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How Whole Life Insurance Works

The purpose of Whole Life Insurance is to provide coverage for the insured, for their entire lifetime.  Traditionally, Whole Life Insurance is a consumer demanded product that offers more than just a death benefit by permitting the policy holder to build equity in the policy.

Paid Up Insurance

Equity implies ownership.  Equity is the value of an asset minus the liabilities associated with that asset.  A Whole Life Insurance policy holder builds equity in the policy as premiums are paid up until the contract matures.  At maturity the policy holder will own 100% of the death benefit and will have zero further liability to pay premiums.  At this point the policy is called a paid-up policy.

Other insurance products provide for a death benefit to be paid if the insured dies while the policy contract is still in force. But the unique feature of Whole Life Insurance is that in addition to the death benefit provided, there is a provision made for the policy owner to actually own the death benefit. This provision, which is guaranteed by a legally binding contract, prevents the value of the Whole Life Insurance policy from being eroded by low interest rates and the ever-increasing cost of insurance to which typical Term and Universal Life Insurance contracts are subject.

The portion of the death benefit which becomes the personal property of the policy holder is called paid up insurance.  As paid up insurance is a legal asset, belonging to the policy holder, it is no longer merely a number promised by the insurance company, and can be used as cash equivalent by withdrawing that value from the policy or using that value as collateral for a loan.

Whole Life Insurance policies were developed because life insurance policy holders were not satisfied with simply purchasing life insurance on a month to month, or year to year basis, while never accruing any equity.   Policy owners wanted to have an option to purchase life insurance that also provided them with the opportunity to develop ownership because with ownership comes control.

Cash Value

The cash value of a Whole Life Insurance policy represents the value of the paid-up insurance in the policy.  This cash value can be withdrawn from the policy at any time.

When a withdrawal is made from a Whole Life Insurance policy, the paid-up insurance, which the withdrawn cash value represents, is surrendered. This reduces the total death benefit by the amount of paid up insurance that was surrendered.  Surrendered paid up insurance reduces the death benefits, and it also inhibits the future growth of a Whole Life Insurance policy permanently.  That is because a withdrawal from a Whole Life Insurance policy can never be returned to the policy and that value, as well as the compounding growth of that value, is lost indefinitely.

Policy Loans

In contrast to a withdrawl, a policy loan leveraged against the cash value of a Whole Life Insurance policy can be repaid to the insurance company.  Furthermore, because a policy loan is not considered a withdrawal it does not affect the compounding growth of the policy like a withdrawal does.

A policy loan is a collateral assignment of a specific amount of the paid-up insurance owned by the policy holder to the insurance company. The insurance company holds the paid-up insurance as surety for the money it lends to the policy holder from the general fund of the insurance company.  This prevents any value from being surrendered from the policy and allows compounding growth to continue based on the entire value of the policy.

Policy loans taken against the paid-up insurance portion of the death benefit in a Whole Life Insurance policy can be used for any purpose the policy owner desires as these loans are not regulated by any governmental regulations.  However, if a policy loan is outstanding against a Whole Life Insurance policy at the time the policy is surrendered or lapses, the loan will be treated as a withdrawal, which could result in a tax liability if the withdrawal is greater than the total premiums (i.e., cost basis) which have been paid for the Whole Life Insurance policy.

As a general rule Whole Life Insurance policy loans are not considered income and therefore do no trigger a taxable event.   This allows the owner of a Whole Life Insurance policy to leverage the cash values of their policy(s) to finance investments, transfer debt, or manage how they best see fit, and create more value than if the cash value remained unleveraged in their policy(s).

Do You Get both the Cash Value and the Death Benefit?

In the sale of Universal Life Insurance policies, a marketing pattern has developed which focuses on the fact that the beneficiary will receive both the cash value accumulation in the Universal Life Insurance policy as well as the death benefit. This is true because the cash value accumulation in a Universal Life Insurance policy merely reflects the money that the policy has accumulated based on extra premiums that were paid for that policy as well as any interest that has been earned on those extra premiums.

With Whole Life Insurance, the cash value represents the paid-up insurance (equity) that the policy holder has established in that policy. Therefore, the death benefit in a Whole Life Insurance policy already reflects the cash values whereas in Universal Life Insurance policies, the cash value accumulation is not a reflection of death benefit at all, but is merely a reflection of premiums that were over paid and any interest that was earned on those over paid premiums, minus fees, loans, interest owed, expenses and any premiums that are due.

So, when a death benefit is paid from a Whole Life Insurance policy, if there is no loan against the paid-up insurance, the beneficiary receives 100% of the death benefit.  If there is an outstanding loan against the paid-up insurance of the policy, then the beneficiary will receive the difference of the total death benefit minus the outstanding loan balance.

In reality, what happens when a death claim is filed against a Whole Life Insurance policy which has an outstanding loan against it, is this: The loan is repaid from the total face value of the policy and the remaining portion of the face value becomes the death benefit that is paid to the beneficiary(s).

Either way, with or without a policy loan, 100% of the total death benefit is paid when a valid claim is made against a Whole Life Policy.

How Does a Whole Life Policy Work

Whole Life Insurance is able to work because the insurance company assumes the risk of managing the premium dollars collected from the policy holder in exchange for providing a legally binding contract that provides a death benefit for the beneficiaries of the policy.  That binding contract lasts for the entire life time of the insured. That is why it is called Whole Life Insurance, because it provides life insurance coverage for an entire life time.

Instead of an ever increasing premium as is found in Term and Universal Life Insurance contracts, premiums for Whole Life Insurance are based on a fixed level premium that is contractually ensured never to go up for the entire life time of the insured.  Premiums can be reduced, or even stopped, in the future but the premiums can never be increased.

As noted above, the coverage provided in Whole Life Insurance is slowly converted to paid up insurance which the policy holder owns rather than the insurance company.  This allows greater liquidity and control over the cash values of the policy.

The faster paid up insurance is established in the policy, the faster the cash value in a Whole Life Insurance policy will accrue.  Keeping this growth of paid up insurance within the guidelines of the Internal Revenue Code’s seven pay period will keep the policy from becoming a Modified Endowment Contract, which will keep the policy’s growth from becoming a tax liability for the policy holder if the policy is ever surrendered, lapses or borrowed against.

Who Buys Whole Life Insurance

Life insurance proceeds are tax free for the beneficiary up to the gift tax limitations.  In addition to this fact, cash values grow tax-differed in Whole Life Insurance policies.  For this reason, in a survey taken by Limra (formerly Life Insurance and Marketing Research Association), 11% of people who purchase cash value life insurance do so not merely for the death benefit but also for the tax advantages.  Twenty-two percent of people purchase cash value life insurance for the ability to transfer wealth tax-free.  The Tax Foundation estimates that $1.68 billion was transferred by clients in 2010, tax-free, and nearly 40% of all such policies were sold with premiums of $20,000 or more annually.[i]

Dividends

Many Whole Life Insurance policies offer dividends to policy holders.  Dividends are paid to policy holders based on the profits which the insurance company has earned over the past year.  Dividend rates are determined by the insurance company’s board and are paid annually to policy holders on the policy anniversary date of each participating policy.

Dividends are classified as a “return of premium paid” by the Internal Revenue Service and are therefore not taxable if they are used to purchase more paid up insurance.  If they are paid to the policy holder directly, dividends will only be considered income once total dividends exceed the cost basis of the policy.

Dividends are not guaranteed to be paid at any specific given rate to policy holders.  However, once a dividend is paid it becomes guaranteed and cannot be removed from the policy without the policy holder’s specific authorization.

Dividends may be used, at the policy holder’s discretion, to:

  • Pay premiums
  • Purchase additional paid up insurance
  • Purchase term insurance
  • Pay interest on a policy loan
  • Pay principle on a policy loan
  • Be paid directly to the policy holder
What Makes Whole Life Insurance Participating vs Nonparticipating?

Not all life insurance companies that sell Whole Life Insurance offer dividends.  If a company does not offer dividends to Whole Life Insurance policy owners, then the policy is considered a non-participating Whole Life Insurance policy.

Participating Whole Life Insurance policies, offer dividends to their policy holders.  Participation in the dividends of a life insurance company can significantly increase the cash values and the total death benefit in a Whole Life Insurance policy over time.  Most Life Insurance Companies that offer participating policies are mutually held Life Insurance Companies instead of stock held Life Insurance Companies.

Fees

All insurance policies have fees associated with them.  The fees associated with Whole Life Insurance policies are fixed and flat, and are already included in the price of the premium for the policy.  This is different than Universal Life Insurance policies which have a premium fee that is based on a percentage of the premium paid.  The higher the premium in a Whole Life Policy is, the lower the fixed, flat fee will cost, percentage-wise, of the premium paid.  In Universal Life Insurance, the higher the premium paid, the greater the fee will become as the fee is based on a percentage of total premiums paid.

For example, compare the fee of a Whole Life Policy vs. a Universal Policy on a $10,000 annual premium:

  • Whole Life: A flat, fixed fee of $75, this is 0.8% of total premium
  • Universal Life: A 6% fee is $600 of the total premium

Some Advantages of Owning Participating Whole Life Insurance

  • Equity creation (paid up insurance) is guaranteed
  • Premium rates are guaranteed to never go up
  • Cash values can be withdrawn at any time for any purpose
  • Paid up insurance can be used as collateral for a loan at any time and for any purpose
  • Growth in the policy is tax deferred
  • Provides guaranteed tax-free income for retirement and long-term care needs
  • Provides guaranteed tax-free income for beneficiaries (transfer of wealth)
  • Provides a guaranteed estate planning tool to avoid needless estate taxes
  • Return on equity is better than average growth on typical savings
  • Policy loans are interest only loans for the life time of the contract
  • Fees are fixed, not based on percentage of premiums paid

Some Disadvantages of Owning Participating Whole Life Insurance

  • Initial premium costs are typically higher than Term Insurance
  • Withdrawals of cash values reduce the long-term growth and cannot be repaid to the policy
  • Policy loan interest rates may be higher than loan interest rates elsewhere
  • As with any loan, interest, if not paid, will compound and be added to the balance of the loan

Overall Whole Life Insurance is an asset purchase that builds equity and provides a guaranteed death benefit.  Due to the level fixed premium, guaranteed for the life time of the Whole Life Insurance contract, Whole Life Insurance becomes a financial tool that can be used wisely to build wealth, provide needed liquidity and legally avoid certain income and estate taxes.  Though Whole Life Insurance may not be for everyone, it continues to remain a solid and secure financial tool that consumers demanded and is used by individuals, families, business owners and companies to keep more of the money they make.

[i] https://www.marketwatch.com/story/10-things-life-insurers-wont-tell-you-1308333194735

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