CHAPTER SIX – THE BIRTH OF THE EIUL

 

National Underwriter Life & Health, May 2, 2005, contained an article on equity indexed Universal Life insurance products, where it was reported that they are starting to show some significant development activity.  Like their equity index annuity counterparts, EIULs have a minimum interest guarantee but also credit interest by linking gains to growth in an equity index.

EIUL sales reached around $150 million in 2004, but it can easily double with new players.  Flat equity markets and weak interest rates should spur growth, at has been predicted by LIMRA and the Society of Actuaries and the ACLI.

Recent success has fed off the activity produced by Equity Indexed Annuities, which also have an upside accumulation and Floor guarantees—considered by most as the reason for the growth in the EIUL market.

At the present time most of the market is dominated by one company, but three other, large, companies are "gathering steam."  In addition, several large Variable Universal Life carriers are watching closely the EIUL players as a means of getting into certain distribution channels. 

However, EIUL products do raise some design and regulatory issues, such as most EIUL products will be funded with flexible premiums (EIAs are often single-premium sales) which means that EIUL carriers will need to find ways to set up the flexible-premium payments.  In the meantime, regulators will want to make sure that the disclosure is adequate so that the customer will fully understand how the policy credits its interest.  Also, at this stage, rules are not clear as to what to illustrate in an EIUL policy.

The Variable Universal Life market is seeing some changes too, such as they are now developing more competitive secondary death benefit guarantees, more free living benefit guarantees, and they are building broader product distribution—primarily because Variable Universal Life is not doing as well as expected at this time.

So, what is this strange mixture of Universal Life and Equity-Indexed Annuities?  The only way to really understand the Equity Indexed Universal Life is to relate it to other life insurance plans.  That is what it is—another life insurance plan, but a vastly different one from permanent whole life or term insurance.

LIFE INSURANCE

It is assumed that those who read this text have a background in life insurance and understand what the product is and how it is used, so it is no surprise when life insurance is considered as a unique plan that provides unique benefits that cannot be copied by any other financial planning instrument.  The primary benefit of life insurance is, of course, to provide cash upon death.  in order to create a level premium, the insurance company "overcharges" in the early years for the death benefit and "undercharges" in later years.

Many life insurance policies have cash values and all cash values stem from the same cause; the excess premium charged in the early years in order to maintain a level premium.  However, cash value is viewed by the general public as simply a by-product of the level premium payment-of-premium method.  This was the view held for many years, until the advent of interest-sensitive insurance products, in particular Universal Life.  In these cases, the cash value is looked upon as a separate and independent part of the policy, from which funds are withdrawn to pay for mortality and loading charges.

 

Some have considered a permanent type of level premium policy as simply a liability held by the insurance company to pay any future claims—the reserves—plus term insurance.  To some this is witnessed by the ability to withdraw all of the cash value, and the policyowner can borrow part of the cash values as a loan.  Regardless of the appearance of two contracts—death benefit and cash value—it is important to understand that it is still only one policy.  This is evidenced by the fact that a policyowner cannot withdraw all of the cash value without also giving up all of the death protection.  Legally, and actuarially, a life insurance policy is an indivisible contract.

Permanent life insurance provides a solid foundation and may be used for several important events during a lifetime, in addition to the death benefit.

1. Final expenses, such as bills, medical costs, funeral costs.
2. Paying off the mortgage or sending the children to college (aka                   "Dream fulfillment)
3. Benefits used to replace salary or pension income.
4. Estate planning, by covering estate needs and bequeaths.
5. Emergency fund—cash values can be withdrawn or borrowed against if                          needed.

One point often forgotten—only life insurance can provide an immediate estate.  If there are others who are economically dependant upon the wage-earner(s), life insurance can provide the cash to take care of those needs. 

Life insurance can be used to preserve an estate by providing cash to pay estate settlement costs.  At the present time, the threshold for estate taxes have eliminated most of the need for life insurance, however, the tax program sunsets in 2010, and with another administration that believes in raising taxes for government programs, one can expect that the "giveaway for the wealthy" (as the estate tax relief program has been called by some–called a "death" tax by others) may cease to exist.  In that case, life insurance can provide the necessary funds to pay estate taxes which, if the past is any indication, can be exorbitant.

TERM INSURANCE

Term insurance is discussed first as it is the simplest form of insurance, actually the basic form of life insurance.  Term life insurance provides either level or decreasing death benefits, and in some cases, increasing death benefits (usually a “rider” to a policy).  The majority of life insurance sold in the U.S. – and probably worldwide also – is term insurance which provides for a level death benefit over the period of the policy, with either level premiums or with premiums that increase with age.  Simply put, it provides a specified benefit for a specified period of time.  Then, when the time is up, the coverage is no longer available and the policy expires. 

Annual term insurance can be for a period of as little as one year, or can be for a lifetime (if anyone would want to pay the premiums).  However, the premiums are higher each year as there is a greater chance of dying the older one gets.  Flight insurance is often used as an example—the premium is paid prior to the flight, and if the policyholder lives through the flight, the policy is no longer in force.  The difference between that insurance and regular term is that the cost goes up as we get older. 

Policyholders did not like the idea of having to pay increased premium each year, so term insurance can be purchased for protection for an established period of time—say ten or twenty years, for example.  Premiums will be level during that time, but if the policy is extended beyond the ten-or-twenty years, as an example, the premiums will be raised (as the policyholder is now 10 or 20 years older).  Basic stuff.

TRADITIONAL WHOLE LIFE INSURANCE

Since we are talking about "investors" in insurance, at this point the fact that life insurance pays a death benefit can be accepted, but that is not important for this discussion.

For most long-term investors, whole life (ala permanent whole life or traditional whole life) insurance may be a superior insurance product in the long run as premiums may be paid tax-free and it is possible to structure a future rebate of unearned premiums, thereby ensuring that actual investments are free.  As pointed out recently by New York Life, even with high initial premiums, whole life insurance policies may require lower premium payments over the longer term.  Many insurance companies provide policyowners with the option of utilizing their current and accumulated dividends values to pay for their premiums.  Depending upon the success of the investments, the long-term cost of premiums is likely to be lower than those for a term life policy.

 

VARIABLE LIFE INSURANCE

The true predecessor to Indexed Universal Life could properly be considered as Variable Life Insurance as it was the first Universal Life policy that provided cash value that fluctuated with securities.  As one would expect, there is confusion among consumers between the Universal Life Insurance, Variable Life Insurance and Indexed Universal Life Insurance.  In order to fully understand and be able to explain the differences, particularly to an otherwise-sophisticated buyer, there are certain major differences and there are some minor differences which, if not understood or presented correctly and fully, can lead to confusion—which when life insurance is discussed, can easily lead to suspicion.  Ultimately, there is either an unknowledgeable policyholder or no policyholder.

 

 

The portfolio typically is a group of mutual funds established by the insurer as a separate account, with the policyowner given some investment discretion in choosing the mix of assets among such investment vehicles as common stock fund, bond fund, &/or a money market fund.  Variable life insurance offers fixed premiums and a minimum death benefit.  The better the total return on the investment portfolio, the higher the death benefit or surrender value of the variable life insurance policy.

Variable life insurance (VLI) was first offered in the U.S. in 1976 with only limited success.  Equitable Life Assurance Society was a pioneer in VLI in the U.S., and suffered through four years of discussion, development and negotiations with the Securities and Exchange Commission (SEC) before the product was approved.  Four years later, John Hancock, followed by Monarch Life, offered VLI products.  Today, many insurers offer some versions of this policy.

VLI was “invented” primarily to offset the effects of inflation and high interest rates on life insurance. Historically, the stock market tends to increase (when it does increase) at a rate higher than inflation, therefore these plans should provide an excellent hedge against inflation.  However, for short term investment results, sometimes inflation goes one way and the performance of investments go the other.

 

VLI has been slow to develop for several reasons, including the following:

1. The policy must be registered as a security under the Securities Act of 1933.
2. The agent selling it, therefore, must be registered under the SEC Act of 1934, and must pass the National Association of Security Dealers (NASD) Series Six Examination to have a license to sell it.
3. Many agents have been uncomfortable selling securities, having been used to products with guarantees.

 

 

In December 1976, the SEC introduced Rule 6E-2 which provided some exceptions from the Investment Company Act of 1940, which provided impetus for this product’s acceptance.  This rule requires that insurance companies provide an accounting to contract holders, imposes limitations on sales charges, and required that insurers offer refunds of exchanges to variable-life purchasers under certain circumstances.  Policyowners must also be given the opportunity of returning to a whole-life policy.

The principal part of Rule 6E-2 is that it defines VLI as a policy in which the insurance element is predominant.  Cash values are funded by separate accounts of a life insurer (not mingled with other funds held by the company).  Perhaps more importantly, the death benefits and cash value vary to reflect the investment experience.  But the policy has to have a minimum, guaranteed, death benefit, and the mortality and expense risks are borne by the insurer.

 

The policy itself is structured like a whole life policy inasmuch as there is a stated face amount at a stated age, and this face amount requires stated level premium amount.  The “variable” element is the cash value, and it rises and falls depending upon the investment results of the investment fund pertaining to that particular VLI policy.  There is no guaranteed minimum for the funds, however the fixed premium VLI policies guarantee that the face amount will not go below the face amount shown on the policy at time of issue, and the level premium is required to keep the policy in force.

 

 

 

 

 

While the original VLI policies had only a money market account and a common stock available for the investment vehicles, there are more choices today.  If the investment account(s) are positive, then the face amount of the policy is adjusted upward at the anniversary date.  However, if the account(s) are negative, the death benefit will decrease but never less than the face amount stated on the policy. 

Investment results of a VLI policy is affected by borrowing.  If a policy loan is taken, the equity of the underlying investment accounts is collateralized and the insurance company moves an account which is equal to the borrowed amount, from the investment account to a “loan guarantee account” which is not subject to market fluctuations.  The fund will earn less (usually 1% or 2%) than the interest charged the policyowner on the loan.  This loan guarantee account will contain these funds until the loan is repaid.

VLI provides against “deflation” by guaranteeing that the face amount of the policy will never be less than the stated face amount on the policy, regardless of the fluctuations of the investment account, as long as the premiums are paid.

 

 

MARKET SHARE OF VLI

 

Prior to 19981, only 3 companies sold VLI products and represented only 1% of the life insurance sold.  By 1981, there were 10 companies selling VLI and market share increased to 2.5% of the ordinary life premium.  Even though the growth of VLI was inhibited by large development costs to the insurance companies, and in particular the licensing requirements for agents and their discomfort with mutual funds products (many agents felt disloyal to the life insurance industry by marketing securities products), VLI products accounted for 6% of the market in 1991, and approximately 15% in 1993.  The Equitable reported that it has a historical net rate of return on its common stock account of over 14% per year for the over 20 years it has marketed VLI products.

ADVANTAGE OF VLI

 

The key advantage of VLI is that the contract holder has the ability to direct his/her account value to the investment that they choose, limited only by the number of investment accounts.  While VLI started with just two investment choices, they now have many choices, such as aggressive stock account, balanced funds, global funds, bond funds, high-yield bond funds, guaranteed interest accounts, zero-coupon accounts and real estate investment accounts. 

VLI has suffered higher expenses with the first types of VLI offered, however they have offered the highest net return available from a life insurance policy from 1976 to 1994 when invested in common stock funds.

 

The policy must be sold with a prospectus which divulges more information to the prospective purchaser than provided by other traditional insurance policies or by companies marketing traditional products.

When VLI operates correctly, the policyowner will have life insurance protection, a “family” of mutual funds for investment purposes, and the ability to direct the investments within those funds, and there is no income tax liability as funds are moved within the contract.  The policy shelters interest, dividends and Capital gains from current income taxation.  Plus:

 

 

The principal disadvantage to many people of the VLI is that once the VLI has been purchased, the policyowner may not increase or decrease the premium, as it is designed be a level premium policy.  Conversely, this can be an advantage as it is a method of “forced savings” and many people who purchase Universal Life policies with the flexible premium frequently use the flexibility as an excuse not to invest, with lapses as a result.

The amount of life insurance is fixed at its minimum level as of the date of the purchase of the policy.  If a policy lapses it may be reinstated as with other life insurance policies, with one exception:  past-due premiums collected must not be less than 110% of the increase in cash value which is then immediately available after reinstatement.  This is necessary as the reinstated policy contains values that assumed the policy had never lapsed, so the additional premium would reflect an increase in the investment account during the lapse period.

Policy loans are available for the amount which equals 75% or more of the cash value at a stated interest or variable interest, rate.

VLI policies are riskier to the policyowners than the traditional life insurance policies, and therefore are subject to more laws, rules and regulations and require more disclosure to the policyowner.  If a person’s financial planning program is built around a highly liquid and still nearly risk-free plan, VLI is a poor substitute to traditional life insurance.

 

UNIVERSAL LIFE

 

Historically, Universal Life (UL) was first mentioned as a concept in 1946 and then later in 1964 in actuarial articles in industry publications.  Regardless of its actuarial origin, the first published concept of the modern UL was presented at a conference in 1975.  The following year, a small company in Atlanta offered the first UL policy, but because of adverse tax problems, it discontinued sales.  In 1979, E.F. Hutton Life (then Life of California) offered UL, and while it was welcomed with open arms by many, others loudly and continually voiced opinions that it was (1) bad for the companies because it made them into nothing but “banks,” (2) it was not good for the consumers as it was too difficult to understand, plus a multitude of other reasons, and (3) it was not good for the agent as the commissions were going to be lower and they were going to have to be under dual regulation (insurance and SEC). 

As they say, “timing is everything.”  During the early 1980’s interest rates on newly invested funds were higher, much higher in many cases, than those earned on established investment portfolios.  This gave UL a head-start on the traditional cash-value products with their interest rates of 3 –3 ½ %.  However, what goes up, must come down, and when interest rates declined, so did the popularity of UL.

Universal Life policies offer flexibility:  flexible premium payments and adjustable death benefits.  After the first (minimum) payment, the policyowner can pay whatever they wish into the policy, and at whatever time they wish, and in some cases, can skip paying altogether if the cash value can cover the premium charges.  And to top it all off, the policyowner can adjust the death benefit with very little difficulty (with one caveat: if the death benefit increases, the insurer may ask for evidence of insurability).

As happens so frequently, companies geared up for the expected bonanza of increased sales and premium income.  But, again typically, many companies believed that since this product “sold itself” and there was so much administrative cost (many projections and other required consumer information) that the agents should be able to live with lower commissions, especially since they would be selling so many policies. 

The agents did not share the production hysteria of so many companies at that time and commissions were not dropped as much as the companies expected.  Administrative expenses were higher than anticipated by many companies.

As mentioned earlier in this text, UL policies are “transparent” since the policyowner can see exactly how the funds are distributed.  They are furnished with many illustrations and examples of the fund distribution and expected returns, and while the policyowner cannot evaluate the adequacy of many of the assumptions, they certainly can see where the money goes.

 

 

The movement of funds in UL follows the following schedule (Note that the term “policy period” is used, instead of typical mode of payments, such as monthly, quarter, annual, etc. The reason is that this is a flexible contract and the premium paying period does not have to be a predetermined time period):

 

1. The policyowner pays a minimum premium to the company.
2. The company subtracts expense charges for the first policy period. (This is called “front-end loading” and some UL policies do not have this charge at this time.)
3. The company then subtracts the mortality charge on the insured’s age and the policy’s net amount at risk.  Premiums for any supplemental benefits (Accidental Death, etc.) are also subtracted.
4. The remaining amount is the initial cash value of the policy.
5. The cash value is credited with interest which then becomes the end-of-period cash value. 
6. UL policies generally have high surrender charges.  The cash value less the charge is the cash surrender value.
7. The second policy period (usually this is a month) starts with the previous cash value.  The policyowner may (or may not) add additional premium at this time.  If the previous period’s cash value is sufficient to cover the mortality and expenses charges (current) then no premium is necessary.  However, if it is not sufficient, the policy lapses unless additional premiums are paid. 
8. For the second policy period, the cash value at the end of the first period is increased by any premium payment, and then reduced by the expense and mortality charge, increased again by interest at the current rate.
9. This process continues until the policy lapses or surrenders.

DEATH BENEFITS

 

An Adjustable Death Benefit

When traditional types of life insurance are written with a certain death benefit (such as $100,000)-that face amount of 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-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 later.) 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 reaches age 95.  (To reiterate, 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. If a policy with a $100,000 death benefit had cash values of $20,000, the amount at risk would be $80,000.)

As the policyowner continues to pay premiums, the cash value increases while the amount at risk for the insurer decreases.  In 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.

 

(Face amount illustration only, policyowner may raise of lower death benefit)

 

OPTION B

 

The second death benefit choice, Option B, provides for an ever-increasing death benefit that is made up not only of 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.

The insured's death at any point results in a death benefit equal to the $100,000 insurance (on this example policy) plus whatever the cash value is at the time of death.

 

 

 

Because it is known from the beginning that the death benefit will increase, the premiums for Option B would be greater than for Option A  so as 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, resulting in values more like those shown in the following illustration.

 

 

 

THE CASH VALUE ACCOUNT

 

CHARGES TO THE ACCOUNT

 

The Insurance Premium:  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, as previously discussed, 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 as discussed above.  If the load is 6%, 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.

 

Other Charges:  Insurers may 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.  As examples, first year charges may be:

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.

 

SINGLE PREMIUM UNIVERSAL LIFE

 

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 could 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.  At the risk of being repetitive, it is important to remember that 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.

 

THE IMPORTANCE OF PREMIUM FLEXIBILITY

 

When a Universal Life policy goes into effect, a minimum level premium payment is established.  For the policy to have any cash value, obviously, some premiums must be paid.  As stated earlier, 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. 

 

As an illustration of the importance of flexible premiums, assume an individual purchased a Universal Life policy with a death benefit of $200,000 with an annual premium of $1,000 and several years later, the cash value grew to $15,000.  At this point, the policyowner's first child enters college and the policyowner wants to skip the annual premium on the policy.  The policyowner can do so because there is adequate cash value to pay for the insurance protection. (See the illustration on the next page.)

 

The policyowner could continue to skip payments for several years while the cash value account takes care of the insurance protection, or the policyowner could make reduced premium payments.  Of course, at some point, the cash value used to pay for the insurance protection could dwindle to the point that no additional funds would be available for insurance protection.  At that point, the policyowner must make a payment or the insurance lapses-there is no more coverage. In addition, since the cash value account was reduced during the years, no premium payments are made, the policyowner could not rely upon those funds to be available for other purposes.

 

INCREASING THE PREMIUM PAYMENT

 

If the insured’s financial condition, in the above example improves, and the policyowner wants to rebuild the cash value account.  Although the original insurance (minimum) premium was $1,000, the policyowner elects to pay $1,500annually.  By increasing the premium payments, the policyowner benefitsbecause the cost of insurance protection remains the same, as the additional paid premium goes to the cash value account to earn interest (Assuming they have not increased the death benefit.)  But remember, the so-called risk corridor-the IRS-dictated minimum of insurance protection to cash value-must be maintained in order for the cash value account to continue receiving favorable tax treatment. At any time, the policyowner can revert to the original premium payment amount or again stop paying premiums entirely.

 

An Illustration of Adjustable Premium and Death Benefit illustrates one of many ways a Universal Life policyowner could adjust the premium and the death benefit over many years. Notice each adjustment can be made independent of the other; that is, the premium can be changed without affecting a death benefit and vice versa, as long as the cash value account is adequate to make the desired adjustment. A summary of the transactions follows the illustration.

 

 

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 $500per year, the cash value grows moderately. When the insured is age 33, the policyowner receives a $1,000 windfall which is deposited into the cash value account with the usual premium.  At age 36 the policyowner withdraws $500, but continues to make level $500payments and the death benefit remains at $100,000.

At age 40, the insured increases the death benefit to $150,000and begins making $900 premium payments.  At age 42, the insured skips one premium payment, then resumes paying at age 43.  At age 44, the policyowner increases the premium payment

At the insured's age 48, the child enters college.  The insured withdraws $4,000 that year and the next year, while continuing premium payments.  At ages 50 and 51, the policyowner withdraws $4,500 each year.  At 52, after the child graduates from college the insured continues paying premiums and keeps the $150,000 death benefit, making no further withdrawals.  At age 55, the insured lowers the premium payment in anticipation of retirement and drops the death benefit to $100,000.  At age 60, the insured makes no more premium payments, and lowers the death benefit to $50,000.  At that time, the cash value is sufficient so that no further premiums are required.

USES FOR THE CASH VALUE ACCOUNT

 

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.

 

Withdrawal Charges: 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.

 

Taxation on Withdrawals:  Policyowners who make partial withdrawals from cash value accounts may or may not have to pay taxes on the withdrawal, depending upon the circumstances.  For policies at least 15 years old, the portion withdrawn is not taxed unless it is greater than the amount the policyowner has put 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 yet 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 has been paid into the policy and the amount of the withdrawal.

 

Paying and Receiving Interest:  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 policyowner's money. Since the money is no longer in the policy's cash value account, no interest is earned on the amount withdrawn.

 

Repaying 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 lees the insurer normally charges.

 

Costs of Withdrawing and Repaying

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:

• Fee paid to the insurer at withdrawal. 

• Reduction of the death benefit (cost to the survivors).

• Loss of interest on the money while withdrawn.

• 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 be considerably higher in the long run than a loan.

 

 

 

In many cases, it will, indeed, be worthwhile from the policyowner's point of view to make partial withdrawals. But policyowners need to be well-informed about the cost of this decision.

 

Total Withdrawals

Universal life policyowners also may withdraw all of the cash value. However, as stated earlier,  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.

 

Policy Loans

Like other cash value life insurance, UL policies allow policy loans up to the cash value amount.  Unlike a withdrawal, 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, just as other lenders.  The rates to be charged are printed in the policy.  

 

For cash values in the account that are drawing interest, insurers sometimes pay a lower rate on the amount borrowed against than on the amount not borrowed. For example, assume there is $10,000 in the cash value account. The policyowner borrows $6,000. The insurer might pay only its guarantee interest rate of 4% on the $6,000 borrowed, but continue paying the current interest rate (guaranteed interest rate plus excess rate) of 8% on the remaining $4,000.

Other insurers may treat a UL 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 suppose the current rate the insurer is paying on the cash value account is 7% and the policy loan rate 6%.  With a wash loan, the 7% rate would be reduced to 6% to match the loan rate.

 

 

STUDY QUESTIONS

1.  Equity Indexed Universal Life Insurance is

     A.  a form of annuity.

     B.  Variable Life under another name.

     C.  a securities product.

     D.  just another life insurance plan, but different from whole life or term insurance.

 

2.  An investment-oriented whole life insurance policy that provides a return to an underlying portfolio of securities is

     A.  a typical Universal Life insurance policy.

     B.  Whole Life Insurance with a side fund.

     C.  Variable Life insurance.

     D.  Variable Annuity Life.

 

3.  One of the main reasons that Variable Life Insurance has been slow to develop is

     A.  that it must be sold by insurance agents who do not understand it.

     B.  the returns on the investment has been horrible.

     C.  that since the policy is a "security," agents must be registered under the SEC.

     D.  the commissions are lousy.

 

4.  One of the major differences between Variable Life and Universal Life/Universal Variable Life insurance, is

     A.  the face amount guarantee.

     B.  Variable Life is only sold by brokers from large insurance agencies.

     C.  Universal Life Products must be sold by those with securities licenses.

     D.  there is no commission paid on Universal products.

 

5.  With Variable Life Insurance, the sale of one fund and purchase of another within the contract

     A.  is a taxable event.

     B.  is not a taxable event.

     C.  is not allowed by the SEC.

     D.  will change the policy from insurance to a bond.

 

6.  The principal difference between Adjustable Life insurance plans and Universal Life is

     A.  only in the commissions.

     B.  Universal Life is a securities product.

     C.  UL policies have neither fixed premiums nor fixed death benefits.

     D.  UL policies have fixed death benefits but flexible premiums.

 

7.  With Universal Life plans, as the policyholder continues to pay premiums,

     A.  the amount at risk for the insured decreases as the cash value decreases.

     B.  the cash value decreases while the amount at risk for the insurer decreases also.

     C.  the cash value increases while the amount at risk for the insurer decreases.

     D.  the amount at risk decreases to zero at age 65.

 

8.  With a Universal Life policy, a portion of the insurance premium and the administrative charge are

     A.  waived.

     B.  charges to the account.

     C.  illegal.

     D.  make the insurance product become a securities product.

 

9.  The feature of the Universal Life that allows the policyowner to raise, lower and even skip premiums

     A.  is the flexible or adjustable premium feature.

     B.  never lets the insurance protection vanish.

     C.  is what determines that it is a securities product.

     D.  makes it hard to pay a commission based on percentage of premium.

 

10.  Universal Life policies that have been in force for at least 15 years and the policyholder wants to make a partial withdrawal,

     A.  would make the entire growth of the cash value taxable as ordinary income.

     B.  the portion withdrawn is not taxed unless it is greater the amount that the

          policyholder has put into the policy.

     C.  the policy would automatically terminate and all cash value would be taxed at

          Capital gains rate.

     D.  if the part withdrawn is less than 50% of the total cash value, there is no tax

          penalty at any time, if it is more, then taxes at a 50% rate will be imposed.

 

ANSWERS TO STUDY QUESTIONS

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