Executive Summary
The fundamental purpose of insurance is to protect against and manage risks that can't otherwise be borne by an individual, from homeowner's insurance to protect against the risk of a disaster to the home, to permanent life insurance to protect against the financial impact of an untimely death. While term insurance can and does fulfill the latter function for most, in many cases clients currently maintain an existing permanent insurance policy, in anticipation of an insurance need that will last for the rest of his/her life. Often that need really does continue for life, but sometimes it does not.
In situations where permanent insurance is no longer needed - whether because the individual accumulated enough wealth than the death benefit protection is simply no longer necessary, or perhaps because the insurance was intended to provide liquidity for estate tax exposure that is simply no longer relevant at the newly permanent and portable inflation-adjusting $5.25M estate tax exemption - the default decision is often to cancel the coverage. After all, what's the point of paying for life insurance that's no longer needed, when it can be surrendered for cash value instead?
The caveat, however, is that in today's low yield environment, many permanent life insurance policies indirectly provide another potential value: a remarkably favorable internal rate of return if simply held until death. Given this potentially appealing "bond alternative" many clients should not only keep an existing permanent policy - despite no need for the death benefit - but even consider making ongoing premiums, paying down loan balances, or even increasing contributions to maintain the policy in force for life! Of course, if the client really needs the cash value or cannot afford premiums, this strategy is not viable, but the policy can still be sold as a life settlement instead to harvest most of the underlying value.
The bottom line, though, is that given the internal rate of return on life insurance held until death, for those who don't need the policy - but don't need the cash value, either - the best decision for unnecessary life insurance might not be to surrender it, but actually keep it anyway!
Taking A Fresh Look At (Existing) Permanent Life Insurance
Permanent life insurance is often maintained for the guaranteed fixed-income-style returns its cash value generates. However, while permanent life insurance does produce some positive rate of return, the net return is often fairly mediocre after expenses - especially as the cost of insurance rises for policyowners in their later years. In fact, for many universal life policies, the net return can even be negative - in other words, the insurance charges actually deplete the policy faster than the growth increases it, introducing the risk that the policy will lapse unless higher premiums are paid. For whole life policies, by definition of the policy structure, payment of the premium is guaranteed to keep the policy in force and the cash value increasing, although the net return may still be extremely low.
However, the prospective return characteristics of life insurance policies are different when accounting for the death benefit. When a policy is held until death, the net proceeds to the beneficiaries immediately step up to the death benefit value, which can provide a significant internal rate of return. In the extreme, a single premium payment of a few thousand dollars can result in a death benefit of several hundred thousand dollars, for an immediate 10,000%+ rate of return!
Of course, the incredibly high return in such a scenario cannot accrue to everyone, or the insurance company would go out of business! Instead, the reality is that the potential to receive a death benefit after only one premium payment is offset by the fact that some people will live far beyond their life expectancy, making a large number of payments - and allowing the insurance company to further grow their premiums - before ever paying a death benefit. This is the fundamental benefit of risk pooling inherent in life insurance; the increased payments for those who don't make it to life expectancy are offset by those who outlive life expectancy, and the average policyowner earns the average return by living to the average life expectancy. (Editor's note: Technically, this equation is adjusted slightly for policy lapse rates, and the overhead costs of the insurance company.)
While the average policyowner merely earns the average return, the reality is that the average return at the average life expectancy can actually be a pretty appealing rate of return in today's environment. Insurance companies invest the majority of their premiums in bonds, and build enormous bond ladders to help manage their expected death benefit payments (which, spread over a huge base of insured individuals, becomes remarkably predictable based on the law of large numbers). As a result, the pricing and internal rates of return on the policy - or more accurately, the balance between the required premium and the anticipated death benefit - are heavily supported by interest rates at the time the policy is issued. In turn, though, this also means that for existing policies, the internal rates of return tied to the death benefit tend to be related heavily to interest rates at the time of issue - which presents a significant opportunity given the recent decline in rates, as "old" policies may be priced based on bonds that are far more appealing than today's available rates!
Evaluating Whether To Surrender An Existing Life Insurance Policy - A Real World Example
A real-world example may help to illustrate. Barbara is a widower client who came in a few years ago to review an existing universal life policy that was issued back in 2000. The policy, which has a $500,000 death benefit, is owned inside an irrevocable life insurance trust (ILIT) for the benefit of her three children, and was purchased as a strategy to replace the impact of potential estate taxes on the family back when Barbara's net worth was $1.4 million but the estate tax exemption was only $675,000. Barbara was able to get coverage, despite being 59 and in relatively poor health, although it was issued with a Table F rating. Given interest rates at the time, it was estimated that a premium of $13,500/year would allow this universal life policy to sustain for Barbara's lifetime.
Unfortunately, though, interest rates have declined significantly since the policy's original issue date; as a result, the insurance now credits Barbara with only the policy-stated minimum (4%/year), and because of her significant cost of insurance charges - due both to the fact that she's now age 70, and the aforementioned Table F rating - and the fact that she cut back on the flexible premiums for a few years in the middle while markets were turbulent, the insurance charges have already overwhelmed any potential growth in the policy. After 11 years, her cash value is only up to $69,627, and even if she makes the $13,500 premium deposit this year and it all grows at 4%, the cash value is projected to be only $74,064 next year. In other words, the insurance charges are so high, that $69,627 (cash value) + $13,500 (premium) = $83,127 plus 4% growth which brings the cash value up to $86,452 will still be depleted by a whopping $12,388 from the insurance charges. And of course, the charges continue to grow higher under the universal life policy as Barbara ages; within 6 years, the charges will be greater than the total of premiums plus growth, and the net cash value will start to decline every year. The policy is projected to lapse in 19 years when Barbara is 89.
Given the fact that the policy is projected to lapse, and that there is no net growth under the policy as the insurance charges and other policy costs (about $12,388) far exceed any growth potential (even at 4% on $83,127 of cash value with another premium payment, it's only $3,325 of growth), Barbara's inclination was to simply cancel the policy (or technically to suggest to the trustee to allow it to lapse, as technically it's the trustee's decision in the case of an ILIT), avoid the insurance charges, and reinvest the cash value. After all, the insurance death benefit isn't needed now that the estate tax exemption has jumped from $675,000 (when the policy was purchased) to $5.25M (far in excess of Barbara's net worth), and Barbara would rather try to invest the money elsewhere where it has a chance to grow - not to mention stopping annual sales from her investment portfolio to plow into an insurance policy where costs exceed any growth potential.
Evaluating The Internal Rate Of Return On Life Insurance
The caveat to Barbara's strategy, though, is that she remains in poor health. While the policy is scheduled to lapse when she turns 89, the life expectancy of even a health 70 year old woman is only about 16 years, and Barbara's life expectancy is even shorter, due to her health conditions. If Barbara were to live only 10 more years - paying in $13,500 x 10 = $135,000 more premiums, on top of her current $69,627 of cash value - she'd turn a little over $200,000 of cash value and premiums into a $500,000 death benefit! Over a 10-year time horizon, that's a whopping 11.8% internal rate of return! Even if Barbara lives to an average life expectancy, the internal rate of return is still 5.1% over the next 16 years. And short of a default of the insurance company itself, those are fixed, guaranteed rates of return (at least, guaranteed if Barbara does in fact die in that year and the cash value hasn't been fully depleted yet)! Given that 10-20 year Treasuries barely yield 2% and even high quality corporate bonds only yield about 4%, these represent remarkably favorable fixed income returns!
However, there is a notable risk to the strategy - if Barbara has unexpected longevity, the policy is projected to deplete just a few years past her life expectancy. In other words, if she lives a bit "too long" she runs the risk of turning her 11.8% or 5.1% return into a -100% return as the policy lapse would result in no cash value (as it would be fully depleted) and no death benefit either. The solution to this is that Barbara can choose to contribute more to her policy - a flexibility allowed to universal life policies - to ensure that the policy will last longer. For instance, if Barbara increases her premium payments to $17,000/year, the policy is projected to last all the way until it matures at her age 100. Of course, if Barbara still passes away in 10 years - which will bring her the same $500,000 death benefit regardless of whether she pays $13,500/year or $17,000/year - then her rate of return will be reduced from 11.8% to "only" 10.1%, and over 16 years her expected return with the higher premium contributions would fall from 5.1% to 3.6%. On the other hand, she substantively reduces the risk of turning the premium payments into a total loss from a potential policy lapse, which may still be an appealing trade-off. (Conversely, Barbara could reduce her premium payments, which will increase the rate of return, especially if she passes away sooner rather than later, but also increases the risk that the policy will lapse if she survives "too long" instead.)
Nonetheless, the bottom line remains: if Barbara doesn't need the cash value (in this case she doesn't, as it's inside an ILIT anyway), and can afford to continue paying the premiums, maintaining the life insurance death benefit as a "fixed income substitute" actually turns out to be a remarkably appealing fixed income investment to maintain for the rest of her life... even if the reality is that the return will only accrue to her beneficiaries and not herself.
Reviewing Permanent Life Insurance Policies - Keep Or Surrender
Different types of permanent life insurance policies will require slightly different types of analysis to evaluate the prospective internal rate of return if held as a death benefit. For instance, whole life policies do not have the premium flexibility that universal life policies do; on the other hand, as long as premiums are paid, whole life policies generally do not have any risk of lapse, either. In addition, many whole life policies are participating - which means they pay dividends - which can both impact the prospective return opportunities, the future death benefit (if the dividends are buying paid-up additions), and/or the premium obligations to maintain the policy (the dividends may be able to partially or fully offset premiums, making the policy "free" to keep and appealing as long as the difference between the cash value and death benefit will still result in an appealing rate of return). In other situations, though, the policy may have an outstanding loan, which potentially undermines the internal rate of return (as loan interest compounds) and can increase the risk that the policy lapses (which in the case of a policy with a loan can trigger a taxable event, in addition to lapsing the policy itself!). Keeping a policy with a loan may still be worthwhile - or even paying off the loan to maintain the policy! - but the appeal of the strategy will vary depending on the specifics of the policy.
In situations where the internal rate of return of the policy is appealing, but maintaining the policy still requires premium payments or cash flows that the client cannot afford, a life settlement provides a viable alternative to consider. Rather than simply surrendering the policy for the cash value, a third party may be willing to purchase the life insurance policy instead to capture the underlying internal rate of return, paying the client more than the cash value of the policy for the privilege. Of course, some clients may feel uncomfortable with the thought of someone else owning a life insurance policy on them, but the fact remains that it is an alternative to capturing at least some of the value of a high internal rate of return on life insurance, whether due to favorable pricing from the original policy, or an adverse change in health (as a decline in health leads to a shorter life expectancy which in turn increases the anticipated return when held until death).
In addition, it's important to note that because of the typically-ongoing premium obligations - and the general fact that a death benefit is not worth as much if you have to wait longer to receive it - an accurate assessment of the client's prospective health to determine an appropriate life expectancy assumption is crucial to the analysis. A good starting point is the life expectancy calculator at LivingTo100, which can take into account some of the client's health, family history, and other factors to develop a customized estimate (and arguably, a good estimate of life expectancy is relevant for many aspects of a client's financial plan!). Technically, though, merely looking at life expectancy is still a bit of an oversimplification to truly determine the expected return on a policy, which should take into account how potential health or other factors impact the entire mortality curve (for instance, some conditions don't reduce average life expectancy much but significantly reduce the potential for significantly outliving life expectancy, which impacts a life-expectancy-probability-adjusted expected return calculation); as a result, larger policies and dollar amounts may benefit from a fully customized actuarial analysis (e.g., the services provided by Actuarial Analytics).
The bottom line, though, is that in today's low-return environment, not wanting or needing permanent life insurance anymore - whether due to a change in estate planning needs because of the increased-and-now-portable $5.25M estate tax exemption, or a general change in needs and circumstances, or a policy that is in danger of lapse due to underperformance - is not necessarily a reason to cancel it. Many existing policies have a significant prospective fixed income return - especially compared to today's fixed-income alternatives - which may provide a reason to keep a policy, or even pay additional premiums or an outstanding loan balance to maintain the future death benefit. The onus is especially significant on ILIT trustees, who must be certain to evaluate all options to fulfill their fiduciary duty on behalf of the trust beneficiaries. If the policy cannot be maintained affordably, or the cash value is needed, a life settlement may still provide an alternative mechanism to harvest the value of the policy without the ongoing obligation to maintain it. So be certain to do the proper analysis before just choosing to surrender a policy, and do the analytics necessary based on the policy projections and the client's health to determine what the best course of action really should be!
