How Does Life Insurance with a Savings Component Work?

Some life insurance policies use a portion of the premium you pay to build cash value–specifically, whole life insurance all types of universal life insurance (current assumption, variable, and indexed).

Technically speaking, this cash value exists by insurance regulation to provide policy owners with a nonforfeiture benefit.  However, if you own one of these cash building forms of life insurance, you do not need to cancel or irrevocably alter the policy to use the accumulated cash value.

What Type of Life Insurance Has a Savings Component?

If you purchase whole life insurance or universal life insurance, the policy will accumulate cash value.  You can use this cash value for any purpose you desire and you do not need to cancel the policy–nor do you need to die–to make use of this cash.

You can think of the accumulated cash value in your life insurance policy as an asset you own, similarly to cash that you own in any savings or investment account.

Term life insurance is not a life insurance policy with a savings component.  So if you happen to own term life insurance, it will certainly take care of your life insurance needs, but your policy will not accumulate any cash value.

How Does a Life Insurance Policy Accumulate Cash Value

Life insurance policies accumulate cash value from three sources:

  1. The premiums the policy owner pays
  2. Guaranteed interest earned on the policy's cash value
  3. Non-guaranteed interest (dividends in the case of  most whole life insurance policies) earned on the policy's cash value

Policy Owner Premiums

In order to put a life insurance policy in force, a policy owner must pay premiums to the life insurance company.  In some cases, this might be just one large premium at the beginning of the policy but usually, this looks more like several premiums paid over the course of many years.

A portion of the premiums received by the insurance company fund the cash building component of the life insurance policy.  This happens because technically, the life insurer charges the policy owner more to insure you for the first several years of the policy than it actually costs to your life.  The excess amount above the true cost of insuring the policy owner goes toward building cash value.

Guaranteed Interest

All cash value life insurance policies pay a guaranteed interest rate on the accumulated value of the policy.  This guaranteed rate does not change and the life insurer does note this guaranteed interest rate in the policy contract.

The life insurer must pay this interest to the policy owner no matter how well or badly the life insurer's investment perform in any given year.

Non-Guaranteed Interest/Dividends

Many cash value life insurance policies also earn non-guaranteed interest (or dividends when whole life insurance).  This amount varies from year to year and the insurance company sets this amount at its discretion.

If the life insurance company experiences very good investment returns, this generally results in higher non-guaranteed interest/dividends paid to policy owners.  Alternatively, if the insurance company experiences poor investment returns this generally results in lower non-guaranteed interest/dividends paid to policy owners.

How Does the Savings Component (cash value) Help You?

Ahhh…this is probably the aspect of life insurance that our clients value the most. Ironically, it is a life insurance policy and most policies do have substantial death benefits attached to them. In some cases, several hundred dollars and in other cases many millions of dollars. But those death benefits are for the people left behind right?

What most of us who own some type of cash value life insurance (whole life or universal life) care about is the cash value because it's the part of the policy that benefits us most while we're still alive.

If you're anything like most people, you have a retirement account or investment account or perhaps several of each? Life happens and there's some emergency that puts you in a tight spot where you need to dip into one of these accounts to cover the temporary cashflow crisis.

But when you call to transfer money or sell stock to meet your immediate cash flow need, you get a long lecture from the “adviser” that manages the account. They tell you about how it's a bad idea to take the money out of the account etc. They remind you that the money in this account is for later and that if you take the money out now, the opportunity cost will cost you big time.

Now, it's not that they are completely wrong, however, if your car needs a new transmission and you need $4k to fix it, what's the point in the lecture? It's not like you're taking the money out of the account to spend on a wild weekend in Vegas.

It's Your Money, Spend It

What if instead of having to hear about how disastrous taking your money out for a good time is, we told you it was okay to spend your money.  Now, we would never advocate blowing it on silly things.

It makes sense to touch it only when necessary (we're not condoning using your cash value to buy that 911 Turbo) but doesn't the notion of knowing that you can use your money and not commit financial suicide in doing so have a certain relaxing notion to it?

A notion that perhaps makes you feel less guilty because you need a new car and you'd rather not pay Wells Fargo or Ford Motor Credit 4-8% more than you have to? Remember you can take a policy withdrawal or loan at any point in time that you have actual cash value in your policy.

Or perhaps it's just a vacation or home remodel you've been wanting to do for a long time.  Most of the “advisers” we've met would have a chill run over them and talk to you in their most stern voice if you told them you wanted to make a withdrawal from your IRA to pay the bill.

Maybe some of this ties into the fact that if you spend your money that's less money for them to “manage” aka charge you asset-based fees on?

But if you're banking with a dividend-paying life insurance policy, what's the harm?  The obvious is you won't have access to borrow the money for something else until you pay it back and…well…there's that whole you have to pay it back part.

Seems like a fair trade to have a system that motivates me to be responsible all the while continuing to pay me money on my money despite the fact that I took it out for an evening on the town for good times (hypothetically speaking that is)?



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