HomeUniversal Life (continued)
Option A pays the face amount at death as it's designed to have the cash value equal the death benefit at maturity (usually at age 95 or 100). With each premium payment, the policy owner is reducing the cost of insurance until the cash value reaches the face amount upon maturity.
Option B pays the face amount plus the cash value, as it's designed to increase the net death benefit as cash values accumulate. Option B offers the benefit of an increasing death benefit every year that the policy stays in force. The drawback to option B is that because the cash value is accumulated "on top of" the death benefit, the cost of insurance never decreases as premium payments are made. Thus, as the insured gets older, the policy owner is faced with an ever increasing cost of insurance (it costs more money to provide the same initial face amount of insurance as the insured gets older).
Both death benefit options - A (level) and B (increasing) - are subject to the same IRS rules and guidelines concerning premium payments and tax-favored treatment of cash values. In order for the policy to keep its tax favored life insurance status, it must stay within a corridor specified by state and federal laws that prevent abuses such as attaching a million dollars in cash value to a two dollar insurance policy. The interesting part about this corridor is that for those people who can make it to age 95-100, this corridor requirement goes away and your cash value can equal exactly the face amount of insurance. If this corridor is ever violated, then the universal life policy will be treated as, and in effect turn into, a Modified Endowment Contract (or more commonly referred to as a MEC).
But universal life has its own disadvantages which stem primarily from this flexibility. The policy lacks the fundamental guarantee that the policy will be in force unless sufficient premiums have been paid and cash values are not guaranteed.
Early universal life policies are sometimes erroneously referred to as self-sustaining policies. In the 1980s, when interest rates were high, the cash value accumulated at a more accelerated rate, and universal life coverage was often sold by agents as a policy that could be self-paying. Many policies did sustain themselves for a prolonged period, but the combination of lower interest rates and an increasing cost of insurance as the insured ages meant that for many policies, the cash option was diminished or depleted.
Interest-Sensitive Universal Life Insurance An interest sensitive UL policy was the first attempt at creating a flexible premium life insurance policy and was created in the 1980s. Interest-sensitive UL policies guarantee, to some extent, the death proceeds, but not the cash function - thus the flexible premiums and interest returns. If interest rates are high, then the investment returns help reduce the required premiums needed to keep the policy in force. If interest rates are low, then the customer would have to pay additional premiums in order to keep the policy in force. When interest rates are above the minimum required or minimum guaranteed interest rate, then the customer has the flexibility to pay less as investment returns cover the remainder to keep the policy in force.
Equity-Indexed Universal Life Insurance
Equity-Indexed Universal Life Insurance or "EIUL" for short, is a fixed universal life insurance policy that was created in the mid 1990s to address concerns about market volatility and provide an alternative to the low interest rates being offered by interest-sensitive UL policies.
EIULs differ from interest-sensitive UL policies in that they credit interest to the policy's cash values based on the upward movement of a particular stock market index - usually the S&P500. The insurance company can then credit the gains in the stock market according to one of several different crediting methods. The most popular is the "point-to-point" method. When the policy is issued, the insurance company "pegs" the stock market's value. At the anniversary of the policy, the insurance company checks the value of the underlying stock index and credits the cash value with the difference up to a cap (specified by the company).
For example, if a policy owner purchased an EIUL on January, and the insurance company used the S&P500 as the underlying index when crediting interest to policy cash values, and the company set a 12 % cap, the process would work like this:
If the S&P500 was 1,100 in January, the insurance company would record the value of the index. On the anniversary of the policy (the next January), the insurance company would record the new value of the S&P500. If the new value of the index was 1,188, that would represent a gain of 8%. The insurance company would credit the policy cash values with 8% for that year.
If the S&P500 lost value (i.e. the value went from 1,100 to 980), the insurance company would simply record a "0", and the policy would show a year of no growth. The policy owner would not; however, lose any money (principal or interest from a previous year) as a result of a negative return on the S&P500.
If the S&P500 was 1,100 in January, the insurance company would record the value of the index. On the anniversary of the policy (the next January), the insurance company would record the new value of the S&P500. If the new value of the index was 1,320, that would represent a gain of 20%. The cap set by the insurance company is 12%, so the insurance company would credit the policy cash values with 12% for that year.
Since the insurance company is assuming the risk for any losses, it represents a trade off for the policy owner: The policy owner gets most of the upside potential of the stock market without any of the downside risks associated with an investment in the stock market.
To accomplish this feat, the insurance company uses a precise mix of bonds and index call options. Most of the premium received for this type of policy is used to buy bonds. A small portion of the premium is used to buy stock options (call options) on an underlying stock index. When the value of the stock index rises, the underlying stock option increases by a multiple of 5, 7, or 10. This produces the gains necessary to credit the policy with the "upside potential" of the stock market without actually having the policy owner invest directly in the stock market.
Variable Universal Life Insurance (VUL) is another type of universal life insurance. There are typically no guarantees associated with this type of life insurance policy. The cash account within a VUL is held in the insurer's "separate account" (generally in mutual funds, managed by a fund manager). The policy owner then chooses the investments he or she wishes to invest in. If those investments do well, the insurance company credits the policy's cash values accordingly. If the underlying investments do poorly, the policy owner can lose their cash value. If the investments do poorly enough, it could cause the policy to lapse due to insufficient funds to cover the costs of insurance.