Cash Value Features
The cash value component is one of the distinguishing features of whole life insurance. Understanding how cash value works, how it can be accessed, and what happens when a policy is surrendered is essential for the exam.
How Cash Value Grows
Cash value accumulates as part of each premium payment is set aside and invested by the insurance company.
The Growth Process
| Step | What Happens |
|---|---|
| 1 | Policy owner pays premium |
| 2 | Insurer deducts mortality and expense charges |
| 3 | Remainder goes into cash value account |
| 4 | Insurer invests funds and credits interest |
| 5 | Cash value grows over time |
Growth Pattern
Cash value growth is slow in early years and accelerates later:
| Policy Year | Why |
|---|---|
| Years 1-3 | Most premium goes to acquisition costs (commissions, underwriting) |
| Years 4-10 | Cash value begins building meaningfully |
| Years 10+ | Compound growth accelerates accumulation |
| At maturity | Cash value equals face amount |
Tax Treatment of Cash Value Growth
- Cash value grows tax-deferred
- No income tax is owed while cash value remains in the policy
- If policy is surrendered, gain (cash value minus premiums paid) may be taxable
Guaranteed vs. Non-Guaranteed Elements
Whole life policies have both guaranteed and non-guaranteed components.
Guaranteed Elements
These are contractually promised by the insurer:
| Guaranteed Element | Description |
|---|---|
| Death benefit | Face amount paid at death |
| Premium | Will never increase |
| Minimum cash value | Guaranteed minimum accumulation |
| Minimum interest rate | Rate credited to cash value (typically 2-4%) |
Non-Guaranteed Elements (Participating Policies)
Participating policies (par policies) may pay dividends based on the insurer's experience:
| Non-Guaranteed Element | Description |
|---|---|
| Dividends | Share of insurer's surplus; not guaranteed |
| Excess interest | Interest above the guaranteed minimum |
Exam Tip: Dividends are NOT guaranteed. They represent a return of excess premium based on favorable mortality, investment, and expense experience.
Dividend Options
When dividends are paid, the policy owner can choose how to use them:
| Option | Description |
|---|---|
| Cash payment | Receive dividends as cash |
| Premium reduction | Apply dividends to reduce premiums due |
| Paid-up additions | Purchase additional whole life coverage |
| Accumulate at interest | Leave with insurer to earn interest |
| One-year term | Purchase one year of term insurance |
Policy Loans
Policy owners can borrow against the cash value of their whole life policy.
How Policy Loans Work
| Feature | Description |
|---|---|
| Collateral | Cash value secures the loan |
| Approval | No credit check or approval required |
| Interest | Charged on loan balance (typically 5-8%) |
| Repayment | Optional; no required payments |
| Maximum loan | Up to approximately 90% of cash value |
Policy Loan Mechanics
- Loan is from the insurer, not from the cash value itself
- Cash value continues to earn interest (though possibly at reduced rate)
- Outstanding loan reduces the death benefit
- If loan plus interest exceeds cash value, policy may lapse
Tax Treatment of Policy Loans
| Situation | Tax Treatment |
|---|---|
| Loan taken | Not taxable (not considered income) |
| Policy surrendered with loan | Gain may be taxable |
| Policy lapses with loan | Gain may be taxable |
| Death with loan outstanding | Loan deducted from death benefit; no income tax |
Example
Policy owner has $100,000 face amount and $40,000 cash value:
- Borrows $30,000 at 6% interest
- If insured dies with loan outstanding:
- Death benefit paid = $100,000 − $30,000 = $70,000 (minus accrued interest)
Automatic Premium Loan (APL) Provision
The automatic premium loan provision prevents policy lapse when premiums aren't paid.
How APL Works
| Step | What Happens |
|---|---|
| 1 | Premium due date passes without payment |
| 2 | Grace period expires |
| 3 | Instead of lapsing, policy automatically borrows from cash value |
| 4 | Loan covers the premium due |
| 5 | Policy remains in force |
Important Points
- APL must be elected by the policy owner
- Interest is charged on the automatic loan
- Available only if sufficient cash value exists
- Prevents unintentional policy lapse
Exam Tip: APL protects against policy lapse due to forgotten or missed premiums, but interest charges apply and the death benefit is reduced by any outstanding loan.
Surrender Value
The surrender value (or cash surrender value) is the amount the policy owner receives if they cancel the policy.
How Surrender Value Works
| Component | Description |
|---|---|
| Cash value | Accumulated savings in the policy |
| Surrender charges | Deductions that may apply, especially in early years |
| Surrender value | Cash value minus any surrender charges and outstanding loans |
Surrender Charges
In early policy years, surrender charges may apply:
- Recoup insurer's acquisition costs
- Decrease over time (often gone after 10-15 years)
- Reduce the net amount received upon surrender
Tax Consequences of Surrender
| Situation | Tax Treatment |
|---|---|
| Surrender value > premiums paid | Gain is taxable as ordinary income |
| Surrender value ≤ premiums paid | No taxable gain |
Example
| Item | Amount |
|---|---|
| Total premiums paid | $50,000 |
| Cash value | $45,000 |
| Surrender charge | $2,000 |
| Outstanding loan | $10,000 |
| Cash surrender value received | $33,000 ($45,000 − $2,000 − $10,000) |
| Taxable gain | $0 (surrender value < premiums paid) |
Nonforfeiture Options
If a policy owner stops paying premiums but the policy has cash value, nonforfeiture options allow them to preserve some value. These are required by state law.
Three Nonforfeiture Options
| Option | Description |
|---|---|
| Cash surrender | Receive the cash surrender value in cash; policy terminates |
| Reduced paid-up insurance | Use cash value to purchase a smaller amount of paid-up whole life |
| Extended term insurance | Use cash value to purchase term insurance for the original face amount |
Reduced Paid-Up Insurance
- Lower death benefit than original policy
- No more premiums required
- Policy remains in force for life
- Cash value continues to grow
Extended Term Insurance
- Death benefit equals original face amount
- No more premiums required
- Coverage lasts for a specific period (based on cash value)
- No cash value in the extended term policy
Example Comparison
Original policy: $100,000 whole life with $30,000 cash value
| Option | Death Benefit | Duration |
|---|---|---|
| Cash surrender | None (policy terminated) | N/A |
| Reduced paid-up | $50,000 | Lifetime |
| Extended term | $100,000 | 15 years |
Key Takeaways
- Cash value grows tax-deferred as part of each premium goes to savings
- Guaranteed elements include death benefit, premium, and minimum cash value
- Dividends are non-guaranteed and represent a return of excess premium
- Policy loans allow access to cash value without surrendering the policy
- Automatic premium loan prevents unintentional policy lapse
- Surrender value is cash value minus charges and loans
- Nonforfeiture options (cash, reduced paid-up, extended term) preserve value if premiums stop
Cash value in a whole life insurance policy grows:
The automatic premium loan provision:
Which nonforfeiture option uses the cash value to purchase term insurance for the original face amount?
Dividends on a participating whole life policy are: