Prior to booming interest rates from the later '70s and early '80s, your life insurance options were pretty much term insurance and whole life insurance (and these nifty things calls endowment contracts that have since gone the way of the dodo). But, as interest rates started to skyrocket and insurance companies appeared to lag way behind, many began tough criticisms of the industry for offering such tiny returns compared to CD's and other interest-based savings vehicles.
The industry maintained that its payment of dividends accounted for the fact that policy loans did not change the dividend paid (essentially taking money out without taking money out) and required a smaller dividend payment. Still, the spread was pretty great and a lot of people began taking large policy loans and placing the money into other savings vehicles with much better returns in the short run.
Some companies tried to combat the interest rate environment by changing the way in which they paid dividends. The Guardian Life Insurance Company of America was instrumental in changing the payment of dividends by pioneering what is now known as Direct-Recognition to compensate for the interest spread.
They paid a higher dividend rate by addressing what all of the insurance companies were fearing, money leaving the contracts. So, Guardian began a practice of paying higher dividends if the money stayed in the contract, and reduced the dividend on loaned values of the policy.
Others in the industry decided to go in a different direction. Instead of changing up dividend treatment, they decided to create a new product. A product that took the guarantees that Whole Life brought off the table, but allowed for an opportunity to make more money on the cash value in the policy if interest rates continued their rally. This new product was called Universal Life Insurance
Universal Life Insurance Definition
Universal Life Insurance (UL) is often described as having a term insurance chassis, and this is a pretty accurate description. It's a term policy with a savings account attached to it, and as long as that savings account has money and/or the expenses outstanding for the life insurance component are paid, the policy remains in force (compare that to term life insurance which typically has an age at which point the policy cannot be renewed).
The term component works just like a yearly renewable term (increasing incrementally each year) starting very cheap and getting to be more and more of an expense as you age. However, once you have a large position of cash accumulated in your UL policy, there's a good chance the interest earned each year, more than covers the premium charges due on the policy.
The interest rate is set by the insurance company that issued the policy and usually remains competitive with market interest rates. Most companies offer a bump in the interest rate on the policy after a certain number of years (typically 10 years in force) this bump ranges but are typically in the range of 50 bps more or less.
There are no dividends paid on a UL policy, only interest credited to the cash portion of the account. This doesn't mean however that the insurance company can't pass on better than expected investment performance or better than expected mortality experience. When an insurance company wishes to do this, it comes in one of two fashions, either a reduction in the term cost of the life insurance or an increase in the interest rate credited to the policy.
Of the three main types of life insurance UL is by far the most complex. It has a lot of features and a lot of specialized vernacular. For a novice first exposed, it can sometimes appear to be a very daunting product, but once broken down, the basics are…well, basic, and it's pretty easy to get a handle on.
One of the most confusing features of UL is all of the different premiums that get quoted when one looks at an illustration. There's Target Premium, Planned Premium, Secondary Guaranteed Premium (sometimes called Guaranteed Premium) 7 Pay Premium, and usually a Premium to Endow with a specific time period. Here's what all this means
Target Premium is the premium target the insurance company has calculated in order to keep the insurance policy's death benefit in force until the targeted endowment age (121). Endowment means something slightly different than the use of the word when it comes to Whole Life Insurance. And endowed UL typically refers instead to a policy whose death benefit can remain in force without any further premium required. Now, there's a very important distinction to be made at this time.
When a UL contract becomes “endowed” or outputs a premium needed to endow a contract, that calculated contract is based on some factors that are not guaranteed. Instead, these factors are based on current conditions and can change. So, it's entirely possible that the required premium will be less to endow, and also very possible that it will be more (ask someone who purchased a UL in the late 80's/earl 90's about this). To help combat this uncertainty, UL premiums can be calculated based on a host of different assumption scenarios.
Mechanically what affects the performance is the policy interest rate also commonly called the crediting rate (how much the money is growing) and the Cost of Insurance (COI) (how much the insurance component is costing). If the COI goes up more than planned (rare) and the crediting rate goes down (happens from time to time) the assumed premium needed to endow at age 121 will go up and vice versa.
The Planned Premium is simply the premium that the insurance agent has specified in the inputs to the illustration (if this has been done). This premium could be missing from an illustration if the agent never specified a premium (no big deal).
Also, if the agent has specified varying premiums (say a lot at the beginning and less in later years or vice versa) the illustration will usually only stipulate the planned premium for the first year where it lists the different premiums.
The schedule of planned premiums (if specified) will be displayed in the ledger portion of the illustration under the premium column.
Secondary Guaranteed Premium
Most UL contracts have some sort of Secondary Guarantee included. A secondary guarantee is a premium amount to be paid to guarantee the death benefit regardless of the traditional requirements to keep a UL in force (insurance costs get paid/money left in the policy) think level term insurance.
The secondary guarantee period generally lasts between 5 and 15 years after which, the guarantee is terminated. The SG premium is typically the lowest premium on the premium list and the insured can usually technically pay less than this premium, but if the requirements to keep the policy in force are not meant, the policy will lapse.
7 Pay Premium
The 7 Pay Premium is the maximum premium that can be paid within the first 7 years and not turn the contract into a Modified Endowment Contract. Not a whole lot to discuss here, this premium is calculated at issue and remains the same unless the contract undergoes a material change.
Sometimes a special endowment premium is calculated, maybe for a 10 pay endowment or a 20 pay endowment. This simply means the amount of premium that would need to be paid to endow the contract after the specified number of years. Again, this is not a guarantee, simply a calculation based on an assumed crediting rate and assumed mortality charges.
Additional Information to Note
Flexibility is generally the key feature of Universal Life Insurance. The premium paid can be as little as the policy expenses, or as high as the insured/contract holder would like to make them (within certain parameters). UL is traditionally referred to as unbundled because the premiums paid are separated into expenses and cash value. Whatever extra is placed beyond expenses goes to the cash value and earns interest.
Additionally, the policyholder can easily adjust their death benefit as they wish. There is a way to increase the death benefit (but that's a conversation for a different day) and the insured can reduce the death benefit by contacting the insurance company and making the request.
Most UL contracts follow a surrender charge schedule. This schedule lasts for 5-20 years and is a reduction of the cash value in the policy if the contract holder lapses the policy.
It should be noted if the contract cash is loaned or withdrawn down to the amount that would be deducted as a surrender charge, and no premiums are paid, the policy will lapse as the insurance company will not use cash that would pay a surrender charge to pay premiums.
Also, if the policy death benefit is reduced, while the policy is still within the surrender period, a pro-rata portion of the surrender charge will be deducted from the cash value.
UL comes in a few different forms, and we'll address those in the future. For now, we'll not their names: Current Assumption, Variable, Indexed, and Secondary Guaranteed.