Cash Surrender Value

What is the Cash Surrender Value?

Cash surrender value is the money that the life insurance policyholder will receive if they actually withdraw before the completion of policy or his death; this value is at times, lower than the maturity value, depending upon the time passed from the date of initiation of the policy till the date of surrendering it.

Explanation

At times, the policyholder may require the amount he has set aside for the insurance policy, for some urgent current need. He may either take a loan against the policy, or he may surrender the policy and withdraw the accumulated savings in the same after the deduction of fees and charges as per the terms and conditions of the policy.

We need to understand that the surrender value is after all previous withdrawals and loan payments, if any taken, against this policy plus the accumulated interest on the same. There may be partial or full surrender variants within the policy and the applicable penalties depending upon the criteria set in the policy.

Cash Surrender Value

How Does Cash Surrender Value in Life Insurance Work?

  • Basically, a policy requires periodic premium payments that are accumulated in the policyholder’s account. Tied to this policy, there is a benefit that the policyholder gets at the time of his death or at the time of the maturity of the policy. This benefit is known as a death cover.
  • Now, as the number of periodic premium payments increases during the tenure of the policy, the amount accumulated under the death or maturity benefit increases. This happens due to accumulated interest on the total amount in the account and bonus terms and conditions. At the end of the policy period or in case of death, this accumulated amount is returned to the policyholder or his heirs.
  • Now suppose the policyholder requires this to use the corpus, then he may surrender the policy. If he surrenders it very early in life, then the accumulated amount is very low, and therefore the surrender charges eat up most of the accumulated amount, and the surrender value is low. Therefore most policies have a surrender period in which the surrender charge is applied, and once this period is over and the amount is required after it, then there is no surrender charge as the accumulated interest has covered it up. In such a case, the surrender value is higher.
  • Now let’s look at why this surrender charge is applied. At the time of selling the policy, there are certain costs incurred by the insurance company related to selling and putting the policy in place by completing the required paper-work. These costs form part of the surrender charges. Once the premiums start flowing in, the insurance companies start investing the same at higher return investments after reserving some amount that they may immediately need in case of sudden payment of a policy is required.
  • Some of the interests earned by the investments are kept by the insurance company, and some of it goes to the policyholder depending upon the policy conditions. Through this investment, the insurance company recovers its costs and makes its profits.
  • As the policy ages, its initial expenses get recovered. So once they are fully recovered and the surrender period gets over, there is no surrender charge on the premature surrender.

How is Cash Surrender Value Calculated?

The calculation of surrender value can vary from one policy to another and is specified in the policy document. However, a simple equation can be as follows:

Cash Surrender Value = Enhanced Accumulated Value – Surrender Charges.
  • Enhanced value can be the total accumulated invested amount, including periodic interest.
  • Surrender charges could be expressed in percentage terms and may vary based on the age of the policy.

Example

Let us understand the below example.

You can download this Cash Surrender Value Excel Template here – Cash Surrender Value Excel Template

Suppose Policyholder Mr. X has a policy for 30 years with annual premiums of $10000 and a cover of $1 million if he prematurely dies; otherwise, after 30 years, the total accumulated amount + 10% bonus on the corpus will be distributed to him. To put this policy in place, the insurance company has incurred $5000 in costs. Further surrender period specified by the policy is ten years during which, a surrender charge of 1% on the premiums unpaid will the chargeable, and none will be chargeable if surrendered after ten years. The return to be received on the premium amount is 5%.

Solution:

Basically, now we understand the given numbers:

Cash Surrender Value Example 1

We need to solve the following equation to arrive at the required FV:

FV = PMT * ((1+r)^ n -1)/r

Cash Surrender Value Example 1-1

  • = 10000 * (1+5%)^30-1)/5%
  • = 664388.48

Cash Surrender Value Example 1-2

So if he remains invested, he will get the FV + 10% of FV = $730,827.32

Cash Surrender Value Example 1-3

Case 1:

If he withdraws after ten years, he will get

Case 1 (given Data)

We need to solve the following equation to arrive at the required FV:

Cash Surrender Value Case 1-1

As there are no surrender charges, the cash surrender value is $125,778.93

Case 2:

If he withdraws before ten years, let’s say in 6 years time

Case 2 (Given Data)

We need to solve the following equation to arrive at the required FV:

Case 2-1 (Fv)

Of this, 1% on unpaid premiums is deducted as a surrender charge.

Premiums un-paid are 24 years x 10000 = 240000

Now we will calculate Cash surrender Value:

Cash Surrender Value Case 2-2

  • = 68019.13– (0.01 x (240000))
  • = $65,619.13

As we can see, the surrender charges are lower than the initial expenses incurred by the insurance company because it adjusts some amount due to the interest it earns on the premium amounts it invested. Therefore the charge reduces as the number of premiums remaining unpaid falls, and after year 10, the insurance company assumes it will recover at least all its cost and therefore charge no surrender charge.

Cash Surrender Value Taxation

According to the Internal Revenue Service (IRS), the tax authority in the US, the cost basis of an insurance policy is the total of the premiums paid. So any amount of surrender value that is greater than the total premium paid is considered as gain.

  • Amount accumulated in the policy is not taxed.
  • Loan payments against the policy are also not taxed.
  • Withdrawal up to the amount of the cost basis is not taxable. Excess of it is taxable at regular income tax rates instead of capital gains tax rate if the policy is “not property described.”

An example can explain the tax calculation:

Suppose the policyholder X received the cash surrender value of $80,000 after the deduction of 5000 surrender charges. The total premium paid by him till then was $70,000, so the amount of income to be taxed is cash surrender value – total premium paid, 80000-70000 = $10,000

Cash Surrender Value vs Cash value

Cash Value is the accumulated amount in the policy account, which in the above example, we have termed as enhanced value. Whereas Cash surrender value is the money that the policyholder will receive if he actually withdraws before the completion of the policy or his death.

In the above example, the surrender charge is the difference between the two, and once the surrender period is over, the cash value and cash surrender value are the same.

Conclusion

To sum up, the calculation of surrender value varies as per the policy terms and conditions, and the policyholder should read the policy documents properly before entering into it to assess whether the given policy is appropriate considering his financial circumstances. The policyholder should also look at the tax consequences of surrendering his policy as per his jurisdiction and then decide whether it is best to surrender the policy or take a loan against the same to meet his immediate need.

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