Universal Life Insurance Uses and Dangers

Universal life insurance can be a useful financial tool in some circumstances.  It can also lead to increased risk for Canadians, both financially and with respect to their life insurance.  Done properly universal life insurance can be a great way to accomplish certain financial planning objectives.  Done poorly, and you can find yourself losing substantial amounts of money or even being left without life insurance.

Universal Life Insurance Fundamentals

Universal life is a life insurance policy intended to be permanent – you would normally expect to keep a universal life insurance policy for life.  One of the key differences with universal life insurance compared with other insurance policies is that you have flexibility in terms of your premiums.  The other key difference is that there’s an investment component to which you can (or, not) add premiums to.

Universal life insurance has two sides to the policy.  One side is the insurance side which has an associated contractual cost.  This cost must be paid to keep the policy in force.  The second side is the investment portion, typically consisting of instruments that look a lot like what you’d expect to see with a mutual fund (they’re not mutual funds, but for simplicity you can consider them such).  You can place premiums into the investment portion, or not.  As long as the insurance costs are paid the policy will continue whether or not there’s any funds in the investments.  Another way to look at these policies is to consider them as a life insurance policy with an attached mutual fund.  Again this is technically incorrect but helps you visualize how the policies wor

Two Types of Universal Life Insurance

Universal life insurance can be split into two categories based on the cost of the life insurance section.  Costs for the insurance side of the policy are generally of two types:  ART, or T100.  ART or “annual renewable term” has insurance costs that start off very low but increase annually until the costs become effectively unaffordable. T100 costs have a higher initial cost but are locked in level for life – they never go up.  So while ART costs initially are much lower than T100 costs, eventually the ART costs will skyrocket past a fixed T100 cost.  

Dangers of Universal Life Insurance

Lose your investments and your insurance:

Consumers should never purchase a universal life insurance policy that has ART insurance costs.  With these policies the insurance costs will eventually increase to being unaffordable, causing you to cancel the policy and being left without life insurance.  The industry gets around this by suggesting you place additional funds into the investments.  The investments grow over time, eventually becoming so large that they can be used to pay the future insurance costs.  Except….when they don’t.  Because the investments are generally not guaranteed, if they don’t provide high enough returns then in the future the insurance costs will drain down your investment portion until it’s $0.  At that point you’ve lost all your investments and are faced with extremely high and increasing insurance costs – which will likely leave you without life insurance.  Therefore you should not purchase a universal life insurance policy with ART, as doing so can lead to loss of both investments and life insurance.  We note that this is not a hypothetical situation – we’ve seen this type of circumstances before.

Uses of Universal Life Insurance

Term 100 substitute:

it used to be that the best way to get permanent life insurance at the lowest price was with a Term to 100 policy.  Today, the best way is to get a properly structured universal life insurance policy.

If you’re seeking life insurance permanently (instead of term), consumer advocates in the past have suggested looking at a Term to 100 policy. A term to 100 policy has premiums that are level for life, with no investments or cash value.  It used to be the least expensive way to purchase lifetime coverage.

Unfortunately after the 2008/9 financial crisis Term to 100 became unprofitable for life insurance companies and most companies simply withdrew this type of policy from the market.  But!  There’s a solution.

You can purchase a universal life insurance policy with a Term to 100 insurance cost.  Then, simply pay the guaranteed level for life insurance costs and place no money into the investment portion. The investment portion exists, but you can ignore it.  This gives you effectively the same coverage as a Term to 100 policy – level premiums guaranteed for life, with no investments. 

Advanced Retirement Planning (Insured Retirement Strategy)

The investment component of universal life insurance has some drawbacks – primarily that the investments have fees higher than you can find elsewhere in the marketplace.  However they have a benefit other investment options don’t have – investments when paid out upon your death are not taxed.  In some cases the tax benefits can outweigh the higher fees.  Insured retirement strategy is once such case (for some Canadians – a good test is whether you have $2MM in investable assets – if not, this strategy is unlikely to work for you. If so, this is a strategy you should investigate). 

Here’s how it works.  You purchase a universal life insurance policy and place as much into the investments as the policy will allow.  LifeInsuranceCanada.com Inc. would need to customize your quote to illustrate this specific case for you.

These investments grow until retirement.  At retirement, you don’t withdraw the investments because doing so would trigger taxes.  Instead, you use the policy as collateral for a bank loan.  The bank loan is an annual payment, where the entire amount of the repayment is recapitalized back into the loan (you don’t pay the loan off just yet).  The result?  You receive a tax-free retirement stream of retirement funds (the annual bank loan).  And because the funds are a loan instead of ‘income’, they don’t impact any other income tested government benefits.  

Upon your death, the insurance portion and the investments are both paid out as a death benefit that isn’t taxed. Importantly – the investments are paid out without being taxed at this point.  Part of the death benefit is used to pay off the full amount of the loan, and any remainder goes to your beneficiaries.

Inheritance Across Generations

Another effective use of universal life insurance is to transfer wealth across generations. It can also be used to gift money to grandchildren as well as gift them a life insurance policy.  

In this example, a grandparent would take out a universal life insurance policy that insures both the grandparent and a grandchild.  The policy is structured to pay on the second death – in this case the grandchild, which makes the policy inexpensive.

The grandparent then pays the insurance costs and fully funds the investment portion of the policy. 

Upon the grandparent’s death, the insured on the policy is now just the grandchild.   Ownership of the policy now transfers to either the parent or the grandchild, depending on your preferences. Both the insurance and the investments are now accessible by the grandchild.  These policies can also be set up so that there are no more premiums due on the death of the grandparent.  The result?  The grandparent has gifted to their grandchild both a fully paid up life insurance policy and a decent sized investment fund that can be used by the grandchild to purchase a house, pay for a wedding, or other expenses.

Neither of these two strategies are suitable for completely online life insurance transactions as they require an experienced insurance advisor familiar with tax and investment regulations.  Nevertheless, Life Insurance Canada.com Inc. is able to assist you with these strategies through phone, email and google meet – no agent visit is required. Contact one of our life insurance specialists today to learn more.