2. Insurance Planning. 9. Life Insurance Flashcards

Question

# **Practitioner Advice:** Describe Endowment Life Insurance

Answer 1

Endowment policies promise to pay the policy face amount on the death of the insured during a fixed term such as 20 or 30 years, as well as the full face amount at the end of the term if the insured survives the term. This is in contrast to term policies, which provide for the payment of the full policy amount only if the insured dies during the policy term. Though these policies have a maturity date set before expected mortality and thus appear to be a form of temporary coverage, they are actually considered a form of permanent insurance. Policies payable only in the event of death are purchased chiefly for the benefit of others. On the other hand, endowment policies, although affording protection to others against the death of the insured during the fixed term, pay to the insured if he or she survives the endowment period to maturity. **Practitioner Advice: Endowment policies are no longer sold in the U.S. In 1984, Congress passed legislation that included definitions of life insurance. Because endowment policies have premiums that are much higher than required for the death benefit, these policies no longer qualify as life insurance, and as a result, lose the benefit of tax sheltered growth of the cash value.**

Answer 2

* Whole Life Insurance is a policy that provides coverage for the whole of the insured's life. * Whole Life Cash Values are provided by insurers and are available to the policy owner at any time by surrendering the policy. The policy owner can also borrow the cash value while keeping the policy in force. * Participating Whole Life policy owners have the right to share in surplus funds accumulated by the insurers, and the surplus is paid out as dividends. * Non-participating Whole Life policy elements are fixed and make no allowance for future values to differ. Concepts relevant to participating whole life policies include: * Dividend Illustration is provided by insurers to prospective purchasers of participating policies. * Dividends Actually Paid may not equal the dividend illustration. * Dividend History is the schedule of dividends actually paid. * Contribution Principle ensures that policy owners receive the surplus in proportion to their contribution. * Universal Life Policy combines the low cost nature of term and the cash value features of whole life. * Variable Life Policy offers an increased the opportunity for the cash value fund to grow, but with greater investment risk to the insured * Some specialized contracts intended to meet the needs of insureds in particular situations were also reviewed in this section.

Answer 3

Term Life Insurance * Term life insurance terminates with no maturity value and therefore nothing is paid to the insured at the end of the term.

Answer 4

* Dividend Illustration - Provided by insurers to prospective purchasers. * Dividend History - Schedule of dividends actually paid. * Contribution Principle - Surplus received in proportion to contribution.

Answer 5

Renewability Convertibility * Renewability and convertibility are two features provided in term life insurance without reference to the insured's insurability status. * The **re-entry option** is available only if the insured can demonstrate that they meet certain insurability criteria. * Endowment is not a feature of term life insurance; it is another type of insurance.

Answer 6

When a life insurance policy is purchased, three distinct classifications of interest are created: * The insured is the person whose death causes the insurer to pay the claim. * The owner is the person who may exercise the rights created by the contract. * The beneficiary is the person receiving the proceeds when the insured dies. To ensure that you have an understanding of life insurance contract provisions, the following topics will be covered in this lesson: * Life Insurance Policy Provisions * Insured Options Upon completion of this lesson, you should be able to: * Define grace period and lapsed policy, * Explain reinstatement provisions, * Describe the clauses in an insurance contract, * List and discuss the insured options, * Identify five different ways a beneficiary may take death proceeds, and * Explain policy illustrations.

Answer 7

The insurer will send the insured a notice of when the premium is due before the due date. If the insured neglects to pay a premium when it is due, the policy does not end immediately. If the insured forgets to pay the premium or decides to end the contract, the grace period provides 31 days to pay the premium without forfeiting any contractual rights and no questions asked. If there is enough cash value in the policy, the premium will be paid, reducing the cash value. If there is not enough cash value to pay the premium, the policy will lapse. The policyholder must pay the premium before the end of the 31 days provided by the grace period to avoid having the policy lapse. However, if the policyholder dies during the grace period, the insurer will pay the proceeds to the beneficiary, minus the overdue premium. Grace Period Example: Assume the policyholder has a stroke and is hospitalized on December 10th, and that the anniversary date of the policy is January 1st with an annual premium of $10,000 on a $450,000 Whole Life policy. If the $10,000 is not paid on January 1st and the policyholder dies on January 18th, the beneficiary of the policy will receive a death benefit of $440,000, as the premium is outstanding less than 31 days (January 1st - January 18th). If the policyholder makes the premium payment in time, the beneficiary will receive the entire $450,000 death benefit. **Exam Tip: Listen in for a quick discussion on the common exam application of the grace period on life insurance policies**. * Make note of key numbers (ex. days to do this or that) * **Grace period provision in a life insurance policy - 31 days to make the premium payment or the policy will lapse**.

Answer 8

After a policy lapses, the insured has an opportunity to reinstate it if specified conditions are met. The opportunity to renew a lapsed policy is called the reinstatement provision. New York has a limit of three years from the date of default in which the owner may reinstate the policy. Furthermore, the insured must not have withdrawn the cash surrender value, but must have chosen a non-forfeiture option that allows the policy to continue. **Practitioner Advice: As previously noted, some states have different regulations that can impact the insured’s rights. For example, the Commonwealth of Massachusetts does not allow for the reinstatement of term life insurance policies. The state has decided that, since term insurance is akin to renting coverage, it does not make sense to pay “back rent” when you know you did not use the policy. Unfortunately, by taking away the consumer’s right to make that decision, the state has created a situation where some people who have become uninsurable cannot buy a new policy. For this reason, it is important that policy owners and professional advisors fully understand existing policy features and options before making any changes**.

Answer 9

Payment of all defaulted premiums without interest. **Evidence of insurability, beyond the good health of the insured, means, among other things, that the insured must**: * Not be engaged in any dangerous occupations or hobbies, * Not be awaiting execution for a crime, * Pay all defaulted premiums with compound interest, and * Repay any outstanding loans with interest.

Answer 10

Insurance contracts are contracts made in utmost good faith. This means an applicant may not answer questions untruthfully or conceal information an honest person would reveal. If an insured is untruthful or conceals material facts, the insurer may go to court and contest the policy for the purpose of voiding the policy. The incontestable clause states that, if there is a valid contract between the insurer and insured, the insurer may not contest the policy to void it after the policy has been in force for two years during the lifetime of the insured. Thus, a life insurer has only a relatively short period of time in which to uncover any fraud. Generally, after the specified time has elapsed, even if a notorious fraud is uncovered, the insurer cannot void the policy. Overall, the incontestable clause prevents an insurer from avoiding claims payments. It is interesting to note this clause was included voluntarily in the contracts of some life insurers after 1850. The motive behind the inclusion was to establish public confidence. Such a public relations effort was required because a few disreputable life insurers were voiding contracts on the slightest technical grounds. **Exam Tip: Listen in for a quick discussion on the common exam application of the incontestable clause on life insurance policies.** Audio: * Incontestable Clause - highly testable feature of a contract * **Means after policy has been in force for 2 years, if insurance company discovers fraud, the insurance company cannot contest or void the contract**.

Answer 11

Both I and II * A life insurance policy may be terminated or contested due to premium non-payment and/or submission of fraudulent claims by the insured.

Answer 12

As the applicant’s age is a key factor in underwriting and pricing the insurance, a misstatement of age, either intentionally or by mistake, causes rating errors. The misstatement-of-age provision causes the insurer to adjust the face amount of insurance to reflect the insured’s true age, rather than allowing the insurer to void a policy if a misstatement is discovered. There is no time limit on this provision - typically the mistake is not discovered until a death claim is being processed. For example, if the insured, Amy Grafton, reported her age to be three years less than it actually was, the benefits, $100,000, would have to be reduced to $92,000, or whatever amount of insurance the premiums would purchase at the insured’s true age. Misstatement-of-Age Provision Example: Upon her death, Mrs. Smith’s son was reviewing her life insurance policies so that he could submit the claim. While reading one policy, he noticed that the photocopy of the original application indicated his mother had been born in 1905 instead of 1908. For all the years since the policy was purchased, his mother had been paying more than she should have for the policy. She obviously had not reviewed the policy information all these years. Fortunately, upon making his claim and pointing out the error, Mr. Smith received a larger death benefit payment based on the amount his mother had paid and her correct age. **Exam Tip: Listen in for a quick discussion on the common exam application of the misstatement-of-age provision on life insurance policies. If the applicant (intentionally or unintentionally) mis-states their age on the application, the insurance company may adjust the death benefit accordingly to what would've been purchased at the time of application, based on the correct age. They won't void the contract. But allowed to adjust the death benefit to the proper age**.

Answer 13

The suicide clause is commonly included in the life insurance contract and allows a life insurer to exclude payment for death by suicide if the suicide occurs within two years from the policy issue date. The purpose of the suicide clause is to control the moral hazard of a person purchasing a policy in contemplation of committing suicide. Note: Many insurance companies have a one-year restriction that is more favorable to the policyholder and permissible under law. The policy will pay for death caused by other illnesses, including mental illness. If, during the underwriting process, there is a history of mental illness that causes the insurer to be concerned about possible suicide, the policy will not be issued. Therefore, after the two-year restriction, the company will pay for suicide deaths because the suicide presumably has been caused by mental illness that occurred after the policy’s inception. Where there is no history of mental illness and the applicant is contemplating suicide, it is improbable that a suicidal person could wait two years to complete the act. Insurers often have a difficult time establishing that the insured’s death resulted from suicide. In one case, within two years of the policy’s effective date, an insured took between 30 and 40 sleeping pills, pulled the phone out of the wall and subsequently died. The autopsy and death certificates each listed suicide as the cause of death. Moreover, this was the second occasion within three months in which the insured had taken an overdose of sleeping pills. Nevertheless, the jury was instructed that the presumption is against suicide in all cases, and that suicide may be assumed only when no other conclusion could reasonably be drawn. As the jury thought it was possible the insured’s death may have been caused by the motive of “self-indulgence,” the insurer had to pay the claim. **Practitioner Advice: If the policyholder commits suicide within the two years of issuance, the insurance company will pay the policyholder’s estate all premiums paid without interest.**

Answer 14

24 months * The suicide clause allows a life insurer to exclude payment for death by suicide if the suicide occurs within two years (24 months) from the policy issue date.

Answer 15

Participating life insurance policies pay dividends to the policy owner. Owners may exercise a choice as to what form the dividends take. There are five potential dividend payout options. Dividends on participating life insurance policies may be: * taken in cash. * used to pay a portion of the next premium. * left to accumulate interest. * used to purchase single-premium, paid-up insurance. * used to purchase one-year term insurance (fifth dividend option). Example (Dividend Payout Options) A $50 dividend may purchase $123 of paid-up whole life insurance at age 40. At the insured’s death, the beneficiary receives the sum of the paid-up additions, plus the face amount of the policy. Even if the insured has become uninsurable, the owner still may acquire more life insurance using this dividend option. If the insured decides at a later date that he or she would like to take some of his or her accumulated dividends in cash, he or she can redeem some of the paid-up additions for the original cash dividend amount. Since this option provides a good benefit for beneficiaries upon death while still allowing access to the cash during life, most insurers use the paid-up additions as the default option. Some companies allow the purchase of a combination of term and paid-up whole life with dividends. Using dividend options allows insureds to increase coverage without incurring acquisition costs and without having to provide evidence of insurability. Thus, dividend options create flexibility in a consumer’s life insurance plan. **Practitioner Advice: Because dividends are small, particularly in the beginning of the contract, it's best to select the paid up additions options. This allows the dividend to be used to increase the cash value in the contract, as well as the death benefit. Some clients think of it as a way to have their death benefit keep up with inflation.**

Answer 16

extended term * If a policyowner does not select a non-forfeiture option after lapsing a policy, the insurer automatically chooses an option. * Frequently, the extended term option is utilized as the default choice.

Answer 17

Life insurance policies with cash surrender values have a loan provision. This provision gives the policy owner the ability to take a loan from the cash value of the policy. The company generally has the right to delay making the loan for up to six months. The interest rate charged for the loan is stated in the policy. Unless the policy provides for variable rates, it remains unchanged, even though general interest rates fluctuate. Interest rates typically range from 6% to 8%. Since 1980, life insurers typically have used variable rates that change with general interest rates. The policyholder loan is secured by the cash surrender value of the life insurance policy. There is no legal requirement for the insured to repay the loan. If the loan is outstanding when the insured dies, however, the insurer deducts the amount of the loan from the insurance proceeds. Taking a loan against a life insurance policy is one alternative to surrendering the policy for its cash value. Taking a loan leaves the policy and some of the life insurance protection in force. **Practitioner Advice: Policy loans are easy to get, do not show up on an insured's credit report, and do not have to be paid back. The disadvantages are that a loan will lower the projection of accumulated cash at retirement, and in most cases, will cause a lower dividend to be paid.**

Answer 18

The fixed-amount option provides the beneficiary with regular, fixed-income payments. Interest income is earned on balances remaining with the insurer. Federal income tax applies to the interest portion of these payments. The payments continue until the death proceeds and the interest thereon is exhausted. This option is a logical choice when people need income for a limited period, such as while social security benefits are unavailable or for an education fund. Using this option, the beneficiary can receive an insurance payment before each tuition bill. **Practitioner Advice: The fixed-amount option is useful for a client who wants to know she will get a certain needed amount, for example, a monthly check to cover her mortgage payment.**

Answer 19

Under the interest-only option, the proceeds are left with the insurance company. The insurer pays the first beneficiary, such as a widow, regular payments composed entirely of interest earnings. The beneficiary can request the full payment of principal at any time. It can be set up so that at the first beneficiary's death, the insurer pays the death proceeds to a second beneficiary, such as a child. The interest-only arrangement can be useful, for example, if the beneficiary has substantial investment, wage or social security income. **Practitioner Advice: The money received in this option is fully income taxable, as it is considered interest only, not a return of principal.**

Answer 20

The life-income option guarantees, for a lifetime, a series of regular payments to the beneficiary. This is the annuity option. The insurer only makes payments under this option if the beneficiary is alive. Assume that Mrs. Johann S. Bach receives the proceeds of a $400,000 policy under the life-income option. Assume she lives only three years beyond Johann. She received only $75,000 of benefits. The remainder of the money she did not receive is pooled to pay benefits to other annuitants. Despite the potential for losing some of the death proceeds, the life-income settlement option is often quite practical. A beneficiary’s need for income ceases when the beneficiary dies. In some cases, there may be no dependent beneficiaries other than a surviving spouse. The life-income option can provide a sure source of income because the payments are guaranteed for life. As the payments include a portion of principal, they will significantly exceed interest-only payments at later ages. The payments will be partly income taxable, with the return of principal portion being excluded form income. This settlement option makes good sense if the surviving spouse is inexperienced in investing money. It is also useful if the surviving spouse has an unscrupulous relative or friend who may talk the beneficiary out of the money if a large lump sum of cash were paid. **Practitioner Advice: There are also refund options available. The client will receive lower monthly payments, but any remainder will be paid to a named beneficiary, instead of being kept by the insurance company.**

Answer 21

Non-forfeiture options: These provide that life insurance policies having a savings value are not forfeited. The types of non-forfeiture options are: * Cash surrender value, * Extended term, and * Reduced paid up option. Policyholder loans: Give the policy owner the right to borrow an amount of money lesser than or equal to the cash value of the policy. Settlement options: Specify how death proceeds are paid: * Cash, * Fixed amount, * Fixed period, * Interest only, or * Life income. Life Insurance Policy Illustrations * Proposed Policy Illustration * In-Force Illustration Riders and Options can be purchased at extra cost to provide additional coverage. Riders include: * Guaranteed-insurability option: Permits the purchase of additional coverage without proof of insurability. * Waiver-of-premium option: Permits disabled individuals to stop making premium payments while maintaining full policy benefits and coverage. * Double-indemnity option: The insurer pays greater death benefit amounts for certain accidents.

Answer 22

Life income Interest only Cash Fixed amount Fixed Period * All of the listed items are considered settlement options except stock. The **basic settlement options include**: * Life income * Interest only * Cash * Fixed Amount * Fixed Period **More than 95% of all life insurance proceeds are taken in cash. In addition, if no settlement option is selected, insurers pay the proceeds in cash by default**.

Answer 23

Grace Period * A **grace period** provides a period of 31 days to pay the premium without forfeiting any contractual rights. * **Incontestable clause** prevents the insurer from contesting the policy to void it after a certain period. * **Reinstatement clause** provides the opportunity to renew a lapsed policy. * **Non-forfeiture clause** prevents the life insurance company from canceling a policy for nonpayment of premiums.

Answer 24

False * The incontestable clause states that the insurer may not contest the policy to void it after it has been in force for a one or two-year period. * However, a life insurance policy may be ended if the insurer has not paid the premiums.

Answer 25

Cash Reduced premium Left to accumulate interest Used to purchase one-year term insurance **Dividends on participating life insurance policies may be**: * taken in cash. * used to pay a portion of the next premium (reduced premium). * left to accumulate interest. * used to purchase single-premium, paid-up insurance. * used to purchase one-year term insurance (fifth dividend option).

Answer 26

Life-Income * Life-Income option guarantees for a lifetime a series of regular payments to the beneficiary. * Cash settlement is lump sum amount paid at the death of the insured. * Fixed amount and fixed period options pay only for a certain period of time.

Answer 27

Upon completion of this lesson, you should be able to: * Explain how death proceeds are taxed, * State the income tax applied to living benefits, * List the regulations to avail of accelerated death benefits, * Discuss the business uses of life insurance, and * Explain the methods of funding business agreements.

Answer 28

Death proceeds are the policy face amount and any additional insurance amounts paid by reason of the insured’s death, less any loans taken against the policy and past due premiums during the grace period. When the beneficiary receives the death proceeds of a life insurance policy, generally no federal income tax applies to this amount. This is reasonable because premium payments for individually purchased life insurance are not deductible from a person’s federal income tax. Generally the only time a death benefit may be taxed deals with business life insurance. Often when a business owns a policy on the life of an employee, it will deduct the premiums paid as a cost of business. Since a tax advantage is taken up-front, the death benefit becomes taxable to the beneficiary upon receipt. If the beneficiary does not take the proceeds as a lump sum of cash, and instead takes a series of payments that includes interest earnings, there is federal income tax on the interest portion. **Practitioner Advice: Why does life insurance receive special tax treatment? Most clients are not aware of why this occurs. The federal government uses tax laws and regulations not only to influence the economy, but also to encourage certain behavior that is good for society. If families provide for themselves, fewer people will end up being dependent on social welfare programs. This alleviates pressures on the government. So, by providing tax incentives, the government hopes people will buy life insurance to support their survivors**.

Answer 29

If a business were to lose a key person, its earning power could be harmed, perhaps seriously. Key employee life insurance can protect business firms from financial problems caused by such losses. After identifying and measuring the potential loss, the business purchases a life insurance policy on the key employee's life. The business is the owner and the beneficiary of the policy, and the key employee is the insured. The business pays the premiums. The key person must be insurable and must give permission for the purchase for this arrangement to work. Key Employee Life Insurance: Risk Management Process * Identify. Key persons in the company must be identified. * Measure. The financial loss that would be caused by the key person’s death is measured. * Estimate. The effect on profits while a replacement is hired and trained is estimated. * Permission. The key person must give permission for the purchase of insurance. * Purchase. The business purchases life insurance for the value measured. * Premiums. Premiums are paid by the business. **Exam Tip: Listen in for an overivew of key employee life insurance characteristics**. Audio: * Key Points to know about key employee life insurance * Policy is on the life of the employee, but the benefits will be paid to the employers (to protect them). Money does not go the employee's family or estate. * Insurable interest need only exist at the beginning of the policy. * Ex. If employee leaves, ok for company to pay premiums, and ultimately collect death benefit when employee dies.

Answer 30

False * **Federal income tax is only applied to the interest part the payment of death proceeds** which are taken as a series of payments that include interest earned.

Answer 31

$6,000 * If the insured withdraws the savings value of a whole life policy, and if this value exceeds the insured's adjusted basis, the excess is subject to federal income tax. * The **insured's adjusted basis is calculated as premiums paid less dividends received**. In Angelina's case the calculation would be: Premiums paid = $30,000 Dividends received = $16,000 Adjusted basis = $14,000 [$30,000 (premiums paid) - $16,000 (dividends received)] Savings value = $20,000 Adjusted basis = $14,000 Excess subject to tax = $6,000

Answer 32

To provide benefits for employees. To protect the firm against loss of a key person. To aid in transferring business ownership. * Business firms purchase life insurance to benefit employees, protect themselves against financial problems caused by loss of a key person and for smooth transfer of ownership. * Life insurance does not cover a business going bankrupt.

Answer 33

To ensure that you have an understanding of annuities, the following topics will be covered in this lesson: * Description of Annuities * Types of Annuities * Use of Annuities * Taxation of Annuities Upon completion of this lesson, you should be able to: * Describe the components of an annuity contract, * Identify the types of annuities, * Explain the uses of annuities, and * Outline the taxation of annuities.

Answer 34

There are many different types of annuities which are based on how they are purchased, the types of benefits received, when benefits begin, and the number of annuitants in the contract. The method of payment can determine the type of annuity purchased. One method is to purchase annuities through serial payments. A level-premium deferred annuity is a series of fixed payments that will be made for a period of time before annuity payments actually begin. A flexible-premium deferred annuity is purchased by unequal payments over a fixed period of time, before annuity payments begin. This method of payment allows for smaller payments to be made by the annuitant, which are within minimum contribution limits set by the insurer. The annuitant often pays an expense charge for the administrative costs associated with this contract, which is a front-end load charge. There are also single premium annuities that are paid in full by one payment. An example is a single-premium immediate annuity, whereby a person will pay for the annuity with one payment at the time they want annuity payments to begin. Another example is a single-premium deferred annuity, which means that one payment is made before annuity payments are scheduled to begin. With a single-premium deferred annuity the deposit earns interest at a minimum guaranteed rate determined annually, which grows tax-deferred in the account. If the account has generated interest that exceeds the minimum guaranteed rate, the excess interest is credited to the account. This excess earnings provision applies to flexible-premium deferred annuities as well. Annuities can be purchased based on the minimum payments an annuitant wishes to receive. An annuity, five years certain guarantees that the annuity will be paid out for five years. If the annuitant dies before the five year period, their successor beneficiary will continue to receive the remaining payments. A period-certain life-income annuity is generally limited to a 20 year payout period, and payments are reduced for longer contract periods. With a cash refund annuity if the annuitant dies before receiving payments equal to the amount of premiums paid, the difference is paid as a refund to the beneficiary. An installment-refund annuity is similar to a cash refund annuity, but payments are made to the beneficiary over time equal to the amount of premiums the annuitant contributed. There are three types of annuities that provide different benefits and allow cash to be invested in various fashions: * Fixed Annuity: This contract provides a guaranteed rate of interest to the assets. The rate can be flexible or can be locked in for certain periods of time. * Variable Annuity: This contract provides a variety of separate accounts which allow assets to be invested in securities such as stocks, bonds, money market accounts, etc. The account owner can transfer assets between accounts. Variable annuities usually contain a fixed account which provides a guaranteed interest rate account. Variable annuities usually provide a death benefit. If death occurs during the accumulation period, the beneficiary may be guaranteed to receive the greater of the account value or the amount invested. * Index Annuity: This contract provides a return on the assets invested that is tied to a market index, typically the S&P 500 Index. There is often a participation rate and cap on these contracts. For example, the contract will pay interest equal to 65% of whatever the S&P 500 Index achieves over a certain time frame. However, the S&P 500 Index return may be capped at, say, 10%. Also, there may be a feature that has a floor. For example, if the S&P Index is less than 2% in a given year, the annuity will pay 2%. When a cap and floor is added to the contract, a collar is created. With the facts present above, a range of 2% - 10% is achieved regardless of how the S&P 500 Index performs for the year. **Exam Tip: Listen in for need-to-know descriptions of annuity payout options and their potential testing applications**. Audio: * Payout features of an annuity - ranges from life only (pays highest amount, but stops when annuitant dies, even if lump sum used to purchase has not been recovered. So riskiest) * 5 year certain annuity - annuity will pay original annuitant for life, but if they die, will pay beneficiary * Period certain life income annuity - defining a period of time, but if annuitant die, beneficiary will continue to be paid * Cash refund - at the time of the death of the annuitant, if original lump sum amount has not been recovered, balance will be paid to beneficiary * Installment refund annuity - same concept - if original purchase not recovered, will continue to pay installments to beneficiary (instead of lump sum)

Answer 35

The primary purpose of annuities is to convert assets into a stream of income that cannot be outlived. They provide tax-sheltered accumulation of assets which can help reduce income taxes during the accumulation period. Additionally, the tax sheltering of assets helps the owner avoid reaching certain income limits, which could trigger adverse conditions, such as taxation of Social Security benefits and phase-out of tax credits and/or deductions. **Practitioner Advice: Imagine a retiree collecting Social Security. They have assets invested primarily in Certificates of Deposit. The interest from the CD’s is simply reinvested rather than spent. That interest is factored into income to determine if the retiree will pay income taxes on their Social Security benefit. By transferring assets from CD’s to a fixed annuity, the reinvested income becomes tax-sheltered and no longer counts towards income for that purpose. This could possibly save Social Security benefits from being taxed.**

Answer 36

During the accumulation phase, the assets invested in an annuity contract grow tax-deferred. When distributions are withdrawn, and if they do not represent a contract that has been annuitized, the date of the insurance contract will determine whether first-in-first-out (FIFO) or last-in-first-out (LIFO) tax treatment will be utilized: * FIFO Method: Pre-August 14, 1982, for distributions. * LIFO Method: Post-August 13, 1982, for distributions. When the contract owner receives a distribution, the date that the original annuity was purchased will determine the appropriate accounting treatment used to calculate ordinary income, if any. Then, unless the owner of the contract is older than 59-1/2, has suffered a disability, or has died, the taxable portion will be subject to a 10% penalty. Annuity Distribution with FIFO Treatment Example: Assume a contract was purchased on 1/15/79 for $5,000 and the account is currently worth $75,000. If a 55-year-old takes a $3,000 distribution, the amount is a tax-free return of basis and not subject to a 10% penalty since it is a pre August 14, 1982, annuity and FIFO accounting is used. The remaining basis is now $2,000 ($5,000 original purchase price - $3,000 distribution). Annuity Distribution with LIFO Treatment Example: Assume the same facts as above except the contract purchase date is 1/15/89. The $3,000 is now taxed as ordinary income and a 10% penalty applies because the owner is age 55 and the disability exception is not applicable. The basis is still $5,000, as LIFO tax treatment was used. Understanding the tax basis of distribution is extremely important when a policyholder wants to annuitize an annuity contract. The net tax basis before the contract is annuitized is used to determine the amount of each annuity payment that is a tax-free return of basis calculated in the exclusion ratio. This net tax basis is the numerator of the formula given below. Continuing with our example, if the FIFO contract is annuitized, the numerator in the exclusion ratio is $2,000; otherwise, it is $5,000, based on the LIFO contract. **Exclusion Ratio: (Basis in Contract ÷ Expected Total Payments) x Annuity Payment Amount = Return of Basis**. Note: If the contract is a deferred annuity with no post-tax basis (e.g., tax-deductible IRA contributions), then the exclusion ratio is zero, because all distributions are taxed as ordinary income.) **Exam Tip: CFP Board frequently tests the tax treatment of annuty withdrawals and post-annuitization distributions. When presented with a question on annuitization distributions and asked to identify the correct taxation, remember that the exclusion ratio formula will provide you with the tax-free portion of the payment. To find the taxable portion, subtract the excluded amount from the entire payment.** Audio: * Annuity Exclusion Ratio: (Basis in Contract ÷ Expected Total Payments) x Annuity Payment Amount = Return of Basis. * We're talking about non-qualified tax-deferred annuities or non-qualified immediate annuities. * Lump sum is exchanged for payments over a specified period of time or over a lifetime. * Each payment will be a return of basis (tax free). * Life expectancy factor - would have to turn to a government table for a factor * Total investment divided by total payments - that amount is received tax free.

Answer 37

The exclusion ratio for each payment is $8,000 [($72,000 ÷ ($10,000 x 9 years)] x $10,000, and $2,000 ($10,000 payment - $8,000 return of basis) is taxed as ordinary income.

Answer 38

To identify the exclusion ratio, the monthly payment must first be expressed annually, $1,050 x 12 = $12,600. Next, the annual annuity payment is multiplied by 20 years to find the total expected payments, $12,600 x 20 = $252,000. Then, use the exclusion ratio to determine the portion of each annuity payment that represents a return of basis. ($97,000 ÷ $252,000) x $1,050 = **$404.17**. Finally, calculate the amount of each annuity payment considered ordinary income by subtracting the return of basis from the annuity payment: $1,050 - $404.17 = **$645.83**

Answer 39

* The structure of annuities: The accumulation period and the distribution period * The types of annuities: Fixed, Variable and Index annuities * The uses of annuities: Tax sheltered income, income for life * Taxation of Annuities: Withdrawals and penalties during the accumulation period and taxation during the distribution period.

Answer 40

$12,000 will be taxable and subject to penalty. * $12,000 represents the gain from the contract which must be withdrawn first. * It will be taxable and subject to penalty.

Answer 41

Annuitant * The amount of income is based on the life expectancy of the annuitant.

Answer 42

Though life insurance policies do not have a standardized format, they do have several general provisions required by the law: * Grace period * Reinstatement privilege * Incontestable clause * Entire-contract provision * Misstatement-of-age provision * Annual apportionment of divisible surplus * Suicide clause In addition to these provisions, many insurance companies include other options: * Dividend options * Non-forfeiture options * Policyholder loans * Settlement options Taxation on the life insurance transaction is applied as follows: * Death proceeds taken as a lump sum of cash are not taxed as income. * Interest earned on death proceeds taken as a series of payments is taxed. * Dividends are not subject to federal income tax. * Savings in excess of the adjusted basis are subject to federal income tax. * Accelerated death benefits are tax-free if all the regulations are met. Businesses purchase the following types of life insurance to provide employee benefits or to cover financial loss incurred by death of an employee: * Group Life Insurance * Key Employee Life Insurance * Split-Dollar Life Insurance Businesses also include life insurance in the following business agreements to finance the transfer of ownership from current to future owners: * Buy-Sell Agreement * Cross-Purchase Plan * Entity plan

Answer 43

False * Activity within an annuity of any type is tax-sheltered.

Answer 44

Contingent beneficiary * A contingent beneficiary has a distinct interest in the policy only if the primary beneficiary predeceases the insured.

Answer 45

Change the insured. * An owner may not change the insured. * In addition to the rights above (i.e., change ownership, assign the policy to secure a loan, and name beneficiaries), the owner may receive dividends, withdraw cash value, and borrow against the policy.

Answer 46

III and IV * Many insurers allow an accelerated death benefit or the early withdrawal of death benefits in cases where the insured is terminally ill. * The IRS issued a regulation applying to the taxation of these early payments in June 1993. These regulations provide that payments meeting a **three-part test will be identified as a qualified accelerated death benefit**: * The insured must be terminally ill. * The reduction of the remaining face value of coverage is limited. * The cash value of the remaining death benefit may not be reduced.

Answer 47

Variable Annuity * A variable annuity contract provides a variety of separate subaccounts which allow assets to be invested in securities such as stocks, bonds, money market accounts, etc. * The account owner can transfer assets between subaccounts. * Variable annuities usually contain a fixed account which provides a guaranteed interest rate account.

Answer 48

Term insurance * Term life insurance is a specific type of policy, whereas industrial, ordinary, and credit are general classification categories.

Answer 49

Separate accounts * Index annuities provide a return on the assets invested that is tied to a market index. * There is often a participation rate and cap on these contracts. For example, the contract will pay interest equal to a stated percentage of whatever the index achieves over a certain period but the overall return may be capped. * Also, there may be a floor, limiting potential losses associated with the index.

Answer 50

The company’s current rate based on the attained age at renewal. * Usually the insurance company charges a rate lower than that stated in the policy. * The stated maximum premium is there as a safety valve for the insurer.

Answer 51

purchase single-premium immediate annuity **Dividends on participating life insurance policies may be**: * taken in cash. * used to pay a portion of the next premium. * left to accumulate interest. * used to purchase single-premium, paid-up insurance. * used to purchase one-year term insurance (fifth dividend option).

Answer 52

A conversion credit is a specific amount credited against the first-year premium of the cash value policy to which the term insurance policy is converted. * A conversion credit is a credit against the new policy’s premiums. * These credits may include a stated dollar amount, such as $2 per $1,000 of insurance, an amount equal to the previous year’s term premium paid, or a fixed percentage of the new policy’s premium.

Answer 53

reinstatement provision * After a policy lapses, the insured has an opportunity to reinstate it if specified conditions are met. * The opportunity to renew a lapsed policy is called the reinstatement provision.

Answer 54

Universal Life * Universal life insurance was created to meet the interests of those consumers who liked the low-cost nature of term insurance and the cash value features of whole life insurance. * This new hybrid product was to be more flexible than its predecessors with features that allowed the insured to determine whether it would function more like term or more like a whole life policy.

Answer 55

31 days * If the insured forgets to pay the premium or decides to end the contract, the grace period provides 31 days to pay the premium without forfeiting any contractual rights and no questions asked.

Answer 56

guarantees that the annuitant dies before the five-year period, their successor beneficiary will continue to receive the remaining payments. * An annuity, five years certain guarantees that the annuity will be paid out for five years. * If the annuitant dies before the five-year period, their successor beneficiary will continue to receive the remaining payments.

Answer 57

$9,375 * Use the exclusion ratio to determine the portion of each annuity payment that represents a return of basis (tax-free amount). **Exclusion Ratio: (Basis in Contract ÷ Expected Total Payments) x Annuity Payment Amount = Return of Basis.** ($150,000 ÷ [$22,500 x 16]) x $22,500 ($150,000 ÷ $360,000) x $22,500 = $9,375 (tax-free return of basis)

Answer 58

Neither I nor II **A Modified Endowment Contract (MEC) means**: * Any funds withdrawn are subject to **LIFO** (i.e., "last-in, first-out") taxation so investment income is withdrawn first * a **10% penalty applies to cash withdrawal or loan before age 59½**.

Answer 59

Level premium term for a longer term than the original policy * Most term insurance policies include a convertible feature. * This feature permits the policy owner to exchange the term policy for a cash-value insurance contract, without evidence of insurability.

Answer 60

Credit life insurance is often packaged and sold when a client is making an expensive purchase, such as a car. * Credit life insurance is often sold in conjunction with a major purchase. * It typically is **much more expensive than traditional term life insurance**. * The premium does not increase each year and the **benefit decreases each year to coincide with the outstanding loan balance**.

Answer 61

II and IV **Annuities have two phases**: * the accumulation phase, and * the distribution phase.

Answer 62

Term life insurance * Term life insurance is often referred to as "pure protection" or "pure insurance" because it pays a death benefit only and has no savings component.

Answer 63

I and IV There are two types of policy illustrations: * proposed * in-force

Answer 64

24 months * The incontestable clause states that, if there is a valid contract between the insurer and insured, the insurer may not contest the policy to void it after the policy has been in force for two years (24 months) during the lifetime of the insured.

Answer 65

Single Premium Immediate Annuity * A single-premium immediate annuity is funded with one payment and the annuitant begins to receive income distributions between 1 month and 1 year from the date of purchase.

Answer 66

adverse selection * Resistance to the higher premiums and lower-cost product opportunities cause many insureds in good health to fail to renew. * The **majority of those in poor health will renew even in the face of higher premiums**.

Answer 67

I, II, and III * When the contract owner receives a distribution, the date that the original annuity was purchased will determine the appropriate accounting treatment used to calculate ordinary income, if any. * Then, unless the owner of the contract is older than 59-1/2, has suffered a disability, or has died, the taxable portion will be subject to a 10% penalty.

Answer 68

30 * With a **cross-purchase plan**, the number of policies needed is equal to: **n x (n - 1), where n equals the number of partners or shareholders**. The number of policies for the partners at Scoots, Inc. is calculated as follows: 6 x (6 – 1) = 6 x 5 = 30

Answer 69

Waiver of premium * The waiver of premium option exempts an insured from paying premiums while they are totally disabled. * Despite non-payment of premiums, the disabled insured maintains all policy rights and can receive participating dividends and increases in cash values. * Usually, there is a six-month waiting period that applies to this benefit.