Living Benefits, Disability Riders, Withdrawals and Partial Surrenders
A life policy can pay while the insured is still alive. It can pay part of the death benefit early, pay a long-term care bill, keep itself in force when the insured is disabled, or hand back some of the cash value without ending the contract. Each of these features changes what the policy will pay later, and a producer who cannot show the change has not explained the feature. Each one is worked with numbers below, and Michigan’s living benefit sections (MCL 500.3928 and 500.3949) are applied. The names, premiums and interest rates in the examples are invented and are not statutory figures.
Accelerated Death Benefits
An accelerated death benefit rider lets the owner collect part of the death benefit while the insured is alive, usually after a physician certifies a terminal illness or a licensed health care practitioner certifies a chronic one. Federal law treats the money as if it were paid by reason of death, so it can be received free of income tax, for a terminally ill insured and, with limits, for a chronically ill one (IRC 101(g)(1)). A terminally ill individual is one certified by a physician as having an illness or condition that can reasonably be expected to result in death within 24 months (IRC 101(g)(4)(A)).
Two Ways to Charge for Acceleration
Dev Okafor holds a $250,000 policy and is certified terminally ill. He elects to accelerate $100,000. Insurers recover the cost of paying early in one of two ways.
Under a lien method, the insurer pays $100,000 and records a lien against the death benefit that grows with interest. Suppose the lien interest is 5% a year, simple, and Dev dies 8 months later. The interest is $100,000 times 0.05 times 8/12, or $3,333.33. The beneficiary receives $250,000 minus $100,000 minus $3,333.33, which is $146,666.67. Dev and his beneficiary together collected $246,666.67.
Under a discount method, the insurer pays less than the amount accelerated. Suppose it discounts the $100,000 for one year at 5%, so it pays $100,000 divided by 1.05, or $95,238.10. The face amount is reduced by the full $100,000, and the beneficiary receives $150,000. Together they collect $245,238.10.
| Method | Paid to Dev | Paid to beneficiary | Total | Cost of acceleration |
|---|---|---|---|---|
| Lien, 8 months | $100,000.00 | $146,666.67 | $246,666.67 | $3,333.33 |
| Discount | $95,238.10 | $150,000.00 | $245,238.10 | $4,761.90 |
The lien costs less if death comes soon and more if Dev lives for a long time, because interest keeps accruing. The discount is fixed on the day it is paid. The policy’s form decides the cost.
What Michigan Says
Michigan does not treat every acceleration rider as long-term care insurance. A life insurance policy that accelerates the death benefit specifically for terminal illness, or for conditions requiring extraordinary medical intervention or permanent institutional confinement, is outside the definition of long-term care insurance if it offers a lump-sum option and neither the benefits nor eligibility for them depends on receiving long-term care (MCL 500.3901(h)). A rider that pays only on terminal illness and offers a lump sum is a life insurance feature, governed by Chapters 40 and 44. A rider that pays when the insured needs care is long-term care insurance, and Chapter 39 applies to it.
An accelerated benefit for long-term care carries a mandatory warning. The policy or rider must provide a disclosure statement at the time of application and again when the accelerated benefit payment request is submitted, stating that receipt of accelerated benefits may be taxable and that the owner should seek help from a personal tax adviser. The statement must be prominently displayed on the first page of the policy or rider and any related documents (MCL 500.3953).
Long-Term Care Riders on a Life Policy
A long-term care rider uses the death benefit as a pool of money for care. Michigan lets an insurer with both life and disability authority market policies that contain both life benefits and long-term care benefits. The life benefits must satisfy Chapters 40 and 44 and the long-term care benefits must satisfy Chapter 39 (MCL 500.3949).
A Rider in Use
A $300,000 policy has a rider that pays up to 2% of the face amount a month, or $6,000, for qualifying care. Mei Lindqvist needs care for 20 months. The rider can pay in two ways.
- Reimbursement pays the actual cost. Her care costs $4,500 a month, so the rider pays $90,000 over 20 months. The death benefit falls to $210,000.
- Indemnity (per diem) pays the monthly benefit without regard to cost. The rider pays $6,000 a month, or $120,000 over 20 months, and the death benefit falls to $180,000. Federal law permits payments made on a per diem or other periodic basis without regard to the expenses incurred (IRC 7702B(b)(2)(A)), but periodic payments above the per diem limitation are taxable (IRC 7702B(d)).
Under indemnity, $180,000 remains in the pool, which is 30 more months at $6,000. A rider of this kind usually reduces the cash value in the same proportion as it reduces the death benefit. If the policy had $30,000 of cash value, the $120,000 paid is 40% of the face amount, so the cash value drops by $12,000 to $18,000. Many riders work this way, but the rider itself controls. Mei’s family inherits a death benefit smaller by every dollar of care paid.
The long-term care part of a life policy is treated for federal tax purposes as a separate contract. No medical expense deduction is allowed for charges against the cash value for qualified long-term care coverage (IRC 7702B(e)(1), (2)).
What Michigan Requires
A fixed, indivisible premium policy that funds long-term care entirely by accelerating the death benefit is considered to provide reasonable benefits in relation to its premiums when it meets all nine of these conditions (MCL 500.3928):
- Premiums are fixed and guaranteed for the life of the policy.
- The guaranteed cash surrender value is stated.
- The death benefit and long-term care benefits are guaranteed for life, with a schedule of the guarantees.
- Mortality, morbidity and other internal charges are guaranteed not to exceed stated maximums.
- Credited interest is guaranteed not to fall below a stated minimum.
- The insurer cannot terminate the benefits except for nonpayment of premium.
- The policy meets Chapter 40’s nonforfeiture requirements.
- An illustration at issue shows the year-by-year progression of cash values and face amount.
- The owner receives an annual report of the current cash value, death benefit and long-term care benefits, showing the change in cash value from interest, premium, risk charges and other charges.
A life policy or certificate with long-term care benefits must come with a policy summary. In addition to the usual summary content, it must explain how the long-term care benefit interacts with the rest of the policy, including deductions from the death benefit, and give an illustration of the benefit amount, its length and any guaranteed lifetime benefits (MCL 500.3951(1)). Once benefits are being paid out of the death benefit, the insurer must send a monthly report listing what was paid that month, how the death benefit and cash value changed, and how much benefit remains (MCL 500.3951(2)). Mei’s family would see the $210,000 or $180,000 shrinking on paper every month.
Several Chapter 39 requirements do not apply to life policies or riders with accelerated long-term care benefits, including the offer of inflation protection and of a nonforfeiture option (MCL 500.3909(4), 500.3910(1)).
Waiver and Disability Riders
Waiver of Premium
A waiver of premium rider keeps a policy in force without premiums while the insured is totally disabled. Typically a waiting period of several months must pass before the waiver begins, and many forms refund premiums paid during that wait. The disability usually has to begin before a stated age. A policy may include a provision protecting it against lapse for an insured who cannot pay because of accidental injury or disease (MCL 500.4040(1)).
On a whole life policy with a $1,850 annual premium, a disabled insured pays nothing for as long as the disability lasts. If it lasts 10 years, the waived premiums are 10 times $1,850, or $18,500, and the cash value continues to grow as if they had been paid.
Waiver of Cost of Insurance and Waiver of Stipulated Premium
On a universal life policy, two different riders do two different things.
A waiver of cost of insurance pays the monthly deductions (cost of insurance and expense charges) while the insured is disabled. It keeps the policy from running out. It does not add anything to the account.
A waiver of stipulated premium credits a stated premium to the account each month as if the owner had paid it. It keeps the policy in force and also adds to the account.
Take a universal life policy with a $250,000 face amount (a level death benefit) and a policy value of $10,000 when the insured becomes disabled. The monthly terms are a 6% premium load, a cost of insurance charge of $0.12 per $1,000 of net amount at risk, an administrative charge of $8.00 and interest of 0.3% a month. The stipulated premium is $250 a month, or $235 after the load. The table shows the policy value at the end of each of six months under three conditions.
| Month | No waiver, no premium | Waiver of cost of insurance | Waiver of stipulated premium |
|---|---|---|---|
| 1 | $9,993.09 | $10,030.00 | $10,228.82 |
| 2 | $9,986.16 | $10,060.09 | $10,458.36 |
| 3 | $9,979.21 | $10,090.27 | $10,688.61 |
| 4 | $9,972.24 | $10,120.54 | $10,919.58 |
| 5 | $9,965.25 | $10,150.90 | $11,151.27 |
| 6 | $9,958.24 | $10,181.35 | $11,383.69 |
With no waiver, the account loses $41.76 over six months, because the charges outrun the interest. With a waiver of cost of insurance, the insurer pays the charges and the account earns interest on the full balance. With a waiver of stipulated premium, the account grows by $1,383.69, because the insurer credits the deposits and the owner’s plan carries on as if the disability had never happened. The waiver of stipulated premium protects the plan the owner was following. The waiver of cost of insurance protects only the policy’s survival. The producer must read which rider the policy has.
Disability Income Benefit
A disability income benefit rider pays a monthly income while the insured is disabled, in addition to any waiver. A common form pays a stated percentage of the face amount each month after a waiting period. On a $100,000 policy at 1% a month, the rider pays $1,000 a month. The death benefit is not reduced by the payments, which separates this rider from an acceleration rider. A life policy may contain, or be accompanied by supplemental contracts providing, only the accident and sickness benefits the statute authorizes for life policies, which include certain benefits for total and permanent disability, and a supplemental contract’s form must be approved by the Director before it is issued (MCL 500.4040(2)). A rider that pays a fraction of face is a small income, not a substitute for a disability income policy.
Payor Benefit
A payor benefit rider is used on a juvenile policy. If the person paying the premiums dies or becomes disabled before the child reaches a stated age, the rider waives the premiums. Aiyana is 5 years old and holds a $50,000 policy with a payor rider. The annual premium is $380. Her father, the payor, becomes disabled when she is 9, and the rider waives premiums until she is 21. Twelve premiums of $380 are $4,560.
Return of Premium Rider
A return of premium rider is added to a term policy and refunds the premiums paid if the insured survives the term. It differs from a return of cash value rider, which pays an amount equal to the cash value in addition to the face amount at death.
Nasir Haddad, age 35, compares two 30-year level term policies for $500,000. The plain policy costs $640 a year. The same policy with a return of premium rider costs $1,900 a year. If he survives the 30 years, he receives back 30 times $1,900, or $57,000. The extra premium is $1,260 a year, or $37,800 over 30 years. The refund is smaller than it looks: if Nasir paid the $1,260 difference at the start of each year into an account earning 3%, it would grow to $61,743 in 30 years. The refund is worth about a 2.53% yearly return on the extra money, which is less than the 3% account.
The rider also pays only on survival. If Nasir lapses in year 15, the rider’s table might return 60% of the premiums paid: 60% of 15 times $1,900 is $17,100. The refund is partial, and if he lapses early, it can be zero. Whether the rider is a good buy depends on whether he will keep the policy for 30 years, and on whether he would instead invest the difference.
Withdrawals and Partial Surrenders
A withdrawal or partial surrender takes cash out of a policy without ending it. A loan takes money without reducing the policy value; a withdrawal removes the money from the policy permanently.
A Universal Life Withdrawal
Carmen Reyes has a universal life policy with a $250,000 face amount and a policy value of $40,000. She withdraws $10,000. The policy charges a $25 fee for withdrawals, which comes out of the value. The value after the withdrawal is $40,000 minus $10,000 minus $25, or $29,975. What happens to the face amount depends on the death benefit option.
- Option A, a level death benefit, usually reduces the face amount by the amount withdrawn, to $240,000. The net amount at risk is $240,000 minus $29,975, or $210,025, almost the same as before ($250,000 minus $40,000, or $210,000). The cost of insurance stays about the same. If the policy did not reduce the face amount, the net amount at risk would rise to $250,000 minus $29,975, or $220,025, and the cost of insurance would go up.
- Option B, the face amount plus the policy value, leaves the face amount at $250,000. The death benefit drops from $290,000 to $279,975 because the value fell. The net amount at risk stays $250,000.
Michigan requires a universal life policy to describe any surrender or partial withdrawal charges (MCL 500.4037(d)(vi)). For a flexible premium universal life policy, the minimum cash surrender value is calculated net of any deductions made for partial withdrawals (MCL 500.4061(1)(a)(i)(F)), so a withdrawal lowers the floor too.
A Whole Life Partial Surrender
Some whole life policies allow a partial surrender by reducing the policy proportionally. On a $100,000 policy with a cash value of $13,500, the owner surrenders 20%. The owner receives 20% of $13,500, which is $2,700. The face amount falls to $80,000 and the premium falls with it. The insurer may defer payment of a cash surrender value for 6 months after demand (MCL 500.4060(2)(h)).
Basis and Tax
For a policy that is not a modified endowment contract, an amount received before death that is not an annuity is included in gross income only to the extent it exceeds the investment in the contract (IRC 72(e)(5)(C)). The investment in the contract is, generally, the premiums paid less amounts already received tax-free. So withdrawals come out basis first, and gain last.
Carmen has paid $36,000 in premiums, so the policy has $4,000 of gain ($40,000 minus $36,000).
- Her $10,000 withdrawal is within her basis and is not taxable. Her basis falls to $26,000.
- Had she instead withdrawn $45,000 from a policy value of $60,000 with the $36,000 basis intact, $45,000 minus $36,000, or $9,000, would be taxable. Her basis would then be zero and every later dollar withdrawn would be gain.
There is an exception in the first 15 years. If a change reduces benefits in that period and a cash distribution results, part of the distribution can be taxed as income first, up to a recapture ceiling set by the Code (IRC 7702(f)(7)(B)). A withdrawal that reduces the face amount on an Option A policy can be such a change, and whether a given withdrawal triggers the rule is a question for the insurer.
A Modified Endowment Contract
A policy that fails the 7-pay test is a modified endowment contract (IRC 7702A). On a modified endowment contract, distributions are taxed gain first (IRC 72(e)(10)(A)(i), (e)(2)(B)), loans are treated as distributions (IRC 72(e)(4)(A)), and a taxable distribution carries an additional 10% tax unless the owner is at least 59 1/2, disabled, or taking a series of substantially equal payments for life (IRC 72(v)).
Suppose the policy has a $40,000 value and a $30,000 basis. A $10,000 withdrawal is all gain because the gain is $10,000. All $10,000 is taxable, and an owner under 59 1/2 owes an additional $1,000. A $5,000 loan from the same contract, instead of the withdrawal, would be taxable as well, with a $500 additional tax. The same withdrawal from a policy that was not a modified endowment contract and had $30,000 of basis would be tax free.
Loan or Withdrawal
A loan leaves the policy value and the face amount in place, but the debt grows. Interest not paid when due is added to the principal and bears interest (MCL 500.4064). A $10,000 loan at 5% with interest left unpaid grows to $16,288.95 in 10 years, and if Carmen dies then the death benefit is $250,000 minus $16,288.95, or $233,711.05. The loan value is the cash surrender value at the end of the policy year, and the insurer may defer a loan for 6 months, except one made to pay premiums (MCL 500.4062(2)). A withdrawal has no debt, but it permanently removes the money and, on some policies, the face amount.
Lesson summary
- An accelerated benefit is charged for by a lien that accrues interest or by a discount, so the cost depends on the form and on how long the insured lives.
- Michigan treats a terminal illness acceleration with a lump-sum option as a life insurance feature, and a rider that pays for care as long-term care insurance (MCL 500.3901(h), 500.3949).
- A life policy that funds long-term care entirely by acceleration is considered reasonable in relation to its premiums when it meets the nine conditions of MCL 500.3928, and the owner receives a monthly report once benefits are paid (MCL 500.3951).
- A waiver of cost of insurance keeps a universal life policy in force, and a waiver of stipulated premium also credits the premium to the account.
- A disability income rider pays a percentage of face without reducing the death benefit, and a payor benefit waives a juvenile policy’s premium if the payor dies or is disabled.
- A return of premium rider refunds premiums at the end of the term, and its value depends on whether the extra premium would have earned more elsewhere.
- A withdrawal comes out of basis first on a policy that is not a modified endowment contract, and gain first on one that is, with an additional 10% tax before 59 1/2.
- A loan keeps the policy value but compounds against the death benefit, and a withdrawal removes the money for good.