Life Insurance and Annuities: Contract Mechanics That Drive Every Recommendation
The life and annuity domain tests contract mechanics rather than product slogans: how coverage attaches, what the insurer can contest, which rights belong to the owner, and how annuity payments are taxed. Expect exclusion-ratio calculations mixed with definition items on beneficiaries and nonforfeiture.
Formation and contestability
Coverage attaches when the application, first premium, and policy delivery are complete; a conditional receipt gives interim coverage only if the proposed insured would have been approved under the insurer's own rules. Underwriting draws on the MIB, prescription databases, paramedical exams, and an attending physician statement for large faces. Application answers are representations, not warranties. Incontestability bars rescission for misrepresentation after two years from issue, and the suicide clause runs the same two years; misstatement of age or sex is handled by benefit adjustment and sits outside incontestability.
Owner rights and policy options
The owner (not the insured or beneficiary) controls beneficiary changes, loans, surrender, and assignment. Grace period is 30 or 31 days; reinstatement usually requires evidence of insurability plus overdue premiums with interest, within three years. Whole life nonforfeiture options are cash surrender, reduced paid-up, and extended term. Settlement options are interest only, fixed period, fixed amount, and life income with refund variants. Universal life cash value is not guaranteed: credited interest and cost of insurance can both move.
Annuity taxation
Fixed annuities credit a declared rate; variable annuities use separate-account subaccounts and are securities; indexed annuities credit an index formula. Exclusion ratio = investment in the contract ÷ expected return.
Worked example. A client places $60,000 in a nonqualified immediate annuity paying $500 monthly for 20 years ($120,000 expected return). Ratio = 60,000 ÷ 120,000 = 50%, so $250 of each payment is tax-free basis and $250 is ordinary income; once basis is recovered, the full payment is taxable.
Traps
Treating UL or indexed crediting as guaranteed; forgetting that variable products need a securities registration as well as a state license; assuming the 10% penalty disappears after basis recovery, when it actually applies to gains taken before 59½ and to all MEC distributions, which are taxed LIFO.