The 15 Most Important Legal Aspects of Life Insurance

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 policy owner, who pays premiums in exchange for the promised death (and other) benefits. Frequently, the policy owner 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 policy owner.) 

Although state laws vary, life insurance contracts are issued with a number of standard provisions. In the typical policy, these provisions: 

  • 1. spell out who the parties to the contract are;
  • 2. explain the need for an insurable interest by the policy owner in the life of the insured; 
  • 3. describe the legal form and contents of the contract;
  • 4. describe the insured’s rights to name and change the beneficiary; 
  • 5. limit the insurer’s right to contest or challenge the validity of the contract after (usually) two years, even if the policy owner made a material or fraudulent misrepresentation in acquiring the policy; 
  • 6. provide a one-month grace period for the payment of premiums; 
  • 7. limit the insurer’s obligation to pay death benefits if the insured commits suicide within (usually) two years of policy issue;
  • 8. provide for an adjustment in the death benefit in the event the insured’s age is misstated; 
  • 9. describe how the policy owner may apply or use dividends, if the policy is participating; 
  • 10. assure minimum cash values in the event of lapse or termination of the policy and provide certain standard options as to how the policy owner may receive these “nonforfeiture” values; 
  • 11. Explain the policy owner’s right to reinstate and the procedures for reinstating the policy in the event of lapse; 
  • 12. provide a number of alternative settlement options that beneficiaries may elect when receiving death proceeds from the insurer; 
  • 13. explain the policy owner’s right to borrow cash values, and spell out the conditions and terms of such loans, including the method of determining the interest rate; 
  • 14. give the policy owner the right to automatically have policy loans pay premiums if premiums are not paid by the end of the grace period; and 
  • 15. explain the policy owner’s right to assign the policy to another person or entity. 

Additionally, in order for a contract to qualify as life insurance for income and other tax purposes it must exhibit risk-shifting and risk-sharing and it must meet the Internal Revenue Code’s definition of life insurance. This limits the amount of cash value relative to the face amount of coverage. 

If the cash value were allowed to be too high relative to the face amount of coverage, there would be: first, insufficient risk shifting and second, an incentive to shelter otherwise taxable investment income in life insurance products.

Increases in the cash values inside a contract that fails to meet the standards of Code Section 7702 are taxable to the policy owner as earned, rather than being tax deferred, as in qualifying life insurance contracts.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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