Unit 3: Basics Of Life Insurance

Question 1

When the owner of a life insurance policy is NOT the insured, what are the 3 parties to the contract?

Answer 1

1. Insurer
2. Insured
3. Owner/applicant

Question 2

What is third-party ownership?

Answer 2

Refers to a situation where the owner of a life insurance policy is someone other than the insured

Question 3

To have a life insurance policy issued on someone else’s life, what is required?

Answer 3

The applicant must have an insurable interest in that person

Question 4

What is insurable interest?

Answer 4

The person applying for the first olive must be at risk of suffering a significant loss if the insured dies, which could be:

•emotional, based on love & affection
•economic, based on financial dependency, such as the insurer’s income

Question 5

In the personal insurance market, insurable interest exists:

Answer 5

•between spouses or domestic partners
•between parents & children
•among other close family members

*insurable interest also exists between lenders (creditors) & the people that owe them money (debtors)

Question 6

In the business insurance market, insurable interest exists:

Answer 6

•among business partners
•between corporations & their officers & directors
•between any type of business & its key employees

*insurable interest also exists between lenders (creditors) & the people that owe them money (debtors)

Question 7

In property & casualty insurance (auto, homeowners, etc.), when must insurable interest exist?

Answer 7

•at the time a loss or claim occurs
•if someone sells a house & it later burns down, the individual cannot claim a loss even if a policy remained in force

Question 8

With life insurance, when is insurable insurance required?

Answer 8

•at the time of application only

Question 9

What is an individual’s estate?

Answer 9

The assets they leave behind at death

Question 10

What is estate creation?

Answer 10

•For people in their working years, life insurance can create an estate if premature death prevents them from doing so themselves
—>the source for most family estates is built over years by saving money out of income, purchasing a home, making sound investments, & other items of value

Question 11

What are some personal uses of life insurance?

Answer 11

•survivor protection
•mortgage payoff
•estate creation
•estate conservation
•liquidity
•cash accumulation

Question 12

What is a life insurance cash value called?

Answer 12

The policy’s living benefits

Question 13

What is the principle of human life value?

Answer 13

The purpose of life insurance is to replace an individual’s economic value & this begins with the calculation:

[the amount of the individual’s annual income] x [# of years until retirement]

Question 14

What is the needs approach?

Answer 14

•used to find the amount of insurance coverage an individual should buy
•instead of focusing on income, looks at the financial situation the survivors will face if the individual dies
•more detailed, more accurate results, & more commonly used than the human life value approach

Question 15

What are the 2 categories of survivors’ financial needs?

Answer 15

1. Cash needs
2. Income needs

Question 16

What are cash needs?

Answer 16

Those that can be met with a lump of money, including:
•final expenses-funeral/burial costs & final medical bills
•debt payoff-home mortgage, credit cards, car loans, other installment loans
•children’s education-a fund to pay the future cost of college or trade school
•emergency fund-unexpected expenses that can cause a hardship for the surviving family

Question 17

What are income needs?

Answer 17

Those created by ongoing living expenses such as food, clothing, utilities, & a mortgage

Question 18

What are the 3 distinct income need periods?

Answer 18

1. Family dependency-the surviving children are too young to support themselves & depend on the surviving parent for their needs
2. Preretirement-also known as the blackout period; the children have grown up & becomes self-supporting, but the surviving spouse has not yet reached retirement age
3. Retirement-now the surviving spouse is no longer earning an income

Question 19

What is the blackout period?

Answer 19

•during the preretirement period
•the social security administration provides benefits for surviving spouses with children under age 16
•when the youngest child turns 16, benefits stop & do not resume until the surviving spouse turns 60

Question 20

What are 3 different types of other financial resources available to survivors when the income earner dies?

Answer 20

1. Existing assets such as bank savings accounts & investment accounts or IRAs
2. Employer life insurance or retirement benefits payable to a surviving spouse
3. Social security that can pay benefits to the surviving dependents

Question 21

What is included in a data gathering/fact-finding interview?

Answer 21

Conducted to acquire information for the needs approach-

•names & DOBs of every member of the family to determine the length of the 3 income periods
•sources & amounts of income available upon the death of the individual
•debt that must be eliminated upon the individual’s death, like home mortgages
•existing assets that can be used to offset survivors’ cash needs upon the individual’s death
•amount of life insurance already owned, including group life insurance obtained through an employee benefit plan
•financial objectives such as the education level desired for the children & retirement income goals

Question 22

What is a buy-sell agreement?

Answer 22

•provides for the sale of a business interest at the death or disability of an owner
•often referred to as “business continuation plans”
•can be funded with life insurance to make sure that purchasers have the money needed to buy a business interest when an owner dies
•the policy is on the business owner’s life & the buyer of the business is the beneficiary
•the amount of the death benefit is the purchase price of the business interest as stated in the buy-sell agreement

Question 23

What are the 2 types of buy-sell agreements?

Answer 23

•entity
•cross-purchase

Question 24

What is an entity plan?

Answer 24

•purchaser of a deceased owner’s business interest is the business entity itself
•when funded by life insurance, the business entity owns a policy on the life of each business owner
•if the business is a corporation, entity plans are often calls “stock redemption plans”—>because the corporation is actually redeeming the deceased owner’s stock
•the term “entity plan” is usually used with non-incorporated businesses such as partnerships

Question 25

What is a cross-purchase plan?

Answer 25

•the surviving owner(s) purchase the deceased owner’s interest in the business
•when funded by life insurance, each partner (or shareholder, if the business is a corporation) owns a policy on the lives of each of the other partners
•if there are more than 2 partners or shareholders, many more policies are needed for a cross-purchase plan than an entity plan

Question 26

What is key person coverage?

Answer 26

•used by businesses to help protect themselves against the financial harm that would result from the death of a key employee
•business owns, pays for, & is the beneficiary of the policy on the key person’s life
•if the key person dies, the insurance proceeds can be used to offset direct financial losses like a drop in sales as well as to help pay the costs of finding a replacement

Question 27

What is an executive bonus plan?

Answer 27

•rather than giving a yearly bonus to an employee in cash, companies can use the money to buy a life insurance policy for the employee
•a business pays the premiums on a life insurance policy which the employee owns
•during life, the employee has full access to the policy’s living benefits, & at death, the proceeds are paid to the beneficiary named by the employee
•section 162 plan
•nonqualified employee benefit arrangement in which an employer pays a bonus to a particular employee
•bonus is tax deductible to the employer as a salary expense
•employee uses the bonus to pay the premiums on a life insurance policy covering her life
•the employee is the owner of the policy & the bonus is included in the employee’s gross income
•when the employee dies, the beneficiary named in the policy receives the death proceeds free of income tax

Question 28

Nonqualified deferred compensation plan

Answer 28

•employer agrees to pay an employee a stated amount of income beginning at retirement rather than paying the money now
•benefits the employee because the money is not taxable until the employee actually receives it
•in return, the employee agrees to work for the employer until a specified future date-typically at retirement
•the deferred compensation benefits are forfeited if the employee leaves the company before then
•if the employee dies before retirement, the deferred compensation benefits become payable immediately to the employee’s surviving spouse or other beneficiary
•companies often buy a life insurance policy to make sure they will have the money to pay those benefits if that happens
•if the policy is permanent insurance, the cash values can be used to help pay the deferred compensation benefits to the employee if they live to retirement
•under the life insurance policy, the company is the owner, premium payer, & beneficiary, and the employee is the insured

Question 29

What are the business uses of life insurance?

Answer 29

•buy sell funding
•key person
•executive bonus
•deferred compensation

Question 30

What is group life insurance?

Answer 30

•a single contract that covers an entire group of people
•typically the policyowner is an employer and the policy covers the employees or members of the group
•often provided as part of a complete employee benefit package
•usually the cost of group coverage is far less than what the employees or members would pay for an individual policy with similar coverage

Question 31

What is industrial life insurance?

Answer 31

•developed as a way for people of limited means to obtain some of the benefits of life insurance
•face amounts usually small ($2,000 or less) & are often bought simply to help pay burial expenses

**premiums come due weekly & are collected in person by producers who go door-to-door

Question 32

What is home service life insurance?

Answer 32

•variation on industrial life insurance
•sold by industrial/home service producers in the neighborhoods where they collect premiums at the houses of industrial life policyowners
•policies larger in size-usually $10k-$25k in face value
•policyowners are encouraged to pay the premiums through an automatic bank draft (often called a “monthly debit plan”) or by mail, so that producers do not have to collect them personally

Question 33

What are the classes of life insurance policies?

Answer 33

•individual vs. group
•term vs. permanent
•participating vs. non-participating
•fixed vs. variable
•industrial & home-service

Question 34

What are the 3 elements of calculating insurance premiums?

Answer 34

1. Mortality-the relative frequency of deaths in a specific population; death rate
2. Interest-earnings on premium dollars between the time they are collected & the time they are paid out as claims
3. Expenses-insurer operating costs, referred to as the “expense load;” adding the expense element to insurance premiums is called “loading”

Question 35

What is “loading?”

Answer 35

Adding the expense element to insurance premiums

Question 36

What is net premium?

Answer 36

•the premium before loading
•[mortality] - [interest]

Question 37

What is the net single premium?

Answer 37

Will fund a policy’s benefit with one premium payment

Question 38

What is the gross premium?

Answer 38

[net premium] + [expenses]

= [mortality] - [interest] + [expenses]

Question 39

What is the premium payment mode?

Answer 39

•reflects how frequently premiums come due
•premiums may be paid monthly, quarterly, semiannually, or annually
•premium calculations are based on the assumption that the policyowner will pay the annual premium mode
•premiums will be higher if not paid annually—>annually is the lowest

Question 40

Individual life insurance

Answer 40

•cost based upon individual insured
•individual policy issues
•policyowner chooses amount of insurance

Question 41

Group life insurance

Answer 41

•cost based on group
•policy issued to employer or group sponsor
•employer determines amount of insurance

Question 42

Term life insurance

Answer 42

•death benefit only
•increasing premiums
•temporary coverage; expedited at the end of the term
•cannot be renewed after a certain age

Question 43

Permanent life insurance

Answer 43

•living & death benefits
•level premiums
•lifetime coverage; no expiration
•protection continues through advanced ages

Question 44

Participating life insurance

Answer 44

•may pay dividends to policyowner
•somewhat higher premium
•can be issued by mutual or stock insurers

Question 45

Non-participating life insurance

Answer 45

•does NOT pay dividends
•somewhat lower premium
•issued by stock insurers

Question 46

Fixed life insurance

Answer 46

•guaranteed cash value
•values expressed in dollar amounts

Question 47

Variable life insurance

Answer 47

•no guaranteed cash value
•values expressed in investment units