Whole life insurance

Whole life insurance, or whole of life assurance (in the Commonwealth of Nations), is a life insurance policy that remains in force for the insured's whole life and requires (in most cases) premiums to be paid every year into the policy.

1. History

All life insurance was originally temporary (term) insurance. However, because term life insurance only pays a claim upon early premature death within the stated term, a number of term insurance policy holders became upset over the idea that they would most likely be paying premiums for 20 or 30 years and then wind up with nothing to show for it. Temporary insurance only pays out 2-3% of the time. This has become known as the "Lost Opportunity Cost" called term insurance.

In response to market pressures, actuaries produced an insurance policy with level contributions that would last a lifetime. These contracts would offer a "cash value" which was designed to be a cash reserve that would build up against the known claim-–the death benefit. These policies would also credit guaranteed interest to the cash value account. Upon maturity of the contract (usually at age 95 or 100), the cash value would equal the death benefit. By guaranteeing the death benefit, the policy owner was assured that insurance coverage would be in force when the insured died, allowing them to unlock and exploit other assets. Upon the death of the insured, the cash value would be surrendered to the insurance company and the beneficiary would receive the death benefit. If, before their death, the insured wished to borrow the cash value and forfeit the death benefit, the cash value would be paid back with interest minus dividends paid, making it the lowest cost way to access one's wealth.

2. Types

There are several types of whole life insurance policies. New York State defines six traditional forms: non-participating (aka "non par"), participating, indeterminate premium, economic, limited pay, and single premium. A newer type is known generally as interest sensitive whole life. Other jurisdictions may classify them differently, and not all companies offer all types. There are as many types of insurance policies as can be written in their contracts while staying within the law's guidelines.

Non-participating

All values related to the policy (death benefits, cash surrender values, premiums) are usually determined at policy issue, for the life of the contract, and usually cannot be altered after issue.

This means that the insurance company assumes all risk of future performance versus the actuaries' estimates. If future claims are underestimated, the insurance company makes up the difference. On the other hand, if the actuaries' estimates on future death claims are high, the insurance company will retain the difference.

2.1 Participating

In a participating policy (also par in the USA, and known as a with-profits policy in the Commonwealth), the insurance company shares the excess profits (variously called dividends or refunds in the USA, bonus in the Commonwealth) with the policyholder. Typically these refunds are not taxable because they are considered an overcharge of premium. The greater the overcharge by the company, the greater the refund/dividend. For a mutual life insurance company, participation also implies a degree of ownership of the mutuality.

2.2 Indeterminate premium

Similar to non-participating, except that the premium may vary year to year. However, the premium will never exceed the maximum premium guaranteed in the policy.

2.3 Economic

A blending of participating and term life insurance, wherein a part of the dividends is used to purchase additional term insurance. This can generally yield a higher death benefit, at a cost to long term cash value. In some policy years the dividends may be below projections, causing the death benefit in those years to decrease.

2.4 Limited pay

 

Similar to a participating policy, but instead of paying annual premiums for life, they are only due for a certain number of years, such as 20. The policy may also be set up to be fully paid up at a certain age, such as 65 or 80. The policy itself continues for the life of the insured. These policies would typically cost more up front, since the insurance company needs to build up sufficient cash value within the policy during the payment years to fund the policy for the remainder of the insured's life.

2.5 Single premium

A form of limited pay, where the pay period is a single large payment up front. These policies typically have fees during early policy years should the policyholder cash it in.

2.6 Interest sensitive

This type is fairly new, and is also known as either excess interest or current assumption whole life. The policies are a mixture of traditional whole life and universal life. Instead of using dividends to augment guaranteed cash value accumulation, the interest on the policy's cash value varies with current market conditions. Like whole life, death benefit remains constant for life. Like universal life, the premium payment might vary, but not above the maximum premium guaranteed within the policy.

3. Requirements

Whole life insurance typically requires that the owner pay premiums for the life of the policy. There are some arrangements that let the policy be "paid up", which means that no further payments are ever required, in as few as 5 years, or with even a single large premium. Typically if the payor doesn't make a large premium payment at the outset of the life insurance contract, then he is not allowed to begin making them later in the contract life. However, some whole life contracts offer a rider to the policy which allows for a one time, or occasional, large additional premium payment to be made as long as a minimal extra payment is made on a regular schedule. In contrast, universal life insurance generally allows more flexibility in premium payment.

4. Guarantees

The company generally will guarantee that the policy's cash values will increase regardless of the performance of the company or its experience with death claims (again compared to universal life insurance and variable universal life insurance which can increase the costs and decrease the cash values of the policy). The dividends can be taken in one of three ways. The policy owner can be given a cheque from the insurance company for the dividends, the dividends can be used to reduce the premium payment, or the dividends can be reinvested back into the policy to increase the death benefit and the cash value at a faster rate. When the dividends paid on a whole life policy are chosen by the policy owner to be reinvested back into the policy, the cash value can increase at a rather substantial rate depending on the performance of the company. The cash value will grow tax-deferred with compounding interest. Most whole life policies can be surrendered at anytime for the cash value amount, and income taxes will usually only be placed on the gains of the cash account that exceeds the total premium outlay. Thus, many are using whole life insurance policies as a retirement funding vehicle rather than for risk management.

5. Liquidity

Cash values are considered liquid enough to be used for investment capital, but only if the owner is financially healthy enough to continue making premium payments (Single premium whole life policies avoid the risk of the insured failing to make premium payments and are liquid enough to be used as collateral. Single premium policies require that the insured pay a one time premium that tends to be lower than the split payments. Because these policies are fully paid at inception, they have no financial risk and are liquid and secure enough to be used as collateral under the insurance clause of collateral assignment.) Cash value access is tax free up to the point of total premiums paid, and the rest may be accessed tax free in the form of policy loans. If the policy lapses, taxes would be due on outstanding loans. If the insured dies, death benefit is reduced by the amount of any outstanding loan balance.

Internal rates of return for participating policies may be much worse than universal life and interest-sensitive whole life (whose cash values are invested in the money market and bonds) because their cash values are invested in the life insurance company and its general account, which may be in real estate and the stock market. However, universal life policies run a much greater risk, and are actually designed to lapse. Variable universal life insurance may outperform whole life because the owner can direct investments in sub-accounts that may do better. If an owner desires a conservative position for his cash values, par whole life is indicated.

Cash values associated with these policies carry provisions alongside their benefits that may not be beneficial for policy owners and insured individuals. Typically, when death benefit is paid out, policy cash values revert back to the issuing company; they are therefore lost. The reason for this is that all policy cash values become owned by the issuing company (a fact that can be verified in the policy contract), they therefore control when and how these are paid out.

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Variable universal life insurance

Variable Universal Life Insurance (often shortened to VUL) is a type of life insurance that builds a cash value. In a VUL, the cash value can be invested in a wide variety of separate accounts, similar to mutual funds, and the choice of which of the available separate accounts to use is entirely up to the contract owner. The 'variable' component in the name refers to this ability to invest in separate accounts whose values vary—they vary because they are invested in stock and/or bond markets. The 'universal' component in the name refers to the flexibility the owner has in making premium payments. The premiums can vary from nothing in a given month up to maximums defined by the Internal Revenue Code for life insurance. This flexibility is in contrast to whole life insurance that has fixed premium payments that typically cannot be missed without lapsing the policy (although one may exercise an Automatic Premium Loan feature, or surrender dividends to pay a Whole Life premium).

Variable universal life is a type of permanent life insurance, because the death benefit will be paid if the insured dies any time as long as there is sufficient cash value to pay the costs of insurance in the policy. With most if not all VULs, unlike whole life, there is no endowment age (the age at which the cash value equals the death benefit amount, which for whole life is typically 100). This is yet another key advantage of VUL over Whole Life. With a typical whole life policy, the death benefit is limited to the face amount specified in the policy, and at endowment age, the face amount is all that is paid out. Thus with either death or endowment, the insurance company keeps any cash value built up over the years. However, some participating whole life policies offer riders which specify that any dividends paid on the policy be used to purchase "paid up additions" to the policy which increase both the cash value and the death benefit over time.

If investments made in the separate accounts out-perform the general account of the insurance company, a higher rate-of-return can occur than the fixed rates-of-return typical for whole life. The combination over the years of no endowment age, continually increasing death benefit, and if a high rate-of-return is earned in the separate accounts of a VUL policy, this could result in higher value to the owner or beneficiary than that of a whole life policy with the same amounts of money paid in as premiums.

1. Regulation of VUL providers

Because the separate accounts are securities, the representative providing a VUL must be working in accordance with the securities regulations of the country or province in which he operates. And because they are life insurance policies, VULs may only be sold by representatives who are properly licensed to sell life insurance in the areas in which they operate. The insurance company providing the policy must also be licensed as an "insurer."

This dual regulation helps protect consumers, who can look up the track record of offenses of any provider listed by the regulating SRO (Self Regulatory Organization) or provincial securities commission.

1. United States. VULs may only be sold in the United States by representatives who have a "producers" life insurance license in the state(s) in which he operates. The insurance company providing the policy must also be licensed in the state(s) as an "insurer." Because the separate accounts are securities, the representative must be working through a broker/dealer registered with the United States' SRO, the Financial Industry Regulatory Authority (FINRA) and himself be registered with FINRA. (FINRA has an online database an investor can use to look up offenses and regulatory actions of any broker or broker/dealer.) The fact of a representative's securities registration will show on his state insurance license as "Variable" as in "qualified for Life and Variable Products." (The exact wording could vary from state to state.)
2. Canada. VULs, as life insurance policies, may only be sold in Canada by life insurance-licensed representatives registered with the insurance regulator in their provincial jurisdiction. Representatives must comply with the life insurance regulations of their respective province (typically, a provincial "Insurance Act"). And, as VULs are life insurance policies, providers must comply with the national life insurance regulations ("Insurance Companies Act") established by The Office of the Superintendent of Financial Institutions (OSFI). Since VULs are presently not considered to be securities in Canada, they are subject to lighter regulatory scrutiny than typical securities products. In Canada, there is no real differentiation between universal life and variable universal life.mkj

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2. Uses

Variable universal life insurance receives special tax advantages in the United States Internal Revenue Code. The cash value in life insurance is able to earn investment returns without incurring current income tax as long as it meets the definition of life insurance and the policy remains in force. The tax free investment returns could be considered to be used to pay for the costs of insurance inside the policy. See the 'Tax Benefits' section for more.

In one theory of life insurance, needs based analysis, life insurance is only needed to the extent that assets left behind by a person will not be enough to meet the income and capital needs of his or her dependents. In one form of variable universal life insurance, the cost of insurance purchased is based only on the difference between the death benefit and the cash value (defined as the net amount at risk from the perspective of the insurer). Therefore, the greater the cash value accumulation, the lesser the net amount at risk, and the less insurance that is purchased.

Another use of Variable Universal Life Insurance is among relatively wealthy persons who give money yearly to their children to put into VUL policies under the gift tax exemption. Very often persons in the United States with a net worth high enough that they will encounter the estate tax give money away to their children to protect that money being taxed. Often this is done within a VUL policy because this allows a tax deferral (for which no alternative would exist besides tuition money saved in an educational IRA or 529 plan), provides for permanent life insurance, and can usually be accessed tax-free by borrowing against the policy.

3. Contract features

By allowing the contract owner to choose the investments inside the policy the insured takes on the investment risk, and receives the greater potential return of the investments in return. If the investment returns are very poor this could lead to a policy lapsing (ceasing to exist as a valid policy). To avoid this, many insurers offer guaranteed death benefits up to a certain age as long as a given minimum premium is paid.

4. Premium flexibility

VUL policies have a great deal of flexibility in choosing how much premiums to pay for a given death benefit. The minimum premium is primarily affected by the contract features offered by the insurer. To maintain a death benefit guarantee, that specified premium level must be paid every month. To keep the policy in force, typically no premium needs to be paid as long as there is enough cash value in the policy to pay that month's cost of insurance. The maximum premium amounts are heavily influenced by the code for life insurance. Internal Revenue Code section 7702 sets limits for how much cash value can be allowed and how much premium can be paid (both in a given year, and over certain periods of time) for a given death benefit. The most efficient policy in terms of cash value growth would have the maximum premium paid for the minimum death benefit. Then the costs of insurance would have the minimum negative effect on the growth of the cash value. In the extreme would be a life insurance policy that had no life insurance component, and was entirely cash value. If it received favorable tax treatment as a life insurance policy it would be the perfect tax shelter, pure investment returns and no insurance cost. In fact when variable universal life policies first became available in 1986, contract owners were able to make very high investments into their policies and received extraordinary tax benefits. In order to curb this practice, but still encourage life insurance purchase, the IRS developed guidelines regarding allowed premiums for a given death benefit.

4.1 Maximum premiums

The standard set was twofold: to define a maximum amount of cash value per death benefit and to define a maximum premium for a given death benefit. If the maximum premium is exceeded the policy no longer qualifies for all of the benefits of a life insurance contract and is instead known as a modified endowment contract or a MEC. A MEC still receives tax free investment returns, and a tax free death benefit, but withdrawals of cash value in a MEC are on a 'LIFO' basis, where earnings are withdrawn first and taxed as ordinary income. If the cash value in a contract exceeds the specified percentage of death benefit, the policy no longer qualifies as life insurance at all and all investment earnings become immediately taxable in the year the specified percentage is exceeded. In order to avoid this, contracts define the death benefit to be the higher of the original death benefit or the amount needed to meet IRS guidelines. The maximum cash value is determined to be a certain percentage of the death benefit. The percentage ranges from 30% or so for young insured persons, declining to 0% for those reaching age 100.

The maximum premiums are set by the IRS guidelines such that the premiums paid within a seven year period after a qualifying event (such as purchase or death benefit increase), grown at a 6% rate, and using the maximum guaranteed costs of insurance in the policy contract, would endow the policy at age 100 (i.e. the cash value would equal the death benefit). More specific rules are adjusted for premiums that are not paid in equal amounts over a seven year period. The entire maximum premium (greater than the 7 year premium) can be paid in one year and no more premiums can be paid unless the death benefit is increased. If the 7 year level guideline premium is exceeded, then the policy becomes a MEC.

To add more confusion the seven year MEC premium level cannot be paid in a VUL every year for 7 years, and still avoid MEC status. The MEC premium level can only be paid in practice for about 4 years before additional premiums cannot be paid if non MEC status is desired. There is another premium designed to be the maximum premium that can be paid every year a policy is in force. This premium carries different names from different insurers, one calling it the guideline maximum premium. This is the premium that often reaches the most efficient use of the policy.

5. Investment choices

The number and type of choices available varies from company to company, and from policy to policy. The current generation of VUL policies have a wide variety of sub-accounts for the policy owner to allocate their cash surrender values into. These newer policies often offer 50 or more separate accounts covering the entire spectrum of asset classes and management styles.

Separate accounts are organized as trusts to be managed for the benefit of the insureds, and are so named because they are kept 'separate' from the 'general account' of the life insurance company. They are similar to mutual funds, but have different regulatory requirements.

6. Tax advantages

• Tax deferred growth of cash surrender values while a policy is in force
• FIFO withdrawal status on premiums paid into the contract
• Income tax free policy loans from policies that are not Modified Endowment Contracts
• Income tax free death benefits (may be subject to estate tax if policy is owned by the insured)

 

Taxes are the main reason those in higher tax brackets (25%+) would desire to use a VUL over any other accumulation strategy. For someone in a 34% tax bracket (Federal & State), the investment return on the separate accounts may average 10%, and at say age 75 the policy's death benefit would have an internal rate of return of 9%. In order to get a 9% rate of return in an ordinary taxable account, in a 34% tax bracket, one must earn 13.64%. Another alternative is a Roth IRA, because one would get the 10% tax free. The contribution limits on the Roth are $5,000 in 2009, and is normally unavailable to those in the 34% tax bracket. An alternative for this in the 34% tax bracket would be to consider using Variable Annuities which does not limit the contributions and withdraw from it without annuitizing the contract.

Other alternatives for those in the 34% tax bracket that own their own companies would be to consider SEP IRA's, company 401k's or retirement arrangements from a company perspective, or to incorporate and consult a tax specialist.

These numbers assume expenses that may vary from company to company, and it is assumed that the VUL is funded with a minimum face value for the level of premium. The cash values would also be available to fund lifestyle or personally managed investments on a tax free basis in the form of refunds of premiums paid in and policy loans (which would be paid off on death by the death benefit.)

7. Risks of variable universal life

• Cost of insurance - the cost of insurance for VULs is generally based on term rates and as the insured ages, the risk of mortality increases, increasing the cost of insurance. If not monitored properly the cost of insurance may eventually exceed the cash outlay depleting savings. If this continues long term the savings will be depleted and insured will be given an option to increase the cash outlay to cover the higher cost of insurance or cancel the policy leaving them with no savings and either no insurance, or very expensive insurance.

• Cash outlay - the cash needed to effectively use a VUL is generally much higher than other types of insurance policies. If a policy does not have the right amount of funding, it may lapse.

• Investment risk - because the sub accounts in the VUL may be invested in stocks and bonds, the insured now takes on the investment risk rather than the insurance company.

• Complexity - the VUL is a complex product, and can easily be used (or sold) inappropriately because of this. Proper funding, investing, and planning are usually required in order for the VUL to work as expected.

8. General uses of variable universal life

 

These are the features typically marketed by insurance companies, however the VUL in most cases will limit the insured to being able to take advantage of only one of these features listed not all. Each of these features can be achieved through other means.

• Financial protection - as with all life insurance programs, VULs can be used to protect a family in the case of a premature death.

• Tax advantages - because of its tax-deferred feature, the VUL may offer an attractive tax advantage, especially to those in higher tax brackets. To attain them, the policy must be highly funded (though still non-MEC), for the tax advantages to offset the cost of insurance. These tax advantages can be used for either...
• Education planning - the cash value of a VUL can be used to help fund children's education, as long as the policy is started very early. Also, putting money into a VUL can be used to help children qualify for federal financial aid, since the federal government does not consider the cash value when calculating EFC (Expected Family Contribution).
• Retirement planning - because of its tax-free policy loan feature, the VUL can also be used as tax-advantaged income source in retirement, assuming retirement is not in the near future and the policy is not a modified endowment contract. Again, the policy must be properly funded for this strategy to work.

• Estate planning - those with a large estate (A filing is required for estates with combined gross assets and prior taxable gifts exceeding $3,500,000 effective for decedents dying on or after January 1, 2009) can sometimes use a VUL as part of their estate planning strategy to reduce or avoid estate taxes by setting up a life insurance trust sometimes known as an ILIT.

9. Criticisms of variable universal life

• Potentially higher costs - VUL policies may be more expensive than other types of permanent insurance, such as Whole Life and traditional Universal Life. Volatility of cash surrender values, especially at late duration, can cause a "reverse dollar cost averaging" effect that results in higher costs of insurance charges. Proper funding of a contract may reduce this risk, but it cannot be completely eliminated.

• Some older VUL policies have limited sub-account choices. This issue has been greatly corrected with the current generation of policies having 50 or more sub-accounts that cover all the major asset classes, with more than one sub-account manager.

• Policy administrative expenses and costs of insurance may increase at the company's whim, subject to a contractual maximum.

• VUL is relatively complex compared to traditional Whole Life or Term Life.

Some criticism is not about the product, but rather the sales tactics used by some insurance agents.

• Projecting the maximum illustrated assumed interest rates (generally, 12%), using current (or assumed) administrative expenses and current costs of insurance, without showing the prospective client several other assumed rates of return, creating a Blue Sky problem.

Some regulators deserve criticism:

• Securities regulators (the U.S. Financial Industry Regulatory Authority (FINRA)) refuse to allow insurance companies to illustrate VUL policies using a stochastic projection (commonly called a 'Monte Carlo Simulation' or MCS), forcing agents to use archaic, antiquated, and deceptive deterministic projections ('straight line' or constant interest assumptions) that are far removed from reality. Illustration software with MCS capability has been available since the mid-1990s, but FINRA has forced the life insurance industry into a corner that virtually guarantees litigation.

 

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Universal life insurance

Universal life insurance (often shortened to UL) is a type of permanent life insurance, primarily in the United States of America. Under the terms of the policy, the excess of premium payments above the current cost of insurance are credited to the cash value of the policy. The cash value is credited each month with interest, and the policy is debited each month by a cost of insurance (COI) charge, as well as any other policy charges and fees which are drawn from the cash value, even if no premium payment is made that month. Interest credited to the account is determined by the insurer, but has a contractual minimum rate of between 2% and 4%. When a earnings rate is pegged to a financial index such as a stock, bond or other interest rate index, the policy is a "Equity Indexed Universal Life" contract.

1. Similar life insurance types

A similar type of policy that was developed from universal life insurance is the variable universal life insurance policy (VUL). VUL allows the cash value to be directed to a number of separate accounts that operate like mutual funds and can be invested in stock or bond investments with greater risk and potential growth. Additionally, there is the recent addition of index universal life contracts similar to equity-indexed annuities credit interest linked to the positive movement of an index, such as the S&P 500, Russell 2000, and the Dow Jones. Unlike VUL, the cash value of an Index UL policy generally has principal protection, less the costs of insurance and policy administrative fees. Index UL participation in the index may have a cap, margin, or other participation modifier, as well as a minimum guaranteed interest rate.

Universal life is similar in some ways to, and was developed from, whole life insurance, although the actual cost of insurance inside the UL policy is based on annually renewable term life insurance. The advantage of the universal life policy is its premium flexibility and adjustable death benefits. The death benefit can be increased (subject to insurability), or decreased at the policy owner's request.

The premiums are flexible, from a minimum amount specified in the policy, to the maximum amount allowed by the contract. The primary difference is that the universal life policy shifts some of the risk for maintaining the death benefit to the policy owner. In a whole life policy, as long as every premium payment is made, the death benefit is guaranteed to the maturity date in the policy, usually age 95, or to age 121. A UL policy will lapse when the cash values are no longer sufficient to cover the cost of insurance and policy administrative expense.

To make UL policies more attractive, insurers have added secondary guarantees, where if certain minimum premium payments are made for a given period, the policy will remain in force for the guarantee period even if the cash value drops to zero. These are commonly called "No Lapse Guarantee" riders, and the product is commonly called guaranteed universal life (GUL, not to be confused with group universal life insurance, which is also typically shortened to GUL).

The trend up until 2007–2008 was to reduce premiums on GUL to the point where there was virtually no cash surrender values at all, essentially creating a level term policy that could last to age 121. Since then, many companies have introduced either a second GUL policy that has a slightly higher premium, but in return the policy owner has cash surrender values that show a better internal rate of return on surrender than the additional premiums could earn in a risk-free investment outside of the policy.

With the requirement for all new policies to use the latest mortality table (CSO 2001) beginning January 1, 2009, many GUL policies have been repriced, and the general trend is toward slight premium increases compared to the policies from 2008.

Another major difference between universal life and whole life insurances: the administrative expenses and cost of insurance within a universal life contract are transparent to the policy owner, whereas the assumptions the insurance company uses to determine the premium for a whole life insurance policy are not transparent.

2. Uses of universal life insurance

• Final expenses, such as a funeral, burial, and unpaid medical bills
• Income replacement, to provide for surviving spouses and dependent children
• Debt coverage, to pay off personal and business debts, such as a home mortgage or business operating loan
• Estate liquidity, when an estate has an immediate need for cash to settle federal estate taxes, state inheritance taxes, or unpaid income in respect of decedent (IRD) taxes.
• Estate replacement, when an insured has donated assets to a charity and wants to replace the value with cash death benefits.
• Business succession & continuity, for example to fund a cross-purchase or stock redemption buy/sell agreement.
• Key person insurance, to protect a company from the economic loss incurred when a key employee or manager dies.
• Executive bonus, under IRC Sec. 162, where an employer pays the premium on a life insurance policy owned by a key person. The employer deducts the premium as an ordinary business expense, and the employee pays the income tax on the premium.
• Controlled executive bonus, just like above, but with an additional contract between an employee and employer that effectively limits the employees access to cash values for a period of time (golden handcuffs).
• Split dollar plans, where the death benefits, cash surrender values, and premium payments are split between an employer and employee, or between an individual and a non-natural person (e.g. trust).
• Non-qualified deferred compensation, as an informal funding vehicle where a corporation owns the policy, pays the premiums, receives the benefits, and then uses them to pay, in whole or in part, a contractual promise to pay retirement benefits to a key person, or survivor benefits to the deceased key person's beneficiaries.
• An alternative to long-term care insurance, where new policies have accelerated benefits for Long Term Care.
• Mortgage acceleration, where an over-funded UL policy is either surrendered or borrowed against to pay off a home mortgage.
• Charitable gift, where a UL policy is donated to a qualified charity, or the policy owner names a charity as the beneficiary.
• Charitable remainder trust replacement, where a policy owner wants to replace assets donated to a Charitable Remainder Trust.
• Estate equalization, where a business owner has more than one child, and at least one child wants to run the business, and at least one other wants cash.
• Life insurance retirement plan, or Roth IRA alternative. High income earners who want an additional tax shelter, with potential creditor/predator protection, who have maxed out their IRA, who are not eligible for a Roth IRA, and who have already maxed out their qualified plans.
• Term life insurance alternative, for example when a policy owner wants to use interest income from a lump sum of cash to pay a term life insurance premium. An alternative is to use the lump sum to pay premiums into a UL policy on a single premium or limited premium basis, creating tax arbitrage when the costs of insurance are paid from untaxed excess interest credits, which may be crediting at a higher rate than other guaranteed, no risk asset classes (e.g. certificates of deposit or U.S. Savings Bonds).
• Whole life insurance alternative, where there is any need for permanent death benefits, but little or no need for cash surrender values, then a current assumption UL or GUL may be an appropriate alternative, with potentially lower net premiums.
• Annuity alternative, when a policy owner has a lump sum of cash that they intend to leave to the next generation, a single premium UL policy provides similar benefits during life, but has a stepped up death benefit that is income tax-free.
• Pension maximization, where permanent death benefits are needed so an employee can elect the highest retirement income option from a defined benefit pension.
• Annuity maximization, where a large non-qualified annuity with a low cost basis is no longer needed for retirement and the policy owner wants to maximize the value for the next generation. There is potential for arbitrage when the annuity is exchanged for a single premium immediate annuity (SPIA), and the proceeds of the SPIA are used to fund a permanent death benefit using Universal Life. This arbitrage is magnified at older ages, and when a medical impairment can produce substantially higher payments from a medically underwritten SPIA.
• RMD maximization, where an IRA owner is facing required minimum distributions (RMD), but has no need for current income, and desires to leave the IRA for heirs. The IRA is used to purchase a qualified SPIA that maximizes the current income from the IRA, and this income is used to purchase a UL policy.
• Creditor/predator protection. A person who earns a high income, or who has a high net worth, and who practices a profession that suffers a high risk from predation by litigation, may benefit from using UL as a warehouse for cash, because in some states the policies enjoy protection from the claims of creditors, including judgments from frivolous lawsuits.
• Cryonics funding, where a life insurance policy funds the costs associated with cryonic suspension.

3. Living benefits of life insurance

Many people use life insurance, and in particular cash value life insurance, as a source of benefits to the owner of the policy (as opposed to the death benefit which provides benefit to the beneficiary). These benefits include loans, withdrawals, collateral assignments, split dollar agreements, pension funding, and tax planning.

3.1 Loans

Most universal life policies come with an option to take a loan on certain values associated with the policy. These loans require interest payments which are paid to the insurance company. The insurer charges interest on the loan because they are no longer able to receive any investment benefit from the money that has been loaned to you.

Repayment of the loan principal is not required, but payment of the loan interest is required. If the loan interest is not paid, it will be deducted from the cash value of the policy. If there is not sufficient value in the policy to cover interest, the policy will lapse.

Loans are not reported to any credit agency and payment or non-payment against them will not affect the policyholder's credit rating. If the policy has not become a "modified endowment", the loans are withdrawn from the policy values as premium first and then any gain. Taking Loans on UL will affect the long term viability of the plan. The cash values removed by loan are no longer earning the interest expected, so the cash values will not grow as expected. This will shorten the life of the policy. Usually those loans will cause a greater than expected premium payment as well as interest payments.

Outstanding loans will be deducted from the death benefit at the death of the insured.

3.2 Withdrawals

 

If done within IRS Regulations, an Equity Indexed Universal Life policy can provide income that is tax-free. This is done through withdrawals that do not exceed the total premium payments made into the policy. Also, tax-free withdrawals can be made through internal policy loans offered by the insurance company, against any additional cash value within the policy. (This income can exceed policy premiums and still be taken 100% tax-free.) If the policy is set up, funded and distributed properly, according to IRS regulations, an Equity Indexed UL policy will provide an investor with many years of tax-free income. This can significantly outperform traditional investments such as; stocks, bonds, mutual funds, CDs or annuities that are placed in taxable and tax-deferred accounts such as; an IRA, 401(k) or 403(b).

Most universal life policies come with an option to withdraw cash values rather than take a loan. The withdrawals are subject to contingent deferred sales charges and may also have additional fees defined by the contract. Withdrawals will permanently lower the death benefit of the contract at the time of the withdrawal.

Withdrawals are taken out premiums first and then gains, so it is possible to take a tax-free withdrawal from the values of the policy (this assumes the policy is not a MEC, i.e. "modified endowment contract"). Withdrawals are considered a material change and cause the policy to be tested for MEC. As a result of a withdrawal, the policy may become a MEC and could lose its tax advantages.

Withdrawing values will affect the long-term viability of the plan. The cash values removed by loan are no longer earning the interest expected, so the cash values will not grow as expected. To some extent this issue is mitigated by the corresponding lower death benefit.

3.3 Collateral assignments

Collateral assignments will often be placed on life insurance to guarantee the loan upon the death of debtor. If a collateral assignment is placed on life insurance the assignee will receive any amount due to them before the beneficiary is paid. If there is more than one assignee, the assignees are paid based on date of the assignment, i.e. the earlier assignment date gets paid before the later assignment date.^{[citation needed]}

4. Types

4.1 Single premium

A Single Premium UL is paid for by a single, substantial, initial payment. Some policies do not allow any more than the one premium contractually, and some policies are casually defined as single premium because only one premium was intended to be paid. The policy remains in force so long as the COI charges have not depleted the account. These policies were very popular prior to 1988, as life insurance is generally a tax deferred plan, and so interest earned in the policy was not taxable as long as it remained in the policy. Further withdrawals from the policy were taken out principal first, rather than gain first and so tax free withdrawals of at least some portion of the value were an option. In 1988 changes were made in the tax code, and single premium policies purchased after were "modified endowment contract" (MEC) and subject to less advantageous tax treatment. Policies purchased before the change in code are not subject to the new tax law unless they have a "material change" in the policy (usually this is a change in death benefit or risk). It is important to note that a MEC is determined by total premiums paid in a 7-year period, and not by single payment. The IRS defines the method of testing whether a life insurance policy is a MEC. At any point in the life of a policy, a premium or a material change to the policy could cause it to lose its tax advantage and become a MEC.

 

In a MEC, the premiums and accumulation will be taxed just like an annuity upon withdrawing. The accumulations will grow tax deferred and will still transfer tax free to the beneficiary under Internal Revenue Service Code 101a under certain circumstances.

4.2 Fixed premium

Fixed Premium UL is paid for by periodic premium payments associated with a no lapse guarantee in the policy. Sometimes the guarantees are part of the base policy and sometimes the guarantee is an additional rider to the policy. Generally these payments will be for a shorter period of time than the policy is in force; for example payments may be made for 10 years, with the intention that thereafter the policy is paid-up. But it can also be permanent fixed payment for the life of policy.

Since the base policy is inherently based on cash value, the fixed premium policy only works if it is tied to a guarantee. If the guarantee is lost, the policy reverts to it flexible premium status. And if the guarantee is lost, the planned premium may no longer be sufficient to keep the coverage active. If the experience of the plan is not as good as predicted, the account value at the end of the premium period may not be adequate to continue the policy as originally written. In this case, the policyholder may have the choice to either:

1. Leave the policy alone, and let it potentially expire early (if COI charges deplete the account), or
2. Make additional or higher premium payments, to keep the death benefit level, or
3. Lower the death benefit.

Many universal life contracts taken out in the high interest periods of the 1970s and 1980s faced this situation and lapsed when the premiums paid were not enough to cover the cost of insurance.

4.3 Flexible premium

 

 Flexible Premium UL allows the policyholder to vary their premiums within certain limits. Inherently UL policies are flexible premium, but each variation in payment has a long term effect that must be considered. In order to remain active, the policy must have sufficient available cash value to pay for the cost of insurance. Higher than expected payments could be required if the policyholder has skipped payments or has been paying less than originally planned. It is recommended that yearly illustrative projections be requested from the insurer so that future payments and outcomes can be planned.

 In addition, Flexible Premium UL may offer a number of different death benefit options, which typically include at least the following:

• a level death benefit (often called Option A or Option 1, Type 1, etc.), or
• a level amount at risk (often called Option B, etc.); this is also referred to as an increasing death benefit.

Policyholders may also buy Flexible Premium UL with a large initial deposit, thereafter making payments irregularly.

5. Criticism

5.1 Unlawfully sold to individuals as an investment

In the US it is illegal under the Investment Advisers Act of 1940 to offer Universal Life Insurance as an "investment" to individuals, but it is frequently offered by agents as a tax-advantaged financial vehicle from which they can borrow as needed later without tax penalties. This also makes it an alternative for individuals who are not able to contribute to a Roth IRA due to IRS income restraints.

5.2 Conflict of interest

Agents who sell Universal Life Insurance often receive commissions equal to the first year of target premiums providing an incentive to sell these policies over other less expensive term life insurance policies.

Proponents respond that it would be inaccurate to state that term insurance is less expensive than universal life, or for that matter, other forms of permanent life insurance, without qualifying the statement with the other factor: Time, or length of coverage.

While term life insurance is the least expensive over a short period of time, say one to twenty years, permanent life insurance is generally the least expensive over a longer period of time, or over one's entire lifetime. This is mainly due to the high percentage of the premiums paid out in commissions during the first 10–12 years.

5.3 Misunderstood risk to policyholders

Interest rate risk: UL is a complex policy with risk to the policyholder. Its flexible premiums include a risk that the policyholder may need to pay a greater than planned premium in order to maintain the policy. This can happen if the expected interest paid on the accumulated values is less than originally assumed at purchase. This happened to many policyholders who purchased their policies in the mid 1980s when interest rates were very high. As the interest rates lowered, the policy did not earn as expected and the policyholder was forced to pay more to maintain the policy. If any form of loan is taken on the policy, this may cause the policyholder to pay a greater than expected premium, because the loaned values are no longer in the policy to earn for the policyholder. If the policyholder skips payments or makes late payments, it is possible that this will need to be made up for in later years by making larger than expected payments. Market factors relating to the 2008 stock market crash adversely affected many policies by increasing premiums, decreasing benefit, or decreasing the term of coverage.

No-lapse guarantees, or death benefit guarantees: A well informed policyholder should understand that the flexibility of the policy is tied irrevocably to risk to the policyholder. The more guarantees a policy has, the more expensive its cost. And with UL, many of the guarantees are tied to an expected premium stream. If the premium is not paid on time, the guarantee may be lost and cannot be reinstated. For example, some policies will offer a "no lapse" guarantee, which states that if a stated premium is paid in a timely manner, the coverage will remain in force, even if there is not sufficient cash value to cover the mortality expenses. It is important to distinguish between this no lapse guarantee and the actual death benefit coverage. The death benefit coverage is paid for by mortality charges (also called cost of insurance). As long as these charges can be deducted from the cash value, the death benefit is active. The "no lapse" guarantee is a safety net that provides for coverage in the event that the cash value isn't large enough to cover the charges. This guarantee will be lost if the policyholder does not make the premium as agreed, although the coverage itself may still be in force. Some policies do not provide for the possibility of reinstating this guarantee. Sometimes the cost associated with the guarantee will still be deducted even if the guarantee itself is lost (those fees are often built into the cost of insurance and the costs will not adjust when the guarantee is lost). Some policies provide an option for reinstating the guarantee within certain time frames and/or with additional premiums (usually catching up the deficit of premiums and an associated interest). No-lapse guarantees can also be lost when loans or withdrawals are taken against the cash values.

6. Miscellaneous

The single largest asset class of all but one of the largest banks in the United States is permanent cash value life insurance, commonly referred to as BOLI, or Bank Owned Life Insurance. During the recent economic crisis, banks accelerated their purchasing of BOLI as it was the single most secure investment they could make.

One banker described BOLI as a "constantly resetting municipal bond that I never have to mark to market."

The majority of BOLI is current assumption Universal Life, usually sold as a single premium contract.

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Term life insurance

Term life insurance or term assurance is life insurance which provides coverage at a fixed rate of payments for a limited period of time, the relevant term. After that period expires, coverage at the previous rate of premiums is no longer guaranteed and the client must either forgo coverage or potentially obtain further coverage with different payments or conditions. If the insured dies during the term, the death benefit will be paid to the beneficiary. Term insurance is the least expensive way to purchase a substantial death benefit on a coverage amount per premium dollar basis over a specific period of time.

Term life insurance is the original form of life insurance and can be contrasted to permanent life insurance such as whole life, universal life, and variable universal life, which guarantee coverage at fixed premiums for the lifetime of the covered individual. Term insurance is not generally used for estate planning needs or charitable giving strategies but is used for pure income replacement needs for an individual. Term insurance functions in a manner similar to most other types of insurance in that it satisfies claims against what is insured if the premiums are up to date and the contract has not expired, and does not provide for a return of premium dollars if no claims are filed. As an example, auto insurance will satisfy claims against the insured in the event of an accident and a home owner policy will satisfy claims against the home if it is damaged or destroyed by, for example, a fire. Whether or not these events will occur is uncertain. If the policy holder discontinues coverage because he has sold the insured car or home, the insurance company will not refund the premium. This is purely risk protection.

1. Usage

Because term life insurance is a pure death benefit, its primary use is to provide coverage of financial responsibilities for the insured or his beneficiaries. Such responsibilities may include, but are not limited to, consumer debt, dependent care, college education for dependents, funeral costs, and mortgages. Term life insurance is generally chosen in favor of permanent life insurance because term insurance is usually much less expensive (depending on the length of the term)^. Many financial advisors or other experts, such as Dave Ramsey, commonly recommend term life insurance as a means to cover potential expenses until such time that there are sufficient funds available from savings to protect those whom the insurance coverage was intended to protect. For example, an individual might choose to obtain a policy whose term expires near his or her retirement age based on the premise that, by the time the individual retires, he or she would have amassed sufficient funds in retirement savings to provide financial security for the dependents.

2. Annual renewable term

The simplest form of term life insurance is for a term of one year. The death benefit would be paid by the insurance company if the insured died during the one year term, while no benefit is paid if the insured dies one day after the last day of the one year term. The premium paid is then based on the expected probability of the insured dying in that one year.

Because the likelihood of dying in the next year is low for anyone that the insurer would accept for the coverage, purchase of only one year of coverage is rare.

One of the main challenges to renewal experienced with some of these policies is requiring proof of insurability. For instance the insured could acquire a terminal illness within the term, but not actually die until after the term expires. Because of the terminal illness, the purchaser would likely be uninsurable after the expiration of the initial term, and would be unable to renew the policy or purchase a new one.

Some policies offer a feature called guaranteed reinsurability that allows the insured to renew without proof of insurability.

A version of term insurance which is commonly purchased is annual renewable term (ART). In this form, the premium is paid for one year of coverage, but the policy is guaranteed to be able to be continued each year for a given period of years. This period varies from 10 to 30 years, or occasionally until age 95. As the insured ages, the premiums increase with each renewal period, eventually becoming financially inviable as the rates for a policy would eventually exceed the cost of a permanent policy. In this form the premium is slightly higher than for a single year's coverage, but the chances of the benefit being paid are much higher.

3. Level term life insurance

Much more common than annual renewable term insurance is guaranteed level premium term life insurance, where the premium is guaranteed to be the same for a given period of years. The most common terms are 10, 15, 20, and 30 years.

In this form, the premium paid each year remains the same for the duration of the contract. This cost is based on the summed cost of each year's annual renewable term rates, with a time value of money adjustment made by the insurer. Thus, the longer the term the premium is level for, the higher the premium, because the older, more expensive to insure years are averaged into the premium.

Most level term programs include a renewal option and allow the insured to renew for a maximum guaranteed rate if the insured period needs to be extended. It is important to note that the renewal may or may not be guaranteed and the insured should review their contract to see if evidence of insurability is required to renew the policy. Typically this clause is invoked only if the health of the insured deteriorates significantly during the term, and poor health would prevent them from being able to provide proof of insurability.

Most term life policies include an option to convert the term life policy to a Universal Life or Whole Life policy. This option can be useful to a person who acquired the term life policy with a preferred rating class and later is diagnosed with a condition that would make it difficult to qualify for a new term policy. The new policy is issued at the rate class of the original term policy. Note that this right to convert may not extend to the end of the Term Life policy. It may extend a fixed number of years or to a specified age, such as convertible to age 70.

4. Payout likelihood and cost difference

Both term insurance and permanent insurance use the same mortality tables for calculating the cost of insurance. A death benefit which is income tax free. However, the premium costs for term insurance are substantially different than those for permanent insurance.

The reason the costs are substantially different is that term programs may expire without paying out, while permanent programs must always pay out eventually. To address this, some permanent programs have built in cash accumulation vehicles to force the insured to "self-insure", making the programs many times more expensive.

Other permanent life insurance policies do not have built in cash values. The policy owner may have the option of paying additional premium in the early years of the policy to create a tax deferred cash value. If the insured dies and the policy has a cash value, the cash value is often paid out tax free in addition to the policy face amount.

Insurance industry studies indicate that the probability of filing a death benefit claim under a term insurance policy is unlikely.^{[citation needed]} One study placed the percentage as low as 1% of policies paying a benefit. The low payout likelihood allows term insurance to be relatively inexpensive. Because of the low likelihood of an insurer having to pay a death benefit, term insurance may offer more coverage per premium dollar - by a factor of up to 10.

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