Universal life insurance

The structure

Whole life bundles everything into one premium and hands you a set of guarantees. Universal life takes the same components and separates them so you can see and control each one.

Money you pay goes into a side account inside the policy. Each month the insurer deducts the cost of insuring you, plus administration charges, from that account. Whatever remains stays invested according to the options you chose.

Two consequences follow. You can see exactly what the insurance is costing you, which is more transparency than whole life offers. And you carry the investment risk that a whole life insurer would have absorbed.

The choice that shapes everything

At issue you pick how the cost of insurance is calculated, and this decision is close to permanent.

Level cost of insurance fixes the monthly charge for life. It is more expensive early and cheaper later. It is predictable, and it is the sensible default for anyone intending to hold the policy to the end.

Yearly renewable cost of insurance starts much lower and rises every year with your age. In your forties it looks like excellent value. In your late seventies the annual charge can be many times what it started at, and it is being deducted from an account that may not have grown enough to absorb it.

Yearly renewable pricing suits a genuinely temporary need or a situation where large deposits early on will build a big enough account to carry the later costs. Chosen for the low initial premium alone, it is how universal life policies fail.

How a universal life policy fails

This is the thing to understand before buying one.

Someone buys universal life at 45, funds it at or near the minimum, and picks yearly renewable cost of insurance because the premium is attractive. The side account stays small because most of each deposit is consumed by charges. Investment returns come in below the illustration.

By 76 the monthly cost of insurance has grown substantially, the account cannot cover it, and the insurer sends notice that a large payment is required to keep the policy in force. The options at that point are to find the money, reduce the coverage, or lose the policy after thirty years of premiums. Buying replacement coverage at 76 is generally not realistic.

None of this is hidden. It is in the illustration, in the annual statements, and in the policy. It simply requires somebody to look.

Avoiding that outcome

Fund it properly. The minimum premium keeps the policy alive today. It does not necessarily keep it alive at 80. Ask what deposit level keeps the policy in force to age 100 under a conservative return assumption, and treat that as the real premium.

Prefer level cost of insurance unless there is a clear reason not to.

Review it every few years. Ask the insurer for an in-force illustration showing whether the policy is still on track at current values. This is the single most useful maintenance task on a universal life policy and almost nobody does it.

Be sceptical of the projected return. Ask to see the illustration at a materially lower rate. If the policy only survives at the higher assumption, it is not as permanent as it looks.

Where universal life fits well

Corporate ownership, where a business holds surplus and wants a tax-sheltered place for it alongside coverage that funds an obligation. The flexibility to vary deposits with cash flow suits a company better than a fixed premium.

High-income individuals who have used all their registered room and can fund the policy well above minimum. Growth inside the policy is not taxed annually, and for someone in that position the shelter is worth something.

People with genuinely irregular income who need permanent coverage and value the ability to pay more in good years and less in lean ones, provided they understand that “less” has a floor.

Where it does not

Anyone buying it because the initial premium is lower than whole life. That comparison is not like for like, and it is the most common reason people end up in the failure case above.

Anyone who will not review it. Universal life is a policy that needs attention. Whole life is not.

Anyone who wants certainty. If the appeal of permanent insurance is that everything is fixed, whole life is the product that does that. See comparing permanent policies.

The tax side

Growth inside the policy is not taxed year to year, provided the policy stays within the exempt test limits set out in the Income Tax Act. Insurers monitor that and will tell you if a deposit would push the policy offside.

Taking money out is a different matter. Withdrawals and surrenders can produce taxable income depending on the policy’s adjusted cost basis, and a policy loan has its own treatment. See tax on cash value and policy loans, and get advice specific to your situation before withdrawing anything.