Life Insurance (Cash Value) ~ Azaa's Weblog

For young families as yet without sufficient financial security to provide for expenses in the event of the premature death of the breadwinner or homemaker, life insurance provides essential protection. By far the cheapest and simplest way to obtain that protection is term life insurance, a no-frills deal whereby premiums buy insurance but do not create cash value.

The alternatives variously called cash value, straight, whole, permanent, or ordinary life insurance combine protection with an investment program.

The traditional cash value policy requires a fixed premium for the life of the insured and promises a fixed sum of money on the death of the insured. A portion of the premium covers expenses and actual insurance, the rest earns interest in a tax-deferred savings program, gradually building up a cash value. The latter can be cashed in by canceling the policy (hence the term ''cash surrender value"), can be used to buy more protection, or can be borrowed at a below-market or even zero interest rate with the loan balance deducted from the death benefit.

On the death of the insured, the beneficiary receives only the death benefit.

Variations called single-premium or limited-payment life policies, have higher up-front premiums so that a policy becomes paid-up the cash value becomes sufficient to cover the death benefit without further premiums. Later, if the insured is still living, the policy begins paying benefits that can supplement retirement income or be converted to an annuity, thus guaranteeing income for life.

The one serious drawback of cash value policies has been that the interest rate is not competitive with other investments. With soaring interest rates and inflation in the 1970s and in the excitement of new investment products spawned by deregulation in the 1980s, upwardly mobile young investors began questioning the value of insurance policies providing neither competitive investment returns nor the flexibility their dynamic personal financial circumstances required. Faced with cancellations and poor sales, insurers came forth with the following:

Universal Life, which clearly separates the cash value and protection elements of the policy and invests the cash value in a tax-deferred savings program tied to a money market rate. The cost of the insurance is fixed, based on the insured's age and sex, so depending on what the cash value portion earns (it is guaranteed to earn a minimum rate, but can earn more if market rates rise), the premium can vary. The insured may also change the amount of protection at any time. Flexibility is the main feature of this type of policy.

Variable Life, which has a fixed premium like straight life, but the cash value, goes into a choice of stock, bond, or money market portfolios, which the investor can alternate. The insurer guarantees a minimum death benefit regardless of portfolio performance, although excess gains buy additional coverage. The attraction here is capital growth opportunity.

Universal Variable Life, a mid-1980s innovation that combines the flexibility of universal life with the growth potential of variable life.

Even with modern policies, however, the question persists: Why sacrifice a portion of income to an insurance company when pure protection can be more cheaply obtained through term insurance and returns as good or better can be obtained by investing directly?

The answer depends on an individual's expertise, self-confidence, and willingness to spend time managing investments.

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What Is Cash Value Life Insurance?

Cash value life insurance is a contract combining payment to beneficiaries, in the event of the insured's premature death, with investment programs.

Buying, Selling, and Holding

How do I buy and sell it?

Through insurance brokers, insurance company sales agents, savings institutions, full service brokers, commercial banks, financial planners, and other financial services organizations.

Is there a minimum purchase amount, and what is the price range?

Annual premiums vary widely with the type of policy and such factors as the age and sex of the insured.

What fees and charges are involved?

Cost of coverage, sales commissions, and insurance company operating costs are built into premiums. Some policies have penalties for cancellation before specified dates.

Does it mature, expire, or otherwise terminate? Policies mature in 10 years to life, depending on the program.

Can I sell it quickly?

Yes. Policies can be canceled and cash values claimed anytime (although actual payment may require several weeks of processing time).

How is market value determined and how do I keep track of it? Policies are not traded in a secondary market. Cash values are determined by accumulated premiums plus investment income and performance.

Investment Objectives

Should I buy cash value life insurance if my objective is capital appreciation? Assuming death benefits are your primary objective, you might buy a variable life insurance policy or a universal variable life insurance policy with investments in a stock fund to gain capital appreciation.

Should I buy this if my objective is income? No, although policies combining annuities provide for income payments on annuitization.

To what extent does it protect against inflation?

Universal, variable, and universal variable policies can offer some inflation protection through adjustable death benefits and the investment of cash values in inflation-sensitive securities.

Is it suitable for tax deferred retirement accounts?

No; life insurance is not an eligible investment.

Can I borrow against it? Yes. Insurance companies will normally loan cash value at lower-than-market rates and reduce the death benefit by the amount of the loan.

Risk Considerations

How assured can I be of getting my full investment back? Insurance companies are highly regulated and there is little risk they will not meet commitments. However, policies that provide for market returns on cash value investments also carry market risk: e.g., a variable life policy invested in a bond fund would lose cash value if interest rates rose, while one invested in stocks would lose in a down market.

How assured is my income?

That depends on how cash values are invested. Policies that invest cash value in money market instruments, for example, are subject to fluctuating income.

Are there any other risks unique to cash value life insurance?

Although heavily regulated, insurance companies are potentially subject to mismanagement and fraud and are not themselves covered by federal protection in the sense that banks, for example, are covered by the Federal Deposit Insurance Corporation.

Is it commercially rated?

Yes. Insurance companies are rated by A.M. Best Co. or Weiss Research.

Tax Considerations

What tax advantages (or disadvantages) does it offer? Income earned on cash value accumulates and compounds tax-deferred. Though subject to federal estate taxes (after a $1 million exclusion) and local inheritance taxes, life insurance proceeds paid to a named beneficiary avoid probate. Proceeds to beneficiaries are normally not subject to federal income taxes. Single-premium life insurance, which offers tax-free cash value accumulation and tax-free access to funds in the form of policy loans, was one of the few tax shelters to survive the Tax Reform Act of 1986.

In 1987, however, tax legislation made tax-free borrowings possible only when a test is met requiring substantial insurance coverage relative to premiums over a lengthy time period.

Economic Considerations

What economic factors most affect buy, hold, and sell decisions?

Inflation and volatility of interest rates gave rise to life insurance policies whose cash values vary with market conditions. Investors concerned about such factors can choose among such "new breed" alternatives, rather than buying traditional fixed-rate policies, and make their choices based on their expectations.

Thus an investor anticipating high inflation and high interest rates would not choose a variable life policy invested in fixed-income bonds but might choose one with a stock fund or one that is

money market-oriented. Variable and universal variable life insurance permit switching between bond, stock, and money market funds to afford maximum market flexibility.