Friday, May 13, 2011

UNIVERSAL LIFE INSURANCE

Universal life insurance provides flexibility to policyholders. It’s similar to whole life, in that you have a cash value that grows, and it encompasses a term life policy, where you decide the terms and renew the policy annually. However, universal  life isn’t simple like term insurance — or even like  whole life. In fact, balancing the options can be quite complicated. So in this chapter, I discuss the basics of universal life insurance, the elements that you get to compare for your particularneeds, and your options in designing the right policy for you.

How Universal Life Works 

Universal life insurance is a form of whole life insurance — but with much greater flexibility. Like whole life, you have two  components: a term insurance policy and an investment
account from which the term insurance premiums are paid. But with universal life,you get to choose your options, and the choices are generally laid out in front of you. You know how the premiums may change the death benefit and cash value, and it’s much clearer how much of the premiums go toward your insurance protection, how much toward your cash value, and how much  toward administrative expense (including commissions).

Start with a planned death benefit that you work out with your agent. You determine your planned premium, based on how much you can afford and the cost of the insurance. The company subtracts an expense charge based on its fees, usually a fixed percentage of the premiums. You’re left with a cash value that generates interest.
But understanding universal life insurance doesn’t end there. From the cash value, the company subtracts the current cost of insurance (the mortality charge), including the charges for any options (or riders), and monthly administrative expenses. Then the company adds in interest that your investment money earns. Your ending cash value is the accumulated value that belongs to you when you cash out (or to your beneficiary when you die).

Often, companies charge you a surrender charge to cash out, leaving you with the surrender value. The surrender charge is usually a small percentage of the total cash value.
Other aspects of universal life to consider include:
  • All the earnings in your investment account are taxdeferred.
  • If you stop paying premiums, the company continues to pay the premium for you by deducting from your policy’s cash value. The company does so until no cash value is left. This is one way to continue coverage without paying premiums.
  • The interest rate is a fixed rate, although it may be a tiered interest rate, in which part is paid at one rate while the balance is paid at a higher rate. For example, your interest rate may be 4 percent for the first $500 and 7 percent for the balance.
  • You can withdraw money that has accumulated in your cash value. If you do, your death benefit decreases because it depends partially upon the accumulated cash value.
  • You can borrow against the cash value of your policy at a fixed rate, generally below market rates.
  • If you increase your coverage, you may have to requalify by taking a medical exam.
  • You probably have to pay a termination fee or surrender charge (backloading). This fee decreases each year you have the policy, but it does lower the amount of your cash value.

Generating Interest 

Insurance companies frequently have two or more interest rates that kick in at different levels. For example, the guaranteed interest rate may be 4 percent on the first $500 and 7 percent on balances over $500. With a balance of almost $8,000, the total interest is just under 7 percent.
When you’re choosing a policy or company from which to buy your universal life policy, pick the one with the highest guaranteed interest so that your cash value grows most quickly.
The interest earned continues to increase and eventually will equal and then exceed the amount you contribute. At this point, the money you pay is, in effect, going directly into your own account.
The interest rate is calculated daily, so you get compounded interest (interest on your interest). For a policy with an interest rate of 7 percent, the annual percentage rate (APR) is actually more than 8 percent. 

Borrowing Against Your Cash Value 

Universal life policies allow you to borrow against your cash value, usually at interest rates below what you can get elsewhere, even for loans secured against other assets. However, borrowing against your policy generally lowers the interest you receive on your cash value, making it equal to or less than the interest at which you borrow.

For example, say that you earn 4 percent on the first $500 of cash value and 7 percent on any amount in excess of that $500. You now have an accumulated cash value, or surrender value, of $7,874. You can borrow $3,000 against this policy at a 6 percent interest rate — well below what you can get at a bank (even for another type of secured loan) — so this deal is quite good if you need the cash. But the interest you earn on the cash value of the insurance policy is no longer the 7 percent of the amount over $500. In fact, the interest you earn takes into account the $3,000 you borrowed, and the total interest you earn on your account is :
  • 4 percent on the first $500
  • 6 percent on the next $3,000 (the amount borrowed)
  • 7 percent on the balance

Death Benefits Options


With universal life insurance, you can choose how much death benefit is to be paid. You have two options, and although the options appear similar, some subtle differences between them can change the amount dramatically. With both options, your premium remains the same throughout the term of the policy, but the death benefit and surrender value differ.

Option 1: Fixed death benefit

When you choose a fixed death benefit, whatever amount you sign up for (in the example, $50,000) goes to your survivors. Inactuality, the face value of the policy — the initial $50,000 — decreases by the

amount you’ve accumulated in your cash value
account. The death benefit remains the same because the decreased face value and the increased cash value add up to the total amount you chose.

Option 2: Increasing death benefit


With the second option, your death benefit increases in line with the increase in your cash value. Your survivors get the surrender value, which certainly appears to be a great deal more for the consumer than what Option 1 provides. So what’s the catch? Why would anyone choose Option 1? With Option 2, your cash value increases more slowly than with Option 1. So you must continue paying the annual premiums, often when you no longer need the same kind of protection you did 25 years earlier. Table 6-2 illustrates the two types of death benefit options you can choose with universal life insurance.

Which option is for me?


If you look at Table 6-2, you can see that the two death benefit options differ significantly. If you die in 25 years, your survivors receive $18,000 more under Option 2. On the other hand, if you don’t die during that time and instead take your surrender value, you’re better with Option 1. In effect, by choosing Option 1, you’re gambling on a long life so that you can withdraw a larger cash value.To determine which option is best for you, you must consider a number of factors: 
  • Your current age and health
  • How much protection your dependents will need as you age
  • Whether you can increase your net worth at a greater rate by investing in other options
  • How much of a gamble you’re willing to take

Premiums 

The amounts of your death benefit, accumulated cash value, and premium are all interrelated with universal life. The more you pay per month in premiums, either the more protection you’re buying or the more cash value you’re building. You can’t have both. The higher the protection you buy, either the higher your premiums or the lower your cash value. And the more cash value you want to build, either the higher the premium or the less protection you’re buying. Because your primary goal in buying insurance is protection, your primary consideration should be the amount of the death benefit. Cash value and your premium cost should be secondary factors, but clearly, your premium should be in line with how much you can afford to pay. 

Choosing your premium 

If you want a universal life policy and believe that you can afford the premium, you need to balance the following three considerations to determine your cash value:
  • Determine how much you can afford from your monthly budget.
  • Decide how much protection you want to purchase.
  • Balance the amount of protection you want to purchase with the amount of premium you can afford.
You invest in a life insurance policy to be covered in case you die, not because life insurance is a good investment. You can generally make more money by putting your money into other investments. 

Prepaying your premium 

With universal life insurance, you can buy in up-front by putting a significant sum into your account, which allows your cash value to increase more because your account is starting at a higher level. Prepaying also allows you to lower your premiums because the accumulated cash value is earning more, which means that more of your earnings can contribute to the cost of the insurance. On the other hand, prepaying also means that you must take a lump sum of cash from somewhere.
Is prepaying for you? Not likely, unless you really want insurance but can’t afford monthly payments. People have generally used prepaid insurance as an investment to build cash value without incurring any tax consequences. But with IRAs, Roth IRAs, and 401(k)s, chances are you won’t be interested in this option.

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