What Does Liquidity Refer to in a Life Insurance Policy
When people think of life insurance they’re typically thinking in the realm of just the death benefit and how their loved ones will be compensated when the insured passes away whether that be unexpected, or potentially after a long life, so the term liquidity in life insurance sometimes catches people by surprise.
In this article we’ll explain what is liquidity in life insurance while offering an alternative known as a life settlement that might offer you more liquidity than your insurance carrier will. We’ll explain the functionality of each type of policy as well so you can see who qualifies for what type of liquidity. If you are looking to learn more about companies that buy life insurance policies we would be happy to help you!
What Does Liquidity Refer to in a Life Insurance Policy?
Beyond the death benefit, also referred to as the face value, permanent life insurance policies sometimes offer access to liquid assets, meaning you can access cash fairly easily. Universal life policies are typically structured in a way where there is a cash value account associated with the policy which can be used for a variety of reasons, and when it comes to liquidity in life insurance, you can either borrow this money in a loan that does not need to be repaid, or you can surrender the policy and take the surrender value in cash while forfeiting the death benefit, thus turning a financial obligation into a liquid cash asset.
What many seniors don’t realize is that they’re likely to get more cash for their life insurance policy if they were to sell the policy to a 3rd party investor in a life settlement than if they were to surrender it or borrow the cash in the loan scenario. If you’re interested in finding out how much liquidity your policy might have if you sold it to an investor, take 30 seconds to fill out the free appraisal form and we’ll get back with you promptly with feedback.
An independent consulting firm concluded that roughly 85% of universal life policies do not end up paying a death benefit, meaning these policies are either lapsing because people can't afford them, or they're being surrendered to access the liquidity in the policy instead of keeping it for the death benefit. They should be trying the life settlement market first before surrendering or lapsing as they may get significantly more.
Life insurance has always been instrumental in providing families and loved ones with financial security upon the death of a breadwinner, but its unique properties can be utilized in a number of different ways. No other financial vehicle can provide the level of liquidity that life insurance does for certain life and business situations when access to capital is essential. (1)
Term life insurance is the most popular form of life insurance because it offers the most coverage for the least amount of money. A healthy middle aged person can get $1MM of coverage for a relatively small amount of money each month in premiums, but the reality is that most people outlive the term and will never receive a death benefit. In a general term policy there is no surrender value so it does not have any liquidity from the carrier, however if you’re aged 65 or older and your term policy is still convertible, you may have some unexpected liquidity in your term policy by selling the conversion to an investor. If you have a term policy and are looking to sell it, fill out the free appraisal form and we’ll see if we can help you. Otherwise, stopping payment on your term policy will eventually lapse the policy and void the original contract, but there is no liquidity if you go this route, so why not try the life settlement market?
There is one exception for Return of Premium term policies which are designed to return all of your money if you live until the end of the term. Depending on your contract, these can have a surrender value on them if you want to give up the insurance, but the reason you got it was to have the coverage and you still get everything back at the end, so surrendering it early will typically not return all of your premiums, but technically there’s some liquidity in it.
Getting back to universal life insurance contracts which are known as permanent life insurance, they are structured in a way where part of your premium covers your cost of insurance and the remainder goes into a cash value account that grows with interest over time. What does “liquidity” refer to in a life insurance policy? Keep reading.
What Does "Liquidity" Refer to in a Life Insurance Policy?
Unless the policy is funded with a large initial premium, the cash value account starts out fairly small, and grows over time so that if you start the policy in your middle age, by the time you retire this cash will have grown significantly. You can use the cash to cover some or all of your future premiums, and you can also borrow it in a loan scenario that does not need to be paid back. In a less common scenario, you can also use your cash value to reduce your coverage and get a paid-up life insurance policy where you won’t have to pay future premiums.
The loan feature is often pitched as a way to save for retirement, but there’s some important details to consider when taking a loan. While the loan does not need to be paid back, it does have an interest rate on it, so you might borrow $50k but if that loan goes outstanding for a long time before the insured passes you may find that loan balance increased to $100k over all those years from the compounding interest accrued; with a 4% interest rate this would occur in just 19 years. If the policy had a $500k death benefit and a loan balance of $100k when the insured passes, the insurance carrier deducts the loan balance from the death benefit and pays $400k instead. And in another scenario if the policy has a cash value of $200k with no loans outstanding and the insured passes, the death benefit is still $500k. Even though a portion of the cash value was considered liquid it does not increase the death benefit.
Through the medium of life insurance, millions of individuals have accumulated savings while providing protection for their families. Insurance companies have pooled these savings and injected them back into the financial bloodstream of the economy. This pool of investment funds has helped to achieve increasingly greater productivity and has raised the standard of living in our society. (2)
Decrease the Increasing Costs
In truth, the real reason for these cash value accounts is to offset the increasing cost of insurance. Universal and whole life policies are structured in a way where the older you get the more expensive your cost of insurance becomes. Your cost of insurance is your main expense covered by your premium, but depending on your age and amount of premium you’re paying, your cost of insurance will eventually be more than the premium you’ve been paying for years.
As an example, if you started the policy at age 40 perhaps your cost of insurance for a $500k policy was $2k a year while your total premium was $5500, but by the time you’re in your 70s that cost of insurance will have increased to maybe $15k a year. Your policy was designed so that you paid $5500 a year even though your cost of insurance was only $2000 in the beginning. That means the remaining $3500 started going into your cash account, and after 30 years your cash account might have a balance of about $125k. With your cost of insurance going up with age, by your 70s it’s significantly more, possibly close to $15k a year now, but you can keep paying $5500 because the difference in actual cost requiring another $9500 to cover the full premium will come out of your cash account. Your cash account will gain some interest based on the $125k balance, increasing it a few thousand before paying the premium, and after it's paid the balance is probably more like $120k now. You’ll have plenty of cash value to help cover the difference for several more years, but eventually that cash account will get down to nearly $0. When this happens you’ll be on the hook for the full cost of insurance, which might be more like $25k a year by then.
If you funded your policy correctly maybe this doesn’t happen until age 90 or 100, but more often than not people decide to skip paying their premium entirely when they’re older, and eventually their cash value reaches a $0 balance much quicker. This is when seniors are often surprised to receive that premium notice for $25k when they’re used to paying just $5500, and are forced to either let it lapse, or perhaps they can recoup some of their investment with a life settlement.
Points to Consider
With a Universal Life policy you can order an in-force illustration to a specific age, such as age 90 or 100. If you order it to age 90 it might show that in order to keep your policy in force until age 90 you must pay $15k a year starting this year. Alternatively if you want it to stay in-force until age 100 you’ll have to pay $20k a year starting this year. The difference is the cash accumulation needed to offset that rising cost of insurance. If you pay a level premium to age 90, and find yourself still ticking at age 91 you might be paying $40k just to keep the policy in force for another year.
Alternatively, with a universal life policy that says you need to pay $20k a year for the next 10 years, you can also get away with paying the minimum premium, which might be $12k this year, but next year it’s $14k, and the year after it’s $19k, then suddenly it’s $30k, etc.
My point to all this is that it’s challenging for people to keep up with these premiums when they get older. Part of paying the premium is taking a chance on how long you might live. Paying the minimum premium might keep your policy in-force for another year, but the longer you live the harder it will be to pay those increasing premiums and you may be in danger of lapsing. The other option is paying more than you need to in order to put some money towards the cash account, but who wants to pay more than they need to? It’s a hard choice and in a lot of ways people get into trouble with their policy when they live longer than expected.
What Does Liquidity Mean in Life Insurance?
If we’re keeping with the same example as above with the $500k policy, what does “liquidity” refer to in a life insurance policy? At age 70 this person has a cash value balance of $125k. At this point they could borrow some of the money to use for retirement, or they could surrender their policy and get nearly $125k assuming they’ve had the policy a while (the surrender value is largely based on the cash value minus any fees which are usually small if the policy has been in-force for a long time). If they tried to sell it to an investor there’s a good chance they could get more than $125k in a life settlement, perhaps significantly more. What most people do at this stage instead of surrendering or selling it is kick the can down the road for a bit longer until they get into trouble. Perhaps they continue making their $5500 premium payment with their eye on that big $500k death benefit, and the policy stays in good standing for another 8 years. Now they have hardly any cash value left, which means their surrender value is hardly anything and there is little liquidity without selling it, and may be facing a large premium that they can’t afford just to keep it in-force for another quarter or another year. At this stage the insurance company hopes that you lapse the policy voiding any obligation for them to pay the death benefit, and the best chance you have at salvaging anything is by trying to sell it to an investor in a life settlement.
What is liquidity in life insurance? In this scenario when the owner has held onto their policy for as long as they could afford it, their liquidity now is nearly $0 if they were to try to get anything from the insurance company. That’s because they used all their cash value to help cover some or all of their premiums.
On the other hand they may have significant liquidity if they were to try to sell their policy. The life settlement market is a multibillion dollar industry with institutional and private investors representing significant sums of money to purchase and maintain existing life insurance policies. If the numbers crunch in the right direction for them, they will make an offer. Let me explain how it works.
How This Works
Investors review existing life insurance policies and try to make a calculated risk for a return on investment. They do this by underwriting the insured’s current health, comparing it with mortality tables, and determining a reasonable life expectancy, or number of years and months an insured is likely to continue living. Using this number along with future premiums, they are able to calculate how much it would cost to keep the policy in force for that amount of time. If the investment looks profitable, they will make an offer to purchase it, which means if the owner accepts the offer, the ownership will change to the investment fund as will the beneficiary, and they assume all future premiums. In essence they are buying you out of the contract.
The life expectancy report is just numbers and nothing is in-fact. They may determine that someone is likely to live 10 years, but that person ends up passing in 5, and that scenario flips the other way too. Someone they assumed would live 10 years may live 15. In the first scenario where the insured passed earlier than expected the investor had a more profitable investment, whereas in the second scenario the investor may have lost money on the investment. By building large portfolios of policies they are able to balance the risk of investing in policies and in turn hopefully provide a reasonable rate of return for their investors. As you can imagine, of course most investors are looking for a good deal, and if they can get away with it, they will pay less than market value on a policy if the seller does not have any other offers. This is why it's so important to work with a life settlement broker. Not only can we get your case in front of a wide variety of investors, but we can also create competition and negotiate for higher offers, making sure we find the most motivated group to buy your policy.
The minimum requirements for a life settlement are that the insured is age 65+ and the policy death benefit is $100k+. Universal life policies are the most commonly sold, but whole life policies are common, and term policies which are still convertible are also sold as well.
The cost of future premiums and the life expectancy of the insured are the two main variables which determine the value of the policy. What does liquidity mean in life insurance? For a life settlement, the amount in which investors are willing to buy your policy will be your liquidity in the policy.
Once people understand that life expectancy plays a part in determining the value, they often assume that only people in their death bed are considered, but this is not true. We see policies purchased where people have another 20 years to live. The difference is how much the investor has to pay up-front. Someone with a short life expectancy is likely to receive 50% - 70% of their death benefit, which may be a lot of money to pay up front, and therefore not a significant amount of time to accrue interest. Alternatively someone who is healthy may only get $10k. The investor is able to purchase the policy for a much smaller amount, but will have to pay premiums for a much longer period of time and may not see any of that money back for another 20 years. The investment accrued more interest over the long period of time and may possibly mature sooner than expected if the health declines during that long stretch of time.
The other reaction people have when they get a $10k offer is that someone is getting rich off of them. The reality is not so bleak. When you take into account how much the investor is likely to pay in future premiums, their profit margin is a lot smaller than they realize. For example, if you had a $250k universal life insurance policy, and your premiums are $15k a year, in 10 years that will cost $150k to keep in force. The profit is not $250k anymore, and really it’s not even $100k because the time value of money reduces the true profitability of this investment. It’s still a good investment for the buyer, but they’re not necessarily getting rich off of you. Would you want to spend another $150k on your policy to keep it in force, or might that money be better spent somewhere else? If you have that extra cash, perhaps there’s another investment that might better serve you. The investor has plenty of capital to pay the $15k a year even if it means they only profit a modest annual interest rate over the 10 years.
Hopefully at this stage you understand liquidity in life insurance, and how doing a life settlement might provide more liquidity than surrendering your policy. We offer help assessing the value of your policy, here is the link to that tool: sell life insurance policy calculator.