Wednesday, November 17, 2010

Life Insurance Primer. Part Four: Universal and Variable Universal Life Insurance

This is the fourth installment of my series of posts on life insurance.  In Part One, I gave a general overview of the different types of life insurance.  In Part Two, I discussed term insurance, the most common form of life insurance.  In Part Three, I discussed whole life insurance, which combines term insurance with a cash value savings account.  In this fourth article, I will discuss two of the more exotic forms of life insurance:  universal life and variable universal life insurance.

Just to recap, the motto of these series of articles is:

Most people should buy term insurance and forget the rest.

This statement is never more true than in the case with universal life insurance.  Even for the most seasoned financial professional, this form of life insurance is downright confusing.  Insurance companies compound the confusion by offering a dizzying array of options designed to pry additional premiums from an unsuspecting customer.  I could shorten this article by saying that most people should steer clear of universal life since it is beyond the understand of mere mortals.  However, I will make a valiant attempt to explain it.  Even if you end up not understanding a word I say, at the very least that will reinforce my statement that most people should forget this form of insurance.

For those of you that I haven't scared off, read on!

Review of Whole Life:

First, let's recap how whole life insurance works.  With whole life, you pay a premium that is higher than an equivalent term policy.  Part of the premium pays for the insurance and part goes into a cash value account.  This cash value account helps to offset the rising cost of insurance as you get older, and you can cancel the policy and withdraw the cash value at any time.  There are two key characteristics of whole life:
  1. The premiums are fixed.
  2. The cash value is guaranteed.
Point #2 requires a little more discussion.  When you purchase a whole life policy, the insurance company guarantees what your cash value will be after one year, five years, ten years, and so forth.  The company's actuaries look into their crystal ball and predict how much interest they think they can earn on the cash value.  If the insurance company does better than these assumptions, the company can either pocket the gain themselves (if the policy is non-participating) or give back some of the gains to the policyholder as a dividend (if the policy is participating).  All is right with the world if that happens.

However, let's say that the insurance company does worse than how they assumed they would do.  Well, since the insurance company guarantees what the cash value will be, they have to suck it up and make good on the guarantee.  Put another way, the insurance company takes on the risk, and they take the hit if they don't do as well as they expected.

How Universal Life Works:

Universal life insurance reverses the two characteristics of whole life:
  1. The premiums are variable.
  2. The cash value is not guaranteed.
With universal life, the consumer gets to choose how much they want to pay each month.  However, this flexibility is somewhat limited.  Usually there is a minimum payment that you have to make in order to keep your policy from being cancelled.  However, beyond that, you are free to pay more than that minimum amount.  Why would you pay more than the minimum?  We'll get to that in a moment.

The second characteristic is that the interest rate that the insurance company uses to grow your cash value also changes from year to year.  If in one year the insurance company does better than expected, they will apply a higher interest rate to your cash value.  If they do worse than expected, they will apply a lower interest rate.  Therefore, you as the consumer get to pocket the reward but you also take on the risk.

So why would you pay more than the minimum?  There are a couple reasons:

To keep the policy from being cancelled:  If the cash value falls below some minimum level, the insurance company cancels the policy because the premiums won't be able to support the cost of the insurance.  Therefore, if the investment results of the insurance company fall below expectations, you might need to pay more towards the premium just to keep the policy from being cancelled. 

To prepay your premiums:  You may decide that you want to pay more than the minimum so that in future years you can reduce your premium payments or even stop paying premiums altogether.

To increase your insurance amount:  Let's say that you originally bought a $250,000 policy, but at a later point in time you decide that this amount isn't enough.  You can pay a higher premium into your policy and any excess cash value can go towards buying more insurance.

To save more money:  Instead of having excess premiums go towards increasing your insurance amount, you can keep the same insurance amount but build up more cash value.  This additional cash value grows and compounds, so you can think of it as another type of savings account.  However, there is a catch.  There is a limit to amount of extra money you can put into the policy.  If you put too much, the policy is no longer considered to be insurance by the IRS, but a Modified Endowment Contract (MEC).  Unlike life insurance, interest earnings in a MEC are taxed.  Usually the insurance company will tell you what the maximum premium amount is to avoid this from happening.

Confused yet?  If not, read on!

Variable Universal Life:

Variable universal life (VUL) is another twist on the universal life insurance concept.  Instead of crediting interest on your cash value at a single rate, you as the consumer can choose the type of investments in which your cash value will be invested.  Similar to a 401k, you can choose a stock fund, a bond fund, a real estate fund, and so forth.  The investment results of your cash value are totally dependent upon your choices.  If you are aggressive investment, you can invest your cash value in 100% stocks.  If stocks do well, you may not need to pay a premiums for years.  If not, you might find that your policy is cancelled for insufficient funds.

As you can see VUL can be an extremely risky proposition, and it isn't for the faint of heart!

You Should Consider Universal Life Insurance If:

The benefit of universal life is its flexibility.  By adjusting your premium payments, you can prepay the policy, give yourself an additional way to save money in a tax deferred way, or increase your insurance benefit.  For families whose needs are changing, this flexibility to adjust premiums and benefits is a big selling point. 

However, on the flip side, in order to take advantage of universal life's flexible nature requires a certain amount of financial sophistication.  Understanding all of the nuances of this type of life insurance often requires the aid of a professional.  Unfortunately, professionals who sell these policies may not have your best interest in mind.  The allure of the almighty commission creates an obvious conflict of interest.

Also, it is very important the realize that you, not the insurance company, bears the investment risk.  If the interest rate is lower than expected, you take the hit.

There are lots of other options related to universal life, but explaining those tries even my patience, so I'll leave that as an exercise to the reader if you are interested.

I'll probably write one more article in this series to summarize everything that I have written.  However, the main message that I want to convey is that life insurance is one of those things that seems simple (you die, your beneficiaries get paid), but it isn't.  There are a dizzying array of variations and options that are enough to make you turn green.  The bottom line is that if you stick with simple term insurance, you should be fine.  Don't be pressured into buying something that you don't fully understand.  At the end of the day, it's your money, not your insurance agent's money!

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