Premium Payment Divided
When you make a premium payment on a cash value life insurance policy, a portion of the payment is allocated to the policy’s death benefit (based on your age, health, and other underwriting factors). The other part covers the operating costs and profits of the insurance company. The rest of the premium payment will be used for the cash value of your policy.
Life insurance companies typically invest this money in conservative yield investments. As you continue to pay premiums on the policy and earn more benefits, the cash value increases throughout the year.
Note
The rate of return you earn in a cash value policy can depend on how the premium payments are invested.
Accumulation Slows Down From Time
When you have cash value life insurance, you usually pay a level premium. In the early years of the policy, a higher percentage of your premium is applied to the cash value. Over time, the amount allocated to cash value decreases. It’s similar to the way a home mortgage works: In the early years, you mostly pay interest while in later years most of your mortgage payments are channelled to the principal.
Every year as you grow older, the cost of your life insurance becomes more expensive for life insurance companies. That’s why the older you get, the higher the cost of buying a term life policy. When it comes to cash value insurance, insurance companies take into account these rising costs.
In the early years of your policy, the bulk of your premiums are invested and allocated to a cash value account. In general, this cash value can grow rapidly in the early years of a policy. Then in later years, the accumulation of cash value slows down as you get older and more premiums are used for insurance costs.
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Tip
Consult your insurance advisor to determine how to calculate the potential accumulation of cash value for your permanent life insurance policy.
Different Policies Collect Cash Value in Different Ways
Accumulation of cash value is not uniform; instead, it varies depending on the type of policy you have.
- Whole life policies provide a “guaranteed” cash value account that grows according to a formula determined by the insurance company.
- Universal life policies accumulate cash value based on current interest rates.
- The variable life policy invests funds in subaccounts, which operate like mutual funds. The cash value increases or decreases based on the performance of this subaccount.
Each type of policy carries a different level of risk. With a lifetime policy, you usually take the least risk because your accumulation of cash value is guaranteed. Variable life policies, on the other hand, can more closely match the level of risk you might consider when investing in the stock market. It is important to understand how to accumulate cash value and the associated risks so that you can choose a policy that suits your risk tolerance.
Step by Step: How Cash Value Grows
Let’s say you buy a lifetime policy with a $ 1 million death benefit when you’re 25 years old. You pay your monthly premiums consistently and each month a percentage of that payment is applied to the cash value of your policy.
Thirty years after you bought the policy, you are 55 years old and the cash value of your account has increased to $ 500,000. Since the policy offers a $ 1 million death benefit and you already have a cash value of $ 500,000, the cost of insurance must cover the remaining $ 500,000.
Ten years later, the cash value of your policy has increased to $ 750,000. Given that you are 65 years old now, the cost of insuring your life is much higher. However, when you take into account your significant cash value, the policy really only insures $ 250,000. The rest of the death benefit to be paid by the policy will come from the cash value.
Here’s a very simplified example: Figures will vary significantly depending on the life insurance company, the type of policy you buy, and in some cases, the current interest rate. For this reason, it is important to research the best life insurance company for you that will offer the most cash value for your investment.
Don’t let the cash value that has been built up in your policy be wasted; the cash value in your policy at the time of your death goes back to the insurance company, not your heirs.
