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.

Term Scenario:
-Premium: $656.88 annually for 20 years
-Contribution to savings per year: $7,250
-Earnings: 6% annually (taxable)

Whole Life Scenario:
-Premium: $7,913.00 annually
-Earnings: Between 4-6% annually (tax free)

Just to clarify, both of these policies contain a rider on them called waiver of premium, which means that if you were to become disabled the premium would be paid by the insurance company. The whole life policy contains paid up additions, which means that you are purchasing additional chunks of death benefit in addition to the original death benefit with your dividend income. The premiums are going to be a little different from insurance company to insurance company, but we’ll work with these rates as they are from one of the companies I represent. We’ll start with the term scenario. The results will include after tax figures.

At 10 years:
-Saved: $93,099
-Death Benefit: $500,000

At 20 years:
-Saved: $237,678
-Death Benefit: $0 (Policy ended)

At 30 years:
-Saved: $470,642
-Death Benefit $0

Now let’s look at the whole life scenario.

At 10 years:
-Cash Value: $65,295
-Death Benefit: $542,773

At 20 years:
-Cash Value: $238,858
-Death Benefit: $711,333

At 30 years:
-Cash Value: $516,249
-Death Benefit: $947,573

Let’s analyze these two scenarios. After 10 years you will have accumulated more money in your savings than the whole life policy had accumulated, however, your death benefit has increased by just under $43,000 to $542,773, while the term policy remains the same. After 20 years things begin to get more interesting. While the savings amount and the cash value are relatively close in amount, you’ll notice that the death benefit has gone to zero. This is due to the fact that the policy had ended after the 20 year period, while the whole life policy’s death benefit has grown substantially. The same situation is apparent in the 30 year scenario. The point is, not only do you have a nice cash value in your whole life policy, but you also have a death benefit of just under $950,000.

The proof is in the pudding my friends. Is term insurance a bad investment? Not at all. Many people simply don’t own whole life insurance because it is expensive. Term is much more affordable, and ideal for younger individuals or people that don’t have the income to spare. You always have the option of converting your term policy to a whole life policy when the income is available to do so. Until then, get yourself a good term insurance policy that will keep you and your family protected.