The process of purchasing and maintaining a life insurance policy can be confusing. Agents and advisors often sell life insurance based on a policy’s features, such as cash value and perhaps low premium payments.
When you purchase a cash value life insurance policy, you’ll receive a projection of the policy’s guaranteed and non-guaranteed features. It’s important to understand that these projections are based on three components:
- Earnings, such as dividends or interest on the cash value
- The cost of insurance, also known as the mortality charge, meaning the actual cost of insuring your life
- Internal policy costs, also known as administrative expenses
These components may have different names, depending on the type of life insurance policy.
Cash value life insurance can be extraordinarily complex, and an agent might gloss over the complexities in order to sell you the policy. Here are some things that can be easily confusing.
Confusion No. 1: The Premium Is the Cost of the Policy
The total “cost” of the life insurance policy is not the premium that you pay. The cost is the sum of the premiums, the mortality charge (cost of insurance) and internal charges. These components will vary in name depending on the policy type and company.
Why does it matter? The costs you don’t pay attention to—like internal policy costs—can reduce your potential cash value. If more of your premium goes to internal charges, there’s less to go into cash value. If you then take a loan against your cash value, high internal charges could potentially eat up the remaining cash value and your policy could lapse with an extra infusion of premium. So that “low premium” policy you snagged is suddenly not cheap.
Unfortunately these costs are not always disclosed as separate items on policy illustrations.
Confusion No. 2: It’s Easy to Compare Life Insurance Policy Illustrations
Life insurance policy sales illustrations are usually at least 10 pages long. These illustrations include projections for multiple scenarios.
These scenarios are based on projections of policy components that are not transparent. It’s challenging to compare projections when you don’t have all of the information, such as internal cost disclosures and actual earnings rates. And sales illustrations might not include historical information, which could provide context.
Confusion No. 3: Life Insurance Is an Investment
Life insurance is a form of insurance, not an investment contract.
Life insurance policies include charges for the cost of insurance. This cost makes life insurance a significantly more expensive asset class. While life insurance policies do accumulate a cash value, it’s important to keep in mind that the cash value is a feature of the policy, not the end game.
Confusion No. 4: Annual Statements Provide All the Information You Need
Life insurance annual statements provide a summary of your policy’s current values, without context.
Annual statements do not show the projected values, so you can’t gauge if your policy is performing as expected. A small percentage of life insurance companies will reference the number of years that the policy is projected to stay in force, based on current assumptions.
But life insurance companies do not disclose the basis for how they determine dividend or interest crediting rates. And they generally don’t disclose when there has been a change to mortality costs.
This could really leave you in the dark about exactly what’s going on with your life insurance policy. The solution is to order an in-force policy illustration and see what is happening and what could happen in various situations, like a cash value loan that you plan to take.
Confusion No. 5: Life Insurance Policies Do Not Require Monitoring
The actual policy performance of cash value life insurance can easily be different than what’s shown on the sales illustration.
You should request an in-force illustration every two to three years. This is the only way to determine if your policy is not performing as expected. In other words, it will show you if there has been a change to one or more of the policy components, and how that change is impacting policy performance. The bottom line is that changes to earnings, the cost of insurance and internal policy costs will impact the performance of the policy.
Confusion No. 6: You Can Always Borrow or Withdraw Money From Your Life Insurance Policy
Cash value life insurance policies allow you to borrow or withdraw funds from your cash value. But actually doing so could have a negative impact on your life insurance. It’s smart to request an in-force illustration from your insurance company prior to withdrawing or borrowing money from the policy in order to determine the impact.
Here are some pitfalls to taking out money from a policy:
- When you withdraw money or take a loan against the policy and don’t repay it, it will reduce your death benefit on a dollar for dollar basis. This means a lower payout for beneficiaries when you pass away.
- Since the cash value is a reserve account on your life insurance policy, withdrawing too much money can create a problem in the future: There may not be sufficient cash value left to offset future increases in the cost of insurance. If your cash value is depleted but charges keep coming, the policy lapses.
- When you borrow money from a life insurance policy, you are borrowing your own money. You are not required to repay a policy loan. The insurance company will charge you interest on the amount that you borrow, while at the same time crediting a lower earnings rate on the amount borrowed. This makes a policy loan less like “borrowing from yourself” than you may have thought.
Getting a Grip on Your Policy
As you can see, buying and maintaining a cash value life insurance policy could become more complicated than you anticipated. Understand the moving parts of the policy (premium, mortality change and internal costs), and that a change in one part can affect the others.
The best life insurance companies offer low internal costs and policy illustrations that are consistent with actual performance, among other qualities.
Be sure to monitor your policy, as you would any other financial instrument.