Understanding Permanent Life
Insurance Terms And Concepts

The main difference between temporary or term life insurance and permanent life (also known as “cash value”) insurance is in the additional benefits that permanent life insurance provides. To be sure, that means the premiums are more — but there are also more advantages and more flexibility. This flexibility can be used to dramatically increase your wealth when used appropriately.

Unlike term life insurance policies, permanent policies have a cash value. That cash value comes originally from part of the premium the policyholder pays. As the policy holder pays premiums, the cash value increases. In addition the cash value grows from interest paid on it. This interest is paid either at an annually declared rate or at a rate that fluctuates with stock market returns.

There are three primary types of cash value policies: whole life, universal life and variable life. We’ve discussed these in more detail in pamphlets that can be found elsewhere on this site. In order to help you understand those pamphlets, we’ve created a ‘cheat sheet’ of useful life insurance terms that you can use while reading.

1. Cash Account Value (CAV) vs. Cash Surrender Value (CSV)

Cash Account Value: The extra money paid in premiums in a permanent life insurance policy goes to the insured’s CAV.

Cash Surrender Value: The amount of money the insured receives if he gives up his insurance policy

The CAV is greater than the CSV, but only in early years of the insurance policy. The rule of thumb is that the cash surrender value equals the cash account value in year 10. However, there can be a difference even up to year 15.

Why is there a difference in the early years? There are two reasons. First, to cover certain expenses of the insurance company — such as underwriting expenses, commissions to insurance agents, and taxes. Secondly, to assure stabilty and profitability of the insurance company.

When the insurance company calculates earnings or surrender charges, it does so based upon the CAV. So, if the CAV has 10,000 but the CSV is 9,000 and a 3% surrender penalty is applied, the penalty would be $300, not $270. If the policy earns 10% interest, the CAV will grow to 11,000, not 9,900.

2. Policy Withdrawals And Policy Loans

Permanent Life Insurance is attractive as an investment vehicle because the cash value increases and those increases are generally not subject to income taxes.

Some of the things that can create taxable income, though, come about from the use of policy withdrawals and policy loans.

Policy Withdrawals

The most obvious way that money taken from a policy can become taxable is through policy withdrawals where the death benefit is reduced. A policy withdrawal is considered to be a partial surrender of the insurance policy.

Is that enough for the withdrawn money to be taxable? No. The income will not become taxable until the total of all withdrawals and other tax-free distributions (such as dividends) exceeds the amount you have paid in — that is, when it exceeds what you have paid in accumulated premiums. This is known as the “cost-recovery first” rule.

However, there are situations in which the income becomes taxable. If there is a cash withdrawal within the first 15 years accompanied by a reduction in death benefits, it will trigger taxable income provisions. In that case, all income growth in the cash surrender value will be deemed to have been received by the policy owner — subject to s statutory ceiling. However, once the 15-year period expires, withdrawal will not trigger immediate taxation.

There are some exceptions to this. For instance, this 15 year rule does not apply to policies issued before 1985. And it does not apply to policy loans, because policy loans are not treated as distributions and do not reduce policy death benefits.

Another exception to the cost-recovery rule are life insurance policies known as modified endowment contracts (MECs), covered below. More specific information on tax treatment of withdrawals can be found in Revenue Ruling 2003-95.

Policy Loans

One of the advantages of a non-MEC life policy, where the owner can build cash, is the loans that can be taken out. These loans can be taken out free of income tax liability. Because of the unique way they are structured, they are called “wash loans”.

In contrast to withdrawals, policy loans are considered to be debts and they are not considered to be distributions. If they were considered to be distributions, there would be a greater chance they would fall under taxable income provisions. Instead, they are considered debts and are not taxable.

The big “take home” is that you do not pay any income tax if you borrow cash value from your life insurance policy!

Imagine! The policy gains value over time, and after a time, a sizable amount of cash value has been built up. You would be able to take out a loan to supplement your retirement income. And, in most cases, you would never have to pay one cent of income tax on the gain. As if the tax-free access to your policy gains wasn’t good enough, it’s quite possible — via the provisions of the “wash loans” — that you would never have to repay the loan!

There are some caveats about policy loans:

     1. The policy loans are charged interest and this can reduce the
         overall value of the policy.
     2. If there is a withdrawal or surrender of the policy, as we mentioned
         above, the cash value may become subject to income taxes. As well,
         a certain ratio between the death benefit and the cash value must be
         maintained.
     3. If the policy is a “modified endowment contract” (MEC), the loan may
         also be taxable.

Insurance companies have created “wash loans” to increase the attractiveness of permanent life insurance policies to buyers. With wash loans, the interest charged on the loan would equal the growth rate on the cash value of the policy — creating a situation where the interest rate and growth rate cancel each other out. Let’s see how this would work.

First, without a wash-loan. Let’s say you have $200,000 of cash surrender value in your policy. You decide to ask the company for a “tax-free” loan from your policy. The insurance company has to charge interest in the policy. If you borrowed $10,000 and the interest rate is 8%, then your policy would be charged 8% on the loan — every year. While your cash in the policy is still growing, is it growing at 8%? If not, if the credit rating of the policy is only 6%, the policy grows at 8% but you only make 6%. There’s a shortfall, and the shortfall will be made up by decreasing the cash value of the policy. Even worse, under that situation, the loan would usually have to be repaid at death.

With a wash loan, the interest charged on the loan would be the same as the growth rate on the cash in the policy. Net effect? The cash in the policy does not have to be used to pay the interest on the loan. On your $10,000 loan, your interest rate is 8% — and the insurance will credit 8% on the same amount of the cash in your policy. The interest rate charged is cancelled out by the interest rate earned.

3. Aspects of Policy Writing: Policy Riders and Underwriting

There are, broadly, 2 primary factors that affect what you will pay for your life insurance policy.

The first factor is the policy riders — additional features offered by the insurance company that you can use to customize your policy. The availability of various riders depends upon the company, the product, and where (in which state) the policy is written.

The second factor is the underwriting — how the insurance company decides whether you are a suitable risk, and, if so, how risky are you?

Policy Riders

Rider Name what it does
Waiver of Premium Waives premium payments during a disability period, after a stated waiting period.
Guarantee Purchase Option Allows purchase of stated amount of coverage at a future date without proving insurability
Long-Term Care Allows purchase of coverage to help pay for long-term care expenses.
Estate Preservation Allows higher death benefit in the first four years.
Return of Premium Premiums paid into the contract to are added to death benefit values. In some cases, contracts even guarantee this additional value.

So why would you want these various riders?

• Waiver of Premium - This is a very important protection. It makes sure that the life insurance policy is not lost because of disability. If the provisions of this rider are invoked, they can make sure that a supplemental retirement plan will self-complete.
• Guarantee Purchase Option - If you should become seriously ill, you could still increase the value of your coverage.-
• Long-Term Care - This protects your wealth from the devastation of crippling and financially expenses should you need long term care.
• Estate Preservation - only available from a limited number for carriers, it can help to offset an estate tax look-back if death occurs in early policy years.
• Return of Premium - easily increase death benefit values.-

Underwriting

When using life insurance to create appropriate wealth-building plans, underwriting is the piece that determines whether the plan will work — it will determine whether, and, at what cost, you can be insured. If you have considerable assets, the underwriting factors become critical. There are many factors that enter into insurability and insurability costs: ratings, management of risk, and how the cover letter gets written.

Ratings

Table Ratings: It’s no surprise that people with certain medical conditions, if insurable at all, will have to pay higher premiums. The table rating determines what the cost of insurance will be. The ratings are given letters or numbers and range from 1-12 or A-L. Some carriers may go even higher, and we’ve even seen table ratings that go to Table 16. The higher the number or letter, the more you will pay for your insurance.

Flat extra ratings: Do you have what the insurance company considers a risky hobby? Do you like to fly? These ratings can greatly increase the cost of insurance. For instance, scuba diving might receive a permanent flat rating of $2.50 per thousand (0.25%). For a million dollars of life insurance, that would be an extra $2,500 in premiums. Temporary ratings may also be assessed, usually for certain medical conditions.

Table Shaving: Several carriers will “shave” the table rating of a client, if the client can be insured. They might shave a table 4 to a standard rating; some will shave from a table 2 rating to standard.

Insurance Risk Management

Insurance is about dealing with risk. Each carrier has its own limits on how much they will insure, that is, how much risk they will take. These limits determine how they go about insuring someone, if at all. If it’s a risk the insurance agency can cover, then they will cover a prospective client in-house. If not, they may still insure someone by spreading out the risk through re-insurance. The next few terms are used to describe how the insured is insured — how the carrier manages their risk.

Retention Limit — This is the amount of coverage a carrier will keep (retain) in-house before they enter the re-insurance market. The amount varies between carriers and can range from $0 (for small agencies) to $30 million (for the larger agencies). The limits do change. This will affect your ability to be insured, and if you are looking for life insurance with a large death benefit, your advisor will want to make sure what current limits are in effect when designing your wealth protection plan.

Auto Bind — Even though there are retention limits, an insurance carrier can automatically cover a client for amounts above their in-house retention limits — without getting approval from their re-insurance partners. How much? It depends upon the agreements (called treaties) that the agency has with their re-insurance partners. It varies with carriers, and can range from $0 to $60 million.

Reinsurance — To offset risk, insurance carriers enter into “reinsurance treaties.” The treaties are used primarily in two situations: where the prospect is in poor health and the carrier does not want to assume the entire risk of insuring the client; or where there is a large death benefit that is above the carrier’s retention or auto-bind limits. When a carrier doesn’t want to assume the entire risk of insuring a client, the carrier will “shop” the case. This means that the carrier enters the reinsurance market to “shop” for an offer to obtain coverage.

Jumbo Limits — Jumbo limits apply when a prospect is looking for a policy with a large death benefit, and the jumbo limits will vary between clients. Jumbo limits are used to determine whether the carrier will need to use reinsurance in order to cover a prospect. These limits factor in both the amount of insurance desired as well as insurance a client already has.

Don’t forget to check to see if your state laws automatically asset protect life insurance policies and annuities.

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