This section focuses only on the cash value feature of permanent life insurance policies. A more detailed discussion of these (often controversial) policies is provided in the chapter on insurance. Here we will not debate such policies’ deficiencies and merits. We will only cover the mechanism that leads to their cash value accumulation.
A portion of each permanent insurance premium payment you make covers: government taxes, the overhead costs of the insurance company, and the actuarial cost of insurance. Remaining amounts of each premium contribute to building up cash value. Cash value in a policy belongs to the policy owner. Funds in cash value accounts accumulate on a tax-deferred basis. In some situations, life insurance cash value may be protected from creditors, depending on state-specific laws.
Cash value accounts may accrue interest over time. The insurer also has the discretion to pay dividends on some policy types, for example, on Whole Life policies. The policy owner can choose whether to withdraw those dividends or keep them in the account where they can help build cash value faster. In this context “faster” is a relative term. Cash value usually grows very slowly in early years. For some policies, it may take an entire decade before any meaningful amount is accumulated.
In addition to being a repository of value in its own right (a pillar), the cash value account can diversify other pillars or investments (for example, in stocks and bonds). Again, I am not addressing whether a cash value pillar is a good addition to your portfolio, but merely that it is (whether we like it or not), a pillar.
Is Life Insurance Cash Value an Investment?
Critics of permanent life insurance policies often point out that insurance cash value accumulation compares unfavorably with investments in stocks and bonds. While my sympathies generally lie with the critics, it’s important to remain intellectually honest. Technically, a non-variable life insurance policy, for example, Whole Life, is not an investment. Rather, it’s more accurate to describe it as having a savings feature. This doesn’t stop some insurance agents from implying that these policies are investments to make them seem more appealing to consumers.
Such policies are characterized by a stream of guaranteed interest payments from a company in a highly regulated industry. A smaller percentage of earnings comes from dividends, which the insurer is not obligated to provide. The interest payments are arguably less risky than typical stock returns, and follow a pattern consistent with fixed income instruments—such as bonds. Since such policies are not equivalent to equity (stock) investments, there’s not much point in comparing their returns to those expected from stocks. Insurance policy cash value will invariably seem inferior in such examinations, but these are not true apples-to-apples comparisons. Additional details regarding this controversial topic are provided in the insurance chapter.
Whole Life Policies offer some interest rate guarantees. As a result, cash value accumulation in such policies is low, yet stable. In contrast, cash value accumulation in variable policies such as Variable Life and Indexed Universal Life may be quite volatile. Again, I defer my critical comments regarding permanent policies to the insurance chapter discussion.