Life Insurance Cash Value: A Practical Discussion
by Peter Katt
As readers of my AAII articles know, I believe the best way to understand the maddeningly complicated life insurance asset is to present various anecdotes on specific issues.
In this spirit, several recent client encounters about aspects of life insurance cash value has prompted me to discuss cash values—not in a historical and comprehensive sense, but with narratives to provide a better practical understanding of cash values for owners of life insurance policies.
It’s My Money and I Want It Now
A client I will call Stan came to me furious because he was being charged interest on cash value loans from his participating whole life policies. Recently, his agent told him that without either premium or loan interest payments his policies would terminate. Stan was furious because of his insistence that no loan interest be charged, since it was his money and he viewed the cash balance like a bank account.
This isn’t the way life insurance cash value works. Life insurance as an asset is not dissimilar to, say, apartment units. If you want cash from the apartment asset (or your life insurance), you take a mortgageand pay interest. This reduces the net value of the apartment (the life insurance death benefits) by the amount of the mortgage ( . Alternatively, you could sell some units (withdraw cash value) to receive cash. You would not create a mortgage ( , but you would reduce the net of your asset (you would own less). This is why a life insurance policy’s cash value is not, nor should it be viewed as, a bank account.
Unattended Cash Value Loans Can Crater a Policy
Stan’s loans accumulated due to a combination of factors. His agent left the business. When Stan moved, the insurance company lost track of the correct address to send him premium notices. As a result, Stan didn’t receive them. Stan also didn’t pay premiums because he thought the premiums were covered within the policy. The premiums were covered by loans. Due to missed premium notices and the loans, the policy eventually reached a tipping point of being in danger of lapsing with phantom income within a year.
Stan, mistakenly believing that the cash values were his to do with as he pleased, then spent hours in discussions and written communications with the insurance company trying to pin blame on them for this situation. He threatened legal action. He churned up a lot of frustration. Even if Stan successfully proved that the company mismanaged this situation, the cost in money and time would have produced a huge net loss to him. The amount at stake was really quite small.
Cash value life insurance with a large loan can cause a policy to lapse without value, but with taxable income. This is because the cash value loan value (known in the tax world as boot) is the gross value of the policy when it lapses. (In this example, the gross value is the loan.) The insurance company’s calculation of the cost basis is subtracted from the gross value and the difference is the reportable taxable income. Note that when a policy lapses with no value but with taxable income, there are no funds from the policy to pay the taxes. This is known as phantom income.
I determined that Stan had three choices to rescue the situation, but only one that was in his best interest. Fortunately, Stan has a relatively high net worth with cash resources. Repaying the loan of approximately $46,000 immediately raises the policy’s cash value by about an equal amount. It also raises the death benefits from approximately $28,000 to $81,000. Taking into account the payments and the death benefit payout at Stan’s life expectancy, the calculated yield is 3.14% of tax-free income based on the current dividend.
In the current low fixed-income yield environment, this is a decent return. More to the point, it is the only way for him to have a positive outcome with this policy. All the other options produce negative financial outcomes, including repaying the loan and then terminating the policy for its surrender value. (Doing so would produce significant taxes.) Because of his negative feelings generated for this insurance company during his long battle, Stan only reluctantly repaid the loan. Astonishingly, during the long ordeal the insurance company spent most of its time defending its practices. To the extent the company suggested repaying the loan as the only real solution, Stan didn’t accept the suggestion because of his total mistrust.
Account Value Is Not the Same as Cash Value
Almost all universal life policies have significant surrender charges that are listed in the contract. They also show up as the difference between the account value and cash value in statements and illustrations. Many clients and advisers don’t understand the difference.
Let’s say a $1 million universal life (UL) policy has a $100,000 account value and a $50,000 cash value. The surrender charge is $50,000. The client could borrow or withdraw against the $50,000 cash value, but not the account value. If the client were to withdraw most of the cash value, the policy could continue for quite some time because the monthly insurance charges are usually deducted from the account value that would be approximately $50,000.
Let’s say that the client wants to reduce the policy from $1 million to $500,000. This would cause half of the $50,000 surrender charge to be incurred, or $25,000. After the reduction to $500,000, the account value would be $75,000 while the cash value would remain at $50,000. (The difference between the account value and the cash value is the surrender charge, the penalty paid for reducing the policy.) Since the surrender charges go down each year, this is a real loss in policy value.
The account value offset by the surrender charge is really a way for the insurance company to hide the sales commissions. If the commissions are lower, the surrender charges are lower and the surrender cash value is higher. This can be done on some universal life policies (not all) by demanding that blending be used to replace base death benefits with term insurance. This blending alters nothing in the policy’s pricing, except to reduce the commissions and surrender charges and increase the cash value.
Can I Have My Cake and Eat It Too?
A client reviewing his annual universal life statement showing $2.5 million cash value for his $10 million policy had a question: Does the cash value add to the death benefit? He then had an epiphany that the answer for his policy is no. So why not take out most of the cash value?
There are two reasons why this shouldn’t be done. First, borrowing or withdrawing cash values will reduce the death benefit by the same amount, so nothing is gained. Secondly, the cash value is the foundation of a permanent current assumption universal life policy (as opposed to guaranteed universal life). The target premiums are set up to level the annual cost of the policy with the buildup of cash value used to support the increasing cost of insurance charges as insureds get older, with the account value reducing the amount of actual life insurance.
The overall management of a level death benefit universal life policy needs to take into account an insured’s potential for a change in health so the target funding age is accurate. For a healthy insured, we need to fund the policy as if he will live to age 100 or beyond—lifetime funding. Depending on the type of policy, this may mean generating a cash value equal to the death benefit at 100. In others, we only need $1 to continue lifetime funding beyond age 100. But if an insured incurs significant health issues, we may decide to fund the policy to an earlier age, if the probability of living to the earlier age is low because of health issues. The goal is to have $1 of cash value when the insured dies.
This, of course, is a theory and not reality, but we can save significant premiums by assessing mortality prospects and minimizing the cash value buildup when mortality probabilities are more in favor of dying around, say, age 85 than age 100. The secret to effective universal life cash value management is not to build it up in the first place, because as I’ve explained, you can’t get it out without reducing the death benefits.
Guaranteed universal life (has low to zero cash values. Unlike other permanent policies that terminate if there is no cash value, guaranteed universal life depends on a specified premium being paid as contracted for the coverage to remain in force, regardless of zero cash values.