The basics of whole life insurance

The basics of whole life insurance

Whole insurance is intended to provide death benefit protection for an insured’s “whole” lifetime. The two main component of the policy, the premium, and the death benefit, typically remain the same through the life of the contract.

Whole life is more expensive than term insurance. The tradeoff is that the insured has insurance for as long as they live, provided they pay premiums. Plus, whole life has the potential to build cash value that can be accessed, whereas Term insurance does not accumulate cash value.

Whole life is typically more affordable, but offers less flexibility, than universal life policies. UL insurance is considered flexible premium insurance, meaning the policyholder can vary the premium amount throughout the life the contract. Whole life typically requires the same amount each payment period.

People who prefer whole life typically see a need for life insurance coverage whether they die in two years or 50. They also like having a fixed premium that doesn’t change.

Like with other types of life insurance, the premium you will pay will depend on the amount of coverage you buy, plus your age, gender, health condition and other underwriting factors at the time you purchase the policy.

Paying expenses up front
Insurance companies will set your whole life premiums at a level so that you pay more of the cost of insurance up front. This way, the insurance company can benefit as much as possible in case you either die early or surrender the policy at a later date. This is similar to how you pay a larger portion of your mortgage interest in the early years of owning a home; the bank wants to collect as much of the cost of borrowing as it can in case you don’t hold onto the mortgage for the entire term.

This also helps the policy build cash value, which earns a set rate of interest each year. It’s the cash value that will pay the higher mortality costs later in the policy. Insurance companies allow policy owners to access these reserves in one of two ways:

Policy loans. Policy owners can borrow against the policy’s cash value. As long as premiums are paid, the insurance coverage remains available, but the death benefit will be reduced by the amount of the loan. If the insured dies with outstanding policy loans, the death benefit will be reduced by the amount of the outstanding loan balance.

Policy surrender. The other option is to surrender the policy and receive the net cash surrender value. This is the gross cash value minus surrender charges, policy loans, and interest. Surrendering the policy means you lose the life insurance coverage.

Some people see whole life insurance as an investment as well as protection. Although the overall rate of return for a whole life policy is not as competitive as other investments, it is typically higher than fixed income investments like government bonds. Plus, the money inside the policy is shielded from market risk.

Whole life insurance death benefits are treated to the same taxation rules as other types of life insurance, meaning they are usually free of federal income tax. Policy loan proceeds are also tax-free because it’s assumed the loan will be repaid to the policy. If a policy loan is still outstanding when a policy is surrendered or when the insured dies, it is essentially treated as if the borrowed amount was received at the time of surrender and used to pay off the loan, which reduces the tax-free death benefit. If you choose to repay the loan, you will often receive a more favorable interest rate than you would through traditional lenders, and the loaned funds will continue to earn interest as if they were never withdrawn.

Some whole life policies, called participating policies, pay a dividend if the insurance company achieves lower mortality and expense costs than it expected. The dividend is paid out of the insurer’s surplus earnings and is not taxed because the IRS considers it a return of the premium you have already paid.