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CFP Module 3 practice questions

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Question 1Principles of Risk Management and Insurance

In risk management terminology, which situation best illustrates pure risk rather than speculative risk?

  1. A trader taking a currency position for profit
  2. A homeowner's property being destroyed by a fire Correct answer.
  3. A company launching a new product line
  4. An investor buying shares hoping the price rises

Explanation

Pure risk involves only the possibility of loss or no loss, with no chance of gain, which is why it is the classic insurable category. Fire damage to property fits this definition because the owner can only lose or stay the same. Speculative risk, by contrast, carries both upside and downside.

Question 2Principles of Risk Management and Insurance

Which risk-handling technique is being used when a firm decides to stop manufacturing a hazardous chemical entirely rather than insure against liability claims?

  1. Risk reduction
  2. Risk transfer
  3. Risk avoidance Correct answer.
  4. Risk retention

Explanation

Avoidance eliminates the exposure by abandoning the activity that creates it, so no loss can arise from that source. Because the firm exits the hazardous activity rather than financing or mitigating it, avoidance is the correct classification. Retention, transfer, and reduction all assume the exposure continues to exist in some form.

Question 3Principles of Risk Management and Insurance

Which characteristic must an exposure satisfy for a loss to be considered insurable under the principle of insurable interest?

  1. The insured must stand to suffer a financial or legal detriment from the loss Correct answer.
  2. The insured must have purchased the policy before the loss occurred by at least one year
  3. The insured must be the only person with any relationship to the subject matter
  4. The insured must own the property outright with no mortgage

Explanation

Insurable interest requires that the insured would suffer a genuine financial or legal loss if the event occurred, which prevents insurance from becoming a wagering contract. Ownership is one way to establish interest, but it is not the only way, and other relationships such as creditor or family ties can qualify. Timing rules vary by line of insurance and are not defined by a one-year waiting period.

Question 4Principles of Risk Management and Insurance

An insured's policy contains a $500 deductible and a 20% coinsurance clause applying to a $200,000 building. A covered loss of $40,000 occurs, and the building's value at the time of loss is $250,000. Ignoring any other provisions, what amount will the insurer pay under the coinsurance formula?

  1. $32,000
  2. $39,500
  3. $31,500 Correct answer.
  4. $24,000

Explanation

The coinsurance requirement is 20% of $200,000, or $40,000, but the limit carried is $200,000, which exceeds the requirement, so no coinsurance penalty applies. The insurer pays the loss of $40,000 less the $500 deductible, or $39,500. A penalty would only arise if the insured carried less than the required amount of insurance.

Question 5Principles of Risk Management and Insurance

Under the principle of indemnity, what is the fundamental purpose of a property insurance payment following a covered loss?

  1. To guarantee the insured a profit from the claim settlement
  2. To replace all damaged property with new items regardless of age
  3. To restore the insured to approximately the same financial position as before the loss Correct answer.
  4. To punish the insurer for underwriting errors

Explanation

Indemnity aims to place the insured back in the pre-loss financial position, no better and no worse, which is why actual cash value and deductibles are used. Paying more than the loss would create a moral hazard and violate the principle. Replacement cost coverage is an exception permitted by contract, not the general indemnity rule.

Question 6Principles of Risk Management and Insurance

A policyholder deliberately sets fire to a warehouse to collect insurance money. Which policy provision most directly bars recovery in this situation?

  1. The salvage condition
  2. The concealment or fraud condition Correct answer.
  3. The appraisal clause
  4. The subrogation clause

Explanation

Fraud and concealment conditions void coverage when the insured intentionally causes a loss or misrepresents material facts to obtain payment. Intentional destruction to collect insurance is the paradigm case for applying this provision. Subrogation, appraisal, and salvage address other matters and do not directly address intentional misconduct by the insured.

Question 7Principles of Risk Management and Insurance

Which statement accurately describes the concept of subrogation in property insurance?

  1. The insured assigns all policy rights to the insurer before any loss occurs
  2. The insurer is barred from recovering from any party responsible for the loss
  3. The insured must repay the insurer for all premiums after a claim
  4. The insurer may pursue a negligent third party to recover amounts paid to the insured Correct answer.

Explanation

Subrogation gives the insurer the right to step into the insured's shoes and pursue recovery from the party that caused the loss, up to the amount paid. This supports the indemnity principle by preventing double recovery by the insured. It is a post-loss right and does not involve premium refunds or a blanket bar on recovery.

Question 8Principles of Risk Management and Insurance

A life insurance applicant conceals a serious medical condition on the application. The insurer later discovers the omission during the contestability period. What is the insurer's most likely remedy?

  1. Pay the full death benefit and increase future premiums
  2. Reduce the death benefit by the amount of premiums paid
  3. Convert the policy to a term policy automatically
  4. Rescind the policy and refund premiums because of the material misrepresentation Correct answer.

Explanation

During the contestability period, an insurer may rescind a policy for material misrepresentation, typically returning premiums paid. Concealment of a serious medical condition is generally material because it would have affected underwriting. After the contestability period expires, most policies become incontestable and the remedy is generally unavailable.

Question 9Principles of Risk Management and Insurance

Which of the following is an example of a hazard rather than a peril?

  1. A windstorm
  2. A fire
  3. An oily rag stored next to a furnace Correct answer.
  4. An earthquake

Explanation

A hazard is a condition that increases the chance or severity of a loss, while a peril is the actual cause of loss. An oily rag near a furnace increases fire risk and is therefore a hazard. Earthquakes, fires, and windstorms are perils because they are the events that cause damage.

Question 10Principles of Risk Management and Insurance

Which type of hazard is present when an insured, knowing a policy will cover the loss, becomes careless about protecting the property?

  1. Moral hazard
  2. Morale hazard Correct answer.
  3. Legal hazard
  4. Physical hazard

Explanation

Morale hazard refers to carelessness or indifference toward loss because insurance is in place, and it arises from attitude rather than dishonest intent. Moral hazard involves a deliberate or dishonest act, such as intentionally causing a loss. Physical hazards are tangible conditions and legal hazards arise from laws or court decisions.

Question 11Principles of Risk Management and Insurance

Which scenario best demonstrates the concept of adverse selection in insurance?

  1. An insurer sells policies in multiple states
  2. An insurer raises premiums after a natural disaster
  3. People with serious health problems are more likely to purchase life insurance than healthy people Correct answer.
  4. A policyholder installs a smoke detector to reduce premiums

Explanation

Adverse selection occurs when those with higher-than-average risk are more likely to seek insurance, which can distort the risk pool and raise costs. The tendency of unhealthy applicants to buy coverage is the classic illustration. Preventive measures and geographic expansion do not describe adverse selection.

Question 12Principles of Risk Management and Insurance

Which of the following is the primary function of an insurer's underwriting process?

  1. To manage the insurer's investment portfolio
  2. To design advertising campaigns for new products
  3. To select and classify risks so that premiums reflect expected loss exposure Correct answer.
  4. To settle claims after a loss occurs

Explanation

Underwriting evaluates and classifies applicants so that each insured is placed in an appropriate risk category and charged a premium commensurate with expected losses. This protects the risk pool from adverse selection. Claim settlement, marketing, and investment management are separate functions.

Question 13Principles of Risk Management and Insurance

An insured holds two fire policies covering the same building: Policy A with a $100,000 limit and Policy B with a $300,000 limit. A covered loss of $80,000 occurs, and neither policy contains an other-insurance clause. How will the loss typically be shared under common law contribution rules?

  1. Policy B alone pays the full $80,000
  2. Policy A pays $20,000 and Policy B pays $60,000, in proportion to limits Correct answer.
  3. Each insurer pays its full policy limit
  4. Policy A pays $40,000 and Policy B pays $40,000, equally

Explanation

In the absence of an other-insurance clause, common law contribution generally allocates the loss in proportion to the policy limits each insurer provided. Policy A represents one quarter of total limits and Policy B three quarters, so the $80,000 loss is split $20,000 and $60,000. Equal sharing and full payment by one insurer are not the default contribution rule.

Question 14Principles of Risk Management and Insurance

Which provision in a property policy establishes the maximum amount the insurer will pay for a covered loss?

  1. The limit of liability Correct answer.
  2. The coinsurance clause
  3. The appraisal clause
  4. The deductible clause

Explanation

The limit of liability sets the maximum dollar amount the insurer will pay for a covered loss under the policy. The deductible reduces the amount payable, while coinsurance may reduce recovery when limits are inadequate, but neither sets the ceiling. The appraisal clause only governs valuation disputes.

Question 15Principles of Risk Management and Insurance

A liability policy written on an occurrence basis covers a loss that happens during the policy period. How does this differ from a claims-made policy?

  1. A claims-made policy covers all future claims without any reporting requirement
  2. A claims-made policy covers only losses that are reported during the policy period, regardless of when the injury occurred Correct answer.
  3. An occurrence policy covers only claims reported during the policy period
  4. A claims-made policy covers only losses that occur outside the policy period

Explanation

Claims-made coverage is triggered by the making of a claim during the policy period, even if the injury occurred earlier, subject to any retroactive date. Occurrence coverage is triggered by when the injury or damage happens. This distinction matters greatly for long-tail exposures such as professional liability.

Question 16Principles of Risk Management and Insurance

Which of the following best describes the purpose of a professional liability policy for an architect?

  1. To cover damage to the architect's office building
  2. To cover employee injuries on the job site
  3. To cover the architect's personal auto accidents
  4. To cover claims arising from errors or omissions in professional services Correct answer.

Explanation

Professional liability insurance, often called errors and omissions coverage, responds to claims that the professional's negligent advice, design, or services caused financial harm. Property, workers' compensation, and personal auto coverages address different exposures. The key is that the claim arises from the rendering of professional services.

Question 17Principles of Risk Management and Insurance

An insured's homeowners policy has a $1,000 deductible and a replacement cost provision on the dwelling. A covered fire causes $15,000 in damage, and the actual cash value of the damage is $11,000. What amount will the insured typically recover for the dwelling loss, assuming the coverage limit is adequate?

  1. $14,000 Correct answer.
  2. $15,000
  3. $11,000
  4. $10,000

Explanation

With replacement cost coverage and an adequate limit, the insurer pays the cost to repair or replace the damage, which is $15,000, less the $1,000 deductible, for $14,000. Actual cash value would have produced a lower figure. The deductible applies once to the covered loss.

Question 18Principles of Risk Management and Insurance

Which principle explains why an insured cannot collect from two insurers for the same loss and end up better off than before the loss?

  1. The principle of indemnity Correct answer.
  2. The principle of adhesion
  3. The principle of proximate cause
  4. The principle of utmost good faith

Explanation

Indemnity limits recovery to the actual financial loss, preventing the insured from profiting from insurance. Other-insurance clauses and contribution rules are mechanisms that enforce this principle when multiple policies apply. Utmost good faith, proximate cause, and adhesion address different doctrinal concerns.

Question 19Principles of Risk Management and Insurance

A restaurant's general liability policy has a per-occurrence limit of $500,000 and a general aggregate limit of $1,000,000. Three separate covered occurrences in the policy year result in losses of $400,000, $400,000, and $400,000. What is the maximum the insurer will pay in total for these claims?

  1. $1,500,000
  2. $1,200,000
  3. $1,000,000 Correct answer.
  4. $500,000

Explanation

Each occurrence is within the $500,000 per-occurrence limit, but the general aggregate caps total payments for the policy period at $1,000,000. The first two claims exhaust the aggregate, so the third claim is not payable. The per-occurrence limit alone does not determine the total available across multiple claims.

Question 20Principles of Risk Management and Insurance

Which statement correctly describes the relationship between risk control and risk financing techniques?

  1. Risk control always involves purchasing insurance
  2. Risk control and risk financing are identical concepts used interchangeably
  3. Risk financing eliminates the possibility of any loss occurring
  4. Risk control reduces or eliminates loss exposure, while risk financing provides funds to pay for losses that occur Correct answer.

Explanation

Risk control addresses the frequency or severity of losses through avoidance, prevention, and reduction, while risk financing addresses how losses are funded through retention or transfer. The two are complementary parts of a risk management program. Insurance is a financing technique, not a control technique.

Question 21Life Insurance

Under a typical level premium term life insurance policy, how are the premiums structured over the policy term?

  1. They decrease as the cash value grows
  2. They remain level for the duration of the term Correct answer.
  3. They increase each year as the insured ages
  4. They are recalculated annually based on investment returns

Explanation

Level term insurance charges a premium that stays constant for the stated term, even though the mortality risk rises with age. The insurer averages the cost over the term so early overpayments offset later underpayments.

Question 22Life Insurance

Which policy feature allows the policyowner to adjust the death benefit and premium within limits without providing new evidence of insurability?

  1. Guaranteed insurability rider
  2. Waiver of premium rider
  3. Nonforfeiture option
  4. Universal life adjustable features Correct answer.

Explanation

Universal life policies permit the owner to change the face amount and premium within contractual limits, subject to underwriting if the face amount is increased. The flexible structure is a defining characteristic of universal life.

Question 23Life Insurance

An applicant completes an application and pays the initial premium. The insurer issues the policy but the agent has not yet delivered it. Under the typical conditional receipt, when does coverage begin?

  1. When the insurer's underwriting department approves the file
  2. On the date of the application or medical examination, provided the applicant proves insurable Correct answer.
  3. Only when the policy is physically delivered and accepted
  4. Thirty days after the application is submitted

Explanation

A conditional receipt provides interim coverage retroactive to the date of application or medical exam, but only if the applicant meets the insurer's underwriting standards. If the applicant is not insurable, no coverage attaches.

Question 24Life Insurance

Which of the following best describes the purpose of a life insurance beneficiary designation?

  1. It determines who pays the estate taxes on the proceeds
  2. It sets the premium schedule for the policy
  3. It establishes the insured's insurable interest at issue
  4. It names the party who receives the death benefit proceeds Correct answer.

Explanation

The beneficiary designation identifies the person or entity entitled to receive the policy proceeds upon the insured's death. Proceeds paid to a named beneficiary generally bypass probate.

Question 25Life Insurance

A whole life policy has a cash value of $40,000 and an outstanding policy loan of $12,000. The insured dies. How much will the insurer pay the beneficiary, assuming no other adjustments?

  1. The face amount less $12,000 Correct answer.
  2. The face amount plus $12,000
  3. $28,000
  4. $40,000

Explanation

On death, any outstanding policy loan plus accrued interest is deducted from the death benefit. The cash value is not paid separately; the beneficiary receives the face amount reduced by the loan balance.

Question 26Life Insurance

Which dividend option under a participating whole life policy uses the dividend to purchase additional permanent coverage at the insured's attained age?

  1. Reduction of premium
  2. Accumulate at interest
  3. Paid-up additions Correct answer.
  4. Cash payment

Explanation

Paid-up additions use the dividend to buy small amounts of additional permanent insurance at the insured's current age, increasing both death benefit and cash value. No further premiums are due on those additions.

Question 27Life Insurance

An insured with a $500,000 decreasing term policy dies in year 15 of a 20-year term. Which statement describes how the death benefit is determined?

  1. It is paid only if death occurs in the final year
  2. It is reduced according to a schedule as the term progresses Correct answer.
  3. It equals the remaining cash value of the policy
  4. It equals the original face amount of $500,000

Explanation

Decreasing term insurance carries a death benefit that declines on a predetermined schedule over the policy term, while the premium remains level. It is often used to match a declining mortgage or loan balance.

Question 28Life Insurance

Which settlement option provides the beneficiary with payments for a specified number of years, with the insurer guaranteeing the amount of each payment?

  1. Life income option
  2. Interest only option
  3. Fixed period option Correct answer.
  4. Fixed amount option

Explanation

Under the fixed period option, the insurer pays the proceeds over a chosen number of years in guaranteed installments. If the beneficiary dies before the period ends, the remaining payments go to a contingent beneficiary or the estate.

Question 29Life Insurance

A policyowner wants to stop paying premiums on a whole life policy but keep some permanent coverage in force. Which nonforfeiture option accomplishes this while producing a smaller face amount?

  1. Reduced paid-up Correct answer.
  2. Cash surrender
  3. Automatic premium loan
  4. Extended term

Explanation

The reduced paid-up option converts the net cash value into a smaller whole life policy that requires no further premiums. Coverage continues for life at the reduced face amount.

Question 30Life Insurance

Which of the following is typically excluded from coverage under an individual life insurance policy?

  1. Death by suicide within the first two years Correct answer.
  2. Death from a heart attack
  3. Death in an automobile accident
  4. Death from a common illness

Explanation

Most policies include a suicide clause that limits the insurer's liability if the insured dies by suicide within a stated period, commonly two years from issue. After that period, suicide is covered.

Question 31Life Insurance

An applicant misstates her age on a life insurance application. When the error is discovered at death, how does the insurer typically respond?

  1. It adjusts the death benefit to what the premium would have purchased at the correct age Correct answer.
  2. It pays the full face amount without adjustment
  3. It denies the claim entirely for misrepresentation
  4. It refunds all premiums paid and cancels the policy

Explanation

The misstatement of age provision allows the insurer to adjust benefits to the amount the premium would have bought at the correct age. This is a standard policy provision that avoids voiding coverage for an honest error.

Question 32Life Insurance

What is the primary purpose of the incontestability clause in a life insurance policy?

  1. To require the insured to submit to annual medical exams
  2. To guarantee the policyowner a loan against cash value
  3. To prevent the insurer from denying a claim for misrepresentation after the contestable period Correct answer.
  4. To allow the insurer to cancel coverage at any time for any reason

Explanation

After the contestable period, typically two years from issue, the insurer cannot deny a claim based on misstatements in the application except for nonpayment of premium. The clause protects beneficiaries from delayed claim disputes.

Question 33Life Insurance

An insured owns a $250,000 whole life policy with a $60,000 cash value and a $20,000 outstanding loan. He surrenders the policy. What amount is taxable as ordinary income?

  1. $40,000 Correct answer.
  2. $0
  3. $20,000
  4. $60,000

Explanation

On surrender, the amount received ($60,000 cash value minus the $20,000 loan equals $40,000) over the cost basis is taxable. If premiums paid total, say, $50,000, the gain is $40,000 minus the basis. The taxable amount is the excess of proceeds over basis, so the gain must be computed against basis.

Question 34Life Insurance

An insured pays $30,000 in premiums over the years on a policy with a $50,000 cash value and no loans. He surrenders the policy. What is the taxable gain?

  1. $0
  2. $20,000 Correct answer.
  3. $50,000
  4. $30,000

Explanation

The taxable gain on surrender equals the cash surrender value minus the cost basis (premiums paid, adjusted). Here $50,000 minus $30,000 yields $20,000 of ordinary income.

Question 35Life Insurance

Which rider allows an insured to purchase additional coverage at specified intervals without proving insurability?

  1. Accidental death benefit rider
  2. Guaranteed insurability rider Correct answer.
  3. Return of premium rider
  4. Long-term care rider

Explanation

The guaranteed insurability rider gives the insured the right to buy stated amounts of additional coverage at specified ages or events without new underwriting. It protects against future uninsurability.

Question 36Life Insurance

An insured's policy includes a waiver of premium rider. The insured becomes totally disabled for six months, satisfying the elimination period. What happens to premiums during the disability?

  1. The policy converts to term insurance
  2. The insurer pays the death benefit early
  3. The insurer waives premiums and the policy stays in force Correct answer.
  4. The cash value is surrendered to pay premiums

Explanation

Once the elimination period is satisfied, the waiver of premium rider excuses premium payments while the policy remains fully in force. Some versions also refund premiums paid during the waiting period.

Question 37Life Insurance

Which statement correctly describes the difference between a primary and a contingent beneficiary?

  1. The primary receives proceeds only if the contingent predeceases
  2. The contingent receives proceeds if the primary is deceased at the insured's death Correct answer.
  3. The contingent is always the insured's estate
  4. Both share proceeds equally at all times

Explanation

The primary beneficiary is first in line for proceeds, and the contingent beneficiary receives them only if the primary is not alive at the time of the insured's death. This avoids having proceeds pass through probate.

Question 38Life Insurance

An insured dies and the policy proceeds are paid to a named individual beneficiary. How are the proceeds generally treated for federal income tax purposes?

  1. Generally received income tax free Correct answer.
  2. Taxable only above the cash value
  3. Taxable as capital gains
  4. Fully taxable as ordinary income

Explanation

Life insurance death benefits paid to a named beneficiary are generally excluded from the beneficiary's gross income for federal income tax purposes. The proceeds may still be included in the insured's estate if the insured held incidents of ownership.

Question 39Life Insurance

A policyowner transfers ownership of an existing policy to an irrevocable life insurance trust. If the insured dies within three years of the transfer, how are the proceeds generally treated for estate tax purposes?

  1. Included in the insured's gross estate under the three-year rule Correct answer.
  2. Excluded because the trust is irrevocable
  3. Excluded because the trust is a separate taxpayer
  4. Taxed only to the extent of premiums paid

Explanation

Under the three-year rule, if the insured transfers an existing policy within three years of death, the proceeds are pulled back into the gross estate. The irrevocable trust only removes the policy from the estate if the transfer occurred more than three years before death.

Question 40Life Insurance

Which of the following best describes the insurable interest requirement at the time a life insurance policy is purchased?

  1. The insurer must hold collateral equal to the face amount
  2. The insured must own property that secures the policy
  3. The beneficiary must expect to lose financially or emotionally if the insured dies Correct answer.
  4. The policyowner must be the insured's employer

Explanation

Insurable interest requires that the beneficiary have a reasonable expectation of financial or emotional loss from the insured's death at the time of application. It must exist at issue, not necessarily at death.

Question 41Life Insurance

A 45-year-old executive wants maximum death benefit protection for the lowest outlay during the next 15 years while children are dependent. Which product most directly fits this need?

  1. 15-year level term Correct answer.
  2. Universal life with minimum funding
  3. Single premium immediate annuity
  4. Whole life

Explanation

Level term for the dependency period provides the largest face amount per premium dollar for a defined time. It matches the temporary need without paying for permanent cash value accumulation.

Question 42Life Insurance

Which provision prevents a life insurance policy from lapsing when a premium is missed, by automatically using available cash value to pay the premium?

  1. Reinstatement provision
  2. Automatic premium loan provision Correct answer.
  3. Grace period
  4. Entire contract clause

Explanation

The automatic premium loan provision borrows against the policy's cash value to pay an overdue premium, keeping the policy in force. Interest accrues on the loan and reduces the eventual death benefit.

Question 43Life Insurance

An insured has a $300,000 policy with a $100,000 accidental death benefit rider. The insured dies of a heart attack. How much does the insurer pay?

  1. $0
  2. $300,000 Correct answer.
  3. $100,000
  4. $400,000

Explanation

The accidental death benefit rider pays only when death results from an accident as defined in the rider. A heart attack is a natural-cause death, so only the base face amount is payable.

Question 44Life Insurance

Which statement about the reinstatement provision is accurate?

  1. It restores the policy only after the contestability period restarts automatically
  2. It applies only to term policies
  3. It typically requires payment of overdue premiums plus interest and evidence of insurability Correct answer.
  4. It allows reinstatement at any time with no evidence of insurability

Explanation

Reinstatement lets a lapsed policy be restored, usually within a set period such as three to five years, upon payment of overdue premiums with interest and proof of insurability. A new contestability period generally begins from reinstatement.

Question 45Life Insurance

A policyowner uses the interest only settlement option for $200,000 in proceeds at a guaranteed 4 percent rate. What does the beneficiary receive annually?

  1. $200,000
  2. $8,000 Correct answer.
  3. $4,000
  4. $12,000

Explanation

Under interest only, the insurer retains the principal and pays interest at the guaranteed rate. Four percent of $200,000 is $8,000 per year, with the principal payable later to a named party.

Question 46Life Insurance

Which type of life insurance policy provides death benefit protection for a stated period only and builds no cash value that the owner can access through surrender?

  1. Single premium deferred annuity
  2. Term life insurance Correct answer.
  3. Universal life insurance
  4. Whole life insurance

Explanation

Term insurance covers the insured for a defined period and pays only if death occurs during that term. It is pure protection with no cash value accumulation, which is why it is the lowest-cost form of death benefit per dollar of coverage. Permanent contracts such as whole life and universal life build cash value and remain in force for life if funded properly.

Question 47Life Insurance

An insured holds a $400,000 level term policy with a guaranteed renewable provision. At the end of the 10-year term, the insured is diagnosed with a serious illness but wants to keep coverage. What does the guaranteed renewable provision require the insurer to do?

  1. Renew the policy only if the insured converts it to permanent coverage
  2. Renew the policy without evidence of insurability, at a premium the insurer may increase by class Correct answer.
  3. Refund all premiums paid and issue a new policy subject to underwriting
  4. Renew the policy at the same premium as the original term

Explanation

Guaranteed renewability gives the insured the right to continue the policy at the end of each term without proving insurability. The insurer may raise the premium, but only according to a rate schedule applied to the whole class of insureds, not because of the individual's health. This protects the insured against losing coverage after becoming uninsurable.

Question 48Life Insurance

A policyowner named his estate as the beneficiary of a $500,000 life insurance policy. The insured dies with $200,000 of outstanding debts and $30,000 of unpaid medical bills. What is the primary consequence of naming the estate rather than a named individual?

  1. The proceeds are automatically divided equally among the insured's children
  2. The insurer must pay the proceeds to the state unclaimed property fund
  3. The proceeds pass directly to heirs and bypass the probate process entirely
  4. The proceeds become part of the taxable estate and are subject to the claims of creditors Correct answer.

Explanation

When the estate is the beneficiary, the death benefit is paid to the estate rather than to a named person, so it becomes an estate asset. That subjects the proceeds to probate administration and to the claims of the insured's creditors. Naming an individual beneficiary generally avoids both probate and creditor access in most states.

Question 49Life Insurance

A policyowner purchased a $1,000,000 whole life policy and, three years later, transferred all ownership rights to an irrevocable life insurance trust. The insured dies five years after the transfer. What is the estate tax treatment of the proceeds?

  1. The proceeds are included only to the extent of premiums the insured paid while owning the policy
  2. The proceeds are included in the gross estate because the trust is revocable by the grantor
  3. The proceeds are excluded from the insured's gross estate because the insured retained no incidents of ownership at death Correct answer.
  4. The full proceeds are included in the insured's gross estate because the policy was transferred within three years of death

Explanation

A key benefit of an irrevocable life insurance trust is removing the death benefit from the insured's gross estate. Because the insured gave up all incidents of ownership more than three years before death, the proceeds are excluded. If the insured had died within three years of the transfer, the proceeds would be pulled back into the estate.

Question 50Life Insurance

An insured owns a whole life policy with a $200,000 face amount and a $50,000 cash value. The policy contains a nonforfeiture provision and the owner stops paying premiums. Which outcome best reflects how the nonforfeiture options interact with the policy's other values?

  1. The insurer must refund all premiums paid, less the cost of insurance protection already provided
  2. The policy automatically lapses with no value payable to the owner because premiums stopped
  3. The owner may elect reduced paid-up insurance, extended term insurance, or cash surrender value, and each option reflects the accumulated cash value Correct answer.
  4. The owner must continue paying premiums until the cash value equals the face amount before any option becomes available

Explanation

Nonforfeiture options protect the policyowner's accumulated value when premiums stop on a permanent policy. The owner typically chooses among cash surrender, reduced paid-up insurance, and extended term insurance, each of which is funded by the net cash value. The options exist precisely because the policy has built value that cannot be forfeited.