LISTEN: Ignorant Certainty (11:59min)

The French essayist Michel de Montaigne (1533-1592) sagely observed: “Nothing is so firmly believed as what is least known.” Although Montaigne’s comments are more than four centuries old, they still apply today – especially when the topic is cash value life insurance.

In the United States, the first forms of cash value life insurance appeared around the time of the American Civil War. Given its long history, it would seem that cash value life insurance would be a well-understood financial product with a clearly-established position in personal financial programs. Yet a quick online search reveals many financial commentators have a strong distrust and outright animosity toward cash value life insurance. Why? Some of the problem is simply financial ignorance, and the tendency to denigrate what is not easily understood.

Cash value life insurance is a complex financial product. But like many complex instruments, cash value life insurance is the integration of several simple financial concepts. The function and logic of cash value life insurance can be reduced to three fairly straightforward financial concepts.

Concept #1. It makes sense that the cost of life insurance increases with age. A basic concept of insurance is spreading the risk of individual financial loss across a large number of people. The cost of insurance is based on the probability of a loss occurring; greater probability equals higher premiums.

Other factors being equal, the likelihood of dying increases with age. Thus, the cost of securing life insurance on an annual basis increases with age. The result of this age-based pricing structure is a hockey stick shaped graph – see the example below (Figure 1) — with low rates of increase through age 50, then climbing dramatically as one approaches life expectancy.

Concept #2. It makes sense to pay for life insurance with level premiums over specified periods. The reality of increasingly costly premiums as one gets closer to dying creates a financial dilemma: Each year, it becomes more costly to protect against an event that is more likely to occur. One way to resolve this issue is to simply drop the coverage. The other is to establish a level premium structure. In this arrangement, premiums are fixed for a specified term, typically for 10, 15 or 20 years. During the early portion of the term, the annual premium is greater than the actual cost of insurance. The insurance company collects this surplus and invests it. Later in the term, the annual premium is less than the actual cost, but the surplus collected from the early years (plus the investment earnings) makes up the difference (see Fig. 2).

For those who want life insurance for term periods ending before the hockey stick of insurance costs starts to bend sharply upward, level term premiums may be a satisfactory financial strategy. However, at older ages many individuals find that the up-front overpayment required for level premiums is just too expensive. Yet unlike other forms of insurance, the probability of loss of life is 100 percent – eventually, everyone dies. Understanding this reality, many people recognize the potential value of keeping life insurance in force for one’s entire life; doing so not only results in a return (to your beneficiary) from premiums paid, but also provides for a greater degree of financial certainty at the end of life. The challenge is how to overcome the financial hurdle of keeping the life insurance in force through old age.

Concept #3. For longer term periods, it makes sense to give policyholders access to their excess premium deposits in the form of cash values. A level premium required to maintain life insurance for one’s entire lifetime is substantially higher than shorter term plans, because the surplus premiums accumulated in the early years of the policy must be substantial to cover the steep costs of insurance later in life (see Fig. 3). For example, a level premium life insurance policy calculated to remain in force until age 100 for a 35-year-old represents a 65-year term period, which is much longer than a 10-, 15- or 20-year term plan.

For many policyholders, placing this much excess premium with an insurance company represents a significant “opportunity cost” to their personal finances, e.g. “What could that money be worth to me if I didn’t use it to build a surplus account for the insurance company to pay the cost of life insurance in my old age?”

Recognizing this issue, life insurers give policyholders co-ownership of these excess premiums – and the earnings from the investment of them – in the form of cash values. Subject to the terms of the policy, these cash values can be accessed by the policyholder in a variety of ways while still maintaining a life insurance benefit.

In policies issued by well-managed insurance companies, it is quite likely that cash value balances will, over time, exceed the premiums that have been paid. Dividends, i.e., the non-guaranteed earnings on the excess premiums, can be received by the policyholder, used to pay future premiums, allowed to accumulate and compound, or applied to the purchase of additional paid-up insurance.

This arrangement is reasonable and equitable for both the policyholder and the insurance company. The cash value feature gives the policyholder a rationale for placing the excess premiums with the insurance company. Larger premiums give the insurance company greater investment capital, longer time periods and greater flexibility to meet the obligation of future claims. At the same time, competition among insurers provides incentives for companies to maximize their cash value accumulations and account features for the benefit of the policyholder.

Even from this brief overview, it should be apparent that combining the three variables of age-based insurance costs, level premiums, and cash value accounts makes for a complex financial product. Some of the distaste for cash value life insurance is probably due to the product’s complexity. Financial literacy in the United States is often sorely lacking. A popular on-line financial advice website dismisses cash value life insurance this way: “In general, this is a very complicated topic and well beyond the scope of what we can easily cover here.” So, if the concepts are over your head, forget it? (Just because most people don’t initially understand how to operate an automobile doesn’t mean they should settle for riding a bike the rest of their lives. That’s why we have driver’s education classes.)

Another reason some financial experts are antagonistic toward cash value life insurance is their belief in the probabilities of not needing life insurance as opposed to the possibilities of really needing it. This is very similar to the mindset of those people who ignore the fat tail consequences of once-in-a-lifetime events (as discussed in the previous article). Using this type of thinking…

You probably think you don’t need life insurance – yet. (After all, you’re still alive.)

You probably think you won’t need or want life insurance in your old age because…

You probably think you will have saved enough for retirement, and…

You probably think you won’t have an estate tax issue, but…

You probably think you will have other assets to leave as an inheritance.

Of course, it is likely that one or more of those probable outcomes won’t come to pass. And then the probability of really wanting life insurance could be much greater.

In contrast, the structure of a cash value life insurance policy makes it possible for individuals to keep life insurance in force for as long they live, using a level premium format. Before the end of life, the excess premiums and their earnings are available to the policyholder in the form of cash values. This results in the following benefits:

The certainty that the annual cost of insurance is level and fixed, and not subject to change in the future.

The certainty that premiums paid will eventually deliver a benefit.

The certainty that excess premiums deposited with the insurance company (as well as the dividends that may result) can be accessed by the policy owner.

The certainty that these features are specifically enumerated and contractually guaranteed.

Cash value life insurance is a complex financial product designed to provide financial certainty to effectively address the worst that could happen, yet provide options for a range of other events as well. Even if hindsight might indicate that other strategies may have been more profitable – in the past – , cash value life insurance continues to have financial relevance because its format recognizes the importance of responding to future unknowns.

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