Universal life insurance was introduced in 1979 as a revolutionary new product. It was the first variation of whole life insurance to offer truly flexible premiums. It also included adjustment provisions similar to those contained in the adjustable life contract. These policies shifted some of the investment risk to the policyowner because the premium was based on interest rates in excess of the guaranteed interest rate, but they did not give the policyowner any option to direct the investment portfolio. Two other features initiated with universal life policies: (1) the policyowner�s ability to withdraw part of the cash value without having the withdrawal treated as a policy loan and (2) the choice of either a level death benefit design or an increasing death benefit design.

The economic conditions of the early 1980s were a perfect incubator for the universal life variation of whole life. The economy was experiencing extremely high inflation rates and very high nominal rates of investment return. The real rate of return, however (nominal rate of return minus inflation rate), was quite low. Inflationary expectations were so rampant that investors were avoiding long-term investments, and the demand for short-term investments was outstripping the supply of funds, leading to what is known as a reverse yield curve (the cost of borrowing short-term funds is actually higher than the cost of borrowing for long-term mortgages). During more normal economic conditions, higher rates for borrowing are associated with longer-term investments, and lower rates are associated with the shortest investment durations.

Both short-term investment returns and inflation were hovering near 20 percent annual rates. This prompted many policyowners with traditional life insurance contracts to pull the cash value out of their existing life insurance contracts via policy loans or policy surrenders and invest the funds directly in these new high-yield investments. This process is commonly referred to as disintermediation.

Life insurance companies were looking for a way to stem this outflow of funds that was forcing many of them to liquidate some of their long-term investments at a loss in order to honor policyowner requests. In such an inflationary environment the traditional fixed-dollar life insurance contract lost much of its appeal.

Stock insurance companies were the first ones to introduce universal life policies. Mutual insurance companies were concerned that federal income tax law precluded them from offering universal life insurance policies; mutual insurance companies that introduced universal life insurance usually formed a downstream subsidiary stock insurance company with the parent mutual insurance company controlling the subsidiary. (See chapter 28 for a discussion of holding companies.) The real advantage was that nearly every insurance company introducing a universal life policy did so through a brand-new company that invested all of its assets into a new money portfolio and earned very high short-term investment yields. These yields seemed astronomical when compared with the yields being earned by traditional life insurance companies with long-term investment portfolios. Although the tremendous immediate advantage of higher yields could not persist over the entire duration of the life insurance contract, it was successfully exploited in the marketplace for the few years it lasted.

After normal investment conditions returned and yields dropped to lower levels, the universal life policies decreased in popularity. Insurers selling universal life insurance started investing in longer-term assets to increase their returns, and the total portfolios associated with universal life policies became very similar to those of seasoned insurance companies with large blocks of traditional whole life policies in force.

The true innovation of universal life insurance was the introduction of completely flexible premiums after the first policy year, the only time a minimum level of premium payments for a universal life policy is rigidly required. As usual, the first year�s premium can be arranged on a monthly, quarterly, semiannual, or annual basis. The insurance company requires only that a minimum specified level of first-year premium payments be equaled or exceeded. After the first policy year, it is completely up to the policyowner as to how much premium to pay and even whether or not to pay premiums.

Of course this sounds too good to be true. If only one year�s premium needs to be paid and the policyowner can skip all other premium payments, life insurance would be free for all years after the first. To the contrary, the aggregate premiums paid, regardless of their timing, must be adequate to cover the costs of maintaining the policy. Consider the analogy of an automobile�s gas tank, where premium payments are synonymous with filling the tank. Premium payments (tank refills) can be made frequently to keep the tank nearly full at all times. With that approach the automobile is never likely to run out of gas. The same automobile, however, can operate on a just-in-time philosophy, where premium payments of minimal amounts are made only as frequently as necessary to keep the car from running out of gas. The vehicle operator has full discretion in deciding how to maintain an adequate amount of gasoline in the car. If the operator fails to keep enough gas in the tank, the vehicle may run out of gas and be inoperable until the tank can be refilled. Likewise, under a universal life insurance policy, if the policy cash value is allowed to drop too low (the cash value is inadequate to cover the next 60 days of expense and mortality charges), the policy will lapse. If an additional premium payment is made soon enough, the policy may be restarted without a formal reinstatement process. However, if an injection of additional funds comes after the end of the grace period, the insurance company may force the policyowner to request a formal reinstatement before accepting any further premium payments.

With the advent of universal life insurance the insurance company shifted the investment risk to the policyowner by asking the policyowner to determine the amount, if any, of prefunding. The policyowner can pay maximum premiums and maintain a very high cash value (keeping the automobile gas tank full at all times). On the other hand, the policyowner can pay minimal premiums and just barely cover the mortality and expense charges because there is little or no prefunding (constantly running near empty).

The higher the amount or proportion of prefunding, the more investment earnings will be utilized to cover policy expenses. This gets down to the basic adage that there are two sources of money: people at work and money at work. By putting money into the policy early, the money starts earning money and therefore reduces the amount of premium payments needed from people at work at later policy durations. The ultimate extreme of prefunding is the single-premium approach, where an adequate fund is created at the inception of the policy to cover all future costs. The more common approach is a level premium structure in which partial prefunding creates an ever-increasing cash value that in turn generates increasing investment returns to offset mortality and administrative costs.

All premium suggestions are based on some assumed level of investment earnings and the policyowner bears the risk that actual investment earnings will be less than that necessary to support the suggested premium. Even though investment earnings cannot go below the guaranteed rate, a long term shortfall may necessitate either an increase in premiums or a reduction in coverage at some future point.

At the other end of the spectrum is the minimum-premium approach, which is virtually synonymous with annual renewal term insurance. There is minimal, if any, prefunding, and premium payments barely cover the current mortality and expense charges. Under this approach the premiums must increase as the insured ages since mortality rates increase with the age of the insured. Premiums increase rapidly at advanced ages because there is still a maximum amount at risk (the cash value is very low, and the mortality rate must be applied to nearly the full death benefit amount). Under the partial prefunding approach, however, cash value increases make the amount at risk decrease (amount at risk equals the policy�s face amount minus its cash value) as the insured ages, and the increasing mortality rate is applied to a smaller at-risk amount.

Under traditional whole life insurance policies insurance companies designed a wide range of level premium contracts, each with a different level of fixed premiums. Contracts with a higher level premium tended to develop larger cash values at earlier policy durations. Once the policy cash value was adequate to prefund the policy totally, the policy could be converted to a guaranteed paid-up status. Under participating designs, dividends could exceed the premiums once the policy had developed a large enough cash value to prefund all future policy elements.

A lot of the misunderstanding of life insurance stems from the investment component of policy prefunding. A one-half percent increase in investment earnings at each policy duration is sufficient to justify a discernible lower gross premium. The difficulty comes in trying to predict what level of investment earnings will actually be developed. It is highly unlikely that investment earnings rates will always increase. The only safe thing to predict is that future investment earnings rates will change. Some of those changes will be downward, and no one knows for sure what the actual pattern will be.

As noted earlier, in the past, policies have generally done much better than the guaranteed amounts. However, because few policyowners discuss life insurance with their friends, the general public is not aware of how much actual performance has exceeded guaranteed or expected levels. In a recent article about the 50th policy year of a whole life policy issued by a company that charges high premiums and generates high early cash values, a policyowner observed that his policy now provides more than five times the original death benefit. The cash value in the policy is more than four times the value of all premiums paid over the 50 years. This particular policy is a participating policy, and the policyowner dividends are now greater than 13 times the annual premium.

It is unlikely that the positive deviations from the guarantees over the next 50 years will be as strong as those mentioned here for the last 50 years. The intense competition and resulting premium reductions have drastically decreased the cash value build-up in the early policy years.

Prudent insurance management requires insurers to seek maximum prefunding before granting any sort of premium reduction or elimination. This is necessary to ensure that the insurance company has adequate funds on hand to honor the promises under the contract even in the worst possible economic conditions in the future. Otherwise, the insurance company will not have enough funds in case that worst-case scenario actually occurs.

Insurance companies are no better than economists (or any other group) at predicting future interest rates and investment returns. But every type of life insurance contract that develops a cash value is highly dependent on those returns. If they are high enough, the insurance company can return part of the premiums. If they are not, the insurer may need all of the investment returns and still have difficulty meeting the promises in the contract. Philosophically and economically it is justifiable to have more premium money collected up front rather than delaying the collection of funds in the hope that rosy economic conditions will prevail in the future.

Under the traditional contracts with cash values the only mechanism for returning any policy overfunding in the early years was policyowner dividends. With universal life policies, however, the accumulations from prefunding are credited to the policy�s cash value and are quite visible to the policyowner. The earnings rates applied to those accumulations are also clearly visible as they fluctuate with current economic conditions. This open disclosure for universal life policies eliminates some of the doubts about fair treatment often directed at whole life insurance.

As noted above, another new feature introduced with universal life policies is the policyowner�s ability to make partial withdrawals from the policy�s cash value without incurring any indebtedness. In other words, money can be taken out of the policy cash value just like a withdrawal from a savings bank, and there is no obligation to repay those funds; nor is there any incurring interest on the amount withdrawn. Withdrawals do affect the policy�s future earnings because the fund still intact to earn interest for future crediting periods is reduced by the amount of the withdrawal. Its effect on the death benefit depends on the type of death benefit in force. (This will be discussed later in the chapter.)

Nearly every universal life policy is issued with a target premium amount. The target amount is the suggested premium to be paid on a level basis throughout the contract�s duration or for a shorter period of time if a limited-pay approach was originally intended to fund the policy. The target premium amount is merely a suggestion and carries no liability if it is inadequate to maintain the contract to any duration, much less to the end of life.

In some insurance companies that target premium is actually sufficient to keep the policy in force (under relatively conservative investment return assumptions) through age 95 or 100 and to pay the cash value equivalent to the death benefit amount if the insured survives either age 95 or 100. On the other hand, some companies with a more aggressive marketing stance have chosen lower target premiums, which are not adequate to carry the policy in force to advanced ages even under more generous (and of questionable validity) assumptions of higher investment returns over future policy years. If in fact the investment return credited to the policy cash value falls short of the amounts assumed in deriving the target premium, the policy may essentially run out of gas before age 95 or 100.

In cases where the policy does run out of gas, the policyowner will be faced with two options: (1) to increase the premium level or (2) to reduce the death benefit amount. Neither one of these options is necessarily desirable, but they are the only acceptable ways under the contract�s provisions to correct for unfulfilled optimistic assumptions about investment returns in the contract�s early years.

Some insurance companies have introduced a secondary guarantee associated with their target premium. These companies have pledged contractually to keep the policy in force for, say, 15 or 20 years and to pay the full death benefit as long as the target premium has been paid in an amount equal to or greater than the target premium amount at each suggested premium-payment interval. Even these guarantees do not extend to age 95 or 100, but they are at least a guarantee that the premium suggested as a target will be adequate to provide the coverage at least as long as the guarantee period. Probably the best indication of whether or not the target premium is adequate to keep the policy in force up through age 95 or 100 is to compare it with premiums for a traditional whole life policy of a similar face amount and issue age. Universal life policy target premiums less than premiums for a comparable whole life policy should be suspect; they may be intentionally low by design because the insurance company does not expect the policy to remain in force until the very end of life in the majority of cases. The only people who will ever really find out whether or not their policy target premiums are adequate are those who pay the premiums religiously throughout the duration of the contract and live to be an age that is old enough to test the target premium.

The flexible features of universal life premiums allow policyowners to make additional premium payments above any target premium amount at any time the policyowner desires without prior negotiation or agreement with the insurance company. (The only limitation on paying excess premiums is associated with the income tax definition of life insurance.) However, the insurance company reserves the right to refuse additional premium payments under a universal life policy if the policy�s cash value is large enough to encroach upon the upper limit for cash values relative to the level of death benefit granted in the policy.

The premium flexibility also allows the policyowner to skip premium payments, again without any prior negotiation or notification, or to pay premium amounts lower than the target premium suggested at the time of purchase. The lower limitations on premium payments have two constraints. The first is that nearly every company specifies a minimum acceptable amount for any single payment. This is easy to understand in that a check for $.50 is likely to generate $5 to $10 (or more) in processing costs. Insurance companies usually set this minimum amount per transaction at a level above their estimated cost of processing such a transaction.

The other constraint for minimum premium payments has to do with whether or not there is enough cash value in the contract to meet the mortality and administrative charges for the next 60 days. In other words, if the tank is running on empty, more premium is required. This constraint is also easily justified.

As mentioned earlier, universal life insurance gives policyowners a choice between level death benefits and increasing death benefits. The level death benefit design is much like the traditional whole life design (see figure 5-5). When the death benefit stays constant and the cash value increases over the duration of the contract, the amount at risk or the protection element decreases. The one new aspect of a level death benefit designed under universal life policies is not really a function of universal life itself but a function of a tax law definition of life insurance that was added to the Code shortly after the introduction of universal life insurance policies, requiring that a specified proportion of the death benefit is derived from the amount at risk. Whenever the cash value in the contract gets high enough that this proportion is no longer satisfied, the universal life policy starts increasing the death benefit even though the contract is called a level death benefit contract. This phenomenon does not occur until ages beyond normal retirement, and it is not a significant aspect of this design.

The increasing death benefit design is a modification that was introduced with universal life policies (see figure 5-7). Put quite simply, under this approach there is always a constant amount at risk that is superimposed over the policy�s cash value, whatever it may be. As the cash value increases, so does the total death benefit payable under the contract. A reduction in the cash value will reduce the death benefit. This design pays both the policy�s stated face amount and its cash value as benefits at the insured�s death. Policies with an increasing death benefit design overcome the criticism of whole life policies that the death benefit is partially made up of the contract�s cash value portion. By selecting the

increasing death benefit option under a universal life policy the policyowner is ensuring that the death benefit will be composed of the cash value and an at-risk portion equal to the original face value of the contract.

There is nothing magical about this larger death benefit amount. As is said often, there is no free lunch. A higher portion of the premium is needed for the larger amount at risk under this design.

There are similarities between the increasing death benefit design for universal life and the paid-up additions option under a participating whole life policy. Under a whole life policy dividends are used to purchase single-premium additions to the base policy. In both types of policies the excess investment earnings are used to increase the cash value and the death benefit.

Because the mechanics of the two death benefit designs and the universal life policies are slightly different, the effect of partial withdrawals on the death benefit amount differs. Partial withdrawals do not reduce the death benefit amount under the level death benefit design. They do, however, decrease the amount of the policy�s cash value and correspondingly increase the amount at risk. As a result, the mortality charge will increase after the partial withdrawal to pay the mortality risk applicable to the greater amount at risk.

Partial withdrawals under the increasing death benefit design will in fact reduce the death benefit payable because the withdrawal decreases the cash value that constitutes part of the death benefit amount. However, such withdrawals will not reduce the mortality charges for the amount at risk because that at-risk amount remains constant. Reducing the cash value by the amount of the partial withdrawal does, however, have a negative impact on the amount of investment earnings credited to the cash value.

Another aspect of policy design ushered in with universal life policies is the differential crediting rate on the cash value, depending on whether there are policy loans outstanding. Most universal life policies credit current interest rates on the cash value as long as there are no outstanding policy loans. Once the policyowner borrows funds from the cash value, the insurance company usually credits a lower interest rate or earnings rate to the portion of the cash value associated with the policy loan. This is another effort to curb disintermediation.

Some of the earliest universal life policy designs had several different bands with different crediting rates. In other words, the first $500 or $1,000 of policy loan interest rate may have been credited with one interest rate and each successively larger band would have carried a higher policy loan interest rate. This structure still exists in a few universal life policies offered in the marketplace today, but by and large, many insurance companies have dropped the multiple-rate, banded approach to premium loan interest charges. It had such a complex structure that it was hard to explain to policyowners, and tracking it required much more complex computer software. Many universal life policies sold today credit the cash value with the current rate for nonborrowed funds and a lower rate, which is often 2 percent of or 200 basis points lower than the current rate, for borrowed funds.

Although universal life insurance policies are still relatively young in the overall realm of life insurance products, some policies are already in their fifth or sixth generation of policy series from the company that introduced them. As with all products, the individual policy designs constantly evolve in response to the economy, competitive pressures, and innovative zeal. As previously noted, most of the first generation of universal life policies were heavily front-end-loaded products. They took a significant proportion of each premium dollar as administrative expenses, and the remaining portion was then credited to the policy cash value account.

After the funds had reached the policy cash value account, they were subject to charges for current death benefits in the form of a mortality charge based on the amount at risk. In most insurance companies the mortality rate actually charged was often in the neighborhood of 50 percent of the guaranteed maximum mortality rate set forth in the policy contract for each attained age of the insured. The difference in the mortality rate actually being charged and the maximum permitted mortality rate published in the policy represents the safety margin the life insurance company is holding in reserve. If the future mortality costs for the block of policies turn out to be more expensive than initially assumed, the insurance company can increase the mortality rate as long as it does not exceed guaranteed maximum rates specified in the contract itself.

After deductions for expenses and mortality, the universal life cash value account is then increased at the current crediting rate to reflect investment earnings on that cash value. These are the dollars at work for the policyowner to help reduce his or her current and future out-of-pocket premium expenses. The actual rate credited is a discretionary decision on the part of the insurance company, and it tends to fluctuate freely, reflecting current economic conditions. There have been times when some insurers were reluctant to credit the current interest rate to the policy�s cash value. As interest rates were dropping gradually and steadily over the last decade, many insurance companies were hesitant to allow their current interest crediting rate to drop below 10 percent, and interest crediting rates seemed to stick around that point. Eventually the economic folly of crediting interest rates in excess of actual earnings on the invested assets became apparent, and single-digit interest rates replaced double-digit rates in the crediting formula.

Interest crediting rates have been the focal point of most of the competition among companies selling universal life policies. There has been very little emphasis on the mortality rates charged or the expense charges levied against incoming premiums. In reality all three concepts constitute the total cost of insurance. Interest rates can be (and have been) intentionally elevated to a level above what the investment portfolio actually supported but they are still viable because of compensating higher levels of mortality charges and expense deductions. When consumers choose to focus only on one of the three elements, it is not surprising that the marketing efforts zero in on that element. The assessment of overall policy efficiency requires that all factors be considered in concert.

As the universal life insurance policies evolved, more of them moved to a back-end loading design. In other words, they lowered or eliminated the up-front charge levied against incoming premium amounts and instead imposed new or increased surrender charges applicable to the cash value of a policy surrendered during the contract�s first 7 to 15 years. Surrender charges are usually highest during the first policy year and decrease on a straight-line basis over the remaining years until the year in which the insurance company expects to have amortized all excess first-year expenses. At that point the surrender charge is reduced to zero and will not be applicable at later policy durations. The actual surrender charge itself can be based on either the cash value amount or on the target premium level. Some insurers have developed a hybrid that depends on both approaches to generate the full surrender charge. The surrender charge usually decreases by the same percentage on each policy anniversary until the applicable charge reaches zero. The net amount payable for a surrendered policy is determined by deducting any applicable surrender charge from the policy cash value minus any unpaid policy loans and interest.

Companies with the highest surrender charges tend to have little or no front-end expenses charged against premiums. Some companies have policies that combine moderate front-end loading and moderate surrender charges. There seems to be a discernible preference for higher surrender charges and little or no front-end loading in most universal life policies being marketed today.

The actual component of the front-end loading can be a flat annual charge per policy plus a small percentage of premium dollars actually received, and a charge of a few cents per each $1,000 of coverage in force under the policy. The charges applicable to the premiums and the amount of coverage are usually deducted monthly from the policy cash value account. Similarly, the current interest crediting rate is also usually applied monthly. These are the deposits and withdrawals from our "gas tank."

Some companies have actually eliminated charges based on the amount of coverage in force. Competitive pressures have also caused many insurance companies to minimize front-end loading in order to emphasize that nearly all premium dollars go directly into the cash value account. The actual expenses are still being exacted internally, but the manner in which they are handled is not easily discernible by the consuming public. For example, expenses can be embedded in the spread between actual mortality costs and actual mortality charges or in the spread between investment earnings and the interest rate credited to the cash value accounts.

It is important to realize that no insurance company is able to operate without generating legitimate costs of operations above the amount needed to pay death benefits only. These expenses must be covered somehow, and the method of allocating them is nothing more or less than a cost-accounting approach. The exact allocation formula is always arbitrary and to some extent guided by the philosophy of the insurance company management team. It must address such issues as equity among short-term and long-term policyowners, the appropriate duration for amortizing excess first-year expenses, and how much investment and operations gains to retain for company growth and safety margins and how much to distribute to policyowners.

The astonishing flexibility of premiums under universal life policies and the ability to adjust death benefits upward and downward have created life insurance policies that can literally keep pace with the policyowner�s needs. The policy can be aggressively funded when the premium dollars are available, and premium payments can be intentionally suspended during tight budget periods, such as the formation of a new business or while children are attending college. The policy death benefit can be increased (sometimes requiring evidence of insurability) if the need exists, and once any temporary needs have expired, the policy can be adjusted downward to provide lower death benefits if that is what the policyowner wants. The ability of a universal life contract to fit constantly changing policyowner needs and conditions has led some companies to label this coverage irreplaceable life insurance. Some see it as the only policy ever needed because its versatility will allow it to compensate for any necessary changes.

Probably the most serious drawback to universal life policies is the competitive forces insurance marketers use to try to convince the prospect that their own version of universal life is better than anyone else�s. In reality all universal life policies are similar, and only future investment performance will really determine which one turns out to be slightly more efficient than its competitors. Consumers will be better off seeking a policy that does well over the long haul than looking for a policy that wins every short-term contest because no policy can be best in all facets at every duration. Sometimes focusing on a single competitive advantage prompts insurance companies to make short-term adjustments that are not necessarily in their own or the policyowner�s best interest in the long-term scenario.