Permanent life insurance in theory is incredibly simple, but industry developments have made this product incredibly flexible. We’ll start with the simple concepts and work our way to the more flexible options.
This is an older staple that has been around forever. The basic concept behind whole life insurance is that the policy is part life insurance, part savings account. The payment structure tends to be fixed and the coverage amount tends to be level (meaning it doesn’t change over time). I’ll explain how this can change in a bit.
The elements are simple. Part of your payment goes to pay for the insurance, part of your payment is saved in the policy where it grows based on the interest paid by the insurance company. The insurance company makes their money by investing your cash value while it is building. The policy grows until you are 121 years old where the insurance company most often simply issues you the payment if you outlive the coverage. Most people don’t expect to live to age 121 which is what makes this a permanent policy. Even if you do outlive the coverage, you still have the cash value.
Have Your Money Work For You
I rarely recommend that people take out whole life policies and simply pay them off over the course of 100-121 years. The only time this really makes sense is for seniors looking for simplified issued whole life policies (this can be more cost effective than term coverage if you have minor to moderate health concerns). The reason is because the coverage tends to be more cost effective if you pay the policy off early (most often in payment for 20 years or a custom payment schedule). The quicker you pay off the policy, the more time the money has to earn interest (instead of paying that premium yourself).
Dividends Are a Policy’s Best Friend
There are two different types of life insurance companies. Stock based and non-stock companies. Stock insurance companies have external shareholders that receive dividend payments. Non-stock companies pay their dividends out to certain policy holders (depending on the type of policy. Whole life policy holders get dividends, term policy holders do not). You can elect for dividends to buy additional coverage and increase the cash value of your life insurance policy causing it to grow over time.
This is another reason paying off the policy early makes sense. Increased cash value means increased dividends and quicker growth. Find a policy with dividends and pay it off quick!
Cash value is a hallmark of whole life. The value is decreasing the amount needed for insurance. Imagine you pass away with a $500,000 coverage amount and $100,000 in cash value. Your beneficiary (the person the insurance company pays when you pass) gets the $100,000 in cash value and the insurance company makes up the $400,000 required to pay your full $500,000 in coverage.
The cash value in your life insurance is valuable. You can borrow against it. The loan is guaranteed to be issued and is secured by the cash value in the life insurance policy. If you pass away while the loan is issued the due amount (including interest) is paid to the lender (often the insurance company) and not your beneficiary.
Many times people will use cash value loans as a safe guard outliving their retirement money. There’s no requirement to repay the loan as long as the loan amount and interest is less than the cash value.
Universal life is whole life’s younger sexier, more flexible, little brother. The hallmark of universal life is the ability to adjust the policy over time. Companies have used these policies to create flexible term policies and artificial long-term policies (until age 85 through 121). These policies are not designed to build cash value. Learn more by checking out our article on Guaranteed Universal Life.
Indexed Universal Life
Universal life policies just like whole life pay a guaranteed amount of interest. Indexed universal life policies use this guaranteed interest to buy options on an index (there are many available, but most often it’s the S&P 500). If the market looses money, the option is not exercised. If the market makes money, the option is exercised and you get the ride the upside. These policies were designed so that stock companies could compete with the dividend offered by non-stock companies.
Permanent policies are not always the best bet for everyone. The best thing to do is to tell your life insurance advisor what you’re trying to accomplish with your policy and allow them to show you the available options. Understanding a bit more about how these policies work before you go into the meeting can help you better understand the options available.