As any regular reader knows, this blog exists primarily to answer common questions about using whole life insurance as a platform for your wealth. This time, I want to tackle the big one: “How does a whole life policy work?”
First, we’ll address the basic components. Once we have established a firm foundation, we can move onto the various optional features that may be added to enhance a whole life policy’s suitability for being a “bank.”
How Does a Whole Life Policy Work? – Basics
It’s important to note before getting too far that there are different types of life insurance companies, and different specific whole life products within the same company.
In answering the question, “how does a whole life policy work,” I will not be able to completely address every variable. If you are looking for a whole life insurance policy—especially one built as a financial platform for your family, business, or non-profit organization—it will benefit you enormously to discuss it with a knowledgeable professional.
For this article, I will focus on dividend-paying whole life insurance policies from mutual insurance companies, that offer non-direct recognition. If that doesn’t make sense, the subsequent paragraphs should help!
Life insurance is paying money to a life insurance company in exchange for a lump sum payout in the event of a death. The amount of this payout is the death benefit.
In term life insurance, the product that most people think of when discussing life insurance, this promise to pay a death benefit is for a specific term of time: 1 year, 10 years, 20 years, 30 years, etc. Different companies offer different options, but 30 years is generally the maximum term. If the insured person is still alive at the end of the term, no payout is made.
If the insured person still wants to be covered by life insurance, they must generally apply for coverage again. That means a higher premium payment—they are older, after all. It also means that they may not be insurable at all. They may be declined coverage if their health has changed significantly due to weight, blood pressure, diabetes, cholesterol, serious illness, etc.
By contrast, in whole life insurance, the company is agreeing to give you coverage for your ”whole life.” That means that you are still insured—as long as premiums are paid—even if you survive well beyond 100 years old. The amount of premium payments is locked in from the start, and can never be increased by the life insurance company.
The death benefit in a term life policy may be stable, or it may decrease, depending on the exact product. The death benefit in a whole life policy may be stable, or it may increase, depending on the product and how it is designed by the agent.
Cash Surrender Value
Because whole life death benefits must be paid at some point in the future, this death benefit carries a present value, called the cash surrender value or sometimes simply cash value.
A metaphor may be helpful. Imagine you meet someone with a sealed box containing $100,000. It’s locked, but it has a timer indicating it will open in 5 years. Assume that you are absolutely certain that the money is real, and that the box will open when the timer reaches 0. What would you be willing to pay now for the guarantee of $100,000 in 5 years?
Pick a price.
Now, imagine that the timer is only set for 1 year in the future. Obviously, a payment of $100,000 in 1 year has more present value than the same $100,000 in 5 years. (For more about the time value of money, see here.)
Returning to a whole life policy, you may choose to surrender your policy at any time. If you do this, the life insurance company is no longer obligated to pay the death benefit when the insured person dies. The company will pay you the present value of the death benefit. Every year that the policy remains in force, the cash value gets closer and closer to the death benefit.
In other words, surrendering the policy in year 5 means a much smaller payout than surrendering in year 30! (The insured person is 25 years older!) The cash surrender value will equal the death benefit at the end of the life insurance contract, which is a specific age of the insured person, such as 100 or 121.
In addition, the cash value is accessible without surrendering the policy using policy loans.
If you own a participating whole life policy from a mutual insurance company, you are also a part-owner of the company. As an owner, you get to participate in the profits of the company. This takes the form of a dividend.
Note that dividends are not guaranteed.
Dividends can be used in different ways, and the policy owner may change between these options at any time.
For example, dividends may be taken as cash. The insurance company sends a check or direct deposits the funds to the policy owner.
Another option is that the dividends may be used to pay the premium for the whole life policy itself. Depending on the length of time the policy has been in force and how it has been designed, this may pay a small portion of the premium or completely pay it with dividends leftover.
Yet another option, and the one that lends itself the most to building a financial platform for all of your affairs, is to purchase Paid Up Additions, or PUAs. With a non-direct recognition company, the same dividend is earned even if there are policy loans outstanding. More on that soon.
Paid Up Additions
PUAs are additional “mini-policies” that may be added to an eligible whole life policy. These mini-policies are purchased with only one premium payment. That’s what the term “paid up” means—there is no ongoing obligation to pay.
Remember that cash value and dividends are primarily influenced by time and total death benefit. PUAs mean more death benefit, which means more cash value and more potential to earn dividends.
“How does a whole life policy work?” Well, as you can see, it’s a little more complicated than a term policy! I’m willing to bet no one ever explained most of this to you. I didn’t know it either, until my life was changed forever by reading Nelson Nash’s book, Becoming Your Own Banker. (To find more recommended reading on whole life insurance and related topics, start here.)
Now that you have the basics, let’s focus on a few optional contract features that allow us to further enhance the growth of the cash value. These contract features are called riders.
How Does a Whole Life Policy Work? – Advanced
Once you see the potential for compounding growth inside a whole life policy, your next question might be, “How far can I take this? Surely there are limits.”
It’s true. Section 7702 of the IRS code, as well as the policies of each specific life insurance company, will govern how far this can be taken without incurring tax penalties.
Without going into detail on the rules here, to get as close to those limits as possible, you will need the aid of two riders.
Term Insurance Rider
The first thing that we looked at in this article is death benefit. Whole life is much more expensive than term life, because the death benefit must be paid so long as the policy is in force. Term life policies are far less likely to pay out, so they are also typically far less expensive.
A term insurance rider allows you to get term insurance inside your whole life contract.
For example, you could buy a whole life policy with a death benefit of $50,000, with a $250,000 20-year term insurance rider. Dividends may be earned on the larger initial death benefit of $300,000. PUAs can grow the permanent death benefit over those 20 years but the term insurance rider will expire after 20 years, so there will be a decrease in total death benefit at that time.
This allows you to earn more in dividends while paying less in required premium. It also gives you more “room” to add PUAs without losing the tax-free status of your policy.
Paid Up Additions Rider
Most people think of life insurance as a “necessary evil.” They want to pay as little premium as possible.
My clients—especially ones that have had their policies for a while—pay as much as they can in premium.
Recall that dividends may be used to buy PUAs. You may also buy PUAs outright using a PUA Rider. When you do this, almost all (about 95%, typically) of the funds go straight to the cash value!
For more detail on replacing banks with your own whole life “bank,” read here.
Whole Life Growth
One more time: How does a whole life policy work? It gets better every single year. Understanding the power of the tool, and planning with that in mind, makes this all the more true. Let’s bring all the pieces together:
- The whole life death benefit has a cash value, guaranteed to increase every year.
- The whole life death benefit can also earn dividends, which can increase the cash value by buying PUAs.
- The term life rider death benefit can earn dividends, which can increase the cash value by buying PUAs.
- You can directly buy PUAs using the PUA rider.
- All of the PUAs, from all sources, can also earn dividends to buy more PUAs.
- The cash value can only increase. Never decrease.
When you are ready to see how this can transform your family and business finances, schedule a time to talk with me.