Universal life insurance – commonly referred to as “UL” – was a new type of life insurance introduced in the late 1970’s. These policies were unique because they offered significant flexibility in both the premiums paid and in death benefit options. Unlike whole life that offered a guaranteed death benefit with guaranteed cash value for a guaranteed premium, UL allowed policyowners to choose the premium to pay (within certain limits), when to pay it, and gave them the option to increase or decrease the death benefit, or even select a death benefit that could increase each year. These early UL policies were all based on “current assumptions.” This means that the performance of the policy depends on the interest rate credited to the policy as well as the current charges assessed against the policy. Today, there are different types of UL products on the market. Current assumption type UL policies are still offered, but now there are also policies that offer death benefits that are guaranteed regardless of the interest rate credited or the policy charges assessed, provided a required premium is paid. In addition, policies are now designed to meet different market needs. Some are designed to focus on affordable death benefit protection while others may focus on accumulating cash value. Details on different types of UL policies are covered in the modules below.
Universal life insurance first came to the market place in the late 1970’s. It offered more flexibility than whole life insurance polices – flexibility in both death benefit options and premium payments. However, to accomplish this increased flexibility, the policy design was significantly more complicated than whole life insurance. Unlike someone who owns a whole life policy, the owner of UL has the option to:
Increase or decrease the initial specified amount. The specified amount is the amount of death benefit applied for. Increases in the death benefit are generally subject to new underwriting requirements.
Increase or decrease the amount of premium paid, and under certain circumstances, skip premium payments.
Vary the frequency of premium payments.
Change the type of death benefit option (level or increasing) provided under the policy. Increases in the death benefit are generally subject to new underwriting requirements.
Universal life death benefits are very flexible. The policyowner has different options to select from and may also increase and decrease the specified amount of insurance. Increases in the specified amount require additional underwriting, however. In general, most UL products offer at least 2 death benefit options – a level death benefit and an increasing death benefit. The level death benefit is called either Option 1 or Option A. The increasing death benefit is called either Option 2 or Option B.
The first diagram is the level death benefit option. Notice that the total death benefit includes the cash value in the policy and that the “pure” death benefit amount at risk decreases as the cash value increases. However, in the second diagram, the total death benefit includes the original specified amount of death benefit (e.g., $100,000) plus an amount that equals the cash value in the policy. So the death benefit in the second example equals $100,000 plus any cash value that exists at the time of death. Since there is an increasing death benefit, this option will cost the policyowner more to maintain. The policyowner may also change options after the policy is issued. The diagram below shows a policy that started out as an Option 1 or A and was changed to Option 2 or B.
Below are excerpts from UL illustrations showing Option 1, Option 2 and a change from Option 1 to Option
Some policies have a third option (3 or C). This is also an increasing death benefit. It increases the death benefit by an amount equal to the total premiums paid rather than increasing by an amount equal to any increase in cash value. Not all UL policies offer Options 2 or 3. Some only offer Option 1, the level death benefit option.
Sometimes in later years the cash value grows to within a certain percentage of the death benefit. If this occurs, the death benefit must grow as the cash value grows to maintain a corridor between the two, even if option 1 (level death benefit) was chosen. The amount by which the death benefit must exceed the cash value decreases as the policyowner gets older and is permitted to be zero percent at age 100. That is, the death benefit and the cash value can be equal at age 100. The death benefit corridor typically occurs in policies where high premiums have been paid resulting in high cash value. The images below show what this looks like numerically as well as graphically.
Unlike term or whole life insurance where a specific premium must be paid by a certain date or the policy may terminate, UL policies have a flexible premium structure. But, while premiums are flexible, the amount of premium paid will impact both the amount of cash value in the policy and how long the policy lasts (the point at which the policy lapses).
Minimum And Maximum Premiums
The law restricts the amount of premium that can be paid into a universal life insurance policy. These maximum limits may vary by policy type and design. In addition to the maximum premiums established by law, the insurance company may restrict the amount of additional premium that may be paid into a policy that is already issued. Therefore, before large sums are sent to the insurance carrier for deposit into a UL policy, the carrier should be contact to find out what limits may apply. While universal life insurance policies do have maximum premium levels, there really isn’t a minimum premium for a universal life policy. The company needs to receive sufficient premium to put the policy in force. But, after that, the policyowner has a certain degree of flexibility as to when and how much premium to pay. Within certain limits, the policyowner may increase, decrease and even skip premium payments. Sound simple? Well, it isn’t simple at all. As will be explained, if the policyowner doesn’t pay sufficient premiums to cover the fees and other charges in the policy, the policy may lapse. And if the policy has a death benefit guarantee, a specified premium paid by a specified date is required to keep the guarantee. The policyowner can pay more than the required premium for the guarantee, but paying less may shorten or void the guarantee. Premium requirements for secondary death benefit guarantees will be discussed later.
Policy Fees And Other Policy Charges
All fees and charges are spelled out in the policy. The fees are necessary to cover the cost of issuing the policy, to support the policy administration and to cover the risk that the insured may die (mortality costs). Most fees are fixed and guaranteed for a specific period or for the life of the policy and will not change. They may take the form of:
• Flat monthly deductions for the life of the policy;
• Percentage of premiums paid;
• Fee for a limited period of time. Fees associated with mortality are known as “cost of insurance” charges (COI). These are based on the age, gender and risk class of the insured and will increase as the insured gets older.
The COI charges and the amount by which they will increase is not guaranteed. That means the amount currently charged at each age and for each risk class could go up in the future. The charges are based on the mortality assumptions used when the product was designed. If future mortality is much worse than assumed, the insurance company reserves the right to increase these costs. However, the insurer can only increase them up to a certain maximum which is stated in the policy. And, any increase must apply to all policies using the same policy form; no individual policyowner can be singled out for this type of increase. COI charges are assessed monthly against the net amount at risk. This is the amount of the total death benefit that exceeds any cash value.
For example, assume that a $100,000 policy has $27,500 of cash value and the monthly policy charge for this insurance is $.36 per thousand of death benefit. The net amount at risk is: $100,000 – 27,5000 = $72,500 The cost of insurance charge deducted that month will be $26.10 (72.5 x .36).
Premiums Are The Primary Driver of Cash Value A UL policy can have cash value. To have cash value, the accumulated premiums paid by the policyowner must be greater than the deductions for fees and cost of insurance. Think of it as a bucket. The premium goes into the bucket and the monthly policy fees and COI charges come out of the bucket. If the premiums paid, plus interest credited to the cash value, are greater than the monthly deductions, there will be cash value in the bucket. If monthly deductions are greater than the premium paid plus any interest credited, then the excess amount will be deducted from any policy cash value.
If there is cash value in the policy, the company will credit it with interest. The policy guarantees that the interest credited to the policy cash value will never drop below a certain amount, such as 3% (depending on the policy form). But, the actual interest credited may be higher and will vary over time based on the results of the company’s own investment portfolio. The bottom line – if the policyowner only pays low (minimal) premiums into the policy, eventually the COI charges, plus other fees, will be likely exceed the premium levels and credited interest. Over time, cash value will be depleted. If the policyowner doesn’t increase the premiums levels to cover these increasing charges, the policy will eventually lapse. On the other extreme, if a policyowner pays in premiums much higher than needed to cover the policy charges, the cash values plus accruing interest may grow significantly. In later years, if cash value is sufficient, the policyowner may be able to skip or even stop making out of pocket premium payments without lapsing the policy.
Cash Surrender Value and Surrender Penalties
The policyowner can access cash value either through policy surrender, policy loans or withdrawals. The amount that the policyowner may receive is limited to the total cash value less a surrender penalty. The surrender penalty is designed to discourage the early surrender of the policy and, in the case of early surrender, to help the insurance carrier recoup some of the initial costs associated with underwriting and issuing the policy. The surrender penalty will vary by product. But, generally, the penalty is highest in the early years and declines until it reaches zero. The length of the surrender penalty period will also vary from product to product, but 15 to 20 years is not unusual.