Free Chartered Life Underwriter (CLU) Individual Life Insurance Planning Questions and Answers — Questions and Answers
Question 1: A 45-year-old business owner wants to implement a plan to ensure the orderly transfer of the business to the two other partners in the event of death. Which of the following life insurance arrangements is most suitable for this purpose?
- A key person life insurance policy.
- A split-dollar life insurance plan.
- A cross-purchase buy-sell agreement funded with life insurance. (Correct answer)
- A group term life insurance policy for all employees.
Correct answer: A cross-purchase buy-sell agreement funded with life insurance.
A cross-purchase buy-sell agreement funded with life insurance is the most appropriate solution. In this arrangement, each business owner purchases a life insurance policy on the other owners. Upon the death of one owner, the surviving owners use the tax-free death benefit proceeds to purchase the deceased owner's share of the business from their estate, ensuring a smooth transition of ownership. Key person insurance protects the business from the financial loss of a key employee but doesn't facilitate ownership transfer. A split-dollar plan is a benefit for an employee, not a business succession plan among partners. Group term life is a general employee benefit and not structured for business succession.
Question 2: Which of the following methods for determining the amount of life insurance needed is most comprehensive and considers the insured's specific financial obligations, future income needs of survivors, and existing assets?
- The Human Life Value approach.
- The Multiple-of-Income approach.
- The DIME (Debt, Income, Mortgage, Education) method.
- The Capital Needs Analysis approach. (Correct answer)
Correct answer: The Capital Needs Analysis approach.
The Capital Needs Analysis approach is the most thorough method. It provides a detailed assessment by calculating the specific capital required to meet various objectives after the insured's death, including paying off debts, providing ongoing income, funding education, and covering final expenses, while also factoring in existing assets and other sources of income like Social Security. The Human Life Value approach focuses on replacing lost future earnings, the Multiple-of-Income method is a simple but less precise rule of thumb, and the DIME method is more detailed than a simple multiple but less comprehensive than a full capital needs analysis.
Question 3: A client has a permanent life insurance policy with a significant cash value. Under which circumstance would a portion of the withdrawn cash value be subject to income tax?
- When the total amount withdrawn is less than the total premiums paid into the policy.
- When the policyholder takes a policy loan that is never repaid.
- When the amount withdrawn exceeds the policy's cost basis (total premiums paid). (Correct answer)
- When the cash value is used to pay the policy's premiums.
Correct answer: When the amount withdrawn exceeds the policy's cost basis (total premiums paid).
Withdrawals from a life insurance policy's cash value are treated on a 'first-in, first-out' (FIFO) basis, meaning the cost basis (premiums paid) is withdrawn first and is not taxable. Only when the total amount withdrawn exceeds the cost basis are the gains subject to ordinary income tax. Policy loans are generally not taxable unless the policy is surrendered or lapses with an outstanding loan balance. Using cash value to pay premiums is not a taxable event.
Question 4: A corporation purchases a life insurance policy on its CEO to protect the company from financial hardship resulting from the CEO's unexpected death. What is the proper term for this type of policy arrangement?
- Endorsement Split-Dollar
- Entity-Purchase Buy-Sell
- Key Person Insurance (Correct answer)
- Executive Bonus Plan
Correct answer: Key Person Insurance
This arrangement is known as Key Person (or Key Man) Insurance. The business purchases the policy, pays the premiums, and is the beneficiary. The purpose is to provide the company with funds to manage the transition period, hire a replacement, and offset potential losses in revenue or creditworthiness following the death of a vital employee.
Question 5: In a split-dollar life insurance arrangement under the collateral assignment method, who is typically the owner of the life insurance policy?
- The employer
- The employee (Correct answer)
- A trust established for the employee's beneficiaries
- The insurance company
Correct answer: The employee
Under the collateral assignment method of a split-dollar plan, the employee is the owner of the life insurance policy. The employee assigns an interest in the policy's cash value and/or death benefit to the employer as collateral to secure the employer's premium payments, which are treated as loans. This contrasts with the endorsement method, where the employer owns the policy.
Question 6: Regarding the federal income taxation of life insurance, which of the following statements is generally TRUE?
- Premiums paid by an individual for a personal life insurance policy are tax-deductible.
- The internal growth of a policy's cash value is taxed annually as ordinary income.
- The death benefit paid in a lump sum to a named beneficiary is received income tax-free. (Correct answer)
- If a policy is surrendered, the entire cash surrender value is treated as taxable income.
Correct answer: The death benefit paid in a lump sum to a named beneficiary is received income tax-free.
The death benefit from a life insurance policy, when paid in a lump sum to a named beneficiary, is generally not subject to federal income tax. Individual life insurance premiums are considered a personal expense and are not tax-deductible. The cash value growth within the policy is tax-deferred, not taxed annually. If a policy is surrendered, only the amount of the cash value that exceeds the owner's cost basis (premiums paid) is taxable.
Free Chartered Life Underwriter (CLU) Individual Life Insurance Planning Questions and Answers
A 45-year-old business owner wants to implement a plan to ensure the orderly transfer of the business to the two other partners in the event of death.
Which of the following life insurance arrangements is most suitable for this purpose?