How Does Life Insurance Gain Value?

How Does Life Insurance Gain Value?

This is one of the questions people often ask when they are investigating the need to secure life insurance. The answer is comes in three parts:

Value as an Inflation Hedge

This form of value relies on the effect of having a fixed premium. The value gained is a result of premiums being comparatively smaller as time passes. As years go by, currency loses its value through inflation. Compare what a single US Dollar will buy now compared to what it would buy 30 years ago and the difference is clear. By having fixed premiums like you find with term insurance policies, the fixed amount being paid becomes a smaller portion of a person’s income since that income will grow with natural inflation. Enhancing this effect is the fact that an older person will have higher underwriting costs and higher premiums than a younger person. A sixty year old person paying premiums on a policy underwritten when they were forty will likely have lower premiums than a person having a policy originated when they are sixty. Because of these factors, fixed premiums become relatively lower for the life of the policy.

Rising Cash Value

Many policies set aside a portion of the premium paid each month in a cash value fund. This fund can be borrowed by the policy holder as a ready source of emergency cash. The amount borrowed is generally deducted from the policy’s payout if that becomes necessary. The terms for paying back this borrowed cash are usually extremely flexible as the money theoretically belongs to the policy holder as their insurance payout. With the importance of life insurance, the money should not be frivolously borrowed, but it does provide a nice resource for someone who needs a source of short term cash to deal with an emergency. Often, borrowing will not require a separate payment, merely an extension of the payment term of the policy.

Time cost of money plus remaining premiums

If one is closer to death, the greater the value of their policy since there is less money to be paid and the premium will be collected sooner. For example, if a person has only 5 years to live, with a $1 million death benefit, and annual premiums of $5000, an investor would be willing to purchase the policy for a significant amount of money. In this case, they may be willing to purchase the policy for over $500,000.

Value as an Investment

Some life insurance policies are a hybrid of insurance and investment vehicle. Given policy names like whole life, variable life, or universal life, these hybrid policies act as any other life insurance policy except for the additional feature that interest is paid on a portion of the premium. Depending on the specific policy, this interest may be a fixed rate like a savings account, or it could change with the financial markets like a mutual fund. Like the cash value on term policies, whole life policies will often allow the policy holder to borrow against the cash value that has accrued. Borrowing on the cash value of either type is usually tax free since it is not considered income.

The fact that life insurance gains value is obvious. What can be less obvious is that it takes years for this value to grow substantially. Because of this, it is recommended that those without life insurance have a policy underwritten as soon as possible to gain the maximum benefit from this growth.