Life Insurance Vocabulary Explained
This is meant to be used as a reference to help understand the words and phrases associated with life insurance and their definitions. It will give you a better understanding of the structure of policies by way of understanding their components.
Life Insurance Working parts definitions:
B. Cash value (guaranteed portion)
C. Dividends that purchase automatic paid-up additions (PUAs)
D. Gross cash value = (b + c) (though some insurance companies call this net cash value)
E. Automatic paid-up additions
F. Manual paid-up additions
G. Waiver of premium
H. Death benefit or face amount
I. Increasing death benefit
J. Interest charged on borrowed cash value
M. Automatic premium loan (APL)
N.Reduced paid-up (RPU) policies
O. Opportunity cost
P. Internal rate of return
A. Premium: The monthly or annual payment you make to the insurance company that goes into your account and also pays for the death benefit. It helps self-impose discipline, and helps money move (which is a critical principle in causing it to grow). The effect is that one premium dollar will do at least five jobs: build cash value, create dividends, maintain waiver of premium (see G), increase the death benefit, and provide the ability to leverage.
B. Cash value: For whole life, a guaranteed dollar figure, which is the amount in the account (not a guaranteed interest rate). This account is guaranteed to increase every year, even if the company does not pay a dividend. A new “floor” (minimum) is set annually on your policy anniversary date, and it can never go down as long as either you or your cash value or your dividends are paying premiums.
C. Dividends: An amount paid to you for being an owner of the policy, or if the life insurance company is “mutual” instead of “stock,” for being an owner of the company. The word “dividend” in this context is a confusing term since it does not perform like a stock dividend. Once policy dividends have been paid, they become part of the guaranteed cash value, which increases on a guaranteed basis every year, even if no dividends are paid. There are many ways to use dividends; most companies have at least twenty options to choose from and you can change them as often as you like. The best option in the early years is generally automatic paid-up additions (see E), which automatically increase the cash value, the death benefit, and future dividend-earning capability. Dividends are not taxable as long as they are left in the policy to buy more paid-up additions (see E). They also are not taxed when borrowed against. And they are not taxed upon withdrawal until you exceed your basis (the amount of premium you’ve put in plus any manual paid-up additions you’ve added).
D. Gross cash value: This is B plus C, the amount you can borrow against. This is your account, 100 percent owned and controlled by you. Recall the CLUE method from page 19: Control, Liquidity, Use, Equity. CONTROL: You own it, you control it, you say when, you say how much, who, how often, and why. The size of your contributions, your access to funds, and the potential use of the money is not determined by the government, a bank, or your credit score. LIQUIDITY: This account is 100 percent liquid within ten days at most insurance companies. (Note, there may not be much net cash value in the first few years of the policy, but whatever is in there is 95 percent available.) USE: Even if you never move a dollar, your cash value account is the single most-efficient and effective place to store money. It’s efficient because it grows in a tax-deferred manner (taxable only if you cancel), and it’s effective because you can borrow against it while it still grows at the gross value. It’s the best place to store “peace of mind” money. And like a Swiss Army knife or a Smartphone, you can use your account in multiple ways, such as:
• emergency savings;
• an entrepreneurial “opportunity fund” such as liquidity for a down payment, bridge loan, or purchase of a cash-flowing
• liquidity for business financing, lease purchases, etc.;
• a hedge against risk such as mutual funds you may still hold in a retirement plan;
• a college savings plan that won’t decrease your child or grandchild’s opportunity to qualify for financial aid.
• money to finance your own (or even someone else’s) purchases or to consolidate higher interest debt;
• an income source that allows you the ability to sequence the spend-down of your other assets more efficiently;
• a simple, tax-efficient way to pass money to heirs, before or after your death.
EQUITY: Just think real estate. Equity in real estate is leverage-able. You can borrow against it, but the underlying asset just keeps on growing, unaffected by the debt. This is the single most misunderstood aspect of this product. You borrow against it, but you don’t take it out. The net cash value is what is left over to still borrow. For example, if you have $100,000 of gross cash value and you borrow $40,000, your account will still grow as if it were $100,000, not $60,000.
NOTE for E and F: The terms “automatic” and “manual” are mine. Insurance companies don’t use them, but I have here in order to help you understand what your opportunities are.
E. Automatic paid-up additions: These are what dividends buy and they do so automatically (assuming you choose this as your dividend election). The dividend purchases a paid-up (meaning no more premiums are due) miniature policy (that gets added to the base policy) that has cash value, dividends and death benefit that all increase annually. Think of it like a fruit tree that grows from a sapling to a large fruit-bearing tree. There is the trunk of the tree, then each new branch adds potential for the tree to produce more fruit. Together, the trunk, branches and fruit grow exponentially in a compound way. We like paid-up additions (automatic or manual) because they allow you to put more cash into the policy and have it be liquid almost immediately. It’s like grafting a new branch onto the tree!
F. Manual paid-up additions: These are cash payments that can be added on an optional basis. They act in the same way as automatic paid-up additions, allowing you to increase your cash value more quickly, as well as adding to your death benefit. Some companies are more flexible with this than others. Some allow monthly payments, others only annual. Some require a little ($100) to keep the door open (use it or lose it), whereas others don’t. Regardless, this is a manual environment, one you control 100 percent within the guidelines of the company and the I.R.S. One important point: There can be too much of a good thing. Add too much money in manual paid-up additions and your life insurance policy (with very effective tax law) will become a Modified Endowment Contract—MEC (with less-than-effective tax law). So make sure you know your particular company’s interpretation of the I.R.S rules and stay within them. This should pique your curiosity: When the I.R.S sets a rule about the maximum amount of money (per amount of death benefit) you could put in a certain place, then maybe that place has some value.
G. Waiver of premium (WP): Not everyone gets approved for this, so if you do, you should accept it. It pays the premium (and sometimes depending on how it’s structured, the manual paid-up addition rider as well) if you become disabled for a minimum period of time, depending on the company. The waiting period is usually six months and the pay-out period often extends to age 60 or 65 with various definitions of disability. Waiver of Premium is not disability insurance, but rather a rider that will let your life insurance continue growing and having new premiums added to it, if you are disabled and not able to add them yourself. It increases economic certainty because of the “self-completing” nature of the coverage. While premiums are being paid under the WP rider, the cash value and death benefit continue to rise and dividends could be taken in cash to supplement any other income. It’s interesting to note that if you have term insurance with WP on it, most insurance companies will allow you to convert to whole life upon disability. What does that say about which is less expensive in the long run?
H. Death benefit or face amount: Death benefit is just what it implies: you die, and the company pays. However, since that chance
is statistically unlikely in the early years, we’ll just be grateful for the peace of mind that comes from knowing our loved ones will be cared for monetarily if we go early. “Face amount” is just another term for the same thing.
I. Increasing death benefit: In most whole life policies, the death benefit or face amount increases every year. This benefit can be defined by one word: inflation. With medical and scientific advances, it’s possible some of you will live 100 more years. You might think 5 percent inflation is high; however, we aren’t talking about the government standard here, but your standard— for which things like travel, top-notch medical care, and schooling increase at a much faster pace. You’ll want your death benefit to be increasing at a fast pace.
J. Interest: The amount the insurance company charges you when you borrow their money. Yes, you are borrowing THEIR money; your cash value is the collateral. Borrowing against your cash value has an interest cost usually between 5 percent and 8 percent, depending on the company. In our research, we’ve found it doesn’t really make as much difference as you’d think. The lower loan interest rate that life insurance companies often use is a variable rate (versus a fixed, but higher interest rate). See also the “direct recognition” section at the end of the glossary.
Do you want the companies you do business with to be profitable?
Do you think insurance companies, banks, mortgage companies, and brokerage firms move their money all the time versus putting it in accounts and letting it sit there for 30 years?
Since you probably answered yes to both questions, let’s think about why the insurance company charges you interest when you borrow against your cash value or CLUE account. The most common question is, “Why do I have to pay interest to use my own money?” The answer is, you don’t. You can withdraw your money out of the life insurance net-cash-value account and go on your way. Or you can leave your money in there to grow and borrow the insurance company’s money collateralized by your cash value, similar to a CD-secured loan. You pay the insurance company an interest rate for the use of their money. The cash-value account is yours to do as you want. The insurance company will pay you dividends on your policy based on the gross cash value, regardless of whether there is a loan against the cash value or not. If you choose not to collateralize your account and get it to do more jobs (see page 35), the insurance company will collateralize it among their general account assets and use it to do many jobs for them. “Why pay 8 percent to a life insurance company when I can borrow at 6 percent from a bank?” you may ask. Micro-economically, looking at the question in a vacuum, you shouldn’t. But macro-economically, looking at the big picture, sometimes paying a higher interest rate is worth the increase in flexibility. Since you control the loan at the life insurance company (unlike at the bank or car dealership), choosing to pay 8 percent gives you freedom and flexibility to skip payments or take longer if necessary to pay it back. Not that you should, but at least you have the freedom to. You also have the freedom to use your policy as collateral and seek a lower interest rate from the bank. In the current low-interest rate environment, this could be a desirable option, particularly if your credit is excellent. “Why pay 15 percent back to my insurance company when they only charge me 8 percent?” If the marketplace is charging 15 percent for an equipment loan, yet you can borrow at 8 percent, then paying the 7 percent difference to your policy in the form of a manual paid-up addition will enable you to profit from the financing deal like a bank would. You can literally pay the difference every month or save it up and add it annually. True Family Banking (see phase 5) would require that 7 percent difference to be fair and square with the marketplace, which is where your economy operates.
K. Owner: This is usually the person who pays the premium, definitely the only person who can borrow against the cash value and control all of the working parts, and often (but not always) the insured.
L. Insured: The person upon whom the policy is written. When this person dies the death benefit is paid. If the insured is not the owner, the insured does not have any rights to the policy. However, the owner may give the policy to the insured at some point in the future without any income tax. (Think about starting this type of policy on your child for a future gift.)
M. Automatic premium loan: It may go by a different name at different companies, but this feature can help you in times of cash-flow challenges by literally recycling cash value to pay premiums and then increasing the cash value. It works the same way as a regular loan, but instead of the money going to you, the money goes to the life insurance company to pay the premium so your cash value increases and your loan increases. It’s a strategy to use for a few years while you get back on track, not one to use forever.
N. Reduced paid-up: This is the “end of the rope” savior in the event that cash flow simply dies and you don’t see a light at the end of the tunnel for many years. The insurance company reduces your death benefit and makes your policy “paid up” so no more premiums are required nor allowed. It’s not a strategy you can undo, but it will keep you from losing the money you’ve paid in so far.
O. Opportunity Cost: Opportunity cost (as defined for the purposes of this book) is what you lose when you let dollars go unnecessarily to a financial institution or the government, or sit unproductively when they could be earning interest. Paraphrasing Heymann and Bloom in Opportunity Cost in Finance and Accounting, “the value of a resource is determined by its use in the best alternative given up.” Remember Mark and Mary’s story about educating their children from page 25? If they had used a 529 plan, they would have given that money to the college and it would have been gone— causing themselves a large opportunity cost because that money and all its growth was at the college instead of in their own accounts. However, by borrowing against life insurance cash value or real estate to pay for their children’s education, Mark and Mary can educate their children and keep the asset growing.
A Note on Direct Recognition: There are two different methods insurance companies use to handle the loaned cash value— direct recognition and non-direct recognition. In a non-direct recognition company, the earnings rate on cash value is totally unaffected by any loans against cash value. In a direct recognition company, the earnings rates on loaned cash value are affected both positively and negatively when the cash value is used as collateral.
Generally, the loaned cash value has a dividend rate that is a certain number of basis points lower than the interest charged on the loan. So if the current-dividend-crediting rate is less than the direct-recognition-crediting rate, then the cash value is affected positively. If the current dividend-crediting rate is greater than the direct-recognition-crediting rate, then cash value is affected negatively. For example, let’s say the current-dividend-crediting rate is 6.5 percent, and the loan rate is 8 percent with all loaned cash value getting a “100 basis point” (1 percent) reduction from the loan rate (bringing it down to 7 percent). That being the case, since 7 percent is obviously greater than 6.5 percent, borrowing against your cash value actually improves your situation because your dividend-crediting rate will be at 7 percent for the borrowed cash value and 6.5 percent for the non-borrowed cash value.
After all the analysis we’ve done on many companies and policies, we’ve found either way works just fine. Maybe consider having both!
P. Internal Rate of Return: The internal rate of return on a policy is what the policy cash value is earning, after costs such as death benefit, commissions, and other policy expenses. As of this writing in 2015, that is between 4 and 5 percent per year. What you can count on is it always being a few percentage points above what a bank would pay on similar liquid accounts like savings and money market accounts.
Butler, Kim D.H. (2016 2nd Ed). Live Your Life Insurance.