There are lots of ways to protect yourself against unexpected financial disaster. You could hide physical gold under your mattress or stash money in offshore accounts, for example. But a more conventional approach would involve selective use of insurance as a supplement to your emergency fund.

And that makes sense, right? You expect your car and homeowners insurance coverage to ease the financial strain of pricey repairs. But a recent insurance industry report finds that many Americans aren't aware there's another form of insurance that can get you out of a bind -- and that's life insurance. The AIG Life Insurance IQ study, released in March 2020, reports that 92% of Americans don't understand the full range of benefits permanent life insurance can offer during their lifetime. The study was developed from responses provided to an online survey of 2,201 U.S. adults in December 2019.

Man staring at his cash emergency fund

Image source: Getty Images.

Those surveyed adults confirm what we all suspect -- that life insurance is confusing. There's term life insurance, which is solely intended to protect your loved ones with a death benefit payment after you're gone. And then there's permanent life insurance, which offers the death benefit plus an investment component. That investment piece is quantified as cash value, and it's funded by a portion of your insurance premiums. Over time, you can tap into that cash value -- which could give permanent life insurance a role in how you hedge against financial disaster.

How insurance cash value works

When you pay your permanent life insurance premium, a portion of your payment goes toward the cost of your coverage and a portion gets earmarked for your cash value account. That cash value earns interest and grows over time. The rate of earnings depends on the policy type -- some policies earn at a fixed rate and others allow you to invest in diversified funds managed by the insurer. Your fund choices depend on the policy type and the insurer, but they might include anything from index funds that mirror major stock indices like the S&P 500 to international bond funds.

Notably, you don't pay taxes on these earnings unless you withdraw them or you let the policy lapse.

Tapping into cash value

It takes five or 10 years of paying premiums to accumulate several thousand dollars in cash value -- but once you reach that point, the insurance company makes it very easy to access your funds. Depending on your policy type, you can withdraw the money directly or borrow against it. Loans usually carry a competitive rate, and no repayment terms. You also won't pay taxes  on these cash disbursements, unless they exceed what you've paid in premiums. Any money you pull out, though, immediately reduces your death benefit.

Fees dampen your returns

The promise of permanent life insurance is that it's both an estate planning tool and a long-term savings account in one. But saving in your life insurance is actually far less efficient than saving money directly in a retirement account or a brokerage account. This is because of the underlying fees associated with your policy and your investments. These can include sales fees, mortality and expense risk fees, administration fees, transaction fees, and fund management fees. Just as high fund management fees dampen your earnings performance in your retirement account, the fees embedded in insurance limit its investment return.

Are cheaper alternatives better?

Critics argue that investors can easily mimic the benefits of permanent life insurance by combining a cheaper term life policy with independent saving and investing. A term life policy might cost you $150 to $200 annually, while a permanent life policy with an equivalent death benefit might be $1,500 or $2,000 annually. You could, for example, purchase the term life coverage, and then independently invest $1,500 a year in low-cost index funds. There's no doubt this approach would give you higher returns.

But there are two more factors to consider.

  1. Term life coverage is temporary. Term life is ideal for younger families who want to secure a death benefit in the short- to medium-term, in case something happens to the primary breadwinner. But the coverage does expire at some point. You may have the option to renew it annually, but the premiums will be much higher as you get older. Permanent life, on the other hand, sticks around as long as you do. And as you age, you can use the accumulated cash value to pay the premiums. That gives permanent life an edge if you're motivated to secure an inheritance for your beneficiaries at the end of your life -- assuming you don't use up the cash value during your lifetime.
  2. Some people aren't good at saving independently. Saving inside a life insurance policy may work for you if you struggle to save That's because it's more forced than traditional saving -- you get a bill each year for the premium. And paying that bill automatically puts money in your cash value account. Yes, your returns will be lower than if you invested those funds independently. But if the option is to save within life insurance or not save at all, you're better off with the life insurance.

The right way to use permanent life insurance

Because of the fees, permanent life insurance should not be your sole saving or investing strategy. Like that gold hiding under your mattress, it's best used as supplement to support your estate planning and long-term financial goals. Once the cash value grows, you can lean on that as a backup emergency fund, or leave it untouched and use it to pay your premiums in retirement.