How Does Universal Life Insurance Work?

In my previous article, "Life Insurance With Cash Value", I have detailed the basic pitfalls of any life insurance with cash value, and the common misleading arguments that agents use to sell these expensive insurance products to you, your spouse, and every family member in your household— the more they can sell you the merrier they are.

Universal life insurance was the new answer to the challenges that consumers had against the industry after the concept "Buy Term And Invest The Difference" was made popular by credible financial experts. The concept presented a serious blow to the industry, so they created their own version of buy term and invest the difference for the consumers, but their version is a perverted one. Consumers often ended up paying even more for the products and getting less for the buck.

Comparing with term life insurance, universal life insurance is much more expensive and it locks you in unnecessarily for the whole life, so even when you get old and no longer earn an income you will still have to pay the insurance expense. The basic pitfalls of universal life insurance are pretty much the same of what I explained in my previous article, so please read if you are seriously considering to purchase life insurance or to cancel it because you suspect that it might be too expensive.

But the cheap term life insurance instead, it will worth every dollar you spend.

Universal Life Insurance has a term insurance component and investment component to it, which was an attempt to mimic the good old "buy term and invest the different", with a little catch of course. The cost of insurance and administrative fee are disclosed, because the traditional permanent life insurance was rightly accused of its lack of transparency by many experts, so the industry made a reluctant improvement to make it seems more transparent. Nevertheless, the policies remained hard to understand by the general policyholders.

Many customers are unaware that the term insurance component of the policy is an annually renewable term, which means the insurance cost increases every year. Some policies are 5 year renewable, which renew the insurance cost every 5 year. Some policies renew every year after the first five years.

The problem with annually renewable term is that it gets expensive every year as you get older, and the cost will become unaffordable after your prime earning years. By then, the company will take the cash from your investment fund component to compensate the increasing cost, until it runs out of cash and the policy will lapse. Many customers couldn't afford the policy after the insurance cost skyrocketed in later years, and had to let the policy lapse and got nothing at the end.

Whereas for the true case of "buy term and invest in the difference", the insured buy a 20 to 30 years term insurance, which lock in the insurance cost for the entirety of its term period, and using the money saved by buying the cheaper term to invest in the market. After the insurance runs out, the insured no longer has working income to protect (retirement), the loved ones (usually children) he or she had to provide for have grown up and moved out, and the debts obligations such as mortgage was paid for, the insured no longer need a life insurance.

Instead, they will have what they really need for retirement— money.

You can adjust your premium by changing the size of your death benefit. You can also choose to increase the cash value by depositing extra cash into it.

You may decrease the size of your death benefit anytime you want, but if you want to increase it, you will have to prove your insurability. This is not a problem, but the agent would tell you to buy universal life insurance for your kids (children don't need insurance b/c they have no income to protect), and say it's a good thing because you will lock in for a cheap rate for them by getting a small size death benefit for their policies, and tell you how your kids can increase the sizes of their death benefits when they grow up. This is how the agents pervert the meaning of flexibility. It's flexibility for them to come up with creative arguments to sell more products, not flexibility for you.

The other thing is the administrative fee. The insurance company will charge expensive administrative fee for managing the investment component of your policy. The investment options are quite limited and they mostly mimic the mutual funds or index funds that are available in the market, which you can easily purchase yourself for much cheaper costs.

However, they will try to justify the administrative fee by saying how your investment is tax free and creditor proof. Let me further explain the pitfall of these arguments.

Any income will be taxed. Life insurance is paid with after-tax money, so its death benefit is tax-free, but not for the cash value component of the policy.

The only reason that it is not taxed is because either it has not been given back to you yet, or the administrative fee has eroded any actual earning. If the cash value only has the original after-tax money that you paid to the policy, but didn't make any profit for you because the hidden fee took the first cut, then of course you shouldn't pay any tax for it.

If you take out the cash value and the sum total is more than what you invested into it with your after-tax income, the government will tax it.

The chance of your cash value being taxed is slim, because the change of you making any real profit with universal life policy is slim. The administrative fee will take the first cut, and if you borrow the cash value they will charge you interest fee, and if you cancel the policy to take out the cash they will charge you a hefty surrender charge. You will be charged with this fee or that fee, at the before, between, and after.

In other words, the administrative fee, the interest cost, and the surrender charge are the taxes.

Thou shall not buy universal life insurance because:

1) The term insurance component is yearly renewable. It will become so expensive after your prime years, when you will have less income and need money the most.

2) There are expensive administrative cost and surrender charge for your cash value.

3) The return rate of the investment component is lower than the market rate that similar investment vehicles in the market provide you, even if the risk is the same.

4) The cash value isn't yours anyway. If you need it, you have to borrow it. See my previous article, "Life Insurance With Cash Value".