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The BISYS Group, Inc. (NYSE: BSG), headquartered in New York City, provides solutions that enable insurance companies, investment firms, and banks to expand their businesses and run their operations more profitably. BISYS currently supports more than 22,000 domestic and international financial institutions and corporate clients through several business units.
BISYS Education Services is the nation’s premier provider of licensing preparation, continuing education, and professional development courses for life, health, long-term care, annuity, and property-casualty insurance products as well as investments. This unit complements its education services with a comprehensive compliance management solution that supports insurance and investment firms and professionals with a sophisticated suite of services that automate the entire licensing process.
BISYS Insurance Services is the nation’s largest independent distributor of life insurance and provider of support services required to sell traditional and variable life and annuity products as well as long-term care and disability insurance. This unit is also the nation’s second largest independent wholesale distributor of commercial property/casualty insurance.
BISYS Investment Services group provides administration and distribution services for approximately 380 clients, representing more than 2,200 mutual funds, hedge funds, private equity funds, and other alternative investment products, with approximately $750 billion in assets under administration. It also provides retirement services to more than 18,000 companies in partnership with 40 of the nation’s leading banks and investment management companies and offers analytical research and competitive information through its Financial Research Corporation (FRC) subsidiary.
BISYS’ Information Services group supports approximately 1,450 banks, insurance companies, and corporations with industry-leading information processing and imaging solutions, turnkey asset retention solutions, and specialized corporate banking solutions. Additional information is available at www.bisys.com.
Eric Alan Anderson is Director of Insurance Education for BISYS Education Services, based in Indianapolis, Indiana. He has almost 25 years of experience creating training and test preparation materials for the financial services industry. In addition to authoring 17 insurance training texts and editing 8 others, he has written newsletters and magazine articles and has developed materials for audio cassette/workbook, videotape, computer disk, and the Web. He has also taught basic English skills courses at the college level and has made presentations to national conferences of insurance associations.
Matt McClure is Editor of Life/Health Products for BISYS Education Services. He maintains 42 titles on BISYS Education Services’ course list, including the Life/Health Concepts license preparation text and its supplementary review materials. Formerly a freelance writer and editor, his work has appeared in numerous nationally published books and magazines. He is a licensed life and health insurance producer.
Richard A. Morin, CIC, is a contract author based in Los Angeles, California. He has 35 years of experience writing and training on a broad range of subjects for the financial services industry. For several years he was an editor for a major insurance training publisher, and he has also worked as an insurance underwriter, a rating supervisor, and a licensed insurance and mutual fund sales representative.
Teresa Chapman has been in the insurance business since 1996, upon graduation from Ball State University in Muncie, IN. She started her career with State Farm Insurance Company as a Life and Health Underwriter. A series of moves with State Farm led to a variety of jobs; supervisor of Life and Health Policy Changes, and Life and Health compliance officer, and culminated in her decision to be a State Farm insurance agent located in Carmel, IN. Teresa now lives in Noblesville, IN, with her husband Trent, a State Farm auto claim representative, and their son, Christian.
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Introduction xxvii Self-Assessment xxxv Chapter 1 Introduction to Insurance 1 Chapter 2 Insurance Regulation 23 Chapter 3 Insurance Law 55 Chapter 4 Underwriting Basics 73 Chapter 5 Group Insurance 91 Chapter 6 Selling Life Insurance 101 Chapter 7 Policy Issuance and Delivery 121 Chapter 8 Types of Insurance Policies 137 Chapter 9 Policy Provisions 177 Chapter 10 Policy Options 205 Chapter 11 Annuities 221 Chapter 12 Group Life Insurance 239 Chapter 13 Social Security and Tax Considerations 247 Chapter 14 Retirement Plans 265 Chapter 15 Health Insurance Basics 281 Chapter 16 Health Insurance Policy Underwriting, Issuance, and Delivery 309 Chapter 17 Health Insurance Policy Provisions 321 Chapter 18 Disability Income Insurance 345
Chapter 19 Medical Expense Insurance 363 Chapter 20 Special Types of Medical Expense Policies 385 Chapter 21 Group Health Insurance 397 Chapter 22 Social Health Insurance 411 Chapter 23 Long-Term Care 433 Chapter 24 Health Insurance Taxation 451 Chapter 25 Practice Exam 1 461 Chapter 26 Answer Key 1 471 Chapter 27 Practice Exam 2 477 Chapter 28 Answer Key 2 487 Appendix A What’s on the CD-ROM 493 Appendix B Need to Know More 497 Glossary 501 Index 527
Chapter 1 Introduction to Insurance ......................................................1
Perils and Hazards 3
Managing Risk 3
Law of Large Numbers 4
Insurable Interest 5
Insurable Risks 6
Insurance Coverage Concepts 7
Limit Of Liability 8
Types of Insurance 9
Types of Insurers 10
Commercial Insurers 11
Nonprofit (Service) Organizations 11
Other Types of Private Insurers 12
The United States Government as an Insurer 13
Domicile and Authorization 14
Insurer’s Domicile (Domestic, Foreign, and Alien Insurers) 14
Authorized Versus Unauthorized (Admitted Versus
Types of Distribution Systems 15
Agency System 15
Mass Marketing 16
Internet Insurance Sales 17 Insurance Producers 17
Categories of Producers 17
Exam Prep Questions 19
Exam Prep Answers 22
Chapter 2 Insurance Regulation .........................................................23
Federal Regulation 24 Paul Versus Virginia 24 South-Eastern Underwriters Decision 24 McCarran-Ferguson Act 25 Privacy Act Of 1974 25 Fair Credit Reporting Act 27 False or Fraudulent Statements 30 Financial Services Modernization Act Of 1999 31 Other Regulating Agencies 32 State Insurance Regulation 32 Commissioner’s Scope and Duties 32 Regulating Insurance Companies 33 Insurer Solvency 34 Investments 34 Taxation of Life Insurance Companies 34 Company Ratings 35 Examination of Insurers 35 Guaranty Associations 36 Marketing and Advertising Life and Health Insurance 36 Producer Regulation 37 Licensing Regulation 37 License Required 37 Exceptions To License Requirements 38 Nonresident Producer Licensing 39 Obtaining a License 40 Application for Examination 40 Issuance of License 40 Temporary Agent Licenses 40 Maintaining a License 41 Change of Address 41 Assumed Names 41 Office and Records 41 Continuation, Expiration, and Renewal of License 42 Notice of Appointment 42 Termination of Appointment 43 License Denial, Nonrenewal, or Revocation 43
Table of Contents
Regulated Practices 44
License for Controlled Business Prohibited 45
Unfair Trade Practices 45
Unfair Claims Practices 47
The NAIC 49
Exam Prep Questions 50
Exam Prep Answers 53
Chapter 3 Insurance Law ..................................................................55
Agency Law 56
Agency Law Principles 56
Formation of a Life and Health Insurance Contract 60
Contract Elements 60
Parts of the Insurance Contract 62
Legal Requirements 63
Contract Construction 63
Contract Characteristics 64
Exam Prep Questions 68
Exam Prep Answers 71
Chapter 4 Underwriting Basics ...........................................................73
The Underwriting Process 74
Selection Criteria 75
Sources of Underwriting Information 75
Field Underwriting 80
Classification of Risks 81
Standard Risks 81
Preferred Risks 82
Determination of Premiums (Rating Considerations) 83
Mortality or Morbidity 83
Premium Mode 86
Loss Ratios 86
Insurance Fund Reserves 87
Exam Prep Questions 88
Exam Prep Answers 90
Chapter 5 Group Insurance ...............................................................91
Types of Groups 92
Group Premiums 93
Group Underwriting Considerations 93
Adverse Selection 94
Probationary Period 94
Eligibility Period 95
Requirements in Group Underwriting 95
Statutory Requirements 95
Optional Requirements 96
Funding of Group Insurance 97
Exam Prep Questions 98
Exam Prep Answers 100
Chapter 6 Selling Life Insurance .......................................................101
Meeting Consumer Needs 102
The Importance of Insurance 102
Costs Associated with Death 102
Human Life Value Approach 103
Needs Approach 104
Income Periods 104
Capital Conservation and Capital Liquidation 105
Estate Planning 105
Other Sources of Funds 106
Living Benefits 107
Advantages as Property 107
Comparing Insurance Policies 108
Comparative Interest Rate Method 109
Interest-Adjusted Net Cost Method 109
Personal Uses of Life Insurance 110
Charitable Uses of Life Insurance 111
Business Uses of Life Insurance 111
Sole Proprietorship 112
Exam Prep Questions 117
Exam Prep Answers 120
Table of Contents xiii
Chapter 7 Policy Issuance and Delivery ..............................................121
Collection of Premium 122 Receipts for Premium 122 Conditional Receipt 122 Binding Receipt 123 Inspection Receipt 124 Temporary Insurance Agreement 124 Submitting the Application and Initial Premium 124 Issuing the Policy 125 Delivering and Servicing the Policy 125 Personal Delivery 125 Mailing the Policy 126 Handling a Claim 126 Payment of Claims 126 Payment Less than Face Amount 127 Producer Responsibilities upon Insured’s Death 128 Policy Replacement 129 Duties of Producers 130 Duties of the Insurer 130 Policy Retention 131 Professionalism and Ethics 131 Fiduciary Responsibility 131 Summary of the Producer’s Responsibilities 132 Exam Prep Questions 133 Exam Prep Answers 135
Chapter 8 Types of Insurance Policies ................................................137
Term Insurance 138
Characteristics of Term Policies 138
Types of Term Policies 139
Advantages and Uses of Term Insurance 141
Disadvantages of Term Insurance 142
Whole Life Insurance 143
Characteristics of Whole Life Policies 143
Types of Whole Life Policies 145
Advantages and Uses of Whole Life Insurance 147
Disadvantages of Whole Life Insurance 147
Flexible Policies 147
Adjustable Life Insurance 147
Universal Life 148
xiv Table of Contents
Variable Life Insurance 151
Variable Universal Life 153
Advantages and Uses of Flexible Policies 154
Disadvantages Of Flexible Policies 154 Industrial Life Insurance 155
Industrial Life Policy Provisions 155 Credit Life Insurance 156
Credit Life Policy Provisions 156 Specialized Policy Forms 157
Family Income Policies 158
Family Maintenance Policies 159
The Family Policy (Family Protection Policy) 159
Retirement Income Policy 160
Joint Life Policies 160
Juvenile Policies 161
Minimum Deposit Policies 161
Modified Premium Policies 161
Graded Premium Plan 162
Mortgage Redemption 162
Multiple Protection 162
Index-Linked Policies 162
Deposit Term Insurance 163
Pre-need Funeral Insurance 163
Advantages and Uses of Specialized Policies 163
Disadvantages of Specialized Policies 164 Insurance Policy Riders 164
Accidental Death (Double Indemnity) 164
Waiver of Premium 165
Disability Income Rider 167
Payor Rider 168
Guaranteed Insurability 168
Return of Premium 169
Return of Cash Value 169
Cost of Living 169
Additional Insureds 170
Substitute Insured Rider 170 Accelerated Benefits 171
Living Benefit Provisions 171
Viatical Settlements 172 Exam Prep Questions 173 Exam Prep Answers 176
Table of Contents xv
Chapter 9 Policy Provisions .............................................................177
Standard Provisions 178
Insuring Clause 178
Consideration Clause 178
Execution Clause 179
Payment of Premium 179
Ownership Rights 179
Applicant Control or Ownership Clause 180
Grace Period 181
Policy Loan Provisions 182
Automatic Premium Loan Provision 183
Incontestability Clause 183
Suicide Clause 184
Entire Contract 184
Assignment Clause 185
Misstatement of Age or Sex 187
Medical Examinations and Autopsy 188
Modifications Clauses 188
Policy Change Provision (Conversion Option) 189
Free Look 189
Beneficiary Provisions 189
Revocable Versus Irrevocable 190
Succession of Beneficiaries 191
Naming of Beneficiaries 192
Designation Options 192
Class Designations 194
Per Capita and Per Stirpes 195
The Uniform Simultaneous Death Act 196
Spendthrift Clause 197
Facility of Payment Provision 198
Exclusions and Limitations 198
Aviation Exclusion 198
War or Military Service Exclusion 199
Hazardous Occupation or Hobby Exclusion 199
Prohibited Provisions 200
Exam Prep Questions 201
Exam Prep Answers 204
xvi Table of Contents
Chapter 10 Policy Options ................................................................205
Settlement Options 206
Interest Only Option 207
Fixed Period Option 207
Fixed Amount Option 208
Life Income Option 209
Withdrawal Provisions 209
Other Settlement Arrangements 210
Third-Party Rights and Creditor’s Rights 210
Advantages of Settlement Options 211
Nonforfeiture Options (Guaranteed Values) 211
Cash Surrender Value 211
Reduced Paid-Up Insurance Option 212
Extended Term Option 213
Insurance Dividends 213
Policy Dividend Sources 214
Dividend Options 214
Cash Dividend Option 215
Accumulation at Interest Option 215
Paid-Up Additions Option 215
Reduce Premium Dividend Option 216
Accelerated Endowment 216
Paid-Up Option 216
One-Year Term Dividend Option 217
Exam Prep Questions 218
Exam Prep Answers 220
Chapter 11 Annuities ......................................................................221
Purposes of Annuities 222
Distribution of a Lifetime Income 222
Accumulation of a Retirement Fund 222
How Annuities Work 223
The Accumulation Period 223
The Annuity Period 223
Nonforfeiture Options 224
Immediate and Deferred Annuities 225
Deferred Annuity Death Benefits 225
Annuity Premiums 226
Single Premium 226
Level Premium 226
Table of Contents xvii
Flexible Premium 226 Determining Annuity Payouts 227 Variable Annuities 228 Regulation as Securities 228 Accumulation Units 229 Annuity Units 230 Annuity Settlement Options 231 Life Annuities 231 Guaranteed Minimum Payouts 231 Joint Life and Survivorship and Joint Life Annuities 232 Temporary Annuity Certain 233 Two-Tiered Annuities 233 Tax-Sheltered Annuities 234 Retirement Income Annuities 234 Equity-Indexed Annuities 234 Market-Value Adjusted Annuities 235 Exam Prep Questions 236 Exam Prep Answers 238
Chapter 12 Group Life Insurance ........................................................239
Legal Requirements 240
Standard Provisions 241
Certificates of Insurance 241
Policy Forms 242
Dependent Coverage 242
Group Conversion Option 243
FEGLI and SGLI 244
Exam Prep Questions 245
Exam Prep Answers 246
Chapter 13 Social Security and Tax Considerations ..................................247
Social Security 248
Covered Workers 248
Types of Benefits 248
Eligibility for Social Security 248
Insured Status 249
Primary Insurance Amount 250
Normal Retirement Age 250
Dual Benefit Eligibility 251
Retirement Benefits 251
Survivor Benefits 251
xviii Table of Contents
Disability Benefits 252
Maximum Family Benefit 253
Earnings Limit 253
Social Security Payroll Taxes 253
Taxation of Social Security Benefits 254
Income Tax Treatment of Life Insurance 254
Individual Life Insurance 254
Group Life Insurance Proceeds 258
Doctrine of Economic Benefit 258
Federal Estate Tax 259
Charitable Uses of Life Insurance 259
Other Gifts of Life Insurance 260
Transfer for Value Rules 260
Section 1035 Policy Exchanges 261
Business Insurance 261
Exam Prep Questions 262
Exam Prep Answers 264
Chapter 14 Retirement Plans .............................................................265
Qualified and Nonqualified Retirement Plans 266 Vesting Rules 266 Defined Benefits Plans 267 Group Deferred Annuity 267 Individual Deferred Annuity 267 Defined Contribution Plans 268 Profit-Sharing Plans 268 Pension Plans 268 Individual Retirement Accounts and Annuities—IRAs 269 Roth IRAs 271 Savings Incentive Match Plan for Employees (SIMPLE) 271 Simplified Employee Pensions (SEPs) 272 KEOGH Plans 273 Tax-Deferred Annuity Arrangements—403(B) Arrangements 273 Plan Distributions 273 Incidental Limitations 274 Taxation of Plan Benefits 274 Rollovers 275 The Employee Retirement Income Security Act (ERISA) 275 Fiduciary Responsibility 275 Reporting and Disclosure 276 Exam Prep Questions 277 Exam Prep Answers 279
Table of Contents xix
Chapter 15 Health Insurance Basics ....................................................281
Types of Losses and Benefits 282 Loss of Income from Disability 282 Accidental Death and Dismemberment (AD&D) 282 Medical Expense Benefits 282 Dental Expense Benefits 283 Long-Term Care Insurance (LTC) 283 Limited Health Exposures and Insurance Contracts 283 Prescription Coverage 284 Determining Insurance Needs 284 Health Care Providers 285 Health Care Plans 285 Commercial Insurers 285 Blue Cross and Blue Shield 286 Health Maintenance Organizations (HMOs) 287 Federal Requirements 288 HMO Organization 289 Basic and Supplemental Services 291 Important Features Of HMOs 293 Preferred Provider Organizations (PPOs) 295 Point-of-Service Plans 296 Exclusive Provider Organizations (EPOs) 296 Emerging Variations 297 Multiple Option Plans 297 Employer-Administered Plans 297 Self-Funding 297 501(c)(9) Trusts 299 Small Employers 299 Cafeteria Plans 300 Multiple Employer Trusts (METs) 300 Multiple Employer Welfare Arrangements (MEWAs) 300 Other Forms of Group Insurance 301 Blanket Policies 301 Franchise Policies 301 Government Health Insurance 302 Workers Compensation 302 Medicaid 303 TRICARE 304 Exam Prep Questions 305 Exam Prep Answers 307
xx Table of Contents
Chapter 16 Health Insurance Policy Underwriting, Issuance, and Delivery ......309
Underwriting Objectives 310
Premium Payments 310
Definition of Premium 310
Earned and Unearned Premium 310
Payment Modes 311
Initial Premium 311
Policy Effective Date 312
Policy Term 312
Policy Fee 312
Delivering the Policy 313
Servicing the Policy 314
Replacement Policies 314
Professionalism and Ethics 315
Fiduciary Responsibility 316
Summary of the Producer’s Responsibilities 316
Exam Prep Questions 317
Exam Prep Answers 319
Chapter 17 Health Insurance Policy Provisions .......................................321
Mandatory Provisions 322 Required Provision 1: Entire Contract; Changes 322 Required Provision 2: Time Limit on Certain Defenses; Incontestability 323 Required Provision 3: Grace Period 323 Required Provision 4: Reinstatement 324 Required Provision 5: Notice of Claim 325 Required Provision 6: Claim Forms 326 Required Provision 7: Proof of Loss 326 Required Provision 8: Time of Payment of Claims 327 Required Provision 9: Payment of Claims 327 Required Provision 10: Physical Examination and Autopsy 329 Required Provision 11: Legal Actions 329 Required Provision 12: Change of Beneficiary 329 Optional Policy Provisions 330 Optional Provision 1: Change of Occupation 330 Optional Provision 2: Misstatement of Age 331 Optional Provision 3: Other Insurance in This Insurer 331
Table of Contents xxi
Optional Provisions 4 and 5: Insurance with Other Insurers 332 Optional Provision 6: Relation of Earnings to Insurance— Average Earnings Clause 333 Optional Provision 7: Unpaid Premium 334 Optional Provision 8: Cancellation 334 Optional Provision 9: Conformity with State Statutes 335 Optional Provision 10: Illegal Occupation 335 Optional Provision 11: Narcotics 336 Other Health Insurance Provisions 336 The Policy Face 336 Free Look 336 Insuring Clause 337 Consideration Clause 337 Policy Continuation 337 Benefit Payment Clause 339 Preexisting Conditions 339 Nonoccupational Coverage 339 Case Management Provisions 340 Exam Prep Questions 341 Exam Prep Answers 343
Chapter 18 Disability Income Insurance ...............................................345
Financial Planning Considerations 346
Alternatives to Disability Income Insurance 346
Definitions and Benefits 347
Probationary Period 347
Elimination Period 347
Benefit Period 348
Defining Total Disability 348
Presumptive Disability 349
Partial Disability 349
Residual Disability 350
Recurrent Disability 350
Permanent Disability 350
Temporary Disability 350
Confining Versus Nonconfining Disability 351
Accidental Means 351
Definition of Sickness 351
xxii Table of Contents
Types of Disability Benefits 351 Short-Term Disability 352 Long-Term Disability (LTD) 352 Lump-Sum Benefits 352 Disability Exclusions 352 Optional Disability Income Policy Benefits and Riders 353 Rehabilitation Benefit 353 Future Increase Option 353 Cost of Living Benefit 353 Lifetime Benefits 354 Social Security Rider 354 Social Insurance Supplements 355 Additional Monthly Benefit (AMB) Riders 355 Hospital Confinement Rider 355 Impairment Rider 355 Nondisabling Injury Rider 355 Waiver of Premium (with Disability Income) 356 Accidental Death and Dismemberment (AD&D) 356 Other Provisions 356 Business Uses of Disability Income Insurance 357 Business Overhead Expense (BOE) 357 Key Person Disability Insurance 357 Disability Buy-Sell Insurance 358 Disability Reducing Term Insurance 358 Exam Prep Questions 359 Exam Prep Answers 361
Chapter 19 Medical Expense Insurance ................................................363
Basic Medical Expense 364
Hospital Expense Benefits 364
Surgical Expense Benefits 365
Regular Medical Expense Benefits 366
Other Medical Expense Benefits 367
Common Exclusions and Limitations 369
Major Medical Insurance 371
Comprehensive Major Medical Benefits 371
Supplemental Major Medical Benefits 372
Covered Expenses 372
Other Major Medical Concepts 373
Medical Expense Limitations 375
Benefits for Other Practitioners 377
Medical Expense Exclusions 377
Table of Contents xxiii
Optional Features and Benefits 379
Prescription Drugs 379
Vision Care 379
Hospital Indemnity Rider 380
Nursing/Convalescent Home 380
Organ Transplants 380
Exam Prep Questions 381
Exam Prep Answers 383
Chapter 20 Special Types of Medical Expense Policies .............................385
Dental Care Insurance 386
Traditional Dental Coverage 386
Exclusions and Limitations 388
Minimizing Adverse Selection 388
Prepaid Dental Plans 389
Limited Policies 390
Dread Disease 390
Travel Accident Insurance 390
Hospital Income (Indemnity) Insurance 391
Vision Care Insurance 391
Prescription Drug Policies 391
Credit Insurance 392
Notice of Proposed Insurance 393
Credit Life: A Corollary Coverage 393
Exam Prep Questions 394
Exam Prep Answers 396
Chapter 21 Group Health Insurance .....................................................397
Group Health Insurance Policy Types 398 Group Coverage Provisions 398 Conversion Privilege 399 Dependent Coverage 400 Coordination of Benefits Provision 400 Records and Clerical Errors 401 Federal and State Regulations Affecting Group Policies 401 Health Insurance Portability and Accountability Act (HIPAA) 401 Continuation of Benefits (COBRA) 402 Omnibus Budget Reconciliation Act (OBRA) 404 Tax Equity and Fiscal Responsibility Act (TEFRA) 405
xxiv Table of Contents
Employee Retirement Income Security Act (ERISA) 405 Age Discrimination in Employment Act (ADEA) 406 The Americans with Disabilities Act (ADA) 406 Pregnancy Discrimination 406 State Regulation 407 Exam Prep Questions 408 Exam Prep Answers 410
Chapter 22 Social Health Insurance .....................................................411
Benefits Under Medicare Part A 413
What Part A Does Not Cover 415
Benefits Under Medicare Part B 415
What Part B Does Not Cover 418
Claims and Appeals 418
Medicare Supplement Insurance 419
Standardized Medicare Supplement Benefits 419
Core Benefits 419
Optional Benefits 420
Standardized Policy Forms 420
Other Standard Provisions 421
Fee-for-Service Plans 422
Health Maintenance Organizations (HMOs) 423
Preferred Provider Organizations (PPOs) 423
Provider-Sponsored Organizations (PSOs) 423
Medicare and Employer Coverage 424
Financial Tests 425
Spousal Impoverishment Rule 425
Medicare Cost Assistance 425
Social Security Disability 426
Workers Compensation 427
Types of Benefits 427
Compensable Injuries 427
Occupational Diseases 427
Types of Disability 428
Compulsory and Elective Compensation Laws 428
Extraterritorial Provisions 428
Second Injury Funds 429
Table of Contents xxv
Exam Prep Questions 430
Exam Prep Answers 432
Chapter 23 Long-Term Care ..............................................................433
History of LTC Coverage 434
Suitable Purchasers 435
Probability of Needing Care 437
Options Other than Insurance 437
Rating Factors 438
Types of Benefits 438
Common Provisions 439
Waiver of Premium 440
Prior Hospitalization 440
Care Level 440
Hospice Care 441
Respite Care 441
Home Health Care 441
Adult Day Care 441
Professional Care Advisor 442
Benefit Amount 442
Benefit Periods 442
Preexisting Conditions 443
Elimination Period 443
Benefit Triggers 443
Activities of Daily Living (ADL) 443
Cognitive Impairment 444
Medical Necessity 444
Qualified Plans 444
Emerging LTC Issues 445
Inflation Protection 445
Nonforfeiture Provisions 446
Marketing LTC Coverage 446
Exam Prep Questions 447
Exam Prep Answers 449
xxvi Table of Contents
Chapter 24 Health Insurance and Taxation .............................................451
Social Security Disability Benefits 452 Tax Treatment of Social Security Contributions 452 Health Insurance 452 Individual Policies 452 Group Policies 453 Sole Proprietors and Partnerships 454 Business Policies 454 Disability Insurance 455 Medicare Supplement and Long-Term Care Insurance 455 Exam Prep Questions 457 Exam Prep Answers 459
Chapter 25 Practice Exam 1 ..............................................................461
Chapter 26 Answer Key 1 .................................................................471
Chapter 27 Practice Exam 2 ..............................................................477
Chapter 28 Answer Key 2 .................................................................487
Appendix A What’s on the CD-ROM ......................................................493
Review Questions and Exam Simulator 493
Installing the CD 494
Customer Service and Ordering 495
Appendix B Need to Know More? ........................................................497
Welcome to Life and Health Insurance Licensing Exam Cram 2! Whether this is your first or your fifteenth Exam Cram 2 series book, you’ll find information here that will help ensure your success as you pursue knowledge, experience, and certification. This introduction explains state insurance licensing programs in general and talks about how the Exam Cram 2 series can help you prepare for your state insurance licensing exam. Chapters 1 through 19 are designed to remind you of everything you need to know in order to take—and pass—your state insurance licensing exam. The two sample tests at the end of the book should give you a reasonably accurate assessment of your knowledge—and, yes, we provide the answers and their explanations to the tests. Read the book and understand the material, and you stand a very good chance of passing the test.
Exam Cram 2 books help you understand and appreciate the subjects and materials you need to pass state insurance licensing exams. Exam Cram 2 books are aimed strictly at test preparation and review. They do not teach you everything you need to know to pass the exam. Instead, we present and dissect the questions and problems I’ve found that you’re likely to encounter on a test. I’ve worked to bring together as much information as possible about state insurance licensing exams.
Nevertheless, to completely prepare yourself for any state insurance licensing test, we recommend that you begin by taking the Self-Assessment that is included in this book, immediately following this introduction. The Self-Assessment tool will help you evaluate your knowledge base against the requirements for a state insurance licensing exam under both ideal and real circumstances.
Based on what you learn from the Self-Assessment, you might decide to begin your studies with some more comprehensive self-study or classroom training, some practice with state insurance exam simulators, or an audio review program. On the other hand, you might decide to pick up and read one of the many study guides available from third-party vendors on certain topics. We also recommend that you supplement your study program with a visit to your state insurance department’s website to get all the details about
how to get your insurance license as well as how to schedule and take your insurance licensing exam.
Licensing is the way governments assure that only qualified individuals are allowed to practice certain important professions, such as being an insurance producer. Because insurance is regulated primarily at the state level, the rules for getting an insurance license vary somewhat from state to state.
Every state requires individuals to pass a qualification exam to get an insurance license. In addition, most states require individuals to meet a prelicensing education requirement before they can take the qualification exam. In some states, the prelicensing education requirement can be met through an approved self-study course—that is, you buy a book that has been approved in advance by the state insurance department and take an exam (not to be confused with the licensing qualification exam) that you send in to be graded. In other states, the prelicensing education requirement can be met only by attending an approved classroom course.
This Exam Cram text is not approved to meet the prelicensing education requirement in any state. It is designed only as a supplementary aid to help you pass the state insurance licensing exam.
Besides fulfilling any prelicensing education requirement and passing the licensing exam, insurance license candidates must also submit a license application to their state insurance department and have it approved. In some states, the license application must be submitted before taking the license qualification exam; in some states, it must be submitted after passing the exam. Call your state insurance department’s licensing division or visit its website to find out what you need to do in your state.
As with other aspects of insurance licensing, specific instructions on how to register for your qualification exam are available from the insurance department. Ask for a licensing information bulletin or a licensing candidate handbook, which will describe where and when exams are given, the fees you must pay, and the testing procedures.
One thing all state insurance qualification exams have in common is that they are closed-book exams. You will not be allowed to take any study materials or notes into the testing room. Even phones and calculators might not be allowed. In some states, the only items exam candidates are permitted to take into the testing room are their wallet and keys.
In most states, insurance qualification exams are given on computers. However, you will not need any computer or typing skills to take the exam. You will be instructed on how to answer questions and given a short practice test to get comfortable with the equipment before the actual qualification exam begins.
When you complete a computer-administered exam, the software tells you immediately whether you passed or failed. Your states will have its own rules for retesting in the event you don’t pass. Those rules will be described in your licensing information bulletin/candidate handbook.
Whether or not your state has a prelicensing education requirement, you’ll want to study in preparation for the license qualification exam. And even if your state has a prelicensing education requirement, you’ll probably want to do some additional studying to make sure you are fully prepared for the exam. Your options for additional study include the following:
In addition, you will surely find Que Publishing’s Exam Cram 2 insurance licensing preparation materials useful in your quest for insurance knowledge. Exam Cram 2 books provide you with a review of the essential information you need to know to pass the tests. They focus on the detailed information in the Concepts texts available from BISYS Education Services. Together, the BISYS Education Services license training packages and the Exam Cram 2 review materials create a powerful exam preparation program.
This set of required and recommended materials represents an unparalleled collection of sources and resources for insurance licensing qualification and related topics. Our hope is you’ll find that this book belongs in that company.
This book by itself will not teach you everything you need to know to pass your insurance licensing exam. It does not cover the state-specific topics that appear on the exam, usually dealing with laws that apply only in your particular state. That information, although it represents a small proportion of the entire exam, is critical to passing the exam. State-specific topics are covered in the state insurance law digests available from BISYS Education Services. This book reviews the rest of what you need to know before you take the test, with the fundamental purpose dedicated to reviewing the non–state-specific information on the insurance licensing exam.
This book uses a variety of teaching and memorization techniques to analyze the exam-related topics and to provide you with ways to input, index, and retrieve what you need to know in order to pass the test.
This book is designed to be read as a pointer to the areas of knowledge on the test. In other words, you may want to read the book through once to get an insight into how comprehensive your knowledge of insurance is. The book is also designed to be read shortly before you go for the actual test and to give you a distillation of the topics covered by the exam in as few pages as possible. We think you can use this book to get a sense of the underlying context of any topic in the chapters—or to skim-read for Exam Alerts, bulleted points, summaries, and topic headings.
We draw on material from each state’s exam outlines and from other preparation guides, in particular, BISYS Education Services’ Property-Casualty Concepts text. Our aim is to walk you through the knowledge you will need and point out those things that are important for the exam (Exam Alerts, practice questions, and so on).
We demystify insurance jargon, acronyms, terms, and concepts. Also, wherever we think you’re likely to blur past an important concept, we define the assumptions and premises behind that concept.
We structured the topics in this book to build on one another. Therefore, the topics covered in later chapters might refer to previous discussions in earlier chapters. We suggest you read this book from front to back.
After you read the book, you can brush up on a certain area by using the Index or the Table of Contents to go straight to the topics and questions you want to reexamine. We use headings and subheadings to provide outline information about each given topic. After you pass the exam and obtain your insurance license, we think you’ll find this book useful as a tightly focused reference and an essential foundation of insurance information.
Each Exam Cram 2 chapter follows a regular structure, with graphical cues about especially important or useful material. The structure of a typical chapter is as follows:
This is what an Exam Alert looks like. An Exam Alert stresses concepts or terms that will most likely appear in one or more license exam questions. For that reason, we think any information found offset in Exam Alert format is worthy of special attention.
Even if material isn’t flagged as an Exam Alert, all the content in this book is associated in some way with test-related material. What appears in the chapter content is critical knowledge.
➤ Notes—This book is an overall examination of entry-level insurance knowledge. As such, we touch on many aspects of insurance that open doors for further inquiry. Where a topic goes deeper than the scope of the book, we use notes to indicate areas of concern or further training.
Cramming for an exam will get you through a test, but it won’t make you a fully competent insurance professional. Although you can memorize just the facts you need in order to become licensed, your daily work in the field will rapidly put you in water over your head if you don’t continue your insurance education.
➤ Tips—Besides Alerts and Notes, we also include tips to help you remember or distinguish certain information that may appear on your license exam.
Pay special attention to Tips because they provide you with various techniques that may improve your exam score!
The bulk of the book follows this chapter structure, but there are a few other elements that we would like to point out:
Life and Health Insurance Licensing Exam Cram 2 is a real-world tool that you can use to prepare for and pass your state insurance licensing exam. We’re interested in any feedback you would care to share about the book, especially if you have ideas about how we can improve it for future test-takers. We’ll consider everything you say carefully and will respond to all reasonable suggestions and comments. You can reach us via email at email@example.com.
Let us know if you found this book to be helpful in your preparation efforts. We’d also like to know how you felt about your chances of passing the exam before you read the book and then after you read the book. Of course, we’d love to hear that you passed the exam—and even if you just want to share your triumph, we’d be happy to hear from you.
Thanks for choosing us as your license exam preparation coach, and enjoy the book. We wish you luck on the exam, but we know that if you read through all the chapters and work with the product, you won’t need luck— you’ll pass the test on the strength of real knowledge!
We include a Self-Assessment in this Exam Cram 2 to help you evaluate your readiness to take and pass your state insurance license qualification exam. It should also help you understand what you need to master for an entry-level knowledge of the industry in which you are about to embark on a career.
Whether you attend a class to get ready for your exam or use self-study materials, some preparation for your insurance license qualification exam is essential. You want to do everything you can to pass on your first try.
You can get all the confidence you need from knowing that many others have gone before you. If you’re willing to tackle the process seriously and do what it takes to gain the necessary knowledge, you can take—and pass—the insurance license qualification exams. In fact, the Exam Crams and the companion state license training packages from BISYS Education Services are designed to make it as easy as possible for you to prepare for these exams—but prepare you must!
You can obtain an outline of exam topics, practice questions, and other information about insurance qualification exams from your state insurance department’s web-site. If your state has contracted with an exam administration company to administer its insurance licensing exams (which is usually the case) you can get the exam information from the exam administrator’s website. Contact your state insurance department for more information.
We have included in this book several review exam questions for each chapter and two practice exams at the end of the book. If you don’t score well on the chapter questions, you can study more and then retake the review questions at the end of each part. When you have gone through all the chapters, take the first practice exam and then score yourself. Review by reading the
explanations that accompany the answer key in the chapter following that exam. If you don’t earn a score of at least 80% on the first practice exam, you’ll want to do some additional study. Go back through this book, and also consult your notes and/or your text from any licensing exam preparation course you took. Then try the second practice exam in this book. Again, shoot for a score of 80% or better on your first try.
There is no better way to assess your exam readiness than to take a high-quality practice exam and pass with a score of 80% or better on your first try for that exam. When you take the same practice exam over and over, you begin to memorize the answers to the specific questions on that exam. It may help you improve your knowledge, but it spoils the value of the exam as an indication of how well you might respond to an exam containing questions over the full range of topics on your state’s exam outline. Even though you must score only 70% to pass the actual exam, shoot for 80% on a practice exam to leave room for the fact that you might be nervous during the actual exam and that the questions on the actual exam might be more difficult than those on your practice exam.
If you did not score 80% or better on your first try, investigate the other study resources available (see the “Need to Know More?” addendum at the end of this book).
If you’ve given your utmost to self-study materials and then taken the exam and failed anyway, consider taking a class. For some people, self-study is not the optimal learning format. The opportunity to interact with an instructor and fellow students can make all the difference. For information about classes available in your area, ask your state insurance department or call BISYS Education Services (800-241-9095) to see whether there are schools using BISYS insurance licensing textbooks nearby.
One last note: Do not use practice exams as your only means of study for the exam. Next to not preparing at all, the best way to assure you’ll fail your license qualification exam is to skip studying and go directly to taking question-and-answer practice tests to assess your readiness to take the exam. Practice exams are a gauge of how well you’ve comprehended your study material—they are not an accurate reflection of the questions you will see on your license qualification exam.
Besides studying for the exam, there are some other things you should do to make sure you perform well on the exam:
Insurance license exams are designed so that they can be passed by individuals with no insurance industry experience or formal insurance schooling, other than any state-required prelicensing education requirement. So if you are completely new to this business, don’t worry. Everything you need to know to pass your qualification exam can be obtained in the study materials referenced here.
In terms of having a successful insurance career after you pass your exam, the most important requirement is a sincere desire to help people solve their financial problems and reach their financial goals. However, there is certain background that can be an asset as you start out in the job. If you have run your own business, you already understand the type of self-discipline and motivation that will help you succeed in your insurance sales activities. If you have some prior sales experience—such as a customer service representative, real estate agent, or some other sales position—you’ll probably have a comfort level with meeting people to discuss and solve their needs. But again, if you’re new to insurance or to sales, have no fear on that account. You will have ample opportunity and resources for learning everything you need to know.
After you’ve undertaken the right studies and reviewed the many sources of information to help you prepare for the license qualification exam, you’ll be ready to take a practice exam. When your scores are positive enough to indicate that you will get through the exam, you’re ready to go after the real thing. Good luck!
|Terms you need to understand:|
|✓||Exposure unit||✓||Authorized or admitted insurer|
|✓||Stock insurer||✓||Unauthorized of nonadmitted insurer|
|✓||Mutual insurer||✓||Insurance agents|
|✓||Reciprocal insurer||✓||Insurance brokers|
|✓||Fraternal insurer||✓||Insurance solicitors|
|✓||Lloyd’s associations||✓||Insurance consultants|
|Concepts you need to master:|
|✓||Methods of managing risk||✓||Limit of liability|
|✓||Law of large numbers||✓||Deductible|
|✓||Speculative risk||✓||Independent agency system|
|✓||Pure risk||✓||Exclusive or captive producers|
|✓||Insurable risk||✓||Direct writing companies|
The future is notoriously unpredictable. Every day, each of us faces the possibility that something might happen that would result in a personal financial loss. Sickness, disability, premature death, and damage or loss of property are examples of things that might cause a financial loss. We know that these things will happen to some people and not to others, but we do not know which things will happen to any particular person. In the face of this uncertainty, the idea and business of insurance was developed as a means for spreading the result of a financial loss among many persons, so the cost to any one person is small.
The basic mechanism behind insurance is relatively simple. The insurance company or insurer receives relatively small amounts of money, referred to as premium, from each of the large number of people buying insurance. A large uncertain loss is exchanged for a specific small amount of premium.
The agreement between the insurer and the insured, the person who is covered by the insurance, is established in a legal document referred to as a contract of insurance or a policy. The insurer promises to pay the insured according to the terms of the policy if a loss occurs. Loss is defined as reduction in the value of an asset. To be paid for a loss, the insured must notify the insurer by making a claim. The claim is a demand for payment of the insurance benefit to the person named in the policy.
To really understand insurance and how it works, you must first understand risk. Risk is the possibility that a loss might occur and is one of the reasons that people purchase insurance.
Notice that risk is not the loss itself, but the uncertainty of loss. There are some losses that are certain to happen eventually, such as when a rug finally wears out after years of use, or the fact that a person will eventually die.
There are two types of risks, only one of which can be covered by insurance:
A peril is the cause of a potential loss. Accident, fire, explosion, and flood are common perils that may be covered by insurance. A hazard is a condition that increases the seriousness of a potential loss or increases the likelihood that a loss will occur. Slippery floors, unsanitary conditions, and improperly stored gasoline are hazards Four types of hazards may contribute to losses:
Risks sometimes result in small losses, such as a stubbed toe or lost pocket comb. But risks may also result in serious financial losses, such as when a person is injured in a car accident or contracts a fatal disease. There are four ways of managing risk:.
1. The first method is to avoid risk. For example, a person might avoid the risk of being in an automobile accident by never getting into a car. However, not all risk is avoidable.
Multiple methods may be employed simultaneously to manage the same risk. For example, purchasing an insurance policy to cover a significant exposure involves risk transfer; selecting a high deductible in order to reduce premiums involves an element of risk retention.
When an individual purchases insurance, the risk is transferred from the individual to the insurer. To make a successful business of accepting the transfer of individual risk, the insurer needs to have some idea of how many losses will actually occur.
Insurance companies cannot predict the losses expected for any given individual. However, using the law of large numbers, insurers are able to predict how many losses will occur in a group. The basic principle of this law is that the larger the group, the more predictable the future losses in the group will be for a given time period. The insurance company cannot reliably predict which people will die, but with a large enough population, statistics can accurately predict how many people in the group will suffer a loss. For example, experience might show that out of a group of 100,000 people aged 40, about 325 will die each year.
For the law of large numbers to operate, it is essential that a large number of similar risks, or exposure units be combined. An exposure unit is the item of property or the person insured. The exposure unit in life and health insurance is the economic value of the individual person’s life. In property and casualty insurance it is the number of cars, homes, and so forth.
The degree of error in predicting future losses decreases as the number of individual exposure units in a group increases. Thus, the larger the group, the more closely the predicted experience will approach the actual loss experience. Insurance companies deal only with averages, in the sense of establishing actuarial predictions of loss experience. By providing for the average risk, the extremes in loss experience cancel each other out.
Actuaries are mathematicians who study and compile statistical data regarding exposure units and risks. This data is the basis for mortality and morbidity tables used to predict probable losses due to death (mortality) or sickness (morbidity) of large groups of people.
Insurance companies collect premiums to cover expenses, profits, and the cost of expected losses. The expected losses are based on the past experience of the average risk. The fact that some people never experience an automobile accident or that some live well beyond their life expectancy is immaterial, because other people are involved in accidents or die prematurely. Those insureds who suffer loss are compensated; many other insureds do not experience sizable losses.
A basic rule governing insurance states that before an individual can benefit from insurance, that individual must have must have a legitimate interest in the preservation of the life or property insured. This requirement is called
A person is presumed to have an insurable interest in his or her own life. An individual is also considered to have an insurable interest in the life of a close blood relative or a spouse. In these cases insurable interest is based on the love that individual would have for the family member and a real interest in protecting the life of that family member.
Insurable interest can also be based on a financial loss that will take place if an insured individual dies. Examples are two partners in a business, each of whom brings substantial expertise to that business. If one partner dies, the business could fail, resulting in a loss to the other partner.
For life insurance, insurable interest must exist at the time of the application for insurance, but it need not exist at the time of the insured’s death. In contrast, property and casualty insurance generally requires an insurable interest to exist only at the time of loss.
Insurable interest affects who may purchase a policy, but not who may ben
efit from a policy. For example, an individual could purchase life insurance
on his or her own life and name a charitable organization as the beneficiary.
Because every person is presumed to have an insurable interest in his or her own life, the policy would be valid. As another example, a doctor who benefits from medical expense reimbursement payments may not have an insurable interest in the health of the insured, but the policyowner, usually the insured or the insured’s employer, does have a personal or financial interest in keeping the insured healthy.
Not all risks are equally insurable. Insurable risks have certain characteristics that make the rate of loss fairly predictable, allowing insurers to adequately prepare for the losses that do occur. The more closely a risk aligns with the following characteristics, the more insurable it is.
The expected loss experience of a group of exposure units cannot be predicted with any certainty unless there are a large number of exposure units in that group. Risks are not considered insurable unless the insurance company has a large enough number of similar (homogeneous) risks and knows enough about their previous loss experience to be able to reliably predict possible future losses.
Because the purpose of insurance is to reduce or eliminate the uncertainty of economic loss, the insurer must be able to place a monetary value on the loss. In life insurance, monetary value is placed on the insured’s human life value or ability to earn an income. In health insurance, economic loss is measured by lost wages or by actual medical expenses incurred. The potential loss must be measurable so that both parties can agree on the precise amount payable in the event the loss occurs.
Because the purpose of insurance is to reduce or eliminate uncertainty, it is obviously not in the public interest to permit the writing of insurance for intentional acts, such as a man jumping off a skyscraper 2 days after purchasing an insurance policy. Uncertainty arises out of not knowing what is going to happen or being unable to predict what is going to happen to the individual exposure unit. If insurance is provided for certain losses, the element of chance is not a factor. Nor is there any element of uncertainty in losses occasioned by natural wear and tear or deterioration, depreciation, or defects in property covered under insurance.
With life insurance, the uncertainty rests not with whether a certain individual will die, but rather with when that individual will die and what financial obligations will be left behind when death occurs. With health insurance, the uncertainty rests less with whether a certain individual will have an accident or become ill sometime during his or her lifetime, but rather with how much expense will be incurred when an illness or accident occurs.
The nature of the loss must be such that an economic hardship would occur should the loss occur. For example, if a person loses 2 days of pay because of an injury, a loss occurs, but it is not significant enough to be covered by insurance.
The nature of the loss must be of such magnitude that it is worthwhile to incur the premium cost to cover potential loss. Thus, a comparison of the potential loss with the cost of premium is a major consideration to the insurance buyer.
Although the ability to predict future losses with a reasonable degree of accuracy is critical to the insuring function, certain types of perils do not lend themselves to prediction. Such perils, when they cause losses, do not establish a pattern of predictability that can be relied on for future predictions of anticipated loss. Examples of excluded catastrophic perils are war, nuclear risk, and floods.
The following material reviews some of the concepts that are important for understanding how insurance works.
The concept of indemnity states that insurance should restore the insured, in whole or in part, to the condition he or she enjoyed prior to the loss. Restoration may take the form of payment for the loss or repair or replacement of the damaged or destroyed property.
In life and health insurance, the concept of indemnity has a slightly different meaning in that a person’s economic value or human life value is the individual’s present and future earning power. For example, a family is indemnified for the financial loss of the breadwinner by being provided with life
insurance proceeds with which to replace present and future income and thus enable the family to maintain its lifestyle. An individual is indemnified for the financial loss of a broken arm by being provided with health insurance proceeds to pay the medical bills and perhaps to cover wages lost due to the injury.
Although the term limit of liability is not used in the life and health insurance field as commonly as it is in the property and casualty field, it means the maximum amount the insurer will pay for a specified insured contingency.
Life insurance policies usually use the term face amount to refer to the maximum liability of the insurer for a death claim. However, the face amount may not always be the maximum amount payable. In the case of a double indemnity provision, the limit of liability for an accidental death may be expressed as “twice the face amount” shown on the face of the policy.
Health and disability policies are more likely to specify a maximum benefit amount or period instead of a limit of liability. Basic medical insurance often has a maximum benefit amount (such as $10,000), and major medical insurance usually has a lifetime maximum benefit (such as $1 million). Disability income policies often limit benefits to a specified maximum benefit period (expressed in weeks or months). Within the maximum benefit limits found in health and disability policies there may be various sublimits—such as daily dollar limits on covered room and board charges, scheduled maximum amounts for various surgical procedures, and weekly dollar limits for disability income benefits.
Deductibles are a common feature of medical insurance coverages (the term has no application in life insurance). A deductible is simply the initial amount of a covered loss (or losses) that the insured must absorb before the insurer begins to pay for additional loss amounts. For example, if a basic medical expense policy pays losses only above a $250 deductible and an insured incurs $1,000 of covered medical expenses, the insured would have to pay the first $250 and the insurer would then pay the additional $750 of expenses.
Disability insurance usually has an elimination period or a waiting period that is similar to a deductible. The elimination period is simply a number of days that an insured must be disabled before disability income benefits become payable. For example, if a policy specifies an elimination period of 7 days and an insured is disabled for 30 days, the policy would pay benefits only for the 23 days following the elimination period.
The purpose of a deductible is to minimize small nuisance claims and to keep premiums down. It might cost an insurer much more just to process the paperwork on $10 and $25 claims than the amount of the claims. Naturally, these costs would have to be reflected in insurance rates if such small claims were covered. Deductibles help eliminate this problem and keep rates down. Insurers usually offer a standard deductible, but give applicants the option of purchasing higher deductibles that result in even lower premiums.
Coinsurance is another concept commonly found in medical insurance policies. It means that within a specified coverage range, the insured and insurer will share the allowable expenses. It is usually expressed in percentages (such as 20%–80%). For example, if a policy has a $500 deductible and a 20%/80% coinsurance provision for the next $10,000 of expenses, a $5,500 medical bill would be settled in the following manner: The insured would pay the first $500 (the deductible amount) and $1,000 of the additional expenses (the insured’s 20% share); the insurer would pay the remaining $4,000 (the insurer’s 80% share).
Insurers market a variety of insurance products. The most common products offered are property, casualty, life, health insurance, and annuities:
10 Chapter 1
dying too soon. Premature death exposes a family or a business to certain financial risks, such as burial expenses, paying off debts, loss of family income, and business profits.
Insurance is provided to the public by three major sources: private commercial insurers (profit-making), private noncommercial insurers (nonprofit service organizations), and the United States government (special nonprofit). Other types of private insurers include reciprocals, fraternals, Lloyd’s, reinsurers, and selfinsurers.
Private life and health insurers are in the business to make a reasonable profit, and are, therefore, called commercial insurers. Stock and mutual insurers are private insurers. Private noncommercial service organizations, like Blue Cross and Blue Shield, operate on a nonprofit basis. A nonprofit status exists when
Introduction to Insurance 11
profits are returned to subscribers in the form of reduced premium or expanded benefits (similar to mutual insurers).
The most common types of insurers are commercial insurance companies.
A stock insurance company, like other stock companies, consists of stockholders who own shares in the company. The individual stockholders provide capital for the insurer. In return, they share in any profits and any losses. Management control rests with the board of directors, selected by the stockholders. The board of directors elects the officers who conduct the daily operations of the business. Capital stock companies control two-thirds of the premiums in the property and liability field and nearly one-half of the premiums in life insurance. If the board of directors declares a dividend, it is paid to the stockholders. Often a stock company is referred to as a nonparticipating company because policyholders do not participate in dividends.
In a mutual company, there are no stockholders. Formation funds must be contributed by someone or some group. Because of the difficulties involved today in obtaining the funds to organize a mutual company, many mutual companies start as stock companies and then mutualize.
In a mutual company, ownership rests with the policyholders. They vote for a board of directors that in turn elects or appoints the officers to operate the company. Funds not paid out after paying claims and not used in paying for other costs of operation are returned to the policyowners in the form of policy dividends. As such, mutual companies are sometimes referred to as participating companies because the policyowners participate in dividends.
Service insurers are unique to the health insurance field, and technically they are not insurers. They are organizations providing prepaid plans for hospital, medical, and surgical expenses. They do not provide cash benefits (except under certain limited conditions) to the plan subscriber, but instead pay the provider of medical services used by the plan subscriber to the extent covered in the contract. Best known of the service insurers are the various Blue Cross and Blue Shield plans. Blue Cross plans cover hospital expenses and Blue Shield plans cover medical and surgical expenses.
12 Chapter 1
There are a few other types of private insurers.
Reciprocal insurers are unincorporated groups of people providing insurance for one another through individual indemnity agreements. Each individual who is a member of the reciprocal is known as a subscriber. Each subscriber is allocated a separate account where his or her premiums are paid and interest earned is tracked. If any subscriber should suffer a loss provided for by the reciprocal insurance, each subscriber account would be assessed an equal amount to pay the claim. Administration, underwriting, sales promotion, and claims handling for the reciprocal insurance is handled by an attorney-in-fact.
Fraternal benefit societies are primarily life insurance carriers that exist as social organizations and usually engage in charitable and benevolent activities. Fraternals are distinguished by the fact that their membership is usually drawn from those who are also members of a lodge or fraternal organization. They operate under a special section of the state insurance code and receive some income tax advantages.
Lloyd’s of London is not an insurance company, but may be compared to a stock exchange. Just as an exchange provides facilities for its members but does not buy or sell securities itself, Lloyd’s provides a meeting place and clerical services to its members who actually transact the business of insurance. Members may be individuals or corporations.
Members are grouped into syndicates, but they remain individually liable and responsible for the contracts of insurance they enter into. Their individual fortunes and resources are pledged as the capital behind their assumption of risk.
An assessment company retains the right to charge policyholders additional premiums if those paid in are insufficient to meet claims.
Reinsurance is a form of insurance between insurers. It occurs when an insurer (the reinsurer) agrees to accept all or a portion of a risk covered by another insurer (the ceding company). In the event of loss, the insured has no
Introduction to Insurance 13
claim against the reinsurer. The ceding company is responsible for the coverage it has written, but it will have a legitimate claim against the reinsurer for any portion of its own loss that is reinsured.
Occasionally, it may be difficult to place a risk in the normal marketplace. If the risk is very large or unusual in nature, typical carriers may be unwilling to assume it. For some special risks, the only market may be with specialty carriers. Excess and surplus lines is the name given to insurance for which there is no market through the original producer, or insurance that is not available through authorized carriers in the state where the risk arises or is located. Such business must be placed through a licensed excess or surplus lines broker, who will attempt to place it with an unauthorized carrier.
Self-insurance is a means of retaining risk. For a risk to be truly self-insured, two important characteristics must be present: a large number of homogeneous exposure units, so that the law of large numbers can be used to predict expected losses; and sufficient liquid assets to pay claims and other costs of retaining risk.
The advantages of self-insurance are that money can be saved if losses are less than those predicted, expenses may be reduced by the elimination of such things as administrative costs and commissions, and the self-insurer has use of the money that would normally be held by the insurance company. The main disadvantages of self-insurance are that actual losses may be more than predicted, and expenses could be higher than expected if additional personnel have to be hired to administer the program.
The federal government provides life and health insurance through various sources. The federal government has offered a variety of military life insurance plans including United States Government Life Insurance (to veterans of World War I), National Service Life Insurance (in 1940) and Servicemen’s Group Life Insurance. Additional occupations are eligible for federal government insurance provided through the Railroad Retirement Act, the Civil Service Retirement Act, and the Federal Employees’ Compensation Act.
Because private insurance policies exclude catastrophic risks, the federal government has stepped in to provide War Risk Insurance, Nuclear Energy Liability Insurance, National Flood Insurance, Federal Crime Insurance,
14 Chapter 1
Federal Crop Insurance, and insurance on mortgage loans. At the state level, governments are involved in providing unemployment insurance, workers compensation programs and second-injury funds, and state-run medical expense insurance plans.
Federal, state, and local governments provide social insurance to a segment of the population who would otherwise be without disability income, retirement income, or medical care.
Social Security provides survivor benefits in the event of death of a covered worker. These benefits include a lump-sum burial amount of $255 plus monthly income benefits to eligible survivors. Social Security also provides disability benefits in the event of the total disability of a covered worker. In addition, the program also provides retirement benefits to covered workers at age 65 or earlier if elected by the individual. The Medicare program is also part of Social Security and accordingly provides medical expense benefits for covered workers beginning at age 65. All these programs will be discussed in more detail in later chapters.
Medicaid is primarily a state governmental program that provides health care benefits for the financially needy. Medicaid is financed by the states with some federal subsidies.
Insurers may be categorized according to where they are domiciled and whether they are authorized to operate within a state.
An insurer is defined not only by its corporate status, but also by where it is located, or its domicile of incorporation. If an insurer is conducting business in the state where it is incorporated, that insurer is a domestic insurer in that state. If an insurer conducts business in a state where it is not incorporated, the insurer is a foreign insurer in that state. If an insurer is conducting business in a country where it is not incorporated, it is an alien insurer in that country. Therefore, an insurer incorporated in California is a domestic insurer when it is conducting business in California. The same company is a foreign insurer when it is conducting business in New York and an alien insurer when it is conducting business in Canada.
Introduction to Insurance 15
Before an insurance company can conduct business it must, by law, receive the authority to do so. Insurance statutes require a company to secure a license from the department of insurance to sell insurance in a particular state. After the insurer receives the license, it is considered admitted into the state as a legal insurer and is authorized to transact the business of insurance. Those insurers not licensed to transact insurance within the state are referred to as unauthorized or nonadmitted. This licensing power (sometimes companies are referred to as licensed and nonlicensed) is used to regulate company activities.
Insurance companies market their products generally in one of two ways: by using producers to sell their products or by selling directly through mass marketing. The vast majority of policies are sold through producers.
Companies that use producers to sell their products vary by whether the producers are employees or independent sales representatives.
Independent Insurance Producers sell the insurance products of several companies and work for themselves or other producers. They sell their clients the policy that fits their needs best among the many insurers they represent and are paid a commission for each sale.
The independent producer owns the expirations of the policies he or she sells, meaning that the agent may place that business with another insurer upon renewal, if in the best interest of the client, and still retain control of the account and be entitled to the commission.
Exclusive or captive producers represent only one company, and have an agency relationship with that company. These producers are sometimes referred to as career agents working from career agencies. Most often, these captive or career producers are compensated by commissions. A career producer’s compensation will normally consist of first-year commissions and renewal com
16 Chapter 1
missions in subsequent years. If a producer hires, trains, and supervises other producers within a specific geographical area, he or she is referred to as a general agent or managing general agent (MGA). The MGA is compensated by commissions earned on business sold by him or herself as well as an overriding commission (overrides) on the business produced by the other producers managed by the general agent.
Direct writing companies usually pay salaries to employees whose job function is to sell the company’s insurance products. Technically, these salaried employees do not function as producers. Commissions are usually not paid and the insurer owns all the business produced.
Mass marketing has grown in general use over the past several years. The most common types of mass marketing systems are direct-response, franchise, noninsurance sponsors, and vending machine sales.
Direct-response marketing is conducted through the mail, by advertisement in newspapers and magazines, and on television and radio. Policies sold using this method have limited benefits and low premiums, such as disability only.
The franchise marketing system provides coverage to employees of small firms or to members of associations. Unlike group policies where benefits are standard for classes of individuals, persons insured under the franchise method receive individual policies that vary according to the individuals’ needs.
Noninsurance sponsors are being used more and more. The most common are banks and companies that issue credit cards. This marketing system reaches a select group of individuals who have a history of periodic payments.
Vending machine sales have traditionally been of travel accident policies sold from coin-operated machines at airports. A large amount of coverage is available at low premiums. The coverage is good only for the duration of a single trip.
Introduction to Insurance 17
Advertising and selling insurance through the Internet are relatively recent developments in insurance distribution. Insurance company websites offer information about insurers, the various lines of insurance provided, and links to regulatory information, financial ratings, and quotation services, as well as “locator” services to put the consumer in touch with a local agent.
The term producer is becoming increasingly common for several reasons. Many states have replaced separate agent and broker licenses with a single producer license. In addition, a major law change in 1999 (discussed later in this course) removed prior legislative barriers between insurers, banks, and securities brokerages, allowing insurance to be sold by a wider range of professionals. Anyone who produces sales of insurance products is a producer.
Producers may function as agents, representing the insurance company, or as brokers, representing the potential insured. In some states, solicitors are still licensed and function as insurance producers.
Generally, life and health insurance agents represent the insurer to the buyer with respect to the sale of life and health insurance products. The agents are appointed by the insurer and usually the agent’s authority to represent the insurer is specified in the agency agreement between them, which is a working agreement between the agent and the insurer.
The life agent may receive the first premium due with the application but usually not subsequent premiums, except in industrial life insurance. The insurance company approves and issues the contract after receiving the application and premium from the applicant through the agent. The agent cannot bind coverage. This means that an agent cannot commit to providing insurance coverage on behalf of the insurance company.
Agents appointed by property and liability insurance companies generally are granted more authority. These agents may bind or commit their companies by oral or written agreement. They sometimes inspect risks for the insurance company and collect premiums due. They may be authorized to issue many types of insurance contracts from their own offices.
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In contrast to the agent-client relationship in which the agent represents the insurer to the purchaser, a broker represents the buyer to the insurer. A broker may do business with several different insurers. Brokers are independent sales representatives who select insurance coverages from these various companies for their clients.
Brokers must be licensed just like agents, and generally their routine activities and functions are similar to that of agents. Brokers solicit applications for insurance and may collect the initial premium and deliver policies. Brokers do not have the authority to bind coverages.
A solicitor is a salesperson who works for an agent or a broker. Most often the solicitor will be licensed as a solicitor. The solicitor’s primary functions are to solicit insurance, collect initial premiums, and deliver policies. Solicitors cannot bind coverage.
A very small group of insurance professionals call themselves insurance consultants. Consultants are not paid by commission for the sales of insurance policies. Instead, they work strictly for the benefit of insureds and are paid a fee by the insureds they represent.
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1. A social device for spreading the chance of financial loss among a large number of people is the definition of
2. Which of the following risks is most likely to be insurable?
3. Roger refuses to travel by airplane. Roger is managing the risk of being in a plane crash by
4. Chianna becomes injured in a car accident caused when she took her eyes off the road to answer her cell phone. This is an example of a
5. Mathematicians who study and compile statistical data regarding exposure and risks for insurance companies are called
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6. Which of the following would not be an example of insurable interest?
7. Kim is injured in a house fire. When the bills come, the insurance company pays 80% of the cost and Kim pays the rest. This is an example of
8. Hoosier Insurance Company is owned by the policyholders. Hoosier Insurance is a
9. Which of the following people represents several insurance companies but owns the policy expirations?
10. Which of the following can bind an insurance company by oral or written agreement?
Introduction to Insurance 21
11. The ZYX Insurance Company is incorporated in Alabama. While doing business in Texas, it is
12. Self-insurance is an example of which method of handling risk?
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✓ Pretext interview ✓ Rehabilitation ✓ Liquidation ✓ Temporary agent license ✓ Producer appointment ✓ Controlled business ✓ Misrepresentation ✓ Twisting ✓ Churning ✓ Defamation ✓ Discrimination ✓ Rebating
✓ Consumer report ✓ Investigative consumer report ✓ Disclosure authorization ✓ Company financial ratings ✓ Guaranty associations ✓ Unfair trade practices ✓ Unfair claims practices ✓ Self-regulation
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Insurance is a public trust because it affects a large percentage of the general public and because it performs what can be construed as a public service by its very nature. The general public has an interest in making sure that insurance activity actually is provided as a service and not a disservice. Insurance is highly regulated to protect the public interest and to make sure coverage is available on an equitable basis.
Regulation of the insurance industry is divided among a number of authorities. The three major channels of regulation of the insurance industry are
Most insurance regulation takes place at the state level, but there are some important regulations at the federal level. The National Association of Insurance Commissioners (NAIC) also plays an important role in insurance regulation.
Federal jurisdiction applies to individuals or companies whose activities affect interstate commerce, which includes most insurance activity. Federal regulation of insurance is primarily used as a means to oversee those areas not covered by state regulation of the industry. The most important sources of federal regulation are outlined in the following sections and include both legislative and judicial aspects.
In the case of Paul v. Virginia, the Court’s decision established, as law, that the transaction of insurance across state lines was not interstate commerce and therefore should be regulated by local law. This decision held for 75 years.
In 1944 that decision was overturned by the Supreme Court, who said that insurance transacted across state lines was, in fact, interstate commerce. This decision had the capability of turning regulation of the insurance industry upside down.
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In order to waylay any impending confusion, Congress enacted the McCarran-Ferguson Act in 1945. This act stated that the federal government had the right to regulate the business of insurance, but only to the extent that such business is not regulated by state law. The main intent of the law was to exempt the insurance industry from most of the provisions of the federal antitrust laws.
In the 1970s the Privacy Protection Study Commission was established. The study found insurers to be one of the major collectors and users of personal information. The Commission’s report resulted in the Privacy Act, which affected the way insurers obtained and handled personal information about applicants and insureds.
Applicants for insurance must be given advance notice of the insurer’s practices regarding collection and use of personal information. Notice must be given promptly and in writing. Notice should be given in the following cases and in the following manner:
The notice must give the applicant or insured the following kinds of information:
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Disclosure authorization forms are required by law to be prescribed and approved by the Commissioner. The disclosure form must be written in accordance with the plain language laws of the state and dated. Disclosure forms state the types of persons authorized to disclose private and personal information (for example, neighbors, employers, and previous or other insurers) and the kind of information that may be disclosed (for example, personal habits, work habits, and health habits such as smoking and drinking). The form must also state the reason information is collected and how it will be used. For instance, the reason personal information is gathered is because the applicant requested a life insurance policy; the information will be used by the underwriting department for the purpose of determining the applicant’s risk category.
The applicant’s signature on the disclosure form authorizes the insurer to collect and disseminate information in the manner described in the notice. The authorization is good only for a certain period of time. For example, if authorization is given to an insurer to collect information with regard to a claim settlement, the authorization is good for 30 months. At the end of this period another authorization must be obtained. The applicant or insured may request, and receive, a copy of the authorization form.
Personal information may be disclosed to persons other than the requesting parties under certain conditions. Among those to whom an insurer may disclose information are producers, other insurers, insurance organizations (such as the Medical Information Bureau), and insurance departments. This type of third-party disclosure may require authorization, but in some instances authorization is not required, as long as the applicant or insured has received proper notification of the insurer’s information practices. In some cases information is passed on to those conducting scientific research, audits, or marketing approaches.
The Commissioner of Insurance has the authority to investigate any insurer, or any agency used by the insurer to collect information, to determine whether the company is in compliance with the Insurance Act. If the Commissioner believes that a violation of the Privacy Act has taken place, he or she can conduct a hearing to determine the facts. If a violation is found, the Commissioner can issue a cease and desist order, but if the violator continues to violate the Privacy Act, the Commissioner can institute a fine of up
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to $10,000 for each violation. If the violation is one that happens with such frequency that it appears to be a general business practice, the fine for each violation can be up to $50,000.
The NAIC Model Privacy Act also provides for the enforcement of individual rights. The individual has the right to information concerning himself or herself, the right to correct inaccurate information, the right to know the reasons for being turned down for insurance, and the right to know any other adverse underwriting decision. These rights are those found under the Fair Credit Reporting Act.
A fine of $10,000, or up to one year in jail is the penalty for any person who obtains information that he or she has no legitimate reason to receive.
When an application is submitted to a life or health insurance company, a consumer reporting agency may be hired to obtain personal information about the applicant to be used in the underwriting evaluation. To protect the consumer’s right to privacy in this situation, the federal Fair Credit Reporting Act was passed in 1970. The Act sets up procedures for consumer reporting agencies to follow in their dealings with businesses to ensure that records are confidential, accurate, relevant, and properly used.
Consumer reports include written, oral, and other forms of communication that a consumer reporting agency has regarding a consumer’s credit, character, reputation, or habits, which is used or collected to determine whether a consumer is eligible for credit, insurance, employment, or other purposes authorized under the Act. Consumer reports may be issued only to persons who have a legitimate business need for the information. Governmental agencies may also be provided with a consumer’s name, present and former addresses, and present and past places of employment.
An investigative consumer report includes information on a consumer’s character, general reputation, personal habits, and mode of living that is obtained through investigation—that is, interviews with associates and friends and neighbors of the consumer. Such reports may not be made unless the consumer is clearly and accurately told about the report in writing within three days of the date on which the report was first requested. The consumer must also be notified that he or she is allowed to request additional information. If that person requests such information in writing, the person who caused the
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investigative report to be made must make a complete and accurate disclosure of the report to the consumer about whom it is written. The disclosure must be made within five days of receipt of the report or when the report was first requested, whichever date is later. If there is an investigative consumer report prepared subsequent to the first one, any adverse information must be verified or must have been received during the three months preceding the subsequent report.
A pretext interview is an interview whereby a person, in an attempt to obtain information about another person, pretends to be someone he or she is not, misrepresents the true purpose of the interview, or refuses to properly identify him- or herself.
Generally, pretext interviews are prohibited. However, such an interview may be conducted when there is evidence of criminal activity, fraud, or misrepresentation.
Consumer reporting agencies collect information on individuals, prepare reports, and make the reports available to persons or organizations having a legitimate reason to receive such information. These agencies may operate for profit—for example, Experian or Equifax. Agencies also may be nonprofit, such as the Medical Information Bureau (MIB) or a credit union.
A consumer may choose to have his or her name and address excluded from any list provided by a consumer reporting agency in connection with a credit or insurance transaction that is not initiated by the consumer. The consumer simply needs to notify the agency that he or she does not consent to any use of a consumer report relating to the consumer in connection with any credit or insurance transaction that is not initiated by the consumer.
Credit agencies are required to provide a notification system, including a toll-free telephone number, to allow consumers to request exclusion of their information. This notification is valid for two years. If notification is made in writing on a signed notice of election form issued by the agency, it is valid until the consumer revokes the request. The consumer may revoke the request at any time.
Consumer reporting agencies are specifically prevented from putting information in their reports about
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These restrictions are not applicable when the consumer credit report is used in connection with a credit transaction of $150,000 or more, a life insurance policy of $150,000 or more, or when it concerns employment of an individual earning $75,000 or more.
Consumers who feel that information in their files is inaccurate or incomplete may inform the consumer reporting agency of any information in dispute. The consumer reporting agency is then required to reinvestigate and record the current status of the disputed material (unless the agency has reasonable grounds to believe the dispute is frivolous or irrelevant) in a reasonable period of time.
If the agency’s investigation finds that the information is no longer accurate or verifiable, it must be deleted promptly. If the dispute is not resolved after reinvestigation, the consumer may file a brief statement (not more than 100 words) concerning the problem. If this statement is filed, the consumer reporting agency must note it in future consumer reports that contain that information (unless it is determined to be frivolous or irrelevant). If credit or insurance is denied or charges are increased, based wholly or partially on information contained in a consumer report, the user of the information must notify the consumer of this fact and report the name and address of the consumer reporting agency that made the report. If credit or insurance is denied or charges are increased, wholly or partially due to information obtained from a person or organization other than a consumer reporting agency, the user of the information must disclose the nature of that information to the consumer if it has been requested within 60 days of the disclosure. It is the responsibility of the user of the information to inform the consumer of his or her right to request this information when the adverse action is communicated to him or her.
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Failure to comply with the provisions of the Act makes the guilty party liable to the consumer for the sum of actual damages sustained as a result of the noncompliance, punitive damages deemed proper by a court, and the costs of an action that enforces liability, plus reasonable attorney’s fees. When the noncompliance is due to negligence, the guilty party must pay the consumer the sum of the consumer’s actual damages, the costs of any successful action to enforce liability, plus reasonable attorney’s fees.
Certain types of false or fraudulent statements have been specifically outlined in federal law as punishable by a fine, a prison sentence, or both. Federal law prohibits persons engaging in the business of insurance whose activities affect interstate commerce from knowingly, with the intent to deceive
The attorney general may bring a civil action in the appropriate United States district court against any person who engages in unfair and deceptive practices as defined in the law and, upon proof of such conduct by a preponderance of the evidence, the person will be subject to a fine of not more than $50,000 for each violation or the amount of compensation that the person received or offered for the prohibited conduct, whichever amount is greater.
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Also known as the Gramm-Leach-Bliley Act (GLBA), this legislation was passed in 1999 primarily to remove depression-era barriers between commercial banking, investment banking, and insurance. GLBA allows financial holding companies to engage in any activities that are financial in nature.
Regulation of these holding companies is managed on a functional basis. This means that regulatory authority is based on what activity is occurring, rather than on what type of company is engaging in the activity. For example, the sale of insurance is regulated by state insurance regulators even if the company making the sale is a bank or securities brokerage.
The law also requires that all the functional federal regulatory agencies establish appropriate information safeguards:
Anyone about whom a company collects any information is a consumer. A customer is a consumer who has an ongoing relationship with the financial institution. Different states define ongoing relationship using different guidelines, so be certain you understand what it means in your state. GLBA protects the confidentiality of personal information. Business information is not covered under this statute. GLBA considers information to be collected when it is organized or can be retrieved by an individual’s name or by an identifying number, such as a policy number. The source of the information is less important than how it is stored and organized.
Information that is publicly available, such as phone numbers listed in a telephone book, is not protected under GLBA. However, the fact that an individual has an insurance policy with a certain company is not public information, so publishing a list of policyholder names and listed phone numbers would not automatically be allowed.
In some cases, consumers and customers are given the opportunity to keep the company from sharing the information it has about them. This is known as the right to opt out. Health information, such as that acquired during a
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medical exam, is subject to a stricter opt-in standard, meaning that companies may not share some health information without getting specific permission to do so from the customer or consumer. However, companies are always permitted to share information with their affiliates.
GLBA requires that a company make two primary disclosures to customers: one at the time of the establishment of the customer relationship, and the second prior to the company disclosing protected information. The first disclosure is to be made at the time a consumer becomes a customer, usually by purchasing a policy. At this point, the company is required to give a clear and conspicuous disclosure to the new customer regarding its policies and procedures for customer privacy. The customer must, at least on an annual basis, receive an updated notice containing the same information.
The second disclosure required by GLBA explains the customer’s right to opt out of information sharing. Each customer must be given the right to opt out and must be told explicitly how he or she may exercise that right. The notice must identify the products and services to which the opt-out right applies. The only other requirement is that the opt-out agreement must be in writing and may be electronic if the customer agrees. If the customer does not take advantage of this option within a reasonable time, the company may share the information with others.
Some insurance products are regulated by both the federal and state government. For example, the Securities and Exchange Commission (SEC) and the state insurance departments regulate variable contracts.
Most insurance regulation takes place at the state level. The body of laws at the state level is called the Insurance Code. State regulation consists of statutes, rules, and regulations. Statutes are the body of law developed by the Legislative branch of government. They outline, in general terms, the duties of the Commissioner and the activities of the insurance department. Rules and regulations are developed by the insurance department to expand upon statutory requirements and carry out legislative intent.
The Insurance Code of each state authorizes the establishment of an insurance department to administer and carry out the insurance laws. In each
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state, a public official will head the department—the title of the official will be the Commissioner, Superintendent, or Director of insurance. The insurance laws of the state usually confer upon the Commissioner all the following powers and duties:
Notice that the Commissioner does not make the insurance laws. He or she is simply in charge of making certain all insurance operations within the state are in compliance with the laws made by the State Legislature.
Before individuals can form an insurance company they must receive approval from the insurance department to organize. They must meet the requirements for incorporation, certificates of intention, and bylaws just as any other corporation. They are required to draw up a charter that states the proposed name of the insurer, location, lines of insurance to be sold, and method of operation. The insurance department will also conduct an investigation to ensure that the organizers are of good moral character.
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The majority of individual life and health insurance is written by stock and mutual companies. A mutual company must have a minimum number of applications for insurance, the advanced premium payment for each application, and a surplus. A stock company must have a specified amount of capital, which is invested, and a surplus amount. In many states domestic insurers must deposit securities that insurance regulations specify as relatively stable and safe, such as government bonds.
Insurance insolvency regulations govern such areas as the organization and ownership of a new company, capital and surplus requirements, reserves, accounting, investments, annual statements, and the rehabilitation and liquidation of impaired insurers. If an insurer gets into trouble, the insurance department will attempt to rehabilitate the company, or if this fails, handle the liquidation. In addition, insurance departments in many states have adopted regulations for the establishment of guaranty associations in the event that an insurer does, in spite of regulations and precautions, become insolvent.
Various state statutes impose capital and surplus requirements and the preparation of annual financial statements, and require periodic examinations of insurers by the insurance department. These laws establish initial financial requirements and help in the early detection of financial problems.
All states have regulations that are intended to assure that insurers invest only in high-quality assets to prevent insolvency. Life insurance companies may invest funds in concerns that are fairly stable in value. These safe investments include municipal bonds, corporate bonds, real estate mortgages, and even policy loans.
Life insurance companies are taxed on both their investment income and underwriting profits. For stock insurance companies, investment income is taxed in the year it is earned; 50% of underwriting profit is taxed during the year earned, and the other 50% is taxed when paid out to stockholders.
The one-half of the underwriting income that is taxed becomes shareholders’ surplus, and the half that has not been taxed becomes policyholders’ surplus. Both types of surplus are collectively known as the earned surplus of an insurance company.
Mutual insurers pay out their underwriting income as dividends to policyholders, so this tax regulation does not generally apply.
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Producers have a responsibility to place coverage with financially sound carriers. There are several organizations that rate the financial strength of insurance carriers, based on an analysis of a company’s claims experience, investment performance, management, and other factors. These organizations include A.M. Best Company, Standard & Poor’s Insurance Rating Services, Moody’s Investors Service, Duff & Phelps Credit Rating Company, and Weiss Ratings. The firms don’t all rate every company, and each firm has a different criteria for which companies will be rated. Each firm also uses a different methodology for evaluating the financial strength of insurance companies. There are at least four different rating scales in use among the five firms (see Table 2.1).
|Table 2.1 Scales in use by Financial Rating Services Firm Scale from Highest to Lowest|
|A. M. Best Company A++, A+, A, A-, B++, B+, B, B-, C++, C+, C, C-, D, E, F|
|Weiss Research A+, A, A-, B+, B, B-, C+, C, C-, D+, D, D-, E+, E, E-, F+, F, F-|
|Standard & Poor’s/Duff AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, & Phelps BB- , B+, B, B-, CCC, CC, D|
|Moody’s Investors Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Service Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca1, Ca2, Ca3, C1, C2, C3|
Consumers might find a rating meaningless, or even misleading, if it is not presented in the context of the scale. For example, an A+ rating sounds as if it belongs at the top of the scale, but only one rating service considers it the top possible rating. From other services, it may be the third or even the fifth highest rating.
The state insurance department must examine the financial affairs, transactions, and general business records of domestic insurers in accordance with specific state insurance laws. Generally, these laws will state that the Commissioner of Insurance may examine the insurer’s records as often as necessary but at least once every three to five years.
The nonfinancial regulatory activities of an insurance department fall under the broad heading of market conduct. Proper market conduct means conducting insurance business fairly and responsibly. A market conduct examination is when state insurance department investigators examine the business practices and operations of an insurer and its agents in order to determine their
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authority to conduct insurance business in the state. During a market conduct examination, state examiners investigate the records and practices of an insurance company and determine whether the company is in fact in compliance with state laws regulating the sales and marketing, underwriting, and issuance of insurance products. Some states conduct market conduct exams in conjunction with their regular financial examinations of insurers; others conduct independent market conduct exams.
State guaranty associations are organized to protect claimants, policyholders, annuitants, and creditors of financially impaired or insolvent insurers by providing funds for the payment of claims and other related policy benefits. The association is composed of insurers authorized to transact insurance business within the state. Association membership exceptions include fraternal organizations and nonprofit companies. Member insurers are assessed certain sums of money to cover the association’s operating expenses. If an insurer insolvency should occur, each member insurer will be assessed additional fees to cover the insolvency.
Guaranty associations are often compared to the Federal Deposit Insurance Corporation (FDIC), which protects bank depositors from bank failures. As with the FDIC, coverage by the guaranty association is subject to limitations, usually something like $300,000 for death benefits, $100,000 for life insurance cash surrender/withdrawal values, $100,000 for health benefits, and an overall cap for individuals.
States often regulate the marketing and advertising of life and health insurance policies to assure truthful and full disclosure of pertinent information when selling these policies. As a rule, the insurer is held responsible for the content of advertisements of its policies. Advertisements cannot be misleading or obscure, or use deceptive illustrations, and must clearly outline all policy coverage as well as exclusions or limitations on coverage (such as preexisting condition limitations).
Most states require insurers to keep a permanent advertising file of all advertisements used in the state until the next regular examination of the insurer by the insurance department, or for a specified minimum number of years, such as 2 or 3.
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Also, many states require the delivery of a Buyers Guide and Policy Summary or Outline of Coverage at the time of policy delivery. The Buyers Guide is a document providing basic information about the insurance policies, and the Policy Summary (life insurance) or Outline of Coverage (health insurance) is a written statement describing the elements of the policy being sold. Generally, it must include the agent’s name and address, the name and office address of the insurer, and the generic name of the policy and each rider.
Producers may function as either an agent or a broker. Agents represent their companies; brokers represent their clients. Because both agents and brokers seek to serve both their clients and companies by matching coverage with need, it is important to know the difference between the two roles. Regardless of their role, producers are governed by the Insurance Code with respect to licensing and unfair trade practices.
GLBA, passed in 1999, contained a small but important section on the regulation of insurance producers, stating that 29 states must have uniform or reciprocal licensing regulations in place by November 12, 2002, or the federal government would begin licensing agents and brokers. Ideas about uniformity and reciprocity of state licenses had already been in the works for years, and the National Association of Commissioners had even drafted a Producer Licensing Model Act (PLMA) that satisfied GLBA. In addition, the PLMA had the advantages of creating some standard statutory language, maintaining individual state authority over licensing, and maintaining important consumer protections.
Under the statutes of most states, no person is permitted to act as an insurance producer unless currently licensed as a producer for the class or classes of insurance involved.
Acting as a producer includes selling, soliciting, or negotiating insurance. In many states, adjusters, consultants, and service representatives must also be licensed, but they are not insurance producers.
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PLMA streamlined the qualifications for insurance producers. Some states still require additional qualifications. The qualifications listed in the Model Act are as follows:
PLMA also defines a standard set of exemptions from the licensing requirements. Generally speaking, people who do not get paid commissions for selling insurance do not need a license. The list of exemptions according to PLMA includes the following:
Insurance Regulation 39
annuities, group or blanket accident and health insurance, or for the
purpose of enrolling people under plans, issuing certificates under plans
or otherwise assisting in administering plans, or performs administrative
services related to mass marketed property and casualty insurance; where
no commission is paid for the service
The majority of states allow for reciprocity in nonresident licensing as required in GLBA. Reciprocity means a mutual exchange of privileges. In the case of producer licensing, it means the recognition of two states of the validity of licenses or privileges granted by the other.
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The NAIC has encouraged states to eliminate any licensing and appointment retaliatory fees that might get in the way of reciprocity, suggesting that states avoid charging nonresident fees that are higher than resident and create a barrier to entry. Check your State Law Digest to see what the rules are in your state.
Requirements for obtaining an insurance license are similar around the country. Generally, they require having reached a minimum age, satisfying education requirements, and passing a state examination.
A resident individual applying for an insurance producer license has to pass a written examination unless exempt as discussed previously. The exam is developed by the Commissioner to test the knowledge of the individual concerning the lines of authority for which the application is made, the duties and responsibilities of an insurance producer, and the insurance laws and regulations of the state.
The Commissioner may, and generally does, make arrangements to contract with an outside testing service for administering examinations and collecting the nonrefundable fee as described by state law. Each individual applying for an examination must pay a nonrefundable fee. If the individual fails to appear for the exam as scheduled or fails to pass the exam, he or she must reapply for the exam and remit all the required fees and forms before being rescheduled for another examination. States may limit the frequency of application for examination.
Licenses contain the licensee’s name, address, and personal identification number; the date of issuance; the lines of authority; the expiration date; and any other information the Commissioner deems necessary.
In most states, temporary agent licenses may be issued for up to 180 days without requiring an examination if the Commissioner considers the temporary license necessary for maintaining an insurance business in the following cases:
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The authority of any temporary license can be limited in any way the Commissioner considers necessary to protect insureds and the public.
After they are licensed, producers have to satisfy certain obligations in order to keep their licenses.
Every licensee must promptly give to the head of the insurance department written notice of any change of business address. Most states require this notice be made within 30 days.
An insurance producer doing business under any name other than the producer’s legal name is required to notify the Commissioner before using the assumed name.
Every resident producer must have and maintain in the state issuing the license a place of business accessible to the public. The designated place of business must be where the licensee principally conducts transactions under the license. The licenses of the licensee and solicitors appointed by the
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licensee shall be conspicuously displayed in a part of the place of business that is customarily open to the public. The producer must keep at the place of business the usual and customary records pertaining to insurance transactions.
Producer licenses generally remain in effect unless revoked or suspended as long as the appropriate fee is paid and the continuing education requirements are met by the due date.
An individual insurance producer who allows his or her license to lapse may, within 12 months from the due date of the renewal fee, reinstate the same license without passing a written examination. However, a penalty of double the unpaid renewal fee will be required for any renewal fee received after the due date.
An insurance producer who is not able to comply with the license renewal procedures due to military service or some other extenuating circumstance (for example, medical disability) may request a waiver of those procedures. The producer may also request a waiver of any examination requirement or any other fine or sanction imposed for failure to comply with renewal procedures.
If a producer is going to function as an agent of an insurer, the producer generally needs to be appointed by that insurer. To appoint a producer as its agent, the appointing insurer needs to file a notice of appointment within 15 days from the date the agency contract is executed or the first insurance application is submitted. If an appointment fee is required, it will be paid by the appointing insurer. Any appointment renewal fees required in subsequent years are also paid by the appointing insurer.
In many states, the Commissioner verifies the eligibility of each producer appointed within the first 30 days after being notified of the appointment. If the producer is found to be ineligible, the insurer is notified within 5 days.
Like the insurance license, as long as the appropriate forms are filed and the appropriate fees are paid by the appointing insurer, appointments remain in effect until terminated or until the producer’s license is revoked or terminated. If the filing of an appointment is late, additional fees may be charged.
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Notice that producers are licensed by the state, and appointed by an insurer. Loss of an appointment does not necessarily mean that the producer has lost his or her license. It simply means that the producer may no longer represent that particular company although he or she is still licensed within the state.
Subject to a producer’s contract rights, if any, an insurer may terminate any of its appointed producers at any time. The insurer must give prompt written notice of the termination and the date to the insurance department (and to the producer when reasonably possible) and must file a statement of facts related to the termination and reasons for it.
If the appointment was terminated because the producer was found to have done something that would be grounds for revocation, denial, or suspension of his or her license, the insurer is obligated to notify the Commissioner, generally within 30 days. If the insurer finds out after terminating the appointment that the producer did something while appointed that would have been grounds for revocation, denial, or suspension of an insurance license, the insurer has to notify the Commissioner when it makes the discovery. As long as this notification is made without malicious intent, whoever makes such notifications is immune from civil liability, and no civil cause of action may be brought against such person.
The Commissioner may place on probation, suspend, revoke, or refuse to issue an insurance producer’s license or may levy a civil penalty for any combination of the following causes, as listed in the PLMA:
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If the Commissioner does not renew or denies an application for a license, the applicant or licensee must be notified and advised, in writing, of the reason for the denial or nonrenewal of the license. The applicant or licensee may make a written demand for a hearing within a reasonable time as specified in state law.
A business entity’s license may be suspended if the Commissioner finds that an individual licensee’s violations were known or should have been known by one or more of the partners, officers, or managers acting on behalf of the business entity and the violation was not reported nor corrective action taken.
A civil fine may be imposed in addition to or instead of license denial, suspension, or revocation. Depending on the violation, fines can range from $100 to several thousand dollars. If a producer is in violation of civil law, the Commissioner can refer the matter to the state attorney general for criminal prosecution and possible imprisonment.
The following material reviews various practices that are prohibited or regulated by law.
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Coverage written on a producer’s own life or health and on the lives or health of such persons as the producer’s relatives or business associates, is called controlled business. Because of the effect that controlled business could have on the insurance industry if people began becoming licensed solely to sell insurance to family and friends, the Commissioner limits such activities. Generally, a licensee is not permitted to earn commission or compensation from controlled business in excess of a stated amount (35%–50% of total compensation, depending upon the state) during a stated time period (usually a calendar year). If a greater proportion does come from controlled business, the practice is in violation of law and the license may be revoked or suspended.
The Unfair Trade Practices Act is divided into two parts—Unfair Marketing Practices and Unfair Claims Practices. In each state, statutes define and prohibit certain trade and claims practices that are unfair, misleading, and deceptive.
A misrepresentation is simply a lie. It is a violation of Unfair Marketing Practices for any person to make, issue, or circulate any illustration or sales material, or to make any statement that is false, misleading, or deceptive.
Misrepresentations include (but are not limited to)
It is illegal for any person to formulate or use an advertisement or make a statement that is untrue, deceptive, or misleading regarding any insurer or person associated with an insurer.
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Twisting occurs when a producer convinces a policyowner to lapse or surrender a present policy in order to sell him or her another one, usually from a different company. This is not to say all policy replacements are wrong. If a producer proves to the policyowner that the protection he or she has is not the best available, and the policyowner decides to replace the old policy with a better one, that policyowner has been well served. However, the producer must be careful that the arguments used on the policyowner can stand the scrutiny of the Commissioner. Any attempt by the producer to misrepresent another insurer by falsely making statements about the financial condition of the company or by giving an incomplete comparison of policies can create legal liability.
Closely allied with twisting is churning, a term describing the practice of using misrepresentation to induce replacement of a policy issued by the insurer the producer is representing, rather than the policy of a competitor.
The impetus behind churning is to allow the producer to collect a large first-year commission on a new policy. Churning is the result of a producer putting his or her interests above those of the client.
It is a violation of Unfair Marketing Practices for any person to deliberately make a false financial statement regarding the solvency of an insurer with the intent to deceive others.
It is illegal for any person or company to make any oral or written statements or to circulate any literature that is false, maliciously critical, or derogatory to the financial condition of any insurer, or which is calculated to injure anyone engaged in the insurance business.
It is illegal to permit discrimination between individuals of the same class or insurance risk in terms of rates, premiums, fees, and policy benefits, due to their place of residence, race, creed, or national origin.
Splitting a commission with a prospect is prohibited in almost every state (California and Florida are exceptions). Rebating is any inducement in the
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sale of insurance that is not specified in the insurance contract. The offer of sharing commissions with the insurance applicant is an inducement in the sale of insurance that is not part of the insurance policy and, thus, rebating.
Rebates include not only cash but also personal services and items of value.
It is unlawful for any person or insurer to collect premiums or make charges that are not specified in the insurance contract.
It is a violation of the Act for any person or organization to commit or be involved in any act of boycott, coercion, or intimidation that is intended to create a monopoly or restrict fair trade in the transaction of insurance. For example, it is unlawful for a bank to force a person to purchase insurance from a particular company or agent as a condition for receiving a loan from the bank. The bank may require that adequate insurance be purchased or be in force to back such a loan but the bank cannot force or intimidate a person into purchasing coverage from a specific insurer as a condition for the granting of a loan.
Claims settlement practices are regulated, in the public interest, for two main reasons:
The Unfair Claims Practices provisions of the Unfair Trade Practices Act are designed to protect the insureds and claimants from any claims settlement practices that are unfair, deceptive, or misleading. The following are considered unfair claims practices:
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Some states have added another provision that makes it an unfair claim practice to offer a settlement or payment in any manner prohibited by law.
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Following an investigation and a hearing, if the insurance department finds that any person or insurer is engaged in any unfair trade or unfair claims practice, the Commissioner may issue a cease and desist order prohibiting the individual or company from continuing the practice. Failure to comply with the cease and desist order can result in a substantial fine (usually $10,000). In addition, fines and loss of license may also be imposed for any company or person guilty of violating the Unfair Trade Practices Act.
The last channel of regulation of the business is self-regulation, that is, those restraints from within the industry either by individual company conscience or by group pressure of insurance associations. There are several intercompany organizations or associations that impose “codes” on their members. In recent years, these industry associations have had a major impact on prelicensing and continuing education laws. For example, often the state Association of Life Underwriters will be the organization that is the major force in obtaining passage of these laws through the state legislature. Continuing education laws are designed to protect the consumer by mandating certain continuing educational requirements if a producer is to maintain his or her license.
The National Association of Insurance Commissioners (NAIC), an association of state Commissioners, although without legal authority as a group, also imposes a strong influence in the area of the industry’s self-regulation.
The NAIC is the organization that has done the most to standardize law between the states. Although the wording—and sometimes the provisions themselves—differ from state to state, for the most part the differences are only slight as each state attempts to follow, in essence, the wording of the “model laws” established by the NAIC.
The model laws include the Individual Accident and Sickness Policy Provisions Law, Standard Nonforfeiture and Valuation Laws, Fair Trade Practices Act, Unauthorized Insurers Service of Process Act, Insurance Holding Company System Regulatory Act, Variable Contract Law, “group life definition and standard provisions bill,” and “credit life and credit health insurance regulation bill.”
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1. Most insurance regulation takes place at the
2. Applicants for insurance must be given advance notice, including all the following types of information except
3. Which of the following does not contain provisions protecting individual privacy?
4. Consumer reporting agencies are prevented from putting information in their reports about all the following except
5. Under the Financial Modernization Act, an individual about whom a financial institution collects any information is a
6. Under the Financial Modernization Act, an individual with whom a financial institution has an ongoing relationship is a
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7. The Commissioner of Insurance has all the following powers except
8. Nonfinancial regulatory activities of an insurance department fall
under the broad heading of
9. Associations organized to protect claimants, policyholders, annuitants,
and creditors of financially impaired insurers are known as
10. Which of the following is not a requirement for obtaining a producer’s license in most states?
11. Which of the following people would be required in most states to obtain an insurance license?
12. A person licensed as an insurance producer in another state who moves to this state has how long after establishing legal residence to become a resident licensee without taking prelicensing education or an examination?
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13. Which of the following individuals is least likely to be granted a temporary license?
14. Business written on the producer’s own life or interests is known as
15. Which of the following is considered an unfair claims practice?
16. An organization that establishes model laws that are often adopted by states with only slight differences is the
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|Terms you need to understand:|
|✓||Express authority||✓||Contract of adhesion|
|✓||Implied authority||✓||Unilateral contract|
|✓||Apparent authority||✓||Executory contract|
|Concepts you need to master:|
|✓||Presumption of agency||✓||Competent parties|
|✓||Agent errors and omissions exposure||✓||Legal purpose|
|✓||Contract formation||✓||Utmost good faith|
|✓||Offer and acceptance||✓||Parol evidence rule|
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An understanding of the law of agency is important because an insurance company, like other companies, must act through agents.
Agency is a relationship in which one person is authorized to represent and act for another person or for a corporation. Although a corporation is a legal “person,” it cannot act for itself, so it must act through agents. An agent is a person authorized to act on behalf of another person, who is called the principal.
In the field of insurance, the principal is the insurance company and the sales representative or producer is the agent. When one is empowered to act as an agent for a principal, he or she is legally assumed to be the principal in matters covered by the grant of agency. Contracts made by the agent are the contracts of the principal. Payment to the agent, within the scope of his or her authority, is payment to the principal. The knowledge of the agent is assumed to be the knowledge of the principal.
If a company supplies an individual with forms and other materials (signs and evidences of authority) that make it appear that he or she is an agent of the company, a court will likely hold that a presumption of agency exists. The company is then bound by the acts of this individual regardless of whether he or she has been given this authority.
An agent has one of three types of authority:
Lingering implied authority means that the agent carries “signs or evi
dences of authority.” By having these evidences of authority, an agent
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who is no longer under contract to an insurer could mislead applicants or insureds. When the agency relationship between agent and company has been terminated, the company will try, or should try, to get back all the materials it supplied to the former agent, including sales materials.
On the other hand, the public cannot assume that an individual is an agent merely because he or she says so. The agent must carry the credentials (for example, the agent’s license and appointment) and company documents (such as applications and rate books) that represent him or her as being an agent for an insurance company.
➤ Apparent authority is the authority the agent seems to have because of certain actions undertaken on his or her part. This action may mislead applicants or insureds, causing them to believe the agent has authority that he or she does not, in fact, have. The principal adds to this impression by acting in a manner that reinforces the impression of authority. For instance, an agent’s contract usually does not grant him the authority to reinstate a lapsed policy by accepting past due premiums. If, in the past, the company has allowed the agent to accept late premiums for that purpose, a court would probably hold that the policyowner had the right to assume that the agent’s acceptance of premiums was within the scope of his or her authority.
All premiums received by an agent are funds received and held in trust. The agent must account for and pay the correct amount to the insured, insurer, or other agent entitled to the money. Any agent who takes funds held in trust for his or her own use is guilty of theft and will be punished as provided by law.
An agent has a fiduciary responsibility to the insured, the insurer, the applicant for insurance, current clients, and so forth. The agent has a fiduciary duty to just about any person or organization that he or she comes into contact with as part of the day-to-day business of transacting insurance.
By definition, a fiduciary is a person in a position of financial trust. Thus, attorneys, accountants, trust officers, and insurance agents are all considered fiduciaries.
As a fiduciary, the agent has an obligation to act in the best interest of the
insured. The agent must be knowledgeable about the features and provisions
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of various insurance policies and the use of these insurance contracts. The agent must be able to explain the important features of these policies to the insured. The agent must recognize the importance of dealing with the general public’s financial needs and problems and offer solutions to these problems through the purchase of insurance products.
As a fiduciary, the agent must collect and account for any premiums collected as part of the insurance transaction. It is the agent’s duty to make certain that these premiums are submitted to the insurer promptly. Failure to submit premiums to the insurer, or putting these funds to one’s own personal use, is a violation of the agent’s fiduciary duties and possibly an act of embezzlement.
The insured’s premiums must be kept separate from the agent’s personal funds. Failure to do this can result in commingling—mixing personal funds with the insured or insurer’s funds.
The legal doctrines of waiver and estoppel are directly related to the responsibilities of insurance agents. An insurer may, by waiver, lose the right of making certain defenses that it might otherwise have available.
Waiver is defined as the intentional and voluntary giving up of a known right. An insurance company may waive its right to cancel a policy for nonpayment by accepting late payments.
Waiver and estoppel often occur together, but they are separate and distinct doctrines.
Estoppel means that a party may be precluded by his or her acts of conduct from asserting a right that would act to the detriment of the other party, when the other party has relied upon the conduct of the first party and has acted upon it. An insurer may waive a right, and then after the policyowner has relied upon the waiver and acted upon it, the insurer will be estopped from asserting the right.
The agent must be alert in his or her words, actions, and advice to avoid mistakenly waiving the rights of the insurance company. As a representative of the company the agent’s knowledge and actions may be deemed to be knowledge and actions of the company.
The agent’s contract or agency agreement with the insurer will specify the agent’s duties and responsibilities to the principal. In all insurance transac
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tions, the agent’s responsibility is to act in accordance with the agency contract and thus for the benefit of the insurer. In accordance with the agent’s fiduciary obligation to the insurer and his or her agency agreement, the agent has a responsibility of accounting for all property, including money that comes into his or her possession. As part of the agent’s working relationship with the insurer, it is important that pertinent information be disclosed to the insurer, particularly with regard to underwriting and risk selection. If the agent knows of anything adverse concerning the risk to be insured, it is his or her responsibility to provide this information to the insurer. To withhold important underwriting information could adversely affect the insurer’s risk selection process. In accordance with agency law, information given to the agent is the same as providing the information to the insurer.
It is the agent’s responsibility to obtain necessary information from the insurance applicant and to accurately complete the application for insurance. A signed and witnessed copy of the application becomes part of the legal contract of insurance between the insured and the insurer.
Finally, the agent has a responsibility to deliver the insurance policy to the insured and collect any premium that might be due at the time of delivery.
The agent must be prepared to provide the insured with an explanation of some of the policy’s principal benefits and provisions. If the policy is issued with any changes or amendments, the agent will also be required to explain these changes and obtain the insured’s signature acknowledging receipt of these amendments.
The company is required to permit the agent to act in accordance with the terms of the agent’s employment contract, and the company must recognize all the provisions of that contract.
In addition, the company must pay the agent the compensation agreed upon in the contract, must reimburse the agent for proper expenditures made on behalf of the principal, and must indemnify the agent for any losses or damages suffered without fault on the part of the agent but occurring on account of the agency relationship.
Errors and omissions (E&O) insurance is needed by professionals who give advice to their clients. It covers negligence, error, or omission by the insurer or producer who is the insurer’s representative. E&O policies protect pro
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ducers from financial losses they may suffer if insureds sue to recover for their financial loss due to a producer giving them incorrect advice (error) or not informing them of an important issue (omission). Because a producer’s office is very busy, he or she must take special care to follow strict procedures in regard to taking applications, explaining coverages, collecting premiums, submitting changes to policies upon an insured’s request, and preparing claim forms.
The formation of a life or health insurance contract differs from the formation of other insurance contracts because the life or health producer usually does not have the authority to bind the insurer.
Insurance policies are legal contracts and are subject to the general law of contracts. This is a distinct body of law that is separate from criminal law (crimes against society) and tort law (legal liability issues usually involving damages for negligence). A contract is a legal agreement between two or more parties promising a certain performance in exchange for a valuable consideration. Under the law, the following elements are necessary for the formation of a valid contract:
There can be no contract without the agreement or mutual assent of the parties. A common intention on all terms of the contract is essential to an agreement and no essential terms of the contract may be left unsettled. Further, the intention of the parties to a contract must be communicated to one another.
The parties to an insurance contract are the insurance company and the applicant, who may become the insured or may name another person to be
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insured. Unless otherwise indicated, it is assumed that the applicant is the prospective insured.
An offer is a proposal that creates a contract if accepted by another party according to its terms. If an applicant gives the insurer a completed application and pays the first premium, the application is an offer. If the policy is issued as applied for, the insurer accepts the offer.
There is no offer if the applicant sends the application to the insurance company without payment of the premium. Such an application is merely an invitation to the company to make an offer. The insurance company makes an offer by issuing the policy. The applicant accepts it by paying the first premium.
An acceptance must be unconditional and unqualified. If an insurance company, after receiving an application and premium payment, issues a policy with more restrictive coverage than that applied for, the company has made a counter offer.
For example, a counter offer occurs if an applicant applies for a standard health insurance policy, pays the premium, and receives a policy containing an exclusionary endorsement for specified physical conditions. The applicant must decide whether to accept the policy as modified. If he or she accepts the policy, there is a contract. If he or she rejects the modified policy, there is no contract, and the applicant is entitled to a return of his or her premium.
Each party to the contract must give valuable consideration. In the insurance contract, the value given by the insurer consists of the promises contained in the policy contract. The consideration given by the insured consists of the statements made in the application and the payment of the initial premium.
The consideration may consist of any of the following:
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It is important to know that part of the applicant’s consideration consists of the statements in the application. A great deal of importance is placed on the representations in the application because the insurance company’s entire decision of whether to contract is based on its evaluation of the information in the application.
For a contract to be binding, both parties must have the legal capacity to make a contract. To have the legal capacity to make insurance contracts, an insurance company must have authority under its charter to issue contracts and be authorized by the state to issue contracts. The company’s representative must also be licensed by the state.
The insured or applicant must be of legal age and be mentally competent to make an insurance contract. Applications of minors must usually be signed by an adult parent or guardian to comply with the legal age requirement for making contracts.
To be valid, a contract must be for a legal purpose and not contrary to public policy. An insurance contract is not against public policy where an insurable interest exists.
Although it is not a legal requirement that all contracts be in writing, insurance contracts always are because of their complex nature. The number of pages that make up an insurance contract varies because of the types of insurance and the individual risks being insured, but all life/health insurance contracts contain four basic parts:
The policy face is usually the first page of the insurance policy. It includes the policy number, name of the insured, policy issue date, the amount of premi
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um and dates the premium is due, and the limits of the policy. The policy face also includes the signatures of the secretary and president of the issuing insurance company. In addition, there are generally clauses required by law to give the insured information on his or her right to cancel, and a warning to the insured to read the policy carefully.
The insuring clause generally also appears on the policy face. It is a statement by the insurance company that sets out the essential element of insurance— the promise to pay for losses covered by the policy in exchange for the insured’s premium and compliance with policy terms.
This section spells out in detail the rights and duties of both parties. Conditions are provisions that apply to the insured and insurer. For example, the conditions include the reinstatement provision, suicide clause, payment of claim provision, and similar standard policy provisions.
In this section, the company states what it will not do. The exclusions are a basic part of the contract and a complete knowledge of them is essential to a thorough understanding of the agreement. Certain risks must be excluded from insurance contracts because they are not insurable.
When the courts have a case involving contracts, it looks at the “rules of construction” to interpret the contract. The rules of construction help identify and establish the intent of the parties to the contract.
There are five major areas that the courts review in order to interpret the contract, establish the intent of the parties, and hand down a ruling.
If the language of the contract is clear the courts do not have to interpret the meaning of the contract. The courts give the words in the contract their “ordinary meaning.” In cases where ordinary words have been used in a technical capacity, the technical meaning of the word is accepted.
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The courts look at the entire contract to determine the intent of the parties. It does not consider material added to the basic contract, nor does it take only parts of the contract to make a determination.
Because the courts assume that when people make a contract they intend for it to be valid, the courts will, if possible, render an interpretation of the contract that makes it valid rather than invalid.
If a contract contains wording that is unclear the courts will interpret the language used against the writer of the contract, unless the wording used is required by law to be stated in a specific manner. Insurance contracts are contracts of adhesion, which means the insured had no part in determining the wording of the contract; therefore, the courts will interpret the contract in favor of the policyholder, insured, or beneficiary.
If a contract contains unclear or inconsistent material between printed, typed, or handwritten text in the contract, the typed or handwritten material will determine intent.
The insurance contract has certain characteristics not typically found in other types of contracts.
The insurance contract requires utmost good faith between the parties. This means that each party is entitled to rely on the representations of the other and each party should have a reasonable expectation that the other is acting in good faith without attempts to conceal or deceive. In a contact of utmost good faith, the parties have an affirmative duty to each other to disclose all material facts relating to the contract. That is not just a duty not to lie, but also a duty to speak up. Failure to do so usually gives the other party ground to void the contract.
An insurance contract is said to be aleatory, or dependent upon chance or uncertain outcome, because one party may receive much more in value than
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he or she gives in value under the contract. For example, an insured who has a loss may receive a greater payment from an insurer for the loss than he or she has paid in premiums. On the other hand, an insured might pay his or her premiums and have no loss, so the insurer pays nothing.
In insurance, the insurer writes the contract and the insured adheres to it. When a contract of adhesion is ambiguous in its terms, the courts will interpret the contract against the party who prepared it.
Insurance contracts are unilateral. This means that after the insured has completed the act of paying the premium, only the insurer promises to do anything further. The insurer has promised performance and is legally responsible. The insured has made no legally enforceable promises and cannot be held for breach of contract. For example, the insured may stop paying premium because he is not legally responsible to continue paying premium.
An insurance contract is an executory contract in that the promises described in the insurance contract are to be executed in the future, and only after certain events (losses) occur.
Insurance contracts are also conditional contracts because when the loss occurs certain conditions must be met to make the contract legally enforceable. For example, a policyholder might have to satisfy the test of having an insurable interest and satisfy the condition of submitting proof of loss.
Generally, insurance policies are personal contracts between the insured and insurer. Generally, insurance is not transferable to another person without the consent of the insurer. Fire insurance, for example, does not follow the property.
A warranty is something that becomes part of the contract itself and is a statement that is considered to be guaranteed to be true. Any breach of warranty provides grounds for voiding the contract.
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A representation is a statement believed to be true to the best of one’s knowledge. An insurer seeking to void coverage on the basis of a misrepresentation usually has to prove that the misrepresentation is material to the risk.
Under most state laws, an applicant’s statements or responses to questions on an application for insurance (in the absence of fraud) are considered to be representations and not warranties.
An example would be a question on the application asking for your sex or date of birth. You represent yourself to the insurance company as being male or female and a certain age. The accuracy of these items is very important to the insurance company issuing the policy. If they are incorrect, they may be considered misrepresentations, and the policy may be voided as a result.
There is a difference between representation of a fact and an expression of opinion. A good example is a question on many applications: “Are you now to the best of your knowledge and belief in good health?” If the applicant answers “yes” while knowing in fact that he or she is not, there is a misrepresentation of actual fact. If, on the other hand, he or she has had no medical opinion and suffers from no symptoms recognizable to a layman, his or her answer is an opinion and thus not a misrepresentation.
Impersonation means assuming the name and identity of another person for the purpose of committing a fraud. The offense is also known as false pretenses. In the case of life insurance, an uninsurable individual applying for insurance may ask another person to substitute for him to take the physical examination.
A misrepresentation is a written or oral statement that is false. Generally, in order for a misrepresentation to be grounds for voiding an insurance policy, it has to be material to the risk.
Concealment is the failure to disclose known facts. Generally, an insurer may be able to void the insurance if it can prove that the insured intentionally concealed a material fact.
Material information or a material fact is crucial to acceptance of the risk. For example, if the correct information about something would have caused the insurance company to deny a risk or issue a policy on a different basis, the information is material.
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Fraud is an intentional act designed to deceive and induce another party to part with something of value.
Fraud may involve misrepresentation and/or concealment, but not all acts of misrepresentation or concealment are acts of fraud. If someone intentionally lies in order to obtain coverage or to collect on a false claim, that would be a matter of fraud. If someone misrepresents something on an application (perhaps a medical treatment the person is embarrassed to talk about) without any intent to obtain something of value, no fraud has occurred.
The parol evidence rule limits the impact of waiver and estoppel on contract terms by disallowing oral evidence based on statements made before the contract was created. It is assumed that any oral agreements made before contract formation were incorporated into the written contract. After contract formation, earlier oral evidence will not be admitted in court to change or contradict the contract. An oral statement may waive contract provisions only when the statement occurs after the contract exists.
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1. Ralph is a producer for Hoosier Insurance Company. His contract states that he is allowed to put the company’s logo on his business cards and the door to his office. This is an example of
2. Tom has always made a practice of having his policyholders mail their premium checks directly to him, and forwarding them on to the insurer, so that he is aware of anyone missing a payment and can contact policyowners directly if that should happen. His contract does not allow this, but the insurer is aware of the practice and has not asked him to stop. This practice is an example of
3. Gina accepts the initial premium when she sells an insurance policy and sends it to the company with the application. Nothing in her contract mentions handling of initial premiums. This is an example of
4. Albert’s life insurance premium is due on the 10th of the month. Because he gets paid at the end of the month, he has always sent the premium late. The insurer has been accepting his premium this way for 3 years. A new CEO comes in and decides to crack down on late premiums, canceling Albert’s policy for nonpayment of premium. Albert contests this decision legally and gets the policy reinstated. The decision to reinstate the policy is an example of
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5. When representing an insurer, a producer acting as an agent has a
responsibility to act with the degree of care that
6. Which element is not necessary for the formation of a valid contract?
7. The initial premium payment sent with an application constitutes
which part of the formation of an insurance contract?
8. Life insurance contracts contain all the following except
9. Ken has paid only four premiums on his health insurance policy when he is hit by a car. The insurance company pays out nearly half a million dollars to cover his treatment and a lengthy stay in intensive care. This is an example of
10. Carol applies for a life insurance policy and pays the initial premium. Carol has
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11. The insurer looks at Carol’s application and decides to offer Carol a modified policy, including an exclusion Carol did not request. The insurer has
12. The failure to disclose known facts is
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✓ Applicant ✓ Policyowner ✓ Insured ✓ Beneficiary ✓ Standard risks ✓ Substandard risks ✓ Preferred risks ✓ Mortality ✓ Morbidity
✓ Adverse selection ✓ Insurance applications ✓ Attending physician’s statement ✓ Agent’s statement or report ✓ Inspection reports ✓ Investigative consumer reports ✓ Field underwriting ✓ Loss and expense ratios ✓ Insurance company reserves
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When the prospect has agreed to purchase an insurance contract and submitted an application, three important functions must take place:
Each of these activities is important—not only to provide the best possible service to the policyowners, but also to comply with state laws regulating the writing of life insurance policies.
It is important to clearly understand all the individuals who might be involved and the parts they play in the life insurance process. These might include the applicant, the insured, the policyowner, and the beneficiary. Although these are four separate roles, they may all be played by one person, or any combination of the four:
Most of the time, the applicant, policyowner, and insured are the same person. For example, a husband who applies for insurance on his own life will be the insured and most often will also be the policyowner.
The term third-party ownership refers to a situation where the policy is owned by someone other than the insured. For example, in a business situation, a corporation may apply for insurance on the life of a key employee. In this case, the corporation is the applicant and the policyowner, and the key employee is the insured. The corporation would also be the beneficiary.
By definition, underwriting is the process of selection, classification, and rating of risks. Simply put, underwriting is a risk selection process. The
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selection process consists of evaluating information and resources to determine how an individual will be classified (standard or substandard). When this part of the underwriting procedure is complete, the policy will be rated in terms of the premium that the applicant will pay. The policy will then be issued and subsequently delivered by the producer.
An underwriter’s job is to use all the information gathered from many sources to determine whether to accept a particular applicant. Individuals applying for individually owned life and health insurance receive more underwriting scrutiny than members of a group. The following concepts apply primarily to individual underwriting. The underwriter must exercise judgment based on his or her years of experience to read beyond the facts and get a true picture of the applicant’s lifestyle. Are there any factors (occupation, hobbies, lifestyle) that make this individual likely to die before his or her natural life expectancy?
Is there any reason to anticipate that this individual will be ill or involved in an accident that will cause high medical expenses? An underwriter cannot, and is not expected to, foresee all circumstances.
An underwriter’s purpose is to protect the insurance company insofar as he or she can against adverse selection—very poor risks and those parties with fraudulent intent. Adverse selection exists when the group of risks insured is more likely than the average group to experience loss.
For instance, in a randomly selected group of 1,000 25-year-old individuals, only two might be expected to die in a given year. Human nature is such that many healthy 25-year-olds do not see the need to buy life insurance and prefer to spend their money elsewhere.
It is only those 25-year-olds who are ill or perhaps employed in dangerous occupations who are likely to buy insurance. An underwriter must take care not to accept too many of these poorer-than-average risks or the insurance company will lose money.
The underwriter has various resources to provide the necessary information for the risk selection process:
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The application is a vital document because it is usually attached to and made a part of the contract. The producer must take special care with the accuracy of the application in the interest of both the company and the insured.
The application, which in actual form may vary from company to company, is divided into sections. Each section is designed to obtain specific types of information. The form of the application may differ from one company to another. However, most applications provide the following information:
Part I of the application asks for general or personal data regarding the insured. This would include such information as name and address, date of birth, business address and occupation, social security number, marital status, and other insurance owned. In addition, if the applicant and the insured are not the same person, the applicant’s name and address would be included in Part I.
Part II of the application is generally designed to provide information regarding the insured’s past medical history, current physical condition, and personal morals. If the insurance applied for qualifies as “nonmedical”, the producer and the insured will complete Part II of the information. In some cases, the proposed insured is required to take a medical examination, and Part II of the application is completed as part of the physical exam.
Part II of the application provides information regarding the past medical history of the insured by asking questions related to the types of illnesses and accidents experienced by the insured—periods of hospitalization and any surgery and reasons for visits to any physician.
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In addition, Part II requires information regarding the current health of the insured by asking for current medical treatment for any sickness or condition and types of medication taken. The name and address of the insured’s physician is also required.
Usually Part II of the application will also include questions regarding alcohol and any drug use by the insured. Avocations and high-risk hobbies are also usually reported on Part II. Generally, any plans for a prolonged trip or stay in a foreign country are also reported in Part II.
Another source of medical information available to the underwriter is an Attending Physician’s Statement (APS). After a review of the medical information contained on the application or the medical exam, the underwriter may request an APS from the proposed insured’s doctor.
Medical examinations, when required by the insurance company, are conducted by physicians or paramedics at the company’s expense. Usually such exams are not required with regard to health insurance (thus the importance of the agent in recording medical information on the application). The medical exam requirement is much more common with life insurance underwriting than with health insurance underwriting.
Simplified issue life insurance requires no medical exam and asks only very basic health-related questions on the application. Usually this type of insurance is available in only low face amounts to reduce the risk of adverse selection against the company.
Beginning in the decade of the 1980s, state legislatures and the insurance industry began developing responses to AIDS and two related conditions:
That these are diseases, like any other disease, is a key point of insurance legislation. Many states instruct insurers to treat AIDS, ARC, and HTLV-III infection exactly as they treat other disease or illness in these ways:
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State legislatures that have adopted specific AIDS insurance regulations often pointedly prevent insurers from attempting to identify in the applicant population those who appear likely to develop an AIDS-related condition. For example, insurers may be specifically prohibited from looking at certain characteristics of individuals in order to attempt to predict these health conditions, especially characteristics such as sexual orientation, marital status, and geographical area of residence. Instead, insurers are expected to develop sound statistical bases (just as they do for conditions such as heart disease or cancer) to draw on in making decisions to do the following:
Currently, state laws vary widely in regard to using certain tests to detect AIDS antibodies and using the results to make underwriting decisions. Blood tests for the AIDS virus prior to policy issuance are a common underwriting requirement. Typically, the proposed insured must sign a consent form before the blood test is performed. AIDS testing is almost always required whenever a large amount of insurance is applied for. Each insurance company sets thresholds for the ages and amounts of insurance for when medical underwriting (including blood tests for the AIDS virus) will be required.
Test results are confidential and certain procedures must be followed to inform the applicant of any positive results. A signed release form is required whenever test results will be disclosed to any party who is not otherwise entitled to the information.
The agent’s statement is part of the application and requires that the agent provide certain information regarding the proposed insured. Generally, this includes information regarding the producer’s relationship to the insured;
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data about the proposed insured’s financial status, habits, and general character; and any other information that may be pertinent to the risk being assumed by the insurer.
The application will also record information regarding the policyowner/insured’s choices with regard to the mode of premium (monthly, annually, and so forth), the use of dividends, and the designation of a beneficiary.
Finally, the signatures of the insured (and the policyowner if different from the insured) are required in the appropriate places on the application. Usually, the producer also signs the application as a witness to the applicant’s signatures.
To supplement the information on the application, the underwriter orders an inspection report, which covers financial and moral information about the applicant, from an independent investigating firm or credit agency. This information is used to determine the insurability of the applicant. If the amount of insurance applied for is average, the inspector will write a general report in regard to the applicant’s finances, health, character, work, hobbies, and other habits.
The inspector will make a more detailed report when larger amounts of insurance are requested. This information is based on interviews with the applicant’s associates at home (neighbors, friends), at work, and elsewhere.
An “investigative consumer report” includes information on a consumer’s character, general reputation, personal habits, and mode of living that is obtained through investigation—that is, interviews with associates and friends and neighbors of the consumer.
Such reports may not be made unless the consumer is clearly and accurately told about the report in writing. This consumer report notification is usually part of the application. At the time the application is completed, the producer will separate the notification and give it to the applicant.
Another source of information that may aid the underwriter in determining whether or not to underwrite a risk is the Medical Information Bureau (MIB). This is a nonprofit trade association that maintains medical information on applicants for life and health insurance.
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The MIB maintains a database of medical information and avocation risks on applicants for life and health insurance. For every 10 applicants, the MIB will have a file on one or two. MIB information is reported in code form to member companies in order to preserve the confidentiality of the contents. The database does not contain any details about the risk. The codes simply alert companies to the fact that there was information obtained and reported by a member company on this particular impairment or avocation risk. The report does not indicate any action taken by other insurers, nor the amount of life insurance requested.
Underwriters compare the MIB file against the information contained in the application. If the MIB file contains a code for a condition that should be listed on the application but isn’t, the underwriter inquires more specifically about that area. For example, an MIB file might contain a code indicating high cholesterol levels, but the application indicates that the applicant had no ongoing medical conditions. This would prompt the underwriter to investigate whether the applicant had misrepresented his or her health status or perhaps had been able to reverse the condition.
In addition to tracking medical and avocation information, the MIB also reports the number of times information has been requested on an individual in the previous 2 years. There are two reasons for this report, which is called the Insurance Activity Index (IAI). The first reason is to allow insurance companies to identify people who frequently replace their insurance policies.
Because most of the costs associated with issuing a policy occur in the first 1 or 2 years, insurance companies are interested in identifying individuals who are likely to cancel their policy after only a year.
The IAI may also identify situations where an individual is loading up on insurance policies by applying for a series of smaller policies that might fall below the radar screen for other underwriting requirements. By purchasing several small to midsize policies, an individual may be trying to avoid drawing attention to the accumulation of an extremely generous death benefit. An insurer may not refuse to accept a risk based solely on the information contained in an MIB report. There must be other substantiating factors that lead an insurer to decide to deny coverage. The MIB must provide explanations to applicants who are denied coverage, allowing consumers to challenge possibly inaccurate information about their medical history.
A key element in the underwriting process is the role of the insurance producer. The producer is in a position to see and talk to the proposed insured,
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to ask the questions contained on the application, and to accurately and completely record the answers to those questions.
Thus, one of the most important functions of the producer is the completion of the application. Much of the information reported on the application becomes the basis upon which to accept or reject the proposed insured. In addition, a signed and witnessed copy of the application becomes part of the policy, the legal contract between the insured and the insurer.
As a field underwriter, the producer can help expedite the underwriting process by the prompt submission of the application, by scheduling the applicant for a physical exam (if necessary), and by assisting the home office underwriter with other requirements such as obtaining an APS.
The most important element of this process for the producer is the accuracy, thoroughness, and honesty displayed when completing the application. Answers to questions must be recorded accurately and completely by the producer.
If the proposed insured is rated or declined for the insurance, it is the producer’s role as a field underwriter to explain the reasons for the underwriting action. Seldom is an individual declined for life insurance but it does happen that he or she might be classified as substandard and thus a rated or substandard policy may be issued in lieu of the one applied for. When this occurs, the producer must be prepared to not only explain the reasons for the substandard rating but also to explain the rated policy that the company has issued.
As was previously stated, underwriting is the process of selection, classification, and rating of risks. Risk classification refers to the determination of whether a risk is standard or substandard based on the underwriting or risk evaluation process. Basically, a standard risk is simply an average risk.
Standard risks are those who bear the same health, habit, and occupational characteristics as the persons on whose lives the mortality table used was compiled. Most insurers offer special but higher rates to persons who are not acceptable at standard rates because of health, habits, or occupation. This is sometimes called “extra risk” insurance. Some companies have coined
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euphemistic names for it in order to avoid the rather insulting implication that persons offered this type of coverage are substandard. There are several methods of determining the extra rate for the substandard class of risk:
If a substandard risk presents an above average risk of loss, a preferred risk presents a below average risk of loss. In an effort to encourage the public to practice better health, the insurance industry has developed preferred risk policies with lower (or preferred) premium rates.
Those applicants who may be eligible for preferred risk classification are those who
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The final step in the underwriting process is the rating of the risk or the determination of the premium. There are three factors used in determining insurance rates:
If underwriters could predict exactly how long each insured would live, they could charge a premium for each risk that was precisely correct for covering the policy face amount, and expenses, while taking into account the interest to be earned on the premium paid. Of course underwriters cannot do this on individual policies, but they can predict the probability of numbers of deaths for a large group of people. This is an example of the law of large numbers in action.
Insurance companies have kept the kind of records required to produce precise predictions, and the result is called a mortality table. The table is based on statistics kept by insurance companies over the years on mortality by age, sex, and other characteristics.
The deaths per 1,000 (mortality rate) is taken from the mortality table and converted into a dollar-and-cents rate. For instance, if the mortality rate for a particular age group is 3.00, it means, on the average, three out of every 1,000 can be expected to die at that age. An insurance company needs to collect $3 from each of 1,000 policyowners in order to have sufficient premium to pay out $1,000 in benefits for the three who are expected to die in that age group.
Health insurance policies use related but much more complex statistics to determine morbidity rates. Morbidity is the likelihood that a person will suffer an accident, contract a disease, or otherwise require medical care. For many
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years, insurance companies have kept records that document the outcome of insuring various types of risks. For instance, they know that older people are more likely to become ill than younger people, so health insurance premiums tend to be higher for older people. Similarly, insurers know that people employed in certain occupations are more likely to be injured than those in other occupations. These determinations are based on what has happened in the past, the company’s and the industry’s experience.
In order to set rates for health insurance, however, insurers need to consider not only how often people will become ill or injured, but how much it will cost when they do. Insurers look at how frequently claims happen among a particular population, or the claim frequency rate, as well as the average dollar amount per claim. These two figures are multiplied to create the aggregate claim amount, which is a primary element in calculating health insurance rates.
Because premiums are paid in advance of claims, insurance companies have money to invest to earn interest. This interest helps to lower the premium rate. It is assumed that all premiums are paid at the beginning of the year and all claims paid at the end. Therefore, it becomes necessary to determine how much should be charged at the beginning of the year, assuming a given rate of interest, to have enough money at the end of the year to pay all claims.
Using the cost of mortality and discounting for interest, there is enough money to pay claims, but we have no money to pay operation expenses. The premium without expense loading is a “net” premium. (Do not confuse “net” as it is used here with the same term sometimes used to indicate a participating premium minus dividends paid.)
An expense loading is added to the net premium in order to
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Loading consists of four main items:
The gross annual premium, the amount the policyowner actually pays for the policy, equals the mortality risk discounted for interest, plus expenses. By definition, the net premium is the mortality risk discounted for interest, without any expense adjustment.
The risk factor increases with age. This is the reason that some life insurance policy premiums increase periodically. For example, the premium for a 1year renewable and convertible term insurance policy increases each year because each year the insured is one year older and thus the mortality risk is greater. This can result in very expensive premiums as the insured becomes older.
The level premium concept was devised to solve this problem of increasing premiums. Mathematically, the level premiums paid by the policyowner are equal to the increasing sum of the premiums caused by the increased risk of mortality. Accordingly, in the early years of the policy, the level premiums paid are actually more than the amount necessary to cover the cost of mortality.
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Conversely, in the later years of the policy, the premiums paid are less that the amount necessary to cover the increased cost of mortality. This “shortage” in the later years of the policy is accounted for by the overcharges (plus interest earned) in the early policy years.
After the single premium amount has been determined, the company will break this amount into smaller amounts (annual, semiannual, quarterly, or monthly) that will be more convenient for the insured to pay.
This frequency of payment is called the premium mode. This is important because the insurance company invests the premium amounts it receives and uses the income as part of the eventual settlement. The more payments the insured wants to break his premium into, the higher the total premium, to include the interest lost by not receiving money for coverage in advance and increased administrative expenses.
Loss and expense ratios are basic guidelines to the quality of company underwriting. A loss ratio is determined by dividing losses by total premiums received. Loss ratios are often calculated by account, by line of insurance, by “book of business” (all accounts placed by each producer or agency), and for all business written by an insurer. Loss ratio information may be used to make decisions about whether to renew accounts, whether to continue agency contracts, and whether to tighten underwriting standards on a given line of insurance. An expense ratio is determined by dividing an insurer’s operating expenses (including commissions paid) by total premiums.
When the combined loss and expense ratio is 100%, the insurer breaks even. If the combined ratio exceeds 100%, an underwriting loss has occurred. If the combined ratio is less than 100%, an underwriting profit, or gain, has been realized.
For example, let’s assume that the ABC Insurance Company realizes $3 million in underwriting losses for all term insurance policies. This same block of business also generates $10 million in premium. The loss ratio in this case would be 30% ($3 million divided by $10 million).
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Further, let’s assume that the ABC Insurance Company has operating expenses totaling $2 million for this same block of term insurance. The expense ratio would therefore be 20% ($2 million divided by $10 Million).
Because the combined loss and expense ratio equals 50%, the ABC Insurance Company has an underwriting gain or profit on this block of term insurance.
Insurers are required to follow certain regulations and laws to be certain they will have the money needed to pay claims as they arise. Funds set aside to pay future, existing, and ongoing claims are known as reserves. Reserves are accounting measurements of an insurer’s liabilities to its policyholders. Theoretically, the reserve is the amount together with interest to be earned and premiums to be paid that will exactly equal all the company’s contractual obligations. Companies must also keep enough on hand to pay claims that might arise should some major catastrophe occur on a local, regional, or national basis. Because insurance premiums are paid in advance, an insurance company always has a certain amount of money that it has not yet earned by providing protection. This amount, too, is considered a reserve, called an unpaid premium reserve. When a policy is canceled before its term ends, unpaid premium is ordinarily returned to the former policyowner.
A life insurance reserve is a fixed liability of the insurer. By law, a portion of every premium must be set aside as a reserve against the future claim from the policy as well as other contractual obligations, such as cash surrender and nonforfeiture values. Accordingly, the policy reserve is equal to the premiums paid plus the interest earned on those premiums and other policy obligations.
Insurance companies demonstrate their solvency to the state insurance departments by showing their assets as well as adequate funds to cover their reserve obligations. In addition to its assets, the insurer must show that it will continue to receive future premiums plus interest in order to cover its reserve obligation.
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1. John fills out an application for a life insurance policy to insure his own life, and for which he plans to pay the premiums. John is playing all the following roles except
2. Life insurance that requires no medical exam and asks only basic medical questions is known as
3. In many jurisdictions, testing for the presence of HIV infection requires all the following except
4. Which of the following is not likely to be contained in an MIB report?
5. If an applicant is rated or declined an insurance policy, the reasons for this decision will be explained to the applicant by
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6. A is a 25-year-old who drinks very occasionally, does not smoke, and
does not have any known health problems. A would probably be classi
fied by an insurer as
7. Which of the following does not have an impact on insurance premium
8. To be certain the insurer has the money available to pay claims as they
arise, it is required to maintain
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✓ Employee group ✓ Multiple employer group ✓ Trust group ✓ Association group ✓ Labor union group ✓ Creditor group ✓ Contributory group ✓ Noncontributory group
✓ Adverse selection ✓ Probationary period ✓ Eligibility period ✓ Nondiscriminatory classifications ✓ Enrollment percentage
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Group insurance provides coverage to many people under one policy. It gets its name from the requirement that several people must first be members of a group before they become eligible to purchase the insurance.
A person who is covered by group insurance does not receive a policy as proof of insurance. As the master policyowner, the group receives and holds the insurance policy. The insured group members receive a certificate of insurance that certifies the coverage, the benefits under the policy, the name of the covered individual or individuals, and the name of the beneficiary if applicable.
The first type of group would be the employees of an eligible employer. This is called an employee group or an individual employer group. The employer is the policyowner and establishes the eligible class of employees to be covered under the group policy.
Usually, this classification will include all full-time employees (including the employer). Further, the classification can also specify full-time, salaried, nonunion employees. By classifying the employee group in this manner, the employer is legally able to exclude certain groups of employees (part-time, union, and so forth) from the eligible class of covered employees. The eligible class of employees may also include retired employees.
A second type of group could be composed of several employers forming a trust fund to combine their workers for life insurance eligibility. This is known as a multiple employer group. The trusts are called multiple employer trusts (METs).
A policy may be issued to the trustees of a trust group if the fund has been
The trustees are the policyholders of the plan that covers eligible employees. This type of plan must not be for the benefit of the employer, union, or association. The individuals who may be considered “employees” as defined by this section are the same as those previously listed under employee group.
A third type of organization eligible for group insurance includes members of labor organizations, such as the United Auto Workers. An association or labor group must have the following characteristics to be considered an authorized group:
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Credit group insurance is written to provide payment of the insured’s debt when he or she dies prematurely or is disabled due to accident or sickness. The creditor is the policyowner and the debtor the insured. Benefits under credit insurance are not permitted to exceed the amount of indebtedness.
Group insurance policies are often able to provide coverage at a lower premium than individual policies. One reason for this is that the administrative costs to cover a group of 50 people are much lower than the administrative costs involved in writing 50 separate policies.
Group insurance premiums are based on the experience of the group as a whole. Premium may be paid entirely by the policyowner, or it may be paid jointly by the policyowner and the insured.
If the insured contributes money toward the premium, the plan is considered contributory. In most states, at least 75% of the eligible employees must participate under a contributory plan. If the premium is paid entirely by the policyowner, the plan is considered noncontributory. All the eligible members must participate in noncontributory plans.
Group life insurance is usually written on a group basis as opposed to an individual basis. In other words, the underwriter focuses on the group as a whole, rather than individual members. Each group participant completes a very short application form, which usually consists of the individual’s name, address, social security number, dependent information, and beneficiary designation.
For group insurance enrollments, there are no medical questions. Thus, no medical underwriting takes place. However, evidence of insurability must be furnished by an employee who wants to join a contributory group after the period of eligibility has ended.
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It is therefore possible for individuals in poor health to receive group insurance benefits because there is no medical underwriting. All eligible participants obtain coverage. However, some underwriting—that is, risk selection—is done to help protect insurers from adverse selection. This underwriting is done on the characteristics of the group rather than the individual medical status of each person insured.
Adverse selection is the tendency for poor risks to seek and be covered for insurance more often than average risks. Thus in a group situation, the underwriter must consider such things as the type of work done, the ages of the participants, and the probability of this particular group being an adverse risk to the company. For example, a group of coal miners presents a much different risk than a group of bank employees.
When a group is written, the underwriter wants the business to stay on the books and thus is concerned about the financial stability of the company. If the company has a history of financial problems—bankruptcy, layoffs due to no work, seasonal employment—possibly the group may be declined for these financial reasons.
The insurer does not necessarily want a group in which there is no turnover. If the loss experience is to be favorable, employees must leave the group due to retirement or terminations and new (younger) employees must take their place. This turnover of employees helps bring some stability in terms of loss experience and possible adverse selection.
A risk will be rejected when the insurer believes the applicant cannot be profitable at a reasonable premium or with reasonable coverage modifications. If a risk is rejected based on information in an investigative report, the applicant must be notified and given the name and address of the reporting company. In health insurance, when renewal is denied, the insured must be given a written explanation for nonrenewal or be notified that the explanation is available upon written request.
Often, individuals coming into a covered group will be required to serve a probationary period before becoming eligible for group coverage. It costs the insurer money to enroll an individual in a group plan. Some groups experience high turnover among membership. It would be prohibitively expensive,
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for example, to cover all workers in a business as of the first day of employment in businesses with high turnover.
To avoid this expense, the insurer usually requires that employees be on the job a specified period of time before the insurance is put into force. This period of time is often 90 days, though it can be longer or shorter.
If the group plan is noncontributory, all individuals become immediately covered after the probationary period. If the plan is contributory, the employees must first fulfill the probationary period, and then must enroll within the eligibility period to avoid medical underwriting. This is one way insurers protect against adverse selection.
The eligibility period typically runs for 30 or 31 days after the probationary period expires. If the group member does not apply during the eligibility period, he or she is generally required to take a medical exam before being eligible for coverage.
If an individual does not enroll during the eligibility period, but wants to enroll later, he or she will generally be required to take a physical examination and will be selected on an individual basis, as if the policy were an individual policy.
The following factors and requirements represent the underwriting criteria for group health insurance.
There are only a few statutory requirements affecting the underwriting of group policies. Perhaps the most significant are laws prohibiting discrimination.
An eligible group must not discriminate in favor of particular individuals. For instance, if an employer has five typists in the same job classification (job title and salary range), the employer cannot single out one typist to receive benefits greater than the other four typists. Therefore, employees will be
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grouped under classifications, such as, “all eligible full-time employees,” “all clerical workers,” “all hourly employees,” “all salaried employees,” “all executives,” “employees working one year or more,” or “employees earning not less than $10,000 but not more than $15,000.”
Optional requirements are usually imposed by the insurance companies, rather than by state law.
The employer should be in charge of enrollment, premium payment, benefit selection, and all other areas of administration that are not an insurance company function.
Most insurers require a minimum number of employees or plan participants before a group health insurance plan may be written. This requirement may vary depending on state laws. Typically, the minimum group size for health insurance is 10 but it could be as low as five or some other number.
The underwriter should determine that individual coverage is based on some plan other than individual selection.
The insurance company requires that a majority of eligible individuals be members of the group of insureds. For example, under a plan of insurance where an employer pays the entire premium, and the employee does not contribute to the premium payment (noncontributory plan), 100% of all eligible employees must be covered. Under a plan where both the employer and the employee contribute toward the premium payment (contributory plan), 75% of all eligible employees must be covered.
The underwriter should determine that the group has not been formed only for the purpose of purchasing insurance. If individuals could form a group for the purpose of obtaining insurance, the chance of adverse selection would increase dramatically.
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The underwriter should first determine that the business is one that the insurer will cover. Because death and illness rates differ in different parts of the country, underwriters may take geographic location into account. Certain parts of the country also are more prone to catastrophic loss from natural disasters.
The underwriter should determine that the group is of such nature that there is a reasonably steady flow of new members into the group. A new insurer also may establish a preexisting condition provision in the group contract that excludes coverage for any condition that exists before the effective date of coverage. This provision will normally exclude these conditions for a period of 6 or 12 months after the effective date of coverage.
Generally, there will also be a requirement that only employees currently working at least 25 hours per week are eligible for coverage.
Several mechanisms for funding group insurance have been developed. Alternative funding allows employers to absorb some of the risk and save premium dollars (and increase cash flow).
For example, a shared funding arrangement allows the employer to self-fund health care expenses up to a certain limit. The employer can select a deductible and pay covered expenses for any individual incurring claims up to that maximum, at which point the insurer assumes the risk.
Under a retrospective premium arrangement, the insurer agrees to collect a provisional premium but may collect additional premium or make a premium refund at the end of the year based on the actual incurred losses.
A minimum premium plan is where the employer agrees to fund expected claims and the insurer funds excess claims. The employer and insurer agree to a trigger beyond which the insurer is liable. The employer is responsible for a minimum premium consisting of administrative expenses, reserves, and a premium for stop-loss to fund claims over the trigger.
A large employer may elect to fully self-fund, or may self-fund a plan but contract for administrative services only (ASO).
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1. The baker’s union and the butcher’s union worked together to form a trust to provide insurance to their employees. This type of group is called
2. Jimmy’s Print Shop and Bryan’s Boutique join to form a trust to provide insurance to their employees. This type of group is called a
3. The candlestick maker offers insurance to its employees. This type of group is called a
4. The United Auto Workers union provides insurance to its employees. This type of group is called
5. General Electricians offers insurance to its employees. About 80% of the eligible employees are currently covered under the plan. The plan is most likely
6. Group insurance generally does not require
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7. Sara is hired to work at a restaurant. She is not eligible to join the
group insurance plan for 30 days. This is an example of
8. Marie has worked at the restaurant for more than a year, but she never
participated in the insurance program. She decides that it is now time
to join. She is required to undergo a medical exam because she is sign
ing up after
9. Which of the following group underwriting characteristics is generally
required by law?
10. Kelsy’s Printing funds all the claims in a year, regardless of the amount of the claim. Kelsy’s insurer manages the paperwork for the claims. What option is Kelsy’s Printing using?
11. Al’s Print Shop pays a provisional premium at the beginning of the year. At the end of the year, Al’s insurer has the right to change that premium by charging more or issuing a refund. Al’s policy is funded using which premium option?
12. PDQ Printing pays for all the routine claims. PDQ’s insurer pays for excess or unexpected claims beyond a specified trigger point. PDQ’s policy is funded using which premium option?
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✓ Inter vivos transfers ✓ Testamentary transfers ✓ Accelerated benefits ✓ Viatical settlement ✓ Buy-sell agreement ✓ Key person life insurance ✓ Deferred compensation
✓ Costs associated with death ✓ Human life value approach ✓ Needs approach ✓ Capital conservation ✓ Capital liquidation ✓ Estate planning ✓ Split-dollar plan
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The loss of human life is tragic in many ways. The financial results alone of such a loss can be devastating. If the principal breadwinner dies, the spouse might not be able to maintain the family on social security benefits. If there were two breadwinners in the family, the surviving spouse might not be able to maintain the family’s lifestyle on his or her income alone. The death of a single parent might leave dependent children without an adequate source of support.
Life insurance products are designed to provide a number of unique and powerful features. But the one benefit all life insurance products have in common is that they provide financial security—a measure of certainty in an area marked by risk and change. And although different clients may find different life insurance products appealing in their particular circumstances, the one reason they all buy life insurance is to obtain that measure of financial security.
Studies show that less than half of American adults own individual life insurance, and the average American adult has just $45,000 of life insurance. Relying on the group life insurance provided at work can build a false sense of security, because coverage is usually insufficient for family needs and generally ceases when employment terminates. Experts agree that few people protect their own “full value” with life insurance, leaving their families at risk.
When an individual dies, he or she typically leaves behind certain costs associated with death, which include
In addition, to those individuals leaving behind a family or others who are financially dependent on them for support, the following financial needs will immediately become apparent:
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The insurance producer is the person most qualified to help potential insureds select the contract of insurance that will best meet their needs.
This needs analysis can be accomplished by identifying the specific financial objectives of the individual by means of a fact-finding interview. This interview covers the following financial needs:
After the needs analysis is complete, the producer should make recommendations about the amount and type of insurance needed by the individual. These recommendations should consider the following:
The human life value concept puts a dollar value on an individual based on the earning potential of the insured, calculated and projected over a period of years (capitalized), taking into account four factors:
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The human life value concept is a way of determining what a family would lose in income by the death of the principal wage earner. By this method, if the insured died, the family could be reimbursed for that loss.
Looking at the needs of an individual and his or her dependents is considered the best method for determining the amount and kind of insurance a prospect should buy. Basically, the needs method looks at such things as
After determining needs, the agent must find out how much the prospect can afford to pay in premium and make further adjustments to the proposed plan based on the prospect’s financial position, keeping in mind the various term policies and riders.
A typical married couple with children will have fluctuating income needs based on the changes in their family. To properly determine how much life insurance protection they will need if an income-earner dies, their needs should be divided into three different income periods. The first period is called the family dependency period because the surviving spouse will have children to support during this time, which means the family’s income needs will be greatest during this period. When the children are no longer dependent on the surviving spouse, he or she enters the preretirement period. Because the surviving spouse qualifies for social security survivor benefits only when he or she has dependent children in his or her care or after reaching the age of
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60, this period is also referred to as the blackout period. Usually, the surviving spouse’s income needs lessen during this period. The final period is called the retirement period. During this period, the surviving spouse’s working income ceases and his or her social security and outside retirement benefits begin.
Because the surviving spouse’s standard of living does not lessen, he or she will require an income comparable to the preretirement period during this time.
There are two methods used to calculate the amount of life insurance needed to supply an individual or family with the desired amount of capital to generate income if an income-earner should die prematurely. Capital conservation (sometimes called capital retention) and capital liquidation (sometimes called capital utilization) differ in how capital is used to generate income for the surviving family.
Under the capital conservation method, income is derived only from interest gained on the principal. But under the capital liquidation method, both the interest and the principal are used to generate income. Generally, this means that a smaller fund is needed when using the capital liquidation method because there is no concern for leaving the principal intact.
Some individuals find the smaller fund required an attractive feature of the capital liquidation method, but the capital conservation method has two significant advantages:
Life insurance can also create an immediate estate for the insured and provide funds that will help preserve the greatest amount of value in the estate.
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The field of estate planning is very complicated. It requires expertise in the areas of wills, taxes, law, and life insurance. Some of the items to be considered when planning an estate are
There are two methods of distributing the estate; inter vivos transfers, or testamentary transfers.
Inter vivos transfers are made while the estate owner is still alive. Transfers can be made as
Testamentary transfers are made by will after the death of the estate owner. If the estate owner dies without leaving a will, which is called dying intestate, the property will be transferred as an intestate distribution under the laws of the state.
In determining the amount and kind of insurance an applicant needs, the agent must consider other sources of income or benefits the applicant currently has, or for which he or she may be eligible under other insurance plans, government programs (such as social security), and retirement plans (pensions, IRAs, Keoghs, and so forth). Some other sources of funds to be considered are
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The primary reason to own life insurance is the death benefit—the money the beneficiaries will receive when the insured dies. But life insurance can also provide benefits for the policyowner while he or she is living.
The living benefit of the most prevalent type of life insurance is the cash value it accumulates. Throughout the years of premium payments, part of these payments accumulates for the insured as a cash value. This cash accumulation may be used as collateral for policy loans or later as retirement income. Many policies allow withdrawals from the policy’s cash value, which can be used to meet emergencies or to pay off debts. Participating policies also pay dividends, which are another form of living benefit.
Although not all types of life insurance policies accumulate cash values or make payments to policyowners, you should recognize these “living benefits” of life insurance:
A life insurance policy’s cash value can be used as a collateral for borrowing money. Suppose an insured goes to a bank to borrow money. The bank will want to determine the type and amount of property the individual can call on to pay off the loan should his or her income be suspended. Life insurance can act as collateral or “back-up” property for the loan.
Another advantage of life insurance as property is one you have already learned—it creates an immediate estate.
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Suppose a man invests in a piece of land. He may have to wait years and years for that land to appreciate. Its value may never quite reach what he had anticipated. If that man were to die the day after buying the land, whether he paid cash for it or not, his family might have difficulty getting the money back that was invested.
Not so with life insurance. The instant a life insurance policy goes into effect, the insured policyowner has established a fund that will be paid to her or her beneficiary—even if only one premium payment has been made. There is no waiting for the property to appreciate in value; no worrying whether the value will actually rise as expected.
There are other advantages to life insurance as property:
Life insurance cost comparison methods are used to compare the cost of one life insurance policy against another in order to guide prospective purchasers to policies that are competitively priced.
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This analysis examines the rate of return that must be earned on a hypothetical side fund in a “buy-term-invest-the-difference” plan so that the value of the side fund will be exactly equal to the surrender value of the higher premium policy at a designated point in time. The higher the comparative interest rate (CIR), the less expensive the higher-premium policy relative to the alternative plan. Outlays and death benefits are held equal. The CIR method requires a computer because the final interest rate is found through trial and error.
To compare two different policies, it is not enough just to compare premiums. A lower premium does not automatically mean a low-cost policy. Cost indexes have been developed to help measure the cost of a policy.
This analysis is conducted over a set time period considering a policy’s premiums, death benefits, cash values, and dividends, recognizing the accumulated interest over the set time period. The NAIC Model Life Insurance Solicitation Regulation requires two interest-adjusted cost indexes for a policy—a surrender cost index and a net payment cost index.
These indexes show average annual costs and payments per $1,000 of insurance on a basis that recognizes that $1 payable today is worth more than $1 payable in the future. Both assume that the insured will live and pay premiums for a period of years. Most companies provide these index numbers on both a guaranteed and an illustrated basis.
The surrender cost index method uses a complicated formula, but the basic process works like this. The policy’s premiums and dividends are accumulated over a period of years (say 10 or 20) at some assumed annual rate of interest, often 4% or 5%. Then the total accumulated dividends are added to the cash value at the end of the period (plus any terminal dividends), and this total is subtracted from the accumulated premium payments. In other words, the projected total cash value of the policy at some point in the future is subtracted from the total premium payments to that same point in the future to find out how much the policy cost. This net cost is averaged over the number of years in the period to arrive at the average cost-per-thousand for a policy that is surrendered for its cash value at the end of the period.
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The net payment cost index is developed in the same way, but it does not assume the policy is surrendered at the end of the period. The same formula is used, but the cash value element is omitted. Instead, this index provides an estimate of the policyowner’s average annual out-of-pocket net premium outlay, adjusted for time value of money.
Cost indexes can be a significant help to life insurance consumers. It’s important, however, to understand that in using cost indexes, the consumer should compare index numbers only for similar kinds of plans and only for the kind of policy for the consumer’s age and the amount he or she intends to buy. Policy features and company service could offset small differences in cost index comparisons.
In addition to providing death benefits—the most obvious purpose of a life insurance policy—life insurance serves a number of other purposes that may fulfill the needs of individuals and businesses. The next two sections discuss personal and business uses of life insurance.
Life insurance is the only financial services product that guarantees a specific sum of money will be available at exactly the time that it is needed. From a personal perspective, life insurance may be used to provide
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If an insured has a terminal illness, a life insurance policy may be his or her last substantial source of money. The life insurance benefits may be made available for medical expenses and living expenses prior to death through accelerated benefit provisions or viatical settlement agreements.
Accelerated benefits are living benefits paid by the insurance company that reduce the remaining death benefit. The government does not consider accelerated death payments to be taxable income, and the policyowner gets between 50–95% of the policy’s full benefit.
Under a viatical settlement, the policyholder sells all rights to the life insurance policy to a viatical settlement company, which advances a percentage (usually 60%–80%) of the eventual death benefit. The viatical settlement company then receives the death benefit when the insured ultimately dies.
Beginning in 1997, proceeds from viatical settlements and accelerated benefits are not taxable as income. Although accelerated death benefits may require a life expectancy of one year or less, viatical settlements may be available for a person who has up to five years to live.
Another use of life insurance is for charitable purposes. In accordance with tax laws, a policyowner may purchase a life insurance contract on his or her life, pay the premiums, and designate a charitable organization as the beneficiary—such as a church, school, hospital, or similar organization. Generally, the premium paid by the insured-donor is tax deductible.
There are generally three types of business organizations: the sole proprietorship, the partnership, and the corporation. Regardless of business type, a business has the same need as an individual—protection against premature death and the delivery of cash exactly when it is needed.
This cash need relates to the disposition of a business interest upon the death of the sole proprietor, a partner or a corporate stockholder. Disposition of the deceased’s business asset usually means the sale of the business, retention of the business within the family or liquidating the business. The difference between a sale and liquidation is that a sale will usually result in the family receiving a fair market value for the business interest. Liquidation is a forced sale that may only bring one-tenth of the true business value.
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In some situations, liquidation of the business is necessary or mandated by law. However, liquidation is the least desirable method of disposing of the deceased’s business interest. The sale or retention of the business requires
A sole proprietorship is an unincorporated form of business whereby an individual owns and manages a business. Even though a sole proprietorship may have several employees, it is the sole proprietor who is generally directly responsible for the success of the business.
The sole proprietor has unlimited liability with regard to the business operation. Creditors can claim both the sole proprietor’s business assets as well as personal assets. When the sole proprietor dies, the business also dies. This business asset becomes part of the deceased’s estate and is commingled with other personal assets subject to taxation, the payment of debts, and claims of creditors.
Generally, the business is the principal asset in the sole proprietor’s estate. It is also normally the only source of income for the family. Upon the death of the sole proprietor, family income ceases and, unless adequate planning has occurred, the business may have to be liquidated for a fraction of its value in order to pay estate settlement costs.
Life insurance can be used to solve the problems created by the death of the sole proprietor. Life insurance may fund a business continuation agreement (also known as a buy-sell agreement) by providing necessary cash with which to keep the business doors open until possibly the business can be sold at its fair market value for the benefit of the family. Life insurance can also be used to provide funds for a competent employee or other qualified person to purchase the business from the surviving family members.
A partnership is a legal, non-incorporated business relationship involving two or more individuals who each contribute their unique skills, talents, and capital for the purpose of owning and operating a business enterprise. As a partnership, each partner has unlimited liability with regard to partnership
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functions. As such, business creditors may claim personal assets for payment of debts.
Generally, by law, when a partner dies, the surviving partner(s) must dissolve the business. The survivor becomes a liquidating trustee and in essence liquidates the business and his or her own job, eliminating the family’s principal source of income. Disposition of the deceased’s business asset is required in order to settle the deceased’s estate.
To a large degree, the problems created by the death of a partner can be resolved by means of a properly drawn buy-sell agreement. If there are only two or three partners, a cross-purchase plan may be advisable in which each partner is bound by the terms of the plan and agrees to purchase a share of the deceased partner’s interest. If there are more than two or three partners, the entity type plan is usually recommended, whereby the partnership agrees to purchase the interest of a deceased partner.
The key element for partnership planning is the funding of the agreements.
Life insurance is the ideal choice to guarantee that the required amount of money will be delivered exactly when it is needed. A cross-purchase plan covering two partners would require that each partner own, pay the premium, and be the beneficiary of a life insurance policy on the life of the other partner.
If the partnership consisted of six partners, each partner would be the owner of five policies for a total of 30 life insurance policies. This is the reason why an entity agreement is usually recommended if there are more than two or three partners. Under an entity agreement involving six partners, the partnership would own six policies.
The principal advantages of the funded buy-sell agreement include
A corporation is an “artificial person.” It is a legal entity that is owned by its stockholders. One of the characteristics that distinguishes a corporation from
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the other business forms is that its life is unlimited. When a working stockholder dies, the corporation continues. Another distinguishing characteristic is that stockholders have limited liability. A stockholder’s risk is limited to his or her investment in the corporation. Personal assets are generally safe from the claim’s of creditors.
Corporations may be classified as closely held or publicly held. A close corporation is typically one that is owned by a few stockholders, often members of the same family. A publicly owned corporation may be owned by several thousand stockholders, such as General Motors. This discussion of corporate insurance needs will be limited to the close corporation.
The death of a stockholder in a closely held corporation means the loss of services of this key person and quite possibly loss of business income. However, the most immediate effect will be the loss of income to the deceased’s family. The choices available to the family are to sell the deceased’s stock, attempt to live off of any dividends that the corporation may pay, or assume a working position within the corporation.
Probably, the most desirable alternative is to sell the deceased’s stock.
Attempting to live on dividend income only will probably not enable the surviving family members to maintain their standard of living for very long.
Assuming the surviving spouse has inherited the deceased stockholder’s shares, he or she may not be knowledgeable or competent enough to assume the position of the deceased within the corporation. In addition, the surviving stockholders may not want a new, inexperienced stockholder working in the corporation. Thus, the purchase of the deceased’s stock becomes a viable alternative, provided there has been adequate planning and there is cash available for the stock purchase.
Business planning to resolve the problems created by the death of a stockholder involves the implementation of a stock purchase or stock redemption plan. A stock purchase plan is similar to a cross-purchase partnership plan, whereby a price is determined and each stockholder agrees to purchase a proportionate share of the deceased shareholder’s stock. The purchase price is naturally funded with life insurance and each shareholder owner, premium payor, and beneficiary of a life policy on the lives of the other stockholders.
This arrangement is feasible when there are only a few shareholders.
In situations with several shareholders, the stock redemption plan is better.
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Under a stock redemption plan, the corporation is the owner, beneficiary, and premium payor of the life insurance policies, and the corporation agrees to purchase the deceased’s stock.
The advantages of the life insurance–funded corporate buy-sell plan include
Section 303 stock redemption is a special type of stock redemption that permits a corporation to partially redeem a shareholder’s stock for purposes of providing cash to cover estate settlement costs. Tax laws generally require that stock redemption be total to avoid taxing the proceeds payable to the family as a dividend. The Internal Revenue Service will permit a partial redemption by the corporation to pay funeral expenses, taxes, and related estate settlement costs.
Key person life insurance protects the corporation from the financial loss sustained when a key employee (the owner, for example) dies. In addition to the corporate owner, a key person could be a sales manager, a vice president, and so forth. When a key person dies, the corporation could experience a loss of income, impaired credit standing, loss of jobs, and customers. To offset this financial impact, the corporation may purchase a life insurance policy on the life of the key person. The corporation would be the owner, premium payor, and beneficiary of the policy. The face amount of the policy would generally relate to the amount of lost corporate income plus the costs of hiring and training a replacement for the deceased key person.
Deferred compensation is an executive benefit that enables a highly paid corporate employee to defer current receipt of income such as an executive bonus and have it paid as compensation at a later date (retirement, death, or disability) when presumably the employee will be in a lower tax bracket. Generally, the employee will enter into an agreement with the employer that specifies the amount of money to be paid, when it will be paid, and the conditions under which the deferred compensation may not be paid.
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The agreement will specify that the amount deferred will be paid as a retirement benefit or in the event of the premature death or disability of the employee. It will further indicate that the individual will forfeit the right to this sum of money if he or she leaves the employer except for retirement, death, or disability.
The advantage of this agreement for the employee is avoidance of current taxation because receipt of the money is deferred and therefore not subject to income tax until it is actually received.
The principal advantage for the employer is that the services of the employee are usually secured for life because the employee will forfeit the right to the deferred compensation except for retirement, death, or disability. In addition, deferred compensation can be viewed as a desirable executive benefit and thus enable the employer to attract and retain key personnel. Funding for the deferred compensation may be life insurance contracts, disability income policies, annuities, mutual funds, and so forth.
Split-dollar plans are not actually types of life insurance policies but rather methods of purchasing life insurance. Under a split-dollar arrangement, a plan of permanent life insurance is jointly purchased by the employee and the employer. Permanent life insurance is used because it provides guaranteed cash values.
The employer’s share of the premium is an amount equal to the annual increase in the policy’s cash value. Accordingly, in the early years of the plan, the employee’s cost will be higher than in the later years when the policy will contain higher amounts of cash value and the employer’s share of the premium will be greater.
The death benefit is also shared between the employee and the employer in proportion to the amount of the premium each is paying. Usually, the employer is the policyowner and thus has control of the policy including its cash value.
Split-dollar plans are an attractive benefit, whereby a key employee is able to purchase life insurance at an attractive cost because of the joint premium payments.
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1. Which of the following should not be taken into account when a producer makes recommendations as to the amount and type of insurance needed by an individual?
2. Ana wishes to purchase enough insurance to support her husband for the rest of his life if she should die prematurely, and then leave a sizeable inheritance for her children upon his death. Which method should be used to calculate the amount of insurance necessary?
3. The type of estate transfer made while the estate owner is still alive is called a(n)
4. The type of estate transfer made after the estate owner dies is called a(n)
5. Suki dies without leaving a will. The distribution of her estate will be handled by a(n)
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6. Ken has terminal cancer and wants to access the death benefit of his life insurance policy to pay medical expenses. How might he be able to do this?
7. Shane is a master carpenter in business for himself. His business is
probably operated as
8. Which of the following would not be financed by using life insurance?
9. Which of the following are costs associated with death?
10. An insurance producer analyzed Bonita’s life insurance needs, taking into account Bonita’s net annual salary, her expenses, her current age, and depreciation of the dollar over time. This producer was using
11. An insurance producer analyzed Dwight’s life insurance needs, taking into account the amount of money Dwight anticipated needing for his funeral and the amount of income that would be required to maintain his family’s standard of living in the event of his death, including projected college costs and the costs of supporting his spouse. This producer was using
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12. Wilma’s husband died 3 years ago, leaving her with two children in grade school. Wilma is most likely in which income period?
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✓ Conditional receipt ✓ Binding receipt ✓ Temporary insurance agreement ✓ Replacement ✓ Fiduciary
✓ Personal delivery ✓ Delivery by mail ✓ Constructive delivery ✓ Policy retention
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The producer is encouraged to collect the initial premium with the application.
Evidence shows that this procedure is most effective in having the insured accept the policy when it is issued. If the insured does not pay the initial premium at the time of application, chances increase that he or she will not accept the issued policy. Another point the producer can make to the applicant is that if the applicant waits to pay the premium, he or she may become uninsurable, or may die before the policy takes effect. Remember, the policy is effective only after the initial premium has been paid.
When the initial premium is not paid with the application, no contract is in force. The applicant is not making an offer to the insurer. He or she is merely inviting the insurer to make an offer by issuing the policy. Because there is no insurance in force under these circumstances, when the producer delivers the policy and collects the initial premium, there may be additional underwriting requirements to be satisfied. Most commonly, the insurance company may require that the insured sign a health statement verifying that no change in health has occurred since the date of the application.
When the underwriting process is complete and the applicant has been approved, the life insurance policy will be issued by the insurance company. The coverage is not effective until the policy is delivered and the initial premium has been paid. Usually the applicant will pay the initial premium with the application. When this occurs, the producer will provide the applicant with a receipt for the initial premium, and the effective date of coverage will depend on the type of receipt issued.
After the producer has completed the application, it is normal to collect the first full premium from the policyowner. The receipt for this premium is generally a conditional receipt.
This type of receipt is conditional because the producer cannot guarantee that the policy will be issued. The conditional receipt explains to the proposed insured that the policy will be issued subject to the approval of the insurance company.
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According to the conditional receipt, if the proposed insured should die before the policy is issued, one of the following will occur:
For example, an applicant has paid the initial premium and completed and signed the application. The producer provides the applicant with a conditional receipt that basically states that the applicant is covered as of the date of the application (or receipt), provided he or she is insurable as a standard risk. Thus, if the applicant were to die before the policy was issued, the beneficiary would receive the face amount of the policy.
On the other hand, if the applicant was found to be a substandard risk, the conditional receipt is null and void and no coverage would be effective until the substandard policy was delivered and additional premium paid. If the policy is not issued as applied for (a substandard rating, for example), no coverage would be in force until the applicant accepts the substandard policy and pays the additional premium required by the rating.
This receipt makes the coverage effective on the date of the application, if the applicant is found to be insurable under the company’s general underwriting rules in effect at the time of application. However, some conditional receipts make coverage effective on the date of application or the date of the medical examination, whichever is later.
A few companies use an “unconditional” or binding receipt that makes the company liable for the risk from the date of application. This coverage lasts for a specified time or until the insurer issues the policy or notifies the applicant the policy is being refused. The specified time limit is usually 30–60 days.
With a binding receipt, regardless of the applicant’s insurability, he or she is covered following completion of the application and the payment of the initial premium and remains covered for the length of the specified term or until notified of refusal. Use of this type of receipt is rare for life insurance policies, though it is commonly used for auto or homeowners insurance.
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Occasionally, a situation will arise where the proposed insured wants to examine the policy carefully before actually purchasing it. In this situation, the policyowner does not pay the first full premium at the time the application is completed. The policyowner signs an inspection receipt for the policy, examines the policy, and then pays the first full premium.
This type of receipt or agreement provides the applicant with immediate life insurance coverage while the underwriting process is taking place whether or not the individual is insurable. In this instance, the insurance protection applied for becomes effective immediately, within the limitations stated in the temporary insurance agreement or receipt.
The insurer has the right to cancel this coverage if the applicant fails to meet the company’s normal underwriting requirements. However, claims incurred during the underwriting period will be paid in line with the terms of the receipt, whether or not the application would ultimately have been approved.
For example, an applicant submits the initial premium and application and is provided with a temporary insurance agreement that states that coverage is effective immediately and will continue during the underwriting process. If the applicant should die during this period, the coverage is in force regardless of the individual’s insurability or risk classification as a result of the underwriting process.
It is important for the producer to submit the application, initial premium, and any questionnaires or other forms to the home office underwriter promptly. The producer should review all forms for completeness and be sure that they are properly signed. Not only does this ensure good relationships with the home office underwriter, but also it is extremely important to the applicant.
Unnecessary delays in issuing the policy can cause the applicant undue anxiety and result in a loss of confidence in the producer.
Because producers are handling money belonging to their clients, it is extremely important that an accurate record of such transactions be kept. It is
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also wise for the producer to keep copies of applications and other information. This avoids unnecessary delay or other problems if the originals are lost.
A life insurance policy may be issued as applied for, modified, or even amended if the applicant does meet the underwriting standards of the insurance company. Although uncommon, an insurer may issue a waiver with the policy that states that death by a particular event will not be covered. This might be done if the insured had a particularly hazardous occupation or hobby. More commonly, an insurer might issue a more limited form of policy or one at lower limits.
Generally, policies are delivered in person by the producer or are delivered by mail.
Because delivery is necessary to complete the sale of a life insurance policy, the best way to assure delivery is to do it in person. If a conditional receipt has not been previously issued, the insurer may require the producer to obtain a statement of good health at the time of policy delivery. In addition to knowing the policy has been delivered, this method also gives the producer an opportunity to
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Legally, the policy is considered “delivered” when it is mailed or turned over to the policyowner or someone acting on his or her behalf. Some companies do mail policies directly to policyowners. However, many prefer to have the producer make a personal delivery.
In some cases, a constructive delivery is deemed to occur when the insurer mails a policy to its producer for actual delivery to the policyowner, because the insurer has issued the policy and released it for delivery. However, a legal delivery has not yet occurred if the insurer requires personal delivery for verification of good health at the time of delivery, or if the policy is being provided to the applicant merely to review and inspect at that time and not necessarily to buy.
A claim and its payment are the end result of the insurance process. With respect to life insurance, it means the insured has died and the beneficiary stands ready to collect from the insurer what is due. Unlike property or casualty insurance, claims made on a life insurance policy are rarely negotiated. They are either paid or denied. When proof of the death of the insured arrives at the insurer’s claims department, the records are checked to make sure the policy was in force at the time of death and that the person to whom the policy proceeds are to be paid is indeed the rightful beneficiary.
When an insured dies, the life insurance company should be notified as soon as possible. In many cases, the family of the deceased is too grief-stricken and shocked even to think about such matters as notifying the insurer. It is the agent’s responsibility, in such a case, to make sure that the company is notified of the claim at the earliest possible moment.
After a company has been given the proper forms, there is usually little or no delay in payment of the claim, especially when it is obvious that the claim is valid—the policy is in force, the beneficiary is available, there is no evidence of suicide within the limitations of the suicide clause, and so on. When an insurer is notified of a valid claim, the claim will be paid in very short order, usually within a few days.
Good will is one of the life insurance industry’s most valuable selling tools.
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This is one of the many reasons why most life insurance companies pay a valid death claim as soon as possible after they receive the proper notification and proof of death.
In most jurisdictions, life insurance companies are required to pay death claims within a specified period of time after proper notification of the claim and receipt of a death certificate. This period is usually two months (60 days).
Should there be a delay in a death claim payment, the usual reason is that the company has not been properly notified of the insured’s death. A formal proof of death form of some type is usually required by the company, in addition to a death certificate completed by the attending physician or the coroner. When an insured dies, the agent should complete any proof of death form the company requires, have it signed by the necessary parties, and forward it to the company as soon as possible along with a death certificate.
In property or casualty insurance, the amount of claims paid is often less than the face amount of the policy. In contrast, life insurance is generally paid for the full face amount of the policy. There are three exceptions to this.
The first exception is when there is an outstanding loan against the cash value of a policy. The amount of the loan, plus any interest outstanding, is deducted from the face amount of the policy before payment is made to the beneficiary.
The second exception is when there is a premium payment due. With insurance premiums, as with many other types of bills, there is a grace period of somewhere between a week and a month after the due date but before the policy expires. If the insured dies within this grace period, the amount of the premium due is deducted from the face amount of the policy before payment is made to the beneficiary.
The third exception happens when an error is made in determining the age or gender of the insured when the policy was issued. If such an error is discovered at the time of death, the insurance company will compute the face amount that the premium would have purchased if the accurate information was used and pay that amount to the beneficiary.
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Such errors are not an unusual occurrence in the life insurance business. Some are intentional, but most are simply mistakes. In either event, the discrepancy is not material enough to void the policy. Just remember that unless one of these three exceptions applies, the full face amount of the policy is paid.
When the producer is informed of an insured’s death, he or she has a number of things to do:
The insured may have chosen a particular settlement option at the time the policy was purchased but may have given the beneficiary the right to change it. Alternatively, the insured may not have selected a settlement option at all.
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In this case, it is entirely up to the beneficiary. In either situation, the producer explains all the available options to the beneficiary.
Technically, replacement means any transaction in which new life insurance or a new annuity is to be purchased, and it is known, or should reasonably be known, that as part of the transaction, existing life insurance or annuity will be
Replacement, simply, is the purchase of one life insurance policy to replace another. Because of the cash values that can build up in a policy and the favorable loan interest rates in older policies, replacement can be disadvantageous to consumers. However, there are good reasons to replace a policy, particularly if it does not meet the current needs of the consumer.
Commissions paid to producers for selling a new policy are particularly lucrative. For this reason, unscrupulous producers have persuaded consumers to give up old policies for new ones, even if it was not in the best interests of the policyholder.
When replacement of life insurance is involved, the producer must comply with all pertinent federal and state regulations. Each state has rules and regulations regarding replacement of life insurance products, which are designed to protect the interests of the insuring public. Frequently, it is not in the best interests of the insured to replace existing life insurance with a new policy:
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The National Association of Insurance Commissioners (NAIC) has adopted a Model Life Insurance Replacement Regulation. The majority of states have replacement regulations based on this model.
Generally, the duties of the producer include obtaining, along with the application, a signed statement from the applicant as to whether insurance is to be replaced and submitting the statement to the insurer.
If replacement is involved, the producer is required to
The producer must take special care when replacing an existing policy with a new policy to make sure that the insured is not misled into purchasing a policy that is to the insured’s disadvantage. The producer also needs to be aware of his or her own errors and omissions liability, particularly in the area of replacement.
The duties of the replacing insurer include
Each state has established time limits for the performance of duties. You should check your state’s regulations to learn specific time limits, such as
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Also, individual state law specifically outlines the method in which records are to be maintained and the length of time the records are to be made available.
The producer becomes involved with the client after original application and delivery at times of change. The client’s needs change at such times as marriage, the birth of a child, and death. The producer acts as the representative of the company in changing beneficiaries, adding amounts of insurance, and facilitating payment of claims. The effectiveness of the producer at these times will lead to retention of the account for the lifetime of the client— often over generations.
All business transactions are based to a certain extent on trust. When it comes to life insurance, the trust factor is especially significant.
Insurance producers have a fiduciary duty to just about any person or organization that he or she comes into contact with as a part of the day-to-day business of transacting insurance. By definition, a fiduciary is a person in a position of financial trust. Attorneys, accountants, trust officers, and insurance producers are all considered fiduciaries.
As a fiduciary, producers have an obligation to act in the best interest of the insured. The producer must be knowledgeable about the features and provisions of various insurance policies as well as know the use of these insurance
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contracts. The producer must be able to explain the important features of these policies of the insured. The producer must recognize the importance of dealing with the general public’s financial needs and problems and offer solutions to these problems through the purchase of insurance products.
As a fiduciary, the producer must know and comply with the state’s insurance laws. Many of these laws are for consumer protection. It is the producer’s duty to comply with these laws and protect the interest of the insured at all times.
The insurance producer is a key person in the process of marketing, underwriting, and delivery of insurance policies. As a marketing representative of the insurer, it is the producer’s responsibility to represent and market the insurer’s products in an ethical and professional manner. This requires knowledge of various insurance products, being aware of a prospect’s insurance needs and problems, and the ability to solve these needs with the proper insurance products.
The producer also has a responsibility to be aware of insurance laws that pertain to marketing of insurance products, such as state-required standards for advertising and sales literature. Generally all advertising, sales presentations, and illustrations must be truthful and must not misrepresent or omit material information.
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1. Lee applies for a policy, pays the initial premium and receives a conditional receipt on March 14. On March 15, he passes the medical exam with flying colors. On March 16, an undiagnosed brain aneurysm bursts, killing Lee instantly. On March 17, the insurer receives the results of the medical exam, which includes no information about the aneurysm. On March 19, the insurer receives the notice of claim. The insurer will
2. Rich applies for a policy, pays the initial premium, and receives a binding receipt on Friday, September 1. On Monday, September 4, the underwriting department decides not to issue the policy and places the file in a pile for notification letters to be sent out at the end of the week. On Wednesday, September 6, Rich is killed in a auto accident. On Thursday, September 7, the insurer receives the notice of claim. The insurer will
3. Brit purchases a policy and tells the producer he wants immediate coverage, regardless of the underwriting outcome. To meet Brit’s demand, the producer is most likely to
4. A policy may be issued all of the following ways except
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5. Which of the following statements is true about submitting the application, premium, and other forms to the insurance company?
6. Which of the following statements describe the best use of a producer’s time when personally delivering the policy?
7. Which of the following statements is false?
8. Alice decides to buy a policy. She pays the first premium and the producer issues a receipt and tells her that she is covered immediately, until she is notified that the policy is either issued or declined. What kind of receipt has Alice received?
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|Terms you need to understand:|
|✓||Term insurance||✓||Variable universal life insurance|
|✓||Whole life insurance||✓||Industrial life insurance|
|✓||Adjustable life insurance||✓||Credit life insurance|
|✓||Universal life insurance||✓||Endowment policy|
|✓||Variable life insurance||✓||Riders|
|Concepts you need to master:|
|✓||Renewable term insurance||✓||Family maintenance policy|
|✓||Convertible term insurance||✓||Family protection policy|
|✓||Level term insurance||✓||Retirement income policy|
|✓||Increasing term insurance||✓||Joint life policy|
|✓||Level premiums||✓||Juvenile policy|
|✓||Face amount||✓||Double indemnity|
|✓||Cash values||✓||Waiver of premium|
|✓||Nonforfeiture value||✓||Accelerated benefits|
|✓||Policy loan||✓||Viatical settlements|
|✓||Family income policy|
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All life insurance provides a death benefit. This benefit is easy to understand. The living benefits—such as loan values, retirement income, and cash withdrawals—set certain life insurance policies apart from others. These additional benefits add to the enormous versatility that life insurance has to meet a wide variety of needs.
Life insurance can be structured to provide
Term insurance is designed to provide life insurance protection for a limited period of time. It might be for 1 year or 10 years, but the face amount of the policy is payable only if the insured dies during the time specified in the policy.
If the insured survives the limited term of the policy, the insurance company has fulfilled its part of the contract and no payment or refund is due.
Term insurance can be compared to a fire policy on a home. The fire policy is purchased to protect the homeowner from financial loss. However, if the home does not suffer a fire loss, the homeowner’s premium is not returned. The homeowner had the peace of mind that comes with insurance protection, but no cash value accumulation or refund.
The premiums for a term policy are usually level over the length, or term, of the policy. At the end of the policy, the policyowner may purchase another policy. The new policy almost always requires a higher premium than the expired policy. This new, higher premium, will then be in effect for the length of the new term.
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Term policies are defined by the nature of the coverage, the options available under the contract, and the way the face amount of the policy changes throughout the life of the policy. The face amount, or face value, of the policy is the amount of money listed on the face page (first page) of the policy. This is the amount that will be paid in the event of the insured’s death.
A renewable term policy is one that may be renewed at the end of the specified period of time for another term period without evidence of insurability.
Thus, a 1-year renewable term policy expires after 1 year but is renewable for additional 1-year periods. A 5-year renewable term policy can be renewed for subsequent 5-year periods. Renewability may be limited to a certain number of renewals or to a specified age, such as 85. The renewable feature must be written into the original policy at the time of purchase.
When a renewable term policy is being renewed, however, the rates will be based on the age the insured has reached at the time of renewal. This is why premiums for renewable term coverage are often called step-rate premiums.
A term policy that is convertible allows the policyowner to convert or exchange the temporary protection for permanent protection without evidence of insurability. Usually, this conversion feature is used to convert term insurance to some form of whole life insurance. If the conversion privilege is exercised it will be at the attained age, meaning the premium paid for the new policy will be based on the insured’s age at the time of conversion. Like the renewability provision, the conversion privilege must generally be written into the contract and spells out the terms of the policyowner’s right to convert.
At the time conversion to permanent insurance is made, the insured generally has a choice of two ages: the present age (called attained age) or the age at the time the original term policy was purchased (called original age).
Premium amounts depend to some extent upon the age of the insured. If the insured converts to permanent insurance using original age, the premiums will be lower than if attained age is used.
When using original age, the policyowner must pay an additional sum, usually consisting of the difference between the lower term premiums over the years, and the higher premiums he or she would have been paying if the
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permanent protection had been bought originally. The policyowner is also required to pay the interest that the insurance company could have earned on those higher premiums, if it had invested them for those extra years.
By paying the difference in back premiums and interest, the policyowner is building an accumulated value in the policy much more quickly than if he or she simply begins paying the higher premiums as for the attained age. The cash value will be well on its way to a meaningful amount.
Some life insurance companies place a time limit on the conversion privilege. This limit is usually based on the expiration date of the original term policy.
The number of years excluded from the conversion privilege on a convertible term policy varies from company to company. For instance, some companies state that the policy must be converted as much as 5 years before expiration of the original policy, after which point, the right to convert is lost.
A reentry option (also known as reissue) is also a common feature of term policies. This option gives the insured the opportunity to provide evidence of insurability at the end of the term in order to qualify to renew the policy at a lower premium rate than the guaranteed rate that is available without evidence of insurability. Essentially, the renewing insured is reviewed as a new applicant for term insurance.
Level term provides a level death benefit and level premium during the policy term. For example, if an individual purchases a 10-year term policy with a face amount of $100,000, both the premium and the face amount will remain constant for the entire 10-year period.
Assuming the level term policy is issued as renewable and convertible, every time the policy renews for a subsequent term period, the policy’s premium will increase due to the increased age of the insured. For example, an insured has purchased $50,000 of 1-year renewable and convertible term insurance.
Each year the policy is simply renewed at the same face amount by the payment of the new, higher premium. A new application is not required nor is a new policy issued. The only thing that changes is the age of the insured and subsequently the policy’s premium.
Decreasing term is also temporary protection for a specified period of time. The face amount decreases throughout the life of the policy down to zero at
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the date of policy expiration. The annual premium for a decreasing term policy remains level during the term of the policy. A common use for decreasing term insurance is to cover a home mortgage. The policy amount decreases each year at the same rate as the balance on the mortgage.
Decreasing term is usually written as convertible but generally is not renewable at the end of the term period. The convertible feature allows the policyowner to convert to permanent insurance usually at any point during the decreasing term of the policy for the available amount of insurance at that point in time. Mortgage life insurance is an example of decreasing term.
Increasing term is another type of term insurance, which is not used as often as level or decreasing term. Increasing term is basically the opposite of decreasing term. The death benefit increases over the life of the policy, and the premium remains level.
Indeterminate premium term is a type of term insurance where the premium may fluctuate between the current premium charge and a maximum premium charge that is stipulated in the insurer’s premium tables, based on the insurer’s mortality experience, expenses, and investment returns.
When a person wants immediate protection and is thinking of starting a permanent insurance policy in the near future, interim term may be used to cover the period of time before permanent protection is to begin. Many companies write interim term on an automatically convertible basis. That is, they provide the insured with temporary term protection that will covert automatically at some future date, usually no later than 11 months. The premium for the interim term is based on the age at application. The premium for the permanent coverage is also based on attained age when permanent protection begins.
Some of the advantages and uses of term insurance are
➤ Initially, the cost of term insurance is low, making it useful for individuals or businesses who may have a large need for insurance but limited financial resources to pay for it.
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Some of the disadvantages associated with term insurance are
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Whole life insurance, sometimes known as permanent insurance or ordinary insurance, is designed to provide protection for the whole life of the insured.
Whole life policies have a number of common characteristics.
Through mathematical science, the premiums for most permanent insurance policies are designed to remain level during the entire period the policy is in force. In the early years of the contract, the insured actually pays in more premium than is needed to provide the current year’s insurance protection, and in later years pays in less than is needed. The net result is that the premium remains the same for the entire period of the contract. In addition, the company has the opportunity to use the money and to invest it at a favorable return. This helps reduce the cost of insurance.
Not only does the premium remain level for the life of the policy, but so does the face amount of the policy. Generally, the policy’s basic face amount will not change for the life of the policy.
As the policyowner continues to pay the premiums, the cash value in the policy accumulates year by year. The amount of pure insurance protection the insurance company must provide decreases as the amount of cash value increases.
Usually, in the first couple of years of the policy, the cash value is equal to zero. Over the life of the policy, there is a steady increase in the amount of the cash value until age 100 when the cash value is exactly equal to the policy’s face amount. An increasing number of people do live past the age of 100, but they are so rare that they may be ignored statistically. Insurance company statistics generally assume that everyone has died by age 100.
The cash value built by whole life policies may be used by the policyowner in several ways, including withdrawing part or all of the cash value or taking a loan using the policy as collateral.
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The cash value in the policy belongs to the policyowner. If he or she wishes to, some or all of the cash value may be withdrawn from the policy. Any withdrawal of cash value will reduce both the face value of the policy and the amount of cash value available.
The policyowner is entitled to this living benefit at any time. If the policy-owner decides to cease paying premiums, he or she may cash the policy in for the available cash value.
The cash value can also be loaned to the policyowner. The term, loan is used, but this loan does not have to be repaid unless the policyowner elects to repay it. Just as with a partial withdrawal of the cash value, a cash value loan (for the available amount of cash at that point in time) that is not repaid will reduce both the face amount of the policy and the cash value available. For example, an insured dies with a $10,000 whole life policy that has an outstanding loan of $1,000, the beneficiary would receive $9,000.
As a policy loan, it is also subject to interest. In order to meet the obligations of all of its policyholders, a life insurance company invests the dollars it receives. These investments earn interest at a rate close to estimates made in advance. When the policyowner takes a policy loan, the amount the company has available to invest is reduced by the amount of the loan. This means that the company will earn less interest than estimated, unless it makes up that amount from some other source. In this instance, the other source available to the company is annual interest charged.
When a policyowner takes out a policy loan, he or she usually continues to pay premiums on the policy. As long as the premiums are paid regularly, the cash value in the policy will generally rise faster than the loan plus the loan’s interest. If the policyowner does not pay the premiums, the policy may lapse. If the policy loan and the interest on it become greater than the total cash value of the policy, the policyowner no longer has sufficient collateral for the loan, and the policy will lapse. The company must warn the policyowner before cancellation to give the policyowner the opportunity to take action to keep the policy in force. To avoid cancellation of the policy, the policyowner can pay enough of the loan and interest to reduce the total outstanding amount to a figure lower than the total cash value of the policy or pay off the entire loan plus interest.
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Whole life policies may be categorized according to how the premium is paid.
Continuous premium whole life is the most common type of whole life insurance sold. These policies stretch the premium payments over the whole life of the insured (to age 100).
This type of policy is often referred to as straight life insurance.
Many policyowners want the lifetime insurance protection afforded by the whole life policy, but do not like the thought of paying premiums for their entire lives. Limited payment whole life policies allow the policyowner to pay for the entire policy in a shorter period of time. The premium for any whole life policy can be broken down into any desired number of installments.
Because the limited pay policy is paid up sooner than the whole life policy, all other factors being equal, the limited pay policy would have a larger annual premium than the whole life policy. Because the premiums are accelerated, the cash values of limited pay policies build at a faster rate than for whole life policies. This means that, for example, the loan value for a limited pay policy after 5 years would be more than for a whole life policy owned for the same length of time.
Common forms of limited payment whole life are 20-payment life (meaning payments spread over 20 years), 30-payment life, and life paid up at age 65.
For example, 20-pay life means premium payments for 20 years but lifetime (to age 100) protection. Life paid up at 65 means premium payments to age 65 but the policy provides lifetime protection.
The most extreme version of a limited pay policy is one that can be paid for with only one premium. For this reason it is called a single premium whole life policy.
The premium for such a policy might be many thousands of dollars. The advantage offered by a single premium policy is that the policyowner will pay less for the policy than if the premiums stretched out over several years.
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By the same token, the person insured by a single premium policy could die shortly after the single premium was paid, thus making the cost of insurance coverage much higher than it might have been had premiums been scheduled over a period of many years.
Indeterminate premium whole life policies are nonparticipating contracts that were developed to compete with participating policies. These policies employ a dual premium concept—a maximum premium and discounts that may reduce the premium. The discounts vary with insurance company investment performance, but the actual premium charged will never be more than the maximum premium specified in the contract.
Current assumption whole life (also known as interest-sensitive whole life) offers flexible premium payments that are tied into current interest rate fluctuations. The insurance company reserves the right to increase or decrease the premium within a certain range depending on interest rate fluctuations. During a period of relatively high interest rates, premiums could be reduced. During periods of low interest rates, premiums could be increased within certain limits. Usually, any premium adjustment is made on an annual basis.
Economatic whole life is a whole life-type policy with a term rider that uses dividends to purchase additional paid-up insurance. Let’s assume that an individual wants $100,000 of whole life but can’t quite afford it. Instead, he purchases $70,000 of whole life with $30,000 of term insurance. Thus, he has $100,000 of death protection at a lower cost.
As policy dividends are declared, they are used to purchase additional paid-up insurance. As the paid-up insurance is added, an equal amount of term insurance is removed from the policy, thus maintaining the full face amount of $100,000 at no additional cost. In reality, the cost of the insurance may decrease as the term amounts are eliminated if a level term rider was used. If a decreasing term rider were used, the reduction of the term insurance would become automatic, but a level premium would be paid for the decreasing term.
When the paid-up additions equal $30,000, the insured now owns $100,000 of whole life but only pays an economical premium for $70,000.
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Some of the advantages and uses of whole life insurance are
Some of the disadvantages of whole life insurance are
Ordinary whole life policies offer premiums, cash values, and face amounts that are determined at the time the policy is purchased, and unless the policyowner takes out a loan or partial withdrawal, generally do not change over the life of the policy.
Flexible policies, in contrast, offer the policyowner the opportunity to change one or more of these components in response to changing needs and circumstances. Each type of policy offers different types of flexibility.
Adjustable life is a policy that offers the policyowner the options to adjust the policy’s face amount, premium, and length of protection without ever having to complete a new application or have another policy issued. Adjustable life
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introduces the flexibility to convert to any form of insurance (such as from term to whole life) without adding, dropping, or exchanging policies. Adjustable life is based on a money purchase concept.
The basic premise becomes not so much which type of policy does a person buy but rather how much premium is to be spent. For example, if an applicant, age 25, states that he or she can afford to pay a $500 annual premium, it then becomes a matter of using this premium commitment to meet the individual’s needs and to identify the type of insurance to be purchased.
To further illustrate, let’s assume the 25-year-old applicant is married with three children and a large home mortgage and has no other life insurance. This person naturally needs a large amount of insurance. Based on the $500 premium, it might be recommended that all or most of that premium be used to purchase several hundred thousands of term insurance.
In later years, this same individual may adjust the premium, the face amount, or the period of the death protection to meet current needs. For example, the insured is now 50 years old and possibly is planning for retirement. The same $500 premium could now be used for some form of permanent insurance protection with guaranteed cash values. The temporary protection is changed to permanent coverage and the death benefit (face amount) would be reduced due to the insured’s age and premium commitment.
If the insured makes an adjustment in the policy that results in a higher death benefit, proof of insurability may be required for the additional coverage.
Universal life was the insurance industry’s answer to the extremely high interest rates we experienced in the decade of the 1970s. Traditional whole life contracts have earned 3 1/2%–5% interest. In an effort to be more competitive, many insurers developed universal life products with relatively high interest rates (8%, 10%, 12%). Universal life is a flexible premium, adjustable benefit life insurance contract that accumulates cash value.
A prime feature of universal life is premium flexibility. Premiums paid into a universal life policy accumulate and, together with interest, make up the policy’s cash value. After sufficient cash value is accumulated, the policyowner has considerable flexibility with regard to subsequent premium payments.
A policyowner under a universal life insurance contract may increase the death benefit without buying another policy, although he or she may have to prove insurability. Also, the policyowner has the freedom to reduce the death benefit. Neither an increase nor a decrease in death benefit requires the issue of a new policy.
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In earlier model universal life policies, a charge or load is deducted from each premium after the first-year premium to cover sales and administrative expenses. The remainder of the premium goes into a cash value account. From this cash value account the monthly amount needed to pay for the desired death benefit is deducted, usually on a monthly basis. When the policyowner pays more premium than is required to provide the desired death benefit plus other costs, the universal life policy accumulates cash values.
As mentioned, a part of the premium goes to pay sales and administrative charges. A typical sales load is 7.5%. Thus, for a $1,000 premium payment, 7.5%, or $75, would be deducted, and the $925 balance would go into the cash value account. Load charges range generally from about 7.5% to as high as 10%.
More recent universal life policies have adopted a back-end (deducted whenever the policyowner withdraws cash from the policy) sales load. These back-end loads usually take the form of service charges for withdrawals from the policy, or policy surrenders, and for coverage changes. By postponing these sales loads until later, universal life policies could be illustrated showing more attractive returns than the earlier policies that subtracted the sales load at the front end.
These back-end loads often decrease to zero over a period of years. For example, if a universal life policy has a 10-year decreasing back-end load, the charge would be 10% in the policy’s first year, 9% in the second year, and so on until withdrawals could be taken without any charge after the 10th policy year.
Two adjustments are made to the cash value account of a universal life policy, usually on a monthly basis. The first adjustment is a charge against the account to pay the cost of the desired insurance coverage.
The second adjustment is a credit to the cash value account of interest at the current rate. The current rate consists of two parts:
Current interest, then, is equal to guaranteed interest plus excess interest.
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The cash value account isn’t always fully credited with interest at the current rate. For some policies, there is an additional load that is generated by simply not paying excess interest on the first $1,000 in the cash value account. Thus, this load is the difference between the guaranteed interest rate and the current rate. For example, in a universal life policy with a guaranteed interest rate of 3.5% and a current interest rate of 8%, the annual load would be 4.5%, and would amount to $45, 4.5% of the first $1,000 of cash value.
The current interest rate is commonly set once a year and guaranteed for the entire policy year. However, not all companies will guarantee their current rate for a full year, instead choosing periods as short as 3 months.
There are two options regarding the death benefit payable under a universal life policy:
Universal life provides cash value loans in the same manner that whole life or any permanent plan of insurance does. If a loan is taken, it is subject to interest, and if unpaid, both the interest and the loan amount will reduce the face amount of the policy.
Many universal life policies will also permit a partial withdrawal or surrender from the cash account. In such a case the policyowner withdraws the desired cash directly from the cash value account and pays a small service charge for doing so. No interest of any kind is credited by the insurer or paid by the policyowner on the amount withdrawn.
Partial withdrawals may be repaid, although any money paid back will be treated as a premium payment and thus subject again to expenses charges if
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it is a front-end (deducted from each premium payment) load policy. With a current interest rate of 10% and a typical expense charge of 7.5%, the cost of a partial withdrawal that is repaid after 1 year is 17.5%, plus the amount of the service charge.
A universal life contract may be surrendered for its cash values whenever the policyowner wants, although a surrender charge (or service charge) is usually applied.
A featured benefit of the universal life contract is the flexibility of premium payments. As long as there is sufficient cash value to pay the monthly cost-of-insurance deductions, the policy will continue in force and policyowners may pay premiums in whatever amounts and at whatever times they want.
If the monthly cost-of-insurance deductions cause the cash value account to reach zero, coverage under the contract expires. However, there is a grace period, usually 30–60 days, during which the policyowner is given the opportunity to pay enough premium to keep coverage in force.
Primarily, variable life insurance (VLI) is a whole life policy designed to protect the policyowner and the beneficiaries from the erosion of their life insurance dollars due to inflation. Thus, it could be said that variable life is designed to be a hedge against inflation.
Historically, during periods of inflation, the stock market usually has kept pace with inflationary trends by increasing in value. In recognition of this fact, the insurers have established separate accounts, which consist primarily of a portfolio of common stock and other securities-based investments. It is these separate accounts that support variable life policy benefits. Policyowners are allowed to choose among various sub-accounts within the separate account that offer different investment objectives, and they can transfer their policy funds among them.
In contrast, the insurer’s general account consists primarily of safe, conservative investments such as high-grade bonds, real estate, certificates of deposit, and so forth. The premium from traditional life insurance contracts is placed in the company’s general account and the entire contract is fully guaranteed by the insurer.
Because the value of the securities in the separate account are subject to change, the death benefit of the variable life policy can also change. If the
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value of the separate account increases, the death benefit may increase. A drop in the investment results of the separate account may cause a decrease in the death benefit from the value in the previous year. However, the death benefit will never fall below the guaranteed minimum, which is the same as the original face value of the policy.
Cash values in a VLI policy are determined on a daily basis according to the investment experience of the separate account, with no minimum amount guaranteed. So, although there is a guaranteed death benefit, there is no guaranteed cash value.
The cash value may be withdrawn at any time on surrender of the policy. The exact amount payable will be the cash value calculated at the time the policy is surrendered.
Typically, up to 90% of the cash value of a VLI policy may be borrowed, subject to interest at a rate of 6%–8% compounded annually. The minimum that will be loaned is generally $100. Loans may be partly or fully repaid at any time as long as the insured is alive and the policy is in force.
Variable life premiums are fixed and payable on a regular schedule, as are whole life premiums. If the policyowner defaults on a VLI premium payment, he or she has a 31-day grace period in which to pay the overdue premium. If the premium is not paid by the end of this period, the policy lapses.
Because VLI places considerable investment risk on the policyowner and offers few guarantees, the federal government has declared that variable contracts are securities. They are thus regulated by the Securities and Exchange Commission (SEC), the National Association of Securities Dealers (NASD), and other federal bodies.
Variable life producers must be registered with the National Association of Securities Dealers (NASD). This registration may be obtained by passing the NASD Series 6 or Series 7 exam.
The variable life product is regulated by the Securities Act of 1933, the Securities and Exchange Act of 1934, and the Investment Company Act of 1940. The following is a brief review of these acts as they apply to variable life insurance:
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At the time of solicitation, variable life illustrations may not be based on projected interest rates greater than 12%. This is known as the 12% rule and it prevents both the producer and the policyholder from assuming excessive and unrealistic rates of return. A variety of policy performance illustrations at different rates would be the preferred method for clearly explaining variable life products. Producers should also stress that rates are not guaranteed and historical performance may not be duplicated in the future.
Other requirements of the federal laws include a mandatory 45-day free-look provision from the date of policy application. Also, variable life policyowners have voting rights. Under the Act of 1940, the policyowner is allowed one vote for each $100 of cash value. The policyowner must be permitted to convert to traditional whole life insurance within 24 months of policy issuance.
Variable life insurance is also regulated by the state insurance departments as an insurance product. In effect, VLI is a dually regulated product. In addition to compliance with securities laws, variable life is subject to the state insurance laws:
Although variable life is essentially whole life with a separate account, variable universal life is essentially universal life with a separate account. It combines the investment features of variable life with the flexibility of universal life. For example, variable universal life premiums are not payable on a fixed schedule, as is the case with variable life. For this reason, variable life is sometimes referred to as scheduled premium variable life, and variable universal life is sometimes called flexible premium variable life.
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Like universal life, variable universal life offers policyowners a choice of two death benefit options and access to the policy’s cash value through withdrawals as well as loans. It also uses monthly deductions from the cash value to pay for the cost of insurance. Rather than crediting cash values with current interest rates, however, the cash value varies with the value of the investments in the separate account, as with variable life. As with variable life, policyowners also can choose among a number of sub-accounts that offer different investment objectives and transfer their policy funds among them.
Also like variable life, variable universal life is dually regulated as a security and insurance. All the regulatory requirements we described previously for variable life insurance apply to variable universal life.
Policyowners naturally hope that the cash value of their policies will grow, but with investments of any kind there’s always the possibility of a loss. If there should ever be a lack of funds in a policy’s account to pay for insurance coverage, the policyowner is given a grace period to deposit enough money in the account to cover the minimum needed to keep the policy in force.
Some of the advantages of flexible policies are
Some of the disadvantages associated with flexible polices are
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The industrial policy is written for a small face amount, usually $2,000 or less, and the premiums are payable as frequently as weekly, and occasionally, monthly. It derived its name from the fact that it was originally sold in England to the industrial class of factory workers. This form of insurance was originally sold in America to workers in industry.
The insured would determine how much he could pay each week and the face amount would be determined by the amount of premium the insured could pay. A company representative would call on the insured each week, usually at home, to collect the premium, which usually ranged from 5 cents to 1 dollar. The policy benefit was used primarily to pay for last illness and burial expenses.
This method of distribution is very expensive for two reasons. First, the mortality rates are higher for industrial policyowners because these insureds tend to have higher than average health risks and poorer than average living standards. Second, having the agent collect the premium each week at the customer’s home increases the cost of this type of policy.
With the rising incomes of workers, increasing consumer awareness, the introduction of social security, and the growth of group life insurance, the need for industrial life has decreased considerably over the last several decades. Today, industrial life represents about 1% of life insurance in force.
Most of the provisions found in individual life insurance policies are also found in industrial life insurance. However, consideration should be given to these provisions and their unique application to industrial policies. Because the face amount of the policy is so small and the cost of this type of insurance is expensive, certain provisions do not have the same impact on industrial insureds as on individual insureds:
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Today we find a variation in the industrial life concept known as home service life insurance. The home service policy is written for a small face amount, usually $10,000 to $15,000 in face value, and is typically sold on a monthly payment plan, either by automatic bank payment or a payment by mail. These insurance policies are subject to the same requirements for standard policy provisions as regular life insurance policies.
The unexpected death of an individual who has time payment obligations can create serious problems for his or her family. Credit life insurance provides that, in the event of the death of an insured debtor, the outstanding balance is usually paid off in full.
Credit life insurance can be written on a group basis or in individual credit life policies. It is usually written as a decreasing term type of coverage so the amount of insurance reduces as the amount of the obligation reduces. Level term insurance may also be written, which would remain level for the term of the loan. The benefits are payable to the policyowner (the creditor) and are used to reduce or extinguish the unpaid indebtedness. Most commonly, credit life insurance provides protection for 10 years or less.
Usually, the individual debtor pays the total premium. The premium is added to the finance contract amount so that, in effect, the insurance premium is being financed along with the item being purchased. The insurance company receives full premium up front. Life insurance companies write credit insurance through lenders such as banks, retailers, auto dealers, credit unions, and finance companies.
If a debtor prepays or refinances the loan, he or she is entitled to cancellation of the credit insurance and a refund of the unearned premium.
Some of the major provisions found in credit life insurance policies are those that provide the following:
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There are a number of life insurance policies that have been designed to fit specialized situations. Some of the more frequently used forms will be discussed here. These forms are merely combinations or modifications of whole life or term life policies. Many of these special policy names vary by company, and many companies have produced variations of these basic combinations.
The endowment policy is another category of permanent insurance. As with other types of policies, the endowment pays a death benefit upon the death of the insured. And like the limited pay policy, the premiums are paid only for a specified period of time. So if the insured is alive at the end of the premium paying period, the policyowner would receive the face amount maturity benefit and the insurance coverage would terminate. Thus, the policy endows at the end of the premium-paying period.
An endowment policy has all the same elements as a whole life policy. The primary difference is that it matures earlier (at a specified age or date), so the cash value must build up more rapidly and the premium is higher per $1,000 of coverage.
The accelerated growth of the cash values of endowment policies resulted in legislation against them. According to the Tax Reform Act of 1984, any policy issued after January 1, 1985, that endows before age 95 will not qualify as life insurance. That means that the policy’s cash value accumulation and its death benefit would be taxed. The endowment policy is included in this book
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because some state insurance exams still cover it, and because some clients may own existing endowment policies acquired before January 1, 1985.
Endowments were purchased for various periods of time—that is, 10 or 20 years, or to age 65.
Another version of the endowment concept was the pure endowment. This policy offered no life insurance protection. The pure endowment provided for the payment of the policy’s face amount only if the insured lived to the maturity date. If the insured died prior to the endowment date, all benefits were forfeited. Because this was essentially a high-risk savings plan (all savings were lost upon early death), it was rarely sold.
Family plans are uncommon, but still included in most state exams. Combining whole life insurance with decreasing term coverage, the family income policy provides temporary protection and permanent coverage. The family income policy provides an income to be paid upon the death of the family breadwinner.
The payout period, which is determined when the policy is purchased, is scheduled to last until the family’s income needs diminish. Family policies are usually sold for periods of 10, 15, or 20 years. Coverage is provided by combining decreasing term insurance with a permanent policy. This may be accomplished by means of a special policy or by actually adding term insurance to a permanent policy.
The family income portion of this type of coverage is supplied by a decreasing term policy. Income payments to the beneficiary begin when the insured dies and continue for the period specified in the policy, which is usually 10, 15, or 20 years from the date of policy issue, and not from the date of the insured’s death. So the longer the insured lives, the less insurance will be needed to meet the income obligations of the policy. That’s why decreasing term insurance is used for a family income policy. So, for example, if Kim has a 15-year family income policy and Kim dies 2 years after purchasing this policy, Kim’s family can expect to receive income benefits for 13 years.
To prevent what might be a burden if the insured dies close to the end of the family income protection period, some companies permit an arrangement whereby the beneficiary would receive an income guaranteed for some specified period of time—say 5 years—should the insured die within the family income protection period.
The amount of monthly income provided by the family income policy depends on the amount of insurance bought. A typical arrangement might be
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$10 of monthly income for each $1,000 of insurance. Some companies may offer more. For example, if Kim purchases a $75,000 family income policy, Kim’s family might expect to receive $750 per month during the family income protection period following Kim’s death.
The death benefit from the permanent insurance protection of the family income is usually paid in a lump sum when the insured dies, even if that occurs after the family income protection period. However, some family policies stipulate that if the insured dies before the end of the family income protection period, the proceeds will be paid at the end of that period. The amount paid is the face value of the policy.
Family maintenance policies are similar to family income policies because they both provide an income to be paid to the insured’s beneficiary. The difference is that with a family maintenance policy, coverage is provided by combining level term insurance with a permanent policy. A family maintenance policy provides income for a stated number of years from the date of death of the insured, provided the insured dies before a predetermined time. The family maintenance portion of the coverage comes from a level term policy.
Here’s how it works. Let’s say Sandy, age 30, wants to provide funds for family maintenance for at least 15 years following Sandy’s death, as long as death occurs before age 45. If Sandy were to die 10 years later, at age 40, this family maintenance policy would pay monthly income to Sandy’s beneficiary for 15 years from the date of Sandy’s death. The permanent insurance portion of the family maintenance policy pays a lump sum for the face value of the policy to the insured’s beneficiary either when the insured dies or at the end of the family maintenance payout period, whichever is stipulated in the policy.
Some companies offer contracts that provide coverage on each of the family members at the time the policy is issued. These combination policies or family plans customarily provide coverage on the principal breadwinner equal to four times the spouse’s and five times the children’s coverage amounts. For example, Bob’s policy might provide $100,000 on himself, $25,000 on his wife, and $20,000 on each child. In this example, the wife and children’s coverage would ordinarily be term insurance and Bob’s would be a permanent policy.
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These additions to Bob’s permanent coverage are sometimes referred to as riders, a concept we’ll look at later in this unit. Spouse term rider and family rider are common names for that coverage.
Under a family policy, term insurance coverage is provided without additional premium for children born or adopted after the policy is issued. The term insurance expires on each child as he or she reaches a specified age— 18, perhaps 21, sometimes as late as 25. Coverage on the children is usually convertible to any permanent insurance without evidence of insurability.
The retirement income policy accumulates a sum of money for retirement while providing a death benefit. Upon retirement, the policy pays an income such as $10 per $1,000 of life insurance for the insured’s lifetime or a specified period. These policies are expensive and cash value accumulation is high to pay for the monthly income. As the cash value in the policy approaches the face amount, the face amount must be increased to maintain the policy’s status as life insurance.
Although most life insurance is written on the life of one person, policies are available to insure the lives of two or more people. A joint life policy may pay the face amount upon the first death among the persons covered by the policy or upon the last death among the persons covered by the policy. Under a first-to-die joint life policy, the contract comes to an end at the first death and there is no further insurance protection for the other person or persons covered by the policy.
Suppose Esther, Sarah, and Rebecca are three sisters who have a $50,000 joint life policy covering all three of their lives. The proceeds are to be shared equally by the survivors upon the first sister’s death. So, when Esther dies, Sarah and Rebecca would each receive $25,000. Suppose Sarah dies soon after Esther. The last surviving sister will receive nothing more from the joint-life policy, because it terminated at the first sister’s death.
Survivor life insurance, or second-to-die insurance, covers two lives and guarantees payment only when the second insured dies. Premiums are usually payable until the second death.
Second-to-die policies are very useful in estate planning. When a surviving spouse dies, the policy can provide money to pay taxes on assets that may have been sheltered at the first death by the marital deduction. The money
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also can be used in certain business applications. Premiums on a survivorship policy can be significantly less than if the two lives were insured separately.
Juvenile insurance can be any type of coverage—whole life, limited payment life, or term insurance—depending on the purpose of having the policy. The criterion for juvenile insurance is that it be written on the life of a person who is not yet considered an adult for life insurance purposes. In most places, this includes anyone who is under the age of 15 (16 in Canada).
A popular juvenile policy is called the jumping juvenile policy. It is normally purchased by a parent for a child. The face amount of this policy might be for as little as $1,000 initially. At the time the child turns age 21, however, the face amount automatically jumps by an amount usually five times greater than the original face amount with no increase in premium and no evidence of insurability required.
Minimum deposit or financed insurance is technically a method of paying for insurance and not a type of policy. It is a high cash and loan value whole life policy. Such policies were devised in the late 1950s to take advantage of the fact that at the time, the Internal Revenue Service allowed the interest paid on a policy loan to be deducted in full for income tax purposes. Thus a prospect could buy such a policy and immediately borrow back the loan value so that, in effect, his or her initial premium outlay was very small. Since that time, however, the IRS has placed restrictions on the interest deduction when the loan is to finance insurance, so its popularity has diminished.
As it is currently used, the cash value of a permanent policy is used to pay the premiums on that policy through the use of policy loans. To achieve sufficient cash value, the first two of these premium payments must be paid by the policyowner; then loans may be used, but only if during the first 7 years of the policy at least four of the seven annual premiums are paid from funds other than policy loans. This is a rule imposed by the IRS.
A modified premium policy is an ordinary life policy in which the premium obligation is redistributed. Premiums are lower during the first 3–5 years of the policy, usually only a little more than would be paid for a level term policy for the same period of time. After this initial period, the premiums go up
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so that they’re somewhat higher than would be paid for an ordinary whole life policy.
A graded premium plan is similar to modified whole life in that initially the premium is very low. Unlike modified life, which has one increase to a higher, level premium for the life of the contract, graded premium policies provide an increase in premium each year for the first 5–10 years of the policy. At the end of this step-rate premium period, the premium remains level for the life of the policy.
It should be noted that graded premium (and modified life) policies build cash value but the amount of the cash value is usually less because of the smaller outlay of premium. Typically, a graded premium policy will have very little, if any, cash value during the graded premium period.
The mortgage redemption policy or rider is simply decreasing term insurance. The benefit amount of the term element is intended to be sufficient to pay off the unpaid remainder of the mortgage loan if the insured dies before paying it off.
Multiple protection policies are combinations of whole life and term whereby the amount of protection is higher in the early years of the policy and less in the later years. For example, the current death benefit may be described as equal to two times the benefit at age 65 (double protection). If the age 65 (and thereafter) benefit is $5,000, the insured has $10,000 of protection up to age 65. In essence, the additional death benefit prior to age 65 is term insurance.
As a hedge against high inflationary periods, many companies offer policies with face amounts increasing by the amount of inflation. The policy amounts are generally linked to the Consumer Price Index (CPI). There are two ways of providing this additional coverage. Either the premium is increased every year to cover the increased insurance amount, or the life insurance company makes assumptions about what it expects the increases to be at policy incep
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tion and the insured pays the same (but higher than average) premium over the life of the policy.
Deposit term insurance is a level term insurance policy that has a much higher premium for the first year than for subsequent years. The initial premium is significantly higher than the average premium needed to cover the cost of mortality during the term period. The excess front-end premium (the deposit) is then set aside to earn interest, and these dollars (deposit plus interest) will be applied to reduce the premium payments required in the following years. The premium levels are set so that the entire deposit will be exhausted when the final annual premium is paid. In effect, this arrangement provides a method of paying a portion of the premium in advance.
For example, the annual premium for a 10-year level term policy for a particular insured may be $500 (total outlay of $5,000). The same type of policy may be purchased as a deposit term contract for an initial premium of $2,500 followed by annual premiums of $200 (total outlay of $4,300). The initial deposit and interest are used to make up the difference in premium. Mathematically, the insurance company actually receives an equal amount of premium for these two policies when the time factor and interest earnings are taken into account.
Funeral insurance or pre-need burial insurance is a type of life insurance used to pay for an insured’s funeral at a particular funeral home. Funeral insurance pays the face amount on an insured’s death. Really, it is just a contract to provide a preplanned funeral and cemetery services funded by a life insurance contract or annuity. Typically, the funeral home has the insured buy a life insurance policy on him- or herself, naming the funeral home as the beneficiary. The funeral home usually is paid a commission on the policy sale as well. The policy purchased will have an increasing face amount so that the funeral will be fully funded, even if burial costs increase.
Advantages and Uses of Specialized Policies
Some of the advantages and uses of specialized policies are
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Some of the disadvantages of specialized polices are
Riders take their name from the concept that they have no independent existence. They have force and effect only when they are attached to a policy.
Riders are special policy provisions that provide benefits that are not found in the original contract, or that make adjustments to it. These special provisions are, in effect, attached to the policy or “ride” it. A rider can also refer to a term policy that is attached to a permanent policy to provide additional or specially needed coverage. Riders can be used to enhance or add benefits to the policy or they can be used to take benefits away from the policy.
A waiver is a type of rider that is usually used to exclude benefits and for which no premium is charged. For example, for underwriting reasons, a waiver may be attached to a policy that excludes benefits for death by a specified cause, such as a particularly hazardous hobby or occupation. The other riders discussed in this section usually require the payment of a relatively small additional premium for the benefits provided. The payment of the rider premium does not increase the cash value of the policy, but only pays for the benefits provided by the rider.
An accidental death benefit (ADB) rider may be added to an insurance policy to provide an additional amount to be paid to the beneficiary should the insured die as the result of an accident. This amount, usually referred to as the principal sum, is usually the same as the face value of the policy and is therefore often referred to as double indemnity. It could, however, be three or more times the face value.
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Whatever the amount, the accidental death benefit may be paid only when the insured dies as the result of an accident.
Accidental death benefits apply if the insured dies in an accident or within a specified period of time after and as the result of an accident. The period of time permitted between the accident and the insured’s death also varies, but it’s most often 3 months, or 90 days.
Certain causes of death are usually excluded:
The accidental death benefit usually ceases either 5 years before or after an individual’s normal retirement age—that is, ages 60, 65, or 70 unless the accident occurs prior to that age. Note, however, that the rider itself can stipulate that the accidental death benefit is to apply for the entire lifetime of the insured, or for the length of the contract. If a policyowner is paying an extra premium for the accidental death benefit and reaches the age at which this benefit no longer applies, the premium drops.
An accidental death benefit rider to a policy may also include additional benefits for dismemberment. If so, it is called an accidental death and dismemberment (AD&D) rider. The dismemberment portion of this rider provides for the payment of the capital sum (the face amount) in the event that, due to an accident, the insured loses two arms, two legs, two hands or the irrecoverable loss of vision in both eyes. Loss is generally defined as the actual severance or removal of the arm or leg as a result of the accident. Again, the loss usually must occur within 90 days of the accident.
The waiver of premium rider exempts a disabled policyowner from needing to pay premiums during the term of disability, while keeping the policy in force. For the waiver of premium to apply, the disability must be permanent and total. Total, as it is used here, can have two connotations:
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Technically, the first definition of total sometimes applies for a stated period of time, and then the second definition might take over as the criteria for deciding whether the disability is total. That is, the company may state that for the first year, all that’s necessary to qualify a disability as total is that the insured be prevented from engaging in his or her usual profession. After the year has elapsed, the company will then apply the broader definition of total—whether the insured can engage in any (not just his or her own) work for gain or profit. Understanding what constitutes permanent disability is somewhat more standardized. In most instances, whether the disability is considered permanent involves a waiting period after the onset of disability. If this waiting period elapses and the insured is still disabled, in the judgment of a company authorized physician, the disability is considered permanent. The length of the waiting period involved varies by company, usually ranging from 3–6 months.
During this waiting period, the permanency and totality of the insured’s disability have not yet been established, so the policyowner must continue making normal payments. When the disability proves to be permanent and total, the company refunds the premiums paid during the waiting period, because they were paid while the insured was, in fact, disabled.
Although premiums are being paid by a company under the waiver of premium rider, the policy remains in full force in every respect, as if the policy-owner personally were making the payments. This means that the cash value of a policy in this situation, and any dividends if it is a participating plan, continue to increase at the usual pace.
What happens when a disabled policyowner recovers from a disability? Suppose John, who is both the policyowner and the insured, was disabled for 2 years, during which time the company paid more than $1,000 in premiums for him under the waiver of premium rider. John has now recovered, so he simply begins paying his premiums again, starting with the next premium when it falls due.
The waiver of premium rider is usually not available when the policyowner reaches a specified age, commonly 60 and sometimes 65. When the waiver of premium rider expires due to the insured reaching a certain age, the company lowers the premium to compensate for the loss of the benefits the rider provided—unless, of course, the company provides waiver of premium benefits free of charge.
If the insured should become disabled shortly before the age at which the rider expires, he or she would still be eligible for the benefit under the waiver of premium rider of the policy. This is true even if the waiting period extends past the normal cut-off age of 60.
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When a waiver of premium rider is attached to a policy, the company cannot arbitrarily drop the rider. It must remain a part of the policy as long as the policyowner continues to pay premiums as agreed. However, if the policy should ever lapse and then be reinstated, the company can refuse to reinstate the waiver of premium rider.
Waiver of premium riders usually contain exclusions for suicide, military service, or injury received while committing a crime.
Because premiums on a universal life policy may fluctuate considerably, most companies provide a waiver of monthly deduction rider on a universal life policy that guarantees only the monthly cost of insurance, not the total premium the insured was paying. Under waiver of monthly deduction, the policy’s cash value will remain intact and continue to earn interest.
Some companies, however, will waive the guaranteed minimum annual premium on a universal life policy, rather than just the monthly cost of insurance. In this case, the rider is usually called waiver of premium and the policy’s cash value will grow not only with the interest credited, but also by the amount of the additional premium payments less the cost of insurance.
Under the disability income rider, the company guarantees the policyowner a regular monthly income for as long as he or she remains totally and permanently disabled. The amount of the income is usually based on the face amount of the policy—$X per month per $1,000 of coverage, for instance. In addition, most disability income riders include waiver of premium. For example, if a policyowner has the disability income rider on a $100,000 policy and the company guarantees $10 per month on each $1,000 of coverage, the policyowner will receive $1,000 per month.
An income under the disability income rider continues for the length of the disability. However, a waiting period is required by most companies to ensure that the disability is, in fact, permanent (by the company’s definition) and total (as determined by a company-approved physician). As in the case of the waiver of premium rider, this waiting period is usually 3–6 months.
Although the disability income rider usually includes the waiver of premium rider, it is possible to have one without the other. It’s essential that you understand the difference between these two important riders:
➤ The waiver of premium rider states that the company will pay the premiums on the policy during the insured’s total and permanent disability.
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➤ The disability income rider stipulates that the company will pay the policyowner a monthly income during any period of total and permanent disability.
Remember, the amount paid under the waiver of premium rider depends on the amount of the policy’s premium. The amount paid under the disability income rider is based on the face amount of the policy.
With most juvenile insurance policies, a parent is the policyowner and pays for the coverage; the child, of course, is the insured. If the parent dies, premium payments will probably cease, so the policy would lapse. Policyowners can protect their (and their child’s) interest in the policy through a payor rider.
This rider states that if the person who’s paying the premiums should die or become disabled before the child has reached a specified age—usually 21 or 25—the company will waive all further premiums until the child reaches that age. This waiver can apply for death only, or for death and disability.
Because the payor is, in effect, insured for the amount the premiums will cost the company in the event of the payor’s disability or death, the payor must prove insurability.
There are times when an insured discovers that due to some circumstance, usually health reasons, he or she has become uninsurable. There may be some existing life insurance, but the insured wants more coverage and discovers he or she is no longer able to purchase it. There is a rider that will guarantee that the insured can purchase more permanent insurance at specified ages, without proof of insurability. This is the guaranteed insurability rider (GIR), sometimes referred to as the insurance protection rider (PIR) or future increase option.
This rider guarantees that on specified dates in the future (or at specified ages or upon the event of specified occurrences such as marriage or birth of a child), the insured may purchase additional insurance without evidence of insurability.
As the option age is reached, the insured normally has 90 days in which to exercise the option or it is lost. The rate for this additional coverage will be
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that for his or her attained age, not the age at which the policy was issued. The rider generally expires at the insured’s age 40.
The amount of insurance that can be purchased on the option dates is usually limited to the amount and type of the base policy. Thus, if the insured had a $10,000 whole life policy with the guaranteed insurability rider, he or she could purchase up to an additional $10,000 of whole life coverage on the option dates.
The return of premium rider was developed primarily as a sales tool to enable the agent to say, for example, “In addition to the face amount payable at your death, we will return all premiums paid if you die within the first 20 years.” The rider is simply an increasing amount of term insurance that always equals the total of premiums paid at any point during the effective years. In reality, the rider does not return premium but pays an additional amount at death that equals the premiums paid up to that time—as long as death falls within the time specified in the rider. By purchasing this rider, the policy-owner is buying term insurance and is, of course, charged for it accordingly.
The return of cash value rider, not often used, was designed to offset the invalid complaint, “When I die, the company confiscates the cash value.” Such a complaint is based on lack of understanding of the mathematics involved in a level face value life insurance policy. However, if the agent can say, “We can attach a rider returning the cash value in addition to the face amount,” the objection is more easily answered than if it is necessary to explain the mathematics involved. The return of cash value rider is similar to the return of premium rider because it is merely an additional amount of term insurance that is equal to the cash value at any point while effective. By buying it, the policyowner is simply getting additional term insurance. In reality, this rider does not return the cash value; it pays an additional amount of insurance equal to the cash value.
With the cost of living rider, the policyowner has the option of increasing the death benefit of his or her policy to match any increase in the cost of living index (usually the CPI-U, the Consumer Price Index-All-Urban). This is accomplished either by changing the face amount of an adjustable life policy (and increasing the premium accordingly) or by attaching an increasing term
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rider to the base term or whole life policy and billing the policyholder for the additional coverage. (There is usually a cap on the increase—for example, 5%.)
Any increase in the death benefit, of course, will mean an increase in premium. Any subsequent decreases in the index will not result in lowering the policy’s death benefit.
Suppose Louise has a whole life policy with a face value of $100,000 and a cost of living index rider. If the CPI-U has gone up by 2%, Louise may increase the face value of her policy by $2,000 up to $102,000.
Note that this increase will result in Louise’s premium being raised. Note also that when the CPI-U goes up, Louise is not required to increase the face value of her policy accordingly.
Riders are also commonly attached to life insurance policies to provide coverage on the lives of one or more additional insureds. Usually these are term insurance riders covering a spouse, one or more children, or all family members in addition to the insured policyholder. Many companies will issue additional insured riders on request. As discussed earlier in this unit, some companies actively market combination coverage policies for family members under the label family protection policy.
Although it seems unusual to allow the substitution of insureds in life insurance, the substitute insured rider permits a change of insureds. This rider is also known as an exchange privilege rider.
The ability to substitute or exchange insureds is desirable, for instance, in business-owned life insurance, when a key employee or business executive is insured for the benefit of the corporation. Should this employee terminate employment or retire, the insurance can be switched over to apply to the employee’s replacement, subject to evidence of insurability. This way, the policy can continue (rather than be terminated and a new policy issued) with the same face amount, and with premiums calculated based on the new insured’s age, sex, and so forth.
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Beginning in the 1980s, many companies offer an accelerated benefits rider, sometimes known as a living benefits rider. This rider allows policyowners who are terminally ill, or who require long-term care or permanent confinement to a nursing home, to collect all or part of their death benefit while they are still alive. This can help relieve some of the financial distress caused by an insured’s inability to continue working and the rising costs of health care.
The purpose of this benefit is to provide the terminally ill person with necessary cash with which to take care of expenses related to the terminal illness—that is, medical expenses or nursing home expenses. Death benefits payable under the policy are reduced by any amounts paid under this rider. Most companies charge an additional premium to add this benefit, but some plans charge for the option only if it is used.
Long-term care (LTC) insurance, which reimburses health and social service expenses incurred in a convalescent or nursing home facility, can be marketed as a rider to life insurance policies.
LTC rider benefits are similar to those found in a LTC policy. The benefit structure includes the following:
In addition, certain optional benefits may also be provided, such as adult day care, cost of living protection, hospice care, and so forth.
There are two approaches to the LTC rider concept. The generalized or independent approach recognizes the LTC rider as independent from the life policy, because the benefits paid to the insured will not affect the life policy’s face amount or cash value. The integrated approach links the LTC benefits paid to the life policy’s face amount and/or cash value.
The living benefit or living needs rider combines life insurance and LTC benefits, drawing on the life insurance benefits to generate LTC benefits. In a
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sense, it’s like borrowing from the life insurance to pay LTC benefits. Under the LTC option, up to 70–80% of the policy’s death benefit may be used to offset nursing home expenses. Under the Terminal Illness option, 90–95% of the death benefit may be used to offset medical expenses. Of course, payment of LTC benefits reduces the face amount of the life policy.
If a chronically or terminally ill insured does not have an accelerated death benefits rider under his or her life insurance policy or wants another option, he or she may want to consider a viatical settlement. Under a viatical settlement contract, the insured, or viator, sells his or her life insurance policy to a viatical settlement provider for a reduced percentage of the policy’s face value.
After the exchange, the viatical settlement provider becomes the owner of the policy and the beneficiary. While the viator lives, the provider must continue to pay premiums to keep the policy in force. When the insured dies, the viatical settlement provider receives the entire death benefit.
Due to the delicate nature of viatical settlements, some states require viatical settlement providers and brokers to be licensed before entering into viatical settlement contracts.
Although a few providers may enter into a viatical settlement contract with a policyowner based on old age, most will only solicit contracts from terminally or chronically ill insureds. A chronically ill person is either unable to perform at least two activities of daily living (eating, toileting, transferring, bathing, dressing, or continence) or needs substantial supervision due to cognitive impairment. A person is considered terminally ill if he or she is not expected to live more than 24 months due to a medical condition. Tax laws require viators to be chronically or terminally ill to receive payments from viatical settlements tax-free.
During the underwriting process, the viatical settlement provider will contact the insured’s physician and/or clinic to verify records and determine his or her life expectancy. The issuing insurer of the life insurance policy will also be contacted to confirm policy terms and ascertain whether any outstanding policy loans exist. Throughout this process, the insured’s information may be shared only with the appropriate people involved in the settlement to protect his or her privacy. If the issuing insurance company has a favorable rating and the settlement is in compliance with state laws, the provider will issue the viator an offer.
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1. What type of insurance is designed to provide life insurance protection for only a limited period of time?
2. A flexible premium, adjustable benefit life insurance contract that accumulates cash values is called
3. Christy has a term policy that will enable her to switch over to a whole life policy at any time during the first half of the term without providing evidence of insurability. What type of policy is this?
4. Which of the following is not an advantage of whole life policies?
5. Janice and Julie are identical twins who both work as teachers and live next door to each other. They each purchase a $75,000 whole life policy at the same time. Janice chooses continuous premium whole life, and Julie chooses a 20-pay whole life policy. Which sister is probably paying a higher premium?
6. Gerald has a state insurance license but no other training or licenses. Gerald can sell any of the following except a(n)
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7. LaKita buys a policy that enables her to adjust the face amount, premium, and length of protection without having to complete a new application or have a new policy issued. LaKita has a(n)
8. What type of policy combines whole life insurance with decreasing term coverage?
9. What type of policy combines whole life insurance with level term coverage?
10. What type of policy combines whole life insurance on one family member with term coverage on other family members?
11. Tim has a life insurance policy that will pay $100,000 if he dies before age 65 and $50,000 if he dies after age 65. Tim probably has a
12. Minimum deposit policies have become less popular due to tax regulations, but they can still be used as long as a certain number of the initial payments are made from sources other than cash value. How many payments must be made from other sources?
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13. What provision might eliminate all future premiums in the event of total and permanent disability?
14. Which of the following provisions reflects a guarantee that at specified ages, dates, or events, the insured may buy additional insurance without a medical exam?
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|Terms you need to understand:|
|✓||Ownership clause||✓||Primary beneficiary|
|✓||Grace period||✓||Contingent beneficiary|
|Concepts you need to master:|
|✓||Ownership rights||✓||Irrevocable beneficiary designation|
|✓||Policy loans||✓||Succession of beneficiaries|
|✓||Automatic premium loan||✓||Class designations|
|✓||Misstatement of age or sex||✓||Simultaneous death act|
|✓||Free look||✓||Common disaster provision|
|✓||Revocable beneficiary designation||✓||Facility of payment provision|
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An insurance policy is a legal contract. Life insurance policies contain provisions setting forth the rights and duties of parties to the contract. Although it is necessary to look beyond the actual wording of the policy contract and into the statutes and court decisions for a full interpretation of these provisions, they are, nevertheless, the basis of the agreement between the company and the policyholder (and the beneficiaries, heirs, and assignees of the policyholder).
This chapter summarizes standard provisions, restrictions, and limitations in life insurance policies. It also reviews beneficiary provisions and permitted exclusions and limitations on coverage.
There are no “standard” policies in life insurance in the sense that there are in the property and casualty insurance field. However, many states have provisions that are required in all life policies so that the following provisions have become more or less standard in such policies.
The insuring clause contains the basic promise of the life insurance company to pay a specified sum of money, in a lump sum or an equivalent income stream, to the beneficiary upon the death of the insured. It sets forth the basic agreement between the company and the insured.
The consideration clause is the second important clause found in every life insurance policy. As its name implies, the consideration clause deals largely with the consideration paid by the policyowner for life insurance protection-the premium.
Part of the insuring clause states that the company promises to pay the policy benefits in consideration of the premium payments. The consideration clause identifies the fact that the policyowner must pay something of value for the insurer’s promise to pay benefits. This valuable consideration is the premium.
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The execution clause simply says that the insurance contract is executed when both parties (the company and the policyowner) have met the conditions of the contract.
The payment of premium provision specifies when, where, and how premiums are to be paid. Usually premiums are to be paid in advance either at the company’s home office or to the agent. The various modes of paying the premium will also be identified, such as monthly, quarterly, semiannually, and annually.
In addition, most insurers permit the premium to be paid by means of a monthly bank draft. This method is referred to by such names as monthly bank or automatic check plan (the actual name of the option may vary by company). The insurer simply sends a monthly premium notice to the policyowner’s bank and the bank sends the insurer a check for the monthly premium.
The least expensive way to pay the premium is annually or by a monthly bank plan. The other premium modes require the payment of a service charge added to the basic premium. For example, an annual policy premium might be $300. The monthly premium might be $25.50, which would total $306 of premium in a year.
The policyowner has certain rights regarding the policy owned. The first of these is the right to name the person or persons to receive the policy’s proceeds in the event of the death of the insured. That is, the policyowner can name the beneficiary.
The policyowner also has the right to decide how the proceeds of the policy are to be paid. A number of options are available regarding the way in which insurance benefits may be distributed, including leaving the decision to the beneficiary. But the initial right to select how the policy proceeds are to be paid out belongs to the policyowner.
The policyowner also has the right to assign the policy. For example, the policyowner could borrow funds from a bank and assign the policy to the bank as collateral security for the loan. When the loan is fully repaid, the policy would be reassigned back to the policyowner. A policy may also be assigned permanently and irrevocably. This is called an absolute assignment. For exam
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ple, the policyowner might want to make a gift of a policy to his daughter. He would accomplish this by making an absolute assignment.
The policyowner might state that a creditor (such as the bank mentioned previously) has the right to take whatever amount is necessary from the policy’s proceeds to pay a debt if the insured should die before the debt is repaid. Or the policyowner might sign a contract that says a creditor can obtain a portion of the policy’s cash value if the policyowner fails to pay the debt as agreed. In either event, the policyowner is using the right to assign the policy.
Another right the policyowner has is to use the policy’s cash value. As pointed out previously, permanent policies accumulate a cash value that may be borrowed. Any cash value accumulated by a policy must be turned over to the policyowner in the event the policy lapses, or in the event the policyowner surrenders the policy. The policyowner also has the right to decide on what schedule he or she will pay for the coverage--annually, semiannually, quarterly, or monthly. Later the policyowner might decide that the chosen premium payment schedule is inconvenient. He or she can then exercise the right to change the schedule.
The policyowner has the right to decide how to use any dividends paid by the company. There are a number of choices regarding dividends available to the policyowner. For right now, you just need to be aware of the policyowner’s right to designate how dividends may be used.
Finally, with convertible term life insurance, the policyowner can change coverage to permanent protection. That is, he or she can convert the policy.
In typical instances, the owner of an insurance policy is also the applicant and the insured. However, for any of several reasons, it might be advantageous for the policy to be owned by a third party. The three parties would then be the insured, the insurer, and the policyowner.
Ownership of a policy by a third party usually means that the value of that policy will not be included in the estate of the insured. This can be of great benefit when the insured has a very large estate, but is short on liquidity.
When the proposed insured is a minor, the applicant can be the minor’s parent or other relative or legal guardian. In such a situation, the applicant--let’s say a parent who’s applying for insurance on his or her son’s life--will probably want to maintain control of the policy until the insured is “of age.” This
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can be accomplished by including a clause that designates the parent--the applicant--as the controller or owner of the policy. Because this clause designates the applicant as the person in control of the policy, it is called the applicant control clause or the ownership clause.
Besides the parent/child relationship, other common situations of this type are the guardian/child and grandparent/grandchild relationships.
If the policyowner fails to make the premium payment, the company won’t immediately cancel the policy; it will allow a specified period of time in which to pay the overdue premium. We call this period of time the grace period.
This grace period is of tremendous advantage to the policyowner. For instance, suppose the premium payment has simply been forgotten; or suppose the policyowner intends to make the payment, but is short of funds for a few days. Because of the grace period, life insurance protection is still available and the beneficiary would still receive the proceeds if the insured died within that period even without the premium having been paid. The amount of the premium owed, however, is deducted from the proceeds.
The grace period can vary, but for most ordinary life policies it’s 1 month (30 or 31 days).
When a policy lapses due to nonpayment of a premium, it can generally be reinstated, provided three conditions are met. These conditions are spelled out in the reinstatement clause of the policy:
Any statements made on the reinstatement application are subject to a new incontestable period (usually 2 years).
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If the policy has not been in force for some time, the policyowner might think it is better to simply purchase a new policy rather than pay back premiums plus interest to reinstate the lapsed policy. However, there are several reasons for considering reinstatement:
This last point is especially true if the policyowner had purchased the lapsed policy 10 or 15 years earlier. Instead of paying attained age rates for a new policy, the policyowner could reinstate the lapsed policy at original issue age rates.
Policy loan provisions are found in policies that include cash values. After a policy has been in force for a specified period of time (usually 3 years), it must contain some cash value, which may be borrowed by the policyowner.
A policyowner always has the right to surrender or cash in a policy in exchange for the full cash value. But in many cases, a policyowner might want to make only a partial withdrawal of the available funds and not fully surrender the contract, so a policy loan is often a more appropriate solution.
Generally, a policyowner may borrow up to the amount of the current cash value less any indebtedness against the policy (previous loans and interest charges). The insurance company will charge interest on cash value loans. The amount of interest is usually relatively nominal and regulated by state laws. Often, if the policyowner agrees to pay the interest in advance, the amount charged will be reduced. A slightly higher interest rate is charged if it is paid at the end of a loan year. Most states allow the insurer to use an adjustable rate of interest in lieu of a fixed loan rate.
If the loan amount and interest due are not paid, these amounts will be considered an indebtedness against the policy and will result in a reduced death benefit should the insured die while the indebtedness is outstanding. In most policies, after the policy has been in effect a certain number of years, failure to repay the loan or to pay interest on it will not void the policy unless or until the total amount of the loan and accrued interest equals or exceeds the
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cash value of the policy, and then only after 30 days’ notice has been mailed to the last known address of the policyholder and his assignee, if any.
The insurer may defer a loan request for up to 6 months from the date of the loan application unless the reason for the loan is to pay premiums due.
The automatic premium loan provision, when included, enables the company to use, automatically, whatever portion of the cash value is needed to pay premiums as they fall due. This keeps the policy in force when it would otherwise lapse due to nonpayment of premiums. Because only permanent insurance policies have cash value, the automatic premium loan provision applies only to permanent policies.
Even with the automatic premium loan provision, of course, the policy must have sufficient cash value to pay the premium due. This means that the automatic premium loan provision is meaningless if the policy has no cash value.
Money lent to the policyowner under the automatic premium loan provision is treated just like any other loan of the policy’s cash value. This means that interest is charged on the loan, and the cash value payable on surrender or death is reduced by the loan amount outstanding.
One final point: Just because this provision has the word automatic in its title, don’t get the idea that it’s automatically included in every policy. In many instances, this provision must be requested and written into the policy.
The incontestability clause states that after the policy (term as well as permanent) has been in force a certain length of time, the company can no longer contest it or void it, except for nonpayment of premiums. The length of time varies, but it’s usually 1 or 2 years.
If the company discovers some reason to void the policy during the contestable period--the first year or two the policy is in force--it can take such action. After the policy has been in force for the specified period, even if fraud is discovered, the company cannot void the policy. This provision makes the life insurance contract a little different from other types of contracts. Usually, contract law specifies that if a fraudulent contract has been enacted, it may be voided or canceled at any time. The incontestable provision limits the period of time in which the insurer may contest the insurance contract as to any misrepresentations or fraud on the part of the applicant.
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The suicide clause is designed to prevent people who are contemplating suicide from obtaining life insurance. To accomplish this, the clause states that if the insured commits suicide within a specified period of time, the policy will be voided.
The length of time varies, but it’s usually the same as the incontestable clause time limit: 1 or 2 years.
After the period of time specified in the policy has elapsed, the company will pay the claim even if the insured commits suicide. If suicide occurs within the time limit, however, the company usually refunds any amount the policy-owner has paid for the coverage. In other words, the company refunds the premiums paid. When refunding premiums in the case of suicide occurring within the specified time limit of the suicide clause, the company usually doesn’t pay any interest that the premium has earned because the interest earned is used to offset part of the costs the company incurred in setting up the policy.
One final point: When included in a policy, the suicide clause applies whether the insured is sane or insane at the time he commits suicide.
A life insurance policy is a contract between the insurer and the insured. Each party has obligations and rights that are spelled out in the contract. In order to make sure that there will be no misunderstanding of what each insurance contract provides, one of the provisions contained in every policy states that the insurance policy itself and the application, when attached to the policy, make up the entire contract between the parties. No company rules, no oral understandings or the like have any bearing on the contract unless they are included in the policy or the attached application.
In addition to the rights and obligations of the insurer and the insured, the policy conditions also designate any restrictions, limitations, or exclusions of the policy. You’ll learn about formal exclusions in detail later. For now, let’s assume that John qualifies for life insurance coverage. However, his hobby is road racing. The insurer might issue a policy on his life with an exclusion-a provision that states, in this case, that no claim will be paid if John is killed while participating in a sports car race.
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Standard policy conditions--the rights and obligations of the insurer and the insured--are included when the company’s standard contract is printed. If it’s necessary to adjust the standard contract to satisfy the particular situation of a given policyowner, the alterations can simply be inserted (often typed) into the contract at the time the policy is issued. If a policy provision is typed into the contract, of course, the company must make certain that the policyowner knows the provision has been inserted and that he or she accepts it.
On occasion, it’s necessary to amend a life insurance policy after it has been issued. This occurs when a policyowner requests that the company add some coverage after the policy has been issued. In such instances, the company simply types or prints up the necessary addition to the policy--or stamps the data on the policy itself--to amend the policy contract. Such changes or additions are called riders, endorsements, or simply amendments. For common additions to policies, most companies have printed forms that can be attached to the policy. In addition, some very short common amendments can simply be rubber-stamped onto a policy. A producer is never permitted to make a change in a policy, whether at the request of a policyowner or for some other reason. Only authorized company officers can make changes or amendments in life insurance policies.
When a policyowner assigns a policy, he or she transfers rights in the policy-either all of them or a stipulated portion--to another party. The assignment clause in a policy states that any assignment the policyowner decides to make must be filed in writing with the company or it will not be valid when the claim is paid.
Suppose Henry decides to borrow some money from the bank. He assigns enough of his policy proceeds to the bank to repay the loan should he die before repaying it himself. Through an oversight, both Henry and the bank forget to notify the insurer of the assignment. If Henry dies before paying off the loan, the insurance company will pay the entire face amount (proceeds) to the beneficiary because the assignment wasn’t filed with the company.
Keep in mind in this section that the type of beneficiary designation has a great deal to do with the policyowner’s capability to assign policy rights. For example, if the beneficiary has been named irrevocably, he or she must agree in writing to the assignment.
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A policyowner, as you know, names the beneficiary of the policy. Under normal circumstances, the proceeds of the policy go directly to this named beneficiary upon the insured’s death. However, the policyowner can, if so desired, direct that a certain amount of the money is to go to another party.
Suppose a man borrows $5,000. He uses the proceeds of his life insurance policy as part of the collateral for the loan. To do this, he signs an agreement that states that if he should die before repaying the entire $5,000, a portion of the proceeds of his policy is to be paid to the assignee--the person or party he’s borrowing from--to pay off any outstanding loan balance. Because the policyowner is using his policy as collateral for a loan, this is known as a collateral assignment.
Because just part of the proceeds are assigned, we sometimes call a collateral assignment a partial assignment.
In addition, the assignee is to receive a portion of the proceeds only under certain conditions, the main one being that a balance remains on the loan when the insured dies. Because this condition must exist, this collateral or partial assignment is also referred to as a conditional assignment.
Obviously, a lending institution or bank won’t lend more than the face amount of the policy under a collateral assignment alone. In fact, most institutions probably won’t lend an amount equal to the face amount, but will limit the loan to something less than the face amount of the policy. Because this is the case, under a collateral, partial, or conditional assignment, the policyowner is usually assigning only part of the policyowner rights in the policy.
It sometimes happens that the policyowner decides to sell or make a gift of a life insurance policy by assigning all rights in the policy to the assignee. For instance, a man might want to give a policy on his life to his son. This type of assignment is made voluntarily, so it’s sometimes called a voluntary assignment.
A voluntary assignment usually involves turning all rights--including the right to use the cash value--over to the assignee. For this reason, it can be called an absolute or complete assignment.
When an absolute assignment is made, the original policyowner usually has no means of recovering surrendered rights. In effect, he or she has designated another policyowner to take over--a change in the ownership of the policy is taking place. This type of assignment is usually permanent.
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In some cases, the policy’s beneficiary can assign a portion of the proceeds (or all of them, technically, although this is unlikely) in about the same manner as the policyowner. However, unless the beneficiary has been named irrevocably, there is actually little to assign.
A revocable beneficiary has only an expectancy as far as the policy is concerned. He or she expects to receive the proceeds--unless the policyowner changes the designation to another person. This makes it unlikely that a lending institution will advance money on the strength of this expectancy.
An irrevocable beneficiary, on the other hand, has more than a mere expectancy in the policy; receiving the proceeds upon the insured’s death is more likely because the policyowner cannot designate another person in his or her stead. An irrevocable beneficiary, then, is more likely to find a lending institution willing to lend money on the strength of the policy than is a revocable beneficiary.
One final point about assignments made by beneficiaries: If the beneficiary dies before the insured does, any assignment made by the beneficiary is no longer valid in most jurisdictions, unless the policyowner agrees in writing that the assignment remains valid if the beneficiary should die first. The proceeds of the policy are paid just as if the assignment had never existed, then, unless a written agreement to the contrary exists.
If the insured’s age or sex is misstated on the application, the insurer has the right to adjust the policy’s benefits to reflect the amount that the premiums paid would have purchased based on the correct age or sex of the insured. The insured’s age is a factor in computing the amount of premium to be paid. If a man said he was 30 at the time his policy was issued, and it came to light upon his death 20 years later that he was actually 32 when the policy was issued, this means that the insured has been paying a lower premium than he should have been for the entire 20 years.
The misstatement of age clause in an insurance policy provides that when a discrepancy in age exists, if the insured is alive the company must adjust the amount of future premiums and request payment of the additional premium the policyowner should have paid. If the insured has died, the company must compute the amount of insurance that the actual premium paid would have purchased at the insured’s correct age and pay the beneficiary that amount.
For example, suppose an insured purchases a policy with a face amount of $50,000. He states his age at the time of purchase as 30 when, in fact, he was
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34. Let’s assume that the premium he was paying would purchase only $47,000 of insurance at age 34. After he dies, the error in age is discovered. His beneficiary will receive $47,000 in proceeds rather than $50,000.
Misstatement of age is not an unusual occurrence in the life insurance business. Some misstatements of age are intentional, but most of them are simply mistakes. In either event, the difference in actual and stated ages is not material enough to void the policy. Most policies contain this misstatement of age clause to rectify this situation should it occur. You should be aware that if an overstatement of age occurs, the company will reduce premium payments or adjust the face amount of the policy upward if the insured dies before the error is discovered.
The same concept applies for misstatement of sex. Due to life expectancy (females have longer life expectancy), males pay more for life insurance than females. Therefore if the insured’s sex has been misstated on the application, an adjustment in the death benefit will be made. If the mistake was found while the insured was alive, an adjustment in the premium would be made.
This provision allows the insurer to make a change in the policy even though the error is discovered beyond the incontestability period.
Some states require life insurance policies to include a provision that gives the insurer the right and opportunity at its own expense to conduct a medical examination of the insured as often as reasonably required when a claim is pending, and to make an autopsy in case of death where it is not forbidden by law.
Modifications or changes in the policy, or any agreement in connection with the policy (such as changes in the beneficiaries, face amount, or additional coverage), must be endorsed on or attached to the policy in writing over the signature of a specified officer or officers of the company. No one else has any authority to make changes or agreements, to waive provisions, or to extend the time for premium payment.
Some modification clauses also specifically state that no agent has the right to waive policy provisions, make alterations or agreements, or extend the time for payments of premiums.
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The policy may contain a provision that permits the insured to exchange a policy for another type of policy form permitted by the company. This exchange is usually made from one policy type to another policy form with the same face amount.
If the exchange is to a policy with a higher premium, the insured merely has to pay the higher premium and no proof of insurability would be required. If the exchange is to a policy form with a lower premium, proof of insurability may be required because this could result in adverse selection against the insurer.
For example, if Charlie discovers that he has only 6 months to live, he might decide to exchange his higher premium 20-pay life for 1-year term insurance with the same face amount. The insurer’s risk has increased while its premium income has decreased. Thus, Charlie has to prove insurability.
No policy of individual life insurance can legally be delivered or issued for delivery in most states unless it has printed on or attached to it a notice stating in substance that during a period of 10 days (some companies allow 20 days) from the date the policy is delivered to the policyholder, it may be surrendered to the insurer together with a written request for cancellation of the policy and in such event, the policy shall be void from the beginning and the insurer shall refund any premium paid. This provision allows the policyholder an opportunity to review the entire contract and reevaluate the purchase decision.
The beneficiary is the person or interest to whom payment of the life insurance proceeds will be made upon the death of the insured. The beneficiary provision enables the insured or the policyowner to direct the payment to any person he or she chooses.
A variety of different parties or interests may be designated as beneficiaries under the life insurance policy. The beneficiary can be a person or an institution, such as a foundation or charity. A specifically designated person, more than one person, or a class or classes of persons also may be named as bene
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ficiaries. The insured may name his or her estate, an institution, a corporation, a trust, or any other legal entity as a beneficiary.
As you should recall, to form an insurance contract, the policyowner must have an insurable interest in the insured at the time of application but not necessarily at the time of death. After a policy is in effect, the policy remains valid even if the insurable interest of the policyowner ceases to exist.
A beneficiary is not required to have an insurable interest, but often does. In many cases, a spouse, parent, or child of the insured person is named as the beneficiary, so the beneficiary does happen to have a coincidental insurable interest in the life of the insured. Nonetheless, there is no need to change a beneficiary designation if the original family relationship changes.
For example, a couple is married and each spouse is the owner and beneficiary of a life insurance policy covering the other spouse’s life. Insurable interest exists at the inception of the insurance contract. Later, this married couple divorces. Legally, the policies remain valid, even though insurable interest has ceased, and there is no obligation to change the beneficiary designations.
However, more than likely, there will be a change in ownership rights, or the beneficiary designations, or both, or the policies will be surrendered when a marriage terminates. If there are children from the marriage, ownership rights may be transferred to the children or the children may be designated as new beneficiaries. If there are no children, the policies will probably be surrendered, because people generally don’t continue to pay life insurance premiums when financial and emotional interest in an insured has ceased.
One of the rights of the life insurance policyowner is the right to designate a beneficiary and to change that beneficiary designation at will. Almost all life insurance beneficiary designations are revocable (changeable). Usually the insured retains the right to change the beneficiary, unless he or she has specifically given up that right. Most policies have a revocable beneficiary.
It is possible, however, for the owner of the policy to give up the right to change the beneficiary designation at will. In such cases there is an irrevocable beneficiary and the designation cannot be changed without the consent of the beneficiary. An irrevocable designation might be used when a court orders a husband in a divorce settlement to continue payment on an insurance policy on his own life, with an irrevocable beneficiary designation on behalf of his wife (the primary beneficiary) and his children (the contingent beneficiaries).
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In the event that the irrevocable beneficiary dies before the insured, the right to select the beneficiary may revert to the policyowner on a reversionary basis.
When an irrevocable beneficiary is named, the policyowner gives up the usual ownership rights to the policy and cannot exercise them without the consent of the beneficiary. For example, the policyowner could not take out a policy loan without the consent of the irrevocable beneficiary.
Even when an irrevocable beneficiary designation has been made, the designation can be changed if the irrevocable beneficiary agrees to it.
Every policy has a primary beneficiary. The word primary means first or most important. Therefore, if Jane is named the primary beneficiary, she is the first person in line to receive the proceeds of the life insurance policy.
It’s possible to name more than one primary beneficiary for the proceeds of an insurance policy. So if Jane and her brother Bob are both named primary beneficiaries, they will both receive their shares of the proceeds before any others.
Because there’s no guarantee that a beneficiary will outlive the insured, it might be wise to name a contingent beneficiary as well. Whether the contingent beneficiary receives anything depends upon--or is contingent upon-something happening to the primary beneficiary that keeps him or her from receiving the proceeds. Thus, a contingent beneficiary will receive the proceeds of the policy only if the primary beneficiary dies before the insured.
It is also possible to designate a tertiary beneficiary. A tertiary beneficiary occupies the third level in the succession of beneficiaries and is entitled to receive the life insurance proceeds following the death of the insured, provided that both the primary and contingent (secondary) beneficiaries have died before the insured.
After the death of the insured, the proceeds belong to the beneficiary. What is left after the beneficiary dies, of course, depends on the settlement option selected to go into effect at the death of the insured. If a lump-sum benefit is paid, the insurance company has no further obligation to the beneficiary. If an option other than a lump-sum payment is selected, or an arrangement is made where benefits continue over a period of time, the beneficiary should name his or her own beneficiary.
If the primary beneficiary dies before the insured and there is no contingent or tertiary beneficiary, the insured’s estate automatically becomes the beneficiary.
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Careless wording of beneficiary designations can result in undesirable consequences. A tremendous amount of time is spent each year in courtroom litigation attempting to determine the beneficiaries and heirs. For this reason the life insurance producer should insist that the applicant word his or her beneficiary designation carefully. For example, if the insured designates his wife (not specifically named) as the beneficiary, a problem may arise. If the insured has married several times, it may be difficult to identify the true beneficiary.
In such a case, does wife mean the insured’s present wife or does it mean his wife at the time the beneficiary was designated? Or does it apply to a wife who is now caring for the insured’s minor children? Who was the intended beneficiary in such a case? It is important that the beneficiary be designated by full name to avoid misunderstanding.
If children are designated as a class to receive the proceeds, and if it is apparently the intention of the insured that an adopted child be included, a disposition of the proceeds will be made to follow that intention.
The insurer will make every effort to make a disposition of the proceeds of the policy in compliance with the wishes of the insured, as long as the insured makes his intention clear. Otherwise, the insurer must distribute the funds according to the apparent intent of the insured or pay the funds into court and seek a judicial determination of the proper distribution.
Beneficiary designations may stipulate that the proceeds be paid to a minor, a trust, or the insured’s estate.
Naming a minor as the beneficiary of a life insurance policy presents problems. The most immediate of these problems is that a minor would not be competent legally to receive payment of and provide receipt for the policy proceeds should the insured die before the minor came of age. If an insurance company paid the policy proceeds without a proper receipt from the beneficiary, it might be liable to pay the proceeds again when the beneficiary reached his or her majority.
To avoid this, insurance companies may hold onto the proceeds, paying interest on them until the beneficiary reaches legal age. Or the company may insist that a trustee or guardian be appointed for the minor, someone who is legally entitled to receive and manage the policy proceeds.
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If a minor becomes eligible to receive life insurance proceeds due to the death of both parents, any part of their estate left to the minor would have to be administered by a general guardian, regardless of whether it includes life insurance proceeds. Thus the life insurance proceeds would be paid to that guardian. Some parents anticipate this problem by establishing a trust to administer the life insurance proceeds and all other property in the estate of the parents in the event that both parents die leaving minor children.
Up to this point, we’ve talked about beneficiaries of policies as if they were always one or more individuals--living human beings. However, this is not always the case. For example, if Jack wants to, he can name his estate as the beneficiary of his policy. The same is true of a company or a trust. All of these may be named as a beneficiary, as can the surviving stockholders of a closely held corporation.
A trust is formed when the owner of property (the grantor) gives legal title of that property to another (the trustee) to be used for the benefit of a third individual (the trust beneficiary). This fiduciary relationship enables the trustee to manage the property in the trust for the benefit of the trust beneficiary only. The trustee legally must not benefit from the trust.
When a trust is designated as the beneficiary of a life insurance policy, the policy proceeds provide funds for the trust. Upon the death of the insured, the trustee administers the funds in accordance with the instructions set forth in the trust provisions.
Although there are many benefits in naming a trust as beneficiary of an estate or a life insurance policy, particularly for minor children, there are drawbacks as well. A trustee will charge a fee for managing a trust. The way the trust property is managed is often left up to the trustee, leaving the trust beneficiary powerless to intervene if the trust is poorly managed. Also, the trustee may not provide resources for the trust beneficiary as he or she or even the grantor would have wanted; the trust beneficiary must request resources from the trustee, and he or she cannot make free use of the property in the trust.
Life insurance trusts are often used to provide management of insurance proceeds on behalf of a beneficiary. Rather than allow the insurance company to administer the proceeds, a policyowner might want the proceeds to be invested, managed, and paid out on a discretionary basis through the use of a trust.
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An inter vivos trust is one that takes effect during the lifetime of the grantor. A testamentary trust is a trust created after the grantor’s death, according to the provisions of the grantor’s will.
The insured’s estate can be named as beneficiary. The insured may direct that the policy proceeds be payable to his or her executors, administrators, or assignees. Such a designation might be made by an insured in order to provide funds to pay estate taxes, expenses of past illness, funeral expenses, and any other debts outstanding prior to the settlement of the estate. Designating the insured’s estate as beneficiary aids in the settlement of the estate by avoiding the need to sell other assets of the estate to pay these last expenses.
Frequently, it is not desirable to name the estate as beneficiary. When money enters an estate and there is no will, the court handling the disposition of that estate is required to distribute the assets according to state law, which may or may not be the way the deceased would have wanted.
In addition, estate costs are usually determined by the size of the probate estate. This means that adding life insurance policy proceeds to the probate estate increases the costs of settling the estate. When policy proceeds go into an estate, they could also be tied up for a considerable period of time, especially if the estate is involved in a dispute.
Finally, when a policyowner leaves policy proceeds to a named beneficiary, there are ways to protect these funds from the beneficiary’s creditors. When the proceeds go into the estate, however, the heirs receive the proceeds in the form of cash, which makes the money more vulnerable to creditors.
Another way of designating beneficiaries of life insurance policies is by group or by class, rather than by individual name. An example of such a designation would be “all my children” or “my brothers and sisters still living.” This designation saves the policyowner the trouble of making changes should the membership of the group be altered due to births or deaths.
Let’s use an example to see how beneficiaries may be designated by class. In 1995, Julio purchased a life insurance policy and listed as the beneficiaries “all my children.” At the time he purchased the policy, Julio had three children--Maria, Jose, and Elizabeth. All three were, therefore, the beneficiaries of Julio’s policy.
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In 1997, Elizabeth dies, so the beneficiaries are Maria and Jose, Julio’s surviving children. In 1998, Julio’s wife has twins, Raoul and Margaret, at which point the beneficiaries to Julio’s policy are Maria, Jose, Raoul, and Margaret.
By designating his beneficiaries by class rather than individually by name, Julio saved himself the trouble of having to change the beneficiaries after Elizabeth’s death and then again after Raoul and Margaret were born. More importantly, Julio made sure that the policy proceeds would be distributed according to his wishes--that is, that all his children would share those proceeds.
If Julio had designated his beneficiaries individually by name rather than by class, it could have led to confusion and, worse, the distribution of the policy proceeds in a manner not in accordance with Julio’s wishes. For example, suppose Julio had named Maria, Jose, and Elizabeth as beneficiaries and then neglected to eliminate Elizabeth as a beneficiary after her death. If Julio had died, part of the policy proceeds might have been paid into Elizabeth’s estate and distributed according to state law rather than to Julio’s remaining children as he intended.
Suppose when Zeke dies he has a $150,000 life insurance policy that names his three sons--Abe, Ben, and Carlos--per capita primary beneficiaries. Each of the three sons would receive $50,000.
Under a per capita beneficiary designation, if one of the named beneficiaries is already dead when the policy matures, the remaining beneficiary or beneficiaries divide his or her share, in addition to receiving his or her own. In the situation we’ve just described--three sons, named per capita primary beneficiaries of a $150,000 policy--if Carlos dies before the father, when the father dies Carlos’ share is divided equally between the other two sons, who would each receive $75,000.
Under a per stirpes (meaning through the root) designation, the proceeds belonging to the deceased brother would not go to the other beneficiaries. In this case, the deceased brother is the root if he has heirs of his own. To those heirs--usually his children--the proceeds of the father’s policy pass through the root (him) to his children.
So, if we have three brothers named primary beneficiaries per stirpes of a $150,000 policy, but Carlos has died, followed by the death of the father, each surviving brother would receive $50,000, with Carlos’ $50,000 share passing on to his heirs.
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Beneficiary designations may seem perfectly clear when read in a life insurance policy. Nevertheless, if an insured and the primary beneficiary are both killed at the same time, problems arise. How can it be determined who died first?
Many states have adopted the Uniform Simultaneous Death Law. Under it, if there is no evidence as to who died first, the policy will be settled as though the insured survived the beneficiary.
Accordingly, the life insurance proceeds would be paid to the estate of the insured, not the estate of the beneficiary. Of course, if contingent beneficiaries are designated, the proceeds would be payable to them. If there is clear evidence that the beneficiary survived the insured, the proceeds are payable to the beneficiary’s estate.
Let’s say Melvin is the insured and his wife Melody is the primary beneficiary of the policy. Their children, Mike and Melissa, are the contingent beneficiaries.
Melvin and Melody are killed in a plane crash. If Melody, the primary beneficiary, lived longer than Melvin, she should get the proceeds and they should be paid into her estate. The proceeds would then go to people designated in her will or in accordance with state intestacy laws if she has no will.
If Melvin lived longer than Melody, the contingent beneficiaries, Mike and Melissa, should receive the proceeds. If there were no contingent beneficiary, the proceeds would go to the insured’s estate. The insured’s will would then designate who should receive the money, or, if he or she had no will, the intestacy laws would control the disposition.
As a practical matter, it is often impossible to determine whether one person outlived another in this type of situation. To deal with this type of problem, the Uniform Simultaneous Death Act has been adopted by most states.
The Uniform Simultaneous Death Act states that if the primary beneficiary and the insured die in the same accident and there’s no proof that the beneficiary actually outlived the insured, the proceeds are paid as if the primary beneficiary had died first. This means that the proceeds of the policy are paid to any named contingent beneficiary(ies) or into the estate of the insured if contingent beneficiaries were not named. But if there’s any kind of proof-such as a witness who says he saw the primary beneficiary move, thus showing signs of life, after an accident that kills both the beneficiary and the insured--the primary beneficiary outlived the insured and the money must be paid to the primary beneficiary’s estate.
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There are times when it is most desirable to avoid this problem of the primary beneficiary living a short time longer than the insured and receiving the proceeds of the policy. It can be accomplished by using a common disaster provision.
A policyowner can make certain that the rights of the contingent beneficiary are protected by including a common disaster provision in the policy. This provision simply writes into a policy that the primary beneficiary must outlive the insured a specified length of time in cases of simultaneous (or nearly simultaneous) death; otherwise, the proceeds are paid to the contingent beneficiary.
The common disaster provision paves the way, legally, for the policyowner to make certain that the contingent beneficiary receives the proceeds if both the insured and the primary beneficiary die within a short time of each other. The policyowner requests this provision in the policy. It states that the primary beneficiary must outlive the insured a specified period of time--usually 10, 15, or 30 days--in order to receive the proceeds. This provision comes into play most frequently when the insured and the primary beneficiary are killed in (or die as a result of) a common disaster, an accident of some kind.
As an example, suppose you buy a life insurance policy, naming your wife the primary beneficiary and your son the contingent beneficiary. You want to protect the rights of your son, in respect to the policy, in the event you and your wife die in a common disaster. You should protect these rights especially if you die first, because in that case, the proceeds might pass on to your wife and then into her taxable estate upon her death a short time later. You can prevent this by adding a common disaster provision to your policy.
One of the unique features of life insurance is that the life insurance proceeds are exempt from the claims of the insured’s (deceased’s) creditors as long as there is a named beneficiary other than the insured’s estate. A similar provision with reference to the beneficiary is the spendthrift clause.
A person who spends money extravagantly is known as a spendthrift. The insured can protect the proceeds of an insurance policy from the actions of a spendthrift beneficiary through the use of a spendthrift clause. This clause in a life insurance policy provides the following:
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The spendthrift clause is designed to protect the proceeds of a life insurance policy from the beneficiary’s spending habits and creditors. The spendthrift clause also prevents the beneficiary from
If the beneficiary fails to pay his or her creditors as agreed, one or more of them may be forced to take legal action to recover the money. If the beneficiary is receiving payments from a life policy that has a spendthrift clause, the creditors cannot attach those payments before they are made to the beneficiary. After the beneficiary has received the payments, however, the creditors can take steps to attach those payments.
The facility of payment provision enables the insurer to select a beneficiary if the named beneficiaries cannot be found after a reasonable time. This provision is most commonly found in group life insurance contracts and industrial life policies. Typically, this provision is found in policies with relatively small death benefits, such as industrial life. Normally, the insurer would select someone who is in the family’s immediate bloodline (a brother, sister, aunt, uncle, and so on).
Life insurance policies used to be written with a number of exclusions. Most life insurance policies today no longer contain these exclusions. However, because many policies containing exclusions of one kind or another are still in force, you should know about the most common ones.
The aviation exclusion restricts payment of benefits in case of death from aviation activities, except when the insured was a fare-paying passenger or commercial crew member. Among the types of aviation restrictions still found are these:
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Companies using any or all of these restrictions will cover civil aviation deaths for an extra premium.
In wartime, it has been common for companies to include restrictions that limit the death benefit paid to usually a refund of premium plus interest or possibly an amount equal to the policy’s cash value. Often in the past, the policy’s benefits were suspended during a war or an act of war. The term, “act of war” has been used to describe the Korean and Vietnam conflicts.
Today, most insurers will provide some form of life insurance coverage for those on military duty. Traditionally, there are usually two types of restrictions or clauses that may be used. The status clause excludes the payment of the death benefit while the insured is serving in the military. The results clause excludes the payment of the death benefit if the insured is killed as a result of war.
By today’s underwriting standards, few applicants are declined life insurance because of their occupations. For example, firefighters and police personnel can purchase life insurance at standard rates. Even commercial airline pilots can usually purchase life insurance (although possibly at higher than standard rates).
Much of the underwriting attention is focused on the applicant’s avocations or hobbies. If an applicant participates in a hazardous hobby such as auto racing, sky diving, scuba diving, and so forth, the amount of insurance that may be purchased may be limited, or an extra premium may be charged due to the additional risk. Depending on the hobby, the death benefit may be excluded if death was caused as a result of the hazardous avocation.
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By law in most states, life insurance policies are not permitted to contain the following provisions:
The law of the state in which the policy is sold governs the contract. The policy may not contain a provision by which the laws of the home state of the insurer govern the policy provisions.
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1. How long is the typical grace period?
2. Which of the following is true about an automatic premium loan provision?
3. The incontestable clause is usually in effect after
4. Harry decides to borrow some money from a bank and use life insurance cash values as collateral. What type of assignment will Harry probably use to secure the loan?
5. Carol has a policy on her ex-husband that she wants to give to their daughter. Carol no longer wants any control over this policy. What type of assignment will Carol probably use to accomplish this?
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6. Carl purchased a life insurance policy when he was 44. The insurer accidentally recorded his age as 42. When the mistake is discovered in a review of the files 5 years later:
7. How long is the free look period in most states?
8. When Tom dies, Rosemary receives the death benefit. If Rosemary had died before Tom, George would have received the benefit. Which statement is true?
9. John leaves his $300,000 estate to his three children to split equally according to a per stirpes distribution. One of his children dies before John does. Upon John’s death, which of the following is true?
Policy Provisions 203
10. Alice and Ken are in a fatal car crash that kills them both. Alice is the primary beneficiary of a policy on Ken’s life. What happens to the policy proceeds?
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|Terms you need to understand:|
|✓||Interest only payments||✓||Extended term insurance|
|✓||Fixed period installments||✓||Reduced paid-up insurance|
|✓||Fixed amount installments||✓||Cash dividend|
|✓||Life income||✓||Accumulation at interest|
|✓||Straight life income||✓||Paid-up additions|
|✓||Refund annuity||✓||Reduce premium option|
|✓||Life income certain||✓||Accelerated endowment|
|✓||Joint and survivor income||✓||Paid-up option|
|✓||Cash surrender value||✓||One-year term option|
|Concepts you need to master:|
|✓||Settlement options||✓||Nonforfeiture options|
|✓||Withdrawal provisions||✓||Dividend options|
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The life insurance policy provides important policy options. These options give the life insurance contract flexibility to meet the needs of the insuring public. Of particular value are the settlement, nonforfeiture, and dividend options available under a life insurance contract.
At one time, life insurance policy proceeds were paid only in the form of a lump-sum cash payment. This often created as many problems for the beneficiary as it solved. For instance, the beneficiary, who is the sudden recipient of a large amount of cash, might have little or no idea of how to use or invest the money. An immature beneficiary might launch into a great spending spree and be broke in a short period of time.
To avoid situations such as these, the life insurance industry developed methods by which the proceeds of a policy could be paid in forms other than a lump sum. These methods of receiving policy proceeds in other than a lump sum are known as settlement options or payment options.
Most policy proceeds are still distributed in a lump sum. It is important that policyowners and beneficiaries understand that settlement options are available and that such options may be tailored to meet individual needs. When a settlement option is chosen, the proceeds of the policy are left with the company. The insurance company invests the proceeds and guarantees that the funds will earn interest.
Unless the policyowner specifies an irrevocable settlement option, the beneficiary may select any of the same options available to the policyowner when the proceeds become payable, even if that option differs from that originally selected by the policyowner.
If there are any outstanding policy loans, they are always deducted from the settlement option chosen. All dividend accumulations, paid-up dividend additions, and any term insurance riders will serve to increase the benefits of the settlement option chosen.
There are four frequently used optional modes of settlement:
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In addition, most companies will agree to distribute the proceeds under any reasonable and actuarially sound mode.
The first settlement option to be described is the interest option, sometimes also called the interest only option. Under the interest option, the life insurance company keeps the proceeds of the policy for a limited time and invests them for the beneficiary, paying the interest earned as income to the beneficiary.
Under the interest-only option, the policyowner may provide a means by which the beneficiary can withdraw all or part of the principal amount of the policy proceeds. The right of withdrawal can take several forms. Consider this example.
The insurance company holds $100,000 of proceeds at interest. Interest is paid to the beneficiary at the rate of so many dollars per month. In addition, the beneficiary may withdraw, at any time, any amount up to the full $100,000 principal. In this situation, the beneficiary can withdraw all or part of the principal, if so desired. The policy can also be arranged so that the beneficiary cannot withdraw any of the principal amount or cannot make any withdrawals for a specified number of years or until a specified age is reached.
If the beneficiary dies while money is still on deposit with the company, the money is paid to the deceased beneficiary’s estate or to a secondary beneficiary (or beneficiaries) named in the policy. If the insured indicated that the contingent beneficiary should continue to receive income, the company pays the contingent beneficiary in the designated manner.
When the insured has not elected a settlement option for the contingent beneficiary, that beneficiary can select the manner in which the proceeds are to be paid.
The fixed period option, along with the remaining two options that we’ll look at, is actually a form of annuity. Under the fixed period option, the beneficiary receives a regular income, comprised of both principal and interest, for a specified period of time. So under this option the principal amount gradually decreases to zero.
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Three factors that determine the amount the beneficiary or payee will receive each time a payment is made under the fixed period option are
For example, if the policy proceeds total $100,000, earn 6% annual interest, and are to be paid out over a 10-year period, the beneficiary can expect to receive approximately $1,100 each month for a total of $132,000. However, if the proceeds are paid out over a 15-year period, the beneficiary would receive approximately $845 per month for a total of $152,100. Note that in both examples the total amount paid exceeds the policy proceeds because of the interest earned.
As with other settlement options, if the primary beneficiary dies before receiving the full amount of the policy’s proceeds, the money remaining is paid to the contingent beneficiary, if one is named in the policy, or into the estate of the primary beneficiary.
The third type of settlement option is the fixed amount option, under which the payee receives payments but the length of time for the payments is not specified. The amount of each periodic installment is established ahead of time and payments continue until the combination of principal and interest has been exhausted.
The three factors that determine how long the payee will receive payments under the fixed amount option are
Suppose the beneficiary is to receive $10,000 per year from $100,000 in policy proceeds that are earning 6% interest annually from the insurer. Payments would extend over a 14-year period and total approximately $140,000. But if the annual payment were increased to $15,000, the income would last for only 8 years and total $120,000. Just as with the fixed period option, the company guarantees that the total amount paid until the proceeds are exhausted will exceed the policy proceeds because of the interest earned.
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In guaranteeing that the payee will receive more money in the long run by taking the proceeds in the form of an income stream, the company is encouraging the payee to leave the proceeds with the company. It also increases its total assets, thus increasing overall earnings for the company—and the payee.
The fourth settlement option is the life income option. As its name implies, the life income option provides for payment of installments for the entire lifetime of the payee. Just as with an annuity, there are at least four distinct methods in which these installments can be paid. Many companies offer additional options. The most common methods of payment are
Using these four settlement options, some custom tailoring may be done between the policyowner and the company. For instance, an insured policy-owner might specify in her policy that if she should die, her husband is to receive only the interest on the proceeds until he reaches age 62; from that point on, he is to receive a life income certain for 20 years.
Additionally, because a beneficiary’s needs change from time to time, most companies will allow the policyowner to change the settlement option as necessary during his or her lifetime.
The withdrawal provision is used in connection with settlement options. Under this provision the proceeds of a policy are held by the insurance com
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pany and earn interest. The insured has the right to withdraw the funds but may withdraw only a limited amount each year. Quite often this withdrawal provision is used to pay for college.
Many policies are written with no provision for any special arrangements in the settlement of proceeds. However, a large number of companies will permit other settlement arrangements. Special settlement arrangements are sometimes desirable in order to accomplish the estate planning objectives of some insureds, and insurance companies will cooperate with almost any arrangement that is reasonable.
An insurance company does not provide trustee services. If an insured, for example, requested a settlement arrangement whereby the insurance company would make payment of the proceeds to two beneficiaries “according to their needs,” the insurance company would probably reject the settlement arrangement because it would require the insurance company to make a judgment determination.
Companies have rules to avoid arrangements that are uneconomical to administer. For example, a company may specify that a minimum of $1,000, or in some cases $2,000, may be placed under a settlement option. It may prescribe that minimum installments payable shall be not less than a certain amount per installment. A company may set a time limit for holding proceeds at interest, such as for the lifetime of the primary beneficiary or the lifetime of a contingent beneficiary.
Although the life insurance contract is between the policyowner and the insurer, after the insured dies, a contractual arrangement exists between the insurer and the beneficiary. The beneficiary may sue the insurer if payment is not received upon proper proof of death.
Likewise, after the insured dies, the proceeds of a life insurance policy belong to the beneficiary, and the insured’s creditors have no right to them. The beneficiary’s creditors, however, may have a right to the life insurance proceeds. Even the cash value of life insurance is generally protected from creditors.
The only exception to these statements is if the premiums that paid for the insurance were from embezzled funds.
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One of the principal advantages for the insured or beneficiary in selecting one of the various settlement options is freedom from investment concerns. If a beneficiary elects a lump-sum settlement of the death benefit, he or she must decide how to use or invest the money. In essence, by electing a settlement option other than a lump sum, the beneficiary is trusting in the expertise and knowledge of the insurance company to administer these proceeds and provide some form of income.
Another advantage of settlement options is the fact that any of the options will guarantee a greater return than simply taking the face amount of the policy. A $100,000 policy will generate a greater death benefit than $100,000 if these proceeds, consisting of principal and interest, are paid to a beneficiary over a period of time.
Nonforfeiture options assure that any cash value accumulation in a life insurance policy is made available to the policyowner should he or she stop paying the premiums for any reason.
The amount of cash value and the rate at which it accumulates depends upon the type of policy purchased by the policyowner. The amount and rate vary from company to company and often from one type of policy to another. In many states, however, permanent policies are required to have at least a small cash value by the end of the policy’s third year.
The following are common nonforfeiture options in cash value policies:
With the cash surrender option, the policyowner can receive the cash accumulation as cash. The minimum cash value is determined by a formula established by law. A portion of each premium paid is allocated to the policy reserve that is a fixed liability of the insurance company. The balance of the
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premium is used to cover certain expenses (acquisition costs, administrative expenses, agents’ commission, and so forth). In the early years of the policy (the first two or three), all the premium is used for the reserve requirement and other liabilities and expenses, so there is no cash value in the early years of the policy.
Usually about the third year of the policy, these initial expenses are covered and the policy’s guaranteed cash value begins to grow. As the cash value grows so do the values associated with the nonforfeiture options. With the cash surrender option, life insurance protection ceases. If the policyowner has borrowed money on a policy loan, the amount yet to be repaid plus interest will be deducted from the cash surrender value.
If Sherry has a policy with a stated cash value of $1,500 and she still owes $350 (including interest) on a previous loan from this cash value, for example, the company would give her on the cash surrender value option a total of $1,150 ($1,500 less $350).
Another nonforfeiture option is called the reduced paid-up insurance option. Under this option, the policyowner essentially uses the cash value of a present policy to purchase a single premium insurance policy, at attained age rates, for a reduced face amount.
Remember the following about the reduced paid-up insurance option:
All reduced paid-up policies are of the same type of insurance as the original policy, except all riders, including those for disability and accidental death, are eliminated.
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The third nonforfeiture option is called the extended term option, in which the policyowner can use the policy’s cash value accumulation as a single premium to purchase paid-up term insurance in an amount equal to the original policy face amount. The length of the term depends on the net cash value that is applied as a net single premium at the insured’s attained age.
Typically, the extended term nonforfeiture option goes into effect automatically if the policyowner isn’t available to make a choice or simply fails to exercise an option.
If a policy loan is outstanding at the time the extended term option is exercised, the company will first deduct the loan outstanding from the cash surrender value of the policy to cancel out the outstanding loan. The reduced cash value will provide term coverage for a shortened period of time and for a face amount that is likewise reduced by the amount of the loan outstanding.
Many life insurance policies have a provision allowing the policyowner to participate in the favorable experience of the insurance company through dividends. Most, although not all, of these participating policies (sometimes referred to as par policies) are sold by mutual life insurance companies rather than by stock companies.
Policies that do not pay dividends are called nonparticipating (nonpar) policies.
Usually the premium for a participating policy is calculated using very conservative assumptions, including an allowance for future dividend payments. The amount, or even the existence, of policy dividends is never guaranteed. But by charging a slightly higher initial premium for participating policies, a company can be fairly sure that it will be able to return at least a small dividend.
As a matter of practice, many companies declare and pay dividends annually. The policyowner is usually offered several options for the settlement of these dividends. The following represents a list of possible dividend payment options. Although these are the most frequently used options, the list is not all inclusive:
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The source of funds from which life insurance policy dividends are paid is the same (basically) as the three factors used in premium computations:
In each of the cases outlined above, the company ends up with excess funds or surplus over those needed to pay claims, pay operating expenses, and make a respectable profit. Life insurance policy dividends are paid out of such funds.
The policyowner has several options available with respect to the receipt of dividends when they are paid and notifies the insurer regarding which option he or she selects.
Policy Options 215
One dividend option is simply to have the company issue the policyowner a check for the dividend amount. This is known as the cash dividend option.
The policyowner can let dividends accumulate at interest with the company. The company will invest the policyowner’s money and add interest earnings to the initial amount of the dividends as such earnings accrue. Of course, any interest is currently taxable. The interest on invested dividends builds up, or accumulates. For this reason, this dividend option is called the accumulation at interest option.
If an insured policyowner should die with a credit to the policy for accumulated dividends and interest, the dividends, plus any accrued interest, are paid to the beneficiary of the policy because this money belonged to the policy-owner.
Keep in mind, with respect to leaving dividends to accumulate at interest, that this money has nothing to do with the cash value accumulation of a permanent policy. This means that dividends left at interest can be used in a cash emergency—the policyowner can withdraw them—without in any way affecting the cash value of the policy.
If a policyowner decides to use dividends as a single premium to buy additional life insurance protection, the additional coverage is fully paid for, or paid up, with that premium. For this reason, we call this option the paid-up additions option.
The amount of paid-up addition per $1 of dividend is based on the insured’s age at the time the paid-up addition is purchased. The amount of the paid-up addition to a life insurance policy is therefore dependent on the amount of the dividend and the insured’s attained age.
No new policies are issued. The base policy is simply amended to reflect the additional paid-up values. Each of these additions will also develop cash value. The face amount and the additions make up the total death benefit if the policy matures as a death claim. Should the policyowner elect to surrender the policy for its cash value prior to that time, both the cash value of the policy and the addition would be paid. When this arrangement is chosen, the insured need not prove insurability for the purchase of the additional coverage.
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If another dividend option is chosen originally and the policyowner later decides to change to the paid-up additions option, any previous dividend amounts generally cannot be used to purchase these additions. However, the policyowner can use current and future dividends to purchase paid-up additions.
The type of insurance purchased as a paid-up addition is usually restricted to the same type as provided in the original policy. If a policyowner is insured by a whole life policy and decides to use policy dividends to purchase paid-up additions, the paid-up additional insurance will be whole life insurance.
There is one more point concerning paid-up additions: the loading charges— the share of the company’s operating expenses—borne by each policy. When current dividends are used to buy paid-up additions, no agent’s commission is involved, nor is there any investigation of insurability. This means that the operating expenses of putting this coverage in force are lower than original policy expenses.
The policyowner can direct the insurer to apply the dividend toward the next premium due on the policy, which is called the reduce premium dividend option. Usually if this option has been elected, the premium notice will show the gross premium minus the dividend and the policyowner simply pays the net amount. If the dividend equals or exceeds the premium amount, the premium payment may be suspended entirely.
As discussed in the text, endowment policies lost their tax advantages in 1985 and have been rare since that time. However, you may still encounter a policyowner with an endowment policy using dividends to accelerate the endowment.
This option actually enables the policyowner to pay up the policy early. For example, the insured has a 20-pay life. By using the dividends over the life of the policy, it may be paid up after 16 or 17 years instead of the full 20 years.
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If the policyowner chooses to do so, he or she can direct the company to use the dividends on the policy to purchase term insurance—term coverage that will be in force for a full year. We call this option the 1-year term dividend option.
Under the 1-year term dividend option, the dividend money is used to buy term coverage of 1 year’s duration, based upon the attained age of the insured, with the amount usually limited to the current cash value of the policy. If there is more than enough dividend money to buy that amount of 1year term coverage, any excess dividend money still belongs to the policy-owner. These extra funds can be applied under other available dividend options.
In addition, the company usually will require a medical examination for the term coverage only if the original policy has been in force and another dividend option has been in effect for several years. If this option has been in effect since the original policy went in force, the company usually requires no additional proof of insurability under the 1-year term dividend option.
A company’s board of directors can declare a policy dividend annually if a surplus exists. This doesn’t mean that the policyowner has to decide which dividend option to select every time the dividend is declared. The policy-owner can set up any one of the options we’ve been discussing as a permanent option to be handled automatically by the company every time dividends on the policy are made available.
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1. Ken is receiving interest only payments on the settlement of his father’s life insurance policy. If Ken dies before the lump sum is paid to him, what happens to the balance of the money?
2. Which of the following is not a factor in determining the amount the beneficiary will receive each time a payment is made under the fixed period option?
3. Which of the following is not a factor in determining the amount the beneficiary will receive each time a payment is made under the fixed amount option?
4. Walter is the beneficiary of his mother’s life insurance policy. He wants to make sure the proceeds will last not only as long as he lives, but also as long as his wife is alive. Walter should select the
5. Which of the following does not affect the payment of life insurance dividends?
Policy Options 219
6. Which of the following is true about paid-up additions?
7. Emily has chosen to receive the payout from her husband’s life insur
ance policy so that she will receive an income for the next 15 years. At
the end of that time, the entire proceeds from the policy will have been
paid out. Emily has selected the
8. Heath has chosen to receive the payout from his wife’s life insurance
policy in such a way that he will have an income for the remainder of
his life, regardless of how long he lives. Heath has selected the
9. Jim has selected to receive only the interest from his mother’s life
insurance policy. When Jim dies, his children will receive the lump-
sum benefit in addition to the benefit from his life insurance policy.
Jim has selected the
10. Carmen has selected to receive $10,000 per month until the principle and interest on her husband’s life insurance policy has all been paid. Carmen has selected the
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✓ Annuity ✓ Contract owner ✓ Annuitant ✓ Beneficiary ✓ Immediate annuity ✓ Deferred annuity ✓ Single premium annuity ✓ Level premium annuity ✓ Flexible premium annuity
✓ Accumulation period ✓ Annuity period ✓ Accumulation units ✓ Annuity unit ✓ Life annuity ✓ Refund life annuity ✓ Life annuity certain ✓ Joint and survivorship annuity ✓ Joint life annuity ✓ Tax-sheltered annuity ✓ Retirement income annuity ✓ Equity-indexed annuity ✓ Market-value adjusted annuity
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Life insurance is designed to protect the insured against premature death. An annuity is designed to protect the annuitant against the risk of living too long and possibly outliving his or her financial resources during retirement. Annuities offer a benefit unknown to other types of financial vehicles: a payout you cannot outlive. Other investments and savings can be depleted and leave an individual with no other resources in dire financial straits. Annuity payments, however, can be arranged to last for life.
Like all insurance, annuities are designed to transfer a risk from consumers to an insurance company. In the case of annuities, the risk being transferred is the risk of outliving your savings. Annuities are not technically “life” insurance, but because annuities are sold by life insurance companies, a basic understanding of the types of annuity policies available is necessary to qualify for a producer license.
Suppose you had a sum of money with which to support yourself for the rest of your life. If you spent too much each month, you would run out of money before you died. If you spent too little, you would not maximize the use of that money—you would die before it was all used up. An annuity eliminates this uncertainty by converting a sum of money into a series of period payments that can be guaranteed to last a lifetime, and sometimes longer.
From the standpoint of the consumer, it could be said that life insurance offers protection against dying too soon, and an annuity offers protection against living too long.
Suppose you don’t have a sum of money that will serve as a fund for your retirement. Well, an annuity can be structured to allow for the accumulation of such a fund over time so that when retirement finally arrives, income payments begin. These payments will continue as long as you live and even afterward to your spouse if he or she survives you.
Annuities exist to distribute a lifetime income or to accumulate a sum of money, if necessary. Generally, this accumulation is designed to be used for retirement.
Like an insurance policy, an annuity is a contract between a purchaser and an insurance company. The purchaser pays the premium and generally is the contract owner. The contract owner has certain rights under the contract.
For example, the contract owner names the annuitant. The annuitant is the insured, the person on whose life the annuity policy has been issued. In most cases, the annuitant is the intended recipient of the annuity payments. Many times the contract owner and annuitant are the same person, but not always.
The contract owner also names a beneficiary, who receives any survivor benefits payable under the annuity upon the death of the annuitant.
Most annuities have an accumulation period, which may be initiated by the payment of a single lump sum or the first of a series of premium payments. During this accumulation period, the principal earns interest and grows year by year. A so-called fixed annuity specifies a fixed, guaranteed minimum rate of interest that will be paid on the principle amount invested in the annuity.
Under this arrangement, the contract owner knows exactly the minimum return that will be earned during the accumulation period. The insurer simply invests each premium in its general investment account and credits the current interest to the annuity’s cash value, but never less than the minimum guaranteed.
A variable annuity offers a variable, non-guaranteed rate of interest that offers the potential—but not a promise—to act as a hedge against inflation.
In all types of annuities, the principal earns interest. The first year’s interest is added to the original principal, and the combined sum then earns more interest in the second year. In other words, we earn interest on interest, or compound interest, in the second and every subsequent year.
The interest earned by the annuity contract is generally not currently taxed as it is with other savings investment vehicles. This untaxed interest goes right on earning even more interest, which is also untaxed currently and added to principal. This tax advantage is an important reason why people buy annuities.
The annuity period starts when the annuitant begins receiving a series of installment payments from the annuity. Each periodic annuity payment is
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made up partly of the premium deposits and partly of the interest those deposits have earned. The interest portion of the payment is taxable as income because it was not taxed as it was earned. The premium portion of the payment is not taxed because annuity premiums are paid with dollars that were taxed before they were paid into the annuity.
Of course, nobody knows exactly how long the annuitant is going to live. However, insurance companies have studied average life expectancies over many years, so that using the law of large numbers, the insurance company has a pretty good idea how long the average person will live. Some people will die before their life expectancy is up, leaving uncollected benefits for the people who live longer than their life expectancy.
An annuity is really a combination of three things: the premium deposits, the interest earned, and a mortality factor. Even after the annuitant has exhausted all deposits and interest, he or she can still collect annuity payments for life due to the insurer’s acceptance of longevity risk.
For a fixed annuity, the cash value accumulation at the beginning of the annuity period is simply “annuitized.” That is, the accumulation is converted into a stream of periodic payments using actuarial principles that take into account the expected longevity of the annuitant, interest earned by the principal balance during the annuity (payout) period, and related factors. The result is a fixed dollar amount payout that remains the same for the rest of the contract.
A different payout measure is used for variable annuities. The payout can change, reflecting the investment experience of the principal.
An annuity contract owner that stops making premium payments during the accumulation period does not lose the value accumulated in the annuity to that point. The contract holder may have several nonforfeiture options, rights to the cash value accumulation up to the point the premiums stopped.
A common option is to permit the contract to become a paid-up contract with the annuitant receiving annuity payments based on that amount.
Another option is to surrender the contract for its cash value and take a lump-sum payment. Surrender, however, is not available after annuity payments begin. Most companies will level some kind of surrender charge, which often scales downward as time goes on.
There are two categories of annuities, based on when annuity payments are to begin. These are immediate and deferred annuities.
A contract is an immediate annuity if income payments to the annuitant are to begin one payout interval (for example, one month or one year) after purchase of the annuity.
A contract is a deferred annuity if income payments are to begin at some further point in the future—perhaps as much as several years from the date of purchase.
Even with an immediate annuity, payments don’t begin on the very next day after the contract is purchased. Instead, payments begin after one full payment period from the date of purchase has elapsed. If the contract calls for monthly installments for example, payments will begin 1 month after the date of purchase. If the contract calls for annual payments, the annuitant will receive the first payment one year after the date of purchase.
Annuity benefit payments are made on either an annual, semiannual, quarterly, or monthly basis. Because the longest period between benefit payments is a year, it follows that payments on an immediate annuity will begin no later than 1 year from the date of purchase. However, if the contract provides for monthly benefit payments, with an immediate annuity, payments could begin as soon as 1 month from the date of purchase.
Because an immediate annuity has no accumulation period during which additional premium payments may be made, an immediate annuity must be paid for with a single premium and is known as a single premium immediate annuity (SPIA).
A deferred annuity can also be a single premium contract or single premium deferred annuity (SPDA). In fact, such persons as professional athletes frequently buy single premium deferred annuities while their incomes are quite high. This deferral period allows a deferred annuity to be used as an accumulation vehicle during the annuitant’s working years as well as a source of lifetime income after retirement.
In the case of a deferred annuity contract, the annuitant could die before annuity payments were scheduled to begin. In such cases, the contract beneficiary is paid the cash value of the contract.
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For fixed annuities, that amounts to the premiums credited to the contract (that is, net of any front-end loads), plus interest, minus any surrender charges. Some companies waive the surrender charges in such cases.
For variable annuities, the cash value depends on the investment experience of the funds supporting the annuity, which could be more or less than the total premium paid into the policy. However, some companies agree to pay a death benefit at least equal to the amount of premium the policyowner paid into the annuity (sometimes plus interest), even if the funds have fallen to a lower amount by the time of death. Other companies pay a stepped-up death benefit on variable annuities: If the fund previously grew to a high level but had fallen to a lower level at the time of death, the death benefit would equal the previous higher level of the fund. Although these proceeds do not represent death protection like the benefits from a life insurance policy, we may still call the amount refunded from a deferred annuity a death benefit.
Let’s look at the various ways to pay for an annuity.
One of the most common ways to pay for an annuity is with a single premium. An annuity purchased by a single lump-sum payment is called a single premium annuity. For example, a life insurance policy could be cashed in at retirement and the cash value used to buy a single premium annuity that will provide income for the rest of the individual’s life.
A second method of buying an annuity is the level premium annuity. Under this arrangement the premiums are paid in periodic installments over the years prior to the date on which the annuity income begins. Level premiums have a “forced savings” aspect to them, much like making regular deposits into a passbook savings account. A common level premium arrangement is the annual premium annuity in which the premiums are paid in yearly installments up to the time the annuity benefits begin. Premiums can also be paid semiannually, quarterly, or monthly.
A flexible premium annuity is like the level premium annuity because annuity premiums are made over a period of time, usually years, until annuity bene
fits are scheduled to begin. The difference is that with a flexible premium annuity, the purchaser has the option to vary the amount of each premium payment, as long as it falls between a minimum and maximum amount—say, between $200 and $10,000. The timing of the payments is also flexible—that is, they needn’t be paid on a fixed schedule.
The flexible premium annuity can be advantageous to persons whose incomes may be subject to considerable fluctuation or who, for whatever reason, cannot pay for an annuity all at once or with periodic premiums that are the same amount each time. If an annuity is used to fund an IRA, it must provide flexible premium payments.
There are five factors used to determine annuity payouts:
The annuitant’s age is important, because the company must determine how long it’s likely to have to make income payments to the annuitant. If Mr. A, age 60, and Mr. B, age 65, both had $100,000 to fund the payment of a lifetime annuity benefit, the amount of Mr. A’s payment would have to be lower than Mr. B’s because the insurance company would expect to pay Mr. A’s benefit 5 years longer than Mr. B’s.
The annuitant’s sex is also a factor used in most states to determine premiums because women tend to live longer than men. However, some states have adopted unisex titles that disregard gender in determining annuity payouts.
As you know, life insurance companies invest premium dollars and earn a certain rate of interest on these investments. When determining payouts for annuities, the companies estimate, or assume, that invested dollars will earn a specified interest rate and that these earnings can increase the amount of the benefits paid out. This assumption is known as an assumed rate of interest, and it is the third factor in determining annuity payouts.
The fourth factor in annuity premium computation is the cost of any guarantees the company has made concerning the total amount (or total number of payments) to be paid. As we’ll cover in more detail later, some annuity
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payout options provide that payments will continue for at least a certain period of time even if the annuitant dies earlier. In such cases, the annuity payout is reduced to cover the cost of the guarantee. The longer the guaranteed payment period, the more the annuity payout is reduced. Finally, to administer annuity contracts, companies incur operating expenses. Payout amounts, therefore, must have an expense factor added to them.
Except as otherwise indicated, the annuities we’ve been discussing up to this point have been fixed annuities—that is, annuities that grow at a fixed rate and pay fixed benefits when the annuitant reaches a certain age. Another type of annuity in which rate of growth of the annuity values may vary according to the performance of the investment medium, and from which benefits may also vary, is the variable annuity.
Variable annuities provide annuitants the opportunity to experience large gains; they may, however, also produce a loss. Variable annuities are characterized by a variable rate of growth and a variable benefit payable to the annuitant.
Under traditional, fixed annuity contracts, the insurance company assumes the investment risk. If investment performance is more than what is required to fund the contract’s guarantees, the difference is added to the company’s surplus. If investment performance is unfavorable, the insurance company, not the contract owner, bears the loss.
With all variable contracts, including variable life insurance and variable annuities, the investment risk is borne by the contract owner. This allows investment gains to be passed through to the contract owner, but it also means that investment losses will be passed through to the contract owner as well.
Buyers can usually choose from a variety of investment accounts, even including the company’s (nonvariable) general account.
Because the contract owner bears the investment risk, the Securities and Exchange Commission (SEC), as well as some individual states, considers variable annuities to be securities rather than simple life insurance products. As a result, variable annuities and those who sell them are subject to federal securities regulations as well as to state insurance regulations.
Variable contracts must be registered with the SEC under the Securities Act of 1933. This means that, generally, the laws and rules that apply to securities also apply to variable annuities.
People who sell variable annuities must be dually licensed. First, they must be licensed by a state to sell life insurance. Second, they must be licensed as registered representatives of a member of the National Association of Securities Dealers (NASD). NASD registration requires passing an exam, either the Series 6 limited registration exam or the Series 7 general securities exam. Some states also require a separate state variable contract or variable annuities license in addition to the life license and NASD registration.
The money paid to an insurance company over the years by purchasers of variable annuities is accumulated in an account that is kept separate from all other fixed annuity and insurance sales. This separate account is used by the company to buy securities that it hopes will keep pace with the cost of living.
The variable annuity contract owner is actually buying accumulation units in the separate account. He or she is not buying shares of stock or other securities. The use of accumulation units is simply an accounting measure to determine a contract owner’s interest in the separate account during the accumulation period, or purchase period, of a deferred variable annuity.
Not all of the purchase payments made by a contract owner go toward the purchase of accumulation units. Before units can be purchased, sales charges and taxes are deducted. Thus, the money used to buy accumulation units is the net purchase payment.
The number of units a net payment will buy depends on the value of an accumulation unit at that time. This value is determined periodically, usually daily. At the risk of oversimplification, the value of one accumulation unit is reached by dividing the value of the separate account by the number of accumulation units outstanding.
An annuitant can never end up with fewer accumulation units than he or she has purchased, although the value of each unit may become either larger or smaller. For example, assume that a net payment of $100 buys 100 accumulation units, and the next day the value of the portfolio held by the separate account increases so that accumulation units are worth $1.05 each. The annuitant still has only 100 units, but each is now worth $1.05 instead of the $1.00 that was paid. If the value of the portfolio had decreased, the accumulation units would be worth less each.
As the contract owner continues to buy accumulation units, these are added
to those already purchased. The dollar value of all the units owned by the
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contract holder equals the number of units the contract holder owns times the value of one accumulation unit. For example, if Frank owns 2,000 units and the value of one accumulation unit equals $5, Frank’s dollar interest in the separate account equals $10,000.
When the time arrives for the annuitant to start receiving payments, another accounting device replaces the accumulation unit. This is the annuity unit, and it serves to determine the amount of each payment to the annuitant during the payout period.
Unlike the number of accumulation units, which increases with each payment into the separate account, the number of annuity units remains fixed. The first step in determining this fixed number is to find the dollar value of the accumulation account that is the contract holder’s interest in the separate account. Recall that this is determined by multiplying the number of accumulation units by the value of each unit.
The second step in the process of finding the number of annuity units is to determine what the first monthly payment to the annuitant will be. Insurance company annuity tables—which take into account the annuitant’s age and sex, the payout option chosen, and deductions for charges—give the monthly annuity payment per $1,000 applied.
For example, suppose that the annuitant transfers $50,000 from the accumulation account and the table shows a value of $5 per $1,000. The first monthly payment to the annuitant would be 50 × $5, or $250.
If the annuity involved were fixed instead of variable, the annuitant would receive that first month’s value for the remainder of the contract. But with a variable annuity, this figure is converted into annuity units by dividing the first monthly payment by the value of an annuity unit at the time. If the first monthly payment is $250 and the value of an annuity unit is then $2.50, the annuitant will own 100 annuity units and, once established, this number will never change.
This number of annuity units remains fixed throughout the remainder of the contract, but the annuity payment will vary according to the value of an annuity unit. If the value of an annuity unit is $2.55 the next month, the annuitant in the preceding example would receive $255. If it is $2.45 the following month, the annuitant would receive $245.
As is the case with life insurance, a number of settlement options are available for annuity contracts.
Life annuities is a general payout category in which the payout is guaranteed for life. Life annuities may be contrasted with temporary annuities, discussed later.
Sometimes known as a straight life annuity, a life annuity pays a benefit for as long as the annuitant lives, and then it ends. Whether the annuitant lives past 100 or dies in 1 month, the annuity payments continue only until he or she dies. In other words, there is not a guarantee as to minimum benefits with a life annuity.
There is a risk to the annuitant that he or she might not live long enough after the annuity period begins to collect the full value of the annuity. If an annuitant dies shortly after benefits begin, the insurer keeps the balance of the unpaid benefits.
This option will pay the highest amount of monthly income to the annuitant because it is based only on life expectancy with no further payments after the death of the annuitant. All other options will reduce the periodic income payments.
Many people were not happy knowing that most or all of their investment would be lost if they were to die after receiving just a few payments. This caused insurance companies to start offering some alternatives that provided a minimum guaranteed payout.
The length of time for which income payments will be made to the annuitant under a refund life annuity contract is the same as that for a straight life annuity. Thus, under a refund life annuity, the annuitant will receive payments for as long as he or she lives.
The main difference between the refund and the life annuity is that a refund annuity guarantees that an amount at least equal to the purchase price of the
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contract will be paid. If the annuitant lives for quite some time after the annuity income payments begin, he or she could receive more in benefits than the contract cost. If death occurs before an amount equal to the purchase price has been paid, the annuitant’s beneficiary receives the rest of the money in cash or installment payments.
Another type of annuity is the life annuity with period certain, which calls for payments for a guaranteed minimum number of years—often 10, 15, or 20.
Most often, the period is 10 years because 10 years is approximately the average life expectancy of a male who retires at age 65. Obviously, the annuitant could outlive the minimum number of years specified in the contract, in which event the income payments continue until he or she dies.
Under a life annuity with period certain, income installments must be paid for the number of years guaranteed in the contract. Therefore, if the annuitant dies after payments have started, but before the guaranteed number of years (the “certain installments”) have elapsed, the annuitant’s beneficiary receives income payments until the remainder of the guaranteed (certain) period has elapsed. Thus, if Archie, the annuitant, retires at age 65 and selects life with 10 years certain and dies at age 70, his survivor will continue to receive the monthly annuity payments for the balance of the period certain, or 5 more years.
With a joint life and survivorship (or last survivor) annuity, there are more than one (usually two) annuitants, and both receive payments until one of them dies. A stated monthly amount is paid to the annuitant and upon the annuitant’s death, the same or a lesser amount is paid for the lifetime of the survivor. The joint-survivor option is usually classified as a joint and 100% survivor, joint and two-thirds survivor, or joint and 50% survivor option.
For example, if the annuitant was receiving $1,000 monthly under a joint and 50% survivor option, the survivor would receive $500 (50% of $1,000) monthly upon the death of the annuitant.
The joint-survivor annuity option should be distinguished from a joint life annuity, which covers two or more annuitants and provides monthly income to each annuitant until one of them dies. Following the first annuitant’s death, all income benefits cease. The joint life annuity can be viewed as a spe
cial case of the straight life annuity, with payments ending at the first death among the joint life annuitants.
As you know, under a life annuity with period certain, if the annuitant lives longer than the certain period stated in the contract, income payments continue for the lifetime of the annuitant. This is not the case with a temporary annuity certain, however. If the insured outlives the period of payments stipulated in the temporary annuity certain contract, payments stop at the end of the period.
Under a temporary annuity certain, the company guarantees that payments will be made for a specified number of years—often 10, 15, or 20 years. Because this income is guaranteed, if the annuitant dies before receiving payments for the specified number of years, the annuitant’s beneficiary receives the payments for the remaining number of years.
A two-tiered annuity is one that has different values available for distribution at maturity depending on whether the value is taken in a lump sum before annuitization or left with the issuer for periodic payments.
These annuities offer relatively high rates, but only if the owner holds the contract for a certain number of years and then annuitizes it. If the annuity is surrendered at any point, interest credited to the contract is recalculated from the contract’s inception using a lower tier of rates.
Although the higher tier of rates is designed to reward annuitization and to make the product more attractive than competing annuities, the lower tier of rates generally makes the contract very unattractive compared to other alternatives. This interest penalty applies under some contracts even if the annuity is surrendered due to the death of the owner.
A few states do not permit sales of two-tiered annuities because of the potential for misunderstanding on the part of consumers or lack of disclosure on the part of agents regarding the conditions that must be met in order for the owner to earn the higher tier of rates. Agents who sell two-tiered annuities must make sure that clients know how the product works and are prepared to commit themselves and their beneficiaries to the annuity for a lifetime.
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To encourage public school systems and tax-exempt charitable, educational, and religious organizations to set aside funds for their employees’ retirements, tax-sheltered annuity plans (TSAs) may be set up and the contributions excluded from the current taxable income of the employees. The plan must be established by the employer and contributions must be used to purchase annuity contracts or mutual fund shares.
Payments received from TSAs at retirement are generally fully taxable to the recipient as ordinary income. However, payments may be spread over a long period of time, and taxable income at retirement is usually lower, perhaps making the tax bracket lower, too.
A retirement income annuity is an ordinary deferred annuity, but with an additional feature—a decreasing term life insurance rider that provides term life insurance with a face amount that decreases each year the policy is in force. The effect is that if the annuitant reaches retirement age—for example, 65— the decreasing term insurance death benefit expires and annuity payments begin providing retirement income. If, however, the annuitant dies before retirement, the decreasing term insurance death benefit is combined with the value of the annuity and then paid to the annuitant’s beneficiary in any settlement option chosen.
Equity-indexed annuities are generally considered to be fixed annuities because they offer a guaranteed minimum interest rate and a guarantee against loss of principal if held to term (as with other fixed annuities, surrender charges may reduce principal if the policy is surrendered early). However, with an equity-indexed annuity, interest crediting in excess of the minimum guaranteed rate is linked to the upward movement of a designated equity index, such as the Standard and Poor’s 500. If the index moves upward, the interest rate is based on some portion of the increase. If the index moves downward, the equity-indexed annuity credits the guaranteed minimum rate.
Suppose Frank has an equity-indexed annuity with a guaranteed minimum interest rate of 6% and is linked to the Standard and Poor’s 500 index. If that index should go up, Frank can expect his annuity interest rate to go up. But
if that index should go down, the lowest annuity interest rate Frank can expect to receive would be 6%, the guaranteed minimum.
Another fixed annuity product with a market-driven aspect is the market-value adjusted (MVA) annuity. Instead of having the annuity’s interest rate linked to an index, as with an equity-indexed annuity, an MVA annuity’s interest rate remains fixed. The market-value adjustment feature applies only if the contract is surrendered before the contract period expires. These contracts must disclose on the first page that the nonforfeiture values may increase or decrease based on the market-value formula specified in the contract. Otherwise, the annuity functions the same way a fixed annuity does.
If an MVA annuity owner decides to surrender his or her contract early, a surrender charge and a market-value adjustment will apply. If interest rates decreased during the contract period, the market-value adjustment will be positive and may add to the surrender value of the contract. However, if interest rates increased over that period, the market-value adjustment will be negative, which would increase the contract’s surrender charge.
Suppose Martha owns a 10-year MVA annuity contract but decides to cash in the contract after the sixth year. By cashing it in early, Martha would be automatically subject to a surrender charge, and because interest rates rose by 2% since she purchased the contract, her market-value adjustment would be negative, forcing her to pay an even higher surrender charge.
Depending on whether the MVA annuity is registered, the market-value adjustment may apply only to interest earned under the contract. However, if the MVA annuity is registered, both principal and interest will be susceptible to a market-value adjustment. Because MVA annuities expose consumers to investment risk, they are classified as securities and people who sell them must be registered with the NASD.
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1. Which of the following is a purpose of the annuity?
2. An annuity might be called the flip side of
3. Annuities are a mechanism for transferring to an insurance company the risk of
4. An annuity that guarantees a minimum rate of return is
5. Devon purchases an annuity that will pay a monthly income for the remainder of his life and then stop making payments. Devon has purchased
6. Albert has purchased an annuity that will pay him a monthly income for the rest of his life. If Albert dies before the annuity has paid back as much as he put into it, the insurance company has agreed to pay the difference to Albert’s daughter. Albert has purchased
7. Marcus purchases an annuity that offers a guaranteed minimum interest rate and a guarantee against loss of principal if the contract is held to term. However, if the NASDAQ moves upward, Marcus’ annuity might end up accruing more than the guaranteed minimum interest rate. Marcus has purchased a(n)
8. Eric purchased an annuity with favorable rates. However, due to
unforeseen circumstances, he needs to surrender the annuity. If the
market has gone up, Eric will need to pay a higher surrender charge
than if the market has gone down. Eric owns a(n)
9. Mikaela has an annuity for which she is the annuitant. Which of the
following are definitely true based on this information?
10. Tracey is paying money into an annuity she hopes will support her retirement years. What period is her contract currently in?
11. Liz purchases an immediate annuity. What must be true about the annuity contract?
12. Which of the following types of annuities are regulated as securities?
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✓ Policyowner ✓ Master policy ✓ Certificate of insurance
✓ Noncontributory plan ✓ Contributory plan ✓ Dependent coverage ✓ Conversion option
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Social and economic changes due to industrialization of our society, the growth of large cities, and the growth of the union movement in the United States, have contributed to the development of group insurance. The influence and political strength of unionized workers have compelled employers to offer group insurance as an employee benefit. Group insurance is usually written as 1-year term insurance.
In keeping with the NAIC Model Group Life Insurance Bill, the legal requirements of group insurance are uniform throughout the majority of states and include the following six basic characteristics:
If the premium is paid entirely by the policyowner (employer or association), it is a noncontributory plan and all eligible employees or members must be covered. If the premium is paid by both the policyowner and the insureds the plan is a contributory plan and at least 75% of all eligible employees or members must be covered.
Group Life Insurance 241
Group insurance policies have special provisions unique to group insurance. Some of these provisions are the same as those found in policies of individual insurance. Most states have enacted or adopted the standard provisions found in the NAIC Model Group Life Insurance Bill. Group policies must contain provisions relating to the following:
In addition to the rights of conversion listed, an insured who dies after coverage has terminated but before the end of the 31-day conversion period will receive the group policy benefit.
In group insurance, the policy is evidence of a contract between the insurer
and the employer or association (the policyowner). The policy is purchased
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for the benefit of the individuals who are covered under the policy, but is issued to the policyowner (the employer or sponsor). When an employee becomes covered by a group life plan, the employer, as the policyowner, retains the master policy itself. As proof of protection, the employee receives a form that certifies the coverage, the benefits under the plan, and the beneficiary’s name.
Because it certifies or states all these things, we call this paper a certificate of insurance. The certificate shows two facts that are extremely important to the insured: the amount of the life insurance protection and the name of the beneficiary.
In addition, the certificate provides enough information so that insureds are aware of the benefits available to them and their rights and obligations.
The face page of the certificate has information on the coverage effective date, dependent coverage, and life insurance benefit amounts. The certificate covers such information as benefit amounts, benefit descriptions, age limits, notice of claim, proof of loss, and the insured’s right to convert to individual coverage in the event of policy termination or employment termination.
There are five main types of group life insurance being marketed to eligible groups: group term life, group permanent life, group creditor life, group paid-up life, and group survivor income benefit insurance. Group insurance is also written to include the dependents of the group members.
One disadvantage of group life insurance is that it is usually only temporary coverage, and an individual member of the group may lose that coverage when he or she leaves the group.
To lessen this disadvantage, group term policies must include provisions to provide for conversion to individual coverage. They may also include continuation of insurance provisions and waiver of premium provisions. Some employers continue group term insurance at reduced amounts for retired workers.
In most cases, it’s possible to include the dependents of employees who are insured under a group life plan. Dependents may be any of the following:
Group Life Insurance 243
The insured’s children can be stepchildren, foster children, or adopted children.
Dependent children must be under a specified age, usually age 19, or to age 21 if attending school full time. The law further requires that any other person dependent on the insured is eligible for coverage. Dependency is proven by the relationship to the insured, residency in the home, or the person being listed on the insured’s income tax return as a dependent. A child may be a dependent beyond the ages of 19 or 21 if that child is permanently mentally or physically disabled prior to the specified age. Dependent coverage is not provided under credit life insurance.
By law in most states, any employee covered by a group life insurance plan must be allowed to convert to an individual permanent life policy upon termination of employment. If an employee leaves the group, which normally happens when terminating employment, most states have laws that permit the departing employee to convert the coverage to an individual permanent life policy without evidence of insurability.
To summarize, here are the characteristics of conversion from group to permanent life insurance:
This conversion privilege may also be used if, for any reason, an employer discontinues group coverage. The same rules apply, except that application must be made within 1 month of the policy’s cancellation rather than 1 month following the employee’s termination.
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The conversion period is usually 30 or 31 days, and coverage is automatically in force during that period. Coverage is often limited to $5,000 or $10,000 or the amount of coverage under the group policy, whichever is less.
Federal Employees’ Group Life Insurance (FEGLI), provides group life insurance automatically for federal employees unless they choose not to be included in the plan. Life insurance in the amount of 1 year’s salary is customarily provided. Another 1 year’s salary may be added but is contributory (the employee must pay that portion of the premium).
Servicemen’s Group Life Insurance (SGLI), is automatically provided for members of the armed forces. The life insurance is provided on a group term life basis as soon as a member enters active duty. The maximum limit is now $200,000, with automatic full-time coverage also applicable to qualified reservists. Premiums are deducted from the service member’s paycheck.
Both FEGLI and SGLI policies are underwritten by private insurers in very large group life insurance contracts.
Group Life Insurance 245
1. According to the NAIC Model Group Life Insurance bill, a true group has at least
2. A contributory life insurance plan must cover
3. Doris dies 15 days after her group coverage is terminated and before she has the chance to convert her policy to permanent coverage. Doris’s beneficiary will receive
4. Which of the following would not qualify as a dependent for group insurance coverage?
5. Which of the following is true about conversion from group life insurance?
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✓ Social security ✓ Fully insured ✓ Currently insured ✓ Disability insured ✓ Primary insurance amount ✓ Total disability ✓ Dual benefit liability ✓ Quarter of coverage
✓ Covered workers ✓ Insured status ✓ Normal retirement age ✓ Retirement benefits ✓ Survivor benefits ✓ Disability benefits ✓ Maximum family benefit ✓ Retirement earnings limit
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Since the time of the Industrial Revolution most individuals and families have not been self-sufficient economic entities. Particularly since the Great Depression, society has wrestled with the problem of numbers of individuals being unable to care for themselves due to unemployment, disability or death of the family wage earner. The social security system was a political response to this issue.
Most U.S. workers participate in social security, a benefit program run by the federal government. To some extent, social security competes with private insurance because it provides a basic level of benefits for death, disability, and retirement.
An automatic cost of living escalator is built into the program, which increases benefits each January to match the increase in inflation.
The Social Security Act covers a wide assortment of social insurance and public assistance (welfare) programs. What we refer to as social security is more properly called Old Age Survivors and Disability Insurance (OASDI).
Generally speaking, OASDI provides the following categories of benefits:
Generally, most workers must be covered under social security. This includes common law employers and employees, most self-employed persons, Armed Forces personnel, and employees of nonprofit organizations.
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The main excluded worker groups are railroad workers and federal employees hired before 1984. Federal employees hired after 1984 are covered. Railroad workers contribute to their own railroad retirement system.
Employees of state and local governments are not covered unless the government entity has entered into an agreement with the Social Security Administration or does not have a retirement program. Generally, most government workers are covered.
Finally, there are certain types of family employment situations in which a family member may not be covered under social security. These include employment of a minor child (under age 18) by his or her parent, employment of a parent as a domestic in the home of the parent’s child, and employment of a parent to do work not in the course of a son’s or daughter’s business.
A covered worker becomes qualified for social security benefits by attaining either fully insured, currently insured, or disability insured status. Insured status depends on how many quarters of coverage a worker has earned. The term quarters of coverage comes from the time when wages were reported to the government each quarter. Now, most employers report wages on an annual basis, but the terminology has stayed the same.
The amount of money needed to earn a quarter of coverage increases automatically each year with increases in the national average wage index. In 2002, for example, a worker earned one quarter of coverage for every $870 in earnings.
A worker may not earn credit for more than four quarters of coverage during any given year. So, for example, if Bill earned $3,500 in 2002 and Bob earned $35,000 in 2002, both of them would be credited with four quarters of coverage.
There is no requirement to work in different calendar quarters. For example, any worker who earned more than $3,480 during January 2002, would have earned four quarters of coverage ($870 × 4) for the year even if no work was performed for the remainder of the year.
To achieve fully insured status, a worker must accumulate at least one quarter of coverage for each year after the person’s 21st birthday and have a minimum of at least six quarters of coverage. This birthday rule enables young workers to achieve fully insured status within a relatively short time. The maximum
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requirement for fully insured status is 40 quarters of coverage, which gives the worker permanent status. Under the 40-quarter rule, when a worker accumulates credit for 40 quarters of coverage, that person is fully insured for life and the status cannot be lost even if the person drops out of the work force.
A worker who is not fully insured will still be currently insured if he or she has earned six credits within the last 13 calendar quarters. For example, a 35year-old worker who did not have the 13 credits required to be fully insured would be currently insured as long as he or she had earned at least six credits within the last 3 years and 3 months.
A special insured status, disability insured, is required if a worker is eligible for disability benefits under social security. This status requires that the worker be fully insured and have earned at least 20 quarters of coverage in the 40 calendar quarter periods ending with the calendar quarter in which the disability begins. This requirement is modified slightly if a covered worker is disabled prior to age 31.
The individual’s insured status determines eligibility for social security benefits. A fully insured person and eligible dependents are entitled to all social security benefits. A worker who is only currently insured has limited benefits available. If a worker is only currently insured at death, social security benefits would be payable only to a dependent child in addition to the lump-sum death benefit of $255.
Social security benefits are expressed as a percentage of the primary insurance amount (PIA). The PIA for a worker is based on his or her average level of earnings and is updated and published annually in tables by the federal government. Most types of social security benefits are some percent of the PIA as set for the year for the worker’s earnings level.
To receive full social security retirement benefits, a person must wait until the normal retirement age to begin receiving such benefits. If benefits are taken before this age, the monthly benefit amount is reduced.
The social security normal retirement age is 65 for workers born in 1937 or before; it increases gradually for workers born after that year until it reaches 67 for all workers born in 1960 and after.
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Often a person is eligible to receive more than one social security benefit. For example, a married individual who has reached age 65 may be eligible to receive a retirement benefit based on his or her own earnings and also a spousal benefit based on his or her spouse’s earnings. In these cases, the person is entitled to receive only the larger of the two benefit amounts instead of both amounts.
A worker receives 100% of his or her PIA as a retirement benefit if benefits are not taken until the normal retirement age. For each month earlier that the retirement benefit is taken, the monthly amount is reduced. At age 62— currently the earliest age at which retirement benefits may begin—the benefit is 80% of the PIA.
A worker’s spouse is also eligible for a retirement benefit based on the worker’s earnings. At age 65, this benefit is 50% of the PIA. The spouse can take a reduced benefit as early as age 62.
A retired worker’s unmarried child is eligible for a benefit of 50% of the PIA if under 18, if under 19 and in high school, or at any age if disabled before
A retired worker’s spouse is eligible for a benefit of 50% of PIA at any age if caring for an unmarried, dependent child of the worker who is under 16 or was disabled before 22.
When a worker dies, several members of his or her family may be eligible for benefits. The surviving spouse is eligible for a benefit at any age if caring for an unmarried child under 16 or a child who was disabled before age 22. This benefit is 75% of the deceased worker’s PIA. When the youngest child reaches age 16, this benefit terminates.
However, the surviving spouse will be eligible for a benefit again when he or she reaches age 60. At this point, the benefit is 71.5% of the deceased worker’s PIA. The spouse could delay the benefit until he or she reaches age 65 and receive 100% of the PIA. If the spouse is disabled, he or she can begin to receive the benefit as early as age 50.
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The period during which the surviving spouse receives no social security benefits is sometimes referred to as the blackout period.
An unmarried child of a deceased worker is eligible for a benefit of 75% of the PIA if under 18, if under 19 and in high school, or at any age if disabled before 22.
A dependent parent age 62 or over who received at least half of his or her support from the deceased worker is eligible for a benefit of 82.5% of the PIA.
If both parents receive benefits, each gets 75% of the PIA.
A lump-sum death benefit of $255 is paid to the deceased worker’s spouse or a dependent child.
Social security defines total disability as the inability to engage in any substantial gainful activity due to physical or mental disability, and the disability must be expected to last for at least 12 months or end in death. Substantial work activity means significant mental and/or physical duties for which a person is compensated.
This definition does not refer to the individual’s occupation prior to disability or to the level of pre-disability compensation. A surgeon earning $200,000 annually may be disabled to the degree that he or she could no longer perform surgery. However, if this person could perform other meaningful work duties (bank employee, school teacher, salesperson, and so forth), he or she would probably not be eligible for disability benefits because they could not meet the social security definition of total disability.
The amount of the disability benefit is equal to the worker’s PIA, which in essence is the same as the individual’s monthly retirement benefit. Disability benefits are payable only for total disabilities. Disability benefits begin with the sixth month of disability. No benefit is paid for a partial disability. If the worker satisfies these conditions, there is still a 5-month waiting period before benefits begin.
The worker is entitled to a disability benefit of 100% of his or her PIA. If the worker’s spouse is caring for an unmarried child under 16 or a disabled child under 22, he or she gets a benefit of 50% of PIA. Finally, each unmarried child is entitled to a benefit of 50% of PIA if under 18, if under 19 and still in high school, or if disabled before 22.
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When several members of a worker’s family are entitled to receive benefits, the family may run up against an overall limitation on benefit payments called the maximum family benefit. Like the PIA, a maximum family benefit is established for each level of average earnings and is updated annually.
When a social security beneficiary reaches normal retirement age, there is no restriction on the amount he or she may earn from employment (or self-employment) without losing social security benefits. But beneficiaries under normal retirement age may earn only up to a certain amount without a reduction in benefits.
One earnings limit applies to the years prior to the year that beneficiaries reach their normal retirement age, and a higher limit applies for the year an individual reaches normal retirement age. The dollar amounts are indexed to inflation and change annually. For example, beneficiaries who had not reached normal retirement age in 2004 had their benefit reduced by $1 for every $1 earned above $11,640. Individuals who reached normal retirement age in 2004 had their benefits reduced by $1 for every $2 earned above $31,080 until the month that they actually reached their normal retirement age. After normal retirement age, no limits apply.
Social security is a pay-as-you-go program. That is, the social security taxes collected from workers are not set aside in an account for each worker, but are used to pay benefits to current beneficiaries of the program. Put another way, when someone begins receiving benefits, he or she is not drawing on a fund of some specific amount that consists of his or her previous tax deposits plus earnings. Those benefits are financed by the taxes currently collected from covered workers.
Social security benefits are financed by a payroll tax on employers, employees, and the self-employed. There is no social security tax on investment income (for example, interest, dividends) or any kind of income other than earnings from employment or self-employment.
The rate of tax is a flat amount set by Congress and adjusted upward from
time to time. The tax rate for employers and employees is currently set at
6.2% (not counting the additional tax for Medicare). The self-employment
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tax rate is 12.4%—twice the employee rate, because self-employed individuals pay both the employee and the employer portion of the tax. The tax rate is multiplied by the relevant earnings figure to compute the social security tax.
If Clarice has $20,000 of earnings from her employer this year, she and her employer combined must pay in social security taxes on this income a total of $2,480 (.062 × 20,000 + .062 × 20,000).
Not all of a worker’s earnings are necessarily subject to the social security tax. The law puts a cap on the maximum amount that is taxed each year; for 2004, the cap was $87,900. This is called the maximum taxable wage base. It is the same for employers, employees, and the self-employed. This wage base is indexed to inflation so that it rises each January.
Social security taxes may not be deducted in computing the federal income tax.
There is an additional payroll tax to help finance Medicare Part A (hospital insurance). The rate is 1.45% for both employers and employees and 2.9% for the self-employed. There is no cap on the amount of earned income subject to this Medicare tax.
A portion (up to 85%) of the social security benefit is includable in the worker’s adjusted gross income for tax purposes. Various formulas apply depending on the level of adjusted gross income, whether the taxpayer is married or single, and if married, whether filing separate or joint returns.
Various tax laws apply to life insurance premiums, proceeds, and benefit payment options.
Life insurance policies have traditionally been given favorable tax treatment. The two major tax advantages of life insurance are
➤ The annual earnings on the cash values generally accumulate on a tax-free basis (until they are distributed).
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➤ The proceeds payable at the insured’s death are generally income tax–free to the beneficiary.
Because of these tax advantages and the competitive returns life insurance policies have paid in recent years, they have sometimes been purchased as accumulation vehicles in addition to their traditional uses.
In order to deter policyowners from quickly accumulating large sums of money in their life insurance contracts and thus using them primarily as an investment vehicle, Congress created a definition of life insurance that all life insurance policies must meet in order to qualify for these tax advantages. To qualify, a policy must meet one of the two following tests:
The guideline premium test is met if the total premiums paid do not exceed the greater of the guideline single premium or the total of the guideline level premiums. The guideline single premium is the total premium payable at one time to fund the future benefits of the contract. The guideline level premium is the level annual amount payable over a period extending to at least the insured’s 95th birthday to fund the future benefits of the contract.
If a contract fails to meet either the cash value or the guideline premium test, it will not qualify as life insurance. This may have the following serious tax consequences for the contract owner:
➤ The inside build-up of earnings in the policy may be taxable each year as income to the policyowner, to the extent these earnings, added to dividends received and the pure cost of insurance, exceed premiums paid.
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➤ Only the pure insurance part of the death benefit proceeds (death benefit less the cash value) will be received income tax–free by the beneficiary.
The taxation rules explained here pertain to life insurance contracts that conform to the definition of life insurance in Section 7702 of the Internal Revenue Code.
The tax consequences of a policy becoming a modified endowment contract (MEC) are serious, although not as serious as those listed earlier for a policy failing to meet the definition of life insurance. The penalties assessed against MECs affect primarily money taken out of the policy on the following basis:
As a general rule, life insurance or annuity premiums paid by individuals are not deductible for federal income tax purposes.
If the beneficiary of a life insurance policy receives the death proceeds in a lump sum, the entire amount of the payment is generally received income tax–free. It makes no difference whether the death benefit is the face amount alone or whether it includes additional benefits, such as double indemnity for accidental death.
Recall that death benefits, however, may be paid out in ways other than a lump sum. Regardless of what option is chosen, only a portion of each individual payment is taxable to the beneficiary as income. That portion of each payment that is principal, derived from the lump-sum death benefit, is received income tax–free.
In other words, the amount of the actual death benefit (equal to what would have been paid as a lump sum) is always paid to the beneficiary on an income tax–free basis. However, if the proceeds are held by the insurance company and paid out to the beneficiary in the form of an income stream, the proceeds
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will earn additional income that will form a part of each payment to the beneficiary. It is only this income element that is subject to income tax.
Accelerated, or living, benefits paid by a life insurance policy fall into the same category as a policy’s death benefits. That is to say, accelerated benefits are received income tax–free so long as they are qualified. Qualified means the insured has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death 24 months or less after the date of the certification. Other stipulations may be applied, but the end result is that those who require access to these benefits may receive the money without having to pay income taxes on it.
Dividends paid to participating policyowners are generally not taxable as income. They are considered a return of premium. However, any interest earned on dividends is taxable. So the accumulation at interest dividend option explained earlier would incur income tax liability for the interest earned on the accumulated dividends.
Any dividend of a MEC that the insurer keeps to pay principal or interest on a policy loan is, just like the loan itself, considered to be money taken from the policy.
Generally speaking, when any proceeds are received from a surrendered or matured life insurance policy, the part of the proceeds, if any, that exceeds the cost of the policy is subject to ordinary federal income tax in the year received. Cost is equal to the total premiums paid (not including any costs for qualified additional benefits), less the sum of any amounts previously received under the contract that were not includable in gross income.
Suppose Olaf surrenders his whole life policy, and it has a cash value of $25,000. During the time he held the policy, Olaf paid $22,000 in premiums. As a result, $3,000 ($25,000 – $22,000) of the cash surrender value will be subject to federal income tax.
Like income payments made as a result of a settlement option in a life insurance policy, income payments made from an annuity are only partly subject to federal income taxation. Federal tax law holds that a fixed part of each annuity income payment is designated as a return of capital, and as such is nontaxable. The remainder of each annuity income payment is considered to be income and is taxable.
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Determining how much of each payment is a return of capital and how much is income is outside the scope of this course. However, after it is determined that the capital has been fully recovered during the course of annuity payments, all of the annuity payment becomes taxable.
As we’ve pointed out throughout this course, one of the most significant advantages of life insurance products is their capability of accumulating cash on a tax-deferred basis. Permanent life products, including variable and universal life products, may accumulate cash values that are not taxed unless and until withdrawn. The same is true of annuities, qualified retirement plans, and IRAs. All of a policyholder’s current earnings are working for him or her, unreduced by a current tax liability.
Note, however, that annuities owned by corporations, for whatever purpose, do not accumulate cash on a tax-deferred basis. On the other hand, bank accounts, stocks, bonds, and other kinds of noninsurance investments pay interest or dividends that are taxed currently.
Proceeds from a group life policy, like those from an individual life policy, are not subject to federal income tax when received by the beneficiary as a lump-sum payment.
Premiums for group life insurance policies, whether paid by the employer entirely or shared by employer and employee, are not deductible by the employee. But a company can deduct such premium payments as a business expense.
When all or part of the premiums for group life insurance are paid by the employer, these contributions are generally not considered as income to the employees covered by the group life policy. However, this rule applies only to the first $50,000 of employer-provided coverage. The cost of coverage in excess of $50,000 will be taxed to the employee.
The doctrine of economic benefit rule appears from time to time with respect to life insurance products, especially those paid for by employers but which are designed to benefit employees. Briefly, this doctrine holds that if an employee receives property or benefit in lieu of income, and that property or benefit would have been taxable income were it received in cash, an economic benefit has been received and will be taxed accordingly.
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Nonqualified plans, such as deferred compensation, that are funded with life insurance and aimed at certain key and/or highly compensated employees, may be affected by this rule. Qualified plans containing insurance on the life of the plan participant may also be affected. Care must be taken if those employees are to escape current taxation on such plans.
Federal estate taxes are imposed on estates that exceed certain amounts. Life insurance proceeds are includable in a deceased insured’s gross estate if
There are two basic ways to make charitable gifts of life insurance, the first of which is to make an outright gift of a policy on the life of the donor. The value of the policy at the time of the gift is generally deductible, with certain restrictions. The charity (the donee) is the beneficiary. The donor may give the charity enough cash each year to pay the premium on the policy; if so, the cash gifts are generally deductible.
When this method of giving is used, it is important that the donee, the charity, be given all the rights of ownership. If the donor retains any control over the policy, the tax advantages (deductions) are lost.
In the second common method of making charitable gifts of life insurance, the donor can retain ownership of the policy, make the charity the beneficiary, and continue to pay the premiums. In this case, the premium payments are not tax-deductible. The amount of the proceeds will be included in the donor’s estate, but will wash out as a charitable deduction. One advantage of this method is that the donor retains the right to change beneficiaries should this become necessary or desirable.
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Gifts other than charitable gifts—including gifts of life insurance—are generally subject to gift tax. The giver of the gift pays this tax. Gift taxes prevent wealthy people from moving large amounts of assets to others in lower tax brackets—such as children or grandchildren—to avoid paying income taxes. However, the annual gift tax exclusion allows a certain amount of gifting to be done without incurring gift tax. For 2004, the annual gift tax exclusion is $11,000 per donee. That is, an individual can give any number of other individuals up to $11,000 each before gift tax is payable. An individual and his or her spouse may make joint gifts of up to $22,000 per donee without incurring gift tax. The annual gift tax exclusion may increase in later years due to inflation.
The most common method of making a gift of life insurance is to give a policy to the donee. If this gift involves the transfer of all the incidents of ownership from the donor to the donee, the gift will probably be considered a gift of a present interest and therefore qualify for the annual gift tax exclusion. Therefore, if the replacement value of the policy, which is usually about equal to the cash value, is $11,000 or less, ($22,000 or less for a joint gift by a donor and spouse), the entire policy can be given away without incurring gift tax.
The second most common method of making a gift of life insurance is to make a gift of the premiums on the insurance. An example of such a gift is when a new son-in-law takes out a life insurance policy and the father-in-law, the donor, gives the son-in-law the money to pay the premium. The policy belongs to the son-in-law, who is the donee of the amount of the premiums. As long as the amount of premium paid by the donor, plus all other gifts made during the same year to the same donee, is equal to or less than the annual gift tax exclusion, the donor should not incur any gift tax.
A donor (or donors) may continue to make gifts of insurance premiums up to the amount of the annual gift tax exclusion each year, as long as desired. The recipient of the gift does not have to pay income tax on the gift.
Life insurance proceeds may not be exempt from income taxes if the benefit payment results from a transfer for value. If the benefits are transferred under a beneficiary designation to a person in exchange for valuable consideration (whether it be money, an exchange of policies, or a promise to perform services), the proceeds would be taxable as income. This section of the tax laws
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is designed to prevent a tax exemption for benefits that are purchased from another party, because the intent of the transaction would be to exchange something of value for tax-free income.
Taxation under the transfer of value rules does not apply to an assignment of benefits as collateral security, because a lender has every right to secure the interest in the unpaid balance of a loan. Nor does it apply to transfers between a policyholder and an insured, transfers to a partner of an insured, transfers to a corporation in which the insured is an officer or stockholder, or transfers of interest made as a gift (where no exchange of value occurs).
Any gain on the exchange of property—such as insurance, endowment, or annuity policies—is generally taxable. However, the tax law recognizes that policyowners should be able to replace certain existing policies with new ones without incurring tax. Under Section 1035 of the Internal Revenue Code, no gain or loss is recognized on the exchange of the following:
Exchanges not coming within these three categories are taxable exchanges.
The premiums paid by companies for life insurance policies used for business purposes are generally not deductible as business expenses, with the exception of group insurance. By the same token, the proceeds from life policies purchased for business purposes are received by the company income tax–free. However, if the business is subject to the alternative minimum tax (AMT), that tax may apply to the death proceeds.
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1. Which of the following people would not be eligible for benefits under social security?
2. Disability benefits under social security require at least a
3. Which of the following policies would not meet Congress’ definition of life insurance?
4. What happens if the contract fails to qualify as life insurance?
5. The penalties assessed against MECs affect primarily
Social Security and Tax Considerations 263
6. As a general rule, for federal tax purposes,
7. Billy is receiving the proceeds of a life insurance policy as an income
stream over a period of several years. What part of the money will be
subject to tax?
8. Carol is eligible for a retirement benefit based on her own earnings
and also a benefit based on her late husband’s earnings. Carol will
9. Social security taxes are often shared between the employer and
employee. What do self-employed people pay?
10. At what age can an individual who is fully insured start receiving retirement benefits?
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✓ Defined benefit plan ✓ Defined contribution plan ✓ Vesting ✓ Group deferred annuity ✓ Individual deferred annuity ✓ Profit-sharing plan ✓ Pension plan ✓ 401(k) plan ✓ Money purchase pension plan ✓ Target benefit pension plan ✓ Individual retirement account ✓ Roth IRA ✓ SIMPLE retirement plan ✓ Simplified employee pension ✓ Keogh plan ✓ Tax-deferred annuity
✓ Qualified plans ✓ Nonqualified plans ✓ Plan distributions ✓ Premature distribution ✓ Rollover ✓ Fiduciary responsibility
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People use many means to plan for retirement. Recognizing the necessity for working people to provide for their retirements, the government offers some significant tax benefits for certain kinds of retirement plans. These are called qualified retirement plans, and this chapter focuses on the plans that apply to businesses and their employees.
In order to be qualified, a retirement plan must meet certain requirements of the Internal Revenue Code with respect to participation, funding, benefits, vesting, and so forth. When qualified, a retirement plan offers significant tax advantages. If a plan qualifies, contributions made on behalf of participants to fund their retirement benefits are
Within the qualified category are two kinds of overall plans:
Setting up and administering qualified plans is a complex, laborious task best left to those who specialize in such activity. There are numerous rules regarding eligibility, participation, the amount of contribution that can be made or benefit that can be paid. However, a life insurance agent who understands the basic aspects of the various qualified plans and how one or the other might meet the needs of a business client can do very well for himself or herself by selling qualified plans.
To be tax-qualified, retirement plans must satisfy the vesting rules included in the Internal Revenue Code. Vesting refers to the schedule an employer
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establishes that spells out the percentage ownership an employee has in the employer’s contributions to the plan or the employee’s accrued benefit. This percentage generally increases as the employee’s length of service increases, until the employee owns 100% of his or her accrued benefit or the amount the employer has contributed to his or her account.
Note that any employee contributions to a plan, whether mandatory or voluntary, must vest 100% immediately when made. In other words, employee contributions are always nonforfeitable.
The minimum vesting requirement consists of a choice between two acceptable schedules. Under one schedule, benefits must be 100% vested after 3 years of service. Under the other, vesting must begin after 2 years of service at an initial amount of 20% and increase in 20% increments so that the employee is 100% vested after 6 years of service.
Defined benefit plans are designed to provide a specific benefit to an employee upon retirement. The amount of the benefit is usually dependent on length of service or highest salary earned or a combination of these. Deferred annuities are commonly used to fund defined benefit plans. These may be issued on a group or individual basis.
With a group deferred annuity, the employer holds a master contract and certificates of participation are given to the persons covered by the plan. Specified amounts of deferred annuity are purchased each year to provide a specified retirement income to an employee.
Another means of funding a defined benefit plan is to take out individual deferred annuities on each plan participant. The premium rate is determined individually, based on attained age and sex. Premiums are level to retirement unless an employee’s compensation changes and an increase in retirement benefits is warranted. In such an instance, an additional annuity contract is purchased to fund the increase in the retirement benefit level.
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Two of the most common defined contribution plans are profit-sharing and pension plans.
A qualified profit-sharing plan must provide a definite, predetermined formula for allocating among plan participants the profits contributed to the plan. However the amount of annual contributions, if any, is usually left to the discretion of the employer. When the employee retires or leaves under certain other circumstances, the contributions that have been allocated to that employee, plus all earnings on them, are distributed to the employee.
Pension plan benefits are generally measured by and based on such factors as years of service and compensation received. The determination of the amount of plan contributions or benefits is not based on the employer’s profits or left to the discretion of the employer.
A money-purchase pension plan requires the employer to make a fixed contribution to the plan each year, which is then allocated among the plan participant’s accounts. At retirement an employee receives whatever benefit may be purchased with the money in his or her plan account.
A target benefit pension plan is a cross between a defined contribution and defined benefit plan. The target benefit plan works much like a money-purchase plan except that a target benefit is specified. The target benefit plan also looks like a defined benefit plan, but it’s only a target and may or may not be reached.
When a profit-sharing or pension plan has been modified to provide a cash or deferred arrangement (CODA), the resulting plan is called a 401(k) plan after the section of the Internal Revenue Code that authorizes it.
The term CODA refers to two different methods by which an employee can defer a portion of his or her pay into a 401(k) plan. In the classic case, the employee will be offered a cash bonus, all or part of which may be placed in, or deferred into, the plan on a before-tax basis. Alternately, the arrangement can take the form of a salary reduction agreement under which the employee elects to reduce his or her salary and place, or defer, the reduction portion
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into the plan, also on a before-tax basis. With either method, plan participants can avoid immediate taxation of the diverted bonus or salary deferral amount. Consequently, no income taxes are paid on these funds or their earnings until they are withdrawn.
The government offers individual retirement accounts and annuities (IRAs) so that people can plan for their own retirement. With an IRA, the amount an individual contributes may be deductible, within limitations, from gross income before taxable income is determined.
The contribution limit will increase in future years. Table 14.1 shows the limits up to the year 2008.
|Table 14.1 Year||IRA Contribution Limits Contribution Limit|
In addition, individuals age 50 and over will be able to make catch-up contributions of an additional $500 per year in the years 2004–2005, and an additional $1,000 per year beginning in 2006.
Whether or not an individual may make a fully deductible IRA contribution depends on the answer to this question: Is the individual, or the individual’s spouse if filing jointly, covered by an employer-maintained retirement plan?
If the answer to this question is “No,” the IRA contribution is fully deductible up to the limit no matter what the adjusted gross income (AGI) of the individual or couple may be. If a married worker’s spouse does not work, the married worker can contribute up to the limit to another IRA on behalf of the spouse in addition to his or her own annual IRA contribution for a total tax-deductible contribution of double the contribution limit per year.
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If the answer to this question is “Yes,” the IRA contribution is fully deductible up to the limit (double the limit if also contributing to a spousal IRA) as long as one of the following holds true:
Married persons not covered by an employer-maintained retirement plan and who file separate returns are considered to be covered if their spouses are covered by such a plan unless they have lived apart from their spouses for the entire year.
These income limitations will increase in future years. In addition, partial deductions are permitted if the limitations are exceeded, but only up to a certain dollar amount. Table 14.2 shows the income limitations up to the year 2007.
|Table 14.2 Income Limits For IRA Deductibility Year Single Married||Filing Jointly|
|Full Deduction Partial Deduction Full Deduction||Partial Deduction|
|2004 Below $45,000 Up To $55,000 Below $65,000||Up To $75,000|
|2005 Below $50,000 Up To $60,000 Below $70,000||Up To $80,000|
|2006 Below $50,000 Up To $60,000 Below $75,000||Up To $85,000|
|2007 Below $50,000 Up To $60,000 Below $80,000||Up To $100,000|
All earnings that accumulate in an IRA do so on a tax-deferred basis. That is, the interest earned on the contributions placed in an IRA are not taxed until withdrawn. This is also true for IRAs funded with nondeductible contributions.
Popular vehicles used to fund an IRA may include
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Taxpayers also can make contributions to a new type of IRA, called either the Roth IRA (after the Senator who proposed it) or IRA Plus. But the traditional or regular IRA that we just looked at will continue to exist.
The tax treatment of these two types of IRAs differs markedly. Traditional IRA contributions are deductible for some taxpayers. In addition, the earnings in traditional IRA accounts, which are tax-deferred as long as they remain in the account, are taxable when they are withdrawn. In contrast, contributions to Roth IRAs are not deductible. In addition to not being taxed while they remain in the account, the earnings in Roth IRAs may generally be withdrawn on a tax-free basis subject to certain restrictions.
To make tax-free withdrawals from a Roth IRA, the account owner must be at least age 59 1/2 and must have held the account for at least 5 years. Tax-free Roth IRA distributions may also be taken after 5 years in the event of the account owner’s death or disability or, with a limit of $10,000, for the purchase of a first home.
Roth IRA contributions are subject to the same contribution limits that affect other IRAs. Each spouse can contribute up to the limit to an IRA (Roth or traditional) in any combination. If both spouses take advantage of this rule, the combined contribution could be as much as double the limit. Availability of Roth IRAs is phased out between $150,000 and $160,000 of AGI for married couples filing jointly and $95,000 and $110,000 of AGI for singles. Availability of the Roth IRA is not affected by participation in an employer-sponsored retirement plan.
Taxpayers with less than $100,000 of AGI, married or single, can convert existing traditional IRAs to Roth IRAs. This involves paying income tax on all deductible contributions and earnings.
Certain small employers may establish a type of qualified retirement plan called a Savings Incentive Match Plan for Employees (SIMPLE). To be eligible to establish a SIMPLE, a business must employ no more than 100 people who earned more than $5,000 the preceding year, and the business must have no other qualified plan.
A SIMPLE can take the form of either an employer-established IRA or a 401(k) plan. Under either format, employees may elect to make contribu
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tions of a percentage of their compensation up to a limit of $9,000 per year in 2004.
The limit is $10,000 in 2005, after which it will be indexed for inflation. In addition, individuals 50 and over will be eligible to make catch-up contributions according to the schedule shown in Table 14.3.
|Table 14.3 Additional Catch-Up Contribution Year Amount of Catch-Up Contribution|
|2006 and after $2,500|
These contributions are not included in the employees’ taxable income, but they are subject to employment tax. Employers must contribute to the SIMPLE by one of the following:
Under the IRA format, employers who elect to match contributions on a dollar-for-dollar basis may in some years reduce the matching percentage to as low as 1%, but may not reduce the matching percentage below 3% for more than 2 years in any 5-year period. The option to reduce the matching percentage is not available under the 401(k) format.
Employer contributions are deductible from the employer’s income, excludable from the employee’s income, and not subject to employment tax. Employees must be immediately 100% vested in all contributions. Distributions from SIMPLE IRAs are generally taxed like distributions from regular IRAs, except that a 25% penalty tax applies to withdrawals made from a SIMPLE within its first 2 years.
Simplified Employee Pensions (SEPs) are a cross between an IRA and a profit-sharing plan. Under a SEP, each eligible employee of an employer establishes an IRA. The employer then makes contributions to the employee’s IRA according to a formula described in the SEP document. The maximum contribution that may be deducted by the employer is 25% of the total compensation paid to all participating employees.
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Self-employed persons may set up their own retirement plans, known as Keogh plans. Self-employed persons may be sole proprietors, partners in a business, farmers, or professionals such as doctors or lawyers. Other individuals who are employed by a company and covered under the company retirement plan may establish a Keogh plan provided they also are self-employed in some other capacity.
Contributions to a Keogh plan are not taxed as current income as long as they follow these guidelines:
A 403(b) arrangement (sometimes referred to as a 403(b) plan) is an employer-sponsored arrangement available to employees of public school systems. Under this arrangement, the employee agrees to let the employer withhold a part of his or her salary. The employer then uses this deferred salary to purchase an annuity. The employee’s current taxable income does not include the amount withheld to purchase the annuity. Employees may have only a certain amount of their salary withheld.
As a rule, funds from a qualified retirement plan or IRA may be distributed at any age when employment is terminated, the plan is terminated, or the employee retires. However, if the distribution is considered to be premature
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distribution (that is, made before age 59 1/2), a 10% penalty tax is usually applied to it. This penalty is in addition to the regular income tax due on the distribution.
The law also places limits on when distributions from a qualified plan or an IRA (with the exception of a Roth IRA) must begin. Distributions to all qualified plan participants or IRA holders must begin no later than April 1 of the year following the calendar year in which the participant reaches age 70 1/2. The minimum amount that must be distributed each year is set by regulation.
The penalty for failure to comply with this distribution requirement is a nondeductible excise tax equal to 50% of the amount by which the minimum amount required to be distributed exceeds the amount actually distributed.
Certain limits are imposed by the IRS on the purchase of insurance as part of a qualified plan. These incidental limitations are designed to ensure that the death benefit of life insurance coverage purchased under a qualified plan be incidental to the other benefits provided by the plan. In a defined benefit plan, the face value cannot exceed 100 times the monthly pension benefit. With a defined contribution plan, when a ordinary life policy is used, 50% of the plan contribution is the limit. With universal life, the formula stipulates 25%.
The only funds that escape taxation at distribution are those that have already been taxed. Distributions may be made in the form of annuity installments or, in the case of a defined contribution plan, in a lump sum. Those made in the form of installments may be made partially income tax–free. The portion of each payment that represents money that has already been taxed to the recipient, if any, is excluded from gross income. Distributions from a qualified retirement plan may also be triggered by the plan participant’s death. Lump-sum distributions of plan benefits on a participant’s death are considered income in respect of a decedent and are generally subject to income tax when received by the estate or other beneficiaries, less any amount the plan participant contributed using after-tax dollars.
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A rollover occurs when money is taken out of an IRA and held in the owner’s possession before it is transferred to a different IRA. Direct transfers of funds between IRAs are not considered rollovers. Rollovers between IRAs may be made only once within a 12-month period. From the date funds are withdrawn from the old IRA, the IRA owner has 60 days to make the deposit to the new IRA. Any funds not rolled over within that 60-day period become taxable to the extent they consist of deductible contributions and earnings on any contributions.
For people changing jobs and receiving their vested interests in their former employer’s qualified retirement plan, those funds will also become taxable unless rolled over into an IRA or another qualified plan within 60 days.
Amounts received from a qualified plan may also be transferred to another qualified plan with the consent of the individual’s new employer. Any such rollover must be made directly or it will be subject to a 20% withholding rate. This is true even if the rollover occurs within the 60-day limit. To escape the withholding rate, the rollover must take place without the plan’s funds ever being in the recipient’s. If such control does occur and the 20% is withheld, the recipient must make up this amount out of other funds or the amount withheld will be subject to income taxation and, possibly, a penalty for premature distribution.
The Employee Retirement Income Security Act (ERISA) was enacted to protect the interests of participants in employee benefit plans as well as the interests of the participants’ beneficiaries.
ERISA mandates very detailed standards for fiduciaries and other parties-ininterest of employee welfare benefit plans, including group insurance plans. This means that anyone having control over plan management or plan assets of any kind must discharge that fiduciary duty solely in the interests of the plan participants and their beneficiaries.
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ERISA requires that certain information concerning any employee welfare benefit plan be made available to plan participants, their beneficiaries, the Department of Labor, and the IRS. The types of information that must be distributed include
In addition to monetary penalties, civil and criminal action may be taken against any plan administrator who willfully violates any of these requirements or who knowingly falsifies or conceals ERISA disclosure information.
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1. Employer vesting schedules apply to
2. Who may contribute to an IRA?
3. Who may not make fully deductible contributions to an IRA?
4. Premature distribution from a qualified plan or an IRA can result in the amount being taxed as income plus a penalty tax of _______%.
5. A rollover from one IRA to another or from a qualified plan to an IRA must be accomplished within what time limit if the owner is to avoid an income tax liability on the amount rolled over?
6. At what age is an individual no longer subject to early withdrawal
penalties under an IRA?
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7. Which of the following organizations would be eligible to offer a 403(b) arrangement?
8. Carmen owns a business that provides a retirement plan to its employees whereby the business makes contributions of up to 25% of the total compensation paid to all participating employees to IRA plans owned by the individual employees. Carmen’s plan is most likely a
9. Delbert is self-employed, and sets up a retirement plan for himself. Delbert most likely sets up a
10. Kim is required to take a $2,000 minimum annual distribution from her IRA. She fails to comply and takes only a $1,000 distribution. Because of this failure, Kim will be subject to a
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|Terms you need to understand:|
|✓||Principal sum||✓||Service area|
|✓||Capital sum||✓||Capitation fee|
|✓||Urgent care centers||✓||Gatekeeper|
|✓||Skilled nursing facilities||✓||Primary care physician|
|✓||Home health care||✓||Preferred provider organization|
|✓||Subscribers||✓||Exclusive provider organization|
|✓||Health maintenance organization||✓||Self-funding|
|Concepts you need to master:|
|✓||Types of health insurance policies||✓||Point-of-service plans|
|✓||Limited health insurance policies||✓||Employer-administered plans|
|✓||Determining health insurance needs||✓||Cafeteria plans|
|✓||Health care providers||✓||Medical savings account|
|✓||Managed care||✓||Multiple employer trust|
|✓||Reimbursement plans||✓||Multiple employer welfare arrangement|
|✓||Service organizations||✓||Blanket insurance policies|
|✓||Prepaid plans||✓||Franchise insurance policies|
|✓||Fee-for-service plans||✓||Government insurance programs|
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Health insurance provides payment of benefits for the loss of income and/or the medical expenses arising from illness or injury. Health insurance is often called accident and sickness insurance or accident and health insurance.
Let’s first review some of the major categories of health insurance and consider their differences.
Disability income insurance, also referred to as loss of time insurance, pays a weekly or monthly benefit for disabilities due to accident or sickness. The primary purpose of disability income coverage is to replace loss of personal income due to a disability. Disability income policies are issued on an individual basis or on a group basis through an employer-sponsored plan, labor union, or association.
Accidental death and dismemberment (AD&D) policies (or riders) pay the policy’s principal sum for accidental death. The principal sum is similar in meaning to a policy’s face amount. This same amount is paid if the insured suffers the actual severance of two arms, two legs, or the loss of vision in two eyes due to an accident. This amount is usually identified as the capital sum if the policy is paying an accidental dismemberment benefit.
AD&D benefits may be included as riders on life insurance policies, as part of disability income insurance, as part of health insurance, or as a separate policy (a type of limited coverage).
Medical expense insurance, commonly referred to as hospitalization insurance, provides benefits for expenses incurred due to in-hospital medical treatment and surgery as well as certain outpatient expenses—such as doctor’s visits, lab tests, and diagnostic services. Hospitalization insurance may be issued as an individual policy covering all family members or as a group insurance policy provided through an employer-sponsored program.
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When medical expense coverage provided for proprietors and partners is paid for by the business, the premiums have traditionally been considered tax deductible to the business but includable as income to the individual. There is no limit to the amount of tax-free medical expense benefits the individual can receive, however.
Dental expense benefits are generally sold as part of group health insurance coverage. Most insurers do not provide individual dental policies. Dental benefits are offered for preventive maintenance (cleanings and x-rays), repair (fillings, root canals, and so forth) and replacement of teeth.
Long-term care (LTC) insurance pays for the care of persons with chronic diseases or disabilities and may include a wide range of health and social services provided under the supervision of medical professionals. LTC often covers nursing home care, home-based care, and respite care (full-time care provided to an impaired individual for a short period in order to give a rest, or respite, to a family member or friend who ordinarily provides that care at home).
There are a variety of special health insurance policies providing limited coverage. To ensure that the insured has sufficient notice that the coverage is limited, every policy that provides limited coverage must, by law, state plainly on the first page of the policy: “THIS IS A LIMITED POLICY.” The following is a list of the main types of limited health policies:
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Prescription medication coverage is normally provided as an optional benefit under a group medical expense policy. The insured and eligible dependents are provided with a stated cost for any prescription medication required. This specific cost is usually $5–15 dollars per prescription. Thus, regardless of the cost of the medication, the insured pays only the stated amount, and the balance of the prescription cost is paid by the insurance company.
Basically, the process of determining health insurance needs is similar to identifying an individual’s life insurance requirements. The principal difference is the risk being insured—premature death or health insurance expenses.
The individual’s and family’s health insurance needs must be identified. These needs are then prioritized in terms of their importance to the family. Other forms of health insurance benefits should be reviewed with regard to this needs analysis:
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After the individual’s total health insurance needs analysis has been completed, meaningful recommendations can be made as to the type and amounts of health insurance required.
Patients have traditionally been seen by physicians in office or hospital environments. Today physicians also see patients in a variety of settings including the following:
The traditional broad health coverage provided by insurance plans provides little incentive for efficient, cost-effective health care delivery. Managed care imposes controls on the use of health care services, the providers of health care services, and the amount charged for these services, usually through health maintenance organizations (HMOs) or preferred provider organizations (PPOs) (discussed in the following sections).
The insurers of health care are not only the traditional stock and mutual companies, and Blue Cross and Blue Shield, but also the health maintenance organizations (HMOs) and PPOs formed by hospitals and physicians to deliver health care directly to enrollees in their plans.
Commercial insurers are stock and mutual life insurers and sometimes casualty companies. Commercial insurers have traditionally provided coverage on a reimbursement basis but have also begun to embrace alternative approaches. Reimbursement plans pay benefits directly to the insured, who is responsible for paying the providers of medical services.
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Commercial insurers offer both individual and group health insurance products. These products include basic medical expense coverage, major medical plans, comprehensive medical plans, disability income policies, and other types of health products.
Blue Cross and Blue Shield (the Blues) are different from traditional commercial insurers in the following important areas:
Blue Cross/Blue Shield organizations, which are often referred to as service organizations, are examples of producers’ cooperatives. Physicians and hospitals that sponsor Blue Cross/Blue Shield plans provide the insurance, so are considered to be the producers in the cooperative.
Blue Cross traditionally has been a hospital service plan and Blue Shield a physicians service plan, but these distinctions are becoming blurred. In most states, Blue Cross and Blue Shield have merged, but each group still covers the expenses for which it was first developed: Blue Cross covers hospital expenses and Blue Shield covers medical and surgical expenses. In some states both Blue Cross and Blue Shield serve as hospital and physician service plans. With occasional exceptions, reimbursements for incurred expenses are made directly to the providers, not to the subscribers.
Members of Blue Cross and Blue Shield are known as subscribers. Subscribers in either plan can transfer their membership from one Blues organization to another in other areas of town, or to other cities or states. Subscribers may also change their coverage from individual to family, from family to group, or any combination of change they need to make. When transfers or changes are made, the subscriber’s coverage continues without interruption.
Blue Cross and Blue Shield plans are called prepaid plans because the plan subscribers pay a set fee, usually each month, for medical services covered under the plan.
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Blue Cross offers broad coverages and pays claims on a service basis. The plan covers hospital daily room and board, outpatient services for minor surgery or accidental injury, medical emergencies, diagnostic testing, physical therapy, kidney dialysis, chemotherapy, and in some cases preadmission testing.
Family plans may also include coverage for dependent handicapped children.
Maternity benefits are also made available the “same as for any other disability.”
Blue Cross also has a supplemental coverage for catastrophic loss, which is similar to commercial major medical plans. This supplement has a deductible and an 80%/20% coinsurance feature.
Blue Shield offers prepaid medical coverage for physician services received by plan subscribers. Again, through the contractual arrangement with the providers, Blue Shield will normally pay the participating physician a predetermined amount for the specific service provided. Usually, this amount will be based on the usual, customary, and reasonable (UCR) fees charged by other physicians in the same geographical area for the same or similar medical procedures.
It is also possible to obtain dental coverage through Blue Cross/Blue Shield, which contracts with dental providers and pays fees on a service basis.
The Blues have also been strongly influenced by managed care. Many Blues subscribers are now covered by a Blues-affiliated HMO or PPO, or POS plan.
Jointly operated (consolidated) Blue Cross/Blue Shield plans are often so comprehensive that supplementing them with major medical coverage is not necessary. Plan provisions applying to consolidated Blue Cross/Blue Shield plans are similar to plan provisions applying to comprehensive major medical plans.
The number of HMOs has grown rapidly in response to increasing health care costs in recent decades.
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The purpose of HMOs is to manage health care and its costs through a program of prepaid care that emphasizes prevention and early treatment. This prepayment, which entitles the health care consumer to a wide range of services, is referred to as a service-incurred basis. In contrast, traditional health insurance coverage is handled on a reimbursement basis, with the insured or provider being reimbursed for all or part of medical expenses actually incurred.
The emphasis on prevention means HMOs cover preventive medicine, such as routine physical and well-child examinations and diagnostic screening paid for in advance. Theoretically, the HMOs’ focus on prevention ultimately leads to reduced health care costs. At the same time, HMOs provide for hospital, surgical, and medical treatment when such services are needed.
One way HMOs differ from traditional health insurance providers is that HMOs have a dual function not shared by insurance companies. Under traditional arrangements, consumers receive the health care itself from one group, the medical profession—physicians, hospitals, therapists, and so forth—and the financial coverage comes from a separate entity—the insurance company. In contrast, an HMO provides both the health care services and the health care coverage.
These two functions are combined because the HMO is comprised of a group of medical practitioners who have contracted to provide specified services to HMO members at agreed-upon prices. In return, each consumer who is a member of the HMO agrees to pay the HMO a specified amount in advance to cover required hospital and medical services.
Although the emphasis on prevention and containing costs was a major factor in the development of HMOs, federal HMO laws further encouraged development by two primary means:
In order to receive government grants, HMOs must
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When an HMO has met the minimum standards as well as other federal and state requirements, it is allowed to operate in a designated service area—often within a certain county or a specified distance surrounding the HMO facilities. Then, the federal law regarding employers comes into play.
The HMO Act of 1973 required employers with certain characteristics to offer HMO coverage by a federally qualified HMO as an alternative to an indemnity plan. Under this law, if the HMO operates in the service area of an employer that has 25 or more employees and that employer provides health care benefits, enrollment in the HMO must be offered as an alternative to traditional health insurance plans. This is often referred to as the dual choice option or dual choice law.
This requirement was repealed at the federal level in 1995, although some states still impose dual choice requirements. Federal law now simply requires that employers “not financially discriminate” in the amounts of employee contribution made toward HMO and indemnity plans. Employers are required to contribute equally to either type of health coverage for employees. However, the employer is never required to pay more for the HMO than it pays for any existing insurance plan already in place.
There are a number of ways to analyze the organization of an HMO. The first concept we’ll address is whether the HMO operates on a for-profit or a not-for-profit basis. Then we’ll look at some other organizational variations.
Usually, but not always, if the HMO is a producers’ cooperative owned and operated by a group of physicians, the HMO is for-profit. If it is a consumers’ cooperative where the doctors are salaried employees of the HMO, it is usually not-for-profit.
The basic structure of an HMO involves contractual agreements with a variety of health care providers and facilities to provide services to HMO subscribers. Within that structure, four models are used, one of which is the group model.
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The group model is sometimes called the medical group model or the group practice model. Under this arrangement, the HMO contracts with an independent medical group that specializes in a variety of medical services to provide those services to HMO subscribers. Under the agreement, the HMO pays the medical group entity, not the individual service providers. The medical group itself chooses how to pay its individual physicians, all of whom remain independent of the HMO rather than becoming salaried employees.
Often, the HMO pays the group a capitation fee, which is a fixed amount paid monthly for each HMO member. Thus, the medical group can make a profit on those members for whom a fee is paid but who use few or no services. On the other hand, the medical group can lose money on frequent users.
A second type of arrangement is the staff model, so named because the contracting physicians are paid employees working on the staff of the HMO. They generally operate in a clinic setting at the HMO’s physical facilities. When hospital services are required, the staff doctors and HMO administration arrange for those services. In some cases, the HMO may even own and operate a hospital.
The network model operates much like the group model, except the HMO contracts with at least two, and more likely several, medical groups rather than just one. In addition, the HMO may make similar contractual arrangements with independent doctors to provide services in their individual offices. The purpose of a network is to increase accessibility to providers as a convenience for HMO subscribers who might otherwise be required to visit a facility far from their homes or workplaces.
The fourth and final model is one that gives HMO members the maximum freedom of choice of physicians and locations. The Individual Practice Association (IPA) model allows the HMO to contract separately with any combination of individual physicians, medical groups, or physicians’ associations. Some HMOs, in fact, have been started by such groups.
In the IPA model, there is no separate HMO facility. Physicians operate out of their own private offices, and their HMO patients may be individuals the physicians were already attending.
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Open and closed panels are yet another way to characterize HMOs. Physicians, hospitals, and other health care providers who have contracts with an HMO are referred to as the HMO’s panel. An open panel means any and all providers who want to provide services for the HMO may do so as long as they agree to the HMO’s requirements.
In contrast, a closed panel is a limited number of health care providers chosen by the HMO. HMO subscribers must receive their health care services from this closed panel of providers in order to have those services paid for on the prepaid plan.
The emphasis of HMOs is prevention, because the benefits offered are broader than those provided by commercial insurers or the Blues. HMO benefits are not limited to treatment resulting from illness or injury because they also include preventive health care measures such as routine physical examinations.
HMOs are required to provide for the following basic health care services:
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➤ In and out of area emergency services, including medically necessary ambulance services, available on an inpatient or an outpatient basis 24 hours per day, 7 days per week.
Many HMOs may but are not required to provide one or more of the following supplemental health care services:
Consumers who want supplemental services may purchase them from the HMO only as an adjunct to the basic health care services the HMO offers.
Members of an HMO may be charged only nominal amounts—copayments— for basic services in addition to the original monthly payment. In many cases, no additional payments are required for services. All of this is spelled out in a descriptive document, which is called either the certificate of coverage or the evidence of coverage.
On the other hand, HMOs are permitted to require copayments on supplemental services as well as charge an amount that is added to the monthly fee.
HMOs may not exclude and limit benefits as readily as commercial insurers because the rationale of an HMO is to provide comprehensive health care coverage.
Some of the benefits an HMO may exclude from coverage, and often do, include
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Some features of HMOs are unique and do not apply to traditional forms of reimbursement insurance.
HMOs often have a gatekeeper system under which the member must select a primary care physician (PCP), who in turn provides or authorizes all care for the particular member. Any referrals, such as to specialists, must be made and authorized by the PCP. In emergency situations, the member’s needs are covered, but generally the individual must notify the PCP as soon as possible if it wasn’t possible to do so when the emergency arose.
As a rule, members have 24-hour access to the HMO. Telephones are answered and referrals and authorizations are made 24 hours a day, 7 days a week. Nursing and medical staff, including PCPs, must be willing to respond during nonbusiness hours as well.
The term open enrollment can mean one of the following:
In the first case, open enrollment allows employees who have not yet joined the HMO to do so if they wish. Those who are already HMO subscribers may at this time also choose to continue in the HMO or to change plans if another health care plan is available.
In the second case, open enrollment may be required by state law, permitting all who apply to join. During this period, which usually lasts 30 days, the HMO generally may not reject any applicant for health reasons. However, some laws permit the HMO to refuse enrollment to people who are hospi
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talized during the enrollment period or who have chronic illnesses or permanent injuries.
When HMO coverage is offered to a group, the HMO may not refuse to cover an individual member of the group because of adverse preexisting health conditions, such as a history of heart trouble that predates enrollment in the HMO. This is different from traditional insurers, which generally have the option of refusing to cover certain group members and of excluding preexisting health conditions.
HMOs are permitted to refuse coverage for individuals with preexisting conditions, except during open enrollment, as discussed previously.
All HMOs are required to have a complaint system, often called a grievance procedure, to resolve written complaints by members. The HMO is required to provide forms for written complaints, including the address and telephone number of where complaints should be directed. Additionally, on providing the necessary forms for a complaint to a member, the HMO must notify the member of any time limits applying to a complaint. Complaints must be resolved within 180 days of being filed with the HMO (with a few exceptions).
HMOs are prohibited from excluding a member’s preexisting conditions from coverage and from unfairly discriminating against a member based on age, sex, health status, race, color, creed, national origin, or marital status. HMOs are also prohibited from terminating a member’s coverage for reasons other than nonpayment of premiums or copayments, fraud or deception in the member’s use of services, a violation of the terms of the contract, failure to meet or continue to meet eligibility requirements prescribed by the HMO, or a termination of the group contract under which the member was covered.
Because HMOs provide service benefits rather than reimbursement benefits, they are required to follow guidelines prescribed by the insurance department to assure quality service to members. These guidelines specify the requirements for reasonable hours of operation and after-hours emergency
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health care and standards to ensure that sufficient personnel will be available to attend to members’ needs. The guidelines also require adequate arrangements to provide inpatient hospital services for basic health care and a requirement that the services of specialists be provided as a basic health care service.
An open-ended HMO (also known as a leaky HMO and point-of-service HMO) is a hybrid arrangement whereby participants may use non-HMO providers at any time and receive indemnity benefits that are subject to higher deductible and coinsurance amounts. The out-of-pocket cost to the participant (and probably the employer, too) is higher, but the arrangement allows participants to remain in control in choosing a health care provider.
Dissatisfaction with the gatekeeper mechanism, delays in receiving care, and problems in obtaining referrals have led many health plans to offer open access. An open-access HMO allows members to receive care from network specialists without first going through a primary care physician (gatekeeper) and receiving a referral. Alternatively, a point-of-service (POS) plan allows members to seek the care of a specialist outside the HMO provider network.
Because the plan does not control the outside provider, POS plans tend to be more expensive than open-access HMOs.
Other efforts to reduce medical costs have resulted in preferred provider organizations (PPOs), arrangements under which a selected group of independent hospitals and medical practitioners in a certain area, such as a state, agree to provide a range of services at a prearranged cost.
The organizers and the providers agree upon medical service charges that are generally less than the providers would charge patients not associated with the PPO. The providers are paid on a fee-for-service basis. Providers are willing to enter into this arrangement in return for guaranteed payment from the PPO and a potential increase in the number of patients.
The people who will receive services choose a preferred provider from a list the PPO distributes. As a general rule, the users have more choices among doctors and hospitals under a PPO than under an HMO arrangement.
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However, some recent HMO structures offer similar arrangements. PPOs fall somewhere between commercial insurers, where the user has unlimited choice of practitioners, and HMOs, where the user might be severely restricted.
Keep in mind that a PPO agrees to pay its full benefits only when a preferred provider is used. If an individual uses a nonpreferred facility, the PPO usually pays a reduced amount (perhaps 80%) and the individual must pay the balance.
Recognizing that emergencies may require treatment in other than preferred facilities or by providers who have not agreed to the PPO arrangement, PPO plans will generally pay in full for emergency treatment regardless of where and by whom it is performed.
Point-of-service plans (POS) are a form of managed care, in which the insured is given a choice of receiving care in-network or out-of-network. In-network means receiving care through a particular network of doctors and hospitals participating in the plan and all care is coordinated by the insured PCP. This includes referrals to specialists and arrangements for hospitalization, which must all be approved by the PCP. In-network coverage is the highest level of coverage within the plan, which means the plan will pay more for medical services and the insured won’t have to submit claim forms. Out-of-network coverage applies when the insured receives care for a provider who does not participate in the plan’s network and the care is not coordinated by the primary care physician.
When the insured receives out-of-network care, he or she will usually pay more of the cost than if it had been in-network care (emergencies excepted). Out-of-network care also means that the insured will have to submit claim forms in order to receive benefits.
Exclusive provider organizations are a type of PPO in which individual members use particular preferred providers, instead of having a choice of a variety of preferred providers. Providers are not paid a salary, but are paid on a fee-for-service basis.
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EPOs are characterized by a primary physician who monitors care and makes referrals to a network of providers (the gatekeeper concept), strong utilization management, experience rating, and simplified claims processing. EPOs can serve as an alternative to or companion to HMOs and PPOs.
Today there are many variations of managed health care providers, including
physician hospital organizations (PHOs), practice management organizations (PMOs), and provider sponsored networks (PSNs) .
The principal differences between these organizations are the parties to the contracts and their basic structure and organization. For example, with the PHO, the physicians and hospitals contract directly with employers to provide health care services. Most of these arrangements are funded through capitation fees much like HMOs.
A multiple option plan is an integrated health plan that may include services of an HMO, PPO, EPO, and/or indemnity plan, all of which are administered by a single vendor (usually an insurance company).
Some employers have reduced costs for health care benefits by self-insuring or offering new options that have become available due to changes in tax laws.
With a self-funded plan an employer, not an insurance company, provides the funds to make claim payments for company employees and their dependents. In the event that claims are higher than predicted, a self-funded health insurance plan can be backed-up by a stop-loss contract. A stop-loss contract is designed to limit the employer’s liability for claims.
There are two variations of this coverage. Specific stop-loss coverage begins to apply after an individual’s medical expenses exceed a predetermined threshold, such as $5,000. Aggregate stop-loss coverage applies when the employer’s liability for group insurance claims exceeds a specified amount. The insurer pays all claims after the specified amount is reached.
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An employer self-funded plan may be an indemnity program that reimburses covered employees for medical care they have received. Or, the employer may provide benefits through the service plan offered under an HMO, or through an insurer’s PPO network.
An insurer may also be used for a self-funded employer under an administrative services only (ASO) contract. Under the ASO contractual agreement the insurer provides claim forms, administers claims, and makes payments to health care providers, but the employer still provides the funds to make claims payments.
Self-insurance has four major advantages:
The following are the main disadvantages of self-insurance:
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Section 501(c)(9) of the Internal Revenue Code provides for the establishment of voluntary employees’ beneficiary associations or 501(c)(9) trusts that are funding vehicles for the employee benefits that are offered to members.
Some employers may prefer to establish a 501(c)(9) trust for some of the tax advantages it provides. Under a regular self-funded plan, contributions to the plan cannot be deducted until benefits are distributed. But contributions to 501(c)(9) trusts are deducted immediately. Accumulated earnings on 501(c)(9) assets are also tax-deductible, unlike earnings on funds in a regular self-insured plan.
Maintaining a 501(c)(9) trust can be quite costly though, and administration of the plan must be exceptional to make it worthwhile to the employer. High losses under the plan may negate any tax advantages a 501(c)(9) trust offers.
Small employers (usually defined as those with fewer than 25 or 50 employees) have been especially hard hit by increases in health care insurance premiums.
Because many group plans are experience rated, small employers see an immediate premium increase whenever claims are particularly high. If the average age of the participants is particularly high, or if claims experience is high, or if there has been even one long or catastrophic illness in a small employer plan, it can have a devastating effect, making health insurance unaffordable for the whole group.
Several states have acted to ensure that health insurance coverages are available at a reasonable cost and under reasonable conditions for small employers, including imposing these requirements:
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A cafeteria plan could be defined as a plan in which employees select health benefits from a variety of coverage options, based on their individual and family needs. Cafeteria plans tend to be more complex (and more expensive) than traditional plans, especially with regard to plan administration, and usually make the most sense for larger employers. Benefits are elected in advance of the year in which they will be used. Taxation of cafeteria plans is regulated by Section 125 of the Internal Revenue Code.
Multiple employer trusts (METs) provide health insurance benefits to small businesses through a series of trusts usually established based on specific industries such as manufacturing, sales and service, real estate, and so forth. Generally, states may require a minimum of five to ten participants for a group to be eligible for group benefits. METs typically have no such requirements and in reality a group of one could be eligible for group benefits.
METs are formed by insurers or third-party administrators who are called sponsors. The sponsor develops the plan, sets the underwriting rules, and administers the plan. To help prevent the possibility of adverse selection, the underwriter must make sure that the sponsor’s underwriting rules are adequate and that he or she adheres to them. This is necessary because an employer with only two, three, or five employees could elect to join a MET because they know of the poor health condition of one of the employees. The underwriting standards must be able to prevent this from happening.
If state law allows, METs may be noninsured. The trustee has charge of the funds, and the policies and all financial activities occur through the trust.
As with a traditional group insurance plan, a master policy is issued to a trustee who is operating under a trust agreement. The master contract has its own policy effective date and renewal dates that the insurer may use for changing rates on the MET’s entire block of business. Each individual employer under the MET has its own effective dates and anniversary dates.
Rates are generally changed on the employer’s anniversary date, but usually not more than once in 12 months.
Multiple Employer Welfare Arrangements (MEWAs)
Multiple Employer Welfare Arrangements (MEWAs) are employer funds and
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trusts providing health care benefits (among other benefits) to employees of two or more employers.
MEWAs need to obtain a Certificate of Authority in order to transact insurance business and must be fully insured by a licensed insurer. MEWAs have recently been used to dupe employers and producers in fraudulent insurance schemes. Before representing a MEWA, agents and brokers should check with the department of insurance and make sure that the entity is properly licensed to do business in his or her state.
In addition to traditional forms of individual and group health insurance, there are some variations known as blanket or franchise policies.
Many types of groups, such as the students of a single school or a group of campers, are indefinite in number and composition and are constantly changing. These characteristics prevent qualification for group insurance under the usual terms.
However, groups such as these can have health coverage at group rates under a blanket policy. Because no employer/employee relationship is involved, the members of such groups are not usually interested in covering themselves for loss of income resulting from their activities as a group. Instead, they usually want only hospital, medical, and surgical coverages.
Blanket policies may be either contributory or noncontributory.
An arrangement that allows very small groups to have some of the benefits of group insurance, especially the lower cost, is called franchise insurance.
Franchise insurance works much like group insurance, but there is no master policy. Instead, each member of the group receives an individual insurance policy. This allows group members to make some coverage choices, but they are required to provide health information on their applications, just as they would for individual policies.
Like true group coverage, franchise insurance offers hospital, surgical, medical, and disability income coverage. Plans may be contributory or noncontributory. One premium is paid for the whole group.
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One example of franchise insurance is coverage sold by mail to groups such as the members of a certain association or holders of certain credit cards. Purchasers receive individual policies at group rates.
Both the federal and state government offer statutory health insurance programs. On the federal level, social security provides disability income benefits and administers the medicare program. On the state level, all states have workers compensation laws and medicaid or some similar form of state-subsidized health care.
Social security benefits were covered in an earlier chapter. In this chapter, we will look at workers compensation, medicare, and medicaid.
Most states require employers to provide workers compensation benefits for their employees. Workers compensation is designed to help the person who suffers from loss of income due to injury or sickness that occurs as a result of his or her occupation.
In order to be eligible for workers compensation benefits the disabled worker must
Workers compensation laws provide for the payment of four types of benefits:
Medical benefits are provided without limit. An injured or diseased employee is entitled to receive all necessary medical and surgical treatment to cure or relieve the condition. Certain maximums or limits may apply to a type of care or a particular medical item, but overall benefits are unlimited.
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Income benefits are paid to employees who suffer work-related disabilities.
An elimination period applies before benefits for loss of wages begin. If the disability continues beyond a certain period, retroactive benefits will be paid for the initial waiting period. A disability may be total (making employment impossible) or partial (resulting in a reduced ability to work). Either type of disability may be temporary or permanent. For permanent total disability or temporary total disability, the benefit is 66 2/3% of weekly wages, subject to minimum and maximum weekly limits. However, for permanent total disability, the dollar maximum and the benefit period are greater (benefits for permanent total disability often continue for life, but benefits for a temporary total disability are limited). People with partial disabilities are able to perform some work, so the laws provide a benefit equal to a percentage of the wage loss (difference between earnings before and after the accident). In addition to benefits for lost wages, the state provides scheduled benefits for specific permanent partial disabilities, such as loss of limbs, sight, or hearing.
Usually these benefits are paid in addition to any other income benefits. Death benefits provide two types of payments. Up to a certain dollar amount is provided as a burial allowance, and the state also provides weekly income payments for a surviving spouse and/or children. Weekly benefits are 66 2/3% of the deceased worker’s wages, subject to minimum and maximum dollar amounts, a maximum time limit, and an aggregate payment limit. Surviving children generally receive benefits until a certain age.
Rehabilitation benefits are now recognized as a valuable tool for reducing workers compensation costs and returning disabled employees to their jobs as soon as possible. Rehabilitation may include therapy; vocational training; devices such as wheelchairs; and the costs of travel, lodging, and living expenses while being rehabilitated.
Medicaid provides health care benefits for the financially needy. It is basically a state program with some federal financial support. Medicaid is designed to provide increased assistance to those who are unable to pay for their medical needs. For those persons aged 65 or over, medicaid principally supplements medicare for those who cannot pay the expenses not covered by medicare. For those not eligible for medicare, it provides medical assistance for certain categories of people who are medically needy—the blind, the disabled, families with dependent children, or medically needy children under age 21.
Medicaid is a federal-state program. The federal government encourages states to increase medical assistance to the indigent, regardless of age, by pay
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ing one-half of the administration cost of state medical assistance programs and 50%–80% of the fees to the providers of services to the needy. The actual federal matching proposition varies inversely with the state average per capita income; therefore, the poorer states receive the larger federal grants.
Generally, medicaid helps to pay for medical services for which the patient cannot pay. Thus, medicaid will cover such services as hospitalizations, physician’s services, diagnostic testing, pregnancies, and so forth.
In addition, medicaid also serves as a supplement to medicare in some situations. For example, medicare currently offers extremely limited coverage for nursing home care. Often medicaid will supplement these limited benefits by paying for nursing home expenses. Other health care expenses not completely covered by medicare may be paid for by medicaid.
The Department of Defense operates one of the largest health care systems in the United States, covering more than 8 million active duty and retired military personnel and their families. In response to increasing health care costs and the closing of many military hospitals, the Pentagon has revised and renamed its health care program. Formerly called CHAMPUS (Civilian Health and Medical Program of the Uniformed Services), the new TRICARE program provides care for all seven of the uniformed services, and incorporates many of the managed care options found in private health care plans. A choice of three health care plans is offered:
Several military organizations also offer TRICARE Supplements, which, like medicare supplements, are insurance plans that cover the deductibles and copayment charges imposed by the TRICARE health plan.
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1. The Albuquerque HMO’s contracting physicians are paid employees working on the staff of the HMO, operating in a clinic setting at the HMO’s physical facilities. The Albuquerque HMO operates as a(n)
2. Star HMO contracts with 14 medical groups to increase accessibility to providers as a convenience for subscribers. Each of the medical groups is paid on a capitation basis to provide services to Star’s subscribers. The Star HMO operates as a(n)
3. The Provider’s Choice HMO was started by a group of individual physicians who each operate out of their own offices. The physicians are paid on a fee-for-service basis with the fees negotiated in advance. Provider’s Choice HMO operates as a(n)
4. Gwyneth’s HMO requires that she receive health care services from a specified, limited number of health care providers chosen by the HMO. Gwyneth’s HMO is
5. All of the following are examples of managed care plans except
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6. A method of payment in which a provider is paid a specific fee monthly for each subscriber is known as
7. Calvin is hit by a car while traveling out of state. When the bill for his emergency services arrives, Calvin’s HMO will probably
8. The Gargantuan Garage company funds its own claims, but it uses another company to make sure the plan is run correctly, acting as a liaison between the insurer and the employer. This arrangement is probably a
9. Julia has a policy that will pay any expenses that she incurs due to in-hospital medical treatment, as well as some of the expenses she incurs on an outpatient basis. Julia probably has a
10. George has a policy that will provide him an income if he is disabled from illness or injury and recuperating at home. George probably has a
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✓ Premium ✓ Earned premium ✓ Unearned premium ✓ Initial premium ✓ Policy effective date ✓ Policy term ✓ Policy fee
✓ Premium modes ✓ Policy delivery ✓ Servicing a policy ✓ Policy replacement ✓ Fiduciary responsibilities
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Health insurance underwriting is the process of selection, classification, and rating of risks. Most companies offering health policies have a variety of policies available, and underwriting standards for each policy are usually established.
Low-limit policies with limited coverages do not require the underwriting that broad-coverage policies with high limits do; the greater the company’s exposure, the more careful the underwriter has to be. Underwriting is generally more restrictive for individual than for group policies. The underwriter’s principal functions are to review applications to eliminate those that do not meet underwriting standards, thus reducing adverse selection, and to classify risks to establish benefits and corresponding premium.
Certain underwriting factors for health insurance may be more or less important than for the underwriting of life insurance. For example, an individual with a serious back ailment presents a major risk for the health insurance underwriter because of the danger of such a chronic condition creating several expensive claim situations. However, for the life insurance underwriter, this same condition may be of little significance because a bad back is not likely to affect the individual’s mortality.
You should understand the definitions of premium, earned premium, and unearned premium, as well as the concept of premium payment modes.
The premium is a sum of money the insured pays the insurer in exchange for or in consideration of the benefits or indemnities provided in the policy.
Premium payment frequency varies, but regardless of frequency, the insured is always paying for the upcoming period. That is, insurance premiums are paid in advance.
Suppose Kathryn’s health insurance premium is $500 per year, which she pays in full on January 1. Because the $500 covers an entire year, the insurer earns the premium as the time passes, having both earned and unearned premium on hand during the policy term. By March 31 of the year, the insurer
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has provided protection for 3 full months, so approximately 25% of the premium represents the amount paid for the period for which protection has been provided and $125 would be the earned premium at that time. The remaining $375 of premium Kathryn has paid is, as of March 31, called the unearned premium.
In the insurance industry, mode of premium payment refers to the frequency with which premiums are paid. Payments may be made
Of these five modes, the least-used frequency for individual policies is weekly.
You probably know that in group health plans employers often deduct the employees’ shares weekly, but it is likely that the employer actually sends the premium to the insurer less frequently.
Insurers generally calculate premiums on an annual basis. If the insured wants to pay by any of the other modes, the premium increases slightly as the frequency increases. The increases allow the insurer to recoup both the additional billing and handling costs and the lost interest the insurer could have earned by having the full annual premium to invest all at once. So, for example, a monthly premium mode results in a premium that is somewhat higher than a semiannual mode. An annual premium mode results in a premium that is somewhat lower than a quarterly mode.
The initial premium, as the name implies, is the first premium the applicant pays in order to place the policy into effect. A health insurance policy goes into force when the initial premium has been paid and the policy has been delivered to the insured, unless the initial premium was paid with the application and a conditional receipt was issued. When the initial premium is paid with the application and the applicant satisfies all the conditions of the conditional receipt, coverage takes effect as if the policy had already been issued.
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A producer should always try to obtain the initial premium with an app and submit the entire package for underwriting. This affords faster protection to applicants, and applicants are less likely to change their minds about purchasing policies when they have money invested in them.
The important thing to remember is that coverage never applies until the insured has paid for it. If the initial premium does not accompany the application, the premium must be collected at policy delivery along with a signed statement that the insured continues to be in good health. The policy is then effective as of the date stated in the policy.
Although it is generally true that a policy is effective when the initial premium has been paid and the policy delivered (or under the conditions of a conditional receipt), there is a better way for a producer to respond when asked when a particular policy takes effect.
The best approach is to state that the policy takes effect on the date specified in the policy as the effective date. Remember that accident coverages usually take effect immediately when the policy is issued, and sickness coverages may require a probationary period. Therefore, different coverages under the same policy might have different effective dates.
When a health insurance policy becomes effective, it will stay in force for the period for which the premium has been paid, unless the insurer or the insured cancels it. In other words, the policy will stay in force for a specified period or term.
The length of the term is governed by the length of time for which coverage is purchased by the premium payment. If a policy calls for annual premium payment, for example, 1 year is the term of the policy. If premiums are paid semiannually, the term extends for each 6-month period for which the premium is paid.
When a policy is issued, some companies charge a policy fee, which is generally a flat amount that helps defray expenses such as acquisition costs, producer commissions, administration, and maintenance of the policy. There are two different ways a policy fee might be handled.
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Usually, the policy fee is added to the premium and is paid annually. For example, the company might charge an annual premium of $300 plus a $15 policy fee, for a total annual premium of $315, which the insured will pay every year.
Some companies, on the other hand, may charge a policy fee only once—at the time the policy is issued. For example, suppose the annual premium is $300 and the policy fee $25. The insured will pay an initial premium of $325, which includes the one-time policy fee, but for succeeding years will pay only $300.
The surest way to be certain the policy is delivered is to do it personally. In addition to knowing the policy has been delivered, the producer has the following opportunities:
It is important in health insurance for the policyowner to have basic understanding of what is and isn’t covered. With today’s high healthcare costs, it is extremely important for the insured to know what the policy limitations are on the different types of medical expenses covered. Sometimes policy premiums are higher than standard (rated up) because the insured does not meet certain basic health requirements or is involved in extra hazardous hobbies or avocations. These facts should be explained to avoid future misunderstandings and/or dissatisfaction. Finally, if the premium was not collected with the application, the company may require the producer to obtain a statement of good health from the insured at the time the policy is delivered and the premium paid.
Legally, the policy is considered delivered when it is mailed or turned over to the policyowner or someone acting on his or her behalf. Some companies do mail policies directly to policyowners. However, many prefer to have the producer make a personal delivery. In some cases, a constructive delivery is deemed to occur when the insurer mails a policy to its producer for actual delivery to the policyowner because the insurer has issued the policy and released it for delivery. However, a legal delivery has not yet occurred if the insurer requires personal delivery for verification of good health at the time
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of delivery, or if the policy is being provided to the applicant merely to review and inspect at that time and not necessarily to buy.
In many industries, closing the sale means the end of the producer/consumer transaction. However, this is not so in insurance. Insurance policies require ongoing customer service throughout the policy period. Competition in the industry is another incentive to provide good customer service because it can make all the difference at renewal time. Good customer service makes insureds feel more comfortable doing business with you and makes them more likely to renew with your agency. Proper service of insurance policies also results in referrals, additional coverage, good public relations, and reduced E&O (errors and omissions—professional malpractice on the part of insurance agents) exposure.
Producers attempting to replace the insured’s current policy with a new policy need to take special care not to mislead the insured or provide coverage that is to the insured’s detriment. Of particular concern is the fact that health conditions covered under an insured’s existing policy may not be covered under a replacement policy because of the exclusion of preexisting conditions, or new waiting periods which may be established.
A producer recommending replacement should give special attention to the exclusions and limitations in the proposed policy as compared to the existing policy. Not all policies cover the same things. If the contracts are different, the replacement policy might not provide the same coverages or the same level of benefits as the existing policy.
A producer should consider the underwriting requirements of the replacing insurer. Will the insurer cover the insured on a basis as favorable to the applicant as the present insurer? Will the underwriter accept the risk at a similar rate, or will differences in the insured’s health or the underwriter’s requirements result in a higher premium rate? Generally there are laws regarding replacement in effect for life insurance, but not health insurance.
Some states have passed no loss-no gain legislation, which requires that when health insurance is replaced, ongoing claims under the former policy must continue to be paid under the new policy, thereby overriding any preexisting conditions exclusion. In replacing group health coverage, a transfer of benefits statement assures that benefits provided under the old policy continue under the new policy.
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There appears to be no benefit to the insured (and great benefit to the producer) when an insurance policy undergoes intracompany replacement (is replaced by a similar policy with the same insurer). Therefore, most general agency and producer contracts specify that the producer’s commission will be limited to a percentage of the increase in premium only when a policy is replaced within the same company. This discourages the producer from replacing existing policies with new policies from the same insurer unless the amounts of coverage (and thus the premium) are substantially increased.
Because the elderly are extremely vulnerable and often victimized insurance prospects, and are most susceptible to being penalized by preexisting conditions limitations, producers should be aware that there are often more restrictive regulations for replacing Medicare supplement policies.
Certainly, there are legitimate circumstances when replacement of a policy makes sense and should be recommended—for example, when broader coverage or higher benefits can be obtained at a lower rate, and preexisting conditions and waiting periods are not issues. However, a producer needs to be very careful in recommending a change in policies or carriers when any potential factors could lead to an uninsured loss that might otherwise have been covered. The producer needs to be aware of his or her own errors and omissions liability, particularly in the area of replacement. Replacement is not illegal, but it is heavily regulated.
All business transactions are based to a certain extent on trust. When it comes to life insurance, the trust factor is especially significant. When asked what factors matter most in a financial advisor, consumers choose ethical performance more than twice as often as financial performance. Ethics and professionalism are critical components of a successful career as an insurance producer.
Ethics means setting a standard of conduct or behavior based on established values. Insurance producers and other industry employees have long sought to distinguish themselves as professionals. A professional is defined as a person in an occupation requiring an advanced level of training, knowledge, or skill.
Professionals enjoy privileges commensurate with their skills, but they also have higher responsibilities in caring for others because of the title of professional. Professionals relate to their clients in a way that reflects well on the entire industry. The highest standard of service is provided by preparing for a new client long before even meeting him or her.
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Insurance producers have a fiduciary duty to just about any person or organization that he or she comes into contact with as a part of the day-to-day business of transacting insurance. By definition, a fiduciary is a person in a position of financial trust. Attorneys, accountants, trust officers, and insurance producers are all considered fiduciaries.
As a fiduciary, producers have an obligation to act in the best interest of the insured. The producer must be knowledgeable about the features and provisions of various insurance policies, as well as knowing the use of these insurance contracts. The producer must be able to explain the important features of these policies to the insured. The producer must recognize the importance of dealing with the general public’s financial needs and problems and offering solutions to these problems through the purchase of insurance products.
As a fiduciary, the producer must know and comply with the state’s insurance laws. Many of these laws are for consumer protection. It is the producer’s duty to comply with these laws and protect the interest of the insured at all times.
The insurance producer is a key person in the process of marketing, underwriting, and delivery of insurance policies. The job requires knowledge of various insurance products, being aware of a prospect’s insurance needs and problems, and the ability to solve these needs with the proper insurance products. The producer also has a responsibility to be aware of insurance laws that pertain to marketing of insurance products. The producer is the primary source of underwriting information. It is the producer’s duty to accurately and thoroughly complete all applications for insurance, collect initial premiums, and promptly submit premiums to the company. In addition, the producer is responsible for providing the insurance applicant with privacy notices and information, such as the Notice of Insurance Information Practices, and finally, to provide the insurance applicant with necessary receipts for the initial premium. Another objective of the producer as a field underwriter is to help protect the insurer from adverse risks. If an applicant is substandard, the producer is responsible for delivering the substandard policy and explaining its limitations and/or extra premium to the applicant.
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1. When a health insurance policy becomes effective, unless it is canceled, it will stay in force
2. Legally, the policy is considered delivered in all of the following situations except:
3. An insurer might require personal delivery
4. No loss-no gain legislation
5. A statement that assures benefits provided under the old policy will continue under the new policy is
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6. Restrictions applying to the replacement of Medicare supplement policies
7. Ally pays for her health insurance monthly. Her identical twin Georgia has the same policy, but pays annually. Which of them probably pays more for the policy?
8. Health insurance coverage never applies until
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|Terms you need to understand:|
|✓||Entire contract||✓||Pro rata return|
|✓||Grace period||✓||Policy face|
|✓||Notice of claim||✓||Insuring clause|
|✓||Claim forms||✓||Consideration clause|
|✓||Proof of loss||✓||Exclusion|
|✓||Payment of claims||✓||Reduction|
|✓||Legal actions||✓||Preexisting condition|
|Concepts you need to master:|
|✓||Mandatory provisions||✓||Unpaid premium|
|✓||Optional provisions||✓||Policy cancellation|
|✓||Change of occupation||✓||Flat cancellation|
|✓||Misstatement of age||✓||Nonoccupational coverage|
|✓||Other insurance||✓||Case management provisions|
|✓||Relation of earnings to insurance||✓||Waiver of premium|
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Because both state insurance laws and insurance policies vary greatly, an attempt has been made to make health insurance policies conform to certain standard regulations. To accomplish this, all states have adopted the Uniform Individual Accident and Sickness Policy Provisions Law. Nearly every state has modified the law to some extent, but all have adopted it in principle.
The law includes 12 mandatory provisions that must be included in individual health insurance policies and 11 optional provisions. Each of the mandatory provisions must be included in each policy, usually in a section of the policy entitled “Mandatory or Required Provisions.” Insurance companies need not use the exact wording of the provisions, but any variations must be at least as favorable to the insured as the original statutory wording.
This chapter presents each provision exactly as it appears in the law, followed by a short discussion of the content. Because the provision language is somewhat stilted “legalese,” don’t be surprised if you have to read a provision more than once.
The following is a review of the mandatory, or required, health insurance provisions.
Here is the exact wording of the provision:
This policy, including the endorsements and the attached papers, if any, constitutes the entire contract of insurance. No change in this policy shall be valid until approved by an executive officer of the insurer and unless such approval be endorsed hereon or attached hereto. No agent has authority to change this policy or to waive any of its provisions.
This provision defines an entire contract as:
Nothing else is part of the contract.
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Unless the insured has made a fraudulent misstatement, the policy cannot be voided or claims denied after 2 years (3 years in some states).
After 2 years, preexisting conditions cannot affect the policy’s benefits. An insurer may specifically exclude coverage for a certain condition if it is named in the policy when it is written.
A grace period of…days (the period varies according to premium payment frequency: seven days for weekly-premium policies; 10 days for monthly-premium policies; 31 days for all other policies) will be granted for the payment of each premium falling due after the first premium, during which grace period the policy shall continue in force.
A policy that contains a cancellation provision may add the following at the end of the above provision: “subject to the right of the insurer to cancel in accordance with the cancellation provision hereof.”
A policy in which the insurer reserves the right to refuse any renewal shall have the following at the beginning of the above provision: “unless not less than five days prior to the premium due date the insurer has delivered to the insured, or has mailed to the last address as shown by the records of the insurer, written notice of its intention not to renew this policy beyond the period for which the premium has been accepted.”
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Insurers must allow the insured a period of grace for premium payment. This is a specified time following the premium due date during which coverage remains intact. During a grace period, the company continues coverage in full force and will accept the premium from the policyowner just as if it were not late.
If a policy is cancelable, the grace period is subject to the policy’s cancellation provision. In an optionally renewable policy the company has decided not to renew, the company must follow certain steps to avoid having the grace period affect its right not to renew. The insurer is required to mail written notice of its intention not to renew to the insured’s last known address at least 5 days before the premium due date.
Before you read this provision, let’s cover some information not specifically mentioned in the provision itself. The insured, unlike the insurer, may cancel a policy at any time. In addition, the insured can simply refuse or fail to pay the premium when it is next due. When this occurs, we say that the policy has lapsed. Whether the policy is canceled by the insurer or the insured or it lapses, the end result is the same—the coverage terminates.
Because this provision is quite long, we’ll cover it in two parts. Here is the first portion:
If any renewal premium be not paid within the time granted the insured for payment, a subsequent acceptance of premium by the insurer or by any agent duly authorized by the insurer to accept such premium, without requiring in connection therewith an application for reinstatement, shall reinstate the policy; provided, however, that if the insurer or such agent requires an application for reinstatement and issues a conditional receipt for the premium tendered, the policy will be reinstated upon approval of such application by the insurer or, lacking such approval, upon the 45th day following the date of such conditional receipt unless the insurer has previously notified the insured in writing of its disapproval of such application.
A lapsed policy is reinstated when either the company or the company’s agent accepts subsequent premiums unless an application for reinstatement is required. In that case, a conditional receipt would be issued to the insured and the insurer has 45 days to notify the applicant of a denial or the policy is automatically reinstated.
The reinstated policy shall cover only loss resulting from such accidental injury as may be sustained after the date of reinstatement and loss due to such sickness as may begin more than 10 days after such
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date. In all other respects the insured and insurer shall have the same rights thereunder as they had under the policy immediately before the due date of the defaulted premium, subject to any provisions endorsed hereon or attached hereto in connection with the reinstatement. Any premium accepted in connection with the reinstatement shall be applied to a period for which premium has not been previously paid, but not to any period more than 60 days prior to the date of reinstatement The last sentence of the above may be omitted from policies guaranteed renewable to age 50, or if issued after age 54, guaranteed renewable for at least five years.
When the policy is reinstated, there is a 10-day waiting period for sickness coverage but no waiting period for accident coverage.
Otherwise, both the insurer and the insured have all the same rights each had the day before the policy lapsed, subject to any endorsements or riders attached at the time of reinstatement.
This lengthy provision is also presented in two parts. Here is the first portion:
Written notice of claim must be given to the insurer within 20 days after occurrence or commencement of any loss covered by the policy, or as soon thereafter as is reasonably possible. Notice given by or in behalf of the insured or the beneficiary to the insurer at . . . . . . . . (insert the location of such office as the insurer may designate for the purpose), or to any authorized agent of the insurer, with information sufficient to identify the insured, shall be deemed notice to the insurer.
If reasonably possible, the insured must give written notice of claim to the insurer or agent within 20 days after a loss.
Here is the remainder of Required Uniform Provision 5. Policies providing loss-of-time benefits payable for at least 2 years may insert the following between the first and second sentences of the above provision:
Subject to the qualifications set forth below, if the insured suffers loss of time on account of disability for which indemnity may be payable for at least two years, he or she shall, at least once in every six months after having given notice of claim, give to the insurer notice of continuance of said disability, except in the event of legal incapacity. The period of six months following any filing of proof by the insured or any payment by the insurer on account of such claim
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or any denial of liability in whole or in part by the insurer shall be excluded in applying this provision. Delay in the giving of such notice shall not impair the insured’s right to any indemnity which would otherwise have accrued during the period of six months preceding the date on which such notice is actually given.
The essence of this provision is that if the policy provides disability income for an extended period, the insurer can require that the insured provide, every 6 months, written notice that the claim is continuing. This provision does not apply when the insured suffers a legal incapacity.
The insurer, upon receipt of a notice of claim, will furnish to the claimant such forms as are usually furnished by it for filing proofs of loss. If such forms are not furnished within 15 days after the giving of such notice, the claimant shall be deemed to have complied with the requirements of this policy as to proof of loss upon submitting, within the time fixed in the policy for filing proofs of loss, written proof covering the occurrence, the character and the extent of the loss for which claim is made.
Insureds should be given forms to provide proof of loss within 15 days. If the insurer fails to do so, however, the insured must file his or her own written proof of loss.
Written proof of loss must be furnished to the insurer at its said office in case of claim for loss for which this policy provides any periodic payment contingent upon continuing loss within 90 days after the termination of the period for which the insurer is liable, and in case of claims for any other loss within 90 days after the date of such loss. Failure to furnish such proof within the time required shall not invalidate nor reduce any claim if it was not reasonably possible to give such proof within such time, provided such proof is furnished as soon as reasonably possible and in no event, except in the absence of legal capacity, later than one year
Normally, written proofs of loss must be furnished within 90 days after the date of loss. But when the claim involves periodic payments because of a continuing loss, proofs must be furnished within 90 days after the end of the period for which the company is liable.
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If it was not reasonably possible for the insured to provide proofs of loss within the time required, the claim is not invalidated. Still, unless the insured suffers legal incapacity, proofs of loss must be furnished no later than 1 year from the date they were otherwise due.
Indemnities payable under this policy for any loss other than loss for which this policy provides any periodic payment will be paid immediately upon receipt of due written proof of such loss. Subject to due written proof of loss, all accrued indemnities for loss for which this policy provides periodic payment will be paid…(insert period for payment, which must not be less frequently than monthly) and any balance remaining unpaid upon the termination of liability will be paid immediately upon receipt of due written proof.
According to this provision, except for claims involving periodic payments over a specified time span, the insurer must make the payment immediately after receiving proof of loss. Payment of periodic indemnities (for disability, for instance) must be made at least monthly.
This long provision actually contains both a required portion and two optional paragraphs. Here is the required section:
Indemnity for loss of life will be payable in accordance with the beneficiary designation and the provisions respecting such payment which may be prescribed herein and effective at the time of payment. If no such designation or provision is then effective, such indemnity shall be payable to the estate of the insured. Any other accrued indemnities unpaid at the insured’s death may, at the option of the insurer, be paid either to such beneficiary or to such estate. All other indemnities will be payable to the insured.
This required portion of the provision states that
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➤ While the insured is alive, all other benefits are paid to the insured unless otherwise specifically designated in the policy.
Here is the first of the two optional paragraphs that are included in Required Provision 9:
If any indemnity of this policy shall be payable to the estate of the insured, or to an insured or beneficiary who is a minor or otherwise not competent to give a valid release, the insurer may pay such indemnity, up to an amount not exceeding $…(insert an amount which shall not exceed $1,000), to any relative by blood or connection by marriage of the insured or beneficiary who is deemed by the insurer to be equitably entitled thereto. Any payment made by the insurer in good faith pursuant to this provision shall fully discharge the insurer to the extent of such payment.
This first optional paragraph is often called the facility of payment clause because it makes claim payment easier under the circumstances described. It stipulates the following:
If a claim is paid under this provision, the payment absolves the company of further liability.
Here is the second of the optional paragraphs that may be included with Required Provision 9:
Subject to any written direction of the insured in the application or otherwise, all or a portion of any indemnities provided by this policy on account of hospital, nursing, medical or surgical services may, at the insurer’s option, and unless the insured requests otherwise in writing not later than the time of filing proofs of such loss, be paid directly to the hospital or person rendering such services but it is not required that the service be rendered by a particular hospital or person.
According to this second optional paragraph, unless the insured specifically directs otherwise, the company may pay benefits to a hospital or person rendering medical or surgical services. However, the company may not require that the insured enter a specific hospital or see a particular doctor.
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The insurer at its own expense shall have the right and opportunity to examine the person of the insured when and as often as it may reasonably require during the pendency of a claim hereunder and to make an autopsy in case of death where it is not forbidden by law.
While the insured is alive and receiving benefits, the insurer may require that he or she submit to a physical examination.
If an insured has died, apparently accidentally, the insurer may have an autopsy performed to determine the exact cause of death.
No action at law or in equity shall be brought to recover on this policy prior to the expiration of 60 days after written proof of loss has been furnished in accordance with the requirements of this policy. No such action shall be brought after the expiration of three years after the time written proof of loss is required to be furnished.
This provision prohibits the insured from suing the insurer within less than 60 days or more than 3 years after filing a written proof of loss.
Unless the insured makes an irrevocable designation of beneficiary, the right to change of beneficiary is reserved to the insured and the consent of the beneficiary or beneficiaries shall not be requisite to surrender or assignment of this policy or to any change of beneficiary or beneficiaries, or to any other changes in this policy.
The policyowner, who is usually the insured, may name a beneficiary either revocably, which means that the insured can change the beneficiary later, or irrevocably, which means the beneficiary designation may not be changed. In other words, the right to change the beneficiary or dispose of the policy or its benefits in any manner one chooses is reserved to the insured unless he or she has named an irrevocable beneficiary.
Suppose Ben has named his wife the irrevocable beneficiary of the accidental death benefit of his health insurance policy. Now he wants to obtain a large loan and the lender agrees to make the loan if Ben will assign any pay
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ments under his policy to the lender. Ben may assign the policy only with his wife’s permission.
The optional provisions are not required to be included in the policy, but if the subject of any of them is contained in the policy, it must be worded in accordance with the wording of the appropriate optional provision.
Here is the first optional provision:
If the insured be injured or contract sickness after having changed his or her occupation to one classified by the insurer as more hazardous than that stated in this policy, or while doing for compensation anything pertaining to an occupation so classified, the insurer will pay only such portion of the indemnities provided in this policy as the premium paid would have purchased at the rates and within limits fixed by the insurer for a more hazardous occupation. If the insured changes an occupation to one classified by the insurer as less hazardous than that stated in this policy, the insurer, upon receipt of proof of such change of occupation, will reduce the premium rate accordingly, and will return the excess pro rata unearned premium from the date of change of occupation or from the policy anniversary date immediately preceding receipt of such proof, whichever is the more recent.
In applying this provision, the classification of occupational risk and the premium rates shall be such as have been last filed by the insurer prior to the occurrence of the loss for which the insurer is liable, or prior to date of proof of change in occupation with the state official having supervision of insurance in the state where the insured resided at the time this policy was issued; but if such filing was not required, then the classification of occupational risk and the premium rates shall be those last made effective by the insurer in such state prior to the occurrence of the loss or prior to the date of proof of change in occupation.
This provision relieves the insurer from paying benefits not anticipated when the premium was established. If an insured’s occupation is more hazardous than the insurer knew, and resulted in injury or illness, the insurer might be required to pay a larger benefit than the premium warrants.
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When calculating how much of the extra premium to return, the company uses the more recent of
If the age of the insured has been misstated, all amounts payable under this policy shall be such as the premium paid would have purchased at the correct age.
When an insured is younger, a premium dollar buys a certain amount of insurance. As the insured ages, the same premium dollar buys less insurance. This provision is similar to the previous provision regarding a more hazardous occupation. If the insured has misstated his or her age on the application, the company may adjust benefits to the amount the premiums paid would have bought had the insured’s correct age been known.
Whether the insured misstated his or her age intentionally or unintentionally, the company adjusts benefits accordingly.
If an accident or sickness policy or policies previously issued by the insurer to the insured be in force concurrently herewith, making the aggregate indemnity for…(insert type of coverage or coverages) in excess of $…(insert maximum limit of indemnity or indemnities) the excess insurance shall be void and all premiums paid for such excess shall be returned to the insured or to the estate.
Or, insurance effective at any one time on the insured under a like policy or policies in this insurer is limited to one such policy elected by the insured, his or her beneficiary or estate, as the case may be, and the insurer will return all premiums paid for all other such policies.
This provision deals with insurance of the same type with the same insurer. If an individual has so much insurance that it is more profitable to see a doctor, enter a hospital, or stay home from work, there might be some tempta
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tion to do just that rather than to have a quick recovery. Such an individual is overinsured—a situation insurers try to avoid.
This optional provision allows an insurer to control overinsurance through its own policies. The company can establish maximum amounts payable to any one insured for certain coverages—disability income insurance being the most common—so no matter how many policies an insured has with this particular company, there is a limit on the amount of benefits that will be paid.
Either of the two provisions may be included in the policy. If the insurer chooses the first paragraph, it is the insurer’s responsibility to decide on the maximum indemnity that will be paid and the type of coverage to which the provision applies. If the insurer uses the second paragraph, coverage is limited to one policy as selected by the insured, the beneficiary, or the administrator of the insured’s estate.
Although the previous optional provision concerned overinsurance with the same insurer, the next two deal with other insurers. Because they are closely related, they are presented together.
If there be other valid coverage, not with this insurer, providing benefits for the same loss on a provision of service basis or on a expense-incurred basis and of which this insurer has not been given written notice prior to the occurrence or commencement of loss, the only liability under any expense-incurred coverage of this policy shall be for such proportion of the loss as the amount which would otherwise have been payable hereunder plus the total of the like amounts under all such other valid coverages for the same loss, and for the return of such portion of the premiums paid as shall exceed the pro rata portion of the amount so determined.
For the purpose of applying this provision when other coverage is on a provision of service basis, the “like amount” of such other coverage shall be taken as the amount that the services rendered would have cost in the absence of such coverage.
If there be other valid coverage, not with this insurer, providing benefits for the same loss on other than an expense-incurred basis
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and of which the insurer has not been given written notice prior to the occurrence or commencement of loss, the only liability of such benefits under this policy shall be for such proportion of the indemnities of which the insurer had notice (including the indemnities under this policy) bear to the total amount of all like indemnities for such loss, and for the return of such portion of the premium paid as shall exceed the pro rate portion for the indemnities thus determined.
The essence of Optional Provisions 4 and 5 is this: If an insured has two or more policies from different companies that cover the same expenses, and if the insurers were not notified that the other coverage existed, each insurer will pay a proportionate share of any claim. Each company must also refund a proportionate share of the excess premiums on a pro rata basis.
The law allows an insurer to include a definition of other valid coverage to cover more than just another insurer’s individual health policy. This allows other benefit sources such as automobile coverage medical payments, union welfare plans, or Blue Cross/Blue Shield benefits to be taken into account.
This provision specifically concerns loss of time, or disability income, coverage:
If the total monthly amount of loss of time benefits promised for the same loss under all valid loss of time coverage upon the insured, whether payable on a weekly or monthly basis, shall exceed the monthly earnings of the insured at the time disability commenced, or the average monthly earnings for the period of two years immediately preceding a disability for which claim is made, whichever is greater, the insurer will be liable only for such proportionate amount of such benefits under this policy as the amount of such monthly earnings or such average monthly earnings of the insured bears to the total amount of monthly benefits for the same loss under all such coverage upon the insured at the time such disability commences, and for the return of such part of the premiums paid during such two years as shall exceed the pro rata amount of the premiums for the benefits actually paid hereunder; but this shall not operate to reduce the total monthly amount of benefits payable under all such coverage upon the insured below the sum of $200 or the sum of the monthly benefits specified in such coverages,
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whichever is the lesser, nor shall it operate to reduce benefits other than those payable for loss of time.
This optional provision is also designed to prevent overinsurance malingering— remaining disabled in order to collect insurance. The provision specifically addresses the relationship between what the insured actually has been earning on the job and the amount of insurance available by failing to return to work.
The insurer may define “all valid loss of time coverage” to take into account other benefit sources such as workers compensation, union welfare plans, or employee benefit payments.
Because this provision allows for computation of the insured’s average earnings over the course of two years, it is often called the average earnings clause.
Upon the payment of a claim under this policy, any premium then due and unpaid or covered by any note or written order may be deducted therefrom.
This simple optional provision enables an insurer to deduct premiums that are due or past due as part of settling a claim.
Let’s break this optional provision into two parts. Here is the first part:
The insurer may cancel this policy at any time by written notice delivered to the insured or mailed to the last address as shown by the records of the insurer, stating when, not less than five days thereafter, such cancellation shall be effective; and after the policy has been continued beyond its original term the insured may cancel this policy at any time by written notice delivered or mailed to the insurer, effective upon receipt or on such later date as may be specified in such notice.
Although this provision may not be used in noncancelable policies, in policies that may be canceled, the insurer may do so by delivering (usually by mail) written notice to the insured’s last known address. Cancellation is effective no fewer than 5 days after the date of notice.
In the event of cancellation, the insurer will return promptly the unearned portion of any premium paid. If the insured cancels, the earned premium shall be computed by the use of the short rate table
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last filed with the state official having supervision of insurance in the state where the insured resided when the policy was issued. If the insurer cancels, the earned premium shall be computed pro rata. Cancellation shall be without prejudice to any claim originating prior to the effective date of cancellation.
When the insurance company cancels, the portion of the premium dollar the insurer has already earned is kept by the insurer and the entire unearned portion is returned to the insured. This is a pro rata return.
When the insured cancels, the insurance company is allowed to retain a portion of premium over and above that which it has earned. The insurer keeps earned premium and a portion of unearned premium, returning the balance of unearned premium to the insured. This is a short-rate return.
A flat cancellation means that a policy is canceled as of its effective date. Usually this means that no premium is charged. For example, when an insured returns a policy during a free-look period, any premium payment will be fully refunded.
Any provision of this policy which, on its effective date, is in conflict with the statutes of the state in which the insured resides on such date is hereby amended to conform to minimum requirements of such statutes.
Although this provision is usually optional, some states insist that it be included in all policies. Not only does the provision help insurers avoid issuing policies that conflict with existing state laws, it can also prevent reissuing policies that are in conflict with any ruling enacted during the time a policy is being or is about to be issued.
The provision applies to the laws of the insured’s state of residence.
The insurer shall not be liable for any loss to which a contributing cause was the insured’s commission of or attempt to commit a felony or to which a contributing cause was the insured’s being engaged in an illegal occupation.
Suppose Dan’s policy contains this provision. Dan’s application stated that he is the proprietor of a small newsstand. After Dan was severely beaten one night by someone who apparently was trying to rob him, he applied for ben
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efits under the hospital and medical provisions of his policy. Upon investigating the incident, police discover that Dan was using his newsstand simply as a front. His real employment is fencing stolen goods, and the beating he suffered was the result of a quarrel with other criminals. Because Dan was engaged in an illegal occupation that contributed to his injury, the insurer will not pay his claim.
The insurer shall not be liable for any loss sustained or contracted in consequence of the insured’s being under the influence of any narcotic unless administered on the advice of a physician.
Injuries or death resulting while the insured is under the influence of either alcohol or narcotics are commonly excluded.
There are a few other policy provisions or concepts you should be aware of that relate to health insurance but are not part of the required or optional provisions specified by law.
The face of the policy is a standard printed form containing the name of the insurance company and providing enough information to give the insured a capsule summary of what type of policy and what type of coverage is provided by the contract. The policy face identifies the insured and states the term of the policy (when it goes into effect and when coverage expires). The policy face also states how the policy can be renewed.
The policy face usually gives a brief statement of the type or types of benefits. However, it is essential to examine the benefit provisions within the body of the contract to obtain a complete understanding of the coverage provided.
As mentioned previously, many states require that health policies contain a free-look provision, allowing individuals to look over the policy for a specified period with the right to refuse it. Usually, this is a 10-day trial period, and in some states, may be a 15- or 20-day period, beginning on the day the
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individual receives the policy. If the individual decides to return the policy by the end of the trial period, he or she receives a full refund of the prepaid premium.
If the individual cancels during the trial period, the insurance company is not liable for any claims originating during that period.
The insuring clause is usually the initial policy clause. In general, it represents the insurer’s promise to pay under the conditions stipulated in the policy.
The insuring clause performs these functions:
In health insurance, the insurance company exchanges the promises in the policy for a two-part consideration from the insured. A health insurance contract is valid only if the insured provides consideration in the form of both of the following:
A number of policy provisions may affect policy continuation.
To remain in force, health policies must be renewed periodically; that is, the coverage remains in force only for the length of time for which premiums have been paid.
A policyowner has the option of canceling a policy at any time by so notifying the insurer, as well as allowing it to lapse at a premium due date by not paying the premium.
When the insurer has the option to refuse to renew, the policy may be one of two types:
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To protect the insured when a valid claim is being paid or is eligible for payment at the time the premium is due, the claim will be paid even if the insurer elects not to renew the policy.
With a cancelable policy, the insurer may cancel coverage at any time, provided it returns any unearned premiums to the insured.
In some policies, the insurer relinquishes its rights to cancel at any time and to refuse renewal at a premium due date. This type of policy is called guaranteed renewable, and it includes several important features:
Nonpayment of premium is the only reason an insurer may cancel or refuse to renew a guaranteed renewable policy. Furthermore, the insurer is not permitted to increase the premiums based on the individual insured’s experience. It may, however, increase the premiums on a class basis. One common classification, for example, is by occupational groups.
The terms noncancelable and noncancelable and guaranteed renewable are often used interchangeably to describe a noncancelable policy. There is one important difference, however. With a guaranteed renewable policy, the insurer may increase the premiums by classifications. With a noncancelable policy, however, the insurer may never increase the premiums. Other features of noncancelable policies are the same as for guaranteed renewable policies.
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Coverage that extends only for a specified length of time is called term insurance. A term health policy cannot be renewed at all. When it expires, the insured must purchase another policy. Flight insurance is a well-known example of term accident insurance.
Health insurance benefits are paid differently depending on the type of policy. How benefits will be paid is set out in the policy’s benefits provision.
Typically, benefits are paid in the form of
By definition, a preexisting condition is any condition for which the insured sought treatment or advice prior to the effective date of the policy. Further, a preexisting condition can also be defined as any symptom that would cause a reasonable and prudent person to seek diagnosis and medical treatment.
Preexisting conditions may be covered by the insurer if they are indicated on the application. The insurer will then review the medical information and, depending on the condition, may elect to cover the problem or exclude it.
Many insurance companies won’t assume the risk of covering people such as steeplejacks for the hazards involved in their occupations. To provide these individuals with general accident and sickness and/or disability income coverage, some companies issue policies that contain a provision excluding job-related injuries.
In order to control the costs associated with medical care, many insurers are instituting provisions to reduce costs while giving the insured options for
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health care. These provisions are variously called case management, managed care, claims control, cost containment, or similar terms.
The second surgical opinion is a provision that can be included in policies that offer surgical expense benefits. This coverage allows the insured to consult a doctor, other than the attending physician, to determine alternative methods of treatment. Although the use of this provision is sometimes optional, it is more often mandatory for certain procedures, such as tonsillectomy, cataract surgery, coronary bypass, mastectomy, and varicose veins.
One cost control mechanism being used by insurers and employers is utilization review. Utilization review consists of an evaluation of the appropriateness, necessity, and quality of health care, and may include preadmission certification and concurrent review.
Under the precertification provision (also known as precertification authorization or prospective review), the physician can submit claim information prior to providing treatment to know in advance whether the procedure is covered under the insured’s plan and at what rate it will be paid. This provision allows the insurance company to evaluate the appropriateness of the procedure and the length of the hospital stay.
Under the concurrent review process, the insurer will monitor the insured’s hospital stay to make sure that everything is proceeding according to schedule and that the insured will be released from the hospital as planned.
Ambulatory outpatient care is the alternative to the costly inpatient diagnostic testing and treatment. Today, ambulatory care is best known to operate in hospital outpatient departments. However, this care can be provided by special ambulatory care health centers, group medical services, hospital emergency rooms, multispecialty group medical practices, and health care corporations.
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1. The grace period varies according to
2. Mike allows his policy to lapse and then applies for reinstatement using the company’s required application. The company does not inform Mike either that the policy has been accepted or that the policy is being rejected. At what point can Mike consider the policy reinstated?
3. The maximum time during which suit can be filed is
4. Which of the following is not a required provision under the Uniform Provisions Model Act?
5. Which of the following is an optional provision under the Uniform
Provisions Model Act?
6. Cindy has a claim for $2,000, and a past due premium of $200. The
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7. If Lois cancels her health insurance policy, the insurer will
8. Carmen gets her health insurance policy on May 1, and on May 3 she decides she doesn’t want it and returns it to the company. On May 6, she is hit by a car. The company
9. CeeCee’s policy is guaranteed renewable. Which of the following may the insurer not do?
10. George has a noncancelable policy. Which of the following may the insurer do?
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|Terms you need to understand:|
|✓||Probationary period||✓||Long-term disability|
|✓||Elimination period||✓||Rehabilitation benefit|
|✓||Benefit period||✓||Future increase option|
|✓||Total disability||✓||Cost of living benefit|
|✓||Presumptive disability||✓||Social security rider|
|✓||Partial disability||✓||Social insurance supplement|
|✓||Residual disability||✓||Additional monthly benefit rider|
|✓||Recurrent disability||✓||Hospital confinement rider|
|✓||Permanent disability||✓||Impairment rider|
|✓||Temporary disability||✓||Nondisabling injury rider|
|✓||Accidental injury||✓||Waiver of premium rider|
|✓||Sickness||✓||Accidental death and dismemberment rider|
|Concepts you need to master:|
|✓||Own occupation||✓||Business overhead expense|
|✓||Any occupation||✓||Key person disability insurance|
|✓||Lump-sum benefit||✓||Disability buy-sell insurance|
|✓||Lifetime benefits||✓||Disability reducing term insurance|
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Disability is often called “the living death.” Earning power, in a sense, dies while life goes on—expenses continue and may even increase.
Disability income insurance is available to continue a portion of earnings while an insured is disabled. Disability income insurance, sometimes referred to as loss of time coverage, is designed to protect an individual’s most important asset—the ability to earn an income.
A family’s future is at stake when the ability to work is in peril. Here are some practical considerations in determining disability income needs:
The following are options people might consider if they develop a disability:
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the market might be down for the stocks, real estate, or other asset to be
Disability income insurance can be defined as a contract that normally pays a monthly benefit, following the elimination period, for total disability due to accident or sickness. Disability benefits may also be paid for partial or residual disability as well as total disability.
An understanding of each of these terms is important because as a producer, you must be able to explain to the insured how this policy will work if he or she becomes disabled. Benefits will be paid in accordance with the policy’s terms and conditions.
A probationary or qualification period may be found in some disability income policies. It is a time period that begins when a policy goes into effect. During this period, no benefits will be paid under the policy. The period is often 15 or 30 days, or even 60 days for long-term policies. This probationary period generally applies to sickness, but not to accidents. Its major purpose is to relieve the insurance company from paying benefits for preexisting conditions—health problems that existed prior to the policy’s inception.
An elimination period is the period of time an insured person must be disabled before benefits begin. The elimination period may be thought of as a time deductible rather a dollar deductible, because benefits are not payable for the elimination period.
The elimination period may be 30, 60, 90, or 180 days, or longer depending on the period elected by the insured. The longer the elimination period, the smaller the insurance premium, because the insured is willing to go without benefits for a longer period of time and the insurer will not have to pay for short-term claims.
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After the elimination period has been satisfied and monthly disability benefits begin, they will be paid for a specific period of time, provided the insured remains totally disabled. This period of time is known as the benefit period.
Typical benefit periods are 1 year, 2 years, 5 years, and to age 65.
Because the major purpose of disability income policies is to provide income when the insured is totally disabled and unable to work, the meaning of total disability is important.
Total disability is always defined in the policy, and different companies may use different definitions. These definitions are based on work activity, and insurers look at work activity in terms of two dimensions: the insured’s own occupation and any occupation the insured may be qualified to perform.
The first way total disability might be defined concerns the occupation in which the particular individual is normally engaged. In this case, total disability is defined as the insured’s inability to perform any or all of the duties of his or her own occupation.
An alternative and more restrictive definition of total disability is the insured’s inability to perform the duties of any occupation for which he or she is reasonably qualified by education, training, or experience.
The term own occupation, which is less restrictive and therefore more favorable to the insured, is more commonly used than the term any occupation. Long-term policies generally use both definitions to cover different periods during the insured’s disability. The term own occupation is generally used for the initial period of disability, which might extend from 2–5 years as stated in the policy. The term any occupation applies to disability continuing beyond the initial period.
Some policies use a two-tier definition that refers to the insured’s own occupation during an initial period of disability and then shifts to any occupation.
These policies usually define total disability as the inability to perform the duties of the insured’s own occupation for a period of 2–5 years, and there
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after the inability to perform the duties of any occupation for which the insured is suited by reason of education, training, experience, or prior economic status. This is known as the loss of earnings test for disability.
Total disability is occasionally further defined in terms of its cause. Some policies may cover only—or cover differently—disability caused by accidental injury, and some may cover only disability caused by sickness.
Although short-term policies often cover only nonoccupational disability, most long-term plans cover both occupational and nonoccupational sickness and accidents. When occupational benefits are provided, they are often reduced by benefits received from workers compensation and social security.
Some older policies also require that in addition to meeting the definition of total disability, the insured must also be confined to the house and under the treatment of a doctor. This is called medically defined disability.
Many disability income policies have a classification called presumptive disability, which automatically qualifies the insured for total disability regardless of whether he or she can work. Conditions that are generally considered to be presumptive disabilities are
Presumptive disability may also be determined using a loss of earnings test. The insured’s level of earnings prior to disability is compared to his or her level of earnings after disability. If post-disability earnings fall below pre-disability earnings by a given percentage, the insured is considered totally disabled.
Some people may suffer only a partial disability. This means the person
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Partial disability is generally not a factor in sickness disability. The insured usually either is or is not sick enough to stay off the job. The usual partial disability indemnity is 50% of the monthly or weekly indemnity for total disability.
Many recent policies have replaced the partial disability provision with a residual disability provision. A residual disability benefit is usually a percentage of the total disability benefit as defined in the policy.
Earnings during partial disability must be at least a stated percentage less than earnings prior to disability—20% less, for example. The percentage of reduction in earnings is multiplied by the normal benefit to determine the residual benefit. If the normal benefits were $1,000 per month, and the insured had a 20% reduction in earnings, the residual benefit would be $200—20% × $1,000.
When a second period of disability arises due to the same or a related cause of a prior disability, the second event is called a recurrent disability.
Most disability income policies stipulate that if the insured returns to work for a specified period of time after the original disability, a recurrence must be handled as a new claim for a new period of disability requiring a new elimination period, rather than as a continuation of a prior claim. Usually, the specified period is 90 days, although some insurers permit 6 months.
A permanent disability is one that reduces or eliminates the insured’s ability to work for the rest of his or her life. Permanent disability results from any injury from which the insured is not expected to recover, such as loss of sight or one or more limbs.
A temporary disability occurs when an insured is unable to work while recovering from an illness or injury, but is expected to fully recover from that illness or injury.
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Some policies may include a provision that differentiates between disabilities in still another way—whether the disability is confining or nonconfining.
A total, confining disability refers to a condition that requires the individual to stay indoors, perhaps in the hospital or at home except for visits to the doctor.
A total, nonconfining disability refers to a condition that disables but does not require the individual to remain confined indoors.
Of the different terms used to define accident, the two that will be discussed here are accidental bodily injury and accidental means.
A policy that includes the accidental means wording is more restrictive than one that refers simply to accidental bodily injury.
For example, Mary is carrying a heavy bag of groceries and strains her back. This accident would be defined as accidental bodily injury because Mary did not intentionally strain her back. However, although the injury was caused by accident it could not be defined as accidental means because the cause of the accident was foreseeable. The term accidental bodily injury encompasses almost all but self-inflicted injuries, subject to any other events the policy excludes. Accidental means, on the other hand, involves a more literal interpretation of accident—an event that is completely unforeseen and unintended.