Universal life insurance is a permanent form of life insurance like a whole life insurance policy but is meant to provide the ability for a higher internal rate of return on the policy like a variable universal life insurance policy, but without bearing the risk of market exposure.
A universal life insurance contract has a cash-value account, and all cost of insurance charges are taken from this account. The policy owner has the ability to fund the contract with as much money as they like (within guideline and MEC limits) and as long as sufficient value exists in the cash value account, the policy will not fall into 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%. As interest rates fluctuate the rate paid by this account will fluctuate as well.
Features of Universal Life Insurance
Universal life insurance is a very inventive and complex life insurance product. At its’ core, you can think about it as a renewing term policy, with a cash value account that can be funded as desired. Any premium amount paid above the cost of the insurance accumulates in the cash account. The cash account is credited with interest, the rate of which is tied to a published rate such as LIBOR.
Here is where it can get complicated. The death benefit of the policy can go above the face amount if the owner chooses this option. This lets the owner put large sums of cash into the policy, while also avoiding it turning into a modified endowment contract. If the death benefit doesn’t rise, it can become a MEC. If the policy is funded sufficiently, the growth in cash value will outpace the rising cost of life insurance. If it is not, this turns into a very expensive policy. Universal life insurance is really only intended for wealthy and sophisticated clients who understand the product completely. Do not buy universal life if you do not fully understand all of the features and are being recommended the product by a trusted advisor.
Rising Cost Of Insurance
The life insurance charges within a universal life insurance contract are similar to a variable universal life insurance contract, priced like a permanent form of nonlevel term life insurance. As the insured person ages, the cost of the insurance will rise, with adjustments to insurance costs happening no more frequently than once a 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 vary but stay below this stated maximum. The 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 or by paying more into the policy as the insured person gets older.
Flexible-Premium Payment Structure
Universal life insurance contracts have a flexible premium structure. This means the owner of the policy can make payments as often as they like, and for any amount, they like (within the guideline premium limits, and with consideration to MEC limits). As long as enough cash value exists in the account to cover the next cost of insurance, the policy will remain active and in good standing.
The flexible premium structure is both convenient for clients and shifts a lot of responsibility for the policy performance on client actions. 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.
Premium payments made are subject to taxes, and when withdrawn 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. Withdrawals are often also subject to a small charge in addition to the surrender schedule. Usually, this is about $20-$50 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 not the death benefit will be reduced by the amount of the outstanding loan. Loans do not need to be paid of on any particular schedule, or at all. If left unpaid, a loan will continue to grow by the amount of interest due each year. Eventually, a large loan will consume all the available cash value, and the life insurance policy will lapse.
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 current cash value by a certain percentage. This keeps the policy “in corridor” and there are no guideline premium limits which 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. While the internal rate of return ultimately realized by the policy is somewhat unpredictable, a high performing variable universal life insurance policy can provide benefits over both whole life insurance and variable universal life insurance, but with additional risks associated with the policy as well. 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.