Universal Life Insurance is a type of permanent life insurance with separate insurance and investing components inside the policy.
Universal life insurance has a defined insurance cost inside the policy. There are two general types of insurance costs – level costs for life (known as Term 100 cost of insurance) and annually increasing (known as YRT cost of insurance).
Premiums with this type of life insurance are not fixed – you can vary how much you pay each month. Any premiums you pay into the policy first go to pay the insurance cost, and any remainder is deposited into the investment component. Alternatively, if your payments are less than the insurance cost that month, any shortfall is paid out of the investment component.
There is only one case where most Canadians should ever consider a Universal Life Insurance policy. If you need permanent life insurance; in this case a Universal Life policy with Term to 100 cost of insurance (so the insurance costs are guaranteed level for life), where you pay the minimum cost of insurance. By ignoring the investment component in this situation the result is a life insurance policy with guaranteed level insurance costs for life, without any investments.
Some universal life insurance polices are sold with an active investment component, normally paired with YRT cost of insurance. The YRT cost of insurance provides inexpensive life insurance costs early in the policy, and hugely expensive insurance costs later in life.
The strategy is that by overpaying into the policy in the early years, the additional premiums are invested inside the policy. Later when the insurance costs become unaffordable, these costs are paid out of the investment portion of the policy that was built up in the early years of the policy.
This is a dangerous strategy and can lead to your coverage being cancelled alter in life after you’ve paid into the policy for many years. Because the investment returns are almost always not guaranteed, if the returns drop in the future then the investment portion ends up being smaller in the future. Less money in the investments means that as the insurance costs are paid from the investments in the future, the investment portion starts to drop towards a $0 balance. Once the balance in the investments hits zero, you either have to pay these huge insurance costs, or the policy is cancelled. This isn’t a hypothetical situation – many Canadians have paid into these policies for decades, have their investments take a tumble, and eventually they’re faced with the choice of paying hundreds of dollars a month, or having the policy cancelled. This is an extremely unpleasant surprise if you’re expecting the policy to maintain level premiums into retirement, or worse, that the policy would eventually require no further premiums.
These strategies are often sold as being great investment strategies. Unfortunately you need to be very aware of the drawbacks of these strategies. First, RRSP’s and TFSA’s are always going to be far better investments than a universal life insurance policy – so don’t consider such an investment type of policy until both of these other alternative investments are fully maximized. Secondly, you’ve now tied your life insurance policy to non-guaranteed investments and that lack of guarantees can result in the cancelling of your insurance policy – a risk not often considered by consumers.
Therefore if you’re looking for permanent, fully guaranteed life insurance, a universal life insurance policy with Term to 100 cost of insurance is a valid and strong choice to be considered. If you’re using a universal life insurance policy as an investment or to pay off the premiums, you are likely taking risks with your life insurance policy that are unnecessary.