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In the past, if a policyholder missed a premium payment and the grace period ended, the policy would lapse, and they would lose any accumulated equity. To address this, many states adopted the standard non-forfeiture law, allowing policyholders to access their cash value even if they stop paying premiums. The cash value and its growth rate depend on the policy type and company, and any loans taken out will reduce the cash value.
Insurers must offer cash surrender values for whole life insurance after three years, though some policies generate cash values within a year. There are three non-forfeiture options for policyholders who surrender their whole life policy: surrender for cash, reduced paid-up insurance, and extended term insurance. These options ensure that policyholders do not lose their accumulated cash value or equity. Once a policy is surrendered, it cannot be reinstated. Non-forfeiture options guarantee that a policy with cash value will not lapse, recognizing the equity built up in the policy.
Policy owners may request an immediate cash payment of their cash values when their policies are surrendered. Any outstanding policy loans or debts reduce the amount of cash value that the policy owner will receive.
The cost recovery rule states that when a life policy is surrendered for its cash value, the cost basis (total premiums paid) is exempt from taxation. If the amount received in a cash surrender is greater than the total of premiums paid (minus dividends paid), the excess is taxable as ordinary income. A partial surrender will allow the policy owner to withdraw the policy's cash value interest-free.
A second non-forfeiture option is to accept a paid-up policy for a reduced face amount of insurance. By doing this, the policy owner uses the policy's cash value as the premium for a single-premium whole life policy at a lesser face amount than the original policy. When this option is exercised, the paid-up policy is a cash value policy like the original, but for a lesser amount of coverage. This means that if the original policy was a participating policy, the new policy will also be a participating policy. Once the paid-up policy has been issued, the new face value remains the same for the life of the policy. Additionally, as with all whole life policies, the new policy will also build cash value.
The insured's current attained age is used for premium calculation, but proof of insurability is not required since the benefit is being reduced. Additionally, riders and accidental death benefits from the original policy are excluded from the premium calculation and are dropped from the new policy.
When an insured selects this option, they have recognized the need for permanent life insurance but no longer want to continue making premium payments. Therefore, this is the option that provides the policyholder/insured with life insurance coverage for the longest period (i.e., permanent whole life protection).
The extended term option permits the policy owner to surrender the policy and use the cash value to purchase a paid-up level term insurance policy. Unless a policy loan is outstanding, the face amount of extended term coverage is identical to the original whole life policy's face amount. No more premium payments are made once the Extended Term option is activated.
Since all elements in a traditional whole life policy are predetermined, the policy owner knows precisely what the cash value will be in any given year. When this option is exercised, the policy's non-forfeiture table shows how long the coverage will last with the given cash value (i.e., 11 years and 165 days).
Extended Term is the default option when a whole life policy lapses, and it is automatically activated.
If there is an outstanding policy loan when the policy is surrendered, the loan balance is deducted from the cash value, and the net cash value buys a paid-up extended term policy with a shorter period.
The extended term insurance option provides the insured with the most life insurance protection (i.e., the highest face amount) in the event of a voluntary policy surrender or non-payment of premium.
When applying for life insurance, policy owners must understand the purpose of the policy they want to purchase. Who's the policy designed to protect (i.e., a child, a spouse, a charity)? What's the policy's intended purpose (i.e., income replacement, debt reduction, estate creation)?
One important element policy owners should consider when purchasing life insurance is the availability of settlement options — the ways death proceeds are paid at the time of an insured's death. In most cases, the selection is made by the beneficiary at the time of the insured's death. However, the policy owner may select a settlement option at the time of application. Failure to arrange for the proper payment of proceeds may defeat the very purpose for which the insurance was intended.
Living benefits allow a policy owner to receive a portion of the policy proceeds while the insured is still alive. The insurer will typically require the policy owner to have a physician certify that the insured has a qualifying condition (i.e., terminal illness) before providing access to living benefits.
The policy owner has the right to designate who will receive any policy proceeds upon the insured's death (i.e., the beneficiary). The beneficiary designation is part of the entire contract. Later in this course, there will be a closer examination of the types of beneficiary designations and unique circumstances that can arise. Beneficiaries are not required to sign the application or be notified of their designation. The policy owner may change the beneficiary at any time, provided the beneficiary is not irrevocable.
The settlement options provision outlines the various ways that the policy's death benefit may be paid to the beneficiary, as well as who has the authority to decide how the funds will be distributed.
All life insurance policies include a variety of settlement options that are available to a beneficiary when an insured dies. The settlement options provide the beneficiary with greater flexibility in receiving proceeds. The principal method of paying death proceeds is a lump sum. In this manner, the beneficiary receives the policy proceeds income tax-free in a single payment.
Following the insured's death, if any settlement option other than the lump-sum option is used, the proceeds will remain with the insurer and be paid in installments. The insurance company must pay interest on the proceeds that remain with them. The interest credited to or paid to the beneficiary is taxable as ordinary income.
The various settlement options available and when they may be used will be examined later in the course.
The spendthrift clause protects a death benefit against the claims of a beneficiary's creditors as well as the beneficiary's own poor financial decisions. It prevents creditors from claiming a right to death benefit funds yet to be paid by the insurer in the form of a settlement option over time. The clause only applies to non-lump-sum settlement options.
The withdrawal provision is often used when the policy proceeds are held by the insurer and earn interest. This provision outlines the steps and requirements for withdrawing any funds left on deposit with the insurer. The beneficiary may have the option to withdraw all of the funds or only a limited amount each year.
The accelerated death benefits provision allows an insured to "accelerate" the death benefit of a life insurance policy while still living if a physician diagnoses and verifies that the insured is suffering from a terminal illness and is likely to die within 12 to 24 months or less. The accelerated benefits provision is typically added to a policy through an accelerated benefits rider or terminal illness rider. Specific conditions for payment must be satisfied for a benefit to be paid. This provision, or rider, is typically offered without a premium increase.
The insured may receive up to a specific percentage (which varies by company) of the death benefit. Any amount paid out under the accelerated benefits provisions will be subtracted from the face value at the time of the insured's death. This is referred to as the effect on the death benefit. Accelerated payment can be made in a lump sum or in monthly installments over a specified period (e.g., one year) and is received tax-free if the insured is terminally ill.
For example, a $100,000 policy providing a 75% accelerated benefit will pay up to $75,000 to the terminally ill insured. The remaining $25,000 is payable as a death benefit to the beneficiary when the insured dies.
When applying for a policy with accelerated benefits, customers must receive a summary of coverage detailing the benefit, the triggers for payment, and the effects on the cash value, accumulation account, death benefit, premiums, and policy loans.
If the benefit is exercised, the insurer must illustrate the impact on the policy, including:
Another type of accelerated benefit is the catastrophic, chronic, or critical illness coverage rider (i.e., dread disease coverage). The terms of this coverage are similar to the terminal illness rider except that the covered disease must be identified or listed in the policy (e.g., cancer, heart disease, renal failure, stroke, AIDS, etc.). Additionally, the rider may provide benefits for those unable to perform at least two activities of daily living (ADLs), such as eating, bathing, dressing, toileting, or transferring.
Some accelerated benefits are available by adding a long-term care rider to a life insurance policy. If an insured is permanently confined to a nursing home and requires long-term care, the policy rider will pay a benefit. A long-term care rider can help safeguard against the financial burden of long-term care. These riders may be added to individual or group policies. For the insured to qualify for an accelerated benefit under a long-term care rider, the (long-term) confinement must be covered by the rider, or additional requirements must be satisfied.
The long-term care rider, similar to an individual long-term care policy, will generally pay benefits when the insured is unable to perform at least two of the basic activities of daily living (ADLs): eating, dressing, bathing, toileting/continence, walking/ambulation, transferring, or taking medication.
There are two different ways that a long-term care rider may be designed. When designed using the generalized or independent approach, the long-term care rider is recognized as independent from the base life insurance policy. As such, the base policy's face amount or cash value is not impacted by any paid-out benefits. When designed using the integrated approach, the base policy's death benefit and/or cash value will be reduced by any long-term care benefits paid out.
For example, suppose Alex purchases a life insurance policy with a $200,000 death benefit and adds a long-term care rider. Under the Generalized (Independent) Approach, if Alex triggers the long-term care rider due to illness, they receive long-term care benefits, say $40,000, without reducing the life insurance policy's face amount. After receiving these benefits, if Alex passes away, their beneficiaries would still receive the full $200,000 death benefit, because the rider's payments are independent and do not impact the core policy value. In contrast, under the Integrated Approach, if Alex's policy uses the integrated design and they claim $40,000 in long-term care benefits, the policy's death benefit is reduced accordingly. So, if Alex passes away after using the rider, the beneficiaries would receive only $160,000, reflecting the amount already paid out for care.