An insurance policy is a legal contract. Period. While it is different than most contracts that the general public enters into on a regular basis, it is still just a contract, and as such must meet all of the requirements of a legal contract. Basically:
F For a consideration (the premium), one party (the insurance company) agrees to pay an agreed-upon sum of money (or to provide services set forth in the contract) if a loss that is covered under the contract, occurs.
A life insurance “contract” can be confusing, technical and misunderstood to the insured, so it would be easy for an insurer to take advantage of the average insured. Conversely, the policyowners (and claimants) can take advantage of the insurer because they can be aware of physical, moral and adverse-selection problems. The laws of contracts as it pertains to life insurance contracts, are specifically developed to eliminate – or at least alleviate – these discrepancies that can lead to serious misunderstandings.
In the United States (and in most other countries) life insurance policy forms must be approved by the regulating authority (usually insurance department of the state) and all policies must contain certain “standard provisions” – which are clearly specified in the law. The states usually do not prescribe the exact wording for these standard provisions, but are guidelines that state that the actual wording must be at least as favorable to the policyowner as the standard provisions.
The standard provisions generally include
There are many other regulations relating to the insurance policy contract, including identifying all policy forms by numbers, format of the first (cover) page, etc. Most states require that the policies be written in “simplified” format, judged by its readability and ease of understanding. The NAIC provides a model act, Life and Health Insurance Policy Language Simplification Model Act, for insurers to use as a guide in this respect.
Courts have rendered decisions throughout the years that bear significantly on the way that provisions are interpreted in life insurance policies. In addition, laws have a direct impact on policy provisions, particularly Internal Revenue regulations, civil rights legislation, etc.
The characteristics of life insurance policies that differentiate them from other business contracts should be understood before discussing the contract rules of law.
An insurance contract is a contract of good faith – indeed, it is utmost good faith. This means that both parties to the contract can rely upon the good faith of the other and therefore cannot deceive or attempt to deceive, or withhold pertinent information from the other party. Simply put, the advantages that each party has over the other, as stated above, are not to be used against the other party. The rule of “caveat emptor,” or “let the buyer beware” does not apply in insurance contracts.
Life insurance contracts are considered as valued contracts, which simply means that the insurer agrees to pay a certain specified sum of money, regardless of the actual economic loss to the insured. A life insurance policy is not a policy of indemnity as are property and casualty and some health insurance contracts, as the amount of money that will be paid has no relation to the actual financial loss sustained by the insured. This can cause moral hazards to be unknowingly insured because the insureds can recover losses for amounts greater than the economic value of lost income or attendant expenses. Therefore, life insurers carefully consider the economic loss that an insured could suffer in the event of the insured’s death or disability.
Life insurance contracts are contracts of adhesion. This means that the terms of the contract are fixed by one party to the contract, and must be accepted or rejected totally (“en totale”) by the other party. This is a very important point, as the courts look upon a life insurance contract as highly specialized and technical, and therefore any ambiguities in the contract will be construed in favor of the policyowner. This is why so many life insurance contract disagreements that go to court are decided in favor of the insured. (This is significant in all insurance policies, not just life insurance. For instance, it applies frequently in liability and homeowner policies.)
Life insurance contracts are conditional, as the insurer’s obligation to pay claims are conditioned upon certain acts, such as payment of the premium and proof of death.
Life insurance contracts are aleatoryin nature, which means that one party can receive more in value than the other party. Therefore there is an element of chance. (As opposed to a commutative contract where each party would receive something of approximately equal value).
Life insurance contracts are unilateral in nature as the insurer is the only party that gives a (legally enforceable) promise in the contract. The owner of the contract does not promise to pay the premiums but if they do make the premium payments in a timely manner, then the insurer is fully under the obligation to fulfill its obligation. Incidentally, this can cause some adverse selection as those insureds who need the insurance, are the ones that will make premium payments in a timely manner.
In order for any contract to be valid, there are four requirements as prescribed by law that must be present:
Legally capable.
The parties to the contract must be legally capable of making a contract. This means that they must have the (legal) capacity to enter into a contract. Intoxicated persons, mental incompetents, enemy aliens, and others who are not capable in the eyes of the law, cannot enter into a contract. A minor cannot make a contract, which is usually the age of 18, but in certain states they can contract for necessities such as food and clothing. In the case of an insurance policy, contracts with minors are voidable at the option of the minor except when the minor has contracted for the necessities. In some jurisdictions, minors as young as 15 can contract for insurance.
Mutual agreement.
There must be an agreement that is based on an offer by one party and acceptance of this offer by another party. Life insurance is different in this respect than other contracts; for instance the insured party is usually solicited by an agent who submits the application to the company. There are situations that arise that indicate whether the mutual agreement is in effect.
The “approval conditional premium receipt” provides coverage only after the application has been approved by the insurer. This type of receipt is seldom used because of the short coverage period provided to the applicant and the complaints of applicant therefore.
The “insurability conditional receipt” is most frequently used. In effect, with this type of receipt, the insurer is considered to have made an offer. The applicant for the insurance accepts this offer by paying the appropriate premium. The insurance becomes effective on either the date of the conditional receipt, or in some cases, the date of the physical examination with the proviso that the applicant is found to meet the insurer’s underwriting criteria. If the applicant should die before the application and any other information required reaches the home office, and if the applicant had met the underwriting standards customarily used by the company, the policy will be considered as issued and the claim would be paid. This type of receipt has been upheld by many courts, but on occasion the courts have felt that the applicant had expected interim coverage for the premiums paid, and therefore they have ruled for the applicant.
The third type of frequently used premium receipts is the conditional binding receipt which effectively provides insurance from the date the insurance is written, both immediate and unconditional. Usually the applicant must have answered all the questions on the application satisfactorily and the coverage is provided for a stated fixed time period, or until the insurance company makes a final underwriting determination, whichever comes first. This type of receipt is used for temporary insurance such as travel insurance policies and temporary health policies, however there are a growing number of companies that use binding receipts. One of the reason for its popularity is that the public is used to binding receipts in their purchase of property and casualty insurance, such as auto and homeowners insurance where the company is “bound” upon completion of the application.
Usually, the effective date of a policy is the date from which coverage starts, agreed upon by both the insured and the insurer, but there can be complications.
A policy may be backdated to “save age.” Since premium is lower at a younger age, this may be allowed if the backdating is not beyond six months – which would otherwise be illegal in many states. This is often used for sales purposes, but it does raise a couple of interesting questions: When is the next premium due? (and) From what date do the incontestable and suicide periods run? Some courts have held that a full year of coverage must be provided for the payment of a full annual premium, although most courts have held that the effective policy date that is shown on the contract, is the date upon which following premiums are due, even though that might mean less than one full year of protection for the first year.
For Suicide and Incontestable clauses, which are usually for a period of two years, the accepted rule is that the earlier of the effective date, or the policy date, is the time from which the clause starts. With backdated policies, therefore, the suicide and incontestable clauses could run from the policy date, but if the policy date is later than the effective date, then the clauses run from the effective date. In some cases, a specific date from which these clauses are to run is written into the contract, and in those cases that date would be used.
For an insurance policy, the consideration is the first premium payment. Legally, subsequent premium payments are “conditions precedent” that must be performed in order to keep the contract effective. In practice, the consideration clause is simple and a typical clause would read:
“We have issued this policy in consideration of the representations in your application and payment of the first term premium. A copy of your application is attached and is part of this policy.”
A contract cannot be used for illegal purposes, including gambling, which are contrary to public policy. Insurance and a wager are distinctly different because the requirement of an insurable interest in the policy removes the policy from any definition of gambling. Besides gambling, any policy that is against public policy is illegal, such as a life insurance policy that is negotiated with the intent to murder.
A life insurance policy must, by law, be based upon an insurable interest. Of course an individual always has an insurable interest in his/her own life and that of immediate family members because of blood or marriage.
Creditor-debtor relationships give rise to insurable interest. The creditor can be the beneficiary for the amount of the outstanding loan with the face value decreasing in proportion to the decline in the outstanding loan amount.
Some business relations can also give rise to insurable interest as an employee may insure the life of an employer, or vice versa, as discussed later in respect to key man insurance and other business uses of life insurance.
Insurable interest must exist at the inception of the contract, and not necessarily at the time of the loss. For example, if a woman purchases a life insurance policy on the life of her fiancé, she is considered to have an insurable interest. If the relationship sours, as long as she continues to pay the premiums, she will be able to collect the death benefit under the policy.
CONSUMER APPLICATION
In a frequently quoted case, a child’s aunt (-in-law) named herself as applicant and beneficiary on the purchase of three life insurance policies on her niece, with the intent to murder the child & collect the insurance proceeds. Since the insurers did not ascertain whether an insurable interest existed in this case, the jury awarded the father a $100,000 wrongful-death judgement, which was substantially greater than the face amounts on the policies. Life insurance companies nationally “sat up and took notice” and since that time (1957) great care has been taken to make sure there is always insurable interest.
The application is considered as the applicant’s proposal to the insurance for coverage and can be considered as the beginning of the insurance contract. Most states require that the application become part of the insurance policy – and if the insurer does not do so, they are estopped (prevented by law) from later denying the correctness or truth of any information on the application. It is extremely important that the application be completed correctly and completely, and rarely does an application with an unanswered question or unintelligible answer will go unnoticed by various employees of the insurance company whose job it is to review applications.
Concealment is the withholding of information of facts that the insurance company should know. As stated earlier, a life insurance contract is a contract of utmost good faith, and the insurance policy depends upon full disclosure of all material information. Whether a fact is materialdepends upon whether the insurer would have acted as it did by issuing the policy and at the premiums it charged, if they had known the actual facts. Therefore, the general rule about materiality is if the facts had been presented accurately and truthfully to the insurer, would the insurer have denied the application, charged a higher premium, or issued a policy with limited benefits.
The doctrine of warranty requires that the statement be absolutely and literally true. However, since it caused hardship to some insureds as the insurer could void a policy if the statement were only technically true, regulations were passed that state, in effect (the wording varies widely), that statements made by the insured were representations, and not warranties. Therefore, the doctrine of warranty is not effective today.
A representation is a statement given to an insurance company concerning personal health history, family health history, occupation and hobbies. These statements are required to be substantially correct; that is, applicants must answer questions to the best of their ability. In most cases, representations are construed by the courts very liberally and they need to be only substantially correct.
A misrepresentation is when a statement given is incorrect. In most states, a materially false representation makes an insurance policy voidable at the option of the insurance company. Fraudulent intent need not be proven in most jurisdictions. In other jurisdictions, fraudulent intent can automatically make the policy voidable, therefore the definition of intent is important and varies by jurisdiction.
An individual who intentionally misrepresents or conceals a material fact, intending to deceive the insurance company in order to gain the benefit of the policy, is guilty of fraud. To be guilty of fraud, there must be intentional misrepresentation or concealment of a material fact, and there must be an intent to deceive in order to receive the benefit.
A discussion of the contractual application of a life insurance policy would not be complete without a mention of the presumption of death. Because of television and the movies, most people feel that they are at least aware of these laws.
The terminology of the life insurance contract states that there must be due proof of the death of the insured before benefits can be paid. This can be particularly difficult if the insured has disappeared and there is no trace of where they are. The basic law is that if a person leaves their place of residence and is neither heard from or seen, or known to be living, after a period of seven years, the person is presumed to be dead. If an insured disappears for 7 years and the absence is unexplained, then the benefits will be paid. Court cases involving presumption of death usually revolve around whether the absence can be explained.
In order to prove that the absence cannot be explained, the beneficiary (who is usually the plaintiff in these cases) attempts to prove that the insured was happy and had no financial problems, and therefore there was no reason for the insured to disappear. The burden of proof falls on the insurer to disprove these facts, and they may attempt to show that the insured was unhappy, financially insolvent, or had a girlfriend not known to his wife (for instance).
The remaining question is: when did the insured die? A few jurisdictions hold that the insured died on the last day of the 7-day period. However, if it can be shown that there was some peril involved (tornado, hurricane, etc.) then the court would generally rule that the date of death was the date of the peril, in which case the death benefit plus interest from that date would be paid.
What happens when the insured has been gone for more than 7 years and the death benefits have been paid to the beneficiary, and the insured shows up again? If the benefits were paid in good faith, the insurance company has the right to recover on the basis that it was simply a mistake in fact. Interestingly, however, if the insurance company did not pay the full death benefit, such as under a settlement agreement (which are quite common in these cases), then the insurance company has no recourse and the beneficiary gets to keep the settlement money that had already been paid.
The pertinent policy provision simply states that (except for accidental death and disability premium payment benefits), the insurer cannot contest the policy after it has been in force for two years while the insured is still alive.
This clause stems from an old English provision, the “indisputable clause” which was used to counteract the very tough warranty provisions in the policies at that time. This clause was more for public perception in the beginning in the U.S., shortly after the Civil War, but became an “institution” when adopted by the Equitable Life Assurance Society in 1879. Its purpose is to remove the worry to the insured and the beneficiary(s) that the life insurance company may not pay. Even if the insured had misrepresented a material fact at time of application, after two years the insured may not be around to contest such accusations of the insurer. It limits the time that the insurance company can use the defense of fraud, concealment or material misrepresentation in order to keep from paying benefits.
Suicide is covered in the same fashion. It is felt that if a person purchases life insurance in anticipation of suicide, they will commit suicide (usually) within two years, or never at all – and this has held true in most cases. Insurers have always had a difficult time in denying claims because the insured committed suicide, even within two years.
CONSUMER APPLICATION
About 30 years ago, in Colorado, an insured who, within weeks of the purchase of life insurance, discovered that his wife was sleeping with his brother, went for a walk in a pasture in fresh snow (his were the only tracks). He carried a single-shot, bolt-action 22 caliber rifle. He was found by his brother later in the day with TWO bullet holes in him, one in the chest (obviously the first, which did not kill him) and the second was through the top of his head – coincidentally he had the rifle barrel in his mouth. The court ruled that it was accidental. (An actual case, from files of a Colorado insurer)
The typical suicide clause states that the insurer will not pay if the insured commits suicide (while sane or insane) for the first two full years from the original application date. For suicide, they will void the policy and return the premium (less any loans). Also, note the “sane or insane” wording. In practice, some courts have consistently held that an insane person cannot commit suicide because a person must know right from wrong in order to commit suicide, even though the suicide provision included this “sane or insane” wording and the policy form was approved by the state insurance department.
Courts will often seek ways of ruling so that dependents can collect benefits. For many years it was widely reported that in the state of Louisiana, which has a very large Catholic population, no life insurance company had ever won a “suicide” case in that state. Catholics believe suicide is a sin and if a Catholic committed suicide, they could not be laid to rest in consecrated ground – causing great suffering to the remaining family members.
The Grace Period provision requires the insurance company to accept premium payments for a certain number of days – typically 31 days for life and health policies and 60 (or 61) days for flexible-premium contracts. The insurance company is obligated to accept the premium payment even if it past the due date and they may not require evidence of insurability as a condition to accepting the premium.
If the insured dies during the Grace Period, the premium due and interest on the premium due may be withheld from the benefit payment. This provision is for the protection of the policyowner and protects them against unintentional lapse. In some ways, this is treated as “free” insurance as if the policy lapses; the insured is covered for the Grace Period with no additional premium, because if they should die during the Grace Period, benefits would be paid (less due premium).
In U.S. life insurance policies only, all policies must contain the Delay Provision. This allows the company the right to defer any cash-value payment or making a policy loan, for a period of up to 6 months after it has been requested. This does not apply to death claims.
The purpose of this little-known provision is to protect the insurance company from mass policyowner action draining assets from the company – similar to the runs on the banks during the depression. Mass withdrawals from banks, securities firms and insurers and reinsurers could cause disruptions in the life insurance industry, particularly in today’s business atmosphere where there are close affiliations between securities firms and insurers.
The delay provision allows time for the insurer to investigate questionable situations and to make financial arrangements if necessary, and further, it provides a cushion from some external event affecting the financial stability of the company.
A “run” on an insurer, where policyowners and creditors demand their money all at once, has occurred in the recent past. The two largest U.S. life insurance company failures, Executive Life and Mutual Benefit Life, initiated runs. There have been other runs on smaller insurers. As of this date, these types of runs have been limited to insurers already in financial difficulties, but with the relationship with non-insurance financial institutions, this may change.
The two types of exclusions generally used are the war exclusion and the aviation exclusion. Underwriting these risks are considered in the Underwriting section of this text.
Occasionally, an aviation exclusion is added to a policy by the underwriting department, usually in those cases where the pilot is flying experimental or military craft or is not experienced. This is not usually added, as even commercial pilots who fly a lot, can qualify for standard insurance. Usually the insured has the option of paying a higher premium instead of the exclusion.
This exclusion is of interest at this time, so soon after the terrorists attacks (Sept. 2001). This is also described in the Underwriting section of this text from the underwriters viewpoint.
There are two types of War Exclusions, status type and the results type.
Under the status clause the insurance company has the right not to pay the death claim if death results while the insured is in the military, regardless of cause of death. Some insurers exercise this right only if the insured is outside of the “home area,” i.e., outside the United States.
The other type, the results clause, the insurer can refuse to pay the death claim only if the death is a result of war activity.
There has been a considerable amount of litigation regarding whether a policy provision is of the status or results type, and also what constitutes a war. If the war against the terrorists continue and there are casualties, it will be interesting to see what stand will be taken by the insurers, especially if there is the anticipated covert action. A lot of litigation can be expected, although it is expected that insurers will stretch definitions on behalf of the insureds when possible in this situation.
The beneficiary clause in a life insurance policy allows the policyowner to determine who will receive the insurance amount in case of death of the policyowner. Within the guidelines of insurable interest, the policyowner can name just about anyone they choose as the beneficiary. As a side note, in the United Kingdom there is no beneficiary clause, all proceeds are distributed according to the decedent’s Will.
The person who is named first to receive the proceeds, is called the primary beneficiary and there can be more than one primary – first named does not mean first on the list or first alphabetically, only that the proceeds are paid first to the primary(s).
The time between naming the primary beneficiary and the time that the insured dies can stretch into several years and the beneficiary may precede the insured in death. If there were no other beneficiaries named, then the proceeds would go into the estate – not a good situation, as there would be added costs. (See below)
The solution to the problem of not having a named beneficiary, is by naming a contingent (or secondary) beneficiary. This simply states that in case the primary beneficiary is not alive to receive the death proceeds of the insured, the proceeds would then go to the person(s) named as contingent beneficiary(s). There can also be more than one contingent beneficiary, and they can be named to receive benefits under a settlement option.
Legally, the contingent beneficiary is a tertiary (later) beneficiary and is usually named at the same time that the primary beneficiary is named. Frequently the relationship between the insured and the contingent (and the primary) beneficiary is identified, such as “All proceeds under this policy shall be paid to Anna Jean Smith, wife of the named insured, if living; otherwise the proceeds shall be paid to Jack J. Brown, nephew of the insured.”
A revocable beneficiary designation is a beneficiary designation that allows the policyowner to change beneficiaries at any time without knowledge of or permission of, the beneficiary. This is rather typical, particularly in policies of smaller amounts.
With a revocable beneficiary designation, the policyowner is the only one who has an interest in the policy and the beneficiary has no position, other than to expect that the proceeds will be paid to them upon the death of the policyowner.
An irrevocable designation cannot be changed without the permission of the beneficiary. This gives the beneficiary significant rights to the policy proceeds, and neither the policyowner or creditors of the policyowner can change the proceeds distribution without the explicit and written approval of the beneficiary.
This is almost the same as joint ownership, except that many policies specify that only the policyowner can withdraw cash values, make policy loans, or take other actions of this type.
A person can name children as beneficiaries. Rather than naming each child individually, parents may name children as a class; for example: "Shared equally among all children born from the marriage of the insured to J. B. Ashe, including adopted children." In this case, the class designation ensures that any 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.
It is not necessary to name only children as a class, for instance all “siblings” can be named, and quite commonly, “All grandchildren of the insured.”
Sometimes insureds name their estates as the beneficiary. This is the least favorable type of beneficiary designation because if the policy proceeds go into the estate, they increase 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. Even if a will existed, indicating how to distribute proceeds, probate court actions can take months to complete. Life insurance proceeds that go into an estate are also more vulnerable to attachment from the deceased person's creditors.
When two or more individuals are named as primary or contingency beneficiaries, one or more might die before the insured, raising questions about how the policy proceeds should be divided among the living beneficiaries. There are two different methods of beneficiary designation that can be used to alleviate this situation.
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 heads" and is translated to refer to "each person." For example, suppose the insured names his four sisters to share equally as primary beneficiaries of his $100,000 policy. If all four are living when the insured dies, each person receives $25,000. But suppose two of the sisters die before the insured. 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 branches," legally refers to a progression through the branch of a particular family member. For the situation described in the preceding paragraph, the following would transpire with a per stirpes designation. 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, so to speak, rather than being divided between the two living sisters.
As a general rule, children are not recognized as competent to handle financial transactions. If an insured insists on naming minors, the insurer might require that a trust be established to hold the policy proceeds until the minors are adults. Alternately, the insurer could arrange to hold the proceeds, pay interest, and disburse the proceeds plus interest when the minors reach adulthood.
Spendthrift Clause or Spendthrift Trust
A spendthrift clause included in some life insurance policies is intended to protect policy proceeds from creditors by establishing a trust to receive the death benefit. Under this arrangement, the policy proceeds are paid out as periodic income rather than in a lump sum. The payout could be arranged 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 may pursue any additional amounts. In still 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.
Uniform Simultaneous Death Act
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, what happens, for example, if the insured and her husband, the primary beneficiary, are killed in the same accident?
CONSUMER APPLICATION
Angela is the insured under a whole life insurance policy. Her husband Dominic is the primary beneficiary. The couple has no children. Angela's sister Stephanie is the contingent beneficiary. Angela and Dominic are involved in an automobile accident; both are pronounced dead upon arrival at a nearby hospital. The question arises: Did Angela die first, making the policy proceeds payable to Dominic, or did Dominic die first, making the proceeds from Angela's policy payable to Stephanie?
If Dominic lived longer than Angela, the policy proceeds would be paid into his estate and distributed according to his will. If Dominic as the primary beneficiary, died before Angela, Stephanie would receive the proceeds as the contingent beneficiary.
Recognizing the 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. Using the above Consumer Application, if the emergency personnel who accompanied Dominic in the ambulance attested that he had vital signs up to the time they arrived at the hospital. Conversely, 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.
The nonforfeiture provision is applicable only to life insurance policies with cash values (although there are other types of insurance that may have this provision, such as some Long Term Care Insurance policies). This provision outlines the options that are available for the insured to collect the cash value if the policy is terminated. It also explains the method that is used to determine these options.
“Nonforfeiture” gets its name, as, historically, early insurance policies had no cash values, so any excess premium paid after mortality and expense charges were deducted, was “forfeited.” This is not allowed in the United States and insurers must comply with the Standard Nonforfeiture Laws that also require the policy to state what mortality table is used and the interest rate in calculating the nonforfeiture values. A table in each cash-value policy is required which shows the cash surrender values and other nonforfeiture options for the first 20 years. (Nonforfeiture options are discussed later in the text)
These laws set forth the situations under which a life insurance policy must have nonforfeiture values and they also stipulate the minimum required values and effectively, require that all policies that collect more than mortality and expense charges, provide nonforfeiture values. It should also be pointed out that the stated interest rate for nonforfeiture values is not the “rate of return” of the policy. Universal Life and Current Assumption Life policies are different, as cash values are derived using the so-called retrospective approach.
The differences between the prospective method of determining cash values for traditional policies, and the retrospective method used for UL and Current Assumption products, is quite technical and beyond the scope of this text. It is mentioned here as a note of interest. When actuaries were trying to develop an insurance policy wherein the cash value accumulation could compete with other non-insurance products, the Standard Nonforfeiture Laws would always prove to be a major stumbling block. Finally, at an international reinsurance meeting in Monte Carlo, through the genius of American actuaries and a German actuary meeting privately, this retrospective method was developed, and the Universal Life insurance policy was “invented.”
Since the cash value in the policy belongs to the policyowner, they will not be forfeited even if the policyowner is not able to pay the premiums. Therefore, the policy offers options as to how the policyowner can receive the cash values.
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 premium 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 which is the basis for the amount due the policyowner. However, Universal life policies have only a minimum cash value guarantee and a variable policy has no guarantee at all. These policies might include an illustration of potential cash values based upon assumed rates, but, unlike the tables in traditional policies, there is no guarantee that those potential values will be available at any given time.
Another nonforfeiture option is to use the cash value to buy paid-up insurance. This provides a reduced amount 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.
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, if the original policy has a $100,000 death benefit, a cash value of $20,000 and an outstanding loan with interest of $5,575, then the death benefit of the extended term policy will be $94,425 and the cash value used to purchase the policy will be $14,425.
The outstanding amounts are deducted from both the cash value and the death benefit to protect the insurance company. If the insured should die soon after opting for the extended term insurance and before repaying the policy loan, the insurer would have lost the loan amount completely since there is no longer any cash value as collateral. If a 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.
Study Questions
1. A life insurance policy
A. is not a contract because it is regulated by the department of insurance.
B. is not subject to judicial review.
C. forms must be approved by the state department of insurance.
2. The rule “caveat emptor“ or “let the buyer beware”
A. does not apply in insurance contracts.
B. means the party to an insurance contract can trust the other party.
C. applies to all contracts, including life insurance contracts.
3. A life insurance contract is conditional
A. on the insurance company’s ability to pay a claim.
B. on the payment of premiums by the insured.
C. upon the insured answering questions on the application truefully.
4. The incontestable clause in a life insurance contract
A. allows the insurance company the right to refuse paying a claim due to the suicide of the insured.
B. limits the time an insurance company can refuse to pay a claim.
C. prevents the insurance company from denying a claim even if the insured stops paying the premiums.
5. An insurable interest
A. must exist at the inception of the contract.
B. does not exist in an employment relationship.
C. a husband may have in the life of his wife ends when they divorce.
6. The application for a life insurance policy
A. is the insurance company’s offer to insure an individual.
B. becomes part of the insurance policy.
C. is a formality and of no consequences.
7. An insurance company
A. does not have to accept a premium if it is late.
B. will not pay a claim if the insured dies within the grace period and the premium was not paid.
C. is required to accept the premium payment, even if it’s past due, within 31 days.
8. The primary beneficiary
A. can not be changed without the consent of the beneficiary.
B. is the same as the contingent beneficiary.
C. is the person who is named first to receive the death proceeds.
9. If a life insurance policyowner names his/her estate as beneficiary the
A. size of the estate increases.
B. proceeds avoid probate.
C. insured’s creditor cannot get to the proceeds.
10. Per Capita is a beneficiary designation that
A. refers to a progression through the branch of a particular family member.
B. is used to indicate that any remaining beneficiaries share all of the proceeds equally.
C. means the beneficiary can borrow against the policy.
11. Life insurance contracts are considered as “valued” contracts which means
A. it is an indemnity contract.
B. one party can receive more in value than the other party.
C. the insurance agrees to pay a certain sum of money, regardless of the actual economic loss to the insured.
12. A life insurance contract
A. requires the parties to be legally capable of making a contract.
B. can be amended and changed by the insured.
C. is “unilateral“ in nature, which means the owner must pay (legally enforceable) the premiums.
13. Usually the effective date of a life insurance policy is
A. the date the insured died.
B. when the application is signed.
C. the date from which coverage starts.
14. Statements made by an applicant are considered
A. outside the life insurance contract.
B. representations.
C. warrantees.
15. When a life insurance policy names an insured, that has disappeared
A. for 10 years or more, they are presumed dead, and the insurer must pay the beneficiary.
B. the insurance company does not have to pay because there is no proof of death.
C. for a period of seven years, the benefits will be paid.
Answers to Chapter Two Study Questions
1C 2A 3B 4B 5A 6B 7C 8C 9A 10B 11C 12A 13C 14B 15C