Certain mandatory provisions are part of a variable contract. Some of the typical provisions that apply to both variable and traditional insurance have been discussed, but there are other important variable provisions that need to be understood.
Variable life policies provide that the death benefit must be equal to the initial face amount as a minimum. While the cash value of the policy is not guaranteed, the initial death benefit is guaranteed and this provides a sense of security to the policyholder.
This states that the cash value of the policy will be determined by the separate account(s) activity of the funds that are held in one or more separate accounts. This is the “heart” of the policy and it allows the policyowner to participate in above-average investment returns and still have the protection of life insurance.
The policy’s face amount—death benefit—must be calculated annually and the method of recalculation is provided (paid-up additions/surrenders, or the cash value increase/decrease method).
While this is a flexible feature, it offers some permanency to the policyowner as the death benefit will remain constant for a year—until the amount has been redetermined. It should be pointed out, though, that this may not always show an increase as if the market drops significantly at the time of redetermination, or shortly before, the death benefit could be lower for that year.
The separate accounts change daily according to the investment value increase or decrease, however the cash values supporting the policy are only determined (revalued) on a monthly basis.
This also can be a risk factor, as changes in the direction of the market can affect the cash value, but in this case, it would only be for a month. This could work for or against the policyholder.
This provision is written into every life insurance policy and means that the policy itself, including a copy of the application, is the entire contract and if it is not written in the contract, it does not exist.
Except for short-term nonrenewable policies, such as temporary policies and travel insurance, life insurance policies have a provision which allows the policyowner to examine the policy and provides for a full refund of premiums if the policy is returned to the insurer, usually within 10 days after delivery or within 45 days after the application was completed.
Variable life has the same two-year contestability period as traditional life insurance. Misrepresentations discovered on the application are grounds for voiding the contract and the insurer must then return the premium. Once the contestability period expires, the policy cannot be voided by the insurer.
If there is a misstatement of age or gender, the premiums will be adjusted to reflect what they should have been—identical to all life insurance products.
As with all life insurance plans, variable contracts can be assigned to another party, either on a temporary basis, as collateral for a loan, or assigned permanently and completely. Insurance interest does not need to be established between the insured and the new owner.
Assignment can be used for personal or business reasons, such as a gift to a friend or relative, or as the transfer of key-man insurance for a business after the person retires or is terminated.
The policyowner may seek to reinstate a policy, particularly if the policy has been surrendered by mistake and the policyowner wants to keep the benefits of the original policy. To qualify for reinstatement, the original policy must not have been surrendered—if the original policy was canceled and the cash value distributed to the owner, reinstatement cannot, of course, be accomplished.
Reinstatement may be possible if the request is made within a certain time frame (usually three years) after the original policy’s default, a written request for reinstatement is submitted, evidence of insurability is furnished and a reinstatement premium is paid with the application. The reinstatement premium usually consists of all past-owed premiums (plus interest usually), unless the company agrees to some other premium.
As a rule, Variable life insurance reinstatements will allocate the premium according to the original separate accounts allocation request, unless it is modified.
The same 31-day grace period as with traditional life insurance is used with variable insurance. Note, however, that Variable Universal Life has a different type of grace period, as discussed later.
Unique to Variable life insurance policies, the insurer must allow for the exchange of the policy for a fixed benefit policy at any time within the first 24 months of the policy’s life, provided premiums are fully and timely paid. The new fixed benefit policy must:
Note: The 24-month minimum time for conversion is determined by federal law; states have the right to establish a longer minimum period.
This provision provides a prospective purchaser of a Variable life plan a sense of security, particularly if they do not know if the variable plan is right for them.
Adjustable Policy Loan Interest Rate provisions are required to target the maximum interest rate to be not more than the greater of Moody’s Corporate Bond Yield Average as of two months earlier, or the interest rate that is used to calculate the cash value, plus one percent. Variable rates must be redetermined a minimum of once a year, but not more than once every three months.
Life insurers are required by law to notify policyowners requesting a loan of the initial loan rate, and they must also notify them with “reasonable” advance notice of any increase in the loan rate on outstanding loans.
Further, insurers that use the variable rate method must also offer the fixed interest rate method as an alternative.
Under the laws of most states, policy loans must be available after the policy has been in force for three years, and they must permit loans of at least 75% of the cash value. Insurers can base the policy loan interest rate on a fixed interest basis, but it cannot exceed 8 percent annually, or on a variable interest basis as discussed above.
Policy loans are often used in estate planning situations and policyowners must understand that there are certain criteria involved, such as outstanding loan indebtedness and interest will be deducted from the death benefit at death. In case of surrender or election of a nonforfeiture option, the indebtedness plus interest will be deducted from the cash value. If, for whatever reason, the outstanding loan balance exceeds the cash surrender value, the policy will be cancelled if the excess indebtedness is not repaid within 31 days of the notice. The policy may stipulate that the loans must be greater than a certain amount, and particularly applicable to variable plans, loan amounts will be withdrawn from a separate account and loan repayments will be deposited into a separate account.
The cover page of a life insurance policy contains descriptions of the policy and with variable insurance, the variable nature of the product itself must be not only printed on the cover page, but the differences between the conventional whole life and Variable life must be highlighted, including the death benefit, cash value, methods of determining benefits, and the guaranteed interest rate credited to funds allocated to the company’s general account.
Variable life insurance policies must contain a provision that states that a separate account’s investment objective cannot be changed without the approval of the state Insurance Commissioner (or Department of Insurance).
Since the primary purpose of life insurance is to provide death benefits, it was inevitable that superior investment performance would be reflected in increased death benefits as a method of combating inflation risk on death benefits. This is, of course, true only for long-term investing, as inflation can exceed increases in the performance of investments over a period of 2 to 3 years. How to link the death benefit to the investment performance of a particular portfolio was a troubling problem for the creators of the early-generation Variable life policies. Soon the insurance companies settled on Target Premium methods, and then two additional methods.
Regardless of the method chosen, as described below, all the early contracts requested the purchaser to select a target level of investment performance as a reference that investment performance would be measured against. Performance of the target level would be used to fund incremental increases in the death benefit, whereas performance below the target would require that the death benefits be adjusted downwards to reflect such adverse performance and which would then help to make up for the deficit.
This system uses excess investment returns (returns in excess of the target rate) to purchase a level single-premium addition to the base policy. In effect, the face amount/death benefit will increase when investment performance equals or exceeds the target rate. This method does not cause as rapid an increase or decrease as the constant ratio method (below) but it does not require an ever-increasing investment return to support increases in death benefits. Additional coverage is added more slowly, but once the increases are added, they are more “solid”. This means that downward adjustments in death benefits are less rapid, and less likely to accelerate in future years. This method also allows a minimum value guarantee that would equal the coverage amount when the policy was first in force.
This method uses any excess investment earnings to be treated as a net single premium, and used for purchasing a paid-up additional amount of coverage. This way, the paid-up additional coverage is not a level death benefit amount, but is a decreasing death benefit. This maintains a ratio between the death benefit and the policy reserve that satisfies the corridor test (as discussed earlier).
Like the level additions model, there is a minimum death benefit guarantee that is equal to the beginning face amount of the policy. If the contract has lower returns than the target level, the policy reserves will decrease to a point below the level that is necessary to maintain the guaranteed death benefit amount. The policy must remain in force long enough so that the investment returns will exceed the target rate in order to raise the reserve to the level that will support incremental increases in coverage, before the policyowner will see death benefit increases.
So far, the history of Variable life insurance policies shows that there have been many more years where earnings were higher than the target rate, than when the earnings were lower. There is no guarantee, but it is expected that overall investment earnings will exceed the target amount during the majority of the policy years.
STUDY QUESTIONS
1. Variable contracts require that the death benefit be calculated annually and the method is provided in the policy, such action is called
A. yearly recalculation.
B. redetermination of the death benefit.
C. Unit Investment Trust disbursement.
D. annual asset valuation procedures.
2. Policy loans for variable contracts are available and under most state laws
A. are available after the policy has been in force for 10 years and can be 100% of the cash value.
B. are available immediately and can be as much as 95% of the cash value.
C. are available after three years and loans may be as high as 75% of the cash value.
D. are available at any time but can only be for 25% of the cash value.
3. Variable life policies provide that the death benefit
A. must be equal to the initial face amount as a minimum.
B. must be equal to the initial face amount as a maximum.
C. will provide 10% of the initial face amount, in 10% increments the next 9 years.
D. must always be not less than $100,000 or more than $1,000,000.
4. The cash value of a variable policy is
A. determined by the investment history of the insurer’s assets.
B. illusory but not flexible.
C. equal to the net amount at risk less the reserve.
D. determined by the separate account activity of the funds in those accounts.
5. Paid-up additions, surrenders, cash value increase or cash value decrease, are all used to
A. redetermine the death benefit annually.
B. to calculate the taxable portion of the investment income of the policy.
C. determine the tax basis for capital gains taxation.
D. establish the loss ratio for the calculation of premium for the following year.
6. In a Variable life product, the separate accounts
A. change annually.
B. change bi-weekly.
C. never change.
D. change daily.
7. To qualify for reinstatement, the original variable policy
A. must have been in force for at least 5 years and then surrendered.
B. must not have been surrendered.
C. must not have any policy loans against it.
D. must first be totally voided, and the policyholder must present evidence of insurability.
8. A Variable life insurance policy may be exchanged for a policy with a fixed benefit
A. after the policy has been in force for 5 years.
B. any times within the first 24 months if the premiums are fully and timely paid.
C. but for a lesser face amount and the policy has had to been in force for 3 years.
D. only if the policyowner become incompetent to handle their own business affairs.
9. The purpose of a target premium for a Universal Life policy was
A. for competitive purposes only.
B. so that the insurance department examiners can determine the experience easier.
C. to establish a reference that investment performance could be measured against.
D. so that substandard extras could be used if needed for underwriting purposes.
10. “Level Additional Model” and “Constant Ratio Method” are used to
A. link the death benefit to the investment experience of a particular portfolio.
B. determine the tax basis for investment separate account for income tax purposes.
C. determine the amount of income that is subject to income tax tax-free.
D. determine two factors: persistency and commission structure.
ANSWERS TO STUDY QUESTIONS
1B 2C 3A 4D 5A 6D 7B 8B 9C 10A