Universal Life Insurance, also called Flexible Premium Adjustable Life Insurance, is a more flexible version of Whole Life Insurance. Universal Life was introduced during the latter half of the twentieth century (the early 80’s) as a way to offer the protection of Term Life Insurance along with a savings element. It provides more flexibility than Whole Life, because the owner can shift their money between the insurance and saving components of the policy in order to meet different needs. In other words, the flexibility comes in that the policyholder can increase the death benefit at the expense of the savings component. It can be a valuable estate planning tool for some investors especially when used in conjunction with Trusts.
Premium payments are split between providing term life insurance coverage and a cash value account. Effectively, all premium payments are deposited to the policyholders account and then the account is charged for the cost of term life insurance as well as administrative fees.
The insurance company uses the funds in the cash value account to make investments, and when the insurance company earns a return on those investments, you share in those profits. Usually the insurance company will invest the money in relatively low-risk instruments such as corporate or U.S. Treasury bonds, mortgages or mortgage-backed securities and money market funds. The return on investment is credited back to your policy, tax-deferred. Depending on your contract, the insurance company may offer a guaranteed minimum interest rate (though it can also be pegged to an index or other financial factor), so regardless of how well their investments perform, you still get a certain minimum return.
Of course, at inception, the guaranteed rate of return and premiums are set at a level where the insurer is able to generate a reasonable profit margin for their services (which include the death benefit coverage, the investment management and account administration). Additionally, since the cost of the term insurance is not fixed, it is able to fluctuate with market forces. If the insurer generates a rate of return in excess of specified thresholds, the rate of return credited to the balance of your account may increase as well (depending on the terms of your contract).
Policyholder Retains Risk
However, it is important to note that the guaranteed interest payment does not mean that the policyholder bears no risk. Depending on the economic environment, inflation and other factors, the cost of the term insurance component may increase to a point where all of the premium or an even greater amount is necessary to pay for the term component of the life insurance coverage. This means that the cash value account is drawn down and the policyholder may have to increase the amount of premium payment to address the issue.
This happened to many investors who purchased policies in the 1980’s, when interest rates were at historic highs. As rates fell, the returns that were expected when the policy was originally priced did not materialize and policyholders found themselves needing to increase their premium payments to make up for the investment return shortfalls.
Increase the Face of your Policy
Subject to a medical examination and insurability, the policyholder can increase the face of their life insurance coverage. This increase simply results in a larger charge against your cash value account for the incremental coverage. Obviously, to maintain the cash value account, you will need to increase the premium payments (unless the returns on your account are excessive).
Depletion of the Cash Value Account
If no premium payment is made, or if the payment made is insufficient to cover the cost of the term life insurance (and administrative fees), the cash value of the account is drawn upon by the insurer of the policy. Once the cash value of the account is brought to zero, the death benefit is no longer in force and the policy lapses.
You also have the ability to take a loan out against the account value or make withdrawals from the account as necessary. However, loans require that you pay interest to the insurance company (either you are borrowing directly from them with the cash value account as collateral or you are reducing the balance of the cash value account, which means the insurance companies have fewer funds with which to invest, thereby reducing their returns on investment). Principal repayment is not required; however loan interest is deducted from the cash value account if not paid directly.
Withdrawals are usually tax free, up to the amount of premium invested in the cash value account. Withdrawals in excess of the premiums invested generally result in taxable income. Some contracts also charge withdrawal fees or penalties, so be sure to read your contract in detail before withdrawing funds.
Additionally, withdrawals and loans result in a lower cash value for payment as a death benefit. While the ability to borrow or withdraw from the account is one of the benefits of universal life insurance policies, policyholders need to consider the disadvantages of doing so.
Universal Life Insurance gives you two benefit options in case of death:
The first option will pay the benefits out of the cash value of the policy (up to the face of the contract). The more cash value your policy has, the less the insurance company is personally responsible for, and the less your policy costs them. Your insurance premiums will vary based on the balance of the cash value account, since the difference between this balance and the face of the policy is the amount the insurance company is responsible for.
The second option pays the face value stated in the contract, in addition to any cash value you accumulate over the years. Since the death benefit is a fixed amount for the life insurance company, this costs the insurance company more. The increase in liability for the insurer means that your premiums will be higher than with the prior option.
Insurance companies are also willing to sell you a “no-lapse guarantee”, which is where the death benefit is guaranteed regardless of the balance in your cash value account. You will need to pay the minimum premium designated in order for the policy to remain in force. Make no mistake though, the cost of such a guarantee is factored into the price of your premium. However, these policies generally remain in effect throughout your possible life-span (up to 121 years of age).
In contrast to traditional Whole Life policies, with Universal Life, you choose how you pay the premiums. With whole life, you must pay by a certain date, before the end of the grace period, or your policy lapses. With Universal Life, you choose the premium payments in a specific period, or may choose not to pay anything at all. Your responsibility is to keep the cash value account above the level necessary to keep the policy in place.
However, there are some rules about premium payments. Though a Universal Life policy owner may choose not to make a premium during a certain billing period, any payments they do make must meet a certain minimum to help the carrier manage the costs of collecting and processing premiums.
Three Premium Types
Generally there are three premiums associated with Universal Life policies. Those are: minimum premiums, target premiums, and maximum premiums.
A minimum premium, when paid, is usually just enough to keep the policy going another year without accruing any cash value. Remember though, that if you pay too little for too long, your policy may lapse.
The target premium would keep the policy in effect for the lifetime of the policy owner. However, there is no guarantee that the policy would last that long if that specific amount is paid. That’s simply the target. Universal Life never guarantees a length of policy regardless of the premium paid.
Maximum premiums are the largest amounts you may pay and still enable the policy to maintain its character as an insurance policy. If you pay too much, the policy becomes an MEC (Modified Endowment Contract) and loses its tax benefits.
If you’re considering a Universal Life Insurance policy, make sure you plan to have it for a while. You can’t become eligible for any kind of return on the policy until you’ve had it for at least 15 years. Also, if you plan to keep it until much later in life, it might be wiser to consider a term life insurance plan, paired with a retirement plan like a 401K. See our discussion on how to transform term life insurance to permanent life insurance.
As with all insurance policies, insurance companies price policies differently. Therefore, it is critical that you compare universal life insurance quotes to find the most affordable universal life insurance policy available to you. Be specific, providing the insurance companies with as much information as reasonably possible (and relevant) and then make sure that the terms quoted to you are comparable. Comparing a policy that offers a no-lapse guarantee with one that does not will only confuse the situation.
Universal Life Insurance policies are complicated contracts and while many features are relatively standardized, each contract is unique. Before investing in a Universal Life Insurance policy be sure to speak with a financial planner, tax accountant, estate planning attorney or other trusted advisor. Additionally, read through the contract in detail (and ask your financial advisor to do the same) to make sure that you are comfortable with the specific terms. Lastly, find a reputable insurance company with whom to work, since you want them to be around throughout your life-time (and beyond) to meet their contractual obligations. Our life insurance quote comparison service can help you find such an institution.