Chapter 1: History and Elements of Life Insurance (Part 1)

As with many institutions of our contemporary culture, the origins of life insurance can be traced to ancient Greece. Some scholars even attribute its roots to the Code of Hammurabi (about 1750 BCE), which provided for the state to pay indemnity for the murder of a household member by a robber. Between approximately 500 BCE and 200 BCE, several prominent Greek religious groups collected and provided burial funds for their members. They commonly believed that the departed could gain the greatest potential favor from the gods through rituals, feasts, and sacrifices, and took great pains to provide for these often-expensive ceremonies.
 

Roman "Collegia" 

Later, Roman “collegia,” which were similar to the Greek societies, gradually evolved into discrete associations with specific benefits and operated from membership contributions. These associations ceased to exist after the decline of the Roman Empire. However, the need for such organizations continued, leading to the establishment of guilds. Organized for religious, social, and economic reasons, guilds also provided relief for several perils, such as shipwreck, loss of home by fire, loss of tools used to make a living, et. al. While these guilds originated primarily in England, they were also present in Japan as Craftsmen’s Guilds.

By the mid-1800s, the English had created the English Friendly Societies, which were actually mutual benefit groups. While not concerned with trade or religion, they did provide some death or burial fund benefits. Such groups were funded by assessments, but since they were not constructed on scientific or actuarial bases, the financial burdens fell to the younger members. Being mostly in good health, these junior members dropped out of the plan. Therefore, some private insurance companies formed, failed, and formed again. All of these groups, though, are the ancestors of the concept of life insurance.

The earliest insurers were wealthy individuals who, either alone or with a consortium of other wealthy persons, assumed insurance risks. They were created for short durations and used for such situations as the voyages of ships. Of course, life insurance could not be written in this fashion because the insured could potentially outlive the insurers. Incidentally, the insurers would sign their name(s) under the amount of the risk that they agreed to bear. Thus, they were called “underwriters.”

1583 gives evidence of the earliest recorded life insurance contract. It was initiated for a period of 12 months on the life of a William Gybbon, for a premium of 75 pounds and with a “face amount” of over 383 pounds. Interestingly, when Gybbon died just before the end of the year, the underwriters refused to pay because they insisted that the contract term used a lunar calendar (whose year is longer than a solar year). The English courts refused to acknowledge the lunar calendar, thus ruling in Gybbon’s favor.

In 1699, the Society of Assurance for Widows and Orphans was established in England as an assessment society and was the first of the “mutual contribution life offices.” It remained in business for 46 years. After it closed, the Amicable Society for a Perpetual Assurance Office was formed. It did not offer a stated death benefit.

In 1761, The Equitable formed a mutual company and is considered the first life insurance company to operate on a modern insurance basis.

The Equitable was followed by The Globe in 1803, as well as other companies in France in the late 1700s and early 1800s. The first stock life insurer in Germany was formed in 1828, and The Prudential (a U.K. company), formed in 1848, was the first company to introduce industrial insurance, circa 1850.

As is typical with many industries in Europe and beyond, government and insurers were intertwined in many ways. Some governments used insurers as a means to raise funds for government expenditures. One of these systems was that of the tontine.

In the late 1600s, Italian financier Lorenzo di Tonti – for whom the tontine is named – proposed to the court of King Louis XIV an annuity scheme to raise significant funds for a French government impoverished by the 30 Years War. The proposed system would work as follows:

Each participant could choose himself or a third party as a “nominee,” for whom a specified sum would be contributed to a pool until the time of the nominee’s death. The pool acquired interest, which was distributed annually to all participants whose nominees survived. As nominees died off and their associated payments remained in the pool, the funds distributed to the survivors grew. Eventually, the entire group of what might be considered annuitants would die, leaving all accrued funds to the government. [1]

Although the French monarchy initially rejected this proposal and tossed di Tonti into the Bastille, it would later use similar means in attempts to financially revive the government. Later still, other governments and private firms employed the tontine scheme, including London’s aforementioned Amicable Society for a Perpetual Assurance Office.

In fact, the tontine once proliferated throughout the U.S. to the point where, at its early-20th century peak, nearly 9 million such policies existed in a country of 18 million households. At the time, tontines held 7.5% of the entire nation’s wealth. Although many people long considered the practice morally dubious at best, the U.S. government did not ban it until an array of dramatic scandals exposed abounding greed and corruption. [2]

The first mutual life insurer in the U.S. was the Corporation for the Relief of the Poor and Distressed Presbyterian Ministers and for the Poor and Distressed Widows and Children of Presbyterian Ministers, founded in Philadelphia in 1759. Renamed in 1990 to The Covenant Life Insurance Company, it is now part of the Provident Mutual Life Insurance Company. In 1849, the state of New York began requiring all insurers to place a security deposit of $100,000 with the state insurance department. This move was instigated by the numerous established mutual insurance companies and effectively halted the creation of new mutuals.

The first U.S. stock insurer was the Insurance Company of North America, chartered in 1792. It primarily sold annuities, and after 10 years had only sold six life insurance policies. As such, it terminated its life insurance business. The first company in the U.S. that sold a considerable amount of life insurance was The Pennsylvania Company for the Insurance on Lives and Granting Annuities, chartered in 1812. The company lasted 60 years before closing its doors.

The Prudential Insurance Company of America introduced industrial life insurance in 1875, a practice soon followed by John Hancock and Metropolitan Life. The marketing of industrial life insurance arguably had the greatest influence on public awareness of life insurance in the United States.

All of this is to say that the concept of insurance – including life insurance – is far from modern. Its value has long been perceived and acted upon. Through its prevalence, it is all too easy to take for granted the aspects of our civilizations that have long rendered such insurance necessary.

Why Life Insurance?

While the idea may seem cold, economists have long recognized that there is economic value to a human life and that this collective value is an important and necessary part of a nation’s economic wealth. The marketplace acknowledges investment in personal development, so any improvements in this investment may be recognized as increases in income or wages. Therefore, any such increases can be seen as an increase in the yield of an investment. For instance, those with college degrees traditionally make more money than those without. This difference in income can then be considered a return on the investment in education.

With such specific monetary value placed on human life comes countless methods to attempt compensation for its unexpected loss. In contemporary society, news media and law libraries alike abound with continuous debates over this value – especially when a third party ends the life in question. Competing ideas about proper modes and amounts of compensation for wrongful death are crucial factors most relevant to the field of liability insurance. As such, the impacts and importance of punitive damages are more properly discussed in those books, as well as in texts that explore property and casualty insurance.

So, what of life insurance? Historically, its approach to computing the value of a human life arguably has been more scientific than legalistic. The “human life value” concept places a dollar value on the services of a person’s life. In the late 1920s, Solomon Huebner introduced this concept in his work The Economics of Life Insurance and later expounded upon it in the 1942 update, where he proposed it as a philosophical framework for analyzing certain economic risks that individuals face.

While there are complex layers and analyses within this framework, it also posits a simpler thesis, which divides into four categories the potential types of loss of capital: premature death, disability, retirement, and unemployment. Since any of these losses can affect an individual’s earning capacity, each has a resultant negative impact on the human life value.

Potential Losses of Capital

Premature Death

Disability

Retirement

Unemployment

The probability of loss from death or disability is considerably greater than from any other commonly insured peril. However, people still generally purchase property insurance, while avoiding the purchase of life (or disability) insurance. When life insurance is purchased, it is usually for an inadequate (and sometimes insignificant) amount.

The human life value concept is a highly recommended area of study for a serious student of life insurance. A general feeling for this concept can be obtained by assessing Dr. Huebner’s “Human Life Value Admonitions” as detailed in The Economics of Life Insurance:

Figure 1-1: The Five Human Life Value Admonitions

Of course, Huebner’s treatise is only one component of defining life insurance and its structuring. Life insurance functions on numbers, statistics, and mathematical principles.

Law of Large Numbers

The entire function of insurance, type regardless, is to guard against financial loss caused by peril. Those who have experienced loss can receive contributions from those who fear they may encounter similar perils. In short, insurance is the sharing of losses.

Insurance relies upon the effects of the law of large numbers to reduce the impacts of speculation and to compensate for inconsistencies in experience.  As applied to life insurance, this law states that the larger the quantity of those insured against premature death, the less the whole of the group’s loss experience will deviate from the expected loss experience.

The law of large numbers does not mean that losses to particular insureds will be more easily predicted. It simply means that, all other things being equal, the greater the number of insured persons, the more accurately the loss experience can be predicted.

If a single person is insured for $1,000, this would be a gamble. Even if the number is increased to 100, it remains so. However, if half a million people are insured for $1,000, anticipated death rates will vary from actual death rates by no more than 1%. Theoretically, if the lives insured on the same bases were of sufficient quantity so that the law of large numbers would be exactly predictable, then there would be no uncertainty in estimating losses during a given period of time, barring catastrophes such as war, terrorist attacks, or epidemics.

The major difference between life insurance and non-life insurance is that while the peril addressed (premature death) is an uncertainty, the probability of death will increase until it is a virtual certainty. Everyone dies eventually. Death is considered a “virtual” certainty as it is possible for a person to outlive the insurance policy.

For instance, a person who lives past age 100 will have outlived the mortality tables. Therefore, if a life insurance policy is to protect an individual throughout the lifetime, a fund must be generated to meet a claim that is certain to occur – even a person age 101 will receive the fund one way or another.

Many people consider insurance a gamble. This is especially true with life insurance, where the belief persists that the insurance company is simply gambling that they will die prematurely. However, a crucial principle of insurance is that it transfers an existing exposure and, through the pooling of similar loss exposures, reduces risk.

In other words, life insurance is a device that spreads the cost of financial loss incurred by death from an individual to a group, so as to minimize the financial loss of each individual.

Insurers much prefer that their insured do not suffer the loss for which they are insured. In life insurance, such losses are inevitable, and the insurer plans for them within the premium structure.

Determining Premiums for Life Insurance

Premiums for insurance should always meet three criteria: they must be adequate, reasonable (or equitable), and should not be unfairly discriminatory.

First, premiums must be adequate for the insurance company to provide the benefits in the contract. Obviously, if the premiums are not adequate then the insurance company will eventually not be able to pay the claims to the insured. Were this to occur, everyone would suffer.

Second, the premium must be reasonable (or equitable) and the insurance company should not be able to earn an excessive profit. One of the strongest forces that keeps premiums from becoming excessive is simply that of competition.

Lastly, the premiums must not be unfairly discriminatory or inequitable. The pursuit of equity is one of the goals of underwriting (discussed in more detail later in this text) and equitable treatment of insureds is accomplished by rating factors such as age, sex, plan, health, and benefits provided.

Theoretically, one could say that each insurance applicant should pay an exclusive (unique) premium to reflect a different expectation of loss, but this would be impractical (imagine agents having to carry an enormous rate manual everywhere). So, classifications are established for applicants to be grouped together according to similar expectations of loss. Statistical studies of a large number of nearly homogeneous (similar or identical in nature or form) exposures in each underwriting classification enable the projection of losses after adjustments for future inflation and statistical irregularities. These adjusted statistics are used to calculate the pure cost of protection – or pure premium – to which the insurance company attaches additional fees for agent commissions, premium taxes, administrative expenses, contingency reserves, other acquisition costs, and profit margin. The result is the gross premium that is charged to the insured.

The gross premium is the cost of protection plus agent commissions, taxes, administrative expenses, and other relevant fees.

Pricing

The pricing of life insurance is a complex, technical, and methodical procedure, performed by actuaries who are arguably the most technically educated professionals in the industry. Nonetheless, to understand life insurance, it is necessary to understand certain elements of its pricing and how such elements apply to the determination of life insurance premiums.

Before the insurer can determine the amount of the premium to be charged to each insured, the probability of losses for the group must be determined. In life insurance, these probabilities are shown on a yearly basis as mortality tables, which form the foundation of life insurance pricing. Pictured below is a mortality table adapted from the most recent Commissioners Standard Ordinary (CSO) tables, published in 2017.

Figure 1-2: Selection from the 2017 CSO Mortality Table

AGE   MALE FEMALE

10      0.09   0.09

20      0.90   0.33

30      1.00   0.48

40      2.06   1.14

50      2.93   2.02

60      6.33   4.93

70      17.16 14.04

80      50.91 39.86

90      166.12         131.25

99      328.33         305.09

References

[1] https://scholarship.law.columbia.edu/cgi/viewcontent.cgi?article=3214&context=faculty_scholarship

[2] https://www.washingtonpost.com/news/wonk/wp/2015/09/28/this-sleazy-and-totally-illegal-savings-scheme-may-be-the-future-of-retirement

Chapter 1: History and Elements of Life Insurance (Part 2)

Net Rates

Net rates are calculated to recognize the probability of the insured event, the time value of the money, and the benefits of the contract. When expenses and other fees are added to the net rates, then they become gross rates.

Practically speaking, companies do not often develop new net rates for each new product introduced, especially if similar products are already in the marketplace. Instead, actuaries will commonly analyze the rates of these existing products to determine if their premiums meet the company’s objectives and profit requirements. If not, adjustments can be made. If existing rates significantly exceed the company’s profit requirements, they may be adjusted downward. If they are inadequate, then the actuaries should determine whether:

They want to continue developing such a product.

They want to maintain a comparative premium so that their sales force can be competitive, even if the premiums do not quite match the company’s objectives.

Benefits can be varied or slightly diminished so that the price will remain competitive.

Risk and Risk-Pooling

Insurance transfers risk from the policyholder to the insurance company. By pooling similar exposures to loss, the insurer then reduces its own risk. But what is “risk”?

According to the International Risk Management Institute (IRMI), risk has two meanings [1]:

Uncertainty arising from the possible occurrence of given events.

The insured or the property to which an insurance policy relates.

The concepts of risk and risk-pooling are vital components of how insurance is structured and how rates are calculated. When issuing life insurance, an insurance company assumes the risk of death posed by each member of the group and pays the group’s losses.

Example

Assume that a sample group of 1,000 people, all age 35, shares the same health status and anticipated lifespan. Furthermore, each group member pays the same annual premium for a $100,000 life insurance policy.

First, we must ascertain the chances of any single group member dying in any given year. Using the most recent Commissioner’s Standard Ordinary (CSO) Mortality Table, 1.41 members are expected to die during the policy year. Ignoring the insurer’s expenses, each policy owner would need to pay $141.00 to cover that year’s cost of insurance to meet anticipated losses:

$100,000 death benefit × 1.41 = $141,000

$141,000 ÷ $1,000 = $141.00

Keep in mind that this computation needs to be recalculated each year. In reality, the actual premium for each member of the group involves a much more complex calculation. It is also crucial to understand that the CSO Table uses different computations for the mortality of males versus females and for tobacco users versus non-tobacco users. Because women and non-tobacco users on average live longer than men and tobacco users of the same age, insurers have more years to collect premiums for them and, as a result, charge them lower premiums.

It is also important to understand that while smaller insurers use the CSO Table, larger insurance companies often develop their own mortality tables based on their own historical loss data. The proprietary loss information of a larger insurer would reflect its losses more accurately than information collected from the general insurance population, especially as it relates to the geographical location of its insureds, along with any other underwriting guidelines that establish the classes of business it writes.

This example is simple and must be taken one step further to explain the process of determining premiums for a level premium policy. In the situation above, the premium should increase each year, and where the mortality rate rises, premiums increase. Then what happens? Inevitably, there will be some insureds – particularly the healthy ones – who drop out as the premiums become too expensive. This means that those who are not as healthy (or are older) will remain, as they are more likely to incur a claim. This is known as adverse selection, which means that those who are more likely to receive benefits will stay, and the better risks will leave. Because of this, insurers are likely to limit the period in which an annual renewable term policy can be renewed, or will adopt much higher premium levels at the older ages to compensate.

Adverse selection is an inevitability. Those who most need life insurance are most likely to purchase and maintain a policy.

For single-premium life insurance plans, a modified CSO mortality table approved by the NAIC is used in calculating minimum non-forfeiture values and policy reserves for ordinary life insurance policies. It depicts the number of people dying each year out of the original population, grouped by age. The formula to obtain those premiums uses the number living at the beginning of the year (such as 100,000 in the previous illustration) decreased by increments as the table’s population ages.

A life insurance policy can be seen as a series of annual renewable term insurance policies that continue to the end of the mortality table. With single premium plans, the premiums are paid in advance for the life of the policy, so the excess funds will have to be invested and then credited properly throughout the life of the contract.

Few people purchase life insurance on a single premium basis because of the up-front premium. Also, due to the ever-increasing premiums for an annual renewable policy, few people are interested in purchasing this type of insurance. An exception exists for special situations where short-term insurance is needed. These problems generally warrant the use of a level premium plan.

Level premium plans were devised so that the company can accept the same premium each year if the premiums collected are the mathematical equivalent of the corresponding single premium. As is obvious, the premiums collected in the early years will be more than necessary to pay for death claims, and the premiums in the later years will not be sufficient to pay death claims. It has sometimes been said that life insurance was the first product that was sold on an installment plan.

The premium is level because of this overpayment of premium in the early years. At any time, the fund, future interest, and future premiums should be mathematically able to pay all death claims as they occur during the time that the coverage continues.

A whole life policy can have premiums paid over the entire policy duration. It can also have level premiums that can be paid over a shorter period, such as 10 or 20 years, or until a specified period, such as age 65.

Reserve Calculation

There is one other important calculation that must be discussed: policy reserves.

In determining this reserve, the policy’s net level premium is established to satisfy a basic relationship: the present value of a future premium equals the present value of a future benefit. This relationship exists only at the point of issuance of the life insurance policy. After that, the value of future premiums is less than the value of future benefits because fewer premiums remain to be paid. Thus, a reserve must be maintained at all times to make up this difference.

The prospective reserve is the amount designated to address the difference between future benefits paid and future premiums received.

The actual amount of life insurance protection at any point in the policy term (before additional fees) is the difference between the policy reserve on a given date and the policy’s face amount on that same date. This is called the net amount at risk.

Simply put, life insurance can be divided into two sections: an increasing reserve and a decreasing net amount at risk.

Figure 1-3: Demonstration of the Risk-Reserve Relationship

Flexible Premium Plans

Many insurers sell policies that have flexible premiums – in other words, the policy owner determines the amount of premium that they would like to pay. This is a feature of universal ­life (UL) and variable universal life. Unlike other policies, the values of a universal life policy are a function of those premium payments made previously and those that are currently being made. As a result, the cash values of UL products are determined differently than demonstrated above. These values are instead dependent on how the policy is structured.

The policy owner may pay whatever premium they wish (subject to company rules). An amount is subtracted from the cash value equal to the insurer’s fees, expenses, and mortality charges. Subsequently, the cash value for the next period will be the fund’s previous balance plus any premium payment made.

The policy’s mortality charges are based on its net amount at risk, merely using a cash value instead of the reserve. Any interest earnings on the cash value are credited to the cash value itself, usually on a monthly basis. In addition, there is usually a surrender charge for early termination of the policy.

The Savings Element in Life Insurance

Many life insurance policies have cash values and all cash values stem from the same cause: the excess premium charged in the early years in order to maintain a level premium. However, the general public usually views the cash value as simply a by-product of the payment-of-premium method. This view persisted for many years, until the advent of interest-sensitive insurance products – particularly universal life. In these cases, the cash value is looked upon as an independent part of the policy, from which funds are withdrawn to pay for mortality and expenses.

Many individuals continue to view a permanent level premium policy as merely a combination of term insurance and the company’s liability held to pay future claims – i.e., the reserves. Much of this perception stems from the policy owner’s ability to withdraw all of the cash value or to borrow part of it as a loan.

Regardless of the appearance of two contracts (death benefit and cash value), it is important to understand that it is still only one policy. This is evidenced by the fact that a policy owner cannot withdraw all of the cash value without forfeiting the death protection. Legally and actuarially, a life insurance policy is an indivisible contract. Unfortunately, some companies and individuals continue to present permanent life insurance as a combination of decreasing term and increasing savings.

Universal life products will be discussed later in more detail, but at this point, it is important to recognize that they – and interest-sensitive products in general – differ from other insurance products in their relative transparency and flexibility.

UL policies are more transparent in the sense that the policy clearly denotes the relationships between its main components – premiums, death benefits, mortality charges, interest, and expenses. By displaying the individual performance of the mortality charges and expenses, cash value, and pure insurance amounts, the policy offers the client significantly greater insight into its overall behavior.

Additionally, UL policies are more flexible than other types of life insurance because the policy owner may increase or decrease (or occasionally, altogether eliminate) both the amount and frequency of premiums paid.

Policy Participation

Life insurance policies can be separated into those that allow for variation based upon the providing company and those that are essentially set in stone. There is also the class of policies that will provide variation depending upon anticipated company or business results.

Non-Participating Policies

Some policies provide that the premiums, benefits, and cash values are non-negotiable. These are traditionally called non-participating policies. They do not alter their features based on improvements in mortality or cash values, and the premiums are fixed as long as the policy is in force. Traditionally, stock companies sold these policies while the mutual companies, which were owned by policy owners, would allow these owners to benefit from a better-than-anticipated experience by issuing dividends. Today, stock companies may issue participating policies and mutuals may issue non-participating policies.

Since traditional non-participating policies do not share the benefits of positive experience from lower-than-expected mortality, higher-than-anticipated interest earnings, or lower expenses and/or taxes, the policy owner has no way to participate in these favorable results. If the policy does not reflect a growing economy, lower taxes, etc., policy owners are tempted to exchange their policies for those that do participate. Of course, those owners who would change policies were generally healthy, while those whose poor health prevented them from making changes would stay with their non-participating policies. Therefore, the premiums would be insufficient on the existing block of business. This is another example of adverse selection.

Participating Policies

Participating policies grant their owners the ability to share in the increased profits of an insurer because the realized results are better than what is assumed when constructing the policy. Actually, these profits initially go toward increasing the surplus of the company. The company will then declare a distributable surplus, which is returned to the policy owners in the form of dividends. For example, if the company is receiving 7% on its investments after having used a 5% assumption when determining premiums, the 2% difference may be returned to the policy owner.

It should be noted that a dividend in a life insurance policy is very different from a dividend in other industries when the profit experience is better than anticipated. Premiums are usually higher for participating policies as they use very conservative assumptions for mortality, interest, and expenses. As such, dividends from a life insurance policy are considered returned overpayment of premiums. This means that they are not considered earnings or income and are therefore not taxable.

Agents representing mutual companies have primarily used policy projections when marketing participating policies that show that the dividends more than compensate for the higher premium, and that these dividends can allow for certain flexibility that non-participating policies cannot provide. This is one reason that stock companies started issuing participating policies.

Dividend Payment Options

The owner of a participating policy may choose how the dividends are paid and which dividend payment option to choose from among those the insurer offers. Five basic options are discussed in the following paragraphs, but many companies do not offer all five.

Cash Dividend

Policy owners may choose to take cash dividends. These payments are taxable only if they exceed the total amount of premiums paid. Premiums for certain riders are not considered policy premium payments and are therefore not included in such calculations.

Premium Reduction

The dividends may be paid towards the cost of the premium. For this option, the amount of the dividend is deducted from the premium and the policy owner is then responsible for the difference. For example, an annual policy premium of $850 can be paid down with $200 worth of dividend payments. The policy owner is then billed for the remaining $650 amount.

Paid-Up Additions

A policy owner may use each annual dividend to purchase a separate paid-up whole life policy. Each of these additions then generates its own cash value and dividends, all of which accumulate on a tax-deferred basis. This dividend option enables the policyholder to increase the amount of life insurance in force without paying out-of-pocket and without needing to provide evidence of insurability.

Accumulation at Interest

The policy owner can opt to leave dividends on deposit with the insurance company. This allows them to accumulate additional interest and affects neither the policy face value nor the death benefit. As this amount is independent of the policy amounts, it can be withdrawn at any time. The interest earned on these dividends is taxed as regular income.

One-Year Term Insurance

Dividends may also be used to purchase one-year term insurance. The amount of term insurance that may be purchased is however much the dividend will buy at the insured’s current age, up to the cash value of the policy. If part of the dividend remains after the term purchase, it is usually left with the insurer to accumulate at interest. Typically, no proof of insurability is required under this option.

Remember, not all of these options are available from every insurance company. In addition, while policy owners normally select a dividend option when the policy is issued, they may later (in most cases) switch to another option if they wish.

References

[1] https://www.irmi.com/term/insurance-definitions/risk

Chapter 2: The Insurance Contract Section 1 (Part 1)

An insurance policy is a legal contract. Although it looks different than the most familiar types (lease agreements, auto loans, etc.), it is at its core a regular contract. As such, it must meet all of the requirements of a legal contract.

For a consideration (the premium), one party (the insurance company) agrees to pay an agreed-upon sum of money (or to provide services set forth in the contract) if a loss occurs and is covered under the contract.

A life insurance contract can be confusing, technical, and easily misunderstood by the insured, so it would be easy for an insurer to take advantage of the average insured. Conversely, the policy owners (and claimants) could take advantage of the insurer if they are aware of physical, moral, and adverse selection issues. The laws of contracts as pertaining to life insurance contracts are specifically developed to eliminate – or at least mitigate – such discrepancies that can lead to serious misunderstandings.

In the United States, life insurance policy forms must be approved by the regulating authority (usually the state’s insurance department) and all policies must contain certain standard provisions that the law specifies. The states do not usually prescribe the exact wording for these standard provisions, but guidelines that state the actual wording must be at least as favorable to the policy owner as the standard provisions demand.

Standard provisions generally include:

Entire contract provision

Contestability provision

Ownership

Assignment

Beneficiary

Grace period

Reinstatement provisions

Misstatement of age or gender

Policy loans

Divisible surplus provision

Nonforfeiture provisions

Settlement options

There are many other regulations relating to the insurance policy contract, such as identifying all policy forms by numbers, the prescribed format of the first (cover) page, etc. Most states require that the policies be written in “simplified” format, which is judged by its readability and ease of understanding. Courts have rendered decisions throughout the years that significantly affect the way provisions in life insurance policies are interpreted. In addition, laws have a direct impact on policy provisions – particularly Internal Revenue regulations, civil rights legislation, etc.

Characteristics of Life Insurance Contracts

There are several characteristics of life insurance policies that differentiate them from other business contracts. It is essential to understand these differences before discussing the more general contract rules of law.

Good Faith

An insurance contract is a contract of good faith. This means that both parties to the contract can rely upon the good faith of the other and therefore cannot deceive, attempt to deceive, or withhold pertinent information from the other party. Simply put, the unique advantages that each party has over the other cannot be used against one another. You have likely heard the rule of caveat emptor – “let the buyer beware.” This rule does not apply to insurance contracts.

Valued Contracts

Life insurance contracts are arranged so that the insurer agrees to pay a certain specified sum of money, regardless of the actual economic loss to the insured. A life insurance policy is not a policy of indemnity, as are property, casualty, and some health insurance contracts. That is, the amount of money that will be paid has no relation to the actual financial loss that the insured sustains. This can cause the unintentional insuring of moral hazards because the insureds can recover losses for amounts greater than the economic value of lost income or attendant expenses. Therefore, life insurers carefully consider the economic loss that an insured could suffer in the event of the insured’s death or disability.

Contracts of Adhesion

Life insurance contracts are contracts of adhesion, meaning that one party fixes the terms of the contract and the other party must accept or reject these terms in their totality. This is a crucial facet of life insurance. The courts view life insurance contracts as exceptionally technical and specialized. Therefore, any ambiguities in the contract will be construed in favor of the policy owner.

Conditional

Life insurance contracts are conditional, as the insurer’s obligation to pay claims hinges on the fulfillment of certain conditions, such as payment of the premium and proof of death.

Aleatory

Life insurance contracts are aleatory in nature, meaning that one party can receive more in value than the other party. Therefore, there is an element of chance.

Unilateral

Life insurance contracts are unilateral in nature, as the insurer is the only party that gives a (legally enforceable) promise in the contract. The owner of the contract does not promise to pay the premiums, but if they do make the premium payments in a timely manner, then the insurer is required to fulfill its obligation. Incidentally, this can cause some adverse selection, as those insureds who need the insurance are the ones who will make premium payments in a timely manner.

Elements of a Contract

In order for any contract to be valid, the law prescribes four requirements that must be present: legal capacity, mutual assent, adequate consideration, and legality. [1]

Legal Capacity

The parties to the contract must be legally capable of making a contract. In the eyes of the law, intoxicated persons, those with insufficient mental capacities, those with political conflicts of interest, et. al., cannot enter into a contract. A minor, who is generally defined as someone younger than 18 years old, cannot usually make or sign a contract.

Mutual Assent

A contract agreement consists of one party accepting an offer put forth by another party. This looks slightly different in life insurance but follows the same basic principle. For instance, many insurance contracts originate when an agent solicits the insured party and then submits their application to the company. Mutual agreement may be attained within one of several possible stages of the overall process:

The insured initiates the contract by submitting an application, with or without a premium. If no premium is submitted, then the insurer considers this an “invitation” to make an offer. The insurer makes this offer by way of issuing the policy. The applicant then accepts this offer by paying the premium upon receipt of the policy.

If the applicant does submit an initial premium, then the insurer construes this as an offer. However, the applicant can withdraw the offer at any time until the company issues the policy. Most states hold that there is no contract in force until the policy is issued, delivered, and received by the insured.

The insurer may also issue a conditional receipt, in which case it offers some form of temporary coverage.

Insurability Conditional Receipt

This is the most frequently used type of receipt. In effect, an insurer that issues this receipt is considered to have made an offer. The applicant accepts this offer by paying the appropriate premium. The insurance becomes effective on either the date of the conditional receipt or in some cases, on the date of the physical examination that meets the insurer’s provisioned underwriting criteria. This type of receipt has been upheld by many courts, but on occasion, the courts have felt that the applicant had expected interim coverage for the premiums paid, and therefore they have ruled for the applicant.

Should the applicant die before the application and/or any other required information reaches the home office, and if the applicant had met the underwriting standards customarily used by the company, the policy would be considered issued and the claim would be paid.

Conditional Binding Receipt

This type of receipt effectively provides insurance from the date the insurance contract is written. Usually, the applicant must have satisfactorily answered all questions on the application, and the coverage is provided for a stated fixed time period or until the insurance company makes a final underwriting determination – whichever comes first. The conditional binding receipt is used for temporary insurance, such as travel insurance policies and temporary health policies. However, there are a growing number of companies that use binding receipts. One of the reasons for its popularity is that the public is used to binding receipts in purchasing property and casualty insurance, such as auto or homeowner’s insurance, where the company is bound upon completion of the application.

Approval Conditional Premium Receipt

This type of receipt provides coverage only after the application has been approved by the insurer. It is seldom used because of the short coverage period provided to the applicant.

Consideration

For an insurance policy, the consideration is the first premium payment. Legally, subsequent premium payments are “conditions precedent” that must be performed in order to keep the contract effective. In practice, the consideration clause is simple. A typical clause would read as follows:

We have issued this policy in consideration of the representations in your application and payment of the first term premium. A copy of your application is attached and is part of this policy.

Legality

A contract cannot be used for illegal purposes that are contrary to public policy. Such purposes include gambling. Insurance and a wager are distinctly different because the requirement of an insurable interest in the policy excludes the policy from any definition of gambling.

Besides gambling, any insurance policy that is against public policy is illegal, such as a life insurance policy that is negotiated with the intent to murder.

Effective Date

In addition to those conditions listed above, an insurance policy requires an effective date. The effective date of a policy is generally the date from which coverage starts and is agreed upon by both the insured and the insurer. However, there can be complications.

A policy may be backdated to “save age.” Since premiums are lower at a younger age, this may be allowed if the backdating is not beyond six months, as it would otherwise be illegal in many states. This is often used for sales purposes, but it does raise some interesting questions: When is the next premium due? From what date(s) do the incontestable and suicide periods run?

Some courts have held that a full year of coverage must be provided for the payment of a full annual premium. However, most courts have held that the effective policy date is the one shown on the contract upon which subsequent premiums are due, even though this might mean less than one full year of protection for the first year.

For suicide and incontestable clauses, which usually span two years, the accepted rule is that the earlier of either the effective or policy date is the time from which the clause starts. Therefore, with backdated policies, the suicide and incontestable clauses could run from the policy date, but if the policy date is later than the effective date, then the clauses would run from the effective date. In some cases, a specific date start date for these clauses is written into the contract, and in those cases that date would be used.

Insurable Interest

By law, a life insurance policy must be based upon an insurable interest. For the purposes of life insurance, an insurable interest exists when the beneficiary would suffer a financial loss upon the death of the insured. An individual always has an insurable interest in his/her own life and those of immediate family members, whether by blood or marriage.

A life insurance policy must be based on an insurable interest.

Creditor-Debtor Relationships

Creditor-debtor relationships give rise to insurable interest. The creditor can be the beneficiary for the amount of the outstanding loan, with the face value decreasing in proportion to the decline in the outstanding loan amount.

Business Relations

Some business relations can also create insurable interest, as an employee may insure the life of an employer (or vice versa). This will be observed in greater detail when discussing key person insurance and other business uses for life insurance.

Timing Is Key

Insurable interest must exist at the inception of the contract, but not necessarily at the time of the loss. For example, if a woman purchases a life insurance policy on the life of her fiancé, she is considered to have an insurable interest. If the relationship sours, as long as she continues to pay the premiums, she will be able to collect the death benefit under the policy.

Case Study

In the 1957 landmark case, Liberty National Life Insurance Company v. Weldon, the aunt-in-law of a 2-year-old child took out three life insurance policies on the child with the intent to murder her and collect the benefits. The courts ruled that the insurers did not ascertain whether an insurable interest existed in the case and awarded the father a $100,000 wrongful-death judgment, which was substantially greater than the policies’ worth. Life insurance companies have since taken great care to ensure that there is always insurable interest.

The Application

The application can be considered the applicant’s proposal to the insurance company to receive coverage and the beginning of the insurance contract. Most states require that the application become part of the insurance policy. If the insurer fails to do so, they are legally prohibited from later denying the correctness or truth of any information on the application. It is extremely important that the application be filled out correctly and completely. Rarely does an application with an unanswered question or unintelligible answer go unnoticed by insurance company employees whose jobs center upon reviewing applications.

Concealment, Misrepresentation, and Fraud

Concealment is the withholding of information that the insurance company should know. As stated previously, a life insurance contract is a contract of good faith, and the insurance policy depends upon full disclosure of all material information. Whether a fact is material depends upon whether the insurer would have acted as it did by issuing the policy – and at the premiums charged – if they had known all of the necessary facts. Therefore, the general rule for determining materiality can be summarized as a question:

If the applicant had accurately and truthfully presented the facts to the insurer, would the insurer have denied the application, charged a higher premium, or issued a policy with limited benefits?

Representation and Misrepresentation

A representation is a statement given to an insurance company concerning personal health history, family health history, occupation, and/or hobbies. These statements are required to be substantially correct; that is, applicants must answer questions to the best of their abilities. In most cases, the courts construe representations very liberally, so that they need to be only substantially correct.

A misrepresentation occurs when a statement given is incorrect. In most states, a materially false representation makes an insurance policy voidable at the option of the insurance company. In most jurisdictions, fraudulent intent need not be proven. In some jurisdictions, a determination of fraudulent intent can automatically make the policy voidable. It is clear then that the definition of intent is crucial. To further complicate matters, the definition itself also varies by jurisdiction.

Fraud

An individual who deliberately misrepresents or conceals a material fact, with intention to deceive the insurance company in order to gain the benefit of the policy, is guilty of fraud. To be guilty of fraud, there must be intentional misrepresentation or concealment of a material fact and an intent to deceive for the purpose of receiving the benefit.

Presumption of Death

A discussion of the contractual application of a life insurance policy would not be complete without mention of the presumption of death.

The terminology of the life insurance contract generally states that there must be due proof of the death of the insured before benefits can be paid. This can be particularly difficult if the insured has disappeared and there is no evidence of their current location. The basic law is that if a person leaves their place of residence and is neither heard from, seen, nor known to be living after a set time period – typically seven years – the person is then presumed dead. If an insured disappears for seven years and the absence is unexplained, then the benefits will be paid. Court cases involving presumption of death usually center upon whether the absence can be explained.

Typically, it takes seven years before a missing person is legally presumed dead.

In order to prove that the absence cannot be explained, the beneficiary (who is usually the plaintiff in such cases) attempts to prove that the insured was happy and had no financial problems, thus had no rational reason disappearing. The burden of proof falls upon the insurer to disprove these facts, and they may attempt to show that the insured was unhappy, financially insolvent, or had a reason to escape their current life situation.

A single question remains: when did the insured die? A few jurisdictions hold that the insured died on the last day of the seven-year period. However, if it can be shown that there was some type of peril involved (tornado, hurricane, etc.), then the court would generally rule that the date of death was the date of the peril. In this case, the insurance company would pay the death benefit plus interest beginning from that date.

What happens when the insured has been gone for more than seven years, the death benefits have been paid to the beneficiary, and the insured shows up again? If the benefits were paid in good faith, the insurance company has the right to recover on the basis that it was simply a mistake. However, if the insurance company did not pay the full death benefit, such as under a settlement agreement (which is quite common in such cases), then the insurance company has no recourse and the beneficiary is entitled to keep any settlement money that had been paid.

References

[1] https://www.law.cornell.edu/wex/contract

Chapter 2: The Insurance Contract Section 1 (Part 2)

Incontestable Clause

This provision simply states that (except for accidental death and disability premium payment benefits) the insurer cannot contest the policy after it has been in force for two years while the insured is still alive.

This clause stems from an old English provision, the “indisputable clause,” which was used to counteract the very stringent warranty provisions in the policies of the time. Initially, the U.S. adoption of this clause was for public perception, but it became a practiced institution when, in 1879, the Equitable Life Assurance Society adopted it into its policy procedures. Its purpose is to remove the concern for the insured and the beneficiary(ies) that the insurance company may not pay.

Even if the insured had misrepresented a material fact at time of application, after two years, the insured may not be present to defend against the insurer’s accusations. The clause limits the time that the insurance company can use defenses of fraud, concealment, or material misrepresentation in order to halt benefits payments.

Suicide Clause

Suicide is covered in a similar fashion. It is felt that if a person purchases life insurance in anticipation of suicide, they will either commit suicide within two years or not at all. This has held true in most cases. Insurers have always had a difficult time with denying claims because the insured committed suicide, even within the first two years of the policy.

The typical suicide clause states that the insurer will not pay if the insured commits suicide, regardless of presumed mental status, for the first two full years from the original application date. In the event of a suicide, they will instead void the policy and return the premium (less any loans). Note that in practice, some courts have consistently held that a mentally ill or mentally incapacitated person cannot commit suicide because such an act requires a degree of awareness that the person in question ostensibly did not have. This has occurred even when the suicide provision has included specific wording regarding mental capacity and the state insurance department approved the policy form.

Courts will often seek ways of ruling so that dependents can collect benefits. For many years, it was widely reported that in the state of Louisiana, which has a very large Catholic population, no life insurance company had ever won a suicide case. Catholicism holds the belief that suicide is a sin and that if a Catholic person commits suicide, they cannot be laid to rest in consecrated ground, thus causing additional suffering for the remaining family.

Grace Period

The grace period provision requires the insurance company to accept premium payments for a certain number of days – typically 31 days for life policies and 60 (or 61) days for flexible-premium contracts. The insurance company is obligated to accept the premium payment, even if it is past the due date, and they may not require evidence of insurability as a condition for accepting the premium.

If the insured dies during the grace period, the premium due and interest on the premium due may be withheld from the benefit payment. This provision is for the protection of the policy owner against unintentional lapse. In some ways, this is treated as “free” insurance if the policy lapses. The insured is covered for the grace period with no additional premium because if they should die during the grace period, benefits would be paid (less the premium due).

Exclusions

Two types of exclusions still used are the aviation exclusion and the war exclusion. These risks are examined further in the underwriting section of this text.

Aviation

Occasionally, an aviation exclusion is added to a policy by the underwriting department, usually in those cases where the pilot is flying experimental or military craft or lacks sufficient experience. This exclusion is not often added, as even commercial pilots who fly frequently can qualify for standard insurance. Usually, the insured has the option of paying a higher premium instead of accepting the exclusion.

War

After the terrorist attacks on September 11, 2001, exclusions were broadened to include “war and terrorism.” This is now a standard exclusion.

Beneficiary Provision

The beneficiary provision in a life insurance policy allows the policy owner to determine who will receive the insurance amount in case of the death of the policy owner. Within the guidelines of insurable interest, the policy owner can name just about anyone they choose as the beneficiary.

Beneficiary Designations

Primary Beneficiary

The person who is named first to receive the proceeds is called the primary beneficiary. There can be more than one primary. The time between naming the primary beneficiary and the time that the insured dies can stretch into several years and the beneficiary may precede the insured in death. If there were no other beneficiaries named, then the proceeds would go to the estate. This is not generally a desirable situation due to the added costs it would present.

Contingent Beneficiary

The solution to the lack of a named beneficiary is to name a contingent (or secondary) beneficiary. Therefore, in the case that the primary beneficiary is not alive to receive the death proceeds of the insured, the proceeds would go to the person(s) named as contingent beneficiary(ies). There can be more than one contingent beneficiary and they can also be named to receive benefits under a settlement option.

Legally, the contingent beneficiary is a tertiary (later) beneficiary and is usually named at the same time as the primary beneficiary. Frequently, the relationship between the insured and the beneficiary is specified. For example, “All proceeds under this policy shall be paid to Anna Jean Smith, wife of the named insured, if living; otherwise, the proceeds shall be paid to Jack J. Brown, nephew of the insured.”

Revocable Beneficiary Designation

A revocable beneficiary designation allows the policy owner to change beneficiaries at any time, with neither the beneficiary’s knowledge nor permission. This is designation is quite typical, particularly in policies of smaller amounts.

With a revocable beneficiary designation, the policy owner is the only one who has an interest in the policy and the beneficiary has no position, other than to expect that the proceeds will be paid to them upon the policy owner’s death.

Irrevocable Beneficiary Designation

As the name implies, an irrevocable designation cannot be changed without the permission of the beneficiary. This gives the beneficiary significant rights to the policy proceeds, and neither the policy owner nor creditors of the policy owner can change the distribution of proceeds without the explicit, written approval of the beneficiary.

This is almost the same as joint ownership, except that many policies specify that only the policy owner can withdraw cash values, make policy loans, or take other similar actions.

Naming the Beneficiary

A person can name children as beneficiaries. Rather than naming each child individually, parents may name children as a class. For example, “shared equally among all children born from the marriage of the insured to J. B. Ashe, including adopted children.” In this case, the class designation ensures that any child born after the policy is issued will benefit. The class designation also avoids confusion if a child dies before the insured and the insured fails to change the designation.

It is not necessary to name only children as a class; for instance, all “siblings” can be named, and quite commonly, “all grandchildren of the insured.”

Sometimes insureds name their estates as the beneficiary. This is the least favorable type of beneficiary designation because if the policy proceeds go into the estate, they increase its size, which could in turn increase estate taxes due when the insured dies. In addition, if the insured failed to leave a will, the executor of the estate would have no way of knowing how the insured’s true wishes regarding the distribution of the policy proceeds. Even if a will existed indicating how to distribute proceeds, probate court actions can take months to complete. Life insurance proceeds that go into an estate are also more vulnerable to attachment from the deceased person’s creditors.

When two or more individuals are named as primary or contingency beneficiaries, one or more might die before the insured. This raises questions about how the policy proceeds should be divided among the living beneficiaries. There are two different methods of beneficiary designation that can be used to alleviate this situation – per capita and per stirpes.

Per Capita

Figure 2-1(a): Per Capita Designation with 4 Living Beneficiaries

A per capita designation is used to indicate that any remaining beneficiaries share all of the proceeds equally. For example, suppose the insured names his four sisters to share equally as primary beneficiaries of his $100,000 policy. If all four are living at the time of his death, each person receives $25,000. But if two of the sisters die before the insured, the two surviving sisters would each receive $50,000.

Figure 2-1(b) Per Capita Designation with 2 Living Beneficiaries

Per Stirpes

A different arrangement applies under a per stirpes designation. Per stirpes – literally, “by branches” – legally refers to a progression through the branch of a particular family member. For the situation described in the preceding paragraph, the following would transpire with a per stirpes designation:

Figure 2-1(c): Per Stirpes Designation with 2 Living Beneficiaries

The two living sisters would receive $25,000 each as originally planned. But the remaining two shares of $25,000 each would pass on to the heirs of each of the deceased sisters – to each sister’s “branch” of the family – rather than being divided between the two living sisters.

Unified Simultaneous Death Act

A Problem of Timing

Angela has a whole life insurance policy. Her husband, Dominic, is the primary beneficiary. Angela’s sister is the contingent beneficiary. Angela and Dominic are involved in an automobile accident and both are pronounced dead upon arrival at the hospital.

The question is, who died first? If Angela died first, the policy proceeds would be payable to Dominic. If Dominic died first, the proceeds would be payable to Angela’s sister. If Dominic lived longer than Angela, the policy proceeds would be paid into his estate and distributed according to his will. But if he died before Angela, her sister would receive the proceeds as the contingent beneficiary.

Recognizing this problem, most states have adopted the Uniform Simultaneous Death Act, which assumes that the primary beneficiary died before the insured. As a result, the policy proceeds are paid to the contingent beneficiary. This is true only when there is no evidence that the primary beneficiary did, in fact, outlive the insured.

Common Disaster Provision

Another way to mitigate this problem is by including a common disaster provision in the beneficiary designation. A typical provision would stipulate that in situations where a single event causes serious injury to both the insured and the primary beneficiary, the policy proceeds are held in trust for a specified period of time (often from one to three months). If the primary beneficiary is alive after the specified period expires, the primary beneficiary receives the death benefit. Otherwise, proceeds go to the contingent beneficiary. This provision might also be called a survival clause or similar.

Yet another option is to arrange for the policy to pay proceeds as periodic income to the primary beneficiary as long as they live. Upon the primary beneficiary’s death, the remaining policy proceeds are paid to the contingent beneficiary. Insurers will work closely with insureds to see that the designation is worded to provide protection for the beneficiaries with the precision that the insured desires.

Non-Forfeiture Provision

The non-forfeiture provision is applicable only to life insurance policies with cash values (although there are other types of insurance that may have this provision, such as some Long-Term Care policies). This provision outlines the options that are available for the insured to collect the cash value if the policy is terminated. It also explains the method that is used to determine these options.

Non-forfeiture is named as such because historically, early insurance policies had no cash values, so any excess premium paid after mortality and expense charges were deducted and forfeited. This prohibited in the United States and insurers must comply with the Standard Non-Forfeiture Laws. These laws also require the policy to specify the mortality table and interest rate used to calculate non-forfeiture values. Each cash-value policy requires a table that shows the cash surrender values and other non-forfeiture options for the first 20 years.

The laws that present the situations under which a life insurance policy must have non-forfeiture values also stipulate the minimum required values, and effectively mandate that all policies that collect more than mortality and expense charges provide non-forfeiture values. It is also notable that the stated interest rate for non-forfeiture values is not the rate of return of the policy. Universal life and current assumption life policies are different, as cash values are derived using the so-called retrospective approach.

Non-Forfeiture Options

Since the cash value in the policy belongs to the policy owner, it will not be forfeited even if the policy owner is not able to pay the premiums. Therefore, the policy offers options as to how the policy owner can receive the cash values.

Cash Surrender

The policy owner may receive the cash surrender value of the policy. This involves withdrawing the entire cash value and surrendering or terminating the policy. The insurance company deducts any outstanding loans, interest on loans, and unpaid premiums before paying the cash value to the policy owner.

Cash value policies include tables showing the cash surrender value for every year the policy is in force, which is the basis for the amount due the policy owner. However, universal life policies have only a minimum cash value guarantee and a variable policy has no guarantee at all. These policies might include an illustration of potential cash values based upon assumed rates, but unlike the tables in traditional policies, there is no guarantee that those potential values will be available at any given time.

Paid-Up Insurance

Another non-forfeiture option is to use the cash value to buy paid-up insurance. This provides a reduced amount cash value life insurance option for which the policy owner never pays another premium. The paid-up policy is the same type of insurance as the basic policy from which the cash value is being used. It does not include any riders or other provisions added to the original policy. Cash values accumulate in the paid-up policy and the policy earns interest. If the original was a participating policy, the paid-up policy will also earn dividends.

The amount of the death benefit for the paid-up policy depends upon how much coverage the cash value will buy. Any outstanding loans and interest are deducted first and the insured’s attained age is used to determine the cost. Administrative expenses will be small because it costs insurers very little to provide a paid-up policy from cash values.

Extended Term Insurance

The policy owner may use cash values to purchase extended term insurance. In this case, the death benefit is the same as the original policy (unless a loan is outstanding) and the extended term is the number of years and days of coverage that can be purchased with the available cash value at the insured’s attained age. Policies that have guaranteed cash values include a table showing how long the term will be, based upon these factors.

If there is an unpaid policy loan, the insurance company deducts the amount of the loan and any interest due from both the cash value and the death benefit amount before determining the length of the extended term. For example, if the original policy has a $100,000 death benefit, a cash value of $20,000, and an outstanding loan with interest of $5,575, then the death benefit of the extended term policy will be $94,425 and the cash value used to purchase the policy will be $14,425.

The outstanding amounts are deducted from both the cash value and the death benefit to protect the insurance company. If the insured should die soon after opting for the extended term insurance and before repaying the policy loan, the insurer would have lost the loan amount completely, since there is no longer any cash value as collateral. If a policy owner simply stops paying premiums and does not choose a non-forfeiture option, insurers automatically set up the extended term insurance unless the policy also includes the aforementioned automatic premium loan provision. This non-forfeiture option provides the most insurance protection for the cash value available.

Minors and Trusts

As a general rule, children are not recognized as competent to handle financial transactions. If an insured insists on naming minors, the insurer might require that a trust be established to hold the policy proceeds until the minors are adults. Alternatively, the insurer could arrange to hold the proceeds, pay interest, and disburse the proceeds (with interest) when the minors reach adulthood.

Spendthrift Clause or Spendthrift Trust

A spendthrift clause included in some life insurance policies is intended to protect policy proceeds from creditors by establishing a trust to receive the death benefit. Under this arrangement, the policy proceeds are paid out as periodic income rather than in a lump sum. The payout could be arranged over a fixed period of time or as a fixed payment for as long as the money lasts. The proceeds are then usually protected from creditors until the terms of the trust have been fulfilled. While this is the intent, the extent of the protection varies by state. Some state laws protect the entire death benefit as long as it is paid in installments, but others allow only a portion of each fixed payment to the beneficiary to be protected by a spendthrift trust.

Chapter 3: The Insurance Contract Section 2 (Part 1)

Settlement Options

Either the insured or the beneficiary uses a settlement option to determine how the death benefit(s) will be paid. Most companies offer all of the options presented in this section. Even though most companies are quite liberal in allowing arrangements not specifically mentioned in the policy, nearly all companies are more liberal with these options while the insured is still alive.

The policy owner can give as much or as little authority as desired in determining settlement options, with the beneficiary having no rights to change the option. Alternatively, the owner could set up a settlement option arrangement that would allow the beneficiary to receive the funds in most any fashion they would prefer. Insurance companies usually work with the beneficiaries to arrive at a mutually satisfactory arrangement.

Lump Sum

The vast majority of policy proceeds are paid in a lump sum. If neither the policy owner nor the beneficiary selects a different option, the insurer will always make a lump sum payment of the face amount of the policy (minus any outstanding loans, interest, or unpaid premiums currently due).

Interest Only

Many policies provide for interest to be paid from date of death, even if a settlement option has not been elected. The interest only option allows flexibility as it permits adjustments to be made in light of changing economic conditions.

Owners or beneficiaries might opt to have the insurer pay interest only – at least for some period of time – in which case the face amount of the death benefit, or the principal, is left with the insurer to be invested and earn interest. The interest is paid to the beneficiary periodically – generally monthly, quarterly, twice a year, or once a year. The policy owner may stipulate the frequency, which the beneficiary may change should they so choose.

Many policies written with the interest-only settlement option also provide that the beneficiary may withdraw all or part of the principal amount at some point. Such a provision can be written in many ways. It can be designed to limit the number of withdrawals or the amount that may be withdrawn at any one time (or within a certain time period). It can also specify that all may be withdrawn after a certain length of time. A spendthrift clause can be used to protect the beneficiary from creditors – if specified in the policy.

Policies may also be written so the beneficiary may not withdraw any of the principal. This raises the question of what happens to the principal amount if the beneficiary dies. There are two possibilities:

The principal is paid to the estate of the now-deceased beneficiary.

The principal is paid to any contingent beneficiary of the original insured.

The first possibility is more typical. Since the money belongs to the primary beneficiary, now deceased, it goes into his or her estate if no alternative arrangement was made when the beneficiaries were designated.

The second possibility occurs only if the eventuality had been pre-arranged at the time of policy issue or prior to the death of the insured. The original arrangement might have been that the contingent beneficiary also receives interest only, rather than the principal amount. But, unless specified otherwise, the principal would at this point be paid in a lump sum either to the primary beneficiary’s estate or to the contingent beneficiary.

Amount Certain

The amount certain settlement option permits the death benefit to be distributed in more than one payment of a fixed amount. This option is either originally specified by the policy owner or selected by the beneficiary. The payment might be made annually, semi­annually, quarterly, or monthly. For example, the beneficiary could receive $2,500 per month for as long as the money lasts. The portion of the death benefit not yet paid draws interest while the insurer controls it. Because of the interest earnings, the final payout will be greater than the original death benefit amount. Dividend accumulations, additions payable, or additional death proceeds, combined with excess interest earned while installments are being paid, will increase the length of time the benefits will be paid. However, they do not affect the amount of each installment.

The amount certain option has more advantages than period certain options because it affords more flexibility. Policy owners can vary the amount of income at different times and beneficiaries can withdraw all or part of the benefit. In some cases, the beneficiaries may have the right to withdraw up to a certain sum in any one year.

Period Certain

Rather than a fixed amount, benefits might be paid for a fixed period of time. The period certain option is an annuity certain over a defined period of months or years (usually not longer than 25 or 30 years). If an insured wants to be certain the beneficiary has at least some income for a certain period of time, this is better than the fixed amount option. Interest is paid on the retained principal. The amount of each payment depends upon the original death benefit amount, interest earned on the decreasing principal, the length of the fixed period, and the frequency of each payment.

Any accumulations of dividends, paid-up additions, or other additional death benefit payments increase the income to the beneficiary, but the number of installments stays constant.

Most companies permit policy owners to give the beneficiary the right to receive the present value of all remaining installment payments in one lump sum. This is called commutation.

Life Income

The life income option pays the death benefit in such a way that the beneficiaries receive an income for the rest of their lives. This option involves the purchase of an annuity contract designed to provide lifetime income (annuities pay a periodic income benefit over a specified period of time). It is not necessary to go into the various types of annuities, but the ones used for settlement options are immediate annuities in most cases. This means that the amount to be distributed will be paid upfront in one lump sum.

The primary advantage of this option is the guaranteed lifetime income. Whether that income is plentiful or even adequate depends upon the amount of the death benefit and the age and sex of the beneficiary. This evaluation uses the rules under which annuities are established. For example, since women live longer than men, a female beneficiary will receive a smaller periodic income than a male beneficiary (all other factors being equal).

Using annuity tables, the insurer establishes the schedule of payments. There are other considerations as well, since a life income annuity option might be set up to benefit more than one person. As an example, the beneficiary might be a husband and two adult children, with the payments continuing to the children after the husband/father dies. In this case, each individual’s portion of the income would be smaller.

Life Income with Period Certain

This option will pay the benefits in installments as long as the primary beneficiary lives. If the primary beneficiary dies before a predetermined period of time, then the installments will continue to be paid to the contingent or secondary beneficiary, until the end of that time.

Example

Jenny was the primary beneficiary under Al’s life insurance policy. Their granddaughter, Leslie, was the contingent beneficiary. Al chose the life income option with a period certain of 20 years so that if he died, Jenny would be taken care of financially. When Al died, the policy benefits allowed a monthly payment of $2,500/month for 20 years. Jenny lived another 5 years after Al. Once Jenny died, Leslie received $2,500/month for the next 15 years.

Under this type of settlement option, the longer the guarantee period, the less the monthly proceeds, and the older the beneficiary, the greater the life income. The problem with this type of option is that the amount of income that the beneficiary will receive entirely depends on the beneficiary’s age. As such, the amount of income that the beneficiary will receive cannot be determined prior to the death of the insured.

Joint and Survivorship Option

Under the joint and survivorship option, the payments are paid for life as long as one of two beneficiaries is alive. In fact, as with all income options, the beneficiaries are annuitants. Depending upon how it is written, this option annuity may continue payments in full (or some fraction thereof) after the death of the first annuitant. These are usually ⅔ or ½ (joint and two-thirds or joint and one-half) payments.

The period certain for this type of option can be 10 to 20 years. This is useful in providing for a retirement income for a married couple.

Individualized Options

Insurers are very flexible in working with the insured and with the beneficiaries, so that all parties are happy. However, the insurance company will not accept any arrangement where it has to exercise its own discretion in fulfilling the terms of the arrangement.

Assignments

Insurance is property – legally and technically – and therefore any ownership rights in a policy can be transferred by the policy owner to another party. The term for this transfer is assignment. There are two types of assignment: absolute and collateral.

Absolute Assignment

As the term would indicate, absolute assignment is the transfer by the policy owner of all rights in the policy to another person.

Occasionally, a life insurance policy is sold for a valuable consideration – usually cash. In business insurance, a policy that is owned by a corporation (key person insurance) may be sold for an amount equal to its cash value upon termination of employment. This is usually accomplished using an absolute assignment.

As stated earlier, an irrevocable beneficiary must consent to an assignment of the policy, as they are effectively a co-owner. The question has arisen as to whether an assignment changes the beneficiary, and the courts are split on this point. It can sometimes be altogether moot, as the new policy owner can change the beneficiary by following the necessary company procedures.

Viatical Settlements

A viatical settlement is the sale of a life insurance policy from a terminally ill party to a third party for more than the cash value of the plan, but less than the net death benefit. The third party then becomes the policy owner, pays the monthly premium, and receives the policy payout when the insured dies.

When the popularity of these plans spiked at the height of the U.S. AIDs epidemic, the NAIC grew concerned over potential abuse by insurers. In anticipation of this, they enacted the Viatical Settlements Model Act. This act requires the settlement firm to disclose certain facts about the transaction, such as eligibility for government benefits, tax implications, the right to rescind, and alternatives such as accelerated death benefits.

Collateral Assignment

Since insurance is property, a collateral assignment is a temporary transfer of only some of the property – policy ownership rights – to another person and is usually used for loans from lending institutions.

The lending institution can collect the proceeds at maturity, surrender the policy and obtain policy loans, receive dividends, and exercise the non-forfeiture rights. On the other hand, the policy owner can collect any disability benefits, change the beneficiary (although subject to the assignment), and elect settlement options (again, subject to the assignment).

The assignee (usually the lender) agrees to pay the beneficiary any proceeds that are in excess of the policy owner’s debt, not to surrender or obtain a loan from the insurance company unless there is a default in premium payments (or default on the debt), and to forward the policy to the insurance company for any change of beneficiary or change in settlement options.

Policy Loans

Virtually all permanent life insurance contracts contain provisions allowing the policy owner access to the cash value of the contract. Policy loans generally enable the owner to borrow up to 90% of the policy’s total cash value, essentially turning it into a living benefit while keeping the contract in force. Each contract will specify the amount of the policy that is available to loan and how interest shall be calculated and collected.

Interest

Currently, most states permit insurance companies to charge interest rates of up to 8% on policy loans. The policy can specify a fixed interest rate or tie the rate formulaically to a known index, such as Moody’s or Standard and Poor’s. While the policy owner is not required to repay the loan amount’s cash value, the loan interest must be paid on an annual basis. However, the mode of payment is completely at the policy owner’s discretion. This means that it can be paid in cash or added to the total value of the loan amount. As one might expect, the latter option increases the overall interest amount that will accrue.

It should be noted that state insurance laws generally restrict the ways in which interest may be charged on loans from variable life insurance policies.

Direct Recognition

Direct recognition is the immediate consideration of present interest rates, mortality experience, and expenses in premiums currently charged. This is critical to the formulation of current assumption whole life and universal life products.

Under the direct recognition principle, a policy loan can have a significant negative impact on dividends paid under participating policies. When determining the dividends to be paid on a particular policy, companies that use direct recognition take into account two factors. The first is the interest rate the insurer earns on the loan. The second is the dividend interest rate the company assumes it would have earned on the cash value if it had not been borrowed. The difference in these two values reduces the dividend.

Example

Frank has an outstanding policy loan of $5,000. He is paying 7% interest, and the insurer assumes a dividend interest rate of 10%. The dividend that is due to be paid is $500.

Since the $5,000 loaned to Frank is not available to earn the assumed rate of 10%, the insurer earns only the 7% interest paid by the borrower: 3% less than assumed. 3% of $5,000 is $150, so this amount is subtracted from the dividend paid. Instead of receiving the full $500 dividend, Frank receives only $350 because of the outstanding loan.

Insurers believe direct recognition is a fairer proposition for all policy owners because it rewards those who do not borrow money. Under this arrangement, those who do not borrow “earn” the higher dividend because all cash value remains with the insurer for earning purposes. Borrowers receive a smaller dividend because not all of their cash value is available to the insurer to earn interest.

Interest Paid on Borrowed Values

When the insured borrows from a universal or variable life policy, the insurer might then pay a lower interest rate on the amount equivalent to the loan. The portion of cash value remaining in the policy still receives the higher current interest rate, while the borrowed portion often receives the initial [minimum] guaranteed rate. Additionally, universal life policy loans might be “wash loans,” wherein the interest charged on the loan cancels out the interest paid on its collateral cash value.

Policies other than universal and variable life also have arrangements for paying a lower rate on loaned cash values. Some companies, for example, pay 1% less on the loaned values than on the remainder of the cash value.

Loan Repayment

Because borrowing cash values represents a loan, repayment is expected even though the loan need never be repaid. The policy owner may continue paying interest on the loan indefinitely. The negative consequences of not repaying loans from cash values include:

Reduction of the death benefit by the amount of the loan and any interest due if the insured dies with the loan outstanding.

Reduction of the surrender value if the policy owner wants to terminate the policy and take the entire cash value.

Effect on dividend payments in participating policies.

Reduction of interest earned.

Potential depletion of values.

Lapse of universal or variable policies caused by depletion.

If a policy is about to lapse because of outstanding loans and/or interest due, the insurance company must notify the policy owner in time to repay the loan or make premium payments to keep the policy in force.

Reinstatement Clause

The reinstatement clause allows the policy owner to reinstate a policy that had lapsed, under certain conditions. The most important requirement is to furnish evidence of insurability and pay past-due premiums.

Without a requirement for evidence of insurability, the company would be especially susceptible to adverse selection. It would be common for an individual to allow a policy to lapse, and then discover that it would be for their benefit to keep the policy in force. Therefore, the company requires the insured to furnish satisfactory evidence of insurability. While good health is the usual requirement, the company may also require information on the insured’s travel habits, occupation, financial condition, etc.

What is interesting about this provision is its relationship to the incontestable clause. If a policy is reinstated, what happens? Does the incontestable period start all over again?

While laws are not very clear on this matter, the general practice is to also reinstate the incontestable clause, making the policy contestable again, but only with regard to statements made in the reinstatement application. While other jurisdictions state that the original incontestable clause is still in effect (period dated from policy date), there are a few jurisdictions that take the view that the reinstatement is a separate contract that has no incontestable period. This is hardly fair because it also means that the policy can be contested for fraud at any time.

Notably, albeit unsurprisingly, courts have been almost unanimous in holding that the suicide clause does not run after reinstatement.

With respect to past-due premiums, there is a legitimate argument that there should be no premiums due for past mortality charges, as no coverage was provided during the lapse period. Therefore, some jurisdictions limit the past-due premium to the increase in reserves between the time of lapse and reinstatement.

Incidentally, reinstatement is not permitted if the policy has been surrendered (or continued as extended term insurance) and the full term of the policy has expired. If the extended term portion has not expired, most companies will reinstate the policy with little or no evidence of insurability. Regardless, reinstatement seldom is allowed if more than five years have elapsed since the policy lapsed.

Misstatement of Age

Policies are required in most jurisdictions to have a misstatement of age provision, which simply mandates that if the insured’s age is found to have been misstated, the amount of insurance will be adjusted to be that which would have been purchased by the premium paid if the correct age were known.

If the misstatement is determined when the policy is in force, and if the age is understated, usually the insured has the option to pay the difference in premium with interest or have the policy reissued at the proper amount to match the premium. If the age is overstated, a refund is usually made by paying the difference in reserves. This provision appears in policies so that a misstatement of age cannot be considered a misrepresentation and thus be used to void the policy.

Renewal Provisions

Life insurance policies can be continued by payment of premiums in a timely manner and for the length of time contracted. Most individual life insurance policies stipulate the guaranteed maximum premium that can be charged by the insurer.

Chapter 3: The Insurance Contract Section 2 (Part 2)

Optional Riders/Benefits

The riders discussed in this section are optional. However, if underwriting requires a rider to be attached to a policy, the policy owner would be advised in advance. Some riders are mandated by law. Riders are even used for substandard risks, as any time the premium increases for underwriting purposes, the insured is informed by a rider so stating. These types of riders are not discussed in this section as they are not among the typical types of riders.

Waiver of Premium

The waiver of premium rider allows the policy to continue without further premium payments if the insured becomes disabled and cannot work. In essence, the insurer takes over the premium payments. The key to this rider is understanding what the insurer means by disability.

Total disability is the inability of the insured to perform any and all important daily duties of that insured’s occupation.

Most companies require six months of continuous disability before the waiver of premium (WP) provision applies. A disability is covered if it begins prior to age 65 (usually) and will continue as long as the insured continues to be disabled. If the disability occurs between ages 60-65, it is common practice for the waiver to cease at 65.

WP is not a continuance of premium, but is a benefit for which there is a premium. Therefore, dividends continue (if the policy participates), cash values continue to increase, and loans may be obtained. WP is in fact a benefit that pays an amount exactly equal to the premiums when the insured becomes disabled.

Benefits will not be paid if the disability results from:

Commission of a crime by the insured.

War or other military action.

Self-inflicted injury.

There are three different provisions regarding WP riders on term policies upon conversion to a permanent plan:

If the insured is totally disabled, the term policy premiums will be waived, but if the policy is converted, the premiums will not be converted on the new permanent policy.

Some companies will honor the waiver of premium on the new permanent policy.

Some companies provide for a waiver of premium on both the term policy and the permanent policy, provided the conversion occurs at the end of the automatic conversion period (when the new permanent policy automatically goes into force, and premiums on the new policy are waived).

Universal Life

When the waiver of premium rider is attached to a universal life policy, the rider works differently than with whole life or term. The usual approach is that the insurer waives only the portion of the premium payment that actually pays for the insurance protection – the mortality charge. Some universal life providers do offer a waiver of premium rider that calls for the insurance company to pay the entire premium. This is advantageous, as it allows cash values to continue growing as originally anticipated. The amount the company pays is limited to the planned premium established when the policy was issued.

Payor Benefit Rider

The payor rider is a form of waiver of premium and is usually written on policies insuring children. With the payor rider, if the person paying the premiums either becomes disabled (under the same conditions described for the waiver of premium rider) or dies, premiums are waived. Disability or death must occur before the child reaches a certain age – usually 21 or 25. Some payor riders, instead of waiving the premiums for disability, do so only if the payor dies.

Payor riders generally require a medical history and exam for the person who is paying the premiums, since it is this person’s health, rather than that of the insured child, that could activate the waiver.

Accidental Death

Accidental death is typically defined in a policy as “death resulting from bodily injury effected solely through external, violent, and accidental means, independently and exclusively of all other causes, with death occurring within 90 days after such injury.”

The accidental death rider (also known as “double indemnity”), when added to a life insurance policy, provides that double (or triple) the face amount of the policy will be paid if the insured’s death is the result of an accident. There is no reason, either philosophically or financially, that a person who dies from an accident should receive so much more insurance benefit than one who died of disease. The popularity is principally because it is relatively inexpensive, and many people just “feel” that they will die from an accident. In actuality, less than 10% of all deaths are the result of an accident.

The accident must be the sole cause of death, and if other factors contributed to the death in addition to the accident, the rider does not apply. Both the cause and the result of the death must be accidental.

Death must occur no more than 90-120 days after the accident, depending on the rider. Some courts have held that the period does not have to be strictly applied. Accidental death coverage usually expires between ages 65-70. Premiums are based upon age at issue.

Certain exclusions apply. Three are the same as for the WP Rider, plus the following:

Death from an accident accompanied by physical illness, mental illness, or disease.

Death from aviation accidents except when the insured was a paying passenger on a common carrier.

Death by accident while the insured was under the influence of alcohol or other drugs.

Death resulting from circumstances that do not appear to be accidental – an exclusion that might require legal action to prove or disprove accidental death. Insurers list the circumstances that apply.

Accidental Death and Dismemberment

Some companies offer an accidental death and dismemberment rider that has the same features as the accidental death rider, plus a benefit paid if the insured suffers accidental dismemberment of specified parts of the body, rather than death. The rider usually applies to loss of eyesight and loss of members such as arms, legs, hands, and feet.

A typical benefits schedule might appear as follows (note: “principal sum” is the face amount of the benefit rider):

LOSS AMOUNT PAID

Sight in both eyes  Principal sum

Sight in one eye     Half of principal sum

One member         Half of principal sum

Two members        Principal sum

Disability Income Rider

Similar to the waiver of premium rider, the disability income rider pays a monthly income directly to the disabled person. The insured must be totally disabled to receive payments and the definition of disability follows the standards described for waiver of premium. The same exclusions also apply.

Disability income riders provide a relatively modest amount of income —commonly $5, $10 or $15 per $1,000 of life insurance coverage. Most companies also require a three- to-six month waiting period following disability before monthly payments begin. After the waiting period, payments are retroactive to the first day of disability.

Accelerated Death Benefit Rider

The accelerated death benefit rider provides for the payment of all or a portion of the death benefit of the policy prior to the insured’s death, if the death is caused by a specific medical condition. There are three types of accelerated death benefit riders.

Terminal Illness

Terminal illness coverage stipulates that a specific percentage of the face amount, such as 25% or 50%, will be paid if the insured is diagnosed with a terminal illness. Generally, the coverage will specify that the insured has no more than six months to one year to live. A physician must certify the terminality of the illness. Additionally, a hospital or nursing home and/or a medical exam ordered by the insurer must provide the same certification.

Insurers usually notify beneficiaries and assignees of an acceleration of benefits. Dividends and cash values, plus death benefits and premiums, will be reduced by the accelerated percentage.

Catastrophic Illness

The catastrophic illness coverage closely resembles the terminal illness coverage, except that the insured must have been diagnosed with one of a number of specified diseases (also known as dread diseases) such as stroke, cancer, heart attack, coronary artery surgery, or renal failure.

This coverage is not as widely advertised or available as it once was, as it has received heavy criticism from insurance departments and public officials due to alleged fear-based sales tactics and difficulties with claims handling. The NAIC has published Accelerated Benefits Model Regulation, which specifies the illustrations that must be provided for prospective purchasers.

Long Term Care Coverage

This final type of accelerated death benefit provides that monthly benefits will be paid if the insured is diagnosed with a chronic medical condition and requires assistance with daily care. Qualifications are strict and their specifics vary by company and individual policy. In general, activation of this benefit requires the following:

Diagnosis of a qualifying chronic illness by a licensed medical practitioner. Examples may include:

Alzheimer’s disease

Arthritis

Asthma

Cancer

Crohn’s disease

Diabetes

Epilepsy

Mood disorders

The diagnosing professional must certify that the condition restricts the performance of at least two of the six activities of daily living (ADLs):

Eating

Bathing

Dressing

Toileting (including related maintenance of personal hygiene)

Transferring (moving unassisted to and from a bed or chair)

Contingency

Due to the restrictiveness of most Long-Term Care benefit riders, there are often additional requirements that must be met satisfactorily to activate these benefits.

Generally, the elimination period is anywhere from two to six months, with some insurers requiring that the policy be in force for a specified number of years before this benefit is triggered.

The monthly benefit typically equals 2% of the face amount of the life insurance policy, subject to a specified maximum amount and a specified total maximum payout. Some companies use a two-tiered approach so that the percentages are reduced in relation to the face amount, such as 2% of the first $100,000 of face amount and 0.5% of the amount over that. The maximum payout is generally 50% of the face amount of the policy.

Note: Some financial planners have suggested a long-term care rider on a life insurance policy instead of a separate long-term care insurance (LTC) policy. There is a danger in this, as in many situations, it is less expensive to purchase both a life insurance policy and a long-term care insurance policy. In addition, the LTC policy has much greater flexibility and more benefits.

Guaranteed Purchase Option

The guaranteed purchase option (GPO) or guaranteed insurability rider can protect policy owners from potential future uninsurability, which would prevent them from purchasing additional life insurance at such time. This rider may be used with cash value policies only and typically may be used only to purchase more cash value coverage. This means that a term policy would not offer this option at all.

Guaranteed purchase riders are offered to younger people who are more likely to remain healthy. The option to purchase more insurance without proving insurability generally ends at the insured’s age 45, but an insurance policy can stipulate a different age.

The insurer offers a number of option dates on which the insured may elect to purchase additional insurance. These standard dates are usually about three years apart and the quantity available depends upon the insured’s age when purchasing the rider and the age at which the option expires. For example, with three-year periods and an option ending at age 40, a 25-year-old could purchase additional coverage at ages 28, 31, 34, 37, 40, and 43, totaling six option dates. A 34-year-old with the same rider would have only three dates at ages 37, 40, and 43.

In addition to these three-year checkpoints, most insurance companies also permit the purchase of additional coverage after the birth of a child, a marriage, or other life events specified in the policy. Overall, riders with this provision cost more than the standard rider.

Aside from the most evident advantage – that the insured need not provide evidence of insurability at later dates – additional future purchases are not subject to new incontestable or suicide provisions. However, since the insured’s age at the time of purchase factors into the cost of additional coverage, there are no price guarantees for these future additions.

Finally, insurance policies enforce a ceiling on the amount of insurance that the GPO can offer. Once the policy owner passes an age (or event) that enables them to purchase additional insurance, they cannot make another purchase until the next available option date. If the policy owner declines to take advantage of an option, that particular option lapses. Often, if a policy owner declines multiple options sequentially, future options are forfeited.

Cost of Living Rider (COLA)

The cost-of-living adjustment rider helps the amount of insurance to correspond with inflationary increases as measured by the consumer price index (CPI). For example, if the CPI rises 1.5% over a year’s time, the policy owner may purchase more insurance equal to 1.5% of the policy’s face value. An upper limit applies and is typically 10% of the face value.

Cost of living riders usually allow the purchase of one-year term insurance that is added to a whole life policy. Some permit a small amount of whole life as paid-up coverage and others might allow a combination of one-year term and the paid-up addition of whole life. If the policy is universal life, the death benefit is simply increased. The COLA rider is usually available only with cash value policies, rarely with term insurance.

The policy owner may choose whether to activate the cost-of-living rider, but must specifically decline it if no additional coverage is desired. Under universal life policies, policy owners must be extremely clear about their desires because if they skip a premium, the insurer will automatically adjust the cash value account to pay both the premium and the cost of adjusting the death benefit to the CPI.

Term Rider

This text previously referenced term riders that are attached to a life insurance policy to enhance its benefits. Term riders may only be attached to cash value policies and the period during which the term rider is in effect may not be longer than the premium-payment period of the cash value policy. The cost of the term rider is added to the cost of the cash value policy, so the policy owner pays a single premium.

Term riders are less costly than separate term policies, but they may be purchased only in conjunction with a cash value policy. As such, the total cost is greater.

Once the term rider is purchased, the insured may not let the cash value policy lapse, while only maintaining the less costly term rider. An insured may, however, cancel the term rider while retaining the cash value policy. However, this practice is discouraged.

The term rider may provide level term coverage or increasing or decreasing term coverage. Most buyers in the contemporary market purchase the coverage to be added to the base policy so that they can purchase a high-value term life insurance rider, or a rider that permits them to make additional premium payments to accelerate the cash value buildup. This may or may not increase the death benefits.

disclosure to the policy owner. If a person’s financial planning is built around a highly liquid, but extremely low-risk plan, VLI is not a suitable alternative to traditional life insurance.

Chapter 4: Traditional Life Insurance (Part 1)

Term Life Insurance Policies

Term life insurance is the simplest and most basic form of insurance. Term life insurance provides either level or decreasing death benefits, and in some cases, increasing death benefits (usually a rider to a policy). The majority of life insurance sold in the U.S. – and likely worldwide – is term insurance, which provides for a level death benefit over the period of the policy, with either level premiums or premiums that increase with age.

Renewable Term Policies

When a term policy has level death benefits with increasing premiums, it is considered a renewable term policy. Yearly renewable term policies (also known as annual renewable term) are the simplest forms of term policies. Also available are 5-year, 10-year, 20-year, and various other durations of renewable term policies. (These are all increasing premium policies.)

Some insurance companies have recently moved away from yearly renewable term (YRT) policies. Such policies traditionally have high lapse ratios and low premiums, leading to unprofitable business. Premiums remain low because policies that compete with YRT, and similar policies offering only death benefits, are purchased mostly on a cost basis.

In addition to lower premiums, companies vary their pricing in other areas. For instance, it is common practice to establish different premiums for smokers and non-smokers. This discount for non-smokers can be substantial – as much as 50% with some companies. When the smoker/non-smoker premiums were developed for general use, actuaries took into consideration the difference in mortality between smokers and non-smokers and decreased the premium for non-smokers, creating a block of preferred risk insureds. Logically, if those with more favorable mortality statistics were removed from the general population, then those remaining would be considered sub-standard, warranting higher premiums.

When companies tried to suggest raising premiums on smokers, marketing departments howled in protest, with the result that if a company raised the premiums on smokers, their agents would write non-smokers and (unless they were captive agents) would place the smokers with those companies that did not differentiate or did not have separate premiums for smokers and non-smokers. This would mean that those companies that accepted the smoker risks would suffer worse mortality than expected particularly those who made no distinction.

The introduction of a re-entry feature established another unique pricing method. The insured may periodically – typically once every five years – be allowed to reenter the lower-priced group of policy owners who have already reentered. The company will lower the insured’s premium upon receipt of current evidence of insurability.

Technically, those who enter at the end of the re-entry period will see premium reductions based on first-year select mortality for their attained age. Select mortality is derived from a table showing the mortality of only those persons who have purchased insurance during the past year. These tables clearly show that such people have a much lower mortality rate in the years immediately following their insurance purchases.

The reasons for this are evident. Unlike those who have been insured for significantly longer, the newly insured have recently passed medical (and other) tests, and, of course, are younger. The mortality curve, which shows the increase in likelihood of death as individual’s age, will show much lower probabilities on such a select basis than those shown on an Aggregate Mortality Table, which encompasses the general population.  Unsurprisingly, the mortality rate of these newly insured is also significantly lower than that of the Ultimate Mortality Table, which assesses the entire group of insureds, except for those within the initial post-purchase period.

Example

Ralph, 40, considers purchasing $100,000 of term life insurance with no re-entry feature. The premium is $185. He also considers a policy with a five-year re-entry feature. The initial premium is $138. However, at the end of five years, the non-re-entry premium would be $228. With submission of evidence of insurability, his re-entry premium would remain $138, which is a 25% savings over the regular term. Ralph must also take into consideration whether he believes his good health will continue through future re-entry dates.

Level Premium Policies

Term insurance may be written for a specified period of years – typically 10 or 20 – or to age 65. Life expectancy term provides level premiums for the expected lifetime of the insured, according to the specified mortality tables. This would lead to some cash value, as non-forfeiture value laws would apply. However, the cash value increases to an upper limit and then decreases to zero by the end of the policy period.

Term-to-age-65 (or a later age, such as 70) provides insurance for a shorter period of time than life expectancy policies. This type of policy is used mostly for life insurance protection during the working years of the insured. The cash values perform as with the life expectancy term policy.

Varying Face Amount Term Insurance

Decreasing Term

Decreasing term, where the face amount decreases over time, is sold in considerable quantity in the U.S. A primary use of decreasing term is for mortgage protection. With such policies, the face amount decreases in value parallel to the decreasing mortgage. This guarantees funds to pay off the mortgage in the event of the insured’s death. The disadvantage of using decreasing term for mortgage protection is that the death benefit does not precisely match the decrease in the amount of mortgage remaining. As anyone with a mortgage can attest, the early years of payments yield extremely gradual decreases in the mortgage due to interest on the unpaid amount. Decreasing term can be written on its own policy or as a rider on another policy.

Increasing Term

Increasing term insurance is seldom sold as a policy. Generally, it is sold as a rider to a permanent insurance plan. Historically, it was popular as a COLA rider during times of unrest and provided for automatic increases in the policy death benefit. These increases referenced a designated index, such as the Consumer Price Index. Increasing term insurance does not require evidence of insurability, so long as the insured continues to accept the added premiums and increased death benefits each year. Traditionally, a separate premium notice is provided to the policyholder each year.

Endowment Insurance

Although endowment insurance is far less popular now than in its heyday, the history of its use has significantly affected current tax law and insurance practices. As such, it is important to understand why.

In contrast to traditional life insurance (and pure endowments, which only pay benefits if the insured lives to the end of the contract period), endowment insurance pays a death benefit at whichever of two events occurs first – the end of the designated accumulation period or upon the policy owner’s death. Its purpose is to provide the policy owner with a predetermined dollar amount to ensure the fulfillment of a specific future financial need.

Especially before the 1970s, endowment policies were significantly more prolific than they are presently. They were generally used to accumulate a specific amount of money for a single purpose, such as for generating a grandchild’s education/college fund (e.g., $20,000 from birth to age 18) or to amass a guaranteed sum of retirement income (e.g., $100,000 from age 40 to age 65). Some insurers still issue endowments for these purposes. However, their rarity and specificity render them exceptionally pricey, causing most potential purchasers to consider alternative financial strategies. So, what did happen to these endowment policies?

In the 1970s and ‘80s, inflation catapulted into the double digits. As a result, most consumers sought savings and investment vehicles other than standard life insurance policies, whose long-term, fixed-dollar amounts became particularly unappealing in the wake of such severe inflation. Because of the existing tax advantages within permanent life insurance, many companies began offering single-premium products that enabled consumers to accumulate significant savings on a tax-deferred basis. Essentially, the owner of such a policy could withdraw both principal and interest as a tax-free loan, so long as the policy would not lapse prematurely. As one might expect, this certain type of life insurance has become an extremely attractive tax shelter.

The use of life insurance as protection from taxation persisted through the late 1980s until Congress passed the Technical and Miscellaneous Revenue Act (TAMRA) in 1988. TAMRA redefined certain life insurance products as modified endowment contracts (MECs) and as such, eliminated their ability to serve as tax shelters. By limiting premiums on permanent life insurance and endowment policies, the act heavily restricted the once marginally regulated practice of tax-safe withdrawals.

Currently, the IRS considers a life insurance policy to be a MEC when it meets three criteria:

It is issued on or after June 20, 1988.

It meets the statutory definition of a life insurance policy.

It does not meet the 7-pay test contained in TAMRA.

The 7-pay test compares the total value of premiums paid for a policy during its first seven years with the amount required to pay up the policy in that same period. If the total amount of premiums paid is less than the amount to pay up the policy, it is a life insurance policy. If this sum of premiums is greater than the pay-up amount, the policy is a modified endowment contract.

In a non-MEC life insurance policy, withdrawals from the cash value are usually made on a first-in, first out (FIFO) basis. This means that the first dollars withdrawn are considered the returns of paid premiums and therefore are not taxed. The remaining funds in the contract are considered gains and are taxed as ordinary income in the year they are withdrawn, but are not accessible until the full amount of premiums is paid out.

Withdrawals from a modified endowment contract are taxed in the opposite fashion. A policyholder who withdraws cash value from this type of policy is taxed on a last-in, first-out (LIFO) basis. In essence, the policy’s gained amount – the interest accumulated via the cash value – is the first source of withdrawals. These withdrawals are taxed as ordinary income in the year that the owner takes them. The policy owner cannot withdraw the tax-advantaged cost basis (cash value) until first depleting the entirety of the policy gain. Additionally, if a policy owner withdraws from a MEC before reaching age 59 1/2, the withdrawn amount incurs a federal tax penalty of 10%.

Under TAMRA, the IRS considers all single-premium life insurance policies to be modified endowment contracts.

Whole Life Insurance

As previously discussed, whole life insurance pays a death benefit (the policy’s face amount) upon the death of the insured – regardless of when the death occurs. Therefore, whole life insurance is essentially any type of life insurance that can be maintained indefinitely. As a result, a universal life insurance policy with sufficient cash value may also be considered a whole life policy.

Traditional whole life policies have lost a lot of market share to newer interest-sensitive products, such as universal life and variable universal life. These new products were introduced when interest rates were relatively high, and agents were able to use projections showing larger interest growth than traditional life. Many insurers believed that the high rates shown in the illustration would continue, so when the interest rates fell, the actual results did not meet the results expected by the insureds, leading to frequent undesirable consequences (and lawsuits). The use and abuse of financial projections are discussed later in this text.

Companies issuing traditional participating whole life policies were not affected so severely because they could credit higher rates of interest through dividends. These interest rates are predicated on the interest received on the entire portfolio of the company, and portfolio rates change much more slowly. Therefore, when interest rates fall, Universal Life products do not fare as well as traditional policies.

To better compete, companies offering traditional whole life introduced flexible provisions such as allowing the policy owner to determine their own future premium payments (within company and tax maximums and minimums).

Limited Payment Whole Life

Limited payment whole life insurance is a way for a policy owner to experience all the benefits of a whole life insurance policy without having to make premium payments for the lifetime of the insured. Insurance companies often refer to these policies as limited-pay whole life.

Like the face amount in a traditional whole life policy, the face amount in a limited payment policy is guaranteed to remain level for as long as the policy remains in force. The policy’s other features match those found in traditional whole life contracts, except for the number of years during which premium payments are required.

The contract’s information page will state the number of years for which premium payments must be made—such as 10 or 20 years—rather than to a specific maturity date (i.e., the insured’s age 95, 100, or 120). Obviously, the modified premium-paying period affects the accumulation of cash value. “Limited payment to age 65” contracts are common.

Current Assumption Whole Life Insurance

A current assumption whole life (CAWL) product serves as a bridge between traditional insurance and more contemporary interest-sensitive products. For this reason, many refer to it as “interest-sensitive whole life” or “fixed-premium whole life.” The CAWL provides non-participating whole life insurance under a more modern and transparent format.

Much like universal life, CAWL policies are “unbundled.” This means that there is a stated allocation of premium payments and interest earnings to the mortality charges, expenses, and cash values. Specifically, the premiums paid are charged for expense charges, and the remainder is a (net) addition to the policy fund. Contrast this with the traditional whole life policy, where the policy owner has no insight into how these funds are allocated.

The CAWL can be either a low-premium or a high-premium plan.

CAWL Low-Premium Plan

In a low-premium plan, the initial indeterminate premium is lower than that of a traditional whole life policy. Consequently, this policy includes a provision allowing the company to re-evaluate the premium using new assumptions for future mortality and/or interest, so long as the assessment remains within the guaranteed assumptions stated in the policy. When the premium is re-determined so that it combines with the existing account value, it should be sufficient to maintain a level death benefit for the life of the policy – if the new assumptions are proven correct. If these new assumptions are higher or lower than those used at the time of issue, the premiums will be adjusted accordingly. If the assumptions are the same, the premium will remain the same.

If the new premiums are lower than the previous premium, the policy owner has three available options:

The policy owner may pay the new, lower premium and keep the previous death benefit. This is generally the most popular choice.

The policy owner may elect to continue to pay the previous premium, maintain the same death benefit, and pay the difference into the fund.

The policy owner may continue to pay the previous premium, but use the difference to purchase an increased death benefit. If this option is chosen, its approval may be subject to the insured’s evidence of insurability.

If the premium is higher than the previous premium:

The policy owner may pay the new, higher premium and keep the previous death benefit.

The policy owner may elect to continue to pay the previous premium, but accept a lower death benefit that the new higher premium can then fund.

The policy owner may continue to pay the previous premium and keep the same death benefit, using some of the cash value to pay the additional premium. This option is usually available only if the account is at a determined level for at least five years in the future.

CAWL High-Premium Plan

The high-premium plan is, as the name implies, relatively high. However, there is a guarantee that the premium will not exceed a stated amount. Some high-premium policies offer a vanishing premium feature that states that the decrease in premiums will continue as long as it exceeds the minimum cash value. Policy owners have been known to confuse this option with a paid-up life insurance policy wherein the policy has no more premiums to be paid.

There are many variations of this policy – some of short-lived duration. The principal difference between CAWL and Universal Life is that the CAWL has a required premium, making it easier for companies to administer. Furthermore, the company has greater control over the cash value accumulation.

Additionally, many argue that it “forces” the payment of an established premium amount. This mirrors one of the well-established advantages of life insurance as a savings or investment vehicle, as many consumers do not consider themselves as having the personal discipline to pay flexible premiums.

Modified Whole Life Insurance

A modified whole life insurance policy is one whose initial premium rate is considerably lower than that of a typical whole life policy. This modified rate period generally lasts between one and five years, after which the premium increases to a rate comparable to other whole life policy premiums. The most notable difference in a modified policy’s behavior is that, unlike a standard whole life policy, it does not acquire cash value during the period of modified premiums. In most cases, this also serves as a waiting period during which death benefits are not payable. Generally, a non-accidental death that occurs during this period would only warrant the return of premiums paid with any interest accrued.

Final Expense Insurance

An extremely common application of modified whole life is final expense insurance, also known as funeral or burial insurance. It typically provides a relatively small amount of insurance, ranging from $2,000 to $50,000, as a form of affordable coverage that can then pay final expenses (burial, cremation, etc.). Generally, this type of policy is marketed toward individuals age 50 and older, who are more apt to consider providing insurance to pay for their final expenses. Often, it is structured to fund a funeral pre-arranged with a specified funeral provider. The underwriting process is also generally limited to a medical questionnaire.

Juvenile Insurance

Typically, juvenile insurance is a whole life policy on the life of a child, issued as an additional rider on a parent or guardian’s application. The purported functions of juvenile insurance are principally as a guaranteed college fund or as a “grow-up plan.” It is also marketed as a guarantee that there will be some life insurance for the child if they face difficulty qualifying later on. However, many agents and financial planners insist that the premiums paid for a child would be better spent as additional coverage for the parent/guardian. [1] The notion is that the death of a child incurs very little financial loss, but the death of a parent/guardian could result in severe hardship.

Joint and Survivorship Life Insurance

Some people want to buy life insurance that covers multiple individuals on a single policy. The premium for this policy is usually less expensive than purchasing separate policies and the underwriting eligibility is usually less stringent. Such policies are sold using both whole life and term contracts.

Joint Life Policies

A joint life policy is also referred to as a first-to-die policy. It is designed to insure multiple people and pay a death benefit when the first insured person dies. Joint life policies are common options for couples who have financial or insurability constraints. The premium charged for a joint life policy will be greater than the premium charged for an individual policy issued to either of the two applicants. However, it is usually less than the combined premiums charged for two individually-issued policies.

Many joint life contracts offer an option that allows the policy to be converted to individual policies on the lives of the insureds. Business partners and stockholders in closely held corporations may use this type of policy, often with special riders added to address requirements of buy-sell agreements, surviving partners of shareholders, and unequal ownership interests.

Survivorship Policies

A survivorship policy, also called a second-to-die policy, is designed to insure two people and pay a death benefit to one or more others designated as beneficiaries – usually heirs to the insureds. Since neither insured receives death benefits from this type of policy, survivorship life insurance is commonly used as an estate-planning tool. Ordinarily, married couples purchase joint and survivorship life insurance. However, applicants do not have to be married to qualify. In fact, insurers may offer coverage for up to three or four joint applicants. The primary underwriting concern for the issuance of these policies is that the multiple insured persons have shared assets. Examples of eligible applicants include spouses, domestic partners, and business partners.

References

[1] https://www.forbes.com/sites/forbesfinancecouncil/2018/02/27/dont-fall-for-the-life-insurance-industrys-juvenile-trick/?sh=7306e14c71b3

Chapter 4: Traditional Life Insurance (Part 2)

History Lesson: Disintermediation

Any discussion of traditional life insurance is not complete without addressing the historical problems of disintermediation.

In the early 1980s, whole life policyholders surrendered these policies for their cash values and transferred these sums to non-insurance products that paid higher interest. In response, insurance companies developed interest-sensitive policies.

Due to this disintermediation, insurers needed to liquidate bonds and other securities at significant discounts. As a result, dividends paid on participating policies could not compete with interest on current assumption policies. Companies tried to alleviate this problem by adapting older policies to be more competitive, hoping to retain their existing customers.

Although insurers had tended to pay higher dividends than necessary, falling interest rates required them to reduce payments to a level below what the policies illustrated. While some insurance companies maintained higher interest rates in order to salvage their customer base others began making high-risk investments to mitigate the decline in returns.

Although rare in the 1980s, 1035 (non-taxable) policy exchanges became a saving grace for many insurers. Some companies used internal exchanges to save themselves, while others would solicit policies from other companies.

Nonetheless, by the early 1990s, some large companies and several small ones became insolvent or fell under the protection of the insurance departments.

Group Life Insurance

Group life insurance is a rather self-explanatory umbrella term for a single insurance contract that covers a group of insureds. It occurs most commonly in the context of employer-employee or organization-member relations.

Essentially, group life insurance is yearly renewable term insurance. Group premiums are paid monthly with the exception of those for certain smaller groups. These premiums may instead be paid quarterly. While insurers usually guarantee premiums for one year only, they may extend this guarantee for competitive purposes.

One common form of group insurance is credit life insurance, which provides a benefit that is equal to the unpaid amount owed to the institution by the consumer. The creditor, which is usually a bank or a finance company, is both the policy owner and beneficiary. Usually, the debtor pays the premiums while any dividends go to the creditor.

Predictably, group credit life insurance can be very profitable to the lender and quite prone to abuse from unethical insurers. In response, most states now have maximum chargeable rates. Furthermore, most states prohibit the purchase of credit life insurance as a prerequisite for obtaining a loan.

Group life insurance often includes an accelerated death benefit, which pays a portion of the face amount of the policy in case of the terminal illness of the employee.

Group Insurance Requirements

While NAIC guidelines don’t require a minimum number of eligible participants, most states do set specific numbers for group life insurance policies.

Generally, only active, full-time employees are eligible for group coverage. The contract usually specifies types of eligible employees who must be covered – typically classifying them under such categories as “salaried employees” or “all hourly employees.” Furthermore, the employees actively work for a standard number of hours per week and the employer providing coverage must be their primary, regular job on the date that they become eligible for coverage.

Onboarding and Offboarding

Employers typically establish a probationary period – usually from one to six months – during which the employee is not eligible for coverage. Under a contributory plan, in which the employee pays part of the premium, the employee then enters an eligibility period of 30-45 days, during which they must apply for insurance. They do not need to submit evidence of insurability.

For noncontributory plans, there is no eligibility period. All employees automatically enter the plan after having completed the probationary period.

Most often, employees are covered for however long they remain with the employer. Furthermore, the employer has the right to continue coverage for employees on temporary leave and upon employee termination. This coverage usually spans 31 days.

Usually, the benefit amount is determined in one of four ways:

As a preset amount for all employees

As a percentage of the employee’s income from the providing employer

As an amount designated for the employee’s job title

Based on the employee’s length of service

Terminated employees may usually opt to convert their group life policy into an individual cash value policy within 31 days of termination. The insurer then pays the death benefit under the group policy within 31 days after the insured withdraws from the eligible group.

Taxation

Current U.S. law dictates that the employee’s first $50,000 of group term life insurance is non-taxable income. However, any amounts exceeding $50,000 may be considered a “taxable fringe benefit.”[1] If the employee contributes toward the plan, then the amount of the contributions is allocated to excess coverage. The formula for determining an employee’s taxable amount is as follows:

Begin with the total amount of an employee’s coverage for each month of the taxable year.

Subtract the $50,000 exemption from each month’s coverage.

Apply the appropriate rate based on the IRS-furnished uniform premium table to any balance for each month.

Subtract the total annual employee contributions from the sum of the monthly costs.

Example

Lourdes, age 45, receives $150,000 of group term life insurance from her employer. She contributes $30 per month for this coverage, or 20 cents per $1,000 of coverage.

Based on this formula, Lourdes had no taxable income for this amount of coverage.

Group Paid-up Insurance

Usually, this is on a contributory plan and the employee’s contributions go toward units of single premium whole life insurance. The employer’s contributions provide an amount of decreasing term insurance, when added with the amount the employee pays for, equals the total amount for which the employee is eligible. Then at retirement, the term insurance portion is discontinued, and the paid-up insurance remains in force on the employee for the remainder of his/her life.

Group ordinary insurance can be any traditional plan (except group paid-up) that provides the cash value life insurance to employees, where the cost of the term portion is paid by the employer, and the cash value portion is paid by the employee (which the employee may refuse to accept).

Group universal life has the typical guaranteed interest rate and a fixed death benefit and loan option, but they also have the flexibility and added returns of the newer life insurance products. Group UL is the same as individual UL, except that Group UL is generally issued (up to a certain amount) without evidence of insurability and is usually high enough to meet the needs of most employees. Group UL products usually pay little to no commission, plus administrative charges are lower than individual plans. Generally, these plans are 100% contributory; therefore, the plans are totally portable.

Retired life reserves (RLR) are a group reserve accumulated before retirement in order to pay premiums on term insurance after retirement. The employer can make tax-deductible contributions to this reserve on behalf of the employees, and these contributions are not taxed as income to the employees. RLRs can be administered through a trust or by a life insurance company, and as long as there are employees participating in the plan, the reserve cannot be recaptured by the employer. If an employee dies (or resigns) prior to retirement, the individual’s reserve value is used to fund the RLR for others in the plan. The plan must be nondiscriminatory and limit the amounts to $50,000.

Supplemental coverages are generally available, either through the insurer of the group or by another insurer that offers supplemental benefits. These benefits can be accidental death, or accidental death & dismemberment.

Some plans also offer survivor income benefits where proceeds are payable in monthly income benefits only. Beneficiaries are not named but are covered by specified beneficiaries in the policy and benefits usually continue as long as there is a surviving beneficiary and sometimes are discontinued if the survivor remarries.

References

[1] https://www.irs.gov/government-entities/federal-state-local-governments/group-term-life-insurance

Chapter 5: Interest-Sensitive Life Insurance (Part 1)

Variable Life Insurance

Variable life insurance (VLI) combines elements of an insurance policy with those of an investment. For this reason, it is regulated by the state insurance departments and the Securities and Exchange Commission (SEC). This means each variable life policy must be filed and approved by the state insurance departments in which it is sold and each insurer must register with the SEC as an investment company. Policy sales can only be made after a prospectus has been provided to the prospective buyer.

Given its combination of investment and insurance components, anyone who sells or markets variable life insurance is required to hold two separate licenses – both a state-issued life insurance producer’s license and a FINRA-issued registered representative’s license of either Series 6 or Series 7 classification.

The Series 6 license only permits an individual to sell certain types of securities, including variable annuities, packaged investments – such as mutual funds ­­— and unit investment trusts.

In contrast, the Series 7 license permits the sale of nearly all types of securities, including stocks, call and put options, bonds, and fixed-income investments. However, the Series 7 license explicitly prohibits the licensee from selling life insurance, real estate, or commodities futures.

Policy Overview

The insurance component of a variable life insurance contract is a form of permanent life insurance that pays a stated death benefit when the insured person dies. However, whereas most other permanent life premiums earn interest as they accumulate in the insurance company’s general account, a variable life policy’s cash value is invested in securities. The policy owner is able to select from a variety of securities options, of which mutual funds are the most commonly chosen. Other widely available options include stock, bond, and money market funds. As there is no singular accumulation pool, a variable life policy guarantees neither a cash value nor a rate at which interest accrues.

Generally, the policy’s face amount shifts with investment performance. When the investment sees gains, the face value of the policy is adjusted accordingly – typically on the policy’s the anniversary date. Conversely, negative account performance will cause this value to decrease. Nonetheless, its level premiums prevent the policy from dropping below its initial face value. This guaranteed face amount, which also protects against inflation, is not available in universal life or universal variable life.

Advantages

The primary advantage of VLI is the policyholder’s ability to choose how to allocate the policy’s account value, restricted only by the number of available investment accounts.

When a variable life insurance policy operates as intended, the policy owner has life insurance protection on the life of the insured and a family of mutual funds and other securities from which to choose for investment purposes. Additionally, the owner can direct the investments within those funds, with no income tax liability when moving accumulated funds within the contract. The better the return on the investment portfolio within the contract, the higher the policy’s total death benefit or cash value.

Disadvantages

For most potential buyers, the principal disadvantage of a Variable Life Insurance policy is its level premium structure. Those who value premium flexibility are therefore unlikely to view it as a viable option. For others, level premiums can be advantageous inasmuch as they essentially force savings. Many people who purchase universal life policies use their premium flexibility – whether intentionally or otherwise – as an excuse not to invest. This can too commonly result in policy lapses.

VLI policies present an additional downside concerning policy lapse. As with other life insurance policies, a lapsed VLI policy may be reinstated – with one significant difference. The past-due premiums collected for reinstatement must equal at least 110% of the increase in the policy’s cash value from the time it lapsed. This portion of the cash value is then immediately available after reinstatement. Such a measure is necessary because the values within the reinstated policy assume that it had never lapsed. Therefore, the additional premium reflects the increase that the investment account would have seen were it active during the lapse period.

Overall, VLI policies are riskier to the policy owners than traditional life insurance policies. As such, they are subject to more laws, rules, and regulations, and require greater

Separate Accounts

Most often, insurance companies allocate collected premium payments to a general account that can be used to conduct regular business operations. However, insurers who issue policies with securities elements (e.g., variable life and variable annuity contracts) are legally required to establish separate accounts for premiums collected from these policies.

A separate account is a group of investments – a portfolio – owned by an investor. As per legislation, premiums paid for variable contracts must be deposited into these investors’ separate accounts, rather than into an insurer’s general account.

The insurance company owns the funds in its general account. These funds are thus considered assets and are subject to any claims of the company’s creditors. In contrast, the insurance company does not own the funds in its separate accounts. These funds are investor-owned and therefore exempt from the claims of creditors.

Volatility

The variable element of variable life insurance is its cash value, which fluctuates according to the behavior of the policy owner’s chosen underlying investments. Because VLI policies are partially investments, contracts do not guarantee an interest rate or minimum cash value. In fact, a policy’s cash value – but not its face value – can depreciate to zero, which may result in termination of the policy. Such an event may be avoided through the addition of certain policy riders.

A variable life insurance policy owner becomes the investment portfolio director. However, they cannot manage individual assets within the selected funds; the insurance company’s portfolio management team handles these transactions. Therefore, those who are experienced in equity investments may be comfortable with the inner workings of variable life insurance. For those without such experience, the daily portfolio fluctuations may provoke anxiety and concern.

Increasing Protection Based on Investment Performance

If the purpose of life insurance is to provide financial benefits to survivors when the insured person dies, then one might argue that superior investment performance should lead to increases in a VLI policy’s death benefit – primarily as a method of keeping pace with inflation. Realistically, although investment performance in equities tends to equal or exceed inflation, this isn’t the case in the short term.

The insurance industry has developed two primary methods to associate a policy’s death benefit with the investment return of its portfolio: level additions and constant ratio. Each approach requires the policy owner to choose a target level of investment performance as a benchmark against which actual investment performance will be measured.

Performance above the target level is used to fund incremental increases in the policy’s death benefit. Performance below the target level requires downward adjustments in the death benefit to compensate for the deficit.

Level Additions

The level additions method uses returns above the target to purchase a level, single-premium addition to the base policy’s face amount. The face amount/death benefit increases so long as investment performance equals or exceeds the target rate. While this method results in slower accumulation of additional coverage compared to other approaches, the added coverage is then more easily supported.

Constant Ratio

To best understand the constant ratio method, it is first necessary to explore two concepts as defined by the Internal Revenue Code (IRC) – the cash value corridor and the guideline premium.

As per the IRC, an insurance policy falls within the cash value corridor if its death benefit never falls below a stated percentage of the policy’s cash surrender value.

Essentially, the guideline premium limits the amount of premiums that can be paid into a policy. To satisfy the guideline premium test, the total of all premiums paid for a policy cannot at any time exceed the cost of buying future insurance benefits.

Like the level additions approach, the constant ratio method uses excess investment earnings as a net single premium, which then purchases a paid-up additional amount of insurance. However, the paid-up coverage is not a level benefit. Instead, it is a decreasing benefit designed to maintain a ratio between the death benefit and the policy reserve. This ratio satisfies both the guideline premium and corridor tests. As investment performance diverges from the target amount, the compensating amount is added to or subtracted from the contract.

Another feature of the constant ratio method is its guaranteed minimum death benefit, which must equal the initial face amount of the policy. This means that if returns earned in the initial stages of the contract are lower than the target level, the policy’s reserves fall below the minimum amount needed to sustain the death benefit. If this occurs, the policy must then remain in force long enough for the investment returns to exceed the target level – thereby returning to an amount that supports incremental increases in coverage – before realizing increases in the death benefit.

Investment Fund Options

Each insurance company selling variable life insurance offers its own menu of investment options. Many insurers offer dozens of funds from which policy owners can choose. These options may include several types of stock funds (e.g., growth, income, balanced, and international) and bond funds with a variety of durations and issuers (e.g., large and small corporations, state governments, and the federal government).

Additionally, many insurance companies offer a managed fund option. In this scenario, the policy owner can deposit all premiums into the managed portfolio fund, allowing the company’s professional money manager to make investment allocation decisions. This alternative appeals to policy owners who do not want to put time and energy into studying the market and making investment decisions.

Cash Values

A VLI policy’s premiums are subject to administrative charges; once these charges are subtracted from the premium, the balance is deposited into the policy’s cash value. The cash value amount is the net asset value of the separate accounts in the policy’s investment portfolio. This amount fluctuates daily. Each day’s net asset value is based on that trading day’s closing price for the issues in the portfolio. The cash value also pays mortality charges associated with the policy in order to support the death benefit.

Policy Loans

In a manner similar to that found in traditional life insurance policies, the cash value in a variable life insurance policy is accessible to the policy owner in the form of a policy loan. A loan interest rate is charged against the portion of cash value associated with the loan, and the earnings on this portion of the cash value are affected by outstanding loans.

When the loan interest rate is lower than the portfolio earnings rate, the insurance company effectively experiences a lower investment return. An insurance company will only show a financial gain in connection with a variable life policy with an outstanding loan if the interest rate charged against the loan is more than the interest earned by the policy’s underlying portfolio.

Policy loans on variable life insurance can be repaid at any time, partially or in full. However, repayment is not a requirement. The outstanding loan accrues interest on a compound basis and, as with all other types of life insurance loans, the amounts of the outstanding loan and interest reduce any death benefit payable when the insured person dies. The policy loan is always fully secured by the policy’s cash value. Therefore, when the outstanding loan and its accrued interest equal the cash value, the cash value is calculated to be zero and the policy terminates.

Nonforfeiture, Reinstatement, and Waiver of Premium

The net cash value in a variable life contract is closely related to the policy’s available nonforfeiture options. As such, the contract’s nonforfeiture provisions are the same as those found in other life insurance policies. The net cash surrender value can be obtained by surrendering the policy to the insurance company. It can also be applied as a single premium to purchase either reduced paid-up insurance or the same amount of extended term insurance.

Variable life insurance policies also contain reinstatement provisions similar to those found in whole life and universal life contracts. Standard waiver of premium options are also similar to those found in other life insurance policies.

The Prospectus

Variable life insurance cannot be sold until the agent has provided a prospectus similar to that required by stock issuers. Originally, the SEC intended for this prospectus to provide potential investors with thorough and accurate information related to the investment and its associated institution. This type of information is much more comprehensive than what is found in life insurance disclosures.

As a result of the SEC’s initial prospectus mandates, the scope of required disclosures is infamously dense and difficult to parse, even for the educated investor. Therefore, the SEC more recently issued an updated mandate that enables the use of a summary prospectus in place of the full-length statutory prospectus.

Still, as the change is relatively recent, it is beneficial to first understand the requirements of the statutory prospectus in order to contextualize its replacement.

Statutory Prospectus

The statutory prospectus presents investment objectives and performance records for each of the underlying investment funds. Additionally, it provides detailed information about the current holdings of all available portfolios. This information is generally accompanied by statistics about a fund’s purchase or sale of individual equities or debt instruments in the previous year.

The prospectus also includes performance projections that assume the portfolio funds generate a fixed level of earnings over the projected time period. Under SEC guidelines, the projected rates of return must be the gross annual rates as calculated post-tax and before any other deductions. Each insurer determines its chosen rate.

Expenses [1]

Originally, the prospectus described in granular detail the expenses that the insurance company charged against the variable life policy. Each type of prospectus includes information about the following fees. However, the summary prospectus prioritizes brevity and clarity, and as such omits much of the dollar-for-dollar accounting for the movement of funds.

Sales Fees and Surrender Charges

The insurer imposes a fee rated at a disclosed percentage of the premium paid. These funds pay insurance sales commissions and company sales expenses.

In instances of early contract termination or early withdrawal from the policy’s cash value, surrender charges compensate for expenses that the company would have charged were the policy still in force.

Mortality and Expense Fees

These fees are calculated as a percentage of a policy’s cash value and compensate the insurer for certain risks associated with the policy, such as the insured’s premature death, sales, and administration costs that are greater than anticipated, etc.

Insurance Cost and Administration Fees

The insurer charges the at-risk amount of insurance based on the insured’s age, gender, and health status. This compensates the insurer for providing the life insurance death benefit.

Additionally, the company charges fees for policy issuance and maintenance, claims handling, and record-keeping. These fees can be charged as a percentage of the cash value or as a flat amount.

Loan Interest

If the policy owner takes a policy loan, an interest amount may be charged, but is not to exceed a state-mandated maximum.

Transaction Fees

A fee may also apply when the policy owner requests certain services, such as transferring money between investment options, altering the policy’s face amount, or making a partial withdrawal.

Underlying Fund Expenses

Mutual funds that contain invested account values charge fees for the amounts held in the funds.

Fees and Expenses for Optional Features

These are the separate and additional costs for any optional benefits, riders, or policy features that the policy owner has chosen.

Summary Prospectus

In March 2020, the SEC adopted Rule 498A, which enables the use of a summary prospectus both initially and for annual updates throughout the lifetime of VLI (and variable annuity) policies. [2] Whereas the statutory prospectus contains significant amounts of dense policy data, the summary prospectus is a far leaner document. It uses non-technical language to provide the account information necessary for a policyholder to make informed investment decisions.

This new legislation states that the summary prospectus may take the place of a traditional statutory prospectus to satisfy existing SEC contract disclosure requirements. However, its cover page must provide a web address/hyperlink to the full statutory prospectus on a publicly accessible webpage, free of charge. Additionally, an investor who receives this prospectus may request a copy of the statutory prospectus in print or electronically – also free of charge. [3]

Initial Summary Prospectus

An initial summary prospectus must still contain a Key Information table that features a contract overview, fee and risk summaries, and disclosures containing more detailed information about relevant risks and benefits.

Updating Summary Prospectus

The updating summary prospectus must contain this same information table, as well as information about any contract changes that have occurred over the previous year.

Furthermore, each type of summary prospectus requires information about any mutual fund investment options on which the variable contract is structured.9

Assumed Risks

As previously mentioned, fixed premium variable life insurance policies are similar to whole life insurance contracts. The principal difference lies in the policy owner’s assumption of the investment risk – by assuming the risk of reinvestment, the policy owner has the potential to benefit from favorable investment returns.

Any positive returns that occur do not allow the policy owner to alter the policy’s death benefits through negotiated adjustments. Rather, favorable adjustments automatically translate into increased death benefit amounts.

Notably, a VLI policy’s actual investment performance does not guarantee a minimum death benefit equal to the original face amount of the contract – regardless of the policy’s actual investment performance. If all premiums are paid when and as required, the insurer guarantees the death benefit will be equal to the original face amount. This amount paid will remain the same even if the investment funds are unable to support the policy’s face amount. Therefore, positive investment experience can enable the variable feature of this policy to provide additional coverage. However, the policy owner will never be required to pay more – or permitted to pay less – than the guaranteed premium.

Therefore, a fixed premium variable life insurance policy guarantees more to the policy owner than do universal and variable universal life policies.

Final Thoughts

The popularity of variable life insurance fluctuates almost entirely in relation to overall investment market conditions. Consumers investing during a low-interest economy are accustomed to higher yields on bonds and other investment returns. As a result, they will often turn to variable life insurance as an alternative to reinvesting in certificates of deposit.

In many cases, the right investment choices enable the variable life insurance to optimize the value of the policy owner’s money to a degree that far surpasses other investment vehicles. However, this should not distract from the fact that variable life insurance is both insurance and investment.

Because VLI contracts must provide death benefits, they cannot compete equally with a separate, investment-only fund that does not need to provide these benefits.

Finally, its hefty combination of administrative fees, mortality, and surrender charges, and miscellaneous expenses significantly reduces the potential for gains during a VLI policy’s early years. As such, it is not intended as a short-term investment vehicle.

References

[1] https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_varlifeinsurance

[2] https://www.sec.gov/news/press-release/2020-57

Chapter 5: Interest-Sensitive Life Insurance (Part 2)

Universal Life Insurance

Introduced to American consumers in the late 1970s universal life (UL) insurance was the first variation of whole life insurance to offer truly flexible premiums, as well as other provisions that collectively enhanced the savings ability of permanent insurance. These contracts enabled cash value increases by crediting interest rates that were higher than the policy’s stated guaranteed rate. As such, some of the risk associated with investment fluctuation shifted to the policy owner.

Two other features of universal life contracts soon became very popular:

The policy owner’s ability to withdraw part of the cash value without need for a policy loan

The option to select a level or increasing death benefit

When universal life insurance began garnering significant attention, the U.S. economy was experiencing high inflation and extremely high investment returns. In reality, the actual rate of return – defined as the rate of return minus inflation – was quite low. However, expectations associated with inflation proliferated so severely that most people avoided investing in long-term financial products. The resulting demand for short-term investments then depleted the necessary funds.

Actual rate of return = rate of return – inflation

This led to the issue known as the reverse yield curve. Typical economic conditions generally feature higher borrowing rates for longer-term investments and lower rates for shorter-term investments.  A reverse yield curve is essentially the opposite – the cost of borrowing short-term funds exceeds that associated with borrowing long-term term funds (e.g., mortgages).

Due to the extreme economic conditions, many traditional life policy owners withdrew the cash value from their existing policies via loans and surrenders. They then directed these funds into higher-yield investments. This process is referred to as disintermediation – a condition from which life insurance companies especially suffer during periods of reverse yield curves.

When policy owners withdraw cash values through either loans or surrenders, insurers lose the anticipated cash values that they would have directed into the high-yield investments. In extreme cases, disintermediation can force insurance companies to liquidate investments at a loss so that they can meet policy obligations.

After many insurers needed to liquidate in this manner, they began seeking more creative means to halt fund depletion. As a result, stock insurance companies introduced and championed universal life insurance, empowered by less concern for the federal income tax laws that severely restricted mutual insurers. Mutual funds that did offer UL generally purchased a downstream subsidiary, of which they would become a parent company.

As a result, nearly every insurance company was able to introduce UL through a new company, which invested its assets in a new money portfolio. This new portfolio then earned extremely high short-term investment yields, especially when compared with those of traditional life companies that invested in long-term portfolios. Although insurers immediately experienced these higher yields, they were unable to prolong this experience throughout a policy’s lifetime.

As one would expect, investment conditions eventually normalized and UL policy yields dropped to their former levels. In response, their popularity waned significantly. Insurance companies again turned toward longer-term investments. Eventually, the total portfolios associated with universal life contracts became similar to those of older insurance companies that maintained large blocks of traditional whole life insurance.

An Adjustable Death Benefit

Unlike most traditional types of life insurance, the death benefit of UL policies is adjustable. A traditional policy with a $100,000 death benefit guarantees that face amount as long as the policy owner pays the premium. In contrast, a UL policy owner may choose to increase or decrease this $100,000 face value (within certain limitations) throughout the life of the policy.

While this adjustment feature does not require a new policy for changing insurance amounts, a policy owner who increases the death benefit may need to provide proof of insurability.

Death Benefit Options

There are two death benefit options from which the policy owner may choose when initiating a policy.

Option A

The first choice provides a level death benefit similar to that found in traditional life insurance policies. While the policy denotes the level benefit amount, the insured may still alter it during the policy period.

Once the policy owner selects the death benefit, the premium is determined. The owner then pays this premium regardless of whether the death benefit changes throughout the policy period. The primary exception to this rule is when the policy owner exercises the unique premium-paying flexibility of universal life. This is discussed later in this section.

Option B

The second choice is for a death benefit that increases throughout the life of the policy. In contrast to the previous option, it consists of both the policy’s face value and cash value amounts. For a policy with a $100,000 insurance amount, the insured’s death results in a death benefit equal to $100,000 plus the cash value amount at the time of death. To account for a death benefit that will increase throughout the policy’s duration, the premiums for this option are higher than for Option A.

The Flexibility Factor

The most unique feature of a universal life policy is the flexibility of its premiums. Like the premiums for other life insurance policies, those paid during the one or two years of a universal life insurance policy are required on a regular basis (annually, semi-annually, quarterly, or monthly).

During this initial period, the cash value is not available to the insured. However, after this period ends, the premiums become truly flexible. This unique flexibility relies on the manner in which the insurer handles the premiums upon receipt.

Once received, premiums are divided into two categories: the cost of insurance – including all administrative fees and expenses – and the savings portion deposited into the cash value.

Each universal life insurance policy allows for three different premium types:

Maximum Premium – Also referred to as the guideline premium, this is the most money that the owner can pay while maintaining the policy within the IRS definition of a life insurance policy (instead of a modified endowment contract).

Minimum Premium – This is the amount required to keep the policy in force. It represents the sum of the actual cost of insurance and the insurance company’s administrative fees and expenses.

Planned Premium – Also known as the target premium, this amount falls in between the maximum and minimum premiums. The insurer calculates this premium based on the insured’s age, the contract’s maturity date, and either the desired cash value at a certain time or the date at which the policy owner wishes to stop making premium payments.

The Importance of Premium Flexibility

When a universal life policy goes into effect, a minimum level premium payment is established. This provides the policy with a minimum cash value. As previously stated, once the cash value grows adequately, this amount can maintain the insurance protection regardless of whether the policy owner pays additional premiums.

The significance of the flexible premium is that it addresses the fluctuating financial situations that many individuals experience in different phases of their lifetimes.

Example

Several years ago, Kareem purchased a universal life policy with a death benefit of $200,000 and an annual premium of $1,000. Now the policy’s cash value has grown to $15,000. Kareem’s first child is entering college and he wants to skip the annual premium on the policy to allocate additional money toward his child’s tuition. Because there is adequate cash value, Kareem can forgo the annual premium without compromising the policy’s insurance protection.

Single Premium Universal Life

Like whole life policies, universal life insurance may be purchased with a single premium paid at the policy’s inception. The benefits of paying one large premium are the same as those for whole life. Furthermore, a higher interest rate on UL cash values can magnify these benefits. Of course, all caution about staying within the cash value corridor in a universal life policy must be observed.

The Adjustable Premium

Most UL policies are purchased not with a single premium, but with periodic payments spread over a number of years. Because universal life offers an adjustable or flexible premium, the policy can be at risk of lapsing if cash value becomes insufficient to uphold the insurance protection. Should this occur, the policy owner must make a payment to keep the insurance in force.

Increasing the Premium Payment

If a policy owner chooses to increase the premium payments without increasing the policy’s death benefit, the amount that exceeds the established premium diverts to the cash value account and accrues interest. Again, all IRS legislation regarding MECs applies to this situation. Furthermore, the policy owner may at any time revert to the original premium amount or entire halt premium payments.

The Cash Value Account

Withdrawals

Universal life policy owners can make withdrawals from the cash value account. Such withdrawals of only a portion of the cash value are sometimes called partial surrenders. The insurer removes the funds from the cash value account so that the policy owner essentially surrenders that portion of the cash value. Most universal life policies also reduce the death benefit by the amount of the withdrawal.

Cost of Withdrawal and Repayment

Example

Jerome wished to borrow $10,000 for the down payment on a new SUV. He did not want to use the auto dealer’s financing service, as they charged a 10% interest rate. Jerome learned that he could borrow $10,000 from his universal life policy with a surrender charge of only $25. Of course, this sounded like a tremendous deal.

However, his insurance agent suggested that he reconsider. The current interest rate on the policy’s cash value was 10%. Therefore, he would lose that interest on any withdrawn money. Repaying the $10,000 into the cash value would incur a 7% ($700) fee. The combination of the loss of the 10% investment returns with the 7% repayment fees means that a loan would incur a 17% penalty.

Arguably, the 10% investment loss would essentially equate to the 10% interest rate of the auto financer’s loan. However, should Jerome die during the loan period, the amount withdrawn from his insurance policy’s cash value would then be subtracted from the death benefit.

At first glance, zero-interest partial withdrawals from a universal life policy might seem immensely preferable to borrowing money, whether from an outside lending institution or from the policy itself. However, the owner must carefully consider the true costs of a withdrawal that will later be repaid to the cash value account:

Fee paid to the insurer at withdrawal

Reduction of the death benefit (cost to the survivors)

Less interest accrual

Charges assessed by the insurer when the amount is returned to the cash value account

In other cases, it will indeed seem worthwhile for a policy owner to make partial withdrawals. Regardless, policy owners must be well informed about the cost of this decision.

Total Withdrawals

Universal life policy owners also may withdraw all of a policy’s cash value. However, payments for the insurance protection are periodically taken from the cash value account. Therefore, withdrawing the entire cash value amount means that the policy owner must make another premium payment to keep the insurance in force. As such, legislation requires insurers to notify policy owners if their insurance protection becomes endangered.

Some insurers charge a penalty if the policy owner removes all of the cash values in the early years of the policy. This penalty is typically a return of all or part of the excess interest earned during the previous 12 months.

Policy Loans

Like other cash value life insurance, UL policies allow policy loans up to the cash value amount. In contrast to a withdrawal, a loan implies that repayment must be made. Furthermore, the policy owner pays interest, though typically at a lower rate than interest rates in the general market. While fixed interest rates are common, some insurers also offer loans at variable rates. Each policy contains the insurer’s specified rates.

For interest-accruing cash value accounts, insurers sometimes pay a lower rate on the borrowed amount than on the amount remaining. For example, a policy owner may borrow $6,000 from a $10,000 cash value account. The insurer might pay its guaranteed interest rate of 4% on the $6,000, while continuing to pay the current interest rate (guaranteed interest plus excess) of 8% on the remaining $4,000.

Other insurers may treat a UL loan as a “wash loan” because the interest rate the borrower pays and the interest rate the insurer pays on the cash value are the same.

For example, the insurer is paying 7% on the cash value account and offering a policy loan rate of 6%. With a wash loan, the 7% rate would be reduced to 6% to match the loan rate, with the two rates essentially canceling out one another.

Final Thoughts

The unique flexibility of both premiums and death benefits makes UL policies an extremely desirable choice. Those seeking the protection of guaranteed death benefits and the ability to make payments that suit varying financial needs might find UL to be a fitting solution. While various types of loans exist, the appeal of zero-interest UL policy loans is certainly something that garners attention. Potential buyers must be wary of the caveats discussed before making the decision to purchase a UL policy or to take a loan against its cash value.

Variable Universal Life

As a contract, VUL is a universal life policy. It features the same flexible premiums, death benefit Options A and B, and the additional standard provisions of a UL policy. However, there is one substantial contract difference that separates VUL from UL – the variable nature of the policy’s account value. One of the defining differences between variable universal and traditional universal life is the variety of available investment options for premiums. VUL offers a choice among a particular set of managed accounts within a group of mutual funds. The insurance company is typically responsible for this account creation and maintenance. Furthermore, some insurance companies have agreements with outside investment firms, wherein the firm maintains separate account portfolios to which the insurance company has access.

Variable universal life (VUL) is the most versatile of the life insurance products. As such, it is extremely popular and warrants discussion at slightly greater depth. VUL features the premium flexibility and policy adjustment capabilities of universal life – albeit without a fixed premium option – and the investment options of variable life. The reasons for its widespread appeal are therefore quite evident.

Whereas an insurance company holds UL account cash values in its general account and credits a guaranteed rate of return, VUL policy owners can place their cash value in any number of separate accounts or subaccounts. As such, the investment performance directly affects the policy’s cash value. In this sense, it may be riskier to skip or lower premium payments, should the cash value investment drop too low to cover the account expenses.

Separate Accounts

The accounts into which the policy owner’s funds are invested are separate from the company’s funds. These funds earn variable returns and – as with mutual funds – their returns or losses are based upon the performance of the separate accounts. As such, the insurer does not guarantee returns on these accounts.

Policy owners can transfer funds between accounts free of charge. The contract establishes the annual number of permitted transfers, which typically range between 4 and 12.

Perhaps most significantly, VUL policies offer a multitude of account choices, including various stock accounts, multiple bond funds, managed funds, and asset allocation funds.

Cash Value

The VUL policy’s cash value consists of net premiums paid, less periodic deductions for the cost of insurance, plus (or minus) returns generated by the policy owner’s accounts. As neither the insurer nor the policy owner can accurately predict future earnings, the insurer does not guarantee the policy’s cash value.

Death Benefits

As with universal life, VUL offers Options A and B. While insurers do not guarantee death benefits, many newer policies provide some protection against declining death benefits. For example, some companies guarantee a death benefit until age 65. Others offer guaranteed death benefit riders for an additional – albeit modest – charge. These riders guarantee that the policy will remain in force even if the cash value reaches zero.

Expenses

While VUL policies contain various forms of expenses, their presentation is quite transparent. Most policies enable the insurer to deduct from premiums as they are paid, with deductions covering marketing costs, premium taxes, and miscellaneous expenses. Additionally, each policy typically indicates a guaranteed maximum deduction amount. Notably, VUL has a reputation for comparatively high expense fees – especially in relation to UL and VLI. However, policy expenses have begun to decrease to more comparable levels.

Prospectus

The insurer must provide a prospectus – and in many states a buyer’s guide – while discussing a policy with a prospective owner. Additionally, the policy owner receives an annual report that provides the most recent statuses of all policy transactions, including any that affect the cash values. As of 2020, the initial and updating summary prospectuses satisfy this requirement.

Standard Provisions

While most of the standard provisions compare to those of other life insurance policies, variable universal policies feature some variations on traditional provisions, as well as several provisions that are unique to this policy type.

Free-Look Provision

The law entitles the policy owner to a stipulated period of time – generally 10 days after the receipt of the policy – during which the owner may return the policy for a refund of all premiums paid. In some states, the refund will reflect investment earnings or losses in the cash value for the period that the insurer possessed this money.

Grace Period

Since the continuation of VUL is dependent on its cash value rather than on premium payments, its grace period functions differently. If the cash value is insufficient to maintain the cost of insurance, the insurer notifies the policy owner that a premium must be paid. The owner then has 61 days from the date of notification to pay the required premium before the policy lapses. Full coverage remains in force during this 61-day grace period.

Reinstatement

Typically, a lapsed VUL policy may be reinstated within the period of time the policy indicates – usually two years. This is generally subject to certain conditions:

The policy owner must send to the company a signed application for reinstatement.

The policy must not have been surrendered for its net cash surrender value.

The company may require evidence of insurability, which then must be provided for reinstatement.

The policy owner must pay premiums which, with interest, are sufficient to keep the policy in force for a stipulated period of time – generally three months.

Conversion Privilege

Unique to VUL policies, this ability enables policy owners to exchange the VUL for a comparable non-variable plan without a tax penalty. IRS Section 1035, allows this exchange of policy for a new one, so long as it insures the same person. The policy owner is therefore not taxed for investment gains earned under the original contract. However, the insurance company may still enforce any surrender fees or similar contract stipulations.

Available Riders and Policy Options

VUL policies typically feature many of the same options available within UL and traditional insurance products. These may include:

Waiver of premium due to disability

Cost of living (COLA) – can appear as either a rider or part of the policy itself. This option may require a separate premium.

Accidental death benefit

Accelerated death benefit

Term insurance rider

Family Insurance rider

Guaranteed insurability rider (GIR) or option – enables policy amount increases on specified dates at standard rates, without evidence of insurability.

The Attractive Flexibility of VUL

Variable universal life insurance is simply a UL policy with an additional component that allows the policy owner to choose investors. By shifting the investment risk onto the policy owner, it then offers them maximum flexibility.

Furthermore, the policy contains no interest rate or cash value guarantees. This means that owners can choose to fund the policy at the level with which they are most comfortable, so long as the premiums paid cover the contract costs without exceeding the SEC premium guidelines.

Variable universal life can be pre-funded so the policy will support itself independent of its cash value. If the premiums contributed to the contract are adequate, this may be accomplished in a relatively short number of years.

Modified Endowment Contracts

When Congress passed the Technical and Miscellaneous Revenue Act (TAMRA) in 1988, certain life insurance products were redefined as modified endowment contracts and no longer permitted to double as tax shelters. Rather than allowing withdrawals from all endowments and permanent life insurance policies on a tax-advantaged basis, TAMRA placed premium limits that restricted the ability of policies to receive favored tax treatment.

The IRS considers a life insurance product a modified endowment contract if it satisfies three conditions:

It is issued on or after June 20, 1988.

It meets the statutory definition of a life insurance policy.

It does not meet TAMRA’s 7-pay test.

Withdrawals from a modified endowment contract are taxed differently than life insurance withdrawals. For instance, if a life insurance policy owner withdraws cash value from the policy, taxation is on a first-in, first-out (FIFO) basis. Instead, modified endowment contracts are taxed on a last-in, last-out (LILO) basis. This means the first dollars withdrawn are gains in the contract (the interest credited to the cash value), and taxed as ordinary income in the year paid. Once all the gain has been withdrawn, the cost basis is then withdrawn and is not taxable because it is a return of premiums paid. In addition, if withdrawals are made from a MEC before the policy owner reaches age 59 1/2, a federal tax penalty of 10% will be applied to the withdrawn amount.

All single-premium life insurance policies are considered by the IRS to be modified endowment contracts under TAMRA.

Using a MEC

Even though the modified endowment contract loses some of the tax advantages of a life insurance policy, it still retains the death benefit. In certain situations, this provides the policy owner an advantage.

A policy owner might consider a variable universal MEC in the context of estate planning. They can initially pay one or more large premiums, then contribute more premiums in the future, should the need arise. The policy still has security-based growth, and when the policy owner dies, the funds go directly to the beneficiaries without first passing through IRS probate. Here, the VUL becomes a valuable planning tool.

However, no one should ever recommend such a plan without discussing the tax consequences to the prospect and if there is the slightest indication that the prospect does not completely understand the situation, and then it is imperative that they consult a tax professional.

Taxation and Regulation

Although VUL is regulated as a security, it retains its status as a life insurance policy for taxation purposes. A VUL policy’s accumulated net premiums and earned interest receive build cash value for the policy, enabling the same tax-advantaged treatment as cash values of traditional whole life policies. However, if the policy owner wishes to pay additional premiums to increase the death benefit, the insurer may require evidence of insurability to prevent the policy from becoming a MEC.

Cash values accumulate free of current income taxes. However, the policy must maintain the legal guideline corridor ratio between the cash value and the death benefit.

VUL death benefit proceeds are tax-free. Furthermore, tax law excludes from the beneficiary’s gross income any lump sum benefits received from the policy.

The IRS views policy loans as a policy owner’s debt rather than as income or a taxable distribution. Additionally, interest paid on a loan for non-business purposes is not tax deductible. However, if a policy fails the 7-pay test and becomes a MEC, loans, and withdrawals are then subject to current income taxes (plus a possible penalty).

In some cases, surrenders, withdrawals, or changes to death benefit options can have tax consequences. For instance, upon total surrender, if the policy owner receives an amount that exceeds the total premiums paid, the excess amount is taxed as ordinary income.

In total, taxation of the VUL has created a very appealing product, particularly for those who are in a higher tax bracket. The IRS dictates that a VUL policy meets the definition of an insurance contract (and obtains the favorable tax treatment), if it satisfies three tests – the cash value accumulation test, the corridor test, and the 7-pay test.

Cash Value Accumulation Test

When the cash value of a permanent life insurance policy exceeds the single premium that would fund all future benefits, the policy no longer meets the IRS definition of life insurance. If a policy does not meet this cash value accumulation test, the policy is disqualified retroactive to the policy issue date. As a result, any income the policy owner receives from that policy then becomes taxable.

Since neither the insured nor the insurance company’s producers can access the mortality tables and present value tables necessary to make this assessment, the insurance company will provide the necessary expertise to ensure that the policy satisfies the definition of a life insurance product.

The Corridor Test

All VUL contracts contain a provision that defines the minimum of pure insurance protection in comparison to the cash value amount. As per the Internal Revenue Code, an insurance policy falls within the cash value corridor so long as its death benefit is never less than the stated percentage of the policy’s cash surrender value.

The 7-Pay Test

As previously mentioned, the 7-pay test calculates the total amount of premiums paid for a policy during its first seven years in relation to the amount required to pay up the policy in that same period. If the total of premiums paid is less than the amount to pay up the policy, it is a life insurance policy. If the total of premiums paid is more than the same amount, the policy is a modified endowment contract

Uses for Variable Universal Life Insurance

Due to the tumultuous economic climate in the United States, suitability under current regulations can be difficult to achieve. Therefore, the many uses of VUL, regardless of their suitability for a particular situation, are beyond the scope of this text. The following list is far from comprehensive but should provide a significant understanding of how VUL policies may be used.

One does not need a variable insurance policy unless they need life insurance. Therefore, individuals who have that need can usually benefit from VUL. Those who choose VUL generally have above-average incomes.

VUL is an important vehicle for those who use insurance to build or transfer their estates. Life insurance is the best vehicle for transferring wealth with fewer hurdles, and the VUL product allows them to transfer their business interests to family members or business partners.

VUL allows an insured to reduce or skip premiums when needed, and to channel excess funds into the plan, where earnings will be tax-deferred.

VUL allows more flexibility for executive bonus plans so that the bonus does not need to coincide with a fixed-premium schedule. The employee can then determine their coverage amount and the investment methods for the cash value.

VUL can also be used for deferred compensation. It has the advantage of an above-average accumulation of funds, which helps the employer to pay future benefits. Since these agreements are generally renegotiated periodically, the coverage can be easily updated.

If a person has securities or securities-based accounts, the VUL offers stability. If a person already has life insurance, it is likely better to add a VUL policy to their insurance portfolio instead of surrendering old policies.

Chapter 6: Taxation of Life Insurance

Income Tax

Life insurance receives favorable tax treatment in the United States and in most other countries. This section will discuss some of the federal income, estate, and gift tax treatments of life insurance.

Premiums

Premiums paid for life insurance policies and individually issued annuities are considered personal expenses and are therefore not tax deductible. However, annuity-funded contributions to a tax-qualified retirement program may be tax deductible. Additionally, premiums associated with medical expenses and long-term care insurance are deductible with certain restrictions.

Any premiums paid to fund life insurance policies whose beneficiaries are nonprofits/charities may be deductible as charitable donations. Furthermore, premiums paid for life insurance, annuities, and health insurance under an alimony agreement may also be deductible.

Finally, employers who pay premiums for employee life insurance, health insurance, or annuities may typically deduct these payments as business expenses.

Death Benefits

Internal Revenue Code § 101(a)(1) states that death benefits from life insurance policies are exempt from federal taxation, provided that the death of the insured caused the contract to mature. For the purposes of this code, death proceeds include the face amount of the policy and any other insurance amounts. These amounts may include those for accidental death, the face amount of paid-up insurance, or additional term rider benefits.

Transfer for Value Rule

If a life insurance policy – or any portion of a policy – is sold to another person or transferred for some type of compensation, its death benefits may lose tax exemption. To calculate the amount taxed, first, add the total amount of premiums paid to the value of compensation for the transfer. Subtract this sum from the policy’s death benefit. The difference is the amount of taxable income.

Example

Benny had a life insurance policy for $100,000. He needed money for a down payment on a new SUV, so he sold the policy for $3,000 to Sam, his brother-in-law.

Nearly 10 years later, Benny died. By that time, Sam had paid premiums of $12,000 (net of dividends) and received the death benefit of $100,000. Since the total amount Sam paid for the policy (the initial investment plus premiums paid) was $15,000, Sam received $15,000 tax free but had to pay taxes on $85,000.

Note that this rule does not apply in situations wherein the transfer recipient is the insured’s partner or a corporation for which the insured is an officer or stockholder. Additionally, a policy that a corporation purchases and then transfers to the insured receives the same exemption.

Taxation of Settlement Options

When the policy owner elects settlement options, life insurance proceeds do not lose their favorable tax treatment, except if there are income taxes due on any interest paid on the proceeds. The interest option of a policy stipulates that any interest the beneficiary might receive is taxable as ordinary income.

Under settlement options and installment options, every payment is considered to contain principal and interest portions. The part that is considered return of principal is not taxed. Amounts that are more than the annual prorated principal are taxable as interest.

Under the fixed-period option, the amount that the insurer holds is divided by the number of installments within that period. The excess of each payment over this amount is considered taxable interest. Similarly, under the life income settlement option, the amount held by the insurer is divided by the recipient’s life expectancy.

Note that the methods used to determine the amount that the insurer holds are extremely complex and, as such, are beyond the scope of this discussion. However, the insurer must furnish this information to the policy owner or beneficiary.

Taxation of Living Proceeds

Living proceeds include dividends, cash values, matured endowments, policy loans, and accelerated death benefits.

Dividends

Typically, the IRS considers dividends to be non-taxable returns of excess premium, except if the policy is a MEC or otherwise fails to meet the IRS definition of life insurance. Furthermore, any dividends received under a non-MEC policy that exceed the total of the premiums paid will constitute ordinary income and be taxed as such.

Cash Value

Any interest credited to a life insurance policy’s cash value is not taxable so long as the policy meets the IRS definition of a life insurance policy. This also applies to MECs.

Usually, losses that may arise upon the surrender of a life insurance policy cannot be deducted as a loss for tax purposes.

Section 1035 Policy Exchanges

IRC Section 1035 allows for the exchange of one life insurance policy for another policy type without tax consequences. Covered exchanges include:

A life insurance policy for another life insurance policy, endowment, or annuity contract

An endowment for an annuity contract or another endowment with a maturity date that is no closer than the initial endowment

An annuity for another annuity

When a Section 1035 exchange occurs, any gain on the old policy is rolled into the new policy, with no tax-affected gain reported. The new policy’s cost basis is adjusted to include the basis of the old policy.

Although the tax code is relatively simple, it does not always provide a clear distinction between an exchange and a surrender-and-purchase. However, the IRS typically mandates that the old contract be assigned to the replacing insurance company in order to prevent the policyholder from receiving surrender values.

Example

George has a life insurance policy that was issued in 1990. The cash value grows at a 3.5% rate and the policy provides little flexibility. His brother-in-law convinces him to replace his policy with a new variable universal life policy. Bob agrees but notes that he has cash values of $23,000 in his old policy. Therefore, he states his wish for the surrender values of $23,000 to be sent directly to him so that he may determine how much he wants to pay for the new policy.

However, his brother-in-law points out that this would negate its status as a 1035 exchange. As a result, he would no longer receive favorable tax treatment for this gain.

Matured Endowments

At one time, endowment contracts were popular vehicles for retirement income. While this is no longer the case, many of these endowments are reaching their maturity dates. So long as a policy satisfies the IRC definition of a life insurance policy, the IRS taxes the endowment proceeds as if the policy were surrendered. The taxable income is the difference between the gross proceeds and the cost basis.

Policy Loans

Policy owners can obtain policy loans from a life insurance policy using the cash value as security. The interest rate charged is stated in the contract.

An individual who pays interest on a policy loan does not receive tax deductions. However, a business that owns a policy covering the lives of key persons may receive tax deductions on interest paid. Of course, this is subject to certain conditions.

Generally, taking a loan from an insurance policy is not a taxable action. However, if the contract is a MEC or an annuity, loans are taxable as income in proportion to the excess of the cash value as it surpasses the cost basis.

Since policy loans reduce a policy’s cost basis, a policy with a large outstanding loan, the net cash surrender value – which is the cash surrender value minus the loan – can be quite small. Therefore, if the policy owner surrenders the policy, the check may be for a smaller amount than expected. Still, the owner may face an extremely large tax bill due to the negative cost basis. Unfortunately, many surrenders occur because the policy owner faces financial difficulties. In these scenarios, the addition of a large tax bill could be disastrous.

Chapter 7: Life Insurance in Financial and Estate Planning

Financial planning is the acquisition and employment of assets in order to maximize the return on these assets. The following steps comprise a general procedure for financial planning.

Establish financial planning objectives.

Develop the specific financial plans by which these objectives can be achieved.

Establish a budget that enables the purchasing of the financial assets.

Periodically review and revise the financial plan to ensure the progression toward achieving the objectives.

It may come as little surprise that life insurance plays a crucial role in establishing financial planning objectives.

In the determination of a financial plan, individuals must carefully consider the risks involved in attempting to reach their objectives. In this sense, life insurance becomes a tool for risk management. It guarantees that the individual’s family, dependents, or business will not have to incur financial loss in the event of the insured’s premature death.

The primary risk mitigate that life insurance offers is its ability to accumulate wealth. A parent with sufficient and reliable income provides for a dependent child not just while the child is young and living at home. As the cost of post-secondary education continues to climb, an uninsured premature death may prevent a child from obtaining a college education. Where a living parent may be able to give financial assistance to a child trying to establish themselves independently, premature death can inhibit the child’s long-term ability to thrive.

The lives of dependents may be a driving factor for obtaining life insurance, but modern life insurance plans also seek to help the insured live more comfortably and happily. These plans now offer a wide variety of fixed-value and variable investments that can contribute to a more robust retirement fund. Once the insured retires, these fixed or variable policies can provide tax preference that is not typically available in other similar investments.

Determining Financial Objectives for Life Insurance Benefits

There are two types of financial planning objectives: cash objectives and income objectives.

Cash Objectives

It is relatively easy to determine cash objectives. Essentially, these consist of what is needed to pay for outstanding obligations, such as mortgages, auto payments, and credit card debts. The figures for such obligations are transparent, exact, and easily accessible. Similarly, final expenses can be quite easily estimated.

Educational funds are a little more difficult, but proper assumptions for tuition growth rates and associated post-secondary costs can enable a fairly accurate approximation.

Income Objectives

Even with the proper expectations for accuracy, calculating income objectives can be extremely technical and complex.

First, one must determine the amounts of money to sufficiently care for the survivors. This takes into consideration all sources of income, including government and employee benefits. Additionally, shifting family responsibilities must be considered. Another principal factor is inflation, which can introduce havoc into a financial plan that overlooks it.

Methodology

Although its purposes are straightforward, the methodology for life insurance-based financial planning is quite technical. The informed planner typically converts net income amounts to a single-sum present value equivalent, accounting for future interest growth. The next step integrates the complexity of the assumptions used to calculate future inflation and interest rates. The formulas and approaches for proper analysis require extensive knowledge and as such, are beyond the scope of this text.

Estate Planning

Life insurance can play an invaluable role in estate planning, wherein it may provide the funds to pay estate tax and other liabilities, as well as the income needs of surviving family members. Many estates feature life insurance as a primary asset of many estates. Consequently, it is a significant source of family income after an estate owner dies.

Life Insurance in the Gross Estate

Life insurance is not included in the gross estate unless one of two scenarios occurs. The first exception is for any life insurance proceeds that are payable to or for the benefit of the insured’s estate. The second exception occurs if, at the time of death, the insured had any incidents of ownership in the policy.

Estate as Beneficiary

If the estate itself is the beneficiary, death proceeds are included in the gross estate even if the insured was not the policy owner. Consider this a compelling reason as to why the insured should never list the beneficiary as the insured’s estate. It also underscores the necessity of multiple contingent beneficiaries.

Incidents of Ownership

Incidents of ownership are the rights to modify the policy in any respect. These modifications include – but are not limited to – the right to change beneficiary, obtain a policy loan, or surrender or assign the policy. If the insured possesses one or more of these rights, the insurance proceeds may be included in the gross estate.

Gifts of Insurance

If an insured assigns any of their policy rights to another person, taxability depends upon whether the rights are assigned for adequate compensation. For gift tax purposes, the value of the policy is its market value, which is the cost of replacement. While the formula for determining this value is fairly complex, it expresses the value of the gift as the sum of the policy’s unearned premiums and the terminal reserve when the gift is given.

If the policy is a single premium policy, paid-up policy, or annuity, then the replacement cost is the single premium that an insurance company would charge for a comparable contract issued at the insured’s (or annuitant’s) attained age.

If an individual gifts insurance premiums on a policy that they do not own, then that premium is considered a gift.

Usually, the IRS does not classify life insurance proceeds as gifts. However, exceptions do arise.  If Person A owns a policy that insures Person B, and Person C is the beneficiary, the proceeds are considered a gift from Person A to Person C.

Additionally, an exception may occur on a policy between spouses. If Spouse A owns a policy on Spouse B wherein the children are the beneficiaries, this effectively constitutes a gift to the children from Spouse A, regardless of whether it is intended as such.

Estate and Gift Tax Exclusion

In 2021, the IRS announced increases in estate and gift tax exclusion rates. For gifts, the 2022 annual exclusion is $16,000 per person and $32,000 per married couple. While these exclusions remained constant for several years, the recent changes reflect the continual impact of inflation on estate and gift tax exclusion rates. [1]

Additionally, the IRS raised the estate tax exclusion threshold to $12.06M for 2022. [2]

Trusts

Within estate planning, certain types of trusts are extremely common. To most effectively ascertain the value of life insurance in these scenarios, it is important to gain at least cursory knowledge of how these trusts may apply.

Irrevocable Life Insurance Trusts

Under an irrevocable life insurance trust (ILIT), the trust itself owns an insurance policy on the life of the grantor. If the grantor lives for more than three years after the establishment date of the trust, all incidents of ownership are relinquished and the policy proceeds are excluded from the grantor’s taxable estate.

By using this trust, death proceeds can be invested or distributed to trust beneficiaries by methods not available under life insurance settlement options. Therefore, proceeds are usually paid in a lump sum and the trustee is responsible for their disbursement according to the grantor’s pre-established requirements.

Furthermore, using a life insurance trust (instead of gifting life insurance outright) means that the policy and donor premiums can receive the $16,000 annual exclusion. However, if the policy has been assigned to the trust, the exclusion may not be available unless the trust agreement features a relevant provision. Therefore, the gift of a policy in trust and future premium payments can be fully taxable gifts that are later added back to the estate for estate tax purposes. There is no income tax savings if the policy insures either the donor or his/her spouse.

References

[1] https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes

[2] https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax

Chapter 8: Business Uses of Life Insurance

Although life insurance is generally purchased for personal or family purposes, it can also fulfill an extremely important commercial need. This area requires considerable specialized expertise. Consequently, the agents, brokers, and insurance companies involved are often very successful. This is not an easy market to penetrate, as the process involves accountants, attorneys, and senior corporate officers. However, those who succeed within this sub-field typically begin with small firms, gaining expertise and clientele in a cycle of positive feedback.

Business uses for life insurance can be categorized into three areas:

Business continuation insurance

Key employee insurance

Nonqualified executive benefits

Business Continuation

Closely Held Firms

Almost 20% of U.S. household assets are held in privately owned businesses. Furthermore, most of these are family businesses. Referred to as closely held businesses, these small companies feature owners who serve as managers and companies with fewer than ten owners.

For the purposes of this discussion, the most important characteristic of closely held businesses is that their ownership is not marketable. This means that should the owner die, the parties interested in purchasing are typically restricted to other owners, employees, or competitors. In any event, the successor(s) may struggle to maintain the business, facing obstacles such as the need to re-establish lines of credit and retain good will among internal and external partners.

The principal types of closely held firms are:

Sole Proprietorships

Partnerships

Closely Held Corporations

Sole Proprietorships

As the name implies, a sole proprietorship is an unincorporated business owned by a single person. Additionally, the owner often manages the business. A business owned and operated by an individual is particularly vulnerable in the event of the owner’s death.

Tax law makes no distinction between business and personal assets in a sole proprietorship. Therefore, when a proprietor dies, the debts of the business become the debts of the estate. The proprietor’s personal representative – or executor – is required to dispose of the business as quickly as possible.

Life insurance can fund this dissolution in several ways. For example, if the business is transferred through a will, the death benefit can satisfy the proprietor’s personal debts, business debts, and estate taxes. This money can also provide a source of interim financing to extend business operations for a short period. Additionally, these funds can finance the transfer of a business to an employee or a child.

Partnerships

A partnership is a voluntary association of two or more individuals for the purpose of conducting a for-profit business as co-owners.

There is one crucial component of partnership law as it pertains to life insurance.

Upon the death of a general partner, the partnership is dissolved. Furthermore, in the absence of contrary arrangements, the surviving partners become liquidating trustees.

Not only must the surviving partners liquidate the business, but they also must pay a fair share of the liquidated business to the estate of the deceased. Unfortunately, liquidating a business nearly always results in the shrinking of business assets. Moreover, the survivors have lost their primary (and often only) source of income.

Often, partners believe that if one partner dies, the surviving partner will buy out the interests of the estate. This oversimplifies the issue in several ways. The surviving partner must be able to amass enough money to purchase the estate at a fair price. In many cases, this may not be possible even with sufficient funds. The surviving partner has a fiduciary relationship with the estate and any surviving partners. Consequently, some states prohibit this purchase.

Closely Held Corporations

Closely held corporations are those owned by relatively few people. The IRS defines such entities by the amount of corporate stock that is owned individually. Typically, at least 50% of a closely held corporation’s stock is owned by 5 or fewer people. [1]

Key Employee Insurance

A key employee is an individual who possesses a unique ability essential to the continued success of a business. This uniqueness may include the capital they control, their technical knowledge, experience, or management ability – any combination of which makes this person a valuable asset to the company. If the death of an individual could severely damage the company, this individual is a key person.

In certain cases, some individuals are so unique or proficient in their abilities that they cannot be replaced. However, an individual can usually be replaced so long as there is sufficient time and collective expertise. In any event, life insurance can provide the infusion of funds necessary to overcome the loss of a key person.

Even the best calculations for the amount of life insurance to purchase essentially rely on informed guesswork. However, it is crucial to estimate the financial loss to the company should a key person die unexpectedly. Therefore, the life insurance benefits should equal the present value of projected lost earnings, plus the funds sufficient to pay the salary of the replacement worker.

In practice, the company often must pay more to the new worker than what they paid to the key employee. An experienced and competent individual is not starting at the bottom, and as such, can rightfully demand a higher salary.

Many types of insurance plans can adapt to accommodate the unique situation of a key employee’s premature death. The following sections examine several nonqualified plans that can furnish these needs.

Permanent Life Insurance

For a typical key employee plan that uses permanent life insurance, the employer pays the policy premiums. The policy’s generated dividends can then pay the income tax that the individual incurs by virtue of being a key employee. (The IRS taxes the employee for the employer-paid premiums, which it classifies as additional income.) Many permanent policies that have been in force for several years may yield dividends that exceed the amount of taxable premium income.

For the key employee, the advantages of life insurance extend far beyond the lifetime guaranteed coverage. Increasing cash values, increasing dividends, beneficiary selection, and policy ownership provide the key employee with many living benefits.

Insurers may only purchase key employee insurance with non-deductible funds. However, IRC Section 101 permits the corporate beneficiary to receive any death proceeds free of income tax.

Term Life Insurance

When an employer opts for term life insurance as key person insurance, the IRS taxes the employee for the premiums that the employer pays. With a term life plan, the employee selects the beneficiary and owns the policy. Generally, term life policies terminate upon retirement to avoid continually increasing premiums. In a scenario wherein the employee is in extremely poor health, they may wish to pay the higher premium under a separate arrangement with the employer.

Salary Continuation Plan

As with the other key person insurance plans, the employer purchases a policy, which is typically a permanent life contract. Under salary continuation plans, the employer is the beneficiary and owner of the insurance policy.

If the employee dies before receiving all promised supplemental pension benefits, the employer pays the remaining supplemental pension benefits to the deceased employee’s beneficiary. The life insurance proceeds fund these payments.

Death Benefit Only Life Insurance Plan

With this type of policy, the employer usually purchases permanent life insurance on the employee and is the policy beneficiary and owner. However, the employee is not taxed for the premiums that the employer pays. Upon the death of the employee, the employer will use the life insurance proceeds to pay death benefits to the employee’s beneficiary for several years. Additionally, while the employer receives the life insurance proceeds tax free, any payments the beneficiary receives are considered federal taxable income.

Collateral Assignment Plan

Under the collateral assignment plan, the insured employee applies and owns the policy, thus can designate the beneficiary. Additionally, the employee is primarily liable for the premium payment.

This plan distinguishes itself from a typical life insurance policy through the use of a separate employer-employee agreement. Herein, the employer agrees to loan the employee an amount equal to the annual increase in the cash value – typically without interest. Consequently, the employee assigns the policy to the employer as loan collateral.

Upon the employee’s death, the employer receives the amount of the loan from the death proceeds – not as a beneficiary, but as a collateral assignee.

The Split-Dollar Approach

Split-dollar plans are not their own life insurance product. Rather, they are a strategic approach that can apply to any life insurance policy that accrues cash value. As such, many key person insurance policies use this method to divide the costs and benefits of life insurance between the employer and the employee. However, much of the procedure is similar to other key person insurance.

With the split-dollar approach, the employer still receives the death benefits in the event of the employee’s premature death. Additional benefits may be allotted to the insured’s beneficiary, including the receipt of a portion of the death benefit. This policy still provides that the employee-designated beneficiary receives the excess cash value from the policy. Furthermore, the beneficiary cannot be changed without the employee’s consent.

Under many permanent policies, the cash values will accumulate to a substantial sum, whereupon the employer can withdraw from the cash value an amount equal to the amount of premiums they have paid into the policy.

At this point, the split-dollar plan terminates and the employee assumes sole possession of the insurance policy. The remaining cash value should be sufficient so that the employee need not contribute further premium payments to keep the policy in force.

The Reverse Split-Dollar Approach

This variation of the typical split-dollar plan enables the employee to build assets, rather than to accrue a death benefit. In such an arrangement, the corporate employer pays the expenses and mortality cost, and the employee assumes ownership of the investment account. In other words, the employer receives the death benefit and the employee attains the accrued cash value.

While specific arrangements within this approach provide certain tax advantages, any such arrangement should be structured with legal and professional accounting advice to retain validity under frequently – and sometimes drastically – shifting tax legislation.

Miscellaneous Uses of Split-Dollar Plans

Sole Proprietor

In certain rare situations, a sole proprietor may not have family members to whom they wish to leave their business. If such is the case, then the business owner may instead opt to sell to an interested employee. Generally, the employee cannot afford to purchase the business outright, so the pair may enter into a split-dollar situation. In this case, however, the employer’s life is the one insured.

Family Split-Dollar Plan

A split-dollar plan can also be used for family matters, such as providing insurance protection for a married child without affecting the existing estate. In this case, the parents typically pay the policy premiums and designate the child’s spouse as beneficiary. In the event of the insured child’s death, the parents receive the total amount of premiums they have paid. In this situation, they are able to provide protection with minimal financial burden and no tax implications; gift taxation is avoided under the $16,000 annual exclusion.

Example

The Bradleys have five children. Ben, the eldest, is married with two children. His parents are concerned that if something happens to Ben, they will have to divert funds from the estate in order to help his family. The parents purchase a life insurance policy on Ben’s life, naming his wife as primary beneficiary and children as contingent beneficiaries. Since Ben is still relatively young, they can purchase a policy with a death benefit sufficient to care for his family. Ben and his wife sign an agreement with his parents so that in the event of his death, his estate will return to his parents the total amount of premiums they have paid.

Additionally, the Bradleys have created a trust for their children. If they die before Ben, the trust will continue making premium payments on the policy, subtracting this amount from Ben’s share of his parent’s estate.

Executive Bonus Plan

The executive bonus plan is quite simple. The employer purchases life insurance policies on selected employees. Because the employer is paying the policy premiums, it may choose whichever employees it deems most financially suitable.

As previously explained, the IRS taxes the employee for the employer-paid premiums, designating these payments as additional income. In contrast, the employer’s premium payments are tax deductible, unless the IRS finds that the payments are “unreasonable.”

The employee owns the policy, names the beneficiary, and retains all other policy rights. However, if the employer retains any ownership interest or the proceeds benefit the deceased’s estate, the death benefits will appear in the employee’s gross estate.

Summary

Undoubtedly, life insurance can be just as crucial for a business as it is for an individual. The risks associated with losing an employee can have considerable impact on a business in the same way that losing a family member affects a family. Furthermore, family-owned businesses incur the compounded effect of such a loss. The ability to mitigate this type of risk is paramount, and life insurance is often the most effective measure against unrecoverable loss.

References

[1] https://www.irs.gov/faqs/small-business-self-employed-other-business/entities/entities-5

Chapter 9: Underwriting (Part 1)

In 17th century Great Britain, commercial marine voyages abounded. Such voyages faced many potential dangers, rendering them exceptionally more costly to complete. Fortunately, some wealthier merchants were willing to assume a portion of the risk involved. To complete this process, they would write the monetary amount of the voyage that they were willing to insure and sign their names below a contract detailing the conditions of the risk.

Thus, these merchants became known as “underwriters,” and a vital component of the insurance lexicon was born. While the insurance business no longer relies upon third-party individuals to insure risks, the term underwriter lives on as the title for those who review and select such risks to insure.

Insurance is inherently a practice of exclusion. As such, insurers cannot accept every applicant. Underwriting is the process of determining whether a potential insured poses an acceptable risk and, if so, at what rate the insured can be accepted.

This chapter discusses the process by which an insurance underwriter determines the amount, type, insurability, and conditions of the risk involved in a potential policy. The underwriter must apply company standards to each applicant, and use these standards to ascertain whether the application represents an acceptable risk.

Selection and Classification

The process of underwriting life insurance consists of two separate functions – selection and classification.

Selection is the process of determining whether the applicant meets the insurance company’s insurability criteria and measuring the risks involved in providing coverage.

Classification is the subsequent process, wherein an underwriter assigns the individual to a class – or group – of insureds with approximately the same loss probabilities.

Although life insurance contains the certainty of loss when policies remain in force for long enough, underwriters deal far more in probabilities than in certainties. While death is a certainty, the time at which it occurs rarely is. By placing the insured within a group possessing similar attributes and health history, life expectancies can be determined in a manner that is both equitable to the insured and profitable for the company.

Underwriters must select those who are eligible to receive insurance coverage and classify the selected insureds according to their potential risk levels.

Adverse Selection

Life insurance companies carefully screen applicants to ensure that individual premiums are based on policy owners of fair health in non-hazardous occupations. In addition to the modes of adverse selection discussed earlier, a primary form of this phenomenon begins when an uninsurable or high-risk applicant seeks a life insurance policy at this standard premium rate.

In life insurance, if the applicants know that an insurance company will offer them insurance without performing any underwriting, those in poor health or who anticipate future issues will apply for the coverage in anticipation of a more favorable rate. Conversely, if applicants know that the insurance company will investigate their insurability status, those in poor health or who constitute substandard risks are far less likely to apply.

Underwriting Factors

The life insurance application includes several areas of information that an underwriter considers during the assessment process. Specific circumstances may warrant the examination of additional factors about the insured’s health status, personal attributes, and lifestyle.

Age

Expected future mortality rates increase as the individual ages. As there is no way to measure a person’s biological age, the underwriters (and actuaries) must rely upon chronological age data.

Typically, age is not a key factor for determining acceptable risk. However, some insurers will not insure a newborn baby or a person of advanced years. For older individuals who may still qualify, the plan’s higher premiums might be extremely unappealing. Alternatively, adverse selection may again occur if these individuals to enter into a contract. In any event, the insurance company is unlikely to insure enough people in substandard risk categories to sufficiently distribute the risk.

Proof of age is not required at the time of application; it is uncommon for people to misstate their ages and relatively easy to obtain any needed verification. Furthermore, a policy’s “misstatement of age” provision addresses any potential risk or premium adjustments.

Sex

By itself, sex is rarely used for selection of risk. However, it remains a classification due to its significance in the construction and use of mortality tables. Statistics have long shown that females have overall lower mortality rates than men of the same age.

Since lower mortality rates indicate that females be charged lower life insurance premiums, it then follows that they should be charged higher premiums for annuities. While this is common practice, questions have arisen regarding the social acceptability of charging different rates based on gender. This has in turn led to the establishment of “unisex” rates, wherein the same premium is used regardless of sex.

Physical Condition

The most important factor in underwriting is the insured’s physical condition. An underwriter will scrutinize several facets of the applicant’s health to determine insurability and risk. A later discussion will address the many sources from which the underwriter gathers health information. However, this information comes primarily from the insured’s statements within the application and from physicians’ statements regarding the applicant’s disclosed health history.

Build

Build includes height, weight, and weight distribution. Popular statistics indicate that being significantly overweight can cause an early demise, but an underwriter must also be aware of how excess weight to any degree might cause or exacerbate other physical conditions.

Abnormalities

The mortality experience of an applicant will depend upon certain physical abnormalities that may affect the body’s major systems. These include the nervous, digestive, cardiovascular, respiratory, or genitourinary systems, as well as other high-function glands.

Problems with the circulatory system, such as high blood pressure and heart murmurs or fibrillation (irregular/erratic heartbeat) are of considerable interest, as they can result in higher mortality rates. A urine specimen can discover internal problems, particularly within the blood and/or kidneys. Conversely, characteristics such as low cholesterol and abstinence from tobacco weigh positively in the underwriting process.

Personal Health History

To ensure proper assessments, insurance companies inquire into those areas of an applicant’s background that are likely to affect future mortality. One primary area of concern is the individual’s health and medical history. However, insurers also investigate non-medical factors, such as overinsurance.

Insurers gather most of this information from the application and from attending physicians or hospitals. Per medical confidentiality legislation, the insurance applicant must sign a form that permits medical institutions to furnish records to the insurer.

If an individual has not had a physical examination for an extended duration, the insurance company can request that the applicant submit to a physical examination. With some exceptions, the insurer covers the expenses for this testing. An applicant can often fulfill the request with a para-medical examination, which is performed in the applicant’s home or office. However, if the underwriter requires more specialized testing, such as a stress test, the potential insured typically must shoulder the associated costs.

If evidence arises of a cardiovascular problem, the insurance company may request an electrocardiogram (EKG and any copies of past EKG results. In such situations, insurers can refer either to an on-staff medical director or, if none is available, forward the medical records and application to a reinsurer for a separate interpretation and assessment.

Family History

Heredity is another principal consideration for underwriters because a great many medical conditions are transmissible through genetics. Therefore, an applicant whose parents achieved longevity with few health issues may expect similar results. Conversely, if both parents died fairly young of inherited heart conditions, then the underwriter will pay particular attention to the applicant’s coronary problems, weight-related health concerns, cholesterol, et al.

Tobacco Use

Insurance companies are well aware of the severe effects on mortality that smoking and tobacco use can cause – even in the absence of other physical detriment. Furthermore, underwriters must pay equal consideration to those health problems that smoking or tobacco use can aggravate. Most insurance companies now have smoker and non-smoker rates. Although rates for smokers are considerably higher, they are still often inadequate – particularly in the cases of heavy smokers.

It should be understood that non-smokers are not a “super standard” class. As smoking continues to decline the U.S. non-smokers will soon be – and in some cases, already are – the standard classification of insureds. In turn, smokers will be considered substandard and will pay additional substandard premiums.

Alcohol and Drugs

If the underwriter knows that the applicant drinks alcohol to excess, they can either offer a substandard rating or deny coverage altogether. However, an applicant who participates in an alcohol treatment or support program may receive eventual acceptance after a designated number of years of disuse. In any event, alcohol use often severely affects the applicant’s health, and tests such as for liver and renal function may be required.

The known use of illegal drugs is grounds for denial of the application. However, situations where the applicant receives physician-prescribed controlled substances require examination. In such scenarios, the underwriter’s primary concerns relate to the reason for the prescription and any potential overuse or misuse. Furthermore, a prospect with a history of occasional or recreational drug use, but who has abstained completely for an extended period, may likely be insurable.

Financial Condition

An applicant’s reputation for meeting financial obligations can strongly indicate any level of moral risk involved in providing insurance. The metric for financial condition encompasses personal net worth and characteristics of the applicant’s income, including amount, source, and permanency. These factors are crucial in underwriting deliberations.

The relationship between a potential insured’s financial condition and life insurance coverage – that which is currently in force and any applied for – may indicate the quality of the applicant’s financial and estate planning. However, if the insurance amounts are uncharacteristically large or otherwise inconsistent with the applicant’s apparent lifestyle or status, the underwriter must again question what information remains undisclosed

Occupation

Due to considerable upgrades to safety legislation, occupational hazards were once far more significant than they are presently. Still, the contemporary underwriter must consider hazards within three occupational categories.

Proximity to sale or use of drugs/alcohol

Workplace environmental factors that can affect an individual’s overall health and wellbeing, e.g., inhalation of harsh chemicals, cramped quarters that enable frequent or rapid proliferation of disease

Professions that entail higher risk of severe accidents (racecar drivers, crop-dusters, et. al.) (Note: Historically, private pilots were unable to obtain life insurance or faced rates that were prohibitive to the same effect. Pilots may now more easily obtain insurance, with rates dependent upon the pilot’s level of experience.)

There are plenty of scenarios in which an individual who receives unfavorable rates due to a hazardous occupation will change to a safer job. Generally, the insured must remain in this newer role for a certain period of time before applying for a rate reduction. Regardless, an underwriter in the initial process typically ignores any hazardous occupation if the applicant has been inactive in that role for at least one year.

Military Service

During peacetime, insurers typically extend offers to military personnel. However, the onset of war triggers widescale adverse selection. This is particularly evident in cases where a serviceperson has just received orders to join a combat unit. In these scenarios, an insurer can deny the application or limit the amount of protection offered. Alternatively, the insurer may include a war exclusion clause. Typically, the clause states that should the insured die in military action, the beneficiary will receive a payout equal only to the return of premiums paid.

Avocations

As new generations experience increasing standards of living, the newly wealthy are spending more than ever in pursuit of exhilaration. As a result, activities such as scuba diving, rock climbing, parachute jumping (skydiving), and hang gliding have seen enormous increases in popularity. These activities can often be hazardous and as such, must be factored into the underwriting process. Oftentimes, an insurer will add a flat premium to cover the added risk. In some situations, the insurer will decline the application altogether.

Overinsurance

If a potential insurer discovers that an applicant appears overinsured, this may provide crucial insight into the applicant’s status. If the amount of protection is greater than normal – perhaps even more than is financially justified – the underwriter must think critically about what the applicant may not be disclosing. In such situations, the underwriter can request records from other insurance companies. However, in most jurisdictions, an insurer may not render an underwriting decision based only upon the records of another insurer.

Additional Considerations

Although uncommon, an underwriter may face two additional areas of concern.

As mentioned, private pilots incur aviation risk. However, this risk can also apply to commercial and military pilots. In cases of definite aviation hazard, the applicant must complete a questionnaire concerned primarily with experience, aircraft type, and flight frequency. Based upon these answers, the insurer may charge an additional premium. However, most scheduled airline pilots and experienced private pilots receive insurance coverage without aviation restrictions.

Another rare scenario centers upon the issue of residence. If a U.S. resident plans to move to another country, an insurer may charge an additional premium or decline coverage depending upon that country’s standard of living or political atmosphere.

Underwriting Information

Underwriters obtain their information from a variety of sources, but primarily from the following:

Applications

Physical examinations

Laboratory testing

Agents’ statements

Attending physician’s statements (APSs)

Inspection companies

Insurance industry-sponsored databases

Applications

A complete and accurate application can make a difference in every stage of the underwriting process. Therefore, the importance of the application cannot be overstated.

Part I of the application contains questions about personal information, including applicant name, sex, date of birth, residential and business addresses, occupations, and relation to the beneficiary(ies). It also asks about the type(s) of insurance applied for and in force, driving records, past policy denials or modifications, and potential lifestyle hazards from aviation, avocations, international travel, et al.

Part II details the applicant’s medical history, including names of attending doctors and hospitals – both present and within the past five, questions regarding the physical well-being of the applicant, alcohol or drug use, and family history.

A copy of the completed application becomes part of the insurance policy.

Physical Examination

If the insurer requires a physical examination, the insurance company will furnish a form for the attending doctor or paramedic to complete. The insurer may also require copies of X-rays, EKGs, EEGs, and various other test results.

These examinations are crucial and can uncover many medical conditions. However, they may still be vulnerable to exploitation by applicants attempting to conceal health problems. These applicants may prepare by dieting and exercising in the period preceding the exam. While underwriters usually use paramedical exams for policies with lower coverage amounts, the insurer generally stipulates a predetermined threshold at which a full physician’s examination is required.

Laboratory Tests

Although laboratory testing gained popularity due to concerns about exposure to AIDS and illegal drug use, increased public awareness of various other health risks has solidified their place in the underwriting procedure. Furthermore, insurance companies have found that the most commonly used laboratory more than justify their costs.

Laboratory tests usually consist of both blood and urine specimens. Labs can test urine for the presence of nicotine, controlled substances, and other medications.

Attending Physician’s Statements

If the prospect’s completed application contains medical history, the underwriter will commonly – and sometimes by company mandate – obtain copies of the applicant’s medical records. These are called Attending Physician’s Statements (APSs). In some cases, the agent or agency will request an APS at the time of application. Furthermore, some insurance companies will pay for the APS if they regard the physician’s charge as reasonable.

An individual’s medical records constitute legally confidential information between the physician and the patient. Therefore, the application will contain an authorization enabling the insurer to request a copy of the medical records from the physician or facility. While the underwriter generally considers the APS to be the most vital source of medical information, it is not always easy to obtain. Doctor’s offices are often known for a lack of urgency in sharing records, and on occasion, physicians have refused to submit records altogether. Since medical records technically belong to the patient, an agent or underwriter must occasionally request that the applicant obtain their own records.

Consumer Reporting Agencies

Under many circumstances, underwriters must order reports for which a hired company interviews the insured (or in some cases, a family member, neighbor, or employer). These reports are commonly called consumer reports and the inspection companies are called consumer reporting agencies. Insurance companies designate a threshold coverage amount. Then, they will order a consumer report for any applicant seeking protection that exceeds this threshold. They will also typically order a report for applicants that exceed a certain age.

The U.S. Fair Credit Reporting Act strictly regulates consumer reporting agencies. The act defines a consumer report as:

[…] any written, oral, or other communication of any information by a consumer reporting agency bearing on a consumer’s credit worthiness, credit standing, credit capacity, character, general reputation, personal characteristics, or mode of living which is used […] in establishing the consumer’s eligibility for credit or insurance […][1]

(Note: These reports are used only for personal insurance.)

In most states, the insurance company must notify the applicant in writing that they may be investigated. The type of investigation and report usually depends upon the insurance amount for which the prospect has applied. In some circumstances, insurers may only require a short form that verifies the applicant’s address, occupation, and employment information. Under other conditions, the insurer requires an intermediate form for additional information.

However, when considerable amounts of protection are at stake – particularly if requested for business purposes – the insurance company will mandate an extremely thorough report. Such a report may require interviewing the applicant’s bank, accountants, and any other business affiliations. These institutions typically bill on an hourly basis, for which payments are the insurer’s responsibility.

Databases – MIB Group

Example

In 2010, Bruce applied for coverage with Blankenship Life Insurance. On the application, he indicated his recent diagnosis of early-stage multiple sclerosis (MS). Blankenship denied his application and coded and submitted information about his illness to MIB Group. 

Shortly thereafter, Bruce moved to another state. The early stages of MS left Bruce vulnerable to sudden seizures. However, he had not experienced any such events and did not report the diagnosis to his new general practitioner. Instead, he found a specialist who monitored his episodes.

Then, in early 2013, Bruce applied for life insurance with Acme Life. He did not mention his MS or his specialist treatment on the application. Upon request, the underwriter at Acme received the MIB report that Blankenship had filed. Then, after seeing Bruce’s MS diagnosis, the underwriter contacted Blankenship, who sent the application details from their files. The underwriter then contacted Bruce, who denied ever having received an MS diagnosis or treatment.

Acme was prohibited from making an underwriting decision based solely upon the information from the MIB Group database. Consequently, they needed to obtain additional verification. Acme required Bruce to submit to a medical examination, which would likely indicate that he had MS. At that stage, they could deny the application. However, if they were unable to verify the MS diagnosis, they could not decline or rate Bruce’s policy.

MIB Group, Inc., formerly known as the Medical Information Bureau, is one of the insurance industry’s most misunderstood organizations. Formed in 1902 to protect insurance companies against applicant fraud, MIB Group is a heavily computerized repository of confidential ­medical information about life or health insurance applicants who have applied for coverage from its member companies.

MIB Group is a membership corporation to which virtually every insurance company belongs. Companies that are not members are usually extremely small or recently established. However, even they often benefit from MIB Group services via reinsurance underwriting on large or difficult cases.

The organization requires members to code and report certain medical impairments as obtained from a medical source or directly from the applicant. Contrary to popular belief, MIB Group data does not display its member companies’ underwriting decisions. Furthermore, the data does not indicate the type or amount of insurance requested. However, the database may include information other than medical conditions. This can be information such as driving records, aviation activity, hazardous sports activity, and criminal activity or association.

Perhaps most importantly, an MIB member may not render an unfavorable underwriting decision – based solely or in part – upon the information contained in this database.

Most states require the insurer to inform the applicant in writing that their information may be reported to MIB. Additionally, the written notice must provide instructions for the applicant to obtain a copy of and/or dispute the MIB report. The authorization to release information to MIB is

typically on the form that contains the release of medical information authorization.

The information contained in the MIB database cannot be used to render underwriting decisions against the applicant.

References

[1] https://www.ftc.gov/system/files/documents/statutes/fair-credit-reporting-act/545a_fair-credit-reporting-act-0918.pdf

Chapter 9: Underwriting (Part 2)

Classification

Until now, this discussion has focused on the selection stage of the underwriting process. During the next stage, the underwriter must determine whether the applicant is insurable, and if so, on what basis. If the applicant does not meet the company’s underwriting criteria, then the application is declined and the process ends.

After the selection stage, the underwriter must decide whether to accept the applicant at standard or substandard rates or – in cases where a medical condition’s impact can be better determined at a future date – whether the application will be postponed.

Example

Phillip is scheduled for a non-cancerous prostate surgery performed by an eminent urologist in three weeks. As he has recently purchased a new house with expensive mortgage payments, he applies for a life insurance policy to help pay the mortgage in the event of his death.

Phillip is in excellent health and financial condition and meets the requirements of the insurer’s standard policy. However, an underwriter would likely decide to postpone the application until a certain amount of time elapses after the surgery. After the designated duration, the underwriter would again review Phillip’s application and issue the policy, so long as no changes have occurred.

The Rating System

In the early years of life insurance, several different individuals might have reviewed medical issues within an application. This list included the underwriter, an independent doctor or one serving as the company’s medical director, the actuary, and anyone else with relevant expertise. The reviewers would either accept or decline the application, providing no further classification. As one might imagine, this method of underwriting left much to be desired. Thus, the numerical rating system was born.

In the numerical rating system, a standard risk has a default rating of 100. The underwriter then judges by credit or debit any factor that affects the applicant’s mortality. These marks typically occur in 25-point increments. As a rule of thumb, many companies classify ratings of 75-85 as preferred, 100-125 as standard, and 150-500 as substandard. Furthermore, an underwriter will usually decline any application rated above 500.

Insurance companies express the above underwriting classifications as tables. The primary tables are all even-numbered and labeled in multiples of 2. For instance, if an applicant’s medical condition adds 50 additional points to their rating, then the application is classified as a Table 2 risk. More severe conditions would then typically be rated at Table 4.

Generally, odd-numbered tables only exist for the purposes of complex ratings that require balancing many crediting and debiting factors.

Note: Some insurance companies use a lettering system in lieu of numbers, wherein Table B corresponds to Table 2, Table D to Table 4, etc.

Example

Herbert applied for a life insurance policy. On the application, he indicated that he is 37 years old, 5’10”, 215 lbs., and has had “a little high blood pressure,” but is not under treatment. He is a non-smoker and non-drinker and remains physically active. His parents are both alive in their 60s and his grandparents both lived into their 90s.

Herbert’s paramedical exam indicated a blood pressure of 155/90. Additionally, the insurance company’s build tables consider him overweight and rate him accordingly.

A standard manual might add 25 points for an overweight rating and 75 points for high blood pressure, then credit 10 points for family history. In addition, a separate rating would increase the combined weight and blood pressure ratings, as this combination places Herbert in a higher risk category.

Although the raw numbers total 190 (100 + 25 + 75 – 10), Herbert’s total classification would be over 200 points. Consequently, he would receive a substandard risk rating.

Practically speaking, Herbert’s weight and blood pressure could determine whether the underwriter might consider a lower rating to remain competitive. If the total rating is Table 6 or lower, but there are no other health factors, another company may offer a Table 4 rating.

Rating Manuals

Underwriters use manuals to interpret various health factors into a numerical value. The larger companies may provide proprietary manuals to their underwriters. However, most underwriters use manuals provided by their affiliated reinsurance companies. These manuals contain most illnesses, impairments, and diseases, in addition to their descriptions and suggested ratings.

Pricing Procedures for Impaired Risks

Insurance companies generally vary premium rates for substandard risks on a plan-by-plan basis. Substandard premiums are lower for plans with higher cash values. This is because the net amount at risk decreases over the policy lifetime, meaning the insurer experiences less risk exposure.

With the exception of level premium plans, substandard premiums do not increase in proportion to the degree of additional expected mortality. This is because expenses, such as commissions, do not increase significantly if a policy is substandard. Often, insurers only pay commissions on the standard portion of the premium.

The table ratings reflect the extra mortality expected for individuals within the same rating class. In the sample table below, the mortality figure (and its associated premium) is represented as a percentage of standard mortality.

TABLE #      (% OF STANDARD MORTALITY)        NUMERICAL SCORE

1        125    120-135

2        150    140-160

3        175    165-185

4        200    190-210

5        225    215-235

6        250    240-260

7        275    265-285

8        300    290-325

10      350    330-380

12      400    385-450

16      500    455-550

Uninsurable/

Rating Over 550

Flat Extra Premium

For substandard risks expected to remain static, underwriters will commonly employ the flat extra premium approach. It is applicable regardless of age or duration of the plan. With this method, the insurer adds a flat premium to the regular premium and, with respect to dividends and nonforfeiture values, defines the contract as a standard policy. Insurers and underwriters most often use the flat extra premium approach for applicants with hazardous occupations or avocations.

After an insurance company issues a policy with a flat extra premium, the insured may apply to have the extra premium removed if their situation has significantly improved. For example, if a hazardous occupation warranted a substandard rating, the insurer may be able to eliminate the extra premium upon a proven change of occupation. However, the burden of proving change in status falls onto the insured, who must notify the insurer and provide full supporting documentation.

Uninsurability

As indicated earlier, any rating above Table 16 is usually uninsurable. Furthermore, many insurance companies will only retain risks below Table 10 or 12. However, these companies will still issue policies via reinsurance facilities, as most reinsurers will accept applicants who are rated at Table 16.

Uninsurable individuals often feel desperate as they realize that they have limited options for protecting their families if they die. Some individuals in this category can use annuities to set up a tax-friendly estate for their survivors. However, this requires initial funds to purchase the annuities.

In many cases, the use of a substandard broker is the best course of action. This broker specializes in obtaining insurance for substandard risks.

Usually, an uninsurable individual is just that – uninsurable. However, many of those with high ratings can find insurance if they are able to conduct thorough research within the market. A denial from one company may not necessarily portend a denial from all companies.

Reinsurance

While reinsurance is a highly specialized field, awareness of how reinsurers function is crucial for understanding many nuances within the business. Financial reinsurance arrangements are responsible for tremendous numbers of non-standard of policies offered, the sizes of available policies, the amount of active insurance companies, and the financial statuses of smaller insurers, and even commissions paid to newer insurers.

Before continuing, it is paramount to remember that there is no legal relationship between a reinsurance company and an insured.

In essence, reinsurance is the transfer of all or a portion of an insurer’s risk via an insurance policy purchased from another insurance company. However, a reinsurer does much more than this definition might imply.

Reinsurance enables an insurance company to:

Expand its capacity

Stabilizes its underwriting results

Finance its expanding volume

Secure catastrophe protection against shock losses

Withdraw from a class or line of business (or a geographical area) within a relatively short period

Share large risks with other companies.

It is quite probable that all life insurance companies rely somewhat upon reinsurance. Truly an international business, most reinsurance on U.S.-based life insurance policies originates from non-U.S. reinsurance companies.

Most reinsurance companies provide products for life and health exposures and are either owned by or affiliated with a property and casualty reinsurance company. Additionally, some reinsurers are merely the reinsurance departments of direct-writing companies. In fact, most American reinsurance was reinsured by such departments of large insurers, including Connecticut General, BMA, and Lincoln National. Most of the reinsurance business has been transferred to professional reinsurance companies – those who deal solely in reinsurance. Moreover, the vast majority of these companies are located outside of the United States.

Rating Impaired Risks

There is a large market for impaired (substandard) risks applying for life insurance. As medical technology continues to advance, the insurance industry changes alongside it. Additionally, powerful computing technology enables insurance companies to compile multitudes of complex statistics, which further clarify the effects of impairment on a particular group’s expected mortality.

As a result, reinsurers have begun to heavily influence methods for underwriting impaired risks. European reinsurers in particular have become pioneers in this sub-field. Reinsurers have competed vigorously for impaired risk business, many of them accepting substandard risks with the understanding that they will also participate in standard business written by the insurer. Reinsurers have conducted seminars in underwriting, participated in industry underwriting and actuarial conventions, and have created and furnished underwriting manuals for underwriters (most life insurance underwriters have at least one, and frequently several, reinsurance underwriting manuals) at no cost to the underwriters.

Reinsurers are generally able to accept business that smaller companies cannot accept, because of the large block of business that they have in force. Reinsurers “reinsure” among each other (technically called “retro ceding”), so compared to a “regular” life insurance company, their number of insured lives is very large so they are able to base underwriting decisions upon their own experience.

Retention

Retention refers to the amount of insurance that an insurance company is willing to accept in its own account. Reinsurance covers the amount exceeding this maximum. As a result, much smaller insurers are still able to compete with nationally available and renowned companies. The argument can be made that, were it not for reinsurers, insurance companies in the United States would number as few as five or six.

An insurance company’s actuary usually determines its retention figure in relation to what the company can safely lose without impairing its surplus.

Types of Reinsurance

Reinsurance can fall under one of two categories – proportional or nonproportional.

Proportional Reinsurance

Proportional reinsurance refers to arrangements where the reinsurer and the direct-writing company share the risk and premium via a predetermined contract. Most reinsurance is proportional.

Nonproportional Reinsurance

Conceptually speaking, nonproportional reinsurance is the simpler of the two categories. In such arrangements, the reinsurer pays a claim only when the loss amount exceeds a predetermined limit. The intended effect of this mode of reinsurance is to stabilize the claims of the direct writer.

Nonproportional reinsurance is further divided into three subcategories.

Catastrophe Reinsurance

This is a common and successful type of reinsurance that protects against multiple insured losses arising from a single incident. Many insurance companies use catastrophe reinsurance – particularly those who maintain large concentrations of risk from such policies as group or travel insurance.

Stop-Loss Reinsurance

Stop-loss reinsurance enables the direct writer to determine the total amount of claims that it can (or wishes to) sustain throughout a single year. Then, the reinsurer pays for the claims that exceed this amount. The reinsurer usually adjusts premiums annually to reflect actual claims experience.

While this form of reinsurance is simple, it has seen little overall excess. Ironically, insurers that have attempted this approach almost always practice a form of adverse selection. With such an agreement, the direct writer inevitably becomes more flexible with risk acceptance. After all, the reinsurer must compensate for any excess in irresponsibly written claims.

Spread-Loss Reinsurance

Spread-loss reinsurance is similar to stop-loss, except that the reinsurer spreads any claims over a specific number of years. As a result, the ceding (direct-writing) company is able to spread its losses over this duration.

Reinsurance Contracts

Facultative Reinsurance

Facultative reinsurance is a method wherein the reinsurer individually underwrites and reinsures each application. The reinsurer may accept or decline the application (risk), rate the policy based on health concerns or other mitigating factors, or accept the application on its original basis.

The ceding company may keep a retention on the case – which may vary by table rating – or cede the entire amount. Often, direct writers will submit facultative cases to a reinsurer to obtain the expertise of the reinsurer’s underwriting department. After the reinsurer has rendered its decision, the ceding company may decide how much of the policy it will retain – if any.

Furthermore, the ceding company may simultaneously submit the case to more than one reinsurer. It may also do this at a later time If the amount is large, the reinsurer may reinsure some of the policy with another reinsurer. This practice is called retrocession. Alternatively, if the reinsurer is unable to find another reinsurer willing to accept part of the risk, then the reinsurer may restrict the amount it will accept.

The principal disadvantage of facultative reinsurance is the time that it takes time to perform the necessary underwriting. Since most of these cases involve medical records that require research and verification, the applicant may purchase insurance elsewhere before any process is complete.

Automatic/Obligatory Treaty

Under an automatic treaty, the ceding company must agree to submit to the reinsurance company a designated class of risk at the time it issues the policy. The direct-writing insurer must still insure the risk up to its typical retention limit and the reinsurer must accept at least part of the reinsurance risk in excess of this limit. Additionally, the reinsurer does not assume responsibility for any underwriting associated with the class of applications in question.

Facultative Obligatory

This hybrid type of agreement obligates the ceding company to submit all facultative business to the reinsurer, who then reviews the case and may accept or decline the policy.

Under these agreements, the direct-writing company is solely responsible for any payments to which a policy entitles its owner, regardless of any terms in the agreement between the insurer and reinsurer.

Reinsurance Plans

There are three types of reinsurance plans that can be used for either automatic or facultative reinsurance.

Yearly Renewable Term (YRT)

Facultative reinsurance almost exclusively employs YRT agreements. Under the terms of an YRT plan, the direct-writing company cedes the net amount at risk (above its retention limit) to the reinsurer. It pays premiums from a table of reinsurance premiums broken down by age, sex, and table ratings.

As the reserves increase annually, the net amount at risk decreases until eventually, the ceding company reassumes the entire amount. YRT-type treaties usually establish a minimum time period for which the reinsurance remains active. The ceding company may only start recapturing reinsured policies after this time elapses.

Notably, YRT premiums are entirely separate from those premiums that the direct writer charges its customers. This is because reinsurers do not have to establish reserves, nor do they incur the expenses (e.g., commissions) that the ceding company faces.

Coinsurance

As the term implies, coinsurance enables the ceding company and the reinsurer to share a proportionate part of each risk as outlined under the terms of the policy. The reinsurer then becomes liable for death claims. The specific amounts are calculated using the size of the policy in relation to the percentage reinsured.

For example, a reinsurer is responsible for half of each risk and will pay half of a death claim made to the ceding company. For this service, the reinsurer receives a certain percentage – a pro-rata share – of each original premium, less an agreed-upon amount for expenses and taxes.

In order for the reinsurer to establish and maintain the necessary reserves for the reinsured amount, the ceding company must pay for the increase in reserves each year.

Modified Coinsurance

Coinsurance has worked for reinsurance for decades. However, companies started asking why they could not keep the reserves for investments themselves. Under the modified coinsurance plan, the reinsurer pays to the ceding company a reserve adjustment each year which is equal to the net increase in the reserve during the year, less one year’s interest on the total reserve held at the beginning of the year (as otherwise, the reinsurer would not be receiving any interest on funds held, which is an important part of the profit). The effect of this arrangement is that the ceding company receives the bulk of the funds developed by its policies.

Assumption Reinsurance

Assumption reinsurance serves as an exception to the principle that the reinsurer and the applicant have no direct legal relationship. Under assumption proceedings, the reinsurer takes full responsibility for the ceding company’s policies. This includes funding any claims payments to which a client may be entitled. As per NAIC regulation, a policy owner must be notified before any such assumption and has the right to consent to or reject the transfer of their policy.

Surplus Relief

Surplus relief is a more technical means of financial reinsurance whose goal is to finance the writing of new business or other development of the company. A smaller company seeking to write many new policies may seek a reinsurer for this purpose.

The more technical aspects of this type of reinsurance are outside the scope of this course. However, in these scenarios, the reinsurer essentially leases a block of the ceding company’s business, paying commission and expenses equal to the anticipated profits to the direct-writing insurer. This frees up present funds that the ceding company can use to develop new business.

Some critics of this type of reinsurance fear that reinsurers are artificially extending the lives of failing companies, eventually leaving the Department of Insurance responsible for finding an existing company to assume active policies. However, many substantial companies have used this type of reinsurance to enable the exploration of new business areas and keep pace with their better-funded competitors.

Chapter 10: Insurance Regulation and Organization (Part 1)

There are numerous overlapping and conflicting viewpoints regarding the matter of state versus federal regulation of the insurance industry. Some proponents of state regulation argue that existing local legislation generally functions well and that individual states can be more responsive to local needs and opportunities. Additionally, many of these advocates favor the decentralization of government, which is a popular stance across commercial industry as a whole.

Invariably, there are also various arguments in favor of federal regulation. Advocates for this approach maintain that insurers incur greater costs when reporting within multiple states. These costs then raise the expenses passed onto customers. Additionally, conflicting regulations among states can be a source of struggle and forfeited business opportunity. There is also concern that state insurance commissioners are often disproportionately responsive to the requests of local insurance companies, rather than those from other states. Finally, some argue that the increasing number of international relationships among insurance companies warrants unified federal oversight.

Federal Regulation

In matters of insurance regulation, the federal government has sometimes exercised its authority in notable ways. Periodically and depending upon the political climate, Congress has investigated insurance industry practices, often to address concerns of consumer protection. Such hearings and investigations have drawn scrutiny and criticism from both commercial and political objectors. Regardless of individual opinions on these actions, they make evident that the insurance industry is a formidable structure within the American sociopolitical landscape.

The IRS

As is evident, the IRS exercises considerable authority over insurance companies, their products, designs, and values via tax legislation. Additionally, it influences the overall demand for insurance and the subsequent taxation of insurance companies.

The Employee Retirement Income Security Act (ERISA) of 1974 has exhibited arguably greater influence on insurance products and marketing than any other instance of federal involvement. Originally, the U.S. government implemented ERISA to protect pension plan funds against the actions of unscrupulous employers. This act simultaneously promulgated regulations that safeguard retirement funds and included a clause that preempted any state laws from regulating certain employee benefit programs – including health insurance. As a result, many critics consider it an unwarranted intrusion of the government into the industry.

The SEC and FTC

Currently, the SEC oversees the design, operation, and marketing of variable life and annuity products. Any publicly owned insurance company must file with the SEC, which directly regulates sales and stock issuances of these companies.

Historically, one of the life insurance industry’s most severe and outspoken critics has been the Federal Trade Commission (FTC), which also exercises various degrees of supervision over many insurance activities.

NAFTA

As insurers began working with insurance industries abroad, government regulation soon shaped these cross-border commercial relations. Notably, the collective governments of North America introduced the North American Free Trade Agreement (NAFTA). NAFTA provides that there shall be relatively unrestricted access between the insurance markets of the U.S., Canada, and Mexico, and it prohibits discrimination between domestic and foreign insurers of those countries.

State Regulation

State legislatures issue laws pertaining to the regulation of insurance companies within their jurisdiction. They refer to these laws as insurance codes. As detailed below, the legislative influence of insurance law extends to the composition of the state insurance department, licensing of companies and agencies, and several other areas involving the financial security and strength of domestic companies.

State-level courts are also highly involved in insurance, as they are usually the final arbiters of conflicts between insurance companies and their policy owners. Perhaps most recognizably, they administer punishment to those who violate insurance laws. However, insurers and agents also use the court system to overturn certain statutes or regulations that may be deemed arbitrary or unconstitutional.

Each state also has a state insurance commissioner who directs the state’s department of insurance. While in most states, the governor is responsible for appointing the insurance commissioner, there are several places in which the general public elects the commissioner instead.

In some states, the insurance commissioner has additional responsibilities, including acting as the state auditor or fire marshal. In others, the entire insurance department is directly associated with other state departments, such as those for banking or securities.

Most importantly, the state exercises its authority over the insurance industry via the issuance of licenses. Every entity – from individual insurance producers and sellers to entire insurance companies – must apply for and receive licenses from the state insurance department. In this way, they are also able to regulate the state-side activities of those non-domestic companies who otherwise operate outside of the regulatory authority of the state.

The National Association of Insurance Commissioners (NAIC)

The NAIC spans all 50 states and Washington D.C., as well as the American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, and the U.S. Virgin Islands. Its stated purpose is to provide “expertise, data, and analysis for insurance commissioners to effectively regulate the industry and protect consumers.”[1]

Several committees comprise the NAIC, many of which deal only in a specific line of the insurance business (e.g., life, health, property & casualty). These committees depend heavily upon the advice, expertise, and knowledge of those in the insurance industry. As such, many insurance executives and technicians belong to various NAIC advisory groups. However, many consumer advocate groups criticize this structure, fearing that the voices representing insurance companies can unduly influence regulators and committees.

Model Regulations

One of the NAIC’s most influential decisions to date is the introduction of model regulations, which are bills and regulations that NAIC members agree are worthy of consideration in all states and territories. Although these models have no special authority, the NAIC suggests that the states adopt them into their regulatory practices. Therefore, the majority of states typically adopt model regulations – either in their entirety or with modest changes that better accommodate the region’s political atmosphere.

Furthermore, the NAIC has accomplished considerable standardization of forms and solvency requirements. They have also enacted a practice of initializing local audit teams to perform both scheduled and unscheduled assessments of insurance companies. These examinations have uncovered many situations that could have severely cost policy owners and company stockholders alike. In fact, this procedure is responsible for the discovery of the majority of potential insurer insolvencies.

Insurance company assessments in NAIC-accredited states must be performed by audit teams with the same accreditation. Furthermore, companies based in non-accredited states must obtain a second examination from an accredited state. Since insurance companies must pay for their examinations, there can be pressure for the state’s insurance department to become NAIC-accredited. As the prevailing accreditation organization, the NAIC has received criticism both for this potential influence over state government and for oversights in regulatory standards that have previously allowed corporate insurance fraud to go undetected. [2]

State Legislation

The principal purpose of state regulation over insurance companies is to ensure that these companies remain solvent. This includes establishing practical guidelines for both standard procedures and mitigation of the risk of fraudulent activity.

For example, state laws typically establish limits as to the size of risks that insurers can assume, with specific requirements for capital and surplus amounts, policy reserve liabilities, and regulation of insurer investments. Additionally, the state insurance department is responsible for the liquidation or conservation of insurance companies that operate within their jurisdiction. This state oversight has significantly minimized losses to policy owners whose insurance companies fail.

Companies Foreign, Domestic, and Alien

State insurance laws dictate the requirements for the organizing and licensing of insurance companies. Furthermore, life insurance companies adhere to their own unique requirements.

State insurance departments can exercise regulatory authority over three different types of insurers:

Domestic insurers – domiciled in the regulating state

Foreign insurers – domiciled in another state or territory

Alien insurers – domiciled in another country

These companies share similar licensing requirements because they must maintain specified assets within the regulating state. A foreign insurer deposits assets with the insurance department of their state of domicile and can provide to the regulating state a certificate to this effect. However, an alien insurer usually must establish a more substantial fund or deposit in trust within the regulated state. Additionally, the alien insurer must assign a resident of the state in which it wishes to do business. This resident serves as the company’s attorney in any legal proceedings that may arise.

Unauthorized Practitioners

Despite fairly comprehensive regulation and auditing, state insurance departments continue to face a perplexing issue – the activities of unauthorized insurers. These rogue insurers do not file financial statements with the department and typically conduct business via the Internet (or previously, via snail mail). As a result, they are often able to evade regulation. However, many states have added legislation to at least mitigate the consequences.

NAIC Model Act Adoption

Several states have adopted the NAIC’s Unauthorized Transaction of Insurance Criminal Model Act, which states that no person can solicit business or become involved in the transaction of insurance from unauthorized insurers. Furthermore, they may not represent any person in procuring insurance from an unauthorized insurer.

Usually, participating states have excluded group life and health insurers from this act. However, the NAIC recommends that life and health insurance policies – which are usually sold through mass-marketing techniques – still be subject to advertising and claim settlement practices. They also recommend that these policies meet the minimum loss ratio guidelines applicable to authorized insurers in that state.

Advertising Restrictions

Some states prohibit any advertising originating from outside of the state for which the product is intended. In other words, Insurer A from State A may not advertise in State B. Some states even permit the insured to legally void any such contract. Furthermore, many of these states allow an insured to initiate legal action against the unauthorized insurer by serving process on the insured’s state insurance commissioner.

Regulation of Policy Documents

Many states require that an insurer’s policy forms be filed and approved within the regulating state. As such, the insurer is prohibited from using these forms until receiving the insurance department’s approval. Furthermore, such regulations typically require the forms to contain certain model provisions such as grace period, incontestability, misstatement of age, and dividends clauses. The forms must meet standards with respect to intelligibility, unambiguity, and clarity of purpose. Finally, some states follow the NAIC model law that states that policy forms may be denied approval if policy benefits are unreasonable in relation to solicited premiums.

Licensure

Despite many variations among state insurance laws, no state permits a person to act as an agent or broker – or in some cases, a fee-based counselor – without first obtaining an insurance license. Unsurprisingly, licensure requirements vary by state. However, a potential licensee generally must successfully complete a written examination for the desired license. Additionally, each agent must be appointed by an insurance company, which then notifies the state insurance department regarding new appointees.

Additionally, so long as it serves due notice and holds a properly executed hearing, the insurance department may refuse, suspend, or revoke an insurance license. These decisions may be reached upon deciding that an agent or potential agent is:

Incompetent or untrustworthy

Fraudulent or dishonest

In violation of the law while acting as an agent

NAIC Model Unfair Trade Practices Act

Although states vary significantly as to which NAIC model acts they adopt and how such laws are implemented, every state in the U.S. has adopted the NAIC Model Unfair Trade Practices Act. This act grants the state insurance commissioner power to investigate or examine company practices, hold hearings on unlawful practices, and issue cease-and-desist orders with penalties for violations. Notably, this model act is so thorough that it replaced the existing FTC jurisdiction in any such matters as cataloged above.

Rebating

One primary concern of the Unfair Trade Practices Act is the practice of rebating. Rebating occurs when an agent returns any portion of commission or premium to the applicant as an incentive to purchase insurance. While illegal in most states, some critics of this ban contend that it restricts an applicant’s ability to fully negotiate with insurance sellers.

Currently, Florida and California permit rebating, albeit within extremely strict guidelines and parameters. Furthermore, these states prohibit unfair discrimination in the granting of rebates – an agent cannot select when and to whom they may offer rebates.

Twisting and Replacement

Twisting occurs when an agent or broker misrepresents information in an attempt to persuade a life insurance policy owner to cancel one policy and buy a new one. This practice is illegal in all circumstances and can result in an agent’s immediate loss of license.

In contrast, replacement is both legal and fairly common practice. This is the simple act of replacing one policy with another during which time the purchaser is fully informed. In order to prevent misrepresentation in these circumstances, most states have laws that require insurers to fully disclose any relevant comparative information when trying to convince a customer to change policies. Additionally, these laws sometimes mandate that the agent notify the insured’s current provider, enabling the current insurer to respond with a counterproposal. Overall, states are intentional and specific regarding the information that insurers must disclose when a policy replacement may occur.

Funds Management

Understandably, states tightly regulate agents and insurers with respect to handling policy owners’ funds. Misappropriation or misuse of funds is illegal, regardless of the duration over which such a practice might occur. Additionally, legislation prohibits the commingling – or combining – of any policy owner’s money with an agent’s personal funds. As such, agents who manage large sums of money must ensure that under no circumstances do a policy owner’s funds reach an agent’s personal account.

Financial Regulation

Although the Unauthorized Transaction of Insurance model law requires some relationship between premiums and risk, the state only regulates life insurance premiums insofar as establishing minimum reserve requirements. In turn, an insurer must receive adequate premiums to post funds to the required reserves.

In addition, insurance companies file annual reports to provide the Department of insurance with overviews of the administrative costs incurred through business operations. States such as New York and Wisconsin have very complex and demanding laws that limit the expenses that insurers may incur. As a result, there are often limitations on product commissions and existing business expenses.

Some states also limit the amount of dividends that a stock insurer may declare. However, most states structure such legislation on the premise that competition is the most significant and effective regulator of insurance premiums.

Blue Books

State law requires each insurance company to file financial statements with each state insurance department under which the company is authorized to do business. Life insurance companies refer to these statements as “blue books” in reference to the typical color of the binders of statements. Insurers must file blue books annually at a minimum and may be required to file more frequently if the insurance department is investigating matters of solvency.

Insurance departments categorize insurance company funds as either capital and surplus or reserve investments. Insurers may use capital and surplus funds for certain types of investments – such as cash, government bonds, or mortgages – whereas reserve funds may be invested in other miscellaneous capital investments. A company’s Board of Directors (or a Board-authorized committee) must grant approval before making any such investments.

Reserves

As discussed earlier in the text, the prospective reserve is the amount designated as a future liability to bridge the difference between future benefits and future premiums.

A life insurance company must establish a minimum reserve, the sufficiency of which must be confirmed by an actuary. In fact, the company’s actuary must file a report that contains the results of certain specified cash-flow tests. In addition to required annual CPA reports, these reports provide insurance departments with a comprehensive financial overview of each insurer in their jurisdiction.

The Insurance Regulatory Information System

State insurance departments use the NAIC’s Insurance Regulatory Information System (IRIS) as an early warning system to indicate when an insurance company is facing potential financial difficulty. The information from within IRIS serves as the foundation for a two-pronged mode of investigation. First, the company’s financial reports are analyzed according to predetermined guidelines. Then auditors from various insurance departments analyze the company’s annual statements and other available financial information. Finally, this analysis is sent to the insurance department of the company’s domiciled state, at which time the department can take further action as necessary.

Final Thoughts

The combination of federal and state insurance regulation serves as a potent deterrent for potential fraudsters – both individual and commercial. However, the sheer volume of insurance products, agents, and consumers, as well as rapidly evolving technology provide more than enough space for dubious practitioners to evade the law. This provides plenty of fodder on all sides of arguments surrounding legislative jurisdiction and authority. Therefore, it is not unreasonable to assume that regulatory bodies and their critics will continue to champion change and reform within both insurance practice and regulation.

References

[1] https://content.naic.org/about

[2] https://www.gao.gov/products/gao-01-948

Chapter 10: Insurance Regulation and Organization (Part 2)

Life and Health Guaranty Associations

In order to protect clients against insurer insolvency, each state has adopted a version of the NAIC’s Life and Health Insurance Guaranty Association Model Act. Under this act, the state forms a guaranty association, which is typically funded by the fees that insurers must pay for company assessments. The act extends protection to policy owners who reside in the state where an insurer has been deemed insolvent. Furthermore, the act covers all of the insolvent company’s policy beneficiaries, regardless of where they reside.

Under the model act, the guaranty association may pay the formerly insured a maximum of $300,000 in life insurance death benefits, but not more than $100,000 in net cash surrender values. Additionally, coverage for annuity cash values and payments – including tax-qualified annuities and structured settlements —is limited to $100,000. Notably, it is nearly impossible to uncover any recorded instance of an annuity holder losing such a significant amount. The primary source of loss within an annuity is anticipated interest growth; the principal always remains intact.

Taxation of Life Insurance Companies

While levels of government influence within the insurance industry have fluctuated tremendously, both federal and state governments have long imposed taxes on life and health insurance companies.

State Taxation

Most states typically charge premium taxes on insurers as the companies receive premiums from policy owners. This means that a portion of a client’s premium fee pays this tax. Unsurprisingly, many consumers and producers/agents within the industry view this premium tax as extremely unfair – and not without reason:

The government only directly taxes the savings of insurance companies.

This is a regressive tax, meaning that its uniform rates disproportionately affect lower-income individuals.

The tax discriminates against cash value life insurance, which inherently costs more and, as such, whose taxed premiums are higher than other policies.

Elderly and substandard insureds pay a higher percentage of this tax because they pay higher premiums.

The premium tax does not account for an insurer’s relative profitability, meaning that it disproportionately affects companies with lower or negative profits.

Moreover, many states enact retaliatory taxation of non-domestic insurers. For example, assume State A charges a 4% premium tax on its domestic insurer, Anyweather Mutual. However, Anyweather also operates as a foreign company within State B, which charges them a 9% premium tax. As a result, when State B opens an office for the Beemerry Group within State A’s jurisdiction, then State A charges Beemerry a 9% premium tax.

Federal Taxation

In federal government taxes life insurance companies based on a figure known as life insurance taxable income (LICTI). Although the gross income to which this figure applies is measured similarly to any other corporation, there are some notable differences.

For tax purposes, a life insurance company’s gross income is divided into five categories:

Premiums

Investment income

Capital gains

Decreases in reserves

All other items of Gross Income

The IRS definition of income extends across all received insurance premiums and policy considerations, including any fees, deposits, assessments, prepaid premiums, reinsurance premiums, and any policy owner dividends a reinsurer may reimburse to the ceding insurer.

Furthermore, the IRS classifies any premiums or deposits on supplemental contracts (and similar sources of premium) as gross income. This category of gross income comprises between 60% and 80% of an insurer’s taxable assets.

Two other notable taxation items:

The IRS taxes any capital gains in the same fashion as those of other corporations.

Net decreases in insurance reserves result in taxable income. While this might seem counterintuitive, the federal government does allow life insurance companies to take tax deductions when these reserves receive net additions. Therefore, when the insurer releases these reserves, this release qualifies as taxable company income.

Life insurance companies are allowed two types of deductions: corporate deductions (expenses of operations, benefits plans, etc.) and those peculiar to the insurance business. This second category includes deductions for all claims, benefits, and losses incurred on insurance and annuity contracts. Additionally, the government allows deductions for certain insurance reserves, including policy reserves, unearned premium reserves, unpaid loss reserves, and advance premium reserves. Finally, insurance companies may deduct policy owner dividends, subject to certain stringent rules.

Taxation of Dividends

For many years, mutual insurance companies had a distinct tax advantage over stock companies. Mutual companies often charge higher premiums than stock companies and return to the policy owner any excess amount as “dividends.” However, these dividends also included investment distributions and underwriting earnings. As a result, many industry and tax specialists (and stock insurers) believed that these earnings did not warrant exclusion from corporate taxation.

Eventually, Congress opted to limit the dividend deduction that mutual companies could take. The exact machinations of this deduction are beyond the scope of this course. However, it essentially taxes a mutual insurer’s surplus in a manner that equalizes taxation amounts with those of stock companies.

Structure and Organization of Life Insurance Companies

Typically, life insurance companies are classified as either stock or mutual organizations. However, some exceptions exist – the Blue Cross-Blue Shield organizations, fraternals, savings banks, and government plans do not fall into either category.

A stock insurance company is owned by its stockholders, whereas a mutual insurance company is owned by its policy owners. Furthermore, a stock company can be owned by other stock life insurance companies, mutual insurance companies, or non-insurance companies. Conversely, a mutual company is owned, without exception, by policy owners. Despite these considerable differences, both types of organizations are structured as corporations. This is because a corporation is the only type of legal organization that provides high degrees of permanence and financial security as it concerns the payment of claims.

Stock Insurers

A stock company is organized to profits its stockholders. Traditionally, they issued non-participating and guaranteed-cost insurance policies wherein the policy owners could not share in the company’s profits or savings. However, stock insurers now also issue participating policies, greatly obscuring the difference between themselves and mutual insurers.

As a stock ownership corporation, a life insurance company must have a minimum capital and surplus to operate before may operate as a certified life insurer. In the late 1950s and early 1960s, these minimums remained quite modest, enabling the formation of many new stock insurance companies.

However, after a company sold stock sufficient to obtain its certificate of authority, the stockholders became its primary sources of new business. As a result, newer companies issued “special policies” that provided policy owners a share in company profits. Due to rampant corporate misrepresentation and the countless mergers and acquisitions among “special policy” companies, the states enacted strict regulations to prohibit such practices.

Mutual Insurers

Mutual companies are also corporations. However, they generally have neither capital stock nor stockholders. After all, the policy owner is both a customer and, in a limited sense, an owner. While the mutual company owns its assets and income, policy owners are typically designated as contractual creditors, retaining the right to vote for the Board of Directors. In practice, a mutual insurer’s assets are held for the protection of its policy owners and beneficiaries. These assets can comprise the company’s insurance reserves, surplus and contingency funds, or any dividends distributed to the policy owners.

Notably, mutual companies can and do issue non-participating policies, in which case the policy owners are treated in the same fashion as customers of a stock insurer.

Forming a mutual company can be incredibly difficult. There must be funds available to cover the expenses of operation, deposits to the insurance department(s), and a surplus and contingency fund – all before the insurer can collect such funds from its operations.

Holding Companies

Holding companies are financial corporations that own or control any number of insurance companies, investment corporations, broker-dealer organizations, consumer finance firms, or other financial service firms. Some stock insurers are owned by conglomerates who are non-financial holding companies that have ownership or control of several companies in unrelated fields.

Upstream vs. Downstream Holding

An upstream holding company is one formed by one or several stock insurers. This company sits atop – “upstream” from – the organization. It is owned by its stockholders and usually owns subsidiaries. Conversely, a downstream holding company sits in the middle of the corporate structure. Mutual companies tend to own downstream holding companies in addition to their subsidiaries.

Insurance departments prefer downstream companies. With an insurer (usually the parent mutual company) remaining at the top of the corporate structure, the insurance departments retain regulatory authority and can therefore prevent most legislative headaches from occurring.

Recently, there have been many mutual companies that have “de-mutualized” in order to obtain equity capital and other financing alternatives. The increasing integration of financial service companies into the insurance industry has made necessary such options.

Outsourcing

The many rapid changes within the financial services industry have resulted in significant corporate restructuring within the insurance business. Outsourcing, for example, has become common practice across the industry. Outsourcing involves the transfer of many administrative and advertising functions to agencies outside of the company.

Many insurers now brand another company’s products and will then hire a third-party administrator to handle claims. Insurers can outsource investments to investment banking firms or other asset management companies. They can transfer the heavily computer-based administration functions to outside service bureaus. Companies can even outsource marketing to third-party providers. As a result, newer generations of insurers have sometimes been dubbed “virtual insurers.”

Organization and Departments

Life insurance companies are organized similarly to most other financial organizations that collect, invest, and disburse funds. They feature the same or similar department names and functions. The following sections catalog the highest offices first and then list other departments in no particular order of significance or function.

Board of Directors

The Board of Directors and its affiliated committees maintain the highest level of authority. In a mutual company, policy owners elect these board members. Within a stock company, the stockholders assume this duty. The Board can then elect the President and other principal officers, to which it delegates the necessary authority.

Executive Officers

The executive officers are responsible for carrying out the policies as determined by the Board of Directors. They consist of the Chief Executive Officer (CEO), the President (who may also be the CEO), and various vice presidents in charge of their designated departments’ daily operations. Depending upon the size of the company, there are usually several tiers of officers, each with a specified supervisory function.

Actuarial

The actuarial department provides several essential functions. Smaller companies may contract a consulting actuarial firm for these functions. Even larger companies often use consulting actuaries for auxiliary services, such as auditing and product development. This department establishes the insurer’s premium rates and calculates reserve liabilities and non-forfeiture values. Furthermore, actuaries analyze earnings and determine dividends and excess credit. They can even function in lieu of legal counsel for creating new policies and forms and can file these forms with the relevant insurance departments.

The actuarial department conducts mortality and morbidity studies, often supervises the underwriting department, and collaborates with the marketing department in designing new policies.

Accounting

Typically, the vice president and the controller oversee an insurance company’s accounting and auditing departments. They are responsible for any auditing and tax matters the company might encounter. Furthermore, most companies place this department in charge of their primary operational computers.

Investment

The investment department, which is usually under the purview of an investment vice president, is responsible for the company’s investments and is the custodian for the company’s bonds, stocks, and other investments.

Legal

In addition to any potential legal matters, the legal department is responsible for regulatory compliance matters and representation of the company in any court proceedings.

Underwriting

See Chapter 9.

Administration

The administration department’s principal function is to provide home office service to agents and policy owners. It is also responsible for human resources (personnel), home office planning, and other similar functions. The corporate secretary is frequently in charge of this operation, while also overseeing the Board of Directors’ meeting minutes and other company records.

Marketing

The Marketing Department (or Agency Department) is the nucleus of all sales activity within an insurance company. In fact, it is arguably the core of the company itself. It marketing department is responsible for the sale of new business, the conservation of old business, and the supervision of certain policy owners’ service. Additionally, it manages advertising, sales promotion, market analysis, and agent recruiting and training.

Without the sales and marketing of its products, an insurance company does not exist in the eyes of potential consumers. As such, it receives a unique section to examine its components.

Depending upon the method of distribution, Marketing Department personnel can vary. Generally, there is a Vice President of Marketing (or similar) and several Assistant Vice Presidents, who typically have their own assistants.

Brokers

Within the life insurance industry, the term “broker” describes a commissioned salesperson who works independently of the insurer with whom he places business. Furthermore, the insurer does not require the broker to satisfy any specific quota or production measurements.

A broker can also refer to an independent life insurance producer who does not maintain loyalty to a particular company, but who specializes in certain products or markets. This type of broker is highly independent and tends to be one of the most knowledgeable types among all agents.

Personal Producing General Agent

A personal producing general agent (PPGA) is an independent, commissioned agent who usually works alone and markets on the basis of personal production. There are two types of PPGAs: traditional and Master General Agents (MGA). In the traditional approach, an insurer hires experienced life insurance agents with a contract that offers direct commissions, override commissions, and an office allowance. MGAs typically sell a single product, such as universal life or a specific health insurance product.

Financial Institutions

Life insurance can now be sold by banks, thrifts, credit unions, mutual funds organizations, and investment banks. While banks are responsible for only 5% of all life insurance products, they write 20% of annuity products. More recently, securities firms have entered into the life insurance arena and sell increasingly large shares of variable products.

The Future of Life Insurance

Longevity

As the average age of Americans increases, life insurers must provide insurance arrangements to facilitate the needs of an older population. The proliferation of accelerated death benefits provides much evidence of this effect. Additionally, average longevity has increased substantially. Therefore, the problem of outliving retirement assets is more immediate and significant than anxieties about premature death.

Both state and federal government currently bears much of the costs of health, retirement security, and long-term care. Although these needs will continue to grow, the government’s ability to pay for them even at the present levels is more than questionable. If the private sector continues to enable spending for these needs, it is not unreasonable to anticipate considerable increases in both financial and political pressure.

Current Trends in Life Insurance

As of 2021, reports indicate that an estimated 52% of American adults own some type of life insurance policy. This statistic has decreased steadily since 2016, at which point it hovered around 60%.[1] With an extremely tumultuous economy and pressing social issues, life insurance has often taken a backseat to more immediate concerns, debt repayment, and health coverage, have kept them from purchasing more life insurance.

The Future of Businesses and Insurance

Small businesses, which are defined as having less than 500 employees, comprise more than 95% of US employers. Many of them do not have group insurance, business insurance, or retirement plants. As a result, there exists a continuing need for insurance in this market. Traditionally, career agents most commonly serve the insurance interests of smaller businesses. This pattern is expected to continue. However, large corporations more frequently benefit from insurers, as many have maintained cost-effective group insurance plans.

Presently, insurance companies must devise ways to more efficiently manage agent and field service compensation. Without significant action in these areas, they will continue to receive business that is impractical and inefficient to retain. An insurance company must give proper consideration to its field agents’ goals in order to ensure that all parties – the insurer, the agent, and the customer – benefit sufficiently from the arrangement.

Conclusion

Despite a continuously shifting economic and political climate, life insurance tends to find a niche where it is needed. However, any stagnation in business should not indicate that it has realized its full potential. With social and economic changes come evolving financial needs, and those who best understand the functions and benefits of life insurance are best suited to adapt their business to the present moment. A deeper understanding of life insurance means greater opportunity to innovate within the industry – and perhaps even beyond it.

References

[1] https://www.policygenius.com/life-insurance/life-insurance-statistics/#life-insurance-by-the-numbers

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