Every life insurance policy involves three roles, and they do not have to be filled by the same person:
The policyowner holds all of the contractual rights and duties: paying premiums, naming and changing the beneficiary, assigning or surrendering the contract, borrowing against cash value, and selecting settlement options.
The insured is the person whose death triggers payment of the death benefit. The insured must consent to the coverage and is the subject of underwriting, but holds no policy rights unless he or she is also the owner.
The beneficiary receives the proceeds when the insured dies.
When the owner and the insured are the same person, the arrangement is often called first-party or insured-owned coverage. Third-party ownership exists whenever someone other than the insured owns a policy on that insured's life.
In third-party ownership, the owner controls the contract, the insured only consents and is underwritten, and the insurer pays the owner-designated beneficiary.
Why arrange ownership this way
Third-party ownership is normal, not exotic. Common examples include:
Key person insurance — the employer applies for, owns, pays for, and is the beneficiary of a policy on a valuable employee.
Buy-sell funding — in a cross-purchase plan each business owner owns a policy on the other owners; in an entity plan the business owns the policies.
Trust ownership — a trust owns the policy so that the insured personally holds none of the ownership rights, a central technique in estate planning.
Family situations — a parent or grandparent owning coverage on a minor child, one spouse owning coverage on the other, or a divorce decree requiring that coverage on a former spouse be owned by the parent raising the children.
Insurable interest and consent
A third party cannot simply insure a stranger. Under the Texas Insurance Code provisions governing life insurance, the applicant must have an insurable interest in the insured — a close family relationship, or a lawful economic interest such as that of an employer, business partner, or creditor. Insurable interest must exist when the policy is applied for, not at the time of death; without it the contract is an unenforceable wager. The insured's consent is also required when another person applies for coverage on his or her life.
Rights follow the owner
The insurer takes direction only from the owner. The insured cannot change the beneficiary, take a loan, or surrender a policy he or she does not own. An owner may transfer ownership by absolute assignment, and many contracts allow a contingent owner to be named in case the original owner dies first.
Tax consequences
Death proceeds paid because of the insured's death are generally excluded from the beneficiary's gross income under federal tax law.
The transfer-for-value rule limits that exclusion when a policy is transferred for valuable consideration: only the consideration paid plus premiums paid afterward escape tax, and the excess is taxable income. Recognized exceptions include transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, to a corporation in which the insured is a shareholder or officer, and transfers where the transferee's basis carries over from the transferor.
Premiums a third-party owner pays are generally not deductible.
Exam tip: the insured's signature is needed to apply; the owner's signature is needed to change anything.
Sample questions
Third-party ownership of a life insurance policy exists whenever:
Someone other than the insured owns a policy on that insured's life
The named beneficiary is a different person from the insured
More than one beneficiary shares the death proceeds
The insured names a contingent beneficiary in addition to a primary beneficiary
An employer applied for, owns, and pays premiums on a key person policy insuring Maria, its chief engineer, with the employer as beneficiary. Maria writes to the insurer asking that her husband be named beneficiary instead. How should the insurer respond?
Make the change, because the insured's wishes control the death benefit
Make the change only if Maria's husband also signs the request
Decline, because naming and changing the beneficiary is an ownership right that belongs to the employer
Decline, because a beneficiary designation may never be changed once the policy is issued
Under the Texas Insurance Code provisions governing life insurance, when must a third-party applicant's insurable interest in the insured exist?
At the time the policy is applied for
At the moment of the insured's death
Continuously from application until the insured's death
Only when the applicant is a creditor of the insured
Which of the following transfers of a life insurance policy for valuable consideration is a recognized exception to the transfer-for-value rule, so that the death proceeds remain fully excludable from gross income?
A sale of the policy to an unrelated investor for cash
A sale of the policy to a co-worker of the insured for cash
A sale of the policy to a corporation in which the insured is neither a shareholder nor an officer
A sale of the policy to a partnership in which the insured is a partner
A corporation applies for, owns, and pays the premiums on a key person policy insuring its chief financial officer, naming itself as beneficiary. For federal income tax purposes, the premiums the corporation pays are:
Fully deductible as an ordinary and necessary business expense
Deductible to the extent they exceed the policy's cash value increase
Generally not deductible
Deductible only in years in which no policy dividend is received
Three equal owners of a business want an arrangement in which each individual owner personally applies for, owns, pays for, and is the beneficiary of coverage on each of the other owners' lives, so that survivors have cash to buy a deceased owner's interest. Which arrangement have they described?
An entity buy-sell plan, with the business owning three policies
Key person insurance owned by the business on all three owners
A trust-owned plan, with the trust holding all ownership rights
A cross-purchase buy-sell plan, requiring six individually owned policies
Ana wants to apply for and own a life insurance policy on the life of her adult brother, Luis. Beyond Ana's insurable interest in Luis, what does Texas law require?
Luis must be named as the policy's beneficiary
Luis must consent to the coverage on his life
Luis must pay at least part of the premium
Ana must transfer ownership to Luis after the policy is issued
An unrelated investor buys an existing $100,000 life insurance policy from its owner for $20,000 in cash and then pays $5,000 in premiums before the insured dies. No exception to the transfer-for-value rule applies. How much of the $100,000 death benefit is taxable income to the investor?
$0
$75,000
$80,000
$100,000
Which of the following arrangements is an example of third-party ownership of life insurance?
A man applies for and owns a policy on his own life, naming his wife as beneficiary.
A woman owns a policy on her own life and later names a trust as the beneficiary of the death proceeds.
A man owns a policy on his own life and assigns the death proceeds to a creditor as collateral.
A corporation applies for, owns, and pays premiums on a policy insuring its chief engineer, with the corporation as beneficiary.
Under the Texas Insurance Code provisions governing life insurance, when must an applicant's insurable interest in the insured exist?
Only at the moment of the insured's death.
Continuously from application until the death claim is paid.
At the time the policy is applied for.
At each policy anniversary, when premiums are due.
An irrevocable trust applied for, owns, and pays premiums on a policy insuring Maria's life. Maria now wants to borrow against the policy's cash value to pay a personal debt. What may the insurer do?
Make the loan to Maria, because she is the insured and the policy exists on her life.
Make the loan to Maria if she provides written notice to the trustee.
Make the loan to Maria up to the amount of premiums the trust has paid.
Refuse the request, because only the trustee, as policyowner, may exercise the loan right.
A policyowner sells an existing life policy for valuable consideration to a buyer who does not qualify under any exception. When the insured later dies, how are the death proceeds treated for federal income tax purposes?
The entire death benefit remains excluded from gross income, as with any death claim.
Only the consideration paid plus premiums paid after the transfer are excluded; the excess is taxable income.
The entire death benefit becomes taxable income to the buyer.
Only the policy's cash value at the date of transfer is excluded; the rest is taxable income.
An employer wants to insure a highly valuable employee so the business is compensated if that employee dies. Which statement correctly describes what the arrangement requires?
The employee must own the policy and name the employer as an irrevocable beneficiary.
The employer may apply for, own, and be beneficiary of the policy because it has a lawful economic interest in the employee, and the employee must consent.
The employer may apply for and own the policy without the employee's knowledge, since the employer pays the premiums.
The employer may own the policy only if the employee's family is named as beneficiary.
Three co-owners of a business fund a cross-purchase buy-sell agreement with life insurance. How is ownership of the policies arranged?
Each owner applies for and owns a policy on each of the other owners' lives.
The business applies for and owns one policy on each owner's life.
Each owner owns a policy on his or her own life and names the business as beneficiary.
A trust owns all policies and each owner is named as an irrevocable beneficiary of his or her own policy.
A third-party owner — such as a corporation or a trust — pays the premiums on a policy insuring another person's life. For federal income tax purposes, those premiums are:
Deductible by a corporate owner as an ordinary and necessary business expense.
Deductible by the insured, since the coverage is on his or her life.
Generally not deductible.
Deductible in the year the death benefit is paid.
Which statement best describes whose signature is needed on a third-party-owned life policy?
The insured must sign to consent to the application; the owner signs to make later changes such as a beneficiary change or policy loan.
The owner signs the application, and the insured signs any later change requests.
Both the owner and the insured must sign every change request after issue.
Only the beneficiary must sign, because the beneficiary has a vested interest in the proceeds.
Third-party ownership of a life insurance policy exists whenever:
The beneficiary named in the policy is someone other than the policyowner's spouse
Someone other than the insured owns the policy on the insured's life
Three or more people are named as contingent beneficiaries
The insurer assigns servicing of the policy to a third-party administrator
A mother owns a life insurance policy on her adult son, with her daughter named as beneficiary. The son telephones the insurer and asks that the beneficiary be changed to his fiancée. The insurer should:
Refuse the request, because only the policyowner may change the beneficiary
Make the change, because the insured always controls the beneficiary designation
Make the change if the son can prove he has been paying the premiums
Make the change only if the current beneficiary agrees in writing
Under the Texas Insurance Code provisions governing life insurance, insurable interest in the life of another must exist:
Continuously from the date of application until the insured's death
At the time the policy is applied for
Only at the moment of the insured's death
At each policy anniversary, when premium is due
A corporation applies for, pays for, owns, and is named beneficiary of a policy on its chief engineer. This arrangement is best described as:
Key person insurance, a common form of third-party ownership
A cross-purchase buy-sell plan
An insured-owned, or first-party, policy
An arrangement that lacks insurable interest and is therefore void
Which transfer of an existing life insurance policy for valuable consideration is recognized as an EXCEPTION to the transfer-for-value rule?
A transfer to the insured's adult child
A transfer to the named beneficiary of the policy
A transfer to an unrelated investor for cash
A transfer to a partnership in which the insured is a partner
Three equal shareholders fund a buy-sell agreement so that each shareholder personally applies for, owns, and pays for a policy on each of the other two. Which statement about this arrangement is correct?
It is an entity plan, because the corporation ultimately benefits
No insurable interest exists, because the owners are not related to one another
Each insured may change the beneficiary of the policy covering his or her own life
It is a cross-purchase plan, and each policy is a third-party-owned contract
It is first-party coverage, because the insureds are also the shareholders
A woman wants to apply for a life insurance policy on her business partner, naming herself as owner and beneficiary. In addition to her insurable interest, what does the insurer require?
A court order approving the third-party ownership
The partner's agreement to pay the premiums personally
The partner's consent to the coverage
Written approval from the partner's spouse and children
A trust owns a life insurance policy on a grantor's life and pays the annual premiums. When the insured dies, the trust receives the death benefit. Which statement correctly describes the federal income tax treatment?
Both the premiums and the death proceeds are deductible to the trust
The premiums are deductible, and the death proceeds are taxable income
The premiums are not deductible, and the death proceeds are generally excluded from gross income
The premiums are not deductible, and the death proceeds are fully taxable as ordinary income
Third-party ownership of a life insurance policy exists whenever:
The policyowner names a beneficiary who is not a family member
Two or more beneficiaries share the death proceeds
Someone other than the insured owns the policy on that insured's life
The insured owns the policy but names an irrevocable beneficiary
An irrevocable life insurance trust owns a policy insuring Maria, and Maria's brother is the named beneficiary. Maria contacts the insurer and asks that the beneficiary be changed to her daughter. The insurer should:
Make the change, because the insured always controls the beneficiary designation
Decline, because only the trust, as policyowner, may change the beneficiary
Make the change only if the current beneficiary consents in writing
Decline, because a beneficiary designation can never be changed once proceeds are payable to a trust
For a Texas life insurance policy applied for by a third party, insurable interest in the insured:
Must exist at application and continuously thereafter, or the policy is void
Must exist at the time of the insured's death for proceeds to be payable
Is not required at all as long as the insured signs a consent form
Must exist when the policy is applied for, though it need not still exist at the time of death
A corporation applies for a life policy on its chief financial officer, pays all premiums, and names itself as beneficiary. Which statement about this key person arrangement is accurate?
The corporation is the policyowner with all contractual rights, and the CFO must consent to the coverage
The CFO is the policyowner because the CFO is the insured and was underwritten
No insurable interest is required because the corporation pays all of the premiums
The CFO may change the beneficiary at any time, since the death benefit is based on the CFO's life
Which of the following transfers of an existing life insurance policy for valuable consideration is a recognized exception to the transfer-for-value rule, so that the death proceeds remain fully income-tax free?
Sale of the policy to a longtime personal friend of the insured for cash
Sale of the policy to an unrelated investor who then pays all future premiums
Sale of the policy to the insured's adult child for its fair market value
Transfer of the policy to a partner of the insured
A parent owns and pays the premiums on a life insurance policy insuring her adult son. For federal income tax purposes, those premium payments are:
Deductible as an ordinary and necessary expense if the son works in the parent's business
Generally not deductible by the third-party owner
Deductible to the extent of the policy's annual cash value increase
Deductible by the insured rather than by the owner
Three co-owners of a business fund their buy-sell agreement with life insurance under a cross-purchase plan. How is ownership of the policies arranged?
The business owns one policy on each of the three owners and is the beneficiary of each
Each owner owns a policy on his or her own life and names the business as beneficiary
Each owner owns a policy on each of the other owners' lives
A trust owns all three policies and the insureds retain the right to change beneficiaries
A grandmother applied for, owns, and pays for a policy insuring her grandson, who is now an adult. The grandson telephones the insurer and requests a policy loan against the cash value. The insurer should:
Decline the request, because only the policyowner may borrow against the cash value
Approve the request, because the insured is the person whose life is at risk under the contract
Approve the request, because the grandson's signed consent to the coverage is already on file
Approve the request, because ownership transferred automatically to the grandson when he reached the age of majority
Third-party ownership of a life insurance policy exists whenever:
The named beneficiary is someone other than the policyowner's estate
More than one beneficiary shares the death proceeds
Someone other than the insured owns the policy on that insured's life
A person other than the policyowner writes the premium check
An irrevocable trust applied for, owns, and pays premiums on a policy insuring the grantor's life. The grantor, who is the insured, wants to borrow against the policy's cash value. Who may request the loan?
Only the trustee, because the trust is the policyowner
The insured grantor, because the cash value accumulated on his life
The insured grantor, provided the trustee gives written consent
The trust beneficiaries acting jointly
When must an applicant's insurable interest in the proposed insured exist?
Only at the time of the insured's death
Continuously from the application date until the insured's death
At the time of application and again when a claim is filed
At the time the policy is applied for
A manufacturer applies for a $2,000,000 policy on its chief engineer, pays the premiums from corporate funds, retains all ownership rights, and names itself beneficiary. This arrangement is best described as:
A cross-purchase buy-sell plan
Key person insurance
An entity buy-sell plan
Trust-owned life insurance
Which of the following transfers of an existing life insurance policy for valuable consideration falls within a recognized exception to the transfer-for-value rule, so that the death proceeds remain fully excludable?
Sale of the policy to an unrelated institutional investor
Sale of the policy to a personal friend of the insured for its cash surrender value
Sale of the policy to a corporation in which the insured is a shareholder
Sale of the policy to the insured's adult child for valuable consideration
A corporation owns and is the beneficiary of a policy on an executive's life. Which statement correctly describes the federal income tax treatment?
The corporation may deduct the premiums as an ordinary business expense
The death proceeds are taxable to the corporation as ordinary income
The executive may deduct the premiums the corporation pays on his life
Premiums are generally not deductible, and the death proceeds are generally excluded from gross income
Three co-owners of a business each purchase, personally own, and pay for a policy on each of the other two owners, naming themselves as beneficiaries. Which statement about this arrangement is correct?
It is a cross-purchase plan, and each policy is third-party owned because the owner is not the insured
It is an entity plan, because the policies fund a transfer of business interests
It is invalid, because insurable interest requires a close family relationship
Each insured may change the beneficiary of the policy covering his own life
A wife applies for a life insurance policy on her husband's life, naming herself as owner and beneficiary. At the application stage, whose signature does the insurer require?
Only the wife's, because she is the applicant, owner, and premium payer
Both the wife's as applicant and the husband's, because the proposed insured must consent
Only the husband's, because the coverage is on his life
Neither, so long as the wife can demonstrate insurable interest
