|Posted: Sun Nov 23, 2008 5:43 am Post subject:
This came from the Life Insurance Guide section
Universal Life Insurance
In this segment
Understanding Universal life
Learning about interest
Borrowing against your cash value
Deciding on death benefits
Determining the pros and cons of Universal life insurance
Universal life insurance provides flexibility to policyholders. It's similar to whole life, in that you have a cash value that grows, and it encompasses a term life policy, where you decide the terms and renew the policy annually. However, Universal life isn't simple like term insurance - or even like whole life. In fact, balancing the options can be quite complicated. So in this segment, I'll discuss the basics of Universal life insurance, the elements that you get to compare for your particular needs, and your options in designing the right policy for you.
How Universal life works
Universal life insurance is a form of whole life insurance - but with much greater flexibility. Like life, you have two components: a term insurance policy and an investment account from which the term insurance premiums are paid. But with Universal life, you get to choose your options, and the choices are generally laid out in front of you. You know how the premiums may change the death benefit and cash value, and it's much clearer how much of the premiums go toward your insurance protection, how much toward your cash value, and how much toward administrative expense (including commission).
Start with a planned death benefit that you work out with your agent's help. You determine your planned premium, based on how much you can afford and the cost of the insurance. The company subtracts and expense charge based on its fees, usually a fixed percentage of the premiums. You're left with a cash value that generates interest.
But understanding Universal life doesn't end there. From that cash value, the company subtracts the current cost of insurance (the mortality charge), including the charges for any options (or riders), and monthly administrative expenses. Then the company adds in interest that your investment money earns. You're ending cash value is not accumulated value that belongs to you when you terminate the policy (or to your beneficiary when you die).
Often, companies charge you may surrender charge to terminate the policy, leaving you with the surrender value the surrender charge is usually a small percentage of the total cash value.
Other aspects of Universal life to consider include:
All the earnings in your investment account are tax-deferred.
If you stop paying premiums, the Company continues to pay the premium for you by deducting from your policy's cash value. The company does so until no cash value is left (these deductions are usually called automatic premium loans). This is one way to continue coverage without paying premiums.
The interest rate is a fixed rate, although it may be a tiered interest rate, in which a part is paid at one rate while the balance is paid at a higher rate. For example, your interest rate may be 4% for the first $1000 and 7% for the balance.
You can withdraw money that has accumulated in your cash value. If you do, your death benefit decreases because it depends partially upon the accumulated cash value.
You can borrow against the cash value of your policy at a fixed rate, generally below market rates.
If you increase your coverage, you may have to re-qualify by taking a medical exam.
You probably have to pay a termination fee or surrender charge (back-loading). This fee decreases each year you have the policy, but it does lower the amount of your cash value.
I've created a chart illustrating the premiums, expenses, death benefit, cash value, and surrender value of a sample Universal life insurance policy.
End of Month Premium Expense Charge Cost of Insurance Death Benefit Interest Credited Ending Cash Value Surrender Value
1 $51.07 $3.83 $27.37 $50,000 --- $7,184 $7,134
2 $51.07 $3.83 $27.36 $50,000 $39.27 $7,203 $7,153
3 $51.07 $3.83 $27.34 $50,000 $39.61 $7,262 $7,212
4 $51.07 $3.83 $27.32 $50,000 $39.94 $7,322 $7,272
5 $51.07 $3.83 $27.30 $50,000 $40.28 $7,382 $7,332
6 $51.07 $3.83 $27.29 $50,000 $40.62 $7,442 $7,392
7 $51.07 $3.83 $27.27 $50,000 $40.96 $7,502 $7,452
8 $51.07 $3.83 $27.25 $50,000 $41.31 $7,563 $7,513
9 $51.07 $3.83 $27.23 $50,000 $41.66 $7,625 $7,575
10 $51.07 $3.83 $27.22 $50,000 $42.00 $7,687 $7,637
11 $51.07 $3.83 $27.20 $50,000 $42.36 $7,748 $7,698
12 $51.07 $3.83 $27.18 $50,000 $42.71 $7,811 $7,761
Total $612.84 $45.96 $327.33 $50,000 $450.72 $7,874 $7,824
Insurance companies frequently have two or more interest rates that kick in at different levels. For example, the guaranteed interest rate may be 4% on the first $500 and 7% on balances over $500. With a balance of almost $8,000, the total interest is just under 7%.
When you're choosing a policy or company from which to buy your Universal life policy, take the one with the highest guaranteed interest so that your cash value grows most quickly.
The interest earned continues to increase and eventually will equal and then exceed the amount you contribute. At this point, the money you pay is, in effect, going directly into your own account.
The interest rate is calculated daily, so you get compounded interest (interest on your interest). For a policy with an interest rate of 7%, the annual percentage rate (APR) is actually more than 8%.
Borrowing Against Your Cash Value
Universal life policies allow you to borrow against your cash value, usually at interest rates below what you can get elsewhere, even for loans secured against other assets. However, borrowing against your policy generally lowers the interest you receive on your cash value, making it equal to or less than the interest at which you borrow.
For example, say that you earn 4% on the first $500 of cash value and 7% on any amount in excess of that $500. You now have an accumulated cash value, or surrender value, of $7,874. You can borrow $3000 against this policy at a 6% interest rate - well below what you can get at a bank (even for another type of secured loan) - so this deal is quite good if you need the cash. But the interest you earn on the cash value of the insurance policy is no longer the 7% of the amount over $500. In fact, the interest you earn takes into account the $3000 you borrowed, and the total interest you earn on your account is
4% on the first $500
6% on the next $3,000 (the amount borrowed)
7% on the balance
Death Benefit Options
With Universal life insurance, you can choose how much death benefit is to be paid. You have two options, and although the options appear similar, some subtle differences between them can change the amount dramatically. With both options, your premium remains the same throughout the term of the policy, but the death benefit and surrender value differ.
Option 1: Fixed death benefit
When you choose a fixed death benefit, whatever amount you sign up for (in the example, $50,000) goes to your survivors. In actuality, the face value of the policy - the initial $50,000 - decreases by the amount you've accumulated in your cash value account. The death benefit remains the same because the decreased face value and the increased cash value add up to the total amount you chose.
Option 2: Increasing death benefit
With the second option, your death benefit increases in line with the increase in your cash value. Your survivors get the surrender value, which certainly appears to be a great deal more for the consumer than what Option 1 provides.
So what's the catch? Why would anyone choose Option 1? With Option 2, your cash value increases more slowly than with Option 1. So you must continue paying the annual premiums, often when you no longer need the same kind of protection you did 25 years earlier.
I've added another illustration showing the two types of death benefit options you can choose with Universal life insurance
Which option is for me?
If you take a look at the illustration, you can see that the two death benefit options differ significantly. If you die in 25 years, your survivors receive $18,000 more under Option 2. On the other hand, if you don't die during that time and instead take your surrender value, you're better with Option 1. In effect, by choosing Option 1, you're gambling on a long life so that you can withdraw a larger cash value.
To determine which option is best for you, you must consider if you factors:
Your current age and health
How much protection your dependents will need as you age
Whether you can increase your net worth at a greater rate by investing in other options
How much of a gamble you're willing to take
'Fixed Versus Increasing Death Benefit Universal Life Policies
Death Benefit Option 1 Death Benefit Option 2
End of year Annual Premium Ending Cash Value Surrender Value Death Benefit Ending Cash Value Surrender Value Death Benefit
5 $612 $1,803 $1,753 $50,000 $1,803 $1,803 $51,803
10 $612 $3,462 $3,412 $50,000 $3,262 $3,262 $53,262
15 $612 $8,322 $8,272 $50,000 $7,822 $7,822 $57,822
20 $612 $12,382 $12,332 $50,000 $11,382 $11,382 $61,382
25 $612 $19,874 $19,824 $50,000 $17,874 $17,874 $67,874
The amounts of your death benefit, accumulated cash value, and premium are all interrelated with Universal life. The more you pay per month in premiums; either the more protection you're buying or the more cash value your building. You can't have both. The higher the protection you buy, either the higher your premiums or the lower your cash value. In the more cash value you want to build, either the higher the premium or the less protection you're buying.
Because your primary goal in buying insurance is protection, your primary consideration should be the amount of the death benefit. Cash value and your premium cost should be secondary factors, but clearly, your premium should be in line with how much you can afford to pay.
Choosing Your Premium
If you want a Universal life policy and the leaves that you can afford the premium, you need to balance the following three considerations to determine your cash value:
Determine how much you can afford from your monthly budget.
Decide how much protection you want to purchase.
Balance the amount of protection you want to purchase with the amount of premium you can afford.
You invest in a life insurance policy to be covered in case you die, not because life insurance is a good investment. You can generally make more money by putting your money into other investments.
Pre-paying your premium
With Universal life, you can buy in up-front by putting a significant sum into your account, which allows your cash value to increase more because your account is starting at a higher level. Prepaying also allows you to lower your premiums because the accumulated cash value is earning more, which means that more of your earnings can contribute to the cost of the insurance. On the other hand, pre-paying also means that you must take a lump sum of cash from somewhere.
Is pre-paying for you? Not likely, unless you really want insurance but can't afford monthly payments. People have generally used prepaid insurance as an investment to build cash value without incurring any tax consequences. But with IRAs, Roth IRAs, and 401(k)s, chances are you won't be interested in this option.
Summing it Up
Let's compare the pros and cons of Universal life insurance.
A lot of flexibility - you can tailor the premiums, cash value, and death benefit to suit your needs. Complicated terms and options; you have to depend on your agent to guide you to the best plan for you.
Premium remains constant for the entire time you're covered, and you can opt for either a fixed death benefit or an increasing death benefit.
Premiums are considerably higher than for term insurance, and if your death benefit remains fixed, you actually reduce the accumulated cash value.
Coverage can be paid-up by the profits from your cash value, and most of your premiums are going to you. Whether from your monthly budget or your accumulated cash value, you're still paying the premium. Not appropriate as an investment due to poor rate of return.
Lifetime coverage and no medical exam (unless you make changes to the policy).
Death benefit coverage may become unnecessary later in life when you have no dependent beneficiaries.
Tax-deferred cash-value earnings, and if you decide to cash-out, the premiums you paid reduce the gain.
Returns aren't as high as other tax-deferred plans such as IRAs and 401(k)s (which allow you to invest your money where ever you want.
Please feel free to go to my website at www.markcolbert.com or, if you have a specific question, you can email me directly. I hope I can answer any questions you might have. If not, I can certainly find an answer right away.
Joined: 13 Oct 2007
Location: Central California