December 6, 2003    Copyright © 2003, Greenwich Financial Management Inc.

Demystifying Insurance, Part 5:

Whole Life

            With term life, the premiums you pay increase exponentially as you get older, until such point, normally around seventy five years old, when the insurance company will no longer offer you the option to renew.  Because of these characteristics, term life should be viewed as a temporary solution to the financial problems presented by the risk of death, and one with an ever-increasing cost.

            With permanent insurance, your premiums do not increase as a function of age, and you normally would intend to keep the policy in force for your entire life. There are two kinds of permanent insurance: whole life and universal life.  We will discuss whole life in this column and universal life in the next.

            The key idea with whole life is level premiums (even though whole life policies can also be designed otherwise).  When you enter into a whole life contract, in effect you are agreeing to two different things.  First, you are agreeing to pay for term life coverage at stipulated rates starting at the face amount (say, $100,000) and decreasing each year until reaching zero in the future (often at the age of 100).   Second, you are agreeing to pay an extra premium that will be put into a pool of investments (together with the premiums of other policyholders) bearing a minimum guaranteed rate of return (generally, a relatively low rate such as 3-4% currently).  At the minimum rate of return, this investment aspect of your policy, the so-called "cash value," will come to equal the original face amount of the policy in the future (at that same future date, say when the insured reaches 100).   So the decreasing amount of term insurance and the increasing amount of cash value complement each other, with the total staying the same in the base case (in our example, a total of $100,000).  Because of the power of compounding interest, whole life premiums are much lower if you start when you are young.

            If the investments made by the insurance company fall below the minimum guaranteed rate, it doesn't impair your policy's face amount of coverage, as long as your insurance company stays solvent (as discussed in our previous column on credit quality).  If the investments are more successful than the guaranteed rate of return, your cash value will outperform the base case.  If the insurer is organized as a mutual life company, "dividends" may be declared and paid to the policyholders.  Dividends normally represent a return of previous premiums and are not taxed.  These dividends may be used in three different ways: as a cash payment back to the policyholder; to reduce or eliminate ongoing premiums; or to purchase "paid-up additions" of additional death benefit.

In whole life policies, sales and administrative charges are normally front-loaded in the first two years.  Also, in later years, the surrender of a life insurance policy could lead to taxation if the cash value has grown beyond total premiums paid. Therefore, it makes more sense to take out term life rather than permanent life if there is any question in your mind that you might discontinue the policy in the future. 

            With whole life, unlike universal life, the insurance company bears all the risk that mortality or administrative costs may rise.  The premiums paid for any given amount of life insurance will correspondingly be higher than with universal life, with the excess possibly returned in the future by way of the dividends.

            With any permanent life contract, there is generally a provision where the policyholder may borrow from the cash value.   Such borrowings reduce the amount of death benefit pro rata until repaid.  Borrowing from the cash value of your life insurance policy will generally be the cheapest source of funds available, as the nominal interest you pay is usually fully credited back to your cash value (or sometimes with the subtraction of a small spread such as ½%).  Because of this free or almost free borrowing feature offered under most policies, the cash value of your life insurance policy can be part of an emergency safety net. When you take out a permanent life insurance policy, make sure you understand the loan features!

Andy Szabo, CFA, is Managing Director of Greenwich Financial Management Inc., a Registered Investment Advisor, which advises individuals and companies on investments, insurance and employee benefits.  Questions or comments welcome by phone (203-531-2877) or e-mail: Szabo@GreenwichFinancial.com.