ELITE ADVISOR BEST PRACTICES
Life Insurance as an Asset and a Hedge - Part One
Structuring and managing policies to maximize client returns and to minimize taxes
By Richard L. Harris
- Cash value life insurance is a unique asset.
- It is a hedge against both premature death and underperformance of other assets.
- It can be managed as other assets are managed.
Cash value life insurance
Life insurance that builds cash value has four unique features that make it different from any other financial asset. Any growth of the cash value in excess of basis is not subject to tax while it is in the policy. If the policy is properly structured and managed, money can be taken out of it without triggering income tax. Regardless of how early (or late) someone dies, the death benefit is payable. At death, the proceeds are income tax-free.
There are three circumstances in which these features have great utility:
- Accumulating cash
- Accessing cash
- Creating money at death in case the insured has not already realized his or her financial goals
The cash accumulation component’s structure depends on policy type. There are two basic policy types and then variations.
Whole life is a fixed premium policy with a specified death benefit and guaranteed cash value. The life insurance company invests the money in its general account. To the extent that the board of directors declares a dividend based on the performance of the general account, the mortality experience versus projected and the actual expenses versus projected expenses, that dividend comes in addition to the guaranteed cash value of the policy. Using the dividend to buy paid-up additions (small amounts of single-premium life insurance) will increase the cash value and the death benefit.
Universal Life (UL) has no fixed premium and offers different potential ways to grow the cash value. There is a guaranteed minimum interest rate, and there are guaranteed maximum mortality costs and expenses. The amount of premium paid into a policy and the type of policy in good part determine how much value is accumulated. Some policies are designed primarily for a death benefit and produce little if any cash value. For policies that are designed to accumulate cash, there are currently three different options for accumulating cash value. All three options are sensitive to the actual mortality costs and expenses.
Options for accumulating cash value
Before going further, it is important to understand the effect of mortality and expense charges on the performance of a policy. The way they are calculated in a level death benefit policy amplifies both the growth and the decrease in value.
In a level death benefit UL policy, the insurance company looks at the face amount of the policy each month. Because the company is paying only the face amount, any accumulated value is taken off the face to determine how much insurance needs to be purchased that month. The insurance company then calculates the cost based on the age of the insured at that time and the mortality table then being used. The more accumulated value a policy has, the less that needs to be insured and the lower the mortality costs. Conversely, the less the accumulated value the policy has, the greater the amount that needs to be insured and the greater the mortality costs.
If you want to see this effect, order an illustration of a UL policy at the reasonably expected rate of return, and then order the policy using the minimum crediting rate. Compare the minimum crediting rate to the current crediting rate. The difference in the value of the policy is not explained simply by the difference in interest rates.
In Part Two of this discussion, we will explore the distinction between “Accumulated” and “Account” value and the cash surrender value of the policy. In order to amortize the various expenses incurred in putting a policy into force, there are decreasing and ultimately disappearing surrender charges that are deducted from the accumulated or account value if the policy is surrendered. The charges also come into play if the face amount is reduced.