how does “cashing out life policy/insurance” work in America? Why can you cash it out while you are still alive?

Question

Is like a special savings account?

In: Economics

Answer 1

Most insurance products reily on an event that likely won’t happen but if it did would be costly. Think like a car accident.

The “math” of insurance is that you can receive more than you’ve paid in but it relies on a rare event occurring.

Back to car insurance, lets say you have a $30,000 car and pay $100 a month in insurance. If you crash the car on month 1, you get $30,000 and the insurance company loses $29,900. If you crash it in year 10, you get $30,000 (not really, but lets just assume for this example) and the insurance company loses $18,000 ($12,000 in payments at $100 a month over 10 years).

The insurance company above only really makes money if you never wreak the car (or they charge a higher premium) and since most people never wreak a car the auto insurance company ends up being profitable.

But everybody dies eventually. So how can life insurance be profitable?

The answer is that there’s basically 2 kinds of life insurance. 1st kind is where they only pay out if you die in certain kinds of ways, such as an accident, but not something like illness. The other kind of life insurance runs more like an investment account than an insurance product.

With this product you pay a monthly fee, the insurance company puts most of that fee into an investment account (they keep as small cut for profit). Then when you die they give you what was in that investment account.

The core meaning here is that it’s impossible to receive more than you’ve paid in. Since everyone eventually dies, the insurance company makes it’s profit off of the small fee they take from each payment.

To be sure clear, this is unlike other insurance because with other insurance the company makes it’s profit when the insured event doesn’t happen. People who pay for car insurance but never get in an accident. But everyone dies.

Now you might see the answer to your question baked in right there. With this kind of life insurance, you can ask for your money back at any time. You take a loss since there’s fees for taking the money out while you’re still alive. But it’s possible and that’s basically what cashing out life insurance is at it’s core.