As you are doing your research, you may often come across pundits who say that the insurance company keeps the cash value when you die. I thought I’d write a quick post to debunk this common myth.[1]
Goal
The goal of this post is to show you that the insurance company does not keep the cash value when you die. I will then explain what the cash value is and what happens to it when you die.
Keep on reading if you’d like to learn what happens to the cash value.
The Quick Answer
This is such an easy myth to bust that I almost feel guilty taking up a whole article to write about it. It is important to know that the cash value is an integral part of the death benefit. That means the Insurance Company Does Not keep the Cash Value when you die. The cash value is quite literally the policy owner saving up the death benefit over the insured’s lifetime. It’s a savings component built into the policy. The cash value is a component of the Death Benefit.
The rest of this article will be devoted to covering the basics and getting down in the weeds. I’ll cover a little bit of the Life Insurance 101 that you need to know. Then I’ll show you what happens to the cash value in both a traditionally-designed policy and a maximum over-funded policy.
Life Insurance 101
The best way to understand the cash value is to walk through how a permanent life insurance policy works.[2] To do that, I’ll use an example of a healthy 45-year old male purchasing a policy with a $1 Million death benefit.
When you buy a $1 Million policy, the insurance company has to figure out how much to charge you. There are two main things that they need to consider.
The first is how much money to put into a pool to pay claims. Just as with any kind of insurance, they need to put money into a pool to cover claims for all the 45-Year old males who will not make it to 46. This is the cost of insurance. The cost of insurance is low when you are young because there is a low risk of death. The cost of insurance increases with age as the risk of death increases. Just imagine the cost of insurance for an entire $1 Million of death benefit when the insured reaches age 85. It could be so expensive that it could jeopardize the policy.
Luckily, the insurance companies have thought of a better structure. They built a savings mechanism into the policy that reduces the net amount at risk as the Cash Value grows over time. So the second thing that an insurance company needs to do is determine how much extra premium they need to collect for the cash value to grow and reach the death benefit by the time the insured reaches their life expectancy.
A 45-year old can expect to live to about 87 years old. The premium needs to be high enough that even with a worst-case growth assumption (The Guaranteed Rate), the cash value will grow to reach $1 Million in 42 years.
You can see that the cash value is a component of the life insurance policy. The insurance company doesn’t keep it when the insured dies. It is paid to the beneficiary as part of the death benefit.
In the next two sections we’ll take a look at how the cash value accumulates in both traditionally designed policies and in maximum over-funded policies.
Cash value in a traditionally-designed life insurance policy
Most people who purchase life insurance want death benefit protection. Moreover, they want to get that protection for as little cost as possible. Because of competition, insurance companies want to keep the premiums to a minimum.
It is important to understand that in a traditionally-designed policy, the insurance company is collecting as little in premium as possible to meet the obligations of the policy. The following graph shows the death benefit and cash value growth over time for a 1 million dollar policy on a 45-year-old.
You can see that the death benefit stays constant over most of the life of the insured. You can also see that the cash value starts off very small and grows over time. It eventually runs into the death benefit at around age 115. The insurance company is on the hook for the net amount at risk. The net amount at risk is the large gap between the death benefit and the cash value. You can easily see the transfer of risk from the insurance company to the policy owner over time.
Again, in order to meet the $1 million death benefit, the insurance company is going to take from the risk pool to cover the net amount at risk and then take the cash value to make up the total death benefit. The cash value is going to the beneficiary as part of the death benefit.
Cash Values in a Maximum Over-funded Policy
People who purchase maximum over-funded life insurance policies are more concerned with cash value accumulation than death benefit. These people are trying to keep the death benefit to an absolute minimum for the amount of premium that they are paying.
The following graph shows an example of a maximum over-funded policy. This is the same 45-year-old contributing premium to a policy with a starting death benefit of $1 Million.
In this graph, you can see that the death benefit is very small relative to the $47,925 premium. You can also see that the death benefit is being pushed up as the cash value grows. Unlike the previous example, the Net Amount at Risk is constant at $1 Million. But notice how small this $1 Million increment is compared to the overall death benefit at Age 100.
Because of the low death benefit, the expense load on the policy is also kept to an absolute minimum. The net amount at risk is nowhere near as much as it is in a traditionally-designed policy.
Conclusion
The goal of this post was to show that the insurance company doesn’t keep the death benefit when you die. The cash value is an integral part of the life insurance policy. It is the savings mechanism that transfers risk from the insurance company to the policy owner over time. The policy owner is essentially saving up the death benefit over time. The insurance covers the risk in the early years when there is not much savings.
When you hear someone say that the insurance company keeps the cash value when you die, they don’t understand what they are talking about.
[1] Be sure to check out this, this, and this where I debunk other common life insurance myths.
[2] This is a very-focused “Life Insurance 101”. If you’d like a much more thorough explanation of how life insurance works, download my Life Insurance 101 e-Book.
