1. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? A life insurance policy is a contractual promise by an insurance company or beneficial association to pay a specified amount of money to a designated beneficiary when the insured person dies. –The contract is between the insurance company and the policyowner who pays premiums in exchange for the promised death benefits. The policyowner is often the person insured, but the policy can be owned by someone, or some entity, other than the insured.

2. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 What is it? Premiums from all contracts are combined into a general account of the insurance company. –This account, in addition to growth/earnings on the investments, is designed to provide adequate funds to pay the promised death benefits as they come due and also cover insurance company expenses.

3. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 What is it? The death benefit is almost always larger than the cumulative premiums paid for an individual policy. –A relatively small percentage of insureds actually die in any one year. Most of the policyowner premiums are collected in the general account and are saved for payment as a death benefit in the future. –Most individuals will live many years before a claim must be paid. The insurance company will accumulate a large number of premiums over time and will have a great deal of time to accumulate additional growth on the invested premiums.

4. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 What is it? When the pricing structure is applied to a large number of policyowners, the individual fluctuations tend to offset each other and the inflows and outflows become extremely predictable when averaged over the aggregate. The primary method of differentiating life insurance policies is as either term or permanent insurance.

5. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 What is it? Term insurance –Generally purchased for a certain (and limited) term of time Example: 5, 10, 20, or 30 years or until age 70 Permanent insurance –Generally meant to be “permanent” –There is a “cash value” associated with the policy May be available to some extent to the policyowner –Permanent policies are typically separated into four categories: Whole life Interest-sensitive or current-assumption whole life Universal life Variable life

6. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 What is it? Another method of classification is by the number of lives insured. –Most policies cover only one life. –Joint life policy Covers two individuals Pays a death benefit at the first death only –Joint survivorship policy (2 nd -to-die or last-to-die policy) Covers two individuals Is not payable until the death of the second (or last) of the insureds

7. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company7 When is the use of this tool indicated? When an individual wants to provide income for dependent family members after the head of the household dies. –Typically until they become self-supporting When an individual wants to liquidate consumer or business debts or mortgages, or to create a fund that will enable his or her family to do so, at the individual’s death. When an individual wants to provide large amounts of cash at death for college expenses or other capital needs

8. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company8 When is the use of this tool indicated? When an individual wants to create an estate (or a larger estate) for surviving heirs. When cash is needed as a liquid source to pay federal and/or state death taxes. When an individual wants to provide funds for remaining (or successor) business partners or owners to buy out the estate’s (or spouse’s) share of the business at the death of the owner/partner under a “buy-sell” agreement. –The insurance may be owned by and payable to the other/successor business partners, or the business itself, or a trust.

9. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company9 When is the use of this tool indicated? When a business seeks economic indemnification for the loss of a key individual. –Known as “key person” life insurance. –The insurance is owned by and payable to the business. –It insures the lives of employees or owners whose deaths could result in serious financial loss to the firm. When an employer seeks to recruit, retain, or retire one or more key employees through a salary continuation plan that will pay benefits to a spouse and/or dependents of a deceased owner or key employee. –The employer desires to transfer the risk of its obligations under the plan.

10. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company10 When is the use of this tool indicated? When a client is seeking an inexpensive and effective way to transfer large amounts of liquid capital to children, grandchildren, or others without the erosion often caused by probate costs, inheritance taxes, income taxes, federal estate taxes, transfer fees, or the generation-skipping transfer tax. When a client wants to provide greatly enhanced charitable gifts. –Using policies owned by the charity –Naming the charity as beneficiary or co-beneficiary of new or existing policies or riders.

11. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company11 Advantages Life insurance provides a guarantee of large amounts of cash payable immediately at the death of the insured. –The amount of the death benefit payable is almost always significantly greater than the premiums paid for the policy. Life insurance proceeds are not part of the probate estate when policy proceeds are payable directly to a specific beneficiary other than the insured’s estate. There will be no public record of the death benefit amount or to whom it is payable.

12. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company12 Advantages Life insurance policies offer protection against creditors of both the policyowner and of the beneficiary. –The amount of protection varies from state to state. –In many states, it is significant. Life insurance cash values provide virtually instant availability of cash through policy loans. –The interest rate for such loans is almost always lower than the rate on loans from other sources. The death benefit proceeds are generally not subject to federal income taxes. –Subject to the transfer-for-value rules

13. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company13 Advantages The increases in the cash value of a life insurance policy enjoy favorable federal income tax treatment. –Interest earned on policy cash values is not taxable unless or until the policy is surrendered for cash. –Subject to the modified endowment contract rules Life insurance proceeds are often exempt from state inheritance taxes. The guarantees and risk management provided by life insurance often brings peace of mind to the policyowner.

14. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company14 Advantages Permanent life insurance, with its cash value accumulations, can provide a method of “forced” savings that aid individuals in long-term savings. –Premiums must be paid anyway or the policy may lapse. –It is important that life insurance “savings” not be made to the detriment of other, more appropriate, savings plans.

15. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company15 Disadvantages Life insurance is often not available to persons in extremely poor health. –Individuals in moderately poor health can almost always obtain insurance if they are willing to pay higher premiums. –Extra charges, to take into consideration the extra risk assumed by the insurance company, are called “ratings.” Life insurance is a complex product that is hard to evaluate and compare. –The time required to gather policy information, decipher it, and compare it with other policies discourages comparison shopping.

16. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company16 Disadvantages The cost of coverage reduces the amount of funds available for current consumption or investment for the future.

17. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company17 Tax Implications No tax deduction is permitted for premium payments on life insurance policies. –Exception: The premium payment on group term life insurance provided by an employer to employees is income tax deductible. Dividends received by the policy owner on a mutual policy are considered a return of premium. –Repayments of this nature are not subject to federal income taxation. Unless the aggregate of dividends paid (and other amounts withdrawn) exceeds the aggregate of premiums paid by the policyowner. –Income tax free dividend distributions reduce the cost basis of the life insurance policy for future gain/loss determination.

18. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company18 Tax Implications Cash value increases on an in-force life insurance policy resulting from investment income are not taxable income. –The cash value build-up in the policy: Enjoys deferral from taxation while the policy remains in force Is exempt from income tax if the policy terminates in a death claim. –If the policy is surrendered for cash, the gain on the policy is subject to federal income taxation. The gain on a surrendered policy is the amount by which the sum of the net cash value payable and policy loan forgiveness exceeds the owner’s basis in the policy. The gains are taxed as ordinary income, while losses are not deductible. –Basis = premiums paid – policyholder dividends – other amounts previously withdrawn

19. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company19 Tax Implications Death benefits payable under a life insurance policy are generally free from federal income taxation. –Proceeds from corporate-owned life insurance policies can increase “adjusted current earnings,” a portion of which may be taxed under the corporate “alternative minimum tax” (AMT). The AMT is generally applicable only if there are large amounts of preferentially treated items relative to the regular corporate income tax. Unless certain requirements are met, the death benefits payable under an employer-owned life insurance contract will be included in the employer’s income to the extent the death proceeds exceed the amounts that were paid for the policy (including premiums).

20. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company20 Tax Implications Transfer-for-value rule –Death proceeds of a policy transferred to certain non-exempt parties for a valuable consideration are taxed as ordinary income to the extent the death proceeds are greater than the purchase price plus premiums and certain interest amounts relating to policy indebtedness paid by the transferee. –Certain parties are exempt from the rule: The insured A partner of the insured A partnership in which the insured is a partner A corporation in which the insured is a shareholder or officer Any party whose basis is determined by reference to the original transferor’s basis (a gift transfer)

21. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company21 Tax Implications The proceeds of a life insurance policy will be included in the estate of the insured for federal estate tax purposes if the insured held any “incident of ownership” at death or at any time during the 3 years prior to death, or if the proceeds were payable to or for the benefit of the estate of the insured. –Incidents of ownership Change the beneficiary Take out a policy loan Surrender the policy for cash Pledge the policy for a loan

22. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company22 Tax Implications Distributions from a life insurance policy classified as a modified endowment contract (MEC) may be taxed differently than if the policy is not so classified. –If a policy is entered into after June 21, 1988 and fails the seven-pay test, it falls into this category and will be taxed less favorably. Failure of the seven-pay test: The cumulative amount paid at any time during the first seven years of the contract exceeds the net level premiums that would have been paid during the first seven years if the contract provided for paid-up future benefits.

23. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company23 Tax Implications –The distributions are taxed as income at the time received to the extent that the cash value of the contract immediately before the payment exceeds the investment in the contract. Penalty tax of 10% applies unless the taxpayer is disabled, over 59 ½, or the distribution is part of a series of equal payments made over taxpayer’s life. –Proceeds paid as a death claim are still tax-exempt.

24. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company24 Alternatives There are no good alternatives to life insurance for providing large amounts of tax-free cash upon death, and for ensuring that a set amount of assets will be available for beneficiaries regardless of when an individual might die. –If an individual is uninsurable, the best alternatives are Accumulation funds Tax-deferred investments Certain forms of guaranteed issue life insurance Alternative investments that incorporate some type of life insurance benefit without underwriting. –Almost any individual who is not terminally ill can purchase some amount of insurance with the payment of the appropriate additional premium.

25. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company25 Where and How do I get it? Direct purchase –Commercial insurance companies –Fraternal organizations –Savings banks Indirect purchase –Professional associations –Membership organizations –Employer group benefit packages

26. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company26 Where and How do I get it? Insurers are generally represented by agents, brokers, and financial planners or agents. For persons with health problems, there are: –Agents who specialize in what is called the “substandard” market –Credit life insurance: Extremely expensive “group insurance” associated with loans for the purchase of automobiles, furniture, and even homes

27. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company27 What fees or other costs are involved? Life insurance is generally sold on a specified price basis. –Companies are free to set their premiums according to their own marketing strategies. “Loading” –Included as a specified part of each premium payment –Covers such things as commission payments to agents, premium taxes payable to the state government, operating expenses, other applicable expenses, and a profit margin for the insurance company

28. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company28 What fees or other costs are involved? “No load” life insurance policies –Do not provide a commission to the selling agent –A cost premium is priced in that approximates the charge by those companies who do pay commissions to agents Covers other marketing costs which are necessary to secure sales to consumers when commissioned insurance agents are not used The bulk of an insurance company’s expenses for a policy are incurred during the year the policy is issued. –It may take an insurance company 5-9 years or longer to recover all of its front-end costs. –These costs include the commission paid to the insurance agent, the internal costs for the entire underwriting process, and administrative work.

29. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company29 What fees or other costs are involved? The state premium tax applicable to all life insurance premium payments is an ongoing expense. –The average level of this tax is about 2.5% of each premium payment. With most cash value policies, the aggregate of commissions payable to the selling agent is approximately equal to the first year premium on the policy. –About half is payable in the year of sale and the other half will be paid on a renewal basis over a period of 3-9 years –Usually ranges between 2 to 8% of the premium

30. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company30 How do I select the best of its type? Policy selection should be broken down into two components: –Stage One: The planner should find the appropriate type or combination of types of policies suitable for the needs of the client. –Stage Two: The planner should focus on the selection of the specific policy that “best” solves the client’s needs.

31. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company31 How do I select the best of its type? When seeking appropriate types of policies, the planner should consider: –Total death benefit required –Duration of the need –The preferences of the client as to living benefits –The amount of premiums the client can afford and the client’s cash-flow abilities and timing preferences. –The type and amount of investment and other risk the client is willing to assume in return for potential enhanced cash value, dividend, and death benefits.

32. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company32 How do I select the best of its type? Some generally accepted rule-of-thumb guidelines in policy selection are: –For durations of 10 years or less, term insurance is usually appropriate. –For durations between 10 and 15 years, both term insurance and cash value coverage should be evaluated. –For durations in excess of 15 years or when it is impossible to ascertain how long coverage will be needed, cash value forms of coverage are usually more cost effective than term.

33. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company33 How do I select the best of its type? –Clients who prefer maximum premium flexibility and death benefit flexibility will want to consider some form or combination of universal life and variable universal life. –Clients preferring to direct the investments behind the policy and who are willing to assume the investment risk will want to consider variable life insurance (such as variable universal life or variable whole life). –Clients desiring a maximum of guarantees and a minimum of risk assumption will prefer the more traditional contracts such as whole life and level term.

34. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company34 How do I select the best of its type? Selecting a specific policy involves a combination of factors that include: –An evaluation of the insurance company’s financial soundness –A comparison of policy guarantees and projections (benefit promises) The company should generally have one of the highest ratings from one or more of the following companies: –A.M. Best Company –Standard & Poor’s –Moody’s Investor’s Service –Fitch, Inc. –Weiss Research, Inc.

35. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company35 How do I select the best of its type? The agent should have experience with life insurance, a minimum of 3 years experience, and be well versed in both insurance knowledge and tax knowledge at the federal and state levels. –Should have, or be working on obtaining, a CFP, CLU or ChFC designation

36. Life Insurance Chapter 18 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company36 Where can I find out more about it? The Tools and Techniques of Life Insurance Planning Tax Facts on Insurance & Employee Benefits Life and Health Insurance Life Insurance: A Consumers Handbook Best’s Insurance Reports Journal of Financial Service Professionals Tax Planning with Life Insurance The Lawyer’s Guide to Insurance