Whole Life Insurance: Complex, Ingenious

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What is whole life insurance? A simple answer, one you might find on a financial information website, might describe whole life insurance as a combination of life insurance and cash value. But once you get past this basic definition, the details and workings of a whole life policy can be quite sophisticated, maybe even confusing. Writing in the January 11, 2009 Palm Beach Daily News, life insurance expert R. Marshall Jones said that:

“Until recently, permanent life insurance was arguably the financial industry’s most complex instrument…”

As with many other complex financial products, whole life insurance is the result of the integration of several basic financial ideas. The starting point for whole life is an understanding of some of the shortcomings with a simple financial instrument, term insurance.

Here’s the big issue with term insurance: As you get older, it gets more expensive. Because statistics show older people are more likely to die than younger people, insurance companies price the coverage accordingly. To illustrate, here are 50 years of scheduled premiums from a reputable life insurer for a healthy 35 year-old male non-smoker to secure $500,000 of life insurance on a yearly renewable basis.

Term-Life Premiums

This pricing, while accurately representing the risks assumed by insurance companies as people get older, creates a dilemma for consumers. As they live longer, and pay increasingly expensive premiums, the cost of insurance becomes prohibitive. Thus, when they are most likely to die, they may not be able to afford the insurance. From a financial perspective, the only way to “win” in this transaction is to die “young,” before the insurance gets too expensive. Given the aversion most of us have to dying, the most likely outcome of yearly term insurance is paying premiums for a period of time, then lapsing the coverage. Even though the consumer may have a real need to provide the financial protection of life insurance, the yearly renewable premium schedule creates a financial incentive to drop the protection as soon as possible – or simply forgo life insurance altogether. This is a lose-lose proposition, for the consumer and the insurance company.

Integrated Solution, Step One
One response to increasing yearly renewable premiums is leveling the premium. Instead of increasing the cost every year, the insurer determines a flat rate for a specified number of years, i.e., for a term. A typical term may be 10, 15, 20 or 30 years. The level term arrangement results in a policyowner overpaying (relative to the true annual cost of insurance) during the early years of the term, then underpaying at the end. For the 35-year-old in the above example, the 30-year level term premium is $490/yr. Compared to yearly renewable term, the level premium is more expensive for the first 10 years, then less expensive for the next 20.

Term vs. Level

To accurately price level term insurance, the insurance company must make some assumptions about the time value of money, because the “additional” premiums they collect in the first 10 years will be invested to subsidize the cost of insurance for the following two decades.

A level term premium schedule significantly resolves the problem of the cost of insurance becoming progressively more expensive in later years – at least during the term. But when the term expires, the problem returns. In our example, the cost to renew $500,000 of life insurance at age 65 is $5,025/yr. – providing the individual can prove excellent health by passing a new physical examination. Even if he is healthy, the new term is limited to 20 years (age 85). And what happens if this man lives to age 86? The scheduled renewal premium is now $207, 990! For one year!

While level term premiums help consumers afford life insurance longer, the same end-of-life problem remains: Just when you are most likely to collect on the life insurance, you may not be able to pay for it. Level term insurance is certainly a win for the insurance company because policyholders pay more premiums longer, but the financial outcome is less clear for most consumers using term insurance – they still are not likely to have an insurance benefit in force at death.

Integrated Solution, Step Two
A lifetime term policy with level premiums would solve the problem. But fairly pricing term for one’s entire lifespan creates a new problem: As illustrated by the yearly renewable table, the cost of insurance rises steeply after age 60. So even with a long time to “overpay” at the beginning, a policy guaranteed to be in-force at age 100 requires a sizable annual premium. In the case of our healthy 35-year-old non-smoker, the lifetime annual premium is $6,165/yr., more than 12 times the annual premium for the 30-year term policy. Unless the consumer has money to burn, the idea of overpaying $5,600 each year (the difference between the whole life and level term premium) for the next 30 years just to keep the premiums affordable in old age probably won’t set well. There’s just too much overpayment for too long to convince most consumers to set aside that much money for an event that may be 50 years in the future.

Enter the concept of cash value. The overpayment of premium in a whole life policy represents reserve capital the insurance company will use to cover the cost of insurance as the policyholder ages. In the meantime, this reserve capital will be invested to generate more capital. A portion of this excess cash value, and the earnings from it, is credited to a cash account tied directly to the policy. While the policy is in-force, the policyowner has the right to access this cash value, through a variety of transactions (loans, partial surrenders, whole life insurance dividends, etc.).

In a typical whole life policy, this cash value can eventually exceed the total premiums paid, i.e, the policyholder not only owns the insurance benefit, but has received a positive return on the premiums.

This blending of cash value and life insurance is a brilliant example of integrated thinking. A whole life policy with a level premium provides economic certainty for consumers – they know how much insurance they will have, they know how much it will cost, and (as long as premiums are paid) they know the insurance will be in-force at the end of their lives. At the same time, the larger premiums give the insurance company greater financial stability. It has greater resources to meet its contractual obligations. And during the lifetime of the policy, the owner also has access to this stable source of cash value (and its growth) as well.

Complexity begets more complexity – and more opportunities
Besides turning the life insurance benefit into an asset instead of an expense, the cash value component opens the door to other possibilities. Dividends* can be received as income, or used to pay premiums. Additional paid-up insurance may be purchased. Depending on the performance of the cash value account, additional premium requirements may change or be eliminated.

Because the benefit paid at death is now certain, life insurance can do more than provide income replacement protection in the event of a premature death. Among other things, the proceeds can be vital in estate and inheritance planning, serve as a supplement to long-term care, pay creditors and fund charities.

Some might argue that it is hypothetically possible to project similar or greater financial results by choosing to use term insurance alongside other accumulation vehicles. On paper, this is possible. But while two simple stand-alone financial products might appear to out-perform whole life in a narrow set of criteria (such as pre-tax accumulation in a 20-year period), they cannot equal the combination of benefits, guarantees and flexibility that result from using a whole life policy. The integration of level premiums and cash value, and the resulting opportunities make life insurance a win-win for all parties.

Just as whole life is a multi-faceted complex financial instrument, there are many ways to position whole life in one’s financial program. Contact us to find out how whole life might best fit your current circumstances.

*Dividends are not guaranteed, and are generally declared annually by the company’s Board of Directors.

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