Whole life insurance is one of three types of permanent life insurance (the other two types being term to 100 and universal life insurance). It’s intended for people who need life insurance for the entire duration of their lives. Funeral insurance and final expense insurance are two common reasons for considering whole life insurance.
Conceptually whole life insurance can be considered to have level premiums for life (this isn’t always the case, see below for variations). To level out the premiums, on an annual basis premiums for whole life insurance are much higher than term life insurance initially, as well as higher than the actual cost of insurance to the insurance company. Effectively you will pay higher premiums in the earlier years of the policy than other choices. However, as premiums are level, eventually the cost of insurance to the company (and the cost of term insurance) will exceed whole life premiums. How does the company make up this loss (where your premiums are less than the cost each year)? The answer is through reserving. In the early years you are paying higher premiums than strictly necessary in those years. The company saves up or reserves that excess overpayment of premium. Later in life when your annual premiums aren’t enough to cover the true cost of insurance in those years, the company can make up that difference in premium out of the reserve that they saved up in the early years of the policy.
Now, if you cancel your policy, the company will refund you a percentage of that accumulated overpayment in premium. That refund is known as a cash value or a cash surrender value.
And that is the basis for a conceptual understanding of whole life insurance; level premiums for life and if you cancel your policy early there may be a cash surrender value, which is a refund of a percentage of your accumulated overpayment in premium.
Whole Life Insurance today
At this point you should note that through the years, companies have variously guaranteed and not guaranteed various combinations of the premiums and the cash values of whole life insurance. In today’s marketplace consumers have plenty of products available that fully guarantee both the premiums and the cash values.
In years past the insurance industry attempted to market whole life insurance as an investment or savings vehicle. The idea is that you purchase a whole life insurance policy and then cancel it in return for the cash surrender value at the appropriate time (such as children’s education, or retirement). To unwary consumers the cash values in whole life insurance looked like big numbers. Unfortunately if they’d simply invested in a real investment or savings product they would have had much more money. As consumers weren’t presented with alternative scenarios, they took what appeared to be large cash values at face value (i.e. without accounting for investment earnings or inflation).
In the 1980’s some people started to catch on to this. Word began to spread that whole life insurance was a horrible product. Companies that advocated a term-only approach gained inroads in the Canadian market place. And consumer advocates started telling everyone to stay away from whole life insurance. The concept of ‘buy term and invest the difference’ took off. Even today, online experts will tell you the evils of whole life insurance. Here’s a recent example, from a site owned and operated by Bell in Canada: http://blog.yourmoney.ca/2009/11/life-insurance-policies-avoid.html
The premise of whole life policies is they combine life insurance with an investment portion that builds up a cash value over time. What your insurance agent isn’t telling you is that the management fees on the investments can erode much of their growth.
Please note – the information in that quote is wrong (you’ll see in the comments many agents objecting to the article. You should be as wary of uninformed experts on the internet as you are of life insurance salespeople). The author of this article is speaking on a large Canadian site as an expert on life insurance. However if you read the above quote you may notice that it actually doesn’t make sense. With whole life there are no discrete investments or management fees. Investments and management fees are actually a part of universal life insurance which is not at all the same as whole life insurance. The author is clearly confusing the two products, possibly having only learned about how these products work from other sites on the internet.
Is there anything inherently evil about whole life insurance? Of course not, it’s an insurance policy with three primary features; cash value, the premiums, and the death benefit. Those three features also have the attribute of being guaranteed or not. Whole life insurance should be evaluated on the basis of these features rather than the spectre of insurance salespeople.
However, as the result of the backlash against whole life, the life insurance companies created a new type of permanent insurance called term to 100. Term to 100 life insurance is basically permanent life insurance (premiums are level for life) but there are no cash values if you cancel. This means premiums can (and are) lower than whole life insurance.
Should you buy whole life insurance? Probably not. But not because the product is bad. It’s as simple as Canadians now have access to other, lower priced options for their permanent insurance, like term to 100 and universal life.
Whole life insurance dividends (how many whole life insurance policies actually work)
One of the perils of whole life insurance comes about as the result of what are called dividends. The first problem is that these dividends are not actually dividends as most consumers view them. They are actually a refund of premium from the insurance company (your own money back) based on the experience of the company for the block of policies that your policy belongs to.
So on an annual basis, let’s say the company charges you $1000 for insurance. Once they review mortality and expenses, they determine that the things went better than expected so they are going to refund you back $50 that year. Is that a dividend? Again, not the way most people view dividends.
Now what to do with that $50? The Canadian life insurance industry has come up with 5 dividend options:
- Term insurance. Your dividends purchase a one year term insurance amount (insurance for one year only).
- Reduce the premium. If your annual premiums are $500 per year, the $50 dividend can be applied to the premium, meaning your new premium is only $450 per year.
- Paid in cash. Just like it sounds. Take your $50 a year and party like it’s 1999. (though worth noting again, this is a refund of your premium, it’s your own money you’re getting back).
- Paid up additions. Your $50 is used to buy a mini-whole life policy. This new policy has a one year premium of $50 (i.e. the insurance is fully paid up for life in the first year). As this mini-policy is in it’s own right a whole life policy, it also has it’s own cash values and death benefit that get added to the main policy’s death cash values and death benefit.
- The fifth dividend option is a blend of both term insurance and paid up additions. Your first year your premiums buy say $100,000 of total insurance. You might structure that as $25,000 of whole life insurance and $75,000 of term insurance (all rolled up inside the whole life policy). Now your $50 dividend is used to buy a paid up addition – a mini whole life policy. Next year you have the same total $100,000 of insurance but it consists of $25,000 of whole life, say $100 paid up addition and now only $74900 of term insurance. Over time the paid up additions are intended to entirely replace the $75,000 of term insurance.
Vanishing premiums – where we are reminded what ‘not guaranteed’ means (it means it can and does go down instead of up)
Up until the 1980’s the common phrase in the life insurance industry was ‘dividends have never gone down’. And until the 1980’s, this was the case. So insurance companies happily showed consumers dividends of say $50 a year, buying paid up additions. Because those paid up additions are just that – paid up – eventually the entire policy consists of paid up additions and no more premiums are due – your policy is paid up, the premiums have vanished.
But in the 1980’s some companies were unable to continue projected dividends. The illustrations they had shown to consumer assuming certain dividends being paid over time were no longer correct. Instead of paying $50 dividend, perhaps the companies only paid $35. Which means that the whole life insurance policy bought less paid up additions that year. Which means when the policy was assumed to have become paid up, it actually didn’t – premiums were still due. This came as an unpleasant surprise to many consumers who’d been paying premiums for years and decades, assuming that their premiums would become paid up. Now these consumers were older and facing retirement and looking forward to no further life insurance premiums. However, the premium bills kept coming.
This resulted in many life insurance companies in Canada being sued successfully over vanishing premiums, perhaps because consumers had not been made aware that dividends were not guaranteed. CTV story here: http://www.cbc.ca/news/story/2001/06/29/LondonLifesuit_010629.html
There is some concern in the life insurance industry that consumers are facing a similiar situation with universal life over the coming years, as a result of the recent stock market crash.
In the end, you should be aware that if you are purchasing a whole life insurance policy that pays dividends, that these dividends are not guaranteed. And that means they can go down – and your policy may not perform as expected. If it fails to perform as expected 20 years from now as you’re facing retirment, are you prepared for that?