December 6, 2003    Copyright © 2003, Greenwich Financial Management Inc.

Demystifying Insurance, Part 6:

Universal Life

Universal life and whole life are the two major forms of permanent life insurance, as opposed to term life.  Universal life has a very flexible structure, allowing for wide fluctuations in premium contributions throughout the life of a policy, as long as payments are adequate or cash value sufficient to keep the policy in force. 

With universal life, there is no fixed agreement by the insurer as to the scheduled "cost of insurance".  The cost of insurance has two components: administration and mortality (death benefit).  Because the policyholder takes the risk that these scheduled costs may increase, premiums on universal life death benefits may be significantly lower than for whole life (though whole life policy holders may potentially recover the higher premium costs in their cash values or through dividends).  Moreover, universal life contracts generally offer maximum cost of insurance clauses that put bounds on the risk.

How big is the risk that the cost of insurance will increase?  Administrative costs are probably moving slightly downward over time owing to the progress of technology, but not that significantly.  However, the cost of the death benefit, the so-called "mortality cost," merits focus.

Measured mortality costs for insurance companies in the United States have been declining over a long period.  Current average life span is 77.2 years; in 1900, it was 47.3 years (source: National Center for Health Statistics, "Health, United States, 2003.")  Better sanitation and public health practices, decreases in infant mortality, improvements in medicine and discoveries in pharmaceuticals have all contributed to this dramatic improvement.  New developments in science, including the decoding of the human genome, promise to further reduce mortality and increase average life span.  Indeed, scientists have begun to discover how caloric restriction, and perhaps other means mimicking caloric restriction, can slow the aging process itself in simpler animals and potentially in human beings.  So although there is the risk that U.S. mortality rates could spike upward, owing to a terrible microbial menace, say, or an unthinkable thermo-nuclear catastrophe, the demographic trend is generally very favorable.

I don't know of any insurance company that contractually obligates itself to pass on to policyholders decreases in the cost of insurance.  Nevertheless, one insurance company, Pacific Life, does have a historical record and a stated policy of sharing with its universal life policyholders decreased mortality costs.  According to examples I have studied, passthrough of decreasing mortality costs could have a very large favorable long-term impact on cash value.  Pacific Life has a credit rating of "AA" rating (the fourth highest of eleven "investment-grade" ratings) on its long-term debt and claims paying ability from S&P, and its variable investment options are reasonably broad.  (My own firm can offer life insurance from virtually all licensed carriers, including Pacific Life.  It is always worthwhile to compare rates across carriers, giving due consideration to premium rates, credit quality and features.)

Universal life comes in two flavors: standard and variable.  Standard universal life offers a minimum annual rate of return, and the insurance company decides on the investments, which are usually mostly bonds.  With variable universal life, the policyholder makes choices from a menu of mutual fund sub-accounts or variable annuities, and there is no guaranteed minimum rate of return.  These option choices can be revised, like a 401-k.  Many of my clients prefer to have this kind of control over their investments. However, poor investment performance could lead to the need for increased premium contributions.  Agents should show illustrations for variable policies giving a variety of investment outcomes, from low to high rates of return. 

Keep in mind that insurance companies are regulated by state insurance commissioners, who may allow premium rates to rise above contractual levels if they conclude that an insurance company's financial viability is threatened.  However, this rarely happens.

Because of its flexible characteristics, universal life is most often chosen as the vehicle for investment or tax shelter oriented policies.  Such policies often include premiums up to the maximum amounts allowed under tax law, with the intention of developing large cash values that accumulate without taxation.  

Andy Szabo, CFA, is Managing Director of Greenwich Financial Management Inc., a Registered Investment Advisor, which advises individuals and companies on investments, insurance and employee benefits.  Questions or comments welcome by phone (203-531-2877) or e-mail: Szabo@GreenwichFinancial.com.