When you own cash value life insurance, your premium payments are allocated three ways. First, a portion of each premium pays for the actual insurance costs. Like term insurance, a specific cost is associated with the policy’s death benefit, based on your age, health, and other underwriting criteria. Second, a portion pays for the insurance company’s operating costs and profits. The remainder goes toward the policy’s cash value.

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.

Whole life policies offer “guaranteed” cash value accounts that increase based on a formula determined by the insurance company. (Guarantees are subject to the claims-paying ability of the insurer.) Universal life policies offer cash value accounts that track current interest rates. Variable life policies allow their owners to invest in accounts that operate like mutual funds, meaning that their cash value accounts can be invested in bond, stock, and other funds, known as sub-accounts. The cash value will grow or decline based on the performance of the underlying sub-accounts.

The amount of your premium that goes toward cash value decreases over time

Over time, the amount that you contribute from each premium toward cash value decreases, because the cost of insuring you increases every year. The pattern is similar to what happens with a mortgage. In the early years of a home loan, you pay mostly interest; in the later years, you pay mostly 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 part of your premium behaves just the opposite of the insurance component. In the early years of the policy, your cash value can grow quickly since more of your premium is available for cash value. In the later years, the cost of insurance consumes more of your premium, so less is left over for cash value.