic services include treating gum disease and diseases of the tissues
surrounding and supporting teeth.
• Prosthodontics – Prosthodontic services include replacing teeth or providing artificial devices, such
as bridgework or dentures.
• Orthodontics – This specialty focuses on correcting irregularities in the teeth and jaws, using devices
such as braces and retainers.
• Pediatric Dentistry – This specialty provides preventive and restorative services for children and
adolescents.
• Oral Pathology – These specialists perform tissue biopsies to treat oral diseases such as oral cancer.
[5.5] LIMITATIONS
Although dental policies cover routine cleanings and visits, exams, x-rays, protective fluoride treatments,
preventive care, and local anesthetics at 100%, dental plans limit the number of such services that can be
provided each year. They also limit benefits for specialties like orthodontics, with calendar year maximums
or lifetime caps.
Most dental plans require a review of suggested treatments to ensure they are reasonable and necessary.
This procedure is called the predetermination of benefits requirement, pre-certification, or prior
authorization. If services are not pre-certified, they may still be covered; however, the dentist and the insured
will not know the amount of benefits to be approved.
Common dental plan limitations include
Cosmetic procedures, unless it’s due to an accident
Services provided by governmental agencies
Treatment covered by workers’ compensation
Duplicate dentures or the replacement of lost or stolen dentures
Oral hygiene instructions or training
Exotic procedures, such as splinting and restoring occlusion
[6] CHAPTER SUMMARY
Health and accident insurance provides essential financial protection against losses resulting from illnesses
and injuries. Throughout this chapter, we've explored how these policies address different types of losses
and operate within various frameworks.
We began by examining the two primary perils covered—accidents (external events) and sickness (internal
conditions)—and how the risk of these events is known as morbidity. We then explored the five major
categories of losses addressed by health insurance: medical expenses, disability income, dental expenses,
accidental injury, and long-term care.
We also analyzed how health insurance can be classified in multiple ways: individual versus group contracts,
private versus government insurance, and comprehensive versus limited policies. Each classification
provides a different lens for understanding how these policies function and whom they serve.
Limited insurance policies, which cover specific perils or circumstances, received special attention. We
examined various types including accident-only, specified disease, hospital indemnity, credit disability, and
others—each designed to address particular needs or fill coverage gaps.
Finally, we explored dental insurance in detail, including its structure, coverage levels, and specialized areas
of treatment. Understanding the distinctions between standalone and integrated plans, as well as scheduled
and non-scheduled benefits, provides important context for this specialized form of health coverage.
For the exam, it is essential to remember that illness arises from factors within the person, while accidents
are external events. It is important to remember that a covered event, such as a hospital stay, may result
from a variety of causes. When addressing exam questions, focus on the aspect under consideration. If the
issue is a daily benefit or the daily cost of a hospital room, a hospital indemnity plan may be the answer. If the
issue is the disease that caused hospitalization, a critical illness policy may be the answer. It is also
important to recognize the different frameworks for considering these policies. Are they group plans or
individual policies? Are they comprehensive or limited? Who provides the coverage? Commercial insurers or
a government entity?
As you prepare for your licensing exam, remember that health and accident insurance represents a diverse
field of products designed to protect individuals from financial hardship when facing health challenges. By
understanding these various policy types and their specific applications, you'll be better equipped to serve
future clients with appropriate insurance solutions.
[6.2] REVIEW NOTES
Learning Objective 1: Distinguish between the key perils covered by health and accident insurance
Key Concepts:
Health and accident insurance indemnifies individuals for losses resulting from injuries and illnesses
The risk of loss due to illnesses or accidents is called morbidity
Illness (sickness or disease) can have a sudden onset or develop over time
An accident is an unintended occurrence caused by an external source that results in a loss
Important Distinctions:
Accidental bodily injury (accidental result): Only the injury must be unintentional
Accidental means: Both the cause and result of an accident must be unintentional
Learning Objective 2: Identify the five major types of losses addressed by health and accident insurance
Major Loss Categories:
Medical expense: Reimbursement for hospital, surgical, and physician expenses
Disability: Income replacement for lost wages due to disabling disease or injury
Dental expense: Coverage for diagnostic, preventive, and regular dental care
Accidental injury: Benefits for injuries in accidents (including AD&D)
Long-term care: Care for individuals who have lost the ability to complete daily tasks
Key Points:
Medical expense insurance provides reimbursement for healthcare costs
Disability insurance replaces income when unable to work (typically 60-70% of earnings)
Long-term care covers physical or cognitive losses from organic causes
Dental insurance focuses on diagnostic and preventive treatments
AD&D pays lump-sum benefits for accidental death or dismemberment
Learning Objective 3: Compare individual versus group health insurance contracts
Individual Contracts:
Direct contract between the insured and the company
Requires application and evidence of insurability
Customizable options to meet individual needs
Higher administrative costs
Group Contracts:
Contract between insurer and group (employer, association, etc.)
Standardized coverage for group members
Premiums based on group risk (experience rating or community rating)
Lower administrative costs due to single monthly billing
Subject to additional regulations like COBRA
Learning Objective 4: Differentiate between private insurance and government insurance programs
Private Insurance:
Purchased through commercial insurers, service providers, and provider groups
Includes self-insured employers and associations
Government Insurance:
Medicare: Federal program for seniors and the severely disabled
Medicaid: Joint federal-state program for low-income individuals
Social Security: Provides disability insurance for those unable to work
ACA exchanges: State-based marketplaces for qualified health benefit plans
Learning Objective 5: Explain the distinction between comprehensive and limited health insurance policies
Comprehensive Policies:
"Open-peril" policies covering a broad range of losses
Cover a wide range of services
Only exclude what is expressly stated
Limited Policies:
Cover specific accidents, sicknesses, or circumstances
Must specify covered perils and coverage amounts
Only cover what is expressly listed
Require "Notice to Insured" stating limited benefits
Often fill specific coverage gaps
Learning Objective 6: Categorize various types of limited insurance policies

Types of Limited Policies:

Accident-only (AD&D): Pays a lump sum for accidental death or dismemberment

Specified disease: Benefits for specific conditions like cancer
Critical illness: Lump-sum payment upon diagnosis of covered condition
Hospital indemnity: Fixed daily payment during hospital confinement
Credit disability: Makes loan payments durinthe g borrower's disability
Blanket insurance: Covers groups with changing membership (teams, passengers)
Prescription drug: Covers medications based on formulary
Vision and hearing: Covers exams and corrective devices
Short-term medical: Up to 90 days of non-renewable coverage
Important Terms:
Principal sum: Death benefit payable under AD&D policy
Capital sum: Amount payable for accidental dismemberment under AD&D
Formulary: List of medications covered by the prescription drug plan
Learning Objective 7: Describe the structure, coverage levels, and specialties within dental insurance plans
Dental Plan Types:
Standalone: Separate deductibles and benefit limits
Integrated: Shared provider network and deductible with medical coverage
Combination: Features of both standalone and integrated plans
Benefit Structures:
Scheduled (basic): Benefits for specific services according to a published schedule
Non-scheduled (comprehensive): Includes deductibles and coinsurance varying by service level
Coverage Levels:
Preventive services: Cleanings, exams, X-rays (typically 100% coverage)
Basic services: Fillings, extractions, root canals (typically 80% coverage)
Major services: Oral surgery, crowns (typically 50% coverage)
Dental Specialties:
Oral surgery: Tooth extraction and surgical treatments
Endodontics: Root canals and pulp treatment
Periodontics: Treatment of gum disease
Prosthodontics: Dentures and artificial devices
Orthodontics: Braces and alignment correction
Pediatric dentistry: Services for children
Oral pathology: Biopsies and disease treatment
Key Limitations:
Predetermination of benefits is required for many procedures
Annual benefit maximums (often less than $2,000)
Exclusions for cosmetic procedures, governmental services, and exotic procedures
EXAM TIPS
When answering questions about accident insurance policies, assume that losses resulting from
complications are excluded
For accident policies, assume a 90-day timeframe for accidental losses unless otherwise specified
Pay attention to context when interpreting the term "indemnity" - it has different meanings for medical
insurance versus disability insurance
Remember that illness arises from internal factors, while accidents are external events
Focus on the specific aspect of coverage being asked about in questions (e.g., daily benefit vs. cause of
hospitalization)
Know the differences between accidental means and accidental results definitions
Understand that Social Security has a strict definition of disability that many don't qualify for
REMEMBER
Morbidity refers to the risk of illness or disability; mortality refers to death risk
AD&D policies require that an accident must be the sole cause of loss for benefits to be paid
Limited policies require a "Notice to Insured" stating that the contract is a limited benefit policy
Dental plans typically cover preventive services at 100%, basic services at 80%, and major services at 50%
Short-term medical policies cannot be renewed and provide up to 90 days of coverage
Credit disability insurance makes the borrower's loan payments while disabled (the lender is both policy
owner and beneficiary)
Long-term care insurance covers physical or cognitive losses from organic causes, not psychological
conditions
Blanket insurance covers group members exposed to the same risks but at different times
The principal sum in AD&D is the death benefit; the capital sum is the dismemberment benefit
Predetermination of benefits in dental insurance determines if services are medically necessary and covered
Chapter 14
[1] HEALTH INSURANCE PROVIDERS INTRODUCTION
Imagine you've just started a new job, and during orientation, you're handed a packet of health insurance
options. You see terms like "HMO," "PPO," "deductible," and "network provider." For many Americans, this
moment can be overwhelming and confusing. Yet understanding these options is crucial for making informed
decisions about your healthcare.
Today's health insurance landscape features a variety of providers and approaches, each with distinct
advantages and limitations. The days of simple indemnity plans, where you visited any doctor and submitted
bills for reimbursement, have largely given way to managed care systems designed to control costs while
maintaining quality care.
In this chapter, we'll explore the evolution from traditional health insurance to modern managed care
networks. You'll learn how health maintenance organizations (HMOs) coordinate care through primary care
physicians, how preferred provider organizations (PPOs) offer more flexibility with provider choice, and how
point-of-service plans combine features of both. We'll also examine group insurance—the most common
source of coverage for Americans—including how it works, who qualifies, and the regulations that protect
consumers.
In some cases, the distinctions between categories of health insurance providers may seem somewhat
blurred. We will focus on their distinguishing characteristics, as the state exam does.
The chapter is divided into the following sections:
• Traditional Health Insurance Policies;
• Managed Care Definition and Characteristics;
• Managed Care Networks;
• Group Health Insurance Plans;
• Alternative Forms of Group Insurance; and
• Regulations That Apply to Group Insurance.
Please note that this chapter covers the general characteristics of health insurance providers. The state -
specific chapter at the end of your course will detail the specific insurance definitions, rules, regulations, and
statutes for your state. In the event of a conflict, state law will supersede the general content.
[1.1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
• Identify the key differences between traditional health insurance policies and managed care plans
• Explain how health maintenance organizations (HMOs) control costs and deliver healthcare services
• Distinguish between the four main types of HMO structures (staff, group, network, and IPA models)
• Compare the features of preferred provider organizations (PPOs) to other healthcare delivery systems
• Recognize how point-of-service (POS) plans combine elements of HMOs and traditional insurance
• Describe the basic characteristics that define eligible groups for group health insurance
• Differentiate between contributory and non-contributory group insurance plans
• Explain how group health insurance plans are underwritten using experience and community rating
• Identify the alternative forms of group insurance, including MEWAs, METs, and franchise plans
• Summarize the key federal regulations that protect consumers with group health insurance
[1.3] KEYWORDS
Before reading this chapter, please review the following keywords. Understanding these basic definitions will
enhance your comprehension of the chapter content.
Administration Services Only (ASO) Plan: A contract in which a self-funded employee welfare benefit plan
contracts with an insurer for administrative services while remaining responsible for the cost of claims. The
insurer acts as a third-party administrator (TPA).
Blue Cross and Blue Shield: This network of insurance service providers pays participating medical providers
directly for a subscriber’s treatment rather than reimbursing the insured. Blue Cross covers hospital
services, and Blue Shield covers individual health care professionals.
Capitation: This method for compensating health care providers is calculated per patient rather than per
service. Health maintenance organizations (HMOs) pay providers a flat amount per person. If the person
never uses the service, the HMO wastes the capitation fee. If the subscriber heavily utilizes HMO services,
the provider incurs a loss.
Case Management (Utilization Review): The process by which a specialist within a person’s insurer reviews
potentially large claims to discuss treatment alternatives with the insured.
Change of Life Event: A commonly experienced occurrence that tends to cause individuals to buy insurance
that’s unrelated to a specific increase in risk. Marriage, divorce, or the birth of a child are common “change of
life” events.
Certificate of Insurance:This document, provided to group plan participants, confirms coverage under a group
plan. Participants are covered under a single master contract and do not receive separate policies. It is also
called "evidence of insurance."
Closed-Panel Network: A form of HMO in which providers deliver services within HMO facilities
COBRA Group: A group that has 20 or more employees and must comply with COBRA mandates.
Coinsurance: A cost-sharing formula in which subscribers pay a percentage of their medical costs up to an
annual maximum.
Community Rating: A measurement that’s used to project a client’s level of risk. Insurers use it when
underwriting and setting premiums for small-group insurance plans. The insurer bases the client group’s
projected claims experience on the surrounding community’s claims experience and costs.
Concurrent Review: A form of utilization review in which health care is reviewed as it’s being provided. The
reviewer monitors the appropriateness of care, with a focus on cost control.
Consolidated Omnibus Budget Reconciliation Act (COBRA): COBRA mandates that employers provide
employees and their qualified beneficiaries with continuing coverage through the company’s group health
plan following a qualifying event.
Contributory Plan: A group insurance plan in which the employees and the employer share the cost of
coverage.
Conversion Privilege: This privilege allows individuals covered under a group plan to convert their coverage to
individual policies upon termination of their group plan coverage.
Copayment or Copay: A fixed dollar amount that HMO subscribers pay per visit. Unlike coinsurance, the
primary purpose of the copay is to cover administration costs.
Creditable Coverage: Defined by HIPAA as previous coverage under another insurance plan when there has
not been a break in coverage that lasts 63 days or longer. When an individual changes plans, creditable
coverage for pre-existing conditions reduces or eliminates any new waiting period.
Dental Maintenance Organization (DMO): A health maintenance organization for dental services. Dentists
contract with the DMO to provide services at agreed-upon fees. Subscribers have a primary care dentist
(PCD) who manages care and provides referrals. Subscribers are responsible for copays and, in some cases,
coinsurance.
Employee Welfare Benefit Plan: An Employee Retirement Income Security Act of 1974 (ERISA) -compliant
plan that’s funded by employers and provides employees with benefits other than pensions.
Enrollment Period: The limited period during which all members may sign up for a group plan. This period
typically occurs once a year and lasts for a set number of days.
Evidence of Insurability: Proof that a prospective group plan participant is an acceptable medical risk. Group
plans have traditionally required evidence of insurability when individuals attempt to enroll outside of
established enrollment periods, thereby controlling adverse selection.
Exclusive Provider Organization (EPO): A hybrid of an HMO and a preferred provider organization. An insured
has direct access to any in-network provider without a referral, but no coverage is provided for out-of-
network care unless there’s an emergency.
Experience Rating: A measurement that’s used to project a client’s level of risk when underwriting large
group insurance. Insurers use it to help set the premiums for group plans. The insurer bases the client group’s
projected claims experience on the average number and cost of claims in past years.
Extension of Benefits: A provision that allows a covered individual to continue receiving benefits for a
covered claim, even after the individual is no longer eligible for coverage. The extension period may be a fixed
period or may last as long as the claim, depending on the terms of the contract.
Franchise Health Plans (Wholesale Plans): These plans provide health insurance coverage to members of an
association or professional society. Individual policies are issued to individual members, and the association
serves as the plan sponsor. Premium rates are typically discounted for franchise plans.
Group Health Insurance: Insurance for a group of people, often employees of a company, under one master
contract. Group health plans are available to employers, trade and professional associations, labor unions,
credit unions, and other organizations. Insurance is extended to individuals in the group through the master
contract. Group insurance doesn’t require individual underwriting or evidence of insurability.
Group Model HMO (Closed Panel): Under this model, the HMO pays a capitation or predetermined fee to the
provider group, while the group pays the physicians for services provided.
Health Insurance Portability and Accountability Act (HIPAA): A federal law that was passed in 1997, which
guarantees that American workers can transfer and continue health insurance coverage when they change or
lose their jobs. HIPAA has also strengthened privacy protections.
Health Maintenance Organizations (HMOs): An organization that offers comprehensive prepaid health care
services to its subscribing members. HMOs emphasize preventive care but also combine the delivery and
financing of healthcare. Subscribers pay a fixed periodic fee rather than a fee per service.
Indemnity Plans (Major Medical Insurance): Traditional insurance plans that are not involved with organizing
or administering provider networks. Instead, they simply indemnify insureds by reimbursing them for covered
costs in accordance with the policy terms.
Independent (Individual) Practice Association (IPA) HMOs (Open Panel): These HMOs are characterized by a
network of physicians who practice in their own facilities and participate in the HMO on a part -time basis.
Master Contract: A group insurance policy that an insurer issues to the group’s sponsor, who becomes the
master policy owner responsible for premium payments—whether paid by the sponsor, collected from
participants, or a combination of both.
Multiple Employer Trust (MET): An MET combines multiple employers (10 or more) into a single pool to
provide group insurance. The MET holds the master contract rather than the participating employers who are
members of the trust.
Multiple Employer Welfare Arrangement (MEWA): A MEWA is a group of two or more employers with a
common bond that join together to provide health benefits for their employees on a self -insured basis. The
law treats them as “employee welfare benefit plans” subject to ERISA and exempt from certain state
insurance requirements.
Natural Group: An organization that exists for some reason other than to obtain insurance.
Network Model HMO (Closed Panel): This network model is similar to the group model; however, it involves
more than one physician group.
Noncontributory Plan: A group insurance plan in which the employer pays the entire group premium.
Notice of Privacy Practices: HIPAA requires health insurance plans to provide new subscribers with a Notice
of Privacy Practices at the time of enrollment and every three years thereafter. The Notice details the health
plan’s compliance with the HIPAA Privacy Rule and the consumer's rights.
Open-Panel Network: A form of HMO in which providers deliver services while working out of their own
offices on a part-time basis.
Participating Providers: Doctors and hospitals that contractually agree to specific fees for the services they
provide to (Blue Cross and Blue Shield) subscribers.
Point-of-Service (POS) Plan: Combines in-network care that’s similar to an HMO with limited out-of-network
care
Pre-Admission Certification: This involves evaluating an individual’s overall health before hospitalization for
surgery to determine whether the requested treatment is medically necessary.
Preferred Provider Organization (PPO): A sponsored network of health care providers that contract with the
PPO to offer their services to PPO subscribers on a fee-for-service basis at prearranged discount prices.
Pregnancy Discrimination Act of 1978: As an amendment to the Civil Rights Act of 1964, this act requires that
women who are affected by a pregnancy, childbirth, or related medical conditions (e.g., abortion) be treated
the same as any other person for employment-related purposes.
Primary Care Physician (PCP): A doctor who provides general medical care for individual network members
(typically of HMOs or POS plans) and controls all of their referrals for specialized care. Also called a
"gatekeeper."
Prospective Review: A form of utilization review that involves analyzing a case before admission to
determine the type of treatment that’s necessary.
Qualifying Event (COBRA): An event that qualifies workers and beneficiaries to access COBRA benefits.
Qualifying events include termination, disability, death, and divorce.
Retrospective Review: A form of utilization review that occurs after medical treatment is provided.
Service Basis: A system of insurance coverage in which consumers contract with service providers (e.g.,
Blue Cross and Blue Shield) to obtain medical services from participating providers in exchange for a
premium.
Service Providers: In exchange for a premium, service providers (e.g., Blue Cross and Blue Shield) offer
benefits to subscribers in the form of services from participating providers.
Small Employer: Generally defined as a business that has 50 or fewer employees; however, the exact
definition varies by state. Small employer groups are subject to special regulations.
[2] TRADITIONAL HEALTH INSURANCE POLICIES
Under the terms of traditional major medical insurance and other similar medical expense plans, consumers
receive healthcare services from medical professionals.
Their insurance companies reimburse them for the cost of those services.
Commercial insurance companies, also referred to as traditional insurers, write major medical health
insurance policies. The list includes life insurance companies, casualty insurance companies, and monoline
companies that specialize in one or more types of medical expense and disability income insurance.
The right of assignment built into most commercial health policies allows policyholders to assign benefit
payments directly to the healthcare provider, thereby relieving them of the need to pay the medical care
provider.
Since these plans indemnify the insured, they are also called indemnity plans. Traditional policies focus on
indemnifying the insured without reference to any specific network of providers. These types of plans have a
national scope.
EXAM TIP!
Be sure to distinguish major medical indemnity plans from hospital indemnity plans, which were previously
described in this program. Any reference to “hospital indemnity” means a plan that pays a fixed daily amount
to the insured. In the context of major medical insurance, any reference to an “indemnity plan” relates to a
traditional reimbursement. Be careful not to get confused. The term “indemnity” can have more than one
meaning depending on the context in which it’s being used.
[2.1] BLUE CROSS AND BLUE SHIELD (SERVICE PROVIDERS)
Blue Cross and Blue Shield were organized as service providers that offered benefits to subscribers in return
for premium payments. They were organized on a local basis. Initially, some affiliates were organized as
unincorporated cooperatives. These organizations aim to secure additional subscribers and will collect
premiums from members, administer the plan, and adjust losses.
Subscriber benefits are services provided by hospitals and physicians within the plan. They provided a
scheduled benefit for all covered services. Blue Cross was organized to cover the costs of hospitalization.
Blue Shield covered physician costs. Eventually, the two organizations joined together to form the Blue
Cross/Blue Shield (BC/BS) organizations we know today. Each is organized by state.
These traditional service providers differed from traditional indemnity plans in two ways:
1. The Blues paid covered amounts directly to the hospital. Participating doctors and hospitals
contractually agree to specific costs for subscribers’ medical services. If there were remaining
balances, they would be billed to and paid by the insured. This process differed from commercial
insurers, which reimbursed the insured.
2. The Blues offered plans underwritten on a community basis. They based premiums on the average
costs and loss experience of the market or community they served. Indemnity plans, on the other
hand, used individual and group experience to rate individual policies and set premiums.
EXAM TIP!
Here are some general characteristics of Blue Cross and Blue Shield that could be referenced on a state
insurance exam:
• Blue Cross covers hospital expenses
• Blue Shield covers surgical and medical expenses
• Blue Cross and Blue Shield offer policies for individual and group coverage
• Blue Cross and Blue Shield members are referred to as subscribers
[2.2] SPECIALIST CARE SCENARIO BEFORE MANAGED CARE: THE FACTS OF THE CASE
Robert Johnson, 54, is an accountant experiencing increasing shortness of breath, chest discomfort during
physical activity, and occasional dizziness. These symptoms have worsened over three months. After a
particularly concerning episode while climbing the stairs, Robert decides to seek medical attention. His
family physician, Dr. Williams, examines him and suspects the existence of a cardiac condition that requires
specialist evaluation. Dr. Williams recommends that Robert see a cardiologist and undergo s pecialized
testing.
[2.2.1] SPECIALIST CARE SCENARIO: COVERED BY TRADITIONAL INDEMNITY INSURANCE
SEEKING CARE
Robert calls Dr. Hartman, a well-regarded cardiologist, directly to schedule an appointment. Robert attends
the appointment without needing prior authorization from his insurance company.
Dr. Hartman examines Robert and orders several tests, including an ECG, stress test, and cardiac
catheterization, at Memorial Hospital. Robert schedules these procedures directly with the hospital's
cardiology department.
PAYMENT PROCESS
Robert pays Dr. Hartman's $100 consultation fee at the appointment, and submits the bill to his insurer for
the hospital procedures totaling $1,200, Robert pays upfront. Robert completes the claim forms from his
insurance company, attaching itemized receipts from Memorial Hospital. Since Robert met his $100 annual
deductible by paying for the initial consultation, Robert's indemnity plan reimburses him for 80% of the
"usual, customary, and reasonable" charges. The insurance company determines that the "reas onable" rate
for the hospital services is $1,200, so they send Robert a check for $800 (80% of $1,000, which is the
remaining amount after his deductible has been met).
Robert has paid $500 out-of-pocket ($100 deductible, 20% of the remaining $1,000, plus the $200
difference between the actual charges and the insurer’s deemed "reasonable" rate).
FOLLOW-UP CARE
Based on test results showing coronary artery disease, Robert needs ongoing care and medication. He
continues seeing Dr. Hartman quarterly, paying upfront and submitting claims for reimbursement each time.
For his prescription medications, Robert pays the pharmacy directly and submits receipts to his insurance
company for partial reimbursement.
[2.2.2] SPECIALIST CARE SCENARIO: COVERED BY A TRADITIONAL BLUE CROSS/BLUE SHIELD PLAN
SEEKING CARE
Robert calls Dr. Hartman, a well-regarded cardiologist, directly to schedule an appointment. Robert attends
the appointment without needing prior authorization from his insurance company.
Dr. Hartman examines Robert and orders several tests, including an ECG, a stress test, and cardiac
catheterization, at Memorial Hospital. Robert schedules these procedures directly with the hospital's
cardiology department.
PAYMENT PROCESS
At Dr. Hartman's office, Robert presents his Blue Shield card. He pays a small copayment of $5 for the visit.
Dr. Hartman's office bills Blue Shield directly for the consultation. For the hospital procedures, Robert
presents his Blue Cross card at admission.
Memorial Hospital, which has a participating agreement with Blue Cross, bills Blue Cross directly for the
covered hospital services it provides. Blue Cross pays the hospital directly according to its pre -negotiated
rates. Blue Shield pays Dr. Hartman directly for the professional component of the hospital procedures.
Robert receives no bills from the hospital for covered services, though he may have a small copayment. If any
services aren't covered under his Blue Cross/Blue Shield plan, Robert receives a bill for those specific items.
FOLLOW-UP CARE
Based on the same test results showing coronary artery disease, Robert needs ongoing care and medication.
He continues seeing Dr. Hartman quarterly, presenting his Blue Shield card and paying only the small
copayment each time. For prescription medications, Robert pays a small copayment at participating
pharmacies, which are billed directly by Blue Shield for the remainder of the cost.
[3] MANAGED CARE DEFINITION AND CHARACTERISTICS
As the cost of medical care has increased, insurers have focused on trying to control the cost of medical
care. Medical cost management is also referred to as cost containment, claims control, case management,
and managed care. Managed care is the process of controlling how policyholders use their policies.
• Policies use deductibles, which are amounts paid by the insured before the insurer begins to cover
claims. A higher deductible will help limit claims and contain costs.
• Policies also use coinsurance, which specifies the percentage of claims covered by the insurer and
the insured. Coinsurance is another essential way to share the cost of medical care.
• Shortened benefit periods can also be cost-containment mechanisms.
Regardless of form or structure, there are at least four general approaches insurers may use for medical cost
management:
• Mandatory second opinions
• Pre-certification review
• Ambulatory surgery
• Case management
The design or structure of a policy and its provisions will affect an insurer’s cost-containment efforts.
[3.1] MEDICAL COST MANAGEMENT
[3.1.1] MANDATORY SECOND OPINIONS
To reduce unnecessary surgical procedures, many health policies include a provision requiring an insured to
obtain a second opinion before undergoing elective surgery. Under the mandatory second surgical opinion
provision, insureds typically pay more in out-of-pocket expenses for those surgeries for which only one
surgical opinion is obtained. This mandatory second surgical option provision can help contain the cost of a
group medical plan.
[3.1.2] PREVENTIVE CARE
Managed care programs also help lower health costs by encouraging preventive care. Preventive care
includes annual physical exams and other procedures that help detect illnesses and medical problems early.
[3.1.3] AMBULATORY SURGERY
Advances in medicine now permit many surgical procedures to be performed on an outpatient basis. These
outpatient procedures are commonly referred to as ambulatory surgery. To further reduce overhead costs,
outpatient procedures can be performed at standalone ambulatory surgical centers (also called “ambulatory
care centers”), which cost much less to operate than a hospital.
[3.2] CASE MANAGEMENT
Case management, also referred to as utilization review, involves a specialist within the insurance company
(e.g., a registered nurse) who reviews a potentially large claim as it develops to discuss treatment
alternatives with the insured. The purpose of case management is to allow the insurer to take an active role in
managing what could become a very costly claim. These utilization reviews are performed on
a prospective, concurrent, or retrospective basis, or a combination of all three.
• A prospective review involves analyzing a case before admission to determine the appropriate
treatment.
• A concurrent review involves a nurse monitoring a patient's hospital stay while the patient remains in
the facility to determine when the patient can be released. This review will also help determine
whether a patient requires home health care or warrants a transfer to anoth er facility (e.g., a hospice
center or extended care facility).
• A retrospective review involves an after-the-fact analysis of care to determine whether it was
necessary and appropriate. The purpose of this review is not to deny claims but to ensure that
treatment and procedures were correctly provided and aligned with the insurance coverage. It serves
as a research tool, efficiently providing large amounts of data. A potential downside is that it is prone
to biases and incomplete data. However, it can help tailor treatment to reduce and eliminate
unnecessary healthcare costs.
[3.2.1] PROSPECTIVE REVIEW
Pre-certification (prospective review) is also referred to as pre-admission or pre-hospitalization. To control
hospital claims and prevent unnecessary medical costs, policy owners must get the insurer’s approval
before entering a hospital for elective surgeries.
Pre-admission testing or certification typically involves evaluating an individual’s overall health to determine
whether the requested treatment is medically necessary. This process helps reduce the length of hospital
stays and prevents unnecessary expenses. Failure to obtain a pre-admission certification in nonemergency
situations reduces or eliminates the health insurance provider’s obligation to pay for services rendered.
In an emergency, hospital pre-admission certification typically requires notification to be given after the
patient is admitted to the hospital.
[3.2.2] CONCURRENT REVIEW
A concurrent review occurs when health care is reviewed as it’s being provided. A case manager reviews
whether the length of one’s hospital stay, the hospital setting, or even the care regimen itself is appropriate.
This ongoing review is designed to minimize costs while maintaining the effectiveness of care.
[3.2.3] RETROSPECTIVE REVIEW
A retrospective review is a “look-back” examination of medical records and treatment after the fact. An
insurance company can use the results to refine its processes, aligning them better with insurance coverage,
which helps when approving or denying future claims. The insurer can also use the information to review its
internal coverage guidelines and criteria for a particular condition.
[4] MANAGED CARE NETWORKS
Managed Care Networks have revolutionized the healthcare landscape by fostering a more coordinated and
efficient approach to patient care. These networks, comprising a variety of healthcare providers and
organizations, collaborate to deliver comprehensive services while controlling costs and improving quality.
By emphasizing preventive care, streamlining administrative processes, and utilizing data -driven decision-
making, Managed Care Networks aim to enhance patient outcomes and ensure that healthcare resou rces are
used effectively. This section delves into the intricacies of Managed Care Networks, exploring their structure,
benefits, and pivotal role in modern healthcare systems.
This section will review the following managed care networks:
• Health Maintenance Organizations,
• Preferred Provider Organizations,
• Point-of-Service Plans,
• Exclusive Provider Organizations, and
• Discount Medical Plan Organization.
[4.1] HEALTH MAINTENANCE ORGANIZATIONS
A health maintenance organization (HMO) is an organization that offers comprehensive, prepaid healthcare
services to its enrolled members. An HMO can be established as either a for-profit company or a not-for-
profit organization. If an HMO is established on a not-for-profit basis, it is considered a consumer
cooperative and is primarily operated by its salaried employees. An HMO that is established as a for -profit
organization can also be a cooperative operated by a group of physicians.
One distinctive characteristic shared by all HMOs is that they organize and deliver covered healthcare
services to their subscribers, as well as finance them. HMOs are sponsored by various groups, including
employers, physicians, hospitals, labor unions, government entities, medical schools, associations, Blue
Cross and Blue Shield, consumer groups, and insurance companies.
[4.1.1] CHARACTERISTICS OF HEALTH MAINTENANCE ORGANIZATIONS
HMOs are regulated at both the state and federal levels. Subscribers must have Access to their HMO,
including referrals, medical consultation, emergency treatment, and authorizations:
24 hours a day
Seven days a week
HMOs must provide a 30-day open enrollment each year, which:
Presents an opportunity for the HMO to advertise its plans to the public
Allows current subscribers to either continue in the HMO or choose a different provider
Must allow non-subscribers the opportunity to join that HMO
[4.1.2] FEDERAL REQUIREMENTS FOR HEALTH MAINTENANCE ORGANIZATIONS
Employers who offer health benefits may also be eligible to offer their employees the opportunity to enroll in
an HMO. For an employer to be eligible to offer an HMO, the following federal requirements and guidelines
must be met:
The employer must have at least 25 employees
The employer must contribute to the plan
The employer HMO plan cannot charge more than a commercial insurance plan
The employer HMO plan must stress preventive care and cover family planning services
The employer HMO plan must maintain minimum reserves
Employer HMO premiums must be established using a community rating approach
[4.1.3] KEY CHARACTERISTICS OF HMOS FOR CONSUMERS
COMPREHENSIVE CARE
Health maintenance organizations combine financing (insurance) and healthcare delivery. They do so by
providing a comprehensive range of health services—from routine doctor visits to emergency and hospital
care.
HMO coverage includes the following:
• Hospital expenses: hospitalization, in-hospital lab work and X-rays, inpatient laboratory services,
Inpatient mental health care, surgical and medical treatment
• Outpatient medical services: diagnostic services, therapeutic services, prescription drugs, nursing
services, substance abuse, home health care
HMOs cover the essential health services defined by the Affordable Care Act; however, they typically do not
cover dental or vision care.
PREVENTIVE CARE
HMOs are known for stressing preventive care. Unlike traditional accident and sickness plans, HMOs cover
preventative services without a deductible. The Affordable Care Act adopted this approach as part of its
legislative model.
PREPAID CARE
Subscribers pay a fixed periodic fee to the HMO rather than paying for each service when it’s received. Co -
payments serve to cover administrative costs. Subscribers can review the procedures for accessing available
services and co-pay requirements in their policy’s certificate of coverage.
In some traditional models, HMOs compensated providers on a capitated basis. Put another way, HMOs paid
providers a fixed fee per patient, regardless of the amount of care provided. This method of compensation is
no longer universally employed.
FUNDING
Insurers often sponsor HMOs. They can also be self-contained or self-funded based on their subscribers’
dues or fees.
PRIMARY CARE PHYSICIANS (GATEKEEPER)
HMOs require subscribers to select a primary care physician (PCP). A PCP is a doctor who provides general
medical care for a particular member and controls all referrals for specialized care and, in some cases,
hospital care. A PCP referral is a special form of pre-approval that HMO members must obtain from their
chosen primary care physician before seeing a specialist or another doctor within the same network. This use
of PCP referrals is called the gatekeeper system, with the PCP serving as the gatekeeper .
LOCAL OR REGIONAL NETWORKS
Unlike traditional major medical insurance plans, HMO networks are local or regional, not national.
EMERGENCY CARE
If an HMO subscriber needs emergency health services, the subscriber can obtain in -network coverage at
any hospital if the emergency is life-threatening. Although pre-approval is preferable, if necessary, the HMO
member should proceed directly to the nearest emergency room and notify the primary care physician as
soon as possible.
[4.1.4] HEALTH MAINTENANCE ORGANIZATION (HMO) STRUCTURES
HMOs employ a range of organizational models to structure services for their subscribers. The structures
that are currently in use are the staff model, group model, network model, and individual practice
association (IPA) model.
In each of these cases, the form can be described as either a “closed panel” or an “open panel” model.
• If the HMO model calls for salaried employees of a physician’s group to work out of an HMO facility,
then the model is defined as a closed-panel network.
• If the HMO provides services through a network of physicians who meet with subscribers in their own
offices, then the organization is defined as an open-panel HMO.
For non-emergency situations, HMOs may require subscribers to pay up to 100% of the billed amount if the
subscriber chooses a healthcare provider who’s outside of the network. This can often apply to pharmacies
as well. HMOs dispense medications through participating pharmacies.
[4.1.4] HEALTH MAINTENANCE ORGANIZATION (HMO) STRUCTURES (continued)
STAFF MODEL (CLOSED PANEL)
Under a staff model, physicians who are employed by the HMO and hospitals that participate in the HMO
provide medical care to subscribers.
GROUP MODEL (CLOSED PANEL)
The group model, also known as the medical group model or group practice model, provides a range of
medical services to its subscribers. With this model, the HMO pays a capitation or a predetermined price for
the group, and the group pays the physicians for the services they provide.
NETWORK MODEL (CLOSED PANEL)
Although the network model is similar to the group model, it involves more than one physician group. Under
the network model, the payment that’s given to a physician is based on a capitation fee.
INDIVIDUAL OR INDEPENDENT PRACTICE ASSOCIATION (OPEN PANEL)
HMOs may also function on an individual or independent practice association (IPA) basis. An IPA is
characterized by a network of physicians who practice in their own facilities and participate in the HMO on a
part-time basis. This model is considered an open-panel network. Because of the number of providers who
can participate, the open-panel model offers insureds the broadest range of choices when selecting a
primary care physician and in-network specialists.
[4.1.5] DENTAL MAINTENANCE ORGANIZATIONS
A dental maintenance organization (DMO) is a type of health maintenance organization (HMO) that focuses
on dental services. A DMO takes the same basic approach to services as other HMOs do. At times, a DMO
may be referred to as a prepaid plan.
[4.2] PREFERRED PROVIDER ORGANIZATIONS
Preferred provider organizations (PPOs), another type of health insurance provider, offer medical
insurance by sponsoring a network of health care providers, such as physicians, hospitals, and clinics. These
providers contract with the PPO to provide their services to PPO subscribers at prearran ged, discounted
prices. In return, the group refers its members to these preferred providers for healthcare services, thus
allowing the providers to expand their patient base.
Groups that contract with PPOs include commercial insurance companies, HMOs, Blue Cross/Blue Shield,
employers, and trade unions. PPO networks, along with HMOs, are a staple of today’s medical insurance
plans, especially those organized to provide major medical insurance and cover all the essential services
defined in the Affordable Care Act
[4.2.1] CHARACTERISTICS OF PREFERRED PROVIDER ORGANIZATIONS
PPOs have some distinct qualities compared to HMOs. For instance, PPOs provide a wider choice of
physicians. PPO members can access needed services by selecting from among the network of preferred
providers. Although we can characterize PPOs as either closed-panel or open-panel, like HMOs, they also
have many distinct characteristics.
FINANCING HEALTH CARE ONLY VERSUS FINANCING AND DELIVERY
Preferred provider organizations don’t assume the role of healthcare providers; instead, they assemble
networks and administer the financing of care. In this respect, they’re closer to the traditional insurance
model than an HMO. However, PPOs are not traditional insurers because they trade access to PPO
participants for negotiated contract pricing. The PPO contract price represents a discount from what may be
considered “usual and customary.” The result is a lower cost for PPOs and their subscribers.
[4.2.1] CHARACTERISTICS OF PREFERRED PROVIDER ORGANIZATIONS (continued)
FEE-FOR-SERVICE
Unlike HMOs, PPOs typically operate on a fee-for-service basis. The cost of each service is scheduled and
incurred when the provider performs it; it is not prepaid. PPOs may require subscribers to pay a percentage of
their medical costs up to an annual maximum. This cost-sharing percentage is called coinsurance.
In contrast, HMO subscribers pay a fixed dollar amount per visit, known as a copayment or copay. Unlike
coinsurance, a copayment’s primary purpose is to cover administrative costs, although it may also serve as
cost-sharing for the care being provided. PPOs may also utilize a combination of coinsurance and copays.
For PPO sponsors, the cost of fee-for-service plans never exceeds the price charged for the service.
Conversely, prepaid plans (HMOs), which pay a fixed amount for medical services in advance, share with
providers what is referred to as “utilization risk.” This risk exists because HMOs must pay providers, even if
the subscriber does not receive any services. On the other hand, HMO providers receive limited
compensation per subscriber, even if the care that a specific subscriber receives is extensive.
PPOS OUT-OF-NETWORK COVERAGE PROVIDED
Unlike an HMO, a PPO provides coverage for nonemergency care outside its network. However, in -network
coverage is better, resulting in lower out-of-pocket costs for subscribers.
Services obtained outside the network are more expensive for two reasons. First, PPOs reduce benefits for
out-of-network services. They require subscribers to pay a higher coinsurance percentage. Second, out -of-
network providers often do not adhere to discounted network price guidelines. PPOs must cover a
percentage of the providers’ usual and customary charges.
For these reasons, out-of-network pricing differentials apply to nonemergency services. If a PPO enrollee
needs an emergency health service, the enrollee will receive in-network coverage, even if the provider is out-
of-network.
DIRECT ACCESS TO ANY PROVIDER
The traditional PPO model does not require referrals from primary care physicians to in -network specialists.
Instead, subscribers can directly seek services from specialists and still receive full in -network coverage.
PPO INNOVATIONS AND OPTIONS
PPO plans may include dental care and long-term care, such as nursing services. They also offer access to
both in-network and out-of-network providers.
[4.3] POINT-OF-SERVICE PLANS
A point-of-service (POS) health plan can be best defined as an entity that combines the features of an
indemnity (traditional major medical) plan with those of an HMO. A POS plan allows the insured to choose
either a network or an out-of-network provider for care.
[4.3.1] IN-NETWORK COVERAGE
With in-network coverage, the insured receives care from a network of doctors and hospitals that participate
in the plan (similar to an HMO). All care is coordinated by the insured’s primary care physician, which
includes referrals to specialists as needed. POS subscribers must follow the referral requirements to receive
full in-network coverage, just like in an HMO. This network coverage offers the highest level of coverage for
subscribers.
[4.3.2] OUT-OF-NETWORK COVERAGE
Insureds who receive out-of-network care pay a higher share of the cost. Subscribers pay a significant
portion of these costs, often in the form of a substantial coinsurance percentage (30% -40%) of usual and
customary charges. Some POS plans go further and base these higher cost-sharing amounts on the lower, in-
network provider costs they incur. They may also impose higher out-of-pocket maximums and deductibles.
Traditionally, in-network costs more closely resemble those of HMO plans, with copays and prepaid
services. In essence, POS plans were designed to offer in-network cost savings (like HMOs) with the added
flexibility of insurance for out-of-network care. Today’s plans offer primary care at a fixed cost per visit, along
with other services at discounted fee-for-service rates. Some require referrals for specialty services, and
others do not.
[4.4] EXCLUSIVE PROVIDER ORGANIZATION
An exclusive provider organization is a hybrid of an HMO and a PPO. Exclusive provider organizations (EPOs)
typically offer more flexibility than HMOs, as they do not require subscribers to obtain referrals to receive
access or coverage for specialist services. They cost less than PPOs because they are similar to HMOs in
terms of restrictions. As with HMOs, individual subscribers must pay all costs for out-of-network care except
in the case of an actual emergency.

[4.5] DISCOUNT MEDICAL PLAN ORGANIZATIONS

Discount medical plan organizations (DMPOs) are not insurance policies; instead, they offer discounts on
certain medical services and are typically regulated by the state's department of insurance.
A discount plan is a business arrangement or contract that provides access to medical service providers for
plan members and the right to receive medical services from those providers at a discounted rate. Individuals
subscribe to these plans by paying fees, dues, charges, or other considerations. Many DMPOs are owned
and operated by insurance carriers and various associations. However, some states may not permit DMPOs.
[4.6] SPECIALIST CARE SCENARIO IN THE MANAGED CARE ERA HMO VS PPO
Robert Johnson, 54, is an accountant experiencing increasing shortness of breath, chest discomfort during
physical activity, and occasional dizziness. These symptoms have worsened over three months. After a
particularly concerning episode while climbing the stairs, Robert decides to seek medical attention. His
family physician, Dr. Williams, examines him and suspects the existence of a cardiac condition that requires
specialist evaluation. Dr. Williams recommends that Robert see a cardiologist and undergo s pecialized
testing.
This table highlights the structural differences between HMO and PPO plans using Robert's cardiac care
journey as an example. The same medical condition follows different administrative pathways with distinct
financial implications, though the clinical care may be similar.
[5] GROUP HEALTH INSURANCE PLANS
Group health insurance is a policy class rather than a provider. However, covered individuals must belong to
a defined category or organization, whether they are company employees or association members. Group
health insurance is a distinct form of coverage with different parameters than an individual policy. For that
reason, it will be described as a distinct source of coverage with its essential characteristics shared among
the carriers that provide it.
More Americans are protected under group medical expense plans than under individual insurance policies.
The benefit to the group member (even assuming a contributory plan) is a significantly lower out -of-pocket
cost than for a comparable personal plan.
[5.1] ELIGIBLE GROUPS
To qualify for group health coverage, the group must be a natural group. The term “natural group” means that
the group must exist for some purpose in addition to obtaining insurance. Qualifying groups include
employers, labor unions, trade associations (associations within the same industry), creditor-debtor groups,
multiple-employer trusts (employers within the same industry), fraternal lodges, and other similar entities.
Group coverage provisions define who is eligible, when individuals, such as new employees, become eligible,
and the open enrollment period. They also describe the required minimum number of participating
employees, policy benefits, limitations, qualifications, and the master policy owner’s responsibilities.
Employer groups may establish different benefit levels under the terms of a group policy for distinct
employee classes within the firm. For example, an employer may offer different benefit packages to full -time
and part-time employees. Other distinctions may be based on whether a position is salaried or hourly.
Benefits may also differ based on union membership or representation.
Groups are prohibited from discriminating against specific individuals within a defined class of participants.
Group health plans share various essential characteristics, including the acceptable nature of a sponsoring
group and the contract’s ownership. They also share certain advantages in terms of cost, continuity, and
individual eligibility. These characteristics apply regardless of whether the employer or another eligible entity
sponsors the insurance.
[5.2] BASIC GROUP PLAN MEMBERSHIP
Group plans require a minimum number of participants to be a group. This minimum varies by state law and
insurance type. In most states, the minimum number of participants in a small employee health plan (also
known as a medical expense plan) is two employees. Groups with fewer than 51 employees are considered
“small groups” governed by size-specific regulations. Other types of group plans, such as those offering
disability insurance or long-term care coverage, may require 10 or more employees. State laws specify the
minimum number of individuals required to be covered under a group policy.
[5.3] PARTICIPATION REQUIREMENTS
As previously stated, group underwriting depends on the underwriter’s ability to gauge the average risk within
a prospective group. Accuracy depends on having the participation of a sufficient percentage of the potential
membership pool. The purpose of these minimum participation requirements is to protect the insurer against
adverse selection and to control administrative expenses. If a group’s participation percentage drops below a
certain threshold, the insurer may terminate the plan. The required participation standards depend in part on
how the group premium is paid. Group health plans may be contributory or noncontributory.
[5.3.1] CONTRIBUTORY PLANS
If employees pay a portion of the group insurance premium, the plan is a contributory plan. Again, the
employer determines the class or classes of employment that are eligible, not individual employees.
Contributory group health plans typically require participation by at least 75% of eligible members. Although
it’s not reasonable to assume that all eligible employees will participate, the insurer still needs a substantial
proportion of eligible group members to participate.
For example, if an employer has 1,000 employees and 400 are full-time workers eligible to participate in the
group health plan. With this limited pool of 400 potential enrollees, the employer needs 300 employees to
participate (75% of 400).
[5.3.2] NON-CONTRIBUTORY PLANS
If the employer pays the entire premium, the plan is non-contributory. Most noncontributory group health
plans require 100% participation by eligible members. The plan sponsor can define which class or classes of
group members are eligible to participate; however, the employer cannot selectively choose participants
from among eligible group members.
For example, an employer may only cover full-time employees and not part-time or occasional workers. If
there are 1,000 employees and 400 are full-time workers, the employer must cover all 400 to achieve 100%
participation.
Please remember, the percentages stated above for plan participation are benchmarks. In other words, they
are guidelines, not laws. Requirements for contributory and non-contributory group plans vary by state.
EXAM TIP!
The limits given here are general standards. For any questions regarding participation, size, or other group
insurance requirements, use the general guidelines.
[5.4] POLICY OWNERSHIP
Insurers issue the group insurance policy, also referred to as the master contract, to an employer or another
sponsoring organization. The employer/sponsor is considered the master policy owner. This contract for
coverage is between the insurance company and the group sponsor.
Individuals insured under a group contract do not receive separate policies. Instead, each individual receives
a certificate of insurance. Participants also receive an outline or booklet with the insured’s name, benefit
descriptions, and beneficiaries. Typically, group health insurance benefits are more extensive than those
provided by individual health plans. Group health plans typically offer broader coverage, often including
ancillary insurance plans, higher benefit maximums, and lower out-of-pocket costs.
[5.5] LOWER COST
When comparing individual and group health plans on a benefit-by-benefit basis, the cost of insuring an
individual under a group plan is lower than the cost of an individual policy. The cost advantage stems from
the group plan’s lower administrative and sales expenses.
[5.5.1] CONSOLIDATED ADMINISTRATION
Group insurance requires less administrative effort by insurers. The insurance carrier covers multiple
individuals under one contract. The policy owner (employer or another sponsor) plays a significant part in
providing information and other services to enrolled participants.
[5.5.2] PREDETERMINED BENEFITS
Another characteristic of group health plans is that the employer predetermines the benefits provided to
individual insureds in conjunction with the insurer’s benefit schedules and coverage limits. Predetermined
benefits and limited options simplify the underwriting process and lower the overall cost of administration.
[5.5.3] INCREASED PERSISTENCY
When an individual drops an individual insurance policy, the contract is lost. On the other hand, when an
individual exits a group and loses coverage, the group contract remains in force. There is a constant flow of
people entering a typical group.
[5.6] UNDERWRITING AND RISK MANAGEMENT
Some factors that determine group health insurance premiums are the group’s size, its claims experience
with previous insurers, and the ages of group members. Depending on the group's size, insurers determine
premiums using one of two basic risk rating methods: the group’s experience rating or
the area’s community [Link] groups (51 or more members) use the experience rating method. Small
employer groups (2-50 employees) use community ratings to underwrite policies.
[5.6.1] GROUP UNDERWRITING
Group insurers establish premiums based on the average level of risk in a prospective group. For large
groups, underwriters calculate risk based on the group’s aggregate past claims, known as the group’s
experience rating. If a group is small, the insurer examines the surrounding community to gauge risk
accurately. A carrier first estimates the probability of losses and their costs, then assigns a community rating
to the group and the surrounding area. If small groups join a larger association, the insurer can base
premiums on the combined experience of the member organizations.
For group underwriting to work, the plan participants must be a representative sample of everyone in the
eligible group, including those who decline coverage. Even when plan membership reflects all eligible group
members, plans must still control access. If they fail to do so, those who are most in need of insurance
(highest-risk cases) will be over-represented, and the plan can become unsustainable due to excessive
claims driven by adverse selection.
Some of the group underwriting considerations that apply to most types of groups include:
• Underwriters must know the reason for a group’s existence
• Underwriters must look for stability, seeking groups with a stable workforce and without an excessive
amount of turnover
• Underwriters want persistency. Groups that change insurers every year do not represent an
acceptable risk.
• Plan designs impose a set method for determining benefits that limits variation (if any) to a schedule
• Insurers need to understand how individual eligibility is determined, and often prefer a probationary
period during which losses due to illness are excluded
• Insurers must determine whether the group plan is contributory or noncontributory
• Insurers consider the prior claims experience of the group when underwriting a large group (51 +
employees)
• Underwriters also examine the size and composition of the group, such as the average age. The higher
the average age of the group, the higher the premium will be.
• The group’s industry or business also affects the premium. Higher-risk jobs with higher-than-average
morbidity rates are characteristic of hazardous industries.
EXAM TIP!
The term “probationary period” can apply to eligibility to join a group or coverage for illness under the terms
of a health insurance policy.
• IF we are talking about employment, we are referencing an establish waiting time before one may join
a group plan.
• IF we are discussing the terms of a policy, we are referring to a provision that delays the excludes
coverage for illnesses (accidents are covered) for between 10 and 30 days a policy is first in force.
[5.6.2] INDIVIDUAL ELIGIBILITY
Group health plans commonly impose eligibility criteria that must be met before an individual member can
participate. The following requirements are common.

Participants are restricted to workers with full-time employment status (30 or more hours per week).
Working individuals age 65 or older must generally be offered the same health benefits as younger
employees.
Many plans also require a minimum of one to three months of employment before a new employee becomes
eligible for coverage. The period during which a new employee remains ineligible for group health insurance
coverage is referred to as a probationary period.
[5.6.3] ENROLLMENT PERIOD
Once employees become eligible for coverage, they have a limited period to accept coverage under the plan.
This period of opportunity is called the enrollment period. Unless the state requires a longer enrollment
period, most providers allow 31 days. If prospective participants do not elect coverage within 31 days, they
forfeit automatic acceptance into the group insurance pool. These individuals may apply for coverage later,
but they will do so as “late enrollees.” Because late enrollees apply for coverage on their own timetables,
they must qualify for coverage as individuals rather than as members of an eligible class. Also, the coverage
will only be available after a late enrollee provides evidence of insurability. Eligibility or enrollment periods
help to reduce adverse selection.
New employees must sign an enrollment card during the new hire open enrollment period. Plans typically
also have annual open enrollment periods to accommodate current employees. If a group member
experiences a change-of-life event (e.g., marriage or the birth of a child), health plans offer special
enrollment periods to accommodate these circumstances.
[5.7] SMALL EMPLOYER GROUP INSURANCE
A small employer is generally defined as a business with a range of two to 50 full-time employees who work
at least 30 hours per week in the business. Employers can also offer group insurance to part -time
employees.
With the passage of the Affordable Care Act (ACA), a group must include, in addition to the employer, at least
one employee (other than an immediate family member). The law allows an employer-owner group to consist
of all of the firm’s partners if there are no other employees. Small group plans generally do not cover
temporary workers; however, this can be arranged at the employer’s option.
Insurers underwrite small-group plans using a community-rated premium that reflects a pool of small
employers or the community at large. All employees must have access to coverage, and the level of coverage
must reflect general group insurance requirements.
[6] ALTERNATIVE FORMS OF GROUP INSURANCE
[6.1] MULTIPLE EMPLOYER WELFARE ARRANGEMENTS
A Multiple Employer Welfare Arrangement (MEWA) is defined under ERISA as an arrangement established
to provide health or welfare benefits to employees of two or more unrelated employers that are not under
common ownership or control. [Department of Labor, ERISA Section 3(40)]. MEWAs are usually establ ished
by the insurers themselves and are subject to federal regulation (ERISA) and state regulation, except in cases
when they conflict with ERISA.
MEWAs may be structured as a trust, corporation, limited liability company, or any other legal entity. The
participating companies may share a common bond, but it is not required. Some are tax -exempt, and some
are not. A MEWA is defined by its function (providing benefits to multiple unrelated employers) rather than by
tax status.
[6.2] MULTIPLE EMPLOYER TRUSTS
The Multiple Employer Trust (MET) is a fully insured Multiple Employer Welfare Arrangement (MEWA)
established by a third-party entity, such as an insurance company or third-party administrator. Its purpose is
to provide group insurance benefits to employers with a small number of employees. The MET combines
multiple employers into a single pool to provide group insurance. Also, the MET holds the master contract
rather than the participating employers.
An employer that wants to obtain coverage for its employees through a MET must first become a MET trust
member by subscribing to it. Covered employees receive a certificate of insurance, just as with a single -
employer plan. The employer’s premium payments are directed into a trust that funds the plan’s benefits and
claims. State regulations about METs can vary. Some states subject METs to the requirements set for small
group insurance (encompassing two to 50 employees).
[6.2] SELF-INSURANCE / SELF-FUNDED PLANS
“Self-insurance” does NOT mean “no insurance.” Companies that provide health insurance on a self -insured
(self-funded) basis do so under the terms of a formal employee welfare benefit plan regulated by ERISA.
These arrangements grant employers greater control over costs and more flexibility in offering benefits.
Employers that offer such plans also fund them and pay for members' claims and benefits. Employers can
offer specific benefits that are best suited to their employees’ needs.
Many employers limit the financial risk associated with covering claims by purchasing stop -loss insurance
from an insurance company. Under the terms of a partially self-insured plan, the employer remains liable for
paying claims. The stop-loss coverage reimburses the employer if the total amount of covered claims
exceeds the risk retention limit (deductible) that’s set in the policy. Stop-loss policies are not suited for every
employer. Instead, they are most effective for large employers that face the risk of significant losses.
[6.2.1] ADMINISTRATIVE SERVICES ONLY PLANS
Administration Services Only (ASO) contracts require an employer to purchase specific administrative
services from an insurer or an independent third-party administrator (TPA). These services typically include
the administration of claims, but can also include prescription drug cards, COBRA administration, and
employee communications.
Self-funded plans commonly use an insurance company’s services to act as a third-party administrator.
Insurers may provide these services without being responsible for claims payment under an ASO contract.
The use of third-party administrators has increased alongside the adoption of self-funding and multiple-
employer welfare arrangements.
[6.3] FRANCHISE HEALTH PLANS
Franchise health plans—also referred to as wholesale plans—provide health insurance coverage to
members of an association or professional society. They are used to cover a group of individuals who don’t
qualify for true group insurance. Unlike other forms of group insurance, franchise plan participants receive
individual policies. The association or society serves only as the sponsor of the plan.
Some characteristics of the franchise health plan include:
• Each participant must complete a health policy application separately, and each one must receive
their own policy
• Premium rates are typically discounted because the sponsor helps market the plan
• Sponsors may offer medical, hospital, surgical, and disability benefits
• Plans can be contributory or noncontributory
Employers can use a franchise arrangement to offer coverage for workers who are not eligible for traditional
group insurance. Such coverages are often referred to as voluntary benefits, worksite benefits, or
supplemental insurance.
[7.1] TERMINATION OF A GROUP PLAN
Group coverage can terminate for one person or family due to individual circumstances, or for everyone if the
plan itself is terminated. The laws governing the termination of group plans or their replacement vary by state.
They may include a notice-of-change requirement or regulations regarding the transfer of coverage for those
insured under the plan being terminated.
Continuation of coverage for individuals may include a limited extension of coverage for a specific condition,
temporary continuation of policy benefits under state or federal law, or conversion of coverage to an
individual plan. Except for the application of state and federal laws, coverage for an employee and his
dependents would end when:
• Group membership ends
• An employee ceases to be eligible for participation (regardless of the reason)
• The master policy is surrendered or canceled
• The employee ceases making any required contribution
Coverage under group plans can continue for many employees and dependents even after employment ends.
For example, COBRA provides for the continuation of group coverage in the event an employee is terminated
or dies. Group plans also provide an extension of benefits once employment ends.
[7.2] EXTENSION OF BENEFITS
Many health insurance plans require an extension of benefits if a covered employee or dependent becomes
sick or disabled when the insured’s group membership is terminated. This extension does not cover new
claims; instead, it continues to pay for existing claims that were in effect at the time coverage ended. The
extension recognizes the loss as covered because it occurred while the person was insured, even if the
treatment extends beyond the policy’s termination date.
If an employee suffers an insured, disabling injury, disability benefits will continue until the disability ends,
even if the insured no longer belongs to the covered group.
For example, let us assume that John suffers a permanent back injury while covered by his employer's
disability policy. After some time, the employer downsizes and terminates John’s position. Despite the
change, John’s disability benefits continue to be paid even though he is no longer employed by the company
because his injury occurred while he was insured, and he has remained continuously disabled since then. re.
A similar extension applies to medical expense policies. Most states mandate extensions of 90 days to 12
months for inpatient care that began while the affected individual was insured, with the majority providing
coverage until hospital discharge or three months, whichever comes first. If John were hospitalized with
pneumonia rather than suffering a back injury, his employer's group medical plan would continue to provide
hospital benefits until his discharge or until the policy's time period expired.
A similar extension occurs when an employer changes insurance companies. If a participant were
hospitalized at the time of the replacement transactions, the previous insurer would provide a temporary
extension of benefits covering the open claim. Similarly, the replacing insurer must cover any employees who
are covered under the old plan. The replacing insurer will commonly credit existing deductible payments and
other employee payments. The replacing issuer will also cover all other claims, new and ongoing , without
reference to any pre-existing condition. The exact terms governing this situation may vary by state.
[7.3] CONSOLIDATED OMNIBUS BUDGET RECONCILIATION ACT
The Consolidated Omnibus Budget Reconciliation Act (COBRA) requires employers to provide group health
coverage to employees and their qualified beneficiaries following a qualifying event. Employees become
eligible for COBRA benefits as soon as they qualify for coverage under their employer’s group medical plan.
COBRA benefits are a continuation of a person’s group insurance, not a conversion to an individual plan. The
benefits are temporary, and the individual insured must pay the full premium. If the employer ceases to
provide group health benefits (e.g., due to bankruptcy), the COBRA benefits will also terminate. If an
employer changes its plan, a COBRA beneficiary has the same option as current employees to enroll in the
new plan.
[7.3.1] COVERED EMPLOYERS
COBRA covers employers that have 20 or more employees. These companies are referred to as “COBRA
Groups.” Employers that fail to comply with COBRA may be stripped of their ability to deduct health
insurance costs as a necessary business expense on their federal income tax return.
[7.3.2] QUALIFYING EVENTS
The law defines the following circumstances as qualifying events for employees covered by COBRA and their
dependents:
• The insured employee dies
• The insured employee divorces their covered spouse
• An insured dependent becomes too old to be covered (e.g., a covered child turns 26)
• The insured employee qualifies for Social Security disability benefits
• The employee voluntarily resigns or retires
• The employer terminates the insured employee for any reason other than gross misconduct
[7.3.3] NOTIFICATION PERIOD
Employers must notify covered employees or their dependents if the insured employee becomes eligible for
COBRA benefits. The law requires employers to provide notice no later than 14 days after the qualifying event
(such as termination).
[7.3.4] DECISION PERIOD
Employees who qualify for COBRA have up to 60 days to decide whether to accept the coverage. Employees
or dependents who fail to notify the employer promptly forfeit their right to elect COBRA coverage. This 60 -
day period begins on the date of the qualifying event or on the date notice is received, whichever is later.
Regardless of when an insured employee elects COBRA, the required premium must be paid back to the date
of separation.
For example, if an employee is terminated on March 31 and decides to accept COBRA on May 30 (60 days
after the termination date), then the employee must pay premiums for April and May at that time.
Additionally, the June premium will be due shortly.
[7.3.5] BENEFIT PERIODS
18 MONTHS: LOSS OF EMPLOYMENT
COBRA-covered employees who voluntarily leave their positions or are terminated for reasons other than
gross misconduct (e.g., stealing from their employer) may continue coverage under the employer’s plan for
up to 18 months, provided they pay the premium.
36 MONTHS: LOSS OF DEPENDENT BENEFITS
Qualifying events (other than the loss of employment) allow beneficiaries or dependents 36 months of
continuous coverage under the employer’s plan. The following list identifies the qualifying events that allow
for up to 36 months of dependent coverage:
The employee dies
The employee divorces a covered spouse (benefits may also continue in cases of legal separation)
The cessation of dependent coverage because a child of the insured reaches the age limit for coverage
29 MONTHS: LOSS OF BENEFITS DUE TO DISABILITY
COBRA covers insureds who qualify for Social Security disability benefits, meaning the covered individual
cannot be gainfully employed. The 29-month COBRA benefit period can provide coverage until the individual
becomes eligible for Medicare.
Individuals who have qualified for Social Security Disability Income (SSDI) benefits can apply for Medicare
after receiving SSDI for 24 months. The special 29-month COBRA benefit period can extend group insurance
both for this 24-month benefit period and the five-month SSDI waiting period that precedes it.
An individual who receives coverage under COBRA may also apply it toward creditable coverage under
HIPAA.
[7.3.6] COBRA PREMIUMS
Employees must pay the entire group insurance premium to maintain coverage, including their monthly share
and the amount paid by their former employer. COBRA beneficiaries pay the premiums directly to an
insurer’s COBRA claim unit. Insurers collect an additional 2% to cover the added cost of COBRA
administration. The terminated employee therefore pays 102% of the group premium, not just the standard
employee contribution.
For example, let us assume that an employee is laid off. The employee’s monthly health insurance
contribution was $200. The employer’s entire premium is $500 per month; therefore, the former employee
must now pay $510 per month ($500 + $10 [2%]) for his COBRA benefits.
[7.4] CONVERSION
Group plans may also provide a conversion privilege. In part, it depends on the type of policy involved. State
law may also govern the requirements surrounding this privilege. Group plan participants may have the
option to convert coverage to an individual plan without evidence of insurability. The Affordable Care Act
makes conversion less relevant in some cases. Beneficiaries typically have 31 days to make that decision.
The downside of converting to an individual policy is the higher cost and more limited benefits.
If the employer allows current employees to convert their group coverage to an individual policy at the time of
termination, then the employer must extend the same option to former employees as their COBRA coverage
ends.
[7.5] HEALTH INSURANCE PORTABILITY AND ACCOUNTABILITY ACT
The Health Insurance Portability and Accountability Act (HIPAA) was passed in 1996. In addition to
protecting patient privacy, it prevented insurers from imposing new pre-existing condition exclusions
whenever individuals changed plans, especially employer-sponsored group insurance, due to changing jobs.
When new employees become eligible to participate in a company health plan, previous coverage satisfies
any exclusionary period, provided there was no gap in coverage of 63 days or more. This previous quali fying
insurance is referred to as “creditable coverage.” As defined by HIPAA, creditable coverage includes
individual major medical insurance, group major medical plans, Medicaid, or other comparable health
insurance plans. HIPAA also governs special enrollment periods following certain life events, such as
marriage, divorce, or the birth of children.
Although the passage of the Affordable Care Act diminishes HIPAA’s impact on group insurance portability, it
still applies to medical expense contracts that are not subject to the ACA requirements, such as Medicare
Supplements and Medicare Advantage plans.
[7.5.1] HIPAA REQUIREMENTS: NOTICE OF PRIVACY PRACTICES
When individuals enroll in a health insurance plan, the HIPAA Privacy Rule requires the plan sponsor to
provide the plan subscriber with a Notice of Privacy Practices (Notice), which must disclose the following:
• How protected health insurance may be used and disclosed
• Individual rights regarding their health information
• The plan’s duty to protect health information
• The enrollee’s privacy rights
• Contact information for questions or complaints
• The need for the enrollee’s permission before making disclosures
• Plan sponsors must provide the Notice no later than when new subscribers enroll. They must also
alert subscribers at least once every three years that a copy of this notice is available.
Finally, health insurance plans must provide revised notice of material changes within 60 days of material
changes. Changes posted on an insurer’s website must be prominently displayed by the effective date of the
change.
[7.6] PREGNANCY DISCRIMINATION ACT
The Pregnancy Discrimination Act of 1978 was an amendment to the Civil Rights Act of 1964. For
employment-related purposes, this law requires that women who are pregnant, have given birth, or have
been affected by related medical conditions be treated in the same manner as those with other health -
related concerns.
In other words, if a woman is pregnant and is unable to perform her employment duties, she will be entitled
to benefits as if she were suffering from any other condition covered by her benefit plan.
Regarding coverage for abortions, plans must cover the procedure if the mother’s life is in danger. Plans must
also cover any complications that may arise from the procedure.
As it relates to disability insurance, pregnancy is treated as a disability to the degree that it results in a
person’s inability to perform her duties. Therefore, if an employer provides any disability insurance, sick -
leave coverage, or medical expense coverage for employees, the employer must provide coverage for
pregnancy and its related medical conditions on the same basis. This act applies to disability insurance,
medical expense coverage, and benefit plans, both insured and self-insured. Covered entities include private
sector employees, employers with 15 or more employees, and public sector employees.
[7.7] SPECIAL REGULATIONS FOR SMALL GROUP HEALTH INSURANCE
Insurers that market group health insurance plans to small business employers must follow specific
regulations. Regulations that define unfair marketing practices prohibited during the sale of individual policies
also apply to small group plans.
Federal law defines a small group as one that has 50 employees or fewer. States generally define a small
group as one with between two and 50 employees.
HIPAA and the ACA both mandate that small group health plans be guaranteed-issue policies for groups that
meet minimum participation requirements. Insurers cannot refuse to cover small groups (up to 50
employees) based on the health history of group members. Benefit plans marketed to these groups must
offer coverage to all eligible employees and dependents. Additionally, insurers cannot discriminate against
an employer based on the nature or category of the business. Insurers must also renew existing, in -force,
small group plans unless the employer fails to pay the premium, engages in fraud or intentional
misrepresentation, or fails to comply with the policy terms (e.g., failing to meet the participation
requirements).
The types of plans available for small groups include healthcare center plans, HMO plans, and small
employer carrier plans. Regarding the latter, the percentage of employee participation is a key underwriting
consideration. In addition, carriers that market small employer health plans must offer at least two health
plans to the employer—one with standard benefits and one with essential (basic) benefits.
Larger groups (with over 50 employees) are not guaranteed coverage, but once they are insured, they receive
guaranteed renewability. However, any group’s renewability may be denied due to nonpayment of premiums,
fraud, termination of coverage in the market, or failure to meet participation or contribution requirements.
[8] CHAPTER SUMMARY
In this chapter, we've explored the diverse landscape of health insurance providers in America. We began by
examining traditional indemnity plans and service providers like Blue Cross and Blue Shield, which reimburse
policyholders or pay providers directly for covered services.
We then investigated managed care approaches aimed at controlling rising healthcare costs. Health
maintenance organizations (HMOs) combine healthcare financing and delivery, emphasizing preventive care
and requiring members to select primary care physicians who coordinate their treatment. We explored the
four main HMO structures—staff, group, network, and independent practice association models—each of
which organizes healthcare delivery differently.
Preferred provider organizations (PPOs) offer more flexibility by allowing members to see specialists without
referrals and providing some coverage for out-of-network care, though at higher out-of-pocket costs. Point-
of-service (POS) plans blend HMO and PPO features, while exclusive provider organizations (EPOs) combine
HMO restrictions with PPO direct access to specialists.
Group health insurance emerged as the predominant coverage source for Americans, typically offered
through employers. We examined how group plans achieve lower costs through consolidated administration,
predetermined benefits, and increased persistency. We distinguished between contributory plans (where
employees share premium costs) and non-contributory plans (fully employer-funded), and explored how
insurers use experience rating for large groups and community rating for small groups.
Alternative group insurance arrangements, such as Multiple Employer Welfare Arrangements (MEWAs),
Multiple Employer Trusts (METs), and franchise health plans, offer options for organizations that might not
qualify for traditional group coverage.
Finally, we reviewed key regulations protecting consumers with group health insurance, including COBRA's
continuation coverage requirements, HIPAA's portability provisions, and the Pregnancy Discrimination Act's
equal treatment mandate.
Understanding these various health insurance providers and their approaches to healthcare delivery is
essential for professionals advising clients on their insurance options.
[8.2] REVIEW NOTES
Learning Objective 1: Identify the key differences between traditional health insurance policies and
managed care plans
Key Concepts:
• Traditional health insurance (indemnity plans) reimburses insureds for healthcare costs after services
are received
 • Indemnity plans focus on indemnifying the insured without reference to specific provider networks
• Blue Cross/Blue Shield operates as a service provider, paying directly to participating providers
• Managed care plans focus on controlling healthcare costs through networks and utilization
management
• Managed care emphasizes preventive care and coordinates the delivery of healthcare services
Important Distinctions:
• Traditional plans: National scope, free choice of providers, higher out-of-pocket costs
• Managed care: Local/regional networks, restricted provider choice, lower out-of-pocket costs
• Traditional plans: Fee-for-service with reimbursement model
• Managed care: Various payment structures, including capitation and discounted fee-for-service
Learning Objective 2: Explain how health maintenance organizations (HMOs) control costs and deliver
healthcare services
Key Concepts:
• HMOs combine financing and delivery of healthcare services
• Members pay fixed periodic fees rather than fee-for-service
• Emphasize preventive care with comprehensive coverage
• Require the selection of a Primary Care Physician (PCP) who acts as a gatekeeper
Cost Control Methods:
• The gatekeeper system requires PCP referrals for specialist care
• Utilization review (prospective, concurrent, retrospective)
• Capitation payments to providers in some models
• Emphasis on preventive care to reduce costly treatments later
• Limited provider networks with negotiated rates
Learning Objective 3: Distinguish between the four main types of HMO structures (staff, group, network,
and IPA models)
Staff Model (Closed Panel):
• Physicians employed directly by HMO
• Care provided in HMO-owned facilities
• Salaried physicians work exclusively for the HMO
Group Model (Closed Panel):
• HMO contracts with physician groups
• Capitation or predetermined payment to the group
• The group pays physicians for services provided
Network Model (Closed Panel):
• Similar to the group model, but involves multiple physician groups
• Payment based on a capitation fee
• Physicians work in HMO facilities
Independent Practice Association (IPA) Model (Open Panel):
• Network of physicians working from their own offices
• Physicians participate in an HMO on a part-time basis
• The broadest range of provider choices for members
• Physicians may see non-HMO patients
Learning Objective 4: Compare the features of preferred provider organizations (PPOs) to other
healthcare delivery systems
Key Characteristics:
• Sponsor networks of healthcare providers who offer services at discounted rates
• Finance healthcare, but do not deliver it directly
• Operate on a fee-for-service basis with scheduled costs
• Provide coverage for out-of-network care at a higher cost to the member
 • Allow direct access to specialists without PCP referrals
Compared to HMOs:
• More provider choice than HMOs
• Out-of-network coverage (unlike most HMOs)
• No gatekeeper requirement
• Often higher out-of-pocket costs
• Fee-for-service rather than prepaid care
Learning Objective 5: Recognize how point-of-service (POS) plans combine elements of HMOs and
traditional insurance
Key Concepts:
• Hybrid model combining HMO and traditional insurance features
• In-network care coordinated through PCP (like HMO)
• Out-of-network care is available at higher cost-sharing (like an indemnity plan)
• Higher deductibles and coinsurance for out-of-network services
Important Features:
• Requires PCP selection and referrals for in-network specialist care
• More flexibility than HMO with an out-of-network option
• Cost-sharing increases significantly for out-of-network care
• In-network costs resemble an HMO structure with copays
Learning Objective 6: Describe the basic characteristics that define eligible groups for group health
insurance
Eligible Groups:
• Natural groups existing for a purpose other than obtaining insurance
• Employers, labor unions, trade associations, and creditor-debtor groups
• Multiple-employer trusts, fraternal lodges
Group Requirements:
• Minimum number of participants (typically 2+ for small groups)
• Stable workforce without excessive turnover
• Clearly defined eligibility criteria for members
• Cannot discriminate against individuals within a defined class
Individual Eligibility:
• Typically restricted to full-time employees (30+ hours/week)
• May require a probationary period (1-3 months) before eligibility
• Limited enrollment periods to control adverse selection
• Special enrollment for qualifying life events
Learning Objective 7: Differentiate between contributory and non-contributory group insurance plans
Contributory Plans:
• Employees pay portion of premium costs
• Typically require 75% participation of eligible members
• Lower employer costs but higher employee costs
• Enrollment periods help control adverse selection
Non-Contributory Plans:
• Employer pays the entire premium
• Typically require 100% participation of eligible members
• Higher employer costs but no employee premium costs
• Less concern about adverse selection
Learning Objective 8: Explain how group health insurance plans are underwritten using experience and
community rating
Experience Rating:
 • Used for large groups (51+ employees)
• Based on the group's actual claims history
• Premiums reflect the group's specific risk profile
• Considers factors like average age, industry, and prior claims
Community Rating:
• Used for small groups (2-50 employees)
• Based on the claims experience of similar groups in the community
• All small groups in area charged similar rates
• Less variation in premiums between small groups
Learning Objective 9: Identify the alternative forms of group insurance, including MEWAs, METs, and
franchise plans
Multiple Employer Welfare Arrangements (MEWAs):
• Two or more unrelated employers providing benefits
• Subject to both ERISA and state regulations
• Can be structured as a trust, corporation, or other legal entity
• Can be fully insured or self-funded
Multiple Employer Trusts (METs):
• Fully insured MEWAs established by third parties
• Combines multiple employers into a single pool
• Trust holds the master contract rather than participating employers
• Employers become trust members by subscribing
Franchise Health Plans:
• Individual policies issued to association/professional society members
• Association serves as plan sponsor
• Each participant completes a separate application and receives an individual policy
• Typically offers discounted premium rates
Self-Funded Plans:
• Employers fund and pay claims directly under ERISA regulations
• May use stop-loss insurance to limit financial risk
• Often use third-party administrators for claims processing
• Greater flexibility in benefit design
Learning Objective 10: Summarize the key federal regulations that protect consumers with group health
insurance
COBRA:
• Requires continuation coverage after qualifying events
• 18 months of coverage for employment termination
• 36 months for dependents after death, divorce, or aging out
• 29 months for disability cases
• Beneficiaries pay 102% of the full premium
HIPAA:
• Ensures portability between health plans
• Protects against new pre-existing condition exclusions
• Requires creditable coverage with no gaps exceeding 63 days
• Mandates privacy protections for health information
• Requires Notice of Privacy Practices
Pregnancy Discrimination Act:
• Requires equal treatment for pregnancy-related conditions
• Treats pregnancy as any other health condition for benefits
• Must cover abortion if the mother's life is in danger
 • Applies to disability insurance and medical expense coverage
Small Group Regulations:
• Guaranteed issue for small groups meeting participation requirements
• Cannot refuse coverage based on health history
• Must offer coverage to all eligible employees
• Cannot discriminate based on business category
Exam Tips:
• Distinguish between indemnity plans and hospital indemnity plans (fixed daily amount)
• Remember, Blue Cross covers hospital expenses, while Blue Shield covers physician expenses
• Know the four HMO structures and their key differences
• Understand the gatekeeper role of PCPs in HMOs and some POS plans
• Differentiate between copayments (fixed amount) and coinsurance (percentage)
• Know the three types of utilization review: prospective, concurrent, and retrospective
• Memorize COBRA qualifying events and continuation periods (18, 29, and 36 months)
• Understand the difference between experience rating and community rating
• Know participation requirements for contributory vs. non-contributory plans
• Recognize the differences between MEWAs and METs
Remember:
• The term "probationary period" can refer to eligibility to join a group or coverage for illness
• COBRA beneficiaries pay 102% of the full premium (employee + employer portion + 2% admin fee)
• Creditable coverage under HIPAA requires no gap in coverage exceeding 63 days
• Small groups are guaranteed issue but must meet minimum participation requirements
• Group plans may terminate when employment ends, but extension of benefits may apply for existing
claims
• PPOs provide out-of-network coverage while HMOs and EPOs generally don't (except emergencies)
• Self-funded plans are regulated under ERISA and may use stop-loss insurance to limit risk
• Group insurance requires a natural group that exists for purposes other than obtaining insurance
• Managed care networks emphasize preventive care and cost control measures
• HIPAA requires Notice of Privacy Practices at enrollment and every three years thereafter
Chapter 15
[1] MEDICAL EXPENSE INSURANCE INTRODUCTION
Imagine waking up with severe abdominal pain that sends you to the emergency room, or receiving a
diagnosis that requires ongoing treatment. How would you pay for these unexpected medical expenses? This
is where medical expense insurance becomes essential in our lives.
Medical expense insurance serves as a financial safety net, protecting you from the potentially devastating
costs of healthcare. Whether it's a routine doctor's visit, emergency surgery, or treatment for a chronic
condition, medical insurance helps make healthcare accessible and affordable.
In this chapter, we'll explore the world of medical expense insurance from the ground up. We'll start with
basic medical expense policies that provide first-dollar coverage for specific services, then move to
comprehensive major medical plans that protect against catastrophic expenses. You'll learn how
deductibles, coinsurance, and stop-loss provisions work together to share costs between insurers and
policyholders.
We'll also examine how legislation like the Affordable Care Act has transformed the insurance landscape by
establishing essential health benefits, prohibiting pre-existing condition exclusions, and creating health
insurance exchanges. Additionally, we'll explore innovative approaches to healthcare financing, including
tax-advantaged accounts that help consumers manage their medical expenses.
As you begin your insurance career, understanding these concepts will be crucial for helping your future
clients navigate their healthcare options. The knowledge you gain in this chapter will provide a foundation for
explaining complex insurance terms and provisions in simple, accessible language.
This chapter is organized into the following sections:
• Medical Expense Insurance Overview
• Basic Medical Expense Insurance Policies
• Major Medical Expense Insurance Plans
• Statutes Governing Medical Insurance
• Innovations and Taxation
[1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
• Distinguish between basic medical expense insurance and major medical expense insurance policies
and their key characteristics
• Identify the different approaches insurers use to provide basic expense coverage, including scheduled
and non-scheduled plans
• Explain the various types of policy deductibles and how they function in medical insurance
• Calculate patient and insurer financial responsibilities using deductibles, coinsurance, and stop -loss
provisions
• Describe the essential health benefits required by the Affordable Care Act (ACA)
• Compare and contrast tax-advantaged health accounts, including HSAs, HRAs, and FSAs
• Explain how high-deductible health plans work with health savings accounts
• Identify key provisions of statutes governing medical insurance, including the ACA and HIPAA
[1.2] KEYWORDS
Before reading this chapter, please review the following keywords. An understanding of these basic
definitions will improve your comprehension of the chapter content.
Actuarial Value: This represents the minimum projected percentage of medical costs that are likely to be
covered by a medical expense policy.
Affordable Care Act (ACA): This Act was enacted to make health insurance more accessible and affordable.
The ACA introduced mechanisms, including government mandates, subsidies, and insurance exchanges.
Basic Hospital Expense Insurance: These policies cover hospital room and board, miscellaneous hospital
expenses (e.g., laboratory work, X-rays, medications), the use of operating rooms, and related supplies. They
reimburse insureds for specified hospital costs up to a stated maximum benefit.
Basic Medical Expense Insurance: These health insurance policies provide "first-dollar" benefits for specified
(and limited) health care. This general term encompasses basic hospital, basic physician, and basic surgical
insurance.
Basic Physician Expense Insurance: These policies cover non-surgical services provided by a physician.
Basic Surgical Expense Insurance: These policies pay for the cost of surgeons, regardless of whether the
surgery is performed in or out of the hospital. Coverage also includes anesthesiologist fees.
Benefit Period: This is either the length of time benefits are paid following a loss or the policy period during
which claims are counted against benefit and cost-sharing limits.
Bronze Plan: This ACA metal tier plan has an actuarial value projected to cover 60% of typical medical costs.
Cafeteria Plans: These plans are employee benefit arrangements developed for businesses in the United
States to offer a variety of employee benefits, including accident and health insurance, on a pre -tax basis.
Employees can select from a menu of benefits to tailor the package to their individual needs.
Calendar-Year (Cumulative or All-Cause) Deductible: This deductible is also referred to as a cumulative or
all-cause deductible. With this deductible, the insured must meet it only once during the benefit period.
Carryover Provision: This provision applies when insureds have not yet met their deductible in the final three
months of the policy year. The provision allows them to “carry over” claims from the final three months of
that year and apply them to the following year's deductible.
Conversion Factor (Relative Value Scale): The relative value scale is one way to create a schedule of
coverage amount for individual services by assigning them a number of units that represents relative cost.
Each unit is worth a certain amount of money. Changes to an entire schedule can be made by adjusting the
dollar value per unit, as long as the value of each service remains constant relative to the others.
Deductible: This is the amount of an expense or loss that an insured must pay before a health insurance
policy begins to pay benefits.
Essential Health Benefits (EHBs): This is a list of 10 benefits that cannot have lifetime or annual caps. The
ACA defined these as necessary benefits for all major medical insurance.
Family Deductible: This deductible limits the total amount due from the entire covered family, regardless of
whether individual deductibles are met. In most cases, the family deductible is equal to two or three times
the individual deductible.
Flat Deductible (Initial Deductible): This is a stated dollar amount that applies to a covered loss (e.g., $500).
This deductible can be applied on a per-occurrence, per-insured, or per-year basis.
Flexible Spending (Accounts) Arrangements (FSAs): These tax-advantaged accounts are set up through an
employer's cafeteria plan. FSAs allow employees to set aside a portion of their earnings for qualified medical
expenses on a "use it or lose it" basis.
First-Dollar Coverage: This describes insurance policies that pay claims without imposing a deductible.
Gold Plan: This ACA metal tier plan has an actuarial value of 80% of typical medical costs.
Health Insurance Exchange: This federal website allows consumers to check their eligibility for government
assistance programs. The site also allows consumers to compare and purchase health insurance plans.
Health Insurance Portability and Accountability Act (HIPAA): The legislation limits pre -existing condition
exclusions by treating all group insurance as a single pool of insureds. Time covered by one plan is
transferable to any other policy, provided there is no gap in coverage of 63 days or longer. It also established
privacy rules regarding the use and dissemination of personal health information.
Health Insurance Portability and Accountability Act (HIPAA) Privacy Rule: This rule provides federal
protection for an individual's health information and gives patients various rights with respect to that
information.
Health Reimbursement (Accounts) Arrangements (HRAs): These accounts are employer-funded and
employer-established in conjunction with high-deductible health plans. HRAs cover cost-sharing amounts
such as deductibles and coinsurance. Unused amounts carry over from year to year and accumulate with
annual employer contributions, but balances are not portable when an employee changes employers.
Health Savings Accounts (HSAs): These portable, tax-advantaged medical savings accounts are available to
U.S. taxpayers enrolled in a high-deductible health plan. The funds contributed to an account are not subject
to federal income tax at the time of deposit or when used for qualified medical expenses.
High-Deductible Health Plan (HDHP): An HDHP is a major medical policy that makes the insured responsible
for the cost of basic expenses (other than preventive care mandated by the ACA). At the same time, the
policy also establishes an annual limit on out-of-pocket costs. The IRS sets the minimum annual deductible
and the maximum out-of-pocket cost for all HDHPs that qualify for use with an HSA.
Impairment Rider: Insurers add an impairment rider to health insurance policies that permanently exclude
claims for a condition disclosed by the insured during the application process.
Integrated Deductible: Insurers use this type of deductible when a major medical plan is packaged with
basic coverages. Amounts paid by the basic policy apply to the major medical deductible.
Internal Limits (Inside Limits): These are annual limits on coverage for specific, covered services.
Look-Back Period: This is the defined period immediately preceding the beginning of coverage during which
an insurer can identify a health concern as a pre-existing condition, subject to the terms of applicable policy
provisions.
Major Medical (Expense) Insurance Policy: This is a health insurance policy that provides broad coverage and
high benefits for hospitalization, surgery, and physician services. The policy is characterized by cost sharing
in the form of deductibles and coinsurance. Major medical plans meet the ACA's minimum essential
coverage requirements.
Medical Savings Accounts (MSAs): These accounts are created to help the employees of small employers
(as well as self-employed individuals) pay for their medical care expenses. MSAs are tax-free accounts set
up with financial institutions, such as banks and insurance companies. Qualified MSAs are available for
employers with no more than 50 employees.
Metal Tiers for Major Medical Insurance: The ACA requires health insurers to offer plans within health
insurance exchanges that conform to its distinct levels of coverage. The four defined "metal tiers" are
Bronze, Silver, Gold, and Platinum.
Out-of-Pocket Maximum: This is the most an insured must pay for covered services in a single plan year.
Per-Cause (or Occurrence) Deductible: With this deductible, the insured must satisfy a deductible for each
accident or illness.
Platinum Plan: This ACA metal tier plan has an actuarial value projected to cover 90% of typical medical
costs.
Portability: Portability describes one's ability to retain access to a group insurance policy when changing
employers.
Pre-Existing Condition: This is a health condition that exists prior to the inception of insurance coverage.
Federal and state laws limit this definition to conditions that manifest within a limited period prior to the start
of coverage.
Pre-Existing Condition Exclusion: The ACA disallows pre-existing condition exclusions in qualifying policies,
but they still exist in other contracts. These exclusions are temporary exclusions for undisclosed conditions
treated during the look-back period.
Relative Value (Approach) Scale: This approach is used in basic surgical insurance to establish benefits for
covered procedures. The scale establishes the value of a single unit and then assigns a number of units to
each covered surgery.
Silver Plan: This ACA metal tier plan's actuarial value is projected to cover 70% of typical medical costs.
Stop-Loss: Traditionally, this was the maximum amount of coinsurance an insured paid in one year. Today,
the term "stop-loss" is often used interchangeably with the phrase "out-of-pocket maximum."
Usual, Customary, and Reasonable (UCR) (Non-Scheduled Plans): Plans that use this approach compare
expenses to what is deemed reasonable and customary for the geographical region of the country where the
service was performed.
[2] MEDICAL EXPENSE INSURANCE OVERVIEW
Medical expense insurance policies are designed to protect against the high costs of medical care due to
accidents and illnesses. Depending on the type of contract, they can cover a wide range of services. There
are two main types of medical expense insurance plans: basic medical and major medical, each with distinct
features.
Basic medical expense insurance contracts are characterized by the following:
• First-dollar coverage, which means no deductibles;
• Relatively modest coverage limits or time frames; and
• Coverage is limited to a specific list of services; if it is not listed, it is not covered.
Major medical expense insurance offers comprehensive coverage for catastrophic medical expenses. It is
characterized by the following:
• Annual deductibles, which can be significant,
• Unlimited coverage for essential services as defined by the ACA and higher limits on other types of
care, and
• Coverage for all medically necessary treatments, such as hospital care, physician services, surgeries,
diagnostics, lab work, medications, nursing, and rehab services, unless explicitly excluded.
Common exclusions from all medical expense policies include:
• Elective cosmetic procedures
• Experimental therapies
• Care provided in government facilities
 • Work-related injuries
• Occupational diseases, which are covered by workers' compensation
EXAM TIP!
Focus on understanding what specifically these policies cover and how they pay benefits, as these are
common test points.
[3] BASIC MEDICAL EXPENSE INSURANCE POLICIES
This section covers basic medical insurance policies that are limited in the range of losses they cover and the
amount of coverage they provide. These policies generally offer "first-dollar" coverage and often don't
impose any deductible. These plans are considered excepted benefits, plans that are exempt from ACA
requirements.
Basic medical expense insurance can be purchased to cover a range of benefits, including emergency
accident benefits, maternity benefits, mental and nervous disorders, hospice care, critical care, home health
care, outpatient care, outpatient treatment, convalescent care, nursing homes, dental and vision, and
nurses' expenses, including private duty nursing. These basic medical expense policy benefits are often
lower than the actual expenses incurred.
Basic medical insurance contracts are characterized by the following:
• First-dollar coverage, which means no deductibles;
• Relatively modest coverage limits or time frames; and
• Coverage is limited to a specific list of services; if it is not listed, it is not covered.
We will examine three major categories of basic medical expense coverage: basic hospital insurance, basic
surgical insurance, and basic physician insurance.
[3.1] HOSPITAL EXPENSE INSURANCE POLICIES
Basic hospital expense insurance covers hospital room and board as well as miscellaneous hospital
expenses. Covered expenses include the following costs that are incurred while the insured is confined to a
hospital:
• Lab and X-ray charges
• Inpatient medicines
• Intensive care
• Use of operating rooms
• Surgical supplies
Hospital room and board benefits cover expenses for occupying the room, general nursing care, food and
beverages, and personal hygiene items. Most basic hospital policies cover hospital room and board
expenses on an indemnity basis (by paying a fixed dollar amount). In such cases, a policy would have a
schedule showing a daily amount for a standard hospital room, and possibly a schedule of per -service
benefits as well. The benefit amount in such policies is not tied to the actual co st of the covered services.
There is no deductible, and a maximum limit on the number of inpatient days and the total amount paid for
services.
For example, if the hospital expense benefit is $200 per day, and the hospital charges $400 per day, the
insured is responsible for the additional $200 per day. In this regard, the policy functions like a hospital
indemnity contract.
One important concept to remember about the basic hospital plan is that it covers any expenses billed
directly by the hospital rather than health care providers. With the exception of nursing care, the policy
covers things rather than practitioners. Health care professionals who can bill independently are covered by
basic surgical or basic physicians (medical) policies.
For example, the cost of surgery is covered by a basic surgery policy, surgical insurance covers the
physicians, and the basic hospital contract covers the use of the operating theater, supplies, as well as the
nursing staff.
[3.2] SURGICAL EXPENSE INSURANCE POLICIES
Basic surgical expense insurance policies cover the costs of surgeons’ services, regardless of whether
surgery is performed in or out of the hospital. Coverage includes the surgeon's fees, the anesthesiologist, and
the operating room.
These policies are commonly written in conjunction with both hospital expense policies and medical
expense policies. Insurers can use multiple approaches to structure the benefits of basic surgical expense
coverage and to determine benefit amounts. The use of surgical schedules or a relative value scale is most
common. A usual and customary approach is more likely found in a minimum essential coverage (MEC) plan,
also known as a "skinny plan." We will describe these plans in the next section.
[3.2.1] SURGICAL SCHEDULE APPROACH
Under the surgical schedule approach (also known as a scheduled plan), the insurer assigns a dollar amount
to each surgical procedure. The schedule lists all procedures covered by the plan. If costs change, the
insurer must update the schedule with all changes.
[3.2.2] RELATIVE VALUE SCALE APPROACH
The relative value scale approach is similar to the surgical schedule but differs by assigning each surgery a
designated number of units rather than a flat dollar amount. To implement this method, the insurer
establishes the fundamental value of a single unit. The carrier then converts the cost of each operation into a
particular number of units. When costs change, the insurance company only needs to adjust the unit value to
affect the benefits for all covered surgeries. The procedure allows insurers to eas ily maintain a consistent
relative difference in costs across the various covered procedures while adjusting for shifts in the cost of
services that affect prices generally. If the cost of a particular procedure changes relative to the others, it can
instead adjust the number of units assigned.
[3.2.5] CUSTOMARY, REASONABLE (NON-SCHEDULED) APPROACH
Non-scheduled plans pay benefits based on a usual, customary, and reasonable (UCR) basis. Under the
terms of a policy using the "UCR" standard, surgical expenses are compared to what's deemed customary
and reasonable for the geographical region where the surgery is performed. This is the most common fee,
which is charged by 70% to 80% of practitioners who offer the service. The UCR approach is the maximum
amount that an insurer will consider as an eligible basis for reimbursing covered costs.
For example, let's assume that the UCR cost of a particular procedure is $2,000 and that the basic surgical
policy pays 80% of the covered cost on a UCR basis. This formula means the insurer will pay up to 80% of
$2,000, or $1,600. The insured will pay the remaining $400. If a practitioner charges $2,400, the insurer still
pays only $1,600, which is 80% of the maximum covered cost, or 80% of what's "UCR." The remaining $800
will be paid by the insured.
Non-scheduled plans are more common with comprehensive contracts and major medical policies.
[3.3] PHYSICIAN EXPENSE POLICIES
This type of contract is often called basic physician expense coverage because it covers a physician's non-
surgical services. These services are often referred to as outpatient services and are generally included with
either the hospital or surgical expense plan, not written alone. This type of insurance provides benefits to
cover a physician's fees for non-surgical care in the hospital, doctor's office, or in the home (i.e., house call).
An amount per visit (i.e., $50) is typically paid for treatment of an injury or illness.
[3.3.1] PHYSICIAN ASSISTANT POLICIES
These policies cover the cost of services provided by physicians and other licensed health care providers
within their range of practice. State statutes generally prohibit denying a claim because a physician assistant
rendered the services.
[4] MAJOR MEDICAL EXPENSE INSURANCE PLANS
Major medical expense insurance offers high maximum benefits and comprehensive coverage under one
policy with a renewable one-year term. The ACA further defined major medical policies that provide a variety
of benefits as minimum essential coverage and cover a significant portion of an insured's anticipated out-
of-pocket costs. Major medical insurance coverage is available as group plans and individual policies
accessed through employer plans, commercial insurance agents, and government-sponsored online
marketplaces established under ACA authority.
Minimum essential coverage must be a core component for any major medical plan to qualify for sale on the
government online exchange. They must also meet the ACA mandate on group plans. Qualified plans cover at
least 60% of projected costs based on an estimate of average use.
Without limit, they also provide the essential health benefits, defined in the ACA, which fall into the following
categories:
• Ambulatory patient services (outpatient services)
• Emergency services
• Hospitalization
• Maternity and newborn care
• Mental health and substance use disorder services, including behavioral health treatment
• Prescription drugs
• Rehabilitative and habilitative services (skills needed for everyday living) and devices
• Laboratory services
• Preventive and wellness services and chronic disease management
• Pediatric services, including oral and vision care
Major medical insurance policies also offer hospice benefits, which generally include coverage for pain
management, home-based services, and counseling.
[4] MAJOR MEDICAL EXPENSE INSURANCE PLANS (continued)
Major medical plans also provide benefits for a variety of durable medical equipment, such as renting
hospital wheelchairs, beds, casts, splints, trusses, braces, and crutches, as well as benefits for prolonged
illnesses or injuries that require extended periods of rehabilitation.
Perhaps the most basic function of major medical insurance is protection against the financial burden of
catastrophic medical expenses. Policies cover both inpatient and outpatient hospital expenses, as well as
other necessary medical expenses. Since the policies offer coverage on an "open-peril" basis, they have
fewer exclusions and cover the gaps that can exist when a consumer relies on basic insurance plans.
Although often subject to network pricing agreements, the underlying basis for major medical insurance is
the UCR standard. Unlike basic medical expense plans, major medical insurance policies typically require
deductibles, coinsurance, and copayment requirements. Insurers often pay claims after the insured pays a
deductible. Once the deductible is paid, the insurer covers most costs, though insureds are responsible for
modest cost-sharing amounts in the form of copays or a coinsurance percentage. Insurance carriers assume
complete responsibility for paying claims after the insured pays the annual maximums set for coinsurance
and other cost-sharing amounts, as stated in the insurance contract. The limit on annual consumer claims
costs is called the out-of-pocket maximum.
Policies may also include some basic first-dollar benefits before the major medical deductible applies. Such
deductibles that separate basic and major medical benefits are called corridor deductibles.
[4.1] SUPPLEMENTAL AND COMPREHENSIVE MAJOR MEDICAL
Major medical expense insurance usually starts where basic coverage ends, either supplementing a basic
plan or functioning as part of a comprehensive major medical policy.
[4.1.1] SUPPLEMENTAL MAJOR MEDICAL
Supplemental major medical policies supplement the coverage payable under a basic medical expense
policy. After the basic policy pays its maximum benefit, the supplemental major medical policy provides
coverage for expenses not covered by the basic policy and for those that exceed the basic policy's maximum
benefit. If a person's treatment extends beyond the basic policy's time limit, the supplemental major medical
policy continues to provide coverage.
The insured must satisfy a deductible once the basic medical expense plan pays up to its specified limit. This
deductible is referred to as the corridor deductible because it falls between the covered basic expenses and
the major medical coverage.
[4.1.2] COMPREHENSIVE MAJOR MEDICAL
A comprehensive major medical policy combines the features of basic expense insurance (first -dollar
coverage) and major medical coverage, but is sold as a single policy. A comprehensive policy covers nearly
all medical expenses, including hospital, physician, surgical, nursing, drugs, and laboratory tests.
Additionally, a comprehensive major medical policy includes a deductible (typically a single deductible per
person with a maximum family deductible).
Major medical plans used to contain a "lifetime maximum benefit" that limited the insurer's total exposure
under the contract. Some policies also contain annual maximum limits on various benefits. With its passage,
the ACA prohibited annual and lifetime limits on services deemed "essential health benefits." Policies may
still impose lifetime benefits limits, but only on a limited number of services deemed non -essential benefits.
Also, grandfathered group health plans, which are exempt from ACA requirements, may continue to impose
these limits more liberally.
[4.2] MAJOR MEDICAL POLICY FEATURES
Cost sharing is an integral element of major medical insurance policies. The term "cost sharing" refers to the
portion of the cost for covered services that insureds must pay out of their own pockets. This element of a
policy is often referred to as the policy's out-of-pocket costs. Examples of cost-sharing include copayments,
deductibles, and coinsurance.
Other out-of-pocket costs not counted as cost sharing include any premiums or penalties an insured may be
required to pay. It's also important to note that if a person's insurance policy doesn't cover charges for a
particular service, the insured's need to pay such a bill is not considered cost sharing.
[4.2.1] DEDUCTIBLES
Most major medical policies include an initial deductible. An initial deductible is a stated dollar amount that
an insured individual must pay before the insurance carrier begins paying its share of covered claims.
Deductibles are primarily used to help control premium costs and reduce overutilization of medical services.
Most deductibles are fixed dollar amounts. Policies can have varying types of deductibles, such as an initial
deductible, a calendar-year deductible, an individual or family deductible, or a corridor deductible. Including
the deductible allows the insurer to offer a high level of protection at a lower premium, since the insured
retains a portion of the risk. The following section lists different types of deductibles.
[[Link]] CALENDAR-YEAR DEDUCTIBLE
The most common form of major medical insurance policy deductible is the calendar-year deductible, also
known as the cumulative or all-cause deductible. This deductible is considered an all-cause deductible
because the insured must meet it only once during the benefit period.
Major medical insurance plans may also include a carryover provision. This provision applies when an
insured has not yet met the policy deductible in the final three months of the policy year. The provision allows
an insured to apply claims paid by the insured in the final three benefit period months to the following year's
deductible.
[[Link]] FLAT DEDUCTIBLE
A flat deductible is the stated dollar amount an insured must pay before an insurance policy pays for a claim
(e.g., $500). Most major medical policies have an annual deductible. The policy applies medical expenses to
the deductible until the insured pays the deductible amount in covered claims. Some coverages may have a
deductible per occurrence, which is referred to as an "initial deductible." Health insurance deductibles
generally apply to each individual insured by the policy.
[[Link]] PER-CAUSE (OR OCCURRENCE) DEDUCTIBLE
With a per-cause deductible, the insured must satisfy a deductible for each accident or illness.
[[Link]] COMMON ACCIDENT OR SICKNESS DEDUCTIBLE
Some major medical policies have a common accident or sickness deductible. These major medical plans
include a provision stating that only one deductible must be satisfied when two or more insureds from the
same family are injured in the same accident or suffer concurrently from the same illness. This common
occurrence deductible generally equals the individual deductible amount.
[[Link]] FAMILY MAXIMUM DEDUCTIBLE
The basic deductible is calculated per covered individual, which can be burdensome for larger families. The
family deductible limits the total amount required from the entire covered family. It usually equals two or
three times the individual deductible.
For example, let us look at a policy with a $1,000 deductible per individual. A two-person family could
theoretically pay as much as $2,000 in deductible costs before receiving any coverage. A family of five could
pay as much as $5,000.
Now, let's assume this family of five's policy has a $1,000 individual deductible and a $2,000 family
deductible. Let us also assume the family has submitted the following claims:
The father has $800 in claims
The mother has $600 in claims
The two oldest children each have $300 in claims
The youngest child has yet to be sick
The total amount in claims equals $2,000 ($800 + $600 + $300 + $300 = $2,000). Even though no single
person has met the individual deductible, the family as a whole met the family deductible, so the family's
insurer will pay the next covered claim.
If a family member meets the individual deductible before the family deductible was met, only that member's
claims are eligible for payment until the other family members satisfy the rest of the family deductible.
[[Link]] CORRIDOR DEDUCTIBLE
When a major medical policy supplements a basic insurance policy without a deductible, the combination
creates a situation in which there is coverage, followed by a gap before major medical insurance applies. This
gap between the basic insurance coverage and the major medical coverage is referred to as a corridor
deductible. The deductible is not applied until the basic coverage has been exhausted.
[[Link]] INTEGRATED DEDUCTIBLE
Insurers use integrated deductibles when a major medical plan is packaged with basic insurance in a
comprehensive policy. An integrated deductible can also apply whenever more than one policy shares a
single deductible.
For example, let us assume that a major medical policy has a $500 deductible. If the insured also has a basic
medical expense coverage of $500 or more, then the amount paid by the basic coverage will satisfy the major
medical deductible in the event of a claim. However, if the basic plan does not cover the entire deductible
amount of the major medical plan, the insured is required to make up the difference.
Another example involves a situation in which a medical expense policy and a prescription drug plan are
subject to a $500 integrated deductible. Rather than pay a $500 deductible for each plan, the money paid for
one deductible applies to both. Essentially, there is only one $500 deductible because participant payments
satisfy both.
[[Link]] FLAT, CORRIDOR, INTEGRATED DEDUCTIBLE SCENARIOS
The following scenario illustrates the difference between a flat deductible without basic insurance, a corridor
deductible, and an integrated deductible.
Let us say that John is hospitalized with a severe illness at the beginning of his insurance policy's coverage
period. The total amount of the covered expenses is $7,000. John has an individual major medical insurance
policy with a $5,000 deductible. The question is, "How much must John pay before his major medical policy
begins to pay his claim?"
Let's consider three variations for this $7,000 claim:
1. John only has a major medical policy.
▪ John pays the $5,000 deductible first because there is no basic, first-dollar coverage;
and
▪ The major medical policy covers the next $2,000 of the claim after the deductible;
therefore
▪ John pays $5,000, and the insurer pays $2,000.
2. John also has a basic medical expense policy that will cover the first $4,000 of his costs, and his major
medical deductible is a corridor deductible.
▪ The basic policy covers the first $4,000, leaving another $3,000 to be paid.
▪ John is responsible for up to $5,000 in the corridor deductible, so he pays $3,000.
▪ John pays $3,000, and the insurers pay $4,000.
3. In this third variation, John also has a basic medical expense policy that will cover the first $4,000 of his
costs, BUT his major medical plan has an integrated deductible.
▪ John still has a basic policy that covers the first $4,000, leaving another $3,000 to be
paid.
▪ John is theoretically responsible for up to $5,000 according to the major medical
policy, BUT because John's deductible is integrated, the major medical policy credits
the amount paid by the basic insurer toward satisfying the deductible.
▪ THEREFORE, the basic policy is deemed to have satisfied the first $4,000 of John's
$5,000 deductible.
▪ THEREFORE, the basic policy pays $4,000, John pays $1,000, and the major medical
plan pays $2,000.
▪ The bottom line is that John pays $1,000, and the insurers pay $6,000.
[[Link]] FLAT, CORRIDOR, INTEGRATED DEDUCTIBLE SCENARIOS (continued)
The results of the above example are illustrated in the table below:
No Basic Insurance Basic Policy with a Corridor Basic Policy with an
$7,000 Total Expenses
Policy Deductible Integrated Deductible
Basic Policy Pays N/A $4,000 $4,000
John Pays $5,000 $3,000 $1,000
Major Medical Covers $2,000 N/A $2,000
Total Amount Covered
$2,000 $3,000 $1,000
by Insurance
EXAM TIP!
When the deductible is integrated, amounts paid by basic insurance offset the deductible.
[4.2.2] COINSURANCE
Coinsurance (also referred to as "percentage participation") is another characteristic of major medical
insurance plans. The purpose of coinsurance is to reduce the overutilization of major medical insurance (i.e.,
unnecessary care) by introducing economic consideration into the decision to access valuable medical
services.
Coinsurance is a type of cost-sharing that defines the percentage of covered expenses the insured shares
with the insurer. After an insured satisfies their deductible, the insurance company pays a percentage of the
additional expenses, while the insured pays the remainder. Coinsurance provisions are effective throughout
the duration of a policy and are described as insurer cost/insured cost.
For example, an 80/20 coinsurance means the insurer pays 80% of any covered expense (after the insured
pays the deductible), and the insured is responsible for the remaining 20% (in addition to the deductible).
Most major medical plans (other than HMOs, which limit out-of-network services to emergency care) pay a
high percentage (70%-90%) of covered claims in-network and at least 60% for out-of-network services.
While coinsurance amounts vary from plan to plan, the insurer must pay at least 50% of the covered
expenses for the plan to qualify as "insurance" rather than a "discount plan."
Let's look at how the math works using a common exam question scenario.
Assume an insured is covered by a policy with a $500 deductible and a coinsurance clause of 80/20. He is
hospitalized for three days and incurred medical expenses of $1,500. How much is the insured responsible
for? How much is the insurer responsible for?
Step 1 – The insured must pay the initial $500 deductible ($1,500 - $500 = $1,000). This leaves $1,000 in
remaining expenses.
Step 2 – We must apply the 80/20 coinsurance clause to the remaining $1,000 in expenses:
•
o The insurer is responsible for 80% of the $1,000. ($1,000 x 80% = $800). So, the insurer's
percentage of the $1,000 is $800, which is what the insurance company must pay.
o The insured must pay $200 in coinsurance, which is the remaining 20% of the $1,000,
obtained by subtracting the insurer's cost from $1,000 ($1,000 - $800 = $200).
Step 3 – We must add the amounts the insured must pay in Steps 1 and 2 ($500 + $200)
Therefore, the insured is responsible for $700 ($500 deductible plus $200 coinsurance). When we subtract
what the insured must pay from the total bill, we get what the insurance company must pay ($1,500 - $700 =
$800). THEREFORE, the insurer is responsible for paying $800.
EXAM TIP!
Regardless of whose cost the question seeks, always calculate the insured’s amount first. If the question
seeks the insured’s portion, you have the answer. If it asks for the insurer’s cost, just subtract the insured’s
portion from the total claim to get your answer. It is simpler with fewer steps.
[4.2.3] STOP-LOSS LIMIT/MAXIMUM BENEFIT
The stop-loss provision limits an insured's out-of-pocket medical expenses. Originally, the term "stop-loss"
referred to the maximum amount of coinsurance that an insured was required to pay before their insurance
carrier assumed 100% of the responsibility for additional claims during the remainder of the policy period.
Today, the term is equivalent to the "out-of-pocket maximum" as defined in the policy.
Policies define the "out-of-pocket maximum" as the total amount of covered costs that the insured is
required to pay during one policy year. The total amount includes the deductible, coinsurance, and any
applicable copays. The "out-of-pocket maximum" does NOT include premiums, charges for services that
exceed "usual and customary," or out-of-network services not covered by the plan. These charges are just a
few specific exclusions.
John is hospitalized with a serious illness at the beginning of his insurance policy's coverage period. The total
amount of the covered expenses is $30,000. John has an individual major medical insurance policy with a
$5,000 deductible. The policy also has a 30% coinsurance requirement, which directs the insurance
company to pay 70% of covered costs and the insured to pay 30%.
Let us consider the cost of care without a stop-loss limit. We will then apply the $9,200 out-of-pocket limit
mandated by the ACA for 2025 and see its impact.
$30,000 Total Expenses Cost Without $9,200 Stop-Loss Cost With $9,200 Stop-Loss Applied
Deductible Paid by John $5,000 $5,000
Amount Covered by Insurance $25,000 $25,000
Apply 70%/30% Coinsurance Split $17,500 – $7,500 $17,500 – $7,500
$12,500 – $9,200 =
Apply the $9,200 Stop-Loss N/A
$3,300 (shifted to the insurer)
Total Cost to John for the Policy Year $5,000 + $7,500 = $12,500 $9,200
[4.2.4] OTHER MAJOR MEDICAL FEATURES AND CONCEPTS
[[Link]] INTERNAL LIMITS
Internal limits are also called inside limits. With the passage of the ACA, insurers can no longer impose
annual limits on essential health benefits. ACA-compliant policies may still limit costs to reasonable charges
and may still establish internal limits on benefits not defined as essential.
Examples of internal limits include the following:
• The policy will only pay for a semi-private room, not a private room
• The policy will pay only usual and customary medical expenses
• The policy will pay lifetime alcohol or drug rehab expenses, but only up to $10,000 or for 75 days, etc.
[[Link]] BENEFIT PERIOD
The benefit period either begins immediately when an accident or illness occurs or when the insured meets
the deductible. Benefit periods vary from policy to policy. For example, some benefit periods end each year,
while others last up to two years.
[[Link]] PRE-EXISTING CONDITIONS
Although the ACA prohibits pre-existing condition exclusions in compliant major medical plans, they still
exist in short-term medical expense policies that fill in coverage gaps. Limitations may apply to all pre -
existing conditions regardless of whether the insured declared them on the application. Traditionally,
insurers rated applicants with existing conditions revealed on applications, or excluded such conditions
permanently with an impairment rider.
When policies are not medically underwritten, insurers lose access to an individual's health history.
Therefore, such policies are priced based on prevailing costs and risks in a particular locale or region. In
these situations, insurers use a blanket pre-existing condition exclusion, which excludes coverage for any
condition that requires coverage immediately before the policy's inception. This exclusion lasts between six
months and two years, depending on the policy type and applicable regulations.
Major medical insurance policies covered by the ACA no longer apply pre-existing condition exclusions,
though they may apply to some limited medical expense policies and Medicare-related policies.
[4.3] SCENARIO: A MAJOR MEDICAL CLAIM
Sarah, a 42-year-old marketing executive, began experiencing severe abdominal pain and fever while on a
business trip. She initially dismissed it as food poisoning. When the pain became unbearable and she
developed a high fever, colleagues rushed her to the nearest emergency room.
At the hospital, diagnostic tests revealed acute appendicitis with complications. She required emergency
surgery followed by an extended hospital stay due to the infection's severity. Due to a widespread infection,
Sarah developed post-surgical complications, including a secondary infection that required additional
treatment. She spent seven days in the hospital, including two days in intensive care for close monitoring of
her condition and IV antibiotic therapy.
After discharge, Sarah required two weeks of recovery at home before returning to work part -time, and
another two weeks before resuming her normal schedule. Fortunately, her employer-provided health
insurance plan with the stop-loss provision significantly reduced her financial burden during this unexpected
medical emergency.
The total cost of her medical care was $40,000.
[4.3] SCENARIO: A MAJOR MEDICAL CLAIM (continued)

[4.4] SARAH'S MAJOR MEDICAL COVERAGE IN ACTION

Component With $3,000 Stop-Loss Without Stop-Loss
$40,000 - $1,000 = $40,000 - $1,000 =
Step 1: Apply the deductible
$39,000 $39,000
Step 2: Apply the coinsurance $39,000 x 20% = $7,800 $39,000 x 20% = $7,800
Step 3: Compute insured’s cost (deductible +
$1,000 + $7,800 = $8,800 1,000 + $7,800 = $8,800
coinsurance)
Step 4: Compute Stop-loss Effect (patient cost-stop-
$8,800 - $3,000 = $5,800 N/A
loss)
Step 5: Total patient cost $3,000 $8,800
$40,000 - $3,000 = $40,000 - $8,800 =
Step 6: Insurer Coverage
$37,000 $31,200
[5.1] THE AFFORDABLE CARE ACT
The Affordable Care Act (ACA), officially titled the Patient Protection and Affordable Care Act
(PPACA), was enacted to improve the quality and affordability of health insurance, reduce the uninsured
population, and lower healthcare costs. It fundamentally transformed health insurance by establishing
minimum standards for major medical policies in federal law. Insurers were required to spend at least 80%
of premium dollars on health care services rather than administrative costs. It also implemented community
rating provisions limiting how much premiums could vary based on age (3:1 ratio).
The Act mandates coverage of 10 essential health benefit categories, including preventive services without
cost sharing, mental health services, and maternity care. It also prohibits insurers from denying coverage or
charging higher premiums based on pre-existing conditions and eliminates lifetime and annual benefit caps
for these essential health benefits. The ACA also expanded Medicaid eligibility, subsidized insurance
premiums, provided incentives for businesses to offer health care benefits, and support ed medical research.
These changes collectively shifted the insurance market toward broader coverage, greater consumer
protections, and more standardized benefits across all major medical policies.
A variety of taxes and cost savings, such as improved fairness in the Medicare Advantage program relative to
traditional Medicare, offset the costs of these provisions. It was under the ACA that state and federal health
insurance exchanges (marketplaces) were created for the individual and small-group markets.
Only qualified health benefit plans that meet specific ACA criteria can be sold in these exchanges.
[5.1.1] EMPLOYER SHARED RESPONSIBILITY PAYMENT
The ACA requires employers that have at least 50 full-time employees (or equivalents) to offer health
insurance to their full-time employees (and their dependents). The employer shared responsibility payment
(ESRP), introduced by the ACA, requires applicable employers to offer affordable, minimum-value health
coverage or face tax penalties.
[5.1.2] EMPLOYER TAX CREDITS
An employer with fewer than 25 full-time equivalent employees that provides health insurance to its
employees may be eligible for a tax credit for a portion of the premiums paid for its employees' benefits.
[5.1.3] ADVANCE PREMIUM TAX CREDITS
Advance premium tax credits (APTCs) may be available to certain individuals and households with income
not more than 400% the federal poverty line (FPL) for their family size. The APTC is a federal tax credit for
individuals that reduces the amount they pay for health insurance premiums on the government Marketplace.
In most states, individuals and families with incomes ranging from 100% to 400% of the federal poverty level
receive federal subsidies when they purchase insurance through a state or federal ex change.
[5.1.4] THE ACA HEALTH INSURANCE EXCHANGE (MARKETPLACE)
The health insurance exchange is a federal website that allows consumers to check their eligibility for
government assistance programs, compare individual and small group health insurance plans, and connect
with insurers to purchase health insurance. Note that the federal government uses the term health insurance
marketplace instead of exchange. For small employers, the Small Business Health Options Program (SHOP)
exchange or marketplace is open to employers with 50 or fewer full-time-equivalent employees.
The government created the exchange to:
• Reduce the number of uninsured persons in each state
• Facilitate the purchase and sale of qualified health plans in the individual market
• Assist qualified employers in each state in enrolling their employees in qualified health plans
• Assist individuals in accessing public programs, premium tax credits, and cost-sharing reductions
Under the ACA, the health insurance exchange performs all the following roles:
• Certifies health plans as qualified, based on predetermined criteria
 • Utilize individual, unique formats for presenting health benefit plan options
• Verify and resolve inconsistent information that applicants provide to the exchange

[5.1.5] OVERVIEW OF ENROLLMENT PERIODS

Consumers have access to available plans during the annual and special open enrollment periods.

[[Link]] OPEN ENROLLMENT PERIOD (OEP)

Open enrollment is the period each year when qualified individuals may enroll or change coverage options in
the exchange. While these have varied over the years, open enrollment generally runs from November 1 to
January 15. Any changes or enrollments taking place before December 16 take effect January 1. Changes
made between December 16 and January 15 take effect on February 1.
[[Link]] LOSS OF COVERAGE
The loss of minimum essential coverage typically counts as a qualifying event that triggers a special
enrollment period. If a person loses his plan, he can enroll in a new plan, either on or off the marketplace
exchange.
The following events may terminate an insurance plan:
• A person's insurer leaves the marketplace
• A person leaves a job (group health)
• Divorce or legal separation
• Death
SPECIAL ENROLLMENT PERIODS
A special enrollment period (SEP) begins 60 days before the termination date of a person's plan; therefore, it
is possible to obtain a new ACA-compliant plan without a coverage gap.
Special enrollment occurs only when an insured has a "qualified event" or "change in status." This allows an
insured to enroll in exchange coverage, or alter existing coverage immediately, without having to wait for the
next OEP. A qualifying event includes loss of job-based insurance, marriage, the birth of a child, or divorce.

[5.1.6 THE STRUCTURE OF COVERAGE: TIERED PLANS

FOUR METAL PLANS
The ACA requires health insurers to offer individual health insurance plans within health insurance
exchanges that conform to the distinct levels of coverage created by the ACA. These levels are defined as
four "metal tiers." Each metal tier is expected to cover at least a certain percentage (or actuarial value) of
expected "essential health benefits" costs. Conversely, it also identifies the percentage of anticipated costs
expected to be paid by the insured through its deductibles, copayments, and out-of-pocket limits.
The four metal tiers and their level of coverage are as follows:
• Bronze Plan: This plan must have an actuarial value of 60%. Individuals who buy a bronze plan should
expect to pay 40% of their covered costs. This is referred to as a 60/40 plan.
• Silver Plan: This plan must have an actuarial value of 70%. Individuals who buy a silver plan should
expect to pay 30% of their covered costs. This is referred to as a 70/30 plan.
• Gold Plan: This plan must have an actuarial value of 80%. Purchasers should expect to pay 20% of
their covered costs through deductibles, copays, and other cost-sharing features.
• Platinum Plan: This 90/10 plan must have an actuarial value of 90%. Buyers only expect to pay 10%
of their covered costs.

[5.1.7] THE STRUCTURE OF COVERAGE: OUT-OF-POCKET MAXIMUMS

Regardless of their tier, all marketplace health insurance policies are subject to the same out -of-pocket
maximum. The out-of-pocket maximum is the most that an insured must pay for covered services in a single
plan year. After an insured spends this amount on deductibles, copayments, and coinsurance, his health
plan pays 100% of the costs of covered benefits. These amounts are adjusted annually. For 2025, the out-of-
pocket limit is $9,200 per individual and $18,400 per family. These limits do not include monthly premiums
or costs for services not covered by the plan.
[5.1.8] DEPENDENT COVERAGE ELIGIBILITY
Dependents of an insured are eligible for coverage under an individual or group plan. For example, let us
assume that a covered employee was previously without dependents and therefore had no dependent
coverage. In that case, any new dependents due to marriage, birth, or adoption are eligible for coverage as of
the date they became dependents.
The following individuals are considered eligible dependents:
• A spouse who is not legally separated
• Unmarried or married dependent offspring up to age 26, which includes all natural-born, adopted, and
stepchildren
[5.1.9] ESSENTIAL HEALTH BENEFITS
The ACA defines a variety of services as "essential health benefits." Medical expense policies must offer the
following list of 10 coverages with no lifetime or annual cap, which the ACA designates as qualifying major
medical coverage:
Ambulatory Patient Services: Ambulatory patient service is healthcare that an insured receives without being
admitted to a hospital. Some examples include visiting a walk-in clinic, a physician's office, a same-day
surgery center, or a hospital emergency room if not admitted.
Emergency Services: Emergency service is healthcare that an insured receives for conditions that, if not
immediately treated, could lead to severe disability or death.
Hospitalization Coverage: Hospitalization coverage is healthcare that an insured receives as an inpatient in a
hospital, such as room and board, nursing care, physician’s expenses, diagnostic testing, and drugs that are
administered during the hospital stay.
Pregnancy, Maternity, and Newborn Care: Maternity care and newborn care describe the ongoing care an
insured woman receives during her pregnancy, labor, and after giving birth. It also provides care for newborn
infants.
Prescription Drugs: The prescription drug benefit covers drugs prescribed by a doctor to treat an acute illness
(e.g., an infection) or an ongoing condition (e.g., high blood pressure.)
Mental Health and Substance Use Disorder Services: Mental health and substance use disorder services
describe the care that an insured receives for behavioral health treatment. It includes the evaluation,
diagnosis, and treatment of mental health and substance abuse issues.
Rehabilitative and Habilitative Services and Devices: Rehabilitative and habilitative services and devices
refer to services and devices that help an insured who suffers from injuries, disabilities, or chronic conditions
to gain or recover mental and physical skills.
Laboratory Services: Laboratory services include the testing of blood, tissues, and other substances derived
from a patient to help a doctor diagnose a medical condition or monitor the effectiveness of treatment.
Preventive and Wellness Services and Chronic Disease Management: Preventive or wellness services
include routine physicals, screening, and immunizations. Chronic disease management is an integrated
approach to managing an ongoing condition, such as asthma or diabetes.
Pediatric Services: Pediatric services are the care that an insured child receives. A participating physician
who specializes in pediatrics serves as the child’s primary care health care professional. Services include
oral (dental) and vision care. Since "vision" is not defined in the statute, the American Academy of Pediatrics
(AAP) and the American Association for Pediatric Ophthalmology developed evidence-based
recommendations. Accordingly, the essential children's vision benefit begins with regular eye screenings
within the medical home and covers a comprehensive eye exam. It also includes refraction for children or
adolescents who fail a screening, have an unfavorable risk assessment, report a visual problem, or cannot
complete a screening.
While limited pediatric dental and vision benefits are mandatory, adult dental and vision coverages are
optional and usually require an additional premium.
Therefore, coverage for children under a parent's individual or group policy may extend through age 26, or
longer if the child qualifies as a disabled dependent. Note, as outlined previously, COBRA permits a child
who "ages out" of a group health plan to continue coverage under the group plan for up to 36 months.
EXAM TIP!
Watch out for child “age-out” questions on the state exam. Pay close attention to whether the question is
referencing state law, ACA requirements, a student, a handicapped child, etc.
[5.1.10] PREVENTIVE COVERAGES
Most preventive services are now covered at 100%, with no cost-sharing requirements, such as out-of-
pocket copays, deductibles, and coinsurance.
These preventive services include:
• Cancer screenings (e.g., mammograms) for breast cancer annually or biennially for women who are
over the age of 40
 • Pap smears for cervical cancer, every three years for women who are aged 21 and older
• Pre- and post-natal services, including folic acid vitamin supplements, screening for gestational
diabetes, breastfeeding support and equipment, and certain immunizations
• All FDA-approved contraception methods, along with related counseling and education
• Domestic violence screening and counseling
• HIV screening
Genetic testing for breast cancer genes for women at high risk (e.g., those with a family history of breast or
ovarian cancer, etc.) and approved clinical trials
[5.1.11] GRANDFATHERED PLAN
A grandfathered health insurance plan is one that has existed in its current form since before the ACA
became law on March 23, 2010. To maintain its "grandfathered" status, a plan must refrain from increasing
deductibles, coinsurance, or any other cost-sharing burden on plan enrollees. In return, a grandfathered plan
avoids certain ACA requirements for major medical insurance. Grandfathered plans are NOT required to:
• Cover preventive care for free
• Cover essential health benefits
• Cover pre-existing conditions in the individual market
Although grandfathered plans don't necessarily cover essential health benefits, they cannot impose benefit
caps on those benefits that they do cover.
[5.1.12] MINIMUM ESSENTIAL COVERAGE PLANS OR "SKINNY PLANS"
A "skinny plan," also called an "MEC plan," is a limited-benefit health insurance plan that offers minimal
coverage while technically meeting certain ACA requirements. It provides minimal coverage, typically
covering only preventive services and wellness-related care, while offering little to no coverage for
hospitalization, emergency services, or expensive treatments.
Some employers use these low-cost policies to avoid penalties, particularly in industries with lower-wage
workers such as restaurants, hotels, and retail. Employers can use these policies because they technically
comply with the ACA requirement to provide minimum essential coverage, even though that coverage is very
limited.
Though skinny plans provide "minimum essential coverage," they do NOT provide minimum value, which,
according to the ACA's definition, means the policy covers at least 60% of the total anticipated cost of
services and provides "substantial coverage" for inpatient hospitalization and physician services. Employees
covered by such plans may qualify for premium tax credits to purchase more comprehensive coverage
through the ACA Marketplace.
Coverage Gaps: Employees may need to purchase supplemental coverage or hospital -only policies to fill the
gaps left by skinny plans.
[5.2] THE HEALTH INSURANCE PORTABILITY AND ACCOUNTABILITY ACT
More than a decade before the passage of the ACA, the Health Insurance Portability and Accountability
Act of 1997 (HIPAA) expanded the federal regulation of health insurance. HIPAA's primary purpose is to help
ensure that individuals will not lose medical coverage or be subject to a new pre-existing condition period if
they change or lose their job. In other words, HIPAA increased access to and portability of health insurance
by reducing or eliminating pre-existing condition exclusions or waiting periods for previously insured
individuals seeking coverage under a new group insurance plan.
Conceptually, HIPAA treated the population of participants covered under all group plans as a single
underwriting pool, at least from the insurability standpoint. Anyone who maintains creditable coverage with
an available carrier can also obtain coverage with any other carrier without being subjected to the restrictions
imposed on new participants.
The essential provisions of HIPAA include, but are not limited to, the following:
• Increased availability of medical expense coverage by placing limitations on what can be included in
pre-existing conditions
• The portability of medical expense coverage
 • Expanded eligibility for COBRA benefits
HIPAA was not an all-encompassing solution to the problem of access. The Act applies only to groups of two
or more, not to individual insurance policies.
[5.2.1] PORTABILITY
The HIPAA portability provisions do not allow employees to take specific insurance from one job to another.
Instead, the legislation places limitations on pre-existing condition exclusions. It allows employees to use
evidence of their previous insurance coverage to reduce or eliminate the length of any pre-existing condition
exclusion when they become covered by a different medical expense plan. The portability provision applies
to nearly all group health plans that have at least two participants (i.e., employees) on the first day of the plan
year. Employers must issue a certificate of creditable coverage to qualified employees upon request.
Let us assume that an insured was previously covered by another group plan, with no break or gap in
coverage of 63 days or more (i.e., the gap cannot be more than 62 days). In this case, both the employee and
the employee's family can qualify for a certificate of creditable coverage. The worker can use this
certificate when applying for coverage under a new plan.
One’s prior coverage reduces the limitations in the new plan. In other words, an employee who has one
month of creditable coverage may apply this toward the satisfaction of one month (i.e., month -to-month) of a
pre-existing waiting period. If an employee's previous coverage is in force for at least 12 months, no pre-
existing condition exclusions can apply.
On the other hand, if an employee is between jobs and has been without coverage for at least 63 days, HIPAA
will not offer protection. The individual is subject to all pre-existing condition limitations and exclusions for
the entire pre-existing condition period as defined in the plan.
[5.2.2]PRE-EXISTING CONDITIONS
An important element of HIPAA is the way it defines the term "pre-existing condition" by limiting the "look-
back period." According to HIPAA, limitations on pre-existing condition exclusions in a medical plan are
permitted only if treatment, advice, care, or diagnosis for the condition is received by the insured within the
six months before an employee enters into a new group medical plan.
If an insured has an undiagnosed condition that is later diagnosed, the pre-existing condition limitation does
not apply. Also, maternity, births, and adoptions are not subject to pre-existing condition language. In the
case of a newborn with a congenital condition, the child must be added to the insurance plan within 30 days
after the child's birth. A comparable 30-day requirement also applies when an insured adopts a child.
HIPAA also limits the period during which a group health policy can deny coverage for pre -existing conditions.
The law limits pre-existing condition exclusion periods to 12 months. For a late enrollee, the pre-existing
condition limitation is extended to 18 months. The length of the pre-existing condition period is reduced by
the length of creditable coverage earned.
Creditable coverage includes group health plans, individual medical plans, Medicare, Medicaid, and other
state- and federally-sponsored and related programs.
Let us assume that a new company employee with a grandfathered plan has 12 months of creditable
coverage through a previous employer. In this case, the employee may use that time to reduce the pre -
existing condition exclusion waiting period under a new plan. Also, the 12 months of creditable coverage do
not need to come from a single employer.
For example, Dan worked for an employer and had coverage under the employer's health plan from March 1,
2023, until April 5, 2024. He then changed jobs and was covered under a grandfathered group plan. Since the
previous plan covered him for more than 12 months (March 1, 2023, is his enrollment date), no pre-existing
condition exclusion can apply, even though the new plan was grandfathered.
[6] INNOVATIONS AND TAXATION
Recent decades have seen a shift in the way people think about health insurance. Although the Affordable
Care Act makes coverage more accessible, the coverage people choose often requires significant cost -
sharing. At the same time, government tax policy has created a variety of financial and administrative
instruments to afford tax advantages to both individuals and employer-sponsored groups. Some innovations,
such as cafeteria plans and flexible spending accounts, provide significant benefits to groups. Other
innovations, such as high-deductible health plans and associated health savings accounts, can benefit
anyone seeking affordable coverage.

[6.1] TAXATION OF MEDICAL EXPENSE INSURANCE

Benefits received through a medical expense policy are not taxable. These benefits are offsetting expenses,
so they are not considered income. The deductible of premiums and other costs depends on the individual's
tax status.
[6.1.1] EMPLOYEES
For individuals who itemize deductions on their tax returns, the following medical and dental expenses are
tax-deductible to the extent they exceed 7.5% of the taxpayer's adjusted gross income (AGI):
• Premiums for medical expense and dental insurance are paid by the employee with after -tax dollars;
and
• Cost-sharing amounts such as coinsurance, deductibles, and certain expenses not covered by
insurance.
For example, let us assume Jane has an AGI of $100,000 and itemizes on her tax return. Also, she
has $8,500 in deductible medical expenses for the year. Since $8,500 is greater than 7.5% of her AGI
($7,500), she has deductible expenses. Her deductible amount is $1,000 because her deductible expenses
exceed the threshold by $1,000.
For employees, medical expenses reimbursed by insurance cannot be deducted from their federal income
tax. Additionally, employees cannot deduct amounts paid for pre-tax benefits through employee benefit
plans. The tax benefit was received when the contribution was made tax-free.
[6.1.2] SOLE PROPRIETORS
The IRS allows individuals who are self-employed or sole proprietors to deduct 100% of their health
insurance premiums as a deductible business expense. This deduction applies to the cost of coverage for an
individual's spouse and children as well. Other medical costs are subject to the same restrictions that apply
to employees; that is, they are deductible only to the extent that they exceed 7.5% of the individual's AGI.
[6.1.3] PARTNERSHIPS AND LIMITED LIABILITY COMPANIES
For partnerships and limited liability companies (LLCs), premiums paid by the partnership are tax -deductible
to the partnership or the LLC.
[6.2] CONSUMER-DRIVEN HEALTH PLANS
A consumer-driven health plan (CDHP) has three elements:
1. A tax-advantaged (pre-tax) savings vehicle (Health Savings or Health Reimbursement Account, or
Archer MSA)
2. A corridor or an integrated deductible
3. A qualifying high-deductible insurance policy
The purpose of these plans is to incentivize individuals to consider the cost of medical services, factoring it
into their decision-making in the following ways:
• The tax-free account allows employees to pay for services using pre-tax dollars and can also fund
their insurance policy deductibles.
• The gap, or deductible, between the participant's tax-free savings vehicle and the major medical
coverage represents an insured's out-of-pocket expense. Prudent management of one's savings
vehicle can help conserve and accumulate funds over time. The accumulated funds may decrease
the insured's out-of-pocket costs during a future emergency.
• The third element is the major medical coverage, which caps the individual participant's risk
exposure.
[6.2.1] HEALTH SAVINGS ACCOUNTS
The Medicare Prescription Drug and Modernization Act of 2003 established a new way for consumers to pay
for medical expenses: health savings accounts (HSAs). An HSA is a tax-favored vehicle for accumulating
funds to cover medical expenses, available to individuals enrolled in an HDHP. Any funds contributed to a
person's HSA are not subject to federal income tax at the time of deposit and will roll over and accumulate
year to year if they are not spent. HSAs are a tax-deductible source of funds for paying qualified medical
expenses at any time without federal tax liability or penalty.
Listed below are some of the characteristics of HSAs:
Other than those used for qualified medical expenses, distributions are subject to income tax and a penalty
of 20%.
HSAs help individuals save for qualified health expenses that they, their spouse, or their dependents incur.
Unused funds accumulate in HSAs from year to year.
Anyone covered by an HDHP can contribute to an HSA and use it to pay out-of-pocket medical expenses.
HSA contributions are tax-deductible.
Employees and employers may also contribute to a worker's HSA on a pre-tax basis through a cafeteria plan.
HSAs are owned by the individuals for whom they are established, regardless of whether their employer
funds them.
The employees own both the funds and the accounts. If they leave the company, their HSAs go with them.
When individuals lose access to a qualified HDHP – either due to a change in employment or by choosing a
different plan:
They can still use the funds already in the HSA; BUT
They CANNOT make additional contributions unless they again become covered by a qualifying HDHP.
[[Link]] CONTRIBUTION LIMITS
Individuals can contribute to their own accounts; however, employers can also contribute to HSAs as an
employee benefit. The IRS limits the total amount of contributions that can be made to an HSA each year. The
contribution limits can change annually, with changes taking effect on January 1.
For 2025, the maximum contribution is $4,300 for an individual and $8,500 for a family.
Individuals aged 55 to 65 years old can make an additional catch-up contribution of $1,000. While the IRS
can also change the catch-up limit, it has remained unchanged for over a decade.
[[Link]] TAX TREATMENT
The owner decides which type of investment to use in the HSA, and the investment's earnings grow tax -free.
The owner can also make tax-free withdrawals to cover current and future qualified health care costs.
Qualified health care expenses include amounts paid for:
• Doctors' fees, prescription drugs, and non-prescription medicines
• Necessary hospital services that are not paid for by insurance
• Retiree health insurance premiums
• Medicare expenses (but not Medigap), qualified long-term care services, and COBRA coverage
• Qualified medical expenses (those incurred by the HSA owner, the spouse, and dependents)
• Non-qualified withdrawals are subject to income taxes and a 20% penalty
• HSAs are fully portable, and assets can accumulate over the years
• Upon death, HSA ownership may be transferred on a tax-free basis to a spouse
[[Link]] ELIGIBILITY
To be eligible for an HSA, individuals must be covered by an HDHP and must not be covered by other medical
expense insurance (e.g., a basic surgical plan). With the ACA's 2010 inception, this restriction does not apply
to the receipt of preventive medical services, which the ACA mandates must be free of charge. Also, using an
HSA does not restrict a person's access to accident insurance, disability insurance, dental insurance, vision
coverage, or long-term care policies.
On the other hand, a person must not be eligible for Medicare. Therefore, individuals younger than 65 are
generally eligible to establish and contribute to HSAs, as long as they have a qualified HDHP. HSA rules also
require that HDHPs limit an insured's out-of-pocket expenses. Also, no one can establish an HSA if they are
claimed as a dependent on another person's tax return.
[6.2.2] HEALTH REIMBURSEMENT ACCOUNTS
Although they are officially titled health reimbursement arrangements, these products are more commonly
referred to as health reimbursement accounts (HRAs). Employers establish and fund HRAs. Similar to an
HSA, unused amounts can be carried forward to cover out-of-pocket expenses in future years.
HRAs serve the same purpose as HSAs, but they are fundamentally different in the following ways:
• There is no limit on annual contribution amounts.
• Employers do not transfer funds to employees; instead, they provide an available credit that can be
used only for expenses approved by the program.
• Reimbursements for approved expenses are tax-free.
• HRA funds are NOT portable. When employees leave an employer, they also leave their remaining
HRA balance behind.
[6.2.3] ARCHER MEDICAL SAVINGS ACCOUNTS
Archer medical savings accounts (Archer MSAs) help employees of small employers (those with no more
than 50 employees) and self-employed individuals pay for their medical care expenses. The MSA program
served as a pilot program for establishing today's HSAs.
Since January 1, 2008, only individuals who participate in grandfathered MSAs may continue to make or
receive contributions. The following requirements apply:
• Participants must be covered by a qualifying HDHP.
• There is a limit on contributions, which is a percentage of the annual deductible.
• Contributions may be made by employers or employees, but only by one or the other in any given year.
• A 20% tax penalty applies if the insured uses funds for non-qualified (non-medical) purposes.
• Unused balances roll over from year to year.
[6.2.4] MEDICARE MEDICAL SAVINGS ACCOUNTS
A Medicare medical savings account (MSA) is a type of Medicare Advantage Plan (Part C) that combines a
high-deductible, Medicare Advantage health plan with an MSA. Medicare deposits a set amount into the MSA
account annually, which can be used for qualified medical expenses. Beneficiaries can use any Medicare-
approved doctor or hospital that accepts Medicare and agrees to treat them. Unused funds remain in the
account and can be used for future health care costs.
One cannot join a Medicare MSA plan if any of these apply:
One's health coverage would cover the MSA plan's deductible
One is enrolled in another Medicare Advantage Plan
One receives TRICARE or VA benefits
One is a retired federal government employee with FEHBP
One is eligible for Medicaid
One is currently receiving hospice care
One lives outside the U.S. for more than 183 days a year
[6.2.5] HIGH-DEDUCTIBLE PLANS
A qualifying high deductible health plan (HDHP) is a major medical insurance plan that makes the cost of
basic expenses – other than ACA-mandated preventive care – the insured's responsibility, while also
establishing an annual cap on out-of-pocket costs. The IRS sets the minimum annual deductible and the
maximum out-of-pocket cost for all HDHPs that qualify for use with an HSA.
For 2025, the deductible minimum and out-of-pocket maximums are as follows:
The minimum deductible is $1,650 for individual coverage and $3,300 for family coverage.
The maximum out-of-pocket cost allowed is $8,300 for an individual plan and $16,600 for a family plan.
[6.3] CAFETERIA PLANS
A Section 125 Cafeteria Plan is a financial vehicle that allows U.S. businesses to offer a variety of employee
benefits, including accident and health insurance, on a pre-tax basis. These plans must meet the specific
requirements of Section 125 of the Internal Revenue Code.
Cafeteria plans also allow employees to choose from among standardized options to customize some key
benefits and better meet their individual needs. Consumer-driven health plans and other benefits are often
offered through a cafeteria plan.
Although sole proprietors, partners, and S-corporation shareholders with a 2% or greater ownership cannot
participate in the plan or access tax benefits as participants, they can still take advantage of the reductions
available to plan sponsors. There are no regulations excluding shareholders of a C-corporation (regardless of
their ownership percentage) from participating in a cafeteria plan.
[6.4] FLEXIBLE SPENDING ACCOUNTS
Although they are officially titled flexible spending arrangements (FSAs), these products are more commonly
referred to as flexible spending accounts. FSAs are tax-advantaged accounts that can be set up through an
employer's cafeteria plan. An FSA allows an employee to set aside a portion of earnings to pay for qualified
medical expenses (e.g., prescription medication) as established in the cafeteria plan.
An FSA comes with the following limitations:
• Individuals cannot participate in FSAs if they have HSAs or an Archer medical savings account (health
reimbursement arrangements are allowed because participants do not take possession of the funds)
• Most FSA balances do NOT roll over from year to year; instead, they are "use it or lose it" accounts
(The IRS allows plans to roll over a relatively small amount to the following year; $640 in 2025)
• Employers cannot reimburse employees for unused funds
• For 2025, the employee contribution limit is $3,200
Unlike the other accounts described in this section, an FSA does not require participants to have an HDHP.
[7] MEDICAL EXPENSE INSURANCE SUMMARY
Throughout this chapter, we've explored the multifaceted world of medical expense insurance, from basic
policies to comprehensive major medical plans.
We began by examining basic medical expense insurance, which provides first-dollar coverage for specific
services with no deductibles but modest coverage limits. We distinguished between hospital expense
policies covering facility costs, surgical expense policies covering physician services, and physician expense
policies covering non-surgical care.
We then delved into major medical insurance, which offers comprehensive protection against catastrophic
expenses through higher coverage limits and broader benefits. You learned how cost-sharing mechanisms—
deductibles, coinsurance, and stop-loss provisions—distribute financial responsibility between insurers and
policyholders, and how to calculate these amounts in various scenarios.
The chapter also covered key legislation that shapes today's insurance landscape. The Affordable Care Act
established essential health benefits, prohibited pre-existing condition exclusions, created metal tier plans
with different actuarial values, and established health insurance exchanges. The Health Insurance Portability
and Accountability Act enhanced coverage portability and limited pre-existing condition exclusions for those
maintaining continuous coverage.
Finally, we explored consumer-driven health plans and tax-advantaged accounts, such as Health Savings
Accounts (HSAs), Health Reimbursement Arrangements (HRAs), and Flexible Spending Accounts (FSAs),
which help consumers manage healthcare costs while providing tax benefits.
The fundamental concepts you've learned—from basic versus major medical coverage to cost-sharing
mechanisms and tax-advantaged accounts—are critical to passing your state licensing exam.
[7.2] REVIEW NOTES
Learning Objective 1: Distinguish between basic medical expense insurance and major medical
expense insurance policies and their key characteristics
Basic Medical Expense Insurance:
• Provides "first-dollar" coverage (no deductibles)
 • Has relatively modest coverage limits or time frames
• Coverage is limited to the specific listed services only
• Includes three main types: hospital, surgical, and physician expense policies
• Considered excepted benefits exempt from ACA requirements
Major Medical Expense Insurance:
• Provides comprehensive coverage for catastrophic medical expenses
• Features annual deductibles and coinsurance requirements
• Offers high maximum benefits with fewer exclusions
• Covers all medically necessary treatments unless explicitly excluded
• Includes essential health benefits as defined by the ACA
• Based on the UCR (usual, customary, and reasonable) standard
Common Exclusions from All Medical Expense Policies:
• Elective cosmetic procedures
• Experimental therapies
• Care is provided in government facilities
• Work-related injuries
• Occupational diseases (covered by workers' compensation)
Learning Objective 2: Identify the different approaches insurers use to provide basic expense coverage
Basic Hospital Expense Insurance:
• Covers hospital room and board plus miscellaneous hospital expenses
• Includes lab/X-ray charges, inpatient medicines, intensive care, and operating rooms
• Typically pays on an indemnity basis (fixed dollar amount)
• Covers expenses billed directly by the hospital, not independent providers
Basic Surgical Expense Insurance:
• Pays for surgeons' services regardless of location (in/out of hospital)
• Includes surgeon's fees and anesthesiologist fees
• Three approaches to determine benefits:
o Surgical schedule approach: assigns a fixed dollar amount to each procedure
o Relative value scale approach: assigns units to procedures with a dollar value per unit
o UCR (usual, customary, and reasonable) approach: pays based on geographic norms
Basic Physician Expense Insurance:
• Covers non-surgical physician services (outpatient services)
• Typically pays a fixed amount per visit
• Usually included with hospital or surgical expense plans, not written alone
Learning Objective 3: Explain the various types of policy deductibles and how they function in medical
insurance
Types of Deductibles:
• Calendar-year (cumulative/all-cause) deductible: met once during benefit period
• Flat deductible: stated dollar amount before insurance pays
• Corridor deductible: the gap between basic coverage and major medical coverage
• Integrated deductible: amounts paid by a basic policy apply to the major medical deductible
• Family maximum deductible: limits the total amount required from the covered family
• Per-cause (occurrence) deductible: separate deductible for each accident/illness
• Common accident/sickness deductible: one deductible for family members with the same condition
• The carryover provision allows claims from the final three months of the policy year to apply to next
year's deductible
Learning Objective 4: Calculate patient and insurer financial responsibilities using deductibles,
coinsurance, and stop-loss provisions
Coinsurance:
 • Percentage participation in covered expenses after the deductible is met
• Expressed as insurer/insured ratio (e.g., 80/20)
• Designed to reduce the overutilization of medical services
• An insurer must pay at least 50% to qualify as insurance
Stop-Loss Provision:
• Limits insured's out-of-pocket medical expenses
• Equivalent to "out-of-pocket maximum" in policy
• Includes deductible, coinsurance, and other copays
• Does NOT include premiums, charges exceeding UCR, or non-covered services
• For 2025: $9,200 individual/$18,400 family maximum
Calculation Steps:
1. Determine total claim amount
2. Subtract deductible
3. Apply the coinsurance percentage to the remainder
4. Add deductible and coinsurance for the insured's total cost
5. Apply stop-loss if applicable
Learning Objective 5: Describe the essential health benefits required by the Affordable Care Act (ACA)
Ten Essential Health Benefits (No Lifetime/Annual Caps):
• Ambulatory patient services (outpatient care)
• Emergency services
• Hospitalization coverage
• Pregnancy, maternity, and newborn care
• Prescription drugs
• Mental health and substance use disorder services
• Rehabilitative and habilitative services and devices
• Laboratory services
• Preventive and wellness services and chronic disease management
• Pediatric services, including dental and vision care
ACA Metal Tiers:
• Bronze: 60% actuarial value (60/40 plan)
• Silver: 70% actuarial value (70/30 plan)
• Gold: 80% actuarial value (80/20 plan)
• Platinum: 90% actuarial value (90/10 plan)
Other ACA Provisions:
• Preventive services are covered at 100% with no cost-sharing
• Dependent coverage through age 26
• No pre-existing condition exclusions
• Employer shared responsibility payment for employers with 50+ employees
• Premium tax credits for eligible individuals/families
Learning Objective 6: Compare and contrast tax-advantaged health accounts
Health Savings Accounts (HSAs):
• Available to individuals with qualifying HDHPs
• Tax-deductible contributions; tax-free withdrawals for qualified expenses
• 2025 contribution limits: $4,300 individual/$8,500 family
• $1,000 catch-up contribution for ages 55-65
• Unused funds roll over from year to year
• Portable (owned by an individual)
• 20% penalty for non-qualified withdrawals
Health Reimbursement Arrangements (HRAs):
 • Employer-established and funded
• No limit on annual contribution amounts
• Reimbursements for approved expenses are tax-free
• NOT portable (funds stay with the employer when the employee leaves)
• Unused amounts can carry forward to future years
Flexible Spending Accounts (FSAs):
• Set up through the employer's cafeteria plan
• 2025 contribution limit: $3,200
• "Use it or lose it" (limited $640 rollover in 2025)
• Cannot participate if one has an HSA or Archer MSA
• No HDHP requirement
Archer Medical Savings Accounts (MSAs):
• For small employers (≤50 employees) and self-employed
• Grandfathered program (no new accounts since 2008)
• Contributions limited to a percentage of the deductible
• 20% penalty for non-qualified withdrawals
• Unused balances roll over from year to year
Learning Objective 7: Explain how high-deductible health plans work with health savings accounts
High-Deductible Health Plans (HDHPs):
• Makes basic expenses (except preventive care) the insured's responsibility
• Establishes an annual cap on out-of-pocket costs
• 2025 minimum deductibles: $1,650 individual/$3,300 family
• 2025 maximum out-of-pocket: $8,300 individual/$16,600 family
• Required for HSA eligibility
Consumer-Driven Health Plans (CDHPs):
• Three elements: tax-advantaged savings vehicle, corridor/integrated deductible, HDHP
• Incentivizes cost-conscious healthcare decisions
• Tax-free account funds, deductibles, and other expenses
• Major medical coverage caps individual risk exposure
Learning Objective 8: Identify key provisions of statutes governing medical insurance
Health Insurance Portability and Accountability Act (HIPAA):
• Limits pre-existing condition exclusions in group plans
• Provides portability of coverage between employers
• Requires a certificate of creditable coverage
• Defines pre-existing conditions with a 6-month look-back period
• Limits exclusion periods to 12 months (18 for late enrollees)
• Applies to groups of two or more, not individual policies
• No gap in coverage greater than 62 days to maintain protection
Taxation of Medical Expense Insurance:
• Benefits received are not taxable
• Employee premiums are deductible if itemized and exceed 7.5% of AGI
• Self-employed individuals can deduct 100% of premiums as a business expense
• Partnership/LLC premiums are tax-deductible to the business entity
Exam Tips:
• Know the differences between basic and major medical policies
• Understand how to calculate deductibles, coinsurance, and stop-loss
• Memorize the 10 essential health benefits required by the ACA
• Know the characteristics and limitations of tax-advantaged accounts
• Remember HDHP minimum deductibles and maximum out-of-pocket limits
 • Understand HIPAA portability provisions and pre-existing condition rules
• Know the four metal tiers and their actuarial values
Chapter 16
[1] DISABILITY INCOME INSURANCE INTRODUCTION
Imagine waking up one morning unable to perform your job due to an unexpected illness or injury. How would
you pay your bills? How long could your savings sustain you? For most Americans, the financial impact of a
disability can be devastating—sometimes even more financially damaging than death. This is why disability
insurance is often called "living death insurance."
While most people understand the need for life insurance, many overlook disability coverage despite the fact
that working-age individuals are more likely to become disabled than to die prematurely. According to
statistics, a 35-year-old has about a one-in-three chance of experiencing a disability lasting at least 90 days
before reaching retirement age.
Disability income insurance serves as a financial safety net, providing regular income when you cannot work
due to a covered illness or injury. It transfers the potentially catastrophic financial risk of disability to an
insurance company in exchange for predictable premium payments.
In this chapter, we'll explore how disability insurance works in both the public and private sectors. You'll
learn about the various forms of disability coverage available, from Social Security Disability Insurance to
individual and group policies. We'll examine how disability is defined, how benefits are calculated, and how
policies can be customized with riders to meet specific needs. We'll also look at specialized disability
insurance products designed to protect businesses when owners or key employees become disabled.
As a beginning insurance professional, understanding disability insurance is essential for helping clients
create comprehensive financial protection plans. The concepts you'll learn in this chapter will provide you
with the foundation to explain this critical but often overlooked form of insurance to your future clients.
The chapter is divided into the following sections:
• Basic Concepts of Disability Insurance
• Qualifying for Benefits
• Government (Social) Disability Insurance
• Individual Disability Income Insurance
• Business Uses for Disability Insurance
• Taxation of Disability Insurance Policies
[1.1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
• Explain the purpose and importance of disability income insurance in financial planning
• Differentiate between the various definitions of disability used in insurance policies
• Identify how individuals qualify for disability benefits under different policy types
• Compare government disability programs with private disability insurance options
• Distinguish between individual and group disability income insurance features
• Analyze the business applications of disability insurance for protecting companies and owners
• Explain how disability insurance benefits are taxed based on premium payment sources
[1] DISABILITY INCOME INSURANCE INTRODUCTION
Imagine waking up one morning unable to perform your job due to an unexpected illness or injury. How would
you pay your bills? How long could your savings sustain you? For most Americans, the financial impact of a
disability can be devastating—sometimes even more financially damaging than death. This is why disability
insurance is often called "living death insurance."
While most people understand the need for life insurance, many overlook disability coverage despite the fact
that working-age individuals are more likely to become disabled than to die prematurely. According to
statistics, a 35-year-old has about a one-in-three chance of experiencing a disability lasting at least 90 days
before reaching retirement age.
Disability income insurance serves as a financial safety net, providing regular income when you cannot work
due to a covered illness or injury. It transfers the potentially catastrophic financial risk of disability to an
insurance company in exchange for predictable premium payments.
In this chapter, we'll explore how disability insurance works in both the public and private sectors. You'll
learn about the various forms of disability coverage available, from Social Security Disability Insurance to
individual and group policies. We'll examine how disability is defined, how benefits are calculated, and how
policies can be customized with riders to meet specific needs. We'll also look at specialized disability
insurance products designed to protect businesses when owners or key employees become disabled.
As a beginning insurance professional, understanding disability insurance is essential for helping clients
create comprehensive financial protection plans. The concepts you'll learn in this chapter will provide you
with the foundation to explain this critical but often overlooked form of insurance to your future clients.
The chapter is divided into the following sections:
Basic Concepts of Disability Insurance
Qualifying for Benefits
Government (Social) Disability Insurance
Individual Disability Income Insurance
Business Uses for Disability Insurance
Taxation of Disability Insurance Policies
[1.1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
Explain the purpose and importance of disability income insurance in financial planning
Differentiate between the various definitions of disability used in insurance policies
Identify how individuals qualify for disability benefits under different policy types
Compare government disability programs with private disability insurance options
Distinguish between individual and group disability income insurance features
Analyze the business applications of disability insurance for protecting companies and owners
Explain how disability insurance benefits are taxed based on premium payment sources
[2] BASIC CONCEPTS OF DISABILITY INSURANCE
[2.1] THE PURPOSE AND PERILS OF DISABILITY INSURANCE
Disability income insurance protects against the loss of income due to disability when a covered peril, such
as an accident or sickness, prevents the insured from working. These policies provide individuals with a
specified income benefit for a defined period.
Disability insurance also serves a crucial function for businesses and business owners. It can help manage
business-related risks in the following ways:
• Assures the continuation of a company when a principal owner becomes disabled by covering
expenses
• Allows the remaining owners to buy out a disabled partner to continue the business
• Provides an important employee benefit in the form of group insurance
• Provides policies that can cover non-occupational disabilities and provide protection in conjunction
with workers' compensation
[2.2] COVERED CAUSES OF LOSS (PERILS)
Disability policies provide benefits if an insured experiences a disabling condition caused by an accident
(accidental bodily injury) or an illness. Coverage for an illness or persistent physical condition may be
restricted under the terms of a policy rider or a policy's pre-existing condition limitation.
When an accident and illness contribute to the same disabling condition, the claim may be referred to as
combined accident and sickness disability, but the insured can still only collect once for the loss of income,
even if two perils were involved.
[2.3] OCCUPATIONAL VERSUS NON-OCCUPATIONAL COVERAGE
Some disability income policies do not cover losses arising from an insured's occupation. Such policies
provide no coverage if the insured can also collect from workers' compensation or other work -related social
insurance plans. This type of disability income contract is referred to as non-occupational coverage. If a
policy pays a weekly or monthly benefit for job-related disabilities as well as non-occupational losses, it
provides occupational coverage.
Insurance carriers that underwrite occupational policies and rate associated risks partially do so based on
the insured's occupation. An occupational disability contract provides coverage around the clock because it
covers the insured both on and off the job. In addition to workers' compensation payments, an insured could
receive individual or group disability insurance benefits, though workers' compensation interacts differently
with each.
• Group disability insurance is often used as an example of non-occupational coverage because it's
coordinated with workers' compensation. Workers' compensation reduces group benefits, which pay
only the minimum benefit amount for injuries unless the group policy benefit exceeds the workers'
compensation benefit. In such cases, it only pays the excess.
• Individual disability insurance policies are an example of occupational insurance. These policies are
not coordinated with workers' compensation. They pay their full policy benefit unless the combined
amount exceeds lost income. In that case, the benefit is reduced because the total benefit can never
exceed the income lost.
[2.4] SHORT-TERM AND LONG-TERM DISABILITY PROGRAMS
Insurers may offer short-term disability (STD) or long-term disability (LTD) programs. The purpose of an STD
plan is to quickly replace a percentage of the insured's income while they recover from a temporary injury or
illness (which is of a less serious nature) that prevents them from working.
Short-term Disability plans:
Are usually offered with an LTD benefit
Usually, pays benefits weekly
Have minimal waiting periods
Typically provide coverage for childbirth as well as medically necessary surgeries
Often pays benefits for up to 180 days
Have a maximum benefit period of two years
LTD insurance provides longer benefit periods and can often address needs stemming from a more serious
injury or illness. Since the LTD benefit periods are longer than those of STD plans, the cost is greater;
however, longer elimination periods can reduce costs. The potential benefit periods range from two years to
age 65. The length of the benefit period depends on:
Whether one applies for group or individual coverage (group benefit periods tend to be longer)
The risk of injury or illness associated with one's occupation
Personal traits such as age, gender, and medical history for individual plans
[3] QUALIFYING FOR BENEFITS
Disability policies define "disability" either as an inability to perform job-related tasks or as an inability to
earn income. Policies may also include additional definitions that address certain circumstances best
categorized as "medical definitions" because they describe a direct physical injury rather than any loss of
income or function that may result.
To receive disability policy benefits, a person must be under a physician's care, regardless of whether the
contract defines disability based on loss of income or the inability to perform employment duties. A loss of
income is presumed. Disability insurance, like other forms of coverage, is meant to restore one's economic
position, not enhance it.
The following definitions found in commercial and government insurance programs use a variety of standards
to determine disability.
[3.1] TOTAL DISABILITY
Disability insurance policies define "disability" as either a loss of income, a loss of the ability to work, or both.
Some policies include an additional caveat: the insured cannot be engaged in "gainful employment" or "in any
occupation for wages or a profit." Insurers added this caveat to ensure that those collecting benefits were
indemnified and were not using insurance to profit from an injury while earning income in some other way.
Similarly, Social Security defines disability as the inability to perform any substantial and gainful work.
[3.1.1] INABILITY TO PERFORM DUTIES
As a rule, disability income policies define disability as the "inability to perform the material and substantial
duties" of one or more occupations. The phrase "material duties" refers to the actual tasks or activities a
person must perform in the course of a job. The term "substantial duties" is also known as a person's "key
duties." These are the essential capabilities that enable a worker to do their job.
For example, a surgeon with Parkinson's disease may be able to hold a scalpel (material duty), but cannot
keep their hand steady to cut safely (substantial duty). The fact that they cannot do both means that they
cannot do either.
[[Link]] OWN OCCUPATION
This definition is used in commercial insurance policies. If an insurance policy's definition of disability uses
the phrase "own occupation," it considers the insured to be disabled if they "cannot perform the material
and substantial duties of their own occupation." Some policies initially define disability using the "own
occupation" definition for the first two years, after one is disabled, then switch to the "any occupation"
definition described below. The expectation in such cases is that the more generous defin ition of the first two
years allows the insured to return to work or find a new type of employment
A disability insurance policy that uses the "own occupation" definition of disability is more beneficial to the
policy owner because it is less restrictive than policies that use an "any occupation" definition and consider
alternative sources of income. On the other hand, these types of policies are more expensive and may be
reserved for certain professions.
[[Link]] ANY OCCUPATION
If an insurance policy's definition of disability uses the phrase "any occupation," it considers an insured to be
disabled if they "cannot perform the material and substantial duties of their own occupation, or any
occupation for which they are reasonably suited by education, training, or experience."
For example, imagine Dr. Smith, a highly skilled neurosurgeon, suffers a hand injury that makes it impossible
to safely perform delicate brain surgeries.
Under the own occupation definition, Dr. Smith would be considered disabled because they are unable to
perform the specific duties of a neurosurgeon—even if they could work in another medical role, such as
teaching or consulting.
Under the any occupation definition, Dr. Smith would only be considered disabled if the injury prevented
them from performing the duties of any job for which they are reasonably qualified. If Dr. Smith could still
teach medical students or practice in a less physically demanding field, benefits might not be paid under this
definition.
EXAM TIP!
In some states (e.g., North Carolina), the exam refers to this definition of disability as "any occupation for
which the insured is reasonably suited." In those states, the label "any occupation" refers to the Social
Security definition of disability, which is described later in the course.
[[Link]] SUBSTANTIAL GAINFUL ACTIVITY
The Social Security Administration's definition of disability for qualifying individuals to receive Social Security
Disability Insurance (SSDI) benefits is known as substantial gainful activity (SGA). The term replaces the
older definition of any gainful work, which may still appear on an exam.
This Social Security definition requires the beneficiary to be unable to engage in any substantial gainful
activity (SGA) because of a medically determinable physical or mental disability that is either:
• Expected to result in death
• Has lasted for a continuous period of at least 12 months
 • Is expected to last for a continuous period of at least 12 months
Gainful work (SGA) may include work:
• Performed for pay or profit
• Generally performed for pay or profit
• Intended for profit, whether or not a profit is realized
• Performed on a part-time basis
[3.1.2] LOSS OF EARNINGS
This definition of disability is now included in most policies. It was originally the most prominent in group
insurance plans. This definition relies on a loss of earnings test to determine whether an income loss has
occurred, and a disability exists. The nature of this test makes it extremely useful for assessing cases in
which a disability diminishes one's ability to earn a living but is not totally disabling.
This test examines earned, active income, including:
Wages
Salary
Commissions
Fees or compensation for services
Earned income does NOT include passive income, such as:
Rental income from real estate
Interest on savings
Investment dividends
If the insured's earnings diminish after a disabling accident or illness occurs, the contract considers the
insured disabled.
[[Link]] PURE LOSS OF INCOME (INCOME REPLACEMENT CONTRACTS)
Typically, a person's actively earned income must decrease by at least 20% to qualify for any type of
disability benefit. If a policy defines disability purely as a loss of income, it's referred to as an "income
replacement contract."
[3.2] RECURRENT DISABILITY
Recurrent disability is a standard clause included in a disability insurance policy. It applies when the insured
suffers a disability, returns to work, but then becomes disabled again shortly thereafter. At times, an insured
appears to recover from a disability but then suffers a relapse (recurrence) of the same injury shortly after
returning to work.
Under the terms of the recurrent disability provision, the latter disability (the relapse) is considered a
recurrence of the initial disability if it occurs within six months after the insured returns to work .
Because the contract considers the relapse as a continuation of the initial disability, the following terms and
conditions apply:
• No new elimination period needs to be satisfied, and the benefits begin immediately
• No new benefit period begins
If the insured had a five-year benefit period and was initially disabled for six months before returning to work,
the insured would then have four and a half years of the benefit period remaining in the case of a recurrent
disability. If a previously disabled insured returns to work and remains at work for a period longer than the
defined recurrent disability period, then a subsequent occurrence would be treated as an entirely new
disability claim. A new elimination period and a new benefit period would apply.
For example, let's assume that Bob owns a disability income policy that pays $1,000 per month with a 30 -
day waiting period. Bob becomes totally disabled and is out of work for five months. He then returns to work
for three months but suffers a relapse of the same disability and is out of work for another four months. How
many months of benefits will be paid?
In this case, eight months. He receives benefits four months after the initial elimination period and then
another four months during the recurrence because there's no elimination period.
If Bob had gone back to work for seven months and then suffered a relapse, he would have collected seven
months of benefits because he would have needed to satisfy a waiting period for each separate disability.
[3.3] PRESUMPTIVE DISABILITY
Presumptive disability is a medical definition of disability. It identifies certain conditions that automatically
qualify an insured for the presumptive disability benefit, which is usually equal to the policy's total disability
benefit. Losses that qualify as presumptive disabilities include the following:
• Double dismemberments
• Total and permanent loss of sight
• Total and permanent loss of hearing
• Total and permanent loss of speech
If the insured's injury is sufficiently severe to fall into this category of disability, the insurance company
waives its other criteria for receiving benefits (e.g., being unable to perform occupational duties). The
insurance carrier also waives any remaining waiting period and begins making payments immediately.
The carrier is compensating the insured for the physical loss, independent of the financial consequences.
The severity of the qualifying condition presumes that the insured is totally disabled. Even if the insured can
work in the future, benefits do not stop. Disability is defined by the medical condition, not the financial loss.
[3.4] OTHER DEFINITIONS OF DISABILITY
Concurrent Disability: When disabling events occur simultaneously and result in a single period of disability,
the condition is referred to as concurrent disability. In this situation, the insured collects only one benefit
because there is only one loss, despite multiple causes.
Delayed Disability: This term describes a total disability that does not occur immediately after an accident;
rather, it develops later. Following an accident, most policies allow a certain period during which total
disability, though delayed, may be deemed to have resulted from the prior accident. This definition allows an
insured to remain eligible for benefits due to the effects of an accident for an extended period. The amount of
time allowed for a delayed disability can be 20, 30, 60, 90 days, etc.
Confining Versus Non-Confining Disability: Some disability policies pay benefits according to whether the
insured is confined (either at home or in a hospital) when disabled. Confined disability requires the insured to
remain indoors. In contrast, a non-confined disability means that the insured is not required to remain
indoors. For example, the insured's physician may suggest the insured take walks while recuperating from an
accident.
[3.5] AT-WORK BENEFITS
Insurers first offered at-work benefits to encourage beneficiaries to return to work. By paying a portion of the
total disability benefit to those who ease back into the workforce, insurers made the return to work more
manageable while potentially decreasing the amount paid out in benefits. Over time, at-work benefits have
become an integral part of disability insurance policies.
[3.5.1] PARTIAL DISABILITY
Partial disability is a functional definition of disability, traditionally defined as:
• The inability to perform one or more of the important or key duties of one's own occupation; or
• The inability to work at one's regular occupation on a full-time basis.
Payment of benefits is based on the insured's resulting loss of income, and the benefit is paid regardless of
whether the disability results from an illness or accident. This benefit, when offered, can be independent of
total disability. It can encourage disabled insureds to go to work on a part-time basis without the fear of
losing all their disability income benefits. It can also allow a partially impaired individual to maintain part -
time benefits while still working part-time.
The amount of a policy's partial disability benefits payable is dependent on whether the policy stipulates a
flat amount or a residual amount. For purposes of this course and exam, the assumption should be that the
standard partial disability benefit is 50% of the policy's total disability benefit.
For example, let's assume that an individual earns $4,000 per month and owns a policy with a total disability
benefit equal to 60% of their income. Therefore, their total disability benefit is $2,400 per month. The
monthly partial disability benefit is 50% of $2,400, which equals $1,200.
[3.5.2] RESIDUAL DISABILITY
Residual disability is a proportional disability benefit that a person collects when working less than full-time
due to a covered disability and suffers an income loss of at least 20%. The amount of income lost defines the
degree of disability. Ultimately, the insured receives a percentage of the total disability benefit.
For example, let's assume that Frank earns $5,000 per month and owns a policy with a total disability benefit
equal to 70% of Frank's income. The total disability benefit is $3,500 per month.
If Frank suffers a disability that results in a 60% loss of income, he will have a residual disability rating of
60%. Frank's policy pays him 60% of his total disability benefit, which equals 60% of $3,500 (a $2,100
monthly benefit). Frank also earns 40% of his pre-disability income, which equals $2,000 per month. The
chart below shows the residual disability.
Frank's Cash Flow During a Period of Residual Disability (Wages Earned + Disability Insurance Benefit
Paid)
Monthly Wage Percent Wages Earned Percent Disability Frank's Disability Cash Flow
Pre-Disability Earned During Claim Disabled Benefit (Wages + DI benefit)
$5,000 0% $0 100% $3,500 $0 + $3,500 = $3,500
$5,000 20% $1,000 80% $2,800 $1,000 + $2,800 = $3,800
$5,000 40% $2,000 60% $2,100 $2,000 + $2,100 = $4,100
$5,000 60% $3,000 40% $1,400 $3,000 + $1,400 = $4,400
$5,000 80% $4,000 20% $700 $4,000 + $700 = $4,700
EXAM TIP!
The loss is defined as a percentage of a person's total income. The residual benefit is expressed as a
percentage of the total disability benefit.
[3.6] OTHER DISABILITY COVERAGES
[3.6.1] CREDIT DISABILITY INSURANCE
Credit disability could be purchased to help make loan payments if the insured ever becomes disabled. If
disability occurs, the credit disability benefits pay the monthly installment. This type of insurance may also
be referred to as a "decreasing term disability policy." Since the policy pays off a specific debt, the benefit
amount typically decreases as the debt is paid down. Similarly, the benefit period lasts until the debt is paid
off. Once the debt is paid off, the disability policy terminates.
[3.6.2] DISABILITY BENEFITS IN LIFE INSURANCE
Two types of disability benefits are found in life insurance: the waiver of premium rider and the disability
income rider. The waiver of premium rider waives the premium if the insured becomes disabled. It's optional
in life insurance but standard in health insurance contracts. On the other hand, disability income benefit
riders provide a small, stated benefit, such as 1% of the policy's face amount (up to $1,000), payable if the
insured becomes totally disabled.
[4] GOVERNMENT (SOCIAL) DISABILITY INSURANCE
Federal and state government programs provide a safety net for individuals injured or suffering from
debilitating conditions. Social Security Disability Insurance provides basic coverage for anyone with a work
history on or off the job. Workers' compensation covers employees injured while engaged in employment-
related activities. While these programs may not be sufficient to address the range of losses arising from a
disabling condition, they offer a baseline of support.
[4.1] SOCIAL SECURITY DISABILITY INSURANCE
The Social Security Administration (SSA) provides disability-related benefits through the Social Security
OASDI program, which is funded by payroll taxes paid by employees, employers, and self -employed
individuals. To be fully insured, Social Security restricts eligibility for Social Security Disability Income (SSDI)
benefits to those who have paid sufficient taxes.
Workers who have paid sufficient Federal Insurance Contributions Act (FICA) taxes for 40 quarters (10 years)
earn permanent, fully insured status. The term "credits" may also be used instead of quarters. Younger
workers qualify by paying sufficient FICA taxes for a reduced number of quarters, calculated on a sliding
scale based on age.
On its website, the SSA defines disability as the inability to "engage in any substantial gainful activity because
of a medically determinable physical or mental disability that is either:
• Expected to result in death, or
• Has lasted or is expected to last for a continuous period of at least 12 months."
The Social Security Administration considers work to be "substantial" if it involves doing significant physical
or mental activities that are usually or actually undertaken for pay or profit. Substantial gainful activity may
also refer to work done to generate a profit, even if it ultimately fails to do so. Also, this can be full-time or
part-time work.
In addition to its formal designation as substantial gainful activity, the SSA definition is often described more
simply as "any gainful work" or "gainful employment." For the sake of recognition, the keyword is "gainful,"
which is not used in commercial insurance definitions.
The Social Security Administration considers work to be "substantial" if it involves doing significant physical
or mental activities that are usually or actually undertaken for pay or profit. Substantial gainful activity may
also refer to work done to generate a profit, even if it ultimately fails to do so. Also, this can be full-time or
part-time work.
In addition to its formal designation as substantial gainful activity, the SSA definition is often described more
simply as "any gainful work" or "gainful employment." For the sake of recognition, the keyword is "gainful,"
which is not used in commercial insurance definitions.
EXAM TIP!
In North Carolina and some other states, the exam describes this definition "any occupation," which can be
confusing. In most states, the "any occupation" definition of disability refers to the commercial insurance
definition: "any occupation for which the insured is qualified by education, training, or experience." If your
question is about SSDI, and the SGA is not an option for their definition of disability, then choose "any
occupation." Also, if you encounter this for SSDI, be cautious when answering questions about the
definitions of disability in commercial disability policies.
Another distinctive aspect of SSDI benefits is the waiting period. Social Security imposes a five-month
waiting period before an individual qualifies for benefits. Benefits can accrue during the sixth month and are
paid at the end of the month, which is the standard monthly pattern for payments. SSDI payments can
continue until the insured is eligible for retirement benefits. One's dependents may also receive benefit
payments.
[4.1.1] BENEFITS
A worker's Social Security Disability Income (SSDI) benefit equals 100% of their primary insurance amount
(PIA), which is an individual's benefit level based on their income history and FICA taxes paid over that time.
Benefits are coordinated (reduced by) workers' compensation benefits.
[4.2] WORKERS' COMPENSATION
Workers' compensation is a form of liability insurance that provides medical, disability, and survivor
benefits to workers injured in work-related accidents or occupational diseases. The program provides a
disability benefit based on the injured worker's wages up to a state-defined maximum. Each state has
enacted laws that require employers to provide workers' compensation benefits for most classes of
employees.
As with many other forms of disability insurance, workers' compensation pays both total and partial disability
benefits. The program also classifies disabilities as either a "temporary disability" or a "permanent
disability." A temporary disability is a condition that temporarily reduces a person's ability to work. On the
other hand, a permanent disability completely diminishes an employee's ability to work. A permanent
disability is often caused by dismemberment, loss of sight, or degenerative conditions.
Workers' compensation is the primary coverage for a work-related disability. To avoid overinsurance, its
benefits coordinate with, or reduce, the benefits paid by other forms of social insurance and group disability
insurance.
[5] INDIVIDUAL DISABILITY INCOME INSURANCE
Individual disability income insurance is an occupational contract because insurers underwrite risks based
on an applicant's occupation and personal characteristics. The issued policy provides 24/7 coverage for
losses due to injuries and illnesses, both on the job and away from work. Insureds receive these disability
policy benefits in monthly income payments.
Insurers typically place a limit on the amount of disability income insurance they write as a percentage of the
insured's income because they are replacing net (take-home) income, and individual policies do not
coordinate with Social Security or workers' compensation. This means the policyholder would receive their
full disability policy benefit. Naturally, if the insured receives benefits from multiple sources, disability
contracts limit the total monthly benefit amount. The total amount an insured receive s may not exceed the
insured's pre-disability earnings.
Insurers limit the amount that they pay to discourage malingering and the temptation to file false claims.
[5.1] BASIC STRUCTURE
Individual disability insurance policies all have a defined benefit period, a limited benefit amount, and a time
deductible in the form of an elimination (waiting) period. After combining these elements, together with the
insured's occupation and personal characteristics, the premium can be determined. Ancillary and optional
benefits, along with these standard features, also affect the monthly cost. Disability policies may also have a
one-time probationary period when they first go into effect, during which only accidents are covered.
[5.1.1] PROBATIONARY PERIOD
A probationary period differs from an elimination period. It occurs only once at the policy's inception. The
probationary period in a disability insurance policy defines the period that must elapse before it covers
illness claims. It is a one-time-only period that begins on the policy's effective date and ends after the policy
has been in force for 15, 30, or 60 days.
The purpose of the probationary period is to exclude coverage for pre-existing sicknesses; that is, it excludes
asymptomatic diseases or medical conditions that are already affecting the insured who has yet to show any
symptoms. The probationary period helps protect the insurer against adverse selection because individuals
who know they're ill are more likely to apply for insurance coverage.
Probationary periods don't apply to accidents because when they occur, they are fixed in time and space. By
definition, we know whether they occurred before or after the coverage went into effect. Also, by definition,
an accident is unintended and unanticipated.
[5.1.2] THE BENEFIT PERIOD
The benefit period defines the maximum length of time per disability claim that an insurer will provide income
benefits to a covered individual suffering a loss of income. The cost of coverage is directly related to the
length of the benefit period as well as the underwriting process. The longer the benefit period, the higher the
cost of the policy.
Underwriting determinations are based on job categories as well as one's health. Rather than charge
additional premiums or exclude coverage, an insurer may shorten the benefit period when issuing disability
income coverage to a substandard risk. Shorter available benefit periods are a standard feature when
covering professions that are inherently higher risk, such as construction trades or manual labor.
Insurance industry terminology divides policies into two categories based on the benefit period length:
• Individual short-term disability insurance policies provide benefits for a few months up to two years
• Individual long-term disability insurance policies are characterized by benefit periods of two years up
to a lifetime (if still disabled) per disability
 • Benefit periods are two, five, or 10 years, or up to the age of 65, or to the person's retirement age. In
rare cases, the benefit period may be a lifetime, provided the disability continues.
[5.1.3] DISABILITY BENEFIT AMOUNTS
Disability income insurers that issue individual policies limit coverage to a percentage of the insured's
income. Long-term disability policies pay benefits monthly. They may offer a coverage limit of up to 60% of
the insured's gross monthly earned income or 80% of the insured's net monthly income.
For example, if an applicant's gross earned income is $4,000 per month, an insurer will allow them to buy a
policy with a monthly benefit of up to $2,400 (60% × $4,000).
Insurers use one of two methods to determine the benefits payable under their disability income policies: the
percent-of-earnings approach or the flat amount method.
[[Link]] THE PERCENT-OF-EARNINGS APPROACH
The percent-of-earnings approach expresses the benefit amount by using a percentage of the insured's pre -
disability earnings. This approach is primarily used in group insurance. If the insured's income increases, the
benefits also increase to maintain the percentage.
For example, if an insured's policy provides a 60% benefit based on a monthly gross income of $3,000, the
monthly benefit equals $1,800 (60% × $3,000). If the insured's income increases to $3,200, the 60% benefit
will increase to $1,920 (60% of $3,200).
[[Link]] THE FLAT AMOUNT APPROACH
The flat amount method is primarily used in individual disability policies. Policies using this method express
the disability benefit as a specific dollar amount. Once this amount is established, it remains the benefit
amount unless the insured purchases additional coverage or includes additional benefit riders to the policy.
For example, if Barry, the policyholder, has $3,000 in gross earned income per month, an insurer could issue
a policy with a monthly benefit equal to 60% of the insured's monthly income, or $1,800. Unlike our previous
example, a policy using this approach defines the benefit as $1,800 in the contract language, NOT 60%.
Because the benefit is defined as $1,800, it would not change in reaction to changes in Barry's income. If
Barry's income rose to $3,300, the policy benefit remains $1,800.
[5.1.4] ELIMINATION (WAITING) PERIOD
The elimination period, also known as the waiting period, is the period immediately following the onset of
disability during which benefits are not payable. The elimination period serves as a time-based deductible in
a disability income policy. Whenever insureds become totally disabled, they must satisfy a waiting period
during which no monthly benefit is payable.
The longer the selected waiting period, the lower the policy premium. Including an elimination period allows
an insurer to reduce coverage costs. The standard waiting periods available in individual policies include 30,
60, 90, 180, and 365 days. Short-term disability plans offer waiting periods of only 7, 10, or 14 days. These
short-term policies are most often found in group insurance.
[[Link]] Loss Settlement
When calculating a disability claim, consider the elimination period:
For example, let's assume George owns a policy with an $800 per month total disability benefit and a 30 -day
elimination period. If George is totally disabled for 90 days, after the 30-day elimination period, he will collect
monthly income for 60 days (two months), totaling $1,600.
[5.1.5] PREMIUMS
Premium rates are based on the selected monthly income benefit. Additional criteria include the following:
• Length of the waiting period
• Monthly income benefit amount
• Length of the benefit period
• Age, sex (gender), income, and health of the applicant
• Insured's occupation
• Whether the insured owns other disability income insurance
Most individual disability policies are sold with a premium that doesn't change with age. On the other hand,
the premiums for employer groups or association-sponsored plans often have five-year age bands.
Premiums increase as the insured ages.
The insurance companies that offer policies with age-sensitive premiums may also offer what they refer to
as annually renewable disability income (ARDI). Insureds who choose this option initially experience a
lower premium that gradually increases. The cost starts out lower than a comparable level -premium policy
but increases above average in the insured's later years.
[5.1.6] EXCLUSIONS
The more common exclusions that appear in a disability income policy include:
• War (declared or undeclared)
• Intentionally self-inflicted injuries
• Aviation-related claims of a pilot or crew member, unless a commercial aircraft or pilot is involved
(which is covered)
• Military service
• Losses that result from engaging in any illegal occupation
[5.2] STANDARD PROVISIONS AND BENEFITS
[5.2.1] CHANGE OF OCCUPATION PROVISION
Under the change of occupation provision, if an individual is covered under a disability income policy and is
injured while engaged in an occupation that's more hazardous than the occupation which is stated in the
policy, the result is that the benefit level is reduced. If the insured is engaged in a less hazardous occupation
than that which was originally stated in the policy, the premium (not the benefit level) is reduced.
[5.2.2] OTHER INSURANCE – RELATION OF EARNINGS TO INSURANCE
The relation of earnings to the insurance clause addresses situations in which more than one policy covers
the same disability claim. In these cases, the total amount of benefits will not exceed the insured's pre -
disability income. If the available insurance is greater than the income lost, the benefit amount from each
policy is reduced on a pro rata basis so that the total amount paid is no more than 100% of the loss.
This approach to overinsurance is one of the differences between individual disability policies and group
insurance, which uses the coordination-of-benefits provision to avoid overinsurance.
[5.2.3] IMPAIRMENT RIDER
This type of rider is also known as an exclusion rider or a waiver for impairments. Insurers use this rider to
exclude certain losses from coverage. The exclusion allows them to cover an applicant at a standard
premium in some cases. At times, the excluded risk stems from an occupation, while in other cases, it may
arise from a previous injury.
Insurers use the exclusion when a specific source of risk is either too high or unable to be accurately
measured. It allows insurers to address problematic information disclosed on an application while still
issuing a policy.
[5.2.4 REHABILITATION BENEFIT
The rehabilitation benefit encourages individuals to actively participate in their recovery. Helping an insured
return to work within one year is an important benchmark for reducing the cost of claims and restoring
individuals to active participation in the economy. This benefit helps an insured gradually transition from
being on disability to becoming productive once again.
The rehabilitation benefit facilitates vocational training to prepare insureds for a new occupation. Under the
terms of a rehabilitation benefit provision, the insurer pays the approved cost of a rehabilitation program as
long as the insured remains permanently disabled and active in the program.
[5.2.5] MEDICAL REIMBURSEMENT (NON-DISABLING INJURY) BENEFIT
The medical reimbursement benefit is commonly referred to as the non-disabling injury benefit. This
provision pays up to a specified amount if the insured suffers an injury and no other claim is filed under the
policy. In other words, the insurer pays for medical expenses up to a stated limit as long as the insured has
suffered an injury. For benefits to be paid, the insured must provide proof of treatment.
[5.3] RENEWAL PROVISIONS
Disability insurance policies are either non-cancelable (and guaranteed renewable) or guaranteed
renewable. Neither type of policy can be canceled or non-renewed by an insurer unless the insured fails to
pay their premium. The difference is that a guaranteed renewable policy may adjust the premium annually,
while a non-cancelable policy premium cannot change once established.
[5.3.1] NON-CANCELABLE AND GUARANTEED RENEWABLE (NON-CANCELABLE)
If a policy is non-cancelable, the insurer guarantees the premium charged at the time the policy was issued.
Because of this guarantee, the carrier cannot raise the rate during the life of the policy. The insurance
company also agrees to renew the policy each year, provided the insured pays the premium. The policy may
terminate at an age stated in the initial contract when it's issued. Insurers typically issue these policies to
individuals in preferred, lower-risk occupational classes.
[5.3.2] GUARANTEED RENEWABLE
Guaranteed renewable policies must also be renewed as long as the policyholder continues to pay
premiums. These policies do NOT ensure the initial premium rate. Instead, these policies give the insurance
carrier the right to raise rates if the cost of disability claims exceeds expectations.
The law prohibits an insurance company from raising a policyholder's premiums. However, a company can
raise rates on an entire class of policies when the rate of loss exceeds the rate anticipated by the product
actuaries. Insurers raise rates to reflect the requirements of actuarial science.
Guaranteed renewable policies are more common, especially for occupations with higher morbidity risk.
[5.3.3] COVERAGE AFTER AGE 65 PROVISION
Disability income policies typically require the insured to be actively working for a stated number of hours per
week if coverage extends beyond age 65. Again, disability income policies are designed to protect a person's
earned income.
[5.4] UNDERWRITING CONSIDERATIONS
Disability insurance underwriting evaluates an applicant's risk of morbidity. Morbidity is the likelihood that a
person will become disabled.
The purpose of disability income underwriting is to protect the insurer against adverse selection and to
prevent it from happening. Underwriting helps to properly classify risks such as preferred, standard, and
substandard classifications.
Some substandard risks are uninsurable and must be declined. However, when a substandard risk is written,
it results in a rated-up premium. Personal underwriting criteria include the proposed insured's age, sex,
gender, and occupation.
• Age: The older a person is, the greater the risk of disability.
• Sex: Statistically, a female seeks medical treatment more often than a male, resulting in a higher
premium.
• Occupation: An insured's occupation impacts rates because more hazardous occupations carry
greater risk. An insured's occupation is an essential element of their morbidity risk:
o Individuals in certain professions (e.g., physicians, attorneys, etc.) engage in less hazardous
lines of work. Also, their income potential is much higher than their potential benefits. If these
individuals become disabled, they're more likely to attempt to return to their respective
practices.
o Other white- and gray-collar occupations are seen as riskier, especially when the incentive to
return to work is lower.
o Many blue-collar occupations have a higher incidence of physical injury and the highest
morbidity rates. In such cases, the insurer will limit policy terms and the benefit period to
either two or five years.
[5.5] INDIVIDUAL DISABILITY INCOME POLICY RIDERS
Policyholders may add additional coverages for an additional premium. Some riders add benefits for
particular types of losses or in specific circumstances. Others address the need to adjust coverage limits or
benefits over time. Still, others help insureds extend their buying power by considering the availability of
social insurance. Let's examine a variety of policy options.
[5.5.1] ACCIDENTAL DEATH AND DISMEMBERMENT (AD&D)
This benefit applies if an accident results in a catastrophic loss, which is defined as death, the permanent
loss of limbs, or a permanent loss of one or more of the senses (sight, hearing, or speech).
The death benefit paid under accidental death coverage is referred to as the principal sum.
The dismemberment benefit is referred to as the capital sum.
The principal sum is the rider's face amount, while the capital sum is typically 50% of the principal sum.
An accidental death benefit may be available up to a limited age (e.g., the age of 70). Also, death must
generally occur within 90 days of the accident to qualify. When accidental death coverage is added to a
disability income insurance policy, the insured must designate a primary beneficiary.
Premiums paid for this type of coverage are not tax-deductible (i.e., they're paid after tax). However, the
benefits payable to the insured or beneficiary are not taxable.
Some refer to AD&D coverage as multiple indemnity coverage.
[5.5.2] SOCIAL INSURANCE SUPPLEMENT
Social Security Rider (Social Insurance Supplement or Social Insurance Substitute)
The Social Security rider coordinates individual disability policy benefits with Social Security Disability
Insurance (SSDI) and other forms of social insurance (e.g., workers' compensation). This rider is commonly
referred to as a social insurance supplement (SIS). It pays the insured a monthly benefit whenever SSDI or
workers' compensation denies or doesn't cover a claim.
An individual disability policy is relatively expensive. It also pays regardless of whether SSDI or other social
benefits apply. By shifting some coverage from a basic disability income benefit to the SIS, both the insurer
and the insured benefit:
The insurer lowers its risk because the rider only pays if social insurance does not.
The insured will ultimately receive sufficient insurance, either from the insurance company or a government
benefit.
The insured also pays a reduced premium that reflects the insurance company's lower risk.
This rider is particularly beneficial for middle-income individuals who may benefit most from social insurance
but struggle with the cost of coverage. The insured must apply for disability payments from all available
government sources to be eligible for this policy benefit.
[5.5.3] ADDITIONAL MONTHLY BENEFIT RIDER
The additional monthly benefit (AMB) rider is a short-term benefit that addresses the insured's needs during
the initial six to 12 months of disability. During the early months of disability, the additional benefits can be
used to supplement disability benefits provided by an employer or help pay other expenses that may be
incurred when an insured is initially disabled. They can also fill the coverage gaps during the five -month SSDI
waiting period.
[5.5.4] GUARANTEED INSURABILITY RIDER (ADDITIONAL PURCHASE/FUTURE INCREASE OPTION)
The future increase option (FIO) rider helps guarantee that a person's coverage keeps pace with income.
Individual policies define a person's monthly benefits as flat amounts that don't automatically change with
their income. The FIO "guarantees" that the insured can purchase additional amount s of disability income
insurance at various specified future dates without evidence of insurability.
The insured can exercise this option as long as their income has increased over the years. Also, the
insured must exercise the FIO if available. The terms of the guaranteed insurability rider are "use it or lose
it." The restriction helps insurers avoid adverse selection. Insurance companies may also refer to this benefit
as the additional purchase option (APO) or the guaranteed purchase option (GPO).
[5.5.5] COST-OF-LIVING ADJUSTMENT RIDER
The cost-of-living adjustment (COLA) rider offsets the impact of inflation that can erode the purchasing
power of a fixed income, such as that provided by monthly disability income benefits. The COLA rider indexes
the monthly or weekly benefit payable under a disability policy to changes in the CPI. Typically, the benefit
amount is adjusted on each disability anniversary date to reflect changes in the CPI.
For example, a $1,000 per month benefit with a COLA rider may be increased each year by the lesser of the
CPI inflation rate or a specified percentage stated in the policy (generally 5%).
This rider doesn't increase coverage like an FIO; instead, the COLA rider increases the benefits paid once a
claim has been made. This rider is also only found with LTD policies.
[5.5.6] LIFETIME EXTENSION RIDER
The lifetime extension rider extends the benefit period beyond the age of 65. Let us assume the insured is
totally disabled due to an injury or illness that occurred before age 65. In this case, benefits will continue
throughout the insured's lifetime, as long as the insured remains totally disabled.
However, the insurer may specify that the injury or illness must begin before a certain age (e.g., age 50) for
the insured to receive full benefits. If the disability begins after the specified period, an insured will receive a
reduced benefit until age 65, at which time benefits will cease.
[5.5.7] HOSPITAL CONFINEMENT RIDER
The hospital confinement rider is an indemnity-type rider. When this benefit is included in a disability
income policy, an additional benefit is paid over and above the regular monthly disability benefit based on the
number of days the insured is confined to a hospital.
The hospital confinement rider also waives the elimination period during the insured's hospital confinement.
Generally, benefits are payable from the first day of confinement for periods of up to six months or 12
months, depending on the policy.
[5.5.8] RETURN OF PREMIUM RIDER
The return of premium rider provides a refund provision for the insured. If included, it refunds a percentage of
all premiums paid during a specific period, provided there has been a favorable claim experience. These
riders may provide refunds at the age of 65 or every five or 10 years after the policy is issued, depending on
the insurer.
[5.5.9] CASH SURRENDER VALUE RIDER
A cash surrender value rider returns all premiums to the policy owner at age 65, less any benefits received
over the contract's life.
Disability Benefits in Life Insurance
There are two types of disability benefits that are found in life insurance—the waiver of premium rider and
the disability income rider. The waiver of premium rider is a provision that waives the cost of coverage if the
insured becomes disabled. It’s optional in life insurance but standard in health insurance contracts. On the
other hand, disability income benefit riders provide for a small stated benefit, such as 1% of the policy's face
amount (up to $1,000), that is payable if the insured becomes totally disabled..
[6] BUSINESS USES FOR DISABILITY INSURANCE
The business uses for disability insurance can be divided into two general categories: group insurance to
benefit employees and individually underwritten plans designed to help assure the commercial entities
weather the loss of key personnel and continue operation.
Group plans share key features with other types of group policies and a design that fits with the company's
philosophy and compensation structure. These plans also coordinate with other disability income sources to
ensure that earnings do not exceed a designated percentage.
Health insurance also facilitates the process of business continuation in the event of a business owner's or
key employee's disabling sickness or injury. In some cases, businesses use disability income insurance with
other legal mechanisms. Some policies are designed to meet specific business needs.
Business overhead expense (BOE) insurance covers business expenses such as rent, utilities, and payroll if
the owner is disabled. Disability buyout policies fund agreements that facilitate the purchase of a disabled
partner's share by the remaining partners. Key person disability insurance compensates a business for the
loss of a key employee by covering the costs of hiring and training replacements.
Unlike group insurance, all these policies are written as individual contracts based on the risk profile of a
business owner, partner, or key employee. While group insurance benefits the average worker in an
organization, these policies benefit the owners, key employees, or the organization itself. The business is
usually the policy's owner, premium payor, and beneficiary.
[6.1] GROUP DISABILITY INCOME INSURANCE PLANS
Group disability insurance shares the following characteristics that apply to all valid group insurance plans:
• The group must be a natural group.
• Insurance companies determine premiums based on a group's aggregate level of risk, taking into
account its industry, occupational categories, and claims experience.
• An employer may offer more than one coverage plan and may restrict participation in each plan by
employee class.
• Insurance companies require a minimum degree of participation to avoid adverse selection.
[6.1.1] QUALIFYING FOR BENEFITS AND BENEFIT PERIODS
Group insurance plans often provide both total disability benefits and partial disability. They also recognize
the circumstances that cause an individual to temporarily leave and later return to the covered group. For
example, military personnel must have the right to reinstate their disability group coverage upon release from
active military duty. As with individual plans, group disability can include short-term plans or long-term plans.
Group Short-Term Disability Income Plans are characterized by maximum benefit periods of relatively short
duration, such as 13 weeks (where allowed by law) or 26 weeks. Benefits are typically paid weekly and range
from 50% to 70% of the individual's pre-disability income, though a higher percentage could be made
available in some cases. The definition of disability is the insured's "own occupation."
Group Long-Term Disability Income Plans provide maximum benefit periods of two years or more,
occasionally extending to the insured's retirement age. Benefit amounts are generally limited to between
50% and 70% of the participant's income. In some cases, the employer will pay for a benefit equal to 50% of
employees' wages and allow employees to increase their coverage to 20% at their own expense.
If an employer provides both a short-term and a long-term plan, the long-term plan typically begins paying
benefits only after the short-term plan ends. Often, long-term plans use an "own occupation" definition of
total disability for the first one to two years of disability and then switch to an "any occupation" definition.
[6.1.2] ELEMENTS OF GROUP DISABILITY INSURANCE
[[Link]] PROBATIONARY PERIOD
Group insurance policies do not usually have a probationary period once coverage begins. Instead, most
group disability plans require new participants to complete a minimum length of service (e.g., 30 to 90 days)
before becoming eligible for coverage.
[[Link]] BENEFIT PERIODS
For group insurance, the benefit periods are identical to those for individual insurance policies. The similarity
includes the distinction between long-term and short-term insurance. Many group plans integrate short- and
long-term benefits by coordinating benefit and elimination periods, as described below.
[[Link]] ELIMINATION PERIOD
Group insurance policies have a uniform elimination period. The elimination period often reflects the full
range of sickness and disability benefits available to employees. For example, let us assume that an
employer provides employees with two weeks of sick leave per year, a six-month STD plan, and LTD
insurance if necessary. A typical corporate benefit package includes the following elements:
• A seven- or 10-day elimination period for the short-term disability benefit
• A 180-day elimination period for the long-term disability benefit
A well-designed package should allow injured workers to move seamlessly between the different disability
benefits.
[[Link]] BENEFIT AMOUNT
Group insurance policies define periodic disability benefits as a percentage of an insured's wages. If the
employee's compensation changes, so does the benefit amount. Unlike individual policies, group plans do
not have a guaranteed insurability option. It is not necessary because group plans build automatic
adjustments into the basic product design. Individual plans, on the other hand, provide a flat benefit amount
tied to a specific point in one's financial timeline, unless flexibility is added through guaranteed insurability.
[[Link]] COORDINATION OF BENEFITS
Group disability plans coordinate benefits with disability income received from government plans, pensions,
and other social insurance programs, such as SSDI or workers' compensation.
Most group plans include provisions that make their coverage supplemental to workers' compensation
benefits so that total benefits received do not exceed a specified percentage of regular earnings. Since
workers' compensation programs typically cap benefits based on the average weekly wage in a given state,
group insurance may still pay a reduced amount.
In some cases, group disability plans limit coverage to non-occupational disabilities because workers'
compensation typically covers occupational disabilities.
EXAM TIP!
For any question of whether group disability insurance is "occupational" or "non-occupational" insurance,
the answer is not that simple. Our suggestion is to choose non-occupational.
[6.2] BUSINESS OVERHEAD EXPENSE INSURANCE
Business overhead expense (BOE) insurance is designed to reimburse a business for business expenses
and payroll if the business owner becomes disabled. However, a BOE policy does NOT cover the owner's lost
compensation due to the disability. Instead, BOE insurance covers the day-to-day costs of business
operations to help the enterprise continue functioning.
Exam Tip!
Disability income insurance provides income until one can return to work.
Business Overhead Expense insurance ensures that a small business owner has a business to go back to.
A BOE policy does not replace the business owner's lost income.
Insurers sell this specialized, individual policy to professionals in private practice, self -employed business
owners, partners, and (possibly) close corporations. The coverage is vital for any small business in which the
business owner either directly generates a significant portion of the company's income or directly oversees
the day-to-day operations.
Business overhead expense policies pay a maximum monthly amount rather than a fixed indemnity. The
defined benefit is a limit, and the policy will reimburse the insured company for actual covered expenses up
to that limit.
Covered Business Overhead Expenses
Rent or mortgage payments Leased equipment
Utilities Employee wages
Telephone and internet service The cost of hiring a person as a temporary replacement
The full list of covered expenses includes all the costs that will continue and must be paid, regardless of the
owner's disability.
[6.2] BUSINESS OVERHEAD EXPENSE INSURANCE (continued)
For example, let's assume that Dr. Jane Dough is the insured under a business overhead expense policy that
pays maximum monthly benefits of $4,500. If Dr. Dough were to become disabled for one month and her
practice's actual monthly expenses were $3,950, the monthly benefits paid would equal $3,950. If Dr.
Dough's actual expenditures were $4,700, her policy would pay up to the monthly maximum of $4,500. The
following table illustrates BOE policy benefits over a four-month period after meeting the elimination period.
Doctor Jane Dough's Business Overhead Expense Insurance Claim
BUSINESS OVERHEAD EXPENSE CLAIM MONTH MAXIMUM BENEFIT OVERHEAD COSTS BENEFIT PAID
MONTH 1 $4,500 $5,000 $4,500
MONTH 2 $4,500 $4,600 $4,500
MONTH 3 $4,500 $4,250 $4,250
MONTH 4 $4,500 $3,950 $3,950
4-MONTH CLAIM TOTALS $18,000 $17,800 $17,200
[6.3] DISABILITY BUY-OUT POLICIES
Disability buy-out policies are used to fund disability buy-sell [Link] buy-out policies
operate like life insurance buy-sell agreements. In this case, the plan sets forth the terms for selling and
buying a partner's or stockholder's share of the business if that partner or stockholder becomes disabled and
can no longer participate in the business. It is a legally binding arrangement funded by a disability buy -out
policy. Benefits that are payable under a disability buy-sell policy are paid to the company (an entity plan) or
another shareholder (cross-purchase plan).

[6.3.1] DISABILITY BUY-OUT (CROSS-PURCHASE) PLANS

In the cross-purchase plan (diagram below), each partner buys a policy that covers each of the other owners.
Each policy is issued for the amount that a remaining partner would pay to a disabled person.
When there are a very small number of partners, a cross-purchase plan may be preferred. As the number of
partners or shareholders increases, this type of policy becomes cumbersome. The number of policies
needed to fund a cross-purchase agreement buy-out can be calculated by using the following formula:
Total Policies = (Number of Partners) × (Number of Partners - 1)
For example, if the partnership consists of three partners, each partner will purchase, own, and pay for a
policy that covers the other two partners. In that case, there will be 6 policies in total.

[6.3.2] DISABILITY BUY-OUT POLICIES (ENTITY PLANS)

In an entity buy-sell plan (diagram below), the company purchases a policy on each partner or shareholder.
The company is the beneficiary of each policy and uses the funds to buy out the disabled partner or
shareholder.
Remember, cross-purchase plans are purchased by shareholders or partners, whereas entity buy-sell plans
are purchased by the company.
Unlike typical disability income insurance contracts, disability buy-out policies contain a provision that
allows the insurer to pay a lump-sum benefit to facilitate the purchase of the disabled partner's interest. A
lump sum can make sense since the policy is purchasing an asset, not replacing an income. If the owners so
desire, the plan often permits the buyout through periodic income payments.
Disability buy-sell policies also have lengthy elimination periods, often as long as two years. The reason is
simple: the plan involves the sale of a disabled partner's or owner's interest in the business, and it's
important to be certain that the disabled person will not return to the company.
A disabled partner can represent a double liability. The remaining partners have the burden of not only picking
up the slack left by the disabled partner's absence but also need to pay an income. Therefore, it's
understandable why the disability buy-sell plan is popular with business owners.

[6.3.3] ELECTIVE INDEMNITY OPTION

Some disability income policies provide an optional lump-sum payment rather than a stream of periodic
payments for injuries named in the contract. In some cases, the insured may select this elective indemnity
option when applying for the policy.
The elective indemnity option is also used in policies that facilitate the transfer of ownership related to
disabilities. These will be described when disability buyout plans are covered.
[6.4] KEY PERSON (EMPLOYEE) DISABILITY INSURANCE
Just as key person life insurance indemnifies a business for a key person's lost services, so too does a key
person disability insurance policy. This type of coverage pays a monthly benefit to a business to cover
expenses for additional help or outside services when an essential person is disabled. The key person could
be a partner or working stockholder of the corporation or even a management person responsible for an
essential function (e.g., a sales manager).
The key person's economic value to the business is calculated as the potential loss of business income and
the expense of hiring and training a replacement for the key person. The key person's value then becomes the
disability benefit paid to the business. The benefit amount may be paid in a lump sum or through monthly
installments. Generally, the policy's elimination period is 30 to 90 days, and the benefit period is one or two
years. The business is the policyholder and premium payor.
Group Disability Income Insurance Plans
Group disability insurance must share the following characteristics that apply to all valid group insurance
plans:
▪ The group must be a natural group.
▪ Insurance companies base premiums on the group’s aggregate risk, including the industry, occupational
categories, and claims experience.
▪ The employer may offer more than one coverage plan, and the employer may restrict participation in each
plan according to the class of employees. Examples of class distinction include the following:
‒ Full-time versus part-time
‒ Union versus non-union
‒ Office staff versus warehouse and assembly line
▪ Insurance companies require a minimum degree of participation to avoid adverse selection.
[7] TAXATION OF DISABILITY INSURANCE POLICIES
When it comes to disability insurance, a fundamental taxation principle is that the IRS generally taxes the
money only once. The IRS either taxes the premiums paid or the benefits received, but not both sides of the
cash flow for the same transaction. The IRS can tax the money going in or coming out, but it cannot tax it both
coming and going. The following section examines how this applies to the various forms of disability
insurance covered in this chapter.
[7.1] GOVERNMENT (SOCIAL) DISABILITY INSURANCE
The taxation of social insurance disability benefits depends on the recipient's program and income.
[7.1.1] SOCIAL SECURITY DISABILITY INSURANCE
Social Security Insurance benefits are partially taxed after a person's total income reaches a certain
threshold: $25,000 for individuals and $32,000 for married couples filing jointly. If total income exceeds the
threshold, 50% to 85% of the benefits become taxable. When determining taxability, the total amount
considered includes 50% of the benefits received, all other taxable income, adjustments, and tax -free
interest.
[7.1.2] WORKERS' COMPENSATION
In general, workers' compensation benefits are not subject to state or federal income tax. The only exception
occurs if an individual receives both workers' compensation and Social Security benefits. Let us assume that
the combined total is high enough so that the Social Security Administration must reduce benefits to avoid
exceeding the program limit. In such a case, the benefits are taxable by the amount of the deduction.
For example, if the combination of SSDI and workers' compensation is high enough to trigger a $200
deduction in monthly SSDI benefits, then $200 of monthly workers' compensation benefits are taxable.
[7.2] INDIVIDUAL DISABILITY INCOME INSURANCE
The taxation of individual disability income insurance policies is as follows.
• Premiums are not deductible: Because premiums are not tax-deductible, the IRS counts the
premiums as part of taxable income and captures a percentage as income tax. Therefore, a person
pays the premiums with after-tax dollars.
• Benefits are not taxable: Because the premiums have been paid in after-tax dollars—regardless of
whether benefits are ever received—the benefits are free of income tax. The IRS has already
subjected the premiums paid to taxation.
[7.3] GROUP DISABILITY INCOME INSURANCE
When it comes to group insurance taxation, two parties are involved: the employer and the employee. From a
taxation perspective, the IRS treats each group differently. There is also some variation in the way employee
contributions and disability benefits are treated.
Employers: The premiums paid by employers are tax-deductible. The IRS considers these premiums a
legitimate business expense because the group policy benefits the employees, not the employer or the
business.
Employees: The following four circumstances can apply regarding the taxation of premiums and benefits as
they relate to employees:
Employer-Paid Premiums If the employer of an insured worker pays the premiums for that worker's disability
insurance, then all of the benefits received by the worker are taxable. The premium is tax -deductible to the
employer and not taxed. As a result, the IRS taxes the funds (benefits) when they're received from the policy
by employees.
Employee-Paid Premiums (Pre-Tax Premiums): If an employee contributes to the group premiums through a
tax-advantaged cafeteria plan or other pre-tax vehicles, the IRS taxes any benefits as income. Since the pre-
tax contribution avoids taxation on the front-end of the policy, the IRS taxes funds received by the employee
on the back-end, often when the need for income and a tax break is more severe.
Employee-Paid Premiums (After-Tax Premiums): Some companies that provide employee-paid insurance
allow or require employees to pay premiums with after-tax dollars. In these cases, the amounts deducted for
premiums are considered a part of taxable income. Since the insured's premium dollars have been taxed, the
benefits received by the insured are tax-free.
Premiums Shared by Employer and Employees: If the employee-paid portion of the premium was a pre-tax
contribution, then the entire benefit is taxable. If the employee-paid premium contribution was made with
after-tax dollars, then the benefit is partially taxable and partially tax-free because the premium was partially
taxable. The tax-free percentage of the benefit reflects the portion of the premiums paid with after-tax
dollars.
[7.3.1] GROUP DISABILITY INCOME INSURANCE EXAMPLE
For example, let's assume that Joe's monthly income is $2,000 per month and that his employer pays the
premium for a total disability benefit equal to 50% of each employee's income. For Joe, a 50% total disability
benefit means $1,000 per month if he becomes totally disabled.
Let's also assume that Joe takes advantage of an available group plan option and pays for an enhanced group
benefit that increases his benefit by 20% of his income, which is $400 per month. Now, if Joe becomes
totally disabled, he will receive $1,400 per month.
The last assumption is that Joe pays his portion of the premium with after-tax dollars.
In this scenario, if Joe becomes totally disabled, he receives $1,400 per month in disability benefits. Of those
monthly benefits, $1,000 is taxable income because the employer paid the premium and deducted it as a
business expense. The additional $400 is income tax-free because Joe paid for this portion of the benefit with
after-tax dollars. This tax-free portion of the monthly benefit ($400) results from funds that have already
been taxed.
Keywords(TEST1)
Prior to reading this chapter, please review the following keywords. An understanding of their basic
definitions will improve your comprehension of the chapter content.
Accidental Bodily Injury: See “accidental results.”
Accidental Means: This describes an unforeseen, unexpected, or unintended event that results from an
action that was not deliberately undertaken. This applies to an accident policy by requiring a mishap’s cause
and result to be accidental for any claim to be payable.
Let’s assume that Pedestrian A accidentally bumps into Pedestrian B and, as a result, is nudged into the
street unintentionally. If Pedestrian A is then hit by a moving vehicle, any injury resulting from the motor
vehicle accident is covered by a policy using the accidental means definition. The action (e.g., cause) that put
Pedestrian A in the street was itself unintended, and the injury (e.g., the result) was an accident.
Accidental Results (Accidental Bodily Injury): This is an unintended consequence of an action that the
insured takes, even if undertaken voluntarily. Policies that use the accidental bodily injury provision are
referred to as “accidental results” policies because they only require for the result of the inj ury to be
unexpected and unintended. This definition is far less restrictive than the accidental means definition.
Additional Monthly Benefit (AMB): The AMB rider can supplement employer-provided disability benefits,
cover gaps in Social Security Disability Insurance (SSDI), or help pay for extra initial expenses if a person
becomes disabled.
Additional Purchase Option (APO): See “Guaranteed Insurability Rider.”
Any Substantial Gainful Work: This phrase is an essential part of the Social Security definition of disability.
The law defines disability as the inability to do any substantial gainful work due to any medically
determinable physical or mental impairment which can be expected to result in death, or which has lasted or
can be expected to last for a continuous period of not less than 12 months.
Any Occupation: For a policy to provide disability income benefits, the definition of total disability requires
the insured to be unable to perform any job for which that insured is “reasonably suited by reason of
education, training, or experience.” See “Any Occupation for Which the Insured is Reasonably Suited.”
Any Occupation for Which the Insured is Reasonably Suited: For purposes of determining a person’s
disability, in the states that use this phrase, it’s the same as the more generally used industry term, “any
occupation.” In the states that don’t use this extended phrase, the phrase “any occupation” is taken more
literally and is, therefore, more strict.
Benefit Period: This is the maximum length of time during which a benefit can be paid. The longer the benefit
period, the higher the cost (premium) of the policy. Rather than charging additional premiums or excluding
coverage when issuing a disability income policy to a substandard risk, an insurer may shorten the benefit
period.
Business Overhead Expense (BOE) Insurance: This form of insurance reimburses the insured company for
business expenses and payroll costs if the business owner/operator becomes disabled.
Capital Sum: This is the accidental death and dismemberment policy benefit that’s paid if the insured
suffers a dismemberment.
Cash Surrender Value Rider: This rider returns all premiums to the policy owner at age 65 if no claims have
been made.
Change of Occupation Provision: This provision allows the insurer to reduce the maximum benefit that’s
payable under the policy if the insured switches to a more hazardous occupation without informing the
insurer. It also allows the insurance carrier to reduce the premium rate being char ged if the insured changes
to a less hazardous occupation. If the insured does change to a less hazardous job, the insurer will return any
excess unearned premium.
Concurrent Disability: This applies when multiple events are involved in causing the same disability. A
person may also experience a loss that fits more than one definition of disability. In either case, the insured
may only claim one benefit.
Confined Disability: Some disability policies may differentiate benefits based on whether the insured is
confined at home or in a hospital. A confined disability requires the insured to stay indoors.
Coordination of Benefits: This is the process that’s used to determine the order in which insurance
companies pay a claim. It’s used both among group insurance companies and in conjunction with social
insurance. The primary insurer pays all claims as if it were the only carrier. The coverage that’s designated as
“contingent” will cover the remaining balance.
Cost of Living Adjustment (COLA) Rider: This rider provides an automatic increase in benefits (typically
tied to the Consumer Price Index, or CPI) in order to offset the effects of inflation. The COLA rider applies
once the insured has filed a claim and has received benefits for more than one year. The rider eases the
impact of inflation on a fixed income.
Credit Disability Insurance: This type of policy makes payments on a loan when an insured borrower
becomes disabled. The policy pays the creditor, not the borrower. See “Decreasing Term Disability
Policy.”
Decreasing Term Disability Policy: These contracts cover a fixed period that starts on the date they’re
issued. As the time elapses, the remaining number of potential monthly benefit payments also decreases
until it reaches zero. Credit disability policies are a form of decreasing term disability policy.
For example, let’s consider a five-year loan. A disability at the end of year one could require the insurer to
make monthly payments for up to four years. However, a disability at the end of year four would require only
one year of monthly payments at the most.
Delayed Disability Provision: This provision applies to a disability income policy which allows a certain
amount of time after an accident for a disability to result, during which the insured remains eligible for
benefits. Most disability policies offer this benefit, which allows some extension of the time between an
occurrence and resulting disability, during which the policy will still cover a resulting total disability.
Disability Buyout Plan: This is a form of a buy-sell agreement that’s funded by insurance policies. This
contractual agreement uses disability policy funds to purchase an owner’s share of a business if that owner
becomes disabled.
Disability Buyout Policy: This is a disability policy that’s designed and used to fund a disability buyout plan.
Disability Income Rider: On a life insurance policy, this rider converts 1% of the policy face amount into a
disability benefit, which is payable if the insured becomes totally disabled.
Elective Indemnity Option: The option allows the insured to receive an optional lump-sum payment for
specific injuries. It can also be used in a disability buy-out policy. When applying for a disability policy, an
insured may choose to add the elective indemnity option.
Elimination Period: This is a duration of time between the beginning of an insured’s disability and the
commencement of the period for which benefits are payable. The elimination period is often considered a
disability policy “deductible,” which correlates directly with the cost of a policy. If an insured wants a lower
premium, she will need to settle for a longer elimination period. If an insured wants a shorter elimination
period, the policy premiums will be higher.
Federal Insurance Contributions Act (FICA) Taxes: These are payroll taxes that are paid by both
employees and their employers and are used to fund Social Security.
Flat Amount Approach: With this approach, even if the insured’s earnings change, the policy benefit
remains the same unless the insured purchases a rider that can be used to change the benefit. This is most
commonly used in individual insurance contracts. In fact, policies utilizing this approach define the policy
benefit as a fixed dollar amount per month.
Fully Insured: This term is used by the Social Security Administration to describe individuals who are eligible
for Social Security retirement and disability benefits. Eligibility is based on paying a sufficient amount in
payroll taxes for the minimum number of calendar quarters. Individuals who have paid enough taxes for at
least 40 quarters (10 years) attain permanent, fully insured status.
Future Increase Option: See” guaranteed insurability rider.”
Guaranteed Insurability Option: See “guaranteed insurability rider.”
Guaranteed Insurability Rider: This rider guarantees an insured’s insurability and gives the insured the right
to buy additional amounts of disability income coverage at predetermined times in the future without proof of
good health.
Guaranteed Purchase Option (GPO): See “guaranteed insurability rider.”
Guaranteed Renewable: This provision states that the insurer must renew an insurance policy up to the
established termination age unless the insured fails to pay the premium. The insurance carrier cannot change
the policy terms but can change the premium rate on a class basis (if necessary).
Hospital Confinement Rider: This rider pays an additional benefit for each day that an insured is in the
hospital over and above the basic policy benefit.
Impairment Waiver: This rider is also referred to as a waiver for impairments. In order to cover an applicant,
insurers use this rider to permanently exclude certain losses, in some cases for a standard premium.
Income Replacement Contract: This contract defines disability as a loss of income and uses that method
to determine disability.
Key Employee Insurance Policy: This type of policy indemnifies an employer if it loses a key employee’s
services.
Lifetime Extension Rider: This rider extends the benefit period beyond the age of 65.
Long-Term Disability Insurance Policy: This is a disability income insurance policy that’s characterized by
monthly benefit payments and a benefit period of two or more years.
Loss of Earnings Test: This test requires a loss of income for there to be a compensable claim. If the insured
can earn as much as his pre-disability income, despite the inability to perform the duties of his former
profession, then there’s no loss and no claim to pay.
Material Duties: This refers to the actual tasks or activities that a person must complete in the course of
doing her job.
Morbidity: This measures the risk of becoming disabled and can factor in personal as well as occupational
circumstances.
Medical Reimbursement Benefit: See “Non-Disabling Injuries.”
Natural Group: This is a group that’s formed for a legitimate purpose other than to purchase group
insurance.
Non-Cancelable: This provision states that the insurer must renew an insurance policy up to the
established termination age unless the insured fails to pay the premium. Also, the insurance carrier can
neither change the policy terms nor the premium rate.
Non-Cancelable and Guaranteed Renewable: See “Non-Cancelable.”
Non-Disabling Injuries: This benefit applies to injuries, which may have been the result of an accident, but
are not necessarily disabling. Many disability policies include a limited medical expense benefit that pays the
actual cost of medical treatment for non-disabling injuries that are the result of an accident.
Non-Occupational Coverage: This is coverage that is provided by a disability income policy that doesn’t
provide benefits for losses occurring due to the insured’s employment.
Occupational Coverage – A disability income insurance policy that provides occupational coverage will pay
a monthly benefit for job-related disabilities as well as non-occupational losses. In other words, it covers the
insured seven days a week and 24 hours a day.
Own Occupation: This term applies when determining a person’s disability. Total disability requires the
insured to be unable to work at the insured’s own occupation in order to receive disability income benefits.
Partial Disability: This occurs when an illness or injury prevents an insured from performing one or more
(but not all) of the key duties of the insured’s own occupation. Alternatively, partial disability can also be
defined as the insured’s inability to work at his job on a full-time basis. In either case, a covered loss occurs if
the result is a decrease in the insured’s income.
Percentage of Earnings Approach: This approach is most commonly used in group insurance contracts.
Benefit plans using this approach define the policy benefit as a fixed percentage of the insured’s income. If
the insured’s earnings change, the policy benefit automatically adjusts to maintain the policy benefit at the
same percentage of income, as defined by the group benefits plan.
Permanent Disability: This term is used in Workers’ Compensation to describe a condition that’s
considered to be permanent in nature. It may include cases of dismemberment or a chronic disabling
condition. The benefit may be a lump-sum payment or weekly income.
Presumptive Disability: This is a disability that provides for the payment of disability benefits if an insured
experiences the level of direct physical harm that’s specified in the policy. The term “presumptive disability”
generally applies when an insured suffers a double dismemberment (loss of two or more limbs), or the
permanent loss of sight, hearing, or the power of speech.
Primary Insurance Amount (PIA): This is the basic monthly benefit that’s available to covered individuals.
Social Security bases the PIA on a person’s income and the amount of taxes on that income.
Principal Sum: This is the accidental death and dismemberment policy benefit that’s paid if the insured dies
due to a covered accident. It equals the face amount of the policy.
Probationary Period: This is a specified number of days (typically from seven to 30) beginning on the
effective date of an insurance policy. During this period, the policy only covers accidents. It excludes any
losses or claims resulting from sickness during this time. The exclusion of claims due to sickness is
important because a person can be ill (infected with a disease) before the illness becomes manifest. This
provision is designed to prohibit a person from buying insurance only when he needs it and then immediately
filing a claim, which results in adverse selection.
Pro-Rata: This refers to the ways that multiple insurers share responsibility for a claim they both cover. Each
carrier covers a proportional amount of the claim based on its percentage of the available insurance.
For example, if an insurance company has 60% of the coverage applicable for paying a claim, that insurer will
be responsible for paying 60% of the claim.
Recurrent Disability Provision: This is a disability income policy provision that specifies a period during
which the reoccurrence of a disability is considered a continuation of a prior disability claim. During that
period, the insurer will then pay benefits without a new elimination period. If the recurrence takes place after
that period, it’s considered a new disability. Being considered a new disability means that the claim will be
subject to a new elimination period. Recurrent disabilities also count against the benefit period that’s
initiated by the original claim rather than starting a new one.
Rehabilitation Benefit: This benefit facilitates vocational training to prepare an insured for a new
occupation. With some disabilities, insureds may not be able to return to their previous employment but can
still work at some kind of job. Under the rehabilitation benefit, the insurer will pay the approved cost of a
rehabilitation program to help the disabled insured return to work.
Relation of Earnings to Insurance: This clause applies when a person has more than one policy that covers
the same disability claim. It states that the total benefit cannot be more than the income lost. Each insurer
pays a pro-rata share of the total amount paid.
Residual Disability: This is related to the proportional disability benefit that a person collects while working
less than full time and suffering an income loss of at least 20%. Insurance companies base residual disability
income payments on the proportion of income that the insured has lost.
For example, an insured suffered a 20% loss of income because of a covered disability. The residual
disability benefit payable would be 20% of the policy’s total disability benefit.
Return of Premium Rider: This rider refunds the insured’s premiums (dollar for dollar without interest) if the
insured doesn’t file a claim. The rider may extend for the life of the policy or for a stipulated period.
Short-Term Disability Insurance: This is a disability income insurance policy that’s characterized by weekly
benefit payments and a benefit period of no more than two years. Group short-term disability policies tend to
have benefit periods of no more than 26 weeks and are integrated with corporate sick time and long-term
disability benefits.
Social Security Disability Income (SSDI): This is available to individuals who meet the definition of being
fully insured and qualify for Social Security Disability Income benefits. A worker’s Social Security Disability
Income (SSDI) benefit equals 100% of the worker’s Primary Insurance Amount (PIA).
Social Security Rider (Social Insurance Supplement or Social Insurance Substitute): This supplement
pays a monthly disability benefit when the insured applies for social insurance, and the social insurance
benefit is either delayed, denied, or less than the amount of the rider.
Substantial Duties: This refers to a person’s essential capabilities which make it possible to do her job.
Temporary Disability: This is used in Workers’ Compensation to describe a condition that’s considered to
be potentially temporary in nature unless re-evaluated at the end of the prescribed temporary benefit period
under state law.
Waiver for Impairments: See “Impairment Waiver.”
Waiver of Premium: This is activated when an insured is disabled and begins receiving benefits. The
insurance company waives premium payments during a disability and keeps the policy in force. The disability
must meet the definition that’s stipulated in the policy and must continue through the waiting period. The
waiver is NOT a loan; instead, the insurance company is “waiving” the premiums.” It’s just as if the premiums
were being paid each month.
Workers’ Compensation: This is a form of liability insurance that provides benefits to workers who are
harmed by work-related occurrences.
[8] DISABILITY INCOME INSURANCE SUMMARY
Disability income insurance provides crucial financial protection against the loss of income when illness or
injury prevents someone from working. Throughout this chapter, we've explored how this specialized
insurance helps individuals and businesses manage the financial risks associated with disability.
We began by examining the fundamental purpose of disability insurance—to replace a portion of income
when a covered person cannot work due to a qualifying disability. We learned that disability can be defined in
various ways, from the inability to perform one's own occupation to the inability to engage in any substantial
gainful activity. These definitions significantly impact when and how benefits are paid.
We compared government disability programs like Social Security Disability Insurance and workers'
compensation with private insurance options. While government programs provide basic coverage, they
often have strict eligibility requirements and limited benefits, highlighting the need for supplemental private
coverage.
We distinguished between individual and group disability policies, noting their different features, benefits,
and costs. Individual policies offer more customization but at a higher price, while group policies provide
cost-effective coverage with standardized benefits. Both types can be structured as short-term or long-term
coverage, with varying elimination periods and benefit durations.
For businesses, we explored specialized disability insurance products that help ensure continuity when
owners or key employees become disabled. Business overhead expense insurance covers ongoing
operational costs, disability buy-out policies fund the purchase of a disabled partner's share, and key person
disability insurance compensates for the loss of essential personnel.
Finally, we examined how disability benefits are taxed, noting the important principle that money is generally
taxed only once—either when premiums are paid or when benefits are received, but not both. This taxation
varies depending on whether premiums are paid by employers or employees and whether they're paid with
pre-tax or after-tax dollars.
As you prepare for your licensing exam and future career, remember that disability insurance fills a critical
gap in financial planning. While clients may focus on protecting against death or property damage, your
understanding of disability insurance allows you to help them protect their most valuable asset—their ability
to earn an income.
[8.2] REVIEW NOTES
Learning Objective 1: Explain the purpose and importance of disability income insurance in financial
planning
Key Concepts:
• Disability income insurance protects against loss of income when covered perils make it impossible
to work
• Often called "living death insurance" because the financial impact can be worse than death
• Provides a specified income benefit for a defined period of time
• Transfers potentially catastrophic financial risk to the insurer for predictable premium payments
Important Terms:
• Accidental bodily injury: Unintended consequence of an action the insured takes
• Morbidity: Measures the risk of becoming disabled based on personal and occupational factors
• Covered perils: Accidents and illnesses that cause disability
Learning Objective 2: Differentiate between the various definitions of disability used in insurance
policies
Total Disability Definitions:
• Own occupation: Cannot perform material and substantial duties of insured's own occupation
• Any occupation: Cannot perform duties of own occupation or any occupation for which reasonably
suited by education, training, or experience
• Substantial gainful activity (SGA): Social Security definition requiring the inability to engage in any
substantial gainful work
Other Disability Definitions:
• Partial disability: Inability to perform one or more key duties or inability to work full -time
• Residual disability: Working less than full-time with income loss of at least 20%
• Presumptive disability: Specific severe conditions like loss of limbs, sight, hearing, or speech
• Concurrent disability: Multiple events causing the same disability period
• Delayed disability: Total disability developing after an accident
 • Confined disability: Requires the insured to remain indoors
Learning Objective 3: Identify how individuals qualify for disability benefits under different policy types
Qualifying Requirements:
• Must be under a physician's care
• Must meet the policy's definition of disability
• Must satisfy the elimination (waiting) period
• Must have loss of income (presumed or actual)
Recurrent Disability:
• Relapse within six months is considered a continuation of initial disability
• No new elimination period needed
• No new benefit period begins
• Relapse after six months is treated as a new claim
At-Work Benefits:
• Partial disability: 50% of the total disability benefit
• Residual disability: Percentage of total disability benefit based on income loss
Learning Objective 4: Compare government disability programs with private disability insurance options
Government Programs:
• Social Security Disability Insurance (SSDI):
o Requires sufficient FICA tax payments (40 quarters for permanent status)
o Uses the substantial gainful activity definition
o Has a five-month waiting period
o Benefit equals 100% of primary insurance amount (PIA)
• Workers' Compensation:
o Covers work-related accidents or occupational diseases
o Provides medical, disability, and survivor benefits
o Classifies disabilities as temporary or permanent
o Primary coverage for work-related disability
Private Insurance Advantages:
• More flexible definitions of disability
• Shorter elimination periods
• Higher benefit amounts
• Customizable with riders
• Coverage for both occupational and non-occupational disabilities
Learning Objective 5: Distinguish between individual and group disability income insurance features
Individual Disability Insurance:
• Occupational contract providing 24/7 coverage
• Uses a flat amount approach for benefits
• Typically limits coverage to 60% of gross income or 80% of net income
• Features a probationary period at policy inception
• Offers non-cancelable or guaranteed renewable options
• Underwritten based on occupation and personal characteristics
Group Disability Insurance:
• Often non-occupational coverage
• Uses percentage-of-earnings approach
• Coordinates benefits with other sources
• No probationary period once coverage begins
• Requires minimum participation to avoid adverse selection
• Premiums based on the group's aggregate risk level
Short-Term vs. Long-Term Disability:
 • Short-term disability:
o Weekly benefit payments
o Minimal waiting periods
o Maximum benefit period of two years
o Often pays benefits for up to 180 days
• Long-term disability:
o Monthly benefit payments
o Longer elimination periods
o Benefit periods range from two years to age 65
o Addresses more serious injuries or illnesses
Learning Objective 6: Analyze the business applications of disability insurance for protecting
companies and owners
Business Overhead Expense (BOE) Insurance:
• Reimburses business expenses if the owner becomes disabled
• Does NOT cover the owner's lost compensation
• Covers rent, utilities, employee wages, and equipment leases
• Pays the actual expenses up to the maximum monthly amount
• Vital for small businesses where the owner generates significant income
Disability Buy-Out Policies:
• Fund disability buy-sell agreements
• Allow remaining owners to buy the disabled partner's share
• Available as cross-purchase or entity plans
• Often have lengthy elimination periods (up to two years)
• May offer lump-sum or periodic payment options
Key Person Disability Insurance:
• Indemnifies the business for the loss of services of an essential person
• Covers expenses for additional help or outside services
• Benefit based on the key person's economic value to the business
• Typically has a 30-90 day elimination period
• The benefit period is usually one to two years
Learning Objective 7: Explain how disability insurance benefits are taxed based on premium payment
sources
Taxation Principle:
• IRS generally taxes money only once (either premiums or benefits)
Individual Disability Insurance:
• Premiums are not tax-deductible (paid with after-tax dollars)
• Benefits not taxable (premiums already taxed)
Group Disability Insurance:
• Employer-paid premiums:
o Tax-deductible business expense for the employer
o Benefits are fully taxable to the employee
• Employee-paid premiums:
o Pre-tax contributions: Benefits are fully taxable
o After-tax contributions: Benefits are tax-free
• Shared premium payments:
o Portion paid by employer: Benefits taxable
o Portion paid by employee after-tax: Benefits are tax-free
Government Disability Benefits:
• SSDI: Partially taxable if income exceeds threshold
 • Workers' compensation: Generally, not taxable
Exam Tips:
• Know the differences between disability definitions
• Understand the elimination period vs. the probationary period
• Remember that individual policies are occupational, while group policies are often non -occupational
• Know that disability benefits can never exceed pre-disability income
• Understand the taxation principle: money is taxed only once
• Remember the key differences between business disability products
Chapter 17
[1] HEALTH INSURANCE PLANS FOR SENIORS INTRODUCTION
Navigating health care options for seniors can feel like trying to solve a complex puzzle. As Americans live
longer, understanding the health care landscape after age 65 becomes increasingly important —not just for
seniors, but for the family members and insurance professionals who help them make these critical
decisions.
Imagine this scenario: Maria just turned 65 and received her Medicare card in the mail. She is overwhelmed
by the choices she needs to make. Should she stick with Original Medicare or choose a Medicare Advantage
plan? Does she need a Medicare Supplement policy? What about prescription drug coverage? And looking
further ahead, should she consider long-term care insurance to protect her savings if she eventually needs
nursing home care?
These questions represent the reality faced by approximately 10,000 Americans who turn 65 each day. The
decisions they make about their health care coverage will significantly impact both their physical and
financial well-being for years to come.
In this chapter, we will unravel the complexities of senior health insurance plans. We will explore the
structure of Medicare—from hospital coverage under Part A to prescription benefits under Part D. We will
examine the differences between Original Medicare and Medicare Advantage plans, and how Medicare
Supplement policies help fill coverage gaps. Finally, we will look at long-term care insurance as a critical
component of comprehensive senior health care planning.
Whether you're preparing to advise clients on their options or planning for your own future health care needs,
understanding these programs is essential for making informed decisions in an increasingly complex health
care environment.
[1.1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
• Explain the four parts of Medicare (A, B, C, and D) and identify the services covered under each part
• Distinguish between Original Medicare and Medicare Advantage plans, including their cost structures,
provider networks, and coverage limitations
• Identify Medicare eligibility requirements for both seniors and qualifying individuals under age 65
• Describe the various Medicare enrollment periods and explain the consequences of delayed
enrollment
• Explain how Medicare claims are processed and the rights of beneficiaries to appeal claim decisions
• Compare the standardized Medicare Supplement (Medigap) plans and identify their core and
additional benefits
• Identify the three levels of long-term care and describe the various settings where care is delivered
• Explain the benefit triggers and qualification requirements for long-term care insurance
• Describe the tax considerations for qualified and non-qualified long-term care insurance policies
• Explain how Medicare, Medicaid, and long-term care insurance work together to address seniors'
health care needs
[1.3] KEYWORDS
Before reading this chapter, please review the following keywords. An understanding of these basic
definitions will improve your comprehension of the chapter content.
Accelerated Death Benefit Rider: Pays out a portion of the life insurance policy’s death benefit upon the
diagnosis of a terminal illness or other condition.
Accepting Assignment: A health provider who accepts the Medicare-approved amount for services as “full
payment” and does not bill any other amounts to the insured.
Activities of Daily Living (ADLs): Activities (bathing, dressing, toileting, transferring, continence, and eating)
that people perform every day, which have been defined as essential to living independently.
Adult Day Care: Care (typically custodial) that is designed for individuals who require assistance with various
activities of daily living while their primary caregivers are absent. This type of care is offered in care centers.
Assisted Living Facility: A residential community that provides some services but is more limited than a
nursing home. This type of facility provides services such as housekeeping, meals, social activities, and
intermittent nursing care.
Automatic Inflation Rider (AIR):A long-term care insurance rider that annually increases the face amount of a
policy, generally at 5% per year for a specified number of years. The cost of these increases is built into the
initial premium.
Benefit Trigger: A loss that triggers a covered long-term care claim, either due to the loss of one’s ability to
perform two or more of the activities of daily living or a cognitive impairment.
Buyer’s Guide for Medigap Insurance: Explains the different Medicare Supplement plans and is titled
“Choosing a Medigap Policy: A Guide to Health Insurance for People with Medicare.” The Centers for
Medicare & Medicaid Services (CMS) and the National Association of Insurance Commissioners (NAIC)
jointly developed this annually updated publication.
Center for Medicare and Medicaid Services (CMS): Federal agency that administers and regulates the
Medicare and Medicaid insurance programs.
Cognitive Impairment: A deficiency in a person’s memory, orientation to the environment, or ability to reason
and make safe judgments. Long-term care insurance policies cover only cognitive impairments resulting from
organic diseases of aging.
Cold Lead Advertising: An illegal practice of using marketing that does not disclose that a sales agent may
call when a person responds to a marketing campaign.
Continuing Care: Care designed to provide benefits to elderly individuals who live in a continuing care
retirement community. Continuing care communities offer a range of living arrangements for residents, from
independent living to nursing home care.
Core Benefits: Benefits that are defined in law and regulation that all Medicare supplement plans must offer
to meet the definition of a Medicare Supplement plan.
Custodial Care: A level of care that is given to meet daily personal needs, such as dressing, bathing, getting
out of bed, and eating; however, it is not medical care. Although medical training is not required, this care
must be administered under a physician’s order.
Duplication of Coverage: It is illegal to sell a second Medigap policy to a person who already has one (other
than a replacement).
End-Stage Renal Disease (ESRD): The progressive deterioration of a person’s kidneys when dialysis or a
kidney transplant is necessary to sustain life.
Formal Care: Paid care that is delivered by professional caregivers.
Formulary: List of medications that are covered by a specific prescription drug plan, along with each
medication’s designated category (generic, prescription, specialty, etc.).
Hands-on Assistance (Help): Physical assistance with one of the activities of daily living or related tasks.
High-Pressure Tactics: Actions that use an explicit or implicit threat, excessive pressure, or a climate of fear
to affect the sale of a policy.
Home Care: Assistance with the activities of daily living and necessary household tasks. Home care may
include both hands-on help and stand-by assistance. Both forms of support are defined as substantial
assistance under the terms of a long-term care insurance policy.
Home Health Care: Care that may include both skilled and unskilled care that is provided in an individual’s
home, typically on a part-time basis. It primarily refers to skilled services provided by health care
professionals such as medication management, wound care, and physical therapy—particularly when
described in contrast to unskilled “home care,” which is personal care in the home.
Hospice Care: Comfort care for the dying. It may be delivered in a facility or at the patient’s home. Individuals
suffering from terminal illnesses forgo medical interventions to treat their terminal disease and instead opt
for care that makes their final months as comfortable as possible.
Hybrid (Asset-based) Long-Term Care Plans: Contracts that use an annuity or whole life policy to guarantee
long-term care benefits. Policy owners who do not need long-term care benefit from the annuity income or
the life insurance benefits.
Informal Care: Personal care a person may receive from unpaid caregivers, such as family members, at
home. As a rule, long-term care policies do not pay for informal care. However, many policies do provide a
training allowance to help family members deliver effective care.
Intermediate (Intermittent) Care: One of the defined nursing care levels that is used in long -term care
insurance. At times, it is referred to as “intermittent care” because intermediate care is often intermittent. It
involves the delivery of limited daily, intermittent (or occasional) nursing and rehabilitative services by skilled
providers based on a physician’s orders.
Lifetime Reserve Days: A hospital benefit that applies when the insured has used up all of their allotted
hospital care days in a standard benefit period under the terms of Original Medicare Part A. Lifetime reserve
days are used once during a person’s lifetime. They are NOT restored with the beginning of a new benefit
period.
Long-Term Care (LTC): A broad range of medical, personal, and environmental services that assist
individuals who have lost their ability to remain completely independent in the community.
Long-Term Care Insurance: An insurance contract that pays for the cost of medical and personal services
that are defined as long-term care for individuals who need assistance with the activities of daily living for an
extended period.
Long-Term Care Partnership Program: A federally supported, state-operated initiative that allows individuals
who purchase qualified long-term care insurance policies to protect a portion of the assets they would
otherwise need to spend on care to qualify for Medicaid.
Medicare: A federally sponsored and administered program that provides hospital and medical expense
insurance, primarily for those who are age 65 and older, as well as some younger individuals receiving Social
Security disability benefits and others suffering from certain named debilitating conditions.
Medicare Part A: This portion of Original Medicare provides coverage of hospital and nursing home care
services for eligible individuals. It also provides home health care and hospice services.
Medicare Part B: This portion of Original Medicare provides coverage for the cost of physicians and other
outpatient medical services for eligible individuals, including durable medical equipment.
Medicare Part C: Medicare Advantage plans are “all-in-one” private insurance policies subsidized by the
federal government as an alternative to Original Medicare. These plans may also provide coverage that
Original Medicare does not, such as prescription drug (Part D) coverage.
Medicare Part D: Prescription Drug Plan (PDP): A program that offers a prescription drug benefit to help
Medicare beneficiaries pay for outpatient prescription medication.
Medicare Select: Select plans are discounted versions of standard Medicare supplement (Medigap) plans
that require policyholders to receive services from a defined network of providers in order to be eligible for
full benefits.
Medicare Supplement (Medigap) Plans: Private health insurance policies for individuals with Original
Medicare coverage. These policies, offered with one of a limited number of approved formats, fill various
gaps in Medicare coverage.
Nonforfeiture (Benefit) Options: Some long-term care insurance policies include a nonforfeiture option.
These benefits will allow an insured to receive some value from his past premium payments if the policy
ultimately lapses.
Nonparticipating Providers: Providers who refuse to accept the established Medicare rates for services and
bill individual Medicare recipients rather than accepting assignment (direct payment) from Medicare. They
may charge up to 15% more than the fee schedule for participating providers.
Original Medicare: Consists of the fee-for-service hospital and medical insurance program that is
administered by the federal government. It includes Medicare Part A (hospital insurance) and Medicare Part
B (medical insurance).
Participating Providers: Medical professionals or organizations authorized to bill Medicare for services,
receive payment directly from Medicare, and accept its scheduled fees-for-services.
Plan A: The most basic of the available Medicare supplement plans that are offered through private insurers.
Plan A contains only the core benefits.
Pool of Money: A concept that describes how some long-term care insurance policies define their aggregate
benefit limit as a sum of money that will last for a defined benefit period if utilized fully every day. The money
lasts longer if the daily cost of care is less than the specified daily amount, or if care is not required every day.
Post-Claims Underwriting: This illegal underwriting process occurs when an insurer approves all applicants
and only underwrites a risk when an insured files a claim. It allows insurers to deny claims based on
information that should have been evaluated before an application was approved and premiums paid.
Respite Care: Health or medical care that is designed to provide a short rest period for a caregiver. It is
characterized by its temporary status.
Shopper’s Guide for Long-Term Care Insurance (LTC): The NAIC publishes “A Shopper’s Guide to Long-Term
Care Insurance,” which explains what LTC is, what it does, and various LTC contract features. It helps
consumers determine whether the costs and benefits make LTC a suitable choice.
Skilled Nursing Care: Daily nursing care that is ordered by a doctor and is medically necessary. It can only be
performed by, or under the supervision of, skilled medical professionals and is available 24 hours a day.
Residential facilities that provide skilled nursing care are called skilled nursing facilities or nursing homes.
Stand-By Assistance: Readily available assistance that can be given if needed to safely complete one or
more of the activities of daily living. Caretakers are physically present and within one arm’s length of their
clients during the activity in question.
Substantial Assistance: Service which indicates that the individual receiving the aid can no longer safely carry
out the task in question independently. Substantial assistance can either be hands-on assistance or stand-by
assistance.
Tax-Qualified Long-Term Care Insurance Contract: An individual policy or group plan that satisfies specific
criteria as defined by the Health Insurance Portability and Accountability Act (HIPAA).
[2] MEDICARE OVERVIEW
Medicare is a federal health insurance program founded in 1965. The federal government administers
Medicare through the Centers for Medicare and Medicaid Services (CMS). Medicare provides hospital and
medical expense insurance to individuals age 65 and older, known as beneficiaries. It can also cover younger
individuals with certain disabilities.
The Medicare federal health insurance program is comprised of four available parts: Part A, Part B, Part C,
and Part D. Each part of Medicare addresses a different aspect of health care, either by covering specific
types of services or offering alternative delivery methods:
• Medicare Part A provides hospital insurance. It also pays for some other types of institutional care.
• Medicare Part B provides supplementary medical insurance for physician visits, preventative care,
and other outpatient care.
• Medicare Part C, commonly known as Medicare Advantage, offers a government-funded, managed
care alternative to Original Medicare. If elected, Part C delivers expanded coverage through privately
owned health maintenance organizations (HMOs) and preferred provider organizations (PPOs).
 • Medicare Part D authorized private plans to cover prescription drugs. Seniors purchase Part D plans
as add-ons to Original Medicare and Medicare Advantage plans that lack prescription drug benefits.
[2.1] ORIGINAL MEDICARE VERSUS MEDICARE ADVANTAGE
There are two ways to access Medicare: Original Medicare and Medicare Advantage. Original Medicare is
administered by the federal government. It includes Medicare Part A (hospital insurance) and Medicare Part
B (medical insurance). Original Medicare provides benefits on a fee-for-service basis, which requires
payment for services when benefits are received.
Original Medicare utilizes various cost-sharing mechanisms.
Medicare Part A assesses a deductible for every new hospital benefit period. After satisfying the deductible,
insureds are responsible for a daily coinsurance amount after the first 60 days of continuous confinement.
Medicare Part B beneficiaries pay an annual deductible at the beginning of each year before coverage
commences. After meeting the deductible, beneficiaries pay coinsurance equal to 20% of all Medicare -
approved costs for physicians and other provider services. Prescription drug coverage can be obtained
separately through a Part D plan.
Although Original Medicare covers a significant portion of health care expenses, it does not cover all costs.
As a result, individuals who select Original Medicare often purchase a Medicare supplement (Medigap) policy
to assist with remaining out-of-pocket expenses such as copayments, coinsurance, and deductibles.
Medicare Advantage serves as a comprehensive alternative to Original Medicare. These bundled plans
incorporate both Part A and Part B benefits and frequently address coverage gaps that lead many seniors to
supplement their Original Medicare with Medigap policies. Structurally and operationally, these plans
commonly resemble traditional HMOs and PPOs.
The final component of Medicare is Medicare Part D, which provides prescription drug coverage. Part D
benefits can be acquired as stand-alone plans or included within a Medicare Advantage policy.
[2.1.1] COMPARISON OF ORIGINAL MEDICARE AND MEDICARE ADVANTAGE
Feature Original Medicare (Part A & B) Medicare Part C (Medicare Advantage)
Administration Federal government Private insurance companies approved by Medicare
Cost Structure Fee-for-service Insurer paid per patient
Deductibles and coinsurance with Regulations set an annual limit on out-of-pocket
Cost Sharing NO annual maximum out-of-pocket costs. Costs vary by insurer. Copays are common.
limit Deductibles and coinsurance may also be employed.
Virtually all plans rely on provider networks (e.g.,
No network restrictions: beneficiaries
HMO or PPO). Care may be restricted to network
Provider Choice can see any provider that accepts
providers except in emergencies (HMOs) or more
Medicare
expensive (PPOs)
Referrals and
Referrals and prior authorizations are required with
Prior No referrals required for specialists
HMOs
Authorization
Coverage Area Coverage is national Network coverage areas are limited
Prescription Not included. Beneficiaries must buy
Usually included
Drug Coverage separate Part D plans.
Plans often include extra benefits such as vision,
Extra Benefits None
dental, and hearing.
Medicare
Needed to meet the unlimited gaps in Not available for purchase. Medigap plans are only
Supplements
Original Medicare for beneficiaries choosing Original Medicare.
(Medigap)
 Full coverage anywhere in the U.S. Usually limited to emergency coverage outside the
Travel Coverage (some Medigap plans also cover plan’s service area; routine care is not covered
foreign travel emergencies) outside of one’s network.
[2.2] MEDICARE ELIGIBILITY
[2.2.1] ELIGIBILITY FOR PERSONS AGED 65 AND OLDER
Individuals 65 years of age and older who are entitled to Social Security benefits also automatically qualify
for Medicare Part A and Part B. Some individuals under the age of 65 are also eligible if they suffer from
specific disabilities or have end-stage renal disease (ESRD), which involves kidney failure and dialysis.
Medicare is considered health insurance for seniors because most individuals become eligible to enroll in
Medicare at age 65. This group accounts for the majority of Medicare enrollees.
Individuals qualify for full Medicare benefits at the age of 65 or older if:
• They are U.S. citizens or continuous, permanent, legal residents of the United States for at least five
years; and
• They or their spouse have worked long enough to be eligible for Social Security or railroad retirement
benefits by earning 40 credits (10 years of work, contiguous or not); or
• They have paid Medicare taxes for at least 10 years or have a spouse who has done so.
Those 65 and older who do not qualify for Social Security retirement benefits may still apply for Medicare and
pay the unsubsidized premium.
[2.2.2] ELIGIBILITY FOR PERSONS YOUNGER THAN AGE 65
Any disabled person who has received Social Security Disability Insurance (SSDI) benefits or Railroad
Retirement Board (RRB) benefits for at least 24 months (following their five-month waiting period) and still
cannot work may become eligible for Medicare before reaching the age of 65.
The program also makes two exceptions to the 24-month rule, which allows benefits to begin sooner.
Persons with amyotrophic lateral sclerosis immediately have access to Medicare without a 24 -month
waiting period. Medicare benefits are immediately available for any person who qualifies for Social Security
disability insurance (SSDI) benefits due to having amyotrophic lateral sclerosis (ALS), also referred to as Lou
Gehrig’s disease.
Persons with end-stage renal disease: Anyone with end-stage renal disease (ESRD) or kidney failure can
receive coverage after receiving a kidney transplant or having been on dialysis for three months.
If a beneficiary also has group insurance coverage through their employer or that of a spouse, the group
insurance plan is the primary coverage for the first 30 months, and Medicare is secondary.
[2.3] ENROLLMENT IN MEDICARE
Enrollment in Medicare Parts A and B is the first step to being covered by Medicare. Individuals who already
receive Social Security benefits are automatically enrolled in Part A and offered the option to enroll in Part B
at age 65. Anyone still working and not receiving Social Security must enroll on their own. Individuals can
enroll in Part A and Part B through the Social Security Administration, in person or online.
Once individuals have enrolled in Original Medicare, they may enroll in a Part D prescription drug plan or opt
out of Original Medicare and choose a Medicare Advantage plan (Part C) instead.
Individuals may enroll in Medicare Part A at any time after they become eligible and should still enroll in Part
A even if they do not plan to retire at age 65. Upon retirement, individuals should enroll in Medicare Part B to
ensure coverage and avoid penalties, regardless of whether they plan to choose a Medicare Advantage plan.
There are three periods during which eligible individuals may enroll in Medicare Part B:
• The initial enrollment period,
• The general enrollment period, and
• A special enrollment period.
There are also two periods during which an individual may change coverage: the annual open enrollment
period and a special annual period for transfers between Medicare Advantage plans.
[2.3.1] MEDICARE ENROLLMENT AND GROUP INSURANCE
Some eligible beneficiaries may delay their Medicare Part B enrollment because they have coverage through
their employers’ group major medical plan.
The Age Discrimination in Employment Act (ADEA) prohibits employers from denying benefits to older
employees. It also requires insurers to provide the same major medical benefits to all workers in eligible
classes regardless of age.
In limited circumstances, it permits employers to reduce certain benefits based on age because the high age -
related cost of providing some benefits may be a disincentive to hiring seniors. In such cases, an employer
may reduce benefits as long as the employer’s cost to provide them remains consistent with the cost of
providing those types of benefits to younger workers.
Employers cannot offer Medicare-eligible workers an incentive to drop group coverage. In fact, employees
age 65 and older may find it advantageous to delay acceptance of Medicare Part B.
Delaying acceptance is allowed if:
• Eligible individuals are still employed at age 65 or older and covered by group health insurance
through work, assuming their employer is a qualified COBRA group with 20 employees or more
In such cases:
• Employees can delay enrollment in Part B and the monthly cost of the premium because their group
insurance would be their primary insurer, and Medicare would be secondary
• Employees will be eligible for a special enrollment period when they retire.
EXAM TIP!
If the exam refers to “group insurance,” especially as it relates to this topic, assume that the exam means a
“COBRA group” of 20 or more employees.
[2.3.2] MEDICARE ENROLLMENT AND INDIVIDUAL AND RETIREE INSURANCE
When an individual who is eligible to enroll in Medicare has an individual health insurance policy, the
individual should immediately enroll in Medicare Part B, along with Part A. Medicare is the primary insurer in
such cases, and any other individual or retiree plan is secondary. The same holds true for non-COBRA
groups, which have fewer than 20 employees
[2.3.3] INITIAL ENROLLMENT PERIOD
The initial enrollment period for Medicare Part B lasts for seven months.
It begins with the three months preceding a person’s birth month and ends after the three months following
the person’s birth month.
For example, if an individual’s birth month is October, that person’s initial enrollment period will begin on July
1 of the year they turn 65 and will end on the last day of the following January.
Enrollments are effective on the first day of one’s birth month or the first day of the month following the
month one enrolls, whichever is later. This same initial enrollment period applies to individuals who want to
enroll in a Medicare Advantage (Part C) plan immediately upon becoming eligible.

[2.3.4] GENERAL ENROLLMENT PERIOD

Anyone who fails to enroll in Medicare Part B during their initial enrollment period may use the general
enrollment period, which runs from January 1st through March 31st of each year. Coverage begins on the first
day of the following month.
Late enrollment in Part B may result in a penalty. The penalty is 10% for each 12-month period during which
the person could have been covered but chose not to be. Once enrolled in Part B, late enrollees can choose
to switch to a Medicare Advantage plan from April 1st through June 30th. This is a one-time only opportunity.
[2.4.5] SPECIAL GENERAL ENROLLMENT PERIOD
With the increase in Social Security’s full retirement age (FRA) to 67, more Americans are working past age
65. Medicare does not penalize seniors covered by COBRA-regulated group plans (employer-sponsored
groups of 20 or more employees) who delay enrolling in Medicare Part B until they retire. Medicare is
secondary (excess) coverage after COBRA-regulated groups; so, in such cases, the employer-sponsored
group is one’s primary insurer.
This exception to the standard initial enrollment exception only applies to those covered by COBRA -
regulated groups. For everyone else, Medicare is primary at age 65.
Qualified individuals can notify Social Security and request a “delayed enrollment” in Part B of Medicare. This
delay is only available to individuals who are actively employed and covered under their own or their
spouse’s employer group medical plan. This is referred to as “active” employment.
This option allows an individual to enroll in Medicare Part B:
• Any time while one is covered under the Group Health plan based on current employment, or
• Any time during an eight-month period following the month one’s group coverage ends or the
termination of one’s employment, whichever occurs first. This eight-month period is referred to as the
“special enrollment period.”
When an individual enrolls prior to or during the first month of retirement, coverage begins on the first day of
the month the insured enrolled. If enrollment occurs during the remaining seven months, coverage begins on
the first day of the month following enrollment.
Individuals who delay enrollment in Medicare Part B until their special enrollment period are not penalized.
However, if one fails to enroll by the end of the eight-month special enrollment period, one will have to wait
until the next general enrollment period and pay a higher (penalty) premium.
[2.4] MEDICARE PREMIUMS A THROUGH D
Each part of the Medicare program has its own premium structure. It depends on one’s eligibility for Social
Security, one’s timely enrollment in certain parts, and one’s income. It is also affected by one’s program
choices as they relate to Parts C and D.
In this section, we primarily address the premium costs faced by most American seniors.
[2.4.1] MEDICARE PART A PREMIUM
Most individuals pay no monthly premium for Medicare Part A because they have earned permanent status
as “fully insured” according to Social Security. Workers who pay sufficient Federal Insurance Contributions
Act (FICA) taxes for 10 years (40 calendar quarters) are defined as having earned this status and thus pay no
premium.
Anyone who does not meet this requirement may still acquire Medicare Part A coverage by paying a premium.
Anyone required to pay for Part A who fails to purchase it when they first become eligible must pay a
premium penalty each month based on the length of their delay.
[2.4.2] MEDICARE PART B PREMIUM
All individuals who select Medicare Part B pay a monthly premium, which is deducted directly from their
Social Security check. For those individuals who do not receive Social Security, benefits are billed monthly.
Most participants pay the standard monthly premium, which changes annually.
Delaying enrollment in Medicare Part B outside of a special enrollment period will result in a 10% lifetime
premium penalty for each 12-month period that enrollment is delayed.
[2.4.3] MEDICARE PART C – MEDICARE ADVANTAGE PLANS
Beneficiaries who opt for Medicare Advantage plans still pay their Medicare Part B premiums because those
premiums also help fund the Medicare Advantage program. Some Advantage plans accept the funding they
receive through Medicare as full payment for any premiums due. Others bill additional amounts to the plan
beneficiaries.
The premium structure varies by company and may be influenced by the nature of the provider network, any
ancillary services provided, and the degree to which beneficiaries share the cost of medical services as they
are provided.
[2.4.4] MEDICARE PART D – PRESCRIPTION DRUG PLANS
Most people choosing Medicare Advantage plans also receive coverage for outpatient prescription
medications. Individuals who choose Original Medicare purchase stand-alone plans. Premiums are unique to
each plan. Factors that influence premium costs include deductibles, copays, the plan’s formulary (list of
covered medications), and the plan's relationship with relevant pharmacy networks.
Beneficiaries choosing Medicare Advantage plans can choose a plan that offers Part D coverage for an extra
premium.
[2.5] MEDICARE CLAIMS
This section focuses on claims filed with Original Medicare. Unlike claims filed with private Medicare
Advantage plans, Original Medicare claims are processed by Medicare Administrative Contractors (MACs) on
a fee-for-service basis. MACs are private health care insurers contracted with the government to serve an
identified multistate region. Individual MACs may process Medicare Part A and Part B medical claims, or
durable medical equipment (DME).
Under the terms of Original Medicare, any cost-sharing amounts for covered medical services are the
patient’s responsibility, unless covered by the insured’s Medicare supplement policy. Cost -sharing under
Medicare Part C (Medicare Advantage) is defined under the terms of the insured’s Medicare Advantage plan.
[2.5.1] PARTICIPATING PROVIDERS AND MEDICARE ASSIGNMENT
[[Link]] PARTICIPATING PROVIDERS
Participating providers are those that accept payment directly from Medicare (“accepting assignment”). In
doing so, they agree to accept the approved Medicare fee as full payment for their services. A participating
provider cannot bill the patient for the balance between Medicare’s reimbursement and the doctor’s usual
charge. This is called balance billing and is strictly prohibited.
[[Link]] NONPARTICIPATING PROVIDERS
Providers that opt out of accepting assignment (nonparticipating or non-assignment providers) must collect
their fees directly from the insured but may charge up to 15% more. The insured is responsible for any
amount over the Medicare-approved amount. In such circumstances, the insured will also need to file a
claim with Medicare to get reimbursed for the cost of care.
[2.5.2] MEDICARE SUMMARY NOTICE
Individuals who receive Medicare-covered services also receive a Medicare Summary Notice (MSN) by mail
every three months. This notice lists all services or supplies that providers and suppliers have billed to
Medicare during the three-month period. It will also show what Medicare paid and what an insured may owe
a provider. This notice acts as a summary of the benefits provided; however, it is not a bill.
[2.5.3] HOW TO FILE AN APPEAL
The patient also has the right to appeal the decision and request a review of any denied claim. There are three
ways for a patient to file an appeal by doing one of the following:
• Fill out a “Redetermination Request Form” and send it to the MAC listed on the MSN within 120 days
of receiving the MSN.
• Use the MSN itself by following the instructions located in the “Appeals Information” section of the
form:
o Explain the reason for the appeal,
o Circle the required personal information, and
o List the disputed service charges.
 • Send a written request to the Medicare contractor at the address listed on the MSN and include:
o The specific dates, item(s) and/or service(s) for which a redetermination is requested,
o One’s name and Medicare number, as well as an explanation for the disagreement, and
o Whether a representative has been appointed, and, if so, their name.
3] MEDICARE PARTS A THROUGH D
[3.1] MEDICARE PART A
Part A (hospital insurance), along with Part B (medical insurance), is the Original Medicare program managed
by CMS and administered through the MACs.
Medicare Part A, which is also called hospital insurance, provides inpatient hospital care, skilled nursing
care, home health care, and hospice care. While Part A is a pre-paid benefit to those designated as qualified
beneficiaries, it is still subject to deductibles, copayments, and benefit period limits.
Any person who is age 65 and older and is eligible for Social Security benefits is covered under Part A with no
monthly cost. The primary source of financing for Part A is federal (FICA) payroll and self -employment taxes.
Unlike many other medical expense policies, Part A assigns a new benefit period per claim rather than per
year.
[3.1.1] MEDICARE PART A: INPATIENT HOSPITAL CARE
Inpatient hospital benefits under Medicare cover the cost of a semi-private room, meals, nursing services,
drugs, tests, the operating room, and other medical services and supplies. Inpatient coverage does not
include physician or surgeon charges.
[[Link]] MEDICARE PART A: BASIC INPATIENT BENEFITS
Each benefit period, Medicare covers up to 90 days of inpatient hospital care, which may be consecutive or
sporadic, with less than 60 days between each admission. These benefits are restored at the beginning of
each benefit period.
For example, if John is in the hospital for 20 days over the course of a two-month total before fully recovering,
he has 70 days left in the current benefit period. If he remains healthy for six months but then returns to the
hospital, he begins a new 90-day benefit period.
[[Link]] MEDICARE PART A: RESERVE INPATIENT BENEFITS
As a backstop to the regular hospital benefits, Part A provides an additional 60 lifetime reserve days. Reserve
days are not restored at the start of each new benefit period. Once they are used, they are gone.
For example, if Jane fully recovers after 92 days in the hospital, she has 90 days of basic hospital care
available the next time she is ill; however, she will only have 58 reserve days left.
[[Link]] THE HOSPITAL BENEFIT PERIOD
Each new benefit period begins on the date a person is admitted to a hospital and ends 60 days after
discharge.
If an insured re-enters the hospital less than 60 days after being released, Medicare considers it as a
continuation of the same benefit period.
If an insured is readmitted to a hospital, but the readmission occurs more than 60 days after the person’s
release, then a new Medicare Part A benefit period begins.
[3.1.2] SKILLED NURSING CARE BENEFITS
Medicare’s skilled nursing care coverage is a short-term recovery benefit in a skilled nursing facility
(SNF). It allows hospitals to move patients when acute care is no longer required, but nursing and
rehabilitation care are still necessary. Beneficiaries qualify for this Medicare benefit immediately following a
hospital confinement of at least three inpatient days. The condition requiring skilled nursing care must be
the same condition that required one’s admission to the hospital.
Skilled care is defined as nursing care and therapeutic services that can only be safely and effectively
delivered by licensed professionals, technicians, or done under their supervision. The benefit period is
subject to the following conditions:
• Medicare covers up to 100 days in a skilled nursing facility.
 • The first 20 days are paid in full. Days 21-100 require a daily co-pay from the beneficiary. The co-pay
changes each year.
• Coverage can end sooner if the patient’s maximum level of recovery has been achieved.
• Medicare does not cover custodial care, which focuses on nonmedical support to help individuals
perform the basic activities of daily living.
[3.1.3 OTHER PART A BENEFITS
[[Link]] INPATIENT PSYCHIATRIC CARE
Medicare Part A covers inpatient care at a psychiatric facility. The program has a lifetime maximum limit of
190 days.
[[Link]] HOME HEALTH CARE BENEFITS
Medicare Part A covers home health care costs, including nursing and physical therapy. By providing physical
or occupational therapy at the patient’s home, providers can reduce costs while improving access to
services.
[[Link]] HOSPICE CARE
Hospice care is comfort care that may be delivered in a facility or at the patient’s home.
Medicare offers hospice benefits to individuals who are diagnosed as terminal with a life expectancy of six
months or less. Medicare initially provides two 90-day benefit periods. A person may receive additional care
in 60-day increments if appropriate medical professionals continue to certify the patient as terminal.
Hospice care also includes family counseling.
[3.1.4] PART A COST SHARING: INPATIENT HOSPITAL COSTS
[[Link]] INPATIENT HOSPITAL COSTS
All beneficiaries must pay the Part A deductible with the first hospital admission during each benefit period.
Once the deductible is paid, there is no copayment for the first 60 days of the insured’s basic inpatient
benefit for that benefit period.
For each of the remaining 30 days of the basic inpatient benefit, Medicare applies a daily copayment, which
Medicare describes as a daily coinsurance amount. If the insured uses any of their lifetime reserve days, they
are also subject to a daily coinsurance amount equal to twice the basic amount.
If one’s lifetime reserve days were to be exhausted in a single benefit period, the insured would be
responsible for any additional expense with no maximum out-of-pocket limit.
Each year, the CMS adjusts the benefits and cost-sharing percentages for Medicare Part A. The various cost-
sharing percentages are based on the Part A hospital deductible.
• The daily coinsurance during the last 30 days of basic coverage per benefit period equals 25% of the
deductible per day.
• The daily coinsurance for using reserve days equals 50% of the Part A deductible.
[[Link]] SKILLED NURSING CARE
Medicare fully covers the first 20 days of care in an SNF. There is no deductible. After 20 days, the insured is
responsible for a daily coinsurance amount that is half the basic hospital rate or 12.5% of the Part A
deductible.
[[Link]] BLOOD
Unless blood is replaced through donation, beneficiaries pay the costs for the first three pints of blood
received as an inpatient.
EXAM TIP!
When answering questions about blood coverage, ALWAYS assume the insured pays for the first three pints
of blood unless blood donations are explicitly stated in the question.
[[Link]] HOSPICE CARE
Beneficiaries pay $5 for outpatient prescription drugs and 5% of the Medicare-approved amount for inpatient
respite care (short-term care given by another caregiver so that the usual caregiver can rest).
[3.1.6] PART A EXCLUSIONS
Medicare Part A does NOT cover:
 • The services of a private duty nurse or attendant in private rooms
• The first three pints of blood
• Personal conveniences (e.g., telephones or television rentals)
• The cost of surgeons and anesthesiologists who are not hospital employees
• Services authorized or paid for by a government entity
• Coverage for hospital stays after the benefit period and lifetime maximum are reached
[3.2] MEDICARE PART B: SUPPLEMENTAL MEDICAL INSURANCE
Medicare Part B is referred to as supplemental medical insurance. Although it is technically optional, Part B
covers essential health care services.
Medicare Part B covers physician services and other outpatient medical services, such as lab work,
diagnostic tests, medical supplies, DME, and many services not covered by Part A. It also covers the cost of
surgeons and anesthesiologists performing inpatient or outpatient surgery when they are not hospital
employees.
[3.2.1] MEDICARE PART B: COVERED SERVICES
Medicare Part B covers medically necessary physician’s services and exams that are performed anywhere in
the United States, including hospitals, clinics, or doctors’ offices. Medicare Part B covers 100% of certain
preventive services, including annual wellness visits, specific screenings (such as cardiac and diabetes
screenings), and vaccinations.
Other covered services include:
Blood
X-rays
Medically necessary outpatient health services and diagnostic tests
Medical supplies
Home health care services for individuals who participate in Part B but not in Part A
Various types of therapy, including occupational, physical, and speech therapy
Prosthetics and DME
Chiropractic services (manual adjustments only)
Please note that the list above is not exhaustive.
[3.2.2] MEDICARE PART B: EXCLUSIONS
Medicare Part B does NOT cover the following services/types of care:
• The services of a private duty nurse or attendant
• Intermediate or custodial care
• Vision and hearing care
• Dental care
• Outpatient prescription drugs
• Cosmetic surgery
• Routine physical examinations and foot care
• X-rays and tests ordered by chiropractors
• Acupuncture and massage
• Physician costs exceeding Medicare’s approved amount
• Services authorized or paid by a government entity
• Long-term care
• Unskilled nursing home care
[3.2.3] MEDICARE PART B: PREMIUMS AND COST-SHARING
Unlike Medicare Part A, all Part B enrollees pay a monthly premium that changes annually. In 2025, the
premium is $185; in 2026, it is projected to increase by 11% to $206.50.
Medicare Part B requires all beneficiaries to pay an annual deductible, which changes each year. In 2025, the
deductible is $257, projected to increase by $31 to $288 in 2026.
EXAM TIP!
It is more important to know whether there is a monthly premium and what the annual deductible is, rather
than the exact dollar amounts. Historically, state insurance exams are unlikely to test numbers that change
each year and require ongoing updates to their question banks.
After the insured meets the annual deductible, Medicare Part B will pay 80% of the covered charges, and the
insured will pay 20% coinsurance. There’s no annual out-of-pocket maximum for Part B claims.
In addition, Medicare Part B (like Part A) imposes a deductible for blood transfusion coverage. Unless the
blood is replaced through donation, beneficiaries pay all costs for the first three pints of blood received as an
outpatient. Medicare Part B covers additional amounts on the same basis as other services, which means the
insured pays 20% of the approved amount as coinsurance.
EXAM TIP!
When answering questions about blood coverage, ALWAYS assume the insured pays for the first three pints
of blood unless blood donations are explicitly stated in the question.
[3.3] MEDICARE PART C: MEDICARE ADVANTAGE (FORMERLY MEDICARE + CHOICE)
Medicare Part C, the Medicare Advantage, was created from the Medicare Prescription Drug, Improvement,
and Modernization Act of 2003 (MMA). This act improved the choice of plans for beneficiaries and further
expanded the use of managed care.
Medicare Advantage (MA) plans are offered by private companies that are approved by Medicare. The
government agrees to pay private companies a fixed amount per individual who chooses an Advantage plan,
typically 95% of the government’s average cost of insuring an individual. In turn, the private insurer provides a
major medical plan that replaces Original Medicare (Part A and B) and relieves the insured from the need to
purchase a Medicare Supplement policy.
[3.3.1] QUALIFYING FOR MEDICARE PART C
To be eligible for benefits under Medicare Advantage (Part C), individuals must be enrolled in Parts A and B.
Part C enrollees must continue to pay the Part B premium and may also pay a premium to their chosen
private insurer. In addition, enrollees must live in the plan’s service area and not be suffering from end-stage
renal disease (i.e., kidney failure).
Individuals choosing MA plans avoid the costs associated with purchasing a Medicare supplement (Medigap)
policy. In fact, the relevant laws and regulations prohibit the sale of Medigap insurance to someone with a
Medicare Advantage plan and vice versa. Enrollments in a stand-alone prescription drug plan (Part D) also
automatically terminate when one enrolls in an MA plan.
An individual may only participate in one MA plan at any time. Individuals wishing to change their Medicare
coverage can do so during the annual Open Enrollment Period, which runs from October 15th through
December 7th each year. Beneficiaries may choose a different MA plan if they already have one. They may
also choose between Original Medicare and Medicare Advantage during this period. Coverage becomes
effective January 1st.
MA plan participants have a second opportunity to change their MA plans during the Medicare Advantage
Open Enrollment Period, which runs from January 1st to March 31st. This opportunity is limited to MA plans
only. Coverage begins on the first day of the month following the plan's receipt of the request.
If a group medical plan covers the individual at or after age 65, coordination of benefits between Part C and
the group plan may apply. Individuals under Part C may also pay for expenses through Health Savings
Accounts (HSAs).
[3.3.2] MEDICARE PART C PLAN TYPES
Medicare Advantage (MA) plans must cover all the services covered under Original Medicare, but may
structure that coverage differently. Therefore, MA plans may have different out-of-pocket costs for senior
health care. MA plans may include additional health care benefits not covered by Original Medicare, such as
dental care or vision and hearing. Some services are standard, and others may be optional or “value -added.”
[[Link]] HEALTH MAINTENANCE ORGANIZATIONS (HMOS)
MA health maintenance organizations follow the same general approach as other HMOs by providing
coverage through a defined network. Participants select a primary care physician who manages care and
approves in-network referrals to specialist services. Insureds pay fixed monthly fees and copays for in-
network services. HMOs restrict out-of-network care to emergency services only.
[[Link]] PREFERRED PROVIDER ORGANIZATIONS (PPOS)
MA preferred provider organizations follow the same general approach as other PPOs by providing coverage
through a defined network that discounts its fees. Insurance companies administer PPOs and typically offer
more freedom than HMOs because they do not generally require referrals for specialist services. They also
provide some coverage for out-of-network services.
[[Link] PRIVATE FEE-FOR-SERVICE (PFFS) PLANS
In a Private Fee-for-Service (PFFS) Plan, an individual may see any Medicare-approved doctor or hospital that
accepts Medicare payments. As with other MA plans, the insurer, rather than Medicare, determines the
amount it will pay and the costs the Medicare enrollee will incur for the services rendered. The plan could
include benefits not covered under Original Medicare.
[[Link]] MEDICARE ADVANTAGE SPECIAL NEEDS PLANS (SNP)
Medicare Advantage specialty plans provide more focused health care for people with specific disabling
(chronic) conditions, in addition to standard health care services. SNPs are specifically for individuals who
are insured under Medicare and Medicaid, live in a nursing home, or suffer from specific chronic conditions
(e.g., end-stage renal disease).
[3.3.2] MEDICARE PART C PLAN TYPES
Medicare Advantage (MA) plans must cover all the services covered under Original Medicare, but may
structure that coverage differently. Therefore, MA plans may have different out-of-pocket costs for senior
health care. MA plans may include additional health care benefits not covered by Original Medicare, such as
dental care or vision and hearing. Some services are standard, and others may be optional or “value -added.”
[[Link]] HEALTH MAINTENANCE ORGANIZATIONS (HMOS)
MA health maintenance organizations follow the same general approach as other HMOs by providing
coverage through a defined network. Participants select a primary care physician who manages care and
approves in-network referrals to specialist services. Insureds pay fixed monthly fees and copays for in-
network services. HMOs restrict out-of-network care to emergency services only.
[[Link]] PREFERRED PROVIDER ORGANIZATIONS (PPOS)
MA preferred provider organizations follow the same general approach as other PPOs by providing coverage
through a defined network that discounts its fees. Insurance companies administer PPOs and typically offer
more freedom than HMOs because they do not generally require referrals for specialist services. They also
provide some coverage for out-of-network services.
[[Link] PRIVATE FEE-FOR-SERVICE (PFFS) PLANS
In a Private Fee-for-Service (PFFS) Plan, an individual may see any Medicare-approved doctor or hospital that
accepts Medicare payments. As with other MA plans, the insurer, rather than Medicare, determines the
amount it will pay and the costs the Medicare enrollee will incur for the services rendered. The plan could
include benefits not covered under Original Medicare.
[[Link]] MEDICARE ADVANTAGE SPECIAL NEEDS PLANS (SNP)
Medicare Advantage specialty plans provide more focused health care for people with specific disabling
(chronic) conditions, in addition to standard health care services. SNPs are specifically for individuals who
are insured under Medicare and Medicaid, live in a nursing home, or suffer from specific chronic conditions
(e.g., end-stage renal disease).
[3.4] MEDICARE PART D: PRESCRIPTION DRUG PLANS
The Medicare Modernization Act of 2003 also created Medicare Part D — the Prescription Drug Plan
(PDP) — which covers the cost of outpatient prescription medications. Eligible individuals include those age
65 or older and eligible for Medicare benefits. Standalone Part PDPs require a beneficiary to be enrolled in
Medicare Part A, Part B, or both. Medicare Part C (Medicare Advantage) enrollees are ineligible since
Medicare Advantage plans include prescription drug coverage. Enrollment in Part D coverage automatically
terminates one’s Medicare Advantage plan.
Other eligible groups include the following:
• Anyone younger than 65 who is permanently disabled and has been receiving Social Security disability
benefits for at least two years,
• Anyone receiving kidney dialysis for permanent kidney failure or in need of a kidney transplant, or
• Anyone suffering from ALS.
[3.4.1] MEDICARE PART D: ENROLLMENT
Like Part B, enrollment in a Medicare Part D is voluntary. Even so, anyone who fails to enroll during their first
opportunity to do so, or who fails to maintain “creditable coverage” for prescription drugs after the age of 65,
may be subject to a lifetime 1% per month premium penalty for each month without such coverage.
The initial enrollment period is the same as that for Part B. It begins with the three months preceding a
person’s birth month and ends after the three months following a person’s birth month. In subsequent years,
an enrollee may change prescription drug plans or move to a Medicare Advantage plan during the annual
open enrollment period (October 15th through December 7th) or during a Special Enrollment Period if a
qualifying life event occurs.
Beneficiaries change coverage during the annual open enrollment period for a variety of reasons, such as the
termination of an available plan, new prescriptions not being covered by the existing plan’s formulary, or
premium increases. Eligible individuals may also be able to change or add prescription drug coverage at other
times when they are eligible for a Special Enrollment Period (SEP) in response to specific life event changes
including the following:
• Moving out of your plan’s service area
• Losing other creditable coverage
• Qualifying for the Extra Help program
• Joining a 5-Star plan in your area, or
• Your current plan stops serving your area or changes its formulary so that it no longer serves your
need
[3.4.2] THE PART D PDP FORMULARY
All Medicare Part D PDPs have a formulary listing all covered prescription medications, sorted into categories
such as generic or brand-name, preferred or not, and multiple pricing tiers. Each plan must cover at least two
different drugs in each class of medications, defined based on use and chemical formula. Plans generally
cover more than two, but they can choose which ones to cover. There are also six classes of medications
that are deemed "protected classes." Part D plans must cover all medications in the six protected classes.
Each plan's formulary can change over time as new drugs are developed and FDA guidelines evolve. After the
first 60 days of the new plan year, a Part D plan may again make changes to its formulary. The plan may only
discontinue coverage for a limited number of reasons, such as:
There is a safety concern,
The FDA changes its guidance on the medication’s use,
There is a temporary shortage of the medication in question, or
A generic form of a removed brand-name drug can be prescribed.
Within the formulary, the drugs will be labeled as Tier 1 (generic drugs), Tier 2 (preferred drugs), Tier 3 (non -
preferred drugs), and Tier 4 (specialty drugs).
[3.4.3] PART D PDPs BENEFIT STRUCTURE AND COST-SHARING
Part D PDPs typically have two layers of coverage—basic and catastrophic. Each plan covers the cost of the
prescription medications listed in its formulary. The degree of coverage is dependent on whether the
medication is a generic, brand-name, or specialty drug. Elements such as premiums, deductibles, and
copays vary with each plan.
The government sets maximum deductibles and out-of-pocket limits, which change each year.
After the insured pays the deductible (if any), the insured pays up to 25% of medication costs, with the Part D
plan and drug manufacturers sharing the other 75%. Once the out-of-pocket limit is met and catastrophic
coverage begins, the insured pays nothing, and all costs are covered by the Part D plan, drug manufacturers,
and the Medicare program. Starting this year, Part D enrollees have the option of paying their out -of-pocket
prescription drug costs in monthly installments over the plan year based on a maximum monthly cap rather
than paying out-of-pocket costs at the point of service.
EXAM TIP!
State insurance exams usually do not test values that change annually; however, they will ask questions
about the basic structure of the plan, including deductibles and having more than one coverage level. It could
also ask about constant percentages and the availability of a monthly installment plan.
[4] MEDICARE SUPPLEMENTS (MEDIGAP)
Medigap or Medicare supplement policies are sold by private or commercial insurers and other health care
providers. to help fill coverage gaps in Medicare. They cover deductibles and coinsurance as well as
additional inpatient care when Medicare benefits run out. These policies are only availab le to individuals with
Original Medicare (Parts A and B). Their benefits integrate with Medicare and therefore must conform to
certain benefit and service standards.
The National Association of Insurance Commissioners (NAIC) was authorized by the federal government to
establish a series of standardized Medigap policy forms, each with a unique configuration of benefits. Only
contracts that conform to one of these forms may be referred to as a Medicare supplement.
Unlike Medicare Advantage, a Medicare supplement policy CANNOT include benefits that duplicate
Medicare benefits. Also, Original Medicare (Parts A and B) limits the types of coverage that Medigap policies
can offer. Unlike Medicare Advantage plans, Medigap policies cannot offer ancillary benefits, such as dental
care. On the other hand, Medigap policies are not restricted by provider networks, and coverage is
nationwide.
Other relevant requirements are as follows:
• A person can have only one Medicare supplement.
• Medigap benefit amounts change each year to reflect changes in Medicare deductibles, coinsurance,
and other relevant provisions.
• Insurers must give policyholders at least 30 days' notice of upcoming annual changes.
• Benefit restrictions and qualifications cannot be more restrictive than those for Medicare itself.
[4.1] MEDIGAP ENROLLMENT
The best time for a person to buy a policy is during the Medigap open enrollment period, which is the six -
month period following enrollment in Medicare Part B. It begins the month in which one is both 65 and
enrolled in Medicare Part B, and lasts six months. During this time, an individual has the right to purchase a
Medigap policy without evidence of insurability.
While Medicare supplements must be guaranteed issue during open enrollment, insurers may medically
underwrite, rate, and decline policy applications submitted at a later date.
All Medigap policies have a six-month pre-existing condition exclusion based on a six-month “look-back”
period that runs from the policy's effective date and encompasses any medical or health -related conditions
identified or treated during that period.
EXAM TIP!
Do not confuse “PLANS” with “PARTS.” “Plans” refer to the Medicare supplement policies issued by
commercial insurance companies. “Parts” refer to the different sections of the government’s Medicare
program. The exam may require you to distinguish between “Plans” and “Parts.” Read carefully!
[4.2] STANDARDIZED PLANS
Federally Standardized Medicare Supplement
The Omnibus Budget Reconciliation Act of 1990 requires all Medicare supplemental (Medigap) insurance
policies to conform to minimum standards. In response to this new law, the National Association of
Insurance Commissioners (NAIC) created a national model regulation to standardize these policies and
provide uniformity and continuity of Medicare supplement benefits nationwide.
Each variation is designated by a letter of the alphabet; both the number and the availability of these forms
have changed over the years. Currently, there are forms ranging from Plan A through Plan N. Plans E, H, I, and
J are no longer sold; however, those who previously purchased them are “grandfathered” and may keep
them. As a result, 10 plans are currently available for purchase.
Additionally, as of January 1, 2020, Medigap plans sold to newly eligible individuals may not cover the annual
Part B deductible. Therefore, Plan C and Plan F, which include these benefits, are not available to individuals
who were not eligible for Medicare before January 1, 2020. Individuals who previously purchased these plans
can keep them, and those who were eligible for Medicare before January 1, 2020, but not yet enrolled, may
still buy one of them.
Plan A is the most basic Medicare supplement plan. It defines the benefits that every other Medicare
supplement plan must also have. The benefits in Plan A are the core benefits of all Medigap plans, which
include:
• Part A coinsurance and hospital costs up to an additional 365 days after Medicare benefits are
exhausted,
• Part B coinsurance (i.e., copayments),
• The first three pints of blood, and
• Part A hospice care.
As for the other standardized Medigap plans, all of them except Plans A and B cover skilled nursing facility
care coinsurance. All plans, except Plan A, also cover the Part A deductible.
[4.2.1] CORE BENEFITS
The foundation of all Medicare supplement plans is the concept of core benefits, which must be included in
all such plans. In addition to offering Medigap plans with additional benefits, all Medigap insurers must offer a
version of the basic Plan A, as well as other plans with additional benefits as defined in pertinent legislation
and regulations. Still, the core benefits must always be present in any policy that is sold as a Medicare
supplement insurance contract.
Medigap Plan A, the most basic Medigap policy, offers the following core benefits (required in all other
Medigap plans as well):
[[Link]] PART A HOSPITAL BENEFITS
• 100% of the daily hospital coinsurance for days 61-90 of inpatient care during a standard Part A
benefit period
• 100% of the daily hospital coinsurance for the insured’s lifetime reserve days of inpatient care
• 365 additional lifetime reserve days, which can be used if all one’s Medicare reserve days have been
used up
[[Link]] PART A HOSPICE BENEFITS
• Medigap core benefits include coverage for 100% of hospice care coinsurance or copayments
[[Link]] PART B MEDICAL BENEFITS
• Medigap policies cover the 20% coinsurance for approved charges above the annual deductible. The
policies do not cover any amount over what Medicare approves.
[[Link]] PARTS A AND B BENEFITS
• The core benefits of Medicare supplement plans also pay for the cost of the first three pints of blood,
which neither Part A nor Part B of Original Medicare covers.
[4.2.2] ADDITIONAL BENEFITS
Please refer to the “Medigap Benefits” chart at the end of this section, which is taken from “Medicare and
You” (2025) and published by the Centers for Medicare and Medicaid Services. Plans B through L provide
additional benefits as well as the required core coverages. Benefits vary by contract. Other available Medigap
plans cover additional cost-sharing elements besides the core benefits. Depending on one’s Medigap policy,
one could be covered for one or more of the following additional coverages, among others, including:
 • Medicare Part A deductible
• Medicare Part B deductible
• Medicare Part B excess charges
• Skilled nursing facility care (daily copay for days 21 to 100)
• Foreign travel emergency (80% up to plan limits)
[[Link]] PLANS K AND L
Plans K and L differ from most plans. Initially, the only expenses they fully cover are the Part A daily
coinsurance amounts. They partially cover most other Medicare Parts A and B cost-sharing amounts until an
annual out-of-pocket limit is reached. Thereafter, they cover 100%.
[[Link]] PLANS D AND G REPLACE C AND F FOR NEW ENROLLEES
As of 2020, Medicare supplements could no longer cover the Medicare Part B deductible. Anyone eligible for
Medicare prior to 2020 was “grandfathered,” meaning they were still eligible to enroll in a Plan C or F if
available. Subsequent beneficiaries new to Medicare were offered supplement Plans D and G, which mirror
the benefits of C and F, respectively, except for the Part B deductible.
[[Link]] PLANS F AND G
In some states, Plans F and G also offer a high-deductible option. With this option, the insured pays for all
Medicare-covered costs (coinsurance, copayments, and deductibles) up to a set deductible amount before
the policy pays anything.
[4.3] MEDIGAP CONTRACT REQUIREMENTS
The laws governing Medicare supplement plans set national standards. The NAIC Model Act governing
Medigap plans established the following requirements:
• Medigap policies must include a 30-day free-look period (right-to-examine provision).
• Medigap policy exclusions, limitations, or reductions may not be inconsistent with or more restrictive
than Medicare.
• Named pre-existing conditions cannot be excluded in medically underwritten policies.
• Medigap plans are issued on a guaranteed issue basis (during open enrollment or a change in Medigap
coverage).
o Policies may include a six-month pre-existing condition exclusion.
o Pre-existing conditions are those that occur during the six-month look-back period
immediately preceding the policy’s effective date.
• Benefits and restrictions must change automatically to reflect changes in Medicare.
• All Medigap policies must be guaranteed renewable for life, but coverage can be canceled for
nonpayment.
• A new probationary period cannot apply to a policy that replaces a similar Medicare supplement
policy.
• Medicare supplements must automatically adjust their benefits to reflect statutory changes in
Medicare.
• Insurers must set policy premiums so that the majority of paid premiums are paid out for claims, and
therefore clients are not overcharged. The law mandates the following loss ratios (claims as a
percentage of premiums):
o The required minimum loss ratio for individual Medigap policies is 65%, and
o The minimum loss ratio for group plans is 75%.
• Insurers use one of three methods to calculate Medigap premium rates:
o Issue age method in which the premium is based on one’s age when the policy is issued,
o Attained age method, in which premiums increase each year with one’s age, or
o Community rating charges the same premium to everyone in a market area, regardless of age.
[4.4] ADVERTISING AND MARKETING STANDARDS
Medigap policies are marketed to those who are covered by Medicare. States strictly regulate the sale of
these policies, their structure, and the services provided to policyholders. State departments of insurance
require policies and their promotion to be reviewed, and they require adequate disclosure to consumers.
The following are typical requirements:
Like other insurance contracts, Medigap policies must be submitted to the state insurance department in
most states before they are marketed.
Medigap policy advertisements must be submitted to the state insurance department at least 30 days before
the company uses them.
At the time of application, insurers must provide all applicants with a copy of the Medicare Supplement
Buyer’s Guide – A Guide to Health Insurance for People with Medicare.
Whenever a Medigap plan is replaced, the agent must provide the applicant with a “Notice of Replacement,”
which both the agent and the applicant must sign.
[4.4.2] PROHIBITED PRACTICES
The following sales and marketing practices are prohibited:
Duplication of coverage: It is illegal to sell more than one Medigap policy to an individual. The producer must
try to determine whether other Medigap coverage exists.
High-pressure tactics: It is illegal to employ any sales approach that results in a purchase due to an explicit
or implicit threat, excessive pressure, or the creation of a climate of fear.
Cold lead advertising: This illegal practice includes any advertising or marketing that fails to disclose that an
agent may be in contact to solicit the sale of a Medicare supplement contract.
Twisting: As with any other insurance policy, it is illegal to use deception or misrepresentation to induce an
individual to replace an existing policy with another contract. The producer must provide an applicant with a
“Notice Regarding Replacement” at the time of application.
[4.4.3] PRODUCER COMPENSATION
The NAIC Model Act governing Medicare supplement policies states that first-year commissions cannot be
greater than 200% of the second-year commissions paid for the same sale. Furthermore, the Commission
amount paid in year two of the contracts must continue for five years. In the case of replacement sales, the
producer cannot receive more than the standard renewal commission, not the higher first -year amount.
For example, if an agent earns $220 as the first-year commission for the sale of a Medicare supplement
policy, he must make at least $110 for that same sale in year two. Also, that agent must continue to earn
$110 annually in years three through six.
[4.5] MEDICARE SELECT
Medicare Select is a type of Medicare supplement that is not available in all areas and works like a closed -
end HMO. Though these plans are Medigap policies, rather than Medicare Advantage plans, they are
managed-care contracts. Medicare Select plan benefits are standardized to match the benefits available in
corresponding standard Medigap policies.
The difference in a Medicare Select plan is that the individual agrees to use certain, insurer -designated
providers in return for a lower premium. As with an HMO, there may be restrictions on access to specialty
services. The insured must choose providers that belong to the network, except in cases of emergencies.
Insureds must get a referral from their primary care physician to see another provider in the network.
Examples of Medicare Select organizations include provider groups, hospital marketing plans, and groups
formed or operated by insurers or third-party administrators.
[5] LONG-TERM CARE INSURANCE
Long-term care insurance (LTC) pays for a broad range of medical and personal services for individuals who
need assistance with the activities of daily living (ADLs) for an extended period. Individuals may need such
assistance either due to cognitive impairment or a physical loss of function. The cause of loss can be an
injury, a critical illness such as a stroke, or one of the organic diseases of aging, including Alz heimer’s
disease or Parkinson’s. The loss of function may also result from a general physical decline that is associated
with advanced age.
LTC provides at least 12 consecutive months of coverage for one or more necessary types of care in a setting
other than a hospital. It does not cover hospital confinements such as medical insurance because it covers
chronic, not acute (sudden), conditions.
Just as disability insurance indemnifies insureds for the financial cost of being unable to work, LTC
indemnifies covered individuals for the cost of support services that enable the insured to live as comfortably
and independently as possible based on the degree to which the insured is impaired.
There are three distinct levels of (nursing) care: skilled nursing care, intermediate care, and custodial
care. Caregivers deliver these levels of assistance in various settings, such as nursing homes, assisted living
facilities, adult day care centers, and home care in the individual’s own home.
The cost of long-term care is intimidating. The median annual cost of nursing home care in the United States
was over $100,000, and the cost of assisted living facility care is approaching $75,000. The cost of
homemaker services or a home health aide is also exceptionally high.
Medicare and Medigap plans provide minimal protection for this risk because they focus on recovery from
illness rather than maintaining an individual’s quality of life. For this reason, individuals need long -term care
insurance, which can be purchased as an individual policy, as part of a group plan, or as a rider to a life
insurance policy.
[5.1] THE LEVELS OF LONG-TERM CARE
The three long-term care levels reflect the types of services recipients need and the level of care they
require. Services range from assistance with personal needs and the activities of daily living to around -the-
clock nursing care. Let us examine each of these levels.
• Skilled nursing care consists of daily nursing and rehabilitative care that may be performed by (or
under the supervision of) skilled medical personnel and based on an attending physician’s orders.
Skilled nursing care includes 24-hour nursing services subject to periodic review by a physician.
• Intermediate (nursing) care involves intermittent or occasional nursing and rehabilitative care based
on a physician’s orders and provided by skilled medical personnel.
• Custodial care involves assisting with personal needs, such as bathing, dressing, walking, eating, and
taking medication. Trained individuals who provide this type of care are generally not medical
personnel; however, the care must be approved and ordered by a healthcare professional.
[5.2] LONG-TERM CARE SERVICES: FORMAL vs. INFORMAL CARE
LTC policies cover formal care, which is care provided by healthcare professionals, senior aides, and others
involved in the business of providing personal care. Individuals receive formal care from paid caregivers,
whether that care is given in a nursing home, other assisted living facility, or within the client’s home.
On the other hand, informal care is unpaid care. This type of care is usually provided by family members,
such as a spouse or children. Although insurance policies do not cover informal care, they may offer a
training allowance to help informal caregivers take on this role.
[5.3] SETTINGS FOR LONG-TERM CARE SERVICES
[5.3.1] NURSING HOMES
Nursing homes are primarily designed to provide skilled nursing care around the clock for individuals with
medical issues and a significant loss of control in their bodily functions, including incontinence. Nursing
home residents often need end-of-life care related to significant chronic conditions or recovery from an
acute illness. Freedom of movement for insureds is often more restrictive compared to assisted Living and
community-based services.
[5.3.2] ASSISTED LIVING FACILITIES
An assisted living facility is a residential community that provides more limited services than a nursing
home. Assisted living communities cannot provide around-the-clock services and care for individuals with
limitations on their abilities, but who are not so debilitated as nursing home residents. Assisted living
facilities offer intermittent nursing services, including medication management. They provide services such
as housekeeping, on-site meal facilities, and social activities. They also provide this care through registered
nurses, licensed physical or occupational therapists, or other health professionals.
Some facilities may be called Residential Care Facilities for the Elderly (RCFEs) and are considered
nonmedical facilities. These facilities are ideal for individuals who are unable to live independently but do not
need 24-hour (full-time) nursing care. RCFEs typically store and distribute all medications for residents to
self-administer. When individuals need assistance with one or two activities of daily living, they may be
eligible for an assisted living facility.
[5.3.3] HOME HEALTH CARE AND COMMUNITY-BASED SERVICES
Home health care and community-based services are provided in an insured’s home, usually on a part-
time basis. It primarily includes skilled care, such as care delivered by visiting nurses. It includes assistance
with medication, wound care, and monitoring chronic conditions. Home health care also in cludes
rehabilitative or physical therapy ordered by a doctor. In many cases, home health care is delivered in
conjunction with personal care, including cooking or cleaning.
[5.3.4] HOME CARE
Home care is personal care. Home health aides assist clients with activities of daily living. Services can
include activities such as transportation, meal preparation, and housework. Home health aides assist
individuals with dressing and bathing, as well as other personal needs. This type of care may include hands-
on help and stand-by assistance, which are both considered substantial assistance in discussions of long-
term care. Home care is also referred to as home setting or personal care.
EXAM TIP!
Some states use “home health care” to encompass “home care” as well. Check the information in the state -
specific chapter of your course.
[5.3.5] ADULT DAYCARE
Adult daycare is for seniors who live at home but whose family members cannot stay at home with them
during the day. Since the primary caregiver is absent or at work, families must make other provisions for the
senior adult’s care. The appropriate facility is an adult daycare center. The level of care is like home health
care. These centers typically provide transportation to and from their location.
[5.3.6] CONTINUING CARE COMMUNITIES
Continuing care communities allow elderly individuals to access progressively more intensive levels of care
without leaving the community in which they live. Residents may start in an independent living apartment
with access to senior-focused services. They may progressively access additional services, at some point,
shifting to the community’s assisted living facility and ultimately a licensed, onsite nursing (skilled -care)
home. This system helps individuals avoid the stress and uncertainty of finding appropriate care and leaving
friends and familial caregivers behind. Some communities offer a guarantee of care if a resident can no longer
afford their services.
[5.3.7] RESPITE CARE
Respite care provides the primary, informal caregiver with relief, time off, or a break from providing care. It
may include an overnight stay by a respite caregiver in the disabled individual’s home or a short -term
admission to a facility. Respite care is also provided at adult daycare centers. Adult daycare is either
medically based (i.e., physical therapy) or recreation-based (i.e., arts, crafts, entertainment).
[5.4] LONG-TERM CARE INSURANCE FOR INDIVIDUALS
Long-term care insurance was developed from various policies designed to cover specific types of care, such
as nursing home care and home health care.
Today, the coverage recognized as long-term care insurance evolved from these policies under the guidance
of state regulators, federal tax authorities, and NAIC models. The stand-alone long-term care insurance
policy is the form of coverage that immediately comes to mind for most people, but it is not the only option.
Currently, there are two other categories of contracts that provide long-term care coverage: life insurance
riders and hybrid contracts (also referred to as linked contracts or long-term care annuities). These forms,
like traditional policies, are based on an NAIC model.
[5.4.1] LONG-TERM CARE INSURANCE – NAIC MODEL MINIMUM STANDARDS
The NAIC created and authored the Long-Term Care Insurance Model Act, which specifies the minimum
standards products must satisfy to be considered long-term care insurance. All 50 states have adopted this
model, either fully or partially.
The NAIC model includes the following types of contracts: standards for LTC policies:
• Contracts must pay benefits based on the loss of physical function or a cognitive impairment
• Hybrid contracts that combine life insurance or annuity benefits with long-term care benefits
• Life insurance riders that pay benefits based on the loss of function or cognitive impairment
NAIC model contracts must also meet the following standards:
• Stand-alone policies must pay for at least 12 months of ongoing care
• Policy owners must be provided with a free-look period during which policies may be returned for a
full refund
• Policies must be guaranteed renewable or non-cancellable
• Policies may not require a previous hospital stay to qualify for benefits
• Policies may not require insureds to receive care in a residential facility before receiving home care
benefits
• Benefits for skilled nursing care cannot be substantially greater than those for intermediate or
custodial care
• The maximum pre-existing condition exclusion must be six months, based on a six-month look-back
period
• Insurers cannot include an impairment rider that limits or denies coverage for specific health
conditions
The NAIC model excludes life policies that pay accelerated death benefits as a lump sum. It also excludes
policies that require prior hospitalization, supplement Medicare, or otherwise require the insured to qualify
for coverage by having a particular medical condition or terminal diagnosis.
Insurers must provide the consumer with an outline of coverage that summarizes policy features and
benefits. Producers who sell LTC are principally responsible for determining the suitability of such plans for a
particular applicant.
[5.4.2] LIFE INSURANCE: LIVING BENEFIT RIDERS
Long-term care insurance may be added as a living benefits rider. These riders take various forms, and state
regulators may treat them differently. Listed below are some of the important types.
[[Link]] ACCELERATED DEATH BENEFIT RIDERS
An accelerated death benefit rider pays out a portion of the life insurance policy’s death benefit upon the
diagnosis of a terminal illness or other condition. Insurers typically pay this benefit as a lump sum. Some
riders pay a monthly benefit if the insured is confined to a nursing home with the expectation that the
insured’s condition will not improve. Insurers deduct any amounts paid as living benefits from the death
proceeds paid to the beneficiary. The NAIC does not include these riders in its model d efinition of long-term
care insurance.
[[Link]] LONG-TERM CARE RIDERS
Long-term care riders use a portion of the underlying policy’s face amount to pay a monthly benefit that helps
cover the cost of long-term care services. Insureds qualify for benefits on the same basis as those who are
covered by stand-alone long-term care insurance policies. The benefit trigger is either the inability to perform
activities of daily living or the diagnosis of a cognitive impairment. These riders may include home health care
and nursing home care, and they often require additional underwriting.
[[Link]] LONG-TERM CARE HYBRID (LINKED) PLANS
Hybrid long-term care (LTC) plans combine the benefits of an annuity (or life insurance agreement) with
those of a traditional LTC policy. With a hybrid LTC policy, the insured has the guarantee of long -term care
benefits or, if no care is needed, the guarantee of insurance benefits for himself or his beneficiaries.
Hybrid products are written using whole life insurance or annuities. Unlike life insurance riders, these
contracts prioritize long-term care insurance. The potential long-term care benefit is greater than the
underlying contract and must be underwritten. The insured or a beneficiary receives any potentially remaining
contract benefits after long-term care benefits have been paid.
[[Link]] THE LONG-TERM CARE (STAND-ALONE) INSURANCE POLICY
The accident and health insurance licensing exam focuses on the individual long-term care insurance policy.
The basics regarding the benefit period, daily benefits, and benefit triggers generally apply to any contract
that fits the definition of “long-term care insurance.” We will now focus on a more detailed examination of
these policy elements as they appear in the stand-alone policy, understanding that they also appear in other
forms of LTCI.
[5.5] BENEFIT TRIGGERS: QUALIFYING FOR LONG-TERM CARE INSURANCE BENEFITS
LTC contracts have two distinct benefit triggers: loss of physical function and cognitive impairment. The loss
of either qualifies the insured for benefits.
[5.5.1] LOSS OF PHYSICAL FUNCTION: THE INABILITY TO PERFORM THE ACTIVITIES OF DAILY LIVING
The first benefit trigger involves the loss of physical function. There are six physical functions collectively
defined as the basic activities of daily living (ADLs): bathing, dressing, toileting, transferring, continence, and
eating.
The inability to perform two or more of six ADLs without substantial assistance qualifies an insured for
benefits.
The NAIC defines substantial assistance as including either hands-on or physical assistance or even stand-
by assistance. Stand-by assistance means that a caregiver is physically within arm’s reach of the insured and
can provide hands-on assistance if needed.

[5.5.2] COGNITIVE IMPAIRMENT

The second long-term care insurance benefit trigger defined by the NAIC Model Regulation is “cognitive
impairment,” defined as a deficiency in one’s:
• Short or long-term memory
• Orientation as to person, place, and time
• Deductive or abstract reasoning, or
• Judgment as it relates to safety awareness
LTC specifically covers conditions related to organic neurological disorders related to diseases of aging, such
as Alzheimer’s disease (ALZ), Parkinson’s disease, and non-ALZ senile dementia. Individuals may also
experience a loss of cognitive ability due to other causes not necessarily related to aging, such as strokes
and brain injuries.
[5.5.3] THE ELIMINATION PERIOD
LTC policies include an elimination period that functions like a deductible, just as it does in a disability
income policy. The insured must cover all costs during the elimination period. Benefits begin when the
elimination period ends.
It helps to restrain the cost of coverage for prospective policyholders. In an LTC contract, the elimination
period often occurs only once because the insured’s condition is often not curable, and the policy focuses on
maintenance rather than recovery.
[5.5.4] WAIVER OF PREMIUM
Traditionally, the waiver of premium provision is an integral part of long-term care insurance contracts.
Contracts typically suspend premium payments while the insured is receiving benefits. Some LTC policies
offer a lower premium by not including this feature; instead, they offer it as an optional rider with a waiting
period of 90 days when an insured qualifies for covered care.
[5.5.5] POLICY EXCLUSIONS
Some losses are excluded from coverage. Long-term care insurance does not cover losses resulting from
war, treatment for drug or alcohol abuse, intentionally self-inflicted injuries, attempted suicide, nervous
disorders, mental illnesses, institutional care received outside the U.S., or care for which benefits are
payable under workers’ compensation.
[5.6] LONG-TERM CARE INSURANCE BENEFITS
[5.6.1] DAILY BENEFIT LIMITS
When benefits are triggered, LTC policies pay them over an extended period. They do so by limiting benefits
to a daily maximum. LTC contracts pay these daily benefits in one of two ways—as a fixed daily
indemnity or based on the actual costs incurred (reimbursement). In either case, a higher daily limit
results in a higher annual premium.
For example, an insured has a long-term care insurance policy with a stated daily benefit of $100. The
insured incurs covered costs of $88 during a single 24-hour period. If the insured has a policy that pays a
fixed daily indemnity, the insured will receive $100. If the insured has a reimbursement policy that covers
actual costs up to $100, the insured will receive $88.
This daily benefit limit in reimbursement policies is also dependent on the type of care received. Home care
is less expensive than nursing home care. Reimbursement policies may set home care limits between 50%
and 80% of the maximum benefit for nursing home care.
For example, an insured purchases a policy with a two-year benefit period and a maximum benefit of $200
per day. This policy will pay up to $200 in daily costs when the insured is confined to a nursing home. If the
insured receives care at home, the insurance policy will pay between $100 and $160 per day.
[5.6.2] BENEFIT PERIODS
The benefit periods in LTC policies define the length of time that benefits will be paid for a single claim.
Available benefit periods may include 12 months, two years, three years, five years, 10 years, or for life. LTC
policies define benefits as a maximum daily amount that is payable during the benefit period, as stated in the
contract. The minimum benefit period is one year, while the maximum is lifetime protection. A commonly
chosen benefit period is three years. It reflects the average nursing home stay, which is approximately 2.5
years.
The notion of a benefit period in a long-term care insurance policy is a flexible one. It reflects a calculation
based on the maximum policy benefit, assuming the insured requires the highest degree of care for a given
period.
For example, assume that an LTC contract is set up to pay a maximum of $100 per day for institutional care
for one year (365 days). This means the total policy benefit equals 365 x $100 or $35,600. Even if the home
care benefit is 50% of the amount for institutional care, or $50 per day, we cannot reduce the value of the
policy. It remains $35,600, which means benefits for care at home would last twice as long as those for care
in an institution.
We call this the “pool of money” concept.
[[Link]] THE “POOL OF MONEY” CONCEPT
The pool of money concept describes the method by which insurers calculate policy benefits. It means the
policy’s total benefits are limited by the number of available dollars rather than by the number of days.
For example, let’s assume that an LTC contract pays a maximum of $200 per day for institutional care and
$125 per day for home care. Also, let’s assume that this policy has a stated benefit period of two years. If
each year is treated as having 365 days, then a two-year benefit period covers 730 days. The maximum daily
benefit (for institutional care) is $200 per day.
730 days x $200 per day = a $146,000 pool of money
This calculation means that an insured could spend up to 730 days in a care facility and receive $200 per day
before using all the available funds. It also means that using the policy to pay for home care would make the
benefits last longer. Let us assume the insured only used the policy to pay for home care, and that the policy
would pay only $125 per day instead of $200. In this situation, the policy would pay benefits for 3.2 years
($146,000 = $125 x 1,168 days). In the end, the same amount of money would be spent in both situations
(i.e., the amount of funds in “the pool”).

[5.7] OPTIONAL LONG-TERM CARE PROVISIONS

As with other insurance policies, long-term care insurance carriers offer a variety of options to their
policyholders. In some cases, states require insurance companies to offer such benefits to all applicants,
even though acceptance is optional.
[5.7.1] THIRD-PARTY NOTIFICATION OF A PENDING LAPSE
Third-party notification of a pending lapse is an important option for a population at risk of physical and
cognitive decline. The provision allows policyholders to designate a third party to receive lapse notices.
When chosen, the feature protects policyholders from inadvertently losing their coverage due to missed
premium payments. When policyholders decline this option, they typically must sign a waiver declining it.
Once a third-party designee is named, the insurance carrier is obligated to send notice of a pending lapse to
both the policyholder and the designated third party. Even if a third-party designee is in place, it is important
for all parties involved to understand the terms of coverage, including grace periods and any reinstatement
rights.
[5.7.2] RETURN OF PREMIUM OPTION
Some LTC policies offer a return of premium rider, which provides policyholders or beneficiaries with a
refund of all or part of the premiums paid if the insured dies without using long-term care benefits. Some
contracts may offer partial refunds, with the claim amount deducted.
Hybrid policies combining LTC and annuities or life insurance have this concept built into their design. Funds
not used for long-term care services are automatically available for retirement income or a death benefit.
[5.7.3] NONFORFEITURE BENEFIT OPTIONS
Some states require long-term care (LTC) insurers to offer nonforfeiture benefits as part of the policy, which
allow the insured to receive some value from the plan if the policy lapses due to nonpayment. This option is
typically available in one of three different forms if the insured ceases to pay premiums after a specified
number of years:
• Reduced paid-up benefit: The insurance company would provide the insured with a reduced daily
benefit amount for the original period.
• Shortened benefit period: The insurance company would provide the insured with the same daily
benefit for a shortened period.
• Return of premium: The insurance company would refund a specified amount to the insured (the most
expensive form). In some states, this option is prohibited from being part of the nonforfeiture
provision.
The nonforfeiture provisions can be a relatively expensive option. At the same time, this option can be an
important one given the cost of long-term care insurance, especially for those approaching retirement. It is
doubly important because income may decline during one’s retirement years. LTC policies cannot be issued
unless nonforfeiture benefits have been offered. The offer is generally made at the time of application or
before the policy is issued. This nonforfeiture option has no age requirement or age limit.
[[Link]] CONTINGENT NONFORFEITURE BENEFIT
The Contingent Nonforfeiture Benefit is a built-in feature in all tax-qualified LTC policies. This provision is
triggered when the insurer enacts a "significant premium increase" as defined in the policy. When triggered,
the policyowner may choose to exercise the reduced coverage or paid-up nonforfeiture options. The benefit
is a form of consumer protection. It prevents an individual from having to give up coverage because of
unaffordable premiums.
[5.7.4] INFLATION RIDERS
The impact of inflation on long-term care costs is significant. At a 5% inflation rate, the cost of care will
double in approximately 15 years. The typical long-term care insurance buyer is in their 50s or early 60s and
has a life expectancy of 20 years or more. This means inflation is an important consideration. For this reason,
virtually all states require insurers to offer inflation protection, at least to applicants under a certain age, such
as 76. Protection may be offered in the form of a guaranteed insurability option and/or an automatic
increase option.
[[Link]] GUARANTEED INSURABILITY OPTION (RIDER)
The guaranteed insurability rider is a form of inflation protection that allows the insured to purchase
additional coverage at future intervals based on an assumed rate of inflation, at their attained age. The rider
resembles a similar disability and life insurance policy option, except this increase in LTC benefits is based
on inflation. It provides an increase in benefits (generally equal to a 5% increase) without requiring the
insured to prove insurability. It may be used in some cases to meet a state requirement for providing inflation
protection.
[[Link]] AUTOMATIC INFLATION RIDER
Many states require an insurer to offer some form of inflation protection to a long-term care plan’s policy
owner. The automatic inflation rider (AIR) meets this requirement by increasing the stated daily benefit of a
long-term care insurance policy, compounded annually, typically at a rate of 5% per year. The annual
increase is often limited to a certain number of years. Insurers build the cost of these increases into the initial
premium.
[5.8] MARKETING, APPLICATIONS, AND UNDERWRITING
[5.8.1] MARKETING AND DISCLOSURES
Long-term care (LTC) is marketed to adults. There is no minimum age requirement other than the
requirement of reaching the age of 18, which is the age of legal majority. Insurers generally stop issuing
stand-alone policies after age 79, though hybrid contracts, such as long-term care annuities, may be issued
to those in their 80s.
Insurers that market LTC must establish marketing procedures to address the following concerns:
• They must ensure that any policy comparisons made by agents or other producers will be fair and
adequate.
• They must avoid selling excessive insurance.
• They must advise buyers that their LTC policy may not cover all costs associated with long -term care.
Whenever an insurer is replacing another LTC policy, that insurer must waive any pre-existing condition
limitations that exist in the replacement policy. Agents must also provide a notice regarding replacement
before an application is accepted.
Other disclosures typically required during the sales process include the following documents, which usually
must be provided no later than the time of application:
• An outline of coverage
• A copy of the NAIC’s Long-Term Care Shopper’s Guide
• A personal worksheet summarizing the applicant’s financial situation and how a long-term care policy
would be suitable for meeting one’s financial needs
Most of the same prohibited sales and marketing practices identified in relation to the sale of Medigap
policies also apply to the sale of long-term care insurance: high-pressure tactics, cold lead advertising,
and twisting.
[5.8.2] PREMIUMS AND RATINGS
Long-term care policy premiums depend on several factors, including age, health conditions, benefit periods,
and level of care. The younger the insured, the lower the premiums. For individuals of the same age, a shorter
benefit period or lower level of care results in lower policy premiums. So will a longer elimination period.
Also, the more optional benefits that are included in the LTC policy, the higher the premium will be.
[5.8.3] UNDERWRITING
Insurers need to carefully determine whether an applicant is insurable before approving an application.
Underwriting practices will vary by insurers. Generally, one’s eligibility to purchase LTC coverage is similar to
one’s ability to buy other types of health insurance plans, such as disability insurance. The main difference
here is that disability insurance focuses on an individual’s ability to earn a living, while LTC focuses on an
individual’s ability to live independently.
Post-claims underwriting, another prohibited practice, is the act of approving all applicants and underwriting
each risk exposure only when a claim is filed. This process results in the insurer denying such claims based
on the insured’s health or for other reasons. This underwriting approach is considered an unfair trade
practice, and its use is prohibited with LTC policies.
[5.9] ASSOCIATION AND GROUP LONG-TERM CARE INSURANCE
[5.9.1] ASSOCIATION (AFFINITY GROUP) LTC
An association’s primary responsibility is to educate its members about long-term care issues so that they
can make informed decisions. As with other types of affinity group insurance, the sponsoring association
provides a marketing channel and addresses member questions. Associations must provide objective
information regarding endorsed long-term care insurance policies or certificates.
The insurer must file the endorsed contract with the insurance regulators, along with a corresponding outline
of coverage and any requested advertisements. The association must disclose the specific nature and
amount of all compensation that it receives from the endorsement or sale of insurance to its members. It
must also disclose the process for selecting the insurance program. The association must also reveal
whether it has interlocking directorates or trustee arrangements with the insurer. An associatio n’s board of
directors must review and approve the insurance policies as well as any compensation arrangements with
the insurer.
[5.9.2] EMPLOYER GROUP INSURANCE
Employers often offer LTC as a voluntary, employee-paid benefit. These types of policies feature simplified
underwriting and discounted premiums. They also allow access to a more extended family group, including
parents and siblings. The provisions in these contracts are the same as those in many individual policies.
Large employers may also offer LTC as a true group policy. Large group plans may provide a limited amount
of coverage to employees on a guaranteed issue basis. Limits apply to both the daily be nefit amount and the
length of the benefit period.
[5.10] TAX CONSIDERATIONS
Under HIPAA, LTC plans (whether group or individual) are classified as accident and health insurance for tax
purposes. This designation means that the premiums paid by an employer under a group plan are tax -
deductible for the employer but not counted as taxable employee compensation. In most cases, expenses
for long-term care services, including premiums for qualified plans, are treated like any other medical
expense. Under the tax code, this treatment means that if such expenses exceed 7.5% of an individua l’s
adjusted gross income, they are tax-deductible.
[5.10.1] NON-QUALIFIED LONG-TERM CARE INSURANCE POLICIES
Unless a policy meets the criteria for being considered a qualified long-term care insurance policy under
federal tax law, it is deemed to be a non-qualified LTC policy. As such, premiums paid on non-qualified
individual LTC policies are not tax-deductible. As for benefits, these benefits are taxable to the extent they
exceed reimbursements for the insured’s actual out-of-pocket expenses. This approach works for
reimbursement policies, but not for policies that pay a fixed daily indemnity, since indemnity p olicy benefits
may exceed actual out-of-pocket costs. In such cases, the insured could incur a tax liability.
[5.10.2] QUALIFIED LONG-TERM CARE INSURANCE POLICIES
HIPAA established qualified long-term care insurance policies as a specific category of insurance contract,
one that offers specific benefits and must meet specific requirements.
The additional tax benefits of owning a qualified long-term care policy are the ability to deduct premiums and
the ability to receive tax-exempt benefits in excess of actual long-term care costs.
• Tax-deductible premiums: Individuals who own a qualified long-term care insurance policy may
deduct their premiums if they itemize. The deductible amount varies by age and changes annually.
• If the policyholder is self-employed, the premiums are fully deductible from their self-employment
(1099) income, just like medical insurance premiums.
• Tax-exempt benefits: Individuals who have a qualified long-term care insurance policy may also
receive tax-exempt benefits in excess of their out-of-pocket expenses.
Tax-qualified plans must satisfy specific criteria to be designated as tax-qualified, regardless of whether they
are individual or group insurance contracts. The HIPAA standards that must be met are as follows:
• The policy cannot pay expenses that are reimbursable under Medicare
• The benefit trigger must be one of the following conditions:
• The insured is unable to perform two of the six ADLs, or
• The insured has a severe cognitive impairment.
• [Note: Some policies may combine bathing and dressing and treat them as one ADL. In such cases,
the loss of one ADL can trigger benefits.]
• The policy is at least guaranteed renewable.
• The policy must not include a cash surrender non-forfeiture option.
• The policy must only provide long-term care services.
• The policy must have a 30-day free-look period.
• The policy requires all claims to be based on a medical diagnosis of a disability that will last at least
90 days.
It must be noted that the diagnosis required to qualify for benefits must include a functional assessment
performed by a healthcare provider with expertise in gerontology. When an insured files a claim, the policy
will require a medical professional to devise a written plan of care. In cases involving the elderly, the
professional should be knowledgeable in the area of geriatrics.
[5.11] MEDICARE, MEDICAID, AND LONG-TERM CARE INSURANCE
Medicare, Medicaid, and long-term care insurance (LTC) address the needs of seniors, but each has a
distinct role and is not interchangeable. The following section offers a quick comparison of these three
coverage types.
[5.11.1] MEDICARE
Medicare is medical insurance in the traditional sense for individuals age 65 and older, as well as certain
individuals with a qualifying severe disability. It provides treatment for acute and chronic illnesses, with the
goal of curing acute conditions and treating chronic diseases to mitigate their effects.
[5.11.2] MEDICAID
Medicaid is a means-tested public program that provides medical and supportive services to individuals at or
below the poverty line. The funding comes from both the federal government and state budgets. Each state
administers its own program. Medicaid services overlap with both Medicare and long-term care insurance.
Low-income individuals age 65 and older can qualify for both Medicare and Medicaid to help cover their
medical costs.
Senior citizens who lack assets can be eligible for long-term services and support (LTSS), which are paid by
Medicaid.
Originally, Medicaid paid for LTSS delivered in nursing homes. Given the increasing costs of such care, the
federal government granted states the authority to devise alternative programs that could deliver these
services using different means, such as in-home care.
Individuals can qualify for Medicaid funding for LTSS only when their countable assets (other than their
residence and some other such property) are depleted. More affluent individuals typically attempt to qualify
for Medicaid while sheltering assets from liquidation by transferring property to relatives. The states examine
asset transfers over the five-year period prior to any application for Medicaid benefits. If an insured transfers
assets to family members, the medical assistance administrators will delay the insured’s access to public
funding for long-term services and support.
[5.11.3] LONG-TERM CARE INSURANCE
LTC policies are the private alternative to the public funding of long-term services and support (LTSS). The
government has recognized its value as the cost of LTSS continues to burden the government’s capacity to
fund it. To encourage individuals to purchase private long-term care insurance, the government authorized
each state to establish a long-term care partnership program.
[5.12.1] LONG-TERM CARE PARTNERSHIP PROGRAMS
The Long-Term Care Partnership Program is a federally supported, state-operated initiative that allows
individuals who purchase qualified long-term care coverage to protect a portion of those assets they would
otherwise need to spend before qualifying for Medicaid.
Partnership policy requirements vary by state, but all must be tax-qualified and provide inflation protection.
All policies must meet consumer disclosure requirements as well.
[6] HEALTH INSURANCE PLANS FOR SENIORS SUMMARY
This chapter has explored the complex landscape of health insurance options available to seniors in the
United States. We began by examining Medicare, the federal health insurance program that serves as the
foundation of healthcare coverage for most Americans age 65 and older, as well as certain younger
individuals with qualifying disabilities.
We distinguished between the two primary ways to access Medicare benefits: Original Medicare (Parts A and
B) and Medicare Advantage (Part C). Original Medicare operates on a fee-for-service basis with nationwide
coverage but leaves significant gaps in coverage that often necessitate supplemental insurance. Medicare
Advantage plans, offered by private insurers, provide an all-in-one alternative with network-based care and
often include additional benefits not covered by Original Medicare.
We explored Medicare eligibility requirements, including the special provisions for individuals under 65 with
certain disabilities or conditions like end-stage renal disease. We also examined the critical enrollment
periods—initial, general, and special—and the significant penalties that can result from delayed enrollment
outside these periods.
The chapter detailed Medicare's cost-sharing mechanisms, including deductibles, copayments, and
coinsurance across all parts of Medicare. We also reviewed how Medicare claims are processed and the
rights beneficiaries have to appeal denied claims.
Medicare Supplement (Medigap) policies were examined as a critical component for those who choose
Original Medicare. We explored the standardized plans, their core benefits, and the additional coverages that
vary by plan letter. We also discussed important consumer protections in the marketing and sale of these
policies.
Finally, we addressed long-term care insurance as an essential consideration for comprehensive senior
healthcare planning. We identified the three levels of care—skilled nursing, intermediate, and custodial—and
the various settings where care is delivered. We examined how long-term care insurance policies work,
including benefit triggers, daily benefit limits, and important policy provisions. We also explored the tax
considerations for qualified and non-qualified policies and how long-term care insurance works alongside
Medicare and Medicaid.
Understanding these programs and how they interact is essential for insurance professionals who guide
seniors through these complex decisions. The choices seniors make about their health insurance coverage
will significantly affect both their access to care and their financial security in retirement.
[6.2] REVIEW NOTES
Learning Objective 1: Explain the four parts of Medicare (A, B, C, and D) and identify the services
covered under each part
Medicare Overview:
• Medicare is a federal health insurance program founded in 1965
• Administered by the Centers for Medicare and Medicaid Services (CMS)
• Primarily serves individuals age 65 and older, plus certain younger disabled individuals
Medicare Part A (Hospital Insurance):
• Covers inpatient hospital care for up to 90 days per benefit period
• Provides 60 lifetime reserve days that are not restored
• Includes skilled nursing facility care for up to 100 days following hospitalization
• Covers hospice care for terminally ill patients
• Includes limited home health care benefits
• Most beneficiaries pay no premium but are subject to deductibles and coinsurance
Medicare Part B (Medical Insurance):
• Covers physician services and outpatient medical care
• Pays for diagnostic tests, lab work, and durable medical equipment
• Covers 80% of approved charges after annual deductible
• Requires a monthly premium from all enrollees
• Does not cover dental, vision, hearing, or prescription drugs
Medicare Part C (Medicare Advantage):
• Private insurance alternative to Original Medicare
• Must cover all services covered by Parts A and B
• Often includes prescription drug coverage
• May offer additional benefits like dental and vision
• Typically uses provider networks (HMOs, PPOs)
• Sets annual out-of-pocket maximums
Medicare Part D (Prescription Drug Plans):
• Covers outpatient prescription medications
• Available as standalone plans or included in Medicare Advantage
• Uses formularies to determine covered medications
• Features a tiered cost-sharing structure
• Includes catastrophic coverage after reaching the out-of-pocket limit
Learning Objective 2: Distinguish between Original Medicare and Medicare Advantage plans
Original Medicare:
• Fee-for-service program administered by the federal government
• Includes Part A (hospital) and Part B (medical)
• No provider networks; beneficiaries can see any provider accepting Medicare
• No referrals required for specialists
• No annual out-of-pocket maximum
• Does not include prescription drug coverage
• Often supplemented with Medigap policies
• Coverage is nationwide
Medicare Advantage (Part C):
• Managed by private insurance companies approved by Medicare
• Combines Parts A and B benefits in one plan
• Most plans include prescription drug coverage
• Often includes additional benefits not covered by Original Medicare
• Uses provider networks (HMO, PPO, PFFS)
• HMOs typically require referrals for specialists
• Features annual out-of-pocket maximums
• Cannot be used with Medigap policies
• Coverage is generally limited to the network service area
Learning Objective 3: Identify Medicare eligibility requirements
Eligibility for Persons Age 65 and Older:
• Must be U.S. citizens or legal residents for at least 5 years
• Must have earned 40 Social Security credits (10 years of work)
• Spouse's work history may qualify the individual for benefits
• Those without sufficient work history may pay unsubsidized premiums
Eligibility for Persons Under Age 65:
• Individuals receiving Social Security Disability Insurance for 24+ months
• Persons with end-stage renal disease (ESRD) after 3 months on dialysis
• Individuals with amyotrophic lateral sclerosis (ALS) are immediately eligible
• No waiting period for ALS patients
Learning Objective 4: Describe Medicare enrollment periods and the consequences of delayed
enrollment
Initial Enrollment Period:
• Seven-month period, including 3 months before, the month of, and 3 months after one's 65th birthday
• Automatic enrollment for those receiving Social Security benefits
• Others must actively enroll through the Social Security Administration
General Enrollment Period:
• January 1 through March 31 each year
• For those who missed the initial enrollment period
• Coverage begins first day of the following month
• Late enrollment penalties may apply
Special Enrollment Period:
 • Available to those who delayed enrollment due to employer coverage
• Eight-month period following the end of employment or group coverage
• No penalties if enrolled during this period
• Only applies to those with COBRA-regulated group plans (20+ employees)
Penalties for Delayed Enrollment:
• Part A: 10% premium increase for twice the number of years delayed
• Part B: 10% premium increase for each 12-month period delayed (lifetime)
• Part D: 1% per month penalty for each month without creditable coverage
Annual Open Enrollment Period:
• October 15 through December 7 each year
• Can change between Original Medicare and Medicare Advantage
• Can switch Medicare Advantage plans
• Can join, switch, or drop Part D prescription drug plans
Learning Objective 5: Explain Medicare claims processing and appeals
Medicare Claims Processing:
• Original Medicare claims are processed by Medicare Administrative Contractors (MACs)
• Participating providers accept Medicare assignment and bill Medicare directly
• Nonparticipating providers may charge up to 15% above the Medicare-approved amount
• Medicare Summary Notice (MSN) is sent to beneficiaries quarterly
Appeals Process:
• Beneficiaries have 120 days to appeal denied claims
• Can use Redetermination Request Form or follow MSN instructions
• Must include personal information and explanation of disagreement
• Written requests must specify dates and services being disputed
Learning Objective 6: Compare standardized Medicare Supplement (Medigap) plans
Medigap Overview:
• Private insurance policies that fill gaps in Original Medicare
• Only available to those with Original Medicare (Parts A and B)
• Standardized plans designated by letters (A through N)
• All plans must include core benefits
• The best time to purchase is during the 6-month Medigap open enrollment period
Core Benefits (included in all plans):
• Part A coinsurance and hospital costs up to 365 additional days
• Part B coinsurance or copayment
• First three pints of blood
• Part A hospice care coinsurance or copayment
Additional Benefits (vary by plan):
• Skilled nursing facility care coinsurance (all plans except A and B)
• Part A deductible (all plans except A)
• Part B deductible (Plans C and F only, no longer sold to new Medicare beneficiaries)
• Part B excess charges (Plans F and G only)
• Foreign travel emergency coverage (Plans C, D, F, G, M, and N)
Special Plan Features:
• Plans K and L have out-of-pocket limits and partial coverage of benefits
• Plans F and G offer high-deductible options in some states
• Plan N covers Part B coinsurance with copayments for some office visits
• Medicare Select plans require the use of network providers for full benefits
Learning Objective 7: Identify the three levels of long-term care and care settings
Levels of Long-Term Care:
 • Skilled nursing care: 24-hour care by licensed medical professionals
• Intermediate care: Intermittent nursing and rehabilitative care by skilled personnel
• Custodial care: Assistance with daily personal needs by trained non-medical personnel
Long-Term Care Settings:
• Nursing homes: Provide 24-hour skilled nursing care
• Assisted living facilities: Offer intermittent nursing services and personal assistance
• Home health care: Skilled services provided in the patient's home
• Home care: Personal assistance with daily activities in the patient's home
• Adult day care: Supervision and activities while the primary caregiver is absent
• Continuing care communities: A Range of services from independent living to nursing care
• Respite care: Temporary relief for primary caregivers
Types of Care:
• Formal care: Paid care by professional caregivers (covered by LTC insurance)
• Informal care: Unpaid care by family members (not covered by LTC insurance)
Learning Objective 8: Explain benefit triggers and qualification requirements for long -term care
insurance
Benefit Triggers:
• Loss of physical function: Inability to perform activities of daily living (ADLs)
• Cognitive impairment: Deficiency in memory, orientation, reasoning, or judgment
Activities of Daily Living (ADLs):
• Bathing, dressing, toileting, transferring, continence, and eating
• Most policies require the inability to perform 2+ ADLs to qualify for benefits
Substantial Assistance Types:
• Hands-on assistance: Physical help with ADLs
• Stand-by assistance: Supervision within arm's length during activities
Policy Exclusions:
• War, self-inflicted injuries, or attempted suicide
• Drug or alcohol treatment
• Mental illness (unless from an organic disease)
• Care outside the U.S.
• Care covered by workers' compensation
Long-Term Care Insurance Types:
• Stand-alone policies: Traditional LTC insurance
• Life insurance riders: Use portion of death benefit for LTC
• Hybrid (asset-based) plans: Combine life insurance or annuity with LTC benefits
Learning Objective 9: Describe tax considerations for long-term care insurance policies
Non-Qualified LTC Policies:
• Premiums not tax-deductible
• Benefits are taxable if they exceed actual care expenses
• No specific requirements under federal tax law
Tax-Qualified LTC Policies (HIPAA Standards):
• Premiums may be tax-deductible as medical expenses
• Self-employed individuals can deduct premiums from income
• Benefits received are generally tax-exempt
• Must meet specific HIPAA criteria:
• Cannot cover Medicare-reimbursable expenses
• Must use specific benefit triggers (2+ ADLs or cognitive impairment)
• Must be guaranteed renewable
• Cannot include cash surrender value
 • Must have a 30-day free-look period
• Claims must be based on a 90+ day disability diagnosis
Policy Features Required for Tax Qualification:
• No prior hospitalization requirement
• No requirement for a higher level of care before a lower level of care is covered
• No cash surrender non-forfeiture option
• Medical diagnosis and plan of care by a healthcare professional
Learning Objective 10: Explain how Medicare, Medicaid, and long-term care insurance work together
Medicare Coverage Limitations:
• Focuses on acute care and recovery, not long-term maintenance
• Covers skilled nursing facility care for up to 100 days following hospitalization
• Does not cover custodial care or extended nursing home stays
• Limited home health care benefits
Medicaid and Long-Term Care:
• Means-tested public program for low-income individuals
• Primary public payer for long-term services and support (LTSS)
• Requires spending down assets to qualify
• Examines asset transfers during a 5-year look-back period
• Covers nursing home care and some home-based services
Long-Term Care Partnership Programs:
• Federally supported, state-operated initiatives
• Allow protection of assets equal to LTC insurance benefits paid
• Policies must be tax-qualified and include inflation protection
• Enable individuals to qualify for Medicaid without spending all assets
Coordination of Benefits:
• Medicare: Primary for acute care and short-term recovery
• Long-term care insurance: Covers extended care needs not met by Medicare
• Medicaid: Safety net after personal assets and LTC benefits are exhausted
Exam Tips:
• Know the differences between Medicare Parts A, B, C, and D
• Understand enrollment periods and penalties for delayed enrollment
• Memorize Medicare cost-sharing amounts and benefit periods
• Know the core benefits included in all Medigap plans
• Understand the three levels of long-term care
• Know the benefit triggers for long-term care insurance
• Understand the tax differences between qualified and non-qualified LTC policies
• Know how the Long-Term Care Partnership Program works
Chapter 18
[1] HEALTH INSURANCE POLICY PROVISIONS INTRODUCTION
Imagine you've just received your new health insurance policy in the mail. As you flip through the pages, you
notice various clauses, provisions, and legal terminology that seem overwhelming. What do these provisions
mean? How do they affect your coverage? And most importantly, how will they impact you when you need to
file a claim?
Health insurance policies contain standardized provisions that protect both you and the insurance company.
These provisions establish the rules governing the relationship between the insurer and the insured, defining
everything from when and how claims must be filed to the circumstances under which a policy can be
renewed or canceled.
In this chapter, we'll explore the world of health insurance policy provisions, beginning with the standardized
provisions established by the National Association of Insurance Commissioners (NAIC). You'll learn which
provisions are mandatory to protect consumers and which are optional but serve important functions for
insurers. We'll also examine how renewability provisions determine the long-term stability of your coverage
and how exclusions and limitations define what isn't covered.
Understanding these provisions isn't just academic—it's practical knowledge that will serve you well as an
insurance professional helping clients navigate their coverage options. Whether explaining a grace period to a
client who missed a premium payment or clarifying how a pre-existing condition might affect coverage,
mastering these concepts will be essential to your success in the insurance field.
This chapter is divided into the following sections:
• NAIC Model Uniform Health Insurance Policy Provisions
• Additional Necessary Policy Provisions
• Renewability Provisions
• Policy Exclusions, Limits, and Restrictions
• Additional Health Insurance Policy Provisions
The state-specific portion of this course (located at the end) details the specific insurance definitions, rules,
regulations, and statutes for your state. In the event of a conflict, state law supersedes the general content.
[1.1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
• Identify the 12 mandatory uniform health insurance provisions required by the NAIC model law
• Distinguish between the 11 optional uniform health insurance provisions and explain their purpose
• Compare different types of renewability provisions and their implications for policyholders
• Recognize common exclusions, limitations, and restrictions in health insurance policies
• Explain how pre-existing condition provisions affect coverage
• Describe additional policy provisions such as coordination of benefits and subrogation
• Differentiate between various beneficiary designations and their implications
• Apply the principle of indemnity to health insurance scenarios
[1.3] KEYWORDS
Before reading this chapter, please review the following keywords. Understanding these basic definitions will
improve your comprehension of the chapter content.
Absolute Assignment: A policy assignment where the assignee receives full control over the policy and full
rights to its benefits.
Accidental Death Benefit Rider: Pays an additional sum to the beneficiary if the insured dies due to a covered
accident, often a multiple of the policy face amount.
Accelerated Benefits Rider: Allows the insured to receive a portion of the death benefit before death if they
have a terminal illness.
Coordination of Benefits (COB): A provision that prevents duplication of benefit payments when an individual
is covered under multiple health plans, limiting total payments to no more than the actual medical expenses.
Entire Contract Clause: Defines the entire contract consisting of the policy form, the insured's application,
and any papers attached to the policy document.
Free-Look Period: The specified number of days (typically 10) after policy delivery during which the
policyholder can examine the policy and return it for a full premium refund if dissatisfied.
Grace Period: The period after a premium due date during which coverage remains in force without penalty
(seven days for weekly premiums, 10 days for monthly premiums, and 31 days for other payment
frequencies).
Guaranteed Renewable Policy: A policy that cannot be terminated as long as premiums are paid, though the
insurer can increase premiums for an entire class of policies.
Impairment Rider: Also called an exclusion rider, it restricts coverage for a specific illness or injury for a
period of years or for the life of the policy.
Noncancelable Policy: A policy that cannot be canceled by the insurer, and premiums cannot be increased
as long as the policyholder pays premiums.
Pre-Existing Condition Provision: A clause stating that coverage will not be provided for health conditions
that existed before the policy became effective.
Proof of Loss: A provision requiring insureds to demonstrate that a loss occurred, typically within 90 days of
the loss.
Reinstatement Provision: Allows a lapsed policy to be put back in force by providing evidence of insurability
and paying past-due premiums.
Subrogation: Allows an insurance company to pursue a third party that caused a covered loss to recover the
amount paid to the insured.
Time Limit on Certain Defenses: A provision that makes a policy incontestable after it has been in force for a
specified period (two to three years), similar to the incontestability clause in life insurance.
[2] NAIC MODEL UNIFORM HEALTH INSURANCE POLICY PROVISIONS
Several years ago, the National Association of Insurance Commissioners (NAIC) created a model law, the
Required Uniform Individual Accident and Sickness Policy Provisions Law. Nearly all states have adopted
this model law or similar legislation. The goal of the NAIC law was to recommend consistent terms,
provisions, and wording standards for all individual health insurance contracts. According to the NAIC model
law, there are 12 mandatory uniform provisions and 11 optional uniform provisions.
All 23 provisions are written in standard language to be used in every case. Insurance companies that wish to
use their own wording must obtain approval from their state regulators, and the language cannot be less
favorable to the insured.
Out of the 23 provisions, 12 are mandatory. Insurance companies must include them in all individually
underwritten contracts. These 12 provisions protect the insured’s interests and are not specific to any
particular type of accident or health insurance policy.
The remaining 11 provisions are optional. In some cases, they only apply to certain policies, such as the
“relation of earnings to insurance” clause in an individual disability policy. In all cases, they serve to protect
the insurance company's interests. When included, they define the insurer’s rights and, in doing so, limit
those rights.
EXAM TIP
To distinguish which provisions are mandatory and which are optional, ask the question, “Who benefits from
the provision?” A mandatory provision is generally there for the insured’s benefit. An optional provision is for
the benefit of the insurer.
[2.1] THE 12 MANDATORY UNIFORM PROVISIONS
[2.1.1] THE ENTIRE CONTRACT CLAUSE
In the context of health insurance, the entire contract clause defines what constitutes the full agreement
between the insurer and the insured. This clause includes:
• The official policy form,
• The signed application, and
• Any attachments, such as riders or endorsements.
This provision serves to protect the policyholder by ensuring:
• Only the listed documents are considered part of the contract—external materials or verbal
agreements hold no weight.
• Once the policy is issued, no changes to its terms can be made unless the insured provides written
consent.
• Any modifications must be approved by an executive officer of the insurance company and formally
added to the policy through an endorsement or rider.
EXAM TIP!
Remember WYSIWYG. “What you see is what you get!”
[2.1.2] TIME LIMIT ON CERTAIN DEFENSES (INCONTESTABILITY)
The time limit on certain defense clauses, also known as the incontestability provision, establishes a
timeframe after which an individual health insurance policy becomes incontestable. Under the NAIC Model
Act, insurers have up to three years to contest information provided in an application. That said, most states
have adopted modified versions of this model, reducing the contestability period to two years. Fraud always
overrides the time limit—no matter how long the policy has been in force. When fraud is discovered, the
insurer may rescind or void the policy as of its original date, refund all premiums paid, and deny all claims. In
other words, the policy never existed. With the passage of the Affordable Care Act (ACA) in 2010, the Time
Limit on Certain Defenses provision is greatly restricted on individual major medical insurance policies
covered by the ACA
EXAM TIP
Unless the test references state law or integrates law and general questions, assume the time limit on
certain defenses is three years because that’s the time limit that was established in the Model Act. In other
cases, check the time limit as defined by state law. If there’s no specific reference, then assume three years
in such cases as well.
[2.1.3] GRACE PERIOD

[2.1.4] REINSTATEMENT
Under certain conditions, a policyholder may reinstate a lapsed accident and health policy. The
reinstatement provision limits reinstatement payments to premiums due within the previous 60 days.
Reinstatement is automatic if the company or its authorized agent accepts the delinquent premium, and the
company does not require a reinstatement application.

Policy terms must provide the policy owner with a defined number of days after the premium due date to
make the delayed premium payment without penalty or loss of coverage. This time is referred to as the grace
period. The minimum grace period depends on the contract’s frequency of premium payments. Under the
NAIC Model Act, the specified minimum grace periods are as follows:
1) Seven days for policies with weekly premiums
 2) 10 days for policies with premiums payable monthly
3) 31 days for other policies (standard)
If the policy owner fails to pay the premium before the grace period expires, the policy will lapse.
To protect the company against adverse selection, reinstatement terms include a 10-day probationary
period. Losses resulting from sickness are covered only if the sickness occurs at least 10 days after the
reinstatement date.
If the insurer requires an application to effect a reinstatement, the provision requires the insurer to respond
within 45 days. If the insurer takes no action on the application for 45 days, the policy is reinstated
automatically. The policy will cover accidents immediately upon reinstatement.
[2.1.5] NOTICE OF CLAIM
The notice of claim provision describes the policyowner’s obligation to notify the insurer of loss within a
reasonable period. This mandatory provision defines this reasonable period as 20 days after the occurrence
or commencement of a disability or as soon after that as is reasonably possible.
For disability claims, an insurer may require the insured to provide a notice of claim every six months to
ensure the disability remains ongoing. This periodic notice of claim requirement applies to any claim that may
be payable for more than two years based on the policy benefit period.
EXAM TIP!
Unless the exam specifies a disability claim or special circumstances, assume the notice of claim is due
within 20 days of the loss.
[2.1.6] CLAIM FORMS (OR PROOF OF LOSS FORM) PROVISIONS
It is the insurance company’s responsibility to supply a claim form to an insured within 15 days after
receiving notice of a claim. If the insurance carrier fails to provide a claim form within 15 days of receiving
notice, the insured can provide proof of loss using any available means. In such cases, the company must
accept the insured’s submission as adequate proof of loss.
[2.1.7] PROOF OF LOSS
Insureds must demonstrate to their insurance company that a loss occurred. They need to provide proof of
loss in addition to notifying an insurance carrier that a loss occurred. After a loss occurs, claimants have 90
days to submit their proof of loss. However, if an insured is legally incapable of providing proof of loss within
90 days, that insured can still provide proof of loss for up to one year after the occurrence. Insurers must
make claim payments, those that are not paid periodically, immediately u pon receiving proof of loss.
[2.1.8] TIME PAYMENT OF CLAIMS
The time payment of claims provision requires the insurer to pay a claim immediately upon receiving
notification and proof of loss. If the claim involves disability income payments, the insurer must make
payments no less frequently than monthly.
EXAM TIP!
When an exam describes the required frequency of disability payments, it may reference the minimum
requirements as “no less frequently than monthly.” An accurate reading is essential.
[2.1.9] PAYMENT OF CLAIMS
The payment of claims provision states that health insurance benefits must be payable to the insured. It also
allows insurers to pay benefits directly to a hospital or medical service provider. If a health insurance policy
provides a death benefit, this provision requires payment of the benefit to a named beneficiary. If a
beneficiary is not named, then the benefits will go to the insured’s estate. If the beneficiary is a minor, then
the insurer must pay the benefits to another relative by blood or marriage.
[2.1.10] PHYSICAL EXAM AND AUTOPSY
The physical exam and autopsy provision gives the insurer, at its own expense, the right to require a physical
examination or autopsy of an insured before issuing a policy or paying benefits, unless prohibited by state
law. A physical exam cannot be requested more than once every six months.
[2.1.11] LEGAL ACTIONS
The legal actions provision states that the policy owner or insured can bring no legal action against an
insurer regarding the disposition of a claim until at least 60 days after the insured provides the required
written proof of loss to the insurer. The purpose of the legal action provision is to provide the insurer with
adequate time to research a claim.
The provision states that any lawsuit the policyholder brings against the insurer must commence within three
years from the date proof of loss was provided. Some states have extended this time limit for bringing legal
action.
EXAM TIP!
Unless your state law specifies a different time frame, assume three years. Also, assume three years if the
question addresses the general topic, and the exam separates general and state-specific questions into
distinct parts of the test.
[2.1.12] CHANGE OF BENEFICIARY
The change of beneficiary provision states that the insured, as a policyowner, may change the beneficiary
designation at any time if the beneficiary is revocable. However, the policyholder cannot change an
irrevocable beneficiary designation without the beneficiary’s written consent.
[2.2] THE 11 OPTIONAL UNIFORM HEALTH INSURANCE PROVISIONS
The original NAIC Model Act recommended 11 optional provisions, which states may modify to fit their
specific requirements.
EXAM TIP!
For state exams that combine general content questions with those covering state law, please compare the
following provisions with the identically named provisions in the law section of your course. If your exam
combines state and general content, use the state law versions of these provisions if they differ. Students
whose exams separate state law and general content into separate sections should use the information in
this chapter to answer questions in the general section of their state exam.
[2.2.1] CHANGE OF OCCUPATION
The change of occupation provision addresses situations in which an insured changes occupation without
notifying the insurance company. A change in occupation means a change in risk level. The change of
occupation provision allows the insurer to address this change without disrupting coverage.
According to this provision, the insurer can make the following adjustments:

• If the insured changes to a less hazardous job, the insurer will reduce the premium and return any
excess unearned funds. The policy benefit will remain the same.
• If the insured changes to a more hazardous occupation, the insurer will reduce the benefits
proportionately, but the premium remains the same.
EXAM TIP!
If the new occupation is less dangerous (i.e., lower risk for the insurer), the premium will be reduced. If the
new occupation is more dangerous (i.e., higher risk for the insurer), the premium will be increased.
[2.2.2] MISSTATEMENT OF AGE
If an insured misstates their age on the health insurance application, the misstatement of age provision
allows the insurance company to adjust benefits accordingly.
• If an insured individual understates their age on an insurance application, the insurer will reduce the
benefits payable to the amount that should have been provided had the correct age been stated on
the application.
• If an insured individual overstates their age on an insurance application, the insurer will increase the
policy benefit, unless the change results in a benefit that exceeds the loss or allowable indemnity. In
such a case, the insurer will reduce the premium and return any excess amount paid.
EXAM TIP:
If the stated age is too low, the benefits will be lowered once the age is raised. If the stated age is too high,
the benefits will increase once it is lowered.
 [[Link]] APPLICATION SCENARIO: MISSTATEMENT OF AGE IN A DISABILITY INCOME POLICY
BACKGROUND: Jordan, a 30-year-old professional, applies for a disability income insurance policy to
secure financial support in case of illness or injury. At the time of application, Jordan mistakenly lists her age
as 25 instead of 30.
POLICY DETAILS:
• Monthly benefit requested: $500
• Annual premium paid: $100
DISCOVERY: After the policy is issued, the insurer discovers the age misstatement. According to the policy's
Misstatement of Age provision, the insurer does not cancel the policy. Instead, it adjusts the benefit to reflect
what the $100 premium would have purchased for a 30-year-old applicant.
ADJUSTMENT OUTCOME:
• Corrected monthly benefit: $400
The new amount reflects the amount of coverage $100 would buy for someone aged 30.
IMPLICATION: Jordan continues to pay the same annual premium of $100, but the monthly disability benefit
is reduced to $400 to align with the correct age-based rate.
[2.2.3] OTHER INSURANCE WITH THIS INSURER
The other insurance with this insurerprovision states that if the insured is already covered by more than one
policy with the same insurer, only the maximum benefit from one policy is payable. The insurer terminates
the other contract and refunds the premium. The purpose of this provision is to prevent an insured from
profiting by being covered by multiple policies purchased from the same insurer. This provision is designed to
protect the insurer.
[2.2.4] INSURANCE WITH OTHER INSURER
If the policy owner possesses duplicate coverage with another insurer on “an expense incurred
(reimbursement) basis,” the Insurance With Other Insurers provision states that the insurers each share
responsibility for paying any claim. The benefit payable is limited to the total loss, and each insurer’s liability
is limited to its proportionate share of the expenses incurred.
For example, let’s assume that this optional provision appears in a medical expense plan. An insurer returns
premiums to an insured on a prorated basis and pays only a portion of the medical expenses incurred. In this
case, it is generally because the insurer has discovered that the insured has duplicate coverage.
The purpose of the “insurance with other insurer” clause is to address the potential problem of over -
insurance. It addresses the same issue as the “coordination of benefits” provision in a group insurance
policy.
[2.2.5] INSURANCE WITH OTHER INSURERS
This form of the Insurance With Other Insurers provision is rarely included in policies today. It is identical to
the previous provision, except that it applies to benefits that are provided on an “other than expense incurred
basis.” This provision applies to insurance policies that pay claims on an indemnity basis, especially those
that cover a “loss of time,” such as disability insurance. This provision allows an insurer to pay benefits to the
insured on a pro rata basis when the insurer was not notified before the claim that the insured had other
health coverage. It also allows for the return of premiums that exceed the amount needed to pay for the
company’s portion of the prorated benefit.
[2.2.6] RELATION OF EARNINGS TO INSURANCE (AVERAGE EARNINGS) CLAUSE
The relation of earnings-to-insurance provision appears in disability income policies. It prevents over-
insurance by protecting an insurer against an insured who purchases multiple policies that, together, pay a
monthly benefit greater than the monthly income lost by the insured. In such cases, the maximum benefit
paid by all insurers combined cannot exceed the income lost. Applicable policies pay benefits on a pro
rata or proportionate basis.
Typically, insurers include this provision in noncancelable or guaranteed renewable policies. This provision
also protects against moral hazards (i.e., filing a false claim). In the current NAIC Model, this provision is
combined with the “loss of time” version of "Insurance with Other Insurers".
[2.2.7] UNPAID PREMIUMS
The unpaid premiums provision states that the insurer may deduct any unpaid or owed premiums from the
policy’s benefits. This clause is generally used when a premium has not been paid by its due date and the
insured suffers a covered loss during the grace period.
If an insurer pays an individual’s accident and health insurance claim during a policy’s grace period, the
insurer may subtract the unpaid premium from the reimbursement.
[2.2.8] CANCELLATION
Most states prohibit this cancellation provision. This clause generally appears in cancellable contracts. It
states that the insurer could terminate or cancel the contract at any time with a five-day written notice to the
insured. Any claims that originated before the cancellation would be paid.
[2.2.9] CONFORMITY WITH STATE STATUTES
As the policy states, the conformity with state statutes clause “modifies the policy to comply or conform
with minimum state requirements.”
EXAM TIP!
This provision’s title may lead one to believe that it is a required or mandatory provision, but it is not. Optional
provisions are for the insurer’s benefit or protection. This provision protects the insurer by ensuring
compliance with the state minimum requirements.
[2.2.10] ILLEGAL OCCUPATION
This clause allows insurers to deny claims when an insured is injured while committing an illegal act (e.g.,
robbing a bank) or engaging in a felonious occupation (e.g., operating a meth lab). If the insurance company
discovers the illegal occupation after it has made a claim payment, it will subsequently deny the claim and
attempt to recover the funds.
[2.2.11] INTOXICANTS AND NARCOTICS
This clause relieves the insurance company of liability for losses if the insured was under the influence of
non-prescribed drugs or alcohol at the time of the loss. This clause does not govern physician -prescribed
drugs that are used as directed.
[3] ADDITIONAL NECESSARY POLICY PROVISIONS
Some provisions are necessary for any insurance policy, although the language is not regulated, and
placement is not mandated.
[3.1] FREE-LOOK (RIGHT TO EXAMINE/RETURN) CLAUSE
Most health insurance policies include a free-look provision, typically giving policyholders 10 days from the
date of delivery to review their policy. During this period, returning the policy entitles the insured to a full
premium refund. Policies sold through direct mail and some specialized policies, such as Medicare
supplements, offer extended 30-day examination periods.
This provision, also called the "right to examine," is usually prominently displayed on the policy's face page.
The notice of the right to examine generally appears on the policy's face page.
For example, if a policy is delivered on January 27th, when will the 10-day free look end? To determine when
it ends, begin counting the day after the delivery date (i.e., January 28th) as day one. Therefore, the free -look
period will end on February 6th.
[3.2] INSURING CLAUSE
The insuring clause is the part of a health insurance policy that specifies the types of benefits provided and
the circumstances under which they will be paid. This clause also identifies the contract’s start date and the
end of the coverage term. Essentially, it defines the insurance company’s promise to pay benefits.
[3.3] CONSIDERATION CLAUSE
For any contract to be legal and enforceable, both parties must exchange something of value. The
consideration is the item of value that gets exchanged. The consideration clause defines the insured’s
consideration, just as the insuring clause defines the insurance company’s promise in exchange.
The policy owner’s consideration consists of the following two elements:
• The premium paid
 • The statements (representations) made on the health insurance application
[4] RENEWABILITY PROVISIONS
Health insurance policies contain a wide range of renewability provisions that define the circumstances
under which an insurer may change or terminate an existing contract. An insured policyholder may cancel an
existing policy at any time by notifying the insurance company in writing. These provisions define the rights of
the insurance carrier. Some provisions are more favorable to the insured, while others favor the insurance
carrier. The available types of these provisions are listed below in order of their favorability to the
policyholder, starting with that which is most favorable:
• Noncancelable policies
• Guaranteed renewable policies
• Conditionally renewable policies
• Optionally renewable policies
• Nonrenewable policies
• Period of time policies
• Cancelable policies
When comparing contracts with comparable benefits, the type of renewability clause will have an impact on
the cost. Insurers will charge higher premium rates if the renewability clause favors the policyholder.
The insurance company can also end coverage if the renewability provision ceases at a certain age (as
stipulated in the policy). Also, as demonstrated by the following provisions, the insurance carrier can always
cancel a policy if the insured fails to pay the premium by the end of the grace period.
[4.1] NONCANCELABLE POLICIES
A noncancelable policy cannot be canceled by the insurer as long as the policy owner pays the premium. In
some cases, contracts refer to this type of policy as “noncancelable and guaranteed renewable.” A
noncancelable policy provides the following double guarantee to the policyholder:
• The insurer cannot terminate coverage unless the policyholder fails to pay the premium, and
• The insurer can neither modify the policy’s terms nor increase the premium.
Since this type of renewal provision is the most advantageous renewal provision for a policyholder, it is also
the most expensive. These policies are renewable up to a specified age, after which the insurer may
terminate coverage.
For example, Kayla, a 35-year-old surgeon, has a non-cancellable disability income policy to protect her high
income. Two years after enrolling, Kayla develops early symptoms of a degenerative condition that could
eventually affect her ability to perform surgery. Despite her health changes:
• Her premiums cannot be increased
• Her coverage terms cannot be modified
The terms of her policy remain as they have been as long as she pays her premiums. This guaranteed stability
provides Kayla with crucial financial security as she navigates her medical career with an uncertain health
future, justifying the higher premium she pays for this level of protection.
[4.2] GUARANTEED RENEWABLE POLICIES
An insurer cannot terminate a guaranteed renewable policy as long as the policyholder pays the premium in a
timely fashion. Additionally, an insurance company cannot alter any policy benefits, conditions, or terms.
An insurance company may increase premiums to reflect changes in risk for guaranteed renewable policies.
However, the provision only allows premium increases based on changes to an entire class of policies, not to
an individual.
For example, a disability income insurer can raise premiums on all policies that are issued to truck drivers
and comparable blue-collar occupations in response to an aggregate increase in morbidity, but it cannot
increase the premiums paid by a specific truck driver because that individual had filed a disability claim.
Some individual disability insurance policies use this renewal provision, as do long -term care insurance
carriers and Medicare Supplement plans.
[4.3] CONDITIONALLY RENEWABLE POLICIES
Under the terms of a conditionally renewable policy, an insurer may terminate the contract under certain
conditions as stated in the policy. There is a guarantee of continuance, but not to the extent of noncancelable
or guaranteed renewable policies. The conditions that allow an insurance company to cancel a policy
typically involve the insured reaching a certain age or losing gainful employment. However, the reasons for
the termination of coverage cannot be related to the insured’s health. They are based on general conditions,
not individual insurability.
As for policy premiums, conditionally renewable contracts can increase premiums at the time of renewal on
a class basis only.
[4.4] OPTIONALLY RENEWABLE POLICIES (RENEWABLE AT THE COMPANY’S OPTION)
The optionally renewable policy provision is much more favorable to the insurance company. This provision
states that the insured has no guarantee of continuance beyond the current policy renewal. The insurer can
continue an optionally renewable policy or terminate any individual contract at its renewal date with notice to
the policyholder. Additionally, the insurer has the option to increase premiums.
[4.5] NONRENEWABLE POLICIES
Nonrenewable policies are generally associated with short-term health insurance. These are policies in
force for one year or less and are considered temporary. Policyholders often use them to bridge anticipated
coverage gaps.
Timeline: Nonrenewable Short-Term Health Insurance
• Month 0: Policy purchase date. Coverage begins for a temporary six-month policy.
• Month 3: Mid-policy review. No option to extend beyond the original term.
• Month 5: Notification of approaching expiration. Reminder to secure permanent coverage.
• Month 6: Policy expiration. Coverage ends with no renewal option.
• Month 6+: Post-coverage gap. The insured must obtain new insurance (employer plan, ACA
marketplace, etc.).
[4.6] PERIOD OF TIME POLICIES
Health insurance policies (e.g., “short-term major medical” plans)—also referred to as term policies—are
only renewable for a stipulated term (e.g., six months) or period. When the “term” expires, so too does the
coverage.
[4.7] CANCELABLE POLICIES
Cancelable policies may be terminated by either the insured or the insurer. The renewability provision in a
cancelable policy allows the insurer to cancel the policy at any time. As with the other insurance contracts,
the insurance carrier must return any unearned premiums. An insurer must also provide the insured with
written notice of cancellation. Since this renewability provision is the least advantageous to an insured, the
premium for this type of plan is lower than that of other plans. An insurer may cancel this type of policy if an
insured files too many claims in a given policy period.
[5] POLICY EXCLUSIONS, LIMITS, AND RESTRICTIONS
The exclusions section is NOT included in the policy face (first page of an insurance policy) . However,
medical expense, disability, accident, and other health and sickness insurance policies frequently indicate
several exclusions or conditions that are not covered, such as:
• Injuries due to war or an act of war, self-inflicted injuries, and injuries that were incurred while the
insured served as a pilot or crew member of an aircraft
• Military service if the insured is covered by the government while in its service. Some insurers also
include a military suspension provision that limits or suspends disability income protection while the
insured is serving in the armed forces.
• Foreign travel may not necessarily be excluded for short trips, but extended stays overseas or foreign
residence generally result in a temporary suspension or loss of coverage.
• Noncommercial air travel (e.g., test pilot, amateur pilot)
• Losses resulting from suicide or the use of drugs or narcotics
o Losses related to a hernia (as an accidental injury)
 • The loss may be covered under a medical expense policy
• Losses due to riots and injuries that are sustained while committing a felony or attempting to do so
• Occupational injuries and illnesses that workers’ compensation covers, or care that is paid by the
Department of Veterans Affairs
• Cosmetic surgery, experimental surgery, vision correction (i.e., eye exams), general dentistry
o Medically necessary cosmetic surgery, vision treatment, and dental treatment may be covered
if the issue is a result of an accident (e.g., a baseball player took a fastball to the face and
needed treatment to resolve vision and mouth issues).
• Medical necessity. Even if an insured has a benefit for a particular service, the insurer will only cover
medically necessary treatments.
For example, while Diedra’s medical expense policy covers appendix removal, the insurance company will
not cover the cost if Diedra wants to “proactively” have her appendix removed without a medical need.
[5.1] PRE-EXISTING CONDITIONS PROVISIONS
The pre-existing condition provision states that coverage under the health insurance policy in question will
not be provided for any health condition of the insured that existed before the policy became effective.
Insurers often use this exclusion to deny coverage for conditions that were not disclosed on the insurance
application. If an applicant does indicate the existence of existing health-related conditions, the insurer can
take one of the following courses of action:
• The insurer can deny the application,
• The insurer can charge more for the policy,
• The insurer can permanently exclude coverage for the conditions and charge a standard premium, or
• The insurer can deem the condition to be relatively minor and either cover it from “day one” or apply
the standard pre-existing condition exclusion.
Disability and medical expense policies that are not affected by the Affordable Care Act (ACA) typically
exclude benefits for losses due to pre-existing conditions, such as illness, disease, or other physical
impairments. This provision is essential in group insurance or other contracts in which no individual
underwriting is performed or in which any such underwriting is simplified.
This provision helps protect an insurer regardless of whether an applicant knows he is ill. Therefore, its
purpose is to protect an insurer against adverse selection. Such exclusions are subject to the “time limit on
certain defenses” provision. In general, insurers may not include this provision with a waiting period of more
than 12 months.
[5.1.1] SCENARIO APPLICATION: MARCUS APPLIES FOR HEALTH INSURANCE
Marcus, a 42-year-old freelance graphic designer, applies for a new individual health insurance policy. On his
application, he discloses that he was diagnosed with mild asthma five years ago but has had no recent flare -
ups. After reviewing Marcus’s application, the insurer has several options:
• Deny the application entirely due to the disclosed condition
• Approve the policy, but charge a higher premium to account for the increased risk
• Approve the policy at a standard premium but permanently exclude coverage for asthma -related
treatments
• Deem the asthma minor, and either:
o Cover it from day one, or
o Apply a 12-month pre-existing condition exclusion (no coverage for asthma-related issues for
a year).
This provision protects the insurer from adverse selection—where individuals with known health issues
might seek coverage only when they anticipate needing care. It also applies even if Marcus was unaware of
the condition at the time of application.
[5.2] IMPAIRMENT (WAIVER FOR IMPAIRMENT) RIDER
An impairment rider is also referred to as an exclusion rider, coverage waiver, or waiver of disability. If a pre -
existing condition is severe enough, the insurer may issue an impairment rider, which will restrict coverage
for the illness or injury in question for a period of years or for the life of the policy. If attached to a health or
disability income contract, it may indicate that the insurer is accepting greater risk. Because the insurer may
be unable to adequately assess the total risk, it may decide to provide coverage for the individual with
coverage limited or excluded for the impairment in question (e.g., illness, injury, etc.). This type of rider can
be issued either with or without an extra premium charge.
For example, a person has been issued a disability income policy. Since the person has undergone several
(left) knee operations, the insurer may attach an impairment rider stating that it will not provide coverage if
total disability results from any injury to the (left) knee. If such a rider is added, the producing agent should
clearly explain the limitation.
If an impairment rider is attached to a policy, its restrictions or limitations must be explained to the policy
owner at the time of delivery. Generally, policy owners must sign a statement indicating they are aware of
and understand the effects and limitations of this type of rider.
[5.3] PROBATIONARY PERIOD/INCUBATION PERIOD
Health insurance contracts often use probationary periods to avoid paying for losses that occurred before
coverage began, but are not yet apparent. In an employer-sponsored group plan, this period takes the form of
delayed eligibility. One must be employed for some period of time before becoming eligible for coverage.
In an individual accident and health insurance policy, the probationary period is a provision that becomes
effective at the inception of the policy or upon reinstatement. It is a one-time event that temporarily delays
coverage for illnesses once the policy is in force.
Coverage for sickness or illness begins only after the probationary period expires, but coverage for accidents
is immediate from the moment a policy becomes effective. Coverage for accidents is immediate because we
can know exactly when and where an accident and the resulting loss occur. On the other hand, the onset of
an illness is less certain. We can contract a disease some days before the symptoms appear. COVID -19 is a
case in point. The probationary period helps the insurer avoid paying claims for illn esses an insured may have
contracted before the policy's effective date. In other words, the probationary period allows an insurer to
deny pre-existing claims.
States limit the length and use of probationary periods, which last a few days rather than weeks and months.
Ten days is a common number, and at most 30.
[6] ADDITIONAL HEALTH INSURANCE POLICY PROVISIONS
[6.1] COORDINATION OF BENEFITS
The coordination of benefits provision, commonly found in group health plans, serves a crucial purpose. It
prevents the duplication of benefit payments and over-insurance when an individual is covered under
multiple group health plans. This provision ensures that the total amount of claims paid from all insurers
covering the patient does not exceed the total allowable medical expenses, thereby avoiding unnecessary
financial burden.
For example, an individual who incurs $700 in allowable medical expenses cannot collect more than $700,
regardless of how many group plans cover the same expenses.
The COB provision designates the primary plan, which is responsible for providing the full benefit amount as
specified in its contract terms. Once the primary plan fulfills its commitment, the insured can submit the
claim to the secondary provider for any additional benefits. However, the total amount received by the
insured will never exceed the costs incurred or the total maximum benefits available under all plans.
Coordinating benefits is appropriate for married couples when each is covered by the other’s employer group
plan, as well as their own.
For example, John and Cindy, a young married couple, each participate in their own company’s health plan
and are also covered as dependents under their spouse’s plan. John’s plan is his primary plan, while Cindy’s
plan is his secondary insurer. Likewise, Cindy’s plan is her primary plan, while John’s plan is her secondary
carrier. For dependent children coverage, the plan of the parent whose birthday comes first during the
calendar year is the primary, while the other parent’s plan is secondary.
Coordination of benefits also applies to workers with Medicare. Workers who are age 65 or older and have an
employer group health plan will receive primary coverage from that plan if their employer has 20 or more
employees (which makes them a “COBRA group” or a group regulated by COBRA). In such cases, Medicare
provides secondary coverage on all claims except for work-related injuries and illnesses.
Medicare is always the primary coverage for anyone with retiree medical insurance through an employer or
any worker covered by an individual health insurance policy. It is also primary when group plans cover
employer groups of less than 20 employees.
[6.2] OWNER’S RIGHTS PROVISION/ASSIGNMENT
This provision states that the policyholder is entitled to all ownership rights under the health insurance
contract, including the right to assign benefits payments directly to service providers. Unlike life insurance,
policyowners do not have an unlimited ability to transfer their rights. They do not have the right to transfer
ownership of their policies.
The right of assignment, included in most commercial health policies, permits policyholders to assign benefit
payments directly to the health care provider. This provision allows the policyholder to avoid paying the
medical care provider out of pocket and subsequently seeking reimbursement from the insurer.
Nevertheless, the right to assign policy benefits does not alter the underlying principle that the policy
reimburses the insured for eligible medical expenses.
[6.3] NO LOSS/NO GAIN PROVISION
These are state laws that are designed to prevent policyowners from profiting from the purchase of
insurance. Such statutes declare that the purpose of insurance policies is primarily to “indemnify” (restore) a
person for a loss. The principle of indemnity involves making policy owners “whole” again or restoring them
to the same financial position they were in before an illness.
[6.4] RESTORATION OF BENEFITS
The restoration of benefits provision states that the amounts paid out for a loss do not reduce the total
available benefits for future claims. In some cases, the restoration is immediate, as with disability insurance,
which has a per-claim benefit. Some types of insurance restore benefits at the end of a policy period. Other
types (e.g., long-term care) may add this benefit as a rider that restores benefits if an insured recovers and
remains claim-free for a defined period.
[6.5] BENEFIT PAYMENT PROVISION
In a health insurance policy, the benefit payment provision states how benefits will be paid. The method of
paying benefits will vary depending on the type of policy. For instance, disability insurance pays a periodic
(weekly or monthly) benefit, while medical insurance indemnifies or reimburses the insured or the medical
care provider for each expense.
[6.6] REDUCTIONS IN COVERAGE
According to the reductions in coverage provision, health insurance policies do not reduce coverage amounts
following a loss. However, most policies have maximum lifetime coverage limits, which are stated in the
policy.
[6.7] MILITARY SUSPENSE PROVISION
This provision temporarily suspends coverage when an insured is called up to active military service. When
the period of service ends, the insured can resume coverage without a loss of benefits or a coverage gap.
[6.8] SUBROGATION
Subrogation occurs when a person with a legal claim against another person transfers the right to pursue that
legal claim to a third party. In an insurance context, this occurs when an insurance company pursues a third
party who caused a covered loss to its client. The insurance company will pay any amount due to its insured
policyholder and then take legal action against the liable third party to recover the amount. Subrogation
allows the insured to get paid faster while allowing the insurer to recover the amount it paid to the insured for
the loss. It also prevents the insured from collecting more than once on a single loss.
[6.9] MODES OF PREMIUM PAYMENT PROVISION
When included, this provision governs the premium mode and allows the policyholder to select from several
premium payment frequencies (e.g., monthly, quarterly, semiannual, or annual). The annual mode is the least
expensive, while the monthly mode is the most expensive. Health insurance policies do not offer a “single
premium” or “paid up for life” payment option
[6.10] WAIVER OF PREMIUM PROVISION
The waiver of premium provision waives the payment of premiums after the insured has been totally disabled
for the specified period (as stipulated in the policy).
[6.11] BENEFICIARIES AND RELATED PROVISIONS
When health insurance includes a death benefit—as in the case of an accidental death and dismemberment
policy—the uniform mandatory provisions include a “change of beneficiary” provision. This provision may
require detailed information commonly associated with life insurance.
Insurance gives the insured the ability to deliver benefits directly to named individuals or institutions without
going through probate. However, if no beneficiary is named, any death benefit is included in the insured’s
estate and is then subject to the delays and costs of the probate process.
[6.11.1] BENEFICIARY TYPES
• A revocable beneficiary may be changed or removed by the policy owner at any time without
notifying or obtaining the beneficiary's permission.
• An irrevocable beneficiary cannot be changed without the beneficiary's written consent. The
irrevocable beneficiary has a vested interest in the policy; therefore, the policy owner cannot exercise
certain rights (e.g., assignment, policy loans, surrender, etc.) without the benefici ary's consent. In
addition, an irrevocable beneficiary has the right to receive a copy of the policy.
[6.11.2] ORDER OF SUCCESSION
An insured may also decide the order in which beneficiaries receive policy death benefits. The order of
succession is as follows:
• Primary beneficiaries: The primary beneficiary is the first or principal person in line to receive the
policy proceeds income tax-free. A policy owner may designate multiple primary beneficiaries and
choose different or equal amounts for each beneficiary.
• Secondary (contingent) beneficiaries: The secondary or contingent beneficiary is the second
individual(s) in line to receive the death benefit. The primary beneficiary must predecease the insured
for this secondary beneficiary to receive any proceeds.
• Tertiary beneficiaries: A tertiary beneficiary is third in line to receive policy proceeds when the
insured dies if the insured outlives both the primary and contingent beneficiaries.
[6.11.3] UNIFORM SIMULTANEOUS DEATH ACT
How a policy responds to common disaster deaths is governed by the Uniform Simultaneous Death Act. It
states that if the insured and primary beneficiary both die in a common disaster (e.g., a plane crash) and it
cannot be determined who died first, the insured will be considered to have survived the primary beneficiary
(or died last). In other words, the primary beneficiary will be considered to have died before the insured.
Therefore, the face amount is paid to the contingent beneficiary.
[6.11.4] COMMON DISASTER PROVISION
The common disaster provision further clarifies these complex situations under the Uniform Simultaneous
Death Act by adding a survivorship clause to a life insurance policy. This clause requires that the primary
beneficiary not only outlive the insured, but also does so for a specified period (typically 14 to 30 days). The
common disaster provision ensures a policy owner that, if both the insured and the primary beneficiary die
within a short period, the death benefits will be paid to the contingent beneficiary. Benefits will only be paid
to the primary beneficiary's estate if the primary beneficiary lives past the minimum period.
[7] CHAPTER SUMMARY: HEALTH INSURANCE POLICY PROVISIONS
In this chapter, we've explored the essential provisions that underpin health insurance policies. We began by
examining the NAIC Model Uniform Health Insurance Policy Provisions, which include 12 mandatory
provisions designed to protect consumers. These provisions establish important policyholder rights, such as
the grace period for premium payments, time limits on when insurers can contest policy statements, and
requirements for filing claims.
We also covered the 11 optional provisions that insurers may include to protect their interests, such as the
misstatement of age provision and coordination of benefits. Remember that mandatory provisions generally
benefit the insured, while optional provisions typically benefit the insurer.
Renewability provisions emerged as a critical factor in determining a policy's long-term value. We compared
various types, from the most favorable noncancelable policies (which guarantee both renewal and fixed
premiums) to the least favorable cancelable policies (which offer minimal protection against termination).
The chapter also addressed important limitations on coverage through exclusions and pre -existing condition
provisions. These elements define the boundaries of coverage and help insurers manage risk while
maintaining affordable premiums for policyholders.
Additional provisions, such as coordination of benefits, subrogation, and beneficiary designations, further
refine how policies operate in real-world scenarios. These provisions ensure that insurance fulfills its primary
purpose of indemnification—restoring the insured to their financial position before the loss without allowing
for profit.
As you prepare for your licensing exam, focus on distinguishing between different types of provisions and
understanding their practical implications for both insurers and policyholders. This knowledge will not only
help you pass your exam but also provide valuable guidance to future clients navigating the complexities of
health insurance coverage.
[7.2] REVIEW NOTES
Learning Objective 1: Identify the 12 mandatory uniform health insurance provisions required by the
NAIC model law
Key Provisions:
• Entire Contract Clause: Defines what constitutes the full agreement (policy form, signed application,
attachments)
• Time Limit on Certain Defenses: Makes policy incontestable after a specified period (typically 2 -3
years)
• Grace Period: Allows delayed premium payment (7 days for weekly, 10 days for monthly, 31 days for
other frequencies)
• Reinstatement: Permits policy restoration after lapse, with a 10-day probationary period for sickness
coverage
• Notice of Claim: Requires notification within 20 days of loss or as soon as reasonably possible
• Claim Forms: Insurer must provide forms within 15 days of claim notice
• Proof of Loss: Must be submitted within 90 days of loss (up to one year if legally incapacitated)
• Time Payment of Claims: Requires immediate payment after proof of loss (monthly minimum for
disability)
• Payment of Claims: Benefits payable to the insured or directly to providers
• Physical Exam and Autopsy: Gives insurer the right to require examination at its expense
• Legal Actions: No legal action until 60 days after proof of loss; must commence within 3 years
• Change of Beneficiary: Allows the insured to change the beneficiary designation if revocable
Exam Tip:
• Mandatory provisions generally benefit the insured
Learning Objective 2: Distinguish between the 11 optional uniform health insurance provisions and
explain their purpose
Optional Provisions:
• Change of Occupation: Adjusts benefits/premiums if insured changes occupation risk level
• Misstatement of Age: Adjusts benefits to reflect the correct age-based premium
• Other Insurance with This Insurer: Prevents duplicate coverage with the same insurer
• Insurance with Other Insurers: Establishes proportionate payment for duplicate coverage
 • Relation of Earnings to Insurance: Prevents disability benefits from exceeding lost income
• Unpaid Premiums: Allows deduction of unpaid premiums from benefits
• Cancellation: Permits termination with five-day notice (prohibited in most states)
• Conformity with State Statutes: Modifies policy to comply with state requirements
• Illegal Occupation: Denies claims for injuries during illegal activities
• Intoxicants and Narcotics: Excludes coverage for losses while under the influence
• Insurance with Other Insurers (non-expense basis): Applies to indemnity-based policies
Exam Tip:
• Optional provisions generally benefit the insurer
Learning Objective 3: Compare different types of renewability provisions and their implications for
policyholders
Renewability Types (Most to Least Favorable):
• Noncancelable: Cannot be canceled or have premiums increased if premiums are paid
• Guaranteed Renewable: Cannot be canceled, but premiums can increase for one's entire class
• Conditionally Renewable: Can be terminated under specific conditions stated in the policy
• Optionally Renewable: No guarantee beyond current term; insurer can terminate at renewal
• Nonrenewable: Temporary coverage (one year or less) with no renewal option
• Period of Time: Coverage for a stipulated term only
• Cancelable: Can be terminated by the insurer at any time with notice
Important Distinctions:
• Premium costs increase with more favorable renewability provisions
• All policies can terminate if premiums are not paid by the end of the grace period
• Noncancelable provides a double guarantee: insurers can neither terminate coverage nor increase
premiums
Learning Objective 4: Recognize common exclusions, limitations, and restrictions in health insurance
policies
Common Exclusions:
• War-related injuries
• Self-inflicted injuries
• Aviation-related injuries (as a crew member)
• Military service
• Extended foreign travel
• Noncommercial air travel
• Suicide or drug use
• Hernia (as an accidental injury)
• Riot-related injuries
• Felony-related injuries
• Workers' compensation covered injuries
• Cosmetic surgery (unless medically necessary)
• Experimental procedures
• Routine vision and dental care
• Non-medically necessary treatments
Limitations:
• Probationary periods delay coverage for illness (but not accidents)
• Impairment riders restrict coverage for specific pre-existing conditions
Learning Objective 5: Explain how pre-existing condition provisions affect coverage
Pre-existing Condition Provisions:
• Excludes coverage for conditions existing before the policy's effective date
• Insurer options for disclosed conditions:
 o Deny application
o Charge a higher premium
o Permanently exclude the condition
o Cover the condition from day one
• Subject to the "time limit on certain defenses" provision
• Waiting periods are typically limited to one year
• Protects the insurer against adverse selection
Impairment Riders:
• Restricts coverage for specific illness/injury
• May apply for a period of years or the life of the policy
• Must be explained to the policyholder at delivery
• May be issued with or without a premium increase
Learning Objective 6: Describe additional policy provisions, such as coordination of benefits and
subrogation
• Coordination of Benefits (COB): Prevents duplicate payments when covered by multiple plans
• Owner's Rights/Assignment: Allows benefit payments directly to providers
• No Loss/No Gain: Prevents profiting from insurance (indemnity principle)
• Restoration of Benefits: Amounts paid don't reduce future available benefits
• Benefit Payment: Specifies how benefits will be paid
• Military Suspense: Temporarily suspends coverage during active military service
• Modes of Premium Payment: Options for premium payment frequency
• Waiver of Premium: Waives premiums after a specified period of disability
• Subrogation: Allows the insurer to pursue third parties responsible for the loss
Learning Objective 7: Differentiate between various beneficiary designations and their implications
• Beneficiary Types and Designations:
• Revocable: Can be changed without the beneficiary's permission
• Irrevocable: Cannot be changed without the beneficiary's written consent
• Order of Succession:
• Primary: First in line to receive benefits
• Secondary (Contingent): Receives benefits if the primary predeceases the insured
• Tertiary: Third in line if both primary and secondary die before the insured
• Uniform Simultaneous Death Act: If the insured and the beneficiary die simultaneously, the insured is
considered to have survived (died last)
• Common Disaster Provision: Requires the primary beneficiary to survive the insured by a specified
period (14-30 days)
Learning Objective 8: Apply the principle of indemnity to health insurance scenarios
Indemnity Principle:
• The purpose is to restore the insured to their pre-loss financial position
• Prevents profiting from insurance
• Coordination of benefits and subrogation support this principle
• Benefit payments are limited to actual expenses incurred
Exam Tips:
• Focus on distinguishing mandatory vs. optional provisions
• Know the differences between renewability types
• Understand how pre-existing condition provisions limit coverage
• Remember that mandatory provisions benefit the insured, while optional provisions benefit the
insurer
• Know the specific timeframes for grace periods, proof of loss, and legal actions
• Understand how the coordination of benefits prevents duplicate payments
Remember:
• The entire contract consists of the policy form, application, and attachments
• Grace periods vary by premium payment frequency
• Renewability provisions determine the long-term stability of coverage
• Pre-existing condition provisions protect against adverse selection
• Coordination of benefits prevents over-insurance
• Beneficiary designations determine who receives benefits and in what order
Chapter 19
[1] INTRODUCTION
Imagine you're a health insurance agent meeting with a client who asks, "Why do I need to answer so many
personal questions just to get health insurance?" This is a common scenario you'll face in your insurance
career, and understanding health underwriting is key to providing a satisfactory answer.
Health insurance underwriting is the critical process that determines who qualifies for coverage and at what
price. It's like the foundation of a house—not always visible to the homeowner, but essential to the
structure's integrity. Without sound underwriting practices, insurance companies could quickly find
themselves paying out more in claims than they collect in premiums, potentially leading to financial
instability or even insolvency.
In this chapter, we'll explore how insurance companies evaluate applications to make fair and financially
sound decisions. You'll learn about the roles various professionals play in this process, from the agent who
conducts initial field underwriting to the underwriter who makes the final determination. We'll examine the
information gathered during the application process, how it's used to classify risks, and the legal framework
that ensures this process remains fair and transparent.
Whether you're explaining to clients why their premium is higher than expected or helping them complete an
application accurately, the knowledge you gain from this chapter will be essential to your success as an
insurance professional. Let's begin our exploration of health insurance underwriting—a process that
balances consumers' need for affordable coverage with the insurance company's need to maintain financial
stability.
[1.1] LEARNING OBJECTIVES
After completing this chapter, you will be able to:
• Explain the purpose and fundamental principles of health insurance underwriting
• Identify the key parties involved in the underwriting process and their responsibilities
• Describe the components of a health insurance application and their significance
• Differentiate between the various types of premium receipts and their implications for coverage
• Classify applicants into appropriate risk categories based on underwriting factors
• Explain how health insurance premiums are calculated and the factors that influence them
• Identify the various sources of underwriting information and their purposes
• Recognize the legal and regulatory requirements that govern the underwriting process
[1.3] KEYWORDS
Prior to reading this chapter, please review the following keywords. Understanding their basic definitions will
improve your comprehension of the chapter content.
Adverse Selection: The tendency for higher-risk individuals to seek insurance coverage, potentially creating
an imbalance in the risk pool.
Application: The document containing information provided when applying for insurance, used by
underwriters to determine qualification for coverage.
Attending Physician Statement (APS): A detailed medical report from an applicant's doctor, requested when
underwriters need additional information about specific health conditions.
Conditional Receipt: A receipt issued when the initial premium is collected with an application, providing
temporary coverage if the applicant proves insurable.
Field Underwriting: The initial screening process performed by producers/agents who gather information and
submit applications to the underwriting department.
Medical Information Bureau (MIB): An industry database that helps insurers share coded medical information
about applicants to prevent fraud and misrepresentation.
Morbidity: The level of risk that a person has of suffering illness or disability within a defined population
group.
Premium: The payment required to keep an insurance policy in force, typically paid in advance.
Risk Classification: The categorization of applicants (preferred, standard, substandard) based on their
likelihood of filing claims.
Underwriting: The process of evaluating applications to determine insurability and appropriate premium rates
based on the level of risk presented.
[2] THE PURPOSE AND CHARACTERISTICS OF UNDERWRITING INSURANCE
Insurance companies aim to provide coverage to qualified applicants while managing risk. However, they
need to exercise caution when deciding who’s qualified to purchase insurance. Issuing a policy to a person
who’s uninsurable is an unwise business decision that can easily result in a company’s financial loss. One of
the primary responsibilities of an underwriter is to protect the insurer against adverse selection.
Remember, adverse selection is the underwriting concept that involves the tendency of poorer risks to seek
insurance coverage or the chance that an insurer will accept applicants who are bad risks (i.e., those in poor
health, those who are moral hazards, etc.). Simply put, those who are most likely to experience a loss are
also most likely to seek insurance. Sound and competent individual or group underwriting will reduce the
likelihood of adverse selection. Just as each insurer determines the premium rates it will charge its policy
owners, each insurer also sets its own standards as to what constitutes an insurable risk versus an
uninsurable risk.
Underwriting—another term for risk selection—is the process of reviewing the many characteristics that
make up the risk profile of an applicant to determine whether the applicant is insurable and, if so, at standard
or substandard rates. The underwriting process involves reviewing and evaluating inf ormation about an
applicant and applying what’s known about the individual against the insurer’s standards and guidelines for
insurability. Basic underwriting requirements vary by company, but the steps in the underwriting process are
pretty similar.
Understanding why underwriting exists is essential. Underwriting is more than just paperwork —it's the
process that protects both insurance companies and policyholders from financial harm. When your clients
ask why they need to answer so many personal questions, you'll need to explain how underwriting helps
create a fair system where everyone pays premiums appropriate to their risk level. Let's explore the
fundamental principles that guide this critical process.
[2.1] PARTIES INVOLVED IN UNDERWRITING
[2.1.1] THE PRODUCER
While acquiring insurance is typically straightforward, many people are involved. For the state exam, it’s a
requirement to understand who participates in the underwriting process to answer questions accurately. In
practice, producers need to understand their role and who they can reach out to if questions arise.
A producer performs the initial step in the insurer’s underwriting process, known as field underwriting. During
this process, the producer determines which risks are desirable and submits those to the underwriting
department for approval.
The producer also has additional duties regarding the application process. A field underwriter or the producer
may solicit appointments, complete applications, collect premiums, and submit applications to the home
office underwriter. Although the producer doesn’t issue the policy, they are responsible for providing any
required disclosure of information practices to an applicant, such as a notice regarding replacement, a life
insurance Buyer’s Guide, an outline of coverage, or a policy summary.
[[Link]] AGENT RESPONSIBILITY
As a field underwriter, the agent initiates the application process and must complete the following essential
tasks:
• Proper solicitation
• Completing the application properly
• Obtaining appropriate signatures
• Collecting the initial premium, and
• Issuing the correct premium receipt
Additionally, all producers possess a fiduciary responsibility when they’re engaged in insurance transactions.
Producers act in a fiduciary capacity for their insurers when collecting premiums, and they also owe a
fiduciary duty to the public.
The application must be completed accurately and truthfully to the best of the agent’s ability. A producer
who has made an unintentional error or honest mistake has committed a tort that’s referred to as an error or
omission. Therefore, it’s recommended for insurers to purchase Errors and Omissions (E&O) insurance to
cover producers’ malpractice or negligence.
[[Link]] PROPER SOLICITATION
As an insurer’s representative, an agent has the duty and responsibility to solicit profitable insurance
applications. At the same time, the agent has an obligation to the insurance-buying public to observe the
highest professional standards when conducting insurance business.
[2.12] THE APPLICANT
The applicant is the person who requests the insurance and completes the application, typically with the
help of a licensed agent. Although the applicant is often the proposed insured, this is not always the case.
By reading and signing the insurance application, the applicant should realize that any false statements on
the application could result in loss of coverage.
[2.1.3] THE PROPOSED INSURED
The proposed insured is the person who’s obtaining the insurance (if approved). The policyholder is the
person who retains all rights and options under the policy and who typically serves as the payor. The payor is
the person ultimately responsible for ensuring premiums are paid when due.
[2.1.4] THE UNDERWRITER
The underwriter is the person who reviews the insurance carrier's application, examines any additional
information about the proposed insured, and classifies the degree of risk posed by the proposed insured to
determine whether the insurer should agree to cover the risk. If the insurer decides to cover the risk, it must
determine the appropriate rate. The role of the underwriter involves selecting, classifying, and rating risks.
Each insurer sets its own standards for what constitutes an insurable risk. A company underwriter
individually reviews all applicants for an individual insurance policy to determine whether they meet the
company’s insurability standards. Ultimately, the underwriters protect their insurer against adverse
selection.
[2.2] THE UNDERWRITING PROCESS
[2.2.1] PRE-SELECTION UNDERWRITING ACTIVITIES
These involve the process by which an agent/producer completes the initial application before it’s submitted
to the underwriting department. Appropriate activities include:
• Obtaining (in complete detail) all policy application questions, including personal physician
information
• Providing insight with regard to possible underwriting rating services, and
• Stressing the importance of answering all questions honestly
An agent cannot legally guarantee or bind coverage.
[2.2.2] POST-SELECTION ACTIVITIES
These involve the activities conducted by the underwriting department once the application has been
received, including:
Evaluating the risk by utilizing all of the appropriate sources of information, or
Determining the acceptability of the risk and whether the applicant will be classified as a preferred, standard,
or substandard risk (a substandard risk may be uninsurable or can be written with a higher premium)
[2.2.3] UNDERWRITING OUTCOMES
Underwriting outcomes affect the insurer and the business it writes; however, they also affect insureds by
determining whether they can secure desired insurance coverage. Lastly, agents or producers are also
affected by underwriting decisions, as positive decisions lead to policy issuance and commission payments.
The underwriting process determines the answer by reviewing and evaluating information about an applicant
and then applying the insurer’s insurability standards and guidelines. Once underwriters evaluate proposed
risks (or insureds) and determine that they’re insurable, underwriters then determine the amount of premium
required based on the likelihood of paying a claim.
[3] THE APPLICATION
Underwriters have several sources of underwriting information available to help them develop a risk profile of
an applicant. The number of sources that are checked generally depends on several factors, most notably
the requested policy’s size and the risk profile developed after an initial review of the application. The larger
the policy, the more comprehensive and diligent the underwriting research must be. If the application raises
questions about the applicant, that can trigger a review of other information sources.
The most common underwriting information sources include the following:
• The application
• An attending physician’s statement (APS)
• The medical report
• Physical exam and laboratory tests (i.e., electrocardiogram (EKG), treadmill examination, blood tests,
or HIV)
• Motor vehicle (i.e., DMV) report
• The Medical Information Bureau (MIB Report)
• Special questionnaires to identify hazardous activities (e.g., sky or scuba diving), racing activities (e.g.,
auto, motorcycle, boats), aviation activities, or hang gliding
• Inspection reports and
• Credit reports.
In some cases, insurers use a non-medical application that requires no additional information beyond the
application itself. This type of application is most often used when the proposed insured desires a low
amount of coverage and is young.
The underwriting process begins with field underwriting that’s performed by the producer. This action
primarily involves the producer recording answers to questions that are asked of an applicant and recorded
on the application. The initial contact with a potential policy owner begins in this phase.
[3.1] PARTS OF THE INSURANCE APPLICATION
For an insurer, the application is its underwriting department’s principal tool for determining whether a
potential insured (the applicant) is eligible for insurance coverage. Regardless of other information sources
used by the underwriter, the application is the first to be reviewed and thoroughly evaluated. Since the
application provides the insurer with a variety of important information, it is the agent’s responsibility to
ensure that an applicant’s answers to the application questions are thoroughly and accurately recorded.
There are three essential parts to a typical insurance application:
• Part I: General Applicant Information
• Part II: Medical and Health History
• Part III: The Agent’s Report or Statement
An underwriter is provided with the application and will review the information in all three sections to
determine whether the proposed insured is insurable. All the fact-finding information on an application will
help the underwriting department determine the individual premiums to be charged.
Exam Tip!
The application also serves as the applicant’s formal request for insurance. A completed application, along
with the initial premium, is the applicant’s consideration.
[3.1.1] PART I – GENERAL APPLICANT INFORMATION
Part I of the application asks general questions about the proposed insured, including name, age, address,
birth date, sex (gender), income, marital status, and occupation. It also includes details about the requested
coverage, such as:
• Type and amount of insurance
• Name and relationship of the beneficiary, if applicable
• Other insurance the proposed insured owns
• Additional insurance applications that the insured has pending
• Additional insureds, if the policy can be written to provide insurance for a spouse or other dependents
Other information that is sought may indicate possible exposure to hazardous hobbies, foreign travel,
aviation activity, or military service. Part 1 of the application also indicates whether the proposed insured is a
tobacco user.
[3.1.2] PART II – MEDICAL AND HEALTH HISTORY
Part II focuses on the proposed insured’s health and health history, and also inquires about the health history
of the proposed insured’s family. This medical section must be completed in its entirety for every application.
Depending on the proposed policy's value, the insurer may require additional medical information. The
carrier may require an individual applicant to take a medical exam, provide a blood test, give a urine
specimen, or all of the above. Physical exams, if requested by the insurer, are performed at the insurer's
expense.
[3.1.3] PART III – THE AGENT'S REPORT (OR STATEMENT)
The agent’s report or agent’s statement is often described as Part III of the application. Actually, the agent’s
report is a confidential communication between the agent, as a field underwriter, and the insurance
company. The agent report is where the agent documents any personal observations about the proposed
insured. Since the agent represents the insurance company’s interests, the agent is expected to complete
this part of the application thoroughly and truthfully.
In Part III, the agent provides additional information about the applicant’s financial condition and character,
the background and purpose of the sale, and the length of time the agent has known the applicant.
The agent’s report also typically asks whether the proposed insurance will replace an existing policy. It is
very rare for health insurance policies to be replaced. However, in some circumstances, insureds may want
to replace an old health policy with a new one to meet their current health needs. If the answer is “yes,” most
states require specific procedures to protect consumer rights when policy replacement is involved.
These procedures typically include:
• Discussing the underwriting requirements that may impose a new and higher premium due to the
insured's new age and possible new medical conditions
• Identifying any pre-existing conditions that may result in limited coverage in the new policy and other
benefit limitations.
• Disclosing that there may be new benefits, coverage limitations, and exclusions.
Exam Tip!
The application is a critical document. Incomplete or inaccurate applications can result in delayed
underwriting or coverage denial. Watch out for exam questions that test your knowledge of the
consequences of misrepresentation!
[3.2] COMPLETING THE APPLICATION
The agent’s responsibility is to ensure that the application is completed fully and accurately. There may be
several consequences of a producer submitting an incomplete application, such as:
• Numerous delays occur
• The applicant chooses to do business elsewhere
 • The insurance company returns the application to the agent for having submitted an incomplete
application
All of the applicant’s replies to specific questions regarding their health history
are representations. Representations are statements that an applicant indicates to be substantially true to
the best of their knowledge and belief, but which are not warranted to be exact in every detail.
Representations must be accurate only to the extent that they’re material to the risk. Misrepresentations are
considered fraudulent only when they relate to a matter that’s material to the risk and when they were made
with fraudulent intent. At the same time, an unintentional material misrepresentation can still result in a loss
of coverage during the first two or three years that a policy is in force.
[3.2.1] APPLICATION SIGNATURES
When a producer completes an application, they must include at least two required signatures: the
applicant's and the producer's. If third-party ownership is present (i.e., the applicant and proposed insured
are different persons), the application requires three signatures: the applicant, the proposed insured, and the
producer.
All insurers require the producer to sign the application as well, or it will not be underwritten. The applicant’s
signature is required on an insurance application to indicate that the application’s statements are true to the
best of the applicant’s knowledge. By reading and signing the insurance application, the applicant should
understand that any false statements on the application could result in loss of coverage.
Exam Tip!
Both the applicant and the agent must sign the insurance application. When the proposed insured is not the
policy owner, all parties’ signatures (except the beneficiary) are required. This detail is a common exam trap!
Scenario Who Must Sign?
The applicant is both the insured and Applicant, Agent
the policyholder owner
Third-party ownership (e.g., parent/child) Applicant, Proposed Insured, Agent
Policy replacement Applicant, Agent, Insured (if different),
plus replacement forms required by law
[3.2.2] CHANGES TO THE APPLICATION
When an applicant makes a mistake in the information given to an agent when completing an application, the
applicant can have the agent correct the information, but the applicant must initial the correction. If the
company discovers an uncorrected mistake, it generally returns the application to the agent. At this point, the
agent must then correct the application. The applicant can then initial the change and return the document to
the insurer.
After a policy is issued, if the insurer discovers that the information on an application is incomplete or
incorrect, the company may rescind or cancel the contract. However, the company may only rescind or
cancel a contract during the policy’s contestable period. Once the policy’s incontestable clause takes effect,
the insurer can no longer rescind or cancel the contract.
Remember, when attached to the insurance policy, the application becomes part of the legal contract
between the insurer and the insured. Consequently, the general rule is that, without the applicant’s written
permission, no alterations of any written application can be made by any person other than the applicant.
With this foundation in mind, let's explore how insurers categorize applicants into different risk classes.
[3.3] CLASSIFICATION OF RISK EXPOSURES (APPLICANTS)
Once all of the information about a given applicant has been reviewed, the underwriter will seek to classify
the applicant’s risk to the insurer. This evaluation is referred to as risk classification. Why do you think
insurance companies need to classify applicants into different risk categories?
In some cases, an applicant poses a risk so significant that they are considered uninsurable, and the
application will be rejected. However, most insurance applicants fall within an insurer’s underwriting
guidelines and are accordingly classified as preferred, standard, or substandard risks.
[3.3.1] STANDARD RISK
First, it's important to recognize that standard rates serve as the baseline for all underwriting decisions.
Standard risk is the term that’s used for individuals who fit the insurer’s guidelines for issuing the policy
without special restrictions or an additional rating. These individuals meet the same conditions as the tabular
risks on which the insurer’s premium rates are based.
[3.3.2] PREFERRED RISK
Additionally, many insurers reward good (low) risks by assigning them to preferred risk classification.
Companies issue preferred risk policies with reduced premiums due to the expectation of a better -than-
average morbidity experience. Some characteristics that contribute to a preferred risk rating include being a
non-smoker, a non-drinker, and maintaining a healthy weight.
[3.3.3] SUBSTANDARD (RATED) RISK
In contrast, a substandard risk is one below the insurer’s standard or average risk guidelines. An individual
can be rated as substandard for many reasons, including poor health, a dangerous occupation, or attributes
and habits that could be hazardous. Some substandard applicants are rejected outright, while others are
accepted for coverage with increased policy premiums.
The percentage increase depends on the degree of additional risk or rating. The terms “rated policy” and
“rated premium” refer to a substandard contract with an above-average premium (rated-up premium).
Exam Tip!
Know precisely the definitions for standard, preferred, and substandard risk. Many exam scenarios will
require you to identify which risk category an applicant falls into based on their health and lifestyle details.
[3.3.4] QUICK REFERENCE – RISK CLASSIFICATIONS

Classification Description Typical Example Factors

Premium Impact
Preferred Lower-than- Lower premiums Non-smoker, ideal
average risk BMI, etc.
Standard Average risk Standard premiums Controlled BP, no
major risks
Substandard Higher-than- Higher Chronic illness,
average risk premiums (rated) risky job
Uninsurable Risk too high No coverage offered Terminal illness, fraud
for coverage
[3.3.5] RISK CLASSIFICATION CASE STUDIES
Let's examine how an underwriter might classify three different applicants applying for the same health
insurance policy.
Case 1: Sarah (Preferred Risk)
•
o 32-year-old software developer
o BMI of 22 (within ideal range)
o Non-smoker, exercises regularly
o No chronic health conditions
o Normal blood pressure and cholesterol
o No family history of early-onset diseases
o No hazardous hobbies or activities
Underwriting Decision: Sarah is classified as a preferred risk because she presents multiple favorable
factors with no negative health indicators. Her premium will be approximately 15% lower than the standard
rate, reflecting her excellent health profile and low likelihood of filing claims.
Case 2: Michael (Standard Risk)
•
o 45-year-old retail manager
o BMI of 27 (slightly overweight)
o Former smoker (quit 5 years ago)
o Controlled high blood pressure with medication
o Family history of heart disease (father)
o No hazardous activities
Underwriting Decision: Michael is classified as a standard risk. While his controlled high blood pressure
and family history create some concern, his condition is well-managed, and he has made positive lifestyle
changes by quitting smoking. He will pay the standard premium rate.
Case 3: Robert (Substandard Risk)
•
o 51-year-old construction worker
o BMI of 33 (obese)
o Current smoker (1 pack per day)
o Type 2 diabetes was diagnosed 3 years ago
o Irregular treatment compliance
o Participates in recreational motorcycle racing
o Recent hospitalization for diabetic complications
Underwriting Decision: Robert is classified as a rated or substandard risk due to multiple high-risk factors.
His occupation, current health conditions, treatment compliance issues, and hazardous hobbies all increase
the likelihood of claims. His premium will be rated up by approximately 50% above the standard rate, and his
policy may include specific exclusions related to his racing activities.
These examples illustrate how underwriters evaluate the combination of factors rather than any single
characteristic when determining risk classification.
[3.4] RISK FACTORS IN HEALTH INSURANCE – “IS THE APPLICANT INSURABLE?”
The risk factors for life and health insurance are similar, but health insurers deal with a broader range of risks.
Unlike life insurance, insureds often file multiple claims throughout the life of their health insurance policy.
Evaluating risks for a health insurance policy is not simply a matter of acceptable versus unacceptable risk.
Even the healthiest of applicants are likely to visit a doctor at least once a year for a physical exam and
bloodwork. Accident and health insurance underwriters must carefully analyze the degree of risk for each
applicant to predict their future health and set the policy’s premium rate.
Insurable Interest: As with life insurance, insurable interest is a prerequisite for issuing a health insurance
policy. An insurable interest exists if the applicant is in a position to suffer a loss if the insured incurs medical
expenses or is unable to work due to a disability.
[3.4.1] PHYSICAL CONDITION AND HEALTH HISTORY
An applicant’s present physical condition is of primary importance when evaluating health risks. Physical
condition refers to the applicant’s health and body build. Obviously, the applicant’s physical build and health
status are also important underwriting considerations. Insureds with physical impairments and unusual body
build, including disproportionate or extreme height and weight, may also pose a higher risk to the insurer.
Typically, an insurer is as concerned with an applicant’s health history as it is with an applicant’s current
health. An applicant’s medical and treatment history can help predict future healthcare needs. Likewise, the
applicant’s family’s health history can help predict an individual’s future healthcare needs.
[3.4.2] MORAL HAZARDS
Applicants' habits or lifestyles can also be troubling signals that may indicate an additional risk for the
insurer. These are referred to as moral hazards.
Examples of moral hazards include, but are not limited to, excessive drinking and the use of drugs. Other
factors that signal a high degree of moral hazard can be a poor credit rating or dishonest business practices.
[3.4.3] OCCUPATION AND HOBBIES
There’s a direct correlation between a person’s occupation and the probability of suffering a disabling
injury. For example, there is little physical risk for professionals, office managers, or office workers. However,
occupations involving heavy machinery, strong chemicals, or high-voltage electrical equipment pose a high
risk for the insurer. In some instances, an applicant may have two jobs. If this is the case, the insurance
company will base the benefits and the premiums on the more hazardous occupation.
An applicant’s hobbies and personal activities, as well as their occupation, may affect an insurance
company’s decision as to whether it will issue a policy. An insurer may not want to write coverage on an
applicant who skydives, bungee jumps, or engages in any other type of high-risk activity or hobby. Hobbies
are also called avocations.
To make a final decision, the underwriter will likely need additional information about an applicant. The
insurer will gather this information by requiring the applicant to complete a special questionnaire.
[3.4.4] AGE AND SEX
The age and sex of the prospective insured are considerations. Generally speaking, the older an applicant,
the greater the risk and the higher the premium.
An applicant’s sex (gender) also impacts risk classification. Men show a lower rate of disability than women,
except at the upper ages. Females are also charged higher health insurance rates than males because,
statistically, they seek medical treatment more often. An insurance company may NOT reject a prospective
insured’s application on the basis of gender.
[4] PREMIUM CALCULATIONS
Premiums are the periodic payments required to keep a policy in force. Insurance premiums are always paid
in advance. Understanding how insurers determine premiums is essential for insurance professionals. This
section explains the mathematical and risk-based factors that influence what clients pay for their coverage.
You will learn about the fundamental formula for health insurance premiums (morbidity – interest +
expenses) and how various elements, such as benefit periods, elimination periods, and claims experienc e,
affect pricing. As an insurance professional, clients will frequently ask you why their premiums are set at
certain levels, and the concepts in this section will equip you to provide clear, accurate explanations.
Whether you are discussing premium modes with clients or explaining how their occupation might impact
their rates, mastering these calculations will be crucial for your success in the field.
[4.1] PREMIUM MODE
The premium mode refers to the frequency of premium payments. If the policy has an annual premium, the
insurer can assess an extra charge if premiums are paid quarterly, semiannually, or monthly. (Industrial
insurance policies have a weekly premium.) These additional modes make it more convenient for the policy
owner to pay premiums, but they also increase administrative costs and delay the receipt of funds for
investment. The more frequent the payments, the higher the policy will cost the insured in total.
[4.2] EARNED PREMIUM
The earned premium is a pro-rated amount of paid-in-advance premiums that the insurance company has
“earned” by already providing the insured coverage.
[4.3] UNEARNED PREMIUM
The unearned premium is a pro-rated amount of paid-in-advance premiums that the insurer has not yet
“earned.” They appear as a liability on the insurer’s balance sheet because they must be refunded if the
policy is canceled.
For example, if your premium is $120 paid in advance for the year, after six months (half of the year), the
insurer will have “earned” only $60 of the $120 you paid. If you were to cancel your policy after 6 months, the
insurance company would have to refund you $60, as they did not “earn” that amount.
[4.4] POLICY TERM
The policy term is the period of time during which a policy remains in existence, as long as premiums are
being paid.
[4.5] POLICY FEE
The policy fee is a small transaction fee charged by some insurers for the first or subsequent years of an
insurance policy, in addition to the regular premium. Policy fees are either paid annually or one time when the
policy is issued.
[4.6] PRIMARY HEALTH INSURANCE PREMIUM FACTORS
The formula for calculating health insurance premiums is:
Morbidity – Interest + Expenses
[4.6.1] MORBIDITY
Morbidity tables reveal the frequency, extent, and duration of disability expected within a given group of
persons. Morbidity rates indicate the average number of persons in a specific group expected to become
disabled in a given year at a given age. Actuaries use these tables and ratios to compute policy premium
rates.
[4.6.2] INTEREST
Insurance companies invest the premium payments they receive from policyholders to earn interest. The
interest earned on premiums is one way that an insurance company can lower its premium rates. When
insurance companies calculate policy premiums, they assume they will earn a specific interest rate. The
higher the assumed (predicted) rate of interest, the lower the premiums will be. The actual interest earned
may be higher or lower than the assumed rate.
[4.6.3] EXPENSES
The expense factor—also referred to as the load, loading charge, or loading factor—is derived from operating
expenses or the funds that the insurer “pays out.” Some of these expenses include agent commissions,
wages for other employees, administrative costs, overhead expenses (e.g., rent), and the regulatory
requirement to set aside reserves to pay future claims. Additionally, companies need to build a percentage
for profits into their calculations, which mutual insurance companies refer to as surplus.
[4.6.4] SCENARIO – PREMIUM CALCULATION
Let's walk through how an insurance company might calculate a premium for Maria, a 45-year-old office
manager applying for disability income insurance:
Step 1: Assess Morbidity Risk
• Base morbidity rate for 45-year-old females in office occupations: $42 per $100 of monthly benefit
• For Maria's requested $3,000 monthly benefit: $42 × 30 = $1,260
Step 2: Apply Interest Factor
• Assuming 3% projected investment return: $1,260 × 0.97 = $1,222.20
• This reduction accounts for the insurer's ability to invest premium dollars
Step 3: Add Expense Loading
• Administrative costs, commissions, and profit margin: 35%
• $1,222.20 × 1.35 = $1,649.97
Step 4: Adjust for Policy Specifics
• 90-day elimination period (15% discount): $1,649.97 × 0.85 = $1,402.47
• 5-year benefit period (versus to-age-65): $1,402.47 × 0.80 = $1,121.98
• Non-smoker discount: $1,121.98 × 0.90 = $1,009.78
Final Annual Premium: $1,009.78
If Maria chose to pay quarterly instead of annually, the insurer would add a premium mode charge:
• Quarterly payment factor: 0.275 of annual premium per quarter
• $1,009.78 × 0.275 = $277.69 per quarter ($1,110.76 annually)
This example illustrates how each component of the premium formula affects the final amount Maria pays,
and how her choices regarding elimination period, benefit period, and payment frequency impact her costs.
[4.7] SECONDARY FACTORS THAT INFLUENCE PREMIUMS
[4.7.1] BENEFITS
The number, level, and type of benefits that a policy provides affect the premium rate. The greater the
amount of the policy benefits, the higher the premium. Or, put another way, the greater the insurance
company’s risk, the higher the premium.
[4.7.2] BENEFIT PERIOD
The maximum period during which an insured collects monthly income will also affect the premium charged.
The most common benefit periods are 12, 24, and 30 months; 5 years; 10 years; 20 years; to age 65; or for
life.
[4.7.3] ELIMINATION PERIOD
An elimination or waiting period is common to most types of disability income insurance and works like a
deductible. On each occasion that an insured becomes totally disabled, a waiting period must be satisfied
before any monthly benefit is payable. The longer the selected waiting period, the lower the policy premium.
[4.7.4] PROBATIONARY PERIOD
A probationary period is a one-time event that must be satisfied before a health insurance policy’s coverage
becomes effective. Accidents are covered immediately, but sickness or illnesses are not covered until the
expiration of a one-time 30-day period. The probationary period helps the insurer avoid paying claims for
illnesses that an insured may have contracted prior to the effective date of the policy. In other words, the
probationary period allows an insurer to deny small pre-existing claims.
[4.8] ELEMENTS THAT INFLUENCE MORBIDITY CALCULATIONS
[4.8.1] CLAIMS EXPERIENCE
To set realistic premium rates, insurers must accurately estimate the dollar amount of future claims. The
most practical way to do so is to rely on claims tables that are based on past claims experience. When
determining the appropriate coverage and final premium rate for group health insurance, the insurer’s
underwriters will use the group’s experience rating.
[4.8.2] AGE AND SEX OF THE INSURED
Health insurance claims costs tend to increase as insureds age. An insured’s sex will also influence
premiums. For life and health insurance, older applicants can expect higher premiums. However, age aside,
female insureds will typically see higher HEALTH insurance premiums, whereas male insureds will typically
see higher LIFE insurance premiums.
[4.8.3] OCCUPATION AND HOBBIES
An insured’s occupation will impact rates since more hazardous occupations carry more risk and therefore
demand a higher premium. Occupational considerations are crucial when classifying and assessing premium
rates for disability insurance.
[4.8.4] COMMUNITY RATINGS
Some health plans use community rating. This type of approach is generally used for smaller groups or
individuals. It utilizes the identical premium rate structure for all subscribers or groups in a community,
regardless of their past or potential loss experience. In other words, the premiums for a community-rated
policy are generally based on the insurer's overall claim experience and healthcare costs in a given
geographic area.
[5] THE INITIAL PREMIUM AND PREMIUM RECEIPTS
A receipt serves as proof of payment for goods or services. In this case, it denotes the applicant’s good -faith
payment of an initial premium in return for the company’s promise to pay. Premium receipts are important
because they can establish a person’s coverage under a policy before the insurer issues the contract.
[5.1] PREMIUMS PAID WITH THE APPLICATION
It is generally in the proposed insured’s best interests to pay the initial premium with their application and to
have the agent forward it to the insurer. The proposed insured will benefit because the insurance carrier will
immediately extend insurance protection; however, there will be significant restrictions.
The producer should collect a premium from the applicant at the time of application, or as early as possible
thereafter. The premium is generally forwarded with the application to the underwriting department. If the
applicant doesn’t make the initial premium payment when completing the application, the agent should still
submit the policy application to the insurance company, even without the payment. Even if a policy is
approved and issued, it will not become effective until the initial premium is collected. An application that’s
submitted without an initial premium is typically referred to as a trial application.
Remember that an applicant’s consideration is one of the requirements for a valid contract. In the case of an
insurance contract, the consideration consists of the first premium payment and the application. An insurer
will not allow an applicant to possess a policy without receipt of the initial premium.
Whenever a consumer pays the initial premium upon completing the application, the producer must leave a
premium receipt with the applicant, which serves as proof that the agent collected the initial premium
payment with the completed application. The type of receipt provided may determine when coverage
becomes effective.
[5.2] PREMIUM RECEIPTS
Applicants who pay a premium deposit with the application are entitled to a premium receipt. The type of
receipt given to the applicant determines precisely when and under what conditions an applicant’s coverage
begins. The date on a premium receipt is always earlier than the policy’s issue date.
There are two types of receipts that insurers may use when their producers collect initial premiums —
conditional receipts or binding receipts. These receipts identify the amount of premium collected and
determine if and when coverage goes into effect. Today, insurers predominantly use the conditional
receipt. Although the binding receipt is still in use, insurers use it only in a limited fashion.
[5.2.1] CONDITIONAL RECEIPTS
Conditional receipts generally provide coverage as of the date of the receipt, provided a specific condition is
satisfied. The insurer will consider the applicant to be insured IF the insurance company deems the applicant
to have been insurable as a standard risk (i.e., proven insurability) on the date of the application. Coverage
will begin on the date of the application or the date of any required medical exam, whichever is later.
Insurability may be accomplished simply by submitting the application. The underwriting department may
review the application and determine an applicant’s insurability based solely on the information that’s
provided. In some cases, an applicant may need to demonstrate proof of their insurability in other ways. In
addition to the application, insurers may obtain information from other sources, such as the Medical
Information Bureau, consumer reports, attending physician statements, medical exams, or other te sts (e.g.,
blood tests).
The commonly used conditional receipt is also referred to as a temporary receipt. A conditional receipt
outlines certain conditions that must be met for the insurance coverage to go into effect. With the conditional
receipt, if the applicant pays the initial premium, coverage is effective on the condition that the applicant
proves insurable on the date the application was signed or the date of the medical exam, whichever is later.
However, if the applicant is found uninsurable as of the date of application or the date of any required
medical exam, no coverage takes effect, and the premium is refunded.
For example, an applicant dies between the application date (or medical exam) and the date the insurer
approves the application. In this case, the coverage is retroactively effective as long as the applicant proves
insurability on the specified date.
[[Link]] INSURABILITY TYPE CONDITIONAL RECEIPT
The insurability type conditional receipt states that the insurance carrier has made an offer of coverage, but
the offer is conditional. The insurer is conditioning coverage on the proposed insured’s insurability. It further
states that the applicant has accepted the conditional offer by paying the premium.
Coverage becomes effective on the date of the application or the date of any required medical exam,
whichever is later. This is the case as long as the proposed insured is found to be insurable as applied for.
Policy delivery is not necessary for coverage to be provided.
For example, an individual signs an application for coverage on August 2 and takes a required medical exam
on August 4. In this case, their protection begins on August 4 because the medical exam was required for
coverage to be provided. If the individual had died before the application was underwritten, the insurer would
still have needed to proceed with the underwriting phase and determine insurability according to its usual
underwriting standards. If an application is approved under such circumstances, the insurer will pay the
claim because insurance was in effect even after the insured died.
However, if the individual doesn’t meet the insurer’s approval guidelines, the insurer will decline the
application. In this situation, the insurer would not pay the death benefit; however, the insurance carrier
would refund the initial premium payment to the policy owner or beneficiary.
Exam Tip!
If the exam refers to a conditional receipt with no further qualification, assume it’s an “insurability type
conditional receipt.”
[[Link]] APPROVAL TYPE CONDITIONAL RECEIPT
In an approval-type conditional receipt, the language is far more restrictive. Approval-type conditional
receipts state that coverage is in force only after the insurer has approved the application. Therefore,
approval-type conditional receipts provide coverage only between the date the insurance policy is approved
or issued and the date it is delivered to the insured. The legal system strongly opposes approval -type
conditional receipts due to their overly restrictive nature. As such, insurers rarely use ap proval-type
conditional receipts today.
Exam Tip!
Unless the approval type is explicitly specified, always assume that “conditional receipt” refers to the
insurability type.
[5.2.2] BINDING RECEIPTS
Binding receipts may also be referred to as temporary insurance agreements or even unconditional receipts.
Under the terms of a binding receipt, coverage is guaranteed until the insurer formally rejects the application.
Even if the proposed insured is ultimately found to be uninsurable, the receipt still guarantees coverage until
the application is rejected. Therefore, the insurer must pay the claim if the applicant dies before the
insurance company formally approves or rejects the consumer’s insurance application.
As with the conditional receipt, a binding receipt typically stipulates a maximum amount that’s payable
during the particular protection period. Binding receipts are far more common for auto or homeowner’s
insurance than they are for life or health insurance.
[5.2.3] CASE STUDY: A TALE OF TWO RECEIPTS
Background:
Two clients applied for identical critical illness insurance policies on the same day, through different agents
with the XYZ Insurance Company.
Client A: Michael Wilson
• Completed application on March 10
• Paid the initial premium at the time of application
• Received conditional receipt (insurability type)
• Had the required medical exam on March 15,
• The medical exam showed no diagnosable conditions
• Suffered a stroke on March 30
• Policy officially approved and issued April 5
Client B: Thomas Garcia
• Completed application on March 10
• Paid the initial premium at application
• Received binding receipt
• Required medical exam completed March 15
• Discovered to have undiagnosed diabetes during the exam
• Suffered appendicitis (unrelated to diabetes) on March 25
• The application ultimately declined on April 8 due to diabetes
[5.2.3] TEMPORARY INSURANCE AGREEMENT
The “temporary insurance agreement” is similar to a binding receipt. In fact, in some jurisdictions, the two
terms are used interchangeably. In contrast to a binding receipt, this agreement provides only a limited
amount of additional protection. However, like a binding receipt, the temporary agreement provides
immediate coverage. Coverage remains in effect during the entire underwriting period. If the insured dies
during the underwriting period, the claim will be paid. The insurer has the right to cancel c overage if the
application is ultimately denied by underwriting. Despite this, claims incurred during the underwriting period
will be paid in accordance with the terms of the receipt, regardless of whether the application is approved.

Exam Tip!
Distinguish between conditional and binding receipts; understanding the following differences is essential for
success on your exam.

•
o A conditional receipt provides coverage only if subsequent underwriting confirms insurability
based on the application date or medical exam date.
o A binding receipt grants immediate coverage until the insurer makes a final decision.
[5.2.4] QUICK REFERENCE – PREMIUM RECEIPTS
Receipt Type When Coverage Begins Key Condition/Notes
Conditional App date or medical exam date if Most common; subject to
insurable underwriting approval
Binding Immediately upon premium Rare in life; coverage until formal
payment rejection
Temporary Between the app and the policy Limited amount; only if the
issue applicant would qualify
[5.3] OFFER AND COUNTER-OFFER
When the applicant completes an application and pays the first full premium, they’re making a legal offer to
the insurer. If the insurer issues a policy as requested, the insurer accepts the offer, and a contract is in
force. However, if the insurer declines the application, the offer has been rejected.
From a legal standpoint, what happens if the insurance company is willing to insure the applicant but only on
a “rated” or substandard form, which will naturally require a higher premium? In this case, the insurer rejects
the initial offer and makes a counteroffer that the applicant has the option to reject. Alternatively, the
applicant may decide to pay the additional premium, provide a statement of continued good health, and
accept the counteroffer.
[6] POLICY ISSUE AND DELIVERY
After underwriting is complete and the company decides to issue the policy, other departments within the
company assume responsibility for issuing it. Once issued, the insurance contract is sent to the sales agent
for delivery to the applicant. The policy is not typically sent directly to the policy owner because it is an
important legal document that should be explained to the policy owner by the sales agent.
Most states require an agent to deliver an outline of coverage to each applicant. In some cases, such as
when selling long-term care insurance, agents must also deliver an NAIC Shopper’s Guide or Buyer’s Guide.
These documents are generally provided before the agent accepts the applicant’s initial premium.
Essentially, a Buyer’s Guide is a generic publication that explains health insurance in a way that average
consumers can understand. It discusses the concept in general terms and doesn’t address the specific
product or policy under consideration.
The policy summary addresses the specific product being offered for sale. It identifies the agent, the insurer,
the policy, and each rider. Additionally, it includes information on premiums, dividends, benefit amounts,
cash surrender values, policy loan interest rates, and the life insurance cost index for the specific policy
being considered.
[6.1] POLICY EFFECTIVE DATE
Determining the effective date of an insurance policy is essential for the following reasons:
• It identifies when coverage becomes effective.
• It establishes the date by which the insured must pay future annual premiums.
• If a receipt (either conditional or binding) was issued in exchange for the payment of an initial
premium deposit, the receipt’s date generally becomes the policy’s effective date in the contract.
If the applicant does not pay the initial premium at the time of application, the policy will not become
effective until the initial premium is paid and received. Though the date a policy is issued may be listed as the
effective date on the contract, coverage cannot truly be in force until the first premium has been paid, which,
in this case, would usually be when the policy is delivered. The policy must be delivered to the applicant, the
first premium must be paid, and a Statement of Good Health must be obtained.
Exam Tip!
When answering an exam question regarding the "effective date of coverage" or "when coverage begins,"
realize the correct answer is NEVER "the issue date" or "date the policy was issued." If a premium was paid
with the application, coverage begins sooner. If no premium accompanies the application, it will not be
effective until the issued policy is delivered and the first premium is collected.
[6.2] CONSTRUCTIVE DELIVERY
From a legal standpoint, an insurance carrier can accomplish policy delivery without physically delivering the
policy to the policy owner. This legal concept is referred to as constructive delivery. An insurance carrier
technically accomplishes a “constructive delivery” when it intentionally relinquishes all control over the
policy and turns it over to a person who’s acting for the policy owner, including the company’s own agent.
Mailing the policy to the agent for unconditional delivery to the policy owner also constitutes constructive
delivery, even if the agent never personally delivers the policy. However, if the company instructs the agent
not to deliver the policy unless the applicant is in good health, there’s no constructive delivery.
A client’s mere possession of a policy doesn’t establish delivery if all of the conditions have not been met.
For example, a policy may be left with an applicant for inspection, and an inspection receipt obtained to
indicate that, during the inspection period, the policy is neither in force nor will it go into force until the initial
premium has been paid.
[6.2.1] INSPECTION RECEIPT
Some proposed insureds may want to review a policy before purchasing it. In this situation, the policy owner
doesn’t pay the initial premium when the application is completed and, therefore, doesn’t receive a premium
receipt. In this situation, the policy owner will not provide a statement of continued good health or pay a
premium when the agent brings them the contract. Instead, the prospective insured will sign an inspection
receipt. The prospective insured will examine the policy and then pay the first full premium. The free-look
period that’s required by all states makes this inspection receipt relatively obsolete in the modern insurance
industry.
Exam Tip!
Inspection receipts are not technically premium receipts. Their purpose is to delay the payment of
premiums. If you see a reference to “premium receipt,” you can automatically rule out inspection receipts.
[6.3] EXPLAINING THE POLICY AND RATINGS TO CLIENTS
After an applicant signs an application, they are unlikely to remember all the essential details of their policy.
This is another reason that agents should deliver policies in person. By personally explaining how the policy
meets the policy owner’s specific objectives, the agent can avert misunderstandings, policy returns, and
potential lapses.
When the insurance company issues a policy as “rated” or substandard, the agent can discuss why the
insured’s need for insurance protection is even more significant because of their identified physical
condition. The explanation is necessary because the rating will require the policyholder to pay an additional
premium.
[6.4] OBTAINING A "STATEMENT OF CONTINUED GOOD HEALTH" FROM THE INSURED
In some instances, the applicant will not pay the initial premium until the agent delivers the policy. If this is
the case, common company practice requires that, before leaving the policy, the agent collect the premium
and obtain a signed statement of continued good health from the insured, indicating that the insured’s
health has not changed since the application was submitted and any medical exam occurred.
The agent then submits the premium with the signed statement of good health to the insurance company.
Because there can be no contract until the premium has been paid, the company has a right to know that the
policyholder has remained in reasonably good health from the time the policyholder signed the application
until receiving the policy. In other words, the company has the right to know if the insured represents the
same risk to the company as when the application was first signed.
[6.5] DELIVERY (POLICY) RECEIPT
When a producer delivers a policy to an insured, the insurance company often wants proof of delivery. The
producer secures this proof by requiring the insured to sign a delivery receipt upon receiving the contract. The
delivery receipt is essential because it can designate the start of the policy’s free-look period.
Delivery Premium Statement of Policy Status Coverage Agent
Scenario Status Health Implications Requirements
Complete Premium paid at Statement of Immediately in Full coverage Obtain delivery
Delivery delivery health signed force begins at receipt; explain
delivery policy features
Premium Premium paid No statement In force based Coverage Verify receipt
Previously Paid with application needed if within on the receipt already in effect was provided;
a reasonable date via a conditional explain policy
time /binding receipt features
Delayed Delivery Premium paid Statement of In force after Coverage may Document the
with the health required statement be denied if reason for the
application if significant verification health has delay; obtain a
delay changed new statement
Inspection Only No premium Inspection Not in force No coverage Clearly explain
paid receipt signed until the that no coverage
premium is paid exists; set
follow-up
COD Policy Premium Statement of In force after the Coverage begins Collect
collected at health signed premium and after the premiums and
delivery statement are company statements;
processed processes the submit promptly
payment
Delivery with Premium paid Statement Pending re- Coverage may Report change to
Health Change reveals health underwriting be denied or the company; do
change modified not leave policy
Constructive Premium paid N/A Legally in force Coverage exists Document
Delivery even without delivery attempt;
physical delivery notify the
company
Free Look Period Premium paid N/A In force but Full coverage Explain free look
cancellable with the right to rights; document
cancel explanation
[7] ADDITIONAL LAWS, DISCLOSURES, AND SOURCES OF UNDERWRITING INFORMATION
When clients ask why insurance companies need so much information, they're often surprised by the variety
of sources underwriters consult. Beyond the application itself, underwriters have access to specialized
databases and reports that help create a complete picture of each applicant. Understanding these
information sources will help you prepare clients for the underwriting process and explain why certain
questions or requirements exist.
Although the primary source of information for an underwriter is the application, additional information may
be required if the application reveals certain health conditions or other risk exposures. The underwriter will
also base a final decision on an assortment of other information, including the producer or agent’s report, an
attending physician statement (APS), MIB, consumer (e.g., credit) or inspection reports, medical or physical
exam results (e.g., medical report), laboratory tests (e.g., blood tests or HIV) or a motor vehicle/DMV report.
Many insurers require an applicant to complete a hazardous activity questionnaire to determine whether the
proposed insured engages in scuba diving, skydiving, any type of racing (auto, motorcycle, boat), aviation
activities, hang gliding, or mountain climbing.
By understanding these information sources, you will be better equipped to guide your clients through the
application process, set appropriate expectations, and help them present their case in the most favorable
light.
[7.1] QUICK REFERENCE – UNDERWRITING INFORMATION SOURCES
Source What It Provides/When Used
Application Primary info: personal, medical, financial
Agent’s Report Agent’s observations, replacement info
Attending Physician Statement Details on specific medical conditions
Medical Information Bureau Past applications, medical codes
Medical Exam/Lab Tests Objective health data (for higher face amounts)
Inspection/Credit Report Financial, lifestyle, and creditworthiness
Special Questionnaires Details on hazardous hobbies, travel, occupation
[7.1.1] THE MEDICAL INFORMATION BUREAU
Another source of underwriting information that focuses explicitly on an applicant’s medical history is
the Medical Information Bureau (MIB), which was formed by more than 700 member insurance companies.
Think of the MIB as the insurance industry's shared memory. When your client mentions they've applied for
insurance before, the underwriter will check the MIB to see what health information was previously reported.
The MIB contains information about an applicant’s prior health history and helps detect any adverse health
conditions the potential insured may experience. The MIB report will also identify life insurance in force with
other carriers and lifestyle habits, such as drug use.
For example, if your client disclosed diabetes on a previous application but omitted it on the current one, this
discrepancy will appear through an MIB check. You should explain to clients that this helps keep premiums
fair for everyone by preventing information gaps.
The purpose of the MIB is to serve as a reliable source of medical information concerning applicants and to
help disclose cases in which an applicant either forgets or conceals pertinent underwriting information or
submits erroneous or misleading medical information with fraudulent intent. A Medical Information Bureau
report may disclose lifestyle habits such as drugs, drinking, overeating, and smoking. The MIB operations
help to minimize the cost of life insurance for all policy owners by preventing misrep resentation and fraud.
Information that’s received from the Medical Information Bureau (MIB) about a proposed insured may be
released to the proposed insured’s physician. One of the primary purposes of the MIB report is to help
insurers avoid high-risk applicants.
The following is a summary of how the Medical Information Bureau works:
If a company finds that one of its applicants has a physical ailment or impairment listed by the MIB, the
company must report the information to the MIB using a code number. By having this information, home
office underwriters will know that a past problem existed if the same applicant later applies for life insurance
with another member company. The information is available to member companies only and may be used
only for underwriting and claims purposes. Information that’s received from the Medical Information Bureau
(MIB) regarding a proposed insured may be released to the proposed insured’s physician.
[7.1.2] THE MEDICAL REPORT
A policy may be issued based on the information that is provided in the application alone. Most companies
have established non-medical limits, meaning that applications for policies with benefits below a certain
amount will not require any additional medical information beyond what’s provided in the application. For
policies that provide more substantial benefits, a medical report may be required to provide additional
underwriting information. This report may come from the insured’s physician or an examinat ion conducted as
part of the underwriting process.
[7.1.3] ATTENDING PHYSICIAN’S STATEMENT (APS)
If the medical section of a person’s application raises questions that are specific to a particular medical
condition, the underwriter may also request an attending physician’s statement (APS) from the physician
who has treated the applicant. A copy of the signed authorization must accompany an insurer’s request for
an attending physician’s report.
For example, when Jason disclosed his type 2 diabetes on his application, the underwriter requested his A1C
levels from the past two years. With well-controlled readings consistently below 7.0, Jason qualified for
standard rates rather than being rated or declined.
The statement will provide details about the medical condition in question. Moreover, attending physician
statements offer detailed insights that standardized exams might miss.
[7.1.4] PRESCRIPTION DRUG DATABASES
These databases reveal your client's medication history, which can tell underwriters a lot about their health.
For example, if records show your client has been taking blood pressure medication for five years, this
indicates a managed but ongoing condition. Prepare your clients by advising them to disclose all regularly
taken medications—even if they consider them "not important."
[7.1.5] SPECIAL QUESTIONNAIRES
When necessary, special questionnaires may be required for underwriting purposes. These questionnaires
gather more detailed information about a non-medical aspect of the applicant’s life.
For example, an applicant engages in mountain climbing as a hobby. In this case, the insurance company
needs detailed information about the extent of the applicant’s participation to determine whether the
insurance risk is acceptable.
The types of information requested in a special questionnaire may be about an avocation, aviation, foreign
residence, finances, military service, or an occupation. The most common of these special questionnaires is
the aviation questionnaire that’s required of any applicant who spends a significant amount of time flying.
[7.1.6] INSPECTION REPORTS
Insurance companies typically obtain inspection reports for applicants seeking large insurance amounts.
These reports contain information about prospective insureds and are reviewed to determine their
insurability. Insurance companies generally obtain inspection reports from national investigative agencies or
firms, which may include information obtained through a telephone conversation with the proposed insured.
As described earlier, the purpose of these reports is to provide an assessment of an applicant’s general
character and reputation, mode of living, finances, and any exposure to abnormal hazards. Investigators or
inspectors may interview employees, neighbors, the applicant's associates, and the applicant herself.
Additionally, the inspection report may include a credit report. When an investigative consumer report is
used in connection with an insurance application, the applicant has the right to receive a c opy of the report.
An insurer’s obligation as it relates to the disclosure of an insured’s non-public information is to give notice,
explain, and allow the insured to opt out.
Inspection reports are not typically requested for applicants who apply for smaller policies. However,
company rules vary regarding the size of policies that require a report by an outside agency.
If an insurance company obtains an inspection report on a prospective insured, it must inform the prospect
that it’s permitted to do so under the Fair Credit Reporting Act.
[7.1.7] CREDIT REPORTS
Some applicants may prove to be poor credit risks based on credit information that’s obtained before a policy
is issued. Therefore, credit reports from the credit bureaus are a valuable underwriting tool. Applicants who
have questionable credit ratings can cause an insurance company to lose money. Applicants with poor credit
standings are likely to allow their policies to lapse within a short time, perhaps even before a second
premium is paid. An insurance company can lose money on a policy that’s quickly lapsed because the
insurer’s expenses to acquire the policy cannot be recovered in a short period.
[7.1.8] CASE STUDY: BUILDING THE COMPLETE RISK PROFILE
Applicant: Jennifer Chen, 43-year-old marketing executive applying for comprehensive health insurance
Initial Application Information:
• Non-smoker
• No reported health conditions
• Family history of breast cancer (mother diagnosed at 51)
• Occasional social drinker
• Regular exercise 2-3 times weekly
Based solely on the application, Jennifer appears to be a preferred risk. However, the underwriter followed
standard procedure by consulting additional information sources.
[[Link]] Information Source Findings:
Source Information Revealed Impact on Risk Assessment
MIB Report Code indicating previous Triggered a request for additional
treatment for anxiety information
Prescription Database Current prescription for anxiety Confirmed undisclosed condition,
medication, Previous short-term Suggested possible sleep issues
sleep medication
Attending Physician Statement Managed anxiety condition (5 Provided context for the condition,
years), well-controlled with showed responsible
medication, no other significant treatment, and reduced the
health concerns concern level
Medical Exam Normal vital signs, Excellent Confirmed overall good health,
cholesterol levels, Slightly Positive cardiovascular indicators,
elevated BMI (26.4) Minor concern about weight
Credit Report Excellent credit history, Stable Positive indicator for premium
employment, No concerning payment, suggests lifestyle
financial patterns stability
[7.2] RELEVANT LAWS
[7.2.1] THE GENETIC INFORMATION NON-DISCRIMINATION ACT
The Genetic Information Non-Discrimination Act (GINA) of 2008 protects Americans against discrimination
based on their genetic information when they apply for accident and health insurance. Insurers cannot use
genetic testing to gather underwriting information.
[7.2.2] UNFAIR DISCRIMINATION
No insurer is permitted to engage in any unfair discrimination regarding applicants for insurance. Sexual
orientation, religious preference, or geographical location are prohibited insurance underwriting factors
because they’re unfairly discriminatory.
Where required by state law, the agent must also sign a form attesting that a disclosure statement has been
given to the applicant. Additionally, a form that authorizes the insurance company to obtain investigative
consumer reports or medical information from investigative agencies, physicians, hospitals, or other sources
generally must be signed by the proposed insured and the agent as a witness.
The insurance company’s name, along with the agent’s name and license identification number, must appear
on the application. It may be printed, typed, stamped, or handwritten as long as it’s legible.
[7.2.3] PRIVACY NOTICE
The HIPAA Privacy Rule protects an individual’s health information and grants patients a variety of rights
regarding individually identifiable health information. Under this rule, when an agent submits an application
that reveals the applicant's personal information, the agent is responsible for providing the applicant with
privacy notices. If there’s an authorized dissemination of private information, the insurer must notify the
affected parties.
Producers must also secure an HIV consent form from the applicant and communicate that blood tests may
be required underwriting practice. In other words, despite the fact that the insurer requires a blood test as
part of its regular underwriting activity, it must still secure a signed consent form that indicates to the
applicant that any blood taken will be screened for HIV and that they’re providing permission for such testing
to be completed.
Exam Tip!
HIPAA mandates that applicants must receive a privacy notice outlining how their personal health
information will be handled. Exams often test your understanding of when and how privacy notices are
required.
[7.2.4] THE FAIR CREDIT REPORTING ACT OF 1970
To protect the rights of consumers whose inspection or credit report has been requested, the U.S. Congress
enacted the Fair Credit Reporting Act (FCRA). The Act applies to any financial institution (including insurers)
that requests consumer reports.
The FCRA established procedures for collecting and disclosing information obtained from consumer
investigations and credit reports. The scope of the FCRA is quite extensive, and its intention is to ensure
fairness. It addresses the issues of confidentiality, accuracy, and disclosure.
For example, let’s assume that an insurer declines a consumer due to poor credit. In this case, the FCRA
requires the insurer to notify the applicant that a copy of the credit report is available through the appropriate
credit bureau.
For insurance companies that are members of the MIB, the FCRA requires them to inform an applicant
whether this report played any part in their decision to deny coverage or charge a higher rate.
[7.2.5] INFORMATION AND PRIVACY PROTECTION ACT
Under the Information and Privacy Protection Act, each insurer must comply with state and federal laws
governing the dissemination of private information about an applicant or insured. This Act also prohibits
insurers from basing their decision solely on previous adverse underwriting decisions from support
organizations, such as MIB and medical reports
[7.2.6] USA PATRIOT ACT
The USA PATRIOT Act was enacted in 2001 to deter and detect terrorism. Under the Act, insurance
companies are required to establish formal anti-money laundering (AML) programs. A life insurance policy
that can be cash surrendered is an attractive money-laundering vehicle because it allows criminals or
terrorists to put dirty money in and take clean money out in the form of an insurance company check.
This Act increased the ability of law enforcement agencies to search telephone and e-mail communications,
as well as medical, financial, and other records, in order to detect and prevent terrorist activities. The Act
also expanded the Secretary of the Treasury’s authority to regulate financial transactions, particularly those
involving foreign and individual entities, in order to protect the United States and its interests.
Insurance companies are required to implement written AML programs that include designating a
compliance officer to update the program, ensuring that appropriate persons are educated and trained in its
use, and conducting ongoing AML training.
[8] CHAPTER SUMMARY
Throughout this chapter, we've explored the multifaceted world of health insurance underwriting —the
process that determines who receives coverage and at what cost. We began by examining the fundamental
purpose of underwriting: to protect insurers against adverse selection while providing coverage to qualified
applicants at fair rates.
We identified the key parties involved in the underwriting process, from the agent who performs initial field
underwriting to the underwriter who makes the final determination. You now understand that the application
serves as the cornerstone of the underwriting process, with its three essential parts providing critical
information about the applicant's personal details, medical history, and the agent's observations.
We explored how underwriters classify applicants into risk categories—preferred, standard, and
substandard—based on factors such as physical condition, occupation, age, and lifestyle. You've learned
that premiums are calculated using the formula "morbidity – interest + expenses," with additional factors like
benefit periods and elimination periods influencing the final rate.
The chapter also covered the various types of premium receipts and their significance in determining when
coverage begins. You now understand the difference between conditional receipts, which provide coverage
only if the applicant proves insurable, and binding receipts, which provide immediate temporary coverage.
Finally, we examined the additional sources of underwriting information, such as the Medical Information
Bureau and attending physician statements, as well as the legal framework governing the underwriting
process, including HIPAA, the Fair Credit Reporting Act, and the Genetic Information Nondiscrimination Act.
As you prepare for your licensing exam and future career, remember that underwriting is not just about
paperwork—it's about creating a fair system where policyholders pay premiums appropriate to their risk level
while ensuring that insurance companies remain financially stable enough to pay claims when needed. Your
ability to explain this process clearly to clients will be essential to your success as an insurance
professional.
[8.2] REVIEW NOTES: HEALTH INSURANCE UNDERWRITING AND POLICY ISSUE

LEARNING OBJECTIVE 1: EXPLAIN THE PURPOSE AND FUNDAMENTAL PRINCIPLES OF HEALTH

INSURANCE UNDERWRITING
Underwriting fundamentals:
• Process of evaluating applications to determine insurability and appropriate premium rates
• Protects insurers against adverse selection
• Balances consumer needs with insurer's financial stability
• Reviews risk characteristics to classify applicants (preferred, standard, substandard)
Key principles:
• Sound underwriting reduces adverse selection
• Each insurer sets its own insurability standards
• Underwriting maintains a fair premium structure
• Ensures company solvency by managing the risk pool
LEARNING OBJECTIVE 2: IDENTIFY THE KEY PARTIES INVOLVED IN THE UNDERWRITING PROCESS
AND THEIR RESPONSIBILITIES
Producer/Agent:
• Performs field underwriting (initial screening)
• Completes applications properly
• Obtains appropriate signatures
• Collects initial premium
• Issues a correct premium receipt
• Has fiduciary responsibility to insurer and client
Applicant:
• Requests insurance coverage
• Provides accurate information
• Signs application
• May be different from the proposed insured
Proposed Insured:
• Person obtaining coverage (if approved)
• Provides health information
• Signs application (if different from applicant)
Underwriter:
• Reviews applications and supporting information
• Classifies the degree of risk
• Determines insurability and appropriate rate
• Protects insurers against adverse selection
LEARNING OBJECTIVE 3: DESCRIBE THE COMPONENTS OF A HEALTH INSURANCE APPLICATION AND
THEIR SIGNIFICANCE
Part I - General Applicant Information:
• Personal details (name, age, address, etc.)
• Policy details (type, amount, beneficiary)
• Other insurance information
• Hazardous activities/hobbies
Part II - Medical and Health History:
• Proposed insured's health conditions
• Family health history
• Required for all applications
• May trigger additional medical requirements
Part III - Agent's Report:
• Agent's observations about the applicant
• Financial/character information
• Background/purpose of sale
• Replacement information (if applicable)
Application significance:
• Legal contract component when attached to the policy
• Basis for underwriting decisions
• Representations must be materially accurate
• Requires signatures from all relevant parties
LEARNING OBJECTIVE 4: DIFFERENTIATE BETWEEN THE VARIOUS TYPES OF PREMIUM RECEIPTS AND
THEIR IMPLICATIONS FOR COVERAGE
Conditional Receipt (most common):
• Coverage effective from the later of the application or medical exam date, IF the applicant proves
insurable
• Insurability type: Coverage begins IF the applicant is insurable as of the application date
• Approval type: Coverage begins only after application approval (rarely used)
• Subject to underwriting approval
Binding Receipt (rare in health insurance):
• Immediate coverage until formal rejection
• Coverage guaranteed even if the applicant is ultimately uninsurable
• Typically has a maximum payable amount
Temporary Insurance Agreement:
• Similar to a binding receipt
• Coverage during the entire underwriting period
• Claims during the underwriting period are paid regardless of the final underwriting decision
Inspection Receipt:
• Not a premium receipt
 • Used when an applicant reviethe ws policy before purchase
• No coverage until the premium is paid
LEARNING OBJECTIVE 5: CLASSIFY APPLICANTS INTO APPROPRIATE RISK CATEGORIES BASED ON
UNDERWRITING FACTORS
Risk classifications:
• Preferred risk: Better than average risk, lower premiums
• Standard risk: Average risk, standard premiums
• Substandard risk: Higher than average risk, higher premiums, or declined
Key risk factors:
• Physical condition and health history
• Age and sex
• Occupation and hobbies (avocations)
• Moral hazards (lifestyle factors)
• Insurable interest
Classification process:
• Evaluates all factors collectively
• Considers current and past health conditions
• Assesses the probability of future claims
• Determines the appropriate premium level
LEARNING OBJECTIVE 6: EXPLAIN HOW HEALTH INSURANCE PREMIUMS ARE CALCULATED AND THE
FACTORS THAT INFLUENCE THEM
Premium calculation formula:
• Morbidity – Interest + Expenses
Primary factors:
• Morbidity: Expected frequency/severity of claims
• Interest: Investment earnings on premiums
• Expenses: Operating costs, commissions, reserves, profit
Secondary factors:
• Benefits: Type, level, and number
• Benefit period: Duration of coverage
• Elimination period: Waiting period before benefits begin
• Probationary period: One-time waiting period for illness coverage
• Claims experience: Past loss history
• Age and sex of insured
• Occupation and hobbies
• Community ratings (for small groups/individuals)
LEARNING OBJECTIVE 7: IDENTIFY THE VARIOUS SOURCES OF UNDERWRITING INFORMATION AND
THEIR PURPOSES
Application: Primary source of personal/medical information
Medical Information Bureau (MIB):
• Industry database of coded medical information
• Helps detect adverse selection and fraud
• Reveals previous applications and conditions
Attending Physician Statement (APS):
• Detailed medical report from the applicant's doctor
• Provides specific condition information
• Requested for questionable medical history
Medical exam/lab tests:
• Objective health data
 • Required for higher face amounts
• May include blood tests, EKG, etc.
Special questionnaires:
• Detailed information on specific risks
• Used for hazardous activities, aviation, etc.
Inspection/credit reports:
• Character, reputation, and financial information
• Required for larger policies
• Helps assess moral hazard
LEARNING OBJECTIVE 8: RECOGNIZE THE LEGAL AND REGULATORY REQUIREMENTS THAT GOVERN
THE UNDERWRITING PROCESS
Fair Credit Reporting Act:
Regulates the collection/ and disclosure of consumer information
Requires notification when reports are used for decisions
Provides consumer access to information
HIPAA Privacy Rule:
• Protects health information
• Requires privacy notices
• Regulates information disclosure
Genetic Information Non-Discrimination Act (GINA):
• Prohibits the use of genetic information in health underwriting
Information and Privacy Protection Act:
• Regulates private information dissemination
• Prohibits decisions based solely on previous adverse decisions
USA PATRIOT Act:
• Requires anti-money laundering programs
• Applies to cash-value insurance products
State regulations:
• Prohibit unfair discrimination
• Require disclosure statements
• Mandate free-look periods
EXAM TIPS
Pay special attention to distinguishing between:
• Conditional vs. binding receipts
• Insurability vs. approval-type conditional receipts
• Preferred, standard, and substandard risk classifications
• Physical, moral, and morale hazards
Common trick questions involve:
• Premium receipt types and when coverage begins
• Application signature requirements
• Consequences of misrepresentation
• MIB information usage and limitations
When answering questions about:
• Premium receipts: Focus on conditions for coverage to begin
• Risk classification: Look for health, occupation, and lifestyle factors
• Application parts: Know what information appears in each section
• Underwriting information sources: Understand when each is used
Remember:
• Both the applicant and the agent must sign the application
 • Conditional receipts are most common in health insurance
• Misrepresentations can void coverage during the contestable period
• MIB helps prevent fraud, but does not make underwriting decisions
• Underwriting protects against adverse selection
• Premium calculation includes morbidity, interest, and expenses
• Field underwriting is the agent's responsibility
• Privacy notices are required under HIPAA
Key definitions:
• Adverse selection: Higher-risk individuals seeking coverage
• Field underwriting: Initial screening by producer
• Morbidity: Risk of illness/disability in a population
• Underwriting: Process of evaluating applications for insurability
• Conditional receipt: Coverage subject to proving insurability
• Binding receipt: Immediate coverage until formal rejection
For the exam:
• Know all parties involved in underwriting and their roles
• Understand when coverage begins with different receipt types
• Recognize factors that affect risk classification
• Identify legal requirements for application completion
• Know how premium calculations work
 Arizona Life and Health Laws and Rules
This chapter outlines Arizona’s laws and regulations governing life and health insurance. It is essential for
prospective insurance professionals to understand these requirements, including the Director’s
authority, licensing standards, producer duties, and prohibited practices.
Reviewing this chapter will enable you to:
• Identify the types of insurance licenses in Arizona, including producer, nonresident, adjuster,
life settlement broker, surplus lines broker, and temporary licensees, and understand the
requirements for obtaining, maintaining, and renewing each license.
• Explain the Arizona licensing process, including application procedures, lawful presence
documentation, fingerprinting requirements, exam attempt limits, assumed business names, and
continuing education obligations.
• Recognize the responsibilities of insurance producers, including fiduciary duties, record-
keeping standards, commission sharing rules, and business conduct expectations.
• Describe prohibited practices under Arizona law, such as misrepresentation, rebating, unfair
discrimination, insurance fraud, and deceptive advertising, and understand the disciplinary
actions and penalties for violations.
• Understand Arizona’s standards for marketing and trade practices, including solicitation,
negotiation, selling, and the regulation of inducements, fees, and vending machine use.
• Explain claims settlement practices, including timelines for payment, unfair claims handling,
and the role of the Insurance Fraud Unit in investigating fraudulent activity.
• Recognize key federal regulations impacting Arizona insurance, including the ACA, GLBA,
FCRA, MHPAEA, GINA, and the CAN-SPAM Act, and understand how these laws interact with
state-level requirements.
The information in this chapter is based on current Arizona insurance laws and regulations. Mastery of
this material will not only support success on the state licensing exam but also help ensure that
insurance professionals operate in compliance with Arizona law, thereby protecting both their clients and
their professional standing in the industry.
[1.2] KEYWORDS
As you progress through this chapter, it is essential that you understand the following key terms:
Producer - A person required to be licensed to sell, solicit, or negotiate insurance business in Arizona.
Fiduciary Duty - The legal obligation of insurance producers to act with honesty, integrity, and loyalty,
putting the interests of their principal ahead of their own.
Misrepresentation - Making false statements about policy terms, benefits, or other material facts, which
is prohibited and can be a felony.
Rebating - The prohibited practice of offering benefits or agreements not expressly written in an
insurance contract as an inducement.
Continuing Education - The requirement for licensees to complete 48 credit hours (including 6 hours of
ethics) during each licensing period.
Unfair Trade Practices - Prohibited methods of competition or deceptive acts in the insurance business
that are regulated by Arizona law.
Insurance Fraud - Knowingly presenting false statements or concealing material facts related to
insurance applications, claims, or other insurance matters.
Certificate of Authority - Evidence of an insurer's authorization to transact specific kinds of insurance in
Arizona.
Nonresident Producer - A person not legally residing in Arizona who may be licensed to act as an
insurance producer under specific conditions.
Unfair Claims Settlement Practices - Actions by insurers that, when performed with frequency, indicate
a general business practice of unfair claim handling.
Insurable Interest - The actual, lawful, and substantial economic interest in the safety or preservation of
the subject of insurance.
Temporary License - A license issued without examination for up to 180 days in specific circumstances
such as death or disability of a licensed producer.
[2.1] INSURANCE LICENSE APPLICATION REQUIREMENTS (REF: 20-285)
Before individuals or business entities can become licensed insurance professionals in Arizona, they
must meet specific application requirements. This section outlines the steps and documentation
required to initiate the licensing process, including the information the applicant must provide and the
prerequisites that must be met before an insurance license is issued.
[2.1.1] LICENSING ELIGIBILITY/LAWFUL PRESENCE (REF:41-1080)
To be eligible for an Arizona resident insurance license, an individual must provide to the Department of
Insurance documentation of their citizenship or legal alien status that verifies the individual’s presence in
the United States is authorized under federal law. The following are examples of acceptable
documentation:
• An Arizona driver’s license or an Arizona nonoperating identification license;
• A driver’s license issued by another state;
• A U.S. birth certificate or certificate of birth abroad;
• A U.S. passport or a foreign passport with a United States visa;
• An I-94 form with a photograph;
• A U.S. Citizenship and Immigration Services employment authorization document or refugee
travel document;
• A U.S. certificate of naturalization or certificate of citizenship;
• A tribal certificate of Indian blood;
• A tribal or Bureau of Indian Affairs affidavit of birth; or
• Any other license issued by the federal government, any other state government, an agency of
Arizona, or a political subdivision of Arizona that requires proof of citizenship or lawful alien status
before issuing the license.
This requirement is waived if all of the following apply to the applicant:
• They are a resident of another state;
• They hold an equivalent license for the same line of authority in the other state; and
• The Arizona license is not being obtained to attempt to establish Arizona residency.
[2.1.2] LICENSE APPLICATION REQUIREMENTS (20-285) - INDIVIDUALS
An individual applying for an Arizona resident insurance producer license must submit an approved
application to the Director and declare under the penalty of license denial, suspension, or revocation
that the statements made in the application are true, correct, and complete to the best of the applicant’s
knowledge. As part of the application process, an applicant is required to provide information concerning
the applicant's:
• Identity;
• Personal history;
• Business record;
• Experience in insurance; and
• Any other pertinent fact the Director requires.
Before approving an individual’s application, the Director must be satisfied that the individual:
• Is at least eighteen (18) years of age;
• Has not committed any act that is a ground for license denial, suspension, or revocation;
• Has paid the required application fees; and
• Has successfully passed the examinations for the lines of authority for which the individual has
applied.
[[Link]] NUMBER OF EXAM ATTEMPTS (20-284(H))
Arizona allows a maximum of four (4) attempts to pass an exam for a specific line of authority within any
twelve (12) month period. If an applicant does not pass an exam after four (4) attempts, they must wait
one (1) year after failing the fourth attempt before they are eligible to take that specific exam again.
[2.1.3] LICENSE APPLICATION REQUIREMENTS (20-285) - BUSINESS ENTITIES
Business entities that wish to transact insurance in Arizona must also be licensed by the state. Before
approving a business entity’s license application, the Director must find that the entity:
• Has paid the required application fees;
• Will be acting within the scope of its partnership agreement, articles of incorporation, or other
chartering documents when the business entity transacts business under the license; and
• Has designated an individually licensed insurance producer who is responsible for the business
entity's compliance with the insurance laws of Arizona. This person is sometimes referred to as
the designated responsible licensed producer (DRLP).
In addition to the above requirements, the application of a business entity must also include the names
of all members, officers, and directors of the business entity. The Director may require a business entity
applicant to provide information on all its members, officers, directors, and its DRLP, as is normally
required for individual insurance licensure.
[[Link]] ASSUMED BUSINESS NAME (20-297)
If an insurance producer intends to do business under any name other than their legal one (known as an
assumed name), they must first notify the Director in writing before using the assumed name.
The Director may deny the use of an assumed business name, require the use of a different assumed
business name, or require the use of an assumed business name if an insurance producer uses or
proposes to use an assumed business name that either:
• Is so similar to the legal name or a name already assumed by another licensed insurance
producer that it would cause uncertainty or confusion; or
• Tends to deceive or mislead the public as to the nature of the business the producer conducts.
• An insurance producer must notify the Director in writing within thirty (30) days of any name
change.
[2.1.4] FINGERPRINTING REQUIREMENTS (20-142(E), 285(E), 286(C), 289(D))
Before the Director grants (or renews) a license to a person or a certificate of authority to a corporation,
they may require the applicant to:
• Provide any document that is reasonably necessary to verify the information that is contained in
an application and other information, including prior criminal records; and
• Submit a full set of fingerprints to the Department for the purpose of obtaining a state and federal
criminal records check.
Business entities must also inform the Director in writing within thirty (30) days of any change in their
members, directors, officers, or designated producers. The Director may then require the entity to submit
fingerprints of any new member, director, officer, or designated producer for the same purpose of
performing a criminal background check.
[2.2] TYPES OF INSURANCE LICENSEES
Arizona state laws classify insurance professionals into various licensee categories based on their roles
and responsibilities. This section will review the following types of licensees:
• Insurance producers;
• Nonresident producers;
• Adjusters;
• Life settlement brokers;
• Business entities;
• Surplus lines brokers;
• Temporary licensees; and
• Vending machine licensees.
[2.2.1] RESIDENT PRODUCERS (20-281(5), 286)
A producer is an individual required to be licensed under Arizona law to sell, solicit, or negotiate
insurance business. Producer licenses are issued for periods of four (4) years and expire on the last day
of the licensee’s birthday month. For example, a license issued to an individual with a birthday on May 13
will expire May 31. No person is permitted to sell, solicit, or negotiate insurance in Arizona for any class or
classes of insurance unless that person is licensed for that line of authority.
Insurance licenses must contain the following information:
• The licensee’s name, address, and identification number
• The date of issuance
• The lines of authority granted
• The expiration date, and
• Any other information the Director deems necessary.
The Director may choose to make insurance license information available electronically, such as by
providing access through a website.
[2.2.2] NONRESIDENT PRODUCERS (20-281(11))
A person who is not a legal resident of Arizona may be licensed to act in Arizona as a nonresident
insurance producer if the following conditions are met:
• The person is currently licensed in their home state as a resident producer and is in good standing.
• The person submits the proper request and required fees for licensure.
• The person submits to the Director their home state application for licensure or an Arizona
uniform application.
An individual applying for a nonresident license is not required to pass the Arizona state insurance exam
for any line of authority for which they are currently licensed in their home state.
A nonresident producer licensed in another state who becomes a resident of Arizona and continues to
act as an insurance producer must apply for and obtain a resident producer’s license within ninety (90)
days.
[2.2.3] ADJUSTERS (20-321)
An adjuster is anyone who adjusts, investigates, or negotiates the settlement of property and casualty
insurance claims in exchange for compensation, fees, or commission. This definition also includes
anyone who holds themselves out to perform any of these services.
Adjusters may act on behalf of either the insurer or the insured.
[2.2.4] BUSINESS ENTITIES (20-281(1), 285(D, E), 290(B))
A business entity is any corporation, association, partnership, limited liability company, limited liability
partnership, or other legal entity that is not an individual or sole proprietorship. As previously mentioned,
business entities must possess an insurance license to transact insurance in Arizona.
When conducting insurance business in Arizona, a business entity insurance producer must have at least
one (1) insurance producer who is individually licensed for the appropriate lines of authority in each of its
offices or places of business.
[[Link]] ASSUMED BUSINESS NAME (REF: 20-297)
If an insurance producer intends to do business under any name other than their legal one (known as an
assumed name), they must first notify the Director in writing before using the assumed name.
The Director may deny the use of an assumed business name, require the use of a different assumed
business name, or require the use of an assumed business name if an insurance producer uses or
proposes to use an assumed business name that either:
• Is so similar to the legal name or a name already assumed by another licensed insurance
producer that it would cause uncertainty or confusion; or
• Tends to deceive or mislead the public as to the nature of the business the producer conducts.
An insurance producer must notify the Director in writing within thirty (30) days of any name change.
[2.2.5] SURPLUS LINES BROKERS (20-407, 411)
Surplus lines insurance refers to insurance obtained from insurers not authorized to transact insurance
business in Arizona. A surplus lines broker is an individual licensed by the State of Arizona to obtain
surplus lines insurance from unauthorized insurers on behalf of their clients.
[[Link]] REQUIREMENTS
Surplus lines insurance may only be procured from unauthorized insurers if it is procured through a
licensed Arizona surplus lines broker, and either one of the following two circumstances applies:
• The Director recognizes the type of insurance coverage as an eligible surplus line, or
• The coverage is not procurable despite diligent efforts to buy it.
The placing of insurance with an unauthorized insurer is not solely for the purpose of securing a lower
premium rate or more favorable terms of the insurance contract (i.e., insurance MUST be placed with an
authorized insurer if it is offered, even if the rates or terms are worse than those offered by an
unauthorized insurer).
[[Link]] SURPLUS LINES BROKERS LICENSING(20-407, 411)
An individual may not act as a surplus lines broker in Arizona unless properly authorized to do so by a
license issued by the Director. An individual who is currently a licensed resident insurance producer
authorized to transact property and casualty insurance may also apply to be licensed as a surplus lines
broker if the Director determines that the producer is competent and trustworthy. Every applicant for a
resident surplus lines broker license must pass the state’s surplus lines insurance exam, even if they
currently possess another Arizona insurance license.
At least one (1) individual in each office or place in Arizona where surplus lines insurance is transacted
must be licensed as either a property or casualty insurance producer and also as a surplus lines broker.
A surplus lines broker license is subject to the same expiration and renewal standards as licenses for
other lines of authority, most notably the four (4) year term limit.
[2.2.6] TEMPORARY LICENSES (20-294)
The Director may issue a temporary insurance producer license, without requiring the individual to pass
an examination, if the Director determines that the temporary license is necessary for the servicing of an
insurance business in the following situations:
• To the surviving spouse or court-appointed personal representative of a licensed insurance
producer who dies or becomes a person with a mental or physical disability. The temporary
license is granted to allow adequate time:
o For the sale of the insurance business owned by the producer;
o For the recovery of the producer and return of the producer to the business; or
o To provide for the training and licensing of new personnel to operate the producer's
business.
• To a member or employee of a licensed business entity upon the death or disability of the entity’s
designated responsible licensed producer; and
• To the designee of a licensed insurance producer who enters active service in the armed forces of
the United States.
In all cases, a temporary license may only be issued for a maximum term of one hundred eighty (180)
days.
In general, a temporary license grants the same rights and privileges as a normal insurance license.
However, the Director may impose conditions or limitations on the authority of any temporary licensee in
any way the Director deems necessary to protect insureds and the public, including requiring the
temporary licensee to have a suitable sponsor who is a licensed insurance producer or insurer and who
assumes responsibility for all acts of the temporary licensee.
[2.2.7] LIFE SETTLEMENT BROKERS (ARS 20-3202)
Life settlement brokers buy, sell, and broker life insurance policies for people who do not wish to keep
paying for their current plans.
Any producer that holds a life insurance license issued by Arizona is eligible to operate as a life
settlement broker. The producer must notify the Director within the first thirty (30) days after beginning to
operate as a broker.
Note: A person who is licensed as an attorney or a certified public accountant, who is retained to
represent the owner and whose compensation is not paid directly or indirectly by the provider or
purchaser, may negotiate a life settlement contract on behalf of the owner without having to obtain a
license as a broker.
[2.2.8] VENDING MACHINES (20-293)
Only a licensed insurance producer who is authorized by the Director may solicit applications for and
issue policies by means of mechanical vending machines. A policy may not be solicited and issued
through a machine if the Director determines:
That the kind of insurance or form of policy to be sold is unsuitable for distribution through vending
machines;
The use of a vending machine may pose a risk of harm to the public; or
The proposed type of vending machine is not reasonably suitable and practical for the purpose.
[2.3] LINES OF PRODUCER LICENSE AUTHORITY (20-286, (A), 321, 331, 332, 411, 411.01, 1580, 1693.01,
2662)
Insurance licenses in Arizona are further divided into different lines of authority, specifying the types of
insurance products or services a licensee can sell or offer. This section will outline the various lines of
producer license authority.
AVAILABLE LINES OF AUTHORITY
An insurance producer may qualify for a license in one (1) or more of the following lines of authority:
• Life: Life insurance is coverage for human lives, including death benefits, annuity benefits,
accidental death or dismemberment benefits, and disability income benefits.
• Accident and health or sickness: Accident and health or sickness insurance covers sickness,
bodily injury, or accidental death, and may include disability income benefits.
• Property: Property insurance is coverage for the direct or consequential loss or damage to
property.
• Casualty: Casualty insurance is coverage against legal liability.
• Variable life and annuity products: Variable products include variable life and annuity contracts.
Licensees must also be registered representatives with FINRA.
• Personal lines: Personal lines insurance is property and casualty insurance sold to individuals
and families for noncommercial purposes.
• Credit: Credit insurance is a limited line for selling credit insurance.
• Crop: Crop insurance is a limited line for selling crop insurance.
• Rental car agent: This license is issued to rental car companies for coverage under rental car
agreements.
• Self-service storage agent: This license is issued to self-storage businesses to write insurance
coverage for stored property.
• Mexican insurance surplus lines broker: This license allows the licensee to sell policies that will
be effective in Mexico, not in the U.S.A.
• Title insurance agents: These agents sell policies that cover losses arising from third-party
claims related to the property's title.
• Portable electronics insurance: Licensees holding this authority can sell insurance covering
mobile electronic devices. The authority is granted to a vendor who can authorize employees to
transact this type of insurance.
[2.4] LICENSE MAINTENANCE AND DURATION
Maintaining an insurance license requires periodic renewals and compliance with certain regulations.
This section provides an overview of maintenance requirements, continuing education obligations, and
the duration of licenses in Arizona. We will also note the responsibility of licensees to report important
changes in personal information, as well as the penalties for noncompliance with license maintenance
laws.
[2.4.1] EXPIRATION, SURRENDER, AND RENEWAL (20-289)
Arizona licenses, other than temporary licenses, continue in force until they expire, or the Director
suspends, revokes, or terminates them. Licenses must be renewed every four (4) years, or they expire. A
licensee may voluntarily surrender their license, by written request, to the Director.
Individual licenses expire on the last day of their birth month if not renewed. Business entity licenses
expire on the last day of the month in which they were originally issued. To renew a license, a licensee
must submit a renewal application, the required fee, and evidence of completed continuing education to
the Director:
If a licensee fails to meet these requirements, they still have one (1) year after their license's expiration
date to renew simply by submitting the normal renewal requirements with an additional $100 late
renewal fee. After a license is expired for more than one (1) year, the former licensee must comply with all
of the pre-licensing requirements.
[2.4.2] INACTIVE LICENSE STATUS DURING MILITARY SERVICE (20-289.01)
A licensee or applicant who is ordered into active military service may request that their license or
application be placed on inactive status by submitting a written request to the department. The license's
inactive status will remain in effect until the end of the term of active military service. A licensee whose
license is on inactive status may not sell insurance, but may receive commissions for insurance sold
before the license became inactive.
[2.4.3] CHANGE OF CONTACT INFORMATION (20-286(C))
All licensees must inform the Director in writing within thirty (30) days of any change in their:
• Residential, business, or email address; or
• Name.
A licensed business entity must notify the Director of any change to its members, directors, officers, or
designated producer within thirty (30) days of the change.
[2.4.4] REPORT OF ACTIONS (20-301)
An insurance producer must report any administrative action taken against them within thirty (30) days
after the final disposition of the matter. The report must include a copy of the order, consent to order, or
any other relevant dispositive document.
Likewise, a producer must also report any criminal conviction they are convicted of to the Director within
thirty (30) days after the conviction’s filing date. The report must include a copy of the initial indictment,
information or complaint filed, the final judgment entered by the court, and all other relevant legal
documents.
[2.4.5] CONTINUING EDUCATION (20-2902, 2903)
As a condition of license renewal, licensees must complete a specified number of continuing education
hours during each licensing period. These requirements differ depending on whether the licensee is a
resident or a nonresident.
[[Link]] ARIZONA RESIDENT LICENSE REQUIREMENTS
To renew one's resident insurance license, a licensee must complete at least forty-eight (48) credit hours
of approved continuing education. Of these hours, at least six (6) must consist of ethics training.
Licensees may receive credit for a specific approved course only once during a single four (4) year license
period.
Licensees will receive a certificate of compliance for each completed course. The Director will not renew
a license unless the licensee provides evidence that the required continuing education hours have been
completed.
[[Link]] ARIZONA NONRESIDENT LICENSE REQUIREMENTS
Nonresident licensees are not required to meet the Arizona continuing education requirement for
resident producers if they provide the Director with proof that they have satisfied the continuing
education requirements of their home state.
[[Link]] RECORD KEEPING
Licensees are responsible for maintaining their own continuing education records. They must keep these
records until the second renewal date after the period for which the continuing education credits were
earned, which means another four (4) years after the date the credits are due.
[2.5] DISCIPLINARY ACTIONS
This section examines the disciplinary actions that may be imposed for violations of state laws or
regulations.
[2.5.1] DENIAL, SUSPENSION, REVOCATION, OR REFUSAL TO RENEW; CIVIL PENALTIES (20-295, 296)
The Director may deny, suspend for up to twelve (12) months, revoke, or refuse to renew an insurance
producer's license for any one (1) or more of the following reasons:
• Providing incorrect, misleading, incomplete, or materially untrue information in one's license
application;
• Attempting to obtain a license through misrepresentation or fraud;
• Improperly withholding or misappropriating funds or property received while engaged in one's
insurance business;
• Intentionally misrepresenting the terms of an insurance contract or application;
• Using fraudulent, coercive, or dishonest practices or demonstrating incompetence,
untrustworthiness, or financial irresponsibility in the conduct of business;
• Violating any insurance law or any rule, subpoena, or order of the Director;
• Having been convicted of a felony;
• Having admitted or been found to have committed any insurance unfair trade practice or fraud;
• Having an insurance producer license denied, suspended, or revoked in any state, province,
district or territory;
• Forging another's name to any document related to an insurance transaction;
• Aiding or assisting any person in the unauthorized transaction of insurance business;
• Receiving commission for a sale of insurance to the state of Arizona when not authorized to
receive such commission;
• Violating laws related to premium financing; and
• Using the insurance producer's license principally to write controlled business, which is defined
as insurance that covers the life or property of a licensee or those in whom the licensee has an
insurable interest:
A business entity’s license is subject to the same penalties if its designated producer or any of the
business entity's members, officers, directors, or managers have committed any of the preceding acts.
Action may be taken against a business entity’s license if the entity knew that one of its producers
committed one of these violations, and neither reported it nor took action against the producer.
If the Director denies a license application, the applicant must have an opportunity to contest the denial
at a hearing. Likewise, the Director must provide current licensees with notice and an opportunity for a
hearing before revoking, suspending, or refusing to renew an in-force license.
[2.5.2] PENALTIES
The Director may impose the following penalties after a hearing:
• A civil penalty of up to $250 for each unintentional failure or violation, up to a maximum total of
$2,500;
• A civil penalty of up to $2,500 for each intentional failure or violation, up to a maximum total of
$15,000; and
• Order the licensee to provide restitution to any party injured by the licensee's actions.
These penalties may be imposed instead of or in addition to a license suspension, revocation, or refusal
to renew. They must be paid to the Director and are in addition to any other applicable penalties under
any other law. These penalties may be imposed even if one's license has been surrendered or has
naturally expired under the law.
[[Link]] EFFECT OF LICENSE SUSPENSIONS AND REVOCATIONS
The Director will not issue a license to any person whose license has been revoked until one (1) year has
passed since the revocation. A person who reapplies for a license after this one (1) year period must
again qualify for the license as if it were their first time applying, which includes the completion of a pre-
licensing education course.
[[Link]] CEASE-AND-DESIST ORDER (20-292)
If the Director has cause to believe that any person is violating or about to violate any insurance licensure
laws, the Director may order the person to cease and desist and may cause a complaint to be filed in the
superior court in Maricopa County to enjoin and restrain the person from:
• Continuing the violation;
• Engaging in the violation; or
• Doing any act in furtherance of the violation.
[2.6] STATE REGULATION
This section will discuss Arizona laws and regulations that govern the following insurance topics:
• Acts constituting an insurance transaction;
• Payment of premiums;
• Certificate of authority;
• Identification of the producer; and
• Producer regulation.
[2.6.1] ACTS CONSTITUTING INSURANCE TRANSACTION (REF: 20-106, 282, 401.01)
The act of transacting insurance includes soliciting and inducing, conducting preliminary negotiations,
selling a policy, and providing services after the policy is in force.
• Negotiate [REF:20-281(10)]: Negotiate describes the act of conferring with, or offering advice to a
prospective insurance purchaser concerning any of the contract's benefits, terms, or conditions.
• Sell [REF: 20-281(14)]: Selling means exchanging an insurance contract by any means, for money
or its equivalent, on behalf of an insurer.
• Solicit [REF: 20-281(15)]: Soliciting means attempting to sell insurance or asking someone to
apply for a particular policy from a particular company.
[2.6.2] PAYMENT OF PREMIUMS (REF: 20-191)
Any insurance premium payment sent by mail on or before the due date is considered a timely payment,
as determined by the postmark on the payment envelope.
[2.6.3] CERTIFICATE OF AUTHORITY (REF: 20-217(A))
A certificate of authority issued by the Director to an insurer is evidence of that insurer's authority to
transact in Arizona the kind of insurance specified in the certificate. A certificate of authority is the
property of Arizona. Upon termination at the insurer's request or revocation by the director, the insurer
must immediately deliver the certificate of authority to the Director.
[2.6.4] IDENTIFICATION OF PRODUCER (REF: 20-229)
An authorized insurer may not issue a policy covering a subject of insurance in Arizona unless the policy
declaration page or endorsement identifies the name of the licensed producer representing the insurer
for that line of authority in Arizona.
[2.6.5] SHARING COMMISSIONS (REF:20-298)
An insurer or insurance producer may not pay a commission or other valuable consideration to a person
for selling, soliciting, or negotiating insurance in Arizona if that person is required to be licensed and is
not so licensed. Likewise, a person is prohibited from accepting a commission or other consideration if
they are required to be licensed and are not.
Unlicensed individuals may still receive renewal and other deferred commissions, provided they were
properly licensed at the time the insurance transaction occurred.
[2.6.6] PLACE OF BUSINESS AND RECORDS (REF: 20-157, 290; AZ CONST ART 14 S 16)
Director Access to Records and Methods of Maintenance
The records, books, and files of all insurance companies and producers are at all times liable and subject
to inspection and examination by the Director. This includes providing these items via email upon the
Director's inquiry or making them available during a physical visit.
When being examined by the Director, every entity being examined and its officers, employees, agents,
and representatives must produce and make freely accessible to the Director or the Director’s examiners
any accounts, records, or other items in the person’s possession that relate to the subject of the
examination. The person being examined is responsible for paying any costs or expenses arising from the
examination.
Records, accounts, documents, and files that must be maintained may be created or recorded by any
process that accurately reproduces or forms a durable medium for storing the required items.
[2.7] UNFAIR PRACTICES
The insurance industry in Arizona operates on the principles of trust and fairness, but instances of unfair
practices can undermine its integrity. To combat these issues, Arizona has established stringent laws and
regulations. This section explores the topics of unfair practices and fraud as they pertain to Arizona
insurance laws, providing an understanding of prohibited activities, regulatory framework, and
disciplinary actions.
[2.7.1] UNFAIR TRADE PRACTICES (REF: 20-442)
No person may engage in any trade practice that is prohibited, defined, or determined to be an unfair
method of competition or an unfair or deceptive act or practice in the business of insurance.
[2.7.2] MISREPRESENTATION (REF:20-443, 443.01, 447; RULE R20-6-801(D))
Knowingly making one of the following misrepresentations is a felony. A person may not make, issue, or
circulate any information or statement that
• Misrepresents any insurance policy's terms, benefits, advantages, payable dividends, or dividends
previously paid on similar policies;
• Misrepresents the financial condition of any insurer or regarding the legal reserve system upon
which any life insurer operates;
• Uses a policy name that misrepresents the true nature of the policy;
• Makes any misrepresentation to any policyholder for the purpose of inducing or tending to induce
the policyholder to lapse, forfeit, surrender, retain, or convert any insurance policy (known as
twisting);
• Refers to the coverage provided by the Arizona Insurance Guaranty Association in connection with
the attempted sale of any insurance policy; or
• Falsely discloses the compensation method or amount associated with a health benefits plan.
• [2.7.3] FALSE OR DECEPTIVE ADVERTISING (REF: 20-444)
• No person may make, publish, disseminate, circulate, or place before the public through any
method any advertisement, announcement, sales material, or statement containing any
statement about the business of insurance, or about any person in the conduct of their insurance
business, that is untrue, deceptive, or misleading.
• No person that is not an insurer may use any name that deceptively infers or suggests that it is an
insurer.
• [2.7.4] DEFAMATION OF INSURER (REF: 20-445)
• No person may make, publish, disseminate, or circulate any statement through any means that is
false or maliciously critical of or derogatory to the financial condition of an insurer or person that
is engaged in the business of insurance. To be considered defamation, the statement must also be
calculated to injure or malign the person or insurer.
 • [2.7.5] BOYCOTT, COERCION, OR INTIMIDATION (REF: 20-446)
• No person may enter into any agreement to commit, or by any concerted action actually commit,
any act of boycott, coercion, or intimidation resulting in, or tending to result in, the unreasonable
restraint of or monopoly in the business of insurance.
• [2.7.6] FALSE FINANCIAL STATEMENTS (REF: 20-447)
• No person may file with any public official, make or deliver to any person, or place before the
public any false statement of the financial condition of an insurer with the intent to deceive. This
law also prohibits making any false entry in any book, report, or statement of any insurer or other
person that is required to maintain records under the law with the intent to deceive:
• Any agent appointed to examine the financial condition of the insurer;
• Any public official that the insurer or person is required to report to by law; or
• Any other person who has the lawful authority to examine the person’s or insurer’s financial
condition or affairs.
• Intentionally omitting to make a true entry of any material fact that is relevant to the person’s or
insurer’s business with the intent to deceive is also a violation of this statute.
[2.7.7] UNFAIR DISCRIMINATION (REF: 20-448)
Any insurer that offers life, disability, property, or liability insurance contracts may not deny a claim or
deny, refuse, refuse to renew, restrict, cancel, exclude, or limit coverage, or charge a different rate for the
same coverage solely on the basis that the insured is or has been a victim of domestic violence. This
statute’s protection also extends to entities or individuals that provide counseling, shelter, protection, or
other services to victims of domestic violence. The fact that an insured or proposed insured is or has
been the victim of domestic violence is not a mental or physical condition and cannot be considered
such by an insurer when taking actions regarding a policy.
This statute does not prevent an insurer from refusing to issue a life insurance policy insuring a person
who has been the victim of domestic violence if either of the following is true:
• The family or household member who commits the act of domestic violence is the applicant for or
prospective owner of the policy, or would be the beneficiary of the policy, and any of the following
is true:
o The applicant or prospective beneficiary of the policy is known, based on police or court
records, to have committed an act of domestic violence;
o The insurer has knowledge of an arrest or conviction for a domestic violence-related
offense by a family or household member; or
o The insurance company has other reasonable grounds to believe, and those grounds are
corroborated, that the applicant or proposed beneficiary of a policy is a family or
household member committing acts of domestic violence.
• The applicant or prospective owner of the policy lacks an insurable interest in the insured.
All insurers must adopt and adhere to written policies that ensure the privacy of, and protect the safety
of, a victim of domestic violence when taking an application, investigating a claim, pursuing subrogation,
or taking any other action relating to a policy or claim that involves a victim of domestic violence. Insurers
must distribute the written policies to employees, contractors, producers, agents, and brokers who have
access to personal or privileged information regarding domestic violence.
[2.7.8] GENDER DISCRIMINATION (REF: RULE R20-6-207)
Though insurers may consider marital status when determining eligibility for dependent coverage or
benefits, they are prohibited from the following actions if they are based on the gender or marital status
of an insured or prospective insured:
• Denying the availability of any insurance policy; and
• Restricting, modifying, excluding, reducing, or limiting the amount of benefits payable, any term,
any conditions, or any types of coverage under a policy.
Practices, including the following, that treat similarly situated persons differently based on gender, are
prohibited:
• Denying coverage to a person of one gender but not the other based on employment type;
• Denying a policy rider to a person of one gender if the rider is available to a person of the opposite
gender;
• Denying maternity benefits to someone buying an individual policy if comparable family policies
provide them;
• Denying dependent coverage to employees of one gender if it is available to those of the opposite
gender;
• Denying disability insurance to similarly employed persons of one gender while covering those of
the opposite gender;
• Treating complications of pregnancy differently from any other covered conditions;
• Reducing, modifying, or excluding benefits relating to coverage involving the genital organs of only
one gender;
• Offering lower maximum monthly disability benefits to similarly employed persons based on
gender;
• Offering more restrictive benefit periods or more restrictive definitions of disability based on
gender;
• Establishing different conditions for a policyholder of one gender to exercise benefit options; and
• Limiting the amount of coverage one may purchase based on one's marital status.
[2.7.9] REBATING (REF: 20-449–451)
No person may make agreements or offer benefits in connection with any life, annuity, or disability policy
other than what is written in the contract. To do so constitutes rebating, which is prohibited. The following
are examples of what is prohibited by this statute:
• Paying or rebating premiums paid for a contract back to the insured as an inducement to buy a
policy;
• Offering or giving any special favor or advantage in the dividends or other benefits under a policy;
and
• Offering or giving any other valuable consideration or inducement not specified in the policy.
Insurers may retain independent third parties to conduct customer feedback to improve their products
and services. Insured businesses and individuals may be offered a reasonable incentive, up to $200, for
providing feedback.
[2.7.10] PROHIBITED INDUCEMENTS (REF: 20-452)
No one may offer any of the following, in any policy, as an inducement to buy insurance of in connection
with an insurance transaction:
• A promise of employment;
• Any shares of stock or other securities, or any interest from either;
• Advisory board contracts, agreements, or understandings that offer, provide for, or promise
special profits; or
• Any prizes, goods, wares, merchandise, or tangible property exceeding a value of $100.
Products or services that are intended to minimize or prevent claims-related losses, expenses, or harm to
the public may be offered or provided. Examples are smoke detectors, risk audits, and Products that
deter property theft.
[2.7.11] FEES (REF: 20-465)
Producers may not charge any fee, in addition to the premium, in connection with
an insurance transaction unless:
• The fee and specific services for which it is charged are disclosed and agreed to in writing by the
insured; and
 • The amount of the fee is reasonably related to the cost of the service rendered and does not
duplicate or increase any fee or service charge included in the insurer's rate filing.
The Director may order any person violating this statute to refund all or part of the fee or service charge
and may impose any applicable civil penalties for the violation.
This statute does not apply to the transaction of commercial or surplus lines insurance.
[2.7.12] UNFAIR CLAIMS SETTLEMENT PRACTICES (REF: 20-461; RULE R20-6-801)
No one may do any of the following acts with sufficient frequency that may indicate it to be a general
business practice:
• Misrepresenting pertinent facts or insurance policy provisions relating to coverages at issue;
• Failing to acknowledge and reasonably respond to communications regarding claims within 10
working days;
• Failing to have reasonable standards for promptly investigating claims, which should typically be
completed within 30 days;
• Refusing to pay claims without conducting a reasonable investigation based upon all available
information;
• Failing to affirm or deny claims within a reasonable time after proof of loss statements have been
completed;
• Not attempting in good faith to settle claims promptly, fairly, and equitably when liability is
reasonably clear, with acceptance, denial, or notice of the need for more time being supplied
within 15 working days.
• As a property or casualty insurer, failing to recognize a valid assignment of a claim;
• Compelling insureds to institute litigation to recover amounts due under an insurance policy by
offering substantially less than the amounts ultimately recovered in actions brought by the
insureds;
• Attempting to settle a claim for less than the amount a reasonable person would have believed
they were entitled to based on written or printed advertising material accompanying or made part
of an application;
• Attempting to settle claims based on an application altered without the insured's knowledge or
consent;
• Making claims payments without a statement of which coverage the claim is being paid under;
• Making known a policy of appealing from arbitration awards in favor of insureds or claimants for
the purpose of compelling them to accept settlements or compromises less than the amount
awarded in arbitration;
• Delaying the investigation or payment of claims by requiring a preliminary claim report and then
requiring an additional formal proof of loss form, when they both effectively contain the same
information;
• Failing to promptly settle claims when liability is reasonably clear under one (1) portion of the
policy to influence settlements under other portions of the policy;
• Failing to promptly provide a reasonable explanation for denying a claim or offering a compromise
settlement;
• Attempting to settle claims for the replacement of any nonmechanical sheet metal or plastic part
which generally constitutes the exterior of a motor vehicle with an aftermarket crash part which is
not made by or for the manufacturer of an insured's motor vehicle without advising the consumer;
• Failing to pay physician charges for reasonable and necessary services provided
within the physician’s lawful scope of practice if the insurance coverage includes diagnosis and
treatment of the condition or complaint; and
• Denying liability for a claim under a motor vehicle liability policy based solely on a medical
condition that could affect the insured's driving ability.
[[Link]] CLAIMS PAYMENT (REF: 20-462)
If an insured provides their insurer with complete and acceptable proof of loss for a first-party claim, the
insurer has 30 days to pay the claim before being required to pay additional interest on the claim amount.

[2.8] INSURANCE FRAUD (REF: 20-463; 20-466.01)

It is a fraudulent practice and unlawful for a person to knowingly:
• Present or prepare a statement that will be delivered to an insurer, insurance producer, or agent
that contains untrue statements of material fact or that fails to state any material fact with respect
to any of the following:
o An insurance policy application
o The rating of an insurance policy
o An insurance claim or any payment related to a policy's terms
o Insurance premiums
o An application for a certificate of authority
o The financial condition of an insurer
o The acquisition of an insurer or reinsurer, including concealment
• Solicit or accept insurance risks for any insolvent insurer, reinsurer, or other licensed
insurance entity;
• Conceal from the Department, or remove from the licensed entity's place of business in Arizona,
assets or records regarding their insurance business;
• Divert the monies of an entity licensed to transact insurance business
A person who acts without malice, fraudulent intent, or bad faith is not subject to any legal liability (such
as a lawsuit) for providing information about suspected, anticipated, or completed fraudulent insurance
acts as long as the information is provided to or received from:
• The Director or the Department;
• Law enforcement officials and their agents and employees; or
• The National Association of Insurance Commissioners, other state insurance departments, a
federal or state agency or bureau established to detect and prevent fraudulent insurance acts, an
organization established by insurers to assist in the detection and prevention of fraudulent
insurance acts, or any employees or agents of these organizations or entities.
In addition, no person employed by any of these organizations or entities is subject to civil liability when
acting within the scope of their employment and without malice, fraudulent intent, or bad faith.
[2.8.1] THE INSURANCE FRAUD UNIT (REF: 20-466)
The Director has the authority to investigate any act or practice of fraud involving the insurance industry.
To assist the Director with this responsibility, the law establishes an insurance fraud unit that operates
within the Department of Insurance and Financial Institutions, which is administered by the Director and
operated by an individual appointed by the Director. The fraud unit is funded through annual assessments
made to all authorized insurers in amounts of up to $1,050 each.
A fraud unit investigator has all the law-enforcement powers of a peace officer in Arizona, but only when
acting within their scope of employment for the Department. The guidelines for conducting fraud unit
investigations are similar to the investigative policies and procedural guidelines of the Department of
Public Safety for peace officers. Since fraud unit investigators are granted the same powers as peace
officers, they must also meet the same qualifications prescribed by the Arizona Peace Officer Standards
and Training Board.
The Director may request the submission of papers, documents, reports, or other evidence relating to a
fraud investigation, and may issue subpoenas and take other legal actions as required by
the investigation. The Director may use this information in the furtherance of any regulatory or legal
action brought as a part of the Director's official duties.
An insurer that believes a fraudulent claim has been made must send to the Director any information
related to the claim, including the identities of the parties claiming loss or damage as a result of an
accident, and any other information the fraud unit may require. The Director will then review the report
and determine if further investigation is necessary. After an investigation, if the Director determines that
fraud, deceit, or intentional misrepresentation of any kind has been committed, they may report the
violations of the law to the reporting insurer, to the appropriate licensing agency, and to the appropriate
county attorney or the attorney general for prosecution. Any person found to have committed a
fraudulent act is guilty of a felony.
[2.8.2] INJUNCTION; RESTITUTION; CIVIL PENALTIES; COSTS (REF: 20-466.02, 20-466.04)
At the request of the Director, the Attorney General may seek an injunction from the superior court
prohibiting a person from engaging in fraudulent practices or acts. The court may then enter any order or
judgment that is necessary to:
• Prevent any fraudulent act or practice; and
• Return any money, real or personal property acquired by a fraudulent act or practice (restitution).
An order of restitution may also include an insurer's expenses in connection with any medical evaluation
or treatment.
In addition to any other penalties for committing a fraudulent act, a person may also be subject to a civil
penalty of $5,000 for each violation. The Director will also forward the name of any person found liable
of a civil offense or guilty of criminal fraud to the appropriate licensing agency.
[2.8.3] NOTICE OF PENALTY FOR FALSE OR FRAUDULENT CLAIMS (REF: 20-466.03)
The claims forms provided by an insurer for filing a notice or making a claim in connection with a policy or
contract must include the following statement in at least 12-point type:
"For your protection, Arizona law requires the following statement to appear on this form. Any person who
knowingly presents a false or fraudulent claim for payment of a loss is subject to criminal and civil
penalties."
[2.9] INSURANCE INFORMATION AND PRIVACY PROTECTION (REF: 20-2101–2122)
Arizona has enacted the Insurance Information and Privacy Protection Law, which applies to all insurers
doing business in Arizona. This section explores the key provisions and implications of this law, which
regulates the collection, use, and disclosure of personal information by insurance companies operating
within the state.
[2.9.1] PRETEXT INTERVIEWS
Pretext interviews to obtain information in connection with an insurance transaction are prohibited,
except as part of a criminal fraud investigation.
[2.9.2] NOTICE OF INSURANCE INFORMATION PRACTICES
Insurance institutions and producers must provide a notice of their information practices to all
applicants and policyholders either when delivering a policy or when first collecting personal information
from a source other than the individual. They must also provide one annually for policy renewals.
[2.9.3] MARKETING AND RESEARCH SURVEYS; DISCLOSURE OF QUESTIONS
Questions during an insurance transaction that are specifically designed to obtain an individual’s
information solely for marketing or research purposes must be clearly identified.
[2.9.4] CONTENT OF DISCLOSURE AUTHORIZATION FORMS
Authorization forms permitting the disclosure of an individual’s personal or privileged information must
state the purpose of the inquiry, be dated, be written in plain language, have a limited timeframe, and give
specifics regarding people, financial institutions, and information being sought. They must also advise
the individuals that they or their authorized representatives are entitled to receive a copy of any
authorization form.
[2.9.5] INVESTIGATIVE CONSUMER REPORTS
An investigative consumer report about an individual may not be prepared or requested in connection
with an insurance transaction unless the individual is informed that they may request to be interviewed.
[2.9.6] THE SALE OF INSURANCE INQUIRY INFORMATION BY CONSUMER REPORTING AGENCIES IS
PROHIBITED
A consumer reporting agency may not provide or sell data or lists that include any information that was
submitted in conjunction with an insurance inquiry about a consumer's credit information or a request
for a credit report or insurance score.
[2.9.7] ACCESS TO RECORDED PERSONAL INFORMATION
After an individual has exercised their right to submit a written request for access to any recorded
personal information an entity may be in possession of, the entity must respond within thirty (30) days
[2.9.8] CORRECTION, AMENDMENT, OR DELETION OF RECORDED PERSONAL INFORMATION
If an insurer receives a written request from an individual to correct or amend personal information,
the entity has 30 business days to either correct, amend, or delete the information in question or
notify the individual of its refusal to do so and why.
[2.9.9] REASONS FOR ADVERSE UNDERWRITING DECISIONS
In the event of an adverse underwriting decision, the entity responsible for the decision must either
provide the affected person with the specific reason for the decision in writing or advise them that they
may seek that information upon written request.
Also, insurance entities are also prohibited from basing an adverse underwriting decision in whole or in
part on the fact that an individual has experienced a previous adverse underwriting decision
[2.9.10] DISCLOSURE LIMITATIONS AND CONDITIONS
An insurance entity may not disclose any personal or privileged information about an individual collected
or received in connection with an insurance transaction unless the disclosure is:
• With the written authorization of the individual;
• To a person, other insurance entity, or medical provider if reasonably necessary
• To an insurance regulatory authority, law enforcement, or other governmental authority;
• To help prevent fraud or prosecute those perpetrating it or other illegal activities;
[2.9.11] PENALTIES
In addition to issuing a cease-and-desist order, the Director may order an entity that knowingly violates
an information and privacy protection law to pay a civil penalty of up to $500 per violation, up to a
maximum of $10,000.
Any person who violates a cease-and-desist order issued by the Director is subject to any one (1) or more
of the following penalties:
• A civil penalty of not more than $10,000 for each violation;
• A civil penalty of not more than $50,000 if the Director finds that violations have occurred with
such frequency as to constitute a general business practice; and
• Suspension or revocation of an insurance institution's or agent's license.
If any insurance entity fails to comply with the information and privacy rights granted to an individual, the
individual whose rights were violated may bring a lawsuit for damages.
[3.1] FAIR CREDIT REPORTING ACT (REF:15 USC 1681–1681d)
The Fair Credit Reporting Act (FCRA) is a federal law that promotes accuracy, fairness, and privacy in the
collection and use of consumer information by credit reporting agencies.

Congress enacted the FCRA to ensure that credit reporting is fair and to protect consumer privacy. It
recognizes the importance of accurate credit information for the economy and individual financial health.
Definitions of important terms:
• Consumer report: A report about a person’s credit, character, reputation, etc.
• Investigative consumer report: A report based on interviews about a person’s lifestyle or character.
• Consumer reporting agency: A business that collects and sells credit information.
• Permissible Uses of Consumer Reports
Credit reports can only be accessed for specific, legitimate reasons:
• Applying for credit, employment, insurance, or renting a home.
• With the consumer’s written permission.
[3.1.1] Investigative Consumer Reports
If a company wants to use an investigative report, it must:
• Notify the consumer in writing.
• Inform them of their right to request more details.
• Certify that the report will be used properly and legally.
[3.2] 18 UNITED STATES CODE (USC) SECTIONS 1033 AND 1034 – PURPOSE (LETTER OF WRITTEN
CONSENT)
In the insurance industry, federal law prohibits individuals with felony convictions involving dishonesty or
breach of trust from working in positions that affect interstate commerce unless they obtain written
consent from a state insurance regulator.
• Section 1033 outlines criminal offenses like fraud, embezzlement, and obstruction of regulatory
processes.
• Section 1034 allows civil penalties and injunctions against violators.
If someone has a qualifying conviction, they must apply for a Letter of Written Consent, which involves
submitting personal documentation, background checks, and proof of rehabilitation. This process
ensures only trustworthy individuals are allowed to work in sensitive insurance roles.
[3.3] MENTAL HEALTH PARITY AND ADDICTION EQUITY ACT (REF: 45 CFR PARTS 146 AND 147)
The Mental Health Parity and Addiction Equity Act (MHPAEA) makes sure that mental health and
substance use disorder (MH/SUD) benefits are treated the same as medical and surgical benefits. This
means health plans must not create extra hurdles or stricter rules for mental health care.
Equal Treatment (Parity)
Health plans must treat MH/SUD benefits equally to medical/surgical benefits.
This includes:
• Costs: Same copays and deductibles.
• Limits: Same number of visits or coverage days.
• Access: Same rules for getting care (like prior approval or provider choices).
Who It Covers
• Large group health plans and insurance companies.
• Thanks to the Affordable Care Act (ACA), it also applies to individual and small group plans.
Types of Protections
• Quantitative: Numbers must match (e.g., 20 visits for mental health = 20 visits for medical care).
• Non-Quantitative: Rules such as prior approval must be applied consistently across both types
of care.
Your Rights
• You can request the rules used to determine whether MH/SUD care is “medically necessary.”
• If a claim is denied, the plan must explain why.
Who Enforces It
• The law is enforced by:
• Department of Labor (DOL)
• Department of Health and Human Services (HHS)
• Department of the Treasury
[3.4] NATIONAL DO NOT CALL LIST
The National Do Not Call Registry is a tool created by the Federal Trade Commission (FTC) to help
consumers reduce unwanted telemarketing calls. It is supported by legislation, including the Do-Not-Call
Implementation Act and the Telemarketing Sales Rule, which require telemarketers to consult the registry
before placing calls.
Consumers can register their home or mobile phone numbers for free at [Link]. Once a number
is added, telemarketing calls must stop within 31 days. The registration remains active unless the
number is disconnected or the consumer requests its removal. The registry blocks most sales calls from
legitimate businesses and prohibits robocalls that promote products or services unless the consumer
has given written consent.
Certain types of calls are still permitted, including those from political organizations, charities, debt
collectors, survey companies, and businesses with which the consumer has had a recent relationship
(within the past 18 months). Companies that violate the rules can face fines of up to $50,120 per illegal
call. The FTC has already taken enforcement action against numerous violators.
[3.5] TELEMARKETING SALES RULE (REF:16 CFR 310; 15 USC 6101–6108; A.R.S. 44-1282)
This law prohibits deceptive telemarketing practices. Before a customer pays, sellers must clearly
disclose:
• The total cost of the goods or services.
• Any important restrictions or conditions.
• Whether refunds, cancellations, or exchanges are allowed.
• The odds of winning, if a prize is involved.
Telemarketers are generally banned from calling Arizona numbers listed on the National Do Not Call
Registry. Each violation can result in a $1,000 fine, and state attorneys general are authorized to take legal
action against violators.
[3.6] GRAMM-LEACH-BLILEY ACT (REF: 20-2121; PUBLIC LAW 106-102)
In 1999, the Gramm-Leach-Bliley Act (GLBA) was enacted to reshape the financial services industry. Prior
to this law, strict barriers separated commercial banking, investment banking, and insurance services.
GLBA facilitated mergers among financial institutions, allowing them to offer a broader range of services
under one roof. This marked a significant shift from the limitations imposed by the earlier Glass-Steagall
Act.
One of the most important aspects of GLBA is its emphasis on consumer privacy and data protection.
The law introduced several key rules to ensure that financial institutions handle personal information
responsibly.
First, the Privacy Rule requires institutions to inform customers about their privacy practices. When a
customer begins a relationship with a financial institution, and annually thereafter, they must receive
clear notice explaining how their personal financial data is collected, used, and shared. Importantly,
customers are given the right to opt out of having their information shared with non-affiliated third
parties.
Next, the Safeguards Rule requires financial institutions to develop and maintain robust security
programs. These programs must include administrative, technical, and physical measures to protect
customer data from unauthorized access and potential threats.
GLBA also addresses pretexting, the practice of obtaining personal information under false pretenses.
The law strictly prohibits this deceptive practice, reinforcing the importance of ethical behavior in
handling sensitive data.
Ultimately, the Gramm-Leach-Bliley Act empowers consumers by giving them more control over their
financial information. It also holds financial institutions accountable for protecting that data, while
encouraging innovation and competition in the financial sector by allowing cross-sector affiliations.
[3.7] AFFORDABLE CARE ACT (ACA) (REF: 45 CFR 144, 146, 147, 148, 150, 154, 155, 156, 157, 164 and
170; and 42 USC 300gg-300gg-91)
"Exchanges" are created by the Affordable Care Act (ACA) health reform bill to help individuals and small
businesses purchase health insurance coverage. The purposes of the exchange include:
• Reduce the number of uninsured in the state
• Facilitate the purchase and sale of qualified health plans in the individual market
• Assist qualified employers in the state in enrolling their employees in qualified health plans
• Assists individuals in accessing public programs, premium tax credits, and cost-sharing
reductions
Under the Affordable Care Act (ACA), the health insurance exchange will perform all of the following
roles:
• Certify health plans as qualified, based on pre-determined criteria
• Utilize individual, unique formats for presenting health benefit plan options
• Verify and resolve inconsistent information provided to the exchange by applicants Essential
health benefits
The exchange shall allow any qualified plans that meet the minimum standards established by the
exchange to be offered in the exchange. All plans must include the following:
• Ambulatory patient services
• Emergency services
• Hospitalization
• Maternity and newborn care
• Mental health and substance use disorder services, including behavioral health treatment
• Prescription drugs
• Rehabilitative services and devices
• Laboratory services
• Preventive and wellness services and chronic disease management
• Pediatric services, including oral and vision care
To support these functions, the ACA is backed by a comprehensive set of federal regulations found in 45
CFR Parts 144–170. These rules ensure fairness, transparency, and accountability across the health
insurance system:
• General Provisions (Part 144) define key terms and market categories.
• Group (Part 146) and Individual Market Rules (Part 148) protect access to coverage and ensure
renewability.
• Market Reforms (Part 147) ban preexisting condition exclusions, enforce coverage for preventive
services, and extend dependent coverage to age 26.
• Surprise Billing Protections (Part 149) prevent unexpected out-of-network charges.
• Enforcement (Part 150) allows federal oversight when states don’t comply.
• Rate Review (Part 154) requires insurers to justify significant premium increases.
• Exchange Standards (Part 155) and Issuer Standards (Part 156) govern how exchanges operate and
how plans are certified.
• Employer Participation (Part 157) outlines how small businesses can offer coverage through SHOP
exchanges.
• Medical Loss Ratio (Part 158) ensures insurers spend most premium dollars on care, not
overhead.
• Insurance Web Portal (Part 159) helps consumers compare plans online.
Together, these provisions form the legal and operational backbone of the ACA, ensuring that exchanges
function effectively and that consumers are protected throughout the insurance process.
[3.8] CAN-SPAM ACT OF 2003 (REF:15 USC 7701; 18 USC 1037)
The CAN-SPAM Act of 2003 is a federal law that sets the ground rules for how businesses can send
commercial emails. Think of it as a digital code of conduct—created to protect people from misleading or
unwanted messages and to encourage ethical marketing practices. At the heart of this law is a simple
idea: email communication should be honest, clear, and give recipients control. Let’s break that down:
Truthful Subject Lines
The subject line of an email must reflect what’s actually inside. This helps prevent confusion or
manipulation.
Clear Purpose
If an email is promoting a product or service, it must say so. This transparency helps recipients make
informed choices about what they engage with.
Valid Contact Information
Every commercial email must include a real, physical postal address. This builds trust and shows the
sender is accountable.
Respect for User Choice
People must be able to opt out of future emails easily. Once someone unsubscribes, the sender must
stop emailing them within 10 business days.

No Unethical Collection Methods

Businesses are not allowed to gather email addresses through shady tactics like scraping websites or
using bots.
[3.9] GENETIC INFORMATION NONDISCRIMINATION ACT (REF: 45 CFR Parts 144, 146, 148; 45 CFR Parts
160, 164; and 29 CFR Part 2590)
GINA was enacted to prevent discrimination based on genetic information in both employment and
health insurance settings. Think of it as a shield that protects individuals from being treated unfairly just
because of what their genes might say about their health risks.
In the Workplace
GINA makes it illegal for employers to:
• Use genetic information when making decisions about hiring, firing, promotions, or job
assignments.
• Request, require, or purchase genetic information about employees or their family members.
• Disclose genetic information, which must be kept confidential like any other medical record.
This means your employer can't ask for your family medical history or genetic test results, and they can't
use that information to make decisions about your job.
In Health Insurance
GINA also applies to group health plans and insurers. It prohibits:
• Using genetic information to determine eligibility or set premiums.
• Collecting genetic information (including family medical history) before or during enrollment.
• Offering incentives in exchange for genetic information, such as through wellness programs.
Importantly, GINA defines genetic information broadly. It includes:
• Results of genetic tests.
• Family medical history.
• Participation in genetic research or services.
• Genetic data about fetuses or embryos in assisted reproduction.
However, GINA does not cover life, disability, or long-term care insurance. Also, it does not apply to
employers with fewer than 15 employees.
[3.10] VIOLENT CRIME CONTROL AND LAW ENFORCEMENT ACT OF 1994 [REF:20-489; 18 USC 1033,
1034; 15 USC 6101-6108, ARS 44-1282]
The Violent Crime Control and Law Enforcement Act of 1994 (Public Law 103-322) is the largest crime bill
in U.S. history. Enacted in response to rising violent crime, it introduced sweeping reforms across law
enforcement, the criminal justice system, and community safety.
Core Purpose
The Act aimed to reduce violent crime through a combination of increased law enforcement presence,
tougher sentencing, and community-based prevention programs.
[5] ARIZONA INSURANCE LAWS, RULES, AND REGULATIONS: REVIEW NOTES
Licensing Requirements
• Producer licenses are issued for periods of 4 years and expire on the last day of the licensee's birth
month
• No person is permitted to sell, solicit or negotiate insurance in Arizona without being licensed for
that line of authority
 • A producer is a person required to be licensed to sell, solicit, or negotiate insurance business in
Arizona
• To be eligible for a license, an individual must:
o Provide documentation of citizenship or legal alien status
o Submit proper application and fees
o Pass the required examination
• An individual may attempt an exam for any specific line of license authority no more than four
times within a 12-month period
• If an individual fails the same exam four times, they must wait one full year before retaking the
exam
Types of Licensees
• Insurance producers
o Resident producers
o Nonresident producers
o Business entities
• Adjusters
o Individuals who adjust, investigates, or negotiates settlement of property and casualty
insurance claims
• Life settlement brokers
o Any producer with a life insurance license can operate as a life settlement broker after notifying
the Director
• Surplus lines brokers
o Licensed to obtain insurance from unauthorized insurers when coverage is not available from
authorized insurers
• Temporary licensees
o May be issued without examination for up to 180 days in specific situations
• Vending machine licensees
o Only licensed producers authorized by the Director may use vending machines
Nonresident Producers
• A person who is not a legal resident of Arizona may be licensed if:
o Currently licensed as a resident and in good standing in their home state
o Submitted proper request and required fees
o Submitted appropriate application
• A nonresident producer who becomes an Arizona resident must apply for a resident license within
90 days
Fingerprinting Requirements
• Applicants must submit a full set of fingerprints to the Department for state and federal criminal
records checks
• Business entities must inform the Director of any change in members, directors, officers, or
designated producers within 30 days
Assumed Business Name
• An insurance producer doing business under any name other than their legal name must notify the
Director in writing before using the assumed name
• The Director may deny the use of an assumed name if it would cause confusion or mislead the
public
Change of Contact Information
• A licensee must inform the Director in writing within 30 days of any change in:
o Residential, business, or email address
o Name
Report of Actions
• An insurance producer must report any administrative action taken against them within 30 days
after final disposition
• A producer must report any criminal conviction to the Director within 30 days after the
conviction's filing date
Continuing Education
• All insurance producers must complete 48 credit hours of continuing education every 4 years
• Six of those hours must be in ethics
License Suspension, Revocation, or Refusal to Renew
• The Director may suspend, revoke, refuse to issue or refuse to renew a license for reasons
including:
o Providing materially incorrect, misleading, incomplete or untrue information in the license
application
o Violating any insurance laws or regulations
o Obtaining a license through misrepresentation or fraud
o Misappropriating funds received in the course of doing insurance business
o Misrepresenting insurance contract terms
o Having been convicted of a felony
o Using fraudulent, coercive, or dishonest practices
Acts Constituting Insurance Transaction
• Transact with respect to insurance includes:
o Solicitation and inducement
o Preliminary negotiations
o Effectuation or selling of a contract of insurance
o Transaction of matters after effectuation of the contract
Negotiate, Sell, and Solicit
• Negotiate means conferring directly with a prospective purchaser about contract benefits, terms,
or conditions
• Sell means to exchange a contract of insurance for money or its equivalent
• Solicit means attempting to sell insurance or urging a person to apply for a particular kind of
insurance
Payment of Premiums
• A premium is considered timely if sent by mail and postmarked on or before the due date
Certificate of Authority
• No insurance company may transact business in Arizona without a Certificate of Authority
• A certificate remains in effect until terminated at the request of the insurer or suspended or
revoked by the Director
Sharing Commissions
• It is illegal for an insurer or producer to pay compensation to a person for services as a producer if
not properly licensed
• A person is prohibited from accepting a commission if they are required to be licensed and are not
Place of Business and Records
• The records, books, and files of all insurance companies and producers are subject to inspection
by the Director
• Every entity being examined must produce and make freely accessible any accounts, records, or
other items related to the examination
Unfair Trade Practices
• No person may engage in any trade practice that is prohibited or determined to be an unfair
method of competition
 • Prohibited practices include:
o Misrepresentation
o False or deceptive advertising
o Defamation of insurer
o Boycott, coercion, or intimidation
o False financial statements
o Unfair discrimination
o Rebating
Misrepresentation
• It is illegal to make, issue, or circulate any statement that:
o Misrepresents policy terms, benefits, advantages, or payable dividends
o Makes false statements about previously paid dividends
o Misrepresents an insurer's financial condition
o Uses misleading policy names or titles
o Induces a policyholder to lapse, forfeit, or surrender a policy
Unfair Discrimination
• Insurers cannot deny coverage or charge different rates based on an individual being a victim of
domestic violence
• All insurers must adopt written policies to ensure the privacy and safety of domestic violence
victims
Gender Discrimination
• Insurers cannot deny availability of any insurance policy based on gender or marital status
• Insurers cannot restrict, modify, exclude, reduce, or limit benefits based on gender
Rebating
• No person may knowingly offer benefits to an insured or make agreements regarding any contract
of insurance other than what is expressly written in the contract
• Insurers may hire an independent third party to conduct customer feedback and offer incentives
valued at a maximum of $200
Prohibited Inducements
• No insurer or producer may offer as an inducement:
o A promise of employment
o Shares of stock or securities
o Advisory board contracts promising special profits
o Prizes or merchandise exceeding $100 in value
Fees
• An insurance producer may not charge any fee in addition to the premium unless:
o The fee and services are disclosed and agreed to in writing
o The fee is reasonably related to the cost of service and doesn't duplicate charges in the insurer's
rate filing
Unfair Claims Settlement Practices
• Prohibited practices include:
o Misrepresenting policy provisions
o Failing to acknowledge communications within 10 working days
o Failing to implement reasonable standards for prompt investigation
o Refusing to pay claims without reasonable investigation
o Failing to affirm or deny coverage within a reasonable time
o Not attempting good faith settlements when liability is clear
Claims Payment
 • After an insured provides acceptable proof of loss, the insurer has 30 days to pay the claim before
being required to pay additional interest
Insurance Fraud
• It is unlawful to knowingly:
o Present statements containing untrue material facts to insurers
o Solicit insurance risks for insolvent insurers
o Conceal assets or records from the Department
o Divert monies of an entity licensed to transact insurance
• The Director has established an insurance fraud unit with law enforcement powers
• Persons found to have committed insurance fraud are guilty of a felony
Insurance Information and Privacy Protection
• The Insurance Information and Privacy Protection Law regulates the collection, use, and
disclosure of personal information by insurance companies
Federal Laws and Regulations
• Fair Credit Reporting Act (FCRA)
o Promotes accuracy, fairness, and privacy in consumer information
• 18 USC Sections 1033 and 1034
o Prohibits individuals with felony convictions involving dishonesty from working in insurance
without written consent
• Mental Health Parity and Addiction Equity Act
o Ensures mental health and substance use disorder benefits are treated equally to medical
benefits
• National Do Not Call List
o Helps consumers reduce unwanted telemarketing calls
• Gramm-Leach-Bliley Act
o Requires financial institutions to inform customers about privacy practices
o Mandates security programs to protect customer data
• Genetic Information Nondiscrimination Act
o Prevents discrimination based on genetic information in employment and health insurance
• Affordable Care Act (ACA)
o Created health insurance exchanges to help individuals and small businesses purchase
coverage
o Requires essential health benefits in all qualified plans
• CAN-SPAM Act
o Sets rules for commercial emails
o Requires truthful subject lines and valid contact information
• Telemarketing Sales Rule
o Prohibits deceptive telemarketing practices
o Bans calling numbers on the National Do Not Call Registry