What is a Universal Life Insurance Policy?
Understanding how it works and the benefits
The benefits of universal life insurance have helped make this form of term life coverage very attractive. However, Canadians are still asking us “what is a universal life policy?”
With a universal life insurance policy, you control how much money you earn every month inside your policy. Tax-deferred earnings are placed into your universal life insurance saving portion every month, collecting interest and increasing your net worth.
The Four Main Parts of Universal Life Insurance
Mortality cost – Unlike whole life policies, universal policies in Canada disclose the “mortality charges”. This is the portion of your premium that covers the “pure” cost of your death benefit. We recommend you choose a universal life insurance policy where your mortality cost does not increase as you get older, instead, keep the mortality cost of your policy the same (or level) throughout your life time.
Administration cost – Policies for universal life insurance in Canada not only disclose your mortality cost, but also disclose what your annual administration charges will be (the cost of administering your policy plus the premium taxes), which is usually in the range of $100 – $125 per year. Universal life insurance policies usually guarantee that your administration charges will not change for the life of your policy.
Savings or investment – Once the mortality costs (cost of insurance) and the administration charges have been deducted from your universal life insurance premium, the remainder of your premium (also referred to as the “cash value”) is placed into an investment savings vehicle where it can grow and earn interest (referred to as the “return on savings”) over the life of your policy. The “cash value” portion of your universal life insurance premium may also be referred to as the “cash surrender value” or “fund value”.
Return on savings and investment – Any interest that your “cash value” earns over the life of your Canadian universal life policy is credited back to the cash value portion annually and invested…so essentially, your money is compounding or earning money. Some companies will even provide a minimum return on investment. Newer universal life policies now disclose how your interest is calculated and invested. They even provide a list of investment options (similar to mutual funds) so you have control over your investment. Needless to say this “return on savings” portion of the universal life policy has become quite popular in the past few years. While they may not earn as high a return as mutual funds, the funds will grow “tax-free”, similar to an RRSP and the funds are “creditor proof”. Also, unlike an RRSP, you will have some options for using this money on a “tax-favoured” basis.
A universal life policy may be the answer if you want to buy term coverage and invest the rest. The buy term and invest the rest strategy is one of the best policy options available and highly recommended for those who believe in buying a term life policy and investing the difference, especially now that we have the Tax Free Savings Account (TFSA) option for the investment portion.
Universal Life Insurance versus Whole Life Insurance
Universal life insurance policies were designed to provide an answer to the advice that you should “buy term insurance and invest the difference”. In addition it provides an answer to some of the complaints about whole life insurance’s failure to disclose how the premium is allocated between the cost of insurance, administration costs, and investment portion and to provide investment options that you can choose.
In a universal life insurance policy, the mortality charges are disclosed and, as mentioned before, we recommend that they should be level (they do not increase as you get older). The administration charges are also identified and frequently guaranteed not to change for the life of the policy. They are generally in the $100 to $125 per annum range. Consequently, the cost of insurance and administrative costs can be shown on the illustration.
It is the investment options inside a universal life policy that have grown dramatically over the past four years. While some of the older policies did not disclose how the returns were calculated, the newer ones are offering a list of investment options that have similarities to mutual funds. In fact, some are designed to provide returns that mirror well known mutual funds and they are managed by mutual funds managers. Examples include S&P Index Accounts, Canadian Index Accounts, Canadian and American Equity Index Accounts, Bond Index Accounts, and 1, 5, and 10-year GIC Accounts.
Whole life insurance policies were designed to provide permanent insurance (the kind that you plan to have when you die) plus have a savings component at a single monthly premium. There has been a lot of this product sold over the years.
Whole life insurance has a level cost of insurance where the costs do not increase each year – what you pay in the first year is the same as in the last year but they do not disclose the cost of insurance. They also do not disclose the administration costs. After the “cost of insurance” and “administration costs” are covered, the balance of the premium is the savings or investment portion. The returns on the savings or investment part is dependent upon excess interest and investment earnings, savings in mortality costs, the operating expenses and the will of “the insurance company board of directors” – they choose what they will pay.
To summarize, apart from a minimum guaranteed return, the policies do not disclose the cost of insurance, the administration costs, or how they calculate the returns on your savings portion. You can not choose where the money is invested and they do not disclose the return you are receiving. You will have an illustration showing a guaranteed “cash value” and another cash value which reflects non guaranteed projected returns.
Why Hold Investments inside a Universal Life Policy
You do not pay any income tax on the growth of the investments while it resides in the policy. This is similar to an RRSP, however unlike RRSP’s there are ways to have the use of the money on a very tax favoured basis. This is often referred to as the Leveraged Deferred Compensation Plan (LDCP). An LDCP is essentially building up cash in a permanent insurance policy and then using the cash for a series of tax-free loans. Our experienced agents can help to provide illustrations for this concept. The deferral is that you wait as long as possible to let the cash grow and then start drawing it out using the policy as collateral with a lender.
You can invest 100% of the savings/investment component in an index where the returns are based on the performance of an index outside Canada. Options include S&P Indexes, American and Global Equity Indexes, and Bond Indexes. Some indexes are tied directly to the performance of well known mutual funds with one policy offering access to indices that emulate over 400.
The funds are “Creditor Proofed” if the policy is set up properly. Creditors cannot get at the funds inside this policy, which is important for many business owners and others who are concerned about lawsuits, however this protection is only available for personally owned policies, while corporate owned policies with the corporation as the beneficiary do not enjoy this creditor protection.
If the policy is set up properly, the entire investment account plus the face value of the insurance policy goes to the beneficiary tax-free on death of the insured. There are not even any probate fees. The same applies to a whole life policy but the cash value may or may not be in addition to the face value depending on the type of whole life policy.