Insurance Ch - 8 Flashcards

Question

EQUITY-INDEXED ANNUITY KEY TERMS * Index Term: * Participation Rate: * Cap Rate: * Floor Crediting Rate:

Answer 1

EQUITY-INDEXED ANNUITY KEY TERMS * Index Term: Period over which index-linked interest is calculated, ranging from 1 to 10 years, with 6 to 7 being the most common. * Participation Rate: Determines how much of the increase in the index will be used to calculate the index-linked interest. * Cap Rate: Some indexed annuities impose an upper limit on the index-linked rate. * Floor Crediting Rate: Minimum index-linked interest rate that will be credited to the contract in a given period.

Answer 2

EQUITY-INDEXED ANNUITY: EXAMPLE * Homer buys an equity-indexed annuity that has: -- A guaranteed minimum rate of 2% -- A participation rate of 75% --A maximum rate of 9% ________________________________________________________________ * On the day Homer purchases his annuity, the S&P 500 index is 1800. * One year later the index is 2050, an increase of 13.88%. * 75% participation rate x 13.88% = 10.42%; however, Homer’s annuity will be credited with the maximum rate of 9%. * If the S&P 500 instead had a return of -7.3%, Homer would be credited with the minimum rate of 2%

Answer 3

ADVANTAGES OF ANNUITY CONTRACTS * Opportunity to defer income taxation * The ability to rebalance the portfolio inside a variable annuity contract without incurring any immediate income taxation on asset sales * Annuities are protected from creditors in some states

Answer 4

DISADVANTAGES OF ANNUITY CONTRACTS * Complexity * Costs and fees * Tax consequences

Answer 5

TAXATION OF ANNUITIES (1 OF 3) Income Taxation * Distributions taken from an annuity BEFORE annuitizing: -- Included in the taxpayer’s gross income until all of the gain in the contract has been distributed -- Further distributions are treated as tax-free returns of basis -- Follow a LIFO approach to income reporting -- Annuities issued prior to August 14, 1982 receive FIFO treatment -- Taxable distributions of earnings are subject to 10% early withdrawal penalty if the account holder is under the age 59½

Answer 6

TAXATION OF ANNUITIES (2 OF 3) * If the annuitant/owner is a high-income taxpayer and the annuity distribution is not made through an IRA or qualified plan, a 3.8% Medicare surtax will apply. * Annuities purchased with pre-tax dollars typically do not have any basis for income tax purposes. -- 401(k) plans and deductible traditional IRAs -- All distributions are taxable as ordinary income -- The 3.8% Medicare surtax does not apply

Answer 7

TAXATION OF ANNUITIES (3 OF 3) Income Taxation * Each annuity payment received from a non-qualified annuity uses an exclusion ratio to split the tax treatment into two pieces: --A tax-free return of basis -- Taxable income * The exclusion amount for a variable annuity is determined by dividing the after-tax investment in the contract by the number of years of expected payout. * Once the investment in the contract has been fully recovered, all payments will be fully taxable as ordinary income.

Answer 8

TAXATION OF ANNUITIES: EXAMPLE 1 * Hope purchased an annuity contract 10 years ago for $100,000. The current value of the annuity is $175,000. Hope decides to withdraw $100,000 from the contract Total Withdrawal = $ 75,0000 GAINS $ 100,000 BASIS

Answer 9

TAXATION OF ANNUITIES: EXAMPLE 2 * Ira has always been a planner and very methodical about his finances. Twenty years ago, he purchased a deferred variable annuity that is now worth $1 million. Unfortunately for Ira, he stepped on a piece of glass and the wound got infected. The infection went untreated, and he died. * The value of the annuity, which was not annuitized, is included in his gross estate, but does not go through the probate estate since it has a named beneficiary

Answer 10

ANNUITY BENEFICIARY DISTRIBUTIONS * To the extent that there is gain in the contract, the beneficiary will report the gain as income. * If there is substantial gain in the contract, the beneficiary may choose to distribute over several tax years. -- Over his or her life expectancy --Distributed within five years after the owner’s death -- Surviving spouse of the owner can treat the annuity as his or own. -- When the beneficiary is not an individual, the five-year rule applies

Answer 11

USES OF ANNUITIES: LONGEVITY INSURANCE (1 OF 2) * Cost of longevity annuity contracts are very reasonable for two reasons: --The contract is purchased at or before retirement, and payments do not generally begin until age 85. -- More than half of those purchasing longevity annuities will not receive any payments

Answer 12

USES OF ANNUITIES: LONGEVITY INSURANCE (2 OF 2) * Qualified Longevity Annuity Contract (QLAC) purchased inside of a qualified retirement plan or IRA will not be considered when calculating required minimum distributions. * To be considered a QLAC, the premium must not exceed the lesser of 25 percent of the account balance or $155,000 in 2023 and $145,000 for 2022. -- The contract must be specified to be a longevity annuity contract at issuance

Answer 13

USES OF ANNUITIES: STRUCTURED SETTLEMENTS * An agreement under which someone who is entitled to receive a large lump-sum payment of money decided, instead, to accept periodic sums of money. * If payments are a result of physical injury, the payments received by the injured party are tax-free

Answer 14

STRUCTURED SETTLEMENTS AND THE SECONDARY MARKET * Sometimes secondary market annuities are called pre-owned annuities or in-force annuities. * These annuities can be purchased from the original owner at a discount or from a third party, and the stream of income is assigned to the purchaser. * Both sellers and buyers of annuities should conduct substantial due diligence prior to entering into this type of transaction

Answer 15

STRUCTURED SETTLEMENTS AND THE SECONDARY MARKET: EXAMPLE (1 OF 2) * Wilma is injured by Betty in an automobile accident. The claim is not settled and ultimately goes to court. Wilma wins the case and settlement money is offered to pay Wilma either a lump-sum payment or a structured settlement making payments over Wilma’s lifetime. Wilma, who is now unable to work, accepts the structured settlement annuity. The court order specifies that Wilma shall receive $2,000 per month for life, with a 20- year guaranteed payment period. Neither Wilma nor the court want Betty or Betty’s auto insurance company to pay the annuity. -Therefore, Betty’s insurance company purchases an annuity from a major life insurance carrier to pay the annuity of $2,000 per month with a 20- year guarantee. -Betty’s auto insurance company is the owner of the policy, the life insurance company is the issuer, and Wilma is the payee

Answer 16

STRUCTURED SETTLEMENTS AND THE SECONDARY MARKET: EXAMPLE (2 OF 2) * Five years into the annuity, Wilma needs money, and because she does not work, she decides to sell some or all of her annuity payments in return for a lump-sum payment. -Wilma sells the annuity at an 8.5% discount rate and receives $203,000 from the structured settlement company. -The structured settlement company then re-offers the annuity for $253,000 (equating to a yield of approximately 5%) over the term of the annuity. -The yield is substantially higher than the yield on CDs or treasuries. A similar 15-year guaranteed annuity of $2,000 per month might cost $300,000 and yield 2.5%

Answer 17

THE IMPORTANCE OF COMPANY CREDIT RATING * The financial stability of the company issuing the annuity contract is of major concern to contract holders and should be a consideration in determining which annuity contract to purchase. * Several rating agencies assess the financial strength of insurance companies issuing annuity contracts. These include A.M. Best (with a rating scale from A++ to S), S&P (with a rating scale of AAA to R), and Moody’s (with a rating scale from Aaa to C).

Answer 18

DEFAULT RISK FOR ANNUITIES * All states have guarantee funds run by the state insurance commission that act as the payor of last resort in the case of an insurance company failure. * While a few insurance companies have failed, no annuity contract holder in the United States has been deprived of promised payments to date

Answer 19

Annual Reset Method - The index-linked interest crediting rate is determined each year by comparing the index value at the end of the contract year with the index value at the beginning of the contract year. Interest is then added to the annuity each year during the term

Answer 20

Annuitization - The time when annuity funds are exchanged for a stream of income guaranteed for a period of time.

Answer 21

Annuitized - The time whe n regular, periodic (such as monthly or annual) payments begin for life or for a specified period of time in excess of one year.

Answer 22

Cap Rate - Some indexed annuities impose an upper limit on the index-linked interest rate.

Answer 23

Cash Refund Annuity - Guarantees that the annuitant or the annuitant’s family will receive the premium payments made to purchase the annuity, but instead of continuing to make periodic payments until there is a full recovery of the premium, the balance is paid in cash at the annuitant’s death.

Answer 24

Equity-Indexed Annuities - Have characteristics of both fixed and variable annuities, either immediate or deferred, that earn interest or provide benefits that are linked to an external equity reference or an equity index.

Answer 25

Floor Crediting Rate - An indexed annuity is the minimum index-linked interest rate that will be credited to the contract in a given period

Answer 26

Guarantee Funds - Run by the state insurance commission, they act as the payor of last resort in the case of an insurance company failure.

Answer 27

High Watermark Approach - Determining index-linked interest is accomplished by comparing the value of the index at various points during the term (usually on anniversary dates)

Answer 28

immediate Annuity - An instrument created when the contract owner trades a sum of money in return for a stream of income that begins immediately.

Answer 29

Index Term - The period over which index-linked interest is calculated for equity-indexed annuities

Answer 30

Indexing Method - The approach used to measure the amount of change, if any, in the index. Some common indexing methods include: (1) the annual reset (ratcheting) approach, (2) the high watermark approach, and (3) the point-to-point approach

Answer 31

Initial Rate - The first rate of interest that is earned under a fixed annuities contract and is guaranteed for a specified period of time.

Answer 32

Installment Refund Annuity - special type of term certain annuity whereby the insurer promises to continue periodic annuity payments after the annuitant has died until the sum of all annuity payments made equals the purchase price of the annuity

Answer 33

IRD Assets - Assets that have a deferred income tax liability that was not paid prior to the date of the owner’s death.

Answer 34

Longevity Insurance - A sophisticated name for a deferred annuity purchased by an individual at or before retirement that will not begin to make payments until that person reaches an advanced age.

Answer 35

Participation Rate - Determines how much of the increase in the index will be used to calculate the index-linked interest.

Answer 36

Pooling of Risk - Spreading of risk among a large number of similar contributors to the pool. Protection is provided to the entire pool of contributors. With annuities, the risk that is being spread is the risk of outliving retirement funds, or superannuation.

Answer 37

Risk-Based Capital - The investment risk assessment undertaken by the insurance company in investing the money backing up the annuity pool.

Answer 38

Secondary Market Annuities - Called pre-owned annuities or in-force annuities. These annuities can be purchased from the original owner at a discount or from a third party, in which the stream of income is assigned to the purchaser. These typically offer a rate of return or yield that is well above the yield available on standard fixed annuities, immediate annuities, or even bonds of a similar credit quality.

Answer 39

Straight or Pure Life Annuity - An annuity that provides a stream of income to the annuitant for life.

Answer 40

Superannuation - The risk of running out of money before death due to long life and can be mitigated by using annuities.

Answer 41

With the surrender of an annuity for a loss, the owner can take a loss that does not include the surrender charge. Thus, option b is not correct. It is not a capital loss. Taking the loss as an ordinary loss is more aggressive, but there is some authority for the position.

Answer 42

Which of the following statements about annuities is not correct? Option a is a true statement as the options can be combined. Option b is a true statement as the annuity owner chooses to invest in a variety of subaccount types, including fixed income. Option c is a true statement as the insurance company is more likely to pay more with the life annuity term certain combined option. Option d is false - only qualified annuities are subject to minimum distribution rules

Answer 43

Variable Annuity The value of both the accumulation units and the annuity units fluctuates

Answer 44

Annuities can help lessen superannuation (risk of outliving funds) and purchasing power (if the annuity is variable). An annuity does not reduce the likelihood of dying (mortality)

Answer 45

Saul purchased a life insurance policy with a face value of $100,000. Unfortunately for Saul, and his wife, Rhea, he died racing “import cars.” At the time of death, the life insurance policy had a cash value of $40,000. The beneficiary was his wife. Rhea, who has a life expectancy of 40 years, decided to take the single life annuity option with the life insurance proceeds. This option will pay her $500 per month for the rest of her life. How much of the monthly payment is taxable? __________________________________________________________ Exclusion ratio = investment ÷ expected payments = $100,000 ÷ (40 years x 12 months x $500) = 41.7%. Inclusion ratio = 1 - exclusion ratio = 58.3% Taxable amount = $500 x 58.3% or $292

Answer 46

Hugh purchased a single premium annuity for $200,000. The annuity pays him $1,000 per month. If his life expectancy was 20 years when he purchased it, how much of each payment is not subject to tax? __________________________________________ Exclusion ratio = $200,000 ÷ (20 years x 12 month x $1,000) = 83.33% Taxable portion = 1- exclusion ratio = 17.67% Non-taxable portion of the payment = $833

Answer 47

Mason, who is now 70 years old, was a diligent saver during his working years and accumulated $100,000 at age 60. He used his savings to purchase a single premium annuity, which pays him $1,000 per month. If his life expectancy was 25 years when he purchased it, how much of each payment is subject to tax? ____________________________________ Exclusion ratio = $100,000 / (25 years x 12 month x $1,000) = 33.33% Taxable portion = 1- exclusion ratio = 66.67% Taxable portion of the payment = $667

Answer 48

All of the following are requirements for Qualified Longevity Annuity Contracts (QLACs), EXCEPT? A. A maximum of $145,000 (in 2022) may be used to purchase the QLAC. B. A QLAC is purchased in an IRA or defined contribution retirement plan. C. In order to be qualified, a QLAC must be annuitized no later than age 85. D. In order to be qualified, a QLAC must be a variable a ______________________________________________ In order to be qualified, a QLAC must be a variable annuity.Rationale Variable and indexed annuities are not permitted to be QLACs. All of the other statements are true regarding the rules for Qualified Longevity Annuity Contracts.

Answer 49

TYPES OF ANNUITIES TEST ANNUITY - " so you don't outlive your money", creates income stream cannot outlive. * Flexible premium (fluctuating income)- pay whenever * Immediate annuity -LUMPSUM, THEN PAY IMMEDIATELY * Deferred annuity -DEFER INCOME TO FUTURE * Pure life annuity (max. periodic payout, no bequests guaranteed) -LIFE ONLY, ZERO TO BENEFICIARY * Guaranteed minimums * Refund annuity -RECEIVING INCOME, THEN DIE, BENEF GET REMAINING OF VALUE. * Joint and survivor

Answer 50

Take an ordinary loss of $20,000. Rationale With the surrender of an annuity for a loss, the owner can take a loss that does not include the surrender charge. Thus, option b is not correct. It is not a capital loss. Taking the loss as an ordinary loss is more aggressive, but there is some authority for the position. INVESTED $50,000 -$3,000 SURRENDER FEE -27,000 SURRENDER VALUE $20,000 GAIN

Answer 51

$667. Rationale Exclusion ratio = $100,000 ------------------------------------------------ = 33.33% NOT (25 years x 12 month x $1,000) TAXABLE Taxable portion = 1- exclusion ratio = 66.67% Taxable portion of the payment = $667

Answer 52

The exclusion ratio. Rationale The exclusion ratio equals the owner’s investment in the annuity contract divided by the expected return on the annuity. The resulting percentage is multiplied by the distribution, or payment, received to calculate the portion of the payment that is NOT TAXABLE

Answer 53

$833. Rationale Exclusion ratio = $200,000 ÷ (20 years x 12 month x $1,000) = 83.33% Taxable portion = 1- exclusion ratio = 17.67% Non-taxable portion of the payment = $833

Answer 54

292. Rationale Exclusion ratio = investment ÷ expected payments = $100,000 ÷ (40 years x 12 months x $500) = 41.7%. Inclusion ratio = 1 - exclusion ratio = 58.3% Taxable amount = $500 x 58.3% or $292