What to watch for when evaluating Universal Life insurance policies?

Universal life insurance has become widely accepted in the 1990s. Actually, it became the #1 life product for most insurance companies. For the insurers and agents/brokers the main attraction, of course, is the increased amount of assets under management that can be achieved with UL. Because of the real advantages and the strong incentives, UL became perhaps even oversold, that is applied indiscriminately. With a few exceptions, UL makes sense only if the client

  • can commit for the long term (need is for long term)
  • has used all available RRSP-room, and
  • is in one of the higher tax brackets.

It works best for people who can put more than the minimum required amounts into the policy. For people who can pay a big lump sum of money upfront, or high contributions in the first few years, the tax deference provided by UL can really be impressive. With lower income tax rates and lower capital gain inclusion rates recently, the tax-advantaged nature of UL has lost some of its lustre, ... but not much, especially for relatively conservative investors in the highest tax bracket.

Understandably, there is fierce competition among insurers who offer UL (and almost all of them already have one or more kinds of UL policy today). Since the product is somewhat complex, computer-generated illustrations play a very important role in demonstrating the features and advantages of UL products. A key issue in this regard is what kind of costs and assumptions are built into these various illustrations. Not well-trained or careless users might assume that if the same premiums and the same investment returns are plugged into some illustration software, then the output will show the exact ranking of those policies illustrated, according to various criteria. Unfortunately, reality is a bit more complicated. It is not just that it might be incorrect to assume identical long term returns from investments offered in the various UL policies. The costs of maintaining these policies differ (Click here to see the cost comparison of two popular policies under a range of varying circumstances), and these differences affect financial results differently at various times, at various levels of funding, or with various investment returns. Even more important, bonus structures (that are important factors in the investment performance of any of these policies) do differ significantly, making mechanical comparison of UL illustrations unacceptable. In some cases, bonuses are conditional, linked to funding level or (even riskier, since it is uncontrollable by clients) to investment performance year by year. Even actual crediting rates, when allegedly following the same indexes, differ among companies, ... but it is not obvious at all for the first glance.

A general rule is: Don't base your decision only on a good looking printout. When comparing illustrations for various UL policies, the reality of assumptions the illustration is based on should be examined, keeping these points in mind:

  • Some companies automatically deduct 2 % from every premium, in addition to the 2% premium tax they are obliged to deduct by law.
  • Some companies do not immediately invest your deposit when they receive it; they wait until a certain amount is collected, reducing by this the time during which your money works for you.
  • In some cases, the return credited to your investments within a policy will reflect the return of the S&P/TSE Composite Index, the S&P 500, other indices, or selected mutual funds. There are two basic kinds of these options: total return, including dividends, and simple price index, excluding dividends. While, e.g., the TSE 300 achieved an 11.3% annual total return between 1982 and 1996, the price index in the same period was just 7.5%. This size of difference means that $100 would grow to $292 in 10 years in the first case, and to $206 in the second.
  • Some policies contain a currency exchange rate exposure, that can easily wipe out any returns on your investments if the price of the Canadian dollar goes up.
  • Management fees and expenses differ very much from one UL policy to the other.
  • In some cases, insurance charges are guaranteed only for a few years; even if there is a guaranteed charge, illustration printouts may use currently applied insurance charges that can be considerably less than the guaranteed charges.
  • It is not enough to see illustrations with one single return assumption; the sensitivity and volatility of the whole projection are also important. Sometime, e.g., the selection of a certain assumption projects a nice picture that would be quite different with a just slightly lower assumed return, because this second return wouldn't trigger various bonuses. An even 10% annual growth produces quite different result than another one - during the same time period - where the annual average is the same 10%, but where this average results from a series of wildly fluctuating yearly returns.
  • Similarly to the previous point, it is very informative to play a bit with numbers in the case of a UL policy where the insurance company promises to credit to the policy 90% of the positive return of a certain equity fund, while whenever the return is negative they would apply the 110% of that negative return. This +/- 10% may not seem considerable, or too unfair, ... until some actual calculation is made. The effect on the return is huge in fact.
  • Some UL policies are the same 'participating' type as many of the more traditional whole life policies are; they pay 'dividends', that might sound very good. In reality, paying out 'dividends' of this kind are totally at the discretion of the insurance company, therefore such policies should be avoided. Life insurance policy dividend is a possible return of the premium paid in excess of what the company needs to provide the guaranteed benefit in the policy contract. Instead of sharing in the profit of the investment by the insurance company, it is rather the passing of the company's risk to the policyholders. Some companies keep huge amounts of surpluses they are obliged to credit to policyholders in reserve funds, instead of actually paying it out to them. This is a good buffer for them against higher than expected administrative and distribution costs.

To get a meaningful evaluation of the merits and competitiveness of a policy, one has to know many details and to 'play' with a few illustrations: try various levels of returns, possibly with the simulation of real life fluctuations, that is when returns go up and down year by year, and at various funding levels. Unfortunately, not all the available software can illustrate policies with fluctuating returns, but the tendency is clearly towards the ability to show a range of possible outcomes (with perhaps even some probabilities attached to each of them), instead of 'quasi-promising' results.

In addition to the monetary (cost, cash value, and amount of death benefit) considerations, one has to pay special attention to the availability of special features of universal life policies. There is a wide range of them, and while Person A may be interested in Feature 1, Person B may be interested in Feature 2. Without giving further details here, I offer a list of features that should be sought and scrutinized. Of course, no policy is ahead of all the others judged on the criteria of availability / quality of each of these features. Even if we found a particular policy as the most attractive for one situation, that fact alone gives only hints, at most, regarding what might be the best choice for a different situation. Therefore, the list below indicates the variability of UL, and, again, the importance of shopping around:

  • riders (life, disability, critical illness, long-term care)
  • guarantees
  • policy fees
  • surrender charges
  • max. number of lives under one policy
  • replacement of insured
  • divisibility of joint-life policies
  • automatic rebalancing of investment portfolios
  • length of time (if any) before new premiums move from side-account into investment portfolio
  • availability of optimizing insurance face amount according to the tax-sheltering need of actual investment value
  • using 'attained age' vs. 'age at issue' when switching from yearly renewable premium rate to level premium structure
  • availability/attainability of preferred rates for people with above-average health
  • availability and size of cash value (or partial/advance payment of death benefit) when disability or critical illness happen, or at time of first death (with joint-last-to-die policies)
  • availability of level premium rates guaranteed at issue, with policies where the client wants to switch from annual renewable rates after a number of years
  • waiver of premium (minimum or planned?) when disability or critical illness strike
  • policy fee differences and availability of option to pay policy fee upstart

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