WHAT IS Cash Accumulation Method
Cash accumulation method refers to a common technique for comparing different cash value life insurance policies. It assumes that the death benefits for the policies are equal and unchanging. The aggregate difference between the premiums paid into the two policies is then evaluated over time.
BREAKING DOWN Cash Accumulation Method
The cash accumulation method is used to rank policies according to their cost effectiveness. When comparing policies using this method, the one that has the most cash value at the end of the trial period is considered the better policy. This comparison requires that the premiums paid for each policy during the comparison period are equal. If they are not equal, then the difference between the two must be set aside, in order to make an apples-to-apples comparison.
For example, if the annual premium paid on the first policy is $1,400 and the annual for the second is $1,100, then $300 must be set aside under the cash accumulation method. An interest rate also must be applied to this set-aside account. If the interest rate was 4%, for instance, then there will be $312 in the set-aside account at the end of the first year.
Next, the face value of the policy with the lower premium must be adjusted. Assume both policies are for $250,000. Take the policy with the lower premium and subtract the the Year 1 value of the set-aside. In the example, the premium on the first policy remains at $250,000, while the second ,must decline by 312 to $249,688.
After these adjustments, the cash value of the first policy for a specific term now can be equated to the cash value of the second. The policy that has the most cash value at the end of the specified term period, say 15 years, is the better value.
PROS AND CONS of the 'Cash Accumulation Method'
The cash accumulated method is the most common way to compare cash-value life insurance policies, which can offer coverage for a lifetime, as opposed to a specific term. It works, as long as the same rate of interest is paid into each policy during the comparison. The method can be applied when evaluating whole life, variable life and universal life policies.
What the cash accumulation cannot do is determine whether term life insurance may be a better option altogether, as opposed to simply comparing cash-value policies.
In general, cash value insurance has higher premiums than term insurance because of the cash value element. Most cash value life insurance policies require a fixed premium payment, of which a portion is allocated to the cost of insurance and the remaining is deposited into a cash value account. The cash value account earns only a modest rate of interest, with taxes deferred on the accumulated earnings.
It’s also important to consider fees and, in some cases, hidden expenses associated with cash value policies. Often, it could be a better option to buy term and invest the rest.