Is Your Life Insurance Policy Money Good? Part 2: About Protection of the Cash Value

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

This week we continue our review of the credit quality implications of life insurance policies by considering the safety of the component called “cash value.”

If you have taken out “term” life insurance, your policy by definition will never develop cash value. Term life is a stripped down form of life insurance that provides a defined death benefit on the life of the insured for a defined term. There is no investment or cash value aspect to such policies.

Permanent life insurance, however, can develop cash value, and it is usually intended to do so. Cash value is like a savings account inside the policy. In many cases, both as illustrated at inception and as it works out in practice, the cash value becomes a higher and higher percentage of the death benefit over time.

Within the category of permanent life insurance, there are two types: whole life and universal life. Whole life is the older of the two types. Typically, a whole life policy lays out a set of level payments for the lifetime of the insured (or up to some very high age such as 100). To support such an illustration, a (fairly low) minimum investment return is guaranteed by the insurer, such as 2% per annum. The insurance company in turn manages the investment of the cash value, often putting a large portion into long-term bonds.

Universal life is a more flexible form of permanent life insurance. There is freedom of the insured person to put in greater or lesser amounts of premiums when due (within limits). Universal life may be either non-guaranteed (the insured person takes the risk that mortality or administrative expenses may rise in the future) or guaranteed (meaning that the policy will be kept in force for the stipulated death benefit, so long as the illustrated minimum premiums are paid, regardless of whether there is cash value in the policy).

Finally, there is within universal life a distinction between “fixed” and “variable.” In the fixed form, the insurer guarantees some minimum return on cash value and manages the investments. In variable life, the insured person chooses from a range of investment options—which often track public mutual funds—by sector and type, such as large cap U.S. stocks, real estate, Asian stocks, and so forth. Variable life investors thus select the type of market risk they face from the menu of choices and have opportunities to change their selections. Under federal law, variable life policies are considered “securities” and can only be offered by insurance agents affiliated with an authorized “broker-dealer.”

The rules of insolvency priority are established under each state’s insurance statute. This matter gets complicated because insurers operate in many states simultaneously. Further, some insurance companies are mutually held and others are stock companies. Then too, individuals also often move from the state where they originally took out an insurance policy.

Concerning the credit status of the cash surrender value, a special advantage of variable life policies is that the assets are held in segregated sub-accounts for the benefit of the account holder. To the extent that the market value of assets in these segregated sub-accounts grows over time as a proportion of the promised death benefit, exposure to the insurance company’s general credit risk diminishes. In the current brutal credit environment, some sophisticated policy holders may see this feature of variable life policies as advantageous.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.