When shopping for life insurance you must decide between term life and permanent life insurance. Term life is the simplest, purest form of insurance, while permanent insurance comes in several forms, with each accumulating cash value in a different way.
One popular type of permanent insurance is universal life. It offers more flexibility compared to whole life insurance but is also more complex.
Continue reading to find out if universal life insurance is a good fit for you.
What is Universal Life Insurance?
Universal life insurance is a type of permanent life insurance. Just like whole life insurance, it covers you for life and accumulates tax-deferred cash value. When you’ve accumulated cash value, you can withdraw or take a loan against it.
The main difference between whole life and universal life is that the latter is more flexible. For example, many universal life policies allow you to increase or decrease your premiums and adjust the death benefit as per your needs. The insurer also allows you to pick the investment options according to your risk tolerance and investment goals. Universal life is more expensive than term, but can be cheaper than whole life.
How does Universal Life Insurance work?
With universal life insurance, a part of your premium goes toward covering the cost of insurance. The remaining part goes into an investment account, called cash value, that grows on a tax-advantaged basis. That means you won’t have to pay interest on the money you withdraw from this account provided the withdrawn amount is not more than the amount you’ve already paid in.
The insurer guarantees that your policy’s cash value will grow at a minimum rate set by them. However, if the market does well, it can grow faster. When your policy accumulates enough cash value, you can take money out via a loan or withdrawal. Otherwise, you can use it to pay future premiums. The insurer will reduce the death benefit by the amount of any unpaid loans or withdrawals if you pass away.
Some universal life policies allow you to raise or lower the policy premium within a certain limit. Anything you pay over the minimum amount gets funneled into the built-in savings account.
The cash value is typically not added to the death benefit, but there are some options regarding dividends or riders that will increase the death benefit.
The death benefit of a universal life policy is not taxable, but any interest earned on an unpaid death benefit is. It’s up to your family how they want to receive the death benefit, as a tax-free single payment or in installments.
Types of Universal Life Insurance
Indexed Universal Life Insurance
Indexed universal life provides coverage for your entire life and builds cash value. The death benefit is set when you sign up for the policy, but it can change. The cash value growth is linked to the performance of a stock index.
A stock index, like S&P/TSX, measures how well the stock market is performing. The insurer picks one or more such indexes and pays interest to policyholders based on how well the selected index performs.
If the index performs well, the cash value will grow faster. However, you get a rate that’s lower than the performance of the selected index. That’s because the insurance company takes a big slice of the pie. And if the market’s performance is not up to the mark, you earn less or nothing. As a result, you may have to pay higher premiums to keep the policy in force.
You will need to closely monitor your policy’s cash value. Your policy can lapse if it doesn’t have enough cash value to cover the cost of insurance and policy expenses.
Guaranteed Universal Life Insurance
If you don’t want your premiums to be linked to market performance, a guaranteed universal life policy may be a good fit for you. With guaranteed universal life, your premiums remain the same throughout, regardless of how market indexes perform. That’s because the interest rate is baked into your policy premiums from the beginning.
This type of life insurance policy comes with a “no-lapse” guarantee. That means as long as you pay the premiums, the coverage won’t lapse. So in a way, it combines the concept of universal life with some aspects of term life. Your premiums don’t change, nor does the policy’s death benefit.
However, the tradeoff is that you will accumulate little cash value (if any at all). That means you’ll have to stay up to date with your premium payments. If you miss one, your policy will likely lapse since there’s usually not enough cash value to cover the cost of insurance and other fees.
Variable Universal Life Insurance
Variable universal life insurance enables you to change your death benefit and adjust premiums as you see fit. You also get the opportunity to invest the cash value in various funds offered by the insurer, according to your risk tolerance and investment goals.
If these funds do well, you will get handsome returns. You can use the cash value to pay future premiums or take money out of it. However, there’s an element of risk, even when you diversify the risks. That’s because it’s almost impossible to predict how the market will perform.
How much does Universal Life Insurance Cost?
Universal life insurance policies, unlike term life, offer lifetime protection and accumulate cash value. As such they are costlier than term life. However, they are less expensive than whole life insurance policies.
Universal life insurance premiums are specific to the person applying for coverage. The main factors that impact your cost of insurance are:
Like other insurance products, universal life insurance gets more expensive with age.
- Coverage amount
Policies issued for larger death benefits cost more than policies with smaller payouts. You’re likely to pay more for a universal life insurance policy with a $500,000 death benefit than with a $250,000 payout.
When you sign up for a policy, the insurance company will review your health through a process called underwriting. You will have to answer some health-related questions and take a basic medical exam.
Applicants in good health receive a more favorable classification and pay a lower premium rate. On the other hand, certain illnesses, like diabetes or high blood pressure, can bump your rates up.
- Family’s medical history
Certain illnesses, like diabetes, have a hereditary component. For this reason, life insurance companies inquire about and evaluate your family’s medical history when you sign up. A family history of illnesses like diabetes, high blood pressure, and cancer can mean higher premium rates.
- Smoking status
Smokers are more likely to die early than non-smokers. So it comes as no surprise that they have to fork out more for coverage.
- Occupation & Lifestyle
A dangerous job or hobby — such as skydiving or bungee jumping — can raise your premium rates.
When it comes to life insurance, men receive higher premium rates than women because the latter has a higher life expectancy. Men pay 38% more than women for the same coverage on average. And the premium gap widens with age.
How do I pay my Universal Life Insurance Premiums?
You may opt to pay premiums monthly or annually. Unlike term or whole life insurance, you don’t get a discount for paying your universal life insurance premiums annually.
You may use the policy’s cash value to pay premiums. And if you miss a premium payment, the insurer will take an equivalent account from the built-in savings account. However, if the cash value cannot cover the cost of insurance, your policy will lapse.
How does the death benefit work?
Like whole life or term life insurance, the beneficiary of a universal life policy receives the death benefit as a single, tax-free payment. However, unlike other life insurance products, universal life insurance gives the policyholder mainly three options to implement it.
- Level: You set the death benefit amount at the time of buying the policy. The death benefit stays the same throughout, as long as you pay premiums. It doesn’t change even when the value of the built-in investment account is low or zero. Upon your death, the insurer pays your family the death benefit amount or the account value, whichever is more.
- Face plus Account Value: Your beneficiaries receive the initial coverage amount and the value of the investment account when you pass away.
- Account value: Your family gets the investment account value — and nothing else — after your death.
In the case of multi-life, joint-last-to-die, or joint-first-to-die policies, the insurer may pay out the death benefit and account value over a period. For instance, the insurance company may pay a part of the death benefit at the death of each insured. And the remaining benefit amount and cash value the insurer may pay after the passing of the last insured person.
How do you access the cash value?
With universal life insurance policies, the cash value grows tax-free. You can access it in the following ways:
- Cash Withdrawals: You can withdraw money from your policy’s cash value any time you want. Cash-value withdrawals are taxable only when they exceed the amount of premiums you’ve paid into the policy. Your death benefit will be reduced by the amount of cash you’ve taken.
- Policy Loan: You can access the policy’s cash value in the form of a policy loan. A policy loan is not taxable as income, as long as it doesn’t exceed the amount you’ve paid into the policy. If you are unable to pay it, the insurer will reduce the death benefit by the amount of the loan. Since you’re basically borrowing your own money, the insurer doesn’t run a credit check or ask questions when you apply for a policy loan.
- Collateralizing the Cash Value: You can leverage your universal life policy by using its cash value as collateral for a loan from a financial institution. However, if you pass away without repaying the loan, the insurer will use the death benefit to pay the lender first. After that, any remaining funds will go to your family.
- Surrendering the Policy: If you give up coverage, you receive the cash surrender value of your policy. The cash surrender value is equal to the actual cash value minus any surrender fee and outstanding loans.
What affects the cash value of a life insurance policy?
A universal life policy allows you to increase or decrease premiums and pick the investment option most suitable to your financial goals. Because of this flexibility, the insurer doesn’t provide a guaranteed rate of return on the cash value.
The growth rate of your policy’s cash value may fluctuate on account of several reasons, such as:
- The performance of the underlying investment option
- The amount of insurance premiums paid by you
- The death benefit amount selected at the beginning
- Any cash withdrawals or policy loans that you have taken
What happens to the cash value if you don’t use it?
The only money your beneficiary receives when you pass away is the death benefit. The insurer walks away with any unused cash value — money that you’ve built up carefully over the years. Let that sink in for a moment.
But that’s not the half of it.
If you withdraw money from your policy’s cash value, the insurer will deduct the amount from the death benefit. And if you take a policy loan and don't repay, it will reduce the payout by the amount of the policy loan.
In other words, it’s a lose-lose situation for you.
Sometimes the cash value is added to the death benefit. So it will depend on your carrier, Dundas Life can help you here.
Advantages of Universal Life Insurance
Universal life insurance products deliver several advantages to policyholders seeking flexibility and greater control over their policy. These include:
Flexibility premium payment options
In the case of whole life insurance, premiums are fixed and must be paid on a regular schedule. In comparison, universal life offers you a lot of flexibility. You decide how much to pay and when. You can pay extra premiums to beef up the policy’s cash value or skip premium payments when your financial condition is less than ideal. Additionally, you can also use the cash value to pay premiums.
Adjustable death benefit
Universal life insurance lets you increase or decrease the death benefit to suit your changing financial needs. For instance, let’s say 20 years down the line you find you don’t need as much death benefit as offered by the policy but would love to have more cash value. With universal life, you can reduce the death benefit amount in exchange for more cash value.
On the other hand, if you realize at some point that you need a higher amount of insurance, you can bump up the death benefit amount also. However, you may have to complete a health exam first.
Cheaper than whole life insurance
Universal life insurance often requires more involvement by the policyholder than whole life. It also offers fewer guarantees. For these reasons, universal life policies tend to cost less than comparable whole life products.
Wide range of investment options
Universal life insurance offers policyholders a range of investment options depending on their risk tolerance and long-term financial goals.
Disadvantages of Universal Life Insurance
Complex and requires close monitoring
Universal life insurance is a complex beast. For instance, these policies don’t grow cash value at a steady rate. Instead, the growth fluctuates depending on the performance of underlying investment options, so you must know how that works and the various fees you’ll have to pay.
Moreover, in the case of a variable universal life policy, you usually need to manage your sub-accounts. So, it’s important you know what you’re doing. Else, the cash value can dwindle fast.
You must also keep close track of your policy’s cash value account. If the cash value drops to zero, your policy will lapse. That will mean loss of investment and having to purchase coverage all over again.
Pay premiums until your death
Most universal life policies require you to pay premiums until your death. For many people, keeping up with the premium payments in their later years can prove difficult, more so if the cash value savings don’t grow as planned. That’s because then you won’t be able to use the policy’s cash value to pay off future premiums.
Universal policies accumulate cash value. But there’s no guarantee of future returns. How much cash value you accumulate depends on two factors:
- The actual cost of insurance
- The rate of interest earned on cash value savings
The actual cost of death benefits goes up as you age. For instance, let’s say you’re a 30-year-old paying $100 a month as the premium. Thirty dollars of that goes toward covering the cost of insurance, while the remaining $70 goes into the policy’s investment account.
However, as the years pass, that number will change. When you hit 65, that split might be $80 for the cost of insurance and $20 for the cash value savings. And if the investments didn’t pan out the way the insurer had hoped, you may find that what you counted on to be your big nest egg doesn’t really amount too much.
High expense ratio
While the cash value component of universal life insurance looks awesome on paper, it may not be so great.
For one, insurance companies charge a much higher fee for managing the investment component of your universal life policy. With other investment vehicles, the fee is typically one percent or lower. Universal life policies, in comparison, charge 3% or even more. As a result, the rate you earn on your policy’s cash value is lower than the actual performance of the underlying investment option.
Apart from a hefty fee for managing the investment account, the insurers can add different fees. You may have to pay a fee for frequently changing the investment options, taking a policy loan, or making a withdrawal.
Another downside is that canceling the policy can be expensive, depending on when you do that. Make sure you talk with an advisor like Dundas Life to understand how much of your cash value you will lose if you terminate the universal life policy in the first 2 years, 4 years, 8 years, and so on.
What is the anti dump-in rule?
The primary purpose of a life insurance policy is to provide a financial benefit to beneficiaries upon the death of the insured. It is there to ensure your dependents can live comfortably after you’re not there to take care of them.
The anti-dump rule ensures that’s how Canadians treat life insurance. That is, as a tool to ensure their family’s financial future — and not as an investment tool.
Permanent life insurance serves two purposes. It offers your family a death benefit upon your death and builds cash value that you can use while alive. The policy’s investment account (aka cash value) grows on a tax-deferred basis if you access the money in it via a withdrawal or loan. Or it grows on a tax-free basis if the policy ends with your (the insured’s) death.
The anti-dump rule prevents people from dumping money in their universal life policies and using them as an investment vehicle — hence the name. It also goes by the name of the 250% rule.
The anti-dump rule states that the cash value of your life insurance policy from the 10th year onward can be no more than 250% of what it was three years prior. In case it does, the policy risks losing its tax-exempt status.
As a result, this rule doesn’t affect your universal life contract for the first seven years. And it’s really in the seventh year that the anti-dump rule starts having some kind of meaningful impact.
Let’s say, the cash value of your universal life policy in the seventh year is $10,000. That means the cash value in the 10th year cannot exceed 250% of what it was in the seventh year. So, the maximum cash value this rule allows in the 10th year is 25,000.
Likewise, if in the eighth policy year the cash value grows to $12,000, the maximum cash value allowed in the 11th year is $30,000. In other words, the cash value in the 9th year impacts the 12th year, the 10th year impacts the 13th year, and so forth.
What is a service account?
Canadian life insurance companies try to prevent deposits that exceed the 250% rule. They do this by transferring excess funds to a fully-taxable account, called the service account. This account grows separately from the investment account. Once the investment account has room to take on more money, the insurer will transfer funds into it from the service account.
For example, let’s say the maximum tax-exempt limit of your universal life policy in its tenth year is $10,000. The policy has a cash value of $8,000 in the ninth year, and you deposit another $4,000 into it. This takes the total cash value to $12,000, which is $2,000 over the tax-exempt limit. The insurer will put the excess money (that is, $2,000) in the savings account. Whenever the financial room becomes available, it will move this money to the investment account (for which it was originally intended).
Who should buy Universal Life Insurance?
Universal life insurance is a good fit for people in special circumstances that require it. If you have a high-net worth and already maxed out other tax-deferred savings accounts, a universal life policy offers you an additional investment vehicle. And in case you have a lifelong dependent, like a special-needs child, who will need care after you pass away, universal life insurance can ensure they receive adequate financial support.
Universal life insurance offers flexibility in premiums and benefits. As such, it can be the right choice for someone who wants the flexibility to change the premium or death benefit as their life circumstances change.
Universal Life vs. Term Life Insurance
Term life insurance is the simplest, purest form of life insurance. In exchange for premium payments, the insurer promises to pay a certain death benefit to your family upon your death. As the name suggests, term life insurance lasts for a limited period. The death benefit and premiums stay the same throughout the term, and there’s no investment component build into the policy. Among all life insurance products, term life insurance is often the most affordable.
Similarities between universal life insurance and term life insurance:
- Both help you protect your family financially from the unexpected
- Both offer a guaranteed death benefit (Although, with universal life, you can adjust the death benefit)
Here’s a quick comparison guide:
Universal Life vs Whole Life Insurance
Whole life insurance is the nearest thing to a “fill it, forget it” life insurance solution. The coverage lasts your entire lifetime, and the premium and death benefit remains the same throughout. Plus, the cash value grows at a guaranteed rate.
All these certainties — lifetime coverage, guaranteed level premiums, guaranteed death benefit, and guaranteed cash value growth — come at a cost. Whole life insurance is more expensive than other life insurance products. It is also the only type of life insurance product that gives you a chance to earn dividends.
Similarities between universal life and whole life insurance:
- Both cover you as long as you live
- Both build cash value that grows at a tax-deferred basis
- Allows you to take money out of cash value via a withdrawal or policy loan
- Allows you to terminate the policy for its surrender cash value
- They offer a guaranteed death benefit (Although, with universal life, you can adjust the death benefit)
Here’s a quick comparison guide:
Universal Life vs Variable Life Insurance
Just like universal life insurance, a variable life policy covers you for life and builds cash value. However, it doesn’t offer the same level of death benefit and premium payment flexibility. In the case of variable life, you can invest your premium dollars in a menu of investment options, like stocks, bonds, and mutual funds.
Here are the similarities between universal life and variable life insurance:
- They both provide lifelong coverage
- Both include an investment account
- Both don’t offer a guaranteed rate of return on cash value
- Let's you to take money out of cash value via a withdrawal or policy loan
- Both allow you to terminate the policy for its surrender cash value
- Offers guaranteed death benefit (Although, with universal life, you can adjust the death benefit)
Here’s a quick comparison guide:
Universal Life vs Term-to-100 Life Insurance
Term-to-100 life insurance is a type of permanent life insurance product. You have to pay premiums to age 100. After that, your premium payments stop — but the coverage doesn’t. Term-to-100 life insurance offers a guaranteed death benefit, has level premiums, and doesn’t accumulate cash value. Because of the last feature, it is more affordable than universal life insurance.
Similarities between universal life insurance and term-to-100 life insurance:
- Both offer lifelong coverage
- They both come with a guaranteed death benefit (Although, in the case of universal life, you can adjust the death benefit)
- Both are less expensive than whole life insurance
Here’s a quick comparison guide:
Is Universal Life Insurance right for you?
Universal life insurance has much going for it, but it also has some drawbacks. It is a complex and unique life insurance product, which means that it is a good choice for people with special needs.
Universal life insurance is a good fit for you if any of these statements describe you.
- You're a high-net individual and have maxed out other tax-advantaged investment options and are looking for another tax-deferred savings option.
- You have a lifelong dependent and are looking for a life insurance product that doesn’t die before you do.
- You want the freedom to invest your premium dollars and are confident about earning a better return than what is offered by whole life insurance.
- You'll need a permanent life insurance product that gives you the flexibility to adjust your premiums and death benefit as your circumstances change.
Dundas Life’s advisors can help you decide if universal life is indeed right for you. They can also help you make an informed choice regarding your coverage and locate the best insurance company.