Updated: Oct 15, 2020
First, I’m going to start with a rant and then show some understanding. The training in the life insurance profession is severely lacking, and I don’t just mean selling skills to help agents be successful.
In my first agency, we had product training every Monday morning from 9am to 11am. However, this was not GOOD product training. We learned WHAT we could do with the company’s products, but not WHY someone would want to do it. Why would someone WANT to spend $10,000 a year for a $500,000 policy, when they could cover the need for $500 a year? I didn’t understand. And I also knew that if *I* didn’t understand, then I couldn’t communicate that reasoning for the client’s best interests to help them see why they would want to do the same. I probably also had plenty of baggage of old myths in my own head at the time as well.
Life insurance contracts are legal contracts and are not 'casual' products. (They may be sold 'casually'... but casualness breeds casualties.) And because they are legal contracts, they have various legal terminology within them – deceptively so. Life insurance contracts are also economic contracts, so there are moving parts to how the money within these contracts work.
Until one decides to truly become an expert in these contracts, they will not understand how LAZY the terminology of most agents really is and they will not understand the economics within these contracts. I’ll also show how these myths came about and perhaps why insurance companies aren’t in a hurry to fix or correct these myths.
Myth #1: “When you die, the life insurance company keeps the cash value and only pays out the face amount.”
There are so many things factually incorrect with that statement, it’s almost impossible to know where to begin. Yet, this myth is perpetuated by most agents that promote “buy term and invest the difference” because “the life insurance company ‘keeps the cash values’ when you die”. It is a lie due to lazy understanding and improper terminology use… and I’ll demonstrate it conclusively.
Let’s start with terminology, and then we’ll move into the economics within the contract.
The term “face amount” is incorrect. The only time “face amount” as a term is used is in two possible places: The insurance company illustration software and perhaps in the illustration itself.
“Face amount” is the amount that begins the calculations in the insurance illustration and is what every calculation is based on for its projections.
If I want to illustrate a policy for $250,000… then that’s what I put into the software.
If I want to illustrate how much life insurance I could buy for $10,000 a year, it will generate an initial face amount. Again, it’s how the software begins its calculations.
Now, smart companies don’t use the term “face amount” in their actual printed illustrations. Here is a screen clip showing the first page of a whole life illustration and it says, “Initial base death benefit” not “face amount”.
It says the same thing at the top of the illustration as well:
Now, in the columns of all the numbers in the illustration, the one on the FAR RIGHT doesn’t say “initial death benefit”. It says TOTAL death benefit:
You’ll notice in this small sample, that the total death benefit grows every year. You’d be upset for paying in all that money and didn’t have an appreciating asset for it.
Initial Death Benefit or "Face Amount" is NOT the same thing as "Total Death Benefit".
Now that we’ve clarified that aspect, let’s clarify the economics of that question: Does the life insurance company “keep the cash value”?
And the answer is no, it does not. But it’s EASY to believe why you can believe that, and I’ll explain why that is.
Here is the formula for Net Death Benefits:
Net Death Benefits = Cash Values + Net Amount at Risk – Any Outstanding Loans
That is a simple formula for how life insurance contracts work. The key part is understanding this is: What is “Net Amount at Risk”?
Here is the definition of what “Net Amount at Risk” is from Investopedia:
Net Amount at Risk
What is 'Net Amount at Risk'?
Net amount at risk is the monetary difference between the death benefit paid by a permanent life insurance policy and the accrued cash value. For example, if a policy's death benefit is $200,000 and its accrued cash value is $75,000, then the amount at risk equals $125,000. The amount at risk determines the cost of protection provided by the policy.
Here’s a lengthier explanation in my “Fundamentals of Insurance” Textbook from The American College:
net amount at risk Under a cash value contract, the accumulated reserve becomes part of the face amount payable at the insured’s death. From the standpoint of the insurance company, the eﬀective amount of insurance is the diﬀerence between the face amount of the policy and the reserve. This amount is called the net amount at risk. As the reserve increases, the net amount at risk decreases if the face amount remains constant.
A cash value life insurance policy does not provide pure insurance but a combination of protection and cash values, the sum of which is always equal to the face amount of the policy. This is illustrated in the figure below for a level-premium whole life policy of $1,000 issued at age 25. Because of the accumulated reserve, a $1,000 permanent life insurance policy does not provide $1,000 of pure insurance, and the company is not “at risk” for the face amount of the policy. The amount of actual insurance is always the face amount, minus the policyowner’s total excess net premium payments, plus interest.
From the insurance company’s perspective, the accumulation is the reserve, and from the policyowner’s perspective, it is the cash value, which is slightly less than the reserve in the early years.
Because the policyowner can withdraw the excess net premium payments in the form of the cash value at virtually any time, these excess net premium payments can be regarded as a savings or accumulation account.
Here’s what it looks like as a graph:
Now, let’s look at this at any age: Let’s use age 55.
At age 55, there’s roughly $200 of cash values for $1,000 of protection. That’s where that yellow dot is.
So, how does the insurance company pay out $1,000 of protection?
They pay the cash values ($200) + the net amount at risk ($800) to equal $1,000.
Note: I remember these kinds of graphs back when I was initially getting licensed! That means EVERY licensed agent is (should be) legally held liable for knowing these concepts… and they AREN'T!
There are different ways to structure the 'net amount at risk':
Set amount at risk: (so that every time you are contributing cash, it's the total of the cash + set amount at risk); commonly referred to as "increasing" death benefit on UL policies. This also has increasing costs because the amount of insurance is 'set' and goes up as you age each year.
Decreasing net amount at risk: This has a level death benefit and the net amount at risk decreases as each premium payment is made to "fill the box".
Now, why isn’t this knowledge so widely available? Because it’s MISSING from the table of numbers on EVERY life insurance illustration!
Here’s the same policy values table as before. Do you see a column for “net amount at risk” for the remaining amount of ‘pure protection’? I don’t.
I see premiums paid per year, dividends, available cash values, reduced paid-up insurance (that’s a rider to dump in more cash to enhance the policy), and I see total death benefit (which is not the same as “face amount” as we covered earlier)… but I don’t see a column for “Net Amount At Risk”.
Why is that?
1. It must not be seen as a necessary disclosure by the NAIC (National Association of Insurance Commissioners) and/or state insurance regulators, or they would include it.
2. Companies must profit from consumer’s lack of understanding of how their cash value policies work. (Everything is a conspiracy, isn’t it?) Term life insurance IS the industry's most profitable product – collect a lot of money over time and pay out ONLY if death occurs while the policy is in force. (Which is typically less than 2% of all term life insurance.)
And THIS is why there are so many agents with a particular company mantra of "buy term and invest the difference" who believes that the CONTRACT states that "you either get the cash values or the death benefit, but not both." I'm sorry, but that's a complete lie based on an incorrect and incomplete understanding of how cash value life insurance works. (They all seem to get their training from the same book because they all say the same things.)
Now that we’ve taken this (unavoidably long) journey together, can we definitively say that “the insurance company ‘keeps the cash value’?” No. It is factually, legally, and economically incorrect.
We’ll cover more myths in the posts ahead.
Comment from John L. Olsen, CLU, ChFC, AEP below doesn't show because of the site's formatting issues. Here are his comments so you can read them: The problem, of course, is that the sort of people who parrot that mistaken mantra (the insurer keeps the cash value on your death) are not likely even to read your quite accurate explanation, much less pass it on to their clients and prospects. They're like... well, Ric Edelman, whose silly discussion of "Sect. 770 plans" reveals that he knows very, very little about life insurance, and that what he does know is often flawed. As we know, David, Sect. 7702 mandates the pure death benefit that a contract must have to be considered "life insurance". It also represents a trap for the clients of agents who don't know about that section and how it will treat a common recommendation of agents (to use the "Guideline Premium Test" in that Section when making a recommendation of a Universal Life policy, recommend using the "initial face amount plus cash value" as the death benefit and funding the contract almost to the maximum allowable to keep the contract's loans from becoming taxable - and then switching the death benefit options from "B" (initial face amount plus cash value" to "A" initial face amount plus mandated increases due to the 7702 "corridor") that will make the contract "much richer, for purposes of taking distributions".
That switch CAN produce a tax disaster for the client (which would not have happened had the agent used the "cash value accumulation test" at policy inception). MOST agents will not understand what I just wrote. You will and do, I know that. For those agents who read this and who did not FULLY understand what I wrote, DO YOURSELF A FAVOR and get some EDUCATION. I highly recommend Steve Leimberg's "Tools and Techniques of Life Insurance Planning" from National Underwrite Company and any article by Ben Baldwin - or David Kinder, for that matter. The career you save could be your own! John L. Olsen, CLU, ChFC President: Olsen Annuity Education www.olsenannuityeducation.com.