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universal life insurance

More Universal Life Thoughts

by Glenn on February 28, 2009

I’ve previously commented on Universal Life Insurance but wanted to expand on that a bit.

Universal life insurance in Canada belongs to the permanent insurance category. Typically you would consider universal life if you’re looking at life insurance needs for the rest of your life – forever. i.e. you know today you want the insurance when you’re 60,70,90 or 300 years old.

A universal life insurance policy consists of two aspects or features. The first one is the insurance cost. The second part is the investment component. Within these two components we have a myriad of options.

Lets look at the insurance portion to start. Note that we can treat the policy as just the insurance portion and completely ignore the investment part. And it’s a good idea to do that as the basis for your investigation. Let’s say you purchase $100,000 of Universal Life (UL). We’re going to be keeping the insurance in force for a good long time, so we need to know what the insurance premiums will look like over the duration of the policy.

There are two basic premium structures available; level and YRT. Level insurance costs means the premiums are set to never change – they’re level for life. No surprises now, or later in life when it comes to the underlying insurance costs. As an aside, we only ever recommend UL with level insurance costs.

YRT premiums, or Yearly Renewable Term, has premiums that go up every year. The premiums are based on your age, so they start out cheap when you’re younger but increase over time.

There are other options available with some companies where they mix these two (YRT for 20 years, then going to straight level) but that’s they all tend to be mixes of YRT and level.

Now lets look at the investment part. The way this works is any money put into the policy above and beyond the basic insurance and administration costs go into the investment part (or you can just pay the base insurance and admin costs and leave the investment part at $0). Let’s say your basic insurance premiums are $50 per month. If you pay $50, you have your life insurance and your investment sits at $0. If you pay $100 a month, the first $50 pays your insurance and the remaining $50 is put into the investment ‘bank account’ where it hopefully grows and earns interest.

What type of investment options are available? Well, these investment options look a lot like mutual funds. They’re not mutual funds but viewing them as such does give us a pretty good snapshot of what they do. And just like mutual funds, the world’s your oyster when it comes to investment options. All the insurance companies have their own myriad of investment options and some of them actually track well known mutual funds. Manulife for example has something in the range of 25 to 50 different investment options. Wawanesa conversely has a handful, most of them the standard index funds (if you’re an index fund kind of investor…and if you’re not you probably should be).

But! just lke mutual funds, these investments are typically not guaranteed. This ability for investments inside a UL policy to crash and burn just like the stock market or your mutual funds is the biggest risk I see. Be aware when reviewing a universal life insurance presentation that if it depends on some investment option, that quite likely that investment option is not guaranteed. If your investments track mutual fund A, and mutual fund A just crashed by 40%……then the investments inside your UL policy just dumped by 40% as well.

Another thing to consider is that some UL policies will offer some guaranteed investment. Something like a GIC type of rate would be common, maybe at 2 or 3%. But you only get those guaranteed rates of return if you actually invest in those GIC types of vehicles. If you invest in the equity based investments, you’ll not have those guarantees so if your illustration shows equity based investments with GIC type of rates, be careful.

The next thing to carefully consider when looking at investments inside a UL policy would be surrender charges. Some investment options require that your money stay inside the policy for a minimum amount of time. Withdrawing money back out from the policy prior to that time results in very heavy charges. I see no need to invest in a product like this when there are plenty of products available that don’t have these fees.

So what’s the benefit of the investment inside a UL policy? Very simply, money invested inside the policy grows on a tax sheltered basis. Just like an RRSP, if you earn $100 inside the policy you don’t have to pay taxes on it as long as the money stays in the policy. Unlike an RRSP, you don’t get a tax break on deposits (which means that RRSP’s are your first line of investment strategy whenever possible).

I’m going to write about some advantages in my next article, but for now, lets look at some pitfalls with universal life. (Note that I believe Universal Life is a great product. But you need to know what you’re getting and what the risks are). Lets say you want to build up a bunch of cash inside the policy for some reason later.

How to do that? Well, we want to shovel as much money into the investment portion as we can, as early as we can. Since we always have to pay at least the base insurance premiums we may decide to minimize those insurance premiums by going with YRT insurance costs. This gives us more money (since YRT premiums are initially lower than the level insurance premiums) to start putting into the investment portion. That early start we assume allows that investment to grow higher, faster. And if things go well, that’s exactly what will happen.

But things can go not so well. Let’s say you go with this strategy, but your investments later crash and burn (remember, the investment portion isn’t normally guaranteed). Now you’ve got poor investments and worse, you’ve got those high YRT premiums to pay since they get expensive later.

Consumers can and have ended up in similiar situations. Because we’re dealing with long durations, sometimes spanning decades, we may not realize the problems until many many years in the future. So it’s vital that you address all of this upfront when you purchase the policy. If you didn’t, now’s the time to pull out your UL policy and have another look at what you’ve got.

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Life Insurance Types – Universal Life Insurance

by Glenn on June 30, 2008

This is part 3 in a 3 part article intended to make the types of life insurance less confusing.

These three articles should be read in order.

  1. Life Insurance Types – Term life insurance
  2. Life Insurance Types – Whole Life and Term To 100
  3. Life Insurance Types – Universal Life Insurance

(Continued from previous article)

The third and final type of permanent insurance is called Universal Life Insurance. Basically what the insurance companies have done is take a Term to 100 policy and added an investment vehicle on the side. The investment vehicle works kind of like an RRSP or a mutual fund, though it is neither.

The investment portion is flexible – you don’t have to put in money, or you can at different intervals (subject to some government guidelines). Let’s say for example the Term to 100 premium inside a universal life policy is $100 a month. If you pay $100 a month, the insurance takes the premium and pays your Term to 100 premium – end of story. So what you basically have is a term to 100 policy.

Now if instead you pay $200 a month into the universal life insurance policy the company takes the first $100 and pays your Term to 100 life insurance premiums. They then take the remaining $100 and put it into the investment portion of your policy. Unlike an RRSP, those contributions are not tax deductible. However like an RRSP, the investment inside a Universal Life insurance policy grows on a tax sheltered basis.

That tax sheltering of the earnings on the investment portion have led to all sorts of weird and wonderful sales concepts from the life insurance industry. If tax sheltering isn’t an issue, UL probably isn’t for you. However for higher income and more affluent individuals, this tax sheltering can be very beneficial.

Here’s two simplified examples. Let’s say your premiums on the Term to 100 policy are $10,000 a year. And let’s assume you have managed to put $100,000 into the investment portion of the Universal Life policy. Let’s make a big jump and assume your investment portion earns 10% :). So your $100,000 investment produces $10,000. Now here’s the cool part. If you use that $10,000 from the investment to pay your life insurance premiums, you’ve just paid your insurance premiums with pre-tax dollars! Doing the same thing outside a Universal Life Insurance policy means you’d probably have to earn $20,000, pay about $10,000 in taxes to leave you with the $10,000 needed to pay your premium.

Another example that is a bit more aggressive involves a bit of leveraging. Let’s say you build up a substantial amount inside your Universal Life Insurance policy over the years prior to retiring. Now you’ve got a ton of cash sitting there that you can’t pull out without paying taxes on (since the earnings inside the policy are only tax deferred until you pull the money out). So instead of pulling the money out of the policy, you use the policy as collateral on a loan from a bank. The loan of course is tax free money. The banks will have some limites on the amount of the loan with relation to the amount of money in the insurance policy, but it can be set up so that you never pay the bank back – they get their loan paid back when you die from the insurance policy (which pays out the life insurance amount plus the investment amount). Voila – getting at tax deferred income without paying the tax on it. No, I have no idea why CRA lets our industry get away with that one :).

Two other points on Universal Life Insurance. First, in addition to having Term to 100 as an insurance component, some companies also offer 1 year term insurance as the insurance component (see the 1 year term insurance explanation in my previous post on term insurance). The idea is that the cheaper premiums of 1 year term in the early years allows you to save more money earlier to invest faster for the later years (more money earlier allows that money to compound for a longer period). If you can make money inside the policy fast enough, you can have a bigger investment portion and have enough money to pay the very high term premiums later in life. Of course if your investments don’t grow fast enough you’re going to end up with a very very expensive life insurance policy later in life when it’s likely too late to do anything about it. Secondly, the investment portion of Universal Life is generally not guaranteed. The old adage ‘past results are not indicative of future returns’ applies in spades. Be careful when evaluating Universal Life insurance scenarios that depend on non-guaranteed portions of the contract.

One last note about Universal Life insurance. If you are looking at permanent insurance, Term to 100 is generally where I’d start shopping as we’d expect that to be the least expensive. For competitive reasons though, sometimes the Term to 100 insurance component inside a Universal Life policy may cost the same or less than buying the Term to 100 policy discretely. It’s worth pricing out a Universal Life policy when looking at Term to 100 just to get the cost differential. If it’s minimal – and in many cases it is – you should consider the Universal life policy. Even if you treat it as a Term to 100 policy and ignore the investment portion, you’re getting the ability to use that feature in the future for little cost.

In summary, the conceptual basis of all life insurance is 1 year term. Averaging out the premiums gives us products like 10 year term and 20 year term which work well for 10 or 20 year needs and is suitable for many people. For people with longer term insurance needs permanent insurance fits the bill. There are three types of permanent insurance; whole life which has fallen out of favour with consumer advocates, Term to 100 which is a stripped down version of whole life without cash values, and Universal Life insurance which is Term to 100 life insurance with an investment vehicle added to it.

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