Whole life insurance, or whole of life assurance (in the Commonwealth of Nations), sometimes called "straight life" or "ordinary life," is a life insurance policy which is guaranteed to remain in force for the insured's entire lifetime, provided required premiums are paid, or to the maturity date. Premiums are fixed, based on the age of issue, and usually do not increase with age. The insured party normally pays premiums until death, except for limited pay policies which may be paid-up in 10 years, 20 years, or at age 65. Whole life insurance belongs to the cash value category of life insurance, which also includes universal life, variable life, and endowment policies.
The other major form of life insurance is term life, which may be individual term policies or group term certificates. As a general rule, term life is intended for temporary use and has no cash value.
Death benefit
The death benefit of a whole life policy is normally the stated face amount. However, if the policy is "participating", the death benefit will be increased by any accumulated dividend values and/or decreased by any outstanding policy loans. (see example below) Certain riders, such as Accidental Death benefit may exist, which would potentially increase the benefit.
In contrast, universal life policies (a flexible premium whole life substitute) may be structured to pay cash values in addition to the face amount, but usually do not guarantee lifetime coverage in such cases.
Hypothetical claims example
A person buys a whole life policy in 1974 at age 30, and names his or her spouse as beneficiary. The person dies in 2004
- Policy face amount $25,000 (includes cash value of $12,242)
- Less outstanding loan - 8,144 ($5,000 loan, plus 10 years interest)
- Plus dividend values + 16,300 (per original scale... actual dividends were greater during this period)
- Death benefit paid = $33,156 amount of check paid to spouse.
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Maturity
A whole life policy is said to "mature" at death or the maturity age of 100, whichever comes first. To be more exact the maturity date will be the "policy anniversary nearest age 100". The policy becomes a "matured endowment" when the insured person lives past the stated maturity age. In that event the policy owner receives the face amount in cash. With many modern whole life policies, issued since approximately 2000, maturity ages have been increased to 120. Increased maturity ages have the advantage of preserving the tax-free nature of the death benefit. In contrast, a matured endowment may have substantial tax obligations.
Taxation
The entire death benefit of a whole life policy is free of income-tax, except in unusual cases. This includes any internal gains in cash values. Of course, the same is true of group life, term life, and accidental death policies.
However, when a policy is cashed out before death it's a different story. With cash surrenders, any gain over total premiums paid will be taxable as ordinary income. The same is true in the case of a matured endowment. This is why most people choose to take cash values out as a "loan" against the death benefit rather than a "surrender." Any money taken as a loan is free from income tax as long as the policy remains in force. For participating whole life policies, the interest charged by the insurance company for the loan is often less than the dividend each year, especially after 10-15 years, so the policy owner can pay off the loan using dividends. If the policy is surrendered or canceled before death, any loans received above the cumulative value of premiums paid will be subject to tax as growth on investment.
It should be emphasized that, while life insurance benefits are generally free of income tax, the same is not true of estate tax. In the US, life insurance will be considered part of a person's taxable estate to the extent he possesses "incidents of ownership." Estate planners often use special Irrevocable Trusts to shield life insurance from estate taxes.
Uses
Personal and family uses
Individuals may find whole life attractive because it offers coverage for an indeterminate length of time. It is the dominant choice for insuring so-called "permanent" insurance needs, including:
- Funeral expenses,
- Estate planning,
- Surviving spouse income, and
- Supplemental retirement income.
Individuals may find whole life less attractive, due to the relatively high premiums, for insuring:
- Large debts,
- Temporary needs, such as children's dependency years,
- Young families with large needs and limited income.
In the second category, term life is generally considered more suitable and has played an increasingly larger role in recent years.
Business uses
Businesses may also have legitimate and compelling needs, including funding of:
- Buy-sell agreements
- Death of key person
- Supplemental executive retirement plans (S.E.R.P.)
- Deferred compensation
While Term life may be suitable for Buy-Sell agreements and Key Person indemnification, cash value insurance is almost exclusively for Deferred Comp and S.E.R.P.'s.
Whole Life insurance operates on the "level premium" system, due to the lifetime nature of the coverage. A rate is established based on the age of the insured at the time of purchase, and generally remains constant (level) until death. Thus, it can be seen that the level premium for a 40-year-old would be substantially more than for someone who bought at age 25. The purpose is to make lifetime coverage affordable at older ages. In contrast, yearly renewable term life rates are very low at younger ages and increase each year with age, becoming prohibitively expensive at older ages. The level premium system results in overpaying for the risk of dying at younger ages, and underpaying in later years toward the end of life expectancy.
Example: A person bought a $25,000 policy and paid monthly premiums of $42.06 + an additional $1.03 for disability waiver rider from age 30 to age 50. They had a stroke and became totally disabled. Premiums were waived thereafter until their death at age 60.
Reserves
The over-payments inherent in the level premium system mean that a large portion of expensive old-age costs are prepaid during a person's younger years. U.S. Life insurance companies are required by state regulation to set up reserve funds to account for said over-payments, which represent promised future benefits, and are classified as Legal Reserve Life Insurance Companies. The Death Benefit promised by the contract is a fixed obligation calculated to be payable at the end of life expectancy, which may be 50 years or more in the future. (see non-forfeiture values)
Most of the visible and apparent wealth of Life Insurance companies is due to the enormous assets (reserves) they hold to stand behind future liabilities. In fact, reserves are classified as a liability, since they represent obligations to policyholders. These reserves are primarily invested in bonds and other debt instruments, and are thus a major source of financing for government and private industry.
Cash values
Cash values are an integral part of a whole life policy, and reflect the reserves necessary to assure payment of the guaranteed death benefit. Thus, "cash surrender" (and "loan") values arise from the policyholder's rights to quit the contract and reclaim a share of the reserve fund attributable to his policy. (see #Example of non-forfeiture values below)
Although life insurance is often sold with a view toward the "living benefits" (accumulated cash and dividend values), this feature is a byproduct of the level premium nature of the contract. The original intent was not to "sugar coat" the product; rather it is a necessary part of the design. However, prospective purchasers are often more motivated by the thought of being able to "count my money in the future." Policies purchased at younger ages will usually have guaranteed cash values greater than the sum of all premiums paid after a number of years. Sales tactics frequently appeal to this self-interest (sometimes called "the greed motive"). It is a reflection of human behavior that people are often more willing to talk about money for their own future than to discuss provisions for the family in case of premature death (the "fear motive"). On the other hand, many policies purchased due to selfish motives will become vital family resources later in a time of need.
The marketing of whole life (and other cash value policies) as a substitute for savings and investments is considered controversial in some circles. Sometimes the regulatory agencies forbid the use of the words "savings" or "investment" by sales people when describing life insurance, insisting that life insurance should only be for "protection" against the economic hazard of death.
When discontinuing a policy, according to Standard Non-forfeiture Law, a policyholder is entitled to receive his share of the reserves, or cash values, in one of three ways (1) Cash, (2) Reduced Paid-up Insurance, or (3) Extended term insurance.
Example of non-forfeiture values
Whole life, issued at age 30 with premiums discontinued after 10 years; premiums paid $12.31 annually per thousand x 10 yrs = $123.10 total; non-forfeiture values are
- Immediate cash payment = $98.13 per thousand, or
- Reduced paid-up insurance $272 per thousand, or
- Extended term coverage of the full amount for additional 15 years +182 days. Extended term is usually the default option.
Note: In the above example, a $10,000 policy would have a $2,720 lifetime paid-up value. Major Life insurance companies have thousands of these small unclaimed "remnants" cluttering their books on the lives of people they cannot locate. Old inactive life insurance policies may have value.
Pricing methods
Non-participating
All values related to the policy (death benefits, cash surrender values, premiums) are usually determined at policy issue, for the life of the contract, and usually cannot be altered after issue. This means that the insurance company assumes all risk of future performance versus the actuaries' estimates. If future claims are underestimated, the insurance company makes up the difference. On the other hand, if the actuaries' estimates on future death claims are high, the insurance company will retain the difference.
Non-participating policies are typically issued by Stock companies, with stockholder capital bearing the risk. Since whole life policies frequently cover a time span in excess of 50 years, it can be seen that accurate pricing is a formidable challenge! Actuaries must set a rate which will be sufficient to keep the company solvent through prosperity or depression, while remaining competitive in the marketplace. The company will be faced with future changes in Life expectancy, unforeseen economic conditions, and changes in the political and regulatory landscape. All they have to guide them is past experience.
Participating
In a participating policy (also "par" in the USA, and known as a "with-profits policy" in the Commonwealth), the insurance company shares the excess profits (divisible surplus) with the policyholder in the form of annual dividends. Typically these "refunds" are not taxable because they are considered an overcharge of premium (or "reduction of basis"). In general, the greater the overcharge by the company, the greater the refund/dividend ratio; however, other factors will also have a bearing on the size of the dividend. For a mutual life insurance company, participation also implies a degree of ownership of the mutuality.
Participating policies are typically (although not exclusively) issued by Mutual life insurance companies. However, Stock companies sometimes issue participating policies. Premiums for a participating policy will be higher than for a comparable non-par policy, with the difference (or, "overcharge") being considered as "paid-in surplus" to provide a margin for error equivalent to stockholder capital. It should be emphasized that illustrations of future dividends are never guaranteed.
In the case of mutual companies, unneeded surplus is distributed retrospectively to policyholders in the form of dividends. Sources of surplus include conservative pricing, mortality experience more favorable than anticipated, excess interest, and savings in expenses of operation.
While the "overcharge" terminology is technically correct for tax purposes, actual dividends are often a much greater factor than the language would imply. For a period of time during the 1980s and '90's, it was not uncommon for the annual dividend to exceed the total premium at the 20th policy year and beyond. {Milton Jones, CLU, ChFC}
With non-participating policies, unneeded surplus is distributed as dividends to stockholders.
Similar to non-participating, except that the premium may vary year to year. However, the premium will never exceed the maximum premium guaranteed in the policy. This allows companies to set competitive rates based on current economic conditions.
Variations
Economic
A blending of participating and term life insurance, wherein a part of the dividends is used to purchase additional term insurance. This can generally yield a higher death benefit, at a cost to long term cash value. In some policy years the dividends may be below projections, causing the death benefit in those years to decrease.
Limited pay
Limited pay policies may be either participating or non-par, but instead of paying annual premiums for life, they are only due for a certain number of years, such as 20. The policy may also be set up to be fully paid up at a certain age, such as 65 or 80. The policy itself continues for the life of the insured. These policies would typically cost more up front, since the insurance company needs to build up sufficient cash value within the policy during the payment years to fund the policy for the remainder of the insured's life. With Participating policies, dividends may be applied to shorten the premium paying period.
A form of limited pay, where the pay period is a single large payment up front. These policies typically have fees during early policy years should the policyholder cash it in.
Interest sensitive
This type is fairly new, and is also known as either "excess interest" or "current assumption" whole life. The policies are a mixture of traditional whole life and universal life. Instead of using dividends to augment guaranteed cash value accumulation, the interest on the policy's cash value varies with current market conditions. Like whole life, death benefit remains constant for life. Like universal life, the premium payment might vary, but not above the maximum premium guaranteed within the policy.
Requirements
Whole life insurance typically requires that the owner pay premiums for the life of the policy. There are some arrangements that let the policy be "paid up", which means that no further payments are ever required, in as few as 5 years, or with even a single large premium. Typically if the payor doesn't make a large premium payment at the outset of the life insurance contract, then he is not allowed to begin making them later in the contract life. However, some whole life contracts offer a rider to the policy which allows for a one time, or occasional, large additional premium payment to be made as long as a minimal extra payment is made on a regular schedule. In contrast, universal life insurance generally allows more flexibility in premium payment.
Guarantees
The company generally will guarantee that the policy's cash values will increase every year regardless of the performance of the company or its experience with death claims (again compared to universal life insurance and variable universal life insurance which can increase the costs and decrease the cash values of the policy). The dividends can be taken in one of three ways. The policy owner can be given a cheque from the insurance company for the dividends, the dividends can be used to reduce the premium payment, or the dividends can be reinvested back into the policy to increase the death benefit and the cash value at a faster rate. When the dividends paid on a whole life policy are chosen by the policy owner to be reinvested back into the policy, the cash value can increase at a rather substantial rate depending on the performance of the company.
The cash value will grow tax-deferred with compounding interest. Even though the growth is considered "tax-deferred," any loans taken from the policy will be tax-free as long as the policy remains in force. In addition, the death benefit remains tax-free (meaning no income tax and no estate tax). As the cash value increases, the death benefit will also increase and this growth is also non-taxable. The only way tax is ever due on the policy is (1) if the premiums were paid with pre-tax dollars, (2) if cash value is "withdrawn" past basis rather than "borrowed," or (3) if the policy is surrendered. Most whole life policies can be surrendered at anytime for the cash value amount, and income taxes will usually only be placed on the gains of the cash account that exceeds the total premium outlay. Thus, many are using whole life insurance policies as a retirement funding vehicle rather than for risk management.
Liquidity
Cash values are considered liquid assets because they are easily accessible at any time, usually with a phone call or fax to the insurance company requesting a "loan" or "withdrawal" from the policy. Most companies will transfer the money into the policy holder's bank account within a few days.
Cash values are also liquid enough to be used for investment capital, but only if the owner is financially healthy enough to continue making premium payments (Single premium whole life policies avoid the risk of the insured failing to make premium payments and are liquid enough to be used as collateral. Single premium policies require that the insured pay a one time premium that tends to be lower than the split payments. Because these policies are fully paid at inception, they have no financial risk and are liquid and secure enough to be used as collateral under the insurance clause of collateral assignment.) Cash value access is tax free up to the point of total premiums paid, and the rest may be accessed tax free in the form of policy loans. If the policy lapses, taxes would be due on outstanding loans. If the insured dies, death benefit is reduced by the amount of any outstanding loan balance.
Internal rates of return for participating policies may be much worse than universal life and interest-sensitive whole life (whose cash values are invested in the money market and bonds) because their cash values are invested in the life insurance company and its general account, which may be in real estate and the stock market. However, universal life policies run a much greater risk, and are actually designed to lapse. Variable universal life insurance may outperform whole life because the owner can direct investments in sub-accounts that may do better. If an owner desires a conservative position for his cash values, par whole life is indicated.
Reported cash values might seem to "disappear" or become "lost" when the death benefit is paid out. The reason for this is that cash values are considered to be part of the death benefit. The insurance company pays out the cash values with the death benefit because they are inclusive of each other. This is why loans from the cash value are not taxable as long as the policy is in force (because death benefits are not taxable).
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