FINA 371 Lecture 9

Life Insurance
Contractual Provisions
Dr. Thuong Harvison
Frostburg State University
6/8/2022
Learning Objectives
• Describe the 12 contractual provisions that appear in life insurance
policies
• Identify the dividend options that typically appear in participating life
insurance policies
• Explain the cash-surrender options (nonforfeiture options) that appear
in cash-value policies
• Describe the various settlement options for the payment of life
insurance death benefits and explain how they might be used when
compared to a trust
• Describe the riders that can be added to a life insurance policy
Life Insurance Contractual Provisions (1/9)
Under the (1) ownership clause, the policyholder possesses all
contractual rights in the policy while the insured is living.
• Rights include naming beneficiaries and surrendering the policy for its cash
value.
• The policyholder can designate a new owner by filing an appropriate form.
The (2) entire-contract clause states that the life insurance policy and
attached application constitute the entire contract between the parties.
• Prevents the insurer from making amendments without the policyholder’s
knowledge.
Life Insurance Contractual Provisions (2/9)
The (3) incontestable clause states that the insurer cannot contest the
policy after it has been in force two years during the insured’s lifetime.
• Protects the beneficiary if the insurer tries to deny payment of the claim years
after the policy was first issued.
• The insurer has two years to detect fraud.
• The insurer can contest a claim after the incontestable period in limited
circumstances.
Life Insurance Contractual Provisions (3/9)
The (4) suicide clause states that if the insured commits suicide within
two years after the policy is issued, the face amount of insurance will
not be paid; there is only a refund of the premiums paid.

A life insurance policy contains a (5) grace period during which the
policyholder has a period of 31 days (or more) to pay an overdue
premium.
• The purpose of the grace period is to prevent the policy from lapsing.
Life Insurance Contractual Provisions (4/9)
• The (6) reinstatement provision permits the owner to reinstate a
lapsed policy.
• To reinstate a lapsed policy, the following requirements must be met:
• Evidence of insurability is required.
• All overdue premiums plus interest are paid.
• Any policy loans are repaid or reinstated.
• The policy was not surrendered for its cash value.
• The policy must be reinstated within a certain period.
• Although it may require a large outlay of cash, it may be cheaper to
reinstate a lapsed policy than to purchase a new policy
Life Insurance Contractual Provisions (5/9)
Under the (7) misstatement of age or sex clause, if the insured’s age or sex is
misstated, the amount payable is the amount that the premiums paid would
have purchased at the correct age and sex.

A (8) change-of-plan provision allows policyholders to exchange their

present policies for different contracts
• Life insurance contracts do not contain many exclusions
• Suicide excluded for two years
• Insurers might insert a war clause to exclude payment if the insured dies as a direct
result of war
• Some policies contain aviation exclusions and exclusions for certain hobbies
Life Insurance Contractual Provisions (6/9)
The (9) beneficiary is the party named in the policy to receive the policy
proceeds.
• The primary beneficiary is the first entitled to receive the policy proceeds on the
insured’s death.
• A contingent beneficiary is entitled to the proceeds if the primary beneficiary
dies before the insured.
• A revocable beneficiary means that the policyholder reserves the right to change
the beneficiary designation without the beneficiary’s consent.
• An irrevocable beneficiary is one that cannot be changed without the
beneficiary’s consent.
• A specific beneficiary is specifically identified.
• A class beneficiary is a member of a group, e.g., children of the insured.
Life Insurance Contractual Provisions (7/9)
• Premiums can be paid annually, semiannually, quarterly, or monthly
• (10) Assignment of the contract: A life insurance policy is freely
assignable to another party
• Under an absolute assignment, all ownership rights in the policy are
transferred to a new owner
• Under a collateral assignment, the policyholder temporarily assigns a life
insurance policy to a creditor as collateral for a loan, but only certain rights
are transferred to the creditor
Life Insurance Contractual Provisions (8/9)
A (11) policy loan provision allows the policyholder to borrow the cash
value.
• The policyholder must pay interest on the loan to offset the loss of interest to
the insurer.
• A policy could lapse if the policyholder does not repay a loan and the total
indebtedness exceeds the available cash value.
• The major advantage of a policy loan is the relatively low rate of interest that
is paid.
• The major disadvantage of a policy loan is that the policyholder is not legally
required to repay the loan, and the policy might lapse if the indebtedness
exceeds the available cash value.
Life Insurance Contractual Provisions (9/9)
Under the (12) automatic premium loan provision, an overdue
premium is automatically borrowed from the cash value after the grace
period expires
• The automatic premium loan prevents the policy from lapsing because of
nonpayment of premiums
• It may be overused and exhaust the cash value
• Proceeds will be reduced if the premium loans are not repaid by the time of
death
Dividend Options (1/2)
• If a policy pays dividends, it is a participating policy.
• Otherwise, it is a nonparticipating policy.
• Dividends come from three main sources:
• The difference between expected and actual mortality experience
• Excess interest earnings
• The difference between expected and actual operating expenses
Dividend Options (2/2)
Policyholders have several ways to take dividends:
• Take the cash
• Reduce the next premium coming due
• Let the dividends accumulate at interest and withdraw later
• Apply toward the purchase of paid-up whole life insurance under the paid-up
additions option
• Apply toward the purchase of term insurance
• Convert the policy to a paid-up contract
• Mature a policy as an endowment
Nonforfeiture Options
• The payment to a withdrawing policyholder is known as a
nonforfeiture value or cash surrender value.
• A policyholder has a right to the policy’s accumulated cash value; all states
have standard nonforfeiture laws.
• Policyholders have three nonforfeiture options:
• Cash value
• Reduced paid-up insurance
• Extended term insurance
Table of Guaranteed Values $100,000
Ordinary Life Policy, Male, Age 37 (1/2)
Table of Guaranteed Values $100,000
Ordinary Life Policy, Male, Age 37 (2/2)
Settlement Options (1/5)
• The policyholder can choose among several options for paying the
policy proceeds
• Or, the beneficiary may be granted the choice
• The most common options include:
• Cash
• Interest option
• Fixed-period option
• Fixed-amount option
• Life income option
Settlement Options (2/5)
• Under the fixed-amount option, a fixed amount is periodically paid to
the beneficiary.
• Under the fixed-period option, the policy proceeds are paid to a
beneficiary over some fixed period of time.
Example: Fixed-Period Option
Income for Elected Period (Minimum Monthly Payment per $1000 of
Proceeds), Interest Rate of 3.5%
Settlement Options (3/5)
• Under the life income option, installment payments are paid only
while the beneficiary is alive and cease on the beneficiary’s death
• Life income options include:
• Life income with guaranteed period
• Life income with guaranteed total amount
• Joint-and-survivor income
Example: Life Income with Guaranteed Period
(1/2)
Example: Life Income with Guaranteed Period
(2/2)
Example: Life Income with Guaranteed Total
Amount
Example: Joint-and-Survivor Income
Settlement Options (4/5)
• Settlement options allow for periodic payments to the family,
restoring their financial security
• Disadvantages include:
• Interest rates offered by insurers may be lower than rates offered elsewhere
• The settlement agreement may be inflexible and restrictive
• Life income options have limited usefulness at younger ages
Settlement Options (5/5)
• Life insurance policy proceeds can also be paid to a trustee, such as
the trust department of a commercial bank
• The use of a trust may be desirable if:
• The amount of insurance is substantial
• Flexibility and discretion in the amount and timing of payments are needed
• The beneficiaries are minor children or mentally or physically challenged
adults who cannot manage their own financial affairs
Additional Life Insurance Benefits (1/5)
• Other benefits can be added to a life insurance policy by adding a
rider.
• Most riders require payment of an additional premium.
• Under a waiver-of-premium provision, if the insured becomes totally
disabled, all premiums coming due during the period of disability are
waived.
• A term insurance rider can be added to a cash-value policy to increase
the total death benefit but still keep the policy affordable.
• These policies are called blended policies.
Additional Life Insurance Benefits (2/5)
• A family rider provides additional life insurance at reduced amounts
on family members to some stated age
• The guaranteed purchase (or guaranteed insurability) option permits
the policyholder to purchase additional amounts of life insurance at
specified times in the future without evidence of insurability
• An advance purchase privilege allows the policyholder to increase the
amount of insurance on the occurrence of some event, such as a birth
Additional Life Insurance Benefits (3/5)
• The accidental death benefit rider doubles the face amount of life
insurance if death occurs as a result of an accident.
• The cost-of-living rider allows the policyholder to purchase one-year
term insurance equal to the percentage change in the consumer price
index with no evidence of insurability.
• The accelerated death benefits rider allows insureds who are
terminally ill to collect part or all of their life insurance benefits before
they die.
Additional Life Insurance Benefits (4/5)
• A viatical settlement is the sale of a life insurance policy by a
terminally ill insured to another party, typically to investors or
investor groups, who hope to profit by the insured’s early death.
• A life settlement is a financial transaction by which a policyholder
who no longer wants to keep a life insurance policy sells the policy to
a third party for more than its cash value.
Additional Life Insurance Benefits (5/5)
The sale of life insurance in the secondary life insurance market is a
problem for many life insurers because of stranger-owned life
insurance (STOLI)
• STOLI is a large policy acquired by a group of investors with the specific
intention to sell the policy in the secondary market
• Insurers will not knowingly issue a policy used for STOLI purposes
• The sale is viewed as a wagering transaction
• There is material misrepresentation or fraud regarding the true purpose of buying the
policy
• Investors may be taking advantage of elderly people