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Universal Life Insurance - The Good, The Bad And The Ugly

by David Frucella

When I want to know the time, I don't care about the inner workings of the clock or how it produces the time, I just want the time. Unfortunately, this page is about the inner workings of Universal Life. It's long and tedious. There's just no other way around it. In my opinion, Universal Life is the most confusing product ever introduced by the insurance industry. If you are considering spending hundreds or thousands of dollars each year on this product, I suggest you read and re-read this page so that you know how this clock works. If you already have one of these contracts, this page will explain whether your policy is doing what it was set up to accomplish, or not. It will also guide you to ask your insurance company the right questions and get the accurate documents to assess the policy's progress.

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Some Boring But Necessary History

About 30 years ago, I sat in a former employer's class anxiously waiting for the product that was going to revolutionize the life insurance industry. It was called Universal Life. It was a product designed to pay current interest rates on cash values (then 15%). Combined with a low mortality charge and low administration costs, everyone that bought the product would be millionaires. It was sold as the solution to every financial problem (much like annuities are sold today). Many of the financial magazines called it "An Almost Perfect Policy." (I think they may have burned all the unsold issues).

Back in the 1980's, I'm not sure the insurance companies really wanted to introduce this product, but the outcry by the consumer groups was getting too loud for them to ignore.

In the late 1970's, things were changing. Consumer groups, led by Ralph Nader started picking on the insurance industry, telling them their products were terrible. The companies were selling outdated, over-priced contracts that mainly consisted of very low interest whole life. The public demanded higher interest crediting of their cash values. As a side note, Term life insurance was almost non-existent at the time, and what Term was available, was grossly overpriced.

The industry had a dilemma. Their cash cow product, whole life, was under attack. Interest and inflation rates were sailing along almost at 15%. Now one thing the industry didn't want to do was to offer a product that offered great interest rates on the cash value and still give the guarantees that whole life offered. There was simply too much risk for them to absorb.

They made a compromise with the critics and the public. They said, "we will give you the higher interest rates you want; however, we want you, the consumer, to share in some of the risk." So they came up with a modified variation of their old long-standing product, Whole Life and called it Universal Life. It unbundled some of the inherent guarantees of Whole Life. Universal Life left the consumer wide open to new risks and the possibility of having their insurance canceled.

To understand Universal Life, you need to understand Whole Life. The best way to explain Whole Life is this: You pay a set guaranteed premium for life - the company will give you coverage on your life (for life) for the amount you chose - the policy gives you paltry cash value - the company holds your cash value, invests your cash value and makes lots of money on it and pays you almost no interest in return - so you get to make the company a very low interest loan and you get some insurance - in other words, you get screwed - got it? Now if you don't think that's true, why do insurance companies own half the world?

So from a historical perspective, you can see why, in the 1970's, that people were upset with the insurance industry.

What Went Wrong?

What went wrong with Universal Life is that the product was introduced into a very high interest rate climate and was sold in a fashion that interest rates would stay high. I was kidded at that meeting 30 years ago by some of my fellow agents when I asked the question, "What happens if interest rates go down?" The mind set in the late 1970's was that interest rates would never go down. My wife and I bought our first house in 1980 and were thrilled that we got a 12% mortgage. How times change.

Fast Forward

Looking back over those 30 years, what do we see and what have the companies learned? The first thing we see is Universal Life produced more class-action suits that any other product the industry ever invented. It created so much confusion for the public that insurance departments throughout the country were overwhelmed with complaints. People had their life insurance cancelled when they thought they had lifetime coverage. In short, it was a disaster. The companies paid a gazillion dollars to settle class-action lawsuits to people who said they were misled by the companies and agents.

Why Did Things Go Downhill?

The main problem, as I see it, with Universal Life is that no one understands how the product works. It is nearly impossible to explain the policy's mechanics. I think explaining the evolution of black holes in the universe is easier. To put this to the test, about 20 years ago, I met with a client who was a high-powered attorney in Washington DC. He negotiated contracts for major hotel chains and was one of the brightest people I ever met. So we sat down and I explained Universal Life. After I was done (about 15 minutes) he said he understood the concept. I turned the tables and asked him to explain it back to me. He couldn't. So we went through it again and repeated the process. He tried again and failed. We gave it one more shot without success. I knew then either the product was doomed or I stunk as a salesman, probably both.

I'm going to attempt to explain the product and tell you why there is a very limited group that should consider purchasing this type of policy or one of its ugly stepsisters, Variable Life, Variable Universal Life and Indexed Universal Life. I will also, at no additional charge, advise those that already own this type of contract as to what they should do now.

"The Bucket"

I want you to picture in your mind a bucket. Universal Life is a "bucket." You put your premium dollars into your bucket (policy) and your bucket holds your money.

Now the goal of a Universal policy is to fill up your bucket with your premium dollars. The insurance company is holding your bucket and controls where your "bucket's money" is invested. The company pays you interest and also determines how much interest your "bucket" money earns. There is a minimum amount of interest (usually around 3-4%) it pays and can be higher. You simply put money in your "bucket." and leave the driving to the insurance company. From there interest was variable.

When the policy is issued, your "bucket" is set up and you've put your first premium in it. This is a critical point. As long as you have money in your "bucket," your policy will stay in force. Here is how it works. You pay your premium; let's say it's $50 per month. At the beginning of the month, you make the payment and the company immediately says "we need some money" and they drill a hole in the bottom of your "bucket." So some money starts to drip out the bottom of the bucket. This money that drips out the bottom is for several things. First, to insure you for that month, the company withdraws what they call the "mortality charge." This is the cost to insure you for the next 30 days. The amount is dictated by your age, sex, smoker status, and the health underwriting class you received when you bought the policy. If you were placed in a very good health class, you would have less withdrawn from your "bucket" than someone who had health problems. What is very important to remember is the "mortality charge" will increase each yesr as you age. Also the "mortality charge" is not fixed. The company can decrease it or increase it, but never higher that the maximum it can charge as stated in the policy. This gives the company a lot of leeway and some companies have stuck it to policyholders by raising the "mortality charge." Remember any adjustment upwards in "mortality charges" makes the leak at the bottom of your "bucket" even bigger. That is not good. Combined with variable interest rates, it's a recipe for disaster.

Second, the company withdraws administrative charges. Some charge about $5 per month, some more, some less. It's usually fixed but can be adjusted up or down by the company.

Third, there may other admin costs, commissions and fees for the company's profit. So your "bucket's" hole gets a little bigger each month. As I said earlier, the main consideration here is, "as long as you have money in your bucket, the policy will stay in force."

Here's the good part - at the end of the month, the company makes a deposit into your bucket. That money is interest that your "bucket" earned that previous month.

Next month the process starts again and as you age, the goal is to fill up the bucket with cash. You need to keep a wary eye on the drip, as it will get bigger. The goal is to fill the bucket with sufficient monies to offset the ever-increasing drip and have the policy in force when the person dies.

The formula is for the "bucket" is:

+ your premium goes in
+ company puts interest in
- company takes out insurance cost (mortality charge - get more expensive every month)
- company takes out admin costs and profit

As long as you have at least $1 in the bucket at the end of any given month, you have insurance. If your "bucket" ever goes to $0, the company will send you a "60-day lapse" letter telling you all the money you have paid in premium has gone away and if you wish to continue the contact, you need to restock your "bucket." Restocking is usually a very expensive proposition. Some of you have already experienced this. This letter comes as a surprise to most and tells you your account is under funded and you need to increase your premium payments. If you don't pay up in the next 60 days, the policy stops. Of course all of this is a complete surprise so you call the company. They tell you your "bucket" is nearly empty and an immediate infusion of cash is needed. You tell them that you've been paying all this money all these years and it's all gone? They say yes and then tell you to have a nice day. You curse the agent for lying to you. Maybe they did, maybe they didn't. But in fact, you should have read (and understood) what you bought.

Back to 1980's...

The interest rate the company is paying you on your "bucket." is the critical part. Let's digress for a minute back to the 1980's and into the 1990's where problems for Universal Life started. It was the crediting interest rate. When people bought this product, companies were projecting outrageously high interest payments to customer's "buckets." Notice I didn't say "guaranteeing," but "projecting." Above I listed what funds the "bucket." There are two components, correct? They are the premium payments and the company's end-of-month interest deposit. When the very high projected interest rate was used, the computer illustration (used at sale) said the customer could put in less money and the company interest crediting would fund the difference. When interest rates started to fall, the company wasn't making the necessary interest payments and the customer was paying too low a premium and policies started to lapse. Why did they lapse? NO ONE WAS PAYING ATTENTION!! As I said above, there must be money in the bucket, either by premiums or interest to cover the drip. And as long as there was sufficient money to cover the ever-increasing drip, the policy stayed in force. In many cases the drip was outpacing the premium deposits and credited interest. The customer was oblivious to the compounding problem (which is why the annual report is important).

Who's To Blame?

There was plenty of blame to spread around. The first target was the agent. They were blamed for presenting too high an interest rate on the initial sale. They were also blamed for not following the policy's progress and alerting the client when things started going downhill. Many of the policies were in self-destruct mode right from the start.

The companies were blamed because safeguards were not in place to protect the customer. Many of their software programs did not have any limitations on the illustrated interest rate. An agent had the ability to use just about any interest rate they wanted. Today an agent can't illustrate anything higher that the company's current interest rate. The companies also were blamed for not giving early warnings to agents or customers before it was too late. They were also blamed for not having customers sign disclosures about the ramifications of the contract and they knew the interest rates were variable and not fixed. Most of what the customer knew was only what they were verbally told. Today, the customer has to sign the exact proposal stating they understand what they are doing and the risks involved.

The insurance commissions were barraged with complaints. Lawyers, smelling blood, swarmed like locusts in the Old Testament. The customers who brought the class action suits didn't make out that well. Some companies reinstated some policies but over all it was a mess. The companies paid huge fines and settlements. Those insured in the state of Florida had a field day with some of the companies.

I suppose that with any new revolutionary product, there are growing pains. The insurance industry had a time of it. From this experience, the industry has produced better products today offering better guarantees and disclosures. Despite the improvements, I don't recommend the product except in specific situations.

The Ugly Stepsister - Variable Life

The concept is the same as above. Variable Life is a "bucket." everything works the same with a major exception. In a Variable contract, you have more control and substantially more risk. You get to invest your "bucket's" money in mutual funds that you pick and the returns (profit or losses) are dictated by your investment decisions. With the Universal Life example above, the company is doing the driving (investing and paying you interest). With Variable life, you do the driving (and hope you don't crash). VARIABLE LIFE IS FOR A SAVY INVESTOR WHO IS WILLING TO TAKE SUBSTANTIAL RISK. I think the variable life purchaser is more in tune with the product's inherent flaws and are willing to gamble more for better results. The big problem with the bucket on a Variable policy is that the values bounce all over the place. One year there could be great returns, the next losses. So additional deposits in a bad year may be dictated.

Another concern I have with variable contracts are the admin fees, management and ancillary charges. They can get quite steep and can put a sizable dent in the bucket, as they are another drip. Of course the buyer of this product is usually one who feels they can beat the market consistently and offset the higher charges not found in Universal Life.

The Newest Darling of the Insurance Industry - Indexed Universal Life

Indexed Universal Life insurance provides a death benefit plus the opportunity to accumulate greater policy value (your bucket) that can generate tax-free supplemental income. Many policyholders pick the crediting strategy that links growth in policy values to the performance of the S&P 500 Index. A fixed account crediting strategy is usually also available.

There was a famous quote by the great Spanish philosopher George Santayana (1863-1952), who said in The Life of Reason: "Those who cannot remember the past are condemned to repeat it." I believe the life insurance industry is about to repeat history. After 2010, the buzz in the insurance business turned to Indexed Universal Life. It has the same ingredients as standard Universal Life with one important twist. Your bucket's investment return tracks the stock market and as I said above, mainly the S&P 500 stock index. Whatever the index returns in a given time period, you get some of the profit added to your bucket (less company expenses as outlined above). Most companies say that if the index returns a loss in any given crediting time period, you will not lose money for that period. Sounds good so far. In good return periods, your bucket gets a percentage of the index's gain.

Companies are "projecting" 9-10% returns on the bucket based on historical returns of the S&P 500 (over the last 25 years) with the guarantee that in any given cediting period, the contract will never lose money. So the "floor return" is zero. What's the ceiling return?

This is where it gets a little tricky. The companies put a "cap" on how much you can make in a crediting period. It may be 10% or 12% - each contract is different. So if the index goes up 20% in a crediting period, you are capped at whatever your contract dictates (less expenses). The company gets the rest. Yoou make money, they make money, what's the problem?

If you hit low or zero interest returns early in the policy's life, you have to make up the lost interest (remember they are projecting 8-9% average return each year) either with big investment returns or you putting more cash into the policy. If your returns are ok, but less than, projected, you still face the same problem. Remember, the salesperson will show you the best-possible outcome and that this is an illustration, not a guarantee. Compare it to the weather reporter that says, "it may rain, but there are no guarantee on that." The guarantees are on the illustration, be sure to look for them and understand the downside.

Who Should Consider Buying A Universal Life Policy?

I have a problem when people call me and tell me they paying $50-100 per month for a Universal Life policy because they bought for an investment or retirement. Someone told them it was a good way to force-save or it was a way to pay for junior's college expenses. Then they tell me their income (which usually is not very high) and that they are not contributing to a retirement plan. This only compounds my frustration. If your income is not high, you should think twice. Here's why.

There is limited percentage of people that should consider buying a Universal Life policy. We recommend Universal Life in estate planning, business succession and other tax-planning situations. We are OK with those that just want lifetime coverage with little expectation of cash value buildup. In those situations, we recommend paying the "guaranteed" premium vs. the "illustrated" premium. In other words, regardless of whatever happens, they will have guaranteed coverage.

Universal Life offers a tax-deferred build up of cash value. For some in the very highest income bracket, may consider this an "investment" type policy. If you buy one for purposes of investment, over-fund the contract and let the cash grow on a tax-deferred basis. At some point (much later on) they can get at the cash via loans or withdrawals and still get a tax-free death benefit. Again, this is advanced financial planning. This strategy is for very high-income people who already have substantial investments, savings and have maxed out all available tax deferred retirement options to include 401Ks and IRAs.

If you are not in the top income bracket here are some financial planning suggestions: (trust me on this - I learned the hard way)

1. Buy some low-cost life insurance if you have dependents - buy it here

2. Have 6 months income saved that is readily available - people get sick - people get fired

3. Eliminate all debt except for a home mortgage - have only one credit card - if you ever get to a billing period where you can't pay off the balance, stick the card in your shredder

4. Max out your contributions to your 401k or IRA - many ignore this. At least take advantage of any company matching funds. If a company will give you 25 or 50 cents for every dollar you contribute, you have an immediate positive return

5. Get some health insurance if you don't have any - even a catastrophic HSA plan is better than nothing

The first 3 suggestions will keep most people busy for some time.

Now who else might consider a Universal Life policy?

If you are looking for level lifetime coverage with no anticipation of cash value growth, Universal Life can be a good choice. You are simply getting a guaranteed death benefit in the future for a fixed cost. If this is what you want, I have no problem with it, although I would prefer you max out your retirement plans options first. Also, if you buy it, plan to keep it. If you cancel this type of policy early, there will be substantial surrender charges assessed againt your cash value.

As I mentioned above, the newer contracts offer better lifetime guaranteed-premium coverage than the 1980's and 1990's versions. Be sure you are paying the lifetime guaranteed premium as many policies offer lower premiums but don't guarantee them for life. Don't find yourself in the same situation as those described above. This is not always clear. Everything will be listed in the proposal you will have to sign. Read everything. If you apply, ask for copies of the policy delivery receipts to be faxed to you prior to final meeting with the agent. When the agent arrives, there will be little time to examine everything before they want you to sign and get out the door. If you get stuck, fax me a copy of the proposal and I will tell you what you're getting. We offer this service free of charge. If more research or company contact is needed, our fee is $225 per hour with a two hour minimum

Already Own A Universal Or Variable Life Policy?

If you already own a Universal or Variable Life policy, you get an "Annual Report" each year. You glance at it - it's a bunch of columns of numbers that make no sense. You then file it away with the other previous year's reports and forget about it until next year. You need to get it out and read it. Fax me a copy and I will go over it with you. Next, you need to contact the company and ask for a "mid-stream" proposal. Some companies call it a "mid-point" or "in force" proposal. If you have a lot of money invested, you want to get that report. It's free for the asking. It is a snapshot report that says, "here is where you are today and here is where you will be in the future." The report will have columns of numbers stating this year projecting values into the future. There should be 2 or 3 set of columns - usually to the left, it should say "Guaranteed Values." It will list the death benefit and accumulated value (that's funny money) and cash surrender value (that's real money). The columns on the left will show a "Guaranteed" interest rate. These columns represent the worst-case scenario and assumes the company is paying the minimum interest and charging the maximum admin and mortality charges.

There may be a middle set of columns that say something like "mid-interest rate." This is set up the same way as the "Guaranteed" columns, but this group shows a middle interest rate scenario (between the guaranteed rate and current listed rate). The third columns show the same data but using the current interest rate and current charges that the company assumes it will charge in the future.

Now if you see any zeros in any of the columns going out into the future, it's time to pay attention as the policy may pre-decease you. Where you need to look is under the "death benefit" column. If the zeros start in the Guaranteed "death benefit" column, this means that if the company falls back to the pre-stated guarantees in the policy immediately and stays there for the duration of the policy, it will lapse on you in the first year you see a zero in that column. That means your "bucket" is empty. This is probably an unlikely scenario, but it's something to pay attention to as time goes on. If the zeros are listed in the "mid-point" or especially the "current" "death benefit" columns, that means problems may be fast approaching. Here you need to make a decision to start putting more money in - surrender the policy and get the remaining cash value out - possibly exchange the contract for better, more current contract - let the policy die (no pun intended). Today's contracts are better, but it depends how much money you have in the contract. If you are planning to put more money in, you need to do it as soon as possible. Once the bucket starts to empty, it does it in a hurry.

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