From time to time, I have clients or potential clients express concern that they are getting ripped off on their insurance policies. Cash value life insurance policyholders are often puzzled by how the insurance company seemingly “keeps their cash value” while their beneficiaries only get the death benefit.
Some of this can be chalked up to a lack of understanding at the time of purchase, particularly if the agent was emphasizing that the policy delivers both a death benefit and a cash value at the time of the sale. While it’s certainly possible that agents can and do improperly explain permanent insurance policies, rest assured that the policy design itself is not flawed and is not ripping anyone off. It’s helpful to understand the underlying accounting and risk pooling mechanisms.
How cash value life insurance actually works
Let’s say for the sake of argument that a client has a policy with $1,000,000 of death benefit and $200,000 of cash value. If the client were to die with this policy in force, the beneficiaries would receive the $1,000,000 death benefit, and the $200,000 of cash value would seemingly “disappear.”
What’s actually going on is that the insurance company has already set aside $200,000 in the form of reserves.
- For the sake of simplicity we will say that this is equal to the cash value, which is largely true for many cash value policies.
- This $200,000 will be released as a down payment on the death benefit.
- Only $800,000 of the death benefit is at risk (commonly referred to as the “Net Amount at Risk” or NAR for short).
- The company must come up with this additional $800,000 to cover the death benefit, if and when they are called to do so.
How do insurance companies pay out death benefit claims?
It’s useful to understand how the insurance comes up with the $800,000 to pay out the death benefit claim. Let’s continue with the previous example.
Insurance companies raise funds to pay for death benefits by assessing mortality charges against the entire block of policyholders. These charges are calculated by multiplying the NAR by an assumed mortality rate. The mortality rate is an actuarially determined number of deaths expected to occur within a population over a certain period of time. For Universal Life policies, the mortality charges are part of the cost of insurance and are deducted from the cash value; for whole life policies, the mortality charges are embedded within the calculation of the annual dividend.
In aggregate, the mortality charges that the insurance company collects are sufficient to pay for the NAR on the policies where death benefits are paid out. Therefore, the $1,000,000 death benefit is actually a combination of the $200,000 of cash value and the $800,000 of NAR - but to the beneficiaries it will simply look like a $1,000,000 death benefit payment.
What it all means for you as the policyholder
What is often described as the “magic” of cash value life insurance is simply the phenomenon where the cash value grows exponentially and shrinks the NAR, allowing the policy to mitigate what would otherwise be crippling mortality charges. This may be considered “cannibalization risk.”
This is why underfunded Universal Life policies can fall apart so quickly and spectacularly in the advanced years. Once the cash value starts to erode, the increasing NAR is multiplied by the increasing mortality rate to determine mortality charges.
Building up cash value can be beneficial for the policyholder. That’s why it is so important to conduct annual reviews to make sure your policy is not at risk of underfunding (unless you are intentionally doing so – perhaps due to poor longevity expectations). It’s also critical that the policy be designed correctly from the beginning. If paying the premiums is not affordable for the buyer, it’s a good idea to think twice about buying the policy to avoid the risk of cannibalization.
The type of policy is important to consider when purchasing a cash value policy. Some types of policies expose the buyer to higher cannibalization risk than others. For example, whole life is a specific type of cash value insurance that forces the cash value to grow to equal the death benefit at an advanced age, largely mitigating this cannibalization risk.
Does your client need a policy review?
I am an Actuary and a Consumer Advocate (not an insurance agent) who helps high-net-worth individuals with $100,000 or more invested in cash value life insurance or annuities to maximize the value of their policies.
High-net-worth individuals and their advisors hire me to help:
- Analyze existing life insurance policies and annuities to provide customized recommendations for optimizing value
- Consider impact of objectives, longevity, tax considerations, and opportunity cost on life insurance and annuity decisions
- Access/design life insurance policies and annuities that eliminate (or reduce) agent compensation and maximize policy value
- Provide an unbiased perspective free from any conflicts of interest
- Avoid making critical mistakes and provide peace of mind
- Provide a qualified appraisal on life insurance policies
To learn more, please contact me.
Disclaimer
Witt Actuarial Services does not guarantee any specific level of performance, the success of any strategy that Witt Actuarial Services may use, or the success of any program. Information contained herein may become out of date; Witt Actuarial Services is under no obligation to advise users of subsequent changes to statements or information contained herein. There is no guarantee that the information contained herein is accurate. This information is general in nature; specific advice applicable to your current situation is only available through an engagement. Any perceived similarity with persons living or deceased is entirely coincidental.