Whole life insurance is the most common form of cash value insurance policy. It bundles death protection with cash value accumulation. Whole life policies offer coverage for the entire life of the insured. Essentially, whole life policies are a form of endowment policy because if the insured lives to age 100 and has paid all required premiums they are paid the face value of the policy.
From the perspective of the policyholder, whole life policies are essentially risk free because everything is guaranteed when the contract is signed. The insurance company bears all risk. It is important to remember that insolvency risk always exists. Check out the Participating vs. Non-Participating article for information on par whole life policies and risk bearing.
Whole life policies accumulate a cash value because premiums include more than the actual cost of coverage and expenses. This excess forms the cash value of the policy and is used to pay future costs, thus reducing future premiums relative to actual cost. Due to the necessary expense loading, cash values typically accumulate more slowly in the early years of the policy.
Policyholders of whole life policies have no say in how the funds are invested. This cash savings is then invested by the insurance company and is guaranteed a fixed rate of return. Insurance companies typically invest these funds in mortgages, long-term bonds and other low risk investments. Though the rate of return is moderately low, the rate of risk is low as well. Due to the low rate of return it is important that the policyholder ensures their return is at least high enough to keep pace with inflation. An alternative that allows policyholders investment control is to take out a policy loan against the cash value of the policy and invest the proceeds. This method is not recommended.
This cash value accumulation feature may act as forced savings for certain individuals who want help saving money. Be aware that unless you derive sufficient benefit from the forced savings feature, there are much more efficient ways to invest and save. The primary purpose of while life insurance is the death benefit.
Policyholders are entitled to the cash value in the amount of the surrender value if they decide to surrender the policy. The surrender value is typically the cash value minus surrender charges and fees. Beneficiaries are only entitled to the face value of the policy when the insured dies.
Because whole life policies bundle death protection with cash value, no explicit distinction is made between the two. Though not obvious, the face value consists of the total cash value of the policy plus death protection. Death protection is equal to the difference between the death benefit and the cash value. The result is that at any given time, the cash value plus death protection equals the full face value agreed upon when the policy is signed. As time passes and more premiums are paid, the cash value of the policy increases and the amount of death protection decreases though the face value remains the same. The result is that at age 100 (assuming the insured lives to this age) the cash value of the policy will be equal to the full face value of the policy. Remember that with whole life policies, at age 100 the policyholder is paid this full face value.
Whole life policies offer three main ways of making premium payments: continuous, limited or single. Continuous payments are standard, generally level and extend from inception of the policy through age 100 (or until the policy holder dies). Limited-payment whole life policies have premiums that cease at a predetermined date, i.e. 20 or 30 years after inception of the policy. Single Premium Whole Life consists of just one lump sum premium payment at the beginning of the policy.
Most whole life policies are participating (par) policies. With par policies, insurance companies will charge higher than necessary premiums with the intent of returning the excess. This return of excess premiums through dividends are not taxable to the policyholder. There are different ways in which these dividends can be utilized. Two of the most common ways are to apply them towards the cost of the future premiums (lowering or even eliminating premium payments), or to use them to increase the face value of the policy (paid-up additions). To learn more about participating policies, check out the article Participating vs. Non-Participating article.
To reiterate an important point, whole life policies guarantee benefits at the inception of the policy so that the insurance company, not the policyholder, bears the risk. This is in contrast to universal life and variable life policies in which the policyholder bears the risk.
