# Understanding Life Insurance

#### Universal Life Insurance

This is the third and final type of permanent life insurance. It’s a weird and confusing blend of term insurance and investments. Unlike term and permanent where all the attributes are blended, universal life insurance has two distinct elements – a life insurance cost, and a savings/investing component. When you purchase a universal life policy you will make decisions on both of those components.

Universal life insurance costs come in two general choices – one year term (1YRT), or term to 100. So when you purchase a universal life, you can have either costs that start very cheap and go up every year, or you can choose level for life.

Now here’s where we get up to shenanigans. **The premiums you pay are not directly related to the insurance costs** – you don’t have to pay the exact insurance costs each year – you can pay more or less. If you pay more than the insurance costs, the company pays the insurance costs then puts any remainder into the investment component. If you pay less than the exact insurance cost, the company will automatically pull money from the investments to make up the shortfall between what you paid and the actual insurance costs.

##### Term to 100 Insurance Costs

Lets start with 3 visual examples. For ease, we’re going to look at a policy where the insurance costs are term to 100 – guaranteed level for life. We’ll assume that the term to 100 monthly insurance costs are $75/month. Let’s examine the interaction between insurance costs, premiums, and investment.

In the first diagram, we decide to pay a premium of $100/month. The first $75 pays the fixed insurance costs for the policy. The remaining $25 is placed into the investments.

In the second diagram, we choose to pay $0 in premiums. The $75 insurance costs must be paid, but since the premiums are insufficient, the $75 is automatically deducted from the investments by the life insurance company.

In the third diagram, we choose to pay exactly the fixed insurance costs each month – $75. This exactly matches the insurance costs, and no money is placed into or removed from the investments. In this scenario, if you always pay the insurance costs (plus related taxes and policy administration fees) your investments will remain at $0 and you effectively have a term to 100 policy as described in a previous section – level life insurance premiums for life, and no investments.

##### 1 YRT Insurance Costs

Premiums | 1 YRT Insurance Cost | Investment | Term 100 Insurance | Investment |
---|---|---|---|---|

$100 | $20 | $80 | $95 | $5 |

$100 | $25 | $75+$80 | $95 | $5+$5 |

… | ||||

$100 | $300 | Previous Investments minus $200 (your premium of $100 plus $200 removed from the investments pays the $300 insurance costs.) | $5+$5+$5+… |

You can see that if you selected 1YRT Insurance initially your investment grows fast where as the Term 100 grows slow. Later, the annual 1YRT costs are higher than the $100 premiums you’re paying so the shortfall gets paid out of the investments.

There are a bunch of different scenarios that can be created. If I assume a high interest rate, high deposits, and 1YRT insurance costs, I might assume that in the future the interest earned in the investment each year exceeds the insurance costs. IF so, I could actually stop paying premiums and the interest alone would pay the premiums.

Lets look at how this 1YRT can go bad. You’ve built a policy with $100 in 1YRT costs and managed to accumulate $1000 in the investments. The intention is to stop paying premiums, by letting the 1YRT costs come out of the investments.

Scenario 1 you earn 10%:

Year | Investments | Interest | Insurance costs | You Pay | Deducted from investments | Inv. |
---|---|---|---|---|---|---|

X | $1000 | $100 | $100 | 0 | $100 | $1000 |

X+1 | $1000 | $100 | $100 | 0 | $100 | $1000 |

Looks good. Our investments are earning enough to pay the insurance costs every year, so we don’t have to pay premiums. But lets look at what happens if you only earn 5%

Scenario 2 you earn 5%:

Year | Investments | Interest | Insurance costs | You Pay | Deducted from investments | Inv. |
---|---|---|---|---|---|---|

X | $1000 | $50 | $100 | 0 | $100 | $950 |

X+1 | $950 | $47.5 | $100 | 0 | $100 | $1000 |

… | ||||||

$50 | $2.50 | $100 | 0 | $100 | $-47.5 |

In the last year in this case, your investment balance went negative. In reality, it won’t go negative – The policy will actually collapse leaving you with two choices – either pay the $47.5 to keep the policy in force, or the insurance comapny will cancel the policy on you. If you pay the $47.5, remember that your insurance costs are 1YRT -so they’re going up every year. So now you bought a policy asssuming that you wouldn’t pay premiums when you got older, but what actually happened is that now you’re much older, and you have to restart paying very expensive premiums and those costs keep going up every year. Or, cancel the policy and have no life insurance after all those years. This is not a hypothetical situation – with 1YRT insurance costs, this exact scenario gets played out after people have had their insurance policies over many years. The solution? You should never purchase a universal life insurance policy that has 1YRT insurance costs to use for life insurance purposes (there are some advanced financial planning/tax purposes for 1YRT, but they’re not appropriate for almost everybody).

Now, lets look at a better scenario. Recall when we looked at Term to 100 I mentioned that they’re mostly unavailable in Canada. Term to 100 insurance costs in Universal Life however is still available. So what if you purchased a universal life insurance policy with Term 100 insurance costs and then paid the minimum required premium each year with $0 going into investments? You end up with a policy with level guaranteed premiums for life,and no investments – which is a term to 100. You effectively have a Term to 100 policy with optional investments that you’re not using.

**Using Universal Life as a Term to 100 by choosing Term 100 insurance costs and paying minimum premiums (no money into investments) is a reasonable and inexpensive way to get permanent life insurance. ***Most other combinations of insurance costs, investments, and premiums are not guaranteed and should be avoided by most Canadians*. A further comment, I wanted permanent life insurance and this is exactly how I solved that – I purchased a universal life insurance policy with Term 100 insurance costs, I pay the guaranteed minimum premium each year. My investment statement from the policy shows a balance of 10 cents. It’s basically pure, lifetime life insurance with level premiums for life.