How it works
Universal life insurance has been around for a number of years, but many people are still not sure exactly how this excellent product works.
Universal life insurance, or "UL," is referred to by a variety of names - "Flexible Premium Life," Flexible Premium Adjustable Life," "Adjustable Life," and others. The most important words are "adjustable" and "flexible," and they don't mean the same thing. Universal life is "adjustable" because the policyowner can request that the death benefit be changed at any time. Each policy has a certain minimum amount of death benefit. In most but not all cases, a request to increase the death benefit will require that the insured person show that he or she is still insurable. Universal life is "flexible" because the owner may vary and even stop premium payments, subject to certain company requirements and maximum limits established by the federal government. The key is that the policyowner is always the person who initiates policy changes. Common questions associated with universal life insurance are:
- How can an insurance company offer that kind of flexibility?
- How is it that I can stop paying premiums without my coverage lapsing?
- What happens to my premiums when I pay them into the policy?
- How much does my insurance really cost me?
Perhaps the easiest way to answer these questions is to describe how a UL policy is built and how it works.
Let's compare it to a funnel with two outlets. One outlet goes to the insurance company, and the other goes to the owner of the policy. As premiums are "poured" into the top of the funnel, the portion that pays for the cost of insurance protection goes to the company's outlet, while any remaining premiums (above the cost of insurance) go to the owner's outlet. In other words, universal life, like any insurance policy, has a cost for the protection. This cost, which increases slightly each year with the insured's age, is usually expressed as the "mortality charge" or "cost of insurance." Any premiums paid in excess of this cost accrue to the owner as "cash value." As long as the premiums poured into the top of the funnel exceed the costs that go to the company's outlet, this cash value will grow.
There's another aspect to UL not present in many other kinds of life insurance. As cash value builds, it earns tax-deferred interest from the insurance company. This interest, which is sheltered from the effects of current taxation, is kept in the policy and helps increase the cash value. In keeping with our funnel analogy, think of interest as an additional deposit into the top of the funnel. As long as the interest deposits and premiums exceed the cost of insurance, this money will be funneled to the owner's outlet, and the cash value will continue to grow tax-deferred each year. However, if you put in less than is required to cover insurance costs, some of the cash value that has built up will have to be used to cover these costs. In other words, money will be backed out of the owner's portion and paid to the company to keep the policy in force.
With universal life, there are many different strategies by which to "fill the funnel." You could pay a minimum amount each month or year, planning for no leftover cash value at the end of the year. Since the cost of insurance increases every year with your age, you would have to increase these minimum payments from year to year. Or, you could pay a pre-calculated, level amount each year. This approach would cause your cash value to increase during the early years when your payment is greater than the cost of insurance, but decrease in the later years when premium payments and interest are less than insurance costs. You could even pay one single large premium, planning to cover all future costs. In this last case, there may be certain undesirable tax consequences if you ever plan to take out some of the cash value.
The primary objective is for the life insurance policy to be in force when the insured dies. Therefore, it is important to make sure that "the funnel" never runs dry. There are some guarantees in the universal life policy to help with this planning. Typically, the company guarantees that the cost for insurance will not be greater than a certain amount spelled out in the policy. The company may also guarantee that the interest credited to any cash value will not be less than some specified rate. If you wish to use only these guarantees as your guide, your required premium may be quite high. However, if you are willing to base your planning on current interest rates and costs of insurance, your premium requirement may be significantly lower.
The interest rate, the costs of insurance, and your premium payments all affect the value and longevity of your policy. You control the amount of premium you pay, while the insurance company controls the current costs of insurance, although these seldom change. The interest rate reflects what the insurance company can earn on your premium payments and cash value. To make sure your policy is there when needed, you should check regularly with the insurance company on your policy's status. In fact, it's a good idea to request a new projection each year from the insurance company. With this information you can monitor your universal life policy to make sure it is there when your beneficiaries need it.