Whole Life Insurance Definition: How It Works, With Examples

Whole Life Insurance

Investopedia / Nez Riaz

What Is Whole Life Insurance?

Whole life insurance, also known as traditional 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. Interest accrues at a fixed rate and on a tax-deferred basis.

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 as there are many types of permanent life.

Key Takeaways

  • Whole life insurance lasts for an insured's lifetime, as opposed to term life insurance, which is for a specific amount of years.
  • Whole life insurance is paid out to a beneficiary or beneficiaries upon the insured's death, provided the policy was in force.
  • Whole life insurance has a cash savings component, which the policy owner can draw or borrow from.
  • The cash value of a whole life policy typically earns a fixed rate of interest.
  • An outstanding loan principal and interest reduce death benefits.

How Whole Life Insurance Works

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. Unpaid loans 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 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. Death proceeds are non-taxable to the beneficiary and are, therefore, not part of taxable gross income.

The death benefit can also be affected by certain policy provisions or events. For example, unpaid policy loans, including accrued interest, reduce the death benefit dollar for dollar. Alternatively, many insurers offer voluntary riders—for a fee—that secure or guarantee coverage, including the stated death benefit. For example, two of the most common are the accidental death benefit and waiver of premium riders, which protect the death benefit if the insured becomes disabled or critically or terminally ill and are unable to remit premiums due.

Many life insurance policies allow the policyholder to designate that the funds from the policy be held in an account and distributed in allotments rather than as a lump sum. 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 insured, 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 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 withdraw a portion of the cash value or cancel coverage, receiving 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.

Uses of Whole Life Insurance

A whole life insurance policy gives individuals and their families financial security against the loss of a breadwinner. For families that rely on the income of a single person, a whole life policy can provide financial security against the sudden loss of a breadwinner.

Whole life insurance are also useful for businesses as a contingency plan for the loss of a key employee or partner. If anything befalls such a key employee, a whole life policy can provide a financial offset to the loss of their skills or expertise. If the deceased is part owner of the company, a whole life policy can provide the remaining owners with enough capital to buy out the deceased partner's share of the business.

Types of Whole Life Insurance

  • There are two main types of whole life insurance, distinguished by how premiums are priced and how policy risk is allocated.
  • Single Premium: This is the most basic type of whole life insurance. The insured pays a fixed premium, which continues to accumulate as cash value and provides coverage for as long as premiums are paid.
  • Limited Payment: This type of policy features higher premiums in the early years of a policy, with lower or no premiums in later years.
  • Modified Premium: The opposite of a limited payment policy, this type of whole life insurance offers lower premiums in the early part of a policy's lifetime.

Whole life insurance policies are further distinguished into participating and non-participating plans. With a non-participating policy, any excess of premiums over payouts becomes profit for the insurer. However, the insurer also assumes the risk of losing money.

With a participating policy, any excess of premiums is redistributed to the insured as a dividend. This dividend can then be used to make payments or increase one's policy limits.

Whole Life Insurance Cash Value

A cash value life insurance policy is similar to a retirement savings account, in that it allows investments to accumulate tax-deferred interest.

Part of each premium payment goes towards the policy's cash value, which can be withdrawn or borrowed against later in life. The cash value of a life insurance policy grows quickly when the insured is young, but it grows more slowly as they get older, due to the higher risks associated with age.

The insured can access the cash value of their policy by borrowing against the cash value, or by withdrawing money in a partial cash surrender. Surrenders will diminish the final death benefit of their policy. You can also use the cash value to cover your monthly premium payments instead of paying out of pocket.

Whole Life Insurance vs. Term Life Insurance

Whole life insurance is similar to term life insurance, in both types of policies offer a payout upon the death of the insured. However, there are important differences. While whole life insurance offers a guaranteed death benefit for the entire lifetime of the insured, a term policy only pays out if the insured dies within a certain time frame—usually 5, 10, or 20 years.

There are other considerations as well. In order to provide greater benefits, a whole life policy requires significantly higher premiums than a term policy with the same coverage limit.

Advantages and Disadvantages of Whole Life Insurance

The main advantage of whole life insurance is that it provides lifelong coverage that never expires or needs to be renewed. While term insurance does not pay off if the insured does not die within the predetermined time period, a whole life policy offers lifelong protection with a fixed premium. It also accumulates cash value, that can be spent on expenses like medical care or retirement.

As an estate plan, whole life insurance can provide extra benefits above a traditional inheritance. In many states, the death benefit is protected against claims by the decedent's creditors. Moreover, the cash value of a life insurance policy is tax-deferred, and loans against the policy are also tax advantaged.

The main disadvantage of whole life insurance is that it is expensive. Whole life premiums are significantly higher than those for a term policy, and they have less flexibility than universal life insurance policies. When choosing a life insurance policy, it is important to consider the potential returns from investing the same money in other vehicles.

Pros & Cons of Whole Life Insurance

  • A guaranteed death benefit that lasts for the entire lifetime of the insured

  • A cash value that the insured can borrow against while they are alive

  • Upon the death of the insured, the benefits are protected from claims by creditors.

  • Tax advantages for cash value growth and loans against the policy

  • Higher monthly payments than term life insurance

  • Premiums have less flexibility than other types of life insurance.

  • Cash value grows more slowly than other types of investments.

How Much Does Whole Life Insurance Cost?

On average, whole life insurance policies are significantly more expensive than term life insurance. Research by finder.com found that the average monthly premium for a whole life insurance policy could range from hundreds of dollars a month to over a thousand, depending on factors such as the level of coverage and the age and gender of the insured.

In contrast, premiums for term life insurance average in the tens of dollars for most insured, although they can be higher for those of advanced age and higher policy limits.

Frequently Asked Questions

What Is the Difference Between Whole Life and Term Life Insurance?

As its name suggests, term life insurance provides a death benefit for a specific term. This type of life insurance, unlike a whole life policy, does not have a saving component. At the end of the term, the policy terminates. Some insurers allow the policyholder to covert their term policy to whole life or renew for a longer term. Whole life insurance is a type of permanent life insurance that provides coverage for the life of the insured. A whole life insurance policyholder can also build cash value in the savings component of the policy.

What Is the Difference Between Universal and Whole Life Insurance?

Universal life insurance and whole life insurance are both permanent life insurance types that offer guaranteed death benefits for the life of the insured. However, a universal life policy allows the policyholder to adjust the death benefit as well as the premiums. As one might expect, higher death benefits require higher premiums. Universal life policyholders can also use their accumulated cash value to pay premiums, provided the balance is sufficient to cover the minimum due. Whole life insurance, alternatively, does not allow for changes to the death benefit or premiums, which are set upon issue.

How Much Is Whole Life Insurance?

The cost of whole life insurance varies and is based on several factors, such as age, occupation, and health history. Older applicants typically have higher rates than younger applicants. Insureds with a stellar health history typically have better rates than those with a history of health challenges.

The face amount of coverage also determines how much a policyholder will pay; the higher the face amount, the higher the premium. Interestingly, certain companies have higher rates than others, independent of the applicant and their risk profile. It's also worth noting that for the same amount of coverage, whole life insurance is more expensive than term life insurance.

Variable Whole Life Insurance Is Based on What Type of Premium?

Variable life insurance premiums can be fixed or variable, allowing the policyholder to remit a premium payment of no less than what is required to cover fees and expenses (e.g., mortality and expense (M&E) fees). As cash value builds, through the remittance of premiums and accumulation of interest, the net risk to the insurer decreases.

As a result, associated fees and expenses may decrease, reducing the minimum premium needed to cover such charges. Alternatively, some insurers outfit their policies with a lapse protection feature, which prevents the policy from lapsing due to insufficient cash value as long as certain level premiums are paid over a specific period.

What Is Modified Whole Life Insurance?

Modified whole life insurance is permanent life insurance in which premiums increase after a specific period. Usually, after five or 10 years, the premiums increase but remain constant thereafter. Traditional whole life insurance premiums, in contrast, remain the same throughout the life of the policy.

The Bottom Line

Whole life insurance provides a guaranteed benefit upon the death of the insured, regardless of when they die. This offers a clear advantage over term life insurance, which only pays out if the death occurs within a specific time frame. However, whole life insurance also has significantly higher costs.

Article Sources
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