Why would anyone want to overfund a life insurance policy?

Overfunded Life Insurance

Overfunded life insurance, what on earth is that?  I hear you cry out.  Perhaps you ran across the concept mentioned briefly somewhere on the internet.  Or maybe someone suggested that you buy an overfunded life insurance policy.

If you're trying to discern the notion of overfunded life insurance, we'll break it down for you and details everything there is to know.

Overfunded Life Insurance: Defined

Overfunded life insurance isn't necessarily anything special. It's life insurance you pay a higher premium to than you otherwise have to.

Some might further define it as a life insurance policy where you fund it to the maximum (i.e., without creating a modified endowment contract) amount you can.  I'll let everyone argue the exact intention of the idea, but for our purposes, I'm going to stick with overfunded life insurance simply being any situation where the policyholder pays a premium higher than the premium that is necessary to keep the death benefit in force.

This definition is very straightforward and practical, but it's of relatively little use to anyone who doesn't happen to have a vast and varied amount of experience in or knowledge of the life insurance industry.  Given that, let's dive into some more focused detail with some examples.

Overfunded Universal Life Insurance

I'm going to start off with universal life insurance because I believe it's easier to understand the concept of overfunding life insurance using universal life insurance.  Don't worry, though, we'll discuss other forms of life insurance before we're done today.

Universal life insurance doesn't have a required premium per se.  Instead, it has a set amount of expenses (we call them monthly deduction in the insurance world) that must be paid each month or else the policy will lapse.  The policyholder can either pay the expenses by premiums he/she pays to the policy, or else the expenses come out of cash value in the policy.

Any amount of money paid to the universal life policy over the expenses will go to cash value that accumulates inside the universal life insurance policy.  Let's use an example to explain this.

Universal Life Insurance Premium Example

Phil owns a universal life insurance policy where the monthly deductions equal $50.  Phil could merely cover the $50 monthly deduction and keep his death benefit in force.  Doing this will accumulate zero cash value inside the policy.

Each new year, there's a likelihood that the monthly deductions will increase as the cost of insurance increases with Phil's age, but if Phil continues to cover the monthly deductions, his policy will remain in force.

If instead, Phil chose to pay a $1,000 premium per month, the excess premium payment will create cash value in his policy.  This excess premium will earn interest declared by the life insurer each year.

Overfunding universal life insurance happens pretty much anytime a policyholder pays a premium to a policy that is more than the monthly deductions.  However, some insurance agents view overfunding universal life insurance paying a premium much higher than just some number over the monthly deductions–for example paying a premium at or near the guideline premium when using the guideline premium test to qualify the policy as life insurance.

Regardless of which camp you fall into, the important take away from this information is that universal life insurance is extremely flexible with regards to how the policyholder pays the premium.  Overfunding a universal life insurance policy is simple and just about anyone with a universal life insurance policy can do it.  You merely begin paying higher premiums towards your universal life insurance policy.  You do not need to send any special notification to the life insurer.  They all know what to do with the additional money received.

If you go overboard and pay a premium sufficient enough to violate the Modified Endowment Contract or 7702 Tests, the life insurer will warn you about this, and most will send back all or part of the premium that violates the test.

BUT some universal life insurance policies are not worth overfunding.  Certain types of policies that exist more or less to provide a death benefit and really only death benefit do possess the capacity to overfund, but doing so will likely be a waste of money.

These products are usually identifiable by a name that includes “guaranteed” somewhere (e.g., Guaranteed Universal Life Insurance or Secondary Guaranteed Universal Life Insurance).  These products build cash value very poorly due to expenses that guarantee a death benefit provided that only a certain premium be paid.  You can overfund these policies, but I'd strongly advise against it.

Overfunded Whole Life Insurance

Unlike universal life insurance, whole life insurance functions very differently.  Whole life premiums are not naturally flexible (but we can functionally make them that way).

A basic whole life insurance policy has a specifically established premium that the policyholder must pay with out-of-pocket money or else arrange to pay the premium through policy dividends, cash value surrender, or a loan from the policy.

This being said, whole life policies can possess the ability to receive excess premium payments.  We do this through the paid-up additions rider.

Adding a paid-up additions rider gives the whole life policy the ability to receive additional premium payments beyond what the insurance company requires for the base whole life policy.  Doing this allows the policyholder to accumulate more cash value more quickly as well as earn guaranteed interest and dividends on this excess premium payment.  Let's use an example to further explain how this works.

Overfunding Whole Life Insurance Example

Marie owns a whole life policy with a base whole life premium of $500 per month.  She also adds a paid-up additions rider to the policy of $500 per month bringing her total monthly premium to $1,000.

Having the paid-up additions rider on the whole life policy allows Marie to pay more money to the whole life policy than the life insurer requires which builds more cash value and compounds a higher amount of cash for both the guaranteed interest and dividends payable to the whole life policy.

Had Marie instead chosen to purchase a whole life policy where the base whole life premium was $1,000 with no paid-up additions, Marie would not achieve as great a return on her money as the policy she currently owns where 50% of her monthly premium is base whole life premium and 50% of the premium is paid-up additions.

I mentioned earlier that practically anyone who owns a universal life insurance policy can begin overfunding it if he/she isn't already doing that.  The same is not true for whole life insurance.

Because the overfunding mechanism for whole life insurance is an elective rider that allows the policyholder to place additional funds into the policy, whole life insurance doesn't automatically come with this ability.  So if you happen to own an old whole life policy, chances are slim that you will be able to begin overfunding it.

If you want to look into the ability to overfund an old whole life policy, here's what you need to sort out.

Will the Life Insurance Company Allow Adding the Paid-up Additions Rider?

The critical component is whether or not the life insurer will allow you to add the paid-up additions rider.  Some companies will, but many will not.  If the company will let you add the paid-up additions rider, understand that doing this is contingent upon your ability to pass medical underwriting to add the rider.  Paid-up additions create death benefit well more than the premiums you pay, so life insurers do worry about an arbitrage for the guaranteed death benefit.

Will Overfunding Create a Modified Endowment Contract?

Adding a rider to a whole life policy resets the seven-year timeline for Modified Endowment Contract compliance.  This means adding a paid-up additions rider will subject your whole life policy to additional MEC testing that might result in failing the test and having your policy reclassified as a Modified Endowment Contract.  You most likely don't want this to happen.

Check the Age of your Policy Against Possible Grandfathering

Older whole life policies (i.e., those issued before the mid and late 80's) enjoy certainly grandfathered benefits for cash accumulation that are not allowed today.  Adding any rider can forfeit these grandfathered benefits so you should be extremely cautious in adding any rider to a whole life policy this old.

Some Whole Life Policies are Better than Others for this

Just like universal life insurance, some whole life policies focus on cash value build up while others focus on the death benefit.  If you overfund a death benefit-focused whole life policy, you won't necessarily waste your money in the same sense that you most likely will overfunding a death benefit-focused universal life insurance policy.  However, specific whole life policies will serve you better when overfunding.

It's somewhat tricky to try and universally give guidance to just anyone who might read this blog, but I will attempt to at least get you pointed in the right direction.

One indicator that a whole life policy might not be best for cash accumulation is the length of the premium paying guaranteed period.  All whole life policies guarantee paid-up status at some point in the insured lifetime.  This could be 10 years, age 65, age 121, or some other point like these examples.

Traditionally, whole life policies with premium payment periods guaranteeing paid-up status at the insured's age 121 (or 120 in some cases) perform worse as cash value accumulation vehicles to other whole life products.  This isn't universally true, however, so please don't take this as a rule never to break when buying whole life insurance.

Some 10 Pay whole life policies can be a tad too restrictive to allow overfunding or to produce any real results when overfunding so you should be a little cautious about this product option as well.  Again, companies differ on this, and some 10 Pay whole life policies can make excellent choices for this purpose.

If you are looking for the surest bet without spending a ton of time trying research this subject.  Whole life policies guaranteed paid-up at age 100 are the safest bet.  While the issuing company might have some other product that ultimately performs better for cash accumulation.  The paid-up at 100 will always be a solid performer producing favorable results when overfunded.

Why Overfund Life Insurance?

Now that you have a baseline understanding of how overfunded life insurance works procedurally, I want to talk about why someone would want to do this.

All life insurance policies that can accumulate cash value guarantee some level of cash value build up in the policy.  They also usually have additional perks to build this cash faster through non-guaranteed interest or dividends paid on the policy.

Overfunding a life insurance policy (both universal life and whole life insurance) allows you to take more significant advantage of the guaranteed and non-guaranteed build up of cash value.

Think of it like this.  When you own a cash value life insurance policy, ownership builds equity (i.e., cash value).  Life insurance affords you the rare opportunity to enhance that equity by contributing more to the policy than you necessarily have to.  Choosing to this means you can seize the cash build up opportunity the policy affords you.

Consider for a moment that if you buy a house, you will probably achieve equity in that home.  Since you have to live somewhere, a lot of financial gurus will suggest that it's often best to buy a house because you will build equity in that home as it appreciates and this will help you grow wealthier over time.

Life insurance can function in a somewhat similar way.  However, life insurance affords you the option to make additional elective contributions to your policy and guarantee that the equity you build increases.  If you find the accumulation rate of cash value in a whole life or universal life insurance policy attractive, then overfunding the policy is merely a way to take more advantage of this accumulation by subjecting more of your savings to this rate of return.

Overfunding Term Life Insurance Equals No

Term life insurance doesn't offer cash value build up and therefore allows no option to overfund.  While term insurance is excellent for several circumstances regarding the need for a death benefit, it offers no cash value benefits so you will not have the ability to overfund it.

When it comes to overfunding life insurance term is out.  You'll have to choose instead between universal life insurance and whole life insurance.

About the Author Brandon Roberts

Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. Brandon was born in Northern New England, and he currently calls VT home. He attended Syracuse University and graduated with a triple major in Economics, Public Administration, and Political Science.

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