Whole life insurance, refers to a life insurance policy that essentially continues until the death of the insured regardless of age. It pays a lump sum on death whenever it occurs provided the contract is kept in force through the required payments being made. This contrasts with term life that has a fixed end date and unless provisions are made for extension the policy ends with the insured still living.
The payout can vary from a fixed sum to one that is wholly dependent on investment performance on what remains after mortality costs and other expenses are deducted.
The premium may be a single, fixed periodic (e.g. monthly), or a periodic payment that may be revised subject to the underlying investment performance and mortality cost.
Some policies will permit a range of flexibility allowing the maximizing of potential payout over a set period (such as ten years). Once this period is over the insured can increase coverage (for an increased premium) or the coverage can be reduced (or anything in between). At any time the target benefit can be set for life. These policies are useful, for example, to those who want increased coverage while they have dependent children and then want to reduce coverage to last their entire life. The advantage of this strategy over choosing a term policy and waiting until later to replace it with a Whole Life contract is that the individual is underwritten for life and are not restricted or prevented in future coverage should they have a serious illness such as cancer.
All values related to the policy (death benefits, cash surrender values, premiums) are determined at policy issue, for the life of the contract, and cannot be altered after issue.
This means that the insurance company assumes all risk of future performance versus the actuaries' estimates. If future claims are underestimated, the insurance company makes up the difference. On the other hand, if the actuaries' estimates on future death claims are high, the insurance company will retain the difference.
In a participating policy (also par in the USA, but known as a with-profits policy in the Commonwealth), the insurance company shares the excess profits (dividends in the USA, bonus in the Commonwealth) with the policyholder – The greater the success of the company's performance, the greater the dividend. For a mutual life insurance company, participation also implies a degree of ownership of the mutuality.
Similar to non-participating, except that the premium may vary year to year. However, the premium will never exceed the maximum premium guaranteed in the policy.
A blending of participating and term life insurance, wherein a portion of the dividends is used to purchase additional term insurance. This can generally yield a higher death benefit, at a cost to long term cash value. In some policy years the dividends may be below projections, causing the death benefit in those years to decrease.
Similar to a participating policy, but instead of paying annual premiums for life, they are only due for a certain number of years, such as 20. The policy may also be set up to be fully paid up at a certain age, such as 65 or 80. The policy itself continues for the life of the insured. These policies would typically cost more up front, since the insurance company needs to build up sufficient cash value within the policy during the payment years to fund the policy for the remainder of the insured's life.
A form of limited pay, where the pay period is a single large payment up front. These policies typically have large surrender fees during early policy years should the policyholder cash it in.
This type is fairly new, and is also known as either excess interest or current assumption whole life. The policies are a mixture of traditional whole life and universal life. Instead of using dividends to augment guaranteed cash value accumulation, the interest on the policy's cash value varies with current market conditions. Like whole life, death benefit remains constant for life. Like universal life, the premium payment might vary, but not above the maximum premium guaranteed within the policy.
Whole life insurance typically requires that the owner pay premiums for the life of the policy. There are some arrangements that let the policy be "paid up", which means that no further payments are ever required, in as few as 5 years, or with even a single large premium. Typically if the payor doesn't make a large premium payment at the outset of the life insurance contract, then he is not allowed to begin making them later in the contract life. In contrast, Universal life insurance generally allows more flexibility in premium payment.
The company generally will guarantee that the policy's cash values will increase regardless of the performance of the company or its experience with death claims (again compared to universal life insurance and variable universal life insurance which can increase the costs and decrease the cash values of the policy).
Cash values are considered liquid enough to be used for investment capital, but only if the owner is financially healthy enough to continue making premium payments. Cash value access is tax free up to the point of total premiums paid, and the rest may be accessed tax free in the form of policy loans. However, if the policy lapses, taxes would be due on outstanding loans. If the insured dies, death benefit is reduced by the amount of any outstanding loan balance.
Performance of Whole Life policies
Internal rates of return for participating policies may be much better than universal life and interest sensitive whole life because their cash values are invested in the money market and bonds, while par whole life cash values are invested in the life insurance company and its general account, which may be in real estate and the stock market. Variable universal life insurance may outperform whole life because the owner can direct investments in sub-accounts that may do better. If an owner desires a conservative position for his cash values, par whole life is indicated.
Universal life insurance is a type of permanent life insurance based on a cash value. That is, the policy is established with the insurer where premium payments above the cost of insurance are credited to the cash value. The cash value is credited each month with interest, and the policy is debited each month by a cost of insurance (COI) charge, which is drawn from the cash value if no premium payment is made that month. The interest credited to the account is determined by the insurer; often it is pegged to a financial index. Because only the amount of interest credited and not the cash value itself varies, UL policies offer a stable investment option. A similar type of policy that was developed from universal life policies is the variable universal life insurance policy, or VUL. VUL's allow the cash value to be directed to a number of separate accounts that operate like mutual funds and can be invested in stock or bond investments with greater risk and potential reward. Additionally, there is the recent addition of Equity Indexed Universal Life contracts that invest in Index Options on the movement of an Index such as the S&P 500, Russell 2000, and the Dow (to name a few). These types of contracts only participate in the movement of Index and not the actual purchase of stocks, bonds or mutual funds. They may have a cap (but not always) as to the maximum amount they will credit interest to and a minimum guarantee which keeps the principle of the contract from losing money in a down year. Typically each year the starting point is last year's ending point which means that: (1) the policy amount is locked end at the end of the year; and, (2) the beginning value from which the movement measured is reset.
Universal life is similar in some ways to, and was developed from whole life insurance. The potential advantage of the universal life policy is in its flexibility and the potential for greater cash value growth if the interest rates offered outperform the insurer's general account (that whole life policy cash value growth is based on). Universal life is more flexible than whole life in two primary ways: the death benefit and usually the premium payment are flexible. The death benefit can be increased (subject to insurability) and decreased without surrendering the policy or getting a new one as would be required with whole life. Also a range of premium payments can be made to the policy, from a minimum amount to cover various guarantees the policy may offer to the maximum amount allowed by IRS rules. The primary difference is that the universal life policy shifts some of the risk for maintaining the death benefit to the insured. In a whole life policy, as long as every premium payment is made, the death benefit is guaranteed to be paid if the insured dies. In a UL the policy will lapse (the death benefit will no longer be in force) if the cash value or premium payments are not enough to cover the cost of insurance. To make their policies more attractive insurers often add guarantees, where if certain premium payments are made for a given period, the policy will remain in force even if the cash value drops to zero.
There are two other areas which differentiate Universal Life from Whole Life Insurance. The first is that the expenses, charges and cost of insurance within a Universal Life contract are transparently disclosed to the insured, whereas a Whole Life Insurance policy has traditionally hidden this type of information from the policyholder. Secondly, there are more flexible exit strategies within a Universal Life contract which increases the flexibility of that contract over a Whole Life policy including Zero interest or wash loans which virtually provide the policyholder the ability to access the growth inside the contract "income tax free."
Universal Life is used as a tax-advantaged way to purchase life insurance. In the early years of the contract, the premium far exceeds the cost of insurance (COI) charges. The difference between the two (the "inside build-up") will grow tax-deferred so long as the policy remains in force. If the policy is held until death, this inside build-up will escape taxation entirely. Policyholders may also be able to access the inside build-up via a policy loan without incurring it as taxable income.
Single Premium UL is paid for by a single, substantial, initial payment. The policy remains in force so long as the COI charges have not depleted the account.
Fixed Premium UL is paid for by periodic premium payments. Generally these payments will be for a shorter period of time than the policy is in force; for example payments may be made for 10 years, with the intention that thereafter the policy is paid-up. If the experience of the plan is not as good as predicted, the account value at the end of the premium period may not be adequate to continue the policy as originally written. In this case, the policyholder may have the choice to either:
1. Leave the policy alone, and let it potentially expire early (if COI charges deplete the account), or
2. Make additional or higher premium payments, to keep the death benefit level, or
3. Lower the death benefit.
Flexible Premium UL allows the policyholder to determine how much they wish to pay each time premium is due. In addition, Flexible Premium UL offers two different death benefit options: 1. A level death benefit (often called Option A), or 2. A level amount at risk (often called Option B). This is also referred to as an increasing death benefit.
Policyholders frequently buy Flexible Premium UL with a large initial deposit, thereafter making payments irregularly.
Often shortened to VUL, Variable Universal Life Insurance is a type of life insurance that builds cash value. In a VUL, the cash value can be invested in a wide variety of separate accounts, similar to mutual funds, and the choice of which of the available separate accounts to use is entirely up to the contract owner. The 'variable' component in the name refers to this ability to invest in volatile investments similar to mutual funds. The 'universal' component in the name is a bit of a misnomer that is used to refer to the flexibility the owner has in making premium payments. The premiums can vary from nothing in a given month up to maximums defined by the IRS code for life insurance. This flexibility is in contrast to whole life insurance that has fixed premium payments that typically cannot be missed without lapsing the policy.
Variable universal life is also considered to be a type of permanent life insurance, because the death benefit will be paid if the insured dies any time up until the endowment age (typically 100) as long as there is sufficient cash value to pay the costs of insurance in the policy.
Variable universal life insurance receives special tax advantages in the United States IRS code. The cash value in life insurance is able to earn investment returns without incurring current income tax as long as it meets the definition of life insurance and the policy remains in force. The tax free investment returns could be considered to be used to pay for the costs of insurance inside the policy. See the 'Tax Benefits' section for more.
In one theory of life insurance, needs based analysis, life insurance is only needed to the extent that assets left behind by a person will not be enough to meet the income and capital needs of his or her dependents. In one form of variable universal life insurance, the cost of insurance purchased is based only on the difference between the death benefit and the cash value (defined as the net amount at risk from the perspective of the insurer). Therefore, the greater the cash value accumulation, the lesser the net amount at risk, and the less insurance that is purchased.
Another use of Variable Universal Life Insurance is among relatively wealthy persons who give money yearly to their children to put into VUL policies under the gift tax exemption. Very often persons in the United States with a net worth high enough that they will encounter the estate tax give money away to their children to protect that money being taxed. Often this is done within a VUL policy because this allows a tax deferral (for which no alternative would exist besides tuition money saved in an educational IRA or 529 plan), provides for permanent life insurance, and can usually be accessed by borrowing against the policy.
By allowing the contract owner to choose the investments inside the policy, the insured takes on the investment risk, and receives the greater potential return of the investments in return. If the investment returns are very poor this could lead to a policy lapsing (ceasing to exist as a valid policy). To avoid this, many insurers offer guaranteed death benefits up to a certain age as long as a given minimum premium is paid.
VUL policies have a great deal of flexibility in choosing how much premiums to pay for a given death benefit. The minimum premium is primarily affected by the contract features offered by the insurer. To maintain a death benefit guarantee, that specified premium level must be paid every month. To keep the policy in force, typically no premium needs to be paid as long as there is enough cash value in the policy to pay that months cost of insurance. The maximum premium amounts are heavily influenced by the IRS code for life insurance. The IRS code section 7702 sets limits for how much cash value can be allowed and how much premium can be paid (both in a given year, and over certain periods of time) for a given death benefit. The most efficient policy in terms of cash value growth would have the maximum premium paid for the minimum death benefit. Then the costs of insurance would have the minimum negative effect on the growth of the cash value. In the extreme would be a life insurance policy that had no life insurance component, and was entirely cash value. If it received favorable tax treatment as a life insurance policy it would be the perfect tax shelter, pure investment returns and no insurance cost. In fact when variable universal life policies first became available in 1986, contract owners were able to make very high investments into their policies and received extraordinary tax benefits. In order to curb this practice, but still encourage life insurance purchase, the IRS developed guidelines regarding allowed premiums for a given death benefit.
The standard set was twofold: to define a maximum amount of cash value per death benefit and to define a maximum premium for a given death benefit. If the maximum premium is exceeded the policy no longer qualifies for all of the benefits of a life insurance contract and is instead known as a modified endowment contract or a MEC. A MEC still receives tax free investment returns, and a tax free death benefit, but withdrawals of cash value in a MEC are on a 'LIFO' basis, where earnings are withdrawn first and taxed as ordinary income. If the cash value in a contract exceeds the specified percentage of death benefit, the policy no longer qualifies as life insurance at all and all investment earnings become immediately taxable in the year the specified percentage is exceeded. In order to avoid this, contracts define the death benefit to be the higher of the original death benefit or the amount needed to meet IRS guidelines. The maximum cash value is determined to be a certain percentage of the death benefit. The percentage ranges from 30% or so for young insured, declining to 0% for those reaching age 100.
The maximum premiums are set by the IRS guidelines such that the premiums paid within a seven year period after a qualifying event (such as purchase or death benefit increase), grown at a 6% rate, and using the maximum guaranteed costs of insurance in the policy contract, would endow the policy at age 100 (i.e. the cash value would equal the death benefit). More specific rules are adjusted for premiums that are not paid in equal amounts over a seven year period. The entire maximum premium (greater than the 7 year premium) can be paid in one year and no more premiums can be paid unless the death benefit is increased. Because the 7 year level guideline premium was exceeded the policy becomes a MEC.
To add more confusion the 7 year MEC premium level cannot be paid in a VUL every year for 7 years, and still avoid MEC status. The MEC premium level can only be paid in practice for about 4 years before additional premiums cannot be paid if non MEC status is desired. There is another premium designed to be the maximum premium that can be paid every year a policy is in force. This premium carries different names from different insurers, one calling it the guideline maximum premium. This is the premium that often reaches the most efficient use of the policy.
The number and type of choices available is dependent on the insurer, but some policies are available with a wide variety of separate accounts, also known as sub-accounts. Some insurers offer over 50 separate accounts with investment styles from very conservative guaranteed fixed accounts, to bond funds, to equity funds to highly aggressive sector funds.
Separate accounts are organized as trusts to be managed for the benefit of the insured, and are named because they are kept separate from the general account which is the other reserve assets of the insurer. They are treated, and in all intents and purposes are, very much like mutual funds, but have slightly different regulatory requirements.
- Tax free investment earnings while a policy is in force
- FIFO withdrawal status after 10 years
- Tax free policy loans from non-MEC policies
- The death benefit is paid income tax free if premiums are paid with after tax dollars
Taxes are the main reason those in higher tax brackets (25 %+) would desire to use a VUL over any other accumulation strategy. For someone in a 35% tax bracket, the investment return on the sub-accounts may average 10%, and at say age 75 the policy's death benefit would have an internal rate of return of 8.5%. In order to get an 8.5% rate of return in an ordinary taxable account, in a 35% tax bracket, one must earn 13.1%. In a Roth IRA, however, one would get the 10% tax free. But the limits on the Roth are low, and the Roth is unavailable to those in the 35% tax bracket. The break-even point may be for someone in a 15% tax bracket, where if he maxed out his Roth contribution, then in a taxable account earning 10%, after tax he would have 8.5%, equal to the IRR on the VUL. These numbers assume expenses that may vary from company to company, and it is assumed that the VUL is funded with a minimum face value for the level of premium. If an individual is unable to max fund the VUL, it may easily be more preferred to use term insurance until able to convert to VUL.
The cash values would also be available to fund lifestyle or personally managed investments on a tax free basis in the form of refunds of premiums paid in and policy loans (which would be paid off on death by the death benefit.)
Risks of Variable Universal Life
- Cost of Insurance - The cost of insurance for VULs is generally more expensive than other types of life insurance policies, mostly due to the permanent nature of the product.
- Cash Outlay - The cash needed to effectively use a VUL is generally much higher than other types of insurance policies. If a policy does not have the right amount of funding, it may lapse.
- Investment Risk - Because the sub accounts in the VUL may be invested in stocks and bonds, the insured now takes on the investment risk rather than the insurance company.
- Complexity - The VUL is a complex product, and can easily be used (or sold) inappropriately because of this. Proper funding, investing, and planning are usually required in order for the VUL to work as expected.
- Fee Impact Over Time - The management fees, or "loading and expense charges" (The Journal of Risk and Insurance, Vol. 54, No. 4 (Dec., 1987), pp. 691-711) can "make it inferior to an open-market insurance and investment strategy".
These account management fees, applied to the total investment account value (unlike the insurance or policy fees, which are fixed and generally do not apply to the compounding account value) reduce the total net return on the portfolio, and can be very large compared to the identical investments held outside the VUL; often by several percent per year. These fees must be stated in every policy, although sometimes cryptically. VUL policies must be held until death to obtain the investment growth as part of the tax-free death benefit, so the fee exposure is typically measured in decades. Since an additional 2% annual fee over 36 years cuts the final portfolio value in 1/2, or a 3% extra fee over 48 years yields only 1/4 the final total portfolio value (see Rule of 72), it can be beneficial to choose to hold the exact same investment outside the Variable Universal Life policy. Since the sales commission for VUL is often in excess of 70% of first year VUL premiums (vs. 2-5% of annual deposits for the same investment held outside the policy) sales agents are often unlikely to wish to discuss these options with you (or show you how to calculate them yourself). See the External Links section below for actual policy excerpts, calculation of fees compared to identical investments held outside the policy, examples illustrating the impact of this risk, and calculation aids to help you discover and compute this risk from a policy contract.
General Uses of Variable Universal Life
- Financial Protection - VULs can be used to protect a family in the case of a premature death. A VUL can be attractive for this need because it is a permanent policy, and, if funded correctly, will not lapse, unlike term insurance. This may give the insured more insurance flexibility in future years.
- Tax Advantages - Because of its tax-deferred feature, the VUL may offer an attractive tax advantage, especially to those in higher tax brackets. If highly funded (though still non-MEC), the tax advantages may even offset the cost of insurance.
- Retirement Planning - Because of its tax-free policy loan feature, the VUL can also be used as tax-free income source in retirement, assuming retirement is not in the near future. Again, the policy must be properly funded for this strategy to work.
- Estate Planning - Those with a large estate can sometimes use a VUL as part of their estate planning strategy to reduce or avoid estate taxes.