Unlike term life insurance policies, which do not build a cash value and always have a levelized death benefit, permanent life insurance policies allow policy owners to select levelized or increasing death benefits (sometimes called option 1 or option 2). Most universal life policies (UL) allow policy owners to switch between levelized or increasing death benefit options with few restrictions.
Whole life policies (WL) can be a bit more complex as these policies are designed to increase the death benefit using dividends to purchase additional coverage. However, policy owners can elect other dividend options which help reduce the amount of additional coverage purchased.
Regardless of your choice, over time, the death benefit of these policies increases as their cash value grows. (Read more about how whole life insurance works.)
Level Death Benefit
In a whole life policy with a levelized death benefit, fees and sales charges are deducted from the premium and the remaining amount is credited to the cash value. The cost of insurance is then deducted from the cash value each month. Over time, as premiums are paid, the cash value of the policy increases and the amount of insurance being purchased each month gradually decreases. For example, in year two a $500,000 policy would have a cash value of $1,500, so only $498,500 of insurance is being purchased.
Upon the death of the insured, the insurance company pays a death benefit consisting in part of insurance and, in another part, a return of the policy’s cash value. For example, assume the owner paid the premium for the above-referenced $500,000 policy for 15 years, accumulating a cash value of $65,000. The insurance company would pay $435,000 for insurance and return $65,000 cash value, for a total benefit of $500,000.
Increasing Death Benefit
Conversely, if the policy is a UL with an increasing death benefit, upon the death of the insured, the beneficiary would receive $500,000 of insurance plus any accumulated cash value.
In UL policies with an increasing death benefit, the owner is always buying $500,000 of insurance. However, the growth of the cash value depends on the amount of premium paid. If the premium is the same as a levelized death benefit policy premium would be, the cash value in the policy with an increasing death benefit would likely be lower since more insurance is being purchased each month.
Terms of WL policies are distinct in that dividends are used to buy additional insurance, thus increasing death benefit by small increments as additional insurance is purchased each year.
Levelized versus Increasing Benefits
A variety of reasons exist for choosing increasing death benefits as opposed to levelized death benefits:
- A policy owner may temporarily need a higher amount of insurance. This works especially well when the insured is younger, and the cost of insurance is lower. The policy owner may later switch back to a level death benefit.
- A policy owner may need a death benefit which will continue to increase. For example, if insurance is being used as part of a business succession plan, levelized coverage may not provide an adequate replacement value for a growing business without an increasing death benefit. (Read more about insurance in a business succession plan.)
- A policy is purchased as part of a savings strategy designed to supplement retirement with the goal of rapidly building cash value by overfunding the policy in the early years. It's worth noting that oversight must be exercised in deploying this strategy: the policy risks becoming a modified endowment contract if the amount of premium paid exceeds the seven pay limit without an increasing death benefit.
The Bottom Line
Once you have determined you need permanent life insurance, consider your options closely. There are many ways to tailor coverage to meet your needs, and an experienced independent insurance broker is an excellent resource of insight and assistance.