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This chapter’s objectives are to: Income tax treatment of life insurance, life insurance contract provisions, incontestability clause, suicide clause, misstatement of age or sex, entire contract clause, cash or payment of premium,...
Lecture No 26 Buying Life Insurance Copyright © 2011 Copyright Pearson © 2011Prentice Pearson Prentice Hall AllHall rights All rights reserved reserved 131 Income Tax Treatment of Life Insurance • Premiums – – • In most cases, individuals cannot deduct the premiums they pay for individual life insurance The primary exception is for someone who is paying premiums on a life insurance policy owned by a charitable organization Death benefits – As a general rule, when an insured dies and a death benefit is paid • • The beneficiary does not have to report the death benefit as taxable income if the proceeds are paid in a lump sum When settlement is made through a series of periodic payments from the insurer – The beneficiary generally can exclude only part of each payment from taxable income – The amount of each payment that represents a distribution of the original death benefit is not taxed » While the portion that is due to interest earnings is subject to taxation Copyright © 2011 Pearson Prentice Hall All rights reserved 132 Income Tax Treatment of Life Insurance • Cash values – If a life insurance policy with a cash value is terminated before death and the contract is surrendered for cash • • – It is likely that there will be taxable income that must be reported in the year of the surrender The amount of taxable income is the difference between the cash received at termination and premiums that were paid during life of the contract While a cash value policy is in force, the annual increments to the cash value (inside buildup) often escapeimmediatetaxation ã Inmanypoliciestheseincrementsarenottaxeduntilthe policyissurrenderedforitscashvalue Copyright â 2011 Pearson Prentice Hall All rights reserved 133 Income Tax Treatment of Life Insurance Cash Values • – – In some policies however, taxation of part of the inside buildup occurs every year The determining factor depends on whether the policy meets the statutory definition of life insurance as specified in the IRC • • – Policies that meet this definition are not subject to immediate taxation of their inside buildup Cash values of policies that cannot meet the requirements will be partially taxed each year According to the IRC, a policy is considered to be life insurance for tax purposes of it meets at least one of two tests • The intent of both tests is to assure that the cash value in a particular policy is not excessive in relationship to the policy’s death benefit – Contracts that are primarily savings vehicles and have a only a nominal death benefit will be unable to pass these tests » Therefore, these contracts will not be granted an income tax advantage for the inside buildup Copyright © 2011 Pearson Prentice Hall All rights reserved 134 Life Insurance Contract Provisions • • The contractual provisions of the life insurance policy are of special significance to the insured Because it is through the wise use of these rights that some of the most valuable benefits of protection can be obtained Copyright © 2011 Pearson Prentice Hall All rights reserved 135 Incontestability Clause • If the policy has been in force for a given period and if the insured has not died during that time – • The insurer may not afterward refuse to pay the proceeds, nor may it cancel or contest the contract, even due to fraud Thus, if an insured is found to have lied about his or her physical condition at the time the application was made for life insurance – And this misrepresentation is not discovered until after the expiration of the incontestability clause • • • The insurer may neither cancel the policy nor refuse to pay the face amount if the insured has died from a cause not excluded under the basic terms of the policy Serves as a time limit within which the insurer must discover any fraud or misrepresentation in the application or be barred thereafter from asserting what would otherwise be its legal right The legal justification for this clause is protection of beneficiaries from doubtful claims by an insurer – That the deceased had made misrepresentations after it becomes impossible for the deceased to defend against or to deny the allegation Copyright © 2011 Pearson Prentice Hall All rights reserved 136 Suicide Clause • • Partially protects the beneficiary from the financial consequences of suicide States that if the insured does not commit suicide for at least a stated period (usually two years after issuance of the contract) – • The insurer may not deny liability under the policy for subsequent suicide If the suicide occurs within two years of the issuance of the policy – The insurer’s only obligation is to return without interest the premiums that have been paid Copyright © 2011 Pearson Prentice Hall All rights reserved 137 Misstatement of Age or Sex • Misrepresenting one’s age in life insurance is material to accepting the risk and normally would become a defense against payment of the proceeds – • Without some control over this possibility – • • If it were not for the incontestability clause It would become possible for people to understate their ages to obtain lower life insurance premiums Proof of age is therefore required before proceeds are paid Under the misstatementofage clause – If it is determined that the policyholder’s age has been misrepresented • • The insurer adjusts the amount of proceeds payable rather than canceling the agreement altogether Proceeds will be adjusted in a similar manner through the misstatementofsex clause – It is common for females to pay lower premiums than males of the same age when purchasing life insurance Copyright © 2011 Pearson Prentice Hall All rights reserved 138 Entire Contract Clause • • Provides that the policy, together with the application, constitutes the entire contract between the parties Desirable for the protection of the insured and the beneficiary because – Without the clause it might be possible to affect the rights of the respective parties through changes in the bylaws or in the charter of the insurer Copyright © 2011 Pearson Prentice Hall All rights reserved 139 Assignments • An insured may wish to assign the benefits of a life insurance policy – • Permission of the insurer is not necessary – • Often as collateral for a loan But the insurer must be properly notified in writing of an assignment or else is not bound by it If the insured dies, the insurer pays the holder of the assignment that part of the proceeds equal to the outstanding debt – Then pays the remainder to the named beneficiaries Copyright © 2011 Pearson Prentice Hall All rights reserved 1310 10 Excluded Causes of Death • • Uncommon for life insurers to exclude coverage for death arising out of specific causes One occasionally used exclusion is the war hazard exclusion – During periods when there is a serious threat of war or other hostilities involving military forces of at least two countries • – • Insurers may insert a war hazard exclusion in policies issued to insureds who are either in the military or of an age that may cause them to become subject to military duty Eliminates insurance coverage for death that is a direct result of war or other hostile actions between countries The aviation hazard exclusion limits coverage for death from aviation activities other than as a farepaying passenger on a commercial aircraft – Rarely found in policies currently being issued Copyright © 2011 Pearson Prentice Hall All rights reserved 1325 25 Settlement Options • • The different ways in which the policyowner or beneficiary may elect to have the benefits of a policy paid Lumpsum option – – – • Proceeds of the life insurance are paid in a lump sum Vast majority of benefits are paid in this manner Insurer’s obligations are over Fixedperiod option – – The insurer pays the proceeds in equal installments over a specific time frame The size of each installment varies with the • • • Desired frequency of payment Length of the total time period during which payments are to be made Interest rate paid by the insurer on proceeds not yet distributed Copyright © 2011 Pearson Prentice Hall All rights reserved 1326 26 Settlement Options • Fixedamount option – – – Used when a specified amount of income is desired The length of time the payments are made is a function of the size and frequency of each payment and the interest rate paid by the insurer on the proceeds Interest earned in excess of the guaranteed level increases the length of time during which payments are made Copyright © 2011 Pearson Prentice Hall All rights reserved 1327 27 Settlement Options • Interest option – – The insurer holds the proceeds of the policy and pays the beneficiary an income consisting of interest only A guaranteed minimum rate is stated in the policy • – With excess interest often used to increase the amount of each payment The beneficiary usually has the right to withdraw some or all of the principal amount Copyright © 2011 Pearson Prentice Hall All rights reserved 1328 28 Settlement Options • Life income options – – Several variations guarantee a beneficiary an income for his or her remaining lifetime Additional guarantees may be made concerning the number of payments that will be made or the guaranteed total dollars to be paid • Regardless of how long the beneficiary lives Copyright © 2011 Pearson Prentice Hall All rights reserved 1329 29 Waiver of Premium Benefit • • • Provides that insureds who become disabled before a specified age will be excused from paying premiums for as long as the disability continues The life insurance policy will have the same cash values, death benefits, and dividends as it would have had if all premiums had been paid Policies vary as to how they define disability for this purpose – • Many contracts also require a sixmonth waiting period after the onset of the disability before premiums are waived This is not expensive and is generally recommended as a way of assuring that the life insurance policy will remain intact regardless of the insured’s health Copyright © 2011 Pearson Prentice Hall All rights reserved 1330 30 Accidental Death Benefit • • • Makes it possible for the beneficiary to receive an accidental death benefit if the insured dies from an accident The size of the accidental death benefit is often equal to the face amount of the underlying policy Numerous restrictions exist in this benefit – • • Common exclusions include death from suicide, death that occur more than 120 days following an accident, death from illness, death due to war or aviation May lead naive insureds to believe that their total death protection has doubled for only an small extra premium However, accidents are far from being the leading cause of death – And accidents that satisfy the definitions of the accidental death benefit are even less common Copyright © 2011 Pearson Prentice Hall All rights reserved 1331 31 Accelerated Death Benefit • • • • • • Also known as a living benefit option Under specified circumstances, a percentage of the policy’s face amount, discounted for interest, can be paid to the insured before death Some insurers consider such payments to terminate all future contractual rights to benefits Others allow some or all of any remaining face amount to be paid to the beneficiary when the insured dies Accelerated death benefits can be an important income source for persons with terminal illnesses Some insurers also offer this option to help pay for an insured’s longterm care needs – An additional agreement known as a longterm care rider may be attached to a permanent form of coverage Copyright © 2011 Pearson Prentice Hall All rights reserved 1332 32 Accelerated Death Benefit • Variations exist among insurers regarding – – – – – The percentage of the death benefit that can be paid on an accelerated basis Whether an additional premium is charged The types of policies for which the main benefit options are available Whether the accelerated death benefit can be payable in a lump sum or only via installments Whether complete surrender of all future policyowner rights accompanies the payment of accelerated benefits Copyright © 2011 Pearson Prentice Hall All rights reserved 1333 33 Accelerated Death Benefit • One of the factors impeding the growth of living benefit options is a concern that the payment erodes the death benefit protection provided for beneficiaries – • Often one of the major reasons for purchasing a life insurance policy in the first place Until recently another problem had been the unclear tax status – Should living benefits be exempt from income taxes in the same way that death benefits are? • The Health Insurance Portability and Accountability Act of 1996 states that – From December 31, 1996 forward accelerated death benefits are excluded from taxable income » If a physician certifies that the insured has a terminal illness that is expected to result in death within 24 months or less Copyright © 2011 Pearson Prentice Hall All rights reserved 1334 34 Spendthrift Trust Clause • • One of the legal rights granted to the life insurance owner in most states is the exemption of death proceeds in cash values from claims of creditors Creditors cannot attach the cash value of life insurance for the payment of the insured’s debts – • Unless the insured has wrongfully bought or paid up a life insurance policy with money rightfully subject to creditors’ claims Neither may the insured’s creditors attach the death proceeds of life insurance Copyright © 2011 Pearson Prentice Hall All rights reserved 1335 35 Spendthrift Trust Clause • May the beneficiary incur large debts using as security the right to receive income from life insurance proceeds? – Technically this is possible unless the state law has a provision to the contrary or unless the law has permitted the attachment of the spendthrift trust clause • • Without such a clause there might be a temptation for an unscrupulous creditor to persuade a beneficiary to purchase goods beyond the ability to pay – • If this clause is attached to a life insurance policy, the beneficiary’s right to that promised income cannot be attached by creditors in any court in the state of residence Secure in the knowledge that the life insurance could be attached Once the proceeds have been paid to the beneficiary – The protection is lost since the money lose its identity as life insurance proceeds Copyright © 2011 Pearson Prentice Hall All rights reserved 1336 36 Grace Period and Reinstatement Clauses • • • Always gives the insured an extra 30 days in which to pay any premium that is due before lapse takes place Can forestall policy lapses as long as sufficient cash values exist to cover the premium due Once the policy actually lapses, special application must be made under the reinstatement clause to restore coverage – – Contracts may be reinstated within a certain period after lapse, usually three or five years, with evidence of insurability Sometimesanewmedicalexammustbetaken ã Butinmostcasestheinsuredisrequiredonlytomakeastatement ofpersonalgoodhealthatthetimeofreinstatement Copyright â 2011 Pearson Prentice Hall All rights reserved 1337 37 Grace Period and Reinstatement Clauses • • All premiums in arrears must be paid plus interest Reinstatement reopens the incontestability clause for another two years – • It is sometimes desirable to reinstate an old policy rather than to take out a new one because the old policy may have certain provisions – • But generally the suicide clause is held not to be reopened Such as more favorable settlement options, immediate eligibility for dividends, or higher interest assumptions Also, no new acquisition costs have to be paid in the reinstated policy, as they would on a new contract Copyright © 2011 Pearson Prentice Hall All rights reserved 1338 38 End of Lecture 26 Copyright © 2011 Copyright Pearson © 2011Prentice Pearson Prentice Hall AllHall rights All rights reserved reserved 1339 ... Misrepresenting one’s age in? ?life? ?insurance? ?is material to accepting the? ?risk? ?and? ?normally would become a defense against payment of the proceeds – • Without some control over this possibility – • • If it were not for the incontestability clause ... offered the paidup additions option – • An economical way to buy additional? ?life? ? insurance? ? – • • Each dividend is used to purchase as much single premium whole? ?life? ?insurance? ?as possible No? ?commission or other acquisition expenses must be ... If this clause is attached to a? ?life? ?insurance? ?policy, the beneficiary’s right to that promised income cannot be attached by creditors in any court in the state of residence Secure in the knowledge that the? ?life? ?insurance? ?could be attached