Cash value life insurance policies differ from term policies in many ways. The major differences are that cash value policies offer permanence and cash value accumulation in addition to death protection. It is very important to understand how this cash value aspect works so as not to be misled. We will use whole life insurance in the below explanation because it is the standard form of cash value insurance.
The cash value accumulation aspect of a whole life policy is more or less a side effect of how whole life policies work. From the beginning of a whole life policy, all aspects are fixed planned and accounted for in advance. A larger premium than actually required for costs is collected in order to cover higher costs in future years. This higher than required premium excess forms the cash value of the policy which earns interest at a fixed rate.
As this cash value increases, the value of death protection decreases though the face value (and thus the death benefit) of the policy remains the same. For example, if the face value of a policy is $100,000 and the cash value accumulated to date is $20,000, death protection equals $80,000. As the cash value increases to $40,000, death protection decreases to $60,000 in order to equal the $100,000 policy face value to be paid out to beneficiaries. In effect, though this face value may remain fixed over the life of the policy, there is a hidden shift in the composition of the payment should the policy holder die. Policy premiums are planned so that at age 100 the cash value of the policy equals the policy’s face value. Essentially, this means that death protection is equal to $0 and the face value paid to beneficiaries will consist solely of the cash value.
Most cash value policies offer policyholders the option to take out policy loans against the cash value of the loan at reasonable interest rates. These loans are typically easier to secure than traditional loans. Policyholders also have the option to surrender (cancel) their policy and receive the surrender value (cash value minus surrenders charges and fees).
Upon death of the policyholder, beneficiaries are only entitled to the face value of the policy. This death benefit may consist of cash value and death protection, but will not exceed the face value of the policy. The policy holder has the option of receiving the cash value of the policy in the form of a surrender value if they choose to surrender the policy. This works because the cash value was collected in order to pay for the future cost of coverage. If the policy is surrendered, those funds are no longer needed to cover future costs and are returned to the policy holder minus fees and charges.
Though many aspects of the policy are fixed at inception, some types of cash value policies (universal life in particular) allow you to make changes to premiums, death protection and other aspects of the policy.