Universal life insurance is a type of permanent insurance. It’s suited for permanent insurance needs, where you need insurance over your entire lifetime.
Conceptually, universal life insurance has two components – the insurance component and an investment component. With most other life insurance products, your premium is insurance costs. This is not the case with universal life. With universal life insurance your premiums are simply the deposit you make into the policy and does not necessarily have a direct connection to the insurance costs. If you pay premiums higher than your insurance costs the amount of money above the insurance costs is placed into the investments. If you pay premiums that are lower than your insurance costs, the insurance company will take the rest of what it needs to cover your insurance costs out of the investments.
How Universal Life insurance works
You will typically have a set premium that you pay into the policy, which may be higher or lower than the actual insurance costs for the policy. Premium tax (about 2.5% in most provinces) is immediately deducted and the balance is placed into the policy.
From this balance, your monthly insurance costs, administration (or policy) fee, and any rider costs are deducted. Any remaining balance is then placed into the investments. If we have a shortfall (when your premiums you paid into the policy are insufficient to cover taxes, insurance costs, policy fees and rider costs) then the outstanding balance will be taken from your investments.
Insurance Costs
Insurance costs (COI or Cost of Insurance) inside a universal life policy comes in two basic flavours, Level or Term to 100, and YRT or Annually Increasing.
Level COI costs are level for life and are commonly available on a fully guaranteed basis from many companies.
Annually Increasing insurance costs are also commonly marketed in Canada. These insurance costs go up every year. They are typically relatively inexpensive initially and become exhorbitant as years go by.
From these two base plans, there are many other less common variations such as YRT to age 80 and then level. There are also ‘quick pay’ options with some companies where your COI costs are guaranteed to be fully paid up after 10,15, or 20 years. (Note, this is not the only way that universal life insurance policies are shown on a quick pay basis, the consumer is advised to be wary, read more about quick pay below).
When selecting a universal life policy one thing that consumers should pay close attention to is the insurance cost or COI and again a reminder that the insurance costs is commonly not connected to your premium. Do not assume that because your premiums are level that therefore your insurance costs are level.
Premium Tax
As noted above, most provinces apply a premium tax of about 2.5%. These taxes were implemented in the 1990’s and for the most part have not changed since (though Quebec increased the premium tax from 2.35% to 2.55% in 2010). In most other types of life insurance the premium tax is buried in the policy and guaranteed not to change by the company. With Universal Life insurance this premium tax is generally not guaranteed by the company. Manulife is one exception to this in that they have one variation of Universal Life where the premium tax is guaranteed not to change.
Investments – Danger Danger!
Investments inside a universal life policy come in hundreds of different variations. Should you die, these investments are paid out as part of the death benefit. In effect, your death benefit on a universal life insurance policy is death benefit = face amount (the amount of insurance) + investments.
These investments look a lot like common mutual funds. They are not mutual funds but they can have similiar benefits and difficulties. Specifically many investments available inside universal life policies track some blend of equities (i.e. stock market picks). So just like mutual funds, sometimes they go up and everything’s coming up roses. Warning #1: If (OK, ‘when’) the market crashes, your investments can drop substantially. If you’re counting on those investments to pay your insurance premiums and the market crashes, you may find that there’s insufficient funds to pay your premiums.
Most universal life insurance policies also have guaranteed investment options similiar to GIC’s, with the accompanying low interest rate. Warning #2: If the poliicy has a GIC type investment option available with a minimum guarantee of 3% and you project your investments at that 3% as being conservative BUT then place your investments into non-guaranteed investments, the 3% guarantee does not apply to your investments and the 3% projection is speculation – you may see a rate of return of negative 35%. Minimum guarantees only apply if you actually place your money into those investment options that have guarantees.
Warning #3: The fact that these investments are not typically guaranteed is one of the biggest problems you can have with a universal life insurance policy. Many consumers are not prepared for what happens if the investments do not perform as expected.
Earnings inside a universal life insurance policy grow on a tax deferred basis. In most cases these earnings are not taxed unless the money is withdrawn from the policy.
Deferred sales charges: Many investments in a universal life policy contain high deferred sales charges. These sales charges are applicable if you attempt to withdraw money from the investments in the first 5-10 years of depositing the funds. They can be a substantial percentage of the investments in the early years of the policy. For example you may deposit $5,000 into the investment portion of the policy,and receive notices that you have that $5000 as an account value. 2 years later you decide to withdraw that $5000 only to find out that there is a $3500 deferred sales charge. So while your account value is at the $5000 that you deposited, if you try to withdraw it you are only going to get back $1500. Again the numbers are for illustration only but do illustrate how high these charges can be.
Universal Life Insurance premiums
As noted above, the premiums you pay into the policy are not directly related to the insurance costs. You can pay the exact costs of the policy, you could pay more (the surplus above the costs goes into the investments) or you can pay less (and the deficit is then taken from the investments – if there is not enough money in the investments then the policy will lapse).
Minimum premium: Minimum premiums on a universal life insurance policy is calculated by the company as the minimum amount required to keep the policy in force, with no money going into the investments. You might use this option if you wanted permanent insurance, by selecting level COI and then paying the minimum premium. This effectively tightens down the universal life insurance policy to being strictly life insurance with no investment component and can make universal life a viable option to whole life or term to 100.
MTAR (Maximum Tax Actuarial Reserve): Because earnings on investments inside a universal life policy can grow in a tax sheltered basis, regulations are in place to prevent consumers from stuffing too much money into the investments – making the insurance policy more of an investment than a life insurance policy. The MTAR is the maximum amount you can place in the investments while keeping the policy on a tax deferred basis. Investments that exceed this MTAR number will cause the policy to become entirely taxable. The MTAR number is calculated by the company and is based on factors such as your amount of insurance and the current investment amounts inside the policy.
Maximum Premium: The maximum premium is also calculated by the insurance company using the MTAR, and is intended to be maximize the amount going into the investments while still keeping the policy on a tax deferred basis. This maximum premium can change over time as it is partially based on actual performance of the investments.
Universal Life Insurance Concepts
Minimum funded: With minimum funded universal life insurance policies, you would normally choose a level or term to 100 COI. Paying the minimum premium in conjunction with level COI means that you effectively have a level cost of insurance for life – no investments are used. With most Canadian companies, policies are available that will guarantee all aspects of the costs except the premium tax. As a result, minimum funded universal life can be a suitable option for consumers looking for permanent life insurance. Warning #4: Because you are paying the bare minimum premium to keep the policy in force, if the company should miss a premium (i.e. you move in 20 years and neglect to change your banking information) you could be in danger of your policy lapsing. One way to overcome this risk is to place two or three months premium into the guaranteed GIC-like investments inside the policy. The intention is not to use these as an investment, it’s simply used as a backup bank account. If the insurance company can’t get premiums from you directly, they will dip into these backup plans, keeping the policy in force and giving you time to correct the oversight.
Vanishing premiums, Paid up policies, paying your premiums with pre-tax funds: All of these concepts are centered around two universal life features; the investments, and the fact that earnings inside the policy are tax deferred. Here’s the way these concepts work: Start with Annually Increasing COI. These costs will initially be very inexpensive but will become exhorbitant over time. You pay a premium above and beyond the minimum premium so that much of your premium goes into the investments. Over time, these investments grow and earn interest. Later, when insurance costs become exhorbitant you continue to pay the same premiums, or perhaps no premiums at all. The insurance costs at that point are projected to be deducted directly from the investments rather than you. Warning #5: This works wonderfully as long as your non-guaranteed investments perform well. If they don’t perform well, there may not be enough money in the investments to pay the premium. Since the insurance costs have to come from somewhere, and it’s not the investments as you’d hoped, to keep the policy in force you now need to continue to pay the premiums. If that happens 20 years into the policy and you have Annually Increasing costs of insurance you will then be faced with paying those exhorbitant premiums out of your own pocket. For consumers struggling with the probability of this happening, please see the stock market crash of 2008 (i.e. some consumers are now faced with this prospect, on universal life policies they purchased 10-20 years ago).
Leveraged retirement
With this concept you build your investments inside your life insurance policy until you retire. Because the earnings inside the policy are tax deferred, growth is assumed to be higher than comparable non-tax deferred investments, i.e. you end up with more money inside the insurance policy at retirement.
The issue now is, if you pull the money out of the insurance policy at that time, you will need to pay taxes on it. The solution is to instead get a bank loan using the insurance policy as collateral. The bank loan is not taxable so you have effectively gained access to your money and the growth on that money, without paying taxes. When yo u die the investments are paid to the bank as a death benefit (which is also generally not taxable).
For example, you build $1,000,000 over 30 years inside the insurance policy. If you pull it out, perhaps you’ll have to pay $250,000 in taxes (these numbers are fictitious and for illustration only). So instead you go to the bank and get a loan for $900,000, tax free. When you die, $900,000 of the death benefit pays off the loan from the bank and the remaining $100,000 goes to your beneficiaries.
Warning #6: This strategy is dependent on non-guaranteed investments, the bank’s willingness to use a life insurance policy as collateral many years in the future, and tax laws – all of which can change.
Summary of strategies: Most universal life insurance strategies center around purchasing annually increasing insurance costs combined with non-guaranteed investments. If the investments don’t perform ,you can end up with little to no investments and a policy where the premiums are unaffordable. Consumers need to be extremely wary of two things; first, investments do not always perform as projected – again see the 2008 stock market crash and accompanying negative 35% return for many people as an example (did your universal life illustration include a year with negative 35% return?) and secondly, assuming that premiums are the same as insurance costs – if your premiums are being split amongst investments and annually increasing insurance costs, and the investments don’t perform, you may find out that your premiums in the future are insufficient to cover the costs of the policy.
Vanishing premiums redux (Danger #7)
Vanishing premium is a term used for a series of successful lawsuits by consumers in the 1990’s against insurance companies. Whole life insurance policies had been illustrated with dividends being used to eventually pay up the premiums in the policy. Consumers had been paying premiums for decades with the expectation that when they hit age 65 the premiums would be paid up. But in the 1980’s, dividends were scaled back by many companies. That meant that the policies did not in fact become paid up as expected. Additional payments would be required to keep the policy in force, for additional periods of 5, 10, 20 years, or longer. Consumers were now facing retirement with lowered income and the expectation that no more insurance premiums were due only to be faced with paying another 5-10 years of premiums.
The insurance industry’s response to those successful lawsuits was to introduce illustration requirements. Now all consumers in Canada who purchase a universal life insurance policy must sign an illustration with some features explained such as the lack of guarantees inherent in some policies. However many consumers do not see the implications, despite signing the illustration. We potentially face a similiar situation today, where consumers who have been paying insurance premiums for many years are facing huge increases in those premiums instead of paid up policies they may have expected.
We’ll illustrate with a fictitious example. A consumer takes out a universal life policy with Annually Increasing COI but decides to pay premiums that are level. Assume the cost of insurance in year one is $25 a month and the premium is $100 a month. So in year one an extra $75 a month goes into the investments to earn interest over time. Fast forward until the consumer is now 65, say in 20 or 30 years.
What we expected to happen was your account value would be $100,000. At 8% this would generate $8000 . Because you purchased annually increasing cost of insurance your insurance costs are now $8000. So we projected that the $8000 of interest would pay your $8000 of insurance costs – and now your policy is paid up.
However what actually happened was a 40% stock market crash so your investments are actually at $60,000. Your $8000 insurance cost must still be paid, and since you’re not paying the premium it comes from the investment which now goes to $52,000. Now things pick up a bit and you earn 8% again after that. So the following year you have $52,000 plus $4160 of interest leaving your account at $56,160. $8000 insurance costs is removed from the account and now you have $48,160.
Three things worth noting in this scenario. First, in the above fictitious example you should notice that the account balance, despite earning a healthy interest rate, is now actually declining over time – every year it gets smaller and smaller. It will eventually go to 0 if the trend continues – even if interest rates after the crash continue well. Secondly the account doesn’t go to 0 immediately – this happens over the course of years. And that means that consumers won’t see the effect of this for years after a crash. And thirdly, and most importantly consider what happens when the investment does go to 0. The consumer is now many years older, perhaps retired and assumed their insurance was paid up in full. In reality what they are going to get is a bill for $8000 (and increasing) a year to keep their policy in force.
While these numbers are purely illustrative, the scenario is not. Some insurance industry professionals see this as a looming problem, where consumers have a ticking time bomb insurance policy, with catastrophic results we won’t see for a few years yet.