If you have watched US television networks lately, you may have come across a commercial that shows two men dressed like miners talking beneath the kitchen floor where seniors are discussing their tight cash flow situation. The “miners” comment on how the individual above doesn’t know she or he is sitting on a gold mine, referencing the fact that they could sell their existing life insurance policy for cash. I tend to cringe every time I see this ad, not because the strategy of selling a policy is necessarily bad, but because the information provided is vague, not adequately explained and possibly misleading.  Before we dig into this, let’s review some basics with respect to life insurance. For one, there are two basic types – term and permanent. 

 

We typically look to a term policy when a defined risk with a finite time horizon is identified, such as when we take out a mortgage and need to insure against leaving our loved ones with a massive debt when we pass. It may also be simply insuring against the loss of income to support those around us. This type of insurance can become very expensive as we get older, however, once mortgages are paid off and we have retired, the need for a term insurance solution diminishes. From a financial planning perspective, this is usually when we advise clients to dispose of such policies as the benefit becomes offset by the increased costs.

 

A permanent policy is designed to address the financial implications of one’s passing, where those risks exist indefinitely. There are many situations where this applies, such as covering a large tax hit in an estate that arises from capital gains on physical property or securities. A permanent policy may also be used to provide a legacy to heirs and charities. I won’t go into all the various types of permanent policies, but suffice to say that they can be funded over a finite period of time (say 10 years) or over the lifetime of the individual. In some policies, a cash surrender value is generated, which can enhance the final death benefit. Policies can also be designed where no further premiums need to be made after a certain period of time (where the cash in the policy is used to cover the pure cost of the face value insurance amount).

 

Insurance policies can be viewed as assets and the cash surrender value of a permanent policy would be listed on your net worth statement (or statement of assets and liabilities if held in a corporation). One would think that, like other assets, a policy could be sold to provide much-needed cash. There are some important things to consider though. First, the rules in the U.S. are different than here in Canada. Outside of Quebec, you cannot sell your insurance policy to a third party (like the company in the advertisements). Second, the transfer of ownership of a life insurance policy can create a tax liability, which is something we routinely examine when individuals look to moving existing policies from individual ownership to their corporation and vice versa.

 

With these points in mind, let’s take a look at what you should consider if the question of keeping or getting rid of a policy comes up. The obvious first question is why you have the policy to begin with. Did it come from an examination of risk within a financial plan? Second, what is your financial capacity to maintain that policy. Third, if you were to sell this policy to a spouse or family member, what is the ability of that individual to maintain that policy and what are the tax implications in that transfer? I am going to look at a few specific situations where a policy need not or should not be sold or exited.

 

We may have an individual (or couple, if it is a joint policy) that is getting on in years and has a term policy that is going to see an increase in premiums. The problem is that this person is facing cash flow constraints.  If the face value of the policy is sizable and the individual wants that death benefit to pass to their heirs, ownership of the policy doesn’t have to be switched to keep it in force. The heirs can simply provide the funds to pay for the policy until the individual’s passing. There is no tax implication because ownership has not changed.

 

We had a recent situation where a senior, who had a joint-last-to-die permanent policy with their deceased partner, was told that in order to keep the policy in force, she would need to pay an additional nominal amount per month. Using her financial plan, we could calculate what that cumulative cost over her life expectancy and compared it to the what the policy would pay out to the children. In this case, it worked out to less than 10% of the death benefit, so it completely made sense to continue the policy. Cash flow was not going to be an issue but, had it been, we would have likely sat down with the beneficiaries to see if they could help keep it in force.

 

There are also examples where an individual or couple have a permanent policy and have paid up all premiums as set out in their original illustration, but are facing a deficiency in the funds within the policy to maintain it for the rest of their life. This typically happens in a universal life policy, which may have been invested in higher risk funds that experienced erosion because of weak equity or bond market performance. As an aside, many polices have seen their dividend generation improve because of higher prevailing bond yields.

 

In the event of a permanent policy that has a cash surrender value, it is possible to borrow against that value in order to augment cash flow. This is not that much different than borrowing against the collateral in physical property or a portfolio. Depending on the other elements of one’s estate, creating a liability against the cash value of a policy might be a good strategy. When we look at this in a corporate-held policy, it becomes more complicated and it definitely requires the advice from tax and wealth professionals.

 

Bottom line, insurance policies are not well understood by many to begin with. If put together on the basis of risks or gaps identified in a comprehensive planning process, then there is less risk that an individual, couple or corporate entity will be a position where cash flows will not support the policy - leading to cancellation or sale. In the event where it looks as though a policy cannot be financially maintained or where it represents an asset that can be sold to provide required liquidity, then an even more careful analysis should be applied. Just like a financial plan should be reviewed on a regular basis, insurance policies should also be put under the microscope alongside those planning reviews.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew Pyle

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.