Unlike the term insurance page, this one is much more difficult to write, so please bear with me. I discuss why there are two types of life insurance in What Type of Life Insurance Policy Should You Buy? but it is worth repeating here.
To understand whole life insurance, you must understand why it even exits. Life insurance is the only one of the dozens of types of insurance that exist that has a cash value component, and there is a very logical reason as to why. Every other type of insurance that you can think of insures a potential event; you might break a leg and have to go to the hospital, you might be in a car accident, your house could be damaged by Mother Nature or burglarized.
But life insurance insures a known event: we all will die. Additionally, that known event gets closer with each passing day, and unlike all other types of insurance, there can be only one claim. Actuaries (those folks who actually design insurance policies) use those three unique characteristics to design policies that are intended to stay in force for your whole life – hence the name.
Since the likelihood of a claim (death) increases with age, the cost of life insurance also increases with age. To make the premiums level, the premium will be more than the cost of insurance in the early years and less than the cost of insurance in the later years. For those risks with an indeterminate time horizon, the level premium structure provides peace of mind that the premiums won't escalate beyond affordability.
The common narrative is that whole life consists of a risk component and a savings component, but that's just an analogy. The cash value isn't really savings per se, but rather the reserve that the insurance company has established to pay future claims. The insurance company makes this reserve available to policyholders in the form of loans. If the insured dies with an outstanding loan on the policy, the insurance company will deduct the outstanding loan from the death benefit. Also, if the owner cancels the policy, the insurance company will give them the cash value, since a reserve is no longer required.
Whole life policies can be either participating or non-participating. Participating policies pay dividends, while non-par policies do not. Dividends are comprised of three components – interest rate, mortality (cost of insurance) and expenses. Although virtually all participating policies illustrate dividends, it is important to remember that they are not guaranteed.
In almost all sales, an illustration is used to help explain how a policy works. It is vitally important that the consumer understand that these illustrations are hypothetical, and that there is no penalty to the insurance company if the actual results are less than those illustrated. Usually, the only guaranteed items on the illustration are the initial death benefit, the column marked “guaranteed cash value” and the premium (as long as a reduced premium isn't illustrated).
Whole life policies are appropriate vehicles to insure long-term or indeterminate term risks. They are more efficient for younger insureds, although they can also be an efficient choice for those well into their fifties. They are the most conservative of all the insurance policies.