Whole Life Insurance: Making the Complex Simple

The French essayist Michel de Montaigne (1533-1592) sagely observed: “Nothing is so firmly believed as what is least known.” Although Montaigne’s comments are more than four centuries old, they still apply today—especially when the topic is cash value life insurance.

In the United States, the first forms of cash value life insurance appeared around the colonial era. Given its long history, it would make sense for whole life insurance to be a well-understood financial product with an established position in personal financial programs. Yet a quick online search reveals that many financial commentators have a strong distrust and outright animosity toward whole life insurance. Why? Some of the problem is simply financial ignorance, and the tendency to denigrate what is not easily understood.

Cash value life insurance is a complex financial product. Yet, like many complex instruments, whole life insurance is actually the integration of several simple financial concepts. The function and logic of whole life insurance can be reduced to three fairly straightforward financial concepts.

Three things to understand about whole life insurance. Three concepts that make up whole life insurance.

The Three Concepts to Understand About Whole Life Insurance

So how do you make sense of whole life insurance and its value? You have to understand that its structure is purposeful and intentional–no part of the design was done on a whim or an accident. As my husband, Todd Langford, would say, it’s structured exactly how it should be. In other words, it’s structured in a way that allows insurance companies to offer optimal benefits while ALSO keeping the lights on for years to come. If insurance companies are going to make guarantees, they must be able to fulfill those. And that requires careful resource management and long-term thinking.

So, without further ado, let’s talk about the financial concepts that make life insurance work the way it should.

1. It Makes Sense for the Cost of Insurance to Increase with Age

A basic concept of insurance is spreading the risk of individual financial loss across a large number of people. The cost of insurance is based on the probability of a loss occurring. In other words, how likely are you to pass away? The higher the probability, the higher the premiums. Age is one of the great determining factors, since death is an inevitable event.

Term insurance, or temporary insurance, is so cheap because it’s NOT guaranteed. There’s a chance the company may never pay a claim, especially when you’re young. Yet, when you hit your 50s and 60s, a 20-year life insurance policy may no longer look like a “what if” to your insurance company, so they adjust prices accordingly.

Other factors being equal, the likelihood of dying increases with age. Thus, the cost of securing life insurance on an annual basis increases with age. The result of this age-based pricing structure is a hockey-stick-shaped graph (Figure 1).

Permanent insurance, or whole life insurance, is a little bit different. Since insurance companies KNOW that they’re going to pay a claim someday, prices are higher from the outset. (However, companies compensate for this by allowing you to access the equity of your policy via the cash value.) This enables companies to ensure proper funding of a guaranteed event, and also maintain level payments for you. You lock your policy in at a minimum guaranteed premium that will never change, based on the age you start your policy. No surprises!

At the end of the day, this structure allows companies to provide great benefits in a way that makes financial sense for the company. And if you’re doing business with a company, you want them to have strong financials.

2. It Makes Sense to Pay for Life Insurance with Level Premiums.

The reality of increasingly costly premiums as one gets closer to dying creates a financial dilemma: Each year, it becomes more costly to protect against an event that is more likely to occur. One way to resolve this issue is to simply drop the coverage. The other is to establish a level premium structure. In this arrangement, premiums are fixed for a specified term, typically for 10, 15 or 20 years.

During the early portion of the term, the annual premium is greater than the actual cost of insurance. The insurance company collects this surplus and invests it. Later in the term, the annual premium is less than the actual cost, but the surplus collected from the early years (plus the investment earnings) makes up the difference (see Figure 2).

If you only want short-term coverage, choosing level premiums can be a good way to go. However, at older ages, many individuals find that the up-front overpayment required for level premiums is just too expensive. Yet unlike other forms of insurance, the probability of loss is 100 percent—eventually, everyone dies, while car and home claims are not guaranteed.

Understanding this reality, many people recognize the potential value of keeping life insurance in force for one’s entire life. Doing so not only results in a return (to your beneficiary) from premiums paid but also provides for a greater degree of financial certainty at the end of life. The challenge is how to overcome the financial hurdle of keeping life insurance in-force through old age.

3. It Makes Sense to Give Policyholders Equity for Long-Term Arrangements.

A level premium required to maintain life insurance for one’s entire lifetime is substantially higher than shorter-term plans because the surplus premiums accumulated in the early years of the policy must be substantial to cover the steep costs of insurance later in life (see Fig. 3). For example, a level premium life insurance policy calculated to remain in force until age 100 for a 35-year-old represents a 65-year term period, which is much longer than a 10-, 15- or 20-year term plan.

For many policyholders, placing this much excess premium with an insurance company represents a significant “opportunity cost” to their personal finances, e.g. “What could that money be worth to me if I didn’t use it to build a surplus account for the insurance company to pay the cost of life insurance in my old age?”

Recognizing this issue, life insurers give policyholders co-ownership of these premiums—and the earnings from their investment—in the form of cash values. Subject to the terms of the policy, these cash values can be accessed by the policyholder in a variety of ways while still maintaining a life insurance benefit. Just like you build equity in your home by paying your mortgage, you can build equity on your Death Benefit by paying premiums.

In policies issued by well-managed, mutual insurance companies, it is quite likely that cash value balances will, over time, exceed the premiums that have been paid. Whole life insurance dividends, i.e., the non-guaranteed earnings on your premiums, can be received by the policyholder, used to pay future premiums, allowed to accumulate and compound, or applied to the purchase of additional paid-up insurance.

This arrangement is reasonable and equitable for both the policyholder and the insurance company. The cash value feature gives the policyholder a rationale for placing the excess premiums with the insurance company. Larger premiums give the insurance company greater investment capital, longer time periods, and greater flexibility to meet the obligation of future claims. At the same time, competition among insurers provides incentives for companies to maximize their cash value accumulations and account features for the benefit of the policyholder.

Whole Life Insurance is Complex

Even from this brief overview, it should be apparent that combining the three variables of age-based insurance costs, level premiums, and cash value accounts makes for a complex financial product. Some of the distaste for cash-value life insurance is probably due to the product’s complexity. Financial literacy in the United States is often sorely lacking. A popular online financial advice website dismisses cash value life insurance this way: “In general, this is a very complicated topic and well beyond the scope of what we can easily cover here.” So, if the concepts are over your head, forget it? (Just because most people don’t initially understand how to operate an automobile doesn’t mean they should settle for riding a bike for the rest of their lives. That’s why we have driver’s education classes.)

Another reason some financial experts are antagonistic toward cash value life insurance is their belief in the probability of not needing life insurance as opposed to the possibility of really needing it. This is very similar to the mindset of those people who ignore the often catastrophic consequences of once-in-a-lifetime events Using this type of thinking…

  • You probably don’t need life insurance—yet. (After all, you’re still alive.)
  • You probably won’t need or want life insurance in your old age because…
  • …you think you will probably have saved enough for retirement, and…
  • …you think you will probably have other assets to leave as an inheritance…
  • …and you are sure you probably won’t have an estate tax issue, but…

The reality is, while you may not experience ALL of these probabilities, chances are you’ll experience one. Or some other probability could occur—divorce, death of a family member, etc. And if something like that should occur, you might wish you had life insurance. Unfortunately, it’s not the type of asset you can just acquire (from a cash value standpoint) overnight. You have to build it over years of diligent premiums.

In contrast, the structure of a whole life insurance policy makes it possible for individuals to keep life insurance in force for as long they live, using a level premium format, which creates CERTAINTY thinking. Before the end of life, the excess premiums and their earnings are available to the policyholder in the form of cash values. This results in the following benefits:

  • The certainty that the annual cost of insurance is level and fixed, and not subject to change in the future.
  • The certainty that premiums paid will eventually deliver a benefit.
  • The certainty that excess premiums deposited with the insurance company (as well as the dividends that may result) can be accessed by the policy owner.
  • The certainty that these features are specifically enumerated and contractually guaranteed.

Cash value life insurance is a complex financial product designed to provide financial certainty to effectively address the worst that could happen, yet provide options for a range of other events as well. Even if hindsight might indicate that other strategies may have been more profitable—in the past—whole life insurance continues to have financial relevance because its format recognizes the importance of responding to future unknowns.

READY TO LEARN MORE ABOUT HOW WHOLE LIFE INSURANCE COULD MAKE A DIFFERENCE IN YOUR FINANCIAL PLANS? Book a free consultation with us to see how whole life insurance might improve your financial picture.

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