Cash value life insurance has grown in popularity over the last several decades due to two distinct differences from term insurance.
Whereas term life insurance expires after the set coverage term, essentially causing you to lose the premium you pay into it every year, cash value life insurance coverage is permanent. You build up the cash value through both the premiums you pay and either the dividends or the returns on the investment of those premiums. Term insurance is an appropriate and cost-effective solution for a temporary need, such as income replacement for a surviving spouse, or funding a buy-sell agreement between business partners.
The benefits of cash value life insurance
The flexibility of cash value life insurance allows you to do a variety of things. At a minimum, the death benefit can be used to provide inheritance to beneficiaries or help to offset estate taxes. During the insured’s lifetime, the underlying cash value can be withdrawn or loaned against to provide cash flow to meet financial goals, such as retirement.
There can be flexibility with premium payments. In some cases, a policyowner facing cash-flow issues may be able to reduce or skip a premium payment, as long as the cash value can support the costs before the next premium payment is due. Often, after years of growth, the cash value has grown enough to support ongoing costs of insurance without additional premium during the insured’s lifetime.
If you don’t have cash value life insurance, it’s a good idea to look into whether it would benefit you. If you do have a policy already, it’s good to know what the different types of cash value life insurance are so you can see whether you have the right policy for your situation, and what your other options are.
What are the different types of cash value life insurance?
There are generally three types of cash value life insurance: whole, universal and variable.
Whole life insurance was the first to show up on the scene. Many insurance carriers issuing whole life policies also pay an annual dividend to policyowners, which either adds to cash value, purchases additional death benefit or can be paid out to policyholders.
When whole life insurance became popular back in the 1980s, interest rates were at all-time highs. However, interest rates have been declining steadily over the past 30 years, and dividends have declined alongside them. This is because carriers are limited in how they can invest policyowners’ premiums, and consequently hold approximately 90% of their assets in fixed income securities such as bonds and mortgages.
Universal life insurance evolved to deliver more flexibility. Whereas whole life generally requires you to pay a consistent premium, universal life can provide flexibility in amount of premium paid year to year, as long as the cash value can support the costs of insurance, or the amount put into the policy in the early years does not fail certain present-value tests. Policyowners also have the ability to choose between a fixed account that earns interest, an indexed account (return is tied to a popular stock market index, such as the S&P 500) or an underlying investment portfolio.
This last investment option describes a third type of policy, called variable life. A pure variable life contract does not allow for as much flexibility in premium as a universal policy, but a combination of the variable and universal features has become a popular choice for new policies. Variable life insurance allows you to invest the cash component of your policy in order to gain greater returns. You have control over the investment allocation — how much to put in stocks versus bonds. Although investments are subject to the stock market risks, unlike a cash equivalent earning interest or dividends, the objective of a variable life insurance is often to provide greater potential returns over time, which may make it a more attractive choice over whole life insurance.
Why should you review your cash value policies?
The biggest reason to review your policy is to decide whether it’s suitable for you and whether it still meets your needs and objectives.
Oftentimes, a death benefit is no longer needed for income replacement or debt payoff. Do you retain the insurance and let the cash value pay the costs? Perhaps you’ve been depleting the cash value; do you put more premium in to keep the policy afloat, or does it make sense to surrender the policy and invest the net proceeds elsewhere? If you still wish to retain the death benefit for inheritance or estate tax purposes, you might be interested in locking in a guaranteed face value, or even increasing it.
If you decide to make a change and are in relatively good health, you may be able to exchange to a new policy tax free. A 1035 exchange allows you to use the cash value to purchase a new policy with enhanced, or additional, benefits. One such additional benefit could be the use of a portion of the tax-free death benefit during the insured’s lifetime for long-term care expenses, a rising concern as life expectancies have risen over time.
Insurance policy needs change as your overarching needs and goals change. We recommend reviewing all your insurance policies — ideally with help from a trusted insurance advisor — as part of the annual review of your financial plan. There are many what-ifs that people don’t typically take into account. What if you or your spouse become disabled? What if you pass away earlier than you expect? What if you or your spouse need long-term care? Do you expect your kids to be burdened with heavy estate taxes?
Reviewing your policies can help you explore and answer these questions, as well as make strategic decisions that align with your goals.
Wipfli Financial can help
Let us help you evaluate the health of your current insurance policies and whether you might benefit from exchanging to a new policy, obtaining more insurance or keeping the policies as they are. We work for the best interests of our clients, helping them plan to achieve the financial future they desire.