Whole Life Insurance

Whole life insurance is a policy that covers the insured's whole life — hence the name — charging level premiums that accumulates a cash value that the insured can surrender, if they wish to terminate the policy, or borrow against, usually at lower interest rates than would be available elsewhere. Whole life insurance is also used in estate planning and business continuation plans, where term insurance would not be feasible. Unlike other insurance, the insurance company will eventually have to pay the benefit for a whole life policy, unless the insured cancels the policy or fails to pay the premiums. In fact, if the insured lives to 100 — or 120, under the newer 2001 standards — the policy matures, and the death benefit is paid to the policyowner.

There are various forms of whole life insurance. Ordinary life insurance (aka straight life, continuous premium whole life, level-premium whole life) provides lifetime protection. If the insured is still alive at 100, or 120 under the newer standards, then the face amount of the policy is paid to the insured. Because the initial premiums exceed what is necessary to cover the possibility of death, part of the premiums for ordinary life are invested for the insured, which accumulates a cash surrender value. The policyowner can surrender the policy for the cash value or borrow against the policy at relatively low interest rates.

Graph showing how premiums for whole life insurance accumulates cash value in early years to pay for the higher mortality charge in later years.

Modified whole life insurance has stepped premiums that allow young people to pay smaller premiums when they are making less, then after a specific time, the premiums step up to a higher level as the insured's income increases. There are often 2 or 3 steps in these policies.

Limited-payment life insurance requires the payment of premiums for a limited time for a lifetime protection. Most of the terms are for 10, 20, 25, or 30 years. At the end of the term, the policy is paid up — the policyowner does not pay any more premiums, but has lifetime protection, desirable for people who do not want to pay premiums in retirement.

An extreme form of this type of policy is the single-premium whole life insurance, which provides lifetime protection for the payment of a single, very large premium. In 1988, Congress classified single-premium whole life insurance as a modified endowment contract (MEC), and eliminated some of the tax advantages of these contracts. Single premium life has the same advantages as other whole life policies:

However, because single premium whole life insurance is considered a modified endowment contract, the gain portion of distributions, in the form of loans, dividends paid in cash or accumulated, or a policy assignment is taxable. However, using dividends used to buy additional insurance is tax-free. An additional tax penalty of 10% will apply to any taxable distributions to the policyholder younger than 59½.

Although limited-payment life insurance accumulates a cash value faster, the premiums are much more expensive for the coverage — the shorter the term, the higher the premiums. Most people can't afford adequate coverage because of the high premiums.

Another closely related type of policy is the endowment insurance policy, which matures by a certain date, when the owner of the contract, if still alive, receives the proceeds of the policy. If the insured dies any time before the end of the term, then the designated beneficiary receives the face value of the policy. Endowment insurance is rarely sold in the United States today, because, after the Deficit Reduction Act of 1984 (DEFRA), the increase in cash value of the policy is taxed to the policyowner, unless it is held in a tax-sheltered account. However, it is more popular in foreign countries.

Combination whole life insurance combines a whole life policy with initial term insurance. The face value of the term insurance declines while the whole life portion increases until the term insurance disappears, and is replaced with a whole life policy that is cheaper than it would have been had a whole life policy been chosen at the start. More of the premium is invested to increase the cash value of the policy as the term insurance decreases. This policy provides greater protection in the beginning for a growing family, then converts more into a cash value policy as the need for term insurance declines.

The Benefits and Drawbacks of Whole Life Insurance

The benefits to whole life insurance includes safety of principal, disciplined saving, tax-free growth, protection from creditors, and beneficiaries receive the proceeds tax-free.

The major drawback to whole life insurance is that the insurance needs of most people declines with age, because the mortgage gets paid off, the kids are educated, etc. So a whole life policy may have a higher opportunity cost — the money used to pay the higher premiums could, instead, be invested for larger returns than that provided by most whole life policies. This is particularly true since insurance policies have much higher expenses than other investments, such as mutual funds. These fees can include a monthly contract fee, a management fee, the fee for the term insurance part of the policy, and many other fees, and up to 3.25% of the premium is for state premium and federal taxes. There is also a surrender charge if the insurance is surrendered within 10 years. Furthermore, most insurance companies do not disclose the rate of return on the cash value of the policy, making it difficult to compare it to other investments. In fact, insurance companies have opposed any legislation requiring such disclosure!

The other major drawback is that initial premiums are much higher for whole life than for term insurance. For instance, a 25 year old could buy almost 10 times the coverage with term life insurance than with a whole life policy for the same premium payments. If the policyholder decides to cancel the insurance within the 1st couple of years, then a significant amount of money will be lost paying for a whole life policy compared to term insurance with the same coverage. Because of selling and other expenses, a whole life policy will have little or no cash value in the 1st few years. In fact, a recent study by the Consumer Federation of America concluded that a whole life policy would have to be held for at least 20 years to get a decent rate of return. Furthermore, inflation diminishes the value of the insurance policy.

Other Whole Life Policies

Because of the drawbacks, the sales of whole life policies has been declining. To remain competitive, insurance companies have developed many variations of the whole life policy to try to compete successfully with other investments, including universal life insurance, variable life insurance, variable universal life insurance, current assumption whole life insurance, and indeterminate-premium whole life insurance.