This discussion pertains to many of the features and provisions commonly found in all types of life insurance policies. As rules and regulations governing life insurance change frequently, many of these provisions were standardized by law and apply wherever insurance transactions take place. Some of the provisions that are not applicable, or seldom used, in financial planning are not discussed.
Many policies include an additional feature that helps prevent an insurance policy from accidentally lapsing. The automatic premium loan provision allows the insurance company to use part of the cash value to pay the premium when the policyowner fails to do so within the grace period, providing there is sufficient cash value. The knowledge of this provision is useful to a financial planner when life insurance is used for various reasons within a financial plan.
The "automatic" part of this provision means the insurer will automatically use the premium loan feature to keep the policy in force. It does not mean this provision is automatically included in every cash value life insurance contract. Typically, the insured must request the automatic premium loan provision in the insurance application.
This transaction is treated as a loan to the policyowner. The insurer expects to be repaid and the policyowner pays interest on the amount used. If the loan is not repaid before the insured dies, amount of the policy loan will be deducted from the death benefit.
The use and designation of Beneficiaries in life insurance is very similar to that of a Trust Beneficiary. The proper usage of Beneficiary designations is of utmost importance, as a careless or unknowing designations can completely destroy the planning objectives, and at a time when there would be no remedial actions that can be taken as the primary bequeathed and designator of the beneficiaries is no longer alive to correct the errors.
Those designated to receive the death benefits or proceeds of a life insurance policy when the insured dies are the beneficiaries. The insured or the policyowner chooses who will be named beneficiaries.
The primary beneficiary is the person or organization legally entitled to receive the proceeds at death. Primary or Class I beneficiaries are always first in line to receive the death benefit.
If the primary beneficiary should die before the insured dies, the death benefit is paid to the contingent or Class II beneficiary. In this case, receiving the death benefits is contingent upon the prior death of the primary beneficiary.
Neither primary nor contingent beneficiaries must be a single individual. For example, a woman might name both her husband and her children as primary beneficiaries or her mother and father. Or this same woman could name her husband as primary beneficiary and her children as contingent, or possibly, her parents and her children as contingent beneficiaries.
In fact, beneficiaries need not be individuals at all - organizations or estates may also be designated. A man might name his wife as primary beneficiary and his alma mater as contingent beneficiary. There are many possibilities.
Unless otherwise stated, beneficiary designations are always revocable, which means they can be changed. This is the most common and most practical way to designate beneficiaries because irrevocable beneficiary remains unchanged forever regardless of any changes in circumstances. An irrevocable beneficiary in essence becomes a co‑owner to the policy and must consent to all policy transactions such as taking out policy loans or changing contingent beneficiaries. The only way this type of designation may be changed is if the irrevocable beneficiary expressly agrees in writing to give up this right.
As stated previously, a person might 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 children 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.
Others besides children could be named as a class. For instance: “All of the insured's siblings.” “All of the insured's siblings' children.” “All of the insured's grandchildren,” etc. Again, there are many possibilities.
When two or more individuals are named as either Class I or Class II beneficiaries, one or more might die before the insured, raising questions about how the policy proceeds should be divided among the living beneficiaries. There are two different ways a beneficiary designation might be handled to account for this situation.
A per capita designation is used to indicate that any remaining beneficiaries share all of the proceeds equally. The legal term per capita, derived from Latin, literally means –“by the heads or polls" and is translated to refer to "each person." For example, the insured names his four sisters to share equally as primary beneficiaries of his $100,000 policy. If all four are living when the insured dies, each person receives $25,000. But if two of the sisters die before the insured does, when the insured dies, each person still living receives $50,000 - the two remaining sisters in this example.
A different arrangement applies under a per stirpes designation. Per stirpes, literally, "by roots or branches,” legally refers to a progression through the branch of a particular family member. For the situation described in the preceding paragraph 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.
Typically, it is not a good idea to name minors as beneficiaries since minors are not legally 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. Alternately, the insurer could arrange to hold the proceeds, pay interest, and disburse the proceeds plus interest when the minors reach adulthood.
An insured may name their estate as the beneficiary. This is the least favorable type of beneficiary designation for several reasons. If the policy proceeds go into the estate, they increase the size of the estate, which could in turn increase estate taxes that become 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 really wanted the policy proceeds distributed. And 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.
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 as a fixed payment for as long as the money lasts or for a fixed period of time. 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 from state to state.
While some state laws protect the entire death benefit as long as it is paid in installments, others allow only a portion of each fixed payment to the beneficiary to be protected by a spendthrift trust. For example, the law might require that if the beneficiary receives more than "X" number of dollars per month under the trust, creditors might pursue any additional amounts. In other states, the income is protected only while it is in the insurer's possession; after a payment is made to the beneficiary, the money is no longer protected. A financial planner will want to learn how spendthrift clause trusts are handled in the states where they do business.
The unhappy possibility of family members dying at the same time or nearly at the same time can cause complications in beneficiary designations. Since it is fairly common for a spouse and/or children to be named as beneficiaries, logically there is concern as to what happens, for example, if the insured and her husband, the primary beneficiary, are killed in the same accident? The following Consumer Application illustrates the difficulties.
CONSUMER APPLICATION
Anna has a life insurance policy, with her husband Donald, as the primary beneficiary. The couple has no children. Anna's sister Nattalie is the contingent beneficiary. Anna and Donald are involved in an automobile accident; both are pronounced dead upon arrival at a nearby hospital. The question arises: Did Anna die first, making the policy proceeds payable to Donald, or did Donald die first, making the proceeds from Anna's policy payable to Nattalie?
If Donald lived longer than Anna, the policy proceeds would be paid into his estate and distributed according to his will. If Donald, the primary beneficiary, died before Anna, Nattalie 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.
CONSUMER APPLICATION
Dominic was married to Angela, named as primary beneficiary on a life policy, with sister-in-law, Stephanie, as contingent beneficiary.
The emergency personnel who accompanied Dominic in the ambulance after a car accident, attested that he had vital signs up to the time they arrived at the hospital. On the other hand, no one in the ambulance with Angela believed she was alive during the trip to the hospital. In this case, there is evidence that Dominic did outlive Angela, so the policy proceeds would be paid into his estate rather than going to the contingent beneficiary, Stephanie.
Another way to mitigate the problem is by including a common disaster provision in the beneficiary designation. A typical provision would stipulate that in situations where there is serious injury to both the insured and the primary beneficiary in a single event, 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 term.
Still another option is to arrange the policy so proceeds are paid as periodic income to the primary beneficiary as long as he or she lives. 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 as precisely as the insured desires.
Whether or not a life insurance policy pays dividends depends upon the type of policy. When an insurer makes more profit than anticipated, certain policies the company issues might share in that surplus. Any such share is called a dividend. The source of the surplus is savings the insurer realizes by reduced operating expenses, better mortality experience than expected and/or higher investment returns than predicted.
Not all policies share in a company’s surplus. Those that do are called participating or "par" policies. Those that do not are called non-participating or "non‑par" policies. Participating policies might be either term or cash value insurance, but dividends on term policies are typically quite small.
Participating policies generally have slightly higher premiums than non‑par policies. Although dividends are not guaranteed to be paid, the higher premiums can help improve the surplus picture. When the policyowner has an outstanding policy loan from the cash value, the policy usually receives a lower dividend than policies without outstanding loans. The courts have ruled that a dividend is legally an overpayment of premium that is returned to the policyholder.
The owner of a participating policy may choose how the dividends are paid - which dividend payment option to choose from among those the insurer offers. Six basic options are discussed in the following paragraphs, but few companies will offer all six.
Remember, not all of these options are available from every insurance company. In addition, while policyowners normally select a dividend option when the policy is issued, they usually may switch to another option if desired.
CONSUMER APPLICATION
A policyowner has an outstanding policy loan of $5,000, for which he is paying 7% interest.
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 the policyowner 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. Three percent of $5,000 is $150, so it ($150) is subtracted from the dividend paid. Instead of receiving the full $500 dividend, this policyowner receives only $350 because of the outstanding loan.
Cash Surrender: The policyowner 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 policyowner.
Cash value policies include tables showing the cash surrender value for every year the policy is in force and that is the basis for the amount due the policyowner. However, a Universal Life policy has 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 nonforfeiture option is to use the cash value to buy paid‑up insurance. This provides a reduced amount of cash value life insurance for which the policyowner 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. No riders or other provisions added to the original policy are included. 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: Finally, the policyowner 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, assume the original policy has a $100, 000 death benefit, a cash value of $20,000 and an outstanding loan with interest of $5,575. 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 possibilities, 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 policyowner simply stops paying premiums and does not choose a nonforfeiture option, insurers automatically set up the extended Term Insurance unless the policy also includes the automatic premium loan provision described earlier. This nonforfeiture option provides the most insurance protection for the cash value available.
Settlement options are the choices either the insured or the beneficiary makes about how the death benefit will be paid. Most companies offer all of the options presented in this section.
Typically, death benefits are paid in one lump sum and this is the “default” option.
The face amount of the death benefit (or the “principal”), is left with the insurer to be invested and earn interest, which is then paid to the beneficiary at a predetermined period of time. The policyowner may stipulate the frequency, which usually may be changed by the beneficiary.
The interest only settlement option may also provide that the beneficiary may withdraw all or part of the principal amount at some point. Policies may also be written so the beneficiary may not withdraw any of the principal, in which case:
The first possibility is more typical because the money belongs to the primary beneficiary, now dead, so it goes into his or her estate. This happens if no alternate arrangement was made when the beneficiaries were designated. The second possibility occurs only if arranged for originally. And, the original arrangement might have been that the contingent beneficiary also receives interest only rather than the principal amount. But, unless specified otherwise, at this point the principal would be paid in a lump sum either to the primary beneficiary's estate or to the contingent beneficiary.
This settlement option permits the death benefit to be distributed in more than one payment of a fixed amount that is either originally specified by the policyowner or selected by the beneficiary and may be made annually, semi-annually, quarterly or monthly. The portion of the death benefit not yet paid draws interest while the insurer controls it.
Rather than a fixed amount, benefits might be paid for a fixed period. 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.
The life income option pays the death benefit and it provides the beneficiaries an income for their lifetime. This option involves the purchase of an annuity contract designed to provide lifetime income. The primary advantage of this option is the guaranteed lifetime income.
Insurance that covers the lives of minor children is often called juvenile insurance for identification purposes. The coverages and provisions for policies written on adult lives are essentially the same for children, whether the policy is term or cash value life insurance.
Financial advisors disagree about the need for life insurance covering a child's life. Opponents cite two major reasons for not buying life insurance for children:
1. The chances of children dying while young are relatively small.
2. Children do not earn income upon which the family relies for day to day living, so their deaths have no significant financial impact.
Without contesting the validity of those arguments, proponents stress these advantages of purchasing life insurance for the child:
1. Because life insurance rates are considerably lower for a young healthy child, juvenile insurance offers the opportunity to buy more insurance for less money.
2. Many people need life insurance as adults, but not everyone remains insurable into adulthood, when deteriorated health could affect the ability to buy life insurance. Juvenile cash value policies ensure that at least some insurance is in place when the child becomes an adult.
3. Like any other cash value policy, a juvenile policy will build cash values that can be used in the future, perhaps as a low‑interest loan to pay for the child's education.
A "jumping juvenile" policy, which might also be called a junior estate builder, covers the child with a death benefit that is initially small. When the child reaches age 21, the death benefit then jumps to a greater face value - usually five times the initial amount.
A juvenile policy often has a payor rider attached. As discussed earlier, this rider obligates the insurer to cover the premiums if the person paying for a child's policy becomes disabled or dies.
A professional and effective planner must be knowledgeable about all aspects of an individual’s personal and business life. While financial planning is usually more of a personal matter, many of those who require planning for their retirement and the handling of their estate are in business, either self-employed, or in business with others. Life Insurance is ideally suited for an effective tool in buy/sell agreements and corporate stock redemption plans.
The need for business insurance arises because the death of people who are vital to the operation of a business can have far reaching effects, including the death of the business itself.
CUSTOMER APPLICATION
Maggie Southerland and Grace Jones were long-time friends and the co‑owners of a successful 10 year‑old retail business. When Grace was tragically killed in a car accident, Maggie suffered a double loss: first, the death of her dear friend and second, the loss of her business. Why her business? While Grace's husband and daughter both wanted Grace's business to continue after her death, they were forced, for financial reasons, to use Grace's share of the business income, causing the store to close.
Neither of Grace's survivors was equipped to contribute financially to the business nor were they equipped by training or personality to help run the business. Seeing the financial problems her friend's family was having, Maggie immediately began sharing profits with them and attempting to add to that amount to buy Grace's half of the business from her heirs. These kind and thoughtful actions unfortunately resulted in cash flow problems for the business and finally, the financial burden forced Maggie to go out of business altogether. Maggie's loss was rooted in the lack of capital to purchase Grace's half ownership from the survivors when Grace died unexpectedly. This loss could have been avoided entirely if Maggie and Grace had executed a buy/sell Agreement.
Buy/sell agreements funded with life insurance provide an immediate source of money for a surviving business partner to buy the deceased person's business interest with no interruption in the business. Life insurance policies used for this purpose are also called business continuation insurance because they help the business to continue as usual even after a very important contributor dies.
A buy/sell agreement for a partnership would stipulate that any surviving partners would purchase the portion of a business owned by a deceased partner. Included in the agreement is the exact purchase price of the deceased person's interest in the business or a specific formula for determining its market value. The agreement must also include a guaranteed method to ensure the money is available when it is needed. Life insurance is the perfect method to guarantee availability of the money and can be used with either of the two types of buy/sell agreements described below
One type of buy/sell agreement is a cross‑purchase plan. Under this arrangement, each partner purchases a separate life insurance policy on every other partner's life for a sufficient amount to buy a share of the partner's interest at death. In the case of Maggie and Grace as discussed above, Maggie would purchase a policy on Grace's life and Maggie would purchase a policy on Grace’s life.
If Maggie and Grace had a third partner, Terry, Maggie would buy two policies - one on Grace's life, one on Terry's. Terry would buy two policies, on Maggie and Grace's lives, and Maggie would own policies on Terry and Grace's lives. Each partner buys separate policies. When Grace was killed in the previous scenario, both Maggie and Terry would have had the life insurance proceeds from their individual policies to purchase Grace's interest from her family.
Another type of buy/sell agreement, the entity purchase plan, arranges for the partnership (the entity) itself to own the life insurance policy on each partner. For example, assume that the business partnership of Maggie, Terry and Grace is called MTG Enterprises. MTG Enterprises as an entity purchases three separate policies - one on the life of each partner. When Maggie dies, the policy proceeds are paid to MTG rather than to Grace and Terry individually. MTG then uses the proceeds to buy Maggie's interest from her heirs.
When a business is a closely held corporation rather than a partnership, a similar life insurance-funded buy/sell agreement can be established. Closely held corporations are much like partnerships, but because they are incorporated, they have stockholders rather than partners. In a closely held corporation the stock is held "closely” by a select group of people rather than being made available for public sale.
It is not unusual for the stockholders and owners of a closely held corporation to be just a few people who serve in many different positions as employees and directors. Often, just one person holds the majority of the stock.
CONSUMER APPLICATION
Clyde Cardwell is the founder and principal stockholder of CC Manufacturing, Inc. There are only two other stockholders, CC's vice presidents, Ty Falani and Moses Shadeeq. Clyde's death could have disastrous financial consequences for the surviving stockholders of CC Manufacturing, especially if Clyde's heirs are not actively working in the business nor interested in doing so. At Clyde's death, Ty and Moses probably would want to continue running the business but Clyde's family might want to receive cash for Clyde's stock and get out of the business. If they were to sell Clyde's majority share of the stock to an outsider, Ty and Moses could find themselves in an unfavorable business relationship.
Using life insurance, a buy/sell agreement can be developed to provide funds for either the corporation as an entity or the individual stockholders, under a cross‑purchase plan, to buy the deceased stockholder's stock. This is known as a partial stock redemption and because these redemption provisions are found in Section 303 of the Internal Revenue Code, this is often called Section 303 redemption. Under an entity plan. CC Manufacturing would use the policy it owns on Clyde's life to redeem his majority stock from the family at a predetermined price and the family would be obligated to sell the stock to the corporation. Or, with a cross‑purchase plan, both Ty and Moses would use the insurance proceeds from their individual policies on Clyde's life to purchase the stock on the same basis.
A buy/sell agreement funded by a life insurance policy that is certain to pay in the event of death is a guaranteed way to ensure that the remaining owners will be able to continue operating their business. The surviving owners purchase the deceased person's business interest at a predetermined price and the deceased's heirs know they will receive a fair payment for that interest and be freed from the burden of any business‑related financial responsibilities.
Buy/sell agreements are complex legal documents that require the services not only of a competent life insurance agent, but also of the business owner's accountant and lawyer.
Another well-known use of business‑related insurance is life insurance written on the life of a key employee, who is someone vital to the successful operation of a business. A key employee might be one of the owners, but it could also be a non‑owner employee without whose unique credentials the company could quickly experience financial problems.
CONSUMER APPLICATION
e-Base Computer Systems, a closely held privately owned company, designs technical computer programs for industrial machinery manufacturers. Two years ago they hired Ralph as a programmer, and during his tenure with the company, he had personally been responsible for a system that doubled the income of e-Base. Because of financing commitments they could not make him a shareholder or partner at this time, but they gave him a compensation package that gave him all that he wanted. However, he was almost irreplaceable with the firm. Therefore, the company purchased “Key Man” insurance on Ralph, with the company paying the premiums, and also named as beneficiary. The face amount was what they expected to have to pay for a replacement if Ralph died. (They also took out a disability income key man insurance policy, in case Ralph becomes disabled and unable to work).
Because a life insurance buyer must have an insurable interest in the life of the insured person, the most important criterion for key employee insurance is that the employee's death would result in economic loss to the employer.
Unlike other insurance‑funded business arrangements, key employee insurance requires nothing but a life insurance policy that names the employee as the insured and the business or employer as the policyowner/ beneficiary. The employer pays the premium and receives the death benefit if the employee dies.
Employers who want to provide a death benefit for the key employee's survivors may add a Term Insurance rider for this purpose. If the key employee dies, the base policy's proceeds are paid to the employer as described above and an additional amount of insurance stipulated in the rider is paid to the employee's heirs.
F NOTE: See discussion of Employee Benefit Plans, Split Dollar Plans, Non-qualified Deferred Compensation Plans, and Supplemental Executive Retirement Plans. Also, note discussion of Variable Life in Non-Qualified Business Plans.
CHAPTER 5 – STUDY QUESTIONS
1. The automatic premium loan provision allows the insurance company to
A. take out a loan against an insurance policy and buy additional insurance.
B. take out a loan against the policy to pay a premium that if not paid would lapse the policy.
C. take out a loan against the policy to pay a mortgage payment.
2. Which of the following named beneficiaries would be the first to receive the death bene-fits?
A. Primary beneficiary.
B. Contingent beneficiary.
C. The insureds son if the insureds spouse dies before the insured.
3. The ”spendthrift” clause is a clause
A. in an insurance policy, to protect death benefit proceeds from creditors, by pay-ing out periodic payments rather than a lump sum.
B. that requires the insurer to monitor where the death benefits are spent.
C. to make sure that all creditors are paid upon the death of the insured.
4. When the beneficiary designation is worded that all beneficiaries are to share the proceeds equally it is know as
A. irrevocable.
B. revocable.
C. per capita distribution.
5. In a buy-sell partnership agreement, when each partner owns a life insurance policy on the life of each of the other partners it is known as
A. a partnership trust.
B. an Entity plan.
C. a cross purchase plan.
6. Dividends from participating insurance policies may be paid out as follows
A. sent directly to the owner’s bank to pay on his/her mortgage.
B. added to the cash value of the policy.
C. paid out in cash.
7. What is the provision, in a life insurance policy, that explains how the death benefits are to be paid to the beneficiary?
A. Modes of payment.
B. Non-forfeiture option.
C. Settlement option.
8. When a business is the owner and beneficiary of a life insurance policy on the life of an important person in the company, the policy is know as
A. Stock Redemption plan.
B. Key Person insurance.
C. Split Dollar insurance.
9. Most states have adopted a law, which clarifies the sequence of death in the case of two people dying in a common accident and not having proof of who died first. This law is called
A. Uniform Simultaneous Death Act.
B. Uniform Disaster Provision.
C. Contingent beneficiary.
10. In the dividend option where dividends are allowed to accrue at interest, when the policy owner dies the beneficiary must
A. pay taxes on the dividends.
B. pay taxes on the interest earned.
C. receive the dividends in cash, and then return the cash to the insurance company to earn interest.
ANSWERS TO CHAPTER FIVE REVIEW QUESTIONS
1B 2A 3A 4C 5C 6C 7C 8B 9A 10B