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Universal Life Insurance
By | March 6, 2010
Universal Life Insurance Explained
Universal Life Insurance is a policy in which part of the premiums are used to buy insurance protection and part are used to invest in the cash value part of the policy. The Insured person’s premium is paid into an “accumulation” fund, maintained by the company. This fund earns varying amounts of interest, according to money market type interest rates. Universal Life also has a “flexible” premium.
The company automatically withdraws enough each year from the “fund” to buy one year of pure insurance protection on the insured. Note: With evidence of insurability you can raise the face value or it can be lowered. Premiums are flexible. The company pays the Face Value AND the Cash Value upon the Insured person’s death.
Although Universal Life is not a “Whole Life Insurance” policy, there are a few similarities. Universal Life policies mature when the insured person reaches 95 years, instead of 100.
Universal life is an interest rate sensitive policy since the policy cash value is used to buy short term interest bearing instruments. A minimum interest rate is guaranteed, but the company usually pays a
higher rate because current available market interest rates are higher than guaranteed interest rates. (Note:at the time of this writing.)
Example, in Whole Life policies, the company effectively has to guarantee interest rates for the rest of your life and hence they have frequently guaranteed interest rates of only 3 or 4%. The company is not taking any substantial investment risk in Universal Life policies.
A corridor of Face Value protection must be maintained above the policy’s cash value to qualify as a life policy for federal tax purposes. There must be a minimum corridor maintained between the Face Value and the Cash Value at all times or else the policy will be considered an investment and not an insurance policy that qualifies for tax deferred advantages in the build up of the Cash Value.
Transparent – The Insured person can see where their premium goes. It is used for mortality and expenses. The remainder is earning interest in the cash value in the accumulation fund/bank account.
Unbundled – The Insured can skip premiums and not suffer a reduced death benefit. The company will deduct mortality and expenses from the Cash Value to keep the policy in force. The Cash Value and Face
Value are “unbundled” from each other.
Option A
Face Value remains level while Cash Value increases. In the early years the Face Value is much higher than the Cash Value and the company would pay the Face Value and the Cash Value upon death of the Insured. In the later years, as the Cash Value approaches the Face Value, the Face Value would go up, maintaining a corridor between the Face Value and Cash Value.
Option B
Face Value increases each year in the same percentage that the Cash Value increases. This has the effect of always keeping the same corridor between the Cash Value and the Face Value. If the Insured dies the policy pays the Face Value, which goes up each year. Hence, option B is more expensive than Option A.
Both options maintain a Face Value which is greater than the Cash Value to maintain a corridor between them.
The company may be able to pay a much higher interest rate for client’s money held in the Universal Life Fund than in conventional Whole Life or Endowment policies, because the interest rate paid by the Universal Life Fund does not have to be guaranteed for many years into the future, as it does in conventional Whole Life or Endowment policies. Since short-term interest rates are sometimes higher than long-term rates, the client benefits. If short-term interest rates drop to low values, the client would not accumulate Cash Value in the fund as rapidly as if short-term interest rates remained higher.
Variable Universal Life – Universal Life Variable
The same as Universal Life only these are not interest sensitive but stock sensitive, tied to mutual fund performance.
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