Liquidity in life insurance is a term used to describe whether or not a policy will be paid out in the future. If a life insurance company owns your policy, and you die within 10 years of applying for it, your payout will be applied to your designated beneficiary rather than being paid back to the insurance company.
Many people get confused at the 20-year mark when they are approaching their “future needs”, but it is important that someone know what liquidity means before they purchase a life insurance policy.
What is Liquidity in life insurance?
The most basic definition of liquidity, borrowed from the investment world, is how soon you can receive your money. Many people are surprised to find out that they have no liquidity at all in their current life insurance policy.
The standard term for the term “liquidity” in life insurance is “covering benefits”. The implication of this phrase is that you will be able to receive your payout under certain circumstances, typically death or permanent disability. This sounds absolutely wonderful, but it also means that if you die within 10 years of applying for your policy, then you are not covered. Everyone’s situation is different, but most people would love to have some degree of liquidity on their policy.
What is an example of liquid in a life insurance contract?
The easiest way to describe liquidity in life insurance is what it looks like in the current market. Most of the really solid non-tobacco applicants will get a policy with a term of 20 years and at that time they will have a cash value somewhere between 25 and 40 percent of their original premium. This means that eight or ten years out from the application date, your investors will get approximately one-quarter of your investment back. This could be $25,000 dollars or more, which is not bad for an investment!
The standard terms for life insurance are 10 years for covering benefits, 20 years for liquidity, and 30 years for full cash value.
What does liquidity refer to?
The liquidity in life insurance of a contract is how long the company will hold onto your cash value or death proceeds instead of paying them back. This is only true for life insurance and does not apply to annuities.
To find out if you have any liquidity on your current policy, you need to check with your life insurance agent or search the internet for terms and conditions. If there is no solid information on their website, then call the agent and ask them what the liquidity on their policies is.
What is liquidity risk in insurance?
If you ask an investment advisor or an insurance agent to explain the risk in liquidity in life insurance, they will tell you that it is the risk of not getting your full investment back.
In order to understand this concept, you need to understand how a life insurance policy works. When you buy a policy and make premium payments each month or year, it is called a “contract”. This contract has a cash value and when the contract ends, then the cash value can be paid out in one of two ways. The first way is by death proceeds and this happens if someone dies before the full amount of premiums has been paid out. The second way is through dividends and this happens if someone dies after premiums are paid in full but before the term ends.
How does insurance provide liquidity?
When you make premium liquidity in life insurance payments. The company receives your premiums and uses those funds to cover future claims. Once the policy is paid up, then your cash value can be used to fund new insurance policies or dividends.
When you buy a term life insurance policy. Then your investors will keep some of your cash value. In their pockets, during the time that policy was in force. So if you have a 20-year term life insurance contract. And invest $50,000 dollars into it with a 50 percent return in premiums every year. Then after five years, you will have earned $20,000 dollars for yourself.
The main argument for a policy with liquidity in life insurance is that it is less expensive. Then a non-liquid life insurance policy. If you pay for a 20-year term and die before your contract is up. Then your company has to pay out your death expense. And send you back the cash value that you had put in. These are called “dividend lapses” and they are expensive to the company. Because they have to hold onto your money until the rest of the contract has been settled. It is important to understand that the company is not going to keep anything on your policy. There will be something held back until they have paid out the cash value of your policy.
If you buy a non-liquid insurance policy and die before it is through paying claims. Then there are no dividends to be sent to you, and you are basically dead.
Not all policies are guaranteed with liquidity in life insurance in them. So some advisors will say that they do not offer any liquidity. This is true in some instances, but it depends on a variety of factors that change depending on different policies. But the key is that liquidity is not a sure thing in life insurance.
The most common disadvantage that people feel when they lose their liquidity is the loss of capital. Since there is only a certain percentage of your cash value to be held back. Then you will be losing capital in the event that you die before your contract is through paying claims. And if your policy has no liquidity. Then you are basically dead because there will be no cash value to go toward new contracts or dividends. If you do not have enough liquidity. Then it means that the company has to pay out all the cash value of your policy. Regardless of how long it takes them. They could get stuck with liquidating assets such as mutual funds, stocks, or bonds.