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    Life Insurance Issues to Be Wary of: Surrender Charges & Leaps of Faith

    by Peter Katt

    This column addresses three life insurance issues.

    The first issue is buying life insurance from buddies whose enthusiasm replaces your good judgment. When this has occurred, there is little motivation to continue the policy as the grind of paying premiums replaces the insurance salespersons’ charisma.

    When you get around to canceling buddy-bought life insurance, you may realize there were some questions left unasked—to your great detriment—and that gets us into the second issue.

    This second issue describes the unfortunate insurance company practice of selling policies that have zero surrender cash value for as long as five years. This makes getting out of such policies a very expensive proposition.

    The third issue concerns the wide chasm between those who believe life insurance is the way to invest, and those who have utter disdain for the very thought of insurance as an investment.

    Insurance Buddies

    Bill occasionally plays golf and shares social moments with John at his golf club. Always there was the low-key suggestion that Bill sit down and talk about his estate planning with John, a self-proclaimed life insurance/estate planning expert. Then there was the golf game in early May 1999 interrupted by rain where Bill found himself in the men’s grill listening to John’s enthusiastic presentation about using life insurance to pay estate taxes. An appointment in Bill’s office followed, and the next thing Bill knew he was insured for $2 million with a universal life policy.

    I refer to this as buddy-buying. Of course, business and professional relationships between social acquaintances can be beneficial to both if the social part is separate from the business part, and competence and integrity in the business relationship are primary.

    But buddy-buying does occur in the financial services industry, including the sale of life insurance. And the result can be the buyer’s remorse—a great deal of it.

    In Bill’s case, his willingness to pay the high $35,000 annual premiums quickly faded because he was never truly committed to the purchase. So, his attorney had him order an in-force illustration for the policy that showed an account value of $55,000, but a surrender value of $0.

    How could there be a zero surrender value after Bill payed premiums of $105,000?

    This is a detail John failed to mention, let alone emphasize.

    Where’s the Beef? (REDUX)

    Unfortunately, there are many permanent life insurance policies that have zero surrender value for as long as five years and very depressed surrender values for as long as 15 to 20 years.

    Insurance buyers usually don’t notice this because policies with zero and very low surrender values almost always show an account value depicting robust policy cash values. But the account value is offset by the surrender charges that will greatly affect the surrender values. And most buyers don’t think of surrendering a policy during the sales process. My November 1994 AAII Journal column, “Permanent Life: Clearing the Fog That Surrounds Policy Cash Values,” (available at www.aaii.com) describes this practice as ‘Where’s the Beef?’ and goes on to explain a pricing strategy that almost always accompanies policies with very large extended surrender charges—known as lapse-supported pricing.

    And this is the situation Bill is facing. He would like to rid himself of the annual insurance premiums, but doesn’t want to take a huge $105,000 loss ($35,000 premiums paid out for three years).

    Unfortunately, there doesn’t seem to be any good solution. If the policy death benefit is substantially reduced to make the premiums far more manageable, surrender charges in proportion to the amount of the reduction are incurred. That is, if death benefits are reduced from $2 million to $1 million, half of the $100,000 surrender charge is incurred, bringing the account value down from $55,000 to $5,000.

    This case offers two lessons:

    • Don’t buddy-buy life insurance, and
    • Don’t ever buy a policy without very substantial surrender values in the first year and thereafter. Demanding substantial surrender values in the first year will assure you have reduced the policy’s selling expenses, and gives you liquidity in case you decide to bail on the policy early.

    A Leap of Faith

    A recent incident involving an individual who was sold life insurance as an investment provides a sharp juxtaposition between those who feel that it is the ultimate investment, and those investment advisers who sound the alarm anytime investing and permanent life insurance are mentioned in the same neighborhood.

    The policy was sold under the so-called Lifetime Economic Acceleration Process (LEAP) philosophy. LEAP proselytizes the idea that the only investment needed is permanent life insurance. Indeed, it criticizes every other investment you might think of. (For the gory details of LEAP’s remarkable claims go to www.leapsystems.com. Also, for a very thorough and informed critique of LEAP, go to www.theinsuranceforum.com for instructions on how to order Joseph Belth’s LEAP articles.)

    Ted was sold whole life policies under the LEAP philosophy with death benefits of $995,000 and annual premiums of $13,200. That doesn’t seem too dramatic until you realize that his annual income is $74,000 with three young children and a wife who does not work outside the home. Even with effective income taxes of 11%, the life insurance premiums represent 20% of his aftertax income.

    In order to pay this premium, Ted was advised to stop contributing to his 401(k) and to annuitize an IRA he inherited with a current value of $120,000. The annuity payments, all subject to income taxes (but, set up to avoid the penalty tax for premature distributions) are to be used to pay some of his life insurance premiums.

    This plan was sold with such fervor that it took some convincing on my part for Ted to understand he should cancel most of the whole life, protect his family with term insurance, restart his 401(k) contributions and not annuitize his inherited IRA.

    Any investment professional could use Ted as the poster boy for the abuse of life insurance as an investment. And I absolutely agree with that.

    However, life insurance as an investment doesn’t have to reside in a black-and-white do-or-don’t-do world. There is room for those of us who can see its advantages in the right circumstances.

    Permanent life insurance’s income tax advantages and flexibility are so great they just cannot be overlooked.

    For details on how life insurance can properly be used for the dual purposes of protection and tax-deferred (and mostly tax-free) savings and investing, see my previous AAII Journal columns (“The Life Cycle of Insurance Needs: A 30-Something Example,” November 1995, and “Using Variable Life Insurance as an Investment Alternative,” July 2000). Both are also available at www.peterkatt.com.

    Also refer to my August 1996 article (“Passing on Your Wealth: Gift Planning and the Use of Life Insurance”) and the previously mentioned July 2000 column for a discussion of the appropriate uses of life insurance as an inter-generation wealth-accumulation asset in place of conventional investing.


    Peter Katt, CFP, LIC, is sole proprietor of Katt & Co., a fee-only life insurance advisor located in Kalamazoo, Michigan (616/372-3497; www.peterkatt.com). His book, “The Life Insurance Fiasco: How to Avoid It,” is available through the author.


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