Understanding Life Insurance: Risks, Policies, and Taxation Strategies

1. Topic 19: Life Insurance • Risk factors • Lifestyle • Occupation • Medical condition • Family history • High risk individuals • Denied coverage • Increased premiums • Exclusion of certain risks: skydivers

2. Topic 19: Life Insurance • Concepts • Mortality: death rates • Morbidity: rates of disability • Expenses: greatest in early years • Commissions • Insurable interest • Required at time of policy inception • Not at the time benefits are paid

3. Topic 19: Life Insurance • Term insurance: temporary • Renewable: to age 70 • Convertible: to whole life • Whole life: permanent/forced savings • Variable: separate account invested based on policy holder’s allocation • Whole life funds go into general account of company • Can increase death benefits/cash value based on investment performance • Universal: can change • Premiums: can skip payments • Death benefit • Cash value separated from death benefit • Variable universal: combine features • Survivorship: second to die policy

4. Topic 19: Life Insurance • Contract provisions • All language contained in contract • Backdating: can be done up to six months • Owner may not be insured • One month grace period for premium payments • Misstate age: adjust death benefit • Loans: amount borrowed subtracted from death benefits • Assignment: generally policies may be assigned • Common disaster: primary beneficiary must outlive insured by 60 – 90 days

5. Topic 19: Life Insurance • Contract provisions • Incontestable: insurer has two years to challenge validity of policy • Exclusions: suicide (one to two years) and war • Settlement options • Lump sum • Annuity • Single or joint life; term certain • Interest only

6. Topic 19: Life Insurance • Dividends • Cash • Accumulate • Reduce premiums • Buy additional coverage • Interest credits • Portfolio method: based on insurer’s earnings of overall portfolio • New money method: based on insurer’s earnings on money invested that year

7. Topic 19: Life Insurance • Riders • Accelerated death benefits: pay benefits if expected to die within year; in nursing home permanently • Long-term care: benefits rider can be added to life insurance policy • Waiver of premiums: if disabled • Guaranteed insurability: can buy more coverage without showing insurability • Double indemnity: twice policy amount if death accidental

8. Topic 19: Life Insurance • Nonforfeiture options • After policy has cash surrender value, • Can get cash within six months • Can get a paid-up policy with a reduced face amount • Can get a term policy with the same face amount

9. Topic 19: Life Insurance • Illustrations • Projection of financial results • Incorporate present value or just nominal values? • Optimistic assumptions? • Clearly label what is guaranteed? • NAIC model does not apply to variable life/annuities • Policy replacement • Regulated by many states • High commissions • May make sense due to reduced mortality charges and in higher interest rate periods

10. Topic 19: Life Insurance • Accelerated death benefits • Allow terminally ill insured to obtain funds prior to death tax-free • Pay for custodial care • Preferable to viatical due to discounts on viatical • Viatical settlements • Terminally ill insured transfers policy for lump sum payment • Benefits tax-free to insured if: • expected to die within two years • can’t perform two activities of daily living • Life settlement • Sell life insurance policy

11. Topic 20: Income Taxation of Life Insurance • Dividends: whole life policies • Not taxable unless total dividends > premiums paid on policy • Loans: whole life policies • Not taxable • Withdrawal of cash value • Not taxable unless withdrawals > basis • If taxable, ordinary income • Surrender • Not taxable unless proceeds > basis • If taxable, ordinary income

12. Topic 20: Income Taxation of Life Insurance • Death benefit: not taxable • MECs: premiums higher than necessary for insurance. • Often single premium policy • Then take cash value prior to death • Test during first seven years of policy • Is it paid up in seven years? • If policy is MEC, • Death benefit is still not taxable • Withdrawals and loans taxed as ordinary income with penalty if under 59 ½

13. Topic 20: Income Taxation of Life Insurance • Transfer for value • Sell policy to someone other than related party (business, co-owner, family member) • Seller not taxed if viatical settlement • Expected to die within two years • Buyer will be taxed on death benefits if greater than basis (ordinary income) • Including premiums paid and purchase price

14. Topic 20: Income Taxation of Life Insurance • Section 1035 exchange • Trade an existing policy for a new policy • Good idea??? • Mortality/interest rate assumptions • Trade a life insurance policy for an annuity • Makes IRS happy • Can also trade life insurance or annuity policy for long-term care policy • Can not trade an annuity for an insurance policy • Would make the IRS sad

15. Topic 21: Business Uses of Insurance • Buy-Sell Agreements • Provides for the sale of business interest on death of owner • Allows heirs to cash out of business • Keeps heirs from becoming co-owners • Keeps ownership with existing owners • Value generally based on formula • Valid for estate tax valuation

16. Topic21: Business Uses of Insurance • Buy-Sell Agreements • Cross purchase • Owners buy policies on each other • Number of policies? • Older owner • Premiums not deductible • Entity • Company buys policy on each owner • Premiums not deductible

17. Topic 21: Business Uses of Insurance • Key Person Life Insurance • Insures life of valued employee: • LeBron • Janitor • Business is beneficiary • Premiums not deductible • Benefits tax-free

18. Topic 21: Business Uses of Insurance • Split Dollar Life Insurance • Employer and employee share cost of premiums • Employer pays cash value portion • Employee pays pure life insurance cost • If employer pays entire premium, coverage above $50,000 taxable • Endorsement method • Employer owns policy • Receives reimbursement for premiums paid • Employee gets balance • Employer paid premiums income to employee • Collateral assignment method • Employee owns policy • Again must reimburse business for premiums paid • Premiums treated as loans: employee must pay interest

19. Topic 22:Insurance Needs Analysis • Life insurance • Anyone financially sad??? • Financial needs approach: determine cash needs, income needs, special needs and then subtract net worth • Income replacement • Debt elimination • College education • Less assets available to meet these needs

20. Topic 22:Insurance Needs Analysis • Life insurance • Human life value approach: • Present value of insured’s future income • Does not consider assets, liabilities, other sources of income • Capital retention approach: • Not only provide present value of future income but capital is maintained also

21. Topic 22:Insurance Needs Analysis • Life insurance • Income retention approach: • Based on income needs of survivor rather than income generated by insured • How soon until surviving spouse will accidentally fall in love? • Income multiplier approach: five to fifteen times annual income

22. Topic 23:Insurance Policy and Company Selection • Life insurance • Temporary needs: term • Permanent needs: whole life • Participating: pays dividends when premiums were “too large” • Cost analysis • Net cost method per $1,000 of coverage = (total premiums – cash value) / number of years policy held • Ignores time value of money

23. Topic 23:Insurance Policy and Company Selection • Life insurance • Cost analysis • Surrender cost index = • (future value of premiums – dividends – cash value)/fv factor for $1 for n years at i rate) • /$1,000 units of coverage • Net payment cost index = • Same as surrender cost index but cash value is not subtracted • Benchmarks: • Age 30: $2 cost per $1,000 • Age 60: $25 cost per $1,000 • Age 80: $125 cost per $1,000

24. Topic 23:Insurance Policy and Company Selection • Life insurance • Company selection: financial ratings • Companies rated based on financial strength • A.M. Best, S&P, Moody’s • Best: insurance companies only • “A+” rating has different meanings • Variable products provide security of subaccounts • Company selection: underwriting • Some companies only want certain types of risk

25. Topic 18: Annuities • Types • Immediate: payments begin now • Deferred: payments begin later • Single premium: one payment • Purchase annuity with 401(k) proceeds • Periodic premium • Single vs. joint and survivor • Period certain: benefits continue for a minimum number of years • Even if die before period ends

26. Topic 18: Annuities • Types • Fixed: periodic payment known • Turn defined contribution plan into defined benefit plan • Variable: periodic payments based on investment performance • Considered securities: must hold Series 6 and insurance license to sell • Oversold/undersold????

27. Topic 18: Annuities • Structured settlements • Receive periodic payments instead of lump sum • For auto accident, medical malpractice, etc. • Payments are tax-free if compensatory including pain/suffering/wrongful death/loss of goodwill • Effectively makes interest tax-free • Punitive, non-physical damages are taxable • Companies buying structured settlements

28. Topic 18: Annuities • Taxation of annuities • Noncontributory-qualified plan • All payments ordinary income • Contributory-qualified plan • Basis / total expected payments = percent of each payment not taxed • Remainder of payment ordinary income • Subject to 10% penalty if not age 59 1/2 • After recover entire basis, all taxable • If die before deferred annuity payments begin • Refund of premiums paid generally not taxable since payment equals basis • No step-up in basis for annuities

29. Topic 18: Annuities • Taxation of annuities • Commercial annuity • Ordinary income and return of capital based on expected payments • Corporate annuities • Must recognize income immediately on increase in value of annuity; no deferral

30. Topic 19: Group Term Life Insurance • Must be nondiscriminatory • Amount of coverage usually multiple of salary • Cost of coverage above $50,000 is taxable • No evidence of insurability required • Even if leave company and convert to individual cash value policy • Inexpensive form of life insurance

31. Topic 19: Group Permanent Insurance • Premiums • Deductible by employer • Taxable to employee • GULPs: employees pay for universal life coverage • Advantage • Group underwriting • Can continue as individual policy after leaving employment • No evidence of insurability required • Must convert to permanent insurance

32. Topic 19: Group Permanent Insurance • Carve Out Insurance • Cover top dogs only • Employer’s cost deductible • Top dogs taxed on premiums paid • Pay bonus to top dogs so they can pay taxes on premiums so they won’t be sad • Employer paid death benefit • Taxable • Not funded by life insurance policy