Cash-value insurance, otherwise known as permanent life insurance, is a type of insurance that accumulates value during your life and pays out to your beneficiaries upon your death. In essence, cash-value insurance is a combined insurance and investment package - you pay a higher premium to have the extra portion put aside and invested by the insurance company. Compare this to term insurance, where your premiums are only applicable toward insurance, and coverage is for a specific period of time.
There are two basic types of cash-value policies:
- Whole Life – You pay a premium throughout your lifetime set by the insurance company based on your actuarial risk at time of purchase, receive income on the cash-value portion of your investment (based on the performance of the insurance company’s investments), and your beneficiaries receive a set death benefit. You are sacrificing control for simplicity here.
- Universal Life – With a universal life policy, you have some flexibility in setting the premium and the death benefit. This generally keeps the premiums lower. You also have some choice in how the cash-value portion is invested, allowing for potentially higher (or lower) returns.
The cash-value component of your policy grows tax-free, serving as a tax-sheltered investment. You may also be able to use it over time to pay a portion of your premiums, supplement your income in retirement, or borrow against it without restrictions and/or credit checks and credit rating effects. Check with individual policies regarding limitations, and make sure you have considered tax effects before borrowing.
Interest rates are of concern – if interest rates drop and stay low, your premiums won't earn enough for the insurance company to cover your benefits. Your cash-value component could drop to zero, resulting in cancellation of your policy (unless you have a guaranteed universal policy).
Of course, you could buy term life insurance and invest the difference in cost in other tax-deferred investments without the insurance company's help. With some patience and attention, you may be able to beat the return from the insurance company (and many experts suggest doing just that). The question is - do you have that patience and attention?
Another benefit of a cash-value policy is in tax issues for your beneficiaries. If constructed properly, the death benefits can be free of both federal income tax and estate taxes, if estate taxes apply.
By going with any cash-value policy, you are making the following assumption:
- You will Live a Long Time - With a cash-value policy, your life insurance costs are pre-set for the rest of your life, whereas with a term policy your premiums rise as you get older and your health gets poorer. Put simply, until one is well into his or her 50’s, the premiums for term life are much cheaper than for cash value life. But as one ages beyond that point, the cost curve for term moves sharply higher than a cash value premium set years earlier. Consequently, the longer you live, the happier you are with a cash value policy.
By choosing a universal life policy, you are making an additional assumption:
- Interest Rates won’t Decline Sharply During your Lifetime – As described above, cash-value policies are going to have greater value if interest rates rise over the long term, and can drop dangerously if interest rates fall. Thus, if you buy a universal life policy when interest rates are historically high — and rates fall downstream — there is the risk your earnings from the cash-value component of the policy won't be high enough to cover the cost of keeping it in force and maintaining the eventual death benefit. Fortunately, if you are considering a universal life policy today, the US economy is moving from a period of historically low interest rates to higher rates. So, according to most experts, this risk is quite small.
Remember, the benefits in cash-value insurance are realized over a very long time horizon, so do your homework before you buy. Check policy details, and make sure you understand all the terms, costs, and potential pitfalls. Don't fall for slick salesmanship by an insurance agent – make sure that savings components and insurance components are explained clearly, without confusing the two segments, and know what questions to ask regarding the downsides. If you follow that path, you are likely to make the best decision about insuring your family’s future.