The Physician’s Life Insurance Primer Series: What is Whole Life Insurance and how does it work?
Although whole life insurance, in its present form, has been around for over a century, it remains somewhat of an enigma for people who want to buy permanent protection, especially as new forms of life insurance have sprung up around it over the last several decades. In this article, we’ll discuss how this type of policy works and some of the features that may be useful within a complete financial plan.
A Whole Life Overview
Whole Life insurance remains a secure way to provide for long-term protection and, when it is fully understood, it can also be a very cost-effective way to own permanent, lifelong life insurance coverage. For people who recognize that the need for life insurance may never go away, whole life insurance is still a great way of providing secure, guaranteed protection.
One of the criticisms of whole life insurance is that it is structured in a way that is not very transparent to the policyholder. Although it offers absolute guarantees as to the amount of premium, face amount and cash value growth; people tend to shy away from it because it the inner workings of the policy are not clear such as they are with a universal life policy.
The best way to understand a whole life policy is to think of it in terms of “what you see is what you get”. Keeping the end in mind – that is, a lifetime of protection that can never be revoked – all a policyholder has to be concerned with is paying the fixed, level premium on time for which he or she will also enjoy guaranteed, tax-favored accumulation of cash values.
As long as the policy is issued by a financially strong, credit-worthy life insurance company, the policyholder can be assured that all of the guarantees and obligations of the life insurer will be met. No fuss, no muss, and no loss of sleep.
How Whole Life Insurance Really Works
When an individual decides on the face amount of coverage needed for protection, the life insurer provides a quote for an amount of premium. The premium is fixed and remains level throughout the life of the policy. The death benefit also remains level and it is guaranteed by the life insurer.
When comparing the amount of premium required for a whole life policy with a term policy, it is clear that the premiums required for a whole life policy are substantially higher than a term policy. The reason for this is, with a term policy, the premium is used simply to buy pure life insurance protection. As a person ages, and their mortality costs increase, term premiums will also increase to a point where they may not be affordable.
With a whole life policy, the insurer takes a portion of the premium payment and puts it into a cash value account where it earns a guaranteed rate of return. As the cash value grows, the life insurer will use some of the accumulated values to offset the higher costs of mortality in the later years of the policy. This is how the insurer is able to keep the premium outlay level.
If the person who owns a term policy finds that they still need coverage in later years, they may not be able to afford it, or, worse, they may not still be insurable. The person who owns a whole life insurance policy will have permanent coverage with premiums that are as low as the first day that the policy was issued.
To accomplish this, the life insurer calculates the mortality costs based on the life expectancy of the policyholder. It then projects how much the cash value will grow over time based on the current cost of money. With these calculations, it can then lock in a death benefit, a level premium and a projected amount of cash value – all guaranteed.
The Magic of Dividends
There is one variable that can actually help the whole life policy to perform better than projected. Mutual life insurance companies pay dividends to their policyholders from their profits, just as many stock companies pay dividends to their stockholders. These insurers are called “participating” life insurers. Dividends are not guaranteed; however, many of the top life insurance companies have a very good track record of paying dividends consistently and in increasing amounts.
When a dividend is paid on a whole life policy, the policyholder has a few choices as to how to apply it:
- Purchase Paid Up Additions: The dividend can be used to purchase a small amount of paid-up life insurance. This small block of paid-up insurance is added to the death benefit and it also has a cash value portion with is added to the accumulation account. Adding blocks of paid-up insurance each year will have a compounding effect on the growth of the cash values. It also serves to increase the face amount of the death benefit each year. The best performing whole life policies have the potential to be fully paid up after a period of time.
- Reduce the Premium Payment: Another way to apply the dividend is to use it to pay the premium. In the early years of the policy, the dividend may only cover a portion of the premium. But, as the size of the dividend increases, it is possible it can eventually cover the entire premium payment.
- Take it or Accumulate it as Cash: Finally, the policyholder can simply take the dividend as a cash payment or leave it to accumulate in separate dividend account where it doesn’t affect the performance of the policy.
Using Cash Values
Whole life insurance also has some living benefits in that the cash value, which accumulates tax free, can be accessed at any time via a policy loan. When cash values are loaned out to the policyholder, they are not considered to be taxable income. The interest charged on the loan is typically well below the market interest rates so it can be a very inexpensive way to fund needs such as college expenses, a business startup, a down payment or to supplement retirement income. Loans on the policy will have the effect of reducing the face amount if they are not repaid.
Whole life policies don’t have to a big mystery. They are all bundled up for a reason and that is so the life insurer can provide the guarantees that it does. As long as the life insurance provider is a high quality company, in strong financial condition with a solid record of paying dividends, you can be assured that your policy will perform at least as well as expected, and, more than likely, it will perform better for secure, cost-effective, life-long coverage.
Check out other articles in The Physician’s Life Insurance Primer series: