Life and Annuity Policies
The Life and Annuity Policies domain tests whether you can read a life contract, follow the money through its provisions, and explain how annuities accumulate and pay out. Expect questions on incontestability, nonforfeiture, dividend and settlement options, ownership and beneficiary designations, policy loans, and the taxation of annuity payments.
Provisions that decide the claim
- Incontestability: after the policy has been in force two years from issue, the insurer generally cannot contest for misrepresentation. The suicide clause runs about two years and pays a refund of premiums.
- Grace period is commonly 31 days. Reinstatement usually requires evidence of insurability plus back premiums with interest, typically within three years (some states allow five).
- Misstatement of age or sex does not void the policy; the benefit is adjusted to what the premium would have bought at the correct age and sex.
- Policy loans accrue interest and unpaid loan plus interest is deducted from proceeds. Automatic premium loan prevents lapse by borrowing the premium.
- Entire contract, free look (10–30 days), and incontestability together define what the insurer can rely on.
Nonforfeiture and dividend options
- Nonforfeiture: cash surrender, reduced paid-up (lower face, no further premiums), extended term (full face for a limited period). Extended term is normally the automatic option when a policy lapses without APL.
- Dividends are a return of premium and are not taxable until cumulative dividends exceed premiums paid. Options: cash, reduce premium, accumulate at interest, paid-up additions, one-year term.
Ownership, beneficiaries, settlement
- The owner controls everything; a beneficiary has only an expectancy unless the designation is irrevocable. Per stirpes versus per capita matters when a child predeceases the insured.
- Settlement options: lump sum, interest only, fixed period, fixed amount, life income with or without period certain.
Annuity mechanics
Immediate versus deferred; fixed, variable (registered as a security), and indexed. Accumulation units versus annuity units. Exclusion ratio = investment in the contract ÷ expected return; once basis is recovered, payments are fully taxable.
Worked example
A whole life policy has a $250,000 face, $40,000 cash value, a $12,000 outstanding loan, and $3,000 of dividends accumulated at interest. The insured dies. The death benefit is $250,000 − $12,000 + $3,000 = $241,000. Cash value is irrelevant because the death benefit, not the surrender value, is paid. If the owner surrendered instead, the taxable gain would be $40,000 + $3,000 − $12,000 − cost basis.
Traps that cost marks
Treating reduced paid-up and extended term as interchangeable; assuming a beneficiary can change the owner's election; assuming dividends are tax-free forever; forgetting that a loan reduces the death benefit; confusing the annuitant, owner, and beneficiary in an annuity.