The Basics of Life Insurance Part II: Whole Life

Known by a few different names, and probably the most tweaked product in the industry, Whole Life (aka straight life in older circles) has a several centuries history of offering guaranteed death benefit for the entire lifetime of the insured.  In the world of guarantees, nothing beats it, and it has been an anchor for conservative savings plans for just about as long as it's been in existence.  It's also one of the most hotly debated products in the insurance industry as opinions run wild about its overall usefulness compared to other products that exist today. 

At it's core, whole life insurance is built on three primary guarantees:

  1. Guaranteed death benefit for the insured's “entire life”
  2. Guaranteed charge for insurance (mortality) that was locked from day one and never allowed to change
  3. Guaranteed rate of return

We'll elaborate a bit more on these three guarantees.

Guaranteed Death Benefit

Once a person has established a whole life contract on their life, the insurance company has guaranteed that if the insured pays the scheduled premiums, the death benefit will be paid.  This comes at one of two possible moments:

  1. The insured dies
  2. The insured reaches the age of mortality and the contract endows (pays out the death benefit to the insured)

The first one is rather easy and self explanatory, but the second one typically takes a little more explanation before people truly understand what it means.

Endowment, I've Come to the End, but I'm Still Alive

All whole life contracts assume an age at which point everyone will be (perhaps should be is more appropriate?) dead.  Anyone holding onto a contract established prior to the 2001 CSO table adoption has a contract that assumes death by age 100 (all new policies using 2001 CSO assume age 121).  This means that if you reach the endowment age (formerly age 100 but now 121, and we'll use 121 for the remainder of all examples in this article) the contract pays out the death benefit.  This feature is true of all whole life contracts.  So, either you'll die and your beneficiary will receive the death benefit, or you'll live to endowment and receive the death benefit yourself.  Those are the two options and all the insured has to do to ensure that this happen is pay the premiums.

Now, it's worth noting that all whole life policies are endowment contracts, and so it'll help you understand what an endowment contracts is.  Endowments are insurance contracts that have the policy owner/insured choose a death benefit amount a period of time (e.g. $100,000 death benefit and 20 years).  The insurance company calculates a premium and guarantees that if all premiums are paid the contract will endow (you could also think mature) and the company will pay the owner/insured the originally selected death benefit amount.  If the owner/insured dies before the end of the selected period of time, the insurance company will pay the beneficiary(ies) the selected death benefit.  In other words, the savings plan will be completed either because all premiums are paid or  the owner/insured dies.

Prior to the mid/late 80's endowments were a very popular product.  And they still are fairly ubiquitous outside of the United States.   Unfortunately for those of us inside the old Starts and Stripes Republic the Deficit Reduction Act of 1984 and the Technical and Miscellaneous Revenue Act of 1988 killed the coveted tax treatment of endowments, and basically ended their run in the U.S.

Guaranteed Charge for Mortality

The premium calculated at issue of the whole life policy is the premium that will be required for the entire life of the policy.  It will never increase or decrease.  As long as it is paid, the policy will remain in force.

Guaranteed Rate of Return

If all of the premiums due are paid to the age of endowment, the insurance company guarantees that the cash value of the policy will equal the original guaranteed death benefit.  Additionally, there will be a guaranteed cash value schedule between policy issue and endowment.  So, lets say that a whole life illustration shows guaranteed cash value of $10,000 year 10 of the policy.  The insurance company is guaranteeing that at year 10 you will have $10,000 in cash value at the absolute minimum.

Going Beyond the Guarantees

In addition to the minimum guarantees offered by a whole life contract, a lot of companies that issue whole life insurance offer additional (non-guaranteed) benefits to policy holders.  These are traditional given to the owner in the form of a dividend.  To understand the main idea behind a dividend, it's helpful to briefly discuss the purpose behind mutual insurance companies.

Mutualality: Policy Holder Ownership

A Mutual insurance company is one owned by it's policy holders.  To share in the profitability of the insurance company, dividends are paid to policy holders.  An insurance contract that is eligible to receive dividends is also commonly referred to as participating policy (it participates in shared profits).  The dividends are cash paid by the insurance company to the insured and can be used as the insured wishes.  Whole life is the most commonly recognized insurance contracts when it comes to the payment of dividends, but it isn't the only one.  Term insurance, disability insurance, long term care insurance, can all be participating products (it really depends on the insurance company).

Another way of thinking about it is this, the insurance company determines what it is going to charge for it's products based on some safe assumptions about doing business.  These assumptions are based on a few considerations:

  1. How many people will die, requiring them to pay a death benefit, this goes into whom they should be willing to issue a contract to, and how much they should be charging for a contract.
  2. How much money they are going to spend on being in business (this also concerns how much they should be charging to do business)
  3. What kind of return they are going to earn on the money they collect and have.

As you can see the three guarantees are back (mortality, expense, return).  Whenever the insurance company charges more for the cost of insuring all of the lives they have covered (i.e. not as many people die with a policy in force as they assumed would) or day to day business isn't as expensive as they thought it would be or they earn more on their money than they thought they would, the insurance company shares in their good fortune with their policy holders (owners) through a dividend.  And it turns out, the insurance company usually does a lot better than they thought they would (many have paid dividends every year for over 100 years).

There's a lot more to discuss on the topic of whole life insurance as it has a lot of different applications to financial planning and such; more of that will come with future posts.


Leave a Reply

  • RSS RSS

  • Archives

  • Categories