Comparing whole life vs universal life insurance

How does whole life insurance work?

Whole life insurance is a very simple style of permanent coverage. In return for a yearly premium, your insurance company promises to pay your chosen benefit to your chosen beneficiary if you die. The key difference between term and whole life insurance (besides time) is what’s known as the cash surplus value, or CSV. Put simply, the CSV is some amount of money that you’ve paid into your whole life insurance policy in excess of the actual cost of your premiums. This is best explained with an example.

Scenario 1: At age 30, John takes out a 10-year renewable term policy, which he plans to renew each decade, without requalifying*. Because his risk of death increases as he ages, his premiums increase with each renewal, shown in the table below.

Scenario 2: At age 30, Jane takes out a whole life insurance policy, with an identical risk of death as John**. Her policy has level premiums for life, so they do not increase as she ages. 

*This is generally a bad idea if you’re healthy, but it makes our example simpler.

**Being female. this is unlikely. Again, it makes the example simpler.

With her whole life insurance plan, Jane will pay higher premiums than John for the first 30 years of the policy. However, her premiums are significantly cheaper than John’s after year 40 of the policy. In fact, John may find the cost of his final term of life insurance to be prohibitively expensive, which means he will not be covered at all.

Cash surplus value (CSV):

It’s this ‘averaging out’ of Jane’s whole life insurance policy premiums that result in her accumulating a cash value. For the first 30 years of her policy, her actual ‘mortality costs’ (the amount life insurance companies collect based on her risk of death) are lower than her actual premiums. The difference between her mortality costs and her premium are what make up her CSV.

Whole life insurance CSV’s can be used as an asset as they grow. They can be used as collateral for a loan or mortgage, for instance. If Jane were to miss a premium payment, her life insurer would likely issue an automatic premium loan (APL) to cover it – this loan would be charged interest until Jane paid it back. Life insurance companies will continue to issue APL’s up to the cost of the CSV – after that the policy will lapse, and the CSV will be forfeited to the life insurance company to cover the remaining loans.

Participating vs non-participating whole life insurance:

CSV’s are invested by life insurance companies, though policy holders aren’t able to choose the investment mix. The interest accrued is then treated in two different ways.

Non-participating (or ‘non-par’) whole life insurance policies - the life insurance company retains any interest from CSV investments. However, premiums for non-participating policies are generally lower, as they factor in these gains.

Participating (or ‘par’) whole life insurance policies - interest is distributed to policyholders (minus a fee) as a policy dividend. If investments result in a loss in a given year, no dividend will be paid, but the policyholder will not lose any CSV. While participating policies have the opportunity to make more than non-participating policies, premiums are higher to reflect this.

Because life insurance companies can theoretically make more investment profit from early payments, they will charge an extra fee to policyholders that choose to pay their premiums monthly. This is to make up for the loss of additional investment interest.

Whole life insurance pros and cons

Here’s a summary of the advantages and disadvantages of whole life insurance vs. universal life insurance policies, as well as compared to other forms of insurance.

How does universal life insurance work?

Universal life insurance is a kind of participating life insurance, but with many extra benefits. Instead of a CSV, universal life insurance policies have an account balance. The life insurance company will take their regular fees and mortality costs for the life insurance policy from the account balance – these are called deductions. The remaining account balance can then be used for whatever investment mix the policy holder wants.

You can think of universal life insurance as a bundle of two products. It’s an investment account, from which your life insurance company deducts the costs of your life insurance policy. Rather than paying premiums, universal policy holders make ‘investments’. These can be of any size and regularity, as long as there’s enough in the account balance to cover the regular deductibles. Those deductibles will be similar to the premiums of a comparable whole life insurance policy, plus additional administration costs.

If you stop making investments, you won’t be issued a loan to cover it – your insurance company will simply continue to deduct their costs until your account balance is zero, after which your coverage will lapse. If your account balance is large enough, it may be able to earn enough interest to cover your deductibles without any further investments!

As with the CSV of whole life insurance policies, the account balance of universal policies is an asset that you can use as collateral for a loan. Unlike whole life insurance, you can also make withdrawals from your account balance. However, this may be considered taxable income, so taking a loan against it might be a better financial decision.

Universal life insurance tax benefits:

One of the major benefits of universal life insurance policies are the tax advantages they offer. Interest earned by your account balance is tax-deferred, up to certian limits. That means it won’t be taxable until it’s withdrawn. If accumulated interest is paid out as part of your death benefit, it may never be taxed! These benefits may be available in some participating whole life insurance policies as well.

The tax advantages of universal life insurance are generally only worth it after you’ve maxed out your contributions to a TFSA and RRSP. That generally excludes anyone who isn’t a high net worth individual. If that doesn’t include you, you may be better off with a whole or term life insurance policy.

Universal life insurance pros and cons

Below are some of the advantages and disadvantages of universal life insurance vs. whole life insurance, or against any other type of life insurance policy.

The Bottom Line

So which is better, whole life or universal life? The choice between the two is almost entirely based on your unique circumstances. That said, we can offer some limited guidance – but know that you really need to compare life insurance quotes, possibly speak to a broker, and make up your own mind.

First, you need to decide if permanent life insurance is right for you. If that’s the case, then whole life insurance is probably a safe bet. We say that because most people can’t take full advantage of the tax-advantages of universal policies, and you’ll never take a loss on your CSV with a whole life insurance policy – that can’t be said for universal policies.

However, if you have enough money to take advantage of the tax-advantages of universal life insurance, or you like more control over your investment mix, then a universal policy could be perfect for you. Just keep in mind that you’ll need to build up a fairly large account balance to truly see the benefit of a more aggressive investment strategy.

Also read:

• How much life insurance do I need?
• 17 life insurance mistakes to avoid
• Life insurance for children
• What is life insurance fraud?