Insurance-based Products

Question 1

Which statements are TRUE about fixed annuity contracts?

I A fixed annuity contract is regulated by each State as an “insurance” product
II A fixed annuity contract is regulated by the SEC as a “security”
III Investment risk is borne by the purchaser of the contract
IV Investment risk is borne by the insurance company that issues the contract

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 1

The best answer is B.

With a fixed annuity, the insurance company collects a premium from the purchaser and invests it in its general account (which holds the investments made by the insurance company). The performance of the investments held in the general account does not affect the amount of the annuity promised to the purchaser. Thus, the insurance company bears the investment risk - which is the risk that its investment value does not grow as fast as its obligations to fixed annuity holders.

A fixed annuity is defined as an “insurance” product and not as a security precisely because the insurance company bears the investment risk, not the purchaser. All insurance is regulated at the State level only - there is no Federal regulation of insurance products.

Question 2

Premiums paid for a fixed annuity contract are invested:

I in the insurance company’s general account
II in the insurance company’s separate account
III primarily in growth equities
IV primarily in fixed income securities

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 2

The best answer is B.

The insurance company’s “general account” of investments collects the premiums paid for traditional insurance policies and fixed annuities and invests them to provide a return that will fund these insurance company obligations. If the underlying investments underperform, the insurer will not reduce the annuity payment to be made. General account investments are heavily weighted to safer fixed income securities.

In contrast, premiums paid for either variable life policies or variable annuity contracts are invested in a legally separate entity called a “separate account.” The performance of the securities held in the separate account will determine the amount of insurance benefit or annuity payment - so they will vary. The underlying securities are typically shares of a designated mutual fund.

Question 3

A customer has a younger brother with severe learning disabilities who is unable to work. The customer wishes to invest enough money to provide $2,500 a month in perpetuity to pay for the brother’s ongoing living expenses. Upon the death of the disabled brother, the intact principal amount will be given to the customer’s children. Assuming that the principal can be invested at a 5% annual rate of return, the required principal amount is:

A. $30,000
B. $60,000
C. $300,000
D. $600,000

Answer 3

The best answer is D.

A perpetuity is a “perpetual payment” - so it is an annuity that goes on forever. If $600,000 is invested at 5%, it gives annual income of 5% of $600,000 = $30,000 without eating into the principal amount. $30,000 annual income / 12 months = $2,500 month income.

The best way to deal with this type of question is to take 5% of the principal amount given in each choice to get the annual income and divide it by 12 months a year.

Question 4

A customer owns a perpetuity that pays $1,000 per month. Assuming that the market rate of return is 6%, the value of the contract is:

A. $16,666
B. $166,666
C. $200,000
D. $240,000

Answer 4

The best answer is C.

A perpetuity makes payments forever. To calculate the value of the contract, you take the annual (not monthly) payment received and divide it by the market rate of interest.

$12,000 annual payment received / .06 = $200,000

Question 5

A customer owns a perpetuity that pays $500 per month. Assuming that the market rate of return is 5%, the value of the contract is:

A. $10,000
B. $100,000
C. $120,000
D. $150,000

Answer 5

The best answer is C.

A perpetuity makes payments forever. To calculate the value of the contract, you take the annual (not monthly) payment received and divide it by the market rate of interest.

$6,000 annual payment received / .05 = $120,000

Question 6

As the economy and the stock market fluctuate, which of the following can the holder of a fixed annuity expect to occur during the payout years?

A. Benefits will fluctuate according to the return the separate account earns
B. Benefits may increase during periods of declining economic growth and a declining stock market
C. Benefits will not fluctuate over time
D. Benefits may decrease during periods of declining economic growth and a declining stock market

Answer 6

The best answer is C.

The benefit payments for a fixed annuity are fixed (the name actually says what it is!), and they will not fluctuate during difficult economic conditions. Even if the insurer’s general account performs poorly, the benefit payments remain the same because the return is guaranteed.

Question 7

Which of the following is MOST likely to fluctuate for an annuitant during the payout period of a fixed annuity?

A. Death benefit
B. Benefit payments
C. Investment return
D. Purchasing power

Answer 7

The best answer is D.

With a fixed annuity, the investment return and benefit payments are guaranteed and fixed. During the payout period, there is no death benefit - the insurance company simply promises to make the fixed monthly payments until the annuitant dies. (Note that there can be a death benefit offered while the purchaser is making payments into the contract.) Because the benefit payments are fixed once the annuity payments start, the purchasing power of those fixed payments will fluctuate depending on the rate of inflation.

Question 8

During the annuity period of a fixed annuity, the insurance company assumes which of the following risks?

I Mortality Risk
II Purchasing Power Risk
III Expense Risk
IV Investment Risk

A. I and II
B. II and III
C. III and IV
D. I, III, IV

Answer 8

The best answer is D.

In a fixed annuity, the insurance company assumes mortality risk, expense risk and investment risk.

• Mortality risk is the risk that the purchaser lives longer than the insurance company expects, and the insurance company is obligated to pay for as long as that person lives.
• Expense risk is the risk that the insurance company’s expenses increase faster than expected - the insurance company caps the expenses that it can charge against the annuity. If these increase beyond the capped amount, this is the insurance company’s problem.
• Investment risk is the risk that the insurance company’s return on its investments does not keep pace with its payment obligations to fixed annuity holders. If its investments fare poorly, the insurance company does not reduce the amount of the fixed annuity payments

With a fixed annuity, the purchaser assumes purchasing power risk - the risk of inflation. If there is inflation, the monthly annuity payments do not increase, so the annuitant’s purchasing power declines over time.

Question 9

Which statement about variable annuity contracts is FALSE?

A. Annuity payments continue for the life of the purchaser
B. A variable annuity contract is defined as a “security”
C. Investment risk is borne by the issuer of the contract
D. Annuity payments are affected by market fluctuations

Answer 9

The best answer is C.

Variable annuity contracts do not promise a fixed monthly payment to the purchaser of the annuity. The performance of the underlying investments that fund the annuity determine the monthly amount to be paid. If the investments perform poorly, this will reduce the monthly annuity payment. Thus, investment risk is borne by the purchaser of the annuity and not by the insurance company that issues the contract - which is why it is defined as a “security” under Federal law.

Also note that because insurance companies are regulated separately by each State, their products, including variable annuities, are also subject to State insurance regulation.

Finally, as with any annuity, payments will continue for the life of the annuitant.

Question 10

Premiums deposited to a variable annuity contract are invested:

I in the insurance company’s general account
II a separate account
III primarily in equity securities
IV primarily in fixed income securities

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 10

The best answer is C.

The premiums paid for either variable life policies or variable annuity contracts are invested in a legally separate entity called a “separate account.” The performance of the securities held in the separate account will determine the amount of insurance benefit or annuity payment - so they will vary. The underlying securities are often shares of a designated mutual fund invested in equities.

In contrast, the insurance company’s “general account” of investments collects the premiums paid for traditional insurance policies and fixed annuities and invests them to provide a return that will fund these insurance company obligations. If the underlying investments underperform, the insurance company will not reduce the insurance benefit or annuity payments. General account investments are heavily weighted to safer, fixed income securities (bonds and preferred stocks).

Question 11

Which of the following are associated with variable annuities?

I Level benefit payments
II Variable benefit payments
III Benefit payments that will fluctuate based on stock market movements
IV Benefit payments that are unaffected by stock market movements

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 11

The best answer is C.

The benefit payments from a variable annuity contract will fluctuate based on overall economic conditions. Variable annuity separate accounts are most often invested in equities. If economic growth increases, the performance of the equity securities held in the separate account will increase and so, the amount of the annuity payments will increase. In difficult economic times, the reverse is true.

Question 12

When a variable annuity is annuitized, which statements are TRUE?

A. Annuity units remain constant; Unit value fluctuates
B. Annuity units remain constant; Unit value remains constant
C. Annuity units fluctuate; Unit value remains constant
D. Annuity units fluctuate; Unit value fluctuates

Answer 12

The best answer is A.

When the separate account interest is “annuitized,” the accumulation units are turned into a fixed number of annuity units. Each payment received is the number of annuity units times that unit’s current value. The value fluctuates each day, since NAV of the underlying mutual fund is computed daily.

Question 13

Which statement concerning the AIR of a variable annuity contract is TRUE?

A. It is the insurer’s best estimate of the future performance for accumulated income retained in the separate account
B. It applies during the accumulation period
C. It must be adjusted annually for inflation
D. It applies only during the annuity period

Answer 13

The best answer is D.

AIR refers to the assumed interest rate used to determine the initial monthly payment to the annuitant - it is set when the contract is annuitized and only applies during the annuity period. Once the first annuity payment is made based on the chosen AIR, if the earnings in the separate account are greater than the AIR, the next payment increases. If the earnings in the separate account are less than the AIR, the next payment decreases.

The AIR has no meaning during the accumulation period. Also note that the prospectus has an “AIR Illustration” that is an estimate of the annuity to be paid based on a conservative growth estimate, but the actual AIR is not set until the contract is annuitized.

Question 14

The Assumed Interest Rate (AIR) associated with variable annuities is the:

A. rate at which the annuity payments are scheduled to increase each year
B. interest rate paid to the annuitant
C. estimated future earnings rate needed to maintain level payments to the annuitant
D. average of past and assumed future rates of return earned by the annuity

Answer 14

The best answer is C.

AIR stands for Assumed Interest Rate. It is a conservative estimate of annual return needed for the insurance company to maintain a constant annuity payment amount. The AIR is chosen by the customer at the beginning of the payout period, based on an interest rate range set by the State. It is an estimated interest rate that the separate account investments must earn to maintain payment amounts. Once the first annuity payment is made based on the chosen AIR, if the earnings in the separate account are greater than the AIR, the next payment increases. If the earnings in the separate account are less than the AIR, the next payment decreases.

Variable annuities do not provide scheduled increases in payment amounts. The insurance company bases payouts on the value of annuity units when it pays them out.

Question 15

Upon annuitization, a customer’s insurer calculated the assumed interest rate (AIR) of his annuity as 5 percent. The account earned 6 percent after the first year. The customer’s next payout amount will:

A. increase
B. decrease
C. remain unchanged
D. increase by the changes in the CPI

Answer 15

The best answer is A.

Payout amounts will change depending upon the actual earnings of the separate account assets. AIR - Assumed Interest Rate - is the assumed investment return needed to maintain a level monthly payment. If the actual investment return exceeds AIR (as in this example), then the monthly payment will increase. If actual investment return is less than the AIR, then the monthly payment will decrease.

Question 16

Which of the following annuity payment options will continue payments to another person for their life after the annuitant dies?

A. Life Annuity
B. Life Annuity with Period Certain
C. Joint and Last Survivor Annuity
D. Unit Refund Annuity

Answer 16

The best answer is C.

A joint and last survivor annuity pays another person (usually a spouse) when the annuitant dies.

Question 17

Which of the following statements are TRUE regarding a life annuity?

I The shorter the expected annuity period, the larger the monthly payment
II The longer the expected annuity period, the larger the monthly payment
III A life annuity usually pays the largest amount of all of the annuity payment options
IV A life annuity usually pays the smallest amount of all of the annuity payment options

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 17

The best answer is A.

The shorter the time period to “expected death” when the separate account is annuitized, the larger the monthly payment will be; conversely the longer the time period to “expected death” when the separate account is annuitized, the smaller the monthly payment will be. Regarding annuity payment options, this must be looked at from the standpoint of the insurance company, that has a large pool of annuitants to cover. The insurance company can afford to pay a larger payment to those persons who it expects will be paid for the shortest time period; it will make smaller monthly payments when it expects to pay for a longer time period. A life annuity lasts only for that person’s life - this is the shortest expected period of the annuity payment options. A life annuity with period certain continues to pay for a fixed time period if the person dies early; a joint and last survivor annuity pays a spouse when one person dies; a unit refund annuity pays a lump sum if a person dies early.

Question 18

The holder of a variable annuity contract elects the settlement option of Life Annuity - 10 Year Period Certain. This individual annuitizes at age 66 and recently died at age 78. Which statement is TRUE?

A. Annuity payments to this individual would have stopped at age 76
B. Annuity payments to this individual will continue to be made to the individual’s beneficiary
C. Annuity payments to this individual will stop
D. Annuity payments to this individual will continue for another 2 years

Answer 18

The best answer is C.

A life annuity with a 10 year period certain guarantees to make payments for life, but if that individual dies prior to the “10 year period certain,” then payments will continue to a beneficiary until a minimum of 10 years’ payments have been made. Since this individual has received payments for 12 years at the time of his death, no more payments will be made.

Question 19

An annuitized account in a variable annuity is most similar to:

A. a mutual fund
B. a whole life insurance unit
C. pension payments
D. an individual retirement account

Answer 19

The best answer is C.

Once a variable annuity separate account interest is “annuitized,” the holder gets a fixed number of annuity units. Each month, the holder gets a payment equal to the fixed number of units x the unit value (which varies based upon the performance of the underlying investments). The payments continue for life. Thus, an annuitized account is most similar to pension payments.

Question 20

Which statements are TRUE regarding the annuitization of a variable annuity contract?

I A Life Annuity payout option may be elected by the policy holder
II Life Annuity-Period Certain is the preferred payout option
III The number of annuity units is fixed; the annuity payment may vary
IV The annuity payment is fixed; the number of annuity units may vary

A. I and III
B. II and III
C. I and IV
D. II and IV

Answer 20

The best answer is A.

Variable annuity contracts allow the holder to elect a payout option that meets that person’s individual requirements. The statement that a life annuity-period certain is a preferred payout option is erroneous - the choice of payout method depends on the needs of the annuitant. Once the contract is annuitized, the number of annuity units is fixed. However, the value of each unit varies with the performance of the underlying securities, hence the monthly annuity payment may vary.

Question 21

During the payout period of a variable annuity contract, the annuitant assumes:

I mortality risk
II market risk
III expense risk
IV investment risk

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 21

The best answer is D.

In a variable annuity, the insurance company assumes mortality risk and expense risk, but not investment risk or purchasing power risk. Mortality risk is the risk that the purchaser lives longer than the insurance company expects, and the insurance company is obligated to pay for as long as that person lives. Expense risk is the risk that the insurance company’s expenses increase faster than expected - the insurance company caps the expenses that it can charge against the annuity. If these increase beyond the capped amount, this is the insurance company’s problem.

Investment risk is the risk that the return on investments held in the separate account does not keep pace with inflation or that it declines. A decline in investment returns will reduce the annuity payments. Market risk is the risk of a general decline in the market prices of the securities held in the separate account. A steep market decline will also reduce investment returns or produce negative returns. This risk is borne by the purchaser of a variable annuity contract.

Question 22

During the payout period of a variable annuity contract, the insurance company assumes:

I Mortality risk
II Purchasing power risk
III Expense risk
IV Investment risk

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 22

The best answer is A.

In a variable annuity, the insurance company assumes mortality risk and expense risk, but not investment risk or purchasing power risk. Mortality risk is the risk that the purchaser lives longer than the insurance company expects, and the insurance company is obligated to pay for as long as that person lives. Expense risk is the risk that the insurance company’s expenses increase faster than expected - the insurance company caps the expenses that it can charge against the annuity. If these increase beyond the capped amount, this is the insurance company’s problem.

Investment risk is the risk that the return on its investments held in the separate account does not keep pace with inflation or that it declines. A decline in investment returns will reduce the annuity payments. If the investment returns do not keep pace with inflation, then the annuitant will suffer loss of purchasing power. Thus, purchasing power risk is also carried by the annuitant; though this is much less of a risk for a variable annuity than for a fixed annuity.

Question 23

A customer buys an annuity requiring an initial payment of $10,000. The annuity offers a 5% Bonus Credit. This means that:

A. the customer is only required to make an initial payment of $9,500
B. the insurance company will pay an extra $500 into the contract on top of the customer’s $10,000 payment
C. the insurance company will issue a check to the customer for $500 upon acceptance of the contract
D. the customer will receive a $500 credit from the insurance company that can be used to buy an additional life insurance policy offered by that company

Answer 23

The best answer is B.

When a variable annuity contract offers a “bonus credit,” the company matches any customer payment made into the contract with an extra payment of anywhere from 1-5% of the amount paid. Since this customer is paying $10,000, the bonus credit of 5% means that the insurance company will pay an extra 5% of $10,000 = $500 into the contract. Usually annuity contracts with a “bonus credit” have higher annual expense ratios - a classic example of the fact that “you don’t get something for nothing.”

Question 24

A customer, age 50, is in the 35% tax bracket. The customer has a non-tax qualified variable annuity separate account to which he contributed $15,000 that has a current market value of $35,000. The customer takes a distribution of $10,000 from the account. The tax that will be due on this distribution is:

A. 0
B. $1,000
C. $3,500
D. $4,500

Answer 24

The best answer is D.

Distributions from non-tax qualified variable annuity separate accounts are taxed on a LIFO (Last In First Out) basis. The original non-tax deductible contribution of $15,000 was the first in. The tax-deferred build up of $20,000 occurred second. When distributions are taken, the “build-up” portion comes out of the account first and is taxed at regular tax rates. After the build-up is depleted, the original investment of $15,000 comes out of the account and is not subject to tax. The customer is withdrawing $10,000 - which is all counted as “build-up” for tax purposes (last in - first out). This is taxable at 35%, plus the customer must pay a 10% penalty tax on a premature distribution (prior to age 59½). The total tax due is 45% of $10,000 = $4,500.

Question 25

A customer, age 59, has a fixed annuity contract with a value of $16,000. The cost basis in the contract is $10,000. If the customer withdraws $5,000 and the IRS taxes distributions on a LIFO basis, the tax consequence of a withdrawal will be:

A. $0 taxable/$0 penalty
B. $0 taxable/$500 penalty
C. $5,000 taxable/$0 penalty
D. $5,000 taxable/$500 penalty

Answer 25

The best answer is D.

Annuity contract contributions are not tax deductible, so the original contribution of $10,000 represents dollars that were already taxed. Any earnings in the account build tax-deferred. So the $6,000 excess value above the cost basis of $10,000 represents the untaxed build-up. IRS rules require that annuity distributions be taxed on a LIFO (Last In First Out) basis - with the build-up portion being the “Last In;” therefore these are the first dollars to be distributed. Thus, all $5,000 will be taxable. In addition, since this individual is under age 59½, the distribution will be subject to a 10% penalty tax for a premature distribution.

Question 26

A customer, age 49, invests $30,000 in a variable annuity contract as a lump sum. After 10 years at age 59, the customer wishes to withdraw $20,000 from the contract. At that point, the separate account is valued at $50,000. The withdrawal is:

A. non-taxable
B. 100% taxable as a capital gain
C. 100% taxable at ordinary income rates
D. 100% taxable at ordinary income rates plus is subject to a 10% penalty tax

Answer 26

The best answer is D.

Distributions from non-tax qualified retirement plans are accounted for on a LIFO - Last-In; First-Out basis. The first item that went into the plan was the original non-tax deductible contribution. The next item than went into the plan was the reinvestment of dividends, interest, and capital gains over time - all of which have been building tax deferred. When distributions commence, the first dollars out of the plan are accounted for as the return of the “build-up” - which was never taxed. The last dollars out of the plan are the original investment (cost basis) which was made with after-tax dollars and hence is not taxed. Thus, in this plan $30,000 was invested; and it built up to $50,000. Thus, the first $20,000 out of the plan is taxable ordinary income; the remaining $30,000 is a non-taxable return of capital. In addition, since this client is under age 59½, a 10% penalty tax must be paid on any distribution, since this is a premature distribution. The customer withdrew $20,000, all of which is taxable as ordinary income, plus an additional 10% penalty tax is due on the distribution.

Question 27

A man invested $20,000 in a variable annuity purchased in a non-qualified account. At age 62, the account has grown to $35,000 and the man withdraws $3,000. The amount of the withdrawal is:

A. tax-free
B. subject to ordinary income tax but no penalty tax
C. subject to penalty tax but not to ordinary income tax
D. permitted to be rolled over to an IRA, if completed within 60 days

Answer 27

The best answer is B.

Contributions to variable annuities are not deductible. Earnings build tax-deferred. When distributions are taken, they are taxed on a LIFO basis. The first monies to be withdrawn represent the never-taxed build up. These are 100% taxable. This client invested $20,000, which has now grown to $35,000. At age 62, he withdraws $3,000 - all of which represents taxable build-up. However, there is no penalty tax because the client is over age 59½.

Question 28

A 62-year old client makes her first withdrawal from a non-tax qualified annuity. This will result in:

A. capital gains taxed at capital gains rates
B. ordinary income taxed at ordinary income tax rates that is subject to a penalty
C. ordinary income taxed at ordinary income tax rates that is not subject to a penalty
D. capital gains taxed at ordinary income tax rates

Answer 28

The best answer is C.

Distributions from non-tax qualified retirement plans are accounted for on a LIFO - Last-In; First-Out basis. The first item that went into the plan was the original non-tax deductible contribution. The next item than went into the plan was the reinvestment of dividends, interest, and capital gains over time - all of which have been building tax deferred. When distributions commence, the first dollars out of the plan are accounted for as the return of the “build-up” - which was never taxed. Thus, the first distributions out of the plan are 100% taxable at ordinary income tax rates. There is no penalty tax (10%) due as long as the money is taken out after reaching age 59½, which is the case here.

Question 29

An investment would be made in a variable annuity in order to get:

I market participation
II market risk reduction
III tax deferred growth
IV tax free income at retirement

A. I and III
B. I and IV
D. II and IV

Answer 29

The best answer is A.

The contribution to a variable annuity is not deductible, but the earnings build tax deferred. Income taken at retirement age is taxable on the portion attributable to the never-taxed build-up.

Contributions are invested in a separate account holding shares of a designated mutual fund, typically an equity growth fund. If stock prices rise, the mutual fund shares will rise in value, which will increase annuity payments, so the investment offers market participation. On the flip side, equity values can also drop, which would reduce the mutual fund’s value, which would reduce the annuity payments - so there is no market risk reduction.

Question 30

Which of the following is NOT an advantage of a variable annuity?

A. Tax-deferred growth
B. Fixed return
C. Lifetime retirement payments
D. Professional management

Answer 30

The best answer is B.

Variable annuity premiums are invested in a separate account that holds an underlying mutual fund and the annuity payment is based on fund performance. Thus, the return is variable - it is not fixed. Variable annuities offer the benefits of tax-deferred growth in the separate account (however the contribution is not deductible); lifetime retirement payments because an annuity contract is being purchased; and professional management of the mutual fund held in the separate account.

Question 31

Which statement is FALSE about the purchase of a non-qualified annuity?

A. Amounts contributed are tax-deductible
B. Earnings are tax-deferred until withdrawal
C. Contributions may be invested entirely in mutual
D. There is no limit on the amount contributed each year

Answer 31

The best answer is A.

Variable annuities are a non-qualified retirement plan. There is no deduction for amounts contributed, making Choice A false. Earnings build tax-deferred, making Choice B true. Contributions are invested in a separate account that buys shares of a designated mutual fund, making Choice C true. There is no limit on contribution amounts, making Choice D true.

Question 32

Which of the following statements comparing fixed and variable annuities is correct?

I Fixed annuities pay for the annuitant’s lifetime; variable annuities pay for varying lengths of time
II Fixed annuities pay the same amount each period; variable annuities pay the same number of annuity units each period
III The insurance company guarantees a rate of return for fixed annuities but not for variable annuities
IV The insurance company guarantees an increasing payout for variable annuities but not for fixed annuities

A. I and II only
B. II and III only
C. III and IV only
D. I, II, III, and IV

Answer 32

The best answer is B.

Fixed annuities pay the same amount each period; variable annuities pay the same number of annuity units each period. The payout may increase or decrease with a variable annuity. The insurance company guarantees a rate of return for fixed annuities, but not for variable annuities. Both fixed and variable annuities make payments for the annuitant’s lifetime.

Question 33

Which statements are TRUE regarding Equity Indexed Annuities (EIAs)?

I In a year of sharply rising stock prices, EIAs will match the positive return of the Standard & Poor’s 500 Index
II In a year of sharply rising stock prices, EIAs will not match the positive return of the Standard & Poor’s 500 Index
III In a year of sharply falling stock prices, EIAs will match the negative return of the Standard & Poor’s 500 Index
IV In a year of sharply falling stock prices, EIAs will not match the negative return of the Standard & Poor’s 500 Index

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 33

The best answer is D.

Equity Indexed annuities are an insurance product and are currently not defined as a “security.” They give a return tied to the performance of the Standard and Poor’s 500 Index, but this is subject to an annual cap of typically 7-9%. Thus, in a year of sharply rising stock prices, they will not give the return of the index. However, they are protected in a falling market and guarantee a yearly minimum return of 1-3%. Thus, they will give a better return than the Standard and Poor’s 500 Index when the market is falling sharply.

Question 34

Which statements are TRUE when comparing Equity Indexed Annuities to Variable Annuities?

I In a year of sharply rising stock prices, variable annuities will outperform equity indexed annuities
II In a year of sharply rising stock prices, equity indexed annuities will outperform variable annuities
III In a year of sharply falling stock prices, variable annuities will outperform equity indexed annuities
IV In a year of sharply falling stock prices, equity indexed annuities will outperform variable annuities

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 34

The best answer is B.

Equity indexed annuities have a cap on their maximum annual return, while variable annuities do not. Thus, in a year of sharply rising stock prices, variable annuities will outperform equity indexed annuities. In a year of sharply falling stock prices, equity indexed annuities will do better, because they protect their positions with put options. This is one of the reasons they have higher annual expenses than variable annuities. In contrast, variable annuity separate accounts can lose sharply in a bear market, unless they offer a principal protection feature, which would increase expenses.

Question 35

Which statement made by a representative when selling an EIA is NOT misleading?

A. “EIAs are regulated by the State insurance commission”
B. “EIAs give a minimum guaranteed rate of return at no cost to the purchaser”
C. “EIAs outperform variable annuities in a bull market”
D. “EIAs are guaranteed by the PBGC”

Answer 35

The best answer is A.

Equity Indexed Annuities are regulated as insurance, so Choice A is true. They do give a minimum guaranteed rate of return, but this adds to the expenses of the product. In a bull market, EIAs are capped to a maximum return of around 9%, so a variable annuity equity separate account will do better. Finally, the only guarantee backing an EIA is that of the issuing insurance company. They are not guaranteed by the Pension Benefit Guarantee Corporation.

Question 36

A representative is making a presentation to a married couple, ages 75 and 77, about their need for continuing income as the expected life spans of the general population have increased. The representative is strongly recommending that the couple buy an equity indexed annuity (EIA). Which statement made by the representative would NOT be misleading and fraudulent?

A. “EIAs guarantee a minimum rate of return that is equal to the Standard and Poor’s 500 Index”
B. “EIAs can be redeemed at any time without penalty if you have an emergency cash need”
C. “EIAs are tax qualified, allowing you to reduce your taxable income by deducting any contribution that you make”
D. “EIAs provide a minimum guaranteed rate of return that is guaranteed by the issuing insurance company”

Answer 36

The best answer is D.

Equity indexed annuities (EIAs) are an insurance product that falls somewhere between a fixed annuity and a variable annuity. They give a return linked to a well-known index, such as the Standard and Poor’s 500 Index, but the return is typically capped to a maximum interest rate per year. Thus, if the cap is 10% and the S&P 500 Index grows by 15%, the customer only gets a 10% return for that year. Thus, Choice A is a misleading statement. If the contract is redeemed early, there are steep surrender charges, making Choice B misleading. There is no deduction for contributions to the contract (these are non-qualified plans) making Choice C a misleading statement. Choice D is true - the contracts have a minimum guaranteed rate of return (like around 3%) that is guaranteed by the insurance company. Of course, if the insurance company fails (which rarely happens, but it has happened), then the guarantee is worthless.

Question 37

An Equity Indexed Annuity tied to the Standard and Poor’s 500 Index is sold with a participation rate of 90%, a 10% cap and a 0% floor. In a year when the S&P 500 Index increases by 20%, the principal will be credited with a:

A. 0% increase
B. 9% increase
C. 10% increase
D. 20% increase

Answer 37

The best answer is C.

Features of EIAs are a “participation rate” along with a cap (maximum) interest rate and a floor (minimum) interest rate. While some contracts have a participation rate of 100%, most have a participation rate of somewhere between 70%-90%. In this example, the S&P 500 index increased by 20% this year, and with a 90% participation, 18% would be credited to the account. However, the cap sets a maximum that will be credited, so in this example, the cap limits the credit to 10%. This limits the customer’s upside, but, in return, in a down market, the customer will not lose any principal because of the 0% floor.

Question 38

An insurance company that sells an Equity Indexed Annuity (EIA) could use which of the following methods to credit the change in investment value?

I Annual reset
II Point-to-point
III High-water mark
IV Moving average

A. I and II only
B. III and IV only
C. I, II, III
D. I, II, III, IV

Answer 38

The best answer is C.

EIAs base the annuity payments on the performance of a broad-based index, such as the S&P 500 Index. However, the return is capped and there is a minimum guaranteed return, regardless of the performance of the index. The most common methods of measuring index performance are the:

• Point-to-point method;
• Annual reset method; and
• High-water-mark method.

Assume that a client buys an EIA that is based on a 7-year return. The “point-to-point” method compares the index value at purchase date to the value at the end date, 7 years later. Any value fluctuations that occur in-between the 2 measurement dates are irrelevant. Another common valuation method is the “annual reset” method, which would measure the return achieved each year over a 7-year life and add interest to the annuity based on the annual reset. The “high water mark” method looks at the index value yearly as of the anniversary date of purchase, and bases the interest added on the highest index value over the product life (7 years in our example) versus the value at the date of purchase.

Question 39

A customer invests $100,000 in an Equity Indexed Annuity contract tied to the Standard and Poor’s 500 Index. The contract has a 90% participation rate and a 15% cap. Interest is credited to the contract under the annual reset method and is compounded annually. The performance of the Standard and Poor’s Index over the next 3 years is:

Year 1: +20%
Year 2: -5%
Year 3: +10%

At the end of year 3, the customer will have a principal balance of:

A. $100,000
B. $115,000
C. $125,350
D. $128,620

Answer 39

The best answer is C.

The first year increase in the index of 20% with a 90% participation means that 18% would be credited to the account - however, because of the 15% cap, this is the first year credit, so the $115,000 balance is worth $115,000 after the first year. Because this is an insurance product, the customer does not bear investment risk, and the “floor” rate is 0% (unless the product offers a higher floor rate). Because of the 0% floor, the balance stays at $115,000 as of the end of year 2. In year 3, the $115,000 balance will grow by 9% (90% of the 10% growth rate) for a balance of $125,350 at the end of year 3.

Question 40

A customer invests $100,000 in an Equity Indexed Annuity contract tied to the Standard and Poor’s 500 Index. The contract has a 90% participation rate; a 15% cap and a 0% floor. Interest is credited to the contract under the annual reset method using the simple interest method. The performance of the Standard and Poor’s Index over the next 3 years is:

Year 1: +20%
Year 2: -4.5%
Year 3: +10%

At the end of year 3, the customer will have a principal balance of:

A. $120,000
B. $124,000
C. $128,000
D. $132,000

Answer 40

The best answer is B.

The first year increase in the index of 20% with a 90% participation means that 18% would be credited to the account - however, because of the 15% cap, this is the first year credit of $15,000. ($100,000 principal x .15)

Under the simple interest method, the second year interest credit is still based on the $100,000 principal amount (there is no “interest on interest” as is the case with compound interest) and because of the 0% floor, there will be no credit.

Under the simple interest method, the third year interest credit is still based on the $100,000 principal amount (there is no “interest on interest” as is the case with compound interest) and because of the 90% participation, 90% of the 10% index increase, or 9% will be credited. The credit will be $9,000. ($100,000 principal x .09).

Thus, the principal value after year 3 will be $100,000 + $15,000 + $0 + $9,000 = $124,000.

Question 41

A client has purchased various insurance policies from different issuers. One policy gives $100,000 of coverage that expires in 5 years. Another gives $100,000 of coverage that expires in 10 years. A third policy also gives $100,000 of coverage and expires in 12 years. The customer has purchased:

A. variable life policies
B. term life policies
C. whole life policies
D. universal life policies

Answer 41

The best answer is B.

Term insurance has a fixed “term” at which point it expires and must be renewed at a higher premium since the client is now older. It is not permanent insurance, since it can be canceled at the end of the term and not be renewed by the insurance company. In contrast, whole life, universal life and variable life cover the “whole life” of the insured individual and are permanent insurance (as long as the premium is paid).

Question 42

All of the following statements concerning a whole life insurance policy are correct EXCEPT:

A. premium payments are level and fixed for the insured’s lifetime
B. the cash value increases based on equity investments
C. the death benefit is fixed and guaranteed for the insured’s entire life
D. policy loans will reduce the amount paid at death

Answer 42

The best answer is B.

Whole life insurance protects the purchaser from increasing premiums as that person ages, and there are no renewals - the policy is good for that person’s “whole” life. With a whole life policy, the annual premium is level, and will start out higher than a term life policy. Part of the premium is invested in the insurance company’s general account and is guaranteed to grow at a fixed rate. As the general account investment portion grows, the policy builds “cash value” that can be borrowed. Any borrowed funds reduce the benefit payment upon death.

Variable life invests premiums in a separate account and typically invests in equities, whereas both whole life and universal life invest premiums in the general account, which must be heavily invested in fixed income securities.

Question 43

What insurance product is also called “straight life” insurance?

A. Term Life
B. Whole Life
C. Variable Life
D. Universal Life

Answer 43

The best answer is B.

Whole life is also called “straight life” insurance because the premium amount is level and fixed throughout the life of the policy. In contrast, term life premiums increase with each policy renewal as the insured individual ages. Variable life premiums can “vary” based on how the investment component performs in the separate account, hence the name and are not fixed. Universal life premiums, in contrast, are “flexible” and allow the insured to pay a lower minimum amount each month that simply covers the cost of insurance or a higher amount that adds a savings component to the premium.

Question 44

Which of the following statements concerning a universal life insurance policy are TRUE?

I The policy owner has a choice of investments for the cash value
II The policy owner can change the amounts of premium payments
III The policy owner can change the amount of the death benefit
IV The policy owner receives a guaranteed, fixed rate of return on cash value

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 44

The best answer is C.

With a universal life policy, the policy owner can change the premium payments and the death benefit. The cash value is invested in the insurer’s general account, so the policy owner does not have a choice of investments and the rate of return is not fixed - it will vary with the return of the general account.

Question 45

Which of the following statements describes a universal life insurance policy?

A. The policy owner can change the schedule of premium payments
B. The cash value is invested in equities in separate accounts
C. The death benefit is fixed and guaranteed for the insured’s entire life
D. Premium payments are low for a young insured and increase with age

Answer 45

The best answer is A.

With a universal life insurance policy, the policy owner can change the schedule of premium payments. After the cash value increases, the owner can skip a premium payment or the policy owner can use the cash value to buy additional insurance. The cash value is not invested in equities, but is invested in the insurer’s general account.

Whole life offers a fixed death benefit that is guaranteed for the insured’s entire life. Term life has low premiums for young insured individuals, but the premiums increase with each renewal as that person ages.

Question 46

Cash value of a universal life insurance policy is:

A. premium payments plus cost of insurance
B. premium payments minus cost of insurance plus interest
C. premium payments, plus or minus growth or loss in the separate account, plus the cost of insurance
D. premium payments, plus or minus growth or loss in the separate account, minus the cost of insurance

Answer 46

The best answer is B.

Both whole life and universal life are “cash value” policies. Premiums are invested in the general account (not a separate account, which is the case for a variable life policy, making Choices C and D incorrect). From the premium payments made, the cost of insurance is deducted. The cash balance that is left over earns interest.

Question 47

Which statement describes a variable life insurance policy?

A. A policy owner has flexibility in skipping some premium payments
B. The cash value increases based on equity investments
C. The death benefit is fixed and guaranteed for the insured’s entire life
D. Premium payments are low for a young insured individual and increase with age

Answer 47

The best answer is B.

Whole life insurance protects the purchaser from increasing premiums as that person ages, and there are no renewals - the policy is good for that person’s “whole” life. With a whole life policy, the annual premium is level, and will start out higher than a term life policy. Part of the premium is invested in the insurance company’s general account and is guaranteed to grow at a fixed, guaranteed rate. As the general account investment portion grows, the policy builds “cash value” that can be borrowed.

Variable life is a variation on whole life where a level annual premium is invested in a separate account, typically invested in equities. Better performance of the securities in the separate account will increase the death benefit, hence the term “variable life,” - so the death benefit is not fixed. The policy builds cash value similar to whole life, but the amount of cash value depends on the performance of the separate account. Part (but not all) of this value can be borrowed, since the separate account performance will vary. Any borrowed funds reduce the benefit payment upon death.

Universal life gives the policyholder the flexibility to skip some premium payments. Variable life invests premiums in a separate account and typically invests in equities, whereas both whole life and universal life invest premiums in the general account, which must be heavily invested in fixed income securities. Term life has low premiums for a young insured individual, but the premiums increase with each renewal as that person ages.

Question 48

Life insurance companies developed variable life policies from the:

A. term life policy
B. whole life policy
C. universal life policy
D. fixed annuity

Answer 48

The best answer is B.

Variable life policies are similar to whole life in that they:

• are permanent insurance policies;
• have fixed annual premiums:
• have an investment component that builds cash value against which owners may take policy loans.

Unlike whole life, which guarantees a fixed rate of return, variable life does not. The rate of investment return depends on the performance of the securities in the separate account that funds the variable policy.

Term life offers no cash buildup - it is a pure insurance product without any investment features.

Universal life policies are also similar to whole life, but in a different way. Universal policies allow the holder to increase or decrease the premiums to buy a different death benefit amount. These policies build cash value from the interest income of the insurer’s investments. Insurers fund universal policies from their general account - not from a separate account. As with whole life, they guarantee a fixed rate of return.

A fixed annuity offers an unchanging annuity payment - there is a guaranteed rate of return. Variable products offer a rate of return that will vary, depending upon the performance of the separate account.

Question 49

Premiums are invested in an insurance company separate account for which of the following policies?

I Whole life
II Variable life
III Universal life
IV Flexible-premium variable life

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 49

The best answer is D.

Variable contracts (either variable life or variable universal life) have the premiums deposited to a separate account. The performance of the separate account determines the ultimate death benefit, so the policyholder bears the investment risk. Flexible premium variable life is another name for variable universal life, which gives policyholders the right to skip a premium payment.

Term life, whole life, and universal life premiums are deposited to the insurance company’s general account. The death benefit is fixed based upon premium contribution and is not subject to investment risk. The insurance company invests the premiums collected through its general account and bears the investment risk.

Question 50

All of the following contracts offer the holder investment options EXCEPT a:

A. variable annuity
B. universal life policy
C. variable life policy
D. variable universal life policy

Answer 50

The best answer is B.

Universal life is a general account product, as is whole life. These do not offer investment options.

All of the variable contracts offer the holder a selection of investment options (called sub accounts). These are from the insurance company’s separate accounts, which buy shares of a designated mutual fund.

Question 51

Which actions taken regarding a universal variable life insurance policy could result in tax liability?

I Cash surrender
II Partial withdrawal
III Loan of up to 95%
IV Payout of death benefit

A. I and II only
B. III and IV only
C. I, II, IV
D. I, II, III, IV

Answer 51

The best answer is C.

Proceeds distributed from a variable life insurance policy are taxable income if there is a distribution of benefits above the amount invested (tax basis) in the separate account. This would include a cash surrender (surrender of the entire policy for its current cash value, terminating the policy) or making a partial withdrawal from the policy. The payment of a death benefit from the policy, while not taxable income to the recipient, is included in the taxable estate of the deceased individual. If the aggregate value of the estate exceeds the estate tax exclusion, there will be estate tax liability. The only way to get cash out of a variable policy without a potential tax consequence is to borrow against the policy. In general, most “cash value” policies only permit a loan of up to 75% of cash value; but if the policy is fully paid, often the loan amount is raised to 95%.

Question 52

A general partnership is buying a piece of real estate to expand its facilities and will finance a portion of the purchase amount with a level debt service mortgage. The partnership wants to protect itself in the event of the unforeseen death of one of the general partners, which could result in the partnership being liquidated. As a safety measure, the partnership should buy a:

A. fixed annuity for each managing partner
B. variable annuity for each managing partner
C. level term life insurance policy for each managing partner
D. property and casualty policy covering the purchased real estate

Answer 52

The best answer is C.

The issue here is that if a “key” partner dies unexpectedly, the partnership could liquidate and the mortgage would still need to be paid off. If the liquidation of the partnership assets were not sufficient to cover the mortgage pay-off, then each remaining partner is personally liable for his or her share of the unpaid amount (because as a condition of getting the mortgage, the bank will require each general partner to personally guarantee the mortgage). If a term life insurance policy is purchased on each managing partner by the partnership, if a partner dies, the insurance policy pays to the partnership. This would provide the money needed to pay off the mortgage.