Navigating Life Insurance Terminology – Episode 028

This transcript was auto-generated and may contain errors.

[00:01] Welcome to the Prosperity Podcast, fresh alternative personal finance talk for independent thinkers who prosper outside of Wall Street. Here’s your host, bestselling author Kim D.H. Butler and No BS Money Guy, Todd Strobel. Hey everybody, welcome to another edition of the Prosperity Podcast. This is No BS Money Guy, Todd Strobel. Once again, I’ve got my co-host and bestselling financial author Kim Butler with us. Welcome, Kim. Thank you, Todd. Glad to be here this morning. And today we are fortunate enough to have another listener send us a question or a show suggestion and we are going to reply to that. Thank you so much for taking the time to ask your question because I’m sure every question that gets asked, there’s a lot more people out there who are thinking the

[00:47] same thing and don’t take the time to call or write in. So we do appreciate that. We’re going to be talking about life insurance terminology and stick in there. We go really fast and we hit really hard so we won’t put anybody to sleep. But a lot of times life insurance agents and even the life insurance industry uses a lot of terms that they assume you as the consumer know. And in most cases, well, you don’t and you probably don’t need to remember them, but you need to understand them. In some cases, a little bit of education can actually have you know more than the agent that you’re dealing with. And if that’s the case, you probably need to find another agent. Kim, why don’t you kind of start down the road on what the resources are and where

[01:34] they might find some information? I think you might even wrote a book on it. Well, you know, that was one of the main reasons for writing the book. So this, of course, is our little tiny live your life insurance book. We call it a book. It’s really more of a booklet. I think the PDF is 46 pages. The hard copy is more like 35. But when I first wrote that, I included a glossary. And the reason that I did that is because there are terms that are very critical to understanding how whole life insurance works. Now, this is the kind of stuff that people talk about around infinite banking or bank on yourself or a variety of other names that you hear. And yet we don’t know about it. And so it’s funny, you know, people will spend hours memorizing terms about

[02:20] the stock market, but they won’t spend hours memorizing terms about a product that’s been around for a couple hundred years and can be a very effective foundation for people’s lives and their financial lives in particular. So I wrote in the book a glossary. And since not everybody likes to read, some people like to listen. We’re going to talk through that. And I love what you said at the beginning. We’ll go fast. We won’t necessarily cover every one of them because you can refer back to the book. But there are some really important terms that have weird words that the insurance industry comes up with that we need to understand and talk through. And so I’ll let you lead us off with what you think the first one should

[02:57] be. Super. Well, I’m going to work right through these again. We’re in the book, live your life insurance. We’ll have a link on here for you that you can purchase this book on Amazon would definitely recommend that you do that. Very quick read. A lot of great information. The first one under letter A would be premium. Yeah, that’s a great one. So when we think of premium, we immediately think of cost. And there’s obviously car insurance and other things that have the word premium associated with them. And yet premium in the whole life insurance world is actually better defined as a deposit or a contribution. Now, we can’t technically use that word because deposit implies maybe a bank account. And though whole life is talked about around the idea of banking,

[03:41] it is clearly not a bank. Life insurance companies are not banks, thankfully, because life insurance companies have 100 percent reserves instead of the seven to ten cents on the dollar that banks do. But premium is just contribution. It’s money going in and it builds both cash value and additional dividends. Again, a lot of people think premium is all cost and that premium just pays for death benefit. But that’s not correct. Premium builds cash value. Got it. So premium is the money that you send to your life insurance company, a portion of which goes to purchase the death benefit, which will pay the beneficiary upon the death of the insured and also builds the cash value inside the policy. And if you have different riders may do some other things.

[04:34] And we’re going to get to those here in just a minute. And premium can be paid in a lot of different ways, can it? Absolutely. Monthly, annually, quarterly is not the most effective, but it is available. And then there are also times that you actually use the cash value that’s in your policy to pay the premium using what’s called an automatic premium loan. And it literally ends up recycling the money. It’s not something that you want to do forever, but it sure can be done if you’re having financial stress in your life for a particular period of time. Super. Well, the second one, which we kind of introduced already, is cash value. So that is your savings account. It’s your liquid money. We use this clue acronym to help us remember what cash value can do for us.

[05:21] And the C for clue is that you completely control it. The L is liquidity. And that means that you can get it in seven days. The U, C-L-U for clue is use it. You can use it for whatever you want. And the E is equity, meaning that it acts like equity. It performs the way equity does. So think about equity in real estate, where you can borrow against it, but at the same time, it keeps working for you. So if you have a home equity loan, you have that money out doing some other job, but at the same time, it’s supporting your house. Well, cash value loans are the same way. If you borrow against your cash value at a life insurance company, you have your full cash value earning dividends unaffected by the loan.

[06:07] And then the loan is in your hands doing whatever it is that you needed it to do. Super. And if there’s one thing that I think that people underestimate so many times is the value of that cash value. We tend to think of life insurance as a cost and that it’s buying a death benefit, but that cash value can be very significant. And it’s got a lot of attributes, I would call them, that a lot of times we don’t really think about. The fact that in most states, it’s lawsuit proof. The fact that it’s often divorce proof. The fact that it’s earning a rate of return. We’re in 2015. In a whole life policy, what would you say the average rate of return is? We’re in the three to five percent range right now, 2015.

[06:56] That’s net, net, net. After all the costs, the commission costs, the cost to run the company and the cost of the death benefit, cash value is going to be earning a net of three to five. You could even say three to four and a half to be safe. It is a little bit dependent on age, not a lot, not as much as people think, but somebody in their 70s is going to have that three percent return. Somebody in their 20s, 30s, 40s, 50s even is going to have up in the four percent range. Correct. And what about taxes on that? No tax, because life insurance is not a taxable account because it is a insurance product. It is. And you know, when you look at the definition of insurance, the goal, I’m searching for the term that I’m looking for.

[07:44] The goal is to replace something. When you have insurance, it replaces whatever was of value. So with life insurance, it replaces a person’s value. That’s called human life value with car insurance or home insurance, of course, replaces our car. So if we destroy our car, if our home burns down, we’re not taxed on that money that comes back to us because it was just a trade for value. So the life insurance and the whole life in particular and the cash value inside it is not taxed, not because of some special loophole, as a lot of people think, but simply because it is a trade or a replacement for value. Super. So take this information to your local bank and ask them if you were to put in a couple thousand dollars,

[08:33] how you would have to set that up to get, say, three and a half percent tax free and then watch the smoke spin. All right. Let’s move on to the next one, which would be letter C dividends. Letter D, I think you mean for dividends. Well, it’s not we’re not going by, like I said, it’s A, B, C, D, not necessarily the first word doesn’t necessarily line up. But I’m glad you made that clear. That’s something I didn’t even know. See, you learn something every day, even about your own book. All right. So dividends are a term also that has to be further defined differently in the life insurance industry than it does in, say, stocks. So when an insurance company pays a dividend, it is to you, the policyholder, in most cases, whole life insurance

[09:27] is done by mutual companies, which are not owned by separate stockholders, but are simply owned by the policyholders that exist. So when an insurance company pays a dividend, they then put that dividend into the guaranteed cash value column. And it can never strong word, never go down again. So literally a new floor is set with the dividend every single year. Now, typically what most people do with their dividends is they reinvest them. And in the insurance world, that is called a paid up addition. And that’s a weird term. But the insurance industry uses a reinvested dividend to have lots of different choices. But one of the choices is a paid up addition. And it literally means exactly what it says.

[10:17] It’s a paid up, meaning you don’t add any more cost or premium or cash value to it. It’s additional insurance. So the additional insurance actually also creates dividend, thereby giving you a very compounding effect for the money. Now, we were just talking about the net interest rate that cash value earns. That is from a combination of the guaranteed cash value increase and the dividend. So we talk about a dividend with an insurance company as an interest rate, but it is technically not an interest rate. It’s a dollar figure. And if you look up on the web, OK, how much to guardian or Mass Mutual or Northwestern Mutual or New York or Ohio or whoever pay as a dividend this year, you’re not going to see an interest rate.

[11:05] You’re going to see a dollar figure, 125 billion or million or, you know, depending on the size of the company, what it is. So it’s dollars. They get added to your cash value. They are not taxed. And they actually also buy more death benefit. And then that cash value earns more dividends in the future. So it’s a evolving, compounding environment that goes on without tax. So the two points I think we should make with this is number one, because of that compounding effect, the compounding effect means that the policy will grow faster the longer that it’s in place, correct? Yes, that is correct. And number two, dividends are not guaranteed. But in most of the cases of these companies you mentioned,

[12:00] they do have a hundred plus year history of paying dividends. Is that also correct? Yes, absolutely. And so that’s an important distinction because the dividends are not guaranteed to be paid. Once they get paid, they become guaranteed. They become a part of the guaranteed cash value, never to go down again. And obviously, if we had, for example, a Coca-Cola dividend that got reinvested, but then the value of the stock of Coca-Cola went down, then in essence, we would lose our dividend. And that’s impossible to happen inside the whole life policy. Got it. Let’s move on to the next one, which would be gross cash value. We’ve probably kind of hit it, but a little summary would probably help. Yep. So let’s use an example.

[12:46] If we have a gross cash value of one hundred thousand dollars and we borrow sixty thousand against that, the dividend is going to be paid on the hundred thousand, not the forty thousand, which you would call the net cash value. Now, I do want to point out that on life insurance illustrations, the column usually reads net cash value. But once you own it, you can start to see that difference between gross cash value and net cash value. And you get your dividends on your gross cash value unaffected by the loans. Super. All right. Let’s go on to the next one, which would be automatic paid up additions. Sure. So the automatic paid up additions are what dividends by. And then we could define the opposite of that as a manual paid up addition,

[13:36] which is what you would put in yourself. So a lot of people that have some knowledge around the infinite banking or from the Palm Beach letter or from the Bank on Yourself book, they’ll read about paid up additions. And you have automated ones that are happening on their own. That’s just what the dividend is buying. You don’t need to do anything other than check the box that you want your dividends to buy paid up additions. But then as you remember, you have the ability to add more paid up additions on top of that. It’s actually called a paid up addition writer. And that’s what we refer to as a manual paid up addition. You’re putting that in. You’re choosing to add to your policy. And that’s extra dollars that are going straight into the cash value,

[14:17] still earning the dividends and increasing the death benefit. Got it. So and we’re not going to say that word today, but that’s my promise to this is we’re listeners. I’m trying to get rid of that word. So automatic paid up additions versus manual paid up addition. So paid up additions is a tool you will run into a lot. Again, if you are working with an agent who is helping you to build cash value as rapidly as possible. This is probably the number one tool they use to do that. I would agree. And yet again, we need to remember that premium builds cash value also. Got it. Paid up additions. See here, I’ve got a couple of questions that just came in. So the manual paid up additions versus the automatic paid up additions.

[15:05] I think maybe an example here would be appropriate to show how the average person might use that. Sure. So let’s say you have a thousand dollar premium per year. So pretty low, but just a little policy that you bought. And let’s say that you are going to reinvest your dividend. So this would be the automatic paid up additions, dividend reinvestment that we’ve been talking about. And let’s say your dividends 20 bucks. So, OK, twenty dollars goes in that year. And that is going to buy more cash value and more death benefit. That’s the automatic paid up addition. Well, you could then add another. Let’s call it nine hundred dollars. It might be a thousand. It might be eleven hundred, but it’s approximately equal the premium.

[15:50] You could add another nine hundred dollars of manual paid up additions. So your premium would be a thousand. Your manual paid up addition to be nine hundred for a total contribution of nineteen hundred dollars. And that nine hundred dollars would go straight into cash value. But around five percent of it would increase the death benefit. And a lot of clients will say, well, I don’t want my death benefit to increase. Well, there’s nothing we can do about it. That death benefit must increase in order to accept the additional cash value and also not be taxed. So that death benefits got to rise every single year. And frankly, we really do want it to, even though some people think they don’t, because it needs to rise in order to beat inflation.

[16:33] Super our waiver of premium, another another rider and another good topic. Absolutely. So this is an additional rider that you would pay for. And it, as it indicates, waves the premium in the event of disability. Now, again, remember, premium in this case builds cash value also. So basically what happens if you have the waiver of premium rider and you become disabled, the insurance company is going to pay that premium for you, not only the cost of insurance, but also the additional contribution to cash value. So as long as the disability meets the definition and is continually occurring, they will pay that premium until you’re age 65 if you’re disabled that long. So waiver of premium rider is an inexpensive rider, relatively speaking,

[17:23] to have, and it essentially guarantees that your policy will stay in force and continue to grow. It’s not disability insurance. Disability insurance is designed to put food on the table if you can’t work. But this is designed to keep your savings going if you can’t work, because typically if you’re not working, you’re not going to be able to keep saving. And yet you need to save money for financial independence down the road and other things. So the waiver of premium rider does that for you. Got it. And back to our example. We had an example that had a base premium, an automatic paid up addition and a manual paid up addition. You’re stating that the waiver of premium would cover all three of those pieces.

[18:04] That’s a good question. So typically, no, typically the waiver premium only covers the base premium. But you can actually get an extra waiver of premium on the manual paid up addition. The automatic paid up addition is going to happen no matter what’s going on. So that, I guess you could say, is, quote, covered. But that manual paid up addition, we don’t typically do this. But if somebody wanted it, they sure could. And that would essentially be a waiver of premium on the manual paid up addition rider. Super death benefit or face amount. Yes. So this is the dollar figure that gets paid when somebody dies. And remember, the insured is not always the owner. So typically, if you own insurance, you’re the insured.

[18:50] And the death benefit is what your beneficiary gets when you die. But we do have a lot of clients where the owner might be a 70 year old person and the insured is, say, a 45 year old person. And so the death benefit would pay when the 45 year old person died in that case, which, of course, we hope is many, many years later. It’s also called face amount. And it is income tax free. It should be noted that it’s not a state tax free. E.S.T.A.T.E. So not state as in the state you live in, but a state tax free. It is not a state tax free. But there are some strategies that can be used to mitigate that problem for many, many people, especially under 2015 law, where five million dollars can be passed without any estate tax.

[19:36] It’s not a large issue. But death benefit income tax free. Kim, before we go any further, I just is there some resources or something you brought for our listeners today? We sure did. We have an e-book available called Financial Planning Has Failed. So if you would like to go to partners number four prosperity dot com slash e-book, you’ll get an immediate download of that. And it’s about 60 pages of some life insurance information and some other interesting things about why we think financial planning has failed. I really appreciate how much time you put into creating resources for our listeners and encourage your listeners to take advantage of all of those resources, because they are just great

[20:20] educational materials that really prepare you to take care of your own finances. Again, that’s something that Partners for Prosperity just goes as far as any company I’ve ever seen. Just making sure that you know how to handle these things yourself. So increasing death benefit is our next term. Sure. So that’s the fact that the death benefit goes up automatically every single year with whole life insurance. And that’s a hugely misunderstood area. I see it all the time where people talk about their death benefit stays level and it’s incorrect. So with whole life, it increases every single year. And that’s even if you’re not adding any manual pay to petitions. Of course, if you are adding manual pay to petitions, extra dollars yourself,

[21:03] it’s going to go up even faster. And again, that increase is important because we needed to do that in order to beat inflation and keep our cash value protected from taxes. How about interest? Interest is a funny one, because technically there isn’t any in the life insurance policy. We talk about dividends as an interest rate, but they are an actual dollar figure. Now, of course, loans have an interest cost. And many people also are under the incorrect assumption that when they borrow against their cash value, they are paying themselves that interest. And they may be only if they’re paying extra interest. So let’s use an example. If you have an insurance company that, say, has a six percent fixed loan rate or might be a variable loan rate, depends on the company

[21:56] and you choose for whatever reason to pay your loans back at 10 percent. Well, the six percent interest cost is going to go to the company. The four percent differential can go into your cash value. However, all along the way, your cash value is earning dividends unaffected by the loan. And that’s where people get confused and they think that their interest is going back to themselves. That’s not true. The interest goes to the insurance company. The dividend goes to the policyholder, the owner. And again, unaffected by the loan. So if you have one hundred thousand dollars cash value, sixty thousand dollars loan, you’re going to get your dividend paid on one hundred thousand, not forty thousand.

[22:38] So your net cost of funds, to summarize, would be the interest that you pay less the dividend you receive. Yeah, it’s interesting. That’s brought up a lot. And technically, it’s an accurate statement. But it does sometimes, I think, mislead people’s thinking, because typically, again, in my example, we have one hundred thousand dollars of cash value in a sixty thousand dollar loan. So we don’t really want to net those out. They’re two totally separate transactions. The hundred thousand is earning the dividend at, let’s say, four percent. And the sixty thousand has the loan cost at six or eight or whatever your insurance company is charging you. And so we want to be careful when netting, because now we’re lumping

[23:25] together a one hundred thousand dollar account with a sixty thousand dollar account and trying to look at the interest in the same light. I think it’s actually better to separate them and to say, my hundreds earning four and my sixty is costing me six or eight or whatever the number is. OK, now we’re going to talk about the different positions inside the life insurance policy. And we’ve talked about this, but the owner. Owner is the person that pays the premium, typically contributes to pay the petitions and controls the deal. The owner, frankly, is the most important person and the first person in the transaction. And the next would be insured. Insured is who the actual insurance is on. The physical body that is being used.

[24:06] I’ll talk to adult parents, sometimes adult parents. I guess all parents are adults, hopefully. I’ll talk to elderly parents, 70, 80 year old individuals that want to ensure their adult children, say a 40 or a 50 year old. The owner is the 70 year old. The insured is the 40 or 50 year old. And then, of course, the beneficiary. That’s who gets the death benefit when the insured dies. So again, in that example, it would be when the 40 or 50 year old died. So typically, the owner is the beneficiary. If the insured is a different person and if the owner and the insured are the same, then a spouse, a trust or potentially an adult child is the beneficiary. And it is important to point out that the owner controls this.

[24:57] So the beneficiary may be changed from time to time at the discretion of the owner. Really, the insured is only involved in the initial transaction, aren’t they? Yes, that is correct. Talk to a client through it. Yesterday, we have a 70 year old that’s going to own insurance on a 40 year old that has a 20 year old child. So it’s fine for the 20 year old to be the beneficiary, but it’s going to be more common for the 70 year old to be the beneficiary until that 70 year old passes on. Now, I do want to make a note. Typically, you don’t want to leave a child under 18 as the beneficiary because then you’re going to get the state involved because they’re not old enough to own money and have a contract, et cetera.

[25:45] So that is a great example of a place where a trust is going to be a better environment. All right. Automatic premium loan. That’s where you use your cash value to pay your premiums. We addressed it briefly earlier. So this is an automatic thing that can happen. You use the cash while you pay the premium. The premium raises the cash value and then you also have a loan. And it’s a great strategy to use if your family’s having financial challenges to keep your premiums going and your cash value growing. And then you pay back the loan when you get past your financial challenges. I think the most important thing that is kind of in my mind right now is that there’s a lot of flexibility in a whole life policy

[26:29] because I have potentially set up manual paid up additions that I can pay up to that amount or maybe not the full amount if I if I don’t have the funds to do so. And then with the automatic premium loans or premium loans in general, I can also use my cash value to help meet the future premiums, which means it doesn’t feel like such a large commitment up front. Absolutely. And very helpful backup plan to make sure that your foundation keeps right on growing. How about reduced paid up? So that’s a strategy that you can use if the overall financial environment has crumbled in a way that you do not see a way out of. So, again, the terminology is exactly what it says. It is reducing and paying up,

[27:19] meaning making no more premiums required. A policy. So let’s say we have a million dollar policy. We’ve been in it for five years and we’re quite elderly in our life. And we just decide, you know what, I’m I’m no longer employed. I absolutely cannot contribute to this in any way. I don’t anticipate this changing. And so I want to take my million dollar policy and let’s say there’s a couple of hundred thousand a cash value. I’ll reduce that policy to say four hundred thousand a death benefit. I’ll still have my two hundred thousand dollars of cash value and my policy will be paid up. It will no longer require or accept additional contributions. And so that’s the challenge is you do this when the the hatchet has dropped.

[28:08] In other words, there’s no potential change in the future for additional desires of contributing because reduced paid up is a fixed and cannot be changed environment. And yet it’s a very, very handy tool to use to save a policy so that we lose so that we don’t lose the cash value. We reduce the death benefit and we don’t have to pay any more to it. If the situation is such that we want to be able to change that back in the future, then we go back to that automatic premium loan as a way to help us through that financial challenge. And sadly, so many times when people hit these financial challenges, they will let a policy lapse versus using this option. And that’s rather sad. Yes, absolutely. And please, please reach out to us if you own whole life

[28:57] and you’re having financial challenges and you are not getting help from your agent or you’re with us as a client. We want to help save those policies. It is so important to keep life insurance on the books. And once you’ve bought it, it’s called whole life for a reason. It’s designed to be there for your whole life. So there are a lot of different ways that we can strategize around getting you out of premium payments temporarily. And we love to help with that. Opportunity cost. Ah, yes, that is what happens when you pay something like a premium, as an example, and you don’t ever get anything back for it. So thankfully, it really plays a very minimal role in life insurance, because as we know, you’re going to get your cash value back.

[29:43] You’re going to get your death benefit back. And yet we want people to be aware of opportunity cost. It’s one of the principles of prosperity, measuring opportunity cost. And it’s something that we need to be conscious of when we’re making financial and economic decisions. And for example, something like car insurance has opportunity costs associated with it. You pay and pay and pay and pay. And frankly, you hope you never have a claim. But the fact is that there’s an opportunity cost because those dollars could have been invested elsewhere. Now, obviously, with car insurance, you have to have car insurance to drive a car. So that’s part of what we accept. But we want to do whatever we can to reduce our car insurance premiums.

[30:23] Whereas our whole life insurance premiums, we typically want to enlarge because we are going to get those back in the form of cash value and or death benefit. Well, I was just going to say opportunity cost is an important economic function that actually affects every single financial decision that we make. If you’re just tuning in, I want to one more time, give the listeners where they can get that free offer you had for them. Absolutely. Partners, number four prosperity dot com slash e-book is a book called Financial Planning Has Failed. And you’re welcome to it. Partners for Prosperity dot com slash e-book. And we have presented a ton of probably pretty detailed information. I encourage anybody to reach out to Partners for Prosperity

[31:08] if you’d like to have a more in-depth discussion. Kim, anything you’d like to say to kind of wrap up? Well, always learning is good. And so thanks for taking the time to listen to this. Thanks to our listener that asked the question. I’m not understanding some of these terms. Can you help me with them? And so we’re happy to do that today and trust that it will be beneficial to all. Super. Well, this is No BS Money Guy Todd Strobel for the Prosperity Podcast once again, thanking Kim Butler. Take care, everybody. Thank you for listening to the Prosperity Podcast. To take control of your money and have it work for you, visit us at Partners for Prosperity dot com. If you liked this episode, make sure you subscribe and leave a review.