CHAPTER SEVEN - TRANSFERS, EXCHANGES AND CHANGES

 

MOVING INTEREST IN ONE ANNUITY TO ANOTHER

 

There are a wide variety of reasons as to why an annuity owner wants to transfer interest, all or part of the interest, to another annuity.

Primarily, the new annuity might be better for the needs of the owner as it may offer benefits, features, options or a rate of return that are better than those he has under an existing annuity.  Or it could be, simply, that he wants to move funds from a fixed annuity to a variable annuity so that his returns on his investments can vary by the experience of the underlying assets. Conversely, he may want to transfer from a variable annuity contract to a fixed annuity so as to provide a more stable and predictable return.

Changing interest in an annuity can be accomplished by transferred ownership of a contract by selling or gifting a contract, in addition to simply exchanging one contract for another.

Federal Income Tax Because of Sale of Annuity

When an annuity is sold, in effect transferring by its owner to a new owner for valuable consideration, any gain or loss is recognized by the owner¹²³ and as ordinary income and not capital gain.¹²⁴

After the sale of an annuity contract or the transfer of interest in an annuity, the investment in the contract of the transferee (the one who has received the transfer) is considered as the consideration paid to buy the contract (or interest in the contract), plus any premiums paid after the transfer, minus any amount that the transferee received before the starting date of the annuity that is excluded from income.  Any amounts received by the transferor are disregarded.¹²⁵

If an annuity is sold after its annuity starting date, the annuity starting date is then adjusted to be the first day of the first period for which the transferee received an amount under the contract as an annuity.¹²⁶

Federal Income Tax Because of Gift of an Annuity

If an annuity is transferred as a gift and the transferor receives no compensation for the annuity transfer, the owner must recognize ordinary income to the extent of the excess of the contract’s cash surrender value over the investment in the contract at the time of transfer.¹²⁷  The Code does not specifically define “cash surrender value,” however it is generally construed to mean the actual amount that would have been received if the former owner had completely surrendered the contract at the time of transfer.

 

If the owner of the contract is a non-person, then this rule does not apply.  However, a distribution of an annuity by a trust does not constitute a transfer without full and adequate consideration.¹²⁸

When an annuity is a gift, the donee’s investment in the annuity is his investment in the contract increased by the amount included in the donor’s income.¹²⁹

If the gift is only that of annuity payments and not the annuity contract itself, the owner of the contract usually remains taxable on the income from the annuity payments and the payments are not included in the donee’s income.  When the annuity is annuitized, a payee other than the owner before annuitization may become the owner of the contract upon annuitization and is taxable on the annuity payments. 

Transferring Annuity to Spouse, or Former Spouse Incident to Divorce

If an annuity contract is transferred to a spouse or a formerly spouse incident to divorce, the owner of the annuity who makes the transfer does not recognize income when it is transferred, the spouse’s investment in the contract is the former owner’s investment in the annuity, adjusted for future premium payments if any, and distributed amounts that are excluded from income.

A “transfer incident to divorce” is when the transfer occurs within one year after the date on which the marriage stops, or is related to the cessation of the marriage.¹³⁰

 

FEDERAL GIFT TAX OF GIFTING ANNUITIES

A gift of a nonqualified annuity contract of annuity payment is subject to the federal gift tax, provided that the gift is complete.¹³¹

When a donor makes a complete gift of an annuity, the donor gives up all rights in the contract.  On the other hand, the complete gift of an annuity payment can allow the donor to still retain an interest in the contract, for instance, a death benefit payment or future annuity payments.  Therefore, the gift tax can apply when a donor gives an entire annuity contract, a series of annuity payments, or a single annuity payment.¹³²

The gift tax that will apply in these situations is the same as if any other property was gifted and gift-tax exclusions apply ($11,000 in 2005 to each of an unlimited number of donees).  If the gift is in excess of the exclusion, the donor must either pay gift tax on the excess or decrease the amount of the unified credit available to the donor under the estate tax.

 

FED. ESTATE TAX OF TRANSFER OF OWNERSHIP AT DEATH OF OWNER

If the rights of ownership in an annuity contract is transferred at death, the value of the annuity contract ownership, including any annuity payments continuing after death, is included in the deceased owner’s estate for federal estate tax purposes.¹³³ Any amount that is included for federal estate tax purposes  will be taxed at the applicable estate tax up to the level where such amounts exceed the level offset by the unified estate tax credit where each taxpayer can exclude an amount established by statute—$1.5 million for 2004 and 2005—from the taxable estate of the taxpayer.  The unified credit amount will be increased in gradual increments until it reaches $3.5 million in 2009, however this law “sunsets” in 2010  and there is movement in Congress at this time to make this law permanent.

If a nonqualified annuity is included in the deceased owner’s estate for federal estate tax purposes, the person who inherits the annuity does not receive a stepped-up basis and his basis is the same as the basis of the deceased owner.¹³⁴

 

TAX IMPLICATIONS WITH REPLACEMENT OF ANNUITIES

Exchange Triggering Gain or Loss for Federal Income Tax Purposes

 

The Supreme Court has held that an “exchange of property gives rise to a realization event when the exchanged properties are ‘materially different,’ that is, when they embody legally distinct entitlements.¹³⁶”

An exchange of annuity contracts usually is assigning a contract to an insurer for the purpose of issuing a new annuity contract, often in order to take advantage of higher interest returns.  There can be changes to a contract, for instance a change in the annuitant’s identity to a new or different person that can effect a replacement of an annuity.  This is a material change that could be considered as a “constructive” exchange of the annuity for a new annuity contract.  Either an actual exchange or a constructive exchange will result in the issuance of a new contract for federal tax purposes.  And, as discussed later, an exchange  could arise when only part of a contract is involved.

IRS CODE SECTION 1035 - TAX-FREE ROLLOVER

Any income tax on an annuity or insurance contract that has been distributed from a qualified plan can be postponed by converting the annuity or insurance contract to a “nontransferable” annuity immediately (according to recent action by the IRS, although within 60 days is still in the regulations – but why take a chance?).  Current taxation on the qualified distribution can be avoided if it is rolled over into a regular IRA, in which case taxes will not have to be paid on the rollover until the IRA starts to distribute its assets.  Any lump sum distribution will be taxed as ordinary income, and any annuity distributions will be taxed as previously discussed.

A partial distribution to an employee of the funds held in their account may be rolled over into a regular IRA unless  (1)  the employee reaches age 70 ½,  (2) payments will be made for 10 years periodically or for the life expectancy of the employee, or  (3) the amounts are not included in the gross income in the absence of the roll over.

When exchanging a nonqualified annuity for another annuity tax free:

(1) The same person must be the obligee or obligees (insureds) under both contracts, and

(2) Exchange must be a “like kind” transfer of one contract for another contract, so exchange proceeds are transferred directly between the issuers or the old and new contracts. 

If proceeds are received by contract owner in cash, the transaction will be treated as a taxable surrender of an existing contract, and will probably be treated as a taxable surrender followed by the purchase of new contract.¹³⁷ 

The IRS has held that the direct transfer of an entire annuity contract into another preexisting annuity contract qualifies as a tax-free exchange under Code Section 1035.¹³⁸

A change in the terms of an annuity contract is considered as a constructive exchange if it meets the requirements of  Section 1035.  However, since an exchange actually or constructively results in the issue of a new annuity contract, there can be some situations where a grandfathering provision is forfeited from tax rules that are enacted after the original contract was issued. 

Exchanging One Annuity Contract for Another

There must be gain or loss realized on an exchange unless there is a specific exception,¹³⁹ there is no gain or loss generally recognized on the exchange of a nonqualified annuity contract for another annuity contract if certain conditions are met—which is a round-about way of saying that the exchange is tax free, or, in IRS “lingo,” it is a “nonrecognition event.¹⁴⁰” 

Under Code Section 1035, an annuity contract is a 1035 contract but which “may be payable during the life of the annuitant only in installments.¹⁴¹ 

Code Section 1035 maintains that an annuity must depend in part on the life expectancy of the annuitant, stating “(Section 1035) treatment is only accorded annuity contracts that are payable over the life of the annuitant.”  In one case, the IRS denied annuity treatment to the conversion of a life annuity to a term certain annuity.  However, recently (1992) the IRS’s position seems to be that Section 1035 applies to exchanges involving term certain annuities.¹⁴²

In respect to exchanging an individual annuity contract for a certificate (an interest) in a group annuity can qualify for nonrecognition treatment according to a 1990 letter ruling that permitted exchange of life insurance contracts for separate participating interests in group life insurance.¹⁴³

Fixed Annuity Contract for Variable Annuity (or vice versa)

The exchange of a fixed annuity contract for a variable annuity contract, or a variable annuity contract for a fixed annuity contract, can qualify for tax-free treatment under Section 1035.¹⁴⁴

Annuity With a Life Insurance Rider

In the case where there was an exchange of an existing deferred annuity for a new deferred annuity contract with two riders, and one of the riders provided term life insurance—the charges for this rider was paid from the new contract’s values each year—the term life insurance qualified as life insurance for tax purposes.  The other rider provided for acceleration of the death benefits under the new annuity contract and the term life insurance rider if the insured became terminally ill. 

The IRS ruled that the exchange of the then existing contract for the new contract did qualify as a tax-free exchange of annuity contracts under Section 1035, the reasoning seemed to be that the presence of the two riders to the new contract did not preclude or in any way alter this treatment where the riders were acquired for a portion of the new contract, and not for any portion of the exchanged contract.¹⁴⁵

Contract Issued by Foreign Insurer or to Foreign Person

As a general rule, an annuity can be exchanged for another annuity contract under Section 1035 if either contract is issued by a foreign company or issuer.  The IRS maintains that the exchange of a nonqualified annuity issued by a domestic insurer for an annuity issued by a foreign insurer, can qualify for nonrecognition treatment under Section 1035.  While the Secretary of the Treasurer has explicit authority to deny such treatment which has the effect of transferring property to any person other than an US person—so far, no such regulation has been issued.

Secondly, if the annuity is issued by an insurer that is not subject to tax codes relating to the taxation of insurance companies, the contract will not be treated as an annuity unless the contract depends upon the life expectancy of one or more individuals, or the company is subject to the before-mentioned taxation.¹⁴⁶

 

CONDITIONS FOR 1035 EXCHANGE

In order for an exchange of annuities to be recognized as a 1035 exchange, in respect to the exchange of one annuity for another annuity, the same person(s) must be the obligee(s) under the annuity received in the exchange, as under the original contract.  While Section 1035 states that it will not apply if the life insurance or endowment policies that are exchanged do not relate to the same insured, evidently this does not apply to the exchange of annuities.

Also, the exchange must be a “like kind” transfer of one annuity contract for another annuity contract in a fashion where the proceeds of the exchange are transferred directly between the issuers of the old and new contracts. 

 

Actually, this pretty much follows the IRS rules for nontaxable exchanges of other property, such as an IRA account to another account, or from a company retirement plan to an IRA, in which cases care is always taken so that the individual does not personally cash out an IRA and then put the money into another.  Treasury Regulations state that “…to constitute an exchange, the transaction must be a reciprocal transfer of property, as distinguished from a transfer of property for money considerations only.”¹⁴⁷

Recently, the IRS held that the direct transfer of an entire annuity contract into another preexisting annuity contract qualified as a tax-free exchange under Code Section 1035.¹⁴⁸  The IRS has maintained that Section 1035 contemplates the extinguishing of an existing contract and the issuance of a new contract.  In a Letter Ruling the IRS stated that the “surrender of an [existing annuity contract] and use of the proceeds toward additional premiums of another [existing contract] cannot be considered an exchange of insurance policies.¹⁴⁹” 

Fixed Annuity Exchanged for a Variable Annuity (or vice versa)

A deferred annuity exchanged for a variable annuity, or a variable annuity exchanged for a deferred annuity, will be considered as a tax free exchange under Section 1035.¹⁵⁰ 

Property Other Than Another Annuity Exchanged for an Annuity

If an annuity meets the Section 1035 exchange requirements except for the fact that the property received in the exchange consists not only of an annuity contract but also of other property or money (which in IRS parlance, is called boot) the exchange of the property that is permitted under Code Section 10345 is still eligible for nonrecognition treatment but if there is any gain, it will be recognized to the extent of the “boot, and no loss will be recognized.¹⁵¹ 

While the IRS has approached this in a couple of different ways, basically, and for these purposes, the most important IRS decision was where it decided that the withdrawal from an annuity of an amount equal to the original premium for the purchase of a life insurance contract and the concurrent exchange of the residual interest in the contract for a new annuity contract, should be treated as a tax-free exchange under Code Section 1035 with boot equal to the fair market value of the life insurance contract.¹⁵² 

 

Income Tax Grandfather Rules in Annuity Exchange

When Congress changes rules applicable to annuity contracts (and for most other types of contracts also) usually after the effective date of the new rules when rules that were in existence prior to the new rules, are allowed to continue if certain conditions are met—grandfathering the existing contracts.  Whether the grandfathered status of a contract that was exchanged continues to apply to the contract that was acquired in the exchange depends, of course, upon the specific grandfather provision applicable. 

As an example, when the rules of tax Code Section 72(e )were revised in 1982, the law provided that money grandfathered under the prior rules should be allowed to be carried over in a Section 1035 exchange.¹⁵³ 

If there is no special rule, then an annuity grandfathered under a provision that was effective for contracts issued on or after a specified date, is exchanged on or after that date, the contract that is received in the exchange probably will not be considered as being grandfathered.¹⁵⁴.

A Nonqualified Annuity Failing to Qualify for 1035 Treatment

If an exchange of a nonqualified annuity fails to qualify for the Section 1035 tax treatment, the “gain” in the annuity contract will be included in the gross income and will not qualify for capital gain treatment but will be taxable as ordinary income.  The gain will be determined as the excess of the cash surrender value of the contract over the unrecovered investment in the contract.

If there is a loss in the transaction, such as where the proceeds are less than the unrecovered investment in the exchanged contract, there could be a loss deduction in certain situations when the original contract was acquired with a profit motive.  In this case, there probably will be a 2 percent floor on miscellaneous itemized deduction which would come into play.

It should be noted, however, that if an exchange does not qualify for nonrecognition under Section 1035, it might qualify for such treatment under another Code provision.  If, for instance, the exchange involves a transfer of property between spouses or former spouses incident to divorce, there will be neither gain nor loss recognized on the transfer.¹⁵⁵ 

Exchange Involving Multiple Annuities

An annuity contract can be exchanged or received in exchange for more than one annuity as the Code specifies that no gain or loss is recognized on the exchange of an annuity contract for another annuity contract.¹⁵⁶  This has not always been the case as for years the IRS ruled otherwise under a 1987 Letter Ruling, but in 1996 and subsequently in 2003, the IRS issued Letter Rulings where it was held that nonrecognition treatment applies to exchanges of more than one contract and to exchanges of more than one contract for a single contract.¹⁵⁷

Still, regardless of the multiplicity of Letter Rulings on the subject, there are still unresolved issues.  For instance it is undecided as to the type of tax treatment that is afforded if one of the contracts received in one-for-two exchange is, itself, exchanged for another deferred annuity contact, or, whether and how the aggregation rule will apply when one or two contracts received in exchange for another contract is annuitized.  If these situations should arise, it would appear that only a private letter ruling could clarify the situations.  Again, mandatory expert advice.

There is one case that has been noted with interest where one annuity was exchanged for two annuities, but the insurer represented that the two contracts would have a single aggregate investment, the annuity commencement date of the contract would be the same, and the two contracts would be tracked for tax purposes as a single contract.  The IRS ruled on this case specifically that the two contracts would be treated as one for purposes of Code Section 72 and funds between the two new contracts would not be a taxable distribution and that distributions would be aggregated in accordance with Code Section 72 regulations.¹⁵⁸ 

Dividing One Annuity Into Two Parts in a Partial Exchange

Sometimes and in some situations, the IRS will consider the exchange of part of an existing annuity for another new annuity,—a partial exchange—as an exchange that is tax free under Section 1035.  In one case settled by the Tax Court where there was surrender charge involved as the annuity owner asked the issuer to transfer part of the contract value to another issuer so that she could purchase a new annuity contract, the IRS not only decided that the taxpayer received unreported taxable income equal to the total amount of the gain, but also assessed a penalty tax for the taxpayer taking a “premature” distribution from her annuity contract.  The Tax Court decided that the taxpayer was essentially in the same situation as before the exchange with the same fund invested (less the surrender charge) except for the fact that the taxpayer in this case then owned two annuities.  The IRS later (1999) announced that it “acquiesced in the Tax Court’s ruling, and further, agreed that as long “as all of the funds in the original contract, less a surrender fee, remain invested in annuity contracts after the transaction, and as long as the proceeds at all times during the transaction remained invested in annuity contracts, the transaction was within the parameters of Section 1035.¹⁵⁹”

The IRS kept its toe in the water however, as while the exchange of part of an annuity contract for another contract can be accomplished tax free under Section 1035 if all the amounts held under the original contract remain in some annuity contract, but they noted that they will continue to challenge transactions where taxpayers enter into a series of partial exchanges and annuitizations as part of a plan to avoid the (Code Section 72) ten percent penalty. In these cases, the IRS stated, they will rely upon all legal remedies to treat the original and new contract as one contract.

In respect to a situation where there was a direct transfer of a portion of the cash surrender value of an existing contract issued by one insurer for a new annuity issued by another, second, insurer, the IRS held that the transfer qualified as tax-free exchange under Section 1035.¹⁶⁰ More technically, they also held that the basis and the investment in the contract immediately before the exchange is allocated ratably between the surviving annuity contract and the new annuity contract based on the percentage of cash value transferred to purchase the new annuity.  However, the same Revenue Ruling directs taxpayers to review Notice 2003-51 [2003-2 C.C. 361] before entering into a partial exchange to find out whether their particular transaction is subject to the interim guidance provided. 

There has been quite an amount of activity with the Treasury Department and the IRS in respect to these situations as there is concern that partial exchange of annuities and the subsequent surrender of or distributions from, either the surviving annuity contract or the new contract should have been entered into for tax avoidance purposes.  In other words, they are watching partial surrenders closely.

In the interim guidance notice, a taxpayer will not be treated as having entered into a partial exchange and the subsequent surrender or distribution for tax avoidance purposes if the taxpayer can show that one of the conditions of the Code has been met or any other similar life event—such as divorce or the loss of employment—occurred between the partial exchange and the surrender or distributions and the surrender or distribution not contemplated at the time of the partial exchange.¹⁶¹

Exchange of an Annuity for Life Insurance or Endowment Contract

In most cases, an annuity can be exchanged or received in exchange, for a life insurance or endowment contract, but the tax consequences will differ depending upon the type of contract that is being exchanged.

An annuity may be exchanged tax free only for another annuity contract.  So, if an annuity is exchanged for a life insurance policy or endowment contract, the exchange is taxable.¹⁶² 

A life insurance contract can be exchanged tax free for another life insurance contract, an endowment contract or an annuity contract.¹⁶³ 

An endowment contract can be exchanged for an endowment contract or an annuity contract.¹⁶⁴ 

Exchange With Assumption of Liability

On occasion, one person who is involved in a Code Section 1035 exchange, as part of the consideration, assumes an liability or receives from the owner, property that is subject to such liability, the acquiring of such liability is considered as a boot (as discussed earlier)to the extent of the value of the liability.¹⁶⁵   How these situations are treated for tax purposes are important in situations where, for instance, a life insurance policy was being exchanged for an annuity contract and a loan on the life insurance policy was extinguished as part of the exchange. 

Changing Annuitants in Relation to an Exchange

When a deferred annuity is purchased, the duration of the payments that are contingent upon the annuitant’s life is determined upon the length of the lifetime of the annuitant.  But while the annuity is in the deferred status the annuitant or the party entitled to receive benefits from the annuity (usually the contract owner) may or may not be entitled to receives benefits.  There are deferred annuities that allow the owner to change the annuitant; or in case of death of one annuitant, a successor annuitant may be named before payments start.  In many respects, the annuitant who is operating only as an annuitant, has no vested rights while the annuity is in its deferred status.  Once the contract is annuitized, however, the annuitant is “fixed” and the annuitant could be the one to whom annuity payments are made.

Any changes in the terms of an annuity, including changing the annuitant from one person to another, can then become a constructive exchange of the annuity for a new contract.¹⁶⁶  If there are no other changes made when the annuitant is changed, the exchange should be treated as a tax free Section 1035 exchange—as long as the obligee is not changed.  (“Obligee” under the regulations is the person to whom an obligation is owed, usually, the insurer.) 

It then  becomes necessary to determine the role of obligee(s) under an annuity—it will depend upon the situation and the facts.  As an example, in case of a deferred annuity, the owner is usually the one to whom an obligation is owed during the deferral stage and there is no obligation to the annuitant or payee of the annuity payments (if different than the annuitant).  In this case, a change in the annuitant shouldn’t have any bearing on the Section 1035 exchange.

However, once the annuity payments start, the obligation of making payments by the insurer is fixed, in which case it is possible that some other person may become the payee of the annuity payments, irrevocably.  Then, the payee may be considered as the obligee rather than the original owner after the annuity starting date.  In that case, with a change in the annuitant at that time, Section 1035 tax free provisions would not apply.¹⁶⁷

 

Note:  When the holder of an annuity is a nonperson (not an individual), a change in the primary annuitant is treated as the death of the holder.¹⁶⁸

 

EXCHANGES INVOLVING INSOLVENCY OF ISSUING COMPANY

Over the past 3 decades, there have been several insurance companies becoming insolvent, some of the companies being issuers of annuities.  In particular, the Baldwin United insolvency in the 1970s created a lot of unrest and uneasiness among annuity owners as a major share of the insurance written by this company was annuities.  Eventually most of the annuities were transferred to Metropolitan Life Insurance Company and other participating companies.  There have been other instances where annuity owners would exchange their annuities to a similar annuity with a more financially stable company.  The IRS and the Treasury Department have been aware of these situations and Revenue Rulings and Procedures have been enacted to provide special handling of exchange in these situations.¹⁶⁹

Basically, the IRS has held that there will be no gain or loss recognized when an annuity contract that had been issued by a life insurance company that is undergoing rehabilitation, conservatorship, or similar actions by a state, is exchanged issued by a different company.  Sometimes a new contract will be funded in these situations by the issuing (troubled) insurance company through a series of payments, but even in these cases there will be no gain or loss considered in the exchange if the taxpayer has assigned all of his rights in the old contract.

In a case where a taxpayer received cash from a withdrawal of an annuity contract issued by a “financially troubled company, the IRS allowed the taxpayer nonrecognition treatment with respect to the cash that he received, but with stipulations:

1. The company was subject to state rehabilitation or similar proceedings;
2. The taxpayer withdraws (or had already withdrawn) all amounts that are allowed to be withdrawn;
3. The cash distribution was reinvested into a contract issued by another company within 60 days; and
4. The transaction would otherwise qualify for nonrecognition treatment under Code Section 1035 that pertains to certain transfers that involve qualified plan funds.¹⁷⁰ 

 

STATE PREMIUM TAXES

While most states do not levy a premium tax on annuities, California is one state that does.  These taxes are due when annuity payments begin by taxing the value (or “premiums”) applied to provide annuity payments.  California has different premium tax structures, depending upon whether the annuity is qualified or nonqualified.

In California the Nonqualified Tax Rate is 2.35%, the Qualified Tax Rate is .50%.  Tax rates can change, so one should be informed of the rate at the time of discussion. 

Premium taxes actually only affect the insurance companies, but they can have an effect on the overall premium of all products.

 

STATE REGULATIONS ON REPLACEMENT

In California, insurance Code Sections 10509-10509.9 in particular, as well as other Section address the regulation of activities of agents and insurers in respect to the replacement of annuities.  It was felt that such regulations were needed so that the activities of insurers and agents in respect to the replacing of existing annuities (and life insurance) could be regulated in an effort to protect the interests of life insurance and annuity purchasers by establishing minimum standards of conduct to be observed in replacement transactions by making sure that the purchaser(s) receives information with which a decision can be made in his or her own best interest, reduce the opportunity for misrepresentation and incomplete disclosures and, of course, establishing penalties for failure to comply with the requirements of these regulations.

Definitions

"Replacement" means any transaction in which new life insurance or a new annuity is to be purchased, and it is known or should be known to the proposing agent, or to the proposing insurer if there is no agent, that by reason of that transaction, the existing life insurance or annuity has been or is to be any of the following:

1. Lapsed, forfeited, surrendered, or otherwise terminated.
2. Converted to reduced paid-up insurance, continued as extended term insurance, or otherwise reduced in value by the use of nonforfeiture benefits or other policy values.
3. Amended so as to effect either a reduction in benefits or in the term for which coverage would otherwise remain in force or for which benefits would be paid.
4. Reissued with any reduction in cash value.
5. Pledged as collateral or subjected to borrowing, whether in a single loan or under a schedule of borrowing over a period of time for amounts in the aggregate exceeding 25 percent of the loan value set forth in the policy.¹⁷¹

"Conservation" means any attempt by the existing insurer or its agent to dissuade a policyowner from the replacement of existing life insurance or annuity.  Conservation does not include routine administrative procedures such as late payment reminders, late payment offers, or reinstatement offers.

"Direct-response sales" means any sale of life insurance or annuity where the insurer does not utilize an agent in the sale or delivery of the policy.

"Existing insurer" means the insurer whose policy is or will be changed or terminated in such a manner as described within the definition of "replacement."

"Existing life insurance or annuity" means any life insurance policy that is under a binding or within an existing life insurance policy or annuity in force including life insurance conditional receipt or a life insurance unconditional refund period.

“Replacing insurer" means the insurer which is a replaces and existing policy/annuity.

"Registered contract" means variable annuities, variable life insurance, investment annuities under which the death benefits and cash values vary in accordance with unit values of investments held in a separate account, or any other contracts issued by life insurers which are registered with the Federal Securities and Exchange Commission.

Exemptions

Unless otherwise specifically included, this article does not apply to the following:

1. Credit life insurance.
2. Group life insurance or group annuities.
3. An application to the existing insurer that there is existing life insurance when a privilege is being exercised.
4. Proposed life insurance that is to replace life insurance under a binding or conditional receipt issued by the same insurer.
5. Transactions where the replacing insurer and the existing insurer are the same; provide however, that agents proposing replacement shall comply with regulations (below) and will provide and leave with the applicant a written statement containing information relating to premiums, cash values, death benefits, and outstanding indebtedness, and dividends and dividend accumulations, if any, for the existing policy, both immediately before and after replacement, and for the proposed life insurance annuity.

Registered contracts shall be exempt from the requirements (below) requiring provision of policy summary or ledger statement information; however, premium or contract contribution amounts and identification of the appropriate prospectus or offering circular shall be required in lieu thereof.¹⁷²

Notice Regarding Replacement

Each agent who accepts an application shall submit to the insurer with which an application for life insurance or annuity is presented, or as part of each application, both of the following:

1. A statement signed by the applicant as to whether replacement of existing life insurance or annuity is involved in the transaction.
2. A signed statement as to whether or not the agent knows or may be involved in the existing life insurance of annuity in the transaction.

When a replacement is involved, the agent shall do all of the following:

1. Present to the applicant, not later than at the time the application, a "Notice Regarding Replacement of Life Insurance" in the form as described below.  The notice shall be signed by both the applicant and the agent and left with the applicant.  Obtain with or as part of each application a list of all existing life insurance or annuities to be replaced and properly identified by name of insurer, the insured and contract number.  If a contract number has not been assigned by the existing insurer, alternative identification, such as an application or receipt number, shall be listed.
2. Leave with the applicant the original or a copy of all printed communications used for presentation to the applicant.
3. Submit to the replacing insurer with the application a copy of the replacement notice.

Every agent who uses written or printed communications in conservation shall leave with the applicant the originals of any materials used. Each agent or broker shall present to an applicant the following notice¹⁷³

 

Every life insurer shall do the following:

(a) Inform its field representatives or other personnel responsible for compliance with this article of the requirements of this article.

(b) Require with, or as part of, each completed application for life insurance or annuity a statement signed by the applicant as to whether such proposed insurance or annuity will replace existing life insurance or annuity.¹⁷⁴

Requirements When a Replacement is Involved

Every life insurer that uses an agent in a life insurance or annuity sale shall do the following:

(a) Require with or as part of each completed application for life insurance or annuity, a statement signed by the agent as to whether he or she knows replacement is or may be involved in the transaction.

(b) Where a replacement is involved:

(1) Require from the agent with the application for life insurance or annuity: (i) a list of all of the applicant's existing life insurance or annuity to be replaced, and (ii) a copy of the replacement notice provided the applicant  The existing life insurance or annuity shall be identified by name of insurer, insured, and contract number.  If a number has not been assigned by the existing insurer, alternative identification, such as an application or receipt number shall be listed.

(2) Send to each existing life insurer a written communication advising of the replacement or proposed replacement and the identification information obtained pursuant to this section and a policy summary, contract summary, or ledger statement containing policy data on the proposed life insurance or annuity.  Cost indices and equivalent level annual dividend figures need not be included in the policy summary or ledger statement.  This written communication shall be made within three working days of the date the application is received in the replacing insurer's home or regional office, or the date the proposed policy or contract is issued, whichever is sooner.

(3) Every existing life insurer or the insurer's agent that undertakes a conservation shall, within 20 days from the date the written communication plus the materials required in subdivisions (1) and (2) are received by the existing insurer, furnish the policyowner with a policy summary for the existing life insurance or ledger statement containing policy data on the existing policy or annuity.  Information relating to premiums, cash values, death benefits, and dividends, if any, shall be computed from the current policy year of the existing life insurance.  The policy summary or ledger statement shall include the amount of any outstanding of any dividend accumulations or additions, and information that is not in violation of any Cost indices and equivalent level annual not be included. When annuities are involved, in the contract summary. existing insurer to furnish it with a copy of the summaries or ledger statement, which shall be within five working days of the receipt of the request.

(c) The replacing insurer shall maintain evidence of the "notice regarding replacement," the policy summary, the contract summary, and any ledger statements used, and a replacement register, cross-indexed by replacing agent and existing insurer to be replaced.  The existing insurer shall maintain evidence of policy summaries, contract summaries, or ledger statements used in any conservation.  Evidence that all requirements were met shall be maintained for at least three years.

(d) The replacing insurer shall provide in its policy or in a separate written notice which is delivered with the policy that the applicant has a right to an unconditional refund of all premiums paid which right may be exercised within a period of 30 days commencing from the date of delivery of the policy.  In the case of variable annuity contracts, variable life insurance contracts, and modified guaranteed contracts, return of the contract during the cancellation period shall entitle the owner to a refund of account value and any indebtedness, the sum may include any other regulation or statute dividend figures need the disclosure information shall be that the replacing insurer may request the policy fee paid for the policy.  The account value and policy fee shall be refunded by the insurer to the owner within 30 days from the date that the insurer is notified that the owner has canceled the policy.¹⁷⁵

Insurer Does Not Propose Replacement

If in the solicitation of a direct response sale, an insurer does not propose the replacement, and a replacement is involved, the insurer shall send to the applicant with the policy a replacement notice as described previously or other substantially similar form approved by the Commissioner.

In those instances the insurer may delete the last sentence and the reference to signatures from the form without having to obtain approval of the form from the Commissioner.

Insurer Does Propose Replacement

If the insurer proposed the replacement it shall do the following:

(1) Provide to applicants or prospective applicants with or as part of the application a replacement notice as described earlier.

(2) Request from the applicant with or as part of the application, a list of all existing life insurance or annuities to be replaced and properly identified by name of insurer and insured.

(3) Comply with the above requirements if the applicant furnishes the names of the existing insurers, and the requirements above of maintaining evidence of the notice, etc., except that it need not maintain a replacement register.¹⁷⁶

Inaccurate Presentation or Comparison, and Unnecessary Replacement

A violation of this article shall occur if an agent or insurer recommends the replacement or conservation of an existing policy by use of a materially inaccurate presentation or comparison of an existing contract's premiums and benefits or dividends and values, if any, or recommends that an insured 65 years of age or older purchase an unnecessary replacement annuity.

For purposes of this section, "unnecessary replacement" means the sale of an annuity to replace an existing annuity that requires that the insured will pay a surrender charge for the annuity that is being replaced and that does not confer a substantial financial benefit over the life of the policy to the purchaser so that a reasonable person would believe that the purchase is unnecessary.

Patterns of action by policyowners who purchase replacement policies from the same agent after indicating on applications that replacement is not involved, shall constitute a rebuttable presumption of the agent's knowledge that replacement was intended in connection with the sale of those policies, and such patterns of action shall constitute a rebuttable presumption of the agent's intent to violate this article.

This article does not prohibit the use of additional material other than that which is required that is not in violation of this article or any other statute or regulation.¹⁷⁷

Penalties for Violation of Regulations

Any agent or other person or entity engaged in the business of insurance, other than an insurer, who violates this article is liable for an administrative penalty of no less than one thousand dollars ($1,000) for the first violation.

Any agent or other person or entity engaged in the business of insurance, other than an insurer, who engages in practices prohibited by this chapter a second or subsequent time or who commits a knowing violation of this article, is liable for an administrative penalty of no less than five thousand dollars ($5,000) and no more than fifty thousand dollars ($50,000) for each violation.

Any insurer who violates this article is liable for an administrative penalty of ten thousand dollars ($10,000) for the first violation.

Any insurer who violates this article with a frequency as to indicate a general business practice or commits a knowing violation of this article, is liable for an administrative penalty of no less than thirty thousand dollars ($30,000) and no more than three hundred thousand dollars ($300,000) for each violation.

After a hearing conducted in accordance with these regulations, the Commissioner may suspend or revoke the license of any person or entity that violates this article.

Nothing in this section shall be deemed to affect any other authority provided by law to the Commissioner.¹⁷⁸

 

STUDY QUESTIONS

1.  Code Section 1035 allows that changing interest in an annuity can be accomplished by exchanging one contract for another, or

      A.  selling or gifting a contract.

      B.  requesting a decision from the probate court.

      C.  moving to another permanent residential address.

      D.  exchanging the annuity for a life insurance policy.

 

2.  Jim and Sally decided to go their separate ways after 15 years of marriage and as part of the settlement, an annuity with Jim as annuitant was immediately transferred to Sally.  This transfer was

      A.  an illegal transfer.

      B.  a surrender and reissue for tax purposes.

      C.  a “transfer incident to divorce.”

      D.  a voiding of the contract and refund of all premiums paid in.

 

3. If the rights of ownership in an annuity contract is transferred at death, the value of the annuity contract ownership, including any annuity payments continuing after death,

      A.  reverts to the next-of-kin.

      B.  must be determined by the probate court.

      C.  is included in the deceased’s estate for federal estate tax purposes.

      D.  is excluded from the deceased’s estate for federal tax purposes.

 

4.  For federal income tax purposes, an exchange triggers realized gain or loss for federal income tax purposes

      A.  in all situations.

      B.  only if the exchange is for equal value.

      C.  only if there is an exchange of property for property differing materially in kind or in

            extent.

      D.  on all corporate or Subchapter S  corporation tax returns.

 

5.  Any income tax on an annuity that has been distributed from a qualified plan can be postponed

      A.  by case-by-case approval of the IRS.

      B.  for not more than 15 years.

      C.  by converting the annuity to a nontransferable annuity immediately.

      D.  if the annuitant becomes disabled.

6.  Under Section 1035, if a fixed annuity is exchanged for a variable annuity,

      A.  then the transaction loses its tax-free treatment.

      B.  the exchange can qualify for tax-free treatment.

      C.  while this transaction would cause the loss of tax-free treatment, if it were a variable

            annuity exchanged for a fixed annuity, the tax-free treatment would apply.

      D.  then the variable annuity would qualify for future tax-free treatment only.

7.  If proceeds are received in cash by the annuity owner and then transferred to the issuer of the new contract, the transaction would

      A.  void any tax considerations for either contract.

      B.  be treated as a taxable surrender of the existing contract and a purchase of a new contract.

      C.  be treated as a non-taxable surrender of the existing contract and a purchase of a

            new contract.

      D.  be considered as illegal as it is obviously is a ploy to avoid taxes.

8.  In California, when an agent accepts an application for an annuity, they shall submit to the insurer along with the application, or as part of the application,

      A.  a statement signed by the agent that states he has informed the applicant that if there are

            existing annuities, this is confidential information and not to be revealed to the insurer.

      B.  a facsimile of the cover page of any such annuity already covering the applicant.

      C.  a statement signed by the applicant as to whether replacement of existing annuities is

            involved in the transaction, and a signed statement as to whether the agent knew or is in-

            volved in the transaction.

      D.  a statement requesting that another agent be assigned because there is other insurance

            coverage essentially the same in force on the individual.

9.  “Patterns of actions” of policyowners who purchase replacement policies from the same agent after indicating on the applications that replacement is not involved,

      A.  merely indicates that the agent is a professional and markets by recommendation of cus-

            tomers.

      B.  shall constitute a rebuttable presumption of the agent’s knowledge that replacement was

            intended in connection with the same of these policies.

      C.  could lead to the return of commissions on the policies.

      D.  can lead to investigation by the Attorney General to makes sure that all applicants receive

            nearly identical treatment and no one is charged more than the others for similar

            coverage.

10.  Basically, the first time an agent violates the California regulations regarding replacement sales, he

      A.  is liable for a penalty of no less than $1,000 for first violation.

      B.  is liable for a penalty of no less than $5,000.

      C.  can apologize and return his commission.
D.  can be convicted of a misdemeanor, have his license revoked, and fined $1,000.

 

CHAPTER SEVEN:

1A     2C     3C     4C     5C     6B     7B     8C     9B     10A