Universal Life Insurance: (Almost) Everything You Need To Know

Why Does Universal Life Insurance Matter?

The tl;dr version:

• Universal life can provide a guaranteed death benefit with potentially guaranteed level (no lapse-guarantee) premiums.
• Some universal life products build non-guaranteed cash value, and offer potentially attractive growth rates on cash values, which can then be used to supplement your future retirement income.
• Life insurance companies can change costs and crediting rates. Sometimes, the terms of the contract allow insurers to change these elements at their discretion for any reason. This happens because universal life is driven by current interest rate and mortality assumptions (as opposed to "worst-case scenario", highest guaranteed mortality expenses). If the mortality rates turn out to be higher (more expensive) than originally projected or assumed, the life insurer can increase policy charges to make up for the increased cost. Because of this, universal life insurance is riskier than whole life insurance, since a significant amount of risk (i.e. the risk of rising future policy charges and lower-than-expected interest credits) is shifted back onto the policyholder.

A Brief History Of Universal Life Insurance

Many people are, understandably, confused by universal life. Some erroneously refer to it as whole life insurance (agents even do this). But… universal life is its own animal, which is very different from whole life in several important ways. 

Whereas whole life insurance is a "bundled" insurance products, universal life insurance ("UL" for short) is an "unbundled", hybrid, life insurance product. Originally, it was designed as a term life insurance policy with a deferred annuity as a technically separate product. The term life product worked just like any other term insurance policy (see the Term Life Insurance section of this guide for more information about term insurance). The deferred annuity was essentially a long-term savings and retirement account held with a life insurance company which could later be converted into a guaranteed retirement income in the future.

Deferred annuities were meant to be held for many years, and then liquidated during retirement. When the money in them was converted into income, however, it created a tax liability for the policyholder.

No good.

It wasn't until the Life Insurance Company of California, which was later renamed E.F. Hutton Life, combined a term policy with an accumulation fund into one single contract, that a true universal life insurance product was born.

By 1983, nearly every major life insurance company had devised its own universal life insurance product. And… life insurance agents began replacing as many whole life insurance policies as they could.

Why?

During the late 1970s and into the early 1980s, whole life crediting rates were "abysmal," compared to the previous 20 - 30 years. This new universal life product had the benefit of being able to capture current interest rates, and thus it looked way more attractive than the fixed whole life policy contract.

Dividend-paying whole life was popular, but dividend rates were slow to adjust to the sharply-rising interest rates in the 1980s.

A lot of life insurance companies encouraged their agents to replace their own whole life insurance products with the shiny new universal life. And so… the "Great Replacement" began.

Most of the sales in the early 1980s were nothing more than life insurance agents swapping out their clients' whole life products for universal life.

By 1985, the replacement business died down because most of the whole life that was going to be replaced with this business had been replaced.

Business was booming, until… the 1980s ended and interest rates fell.

Because UL contracts were originally designed to work in a high interest rate environment, and often contained high expense loads, they crashed and fell apart under low(er) interest crediting rates.

Today, old school current assumption fixed ULs are almost non-existent, but… there are plenty of iterations left. In general, universal life functions best as supplemental permanent life insurance and should be used in situations where neither term nor whole life insurance are appropriate.

What Is The Purpose Of Universal Life Insurance?

Generally speaking, life insurance exists (ultimately) to create certainty out of uncertainty - the uncertainty of your own death, disability, or chronic illness and also uncertainty about whether you will save up enough money.

No one knows exactly when they will die or if they will become disabled or sick before accomplishing everything they want to accomplish in life. And, that fact has a "trickle down" effect which makes it difficult (and in some cases impossible) to make long-term financial plans - plans you need to make in order to be (and feel) financially secure. In some cases, this uncertainty affects even short-term plans.

Universal life insurance helps remove some of this risk, by providing some certainty about the availability of future income and savings.

Universal life insurance was originally created as a reaction to low interest rates in the 1970s, and is a hybrid product which was (and still is) designed to compete against whole life insurance (primarily as a pseudo investment and cash value driven insurance product). As such, it shares similar purposes:

• To provide death benefit protection and;
• To provide a cash value which you can use for any reason while you're alive.

There are many technical differences between whole life and universal life, but the primary practical difference is one of flexibility.

Like whole life insurance, when you own a universal life insurance policy, you may choose essentially between lower premiums or higher cash value accumulation potential. However, unlike whole life insurance, universal life insurance has no base or guaranteed premium. This means you can increase, decrease, stop and restart premiums whenever you want. As long as there is enough cash value to pay for the cost of insurance charges, there is no required premium to keep the policy in force. You can also vary the death benefit such that it remains (mostly) level or you can elect to have it increase over time. The death benefit can be changed after the policy has been issued, allowing you to either increase it or decrease it as needed. Decreasing the death benefit generally requires the policyholder to notify the insurance company of the change, while increasing the death benefit generally requires additional underwriting to prove insurability for a higher insurance amount. Unlike whole life insurance, universal life insurance never endows. Because of this, it is never "paid in full". Instead, it is assumed the cash value of the policy will generate sufficient interest earnings to pay for the insurance for the remainder of the insured's life.

The insurance company, on the other hand, also has some choices. It can adjust internal costs to allow lower out of pocket premiums or force insurance charges higher. It can also raise and lower crediting rates, generally at its discretion.

3 Major Types Of Universal Life Insurance

Current Assumption Universal Life

Current assumption universal life is a universal life insurance policy that pays interest to cash values based on current interest rates. The interest rates can change, though most universal life policies of this type also come with a standard minimum guaranteed rate, which does not change.

Indexed Universal Life

Indexed universal life insurance credits interest based on the movement of a stock market (or other) index. It is not a direct investment in these indices, but rather an interest crediting strategy designed to provide more upside potential than a current assumption universal life policy.

Variable Universal Life

Variable universal life insurance credits or subtracts interest based on the underlying value of subaccounts, which are direct investments in various financial markets - usually, stock markets.

The Annually-Renewable Term Chassis Of Universal Life Insurance

The Term Chassis Of Universal Life Insurance

Embedded within every universal life policy is a term insurance policy.

The term policy gives you one year's worth of death benefit protection for a set premium which does not change for the entire year.

At the end of the year, the term policy automatically renews at a higher rate, but your premium is expected (though not guaranteed) to remain level.

Life insurance companies disclose most (but not all) costs in a UL policy in a cost disclosure section of a universal life insurance policy illustration. The big appeal of a universal life policy is supposed to be the fact that they are completely transparent. However, as you'll see later, we need to do one extra step to understand all of the costs of the policy.

Conceptually, the internal policy charges would look similar to an annual renewable term policy, like this:

However, universal life premiums are generally levelized, meaning they remain flat or level for the life of the policy. In most cases, the level premium is not guaranteed, so while the insurer can assume the premium will remain level, there is no guarantee that the premium will actually remain level forever.

This is because universal life is an assumption-driven product. Assumed costs (which are not guaranteed) and assumed crediting or interest rates (which are also not guaranteed) are what drive the premium rates for universal life.

Of course, universal life does have minimum guaranteed (gross) crediting rates and maximum mortality charges, but policy illustrations run under these minimum and maximum assumptions rarely hold together well. The product is usually designed to run under the non-guaranteed assumptions, not the guaranteed ones.

A Review Of How Level Premium Funding Works

Level premium funding is covered elsewhere in this guide, but I shall provide a review of it here as well.

"Level premium funding" is a premium payment and scheduling scheme which helps keep the premiums for universal life insurance level for a set period of time, potentially lasting for the entire term of the contract (which is usually age 100 or age 121).

If you're a detail-oriented person, or a spreadsheet junkie, then I recommend you check out the book, Actuarial Aspects of Individual Life Insurance and Annuity Contracts, by Albert E. Easton and Timothy F. Harris, where these (and other) insurance concepts are fleshed out in more excruciating detail.

The way this works is… the insurance company collects more than what it actually needs to pay for the death benefit. By doing so, it establishes a cash reserve.

This reserve is, in actuality, a liability that the insurance company needs to pay the future death benefit. There are lots of different ways insurers can establish reserves but… they all basically work the same way.

Whenever a life insurance policy has a level premium, you can be sure the insurer is collecting more premium than it really needs and then investing that money on your behalf.

For all fixed universal life policies, the reserve is invested in the insurance company's General Investment Account (GIA). For variable universal life policies, the money is allocated to one or more separate accounts which function like mutual funds. More on that later.

Death Benefit Options

Options, Options

Most universal life insurance policies offer you a choice of 2 death benefit options: Option A (or Option 1) or Option B (or Option 2).

Sounds kind of like a Chinese restaurant, doesn't it?

Except that here, your options determine how your death benefit and cash value (if any) behaves.

Option A

Under Option A, you specify the amount of insurance (face amount) you want, and the insurance company maintains this insurance amount for you as decreasing term insurance. The death benefit, then, equals the cash value plus any remaining term life insurance in the policy (i.e. any remaining pure insurance).

If you read the whole life insurance section, and this sounds somewhat familiar, it's because it's exactly how whole life insurance death benefits work.

As the cash value grows, the amount of pure insurance in the policy decreases. If cash values approach the face amount before policy maturity (usually age 100 or age 121), then an additional amount of insurance is automatically purchased, which creates something called a "corridor." This corridor is maintained in addition to cash values and the original face amount of insurance.

Option B

With Option B, your death benefit is equal to the face amount of insurance (pure insurance) plus the cash value. In essence, you are buying a level term insurance policy (as opposed to a decreasing term insurance policy) and also building a cash value.

Cash values under this option must be tightly controlled, since IRS regulations prohibit them from growing disproportionately larger than the term insurance death benefit.

This ratio of cash value to death benefit is maintained under one of two definitions of life insurance specified under section 7702 of the Internal Revenue Code. The insurer will either perform a Cash Value Accumulation Test (CVAT) or a Guideline Premium Test (GPT). The policy's premium payments, cash value, and death benefit amounts must pass this test to be considered life insurance (as opposed to an investment product.

How Cash Value In A Universal Life Policy Works

What Cash Value Means In A Universal Life Policy

Unlike whole life insurance, cash value in a universal life insurance policy is simply an accumulation fund or policy value fund. In the industry, we call it the "pot of money."

It's sole purpose, from the perspective of the insurance company, is to pay for the cost of the term insurance.

That's it.

As long as there is money in the cash value to cover policy charges, you're good.

Premiums are, of course, scheduled but policyholders may pay more (up to a certain limit) or less (including $0) than the scheduled amount.

Premiums paid to the insurance company are credited directly to the cash value of the policy. Policy charges, including cost of term insurance, are then deducted from the cash value. After charges have been deducted, interest (if any) is credited back to the cash values.

The actual credited interest depends entirely on what those cash values are invested in.

Bottom line: As long as there is money in the cash value account sufficient to pay for the term insurance, you have an insurance policy. If, at any time, your cash value drops to $0, your universal life insurance policy terminates and you have no more life insurance. The only exception to this is Guaranteed (or "No-Lapse") Universal Life, which generally does not have cash value or has low cash value.

Other than that, the insurance company does not strictly enforce specific premium or cash value levels.

Policyholders may pay premiums up to the policy's premium limit or up to the MEC guidelines (discussed elsewhere in this guide), they may reduce premiums, or a policyholder may stop them entirely  and… a policyholder may also withdraw cash value from the policy at any time for any reason.

Policy Value vs Net Cash Surrender Value

Unlike whole life, universal life cash values are divided into two different values - the policy value and the net cash surrender value.

The policy value is defined as: "The total value in the policy, which consists of premiums paid and credited interest, minus policy charges and partial withdrawals."

However, all universal life policies also have declining surrender charges, which are charges in addition to the basic policy charges, which last for many years. These charges are only paid if you surrender the policy for its cash value during the surrender period. Once the surrender period is over, no surrender charges are paid.

The net cash surrender value is the cash value minus the surrender charges. It is essentially the cash value available to you as a policyholder if you decide to borrow against the policy or surrender it for its cash value.

Sample Universal Life Policy Illustrations

Guaranteed No-Lapse Universal Life Insurance

Guaranteed No-Lapse (sometimes called "Universal Life With Secondary Guarantees" or "GUL") generally does not build much (or any) cash value. Instead, it provides a level death benefit. The insurer charges a guaranteed level premium as long as all premium payments are made on-time and no policy loans are taken.

Guaranteed No-Lapse Universal Life Illustration

This policy runs to the insured's age 121 and is taken out on a 35 year-old male, standard, non-smoker. Notice the death benefit remains level for the entire time.

From year 15 to year 35, this policy builds a non-zero amount of cash value. It is never substantial and is not meant to be a permanent cash value. If a premium is ever paid late, and the no-lapse guaranteed minimum premium is not paid, the guarantee disappears and the policy may lapse.

A policyholder can pay more into this policy to build up the policy value, but these policies are generally not designed for high cash value accumulation.

Because substantial premiums are paid into this policy over long-periods of time, it is possible to pay more in premium than you receive as a death benefit. In this case, the cumulative premiums paid over 65 years totaled just $406,965 - a lot of money, but still less than the total face amount of insurance.

When buying GUL, it's a good idea to verify the total premiums paid will never exceed the death benefit amount.

Additionally, GUL is very sensitive to when premiums are paid. Paying early or late can suspend the no-lapse guarantee provisions, or terminate them altogether. This is partially due to the fact that some insurers use a combination of a minimum premium amount plus a guaranteed interest rate to determine whether the no-lapse guarantee will be in effect. Other insurers use a more complex formula to determine whether a special extended no-lapse guarantee rider will be triggered.

Paying premiums early sometimes shunts premium dollars into a "shadow account" or "multi-tiered shadow account", which can earn less than the guaranteed rate in the contract. Premiums paid over and above the minimum premium may be assessed a large premium charge before normal mortality and expense charges are deducted and interest is paid on that premium.

Premiums paid late or "off schedule" can also cause unexpected or poorly disclosed charges to be triggered, suspending or terminating the guarantees in the policy.

These various expense mechanisms are loosely referred to as "trap doors" in the insurance industry, and can either prevent the no-lapse guarantee provisions from being triggered or cause previously-triggered guarantees to terminate unexpectedly.

All this to say that, sometimes, a guarantee isn't what you think it is.

Current Assumption Universal Life (Option A)

Current assumption UL credits cash values according to current interest rates. In this example, the gross interest rate (before policy charges) is 4.25%. This interest rate can change over time with interest rates in the marketplace, and tend to follow bond interest rates over the long-term.

Because current assumption UL builds cash value, a common question arises: "how much does the insurance cost as versus the cash value?" In a UL, these policy charges can be broken out by month and by year.

First, the total illustration under option A:

In this illustration, premiums of $11,693 are paid in the first year, which generates a policy value of $6,835, and a net cash surrender value of $1,390.

How much goes towards cost of insurance? It might be intuitive to say $4,858, since this is the difference between the premium paid and the policy value, or… maybe $10,303, since this is the difference between the premium and the net cash value.

But, universal life insurance is an "unbundled" insurance product, meaning you can "see inside" of the policy and break out most of the internal charges.

Like this:

These charges are broken out monthly, so you can get very granular with this. Of course, you can also see charges annually:

Policy charges never seem to end, do they?

In reality, various charges drop off over time in this particular illustration. Those costs are designed to help pay for various benefits within the policy and, when they have sufficiently covered the cost of the benefit, they drop off. For example, the per $1,000 charges stop in year 10.

However, not all policy charges are disclosed in the illustration. This policy's advertised gross interest crediting rate is 4.25%. But, if you start in the first year of this policy, subtract all itemized costs, and then add back in the interest, you will see it is not a 4.25% net rate.

No problem, as the insurer does tell us it's the gross interest rate. So, take the premium, add 4.25% interest, then subtract all the costs.

Uh oh!

The difference between the gross crediting rate and net rate credited to the policy is between $100 and $300 "off."

To get at the real cost of the policy, you must "reverse engineer" the policy. This is relatively straightforward since:

Net cash surrender value = (Premium - Expenses) + interest crediting

So, subtract out the gross crediting rate of 4.25% (interest earnings) and then subtract the premium from the remaining cash value. Whatever is left is not premium, and it is not interest earnings. It is therefore, by definition, the cost of the policy. You must do this each and every year (remembering to add the previous year's cash value and subtracting the total net cash value at the end of the year) to get at the true annual cost for the policy.

When you do, you end up with these as your total policy costs:

As you can see, the annual policy costs grow quite large. Based on the policy's illustration, you'd think they shrink over time.

This is not true, and we know from looking at term life insurance policy costs that term costs only grow over time. In fact, annually-renewable term costs are guaranteed to grow each and every year. And, all universal life policies are built on a 1-year annually-renewable term policy chassis.

So, it doesn't make sense that they would decrease over time.

And… we see that they don't. In year 86 alone, the total costs for the policy are $127,728 for a little over $6.1 million of death benefit. Total cumulative costs for this policy are roughly $3.2 million.

Current Assumption Universal Life (Option B)

Option B of this same policy allows the policyholder to increase the death benefit each year by adding cash value on top of a level death benefit.

Like so:

The face amount of insurance is $1 million, just as the previous option, but this time cash value is added to the death benefit amount, which allows it to grow over time.

Here's how that affects the total costs of the policy:

Because the cash value is being added to the face amount instead of helping to replace it, the cost of maintaining the insurance increases. This also results in a lower total net cash value, lower total death benefit, and total cumulative internal charges of about $3.8 million.

In general, trying to have both insurance and savings/cash value is more expensive than using the cash value to replace the pure insurance amount (as is done in Option A and also in whole life insurance).

Equity-Indexed Universal Life (Option A)

Equity-indexed universal life is an equity-linked universal life insurance product. It is not a direct investment in the stock market. More on that in a moment.

This is the hottest universal life product on the market right now, and it doesn't show signs of stopping. The product itself is driven by a precise mix of bonds and index options contracts (which is explained in more detail in the Crediting Rates And Options In Universal Life section below).

When illustrating these products, life insurance agents tend to be a little too… how shall I say this… "optimistic." Most indexed universal life insurance illustrations need to take a "chill pill" and bring those illustrated rates back to reality.

Here's what I mean:

When you see indexed life products being illustrated, usually you see agents use 6%, 7%, or even 8% or more as the illustrated rate.

This is way too high.

How do we know it's too high?

Because… in general, life insurance companies are not earning quite that much (overall) on their indexed universal life portfolio.

Bobby Samuelson, former MetLife (now Brighthouse) Senior Vice President and head of product development and pricing for life and annuity contracts, has extensive experience in the indexed life marketplace. He is also an independent consultant for major life insurers in the indexed UL space, guiding insurers on product design and pricing.

The reason I bring this up is because he has said, on numerous occasions, that when illustrating indexed life insurance, keep expectations in line with what the product actually is.

His recommendation? Illustrate indexed universal life at 1% over current assumption rates. His reasoning is pretty straightforward. At its core, indexed universal life insurance is a fixed life insurance product (or, in industry jargon, a "general account product."). As such, it functions more like a current assumption or fixed universal life than it does a variable universal life or an index fund (or some other equity product).

According to Samuelson, these products may perform between 25 and 50 basis points (0.25% to 0.50%) over a current assumption universal life product.

Even with high cap rates over 13%, Samuelson's recommendation is to illustrate at 1% over current assumption UL (which would set the illustrated rate at 5.25%), which is what I did here: