Use Cash Values Without Confusing the Choices

Introduction

A permanent life policy can build cash value: money inside the policy that the owner can use while the insured is still alive. There is more than one way to use it, and the ways have very different effects. One choice keeps full coverage but creates a debt. Another removes money for good. Another ends the policy entirely.

This lesson shows how to tell those choices apart and predict what each one does to the money and the coverage.

Every policy, person, and dollar amount in this lesson is fictional and stipulated for teaching. Real results depend on the actual policy's terms.

What You Will Be Able to Do

• Explain why cash value and the face amount are different numbers.
• Tell a policy loan apart from a withdrawal (partial surrender), and predict how each affects the death benefit.
• Compare cash surrender, reduced paid-up insurance, and extended term insurance when an owner stops paying premiums.
• Distinguish participating from nonparticipating policies, and describe the common ways a dividend can be used.

Before you start: You should know how whole life builds cash value (Understand whole life and premium schedules), how flexible-premium policies work (Separate flexible premiums from investment risk), and what a lapse is (Keep coverage in force and understand a lapse).

Start With Two Different Numbers

The face amount is the coverage amount, the death benefit the policy is built to pay when the insured dies. The cash value is the value that has built up inside the policy. The owner may be able to use it while the insured is alive.

These two numbers are not the same, and the cash value is usually much smaller, especially in a policy's early years.

Example (fictional): A whole life policy has a $100,000 face amount. After several years, its cash value is $18,000.

• If the insured dies, the starting point for the claim is the $100,000 face amount.
• If the owner gives up the policy for cash, the starting point is the $18,000 cash value, not $100,000.

The reason is that the face amount is a promise to pay at death. The cash value is a separate, smaller amount that has built up and that the owner can reach while the insured is alive. Giving up the policy means giving up the death promise, so the owner only gets the built-up value.

Necessary qualification: Neither number is always the exact amount paid. Debts, charges, unpaid premiums, and dividend values can adjust it. Adjust only by the facts you are actually given.

Watch for: "The cash value equals the death benefit." It doesn't. They answer different questions: What is paid at death? versus What value has built up that the owner can use now?

Borrowing: A Policy Loan

Policy loan: The insurer lends the owner money and uses the policy's value as security. Think of it as borrowing against the cash value, not taking the cash value out.

Because it is a loan, it comes with interest. The policy states the interest rate or how the rate is set. Any amount still owed, including unpaid interest, is called the policy debt (or indebtedness).

Example (fictional): The owner of the $100,000 policy with $18,000 of cash value borrows $5,000. A year later, unpaid interest has raised the debt to a stipulated $5,300. The owner has not repaid anything.

• The cash value still exists inside the policy, but $5,300 of it is now backing a debt.
• If the insured dies now, the beneficiary receives $100,000 − $5,300 = $94,700 (assuming no other adjustments).
• The owner may repay the loan. Repaying removes the debt and restores the full benefit.

This works because a loan does not erase the death benefit promise. The insurer is simply collecting what it is owed out of the money it pays.

Change one fact: Suppose the owner keeps not paying interest for years and the debt keeps growing until it reaches the value available to support it. At that point, the policy can terminate under its terms, after any notice the contract and applicable rules require. A loan that is never managed can end the coverage.

Watch for: "A loan is free money from my own account." It isn't free. Interest builds up, unpaid debt reduces what is paid at death or surrender, and growing debt can end the policy.

Removing Money: A Withdrawal or Partial Surrender

Withdrawal (also called a partial surrender): The owner takes part of the value out of the policy. Nothing is borrowed, so nothing has to be repaid and no loan interest builds up. But the money is gone from the policy.

Withdrawals are most associated with flexible-premium policies such as universal life. Not every policy permits them, and those that do set their own limits and charges.

Example (fictional): A universal life policy has a $200,000 death benefit and $30,000 of cash value. The owner withdraws $4,000. This fictional contract states that the death benefit drops by the amount withdrawn.

• Cash value: $30,000 − $4,000 = $26,000
• Death benefit: $200,000 − $4,000 = $196,000
• Debt: $0, because nothing was borrowed

Change one fact: A different fictional contract uses another formula, and under it this same $4,000 withdrawal lowers the death benefit by a stated $6,000. That is not a mistake. Some contracts reduce the death benefit by more than the amount withdrawn, and the effect can also depend on which death benefit option is in place. There is no single dollar-for-dollar rule that fits every policy. The contract's formula decides.

Watch for: "Every withdrawal lowers the death benefit by exactly the amount taken." Use the rule the policy states, or the facts the question gives you.

Loan or Withdrawal? Ask These Questions

• Is there a debt to repay? Loan: yes. Withdrawal: no.
• Does interest build up? Loan: yes. Withdrawal: no loan interest, though the contract may charge a fee.
• Is the value still in the policy? Loan: yes, but it is backing a debt. Withdrawal: no, it is removed.
• Can the owner undo it? Loan: repaying removes the debt. Withdrawal: the removed amount isn't "repaid," and any lost benefit follows the contract's rules.

Check 1: An owner takes $3,000 from a fictional policy. A year later, the owner's statement shows $3,240 owed and growing. Was this a loan or a withdrawal? What happens to the death benefit if the insured dies today and nothing else applies?

Answer: Explanation

It was a loan. The clue is the growing amount owed: withdrawals create no debt and no loan interest. If the insured dies today, the $3,240 debt is subtracted from the death benefit. The tempting mistake is to subtract only the original $3,000. The debt includes the interest that was added.

Giving Up the Policy: Cash Surrender

Cash surrender: The owner ends the policy and takes its cash surrender value. Coverage stops. Nobody will receive a death benefit later from this policy.

The cash surrender value is the cash value after the deductions the policy allows, such as surrender charges, outstanding debt, and certain unpaid premiums.

Example (fictional): Return to the whole life policy with $18,000 of cash value and $5,300 of debt. There is no stated surrender charge and no unpaid premium.

• Cash surrender value: $18,000 − $5,300 = $12,700
• Coverage after surrender: none

Don't count a deduction twice. If a question says the net cash surrender value is $12,700 and the debt is already included, the owner receives $12,700. Subtracting the $5,300 again would charge the debt twice.

Watch for: "Surrender lets me take the cash and keep my coverage." Surrender ends the policy. If the owner wants some coverage to continue, the next section covers the options that do that.

Stopping Premiums Without Losing Everything

When an owner stops paying premiums on a policy that has cash value, that value doesn't simply disappear. The policy's nonforfeiture provision ("nonforfeiture" means "not lost") describes the options. There are three common ones:

1. Cash surrender. Take the cash surrender value. Coverage ends.
2. Reduced paid-up insurance. Use the value to buy a smaller amount of permanent coverage. No further premiums are due.
3. Extended term insurance. Use the value to buy term coverage, generally at the policy's face amount, for a limited time. When that time runs out, coverage ends.

Example (fictional): The $100,000 whole life policy has $18,000 of cash value and no debt. The owner stops paying premiums. This fictional contract's table shows:

• Cash surrender: $18,000 cash; coverage ends.
• Reduced paid-up: $41,000 of permanent coverage; no more premiums.
• Extended term: $100,000 of coverage for 14 years and 3 months; no more premiums.

The same $18,000 can buy either a smaller amount for life or the full amount for a limited time. Reduced paid-up gives up size to keep permanence. Extended term gives up permanence to keep size.

Change one fact: Now suppose the policy has the $5,300 debt. Less net value is available to buy anything. The paid-up amount would be smaller, and extended term coverage is typically the face amount reduced by the debt, possibly for a shorter period. The contract explains exactly how debt changes these values.

Necessary qualifications:

• Not every policy offers every option. A contract must be read to see which ones it includes.
• If the owner doesn't choose, the contract names which option applies automatically. Look for it in the policy; don't assume it is always the same one.

Watch for: Mixing up the two paid-up words. Reduced paid-up = smaller benefit, permanent. Extended term = same face (less debt, if any), limited time.

Check 2: An owner stops paying premiums and says, "I want to keep the full face amount, and I understand the coverage won't last for life." Which option fits? Which option fits an owner who says, "I want coverage that never runs out, even if it's smaller"?

Answer: Explanation

The first owner is describing extended term insurance: full face amount (less any debt), for a limited period. The second is describing reduced paid-up insurance: a smaller benefit that lasts for life with no further premiums. The tempting mistake is to pick reduced paid-up for the first owner because the word "paid-up" sounds like it keeps everything. "Reduced" is the clue that the benefit gets smaller.

Participating vs. Nonparticipating Policies

A participating policy is eligible to share in the insurer's divisible surplus through dividends. A dividend is a payment the insurer may declare when its actual results (such as investment earnings, deaths, and expenses) turn out better than it planned for.

A nonparticipating policy is not eligible for dividends. It has no dividend to use.

Participating means eligible, not guaranteed. Dividends are not guaranteed. The insurer decides whether to declare one and how much.

• A long history of past dividends does not promise future dividends.
• A projection or illustration showing future dividends is an estimate, not a promise.

Example (fictional): A participating whole life policy's illustration projects that dividends will eventually cover the premium. That projection does not make the policy paid-up. If actual dividends come in lower, the owner still owes whatever premium the dividends don't cover.

Ways to Use a Dividend

When a dividend is declared, the owner can typically choose how to use it. Policies offer cash or a premium reduction. Many offer more options:

• Cash: The insurer pays the dividend to the owner.
• Reduce the premium: The dividend pays part of the next premium. Fictional: a $2,400 premium and a $600 dividend leave $1,800 for the owner to pay.
• Accumulate at interest: The dividend stays with the insurer and earns interest.
• Paid-up additions: The dividend buys small pieces of extra paid-up permanent coverage that are added on top of the base policy. Fictional: the $600 dividend buys a stated $1,500 of additions, so the death benefit becomes $101,500.
• One-year term insurance (if the policy offers it): The dividend buys extra term coverage that lasts one year.

Paid-Up Additions Are Not Reduced Paid-Up

These two sound alike but move in opposite directions:

• Paid-up additions answer: How can a dividend add coverage? They increase the death benefit while the policy continues.
• Reduced paid-up insurance answers: How can I keep some permanent coverage after I stop paying premiums? It replaces the original coverage with a smaller amount.

The fact that distinguishes them: additions come from a dividend and are added to a policy that keeps going. Reduced paid-up comes from the cash value after the owner stops paying premiums.

Check 3: An owner's participating policy has paid a dividend every year for 20 years. They plan to stop paying premiums because "the dividends will cover it from now on." What is the flaw in this plan? Then: an owner of a nonparticipating policy asks to use this year's dividend to buy paid-up additions. What's the issue?

Answer: Explanation

First owner: dividends are not guaranteed, and past payments don't promise future ones. If a future dividend is smaller than the premium, or isn't declared at all, the owner still owes the difference. Relying on dividend history doesn't make a policy paid-up.

Second owner: a nonparticipating policy is not eligible for dividends, so there is no dividend to use. The tempting mistake is to assume every permanent policy pays dividends.

Compare the Choices Side by Side

Each choice answers a different question:

• Policy loan asks: Can I get money now and keep the policy? Yes, but it creates a debt with interest, reducing what is paid until repaid.
• Withdrawal / partial surrender asks: Can I take some value out for good? Yes, if the policy allows. No debt, but the value is gone and the benefit usually drops by the contract's formula.
• Cash surrender asks: Can I end the policy and take its value? Yes. Coverage ends.
• Reduced paid-up asks: Can I stop premiums and keep lifelong coverage? Yes, at a smaller amount.
• Extended term asks: Can I stop premiums and keep the full amount for now? Yes, for a limited time.
• Dividend options ask: How do I use a declared dividend? Only if the policy is participating and a dividend is declared.

Practice on Your Own

Use only the facts given. All amounts are fictional.

Question 1: A whole life policy has a $150,000 face amount and $22,000 of cash value. There is no debt and no surrender charge. The owner surrenders the policy. How much do they receive, and what coverage remains?

Answer: Explanation

They receive $22,000, the cash surrender value, and no coverage remains. The tempting wrong answer is $150,000. That is the face amount, which is paid only at death while the policy is in force. Surrender gives up that promise.

Question 2: A policy has a $250,000 death benefit. The owner borrowed against it, and the debt including unpaid interest is now $11,500. The insured dies, with no other adjustments. What does the beneficiary receive?

Answer: Explanation

$250,000 − $11,500 = $238,500. Unpaid loan debt, including interest, is subtracted from the death benefit. A common mistake is to subtract only the amount originally borrowed and leave out the interest.

Question 3: A universal life policy's contract states that a withdrawal reduces the death benefit by the amount withdrawn. The death benefit is $180,000 and the cash value is $25,000. The owner withdraws $5,000. Give the new cash value, the new death benefit, and the debt.

Answer: Explanation

Cash value $20,000, death benefit $175,000, debt $0. A withdrawal removes value without creating a loan. These numbers work only because the contract states a dollar-for-dollar reduction. Under a different formula, the death benefit could drop by more.

Question 4: An owner stops paying premiums on a $100,000 whole life policy with no debt. Six years later, the insured is alive, but the policy no longer provides any coverage. The owner never surrendered for cash. Which nonforfeiture option most likely applied, and why?

Answer: Explanation

Extended term insurance. It provides coverage for a limited period, and when that period ends, coverage ends. Reduced paid-up would still be in force, because it is permanent. Cash surrender is ruled out because the owner didn't take the cash.

Question 5: A participating policy declares a $900 dividend. The annual premium is $3,000. The owner chooses the premium-reduction option. How much does the owner pay? Would the answer change if the owner chose paid-up additions instead?

Answer: Explanation

With premium reduction, the owner pays $3,000 − $900 = $2,100. With paid-up additions, the owner pays the full $3,000, and the $900 buys extra paid-up coverage that raises the death benefit. Same dividend, different use: one lowers the cash the owner pays, the other adds coverage.

Question 6: Someone says, "Paid-up additions and reduced paid-up are basically the same thing, since both are paid-up insurance." Explain what's wrong.

Answer: Explanation

They move in opposite directions. Paid-up additions are bought with dividends and add coverage to a policy that keeps going. Reduced paid-up is bought with cash value after premiums stop and replaces the original coverage with a smaller permanent amount. Sharing the words "paid-up" (no more premiums owed for that coverage) doesn't make them the same choice.

What to Remember

• Cash value is not the face amount. Surrender pays the cash surrender value; death pays the death benefit, adjusted only by stated facts.
• A loan creates debt plus interest. Unpaid debt reduces what is paid, and debt that grows large enough can end the policy under its terms.
• A withdrawal removes value for good. There is no debt, but the benefit usually drops by the contract's formula, which is not always dollar-for-dollar.
• Cash surrender ends coverage. Don't subtract the same deduction twice.
• Reduced paid-up = smaller, permanent. Extended term = face amount (less debt), limited time. Not every policy offers every option; the contract names the automatic one.
• Participating policies may pay dividends; nonparticipating policies don't. Dividends, past dividends, and projections are never guarantees.
• Dividend uses: cash, premium reduction, accumulation at interest, paid-up additions, and one-year term if the policy offers it. Paid-up additions add coverage; reduced paid-up shrinks it.

Review: Participating does not mean a dividend is guaranteed

• Participating vs. Nonparticipating Policies
• Ways to Use a Dividend

Review: Two meanings of paid-up

• Stopping Premiums Without Losing Everything
• Ways to Use a Dividend