Ohio Department of Insurance Updated OH-Life-Agent-Series-11-44 Exam Questions and Answers by crystal

Under Section 1035 of the Internal Revenue Code, a policyholder can exchange a life insurance policy for another life insurance policy, an endowment policy, or an annuity contract without recognizing a gain or loss, provided the exchange is made directly between insurance companies and the policyholder does not receive any cash or other benefits in the process. This tax-free exchange allows the policyholder to replace outdated or underperforming policies without immediate tax consequences.

Insurance contracts are consideredUnilateral Contractsbecause only the insurer makes a legally enforceable promise. The insurer promises to pay benefits upon the occurrence of a specified event (e.g., death, illness), while the policyowner is not legally bound to pay premiums; however, failure to pay premiums results in policy lapse.

In Ohio, when a life insurance application is submitted without the initial premium payment (i.e., not prepaid), the coverage does not become effective immediately. Instead, the policy becomes effective on the date the policy is delivered to the applicant and the first premium is paid, provided the applicant's health status remains unchanged. This ensures that the insurer has received both the necessary payment and confirmation of the applicant's insurability before coverage begins.

According to the Ohio Life Insurance Study Guide:

"If the initial premium is not paid with the application, coverage becomes effective upon delivery of the policy and payment of the first premium, assuming the applicant's health has not changed."

A Modified Endowment Contract (MEC) is a life insurance policy that has exceeded the premium limits set by the Internal Revenue Code, specifically under the "seven-pay test." When a policy becomes a MEC, it is often because it has been funded with higher premiums in a shorter period, transforming it into an investment vehicle rather than a traditional life insurance policy.

The tax treatment of MECs differs notably from standard life insurance policies. While the death benefit remains income tax-free to beneficiaries, any distributions (including loans and withdrawals) taken before the insured's death are taxed on a last-in, first-out (LIFO) basis. This means that earnings are considered withdrawn first and are subject to income tax. Additionally, if the policyowner is under age 59½, a 10% penalty may apply to the taxable portion of the distribution.

This tax treatment aligns more closely with that of investment products, hence the characterization of MECs as investment vehicles.