Permanent Life Insurance

Permanent life insurance is a term sometimes used for life insurance, such as whole life or endowment, where the sum assured is due to be paid out at the end of the policy (assuming the policy is kept current) and the policy accrues a cash value.

This is contrasted with Term life insurance where insurance is purchased for a specified period (such as 5, 10, or 20 years) and a benefit is only paid out if the insured dies during this period.

As permanent life insurance program is designed to pay out a benefit in all cases, the premiums are much higher than for term assurance, which can be regarded as pure death benefit with no investment element. Thus many people select term insurance for its low cost, and they may invest the difference in separate investments. Another commonly used tactic is to utilize the slow, steady, growth within the cash value of permanent life insurance as a conservative savings strategy to hedge against the risk of the market.

The three basic types of Permanent Life Insurance are Whole Life, Universal Life and Variable Universal Life.  Whole life is tied to a company’s performance with dividends and interest credited, while the latter two are more directly linked to investment performance, thus shifting some risk to the policyholder.

Whole Life Insurance
Whole life is a life insurance policy which is guaranteed to remain in force for the insured's entire lifetime, provided required premiums are paid, or to the maturity date.   Premiums are fixed, based on the age of issue, and usually do not increase with age.  Normally you pay premiums until death, except for limited pay policies, which may be paid-up in 10 years, 20 years, or at age 65.  Also, sometimes called "straight life," or "ordinary life." Whole life insurance belongs to the cash value category of life insurance, which also includes universal life, variable life, and endowment policies.

The death benefit of a whole life policy is normally the stated face amount.  However, if the policy is "participating", the death benefit will be increased by any accumulated dividend values and/or decreased by any outstanding policy loans.  Certain riders, such as Accidental Death benefit may exist, which would potentially increase the benefit.

A whole life policy is said to "mature" at death or the maturity age of 100, whichever comes first.  To be more exact the maturity date will be the "policy anniversary nearest age 100".  The policy becomes a "matured endowment" when the insured person lives past the stated maturity age.  In that event the policy owner receives the face amount in cash.  With many modern whole life policies, issued since approximately 2000, maturity ages have been increased to 120.  Increased maturity ages have the advantage of preserving the tax-free nature of the death benefit. In contrast, a matured endowment may have substantial tax obligations.
The entire death benefit of a whole life policy is free of income-tax, except in unusual cases.  This includes any internal gains in cash values.  Of course, the same is true of group life, term life, and accidental death policies.

However, when a policy is cashed out before death it's a different story.  With cash surrenders, any gain over total premiums paid will be taxable as ordinary income.  The same is true in the case of a matured endowment.

It should be emphasized that, while life insurance benefits are generally free of income tax, the same is not true of estate tax.  In the US, life insurance will be considered part of a person's taxable estate to the extent he possesses "incidents of ownership." Estate planners often use special Irrevocable Trusts to shield life insurance from estate taxes.

Cash values are an integral part of a whole life policy, and reflect the reserves necessary to assure payment of the guaranteed death benefit. Thus, "cash surrender" (and "loan") values arise from the policyholder's rights to quit the contract and reclaim a share of the reserve fund attributable to his 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. However, some whole life contracts offer a rider to the policy which allows for a one time, or occasional, large additional premium payment to be made as long as a minimal extra payment is made on a regular schedule. 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 every year 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). The dividends can be taken in one of three ways. The policy owner can be given a cheque from the insurance company for the dividends, the dividends can be used to reduce the premium payment, or the dividends can be reinvested back into the policy to increase the death benefit and the cash value at a faster rate. When the dividends paid on a whole life policy are chosen by the policy owner to be reinvested back into the policy, the cash value can increase at a rather substantial rate depending on the performance of the company.

The cash value will grow tax-deferred with compounding interest. Even though the growth is considered "tax-deferred," any loans taken from the policy will be tax-free as long as the policy remains in force. In addition, the death benefit remains tax-free (meaning no income tax and no estate tax). As the cash value increases, the death benefit will also increase and this growth is also non-taxable. The only way tax is ever due on the policy is (1) if the premiums were paid with pre-tax dollars, (2) if cash value is "withdrawn" past basis rather than "borrowed," or (3) if the policy is surrendered. Most whole life policies can be surrendered at anytime for the cash value amount, and income taxes will usually only be placed on the gains of the cash account that exceeds the total premium outlay. Thus, many are using whole life insurance policies as a retirement funding vehicle rather than for risk management.

Cash values are considered liquid assets because they are easily accessible at any time, usually with a phone call or fax to the insurance company requesting a "loan" or "withdrawal" from the policy. Most companies will transfer the money into the policy holder's bank account within a few days.

Cash values are also liquid enough to be used for investment capital, but only if the owner is financially healthy enough to continue making premium payments (Single premium whole life policies avoid the risk of the insured failing to make premium payments and are liquid enough to be used as collateral. Single premium policies require that the insured pay a one time premium that tends to be lower than the split payments. Because these policies are fully paid at inception, they have no financial risk and are liquid and secure enough to be used as collateral under the insurance clause of collateral assignment.)[18] 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. 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.[19]

Internal rates of return for participating policies may be much worse than universal life and interest-sensitive whole life (whose cash values are invested in the money market and bonds) because their cash values are invested in the life insurance company and its general account, which may be in real estate and the stock market. However, universal life policies run a much greater risk, and are actually designed to lapse. 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.

Reported cash values might seem to "disappear" or become "lost" when the death benefit is paid out. The reason for this is that cash values are considered to be part of the death benefit. The insurance company pays out the cash values with the death benefit because they are inclusive of each other. This is why loans from the cash value are not taxable as long as the policy is in force (because death benefits are not taxable).

Universal Life Insurance
Universal life insurance is a type of permanent life insurance.  Under the terms of the policy, the excess of premium payments above the current cost of insurance is credited to the cash value of the policy.  The cash value is credited each month with interest, and the policy is debited each month by a cost of insurance (COI) charge, as well as any other policy charges and fees which are drawn from the cash value, even if no premium payment is made that month.  Interest credited to the account is determined by the insurer, but has a contractual minimum rate (often 2%). When an earnings rate is pegged to a financial index such as a stock, bond or other interest rate index, the policy is an "Indexed Universal Life" contract.  

Universal life is similar in some ways to, and was developed from, whole life insurance, although the actual cost of insurance inside the UL policy is based on annually renewable term life insurance.  The advantage of the universal life policy is its premium flexibility and adjustable death benefits. The death benefit can be increased (subject to insurability), or decreased at the policy owner's request.

The premiums are flexible, from a minimum amount specified in the policy, to the maximum amount allowed by the contract.  The primary difference is that the universal life policy shifts some of the risk for maintaining the death benefit to the policy owner. In a whole life policy, as long as every premium payment is made, the death benefit is guaranteed to the maturity date in the policy, usually age 95, or to age 121.  A UL policy will lapse when the cash values are no longer sufficient to cover the cost of insurance and policy administrative expense.

To make UL policies more attractive, insurers have added secondary guarantees, where if certain minimum premium payments are made for a given period, the policy will remain in force for the guaranteed period even if the cash value drops to zero.  These are commonly called "No Lapse Guarantee" riders, and the product is commonly called guaranteed universal life (GUL, not to be confused with group universal life insurance, which is also typically shortened to GUL).

Another major difference between universal life and whole life insurances: the administrative expenses and cost of insurance within a universal life contract are transparent to the policy owner, whereas the assumptions the insurance company uses to determine the premium for a whole life insurance policy are not transparent.

A Single Premium UL is paid for by a single, substantial, initial payment. Some policies do not allow any more than the one premium contractually, and some policies are casually defined as single premium because only one premium was intended to be paid.  The policy remains in force so long as the COI charges have not depleted the account. These policies were very popular prior to 1988, as life insurance is generally a tax deferred plan, and so interest earned in the policy was not taxable as long as it remained in the policy. Further withdrawals from the policy were taken out principal first, rather than gain first and so tax free withdrawals of at least some portion of the value were an option.  In 1988 changes were made in the tax code, and single premium policies purchased after were "modified endowment contract" (MEC) and subject to less advantageous tax treatment.  Policies purchased before the change in code are not subject to the new tax law unless they have a "material change" in the policy (usually this is a change in death benefit or risk).  It is important to note that a MEC is determined by total premiums paid in a 7-year period, and not by single payment.  The IRS defines the method of testing whether a life insurance policy is a MEC. At any point in the life of a policy, a premium or a material change to the policy could cause it to lose its tax advantage and become a MEC.

In a MEC, the premiums and accumulation will be taxed just like an annuity upon withdrawing. The accumulations will grow tax deferred and will still transfer tax free to the beneficiary under Internal Revenue Service Code 101a under certain circumstances.

Fixed Premium UL is paid for by periodic premium payments associated with a no lapse guarantee in the policy. Sometimes the guarantees are part of the base policy and sometimes the guarantee is an additional rider to the policy. 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. But it can also be permanent fixed payment for the life of policy.

Flexible Premium UL allows the policyholder to vary their premiums within certain limits. Inherently UL policies are flexible premium, but each variation in payment has a long term effect that must be considered. In order to remain active, the policy must have sufficient available cash value to pay for the cost of insurance. Higher than expected payments could be required if the policyholder has skipped payments or has been paying less than originally planned. It is recommended that yearly illustrative projections be requested from the insurer so that future payments and outcomes can be planned.

Variable Universal Life Insurance
A similar type of policy that was developed from universal life insurance is the variable universal life insurance policy (VUL).  VUL allows 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 growth.  Additionally, there is the recent addition of index universal life contracts similar to equity-indexed annuities credit interest linked to the positive movement of an index, such as the S&P 500, Russell 2000, and the Dow Jones.  

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 separate accounts whose values vary—they vary because they are invested in stock and/or bond markets.  The 'universal' component in the name refers 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 Internal Revenue 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 (although one may exercise an Automatic Premium Loan feature, or surrender dividends to pay a Whole Life premium).

Variable universal life is a type of permanent life insurance, because the death benefit will be paid if the insured dies any time as long as there is sufficient cash value to pay the costs of insurance in the policy.  With most if not all VULs, unlike whole life, there is no endowment age (the age at which the cash value equals the death benefit amount, which for whole life is typically 100).  This is yet another key advantage of VUL over Whole Life. With a typical whole life policy, the death benefit is limited to the face amount specified in the policy, and at endowment age, the face amount is all that is paid out.  Thus with either death or endowment, the insurance company keeps any cash value built up over the years.  However, some participating whole life policies offer riders which specify that any dividends paid on the policy be used to purchase "paid up additions" to the policy which increase both the cash value and the death benefit over time.

If investments made in the separate accounts out-perform the general account of the insurance company, a higher rate-of-return can occur than the fixed rates-of-return typical for whole life.  The combination over the years of no endowment age, continually increasing death benefit, and if a high rate-of-return is earned in the separate accounts of a VUL policy, this could result in higher value to the owner or beneficiary than that of a whole life policy with the same amounts of money paid in as premiums.

Because the separate accounts are securities, the representative providing a VUL must be working in accordance with the securities regulations of the country or province in which he operates.  And because they are life insurance policies, VULs may only be sold by representatives who are properly licensed to sell life insurance in the areas in which they operate.  The insurance company providing the policy must also be licensed as an "insurer."

Variable universal life insurance receives special tax advantages in the United States Internal Revenue 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.

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 month's cost of insurance. The maximum premium amounts are heavily influenced by the code for life insurance. Internal Revenue 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 persons, 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. If the 7 year level guideline premium is exceeded, then the policy becomes a MEC.

To add more confusion the seven-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 varies from company to company, and from policy to policy. The current generation of VUL policies have a wide variety of sub-accounts for the policy owner to allocate their cash surrender values into. These newer policies often offer 50 or more separate accounts covering the entire spectrum of asset classes and management styles.
Separate accounts are organized as trusts to be managed for the benefit of the insureds, and are so named because they are kept 'separate' from the 'general account' of the life insurance company. They are similar to mutual funds, but have different regulatory requirements.

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 34% tax bracket (Federal & State), the investment return on the separate accounts may average 10%, and at say age 75 the policy's death benefit would have an internal rate of return of 9%. In order to get a 9% rate of return in an ordinary taxable account, in a 34% tax bracket, one must earn 13.64%. An alternative for this in the 34% tax bracket would be to consider using Variable Annuities which does not limit the contributions and withdraw from it without annuitizing the contract.

Other alternatives for those in the 34% tax bracket that own their own companies would be to consider SEP IRAs, company 401ks or retirement arrangements from a company perspective, or to incorporate and consult a tax specialist.

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. 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.)