Monday, November 1, 2010

Life Insurance Primer. Part Three: Whole Life Insurance

This is part three in my series of articles on life insurance.  In Part One, I gave a general overview of the different types of life insurance.  In Part Two, I discussed term insurance, the most common form of life insurance.  In this article, I will give an in-depth description of whole life insurance.  Before I begin, I want to repeat the statement that I made in the first article in this series:

Most people should buy term life insurance and forget the rest.

That being said, it never hurts to understand the other forms of life insurance, if only to see why they are too confusing for most consumers.

How Whole Life Works:

Whole life insurance gets its name from the fact that it lasts for your whole life.  In its most common form, you pay the same premium for your entire life.  This is in contrast to term life insurance where the policy renews at a higher premium after some number of years.  The other characteristic of whole life insurance is that it accumulates cash value.  You can think of a policy's cash value as an investment account that the insurance company sets aside in your name.  Every year, this account grows and accumulates more money.  If you cancel the insurance policy, any money in the account is yours to keep.  However, if you die, your heirs get the face value of the insurance policy.

Here is a simple example.  Let's say you buy a whole life insurance policy that pays $500,000 if you die.  After 20 years, you might decide that you don't need the insurance anymore so you cancel the policy.  Let's say that over 20 years, $50,000 has accumulated in your cash value account.  When you cancel your policy, the insurance company sends you a check for $50,000.  On the other hand, let's say that the unthinkable happens and you die after 20 years.  The insurance company sends your heirs a check for $500,000, which is the amount of insurance that you bought.

Contrast that to a term life policy that doesn't accumulate any cash value.  Let's say that in the above example you purchased a term life policy for $500,000.  If you cancel your policy after 20 years, the insurance company sends you a check for $0.  In other words, you get nothing!  However, if you die after 20 years, your heirs get a check for $500,000.

It sounds like whole life insurance is a better deal.  After all, you get a check from the insurance company when you cancel your policy.  Who doesn't like to get checks in the mail from insurance companies (or any company for that matter)?  The downside is that the monthly premium that you pay to the insurance company is higher in the early years of the policy than what you would pay for term insurance.  In some cases, it is a lot higher.  It is possible that you could come out ahead if you buy term insurance, take the money that you saved by not buying term, and invest it yourself.  This is commonly known as "buy(ing) term and invest the difference".

Setting the Premium:

The mechanics of how a whole life policy works is quite complicated.  I will try to break is down with a hypothetical example.  This example is in no way representative of any specific policy.  In other words, I just made these numbers up.

As mentioned above, in the early years of the policy, you are paying more for whole life than you would for term life.  That means that the insurance company only needs a portion of your premium to cover the risk of providing you with insurance.  Let's say that your $500,000 whole life premium is $6000 for the year, but it only costs the insurance company $1000 to provide you with term insurance.  That means that there is a $5000 surplus.  That surplus gets put into the policy's cash value account, minus the usual fees and expenses that the insurance company will deduct.  Normally in the early years of the policy, the insurance company's fees are quite high because they have to pay a commission to the salesperson who sold you the policy.  You might end up with only $1000 being deposited into your cash value account.

Here is what your policy looks like after one year:

$6000 premiums paid
- $1000 to cover the cost of $500,000 of insurance
- $4000 to cover fees and expenses
= $1000 deposited into your cash value account

Total cash value after year 1 = $1000

In the second year, you continue to pay $6000 in premiums since the premiums always stay constant.  Since you are a year older, the cost to provide you with $500,000 of insurance might rise to $1100.  However, since you have $1000 in your cash value account, the insurance company only has to provide you with $499,000 of insurance.  Why is that?  Remember if you die, your heirs get $500,000.  The insurance company uses $1000 from your cash value plus $499,000 from its own bank account to pay your heirs.  Therefore, the insurance company only needs to provide you with $499,000 of insurance.  This might only cost the insurance company $1050.  Also, in the second year, the fees and expenses might drop to only $2000 because most of the salesperson's commission is paid in the first year.  Finally, the insurance company will credit you with some amount of interest on the cash value you have already earned.

Here is what your policy looks like after two years:

$6000 premiums paid
+ $10 in interest on your cash value
- $1050 to cover the cost of $499,000 of insurance
- $2000 to cover fees and expenses
= $2960 deposited into your cash value account

Total cash value after year 2 = $3960

This table gives a quick synopsis of how this hypothetical whole life policy might work:

Year Beginning Cash Value Premiums Paid Interest on Cash Value Insurance Required to Buy Cost of Insurance Expenses Ending Cash Value
1$- $6,000.00 $- $500,000.00 $1,000.00 $4,000.00 $1,000.00
2$1,000.00 $6,000.00 $10.00 $499,000.00 $1,050.00 $2,000.00 $3,960.00
3$3,960.00 $6,000.00 $39.60 $496,040.00 $1,075.00 $1,000.00 $7,924.60
4$7,924.60 $6,000.00 $79.25 $492,075.40 $1,100.00 $1,000.00 $11,903.85
5$11,903.85 $6,000.00 $119.04 $488,096.15 $1,125.00 $1,000.00 $15,897.88

The main thing to take away from this example is that the cash value that accumulates in your account reduces the amount of insurance that the insurance company must cover.  Even though your risk of dying goes up with age, your cash value offsets this rising cost.
In the early years of the policy, whole life insurance is more expensive than an equivalent term policy.  This is because some of your whole life premium is syphoned off into your cash value account.  However, in the later years of the policy, your whole life premium will be cheaper than an equivalent term policy because your cash value reduces the amount of insurance that the insurance company needs to buy on your behalf.  Of course, you can do what is known as "buy term and invest the difference", meaning that you can buy term insurance and invest the money that you save yourself, and then use that money in your later years to pay for more expensive term insurance in your later years.  Or you can just drop your term insurance and use the money that you've accumulated for your retirement.

So which is a better deal:  investing the difference yourself, or letting the insurance company invest your money for you in the whole life cash value account?

That is a hard question to answer because in most cases, insurance companies do not make it easy to figure out which is a better deal.  When you buy whole life, your insurance agent will give you an impenetrable document known as a policy illustration.  This document will contain your yearly premium and your guaranteed cash value.  However, this doesn't tell you how much is being deducted for expenses and for the cost of insurance, so you have no way of knowing what interest rate you are getting from the insurance company.  Whole life policies have very high expenses in the early years (mostly to pay the commission of your salesperson), but it generally is hard to find out what they are.  The only thing you might notice is that your cash value will not accumulate very much money in the early years.  Likewise, you won't see an interest rate on the illustration.  Yes, your cash value will grow, but you won't know how much is being taken out to pay for the insurance, so you won't be able to compare it to, say, a Certificate of Deposit.

Varieties of Whole Life Insurance:

There are two main varieties of whole life.  The simplest is non-participating whole life (or non-par).  With this type, you are guaranteed a certain amount of money in your cash value account every year.  It is up to the insurance company to meet this obligation.  If the insurance company's investments do better than expected, then the insurance company keeps the profits.  If not, then the insurance company must make up the difference.

The second variety is called participating whole life.  With this type of insurance, the insurance company still guarantees you a certain cash value.  However, if the insurance company's investments do better than expected, they will share some of the profits with you.  This additional profit is called a dividend, and it is given to you as an additional payment into your cash value.  While extra money is always welcome, it is hard to predict what this dividend will be since the insurance companies generally don't share with you how they invest their money or what their past returns are.  Thus, you are making a leap of faith that the insurance company is going to invest its money better than you would.

You Should Consider Whole Life Insurance If:

As you can see, whole life insurance is both complicated and opaque - two qualities that you don't like to see in an investment.  Most people dont' fully grasp the mechanics of how the policy works, and insurance company's don't provide enough information to compare buying a whole life policy versus investing on your own.  Therefore, it is hard to recommend a whole life policy to most people.  However, there are a couple of positives:

- The premiums for whole life insurance are constant for your entire life.  They are guaranteed never to go up.  Therefore, if you think you might need life insurance for most of your life, you may benefit from a constant premium.  However, a level term life insurance policy might work better for most people.

- Money accumulates in your cash value account tax-free.  You do not pay taxes on the amount of interest that accumulates in your cash value until you withdraw the cash from your account.  In this way, it is similar to an IRA or 401(k).  If you have maxed out your contributions into these investment accounts, and you are looking for a way to put away more tax-deferred savings, then you might want to look into a whole life policy.  However, since you have no good way to judge the quality of the insurance company's investments, you might come out ahead by investing in a taxable investment.

- The cash value feature provides you with a forced savings account.  One check gives you both insurance protection and savings.  If you think you would have trouble saving and investing on your own, you may want to consider a whole life policy.  However, you should consider automatic deductions into a savings account or other "set-it-and-forget-it" options.

Overall, there isn't enough upside to recommend a whole life insurance policy to most people.  Most people are better off buying term insurance and investing in something that has fewer fees and better disclosures.


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