10/23/23
There are two types of universal life insurance – the good kind, and the bad kind. But before we get into that, lets look at how universal life insurance works.
Universal life insurance has two discrete components in the policy – an insurance component, and an investment component. The insurance component can be considered as a term insurance policy if it stood on it’s own. The investment component, unlike whole life, is discrete and trackable – you can actively view your balance, and determine the type of investments that you have.
Costs for the insurance component can be paid in one of two ways, either directly by you as a premium, or they can be paid out of the investment component. Either way, the insurance costs must be paid each month – if you don’t pay them directly through premiums then the life insurance company will automatically pay them from your investments. If you don’t pay the premiums directly, and there’s no funds left in the investments, then your policy will lapse.
Any ‘premiums’ or deposits that you pay into the policy are not directly related to the insurance costs. You can pay more than the insurance costs, and any amount over the insurance costs are deposited into the investments. If you pay less than the insurance costs (or pay nothing in a month), then the shortfall to cover the insurance costs are withdrawn from the investments.
A simple example. If your insurance costs are $100/month, in the early years of the policy you could pay $150 as your ‘premium’. That would result in the first $100 covering the monthly insurance costs, and the remaining $50 being deposited into the investments.
Now lets say that your $50/month into the investments grow over time so that there’s $1000 in the investments. You could then stop paying premiums entirely, and the life insurance company will start withdrawing the $100/month insurance cost from the investments. The insurance costs will be withdrawn from the $1000 at $100/month for the next 10 months and at that point if nothing changes, the policy will lapse.
This is where we get into the ‘good’ and the ‘bad’ kind of universal life. There are two basic types of term insurance structures found in universal life insurance. You select your term type when you purchase the policy.
The first basic kind of term policy is Term to 100. In this structure, your insurance costs are level and guaranteed for life. If your insurance cost is $100/month today, it’ll continue to be $100/month when you’re 85 years old – they never change.
With this type of policy (called Universal Life with Term to 100 Cost of insurance) you could simply pay the minimum guaranteed insurance cost each month. That will cover the insurance costs, keep the policy in force, and result in an investment balance of $0. Doing it this way gives you effectively a Term to 100 policy; fully guaranteed level premiums for life with $0 investments (which is a Term to 100 policy definition). Nothing can really go wrong in this scenario as everything is level and guaranteed, and universal life insurance when used in this fashion is a viable alternative to Term to 100 life insurance.
The second type of term life insurance that’s generally available is YRT or Annually Renewable Term. This insurance pricing structure has premiums that are age based – they go up every year. Initially costs are very low, but because they go up every year, eventually they become unaffordable.
Restating our example from above but with a YRT insurance cost structure, lets say your insurance costs start at $25/month with this type of policy. Like the Term to 100 example above,you pay a deposit of $100/month. In the first month, your $100 is split by the company, $25 to pay for the insurance, and $75 goes into the investments.
Eventually your insurance costs go to say $150/month. You continue to pay $100/month. This covers part of your insurance costs, and the remaining $50 shortfall in insurance costs is withdrawn from your investments.
Here’s the bad part. The investments are not guaranteed and can be volatile. Initial projections on these policies often speculate that investments in the early years will be sufficient to cover the shortfall in your deposits when the insurance costs eventually exceed what you’re paying every month. At that point, your investments will start to decline and trend toward $0. When that happens (and it does happen in many cases), you’re now a lot older, you have a policy that you’ve paid into for many years, and are faced with now paying those ever increasing premiums directly out of pocket – which is likely to be very bad news if you’re in retirement and faced with premiums going to $700/month....$800/month, etc. In that case many people simply lapse their insurance coverage as it’s now unaffordable. You’re now much older and out of life insurance with no good alternatives – thus the reason this is a ‘bad’ type. It can leave you old, without life insurance, and no opportunity to get an affordable policy, plus all the premiums you’ve paid to date are gone.
If you’re seeking low cost permanent life insurance, then a universal life insurance policy with guaranteed Term to 100 insurance costs is a strong contender. These policies can be compared directly, dollar for dollar, with a term to 100 life insurance policy. For example, if you’re seeking life insurance for final or funeral expenses and thus looking for low cost life insurance with guaranteed level premiums for life, and no other costly attributes, then Universal life insurance with term to 100 insurance costs is a viable alternative to term to 100.
For almost everyone, and anyone that has NOT maximized your RRSP’s and TFSA’s, then any sort of insurance strategy that combines YRT insurance costs structure and investments will be a poor choice (in fact, we would not offer this to consumers). Not only are you exposed to losing your life insurance in the future, you have far better alternative investment options available to you – RRSP’s and TFSA’s.
In some cases, where you have maximized your RRSP’s and TFSA’s and are seeking additional retirement income, then there are a variety of investment strategies that use universal life insurance that can be very attractive – but only after your other tax sheltered investment options are maxed out. Before that point, avoid universal life insurance for those purposes. After that point, absolutely consider universal life insurance as a supplemental investment strategy.