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 With a whole life insurance policy, you're combining the benefits of a term policy with that of an investment. That means a whole life policy has two components to it, an insurance component and an investment component. Therefore, when you're paying your annual premium on this type of life insurance policy, those payments needs to fund both of these components.
Premiums on Whole Life Policies
During the early years of a whole life policy a smaller portion of the premium will go towards the cost of providing life insurance. But as you age the cost to provide insurance will rise and a larger portion of the total premium will go towards funding life insurance. When that happens a smaller portion of the premium will go towards the investment, or reserve.
It's important to understand how this funding works because it helps to establish the policyholder's expectations with respect to the cash values of their accounts.
Cash Surrender Values
Because whole life insurance has this investment feature, the policy will also have a cash surrender value. This is the money you would be paid if you decided to give up or "surrender" your insurance policy. Alternatively you may also be able to use this cash value to pay for the cost of providing insurance in the future.
You need to be careful not to think of whole life insurance as a true investment option. Often insurance salespersons talk of the policy's rate of return as if this return is guaranteed. That is certainly not the case, and the paperwork will clearly explain the investment numbers are projections or hypothetical examples. This means the actual cash value of the account will likely be different than the original projections.
In addition, the cash value of the policy does come at a cost. You are adding an investment feature and that requires funding via insurance premiums. So whole life insurance policies will be more expensive to have and hold than a policy that only provides a life insurance benefit.
If you've got a tight budget, you should not sacrifice the face value of insurance to fund an investment. The primary purpose of any life insurance policy is to provide insurance coverage to protect your family or loved ones from a financial hardship. Try not to lose sight of this fact when dealing with an insurance salesperson.
Whole Life Dividends
In addition to providing the policyholder with a cash value, certain whole life plans also provide for dividends. Dividends are paid when the actual cost to provide insurance turns out to be less than the insurance company assumed in their original forecast. When this occurs, the insurance company might return a percentage of your insurance premium back to you in the form of a dividend.
Keep in mind that even if a policy carries a dividend feature, payment of the dividend is never guaranteed.
Permanent Life Insurance
Because of the way that the insurance premiums are calculated with whole life insurance, the policy is considered permanent life insurance. A permanent life insurance policy is one that will continue to provide for insurance coverage as long as you continue to make your annual premium payments.
Another important consideration when evaluating policies is the fact that premiums for whole life policies are also usually "level" premiums, meaning they will not increase over their lifetime. So for policyholders that want a policy they can buy and forget about, a whole life policy makes a lot of sense - especially if they can afford the premiums. Said another way, if a policyholder can afford the premiums when they are younger, the policy should seem more affordable in later years.
Whole Life versus Term Insurance
By now you should have a good feel for what to expect when you buy a whole life insurance policy. But as mentioned earlier, the primary reason for purchasing a policy is to provide for insurance. And the least expensive way to buy life insurance is through a term life insurance policy.
That being said, it's worth summarizing the difference between whole life policies versus a term insurance policy, this will help you to make an informed decision:
- Since whole life has an investment component, this type of policy accumulates value over time. Term insurance policies do not provide for a cash value.
- Whole life insurance is considered permanent life insurance. Term life insurance is just as the name implies, it is purchased for a term and those terms can be as short as one year.
- Whole life insurance policies are usually structured so that the premium stays level over the life of the holder. With term policies - especially one year renewable term - the annual premium will likely increase as the policyholder ages.
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