Policies as Savings Instruments

Universal Life is a type of permanent life insurance based on a cash value. That is, the policy is established with the insurer where premium payments above the cost of insurance are credited to the cash value.
The cash value is credited each month with interest, and the policy is debited each month by a cost of insurance (COI) charge, and any other policy charges and fees which are drawn from the cash value if no premium payment are made that month. The interest credited to the account is determined by the insurer; sometimes it is linked to a financial index such as a bond or other interest rate index.

Policies as Investment Instruments

A similar type of policy that was developed from universal life policies is the Variable Universal Life insurance policy, or VUL.
VUL’s allow 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 reward.
Additionally, there are Equity Indexed Universal Life contracts analogous to Equity Indexed Annuities that invest in Index Options on the movement of an Index such as the S&P 500, Russell 2000, and the Dow (to name a few).
These type of contracts only participate in the movement of Index and not the actual purchase of stocks, bonds or mutual funds. They may have a cap (but not always) as to the maximum amount they will credit interest to and a minimum guarantee which keeps the principal of the contract from losing money in a down market. Typically each year the starting point is last year’s ending point, meaning the policy amount is locked in at the end of the year; and the beginning value from which the movement measured is reset.

Types of Universal Life

Universal Life is similar in some ways to, and was developed from Whole 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 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.

Guaranteed Universal Life

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 GUL, or Guaranteed Universal Life.

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 from Whole Life insurance: 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.

Single Premium Universal Life

A Single Premium UL is paid for by a single, substantial, initial payment. Some policies do not allow anymore 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 (basis), rather than gains first and so tax free withdrawals of at least some portion of the value was an option.

However in 1988 changes were made in the tax code, and single premium policies purchased after was considered a “Modified Endowment Contracts” (MEC) and subject to less advantageous tax treatment.

Policies purchased previous to 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.

What defines a MEC?

Mandated by the IRS. The test used to determine if a policy is a MEC is called the 7-pay test. The 7-pay test has nothing to do with the actual number of premium payments. Instead, it is a limitation on the total amount you can pay into your policy in the first seven years of its existence. The test is designed to discourage premium schedules that would result in a paid-up policy before the end of a seven-year period.
Hence, transforming your policy into a modified endowment with all of the corresponding tax advantages. (Also see “Maximum Premiums” in Universal Life)

Fixed Premium Universal Life

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 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 it to a 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 (rate of return or interest) 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:
Leave the policy alone, and let it potentially expire early (if COI charges deplete the account), or make additional or higher premium payments, to keep the death benefit level, or 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. In fact the number of lapses was immense and primarily based on the fact that insureds where quoted performance levels that were never met and hence their premiums rose steadily until all cash value was depleted in the policy and

Type / 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:

1. A level death benefit (often called Option A or Option 1, Type 1, etc)

2. A level amount at risk (often called Option B, etc). This is also referred to as an increasing death benefit.

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

Interest Rates Risk in Universal Life

A UL policy 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 1980’s 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.


Possible Alternative for 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 (i.e., 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.

A possible Alternative to Long Term Care Insurance, where new policies have accelerated benefits for Long Term Care Insurance.

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 Alternative, for example when a policy owner wants to use interest income from a lump sum of cash to pay a term life 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 (i.e., Certificates of Deposit, US Savings Bonds).

Whole Life 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 Universal Life Insurance as a warehouse for cash, because in some states the policies enjoy protection from the claims of creditors, including judgments from frivolous lawsuits.

Loan on Cash Values

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 values 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 policyholders credit rating. If the policy has not become a Modified Endowment (MEC), the loans are withdrawn from the policy values as premium first and then any gain.

Taking Loans on UL’s will affect the long term viability of the plan. The cash values removed by a loan that is 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. An illustration showing the effect of a loan is recommended in order to assess the outcome of this change.


Most Universal Life policies come with an option to withdrawal 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 (basis) 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). Withdrawals are considered a material change and cause the policy to be tested for MEC status. As a result of a withdrawal, the policy may become a MEC and could lose its tax advantages.

Withdrawing values will effect the long term viability of the plan. The cash values removed by a loan will no longer be 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. An illustration showing the effect of a withdrawal is recommended in order to assess the outcome of this change.

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. ie – The earlier assignment date gets paid before the later assignment date.

Additional Risk in Universal Life

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.