FP512- Risk Mgt, Insurance & EE benefits Flashcards
Which of the following limits an insurer’s liability for covered losses?
I. Misrepresentations by an agent acting within the agent’s authority
II. An insurable interest by the insured
III. Other insurance coverage
IV. The actual cash value of a loss
A) II, III, and IV
B) I, III, and IV
C) I, II, and IV
D) II and IV
Explanation
A) The answer is II, III, and IV.
Options II, III, and IV are factors limiting an insurer’s liability for covered losses, but I is not. An insurer is bound by an agent’s misrepresentations while acting within the scope of the agent’s authority.
LO LO 1.3.1
Which of the following are important when selecting an insurance company?
I. Competence
II. Training
III. Ratings by the ratings companies
IV. History
A) III and IV
B) I, II, III, and IV
C) I and III
D) III only
LO LO 1.8.1
Explanation
A) The answer is III and IV.
Options III and IV, along with the NAIC Watchlist, the size and age of the company, operating ratios, persistency, average policy size, lines of business, investment returns, and direct recognition, are all things one should look at when evaluating an insurance company. Competence and training are important when evaluating insurance producers, not companies.
Which of the following is an insurance producer who has the authority to hire agents to work for them?
A) A career agent
B) A captive agent
C) A broker
D) A producing general agent
LO LO 1.3.1
Explanation
D) The answer is a producing general agent. Producing general agents may, but do not have to, hire agents to work for them. The other options represent individual producers.
Which section of an insurance contract includes information provided by the applicant?
A)The insuring agreement
B)The conditions section
C)The exclusions section
D)The declarations section
Explanation
The answer is the declarations section. The declarations section includes information provided by the applicant, and it may be transcribed from the application, or the application itself may be attached. The insuring agreement identifies what is insured, for what amount, and under what conditions. The exclusions section identifies circumstances or situations that would preclude the company from paying a claim. The conditions section states the rights and duties of the insurance company and the policy owner.
Which of the following is an example of a moral hazard?
A) A person falls and breaks her hip.
B) A homeowner carelessly burns leaves on a windy day, resulting in fire damage to his house.
C) A car is damaged by a hailstorm.
D) A driver slams on her brakes for no reason other than to cause the driver behind her to rear-end her car.
Explanation
D) The answer is a driver slams on her brakes for no reason other than to cause the driver behind her to read-end her car.
A moral hazard occurs when dishonesty causes a loss or causes the amount of the loss to be overstated on a claim. Intentionally causing a loss is an example of a moral hazard.
The pairs and sets option of loss settlement under a homeowners policy allows the insurance company to
A) sell the damaged property as a pair or set only.
B) repair or replace any part of the pair or set to its value before the loss.
C) sell the pair or set for its salvage value.
D)pay the full replacement cost of the pair or set.
LO 1.7.1
Explanation
B) The answer is repair or replace any part of the pair or set to its value before the loss.
This option allows the insurer to repair or replace any part of a set or pair, or pay the insured the difference between the actual cash value of the pair or set before and after the loss.
18 of 20
Which of the following statements concerning the collateral source rule are CORRECT?
I. The rule states that a person who commits a tort will be liable for full damages.
II. The person who commits a tort is liable for full damages, even though the plaintiff has other sources of recovery available.
III. The collateral source rule prevents the person who committed the tort from benefiting because of fortuitous circumstances.
IV. The collateral source rule prevents an insurance company from receiving a portion of the insured’s right to recover from the defendant.
A) II, III, and IV
B) I, II, III, and IV
C) I and II
D) I, II, and III
Explanation
D) The answer is I, II, and III.
The collateral source rule states that a person who commits a tort is not entitled to a reduction of damages simply because the injured person has other sources of recovery, such as insurance.
Which of the following statements regarding insurance contracts are CORRECT?
I. An insurance policy is conditional, in that the insurer is obligated to compensate the insured only if certain conditions are met.
II. A warranty is merely a promise made by the insured to the insurer that is part of the insurance contract and, as such, must be adhered to by the insured.
III. Representations are statements made by the proposed insured to the insurer in the application process.
IV. Concealment occurs when the insured is silent about a fact that is material to the risk.
A) I and II
B) I, II, III, and IV
C) II, III, and IV
D) I and III
LO 1.6.1
Explanation
The answer is I, II, III, and IV. All of the statements are correct.
Which of the following are particular risks?
I. Premature death
II. Disability
III. Unemployment
IV. Earthquake
A) I, II, and III
B) I and II
C) II and III
D) I, II, III, and IV
Explanation
A) The answer is I, II, and III.
The risk of premature death, disability, and unemployment directly affect an individual. Particular risks are risks that affect only individuals, such as the possibility of the loss of income or assets because of the inability to earn income (e.g., premature death, dependent old age, sickness, disability, unemployment).
The risk of an earthquake is a fundamental risk.
You have a meeting with Oscar, 26, and his wife Judith, 25, this afternoon to review their risk management plan. They have two children, two cars, a home, and a boat. Oscar works at the local bank, and Judith works at an engineering firm. Which of the following statements regarding their risk management plan is CORRECT?
I. They have a limited amount of liability exposure.
II. They have a higher probability of becoming disabled versus experiencing premature death.
III. Having liability insurance on their cars is more important than collision coverage.
IV. Long-term care insurance should not be a priority within their risk management plan.
A) III and IV
B) II, III, and IV
C) I, II, and III
D) IV only
Explanation
B) The answer is II, III, and IV.
They have unlimited liability exposure. A car accident could lead to an unlimited amount of liability depending on the circumstances, as well as the possibility of negligence occurring on their property. Statements II, III, and IV are correct. There is a higher probability of becoming disabled than of experiencing premature death, and it is much more important to have liability insurance on a vehicle than collision coverage. Liability claims may be much higher than any type of collision damage to a vehicle. Both Oscar and Judith are too young to consider long-term care insurance at this time.
LO 1.2.1
Frank is severely injured in an automobile accident caused by another driver, Henry. At trial, the court orders Henry to pay Frank $100,000 as compensation for the pain and suffering resulting from his injuries. Which of the following types of damages for which the award was granted is CORRECT?
A) Comparative
B) General
C) Punitive
D) Special
LO 1.5.1
B)
The answer is general. General damages compensate an injured party for intangible losses, such as pain and suffering, which cannot be measured monetarily.
Augusto and Celena have an HO-3 homeowners policy on their home. The dwelling is insured for $150,000. As the result of a kitchen fire, their home suffers extensive structural and smoke damage and is made uninhabitable for nine months. They rent a hotel room while the damage is repaired, incurring expenses of $13,500. It also costs them $4,000 for meals during their hotel stay, for a total of $17,500. Which of the following statements regarding the couple’s coverage under their HO-3 policy is CORRECT?
A) The HO-3 policy covers the entire $17,500 in expenses.
B) The HO-3 policy does not cover any of their living expenses while their house is uninhabitable.
C) The HO-3 policy covers the full $13,500 in rental expenses but does not cover the $4,000 for meals.
D) The HO-3 policy covers only the first $15,000 of the $17,500 in expenses.
Explanation
A)
The answer is the HO-3 policy covers the entire $17,500 in expenses.
Coverage D of a homeowners policy pays living expenses, including lodging costs and meals, incurred when the house is made uninhabitable by a covered peril. Under an HO-3 policy, Coverage D is limited to 20% of the Coverage A limit on the dwelling. In Augusto and Celena’s case, coverage under Coverage D is $30,000 ($150,000 × 20%), so their lodging expenses and meals are fully covered.
Which of the following homeowners policies is designed for the owners of condominium units and cooperative apartments?
A) HO-8
B) HO-2
C) HO-6
D) HO-4
Explanation
The answer is HO-6. HO-6: Unit Owner Form (for Condominium Owners) covers the personal property of the insured for the same named perils listed in a HO-2 policy, except HO-6 insurance is for people residing in a condominium or cooperative apartment. This type of policy also provides liability protection.
James is a delivery driver for ABC Pizza. He gets into an accident and is ticketed for speeding while delivering one of ABC Pizza’s delivery orders. The victim’s attorney plans on going after ABC Pizza for special and punitive damages. Which of the following terms best describe why ABC Pizza being held liable for this accident?
A) Strict liability
B) Comparative negligence
C) Vicarious liability
D) Contributory negligence
Explanation
The answer is vicarious liability.
Vicarious liability results from when a person is liable for torts committed by someone else. For example, parents may be liable for the torts committed by their children, and employers can be liable for the torts committed by their employees.
The principle of strict liability holds tortfeasors—parties who commit a tort—liable for damages sustained by their actions or from their products, whether or not they were deemed at fault.
Under the contributory negligence rule, a person cannot recover damages if his own negligence contributed in any way to his injuries.
Under comparative negligence, damages are adjusted to reflect the extent to which the injured party’s own negligence contributed to his injuries.
LO 2.4.2
A personal liability umbrella policy (PLUP)
I. is written only for persons with substantial underlying liability insurance.
II. provides additional coverage to the underlying policies.
III. has a drop down limitation that will apply in most cases.
A) II and III
B) I, II, and III
C) I and II
D) I and III
The answer is I, II, and III. All of these statements correctly describe a characteristic of the PLUP.
Which of the following statements regarding personal auto policy (PAP) Part B Medical Payments coverage is CORRECT?
I. Part B of the PAP provides payment for the reasonable and necessary medical expenses of an insured as a result of an automobile accident.
II. The insureds under Part B include the named insured, spouse, and any family members while they are occupying a motor vehicle, or when, as a pedestrian, they are struck by a vehicle.
A) I only
B) II only
C) Both I and II
D) Neither I nor II
C) Both I & II
The answer is both I and II. Part B: Medical Payments coverage provides payment for the reasonable and necessary medical expenses of the insured as a result of an automobile accident. Expenses must be incurred within three years of the incident, and limits are provided on a per-person, per-occurrence basis. Individuals covered by Part B include the named insured, spouse, and any family member while they are occupying a motor vehicle, or when, as a pedestrian, they are struck by a vehicle.
A client is shopping for homeowners insurance. He wants a policy that will provide open-perils coverage on both the dwelling and his personal property. Which of the following policies without an endorsement will meet his needs?
I. HO-2
II. HO-3
III. HO-5
A) I only
B) I, II, and III
C) II and III
D) III only
The answer is III only. The only policy that provides open-perils coverage on both the dwelling and personal property without an endorsement is an HO-5 policy. Coverage under an HO-2 policy provides named-perils coverage on both the dwelling and personal property. An HO-3 policy provides open-perils coverage on the dwelling but named-perils coverage on personal property.
The National Flood Insurance Program provides subsidized flood insurance for property owners in qualified areas and
A) is mandatory for all people in qualified areas.
B) is considered to be in force immediately if elected during the first 30 days in which the insurance becomes available to a community.
C) does not provide coverage for any personal property.
D) does not have a deductible.
B) The answer is is considered to be in force immediately if elected during the first 30 days in which the insurance becomes available to a community. Coverage is effective immediately if elected within the first 30 days of availability. Although not mandatory, mortgage lenders generally require homeowners to purchase flood insurance in flood-prone areas. Contents coverage applies to household and personal property usual or incidental to the occupancy of the dwelling. In addition, a deductible may apply to any claims.
Steven has a dog that has been known to wander through the neighborhood. His home is covered by an HO-3 policy. If Steven’s dog bites a mailman three blocks away from his home, which of the followings statements regarding Steven’s homeowners insurance coverage is CORRECT?
I. Steven will not have any coverage because the bite did not take place at his personal residence.
II. Coverage E of Steven’s policy may apply or provide coverage if he is found to be legally liable (dog bite lawsuit).
III. Coverage F of Steven’s policy may be applied to any medical bills, typically up to $1,000.
A) II and III
B) I only
C) II only
D) III only
The answer is II and III. Steven will be covered if his dog bites the mailman on or off his property. Coverage E will apply only if he is found to be legally liable, and Coverage F will apply to any medical bills typically up to $1,000. Coverage F does not require Steven to be at fault to provide coverage.
LO 2.2.2
Milt has an HO-3 homeowners policy, and his home is for $200,000. He has two detached garages on the premises—one is for personal use, and he operates a small home-based business in the other. Each garage has a replacement cost of $25,000. How much coverage does Milt have under Coverage B (Other Structures) of his homeowners policy?
A) $20,000
B) $40,000
C) $25,000
D) $50,000
The answer is $20,000. The coverage under Coverage B of a homeowners policy is 10% of the coverage on the dwelling ($200,000 × 10% = $20,000). Coverage B does not apply to the garage used for business purposes.
LO 2.1.1
Which of the following vehicles is NOT eligible to be covered under a personal auto policy (PAP)?
A) An automobile owned by a corporation
B) A snowmobile
C) A motorcycle
D) A pick-up truck
The answer is an automobile owned by the corporation. An automobile must be owned by an individual to be eligible for PAP coverage. Motorcycles and snowmobiles are considered nonstandard vehicles. Though not included under the definition of a covered auto, these can be added to a personal auto policy with an endorsement.
LO 2.3.1
Rebecca owns a gift shop near her home, which she also owns. She takes the bus everywhere she goes. In her spare time, she occasionally engages in activities that could possibly result in bodily injury to innocent bystanders if anything accidentally went wrong. Which of the following forms of insurance should Rebecca consider to avoid risk exposures from potential tort liability?
I. Homeowners policy
II. Personal auto policy
III. Umbrella liability policy
IV. Commercial liability policy
A) II and IV
B) III and IV
C) I and II
D) I, III, and IV
D) The answer is I, III, and IV.
As a businessowner, Rebecca should have a commercial liability policy for her business, most likely as a part of a businessowner’s policy. As a homeowner, she should have homeowners insurance, and since she is a businessowner and potentially a target for lawsuits, a liability umbrella policy is also a good idea. Since she does not drive, she has no need for a personal auto policy.
LO 2.4.2
All of the following are exclusions from Coverage C: Personal Property of a Homeowners Policy except
A) animals, birds, and fish.
B) jewelry.
C) property of roomers or boarders.
D) credit cards.
The answer is jewelry. Jewelry is covered under Coverage C; however, coverage is typically limited to a maximum dollar amount of $1,500. The addition of an endorsement can increase the coverage limit for jewelry and other personal property items.
Comprehensive personal liability coverage (CPL) can be acquired in which of the following ways?
I. as an endorsement to a personal auto policy (PAP).
II. as an individual CPL policy.
III. as part of a homeowners policy.
A) I and III
B) III only
C) I, II, and III
D) II and III
The answer is II and III. CPL coverage is not available through PAPs.
LO 2.2.2
Which of the following statements regarding Coverage E and Coverage F within a standard homeowners insurance policy is CORRECT?
I. Medical payments coverage (Coverage F: Medical Payments to Others) will automatically pay for bodily injuries, regardless of fault, typically up to $1,000 per occurrence on or off the premises.
II. Personal liability coverage (Coverage E: Personal Liability) protects the insured homeowner and all resident family members against personal liability for bodily injury and property damage that may occur on or off the premises due to negligence, up to $300,000 per occurrence.
III. Coverage E may cover the insured for injuries or property damage caused while playing golf.
A) II only
B) I and III
C) I only
D) I, II, and III
The answer is I and III.
Coverage F is protection that will automatically pay for bodily injuries regardless of fault.
In contrast, Coverage E only pays for bodily injury and property damage for which the insured is legally liable.
If the insured causes damage to property or others while golfing, Coverage E will cover the insured up to the policy limit of $100,000. Also, Coverage E may cover the insured for injuries or property damage resulting from negligence while on the golf course.
LO 2.2.2
Which of the following policy sections do homeowners and auto policies share?
I. Liability coverage
II. Comprehensive coverage
III. Medical payments coverage
IV. Duties after a loss
A) I, III, and IV
B) I and III
C) I only
D) I, II, III, and IV
A) I,III & IV
The answer is I, III, and IV. All of these sections are included in both homeowners and auto policies, except comprehensive coverage, which is only a part of a personal auto policy.
Which of the following statements regarding the basis for policy premiums on a personal automobile policy (PAP) is NOT correct?
A) Young male drivers have the highest rate of automobile accidents.
B) A multicar discount is generally available for insureds who own more than one automobile.
C) Farm-use vehicles generally have higher premiums.
D) An automobile that is driven only for pleasure costs less to insure than one that is driven to work daily.
Explanation
The answer is farm-use vehicles generally have higher premiums. Farm-use vehicles generally have reduced premiums.
Which of the following are types of automobile insurance coverage under a personal auto policy (PAP)?
I. Uninsured motorists
II. Liability insurance
III. Medical payments
IV. Property damage
A) III and IV
B) I, II, and III
C) I and II
D) I, II, III, and IV
The answer is I, II, III, and IV. All of these are types of insurance coverage under a PAP.
Which of the following is true for property coverage in a commercial package policy (CPP)?
I. A CPP provides broader coverage but is a bit more expensive than a collection of monoline forms.
II. No customization is allowed, as all potential risks are covered in the standard CPP.
III. The standard CPP includes building, contents, and commercial automobile coverage.
IV. The CPP is designed for larger businesses.
A) I, II, III, and IV
B) III and IV
C) I, II, and III
D) IV only
Explanation
The answer is IV only.
A CPP is a standard package of what used to be monoline forms offered at a discount. The standard CPP includes coverage for buildings, contents, and liability coverage. Additional coverage is available for things like commercial autos, glass, and specific, unique-to-the-business causes of loss. Thus, a CPP is customizable so it can accommodate many different businesses. The CPP is designed for larger businesses, while the business owner policy is designed for smaller businesses.
LO 2.4.1
Jeff owns a life insurance policy on his own life. The policy is not a modified endowment contract (MEC). His basis in the policy is $10,000. This year, he pays premiums of $1,000 on the policy, receives dividends of $300 in cash, and takes a withdrawal of $5,000. In addition, the cash value of the policy increases by $2,000. Which of the following statements regarding the income tax consequences of this policy is CORRECT?
I. The premiums of $1,000 are tax deductible.
II. The $2,000 increase in cash value is excluded from gross income.
III. The dividends of $300 are included in gross income.
IV. The withdrawal of $5,000 is included in gross income.
A) I, II, III, and IV
B) I and III
C) II only
D) II and IV
C) II only
The answer is II only.
The increase in cash value of a life insurance policy is not taxable to the owner of the policy as long as it remains in the policy.
Premiums on individual life insurance policies are not tax deductible.
Dividends are generally considered to be a return of premium and are not taxable.
Withdrawals from non-MEC contracts are not taxable unless they exceed the owner’s basis.
Which of the following factors should be considered when utilizing the financial needs analysis method in determining the required amount of life insurance?
I. The family expenses that will remain after the wage earner dies
II. The value of the wage earner’s life
III. The income that can be generated by the surviving spouse
IV. The number of dependents
A) I, III, and IV
B) II only
C) I, II, and III
D) I, II, III, and IV
The answer is I, III, and IV.
The value of the life lost is not considered in the needs approach. Rather, the focus is on the financial needs and remaining resources of the surviving dependents.
Policies that pay dividends are said to be participating policies. Which of the following policies pay dividends?
A) Annual term policies
B) Universal life policies
C) Multi-year term life policies
D) Whole life policies
D). The answer is whole life policies. Only participating whole life policies pay dividends that are essentially a return of premium when a mutual life insurance company has better-than-expected operating results. While universal life policies pay interest, neither universal nor term life policies pay dividends.
LO 3.3.2
Whole life insurance nonforfeiture options allow a policyowner to
I. surrender a whole life insurance policy and receive the net cash value (cash value less any applicable surrender charges and/or outstanding policy loans).
II. stop paying premiums on a whole life insurance policy and exchange the net cash value for a reduced paid-up single-premium permanent life insurance policy.
III. stop paying premiums on a whole life insurance policy and use the net cash value as a single premium to purchase a paid-up term life insurance policy with a face amount equal to the face amount of the original policy for a specified period.
A) III only
B) II and III
C) I and II
D) I, II, and III
The answer is I, II, and III.
There are three common nonforfeiture options available when surrendering or discontinuing premium payments on a whole life insurance policy. Under the cash surrender value option, a policy owner can surrender the policy and receive the net cash value.
By electing the reduced paid-up insurance option, a policy owner leaves the net cash value of the original life insurance policy with the company and receives a smaller amount of fully paid-up insurance of the same type.
If the policy owner chooses the extended term insurance option, the net cash value is used as a net single premium to purchase a paid-up term insurance policy.
Carolyn was the beneficiary of her spouse’s life insurance policy with a face amount of $1,000,000 She elected the single life annuity settlement option. The settlement option will pay her $4,500 per month, and her life expectancy is 30 years. How much of each monthly payment is taxable?
A) $2,777.85
B) $0
C) $1,722.15
D) $3,033.95
The answer is $1,722.15.
The total amount Carolyn will receive from the settlement option is $1,620,000 ($4,500 × 360). Her tax basis is $1,000,000, so her exclusion ratio is 0.6173 ($1,000,000 ÷ $1,620,000).
Therefore, $2,777.85 of each payment is excluded from gross income ($4,500 × 0.6173), and the remainder ($1,722.15) is taxable.
In addition, the taxable income may be subject to the 3.8% Medicare contribution tax.
LO 3.2.5
Which of the following statements concerning federal income tax and annuities is CORRECT?
I. The premium invested in the annuity accumulates on a tax-deferred basis.
II. Generally, amounts received as withdrawals during an annuity’s accumulation period are taxable, to the extent the withdrawal represents gains earned by the contract.
A) Neither I nor II
B) II only
C) I only
D) Both I and II
The answer is both I and II.
When contributions are left to accumulate, the earnings credited to the contract are not taxable until withdrawn by the annuitant.
If a client wishes to be rewarded with lower life insurance premiums for maintaining good health, which of the following types of life insurance policies would be most appropriate?
A) Decreasing term
B) Whole life
C) Convertible term
D) Reentry term
The answer is reentry term. Reentry term is a policy under which the insurance company may renew coverage at a lower premium rate than the guaranteed renewal rate, provided that, at the time of renewal, the insured furnishes satisfactory evidence of continued insurability. A reentry term policy, therefore, rewards individuals who remain in good health as they continue to age while maintaining insurance coverage for other insureds who no longer qualify for lower rates.
LO 3.2.1
Nancy and Joe are married and in need of permanent life insurance. They anticipate their incomes substantially increasing in the next three to eight years, but right now, they are on a tight budget. Which of the following is the best form of permanent life insurance for the couple?
A) Decreasing term insurance
B) Modified premium whole life
C) Limited-pay whole life
D) Current assumption whole life
The answer is modified premium whole life.
With a modified premium whole life insurance policy, premiums are lower for the initial three to five years after issue and then increase once thereafter. As such, modified whole life is simply an ordinary life policy with a unique premium payment structure that accommodates a policy owner who expects to experience an increasing salary in the near future.
Assume Greg dies of a heart attack, and Jackie receives the $50,000 death benefit provided by his group life insurance policy and $150,000 from his individually owned universal life insurance policy as lump-sum payments. What amount must Jackie include in her gross income?
A) $150,000
B) $50,000
C) $0
D) $200,000
The answer is $0. When Greg dies, Jackie receives a $50,000 death benefit under his 20-year level term policy and a $150,000 death benefit (two times his salary of $75,000) under his group life policy. Because she receives the benefits in one lump sum, they are not included in her gross income.
LO 3.2.5
Which of the following correctly identifies the primary purpose of a buy-sell agreement funded with life insurance?
A) To allow the business to purchase a deceased owner’s share of the business from the estate
B) To pay the deceased’s estate tax liability
C) To guarantee marketability of closely held stock
D) To include policy cash values as a corporate asset
The answer is to allow the business to purchase a deceased owner’s share of the business from the estate.
The primary purpose of a buy-sell agreement funded with life insurance is to provide the cash required by the agreement to allow the surviving partner(s) to buy the deceased partner’s share from his heirs or estate in the event he dies before retiring.
Which of the following statements regarding the misstatement of age clause in a life insurance policy is CORRECT?
I. The face amount of the policy will be adjusted to the amount of insurance that the premium paid would have purchased based on the insured’s correct age.
II. In many cases of misstatement of age, insured’s understate their age to reduce the premiums.
A) II only
B) Neither I nor II
C) Both I and II
D) I only
C) The answer is both I and II.
By understating their age, insureds could reduce life insurance premiums. The misstatement of age clause provides that if a misstatement of the insured’s age is discovered after the policy is issued, the insurance company can adjust the face amount of the policy to an amount that the premium would have purchased had the insured’s age been stated correctly.
A client just purchased a house and took out a $300,000 mortgage with a repayment term of 15 years. She wants to purchase a life insurance policy that will provide a death benefit equal to the unpaid mortgage balance if she dies with a mortgage. She wants a level premium and does not feel she will need life insurance once the mortgage is paid off. Which of the following life insurance policies best meets the client’s needs?
A) Decreasing term life insurance
B) 30-year level term life insurance
C) Whole life insurance
D) Decreasing whole life insurance
The answer is decreasing term life insurance. A decreasing term life insurance policy is the best choice for this client because it provides a level premium and a death benefit that decreases over time. Historically, this type of policy has been used as mortgage protection insurance because the decrease in death benefit approximates the declining principal as mortgage payments are made by the homeowner. Level term life insurance provides fixed premiums, but the face amount remains constant. Decreasing whole life insurance is not a type of policy. Whole life insurance is not appropriate because, although the premiums are fixed, the face amount remains constant, and the policy provides a cash value.
Settings
Which of the following factors should be analyzed when assessing the cost of a universal life insurance policy?
I. The actual interest rate credited to the policy
II. The actual mortality charge assessed to the policy
III. The guaranteed interest rate specified in the policy
A) II and III
B) I, II, and III
C) I and II
D) I and III
The answer is I, II, and III. All of these factors should be analyzed when assessing the cost of a universal life insurance policy.
Under which life insurance settlement option are proceeds paid to the beneficiary at a set dollar amount per month until all principal and interest are exhausted?
A) Interest only
B) Fixed period
C) Life income
D) Fixed amount
D) The answer is fixed amount.
Under the fixed-amount option, a fixed amount is paid until both the principal and interest are exhausted. The amount paid remains unchanged, but the period in which the payments are made depends on how much is to be paid each period.
Norberto and Maria are considering purchasing an annuity to provide additional retirement income, but they are concerned about needing to withdraw funds from the annuity before they retire. Which of the followings statements regarding withdrawals from their annuity is CORRECT?
I. Withdrawals will consist of taxable earnings until all the earnings have been withdrawn (LIFO rule).
II. Withdrawals may be subject to a 10% penalty tax if taken before age 59½.
A) II only
B) Neither I nor II
C) Both I and II
D) I only
C) The answer is both I and II.
Withdrawals will consist of taxable earnings until all the earnings have been withdrawn (LIFO rule), and withdrawals may be subject to a 10% penalty tax if taken before age 59½.
Settings
Jalen purchased a term life insurance contract with a death benefit of $200,000 and a two-year suicide clause. He committed suicide less than six months after he purchased the policy. What is the required payment from the insurance company to the beneficiary?
A) The insurance company would pay half of the death benefit.
B) The insurance company would not pay anything.
C) The insurance company would pay the full $200,000 death benefit.
D) The insurance company would return all premiums without interest to the beneficiary.
D) The answer is the insurance company would return all premiums without interest to the beneficiary. The suicide clause stipulates that, if the insured commits suicide within a specified period (usually two years), the insurance company is only liable for a return of the insured’s premium payments, not the policy’s death benefit.
Donald is married and has two small children. Both he and his spouse are employed outside the home. They spend both incomes, have a mortgaged home, keep credit cards with outstanding balances each month, have little savings, and care for aging parents.
Based on Donald’s current life risk exposures, which of the following can be addressed with life insurance?
I. Death before debt repayment
II. Death before accomplishing personal goals
III. Death of an income earner
IV. Estate tax liability
A) III and IV
B) I and III
C) II and IV
D) I and II
The answer is I and III. In this situation, the risks Donald should address are paying off debt and replacing lost income. Given these facts, there is no concern for estate taxes, and personal goals are not something that can be insured against.
LO 3.1.1
7 of 30
Which of the following universal life options pay a level death benefit?
I. Option A
II. Option B
A)II only
B)I only
C)Neither I nor II
D) Both I and II
B) I only??
Question #10 of 30
Several years ago, Diego purchased a $400,000 whole life insurance policy on his life. He has paid cumulative premiums over the years of $20,000 and has accumulated a cash value of $25,000. This year, he was diagnosed with a rare liver disease, and, as a result, his life expectancy is only six months. Because of his large medical costs, he is considering selling his policy to a viatical settlement company. The company has offered him $250,000 for the policy. He would also like to explore other ways to generate cash from the policy.
Which of the following statements regarding Diego’s situation are CORRECT?
I. If Diego sells his policy to the viatical settlement company, he will be taxed on any gain from the sale if he dies more than two years later.
II. If the viatical company collects the death benefit as a result of Diego’s death, the proceeds will be tax free to the company.
III. If Diego sold the policy to his cousin for $250,000, his cousin would be subject to ordinary income tax on a portion of the life insurance benefit when Diego dies.
IV. If Diego takes a loan from the policy, some or all of the loan will be subject to ordinary income tax if the policy is classified as a modified endowment contract (MEC).
A) I and II
B) I, II, and IV
C) III and IV
D) II and III
The answer is III and IV.
Because Diego is terminally ill (i.e., expected to die within two years), he will not be taxed on the proceeds received from the viatical settlement company, even if he lives longer than two years.
When the viatical settlement company receives the death benefit, part of the death benefit will be taxed at ordinary income tax rates to the company.
The sale of the policy to Diego’s cousin would be considered a transfer for value. His cousin would be taxed on the death benefit (less any amounts paid) because the transfer-for-value rules cause the death benefit to become taxable.
With a MEC, loans or distributions from the policy are taxed on a last in, first out basis, meaning that any earnings in the policy are taxed first.
LO 3.2.4
Question #11 of 30
Which of the following characteristics of life insurance contracts create favorable tax treatment?
I. Death benefits paid to a beneficiary are not usually taxable as income.
II. Income taxes on investment gains are tax-deferred.
III. The earnings on the cash value are not taxed during the accumulation period.
A) I and III
B) II and III
C) I and II
D) I, II, and III
The answer is I, II, and III. All of these are income tax characteristics of a life insurance policy. Generally, such a policy is accorded favorable tax treatment under law.
LO 3.2.5
12 of 30
Which of the following statements regarding variable universal life insurance is CORRECT?
I. This policy contains investment options and no minimum guaranteed rate of return.
II. Planners must have state variable insurance and securities licenses to sell variable universal life insurance.
III. Cash values can decline to zero, causing the policy to lapse unless additional premium payments are made.
IV. Variable universal life insurance policies are suited for individuals with lower risk tolerances and investment experience.
A) I, II, III and IV
B) II and III
C) I and IV
D) I, II, and III
The answer is I, II, and III. Variable universal life insurance policies are suited for individuals with higher, not lower, risk tolerances and investment experience.
LO 3.2.5
14 of 30
Which of the following statements regarding the reinstatement clause in a life insurance policy is true?
A) Policy loans are forgiven due to the lapse.
B) The owner can reinstate a lapsed policy without repaying missed premiums.
C) Proof of insurability is never required prior to reinstatement.
D) No insurance coverage will have been in place from the date of the lapse to the date all reinstatement requirements are submitted.
D). The answer is no insurance coverage will have been in place from the date of the lapse to the date all reinstatement requirements are submitted. Assuming reinstatement is granted, no coverage is available during the lapsed period.
Question #15 of 30
Which of the following is NOT a whole life insurance policy dividend option?
A) Fifth dividend option
B) Cash option
C) Paid-up additions
D) Life income option
D). The answer is life income option. Life income is a settlement option.
LO 3.3.2
Question #20 of 30
Which of the following statements regarding the accidental death benefit (ADB) rider is CORRECT?
I. The ADB rider is no longer synonymous with the term double indemnity.
II. For large amounts of life insurance, the maximum amount of ADB rider offered by an insurance company is usually substantially less than the face amount.
A) II only
B) Both I and II
C) I only
D) Neither I nor II
B) The answer is both I and II. Both statements are true of the ADB rider.
LO 3.3.3
Question #21 of 30
In calculating life insurance needs, which of the following can be defined as the present value of the family’s share of the decedent breadwinner’s future earnings?
A) Net present value
B) Human life value
C) Conversion value
D) Portfolio value
B) The answer is human life value. Human life value is the family’s share of the earnings of the breadwinner. The projected value of the decedent breadwinner’s future earnings is discounted to its present value to determine the human life value.
LO 3.4.1
23 of 30
Antonio is looking for ways to reduce expenses in retirement. He has been paying premiums on a whole life policy. His health is not great, and his life expectancy will be shorter than a normal person his age. Which of the following strategies and reasons would be appropriate for Antonio?
A) Antonio could take a reduced paid-up life policy and eliminate future premiums. Since his health is not great, this would give his heirs the maximum inheritance if he died within the next 10 years.
B) Antonio could convert his policy to an extended term policy. According to the insurance company, his policy would last past a normal life expectancy, and the full death benefit would go to his heirs without additional out-of-pocket expenses, as long as he passes away within the extended term period.
C) Antonio could surrender the policy for cash because he could invest the money for his heirs at a better return and still reduce his expenses.
D) “Antonio could add an accidental death and disability (AD&D) rider.”
B) The answer is Antonio could convert his policy to an extended term policy. According to the insurance company, his policy would last past a normal life expectancy, and the full death benefit would go to his heirs without additional out-of-pocket expenses, as long as he passes away within the extended term period.
Because of his shortened life expectancy, taking a cash surrender would provide the least amount of money for his heirs. Utilizing an extended term policy would create the most resources for his heirs. The AD&D rider would do nothing to benefit Antonio.
LO 3.5.1
25 of 30
Under a Section 1035 exchange, which of the following policies may be exchanged on a tax-free basis?
I. An endowment policy exchanged for another endowment policy, in which the beginning date for regular payments is no later than the original contract qualified long-term care contract, or annuity contract
II. One annuity contract exchanged for another annuity contract
III. A life insurance policy exchanged for another life insurance policy(on the same insured), annuity, or endowment contract
IV. An annuity contract exchanged for a life insurance policy
A) I, II, and III
B) I and IV
C) I and II
D)II and III
A) The answer is I, II, and III. Statement IV is not an eligible tax-free exchange under Section 1035. A taxable event occurs if an annuity is exchanged for a life insurance policy or endowment contract.
LO 3.5.2
All of the following statements concerning categories of annuities are correct except
A) a joint-and-last-survivor annuity provides income that ceases only upon the last death among the covered lives.
B) a straight life annuity provides periodic (usually monthly) income payments that continue as long as the annuitant lives and terminates at the annuitant’s death.
C) an annuity may be paid periodically in a fixed amount for a period determined by the insurer.
D) a deferred annuity is one in which the first benefit payment is made one payment interval after the date of purchase.
D) The answer is a deferred annuity is one in which the first benefit payment is made one payment interval after the date of purchase.
A single premium immediate annuity is one in which the first benefit payment is made one payment interval after the date of purchase.
LO 3.6.1
All of the following statements regarding indemnity health insurance plans are correct except
A) these plans are sometimes called traditional plans.
B) these plans include neither a deductible nor a coinsurance provision but reimburse the insured according to a scheduled list of allowed costs.
C) these plans are no longer common.
D) these plans allow for generous limits on the amount payable for any event.
D) The answer is these plans allow for generous limits on the amount payable for any event. Plans that provide indemnity coverage impose rigid limits on the amount payable for each event.
The Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA)
I. provides former employees with continuation of group health insurance for a maximum of 12 months.
II. allows the premium for continuation of group health insurance coverage to be as high as 102% of the existing group rate.
III. applies to covered employees, their spouses, and dependents.
IV. requires employers with 20 or more employees to provide for the continuation of group health insurance in the event of termination or other qualifying events.
A) I, II, III, and IV
B) IV only
C) II, III, and IV
D) I and II
Explanation
The answer is II, III, and IV. COBRA provides for the continuation of group health insurance coverage for employees in the event of termination or other qualifying events for 18–36 months. This assumes the employee pays the premium, which can be as high as 102% of the current group rate.
Which of the following services are covered by Medicare Part B?
I. Physicians’ services
II. Routine exams for eyeglasses
III. Drugs that cannot be self-administered
IV. Routine foot care exams
A) I and III
B) I and IV
C) I, II, and III
D) II and IV
A) The answer is I and III. Medicare Part B does not cover routine exams for eyeglasses or foot care.
LO 4.4.1
Arthur is a full-time employee of the ABC Company. ABC has 18 full-time and eight part-time employees, and it provides a group health plan for its full-time employees. This year, Arthur turns 65 and voluntarily terminates his employment with ABC in order to retire. Assuming Arthur was covered by the ABC health plan when he retired, which of the following statements regarding Arthur’s eligibility for COBRA continuation coverage is CORRECT?
A) Arthur is not eligible for continuation coverage because he is eligible for Medicare.
B) Arthur is not eligible for continuation coverage because he voluntarily resigned.
C) Arthur is eligible for up to 18 months of continuation coverage.
D) Arthur is not eligible for continuation coverage because ABC has fewer than 20 full-time employees.
Explanation
C) The answer is Arthur is eligible for up to 18 months of continuation coverage. Termination of employment, including voluntary resignation and retirement, is a qualifying event for purposes of COBRA, as is becoming eligible for Medicare. Each of ABC’s eight part-time employees counts as half an employee for purposes of the 20-employee rule, so ABC is subject to the COBRA requirements.
LO 4.1.1
Which of the following statements regarding Medigap required provisions is CORRECT?
I. Medigap policies must be guaranteed renewable.
II. Medigap policies must have a 90-day free-look period.
III. Medigap policy benefits must be automatically adjusted for changes in Medicare,
IV. Pre-existing condition limitations may not last longer than 12 months from the date of issue.
A) IV only
B) I, II, and IV
C) I and III
D) II and III
c) The answer is I and III.
Medigap policies must have a 30-day free-look period. Pre-existing condition limitations may not last longer than six months from the date of issue.
LO 4.4.2
Which of the following disability income policy riders provide a benefit if an insured returns to work at lesser pay?
A) The residual disability rider
B) The future increase option
C) The partial disability rider
D) The social insurance substitute benefit
Explanation
The answer is the residual disability rider. The residual disability rider provides a benefit to an insured who has returned to work at lesser pay. In order to qualify, the insured must have at least a 20% reduction in pay.
Which of the following statements concerning long-term care (LTC) insurance is CORRECT?
I. The types of benefits provided by LTC policies include skilled nursing care, intermediate care, custodial care, home health care, and adult day care.
II. To qualify for favorable tax treatment, Alzheimer’s disease may not be excluded from LTC policies.
A) Neither I nor II
B) II only
C) Both I and II
D) I only
The answer is both I and II. There are seven basic types of services covered by the standard LTC policy, including skilled nursing care, intermediate nursing care, custodial care, home health care, assisted living, adult day care, and hospice care. To qualify for favorable tax treatment, LTC policies must have certain consumer protection features (e.g., contracts cannot exclude any specific illness, including Alzheimer’s disease).
All of the following types of Medicaid assets generally count when calculating one’s eligibility for Medicaid except
A) checking and savings accounts.
B) certificates of deposit.
C) stocks and bonds.
D) life insurance with a face amount of less than $1,500.
The answer is life insurance with a face amount of less than $1,500. In addition, one motor vehicle, personal property and household belongings, and one’s primary residence, with some limitations, generally do not count when calculating eligibility for Medicaid.
LO 4.1.2
Which of the following statements regarding Medicare is CORRECT?
I. Medicare coverage would be secondary to any health insurance coverage carried by individuals through their employer health plans.
II. Medicare Part A provides hospice care.
III. Medicare Part B provides routine foot care exams.
IV. Medicare is a federal government health insurance plan.
A) II, III, and IV
B) II and III
C) I, III, and IV
D) I, II, and IV
The answer is I, II, and IV. Medicare Part B does not provide routine foot care exams.
LO 4.4.1
Noncancelable disability income insurance policies are different from guaranteed renewable disability income insurance policies because noncancelable disability income policies
A) can be canceled by the insurance company midterm.
B) cannot have a premium change.
C) are not guaranteed renewable.
D) are less expensive than guaranteed renewable disability policies.
B) The answer is cannot have a premium change.
A noncancelable disability income insurance policy is a continuous term contract guaranteeing the right to renew for a specified period with a guaranteed premium. Therefore, all noncancelable disability income policies are also guaranteed renewable.
Guaranteed renewable disability income contracts allow for automatic renewal but permit the insurance company to raise the premium for an entire class of insureds. Noncancelable policies are more expensive than guaranteed renewable policies.
LO 4.5.1
Which of the following statements concerning the tax treatment of qualified long-term care (LTC) insurance is CORRECT?
I. Self-employed persons may not deduct premiums paid for qualified LTC insurance policies.
II. Persons who itemize deductions can deduct the premiums for qualified LTC policies, subject to certain limits.
A) II only
B) Neither I nor II
C) I only
D) Both I and II
Explanation
A) The answer is II only. Self-employed persons may deduct premiums paid for qualified LTC insurance policies.
Which one of the following statements accurately describes a provision of the health insurance continuation coverage requirements of COBRA?
A) Employers with 20 or more employees must offer continuing health care coverage to former employees and/or their dependents upon the occurrence of a qualifying event.
B) Continuation coverage need not be offered to employees who voluntarily terminate employment if the employer typically employs fewer than 30 persons.
C) Continuation coverage need not be offered to employees who are terminated involuntarily, but must be offered to employees who voluntarily terminate their employment.
D) If an employee voluntarily terminates employment, continuation coverage must be offered to the employee for 24 months after the date of termination, regardless of whether the employer still carries such coverage on remaining employees.
Explanation
The answer is employers with 20 or more employees must offer continuing health care coverage to former employees and/or their dependents upon the occurrence of a qualifying event. In most cases, employees may maintain group health insurance benefits for up to 18 months after leaving work. Employers with 20 or more employees normally have to offer this extended health insurance coverage to terminated employees. The Department of Labor identifies several events that may allow for COBRA coverage, including voluntary or involuntary termination of the covered employee’s employment for reasons other than gross misconduct and reduced hours of work for the covered employee.
LO 4.1.1
Which of the following are common characteristics of preferred provider organizations (PPOs).
I. Participating providers are paid on a fee-for-service basis as their services are used.
II. Covered individuals have financial incentives to receive treatment within the PPO.
A) II only
B) I only
C) Neither I nor II
D) Both I and II
Explanation
The answer is both I and II. Participating providers are paid on a fee-for-service basis as their services are used, and covered individuals have financial incentives to receive treatment within the PPO.
LO 4.2.1
Which of the following single-coverage health plans qualify as a high-deductible health plan that can be used in conjunction with a health savings account in 2019?
I. Plan A: $1,000 deductible; $4,000 maximum out of pocket
II. Plan B: $2,500 deductible; $4,000 maximum out of pocket
III. Plan C: $3,000 deductible; $5,000 maximum out of pocket
A) III only
B) I only
C) I, II, and III
D) II and III
The answer is II and III. For 2019, a high-deductible single-coverage health plan must have a deductible of at least $1,350 and a maximum out of pocket of $6,750. Both Plan B and Plan C meet this test.
LO 4.2.1
Under the Health Insurance Portability and Accountability Act, a chronically ill person is unable to perform how many activities of daily living (ADLs) for a period of at least how many days?
A) 3, 30
B) 2, 90
C) 3, 60
D) 2, 60
Explanation
B) The answer is 2, 90.
Under a qualified long-term care policy, a chronically ill person is expected to be unable to perform, without substantial assistance from another person, two ADLs for 90 days.
LO 4.1.1
Which of the following disability income policy continuation provisions guarantees the renewal of the policy for a stated period without any increase in premium?
A) Conditionally renewable
B) Optionally renewable
C) Noncancelable
D) Guaranteed renewable
Explanation
The answer is noncancelable.
A disability income insurance policy that is noncancelable provides the greatest amount of security for the insured (at the greatest premium outlay). With this provision, the insurance company guarantees the renewal of the policy for a stated period without any increase in future premiums.
LO 4.5.1
Anniki purchases a disability income insurance policy for which she and Frank pay all of the premiums. She is unable to work for several months due to an accident, and she receives $10,000 in disability benefits under her policy. Which of the following statements regarding the income tax treatment of the premiums and benefits of this policy is CORRECT?
A) The premiums are deductible and the benefits are tax free.
B) The premiums are deductible and the benefits are taxable.
C) The premiums are not deductible and the benefits are tax free.
D) The premiums are not deductible and the benefits are taxable.
Explanation
The answer is the premiums are not deductible and the benefits are tax free. The premium for an individual disability income insurance policy is a nondeductible personal expense, and the benefits are tax free.
LO 4.5.1
When evaluating medical insurance coverage, which of the following factors would NOT be important?
I. Whether the doctors and hospitals the client wishes to use are in network.
II. Total projected out-of-pocket costs including deductibles, copays, and maximum out-of-pocket expense limits.
A) Neither I nor II
B) Both I and II
C) I only
D) II only
B) The answer is both I and II. Both of these factors should be considered.
LO 4.3.1
Loretta has a $200 deductible and a 20% coinsurance for her medical expense plan. Her first medical bill of the year is $1,200. Loretta will pay the $200 deductible. How much money must she pay in addition to the deductible?
A) $240
B) $800
C) $200
D) $1,000
Explanation
The answer is $200. Her first bill of the year is $1,200. She pays her $200 deductible and will still owe 20% of the $1,000 left over after the deductible is subtracted ($1,200 – $200 (deductible) = $1,000 × 20% coinsurance = $200).
Judson recently turned 75 and has been blind for two years. He has trouble walking and is unable to cook for himself. His family told him that he needs to consider moving into an assisted living facility. Judson previously purchased a tax-qualified long-term care insurance policy. After analyzing the scenario, will he be considered chronically ill and trigger the benefits of the policy?
A) No, Judson is not considered chronically ill. Sight is not considered an activity of daily living, although cooking is.
B) Yes, Judson is considered chronically ill. He has been unable to perform two activities of daily living for more than 90 days.
C) No, Judson is not considered chronically ill. Neither sight nor cooking is considered an activity of daily living.
D) Yes, Judson is considered chronically ill, as long as he can prove to the insurance company that he is blind and unable to cook for himself.
Explanation
C) The answer is no, Judson is not considered chronically ill. Neither sight nor cooking is considered an activity of daily living. Therefore, Judson is not considered chronically ill, and his benefits will not be triggered.
LO 4.6.1
When evaluating medical insurance coverage, which of the following factors would NOT be important?
I. Whether the doctors and hospitals the client wishes to use are in network.
II. Total projected out-of-pocket costs including deductibles, copays, and maximum out-of-pocket expense limits.
A) Neither I nor II
B) Both I and II
C) I only
D) II only
B) The answer is both I and II. Both of these factors should be considered.
LO 4.3.1
Which of the following objectives might be satisfied by an employer’s use of a nonqualified retirement plan?
I. The employer wishes to exceed the maximum benefit and contribution limitations of a qualified plan.
II. The employer wishes to reduce the reporting and disclosure workload required by a qualified plan.
III. The employer wants to provide a stand-alone benefit that allows highly compensated employees to defer current income as a means of supplementing retirement income.
A) I and II
B) II and III
C) I and III
D) I, II, and III
D)
The answer is I, II, and III. All of these statements describe situations in which an employer might choose to use a nonqualified retirement plan.
LO 5.1.1
Which of the following funding vehicles used in nonqualified deferred compensation (NQDC) planning allows the executive/employee to defer income tax until he receives payments from the plan?
I. A secular trust
II. A rabbi trust
III. Stock that is subject to a substantial risk of forfeiture
A) I, II, and III
B) I only
C) III only
D) II and III
Explanation
The answer is II and III. An executive/employee covered under an NQDC plan can defer taxation if the assets used to fund the plan are subject to a substantial risk of forfeiture or are in a rabbi trust. A secular trust does not afford income tax deferral to the executive/employee.
LO 5.2.1
Which of the following are restrictions imposed on distributions from nonqualified plans by the American Jobs Creation Act of 2004?
A) Executives who leave a company cannot take a distribution from the plan for at least one year after the date of separation.
B) Plan distributions are generally payable only upon separation of service.
C) The period over which the distribution will be paid may be determined by the participant immediately before leaving the company.
D) A significant restriction is imposed on the use of offshore rabbi trusts designed to avoid U.S. income tax.
D)
The answer is a significant restriction is imposed on the use of offshore rabbi trusts designed to avoid U.S. income tax.
The American Jobs Creation Act of 2004 imposed a significant restriction on the use of rabbi trusts designed to avoid U.S. income tax.
The act also provides that executives who leave the company cannot take a distribution from a nonqualified plan for at least six months after the date of separation. The period over which the distribution will be paid may not be determined by the participant, but must be specified in the plan document. Plan distributions are generally payable upon separation of service, death, disability, change in ownership of the company, or unforeseeable emergency (as defined by the IRS).
LO 5.1.2
Which of the following statements regarding a rabbi trust is CORRECT?
A) It is a trust that involves formal funding of the nonqualified deferred compensation (NQDC), thereby making the value of the trust assets immediately taxable to the trust beneficiary.
B) It is a trust used solely and exclusively for religious institutions.
C) Trust earnings are not currently taxable to the employer.
D) It is a trust in which the assets remain available to the claims of the employer’s general creditors, thereby constituting informal funding of the arrangement.
Explanation
D) The answer is it is a trust in which the assets remain available to the claims of the employer’s general creditors, thereby constituting informal funding on the arrangement.
A rabbi trust is an irrevocable trust in which the assets remain available to the claims of the employer’s general creditors and is a common method of informally funding an NQDC plan.
LO 5.2.1
Which of the following statements regarding the substantial risk of forfeiture requirement of nonqualified deferred compensation plans is CORRECT?
A) If there is a substantial risk of forfeiture, the deferred compensation will be treated as constructively received.
B) If there is a substantial risk of forfeiture, the executive is considered to have current taxable compensation income.
C) An unsecured promise to pay qualifies as a substantial risk of forfeiture because there is no guarantee that the executive will receive the deferred compensation.
D) A rabbi trust qualifies as a substantial risk of forfeiture because the funds set aside for the executive may not be used to satisfy the employer’s creditors.
Explanation
C) The answer is an unsecured promise to pay qualifies as a substantial risk of forfeiture because there is no guarantee that the executive will receive the deferred compensation. If there is a substantial risk of forfeiture, the deferred compensation will not be treated as constructively received, and the executive is not considered to have current taxable income. A rabbi trust qualifies as a substantial risk of forfeiture because the funds set aside for the executive may be used to satisfy the employer’s creditors.
LO 5.1.2
Which of the following are disadvantages of an excess benefit plan?
I. The plan is subject to ERISA.
II. Vesting schedules may not favor highly compensated employees.
A) II only
B) Neither I nor II
C) Both I and II
D) I only
Explanation
The answer is neither I nor II. Excess benefit plans are not subject to ERISA requirements because they are unfunded plans.
LO 5.1.1
A cashless exercise of stock options
I. provides the employee with cash only.
II. provides the employee with stock only.
III. involves no cash outlay by the employee.
IV. works best for employees with insufficient cash to exercise the option.
A) I, II, III, and IV
B) III and IV
C) I, II, and III
D) I and II
Explanation
B) The answer is III and IV. The employee receives the net amount of the stock (the stock remaining after the sale of shares) or all cash. When an option is exercised, the employee has to pay to buy the shares. If the employee does not have enough cash to exercise the options, then a cashless option becomes a viable choice. The option is exercised, after which sufficient stock is immediately sold for the fair market value to realize the cash needed to pay for the exercise and any costs and taxes associated with the sale. The employee receives the net amount of the stock in either stock or cash.
LO 5.4.1
Which of the following statements pertaining to nonqualified deferred compensation plans is CORRECT?
I. The salary continuation approach uses some portion of the executive’s current compensation to fund the promised compensation benefit.
II. With a pure deferred compensation arrangement, the plan is funded with money the employer has set aside from current earnings to benefit the executive in the future.
A) II only
B) I only
C) Both I and II
D) Neither I nor II
Explanation
D) The answer is neither I nor II. The pure deferred compensation arrangement uses some portion of the executive’s current compensation to fund the promised compensation benefit. With a salary continuation approach, the plan is funded with money the employer has set aside from current earnings to benefit the executive in the future.
LO 5.2.1
The economic benefit doctrine (Section 83) requires
A) that stock options are deductible by the employer in the year granted.
B) that the present value of a not-to-compete restriction be included as employee income.
C) future consulting fees that are paid after retirement to be currently included as employee income.
D) restricted stock to be included as employee income if there is no longer a substantial risk of forfeiture.
D)
The answer is restricted stock to be included as employee income if there is no longer a substantial risk of forfeiture. Section 83 requires the employee to include as income any property that the employee has the right to enjoy, or the employee’s right to the property is no longer subject to a substantial risk of forfeiture. Consulting services after retirement are subject to risk of forfeiture.
LO 5.3.2
Which of the following are nonqualified deferred compensation plans?
I. Salary reduction arrangement
II. Pure deferred compensation arrangement
III. Salary continuation arrangement
IV. Ultimate benefit arrangement
A) I, II, and III
B) I and II
C) II and III
D) II, III, and IV
Explanation
The answer is I, II, and III.
There are two broad ways to structure a nonqualified plan. The first is as a salary reduction or pure deferred compensation arrangement. With this approach, the plan uses some portion of the executive’s current compensation to fund the promised compensation benefit, usually payable at the executive’s retirement date.
Alternatively, the plan may be structured with a salary continuation approach. To implement this arrangement, the plan is funded with money that the employer has set aside from current earnings to benefit the executive. The salary continuation approach is preferred by most executives because they are not sacrificing any of their own compensation to fund the benefit.
LO 5.3.1
In which of the following situations is implementing a nonqualified plan appropriate for an employer?
I. When an employer wants to provide a deferred compensation benefit for all employees
II. When an employer wants to provide additional deferred compensation benefits to an executive who is already receiving the maximum benefits/contributions under the employer’s qualified plan
III. When the employer wants to provide all employees with tax-deferred compensation benefits
IV. When an executive wants the employer to help with meeting certain financial planning goals
A) II and IV
B) I and IV
C) II, III, and IV
D) II and III
Explanation
The answer is II and IV. Statements I and III do not describe situations that are appropriate for implementing a nonqualified plan. An employer will use a nonqualified plan to provide a deferred compensation benefit to an executive or group of executives, or when the employer wants to provide certain key employees with tax-deferred compensation benefits.
LO 5.3.1
Incentive stock option (ISO) requirements include which of the following?
I. ISOs must be part of a written plan approved by the stockholders.
II. The expiration date cannot exceed 10 years from the date of grant.
III. The exercise price of the ISO must be at least 25% less than the market price of stock at the time of the grant.
IV. The shares received through the exercise of ISOs cannot be sold within one year from the date of grant and two years from the date of exercise in order to maintain favorable tax treatment.
A) I, II, III, and IV
B) I and II
C) III and IV
D) I, II, and III
Explanation
The answer is I and II. ISOs must be part of a written plan approved by the stockholders. The expiration date cannot exceed 10 years from the date of grant.
The exercise price of the option cannot be less than the market price of the stock at the date of the grant. The shares received as a result of exercising the ISOs cannot be sold within two years from the date of grant and one year from the date of exercise, otherwise the favorable tax treatment will be lost.
LO 5.4.1
A phantom stock plan
I. is a type of unfunded deferred compensation plan.
II. pays benefits in cash.
III. is based on the value and transactions of an imaginary stock that mirrors the value and transaction of the employer’s stock.
IV. has an exercise date that is controlled by the employer.
A) II, III, and IV
B) I, II, and III
C) II and III
D) I, II, III, and IV
The answer is I, II, III, and IV. All of these statements are correct. The primary purpose of this plan is to reward executives for achieving specific performance goals.
LO 5.5.2
Which of the following statements regarding excess benefit plans is CORRECT?
I. They provide excess retirement income to executives.
II. They provide the executive with the difference between the amounts payable under his qualified plan and the amount that he would have received if the Section 415 plan limitation did not exist.
Iii. They can discriminate in favor of highly compensated employees.
A) I only
B) II only
C) I and III
D) I, II, and III
The answer is I, II, and III.
Excess benefit plans provide excess retirement income to executives, provide the executive with the difference between the amounts payable under his qualified plan and the amount that he would have received if the Section 415 plan limitation did not exist, and can discriminate in favor of highly compensated employees.
LO 5.5.1
Settings
Malone’s employer recently offered him stock appreciation rights (SARs) with respect to 10,000 shares of the company’s stock. The terms of the SARs entitle Malone to be paid the difference between the fair market value (FMV) of the stock at the time of exercise and the FMV of the stock at the time of the grant. If the FMV of the stock was $5 on the date of the grant and $9 when Malone exercised the SARs, what is the amount of the award Malone will receive?
A) $90,000
B) $50,000
C) $40,000
D) $0
C) $40,000
Explanation
The answer is $40,000. Malone is entitled to receive an award of $4 per share, or $40,000 (10,000 shares × $4 difference between value at grant and value at exercise).
LO 5.5.2
Bargain Element
Difference between market value of stock at a particular time and option’s exercise price.
20 of 30
Jonathan was granted enough nonqualified stock options (NQSOs) to purchase 10,000 shares of Capital, Inc. stock at $10 per share two years ago. He exercised the options this year when Capital, Inc. stock was
$25 per share. Three years later, Jonathan sells the 10,000 shares for $100 per share. Which of the following statements regarding the tax ramifications of Jonathan’s transactions are CORRECT?
I. Capital gains tax is due the year the options are granted to Jonathan.
II. Jonathan’s cost to exercise all of the NQSOs is $50,000.
III. Jonathan will have a $750,000 capital gain when he sells the stock at $100 per share.
IV. Jonathan will have an additional $150,000 included in his W-2 compensation income, which is a type of ordinary income, subject to payroll taxes this year.
A) I, II, III, and IV
B) I, II, and III
C) I and II
D) III and IV
The answer is III and IV. Jonathan will have a $750,000 capital gain when he sells the stock at $100 per share. His adjusted tax basis is $25 per share,
LO 5.4.1
27 of 30
Closely held corporations that would like to reward valuable employees but do not want additional shareholders may consider using
A) junior class shares.
B) NQSOs.
C) phantom stock.
D) restricted stock.
The answer is phantom stock. Closely held corporations wishing to reward their highly valued employees without adding more shareholders may use phantom (or shadow) stock arrangements. Such arrangements are structured as fictional deferred compensation accounting entries, where the base value is equal to the current value of the corporation’s common stock.
LO 5.5.2
Which of the following statements regarding the substantial risk of forfeiture doctrine and nonqualified deferred compensation plans is CORRECT?
I. If there is a substantial risk of forfeiture, the executive will be considered to have received taxable income.
II. If there is a substantial risk of forfeiture with respect to the set-aside assets in a nonqualified plan, the deferred compensation will not be treated as constructively received.
A) Neither I nor II
B) II only
C) Both I and II
D) I only
The answer is II only. Only statement II is correct. If the funds within a nonqualified plan are subject to a substantial risk of forfeiture, the executive will not have received taxable income.
LO 5.1.2
Which of the following may create a current income tax liability upon exercise?
A) Incentive stock option
B) Nonqualified stock option
C) Neither a nonqualified stock option nor an incentive stock option
D) Both a nonqualified stock option (NQSO) and an incentive stock option (ISO)
Explanation
The answer is both a nonqualified stock option (NQSO) and an incentive stock option (ISO). Both ISOs and NQSOs may create a current income tax liability. The exercise of an NQSO creates additional W-2 compensation or ordinary taxable income that is subject to FICA or payroll taxes. The exercise of an ISO creates an individual alternative minimum tax (AMT) adjustment item. This item, if large enough, may result in current AMT liability.
LO 5.1.2
Which of the following statements correctly describes a concept related to nonqualified deferred compensation?
I. The availability of deferred compensation plan funds to the employee, without substantial restriction, generally results in constructive receipt.
II. Substantial risk of forfeiture exists when the employee’s receipt of deferred compensation benefits is contingent upon performance of substantial services in the future.
III. An example of substantial risk of forfeiture provisions would be the employee’s loss of rights to the plan benefits because of disability or premature death.
IV. The employee’s receipt of anything that can be assigned a cash value results in economic benefit and taxation.
A) I, II, and IV
B) I and II
C) III and IV
D) I, II, III, and IV
The answer is I, II, and IV. Statement III is incorrect because disability or premature death does not create a substantial risk of forfeiture.
LO 5.3.2
Which of the following statements regarding the tax implications of employee stock purchase plans are CORRECT?
I. Alternative minimum tax (AMT) is applied at the time of exercise.
II. There are no tax ramifications at the date of grant.
III. There are no tax ramifications at the date of exercise.
IV. Upon sale of the stock, ordinary income is recognized.
A) II, III, and IV
B) I, II, and III
C) I and II
D) III and IV
The answer is II, III, and IV.
There are no AMT consequences at the time of exercise. There are no tax ramifications at the date of grant or date of exercise. Upon disposition of the shares, the employee will recognize ordinary income based on the lesser of the fair market value (FMV) of the stock at the grant date, less the option price, or the FMV of the stock on the disposition date (or date of death, if sooner), less the option price. The balance of any gain is treated as capital gain. If the option is equal to the FMV of the stock at the date of grant, all gain upon disposition will be a capital gain as long as the shares are held by the employee for at least two years from grant of the option and one year after the exercise.
Becky, a key executive at ABC, Inc., is a new participant in the company’s phantom stock plan. Her supervisor told her that this is a long-term incentive plan used by businesses to award executives for exemplary performance. Which of the following are features of this type of plan?
I. It is a type of unfunded deferred compensation plan.
II. It pays benefits in cash.
III. It is based on the value and transactions of an imaginary stock that mirrors the value and transaction of the employer’s stock.
IV. It has an exercise date that is controlled by the employer.
A) I, II, III, and IV
B) II, III, and IV
C) I, II, and III
D) II and III
The answer is I, II, III, and IV.
All of these statements are correct regarding phantom stock plans. The primary purpose of this plan is to reward executives for achieving specific performance goals.
Andrea was in an accident this year and is now disabled. She is receiving disability benefits from a disability policy that was paid for by her employer. Which of the following statements regarding the disability benefits is CORRECT?
A) The entire benefit will be tax free.
B) The entire benefit will be taxable.
C) Only the benefit received over $50,000 will be taxable.
D) The benefits received from her employer’s policy will reduce the amount of Social Security disability benefits that she is eligible to receive.
Explanation
B) The answer is the entire benefit will be taxable. Because the employer paid the premiums, the entire amount of disability benefits received will be taxable. Social Security disability benefits will not be reduced by other disability benefits. However, if Andrea is eligible to receive Social Security benefits, the disability benefits from her employer disability policy may be reduced.
LO 6.3.1
Which of the following types of life insurance (offered as group life) is beneficial to both the employer and the employee from a tax standpoint?
A) Group term life insurance
B) Group universal life insurance
C) Group ordinary life insurance
D) Group paid-up life insurance
A)
The answer is group term life insurance. Group term life insurance premiums are deductible by the employer and excludable from income by the employee if the face value does not exceed $50,000.
LO 6.1.1
What is the length of the coverage period for a terminated employee under COBRA?
A) 0 months
B) 29 months
C) 36 months
D) 18 months
D) 18 months
Explanation
The answer is 18 months. Terminated employees qualify under COBRA, and the required coverage period is 18 months. If an employee meets the definition of Social Security disability, the required period of coverage under COBRA is 29 months.
LO 6.2.3
Settings
Which of the following is the definition of copayments in a group health insurance policy?
A) The most the insured will have to pay in any given year before the insurance company pays 100% of claims
B) The percentage of medical expenses that are paid by the insurance company once the deductible has been met
C) The premium paid in order to obtain coverage
D) A flat amount that is paid per service, such as for doctor visits or emergency room visits
Explanation
The answer is a flat amount that is paid per service, such as for doctor visits or emergency room visits. Copayments are a flat amount that is paid per service, such as for doctor visits or emergency room visits. Copayments are not premiums. Coinsurance is a percentage of the expenses that are paid by the insurance company once the deductible has been met for covered services.
LO 6.2.1
