What it means
Life insurance comes in two broad forms. Term insurance covers a fixed period such as twenty years and pays nothing if you outlive it, while whole life lasts for life and is certain to pay out eventually.
That certainty is part of why whole life premiums are much higher than term premiums for the same sum insured. The word traditional distinguishes this product from flexible versions such as universal life.
In a traditional policy the premium is level, the death benefit is fixed and the insurer guarantees a minimum cash value schedule. The policyholder does not choose how the money is invested, since the insurer holds the assets within its general portfolio.
Part of each premium pays for the cost of insurance and the insurer's expenses, and the rest builds cash value. That cash value grows at a guaranteed rate and, in a participating policy, may be boosted by dividends, which are a share of the insurer's surplus.
Dividends are not guaranteed and depend on the insurer's experience. Policyholders can borrow against the cash value, usually at a stated interest rate, and unpaid loans reduce the death benefit.
They can also surrender the policy for its cash value, although surrender in the early years often returns less than the premiums paid. Tax treatment of growth, loans and payouts varies by country, so professional advice is needed.
For business owners, whole life is used in estate planning, in funding buy-sell agreements between partners and in key-person cover, where a company insures an individual whose loss would hurt the business. The cash value can also be shown as an asset on the company's balance sheet in some cases, subject to accounting rules.
The main criticism is cost and inflexibility. Returns on the cash value are often modest compared with other investments, and the long-term commitment is heavy, so many advisers suggest comparing it with buying term cover and investing the difference.
In practice
Real-world examples.
Example
A 35-year-old owner of a small design studio buys a whole life policy with a $500,000 death benefit to protect her family. She pays the same premium every year and sees the cash value grow. If she needs a bridging loan later, she can borrow against it.
Example
Two business partners in a logistics company each take out a whole life policy on the other. The proceeds would let the surviving partner buy out the deceased partner's share from the family. The policies sit alongside a written buy-sell agreement.
Example
A retired engineer uses a whole life policy as part of his estate plan. He names his grandchildren as beneficiaries so they receive a known sum when he dies. He also checks annually whether the dividends are meeting the insurer's projections.
Formula
Calculation
Cost of cover to date = total premiums paid - cash surrender value
Suppose a policyholder pays a level premium of $3,600 a year for 10 years, so total premiums paid are 3,600 x 10 = $36,000. The policy's cash surrender value at the end of year 10 is $28,000 (an illustrative figure from the insurer's schedule). Cost of cover to date = 36,000 - 28,000 = $8,000, or 8,000 / 10 = $800 per year for a death benefit that has been in force throughout.Case study
Seen in the real world.
Cobblestone Print Works is a fictional family company used for this illustrative case. Its two owners wanted to make sure the business could continue if either died, so they each bought a $400,000 traditional whole life policy on the other. Premiums were paid personally and the policies were assigned to a trust.
Twelve years later, one owner died unexpectedly. In this illustrative story, the death benefit gave the surviving owner the cash to buy the deceased owner's shares at a pre-agreed price, and the family received fair value without the business having to borrow. The lesson is that the guaranteed payout made the plan dependable even though the premiums were high.
Watch out
Common mistakes.
- Treating the policy as a pure investment. Part of each premium covers insurance and costs, so early cash values are lower than premiums paid.
- Assuming dividends are guaranteed. Only the contractual amounts are guaranteed, and projections of dividends can fall short.
- Surrendering early without checking the cost. Early surrender often returns less than the premiums paid, and there may be tax on gains.
Questions
People also ask.
What is the difference between whole life and term life?
Term covers a set period at a lower cost and pays only if you die in that period, while whole life lasts for life and builds cash value.
Can I borrow against a whole life policy?
Yes, usually up to a percentage of the cash value, but unpaid loans and interest reduce the death benefit.
What happens if I stop paying premiums?
Depending on the contract, the policy may lapse, convert to a smaller paid-up policy or use cash value to keep itself going for a time.
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