A whole life insurance policy is the most basic permanent life insurance policy available. It offers guaranteed cash values, guaranteed death benefits, and in most cases it also guarantees level premium payments (although this is not always the case). When the insured dies, it's vital to understand how the whole life policy pays a claim.
Cash Value vs. Death Benefit
When you buy a whole life insurance policy, you are buying a death benefit with a cash reserve, called a "cash value." The cash value of the life insurance policy represents money that is built up against the death benefit to reduce the "net amount at risk" for the insurance company. The net amount at risk is the difference between the death benefit and the cash value. It also represents a literal savings that generates interest to hold down the future cost of mortality built into every life insurance policy. Cash value can be thought of as "equity," similar to the equity of a home.
Effect of Dividends
Some whole life policies offer dividends, which represent a return of premium up to the policy's basis (the amount of premium you have paid so far). This dividend is normally used to buy additional paid up insurance which has its own cash value that earns interest.
Payment of Life Insurance Death Benefit
When a death claim is filed, the whole life policy pays an amount equal to the death benefit minus any existing life insurance policy loans. Only the death benefit is payable to the beneficiary. The cash value of the policy is a function of the savings component that was used to support the death benefit and is essentially used as part of the death benefit.
Taxation of Death Benefits
Taxes are generally not due on death benefit proceeds. However, the death benefit may be included in the insured's estate for estate tax purposes.
A common misconception is that the beneficiary receives, or ought to receive, both the cash value and the death benefit. This comes from a general misunderstanding of what the cash value represents. The cash value is inseparable from the death benefit. The reason that premiums are able to stay level in a whole life policy is because the policy is designed to become cheaper over time and the interest generated by the cash value helps hold down the future cost of insurance. Essentially, the contract is designed to use the cash value as a way to self-insure the policy owner/insured. This is why whole life matures at age 100. When the insured reaches age 100, there is literally no insurance left. It is all cash value. A claim to both the cash value and the death benefit would be "double-dipping" since the cash value essentially functions as part of the death benefit that has been earned in the policy and is accessible prior to contract maturity. This also explains why policy loans reduce not just the cash value, but the death benefit as well, by the amount of the loan.
- "Ernst & Young's Personal Financial Planning Guide, 5th Edition"; Martin Nissenbaum, Barbara J. Raasch, Charles L. Ratner; 2004
- "Practicing Financial Planning for Professionals, Practitioner's 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
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