Should you keep a poorly designed whole life insurance policy or ditch it and move on?

Should You Cancel Your Bad Whole Life Insurance?

The decision to cancel whole life insurance is not always an easy one.  We understand this.  We've discussed this subject with numerous people.  The biggest concern is still the money already paid to a whole life insurance policy.  The gist of the conversation goes something like “I already paid the premium and if I cancel I won't get that money back, so perhaps I should wait until I at least break even on my bad whole life policy before I cancel it.”

I completely understand the emotional pain tied to exiting when the money received equals some number less than the premiums paid.  It's a loss and not one you can claim on your taxes.  But perhaps focusing on this loss is precisely what the insurance company wants you to do. Possibly focusing on this loss creates more significant losses you never thought about.

The Sunk Costs of that Bad Whole Life Policy

Let's talk for a minute about sunk costs.  These are costs you incur that are gone, and you'll never regain the resources lost to them.  You'll hear the term in business and economic circles quite often because these disciplines stress the importance of ignoring sunk costs when making decisions following the price.

Let's use an example to explain:

Sunk Cost Example

Chris owns a men's fashion company that sells direct to consumers.  He recently spent months and many thousands of dollars creating a new line of dress shirts he hopes will be the next big thing in the men's fashion.  After a few months following the launch, it's becoming apparent that this idea won't be the one that brings riches and notoriety to Chris as a fashion mogul.

Chris is reluctant to shut down the new dress shirt line because of all the time and money spent developing it.  He's hoping he can at least recover his costs of bringing the line to market.

Focusing on the expense of developing and bringing the dress shirt line to market and using it as a reason to keep the failed project alive exemplifies a decision made by focusing on sunk costs.  From day one of the product launch, the money made (or not made) from the new product is immaterial to the expense associated with developing and bringing it to market.  The time to worry about that was many months and thousands of dollars ago.  Once Chris spent the time and money, it no longer matters concerning the money he makes selling the shirts.

At least it doesn't matter for decisions he makes to keep the product line around.  I say this because Chris' failed attempts to make the product line work could very likely prevent him from identifying the idea that will actually work and will make him wealthy.  So Chris' focus on the money and time spent as a reason to keep the project alive leaves him worrying about something he already paid and cannot get back.

Once you buy a whole life policy, the expenses deducted from your premium paid are gone.  The insurance company is never going to give them back to you, and any attempt to hold onto the policy until it recovers the money you lost could set you back many thousands of dollars in lost time accumulating cash with an alternative option.

This is easy to say from an academic perspective, but I assure you many people focus on the sunk cost and become emotionally attached to the money they'll never get back from initial life insurance fees.

Let's use a case study to understand this a bit further.

The Bad Whole Life Purchase

Jacob buys a whole life policy that seems like an okay deal in terms of cash value performance, but he feels like whole life insurance should have had more to offer.  The agent that sold the policy assured him he was making the right decision with this policy and provided many materials speaking to the superior strength of the insurance company as well as the many benefits afforded by whole life insurance.

Given the reassurance, and the lack of immediately available information on the subject, Jacob moved forward and bought the policy, but a nagging feeling persisted causing him to reach out to other life insurance professionals after the purchase to obtain a second opinion.  They always wait until after…I don't know why.

Sadly, Jacob discovers that other options existed and several of those alternatives perform far better for him than the policy he purchased.  But at this point, Jacob feels like canceling his current whole life policy leaves him with a significant loss because there's so little cash value currently his policy.  A large portion of the premium he paid is gone and walking away from this policy leaves him feeling foolish for not taking additional steps before he bought this policy.

Jacob begins to think that his best course of action is to sit tight and pay additional premiums until his current whole life policy breaks event.  Then he can buy a better policy and not take a loss on his decision to purchase his current whole life policy.

Here is a ledger showing us the projected values for Jacob's policy over the next 20 years:

Bad Whole Life Insurance Example

According to the ledger, if Jacob plans to keep the policy at least until he breaks even, he'll need to keep it for 13 years.  That means Jacob has to make 12 additional premium payments of $20,000 just to walk away from the policy without “losing money.”

What happens if Jacob walks away and simply starts over again?

Let's assume that Jacob will start over again at the beginning of year two.  That gives him enough time to have money for the second $20,000 premium.  Also, we're not going to worry about a 1035 exchange for the $1,967 because that'll slightly handicap the performance of the new policy versus Jacobs current policy.

Here's a policy we would design for Jacob in this situation:

Good Whole Life Insurance Example

Notice that by walking away and starting a new policy and paying the second planned $20,000 premium to this policy, Jacob is already ahead of his original plan.  Sticking with the old policy, he'd have $4,954 in cash value in the policy at the end of the second policy year.  With our design, he has $15,497.  That's $10,543 more than if he chose to keep paying the exact same premium to the old policy in a feeble attempt to recoup his losses.  He's actually digging a bigger hole.

Notice also the difference in cash value at the year he finally breaks even with the old policy, year 13.  The old policy is $46,066 behind the better policy.  So Jacob could wait 13 years, pay 13 premiums of $20,000 each year, and walk away with his “money back.”

Or…

He could pull the band-aid off, jump to the new policy with a “loss” of his initial $20,000 premium and end up $46,000 ahead in 13 years.

Losing $80,000 to save $20,000

On top of all this, look at year 20.  Originally Jacob hopes to have $555,812.  At this point, his current policy will certainly have a positive return.  Achieving 3.04% per year on his money at this point is respectable in today's interest environment.

But had he taken the initial $20,000 loss and moved on to a new policy, he's projected to have $637,601.  That's $81,789 more than his original policy.  So not wanting to take the “loss” from his initial $20,000 premium results in an $82,000 loss in the future when Jacob could have really used the money.

Waiting Could Ruin all Hope

But what if he does wait?  What if Jacob can't shake the horror of walking away at a loss and keeps his policy until he breaks even and then changes to a new policy?  At that point moving to a new policy isn't a better choice.

By the 20th year, he'll have $487,257.  I'm assuming that he would transfer his cash value from the old policy via 1035 exchange to the new policy.  So instead Jacob should keep the old policy and still have lost himself nearly $82,000 by the 20th premium payment.  On top of this, the difference in cash value between the wrong policy and the excellent policy will only grow as time goes on (i.e., in years 21+).

Let's pretend for a moment that switching at this point could produce better cash value results for Jacob.  He's now 13 years old and fingers crossed he can still qualify for life insurance.  We know that life insurance becomes much more expensive as you age, so waiting like this costs Jacob a lot of money.

When to Cancel the Whole Life Insurance Policy

If you purchased the policy within five years and find out it was a lousy execution for cash value design, there's a strong chance you should walk away with a better policy.  Yes, you might have technically lost some money in terms of premiums paid to be less than current cash surrender value, but you are going to lose way more in future cash value while waiting for the wrong policy to just be a little bit less harmful.

Even though my example above skipped the 1035 exchange of what little cash value was in the old policy, it might be worth taking this step to transfer any money (even a small amount) over to the new policy.  You'll at least keep your old cost basis, so that original premium payment (or a couple of payments) still counts towards your cost basis.

The Investor's Fallacy

I've run into a great many people who are in a similar situation to Jacob, and I'm always intrigued by the difficulty they have walking away from a bad decision.  My personal theory is it's a mind game they play.  If they don't cut ties with the old policy, they haven't officially (in their mind) made a bad decision.  It's akin to the person who thinks that by delaying a decision you've somehow taken a timeout and prevented yourself from having to make a decision–the truth is you've chosen to say no.

I also think that this thought process comes from old investment advice about waiting for asset price recovery.  When assets like stocks or real estate decline in value, we often advise people to stay put and not rush to judgment about the decision to purchase the asset.  Selling will only lock in a loss, as I've heard many investment salespeople say.

But whole life insurance isn't an investment in the traditional sense.  We know if you look at one type of policy compared to another, there's a good chance that the difference in performance will hold for most years.  Sure dividends could change, but a poorly designed whole life insurance policy isn't going to suddenly upend a perfectly designed policy due to dividend changes.

For the better whole life design to fall behind the poor whole life insurance design, the dividend at the company for the better whole life policy would need to drop by an unprecedented degree (for those keeping the score at home, the amount is around 200 basis points).

A Bad Whole Life Purchase Isn't going to Magically Become Better

Unlike an investment in stocks or real estate where the market might behave irrationally for a while and then return to normal, bad whole life insurance won't magically change and become wildly better.

If you buy whole life insurance intending to accumulate cash value with it, design matters…a lot.  Buying a poorly designed whole life policy is nothing like purchasing a stock that gets hammered by a bad quarter or some news report unfavorable to the company's mission.  Time isn't going to fade the unfortunate price fall.

Also unlike an unfortunate stock price fall, throwing more good money at a bad whole life policy won't augment returns when things go back to normal in the future–a bad design is it, there is no return to normal.  A poorly designed whole life policy will always be a poorly designed whole life policy and will always lag better-performing policies issued around the same time.

The money you think you are saving by staying the course to at least break even is costing you big time on future cash value growth you forfeit by not correcting your error as quickly as possible.  Making mistakes is a part of life.  People don't often (nor should they) judge you by the mistake you make.  Instead, they often judge you (rightfully so) by how you handle those mistakes.  You can't wait out a bad whole life purchase.  Your only option is to take swift and decisive action to mitigate the losses.

About the Author Brandon Roberts

Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. Brandon was born in Northern New England, and he currently calls VT home. He attended Syracuse University and graduated with a triple major in Economics, Public Administration, and Political Science.

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