Life Insurance Definition of Cash Value of Policy

What is Cash Value?

• Cash value represents the value of a life insurance policy if the owner of the policy decides to cash it in instead of keeping it as life insurance. After paying monthly premiums month after month and year after year, cash value policies build cash value. Since all cash value policies have an investment component in addition to the life insurance, the amount of cash value depends on the monthly premium, the internal rate of return and other parameters established by the insurance company.
  
  

How it Works

• Start with the fact that the cost of life insurance increases as the insured ages. To track this, insurance companies use a mortality table to determine the cost per $1,000 of coverage based on age. The mortality table operates internal to the cash value policy. As owners invest their monthly premium into a cash value policy, a portion of the premium goes to buy insurance per the mortality table and what's left goes into an investment account. Over time, the investment account grows and the cash value of the policy grows. At any point in time, if owner decides to cash in the policy, she will get the cash value of the policy applicable at the time she cashes it in.
  
  

Advantages

• Cash value policies have three primary advantages. First, they can be used to facilitate permanent life insurance, which has long-term tax and estate-planning benefits. For example, upon the death of the insured, life insurance proceeds are not taxed and the proceeds do not have to process through probate. For this reason, individuals should be insured their "whole life" and cash value policies make this possible. Another advantage is the fact that policy owners can borrow against the cash value without having to cancel the insurance contract. Finally, if the owner of the policy decides not to keep the life insurance, she can cash it in and receive back a percentage of what she invested into the policy.
  
  

Disadvantages

• The disadvantage of cash value policies is the cost relative to term insurance. Term insurance carries no cash value and is much cheaper than cash value policies. In fact, some in the life insurance industry say buy term and invest the difference is a much better strategy than buying cash value policy. For example, if a family can buy a $200,000 term life insurance policy for $20 a month compared with paying, say, $45 a month for a $200,000 a month cash value policy, the family would be better off buying the term policy at $20 a month and invest the remaining $25 into a separate account. In essence, they can grow their own cash value. In addition, more often than not, the family can receive a higher return with the separate account.
  
  

Applications

• Cash value policies are best deployed as a permanent insurance strategy to take advantage of tax and estate planning benefits. Although the ability to cash it in and borrow against it has benefits, these are not good reasons to by cash value life insurance. As noted, individuals may be better off buying term insurance and investing difference if building cash value is the primary concern. This is the reason why the most common cash value policy is referred to as "whole life" because individuals should keep it their whole life.