Universal Life Insurance Definition
Universal life insurance is a form of permanent insurance that evolved out of the experience with whole-life insurance. The defining features of universal life insurance are flexibility of premiums and the death benefit. Most of this flexibility derives from the policyholder’s ability to use the policy’s cash value accumulations to pay premiums and adjust the death benefit either upward or downward.
History of Universal Life Insurance
Whole life insurance was the first type of permanent insurance. Its premiums were so much higher than those of term insurance – the first type of life insurance – that many whole-life policies lapsed due to non-payment of premiums. (Indeed, life-insurance company reserve calculations are based on the assumption that a certain proportion of policies issued will lapse.) In order to keep more permanent-insurance policies in force, the companies developed a product designed to allow premiums to be paid by the cash value generated by the policy.
This flexibility is of greatest benefit to those who require it in order to be able to carry life insurance. Those people are likely to be young, with moderate incomes, who are unable to buy enough permanent insurance to cover their insurance needs unless they can pay lower premiums than those offered by whole life policies.
Details of Universal Life Insurance
Universal life insurance premiums are often monthly, as this is often more congenial to those of moderate means. The monthly premium is partly allocated to satisfy the cost on insurance (COI), which is the amount actuarially necessary to support a death benefit of given size. The rest of the monthly premium goes to the policyholder’s cash value account, which receives credited monthly interest. It takes a few years for cash value to accumulate significantly. When it does, the policyholder has the option of using it to pay the policy premiums. In addition, the death benefit may be adjusted up or down to reflect both the policyholders’ willingness and ability to pay premiums.
Benefits of Universal Life Insurance
Some of the benefits of universal life insurance are shared in common with other types of permanent insurance, such as whole-life insurance. Premiums exceeding the cost of insurance are used to create a cash account, whose investment gains accrue tax-deferred. (The beneficiary is not usually taxed on the income provided by the death benefit.)
The cash value inside a universal life insurance policy is often used as loan collateral. The policyholder can borrow against this cash value and realize tax-free income in the process. Part of the death benefit can be dedicated to loan repayment.
An informational benefit of universal life insurance is that it makes all the expenses, fees, charges and the cost of insurance visible to the policyholder – unlike whole-life insurance, in which the insurance contract does not disclose this data to the customer.
Suitable Candidates for Universal Life Insurance
The flexibility of premiums and death benefit are the signature features of universal life insurance. As noted above, the largest group of gainers from universal life is young families of moderate means who use premium-flexibility provisions to tap the cash value in their accounts to pay the policy premiums. These are the people who need life insurance the most. However, an entirely different demographic class of policyholders also stands to benefit from universal life; namely, high-income households nearing retirement. Two variants of universal life are typically employed in serving this group.
Universal life insurance is particularly suitable for combining with two of the most popular investment-related features of recent years. Variable insurance allows the cash value to be determined by investments in separate accounts that are just like mutual funds. Indexed insurance ties cash-value accumulation to the performance of some financial index of overall market performance. Either variant is suitable for high-income households striving to create supplemental retirement income.
Whereas low-income households utilize premium flexibility in order to fully fund insurance need by drawing down cash value, high-income households do just the opposite. They “overfund” their policy relative to actual insurance need in order to maximize cash value. The tax benefits of life insurance are the lure of this strategy. High-income households can easily max out the contribution limits of qualified retirement plans with plenty of money left over for additional investment. Contributions to the cash-value account of a universal life insurance policy will grow tax-deferred. Eventually, the cash value can be tapped via withdrawals or tax-free loans.
Certain rules must be followed and limitations honored in order to make this game plan work. Even though the life-insurance policy is “overfunded,” the IRS rules governing modified endowment contracts must be respected – otherwise the tax benefits of the strategy are threatened. Premature surrender of the policy will lead to surrender charges imposed by the insurance company, so policyholders should plan to contribute for at least 10 years to outlive the charges. Lapse of the policy – a bugbear of low-income policyholders who must be careful not to reduce cash value below the level at which it can pay premiums – is also a threat to high-income policyholders. Policy lapse will convert outstanding loans into taxable income, which will transform a tax shelter into a tax problem. The death benefit will be reduced by withdrawals and loans outstanding at death. While the death benefit is income-tax-free to beneficiaries, it is still included in an estate. This could result in benefit-depletion due to estate taxation.
Drawbacks of Universal Life Insurance
Some of the drawbacks of universal life insurance – such as high premiums necessary to keep the policy in force – are mirrored by other forms of permanent insurance. Unlike the other forms, universal life is flexible enough to provide an internal solution to some of its own inherent problems. Still, policyholders cannot have their cake and eat it too. They can either suffer reduced cash value in order to keep the policy in force at face value or maximize cash value and income by reducing face value. The complexity of tax law requires careful attention paid to rules and regulations, so as not to vitiate the benefits of universal life insurance. This highlights the necessity of suiting the tool to the purpose – and taking safety precautions to avoid injury from the tool itself.
Contributions to Universal Life Insurance
In its infancy, universal life encouraged very large premium contributions to contribute to the investment performance of the cash account. The IRS eventually cracked down on this practice. Today, single-premium forms of universal insurance are referred to as Modified Endowment Contracts and are subject to close regulation by the IRS in order to limit the tax benefits they provide.
Although flexible premium payments are the classis motivation behind universal life, there are fixed-premium variants. Fixed premiums are usually employed in order to create “paid-up” insurance and obviate the need for further premium payments.
Universal life insurance is the most flexible of all forms of permanent insurance. Flexible premium contributions can be used for such diametrically-opposite purposes and satisfying full insurance need by reducing cash value and supplementing retirement income by enhancing cash value. Universal life insurance shares the drawbacks of permanent insurance, but when used correctly it is a valuable addition to the tool kit of many households.
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