CHAPTER TWO - UNIVERSAL LIFE INSURANCE

 

Whole life and limited pay life policies are the proven mainstays of the life insurance industry.  These traditional types of insurance, while still providing the best insurance answers for some situations, came under fire in inflationary times, especially when interest rates rose dramatically.  As a result, many consumers began to look for other sources of cash accumulation that would provide a better return than the modest rates insurance policies guarantee.  Now that the “bloom is off the rose,” or so it seems, the “modest” rates are of interest because they are guaranteed.

 

Willingness to Take Risks

 

For those who wanted the security insurance provides, the answer was usually to buy Term Insurance at a lower rate and invest the premium savings in higher‑paying mutual funds, money market funds, the stock market, and similar vehicles.  Consumers who did not feel they needed insurance took all of their money elsewhere, clearly signaling to insurers a readiness to take some investment risk in order to get a higher return.

 

Flexibility

 

Not only did consumers want more return on their money, they also wanted more flexibility.  Traditional life insurance policies require policyowners to pay the premium on time, every time, or lose the insurance protection, retaining only the cash values protected by nonforfeiture provisions. No matter how tight the policyowners finances might become due to unforeseen economic straits - loss of a job, an unexpected major expense, or whatever - the insurer demanded the premium to be paid on time.  Modern consumers also wanted payment flexibility in order to deal with economic uncertainties.

 

Insurance Industry Response:  Universal Life

 

The foregoing is a simplistic sketch of the environment that gave birth to Universal Life insurance policies.  These policies will be discussed in detail in later chapters, but the essence of these non‑traditional policies is that they provide:

 

1. The protection element of life insurance.
2. An option to alter the death benefit amount during the policy period.
3. A modest guaranteed interest rate.
4. The potential for a higher, more competitive interest rate.
5. Flexibility in the size and frequency of premium payments.

 

These non‑traditional policies have many of the same features as traditional cash value life insurance.  Also, like Term Insurance, the insurance protection could cease under certain circumstances, as you will see.  Although these policies are most often called Universal Life, they are also known as adjustable premium Whole Life and flexible-premium adjustable life policies.  But it's not only the premium that is adjustable.

 

An Adjustable Death Benefit

 

When traditional types of' life insurance are written with a certain death benefit (face amount), the policy remains in effect as long as the policyowner pays the premium, but if no premium is paid, the insurance can terminate.  One important feature of Universal Life policies is that the death benefit is adjustable ‑ it could be $100,000 at the beginning of the policy period, but it might drop down to $50,000 at some point and later rise to $175,000.  Within certain limitations, the policyowner controls these adjustments.

 

With this adjustment feature, no new policy is needed to reflect the different amount of insurance.  The adjustments are made to the existing policy.  When the policyowner increases the death benefit, some insurers require proof that the insured person is still insurable and in good enough health to meet the insurer's standards.

 

Death Benefit Options

 

At the onset of a Universal Life policy, the policyowner chooses one of' two death benefit options:

 

Option A: The first choice, Option A, provides a level death benefit similar to traditional life insurance policies. This level benefit is stated in the policy, but the insured still has the option to increase it or decrease it during the policy period.

 

When the death benefit is selected, the premium is determined, with part of it destined to pay for the insurance coverage (the death benefit) and part to be deposited into the cash value account to earn interest.  The policyowner pays this same premium regardless of whether the death benefit is increased or decreased during the policy period. (An exception is when the policyowner exercises the premium-paying flexibility of Universal Life, discussed below)  Thus, the policy provides a level death benefit and a cash value account that accumulates interest.

 

It is important to differentiate between the death benefit - the insurance protection - and the cash value.  For a Universal Life policy to receive the special Internal Revenue Code (IRC) tax considerations that apply to insurance policies, there must always be an amount at risk until the insured's age 95.  The amount at risk refers to the amount for which the insurer is at risk, and is the difference between the face amount (death benefit) of the policy and its cash value.  For example, a policy with a $100,000 death benefit currently has cash values totaling $20,000.  The amount at risk in this case is $80,000.

 

As the policyowner continues to pay premiums, the cash value increases while the amount at risk for the insurer decreases.  The IRC mandates that the cash value must not equal the amount at risk until the insured reaches age 95.  At times when earnings are high, it would be possible for the cash value and the amount at risk to be nearly the same.

 

If the cash value begins to approach the amount of insurance, the death benefit must be raised.  The Internal Revenue Code dictates a certain minimum amount at risk that must be maintained in order for the policy to continue to be treated as life insurance and not as an "investment."  This minimum amount is often referred to as the tax corridor or the risk corridor.

 

Option B: The second death benefit choice, Option B, provides for an ever‑increasing death benefit that consists of not only the amount of insurance, but also the amount of the cash value account.  For example, if the original death benefit at the onset of' the policy is $100,000 and the cash value is $45,000 when the insured dies, the beneficiary of' the policy will receive a $145,000 death benefit.

 

Because it is known from the beginning that the death benefit will increase, the premium payment for Option B is greater than for Option A to pay for the increasing amount of insurance protection.  An individual could choose to pay the same premium for an Option B type of policy as for an Option A type policy, but the cash values would grow at a reduced rate.

 

Interest On The Cash Value Account

 

Current Interest Rate: The insurance company periodically sets aside the dollars required to pay for the Universal Life policy's insurance protection. On the remaining money in the cash value account, the insurer pays interest at its current interest rate.  The rate is made up of two distinct rates:

 

(1) The minimum guaranteed interest rate specified in the policy, typically 4 to 41/2%, plus

 

(2) The excess interest rate, which is some rate in excess of the guaranteed interest.

 

For example:

 

The specific excess rate is set at the insurer's discretion.  Some insurers use a rate that reflects a known financial index, such as the yield on U.S. Treasury securities.  The excess rate changes as financial indicators change.  So, in the example above, 7.5% interest would be paid for a period of time, but if the excess rate changed, let's say to 3.25%, the next time interest is credited to the cash value account, it would be at a rate of 7.75% (4.5% + 3.25%).

 

The period for which the current interest rate applies varies.  Some companies guarantee a rate for a full year, others for no more than three months. Additionally, some insurers pay excess interest only on the cash value that is greater than a specified amount. For example, if the specified amount is $5,000 and the cash value is $8,000, the lower guaranteed rate would apply to the first $5,000 and the higher rate to the remaining $3,000.

 

 

 

Charges to the Account

 

The Insurance Protection: Of each premium paid, a portion pays for the life insurance protection.  This amount, based upon mortality rates for the particular individual, is typically taken as an adjustment to the cash value account once a month.  Then, another portion goes to the cash value account to draw interest.

 

Loading: Not all of the remaining payment draws interest, however, because sales and administrative expenses must be paid.  This charge is called a load or loading.

 

Expenses may be deducted as front‑end loads or back‑end loads.  In a front‑end loaded policy; the insurer deducts a certain percentage from each premium payment before crediting it to the cash value account.  If the load is 6%, for example, and the premium payment is $1,000, $60 would be deducted, leaving $940 for the cash value account.

 

Recent Universal Life policies are more often back‑end loaded, which means the entire premium payment is deposited into the cash value account.  The back‑end loading comes into play if and when the policyowner performs certain transactions in the cash value account, such as surrendering the policy for its cash value.  The advantage of back‑end loaded policies is that the cash value account has more money to earn interest in the early years.  The disadvantage is that some back-end loads are quite high.

 

Some insurers offer the equivalent of a no‑load arrangement, whereby the insurance company takes a percentage of current earnings, similar to no‑load mutual funds.  Transactions that typically incur loading charges will be discussed below,

 

Other Charges:

 

Insurers might also charge a flat fee to cover the cost of maintaining and servicing the policy. This may be an annual fee or a monthly fee.

 

Some insurers have first year charges that apply in addition to all other policy charges. After the first year the policy is in force, these charges no longer apply.  The following are some examples of first year charges:

 

1. Up to one dollar per thousand dollars of insurance coverage.
2. No excess interest paid on the first $1,000 cash value, which in effect is a charge because that interest is lost to the policyowner.
3. A flat monthly fee paid in addition to any other policy charges.

 

Insurers provide the Universal Life policyowner with an annual statement that shows exactly what transactions occurred and what charges were assessed during the year.

 

 

Universal life premium

 

Like Whole Life policies, Universal Life insurance may be purchased with a single premium paid at the policy's inception.  The benefits of paying a single large premium are the same as those for Whole Life and might even be magnified as the result of the current interest rate paid on Universal Life cash values.  Of course, all of the cautions about maintaining the risk corridor in a Universal Life policy must be observed.

 

The Adjustable Premium

 

Most Universal Life policies are purchased not with a single premium, but with periodic payments spread over a number of years.  Whereas traditional life insurance policies have a fixed level premium, payable on a regular schedule, Universal Life offers an adjustable or flexible premium.  This feature permits the policyowner to raise, lower and even skip premiums.  However, lowering or skipping premiums is possible only if enough cash value has accumulated to pay for the pure insurance costs and any administrative charges.  If the cash value is not adequate, a payment must be made to keep the insurance in force.

 

When a Universal Life policy goes into effect, a certain level premium payment is established.  For the policy to have any cash value, obviously, some premiums must be paid.  Once the cash value grows adequately, this amount can be used to keep the insurance protection in force whether or not the policyowner pays additional premiums.

 

 

 

 

Example of Universal Life Flexibility

  

 

At age 30, the insured purchases a Universal Life death benefit of $100,000 for a $500 annual premium.  This coincides with the birth of a child.  At $500 per year, the cash value grows moderately.  When the insured is age 33, she receives a $1,000 windfall, which she deposits into the cash value account along with her usual premium.  At age 36, she withdraws $500. She continues to make level $500 payments and the death benefit remains at $100,000.

 

At age 40, the insured increases the death benefit to $150,000 and begins making $900 premium payments. At age 42, she skips one premium payment, and then resumes paying at age 43.

 

At age 44 she increases the premium payment to $1,500 per year, retaining the $150,000 death benefit.

 

At the insured's age 48, her child enters college. She withdraws $4,000 that year and the next year while continuing premium payments.  At her ages 50 and 51, she withdraws $4,500 each year.  At 52, when her child is graduated from college, the insured continues paying premiums and keeps the $150,000 death benefit, making no further withdrawals. At age 55, she lowers the premium payment and drops the death benefit to $100,000.  At age 60, she stops paying premiums and lowers the death benefit to $50,000, at which time her cash value is sufficient that no further premiums are required.

 

Universal Life and the Stages of Economic Life

 

While Universal Life can be used throughout the lifetime of the insured, many professionals have determined that the average individual goes through several specific states of life where economics plays a large part.  The example shown above indicates several, but it is worthwhile to examine each of these stages.

 

Career Stage:  Universal Life (UL) is perhaps the very best solution for providing death benefits at a minimum cost, which is so important in the early stages of ones career while the future is bright but the income is still slight.  The accumulation of the cash value and level lifetime premiums can be easily adjusted at a later date and with the same policy.

 

Career Developing (usually age 35 to 50):  This is a very financially active period, as home buying, children to college, the need to purchase “big-ticket” items, and retirement plans occur at this time.  The career and family income generally is increasing during this period of time, so the UL can be utilized by the increase of the cash value or of the death benefit, whichever was chosen.  If the increasing death benefit option was elected, then there will be no insurability problems.

 

Phase of Accumulation Peaks:  The kids are gone, consumer loans have been largely eliminated, and mortgage payments are either non-existent, or well under control.  Now, cash values can grow at current interest rates with a guaranteed interest rate minimum and the cash value accumulations grow at tax-deferred basis.  Also, because of TEFRA (1982) and TAMRA (1988), federal guidelines now will cause the death benefits to rise automatically, even if the level death benefit is elected. 

 

Just Prior to Retirement:  The approximate five-year threshold just prior to retirement is when close looks are made at retirement funds and the conservation of assets is of prime importance. At this time, generally conservative investing of assets occurs.  It is not too late to change a pattern of funds, and UL can be used very effectively in this stage.  If there are sufficient cash value accumulations, then the cash outlay can be reduced – or even eliminated – without sacrificing death benefits.  If there may not be enough funds for retirement, then the death benefit can be reduced which will increase the cash value growth.

 

Retirement:  Withdrawals and loans from UL can provide an income, either for life or for a specific time.  If retirement is prior to age 65, the cash value accumulation can be used until Social Security benefits are available. 

 

Death: The final chapter.  UL can pay a death benefit, even after it has paid a retirement income.

 

UNIVERSAL LIFE DURING PERIODS OF ECONOMIC DOWNTURN

 

According to a Life Insurance Management and Research Association (LIMRA), for the last quarter of 2001 84 insurance companies that had a Universal Life premium increase of 18%, annualized premium for UL grew 25% in the last quarter, while there were significant decreases of Variable Life , Variable Universal Life and Whole Life.  LIMRA credits the fact that owners of UL policies, as well as agents who sell them, are comfortable with the guarantees in such a volatile economic environment.

 

There are many and different types of Universal Life available, and the best type provide excellent death benefits and competitive death benefit amounts (at all ages) and also secondary guarantees for lifetime no-lapse protection.  This should allow the policies to stay in force even if there is no cash value, and the policy should be capable of guaranteeing the death benefit for 30, 40 or 50 years or for the lifetime of the insured.

 

A good product also has a “super” preferred class for non-smokers in good health in ages 20 - 80, as they will be able to better enjoy the low cost of insurance (COI) charges which in turn leads to better death benefit results.

 

The policy should be able to allow the policyowner to increase, decrease or stop the premium payments, and restart them later if there is sufficient cash value to keep the policy in force.

 

Premium payments less a sales charge, should be invested in a general account by the insurer, and the interest should be earned at a pre-determined and stated rate.

 

The “best” UL and Variable Universal Life (VUL) policies allow withdrawals from the cash value, usually after the policy has been in force for one full year.

 

Riders should be available, such as an accelerated benefit, which provides a living benefit in case of a terminal illness, and other riders – such as supplemental term coverage.

 

Leading producers of Universal Life products use the UL for business purposes, such as where life insurance policies are used for a buy-out of a principal in case of death, as UL is clearly the best method of funding for buy-outs in most situations of this type.  If some of the partners or owners are not insurable, a Joint and Last Survivor UL policy works well, even though the company will have to wait for the death of the second insured to complete the arrangement, but that would still be much better than funding the contract with after-tax dollars.

 

Another situation would be where there is a wealthy insured approaching 90 who has a Whole Life/term policy.  A 100% guaranteed Joint and Survivor UL (JSUL) could be used, as in these older years, the values of other types of insurance drop dramatically. 

 

There are a lot of questions floating about now in respect to the new Estate Tax Laws, which can be reinstated after 2010 unless the congress does something about it.  Term Insurance won’t do nearly as well as JSUL in most of these situations, and questions must arise as to whether the insured can convert the Term Insurance if the government decides not to repeal the federal estate tax.  (See later discussion of Estate Tax Repeal Rider later in this text)

 

All-in-all, reports from top producers indicate that the fast cash buildup and low surrender charges of the JSUL policies are very appealing for estate planning, even if the estate tax is repealed (or not).

 

Another enterprising agency markets a special Universal Life product to volunteer firefighters, emergency medical technicians and rescue personnel – of which there is reported to be in excess of 800,000 in the U.S.  These persons receive no compensation for their work and since most of them seem to come from middle income families, they usually do not have adequate life insurance protection.  This “special” UL product is used for a “Length of Service Awards Program” which is a non-qualified plan funded by individual UL policies and a Variable Annuity contract. 

 

The assets in the plan are owned by the plan trust and grow tax-deferred until the participant’s retirement, when the participant would receive a specified benefit - up to $250 a month, depending upon length of service in the fire district.  Eligibility is the attainment of age 65 with a 10-year vesting schedule, when at retirement the participant may either surrender the policy for cash to add to the monthly annuity benefit up the maximum; or they may take ownership of the policy, retain the insurance protection and receive a lower monthly benefit.

 

The “cap” of $250 per month is in response to the 1996 Minimum Wage Act, and they are therefore exempt from Section 457 of the Federal Tax Code.  By setting this $250 per month maximum retirement benefit, the plan can provide life insurance protection of $25,000, and premiums are usually set to endow the policy at age 100.

 

Variable Universal Life is not considered for this program as the 1996 law does not allow for employee-directed investment accounts. 

 

Underwriting is individually on a group basis, where the underwriters evaluates the entire group and “trades” preferred risks for rated risks, thereby allowing for an across-the-board rate.  There are few uninsurables in this business, as most volunteer firefighters like to keep in shape, just as the professional firefighters.

 

Another example of how imaginative professionals can take advantage of the tremendous flexibility of Universal Life.

 

Multiple Uses for Cash Value

 

In addition to keeping the insurance protection in place, it may be used for other purposes.

 

Withdrawals: Universal Life policyowners are permitted to make withdrawals from the cash value account.  Withdrawals of only a portion of the cash value (rather than all of it) are sometimes called partial surrenders because the policyowner is surrendering or giving up part of the policy.  The withdrawal is made from the cash value account, so that portion of the cash value is surrendered.  Most Universal Life policies also reduce the death benefit by the amount of the withdrawal.

 

 

Back-End Loading vs Front End Loading

 

While this illustration shows the cash value account reduced to $3,000, in reality it would be reduced even more because of fees charged for the withdrawal.  When a policy is back‑end loaded, this is one of the situations where the expense loading applies.  Front‑end loaded and no‑ load policies are also likely to assess a charge for withdrawals.

 

Partial Withdrawals

 

Policyowners who make partial withdrawals from cash value accounts may or may not have to pay taxes on the withdrawal.  For policies at least 15 years old, the portion withdrawn is not taxed unless it is greater than the amount the policyowner has paid into the policy.  For example, if premiums paid total $20,000 and the policyowner takes out $20,000, there is no tax due since $20,000 represents a return of capital on which the policyowner has already paid taxes.  If the same policyowner withdraws $21, 000, however, taxes are due on the $1,000, which is considered interest.

 

Policies that have not been in force 15 years when a partial withdrawal is made are subject to more complex rules dealing with the specific age of the policy, how much premium has been paid and the amount of the withdrawal

 

Repayment of Withdrawal

 

Because a withdrawal is not the same as a loan, the amount withdrawn does not have to be repaid, nor is any interest charged the policyowner for using the withdrawn sum.  From the insurance company's viewpoint, withdrawal is simply a return of the policyowners money.  Since the money is no longer in the policies cash value account; no interest is earned on the account withdrawn

 

Partial Withdrawals

 

The policyowner is permitted to return the amount withdrawn to the Universal Life cash value, but repayment does not restore the death benefit to its original level.  The insurance company might permit the policyowner to restore the original death benefit, but usually will require proof that the insured is still in good health and insurable.

 

In addition, whether or not the death benefit is restored, repayment of the withdrawal is considered to be a premium payment and is subject to whatever fees the insurer normally charges.

At first glance, partial withdrawals from a Universal Life policy might seem immensely preferable to borrowing money - whether from an outside lending institution or from the policy itself - since no interest is charged and the policyowner can return the money to the policy later.   However, careful consideration should be given to the actual costs of a withdrawal that will be repaid to the cash value account, such as

 

1. Fee paid to the insurer at withdrawal.
2. Reduction of the death benefit (cost to the survivors).
3. Loss of interest on the money while withdrawn.
4. Charges assessed by the insurer when the amount is returned to the cash value account.

 

Even apart from the reduction in the death benefit, the other costs can eventually be considerably higher than a loan.  For example, assume that the policyowner could borrow the same amount of money from his bank at 10% interest or could withdraw the money from his cash value without paying interest which could be as little as $25.

 

Assume the cash value account is receiving a current interest rate of 10%.  The policyowner will not receive this 10% on the amount withdrawn.  However, if the policyowner wants to repay the amount withdrawn and the policy is front‑end loaded with a 7% expense charge, then the policyowner has lost 10% interest and paid the 7% expense charge.  Therefore this “interest‑free” withdrawal has really “cost" 17% plus the $25 surrender fee.

 

In some situations, it could be worthwhile from the policyowners point of view to make partial withdrawals, but they should be informed about the cost of this decision.

 

Withdrawal of Entire Cash Value

 

Universal Life policyowners also may withdraw all of the cash value.  However, as previously stated payment for the insurance protection is periodically taken from the cash value account.  If the entire amount is withdrawn, no money is available to continue the insurance coverage.  Therefore, the policyowner must make another premium payment to keep the insurance in force.  Insurers are required to notify policyowners if the insurance protection becomes endangered.

 

Some insurers charge a penalty if the policyowner removes all of the cash values in the early years of the policy.  This typically involves taking back all or part of the excess interest earned during the previous 12 months.

 

Repayment of Policy Loan

 

Like other cash value life insurance, Universal Life policies allow policy loans up to the cash value amount.  Unlike a withdrawal discussed in this text, a loan is expected to be paid back and the policyowner pays interest, typically at a low rate relative to interest rates in the marketplace.  While fixed interest rates are common, some insurers offer loans at variable rates, similar to lending institutions.  The rates charged for a policy loan are stated in the policy.

For cash values that are drawing interest, some insurers pay a lower rate on the amount borrowed than on the amount not borrowed.

 

 

Other insurers may treat a Universal Life policy loan as a so‑called wash loan because the interest rate the borrower pays and the interest rate the insurer pays on the cash value are the same, so each rate "washes out" or equalizes the other.  For example, the current rate the insurer is paying on the cash value account is 7% and the policy loan rate is 6%.  With a wash loan, the 7% rate would be reduced to 6% to match the loan rate.

 

There are many variations among the features of the Universal Life policies issued by various companies.  Even so, the advantage of these policies over traditional Whole Life policies is evident.

 

 

 

 

 

 

CHAPTER 2 – STUDY QUESTIONS

 

1. One important feature of Universal Life policies is that the death benefit is

A. a fixed amount.

B. adjustable.

C. paid only in monthly installments.

2. For a Universal Life policy to receive special tax consideration, there must always be

A. level premiums.

B. a level cash value.

C. an amount at risk until age 95.

3. “Guaranteed rate + Excess rate = Current interest rate”

A. The method for determining the currant interest rate on a UL policy.

B. The method for determining the investment experience of a mutual fund.

C. The method for calculating the Target premium of a Universal Life policy.

 

4. Most Universal Life policies are purchased

A. with fixed premiums, which are inflexible and level.

B. with adjustable and flexible premiums.

C. with a single premium.

5. A “Wash Loan” with a Universal Life policy is

A. where the insurer forgives the loan.

B. when the insurer does not charge interest on a policy loan.

C. when the interest charged is equal to the interest paid and the cash value is equal to the loan amount.

6. The option that allows the insured/owner of a Universal Life policy to select a death benefit that would include both the face amount of insurance and the cash value of the policy is generally known as

A. Option A.

B. Option B.

C. conversion option.

7. In a front-end loaded Universal Life Policy.

A. the insurer does not charge any expenses towards the premium until the owner withdraws money from the account.

B. the insurer deducts a percentage from the premium before crediting the account.

C. the insurer does not deduct for any expenses either up front or back-end.

8. Joe has a Universal Life policy with Option B. The death benefit is $50,000 and after 20 years the cash value is $25,000. He borrows $10,000 from the policy and shortly the-reafter dies. His beneficiary will receive

A. $50,000.

B. $40,000.

C. $65,000.

9. Under the same circumstances as Question 8, Joe has paid into the policy $20,000 and withdraws $25,000 from the cash value, before he dies. He will have to pay income tax-es on

A. $25,000.

B. $5,000.

C. $45,000.

10. In the last quarter of 2001 which cash value policy showed the most increase in sales?

A. Whole Life.

B. Variable Life.

C. Universal Life.

 

 

 

 

ANSWERS TO CHAPTER TWO REVIEW QUESTIONS

1B     2C     3A     4B     5C     6B     7B    8C     9B     10C