Chapter 10: Life Insurance Planning and Purchasing Decisions

Question 1

human life value approach

Answer 1

An approach that measures a person’s human life
value in terms of the present value of that portion of estimated future earnings which, if he or she lives long enough to achieve all the earnings, will be used to
support dependents.

Question 2

multiple of income approach

Answer 2

A simplistic approach that determines life insurance

needs based on the client’s current annual income. Takes into consideration already accumulated insurance.

Question 3

financial needs analysis approach

Answer 3

An approach that determines how much life insurance is needed to provide a principal sum that will be liquidated to meet survivors’ lump-sum and ongoing income needs

Question 4

capital needs analysis approach

Answer 4

An approach that determines how much life insurance is needed to provide a principal sum adequate to fund survivors’ needs while preserving the principal

Question 5

Lump sum needs at death

Answer 5

• final illness costs that insurance does not cover
• repayment of outstanding debt, perhaps including a home mortgage loan that becomes due and payable upon death
• estate taxes, if applicable
• probate and attorney’s expenses
• funeral, burial, or cremation expenses, as applicable
• operational expenses to cover survivors’ ongoing, short-term household expenses

Question 6

surrender cost index

Answer 6

The surrender cost index indicates the cost of surrendering the policy for the cash value at some future point in time, such as 20 years. The index shows the average amount of each annual premium that is not returned if the policy is surrendered for its cash value.

Question 7

Measuring the cost of insurance

Answer 7

Premiums ($1,600 × 20) $32,000
Minus dividends 7,200
Minus cash value 28,000
Net cost –$ 3,200
Net cost per $1,000 –$ 32.00
(–$3,200 ÷ 100)

Question 8

Net payment cost index

Answer 8

The other interest-adjusted cost index is the net payment cost index. This index evaluates
the cost of insurance protection based on the assumption that the insured dies at the end
of the policy’s 20th year. It is useful for a client who is more concerned with the death benefit
rather than the cash value.

Question 9

Illustration rules

Answer 9

Each illustration used in the sale of a life insurance policy covered by the new regulation
must be clearly labeled “life insurance illustration” and must include the following:
1. name of the insurance company
2. name and business address of the insurer’s agent
3. name, age, and gender of the proposed insured
4. the underwriting or rating classification upon which the illustration is based
5. the generic name of the policy (for example, whole life, universal life, and so on)
6. the initial death benefit amount
7. the dividend option election or application of non guaranteed elements if
applicable

Question 10

The NAIC model regulation prohibits insurers and their agents from the following:

Answer 10

1. representing the policy as anything other than a life insurance policy
2. using or describing nonguaranteed elements in a manner that is misleading or has the capacity or tendency to mislead
3. stating or implying that the payment or amount of nonguaranteed elements is guaranteed
4. using an illustration that does not comply with the illustration regulation
5. using an illustration that is more favorable to the policyowner than the illustration based on the illustrated scale of the insurer
6. providing an applicant with an incomplete illustration
7. representing in any way that premium payments will not be required for each year of the policy in order to maintain the illustrated death benefits, unless that is the fact
8. using the term “vanish,” “vanishing premium,” or a similar term that implies the policy becomes paid up, to describe a plan for using nonguaranteed elements to
   pay a portion of future premiums
9. using an illustration that is not “self-supporting”

Question 11

NAIC annual reports for universal life insurance illustrations must be sent to policy owners and must include:

Answer 11

• all transactions affecting the policy during the reporting period
• cash values at the beginning and end of the period
• death benefit at the end of the reporting period (for each life covered)
• the cash surrender value at the end of the period after deduction of surrender charge (if any)
• the amount of outstanding policy loans, if any, at the end of the report period
• a special Notice to Policyowners if the policy will not maintain insurance in force until the end of the next reporting period unless further premium payments are
made

Question 12

Traditionally, most replacements were considered detrimental to the policyowner for at
least three reasons:

Answer 12

• The policyowner had already incurred the high first-year expenses associated with a new policy.
• Premiums under the new policy might be higher due to the insured’s increased age.
• The suicide and incontestable provisions under the existing policy might expire sooner, if they have not already done so, than those in the replacement policy.

Question 13

1035 exchange

Answer 13

Sec. 1035 of the Internal Revenue Code permits a
policyowner who exchanges one insurance contract for another in a “like-kind exchange” to receive certain tax advantages.

Question 14

1035 exchange rules

Answer 14

A life insurance contract may be exchanged for a life insurance contract or an annuity.

An annuity may be exchanged for an annuity, but an annuity may not be exchanged for life insurance.

Question 15

Substandard risk and substandard coverage

Answer 15

an individual who belongs to a class with a higher-than-standard mortality rate is referred to as a substandard risk. 
Insurance on these individuals is called substandard coverage.

Question 16

The majority of companies assume that each substandard applicant falls into one of three
broad groups:

Answer 16

• additional hazard increases with age (example: high blood pressure)
• additional hazard remains approximately constant (examples: occupational hazard, some physical impairments)
• additional hazard decreases with age (examples: past illnesses, surgical operations)

Question 17

rate-up age method

Answer 17

If an applicant is substandard rates an insurance company may choose to rate the applicant at an age applicable to the conditions they see. I.e. a 25 year old male may be in the same category as a 33 year old male and therefor insured at the same rates as that group of individuals.

Question 18

extra percentage tables

Answer 18

These extra percentage tables classify applicants
into groups based on the expected percentage of standard mortality and charge premiums that reflect the appropriate increase in mortality.

Question 19

flat extra premium

Answer 19

Under this method, the standard premium for the policy in question is increased by a specified number of dollars per $1,000 of insurance. Assessed as a measure of the extra mortality involved, the flat extra premium does not vary with the age of the applicant.

The flat extra premium method is generally used when the hazard is thought to be constant.

Question 20

Liens

Answer 20

When the extra mortality to be expected from an impairment is of a distinctly decreasing and temporary nature, such as that associated with convalescence from a serious illness, an insurer may create a lien against the policy for a number of years, with the amount and term of the lien depending on the extent of the impairment.
should death occur before the end of the period specified, the amount of the lien is deducted from the
proceeds otherwise payable. Consequently, the death benefit is reduced during the first few years of coverage.

Question 21

Ways to deal with substandard applicants

Answer 21

Hazard increases with age
–– Age rate-up
–– Extra percentage table
• Hazard remains constant
–– Flat extra premium
• Hazard decreases with time or is temporary
–– Flat extra premium
–– Lien
–– Special dividend class
–– Limit policy type to one with high savings component

Question 22

A viatical settlement?

Answer 22

A viatical settlement involves the sale of a terminally ill insured’s life insurance policy in exchange for a percentage of the face amount.

Question 23

Life settlement

Answer 23

A life settlement involves transferring the ownership of a life insurance policy to a thirdparty investor, much like a viatical settlement, but in cases where the insured is not chronically or terminally ill. Life settlements provide a relatively new way for seniors to convert their life insurance policies to cash.

Question 24

stranger-originated life insurance (STOLI)

Answer 24

A controversial segment of the life settlement market involves stranger-originated life insurance (STOLI). In a STOLI arrangement, speculators initiate coverage on older persons and fund the premium payments with intentions of profiting upon the death of the insured.

Question 25

Entity agreement

Answer 25

Under an entity agreement, the firm itself enters into an agreement with each owner specifying that, on the death of an owner, the firm will buy the business interest of the deceased and the deceased’s estate will sell it. Technically, the firm liquidates the interest of the deceased partner or redeems the stock of the deceased stockholder. The firm carries life insurance
on each owner, with the firm as beneficiary, to provide the money to fund the entity
agreement.

Question 26

Cross-purchase agreement

Answer 26

Under a cross-purchase agreement, each partner or stockholder is both a seller and a purchaser. The cross-purchase buy-sell agreement provides that, on the death of one owner, his or her estate will sell the deceased’s interest, and the other owners will buy it. To
fund this type of agreement, each owner should carry and be the beneficiary of insurance on the lives of the other owners. For example, if there are three equal partners, the two surviving partners will each purchase one-half, or another agreed-upon share, of a deceased
partner’s interest.

Question 27

Sec. 79 plans

Answer 27

Group term life plans

Question 28

Transfer-for-Value Rule

Answer 28

This rule providesthat if a policy is transferred from one owner to another for valuable consideration, the
income tax exclusion is lost. When the insured dies in these cases, the policy beneficiarywill recover income tax free only the amount the transferee-owner paid for the policy, plus Life Insurance Planning and Purchasing Decisions 10.43 any premiums subsequently paid.

Question 29

cash value accumulation test

Answer 29

Under this cash value accumulation test, the cash
value generally may not exceed the net single premium that would be needed to fund the policy’s death benefit. The insurance company calculates the net single premium using an assumed interest rate and certain mortality charges.

Question 30

guideline premium and corridor test

Answer 30

Policies that are designed to pass the guideline premium and corridor test must meet both of the
requirements.
The guideline premium requirement limits the total premium that may be paid into the policy at any given time.
The policy meets the corridor or death benefit requirement, the second prong of the test, if the contract’s death benefit exceeds a specified multiple of its cash value at all times. This multiple varies according to the insured’s attained age.

Question 31

modified endowment contract (MEC)

Answer 31

A policy is treated as a modified endowment contract if it fails a test called the 7-pay test. This test is applied at the inception of the policy and again if the policy experiences a material change.

The 7-pay test is designed to impose MEC status on policies that take in too much premium during the first 7 policy years, or in the 7 years after a material change.

MEC contracts may be subject to:

• Income-first or LIFO tax treatment on distributions or loans
• 10% penalty on distributions if not 59 1/2

Question 32

Inside build up

Answer 32

The inside buildup is, the increase in the cash value of a permanent life insurance policy. The inside buildup is not subject to taxation as long as it is left inside the policy

Question 33

Lifetime gift tax exempt amount

Answer 33

The lifetime amount that a person can gift on a tax-exempt basis in 2013, is $5.25 million.
This amount increases with inflation thereafter.

Question 34

Annual gifting exclusion

Answer 34

In 2013, qualifying gifts of $14,000 or less can be made
annually by a donor to any number of donees without gift tax. $28,000 if married.
The annual
exclusion is in addition to the lifetime tax-exempt amount of $5.25 million

Question 35

Non-taxable gifts

Answer 35

• gifts that do not exceed the annual exclusion
• gifts to the donor’s spouse
• gifts to charities
• tuition paid directly to an educational institution for someone
• medical expenses paid directly to a medical institution for someone
• gifts to a political organization for its use

Question 36

Federal Estate Tax

Answer 36

gross estate - deductions = Taxable estate

Gross estate = all property owned by the estate

Deductions to the estate = debts, reasonable costs, all transfers to a qualified charity.

Question 37

taxation of federal estate tax and gift tax to spouse.

Answer 37

neither are taxable if a transfer or gift takes place to the spouse.

Question 38

Inclusion of life insurance in calculating the taxable estate

Answer 38

• Including life insurance can often mean the difference between a federal estate tax liability and no tax liability.
• Life insurance proceeds are included in the estate of an insured if he or she possessed an incident of ownership in the policy at the time of his or her death.
• Life insurance proceeds are included in the gross estate of an insured who transferred incidents of ownership in the policy by gift within 3 years of his or her death.

Question 39

Life Insurance Payable to the Estate?

Answer 39

Generally life insurance should not be made payable to the estate because:
• Insurance payable to a decedent’s estate subjects the proceeds to the claims of the estate’s creditors
• Insurance payable to a decedent’s estate subjects the proceeds to costs of probate administration, such as executor’s fees, but provides no corresponding
advantages.

Question 40

Federal estate tax marital deduction

Answer 40

of Unlimited Marital Deduction. The unlimited marital deduction is a provision in the United States Federal Estate and Gift Tax Law that allows an individual to transfer an unrestricted amount of assets to his or her spouse at any time, including at the death of the transferor, free from tax.

Question 41

A major advantage of the financial needs analysis approach is?

Answer 41

that it does take into account factors that would be available in the event of the insured’s death, such as Social Security benefits and future earnings by a spouse.

Question 42

Taxation on a 1035 exchange

Answer 42

A taxable event occurs when an existing insurance policy with a cash value is surrendered, even if the policyowner then uses the proceeds to purchase another policy on the same insured. A 1035 exchange can avoid taxation, but it must involve a transaction that takes place directly between the insurers.

Question 43

Extra percentage tables vs flat extra premium method of dealing with risk.

Answer 43

The most common method of dealing with risks that present an increasing hazard is to use extra percentage tables.
A flat extra premium is normally used when the hazard is thought to be constant or decreasing.

Question 44

Are viaticals subject to SEC regulation?

Answer 44

Viaticals are not deemed securities and are not subject to SEC regulation.

Question 45

Federal privacy laws regarding viaticals.

Answer 45

There are no federal privacy laws regarding viatical agreements.

Question 46

Life insurance and buy sell agreements are used how?

Answer 46

One of the common uses of life insurance in business is to serve as a method of funding, not of replacing, a properly designed buy-sell agreement.

Question 47

Primary goal of life insurance for young clients vs elderly clients?

Answer 47

Young: Estate enhancement.
Elderly: Estate liquidity.