Life Insurance: Face Value vs. Cash Value
Cash value life insurance is permanent insurance. It pays a death benefit no matter how long you live, provided you keep the policy in force. Life insurance is unique among forms of insurance, in that all insureds will eventually die. The law, therefore, requires insurance companies to set aside reserves in order to pay these inevitable death claims. The older you are, the higher these reserves must be. The cash value of your policy reflects the reserves the insurance company has set aside to back its promise to your heirs to pay a death benefit.
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History of Life Insurance
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The earliest life insurance contracts were pacts between Chinese merchants and seafarers, which date back to 5,000 B.C. The ancient Greeks also had mutual aid societies that helped to cover burial costs for the deceased, and arranged for the care of widows and orphans. During the Middle Ages, guilds and craftsmen societies also bonded with one another to provide for the families of deceased members. Edmond Halley, the astronomer who discovered Halley's comet, developed the first actuarial table of life expectancies in the late 1600s. The first American life insurance company was the Corporation for the Relief of Poor and Distressed Widows and Children of Presbyterian Ministers, formed in 1759.
Types of Cash Value Life Insurance
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Cash value life insurance comes in two main types: whole life and universal life. Whole life policies feature a guaranteed level permanent death benefit, guaranteed level premiums, and a guaranteed rate of interest on cash value as it builds up over time. At age 121, the guaranteed cash value will reach the guaranteed death benefit amount, the policy "endows" and the insurance company will send you the check. By contrast, universal life policies feature a level death benefit, which is frequently guaranteed to life (or to a certain age, such as age 80 or 100), and flexible premiums. The cost of insurance increases as you get older. You must keep enough money in the cash value to cover the cost of insurance premiums. The cash value acts as a reserve to help pay down premiums later in life, when they become more expensive.
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Death Benefits
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Life insurance death benefits are generally tax-free under current tax law. However, if the owner sells the policy to a third party in exchange for anything of value, the policy may lose its tax-free death benefit under transfer-for-value rules. However, Congress has made an exception for viatical settlement policies. If you have a medical condition that's expected to result in your death within 24 months, you can get an early, tax-free payout of the death benefit.
Cash Value
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Life insurance companies set aside two kinds of reserves against the certainty of having to pay a death claim on in-force policies: legal reserves and surplus. Legal reserves are the minimum required reserves set aside in investments approved by state regulators. Surplus reserves are the property of the company, which can use them in whatever manner it wishes. A company can invest surplus capital in its general fund, or it can return the capital to its owners in the form of dividends. Mutual companies are owned by policy holders, so they can distribute dividends by check, or credit them to the cash value accounts of permanent life insurance policies. In the latter case, these dividends typically go to purchase small amounts of fully paid-up life insurance, which the policy holder can cash in at any time.
Accessing Cash Value
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A permanent policy owner who wants access to the cash value of his policy can access it by surrendering the policy outright (which may generate a capital gains tax bill); by withdrawing part of the cash value; or by borrowing cash from the insurance company, using the policy as collateral. The insurance company charges interest on the loan, and the owner can either repay the loan, or let the life insurance company subtract the loan balance from the eventual death benefit.
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