Universal life insurance

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Universal Life is a type of permanent life insurance based on a cash value. That is, the policy is established with the insurer where premium payments above the cost of insurance are credited to the cash value. The cash value is credited each month with interest, and the policy is debited each month by a cost of insurance (COI) charge, which is drawn from the cash value if no premium payment is made that month. The interest credited to the account is determined by the insurer; often it is pegged to a financial index. Because only the amount of interest credited and not the cash value itself varies, UL policies offer a stable investment option. A similar type of policy that was developed from universal life policies is the variable universal life insurance policy, or VUL. VUL's allow the cash value to be directed to a number of separate accounts that operate like mutual funds and can be invested in stock or bond investments with greater risk and potential reward. Additionally, there is the recent addition of Equity Indexed Universal Life contracts that invest in Index Options on the movement of an Index such as the S&P 500, Russell 2000, and the Dow (to name a few). These type of contracts only participate in the movement of Index and not the actual purchase of stocks, bonds or mutual funds. They may have a cap (but not always) as to the maximum amount they will credit interest to and a minimum guarantee which keeps the principle of the contract from losing money in a down year. Typically each year the starting point is last year's ending point which means that: (1) the policy amount is locked end at the end of the year; and, (2)the beginning value from which the movement measured is reset.

Contents 1 Universal life and whole life insurance 2 Uses 3 Types 3.1 Single Premium 3.2 Fixed Premium 3.3 Flexible Premium 3.4 Universal life insurance 3.5 Variable universal life Insurance 4 See also

Universal life and whole life insurance

Universal life is similar in some ways to, and was developed from whole life insurance. The potential advantage of the universal life policy is in its flexibility and the potential for greater cash value growth if the interest rates offered outperform the insurer's general account (that whole life policy cash value growth is based on). Universal life is more flexible than whole life in two primary ways: the death benefit and usually the premium payment are flexible. The death benefit can be increased (subject to insurability) and decreased without surrendering the policy or getting a new one as would be required with whole life. Also a range of premium payments can be made to the policy, from a minimum amount to cover various guarantees the policy may offer to the maximum amount allowed by IRS rules. The primary difference is that the universal life policy shifts some of the risk for maintaining the death benefit to the insured. In a whole life policy, as long as every premium payment is made, the death benefit is guaranteed to be paid if the insured dies. In a UL the policy will lapse (the death benefit will no longer be in force) if the cash value or premium payments are not enough to cover the cost of insurance. To make their policies more attractive insurers often add guarantees, where if certain premium payments are made for a given period, the policy will remain in force even if the cash value drops to zero.

There are two other area's which differentiate Universal Life from Whole Life Insurance. The first is that the expenses, charges and cost of insurance within a Universal Life contract are transparently disclosed to the insured, whereas a Whole Life Insurance policy has traditionally hidden this type of information from the policyholder. Secondly, there are more flexible exit strategies within a Universal Life contract which increases the flexibility of that contract over a Whole Life policy including Zero interest or wash loans which virtually provide the policyholder the ability to access the growth inside the contract "income tax free." There are many variables to be considered. Basically, when you pay into a universal life policy, all of the money goes into a holding account which is invested by the insurance company, at the buyer's direction into one or more kinds of investments. Essentially, the selection of investments being the buyer's responsability, transfers most of the risk in this kind of policy, to the buyer. The investments may range from daily interest and term deposits to mutual funds or segregated funds. [Poorly performing mutual or segregated funds could create negative growth in the policy, requiring additional deposits over and above what was originally projected.] The money in your holding account grows tax sheltered, and from it, the insurance company draws money to pay for your life insurance and administrative costs for looking after this holding account.

There is often a minimum rate of guaranteed growth, roughly at or about 3%. Any growth beyond what is required for cost of insurance and administration accumulates tax sheltered as savings which can be drawn out at a later date for things like education or retirement. Under current tax laws, there is also the possibility of leveraging cash out of this kind of policy by assigning it to a bank and taking a tax free loan against the policy.

The cost of buying a universal life policy varies from a guaranteed minimum to support the cost of life insurance to a maximum only limited by law to keep the policy tax exempt. Paying more money into the policy than is required to keep the life insurance in force, creates a growing pot of tax sheltered cash which can be accessed at a future time. A reasonable expectation of growth in the holding account might be, by today's standards, in the range of 5% to 7% but it could be more or less. This kind of policy is most often used by people who are trying to tax-shelter money and who wish to have future life insurance premiums paid with before tax dollars. Remember, at the 50% marginal tax bracket a 5% sheltered growth is equivalent to a 10% non-sheltered growth. The "net growth" is what's important, not the "gross".

The Income Tax Act of Canada imposes certain restrictions on Universal Life policies. If a person intends to overfund a universal life policy, it's important to pay attention to the 10-year, 250% rule. This rule limits contributions to a policy as of year 10 forward to 2.5 times the fund value 3 years previously. This anti-dump-in provision may come as a shock to policyholders who do not make earlier fund deposits of a sizeable amount. The Income Tax Act also allows a policy's death benefit to grow each year. The 8% test limits how much additional deposit room is created in the policy as a result of the growth. The 8% rule only applys to those who are making maximum deposits into their policy.

Uses

Universal Life is used as a tax-advantaged way to purchase life insurance. In the early years of the contract, the premium far exceeds the cost of insurance (COI) charges. The difference between the two (the "inside build-up") will grow tax-deferred so long as the policy remains in force. If the policy is held until death, this inside build-up will escape taxation entirely. Policyholders may also be able to access the inside build-up via a policy loan without incurring it as taxable income.

Types

Universal Life policies are among the most difficult of all life insurance contracts to compare. Generally, it is impossible to make an apples to apples comparison because there are so many variables relating to investment options, when and how much investor bonus is paid, if any, surrender fees and management fees. The constant factors on which we can focus are; (a) Cost of insurance; (b) Whether the cost of insurance is level (Term to age 100) or increasing yearly (YRT -yearly increasing term); (c) Growth rate assumption, probably between 5% to 7%; (d)Amount of initial death benefit; (e) Amount of money to be deposited; (f) Number of years deposits are to be made; (g) What your objective is, ie, maximize cash surrender value at a certain age, guarantee insurance coverage for life, guarantee paid up policy within certain time period, etc.

Single Premium

Single Premium UL is paid for by a single, substantial, initial payment. The policy remains in force so long as the COI charges have not depleted the account.

Fixed Premium

Fixed Premium UL is paid for by periodic premium payments. Generally these payments will be for a shorter period of time than the policy is in force; for example payments may be made for 10 years, with the intention that thereafter the policy is paid-up. If the experience of the plan is not as good as predicted, the account value at the end of the premium period may not be adequate to continue the policy as originally written. In this case, the policyholder may have the choice to either: 1. Leave the policy alone, and let it potentially expire early (if COI charges deplete the account), or 2. Make additional or higher premium payments, to keep the death benefit level, or 3. Lower the death benefit.

Flexible Premium

Flexible Premium UL allows the policyholder to determine how much they wish to pay each time premium is due. In addition, Flexible Premium UL offers two different death benefit options: 1. A level death benefit (often called Option A), or 2. A level amount at risk (often called Option B). This is also referred to as an increasing death benefit.

Policyholders frequently buy Flexible Premium UL with a large initial deposit, thereafter making payments irregularly.

Universal life insurance

Universal life insurance (UL) is a relatively new insurance product intended to provide permanent insurance coverage with greater flexibility in premium payment and the potential for a higher internal rate of return. A universal life policy includes a cash account. Premiums increase the cash account. Interest is paid within the policy (credited) on the account at a rate specified by the company. This rate has a guaranteed minimum but usually is higher than that minimum. Mortality charges and administrative costs are charged against (reduce) the cash account. The surrender value of the policy is the amount remaining in the cash account less applicable surrender charges, if any.

With all life insurance, there are basically two functions that make it work. There's a mortality function and a cash function. The mortality function would be the classical notion of pooling risk where the premiums paid by everybody else would cover the death benefit for the one or two who will die for a given period of time. The cash function inherent in all life insurance says that if a person is to reach age 95 to 100 (the age varies depending on state and company), then the policy matures and endows the face value of the policy.

Actuarially, it is reasoned that out of a group of 1000 people, if even 10 of them live to age 95, then the mortality function alone will not be able to cover the cash function. So in order to cover the cash function, a minimum rate of investment return on the premiums will be required in the event that a policy matures.

Universal life policies guarantees, to some extent, the death proceeds, but not the cash function - thus the flexible premiums and interest returns. If interest rates are high, then the dividends help reduce premiums. If interest rates are low, then the customer would have to pay additional premiums in order to keep the policy in force. When interest rates are above the minimum required, then the customer has the flexibility to pay less as investment returns cover the remainder to keep the policy in force.

The universal life policy addresses the perceived disadvantages of whole life. Premiums are flexible. The internal rate of return is usually higher because it moves with the financial markets. Mortality costs and administrative charges are known. And cash value may be considered more easily attainable because the owner can discontinue premiums if the cash value allows it. And universal life has a more flexible death benefit because the owner can select one of two death benefit options, Option A and Option B.

Option A pays the face amount at death as it's designed to have the cash value equal the death benefit at age 95. Option B pays the face amount plus the cash value, as it's designed to increase the net death benefit as cash values accumulate. Option B does carry with it a caveat. This caveat is that in order for the policy to keep its tax favored life insurance status, it must stay within a corridor specified by state and federal laws that prevent abuses such as attaching a million dollars in cash value to a two dollar insurance policy. The interesting part about this corridor is that for those people who can make it to age 95-100, this corridor requirement goes away and your cash value can equal exactly the face amount of insurance. If this corridor is ever violated, then the universal life policy will be treated as, and in effect turn into, a Modified Endowment Contract (or more commonly referred to as a MEC).

But universal life has its own disadvantages which stem primarily from this flexibility. The policy lacks the fundamental guarantee that the policy will be in force unless sufficient premiums have been paid and cash values are not guaranteed.

Universal life policies are sometimes erroneously referred to as self-sustaining policies. In the 1980s, when interest rates were high, the cash value accumulated at a more accelerated rate, and universal life coverage was often sold by agents as a policy that could be self-paying. Many policies did sustain themselves for a prolonged period, but the combination of lower interest rates and an increasing cost of insurance as the insured ages meant that for many policies, the cash option was diminished or depleted.

Variable universal life Insurance

Variable universal life Insurance (VUL) is not the same as universal life, even though they both have cash values attached to them. These differences are in how the cash accounts are managed; thus having a great effect on how they are treated for taxation. The cash account within a VUL is held in the insurer's "separate account" (generally in mutual funds, managed by a fund manager).

• Variable universal life insurance
• Group permanent life insurance
• survivorship universal life insurance
• group universal life insurance

See also