Just say no to no cash values

May 1, 2002 (original: May 16, 2001)

Life insurance agents often downplay the importance of cash surrender values. You may regret listening to them.

First, a review. There are two main types of life insurance: term and cash value. Term insurance is pure protection, whereas cash value life insurance combines protection and savings. The main types of cash value policies are traditional whole life, universal life, and variable universal life. All cash value policies operate like an interest-bearing checking account. You pay premiums into the policy, and the company deducts insurance and expense charges and credits investment earnings. If you decide to terminate the policy, the company subtracts a surrender charge from the internal fund balance and gives you the remainder, which is called the cash value or the surrender value or the cash surrender value.

A brief history of cash surrender values

Cash surrender values did not become mandatory in the U.S. until the late 19th century. Prior to that, people who could not continue to pay premiums might lose their entire investment in the policy. A succession of nonforfeiture laws refined the methodology for determining minimum cash surrender values. The minimum values for today’s policies are governed by each state’s Standard Nonforfeiture Law. When an insurance company designs a new life insurance product, it has to file a memorandum with the state insurance department demonstrating compliance with the Standard Nonforfeiture Law. Actuaries, regulators and consumer groups are now discussing how to update these nonforfeiture laws for the 21st century. Some proposals would eliminate mandatory cash surrender values.

Why do you absolutely, positively want your policy to have a cash surrender value at all times of the day and night and every day of the year and every year for the life of the policy? Because if you decide that you want to drop the policy, you will lose a valuable tax-saving opportunity if the policy has no cash surrender value.

Here’s the deal: Section 1035 of the Internal Revenue Code allows you to do a tax-free exchange from a life insurance policy to an annuity. If you have a gain in the life insurance policy, a "1035 exchange" lets you defer paying income tax on the gain. What if you have a loss; that is, what if the surrender value of the policy is less than the total premiums that you’ve paid? Losses on life insurance policies are generally not deductible, but — here’s the trick — in a 1035 exchange the cost basis of the life insurance policy carries over to the annuity, and it can then be used to avoid paying income tax on future gains in the annuity.

Example: You’ve paid $100,000 into a life insurance policy that has a cash surrender value of only $60,000, and you’ve decided that you want to replace the existing policy with something better. Instead of dropping the policy or exchanging it for a new life insurance policy, you can do a 1035 exchange to an annuity and buy a new life insurance policy with other money. The annuity will have an initial value of $60,000 and a cost basis of $100,000. So you can wait until the $60,000 grows to $100,000 and then cash out the annuity, with no income tax due on the $40,000 gain. Or you could let your money continue to grow inside the annuity and pay tax later on gains above $40,000. Or you could put more money into the annuity with the goal of getting a $40,000 gain more quickly.

And what if your policy has no cash value? Well, my friend, in that case you’re in deep doo-doo. It’s unlikely that you’ll be able to do a 1035 exchange, which means that you’ll miss out on a nice tax shelter. You have one chance: if you can persuade the insurance company to voluntarily waive a small amount of the surrender charge, you’ll have a cash surrender value that will let you do a 1035 exchange to preserve the cost basis. Your personality will determine how you go about that task. Some people will make nice with the company, while others will have their attorneys write a nasty letter. Whatever works. For your convenience, I’ve prepared two form letters that you can use.

Kissy-kissy version

Dearest Insurance Company:

I love you. You are such a nice insurance company. I’m sorry that I’ve never told you how often I think about you.

I love your home office, too. It is very pretty, and it smells nice.

Could you do me an itty-bitty favor? I noticed that my life insurance policy has no cash surrender value. I’m sure that this was just an oversight, because you’re so busy helping people with your wonderful products. Could you give me a tiny cash surrender value? It would really mean a lot to me. Thank you very, very much.

Your adoring policyholder,

Punch-in-the-nose version

Hey, bozos:

You should fire the person in your legal department who drafted the defective life insurance contract that you sold me. My policy has no cash surrender value, so I can’t carry over my cost basis to an annuity in a 1035 exchange.

This really sucks, and it’s entirely your fault. It would cost you just a few dollars to provide a benefit that could be worth thousands of dollars to your policyholders. Doesn’t anyone at your company review your products before you sell them to the public?

I want you to amend the contract to provide a small cash surrender value. If I don’t hear from you within 14 days, I will take other actions to protect my interests.


When an auto manufacturer sells defective cars, there’s a recall. When a toy manufacturer sells defective toys, there’s a recall. When a life insurance manufacturer sells defective life insurance policies...well, there ought to be the equivalent of a recall. One way to fix this problem is to put an endorsement on all new and existing life insurance contracts. The wording could be something like this: "If this Policy is exchanged for an annuity issued by the Company or another insurance company, the Cash Surrender Value will be the greater of $25 or the amount determined in accordance with the other provisions of the Policy."

This defect in life insurance contracts probably hurts hundreds of thousands of people every year. There are about seven million cash value policies sold to individuals each year. The great majority — let’s say 90% — are sold by commissioned agents, and the great majority of agent-sold policies — let’s say 80% — have no cash value in the first year. Most companies lose at least 5% of their policyholders in the first year, and first-year termination rates of over 10% are not unheard of. But let’s say 5%. Multiply 7,000,000 by .90 and then by .80 and then by .05, and you get 252,000. And that’s with conservative assumptions, and ignoring policies that terminate after the first year with no cash value. So this isn’t something that affects just a few people.

If you have an unwanted life insurance policy that has a cash value, here are a few tips about implementing the 1035 exchange to an annuity:

The owner of the annuity should be the same as the owner of the life insurance policy, and the annuitant should be the same as the insured.

You can make the best use of the rolled-over cost basis if you avoid variable annuities that have high annual expenses and high surrender charges. That means sticking to low-load annuities, such as TIAA-CREF’s Personal Annuity Select and Vanguard’s Variable Annuity Plan, that don’t pay high commissions to salespeople. If you want a fixed annuity, look at the fixed account in TIAA-CREF’s variable annuity.

If you want to roll over only a portion of the life insurance policy’s cash value, you have two choices: (1) you can roll over the entire amount and then take a withdrawal from the annuity (that’s one reason to choose a low-load annuity with no surrender charge); or (2) if possible, you can withdraw money from the life insurance policy before you do the exchange.

If you want to do an exchange from a life insurance policy with a loan, it’s probably best to have the life insurance company wipe out the loan and transfer the net cash value to the annuity issuer; some annuity companies will not do exchanges with loans. (Warning: If the policy has a gain, this could trigger income tax.) You could also repay the loan and then transfer the gross cash value.

Most 1035 exchanges are done from one life insurance policy to one annuity, but some insurance companies are willing to do exchanges from several life insurance policies to one annuity, or from one life insurance policy to several annuities. But one-to-one is the standard method, and you should consult a tax professional before you try something different.

After the 1035 exchange is completed, you should contact the annuity issuer to verify that the annuity’s cost basis is correct. In my experience, insurance companies are surprisingly unreliable at handling 1035 exchanges properly. A common error is to report the rolled-over cash surrender value, rather than the rolled-over cost basis, as the new annuity’s cost basis. This obviously defeats the purpose of the 1035 exchange. It’s also possible that the company will initially get things right but that someone will review the records later, decide that a mistake was made and make a change — without notifying you. And here’s a real problem: if the life insurer does not report any cost basis to the annuity issuer, the IRS may argue later when you take money out that the cost basis is zero. Ouch.

There is no limit to the number of 1035 exchanges that you can do. After you exchange the life insurance policy for an annuity, you can exchange the annuity for another annuity (but you can’t exchange an annuity for a life insurance policy, because that would create a tax loophole that would be too good to be true). Don’t forget, however, that insurance companies probably lose money on annuities that aren’t kept in force for at least a few years, so it is rude to drop an annuity soon after buying it. You ought to do your homework before you buy the annuity, so that you don’t need to do another switch for a while. (It is also rude to drop a life insurance policy soon after purchase, but that act is easy to forgive because so many life insurance policies are sold inappropriately.)

Losses on annuities are ordinary losses, which are deductible against ordinary income. So does it sound like a clever idea to do a 1035 exchange to an annuity, and then cash out the annuity and deduct the loss? Be prepared for a challenge from the IRS, which may understandably view your maneuver as a transparent attempt to turn a nondeductible loss on a life insurance policy into a deductible loss on an annuity. And even if the IRS accepts the 1035 exchange, it could argue that the cost basis for the purpose of computing the deductible loss is less than the cost basis used in computing gains. Also, some tax experts believe that annuity losses are subject to the 2% floor on miscellaneous itemized deductions; that will make losses nondeductible for many people.

Zero cash values: A case study

A retired couple retained me to review their life insurance policies. They were particularly concerned about a $5 million second-to-die policy that they had purchased one year earlier. They had paid an initial premium of $48,100, but they did not want to pay a second $48,100 premium to keep the policy in force. I examined the policy and agreed that it made sense to terminate it. I suggested that we do a 1035 exchange to an annuity to use the $48,100 cost basis as a tax shelter. Unfortunately, the policy had a $180,000 surrender charge that wiped out the $71 account value and also made it impractical to add money to the policy to create a small cash surrender value.

My client contacted the company’s general agent and asked about doing a 1035 exchange, but the general agent said that an exchange was not possible because the policy had no value. I gave up on that agent and turned to AnnuityNet.com, which distributes a low-load variable annuity from the same insurer. They got the insurer to waive the surrender charge so that the tiny account value would become the cash surrender value, allowing the $48,100 tax basis to carry over to the annuity.

My client can now add money to the annuity, and the first $48,029 (i.e., $48,100 – $71) of investment gains will be tax-free. For example, if they deposit $50,000, the new cost basis will be $98,100 (i.e., $48,100 + $50,000), and they can let the $50,071 account value grow to $98,100 without any income tax. If they die in the interim, their executor may be able to use the excess cost basis as a deduction against ordinary income on their final income tax return.

The next step: Big is better than small

Now that you see the importance of having at least a small cash surrender value, why stop there? If small is good, wouldn’t big be better? Yes indeed, and here’s why:

  • There is a close relationship between cash values and commissions. The reason that agent-sold policies usually don’t have any surrender value in the first year is that the insurance company spends the entire first-year premium on commissions and other selling expenses. When you look at a sales illustration for a life insurance policy, the first thing to check is the first-year cash surrender value, because that will give you a good clue to where your money is going. Is it staying in the policy for your benefit, or is it going to the agent and the other people involved in selling the policy? If you don’t want to pay high commissions, you have two choices: (1) you can buy a low-load policy, which has low distribution costs (and therefore high first-year cash values) because it is sold directly to the public or through fee-for-service advisers; or (2) you can use blending (also called "dial-down commissions") to reduce the commissions and improve the cash values and death benefits of agent-sold policies. For more information, see the list of low-load products and "The Basics of Blending" at glenndaily.com.
  • There is a close relationship between cash values and the fair treatment of all policyholders, which means those who keep their policies in force for a long time as well as those who don’t. Cash values provide terminating policyholders with a share of the internal fund created by premium payments; they promote equity between terminating and persisting policyholders. When cash values are artificially low, terminating policyholders are forfeiting their share of the pie for the benefit of the insurer or the sales agents or the persisting policyholders; this is called lapse-supported pricing. Proponents of lapse-supported pricing argue that it is expensive to provide cash values, and there is some truth to that. The insurer has to put up more capital to support the business, and it has to give greater weight to liquidity in choosing investments. In that sense, cash values create inefficiency. But the fact remains that the essence of lapse-supported pricing is robbing Peter to pay Paul. From that perspective, cash values are expensive in the same way that it is expensive to buy merchandise in a store instead of stealing it. For more information about this issue, see "Lapse-supported pricing: Is it worth the risks?" at glenndaily.com.
  • At the time of purchase you may plan to keep your policy for a long time, but the odds are against it. Based on industrywide experience, more than one-third of all cash value life insurance policies are dropped or replaced within 10 years, and more than two-thirds within 20 years. Lapse rates vary by company, issue age and type of product, but even high-quality companies lose a lot of policyholders. When you drop or replace a policy you receive the cash surrender value, so a higher cash value means that you’ll have more money to reinvest.
  • A high cash value makes it easier to dump a policy if its performance or the insurer’s financial strength declines. If insurability isn’t a problem, you’re not faced with the tough choice of accepting a large loss by bailing out or possibly losing even more money by staying in.
  • If the company gets into financial trouble and is taken over by regulators, a higher cash value will let you keep the policy going for a longer time without having to pay additional premiums. No one likes to throw good money after bad, and a high cash value gives you more freedom to wait and see.
  • The cash value determines the maximum loan that you can take against the policy for premium payments or any other purpose.
  • If you own the policy outside an irrevocable trust, the cash value is an asset that you can put on financial statements to support a bank loan application.

In sum, cash values are your safety net against unforeseen events. High cash values offer more protection than high financial strength ratings and should be given considerable weight in choosing a policy.

Life insurance policies designed for corporations and wealthy individuals have high early cash values. Sophisticated buyers demand that. You don’t have to settle for less.