It's Not "Both/And" – It's "Either/Or"

One of the biggest problems most people face, when it comes to analyzing the value and benefits of permanent life insurance policies, is the inability to really understand “cash surrender value.” Many people equate it with savings or an investment—and there are a lot of life insurance agents who exploit that misunderstanding. If you don't understand what a cash surrender value really is, you open yourself up to making big mistakes.

So what is a "cash surrender value"? The keyword is "surrender" and you will notice that a lot of life insurance agents just dispense with the word by shortening the terminology up to "cash value." But surrender is an important word because it underscores what has to happen in order for you to get your hands on that money.

Surrender has some interesting synonyms. They include quit, give up, hand over, relinquish, forgo, cede, forfeit and capitulate. All in all, it's not what I would call a positive list of words or thoughts, but that word "surrender" and its synonyms go a long way to describe what must take place before the cash surrender value of a life insurance policy can become your money.

Where do the actual cash surrender values shown in a whole life policy come from?

In one of the first articles I ever wrote for Canadian MoneySaver I talked about how all life insurance is term insurance. This is based upon the simple argument that term insurance is a policy where all you purchase is protection. That protection pays your beneficiary a benefit (usually a lump sum) if you die. It's like car and house insurance. If you don't die, the premiums you paid are gone. Gone where? To pay the death benefit for others who bought the same life insurance and did die.

The problem with term (although it's not really a problem—read to the end) is that the price for term insurance becomes higher as you get older. Why? Because the older you get the greater your risk of dying. That means that the company will have to pay more death claims for people at your older age than it will have to pay for those who are at younger ages. More claims means the company needs more premiums and, unlike the government, life insurance companies can't force younger people to pay the costs of older people. If a life insurance company tried to do that, a competing life insurance company could charge a lower rate to the younger person, based upon the actual cost of the younger person, and the company charging the higher premium would get much less business.

Of course those life agents who recommend whole life for everyone—and yes, there are still agents out there who do that—will argue that you are better to buy whole life because it keeps the premiums level. And even better, they say, "the whole life policy has cash values which are an important investment for your future." Note that I left out the word surrender in that previous line. Also note that I completely and totally disagree with that characterization of a cash surrender value.

While whole life keeps your premiums level, it does so by charging you a lot more (and I mean a lot more) than the price of term life insurance for the same coverage. The extra money, over and above the cost of actually insuring you that year (the term insurance that’s inside the whole life), goes into a reserve that the company builds up in order to pay the future costs for insurance. That way, when those higher internal term costs in the whole life start to really go up (while at the same time you are continuing to pay the same old level premium, which is now lower than the price of term insurance would be at your older age), the company can dip into that built-up reserve to keep the policy going.

Let's take a look at a very simple example to better understand the mechanics.

A 35-year-old, female non-smoker is thinking about buying a $250,000 whole life policy. She can get a fully guaranteed whole life policy for $1,462.50 per year—a very competitive product. (You can verify that for yourself by running a comparison of guaranteed whole life at www.term4sale.ca.)

By comparison, that same female at age 35 can get a 10-year term life insurance policy for $137.50. I think most would agree with me that $1,462.50 is a lot more than $137.50.

Both policies do the exact same job if our insurance buyer dies anytime during the first 10 years: her beneficiary will get $250,000.

But, as the life agents who are fans of whole life would argue, there is no cash value (don't forget the missing word "surrender") in the term policy. These whole life folks will argue that, if she lives, she will have thrown away her money buying term. Really?

Where do the cash surrender values come from? Let’s look. The difference in price between the two policies is $1,325.00 ($1,462.50-$137.50). Over 10 years that is a $13,250 difference in cost, without adding any interest. By comparison the whole life policy has a 10th year cash surrender value of $13,000. Some would argue "that's not too bad." But here's where the "either/or" comes in.

Let's assume our insurance buyer dies in the 10th year. What does the whole life policy pay the beneficiary? It pays the $250,000. What about that $13,000 cash surrender value?

The $13,000 does not pay in addition to the $250,000. I usually explain that this is part of the death benefit, and it is. Other consumerists have characterized this as the life company stealing money if you die. While I would consider that a strong mischaracterization, it is actually no more misleading than a life insurance agent who calls a cash surrender value a cash value when explaining a whole life policy to a consumer. And it is certainly a useful way to undo the damage a life insurance agent does to a consumer who explains a whole life insurance illustration by pointing to the insurance death benefit, and then to the cash surrender values and saying, "And, here is your cash value." That's wrong, really wrong. It's "Or here is your cash surrender value." You can have one, or you can have the other, but you don't have and you can't have both.

The only way you can convert the cash surrender value into actual cash is to quit (surrender) the policy, period.

At that point the agent who loves whole life will rush in and say, yes, but you can take a policy loan for more than 90% of the cash surrender value. While that's true, in what other circumstances do you have to borrow your own money? The reason that you have to borrow the money is because the money does not belong to you; it belongs to the life insurance company. That's why, if you die, your beneficiary doesn't get it. The only way you can get it is to surrender (quit) the policy.

To further underline the point, if you take a policy loan and die, the company will deduct the loan from the death benefit.

By contrast, if our 35-year-old buys the term policy, and saves the $1,325.00 per year, then dies after 10 years, her beneficiary will get the $250,000 death benefit and would also get the $13,250 plus interest.

The next time you are looking at those cash surrender values, and thinking you have both those and the life insurance death benefit, remember, you don't. And if you are dealing with a life insurance agent who does not make that clear for you, it's time for a different agent.

I earlier said that the problem with term is that the price goes up. That is not really a problem—it's a convenient blessing. Most people need life insurance when they are young, have a lot of dependents (young family) and very few assets. To protect their family, they need a lot of life insurance and term lets them buy a lot of life insurance for a relatively small premium because they are young. Those premiums only get bigger as they get older but then their assets grow as do their children. Eventually, once the kids leave home, and they have accumulated enough money to retire, they can say goodbye to buying term.

Finally, I would not recommend a 35-year-old female buy 10-year term. She would be much better off buying a 30-year term policy which would cost about $305 per year.

Should everyone buy 30-year term? Absolutely not! Tune in for my article, That's A Solution Looking For A Problem in the next issue of Canadian MoneySaver.

Bob Barney, President, Compulife Software Inc., Kitchener, ON (888) 798-3488, barneyrl@compulife.com, www.compulife.com