Life Insurance & Advanced Concepts (Chapter 4 & 5) Flashcards by Riley Giauque

Used to purchase life insurance so that the proceeds are not included in the gross estate of the insured in order to avoid estate taxes on the proceeds.

ILIT - Irrevocable Life Insurance Trust

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This requirement serves the goal of preventing speculation on human life

Insurable Interest

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If Wally is the insured, Hilda is the policy owner, and Ed is the beneficiary. When Wally dies, the death benefit is considered a taxable gift from who for estate tax purposes?

Hilda

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The process by which insurance companies decide whether to provide insurance to a customer and under what terms?

Underwriting

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When is the asset accumulation phase?

20’s to mid 50’s

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Is the process of transferring all or part of the policies ownership rights.

Assignment

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When is the distribution gifting phase?

Mid 40’s to life expectancy

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This phase is characterized by relatively high debt and low savings.

Asset Accumulation

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This approach of death benefit calculation for an insurance policy suggests that the death benefit of a clients life insurance should equal the economic value of his future earnings stream discounted to its present value while considering his tax and consumption patterns.

Human-Life Value Approach

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What are the 3 steps in calculating human life value for insurance coverage needs?

1) Determine the families share of earning by identifying annual earnings of person minus personal expenses and taxes
2) Determine WLE (number of years they would have continued to accrue income)
3) Calculate the PV of families share using inflation adjusted ROR

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Approach that estimates the cash needs of family at death of the insured: final expenses, eliminating debt, funding goals, income needs for spouse/family, retirement needs for surviving spouse

Needs Approach

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6 months to 2 years after the death of the bread winner

Readjustment period

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The period where the present value of cash needed over the dependent parents remainder of live and children’s lives until they reach age of majority

Dependency Period

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The period between the cessation of survivor benefits and the receipt of widow(er) or retirement benefits is sometimes referred to as the ___________.

Blackout Period

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A method for calculating death benefit that divides the families share of earnings by an inflation-adjusted discount rate, which takes into consideration expected ROR and inflation.

Capitalized Earnings Approach

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What is the general benchmark metric that is the general guide for life insurance needed?

12-16 times gross pay

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What are the four most common types of permanent life insurance?

1) Universal
2) Whole
3) Variable
4) Modified Endowment Contracts

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Equals the probability of dying within the year times the Face Value of the Policy

Mortality Cost

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This type of policy permits the policyholder to renew the purchase for the same amount of term insurance in subsequent years without evidence of insurability, but premiums on the policy increase each year to reflect the increasing mortality risk being undertaken by the insurer.

Annual Renewable Term

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This type of insurance charges a fixed premium each year over a specified period of years so the premium does not increase within the period.

Level Premium Term Insurance

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This type of insurance allows the owner to pay the same premium for the insurance protection each year. The death benefit will decrease each year, however, to offset the increasing mortality cost due to the passage of time. (ie. Use when paying off mortgage)

Decreasing-Term insurance

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Insurance that allows for unequal and varied premium payments. Excess premiums are deposited into a cash accumulation account earning limited interest. The policy will not lapse as long as there is sufficient cash to cover mortality and expense fees.

Universal Life Insurance

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Permanent policy that requires the owner pay a specific level premium each year until the year of death (or age 100, 120)

Ordinary (or straight) Life Policy

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Making premium payments on a permanent policy over a limited time period.

Limited-Pay Policies

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This type of policy gives a person the opportunity to purchase a whole life policy with initial lower premiums which increase as the insureds income increases.

Modified Whole Life

Policy that provide for a fixed premium payment and permit the cash value of the policy to be professionally managed by the insurance company or an outside investment manager.

Variable Whole Life Policies

How are growth in cash value and death benefit subject to taxation?

They are exempt as long as policy is not surrendered during insured's lifetime

Congress imposed 2 tests to determine whether a life insurance contract meets the definition of a MEC

1) Guideline Premium & Corridor Test | 2) 7-Pay Test

The first _________ received by employees under a group term insurance contract paid for by employer is excluded from tax unless employee is a sole proprietor, partner, or more than 2% shareholder.

$50,000

Good place to look for an outline for the most pertinent information regarding a life insurance policy

Declarations page

Life insurance can be back dated to take advantage of lower rates at a younger age. Backdating usually does not exceed 6 months and requires payment of premiums back to that date. The date the contract begins is called the ________________.

Effective Date

Al, age 50, receives $150k in group term insurance paid by company. Al's marginal tax rate is 25% and insurance for his age is $0.23 per thousand dollars. 1) What is the amount of taxable excess insurance coverage? 2) The imputed premium of insurance in excess of tax free group limit is? 3) What is the out of pocket cost?

1) $100k 2) 276 = (.23 * 12 months * 100 units) 3) $69 = (.25 * 276)

Typically spans 31 days after premium due date for policy owner to avoid overdue premium and undergoing additional underwriting.

Grace Period

States that once the policy has been in force for a period of time (typically 2 years) the insurer may not cancel the policy if it later discovers a material misrepresentation, ommission, or concealment.

Incontestability

Death Benefit Calculation

Monthly Premium / Cost per unit x 1000 (per thousand $'s)

Suicide Clause

1) Insurance policy will not pay DB to beneficiary but will refund premiums paid within 2 years 2) Usually comes with a 2-year exclusion (meaning after 2 years suicide will pay out benefit)

Provided that past premiums are paid to the insurer, and satisfactory evidence of insurability is provided the insurer may reinstate a life insurance policy up to ____________ after the policy lapse.

5 years

Specifies that the death benefit will only be paid to the beneficiary if the beneficiary survives the insured by a specific number of days (usually 30-60).

Survivorship Clause

If the insured and the beneficiary die in a common accident and the order of deaths is uncertain, the policy death benefit is distributed as if the beneficiary had predeceased the insured and is distributed to the contingent.

Simultaneous Death Provision

What is another word for a policy "rider?"

Endorsement

Gives the policyowner the right to buy additional specified amounts of insurance at specified dates or events without the insured having to prove insurability

Guaranteed Insurability Rider

What is the pneumonic for remembering the 6 Activities of Daily Living and what are they?

BED TC 1) Transferring 2) Bathing 3) Eating 4) Dressing 5) Toileting 6) Continence

In this type of contract selection if the beneficiary dies early the insurance company promises to make a specified number of payments under the contract.

Income with Period Certain

With this contract settlement option when one annuitant dies the survivor will receive a reduced payment for the rest of his/her life.

Joint and Last Survivor Income

House replacemen cost $500k. $300k of insurance with co-insurance of 80%. House suffers $150k loss, what will insurer pay?

($300,000/($500,000 * .80)) X $150,000 = $112,500 (Amt purchased / Co-insurance) X Loss

What is the key difference between implied and apparent authority?

With apparent authority, none actually exists.

When must an insurable interest exist for a life insurance claim?

At policy inception only

What word means, "the amounts exchanged may be unequal in an insurance contract?"

Aleatory

``` Severity = __________ Frequency = ______________ ```

Severity = Size Frequency = Number of losses

What is the difference between universal and whole life?

Whole Life: Consistent Premiums, Guaranteed Cash Value Accumulation Universal Life: Flexible Premiums and Death Benefit

What is the difference between Variable and Variable universal?

Variable has fixed premiums Variable Universal has flexible premiums

When stated in an insurance policy means that the insured receives dividends...

Participating

Level Premium, Declining Death Benefit, No Savings Component

Decreasing Term

Calculated by logically examining a circumstance or existing information regarding a situation.

Priori Probability

Looking at risk from your (the client's) point of view

Subjective probability

Looking at something from an unbiased standpoint

Objective

Premium payments on life insurance policies are/aren't tax deductible?

Are NOT

When individuals have a life insurance policy that covers their own lives how is the death benfit taxed for both estate taxation and income taxation?

Countable towards gross estate tax exemption Free from income taxation

What is the accounting method used to determine the income distribution method for a MEC policy?

LIFO (interest distributed first)

Occurs when a policy owner sells the life insurance policy to a third party for more than the cash surrender value, but less than the death benefit value. (In most cases the insured is neither chronically or terminally ill.)

Life Settlement

When is an illness considered "terminal?"

24 months or less (must be certified by a physician)

Entitles a qualified insured to receive a pre-death benefit deemed non-taxable because they are treated as an advanced payment of death benefit.

Accelerated Benefits Provision

The sale of a life insurance policy to a third party provider when the insured is terminally or chronically ill.

Viatical Settlement

Proceeds from a viatical settlement or accelerated for someone with a terminal illness must be used to fund __________ to remain tax free.

No restrictions

Proceeds from a viatical settlement or accelerated for someone with a chronic illness must be used to fund __________ to remain tax free.

Medical or Long Term Care Expenses

How is a chronic illness defined?

Within the past 12 months, a healthcare practitioner has certified that the individual has been unable to perform, without substantial assistance at least 2 activities of daily living for at least 90 days. OR If substantial supervision is required to protect person from threats to health and safety due to cognitive disability

Qualified Viatical settlements reasonable payments: 1) Less than 6 months (life expectancy): 2) 6 - 12 months (life expectancy): 3) 12 - 18 months (life expectancy): 4) 18 - 25 months (life expectancy): 5) 25 months or longer (life expectancy):

1) 80% 2) 70% 3) 65% 4) 60% 5) Greater of cash surrender value or accelerated death benefit available in policy

Legal arrangements that require the sale of a business interest (if death of owner usually with estate) owned by one individual to another individual or entity upon triggering event.

Buy-Sell Agreements

This type of buy-sell agreement obligates the business entity to purchase an owners interest in the entity upon that owners death.

Entity Purchase

Established and funded by the company so that when the employee retires, there is enough money to purchase the interest.

Sinking Fund

When each party to an agreement purchases a life insurance policy on the life of all of the other parties to the agreement so that the death benefit is sufficient to purchase the interest of any deceased owner.

Cross purchase buy-sell agreement

When a family member or key employee has a desire to purchase the business when the owner dies thus purchasing a life insurance policy on the owner.

One Way Buy-Sell Agreements

Business has first option to purchase deceased owners interest, surviving owners given option to buy if declined by business, any interest remaining not purchased by owners is purchased by business.

Wait and See (Buy-Sell agreement)

In order for a business to avoid taxation of buy sell agreements, the business must do three things, what are they?

1) Notify the employee in writing that the business intends to insure the employees life 2) Obtain written consent from employee to be insured (even after employment terminate) 3) Inform employee in writing that the business will be beneficiary of any proceeds payable upon death of employee

In addition to notice of consent, for tax purposes of buy sell agreement 1 of 4 things must happen... (failure to comply will result in death benefit being taxed as ordinary income)

1) At time of issue, employee is highly compensated 2) At time of death, employee was still employed during 12 months prior to death 3) Death Benefit paid to insureds heirs 4) Death Benefit used to purchase insureds ownership interest from insureds heirs or estate

Common with professional athletes and used to defer receipt of taxable income until such time as the athlete is beyond his peak earning period.

Salary Reduction Plans

A deferred compensation agreement between the company and key executive whereby the company agrees to provide supplemental retirement income to the executive and his family if certain pre-agreed eligibility and vesting conditions are met by the executive

SERP - Supplemental Executive Retirement Plan

Irrevocable trusts designed to hold funds and assets for the purpose of paying benefits under a Non-Qualified, deferred compensation arrangement. Funds are set aside and are not available to employer or subject to claims. (Tax is deferred until participant is vested.)

Secular Trusts

If an employer sets aside funds for an employee and there is no risk that the employee will not receive funds, then funds are taxable.

Economic Benefit Doctrine

A discriminatory benefit plan using life insurance where the employer and the employee share the cost of a life insurance policy.

Split Dollar Arrangement

Under the split-dollar life insurance plan using this method the employer owns the life insurance policy on the employee and the employer pays the policy premium. (Usually premiums loan repaid to employer upon employee death.)

The Endorsement Method

Under a split dollar life insurance plan using this method the employee owns the insurance policy and the employer makes a loan to the employee to pay the premiums. (Premiums typically returned to employer upon death of employee.)

The collateral assignment method

Is designed to protect a business upon the loss of a key employee.

Key Person Life Insurance

Can protect the business by providing funds to sustain operations and replace lost revenue while disabled key employees recover.

Key person disability insurance

Items like medical expense insurance, disability insurance, life insurance, and other benefits.

Fringe Benefits

This may be attractive to key employees who are in need of additional personal insurance and to a business seeking to provide some additional benefits at low net cost with easy administration.

Section 162 Bonus Plan (Group Carve Out Plan)

Where does the built up cash value in a whole life policy come from?

The net premium is greater than the mortality cost in the early years

Takes into consideration the income replacement needs of a person's survivors including income during the readjustment period, income to widower, and educational funds.

Needs approach

Evaluates the estimated present value of income generated over a person's work-life expectancy that is needed (and adjusted for consumption and taxes.)

The human life approach

This type of plan usually set up to discriminate by providing additional benefit to select number of employees. Employer pays bonus that equals premiums on life insurance policy that is deductible to employer while employee will report as taxable income. Policy owned by employee or trust.

Section 162 Bonus Plan

For life insurance policies to qualify for tax exclusion, the taxpayer must be either __________ or ______________.

Terminally or Chronically Ill

How long would someone have to wait to receive SS disability benefits if they qualify?

5 months

Partial disability benefit is usually ____% of total disability benefit

50%

How is a residual disability benefit calculated?

Percentage of total disability benefit that equals percentage reduction in earnings

Makes up the difference between wages earned before disability and after disability

Residual Benefit

How is the taxability of disability benefits calculated?

The annual dollar amount that you have already paid taxes on will be received in benefit tax free (the dollar amount that you have not paid taxes on will be taxable upon receipt of benefit)

What is a Rabbi Trust? What is the downside of a Rabbi Trust?

- Assets are contributed from employer into irrevocable trust - Downside is that the assets are not protected against creditors or insolvency

Assets informally committed to an employee through a Non qualified plan will ______________ .

Count as taxable income

What is the difference between a secular trust and a rabbi trust?

With a secular trust, participants do not have substantial risk forfeiture

When there is not substantial risk forfeiture in a NQ retirement plan, benefits are _____________ .

Typically taxable to the employee that year

If at any time during the first seven years of a life insurance policy's existence, the cumulative premium exceeds the net level premium for the policy, it will be deemed a MEC.

7-pay test

Dividends returned to policy holder less than premiums paid are considered ________________ .

Return of premium and are NOT taxable

What is the difference between the Capitalized Earnings Approach and the Human Life Value Approach?

There is no need to calculated WLE (Work Life Expectancy)

When the cash value and death benefit are treated differently

Unbundled

Universal Life is NOT the most cost effective for insurance because why?

Mortality and Expense fees increase each year and must be paid to keep the policy in force

What are the 3 main disadvantages of whole life insurance?

1) High Premiums 2) Low Guaranteed Returns 3) No hedge against inflation (No DB accumulation)

Advantages of Whole Life insurance? (6)

1) Guaranteed Premiums 2) Guaranteed Growth 3) Guaranteed Death Benefit 4) Permanent Protection (As long as premiums paid) 5) Cash Value can be accessed through loans 6) Savings Element

How are dividends on life insurance policies treated for tax purposes?

Non-Taxable return as part of the owners premium, up to the amount of premiums paid... from that point any additional dividends are taxable

Period by which an insured can decline an insurance policy and get a full refund.

Free look period

Option to purchase a single premium whole life insurance policy using the cash value of a previous policy.

Reduced Paid Up Insurance