Chapter 9: insurance contracts

Question 1

Characteristics of fixed annuities

Answer 1

– Is a guaranteed life product
– invested in general account
– fixed return and fixed payments.
– guaranteed
– company bears investment risk.
– Vulnerable to inflation

Question 2

Characteristics of variable annuities

Answer 2

• Are variable life products
  – Funds are in a separate account.
  – variable return and variable payments. I.e. – payments to the annuitant vary, dollar amount per performance of the separate account.
  – not guaranteed.
  – investor bears investment risk
  – resistant to inflation

Important: variable annuities are considered securities, thus require a series 7 license.

Question 3

Common characteristics of fixed and variable annuities

Answer 3

– Guaranteed payments for life.
– tax-deferred earnings
– Professional management
– investor loses control of principal upon annuitization

Question 4

Variable annuity separate account

Answer 4

– Rules established via Investment Company Act of1940
– Funds must be separate from the general account.
– is like a mutual fund, but cannot be marketed as a mutual fund
– must be sold with a prospectus.
– Separate account must be registered under the investment company act of 1940
– separate account managed by board of managers or directors
- Investment returns are not guaranteed

Question 5

Annuity general account

Answer 5

– Fundamentally invested in long-term debt instruments.
– primary objective is providing stable return to fund guarantees on fixed products 

Question 6

Immediate annuity versus deferred annuity

Answer 6

– Are differentiated by when the payments to the annuitant begin

Question 7

Immediate annuity

Answer 7

– May only be funded by a single lump sum payment, because contract begins payment on first interval, after deposit is received
- Annuitant may select monthly or annual payments

Question 8

Deferred annuity

Answer 8

• Can be purchased as lump sum or periodic (flexible-premium deferred annuity)
• Payments to annuity are delayed until contract is fully annuitized

Characteristics:
- Dollars invested are usually after-tax
- Growth is tax deferred
- income payments begin after contract is annuitized, cost basis is divided over years of life expectancy
- Usually to accumulate funds in retirement

Surrender value:
- If surrendered before 59 1/2, taxed as income plus 10% early withdrawal penalty
- If surrender only a protection through random withdrawal, IRS will default to LIFO taxation. This means deferred gain taken out and taxed first

Question 9

Accumulation period

Answer 9

• The phase when annuitant is depositing money into the annuity contract
• begins on date that annuity contract becomes effective and continues until the payout period begins.

Question 10

Accumulation units

Answer 10

• accounting measure used to identify the contract owner’s interest in the separate account during the accumulation period.
• through accumulation phase, annuity’s value is expressed via increasing number of units
• Value of units correlated with performance of the separate account
• Units are purchased by the separates accounts NAV, like a mutual fund

-An annuitant’s interest in the separate account is determined by multiplying the number of accumulation units owned by the value of each accumulation unit.

Ex: an annuitant with 1,000 accumulation units valued at $6.00 per unit would have an interest in the separate account valued at $6,000.

Question 11

Annuity units

Answer 11

• Accumulation units become annuity units once accumulation period ends
• After accumulation phase, annuitant can either 1) take lump sum or 2) take periodic payments. The latter occurs through purchase of accumulation units.
• Exchange of accumulation units into annuity units occurs on the date of annuitization. The exchange rate is a combination of factors that consider the annuitant’s age, life expectancy, settlement option selected and the Assumed Interest Rate (AIR).

Question 12

How to convert accumulation units to annuity units

Answer 12

1. Calculate the annuitant’s interest in the separate account: multiply the number of accumulation units by the current value per unit.
2. Calculate the first monthly payment: This is an actuarial factor based on the annuitant’s age, life expectancy and settlement option selected. For example, if the annuity contract is worth $100,000 and the actuarial rate is $5 per $1,000 in the account, the first monthly payment is $500 (100 units $1,000 × $5 per unit).
3. Calculate the value of future payments: This is based on the value of each annuity unit. For this example, assume that each annuity unit is worth $2.50 at the time of the first monthly payment. In order for the annuitant to receive $500, 200 annuity units must be liquidated ($500 ÷ $2.50 per annuity unit = 200 annuity units). At this time, the number of annuity units is fixed. Each future monthly payment will be the redemption value of 200 annuity units.

Question 13

Assumed interest rate (AIR)

Answer 13

-The investment portfolio of the variable annuity is assigned an assumed interest rate.
-The insurance company assigns this rate as an assumption of a reasonable rate of return on the investments in the separate account. This rate is not guaranteed; it is merely a reference. The registered rep may not suggest to the client it is guaranteed.

*The assumed interest rate (AIR) is part of the annuity contract and is used to calculate the amount of each annuity payment over time.

-Note: performance rate is compared to AIR (%), but payment is compared to the previous month’s amount ($).

Once the AIR is set, it will not change for the remainder of the contract. It functions as a projection of future returns and as a benchmark used to calculate income payments.

Question 14

Settlement options - straight-life annuity

Answer 14

This option gives annuitants the highest periodic payment but carries the most risk. Annuitants receive payments as long as they live. Upon the annuitant’s death, all payments end. Therefore, if the annuitant dies after receiving only one payment, no other payments will be made. This option is also called Life Only or Life Income.

Question 15

Settlement options - life annuity with period certain

Answer 15

Annuity payments will be made for a minimum period of time (usually 10 or 15 years). If the annuitant lives longer than the period certain, the annuitant will continue to receive payments for life. But if the annuitant dies before the end of the period, the beneficiary will continue to receive payments for the remaining years of the period certain.

For example, if an annuitant has a 10-year period certain annuity and dies after receiving payments for 5 years, the beneficiary will receive the remaining 5 years of payments.

If the annuitant dies after receiving payments for 13 years from a 10-year period certain option, no further payments will be made because the company is obligated to pay only up to the annuitant’s death if he or she outlives the period certain of the contract.

Question 16

Settlement options - period certain (fixed period)

Answer 16

There is no life guarantee with this option.

With this method, periodic payments are made to the annuitant for a specified number of years (usually 10 or 15). If the annuitant dies before the end of the period, the remaining payments due will be made in a lump sum or in installments to the named beneficiary.

Question 17

Settlement options - unit refund life annuity

Answer 17

This option provides periodic payments during the annuitant’s lifetime. If the annuitant dies prior to receiving an amount equal to the value of the annuity units, the remaining portion will be paid in a lump sum or installments to the beneficiary.

Question 18

Settlement options - Joint and last survivor life annuity

Answer 18

With this option, payments are made to 2 people. If one annuitant dies, payments continue to be made to the surviving annuitant. All payments cease when the remaining person dies.

Question 19

Voting rights

Answer 19

• Contract owners of variable annuities have voting rights with regard to the separate account.
• Votes can be cast in person or by proxy.
• Voting privileges are for election of members of the board, changes in investment policies of the separate account, and other issues as defined in the Investment Company Act of 1940.
• For every $100 of cash value in separate account, the policyowner has one vote. Issues requiring policyholders’ approval include changes in investment objectives and the election of officers or managers of the separate account.

Question 20

Mortality guarantee

Answer 20

• The annuity company guarantees that it will make payments as long as the annuitant lives through a mortality guarantee.
• The insurance company deducts a mortality expense risk fee from the separate account to protect itself against an annuitant outliving their expected mortality.

Question 21

Expense guarantee

Answer 21

• Annuity companies are required to project their administrative expenses for annuity contracts.
• The expense guarantee establishes the maximum they can charge the contract.
• The annuity company is responsible for any increase in expenses beyond the amount guaranteed in the contract.
• An operating expense risk fee is deducted from the separate account to protect the company against rising operating expenses.

Question 22

Death benefit

Answer 22

• Annuity contracts also have a provision for a death benefit in the event the contract owner dies during the accumulation period; the beneficiary will then receive the greater of the gross payments made into the contract or the accumulated value at the time of the owner’s death.

Question 23

Surrender value

Answer 23

• An annuity can be terminated anytime during the accumulation period for its surrender value, which is the current value of the assets held in the separate account less any surrender charges.
• Contracts with high and/or long-term surrender charges may not be suitable for older investors.
• These charges should also be factored when considering a 1035 exchange. No termination, either whole or in part, can occur once annuity payments have begun.

Question 24

Exchange privileges

Answer 24

Annuities typically have loan provisions, partial redemptions, and exchange privileges during the accumulation period. These features vary from product to product, and are outlined in the contract when applicable.

Occasionally, it might be in a policy holder’s best interest to exchange one insurance product for another. A 1035 exchange allows a policyholder to roll the cost basis from the first product into the second, thereby deferring recognition and tax on any capital gain realized in the exchange. The following are allowable exchanges:

1. A life insurance contract to another life insurance contract;
2. A life insurance contract to an annuity;
3. An endowment contract to an annuity contract; and
4. An annuity contract to an annuity contract.

IMPORTANT: An annuity contract may not be exchanged for an insurance contract.

Although they enjoy special tax deferral privileges, 1035 exchanges raise suitability concerns which should be reviewed by a principal. These include the consequences of possible surrender charges on the old policy, the initiation of a new surrender period on the new policy, and sales charges assessed on the new product.

Question 25

Sales charges and expenses

Answer 25

Variable annuity contracts have sales charges that are similar to those of mutual funds.

FINRA conduct rules established that the sales charge on a variable annuity contract is fair and reasonable over the life of the contract. The sales charge pays for sales and marketing expenses, administrative expenses and other costs of distribution.

All variable annuity contracts that are funded by a specific separate account are subject to the same sales charge, regardless of whether the annuity is funded by a single premium or with periodic installments. Any breakpoints and rights of accumulation available to the contract owner are established in the prospectus.

Question 26

Level sales charge

Answer 26

Variable annuities can be sold on a level sales charge, or level load, basis. Level sales charges are deducted from each installment made into the contract.

Question 27

Deferred sales charge

Answer 27

Annuities can also be offered with a deferred sales charge to cover the operating expenses and commissions associated with the contract. Under the deferred sales charge method, the charge to the contract owner is usually contingent on the length of time that the annuity is held, and is assessed at withdrawal.

When considering a replacement or 1035 exchange of an existing variable annuity contract, a representative should clearly explain whether a new surrender charge period will start, and any other changes in access to funds or liquidity features. The beginning of a new surrender charge may make a change to a new contract unsuitable, particularly for senior investors.

Question 28

Other charges and expenses not included in sales charges

Answer 28

The sales charge is made up of several elements, which are designated in the prospectus. An annuity has other expenses that are not part of the sales charge. These expenses are deducted from the assets or income of the separate account. These additional expenses include the following:

• Investment management fee;
• Mortality risk fees
• Expense risk fee;
• Premium taxes; and
• Administrative expenses.

Question 29

Variable life insurance basics

Answer 29

• some funds go into separate fund in an effort to keep pace with inflation.
• Both FINRA and the state insurance departments have regulatory authority over variable life products.
• amount and frequency of premium payments are fixed.

Question 30

Universal life insurance basics

Answer 30

• contract owner is allowed to vary the amount and frequency of premiums as long as the minimum cash value maintained is sufficient to support the cost of insurance
• unlike variable life, a variable universal policy may or may not have a minimum guaranteed death benefit.

Question 31

Variable life insurance loans

Answer 31

• after the policy has been in place for at least three years, must allow a loan up to 75% of the cash value
• must be paid back at established interest rate
• If not repaid, equates to a partial surrender, and the amount of the loan is subtracted proportionately from the death benefit.
• if separate account suffers huge losses and the cash value goes negative, policy owner must pay enough to go positive within 31 days

Question 32

Expense limitation

Answer 32

Any administrative expenses above the contractually stated maximum charges are the responsibility of the insurance company.

Question 33

Cash value

Answer 33

There is no minimum guaranteed cash value in a variable life policy. The cash surrender value can be less than the amount that was available when the policy was issued because it depends on the investment performance of the separate account. The actual amount available is the value calculated at the time of surrender.

Question 34

Termination

Answer 34

At termination, if a policyholder stops making premium payments into the policy, the owner is entitled to the surrender value of the policy.

Question 35

Surrender value

Answer 35

This is the cash value of the policy minus any outstanding loans or unpaid interest charges. The nonforfeiture clause provides that the policyowner receive the accumulated cash value should premium payments cease and the policy is surrendered.

The cash surrender value can be less than the amount that was available when the policy was issued. The actual amount available is the value calculated at the time of surrender.

Question 36

Exchange privileges among investment alternatives

Answer 36

Policyowners are entitled to exchange all or portions of their assets held in the separate account among alternative investments available in the account. These exchanges are free of any charges and do not create tax liabilities.

Policyowners have the right to exchange one form of permanent insurance policy for another type of permanent policy. In the case of a variable life policy, the conversion could be to either a traditional whole life or universal policy. The insurance company must allow the conversion to a more conventional whole life policy for the first 2 years without having the insured provide any additional evidence of insurability.

Question 37

Sales charges – what is permitted for variable life insurance?

Answer 37

• The maximum sales charge allowed on a variable life insurance policy is 9% computed over a period of up to 20 years;
• Free-look period: If the policy is surrendered during the first 45 days, the contract holder will receive a full refund of the premiums paid;
• During the first year of the policy, the maximum sales charge is 50% of the premium paid; and
• If a policyowner surrenders a variable life policy during the first 2 policy years, the owner is entitled to the NAV of their account plus a refund of any charge that exceeds 30% of the first year’s premium plus any charge that exceeds 10% of the second year’s premium.

Question 38

Policy charges for variable life insurance

Answer 38

• Mortality costs;
• Investment management fee;
• Administrative expenses; and
• Cost of insurance.

The largest cost incurred by the insurance company that is levied against the value of the variable annuity separate account is the investment management fee.

Question 39

Valuation of a Variable Life Insurance Policy

Answer 39

• variable life insurance policy valuation is directly related to the performance of the separate account.
• The policyowner assumes all risks associated with the performance of the separate account.
• Fluctuations in the value of the separate account will affect both the policy’s cash value and death benefit.
• The cash value is usually calculated on a daily basis, but must be calculated at least monthly.

Know This! Market risk is the greatest investment risk in a variable life insurance policy because the performance of the separate account fluctuates with that of the overall market.

Question 40

Variable life insurance death benefit

Answer 40

• have a guaranteed minimum death benefit.
• minimum is the face amount of the policy at the time of issuance.
• Most states allow a “suicide clause.” This does not require the payment of a death benefit if the insured should die by suicide within the first 2 years of the policy. In such cases, the insurer would refund the premiums paid to date.
• Also, mortality tables consider a person statistically dead at age 100; therefore, death benefits are typically paid at that time.

The actual death benefit is determined by the performance of the separate account. There is an assumed interest rate (AIR) that is stated in the policy. If the performance of the separate account is greater than the AIR, the death benefit may be greater than the minimum. A decrease in the performance below the AIR can cause the death benefit to decrease, but it can never fall below the policy minimum. The death benefit must be recalculated at least annually.

Question 41

Riders and living benefits

Answer 41

• Used primarily as a means for individuals to customize their policies to meet their individual needs.

If the additional rider increases the risk to the insurer, proof of insurability will generally be required. Most riders also require the payment of an additional premium. Some riders, however, are often included in the policy for free, such as terminal illness (living need) rider, the automatic premium loan, and exclusions.

Some riders provide benefits in the event of the insured’s disability, while other riders provide for partial payment of the death benefit prior to the insured’s death, called accelerated or living benefits riders.

Question 42

Variable annuity living benefit riders

Answer 42

Living benefit riders provide market growth with downside risk protection in addition to the reliable and predictable income stream delivered by annuity contracts.

There are three types of living benefit riders that produce these guarantees:
- Guaranteed minimum withdrawal benefit rider;
- Guaranteed minimum income benefit rider; and
- Guaranteed minimum accumulation benefit rider.

Question 43

Guaranteed minimum income benefit rider

Answer 43

Guarantees a minimum return on the investments (ROI) in subaccounts.

Based on this return, the annuitant is guaranteed a minimum income. This rider must usually be added at the time the annuity is purchased, and the contract must be annuitized before the rider can be used.

For example, this rider might guarantee that a monthly payment will never be less than 75% of the first payment. If the first payment to the annuitant was $1,200, this rider guarantees that monthly payments will never be less than $900, regardless of how the investments in the subaccounts perform.

Question 44

Guaranteed minimum withdrawal benefit rider

Answer 44

Guarantees a return of all premiums paid, regardless of how the investments in the subaccounts perform.

The annuitant must make annual withdrawals, with each limited to a certain percentage of the premiums paid. This rider does not return the premiums paid as a lump-sum payment. This option protects the annuitant against investment losses.

For example, suppose $100,000 was paid in premiums for a variable annuity, and a rider was purchased that guarantees a 6% withdrawal rate. The rider guarantees that $6,000 can be withdrawn (or 6% of the $100,000 paid in premiums) annually without penalty even if the investments in subaccounts have done so poorly that the annuity is only worth $70,000. The total amount of withdrawals is limited to the premiums paid or $100,000 in this example.

Question 45

Guaranteed minimum accumulation benefit rider

Answer 45

Guarantees that an annuity will be worth a minimum amount by a set date, even if the investments in the subaccounts do poorly.

For example, this rider might guarantee that an annuity will earn at least 5% per year by the end of 10 years. If the annuity has only earned 3% per year once those 10 years have passed, the insurer will add the difference.

Question 46

Guaranteed minimum death benefit rider

Answer 46

Guarantees the minimum amount of the death benefit the insurer will pay the beneficiary if death occurs before the insurer starts to make monthly payments. Some guaranteed minimum death-benefit riders may also “step up” this guaranteed death benefit amount, or they may add interest to the amount from time to time.

Question 47

Waiver of Premium

Answer 47

waives the premium for the policy if the insured becomes totally disabled. Coverage remains in force until the insured is able to return to work. If the insured is never able to return to work, the premiums will continue to be waived by the insurance company. Most insurers impose a 6-month waiting period from the time of disability until the first premium is waived. If the insured is still disabled after this waiting period, the insurer will refund the premium paid by the insured from the start of the disability. This rider usually expires when the insured reaches age 65.

Question 48

Accelerated Benefit or Living Needs Rider

Answer 48

provides for an early payment of part of the policy death benefit if the insured is diagnosed with a terminal illness that will result in death within 2 years, or has other qualifying conditions. It does not cover disability. The purpose of this rider is to provide the insured with the necessary funds to take care of necessary medical and nursing home expenses that incur as a result of the terminal illness. Many insurance companies do not charge for this rider since it is simply an advance payment of the death benefit. The remainder of the policy proceeds are payable to the beneficiary at the time of the insured’s death.

Question 49

Conditions for access – Accelerated Benefit or Living Needs Rider

Answer 49

• A terminal illness;
• A medical condition that requires an extraordinary medical intervention (such as an organ transplant) for the insured to survive;
• A medical condition that without extensive treatment drastically limits the insured’s lifetime;
• Inability to perform activities of daily living (ADLs);
• Permanent institutionalization or confinement to a long-term care facility; or
• Any other conditions approved by the Department of Insurance.

The maximum benefit is typically a percentage of the face amount of insurance, usually 50%, but it is legal for the insurer to pay up to 100% of the death benefits before the insured dies. There may also be a dollar limit, such as $100,000. The face amount of insurance is reduced after the payments. The accelerated death benefit payout will not necessarily result in a reduction of the premium; however, premium may be waived.

Question 50

Effect on death benefit – Accelerated Benefit or Living Needs Rider

Answer 50

Know This! Accelerated benefit = early payment of part of death benefit to the insured from the insurer for qualifying medical expenses.

Effect on Death Benefit: If an insured withdraws a portion of the face amount by the use of the accelerated benefits rider, the benefit payable at death will be reduced by that amount, plus the amount of earnings lost by the insurance company in interest income.

Payable Death Benefit = Face Amount - Amount withdrawn - Earnings lost by insurer in interest

Example:
The policy’s face amount is $100,000; however, due to a terminal illness, the insured had to withdraw $30,000 from the policy 3 years before his death. Since this amount was withdrawn, the insurance company lost $300 worth of interest. Upon the insured’s death, the beneficiary received $69,700 in death benefit:

$100,000 (face amount) - $30,000 (accelerated benefit) - $300 (lost interest) = $69,700

Question 51

Long-term conditions for Payment - Accelerated Benefit or Living Needs Rider

Answer 51

The accelerated benefits rider permits an insured to submit a claim for living benefits from a policy under one of the following circumstances:

• Diagnosed with a terminal illness;
• Needs long-term care;
• Requires permanent confinement to a nursing home, or
• Diagnosed with a dread disease.

The payment of these benefits usually falls into one of the following categories:
- Long-term care, which generally allows the insured to use part of the policy’s face amount to pay nursing home or at home care;
- Dread Disease, which pays (usually limited to ¼ to ½ the death benefit) to cover the cost of heart attack, organ transplant, cancer treatment, or other catastrophic disease;
- Terminal illness, which pays most of the death benefit.

The insurer has the right to require the insured to submit to examination by a physician of the insurer’s choice (and at the insurer’s expense) to confirm the diagnosis.

Question 52

Long-term care benefit impact on death benefit - Accelerated Benefit or Living Needs Rider

Answer 52

Any policy of life insurance may pay the death benefit early under the following circumstances:
- Terminal illness;
- Catastrophic illness; or
- Eligibility for long-term care.

Question 53

Primary insured rider

Answer 53

A primary insured rider provides policyowners with additional term insurance on the primary insured with guaranteed convertibility.

Question 54

Additional insured rider

Answer 54

The other insured rider provides coverage for one or more family members other than the insured. The rider is usually level term insurance, attached to the base policy covering the insured. This is also known as a family rider. If the rider covers just the spouse of the insured, it can be specified as a spouse term rider, and allows the spouse to be added to coverage for a limited period of time and for a specified amount (it usually expires when the spouse reaches age 65).

Question 55

Family rider

Answer 55

Incorporates the spouse term rider along with the children’s term rider in a single rider. When added to a whole life policy, the family term rider provides level term life insurance benefits covering the spouse and all of the children in the family.

Family Term = Spouse Term + Children’s Term

Question 56

Non-family insureds

Answer 56

The substitute insured or change of insured rider does not permit an additional insured, but instead allows for the change of insureds, subject to insurability. It is most commonly used with Key Person insurance when the key person or employee retires or terminates employment. The rider permits the policyowner, owner or employer, to change the insured to another key employee, subject to insurability

Question 57

Child insurance rider

Answer 57

A child insurance rider provides term insurance protection for children and offers guaranteed convertibility