Life Insurance – Uses, Expenses, Types

Life Insurance as a Financial Investment Vehicle

Life insurance is a valuable tool for preserving wealth and building wealth, while substantially eliminating market risk. This creates a peace of mind no other investment vehicle can provide. Life insurance is not the only good investment class, but it should at least be considered every time a financial plan is designed or reviewed.

Summary of Benefits

Life insurance, particularly indexed universal life insurance (IUL), offers a wide range of potential benefits presented in detail on the website pages below in this menu column. They are listed here:

  • an immediately available death benefit (in case of untimely death)
  • tax-free growth
  • tax-free lifetime income (via policy loans paid back with death-benefit proceeds)
  • income-tax-free death benefit
  • asset protection
  • perpetual elimination of all taxes when owned in a dynasty trust
  • risk-free growth of policy value via 0% “floor” (no exposure to negative market returns)
  • upside growth tied to (but not invested in) one or more selected market indices
  • living benefit options (e.g., for long-term care, chronic or serious illness)

Obviously, an IUL policy cannot do everything at the same time. It is said that IUL can provide any two of a lifetime income, living benefits, and a death benefit, but not all three. IUL policies can be flexible financial vehicles, however, adaptable to changing personal and financial circumstances of the owner and/or the insured and beneficiaries.

Special Tax Treatment

The investment benefits of life insurance come from the tax advantages that U.S. tax law has conferred. Assets in a life insurance policy grow income-tax free, and the policy death benefits are paid income-tax free. Living benefits (e.g., under a long-term-care rider) are paid tax-free. Further, loans from the insurance carrier to the policy owner based on the cash value of a policy are tax-free.

Combine these benefits with the tax treatment of an irrevocable dynasty trust (no estate or GST taxes) and you and your descendants will never pay taxes again, forever!

Expenses of Life Insurance

A misleadingly false myth about life insurance, perpetuated out of ignorance or greed, is that life insurance is never a good investment because its costs and fees erase its tax advantages. In fact, however, even conservative comparisons show that well-designed IUL outperforms stock investment accounts, qualified retirement plans (e.g., 401(k), 403(b)) and IRAs. 

Fees charged in an indexed universal  life (UIL) insurance policy, for example, generally include (i) the cost of insurance (COI), (ii) premium loading fees, and (iii) expense charges (administrative fees, etc.). The total amount of fees paid by a policy owner over the life of a policy is influenced not only by the selection of a particular policy issued by a particular company, but also how the policy is designed. For example, all other things being equal, a life insurance policy designed with an increasing death benefit has lower total costs than a policy having level death benefit.

Premium-loading fees (essentially, some percentage of premiums paid into the policy) are paid annually as long as premiums are paid into a policy. These fees go away when no more premiums are paid. The bulk of policy expense charges also go away at some point, usually after about 10 years. The cost-of-insurance continues for the life of the policy as long as there is a net amount at risk (NOR), which is the difference between the value of the death benefit (DB) and the cash value (CV) in the policy.

NOR = DB – CV

In a well-designed and well-managed policy, cash value increases over time; therefore, the net amount at risk decreases. Thus, even though the COI per unit NOR generally increases as the age of the insured increases, the actual total COI generally decreases.

As suggested above, expenses in a life insurance policy are “front-loaded”, that is, a greater portion of fees are paid during the initial years of a policy. When a policy is in force over several decades, which is the idea in most cases, the overall total policy expenses of IUL are typically considerably less than total management costs in a managed investment account over the same time period.

One way to view policy expenses is that they are the price of obtaining the tax benefits of life insurance, that is, tax-free growth and distribution. But do not forget that life insurance also provides a death benefit starting in year 1. If the owner of a conventional stock investment account were to die in year 1, the “death benefit” would basically be the starting account value. In sharp contrast, the beneficiary of a life insurance policy would receive the full, substantial death benefit. This is the type of huge leverage that no conventional stock account can match.

What is Life Insurance under the U.S. Tax Code

IRC Section 7702 defines life insurance. If a financial instrument qualifies as life insurance under § 7702, then it is eligible for the tax benefits described above. If not, then it is generally subject to the usual taxation of investment portfolios. The key distinguishing trait of life insurance is the death benefit. The U.S. Congress granted tax benefits to life insurance for public policy reasons, that is, to encourage taxpayers to ensure the financial security of their dependents (and also because the insurance lobby is influential). If a policy includes sufficient death benefit relative to premiums paid and/or cash value, then it is life insurance under § 7702. IRC § 7702 contains two alternative, complex tests under which a policy may qualify as life insurance: the GPT and the CVAT. The guideline premium and corridor test (GPT) basically controls the amount of premiums that can be paid into a policy relative to the death benefit. The cash value accumulation test (CVAT) allows a generally unlimited flow of premiums to be paid into a policy, as long as the death benefit increases to satisfy a minimum death-benefit-to-cash-value ratio. One or the other test must be selected at the time a policy issues, and the test may not be switched later. A GPT policy tends to perform better for a client wanting to build cash value and death benefit over a longer period. Once cash value growth in a GPT policy reaches the so-called “corridor”, the policy performs better because the corridor represents the lowest NOR (see equation above). A CVAT policy tends to perform better for a policy owner looking to access cash value in early years or to pay lump sum premiums. Universal life insurance (UL) policies (described below) are usually GPT policies. Whole life insurance (WL) usually uses the CVAT.

Types of Life Insurance

The most flexible, risk-free and potentially profitable type of life insurance (LI) is indexed universal life insurance (IUL), also referred to as equity-indexed universal life (EIUL). On balance, IUL is the most useful LI for wealth building and income, and this website focuses on IUL. Nevertheless, various other types of LI may be well-suited for particular circumstances in financial plans and are described briefly along with IUL, below.

Term Life. Term life is useful for providing the most death benefit for a given amount of premium paid. For example, the most important concern of an income-earner supporting family members (spouse, children, parents) is their financial security in case of the income-earner’s untimely death. For immediate financial security, term life insurance is the best. On the other hand, over the long term, no cash value accumulates, and annual premiums increase along with the age of the insured.

Guaranteed level term (GLT) insurance is purchased for a given term (e.g., 5, 10, 20 years) and the premium will stay level for the term. It can usually be renewed at the end of the term without underwriting (medical exam), but there is no guarantee what the rates will be.

Annually renewable term (ART) is generally the least expensive way to buy life insurance, but the policy renews every year, meaning it re-prices every year. As the insured ages, the premiums climb.

Return of Premium insurance relieves some of the pain of term insurance, which is the feeling that the monthly or annual premium payments were a total waste, generating no benefit (except peace of mind) unless the insured dies. By paying an additional charge to the basic premium over the term of a level policy, the policy owner receives the full amount of premium paid at the end of the term (i.e., if the insured does not die during the term).

Convertible Term insurance includes an option to convert to a permanent policy without medical examination. When buying term life insurance, it is important to get strong conversion rights, that is, rights to convert the term policy to a permanent policy. In fact, for various reasons, only one in 100 term policies ever pay a death benefit. 

Whole Life (WL). Whole life insurance is relatively simple and straight-forward: generally, for the same amount of premium paid over the life of the policy, cash value grows within the policy and the insurance company pays a certain amount of death benefit upon death of the insured. A policy owner can take tax-free loans against the cash value. There are variations among whole life policies. Some are limited-pay, meaning the policy owner can pay premiums for a limited number of years (e.g., 10 or 20 years), rather than needing to pay premiums over the insured’s entire life. A single-premium policy is paid up in full with a single lump-sum payment. A disadvantage of WL policies compared with IUL is that growth potential is less; the relatively low interest rate for crediting WL policies is generally in the range 3 – 5 percent. Also, the breakdown of expenses and fees is less transparent in WL than in IUL. Further, WL is less flexible regarding the amount and timing of premium payments and optional riders (long-term care, chronic care). Some proponents of WL incorrectly claim that the cost of insurance (COI) in WL does not increase as the insured ages. That is a false claim. COI in WL does increase with age. The confusion (deception?) arises perhaps because premiums are level for the life of the policy; in other words, premiums in the early years of a WL policy are heavily loaded to lower the premium amounts in later years. For a given account cash value, the NOR in WL (under CVAT) is typically higher than the NOR in IUL (under GPT). Therefore, COI in the WL is significantly higher than COI in the IUL. “Blending” should be used in the design of a WL policy. Blending means that term insurance is used to bolster the WL death benefit to bring policy DB up to desired levels (higher DB permits higher cash value). Blending results in significantly lower fees for the policy owner, as well as in reduced commissions to the broker (that’s OK, greed is not good). The term death benefit can be replaced later using accummulated cash value, or simply surrendered.

Universal Life (UL). “Universal life insurance” is a general term given to life insurance created decades ago to overcome some of the limitations of traditional WL. UL offers the potential for interest rates higher than the typical 3 – 5 percent of WL.The expenses charged in UL policies are generally transparent (esp. when requested from the carrier), so the assumptions made in policy illustrations (forecasts) can be more reliably tested. Also, instead of being fixed as in WL, death benefit amount, premium amounts and the timing of premium payments in a UL policy are flexible to some extent.

Indexed Universal Life (IUL). IUL can provide significant (i) tax-free income, (ii) death benefit, and (iii) living benefits (i.e., long-term care, chronic illness and critical care), but not all three out of the same policy.

IUL provides virtually risk-free wealth building: the cash value of IUL is credited with a positive interest rate in a bull market, but never gets a negative interest rate. In a bear market, zero is the hero.

In an IUL policy, the interest rate used to credit the account (add to cash value) may be (but need not be) tied to the return of one or more market indices. The cash value of the policy is never actually invested in the markets; rather, the crediting interest rate is tied to the market through one of more formulas selected by the policy owner. Also, as in virtually all life insurance policies (except variable LI), the crediting rate has a guaranteed “floor”, usually zero percent (0%) or one percent (1%). That means that if the markets go backwards (have negative returns), the cash value in the IUL policy is preserved. Thus, the cash value in IUL has upside potential, but never downside losses. Various formulae may be used to calculate the crediting rate. For example, all or a portion of a policy’s cash value account might be tied to the S&P 500 index, annual point-to-point, with a 100% participation rate and a 12% cap. That means that if the S&P 500 index increased 8% from January 1 (point 1) to December 31 (point 2), then the cash value would be credited with an 8% interest rate. If, however, the point-to-point index return were 15%, the cash value would be credited at only 12% interest rate, not 15%, because of the 12% cap.

Thus, IUL offers good upside growth potential, while eliminating the risk of negative return, thereby protecting principal from year to year. The cost of eliminating risk is the limitation of upside growth potential (e.g., through a cap and/or a participation rate). Risk-free investment growth provides peace of mind and certainty, especially important for older investors who do not necessarily have decades to recover losses or who need to use their assets for daily living expenses.

How do insurance companies provide risk-free indexed growth and a guaranteed floor? An insurance carrier does not invest your cash value in stocks or other risky investment vehicles. Instead, a carrier firstly buys reinsurance to cover the risks of paying your death benefit (COI), then invests most of its investment assets in no-risk bonds, but also buys options to purchase indexed funds. If the index goes up, the carrier exercises its options and cashes in on the profit. If the index goes down, the options expire at a small loss covered by the bond interest.

IUL should always be designed using Option B (increasing death benefit), not Option A (level death benefit). Option B lowers total policy costs over the life of the policy. Option B also lowers broker commissions (which is OK; greed is not good).

Guaranteed Universal Life (GUL). Guaranteed universal policies have the advantage of a guaranteed death benefit as long as premiums are paid as agreed. For a given amount of premium, the death benefit is higher than in a comparable WL policy. These policies are NOT “set and forget”, however. One problem with GUL is that the so-called guarantees can lapse if premiums are paid too late, or even too early! The so-called guarantees are conditional guarantees. Another problem of GUL is that policies sold now, in our current low-interest-rate economy, have a low, fixed, crediting interest rate. If and when interest rates rise, and inflation with them, the policy crediting rate will remain low.

Variable Universal Life (VUL). Variable life insurance can be viewed as an insurance wrapper around an investment portfolio. The investments in segregated policy accounts can grow and be distributed free of income tax and capital gains taxes, as in non-variable policies. Yet, it is risky! Except for a guaranteed minimum death benefit (while the policy is in force), there are no guarantees. The policy’s cash value goes up and down with the investment portfolio. Except for the extra management and expenses required, however, the risks are comparable to a standard investment portfolio, but without taxation! To stay in compliance with the GPT, the cash value and the death benefit must be adjusted to stay in the “corridor”. Several bad years in a row could wreck the policy just as they can wreck an investment portfolio exposed to the markets. As in other UL policies under GPT, an insurance adviser can control policy expenses by reducing the death benefit and, thereby, COI. On the other hand, if the policy has some good returns following a reduction in death benefit, the policy might force out cash (taxed at ordinary income) to get death benefit and cash value back into the corridor. For relatively affluent clients, “private placement life insurance” (PPLI), a negotiated, customized VUL policy with lower costs, is worth considering. VUL is classified a a security, as well as an insurance product, so it cannot be purchased directly through Shoreview LLC.