Explaining the answer to the question "What does liquidity refer to in a life insurance policy?" can be complex, so let's break it down as easily and simply as possible.

The liquidity of an asset is the ease with which it can be turned quickly — without a significant loss in value — into cash. Cash savings accounts and money market instruments are considered liquid assets. Other assets, such as exchange-traded securities, may also be deemed fairly liquid if the owner is not expected to face significant hurdles to selling the asset at (or close to) value in a short time period. Some life insurance policies can be considered assets if policyholders have access to cash values that can be withdrawn or borrowed once a determined amount of premium has been paid.

The liquidity of a life insurance policy refers to the availability of cash value to the policyholder. The concept of liquidity in a life insurance policy essentially applies to permanent life insurance as this type of policy can accumulate cash value over time. Term life insurance policies do not have this feature and are, therefore, not deemed to be liquid.

What Determines Liquidity for Cash Value Life Insurance?

The degree of liquidity for a permanent life insurance policy depends on the structure of the contract with the insurer and how the accumulating cash funds are invested.

In general, whole life policies offer the most liquid type of insurance. The cash value is typically held in a cash account to grow at an interest rate established by the insurance contract. The insured has the right to withdraw the money as long as certain conditions are met. Universal life policies can provide similar liquidity, but the accumulation of cash value is based on current interest rates.

In contrast, variable life and variable-universal life insurance policies invest your premiums in financial market instruments such as stocks. The cash amount you're allowed to access may grow faster over time compared to other types of permanent life policies. However, to access your money, you'll have to sell your stake in the investments. The transaction could involve a loss if the securities have decreased in value since the time they were purchased by your account. Therefore, these types of policies are considered less liquid than whole life.

How Can Liquidity in an Insurance Policy Be Useful?

Access to cash value can be especially helpful for retirees. Longer life expectancy, along with ever-increasing costs of living and medical care, can wreak havoc on even the best-planned retirement budgets. Cash value policies can be structured for access to one-time or periodic monthly withdrawals to meet unexpected expenses as well as retirement lifestyle goals. Keep in mind: If loans are not repaid, the death benefit is reduced by the loan amount.

Taxes are deferred on earnings that accumulate within your cash-value account. The loans against your cash value can be free from federal taxes as long the policy isn't lapsed or canceled while the funds are outstanding. These options can add up to big tax advantages, particularly if you are in a high-income bracket.

Key Takeaways

What does liquidity refer to in a life insurance policy? In short, the liquidity of a life insurance policy refers to the availability of cash value to the policyholder. A permanent life insurance policy covers the insured for life, offers cash value and can be considered an asset with liquidity.

Term life insurance policies cover the insured for a set period of years, do not offer cash value and, therefore, are not considered assets or liquid. However, both policies promise a death benefit if the insured passes away during the coverage period.

With this information in your pocket, you can better plan for your needs when you retire.