What Is Universal Life?
Universal life insurance is a popular product sold to high net worth clients. This is a product that claims to give you the best of both worlds – insurance and investments, and also grants you flexibility according to your preferences. It allows policy holders to adjust the sum assured, premium term and cash value accumulation according to their current priorities and needs.
How Do Universal Life Policies Work?
To understand how a universal life policy works, we’ve broken it down in three parts – premiums, cash value, and death benefit.
Premiums - Universal life insurance can involve either regular premium payments or a lump sum single premium, but the single premium version is more popular due to the attractiveness of being able to discharge all your obligations from the onset. However, regular payments are usually still involved even with single premium plans, because universal life policies are usually sold hand-in-hand with another product – a bank loan.
Cash value - The cash value of the policy depends on the crediting interest rate of the policy. After the single premium is paid and fees are deducted, the insurer will credit interest on the policy every year. The interest rate typically involves a guaranteed and non-guaranteed component (e.g. guaranteed 2% p.a. and an additional non-guaranteed 1% p.a.). With this, the cash value of the policy grows every year.
Death benefit - Universal life policies usually cover for whole of life, and the death benefit tends to be relatively large, in the range of millions. For example, a middle-aged man may purchase a plan for USD 1,000,000 with a sum assured of USD 5,000,000.
To fund the death benefit, mortality charges or cost of insurance, are deducted from the cash value every year. The charges are typically not level across the term of the policy, but rather depend on the attained age of the policyholder. Hence, mortality charges are expected to go up over time as the policyholder ages.
Why Do People Buy Universal Life?
For a product that gives a large payout upon death, the uses are numerous, but the main reason is to help the wealthy with legacy planning. Take for example, John, a 50 year old successful businessman with total assets of USD 10 million. He estimates that he will only need USD 2,000,000 to cover his expenses over his lifetime. That leaves USD 8,000,000 for his loved ones when he passes on.
Let’s assume John takes up a universal life plan with a premium of USD 1,000,000, with a sum assured of USD 5,000,000. This means that upon death, he would significantly magnify the assets he leaves behind for his loved ones, from USD 8,000,000 up to USD 12,000,000.
So Why Borrow To Buy A Universal Life?
The reason is simple – to reduce the initial capital outlay, and also to bank on leverage to enhance returns. Many clients we work with share that the ability to purchase a universal life plan through leverage makes them attractive. This allows the policy owner to keep a good portion of their assets in cash, which can be used to generate more returns through other investments.
At the point of purchase, it is likely that clients are able to get a bank loan with an interest rate that is lower than what the insurer credits on the universal life policy. Thus, the policyholder earns a positive interest rate spread of the policy over the bank loan. Here is a simple illustration using John’s example above, which involves a single premium amount of USD 1,000,000.
John borrows USD 600,000 from the bank, which charges him an interest rate of 2% p.a. with the full principal repayment in, say, 20 years. The crediting rate of the policy is 3% p.a, and for simplicity, let’s assume that there are no commissions, mortality charges and other expenses in the policy. Without a bank loan, the annualised return for the policy would naturally be 3%. John makes an upfront payment of USD 1,000,000, and if he surrenders the policy in 20 years, he will get back around USD 1,806,111.
With a bank loan, however, he would only need to cough out USD 400,000 from the start. The interest on the loan would be USD 12,000 a year. At the end of 20 years, he would get USD 1,806,111 from the policy if he surrenders, but pay back the loan amount of USD 600,000 and the last interest payment of USD 12,000, giving him net proceeds of USD 1,194,111. His annualised return will go up from 3% to 3.86%.
Sounds Like A Good Deal So Far, Should I Just Purchase It Now?
Universal life is not without risks, and sometimes customers are not sufficiently informed before purchasing. Here are some of the common risks that customers may not be aware of.
Currency risks – Universal life policies are usually denominated in USD. From the perspective of a SGD policyholder, if the USD appreciates against the SGD, the death benefit will be higher. This may sound like a good thing, but remember that your bank loan payments are paid in USD as well. The same applies the other way round – if the USD depreciates, your bank loan payments become cheaper, but so does the death benefit. As such, you would be exposed to a different set of risks whenever the USD strengthens or weakens.
Interest rate risks – Since universal life policies are usually partially funded with a bank loan, the interest rate of the loan could rise, wiping out the positive interest rate spread or even becoming negative. Leverage is a double-edged sword, and in this sense could work against you and reduce the returns on the policy. In the above example, if the bank interest rate were to rise to 3.5% p.a., interest payments would surge from USD 12,000 to USD 21,000. The corresponding annualised return at the end of 20 years would fall from 3.86% to 2.58%.
Cost of insurance – As mentioned previously, mortality charges will go up as you age. If we were to use a 40 year old male as a basis, mortality charges can be four times higher when he reaches age 60, and even 30 times higher at age 80. These will naturally erode the cash value of the policy over time. In the U.S, there have been cases when the cash value of the universal life policies hit zero during the policyholders’ older years, and they either had to top-up or lapse the policy. Some policyholders claimed that they were not informed, and had a rude shock when informed by their insurer that the plan would lapse unless they did a top-up. They were well in their 70s or 80s then, and certainly did not expect the universal life policy they purchased decades ago to come back and haunt them. Some plans come with a no-lapse guarantee benefit, but this obviously comes at a higher cost.
High commissions - Universal life policies are extremely lucrative to agents and bankers. Upfront commissions are usually between 6% to 10% - and are based on the single premium amount inclusive of the loan. This means that the salesperson will also take a cut out of your bank loan! Hence, in John’s case, even though he only paid USD 400,000 upfront, the total commissions paid will be based on USD 1,000,000. This amounts to USD 80,000, assuming an 8% upfront commission rate. If you base this on what he actually paid (USD 400,000), it is a hefty 20%. This is why there are often referral arrangements between the agents and banks – both sides benefit quite substantially from every sale.
Should I Use It For Investments?
Due to the ability to use leverage, there are some who view universal life as an alternative investment vehicle. But considering the long time horizon, are the returns considered attractive? One should also remember that when mortality charges start to get more significant, your returns will slowly get eroded, and you may even get less than the common guaranteed crediting rate of 2%. If the policy does not have a no-lapse guarantee, it is even possible for all your capital to get wiped out during your older years.
On a related note, don’t be misled if a salesperson tries to imply that the guaranteed crediting rate is the minimum return you will get – this is one tactic used by some agents or bankers not only for universal life, but also endowment plans or whole life plans . The guaranteed crediting rate is before fees and expenses.
If used mainly for legacy planning, universal life is more applicable. An estate can be created immediately for the next generation, or for charitable purposes. Just make sure you secure the no-lapse guarantee benefit, or it is entirely possible that the insurer and salesperson end up becoming the sole beneficiaries. Universal life plans are essentially a convenient wrapper combining both investment and insurance elements into a single product. This usually comes at a higher “hidden” cost as it is embedded within the deductions and premium pricing.
You will never go wrong as long as you keep your insurance and investments separate.