Defining Universal And Whole Life Insurance

Presented by the College for Financial Planning

DENVER - There was once a time when life insurance was relatively simple. "Whole life insurance, with its tax advantages and inherent stability of principal, was about the only real permanent insurance option heading into the 1970s" said Michael Snowdon, CFP, CMFC, CFP Program Manager with the College for Financial Planning.

Under a whole life policy, the purchaser agrees to pay regular premiums to an insurance company in exchange for a guarantee of a specified benefit payable to their spouse or other beneficiaries upon their death. Earnings on a whole life policy are set by the insurance company based on the overall return on its investments. Earnings above and beyond those required to cover the death benefit go to the policy's cash reserve, which you can borrow against, withdraw, use to pay premiums, or allow to accumulate for long-term goals such as retirement.

Then, interest rates skyrocketed. People began taking a hard look at the rate of return they were receiving from their whole life policies, and comparing this with what they would be earning if their money was invested instead in the stock or bond markets, or just money market funds. Insurance agents were asked some pretty tough questions. Responding to this pressure to compete with investment products, the insurance industry developed the "universal" life insurance policy.

Universal life allows the purchaser to set the premium and the death benefit. As such, it lets people establish a permanent policy with a lower premium than they would have to pay under a whole life policy. Under whole life, premiums are set by the insurance company based on long-term interest rates and actuarial tables predicting the period of time over which the premiums will be paid.

The flexibility provided by the universal policies is attractive. Also, higher interest rates mean money doesn't have to work as hard to generate the same return. As a result, universal life premiums are typically lower during periods of high interest rates than whole life premiums for the same amount of coverage. And, while the interest paid on universal life insurance is often adjusted monthly, interest on a whole life policy is adjusted annually. This means that during periods of rising interest rates, universal policy holders see their cash values increase much more rapidly than those in whole life policies.

Interest rates in this case are a double-edged sword. As with any attractive option, there is an associated risk. In this case, you are betting long-term interest rates will remain where they were when you bought the policy. If rates fall significantly after you purchase the policy, the odds are good that the premium stream won’t cover the cost of keeping the universal life policy in force and maintaining the death benefit payable sometime in the future. If the worst case scenario occurs and interest rates drop (as they have since the 1970s), it is likely the premiums paid on the universal policy will need to be increased to generate enough income to cover the projected cost of the death benefit. If premiums do fall short, the policy could eventually lapse - becoming completely worthless. While your agent should make it very clear to you that you are running into a situation where this might happen, the lapsing of a policy you might have been paying into for years is a significant potential drawback. This is something that will never happen with whole life.

A third variation on life insurance is a variable policy, which pushes hardest against the line between insurance and investment products. While a universal policy allows the policyholder greater control over premiums and death benefit values, the variable life insurance policy allows the policyholder to make choices among a number of different investment options. This places 100% of the investment risk on the shoulders of the policyholder, but allows choice between a number of options typically available only through a traditional investment like a mutual fund. The typical combination is usually a money market fund, a bond fund, and an equity fund, or a combination of these three.

Some variable policies also offer a guaranteed interest account. However, if guaranteed interest is your goal it makes little sense to pay the typically higher fees associated with a variable product for something readily available in a whole life or universal policy,

Which approach is right for you? The appropriate choice depends upon your short-and long-term financial objectives, time to retirement and family situation, among other things. Also, the three types of life insurance outlined here represent only some of the options available. Therefore, before making a decision to take on coverage, or alter your existing coverage, check with your financial advisor or insurance agent to see what type of policy - if any - makes the most sense for your individual situation.

© May, 2000, the College for Financial Planning, all rights reserved. The College for Financial Planning admits students of any race, color, creed, age, sex, disability, and national or ethnic origin. CFP and CERTIFIED FINANCIAL PLANNER are federally registered service marks of the Certified Financial Planner Board of Standards, Inc. Information in this article is generic in nature, and should not be construed as providing advice for a specific financial planning situation.

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