Ignoring this client asset may become an advisor's nightmare

Key Points
  • Permanent life insurance with cash value allows clients to grow a pot of money that they can access free of taxes via a policy loan.
  • These insurance contracts require periodic review to prevent them from lapsing and to ensure that their premium and interest rate assumptions are still correct.
  • Failure to maintain these contracts could result in sharp cost increases, loss of coverage and, in the worst case, surprise income taxes.
Caiaimage/Trevor Adeline | Getty Images

When it comes to clients who own permanent life insurance with cash value, financial advisors have both an asset and a liability.

On the one hand, clients appreciate having a financial advisor who can analyze the contract and ensure that it still meets their goals.

"It's a perfect way to build relationships with clients, especially when it's a policy you didn't sell, and you look like a rock star," said Thomas J. Henske, a certified financial planner and partner at Lenox Advisors in New York.

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However, if an advisor chooses to ignore the insurance contract, you may end up with a train wreck.

"Suddenly the client is in their 60s, 70s or 80s, and they get a letter that says the policy has lapsed because it didn't have enough cash value to support the costs," Henske said.

"That's not going to be a good day," he said.

Here's what you should know about the proper care and maintenance of your client's life insurance.

Cash value
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With permanent life insurance, a portion of your client's premiums is directed toward a cash-value account, where it grows tax-deferred.

Depending on the contract, the insurer might credit a stated rate of interest toward the cash value — as is the case with universal and whole life.

In variable life contracts, clients can invest their cash value in the market via sub-accounts.

What's the purpose of the policy today? It's likely changed in the last 20 years due to the client's situation and because of the policy itself.
Michael Michlitsch
director of ValMark Financial Group's policy management company

Used properly, these insurance policies can act as a source of tax-free money in retirement, in the form of a policy loan.

If a client withdrew their contributions to the policy, they'd get them tax-free, but any earnings withdrawn could be subject to income taxes.

With a policy loan, however, that same client can borrow from the cash value free of taxes and use the contract as collateral.

Tax-free cash in retirement allows retirees to adjust their income and manage their tax brackets.

Where it goes wrong
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Insurance companies use a set of assumptions — including crediting rates and internal expenses — when they initially illustrate the performance of a cash value life insurance policy.

The variables plugged into the assumptions can change over time, so a decades-old illustration may no longer accurately show the contract's performance.

"For variable universal life, some of the original illustrations from 20 years ago assume a 10% to 12% rate of return," said Michael Michlitsch, director of ValMark Financial Group's policy management company.

Suddenly the client is in their 60s, 70s or 80s, and they get a letter that says the policy has lapsed because it didn't have enough cash value to support the costs.
Thomas J. Henske
partner at Lenox Advisors

"They likely haven't performed at that rate, so we run an in-force illustration at 6% or 7%, and that shows that the policy is far behind," he said.

It's only through an updated illustration that an advisor might figure out whether an insurance policy requires additional premiums to remain in force or whether a loan is imperiling the cash value.

"In the illustration, if you see the cash value runs out in 20 years and the premiums paid don't support the contract — that's what I'm looking for," Henske said. "Analyze that illustration and simultaneously share it with the client."

Need for review
Martin Barraud | Caiaimage | Getty Images

Life insurance may not require the quarterly review you would give to a 401(k) plan, but you should still make a point of going over contracts periodically.

Advisors recommend obtaining an in-force illustration from the insurer every year to three years.

Here are four factors to weigh during a review:

1. Policy administration: Has the client made timely and correct premium payments? This sounds intuitive, but sometimes contract holders forget. Occasionally, insurers make administrative errors and the premiums aren't correctly applied, said Michlitsch.

2. Performance: Don't rely on a policy illustration from years ago.

Neither interest rates nor stock market performance are today what they were in 1999.

Ask for an in-force illustration with updated assumptions.

Be cautious if there are outstanding loans. In that case, you may have to shift gears, either by reducing the amount the client plans to borrow or by funding more premiums.

"You have to manage clients' expectations because the policy might not support it," said Tom Love, vice president of insurance analytics at ValMark Financial Group.

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3. Applicability to the financial plan: If a client bought a policy years ago, revisit his goals for the contract. Did he want to grow the cash value or was his priority the death benefit?

If those goals have changed, then the advisor might need to revisit the policy's funding and the amount of death benefit.

"What's the purpose of the policy today?" asked Michlitsch. "It's likely changed in the last 20 years, due to the client's situation and because of the policy itself."

4 .Beneficiary designations: Key events such as a divorce or marriage should kick off a review of the beneficiary designations. Be sure that you have current contract information for all the parties listed.

"Beneficiaries marry and move," said Love. "It doesn't always get communicated to the insurance company."