United States
Hong KongLife insurance: term, whole, universal, variable
Term provides pure death benefit for a period. Whole life guarantees premium, death benefit and cash value. Universal life is flexible with interest-crediting risk on the owner. Variable places investment risk on the owner entirely.
Four families, and the way to hold them is by asking who carries which risk.
| Type | Premium | Cash value | Who carries investment risk |
|---|---|---|---|
| Term | Level for the term, then rises | None | Nobody - no investment element |
| Whole life | Level and guaranteed | Guaranteed | The insurer |
| Universal life | Flexible | Credited at a declared rate, with a guaranteed minimum | Shared |
| Variable life | Fixed | In subaccounts | The owner |
| Variable universal life | Flexible | In subaccounts | The owner |
| Indexed universal life | Flexible | Credited by a formula linked to an index, with a floor and a cap | Shared |
Term is the default answer
For a temporary need - income replacement while children are dependent, a mortgage, a business loan - term is almost always the correct recommendation on the exam.
It is the cheapest way to buy a given death benefit, and the need it covers is finite. Where a question describes a young family with a mortgage and limited cash flow, permanent insurance is the distractor.
When permanent is right
- A permanent need - estate liquidity, a special needs dependant, a business obligation with no end date.
- Estate tax funding, often through an irrevocable life insurance trust.
- Buy-sell funding where the obligation persists.
- A client who has exhausted other tax-advantaged capacity and wants the tax-deferred build-up.
- Charitable giving structures.
The pattern: permanent insurance answers permanent needs. Anything with an end date is term.
Variable life and variable universal life are securities as well as insurance. Selling them requires securities registration in addition to an insurance license, and a question describing an insurance-only agent recommending one is testing that.
Taxation, which is where the marks are
Death benefits are generally received income tax free. Cash value grows tax deferred. Loans against cash value are generally not taxable while the policy remains in force.
Surrender produces ordinary income on the gain above basis. Basis is generally premiums paid less any tax-free distributions.
The two rules that break the pattern
The transfer-for-value rule: a policy transferred for valuable consideration loses the income tax exclusion on the death benefit, unless an exception applies - transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is an officer or shareholder.
And the modified endowment contract. A policy funded too quickly, failing the seven-pay test, is taxed on distributions on a last-in first-out basis with a penalty before 59½. Once a MEC, always a MEC.
Dollar limits here are indexed annually and several were changed by recent legislation. Confirm the current figure before relying on it, and expect the exam to test the rule rather than the number.
Common questions
What is the difference between term and whole life?
Term provides a death benefit for a period with no cash value. Whole life guarantees premium, death benefit and cash value for life, with the insurer carrying the investment risk.
When is term insurance the right answer?
For any need with an end date - income replacement while children are dependent, a mortgage, a business loan. It is the cheapest way to buy a given death benefit.
How is life insurance taxed?
Death benefits are generally income tax free, cash value grows tax deferred, and policy loans are generally not taxable while the policy is in force. Surrender produces ordinary income on the gain above basis.
What is the transfer-for-value rule?
A policy transferred for valuable consideration loses the income tax exclusion on the death benefit, unless an exception applies - such as transfer to the insured or to a partnership in which the insured is a partner.
What is a modified endowment contract?
A policy funded too quickly and failing the seven-pay test. Distributions are taxed last-in first-out with a penalty before 59½, and once a MEC the policy remains one.