Are your life insurance sales proposals misleading?Article added by Ken Godfrey on October 18, 2011
Ken Godfrey

Ken Godfrey

Arlington, VA

Joined: March 12, 2011

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Many life insurance companies and financial professionals continue to include misleading comparisons in their sales proposals and insurance illustrations. As a result, many consumers may be making the financial decision to purchase permanent life insurance based on inaccurate comparisons and skewed projections.

Individuals and companies purchase permanent cash value life insurance for a variety of reasons. Some life insurance purchasers are very interested in the potential tax deferred appreciation of the cash values, while others are focused solely on the death benefit coverage.

Therefore, many insurance companies and professionals compare the various rates of return of life insurance to the equivalent taxable yield of other investment alternatives to highlight the value of owning permanent insurance. Improper comparisons and calculations can be misleading and may skew the results in favor of a particular type of investment.

Internal rates of return

In order to calculate the equivalent taxable yield on an investment compared to life insurance, the internal rate of return of the insurance must first be calculated. There are several ways to illustrate the internal rate of return for a cash value life insurance policy. Given their complexity, it is often easiest to use Microsoft Excel to make these calculations. Let’s look at a simplified single premium life insurance illustration.



Below are three different rates of return calculations for the life insurance policy:
    1. Annual IRR on cash values — This is the annual increase in cash values from year to year. This calculation can be made on either the a) account values or b) cash surrender values (factoring in policy surrender charges). This return is calculated by dividing the end of year cash value by the previous end of year cash value plus any premiums paid, minus one.

    Any policy withdrawals/surrenders/loans should also be included in the calculation. This calculation often assumes an annual premium payment at the beginning of the policy year for simplicity.

    Account value example:
    • Beginning of year account value = $0
    • Annual premium paid beginning of year = $100,000
    • End of year account value = $95,000
    • Divide $95,000 by $100,000, and you get .95 or 95 percent
    • Subtract 1 or 100 percent, and you get a -.05 or -5.0 percent annual rate of return
In this example, the rates of return are positive beginning in year two.
    2. Cumulative IRR on cash values — This is the cumulative rate of return on policy cash values. Similar to above, this calculation can also be made on either the a) account values or b) cash surrender values (factoring in policy surrender charges).

    Because many of the insurance policy expenses are front end loaded and returns in the early years are often negative, this calculation provides a better view of the long-term cash value performance. This calculation incorporates all cash inflows (premiums) and outflows (withdrawals/surrenders/loans).

    See the chart below for the differences in annual vs. cumulative IRRs on cash values. Once the surrender charges disappear, the corresponding rates of return on the account values and cash surrender values become equal.



    3. IRR on death benefit – This is the cumulative rate of return on the death benefit, assuming death occurs in each year. This calculation incorporates all cash inflows (premiums) and outflows (withdrawals/surrenders/loans).

    For permanent life insurance, this is the expected return over the life of the policy if held until mortality. The cumulative death benefit rate of return declines over the years due to compound interest. See the chart below.

The tax deferred accumulation of life insurance cash values is only achieved if the policy is held until mortality. If the policy is not held until death, any policy gains will be treated as ordinary income. Therefore, the annual and cumulative IRRs on cash values can be further evaluated assuming the policy is prematurely surrendered and any cash value appreciation taxed.
Moreover, for an in force life insurance policy, it is important that the rates of return are calculated on a sunk cost basis. This means that all prior policy cash flows are ignored and the current cash values are used as the initial premium/investment contribution.

Equivalent taxable yields

Once the internal rates of return are calculated for the life insurance policy, the equivalent taxable yield of an alternative investment can be determined. Since life insurance proceeds are received income tax-free at death, most equivalent taxable yield calculations are shown assuming death occurs in each year.

Making equivalent taxable yield calculations is not as simple as dividing the insurance rate of return on death proceeds by one minus the tax bracket. In the IRR on death benefit example above, assuming a 35 percent tax rate, this would show a pre-tax equivalent yield for an alternative asset of 26.9 percent, assuming death in year 10 compared to 17.5 percent for the life insurance.

Showing the equivalent taxable yield calculation this way assumes that the asset is fully taxable at ordinary income tax rates each and every year (e.g., checking account, savings account or CD). Therefore, this calculation can be extremely misleading because the life insurance results are shown in the most favorable light possible.

In reality, the alternative asset may have unrealized gains that are tax deferred, realized gains that are subject to capital gains and not ordinary income tax, receive an income in respect of a decedent deduction at death and/or receive a step up in basis at death.

For example, an asset that has gains that are 100 percent unrealized and receives a step up in basis at death will produce the same results as a life insurance policy (before estate taxes if applicable).

For instance, a homeowner does not pay income tax each year on the appreciation of the home and heirs will receive the house at death and take a basis equal to the fair market value at the date of death. Therefore, there will have been no income tax liability on the appreciation of this home. If cash flows are similar and the rate of appreciation on the home each year is equal to the IRR of a life insurance policy, then the two investment results will be equivalent and there is no need to adjust the life insurance IRR to a pre-tax equivalent yield.

Many life insurance companies and financial professionals continue to include these types of misleading comparisons in their sales proposals and insurance illustrations. As a result, many consumers may be making the financial decision to purchase permanent life insurance based on inaccurate comparisons and skewed projections.

Making these misleading comparisons may open the insurance company and/or producer to unwanted lawsuits in the future.

When comparing life insurance to other types of investments, it is important to understand the asset types, ownership structures and corresponding income and estate tax (if applicable) treatments to create an accurate comparison. There are many types of assets and ownership structures, so it is important to make sure the comparison is accurate and disclose the methodology and assumptions made for the calculations.

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