Cash Value Life Insurance

In broad terms, life insurance can be categorized as either (1) term insurance, which lasts for a finite period of time (e.g., 1, 5, 30 years) and simply provides a death benefit, or (2) permanent insurance (e.g., whole life, variable life, universal life), which also provides a death benefit, but will remain in effect as long as the premiums continue to be paid, regardless of how long the insured lives. Permanent insurance is accomplished by “over funding” the cost for the “pure” death benefit in the early years of the policy. This way the premium can remain level even as the insured ages and the cost of the “pure” life insurance increases. The “over funding” is accounted for in what is known as the cash value account. The cash value is the nonforfeiture value the policyowner is entitled to if all or part of the policy is terminated prior to payment of the death benefit. The cash value of the policy is often referred to as the investment component.

A major benefit of cash value insurance is that the policyowner can borrow from the insurance company against the accumulated cash value, often at a relatively low interest rate. Those funds can be used to finance retirement plans, pay college tuition, assist a child with a mortgage, or for any other purpose.

For more information on life insurance, see our separate topic discussion, Policy Types.

Whole Life

For those who elect to buy a whole life policy, insurers will deposit the portion of the premium you pay that is not used for expenses, taxes, and mortality costs, in their “general account.” Insurers invest money in their general account primarily in long-term fixed-rate securities (e.g., bonds, mortgages) that typically provide modest returns to the company. Some of the investment returns may be paid to the policyowner through dividend distributions (if applicable), but these returns reflect the insurance company’s overall performance and are not guaranteed. Policyowners have no control over how the funds are invested or how the returns are generated. However, the insurance company will guarantee a minimum cash value accumulation.

Caution: Guarantees are subject to the claims-paying ability of the issuing insurance company.

Whole life policies have several drawbacks. Because the cash value grows from primarily fixed-rate investments, they generally provide long-term returns that can be significantly less than what can be earned on other types of investments. Further, the policyowner is unable to influence the cash value account investment allocation.

In addition to whole life, insurers have developed other types of cash value policies, including variable life, universal life, and variable universal life, that offer more flexibility.

Variable Life

With a variable life insurance policy, policyholders have a choice in deciding how to invest the cash value account in their policy. The cash values are held in subaccounts. The insurance company will usually offer a wide variety of investment options, such as domestic investment vehicles and international stock, as well as a fixed rate option, so that the policyowner can diversify the cash value account with selections that are most appropriate for his or her personal financial situation. The return on the cash value account will be dependent on the performance of the underlying subaccounts. There is no guaranteed minimum cash value as with whole life. A variable policy may be appropriate for those who can tolerate the degree of risk associated with each type of investment and who want more control over their financial assets.

Universal Life

With a universal life policy, the insurer invests the cash value in a fixed-rate account that is subject to change at regular intervals. Policyowners have no control over how the funds are invested. These accounts can yield attractive returns when rates on fixed-rate investments are high. However, long-term returns can’t easily be predicted. The insurance company will provide a predetermined minimum interest rate on the cash value account. Universal life policies typically allow policyowners to raise or lower their premiums on an annual basis, unlike whole life or variable life. This flexibility with premium payments is one of the primary advantages of universal life.

Variable Universal Life

Variable universal life insurance policies, a combination of universal life and variable life, provide policyholders with the investment option and control features of variable life and the premium and withdrawal features of universal life. Like variable life, variable universal life gives the policyowner the freedom to choose how his or her cash values are invested. A variable universal life policy may be appropriate for someone who can tolerate the higher degree of risk involved, and who wants maximum flexibility for premium payments and withdrawals.

Caution: Variable life insurance and variable universal life insurance policies are offered by prospectus, which you can obtain from your financial professional or the insurance company. The prospectus contains detailed information about investment objectives, risks, charges, and expenses. You should read the prospectus and consider this information carefully before purchasing a variable life or variable universal life insurance policy.

The “Living Benefits” of Your Policy

Loans

One of the benefits of cash value life insurance is the ability to borrow from the insurer using the policy cash value as collateral. All permanent life policies typically allow policyholders to borrow against their cash value.

The insurer makes the loan from the insurance company’s general funds, using the policy’s cash value as collateral. Some policies set the interest rate at an amount equal to the amount the company credits to the policy’s cash value. Other policies set the amount slightly higher than the amount credited to the cash value. Interest starts accruing immediately, and is either fixed for the life of the contract or changes periodically in step with a published bond index.

Taking a loan against an insurance policy reduces both the cash value and the death benefit. While there is no requirement to pay back a loan, if it is not repaid before the insured’s death, any outstanding loans and interest will reduce the death benefit that beneficiaries receive.

Policy loans generally do not generate immediate tax liability for the policyowner as long as the policy remains in force. However, if the policy lapses or is surrendered, the policyowner will be required to include the outstanding loan balance as gross income to the extent the loan proceeds exceed the investment (premiums) in the policy.

Withdrawals

Variable universal life and universal life insurance policies also allow policyholders to make withdrawals. To make a withdrawal, one only needs to pay a small administrative fee. The downside to policy withdrawals is that they permanently reduce the policy’s cash value and death benefit. In addition, if the policy is classified as a modified endowment contract (MEC), withdrawals, including loans and partial surrenders, will be subject to immediate taxation to the extent that the policy’s cash value exceeds the premiums paid. In addition, withdrawals from a MEC made prior to age 59½ may result in a 10 percent penalty, unless an exception applies.

If you have questions, contact the Experts at Henssler Financial: