How
a Universal Life Insurance Policy Works
Universal life (UL), also known as “flexible
premium adjustable life”, combines features of term
and whole life insurance to provide affordable death protection
with considerable policy flexibility. The unique policy
design of universal life insurance makes it easy to separate
administrative costs, insurance charges and earnings which
is very useful in determining how a specific policy is
performing.
Universal Life Premium Payments and Deductions
The premium payments for universal life insurance policies are flexible and may be increased or decreased depending on changing needs. The policy owner has the option of paying the minimum premium necessary to cover policy costs and insurance charges or can pay a significantly higher premium to grow cash values for college planning or supplemental retirement income. As long as there is sufficient cash value in the policy, premiums may even be skipped. If the cash value is insufficient to cover policy costs and insurance charges, an increased premium must be paid. If the premium payment does not cover policy expenses and insurance charges, and there is no cash value available to meet these costs, the policy will lapse and the insurance coverage will no longer be effective.
When the premium is paid, sales loads and premium tax charges are initially deducted. The charges vary among insurance companies but are usually around 3-7%. These deductions are taken before the premium is placed in the accumulation fund.
Accumulation Fund and Monthly Charges
After the premium loads are deducted, all excess premiums go into the cash value account also referred to as the accumulation fund. This account builds cash value that grows tax deferred and is credited a current interest rate. Each month, from the accumulation fund, monthly charges are deducted for insurance costs, riders and any additional administrative expenses. The insurance costs are based on the net amount of insurance at risk which is the face amount (death benefit) of the policy less the policy’s cash value. Assuming a level death benefit of $100,000 and a cash value of $35,000, the net amount of insurance at risk would be $65,000. In this case, insurance costs would be based on annual renewable term (ART) insurance rates for the insured’s attained age and health class for $65,000 of insurance protection. ART rates increase annually as the age of the insured increases so cash values need to grow in the early policy years to offset higher insurance costs at the older ages.
With universal life policies, costs of insurance will vary among competing insurance companies. All companies offer a current schedule of insurance costs and a guaranteed schedule of insurance costs. The current costs of insurance are determined by the insurance company and are based on actuarial expertise, claims experience and investment acumen. Current insurance costs are not guaranteed and can be increased by the insurance company if economic circumstances deteriorate or if claims experience is underestimated. If insurance costs are increased, costs must be increased for all “like” policies in the same policy class. There can be no discrimination. Insurance costs can never exceed the guaranteed schedule of costs which is established in the insurance policy.
Interest Credits
The cash value account (accumulation fund) offers grows
tax-deferred growth at a current interest rate. Each
insurance company declares its own current interest rate.
These interest crediting rates will fluctuate as market
conditions change. Each month the cash value is credited
with the current interest rate. This rate may change
monthly but will never be below the guaranteed minimum
interest crediting rate established in the life insurance
policy. Historically, most companies offered guaranteed
rates at 3-4% but many companies offering new policies
have lowered the guaranteed minimum rates to 2% due to
the sustained low interest rate environment.
Surrender Charges, Withdrawals and Policy Loans
Policy cash values may be access at any time subject
to certain restrictions and the applicable policy surrender
charges. Surrender charges are amounts deducted from
the accumulated cash value upon surrender or cancellation
of the insurance policy. Generally, all companies have
a surrender period for the first few policy years. Depending
on the insurance company the surrender period can extend
out to a full 15 policy years. With most insurance companies,
the surrender charge decreases each year by a certain
percentage to eventually be zero at the end of the surrender
period. The surrender charge is designed to discourage
policy owners from canceling their policies early as
well as to ensure that the insurance company recoups
its costs of underwriting the policy.
Withdrawals from
cash surrender value can be made at any time subject
to specific policy limitations. Cash
withdrawals can be accessed tax free up to the policy’s
premium basis. The premium basis is the total amount
of premiums paid into the policy to date. After the policy’s
premium basis is reached, any withdrawals are subject
to taxation. For this reason, after the policy’s
basis has been withdrawn, tax free policy loans are generally
used to access cash values. When a policy loan is made,
funds are actually borrowed from the insurance company
and a reasonable interest rate of 6-8% annually is charged.
Loan interest will accrue until the loan is repaid. While
the loan is accruing interest, the policy cash values
are also getting credited with an interest rate based
on the prevailing rate, currently 3-5% with most companies.
Therefore, there is a net loan rate, which is the difference
between the actual interest rate charged by the company
less the current credited rate on the policy cash value.
Currently net loan rates are somewhere between 2-4%.
After the first five policy years and subject to certain
conditions, many companies offer preferred loans which
have a net loan rate of 0%.
As long as the policy retains enough cash value to pay
insurance costs and fees, taxes can permanently be avoided
using the withdrawal to basis then policy loan approach.
If however, the policy lapses due to lack of cash to
pay policy costs, all cash received from the policy in
excess of the policy basis will be subject to income
taxes. Policy loans do not have to be repaid as the loan
amount with interest can be deducted from the policy
face amount at death. For more information on taxes and
life insurance see, “Life Insurance Tax Advantages".
New Guaranteed Universal Life Insurance Policies
The uncertainty of future insurance costs and interest rate fluctuations in traditional UL policies has made the lifetime guaranteed universal life polices very popular. These policies offer the attractive feature of guaranteed level rates for life. Like level term insurance, rates can be “locked in” or “dialed in” for a desired period of time. This “dial in” option is especially attractive to individuals at older ages that may want guarantees longer than what are available with level term insurance policies. Lifetime guaranteed universal life policies are mainly purchased for the death benefit guarantee so cash values are usually a secondary concern. If fact, most people seeking a guaranteed UL want very little cash value growth as this keeps the premiums lower. Lifetime guaranteed universal life insurance is also referred to as “level term insurance to age 100”.
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