Whole Life Insurance: (Almost) Everything You Need To Know

Here is an example of the relationship between the cash value, the pure life insurance, and the death benefit inside a whole life policy starting with $0 cash value and $100,000 pure life insurance.

As the cash value grows, the pure life insurance amount decreases by an equal amount.

Here is how the relationship between the cash value, the pure life insurance, and the death benefit changes over time as the cash value of the policy increases.

When the policy matures or endows, here is how that relationship looks.

In the above example, the policy's death benefit is always worth $100,000, regardless of when you die. What changes is the ratio of cash value to pure insurance. Specifically, as cash value increases, the insurance inside the policy decreases to zero. This feature of whole life insurance means that you can make a long-term savings plan, and be assured that you reach your future savings goals, regardless of whether you live or die. 

In addition to the basic guaranteed cash value and pure insurance benefit, some policies can be enhanced (sometimes significantly) with annual dividend payments from the issuing life insurance company, special policy riders (i.e. modifications to the base policy), or both. More on that, later.

This is very different from term life insurance, which has no cash value, and universal life insurance which has a cash value account associated with the policy, but with no built-in contractual guarantee against loss.

Why Does Whole Life Insurance Matter?

The tl;dr version:

• A whole life policy is a safe, convenient, and predictable way to build a long-term savings while also protecting against the financial risk of death. 
• Whole life insurance is not an investment. If all required premiums are paid, its cash value and death benefit are guaranteed to grow every year, will never decrease in value, and the policy has certain tax advantages. Instead of risking your money, a whole life policy protects you from financial risk, and provides both immediate and long-term financial protection for you and your family.
• Whole life insurance gives you more certainty about your future. You can match known (or expected) future expenses to your whole life's guaranteed cash value, death benefit, or both.
• Most whole life insurance has guaranteed level premiums and provides both guaranteed and non-guaranteed growth of cash value, so you can better plan for your future.
• Whole life insurance helps you build personal credit, which you own and control. The credit is accessed through the policy loan function, and can be used as unique financing tool for personal or business purposes, allowing you to augment the inherent benefits in the policy, further growing your guaranteed cash values.
• Whole life insurance provides an insurance death benefit that is generally income tax-free, so you can pass on any unused savings to your beneficiaries when you die. This death benefit can be used by your family to pay bills and other expenses or it may be given to a charity or non-profit you believe in, allowing you to leave a legacy you can be proud of.

Common Types Of Whole Life Insurance

Life insurers offer a few different whole life options today. Here are just a few of the most common types.

Participating Whole Life Insurance (Dividend-Paying Whole Life)

This is, by far, the most common type of whole life sold today and the one covered most extensively in this guide.

Most insurance companies that sell whole life, sell this iteration and… for good reason. It's very competitive, offers some unique features not found elsewhere and… it's 30% more awesome than other types of whole life. Dividend-paying whole life pays dividends to policyholders (based on company profitability and performance) which can be used in a variety of ways… one of which is to add substantial growth to the guaranteed cash value.

While some erroneously claim that dividends are merely a return of overpaid premium, this view is a gross oversimplification of what's going on with the dividend payment. Dividends generally represent a share of company performance in 3 key areas:

1) Mortality savings. The insurance company returns excess premium as dividend when mortality claims (death benefit payouts) are less than initially projected. The insurer tends to calculate mortality expenses conservatively since it cannot raise premiums later if mortality turns out to be worse than expected due to the fact that base premiums for whole life are guaranteed level and cannot be increased. 

2) Operational savings. When the company spends less than expected on company operations (i.e. expenses needed to run the business), it returns the excess to policyholders via the dividend. Like mortality expenses, insurers tend to calculate these expenses conservatively to ensure there's always enough money to run the business.

3) Investment gains. When the insurer earns more on its investments than the guaranteed rate of the policy, it pays the excess to policyholders in the form of a dividend, less an amount held back in reserve for surplus capital. For example, if an insurer sells a whole life policy with a 4% guaranteed rate, and it earns 5% from its investments, it pays out the excess (less an amount held back for surplus capital and reserves) to the policyholder.

Graded-Benefit Whole Life Insurance

Graded-benefit whole life allows you to get life insurance if you have a medical condition that would otherwise prevent you from buying life insurance. Basically, the insurer will allow you to buy the face amount (the total death benefit) over time.

In the first year of the policy, benefits are "graded," meaning you don't have the full benefit yet. If you die before full benefit maturity, your heirs only get the graded benefit that's earned thus far. So, on a $150,000 policy, if your benefits start out at $50,000, your heirs would only get $50,000 if you died. It's not great, but it's better than nothing. Over time, the death benefit increases so that by the 3rd, 4th or possibly 7th year, you have the full death benefit.

Graded Premium Whole Life Insurance

Graded premium whole life lets you buy the insurance and rig the premium payments so that they're cheaper in the early years of the policy. So, for example, you might only pay half of what you normally would pay for the first 10 years of the policy contract. After that, your payments gradually increase to the full payment. Actuarially (mathematically), your total premium outlay will be the same as any other straight whole life plan so you're not getting shortchanged in any way. It's just a flexible way to pay for the policy.

Indeterminate-Premium Whole Life Insurance

Let's say you want really cheap whole life and you think there's a company out there that can afford to charge you less than everyone else. Indeterminate whole life might be your savior. It's a policy where the premiums are based entirely on the insurance company's expenses, mortality experience, and other costs.

So, if your insurer runs a tight ship, you could see your premiums drop substantially over time. The contract specifies a maximum premium that you only pay under a worst-case scenario. Otherwise, you pay a premium that's less than the guaranteed maximum with the potential for it to go down from there. Sometimes, it won't budge though - especially if the insurer is having a hard time controlling internal costs. Sometimes, it will increase. But, it will never go higher than the guaranteed max premium stipulated in the contract.

Limited-Payment Whole Life Insurance

The insurance company figures out what it would cost to provide you with coverage for your whole life and then schedules premium payments for a set number of years. For example, a 10-pay whole life has you paying premiums for 10 years. After that, the policy is paid-in-full, and no further premiums can be made and… you get to keep your insurance policy forever. A 20-pay whole life requires you to pay premiums for 20 years. Life paid up at 65 requires that you only make payments to your age 65, and life paid up at 85 requires you to pay until your age 85. Life paid up at 95 requires you pay premiums until age 95.

Minimum-Deposit Whole Life Insurance

This policy is for you if you don't have a lot of money to spend on premiums. Basically, as soon as you make the first premium, cash value starts building in the policy. Then, that cash value is used to pay for future policy premiums. This keeps the death benefit level, but it also reduces your total out of pocket costs. I don't actually see this one very often, but I think it's a cool concept for young people just starting out who only want death benefit and don't care about cash value growth.

Single-Premium Whole Life Insurance

This is the outlier of the bunch. Unlike other whole life policies, this one only requires one premium payment. In that sense, it's sort of like a limited-pay whole life policy but actually it's more like paid-up additional insurance on a dividend-paying whole life policy. The insurance company calculates the premium payment, called a "net single premium", required to maintain insurance coverage for the rest of your life. It's just one premium payment and you're done.

The downside is that the IRS reclassifies this type of policy as a "modified endowment contract" or MEC. Because of that, you lose the most important aspects of the tax benefits associated with the cash value (which is only important if you plan on withdrawing the cash value for any reason during your lifetime).

Money will accumulate tax-deferred, but you cannot withdraw or borrow from the policy prior to age 59 1/2 without paying a penalty. Also, all cash value withdrawals are subject to ordinary income tax.

Major suckfest right there if you're looking for supplemental retirement income, but… this type of policy can be used very effectively in estate planning cases or if you want to make a charitable donation after your death.

Two Ways To Design A Whole Life Policy

There are two basic ways a whole life policy can be designed: high initial death benefit focus or... high initial cash value focus.

Whole Life Insurance With A Death Benefit Focus

A basic use of whole life insurance is to use its guaranteed death benefit to pay for final expenses or to offset a future estate tax liability.

Final expense insurance is a huge market and accounts for many of the whole life sales in the U.S.

But since most types of whole life insurance sold today are dividend paying (participating) whole life insurance, you can also use it to buy a future death benefit discounted to today's dollars instead of having to pay for more death benefit than you want or need right now. This makes it a great option for estate planning.

For example, let's assume at age 50, you discover you'll probably want or need $250,000 of death benefit by age 90 because you believe you have a high probability of living to at least this age based on your family history and your own current lifestyle and habits (i.e. you're currently very healthy and all your relatives lived beyond age 90). You assume you'll need this money to cover some future estate taxes.

So, what you do to solve this problem is buy $250,000 of future death benefit, discounted to today's dollars. That might mean buying just $117,000 of death benefit and letting the future projected (non-guaranteed) dividends grow the death benefit to the $250,000 you'll need in the future. That lower initial death benefit amount means you only pay premiums of $2,572 per year. Those premiums are guaranteed to never increase. The benefit here is you're only paying for $117,000 of death benefit but actually getting $250,000 by age 90.

Why not just use existing savings or investments? Because... If your estate tax bill at death is $250,000, you must use $250,000 from your investments to pay for future estate taxes. In essence, the estate taxes are paid at a ratio of $1:$1.

However, by using whole life insurance, you only pay ~$102,000 in premiums but receive the benefit of $250,000 - less than half the cost of paying for the taxes out of your investment earnings… meaning more of your money passes along to your heirs.

This basic illustration shows how a simple dividend-paying whole life policy can be a powerful tool for estate planning.

If you live beyond age 90, the whole life insurance death benefit keeps growing.

Of course, the risk with the whole life policy in this scenario is that the dividends are less than projected and you may end up with a lower death benefit than you wanted at age 90. However, if dividends at least match the current dividend scale, you'll always be assured enough death benefit for your needs, regardless of how long you live. In some cases, additional premium can be added to make up for lower-than-expected dividends. If you decide later you no longer want your whole life policy, you can surrender it for its cash value. After age 77, in this illustration, you get back all the premiums you paid into the policy, making your net cost $0.

Whole Life Insurance With A Cash Value Focus

A cash value focused or accumulation focused whole life policy emphasizes cash value growth over death benefit growth in the early years of the policy. 

These policies are often used as a supplement to retirement income, but can also be used in more advanced financial strategies like Infinite Banking and other similar strategies. The high cash value growth inside these policies might also be useful as a hedge against other volatile assets or investments. 

Using whole life insurance in this way allows you to grow a personal savings you can use throughout your entire life (not just during retirement) as well as a substantial death benefit for end-of-life needs. In some cases, the death benefit of a cash value driven policy can be substantially higher in the later years of the policy than the death benefit in a death benefit focused policy.

Here is an example of how a cash value focused policy might look.

Regardless of whether your policy is death benefit focused or cash value focused, all whole life policies require a consistent flow of premium payments to function correctly.

Whole Life Insurance Premium Payment Options

Premiums are calculated and billed annually. However, these annual premium payments can be broken up into semi-annual, quarterly, or monthly payments for a fee, calculated as an annual percentage rate (APR). Annual means you make one premium payment per year. Semi-annual means you make 2 premium payments per year. Quarterly means you make 4 premium payments per year (one payment every 4 months). Monthly means you make 12 premium payments per year (one payment per month).

Here's an example of how different payment modes might look for a whole life policy.

The premiums collected by the insurance company are then invested on your behalf to help pay for the future death benefit of the policy, to generate cash value, to grow capital reserves and surplus to protect all policyholders, and to generate excess profits for the insurer. If the policy is a participating (dividend-paying) whole life policy, those excess profits are returned to the policyholders through an annual dividend payment.

Payment Options 

In addition to different payment modes, you can alter the regularity and consistency of your premium payments, as well as the length of time you pay premiums, in one of several ways.

Scheduled Premiums

Scheduled premiums are the most common way policyholders pay their premiums. The insurance company sets an annual, semi-annual, quarterly, or monthly premium schedule for you. Then, you pay premiums according to that schedule. For monthly premiums, most insurance companies require you set up an automatic monthly draft from your checking account to pay premiums. Typically, for whole life, premiums are payable to your age 100.

Unscheduled Premiums

Unscheduled premiums usually refers to paid-up additional insurance (PUA) premiums. Paid-up additional insurance is optional insurance you can buy in addition to your normal (called "base") whole life insurance, up to a maximum annual threshold (maximum annual payment limit).

Why would you ever want to do this?

Because it increases your death benefit, cash value, and future potential dividend payments.

For example, let's assume you make base whole life premiums of $1,000/yr and your paid-up additions maximum annual payment limit is $5,000/yr. This limit indicates that you can make excess premium payments in the amount of $5,000 per year without any medical underwriting or any other permission from the insurer.

This is super-nice if you ever become ill or can't qualify for insurance or… you just want to increase your policy's cash value and death benefit. You simply send in a check to the insurer and they must let you purchase more insurance—no questions asked. Even with unscheduled premiums, however, some life insurers restrict your unscheduled payments to certain times of the year while other insurers allow you to send in the unscheduled payment whenever you want.

Either way, you aren't required to make these premium payments or… you may be required to only make a minimum payment to keep the door open for future unscheduled paid-up additional insurance premiums (depending on the insurance company and the policy contract).

The annual payment limit is… annual. Meaning it resets every year so if you buy the maximum paid up additions this year, you can turn around and do the same thing next year and the year after that and so on. Some life insurance companies "roll over" unused annual payment limits to the following year, while others do not.

These unscheduled and optional paid-up additional insurance premiums are the best way to increase your policy's cash value over and above the guaranteed growth rate.

Unscheduled premiums might also be possible if your policy has a convertible term rider attached to the base policy, or if your policy has a combination term insurance/PUA rider.

Temporarily Stop Premiums

Dividends in a dividend-paying whole life policy (most whole life policies sold today are dividend-paying whole life) may be used to pay some or all of the premiums. Dividend payments are not guaranteed in any given year, so temporarily reducing premiums this way is a temporary and non-guaranteed way to reduce or stop premium payments.

Some insurance companies allow you to offset premium payments by surrendering ("cashing in") accumulated paid-up additional insurance and dividends to pay base whole life premiums, which is a more stable way to temporary reduce or eliminate premium payments.

Permanently Stop Premiums On A Guaranteed Basis

Almost every whole life policy has a "reduced paid-up" (RPU) option that lets you permanently stop paying premiums. The insurance company calculates how much insurance it can afford to give you based on your current cash value and what it is guaranteed to pay you through the guaranteed cash value growth function. As a result, RPU reduces your death benefit and guarantees no more premiums are due ever again. You also do not have the option of restarting premiums later.

In other words… you're done paying premiums. Your policy is paid-in-full.

This also tends to have the effect of slightly improving the rate of return on your cash value, though net cash value growth slows down because you're no longer adding premiums.

Modified Endowment Contract (MEC) Limits

A Modified Endowment Contract (MEC) is a special reclassification of a life insurance policy caused by a violation of certain IRS premium funding rules. A MEC usually happens when an overzealous agent designs a policy with an overly aggressive premium funding schedule, or a policyholder funds a life insurance policy too heavily with unscheduled premiums. But a MEC can also potentially happen when policyholders are too aggressive with policy loans or partial surrenders, particularly in the early years of the policy. 

The IRS is very clear on how life insurance policies can become modified endowment contracts. First, the policy issue date is checked to be on or after June 20, 1988. Second, the policy must meet the statutory definition of a life insurance policy under section 7702 of the Internal Revenue Code. Third, the life insurance policy must fail the Technical Miscellaneous Revenue Act (TAMRA) 7-pay test.

Whole life policies issued and kept in force prior to June 20, 1988 are immune from MEC testing and will never be taxed as modified endowment contracts. However, any lapse and subsequent renewal becomes a new policy and is then subject to the 7-pay test.

The 7-pay test determines whether total premiums paid on a whole life policy within the first 7 years of the policy are more than what was required to keep the policy in-force. In other words, the MEC limit is equal to the annual premium that would pay the policy in full after the payment of seven level annual premiums.

One more thing: the MEC testing resets if any material changes are made to the policy (this includes a material change to a previously "grandfathered", MEC-immune, policy). An example of a material change would be increasing or decreasing the face amount of insurance through withdrawals or surrenders or underwriting to expand the existing policy to include additional insurance. This can be especially awful for older policies which were previously immune to MEC testing and which would be classified as MECs under current tax law.

For example, let's say you own a whole life policy worth $100,000. The MEC limit for that policy was calculated to be $2,000 per year for the first 7 years. That means you can pay up to $2,000 in premium every year without the policy becoming a modified endowment contract.

If, however, you pay $3,000 in year 3, you cannot fix the error by paying $1,000 in year 4. The excess premium causes the total cumulative premium payments ($7,000) to exceed the cumulative MEC premium limit of $6,000 by year 3.

If that sounds a little confusing, don't sweat it. It's pretty simple, since the calculations are done for you by the insurance company before your policy is even issued and… MEC testing and status is carefully monitored every year by the insurance company.

Life insurance companies understand that most clients want to avoid their whole life policy becoming a MEC and will warn you when your premiums are about to exceed the limits. They will also advise you to redirect premium and may have policies and procedures in place to automatically put any excess premium into a premium holding account until or unless you approve the MEC status for your policy in writing or via verbal confirmation over the phone.

So, to recap, most clients, most of the time, are better off avoiding Modified Endowment Contract (MEC) limits because it will make it much harder to effectively use the policy's cash value while they're alive.

Interest Paid To Whole Life Cash Values

As mentioned earlier, whole life insurance cash values earn guaranteed interest but… insurance companies also have the option to pay additional interest or credit more money to the policy through one of several methods.

Here is how the basic cash value buildup happens in a whole life policy.

A whole life policy starts out as pure life insurance protection, with 100% of the death benefit being comprised of insurance. Each year, the cash value builds up inside the policy, which acts as a reserve against the death benefit. This cash reserve is what will pay for the future death benefit. Because of this fact, the insurance amount (called "net amount at risk") decreases as the cash value of the policy increases.

In addition to the basic, guaranteed, cash value buildup, additional interest can be credited to the policy using one of several methods.

The Participating Rate

Mutual life insurance companies are usually the only companies that offer this type of interest crediting on whole life insurance. This is because a whole life policy sold by a mutual insurance company represents both a life insurance policy and partial ownership of the insurance company. Meaning, owners of dividend-paying whole life insurance are (almost) always part owners of the issuing life insurance company which is why they are entitled to annual dividends.

Insurers that pay dividends on their whole life policies do so based on company performance and then divide payments meritoriously among policyholders according to each policyholder's death benefit, cash value, length of time the policy has been held, and other factors.

Here's a basic overview of how a dividend-paying whole life policy normally works.

As dividends are paid, the policyholder may elect to have these dividends reinvested into the policy. By doing so, the dividend buys paid-up additional life insurance (PUA). The PUA is like a miniature whole life policy stacked on top of the base whole life policy. Each PUA "block" that's purchased has its own death benefit, cash value, and generates its own dividends which, in turn, can be used to buy even more paid-up additional life insurance.

Generally, the more a policyholder pays in premiums, the more they are contributing to the insurer's general investment account and to the dividend pool (called "divisible surplus"). The more a policyholder contributes to the dividend pool, the more dividends they receive when the insurer declares a dividend payment. Dividends can be used in a variety of ways. For example, the policyholder can choose to:

• Buy additional paid-in-full insurance (paid-up additional insurance), which increases the death benefit and, as a consequence, the cash value and future potential dividends, of the policy;
• Receive dividends as cash;
• Invest with the insurer in either a fixed or variable-rate investment account;
• Buy supplemental term insurance;
• Pay premiums due on the policy.
• Pay down policy loan interest, principal, or both.

Since dividend payments are based on company performance, they're not guaranteed in any given year, but… when the insurer does pay them, they become part of the guaranteed cash value and you cannot lose them.

Calculating Dividend Payments On A Whole Life Policy

There are several different methods insurance companies use to determine who gets what:

• The asset share method
• The source of earnings method
• The fund method
• The percentage of premium method
• The experience premium method
• The reversionary bonus method

One of the more popular methods is the classic "three factor method." The three-factor method uses - wait for it - 3 factors (Oh my God, unbelievable!) to determine the dividend you receive from the insurer.

These 3 factors are:

• The investment factor
• The mortality factor
• The expense factor

The Investment Factor is exactly as it sounds. It's earnings from the insurance companies investments (which also include various business activities that are not normally associated with traditional investing). When the insurance company earns more on its investments than it needs to pay the guaranteed rate on the policy, the excess can be paid out to policyholders as a dividend. In practice, the insurer may put the excess into the company's surplus funds and then declare a dividend based on how much money it has in surplus.

The Mortality Factor refers to how many people died during the year. Morbid, I know.

But, here's the good news: If fewer people die than expected, everyone benefits by getting more money back in the dividend. This assessment is made each year, but is also assessed over long periods of time. There have been more than a few instances where insurers have looked back decades and found significant improvements in mortality. And, based on these improvements, the company raised the current dividend payment for whole life policies that were issued decades ago to reflect those improvements. 

In practice, insurance companies tend to calculate mortality conservatively since they cannot raise premiums on whole life policyholders later if their mortality projections turn out to be wrong. 

The Expense Factor refers to operating (and other) expenses. One of the largest expenses for a life insurance company is issuing new life insurance policies. On average, it takes a life insurance company 10-15 years to recoup its costs for issuing a new policy, especially if it's a whole life policy.

... Which is why insurers don't like it when people cancel their policies… it costs everyone money. If expenses come in lower than expected for the year, then this money is added to the dividend.

Of course, these factors can also be adjusted for other variables and may include other costs or credits. It's unusual for an insurance company to tell anyone what the exact formula is for determining dividend payments because that's considered proprietary information and a competitive advantage in the marketplace.

However, insurance companies are very willing to tell you the general formula for determining your cash value increase and dividend payments. This is awesome because it means you can geek out on some of the finer details of your whole life insurance policy, if you want to.

A common formula for calculating the total cash value increase (including dividends) is to apply the dividend interest rate to the previous year's cash value plus current year's net premium after mortality and (other) expense charges.

Here's an example of how this dividend calculation looks.

Dividends are always paid retrospectively (after the fact) so… money used to pay the dividend is usually accumulated in the surplus account until the end of the year when the dividend is declared. Insurers are generally very conservative and use the company's surplus to protect the mutuality (the company and its policyholders) from a variety of economic and business shocks.

Even so, when the board of directors declares a dividend payment, those dividends tend to be very generous relative to the guaranteed interest paid to policy cash values. In dividend-paying whole life, it's assumed that the dividend is what will drive current and future policy performance.

For this to happen, insurers need to protect the long-term viability of dividend payments for its owners (the policyholders), which is why most mutual life insurers have a history of paying dividends for over 100 consecutive years. Some of the older mutuals in the U.S. have paid dividends for over 175 consecutive years.

The Interest Sensitive Rate

Oh great. Whole life insurance with feelings.

No, no. Just another method to credit excess interest to a whole life policy.

Interest sensitive whole life credits interest to cash values, in part, by pegging cash value performance to current market interest rates. As these rates fluctuate, the whole life policy's cash value may be credited with more or less interest.

This method is not nearly as popular as it once was because of the fact that interest rates have fallen for the past 37 years and have remained too low to make this type of policy attractive to buyers. However, as of 2023, new money rates have risen. Even so, most life insurers have been reluctant to reintroduce interest sensitive whole life.

The Variable Interest Rate

Whole life may be credited with interest tied to the performance of the stock market.

The insurer may allow part or all of the premium to be invested directly into the stock market. The direct investment in the market typically allows some of the premium to be invested in the insurer's separate account consisting of mutual funds.

The separate account is different from the insurer's general investment account and is not guaranteed against loss. Because of this, variable interest earnings in whole life can cause whole life cash values to fluctuate both up and down and may put you at risk of losing some or all of your cash value.

The Equity-Indexed Rate

An equity-indexed strategy requires the insurer to take full control over the investment strategy. With most indexed strategies, you are paid based only on the upward movement of a stock market index. All market losses are ignored.

Some insurance companies also offer indices that let you capture gains based on market downturns, incorporate volatility control in an attempt to smooth out crediting rates to cash values, and other more complex crediting strategies which affect cash value growth in different ways.

The insurer is able to do all this by using a very precise mix of bonds and index call options. With an equity-indexing strategy, you are not credited with dividends on the underlying index. Instead, the insurer pays interest based on a proprietary or non-proprietary crediting formula.

If the underlying index options are profitable, they will credit your policy with interest based on their profit, up to a cap (which is specified in the contract). Insurers can also limit interest credited using participation rates, which limit your participation in the underlying stock market index.

If this sounds like a complicated method of crediting interest to your cash values, it's because it is.

Very complex.

So complex that almost no life insurer actually retains the risk themselves. Instead, they buy stock options that make this strategy possible and push the equity risk onto an investment bank.

Since there are only a handful of major investment banks in the world capable of servicing a life insurance company and the massive amounts of premium dollars flowing through their accounts, every insurer is essentially doing business with the same investment banks and counterparties when they do these deals.

To understand how equity indexing works, it's helpful to get a handle on some of the "lingo" used by agents and insurance companies.

The Index

An index represents a number used to measure the general behavior of stock prices by measuring the current price behavior of a representative group of stocks in relation to a base value. The Dow Jones, for example, measures 30 of the largest and most established companies in America; often referred to as "blue chip" companies. It consists of companies like Walt Disney, Wal-Mart, and Microsoft. The S&P 500, on the other hand, measures 500 large cap companies, most of which are American.

To make an equity indexed contract work, there needs to be two components: bonds (or bond-like instruments) and index call options.

A bond is a debt instrument - a loan if you will - made by the Government or a corporation to another party, usually an institution like a bank or a life insurance company. These pay a fixed rate of return. If the bond is going to pay (i.e. if the debtor - the Government or the corporation - does not default on the bond) it will pay the stated interest rate. There is no variance in what it pays.

Next is the call option.

The Call (or Put) Option

An index call option is a stock option. A stock option is the right - but not the obligation - to buy or sell stock for a preset price (which is set when the option is purchased).

There are two types of options: put options and call options.

A put option is the right to sell stock at a preset price, and a call option is the right to buy stock at a preset price. So, for example, if you thought that a company's stock was set to gain value, but you weren't 100% sure that it would, you could buy a call option for much less than buying the actual stock.

Conversely, if you thought a company's stock was set to plummet, then you might buy a put option.

Why buy stock options?

Simple.

With options, you are able to control a large amount of stock with very little money up front. You don't actually own the stock and you don't ever have to buy the stock, which is what gives you protection if the stock doesn't do as well as you expected.

However, there is an expiration date for every option. And, the longer the expiration date, the more expensive the option will cost (i.e. a 3 month call option may cost $500, but a 1 year call option may cost $750).

An index call option is a call option on a stock index - usually the S&P500 stock index. But, it could be on any stock index.

Some insurance companies use call options on the S&P, the Dow, and even international indices. And, sometimes, an insurance company will buy put options if they want to offer policyholders the opportunity to gain from a downward movement in an index.

Insurance companies are able to use a very precise mix of bonds (to guarantee the contract owner's principal plus a small amount of appreciation) and index call (or put) options (to capture the upside potential of the stock market) to produce a new type of contract that gives the contract owner the upside potential of the stock market, without any of the downside risks associated with a direct investment in the stock market.

The insurance company purchases the index call options to ensure that all of the obligations of the index contract can be fulfilled. This is known as "hedging".

When an insurer hedges its risk, they are essentially moving that money out of their own general account and pushing the risk onto another company to fulfill the promises of their contract.

While equity indexed contracts do provide a guaranteed minimum interest rate, the guaranteed rate is usually weaker than in traditional 'declared rate' or dividend-paying contracts, but this is because the focus is on the upside potential of the contract and not the guaranteed rates.

If fixed rates, or the conventional dividend rate, is higher or comparable to indexed returns and you would like to take advantage of the dividend rates inside of an indexed whole life policy, some contracts provide the option to switch to fixed or a dividend rate or… the insurer will allow you to throttle the amount of dividends or paid-up additional insurance that gets allocated to the equity indexing strategy.

Of course, it's not all fun and games. The party ends where the cap and participation rates begin.

Caps And Participation Rates

A cap is exactly what it sounds like. If an insurer sets an annual cap at 12%, it means you can never earn more than 12% per year in that policy. So, if the market delivers 15% returns, and your policy's annual cap is 12%, you earn… 12%.

That's it. Where does the rest go? It goes nowhere.

Insurers buy stock options to match their liabilities. So, an insurer may sell stock options struck at the minimum guaranteed interest rate in the contract and options struck at the maximum (capped) rate in the contract. In essence, the insurer is not looking to profit from the stock options in the same way any other investor might. Instead, they want to get rid of the risk while still satisfying the guarantees and terms of the contract.

Caps are usually designed with a minimum and maximum. Sometimes, there is no maximum and instead there is a spread. With today's whole life indexed options, insurers tend to prefer caps over spreads.

Minimum annual caps (the lowest the insurer can set the cap) is usually between 3% and 5%. So, an insurance company could lower your cap from 12% to 7% or 5% if it wanted or needed to. Insurers can also set monthly caps, which cap out your monthly earnings.

In addition to this, insurance companies set participation rates. A participation rate determines how much of the gain you receive from the call options. A 100% participation rate is typical, meaning you get the full benefit of the options contract, but some insurers have minimum participation rates of 75% or less.

Is it too good to be true?

There is no magic, only magicians, as they say.

Cap and participation rates are based on what an insurance company can afford to offer. Current in-force policies, previous claims experience, options budget, current market price for options, bond yields in the insurer's general account, and many other factors all affect the cap and participation rate an insurer can offer. And these cap and participation rates might vary significantly from company to company.

Ultimately, cap and participation rates are based on the cost for the underlying options contracts and the options budget the insurer has available to buy those options. As option budgets shrink, so do cap and participation rates. As options prices increase, cap and participation rates fall accordingly. The reverse is also true.

It's reasonable to assume indexed crediting strategies can earn up to 50 basis points (0.50%) over a fixed-interest account over the long-term.

Important Whole Life Insurance Policy Riders And How To Use Them

Paid-Up Additional Insurance Rider (PUA Rider)

This nifty little rider gives you the ability to make additional payments on your life insurance policy (buying small "blocks" of paid-up additional life insurance), up to a maximum annual limit set by the insurance company.

Paid-up additional insurance is one of the best ways (perhaps the best) to increase your death benefit, future dividend payments, and cash value. Because this rider buys paid-in-full insurance, only one premium is required each time you elect to buy extra coverage.

As such, the cost per $1,000 of insurance is extremely high which results in most of the money being allocated to the cash value of the paid-up insurance to guarantee the future death benefit payout. This also means the return on paid-up additions cash value is high, since the premium cannot buy much pure insurance coverage so less of your premium (and interest earnings) goes toward the cost of insurance.

If you've ever read or heard an insurance agent or financial advisor tell you they will "overfund" your whole life policy, this is how they do it. They schedule at least some of your total premium as paid-up additional insurance rider premiums.

If a substantial amount of your premium dollars are diverted to paid-up additional insurance, you will have positive cash value in the first year of the policy and it will start growing at a faster rate than if you did not use the paid-up additions rider. Over the long-term, this rider also tends to produce a higher death benefit amount than without the rider.

Supplemental Term Insurance Rider

Supplemental term insurance riders allow you to blend term insurance into a whole life policy, so your policy is part term, part whole life. Sometimes, you'll hear this described as "term blending."

The term insurance portion of the policy starts out as pure insurance and is slowly converted into whole life over time. The conversion process is usually driven by non-guaranteed dividends but may also be influenced by other factors.

These policy designs require more effort on the part of the agent to set up and manage, but have become very popular in recent years because they lower the cost of insurance in the early years of the policy.

That lower initial cost can be exploited one of several ways.

Traditionally, the term blending option was used to lower the initial cost of whole life so whole life insurance sellers could better compete with universal life.

But, some savvy agents discovered that term blending also allowed more premium to be paid into the policy before hitting MEC limits, thus accelerating its cash value growth. Because the early year costs are low, more premium makes its way back into the policy's cash value and earns interest.

The net effect is rapid (and high) early year cash values. However, long-term cash values may or may not be higher than they otherwise would be and the long-term performance of the policy ultimately hinges on how the insurer prices the supplemental term rider and how that rider is paid for.

Overloan Protection Rider

There is exactly one company that offers this option with whole life insurance. Many companies offer this on universal life, but I thought I'd mention it here because it is both unique and serves a very important purpose.

There's no cost to have it or use it. What it does is… it prevents your whole life policy from lapsing due to policy loans. Instead of lapsing, your policy will stay in-force and automagically convert into a "reduced paid-up" (RPU) policy if you have any outstanding policy loans which exceed 99% of your policy's cash value.

The company also changes the dividend option to paid-up additions when the rider is triggered, unless you select the "dividends as cash" option. All other supplemental riders are terminated and no more premiums can be paid into the policy.

One last thing about this rider is… you must be at least 75 years old and the policy must have been in force for 15 years for it to take effect. So, basically, this is designed to prevent you from lapsing your policy in your old age and triggering a massive tax bill for any gains you realized in the policy. That's mucho important when using a whole life policy for supplemental retirement income.

Extended Coverage Rider

This rider option adds additional insurance coverage for a family member. It's kind of like getting 2 (or more) policies in 1. Most of the time, the coverage is extended to your spouse and children. The supplemental insurance death benefit has its own premium and terms and cannot be separated from the base whole life policy. Usually, the extended coverage is term insurance.

Terminal Illness Rider

Most whole life insurance comes with an accelerated death benefit rider of some sort. This means you get to spend your death benefit before you die.

There's a catch, of course (isn't there always?). For the terminal illness rider to kick in, you have to be expected to kick the bucket within 12 or 24 months. Still, it's a way for you to enjoy your death benefit while you're still alive and go make peace with the world before your time is up.

A few things about these riders. Normally, there is no cost to add this rider onto your policy but there is a cost if you ever decide to use it. Costs vary by insurer and death benefit amount being accelerated. It's usually very reasonable and worth having. Accelerated death benefit payments also reduce the death benefit and policy cash value, which should be obvious but I'm throwing it out there just in case it's not.

Insurance companies also tend to stipulate minimum acceleration amounts and allow you to take the acceleration as monthly payments or as a lump sum. Good news is… accelerated death benefits are usually tax-free.

Chronic Illness Rider

Similar to the terminal illness rider, this rider benefit lets you spend down some or all of your death benefit before you die. However, to exercise this rider, you have to suffer a heart attack, stroke, or have some other permanently disabling event and it has to be verified by a healthcare practitioner.

Some policies will also allow you to use the death benefit to pay for long-term care costs, but you must be expected to need care for the rest of your life to qualify for the death benefit acceleration. Some riders allow you to suffer non-permanent disabling events but this tends to be expensive for insurance companies to underwrite. So, most specify that your chronic illness be permanent.

On the upside, most insurance companies do not charge extra to have this rider. Some will, however, charge you if you decide to use it while others won't.

Disability Waiver of Premium Rider

If you become disabled, the insurance company will waive the premium payments until you are back on your feet (up to the maximum payment allowance). Normally, this rider option is good for either a 3-year disability or a 6-year disability, with some companies offering a 2-year benefit or grade benefits depending on your age.

Most insurers also require you to be disabled for at least 6 months before they will waive the premium payments.

If you're concerned about disability, look for a company that offers "own occupation" definition of disability. Most companies only offer "any occupation" definition of disability.

The difference is… huge.

With an "any occupation" definition of disability, the company will only waive premiums on your policy if you are unable to do any work at all. Meaning, if you can still pump gas at a gas station, you can still work or… if you can still sweep floors or work for minimum wage, you won't qualify for disability coverage.

"Own occupation" means you cannot work in your primary occupation or line of work doing the exact same job you were doing before you became disabled. If you do some kind of skilled labor job, or own a business, or you're a high-level executive, this is usually the definition of disability you want to have from your insurance company. It's more favorable to you and thus easier to get approved for the disability benefit if you ever need it.

Guaranteed Purchase Option Rider

Handy if you know you'll be purchasing more life insurance in the future. Otherwise, not worth the extra cost. This rider lets you buy more life insurance at specified ages without going through medical underwriting to prove your insurability. That means, if you get sick later on in life, you can still get life insurance.

There's usually a hefty fee for this option as you're basically putting the life insurance company on the hook for potentially high-risk coverage (high risk for them). In most cases, I recommend folks buy a separate convertible term policy but in unusual circumstances, this rider can make sense.

Historical Performance Of Whole Life Insurance

One of the best ways to understand how whole life insurance works and performs is to look at its historical performance.

The risk here, of course, is getting trapped by "historical determinism." Historical performance numbers are a cool way to learn about how whole life works, and… they help you better understand how whole life insurance has done in the past but… past performance is in no way predictive.

In other words, looking at a life insurance company's past performance can't tell you anything about how well it will do in the future. It just can't. What it can give you is insight as to how it might perform in specific economic climates.

Here are a few examples from a well-run, large mutual life insurance company:

Whole life does have amazing potential for both males and females (even males in their 50s!), as you can see.

The 35 year old female earned a return on cash value of 5.86% per year and a return on death benefit of 6.86%. The 45 year old male earned a return on cash value of 4.80% per year and a return on death benefit of 5.55%. The 55 year old male earned a return on cash value of 5.89% and a return on death benefit of 6.23%. 

In all 3 cases, the policyholder earned far more than was originally illustrated.

These returns are annual compound returns (actual growth rates experienced by the policyholder), net of all fees, commissions, and taxes (cash values are generally not subject to taxation).

Few financial products, and even many investments, struggle to give individuals this type of return on their savings. Return isn't everything, of course, but it is something.

With that said, some whole life products haven't returned anywhere near this return. Many whole life policies tend to return between 2% and 3% per year, compounded. Well-designed whole life policies from major mutual life insurers (i.e. policies designed specifically for cash accumulation) can potentially return between 4% and 6% per year, compounded.

How To Access Your Whole Life Cash Values

As owner (or member) of a mutual life insurance company, you have indirect control over how your premium dollars are invested——you can either let the insurer invest your premiums for you in the general investment account or… you can remove them from the policy and invest them elsewhere. This is accomplished through either partial surrenders or policy loans.

In the case of policy loans, your premium dollars remain invested in the general account, while you use borrowed funds for some other purpose. More on that in a moment.

Partial and Full Surrenders

A surrender or withdrawal is nothing more than you selling your insurance policy back to the insurance company for its cash value (which is the cash surrender value of the policy). There is no discount or negative value applied to this sale.

The insurer gives you the full market value and, in some cases, a "terminal dividend" (final dividend payment) plus a premium refund credit. And, the sale is guaranteed.

They cannot turn you down.

In rare and unusual circumstances, an insurer might delay paying you for up to 6 months but nothing like this has happened in the industry since the Great Depression in the 1930s when the government forced banks and insurance companies to declare a bank and insurance company holiday (today's insurance companies have much more control over whether an insurance company holiday happens, however).

Moving right along…

You can cash in part of your policy (called a "partial surrender") or all of your policy (called a "full surrender"). Surrenders reduce the cash value and death benefit in the reverse order that they were added to the policy. A reduction of $1 in death benefit does not necessarily result in a reduction of $1 in cash value. It all depends on your individual cost of insurance (which is determined by your age, health status, and when you purchased the policy) and when you surrender it.

Surrenders are considered permanent withdrawals (resulting in permanent reductions to the death benefit) and you generally cannot put the money back into the policy. Because of this, most policyholders opt for policy loans unless they are winding down their policy and using the cash values for supplemental retirement income.

Surrenders are usually processed within 3-5 days and checks or direct deposits made within 5 to 10 days of the initial surrender request. Meaning, if you make a surrender request on the 1st of the month, you will probably have your money sometime between the 5th and the 10th of that month. Of course, this depends on the insurer and their internal procedures for processing requests. Some are a little faster, some a little slower.

Policy Loans

A policy loan is a secured or collateralized loan against the value of the life insurance policy. You may take as many loans as you want, up to the full loan value of your cash value, which is usually between 80% and 90% of the net cash surrender value (the value you would get if you completely surrendered your policy for cash).

Policy loans are guaranteed issue loans, meaning you cannot be turned down so long as you have cash value available to secure the loan. Unlike conventional loans, there is no credit check (and no "dinging" of your credit) with a life insurance policy loan. It will not show up on your credit report and does not affect any other credit-based or credit-dependent product or service, like auto insurance or credit card APRs. Funds are typically released from the insurer and deposited into your bank account within 5 business days, though some insurance companies can take up to 10 business days to deliver a paper check. Direct deposit of loan funds is generally quicker than check delivery. Some insurers also allow expedited loan processing, allowing policyholders to receive the loan money in as little as one or two days.

The only exception to this is if there is ever a "run on the life insurance company". Similar to a "run on the bank", a "run" occurs when the majority of an insurance company's policyholders simultaneously demand all their money back. The insurance company might not be able to fulfill all policyholder demands, or it might cause extreme financial strain on the insurer, and might jeopardize the stability and solvency of the company.

To prevent this, and to ensure all policyholders are repaid in full, an insurer might delay all disbursement requests (surrenders and loans) for up to 6 months. This gives the company sufficient time to "unwind" various investments to meet policyholder disbursement requests. It's important to keep in mind this is an emergency-only action, which has never occurred in the history of the insurance industry. However, something close to a "run" happened during The Great Depression, where policy loan and surrender requests increased dramatically to the point where state governments forced an insurance company holiday and life insurers had to slow down (but not stop) disbursement requests, prioritizing policy loans and surrender requests for essential expenses like rent, mortgage payments, tax payments, and food. Life insurers continued to pay death claims as normal, however.

Anyway, because surrenders or withdrawals are permanent changes to the policy, most policyholders use policy loans prior to retirement. Policy loans are tax-free as long as the policy remains in-force and it does not result in a permanent reduction in the death benefit or cash values.

Instead, policy loans temporarily reduce the net cash value available for borrowing and the net death bnefit payable while the loan is outstanding. When policy debt is repaid, both the cash value and death benefit increase to their pre-loaned values.

As mentioned before, you may take as many policy loans as you wish, provided there is sufficient cash value to back the loan. Each loan is automatically consolidated with previous loans, making policy loans, in effect, one single loan. You can, of course, keep each loan segregated in your own personal accounting or budgeting system but the insurance company will not do this for you. The loans are considered "non-amortizing loans", meaning there is no set repayment schedule. Instead, the insurer charges interest on the loan and bills you for that interest annually.

Whole Life Policy Loan Rates And Interest

Policy loan rates are annual percentage rates (APR), which do not take into account the effect of compounding interest. In that sense, policy loan interest is non-compounding.

However, unpaid loan interest at the end of the year does get added to the policy loan principal. If you do not pay this interest, it will start to compound. If you repay your policy loans, the net effect is not harmful to you. Even if you don't repay your loans, the cash surrender value is used as collateral for the loan and is compounding against the loan. Most of the time, insurance companies use a daily accrual method for calculating policy loan interest.

This means interest is only assessed on the outstanding principal balance. Using the daily accrual method, life insurance companies always allow you to repay loan principal before applying any money to interest. This can help you pay off the loan faster than if you had used a traditional loan (which requires interest be repaid before principal).

At the end of the year, the insurer will bill you for the interest on the loan. You may choose to pay some or all of this interest out of pocket. Any interest you do not pay out of pocket is added to the loan principal and interest is charged on the new principal amount.

Some life insurers bill 12 months of interest in advance, however, instead of using the daily accrual method. When the insurance company bills interest in advance, you must choose to either pay interest out of pocket when the loan is issued or opt to have the interest added to the loan amount.

Repaying Whole Life Policy Loans

One of the nice things about policy loans is you have complete control over the loan repayment schedule.

You can make policy loan repayments monthly, weekly, bi-weekly, semi-annual, quarterly, or some other repayment frequency. It's totally up to you and the insurer will not hassle you for money or a specific payment schedule.

You can also pay nothing, just the interest on the loan at the end of the year, $50 per month, $72 per month, some other arbitrary dollar amount per month toward just the loan principal, or create a fully amortized repayment schedule similar to what you'd get from a bank or credit union.

You can schedule repayments similar to a fixed payment loan, a credit card, or some other revolving line of credit. You can pay 3 years interest-only, followed by a balloon payment to pay off the loan in full. 

If you need to temporarily stop repayments, you can.

If you want to defer payments for a year, you can.

If you only want to pay the interest on the loan, you can.

If you want to accelerate payments, you can.

If you don't want to repay your policy loans, you can do that too.

Basically, you can repay these policy loans any way you want.

Stopping Premiums While Repaying Loans

Something else to note: If you need to temporarily stop premium payments while repaying a policy loan, most whole life policies have the option of going on "alternate payment option" or "premium offset", where premiums can be temporarily stopped while making loan repayments. The insurance company will use dividends, paid up additions, or a combination of both to continue making premiums while you repay your policy loan.

A Policy Loan Repayment Example

In the following example, let's compare a conventional loan at 5% APR and repayment rate to a life insurance policy loan at a 5% APR and repayment rate, assuming the daily accrual method:

Conventional Loan @ 5% APR/Repayment Rate Using The Daily Accrual Method

Policy Loan @ 5%APR/Repayment Rate

The savings seems small in this example. By taking on a policy loan, you save $38.67 over a conventional loan. If you make weekly loan payments, you accelerate the payoff, saving even more money. With the conventional loan, this is not possible unless you make extra payments over and above the scheduled monthly payment. With a policy loan, you simply change the payment frequency to realize additional savings.

At higher interest rates, the savings can be substantial. Here is the same loan at an 8% APR:

Conventional Loan @ 8% APR/Repayment Rate

Policy Loan @ 8% APR/Repayment Rate