Universal life (UL) insurance policies became popular a few decades ago, when they were touted as being more flexible and modern than traditional life insurance policies. The trouble is, they have features that need attention by policyholders as they near the end of their lives.
Another problem is that these policies were sold as tax-effective investment vehicles, overlooking the fact that they’re still life insurance policies whose primary function is to help support your loved ones when you die.
First, let’s learn a little more about UL policies and read about a real-life example involving the potential trap. Then, let’s look at four possible strategies you can implement to protect yourself and your family from unpleasant surprises.
Background on UL policies
Despite being promoted as an investment vehicle, a UL policy is still life insurance—it pays a death benefit if you die while the policy is in force. However, unlike many traditional life insurance policies, the premiums you pay aren’t fixed. In any year, you’re allowed to pay a premium that’s higher than the actual cost of insurance for the year. This excess amount accumulates as a cash value and is credited with interest or investment earnings.
The good news is, the interest or investment earnings on the cash value you hold isn’t taxed while it’s accumulating, which is why UL policies were sold as a tax-effective investment vehicle. Another tax advantage is that the death benefits paid under the policy aren’t subject to income taxes.
Under the terms of each UL policy, you might be able to withdraw the cash value at a later date and cancel the policy, if you decide not to continue the policy until you die. At that time, you’d be taxed on the interest or investment earnings on the amount of the cash value that exceeds the premiums you’ve previously paid.
Once you’ve accumulated a cash value, you’re permitted to pay a premium that’s less than the actual cost of the insurance for the year. In this case, to keep the UL policy in force, the insurance company draws the amount of the premium shortfall from your cash value to cover the full cost of the insurance. If your cash value is reduced this way for several years, your cash value could drop to zero and the insurance company would cancel your policy. Unfortunately, this situation can be common for someone in their 70s or older, since the annual cost of the insurance increases dramatically as you age.
A real-life example of the trap
The potential trap with UL policies can be illustrated by a real-life example that was recently brought to my attention. A family friend took out a UL policy in his late 50s. The sales agent recommended that he pay a premium amount each year that was well above the cost of insurance at the time the policy was sold. The policy accumulated a cash value for several years, and all seemed well.
However, when the family friend reached his 70s, he recognized that he might not continue to remember to pay the annual premium to keep the policy in force. So, he set up an auto-pay feature that automatically paid a fixed amount from his bank to cover the premiums to the insurance company.
However, the family friend didn’t realize that the cost of the insurance might rise significantly and that the auto-pay premium amount could then drop below the cost of insurance, which is exactly what happened to him. Eventually his cash value dropped to zero, and the insurance company canceled the policy.
The family friend died of COVID in his mid-80s, after he’d been quite frail for many years. His son applied for the insurance amount to help the surviving mother, and at that time, he learned that the insurance company had canceled the policy.
The insurance company had repeatedly mailed notices to the father, warning him of the impending cancelation. The problems were, the policyholder was too frail and distracted to pay attention to these notices, and the sales agent who sold him the policy was long gone.
This situation reveals a potentially serious flaw of UL policies: These policies should be designed to recognize that policyholders can become frail or suffer from dementia near the end of their lives, at a time when they might not respond to mailed notices. And neither the insurance company nor the policyholder can count on the sales agent being around to intervene many years after the policy was sold.
Four possible strategies to prevent unpleasant surprises
If you own a UL policy and are nearing or in your 70s, there are four possible steps you might want to consider taking to prevent unpleasant surprises from happening to you and your family.
First, inform your insurance company of a trusted contact who should be contacted if you stop responding to important notices. Many financial institutions and insurance companies are adding this feature due to their growing awareness of the problem of aging policyholders. You can often easily name a trusted contact by going online and updating your information.
Note that your trusted contact can only notify you if you’ve been receiving notices from the insurance company. They can’t act on your behalf unless you give them the legal authority through a power of attorney.
Second, check to see if your policy provides a no-lapse guarantee. Such a policy would keep your policy in place if you’ve made a minimum level of premium payments, even if the cash value has dropped below zero. Ask your insurance company or your agent whether your policy has such a feature and document the conversation. If your policy has such a feature, an auto-pay policy could keep your policy in force.
Here’s a third possible strategy: If you anticipate that there’ll be a time when you might be frail and not paying attention to key financial accounts, you could convert your UL policy to a traditional insurance policy with a fixed premium amount. This would allow you to keep the policy in force by automatically paying the premiums. Check with your insurance company—some let you take this step.
Finally, here’s a fourth possibility that occurred to another family friend in her 90s. The cash value on her UL policy was quickly dropping to zero as she paid premiums that were less than the cost of insurance, However, since she had been reading the notices from the insurance company, she was aware of the situation. She decided to let the policy expire, realizing that her adult children were financially independent and didn’t need the insurance. She communicated her decision to her adult children, so there would be no surprises after she passed away.
The bottom line is, if you’re in your 70s or older and own a UL policy, you don’t want to leave an unpleasant surprise to your family. Devise a plan for the policy now that will last for the rest of your life, no matter what happens.