If you’re looking for information on life insurance, you’ve most likely come across the words “cash value” more than once. Do you know exactly what cash value means, how it’s generated and how it can benefit you? In this article we will talk about everything you need to know about this concept that is key to permanent life insurance plans.
Cash value is very important because it will be the product of the efforts you make over the years to pay premiums, generating savings that will benefit you in the long run. Keep reading to find out how cash value in life insurance works.
Cash Value in Life Insurance: Article Contents
The first thing you should know about cash value is that not all life insurance policies includes this benefit. They are only applicable to permanent life insurance policies and are not offered with temporary or term life insurance policies.
All types of permanent life insurance plans, whether whole life, universal, variable or variable universal share two basic characteristics: they last for the policy-holder’s entire life and they generate cash value. In fact, sometimes permanent life insurance is called cash value life insurance.
With all permanent life insurance, the policy-holder is required to pay premiums, whether they are one-time premiums, twice yearly or monthly, in exchange for the coverage purchased. The money paid as premiums is what accumulates cash value over time.
This occurs because policy-holders are actually overpaying for their insurance for a good part of the term of the policy. Premiums are used to pay for the risk the insurance company assumes by extending coverage to the insured. And when a person is young, the risk is very low. However, premiums are always the same, meaning that you pay more during the first years of the policy than the cost of the risk assumed by the insurance company. Consequently, when the insured is older and their risk of mortality is very high, the insurance company doesn’t increase your premiums. At the same time this generates an over payment, or surplus with the payment of each premium.
The insurance company then invests this surplus into one or more associated savings and investment accounts. Depending on the type of life insurance you buy, the investment accounts are more conservative (as is the case with whole and universal life insurance), or more risky (as is the case with variable and universal variable life insurance).
The investments generate profits that accumulate and build up what is known as cash value. These earnings are subject to differed taxes, which is a big advantage.
In addition, this money is exclusively for the insured to use. Except under very specific circumstances, the funds cannot form part of the death benefit the beneficiaries of the policy receive.
The cash value can be used to take out a loan against its future value, or you can make partial withdrawals from it. You can also withdraw all the funds from it, which is known as surrendering the policy.
As you can see, cash value is one of the key components of permanent life insurance. It is such a defining factor that these types of policies can be summed up in just two concepts: face amount (the amount of the death benefit or coverage) and cash value.
Because of this, it is common for cash value to be confused with another concept relating to these types of policies known as surrender value. The surrender value is the amount of money the insured receives if they decide to return the policy and stop paying premiums. In this situation, the insurance company hands over the surrender value, or the amount the user has paid over time and the cash value this has generated, less any possible expenses. This ensures that the insured recovers what they’ve paid in as well as the savings the money has generated. Logically, they lose any right to coverage upon death and no one will receive a death benefit.
Insurance companies are more concerned than anyone in ensuring that these funds consistently generate cash value as this makes their products more attractive to the general public. Furthermore, the higher the cash value of a policy is, the lower the actual payout the insurance company will have to hand over when the insured dies will be. This is due to the fact that, as the added value of the policy increases, the risk assumed by the company decreases, since this cash value partially compensates the insurance company.
Here is an example of how this works: If a policy has a death benefit of $100,000 dollars, and provided that the insured has not withdrawn funds from or have outstanding loans against the cash value, the policy will have an accumulated cash value of $10,000 dollars that the insured has not claimed and belongs to them. Upon their death, the death benefit the company will pay out is $100,000, but since there are $10,000 accumulated that only the insured can claim (and is no longer able to do so), the insurance company will only have to pay out $90,000 for the death benefit in this case.
The best way to take advantage of the cash value in your life insurance policy is to use it strategically. Insurance policies have many possible uses, and the main ones are:
Withdrawing Funds. A popular option is to take out withdraws against the policy’s cash value. Taxes are differed on the money you take out, making this a very attractive option. On the other hand, policies generally restrict the number of withdraws you can take over a certain period of time, and they can also set a maximum amount for these.
Loans. Taking out loans against the cash value is one of the most common uses. The insured can apply for a loan that is equal to the entire amount they’ve accumulated as cash value. These loans have several advantages: you don’t have to qualify to get them, they have very competitive interest rates, and you don’t pay taxes on them. Just like with many other types of loans, the insurance company charges interest on the principal amount of the outstanding debt. It is also important to keep in mind that if you take out a loan against the cash value of your policy and die before it is paid off, the insurance company will deduct the outstanding balance of the loan from your death benefit, meaning that your beneficiaries will receive less money. On the other hand, if your debt is greater than the cash value, there is a risk that your policy might expire and you will lose coverage.
These types of loans offer attractive conditions and are very helpful in the event unexpected expenses arise. You can take out a loan against the cash value of your insurance policy as a short-term solution if you run out of cash if you lose your job, for example.
Payment of Premiums. One way to use the cash value accumulated by your insurance policy is to use it to cover premiums, allowing you to keep more of your cash each month. This allows you to stop paying premiums for a period of time, and use the cash value to cover them. Take care not to do this for too long, as this can end up using all the accumulated value and your policy might expire.
Partial or Total Surrender. As we’ve seen above, if the insured decides to end the relationship with the insurance company and surrenders their policy, they receive the added value (less costs, commissions and any outstanding loans). Of course, if you do this during the first few years of the policy, the cash value will be low or nonexistent. The longer you’ve had the policy, the better. Because of this, older people who don’t need to leave the death benefit to anyone can choose to surrender their policy to have more cash in the final years of their life.
As you can see, the importance of cash value in life insurance is not something you should overlook. If you are in the process of purchasing a policy, ask your insurance company how the cash value they offer works. Make sure you understand their characteristics and how the savings accounts associated with the insurance function. And make sure to ask about the conditions under which you can have access to these funds. The more information you have, the better you will be able to make the most of your policy’s cash value.