How Cash Value Builds in a Life Insurance Policy

In order to understand what cash value is in a life insurance, we first need to understand the concept of a life insurance policy. A life insurance policy basically provides financial and monetary protection to the dependants of the insured after his or her death. A life insurance policy is a legal contract between the insurer or the insurance company and the policyholder. It ensures a guaranteed payment to the beneficiaries of the insurer upon his/her death. Various life insurance channels are present like term life, variable universal life, whole life and universal life.

A life insurance policy is comprised of three major components. These are:

Death Benefit:

 Death benefit is the sum of money which is guaranteed by the insurance company to the beneficiaries of the insured upon his or her death. The death benefit amount is chosen by the insured on the basis of the estimated future requirements of the dependants. There needs to be an insurable interest which is determined by the insurance company and if the insured fulfills the requirements of the company, he/she is eligible for the coverage.

Premium:

The cost of insurance (COI) which covers costs like administrative fees, policy maintenance fees and mortality costs helps determine the premium payments. Some factors that have an effect on the premium payments are occupational hazards, insured’s age, personal risk propensity and medical history. As long as the insured pays the premium amount on time, the insurance company has an obligation to pay the death benefit as stated in the policy.

Cash value:

 Cash value in case of a permanent or universal life insurance generally has two uses. It acts as a savings account in which cash accumulates on a tax deferred basis. This account can be used by the policyholder during the lifetime of the insured. Some policies tend to restrict withdrawals by the policyholder which depends on the use of the withdrawn money. Cash value of life insurance also offsets the rising cost and provides insurance and safety as the age of the insured increases.

What is Cash Value Life Insurance?

This is a permanent life insurance as it gives coverage for the life of the policyholder. Generally, cash value life insurance demands higher premiums than other term insurance plans because of the presence of the cash value element. Cash value life insurance policies demand a fixed premium payment out of which a part is used for the cost of insurance and the remaining amount is transferred into a cash value account. The insured earns interest on this amount on a tax deferred basis. The risk of the insurance company decreases as the cash value increases as it offsets a portion of the insurer’s liability.

After there are sufficient funds accumulated in the cash value savings account, these funds can be used by the insured to build an investment portfolio that can help the insured in maintaining and accumulating wealth, take a loan at a rate which is lower than the bank’s interest rate, supplement the retirement income and can also be used to pay the premium amount of the insurance policy.

The process of cash value accumulation varies on the type of policy and the life insurance company. Normally, the process of cash value accumulation has the following details.

The premium payments are divided:

 The premium payments made on a cash value life insurance policy are divided into different components. One part goes towards the death benefit of the policy which is based on the health, age and other underwriting factors. The second part is used to cover the operating costs of the life insurance company. The remaining amount is for the cash value of the policy. This amount is generally invested in a conservative investment. As the insured pays the premium and keeps earning more interest on this amount, the cash value of the policy builds up over time.

The accumulation of cash value generally slows down as time increases. In a cash value insurance, the insured keeps paying a fixed amount of premium. In the early years of the policy, a large portion of the premium is allocated to the cash value which starts decreasing over time. This is because as the insured ages, the cost of the insurance company increases. Thus, a greater portion of the premium goes toward the operating costs of the company.

The accumulation of cash value varies from policy to policy. In case of a whole life policy, a guaranteed cash value account is provided which grows according to a formula determined by the insurance company. In case of universal life insurance policies, accumulation of cash value is dependent on the current interest rates. For variable life insurance policies, the amount is invested in sub investments. The cash value increases or decreases according to the performance of these investments.

Most policyholders commit the mistake of wasting their cash values. Upon the death of the policyholder, any amount remaining in the cash value account goes to the insurance company. To ensure that the cash value is not wasted, the policyholder can use it for the following purposes.

Pay for the premium amount using the cash value. This helps in saving up the premium amounts. In case a sizable amount has been accumulated in the cash value account, the policyholder can take a loan against that account. In case the insured needs funds, he or she can also withdraw the amount in the cash value account according to the policy rules. The insured can also choose to use these funds to create a retirement portfolio. Another use can be to increase the amount of death benefit to the beneficiaries.

Insurance advisors should be consulted to determine the potential cash value accumulation and how to ensure that the amount does not go to waste.