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From Stick House To Brick House

Sangita Joshi Rousseau

Whatever your financial condition, cash reserves are valuable; there is never a point where you can say you won’t need them.

But while cash reserves are desirable and necessary, the safety and liquidity they require have opportunity costs; this cash could perhaps yield better returns if placed in other investments. The perceived impact of these opportunity costs is magnified by the current low-interest rate environment. When many safe, liquid financial instruments credit less than one percent interest, it’s hard to be excited about keeping money in them.

It prompts the question: Are there alternatives?

There are. Under the right circumstances, and with thoughtful planning, life insurance cash values could be an attractive destination for longterm cash reserves.

Characteristics of Cash Values

If you were looking for a good place to hold cash reserves, you would certainly want these features: security, liquidity, tax advantages, and higher returns. Here’s how cash values fit that criteria:

• Although cash value accumulations are not backed by the Federal Deposit Insurance Corporation (FDIC), the financial stability of insurance companies is in many ways comparable to, and some might argue, even exceeds that of banks. (More on this later.)
• In conventional whole life insurance policies, there are guaranteed accumulations1, as well as a history of consistent dividend2 payments.
• Cash value policies from highly-rated life insurance companies have current annualized dividend rates in excess of 5 percent.
• Cash value increases are not subject to taxation while they remain in the policy.
• Policy owners may access cash values either as withdrawals or loans.3 Taxation applies only if the amounts withdrawn exceed the total premiums paid.

If a cash value account existed as a separate financial instrument, everyone would consider it for cash reserves. But you can’t have the benefits of cash values unless you own a whole life insurance policy. And that means paying for a life insurance benefit.

With a permanent life insurance policy, premiums purchase life insurance protection and build cash reserves. In a typical premium schedule, these cash values accumulate slowly in a policy’s early years because a larger percentage of premiums are allocated to insurance costs, reflecting the insurance company’s risk from an insured dying well before life expectancy. Consequently, for some policies, there may be no available cash value until several years of premiums have been paid.

Thus, life insurance cash values are not a good starting point for accumulating cash reserves. However, once you have cash accumulated, you may want to consider a gradual transition of these reserves into life insurance cash values. Two strategic elements to facilitate this transition: Paid-up additions and convertible term insurance.

Paid-Up Additions Rider4
Besides accumulating cash values through regular premium payments, the process can also be accelerated with additional premiums. In what might be considered analogous to extra principal payments on a mortgage, “extra” premiums are used to buy chunks of paid-up insurance and cash value, which is added to the existing policy. Paid-up additions can significantly increase cash values, even in a policy’s first year.

However, to maintain its status as a life insurance policy and preserve some of the tax advantages, there are restrictions on how many paid-up additions can be purchased in a policy year, and how quickly the policy can be paid up. A primary factor in these restrictions is the size of the insurance benefit. And that’s where convertible term life insurance may play a part.

Convertible Term
If you can’t have cash values without having life insurance, and the size of the insurance benefit determines how much cash value can be added, how much permanent life insurance will you need for your long-term cash reserves? Nobody knows. But you can secure options to add permanent life insurance in the future with a large term insurance policy that has conversion privileges. This feature allows a policy owner to incrementally exchange portions of the term coverage for a permanent policy (or policies).

To illustrate: A 35-year-old male buys a $2 million convertible term policy, which represents his current economic value. Over the next two years, he accumulates $20,000 of cash reserves in a savings account (safe, but earning less than one percent). At 37, he converts $200,000 of the term policy to a whole life contract (while keeping the remaining $1.8 million term benefit in force), and systematically transitions his cash reserves into the policy, both as premiums and paid-up additions. He continues to accumulate additional cash reserves in the savings account, and at a later date, converts another $200,000 to transfer these funds to cash values. This approach delivers several important benefits:

• There is a high level of immediate life insurance protection at an affordable premium.
• By accumulating first in a bank account, there is enough total liquidity to manage the low cash values during a permanent policy’s early years.
• At the same time, paid-up additions can accelerate cash value growth.
• Cash values currently have higher rates of return than savings accounts, plus tax advantages.
• The policy owner has flexibility to manage life insurance protection, determine premium allocations, and select future conversion amounts.

So… “Stick House, Brick House?”
Are life insurance cash values really a viable alternative for cash reserves? In an October 2012 article “Banks Versus Insurance Companies, Which is Safer for Your Money?” authored by the financial analysis company FSFG, there is a comparison between a stick-built home and a brick one:

Banks, the stick house, are good for storing liquid cash for short term needs due to their accessibility. Insurance companies, the brick houses, are the strongholds that best protect your savings from the many dangers that exist within the financial industry.

Do you have cash reserves that could be transitioned to whole life insurance with cash values? You’ll always have a need for cash, and there may be real benefit in keeping some of it in a “brick house.”

It might be worth your time to meet with a financial professional and see if the details of your personal finances are a good fit for this strategy.

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