The original cash value instrument
In response to market pressures, actuaries conceived of an insurance policy with level premium payments that were higher than traditional term insurance contracts. These contracts would offer a “cash value”, which was designed to be a cash reserve that would build up against the policy’s death benefit.
These policies would also credit interest to the cash value account and upon maturity of the contract (usually at age 95, 100, or even 120), the cash value would equal the death benefit.
This produced a benefit to both the policy owner and the insurance company. By guaranteeing the death benefit, the policy owner was assured that insurance coverage would be in force when the insured died. The insurance company benefited because with every premium payment made, a relatively large percentage was profit, and thus this afforded the insurer the ability to absorb an increase in the cost of insurance, while allowing premiums to remain the same.
Types of whole life
There are several types of whole life insurance policies, defined by traditional forms which may vary slightly from state to state:
As mentioned, other jurisdictions may classify them differently, and not all companies offer all types. There are as many types of insurance policies as can be written in their contracts while staying within the law’s guidelines.
All values related to the policy (death benefits, cash surrender values, premiums) are usually determined at policy issue, for the life of the contract, and usually cannot be altered after issue.
This means that the insurance company assumes all risk of future performance versus the actuaries’estimates. If future claims are underestimated, the insurance company makes up the difference. On the other hand, if the actuaries’ estimates on future death claims are high, the insurance company will retain the difference.
In a participating policy, the insurance company shares the excess profits (dividends or refunds) with the policyholder. Typically these refunds are not taxable because they are considered an overcharge of premium. The greater the overcharge by the company, the greater the refund/dividend. For a mutual life insurance company, participation also implies a degree of ownership of the mutuality.
NOTE: the distinctions between a Mutual Life insurance company and a Public Company can be of great fundamental significance. As we stated before, a Mutual Life Insurer shares both in profitability as well as risk with the insured and in fact plays a role of co-ownership (or skin in the game), while a Publicly Traded Company may have different priorities related to share holders and board of directors. This is not to say that principally a Publicly Traded Company does not have a clients best interest at heart; however obviously the paradigm is a different one.
It is illegal to market a Life Insurance policy, even that of a Publicly Traded Company as a securities instrument. Although variable policies are treated as a security and require the appropriate licensing and risk disclosure.
Similar to non-participating, except that the premium may vary year to year. However, the premium will never exceed the maximum premium guaranteed in the policy.
A blending of participating and term life insurance, wherein a part of the dividends is used to purchase additional term insurance. This can generally yield a higher death benefit, at a cost to long term cash value. In some policy years the dividends may be below projections, causing the death benefit in those years to decrease.
Similar to a participating policy, but instead of paying annual premiums for life, they are only due for a certain number of years, such as 20. The policy may also be set up to be fully paid up at a certain age, such as 65 or 80. The policy itself continues for the life of the insured. These policies would typically cost more up front, since the insurance company needs to build up sufficient cash value within the policy during the payment years to fund the policy for the remainder of the insured’s life.
A form of limited pay, where the pay period is a single large payment up front. These policies typically have fees during early policy years, should the policyholder cash it in.
This type is fairly new, and is also known as either excess interest or current assumption whole life. The policies are a mixture of traditional whole life and universal life. Instead of using dividends to augment guaranteed cash value accumulation, the interest on the policy’s cash value varies with current market conditions. Like whole life, the death benefit remains constant for life. Like universal life, the premium payment might vary, but not above the maximum premium guaranteed within the policy.
Simplified Issue or Final Expense
Insurance companies have in recent years developed products to offer to niche markets, most notably targeting the senior market to address needs of an aging population.
Many companies offer policies tailored to the needs of senior applicants. These are often low to moderate face value Whole Life insurance policies, to allow a senior citizen purchasing insurance at an older issue age an opportunity to buy affordable insurance. Simplified Issue may also be marketed as Final Expense insurance inferring coverage of funeral expenses.
Simplified Issue insurance policies: are Whole Life policies that, although available at any age, are usually offered to older applicants. This type of insurance is designed to cover funeral expenses when the insured person dies. In some cases, the applicant may even sign a pre-funded funeral arrangement with a funeral home at the time the policy is applied for.
The death proceeds are then guaranteed to be directed first to the funeral services provider for payment of services rendered. Most contracts dictate that any excess proceeds will go either to the insured’s estate or a designated beneficiary.
Some life insurance companies offer products at lower face amounts that skip many of the physical underwriting steps.
There is also usually a shorter application and the policy usually takes less time to issue. However keep in mind that although a Simplified Issue policy may not require a physical exam, this implies higher than normal risk to the insurance company which will be translated into a premium that is slightly higher. However, the face amounts (death benefits) are relatively small and therefore the added cost is generally inconsequential.
Some of the Advantages of a Simplified Issue Policy
No medical exam
Instant approval for qualified applicants
Generally smaller face amounts
Requirements for Whole Life
Whole Life insurance typically requires that the owner pay premiums for the life of the policy. There are some arrangements that let the policy be “paid up”, which means that no further payments are ever required, in as few as 5 years, or with even a single large premium.
Typically if the payer doesn’t make a large premium payment at the outset of the life insurance contract, then he or she is not allowed to begin making them later in the contract’s life. However, some Whole Life contracts offer a rider to the policy which allows for a one time, or occasional, large additional premium payment to be made as long as a minimal extra payment is made on a regular schedule. In contrast, Universal Life insurance generally allows more flexibility in premium payment.
Guarantees and Liquidity
The company generally will guarantee that the policy’s cash values will increase regardless of the performance of the company or its experience with death claims (again compared to Universal Life insurance and Variable Universal Life insurance which can increase the costs and decrease the cash values of the policy).
Cash values are considered liquid enough to be used for investment capital, but only if the owner is financially healthy enough to continue making premium payments. Single Premium Whole Life policies avoid the risk of the insured failing to make premium payments and are liquid enough to be used as collateral. Single Premium policies require that the insured pay a one time premium that tends to be lower than the split payments due to the fact that a lump sum is being paid at once. Because these policies are fully paid at inception, they have no financial risk and are liquid and secure enough to be used as collateral under the insurance clause of collateral assignment.
Cash value access is tax free up to the point of total premiums paid (what is referred to as Basis), and the rest may be accessed tax free in the form of policy loans. If the policy lapses, taxes would be due on outstanding loans. If the insured dies, death benefit is reduced by the amount of any outstanding loan balance. Internal rates of return for participating policies may be much worse than Universal Life and interest sensitive Whole Life (whose cash values are invested in the money market and bonds) because their cash values are invested in the life insurance company and its general account, which may be in real estate and the stock market.
Variable Universal life insurance may outperform Whole Life because the owner can direct investments in sub-accounts that may do better. Then again they may not and Variable Universal life policies hold the inherent risk of market investment and are generally not a conservative position such as Participating Whole Life.