Vol 6 No 6		October 2004

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Hidden Surrender Charges in Life Insurance

"The agent recommending that the Manulife policy be replaced either didn't understand that it was subject to hidden surrender charges or, if he did, decided not to disclose this because it would interfere with his sale."

Our April 2003 Perspectives discussed avoiding purchasing policies with large and enduring surrender charges. These policies have an Account Value that is robust relative to premiums paid, but have very low Surrender Values. The difference between the Account Value and Surrender Value is a surrender charge. Surrender charges are well documented in the policy contract. Even though these surrender charges are fully disclosed, many buyers don't pay much attention to them or their importance.

More insidious are surrender charges that are hidden. Some participating whole life policies have cash values that are considerably lower than the internal asset share in the early years of the policy, and later surge in order to catch up. Because there is no disclosed Account Value and Surrender Value, only a cash value, non-experts are not likely to detect these hidden surrender charges. I recently had a case where an insurance agent was trying to replace a Manulife participating whole life policy purchased in 1997. The total premiums that have been paid are $3,031,917, but the projected cash surrender value for June 2005 is only $1,791,016. This difference of $1,240,901 isn't entirely due to insurance agents' commissions. Such a policy, without hidden surrender charges, should have a cash surrender value of around $2,750,000. My best estimate is that this policy is subject to hidden surrender charges that could be as much as $1,000,000. It is almost certain that these hidden surrender charges are going to be released into the policy in the near future. This can be seen by calculating the year-to-year increase in projected cash values, taking into account illustrated premiums paid. Table 1 shows this for selected policy years:

Table 1 - Year-to-Year Cash Value Build-Up - Manulife $13,288,000 Policy
(Actual yield will depend on dividends that aren't guaranteed)

The cash value build-up appears to be artificially low until policy year 13, when hidden surrender charges seem to be in effect, then appears to be too high in policy years 13 through 21, seemingly reflecting the release of the hidden surrender charges. After policy year 21 it looks as though the illustrated values settle into an appropriate pattern. (There is no guarantee that Manulife will make good on returning this policy's true asset share, but it is very likely that the pattern in Table 1 will occur).

Another way of understanding the profound potential for loss if this policy is terminated now, with hidden surrender charges being incurred, is to compare it to purchasing a CD that will incur surrender charges if terminated early. Think of purchasing a CD that guarantees 6% compounding interest for 10 years, but will incur surrender charges if terminated early. If $100,000 is invested it will mature for $179,085 in 10 years. Let's say that the surrender value of the CD after five years is $105,000, although its gross value is $133,823. This represents a surrender charge of $28,823. In five years another bank proposes to exchange this CD with a new 5-year CD having a guaranteed yield of 8%. An 8% yield is better than the 6% yield on the existing CD, but this doesn't take into account the release of the surrender charges over the last five years. The existing CD's effective yield for the last five years is 11.1% measured using the $105,000 surrender value after five years and maturity value of $179,085 in another five years.

The agent recommending that the Manulife policy be replaced either didn't understand that it is subject to hidden surrender charges or, if he did, decided not to disclose this because it would interfere with his sale. A policy subject to hidden surrender charges is likely to be a poor candidate for replacement until the surrender charges have been fully released, because while they are being released the policy is an excellent value. It may be appropriate to consider replacing such a policy after the surrender charges have been fully released, but not until that time.