Although it would be necessary to read the policy itself to see what's really happening, my suspicion is that the policy involved is a cash value policy -- probably a Whole Life plan -- that has an automatic premium loan provision in place.
This is not necessarily true. She could have taken out a straight loan for $1,000- no APL is needed, sometimes people DO need to tap into that money.
Normally the premium on a whole life plan includes (1) the cost of the charges for mortality based on your sex, age and health at inception, (2) charges to cover such things as administrative expenses, premium taxes, and any residual sales commissions, etc), and (3) an additional amount that builds up in the policy and earns interest. That cash value builds up and in later years is essentially drawn down to help pay or subsidize the premium as mortality charges increase with age.
Again, not necessarily. This depends upon the provisions of the policy. Many people will have an accrued CV beyond the value of their policy because they continued to pay, or overpaid, premiums.
The amount of cash value of that accumulates is also influenced by prevailing interest rates.
While $10,000 of life coverage is no longer a significant amount, whether you should surrender the policy and get the rest of the cash value out or you should instead continue to pay premium and keep it in force normally would depend on your health (that is if you've become afflicted with a serious condition and can no longer buy standard priced life coverage). If you need coverage to protect your dependents, for most folks in average health, seeking the maximum amount of life protection for their dependents for dollar spent, only term makes sense.
It really depends on a lot of factors. I don't know that I would recommend cashing out this policy. If the OP is in poor health, they should keep it. It will continue to accrue Cash Value. Also, keep in mind, this policy was written when the OP was younger. OPs rates will have risen since then, perhaps dramatically, based upon a number of factors.
What OP really needs to do it call the agent or company that issued the policy and ask what the cash surrender value is, minus the outstanding loan and interest. They should also ask for an illustration and a review of said illustration, which will provide them with a timeline for potential and actual growth of the policy. They should also request a dividend and premium history, and they should sit down, with an agent, and assess their best options regarding the policy. Regarding the tax issues- I am not sure about the legality of the loan and your tax responsibility to it. You need to ask an agent, as well as your accountant, about what the potential repercussions upon you might be. You may- *may*- be able to pay off the loan with dividends, as well as the interest, either now or eventually. There may also be tax consequences for surrendering the policy and getting a check for the remaining value. You need to keep that in mind.
OP, also keep in mind, it's usually easier to get more insurance when you're already insured. It may sound like I'm trying to get you to keep the policy, but I'm not; these are just all things that you really want to carefully consider prior to surrendering the policy.