What is Universal Life Insurance?
Universal Life Insurance is a type of permanent life insurance. It was created in the early 1980’s to take advantage of the rising trend of consumers’ interest in managing their own investments. No insurance product up until this point allowed for an active role for the consumer.
Most types of life insurance were (and still are) passive; Once purchased, they are reasonably straightforward and require little ongoing management.
Universal life, on the other hand, includes many moving components that provide choice and must be actively managed.
Let’s examine what these components are:
- Death Benefit/Face Amount: Common to all insurance products, you, the consumer chooses the amount of insurance you want to purchase. However, you must choose at the time of purchase whether you want yearly/annual (YRT/ART) adjustable term rates OR level cost rates. This is the cost of your life insurance (mortality charge). Either you will have an increasing cost every year based on age (the schedule is in the policy – not for the feint of heart) OR you will pay a higher but constant rate throughout the policy’s life – level cost. Or you can start with renewable term and switch to level cost at a later date that is predetermined, for example age 85 OR some policies allow you to choose the year/age when you want to switch . The choice must be made with care; if you start with low YRT/ART rates your cost will be low initially but escalate as you age whereas the level cost is higher but locked in at that time of purchase.You must also choose the “death benefit option”. This will determine the actual amount the insurance company pays out at as a claim.
- If you choose “LEVEL FACE” then your beneficiary gets the amount you contracted for, that is, the death benefit/face amount.
- If you choose “LEVEL FACE PLUS DEPOSITS” then your beneficiary will receive the death benefit/face amount PLUS gross deposits made into the plan.
- If you choose “LEVEL FACE PLUS ACCOUNT VALUE” then your beneficiary receives the death benefit/face amount PLUS the value held within the policy account. (See below under investments.
- Expenses: these are policy related and include monthly administration fees and most likely transaction fees (see below under investments) and sales charges and will differ among the various insurance companies. These remain usually fixed and in addition the minimum premium includes the provincial tax applicable in each province.
- Investments: This is where you take control and why this product was created in the first place. Deposits into the policy can build a pool of savings in the account, called the account value or the accumulation fund. Universal Life policies provide you with a range of options for investment. Usually, fixed-interest options such as guaranteed term deposits, or simple savings accounts , as well as equity and indexed options are available. Certainly different carriers have different options, and like all investments careful selection based on management and performance should be considered. Like all investments, your personal risk tolerance and return expectations must be considered. Pay attention to any minimum guarantees in the policy. Older policies have some nice guarantees contractually built in. Newer policies tend to have none.
It is important to understand that the investment portion is completely optional. If you choose to set your premium to cover the basic mortality and expense charges then you will simply have a permanent policy. If you choose to contribute over and above the minimum charge then you select where you would like the additional money to go – the investment portion. You can change or stop this additional amount at any time. This flexibility is what makes this product so unique.
The investments grow tax deferred inside the policy. Active management of your investments inside the universal life policy is as important as managing any of your regular investments. You can request monthly statements, quarterly, semi or annual depending on your preference from most insurers. As your investments grow you should build up cash value. You have access to this cash at any time.
Before removing cash from your policy you must understand that in the early years of the life policy there are substantial charges for the insurance company. These expenses have to be recovered and are quite high in the early years and diminish to zero over time. There is a schedule of surrender charges inside the policy contract. Different insurance companies have different schedules but most decline to zero between year six and ten.
Therefore your cash surrender value is your cash value LESS any surrender charges (and any loans if you’ve borrowed from the policy). If you are not sure check your last statement. It will be listed there. Insurance companies are striving to make these statements easier to understand.
Under a Universal Life policy you must cover the minimum cost of the insurance (mortality and expenses) in order for your policy to remain in force. A policy owner that only contributes the minimum cost will not build up any cash value. Without cash value a missed premium could result in the loss of the insurance coverage. For those plans that have a good build up of cash value the minimum cost of the insurance can be removed from the accumulating (cash) account without additional deposits.
Money in the accumulating account can be removed, borrowed against, used as collateral, and used to offset the cost of the minimum insurance.
There is also a maximum deposit allowable. The formula is defined in the Income Tax Act. If the maximum is exceeded, the policy will lose its tax status as “exempt” and may be taxed as an investment. Most insurance companies have mechanisms to make sure that this will not be the case.
A special note for the Policy Illustration:
A policy illustration is designed based on assumptions. If you are contributing additional deposits to be invested then you need to pay attention to the illustrated rate of return – especially if you have chosen a variable cost of insurance (YRT/ART). Why? The rate of return will determine the growth of your deposits necessary to pay for the rising cost of insurance. If you do not achieve the illustrated growth then you may end up having to pay additional sums of money in later years in order to meet the minimum requirements and not have your policy lapse.
All illustrations usually use an assumed rate and show an alternate scenario with a lower rate. The alternate must meet your minimum cost and it needs to be illustrated at a rate of return that is reasonable.
If you choose a level cost of insurance then you already know what your minimum cost is throughout your policy. If you contribute additional deposits for investment then your illustrated rate and alternate rate will only demonstrate how much money you will accumulate with time.
Reality check is when you receive your statements. Actual performance results can differ from the assumptions made. You may choose to increase, decrease, or stop additional deposits. Any changes will affect the financial performance of your plan, therefore, it is imperative that you continually manage the plan.
Same example as above: primary projected rate of return is 5.5%. The alternate (favourable) will show +2% (7.5%) and negative (adverse) -2% (3.5%). Witness the difference in cash surrender value.
Who should buy this plan??
Anyone that needs life insurance and is looking to purchase a permanent plan.
The flexibility to add additional funds if needed, is an excellent option as people’s lives change. If you’ve maxed out on RRSP’s or employer pension plans, TFSA’s, etc. and like the idea of insurance AND additional money growth that is tax deferred, then this product is an excellent choice. The growth can help supplement retirement income, fund your children’s education, start a business, or any other financial goals you may have.
This product is especially appealing to business owners for insurance, pension building, wealth accumulation, and tax minimization strategies.
Anyone more willing to make and control their own investment decisions and take on the risk. Anyone that requires more flexibility with designing their own plan.
Cost oriented people that prefer to see the “unbundling” of the cost of insurance, expenses, and investment performance.
Anyone with a “buy term and invest the rest” mentality – that is the UL policy in a nutshell. Money over and above the cost of the term (either you will have a variable term cost or a level to age 100 term cost or some combination of the two) but the rest (“additional money”) can be invested in a tax deferred environment.
Anyone planning for their estate. If you want to leave money to family, charity, church, then you must buy permanent life insurance as opposed to term. The need for permanent insurance fulfills the requirement to leave funds on death for estate taxes, probate fees, capital gains, final expenses, etc.
Conclusion:
Universal life is a great permanent life insurance plan that combines life insurance protection with a tax deferred savings/investment account. The flexibility built into the plan makes it suitable for anyone needing life insurance protection that wants a plan tailored to their own needs.