Cash value life insurance is often misunderstood and often painted as a bad product. Much of the criticism centers around the cost of the coverage compared to term insurance. There are several "experts" that say you should buy term and invest the difference. This platitude sounds good, but is that really good advice.
Although term insurance is generally affordable, it has its limitations. The coverage will generally cover 10, 20, or 30 years. The death benefit part of the plan only works if you die during this coverage period. This doesn't happen very often. According to conventional wisdom only 2% of term insurance policies end with a death claim. That is by design, most term insurance ends well before life expectancy.
The other half of the formula is to invest the difference. This requires discipline that is not always present. If you do not invest the difference, the strategy fails.
Most people that buy term insurance feel that after a period of time, the need (or want) for the insurance goes away. For example, once their kids are out of college, married, living on their own, then need for insurance isn't there. I thought the same thing - up until our grandchildren came along. The desire to have coverage became much greater - in fact I own more permanent life insurance now then when my kids still lived at home. For a deep analysis check out our blog here: Myth of Buy Term and Invest the Difference
The Case For Cash Value Life Insurance
Permanent life insurance is designed to provide coverage throughout your lifetime. When designed appropriately, the coverage will be there when you pass away, providing an income tax free death benefit to your family.
In addition to the death benefit aspect, there are significant cash value benefits. The excess premiums that you pay (the premiums that are in excess of the underlying mortality costs) will build up cash value inside the policy. In a sense, you are buying term coverage and investing the difference withing a 'tax wrapper' called cash value life insurance. The growth in cash value is not subject to income tax, and can be accessed for any purpose. In addition, the values are creditor protected (this varies by state).
Types of Cash Value Life Insurance
The original form of Cash Value Life Insurance is Whole Life. With whole life insurance you get guaranteed death benefit coverage AND guaranteed cash values with a level premium. At the companies discretion, pays a dividend, which by definition is a return of excess premium. This dividend can be used to either reduce premiums or increase both the death benefit and cash value.
The down side to whole life insurance is that guaranteeing both cash value and death benefit is expensive. In addition, the whole life policy lacks flexibility - the premiums are required to be paid. Due to these limitations, insurance companies developed 'universal life' policies.
Universal Life policies are flexible in both death benefit and premiums paid. They come in 3 generic types:
- Universal Life - Cash Values are credited an interest rate set by the insurance company. The rate is based off of the general account of the insurance company. These returns are generally based on corporate bond returns and mortgages. Historically these returns are in the 5-7% range, but today, the rates are in the 4-5 % range.
- Variable Universal Life - Cash Values are 'invested' in separate accounts which are similar to mutual funds. These funds range from conservative bond funds up to aggressive small cap growth funds. There is much more upside potential, however, there can also be losses as well.
- Indexed Universal Life - Cash Values are credited interest based on the performance of an index. The S & P 500 is the most common index used. The crediting rate will match the S & P on a 1 year point to point bases subject to a cap or maximum rate and a floor or minimum rate. Caps are currently in the 8.5% - 10% range, with floors typically 0-1%.
Of the 3 designs, if the goal of the life insurance product is to provide cash values with a residual death benefit, the Indexed Universal Life or IUL is the most popular.
Challenges with Selling Cash Value Life Insurance
Today life insurance are sold using an illustration or a projection of values. These illustrations are designed to show the client projected values based on both current and guaranteed assumptions. Due to regulations, there is a significant amount of disclosure that comes with these illustrations. The disclosure is design to help the client understand the risks associated with the various features of the product.
Having an understanding of how the product performs is helpful, but it does not show the full value of you can benefit from cash value life insurance. It is helpful to have supplemental reports and/or concepts that will put the benefits into the proper context.
A useful tool we developed is 'A Comparison of Alternatives'. This tool shows how accumulating cash value within a life insurance policy compares to various alternatives. The alternatives include taxable, tax deferred, and tax deductible alternatives. It is not meant to determine if you should do one or the other, but merely how they compare based on your specific situation (age, health, tax bracket, etc.). You can learn more about this tool here: New IUL Software
Comparing Today's IUL Contracts
As discussed above, illustrations can be complicated. This issue is exacerbated with AG49 (illustration regulations that impact how you illustrate IUL's). AG49 has lead to some unfortunate developments in product design. To get around illustration restrictions carriers have moved to bonuses and multipliers.
A multiplier takes the return credited off of an index and increases it by a factor. For example: 50% multiplier with a cap of 10%; the cost of the multiplier is 4%.
If the market goes up 11%, you would be credited 15% (10% Cap + 50% Multiplier = 15%). These multipliers come at a cost. The costs vary, but can be as high as 7-8% of cash value.
The impact to the illustration is that it allows you to show higher returns than AG49 will allow otherwise. The problem with the multipliers is that they hide the risk. Since the multipliers are typically paid for by an asset charge, in the event the markets are negative, your floor is no longer zero. In the above example, on a down year, your floor is no longer 0, it would be (-4%).
In order to make a proper comparison, you have to look at 3 factors:
- Base cost of insurance - total charges not counting the cost of multipliers.
- Cost of Multiplier - specific or implied charge to buy additional return.
- Caps, Floor, Multiplier - will determine the actual interest credited to your policy.
Once you have analyzed the structure above, it is helpful to perform back-testing. We have developed a tool that analyzes the historical frequency of 20 year returns. With this data, you can determine a likelihood of achieving various returns. By risk adjusting the returns, you can run each carrier at the appropriate rate.
What does this all mean for you and your clients?
Cash value life insurance brings many benefits when structured properly. These benefits include:
- Cash value grows on a tax deferred basis
- You can access the cash values at any time, without incurring tax
- Death benefits are income tax free (estate tax free if structured correctly)
- Provide supplemental tax free retirement income
- Not subject to creditors
The above benefits are true of all types of cash value life insurance. IUL contracts add the following additional benefits:
- Upside gains tied to the market (subject to a Cap)
- Downside protection when the markets drop (beware of cost of multipliers)
Due to the nature of the IUL products, it is difficult to compare products. This issue is exacerbated by the introduction of AG49 and multipliers. In addition, once you pick the right product, structure it properly, the next challenge is how do you communicate its value?
Advisors Resource Company has the experience and expertise to guide you through this process. Our Leverage Life Process will give you the tools and confidence to bring these solutions to your clients.