How to evaluate a cash value life insurance policy

Every day that I turn on the radio, I hear cash value life insurance get denigrated. The problem is, the comments are highly generalized and rife with big assumptions that aren’t always true.

First of all, let’s back up and look at what cash value life insurance is compared to term life insurance. Cash value life insurance is also known as permanent life insurance. Some people also call it “whole life”, because that version has been around for decades. But there are other types that are NOT whole life.

Boiling things down, cash value life insurance is designed such that the face value of the policy can be paid when the policy holder dies. So how DOES it work? Basically, you buy a policy with a given face value. Imagine we picked a policy that offered $100,000, payable upon death to the beneficiary. So how can an insurance company come up with a way to guarantee paying this amount of money at some random time in the future? They collect premium payments form you, and use part of it to buy some immediate term life insurance and the rest is set aside to build up “cash value”. As more and more premiums are collected over the years, the cash value builds up.

The cornerstone of cash value

What is cash value? Essentially, it provides a cornerstone of the face value. Imagine you had built up a $30,000 cash value to back the $100,000 face value. At that point, 30% of the insurance is covered by the cash value, meaning the insurance company only needs to buy an additional $70,000 of term life insurance. At a certain point, they no longer have to collect premiums from you. Instead, interest from the cash value can be used to fund term life insurance making up the difference.

This is what leads to haughty TV and radio show hosts balking at how insurance companies “only pay you the face value” and “keep the cash value for themselves”. Ahem. If you have a $100,000 policy backed by $30,000 of cash value, where do you get the idea that they owe you $130,000?

This is just the scenario I heard the other day on the radio. Most of the time, the dollars aren’t mentioned. Instead, the radio personality seems to imply that you could have racked up $50,000 of cash value, and yet only get paid something smaller, like $25,000. That WOULD be horrendous. What they don’t mention is that the face value is typically HIGHER than the cash value.

Some real numbers

The only real numbers i often hear on various shows is how cheap term life insurance is compared to cash value. Like how dollar for dollar, term life costs 5% of cash value life insurance.

In a rare moment, I heard someone call in with numbers precisely matching what I’ve said so far. This caller had paid $20,000 in premiums over 25 years, and built up a $30,000 cash value, backing a $100,000 face value policy. His primary concern was that if he cashed in this policy in order to ditch it, he would get the first $20,000 tax free. It would be consider return of capital and not cost a cent in taxes. The host tried to say people almost never have tax consequences. But in this case, he would be facing a $10,000 profit. This is where he would need to talk to an accountant. I don’t know if that would be long term capital gains, or something completely different.

The talk show host couldn’t believe his ears. He repeated his usual complaints about how you never GET the cash value. And then I heard the caller reveal the face value of $100,000. When he dies, his wife will ONLY get $100,000 and not the additional $30,000. Instead, the insurance company is keeping that money for itself! Sorry, but that is grossly wrong. At this stage, the insurance policy has $30,000 in cash along with an additional $70,000 of actual insurance. Liquidating everything would result in a combined total of, surprise, $100,000 to pay out. There is not pile of gold left behind that the insurance company dumps into a giant vault and begins to swim in like Scrooge McDuck.

HINT: Insurance companies gear things such that they rack up their maximum profits at the beginning not the end. Term life insurance policies tend to get cancelled within a couple years. Same for many policies. Things change and people stop paying premiums. Insurance companies aren’t dumb. They want to rack up their profits early and move on.

What really stunned me was how the talk show host failed to look at the actual growth of the caller’s insurance investment. The¬†caller has the opportunity to borrow against the cash value, perhaps to fund retirement. In that event, imagine they could borrow the entire $30,000. It’s usually something less to avoid collapsing the whole policy, but let’s assume they can take it all. We should be asking, what was the rate of return on that?

Actual yield of a whole life policy

If the caller invested $20,000 and accumulated $30,000 over 25 years, we can easily calculate the annualized growth rate. Simply take $30,000/$20,000 and take the 25th root. Result? 1.6% annualized growth. THAT is the indicator that this policy was horribly set up. THIS is the reason I would dump the policy and instead take the cash elsewhere, like buying up a big chunk of VNR stock.

With $30,000, the caller could buy roughly 1350 units of VNR. That would yield $283.50 every month, resulting in a hair over $3400 annually. In ten short years, the caller could easily double his money due to VNR’s 7.5% yield. This is much better than the dismal 1.6% yield which isn’t even keeping up with inflation. And this analysis assumes no growth in distributions from VNR.

Or take this $30,000 and buy KO, WMT, GIS, or a dozen other solid companies you have known about your whole life. Or perhaps buy a real estate note. Anything is better than 1.6% in my book.

Thankfully, the EIUL I have setup is designed properly. The face value has been dialed back to the minimum amount allowed by the IRS. This means that the cash value will grow much faster than 1.6%. My agent plugged in a estimate of about 8% based on a 20 year look minus 10%. This paints a very conservative estimate. 8% of growth¬†is certainly possible even though mutual funds are averaging 4% thanks to an EIUL’s ability to guard against market drops.

Happy investing!

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