Which one is the best choice?
Cash value life insurance is…
A. an expense.
B. a combination of protection and savings.
C. a way of prepaying future insurance costs.
You have probably read many times that there are two types of life insurance: term and cash value. Term insurance is pure protection, while cash value life insurance combines protection with savings.
Or perhaps the writer has put his thumb on the scale by calling cash value life insurance “permanent insurance,” as opposed to “temporary” term insurance. The actuary Charles Trowbridge had a wonderful observation about these loaded names: “There is nothing more permanent than a term policy fully in force at the time of the insured’s death — and nothing more temporary than a whole life policy that lapses shortly after issue.”
Terminology aside, this is a case where the description suggests the analysis. If cash value life insurance is a package of protection and savings, then you should naturally want to unbundle the package to figure out what you are paying for the protection and what you are earning on the savings.
Here’s an experiment that you can try: Get into your time machine, go back to 1850, find some people who know something about life insurance, and ask them how whole life insurance compares with buying term and investing the difference.
They won’t know what you’re talking about, because guaranteed cash surrender values did not become available until the late 1860s and the following decades. For consumers in 1850, whole life insurance was a way of making life insurance affordable until death. By charging more than the actual cost of death claims in the early years, the insurance company could charge less than the actual cost of death claims in the later years. When policyholders paid a level premium for life, they were prepaying some of the future costs of insurance.
If cash value life insurance is a way of prepaying future insurance costs, then you should naturally want to figure out what incentive the insurance company is giving you to prepay. Suppose you know the minimum amount to keep the policy in force each year. If you pay $1 more than the minimum this year, how much less than the minimum can you pay next year? And if you pay this year’s minimum plus next year’s discounted minimum, plus $1, how much less than the third year’s minimum can you pay? And so on. Each opportunity to prepay can be expressed as a rate of return that is earned by not having to pay a future premium, in the same way that multi-year magazine subscriptions provide a rate of return by prepaying the renewal costs.
There’s more. If the policy has a level death benefit, the prepayment is lost at death. So there are two possible outcomes: you earn a return of x% if you survive until the end of the prepayment period (with a probability of y%) and you lose all of your money (a -100% return) if you die (with a probability of 1-y%).
There’s still more. As you extend the prepayment period, you face greater uncertainty about your future health, your future opportunity cost of money and other relevant factors, such as your need for life insurance.
So it is not a simple matter to come up with an “optimal” premium schedule for policies like this. In fact, the problem may be mathematically intractable for long-term horizons unless you make simplifying assumptions. What you can say with some confidence is that the illustrated premium schedule is probably not optimal, except by accident.
What about paying a single premium for, say, a no-lapse universal life policy? That means that you are prepaying all of the future insurance costs to (usually) age 121. Are there any other significant costs that you would consider prepaying to age 121? Medical costs? Food expenses? Can you defend a single premium by invoking the “peace of mind” of knowing that no more premiums will be needed to keep the policy in force for life?
If you are reviewing a cash value life insurance policy, which tool should you reach for: a “buy term and invest the difference” analysis or a prepayment analysis? That will depend on the situation. Is the cash value policy being used as a place to put savings for retirement? A “buy term and invest the difference” analysis will help guide that decision. And you can complement it with a prepayment analysis to take advantage of whatever premium flexibility the policy provides.
Is the policy being used to provide liquidity at death? The protection and savings view isn’t helpful here. Look at rate of return on death, actuarial net present value (or the “money’s worth ratio”) and prepayment incentives (or, sometimes, disincentives).
For many people, a third view of cash value life insurance is prominent. They get a premium notice and the cash value policy seems like an expense, just like health insurance and the phone bill. This can lead to poor decisions.
If the policy is an expense, it’s natural to want to pay as little as possible for it, and it’s certainly not hard to find sales illustrations that create unrealistic expectations about the cost of cash value life insurance. You may also be attracted to options, such as using whole life dividends to pay premiums, that reduce the expense.
On the other hand, if the policy is an investment, interesting questions arise. Is it a good place to put money? How much money should be invested, and when? How does the policy design affect its performance? How should the policy be managed after issue to improve the return?
To answer the question at the beginning, B or C but not A.