Legally, life insurance is a contract, governed principally by state law.
A life insurance contract promises to pay a specified amount of money to a designated beneficiary when the insured person dies. The contract is between the insurance company and the policyowner, who pays premiums in exchange for the promised death (and other) benefits. Frequently the policyowner is the person insured, but someone other than the insured may own the policy.
In return for its promise to pay death and other benefits under the contract, the insurance company charges a premium to provide adequate funds to pay death benefits when they come due and to cover insurance company expenses and profits. (Ultimately, though, the death benefit paid by the insurer on any given policy may significantly exceed the total of the premium(s) paid by the policyowner.)
Although state laws vary, life insurance contracts are issued with a number of standard provisions. Keep reading to find out 15 legal issues that should be addressed in most life insurance policies, from the 6th Edition of ”The Tools & Techniques of Life Insurance Planning” (2015, The National Underwriter Company).
1. A typical life insurance policy should spell out who the parties to the contract are.
A life insurance policy is a legally enforceable contract issued by the insurer in consideration of the application and the payment of premiums. The essence of that contract is that:
If the insured dies while this policy is in force, we will pay the Sum Insured to the Beneficiary, when we receive at our Home Office due proof of the Insured’s death, subject to the provisions of this policy.
There are four parties to the life insurance contract:
- The insurer;
- The insured;
- The applicant-policyowner; and
- The beneficiary.
See also: Do you know these annuity terms?
2. A typical life insurance policy should explain the need for an insurable interest by the policyowner in the life of the insured.
Insurable interest is a key principle in life insurance law. It is the requirement imposed by law (and by insurers) to prevent a “gaming” or “wagering” by one party on the life of another through insurance. Simply put, to insure the life of an individual, the applicant must have an insurable interest, i.e., a greater concern in the insured’s living than dying.
3. A typical life insurance policy should describe the legal form and contents of the contract.
The life insurance policy is highly consumer protection oriented and unique in the law of contracts. In legal parlance, it is an “aleatory, unilateral contract of adhesion.”
Aleatory means that the insurer’s promise to pay the policy proceeds is conditioned upon an uncertain event (i.e., the insured’s death within the term of the contract).
Unilateral describes the fact that the insurance company is the only party to the contract which makes a legally enforceable promise. (The policyowner’s payment of premiums is technically a “condition precedent” to the insurer’s liability.) The insurer promises to pay a specific dollar amount if the insured dies while the policy is in force. Note that the policyowner makes no promise to continue paying premiums and there is no way the insurer can require the policyowner to continue paying premiums.
Adhesion is a legal recognition that the policyowner was not in a position to negotiate with the insurer on the terms of the contract and the resulting document is not evidence of the normal “give and take” negotiation and bargaining found in a standard contract. The insured may adhere to the terms of the policy but cannot change them. Furthermore, the legal terms of the life insurance contract and underlying mathematical assumptions make it difficult for the policyowner to understand. For these reasons, courts will not insist that the policyowner meet the same degree of strict compliance to the terms of the life insurance contract as it might in the case of the typical agreement. Because the insurance contract is a “take it or leave it” agreement in which the insurer selects all wording and there is no negotiation of the terms, ambiguities are typically interpreted in the policyowner’s (and beneficiary’s) favor and against the insurer.
For these reasons, many courts have adopted one or more theories that have made it possible to construe insurance policy language strictly against the insurer. But because the life insurance contract is one requiring a great deal of reliance on the statements of the insured and/or applicant-owner, honesty — rather than reliance on the leniency of the courts — should be the watchword in the contractual process.
4. A typical life insurance policy should describe the insured’s rights to name and change the beneficiary.
A beneficiary is a person (or entity) named (or designated such as by a check off) by the policyowner to receive the death benefits under a life insurance policy at the death of the insured. A revocable beneficiary is one whose potential receipt of the proceeds can be cut off, or revoked, at any time by the policyowner. An irrevocable beneficiary is one whose interest in the contract cannot be changed or reduced by the policyowner without his consent of the beneficiary. Such a beneficiary has a vested right to the death benefit as soon as he or she is named irrevocably.
Within reasonable limits, the policyowners can change the beneficiaries as often during lifetime as they want – and name anyone else they want as beneficiaries — subject to the procedures specified in the policy.
A policyowner can, and should, name more than one beneficiary.
5. A typical life insurance policy should limit the insurer’s right to contest or challenge the validity of the contract after (usually) two years, even if the policyowner made a material or fraudulent misrepresentation in acquiring the policy.
The incontestable clause typically is stated as follows:
We will not contest the validity of this Policy, except for nonpayment of premiums, after it has been in force during the Insured’s lifetime for two years from the policy date. This Provision does not apply to any rider providing disability or accidental death benefits.
6. A typical life insurance policy should provide a one-month grace period for the payment of premiums.
The policyowner’s payment of the premium is a “condition precedent” to the insurer’s duty to pay a death claim. So nonpayment of premiums will cause a life insurance policy to lapse. Even an insured in a coma or a person legally adjudicated mentally incompetent must pay premiums in a timely manner or the coverage will end. The insured’s rights under the contract end if the specified premium is not paid at the dates specified in the contract.
See also: Premium financing is dead. Or is it?
7. A typical life insurance policy should limit the insurer’s obligation to pay death benefits if the insured commits suicide (usually) within two years of policy issue.
Suicide is the intentional killing of oneself. The following verbiage is common for a life insurance policy:
If the insured commits suicide, while sane or insane, within two years from the Policy Date, our liability will be limited to the amount of the premiums paid, less any debt and partial surrenders, and less the costs of any riders.
If the insured commits suicide, while sane or insane, within two years from the effective date(s) of any increase in insurance or any reinstatement, our total liability shall be the cost of the increase or reinstatement.
8. A typical life insurance policy should provide for an adjustment in the death benefit in the event the insured’s age is misstated.
Mortality can vary considerably with age. So obviously, age is a crucial factor in the calculation of the proper life insurance premium for a given class of risk. If the wrong age is stated on the application (regardless of whether by deliberate misstatement or because the insured just did not know his date of birth), the insurer cannot charge the appropriate premium and the policyowner may pay much more or much less than what should have been paid. The insurance company trusts the applicant to be truthful and as a matter of convenience to both parties (and as a good marketing practice) does not require a birth certificate or other proof of age at the time of purchase. In fact, it is not until the insured dies and the death certificate accompanies the claim for payment that the insurer has documentation as to when the insured was born. So it is not until then that the insurer can compare the ages, meet its burden of proving that the age in the application was incorrect, and make the appropriate adjustment.
9. A typical life insurance policy should describe how the policyowner may apply or use dividends, if the policy is participating.
Owners of participating life insurance contracts are entitled to dividends if the insurer has sufficient earned surplus. The term participating means that the policyowner can participate in that surplus—if there is one. Confusion may result for the following reasons:
- Both mutual insurance companies (owned solely by policyowners) and stock companies (owned solely by outside shareholders) can legally issue participating (par) policies (although stock companies traditionally have issued nonparticipating (nonpar) contracts).
- Both types of companies can write checks called dividends.
Profits enjoyed by a stock company are not typically shared with the policyowners; they usually go only to investors (shareholders) in the company’s stock and are taxed in the same manner dividends from General Motors or IBM would be.
But the distributed surplus paid to owners of participating policies is very different than the profits paid out to owners of a stock company even though both distributions may be called dividends. A dividend paid to an owner of a participating contract is actually deemed to be a return of “excess premium” due to the generous margins built into the premium calculation assumptions.
See also: 10 top dividend-paying stocks
10. A typical life insurance policy should assure minimum cash values in the event of lapse or termination of the policy and provide certain standard options as to how the policyowner may receive these “nonforfeiture” values.
State laws and policy provisions combine to provide a number of protective options for the policyowner who stops paying premiums (for whatever reason) after the policy has been in force for a number of years. The policyowners do not lose the equity in their policies (assuming the type of policies in which the premiums exceed the current cost of carrying term insurance), but can use it advantageously in several ways. In other words, in level-premium contracts where policies require that a reserve be established in early years to meet higher insurance costs as the insured grows older and the probability of death grows greater, the insurer releases that reserve to the policyowner when the insurer is no longer obligated under the contract. The policyowner will receive an equitable portion of the total values his or her premiums have helped to accumulate.
How much the policyowner will receive is a function of:
- A statutory formula, and;
- The insurer’s internal policies (the insurer can promise to pay more than the statutory minimum). The values the insurer will pay are printed in the policy.
Generally, at least twenty years’ (or the term of the policy, if less) of values are shown.
See also: The value of cash value life insurance
11. A typical life insurance policy should explain the policyowner’s right to reinstate and the procedures for reinstating the policy in the event of lapse.
A policy lapses when the policyowner does not pay premiums by the end of the grace period. (A policy expires when it has run past its grace period with premiums unpaid and has exhausted any benefits available under the nonforfeiture option or when the policyowner has allowed the policy to lapse by not paying the next premium due and then decides to cash in the policy.)
However, policyowners can resuscitate a lapsed policy if the insured meets certain tests and the policyholder puts the insurer back to the financial position it would have been in had the policyowner never allowed the policy to lapse. Almost all states require that life insurance contracts contain a clause allowing reinstatement — a restoration and, according to most courts, a continuation of the original contract.
12. A typical life insurance policy should provide a number of alternative settlement options that beneficiaries may elect when receiving death proceeds from the insurer.
- Leave the proceeds with the insurer and receive annual interest payments;
- Accept the proceeds in installments for a specified period of time (fixed years installments);
- Accept the proceeds in installments of a specified amount (fixed amount option); and
- Accept the proceeds as a life annuity (systematic liquidation of principal and interest) for the life of one or more persons.
13. A typical life insurance policy should explain the policyowner’s right to borrow cash values, and spell out the conditions and terms of such loans, including the method of determining the interest rate.
The ability to use the contract as a source of emergency or opportunity cash is one of the most valuable attributes of permanent life insurance. Virtually all cash-value policies include a policy loan provision. As property, the policy can also serve as collateral for a loan from a bank or other lender but more often the insurer will provide the cash under the more favorable terms of the policy’s loan provisions.
When a policyowner borrows money directly from the insurer what is actually occurring is something other than a loan in common parlance. The difference is this: In a true loan the borrower must agree to repay the money. A policy loan does not require repayment. It is more like an advance of the money the insurer will eventually pay out under the contract. The policyholder is receiving an advance — of his own money.
14. A typical life insurance policy should give the policyowner the right to automatically have policy loans pay premiums if premiums are not paid by the end of the grace period.
According to the relevant case law: “Premium loans are advances of policy cash values that the insurer makes to the policyowner for the purpose of paying the premium. Automatic premium loans are advances the insurer makes under a policy clause providing that, if the policyowner fails to pay a premium by the end of the grace period, the insurer will automatically advance the amount of the premium if the policy has a sufficient net cash value.”
If the loan value of the policy is insufficient to pay an annual premium, the insurer will typically pay a semi-annual, quarterly, or monthly premium although it is not required to do so. When the loan value is so small that it will not even cover a monthly premium, nonforfeiture benefit options will apply.
See also: 15 little-known life insurance tax facts
15. A typical life insurance policy should explain the policyowner’s right to assign the policy to another person or entity.
As property, policyowners can transfer their life insurance contracts to other persons or entities. A policyowner can transfer either all or only some of the “bundle of rights” that comprises a life insurance policy to almost any person or entity.
- The absolute assignment, and;
- The collateral assignment.
An absolute assignment, as its name implies, transfers all the policyowner’s rights irrevocably. A collateral assignment, again as its name implies, assigns so much of the death benefit as necessary for as long as necessary to secure a lender’s rights.
But no more of the proceeds will go to the lender than the amount of debt owed.
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