A life insurance policy’s cash value is generated by premiums that are greater than necessary to cover the "pure" cost of death benefit protection, at least in the early and middle years a policy is held. This may seem like a rather simple concept. However, as you will see, some consumers and their advisers can’t help being confused about the policy’s cash value because some life insurance companies use complicated policy pricing and illustration practices.
There are two basic types of life insurance: term and permanent. Term insurance provides a death benefit and nothing more. It is pay as you go, and as the insured gets older, the premiums increase dramatically.
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Permanent life insurance, which includes whole life, universal life, interest-sensitive life and variable life, is priced to produce relatively level premiums throughout the life of the policy. To do this, it is priced four to eight times higher than the initial term insurance premium in order to create a policy surplus. This policy surplus is known as the cash value, which accumulates on a compounding, tax-deferred basis, and is part of the death benefit. The difference between the policy’s death benefit and its cash value is the risk portion of the policy. For example, if the policy’s death benefit is $100,000 and its cash value is $15,000, the risk portion of the policy is $85,000. In a sense the insured is self-insuring $15,000 of the $100,000 total death benefit. The policy’s cash value has three functions: It reduces the amount of the policy’s actual risk portion, it provides funding as the risk portion’s unit cost increases as the insured grows older, and it provides living benefits via withdrawals, loans, or policy cancellation when the policyowner would receive the policy’s cash value.
The permanent policy’s cash value is its foundation and it provides a marker for evaluating and predicting future performance. In its purest sense, the policy’s cash value is the policy’s asset share. By making various assumptions, a specific policy’s expected asset share can be calculated and compared with its projected cash value. Essentially, a pricing model can be used that will "account" for the various policy expenses (commissions, underwriting, administrative, etc.), mortality costs, taxes and profit as debits, and that will also credit the policy with earned interest. The resulting figure is the tested policy’s "asset share." Comparing a policy’s illustrated actual (or projected) cash value with an amount that can realistically be expected for such a policy provides important information that can be used to understand the policy’s pricing structure.
First, some life insurance companies present information about their policy’s cash values that is misleading. Specifically, on their illustrations and annual statements some companies identify a policy "account value" or "accumulation value."
This figure is then offset by surrender charges and the resulting sum is often identified as the policy’s surrender value. Unfortunately, in most cases this "account value" column is largely fictional--it can’t be borrowed against, it can’t be used to pay mortality or other policy expenses and it can’t be obtained by surrendering the policy.
Table 1 depicts an example of a life insurance policy illustration that utilizes this practice. The confusing "account value" is in the first column; the surrender value (what you would receive if you surrendered the policy at that time) is in the second column, while the last column in the table is my own estimate of this policy’s actual asset share, or cash value--clearly much lower than the "account value" in the first column. I have a hard time understanding what the "account value" in Table 1 depicts, and it could easily mislead consumers into believing that their policy’s cash value is much higher in the early years than it actually is.
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Another fairly common issue that causes a good deal of confusion is the opposite of the fictional account value problems described above. It is the deliberate withholding of policy cash value for a short or extended period of time. This is a pricing strategy known as lapse-supported, which causes policyholders who cancel (lapse) their policies to receive less asset share (cash value) than the insurance company could realistically pay for some period of time, usually five to 10 years. Theoretically, this can allow the insurance company to "reward" policyholders who continue to hold onto their policies with greater policy cash value than would otherwise be possible; in effect, remaining policyholders may "profit" from the losses of the policyholders who cancel their policies and receive less value than they would otherwise be entitled.
Table 2 illustrates a lapse-supported pricing strategy. The first column is the policy’s illustrated cash value. The remaining two columns are independently calculated sets of cash values (policy’s asset share); the first set is a "straight-line" calculation that ignores the effect of lapse support, while the other calculation takes lapse support into account.
As you can see in Table 2, a lapse-supported pricing strategy has the potential to generate greater cash values (in Table 2, 25% more) by transferring "asset share," plus interest, from policyholders who cancel their policies during the period that their policy’s cash value is below the actual asset share. In theory, how does this work? Refer to the second policy year in Table 2. This policy’s straight-line asset share is $17,184, while the surrender or cash value is $1,529. The loss suffered by a policyholder who cancels his policy in the second year is $15,655 ($17,184 - $1,529). If 5% of all policyholders cancel their policy in the second year, the pro-rata gain for the illustrated policy is $782.75 ($15,655 × 0.05) plus the policy’s interest crediting rate of, say, 6.0%, for a total "profit" for remaining shareholders of $829. This $829 "profit" is then added to the lapse-supported asset share, or $18,013. (These calculations assume that everyone has purchased the same size policy and all cancellations occur at the same time.)
It should be obvious that lapse-supported pricing depends on two major things: the amount of "asset share" that is deliberately withheld; and the number of policies that are lapsed or canceled. Table 3 depicts the same policy in Table 2, except that the assumed rate of policy cancellations is doubled.
By doubling the assumed policy cancellation rate, the projected cash value increases by 35% over the lapse-supported asset share projection in Table 2 and by 67% over the straight-line asset share projection.
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Determining straight-line and lapse-support asset share is similar to an astronomer mapping a solar system in which some of the planets can’t be seen, but their positions can be calculated by measuring their gravitational force on the planets and sun that can be seen. In this case, we don’t know what lapse rates a company is anticipating when they make their pricing projections, but we also have no good way to accurately monitor their actual policy lapse experience.
There are several Canadian life insurance companies that sell permanent life insurance policies with absolutely no cash value, at any time. These are the ultimate lapse-supported permanent policies. Although policies sold by these Canadian companies must be purchased in Canada (and some of the Canadian companies require that the insured have at least a business interest in Canada), some U.S. life insurance salesmen are marketing these policies. Table 4 is a demonstration of a zero cash value permanent policy sold by some Canadian life insurance companies.
A remarkable aspect of the Canadian zero cash value permanent policies I have reviewed is that the premiums and death benefits are guaranteed. My calculations indicate that some of these Canadian companies offering guaranteed zero cash value permanent policies are being very aggressive with their pricing assumptions, bringing into question how reliable their guarantees will turn out to be.
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There are, however, significant problems associated with lapse-supported pricing. Besides consumers not understanding this policy pricing scheme, most don’t even know it is being used in their policy. A few companies try to cover up the very low projected cash values in the early and medium term by combining the two cash value issues discussed above. That is, they have an accumulation value column that illustrates a much higher value, but of course the amount in this accumulation account can’t be borrowed against, surrendered for, or used to pay internal policy costs.
Cash value life insurance is challenging enough keeping track of the various policy expenses, taxes, profit objectives and investment yields, without adding another unknown "moving part," the estimated number of policies that are canceled or lapsed, to the pricing formula. If the number of policy lapses are lower than has been estimated by the insurance company for lapse-supported pricing, this alone will cause the actual cash values to be lower than the projections in the policy illustrations. Even if the number of policy lapses has been close to the estimates, we have no way of knowing whether the company’s executives will actually "reward" remaining policyholders by redistributing the losses suffered by the policyholders who canceled because the company’s lapse-supported pricing strategy isn’t even acknowledged by the insurance company.
For consumers who already own lapse-supported policies, there are two major issues. As many consumers have learned, permanent life insurance is priced-to-the-market (see the August 1994 life insurance column). Pricing assumptions change, and especially vulnerable to change are insurance company investment yields. This can cause projected annual premium payments (either the amount of the premium or the number of years it is supposed to be paid) to change quite dramatically. What owners of lapse-supported policies don’t generally realize is that the number of policies that are canceled can also affect the pricing of their policy. Secondly, the replacement of a lapse-supported policy with a new one can result in a large loss to the policyholder.
Life insurance planning and purchase issues are complicated enough without introducing these shell games.
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Peter Katt, CFP, LIC, is sole proprietor of Katt & Co., a fee-only life insurance adviser located in West Bloomfield, Michigan (810/360-4468). His book, "The Life Insurance Fiasco: How to Avoid It," is available through the author.
© AAII Journal November 1994, Volume XVI, No. 10