The Visible Policy
Page 7, Deconstruct That!
How Does Participating Whole Life Insurance Work?
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Under the Hood

Let us get our hands dirty and lift the hood on my '96 Policy WL.  Inside we will see that there is not just one engine.  Four interrelated "machines" function together to keep this baby running smoothly.   opened hood with 4 engines

To fully understand what is under the hood, we also need to examine several concepts underlying the operation of the machines.

As I describe the policy machines below, understand there is not actually an "account" for my policy's cash value.  It is not segregated from the cash value of other policies.  To describe how my single policy can function profitably on its own, it is easiest to imagine that a separate account does exist.  In reality, the machines function at the mutual level, involving all participating policies.

Core Policy Machine

Dividends may never be reinvested.  There may never be additional insurance purchased above the $100,000 face value of the policy.  Therefor most of the inner-workings of the policy need to exist within the Core Policy Machine.  Known components of this machine include:
  1. premium payment, $1764 annually
    After the second policy year, I believe this breaks down something like:
    • [~ $52 to ~ $152] to commission, taxes, and fees
      In policy years 3, 4, and 5, this is probably around $152.  After that, it seems to decrease a lot; I do not know how much.  Since $100 is a nice round number, let's send $100 more per year to investment.
    • [~ $152] to cost of insurance
    • [~ $160] to premium rebate (credited as dividend)
    • [~ $1300 to ~ $1400] to a clocked investment mechanism
      After the fifth policy year, this probably increases to at least $1400.

  2. commission and other fees
    Money for commission comes from my premium payments.

  3. Guaranteed Cash Value (GCV)
    This comes into existence at the end of the third policy year.  By the end of the sixth, the increase in GCV will almost always be greater than the premium payment, usually by hundreds of dollars.  Obviously there is an assist from core earnings.  (If I keep the policy into my 80's, cost of insurance drags down the increase in GCV below the annual premium payment.)

  4. accumulator
    Money not yet accounted to the policy is stored here.  While within the accumulator, this money does have earnings, probably about as much as a high-quality bond fund (currently about 7.5%).  Since it is internal to the machine, it cannot be detected, but something is helping to pay for the increases in Guaranteed Cash Value.
    • clocked investment earnings
    • premium rebate earnings
    • (possibly) inner accumulator
      During the first and second policy years, much of the premium is devoted to commission and one-time fees such as the required blood test.  I do not believe all of it is used up, however.  It is quite possible that whatever investment dollars are left during those two years are stored with the account. These will be distributed as part of Guaranteed Cash Value.  One scenario would have this distribution be about $200 per year, beginning at the end of the fourth policy year.  The inner accumulator has earnings of its own, so it could feed GCV $200 per year for several years.

    • core earnings spigot
      Extra money will eventually be needed on an annual basis.  As time passes, the annual gain in Guaranteed Cash Value (GCV) becomes significantly higher than the entire premium payment.  When this occurs, the spigot is opened, releasing the exact amount of money needed.  This money is not "dividends"; it is literally payments from the core earnings of the mutuality given to my account to meet the policy's contractual commitments.  Hence, I do not even try to attach a "rate"; the job of the actuaries who designed my policy was to assure that under the worst potential circumstances, NYLIC could meet its contractual commitments to me and other policyholders.
The core earnings spigot links the fiction that my policy is isolated from all the others, to the reality that all the participating policies operate as a mutual whole.  Most of the policy's cash value exists as legal reserves (usually referred to as simply "reserves"), which are mostly invested in high quality bonds.  Reserves are required by law to backup each permanent policy.

Dividend Machine

You are probably as tired of reading it as I am of writing it:  "Dividends are not guaranteed."  People I respect have indicated that this is an extremely important point which cannot be overstated.  (Well, if it can be, it will be on my site, gosh-darn it!)  Anyway, assuming there is a divisible surplus during a policy year, here are the components which make up the Dividend Machine:

In 2001, the Equitable Life Assurance Society in the United Kingdom virtually collapsed.  This is a very old mutual, older than the United States of America.  One of the primary reasons for the collapse was that they had no surplus reserves.  The surplus did not run out; in utter hubris the management at the time felt that no surplus was necessary.  Hard times hit, and now they face a huge shortfall.

There are sites on the web which claim to represent the interests of the policyholders.  A common complaint is that the huge surplus of such&such a mutual insurance company is cheating the policyholders.  These folks have it backwards.  A large surplus, with conservative actuaries guarding it from shortsighted managers and marketers, is the main guarantee policyholders and annuitants have that their funds will still exist 30 years down the road.

Paid-Up Additions (PUA) Cash Value Machine

When more insurance is bought, essentially one of two mini-policies is created or extended.  My annual statements make it clear they are accounted separately.
  1. PUA purchased by reinvested dividends
  2. PUA purchased via my OPP rider

Each secondary policy has two kinds of earnings:

  1. linear increase in value (LIV), guaranteed
    This money comes from core earnings, and is distributed before the divisible surplus.  In a way, it corresponds to the increase in guaranteed value within the Core Policy Machine.  The increase is linear, not compounded.  Here is a simplified example.  At age 50, I buy $2500 in Paid-Up Additional insurance.  It costs $1000 ($1031 if OPP, which includes a 3% load).  Since the policy matures in 50 years, there will be 50 linear payments of $30:

    (2500 - 1000) / (100 - 50) = $30

    LIV may be thought of as a ramp or as a percent of goal (%g).  As a ramp, it is simply a straight line from $1000 to $2500.  As a percent of goal, no matter which year, it is 30/2500=1.2%g.  (The previous two sentences continue the example.)  For reasons only Fred the Actuary fully understands, LIV isn't exactly linear.  It is pretty close, though, and at age 100, PUA Cash Value will be equal to PUA Death Benefit.

    LIV is to Paid-Up Additions what GCV is to Base Death Benefit.  About the only difference is that GCV accumulates even less linearly.

  2. PUA cash value eligible to earn dividends
    Dividends are never guaranteed.  Usually they are paid, however, and always in a "compounding" manner (ie, dividends earned one year earn dividends of their own the next year).
Paid up additional insurance can be sold back.  It is sold at its original purchase price.  Earnings gained via linear increase in value become orphaned cash value.

Loan Machine

The ability to take out a loan from the insurance company, using the policy as collateral, is an important benefit to many policyholders.  I have not taken a policy loan to date, so my knowledge of this machine is limited to what the policy says about loans, and what several experts have told me.

The loan interest rate varies.  On my policy, it will never go lower than 5.5%.  For as long as I have been monitoring it, the rate has been 7.57%.  The maximum rate is determined as follows:

Quote from Policy
... The loan interest rate will not be more than the Monthly Average Corporate yield shown in Moody's Corporate Bond Yield Averages published by Moody's Investor Services, Inc., or any successor to that service ...

NYLIC can set the rate as often as every three months.  A rate change is applied to pre-existing loans.  Certain other companies offer a fixed interest rate for loans, as set within each policy.  The trade-off is that these companies lower the dividend crediting rate on your policy while a loan exists.

from:  Ricky's Guide for the Participating Whole Life Connoisseur
direct recognition non-direct recognition
dividend rate lowered by loan dividend rate unaffected by loan
fixed loan interest rate varying loan interest rate

So far I have not described much of a machine.  The policyholder gets a loan, using the policy as collateral.  He pays it back with interest.  No big deal.

However, this simple scenario is probably an infrequent use of a policy loan.  The really unique thing about a life insurance policy loan is that you may not have to pay it back (at least not while living).

Now this is a machine!  Here are some of the details.
  1. not taxed
    The IRS does not tax loans.  It does not matter whether it is a traditional loan from a bank, or a policy loan from an insurance company.  (But see item 3 below.)
  2. no risk to the insurance company
    They have your policy as collateral.  You already have a lot of your policy's money.  They do not have to give that part again to you or your beneficiary.  A loan cannot be taken for more than the cash value of the policy.  Should a policy anniversary occur, and the loan principle plus interest be greater than cash value including new dividends, the difference must be paid within 31 days.  You will receive formal notification should a shortfall occur.
  3. additional risk to policyholder or beneficiary
    • If you surrender the policy while a loan is outstanding, cash value will first be used to pay principle plus interest, then the remaining cash value will go to the policyholder.  The insurance company will automatically terminate the policy if you were notified that there was a cash value shortfall, and you did not make up the difference.
    • Should the policy be surrendered or terminated, the IRS will consider the loan to have become income .  Policy income will include the loan principle plus any cash value received from the policy after the company subtracts what you owe them.  That portion of this sum which exceeds cost basis will be taxed as ordinary income (i.e., generally more than capital gains).
    • If you are lucky enough to die before the loan is repaid, the IRS does not try to unscramble eggs.  The loan remains a loan, and it is not taxed.  However, your beneficiary is affected.  The loan principle and outstanding interest is deducted from the Death Benefit, and she receives the remainder.  Death benefit distributions are not considered taxable income, although it is possible estate taxes could apply.
  4. interest due at the end of each policy year
    It accrues each day, though.  (Certain other companies pre-charge interest at the beginning of the year, in expectation that the loan will not be repaid during the year.)
    • If the interest is paid out of pocket, the other policy machines are unaffected.
    • Dividends and/or sell backs of PUA may be used to pay interest.  Obviously, the related policy machines will be affected if their fuel is reduced.  The policyholder cannot sell back PUA if this would reduce the policy's cash value below the loan principle.
    • If the interest is not paid by one of the preceding methods, your loan will automatically be increased to cover the amount of interest due.
    • Interest payments on your loan make up for the earnings the mutuality is not gaining on the loan principle.  If the principle were still with NYLIC, it might be earning 7.5%, benefiting all mutuality members.  You make up the 7.5%.  Thus all members, including yourself, still benefit from its earnings.  The principle remains invested — in you.
  5. loan repayable at any time
    So long as interest payments are made, and the policy cash value exceeds principle, the loan can be repaid in three months or three decades.
  6. loan used any way policyholder desires
    The insurance company does not care what you do with the loan money.  You can make a down payment on a house, invest in mutual funds, or blow it in Las Vegas.
  7. automatic premium loan
    The policyholder may request that his annual premium be paid by a policy loan.  If the policy has sufficient cash value, NYLIC will do so.  However, the policyholder cannot pay more than two consecutive premiums with a loan.


Here we will describe several terms which are not machines unto themselves, but help explain how the entire policy engine works as a whole.

Reserves:  the Bigger Picture

My goal in this section is to give a broader view of the policy machines.  We'll look at the mutuality itself, known as NYLIC.  Since its wholly-owned subsidiary NYLIAC also sells insurance products, we'll look at that as well.

NYL is split this way for several reasons.  Fixed annuities and universal life insurance involve conservatively invested funds, but their rate of return is expected to vary more frequently as the economy changes.  Thus the reserves backing up those policies must be more dynamically invested than those for whole life and term policies.  The reserves of NYLIC tend to be invested for maximum stability, typically in long and medium term bonds.  It is also generally wise to separate the assets of the owners ("participants" with whole life polices) from customers (all other policyholders).

The variable products involve separate accounts, with the policyholders having direct control of their investment.  They can move their cash value as they like between a variety of these accounts, which are basically mutual funds.  Essentially, the policyholders of these products are responsible for their own reserves.  However, unlike whole life, universal life, and fixed annuity policyholders, the variable policyholders directly own and manage their cash value.  For everyone else, their cash value is owned by the policy, not the policyholder.  This cash value is in the "general accounts", which make up most of the reserves.

Much of the income related to a mutual insurance company derives from earnings on its reserves.  There are two main classes of reserves:

Let us peek into New York Life.  Information in the following table is derived from their 2001 Annual Report.

(millions) 31 December 2001 31 December 2000
total legal reserves
(incl. deposit funds)
$57,432 $21,085 $54,963 $17,567
total surplus reserves $8,534 $1,542 $8,516 $1,308
bonds (part of reserves) $44,936 $19,273 $41,141 $15,604
premium income
(incl. deposit funds)
$10,733 $5,193 $10,143 $4,222
investment income $4,826 $1,476 $4,683 $1,363
benefit payments $4,047 $1,816 $4,568 $2,117
withdrawals $3,991 --- $6,650 ---
increase to reserves $3,868 $4,193 $1,016 $3,046
net gain after taxes $2,602 $-40 $2,331 $8
dividends $1,408 $1 $1,512 $1
increase to surplus $18 $234 $61 $-37

There is a lot more data in the official Report.  I only display the information necessary for this topic.  I wanted to illustrate:

I believe this pattern to be generally true for American mutual insurance companies.  In the United Kingdom and many other countries, the economies do not have a long history of available high-quality bonds.  Thus the mutual life insurers (and stock companies) have a much higher reliance on stocks within their reserves.

Cost of Insurance

If the policyholder dies, the beneficiary gets paid more than accumulated cash value.  The extra money has a cost, called cost of insurance (COI).  Within my participating Whole Life policy, this cost is split into two or three parts.  The primary part involves the policy's base death benefit.  In my case, this remains $100,000 for the entire life of the policy.  My premium payments must cover this cost of insurance.

The other two parts involve the two PUA sub-accounts (PUA purchased by dividends, and PUA purchased directly via a policy's OPP rider).  As stated above, the cash value of these sub-accounts gets a little higher each year, and at policy maturity, the PUA cash value equals the PUA death benefit.  However, if you die before the policy matures, then there is a cost of insurance relating to the PUA.  However, this cost is not paid by the premium.  The premium remains the same whether there is $0 PUA or $77,000 PUA.  A feature exclusive to participating Whole Life policies is that the mutuality as a whole pays the cost of insurance for PUA.  It is like a last tribute bestowed to an owner upon his death.

Within the Base Policy Machine, cost of insurance is in an arithmetic war for the life of the policy.  On the one hand, as a policyholder ages, it gets more expensive to insure him.  (I.e., he is more likely to die.)  This drives COI up.  On the other hand, the amount which needs to be insured grows less and less.  I call this amount the Insured Death Benefit (IDB).  IDB grows smaller because guaranteed cash value (GCV) will cover part of the death benefit should the policyholder die.  In other words:

InsuredDeathBenefit = BaseDeathBenefit - GuaranteedCashValue

Since GCV increases over policy life, IDB decreases.  Thus the COI remains manageable for the policyholder's life.  Even though the cost per $1000 of insurance gets very high for someone above 60 years old (and then higher), there are less and less thousands needed.

Cost Basis

The total amount paid for a life insurance policy is called cost basis.  On a whole life policy it includes the sum of all premium payments made with out-of-pocket cash.  It also includes the price paid for extra PUA bought under an OPP rider (Option to Purchase Paid-up additional insurance).  Any distributions you receive from the policy are subtracted.  Dividends which you choose to reinvest in the policy (via normal PUA purchases) do not affect cost basis.  If dividends are not reinvested, they are considered refund of excess premium and are not added to the cost basis.

Money you borrow from your policy does not lower cost basis.

A policyholder has the right to permanently withdraw cash value from his policy, so long as the remaining cash value within the policy is greater than or equal to cost basis.  In a participating Whole Life policy, this involves PUA sell-backs.  (I am not sure, but it is likely that any orphaned cash value would be withdrawn first.)  These withdrawals are not loans; part of the policy's cash value is transferred tax-free to the policyholder.  It is considered a tax-free event because you paid for the policy with after-tax dollars, which you are simply getting back.  If the policy allowed a withdrawal below cost basis, then there would be a taxable event.  Of course, any money that is withdrawn lowers the policy's cost basis.

Orphaned Cash Value

It is possible to sell back some or all of the accumulated Paid Up Additional Insurance.  This is commonly done is to help pay the premium internally to the policy, so that the policyholder does not have to pay it from out of his pocket.  Dividends are the normal means to pay internally.  However, if one wishes to stop paying in as few years as possible, dividends by themselves will not be sufficient.  By selling back some of the PUA, enough money can be generated to pay the premium.  Eventually, dividends are projected to be sufficient, and PUA need not be sold back any more.

New York Life projected that my policy might begin "paying for itself" after 12 years.  For the next nine years, it would be necessary to supplement the dividends by selling back PUA.  Each year, dividends would be higher and the amount of PUA sold-back would be less.  During this period, total Death Benefit would reduce from $110,052 to $103,425.  In the tenth year (my 22nd policy year), dividends would finally be sufficient in and of themselves.  Dividends would once again start purchasing PUA if I so chose, and total Death Benefit would begin rising again.

There is a negative side effect to all this, however.  When PUA is sold back, the linear earnings gained by that PUA are not fully recovered.  Much of it remains within the policy as orphaned cash value (OCV).  Why is this negative?  Because the "orphaned" cash is no longer part of the PUA Cash Value Machine.  It will no longer have linear earnings of its own.  It is still part of the cash value basis eligible to earn dividends, but it has been cut off from the guaranteed earnings of the PUA machine.  In other words, orphaned cash value acquires the same status as cash value accrued via Guaranteed Cash Value.

I personally choose not to sell back PUA.  If for some reason I was not able to sufficiently fund my policy to avoid this (due to unemployment, etc.) then I might do so out of necessity.  Otherwise, it would annoy me too much, watching the PUA insurance drop $7000 or more while inflation is decreasing the spendable value of my base death benefit.  PUA is a feature of Whole Life insurance not available to other types of permanent insurance.  Selling it back when one does not need to do so essentially robs the policy of one of its advantages.

Why does Orphaned Cash Value Exist?  Don't worry; nothing unethical is happening.  The cash still belongs to the policy.  In addition to earning dividends, it is available as loan value.  If the policy is surrendered, the policyholder gets it all back.  It is used to help pay the Death Benefit associated with PUA remaining within the policy.  Here are some values from my policy illustration, with the aforementioned nine years of PUA sell-backs:


PUA Cash Value
plus OCV

Death Benefit

DB Funded

 3 $160 $534  30.0%
12 $4,833 $11,968  40.4%
21¹ $3,568 $3,425 104.2%
25 $4,387 $4,485  97.8%
30 $7,424 $8,609  86.2%
¹TCV = $37,068
¹TDB = $103,425
21² $19,770 $37,828  52.3%
²TCV = $53,270
²TDB = $137,828
²Estimate if payments had continued for 6 more years.
$33,000 vs $21,168 out-of-pocket dollars.

The first Year 21 is shaded because PUA DB is lowest then.  As you can see, PUA CV plus OCV is actually higher that year than the associated Death Benefit.  As the notes show, Total Cash Value is still significantly less than Total Death Benefit.

In the 22nd year, dividends become high enough so that PUA can begin to build up normally again, and PUA DB is soon higher than its Cash Value.  Policyholders who do not sell back PUA get more bang for their Death Benefit buck.

The second Year 21 represents a case where normal premium payments continued until dividends were high enough that no PUA sell-backs were necessary.  (This "extra-payment" case is referred to as XP elsewhere on the site.)

Accesses since 6 June 2001
last modified 22 November 2010
© 2001 - 2010 by Rich Franzen

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No content within The Visible Policy has been approved, authorized, or verified by New York Life or any of its representatives.  I have attempted to fairly and accurately portray the policy, but there are likely to be mistakes.  Over time, I shall endeavor to correct any misinformation found herein.
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