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Cash Value or "Permanent" Life Insurance Policies: Why you may need one

The two basic forms of permanent cash value-type policies are universal life insurance and whole life insurance. The disadvantage of these policies is that you pay a lot more for them. Of course, if you can afford to pay for it and it serves your needs, then it is well worth it, and actually becomes an advantage.

Whole life insurance is definitely a permanent policy. Universal life insurance is so flexible, it can be a short term, long term, or even a permanent policy, depending on how it is structured, what the guarantees are, and how it is funded (i.e., how much is being paid into the policy).

The first and most obvious use for a permanent life insurance policy is to cover permanent needs. Certainly the need for money to cover funeral and burial expenses is permanent. That is to say that such a liability never goes away until you die and those costs are paid for (unless you get abducted by an alien, but who can ever predict their tastes in order to know whether they might ever even want you?).

If your net worth is enough to cause grievous taxes to be paid upon your demise, then your tax liability is permanent -- unless you are able and willing to give away everything you own well before you die, in which case you would  pay the gift taxes instead.

Uncovered medical bills that could be left unpaid at death are a potential permanent liability. Mortgages are not supposed to be permanent, but have you ever seen how many people who have their home paid off or are well on their way, end up taking out a loan against their equity? When the children are grown up and gone there is less liability from that perspective, but the remaining liabilities will have risen due to the cost of inflation.

If you have some "term" needs and some "permanent" needs, then getting two policies, one term and the other permanent; or getting one policy that has a mix of the two (base policy permanent with a term rider added) can be a perfect solution!

Pension Maximization is another significant permanent need for life insurance. This requires a little more explanation.

When a person is retiring, many companies give them several retirement payout options. To keep it simple, the two basic options are: single life, and joint and survivor.

The idea is that with the single life payout you get the highest amount of monthly income for your retirement; but if you die, that's it, no more money is paid out! So married people usually don't choose that option, because if the retiree dies, the spouse gets nothing. So they end up with the joint and survivor option that pays out much less but will continue to pay out to the spouse if the retiree dies.

That is an unfortunate and inflexible compromise, because if the spouse dies first, the retiree keeps getting paid, but at the reduced amount; and if they both live a long time they're still continuing at the reduced amount.There is a better solution, if the potential retiree is in good health.

Let's say that the maximum payout is $3,000 monthly, and the joint and survivor option is $2,000 monthly. The retiree plans to choose the single life option and get the maximum payout of $3,000 instead of settling for $2,000 monthly. The retiree gets insured with a permanent life insurance policy, the amount of coverage being sufficient to provide his spouse with at least $2,000 a month if he dies. (Which is what it would have been under the joint and survivor option.)

If that insurance costs $650 monthly, then they are left with $2,350. That's $350 more than they were going to get!

Now what happens if the spouse dies first? The retiree can either keep the insurance going for a different purpose, or he can cancel it, and he will most likely have cash value coming to him, and his income now jumps up to $3,000 a month! If they both die, their children get the life insurance proceeds; whereas under the joint and survivor option the children wouldn't get anything if both parents passed away!

Even better is planning for this solution way before retirement time; that way the insurance will cost much less!

Don't buy Universal Life Insurance (without reading this first)!

Universal Life Insurance (AKA: Flexible Premium Adjustable Life Insurance) Policies vary radically from policy to policy and company to company. They can have price guarantees as low as only 3 years or as high as 60 years. There are some that, under certain conditions, will give a lifetime guarantee.

With universal life insurance, the price doesn't necessarily go up after the initial guarantee period. It depends on how much time has lapsed and how much cash value has accrued, based on the amount put in plus interest earned.

At the point where the guarantee ends the policy may continue on as is, if interest rates have stayed high enough to earn good rates of return which have been left to add to the policy cash value; and if the life insurance company has experienced good profits. Otherwise, if the policy has performed poorly, or wasn't structured for the long term, then the policy owner would have to increase premiums or else the internal increases in policy costs would be paid for out of the policy's cash value; which could mean the cash values disappear and the policy terminates.

That is the nature of universal life insurance. It is flexible, and depending on how it was designed, it can put a lot of the risk and rewards in the lap of the client instead of being borne by the life insurance company. Universal life insurance is so flexible that it can be a treacherous policy, or an excellent policy.

What is meant by treacherous? When a person is lead to believe that their policy is a "permanent" one, or is a "level premium forever" policy, and the guarantees were never focused on, and they trust that everything is going fine, and they never look at their annual statement that gets mailed to them from the life insurance company, and if their policy has performed poorly or wasn't structured for their expectations, they might wake up one day and wonder what happened to their policy and all the cash value they dreamed about. It has happened to some people, but it can be avoided.

The key is to understand the structure, pricing, and guarantees of any specific policy, and match them to your needs; and then as time passes, observe how the policy is performing. The structure, pricing, and guarantees of a universal life insurance policy depend, in part, on what the main purpose of the policy is. Is the main focus on the potential cash value build-up, with the death benefit being the secondary concern? Or are the death benefit and the price guarantees the main concern?

A good broker or agent will know the differences in various policies and be able to listen to what the client would like to accomplish and what level of risks they are willing to take and then recommend the appropriately designed plan. Computer print-out proposals will show the numbers, the guarantees, the risks, and the rewards.

The price guarantees of universal life insurance that were talked about earlier guarantee that, for a certain time, the premium (price) would not have to be increased in order to keep the life insurance policy in force. Otherwise, if there is not enough premium to keep a policy in force and more money is not paid into the life insurance policy, it can automatically terminate and no coverage would be in force. In this situation a policy is said to have lapsed. Price guarantees are often called no-lapse guarantees.

A universal life insurance plan often has three different premium levels to choose from. They are sometimes referred to as minimum premium, target premium, and maximum premium. The no-lapse guarantee may be based any of those levels, or all three (giving longer guarantees for higher premium levels).

In addition, most universal life insurance policies will allow the policy owner to choose any premium amount wanted, as long as it is not less than the minimum or greater than the maximum.

Properly understood, the flexibility is the beauty of universal life insurance. It can be custom designed to fit a budget and/or a need! Premiums can even be increased or decreased at a later time to accommodate changing needs and/or changing budgets. If enough cash value has built up, premiums can even be suspended! However, it is important to know that if the cash value becomes depleted, payments would have to be started up again so that the policy won't lapse -- also, the new start up premium could be higher. It does need to be realized as well that changing the premium may increase or decrease the guarantees. Having pointed out the pitfalls should not take away from the fact that the flexibility of a universal life insurance plan makes it a great financial and estate planning tool! In fact, there is even more flexibility to come -- read on!

The death benefit (or face amount) of a universal life insurance policy is also flexible in two different ways! The first way is that the death benefit can be increased or decreased later on as needs change. The second way is that the policy owner can choose either a level death benefit, often known as "option A"; or an increasing death benefit, often known as "option B". This too can be changed later on. Of course, it either costs more to have the increasing death benefit, or if you don't pay extra, it can decrease the guarantees and/or the cash value that would accumulate.

Equity indexed or equity linked universal life insurance is an innovative, newer form of universal life insurance which allows a conservative indirect link to a stock market index, and allows a certain participation percentage of increase based on the increase in the stock market index.

For example, let's say that the policy's participation level is 70% of the increase (it could be higher or lower), and that the increase in the index was 20%. That means that the policy's cash value would increase 14% (70% of 20% is 14%).

On the other hand, the downside risk is minimized because these kind of life insurance policies usually have a minimum guarantee of a 3% increase. That means that if the stock market is down, say 15%, the life insurance policy cash values don't go down, the life insurance policy still credits 3%! Of course, there are still internal costs in the policy, which in a worse case scenario could eat into the cash values. For example, if the life insurance company has to pay out more claims than expected, they could have to raise the policy costs of everyone. This means that if a person chose not to pay more for their policy, the additional cost would come out of the cash values.

It should be noted that the life insurance policy is not participating in the actual stock market index, nor in the actual stocks that are in that index. Consequentially, it does not benefit from the dividends of those stocks.

That is a simplistic overview of how a stock market indexed linked life insurance plan might work.  As in other areas of this web site, there is no intention here to explain the workings of, nor generate interest in, any specific life insurance policy.

Being that such a life insurance policy has no big downside risk and does have an upside potential that could be higher than a traditional life insurance plan, it does look fantastic. It is worth noting that since it doesn't have a big downside potential, it can't be expected to have a colossal upside either. What might the life insurance policy's potential be like? In some years it could be 17% or more; in other years only 3%. Based on the last 20 years of index history, it would have probably performed similar to a regular universal life insurance policy. And the future? It could be that this kind of life insurance does even better that others, and it could be it does the same or worse. It's your call!

Whole Life Insurance -- the Nitty-gritty

Please note that any reference to whole life insurance is referring to interest sensitive whole life or dividend-paying type whole life insurance.

If a person has a financial liability that is permanent, such as the "death taxes" that will be a lien against many people's estate, then specially documented whole life insurance is the permanent solution to their permanent problem. Or, if a person can afford and wants both a strong focus on cash value and super price guarantees, then whole life is the answer. No matter what age a person is when they start a whole life insurance plan, it will be guaranteed to age 95 or 100 as to both the premium (price) and a maturity cash value. With respect to the maturity cash value, that means that if you chose a life insurance policy with a death benefit of $250,000 then the minimum guarantee is that at age 100 (or age 95), if you have not yet died and passed that $250,000 on to your heirs then the policy would have grown the cash value to be worth $250,000, which would now be distributed to you (there would be tax consequences). That $250,000 is the minimum it would have grown to, assuming that you took out no cash earlier on (which you are perfectly free to do if you want). That is the worst case scenario, but it can grow to a much greater sum if things go well. For example, it could grow to $500,000 or even $1 million!

Note: the following four paragraphs dealing with accessing cash values of your whole life insurance policy are also pertinent to cash values of universal life insurance policies, although guarantees won't be the same, you'd need to compare actual policies.

As mentioned before, if you so wish, it is possible to "borrow out" cash from your whole life insurance policy for any needs you might have. If you simply surrender the policy and take the money, any portion of the cash that is an increase above the principal you put in will be taxed. By "borrowing" the cash from your whole life insurance policy, no taxable event is triggered.

Technically, the cash values are supposed to be explained as tax deferred, not tax free. The truth is, they may only be tax deferred, meaning tax will have to be paid on them someday; or they may end up being tax-free altogether. If you die, the actual life insurance portion and the cash value are lumped together as one whole and called the death benefit, or life insurance proceeds, which, under most circumstances, are exempt from income tax.

So if you borrow money from your whole life insurance policy, but still leave enough money in it, plus whatever payments you make to keep the policy going, and later you die without having repaid the money back into your policy, it is our understanding and opinion that the cash value you borrowed from the policy will be considered as if it were part of the death benefit, and thus not subject to income taxes. That also means that the money you had borrowed from your whole life insurance policy will be subtracted from the death benefit that your beneficiaries will receive. However, if you borrow out the money from your whole life insurance policy and later you discontinue the policy, taxes will be imposed retroactively on that money you had "borrowed" out and didn't repay (to the extent that it was money in excess of the principal paid in). Also, if you live to age 100 and the policy matures and pays out the cash value to you, you would have to pay taxes on any of that money that is in excess of the principal paid in, and/or any of the same kind of money that you had borrowed out earlier. Some life insurance policies now provide an extended maturity option that lets the policy extend it's maturity date beyond age 100 in case it becomes necessary to do so for tax purposes. Usually at that point, any premiums are waived, or in other words, if the policy wasn't already paid up, it now becomes so.

With respect to how otherwise favorable it is to borrow out the money, it depends on the profitability and practices of the life insurance company, the amount of time passed since you started your whole life insurance policy, and the actual provisions and guarantees of your policy. Often, after you've had your whole life insurance plan for ten or more years (or fifteen or 20 years), you may be able to borrow out some cash value with the net effect being zero interest charged against the policy.

Some people really like the concept of whole life insurance, but can't afford it. Often the solution is a mix of whole life insurance and term life insurance, which costs less than a 100% whole life insurance policy. Then, when they are making more money they can convert the term life insurance to whole life insurance; or they could even start with all term life insurance and convert to whole life later (though there is an advantage in locking in the whole life insurance rates while one is younger!).

Another idea that works well with having a mix of whole life insurance and term insurance is with the end in mind of handling different needs. The term life insurance part of the mix could be to handle a need such as to pay off the mortgage if you die. That need has a planned end after so many years.

In conjunction with the term life insurance, you take out whole life insurance coverage to cover some other needs, which are of a more permanent nature. If the time comes that you have paid the mortgage off and are still alive and kicking, you can cancel the term insurance, and meanwhile you still have the whole life insurance portion of the mix that can continue and be there for you and your family to handle those permanent liabilities that life insurance proceeds can take care of.

By that time, if the whole life insurance policy has performed as projected (projected is not guaranteed), then the cash values would have built up enough to even cause the death benefit to increase; thus your whole life insurance policy can keep up with inflation. If the policy doesn't perform as well as expected, there still will be some cash value built up since whole life insurance has a minimum guarantee of cash value that continues to increase until maturity!

Note: The following three paragraphs dealing with suspending premiums and "limited pay" whole life insurance plans are also pertinent to some universal life insurance plans.

Some people want to have permanent life insurance but do not want to make payments on it indefinitely. Some whole life insurance plans will project (not guarantee) that after a certain amount of years, usually more than ten and less than twenty years (it mostly depends on current interest rates), you may be able to suspend the premium payments. If you arrive at that point where there is enough cash value to suspend premium payments, some policies will guarantee that you'll never have to make any more payments, while other policies will only project (not guarantee) that you'll never have to make more premium payments.

There are other types of whole life insurance policies that are designed to be guaranteed limited pay policies. They will guarantee that you will only have to make a predetermined amount of payments. Some have payment periods of ten years, others fifteen or twenty years, others to age 65, and some even offer a one single lump sum payment.

As you can imagine, a fifteen-year mortgage has higher payments than a thirty-year mortgage. You may pay less over all with a shorter term, but make higher payments so that you can pay it off quicker. It is the same with limited pay whole life insurance. The shorter the term, the higher the premium payments. If you can afford it, it's nice to get it paid for and done with!