“The future ain’t what it used to be.” – Yogi Berra
(This article is a bit on the technical side, but understanding the concepts could be important.)

Universal life (UL) is a type of permanent life insurance policy introduced in the early 1980s. Some of the features of UL were quite innovative, but because of the economic climate in which UL was introduced, the true long-term impact of these UL innovations is only now becoming understood. Since many long-term owners of UL policies are just now coming to grips with these issues, it is important to understand the concepts and factors that impact UL contracts, and how to address them.

First, a short (but necessary) explanation of the financial concepts that affect UL:

The Difference between Projections and Guarantees

In a traditional permanent insurance policy, such as Whole Life, both the annual premium and death benefit are fixed and guaranteed for one’s “whole life,” typically to age 100. As premiums are paid, a portion of the payment is designated as “cash value,” which is considered the owner’s equity in the insurance benefit. If the insured does not die before age 100, the policy “matures” and the insured receives what would have been the death benefit as a cash payment. (Every policy contains a schedule which defines the terms of these guarantees.)

Because life insurance companies have a contractual commitment to deliver an insurance benefit at any time, the determination of premiums and guarantees is based on extremely conservative risk assessments. Insurance companies overestimate how many policyholders will die, and overestimate how much it will cost to operate the company; they underestimate the rate of return they will achieve on the reserves they have accumulated to pay claims. If claims and operating costs are lower than anticipated and/or investment returns are higher, these savings are returned to policyholders in the form of dividends*. Often, these dividends are added to cash values, and may also be used to increase the insurance benefit.

Since most insurance companies regularly surpass their conservative estimates, dividends can cause both cash values and life insurance benefits to dramatically increase beyond the guarantees specified in the contract over time. Thus, when illustrating their policies to potential buyers, insurance companies are permitted to present illustrations featuring both guarantees and projections based on dividends. While the planning rate in the illustration is not an exact determination of future performance, showing projections is a reasonable practice since most long-established insurance companies have paid dividends every year for over a century. In short, a good permanent life insurance policy is designed to exceed its guarantees, and will almost always do so.

*Dividends are not guaranteed and are declared annually by the company’s board if directors.

UL Tilts Toward Projections, Away from Guarantees

In several ways, UL policies capitalize on the spread between guaranteed and projected performance. Instead of establishing fixed premiums and guarantees, UL contracts allow the policyholder flexibility in premium payments, based on the current performance of the insurance company. Within certain parameters, policyholders can make premium payments as large or small as they want, as often as they want, provided there is always enough cash value to cover the current cost of insurance and keep the policy in force. If there is ever an occasion where there is not enough premium and/or cash value to cover the cost of insurance, the policy is terminated.

Using the same format of illustrating both guaranteed and projected performance, a prospective UL policy owner can select a premium schedule that may not be guaranteed to age 100, but is projected to last until age 100. This decision, to base the structure of the policy on projected performance instead of guaranteed performance, results in lower premiums and cash values, but still offers the possibility of an insurance benefit being in force for one’s entire life. The idea of paying less for a permanent insurance benefit has been (and is) a major UL selling point with some consumers.

Depending on the insured’s age when a UL policy is purchased, the spread between the guarantee and projection can be significant. For example, a 40-year-old could select a premium schedule which guarantees the policy’s benefits to age 70, while the projection shows coverage lasting to age 100. This leaves a lot of room for variation between the projections and actual performance. If any of the factors that figure into actual performance are below projections, the policy will either expire before age 100, or require additional premium to compensate for the under-performance.

Among the factors that affect policy performance, the rate of return on invested reserves is the hardest to predict and control. In the 1980s, interest rates were quite high, relative to today. Many UL policy illustrations used high interest rates, producing optimistic projections that haven’t come close to reflecting actual performance. As a result, many long-time policyholders now find themselves in a dilemma: they must increase their premiums or forfeit their insurance. In some cases, the premium required to maintain the coverage at advanced ages is prohibitive. This is especially troublesome for individuals who intended the insurance benefit from a UL policy to facilitate estate plans, because the plan requires an insurance benefit to be paid at death.

UL Warning Signs and Remedies

If you own a UL policy, and want to assess its status, one of the steps you can take is to receive an updated projection of values and guarantees. Most UL policies can deliver the same guarantees as whole life policies if the premium is increased, and you’ll want to know the numbers.

As you scan the illustration, see if there is a point where cash values begin to plateau or decline. This is an indication that the cost of insurance will begin out-pacing projected premiums and interest crediting rate, and the policy is moving toward termination. This decline in cash values may be quite gradual at first, but the shorter the time period to the plateau, the sooner you may need to consider corrective measures.

Even if the plateau is further out on the projection, it is particularly important for older policyholders to address adjustments as soon as possible. The cost of insurance climbs at an accelerated pace beginning around 60, and at later ages, adjustments may no longer be economically feasible.

Besides adding premium, UL policyholders may have the option of reducing the insurance benefit to enhance guarantees. While this option may not be ideal, it at least preserves some benefit for the premiums that have been paid, whereas a lapsed UL contract isn’t any different than an expired term life insurance policy – a lot of premiums out-of-pocket, but no financial benefit if you are still living.

Some UL policy owners may not have intended to keep the insurance for their entire life. But owning a life insurance benefit is a valuable asset, and the appreciation of what life insurance can provide often increases with age. It is prudent to determine if there are ways to preserve your insurability and integrate it into your existing financial programs.