What Is Cash Value?
Life insurance companies use cash value life insurance as a cash reserve for themselves. They sell cash value products like whole life insurance or universal life with the intention of building long-term customers. The insurers selling these things are stupid. They want to make money off of them. But, they also don't want to turn away individuals. Insurers know that poor products don't survive in the marketplace. While existing customers may keep a policy that is merely "OK", they'll never buy another one.
Life insurance companies became aware, long ago, that their customers were unsatisfied with paying premiums for life insurance for their entire life and never receiving anything in return. These policies expired after a set term. The policy was then worthless to the consumer.
Some very savvy actuaries (professional mathematicians) decided to increase the premiums paid to life insurance policies and level out those premiums so that they would never increase. In addition to this, part of the premium, plus interest, would be set aside to pay for future costs of insurance. The money that is set aside is the cash value.
I'll focus on whole life insurance for a moment, since this is the most basic form of cash value insurance. It's also one of the most misunderstood. There are several types of whole life insurance on the market. They can broadly be placed into two categories: dividend-paying and non-dividend paying.
Dividend paying life insurance is life insurance which earns dividends. Simple right? The insurance company collects premiums and invests those premiums on your behalf. The cash reserve that builds up against the death benefit represents what's called the "guaranteed rate of return" of the policy.
However, company profits are also shared with policyholders. Companies selling whole life insurance often "over-collect" premiums from policyholders, since they're trying to be conservative in their assumptions about how much money they need to have on hand to pay insurance claims. This overage is returned to the policyholder when a dividend is declared.
Some of the dividend will represent actual profits, however, once all of the overage is returned to the policyholder. Instances where no further premiums are being paid to the life insurance policy, and yet dividends are still being earned are a demonstration that the dividends clearly represent profits of the company being paid to policyholders.
These dividends may be used to purchase additional paid up life insurance, which requires no further premiums but which generates its own cash value and, in turn, its own dividend payments.
Non-dividend paying life insurance is life insurance that does not pay dividends. Instead of sharing company profits or returning overage charged, the insurer simply credits the policy with interest based on its contractual guarantee to the policyholder. Premiums may be slightly lower on these types of policies, but the potential gain you realize in the cash value is also lower.
The big misconception about whole life insurance is that the cash value, in and of itself, is a ripoff. This couldn't be further from the truth. To clear up this misconception, we should look at what's actually happening here.
Cash Value As Cash Advance
You should really think about the cash value of a whole life insurance policy as a cash advance. A cash advance on what? Well, the cash value of the policy is a cash advance on the death benefit. Life insurance companies make it clear that the cash value is a savings, but they don't really describe the nature of the savings. The marketing division of most life insurance companies are interested in marketing, not education.
Life insurance actuaries, however, are interested in describing what is happening in these policies. They must be accurate. If they aren't the policy will not work. Actuaries design life insurance policies, and they never make the distinction between death benefits and cash values that marketing companies and the marking arm of life insurance companies do.
The cash value is a cash reserve building up against the value of the death benefit. As the cash value builds up, the difference between the cash value and the face amount--the death benefit itself--decreases. In fact, this difference between the cash value and the death benefit is called the "net amount at risk." It's called this because this is the amount of money that the insurance company stands to lose if a claim is filed on that policy.
The cash value represents money earned to satisfy that claim. Now, it should become even more clear why actuaries do not distinguish between "cash value" and "death benefit." They are essentially the same thing. What changes over time is your access to the death benefit.
When you borrow against a life insurance policy, the insurer reduces the amount of death benefit it will pay by an equal amount. If the cash value and death benefit were actually separate from each other, then the death benefit would be unaffected.
Is cash value life insurance evil? Not at all. Is it right for everyone? Certainly not. Different policies pay different rates of return. This is no different from any other conservative investment in the marketplace. The life insurance company doesn't steal your cash value when paying the death benefit. It merely gives the rest of the death benefit, which was illiquid during your lifetime, to you.
When you buy whole life or any cash value policy for that matter, keep this in mind. You'll get exactly what you pay for. But, you should understand exactly what you're actually getting.
Cash value is sometimes referred to as "trash value" by some financial advisers. These advisers mainly have a bone to pick with the low paying interest rates on many whole life policies. It's true that many whole life policies do pay 2 to 3 percent on the cash value. That's low. It's like buying a bank CD. So, it's about as evil as buying a bank CD, if you will.
Some advisers focus on the idea that the insurer doesn't pay you the cash value and the death benefit when you die. This is normally true, but there is a reason for this. The cash value is the death benefit. I have no idea why this escapes as many insurance professionals and CFP (Certified Financial Planners) as it does. It's life insurance 101.
The cash value is money set aside to pay for the future death benefit claim. This is money that is actually earned by the insurance company through its various investments. The fact that it's made available to you during your lifetime means that it's essentially a cash advance on the death benefit. You can't have your cake and eat it, too. Which means, you can't have two death benefits when you're only paying for one.
Some advisers criticize life insurance companies for charging interest on life insurance policy loans. This, too, is a baseless argument. It's a loan. It's not a withdrawal. It's like taking loan against the equity value of your home.
You can't withdraw money from a whole life policy, unless you're withdrawing dividend payments. This is because the policy's death benefit isn't payable until your age 100, the cash value is the death benefit, and therefore you can't withdraw the death benefit until age 100.
At the end of the day, if you're comfortable with the terms of the contract, and you understand what you're really getting, then buy a cash value policy. If you're not comfortable with the terms, don't buy one.