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Taxation, Riders, and Adjusting Life Insurance for Inflation
In this section we elaborate on the following:
Tax treatment of life insurance benefits
Descriptions of different life insurance policy riders
How life insurance needs can be adjusted for inflation
In the United States, we typically pay individual life insurance premiums out of funds on which we previously had paid income taxes. That is, premiums are paid from after-tax income. Therefore, there are no income taxes on the death benefit proceeds.
In general, when premiums are paid from after-tax income, death benefits are not part of the beneficiary’s or anyone else’s gross income .
Therefore, whether the death is soon or long after purchasing a $100,000 life insurance policy, the named beneficiary, regardless of relationship, would not incur any federal income taxes on the proceeds, including gains within the cash value portion of the policy.
Nontaxable proceeds also include nonbasic benefits such as term riders, accidental death benefits, and paid-up additions. Some life insurance policies include dividends, and these policyholder dividends are excluded from federal income taxation.
The federal government reasons that dividends constitute the return of an original overcharge of premiums. The premiums were paid with after-tax dollars, so any portion of those premiums, returned as a dividend, must have already been taxed as well.
Taxation – Continued
Except for single-premium life insurance, the purchase of most life insurance is motivated primarily by a need for death protection.
The availability of private life insurance reduces pressures on government to provide welfare to families that experience premature deaths of wage earners. Furthermore, life insurance is owned by a broad cross section of U.S. society.
This, along with effective lobbying by life insurers, may help explain the tax treatment of life insurance.
Life Insurance Riders
Through the use of riders, life insurance policies may be modified to provide special benefits.
Under specified circumstances, these riders may:
Waive premiums if the policyholder becomes disabled
Provide disability income
Provide accidental death benefits
Guarantee issuance of additional life insurance
Pay accelerated death benefits (before death)
Waiver of Premium
The waiver of premium rider is offered by all life insurance companies and is included in about half of the policies sold. Some companies automatically provide it without charging an explicit amount of additional premium.
The rider provides that premiums due after commencement of the insured’s total disability shall be waived for a period of time. A waiting period of six months must be satisfied first.
In flexible premium contracts such as universal and variable universal life, the waiver of premium provision specifies that the target premium to keep the policy in force will be credited to the insured’s account during disability .
If a premium was paid after disability began and before the expiration of a waiting period, the premium is refunded. When disability begins before a certain age, usually age sixty, premiums are waived as long as the insured remains totally disabled.
Definition of Disability
To qualify for disability benefits, the disability must be total and permanent and must occur prior to a specified age. Disability may be caused by either accidental injury or sickness; no distinction is made.
Typically, for the first two years of benefit payments, the insured is considered totally disabled whenever he or she, because of injury or disease, is unable to perform the duties of the regular occupation. Beyond two years, benefits usually continue only if the insured is unable to perform the duties of any occupation for which he or she qualified by reason of education, training, and experience.
A minority of insurers uses this more restrictive definition from the beginning of the waiver period. Most insurers and courts interpret the definition liberally. Most riders define blindness or loss of both hands, both feet, or one hand
and one foot as presumptive total disability.
Typically, disability longer than six months is considered to be permanent. Circumstances may later contradict this assumption because proof (generally in the form of a physician’s statement) of continued disability is usually required once a year up to age sixty-five.
The disability income rider provides a typical income benefit of $10 per month per $1,000 of initial face amount of life insurance for as long as total disability continues and after the first six months of such disability, provided it commences before age fifty-five or 60.
Under some contracts, payments stop at age sixty-five and the policy matures as an endowment, but this is less favorable than continuation of income benefits.
The definitions of disability for these riders are like those for waiver of premium provisions. Most disability income insurance is now sold either through a group plan or as separate individual policies. Most life insurers do not offer this rider.
Accidental Death Benefit
The accidental death benefit rider is sometimes called double indemnity.
It usually provides that double the face amount of the policy will be paid if the insured’s death is caused by accident, and sometimes triple the face amount if death occurs while the insured is riding as a paying passenger in a public conveyance. Figure 19.8 illustrates the accidental death benefit rider.
A typical definition of accidental death is, “Death resulting from bodily injury independently and exclusively of all other causes and within ninety days after such injury.”
Certain causes of death are typically excluded: suicide, violations of the law, gas or poison, war, and certain aviation activities other than as a passenger on a scheduled airline. This rider is usually in effect until the insured is age seventy.
Guaranteed Insurability Option
Many insurers will add a guaranteed insurability option (GIO) to policies for an additional premium. This gives the policyowner the right to buy additional amounts of insurance, usually at three- year intervals up to a specified age, without new proof of insurability.
The usual age of the last option is forty; a small number of insurers allow it up to age sixty-five. The amount of each additional purchase is usually equal to or less than the face amount of the original policy.
If a $50,000 straight or interest- sensitive life policy with the GIO rider is purchased at age twenty-one, the policyowner can buy an additional $50,000 every three years thereafter to age forty, whether or not the insured is still insurable. By age forty, the total death benefit would equal $350,000.
The new insurance is issued at standard rates on the basis of the insured’s attained age when the option is exercised. The GIO rider ensures one’s insurability. It becomes valuable if the insured becomes uninsurable or develops a condition that would prevent the purchase of new life insurance at standard rates.
Accelerated Death Benefits
Some medical conditions regularly result in high medical expenses for the insured and his or her family or other caregivers. The need for funds may significantly exceed benefits provided by medical and disability insurance because of deductibles, coinsurance, caps on benefits, and exclusions, and (perhaps primarily) because of having purchased inadequate coverage.
Accelerated death benefits are triggered by either the occurrence of a catastrophic illness or the diagnosis of a terminal illness, resulting in payment of a portion of a life insurance policy’s face amount prior to death.
The accelerated benefits are also called living benefits, or terminal illness rider. Usually, the terminally ill insured can receive up to 50 percent of the death benefits to improve quality of life before death. Often, the coverage is provided without an additional premium.
The benefit can usually be claimed when two doctors agree that the insured has six months or less to live. When the insured desires greater amounts, he or she may use a viatical settlement company to transfer the ownership of the policy to a third party in return for a higher percentage of the death benefits, perhaps 80 percent.
Catastrophic Illness Coverage
When a catastrophic illness rider is added to a life insurance policy (usually requiring an additional premium), a portion (usually 25 to 50 percent) of the face amount is payable upon diagnosis of specified illnesses. The named illnesses differ among insurers but typically include organ transplantation.
As benefits are paid under either a catastrophic or terminal illness rider, the face amount of the basic policy is reduced an equal amount, and an interest charge applies in some policies. Cash values are reduced either in proportion to the death benefit reduction or on a dollar-for-dollar basis.
Adjusting Life Insurance for Inflation
Participating policies, current assumption whole life policies, and universal life policies recognize inflation in a limited manner.
Participating contracts can respond to inflation through dividends. Dividends can be used each year to purchase additional amounts of paid-up life insurance, but these small amounts of additional protection seldom keep pace with inflation.
Interest-sensitive contracts partly recognize inflation by crediting investment earnings directly to cash values. We say “partly recognize” because cash values in these policies are primarily invested in short- term debt instruments like government securities and in short-term corporate bonds, and the interest
rates for these have an expected inflation component at the time they are issued.
The expected inflation component is there because, in addition to a basic return on the money being loaned and an increase to reflect financial risks of failure, investors in debt instruments require an incremental return to cover their projections of future inflation rates.
Thus, contracts with direct crediting of insurer investment returns to cash values give some recognition to inflation. The recognition is weak, however, for two reasons. First, the protection element of these contracts does not respond quickly, or at all for type A contracts, to inflation. 
Buy More Life Insurance
As long as you are insurable, you can buy more life insurance as your needs increase. What if you become uninsurable? You can protect yourself against that possibility by buying a policy with a guaranteed insurability option; however, this has drawbacks.
First, the option is limited to a specified age, such as forty, and you may need more insurance after that age.
Second, you must buy the same kind of insurance as the policy you have. Third, the premium will be higher due to your age.
Buy a Cost-of-Living Rider or Policy
Another alternative is the inflation rider (or cost-of-living), which automatically increases the amount of insurance as the consumer price index (CPI) rises.
It provides term insurance in addition to the face amount of your permanent or term policy up to a point.
If, for example, you have a $100,000 whole life policy and the CPI goes up 5 percent this year, $5,000 of one- year term insurance is automatically written for next year at the premium rate for your age. You are billed for it along with the premium notice for your basic policy.
Because your premium increases with each increase in coverage, you may conclude that you bear the risk of keeping your coverage up with inflation. Keep in mind that no evidence of insurability is required. You do not have to accept (and pay for) the additional insurance if you don’t want it. If you refuse to exercise the option, however, it is no longer available.
Buy a Variable or Variable Universal Life Policy
The face amount of variable life and variable universal life (except for the level face amount type) policies fluctuates with the performance of one or more separate accounts.
You have the option of directing most of your premiums into common stock accounts where long-run returns are expected to offset CPI increases.
If you buy a variable life policy, you assume the risk that the equity markets may be going down at the same time that the CPI is going up.
Should you buy a variable life policy? The answer depends on you. How much investment risk are you willing to take in coping with inflation?
In this section you studied taxation of life insurance, major policy provisions, common life insurance riders, and accommodations to life insurance for inflation:
There is no taxation on death benefits in life insurance (nor on dividends in participating policies).
Life insurance riders:
1. Waiver of premium-allows premiums to be discontinued for a period of time in the event of insured’s total disability
2. Disability income-pays a benefit in the event of insured’s total disability
3. Accidental death benefit-double indemnity for death caused by accident
4. Guaranteed insurability-allows insured to purchase additional insurance at intervals without new evidence of insurability
5. Accelerated death benefits-allows insured to receive up to 50 percent of death benefit to improve quality of life before death
6. Catastrophic illness-pays portion of face amount upon insured’s diagnosis of specified illness
Effects of inflation can be managed by using dividends to purchase additional amounts of paid-up insurance, buying a cost-of-living rider, or buying variable insurance or variable universal life insurance.
The premium on Bill Brown’s traditional whole life policy was due September
1. On September 15, he mailed a check to the insurance company. On September 26, he died. When the insurance company presented the check to the bank for collection, it was returned because there were insufficient funds in Bill’s account. Does the company have to pay the claim presented by Bill’s beneficiary? Why or why not? What provisions might result in payment?
2. If you don’t need life insurance now but realize you may need it sometime in the future, would you be interested in buying a guaranteed insurability option, if it were available, without buying a policy now? Why or why not?
3. Describe the nature of what is purchased by the dividend on a life insurance policy when it is used to buy paid-up additions.
4. What desirable features characterize the policy loan provision of a cash value life insurance policy relative, for example, to borrowing money from a bank? How do policy loans affect death benefits?
5. Can you think of any ways that the terms of an accidental death benefit rider might encourage moral hazard?
6. When the dollar value of your home increases because of inflation, the insurer normally automatically increases the amount of insurance on your dwelling and its contents. Why does your life insurer require evidence of insurability before allowing you to increase the face value of your universal life insurance policy? (Assume no cost-of-living rider or guaranteed insurability rider.) How do you explain this difference between insuring homes and human lives?
 Tax law changes in 1988 made single-premium surrenders and policy loans undesirable because any gain over net premiums becomes taxable immediately. Furthermore, gains are subject to an additional 10 percent tax penalty if the policyowner is less than age fifty-nine and a half. Thus, the tendency of single-premium buyers is to let the policy mature as a death claim. At that time there are no adverse income tax effects.
 An alternative to the waiver of premium rider for flexible premium contracts waives only the amount required to cover mortality cost and expense deductions.
 Policies with flexible face amounts usually issue the accidental death rider for a fixed amount equal to the basic policy’s initial face amount.
 Small recognition in total death benefits exists in type B universal policies because any increases in cash value as a result of higher interest rates are added to a level amount of protection. Dividends may be used to buy additional amounts of insurance, but the relationship to inflation is weak.
END of UNIT
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