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What is universal life insurance?

by Mark Cluett
21 min read

Universal life insurance is a form of permanent life insurance that offers financial protection through lifelong coverage combined with flexible payment and multiple investment options.

The primary purpose of universal life insurance (also known as UL) is to provide guaranteed lifelong coverage, while giving you options to invest and build wealth for your beneficiaries within the insurance policy.

While whole life insurance also offers cash value and investment components, universal life insurance is unique; it allows you to choose the insurance cost and investment options within your policy based on your investment goals and risk tolerance.

KEY TAKEAWAYS

  • Universal life insurance acts as both life insurance coverage and an investment vehicle
  •  It offers flexibility in how you pay premiums, a broad range of investment options, the ability to access its cash value, and added affordability depending on how you structure your coverage
  • On the other hand it is incredibly complex, gets increasingly costly (depending on your coverage), uncertain investment returns, require constant monitoring, and has many associated fees when accessing its cash value
  • Contact an experienced broker to help you navigate the intricacies of universal life insurance, as there are many moving pieces you need to be aware of before you decide its the right coverage for you

How does universal life insurance work?

Universal life insurance is an “unbundled” permanent insurance plan: your premium payments are transparently segregated between the pure cost of lifelong insurance coverage and an investment component. 

Similar to other life insurance products, a policyholder makes periodic premium payments for universal life coverage. The insurance company deducts a portion from the premium to meet the cost of insurance and administrative charges. The balance is deposited into an investment account and earns tax-deferred interest. The amount left in the investment account, also known as account value, earns interest, based on the investment option selected. 

A policyholder can choose to only make the minimum deposit amount to cover the cost of insurance and have the policy continue to remain in force. However, this would mean not taking advantage of universal life’s unique feature: the investment account value that grows on a tax-deferred basis. You are not required to pay any tax on the investment account returns, provided the account value does not exceed a certain amount (a legal requirement we’ll explain further).

How is the cost of insurance calculated in universal life insurance?

Universal life insurance offers flexibility to choose how the cost of your life insurance should be calculated:

  • Yearly Renewable Term (YRT): Insurance premiums are calculated using the cost of one-year life insurance based on the insured person’s attained age. The rates increase from year to year until age 100, or another age you can specify (75, 85 etc). In initial-years YRT-based pricing looks attractive due to lower pricing and annual renewability. However the cost can become prohibitive with time.
  • Level Cost of Insurance (LCOI): Insurance premiums are fixed and guaranteed for the life of the policy and are charged to the age of 100. Level premiums are higher than in YRT during the initial years, but as the insured person grows older, the premiums will stay level.
  • Level Switch COI: Allows for premiums to be switched from YRT to level guaranteed rates which are charged up to the age of 100
  • Limited Pay: Limited pay is a form of LCOI, but the policy becomes fully paid up at the end of the limited pay period. This is the most expensive option in the early years as you are paying for the entire length of the policy in a limited number of years.

With YRT, since the premiums are lower, the account value grows faster for the first few years, as compared to LCOI. However, as your age increases, the cost of YRT insurance increases exponentially, and so the account value grows relatively less in later years.You will need to pick an option that suits your needs. And, some providers allow you to switch from YRT to LCOI or vice versa.

What are the investment options available within a universal life policy?

Most universal life products offer a wide range of investment options. One needs to choose the option that meets their investment objectives as well as their risk tolerance. You may have the option to hold more than one investment account within your universal life insurance policy. In this case, you will also need to specify in what proportion premiums are to be allocated to your different accounts.

Here are some of the commonly available investment account options across insurers:

  • Daily Interest Account (DIA): This investment option is similar to a standard savings account. Interest is calculated and credited every day. The interest rate is set by the insurer and may fluctuate.
  • Guaranteed Interest Accounts (GIA): These typically have a time-frame or term of 1, 5 or 10 years and will have guaranteed interest rates for that period.
  • Variable Interest Options (VIO): These market-linked options may potentially provide much greater returns, but also carry higher risk. Unlike a Guaranteed Interest Account, these have no maturity date and the investment account can continue to accumulate for the life of the policy. Interest offered depends on the performance of indices, mutual funds, or other managed portfolios.

How does a universal life insurance death benefit work?

The universal life insurance death benefit also works differently than term or whole life insurance. Beneficiaries receive a tax-free, lump sum death benefit (that part is the same) but there are three options for implementing it:

  • Level: The death benefit is fixed at the time of purchase and remains the same throughout the life of the policy as long as the premiums are in good standing. This holds true even if the account value is low or in the negative when the policy holder passes away. Your beneficiaries will receive the fixed death benefit or the account value – whichever of the two is higher.
  • Face plus Account Value: The death benefit includes the initial insurance coverage in addition to the investment account value.
  • Account Value: The beneficiary receives only the value of the investment account when the insured passes away.

There are other less-common options such as death benefit with return of premium, death benefit with inflation indexing, and more. If there are any leftover funds in the service account, they too will be paid out to the beneficiary.

In policies with joint-first-to-die, joint-last-to-die, or multi-life options, the death benefit and account value may be paid out in parts in a prolonged process. For example, at the time of each insured’s death a percentage of the death benefit may be paid out. The remaining death benefit amount as well as the account value would then be paid out once the last insured person passes and the policy terminates.

Finally, you may also be able to increase the death benefit by purchasing additional insurance within the universal life insurance policy over the period it is active.

How do I pay my universal life insurance premiums?

Policyholders may choose to pay their premiums monthly, annually, or over any timeline they wish as excess funds will go towards the investment component of the policy. In universal life insurance, a modal factor is generally not used. You pay no extra funds if you choose to pay your premiums monthly, instead of annually. This is in contrast to premium payment options for term and whole life insurance. That said, most people with universal life insurance policies do choose to pay their premiums on a monthly basis.

However, note that if no premium is paid, an equivalent amount is taken from the investment account to cover the cost of life insurance and the policy will remain in force. If the investment account’s value can no longer cover the premiums, the policy will lapse.

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How do you access the cash value of a universal life insurance policy?

Similar to whole life policies, universal life allows policy holders to access the cash value savings account that earns tax-exempt interest. There are 4 ways to do so:

  • Cash Withdrawals: You may withdraw the cash value partially or fully. The cash value of your policy is different from the investment account of the policy; it is adjusted for redemption or withdrawal fees. Cash withdrawals reduce the death benefit payable and may also be subject to taxation.
  • Policy Loan: You may access the cash value by seeking a policy loan from the insurance company, by using the investment account’s cash value as collateral. Policy loans may be subject to taxation.
  • Collateralising the Cash Value: You may obtain a line of credit from another financial institution by using the policy as collateral. In this case, there is no taxation of the policy as you are not withdrawing from it. However, if you pass away while the loan is still outstanding, the lender is paid from the policy proceeds first and the balance is then distributed to your beneficiaries.
  • Surrendering Your Policy: If you no longer need your policy’s coverage, you may choose to surrender it. The cash surrender value will be paid out to you. Surrender charges may apply.

Universal life insurance provides flexibility … but only if it’s managed with great scrutiny.

What affects the cash value of a universal life policy?

Since a universal life policy offers flexibility in making premiums payments, therefore there are no guarantees to the amount of cash value accessible in the future. The cash value may fluctuate over time due to:

  • The timing and amount of insurance premiums
  • The rate of return earned on the selected investment option
  • The type of cost of insurance option and the death benefit selected
  • Any cash withdrawals or policy loans made from the policy
  • Any changes made to the coverage

What are the advantages of universal life insurance coverage?

Universal life plans can be tailored to meet personal financial objectives

  • Flexible payment options: Universal life policies do not have a fixed premium amount. You may instead select the timing and amount of premiums payments. You may pay just enough to cover the insurance cost and conserve your additional cash. Alternatively, you may choose to pay the maximum possible amount, that does not trigger the anti dump-in rule (see below).
  • Broad range of investment options: Universal life products offer a range of investment options that you can choose from depending on your investment style and risk tolerance. You can be as involved as you may want in managing the investment portion of your policy. 
  • Affordability: Universal life is usually more affordable than whole life insurance. Since the responsibility of managing the account value is vested with the person seeking insurance, the cost of the premiums are therefore lowered as compared to whole life insurance, where the insurance company manages and guarantees the investment returns.

Universal life insurance is an incredibly complex product. Speak with an advisor before you jump in and find out how it works from both an insurance and investment perspective.

What are the disadvantages of universal life insurance coverage?

  • Complexity: Universal life is a complex insurance product where the responsibility of managing the account value and the returns is vested with the insured individual, rather than the insurance company. The significant amount of flexibility the product offers also creates a high degree of uncertainty about the fulfilment of insurance objectives, as neither the death benefit nor the cash values are guaranteed in this product. It’s important to speak with an experienced advisor in making the right decision regarding the available options, when selecting your universal life policy. 
  • Increasing costs: If you have chosen the annual renewable term, the insurance costs will increase with age. The cash value build up in the initial years will be utilised to pay the higher premium in the later years. If you’re only intending to keep the coverage for a few years then buying a term life policy will save you much more money.
  • Uncertain returns: While universal life insurance policies are meant to offer you access to cash value, there is no guarantee of future returns. The cash value available to you depends on the annual cost of your coverage and returns of the invested savings in account. The internal charges of the policy may increase every year. In addition, the interest rate or investment return that you earn may reduce or turn negative with time, due to market volatility or decline in interest rates and significantly erode the account value. 

  • Constant monitoring:  Universal life policies also require ongoing monitoring to ensure that you have adequate cash value in the policy to pay for the premiums. Not only are the returns from this policy indeterminate, the mortality costs may also increase with age. These costs can eat away at cash value, require higher premiums, or cause a policy to lapse. For instance, if the interest rate return on the account value reduces or if the cost of insurance increases with age, you could find yourself adding additional monthly premium payments or your policy may lapse if you can’t pay the larger premiums.

  • Higher Management Expense Ratios: The investment options included in such policies carry higher expense ratios

  • Fees: Universal life policies have various fees embedded in their structure. You may be charged a fee if you decide to terminate your policy, request for frequent changes to your investment options, or request a cash withdrawal or loan from the policy.
What is universal life insurance?

What is the anti dump-in rule?

The anti dump-in rule (also known as the 250% rule) is a Canadian tax law that limits the size of policy payments to prevent the policy from becoming an investment improperly growing on a tax-sheltered basis. It allows a universal life insurance policy’s investment account value to accumulate on a tax-deferred basis (if accessed by the insured during their lifetime) or a tax-free basis (if accessed by the beneficiaries after the insured’s death). 

However, you cannot continue to make deposits of any size and let them grow on a tax-advantaged basis. The limit is the aforementioned 250% rule: the account value in any particular year must not exceed 250% of its value from 3 years prior. If it does exceed that value, the policy loses its tax-exempt status. 

This check-up on the account value starts on the 10th anniversary of the policy and continues for the rest of the policy’s life.

So why should you be concerned about the tax-exempt status of your account value? For one, it grants you the opportunity to leave a larger amount of money to your beneficiaries. Alternatively, it allows you to access and use the proceeds from your account value and defer the taxes until your death.

What is a service account?

Life insurance companies proactively seek to prevent excessive deposits by transferring excess funds (if a policy holder makes a deposit over the tax-exempt limit) to another account called the service account. This account grows separately and is fully taxable. If the financial room becomes available again within the investment account, the policyholder is able to move funds from the service account back to the original investment account.

Universal life insurance versus term life insurance

Term life insurance

Term life insurance is the simplest form of life insurance: policyholders pay a flat, level premium for a fixed amount of coverage. 

  • Term life insurance coverage is for a predetermined number of years (thus why it’s called “term”). 
  • The term and death benefit are determined when the insured purchases their policy. 
  • If you pass away while the policy is in effect, your beneficiaries will receive the death benefit as a tax-free, lump sum of money. 
  • Term life insurance is the least expensive and – typically – easiest to understand of all forms of life insurance.

Learn more about term life insurance here.

Similarities between term life insurance and universal life insurance

  • Both whole life insurance and term life insurance offer financial protection for family, loved ones, or businesses partners left behind if you unfortunately pass away
  • Both have a predetermined death benefit which pays out to chosen beneficiary upon the policyholder’s death

Difference between term life insurance and universal life insurance

Term Life InsuranceUniversal Life Insurance
Lasts for a specific period of timeIs a form of permanent insurance
No cash value or maturity benefitHas a cash value component
Modal factor is applied to non-annual premium paymentNo modal factor
Cost-effective form of insuranceMore expensive than pure term life insurance

Universal life insurance versus whole life insurance

Whole Life Insurance

Whole life insurance provides coverage from the day a policyholder is approved for their policy until they pass away. 

  • Whole life insurance has a level premium throughout the insured’s life and consists of both the death benefit and a cash value component. 
  • Policies can be participating (where the policy holder is eligible to receive dividend payments and can even choose to pay their premiums with them) and non-participating.

Learn more about whole life insurance here.

Similarities between whole life insurance and universal life insurance

  • Both whole life insurance and universal life insurance are types of permanent life insurance: They provide lifelong coverage
  • Both consist of two components: an insurance component and a savings/investment component
  • The customer may take a policy loan, use the policy as collateral, or choose to surrender the policy and receive the cash value, if they so choose

Differences between whole life insurance and universal life insurance

Whole Life InsuranceUniversal Life Insurance
Fixed and guaranteed premiums for the life of the policyNo contractual premium payments
Premiums are based on a predetermined scheduleMay choose the amount and frequency of payments, depending on account value
Additional payments over and above the contractual premium may require underwriting approvalFlexibility to make additional deposits (as long as anti-dumping rules are followed)
Premium is non-transparent and is guaranteed as a wholeMortality costs, administrative charges, and policy fees are transparent and separately guaranteed
Investment choices are made by the insurerInvestments are chosen by the client, from a  range of options provided by the insurer
Not flexible: Policyholder must choose the guaranteed death benefit and premium payment term when applying for the policyExtremely flexible: Policyholder may choose to increase or decrease their death benefit, premium payments
There is a modal factor: Monthly, quarterly, or semi-annual premium payment options are costlier than the annual optionThere is no modal factor: Pay at the frequency you choose
Offers guaranteed minimum cash value and death benefitPolicyholder chooses investment options; no guarantee of returns for market linked investments
Death benefit is guaranteed, as long as premium payments are madeDeath benefit is not guaranteed, may reduce if mortality costs increase or if the account value reduces
Option to collect dividends: Participating versus non-participatingThere is no dividend concept
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Universal life insurance versus term-to-100 life insurance

Term-to-100 life insurance

Though it has the word “term” in its name, Term-to-100 life insurance (T-100) is actually a form of permanent life insurance. 

  • The premiums are level until the age of 100. 
  • Once the insured crosses the 100 year threshold, the policy converts to paid-up life insurance. 
  • Further premium payments are not required and the policy remains in force. 
  • The death benefit is fixed throughout the term and determined when one applies for the policy.

Learn more about Term-to-100 life insurance.

Similarities between term-to-100 life insurance and universal life insurance

  • Both T-100 and universal life insurance are types of permanent life insurance: They provide lifelong coverage
  • They are both generally used for estate planning, though T-100 may be used on a more modest scale, predominantly for funeral expenses

Differences between term-to-100 life insurance and universal life insurance

Term-to-100 life insuranceUniversal Life Insurance
The premium is fixedNo fixed premium
No cash valueHas a cash value component
Fixed death benefitDeath benefit varies
It is the least expensive form of permanent life insuranceTypically more expensive than other forms of permanent life insurance

Should I get universal life insurance?

  • If you have maxed out your tax-advantaged investment options such as Tax Free Savings Accounts (TFSAs) and Registered Retirement Savings Plans (RRSPs), universal life insurance is another tax-advantaged option for savings.
  • Universal life insurance is a good estate planning tool; it can be used to leave a growing tax-free sum of money to your beneficiaries. 
  • If you have the discipline to contribute regularly even without the “forced savings” that whole life insurance includes in the form of fixed and regular premiums, and you are also confident in your ability to choose better-performing funds for the investment account, you should consider universal life.

Please keep this last point in mind. Universal life insurance is often mis-sold to those who don’t truly need it, with the promise that the coverage can pay for itself. These calculations are based on an estimated rate of return from the investment value of the policy which may not be realistically sustainable. Speak with an advisor you trust before applying for a universal life insurance policy, as there may be better alternatives for your coverage needs.

How to pick a universal life insurance policy?

If you do decide to apply for a universal life insurance policy, you should consider a few things:

  • Does the product offer a range of coverage options? For example, can you choose a joint-first-to-die or multi-life policy?
  • What are the options for the investment account? The product needs to have investment alternatives that meet your risk tolerance level. For example, conservative investors would prefer fixed interest deposits, whereas those with higher risk tolerance may choose market-linked funds.
  • What are the management charges for the investment options, the policy administration charges and the mortality charges? With universal life insurance all the components are separately illustrated – you can compare the components to ensure you get a cost-effective product. 
  • What riders and benefits does the product offer? Does it have term riders allowing you to buy additional term coverage, child protection riders, riders to cover accidental death and disability etc? Research or speak to an advisor to determine what riders and options are important to you before choosing a policy.

PolicyAdvisor’s licensed experts can help you compare a wide range of universal life insurance products and make an informed choice for both your coverage and financial goals. Book some time with us to see what your options are and if universal life insurance coverage is the right product for you.

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