Life Insurance and the Elderly: Leveraged, Already-Bought Assets that Should Not be Wasted

Wednesday, December 4, 2013 at 1pm
By John Friedman

I just caught the tail end of a Dave Ramsey segment (he of AM radio financial advice call-in show) during which Dave, hater of all things debt, recommended that a son tell his 80-something year old parents to surrender a life insurance policy that had a death benefit of $150k and a cash surrender value of $100k, because doing so would allow them to pay off their mortgage.

I did not hear anything about the mortgage, so I can’t say how onerous that mortgage was, but I did hear enough about the insurance to make me question Dave’s advice and think to myself, debt-haters gotta debt-hate.

Like Dave, I am not a big fan of cash value life insurance. Cash value life insurance is a general term I use to encompass all life insurance policies that collect some cash inside the policy — cash which the owner of the policy is always free to take out of the policy if the owner wants to give up the policy all together. I also refer to that kind of life insurance as “complex” life insurance, to distinguish it from the other kind of life insurance that most people know — the kind that pays a death benefit if you die before your time and which does not collect cash within it — which I often refer to as “simple” life insurance.

Language fail is a sad fact of life within the Financial Services Industrial Complex, and life insurance, very much a part of that FSIC, clearly suffers from language fail. Here are a bunch of labels and descriptors for the two types of insurance (and there are plenty more than this!):

 

Simple

Temporary
Term
Relatively inexpensive
Pure insurance
“If you die” insurance
Insurance designed to lapse before you die

 

 Complex

Permanent
Cash Value
Relatively expensive
Insurance with a savings component inside
“When you die” insurance
Insurance designed to be in existence when you die

 

For most people, complex insurance is . . . too complex; they literally cannot understand the statements they get, because there are lots of numbers on the statement, all of which attest to the status of the life insurance policy, but none of which seem to have much to do with any of the other numbers on the statement or with any of the numbers on previous statements. This is not to say that there are zero good uses for complex insurance — it can be a great fit for wealthy folks and very high earners — but it is to say that, for most Normal Folks (NFs), there are precious few good uses.

*  *  *

In the Dave example from up above, we have two basic numbers with which to work: first, if the insured parent died today (I did not hear enough about the insurance policy to know whether it insured the husband or the wife, or both; I’ll assume here it insured just one of their lives), then the policy would pay a death benefit of ~$150k, and, second, if the parents wanted to get their cash out of it today, they’d receive ~$100k and no longer have the life insurance.

Those two numbers together tell us much, but by no means all, of the insurance policy story. For instance, we know from the cash value figure that this is some kind of complicated insurance (some of the most common types of which are Whole Life, Universal Life, and Variable Universal Life) because only complex insurance has a cash value.

And from the amount of that cash value and how large it is relative to the size of the death benefit we can surmise that, pretty much regardless of which type of complex insurance this policy is, the odds are pretty good that the son’s parents can keep that policy up and running without putting any cash into it. For instance, if premiums (premia?) are still coming due — and fairly often in the latter stages of complex policies all the premium paying has already been done premium-paid — then they can use the cash value in the policy to pay those premiums. And that means that the parents can keep their life insurance policy afloat without having to dig into their pockets. In addition, most complicated life insurance policies allow the owner of the policy to take loans against the cash value in the policy (hey, I said it was complicated stuff, right?). Sometimes that can work well too. And no doubt a good life insurance guy or gal — chess-player-like, them all — could look to a lot of the design twists and quirks of the policy to do some clever tweak that would make it possible and optimal for the parents to keep that insurance policy in force without any further ado, inconvenience or Money-Out. No muss no fuss.

So my hunch is that keeping that policy up and running is easily doable without the parents having to put cash in.

*  *  *

And that brings us to the other side of the decision — the leverage side. As I use it here, the term “leverage” refers to getting a big bump-up on some of your dollars, as in “I bought it for a buck, and as a result of the leverage in what I bought, it returned back to me a buck fifty,” and as in “I bought the insurance for $2k a year, so that, after ten years, I’ll have spent $20k to own it, but if I die it’ll pay me a million bucks, and that’s 50-to-1 leverage.”

So do you see the leverage involved here? Just replace the buck and the buck fifty in the first example and add a bunch of zeros and you’ll arrive at the parents’ situation, i.e., if the parents leave the $100k in the life insurance policy, then they are going to get a nice bump-up, all the way up to $150k, sometime in the future. As in: a buck’ll get’ch’ya a buck-fifty in no time.

Or will it? How much into the future might the parents’ leverage pay off? That’s the question, isn’t it? That’s the bet, with the insurance company on one side of the wager and the parents on the other.

Most life expectancies these days are in the mid-80s, which means that most people in their 80s are likely to remain aloft atop the thermals of life’s mortal plane for a number of years countable on the fingers of one, and perhaps two, hands. So let’s (a) assume that the death benefit for the policy remains constant at $150k, and (b) assume that the cash value remains constant at $100k (both of these assumptions are quite possibly incorrect given that many complicated life insurance policies offer up great big bouncing balls for both of those numbers — that’s one of the ways in which they are complicated and one of the reasons that the statements for these policies are so hard to decipher when you look at, say, the current year’s statement versus the previous year’s statement), and then (c) let’s say that we can presciently know, with 100% certitude, that the insured parent has five years left to float aloft life’s thermals. Doing the math, and doin’ it quick ‘n dirty, the return on their $100k of cash turning into a $150k death benefit is $50k, which is a 10% simple (not compounded) return on their cash per year.

I’ll just bet you that they are paying less than that on their mortgage.

If that’s all true, then if I were them I’d like the way things are just fine; the numbers say hold on hold on hold on to that insurance policy and stay stay stay with that mortgage.

*  *  *

And let’s close by looking at it from the insurance company’s perspective. From its perspective, if the parents give up the policy the InsCo has to pay them $100k. But if they keep the policy, then the InsCo is on the hook for $150k — due and payable maybe today, maybe tomorrow, maybe a dozen years from now. The InsCo doesn’t know, and neither do the parents or the son. It’s a guess.

But you wanna know what’s not so much of a guess? The InsCo is gonna be very happy if the parent’s listen to Dave Ramsey’s advice and give up their policy because (a) the InsCo has already been paid very handsomely for issuing and maintaining the policy, and (b) it just escaped lock stock ‘n barrel the main cost — that $50k death benefit bump on top of the cash value in the policy — of having issued the policy in the first place.

So, yea, it’s nice to not have a mortgage when you’re in your 80s, but, yea again, sometimes the numbers tell you that you should.

Which brings us to Friedman’s Law of Ecstatic Insurance Companies, which comes in two parts, as follows:

 

Never make an insurance company ecstatic.

You make an InsCo ecstatic when you surrender
an insurance policy just as you are coming into sight
of the main thing you bought when you bought
the insurance policy in the first place.

 

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