A Simple Way to Understand the Key Features of Whole Life Insurance

I find that many do not understand the essential relationships between base and PUA premium, cash value, and death benefit in whole life insurance. Maybe this will help.

This very simple thought experiment will inoculate you against the many errors that circulate online regarding why the values (cash values and death benefits) change relative to premiums (base and PUA) the way they do in dividend-paying whole life insurance.

For instance, promoters of life insurance policy design that we might call excessively “tight,” where very little of the total annual premium is allocated to the base, will say that “base buys death benefit; PUA buys cash [value].”

This is false.

Let’s jump into the thought experiment to understand why.

I promise to pay $10,000 to my friend Bob in one year from now. I enumerate this promise in writing and stipulate that the bearer of this promise to pay is entitled to claim the $10,000 from me in one year’s time. I give this legally binding document to Bob.

Let’s suppose that Bob turns around the next day and sells the document to Sally.

Since Sally has to wait 364 days to present the document to me and collect her $10,000, Sally will pay less than $10,000 to Bob. Let’s say that Bob sells Sally the document for $8,000. At this point, we can say that the present value of the $10,000 364 days from now is $8,000.

We can add one wrinkle.

Suppose, instead, that I told Bob I’ll promise to pay the bearer of the document $10,000 one year from now if and only if the bearer of the document pays me $500 per month until the $10,000 becomes payable (at the end of one year).

In this case, if Bob were to turn around the next day and sell the document to Sally, the price Sally would pay wouldn’t just be the present value of $10,000 in 364 days (e.g. $8,000). It would be the net present value. Sally would have two factors to consider: the 364 day waiting time and the on-going payments required to for the document to be valid (the $500 per month).

If before Sally was willing to pay $8,000, she’ll now pay less. Exactly how much less depends on how much she discounts each of the $500 per month payments over the next 364 days. Let’s suppose that Sally is now willing to buy the document from Bob for $3,000. We can say that the net present value of $10,000 payable in 364 days is $3,000.

If you understand the logic of this little example, then you’re in a position to understand the essential features of dividend-paying whole life insurance.

Whereas in the example we supposed a future cash flow of $10,000 one year from now, in life insurance we have the death benefit. That’s all death benefit is: a contractually guaranteed promise to pay a future cash-flow when the insured reaches the age of 121 or when the insured graduates, whichever comes first, so long as certain premiums are paid in the meantime.

Whereas in the example we supposed an on-going required payment schedule of $500 per month to keep the document in good standing, in life insurance we have the base premium. Base premiums are the payments required to keep a dividend-paying whole policy “in-force” (i.e. to keep the death benefit payable). If Sally stopped paying the $500 per month, she wouldn’t be able to claim the $10,000. If a policy owner stops paying base premium, the life insurance company is no longer obligated to pay the death benefit (this is called a “lapsed” policy).

In the example we said that Bob could sell the promise to pay to Sally for $3,000. In life insurance, we call the net present value of the death benefit the cash value (also known as “surrender value” or “cash surrender value”). It’s the amount of money that the life insurance company would pay to the policy owner should the policy owner decide to quit, never pay another premium, and forfeit his claim to the death benefit.

We have one more feature of contemporary dividend-paying whole life insurance to integrate into our example: the Paid-Up Additions or PUA premium.

First of all, what is PUA?

The “Additions” in Paid-Up Additions means additional death benefit. When you make a PUA premium payment, you are literally adding more death benefit to the life insurance policy. In other words, a PUA premium increases the magnitude of the future, promised cash flow.

The “Paid-Up” part of Paid-Up Additions means that the additional death benefit that the PUA premium purchased is “paid-up.” This means that no further premium in the future will be required in order to maintain the newly purchased death benefit. We say that the death benefit purchase is therefore “paid-up” In other words, PUA premium increases the magnitude of the future, promised cash flow without increasing the on-going cost.

Consider this. If you increase (A) the magnitude of a future cash-flow without adding to (B) the on-going cost required to keep the promise to pay in good standing, then what will be the effect on (C) the net present value of the future cash-flow?

In other words, if C = A — B, and if you increase A without changing B, what is the effect on C? Of course, the value of C, the net present value of the future cash flow, must also increase.

This is why PUA premium has a disproportionate impact on cash value generation in the early years of a whole life insurance policy: it increases the magnitude of the death benefit without adding to its future cost.

But let’s not forget base premium! A whole life insurance policy with no PUA premiums paid over the life of the policy will generate cash value. However, the cash value generation occurs much slower.

Consider why. If C = A — B, and if you slowly reduce the value of B, then the value of C will grow, but only slowly. Remember, B symbolizes a lifetime of future base premium payments (more specifically, the present value a lifetime of base premium payments). So, for changes in B to have a meaningful impact on C, two things have to happen: premiums must actually get paid (the future stream of payable base premiums must decrease) and years of time must pass.

Compare to the effect of PUA premium that increases the magnitude of the death benefit now. This is why if you were to read an actuarial textbook (I know, what a joyful thought), you might find a curious explanation of PUA premium. Textbook authors will say that the purchase of death benefit with PUA premium is essentially the purchase of a miniature single-premium (or single-pay) whole life policy that just so happens to be grouped together with a conventional (multiple-pay) life insurance policy. In fact, life insurance companies calculate two different dividends that are ultimately paid to a policy owner. One dividend corresponds to base premium and another corresponds to PUA premium. Companies will even show this on a policy owner’s annual report, which usually leads to confusion, e.g. “Why am I seeing two different dividends?!” Now you know why.

Let me reiterate, it is wrong to say that base premium does not contribute to cash value generation. It is usually (though not always) the case that base premium does not generate cash value in the early years of a policy, but it definitely will. This is the same thing as saying that “as you reduce the outstanding cost of a future cash flow, the net present value of the future cash flow must increase.” Fun fact: the ontological status of that statement is the same ontological status as the statement “2+2=4.” In other words, it’s true by definition.

This is why it is false and misleading to say that “base buys insurance; PUA buys cash.” The dichotomy is unwarranted. Both premiums buy insurance and both premiums contribute to cash value generation. Do base and PUA premium affect death benefit and cash value generation differently? Sure. But it is not the case that each premium only impacts one value.

In fact, it would be impossible, since a reduction in the cost of a future cash flow must eventually reduce its the net present value (base premium generates cash value), and since PUA premium only generates cash value (“buys cash”) by increasing the magnitude of the death benefit (“buying insurance”).

By the way, we now have sufficient actuarial understanding to see why term insurance does not generate cash value. We can only have a net present value of a future cash flow if we have a future cash flow. But the death benefit (future cash flow) on a term insurance policy is not certain, it’s conditional. Whereas with whole life insurance, the death benefit will be paid (either upon graduation or age 121 of the insured), with term insurance the death benefit might be paid. In fact, statistically speaking, it’s extremely unlikely that the term insurance death benefit will be paid, since around 99% of term policies either lapse (the owner stops paying the premium) or terminate (the intended duration of the contract is fulfilled while the insured is still living). In short, there is no net present value of a non-guaranteed (and extremely unlikely) future cash flow; therefore, typical term insurance that lasts 10, 20, or sometimes 30 years, has no cash value.

We also have sufficient actuarial understanding to see why it doesn’t make any sense to “unbundle the savings component from the insurance component” of whole life insurance with the financially-engineered Frankenstein product called universal life (or it’s other Frankenstein cousins including equity indexed universal life, indexed universal life, or variable life).

Unless you’re God who is capable of reformulating the laws of the universe, you can’t “unbundle” the net present value from a future cash flow. This is literally a non-nonsensical idea.

Instead, in universal life, the notion of a guaranteed future cash flow is virtually eliminated. That this batch of products and its mutant cousins can be legally called “permanent insurance” just like whole life insurance is an affront to the English language. With universal life, the permanent aspect of permanent insurance is almost totally eliminated (there’s usually a very small so-called “minimum death benefit” that is guaranteed) and in it’s place is the very poorly understood product known as One-Year Term or OYT (also known as annually renewable term).

I’ve written on this before, and boy oh boy did I ruffle feathers. In that article, I pointed out that, just like it sounds, OYT renews each year, and when it does, premium payable for the upcoming year is recalculated in accordance with the now higher attained age (and risk of mortality) of the insured. In particular, I wrote:

Importantly, what the future premium increase will be is unknown. That’s the “non-guaranteed” element of non-guaranteed, annually renewable term insurance. Guess who is responsible for the uncertainty of that future premium increase? Guess who gets to decide by just how much the premium will increase in the future?

The consumer pays. The company decides.

An adviser who uses OYT (in this case, in a blended term-PUA rider, as discussed in the prior article) objected strenuously to my characterization. His point was that the government indirectly regulates the degree to which the premium on OYT can increase one year to the next (by regulating reserve requirements and mortality rate pricing).

Why one would opt for government enforcement of price fixing over voluntary, contractually specified guarantees is an issue for another time. It suffices for our purposes here to point that while maximums may be set by law, the degree to which premiums vary within legal limits is still uncertain and non-guaranteed. In other words, how much death benefit a given premium payment will purchase depends on future, uncertain mortality experience.

What is also true is that exponentially rising mortality cost will eventually force the premium excessively, legally high. When this happens in universal life products, the cash account is drained to help offset the exponentially rising premiums. At least with OYT, the policy owner can drop the rider when premiums begin to skyrocket, and still keep the policy in-force. With universal life, the option is to endure the decreasing cash account, pay higher premium out-of-pocket, accept a lower and diminishing death benefit, or to cancel the policy.

The point is that universal life does not unbundle anything. It allows an individual to purchase OYT and send the life insurance company money to invest on the individual’s behalf. The guaranteed death benefit (future cash flow) at natural mortality is a mere shadow of what it is on a similarly funded whole life policy. Consequently, there is no cash value, no net present value of a future cash flow in universal life like there is in whole life.

Hopefully you’re starting to see how the concept of net present value is extremely valuable for proper classification and to understand what happens in whole life insurance and why.