Adjustable premium

What Is Adjustable Premium?

An adjustable premium refers to a life insurance policy feature, primarily found in universal life insurance, where the policyholder has the flexibility to modify the amount and frequency of their premium payments within certain limits. This flexibility is a core characteristic of universal life, a type of permanent life insurance that falls under the broader financial category of personal finance and wealth management. Unlike traditional whole life policies with fixed premiums, an adjustable premium allows policyholders to adapt their payments based on their financial circumstances and the policy's accumulating cash value.

History and Origin

The concept of adjustable premiums emerged with the introduction of universal life insurance in the late 1970s and early 1980s. Prior to this, traditional whole life insurance dominated the market with its rigid, fixed premium structure. However, the economic climate of the late 1970s, characterized by high inflation and fluctuating interest rates, highlighted the limitations of these rigid policies. Consumers and insurers sought greater flexibility. Universal life insurance, designed to address these concerns, combined elements of term life insurance and an investment component. Life Insurance Company of California (later E.F. Hutton Life) launched "Total Life," a precursor to modern universal life, in 1979. By the end of 1983, most major insurers had introduced their own universal life products, many featuring an adjustable premium.¹³ This innovation allowed policies to better adapt to changing economic conditions and policyholder needs, contrasting with the fixed-rate guarantees of older whole life contracts.¹²

Key Takeaways

• An adjustable premium offers flexibility in payment amounts and frequency for certain life insurance policies.
• It is a defining characteristic of universal life insurance.
• Policyholders can increase, decrease, or even skip premium payments, subject to the policy's terms and cash value.
• This flexibility can help policyholders manage their insurance costs in response to changing financial situations.
• Adjustable premiums require careful monitoring to ensure the policy remains in force and does not lapse.

Formula and Calculation

While there isn't a single universal formula for an adjustable premium itself, the amount a policyholder pays influences the policy's cash value, which in turn affects the sustainability of future premiums. The mechanics involve a regular deduction of the "cost of insurance" (COI) and other fees from the cash value. The remaining cash value then earns interest.

The net amount added to or subtracted from the cash value can be expressed as:

$\text{Cash Value Change} = (\text{Premium Paid} - \text{Policy Charges}) + \text{Interest Earned} - \text{Cost of Insurance}$

Where:

• Premium Paid: The amount the policyholder pays into the policy. This is the adjustable premium.
• Policy Charges: Various fees and administrative costs deducted by the insurer.
• Interest Earned: The interest credited to the cash value, which can be fixed or linked to an index.
• Cost of Insurance (COI): The amount deducted to cover the actual insurance protection, which typically increases with age.

The adjustable premium allows the policyholder to manipulate the "Premium Paid" component to maintain the desired death benefit and cash value.

Interpreting the Adjustable Premium

The interpretation of an adjustable premium lies in its strategic use for managing a life insurance policy. A higher adjustable premium payment than the minimum required can accelerate the growth of the policy's cash value. This increased cash value provides a buffer, allowing the policyholder to potentially skip or reduce future payments if financial hardship arises, without causing the policy to lapse. Conversely, consistently paying only the minimum or skipping payments can deplete the cash value, increasing the risk of the policy terminating if the cash value can no longer cover the internal costs.

Policyholders often use the adjustable premium feature to align their insurance costs with their evolving financial capacity. For instance, during periods of higher income, they might overfund the policy to build a stronger cash value. During times of financial strain, they can temporarily reduce or pause payments. Understanding the impact of premium adjustments on the policy's long-term viability and cash value accumulation is crucial for effective financial planning. It also impacts potential policy loans or withdrawals.

Hypothetical Example

Consider Maria, a 35-year-old professional, who purchases a universal life insurance policy with an adjustable premium. Her initial planned monthly premium is $200.

Scenario 1: Financial Success
Five years later, Maria receives a significant promotion and a substantial salary increase. To accelerate her policy's cash value growth, she decides to increase her adjustable premium payments to $300 per month. This additional $100 contributes directly to her cash value after policy charges and the cost of insurance are deducted. Over time, this higher payment allows her cash value to grow more rapidly, potentially enabling her to take a tax-deferred withdrawal in the future or even cover policy costs later in life.

Scenario 2: Temporary Setback
After 10 years, Maria faces an unexpected medical expense, temporarily straining her finances. Instead of letting her policy lapse, she uses the adjustable premium feature to reduce her monthly payment to $100 for six months. Her policy's existing cash value is sufficient to cover the remaining cost of insurance and policy charges during this period. Once her financial situation stabilizes, she resumes her $200 monthly payments, or even increases them to replenish her cash value, avoiding a policy lapse.

Practical Applications

Adjustable premiums are predominantly found in universal life insurance policies, making them a key consideration for individuals seeking flexible life insurance coverage. This feature is particularly relevant in:

• Estate Planning: An adjustable premium allows individuals to adjust their funding of a policy designed for estate planning purposes, ensuring the death benefit remains intact for beneficiaries while adapting to changes in estate tax laws or personal wealth.
• Retirement Planning: Some policyholders utilize the cash value component of universal life policies as a supplementary savings vehicle for retirement. The adjustable premium offers the flexibility to contribute more during high-income years and potentially draw from the cash value or reduce premiums during retirement.
• Business Succession Planning: In business contexts, universal life policies with adjustable premiums can be used for key person insurance or funding buy-sell agreements. The flexibility allows businesses to adapt premium payments to their evolving financial health.
• Variable Economic Conditions: The adjustable nature of these premiums provides a mechanism for policyholders to respond to shifts in the economic landscape, such as periods of high inflation or low interest rates, by adjusting their contributions to maintain policy performance. However, sustained low interest rates have also led to unexpected premium increases for some older universal life policies, highlighting the complexities involved.¹¹ This has sometimes resulted in lawsuits against insurers who raised premiums on older universal life policies.¹⁰

Limitations and Criticisms

While offering flexibility, adjustable premiums in universal life insurance policies come with notable limitations and have faced criticism. One primary concern is the potential for policies to lapse if the cash value cannot sustain the rising cost of insurance, especially in later years. Policyholders, initially drawn by the flexibility, may not fully grasp that the internal cost of insurance typically increases with age. If interest credited to the cash value is lower than projected or if premium payments are insufficient, the cash value can erode, leading to a demand for significantly higher payments to keep the policy active.⁹ Some policyholders have experienced substantial and unexpected premium increases, with some reporting jumps of over 200%.⁸

Furthermore, the complexity of universal life policies, particularly those with an adjustable premium, can make it challenging for the average consumer to understand.⁷ Critics argue that these policies are sometimes misleadingly sold as investments rather than primarily insurance products, obscuring the underlying fees and risks. The Consumer Federation of America has highlighted the difficulty buyers face in comparing prices and costs for cash value life insurance policies, including universal life.⁵, ⁶ This lack of transparency can lead to policyholders making ill-informed decisions about their premium payments, potentially jeopardizing their long-term coverage. The intricate interplay between the adjustable premium, investment returns, and various policy charges necessitates a thorough understanding to prevent unexpected outcomes.⁴

Adjustable Premium vs. Fixed Premium

The fundamental difference between an adjustable premium and a fixed premium lies in the policyholder's control over payment amounts.

An adjustable premium, characteristic of universal life insurance, provides the policyholder with the ability to modify payment amounts and frequency. This means they can pay more to build cash value faster or pay less (or even skip payments) if the cash value is sufficient to cover policy charges, offering considerable liquidity. In contrast, a fixed premium, typical of whole life insurance and term life insurance, mandates a consistent payment amount for the life of the policy or for a specified term. While the fixed premium offers predictability and simplicity, it lacks the adaptability to changing financial circumstances that an adjustable premium provides.

FAQs

Can an adjustable premium policy lapse?

Yes, an adjustable premium policy can lapse. If the policyholder consistently pays too little or skips too many payments, the policy's cash value may eventually be insufficient to cover the cost of insurance and other policy charges, leading to the policy terminating.

##³# How often can I adjust my premium payments?
The frequency with which you can adjust your premium payments depends on the specific terms and conditions of your universal life insurance policy. Some policies offer significant flexibility, allowing adjustments monthly or annually, while others may have more restrictive guidelines. It's important to consult your policy document or speak with your insurance provider.

Does an adjustable premium mean my payments will always go down?

No, an adjustable premium does not mean your payments will always go down. While you have the flexibility to reduce payments, the actual cost of insurance within the policy typically increases with your age. If the interest earned on your cash value is not enough to offset these rising costs, you may need to increase your adjustable premium payments to keep the policy in force, especially in later years.

##²# Is an adjustable premium policy suitable for everyone?
An adjustable premium policy is not suitable for everyone. While it offers valuable flexibility, it also requires a greater understanding of how the policy operates and more active management by the policyholder. Individuals who prefer simplicity and predictability in their financial commitments may find fixed premium policies like whole life or term life insurance more appropriate.

What factors influence the cost of insurance in an adjustable premium policy?

The cost of insurance (COI) in an adjustable premium policy is influenced by several factors, including your age, health, the death benefit amount, and the insurance company's mortality and expense charges. As you age, the COI generally increases. Investment performance of the policy's cash value also plays a role, as better returns can help offset the COI and reduce the need for higher premium payments.¹