Permanent life insurance allows owners to select two death benefit options for when the policyholder dies: a level death benefit, which is the same whenever a person dies, be it shortly after purchasing a policy or many years down the road, or an increasing death benefit, which rises in value over the years. These are sometimes called Option 1 or Option 2, respectively. Most universal life (UL) insurance policies allow owners to switch between level or increasing death benefits with few restrictions.

Whole life insurance policies have a few more options to consider. These policies produce dividends that can be used to purchase additional coverage, thus increasing the death benefit. However, other dividend options include taking cash, reducing premiums or earning interest on accumulated dividends.

Depending on which choice you make, the death benefit of a policy can increase as the cash value grows. (Read more about how whole life insurance works.)

Level Death Benefit

In a whole life policy with a level death benefit, fees and sales charges are deducted from the premium and the remainder 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 purchased each month gradually decreases. For example, in year two, a $500,000 policy might have a cash value of $1,500. Therefore, only $498,500 of insurance is purchased.

Upon the death of the insured, the insurance company pays a death benefit consisting of insurance and a return of the policy's cash value. Assume the owner paid the premium for a $500,000 policy for 15 years, accumulating a cash value of $65,000. The insurance company would pay $435,000 for insurance and return the $65,000 cash value, for a total benefit of $500,000.

Increasing Death Benefit

Conversely, if the policy is universal life insurance with an increasing death benefit, upon the death of the insured, the beneficiary receives $500,000 of insurance plus any accumulated cash value.

In UL policies with an increasing death benefit, the owner buys $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 what a level 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 whole life policies are distinct in that dividends can be used to buy additional insurance, thus increasing the death benefit by small increments as additional insurance is purchased each year.

Level vs. Increasing Benefits

A variety of reasons exist for choosing increasing death benefits as opposed to level 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 that will continue to increase. For example, if insurance is being used as part of a business succession plan, level death benefit coverage may not provide an adequate replacement value for a growing business without an increasing death benefit. (Read more about insurance in succession planning.)
  • A policy is purchased as part of a savings strategy designed to supplement retirement to rapidly build cash value by over-funding 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 test without an increasing death benefit.

The Bottom Line

Once determined that 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.