Whole-Life Insurance

Overview 

Whole-life insurance was created to address the problems with term insurance. The biggest problem with term life insurance is that it is purchased for a stated period of time. If the insured dies after the term ends, the beneficiary does not get the premiums and does not receive the death benefit because the insured did not die during the term. Many term policies will allow the owner to renew the term each year, but the owner has to pay more in premiums with each successive year. Let us assume that a person wants a $1,000 death benefit. If the insured is 25 years old, the term premium is very low, but when they reach age 100, the annual premium will be the same as the death benefit. Chart 1 illustrates the cost of term insurance. What if someone wants to buy insurance that will pay a death benefit when the insured dies, no matter when that may be? What if the owner of the policy does not want to have to budget for the increases in the term premium? The policy that answers these questions is a whole-life policy. When the owner buys a whole-life policy, he or she is planning for the policy to last for the insured’s “whole” life. The owner pays the same premium each year. In the early years, the premium will be higher than the cost of term insurance. These extra premium dollars become the cash-value of the policy and go into the cash-value account for the policy. The cash-value account will provide a source of money to help offset the costs of the term insurance in the later years, when the premiums are no longer able to meet the costs on their own. Chart 2 may help you see how this works.

 The Cash-Value Account

 The cash-value account of a whole-life policy is similar to having a savings account within the policy. After the insurance company takes the amount of money it needs from the premium to meet the cost of term insurance, the extra dollars go into the cash-value account. The insurance company invests the cash-value account money for the owner. The government has told insurance companies that they must invest the money in the cash-value account a certain way. Most of the investments go into highly rated bonds and mortgages. The average gross return of these investments has been between 5 percent and 6 percent over the past 75 years. While you cannot depend on future returns to be the same as past returns, this average may give you an idea of what the cash-value account may return. The insurance company keeps some of that return as a management fee. In a fixed cash-value account the insurance company guarantees a specific return. If it makes more, it keeps the excess; however, when interest rates are low, it must make up the difference between its investment return and the guaranteed rate. With a variable cashvalue account, the insurance company guarantee is lower than with a fixed account, but if returns exceed the guaranteed rate, part of the excess is credited to the cash-value account. The cash-value account belongs to the owner of the policy. The owner can borrow it from the policy or withdraw it entirely. Usually the insurance company charges a fee for both options. If the owner borrows from the cash-value account, the insurance company will treat it as a loan, and charge the owner interest. Therefore, if the owner takes a loan, he or she will owe the premiums, plus the interest on the loan until the loan is repaid. If the insured dies while there is a loan on the cash-value account, the death benefit will be paid minus the loan and any interest still owed. If the owner withdraws the money, he or she will owe income taxes if the amount received is greater than the premiums paid and the policy will be cancelled. Remember the beneficiary will not owe income taxes on the death benefit.

The Death Benefit 

When the insured dies, (be it the day after the insurance is activated or at age 120), the insurance company will pay the beneficiary the death benefit only. The insurance company will use any cash-value account to lower the amount it has to pay. The beneficiaries will not get the money in the cash-value account and the death benefit. As an example, say someone buys a $10,000 wholelife policy on his or her life at age 25. If the cash-value account is $8,000 when the person dies, the insurance company will pay the beneficiary $10,000 not $10,000 plus the $8,000 in the cash-value account. Thus it only costs the insurance company $2,000 ($10,000 - $8,000), since the money in the cash-value account belonged to the owner and could have been withdrawn at any time.

Buy Term and Invest the Difference? 

At this point, you may be thinking that you could buy a renewable term policy with cheaper premiums, and invest the extra dollars yourself. That way the beneficiary would get both the investment account and the death benefit. However, many people find that when they try “investing the difference,” they spend those dollars before they invest them. Then, without the invested money to help pay the higher term premiums in later years, they are no longer able to keep the term insurance. Another nice thing about the cash-value account is that its returns are income tax-free. You would probably have to pay taxes on the gains if you invested the money yourself. However, for some individuals, buying term and investing the difference may make sense. If you have the discipline to save the extra money, and you know you can earn a higher return on your money than in an insurance policy, then buying term and investing the difference may work.

A Final Word on Whole Life

 When you buy a whole-life policy, you will probably be shown an illustration of the policy values for each year until the insured reaches the age of 100. Be sure to ask your agent what values are guaranteed. Unless the insurance company fails, then you can count on the guaranteed values. If you like the idea of insurance that will last for the “whole” life of the insured, but are leery of paying the fixed whole-life premiums, then you may also want to look at a universal-life policy. (See Life Insurance: Universal-Life Insurance, Virginia Cooperative Extension publication 354-146.) This type of policy often does not promise the guarantees that a whole-life policy does, but provides more flexibility.

TERM INSURANCE

Overview

 Term insurance is basic life insurance. It is the easiest type of policy to understand. A life insurance company will charge a dollar amount, known as the premium, to provide the beneficiary with a tax-free cash benefit if the insured dies in that year. A beneficiary might be a spouse, children, or anyone else the owner wants. If the insured does not die in that year, no cash benefit is paid. The premium paid to the insurance company was the cost of the death benefit protection for that year. The owner does not get the premium back if the insured does not die. In order for the insurance company to agree to pay a death benefit to a beneficiary, the company will want to make sure that the insured does not have any health problems that will increase the odds that they would have to pay the death benefit. Therefore, the insurance company will probably ask insured to be examined by a doctor. This process of deciding whether the insurance company will issue a policy is known as underwriting. 

Annual Renewable Term

 With a renewable term policy, the insured will need to visit the doctor to get the first year of insurance. After the first year, the owner will have the option to buy another year’s worth of insurance without a second doctor’s visit. The owner may continue to renew the policy year after year, as long as he or she agrees to pay the premium each year. With term insurance the premium for the same amount of death benefit will go up each year. Let us assume that you want a $1,000 death benefit. If you are 25 years old, the term cost is very low, but when you are age 100, the annual premium will be the same as the death benefit, $1,000. The following chart may help you get an idea of the cost of term insurance.

Level-Premium Term As stated, each year the owner renews a term policy, the cost of the policy will go up because the insured is getting older. Instead of buying term insurance on a year-to-year basis, the owner can buy a policy with fixed costs for five or more years at a time. The longest term is usually 20 or 30 years. These policies are called level-premium term because the premium stays the same for the length of the term. The fixed cost in the early years will be higher than the annual term cost, but the later years it will cost less than the annual term cost. The up side is that the owner does not need to budget for yearly increases in cost, and the total premiums paid over the term of the policy could be quite a bit lower than annual renewable term premiums. For example, your husband is a 25-year-old male. You have a child and you want her to have $100,000 to go to college if your husband dies. Let’s also assume that your child is now 2 years old. It may make sense to buy a $100,000 20-year term policy, because at 22, your child may be out of, or close to finishing college. • 20-year term annual premiums are $150 per year; total cost $3,000. • 1-year annual renewable term premiums start at $130 in the first year, but in the 20th year, the annual premium has risen to $560; total cost $5,800.  Often, the owner can renew these longer term policies, but the new premium will be higher if the policy is kept longer than the stated number of years.

Group Term

 Many times a company will purchase group term policies for its workers. Group term policies usually provide a cash payment to the worker’s named beneficiaries if the worker dies while employed by that company. The cost for this type of policy is very low, and sometimes free. The employee may be able to convert the policy to an individual policy if he or she changes jobs. Talk with your human resources contact to see if you have a group term benefit.

 Decreasing Term

 Many agents no longer sell decreasing term. This type of term policy is similar to a longer term policy, but will pay the highest death benefit in the first year. Each year thereafter, the death benefit will be lower and lower, until it goes away entirely. Your costs can vary from year to year, but usually remain level. If you have bought a home, you may be tempted to buy this type of policy to cover your family’s mortgage if you were to die. However, with a regular term policy, your family will have the difference between the death benefit and the mortgage balance to use for other things if they decide to keep the house and pay off the mortgage. 

Convertible-Term

 In this overview, we have only looked at term policies. Another type of policy is known as a permanent policy. A permanent policy will help you plan your payments to insure your entire life. In other words, no matter when you may die, a permanent policy (if designed correctly) will pay a death benefit. You may be thinking that you could achieve the same goal by renewing your term policy. This is true, but the costs will keep on rising as you get older, to the point where they may be too high to keep paying. A convertible term policy will allow you to start with a term policy, but later, you can convert (or switch) your policy into a permanent policy. Permanent policies such as whole-life, universal-life, and variable universal-life are covered in Life Insurance: Whole-Life Insurance, Virginia Cooperative Extension publication 354-145; Life Insurance: Universal-Life Insurance, Virginia Cooperative Extension publication 354-146; and Life Insurance: Variable Universal-Life Insurance, Virginia Cooperative Extension publication 354-147. If you know you have a lifetime need for insurance, it makes sense to look at a permanent policy as soon as possible. However, if you need a policy now, but you do not have a lot of money to pay premiums, a convertible-term policy may work for you. In a few years, if your income is higher, you will be able to afford a permanent policy and you can convert the term policy to a permanent policy. A Final Word on Term Insurance Term insurance is good way to protect your beneficiary for a limited amount of time. Term insurance also allows for the lowest cost if your need for the policy is only temporary. If you are a disciplined saver, buying a term policy and investing the difference between the cost of the term policy and the cost of a whole-life policy means your beneficiaries will have both the death benefit and the value of the investments. In addition, you will have the investment account to assist you in paying the higher premiums in the later years of the policy.

Definitions of Terms

 Beneficiary – The person or entity receiving the death benefit at the death of the insured.

 Cash Value – The amount of total premiums paid for a policy minus the costs for insurance in whole-, universal-, and variable universal-life policies. The cash value grows tax-free in an insurance policy.

 Death Benefit – The total cash payment made to the beneficiary upon the death of the insured. Insured – The person on whose life the insurance has been purchased. If the insured dies, a death benefit will be paid to the named beneficiary.

 Owner – The person or entity who owns the insurance policy. The owner may or may not be the insured. The owner can designate the beneficiary, and is responsible for paying premiums. See Life Insurance: The Impact of Ownership, Virginia Cooperative Extension publication 354-142, for more information on the impact of ownership.

 Premium – The amount billed to the owner of an insurance policy (usually monthly, quarterly, or annually) by the insurance company. In term and whole-life the full premium must be paid to keep the insurance. In universal- and variable universal-life, the amount billed may or may not be a mandatory payment to keep the insurance

The Different Types of Policies

Life Insurance Overview

A life insurance policy provides a cash payment when a person dies. This payment is known as the death benefit. Many people buy life insurance to protect the people who are dependent on them. Others buy life insurance as a way to leave a cash gift to their spouse, children, grandchildren, and charities at their death. If you have made the decision to buy a policy, you may wonder which type of policy to choose since there are several different types of policies.
The policy is written on the life of a person, known as the insured. The owner makes payments, known as premiums, to the insurance company for the policy. In return, the insurance company agrees to pay the death benefit to the beneficiary if the insured dies within the stated term.

Term

Term insurance is the most basic type of life insurance. The policy is written for the term of the policy, usually from one to 30 years. If the insured dies within the stated term, the insurance company pays the death benefit to the beneficiary. When the term ends, the insurance ends. The premiums for term insurance are usually the lowest among the different types of life insurance, but will increase with the age of the insured. There is no cash value in a term life policy. (Cash value will be discussed in greater detail later.) This means there is no money for loans or to pay for the insurance if you can’t pay the premiums.
Many employers offer a type of term insurance known as “group” term to their workers. Group policies cost less, and many companies pay the premiums. Generally, the policy is only good for as long as the worker stays with the company.
Term insurance is suggested for those who only need the death benefit for a certain period of time. See Life Insurance: Term Insurance, Virginia Cooperative Extension publication 354-144, for more information on term insurance.

Whole-Life

A whole-life policy pays a death benefit no matter when the insured dies. In most cases, the policy will guarantee the death benefit. The premiums are usually much higher than a term policy and the full premium must be paid each year. Whole-life policies have cash value. The difference between the premium and the actual cost of the insurance is put into a special account, known as the cash-value account. This cash-value account may be used to help the insured pay the “fixed” premium payments in later years. The policy owner may borrow against the cash value or receive the cash value if the policy is canceled. There may be charges associated with borrowing against the cash value or canceling the policy before the death of the insured. The insurance company may charge interest if the money is borrowed and fees to close out the account if the policy is canceled. At death, the beneficiary only receives the death benefit, not the death benefit and the cash value.
Whole-life works well for those who want a guaranteed death benefit no matter how long the insured lives, and who have enough money to pay the premiums. See Life Insurance: Whole-Life Insurance, Virginia Cooperative Extension publication 354-145, for more information on whole life.

Universal-Life

A universal-life policy is similar to a whole-life policy. However, a universal-life policy gives the policy owner the choice of changing the premium and even the death benefit.
For example, the owner may decide to double the premium paid one year. The extra money will go in the cash-value account. Most universal life policies have cash-value accounts that pay at least 3 percent or 4 percent interest. Another year, the owner may decide not to pay any premium, and use money in the cash-value account to pay the costs for that year. Policy owners may have a higher death benefit while their children are young, and a lower the death benefit once their children are grown.
There are some limits to the changes that can be made. The policy owner needs to be careful not to pay too little, and end up with no cash value. If this happens, and the owner still wants the insurance, he or she will need to buy a new policy. Some policies allow the beneficiary to receive both the death benefit and the cash-value account at the death of the insured. Be sure to read the policy closely as some only pay the death benefit.

Variable Universal-Life

A variable universal-life policy is a special type of universal policy. It allows the cash-value account to be invested in stock funds, bond funds, and other assets (much like mutual funds). These funds may allow the cash value to grow at higher rates than fixed-rate whole-life or universal-life policies. The down side is that these funds may also have losses. Many variable policies also offer a fixed account with a low guaranteed interest rate as one of the options. If the returns are low (or negative) then the owner may need to pay more premiums to keep the policy.
A variable universal-life policy is for people who want lifetime coverage, and who can tolerate risk. The buyer of a variable universal-life policy would prefer to invest money in stocks and bonds to safer assets. See Life Insurance: Variable Universal-Life Insurance, Virginia Cooperative Extension publication 354-147, for more information on variable life.