Everyone wants something for themselves. One difficulty in selling life insurance is that the death benefit will be paid to someone other than the insured. After all, this is the primary purpose of life insurance—to protect beneficiaries after the death of the insured. But the insured often balks at having to pay the premiums, particularly if the children are older and other assets are available for the surviving spouse or partner.
There are a couple of ways to change this perception by stressing the “living benefits” that are available with life insurance. While these benefits are not actually new, expanded offerings with more options and a greater recognition of the importance of these benefits is affecting the way that life insurance is sold.
The traditional option of providing lifetime benefits is to overfund a life insurance policy to build cash value that can be accessed through withdrawals and loans, generally in an income tax-free manner. The drawback with this approach is in “overfunding”—paying more than is required to sustain the policy.
The other option is the so-called “living benefits,” which are updated versions of accelerated death benefits (ADBs) that were originally developed in the late 1980s in response to the AIDS health crisis. Many AIDS victims had large medical and nursing expenses they were struggling to pay.
They also had life insurance policies that would pay when they died but did not have cash value to provide any benefit while they were alive. Rather than have the insureds sell their policies to a viatical or life settlement companies, life insurance companies developed accelerated death benefits. Two types of ADBs were offered: for “terminal illness” and “chronic illness.”
Uncertainty over the tax consequences of the distributions and the status of life insurance policies that offered such a benefit delayed the widespread promotion of these benefits. The concerns were mostly resolved with proposed regulations in 1992 and enactment of IRC 101(g) as part of HIPPA in 1996. In recent years, clients have become more concerned about health care costs and the possibility of outliving their resources, so these benefits have become much more popular and prompted more widespread availability.
While these benefits were developed to help pay for medical expenses, in most cases there is no requirement that the funds advanced be used for this purpose. This provides some great flexibility for the client who can decide how to use the funds when the need arises. Some popular uses of the funds, other than nursing or medical expenses, include taking vacations with family members, buying or modifying houses for family members, or in one case, building a swimming pool so that the grandchildren would come and visit their grandmother after grandfather’s death.
The most commonly offered benefit is for insureds diagnosed with a terminal illness (this may be referred to as fatal illness or another term depending on the state and contract). This benefit may be available on term as well as permanent policies.
Terminal illness means that life expectancy is less than 12 or 24 months, depending on the contract and the state of issue. Early benefits used the 12-month test, but IRC Section 101(g) permits the use of a 24-month test. Most benefits paid under a terminal illness exception are paid in a lump sum and will be income tax-free.
The next most common ADB is the “chronic illness” benefit. As originally developed, this benefit required nursing home confinement, although this is no longer the case for most policies in most states. Most policies use the same standard for payment as long term care policies—the inability to perform 2 of 6 activities of daily living. Other policies still require nursing home confinement. Benefits are only paid if the condition is permanent and there is generally an elimination period, such as 90 days.
Payment options vary widely for this benefit. Payments may be paid monthly or in a lump sum. They may be to reimburse actual medical or nursing expenses. Or they pay on an indemnity basis. Monthly indemnity payments may be at the per diem limit for qualified long term care ($310 per day in 2012) or some other amount. The total amount that will be paid also varies widely. Some carriers offer a formula approach where a percentage of the death benefit or other amount is available. Some carriers underwrite the benefit at the time of the benefit request and others provide a discounted death benefit based on mortality tables. Except under a formula approach, the insured typically will not know in advance how much is available under the benefit.
The taxation of the chronic illness benefit is not as clear as the terminal illness benefit because of the wide variation in benefits offered. Under section 101(g), amounts paid in the same manner as qualified long-term care benefits will generally be income tax-free. The tax status of other benefits is not so clear.
Even if the benefit is taxable, the insured is likely to have medical expenses that will offset part or all of the income. Some life insurance carriers offer hybrid life and long-term care policies. Benefits under these policies are subject to different rules and requirements. Clients should be advised to consult with their tax advisers regarding the taxation of the benefits.
The chronic illness benefit is a very popular benefit with clients because it enables them to address a major concern about the need for and the cost of nursing home care. Many clients are unable to qualify for long term care insurance because of health issues, but because this benefit is available on a life insurance policy and is subject to life insurance underwriting standards, clients who have been turned down for long-term care may still qualify.
With funds available from the life insurance policy, it is possible to select a longer waiting period on a long term care policy that the client may have. For those without long term care policies, this provides an option for access to funds if the need arises.
The third living benefit that is available on some policies is the “specified medical condition” option. This option pays a smaller amount if the insured experiences certain medical conditions such as a heart attack, stroke, organ transplant or certain types of cancer.
This benefit is usually payable more than once, so if a client experiences more than one episode or another medical condition then the benefit will be payable again. This amount is usually paid as a lump sum and on a formula basis such as the lesser of 10% of the death benefit or a maximum amount such as $25,000.
Since there is a wide variation in the benefits available and the way that the benefits are determined and paid to the insured, producers need to do their due diligence on these living benefits. In addition, there are some other items for a producer to consider as he or she reviews the options.
First, is there a charge for these benefits? Check with the carrier as to whether there is a separately stated charge for the benefits. Separate charges are unlikely for the terminal illness benefit.
Second, what happens at the death of the insured? The death benefit will be reduced by the amount already paid and an interest charge. Initial benefits may be reduced by the first-year interest charge. However, interest will be charged in subsequent years and the rules and rates for charging interest are likely to be different (and higher) from the policy loan rules and rates.
Third, what happens if the insured lives longer than expected? This could result in a lapse of the policy as the loan and interest may exceed the death benefit. This may result in taxable income to the insured—not a result he or she was expecting. Check with the carrier to ensure that the policy has a no-lapse rider so that this will be avoided.
In one situation, a terminal illness benefit was paid and the insured lived another 15 years. There was no death benefit paid, but the policy did not lapse because of the no-lapse rider.
Finally, what if the policy is owned by an irrevocable trust? The benefits are paid based on the condition of the insured, but will be paid to the owner of the policy, not the insured. If the policy is owned by a trust, then the benefit will be paid to the trust.
Since the trust is irrevocable, the benefit cannot generally be paid to the insured but payments could be paid to other trust beneficiaries, such as the spouse or children of the insured. Note that if the policy is owned by someone other than the insured and is “business related,” then any accelerated benefits are not subject to the rules of IRC section 101(g) and may be taxable.
Living benefits are a great way to show clients the “WIIFM factor” when they are looking at life insurance. They provide flexibility, address most clients concerns about needing access to funds in the future and are not limited in how the funds have to be spent. These benefits will help to sell life insurance. After all, which clients don’t like getting something for themselves?
Hugh F. Smart, JD, CLU, ChFC, is AVP and director of advanced markets for Columbus Life Insurance Company, Cincinnati, Ohio