Cash Surrender Value

Cash surrender value is the amount a life insurance company pays the owner of a permanent policy who gives the policy up before it ever pays a death benefit. It is the value the contract has accumulated, reduced by whatever the contract is still entitled to deduct, and taking it ends the coverage.

Two naming points are worth settling first. The Internal Revenue Code uses this exact phrase as a heading: section 7702(f)(2)(A) is titled "Cash surrender value", while 7702(f)(2)(B) is titled "Net surrender value". Bare "surrender value" is the market's shorthand and appears in neither heading, which is why this page is titled the way it is. More importantly, the phrase names slightly different amounts in the tax code and in insurance regulation, and the number that actually reaches the policyholder is a third one. This page uses it in the sense the state nonforfeiture laws use it, which is also the sense a policyholder means: the amount the insurer will pay on surrender. Section 7702(f)(2)(A) attaches the same words to a different figure, computed without regard to any surrender charge or policy loan, so a tax provision and a settlement statement can print the phrase against two different numbers on the same contract. That disambiguation, with all four definitions quoted and a worked example, belongs to the cash value life insurance page and is not repeated here. What this page is about is the surrender decision itself.

The reason a permanent policy has any cash value is a statute, not a product designer. Each state has a standard nonforfeiture law governing what a policyholder does not forfeit by stopping payment. California's runs as Article 3a of the Insurance Code, headed "Standard Nonforfeiture Law for Life Insurance" (sections 10159.1 to 10167.5), and section 10160 opens by providing that no policy of life insurance shall be delivered or issued for delivery in the state unless it contains in substance the listed provisions, "or corresponding provisions which are at least as favorable to the defaulting or surrendering policyholder as are the minimum requirements". Read that carefully: the values printed in the contract are a floor the insurer may exceed and may not go under. Nonforfeiture law is state law, so the mechanics below are California's and another state's numbers can differ; the structure is the part worth carrying.

The default outcome is insurance, not money, and that surprises people. Section 10160(a) requires that after premiums have been paid for at least one full year, a missed premium entitles the owner, on proper request made not later than 60 days after the due date of the premium in default, to a paid-up nonforfeiture benefit on a plan stipulated in the policy. Section 10160(b) then requires that on surrender within 60 days after that due date, and only after premiums have been paid for at least three full years in the case of ordinary insurance or five full years in the case of industrial insurance, the insurer pay "in lieu of any paid-up nonforfeiture benefit, a cash surrender value". Section 10160(c) supplies the sting: a specified paid-up nonforfeiture benefit becomes effective as the policy states unless the person entitled to elect chooses another available option within that 60-day window. Doing nothing is therefore a decision, and what it usually buys is a smaller permanent death benefit rather than a check. Section 10160(d) covers the other direction: once a policy is paid up, a cash surrender value is payable on surrender within 30 days after any policy anniversary.

Where to read the number, and what the printed number assumes. Section 10160(e) requires the policy to carry a schedule showing the cash surrender value and the paid-up nonforfeiture benefit available on each policy anniversary during the first 20 policy years, or the term of the policy if shorter. The schedule is calculated on two stated assumptions: that no dividends or paid-up additions have been credited, and that there is no indebtedness to the insurer on the policy. Both assumptions matter in practice. A participating policy whose dividends have been buying paid-up additions is generally worth more than the schedule says, and a policy carrying a loan is worth less, because the loan comes off before anything is paid. An in-force illustration from the insurer, rather than the printed table, is what settles the actual figure on a given day. The statute also lets the insurer keep the money for a while: the same section requires the policy to reserve the insurer's right to defer payment of any cash surrender value for six months after the demand is made with the policy surrendered, so a surrender is not necessarily a source of cash this month.

The tax is ordinary, and the loss usually is not deductible. Amounts received on surrender are taxed to the extent they exceed the investment in the contract, and the character is ordinary income rather than capital gain. Revenue Ruling 2009-13 puts it plainly in its first fact pattern, concluding that the income recognized "on the surrender of the life insurance contract is ordinary income". The insurer reports the distribution on Form 1099-R, whose title names insurance contracts alongside pensions and annuities. Running the other way, surrendering for less than the premiums paid generally produces nothing deductible, and the reason is instructive rather than arbitrary: the courts have held for ninety years that total premiums are not the cost of the contract, because, as the Third Circuit put it in a passage Revenue Ruling 2009-13 quotes, "[t]he part of the premiums which represents annual insurance protection has been earned and used." You consumed coverage; that part was never an investment to lose. A second rule closes the door on whatever is left, because section 165(c) limits an individual's deductible losses to those incurred in a trade or business, in a transaction entered into for profit, or by casualty or theft, and personal life insurance is none of the three. One further point sits on the boundary of this page: if a loan is outstanding when the contract is surrendered or lapses, the loan counts as an amount received, and the cash value life insurance page works that through in full.

The early-year numbers are the ones to ask for before signing, not after. On most permanent policies the guaranteed surrender value in the first several years is far below the premiums paid, and California's own statute reflects the shape of it by not requiring any cash surrender value at all until three full years' premiums have gone in on an ordinary policy. That schedule is printed in every contract and is available before purchase, so the least expensive time to discover what an early exit pays is while the decision is still open.

1. Premium builds a value inside the contract. What is left after the expense load and the cost of insuring the risk is credited to the policy.

2. The contract prints a guaranteed schedule. Under California Insurance Code section 10160(e) the policy must show the cash surrender value and the paid-up nonforfeiture benefit for each anniversary in at least the first 20 policy years, assuming no dividends and no loan.

3. Stopping premiums triggers the nonforfeiture provision. The specified paid-up benefit takes effect automatically unless another available option is elected within 60 days of the due date of the unpaid premium.

4. Electing cash ends the coverage. The cash surrender value is paid in lieu of the paid-up benefit, and the policy is over.

5. The insurer deducts what the contract allows and reports the taxable part. Any surrender charge still inside its schedule and any outstanding loan come off the check; the gain over the investment in the contract is reported on Form 1099-R.

A hypothetical, showing the gain. Rosalind's whole life policy reaches its twenty-second anniversary. The schedule shows a guaranteed cash surrender value of $86,400, the surrender charge schedule has expired, and there is no policy loan. She has paid $61,900 of premiums and has taken nothing out, so her investment in the contract is $61,900. She surrenders. The check is $86,400, and $86,400 − $61,900 = $24,500 is ordinary income on that year's return.

A second hypothetical, showing the loss that is not a loss. A different policy, eight years old, has paid in $31,500 of premiums and shows a guaranteed cash surrender value of $18,700. Surrendering produces a $12,800 shortfall, and none of it is deductible on a personal policy, because the missing amount paid for eight years of coverage that was in force the whole time.

A third route, from the same schedule. Instead of taking the $86,400, Rosalind can elect the paid-up nonforfeiture benefit the same table states. The accumulated value is applied as a single premium to a smaller amount of permanent coverage, no further premiums are due, nothing is received, and so nothing is taxed now. Whether that is better than the cash depends on whether anyone still needs the death benefit.

Pros

• The value is a legal minimum rather than a promise, because a standard nonforfeiture law makes it a condition of issuing the policy in the state.
• The guaranteed schedule is printed in the contract, so the worst case for each of the first 20 years is knowable before the policy is bought.
• Taking the cash is a settled, administratively simple exit, with the insurer reporting the taxable amount rather than leaving the owner to compute it.
• Where the coverage is genuinely no longer needed, surrender converts an asset that was doing nothing into one that can.
• The alternative on the same schedule, a paid-up amount of insurance, keeps coverage in force with no further premium and no tax today.

Cons

• Surrender is final. The coverage ends, and reinstating or replacing it depends on the insured's health and age at that later date.
• The early-year values are severe. A policy given up in its first several years typically returns far less than the premiums paid, and the shortfall is not deductible.
• The printed schedule assumes no loan and no dividends, so the number a policyholder remembers is often not the number they will receive.
• A surrender charge still inside its schedule reduces the payment, and on some contracts a market value adjustment moves it again.
• Payment is not necessarily prompt. California's statute has the insurer reserve the right to defer a cash surrender value for six months after the demand, so the money is not a substitute for an emergency fund.
• The gain is ordinary income in a single year, which can push other income into a higher bracket or across an income-tested threshold.