In this article we are going to look at what the insurance companies do with the overpayment in the early years of a whole life insurance policy.  (Please refer to Part 1, Part 2, Part 3 and Part 4 in this series before reading this article). We know from the previous article in the series that the monthly premiums in the early years of a whole life insurance policy are much higher than the "pure cost of insurance" which is the green line that increases exponentially with age (see below graph). The reason people agree to overpay is that they will be able to afford the premiums later on in life (note how the "pure cost of insurance" indicates the premiums become unaffordable as you get very old).

But what does the insurance company do with the over-payments?  As you can imagine, they don’t just put in under the mattress! They take the money and purchase a bond portfolio (with some stocks and other investments).  Usually the bonds are of a very long term, and of very high credit quality (i.e. 30 year government bonds).  They do this because these insurance policies are going to be in place for a very long time in most cases and they need to make sure that they have the money to pay the claims.  The level of stocks, short term bonds, and bonds of lower credit quality are kept to a minimum.  So, the over-payments you make are put into an investment portfolio by the insurance company to pay for the "underpayments" later on in the policy.  REMEMBER: these portfolios have LOTS of time to grow, and the values of these "overpayment investment portfolios" can become quite large.  This is important to know for future articles in this series. For now, we can see that it lowers the monthly premiums for the entire policy – this is due to factoring the compounding growth of the investment portfolio over time.  So the area under the graph during the "overpayment" phase (early years) will be LESS than the area under the graph of the "underpayment" phase (later years). I should point out that on the graph below, I did not emphasize this difference enough.  To be clear: the reason the area  under the graph (between the pure cost of insurance and the premium amount) for the early years is smaller than the area under the graph in the later years is due to the effect of compounding growth. In Part 6 of the series we are going to look at what happened with Whole Life policies in the 1980’s (high interest rates = high yielding bonds) which caused a lot of change in the life insurance industry thereafter… (I’ll give you a hint: the insurance companies made a lot of money on the bonds and ended up making WAY TOO MUCH profit.)

 If you look at the graph below, you can see that the "overpayments" go into this "overpayments savings portfolio".  This investment account portion of the whole life policy grows over time through growth of the investments and the ongoing contributions.  If you wish you can make withdrawals from this account – known as a policy withdrawal.  But once you do, you have to pay tax on the withdrawal.  It is similar to a capital gain, but it is known as a "policy gain".  The amount of tax you pay is your marginal tax rate multiplied by the difference between the pure cost of insurance and the total amount of premiums you paid, and then pro-rated for how much of a withdrawal you make.  If you were to cancel your policy and forfeit your insurance coverage you would recieve all the excess cash (known as the "cash surrender value") and receive a form that would indicate your gain that would be included as taxable on your tax return for that year.

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