REVIEW NOTES: LIFE INSURANCE

Review Notes: Basic Principles of Life and Health Insurance ....................................................................... 1

Review Notes: The Nature of Insurance ..................................................................................................... 10
Review Notes: Legal Concepts of Insurance ............................................................................................... 14
Review Notes: Life Insurance Policy Types ................................................................................................. 21
Review Notes: Life Insurance Policy Provisions, Options, and Riders ........................................................ 27
Review Notes: Life Insurance Premiums, Proceeds, and Beneficiaries ...................................................... 34
Review Notes: Life Insurance Underwriting and Policy Issue ..................................................................... 39
Review Notes: Group Life Insurance ........................................................................................................... 45
Review Notes: Annuities ............................................................................................................................. 48
Review Notes: Social Security ..................................................................................................................... 51
Review Notes: Retirement Plans................................................................................................................. 52
Review Notes: Uses of Life Insurance ......................................................................................................... 55

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REVIEW NOTES: BASIC PRINCIPLES OF LIFE AND
HEALTH INSURANCE

The Role of Insurance

 In general terms, insurance can be defined as a legal contract that transfers an uncertain risk from one
party to another.
 Insurance can also be described as the transfer of risk through the pooling or accumulation of funds
because it distributes one person’s risk among a large number of people.
 The insured transfers the possibility of suffering a large financial loss to an insurer in return for paying
a relatively small, contractually defined premium.
 Insurance helps to reduce the financial uncertainty of the policy owner that could otherwise result
from future losses.
 Insurance has become an essential element of any financial planning process.

Benefits and Costs of Insurance to Society

 Insurance policies indemnify policyholders.
 To indemnify means to restore a person to the financial position they experienced prior to the insured
loss.
 The ability of insurance to eliminate the potential cost of unexpected or untimely losses is arguably its
most significant advantage.

Types of Insurance Companies

 There are many ways to classify insurance carriers, including:
‒ Where the company was formed
‒ How ownership is structured
‒ Whether the company is authorized to conduct business in a given state, or
‒ Whether the insurer is a commercial carrier or government provider

Private versus Government Insurers

 Private citizens own commercial insurers, which may be proprietary or cooperative.
 Federal and state governments also offer a variety of coverages, commonly referred to as social
insurance.
 Federal and state-owned government insurers either:
‒ Cover catastrophic perils or losses that are not insurable by commercial insurers, or
‒ Cover insurable risks in competition with, or instead of, commercial insurers.
 Examples of social insurance programs include:
‒ Social Security
‒ Original Medicare
‒ Medicaid
‒ SGLI and VGLI
‒ National Flood Insurance Program
‒ Federal Crop Insurance Corporation

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Private (Commercial) Insurance Companies
 Companies that sell more than one line of insurance are referred to as multi-line insurers.
 A company that only sells one line of insurance is a monoline insurer.
 Stock and mutual companies are both be considered commercial insurers, and, as such, both can write
life, health, property, and casualty insurance.
 Regulators require companies to maintain a certain percentage of surplus revenue as reserves to pay
future claims. These funds are referred to as statutory reserves.

Stock Companies – Non-Participating

 A stock insurance company is one that’s owned by private investors (stockholders or shareholders).
 Stock insurers are incorporated under state laws, are structured like any other corporation, and their
goal is to make profits for their shareholders.
 Typically, they’re publicly traded.
 A portion of the company’s profits may be distributed to shareholders as dividends.
 Stock insurers issue non-participating insurance policies.
 Non-participating policies don’t pay policy dividends.
 Purchasing a non-participating policy does NOT give policy owners any other privileges of
ownership.
 Post-tax earnings (earned surplus) that are retained by a company are considered equity and are
owned by the shareholders.

Mutual Companies – Participating

 Mutual insurance companies are also organized under state laws but are owned by the
policyholders.
 Policyholders have the right to vote for the board of directors.
 Mutual insurance companies are considered participating insurers because policy owners receive a
share of surplus revenue in the form of policy dividends.
 Mutual insurers hold such excess earnings as a divisible surplus.
 Mutual insurers return this surplus to their policy owners by paying policy dividends.
 Policy dividends represent a refund of that portion of the premium remaining after a company has set
aside the necessary reserves.
 In some cases, a stock company may be converted into a mutual company through a process that’s
referred to as mutualization.

Assessment Mutual Insurers

 Assessment mutual companies are classified by the method in which they charge premiums.
 Pure assessment mutual companies charge no premium in advance; instead, each member is assessed
a portion of the losses that occur.
 Advance premium assessment companies charge premiums but levy assessments if the premium is
insufficient.

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Fraternal Benefit Societies
 Fraternal societies are not-for-profit organizations noted for their social, charitable, and benevolent
activities.
 Fraternal membership is based on religion, nationality, or ethnicity.
 Fraternal societies also issue insurance covering their members.
 To be characterized as a fraternal benefit society, the organization must have the following
characteristics:
‒ It must be non-profit.
‒ It must have a lodge system, including ritualistic work and a representative form of government.
‒ It must exist for reasons other than obtaining insurance.

Reciprocal Insurers
 A reciprocal insurer is an unincorporated organization in which individual members (also referred to
as subscribers) agree to insure one another.
 Unlike mutual or stock insurers, reciprocal policyholders don’t transfer these risks to a separate
corporate entity. Each policyholder individually assumes a share of the risk.
 This arrangement makes the reciprocal insurer a risk-sharing mechanism rather than a form of risk
transfer.
 Policyholders receive policy dividends as well as their share of the company surplus (capital) if they
terminate their membership.
 An attorney-in-fact handles transactions for the reciprocal insurer.

Risk Retention Groups (RRGs)

 A risk retention group is a specialized insurance company that’s created to provide liability
insurance for individuals and entities with a common bond.
 The federal law requires risk retention groups to follow the laws of their home state.
 Risk retention groups are only licensed in their state of domicile. In other jurisdictions, federal law
prevails.
 Risk retention groups hold on to risks and process claims

Risk Purchasing Groups (RPGs)

 As with a risk retention group, a risk purchasing group provides insurance for individuals and entities
with a common bond.
 RPGs differ from RRGs because they purchase coverage for their members from an insurance
company rather than act as the insurer.
 The risk purchasing group becomes a master policyholder, and its members receive certificates of
insurance.

Reinsurers and Retention Limits

 Reinsurers insure other insurance companies that seek to limit the loss they would face if a substantial
claim became payable.
 The insurance company that transfers its loss exposure (risk) to another insurer is referred to as the
primary insurer or ceding company.
 The portion of the risk that a ceding insurer retains is considered the net retention.

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  The insurance company that accepts the risk is the reinsurer (also referred to as the assuming
company).
 There are two types of reinsurance contracts:
‒ When two companies arrange for an automatic sharing risk based on specific criteria, it’s
considered treaty reinsurance.
‒ When a primary insurer seeks reinsurance for a specific exposure without an ongoing agreement,
it’s considered facultative reinsurance.

Captive Insurers
 A captive insurer is established and owned by a parent firm(s) to cover the parent’s loss exposure.

Surplus Lines Insurance

 Surplus lines carriers provide types of coverage that are not available through authorized carriers.
 Consumers place the coverage through a surplus lines broker for high, substandard, or unusual risks
that are rejected for coverage in the authorized market.

Lloyd’s of London
 Lloyd’s of London is a syndicate of individuals that individually underwrite insurance but is NOT an
insurer.
 Lloyd’s function is to provide coverages that may otherwise be unavailable.

Self-Insurers
 A self-insurer establishes a self-funded plan to cover potential losses.
 A self-insurer will often seek an insurance company that will provide insurance above a specified
maximum loss level.

Insurer Classifications
Insurers Classified by Authorization
 An insurer with a certificate of authority that allows it to do business in a particular state is referred
to as an authorized or admitted insurer.
 Generally, an unauthorized (non-admitted) insurance company is not permitted to conduct
insurance operations unless it qualifies as a surplus lines carrier.

Insurer Classified According to Domicile

 A domestic insurer is organized and incorporated in the state in which it writes business.
‒ For example, if XYZ Insurance Company is incorporated in Wisconsin and writes policies in
Wisconsin, it’s a domestic company in that state.
 A foreign insurer is authorized in one state but organized and incorporated under a different state’s
laws.
‒ For example, if XYZ Insurance Company is incorporated in Wisconsin but transacts insurance in
Iowa, it acts as a foreign insurance company in Iowa.

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  An alien insurer is an insurer that’s organized under the laws of a different nation.
‒ For example, Sun Financial Services of Toronto, Canada, is an alien insurer.

Departments within an Insurance Company

 The marketing or sales division is responsible for increasing the number of prospective applicants.
 The sales department completes applications and conducts face-to-face appointments with
prospective buyers.
 The underwriting department reviews applications, conducts investigations, determines whether to
issue coverage, and assigns risk classifications.
 The claims department investigates, processes, and pays claims.
 The actuarial department calculates policy rates, reserves, and dividends.

Key People Within an Insurance Company

Producers
 The term “Producer” refers to individuals who are licensed by the state regulatory authority to
solicit, sell, or transact the placement of insurance products with the buying public.
 Licensed producers act in a fiduciary capacity on behalf of both their insurers and their clients.
 The various types of producers include:
‒ Agents represent one or more insurers under the terms of an appointment contract.
‒ Brokers represent themselves and the insureds.
‒ Solicitors are licensed in some states to represent a producer and solicit prospective applicants to
meet and discuss their insurance needs with that producer.
‒ Service Representatives work in some states under a limited authority.
• They’re insurance company employees in some states that hold a limited license.
• They don’t earn commissions for sales.
• They’re not required to be licensed unless they solicit, countersign policies, or collect
premiums from policy owners.

Underwriters
 Underwriters identify, assess, examine, and classify the amount of risk represented by an applicant.
 Underwriters approve or decline applications and determine the cost of insurance.

Actuaries
 Actuaries calculate policy rates, reserves, and dividends.

Adjusters
 Adjusters investigate insurance claims to determine whether they should be settled or denied.
 A public adjuster is compensated for acting on behalf of an insured regarding the settlement of an
insurance claim.

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How Insurance is Sold
 Most consumers purchase insurance through licensed producers who market insurance products and
services to the public.
 Typically, these producers are agents who are appointed to represent one or more insurance
companies.
 Agents can bind insurance; in other words, they can commit the insurer to cover a risk exposure—at
least temporarily.
 Some consumers may work with brokers who work for insureds to place coverage. Brokers are not
appointed by the insurer and don’t have the authority to bind coverage.
 In a sales transaction, agents represent the insurer, while brokers represent the buyer.

Career Agency System

 A career agency is often a branch of a major stock or mutual insurance company.
 A career agency may exist to represent an insurer in a specific geographical area or market.
 A general agent (GA) typically runs a career agency.
 The GA recruits, trains, and supervises career insurance agents.
 The GA has a vested right in any business that’s written by those agents who sell for the agency.
Managerial System
 The managerial system is a form of career agency.
 The insurance company hires a salaried branch manager to run the agency.
 The branch manager supervises agents and receives a salary and a bonus based on meeting sales and
recruiting goals.

Personal Producing General Agency System

 The personal producing general agency (PPGA) system resembles the career agency system, but
PPGAs don’t recruit, train, or supervise career agents.
 A personal producing general agent focuses on selling insurance in an assigned market or geographic
area.
 PPGAs are generally responsible for maintaining their own offices and administrative staff.
 Agents who are hired by a PPGA are considered employees of the PPGA, not the insurer.

Independent Agency System

 The independent agency system is not tied to any particular insurance company.
 Independent agents represent any number of insurance companies through contractual agreements.

Other Methods of Selling Insurance

 A large volume of business is also marketed through direct selling and mass marketing methods.
 Insurance companies that use the direct selling method deal directly with consumers.
 Direct sellers use vending machines, advertisements, or salaried sales representatives who are
licensed.
 Insurance is also sold through mass marketing techniques, such as over the Internet, newspapers,
magazines, radio, and television ads.
 Mass marketing methods provide exposure to many consumers, often using direct selling methods
with occasional follow-up by agents.

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Evolution of Industry Oversight
 The insurance industry is regulated by a number of authorities, including some within the industry
itself.
 The primary purpose of this regulation is to promote public welfare.

Federal Court Cases and Legislation Affecting Insurance Industry

Regulation
 In the 1868 case of Paul v. Virginia, the United States Supreme Court ruled that the sale and issuance
of insurance is not interstate commerce, thereby upholding a state’s right to regulate insurance.
 In the 1944 case, the United States v. Southeastern Underwriters Association (SEUA), the United
States Supreme Court revisited the issue of state versus federal regulation.
‒ The Supreme Court reversed Paul v. Virginia and ruled that the insurance industry is a form of
interstate commerce.
‒ The Court determined that the federal government should regulate insurance.
 In 1945, Congress passed Public Law 15—the McCarran-Ferguson Act. The McCarran-Ferguson
Act created the following:
‒ It called for the states to continue their regulation of the insurance industry because it was in the
public’s best interest.
‒ It also made possible the application of federal antitrust laws so far as state laws did not regulate
such activity.
‒ Today, the insurance industry is both state-regulated and in conformity with federal antitrust
requirements.
‒ Any person who violates the McCarran-Ferguson act faces a fine of $10,000 or up to one year in
prison.
 In 1970, the Fair Credit Reporting Act was enacted to protect privacy by requiring the fair and
accurate reporting of consumer information and for insurers to inform applicants about any
investigations being made
‒ If insurers deny coverage or charge higher rates due to a consumer report, the applicant must
receive the name of the relevant reporting agency.
‒ Insurers that fail to comply are liable for actual and punitive damages.
‒ The maximum penalty for obtaining consumer reports under false pretenses is a $5,000 fine and
up to one year in prison.
 In 1994, Congress amended Sections 1033 and 1034 of the United States Code (USC) regarding
Fraud and False Statements.
‒ It’s a criminal offense for felons who are convicted of crimes involving dishonesty or a breach of
trust to participate in the insurance business without a “Letter of Written Consent” from their
state insurance regulators.
‒ The law makes it illegal to lie, falsify, or conceal information from a federal official.
‒ Any person that engages in intentionally unfair or deceptive insurance practices is violating
federal law.
‒ Other violations include embezzling money, misappropriating insurance premiums, and writing
threatening letters to insurance offices.
‒ The punishment for violation is a fine of up to $50,000, up to 15 years in prison, and license
revocation.

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  In 1999, the Financial Services Modernization Act removed the barriers that kept commercial
banks, investment banks, retail brokerages, and insurance companies from engaging in each other’s
lines of business.
 In 2001, the USA PATRIOT Act was adopted in response to the terrorist attacks of September 11
terrorist attacks. The law aims to detect, deter, and disrupt terrorist efforts and funding while
prosecuting international money laundering.
 In 2003, the Do Not Call Implementation Act implemented the Do Not Call Registry.
‒ The Act allows consumers to list their phones so that telemarketers (including insurers) cannot
legally make solicitation calls.
‒ Calls made on behalf of charities, political organizations, and surveys are exempt.

National Association of Insurance Commissioners (NAIC)

 The National Association of Insurance Commissioners (NAIC) is an industry association that consists
of all state insurance regulators.
 The NAIC brings together regulators and industry personnel on committees that study various aspects
of insurance practices, laws, and regulations.
 The organization has four broad objectives:
1. To encourage regulatory uniformity among the states
2. To promote efficiency in the administration of laws and regulations
3. To protect policy owners and consumer interests, and
4. To preserve state regulation of the insurance business
 The NAIC recognizes that state laws regarding insurance marketing, trade practices, and regulations
may vary, but share more similarities than differences. Model Acts and Model Regulations developed
by the NAIC provide a template for individual state legislators and regulators.
 The NAIC is not a regulatory organization. Instead, the models it creates provide a common
framework for state officials that allow the various governing bodies to meet the specific needs of
their respective jurisdictions while helping to streamline the legislative and administrative processes
and helping to standardize the outcomes.
Unfair Trade Practices Act (Model)
 Most jurisdictions have adopted their own version of the NAIC model “Unfair Trade Practices Act.”
 This Act gives the head of each state insurance department the power to investigate insurance
companies and producers.
 It authorizes them to issue cease and desist orders and impose penalties.
 The Act also gives officers the authority to seek a court injunction to restrain unfair activities, such as
misrepresentation and false advertising, coercion and intimidation, and unfair discrimination.
NAIC Advertising Code
 Many states also subscribe to the NAIC’s Model Advertising Code, which labels certain words and
phrases as misleading by their very nature.
 These misleading words or phrases can never be used in any insurance advertisement.

The National Conference of Insurance Legislators (NCOIL)

 In 1969, the National Conference of Insurance Legislators (NCOIL) was formed. The NCOIL’s
principal membership is comprised of state legislators from around the nation that serve on state
insurance and financial institutions committees.
 As with the NAIC, NCOIL works to preserve state regulation of the industry, but it also works to
educate public policymakers on related issues.
 NCOIL also writes model laws.

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The National Association of Insurance and Financial Advisors
(NAIFA)and The National Association of Health Underwriters (NAHU)
 These organizations created a Code of Ethics which details the expectations of agents in their duties
toward clients.
Agent Marketing and Sales Practices Some standards in various states include:
 Selling to Needs: An ethical agent learns the client’s needs and determines the best way to address
those needs.
 Suitability of Recommended Products: Correlation between a recommended product and the
client’s needs and capabilities
 Full and Accurate Disclosure: Inform clients about all aspects of recommended products.
 Documentation: The ethical agent documents each client meeting and transaction.
 Client Service: The ethical agent knows that a sale doesn’t mark the end of a relationship with a
client but rather the beginning.
Producer Responsibilities:
 Provide customers with the best service possible.
 Solicit new business for their companies by helping clients acquire products from application to
policy delivery.
 Guide customers to the right products that meet their needs and maintain a relationship with them.
 Build a business by keeping current customers satisfied and actively seeking referrals.

Rating Services
 Rating services help to publicize the financial health of insurers.
 The financial strength (solvency) and stability of an insurance company are two vitally important
factors.
 The PRIMARY purpose of a rating service company (e.g., A.M. Best) is to determine an insurer’s
financial strength.
 Financial strength can be evaluated by examining a company’s reserves and liquidity.
‒ Reserves are the accounting measurement of an insurer’s future obligations to its policyholders.
They are classified as liabilities for the insurance company.
‒ Liquidity indicates a company’s ability to make unpredictable payouts to policy owners.

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REVIEW NOTES: THE NATURE OF INSURANCE
 In generic terms, insurance is defined as the transfer of risk from one party to another in exchange for
a fee (premium) by means of a legal contract.
 Insurance spreads each insured’s risk of loss across many people participating in an insurance
company’s risk pool by paying a premium.
 Insurance reduces financial risk and spreads the risk of loss from one individual to many.

Principle of Indemnity (Indemnification)

 Operating on the “Principle of Indemnification,” the goal of an insurance carrier is to “restore”
insureds to their original financial position following losses.
 The same principle stipulates that insureds will not profit or gain by their losses. In other words, they
will not receive more than they lost.
 Most accident, health, property, and casualty insurance contracts are all contracts of indemnity.

Law of Large Numbers (Spread of Risk)

The law of large numbers holds that, based on experience, the greater the number of homogenous loss
exposures, the more likely the overall likelihood of loss can be predicted.
 The law of large numbers does NOT predict whether an individual suffers a loss.
 The law of large numbers helps predict the losses that those in the risk pool will suffer in the
aggregate.
For example, let’s assume that a carrier insures one million people against accidental
death. In this case, the carrier is more likely to accurately predict the number of
accidental deaths than a company that insures only 1,000 people against the same peril.

Adverse Selection
 Adverse selection is defined as the tendency for higher-than-average risks to seek out insurance more
frequently than those who are lower risk.
 If an insurer suffers a financial loss due to adverse selection, it has inaccurately calculated the risk of
loss and consequently charged inadequate premiums. Companies must avoid adverse selection to be
profitable and stay in business. Sound and competent underwriting may reduce the chance of adverse
selection.

Perils, Loss, and Hazards

Perils (CAUSES of Loss)
 A peril is the immediate and specific cause of a loss. Each line of insurance covers a different set of
perils and losses.
 Accident and health insurance policies cover losses that are caused by illnesses and accidents.
 For life insurance and annuities, the primary covered peril is death.
 Life insurance protects against premature death.
 Annuities protect income when a person’s life span is greater than the statistical average, and the
insured would otherwise outlive his assets.

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Named Perils versus Special (Open) Perils
 Insurance contracts that cover Specified or Named Perils will individually list perils that they cover.
 If a loss is caused by a peril that’s not listed within the insurance policy, then the loss is not covered.
For example, an accidental death and dismemberment policy only covers certain losses,
and only those due to accidents. By naming and defining specific causes of loss, a named-
peril policy defines covered losses narrowly.
 Insurance contracts that use a Special or Open Peril definition of covered causes of loss offer
insurance that protects against a broad spectrum of potential losses. These policies start by stating that
they cover all direct causes of loss and then list any excluded perils.
 Any peril that’s not explicitly excluded is covered.
For example, an individual disability income policy covers losses due to either illnesses or
accidents. They also cover job-related losses as well as those that are not.

Loss
 A loss is defined as an unintended and unforeseen reduction or destruction of financial or economic
value.
 A loss can also be defined as either an accident or an occurrence.
 An accident is an unforeseen, unexpected, unintended, and sudden event, which occurs at a specific
time and specific place.
 An occurrence is any event that causes a loss. Occurrences include accidents, illnesses, and losses
that are caused by repeated or continuous exposure to conditions over time.
[EXAM TIP: Every accident is an occurrence, but not every occurrence is an accident.]

 A Direct Loss results when a person is hurt, killed, or property is damaged or destroyed.
 The peril is the proximate cause of the direct loss.

 An Indirect Loss is also referred to as a “Consequential Loss” because the loss results from a direct
loss.
For example, if an individual suffers an injury that causes her to be disabled for six
months, her injury is a direct loss. The individual’s loss of income, which occurs
because the injury results in her inability to work, is indirect.

 Loss exposure is the risk of a possible loss. Basically, any situation that presents the possibility of a
loss.

 Homogeneous exposure units are similar objects of insurance exposed to the same group of perils.
 A loss exposure consists of loss exposure units.

Hazards
 A hazard increases the possibility that a loss will occur.

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 Examples of hazards include icy roads, driving while intoxicated, and improperly stored
toxic waste.

 Physical hazards are physical or tangible conditions existing in a manner that makes a loss more
likely to occur.
Poor health and ice on roads are examples of physical hazards.

 Moral hazards make a loss more likely to occur due to the dishonest character of the insured.
 Properly defined, a moral hazard occurs when the insured is much more intentioned and conscious of
participating in wrongdoing that’s more likely to lead to a loss.
For example, a dishonest person is more likely to lie to their insurance company, both
on an application and when submitting a claim.
Negative habits such as drug use, alcohol abuse, and smoking are commonly associated
with moral hazards.

 Morale hazards arise from a state of mind related to the indifference of an insured to whatever loss
may occur.
 The insured unintentionally creates a loss situation because he doesn’t care about loss prevention since
the property is insured.

Risk
 Risk is defined as the potential or uncertainty for loss.

Types of Risk

 Speculative risks are not insurable because they offer the opportunity for gains as well as losses.

 Pure risks are insurable because there’s only the potential for loss, not gain.

Elements of an Insurable Risk

 In general, insurable risk must include the following elements:
‒ An insurable loss must be due to chance (accidental), which means that the cause must be
outside of an insured’s control. This characteristic helps insurers avoid adverse selection.
‒ An insurable loss must be definite and measurable, which means that the time, place, and
amount are known.
‒ An insurable loss must be predictable, which means that the probability of loss in the future can
be calculated. There must be a sufficient number of homogeneous loss exposure units to do so.
‒ An insurable loss cannot be catastrophic, which means that a loss cannot be too big or
uncertain to calculate. The loss exposure must be reasonable.
‒ The loss exposure to be insured must be substantial.
‒ The premium cost must be economically feasible; it must be small relative to the covered loss
exposure.

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Insurance Risk Classifications
 Typically, an insurer will place a risk into one of the following three classifications:
‒ Standard risks are considered to have an average potential for loss.
‒ Substandard risks have a higher-than-average potential for loss. Substandard risks may either
pay a higher premium for coverage or be declined altogether.
‒ Preferred risks are judged to be a better than average risk for an insurance company because
they have a lower-than-average potential for loss.

Risk Management
 The process of analyzing exposures that create risk and designing programs to handle them is referred
to as risk management.
 Risk may be reduced or managed by purchasing an insurance contract.

Methods of Handling Risk

 Risk avoidance means eliminating an activity or condition that exposes a person to a type of loss or
specific perils.
 Risk reduction is the process of taking deliberate actions to reduce the likelihood or severity of a loss.
 Risk retention is a conscious strategy of maintaining reserves to address the risk of losses.
 Risk transfer features a legal contract that transfers risk from one party to another. In general,
insurance contracts are risk transfer arrangements. They transfer the risk of loss defined in the policy
to the insurer in exchange for a known fee or premium.
 Risk-sharing spreads risk among multiple parties. Each party assumes a portion of the risks covered
by the arrangement, such as with reciprocal insurance companies.

 Risk pooling spreads risk by distributing the cost of possible losses over a large number of
individuals. It transfers risk from an individual to a group.

 Reinsurance is defined as the transfer of risk from one insurer to one or more other insurers.

Prevention
 Another risk management tool that’s available is loss prevention. Loss prevention involves taking
actions to eliminate damage or loss.

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REVIEW NOTES: LEGAL CONCEPTS OF INSURANCE
General Law of Contracts
 Insurance contracts are binding legal agreements between two parties—a policyowner and insurer. In
most cases, the policyowner is also the insured. Some life insurance policies are not owned by the
person being insured.
 If an insurance exam asks for the identity of the party that enters into an agreement with an insurance
company when buying a policy, the proper answer is “the policyowner,” even if “the insured” is also
given as a choice.
 The only time “the insured” is the correct answer is when “policyowner” (or “policyholder”) is not
given as a possible answer.
 The beneficiary is not a party to the contract.
 The following four essential elements must be contained in every contract for it to be legally valid and
binding (enforceable). We can remember them using the mnemonic “C.L.O.C.”.
1. Competent parties
2. Legal purpose
3. Offer and acceptance
4. Consideration
 The four elements can be remembered using the mnemonic “C, L, O, C.”

Competent Parties
 The parties to the contract must be legally competent and must possess the capacity to make binding
agreements.
 The parties must be mentally sound, sober, of sufficient age, and not disqualified on other legal grounds.
 Individuals that may be barred from entering into a legally binding contract include:
‒ Minors as defined by state law
‒ Insane or mentally incompetent individuals
‒ Individuals who are under the influence of alcohol or drugs at the time of application
‒ Persons who are forced or coerced into a contract
‒ Enemy aliens
‒ Convicts (based on state law)

Legal Purpose
 For a contract to be enforceable, the contract must have a legal purpose. The object of the contract
and the reason for the parties to enter into the agreement must be legal.

Offer and Acceptance

 Both parties to the insurance contract must agree to the contract terms before they become valid and
in-force.
 The first party that commits to the contract is offering to enter into a legally binding agreement.
 The second party’s commitment is legally considered an acceptance of the offer.
 An offer plus an acceptance is often referred to as the agreement.
 When the applicant for an insurance policy submits a completed application and pays the initial
premium, she’s making an offer. When the insurer issues the policy as requested, it accepts the offer.

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  If a consumer submits an application without an initial premium, the consumer is NOT making an
offer because no transaction can be completed without the payment of the initial premium. Instead, the
consumer is asking the insurer to make an offer by issuing a policy. The consumer accepts the offer by
paying the initial premium.

Consideration
 For any agreement to be binding, both parties must provide each other with some item of value, which
is the definition of “consideration.”
 An applicant’s consideration is the premium paid and the representations (i.e., statements) made.
 The insurer’s consideration is the promise to pay legitimate claims.
 Consideration is the binding force of any insurance policy.

Special Features of Insurance Contracts

Aleatory Contract
 An insurance contract is an aleatory contract because one party may recover more in value than he
has paid.
 The value of the policyowner’s potential benefit (i.e., claim payment) is generally higher than the
value (i.e., premium) that’s received by the insurer.
 There’s no guarantee that the insured will receive a benefit. Performance is based on an uncertain
future event involving unequal bargaining value.
For example, an individual who has a disability insurance policy will collect benefits if
she becomes disabled. However, if no disability occurs, benefits are not paid.
Another example illustrating the aleatory nature of insurance contracts is a life insurance
policy that pays out a $20,000 death benefit after only $100 of premiums were collected.

Contract of Adhesion
 Insurance policies are contracts of adhesion.
 They’re contracts that are prepared by only one of the parties—the insurance company.
 There’s no negotiation regarding the terms. The insurer sets the terms, and the applicant can either
“take it or leave it.”

 In any contract of adhesion, the party that dictates the contract terms must make those terms clear.
 The doctrine regarding ambiguities in a contract of adhesion favors the party that did not create the
contract terms. When it comes to insurance policies, the courts will rule in favor of the insured.

 The doctrine of reasonable expectations stipulates that an insurance contract may be interpreted by a
“reasonable” consumer to mean what the producer or insurer has indicated it means or what he has
interpreted or expected it to mean.

Unilateral Contract
 Insurance policies are unilateral contracts because only the insurer makes an enforceable promise.
 Insurers promise to pay benefits upon the occurrence of a specific event, such as death or disability.

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  The applicant makes no promise to continue the policy and can cancel it at any time.
 The insurer’s promise remains in force as long as the policyowner pays the required premium.

 Most forms of insurance are personal contracts because they’re non-transferrable.

 Insurance contracts always insure a person, even when they insure property. A homeowner’s policy
doesn’t merely cover a house; it also covers the person who owns the house. When the person sells the
house, the coverage cannot be transferred to the new owner.
 Life insurance is an exception to this rule. Life insurance is NOT a personal contract.
 Life insurance contracts can be treated as financial assets. They can be used collateral for loans and
can be sold to third parties under the terms of a viatical or senior settlement.

Conditional Contract
 Insurance policies are conditional contracts because the insurance company’s performance is
contingent on the occurrence of uncertain future events.
 The insurer must only fulfill its promise to pay if a covered loss occurs while the policy is in force.
 The insurer’s obligations under the contract are conditioned on the performance of specific acts by the
insured or the beneficiary. For example, the insured must provide notice of claim and proof of loss.

Valued Contract or Indemnity Contract

 Insurance policies indemnify an insured in one of two ways. Some policies have a fixed value, while
others have benefits that are tied to the loss of assets, income, or health.

 A valued contract, such as life insurance, pays a stated sum regardless of the actual loss incurred.

 An indemnity contract pays an amount which is equal to a loss that’s identified in the policy.
 Some contracts of indemnity are reimbursement policies that directly reimburse the insured for claim-
related expenses.
 Other indemnity contracts define their benefits as a certain amount of money per day, week, or month
to offset a loss of revenue (as in a disability policy) or some portion of periodic expenses (such as
long-term care).

Insurable Interest
 Insurable interest can be defined as the kind of financial interest a person must have in themselves or
another person to purchase legally enforceable insurance coverage.
 Most policies require insurable interest to exist at the time of purchase and at the time of claim.
 For a life or health insurance contract, insurable interest is only required at the time of the application.
Insurable interest doesn’t need to exist at the time of claim.
 To have “an insurable interest” in oneself or another person, an individual must have a reasonable
expectation of benefiting from the other person’s continued life. Conversely, she will suffer a financial
loss if the person becomes ill, suffers an injury, or dies.

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Negotiating and Issuing Insurance Policies
 An insurance policy is a written contract in which one party promises to compensate another against
loss from an unknown event.
 A policy rider or endorsement is a legal attachment which amends a policy.

Utmost Good Faith

 Utmost good faith means that the policyowner and the insurer both know all of the relevant
information that’s material to the agreement. The critical concept is full disclosure.

Reasonable Expectations
 The Doctrine of Reasonable Expectations is the legal principle which stipulates that the terms of
contracts should be interpreted as may reasonably be expected when ambiguous.

Warranty
 A warranty is a statement that’s guaranteed to be true in every respect. It becomes part of the contract
and can be grounds for revoking the agreement if found to be untrue.

Representation
 A representation is a statement which is made by the applicant and is considered to be true and
accurate to the best of the applicant’s belief.
 A false statement made by an applicant that would influence an insurer in determining whether to
accept the risk is considered a material misrepresentation.

Concealment
 Concealment is defined as the failure or neglect by the applicant to disclose a known, material fact.
 An insurance company has the right to rescind the insurance contract in response to either an
intentional or unintentional concealment.
 The insurer must prove the concealment exists and that it’s material to the insurance policy.

Void versus Voidable Contracts

• For example, if a life insurance applicant asks his friend to impersonate him during a medical
exam in hopes of qualifying for coverage, any resulting policy would be void. It would never be in
effect because the insurance company doesn’t have the right person’s consideration. Also, it
doesn’t have medical data about the applicant which is necessary to underwrite the policy.

 The injured party may have the right to terminate the agreement.

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 Fraud
 Fraud is an intentional misrepresentation regarding a claim or policy application that a consumer
makes to obtain benefit payments or policy coverage under false pretenses.
 Life insurance contracts cannot be voided after they have been in force for two years. After two years,
the policies become incontestable.
 Guaranteed renewable health insurance policies usually have two or three years, depending on state
law. After this time, they also become incontestable.
 The ability of insurers to void other health insurance policies due to fraud is not necessarily limited.
This will be addressed in the section titled “Time Limit on Certain Defenses.”

Parole Evidence Rule

 The parole evidence rule limits a contract to its written terms. Oral statements that are made before
the formation of a contract are not admissible in court unless they become part of the written contract.

Waiver
 A waiver is the voluntary surrendering (giving up) of a known right.
 A waiver is also defined as “the deliberate, voluntary, or intentional abandonment of a known right by
an insurer.”
 One example of an insurer waiving a right occurs if an incomplete application is mistakenly accepted.
Once the policy is issued, the insurer cannot contest a later claim based on the missing information.

Estoppel
 Estoppel requires an insurer to abide by misleading or incorrect statements that are made by one of its
agents, even if it can demonstrate that the governing policy form contradicts the agent.
 Under certain circumstances, this legal principle prevents the insurer from escaping the consequences
of its agent’s actions as long as they were within the scope of the agent’s authority.
 Estoppel applies when ALL of the following elements are present:
‒ An agent is acting within her authority.
‒ The agent makes an inaccurate representation on behalf of the insurance company.
‒ A consumer relies on the information being correct.
‒ When a circumstance arises that tests the validity of the questionable representation, the
insurance company refuses to honor the agent’s words.
‒ The insurer’s decision causes financial harm to the consumer.

The Law of Agency

 Insurers grant agents the authority to sell, solicit, and negotiate contracts of insurance, and bind them
on their behalf.
 When acting within the scope of their authority granted, an act of the agents is an act of the principal.
 The relationship between an agent and the company represented is governed by agency law.

Principles of Agency Law

 The four essential principles of agency law include:

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 1. Acts of an agent are equal to the acts of the principal.
2. Under law, a contract that’s completed by an agent is also completed by the principal.
3. Payments that are received by an agent for the principal are received by the principal.
4. If an agent knows it, it’s presumed that the insurance company does as well.

Agent Authority
 “Authority” is what an insurer grants a licensee to transact insurance on its behalf.
 In reality, an agent’s authority can be quite broad.

Express Authority Express authority is the agent’s authority which is expressly granted in his agency
contract.
 The principal deliberately gives this authority to one or more agents.
 For example, an agent has the express authority to bind coverage for applicants on behalf of the
company.

Implied Authority Implied authority describes the authority we assume an agent needs to transact the
principal’s business as expressed in the contract.
 Implied authority is incidental to express authority.
 Implied authority encompasses the little things an agent needs to do to accomplish the tasks expressly
assigned to him under the terms of his agent contract.

Apparent Authority Apparent authority is the appearance of authority regardless of whether it

actually exists.
 Apparent authority relies on the perception of an agent’s authority based on the actions, words, or
deeds of the principal.

Brokers versus Agents

 Insurance producers may be agents or brokers.
 An agent has an agent’s contract, while a broker has a broker’s contract.
 In a sales transaction, agents represent the insurer, but brokers represent the buyer (or applicant).
 A broker cannot bind coverage; however, an agent can.

Agent versus Solicitor Authority

 Some states license solicitors.
 Solicitors have the authority to seek out insurance applicants for a company, but don’t have any
authority to bind coverage on behalf of a company.
 Solicitors arrange for prospective clients to meet with an agent.
 Agents are authorized to handle all of the necessary steps of an insurance sale, from solicitation to
sales to taking and binding an application.

Agent as a Fiduciary
 An agent is a fiduciary because an agent holds a position of financial trust and confidence as it relates
to both consumers and insurers.

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Other Legal Concepts Related to Insurance
Subrogation
 Subrogation is the insurer’s right to pursue liable third parties for amounts that are paid out in claims
which are made by the insured.

Tort Law
 A tort is a wrong against an individual as opposed to a crime, which is a wrong against society.
 Torts are adjudicated in civil court, rather than a criminal court.
 Civil courts also judge cases involving contracts, which fall under contract law.
 Torts most often occur when one individual wrongs another individual by failing to act in a reasonable
or prudent manner. This is referred to as negligence.
 There are several types of negligence, including:
‒ Simple negligence is a failure to act (or not act) in a reasonable or prudent manner.
‒ Gross negligence results from a reckless disregard for the need to act reasonably.
‒ Willful and wanton negligence combines a reckless disregard for reasonable standards of care
and an awareness that harm will probably occur.

Errors and Omissions (E&O) Insurance

 Insurance agents need errors and omissions (E&O) liability insurance, which covers injuries resulting
from an error that’s made in rendering or failing to render professional services.

 Not effecting insurance coverage or a policy change when requested

 Administrative and premium calculation errors
 Misstating insurance coverages, or not explaining policy provisions properly
 Incorrectly identifying client loss exposures, or failing to recommend coverages
 Forwarding inaccurate or incomplete information about a client to a carrier
 Improperly handling a claim

 Criminal, illegal, or dishonest acts

 Malicious acts
 Libel and slander
 The intentional violation of any law, regulation, statute, or ordinance

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REVIEW NOTES: LIFE INSURANCE POLICY TYPES
General Concepts of Life Insurance
Types of Life Insurance Policies
Industrial life insurance issues small face amounts, such as $1,000 or $2,000. Premiums are paid weekly
and collected by debit agents. They were designed for burial coverage.

Group life insurance is written for members of a group, such as a place of employment, association, or a
union. Coverage is provided to the members of that group under one master contract. The group is
underwritten as a whole, not on each member. Typically, group life insurance doesn’t require evidence of
insurability and is cheaper than individual life insurance.

Ordinary life comprises several types of individual life insurance, such as temporary (term) and
permanent (whole).

Term life insurance gives a person the most considerable amount of coverage for a limited period. Term
insurance is only in effect for a limited period because it has a TERMination date. Term insurance is an
inexpensive type of insurance, which makes it an attractive option for policies with a significant face
value. Term life is the CHEAPEST type of pure life insurance due to the fact that it has a termination date
and doesn’t have any cash value. Term life insurance will ALWAYS be cheaper than a whole life policy
with the same face value. It provides pure death protection since it only pays a death benefit if the insured
dies during the policy term.

Level term insurance, also referred to as level premium level term, requires a fixed, low premium in
exchange for level protection that lasts a specified period. For example, if a person needs life insurance
that provides coverage for the remainder of her working years and wants to pay as little as possible, she
will need Level term.

Level term life insurance is often renewal and convertible. For example, a person has a 10-year renewable
and convertible term policy. At the conclusion of the 10 years, the policy terminates, or she can renew it. If
she renews it, the premium price will go up, and she will have the policy for another 10 years. This cycle
can continue until she’s too old to renew it or it’s too expensive. All TERM insurance has a final
TERMINATION date after which it can no longer be renewed. If the policy is CONVERTIBLE, a person
can CONVERT it to whole life (think, rent to own) at any time. Whenever a person renews or converts
ANY insurance, she doesn’t need to worry about her health (i.e., her insurability is locked in). However,
the price will always rise because her current (attained) age is used for your new policy. Term life
insurance is typically thought of as “renting.” The concept is that a person has a roof over her head, but the
price of renting is going to rise until it no longer makes sense to continue renting or, at some point, the
rental contract is TERMINATED, and she gets kicked out.

Premiums are initially higher for non-renewable level term insurance than renewable term life insurance
because they’re level throughout the policy period. However, with renewable term insurance, the
premiums will increase at each renewal and eventually exceed those of standard level term insurance.

Decreasing term life insurance provides an annually decreasing face amount over time with level
premiums. A decreasing term policy is a type of life policy with a death benefit that adjusts periodically
(according to a schedule) and is written for a specific period. Decreasing term policies are generally
written for the protection of a mortgage or other debt that typically decreases over time until it’s paid

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off. For example, a 15-year decreasing term policy could protect a 15-year mortgage. As the mortgage
balance reduces each year, the face value of the insurance policy will adjust accordingly to match. After
the mortgage is paid off, the insurance policy will expire.

Credit policies are typically purchased using a decreasing term life insurance policy, with a term that’s
matched to the length of the loan period and the decreasing insurance amount matched to the declining
loan balance. Since credit life insurance is designed to cover the life of a debtor and pay the amount
due on a loan if the debtor dies before the loan is repaid, credit policies can only be purchased for up to
the amount of the debt or loan outstanding. For example, if a person wants an insurance policy to protect a
$20,000, five-year auto loan, he could use a five-year decreasing term life insurance policy with an initial
face value of $20,000. He will pay the same level premium every month for the five-year term of the
policy. The face value will start at $20,000 and change according to a schedule (the auto loan). After five
years, the car will be paid off, and the insurance policy will no longer be needed.

Increasing term life insurance provides an increasing face amount over time based on specific amounts
or a percentage of the original face amount.

Convertible term life insurance policies have a provision that allows the policyowner to convert the
term insurance into a permanent insurance policy without proof of insurability. For example, John
took out a low-cost term life insurance policy when he was young to take advantage of his excellent
health. Knowing that the policy would eventually terminate, John wanted the option to convert the policy
to a permanent one for final expense benefits when his finances improve. The conversion privilege of a
group term life policy allows an individual to leave the group term (temporary) plan and convert his
insurance to an individual (permanent) policy without providing evidence of insurability.

Term life insurance policies are typically converted using the insured’s attained (current) age, not the age
of the insured at the time of the original application. The insured’s age is a primary factor for calculating
premium costs. Therefore, using the insured’s current (attained) age will result in higher premiums than
using the insured’s original age. For example, a $25,000 policy on a healthy seven-year-old boy will cost
substantially less than a $25,000 policy on a 57-year-old man.

Whether converting an individual or group term insurance policy, the insured’s insurability is guaranteed.
However, the cost of the policy will be based on her current (attained) age, not the age when she applied
for the original term policy. Convertible term insurance allows the insured to enroll in temporary coverage
and later change it to permanent coverage without insurability (good health). However, the premiums will
increase due to using the insured’s attained age.

Renewable term insurance guarantees the insured the right to continue term coverage after the expiration
of the initial policy period without proving insurability. When a term policy is renewed, the insured is
not required to prove insurability. However, the premium price will rise because the insurance company
will use the insured’s current or attained age to determine the new premiums. If a customer wants
coverage at the lowest possible cost that was good for a limited period but offers the ability to continue the
coverage after the expiration, the customer will want a renewable term policy.

Annual renewable term coverage provides a level face amount that renews annually. This type of
coverage is guaranteed renewable annually without proof of insurability.

Whole life insurance provides a permanent death benefit for the entire life of the insured, but it also
provides living benefits in the form of cash values and policy loans. Whole life insurance typically has a
level premium and matures once the insured attains the age of 100.

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Advantages of whole life insurance:
 Covers the entire life of the insured
 Living benefits – cash value and policy loans
 Fixed premiums

Drawbacks of whole life insurance:

 Protection is more expensive than term insurance because of the policy’s living benefits
 Premium paying period may extend beyond the income-earning years

Whole life is often compared to BUYING (e.g., BUYING a house). The idea is a person can pay off a
house slowly or quickly; however, regardless of how it’s paid, once it’s paid for, the person owns the
house. There are several types of whole life. All whole life policies have the same types of benefits. The
only difference in “types” of whole life is how the policy is paid. All whole life policies last until death or
to the age of 100, have a fixed premium, and offer level benefits with cash value accumulation regardless
of how it is paid.

Types of whole life insurance include:

 Straight life: This is basic whole life insurance with a level face amount and fixed premiums that are
payable over the insured’s entire life, or to the age of 100 (maturity of policy).
 Limited Pay Whole life: This is whole life insurance in which the insured is covered for her entire
life, but premiums are paid for a limited time. As the premium payment period shortens, the total cost
for the insured decreases, and the policy’s cash values increase faster. For example, under a life paid-
up at age 65 policy, premiums are only paid until the insured is 65 years old. With a 20-pay life
policy, the insured only pays for 20 years. All policy provisions and insurability being equal, a 40-
year-old insured would pay more for the 20-pay life than she would for a paid-up at age 65 policy.
Additionally, her cash value would accumulate at a faster rate. Both of these policies are in effect until
the insured’s death or until she reaches the age of 100.
 Single premium whole life: Allows the insured to pay the entire premium in one lump-sum and have
coverage for her entire life.
‒ An immediate non-forfeiture value is created
‒ Immediate cash value is created
‒ A large part of the premium is used to set up the policy’s reserve
 Modified whole life: This type has low premiums in the early years and jumps to a higher premium in
the later years but remains fixed after that. Premiums increase just once.
 Graded whole life: Under a typical graded premium life insurance policy, the premium increases yearly
for a stated number of years, then remains level. Premiums continue to stay level for the remainder of
the policy. For example, a policy can start low in a graded whole life insurance policy and increase a
small amount every year up until the fifth year, then it will level off for the remainder of the policy.

Special Use Policies

In addition to the basic types of life insurance policies, there are a number of “special use” policies
insurance companies offer. Many of these are a combination (or package) of different policy types and are
designed to serve a variety of needs.

Family plan policies are designed to insure all family members under one policy. Usually, the family
head is covered by permanent (whole life) insurance, and the spouse/children are included on the same
policy as level term life riders (family term riders).

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The term coverage on the spouse and children is typically convertible to permanent coverage without
evidence of insurability as long as it’s “attached” to another person’s policy. Think sidecar on a
motorcycle. Riders must RIDE on something.

Family plan policy example:

 Husband – Whole Life Policy
 Wife (spouse) – Term Policy which is convertible without proof of insurability
 Children – Term Policies which are convertible (typically at the age of 18 or 21) without proof of
insurability; premium remains the same regardless of the number of children

Family income policies combine whole life insurance and decreasing term insurance. It provides monthly
income to a beneficiary if death occurs during a specified period after the date of purchase. If the insured
dies after the specified period, only the face value is paid to the beneficiary since the decreasing term
insurance expired. Income needs typically DECREASE over time because the household debt shrinks.

Family maintenance policies combine whole life insurance and level term. They provide income to a
beneficiary for a selected period if an insured dies during that period. At the end of the income-paying
period, the beneficiary also receives the entire face amount of the policy. If an insured dies after the end of
the selected period, the beneficiary receives only the face value of the whole life policy. Maintenance
“maintains” the family using level term insurance. This means that the family will receive a benefit for a
preset number of years after the insured’s death.

Multiple protection policies pay a benefit of double or triple the face amount if death occurs during a
specified period. If death occurs after the period has expired, only the policy face amount is paid. The
period may be for a specified number of years (e.g., 10, 15, or 20 years) or to a specified age (e.g., the age
of 65). These policies are combinations of permanent insurance and level term insurance.

Joint life policies cover two or more people. The age of the insureds is averaged, and a single premium is
charged. It uses permanent insurance (as opposed to term) and pays a death benefit when one of the
insureds dies. The survivors then have the option of purchasing an individual policy without evidence of
insurability. The premium for a joint life policy is less than the premium for separate, multiple policies.
ONE policy covers two. This is similar to a “joint account” with a bank – one account (or policy, in this
case) for two people.

A variation of the joint life policy is the joint and survivor policy, or a “survivorship life policy” (it can
also be referred to as a “second to die” policy). This plan also covers two lives, but the benefit is paid upon
the death of the last surviving insured. Compared to the combined premium for separate life insurance
policies on two individuals, the premium for a survivorship life policy is lower.

Juvenile Insurance is life insurance written on the life of a minor. The adult applicant is typically the
premium payor until the child comes of age and can take over the payments.

Credit life insurance is designed to cover the life of a debtor and pay the amount due on a loan if the
debtor dies before the loan is repaid. It’s issued in an amount that’s not to exceed the outstanding loan
balance and is generally paid entirely by the borrower. A decreasing term policy is most often used.

Non-Traditional Life Policies

Interest-Sensitive Whole Life: Interest-sensitive life insurance (current assumption whole life insurance)
is a type of whole life insurance in which the cash value can increase beyond the stated guarantee if
economic conditions warrant. It also allows the insured to increase the face amount or use the extra cash

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value to lower future premiums. Premiums can vary to reflect the insurer’s changing assumptions
concerning its death, investment, and expense factors. CAWL (current assumption whole life) policies are
almost always an MEC due to accelerated premiums.

Adjustable life policies are distinguished by their flexibility from combining term and whole life
insurance into a single plan. The policyowner determines how much protection is needed and how much
premium he’s willing to pay. Adjustable life insurance allows a person to vary his coverage as his needs
change without requiring evidence of insurability. Consequently, no new policy needs to be issued when
changes are desired. Adjustable life has all the usual features of whole life insurance.

Universal life is a variation of whole life insurance and is characterized by considerable flexibility.
Changes may be made with relative ease by the policyowner with these flexible-premium policies.
Investment gains go toward the cash value. Unlike whole life (with its fixed premiums, fixed face
amounts, and fixed cash value accumulations), universal life allows its policyowners to determine the
amount and frequency of premium payments, which will adjust the policy face amount. Essential
characteristics of a universal life policy are flexible premiums, flexible benefits, no minimum death
benefit, and cash value withdrawals. Cash value accumulations are subject to a minimum interest
guarantee. Any surrender charges of a universal policy must be disclosed.

Equity Index Universal Life insurance (EIUL) is a permanent life insurance policy that allows
policyholders to tie accumulation values to a stock market index, such as the S&P 500. Indexed universal
life insurance policies typically contain a minimum guaranteed fixed interest rate component and the
indexed account option. Indexed policies give policyholders the security of fixed universal life insurance
with the growth potential of a variable policy linked to indexed returns. The potential extra interest is
based on the investments of the company’s general account.

Modified Endowment Contracts (MECs) are policies that are overfunded, according to IRS tables.
Policies that don’t meet the seven-pay test are considered MECs and will lose favorable tax treatment.
The seven-pay test is a limitation on the total amount a person can pay into a policy in the first seven years
of its existence. The test is designed to discourage premium schedules that result in a paid-up policy before
the end of a seven-year period.

For example, if the yearly premium is $500, over seven years, the total amount paid would equal $3,500. If
a person paid $3,501, the policy has exceeded the 7-pay test and is no longer a life insurance contract.
Instead, it will be taxed as an investment.
 If withdrawn before age 59 1/2, there’s a 10% penalty.
 Taxation only occurs when cash is distributed.
 Funds that are withdrawn from an MEC are subject to last-in-first-out (LIFO) tax treatment, which
assumes that the investment or earnings portion of the contract’s values is withdrawn first (making
these funds fully taxable as ordinary income).
 Penalties and taxes may be assessed on premature distributions (i.e., policy loans) from a modified
endowment contract (MEC).

Variable Insurance Products

Due to the transfer of investment risk from the insurer to the policyowner, variable insurance products are
considered both securities contracts and insurance contracts. A producer is required to register with the
National Association of Securities Dealers to sell variable products.

Variable whole life insurance was created to help offset the effects of inflation on death benefits.
Variable whole life insurance is permanent life insurance with many of the characteristics of traditional

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whole life insurance. The main difference between traditional whole life insurance and variable whole life
insurance is how the policy’s cash values are invested. With traditional whole life insurance, these values
are kept in the insurer’s general accounts and invested in conservative investments that are selected by the
insurer to match its contractual guarantees and liabilities. With variable life insurance policies, the policy
values are invested in accounts that are separate from the insurer’s general accounts. These accounts allow
the policyowner the option to direct the investment choice and offer common stock, bond, money market,
and other securities investment options. Values that are held in these separate accounts are invested in
riskier, but potentially higher-yielding, assets than those held in the general account. The primary
characteristics of a variable life policy include fixed premiums, a guaranteed minimum death benefit
which fluctuates over the minimum, and cash values which fluctuate and are not guaranteed.

Variable universal life (VUL) life insurance combines all the characteristics of universal life and variable
life. In a VUL, the cash value can be invested in various separate accounts, similar to mutual funds. The
choice of which of the available separate accounts to use is entirely up to the contract owner. The ‘variable’
component in the name refers to the ability to invest in separate accounts whose values vary because they’re
invested in the stock and bond markets. The ‘universal’ component in the name refers to the flexibility the
owner has in making premium payments. Variable universal life insurance provides the policyowner with
flexible premiums, adjustable death benefits, a guaranteed minimum death benefit. It gives the insured
growth potential for higher returns and the potential for loss. Evidence of insurability can be required for an
individual who’s covered by a variable universal life policy when the death benefit is increased.

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REVIEW NOTES: LIFE INSURANCE POLICY
PROVISIONS, OPTIONS, AND RIDERS
Standard Life Insurance Provisions
Entire Contract:
 The entire contract includes the actual policy and the application.
 It states that nothing outside of the contract (the contract includes the signed application and any
attached policy riders) can be considered part of the contract.
 It also assures the policyowner that no changes will be made to the contract or the waiver of any of the
provisions after it has been issued, even if the insurer makes policy changes that affect all policy sales
in the future. However, this doesn’t prevent a mutually agreeable change or modification of the
contract after it has been issued.
 Any change to a policy must be made with the approval of an executive officer of the insurance
company whose approval must be endorsed on the policy or attached in a rider.
 The execution clause states that the insurance contract will be executed when both parties (the insurer
and the policyowner) have satisfied the conditions of the contract.
 The privilege of change clause (or policy change provision) outlines the conditions under which the
company will allow the policyowner to change the policy’s coverage.
Insuring Clause (or Insuring Agreement):
 The insuring clause is the insurer’s basic promise to pay specified benefits to a designated person in
the event of a covered loss.
 This is the part of the insurance policy that identifies the specific type of benefits or services that are
covered by the policy and the circumstances under which they will be paid.
 The purpose of this clause in an insurance policy is to specify the scope and limits of the coverage
provided.
 Any promises that the INSURER makes will be in the INSURING clause.
Consideration Clause:
 A policyowner must pay a premium in exchange for the insurer’s promise to pay benefits.
 A policyowner’s consideration consists of completing the application and paying the initial premium.
 The amount and frequency of premium payments are contained in the consideration clause. For
insurance, the insurance company exchanges the promises in the policy for a two-part consideration
from the insured.
 Consideration is an exchange of an item of value on which a contract is based.
 An insurance contract is valid only if the insured provides consideration in the form of the initial full
minimum premium required and the statements that are made in the application.
 The applicant states, “Please CONSIDER me for insurance. Here is my completed application, my
initial premium, as well as how much money and how often I agree to pay. Please CONSIDER me!”
Incontestable Clause:
 In a life insurance contract, this is the clause that prohibits the insurer from questioning the validity of
the contract after a certain period has elapsed.
 The period is typically two years from the policy’s issue date. Since state requirements may be
different, they will be covered in the state law portion at the end of the course.

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Physical Exam and Autopsy:
 The physical exam and autopsy provision entitles a company, at its own expense, to make physical
examinations of the insured at reasonable intervals during the period of a claim, unless it’s forbidden
by state law.
 Only the state can forbid an autopsy. A person (and her family) gives up her right to refuse when she
applies for insurance.
Misstatement of Age or Sex:
 Allows the insurer to adjust the policy benefits if the insured’s age or sex is misstated on the policy
application.
 The misstatement of age provision allows the insurer to adjust the benefit payable if the age of the
insured was misstated when the application for the policy was made.
 The insurer can adjust the benefit to what the premiums paid would have purchased at the insured’s
actual age.
 At the time of application, if the insured were older than what’s shown in the application, benefits
would be reduced accordingly. The benefits would be increased if the insured were younger than
what’s listed in the application.
Owner’s Rights Provision
 Defines the person who may name and change beneficiaries, select options available under the policy,
and receive any financial benefits from the policy.
Assignment Provision
 The assignment clause or provision is the right to transfer policy rights to another person or entity.
The new owner is referred to as the assignee.
 An absolute assignment occurs when the assignee receives full control of the policy and the rights to
the policy benefits from the current policyowner. Under an absolute assignment, the transfer is
complete and irrevocable, and the assignee receives full control over the policy and full rights to its
benefits.
 A collateral assignment is the partial and temporary transfer of rights to another person or entity.
Collateral assignments are typically intended for securing a loan with a creditor. A collateral
assignment occurs when the policy is assigned to a creditor as security or collateral for a debt. If the
insured dies (or possibly becomes totally\permanently disabled), the creditor is entitled to be
reimbursed out of the benefit proceeds for the amount owed. The insured’s beneficiary is then entitled
to any excess of policy proceeds over the amount due to the creditor.
Free Look:
 Once the policy is delivered, the policyowner is permitted a certain number of days to look over the
policy and, if dissatisfied, return it for a refund of all premiums paid.
Grace Period:
 The grace period is a specified period after a premium payment is due, during which the protection of
the policy continues despite the fact that the payment for the renewal premium has not yet been
received.
 The policyowner is given a number of days after the premium due date and, during this time, the
premium payment may be delayed without penalty, and the policy continues in force.
 If the insured dies during the grace period of a life insurance policy before paying the required annual
premium, the beneficiary will receive the face amount of the policy less any required premiums.
 The purpose of the grace period is to give the policyowner additional time to pay overdue premiums.

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Reinstatement:
 The reinstatement provision allows the policyowner to reinstate a policy that has lapsed as long as the
policyowner can provide proof of insurability and pays all back premiums, outstanding loans, and
interest.
 Most states allow reinstatement for up to three years after a policy has lapsed. However, for some
states the reinstatements are from five to seven years.
 This provision specifies that if an insured fails to pay a renewal premium within the time granted, but
the insurer subsequently accepts the premium, coverage may be restored.
 Under certain conditions, a policy that has lapsed may be reinstated.
 Reinstatement is automatic if the company or its authorized agent accepts the delinquent premium,
and the company doesn’t require an application for reinstatement. If it takes no action on the
application for 45 days, the policy is reinstated automatically.
 To reinstate any policy, a person needs a reinstatement application, statement of good health, and
payment of all back premiums.

Provisions and Options Related to Cash Value

Non-Forfeiture Options
 When a policyowner decides he doesn’t want his life insurance policy any longer, he has the option to
surrender his policy. If there’s cash value remaining, the policyowner must use one of the following
non-forfeiture options:
‒ Cash Surrender: Allows the policyowner to receive the policy’s cash value and, at this point,
the policyowner no longer has coverage. Typically, the maximum length of time a life insurance
company may legally defer paying the cash value of a surrendered policy is six months (delayed
payment provision).
‒ Extended Term Option: Permits the policyowner to use the policy’s cash value to buy level,
extended term insurance for a specified period. No premium payments are made. The coverage
provided with the extended term non-forfeiture option is equal to the net death benefit of the
lapsed policy.
‒ Reduced Paid-Up Option: The policyowner pays no more premiums, but the face amount is
decreased.
 If the insured is closing her account (surrendering her policy), the insurance company is questioning
what it should do with her cash (so that she doesn’t forfeit it).
Policy Loan Provisions:
 Policies that have cash value also have policy loan and withdrawal provisions. These policies must
begin to build cash value after a certain number of years. In most states, the period is three years.
 Policy loans (with interest) cannot exceed the guaranteed cash value, if so, the policy is no longer in
force.
 The policyowner has the right to the policy’s cash value.
 Policy loans are not taxable.
 At time of the insured’s death, any loans (with interest due) will be deducted from the insured’s policy
proceeds.
Automatic Premium Loans:
 This provision allows the insurer to automatically use the policy cash value to pay an overdue
premium. Therefore, it allows the insurance company to deduct the overdue premium from an
insured’s cash value by the end of the grace period if a payment is missed on a life policy.
 There’s no cost associated with this provision.

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  The automatic premium loans provision is similar to using a savings account for overdraft protection,
but there’s no fee. Instead, there’s simply interest charged for borrowing the funds. If the loan is not
repaid, interest is added to the loan.
 Outstanding loans are subtracted from any death benefit or cash surrenders if they’re not paid back
first.
 The insurance company can AUTOMATICALLY take out a LOAN for the insured against his CASH
VALUE to cover his PREMIUM in the event the company doesn’t’ receive his payment.
 Automatic premium loans can continue for as long as the insurer doesn’t receive payment and the
policyowner has cash value remaining in the policy. Once all of the cash value is gone, if the
policyowner doesn’t start paying, the policy will lapse.
 The automatic premium loans function in the same manner as any other cash value loan.

Provisions and Options Related to Policy Proceeds

Beneficiary Designation:
 This is where the policyowner indicates who’s to receive the proceeds.
Change of Beneficiary:
 The policyowner may change the beneficiary designation at any time unless a beneficiary has been
identified as irrevocable.
Settlement Options:
 The methods by which the policy proceeds can be paid out or settled.
 Typically, the beneficiary chooses the settlement option at the time of the insured’s death.
 The spendthrift clause stipulates that the policyowner may select a settlement option at the time of
application.
Accelerated Benefits Rider:
 This rider allows the insured to receive a portion of the death benefit prior to death if the insured has a
terminal illness and is expected to die within one to two years. Regardless of the amount withdrawn in
an accelerated death benefit, it will decrease the death benefit when death occurs.
 For example, an insurance company may know that a person is going to die soon, which means it’s
going to be paying out the benefit soon. To make things a little easier and less stressful, the company
will give the insured some of the proceeds NOW and deduct from what would go to the beneficiary
upon the insured’s death.
Long-Term Care Rider:
 A long-term care rider is a type of accelerated benefits rider that will pay a benefit if the insured is
permanently confined to a nursing home and requires long-term care or is unable to perform two or
more activities of daily living.
 Activities of daily living (ADLs) include eating, dressing, bathing, toileting/continence,
walking/ambulation, transferring, or taking medication.

Provisions and Options Related to Policy Dividends

Dividends:
 Participating policies pay dividends to policyowners if the company’s operations result in a divisible
surplus.
 Dividends are a return of overcharged premiums and are therefore not taxable.
 Insurers typically pay dividends on an annual basis.

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Dividend Options:
 The following dividend options are available to policyowners for settling dividend payments:
‒ Cash Option: The insured simply takes the cash.
‒ Reduced Premiums Option: Reduces premium payments by having the insurance company
retain the money and charge less the following year.
‒ Accumulate Interest Option: Allows dividends to accumulate interest. Interest is the only part
of a potential dividend for which the policyowner may be taxed.
‒ Paid-Up Additions Option: Purchases single payment whole life coverage.
‒ One-Year Term Option: Purchase one-year term protection.
 Unlike non-forfeiture options, the policy remains active when a dividend option is selected.

Life Insurance Policy Riders

Waiver of Premium Rider:
 This rider allows the policyowner to waive premium payments during a disability and keeps the policy
in force; it doesn’t provide cash payments to the policyowner.
 The disability must be total and permanent and must have sustained through the waiting period (either
90 days or six months).
 After a certain age (typically the age of 60 or 65), the waiver of premium rider is void, unless it’s
currently in use.
 The waiver of premium covers the PRIMARY INSURED, not any additional insureds.
 This provision does NOT provide income and is NOT a loan. Instead, the insurance company is
“waiving” the premiums” and treating it as if the insured made the premium payments each month.
Accidental Death Benefit Rider (Double Indemnity):
 This rider may be added to a permanent or temporary life insurance policy.
 It pays an additional sum to the beneficiary if the insured dies due to an accident.
 The amount paid is a multiple of the policy face amount, such as double or triple the original benefit.
This is truly the cheapest way to add a large amount of coverage for a specific period.
 Provides an additional amount of insurance that’s typically equal to the face amount of the base policy
if the cause of death was the result of an accident.
Accidental Death and Dismemberment Rider:
 This rider may be added to a permanent or temporary life insurance policy, and it pays benefits for
dismemberment and accidental death.
 It pays a principal sum (face amount) for loss of both hands, both arms, both legs, or loss of vision in
both eyes.
 Pays capital sum (half of face value) for loss of one foot, one hand, one eye, etc.
 One foot and one hand = 100% face value.
Guaranteed Insurability Option Rider:
 This rider allows a policyowner to purchase additional life insurance coverage at specified dates
without providing evidence of insurability.
 It also includes specific events (e.g., marriage or birth of a child) without requiring the proof of
insurability.
 The benefit is typically allowed every three years, up to the original face amount of the policy.
 This feature is also referred to as the future increase option.
Cost of Living Rider:

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  This rider allows the policy face amount to be adjusted to account for inflation based on the Consumer
Price Index (CPI).
Payor Provision (Rider):
 The payor provision is typically attached to juvenile policies to protects the insured in the event that
the PAYOR dies or is disabled.
 With this provision, if the adult premium payor of the juvenile policy dies or becomes disabled, the
premiums will be waived until the child reaches a specified age (e.g., age 18, 21, or 25).
 This provision is also referred to as the payor clause.
Term Rider:
 A term rider allows an applicant to have excess coverage by adding an additional term rider to her
primary policy.
 A term rider is an economical way to add a large amount of additional insurance to a permanent life
insurance policy.
 Term riders covering the life of the insured can be level, increasing, or decreasing term.
Return of Premium Rider:
 This rider returns the total amount of premiums paid into the policy, in addition to the face value, as
long as the insured dies within a specific period that’s specified in the policy.
 It also returns premiums to the living insured at the end of a specified period as long as the premiums
have been paid.
Other Insureds Provisions:
 Other insured or dependent riders may be added to a primary policy to cover a spouse or “another
insured,” children, or adopted children.
 Family plan policies typically cover the family head with permanent insurance, and the coverage on
the spouse and children is term insurance in the form of a rider.
 A term rider for other insureds is always level term.
 Adding a term rider is cheaper than having every family member obtain their own policy.
‒ For example, the primary policy may be on a father, but the mother and the children are riding
on (attached to) the father’s policy as term riders. Term riders allow for additional family
members to be covered under one policy by attaching everyone to the primary policy.
Child Term Rider:
 A child term rider is a life insurance product that rides on the primary parent’s policy and covers the
lives of the children.
 The child term rider is typically one flat premium, regardless of the number of children covered.
 Remember, a child term rider pays a benefit to the beneficiary (parent) if the child dies; it doesn’t pay
the child.
Spousal Term Rider:
 A spousal term rider is a life insurance product that rides on the primary policy and covers the life of
the primary insured’s spouse.
 Remember, a spouse term rider pays a benefit to the beneficiary (primary insured) if the spouse dies; it
doesn’t pay the spouse.

Common Exclusions or Restrictions

Exclusions:
 An exclusion is a feature of a life insurance policy stating that the policy will not cover certain risks.

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  Exclusions and restrictions are situations or conditions which are not covered or are covered with
substantial limits.
 The exclusions section is NOT included in the policy face (i.e., the first page of an insurance policy).
War or Military Service
 The insurer will not pay the claim if the insured dies or is injured while in active military service or
due to an act of war.
Aviation
 The insurer will not pay the claim if the insured dies due to involvement with aviation. Typically, this
is limited to high-risk aviation (e.g., stunt pilot, instructor/student pilot, or a military pilot).
 Although uncommon, it may also exclude the period during which insured is serving as a pilot or crew
member of an aircraft.
Hazardous Occupation or Hobby
 If the insured dies as a result of a hazardous occupation or hobby, the insurer will not pay the claim.
 To deny the claim, the activity or occupation for which the claim is being denied must be explicitly
excluded in the policy (i.e., part of the entire contract).
 The change of occupation provision allows the insurer to reduce the maximum benefit payable under
the policy if the insured switches to a more hazardous occupation or reduce the premium rate charged
if the insured changes to a less hazardous occupation.
Criminal Activity
 Losses due to injuries that are sustained while rioting, committing a felony, or attempting to do so,
also may be excluded.
‒ Illegal Occupation: This provision specifies that the insurer is not liable for losses that are
attributed to the insured’s being connected with a felony or participating in an illegal occupation.
‒ Intoxicants and Narcotics: The insurer is not liable for any loss that’s attributed to the insured
while intoxicated or under the influence of narcotics.
Suicide Clause:
 The policy will be voided and therefore no death benefit will be paid if the insured commits suicide
within one to two years from policy issuance. The primary purpose of a suicide provision is to protect
the insurer against the purchase of a policy by a person who’s contemplating suicide.

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REVIEW NOTES: LIFE INSURANCE PREMIUMS,
PROCEEDS, AND BENEFICIARIES
Purpose of Premiums
 The insurer receives a premium from a policyowner in exchange for insurance protection. The
premium is part of the policyowner’s consideration or the “binding force” in the contract, which
cements the agreement between the insurer and policyowner.

Factors in Premium Calculation

 Mortality Factor: A measure of the number of deaths in a given population. Mortality is based on a
large risk pool of people and time. Insurance companies use mortality tables to help predict the life
expectancy and probability of death for a given group.
 Interest Factor: Insurance companies invest the premiums they receive in an effort to earn interest.
The rate of earnings on investments is one of the ways that an insurance company can reduce
premium rates.
 Expense Factor: As any other business, insurance companies have operating expenses that need to
be factored into the premiums being charged. The expense factor is also referred to as the loading
charge.

Other Factors That Impact the Premium Amount

 Age: The older the person, the higher probability of death and disability.
 Sex/Gender: Women tend to live longer than men; therefore, their premiums are generally lower.
 Health: Poor health increases the probability of death and disability.
 Occupation: A hazardous job increases the risk of loss.
 Hobbies: High-risk hobbies also increase the risk of loss. Remember, these are typically only
important at the time of application. For example, a person is obtaining life insurance and states that
he’s never been skydiving (which is true). Then, five years later, the person goes skydiving for the
first time and dies in an accident. In this case, the insurance company will pay the death benefit.
 Habits: Tobacco use presents a higher risk than for non-smokers.
 Benefits, options, and riders: The number and types of benefits provided by a policy affect the
premium rate. The greater the benefits, the higher the premium. Or, put another way, the greater the
risk to the company, the higher the premium.
 Premium mode refers to the premium payment schedule and permits the policyowner to select the
timing of premium payments. Options include annual, semiannual, quarterly, and monthly. The
more frequently the payments are made, the more it’s going to cost overall. Ideally, if a person is able
to make one payment in a lump-sum to start and “pay up” the policy, she will save the most money.
Also, her cash value will begin to accumulate immediately. The higher the premium payments, the
quicker the cash value will accumulate. The higher the frequency of payments, the higher the total
premiums.

Premium Terms and Funding

 An insurance company’s reserves represent money that (together with future premiums, interest, and
survivorship benefits) will fulfill an insurance company’s obligations to pay future claims. Each state
has its own reserve requirements.
 The earned premium (the amount of premium to which an insurer is entitled for the insurance
coverage provided) and the unearned premium (the premium collected from the policyholder for
future coverage) make up the insurer’s total premium.

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  Cost basis represents the premiums paid into the policy minus total dividends received in cash or used
to offset premiums.
 Net premium is a premium that makes provision for mortality (death benefit) losses only while being
influenced by the interest rate assumed, gender, the benefit to be provided, and the mortality rate.
 Gross premium is the premium charged by an insurer and is comprised of or influenced by all factors
of mortality, interest, and expenses. It’s the actual premium paid by the policyowner for life insurance
coverage. (Gross premium = Net premium + Insurer expenses).
 Single premium funding: The policyowner pays a single premium that provides protection for life as
a paid-up policy. Single premium funding provides for the lowest total premium and fastest build-up
of cash value.
‒ For example, John, a 30-year-old non-smoker, buys a $100,000 whole life policy for one single
premium of $70,000.
 Level (fixed) premium funding: The policyowner pays more in the early years for protection to help
cover the cost in later years. This allows the premiums to remain level throughout the life of the
policy. The shorter the premium-paying period, the higher the periodic premiums.
‒ For example, John can buy that same $100,000 whole life policy for 10 (annual) level premiums
of $8,000 each ($80,000 total premiums); or John can buy that same $100,000 whole life policy
for 840 level premiums (monthly for 70 years) of $105 each ($88,200 total).
 Modified premium funding is characterized by an initial premium that’s lower than it should be
during an introductory period (typically the first three to five years). After this time, the premium will
increase to an amount that’s greater than what the initial level premium would have been and then
remains level or constant for the life of the policy.
‒ For example, John can buy that same $100,000 whole life policy for 36 initial fixed premiums
(monthly for three years) of $50 each ($1,800 total introductory) and then an additional 804
fixed premiums (monthly for 67 years) of $110 each ($88,440 total remainder). ($1,800
introductory + $88,440 for reminder = $90,240 total).
 Graded premium funding is a contract that’s characterized (like modified) by a lower premium in
the early years of the contract. However, premiums increase annually for the initial period. Then, it
increases to an amount that’s higher than what the initial level premium would have been, but
thereafter remains level or constant for the life of the policy.
‒ For example, John can buy that same $100,000 whole life policy for monthly payments of $20 for
year 1, monthly payments of $40 for year 2, monthly payments of $50 for year 3, monthly
payments of $75 for year 4 ($2,220 total introductory), and then an additional 792 fixed
premiums (monthly for 66 years) of $120 each month ($95,040 total remainder). ($2,220
introductory + $95,040 for reminder = $97,260 total).
 Flexible premium funding allows the policyowner to adjust the premiums throughout the life of the
contract.
 Minimum deposit financing allows the policyowner to use policy loans to pay premiums that are due
each year. The policyowner only pays the difference between the premium due and the amount
borrowed (plus interest on the policy loan). Depending on the type of policy, a policyowner may be
able to use the policy’s cash value and dividends to pay the premium.

Comparing Life Insurance Policy Costs

 The cost of life insurance is largely dependent on an individual’s specific circumstances and
requirements. However, cost estimates are useful so that the consumer can consider every factor when
making a buying decision. A lower premium doesn’t automatically equate to a lower-cost policy. To
that extent, cost indexes have been developed to aid in the process of measuring an insurance policy’s
actual cost.

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  Surrender Cost Index: Uses a complicated calculation formula in which the net cost is averaged
over the number of years during which the policy was in force to arrive at the average cost-per-
thousand for a policy that’s surrendered for its cash value at the end of that period.
 Net Payment Cost Index: Uses the same formula as the Surrender Cost Index, with the exception
that it doesn’t assume that the policy will be surrendered at the end of the period. The net payment
cost index is useful if a person’s primary concern is the amount of death benefits provided in the
policy. It helps compare future costs (e.g., 10 to 20 years) if a person continues to pay premiums and
doesn’t take the policy’s cash value.
 The interest adjusted cost method calculates the cost of life insurance by taking into account the time
value of money (i.e., the investment return on sums placed in premium dollars had these sums been
invested elsewhere).
 The traditional net cost method adds a policy’s premiums and subtracts both dividends (if any) and
cash value.

Policy Proceeds
 Living Benefits: A living benefit is the option to use some of the future death benefit proceeds before
death.
 Cash Value: The cash (equity) that accumulates and may be borrowed against, used as collateral,
utilized as supplemental retirement income, or may be withdrawn for emergencies or other situations
in which cash is needed.
 Accelerated Benefit: Allows a person who’s be certified by a physician as terminally ill to access the
death benefit. To be considered terminally ill, a physician must certify that the person has a condition
or illness that will result in death within two years. After the certification, the insurance company now
knows that it will soon be required to pay out the benefit. As a result, it will allow the person to use
some of the proceeds now and deduct it from what’s paid to the beneficiary later.
 Viatical Settlement: Allows a person who has a terminal illness to sell his existing life insurance
policy to a third party for a percentage of the death benefit. The new owner continues to make the
premium payments and will eventually collect the full death benefit. The original policyowner is
referred to as the viator, while the new third-party owner is referred to as the viatical or viatee.
 Life Settlement: A life settlement is the sale of an existing life insurance policy to a third party for
more than its cash surrender value, but less than its net death benefit. An insured is not required to
have a terminal illness to participate in a life settlement.
 Policy Dividends: Dividends are a refund of a part of the premium under a mutual insurer’s
participating policy. The policyowner may use dividends for cash payments, to pay the insurance
premium, to purchase additional paid-up whole life insurance, to purchase one-year term insurance, or
as an investment to accumulate interest. Although not directly tied to the policy proceeds, dividends
are still considered a living benefit.
 Death Benefit Settlement Options: Although customarily selected by the beneficiary, the
policyowner may select a settlement option at the time of the application and may change the option at
any time during the insured’s life. If selected by the policyowner, the settlement option cannot be
changed by the beneficiary. Death benefit settlement options include:
‒ Lump-Sum: Death benefit is paid in a single payment, minus any outstanding policy loan
balances and overdue premiums. The lump-sum option is considered the automatic (or “default”)
option for most life insurance contracts.
‒ Interest Only: The insurance company holds the death benefit for a period and pays only the
interest earned to beneficiaries.
• A minimum rate of interest is guaranteed, and the interest must be paid at least annually.
‒ Fixed Period (Period Certain): The insurer pays proceeds (including interest and principal) in
minimum guaranteed dollar payments over a specified number of years.
‒ Fixed Amount: The insurer pays a fixed death benefit in specified installment amounts until the
proceeds are exhausted. The larger the installment payment, the shorter the payout period.

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 ‒ Life Income: This provides the beneficiary with an income that she cannot outlive. Installment
payments are guaranteed for as long as the recipient lives. The amount of each installment is
based on the recipient’s life expectancy and the principal benefit.
‒ Joint and Survivor: Benefits will be paid on a life-long basis to two or more people. This
option may include a period certain, and the amount payable is based on the ages of the
beneficiaries.

Beneficiaries
 There are very few restrictions as to who may be named a beneficiary of a life insurance policy. A
beneficiary can be either specific (a person who’s identified by name and relationship) or a class
designation (a group of individuals, such as the children of the insured). If no beneficiary is named or
if all beneficiaries die before the insured dies, the death benefit will go to the insured’s estate. The
policyowner is the ultimate decision-maker. However, in the underwriting process, the underwriter
may consider the issue of insurable interest. Examples of who can be beneficiaries include:
‒ Individuals
‒ Businesses
‒ Trust
‒ Estates
‒ Charities
‒ Minors
‒ Class

Distribution By Order of Succession

 Primary: The first in line to receive death benefit proceeds.
 Secondary (contingent): The second in line to receive death benefit proceeds if the primary
beneficiary dies first.
 Tertiary: The third in line to receive death benefit proceeds. If one is not named, the death benefit
will go to the insured’s estate.
 Distribution by Descent
‒ Per Stirpes (meaning by the bloodline): If a beneficiary dies before the insured, benefits from
that policy will be paid to that beneficiary’s heirs.
‒ Per capita (meaning by the head): Evenly distributes benefits among all named living
beneficiaries.

Changing a Beneficiary
 Revocable Beneficiary: The policyowner may change the beneficiary at any time without notifying
or obtaining the beneficiary’s permission.
 Irrevocable Beneficiary: The beneficiary cannot be changed without the beneficiary’s written
consent. The irrevocable beneficiary has a vested interest in the policy. Therefore, the policyowner
cannot exercise certain rights (e.g., taking out a policy loan) without the beneficiary’s consent.

Special Situations
 Uniform Simultaneous Death Act: If the insured and the primary beneficiary die at approximately
the same time as the result of a common accident with no clear evidence as to who died first, the act
will assume that the primary beneficiary died first. This allows the death benefit proceeds to be paid to
the contingent beneficiary(ies).
 Common Disaster Provision: With this provision, a policyowner can be certain that if both the
insured and the primary beneficiary die within a short period, the death benefits will be paid to the
contingent beneficiary.

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  Spendthrift Clause: Prevents the deceased’s creditors from obtaining the death benefit and prevents a
beneficiary from recklessly spending benefits by requiring the benefits to be paid in fixed amounts or
installments over a certain period.
 The facility of payment allows the insurance company to pay all or a part of the proceeds to a person
who’s not named in the policy, but has a valid right. Facility of payment is often done on behalf of a
minor or when the named beneficiary is deceased.

Tax Consequences of Life Insurance

 Premiums that are paid on individual life insurance policies and premiums that are paid for life
insurance used for business purposes (the company’s benefit) are generally not tax-deductible.
However, exceptions allow premiums to be tax-deductible for:
‒ Premiums on an insurance policy to benefit a charity
‒ Premiums on an insurance policy to benefit an ex-spouse as court-ordered alimony
 Employer-paid premiums that are used to fund group insurance for the benefit of employees are tax-
deductible for the employer.
 Living benefits can have tax implications depending on the situation.
 Cash Value: For policies that are not surrendered, the cash value grows on a tax-free basis. If the
policy is surrendered for its cash value, the portion that exceeds the premiums paid is taxable. As long
as the cash value remains in the policy, taxes will never be imposed on any portion, not even the
amount that exceeds the cost basis.
 According to the IRS, proceeds from a policy loan don’t count as taxable income. However, if a
policy is surrendered or lapses, the IRS is notified of the taxable event and taxes may be required.
 Accelerated Death Benefit: Under a life insurance policy, when benefits are paid to a terminally ill
person, the benefits are received tax-free.
 Dividends are received tax-free. However, if the policyowner chooses to leave the dividends with the
insurance company as an investment, any interest that accumulates will be subject ordinary income
tax.
 The transfer for value rule applies when a life insurance policy is sold to another party before the
insured’s death. For this reason, most states require a viatical settlement company or life settlement
company to inform the client that the proceeds could be taxable in certain situations and it should be
recommended that they consult with a tax advisor.
 1035 Exchange: When an existing life insurance policy is assigned to another insurer for a new
contract, the transaction may be treated for tax purposes as a Section 1035 exchange. Policy
exchanges that qualify as 1035 exchanges are not taxable. A Section 1035 exchange enables the
postponement of tax consequences.
 Under the Economic Benefit Doctrine, any benefit granted to an individual that has an economic or
financial value must be included as compensation for income tax purposes in the year in which the
benefit is granted. Individual life insurance generally avoids this doctrine since premature death can
cause a substantial risk to a surviving family.
 Life insurance proceeds that are paid to a beneficiary as a lump-sum are generally received tax-free.
Additionally, proceeds pass directly to the beneficiary and are not subject to attachment by the
insured’s creditors.
 If death benefits are paid to a beneficiary in installments (as opposed to as a lump-sum), the principal
is received tax-free and any interest received is taxable.
 Another tax cost that’s typically associated with death is the federal estate tax (although most
relatively simple estates don’t require the filing of an estate tax return).

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REVIEW NOTES: LIFE INSURANCE UNDERWRITING
AND POLICY ISSUE

 Underwriting is the process that’s used by an insurance company to determine whether an applicant is
insurable and, if the applicant is insurable, how much to charge for premiums.
 The underwriter will utilize several different types of information when determining the insurability of
the individual.
 Material facts can affect an applicant being accepted or rejected.
 One of the primary responsibilities of an underwriter is to protect the insurer against adverse selection.
 The underwriter classifies each proposed insured’s risk and selects only those with an acceptable risk
based on the insured’s underwriting guidelines.

 The underwriting process involves reviewing and evaluating the applicant’s information and
establishing individual guidelines against the insurer’s standards and guidelines for insurability and
premium rates. The larger the policy, the more comprehensive and diligent the underwriting process.
 The most common sources of underwriting information include:
‒ The application
‒ The medical report
‒ Attending physician’s statement
‒ The Medical Information Bureau
‒ Special questionnaires
‒ Inspection reports
‒ Credit reports
 Application: The application is the starting point and primary source of information that’s used by an
insurance company in the risk selection. Although applications differ from company to company, they
all have the same general components. Insurable interest must exist between the policyowner and
insured at the time that the application is made (not at the time of death/loss).
 Insurable interest exists when the death of the insured would have a clear financial impact on the
policyowner.
 An application has the following three parts:
‒ Part I of the application includes:
• General information (e.g., age, date of birth, gender, address, marital status, occupation)
• Details about the requested insurance coverage (e.g., type of policy, amount of insurance,
name and relationship of the beneficiary, other insurance the proposed insured owns)
• Other information personal information
‒ Tobacco use
‒ Hazardous hobby
‒ Foreign travel
‒ Aviation activity
‒ Military service

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 ‒ Part II of the application includes:
• Medical information and health history
• A medical section which must be completed in its entirety for every application (depending on
the proposed policy, this section may be all that’s required in the way of medical information)
• The disclosure that the individual to be insured may be required to take a medical exam or
provide a blood test or urine specimen
‒ Part III of the application includes:
• The agent’s report (statement) which contains the agent’s observations of the applicant
• The applicant’s financial condition, character, background, the purpose of sale, and how
long the agent has known the applicant.
• (Because the agent represents the insurance company’s interests, the agent is expected to
complete this part of the application thoroughly and truthfully.)
 Policies below a certain face amount (e.g., $50,000, or even $100,000) will not require additional
medical information, other than what’s provided by the application. However, they require a medical
report for further information.
 Credit Reports: An applicant’s credit history may be used for underwriting and determines the
likelihood of the premium payments being made. The Fair Credit Reporting Act (FCRA) requires the
applicant to be notified in writing if a credit report will be used. The applicant must also be notified if
the premium is increased because of a credit rating.
 Warranty: Warranties are statements that are guaranteed to be literally true. A warranty that’s not
literally true in every detail, even if it’s made in error, is sufficient to render a policy void.
 Representations include statements made by the applicant that are substantially true to the best of his
knowledge but are not warranted as exact in every detail.
 Medical Report: A medical report is often used for underwriting policies with higher face amounts. If
the medical section’s information warrants further investigation into the applicant’s medical
conditions, the underwriter may need an attending physician’s statement (APS).
 Inspection Reports: This report provides information about the applicant’s character, lifestyle, and
financial stability. Due to their cost, inspection reports are typically only requested for more extensive
coverages. However, company rules vary as to the sizes of policies that require a report by an outside
agency. When an investigative consumer report is used in connection with an insurance application,
the applicant has the right to receive a copy of the report.
 Companies are allowed to obtain inspection reports under The Fair Credit Reporting Act. The FCRA
regulates how credit information is collected and used to protect the rights of the consumers for whom
an inspection or credit report has been requested. It established procedures for the collection and
disclosure of information obtained on a consumer through investigation and credit reports.
 If an insurance company requests a credit report, the consumer must be notified in writing. This report
provides information about the applicant’s character, lifestyle, and financial stability. When an
investigative consumer report is used in connection with an insurance application, the applicant has
the right to receive a copy of the report.
 Medical Information Bureau (MIB): The MIB is a non-profit trade organization that maintains
medical information about individuals. Information from the MIB is used by life and health insurance
companies to help avoid adverse selection by applicants. It detects misrepresentations, helps identify
fraudulent information, and controls the cost of insurance. Information received or released from the
Medical Information Bureau about a proposed insured may be released to the proposed insured’s
physician. An insurance company will NOT notify the MIB if an application is declined. One of the
primary purposes of the MIB report is to allow an insurer to avoid high-risk applicants.

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 USA PATRIOT Act: The USA PATRIOT Act was enacted in 2001 and requires insurance
companies to establish formal anti-money laundering programs. The purpose of the act is to detect and
deter terrorism. A life insurance policy can be cash-surrendered, which can be an attractive money-
laundering vehicle because it allows criminals or terrorists to put dirty money in and take clean money
out in the form of an insurance company check.
 Special Questionnaires: These are used for applicants who are involved in particular activities, such
as aviation, military service, or hazardous occupations or hobbies. The questionnaire provides details
regarding the amount of time the applicant spends on these activities.
 Fair Credit Reporting Act of 1970 (FCRA): The FCRA regulates the amount of credit information
can be collected and protects the rights of consumers for whom an inspection or credit report has been
requested. Information regarding an individual’s credit standing and general reputation is contained in
a consumer report. The FCRA established procedures for the collection and disclosure of information
obtained on consumers through investigation and credit reports. If an insurance company requests a
credit report, the consumer must be notified of this fact in writing. The applicant has the right to
receive a copy of the report when an investigative consumer report is used in connection with an
insurance application.

 The Health Insurance Portability and Accountability Act (HIPPA) is a privacy rule that provides
federal protections for an individual’s health information. Furthermore, HIPAA gives patients a
variety of rights concerning individually identifiable health information. When an agent submits an
application that reveals personal information regarding an applicant, the agent is responsible for
providing the insurance applicant with privacy notices.
 In applicable situations, producers must also secure an HIV consent form from the applicant and
communicate that blood tests may be required. In other words, despite the fact that the insurer requires
a blood test as part of its regular underwriting activity, it must still secure a signed consent form which
indicates to the applicant that any blood taken will be screened for HIV and that he’s providing
permission for such testing to be completed.
 Applicant Ratings: Once all of the information about a given applicant has been reviewed, the
underwriter seeks to classify the applicant’s risk to the insurer. This evaluation is referred to as risk
classification.

 Once all the information about a given applicant has been reviewed, the underwriter will utilize
several different types of information in determining the insurability of the individual and the risk that
the applicant poses to the insurer. This evaluation is known as risk classification. The following rating
classification system is used to categorize the favorability of a given risk:
 Preferred: This classification is characterized by low risk and low premiums. Some of the following
may result in a policy being issued with a preferred insurance premium:
‒ The applicant doesn’t smoke or drink.
‒ The applicant has good personal/family health history.
 Standard: This classification is characterized by average risk with no extra ratings or restrictions. The
policies will have standard terms and rates.
 Substandard: This classification is characterized by high risk and rated up (higher) premiums due to
chronic conditions, insulin diabetes, or heart disease.
 Declined: This means the applicant is not insurable because the potential of loss to the insurance
company is too high. The applicant has a terminal illness or too many chronic conditions.

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 Field underwriting is completed by an agent. Unlike the insurer, the agent has face-to-face contact
with the applicant, which can aid the insurer in risk selection. As field underwriters, agents help
reduce the chance of adverse selection, assure that the application is filled out completely and
correctly, collect the initial premium, and deliver the policy. Other duties include:
‒ Forwarding the application to the insurer in a timely manner
‒ Seeking additional information about the applicant’s medical history (if requested)
‒ Notifying the insurer of any suspected misstatements in the application
‒ Assuring that the application is filled out completely and correctly
‒ Collecting the initial premium
 In addition, agents have the responsibility and duty to solicit only profitable business. Therefore, an
agent’s solicitation and prospecting efforts should focus on cases that fall within the insurer’s
underwriting guidelines and represent profitable business to the insurer.
 Upon policy delivery, agents must deliver the life insurance buyer’s guide and policy summary to the
applicant. A life insurance producer may also be required to obtain a signature on a good health
statement at the time of policy delivery.

 If an agent realizes that an applicant has made an error on an application, the agent must correct the
information and have the applicant initial the changes.
 An incomplete application will be returned to the agent.
 The agent can NEVER change the application without the customer present to initial the changes.
 Buyer’s Guide: This document provides general information about the types of life insurance policies
available in simple language that can be understood by the average person. (i.e., a general description
of whole life, a general description of term life, essential characteristics of variable life, etc.).
 Policy Summary: This provides specific information about the policy purchased, such as the
premium and benefits. The policy summary allows a person to quickly identify the specific “health
insurance” that she purchased (e.g., Medicare Supplement, Major Medical, Critical Illness, Long-term
Care, etc.).
 Suitability Form: This ensures that the customer is best suited for the policy he’s purchasing and help
prevent the sale of unnecessary insurance. For example, a 75-year-old customer who’s living off of
Social Security is not suitable for a single premium deferred annuity because she would be giving up a
large sum of cash that she may need to live on and could possibly not live long enough to collect on
the annuity.
 Signatures: The agent and the applicant are both required to sign the application. If the applicant is a
person other than the proposed insured (except for a minor child), the proposed insured must also sign
the application. In most states, having a policyowner (applicant) who’s different from the insured
(parent and minor child) is considered third party ownership. For an insurance policy, once a minor
reaches the age of 15, he’s eligible to enter into a contract.
 If an agent fails to deliver a fully completed and accurate application, the insurance company will
return the agent’s application.

 Agents should make every effort to collect the initial premium with each application. However, if the
premium is not collected with the application, the policy will not become valid until it’s collected.
 Once the initial premium is collected, the agent issues a premium receipt to the applicant.

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 The only time a customer will receive a receipt is if he pays his initial premium at the time of
application. No receipt will be given at any other time.
 There are two types of premium receipts which determine when coverage will begin—conditional
receipts and binding receipts.
‒ Conditional Receipt: The producer issues a conditional receipt to the applicant when the
application and premium are collected. The conditional receipt indicates that coverage will be
effective once certain conditions are met. If the insurer accepts the coverage as applied for, the
coverage will take effect from the application or medical exam date, whichever is later.
‒ Binding Receipt: The binding receipt—also referred to as the temporary insurance agreement—
provides coverage from the date of the application regardless of whether the applicant is
insurable. Coverage typically lasts for 30 to 60 days, or until the insurer accepts or declines the
coverage. Binding receipts are rarely used in life insurance; instead, they’re often used in auto
and homeowners’ insurance. Under a binding receipt, coverage is guaranteed until the insurer
formally rejects the application. This may also be described as the insurer being bound to
coverage until the application is formally rejected. Even if the proposed insured is ultimately
found to be uninsurable, coverage is still guaranteed until rejection of the application.

 As described under the conditional receipt, coverage is not effective without the collection of the
initial premium, approval of the application, and followed by policy issuance and delivery. If the
initial premium doesn’t accompany the application, the premium must be collected by the agent. In
some cases, the insurer requires the agent to collect a good health statement from the insured at the
delivery time. If the initial premium is not submitted with the application, the policy effective date is
established by the insurer. In this case, it could be the date the policy is issued.
 Generally, for a policy to be in effect:
‒ The insurer must issue the policy
‒ The insured must submit the initial premiums, and
‒ (If applicable) The insured must sign a statement of continued good health.
 The effective date is important for two reasons, (1) it identifies when the coverage is effective and (2)
it establishes the date by which future annual premiums must be paid.
 Backdating: This is the process of predating the application by a certain number of months to
achieve a lower premium. Listing a younger age at the time of application results in a lower premium.
A backdated application results in a backdated policy effective date if it’s approved by the insurer.
Applications can typically only be backdated for up to six months. This process is also referred to as
“saving age.” In addition, the next premium is due at the backdated anniversary date.

 Policy issue occurs when the insurer “approves” the application (i.e., it is “issuing the policy”).
 The insurance issued contract is sent to the sales agent for delivery to the applicant. The policy is
generally NOT sent to the policyowner because the sales agent should personally explain it to the
policyowner.
 Technically a policy could be ISSUED and not be delivered for days or weeks later.
 Constructive Delivery: Policy delivery may be accomplished without physically delivering the
policy into the policyowner’s possession.

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 Constructive delivery occurs if the insurance company intentionally relinquishes all control over the
policy and turns it over to a person who’s acting for the policyowner, including the company’s own
agent. Mailing the policy to the agent for unconditional delivery to the policyowner also constitutes
constructive delivery, even if the agent never personally delivers the policy. If the company instructs
the agent not to deliver the policy unless the applicant is in good health, there’s no constructive
delivery.
 The Statement of Continued Good Health: This verifies that the insured has not become ill,
injured, or disabled during the policy approval process (the time between the submission of the
application and the delivery of the policy), or did not submit the initial premium with the application.
It’s used when the applicant did not submit the initial premium with the application in such cases.
Common company practice requires that, before leaving the policy, the agent must collect the
premium and obtain a signed statement from the insured which attests to her continued good health.
Statements of good health are also used when reinstating a policy.
 Personal delivery of the policy is a good practice since it allows the producer to explain the coverage
to the insured (e.g., riders, provisions, and options). Personal delivery also builds trust and reinforces
the need for the coverage. All of the following acts can be considered means of policy delivery—
mailing the policy to the agent, mailing the policy to the applicant, and the agent personally delivering
policy. Delivery is important since the policyowner must sign a document to indicate that the policy
has been received (and the free-look period and contestable period commences).

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REVIEW NOTES: GROUP LIFE INSURANCE
Principles of Group Insurance
 Unlike individual life insurance which is written on a single life, group life insurance is written on
more than one life.
 Group life insurance is typically written for employee-employer groups and is most often written as an
annual renewable term policy.
 An important underwriting principle of group life insurance is that the insurance must cover all or a
large percentage of the persons in the group.

Contributory and Non-Contributory Plans

 Contributory – An employee group plan in which employees share the cost. The insurance company
requires at least 75% of all employees to participate.
 Non-Contributory – An employee group plan in which employees do NOT share in the cost. The
insurance company requires 100% of all employees to be eligible.

Features of Group Insurance

 Features that separate group insurance from individual insurance include:
‒ With group insurance:
• The individual is not required to provide evidence of insurability since group underwriting
is involved.
• The insureds (employees) are not policyowners and only receive a “certificate of
insurance” to prove that they have coverage.
• The employer is the policyowner and receives one master contract (policy).
‒ Group insurance has lower overall costs due to lower administrative, operational, and selling
expenses associated with group plans.
‒ The master contract allows for the flow of insureds, or the entering and exiting under the policy
as members join and leave the group.
‒ Group insurance is typically issued as annually renewable level term insurance, which provides a
fixed amount of coverage throughout the term of the contract.
 Although the employer is the policyowner, the employee still has an “incident of ownership” by
naming the beneficiary.

Eligible Groups
 Groups must exist for a purpose other than obtaining insurance.
 Among others, group life insurance can be formed by the following organizations:
‒ Single-employee groups
‒ Multiple-employee groups
‒ Labor unions and trade associations
‒ Credit/debit groups
‒ Fraternal organizations
‒ Trustee groups (established by two or more employers or labor unions)

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Eligibility of Group Members (Employees)
 The employee must be full time and actively working.
 If the plan is contributory, employees must approve of automatic payroll deduction.
 A new employee probationary period is typically one to six months.
 During the enrollment period, an employee has 31 days to sign up. Otherwise, he may need to provide
evidence of insurability.

Classification of Risk
 Insurers require a minimum number of group members/employees to participate in a group insurance
plan in order to minimize adverse selection.
 Adverse selection means that the people who are most likely to need life insurance will purchase life
insurance in greater numbers than those who are in good health.
 After all necessary information is collected on an applicant, the underwriter will classify the applicant
based on the degree of risk assumed.
 The following rating classification system is used to categorize the favorability of a given risk:
‒ Preferred: Low risk and lower premiums
‒ Standard: Average risk with no extra ratings or restrictions
‒ Substandard: High risk (rated up) with higher premiums
‒ Declined: Not insurable - Potential of Loss to Insurance Company is Too High
 Lower risks tend to have lower premiums.
 If an applicant is too risky, the insurer will decline coverage

How Benefits Are Determined

 Most employers will establish benefit schedules according to the following:
‒ Earnings
‒ Employment position
‒ Flat benefit
 Conversion to an individual policy: If a member’s coverage is terminated, the member and his
dependents may convert their group coverage to individual whole life coverage without being required
to show proof of insurability.
 Conversion Period: An individual must apply for individual coverage within 31 days after the date of
group coverage termination.
 Under the group policy, an individual is covered during the conversion period.
 Group Policy Termination: If the master policy is terminated, each individual member who has been
insured for at least five years is permitted to convert to an individual policy that provides coverage up
to the face value of the group policy

Group Credit Life

 Group Credit Life: Group credit life policies are established by organizations (e.g., banks and finance
companies) and stipulate that, if the insured dies before a loan is repaid, the policy benefits will be
used to settle the loan balance.

Taxation of Group Life Insurance Plans

 For a group life insurance plan to receive favorable tax treatment, there are specific requirements to
ensure that an average employee is not discriminated against in favor of higher-level employees.
 If premiums for group life insurance are paid by the employee, they’re not tax-deductible.

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  If premiums for group life insurance are paid by the employer, they can be deducted as a business
expense.
 Proceeds from a group life policy are tax-free if they’re taken in a lump-sum.
 Proceeds taken in installments will be subject to taxes on the interest portion of the installments.

Group versus Individual Insurance

GROUP INDIVIDUAL
One master policy is issued to the group Each covered person possesses her own policy
Covered members have the same
Each person selects her benefits /coverages
benefits/coverages
Only eligible group members can apply Any individual can apply
Group underwriting Individual underwriting
Coverage ceases when the member leaves the Coverage continues as long as the premium is
group paid
Less expensive with few restrictions More expensive with more restrictions

 The essentials of group versus individual forms of insurance apply to life and health insurance.

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REVIEW NOTES: ANNUITIES
Purpose and Function
 While life insurance protects against the risk of premature death, annuities protect against the risk of
living too long and outliving income.
 Annuities are a way of providing a stream of income for a guaranteed period.
 Simply stated, an annuity is started with a large sum of money that will be paid out in installments
over a preset period or until the money is exhausted.
 The monthly amount of benefit an annuitant receives is based on factors such as principal amount, rate
of interest earned by the annuity, and length of the payout period.
 The contract owner is the individual who purchases the annuity, pays the premiums, and has rights of
ownership.
‒ The owner may be the annuitant, the beneficiary, or neither.
 During the liquidation phase of an annuity contract, the income benefits that are distributed at regular
intervals are normally payable to the annuitant.
 The beneficiary is the person who receives survivor benefits upon the annuitant’s death.
 Most annuities have two phases—the accumulation (pay-in) period and the annuity (pay-out) period.
 The accumulation period may typically continue even after the purchase payments cease.
 The annuity period is also referred to as the liquidation period, annuitization period, or payout period.
This is the time when the money that has accrued during the accumulation period is paid-out in the
form of payments to the annuitant

Structure and Design

 Funding Method: When defining an annuity, (describe how it’s paid for) + (describe how it pays the
annuitant) SINGLE PREMIUM (the annuitant pays once) + DEFERRED (it starts paying the
annuitant at least one year later).
 An annuitant CANNOT make installment payments and get paid immediately.
 Single Payment = a lump-sum payment
 Periodic Payments (Flexible Premiums) = installments paid over a period of time

Date Income Payments Begin

 Immediate Annuities: Purchased with a lump-sum payment, and will start providing income
payments within the first year, typically starting 30 days from the purchase date. Its purpose is to
provide for the liquidation of a principal sum.
‒ Commonly used to structure the payment of liability insurance settlements, lottery winnings, and
other large sums.
‒ This type of annuity is also referred to as a single premium immediate annuity (SPIA).
 Deferred Annuities: These start providing income payments after the first year and are typically
purchased with either a single lump-sum payment (single premium deferred annuity) or from monthly
payments (flexible premium deferred annuity).
‒ For example, a fixed deferred annuity pays out a fixed amount for life starting at a future date.
Interest credited to the cash values of annuities is deferred until distribution. Other characteristics
of deferred annuities include:
• When a deferred annuity is canceled during the early contract years, the insurer will
generally assess a back-end load (referred to as surrender charge).
• The “bailout” feature, which may be found in single premium deferred annuity contracts,
waives surrender charges when the interest rate falls below a stated level.

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 • Before a deferred annuity contract can be terminated for its surrender value, the insurer must
first obtain authorization from the owner.
• The accumulation value of a deferred annuity is equal to the sum of premiums paid, PLUS
interest earned, MINUS expenses and withdrawals

Payout Options
 Straight Life Income Payout Option: This option pays the annuitant a guaranteed income for her
lifetime. When the annuitant dies, no further payments are made to any person. This offers protection
against exhaustion of savings due to longevity.
 Fixed Amount Option: This option provides the annuitant with a fixed payment until the contract
value is exhausted, regardless of when that will be. If the annuitant dies before the contract is
depleted, the beneficiary receives the remainder.
 Cash Refund Payout Option: This option pays a guaranteed income to the annuitant for life. If the
annuitant dies before all the money is exhausted, a lump-sum cash payment of the remaining funds is
paid out to the annuitant’s beneficiary.
 Installment Refund Payout Option: This option pays a guaranteed income to the annuitant for life.
If the annuitant dies before the money is exhausted, the beneficiary will continue to receive the same
monthly installment payments.
 Life with Period Certain Payout Option (Life Income with Term certain): This option is
designed to provide the annuitant with guaranteed payments for her life or to the beneficiary for a
specific period. It designed so that benefit payments will continue for a minimum number of years
regardless of when the annuitant dies.
‒ For example, if an annuitant selects a 20-year period certain and dies after 10 years, the
beneficiary will receive payments for another 10 years.
 Joint and Full Survivor Payout Option: This option pays out the annuity to two or more people
until the last annuitant dies. If one of them dies, the other will continue to receive the same income
payments. There are two additional options made available with a joint and survivor payout:
‒ Joint and Two-Thirds Survivor: Survivor will have payments reduced to two-thirds of the
original payment.
‒ Joint and One-Half Survivor: Survivor will have payments reduced to one-half of the original
payment.

Investment Configuration
 Annuities can also be defined by their investment configuration, which will determine the amount of
income the benefits pay. The two types of annuity classifications are fixed and variable.
‒ Fixed Annuities: Provide a guaranteed rate of return. Fixed annuities credit interest at a rate
that’s no lower than the contract’s guaranteed rate.
‒ Variable Annuity: Doesn’t provide a guaranteed rate of return because of the investment risk.
The cash value is based on the results of these investment funds. A statement must be provided
to the owner of the annuity at a minimum of once per year.
‒ Variable annuities can be classified as either immediate or deferred. Insurers that deal with
variable annuities are subject to dual regulation by the SEC and the state’s Office of Insurance
Regulation.
 Accumulation Units: In a variable annuity, the value of the accumulation units varies depending on
the value of the securities investment that’s a part of a variable annuity.
 Annuity Units: When the variable annuity is to be paid out to the annuitant, the accumulation units
are converted into annuity units. These payouts can vary from month to month and will depend on the
investment results. Although the number of units doesn’t change, the value of each unit will change.

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 The amount of each variable annuity benefit paid to an annuitant varies according to the market value
of the securities in the separate account.
 Equity Indexed Annuities (EIAs): A type of fixed annuity that offers the potential for a higher return
than a standard fixed annuity. These EIAs may be tied to the Standard and Poor’s 500 Index or the
Composite Stock Price Index.
 Single-Life Annuities: Characterized by having only one annuitant.
 Tax-Sheltered Annuities: Limited exclusively for employees of religious, charity, or educational
groups. These annuities are also referred to as 403(b) plans.
‒ Accumulation payments often come from voluntary salary reductions.
‒ The annuitant may have an individual account contract
 Income Tax Treatment of Annuity Benefits: Annuity benefit payments consist of principal and
interest. The portion of annuity benefits that consists of principal (premiums paid into the annuity
during the accumulation period) is not taxed and may be referred to as the owner’s “cost basis.” The
portion of the annuity benefits that’s interest earned on the principal is taxable as ordinary income.
Interest income must be reported for federal income tax purposes upon receiving distributions or
income benefits from the contract.
 Exclusion Ratio: This is a simple way to determine what portion of each annuity benefit payment is
taxable: Exclusion ratio = Investment in the contract ÷ Expected return.
 Partial withdrawal: This is when funds are taken from an annuity before age 59 1/2. The withdrawal
is considered 100% interest and is therefore taxable as ordinary income.
 A 10% tax penalty is applied if a distribution is received before the annuitant reaches age 59 1/2. After
this age, withdrawals don’t incur the 10% penalty tax, but are taxable as ordinary income.
 1035 Exchange: This provision applies to annuities. If an annuity is exchanged for another annuity, a
gain (for tax purposes) is not realized. This is also true for a life insurance policy or an endowment
contract that’s exchanged for an annuity. However, an annuity cannot be exchanged for a life
insurance policy.
 Qualified Annuity Plan: This plan is a tax-deferred arrangement that’s established by an employer to
provide retirement benefits for employees. The plan is qualified because of having met government
requirements.
‒ A qualified annuity is an annuity that’s purchased as part of a tax-qualified individual or
employer-sponsored retirement plan, such as an individual retirement account (IRA).
‒ In the accumulation phase, a qualified deferred annuity may be used to fund an IRA and permit
continued contributions within the maximum limits set by the IRS. IRA funds that have been
annuitized no longer permit contributions.

Suitability of Annuity Sales for Senior Customers

 When making recommendations to a senior consumer regarding the purchase or exchange of an
annuity, an agent must have reasonable grounds for believing that this recommendation is suitable for
the senior consumer. This recommendation should be based on the facts disclosed by the senior
consumer and should include an evaluation of his investments and other insurance products along
with his financial situation and needs.

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REVIEW NOTES: SOCIAL SECURITY

Characteristics of Social Security

 Social insurance is provided by Social Security, also referred to as OASDHI.
 Social Security is “funded” by payroll taxes that are collected from employees, employers, and those
who are self-employed.
 Social Security was established to assist people who could not afford to sustain their way of life
because of unemployment, disability, illness, old age, or death.
 Social Security benefits are based on how long a covered worker has worked throughout his life.
 The primary insurance amount (PIA) determines the full amount of retirement benefits for an eligible
person at the age of 65.
 Benefits that are payable by Social Security are based on what an individual worker has contributed to
the program.
 Social Security establishes benefit eligibility based on an “insured” status.
 Coverage does NOT guarantee benefit eligibility.
 To obtain fully insured status, a covered worker must accrue a total of 40 quarters of credit.

Types of OASDI Benefits

 Retirement benefits
 Survivors’ benefits
 Social Security survivors’ benefits or death benefits – These pay a lump-sum death benefit or monthly
income to survivors of deceased covered workers.
 Survivors’ benefits – These include a $255 lump-sum death benefit, surviving spouse benefits, child’s
benefit, and parent’s benefit.
 A surviving spouse without dependent children is eligible for Social Security survivor benefits as
early as the age of 60.
 Survivor benefits are also available to:
‒ A spouse of any age who’s caring for children under the age of 16
‒ Children under the age of 18
‒ Children under the age of 19 who are full-time students
‒ Children at any age if they’re disabled before the age of 22 and they remain disabled
‒ A Social Security benefit of 75% of the Primary Insurance Amount (PIA) is given to an underage
child of a deceased worker

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REVIEW NOTES: RETIREMENT PLANS
Qualified Plans versus Non-Qualified Plans
 Qualified plans are retirement plans that meet federal requirements and receive favorable tax
treatment. Qualified plans provide tax benefits and must be approved by the IRS. The plans must be
permanent, in writing, communicated to employees, and cannot favor highly paid employees,
executives, or stockholders.
 The two primary types of qualified plans are defined benefit and defined contribution plans.
 To comply with ERISA minimum participation standards, qualified retirement plans must allow the
enrollment of all employees who are over the age of 21 who have been employed for at least one year.
 If more than 60% of a qualified retirement plan’s assets are in key employee accounts, the plan is
considered “top-heavy.”
 Qualified plans have the following features:
‒ Employer contributions are tax-deductible as a business expense.
‒ Employee contributions are made with pre-tax dollars and the earnings grow tax-deferred until
withdrawal.
‒ In a qualified retirement plan, the annual addition to an employee’s account cannot exceed the
maximum limits as set by the Internal Revenue Service.
 Non-qualified plans have the following characteristics:
‒ They’re not required to be approved by the IRS
‒ They can discriminate in favor of certain employees
‒ Contributions are not tax-deductible (i.e., they’re after-tax)
‒ Interest earned on contributions is tax-deferred until withdrawn at retirement

Tax Benefits of Qualified Plans

 Employer’s contributions are tax-deductible and not treated as taxable income to the employee.
 Employee contributions are made with pre-tax dollars.
 All funds grow tax-deferred and employees are only taxed at the time of withdrawal.

Withdrawals and Taxation

 Withdrawals made by the employee are treated as taxable income.
 Withdrawals made by the employee prior to the age of 59 1/2 are assessed an additional 10% penalty
tax.
 Distributions are mandatory by April 1 following the year in which the person turns age 72. The
failure to take the required withdrawal results in a 50% excise tax on those funds.
 Funds may be withdrawn prior to the employee reaching age 59 1/2 without the 10% penalty tax for
the following reasons:
‒ The employee dies or becomes disabled
‒ A loan is taken on the plan’s proceeds
‒ The withdrawal is the result of a divorce proceeding
‒ The withdrawal is made to a qualified rollover plan
‒ The employee elects to receive annual level payments for the remainder of his life
 The Employee Retirement Income Security Act (ERISA) of 1974 was enacted to provide minimum
benefit standards for pension and employee benefits plans, including fiduciary responsibility,
reporting and disclosure practices, and vesting rules.
 The overall purpose of ERISA is to protect the rights of workers who are covered under an employer-
sponsored plan.

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Employer-Sponsored Plans
 Defined benefit plans pay a specified benefit amount upon the employee’s retirement.
‒ When the term pension is used, it’s typically referring to a defined benefit plan.
‒ In a defined benefit plan, the benefit is based on the employee’s length of service and earnings.
‒ Individual and group deferred annuities mostly fund defined benefit plans.
 Defined contribution plans don’t specify the exact benefit amount until distribution begins.
‒ The two main types of defined contribution plans are profit-sharing and pension plans.
• Profit-sharing plans are a type of retirement plan that set aside a portion of the firm’s net
income for distributions to employees who qualify under the plan. Plans must provide
participants with the formula being used by the employer for contributions. The
contributions may vary on a yearly basis, and contributions and interest are tax-deferred
until withdrawal.
• With pension plans, employers contribute to a plan based on the employee’s compensation
and years of service; it’s not based on company profitability or performance.
 Money purchase plans allow employers to contribute a fixed annual amount, apportioned to each
participant, with benefits based on funds in the account upon retirement.
 Target benefit plans have a target benefit amount.
 Stock bonus plans are similar to a profit-sharing plan, except that the employer’s contributions are
not dependent on profits and benefits are distributed in the form of company stock.
 401(k) plans allow employers to make tax-deductible contributions to the participant, either by
placing a cash bonus into the employee’s account on a pre-tax basis or the individual taking a reduced
salary with the reduction placed pre-tax in the account. The account’s funds are taxable at the time of
withdrawal.
 Tax-sheltered annuities are a particular class of retirement plans that are available to employees of
specific charitable, educational, or religious organizations.
 Simplified employee pension (SEP) plans are basically an arrangement whereby an employee
(including a self-employed individual) establishes and maintains an IRA to which the employer
contributes. Employer contributions are not included in the employee’s gross income. A primary
difference between a SEP and an IRA is that considerably more money can be contributed to an
employee’s SEP plan.
 A Savings Incentive Match Plan for Employees (SIMPLE) plan is available to small businesses
(including tax-exempt and government entities) that employ no more than 100 employees who
received at least $5,000 in compensation from the employer during the previous year. An employer
can choose to make non-elective contributions of 2% of compensation on behalf of each eligible
employee. To establish a SIMPLE plan, the employer must not have an existing qualified plan.
 Keogh (HR-10) plans are for self-employed persons, such as doctors, farmers, lawyers, or other sole-
proprietors. Keoghs may be defined contribution or defined benefit plans. Contributions are tax-
deductible, and interest and dividends are tax-deferred.
 IRAs are established by individuals who have earned income and want to save for retirement.
 Traditional IRAs allow for an individual to contribute a limited amount of money per year, and the
interest earned is tax-deferred until withdrawal. Contribution limits are indexed annually and are
currently at $6,000 per year or 100%of earned income. Any person who’s 50 or older may contribute
an additional $1,000, thereby making her maximum annual contribution $7,000. Some individuals
may deduct IRA contributions from their taxes based on their adjusted gross income (AGI), but all
withdrawals are taxable as ordinary income. If an individual or spouse is not covered by an employer-
sponsored retirement plan, the entire contribution is tax-deductible (regardless of AGI). Withdrawals
that are made prior to age 59 1/2 are assessed an additional 10% penalty tax.
 To avoid penalties, traditional IRA owners must begin to receive payment from their accounts by no
later than April 1 following the year in which they turn the age of 72.

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 Funds may be withdrawn from an IRA prior to the employee reaching the age of 59 1/2 without being
subject to the 10% penalty tax (however, the interest is still taxable) for any of the following reasons:
‒ Death, disability, first-time homebuyers (up to $10,000 lifetime), education (no dollar
maximum), health insurance premiums (if unemployed), and qualified medical expenses
 Roth IRAs are designed so that withdrawals are received income tax-free. Contributions to Roth
IRAs are subject to the same limits as traditional IRAs, but are not tax-deductible. Interest on
contributions is not taxable as long as the withdrawal is a qualified distribution. Qualified
distributions must occur after five years, or due to the death or disability of the individual, or for a
first-time homebuyer (up to $10,000), or having reached the age of 59 1/2.
 A rollover is the transfer of funds from an IRA or qualified plan to another.
 Rollovers are subjected to a 20% withholding tax if eligible rollover funds are received personally by
a participant in a qualified plan unless the funds are deposited into a new IRA or qualified plan within
60 days of distribution.
 Funds that are transferred directly from one qualified IRA to another qualified IRA are not subject to
this withholding tax. This also includes a trustee-to-trustee transfer of rollover funds instead of
personally receiving the funds and then rolling them over. This election permits the participant to
avoid mandatory income tax withholding on the amount transferred.
 A surviving spouse who inherits IRA benefits from a deceased spouse’s qualified plan is eligible to
establish a rollover IRA in their own name.
 Rollover contributions to an individual retirement annuity (IRA) are unlimited by dollar amount.

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REVIEW NOTES: USES OF LIFE INSURANCE
Determining the Proper Insurance Amounts
 Human Life Value Approach: Calculates the amount of money that a person is expected to earn over
his lifetime to determine the face amount of life insurance he needs, thereby placing a dollar value on
an individual’s life.
 Needs Approach: A method of life insurance planning that identifies the needs of an individual and
their dependents. This approach determines the total funds available to a family from all sources and
subtracts the amount needed to meet their financial objectives. It takes into consideration:
‒ Final expense fund
‒ Housing fund
‒ Education fund
‒ Monthly income
‒ Emergency fund
‒ Income needs (if disabled or ill)
‒ Retirement income
‒ Estate conservation (using life insurance to enable heirs to pay estate taxes)
‒ “Needs” include ANY PERSON or ENTITY who’s dependent on that person (e.g., child,
charity, or pet)
 The needs approach to personal life insurance planning may involve creating a lump-sum to provide
for such things as education, retirement, and charitable contributions.
 The needs approach to personal life insurance planning also includes the creation of an emergency
reserve fund that’s primarily designed to cover the cost of unexpected expenses.

Business Uses of Life Insurance

 Buy-Sell agreements—also referred to as business continuation agreements—are used to assure the
business’s ownership is appropriately transferred upon the death or disability of an owner or partner.
Third-party ownership of life insurance policies is widely used in business insurance and estate-
planning situations.

Buy-Sell Funding for Sole Proprietors

 There’s a two-step business continuation plan to keep a business running after the proprietor’s death,
whereby the employee takes over management of the business:
1. Buy-Sell Plan: An attorney drafts a buy-sell plan which indicates the employee’s agreement to
purchase the proprietor’s estate and sell the business at a price that has been agreed upon
beforehand.
2. Insurance Policy: The employee purchases a life insurance policy on the life of the proprietor.
The employee is the policyowner, beneficiary, and pays the premiums. Upon the proprietor’s
death, the funds from the policy are used to purchase the business.

Buy-Sell Funding for Partnerships

 There are two types of buy-sell agreements for partnerships:
1. Cross-purchase plans
2. Entity plans
 In a cross-purchase plan, each partner buys, pays the premiums, and is the beneficiary of a life
insurance policy on each of the other partners. The amount of the policy is equivalent to each partner’s

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 share of the business. When one partner dies, each of the other partners receives the death benefit from
the life insurance on the deceased partner, which is then used to purchase the business ownership of
the deceased partner.
 In an entity plan, the partnership itself agrees to buy the deceased partner’s share of the business.
Entity plans are best for businesses with several partners. In this case, the business purchases, pays the
premiums, and is the beneficiary of life insurance on each partner.

Buy-Sell Funding for Closely Held Corporations

 Unlike a partnership, a closely held corporation (e.g., an incorporated family business) is legally
separate from its owners and exists after one or more owners dies. A closely held corporation may
purchase either buy-sell plans (i.e., either cross-purchase or entity). The difference is that an entity
plan is referred to as a stock redemption plan for closely held corporations.
 Closely Held Corporation Cross-Purchase Plan
‒ Similar to partnership cross-purchase plans, a closely held corporation cross-purchase plan
requires surviving stockholders to purchase the deceased stockholder’s interest in the company.
The deceased stockholder’s estate sells the interest to the surviving stockholders. The
corporation is not part of the buy-sell plan. Each stockholder owns, pays the premiums, and is
the beneficiary of life insurance on each of the other stockholders in an amount that’s equal to
his share of the corporation’s purchase price.
 Closely Held Corporation Stock Redemption Plan
‒ Similar to the partnership entity plan, the corporation purchases it, is the owner, pays the
premiums, and is the beneficiary of life insurance policies on each stockholder. The amount of
life insurance is equal to each stockholder’s share of the corporation’s purchase price. When a
stockholder dies, the corporation purchases, or redeems, the deceased stockholder’s share.
 Key Person Insurance: The purpose of key person insurance is to prevent the financial loss that may
result when an owner, officer, or manager dies.
‒ It pays for finding and training a replacement if the key employee dies prematurely.
‒ The company purchases, owns, pays the premiums, and is the beneficiary of the key person’s life
insurance policy.
‒ The premiums are not deductible for income tax purposes. However, the death proceeds received
by the business are not taxable.

Employee Benefit Plans

 Deferred compensation is an executive benefit that an employer can use to pay a highly paid employee
at a later date, such as upon disability, retirement, or death.
 A salary continuation plan works the same as deferred compensation except that the employer funds
the plan rather than the employee. The employer establishes an agreement whereby an employee will
continue to receive income payments upon death, disability, or retirement.

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