Life & Viatical Settlements
Chapter 2
Viatical Investing
Many professionals compare investing in a viatical settlement contract to buying a zero-coupon bond with an uncertain maturity date. In the case of viaticals the return depends on the seller’s life expectancy and the date he or she actually dies.
Many investors might be surprised to learn that viatical settlements grew from the AIDS epidemic in the mid-1980s. The early victims of AIDS were mostly men and mostly unmarried. Even though they generally did not have families they did have life insurance policies. At the time mortality rates were high with life expectancies short (often due to the late-stage diagnosis). As the AIDS victims grew sicker their ability to work decreased, often leading to loss of their jobs, followed by loss of medical coverage. Viatical settlements seemed like a way to help the dying as well as offering investors higher than average returns.
The result was a quick rise in popularity for viatical settlements contracts. Unfortunately for all concerned, there was little regulation that applied. Even though investors were investing in insurance contracts, the situation was unique enough that insurance regulators did not necessarily have jurisdiction.
Viators saw selling their life insurance contracts as a way of gaining badly needed cash and investors saw an unusual opportunity to make money. It should have been a winning combination. Since there was little regulation, viatical settlements ended up with a bad reputation in the investing community. Large sales commissions tempted the unethical salespeople to sell the contracts any way necessary. The honest salespeople were typically poorly trained, often making assumptions that simply were not true. Therefore, as a result of greed, poor training, and inadequate knowledge many problems developed.
Although the early contracts saw many abuses, the basic concept can still be a win-win opportunity. The terminally ill can gain cash while investors gain earnings. In a 2002 study of hospice financial counselors having experience with viatical settlements, it was reported that many saw positive results for their patients. That doesn’t mean anyone should assume all such contracts are without risk; the opposite is true. There is indeed risk involved. One of the most famous viatical cases involved the Mutual Benefits Company headed by Peter Lombardi in Florida. He is now residing in prison as a result of his $1 billion Ponzi scheme.
Viatical Settlement Participants
As the various states enact legislation to control how viatical settlements are established and maintained they are likely to continue attracting investors. There are several parties involved in a viatical settlement:
Most viators probably use brokers to help negotiate the process of selling their policy. Few people would be educated enough to correctly handle such a transaction on their own. Additionally, terminally ill individuals may not be up to the task of correctly maneuvering through this type of contract.
There have been some problems with purchasing life insurance policies solely for the purpose of selling them through viatical settlements. When this happens, terminally ill individuals attempt to cover up their illness in order to qualify for the policy. Since this could invalidate the policy when it comes time to disperse death benefits, viatical firms typically do their own medical and insurance investigations to circumvent this since “contestable clauses” would then apply. A contestable clause allows the issuing insurance company the right to refuse payment within two years of policy issue if underwriting was based on misinformation or omitted information.
Specifically, the incontestability clause in life insurance policies is a provision setting forth the conditions under which benefits may be refused and the time period during which the insurer may contest or void the policy. After that time has passed (normally two years) the policy cannot be contested so benefits would be paid at the time of death. Some policies may still be contestable after two years for “material misrepresentation,” which would be fraud. Not all states nor all situations will allow funds to be withheld on those grounds, however. Viaticals have created an industry problem: some people are lying on life insurance applications for the express purpose of obtaining the contract, then selling it to viatical funding firms.
The Viatical Contract
Even a badly written viatical contract is still a legal document. Although the original viatical contracts were far less regulated than they are today, most transactions are still regulated to some degree by state and federal laws. As a result, most contracts include some standard provisions.
The early viatical agreements initially had no state or federal rules that applied specifically to viatical contracts. As a result, each viatical funding firm used its own unique contract. Even the participating parties could be identified differently from contract to contract. This required the investor to be very attentive to all terms and provisions in the contract he or she participated in.
Contracts can be difficult to understand even when provisions are highly regulated, as they are for insurance policies. When there is no regulation, they can be especially difficult to understand. Although the life insurance policies being sold are highly regulated, such regulation does not apply to viatical settlements. Some viatical contracts may be much more complicated than others. States are implementing viatical legislation to prevent some of the past experiences viators and investors have had.
Legitimate viatical companies use contracts that meet standard contract agreements and are usually multi-page in length. While each investor will develop their own viatical criteria through experience and preference, there is generally basic criteria that should be followed, including:
1. Length of time in the viatical settlement industry.
2. Whether or not they buy directly from the viator; most specialists feel it is best to buy directly from the viator.
3. Whether or not investors may buy directly from the viatical buyer; most specialists prefer to avoid going through marketing firms.
4. Licensing status; viatical funding firms should be licensed (or its parent company should be licensed) to do business in the state where the viatical contract is being sold to investors.
5. In some cases, securities compliance, meaning the company is registered with the state department in charge of securities. This is not necessarily required in all states.
Before investing, investors should be sure the viatical funding firm meets all the above requirements, not just some of them.
Consumers are often told to verify an entity’s licensing status, but few people actually do so. In this case, it is critical simply because there have been so many bad viatical contracts presented to investors. It is also important that the company be licensed in the state where the product is being sold. Viatical settlement contracts work best when they are ruled under the laws of the state where the investors live.
Many legitimate companies (as well as those not so legitimate) market viatical contracts under other names. For example, XYZ company may form a sub-company to market its viatical investments, naming the sub-company something completely different. There are many reasons why a company would form a separate arm of the company to market viaticals or any other type of investment vehicle, including:
1. Administrative costs;
2. Potential future state or federal regulation; and
3. Existing regulations.
Contract Standardization
Investors and viators alike are likely to agree that the most difficult aspect of viatical and life settlements has been the lack of uniform standardization. States are changing this through legislation, however. Initially nothing about the contracts was standardized; not even the language and contract definitions.
All contracts are drafted for the protection of the contract writer. The early viatical contracts were no exception. While the majority of states now have laws that dictate many elements of the contract, it is still necessary for contract participants to be aware that the contract they sign is not necessarily written for their express benefit. Even so, most contracts have standard terms, clauses and conditions.
There are common elements to most viatical settlement contracts however, including:
There may also be what is called a “hold harmless” clause in the contract, unless forbidden by the state of issue. This clause is used to reduce lawsuits. In effect, a “hold harmless” clause prevents the viator from blaming the viatical company or escrow agent for anything other than willful wrongdoing or gross negligence.
Beyond the listed eight items above, contracts vary widely. While all contracts must conform to federal and state laws, in many cases the language may still differ among contracts, so all participants must read them carefully prior to signing. Those who sell life and viatical settlements must also read the contracts they are representing. Unfortunately, individuals engaged in selling life and viatical contracts often fail to read the very product they represent.
The amount the viator will receive will depend upon the specific situation, such as his or her current health and the aging of the life policy.
Viatical Settlement Terminology
The following are viatical settlement contract terms all participants need to know:
Beneficiary:
The person or company who will receive the proceeds of the insurance policy once the insured or viator has died.
Clean sheeting:
Clean sheeting is a fraudulent practice that involves obtaining life insurance by submitting an application that hides adverse applicant information from the insurance company. When the policy is purchased with the intent of selling it, the facts hidden may include a known terminal or life-threatening illness or probability of illness.
Contestability Period:
Conditions set by an insurance company in which the company can contest the payment of a death benefit or cancel the policy should the insured die within a certain time period or under certain conditions or should the policy have been obtained fraudulently. Typically, the time period in which an insurance company can contest an insurance policy is two years.
Escrow Company:
A company sometimes affiliated with or owned by the viatical settlement provider, which is set up to receive investment money from individuals for the purchase of viatical settlement contracts and which is to hold insurance policies purchased from viators. Often escrow companies pay the premiums on such policies and pay the proceeds to the investors upon death of the viator. It is important for the potential investor to investigate fully the credentials of the escrow company and any links which may exist between the escrow company and the viatical settlement provider. Recent apparent fraud has involved disappearances of such escrow companies or their personnel and the investors' funds.
Face Value/Death Benefit:
The death benefit, often called the policy’s face value, is the amount of money to be paid by the insurance company to the beneficiary upon the death of the insured.
Fractional and Pool Interests:
Some viatical settlement providers take a large life insurance policy and fractionalize its death benefits, selling the fractional pieces to multiple investors. They can also create a pool of viated policies and then sell fractional interests in the pool to investors.
Viator:
A person whose life is insured by a life insurance contract or certificate who wishes to sell or has sold the beneficial interest in his or her life insurance contract for a lump sum.
Viatical Investor:
A person who purchases the death benefit of a life insurance policy, or a fractional interest in such a death benefit, or an interest in a pool of such death benefits or fractional interests either directly from the viator or from a viatical settlement provider. More recently, such investments have been sold in the form of interests in companies, such as limited-liability companies, formed for the purpose of buying viaticals.
Viatical Settlement Contract:
An agreement between a viator and a viatical settlement provider or company [see below] to transfer the life insurance death benefit of the viator in exchange for money, typically for an amount of money less than the total death benefit of the policy.
Viatical Settlement Provider/ Viatical Settlement Company:
A person or company that buys or arranges purchases of the life policy’s death benefits from the policy owners for less than the expected death benefit amount, for the purpose of reselling them. Viatical settlement providers then sell the death benefits, at marked-up prices, as investments to individuals who expect to receive profits upon the deaths of the viators.
"Wet Ink" Policy:
“Wet ink” policies are a term generally associated with stranger-oriented life policies that are immediately sold within weeks of policy issuance, when the “ink is still wet” on the application. The newly issued life insurance policy should go through its two-year policy contestability period before investors consider such viaticals.
Individuals considering selling their life insurance policy for payment of a reduced face amount must realize that ownership of their policy will change. While this may seem obvious, there have been many instances where the policy owner did not seem to fully realize this. Policy “ownership” designates who the policy legally belongs to. It is the owner who has the right to change beneficiary designations.
When a viatical company or its agent is named policy owner, there is the additional risk that the policy will become subject to creditor’s liens, including claims in a divorce or bankruptcy court. Obviously, it becomes important for viatical and life settlement investors to be aware of this.
Some life insurance contracts have “irrevocable beneficiaries.” Irrevocable means the person or entity designated as the life insurance contract’s beneficiary cannot be changed without the written consent of the irrevocable beneficiary. A life insurance policy can have both an irrevocable and a revocable beneficiary simultaneously, if the insurer allows it. Investors are best served when they are designated as irrevocable beneficiaries. That does not necessarily mean the contract will always read that way. Sometimes the contract’s irrevocable beneficiary is the escrow trust. It may remain as the escrow trust or be transferred to the investors at the time of closing.
Generally, viatical firms will only buy policies that are issued by solvent insurers; obviously the point is to receive payment upon the death of the insured. While states do generally have insurer guaranty funds, no company wants to deal with the procedures required to receive policy benefits under such circumstances. Many viatical firms also require the issuing insurer have a top financial rating, since they do not want to deal with companies that become insolvent at a later date. There may be firms that will accept policies that are issued by lower rated companies, however. Again, this is something that participants should be aware of. If this information is not disclosed, it is important to inquire as to the company’s financial rating.
Each viatical firm will have specific requirements regarding the life insurance contracts they will buy. Such requirements will relate to life expectancy of the insured (viator), the age of the policy (for the incontestability clause), the insurer rating, and other elements the viatical firm considers important. The amount the policy owner may expect to receive for his or her policy will be directly related to the time the insured is expected to live and other relevant factors.
The escrow account and the manager of that account are important elements for the investor. Escrow agents/trustees are responsible for the safekeeping and disbursement of purchase funds, viaticum, and policy premiums. It is not their job to offer investment advice or make independent decisions. Their job is to keep records and write checks. If the escrow agent/trustee fails to pay policy premiums, the policy could lapse; obviously not what the investor wants to experience.
Escrow agents and trustees should not be allowed to share in the profits of the business. They should be third-party entities that are paid a fee for their services. Usually investors may see a profile of the escrow agents and trustees. Most professionals feel the escrow account should not be set up in the name of an individual, law firm, or accounting firm. Doing so could mean the funds could be attached by the IRS, creditors, or individuals involved in a lawsuit against the person, or business firm. If the account became very large (some involve millions of dollars) there would also be great temptation to misuse the funds if they were controlled by a single individual or business firm.
Legitimate viatical companies use a nationally or federally chartered bank for escrow accounts. In some states, this is a requirement. While this does not guarantee legitimate business practices, it is a step in the right direction.
Some escrow trusts are interest-bearing accounts. If this is the case, investors should inquire as to whether or not they will share in the accumulated interest that is earned. Companies that keep all the interest earnings have less incentive to disperse investment funds quickly.
Many types of investments have administrative costs and fees, but investors must still make note of any in the viatical contract. Like so many types of investments, such fees can and will vary among contracts. While the purchase price may be all inclusive, this cannot be automatically assumed.
Some viatical contracts allow investors to do their own policy servicing and tracking. While this might initially seem like a good way to save money or simply follow the investment, some questions should be asked. If the investor initially wants to service the account themselves, what happens if he or she changes their mind? Is it possible to shift the job back to the viatical company? There have been many cases where the viator moved or contact was lost with them. It is important to keep contact with viators since it is their death that triggers insurance payment from the life insurance company holding the policy.
When a viator lives beyond their expected time of death investors must continue to support their investment in the form of paying policy premiums and any other expenses associated with the life insurance contract. This might include administrative costs of the viatical firm, such as tracking the insured individual and other administrative functions. Some viatical and life settlement contracts may have a specified time in which additional funds must be supplied by investors. If the investor fails to pay the required additional funds for premiums or other costs, the viatical firm may use other legal means to collect them.
When a life insurance policy is owned by several investors, as is often the case, it could mean that some of the investors end up paying additional funds on a viator that lives beyond his or her expected lifespan, while other investors fail to pay. Most viatical and life settlement contracts expect this problem and have solutions in place to prevent the life policy from lapsing due to nonpayment of premiums. Solutions may vary, but often viatical firms take loans out against the policy cash values or dividends to pay the required premiums. They might also use excess in reserves from policies of other insured’s who died sooner than expected, leaving excess funds in the escrow accounts. Many viatical and life settlement firms keep the funds remaining in escrow when a viator dies sooner than estimated to cover such occurrences as this.
Since the length of time a life insurance policy must be supported determines the cost to investors, correctly evaluating the expected lifespan of a terminally or chronically ill viator is extremely important to the viatical participants. Viatical firms will request current medical records from policy owners to determine their investment risk. Like insurers, viatical firms review medical records prior to entering into a contract with the policy owner. Also, like insurers, viatical firms employ analysts to make judgments on the likely lifespan of the terminally or chronically ill insured individual. However, there is no sure way to make judgments of this kind. The insured persons may die sooner or later than expected, and this is the risk investors accept. The risk can be minimized however, by using sound underwriting practices, including contacting attending physicians and considering new trends in medical treatments.
Unfortunately, investors may have no way to verify the viatical firm has correctly evaluated the viator’s medical information or that the information given to the investors is accurate. While we would like to assume that all viatical firms are honest, past experience has taught us that many will misrepresent the medical history of the viators in order to obtain investors. Due to privacy concerns, in most states investors are not allowed to view or otherwise obtain the medical records of viators. Investors must rely on the past performance of the companies they deal with. A company that has been reliable in the past will generally continue to be reliable today and into the future, unless other factors change, such as management. If pertinent conditions change, investors may want to re-evaluate the viatical firm.
In states that have passed viatical and life settlement legislation, there is the right to cancel or rescind the purchase within a specified time period. The time period might be dictated by state statutes or by the contract itself. If the viator or investor has buyer’s remorse, he or she can cancel within the stipulated time period and receive a full refund, less any loans, charges, or other costs that are specified in the contract. In the case of a viator, he or she must return all money received when their policy was sold.
There may be rescission fees since companies acquire costs during the processing of a life insurance contract purchased from a viator. There may also be rescission fees for investors that cancel. Viatical firms take time to process orders, and it is reasonable to be compensated for their time and expenditures in doing so.
Most viatical and life contracts have risk disclosure forms. These may be just a paragraph or two long or they may be several pages long, depending on the company and the product concerned. Generally, they ask the participant to certify that he or she has read all disclosures, contracts, and relevant forms and have understood their content. They also usually suggest the participant seek the advice of counsel, whether that may be an attorney, financial advisor, tax specialist, or accountant. The participant has, upon signing the risk disclosure, confirmed that they are aware of and accept all risks associated with the viatical or life settlement contract. What risks are they referring to? There are several, including the following:
There is another risk that may or may not be on disclosure forms (unless mandated by state statutes): if the insurer becomes insolvent, even in states with insurance guaranty programs, the investor may experience great delays in payment and the amount of payment will not be guaranteed since full death benefits may not always be paid.
Unless terminology is uniform by state statute, investors and viators will see some variance in terms used. The term “maturity risk” is often used when speaking of the viator’s predicted life expectancy. The term “cancellation risk” may be used when there is the risk that the investor will have no claim or only a partial claim to the total death benefit in a life insurance policy.
It is important to realize that viatical and life settlement investments do carry real risks for the investor. The maturity date is not guaranteed; the annual rate of return cannot be actually determined until the insured’s death; finally, the viatical settlement is not a product of or guaranteed by any financial institution. Viatical and life settlement investments are subject to investment risk and possible loss of principal.
Investors are seldom aware that viatical firms will sell investors life insurance policies that were rejected for their own portfolios, due to risk factors. In fact, some life insurance policies may be accepted solely for the purpose of earning commissions from sales to investors. Therefore, it may be better to purchase viatical investments through a stockbroker or licensed insurance agent, since these individuals are more likely to be professionals that represent several viatical companies as well as other financial products.[1] Licensed professionals have a legal obligation to perform due diligence for their investors that may not legally exist for other individuals selling viatical settlement and life settlement investments.
Securities
Viatical settlement contracts are sometimes sold as securities. Investors should be aware of the risks involved, of course, and the differences between viatical settlements and other types of securities.
Most often the investor in a viatical settlement contract is dependent upon the viatical settlement provider (or another party selected by the viatical settlement provider) to see to it that the viatical settlement contract and the underlying life insurance policy is maintained. This involves anything from determining the life expectancy of the viator to maintenance of the life insurance policy, such as paying premiums and filing for the death benefit upon the death of the viator.
Most states require viatical settlement contracts that are sold or packaged as securities to be regulated as such. As with most securities, there are risks involved. Too often those risks are not adequately disclosed to the investor. Unfortunately, past experience has shown many instances of fraud in the viatical industry. While states either have or will address issues that lend to fraud, viatical and life settlement participants must still use sound judgment, independent of any state requirements.
As always, anyone considering investing money in any security should thoroughly research the product, the individual, and the company offering the security. A polished sales technique, high-pressure sales tactics, or promises of huge returns should not be a replacement for researching the investment and the person or company offering it.
All investors should be aware of several things prior to investing in a life or viatical settlement contract, in a pool of such contracts, or in any venture investing in life and viatical settlement contracts. Some of the important questions investors should ask themselves include:
Investors should not invest in any viatical-related investment until they have all viatical information in writing and feel they understand the information. If they do not understand any portion of it, investors should consult with someone experienced in viatical settlements, but not associated with the viatical firm selling the settlement.
It is Important to Remember
Some life insurance policies offer an accelerated death benefit option that allows the insured the option of receiving up to 80% of the death benefit at any time within the last year of their projected life. The remaining 20% is then paid to the insured's estate. Policies that offer this may circumvent the need to enter into a viatical settlement since it is unlikely the policy owner would receive 80% of the death benefit from a viatical settlement.
Application Clean Sheeting
The term clean sheeting came about because some agents presented a life or health application to the issuing insurer that did not contain all the facts necessary for appropriate underwriting of the risks involved. Since the application appeared “clean” of health problems or other underwriting issues, it became known as “clean sheeting” the application. Unscrupulous individuals in the viatical industry also use "clean sheeting" by intentionally failing to disclose the applicant's status as being terminally or chronically ill. It was easy to do initially because most insurance companies avoided the added costs and invasiveness of medical exams and blood tests by relying on an industry honor system below a certain policy face value. Larger policies would be underwritten more extensively prior to issuance. This is changing as the viatical industry grows, with insurers beginning to underwrite even smaller policies more extensively.
Some viatical agents and brokers have assisted and encouraged viators to commit such fraud because it not only provided more policies than would be available through legitimate means, but it also provided a much higher rate of return due to the fact they can be bought from viators so cheaply under these conditions.
In legitimate transactions, ill policy owners usually receive 50%-70% of the face value of the policy. However, a "clean sheeted" policy viaticated during the contestable period may offer as little as 10% of the face value because it carries the high risk of rescission, or cancellation by the insurance company, due to fraud. States either have or will be addressing this issue through legislation.
Wet Ink Policies
It is best for viatical investors when the life policies they are investing in are at least two years old so that contestability periods have been satisfied. When a policy is purchased for viatical or life settlement immediately after the policy has been issued, it is called a wet ink policy, because the “ink has not had sufficient time to dry”. After the policy is issued, the insured person sells his newly issued policy or even multiple policies from different insurance companies within weeks to a settlement provider using a broker.
Most people do not suddenly find out their life is terminal within weeks of purchasing a new life insurance policy. To see that happen repeatedly within a short period of time with the same broker or provider is strong evidence that they are both well aware that the policies have been "clean sheeted." Individuals involved in this practice use many practices (changing beneficiaries, policy assignment, and so forth) in an attempt to hide the activity.
Contestability Period
Some settlement providers delay reporting that the policy has been viaticated until the contestability period is over. Perhaps they falsely believe it is not a crime when they wait to report the viatical activity or perhaps they purposely intend to deceive the insurer and the viatical investors. Whatever the case, states are passing or have already passed required reporting procedures to halt this practice. If the parties attempt to hide the viatication of fraudulently obtained policies from the insurance company for as long as possible they obviously understand contestability issues.
Insurance companies have a contestability clause for two years after issuance, during which time it may be rescinded by the insurer for fraud in the application. After this period ends, the insurer is obligated to pay the death benefit, regardless of any fraud in the application. Because policies viaticated during the contestability period may be rescinded they bring a much lower price in the market.
Insured’s Life Expectancy
In a viatical or life settlement the maturity date of the investment is the date of the viator’s death, which releases the policy’s death benefits to the listed beneficiaries. To determine their rate of return investors, rely on a report that projects the life expectancy of the insured. A reliable viatical firm will use only individuals who are skilled at making such projections. Investors should specifically ask about the skills of the analysts performing this job since an individual who is not sufficiently trained or experienced is likely to make the investment a poor choice.
Viatical investing is highly speculative and risky. Although the insured is terminally ill, predicting the insured’s time of death is far from an exact science. New drugs and treatments have compounded the risk for investors because they help policyholders live longer.
Viatical settlements are illegal under Canadian insurance legislation so Canadian investors should not be involved in viatical investments at all.
Cases of Fraud
One of the reasons the states have been passing viatical settlement legislation is due to the cases of fraud that have occurred. Financial Federated Title & Trust, and Asset Security Corporation pled guilty after being charged with conspiring to recruit insurance agents to defraud more than 3,000 investors while purchasing viaticated insurance policy investments over a three year period.
American Benefits Services was ordered to pay $129 million restitution on a corporate guilty plea where the company fleeced people with promises of high returns on purchases of life insurance policies from the terminally ill. Investors were told that their money would be used to purchase a beneficial interest in viaticated insurance policies, and that medical overviews were being performed on the insured persons whose policies were being bought.
Although at least $115 million in investor monies was taken in, the promoters used only $6 million of these funds to buy insurance policies whose total face value was just over $7 million. They used the balance of the money for purposes totally unrelated to the purchase of viaticated insurance policies, such as the purchase of twenty-five houses in Florida, Vermont, South Carolina, Massachusetts, Georgia, and Toronto, two helicopters, thirty-four luxury automobiles, three motorcycles, several jet skis and boats and a Fort Lauderdale burrito shop.
A company named Personal Choice Opportunities (PCO) misled investors when they sold viatical securities in the form of loan transactions. Investors lent money to PCO for them to purchase the benefits of life insurance policies from terminally ill individuals on the promise that they would receive a return on their investment of 21-25% per annum. However, the funds were not used to purchase life insurance policies but instead kept by the company. No evidence of any valid life insurance policies being purchased was ever discovered.
Repercussions for the Industry
Life insurance premiums are based on actuarial tables, but these tables are worthless in fraudulent applications. When the risk of issuing policies cannot be fairly calculated, it eventually affects the honest insurance-buying public. Insurance companies cannot afford to pay out large death benefits after collecting small premiums for only a few years. Even if they don't go bankrupt the added costs are eventually passed on to their other honest policyholders.
If the viatical industry as a whole cannot effectively police itself, states must then pass legislation to do so, and many states have. Investors will not invest if the industry is perceived to be dishonest. The industry could disappear by either being legislated out of existence or through lack of investor confidence.
Investor Risks
Investments have risk; there should be no surprise in that statement. Most people attribute Robert Worley, Jr. of New Mexico as having initiated the first viatical settlement investment. In the mid 1980s he brought together investors to fund the purchase of a terminally ill client’s life insurance policy. These investors formed a company called “Living Benefits.”
Viatical settlements present risk for their investors, just as other types of investments do. Investors pay a discounted amount for the life policy’s death benefit. The actual amount paid to purchase the rights to the death benefit will vary, based on local practices and any state requirements that may apply, but it is common for the seller to receive 50 to 60 percent of the actual death benefit (face value or face amount). Investors hope to see early returns while the insured obviously hopes to delay them (investor returns are triggered by the insured’s death). It is the deep discounts on the death benefits that provide the potential of high returns. However, it is important to remember that there are no guarantees in viatical settlements. Even the very sick may have an unanticipated return to health or delay in death.
The level of viatical risk varies based upon the life policy purchased. Most professionals give investors the following recommendations when considering investing in a life insurance policy:
Although we did not list it, investors are also wise to know their own state laws regarding viatical settlement contracts. Most people would like to believe that agents and viatical companies know and follow their state’s laws, but no investor should automatically assume this will happen.
Viatical agents and representatives should certainly know their state’s laws. A salesperson might assume that the viatical company will know and follow applicable laws, but that cannot be assumed. By knowing and understanding state laws, viatical representatives will protect not only their clients, but themselves as well.
Following the nine recommendations provides valuable investment guidelines but does not guarantee all will go well with the investment. Each listed item is more complex than one might realize. While many states require full disclosure, like all investments, loss of investment funds is always possible. Many viatical companies actually invest their own funds in viatical settlements, but that does not guarantee the outcome either. Since there are many variables, including a viator that gains their health unexpectedly, risk is always present.
An important term in the viatical industry is “maturity risk.” It refers to the possibility that the insured (viator) may not die as quickly as was predicted. Maturity risk is highest when the life policy paid more for the death benefits. For example, if the viator was paid 80% of the death benefits there is less room for profit if he or she lives beyond projections. If the viator was paid 50% for the same death benefits, longer life is less likely to result in investment loss. Each year of life beyond the initial projection results in reduced yields for investors. If the viator lives long enough, the investors will actually lose money because there will still be expenses, such as premiums and administrative costs.
There are many risks in all investments, but the viatical industry operated without restraint long enough to invent some new risks. While many of the previous risks may be minimized through legislation of viatical practices, no investor should think the risks totally evaporated.
It is generally the viatical company that selects the insured, evaluates his or her life expectancy, verifies the insurance coverage and assignability, and sets the policy purchase price. It is evident that the investor must fully trust the viatical company, so it is important to know who the investor is placing their trust with.
In the eighties and nineties there were plenty of viatical scams. While there were honest companies, there were also many dishonest ones. “Buyer beware” was the viatical theme. The maverick companies were hard to recognize since they used the same industry terms; investors had little tools available to distinguish between the companies that were trustworthy and those that weren’t. Viators also faced problems; viators signed over their life contracts without receiving adequate compensation for them. No one was surprised when the states began passing viatical legislation.
The National Association of Securities Administration Association (NASAA), a regulatory body, issued a public warning in 1985 about the many abuses in the viatical industry that were occurring. The viatical settlement can be very valuable to the viator needing cash during their terminal or chronic illness and there are many investors who have had good returns from viatical investments. The concept is one that should provide a win-win situation when performed ethically and honestly.
Understand the Product
When investors invest funds in a viatical settlement product they are buying a prediction of investment maturity. In other words, they are buying into a life insurance policy based on the prediction of the insured’s death. In order to invest wisely, the investor must know two primary things: how the prediction of death (investment maturity) was arrived at and secondly, how a life insurance policy functions. Obviously, the investor must also feel certain they are dealing with a viatical firm that is legitimate, but for our purpose in this section, we will assume the firm has been evaluated and found to be trustworthy.
Maturity Risk
Analysts who measure risk, like any profession, can be excellent, average, or just plain bad at their job. Insurance companies cannot afford an analyst who is bad at their job since their industry is based on knowing their risk when they issue an insurance contract. That doesn’t mean insurers never have a bad analyst, but it is unlikely that one would remain employed in the insurance industry for long.
When viatical settlements first came out in the 1980s most companies did not employ seasoned risk analysts. There were little or no requirements of them to provide accurate estimates of maturity risk (dates of probable death) and little investor understanding of the necessity of doing so. It is important to again stress that investors are buying predictions when they invest in a viatical settlement contract. A poor prediction could mean more than just poor yields; it could also result in loss of investment funds.
When a life insurance policy is first issued, the life insurance company has determined risk based on longevity of the insured. The insurer wants the insured to live a long life. The majority of life insurance policies issued never pay out death benefits; most policies lapse prior to the insured’s death. Insurers traditionally did minimal underwriting, relying primarily on the agent, the policy application and the two year contestability period. Since most policies do not pay out benefits, this method has been reliable (although the viatical industry is causing many insurers to re-think their policy-issue position).
While the life insurance industry relies on their clients living a long full life, the viatical industry relies on their clients dying – the sooner the better. Both industries revolve around life insurance contracts but their focus is very different.
Since the viatical industry invests based on death expectancy versus life expectancy viatical firms spend more time looking at medical reviews, often obtaining medical records for the last two years (or more if the situation calls for it), laboratory data, any reports from specialists, and statistical information. Viatical analysts may talk with the attending physician since they often learn more from talking with the doctor than is written in the medical reports. A reliable viatical firm will want to talk with the doctor for another reason: to learn of any misleading or outright fraudulent medical information provided by the viator.
In the early years viatical firms did very little reliable evaluation since their priority was selling the contracts to investors. Predictions of the investment’s maturity (which is the date of the insured’s death) were based on flimsy information. With state legislation came more reliable predictions since companies were forced to disclose more information on how such maturity dates were determined.
Reliable viatical companies will use a combination of contract maturity prediction methods, including:
Clinical
Companies that hire medical specialists (usually individuals with a specialty in the disease) rely on their expertise, based on education and experience in the condition, to determine the predicted time of death. These individuals will review existing medical records to determine, based on their experience with the condition, how much longer the viator could be expected to live. Even though clinical evaluations use established statistical information and experienced personnel, it is always a prediction and never an exact science. Clinical evaluation may not consider current health studies of the disease or illness and may not necessarily include recent data that indicates those with the condition are living longer. For example, a new medication may be providing positive results regarding length of life that are not included in clinical evaluations. Some professionals believe clinical evaluations routinely understate life expectancies allowing investors to expect higher yields than would actually materialize.
Statistical
Statistical evaluations rely on past data. Each medical condition has an average life span. While that may be sufficient for some types of insurance, viatical settlement contracts work best when information is individualized. Statistical evaluations utilize the law of large numbers to arrive at a conclusion; general statistics do not take into consideration a person’s individual characteristics that can affect risk maturity. Additionally, past information will not take into account recent medical advances that can prolong life.
Multi-Disciplinary
Investors should prefer the multi-disciplinary viatical underwriting approach because it uses information from more than one source. The investor will receive the highest yields when maturity risk (the date the viator dies) is correctly calculated. This approach will use medical specialists, statistical information, physician communication, and current medical advances to determine maturity risk. Even drugs that are not currently approved by the FDA may be included in their analysis since it may affect longevity if the viator is involved in clinical trials.
Minimizing Investment Risk Through Knowledge
If investors have underwriting information available to them, they are more likely to maximize their yields by selecting viatical settlement contracts that utilize broad analysis, thus providing accurate maturity risk estimations. It may be possible to request this information from the viatical firm. Companies should be willing to disclose their form of analysis even if an outside company performs the service.
It is generally best if evaluations are performed by contracted third parties, an entity not associated with the viatical firm. Such companies perform analysis for multiple companies and have no direct tie to any particular company. It is still important that the contracted party have past experience with viatical analysis since the criteria for evaluating longevity of life for viatical contracts is not the same as it would be for other entities, such as insurance companies. Those who provide this service, whether a contracted party or an individual that works directly for the viatical firm, must have the ability to understand the medical conditions associated with the terminal or chronic illness. Lack of understanding can mean poor analysis and projection of longevity of the viator. Those who make such judgments must understand the treatments that are likely to be used as well as any new medications or therapies that might be utilized.
Investors should never assume that the insured will not try new or additional care treatments after they sell their life insurance policy. In fact, the money they receive for their policy might actually be financing additional treatments, including organ transplants. Viatical companies understandably want the viators to be predictably terminal rather than unpredictably terminal, which is sometimes the case.
Evaluators may have different styles or arrive at different conclusions since this is not an exact science. Evaluators make predictions regarding the viator’s possible life expectancies. Of course, those who use as much information as possible in making viatical predictions are likely to be more accurate than those who use less; some will also be better at their jobs than others. Therefore, it is also a good idea to look at past performance of the evaluating person or company.
Life expectancies of less than 30 months are considered short evaluations by most companies. While many factors will be considered most are based on actual disease progression.
It is not unusual for the life expectancy prediction to change. This might happen because a new drug is introduced that works well for the viator, or because the individual improves due to life style changes. It can be impossible to predict what new procedures or drugs may come in the future. Additionally, not everyone follows what is considered “normal” disease progression.
Not every disease or illness is considered terminal. As every agent knows, some diseases, while unpleasant, do not necessarily end life sooner than normal. When viatical settlements were first written on AIDS victims it was thought that all would die young, but today that is no longer the case; what is normal today may not be tomorrow as new technology develops.
A New Issue: Viator Fraud
If there is money to be made, fraud will follow. Most people would not expect an individual to fraudulently claim they are terminal, but it happens. An individual who owns a life insurance policy contacts a viatical settlement company to sell their policy and presents false medical information indicating they are terminally ill. Only if the viatical company contacts the listed physician during the underwriting analysis would such fraud likely be discovered. If the fraud goes undetected investors end up investing in a policy that could go on for years, with the result being lost investment funds.
With current technology it is possible to both modify and create medical records. If the viatical underwriting departments do not make personal contact with physicians it is likely that such fraud will not only go undetected, but also grow. Unfortunately, the risk of fraudulent medical records falls on investors. It is seldom possible to receive compensation from the fraudulent viator.
Prior to viatical settlement opportunities, individuals who fraudulently obtained life insurance policies did so for their beneficiaries and usually the insured was genuinely ill and facing death. The insured had no personal stake in the policy since he or she would not benefit from the death proceeds. If the insured died within the two year contestability period his beneficiaries may not receive anything, but if he or she lived beyond the contestability period the insured’s heirs would receive the death benefits in most cases (though not necessarily in all cases).
For the viatical firm and their investors, fraudulently obtained policies present a huge risk. Many states now require full disclosure on contestability periods to help investors avoid the possibility of insurers refusing to pay death benefits due to misrepresentation on the policy application or omission of relative facts.
While most policies will pay death proceeds after the contestability period has passed, that is not always the case. Some states specifically recognize exceptions to the incontestability clause. It may also be possible that the state may grant an exception to an insurer’s request to refuse payment; insurers are most likely to seek this on very large policies.
Life insurance policies have included incontestability clauses for more than 100 years. It is mandated by state legislatures to circumvent legal battles over payment of death proceeds after the contestability period has passed. They allow insurance companies two years from the policy issue date to discover irregularities in the application. After two years, the insurer is not allowed to contest the coverage upon the insured’s death.
Incontestability clauses are not intended to permit fraud, however. The intent is to establish time limits during which insurers must discover whether or not fraud exists. Therefore, an insurer that fails to seek out evidence of fraud through complete underwriting does so at its own peril. In the past, only basic underwriting was typically done since the risk of fraud was relatively small. Larger policies were understandably underwritten more extensively than smaller ones. With the advent of increasing fraud with the intent of selling the policies to viatical firms, insurers are likely to increase their level of underwriting to protect themselves.
Some life policies are applied for under one name, with another representing the insured in order to avoid effective underwriting. Their goal is to survive for two years (through the contestability period) so the insurer will pay the death proceeds. Several states allow the insurer to refuse payment where use of an imposter can be proven, despite the incontestability clause. There are strict and specific rules that apply to refusing to pay the death proceeds following the contestable period:
Viator Tracking
Not all viators are sick enough to be hospitalized or confined to their home. It is common for viators to travel or move frequently based on a desire to see their children or grandchildren or due to the medical facilities available. Obviously, it is necessary to know where viators are so dates of death will be known.
Some viatical firms employ outside firms to track the viators; others perform this duty themselves. Some tracking is done through the Social Security system, although that is a slower way of knowing when death occurs due to the time it takes the data to appear.
Most firms keep in periodic contact with viators and may require a third party person be assigned. This third party allows the viatical firm to track the viator’s health progress without making direct contact.
Life Insurance Contracts
Any person investing in a viatical settlement contract must understand how life insurance policies work. It is not necessary to become an expert on insurance, but basic understanding can make the difference between a bad investment and a good one.
A life insurance policy is a contract. The contract stipulates that for a financial payment (the premium) a specified party (the insurer) will pay another party (the insured’s beneficiary) a defined amount of money upon the occurrence of death. Having said that, there is much more to life insurance contracts than this simple statement indicates.
Life insurance is intended to protect those that would be financially affected by another’s death. The insured is typically the major wage earner in the family, but it may also be any other person of importance, such as the family caregiver. Companies often carry life insurance on key employees, since their death would adversely affect the company they work for.
Life insurance insures one's life, not their death – although it is their death that triggers benefit payment. Life insurance, therefore, insures one's life against death. Even that is over simplified since there are many forms of life insurance and many goals that might be met through life insurance contracts.
Basic Concepts
Life insurance is not necessarily complex but it does require some basic knowledge. Normally the questions considered involve “how much is enough?” and “how long will I need to keep this life insurance coverage?” When it applies to viatical settlements, the questions may be “when was this policy purchased?” and “is it beyond the two-year incontestability clause?”
Insurance Companies Measure Risk
Every applicant represents a risk to the insurance company. Questions are asked on the application to help the insurer judge the risk involved. Sometimes a medical examination is also required. This might be as simple as a nurse coming to the applicant’s home for blood and urine samples or more complex if there is a higher potential risk involved.
Life insurance companies use actuaries to calculate the risk involved with issuing the policy. Mortality tables are used by the actuaries when determining the likelihood of the applicant dying prematurely. Besides the obvious attention to the applicant’s health status, the insurance company also looks at lifestyle with specific questions that might include:
· Does the applicant smoke or chew tobacco products?
· Does the applicant drink alcohol and, if so, how much and how often?
· Does the applicant have a regular exercise routine, such as walking or other type of activity?
· Is the applicant socially active (studies show people who interact regularly with others live longer)?
These are not the only lifestyle questions that may be asked but they demonstrate the types of questions that may be on an application. By looking at the characteristics shared by groups of people actuaries improve the accuracy of their predictions, which affects the benefits the insurance company is likely to pay.
Underwriters tally the information provided, adding points for unfavorable findings and subtracting points for favorable findings. The lower the applicant’s score, the better his or her rating will be. The final point score determines if the premium rate will be standard, substandard, or preferred. Those who pose the least risk will be the individuals who do not smoke or chew tobacco, are not overweight, and without a history of heart disease or other serious medical conditions. Not all life insurance companies offer a preferred premium rate for the very healthy individual, so it might be wise to search for a company that does offer lower rates for those who qualify. The vast majority of life insurance policies are issued at standard rates.
It is important to note that one insurer’s standard rate may cost more or less than another’s. Applicants and insurance producers should not assume that all companies charge the same rates.
The applicant has an obligation to tell the truth on their applications for insurance coverage and the writing agent has an obligation to disclose to the insurer all the information he or she received from the applicant. The agent should further disclose any indication that the applicant might not be disclosing their full medical history. For example, the agent sees an oxygen tank in the corner but the applicant does not mention needing oxygen. The agent should ask specifically if the applicant requires oxygen (this is true even if this question is also on the insurance application). In some states agents may not fill out the medical portion of the application on the applicant’s behalf; if this is the case it may be especially important to go over the questions with the applicant prior to the applicant completing the medical portion of the application. If the applicant lies or omits important medical information the insurance company can rescind the policy or deny a claim for the first two years following policy issuance.
Types of Life Insurance
There are different types of life insurance available. Many financial planners insist that only term life insurance should be purchased, but it really depends upon the goals of the insured. While term insurance certainly plays an important role in financial planning, especially for young adults who have limited resources, there are situations that call for other types of life insurance.
Once the amount of coverage necessary has been determined, the individual must decide upon the type of coverage they wish to purchase. There are two basic types of life insurance: permanent and term (although each category has subtypes).
Permanent insurance, as the name implies, covers the individual for their entire life; it is intended to be a permanent purchase. Upon death, benefits are paid and the policy ends.
Term insurance offers a predetermined “term” of coverage, such as one year, five years, ten years, or more. When the term ends, the coverage ends, although it may often be renewed at higher premium rates. Upon death, the policy also ends with payment of the death benefit.
Permanent insurance is typically used for a financial need that is continuous and often involves a goal beyond just death benefits. Often permanent insurance is used to supplement retirement income, for example. Term insurance is best suited to young adults that have not yet acquired a great deal financially. These consumers may be in the early years of marriage and child rearing, have a new mortgage, and multiple debts associated with establishing themselves in the community. They may be in the early stages of their career as well, when earning ability is relatively low. As time goes by their income will rise and their career will prosper but for now, they must have coverage that is effective but inexpensive.
What Will the Insurance Cost?
There are two parts to life insurance premiums: mortality cost and policy expense cost. The mortality cost is determined by the odds of the insured dying prematurely. Insurers are very good at determining the likelihood of premature death by gender, age, and occupation. Questions on the life insurance application directly relate to how the insurer determines their mortality tables.
Policy expense costs relates to the costs of conducting business, such as staff, underwriting expenses, and agent commissions. Each life insurance policyholder contributes a share to these expenses through the premium costs they pay. Mortality costs increase each year as the insured ages (and risk of dying increases). Policy expenses can, of course, go up too but they tend to remain fairly steady.
Permanent policies that have level premiums average out the cost over the length of the policy. This means that the insured is actually overpaying their premiums in the early years of the policy in order to keep premiums the same in the later years when premiums would normally be higher. The overpayment in the early years is set aside in a reserve the insurer calls cash value. If the policy is canceled the insured receives the premium overpayment (cash value) back. In the first years of the policy there is additional expense of such things as underwriting and agent commissions, so there is not much cash value available.
Term insurance never has a cash value even when the premiums are leveled, with the insured paying higher premiums in the early years to make up for underpayments in the last contract years. Therefore, no refund is available if the insured cancels the policy. As a result, many professionals feel that level term premiums are not always a good idea, although if the insured knows he or she plans to hold the policy long-term, they may find better pricing over time in level term policies. If the insured is not sure he or she will hold the contract for an extended period of time, then it gives the potential of overpaying in the first years with no guarantee of return of the extra premium if the policy is discontinued. Term insurance is the least expensive form of life insurance and it may be best to simply pay rising costs each year in an annually renewable policy. Usually income rises with time, so even though the term insurance policy will experience increased premium costs, they will still be relatively inexpensive compared to other forms of cash value life insurance policies.
Term Insurance
Term life insurance does not build cash reserves. Term life insurance may be combined with other products, such as annuities or mutual fund accounts that do have cash reserves, but the actual term insurance contract has no cash reserves.
Under term insurance:
1. The insured must die before the term expires (the period of time during which the policy is effective) in order for the beneficiary to receive insurance benefits.
2. Upon the specified term’s expiration date the insurance ends. A new term may be started, however, depending upon the terms of the policy.
3. The cash outlay (premium) is relatively low, especially at younger ages. Costs do increase with acquired age.
Term life insurance has some variations based on the length of the insurance policy term, renewability options, price guarantees, and conversion options.
Even within the types of insurances, there can be sub-categories. Term insurance has basically four categories although there can be variations of each. The four types are:
1. Annual renewable term insurance, which is renewable each year regardless of the insured's health. The premium will be higher each year due to increased age.
2. Convertible term, which allows the insured to exchange the policy without evidence of insurability. The exchange often means converting to a whole life policy or an endowment type of policy.
3. Decreasing term, which is often called Mortgage Insurance. The death benefit decreases over a specified period of time although the premium usually remains level.
4. Level term insurance generally has both a level death benefit and level premium cost for the entire term of the policy.
Annual renewable term comes up for renewal each year, as the name implies. As the term expires each year, the insured purchases a new annual term policy, with a higher price since the insured is now a year older. As one ages, risk of early death becomes more likely so cost is higher (mortality expenses raise). Annual renewable term is renewed for twelve month periods (annually).
Generally, annual renewable term is not underwritten each year; the insured merely has to pay another premium to renew the policy for an additional year. At some point, however, it is likely that this no longer becomes possible. Based on the contract language the policy will have a maximum renewal ability specified in the policy. While it may be as little as ten years, it could also be as long as age 100.
Renewability is not the only thing that may be guaranteed. Premium levels may be guaranteed for some specified period of time as well. It would be unlikely that premiums would be guaranteed until age 100, but they may be guaranteed for five or ten years. Changes in health will not affect term policy pricing. In many cases, term life policies have conversion ability, meaning the insured can elect to exchange their term life policy for a permanent life insurance policy. Many policy owners choose to do this when their health deteriorates, although that may not necessarily affect the term policy renewability. Policy conversion will not require underwriting since it is guaranteed in their term life policy. No underwriting means no health questions are asked at the time of conversion.
Some term life insurance policies will have a fixed-rate level term feature. As we know, this means the amount of premium paid stays the same over a specified time period. The price may be locked in for as few as five years or as long as 30 years. Statistically, policy owners keep level term policies longer than annually renewable contracts so it is good for insurance companies to promote fixed-rate level term policies. Underwriting is expensive so it is not surprising that insurers want issued policies to stay on the books. Because insurers know the policies are more likely to stay active, competition often brings about pricing advantages that are not available with annual renewable term contracts.
Level term insurance policies are typically convertible to permanent insurance contracts without evidence of insurability. In other words, the insured will not have to prove their health status at the time of conversion because there will not be any underwriting for the new policy. Some policies may only have conversion privileges for a specified time period, such as ten or twenty years from when the policy is first issued. For example, if the level term policy allows conversion only within the first ten years of the policy, once that time period has passed, the insured would have to successfully complete underwriting requirements in order to convert over to a permanent life insurance policy. Since health conditions are more likely to develop with age, an individual who feels they may want permanent insurance would be wise to convert during the period of time when underwriting is not a concern.
Most professionals feel it is vital that the term policy have the option of converting to permanent insurance regardless of current health status. Since term contracts often have a maximum guarantee for renewability there may be a point when the term policy cannot be renewed without evidence of insurability. Having a conversion option offers protection that can prove important if a health situation develops. No one can predict the future; it just makes sense to cover all possibilities.
Reentry renewable level term policies offer the lowest term rates, but there is a reason for that: renewal each policy term is priced based on current health status. In other words, the reentry annually renewable term policy continues to be low priced only if the insured remains healthy. If the insured’s health status declines, his or her renewal rates climb higher and quicker than any other type of term policy upon reentry to a new policy term. Only if the individual can reenter and reapply as very healthy do their rates remain at preferred levels (low). Insurance companies are not required to offer the lowest rates on reentry renewable level term contracts so the insured must continually shop the competition. To emphasize this vital point: rates on reentry renewable level term is very low for the healthy individual but potentially the most expensive in the marketplace if the insured is no longer in good health.
Reentry renewable level term policies should always have a conversion clause so that the insured can change to permanent insurance if his or her health declines. If coverage continues to be necessary, converting to permanent insurance may be the best option when illness occurs under the reentry renewable level term policy.
While it may seem that reentry level term insurance is never a good choice that is not really true. There are reasons that such insurance is a good choice. For example, a young family that needs a large amount of insurance but that has few dollars available would do well to purchase reentry level term insurance, but they should make sure it is renewable for at least five years (longer for some situations). Also be sure that there is the option to convert to a permanent life insurance policy. We cannot say it often enough: no person knows what the future may bring. If health status changes dramatically having a conversion option can mean the difference between leaving beneficiaries sufficiently supported or in poverty upon the death of the insured.
If there is the choice between reentry level turn and traditional non-reentry term insurance select the non-reentry term. It is worth a little more money to keep preferred rates without having to qualify each time policy renewal comes around.
In all cases, agents should stay with financially high-rated companies. If A.M. Best is the standard being used, the companies should have an A rating or better. Represent only guaranteed renewable and convertible term products if possible. Although your clients may not realize it, you are doing them a favor by making sure they can renew their coverage and convert to a permanent contract if their health situation takes a turn for the worse.
Decreasing term insurance is a type that most consumers are familiar with, especially if they have a home mortgage. Under decreasing term insurance the coverage decreases annually but the premium remains level for the duration of the specified period in the contract. There are two types of decreasing term insurance:
1. Level decreasing term, and
2. Mortgage decreasing term.
Level decreasing term insurance reduces coverage a flat amount each year. The amount of decrease is often stated as a percentage per year.
Mortgage decreasing term insurance reduces coverage to correspond to the mortgage payoff amount. In the first few years, the reduction in coverage will be small since most of the mortgage payment goes to interest, not principal. In the later years of the mortgage the decrease will be more dramatic, to match principal payoff. The actual reduction of coverage is tied to the mortgage interest rate and the length of the mortgage, such as twenty or thirty years.
In most cases, the premium doesn’t change during the duration of the insurance term chosen. It is important to realize that near the end of the insured term there is very little insurance actually in place. The amount of coverage has steadily decreased along with the amount of money owed on the insured home. Seldom are these types of policies renewable either. If health conditions have developed, these policies are not designed to protect beneficiaries from an early death; they are merely designed to protect the mortgage. In many cases, the rates for mortgage decreasing term are not competitive when compared to other types of term insurance. It may be better to purchase a different type of term policy, with the intent of using it to pay off any mortgage balance. Only if such insurance is court ordered (as may happen in a divorce) should anyone buy a level decreasing term insurance policy. There are simply better options available.
When a person has a mortgage, the mortgage-holder may offer mortgage level term coverage. The premium rates are seldom good. Most people can do better in the open market unless their health is very poor or they have health factors that would eliminate their eligibility for other life insurance policies. It is important to remember that mortgage companies usually list themselves as the beneficiary of the policy. If the insured dies the policy pays off the house (making the mortgage company the beneficiary); family members will receive nothing in most cases.
Many policies offered through mortgage companies, banks, and other institutions cover only accidental deaths. Since even young people are more likely to die from natural causes, accidental death policies are seldom a good choice. No matter how inexpensive the policy is accidental death plans are not likely to be a wise buy.
Permanent Insurance
Permanent Insurance is coverage designed to last throughout the lifetime of the policy owner. Although permanent insurance, such as universal life policies, are nearly always sold by an insurance agent, there are some types that may be purchased over the internet or through institutions, such as banks. However, it is likely that an agent still is involved in some way, depending upon state requirements.
The role of the agent should not be taken lightly. Since permanent insurance is complex it is important that the selling agent be well versed in the products. Buying term insurance is relatively easy since there are no cash values and it is pure death protection; it is the least complex type of insurance. Permanent insurance, on the other hand, is complex. Using an agent to purchase any type of insurance, including term insurance, doesn’t cost the consumer any higher premiums, so individuals may as well utilize the expertise of an agent regardless of the type of coverage being purchased. A good agent will help determine the right amount of coverage and make suggestions that the average consumer is unlikely to consider. A professional agent can mean the difference between being poorly insured and adequately insured. In addition, if the applicant has health issues an agent may be essential in finding a company that will accept the risk. Using an agent doesn’t necessarily mean meeting with an agent face-to-face since many companies utilize agents online or over the telephone with similar results. As long as the agent is able to adequately and professionally complete the transaction with the consumer’s needs and goals in mind, the end result is likely to be satisfactory.
There are many types of agents, from the career agent specializing in life insurance products to the guy who sells one or two policies a year as a sideline. Most professionals feel the full-time professional agent is the best avenue.
Unfortunately, insurance agents have been unfairly represented as individuals who take advantage of the average consumer. Most agents realize that their livelihood is based on referrals and therefore they strive to provide good efficient service to their clients. An experienced life insurance salesperson is an advantage for the consumer since the agent will steer them to the right products and help them maneuver through the vast amount of choices available in permanent life insurance options.
Some life insurance may be available through work but the rates are not always a good buy, especially if the worker is young. Group rates are priced on the medium of the group as a whole. If the workplace has a high percentage of older ages the cost may be higher than necessary. Additionally, since younger workers may change jobs it is important to know if the coverage ends when the job ends or if conversion to private insurance is possible.
Perhaps the largest failing of permanent insurance is purchasing less than necessary to keep premium costs down. While some life insurance may be better than none at all, being underinsured is not an advantage for the beneficiaries. If the individual cannot afford sufficient permanent insurance it should be subsidized with term insurance. Permanent insurance is more expensive than term insurance. Some consumers may want permanent insurance for the cash values they acquire but being under-insured is a major financial planning error. While there are valid reasons for buying permanent insurance, it should never be purchased unless sufficient death benefits exist in the policy. The primary reason for buying life insurance is to insure against premature death; if that goal is not met, then the reason for buying it has not been met either.
Surprisingly, many people buy multiple small life insurance policies rather than one with sufficient death benefits. This seldom makes sense from a cost perspective. Buying multiple smaller policies is typically more expensive than purchasing one comprehensive life insurance policy. It probably happens because each small policy does not seem very expensive so consumers impulse-buy rather than actually taking the time to analyze their needs and buying one good contract.
Many small inexpensive policies have a major flaw: they pay only for accidental deaths. These may even be free through banking institutions and membership organizations. Statistically even young adults are much more likely to die from natural causes, not accidents.
Many consumers would say they have not purchased multiple smaller policies when in fact they have. The reason they don’t realize it is simple: they weren’t purchased from agents. Maybe they have a policy through their credit cards, one with their credit union, another from their bank, and yet another from their mortgage company. Some of these may be free, but if they cost a dime, the coverage has been purchased. Many of these will be accidental death plans, which are typically a waste of money. Policies that are “free” are nearly always accidental death plans. The money spent on these small policies could be banded together and used to purchase one adequate policy.
All insurance decreases one’s financial risks, even the policies that are never collected on (such as fire insurance on our homes). No one buys insurance because they know for certain that a loss would occur; they buy insurance because there is the possibility of loss. Life insurance is perhaps the one sure thing since all of us will eventually die. For any parent, life insurance should be one of their top priorities. Since no laws require the parent to protect their child in the same way companies and states require drivers to insure their cars or potential liability, life insurance can be overlooked when it is actually extremely important.
Those with sufficient cash flow (to afford the premiums) and who will need coverage for at least fifteen to twenty years will want to consider permanent cash value coverage, such as a universal life insurance policy. As an individual ages term insurance can become very expensive, making permanent life products seem more reasonably priced considering the cash value portion that will eventually be available.
A cash value policy is similar to a term policy with a built-in savings component. Many call this an investment, but the cash values should not be considered an investment since there are so many better ways to invest for the future. The accumulating cash is a savings component rather than an investment. This may seem like a minor distinction but it is important that consumers not consider cash value life insurance policies similar to mutual funds or annuities. Basically, a cash value policy is simply a convenient way to pay for a lifetime of term insurance coverage. In the year it is purchased it will cost much more than term insurance because overpayment is occurring in level priced policies. The early over-payments are used to defray the higher cost of coverage at older ages (later on in the policy) and reduce the amount of coverage needed; if cash values exist less coverage is then needed.
For example, Ted bought $100,000 in benefits in a permanent life insurance contract. Twenty years later there is $20,000 in cash values; if he still needs $100,000 available he can actually insure his life for just $80,000 at this point, relying on the cash values to make up the difference.
Cash values earn interest. The insured can take some or all of the accumulated dollars even if they terminate the insurance policy. Even if the policy is kept active, the insured can take a policy loan against the cash values. A loan will reduce the death benefit so this should not be done without due consideration of the impact a sudden death might have on the family’s financial situation if there is a reduced death benefit.
When a permanent policy is purchased certain levels of death benefits and cash values are guaranteed by the issuing company. The insurer usually projects higher levels of death benefits and cash values, but even if minimum levels are met, there are certain guarantees. While premiums are higher due to the cash values that accrue, if the insured will need the protection for many years, it is generally worth the added cost. Those who want or need coverage for their entire life most certainly would want to purchase cash value products rather than term insurance.
We sometimes hear that it is better to “buy term insurance and invest the difference” in premium, but this is seldom practical, unless it is for a short-term need and even then it is unlikely to happen. Why? Few people actually invest the difference. Over a long period of time, buying term and investing the difference may not even be prudent. If the policy will be held for 20 or 30 years or more, buying cash-value insurance is usually a better deal than term due to the rising cost of insurance as the individual ages. Especially if the policy is allowed to lapse or surrendered, the cash values on a long-held policy will actually return the premiums that have been paid. The insured may end up with more cash upon surrendering a cash-value policy after a couple of decades that he or she would have paid for term insurance. Part of the reason for this is the income-tax advantages held by cash-value life insurance policies. The policy values are not taxed until the policy is surrendered and the cash values taken. They escape income taxation entirely if the policy is held until death.
The largest disadvantage to a cash value policy, as we previously said, is the tendency by those who buy them to purchase a too low death benefit. Because the cost is higher than term insurance, people often reduce the amount of protection they purchase to bring the premiums to the level they desire. Maybe they intend to eventually purchase larger death benefits; maybe they just don’t really believe they will die prematurely. Whatever the reason buying too little life insurance is a big financial planning mistake.
Permanent insurance has several characteristics:
1. The premium remains level throughout the policy's lifetime.
2. The contract builds up cash reserves in the early years, which allows the company to maintain level premiums even though the insured becomes older which would normally trigger higher premiums. These reserves also bring about a "cash value" that may be borrowed by the policyholder or may be taken as surrender proceeds if the policy is canceled.
3. A whole life contract, by definition, can be kept at the same premium level for the lifetime of the insured.
There are several types of permanent insurance. Whole life is the old standard and is still sold by many agents. It has the highest annual charges but also the strongest guarantees for the buyer. For those who want flexibility, however, it is hard to overlook the universal life insurance policy.
Universal Life Insurance Policies
Many consumers are aware of the term "universal life," but have only a vague idea of what it actually is. A universal life insurance policy is a life insurance policy in which the investment, expense and mortality elements are separately and specifically defined. The policy owner selects a specified death benefit, which typically remains level. The death benefit may, however, be one that increases over time, coinciding with the increased cash value of the policy (death benefit Option II), or, alternatively, the death benefit can remain level regardless of the underlying value changes (death benefit Option I). A "load" is deducted by the insurance company from the premium amount paid by the policyholder for defined insurer expenses. The premium remaining is then credited towards the contract owner's policy cash values. Mortality charges are next deducted. Interest earned on the remaining cash is credited at whatever percentage current rates happen to be. Since specific policy details do vary from company to company, variations will occur. Increased expenses or "loads" and/or increased mortality rates will also result in lower cash values. Just like annuities, there is usually a minimum contractual guarantee on the interest rate earned; typically, around 4 or 4.5 percent. Mortality costs also generally have a guaranteed maximum premium charge for the pure cost of the death benefit. Most insurance companies do not charge that maximum rate, however. Typically, the rate actually charged is lower.
Many consumers assume there is a "standard" universal life insurance policy that is somewhat uniform from company to company. Actually, there is no such thing as a "standard" universal life policy. The level of premium paid, the amount of the death benefit, and the length of time over which premiums are paid are variable. While the first policy year may have a stated minimum premium due, following that first year, the contract owner may usually vary all factors: the premium amount, the payment date, and the frequency of the payments. These features are what make this type of policy favored by consumers. These features are sometimes called "stop-and-go features" or options. The ability to discontinue payments and then resume them at a later date does not require reinstatement of the policy. As long as there are enough cash values within the policy to pay the required expenses and mortality rates, the policy will remain in force. The policy will terminate if the cash values are not adequate, although there is usually a grace period allowed of up to 60 days.
Universal life is similar to whole life in that it allows the insured to build up a cash value within their policy. While whole life does not typically disclose what the insured receives for their money, universal life does allow the insured to see what portion of the premiums went toward covering company expenses and how much was used for the insurance protection, and how much made up the savings component. Initially, universal life was fairly easy to understand, even for nonprofessionals. As time went by, however, many observed that universal life policies became more difficult to understand.
Universal Life Policies Compared to Traditional Plans
The combination of traditional life insurance forms and annuities is not as simple as it might appear. The most important difference is the addition of cash values that build up in the life portion at variable interest rates (based on current interest rates) rather than in predetermined and guaranteed long-term cash values as one would see in whole life insurance contracts. Universal life policies have guaranteed interest rate minimums that were originally near 4% in the 1980s. Excess rates (the amount actually credited) were determined by money market rates or sometimes by external indexes that were usually stated in the contracts. Each year the insured paid a flexible premium, which was sometimes called a “contribution” since the amount was voluntary above certain specified minimums. After deducting expenses and a risk charge for the term insurance protection from the contribution, each month the insurer credited the remainder to the cash value of the contract.
Universal life policies are also different from traditional insurance in how the potential use of cash values is allowed. Traditional life insurance only permits full cash-value withdrawal when the policy is surrendered or allows loans up to the cash-value amount. The universal life insurance policy adds the option of partial withdrawals, sometimes with extra fees charged. These withdrawals are not considered loans, but they do reduce the policy’s face and cash values just as traditional policies do. The general purpose of the cash value buildup is not intended for sporadic emergency withdrawals at younger ages however, since these values are needed for paying the increasing cost of the term protection in the policy (term life costs more as the insured ages). Universal life does expect to see some withdrawals as the insured ages since one-time expenses might happen for various reasons, such as a child going to college or to fund a nursing home confinement for an elderly parent.
Another difference from traditional life products is the universal life insurance policy’s adjustable death benefits. Initially, policyholders will select one of two basic forms: the fixed face value or a face value that pays the face value purchased plus the accumulated cash values.
At any time following the initial selection the policyholder may decrease the face value to specified minimum amounts or he can increase it with evidence of insurability without rewriting the contract. It is important to note that insurability must be proven in order to increase the death benefit.
How do these differences apply to the general policyholder? They may make universal life insurance products advantageous, depending upon the insured’s personal situation, which always must be taken into account. As always, one of the most important considerations is adequate levels of life insurance. If the individual cannot afford the universal life policy’s premiums, he or she may need to remain with term insurance protection until universal life products become affordable. If the universal life product is affordable at sufficient insurance levels, the advantages include:
1. Flexibility in premiums, benefits, and withdrawals, and
2. Cash-value increases that reflect current interest earnings and mortality rates.
As with all insurance, there may also be disadvantages to purchasing universal life insurance products. Flexibility, while usually a good element, may also have a pitfall. Not all policyholders will use common sense when considering withdrawal of cash values. Those who understand how the policy best performs will only make changes when they are necessary by real needs or economic adversity. Universal life allows the insured to make even bad changes to their policies, so agents are likely to see some changes that appear foolish (and indeed are foolish). Too much flexibility is often a disadvantage since consumers do not exercise careful thought to the changes they have the ability to initiate. Part of preventing foolish choices is providing proper information and education regarding the universal life product they have purchased. Once provided, however, it is still the insured’s right to make any changes the contract allows.
Another possible disadvantage is a false sense of what the universal life product will produce in cash values. While there is a guaranteed rate specified in the policy, usually the amount actually credited is higher. In severe economic downturns the minimum guaranteed rate is a safety net; unlike stocks this product will not lose value. In most cases, the insurance policy will credit higher values than the guaranteed rate. However, no policyholder should believe that their policy will always pay rates high enough to be a substantial financial investment – it is life insurance, not an investment.
The insurance industry did actually experience agents selling universal life products with projected interest rates far higher than would actually be paid. Since the software supplied by insurance companies allowed the selling agent to enter any interest rate they wanted, some agents entered unrealistic figures selling products on the basis of unrealistic projections for future earnings. Most states took steps against those agents and hopefully this problem has primarily been solved. Interest rates, even properly projected rates, do not apply to the entire premium paid; they are calculated only on what is left after expenses and term insurance coverage is subtracted. As the insured ages, the amount it takes to buy the term coverage increases so the amount of remaining premium earning interest is reduced. The policy may refer to “gross rates of return” and “net rates of return” to reflect this important point.
When universal life contracts first appeared in the marketplace in the 1980s, interest rates were very high, encouraging this type of product development. Agents could present very favorable outlooks using universal life products that combined the advantages of cash-value life insurance with higher yields possible through the “invest-the-difference” philosophy. As interest rates came down it became more difficult to do that with most types of cash value life insurance products. Increased yields on money market funds, corporate and government bonds, and other types of investments during high interest periods hurt any type of cash value life product, encouraging a return to purchase of term policies. Products like universal life were the insurance industry’s answer to this problem.
Universal life is a trade name, not a specific policy type. Insurers may use various names for policies that meet the universal life definition. If the policy has similar characteristics it may be a universal life insurance policy, even though it has a different name. Universal life plans divide death protection and cash-value accumulations into separate components. This division distinguishes them from the traditional cash-value policy that is an indivisible contract with unified death protection and cash value accumulations. Universal life is able to guarantee more competitive rates of return from year to year than can traditional cash-value products. Flexibility is achieved by adjusting the amounts of savings and protection to meet the needs of the individual policy owner.
Flexibility can be very important to a policy owner. As we go through life there are times when we have more cash than other times. When children are young there may be emergencies that take all available cash, temporarily leaving no dollars for insurance premiums. Times of unemployment may also require premium payments to be skipped until the insured is able to return to work. Cash values will keep the policy active even though the insured cannot pay premiums during difficult financial times. As children grow, becoming financially independent, more premium dollars are probably available. As the cash-value fund grows in the policy it will eventually help supply retirement income.
All types of life events can affect a person’s ability to continue paying their premiums. Such things as divorce, deaths in the family, births, remarriages, and responsibilities relating to disabled children or parents, or any number of other events can affect the insured’s ability to pay premiums on a regular basis. A universal life policy is able to keep the policy in force during difficult times by dipping into cash reserves to pay premiums that are due.
Premiums
Insurance contracts have premiums; a premium is the payment the insured makes for his or her insurance coverage. The premium due date will be listed on the policy. The insured has the option of paying premiums monthly (usually through a bank draft), quarterly, semi-annually, or annually. Annual premiums may be less than quarterly or semi-annual payments. If the insured pays their premiums monthly through a bank draft costs are likely to be less than monthly payments the insured must manually mail in.
Policies have grace periods for payments. This is the amount of time allowed past the premium due date to pay the premiums without lapsing the policy or providing proof of insurability. If the premium is not paid within the grace period the policy will lapse and the life insurance coverage ends (except in policies that have provisions to pay the premium from cash values). Reinstatement may require proof of insurability.
Policy Options
Cash value or participating insurance policies offer three sets of options: nonforfeiture, dividend, and settlement options.
Nonforfeiture Options
Nonforfeiture options provide an avenue of premium refund. If the owner discontinues paying premiums the insured may:
1. Surrender the policy for its cash value, if any;
2. Convert the policy to a paid-up contract of the same type but with a reduced face amount; or
3. Convert to a paid-up term policy for its full-face amount for a period usually shorter than the original policy. This is called extended term insurance.
If the policy is participating the insurance under the reduced-paid-up option continues as participating. Insurance under the extended term option often becomes non-participating. Some companies might continue the extended term as participating but at higher rates.
Policies commonly have provisions that automatically convert to extended term insurance if the owner discontinues payments and fails to elect one of the other available options.
Dividend Options
Dividends are paid on insurance policies participating in the insurance company’s earnings. It is usually expressed as “par” for participating and “non-par” for non-participating insurers. Mutual insurers are commonly companies that issue dividends to their policy owners. Stock insurers may issue both non-par and par policies, but most stock insurers issue only non-par policies.
A par company generally pays dividends in cash, but typically no money is actually transferred unless the policy is paid up (all premiums have been paid). The insurer applies the cash dividend towards the next premium that comes due.
Dividends may be “accumulated as interest.” The insurance company retains the dividends in this situation and accumulates them at not less (and usually more) than the interest rate specified in the policy.
Dividends may also be used to buy paid-up additions to the policy at net rates. This is an opportunity to acquire low cost insurance since these additions are purchased at net rates. In other words, the insurance is purchased without the expense allowance. This can be especially important if the insured has experienced declining health since this additional coverage is purchased without regard to current health or even occupation (some occupations are considered high risk) when the dividend is paid. Paid-up additions must be the same type as the policy the dividend is paid on. Paid-up additions may be selected for current dividends at any time without proof of insurability.
Another dividend option is one-year term insurance. Under this option the amount of insurance that can be purchased by the dividend is often limited to the cash value of the policy. If the dividends exceed the amount required to purchase the maximum term insurance the policy owner may elect to use the excess for a different option available under the policy.
If the policy owner wants additional death protection either the paid-up insurance or the one-year term dividend option is a good choice. If the insured is more interested in saving money for retirement the accumulate-at-interest dividend option could be chosen. Interest paid on dividend accumulations is taxable income but annual increases in the cash value of paid-up additions are not generally subject to current income taxation. As always, it is important to consult with a tax expert.
Settlement Options
The generally accepted method of paying proceeds from a life insurance policy is by lump sum distribution. However, two alternative methods offer periodic payments:
1. The interest-only option, and
2. The annuity options.
If the annuity options are elected there are several choices available, including lifetime income options, installments for a specified time period (such as twenty years), and installments of a fixed amount of money each month or each year. The amount of income available and the time over which income is available is directly related to the amount of money deposited into the distribution vehicle (the annuity). Obviously, the more money deposited the more income one will receive.
The word "annuity" means "a payment of money." The insurance industry designed them to do just that. Choosing an annuity payout option requires understanding of how payout options work.
There tends to be some standard options offered:
1. Lifetime Option (Single Life): For as long as the annuitant lives, he or she will receive a check each month for a specified sum of money. The payment amount received each month will never change. This option will pay the maximum amount in comparison to other available annuity payout options. Selecting the lifetime option is a gamble. If the annuitant lives a long time, he or she could collect handsomely over time. If their life is cut short, the insurance company will keep any balance left unpaid. No leftover funds will be distributed to any heirs.
2. Joint-and-Survivor (Two or More Lives): Under this option, the insurance company will make monthly payments for as long as either of two named people lives. In some cases, it could involve more than two lives, but usually there are just two people involved as annuitants. This option is often utilized by married couples. However, the couple need not be married. Any two people named will be honored by the insurance company.
3. Life and Installments Certain: The key word here is CERTAIN. The "certain" period of time is usually either ten or twenty years but may be another time period also. This option states that should the annuitant die prior to the stated "certain" time period, payments would then continue to the beneficiary until that specified number of years had been met. On the other hand, the annuitant may receive payments longer than the "certain" period stated. That is where the "life" part comes in.
4. Cash Refund Annuity: If the annuitant dies before the amount invested has been paid out by the insurance company, then the remainder of the invested money (plus interest) will be paid out in monthly installments or in a lump sum to the named beneficiary or beneficiaries.
In each of these options, the insurance company pays nothing beyond the agreed period of time:
1. Single Life = nothing after the death of the annuitant (no beneficiary designated money);
2. Joint and Survivor = nothing after BOTH named people have died (no beneficiary designated money);
3. Life and Installment Certain = nothing after the death of the annuitant or until the stated time period; whichever comes last (so a named beneficiary could receive something if the annuitant died prematurely).
4. Cash Refund = nothing after the full account has been paid out whether to the annuitant or a beneficiary.
A lifetime option will mean a higher monthly payment to the insured but the insured is gambling that he or she will live long enough to receive more than they deposited into the annuity. If the annuitant dies before they receive the amount deposited the insurance company keeps any remaining money; heirs receive nothing. However, when considering retirement financial security is the first consideration, not potential beneficiaries.
Under the interest-only option the insurer retains policy proceeds paying interest to the beneficiary. A minimum interest rate is guaranteed with the actual interest payment determined by the amount the insurer earns. Although there are minimum guarantees, the amount actually paid has traditionally been higher.
State Required Provisions
Each state will have specific state requirements. While these may vary from state to state (so we are not quoting any specific state’s provisions) there does tend to be some basic requirements in all states. There will be some provisions mandated by the state, some provisions allowed by the state and provisions the insurer feels are necessary. Some provisions are included to protect the insurer from excessive claims although that is more likely to occur in health contracts than in life contracts.
Generally, all states have specific items they feel are necessary for consumer protection, which may include incontestability, misstatement of age (sometimes even misstatement of sex), deferment, nonforfeiture, loan values, grace periods and reinstatement provisions. It is always important to know one’s own state laws; as an insurance professional this is an agent’s duty and moral obligation to his or her clients. It is also an obligation the agent has to the companies they license with.
Incontestability
The incontestability provision prevents the insurer, following a specifically stated period of time, from rescinding (contesting) the policy on the basis of misstatements made or omission of facts on the original application. While the applicant may not have intended to leave out information or state the facts incorrectly, during the initial period following policy issuance the insurer could rescind the policy for such occurrences. States want that period of time to be reasonable so they impose incontestability requirements.
Exact wording will vary based on state requirements but the incontestability statement may be similar to the following:
“This policy shall be incontestable after it has been in force during the lifetime of the insured for a period of two years from the date of issuance, except for nonpayment of premiums.”
If premiums are not paid in a timely manner, the policy will lapse independent of any omission or misstatement of application facts. The courts have interpreted the clause in favor of consumers, allowing it to become an agreement to disregard consumer fraud. It makes sense to do so since it would be impractical to gather enough evidence or find sufficient witnesses to prove the applicant intended to defraud the insurance company. The insurers also realize that misstatements and omissions in the application sometimes result from agents who wish to receive a commission. In other words, the applicant claims he or she did in fact disclose the information to the agent, but the agent failed to disclose them to the insuring company.
One advantage of incontestability clauses that agents and policy owners alike may not be aware of is how it affects beneficiaries. The clause is valuable to them because it prevents delayed settlements resulting from long and costly court action if the policy has been in force for more than two years.
Misstatements in the Application
Generally, misstatements concern the applicant’s age, but it can involve the stated gender as well. The incontestability clause does not excuse the misstatement of age or sex since they are primary life insurance rating factors. Obviously the older an individual is the greater the risk to the insuring company. The gender is also a factor since women generally live longer than men. However, such misstatements would seldom cause the policy to be rescinded although the insurer is allowed to adjust premium rates and back charge to the inception of the policy for any additions that are owed in premium. If the insured is deceased, an adjustment would be made in the face amount of the policy to correctly reflect the premiums that were paid. In other words, the beneficiary is paid the amount of proceeds the premiums would have purchased if the age and sex had been correctly stated.
The author is not aware of any adjustments stated in policies for surgical sex changes. Generally, issues of this nature must experience a court case before it becomes legally addressed in policies. However, even in surgical sex changes it is likely that insuring factors would be based on the gender at birth since all those attributes (risk factors based on age and gender) would still exist.
Deferment Clause
In the 1930’s insurance companies experienced multiple policyholders withdrawing or borrowing cash values from their policies simultaneously. This forced insurers to sell assets at depressed prices, causing the companies substantial financial losses that would not otherwise have occurred. Since then life insurance companies have been required to include a clause giving them the right to defer payment of cash or loan values in policies for a period not to exceed six months, unless the loan is for renewal of premiums.
The deferment clause does not apply to death proceeds when the insured dies, although it may apply to lump-sum withdrawals of proceeds left with the company under the interest-only option or the prepayment of any guarantees under an installment or life income option.
Nonforfeiture
Since cash-value contracts contain nonforfeiture provisions, the cash-value rights in a policy are not forfeited if the policy is discontinued.
Loan Values
Many types of life insurance policies develop cash values. Term insurance never develops cash values, so this would apply to the various forms of permanent life insurance. Some term policies are coupled with such things as annuities but only the non-term portion would acquire cash values.
If the policy owner wants to keep his or her life insurance policy in force while still acquiring cash he or she can arrange a loan from the insurer up to the cash value in the policy. The insurer lends the money at the guaranteed policy rate; the rate varies so it is necessary to consult the policy and policy attachments.
Some policy owners may feel it is unfair to charge interest when they withdraw their own policy values but there is a valid reason for doing so. Insurance companies take into consideration the investment income of the cash values when computing premium. Therefore, if the policy owner withdraws the cash values the insurer must be compensated for the investment income they lose.
Originally the purpose of policy loans was to provide a source of funds for policy owner emergencies, but people soon realized they could use the money for any purpose – not just emergencies. Savvy investors pulled their cash values through policy loans and invested them in short-term vehicles at higher rates to earn a profit. For example, a policy owner earning 5 percent on his cash values might withdraw the money and invest in short-term financial paper at 8 percent, earning a higher rate than he could have in his life insurance policy. This became a widespread occurrence and it put insurance companies at a competitive disadvantage.
The National Association of Insurance Commissioners, partially as a result of this problem, approved a model bill permitting a policy loan provision for new polices that allowed periodic adjustments of the policy loan rate. The adjustments are based on specified indexes of long-term corporate bond yields. The maximum loan rate for each policy must be determined at regular intervals, at least once a year but not more often than once in any three-month period. The rate charged may be increased if the increase would be 0.5 percent per annum. It must be decreased if the decrease would amount to 0.5 percent per annum. The NAIC model bill permits a fixed policy loan interest rate of 8 percent in place of the variable rate.
Grace Periods and Reinstatement
Insurance contracts provide a grace period during which the insured may pay their premiums without losing insurability. While it is never wise to pay premiums late, the grace period does allow policy owners to maintain their policies even if premiums are paid late, as long as they are paid within the grace period allowed. Grace periods are 30 or 31 days following the premium due date. If late premiums are paid within this time period the policy remains in effect, as though premiums had been paid on time.
If premiums are not paid by the end of the grace period policies without cash value will terminate. Those with cash values will be placed on the appropriate nonforfeiture option. If death occurs during the grace period any unpaid premium will be deducted from the life proceeds the beneficiary receives.
Policyholders may reinstate their lapsed policy within specified time periods. He or she will be required to pay all back premiums prior to reinstatement and provide proof of insurability. The length of reinstatement varies but usually the time is three to five years. If reinstatement is sought by the insured within a short time of lapse proof of insurability may be no more than a simple statement made by the policyholder. For longer periods of lapse the insurer may require a medical examination similar to what a new application would require.
Allowed Policy Provisions
Some policy provisions are allowed since they do not violate state or federal requirements. State laws generally allow insurers to include restrictions for such things as suicide, aviation, and war, for example.
Suicide
If an individual was suicidal it would be logical to first buy a life insurance policy naming loved ones as beneficiaries. This would be considered “adverse selection.” Obviously, it would not benefit insurers to have very many people buy a policy and then commit suicide. Therefore, there is a restriction in life insurance policies restricting benefits when death is the result of suicide. Polices will not pay benefits for suicide within two years from the date of issuance (a few restrict payment for one year). Insurers must still return all premiums that have been paid but no death benefit is due.
Aviation
Aviation restriction provisions are usually limited to planes flown by nonprofessionals and the insured individual. Flight in commercial airlines would not be restricted. Usually the provision states exclusion “for aviation deaths, except those of fare-paying passengers on regularly scheduled airlines.” Military aircraft is typically excluded since that would imply active duty in the military, which would be covered by military life insurance. Military exclusions may read similar to: “exclusion of deaths in military aircrafts only; exclusion of pilots, crew members, or student pilots and aviation death while on military maneuvers.” There was a time when only policies issued during periods of war would include these clauses but today, with America involved in non-declared war conflicts, these are more likely to appear in contracts.
War
War clauses vary widely so it is always important to review the actual policy for details. Some policies will totally prohibit payment for deaths resulting from war in any capacity while others will prohibit payment only for specific situations. If the death occurred while the insured was in the military, for example, but the death itself was not related to war activities the policy might still pay benefits to the beneficiary. The insurer will refund any premiums that were paid or an amount equal to the policy reserve.
General Provisions
Insurance companies certainly underwrite and create policies with profits in mind. It would actually be unethical for them to do otherwise since they must remain in business if they are to pay out benefits to those that deserve them. Even state and federal laws recognize that insurers must remain profitable. With that goal in mind, there are general provisions designed for the protection of the insurer, which in turn protects policy owners.
Deduction of Indebtedness and Premium Refund
Indebtedness to the insurer from a policy loan will be deducted from any proceeds payable to a beneficiary at death, or from cash values upon surrender of the policy. Insurers may refund unused premiums if the insured dies with an insured term paid for, but this is not generally required by law.
For example: Ivan Insured mails a quarterly life insurance premium payment to his insurance company on December 15th for the policy term from January 1 through March 31. On December 28th he unexpectedly dies from injuries incurred in an automobile accident. His insurer may or may not automatically refund his quarterly payment to his estate, depending upon company practice.
His insurance company is not required to return his premium but may do so if it is their normal practice to do so. Even when an insurance company does not ordinarily return unused premium, they may do so upon request. Therefore, estate administrators typically do request refund of unused premiums as a matter of standard estate settlement practices.
Change of Beneficiary
When an application is taken for life insurance coverage the agent requests a primary beneficiary listing. The beneficiary may be a single person or multiple people. When multiple people are named the application will request a listing of each beneficiary percentage of proceeds upon the insured’s death. For example, it may state: Mary Maxwell: 50% and James Higgins: 50%. If the agent is wise, he or she will also request a contingent beneficiary in case the first named beneficiary or beneficiaries predeceases the insured.
In most policies the applicant reserves the right to change the primary and contingent beneficiary designations. In many cases change of beneficiary is merely a matter of filling out a new beneficiary designation form, but some companies may require the original policy be returned along with the completed form.
Assignment
In property insurance contracts the consent of the insurer is needed to assign benefits to another, but this is not typically the case for life insurance contracts. However, the life insurance company is likely to require notice of assignment be filed with their home office. This is usually considered a consumer protection measure.
Beneficiary Designations
While it is not mandatory, the wise policy owner will always name an individual or individuals as policy beneficiaries. Seldom would entering “estate” on the beneficiary line be wise. Policy benefits bypass probate proceedings when a person is the listed beneficiary. The designation may be either revocable or irrevocable. Most people would always choose a revocable designation, meaning the insured can change his or her named beneficiary any time they wish to, and usually as often as they wish.
If the beneficiary designation is irrevocable all policy rights are vested in the beneficiary and the policy owner may not assign the policy or borrow on it without first getting the beneficiary’s permission. An irrevocable beneficiary designation may be either reversionary or absolute. In reversionary designations the policy rights revert to the policy owner if the beneficiary dies first. In absolute designations the value of the policy is included in the beneficiary’s estate for the beneficiary’s heirs.
It is important to be precise when listing beneficiary designations. An agent is unlikely to allow his or her client to simply list “Granddaughter Nancy” for example. While there may currently be only one granddaughter named Nancy there is no way to know what the future may bring. It is important to list full names so there is no doubt as to who the intended beneficiary is. If available, listing the beneficiary’s Social Security number is also advisable.
Policy forms allow both a primary and secondary beneficiary listing. The secondary beneficiary is often referred to as the contingent beneficiary designation. The contingent beneficiary would receive the life insurance proceeds if the primary beneficiary had died prior to the insured individual.
Some third-party rights do exist in life insurance contracts. Beneficiary rights are determined by the type of beneficiary designation and by the ownership of the policy. In some cases, the beneficiary is both the beneficiary and the policy owner; certainly, he or she can then exercise all policy rights by virtue of contract ownership. The owner may exercise all policy rights including policy loans and assignments regardless of the type of beneficiary designation.
If the beneficiary is not also the owner but is revocably designated as beneficiary he or she has a contingent interest in the policy. This is an interest that is contingent upon the subject dying prior to the named beneficiary and prior to revoking that person in favor of another. A revocable designation may be changed to someone else if the insured wishes to.
A person named as an irrevocable beneficiary has a vested interest in the policy. He or she can deny the owner permission for policy loans, assignment and any other action relating to the policy that would affect the proceeds the irrevocable beneficiary would receive, assuming he or she outlives the insured.
Creditors’ rights to the insured’s cash values and life insurance proceeds are generally restricted by common law, federal statutes, and state statutes. Sometimes creditors’ rights depend to some degree on how the beneficiary designation is stated. If the insured dies and the beneficiary designation listed “estate” it will likely make the funds available to creditors. It may be possible to legally attach a life insurance policy but the availability of any cash reserves or values would depend on the policy’s provisions. If removing the cash values will not cancel out the policy, the courts may allow it. Even so, if the right to collect is a policy option to be exercised by the insured, the insurance company is not obligated to pay the cash value until the insured elects that option, so creditors may not be able to actually receive the cash values. Creditors do not have the right of election and the courts will not typically force election on the insured. Creditors can claim cash values only through formal bankruptcy proceedings.
In the case of death, the courts have ruled that policy proceeds then belong to the named beneficiaries, as long as “estate” was not listed rather than an actual person. As a result, proceeds are not subject to the insured’s creditors because they now belong to the third-party beneficiaries. If the insured owes taxes, usually collection is limited to cash values, not death proceeds.
Two federal statutes concern creditor’s rights to life insurance: federal tax liens and bankruptcy. The federal government can collect its tax claims directly from the insured’s insurance company, although it is limited to the policy’s cash values. If the insured dies prior to paying the taxes he or she owes, the tax claim is still collected but it is limited to the cash values contained in the policy immediately prior to death.
When a policy owner files bankruptcy the Federal Bankruptcy Act determines how life insurance policies are treated.
State statutes have generally exempted life insurance from creditor’s claims, although each state will have variances. State statutes take precedence over the Federal Bankruptcy Act. Crossman Co. v. Ranch in New York stated exemptions on life insurance proceeds were enacted for “the humane purpose of preserving to the unfortunate or improvident debtor or family the means of obtaining a livelihood and preventing them from becoming a charge upon the public.”
In many states the exemption extends only to policies payable to the insured’s spouse and children. In some states it extends the protection to any person that was dependent upon the insured, which could even include aged parents. Some states extend this creditor protection to any listed beneficiary (that is not the estate). In most states this protection includes not only the death proceeds but also any cash values. A few states provide protection from creditors to the beneficiaries as well as the insured. If the statute is not applicable to the beneficiary’s creditors the insured may provide this protection by including a spendthrift trust clause in the policy settlement agreement. This clause gives the beneficiary protection from their personal creditors. A spendthrift trust clause requires the policy owner to elect an installment settlement option. Only the proceeds held by the insurer for the benefit of the beneficiary are protected; any money the beneficiary receives is then available to creditors.
Every time an application for life insurance is made the applicant has several decisions to make. These decisions concern beneficiary designations as well as ownership and policy options. All decisions are important.
Policy Payments
Policyholders and beneficiaries may receive payments under the terms of their life insurance policy. The payment amount depends upon a variety of factors relating to the policy. Obviously, a term insurance policy would not have any cash values whereas a universal life insurance policy might. Even in a permanent policy, such as universal life, payments would depend upon how many and how long premiums have been paid. It would also depend how the insurance carrier handles policy costs.
Cash Values
All forms of permanent insurance, such as universal life, have cash values if sufficient premiums have been paid. The policy will state the amount of cash value available each year the policy remains in force. A cash value policy is expensive if the insured does not keep the policy active for a sufficient length of time; short term life insurance needs are best suited to term coverage (with no cash values). Experts recommend cash value policies be kept for no less than ten years. For those that do select cash value products and keep them long enough to make the cost worthwhile cash values can be effective in supplying retirement income or emergency cash.
Cash values may be accessed at any time at the policy owner’s request. However, there are other options besides just withdrawing the funds. These options include:
1. Borrowing against the policy. Once money is borrowed, if the insured dies prior to repaying the loan, the amount borrowed will be subtracted from the benefits that are payable to the listed beneficiaries.
2. Buying reduced coverage. If the insured finds he or she is not able to pay the premiums but still wants to keep the coverage, it is possible to get reduced permanent life insurance. The cash value is used to buy a smaller policy that is paid in full.
3. Changing to term insurance. If it becomes difficult to manage the premiums in a cash value life insurance policy, the insured could elect to reduce the cost by using cash values to purchase a paid-up term life policy, assuming sufficient cash values exist to do this. When the term contract ends, coverage also ends. This may be referred to as extended term life insurance.
Dividends
For insurance purposes, dividends are refunds of premiums for those who have participating policies. A participating policy (called a par policy) is one that has a premium fixed at an amount higher than the insurance company believes will be needed to cover the costs of providing protection. The extra payment is returned to the policyholder as a dividend after the actual insurance costs are determined. The policy owner is guaranteed not to have to pay higher premiums than those stated in the policy. The dividends can be used to pay the lower premiums, buy additional insurance, or earn interest if left in the policy cash values.
Nonparticipating policies, referred to as non-par policies, have premiums fixed as close as possible to the actual cost of providing the coverage. As a result, there would not be any dividends paid to the policy owner.
Proceeds
Proceeds are paid to a listed beneficiary when the insured individual dies. To receive the proceeds the beneficiary must file a claim with the insuring company. Once the proper filing has been made, the individual will receive the face amount of the policy, called the proceeds. Proceeds can be received in one of several ways, called settlement options. The settlement options include:
1. Lump-sum option, which allows the beneficiary to receive the entire amount in cash.
2. Amount option, which allows the beneficiary to take a certain amount each month until the money and interest run out.
3. Time option, which allows the beneficiary to take the money plus interest paid out over a specified period of time (such as ten or twenty years) on a monthly installment basis.
4. Interest option, in which the cash values are left on deposit with the insurance company to earn interest indefinitely. The recipient simply withdraws the interest earning periodically as the need for cash arises.
5. Lifetime income option, in which the individual receives a guaranteed income for their lifetime. The payments consist of interest only so they can never run out.
Special Clauses
While all contracts can be intimidating, some of the most difficult contract language is found in insurance policies that have special clauses. Special clauses may do multiple things, depending upon the insurer’s intent. These clauses might limit the insured’s rights or grant the policy owner important privileges. Agents must understand and be able to communicate the options or limitations special clauses contain.
Nearly all policies have clauses of some sort. They might include:
1. Incontestable clauses, which state that the insured has a “temporary” policy for a specified length of time; incontestability of the coverage is typically two years. If the insurer finds the insured has lied or misrepresented the facts on their application for the specified period of time the company may refuse to pay a claim or even rescind (take back) the coverage entirely. Of course, a life insurance policy would end anyway upon the death of the insured, so rescission is not really an issue if the insured has died.
2. Waiver-of-premiums clause, which waives premium payments after a stated period of qualified disability, often six months. The length of time the clause will pay premiums depends upon the contract. This provision is particularly important when the insured becomes disabled, sick, or injured and cannot work for a period of time. Without this provision failure to pay the premiums, even if it is due to a disabling injury, will mean lapse of coverage. Some policies will pay the premiums on the insured’s behalf up to the age of sixty-five, so this provision is a significant benefit to the insured individual and his or her family.
3. Automatic premium loan, which will pay the premium on behalf of the insured if he or she fails to do so. The premiums are charged against the policy as an automatic premium loan so the policy does no lapse. Interest will be charged on the loan.
4. Accidental death benefit, which might also be called an indemnity. An indemnity clause promises the policy will pay an extra amount if the insured dies as a result of an accident rather than natural causes. We sometimes hear this referred to as a “double indemnity clause” when the insurer will pay double the face value when death results from an accident. It can be more than a double indemnity, depending upon contract terms; it could be triple indemnity or even quadruple indemnity. There are often some identifying requirements for indemnity payment; for example, the insured may have to die within 90 days of the accident to receive these additional proceeds. If he or she lives longer than the requirement, it would not be treated as death by accident, but instead it would be considered death by natural causes (so no indemnity payment would be available). Most policies do charge an additional premium for the accidental death benefit, but it is typically very low since accidental death is not as likely as natural death. The actual premium will depend upon risk factors for the insured.
5. Assignment clause; if the insured has kept the right to change his or her life insurance beneficiary, the policy can be assigned to another party to serve as security for a debt or loan. Some banks will lend money on a life insurance policy if it can be assigned to them, for example. If the insured does not have the legal right to assign the life insurance policy, then the beneficiary would have to give permission to do so.
6. Non-cancelable clause, which allows the insured to continue an insurance policy for as long as the premiums are paid. It cannot be canceled for any reason other than nonpayment of premium. This becomes very important if the insured develops a medical condition that renders him or her uninsurable.
7. Guaranteed insurability option, which allows the policy owner to buy additional insurance at some point without proving his or her current insurability. Like the non-cancelable clause this becomes important if health status changes, making the insured uninsurable. Typically, this option is available to new applicants who are under the age of forty who are buying a whole-life, universal life, or endowment policy. Although the availability of buying additional insurance depends upon contract language, often additional insurance is available every few years until the age of forty. The amount of additional insurance available may be limited so it is important to read the policy carefully.
8. Exclusions: some policies exclude certain situations entirely from coverage. For example, non-fare airplane flight is often completely excluded under the policy exclusions. Exclusions tend to be similar in all policies but since there may be some variance the buyer should shop around if a particular exclusion applies that he or she would like covered by their life insurance policy. In many cases, if death results from an exclusion companies will return premiums if the death occurs within the first two policy years.
End of Chapter 2