AAII Journal - November 1999
To get the maximum policy value of insurance that is purchased to remain in force until the insured dies, the cash value should be periodically monitored, with careful adjustments made as the need arises.
Managing the Cash Values of Permanent Life Insurance
By Peter Katt
The need for life insurance can be divided into two categories: If-I-die and When-I-die.
If-I-die life insurance refers to having protection for a specified period of time. An example of If-I-die life insurance is insuring the family income earners so that there are sufficient resources to raise children in the event that one or both parents pass away. Once the children are raised, the need for this coverage ceases.
Because If-I-die life insurance is needed for a relatively short time frame, term insurance or low cash value permanent life insurance works just fine.
When-I-die life insurance is intended to remain in force until the insured dies. Examples of When-I-die life insurance are:
- The insured receives a pension that stops upon his or her deathlife insurance can provide the insureds spouse with the equivalent of the missing payments in the event the spouse survives the pensionerand
As an estate-planning asset. When-I-die life insurance is permanent insurance that can be whole, universal, or variable life. This column discusses the management of permanent life insurances cash values.
Cash Values Importance
I ndividuals with permanent life insurance, or those intending to buy it, often comment that they are not interested in the policys cash values because they only bought the policy for the death benefits. This misstates the importance of a permanent policys cash values. When a healthy insured buys permanent life insurance, there is a possibility they may live to policy maturity, which is commonly is set at age 95 or 100. For example, the probabilities that healthy 50-, 60-, or 70-year-old non-smoking males will live to age 100 are 3%, 3.5%, and 4.5%, respectively. For second-to-die insurance, the probabilities that at least one healthy spouse of a couple where both are age 50, 60, or 70 will live to age 100 are 14%, 15%, and 18.5% respectively. Therefore, at the time of purchase, it must be assumed that healthy insureds may live to policy maturity, so a prudent policy design uses this as its foundation.
Permanent insurance endows for its cash values at maturity. The policy should be designed so that its cash values are equal to the death benefits at maturity. Therefore, a permanent policys premiums must be sufficient to maintain the goal of endowment at maturity, at least until it becomes known that an insureds health has deteriorated to such an extent that living to age 100 has become nearly impossible. (More on this issue later).
But what role does a permanent policys cash values play for an insured who passes away before policy maturity? The fact is, for a level death benefit permanent life insurance policy, the cash value on the day the insured dies (as long as it is before policy maturity) is completely irrelevant. That is, a $1 million policy with $100 of cash value will pay the same death benefit as a $1 million policy with $800,000 of cash value. This fact frequently leads me to facetiously comment that if clients will tell me when they will die, I can design their policy to have one dollar of cash value on that day and save them a good deal of unnecessary premiums.
Knowing such a thing is, of course, impossible. However, some insurance agents do recommend permanent policy designs whose premiums are projected to continue the policy only to life expectancy. By definition, life expectancy is a date
when it is expected that about half of a given population will have passed away and about half will still be alive. Its the half that are expected to still be alive that causes prudent advisors to recommend policy designs that will endow at maturity.
A permanent insurance policy set up to endow at maturity should not then be put into a drawer and forgotten. While all life insurance policies should be monitored and managed, this is especially true for permanent life insurance.
Permanent life insurance has four important areas that need to be reviewed (and I recommend that monitoring occur every two years):
- Has the insureds family and financial situation remained relatively constant and are the goals for the permanent insurance policy the same? If significant changes have occurred, this may affect how compatible the policys design is with these new conditions or circumstances.
Are the insurance companys financial strength ratings still strong and has the company maintained its policy pricing commitments?
Are policy adjustments needed to keep benchmark cash values on track to endow the policy at maturity because of changes in the policys performance due primarily to its investment component?
Has the insureds health changed in a significant way?
A significant change in the insureds health may be highly predictive that it is no longer a realistic possibility that they will live to age 100. While obtaining such specific health information may seem morbid, it can save the insured a good deal of money, because they can avoid the payment of potentially unnecessary premiums.
For example, an insured now age 82 with a $1 million policy purchased at age 60, who has recently been diagnosed with a cancer that has no successful treatments and a life expectancy of no more than five years, could stop paying any further premiums if the policys cash values have been maintained at prudent levels. If the annual premiums are $23,000 a year and the insured does die in five years, having the forethought to stop paying premiums would save the insureds heirs some $115,000. Although the recommendation would be to stop paying premiums, I would still advise prudently investing in a side-fund in case a cure were found and the insured was returned to good health. In that event, past premiums would be paid to get the cash values back to the proper benchmark on their way to possible policy endowment.
Endowment at Maturity
When a policy endows at maturity, the policys cash values are paid to the policyowner. Unlike a policys death benefits, which are income tax-free, the payout of a policys cash values because of endowment is a taxable event. For example, the taxable gain for a $1 million policy purchased at age 60 that endows at age 95 is about $300,000. The prospect of policies endowing at maturity causing this magnitude of unexpected income tax exposure and increasing longevity, (especially among persons buying large amounts of life insurance at relatively older ages) has motivated many life insurance companies to add a rider to their permanent policies that provides they will become paid-up for approximately their cash values at maturity. As a paid-up policy, it will continue to earn interest with its death benefits paid out at the insured(s) demise as tax-free death benefits. Unfortunately, it isnt clear that this rider will actually work, because there is no clear guidance in the tax code.
Certain creative and aggressive marketers of life insurance have devised various methods for promising permanent policy performance without maintaining adequate policy cash values. Such policies are promised to have guaranteed premiums that are lower than for those companies who dont make such promises.
Table 1. A Comparison of Projected Policy Values