A major feature of whole life insurance is its cash value reserve. The cash value is money that accumulates as part of the policy contract.
The cash value is technically a reserve. This reserve may be used at any time during the life of the policyholder. Unless there are portions of the policy that contain paid-up life insurance, the only way to access the cash value in a whole life policy is through policy loans.
Significance
The cash value reserve builds up against the value of the death benefit. This is necessary, since the cost to provide the death benefit rises each year. Unlike term life insurance, whole life insurance must provide life insurance until the policyholder turns 100. In order to do this, significant premiums must be collected and invested. On top of this, the death benefit purchased must decrease over time. With rising costs of insurance, the insurer faces significant risks if the same amount of insurance must be paid out, and paid for, throughout the life of the insured individual named in the contract. The difference between the cash value of the policy and the actual death benefit payable is called the net amount at risk. The net amount at risk is the amount of money that the insurance company stands to lose if the policy pays a claim. A reduction in the net amount at risk means that the insurance policy becomes less risky for the insurer over time. This is because reducing the net amount at risk effectively replaces the death benefit with the cash value, or cash reserve, of the policy.
Benefit
When your heirs receive a death benefit payout, they are receiving money that is partially made up of the cash value and partially made up of the original death benefit promise made by the insurance company. This money is paid out to your heirs on an income tax-free basis.
Misconception
A common misconception about whole life insurance is that the cash value portion is taken by the insurer and the death benefit is all that is paid out to the beneficiaries. This somewhat misses the point. While it is true that the beneficiary does not receive both the original death benefit amount plus the accumulated cash value, the policyholder also did not pay for the original death benefit amount plus the cash value. When the net amount at risk decreases, the policyholder is purchasing less and less death benefit over time. Thus, the cost of insurance is decreasing over time. This is known in advance by the insurance company, so they can make their premium calculations accordingly. What is happening is essentially a process of self-insuring. If the beneficiary was to receive both the death benefit and the cash value of the policy, the premiums would need to be higher, since the net amount at risk would never decrease. In fact, the cost to provide the death benefit would increase as the insured individual in the policy got older. This actually happens on some types of permanent life insurance policies, but whole life does not use this pricing scheme.