Universal life

What Is Universal Life?

Universal life (UL) is a type of permanent life insurance that offers both a death benefit and a cash value component. As a product within the broader life insurance category, it distinguishes itself by providing policyholders with significant flexibility in managing their premium payments and death benefits, unlike the more rigid structure of traditional whole life insurance. The cash value grows tax-deferred based on credited interest rates, which the insurer declares and can change over time, though often subject to a guaranteed minimum. This flexibility allows policyholders to adjust their coverage as their financial circumstances or needs evolve, making universal life a dynamic tool for long-term financial and estate planning.

History and Origin

Universal life insurance emerged in the late 1970s and gained significant popularity in the 1980s, driven by a period of high interest rates.²², ²³, ²⁴ Traditional whole life policies, with their fixed premiums and guaranteed, but often lower, cash value growth, seemed less appealing compared to the flexible and potentially higher-earning new universal life products. Insurers developed universal life to offer a more adaptable option, allowing policyholders to alter premiums and death benefits in response to changing economic conditions and personal needs.²¹ Its introduction marked a notable shift in the life insurance industry, as it provided a hybrid solution combining features of term insurance with a savings component, designed to thrive in a fluctuating interest rate environment.¹⁹, ²⁰ The product's flexibility was a key innovation that responded to consumer demand for greater control over their insurance policies. The New York Times notably covered its emergence in early 1982.¹⁸

Key Takeaways

• Universal life insurance is a permanent life insurance policy with a cash value component that grows on a tax-deferred basis.
• It offers flexible premiums and an adjustable death benefit, allowing policyholders to adapt their coverage.
• The cash value earns interest at a rate declared by the insurer, typically with a guaranteed minimum, but can fluctuate.
• Policyholders can access the cash value through withdrawals or policy loans.
• Universal life policies require careful monitoring to ensure that the cash value is sufficient to cover rising costs of insurance, particularly in low interest rate environments.

Interpreting Universal Life

Understanding a universal life policy involves grasping its two main components: the cost of insurance (COI) and the cash value accumulation. The COI covers the pure insurance risk and administrative expenses, typically increasing with the policyholder's age. The remaining portion of the premium payments, after deductions for COI and other fees, contributes to the cash value. This cash value grows based on interest rates credited by the insurer.

Interpreting the health of a universal life policy requires regular reviews of its "in-force illustration," which projects the policy's future performance based on current assumptions. Policyholders should pay close attention to how changes in credited interest rates and increasing COI charges might affect the policy's ability to maintain its death benefit until the desired age. If the cash value growth is insufficient to cover the rising internal costs, additional premiums may be required to prevent the policy from lapsing. This makes ongoing monitoring crucial for universal life policyholders.

Hypothetical Example

Consider Sarah, a 35-year-old professional who purchases a universal life policy with an initial death benefit of $500,000. She opts for a flexible premium payment structure, initially paying $250 per month.

In the early years, a larger portion of her premium goes towards the cost of insurance and administrative fees, with a smaller amount contributing to her cash value. The cash value begins to accumulate, earning interest at the rate declared by the insurer, for example, 3.5%.

Five years later, Sarah gets a significant raise. She decides to increase her premium payments to $400 per month. This increased payment accelerates the growth of her cash value, as more money is credited to the accumulation account after the monthly deductions. Alternatively, if Sarah faced a temporary financial hardship, she could reduce her premium payments, or even skip a few payments, as long as her accumulated cash value was sufficient to cover the monthly costs of insurance and keep the policy in force. This demonstrates the flexible premiums feature of universal life.

Years later, when Sarah's children are approaching college, her policy's cash value has grown to $70,000. She decides to take a policy loan of $20,000 against her cash value to help with tuition expenses. The loan is typically tax-free, and she can repay it at her leisure, though interest accrues. If she doesn't repay the loan, the outstanding amount will be deducted from the death benefit paid to her beneficiaries. This example illustrates how the cash value component of universal life can serve as a liquid asset during her lifetime while still providing long-term protection.

Practical Applications

Universal life insurance serves various practical applications in financial planning due to its inherent flexibility:

• Long-Term Financial Protection: It provides lifelong coverage, ensuring a death benefit is paid to beneficiaries, which can be crucial for estate planning and providing for dependents.
• Wealth Accumulation and Access: The cash value component grows tax-deferred, offering a potential source of funds that can be accessed through withdrawals or policy loans for various needs, such as retirement income, funding education, or covering emergencies. The IRS generally states that the growth in cash value is not taxable as it accumulates, and loans are typically tax-free up to the amount of premiums paid.¹⁶, ¹⁷
• Flexible Premium Payments: Policyholders have the ability to adjust their premium payments within certain limits. This flexible premiums feature is particularly useful for individuals with fluctuating incomes or those who anticipate changes in their financial capacity.
• Adjustable Death Benefit: The policyholder can often increase or decrease the death benefit to align with changing family needs, such as the birth of a child or the independence of adult children.
• Business Planning: Businesses may use universal life policies for executive bonus plans, key person insurance, or deferred compensation arrangements, benefiting from the tax-deferred growth and accessible cash value.
• Specific Universal Life Variations: Beyond traditional universal life, products like indexed universal life (IUL) and variable universal life (VUL) offer different approaches to cash value growth, linking it to market indexes or investment subaccounts, respectively.

Limitations and Criticisms

Despite its flexibility, universal life insurance policies carry several limitations and have faced criticism. One significant concern is the potential for policies to underperform or even lapse if credited interest rates decline or if the policyholder consistently pays minimum premium payments. The cost of insurance (COI) component of universal life policies typically increases with age, which can lead to higher charges over time. If the cash value growth does not keep pace with these escalating costs and other fees, the policyholder may need to pay substantially higher premiums to maintain coverage, or the policy could terminate without value.¹⁴, ¹⁵

Another criticism often leveled against universal life, particularly older policies or those sold with aggressive projections, is the lack of guaranteed performance. While many policies include a guaranteed minimum interest rate, the actual rate credited can fluctuate, impacting the rate of cash value accumulation. This contrasts with the fixed interest rates often associated with whole life insurance. Some critics argue that the complexity of universal life policies, especially variations like indexed universal life, makes them difficult for the average consumer to fully understand, potentially leading to unrealistic expectations.¹³ Regulatory bodies, like the National Association of Insurance Commissioners (NAIC), have developed model regulations to address disclosures and illustrations for universal life products to help consumers understand these complexities.¹⁰, ¹¹, ¹²

Furthermore, early termination of a universal life policy can result in significant financial loss due to surrender charges, which can negate much of the accumulated cash value.⁹ Policyholders may find themselves "handcuffed" to policies with escalating costs in later life, particularly if initial projections were overly optimistic and not based on conservative assumptions.⁸ Issues arising from low interest rate environments impacting older universal life policies have also drawn attention, with some insurers increasing charges to offset lower investment earnings.⁶, ⁷ Reuters reported on the "long slow death of old life insurance policies" due to persistent low interest rates, highlighting the challenges faced by policyholders with older universal life policies.⁵

Universal Life vs. Whole Life Insurance

Universal life and whole life insurance are both types of permanent life insurance that offer a death benefit and build cash value. However, they differ significantly in their flexibility and guarantees.

The primary distinction lies in flexibility versus guarantees. Universal life offers more adaptable premium payments and an adjustable death benefit, appealing to those whose financial situations may change. Its cash value growth is tied to declared interest rates, which can offer greater potential gains in high-interest environments but also risks lower returns if rates fall. In contrast, whole life insurance provides fixed premiums and guaranteed cash value growth, offering predictability and stability for those who prioritize certainty in their long-term financial planning.

FAQs

What does "flexible premiums" mean for universal life?

Flexible premiums in universal life insurance mean you can adjust the amount and frequency of your payments within certain limits. If your cash value has sufficient funds, you can even skip a premium payments without the policy lapsing. This flexibility allows you to adapt payments to your changing financial situation.

Is the cash value in universal life taxable?

The cash value in a universal life policy generally grows on a tax-deferred basis, meaning you do not pay taxes on the growth each year.⁴ If you take policy loans against the cash value, they are typically tax-free. However, if you withdraw more than you've paid in premiums or if the policy lapses with an outstanding loan, taxes may apply.², ³

Can a universal life policy lapse?

Yes, a universal life policy can lapse. This typically occurs if the accumulated cash value is insufficient to cover the rising costs of insurance and other fees, and the policyholder does not pay enough premium payments to make up the difference. Regular monitoring of your policy's performance is crucial to prevent unintended lapse.

What are riders in universal life insurance?

Riders are optional provisions that can be added to a universal life policy to enhance or customize its coverage. Common riders might include an accelerated death benefit for terminal illness, a waiver of premium in case of disability, or a long-term care rider, among others. These add-ons typically incur an additional cost.

How do interest rates affect universal life policies?

Interest rates are crucial for universal life policies because the rate at which your cash value grows is directly tied to the interest rate credited by the insurer. If interest rates are high, your cash value may grow more quickly. Conversely, in a low interest rate environment, cash value growth may be slower, potentially requiring higher premium payments to maintain the policy.¹