During a conversation I had the other day I remember a great way to explain the inter-workings of a Universal Life insurance policy. I had sort of forgot about this explanation but it’s a good one. I figured I’d share it with all of you.
One of the biggest downfalls of Universal Life insurance is the complexity of the product. I have previously written about the historical and structural overview of a Universal Life policy. From here I am going to give you a different explanation of the way in which a Universal Life insurance policy works and the problems with it.
Your Universal Life insurance policy is a bucket. The life insurance company is going to hold your bucket for you. In fact, they are going to hold it under to spigots. One spigot will represent your premium and the other spigot will represent the interest rate credited by the insurance company. As long as there is water in the bucket, even just a drop, you have your Universal Life insurance policy. If the water runs out so does your life insurance policy. So you are probably wondering how your water could run out with two spigots?
The life insurance company is also going to drill a few holes in your bucket. Three to be exact. The first hole will be the biggest it is a result of mortality charges. Think of the bucket made out of iron. If you know anything about iron and water is that it causes rust. What does rust do? It eats away the iron, the hole gets bigger. The life insurance company is also going to put a couple of smaller holes in the bucket as a result of administrative charges and then another hole for miscellaneous fees and costs (i.e. commissions).
The first step is to pay the premium and turn on one of the spigots. Depending on when and how often you pay your premium determines when and how strong the water flows into the bucket. Just don’t forget about the three holes that cause water to drip out of the bucket every month. Drip, drip, drip. Then at the end of the month the life insurance company will turn on that other spigot to splash in some water. Of course, if it’s a Variable Universal Life insurance policy, it will be more of a two way spigot (is that possible?) some months you might get water and other months they might take water. Then the whole process starts all over again.
Here’s the thing. The life insurance company and the agent selling you the Universal Life insurance policy tell you that there’s flexibility in how much and how often you put water in the bucket (through paying premiums). What they don’t always tell you is that the holes don’t go away. In fact, the biggest hole keeps getting bigger little by little and month by month.
Then you are told that you can access your money through surrenders and loans. When you take a loan from one of these Universal Life insurance polices you basically reach in and take a scoop full of water out of the bucket. Then the life insurance company drills another hole, but don’t worry they plug this hole. As long as you put some of that scoop of water back in, they keep the plug in the hole. However, if you don’t add the extra water they remove that plug every month to let some water drip out.
In the end it becomes a balancing act to make sure there is water in the bucket today, tomorrow and x amount of years from now. The problem is that the only thing you control is one spigot (premium). Everything else can and probably will change at any time. The other spigot might put more or less water than you thought into the bucket. The holes could drip out more or or less water. The rust might speed up the dripping. This creates a lot of unknowns and the life insurance industry sells it to you as “flexibility”. Make sense?
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While a guaranteed UL has some great uses, I find that the cost as compared to whole life insurance is such that why not use WL, with all its options
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Thank you for the comment. I like that you brought up guaranteed UL. For the post I didn’t mention it on purpose as to try to keep things simple. Under most situations I have seen and designed whole life policies that provide the same benefits of a guaranteed UL with a lot more flexibility. What most people don’t realize is that a guaranteed UL gives up all the flexibility that ULs are known for.
It may be because of where I work, but I have never seen anyone sell anything except a guaranteed UL, but I have only been in the business for 2 years and have been told that they are a *relatively* new product
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@Evan
That is pretty interesting. I actually use to work for a company that claimed to be a mutual company and the product they wanted sold was VUL. I’m going to have to put up a post on the guaranteed UL. I’m just really not a fan except for some very specific circumstances. What do you focus on in your financial business?
I am Director of Financial Planning for a financial planning firm – so I don’t focus on anything in particular. I am in house aid to about 40 planners. So I have to adapt to whatever that particular planner does, i.e. estate planning, business planning, straight term sales, or a mixture of those and more.
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