Edward A. Zurndorfer
The month of September has been designated by the Life Insurance and Market Research Association (LIMRA) as “Life Insurance Awareness Month.” Since many federal employees have a need for life insurance, the FEDZONE is presenting a series of columns during September discussing issues associated with understanding and purchasing life insurance. This is the second of these columns and discusses the subject of cash value (permanent) life insurance.
Cash value or permanent life insurance is designed to provide lifelong life insurance protection for individuals who need such protection. As long as the life insurance policyowner (normally the insured, but not always) pays the insurance premiums, the death benefit will be paid to beneficiaries upon the death of the insured. Permanent life insurance policies are designed and usually priced in order for the policyowner to keep the policy over a long period of time (at least 35 to 40 years).
The Federal Employees Group Life Insurance (FEGLI) is not a group-sponsored permanent life insurance plan. It is a group-sponsored term life insurance plan. A federal employee who has a temporary (less than 35 years) need for life insurance coverage – for example, the purpose of the life insurance is income protection for family members or to pay off a large debt such as a mortgage – is advised to be enrolled in either FEGLI or to apply for an individual term life insurance policy offered by a private insurance company.
Permanent life insurance policies come in different types or varieties – most notably whole life, ordinary life, universal life, adjustable life and variable life. These policies have a feature known as cash value, or more precisely, the cash surrender value (the amount of cash to be paid to a policyowner after expenses are deducted). In order for the policy to accumulate an amount of cash value, the policyowner pays a higher insurance premium compared to an equivalent (with respect to the pure death benefit) term life insurance policy.
The cash surrender value found in permanent life insurance policies allows the policyowner several options with respect to what to do with the cash surrender value including:
- the policyowner can cancel or surrender the policy and receive the cash value as a lump-sum payment. However, policyowners need to understand that the lump-sum payment is subject to federal and state income taxes. Also, depending on the insurance product and the insurance company issuing the policy, there may be surrender changes that will reduce the amount of the lump-sum payment.
- if the policyowner needs to stop or can no longer afford to pay the premiums, he or she may be able to use the accumulated cash value to pay for the pure death benefit in the policy for a specified time or to provide a lesser amount of a death benefit covering the insured for a lifetime.
- the policyowner can usually borrow from the insurance company using the cash value as collateral. Unlike loans from most financial institutions, the loan is not dependent on credit checks or other restrictions. The loan must be eventually paid back by the policyowner to the insurance company. If not, then the beneficiaries will receive a reduced death benefit when the policyowner dies.
It is important to note that with these different types of permanent life insurance policies, the cash value of a policy is different from the policy’s face value amount. The face amount is the amount of money that will be paid at the death of the insured or when the policy matures. On the other hand, cash value is the amount available if the policyowner surrenders a policy before its maturity (before it “endows”) or upon the death of the insured. The cash value may also be affected by the insurance company’s overall financial situation or experience, which can be influenced by mortality rates, expenses and investment performance.
The different types of permanent life insurance policies are now discussed.
Whole Life Insurance
Whole life insurance is designed to stay in force throughout the insured’s lifetime. As long as the policyowner fulfills his or her obligations under the policy – namely, pay the insurance premium – the policy remains in force, regardless of any changes in the health of the insured that may occur.
Identical to level term life insurance policies, the premiums paid in whole life insurance policies are designed to be level, not increasing over time even as the insured (usually the policyowner) gets older. A portion of each premium payment is set aside to earn interest. This means that over time, a whole life insurance policy will develop cash value. The accumulated cash value forms a reserve which enables the insurance company to pay a policy’s full death benefit while keeping premiums level. After a certain number of years, and a minimum of premium payments, there may be sufficient cash value in the policy that would allow the policyowner to suspend the premium payment and use the cash value to pay the required premium. But once the cash value is used up, the policyowner needs to pay the required premium. Otherwise, the policy will lapse.
There are a number of variations of whole life insurance, including:
- Ordinary life. An ordinary life policy assumes that premiums will be paid until the insured dies. Premiums are determined by the insurance company based on the assumption that the insured will die by a certain age – typically age 100 – and that premiums will be paid by the policyowner until that age. Of course, if the insured dies before that time, the insurance company will pay at least the death benefit, plus any accumulated cash value. IF the insured lives to age 100, the insurance company will pay the face amount of the death benefit to the policyowner. This means that the policy has “endowed.”
- Limited-payment life. This type of whole life policy assumes that all premium payments are made over a specified limited period, typically ranging from five to 30 years. Premiums for a limited payment whole life policy are generally higher that for an ordinary life policy because the payment period is shorter in order for the policy to endow at any age younger than age 100.
- Adjustable whole life insurance. With adjustable whole life insurance, premiums are recalculated at set time periods – typically every five to 10 years – to reflect current interest rates.
Universal Life Insurance
Universal life insurance contracts differ from traditional whole life insurance policies by specifically separating and identifying the mortality, expenses and cash value parts of a policy. Dividing the policy into these three components allows the insurance company to build a higher degree of flexibility into the contract. The flexibility allows (within certain limits) the policyowner to modify the face amount of the policy or the premium in response to changing needs and circumstances.
A monthly charge for both the mortality and the expenses elements is deducted from a policy’s account balance. The remainder of the premium is allocated to the cash value element, where the funds earn interest. Unlike traditional whole life policies, complete disclosure of these internal changes against the cash value element is made to the policyowner in the form of an annual statement.
Many universal life insurance policies have several different provisions by which the accumulated cash value can be available to a policyowner during his or her life without causing the policy to lapse. There are various surrender options for the cash value if a policy is terminated without the insured dying.
Universal life insurance policies are useful for policyowners who expect their life insurance guidelines, a universal life insurance policy can be modified by changing the death benefit or premium payment.
Universal life insurance may be purchased from several different life insurance companies. IT may also be purchased through a licensed insurance agent or broker.
Variable Life Insurance
Variable life insurance combines the traditional tax-deferred savings functions of life insurance with the growth potential of equities. Like whole life insurance, variable life insurance policies have fixed premiums and a guaranteed minimum death benefit. Unlike whole life insurance policies, variable life insurance permits policyowners to allocate a portion of each premium payment to one or more investment options after a deduction for mortality and expense charges.
The policyowner can allocate and switch his or her investment choices choosing, for example, from among a wide variety of investment options depending on their suitability and objectives. The death benefit and cash value of a variable life insurance policy will increase or decrease based on the performance of the investment options chosen. But the death benefit will not drop below an initial guaranteed amount, unless policy premiums are not paid or if loans or other withdrawals are taken from policy cash value. The ultimate death benefit is subject to the claims-paying ability of the insurer and any guarantees do not apply to the performance of the investment subaccounts.
Since the investment options inside a variable life insurance policy usually involve investment products/securities, the Securities and Exchange Commission (SEC) requires this type of life insurance policy to be accompanied by a Prospectus for the prospective buyer. The Prospectus explains how the insurance policy works, its risks, and all expenses or charges associated with the policy. In addition, the SEC requires individuals selling variable life insurance policies to be licensed to sell securities through the Financial Industry National Regulatory Authority (FINRA) with at least a Series 7 securities license. The individual selling variable life insurance policies must also be licensed as a life/health insurance agent or broker through the state in which he or she intends to sell policies to state residents.
There are also variable universal life (VUL) insurance policies that is offered by several insurance companies. A VUL combines features found in both universal life and variable life insurance policies.
Variable life insurance is only appropriate for individuals with specific life insurance protection needs. Substantial fees, expenses, and tax implications generally make variable life insurance unsuitable as a short-term savings vehicle. You will be required to pay a certain amount of premiums or maintain sufficient cash value to cover your policy’s fees and expenses. Loans or poor investment performance may also lower your cash value. Failure to maintain sufficient cash value may cause your policy to lapse and terminate. Variable life insurance involves investment risks, just like mutual funds do. If the investment options you selected for your policy perform poorly, you could lose money, including your initial investment. The prospectus does not describe the amount of insurance you purchased and the amount of fees you will pay. Therefore, you should also review any additional materials provided to you when you purchase your policy.
The federal tax rules that apply to variable life insurance can be complicated. In addition, there may be state tax implications. Before investing, you may want to consult a tax adviser about the tax consequences of investing in variable life insurance.
Investors should carefully consider the investment objectives, risks, charges and expenses of variable life insurance and the underlying investment accounts before investing. The prospectus and summary prospectus contains this and other information about variable life insurance. The prospectus and summary prospectus is available from your financial advisor and should be read carefully before investing.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. Neither Raymond James, the Financial Advisors, STWS, nor Mr. Zurndorfer are affiliated with, endorsed by, or authorized to speak on behalf of the U.S. Government, the Federal Employee Retirement System, or any other Federal Government-sponsored benefits programs or retirement plans.