Cash Value Insurance Basics
There are three different ways your premium payments are allocated within a cash value insurance policy. The first allocation is made towards the actual cost of the insurance. In all insurance, you have to remember that a specific amount of money is required in order to pay the actual cost of the insurance. In other words, what does it cost the insurance company to insure you and maintain the policy death benefit. The next allocation of your premiums payments goes towards the administrative costs of the company. It costs a certain amount of money to hold a policy on the books, and this cost is paid by the policy owner. Lastly, the remaining amount of premium payments goes directly to your cash value in the policy.
How cash value grows
We’ve already said that a portion of every premium payment goes toward your policy’s cash value. So, it’s easy to understand that the cash value of a policy will grow as additional premiums are made. The cash value of a policy may also grow because of earnings.
All types of permanent life insurance policies offer different formulas as to how the cash values are calculated. Whole Life policies, for example offer a “guaranteed” cash value account. The formula is determined by the insurance company and varies from company to company. Generally speaking, this formula is subject to the claim paying ability of the insurance company. Universal life policies cash value accounts mirror current interest rates and variable life policies (please consult with a prospectus) allow their owners to invest to choose various sub-accounts and operate similar to mutual funds. In other words, the cash value accounts can be invested in sub-accounts such as stock, bonds or other funds. Keep in mind though that the cash value will grow and decline based on the performance of the sub-accounts which you have chosen.
Cash Value Premium Portion Decreases Over Time
The amount that is allocated from the premium payment to the cash value decreases over time because of the increasing cost to insure your life. It is very similar to the way your principal and interest payments on your mortgage works. More of the monthly payment goes towards the interest in the early years and it transitions over the life of the mortgage to pay down principal.
Let’s take a very simplified example and assume you’re paying a $25-per-month premium for cash value insurance. In the early years of the policy, it costs relatively little to insure you–say $5 a month–because your odds of dying prematurely are low. In the later years of the policy, the cost to insure you is much greater–say $20 a month–because the insurance company knows that the odds are much greater that you will die as you grow older.
The cash value and insurance components work exactly opposite of each other. The cash value will grow faster in the early years since most of your premium is available to build the cash value. As you get older though, the cost of insurance consumes most of your premiums.
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