Reduce Your Life Insurance Costs

When interest rates fall, many of us consider refinancing our mortgages. We review the long-term savings versus the refinance costs and make a decision. Physicians can do this with their home mortgages, investment properties, and maybe even business loans. It is a common practice.

However, many physicians do not realize they can apply a similar cost-reduction and wealth enhancement strategy with another of their long-term assets: permanent (also called “cash-value”) life insurance. Ahead, we explain why you should consider reviewing your life insurance as you likely have already done with your mortgage.

How Life Insurance and Real Estate are Similar: Taxes

While our tax code may change under a new president, real estate and cash-value life insurance remain “tax-advantaged” asset classes—enjoying superior tax treatment over recent decades. With real estate, you can write off depreciation on business real estate, deduct interest payments on home mortgages, and enjoy up to a $500,000 capital gains exemption on the sale of the primary home, among other benefits. With cash-value life insurance, you can enjoy tax-deferred growth of gains within the policy, while death benefits are generally paid to beneficiaries income tax-free.

Further, both can utilize a powerful tax benefit that few other assets are afforded: the ability to move from one piece of real estate/life policy to another using a tax-free like-kind exchange. For real estate, these exchanges are controlled under tax code 1031; for life insurance, 1035. This shared tax benefit plays a role reducing in long-term costs. A 1035 exchange permits moving from an existing policy to another one (perhaps to lower costs or reap better distributions), without realizing built-in gains within the policy, and without any tax consequences.

How Life Insurance and Real Estate are Similar: Variable Costs

Both real estate and cash-value insurance have ongoing expenses like the interest cost of a mortgage for real estate and, with life insurance, the mortality cost of insurance (COI). These expenses accrue over time; the key is to monitor them and position yourself advantageously if the outside environment changes.

If interest rates fall below your current mortgage rate, you can refinance to take advantage of the lower rates, assuming closing costs will not completely eat up the savings. In some ways, the strategy is similar for cash-value life insurance. You may be able to exchange your existing policy for a new policy that provides lower costs and/or better net withdrawals. It is a relatively simple analysis—but it helps to go a little deeper.

How to “Refi”/Exchange

Unlike a mortgage, you do not actually “refinance” an existing cash-value life insurance policy—you exchange it for a new one, using the 1035 exchange provision described above. This is generally a simple process, but it usually requires new underwriting. This is important, because just as you would not refinance your mortgage if the closing costs are higher than the expected interest savings, neither should you exchange a policy for a new one if your health has worsened since you first acquired the policy because the costs of the new policy will likely exceed the costs of your existing policy.

With the help of a knowledgeable advisor, you can determine these factors in advance and model the numbers so you have all the information before making the exchange.

Note: if you have maintained a healthy lifestyle and remain in good health, there may be further financial incentive to exchange the policy.

Five Reasons to Exchange Related to Costs

There are five potentially cost-lowering reasons why owners exchange existing policies for new ones:

1. Industry-Wide COI Reductions: As a physician, you know people are living longer today. As a result, COIs have been dropping across the industry. Lower COIs mean lower insurance costs which mean better policy performance. If you began a policy more than 10 years ago, exchanging into a new policy with updated COIs could be reason enough to see greater cash value growth and distributions in future years.
2. You Are Still in Great Health: Did you get a top rating when you received your cash-value policy initially? Are you still in good health? If you answered “yes” to both questions, you may have the most to gain financially from a 1035 exchange because of the way insurance carriers price their policies. The carrier only had a snapshot of your health when they issued your policy (perhaps a physician's statement and blood/urine samples). They have no idea of your current lifestyle or health since policy issuance. With such little information, and potentially millions of dollars on the line, it is not surprising that the carrier's internal cost accounting gradually diminishes the value of your “preferred” or “super preferred” rating. After all, how do they know you haven't started smoking or gained significant weight? The bottom line: if you can still qualify for a top underwriting rating, you may have the most to gain by exchanging into a new policy to “revive” a lower COI structure. Your cash values and distributions could benefit significantly.
3. Costs Structures Between Companies: Separate from the specific COI expense, insurance carriers vary in their overall product pricing structures, even within the top-tier companies. Because some carriers' products are known for being more expensive in their cost structures, additional long-term cost savings can be gained by exchanging from one carrier's products to another carrier.
4. Moving to Policies with Lower “Access” Costs: What are “access” costs? The most important one by far is the “net loan rate” the insurance carrier will charge you for borrowing from your cash values. Beyond your basis (what you paid in over the years as premium), you will likely want to borrow additional cash value against your death benefits to access your cash value while you are alive—that's what makes your access to these amounts tax-free. Thus, the loan rate your carrier charges is significant—and unfortunately, often hidden by unscrupulous agents selling high-loan-rate policies. If you own a cash-value policy, part of your strategy for doing so is likely to access those cash values, perhaps in retirement. In fact, it is exactly this reason that both co-authors own such policies. If so, “access” costs are just as important as accumulation costs.
5. Moving to Mutual Companies: Some policy owners exchange their policies to those issued by mutual insurance companies—companies owned by the policyholders themselves. The rationale is that they are more likely to get the benefit of future COI reductions or avoid future loan rate hikes (and other cost efficiencies) as owners of the company, as opposed to owning policies issued by stock insurance companies where these savings may just mean more profits for shareholders. For a long-term asset like life insurance, eliminating the conflict between shareholders and policy owners may be a wise decision.

Two Reasons to Exchange Your Policies for Performance

In addition to lowering costs, many life policy owners consider exchanging their policies because of investment performance. Let's look at two reasons here:

1. Taking Advantage of New Product Features: How much more can your cell phone do for you now as compared to 10 to 15 years ago? While the differences in life policies may not be as visually dramatic as your old versus new iPhone, they can be just as dramatic financially. Policy elements such as return multipliers, index participation rates, long-term care riders, and benefit distribution riders are new to the industry over the past few years and can be beneficial for the right client. If the underwriting rating has not changed, these factors alone may be attractive enough to justify a 1035 exchange.
2. Moving from a Bond-Based Whole Life Policy to One With Some Stock Market Exposure: Anyone following investments knows the last decade has not been kind to bonds and other investments that are based on interest rates. With the federal funds rate at 0 percent or close to it from 2009-2016, many such bond-based or interest-rate-based asset classes have underperformed expectations. A whole life insurance policy is such an asset class, as its growth is based on an insurance company's dividend. With insurance companies' portfolios heavily bond-based, it is not surprising that most of the top-rated life insurance companies have seen their dividend rates decline steadily for the past decade. Though rates have climbed a bit recently, it may be awhile before they rise enough to see whole life policies return to what they yielded pre-2009.

As a result, for many clients looking for a decade or more of future growth in their policies, an exchange to a type of product that provides more upside than a whole life bond-based product may make sense. A description of these types of products is beyond the scope of this article but will be covered in the future.

CASE STUDY: Doctor Dan Improves Performance Exchange to Different Type of Product

Dan purchased a whole life policy at age 40 from a large well-known carrier, and he is now 52. While the carrier is a very solid one, as is their whole life product, it is also known in the industry to have relatively high expense charges. Dan was super-preferred when he initially purchased the policy and has maintained good health. Dan wanted to see how his whole life policy would compare with a different type of policy, perhaps one with more upside on the investments and lower cost structures, taking advantage of COIs and perhaps a different company's product.

We modeled several scenarios for Dan. We found that, if he were to 1035 exchange his whole life policy to a universal life policy with another top-rated company, he would enjoy significantly improved performance. While insurance carriers do not publish their COIs for whole life products, knowledgeable advisors can examine head-to-head performance numbers with identical ages, underwriting classifications, and assumed rates of return to see how the difference in distributions from the policy are impacted, thereby comparing their underlying cost structures. For Dan, a 52-year-old “preferred” risk, and assuming a 5.85 percent rate of return for each policy, the results are quite dramatic. The distributions in his current whole life policy are projected to be $53,696 annually for 20 years starting at age 65. With the same assumptions, the distributions from the new universal life policy would be $98,476 annually for 20 years starting at age 65. This is nearly $45,000 of annual improvement—or nearly $900,000 of increased distributions over 20 years!

This dramatic improvement is due to the factors discussed above: 1.) likely improved COIs moving from the whole life product to the universal product (we don't use exact numbers here because, per above, COIs for whole life products are not published) and 2.) the improved costs of accessing the cash values in the universal life policy vs. the whole life policy (see reason #4 above).

Conclusion

Any physician who owns cash value life insurance should at least explore an exchange to a more efficient policy to determine if it would be more beneficial in the long run. Nearly all doctors review their mortgages and contemplate refinancing; an exchange is similar, and may work just as well. We encourage you to examine your options.

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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.