How To Use Your Life Insurance Policy
Updated: Mar 15, 2022
A lot of life insurance companies train their sales agents to emphasize the loan feature on permanent life insurance policies. Hey, what a great deal, you can grow your money with interest, and you can borrow this money later and you don’t even have to pay it back. What a great way to save for retirement! Sounds good, right? Not so much. Let’s take a closer look.
If you need the coverage, but need cash, the loan could be a good option if you're in the position to pay it back within a relatively short period. If you can't pay it off, or don't want to, taking a loan can put you in danger of eventually lapsing your policy.
If you don’t necessarily need the coverage anymore, you could sell life insurance policy with a life settlement to access possibly even more cash that way. If the insured is age 70+ and the death benefit is $100k+, you may receive a cash payment valued less than the death benefit and greater than the surrender value. Want to know how much your policy is worth to an investor? Use our sell my life insurance policy calculator form, and we’ll give you some numbers to consider.
Should I Borrow Money from my Life Insurance Policy?
Going back to the sales process of permanent life insurance, the loan feature is great if you’re in a pinch and need access to cash quickly. People often ask what does liquidity refer to in a life insurance policy, and this would be one of your answers. Other than quick access to cash in the loan scenario, from my perspective, the loan sets you up to lapse your policy even faster than it typically would if you didn’t.
An independent study found that 85% of universal life policies do not end up paying the death benefit because the policy was either surrendered or lapsed, so this gives you a good idea of how often this happens.
Most universal life and whole life policies are designed with an increasing cost of insurance. The older you get, the more expensive your insurance costs become, and if you don’t have cash in your cash value account to cover the difference, you may find yourself having to pay significantly more than you expected on premiums to keep the coverage going. If you take a loan on your cash value, you're reducing this needed balance that keeps your premiums affordable.
In a typical plan, you might start the policy out paying $5k a year in premiums. Your cost of insurance when you were young was $1500 a year, so the remaining $3500 went into your cash value account, which grows with interest over time. By the time you reach retirement age you’ve accumulated quite a bit of cash in your cash value account, but your cost of insurance went from $1500 a year and now it’s up to $10k this year, and a few years down the road it might be $20k a year. You can continue making the $5k premium payment and the remaining amount required to pay your cost of insurance will come out of your cash value account to cover the difference in this later stage of life. When your policy is properly funded, it should stay in-force at this price until a certain age, such as age 90 or 100, depending on how it was illustrated, and what happens to the cash value account is that it eventually stops growing and the balance starts declining as it continues paying more and more to cover that increasing cost of insurance. By a certain age this decline starts happening at a rapid rate due to larger costs and smaller interest credits from a smaller balance, until it reaches $0. At that point you’re on the hook for the full cost of insurance and have to either cut a big check to pay the premium, let it lapse, or better yet, try to sell the policy to an investor with a life settlement.
Many people reach retirement and see that they have over $100k accumulated in their cash value now. If they need money, that loan scenario might be tempting, but here’s what happens.
Let’s say they decide to borrow $50k, and the death benefit on the policy is $500k. If you don’t pay that loan back, your death benefit is reduced by the balance, so in the beginning it becomes $450k instead of $500k, and each year the insurance company has to charge interest on that loan. You could pay that interest out of pocket, but it’s certainly more tempting to pay it with your policy. Over 10 years that $50k loan looks more like $80k, and now your death benefit has decreased to $420k.
What’s unfair about this scenario, is that if you have a $500k policy with no loan, and a cash value of $100k, the death benefit does not increase to $600k, it’s still $500k. But as soon as you borrow your own cash value, it reduces your death benefit until you pay it back. In essence, the death benefit is used as collateral for the loan, and is paid off upon death by reducing the death benefit. And the cash value is really structured as a way to fund the increasing cost of insurance with age.
If you borrow $50k and eventually your policy lapses, you could be liable for income tax on the balance of your loan if it exceeds your cost basis on the policy since you borrowed the money and then terminated the life insurance contract. So again, if you’re in this situation, you’re probably better off selling the policy with a life settlement to avoid triggering this potentially taxable event.
I mentioned earlier that taking a loan will likely put your policy in danger of lapsing much sooner. When you had $100k in cash value, your annual interest may have been accumulating $3k - $5k a year in credits, which was helping to offset your increasing cost of insurance. But when you take a loan, the insurance company recognizes this money differently, and if they even credit you interest on it, then it will be at a reduced amount. So now that you’ve reduced your balance you’re earning less interest credit, more like $1500 - $2500 a year, all the while draining your cash value account even faster.
The great thing about universal life policies is that if you have cash accumulated in the policy, you can decide to skip paying premiums this year, and possibly even for years to come. If you told a 75 yr old who’s retired that they could skip paying premiums for another 10 years and their policy will stay in force, a lot of people will do it assuming they probably won’t live past 85. Well, eventually they turn 85, and their next premium payment is $30k just for another year of coverage because their cost of insurance has gone up so much. Most people can’t afford that and the policy ends up lapsing, that is unless you do a life settlement to recoup some if not all of your investment.
With this scenario in mind, if you’re borrowing money from the policy, chances are you’re probably not making premium payments anymore, so instead of the policy lapsing in 10 years in this example, it will probably lapse in more like 4 years. So you’re in your mid 70s now with a life insurance policy you can’t afford anymore, or don’t want to pay into anymore, and you probably have another 10 years of life left. What do you do?
If you’re finding yourself in this scenario, or you don’t need the policy anymore, the best solution might be selling the policy with a life settlement.
A life settlement is the sale of an existing life insurance policy to a 3rd party investor. In this legal arrangement, the investor takes over ownership of the policy and assumes all future premiums. They pay you a cash settlement today to buy the contract, and they collect the death benefit upon the insured’s passing. In most arrangements, once the policy is sold, you're no longer financially obligated to any of the premiums or death benefit.
Even clients with cash value sell their policy when they decide they don’t need the coverage anymore, or realize the future costs are too much and they’re better off selling it with some value left in it now. The investor will take into account the cash value amount because they can use this money to pay future premiums as well, which is money they can pass on to you in their offer.
If you have taken a loan on your policy, you can still try to sell it. When an investor reviews a policy with a loan on it, they have to factor in paying off that loan when they take over the contract. They don’t want the loan balance to accumulate, reducing that death benefit. They would rather pay it off now to level up the contract, and pay premiums moving forward to keep the policy in-force. So if you have a $30k loan balance, and the investor is calculating the ability to pay $80k for the policy, what that really means is they’ll pay you $50k, while they pay off the $30k loan balance.
If they had no loan balance and just a $0 cash value, they would have gotten the full $80k.
Life Settlement Market
The life settlement market has been maturing for over 20 years, and is now a multi billion dollar industry. When an investor reviews a policy, they’re underwriting the insured’s medical records to come up with a reasonable life expectancy. If that number happens to be 10 years, and the annual premiums leveled out are $10k a year, then the investor knows they’re likely going to have to pay $100k over 10 years just in premiums.
If the policy they’re reviewing is a $500k policy, that means there’s a good amount of money left over to pay both a settlement upfront while also factoring in annual interest rates to make the investment worthy. Perhaps they offer $150k to purchase this policy.
At first glance the $150k looks like a lot less than the $500k death benefit, but when you factor in $100k in premiums, the investors cost on the policy is already $250k, and they’re putting that money out over a 10 year period before getting anything back. With an interest rate of around 10% a year, they’ll make a decent return on their investment, and you will save yourself from paying another $100k into the policy, plus you’ll have the $150k settlement to use as you please.
Once you’ve settled, you won’t need to borrow money at this point, you’ll simply have it. The proceeds from a life settlement can be used for anything. Many folks consider investing the money elsewhere in something where they have more control. It’s possible a settlement could help you afford a vacation home that’s also a rental property, or maybe you feel more comfortable putting the money in an annuity that protects you from market fluctuations while growing your investment long term.
Others might use it to supplement their retirement income. If you’re in need of long term care, this might be the way that you can afford the care that you need.
And if your financial situation is pretty good, then you might rather just distribute wealth while you’re still living. Watch one of your kids invest the money wisely while the other buys endless toys. Whatever makes them happy, right?
The full buyout with cash upfront is the most common type of life settlement arrangement, however there are different options for different needs.
Another option is simply a reduced death benefit that still pays upon the passing of the insured. Perhaps you own a $1MM life insurance policy, but the premiums are getting too expensive. You still want your loved ones to receive a death benefit, though, and maybe based on your age, health, and future premiums, you only get an offer for $50k to buy it upfront. If you took no money today, and instead simply took a reduced death benefit, perhaps they’re willing to offer $250k as a death benefit.
In this arrangement the buyer will take over premium payments until you pass away, and whether that’s next year or in 15 years, no matter what they’ve agreed to pay $250k to your beneficiaries while they keep the remaining $750k. Keep in mind they're likely paying around $400k - $500k in premiums over this time, so their profit isn't quite as large as it first appears, and your gain is larger too when you no longer have to pay those premiums.
The reason this buying group is willing to offer so much more in the reduced death benefit is because they don’t have to pay a large sum upfront. From an investment standpoint, the money they would typically pay upfront will not be returned for many years, and as such, they need to make interest on that money each year it is invested for it to make sense, which accumulates much faster when it’s a large sum upfront.
When they’re only responsible for paying the premiums, there’s a lot less interest accumulating in the beginning years of the contract. Perhaps you like this option more than taking a lump sum upfront is it eventually yields more money to your beneficiaries.
Another type of offer is known as a retained death benefit. Similar to the previous example, an owner of a $1MM life insurance policy is offered $100k to buy out their policy, which is based on a 12 year life expectancy and premiums of $40k a year. The insured feels strongly that they’re not going to live 12 more years, and thinks they probably don't even have 6 years left.
Instead of taking $100k upfront, they take $25k upfront with the opportunity to end up receiving part of the death benefit upon passing. The investor offers a declining death benefit arrangement where each year the insured continues living the death benefit paid to their beneficiaries reduces by the premium amount plus interest.
In this arrangement if the insured passes within 1 year of the contract, the investor will pay nearly the full death benefit minus the settlement paid upfront and the premiums paid, so let’s say $930k. If they pass within 2 years, it drops down to $875k; 3 years goes down to $800k; 4 years is down to $700k; 5 years is $550k, 6 years is $400k, 7 is $150k, 8 is $0.
What’s happening here is the investor is placing more of the risk on you and less on them. They’re paying less for the policy upfront, but they may end up making less return on this investment if the insured passes early. They won’t lose money on it, but they won’t make much either. And if the insured lives more than 8 years, well, the investment ends up being more profitable for them since they paid less for it upfront.
This last scenario is a tough decision, and ultimately comes down to whether or not the insured feels strongly that they have less time left than what has been predicted by the underwriter, and this very well may be the case. It also places more risk on you as you may end up only getting the initial $25k out of the deal.
It’s often advised to take the money upfront as it makes for a cleaner sale. The declining death benefit can leave you wondering if you made the right choice for years to come, and may ultimately regret it. In a clean sale with all the money upfront, you’re walking away from the contract in its entirety. You accept the deal you’ve taken and you move on. Of course it’s entirely possible that you end up getting the better deal with the retained death benefit too. You know your health better than the underwriters do, and you’ll have to make that decision.
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The average age for filing bankruptcy has increased and the rate of bankruptcy among those ages 65 and older has more than doubled since 1991, say researchers Teresa Sullivan of the University of Michigan, Deborah Thorne of Ohio University and Elizabeth Warren of Harvard Law School. (1)
We encourage you to consider the blessing and protection that life insurance can be for you and your family. If you need to consider selling, we are here to help but we want you to make the best decision for you and your family. If you find yourself asking "can you sell a term life insurance policy" reach out to us today.
Before you get bogged down with making the right type of offer decision, let’s take a closer look at your case. You can fill out our free appraisal form, or give us a call at 213.784.1481. If you're thinking about taking a loan on your policy, be careful and consider whether or not you can pay that loan back, or need the coverage much longer as your policy could end up in danger of lapsing much quicker if you take that loan.
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