Understanding whole life insurance

As we travel down the life insurance highway, the first “fork in the road”, so to speak, arises with the choice between term or permanent coverages.

The distinction is not artificial — each type of coverage has its own features and benefits, and will appeal to different needs and different circumstances, or will each appeal to the same person at different stages of their life.

Let’s follow the permanent route. This route also quickly splits into two paths: whole life and universal life, both variations on the permanent life insurance theme. We’ll discuss universal life in a future article. For now, let’s get familiar with whole life insurance, so named because it is intended to cover the insured for their “whole” life, although they ordinarily run until age 100.

In the case of term insurance the premium will increase as you age, because your risk of dying increases as you age. This is nice when you’re young because you get a lot of coverage for a minimum price. But term insurance can get really pricey as you age, especially in your late ’40s and beyond.

Whole life insurance addresses this escalation in premium expense. Your premiums will generallye flat until you die, or until the policy is fully paid for.

The trade-off is that your premium cost will be higher when you are younger, but it will be lower (than it would have been under term insurance) when you are older.

How the insurance company handles the premium on your whole life policy is actually quite interesting. Of course, there is the “mortality charge” — delightful term, isn’t it? But accurate. It’s the cost of the pure insurance coverage. This charge will increase with your age, just as it does with term insurance. Then there’s the insurance company’s cut which covers its management and overhead costs as well as providing a profit.

The last part of the premium, and this is the interesting part, goes to a “reserve” to offset your continually increasing mortality charge. This becomes the “cash value” of the policy. This money earns interest although you may be disappointed to learn that the insurance company is under no obligation to disclose how much interest the reserve is earning. Traditionally the return has not been particularly good, becoming the basis of the “buy term and invest the difference” school of thought.

The “cash surrender value” (CSV) offers a number of potentially valuable features to the policyholder. The CSV grows as long as the policy is in force. If you die, your beneficiary will receive the death benefit, but the insurer will keep the cash value.

If you give up your whole life insurance policy, you will receive the CSV but lose your protection. Also, cash values are taxable, so get professional advice regarding, for example, purchasing an annuity, instead of receiving a lump sum pay-out.

There is a way to have your cake and eat it too. You can borrow against the CSV by taking out a “policy loan”. This allows you to tap into the cash value while retaining your coverage.

The insurer will set the rate of interest that you pay against the loan so that your payments will replace the investment return that the insurance company would have received on the amount you borrow. If you were to die with the loan still outstanding, the insurer would pay your death benefit, less the outstanding debt, and less any accrued interest owing.

The CSV for most whole life policies is equivalent to the death benefit at age 100. If the insured reaches that age, the insurer may pay out the full face amount. If it does make this payment, a portion would be taxable. The death benefit, on the other hand, is not taxable.

Before the advent of universal life, whole life was the only game in town for permanent insurance. We’ll show you in a future article that universal life is what whole life was always meant to be.