Relative Policy Value of Life Insurance

Barry D. Flagg, CFP, CLU, ChFC

Inventor and Founder of THEInsuranceAdvisor.COM

Last month, we discussed the stability of pricing representations which is also a factor of suitability.  This month we discuss the cash value of life insurance as a factor of suitability.

The suitability of a permanent life insurance product is also influenced by the degree of cash value liquidity throughout the life of the policy. All other factors being equal, the higher the liquid cash value after deduction of cost of insurance charges and policy expenses (including contingent surrender charges), the more suitable the policy.  As such, measuring cash value liquidity for the life insurance products are based on the following formula: Premiums - COIs - E + i% = Cash Value. More weight should be placed on higher liquidity and policy value over the short term, and to a lesser degree over the mid term and long term measurement periods.

Cash value, or cash surrender value (CSV), is a defining characteristic of permanent life insurance. In simple terms, CSV is the value available to the policyholder if the policy is surrendered (i.e., cash value minus surrender charges).  But since CSVs do not account for paid-in premiums, they offer no basis for direct comparisons of policy values.  The chief regulatory body of the financial services industry has regulations that “strictly prohibit” comparing illustrations of hypothetical life insurance policy values for the purpose of determining policy suitability or competitiveness because such comparisons omit material facts and are “misleading”. On the other hand, liquidity ratios can be used to compare relative policy values and account for paid premiums. A policy’s liquidity ratio equals CSV at the end of a given policy year divided by the cumulative premiums paid through the end of that policy year. 

In general, higher CSVs and higher liquidity ratios give policy holders more planning options, greater flexibility, and better exit strategies in the event of changes in facts and circumstances or changes in tax law or other regulations. If all other suitability factors are equal, then higher CSVs, higher liquidity ratios, and lower or levelized surrender charges are considered more suitable. 

While a policy does not necessarily need to endow, funding the policy to endow offers policyholders benefits. First, if a policy does not endow, the policyholder can potentially lose the entire investment in the insurance contract as well as the death benefit. Also, if the policy is funded to endow, some insurers will extend maturity beyond the original endowment/maturity age.  In that case, if the policyholder survives beyond the original maturity date, the CSV is paid at maturity but is taxable to the extent the CSV exceeds the premium “investment.” Similarly, no deduction is allowed for any loss (i.e., CSV minus premiums) realized on the policy.  However, because policy cash values are surrendered upon the death of the insured, any benefits of endowing the policy cash value in an amount to equal to the face amount must be weighed against the added premium required to endow. 

Products with lesser cash values can also be suitable if cash values are unimportant to client objectives, particularly if foregoing cash values results in an additional pricing advantage.  For products with cash values, the actual historical performance of invested assets underlying policy cash values is clearly also a suitability consideration, for the same reason that few if any investors would invest in a mutual fund without at least inquiring about past performance. 

In all cases, suitability is relative to both client objectives and peer-group product alternatives.  For instance, products with guarantees and correspondingly higher expenses can certainly be more suitable for clients with a conservative risk profile than would be products with lower expenses but no guarantees.  Products within whichever peer-group best matches client objectives also offering lower and stable expenses and superior actual performance of invested assets underlying cash values are most suitable of all. 

Finally, persistency (i.e., the percentage of policies that remain inforce from one year to the next) can also influence relative policy value. When a policy terminates with no value or is voluntarily surrendered, it is considered to have lapsed. Since premature surrender may indicate the policyholder’s dissatisfaction with service, low lapse rates, (i.e., the rate at which a particular insurers’ policies have lapsed), may suggest greater customer satisfaction. Also, all other factors being equal, insurers with low lapse rates can often price policies more competitively because they have more margin available from the greater renewal premiums. In any case, low lapse rates and high persistency may tend to suggest greater relative value.

While liquidity can be less relevant in certain plan designs, policies with higher cash values and greater liquidity than relevant benchmarks are generally considered more appropriate than policies with lower cash values and more limited access to policy cash values. On the other hand, policies with little or no cash value can certainly be suitable in certain planning situations where cash values are not relevant to the planning objective, and where there is a beneficial trade-off of lower or no cash values in exchange for discounted costs and/or additional guarantees.