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Permanent life insurance, as a necessary part of the level premium approach to funding the death benefit, creates a reserve. Under a whole life insurance policy’s level premium plan, premiums remain level for the life of the insurance policy even though the likelihood of the insured’s death increases as he or she becomes older. For the level premium plan to provide adequate funds to pay death benefits no matter when death occurs, the premiums paid in the early years of the policy are more than sufficient to purchase the death benefit; in fact, they are greater than required to pay the death benefit. These excess premiums create a fund that is held in trust by the insurance company for the benefit of policy owners; that fund is the policy reserve. The policy reserve in a permanent life insurance policy is approximately equal to the policy’s cash value.
In addition to the favorable income tax treatment generally given to life insurance death benefits, cash values also receive certain tax benefits. Principal among those tax benefits is the tax deferral of cash value growth. As a result of cash value growth, a life insurance policy’s cash value can exceed the aggregate net premiums (i.e., premiums less dividends, paid for the policy); the result is gain. The policy gain is shielded from income taxation until the gain is withdrawn or the policy is surrendered.
As new life insurance policies were introduced, particularly variable life insurance and variable universal life insurance, more emphasis began to be placed on the investment aspect of life insurance policies, specifically on the cash values that accumulate as premiums are paid by the policy owner and interest is credited by the insurer. The cash value that is accumulated in a life insurance policy depends, in part, on the type of life insurance purchased (the amount of the death benefit and the age of the insured also play big roles in cash value growth). The cash value increases as premiums are paid and interest is credited. Because the cash value growth in life insurance is tax-deferred, the accumulation of cash value tends to be more rapid than if withdrawals were taken from the cash value each year in an amount sufficient to pay the tax liability on the growth.
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