How Universal Life Insurance Policies work – a Simplified Guide

Universal Life policies first became popular in the early 1980s, and had been developed a few years earlier.  They are considered unbundled policies, in that the various parts of an insurance policy, which include the term insurance, the cash value and the expenses, are priced separately and stated in the contract.

universal life insurance – a simplified guide

This was a response to other styles of life insurance like whole life insurance and what many people saw as their disadvantages.  With a traditional whole life policy, there is a premium per $1,000 of coverage depending on the policy owner’s age, sex and health.  This premium includes allocations to the insurance, the expenses and profits of the insurance company, and the allocation to the cash value.  However, none of these costs are broken out for the consumer.  For example the cost of the insurance is not stated.  The investment portion of a participating whole life policy comes from the insurance company returning part of the premium after determining their expenses and profitability.  The rate of return on this portion is variable, but has been quite stable over time.  The insurance company decides what the rate of return will be.

Investments and Cash Surrender Value

The cost of the insurance and the expenses need to be paid for.  This is often referred to as the minimum premium.  More premiums than the minimum can be paid into the policy, and these extra premiums go into the investment portion of the policy to create the cash value.  By over funding the premium can be paid in as little as 5 years.  So the premiums can be adjusted over time, compared to other policies with fixed premiums.

The investment fund will have options as to what can be invested in, and multiple options can be chosen.  Options can include guaranteed investment certificates, and funds featuring stock or bonds, or a combination.  There can be funds that allow investments from other countries or sectors.  Many insurance companies have features they use to help promote themselves above the competition.  They may include funds from other companies like mutual fund companies.  However one needs to look at how expensive some of these funds may be in a universal life contract.  The expense of these funds is measured by their management expense ratio (MER), which is deducted from a fund before the investor gets the rate of return.  Some companies have special hybrid investments available like BMO who has a investment options that uses option calls to guarantee there is never a year with a negative return for that fund.  Investment options need to be monitored over time

Insurance Cost

A Universal life policy, in contract, has a stated cost of insurance, stated and often guaranteed expenses, and a choice of investment options that the client can choose.  Two types of insurance can generally be chosen, annual renewable term insurance, or guaranteed term to 100 insurance.

Annual Renewable Term Insurance

Annual renewable term insurance starts out very cheap, as the cost for this insurance is based on the cost to insure a person for one year.  The cost to insure a young person for one year is very low, but very high for an older person.  The cost of this insurance increases every year, and increases on a curve, or at an increasing rate.  So it is important to do projections over a lifetime if one uses this type of insurance.

The idea with annual renewable term insurance is to pair it with a growing investment account.  That means that there is enough funding going to the policy to have the cash value growing at a significant rate, as well as have insurance and expenses paid for.  In that case the cash value can grow to a point where the cash value becomes a major portion, or all of the protection.  The consumer is becoming self-insured by using the lowest insurance cost, while building their own fund which they own and control.

However a universal life policy can go very wrong if it has annual renewable term insurance, and is not properly funded, or monitored over time.  In that case the constantly increasing cost of insurance can eat up the accumulated cash value, and the policy can become too expensive to keep.  If one is concerned about the status of their existing universal life policy, they can request an inforce illustration to show a projection of the current insurance costs and cash values.

Term to 100 Insurance Cost

The other cost of insurance available is guaranteed term to 100.  This insurance has a guaranteed level cost over the life of the insurance policy.  The cost of the insurance is initially higher than annual renewable term, but never increases in premium.  The term to 100 uses one premium which is blended that covers the cost of the insured over their lifetime.  It also never expires.  The initial premium will cover the cost of the term to 100, so the cost of the premium will also never have to increase.

Again one can pay more than the cost of the term 100 to build up a cash value in the investment portion of the Universal Life policy.   One can accumulate a large cash value, or a smaller one, depending on the insured’s needs.  One can plan to have enough cash value, as an example, to be able to pay for the insurance premium during one’s retirement years from the investment earnings of the cash value.  One needs to be conservative in one’s estimates though, because investment results are not guaranteed.

A benefit of universal life policies is that the cash value can be set to be paid as a death benefit to the beneficiaries in addition to the life insurance.  Insurance benefits are paid tax free.  This is in contrast to a whole life policy where the cash value is part of the life insurance, and only the life insurance benefit is paid.

Expenses

The annual expenses of a universal life policy are usually guaranteed and are expressed as an annual or monthly cost.

Advantages of Universal Life Policies

  • Increased transparency of insurance, expenses and cash values
  • Potential lower cost of insurance and lowest cost of permanent life insurance
  • Potential for better investment returns
  • Expenses guaranteed not to increase
  • Ability to choose a wide variety of investments based on the policyholder’s preferences and comfort level.
  • The ability to take money back from the cash surrender value without creating a policy loan or partial surrender of the policy.
  • The ability to have the cash value and the death benefit both pass tax free to the next generation.

Disadvantages of Universal Life Polices

  • Increased complexity due to the investment choices, and variable premiums payable – these policies need to be monitored and possibly adjusted over time. A whole life policy is simpler to manage.
  • Annual renewable term will eventually make the policy very expensive and expire. The cash value needs to be there to compensate.
  • Investments can give negative returns and which will cause the cash value to be less than expected.

You can get quotes on universal life on our insurance quoter online calculator, but this is a complex product that should be created with the help of a broker experienced with all types of insurance.

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