What is the difference between the death benefit and cash value of an insurance policy?
The Death Benefit is what the Insurance company pays out to the beneficiary when the insured individual passes away.
The Cash Value is the amount of cash the Owner of the policy has access to by taking out a loan on the policy, making a withdrawal from the policy (if it allows you to do so), or when the policy is canceled, the Owner receives the cash value assuming there are no surrender charges, fees you pay when you cancel a policy within the first 10 to 20 years.
Depending on the type of policy, the beneficiary can receive both the cash value and death Benefit. But in most cases, when the insured dies, the beneficiary only receives the Death Benefit and the Insurance company keeps the cash value. So let's say someone has a $100,000 death benefit and a $30,000 cash value. When they die, their family would get a check for $100,000. I know that some people struggle with the concept of the insurance company keeping the $30,000, but the insurance purchased was for $100,000, the cash value represents excess premium paid and an interest rate paid by the insurance company. The difference between cash value and the death benefit is what insurance companies call "Net amount at risk" as in it's the amount they're on the hook for. The $30,000 would represent the return of part of the premium and some interest and the other $70,000 would be the insurance amount totaling $100,000. Imagine a situation where the $30,000 would keep growing over many years and it becomes $100,000. That's when a policy "matures", meaning that the death benefit and cash value is the same amount, the insurance company has no risk anymore, and that the owner has effectively paid for their own insurance because what they have is a glorified savings account.
Term Insurance is a type of Insurance that doesn't have any cash value, and it's why it's the least expensive because none of the monthly cost is going into a "savings account" called cash value
I don't think I've ever written this much about life insurance, is anyone still awake?
The Death Benefit is the actual benefit paid when the insured dies. The Cash Value is the amount inside a Permanent Life Insurance policy either in a "dividend" account if a Whole Life Policy, or a fixed, interest bearing account if Universal Policy, or stock and bond mutual funds or even a fixed account if a Variable Life Policy. It is the amount over and above the premiums that go toward just covering the cost of insurance. The Cash Value grows tax deferred and is available for loan or withdraw net of any surrender penalties, if any.
In contrast, a Term Policy only last for a certain "term" or time period and has no Cash Value. The premiums simply pay for the cost of insurance. A Permanent Policy: Whole Life, Universal Life, or Variable Life, is "permanent" and lasts as long as enough premiums are paid to keep the policy in force. Any monies/premiums in excess of the minimum premiums to keep the policy in force will go into the Cash Value.
With a Whole Life, the insurance carrier gets to determine the amount or percentage of dividends to be paid sets. A Universal Life is more transparent and the interest rate is set at the beginning of each term/year for the fixed account. With a Variable, there are many investment choices ranging from stock and bond mutual funds, commodity funds, and even a fixed account. A Variable has more internal costs, but also more choices.
Finally, there are two types of Death Benefits, increasing and level. With increasing, you are purchasing a fixed amount of life insurance (death benefit) along with the increasing cash value. For instance, with a $500k increasing death benefit, any cash value will increase the overall death benefit if the insured dies. If the cash value is $25K, the death benefit would be $525K. With level, the policy, the total death benefit remains at $500K. If the cash value is $25K, then you are only "buying" $475K of life insurance. Therefore, as the Cash Value increases over time, the actual life insurance being purchased is decreasing. You are, in essence, self-insuring over time as the cash value grows.
The first question you need to ask yourself is, do I need life insurance to insure a risk and for how long? That will determine whether you even need life insurance and whether it should be term or permanent. One thing you should know is that all term is convertible to permanent. So if you feel that you will likely only need the insurance for a certain time period, term is the way to go. If you then find that you have a terminal situation and getting near the end of the term, you can convert into permanent.
So many times, a 10 year term and investing the difference is the most cost effective, flexible way to go. Then 9 1/2 year into the term, if you still need insurance, get underwritten again for another 10 year term. If you are uninsurable, then convert. If not, begin a new term policy while investing the difference.
The only reason I bring this up is that while permanent life insurance has its place, it is sold far too often when term will work just fine.
Hope this helps, Dan Stewart CFA®
One of the most utilized tools in funding an estate plan is term or permanent life insurance. Purchasing a life insurance policy gives an individual or couple the ability to transfer the financial risk of loss of income or the burden of estate taxes to an insurance company in exchange for paid-in premiums. Life insurance carriers offer two main benefits to insured individuals when a transfer of risk occurs: death benefit proceeds and cash value savings. The death benefit is the amount payable to beneficiaries of the insured individual once the insured passes away, and the cash value balance is a forced savings component available to the insured while he is still living.
Life Insurance Death Benefit
A person typically purchases a life insurance policy to secure a death benefit made payable to the survivors of the insured once he is no longer living. Insurance companies offer a total death benefit for whatever amount is deemed appropriate by the insured as long as the policy is in force and premiums are paid. The insurance company pays the death benefit as a tax-free transfer to named beneficiaries once the carrier is made aware of the insured's death, and the beneficiaries can use the funds without restriction.
Life Insurance Cash Value
With permanent life insurance policies such as whole life or universal life, insured individuals have the ability to accrue savings within the cash value of the policy. The cash value of a life insurance policy equals the total amount of premiums paid minus the cost of insurance and other charges assessed by the carrier. Cash value balances can also fluctuate based on the underlying investment in which the balance is allocated. Unlike the death benefit, cash value balances are available to the insured or owner of a life insurance policy while he is still alive, either through a partial surrender of the policy or by way of a policy loan. Any remaining cash value left once the insured dies is either added to the death benefit or is forfeited to the insurance company.
The death benefit is the amount the insurance company pays at the death of the insured. In a term policy, it is normally a fixed number. In a policy that accumulates a cash balance, it can fluctuate based on the design. Understanding the basics of insurance is difficult at best, and normally life insurance should be considered in most cases an income replacement policy. In other cases, it is used for legacy and estate tax uses, and to fund buy/sell arrangements. It can be term or permanent, meaning for the lifetime of the insured in the latter case. So what is the cash value? It is the excess amount of premium paid to the policy that is above the normal expenses found in the policy. The cash value is designed to help "pay up" the premium for future years if there is enough. The cash will accumulate at an interest rate set by the company and can fluctuate. There are also other ways the excess balance can accumulate interest via variable or index accounts. Depending on the policy, the actual cost of the policy is the outstanding death benefit. For example, in a cash value policy, if the death benefit is $100,000, the cash value is $20,000 (assuming the cash builds inside the policy), then the amount of actual insurance is $80,000. So, the costs are based on the actual insurance the company has to pay at death. If you died, essentially the company pays the $20,000 to your beneficiaries (your interest) and the $80,000 comes from insurance. This is how most polices work. It can be confusing, but an educated planner will fully analyze your policy if there are any questions. I can do this fairly easily.
The cash value of a life insurance policy is the amount you can withdraw or take loans against, the death benefit is the amount payable to your named beneficiaries.
A few points to remember:
- Only permanent insurance (like whole life and universal life) has the capability to build up cash
- Term insurance can never build up cash
- Return-of-Premium term can deliver a return of your premiums at the end of the term, but it is not the same as cash value
- Your heirs do not receive both the cash value and the death benefit, just the death benefit
- With a cash value policy that builds up a lot of cash (like after 20 years or more) the cash value will push up the death benefit
- Even in that case, your heirs do not receive both
- Think of it this way, your heirs get the cash value or the face value of the policy, whichever is greater
Remember that the primary purpose of life insurance is the death benefit. To achieve significant cash value, buy a policy with a lower death benefit target. In that way, every dollar into the policy will be divided a bit more to the cash value. Why? Because the lower the death benefit, the lower the cost of insurance.
Know why you want life insurance before you buy.