Americans are underinsured — a 2019 study placed the percentage of adult Americans with life insurance coverage at roughly 60 percent, according to the Insurance Information Institute.
Many of those covered have only group insurance through work. There is a large gap between insurance need and the coverage people have.
Insurance, like any other financial product, should be tied to needs and goals. Many people want to provide for their loved ones in the event of their premature demise.
That’s not the only reason for life insurance; some people want it to pay debts or for funeral expenses; some want to leave a legacy, either to a charity or family. There are a number of valid nontraditional uses for life insurance as well, including as a source of retirement income.
There are many reasons people don’t solve their underinsurance problem. They may not know what to do; they perceive it as too complex or too expensive. The solution is never in ignoring the problem; the solution is in finding what will work within your constraints.
Often you can make a situation better than you might think. The suite of universal life products provide realistic solutions for many people.
Why Universal Life Insurance?
Universal life insurance fills an important need. Term insurance is temporary protection; it doesn’t address permanent needs. Whole life, the traditional permanent life insurance solution, tends to be rigid and pricey.
Universal life insurance solves these two problems — it is permanent insurance that builds cash value but is reasonably flexible to meet changing circumstances.
It provides coverage designed to last your entire life. And you can make some changes, such as reduction in coverage or changes to premium payments, that are not available in traditional whole life products.
While there are differences from company to company and policy to policy, universal life comes in three basic forms: universal life, variable universal life, and index universal life. Each meets specific needs. And we should also give at least passing mention to a fourth from, guaranteed universal life.
What Does Universal Life Insurance Provide?
Universal life insurance (UL) combines insurance protection with cash value accumulation. It is an unbundled product, meaning you get to see all the specific costs and charges the product has. This is in direct opposition to whole life, where few if any of the actual cost elements are disclosed to the policyholder.
UL combines an annual renewable term insurance with a cash accumulation account. The cost of the insurance is age based; the rate increases as the insured gets older. The accumulation account is a fixed account; it pays a market-based rate of interest with a floor, or minimum amount that the account can earn.
When you pay a premium, the premium is subject to a premium expense charge. In non-insurance vernacular, we call that a sales charge. Any state premium tax is typically a part of the sales charge. There is a charge for the cost of insurance, and typically a monthly charge as well. There can also be other costs associated with specific additional riders or benefits.
Overall the costs are not insignificant, but the more important question for the consumer is the value of paying the costs versus the value of having the protection.
The cost of the actual insurance component is based on the amount “at risk” to the insurance company. If you consider a policy with a level death benefit, the amount at risk is the difference between the policy’s cash value and the death benefit that the insurance company could have to pay.
That is the amount the insurance company would need to come up with, over and above the cash value, to pay the beneficiary or beneficiaries. As the policy cash value grows, the amount at risk decreases; the actual insurance amount should decrease across time for a policy with a level death benefit.
The policy owner can increase the premium payments or decrease the premium payments to meet their needs. There are tax limitations which make putting in too much money detrimental. Within reason, however, the policyholder can increase payments to grow cash value or lower payments during periods where cash flow is tight.
Underfunding a policy on a long-term basis causes problems; the cash value doesn’t grow sufficiently to offset the increasing costs of the age-based insurance and the policy can collapse. Underfunding does not work well except for short-term situations.
In the event the policyholder desires to reduce coverage at some point in the future, UL is pretty accommodating. Whole life has no flexibility here; this is a major advantage for UL.
UL can be safe and stable. Most policies have a minimum no lapse guarantee premium; if the policyholder makes those premiums on an ongoing basis, the policy is guaranteed to stay in force.
UL is a solid conservative way to have permanent insurance with flexibility to meet changing needs. Its major downside is the lack of investment flexibility, offering only a single fixed account investment option. Variable universal life addresses that concern.
What Is Variable Universal Life?
Variable universal life (VUL) offers a variety of investment options to address the lack of investment flexibility in traditional UL. The aspects of VUL are otherwise the same as with UL; you have the same costs plus new ones. You have the same premium flexibility and other options.
VUL polices will typically have a number of investment options, similar to a portfolio of mutual funds you might find in a 401(k).
The funds are generally not mutual funds; they are insurance subaccounts, specific to the insurance policies in which they are used.
These funds, like other investment funds, have management fees that are paid by the investor. The policy owner can choose between the investment options and a fixed account, just like the fixed account in the UL.
Having these investment choices gives the policyowner far greater opportunity for long-term growth in a VUL than in a UL.
But with greater opportunity comes greater risk. The UL’s sole fixed account cannot lose money; in a UL you can’t earn less on your investment account than the guaranteed rate of that account. You can still lose money in the policy if costs exceed what the policy earns or takes in, but you can’t have investment loss in a UL.
You can have investment loss in a VUL. Market-based investments bring the opportunity for losses. The policyholder can generally exchange between VUL investment options without cost.
VUL brings in a far superior investment selection to the dearth of choice within the UL. The policyholder can have more risk, but also far more opportunity. The VUL gives the policy the chance for significantly improved long-term returns compared to the relatively stodgy UL fixed account.
Indexed universal life is an attempt to bridge this risk-reward gap to provide policyholders the upside of investments without the downside of increased risk.
What Is Indexed Universal Life?
Indexed universal life (IUL) has the ability to capture some of the upside of market investments without the typical risk of loss the investor is exposed to in the market. Some IUL policies have both an investment account and a fixed account.
The investment component in an IUL policy is based on a market index. The funds are not invested in an index fund; the insurance company manages the funds. The return to the investor is based on the performance of a selected index. The return is tied to the index but is not the same as the index return. There are several ways the policyholder’s return will deviate from the index return.
Generally the policy will have a floor, typically zero.
No matter what happens with the index, the policy’s investment account cannot earn less than the floor amount.
The policy will have a participation rate: the rate at which index performance is credited to the account.
For example, a policy with a participation rate of 50 percent would earn half of what the index returned during the same period; a policy with a participation rate of 75 percent would similarly earn three-quarters of what the index earned.
The policy can earn based on rate differences for whatever period is established by the policy, such as monthly or annually. Earnings are credited as specified by the policy, often annually. Dividends are not a part of the return calculation and do not improve the investor’s returns.
The policy may have a cap rate. This is the greatest rate the policy can earn. If the cap is 10 percent, that is the most the investment account will earn even if the index were to go up by 20 or 30 percent.
The policy may also have a spread. The spread is an amount between what the index returns and what the policy is credited. For example, a policy with a spread of 4 percent would earn 2 percent when the index earned 6, and would earn 8 percent when the index earned 12.
Not all IULs have a cap rate or a spread; they are often used in conjunction with the participation rate to control risk to the insurer. A policy with a higher participation rate is more likely to use another control, such as a cap or spread, to limit risk.
For the policyholder, the IUL does two primary things. It provides some market-based return, boosting potential long-term returns above what could be expected from a straight UL. It also removes the downside of negative investment performance from the equation, solving a problem of VUL policies.
IULs offer conservative investors the opportunity for a limited version of market upside without taking any market risk. Their funds are not invested in the market and they have no exposure to the market directly. They forgo a portion of the return in exchange for a lower level of risk.
What Is Guaranteed Universal Life?
Guaranteed universal life (GUL) is a permanent policy that does not build cash value. Its premium is determined to maintain the policy in force through an age determined in advance, generally somewhere between 95 and 121.
It works, for the policyholder, like a permanent form of level term insurance: no cash value, no flexibility.
It doesn’t fit in with the norm of the other UL policies, where the buildup of cash value and the flexibility are the main attractions. It bears mention in that it is a form of UL, just not a form that typically competes directly with the others.
The Bottom Line
Life insurance is sometimes promoted as one of the last of the great tax shelters. It builds cash value tax deferred, and used correctly, can provide capital or income to the owner without tax consequences.
That “used correctly” is a big caveat, however; the policy needs to be managed to remain in force and the distributions need to be proper and appropriate for the value in the policy. We’ll talk about that next week when we talk about using these polices for tax-free retirement income.
Life insurance products can be complex; they’re certainly not unique in that. They can be powerful as well; complexity is a byproduct of their usefulness.
It is safe to say that many Americans are underinsured. The forms of universal life offer an array of options across the risk spectrum to address that shortage while providing flexibility to meet changing needs. In some cases, term or whole life may be the most appropriate choices.
But neither can match the universal life insurance suite of products for accumulation potential with flexibility. If you have a desire to leave something behind in this world, these options bear scrutiny.