The Baldwin Method of Comparing Life Insurance Policies

The Baldwin method is a somewhat more complete variation of the Belth yearly rate of return method that seeks to cure some of the inadequacies of the previously discussed comparison methods. Perhaps its most notable feature is that it combines both rate of return with the value of the insurance actually received into one measure. It also adjusts for policy loans and for the opportunity cost of funds and incorporates tax considerations. Despite this relative comprehensiveness, it is basically a user-friendly system. 

It works like this:

1. Determine how much life insurance is provided by the policy in any given year. This is computed by subtracting the total current asset value (what you would get if you cashed the policy in today) from the total death benefit to determine the “net amount at risk.”

2. Determine what has been paid to maintain the life insurance in force for the year. This is computed by adding the premium, the net after-tax loan interest cost (if any), and the net after-tax (opportunity) cost of cash left in the policy. The opportunity cost of the cash left in the policy is the cost of not borrowing from the policy if you could have invested policy loans at a greater after-tax return than the after-tax cost of borrowing from the policy.

3. Determine the cash benefits received as a result of maintaining the policy in force for the year. This is computed by adding the current year’s divided (if any) to the current year’s increase in cash value, account value, or asset value.

4. Determine the investment in the contract. This is computed by subtracting any loans outstanding (plus any unpaid interest) from the total asset or cash value.

5. Determine the dollar amount of return (net gain or loss) earned in the current policy year. To derive this amount, subtract the costs derived in (2) from the benefits derived in (3).

6. Determine the cash-on-cash return for the year. This is computed by dividing the net gain or loss [from (5)] by the amount invested [from (4)].

7. Determine the equivalent taxable return. To derive the before-tax rate of return that is necessary to provide an after-tax return that is equal to the currently tax-free return in the policy, divide the rate of return in (6) by (one minus the combined tax rate).

Example. If the combined local, state, and federal tax rate is 40 percent and the rate of return in the policy is 5.4, you would need to earn 9 percent in taxable investments to have 5.4 percent left after tax [5.4% ÷ (1 – 40%) = 9%].

1. Determine the value of the life insurance protection received for the year. This is the truly new element added by Baldwin’s method. It recognizes that the value of life insurance protection can vary from person to person and is at least partly subjective. Some people have no need for insurance protection and place no value on the life insurance protection provided by the policy. For these people, the equivalent taxable rate of return in the policy is the total measure of the value of the policy.

However, most people will place at least some value on the insurance protection. In general, if protection is desired, its value should be equal to at least the absolute minimum term insurance cost for an equivalent amount of protection available to the insured. That is, the most accurate cost per thousand dollars of coverage would be the figure you could obtain as a result of applying to an insurance company for an equivalent amount of term insurance, submitting to medical examination, and receiving an offer for term insurance at a contractually guaranteed rate. Once the equivalent retail value of term insurance is determined, it is multiplied by the amount of life insurance (in thousands) provided by the contract [from (1)] to determine the value of the insurance in the contract.

1. Determine the total value received (total benefits) as a result of continuing the life insurance contract. The total value is equal to the year’s net gain or loss [from (5)] plus the life insurance value [from (8)].

2. Determine the percentage return on the total benefits. This is computed by dividing the total benefits [from (9)] by the amount invested [from (4)].

3. Determine the equivalent after-tax return that matches the tax-deferred/tax-free return from the life insurance contract. Divide the percentage rate of return [from (10)] by (one minus the combined tax rate).

The Baldwin method overcomes some of the problems associated with the other comparison methods, but still depends on the values shown on the ledger statement, which must be closely scrutinized for accuracy and the reasonableness of the underlying assumptions. Also, like the Belth methods, it provides a series of annual rate of return figures for as many policy years as you wish to measure. It is quite possible for each of two policies to show superior performance for some years and inferior performance for others relative to each other. Therefore, rankings of policies may be ambiguous.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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