Life Insurance Basics
Insurable interest and purpose
A valid life policy requires insurable interest at the time of application - a financial or emotional loss at death. An individual's interest in their own life is presumed. Business uses depend on demonstrable economic loss: key person coverage, buy-sell funding, deferred compensation, and split dollar. STOLI (stranger-originated life insurance) - procuring coverage with no insurable interest for resale - is illegal; a life settlement/viatical sale of an existing policy is generally permissible after issuance.
Underwriting
Underwriters classify risk using the application, MIB reports, attending physician statements (APS), paramedical exams, inspecting/credit reports, and questionnaires. Outcomes: preferred (below-average mortality), standard, substandard (rated, often table-rated), or declined. Nonsmoker classes are usually separated. Trap: the agent is the field underwriter and may not make promises of acceptance - only the home office binds coverage.
Premiums and payment
Premium = mortality (death risk), interest (earnings assumption), and expense (loading). Paying annually is cheapest because of fewer mode charges; monthly modes cost more. A conditional receipt provides coverage effective on the date of the application or the medical exam (whichever is later) only if the applicant proves insurable.
Taxation
Death proceeds are ordinarily income tax free; cash value grows tax deferred. Loans are not income while the policy stays in force (but reduce proceeds; outstanding loan interest can create income). If a policy becomes a modified endowment contract (MEC) - failing the 7-pay test - distributions are taxed LIFO with a 10% penalty before 59½. A transfer for value makes death proceeds income-taxable unless an exception applies. Dividends are a return of premium, not taxable until they exceed basis.
Worked example: Applicant completes an application Thursday and is issued a standard policy Tuesday. If death occurred Monday under a conditionally binding receipt, the insurer pays; without that receipt, no coverage existed.