Universal life insurance is not the cheap alternative to whole life insurance

By Brandon Roberts

The Insurance Pro Blog


It's important to know that universal life insurance policies that were design and implemented correctly are fine; it's the policies that out of inexperience, misunderstanding or sheer nefariousness were designed and implemented incorrectly that are a cause for concern.

Universal life insurance rolled out to a lot of excitement and confusion. Originally released in the late 70s, this products was incredibly innovative for its day. A premium that could be adjusted (at will) up and down and the ability to surrender cash values without taking a policy loan to get them. Sounds like standard operating procedure these days, but it certainly wasn't the case when it first arrived on scene. The industry and regulators were up in arms about whether or not the product could even be considered life insurance. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) made a final decision on that. The answer was yes. TEFRA was one of those hoorah Republican/Grover Norquist drag-the-government-into-the-bathroom-and-drown-it-in-the-bathtub sort of legislative accomplishments.

Then, like a crackhead on day two of a detox program, the government quickly realized it needed a hit and passed the Deficit Reduction Act of 1984. DEFRA took a mean swipe at the life insurance industry as it sought to eliminate the use of life insurance as a fairly unlimited tax shelter (and entire careers were made in the matter of months as money rushed to life insurance to be grandfathered from DEFRA's new rules). So, with the hide-your-money train pulling out of the station, insurance agents who neglected to buy a ticket had to turn to some other sales idea to write business. And then, mathematical and insurance illiteracy set in ...

When universal life insurance first arrived on scene, interest rates were high. Level premium life insurance is priced in part based on interest rates — the higher the rate, the lower the required premium and vise versa. So, when universal life was paying double digit interest rates, it was easy to show a very low assumed outlay compared to whole life insurance, and the price war began. For whole life, there was absolutely no way to compete.

The increasing COI curve ... oh right ... I forgot. Whole life die-hards love to talk about the increasing cost of insurance (COI) schedule on a universal life insurance contracts. They like to pretend that some magic fairy dust was sprinkled on whole life insurance, making it immune to the notion of a rising cost of insurance over time. It's nice to live in a world of unicorns and candy mountains, but eventually, someone steals your spleen and you have to come back to reality and understand that whole life insurance isn't exempt from this notion; it's just designed to deal with it in a more automated fashion.

The difference is simply that whole life takes the rising COI schedule into account from day one and requires a much higher outlay. It assumes a much lower interest rate than most UL contracts have. Whole life does guarantee the interest rate, so if the insurance company gets it wrong, they promise to make up the difference. At four percent, I'm not aware of a situation where any issuer of whole life insurance has failed to exceed this investment return on reserves.

The big problem arises when inexperienced or unscrupulous agents decide that a low initial insurance cost combined with a higher interest rate means less required outlay (i.e. cheaper insurance!). This is a path to failure. Universal life insurance is merely a play on assuming the variable interest rate will perform better than whole life's guaranteed rate. But this does not mean you should cheap out on the premium. Your best bet is to fund universal life insurance at an equivalent outlay to whole life insurance. In other words, if a $1,000,000 whole life policy costs $10,000 each year, then you should place $10,000 each year into a universal life insurance policy with a death benefit of $1,000,000.

If the interest rate is higher, you could potentially save money later on, but assuming it'll work out in the beginning is a fool's bet. Remember, time has a cost to it. Best to let that benefit you rather than be your enemy when it comes to a financial or insurance plan.

Imploding universal life policies?

We've probably all heard the stories. Universal life insurance is a black eye for the industry because of it's shady past. Statistics don't support this theory, as the Society of Actuaries's latest analysis on lapse rates by product line shows us that universal life only has roughly a 1 percent higher lapse rate than whole life insurance.

Sure, we've all heard stories from those who have met a prospect or client who had a policy that was chronically underfunded and needed help (I have myself). But let's remain realistic about what this means. If you met 100 people a year who had this problem, you wouldn't have even begun to meet a spec of dust that was blown by a calm breeze off the surface of the industry's total sales of this product.

This isn't intended to down play the significance that a poorly designed and executed universal life insurance contract has for an insured or policy owner. And it also doesn't mean that we can all ignore the importance of properly funding universal life insurance. Let's also keep in mind that the SOA data only counts policies that have ended. Policies that could still be on a one-way track to an upset policy owner no doubt still lurk among our midst.

So, it's important to know that universal life insurance policies that were design and implemented correctly are fine; it's the policies that out of inexperience, misunderstanding or sheer nefariousness were designed and implemented incorrectly that are a cause for concern. And for future reference, we'd all do a lot better in remembering that there's no magic fairy dust on either end. Insurance companies weren't taking you for a ride all these years with their whole life premiums; they were building adequate reserves to keep your policies in force. You can do the same thing with universal life insurance, if you choose to do it.