Universal life insurance is a permanent form of life insurance with more flexible terms than a whole life insurance policy. The policy owner has the flexibility to send additional premium payments over what is required, skip premium payments, and you can even increase the death benefit of the policy by over-funding it. A universal life insurance policy is a complicated form of life insurance, and interest is paid on the cash value instead of the policy paying dividends. The actual cost of the insurance rises over the lifetime of the policy and is not guaranteed, and the interest rate on the cash value changes with market interest rate conditions.
As an overview of the policy structure, a universal life insurance contract has a cash-value account, and all cost of insurance charges are taken from this account periodically. The policy owner has the ability to fund the contract with as much money as they like (within guidelines of the policy and the MEC limits given by law). As long as sufficient value exists in the cash value account to pay the life insurance charges, the policy will not fall into the grace period or lapse. The cash value of a universal life insurance contract will pay at least a guaranteed minimum rate of interest, set by law to be no less than 2%. The rate is tied to an index rate, and if interest rates go up the policy will pay higher interest. As interest rates fluctuate the rate paid by this account will fluctuate as well.
How to Understand Universal Life Insurance
As mentioned above, universal life insurance is a complex life insur ance product. There are a lot of different pieces to understanding a universal policy and before you purchase one you should definitely educate yourself in addition to consulting a trusted financial advisor. If not properly managed, a universal life insurance policy can cost a lot of money. In general, we do not recommend that clients purchase universal life unless they are sophisticated and they are wealthy enough to fund the policy extremely well.
A good way to imagine a universal life insurance policy is to think about it in separate pieces. The cash value account is like a savings account that pays at least 2% interest and the payer can put money in whenever they want. The insurance piece is like a renewable term life insurance policy, where every year the price rises as the insured person ages. In later years, the price of the insurance is extraordinarily high. Every month, the insurance charge comes out of the savings account to pay the policy. As long as there is enough money to pay for the insurance the policy will stay in force for at least the face amount.
The interest paid in the account is not taxable as long as the money isn’t withdrawn, so the advantage of a universal life policy is the ability to stuff it full of money early on and let the interest add up. Always look at multiple illustrations of value over time, given different payments and interest rate conditions.
Rising Cost Of Insurance
The life insurance charges within a universal life insurance contract rise over time. As the insured person ages, the cost of the insurance goes up. The adjustments to insurance costs happen no more frequently than once a year but they do tend to rise every single year. When the contract is taken out there is a guaranteed maximum cost of insurance at each age, and almost always the actual cost will stay below this stated maximum. The big issue with the rising price of insurance is that the cost can become very high in late policy years, and the owner needs to be prepared to cover these costs either through cash value growth by funding the policy well and letting the interest add up or by paying way more into the policy as the insured person gets older.
Having a low cash value and paying only the minimum insurance costs is a huge mistake. While it will keep the policy from lapsing for a while, it will be much more costly over the lifetime of the policy than just buying a whole life policy. Only wealthy individuals with the ability to pay well over the minimum insurance charges should consider a universal life insurance policy.
Flexible-Premium Payment Structure
Universal life insurance contracts have this flexible premium structure. The owner or payer of the policy can make payments as often as they like, and for any amount they like. As long as enough cash value exists in the account to cover the next insurance charge deduction, the policy will remain active and in good standing. The minimum amount that must be paid is the amount to cover the insurance charges, but the illustrated premiums will always be more than the minimum.
This is where potential buyers and even owners of the policy tend to get lost. The insurance agent will illustrate premium payments, but the owner does not need to follow the amount or schedule that the agent illustrated at all. The illustration is more of a planning tool to maximize the efficiency of the policy. In a term or whole life policy, the illustration is more directly showing the exact amount and timing of premiums that must be paid.
The flexible premium structure is an advantage for the right person but a detriment for many who do not understand it. The initial illustration assumes that clients will fund the policy at certain intervals and with a certain sized premium, and if clients fail to meet these expectations the policy will not often perform as well as they anticipate.
One extremely important concept to understand is that even if the client pays premiums exactly as they are illustrated, the policy will not necessarily perform as illustrated because the cost of insurance and interest rates paid are impossible to predict exactly.
When withdrawn, the cash value may be subject to surrender charges for a stated rate of time in the contract, usually between 10 and 15 years of the policy issue.
Interest Paid On Account Value
Any excess premium paid over the cost of insurance will accrue in the cash value. This cash value account will usually earn a stated rate of interest. The interest rate will usually adjust as market rates adjust, and is guaranteed to at least pay a minimum return of 2%. Alternately, some universal life insurance contracts have cash value returns tied to an equity index such as the S&P 500.
Withdrawals And Loans From Cash Value
Most universal life insurance policies allow clients to take withdrawals from the cash value, or to take loans from the policy against the value. Withdrawals are usually subject to surrender charges within the first 10 to 15 years of the policy being issued, depending on the insurance company and the particular policy series issued, as they all differ. Surrender charges start high and then decrease over time. They may start at 10% and each year 1% comes off for instance.
Withdrawals are often also subject to a small charge in addition to the surrender schedule. Usually, this is about $20-$50 for each withdrawal, depending on the company.
Withdrawals are only taxable on the gain, and the gain is the last money to come out of the policy for tax purposes (first in first out accounting). Withdrawals will also reduce the death benefit by the amount of the withdrawal, dollar for dollar.
Loans do not reduce the death benefit if paid back, but if there is a loan outstanding the death benefit is reduced by the amount owed. Loans do not need to be paid-off on any particular schedule, or at all. If it is left unpaid, a loan will continue to grow by the amount of interest due each year. Eventually, a large enough loan will consume all the available cash value, and the life insurance policy will lapse. The interest rate on the loan is greater than the interest rate that the life insurance company pays out to the client on the cash value, after all.
Intended Purpose Of Universal Life To Obtain High Value
A universal life insurance policy when well funded, has the potential to grow faster than a whole life insurance policy over time. This is due to the variable interest paid on the cash value of the policy. The policy can also provide more safety than a variable universal life insurance policy because it is not subject to market fluctuation (unless it is equity-indexed).
A policy that is well funded early has the potential to perpetuate itself over time without premium payments being made into the policy after a certain point. Clients must be aware that deviations in the interest rate from the illustrated rate, and deviations in payments made will affect the returns of the policy. Not all policies will necessarily ever become self-sustaining if not funded appropriately.
Some clients may intend a policy to gain significant amounts over time, and then withdraw the amount of the premiums paid tax-free. If done correctly enough cash value will be left in the policy from the gain to continue to keep the policy in force without additional premium payments.
CVAT Death Benefit and Rising Death Benefit
A policy with cash value also can provide a higher death benefit for beneficiaries, if the appropriate options are selected at issue. A policy that uses CVAT for death benefit determination will adjust the death benefit up continuously to always maintain a death benefit that exceeds the current cash value by a certain percentage. This keeps the policy “in corridor” and there are no guideline premium limits that can be violated (guideline premium limits are limits on total premiums that can be paid into a life insurance policy by the government).
A policy can also have a rising death benefit, where the death benefit will rise dollar for dollar with cash value increases, or conversely it will fall dollar for dollar with cash value decreases. A high-performing policy can utilize these options to provide a higher death benefit without new life insurance being issued.
Not An Investment But Alternative Permanent Insurance
A universal life insurance policy can not be marketed to clients as an investment, because policy performance depends on many factors both in the client’s control and not in a client’s control. At Life Ant, we recommend that only clients who fully understand the product consider a universal life insurance contract as a viable permanent life insurance option.
For more reading on Universal Life insurance check out the National Association of Insurance Commissioner’s (NAIC) resource here.