10.6 Life Insurance

• Library: Estate Planning in Virginia (Virginia CLE) (2022 Ed.)

10.6 LIFE INSURANCE

10.601 Introduction.

The following paragraphs focus on the non-business use of life insurance in a client's estate, including common types of policies, general principles of taxation, and estate planning uses. ¹⁵⁰⁷

10.602 Types of Insurance.

A. Term Insurance.

1. Features.

Term insurance provides pure insurance protection for a stated term with no cash value. Premiums paid provide insurance coverage for the premium period only. Consequently, premiums increase annually as the insured ages, unless the insured selects a level premium for a stated period. In that case, premiums initially will be larger than the standard term policy but lower in later years. Term insurance is typically renewable regardless of insurability for some guaranteed period of time, either a term of years or until a certain age. Term insurance may have a convertibility clause that guarantees the right to convert to permanent insurance, generally without proof of insurability at the time of conversion. Individual term insurance can be an excellent vehicle to provide protection against premature death for a temporary or indeterminate period. It is particularly popular with younger individuals, who often have the greatest need for life insurance protection to provide for surviving family members but cannot afford the higher cost of cash value policies providing the same face amount of protection.

2. Individual and Group.

An individual term policy is one owned by the insured or by another owner on the life of the insured individual. Group term insurance is often provided to a group of employees under an employer's plan through a master group policy with a life insurance company. The employees have individual coverages for which they can designate beneficiaries and that is generally assignable as well. The master group policy usually provides renewable term coverage that will terminate for an individual when he or she ceases to be a member of the group, or perhaps upon attaining a specified age. The premium for each insured under a group term policy is generally less than the premiums for individual term insurance for the same individuals and is often available without the requirement of a physical examination.

B. Cash Value Insurance.

1. Whole Life.

Whole life insurance (sometimes called "ordinary life" or "straight life") provides a guaranteed death benefit with premiums at a set rate for life up to age 100 or older, at which time the policy matures or endows, that is, its cash value equals the face amount of the policy. Whole life typically offers a fixed, progressive increase of cash value against which the insured may borrow, often at favorable rates, or which the insured may realize upon surrender of the policy or use for additional paid-up insurance. Dividends on the cash reserve can be used to help pay future premiums, thus making them reduce or "vanish."

2. Universal Life.

Universal life is basically a combination of a renewable term policy and a cash accumulation account. The premium is first applied to the cost of term insurance to provide the death benefit, with the balance credited to the "side fund" where it earns interest. As long as there is sufficient cash value in the side fund to cover the term cost of the death protection, additional premiums are not needed. The policy is said to be "universal" in that it is flexible—the insured can vary the amount of the premiums and the death benefit according to his or her needs. Cash values increase based on scheduled or flexible premium payments together with performance on the insurance company's general asset account portfolio (predominantly invested in bonds).

3. Variable Life.

Variable policies allow the client to allocate cash values among a number of investment choices, such as stocks, bonds, money market funds, real estate, or a combination thereof. Variable life usually requires the payment of fixed premiums with a death benefit at least equal to the policy's face amount. Variable universal life policies are essentially universal life policies with the variable investment option with the side fund. The variable life and variable universal life policies must meet certain diversification requirements under the Internal Revenue Code to receive tax-favored income tax treatment for life insurance. ¹⁵⁰⁸ Variable policies are often thought to provide a better hedge against inflation and high interest rates, but they require the client to have a tolerance for investment risk, and they generally are somewhat more expensive. ¹⁵⁰⁹

4. Joint Life.

Joint life, also called survivorship or second to die, insures the lives of two persons. Typically, the joint life policy is payable on the death of the second insured. Survivorship riders can be placed on individual policies to reach essentially the same result. With the unlimited marital deduction, the second to die policy is a way of providing estate liquidity when the deferred estate tax on marital deduction assets is payable. Generally, joint life premiums are less than the combined premiums necessary to insure the individuals separately. Disadvantages are that no proceeds are available at the death of the first insured, and the disposition of the policy if divorce occurs may be unclear (some policies allow conversion to separate life policies).

A "first to die" policy insures the lives of two persons, but proceeds are payable upon the death of the first to die. It is generally more expensive than insuring the life of only one of the persons and more expensive than a survivorship policy.

5. Variations.

There are extensive variations on the above policies, and others exist that are not even mentioned above. These variations can offer purchase or financing (split-dollar) options, ¹⁵¹⁰ cash value investment alternatives, and death benefit variations, or a combination thereof to suit the particular client's needs. ¹⁵¹¹

10.603 Reasons to Use.

A. Liquidity.

1. Debts, Expenses, Taxes, Bequests.

One of the primary uses of life insurance is to provide liquidity for an estate to pay debts, expenses, taxes, or bequests, and thereby to avoid an untimely, forced sale of an asset or a loan at perhaps unfavorable interest rates in conjunction with a mortgage or pledge of assets. With the unlimited marital deduction, in most cases only the estate of the second United States citizen spouse to die will have estate taxes to pay, so joint life policies are often used for this purpose. Nevertheless, there are situations where single life coverage may be more economical and more appropriate, such as where aggregate estate taxes can be saved through disclaimer, partial QTIP election, or otherwise by paying estate tax at the death of the first to die. ¹⁵¹²

2. Support for Survivors.

Replacing earnings lost upon the death of the principal wage earner is a major consideration in the use of life insurance. Typically, the estate planner determines the client's insurance requirements by calculating the current and projected needs of the client's survivors reduced by the funds available to meet them.

3. Long-Term Care and Accelerated Death Benefits.

Long-term care coverage can be added to a life insurance policy, usually by rider, to defray the costs of long-term care. Any payment reduces the policy death benefit up to a maximum percentage (for example, 50 percent). Accelerated death benefit riders allow prepayment of death benefits upon contracting a calamitous or terminal illness.

B. Investment or Business Use.

If the client is not acquiring insurance to pay debts, expenses, or taxes or for support of survivors, buying insurance primarily turns on a comparison of the insurance rate of return with that achieved through an alternative investment. The attraction of life insurance is that it allows a tax-free build-up of income with the ultimate proceeds received income tax-free. Policy loans in the meanwhile are generally not taxable. Of course, a premature death (expected or unexpected) would dramatically tip the balance in the favor of life insurance. Where the insurance proceeds are removed from the taxable estates of the insured and his or her spouse, there is a tremendous enhancement of value for the benefit of survivors. ¹⁵¹³

In the business arena, life insurance can be used to fund a buy-sell agreement to assist the client in acquiring a business partner's interest in the business (and vice versa). See Chapter 7 of this book for a more detailed discussion of the use of life insurance in closely held business succession planning.

C. Asset Preservation.

1. Creditor Protection.

The laws of most states, including Virginia, give life insurance benefits extensive protection from the insured's creditors. ¹⁵¹⁴ Group life insurance and its proceeds are exempt from creditors' claims, both during the lifetime of the insured and upon his or her death, whether the proceeds are payable to the insured's estate or to a named beneficiary. ¹⁵¹⁵ Group life insurance through the Virginia Retirement System is, however, subject to administrative and judicial action to enforce child and spousal support obligations. ¹⁵¹⁶

The person "who can, may, or will receive the benefit" of life insurance is entitled to receive the proceeds exempt from any claims of the creditors of the insured if the person is "the insured or owner of the [policy] or the spouse or intended spouse of, dependent child of, or any other person dependent on, the insured or owner" of the policy, except to the extent that the policy has been transferred or premiums paid with intent to defraud creditors. ¹⁵¹⁷ This exception does not apply to a policy issued or effected during the six months preceding the date that the person who files for the exemption "(i) files a voluntary petition in bankruptcy; (ii) becomes the subject of an order for relief or is declared insolvent in any federal or state bankruptcy insolvency proceeding; or (iii) files a petition or answer seeking for himself any reorganization...