About Life Insurance: The Basics

You probably have a pretty good idea of how your financial portfolio works, but few policy owners understand the mechanics of their permanent life insurance (Whole Life, Universal Life, Variable Life, etc.) This is partly because life insurance is among the most complex products sold to American consumers and partly because it has never been thoroughly explained to you. To manage your investment it is important to understand how policies work. Basically, all permanent policies work on some variation of the following:

Permanent life insurance is designed to be in force as long as you live (hence the name) and includes both a protection component and an investment (cash value) component. For most permanent insurance, the protection component is fixed as long as the policy is in force, while the cash value component depends on how much is deposited and the return on accumulated principal.

The premiums you pay are applied partly to mortality charges (the risk that you will die in any particular year), partly to expenses (operating the companies and paying the insurance agents and brokers) and partly to accumulation of principal (cash value – see chart). The cash value grows through deposits from premiums plus interest or dividends. Mortality charges increase with age, at some point exceeding the premiums, at which time they are subsidized by withdrawal of principal. Premiums are calculated so that the cycle of growth and withdrawal of value is funded to keep the policy solvent through maturity, typically age 100. The graph shows three (of many) possible cash value trajectories: growing to the value of the death benefit (you receive either the cash value or the death benefit, not both), decreasing to zero (but not until after your life expectancy), or crashing (falling to zero before life expectancy and lapsing the policy).