The main purpose of a life insurance policy is to make sure that your family is provided with a sum of money which can replace your income if you pass away.
In some cases, however, you might benefit more from a policy which – in addition to a death benefit – also provides you with living benefits, like cash value, which you can access during your lifetime. This type of life insurance is called cash value life insurance. It is another name for permanent life insurance, which provides a cash value component.
With cash value life insurance, your coverage starts right from the moment the policy comes into force and ends only when you die. Unlike a term life policy, it does not have any expiration date. It can, however, lapse if you are unable to pay the premiums for any reason.
The premium you pay is usually divided into three portions – one portion for the death benefit amount, one portion for the cash value component, and one portion for the insurance provider’s operating costs.
The cash value of your policy increases with every premium payment you make. You can access it for your financial needs if and when needed – either by making a partial withdrawal or by getting a loan.
You are allowed to withdraw a portion of your policy’s cash value without paying any fees or penalties. The amount you withdraw, however, will get deducted from the face value of your policy.
For example, if your policy has a death benefit of $200,000, and if you withdraw $20,000 from the cash value portion, your policy’s death benefit gets reduced to $180,000, which is the amount your family will receive if you were to pass away.
If a partial withdrawal is not sufficient to cover your financial needs, you can get a loan from your insurance provider using your policy’s cash value as collateral.
The amount you borrow needs to be paid back with interest. If you pass away before repaying the loan, the total outstanding amount (the amount you borrowed plus the interest charged by the insurer) will be deducted from your policy’s death benefit.
You are not required to pay any taxes on the amount you withdraw or the loan you get from the insurer – as long as it does not exceed the amount you have paid into your policy’s cash value account up until that point. If it exceeds the amount you have paid into the cash value account, it will be treated as taxable income.
The rate at which the cash value grows depends on the type of policy.
In this type of policy, the cash value tends to grow at a fixed rate, which is guaranteed by the insurance company. So, you are assured of cash value growth year after year – regardless of the company’s performance or market conditions.
With universal life, the cash value account accrues interest and grows in value as long as the policy stays in effect. There is a minimum guaranteed interest, which is credited to your account by the insurer on a regularly irrespective of other factors.
The interest rate tends to go up if the insurance company and market performs well. As a result, your policy tends to build cash value at a faster rate.
In this type of policy, the cash value component is linked to a market index like the S&P 500 or Nasdaq 100. So, the rate at which your policy accumulates cash value depends on the performance of the index.
The interesting thing to be noted here is that the money in your cash value account is not invested in the market at all.
It earns interest based on the index’s performance. If the index performs well, your policy’s cash value account tends to earn a higher rate of interest. If it performs poorly, the rate of interest tends to go down.
One of the downsides of an indexed universal life policy is that there is usually a cap on the amount of interest your cash value account can earn. So, even if the market index performs spectacularly well, you are not likely to get proportional returns on your investment.
In this type of policy, the cash value growth rate is highly variable and entirely dependent on market performance.
The insurance provider usually offers you several equity and debt-based investment accounts to choose from. Depending on your preference and risk tolerance, you can choose the sub-accounts where you want your money to be invested.
Given below are the common factors that insurance providers take into account while calculating your policy’s premium.
As is the case with any other type of life insurance policy, the premium of a cash value insurance policy increases proportionately with the amount of coverage you need. The larger the coverage amount, the higher the premiums.
Your age is one of the primary factors which determine your insurability, based on which your policy premium is calculated. If you are young, you will pay lesser than an older person for the same amount of coverage, owing to your lower mortality risk.
If you are a man, you will be charged a slightly higher rate compared to a woman of the same age for the same amount of coverage. This is because women, on average, tend to have a longer lifespan than men.
If you are free of pre-existing conditions and in good health, you will qualify for the lowest risk class, which means your premium will also be lower compared to someone who is diabetic or suffering from hypertension.
The occupational fatality rate in high-risk occupations like mining, roofing, construction, trucking, logging, and firefighting is much higher compared to most other occupations. So, if you work in any of the aforementioned occupations, you are likely to pay a higher premium compared to a teacher or an investment professional.
The medical history of your family members is also a factor that is taken into account by the insurance company while calculating your policy premium.
If one or more of your family members have diabetes, heart disease, or cancer, you might be genetically predisposed to developing these problems as well. In which case, the insurer might bump up your premiums.
Many insurance companies check the driving record of the applicants during the underwriting process. If you have a clean driving record, you are likely to qualify for a lower risk class compared to someone who has piled up many traffic violations or a DUI.
A cash value life insurance policy covers you until your death. The policy stays in force as long as the premiums are paid regularly – irrespective of other factors. Knowing that your dependents do not have to rely on anyone for their financial needs in your absence can give you a tremendous sense of security.
One of the biggest advantages of a cash value life insurance policy is that you can use the cash value component like a savings account, which can be accessed from time to time for your financial needs. There are three ways in which you can access your policy’s cash value.
You can withdraw a portion of your policy’s built-up cash value. The amount of money you can withdraw depends on the terms and conditions of your policy.
You can take out a loan from your policy's cash value account. There are three advantages to borrowing against your policy’s cash value.
If you have a universal or variable life policy, you can use the accumulated cash value to pay your premiums as well. This provision can be extremely beneficial for you during periods of financial instability – if you are between jobs, if you are dealing with a health problem, if your business has suffered a loss, and so on.
During these times, you can pay the premiums using the built-up cash value and make sure that your policy does not lapse.
For example, if you are a 30-year-old non-smoker, a 20-year, $250,000 term life policy will cost around $12 per month. A $250,000 whole life policy, on the other hand, is likely to cost you around $200 per month.
Understandably, not many people can afford to pay $200 per month for life insurance coverage. Data from the Society of Actuaries reveals that nearly 40% of whole life policyholders tend to terminate their policies within 10 years, as a result of not being able to afford the premium payments.
Many people tend to think of cash value life insurance as an investment. It is, however, not true at all. The returns you get on the cash value component are meager compared to what you can get if you invest the same amount of money in an index fund.
Purchasing a cash value life insurance policy might be a good idea under the following circumstances.
If you decide that you no longer need lifelong coverage, you can surrender your policy. Once you do, the insurer will pay you the accumulated cash value.