Chapter 4 - Life insurance Premiums, Proceeds, and Beneficiaries

Question 1

Accelerated Benefit (Option) Rider

Answer 1

Allows the insured to receive a portion of the death benefit prior to death if the insured has a terminal illness and is certified by a physician as expected to die within 1-2 years

Question 2

Beneficiary

Answer 2

The person or entity designated in a life insurance policy to receive the death proceeds

Question 3

Cash Value

Answer 3

The equity or savings element of whole life insurance policies

Question 4

Class Designation

Answer 4

A beneficiary group designation (for example, all of my children), opposed to specifying one or more beneficiaries by name

Question 5

Common disaster provision

Answer 5

A provision of the Uniform Simultaneous Death Act which ensured a policyowner if both the insured and the primary beneficiary die within a short period of time, the death benefits will be paid to the contingent beneficiary. It also states that the primary beneficiary must outlive the insured a specified period of time in order to receive the proceeds.

Question 6

Contingent (Secondary) Beneficiary

Answer 6

The beneficiary second in line to receive the death benefit proceeds if the primary beneficiary dies before the insured.

Question 7

Earned Premium

Answer 7

The amount of premium paid by the policyowner for policy coverage or insurance protection already received.

Question 8

Expense Factor

Answer 8

Also known as the loading charge, is a measure of what it costs an insurance company to operate

Question 9

Fixed Amount Installment Option

Answer 9

Pays a fixed death benefit in specified installment amounts until the principal and interest are exhausted

Question 10

Fixed/Level Premium

Answer 10

A concept of averaging what would be the total single premium for a policy over periodic payments. More periodic payments = higher total premium

Question 11

Fixed period or period certain option

Answer 11

Pays the death benefit proceeds in equal installments over a set period of years. The dollar amount of each installment depends upon the total number of installments

Question 12

Graded premium

Answer 12

A premium funding option characterized by a lower premium in the early years of the contract with premiums increasing annually for an introductory period. After the introductory period, the premium jumps to an amount higher than what the initial level premium would have been, and then remains fixed or constant for the life of the policy.

Question 13

Gross (annual) premium

Answer 13

The net premium for insurance plus commissions, operating and miscellaneous expenses, and dividends.

Question 14

Interest Factor

Answer 14

A calculation for determining the amount of interest an insurance company can expect to earn from investing insurance premiums

Question 15

Interest Only Option

Answer 15

A death settlement option where the insurance company holds death benefit for a period of time and pays only the interest earned to the named of the beneficiary. A minimum rate of interest is guaranteed and the interest must be paid at least annually.

Question 16

Irrevocable Beneficiary

Answer 16

A beneficiary which may not be changed by the policyowner without the written consent of the beneficiary

Question 17

Joint and Survivor Option

Answer 17

A settlement which guarantees that benefits will be payed on a life-long basis to two or more people. This option may include a period certain and the amount payable is based on the ages of the beneficiaries.

Question 18

Life Income Option

Answer 18

A death benefit settlement option which provides the beneficiary with an income that they cannot outlive. Installment payments are guaranteed for as long as the recipient lives. The amount of each installment is based on the recipient’s life expectancy and the amount of principal.

Question 19

Life Settlement

Answer 19

An agreement in which a policyholder sells or transfer ownership in all or part of a life insurance policy to a third party for compensation that is less than the expected death benefit of the policy.

Question 20

Lump Sum Option

Answer 20

a death settlement option where death benefit is paid in a single payment, minus any outstanding policy loan balances and overdue premiums. The lump sum option is considered the automatic (or “default”) option for most life insurance contracts.

Question 21

Modified Premium

Answer 21

Demonstrates the incidence and extend of disability that may be expected from a given group of persons.

Question 22

Mortality Rate

Answer 22

A measure of the number of deaths (in general, or due to a specific cause) in some population, scaled to the size of that population, per unit time.

Question 23

Net Payment Cost Index

Answer 23

A formula used to determine the true cost of a policy for a policyowner. It uses the same formula as the Surrender Cost Index with the exception that it doesn’t assume that the policy will be surrendered at the end of the period. The net payment cost index is useful if one’s primary concern is the amount of death benefits provided in the policy.

Question 24

Net (Single) premium:

Answer 24

A premium calculated used to calculate an insurer’s policy reserves factoring in interest and mortality

Question 25

Per Capita (by the head):

Answer 25

evenly distributes benefits among all named living beneficiaries

Question 26

Per Stirpes (by the bloodline)

Answer 26

Evenly distributes benefits amongst a beneficiaries heirs in the event that a beneficiary dies before the insured

Question 27

Premium Mode

Answer 27

The frequency in which a policy owner elects to pay the premiums

Question 28

Primary Beneficiary

Answer 28

The first beneficiary in line to receive the benefit proceeds upon the death of an insured

Question 29

Policy Proceeds

Answer 29

The amount actually paid as a death, surrender, or maturity benefit. In the case of a death benefit, in includes the face value plus any earned dividends less any outstanding loans and interest. If surrender benefit, the amount includes any cash value less surrender charges and outstanding loans and interest. If maturity benefit the amount includes the cash value less any outstanding loans and interest.

Question 30

Reserves

Answer 30

The money set aside (required by the state’s insurance laws) to pay future claims

Question 31

Revocable Beneficiary

Answer 31

A beneficiary that the policy owner may change at any time without notifying or getting permission from the beneficiary

Question 32

Settlement Options

Answer 32

Are optional modes of settlement provided by most life insurance policies. Options include lump-sum cash, interest-only, fixed-period, fixed-amount, and life income.

Question 33

Single Premium Funding

Answer 33

a policy funding option where the policyowner pays a single premium that provides protection for life as a paid-up policy

Question 34

Spendthrift Clause

Answer 34

A Clause which prevents creditors from obtaining any portion of policy proceeds upon an insured’s death. Additionally, the clause can be selected by the policyowner to prevent a beneficiary from recklessly spending benefits by requiring the benefits to be paid in fixed amounts or installments over a certain period of time

Question 35

Surrender Cost Index

Answer 35

A cost comparison calculation formula where the net cost is averaged over the number of years the policy was in force to arrive at the average cost-per-thousand for a policy that is surrendered for its cash value at the end of that period

Question 36

Tertiary Beneficiary

Answer 36

The third beneficiary in line to receive the death benefit proceeds if the primary and contingent beneficiaries both die before the insured

Question 37

Unearned premium

Answer 37

Premium which has been paid by a policyowner for insurance coverage which has not yet been provided

Question 38

Uniform Simultaneous Death Act

Answer 38

States that if the insured and the primary beneficiary die at approximately the same time for a common accident with no clear evidence as to who died first, the law will assume that the primary died first, this allows the death benefit proceeds to be paid to the contingent beneficiaries

Question 39

Viatical Settlement

Answer 39

Involves Someone with a terminal illness selling their existing life insurance policy to a third party for a percentage of the death benefit. In this agreement, the owner of a life insurance policy sells the policy to another person in exchange for a bargained for payment, which is generally less than the expected death benefit under the policy. The original policyowner is called the Viator and the new third-party owner is called the Viatical, or sometimes referred to as the Viatee

Question 40

Actuary

Answer 40

Mathematicians who are responsible for bringing together the financial and statistical data that have an influence (and health) insurance premium rates

Question 41

Three primary factors are considered when computing the basic premium for life insurance:

Answer 41

Mortality, Interest Expense. Of these, the mortality factor as the greatest effect on premium calculations. While the insurer’s interest and expense factors are generally the same for all of its policyholders, the mortality factor can vary greatly depending on personal characteristics of individual insureds.

Question 42

Morality Factor - Death

Answer 42

The principles of life insurance depend on accurate mortality data. Mortality is the average number of deaths that are expected to occur each year for specific age groups. Statistics compiled over many years show the number, and at what ages, people are expected to die. These statistics become mortality tables, which reflect death rates at each age. Mortality is based on a large risk pool of people and time. Insurance companies use mortality tables to help predict the life expectancy and probability of death for a given group.

Question 43

Premium

Answer 43

An insurance premium is a payment of money an individual or business periodically (monthly, quarterly, annually) pays for an insurance policy. Insurance premiums are paid for policies that cover healthcare, auto, home, and life insurance.

Question 44

Interest

Answer 44

Insurance companies invest the premiums they receive in an effort to earn interest. This interest is one of the ways an insurance company can lower the premium rates.

Question 45

Expense

Answer 45

The third factor affecting premium rates is expense. As as with any business, an insurance company has various operating expenses. Personnel must be hired and paid, supplies, rent, local, state, federal taxes, etc. Thus, an expense factor is computed and included in the premium rates for life insurance. Sometimes the expense factor is called the “loading charge.”

Question 46

Other premium Factors

Answer 46

Age, Sex, Health, Occupation or avocation, Hobbies, Habits (like tobacco use)

Question 47

Three risk classifications used by insurers are:

Answer 47

Preferred, standard, and substandard

Question 48

Rating

Answer 48

Adjusting the premium to reflect the increased risk

Question 49

Premium Payment Options

Answer 49

Annual, Semi-annual, quarterly, monthly. NOTE: The higher the frequency of payments, the higher the premiums. This is because the interest earned to the insurer is decreased while the administrative costs are increased.

Question 50

Level Premium Funding

Answer 50

The insured pays more than the insurance protection requires during the policy’s early years. In the policy’s later years, the increasing mortality charge would normally increase the premium to a very high level; however, the excess paid in the early years is used to help fund the additional cost in later years.

Question 51

Single Premium Funding

Answer 51

The policyowner pays a single premium that provides protection for life as a paid-up policy. Normally associates with whole life insurance.

Question 52

Reserves

Answer 52

Money set aside (required by the state’s insurance laws) to pay future claims.

Question 53

Cash Value

Answer 53

applies to the savings element of whole life insurance policies that are payable before death.

Question 54

Tax of treatment premiums

Answer 54

As a general rule, premiums paid for personal life insurance policies by individual policyowners are considered to be personal expenses and, therefore, are not tax deductible. Also, premiums paid on individual life insurance policies are generally not deductible. Premiums for life insurance used for business purposes are generally not tax-deductible. The exceptions to these rules are:

• Premiums used for a charity are tax-deductible
• Life insurance premiums paid by an ex-spouse as court-ordered alimony are tax-deductible
• Employer-paid premiums used to fund group life insurance for the benefit of employees are tax-deductible

Question 55

Tax Treatment of Cash Values

Answer 55

If cash value is surrendered, the portion that exceeds the premiums paid is taxable. The total of the premiums paid into the policy minus total dividends received in cash or used to offset premiums is referred to as the cost basis for policies that are not surrendered, the cash value grows tax-free. As long as the cash value stays in the policy, taxes will never be imposed on any portion, not even the amount that exceeds the cost basis.

Question 56

Death Benefits

Answer 56

The death proceeds of a life insurance policy can be paid out in a variety of ways. The choice is up to the policyowner as a right of ownership. Or the policyowner may leave the decisions to the beneficiary. These payment options are known as a right of ownership, or the policyowner may leave the decision to the beneficiary. These payment options are known as settlement options. The selection of the appropriate settlement option should be based on the wishes of the insured and the needs of the beneficiary. The variety of options insurers offer makes the selection fairly easy, because it usually depends on the beneficiary will need the entire amount at once or as income payable over time. The settlement options available to policyowners: lump-sum, interest-only, fixed period, fixed amount, and life income.

Question 57

Lump-sum cash option

Answer 57

Death benefit is paid in a single payment, minus any outstanding policy loan balances and overdue premiums. The lump sum options is considered the automatic (or “default”) option for most life insurance contracts.

Question 58

Interest-only option

Answer 58

The insurance company holds the death proceeds for a specified period of time and at regular intervals pay the beneficiary a guaranteed rate of interest on the proceeds. the proceeds are paid out at the end of the specified period, either in cash or through other settlement options. Because the interest is paid out rather than accumulated, the proceeds of the policy remain the same and intact. A minimum rate of interest is guaranteed and the interest must be paid at least annually

Question 59

Fixed-Period Option

Answer 59

Also called period certain, the death benefit proceed is paid in equal installments over a set period of years. Part of the installments paid to a beneficiary consist of interest calculated on the proceeds of the policy. The dollar amount of each installment depends upon the total number of installments.

Question 60

Fixed-Amount Option

Answer 60

The policy proceeds plus interest are used to pay out a specified amount of income at regular intervals for as long as the proceeds last. The policyowner or beneficiary requests the size of payment desired. The amount of each income payment is fixed, and the duration of the payment period varies according to the payment amount. If excess interest is credited, it will be used to extend the payment period. The amount of each payment remains the same. The fixed-amount option involves the payment of equal installments of a stated amount, payable under the principal and interest are exhausted.

Question 61

Life Income Options

Answer 61

provides the beneficiary with an income that they cannot outlive. Installment payments are guaranteed for as long as the recipient lives. The amount of each installment is based on the recipient’s life expectancy and the amount of principal. This gives the potential for a greater return, or the potential for greater loss, based on how long the insured lives. A joint and survivor option guarantees that the benefits will be payed on a life-long basis to two or more people. This option may include a period certain and the amount payable is based on the ages of the beneficiaries.

Question 62

Annuity Income Options

Answer 62

Straight Life income option, cash refund option, installment refund option, life with period certain option, joint and survivor option, period certain option

Question 63

Living Benefits

Answer 63

In addition to the cash surrender option, policy benefits are available to living insureds through accelerated benefits and viatical settlements

Question 64

Accelerated Benefits

Answer 64

Accelerated benefit provisions are standard in most individual and group life insurance policies. Through these provisions, people who are terminally or chronically ill have tax-free access to policy death benefits. People suffering from AIDS, cancer, heart disease, Alzheimer’s disease, or other terminal or sever chronic illnesses often experience devastating financial hardships. During such times, funds from accelerated benefits help them maintain their independence and dignity. These funds are usually used for such necessities as rent, food, and medical services.

Question 65

A person is considered terminally ill when:

Answer 65

A physician certified that the person has an illness or condition that can be reasonably expected to result in death within two years. To be considered chronically ill, a licensed health care practitioner must have certified within the previous 12 months, that the person:

• Is unable to perform, without substantial assistance, at least two activities of daily living for at least 90 days due to a loss of functional capacity
• Has a similar level of disability as defined by regulations
• Requires substantial supervision to protect the person from threats to health and safety because of severe cognitive impairment.

Question 66

Viatical Settlements

Answer 66

Through viatical settlements, individuals with a terminal illness or sever chronic illness sell their life insurance policies to viatical companies for a percentage of the face value. The new owner continues to make the premium payments and will eventually collect the entire death benefit. The original policyowner is called the Viator and the new third party is called the viatee. The policies must have been in force beyond the contestable period. The price viatical companies pay for policies depends on the insured’s life expectancy and the cost of future premiums. The NAIC has adopted model standards for fair payment. Under these guidelines, insureds receive anywhere from 50-80% of the policy face value. When a viatical company purchases a policy it becomes the policyowner and is responsible for paying premiums. The company receives the death benefit when the insured dies.

Question 67

Tax Treatment of Proceeds

Answer 67

Premiums: Not Tax Deductible
Death Benefit: normally tax-free if taken as a lump sum. subject to a federal estate tax under certain circumstances and normally included in the policyowners gross estate.
Death benefit installments: Principal is tax free - interest is taxable.

Question 68

To understand the taxation of life insurance proceeds, remember one basic principle…

Answer 68

death benefits paid under a life insurance policy to a named beneficiary are generally free of federal income taxation. However, interest from death benefit proceeds left with the company is taxable income. Proceeds paid in installments are taxable because they include interest earned on the proceeds. The same principle applies in the case of life insurance policy dividends. Dividends are generally free form income taxation, but interest under a dividend option is taxable in the year the interest is paid.

Question 69

Annuity Rule

Answer 69

A fixed unchanging portion of each payment is considered a return of principal and is excluded from gross income for tax purposes. Thus, this means the portion of the proceeds representing principal are received tax free. The balance of each payment representing interest income is taxable as ordinary income. The percentage of each payment to be exempted is determined by dividing the insured’s investment in the contract by expected return. The expected return is based on the insured’s life expectancy.

Question 70

Transfer for Value Rule

Answer 70

If a policy is transferred by assignment or for “valuable consideration” (i.e., the policy is sold to another party) and the insured dies, the new owner of the policy will be taxed on the amount of proceeds which exceed the amount paid for the policy. This includes any premiums paid. However, the rules does not apply to transfers for value to the insured, to a partner (or partnership) of the insured, or to a corporation in which the insured is a shareholder for an officer.

Question 71

Three reasons a policyowner may receive proceeds from a life insurance policy while alive:

Answer 71

• The result of a policy surrender
• As accelerated benefits
• As a payment received in a viatical settlement

Question 72

Policy Surrender

Answer 72

When a life insurance policy is surrendered, the amount of tax is determined by the cost basis. Only the amount of proceeds that exceed the cost of the policy are taxable. (policyowner’s cost basis is calculated from total premiums paid, less policy dividends received, any policy loans or extra premiums paid)
In other words, a policyowner who receives cash value for a surrendered policy must pay taxes on any gain.
Endowment policy proceeds will be partially taxable under the rule of constructive receipt.
The policyowner has 60 days after the policy maturity date to exercise an annuity option before the rule of constructive receipt takes effect. CONSTRUCTIVE RECEIPT

Question 73

1035 Policy Exchanges

Answer 73

Another provision of the internal revenue code pertains to life insurance policies that are exchanged or transferred for another “like-kind” policy. Typically, when an individual realizes a gain on a financial transaction, that gain is taxed. However, if a policy is exchanged for another like-kind policy, Section 1035 of the Tax Code stipulates that no gain or loss will be recognized. Consequently, the transaction is not subject to any tax. The following kinds of exchanges are allowed under section 1035:

• A life insurance policy exchanged for another life insurance policy, endowment policy, or annuity contract
• An endowment policy exchanged for an annuity contract
• An annuity contract exchanged for another annuity contract
• A section 1035 exchanged enables the postponement of tax consequences

Question 74

Life insurance death benefits are paid without income tax consequence, however there is one exception…

Answer 74

if another transfer for value rule applies, the recipient of the proceeds will be taxed on a portion of the proceeds that exceed the amount paid for the policy.
Federal income taxes must be paid on interest earnings from death benefit proceeds or policy dividends that have been left with the company

Question 75

Cost indexes

Answer 75

Have been developed to help in the process of measuring an insurance policy’s actual cost. Here are two of these indexes:

• Surrender cost index: uses a complicated calculation formula where the net cost is averaged over the number of years the policy was in force to arrive at the average cost-per-thousand for a policy that is surrendered for its cash value at the end of that period.
• Net payment cost index: uses the same formula as the surrender cost index with the exception that it doesn’t assume that the policy will be surrendered at the end of the period. The net payment cost index is useful if one’s primary concern is the amount of death benefits provided in the policy. It is helpful in comparing future costs, such as in 10 to 20 years, if one will continue to pay premiums and does not take the policy’s cash value.

Question 76

Who can be beneficiaries?

Answer 76

Individuals, businesses, trust (provides management of the proceeds; policy proceeds may be reduced by trust administration fees), estates (creditors have rights to life insurance policy proceeds when the beneficiary is the insured’s estate), charities, minors (guardian may need to be appointed)

Question 77

When naming a minor as a beneficiary, the insurer may:

Answer 77

• make limited payments to an adult guardian for the benefit of the minor beneficiary
• Retain the policy proceeds at interest to be paid out when the child reaches the age of maturity or when an adult guardian is appointed
• Place the proceeds in a trust for the present or future benefit of the minor, as determined by the trustee

Question 78

Per Strirpes

Answer 78

“by way of” or “by branches.” a per strirpes distribution means that a beneficiary’s share of a policy’s proceeds will be passed down to the beneficiary’s living child or children in equal shares should the named beneficiary predecease the insured.

Question 79

Irrevocable Beneficiary

Answer 79

When a beneficiary is designated irrevocable, the policyowner forfeits the right to change the beneficiary. For all practical purposes, the policy is owned by both the policyowner and the irrevocable beneficiary. An irrevocable beneficiary has the vested right in the policy and the policyowner cannot exercise any right that would affect the vested rights of the beneficiary without the beneficiary’s consent.

Question 80

Uniform Simultaneous Death Act

Answer 80

Stipulates that if the insured and the primary beneficiary are killed in the same accident and there is not sufficient evidence to show who died first, the policy proceeds are to be distributed as if the insured died last.

Question 81

Common Disaster Provision

Answer 81

gives policyowners greater control over payment if the policy proceeds. This provision activates only when the insured and the primary beneficiary die as a result of the same accident. it states:
-If the insured and primary beneficiary die in the same accident, it is presumed that the insured died last (consistent wit the Uniform Simultaneous Death Act); and
-The primary beneficiary must outlive the insured by a definite period of time, as stipulated by the policyowner (usually from 60-90) or it is assumed that the insured died last
Thus with a common disaster provision, a policyowner can be sure that the death benefits will be paid to the secondary beneficiary (if there is one) or to the insured’s estate. death benefits will be paid to the secondary beneficiary (if there is one) or to the insured’s estate.

Question 82

Spendthrift Trust Clause

Answer 82

another commonly used clause in life insurance policies. It is designated to help protect beneficiaries from the claims of their creditors. More precisely, it shelters life insurance proceeds that have not yet been paid to the beneficiary from the claims of either the beneficiary policyowner’s creditors. The spendthrift clause does not apply to the proceeds paid in one lump-sum. Proceeds may be held in trust by the insurer and paid tot he beneficiary in installments over a period of time. The spendthrift clause pertains to these installment payment arrangements. Generally, the clause states that policy distributions payable to the beneficiary after the insured dies are not assignable or transferable and may not be attached in any way.
The spendthrift clause does not operate to protect proceeds that belong to the policyowner and are payable as income to the policyowner. It applies only to money held in the trust by the insurance company that is set aside to be paid to the named beneficiary at some future time. Spendthrift trust clauses are valid in most of states and are found in many life insurance policies.
**A spendthrift clause is also a statement in a settlement agreement that indicates that the proceeds of the policy will be free from attachment or seizure by the beneficiary’s creditors.

Question 83

Facility of Payment Provision

Answer 83

There are a few limited situations in which an insurer may pay proceeds to someone not designated as a beneficiary. A facility of payment provision, most typically found in industrial policies, permits an insurer to pay all or a portion of the proceeds to someone who, though not named in the policy, has a valid right. These situations include cases in which

• The named beneficiary is a minor
• the named beneficiary is deceased
• no claim is submitted within a specified period of time
• Costs were incurred by another party for the deceased insured’s final medical expenses or funeral expenses