Whole Life Insurance

What Is Whole Life Insurance?

Whole life insurance provides permanent death benefit coverage for the life of the insured. In addition to paying a death benefit, whole life insurance also contains a savings component in which cash value may accumulate on a tax-advantaged basis. These policies may be known as “traditional” life insurance.

Whole life insurance policies are one type of permanent life insurance. Universal life, indexed universal life, and variable universal life are others. Whole life insurance is the original life insurance policy, but whole life does not equal permanent life insurance.

Understanding Whole Life Insurance

Whole life insurance guarantees payment of a death benefit to beneficiaries in exchange for level, regularly due premium payments. The policy includes a savings portion, called the “cash value,” alongside the death benefit. In the savings component, interest may accumulate on a tax-deferred basis. Growing cash value is an essential component of whole life insurance.

To build cash value, a policyholder can remit payments more than the scheduled premium (known as paid-up additions or PUA). Policy dividends can also be reinvested into the cash value and earn interest. The cash value offers a living benefit to the policyholder. Over time, the dividends and interest earned on the policy's cash value will often provide a positive return to investors, growing larger than the total amount of premiums paid into the policy. In essence, it serves as a source of equity.

To access cash reserves, the policyholder requests a withdrawal of funds or a loan. Interest is charged on loans with rates varying per insurer. Also, the owner may withdraw funds tax-free up to the value of total premiums paid. Loans that are unpaid will reduce the death benefit by the outstanding amount.

Withdrawals and unpaid policy loans reduce the cash value of the policy. Depending on the policy type and the size of its remaining cash value, a withdrawal could moreover chip away at the death benefit or even wipe it out altogether. While some policies are reduced on a dollar-for-dollar basis with each withdrawal, others (such as some traditional whole life policies) may actually reduce the death benefit by an amount greater than what is withdrawn.

Whole life insurance is different from term life insurance, which only provides coverage for a certain number of years, rather than a lifetime, and only pays out a death benefit. Term life does not have a cash savings component.

Special Considerations

The death benefit is typically a set amount of the policy contract. Some policies are eligible for dividend payments, and the policyholder may elect to have the dividends purchase additional death benefits, which will increase the amount paid at the time of death. Alternatively, unpaid outstanding loans taken against the cash value will reduce the death benefit. Many insurers offer riders that protect the death benefit in the event the insured becomes disabled or critically or terminally ill. Typical riders include an accidental death benefit and waiver of premium riders.

The named beneficiaries do not have to add money received from a death benefit to their gross income. However, sometimes the owner may designate that the funds from the policy be held in an account and distributed in allotments. Interest earned on the holding account will be taxable and should be reported by the beneficiary. Also, if the insurance policy was sold before the death of the owner, there may be taxes assessed on the proceeds from that sale.

As is the case with any kind of permanent policy, it's important to thoroughly research all insurers being considered to ensure they're among the best whole life insurance companies currently operating.

Example of Whole Life Insurance

For insurers, the accumulation of cash value reduces their net amount of risk. For example, ABC Insurance issues a $25,000 life insurance policy to S. Smith, the policy owner and the insured. Over time, the cash value accumulates to $10,000. Upon Mr. Smith’s death, ABC Insurance will pay the full death benefit of $25,000. However, the company will only realize a loss of $15,000, due to the $10,000 accumulated cash value. The net amount of risk at issue was $25,000, but at the death of the insured, it was $15,000.

Most whole life insurance policies have a withdrawal clause, which allows the policyholder to cancel coverage and receive a cash surrender value.

History of Whole Life Insurance

From the end of World War II through the late 1960s, whole life insurance was the most popular insurance product. Policies secured income for families in the event of the untimely death of the insured and helped subsidize retirement planning. After the passing of the Tax Equity and Fiscal Responsibility Act (TEFRA) in 1982, many banks and insurance companies became more interest-sensitive.

Individuals weighed the benefits of purchasing whole life insurance against investing in the stock market, where annualized return rates for the S&P 500 were, adjusted for inflation, 14.76% in 1982 and 17.27% in 1983. The majority of individuals then began investing in the stock market and term life insurance, rather than in whole life insurance.