We need to separate fact from fiction about life insurance with cash values

Cash Values…how I’ve MYTHed you!

By on in with comments

OK, right now I’m ticked.  I was preparing a blog post that addressed how life insurance is the most unique financial instrument in the world today, but in doing some research I happened across some sites written by self-proclaimed experts that made my blood boil.  And of course they play the “deception” card… how advisors who recommend cash value life insurance to their clients are so unethical and self-interested.  ARGHH!!

Today’s blog is my humble attempt to set the record straight.  There is a tremendous amount of confusion and misinformation around the topic of life insurance that needs to be dealt with head-on.  I’ll address a major question today, and then other issues in future posts.  Here goes.

Myth #1 Cash value life insurance in a rip-off:  on the contrary, a participating cash value policy can be the most cost-efficient way to purchase your life insurance.  Notice the term “participating”.

As with all life insurance products that offer a guaranteed level premium over the years, we over-pay in our early years (relative to the risk of there being a payout) so that we can be underpay in our later years.  With participating policies, the insurance company takes more premium than it needs early in the contract and this excess is invested in what can be best described as a conservative mutual fund called a Participating Fund.  It has to be conservative, because it is from this account that benefits are paid – whether policy loans, withdrawals or insurance proceeds – so liquidity is important.  As owner of a participating insurance policy, your policy is credited with a minimum of 97% of the return on that fund each year.  Thus the name: you are participating in the performance of the fund.  The remainder goes to the insurer, forming part of corporate profits on behalf of its shareholders.

Your life insurance should not be your best investment… but it won’t be your worst either. In fact, having cash values in your life insurance can offer the most cost-efficient way to fund your insurance needs long-term.

What it all means to the customer is that the value inside the policy grows each year, and these values can be accessed either through taking a policy loan or a direct withdrawal.  If at some point in the future you deem the insurance unnecessary, you can return the policy to the insurer in exchange for its cash value.  Over the course of 20-25 years, you can expect the cash value to be at least equal to the cumulative total of all the money you’ve put in.  Even if you do nothing more than break even, having enjoyed the protection for your family over an extended period of time at a cost of what is essentially the opportunity cost of those premiums is a pretty cost-effective way to pay for your life insurance.

Myth #2  When I take a policy loan, the insurer is lending me my own money but charging interest!  Nope.  When extending a policy loan, the insurer is lending you money based on the collateral you have in your policy.  Anyone who has ever taken out a home equity loan understands this concept well.  When we borrow against the equity in our homes, we are not “borrowing our own money”, but rather using the assessed value of the home as collateral.  What about the interest?  We pay interest on our home equity loan because we clearly have not relinquished the use of the home in exchange for the loan.  We continue to own the house, and to benefit from the ongoing ownership as its value appreciates over time notwithstanding that we have a loan against some of our equity in the property.  Likewise, the cash growth inside your par insurance policy continues to grow undisturbed even though there is a loan against part of the value.

Myth #3:  When I die, the insurance company only pays out the guaranteed death benefit and keeps all the cash value.  This is a misleading statement based on misunderstanding.  As I mentioned earlier, the value in a cash value policy represents the internal reserve of the policy, similar to the equity portion of your house.  When you sell your house, you don’t get the full selling price and the equity; the equity forms part of the value of the house.  In similar fashion the cash value in the policy forms part of the insurance benefit.

This is where cash value insurance policies diverge into two categories.  We have already read about “participating” policies that generate a dividend (refund of premium); there are also “non-participating” policies that do not have any dividend component.  The premium is lower than that of par policies to reflect the fact that there is no excess going into the participating fund (the conservative mutual fund we spoke about earlier).

An added benefit of par policies is that the dividend that is credited each year to the policy can be applied in a number of different ways, but every dividend option reflects added value to the owner.  In its simplest form, the dividend can be paid out in cash each year in the form of a cheque to the owner.  This option is rarely used because of the tax consequences and the loss of the benefit compounding serves over the long term.  At the other end of the spectrum, the dividend can be used to purchase a single premium slice of paid-up life insurance.  As an example, a dividend of $100 is declared on your policy and is used to purchase $2000 in paid-up life insurance (the amount it can afford to purchase for you is determined by your age… the older you are, the less it can afford to buy).  This $2,000 is then applied as an addition to the basic benefit on your policy…hence it is called a “paid-up addition” (PUA).

What this means to the policy-owner is that, over time, the amount of insurance benefit will gradually climb and when the time comes, the insurance benefit will include both the basic amount of the contract PLUS the sum of all PUA’s that have been accumulated over the years.  It’s not uncommon to see a policy that is 20 or 25 years old pay a benefit that is 2-3 times the size of the original contract.

There’s much more that we could discuss on this topic, but in the interest of your time I’m going to close this topic off.  Sometime soon, I’ll post a blog about the illustrations that advisors use to demonstrate the workings of these types of policies.  Let’s end it for today by saying that you should always seek the counsel of a qualified, professional full-time advisor when considering your life insurance purchase.

If you have specific questions that I can help with, feel free to comment and I’ll respond.