The most valuable feature of a life insurance policy is the carrier's promise to pay upon death. But if you purchased a Universal Life (also known as Adjustable Life or Flexible Life) policy in the 80s or 90s, there's a good chance you might lose that coverage before you can collect the death benefit. In this series of articles, I'll explain how Universal Life works, why it might be failing, and what you can do about it.
All life insurance is built in the same way at its base. First, the insurance carrier assesses the risk of you dying while covered, based on your age, gender, health, and other factors. Next, they make an assumption of how much interest they can earn on the premiums they collect from you while you're living. Finally, they calculate how much premium they need to collect from you over the life of the policy so that your premiums, plus interest, cover the cost of the risk, plus a profit for the company.
With most life insurance products, those premiums are fixed for the duration of the coverage, and the insurance company takes all the risk that their assumptions might be wrong. In other words, if more people die while covered than they anticipated, they'll make less money. If interest rates are lower than they assumed, they'll likewise make less money.
Universal Life is a different animal. Developed in 1979, when interest rates were off the charts, universal life was designed as a product that would allow consumers to take advantage of high interest rates, without the insurance company having to commit to continuing to pay those high rates over their clients' entire lifetimes. It works exactly as described above, except that with Universal Life, it's the consumer who takes on the risk that interest rates will decline, or that more people will die than the carrier assumed.
That's not necessarily a bad thing, since with risk comes potential reward. By making their interest rate and mortality assumptions transparent, the insurance carrier put the power in the consumers' hands to decide how much premium they wanted to pay into the product. So, consumers gained flexibility. In addition, consumers were able to take advantage of the high interest rate environment of the 70s, 80s, and, to a lesser extent, 90s. Properly managed, a Universal Life policy purchased in the 80s had the potential to offer more coverage, more cash value growth, and lower premiums than a whole life policy with the same death benefit.
The downside of this flexibility is that when interest rates fall, which has been the overall trend since about 1981, it's the consumer who has to deal with the consequences. Since the interest rate on a Universal Life policy helps to pay its cost, a policy that is earning less interest than projected needs to make up the difference somehow. Either the consumer must pay a higher premium to compensate for the lack of interest earned, or the policy uses its own cash value to make up the difference. With most Universal Life products that were on the market before the turn of the millennium, if the policy's cash value reaches zero, the policy lapses without value, and the consumer loses their coverage.
So that's a broad overview of how a Universal Life policy works, and why you might find yourself in a situation where it's failing. Next time we visit this topic, I'll dig into some of the inner workings of a Universal Life policy, making it easier to understand your policy statement, and then we'll discuss some potential solutions to this scenario. If you have questions, feel free to post in the comments below, or contact us. We'll be happy to review your specific situation.