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Understanding Universal Life Insurance

As a society, financial independence is what we’re all striving for, particularly in this unstable economy. The best way to achieve it is to take things into your own hands; and make thoughtful investment decisions.

Insurance can be an investment vehicle where you can have the best of both worlds.  It’s a way to build financial independence and leave money to your heirs, provided you get insurance with an investment component.

Universal life insurance is a type of insurance that builds wealth. To see if this type of life insurance is something you should look into, below we will look at the basics to understanding universal life insurance (UL).

What is Universal Life Insurance?

Just like whole life insurance, it offers low-cost protection and has a savings element to help build-up cash value. The main difference is that with UL insurance, the policyholder can use the interest from the policies’ accumulated savings to help pay for the insurance premiums.

The Flexibility of Universal Life Insurance

One of the best things about UL insurance is its flexibility, because it allows you to:

  • Alter your monthly deposit;
  • Choose an increasing death benefit or a level benefit; and,
  • Adjust investment choices within a tax-sheltered account.

Variables to Consider Before Buying Universal Life Insurance

Because of UL’S flexibility there are variables to consider before buying this policy. Below we will look at tips to understand them better:

  1. Level Cost Insurance (COI) vs. Increasing Cost of Insurance (COI): Level COI guarantees that the cost of policy stays the same for life; while increasing COI offers a lower initial cost that escalates annually. The advantage of this is that it can accumulate cash quicker in the early years; the disadvantage is that if the investment portion doesn’t perform well, you will have escalating premiums.
  1. Risk Profile Choices: As with all investments, you have to decide what your risk level is – play it safe, or go for a higher possible return. For example, you can choose a safer savings account such as a GIC. Since this is such a major component of investments, you need to know your personal risk level.
  1. Death Benefit Choices: You can choose an increasing benefit (the basic face amount and any cash accumulation), or a level death benefit (limited to the basic face amount). The benefit of choosing a level death benefit is that the risk charge can decrease as the cash value builds. You end up with a lower risk charge, and higher cash accumulation.
  1. Accessibility to Cash Value: A lot of UL policies have very high costs associated with terminating coverage in the policies early years.
  1. Research: Policies can dramatically change between companies, so it is best to go to an independent broker to get advice that is unbiased.

One of the biggest questions you probably have now, is “What are the tax benefits of Universal life insurance?” Below we talk about the top tax benefits for Canadians.

Top 5 Tax Benefit Advantages of Universal Life Insurance

  1. Tax Free Death Benefits: Whether you choose a level COI or increasing COI, the policy amounts paid to beneficiaries is tax free.
  1. Tax Shelter: Universal life insurance policies have a policy accumulation fund component; and it grows on a tax sheltered basis. The majority of Canadian insurance companies offer a range of investment options, for all risk levels.
  1. No Impact on contribution limits for RSP and Tax-Free Savings Accounts: UL insurance contributions stand alone from all other tax-free savings or retirement accounts.
  1. Pre-tax Dollars for Accumulation Fund Withdrawals: When you use your policy accumulation fund so you can offset premiums in the future, you do it with pre-tax dollars. So the money within the fund will continue to grow under the protection of a tax shelter.
  1. No Tax Ramification: If the accumulation fund stays within the policy and is used against future premiums, there are no tax ramifications.

As you can see, choosing life insurance with an investment component, while a great idea for select people, it can be complicated. It’s very important to make an informed decision and weigh the pros and cons of each type. Universal life is really beneficial to some, but it’s not for everyone. Consult with a knowledgeable broker to learn more.

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Chantal Marr About the author: Chantal Marr is President of LSM Insurance, a leading Canadian life and health insurance brokerage, where she is in charge of product development. She has a B.A. from Laval University and Bachelor of Education from the University of Western Ontario. Chantal is a member of the Independent Financial Brokers of Canada, which gives her the flexibility to deal with all major insurance companies.

{ 18 comments… add one }
  • LifeInsuranceCanada.com July 27, 2015, 11:44 am

    1) -MER on TD TSX index fund e-series when purchased directly = 0.25%.
    -MER on TD TSX index fund e-series when purchased via a UL policy = 1.99%.

    2) The regulations that dictate how much you can invest inside a UL policy are changing and becoming more restrictive. If you’re looking to actually invest inside a universal life policy, you should do so now. If you wait, you will have less opportunity to take advantage of the tax benefits of these policies.

    3) The common terminology when talking about investments inside a UL policy is that it’s appropriate for ‘some’ people. Practically, ‘some’ means ‘almost nobody’. You need to have RRSP’s, pensions, RESP’s and TFSA’s all maxed out before this likely makes any sense. What’s missing in most UL investment sales is a comparison of alternatives.

  • JS July 27, 2015, 12:21 pm

    MDJ, do you have an universal life insurance for yourself?

    • FT FrugalTrader July 27, 2015, 7:56 pm

      @JS, I do not have UL, only term life.

      • Alpha Centauri July 28, 2015, 2:56 pm

        I think term life makes way more sense for most people. I remember having a discussion with an insurance salesman recently. He did the usual fussing over how universal life was so much better: the tax-free benefit, the cash component, the nest egg for your heirs, etc, etc. I couldn’t help but notice that my ANNUAL term premium was about the same as a few months of universal life. I sure could tell this insurance salesman got a helluva better commission if he sold universal life! I was rather upset, because I think he failed to convey why people should buy life insurance. You do not buy life insurance to get a cash component or leave a nest egg when you die at age 95. You get life insurance for one reason only: in case of a catastrophe, you need emergency support for your dependent children and spouse! Plain and simple. Your home, RRSPs, TFSAs, RESPs and other outside investments should more than handle everything else.

  • Chantal Marr LSM Insurance July 27, 2015, 12:38 pm

    @ LifeInsuranceCanada You make some very good points.

    In some instances a Minimum Funded UL is actually less expensive than a T100.

    The tax sheltering was a bigger feature in years gone by before TFSAs, RESPS and increasing RRSP limits. But they are still some wealthy Canadians who can benefit from this.

    Also if you use the Accumulation Fund from a UL to pay your premiums you are paying your premiums tax free with money that has grown on a tax sheltered basis.

  • LifeInsuranceCanada.com July 27, 2015, 3:07 pm

    >>>>Also if you use the Accumulation Fund from a UL to pay your premiums you are paying your premiums tax free with money that has grown on a tax sheltered basis.

    Yes, you can. But you can do the same thing from within a TFSA with a much much lower MER – so higher rate of return.

    Again, the problem with these sales strategies is that the positive benefits are promoted (fair enough), but without providing the consumer with a comparison of alternatives – those alternatives which are almost always better than investing in a UL.

    I’m a glass is half empty person when it comes to investing in a UL policy.

  • Chantal Marr LSM Insurance July 27, 2015, 3:15 pm

    You could use a TFSA assuming there is enough contribution room and the government does not change the contribution limits or rules around the TFSA plan. This would also involve more paperwork (not a huge issue) But it would involve selling investment within TFSA and applying the money to UL policy.

    Good point the need for disclosure. Disclosure rules on UL policies have increased but more is likely needed. 10-15 years ago signed illustrations were not even required.

  • LifeInsuranceCanada.com July 27, 2015, 3:37 pm

    I was working as an illustration actuary when they brought out the illustrating signature requirements (I’m not an actuary, so they changed the title of the role when I took it on).

    The purpose behind signing UL illustrations isn’t for disclosure. It’s to CYA for the insurance companies.

    Here’s an example of the downside of these policies:
    http://www.milliondollarjourney.com/is-your-life-insurance-policy-about-to-implode.htm

    I don’t mean to be contradictory, but I do think it’s important for consumers to realize that these ‘benefits’ are not meant for almost any of us. The industry likes to sell them, but they’re for the most part, not good for consumers.

  • Chantal Marr LSM Insurance July 27, 2015, 3:53 pm

    Its an interesting discussion. A lot of insurance companies have exited the UL market place. Assumption Life and RBC have left and all the other have all increased their level cost UL rates by 30% or more. These products are very tough on insurers in a low interest rate environment.

  • Chantal Marr LSM Insurance July 27, 2015, 4:04 pm

    An example of this. I took out a level cost UL policy in 2000.

    The current cost all things being equal has increased by 37% and the plan has a very aggressive minimum interest rate guarantee.

    I’m not saying it is or would have been a fit for everyone but I’m certainly glad I bought this policy.

  • Manish July 27, 2015, 5:46 pm

    Is this a paid post??
    I never expected to read such articles on MDJ. The benefits are highlighted and negatives are buried in an external link. Its not a balanced article. It seems to imply that UL is suitable for vast majority of readers. Actually the converse is true. Its toxic for vast majority of readers and might be useful for a very small subset.

  • M July 28, 2015, 11:20 am

    Excellent summary, but, looking at my UL policies, there are costs which appear small at first glance but are in fact very high in UL policies (that the insurance sale agent would rarely if not never tell you until after the fact, e.g. too late):
    – deposit load: 2% of new deposits;
    – coverage cost: 3%;
    – policy charges: $144 ($12/month);
    – high costs of riders and options;
    – Industrial Alliance Maximizer option (increasing term UL): 1-2% so that after 10 years, the policy face amount goes down by 10% per year until it reaches $10,000;
    – mgt fees for the investment vehicles: the agent makes you believe that your investments are in CI, Fidelity… mutual funds while all along there are only the insurance co’s index funds that follow those mutual funds at charges of 2-3% per year instead of less than .5-1% for index funds and ETFs outside the policy;
    – ultra-high surrender charges before 10 years;
    – all investment gains at surrender time are 100% taxable, including those that were used to pay the policy – our result was that after 10 years, we had less left than the initial deposit for investment.

    Now, do the maths. That’s a lot of $ taken out of your insurance policy tax-sheltered (but not fee-sheltered) investments and worse, you cannot deduct any of those costs from your taxes.

    I got rid of my IA policy that we were tricked into buying and stuck in keeping for 10 years. Meanwhile, the Ottawa broker agent did some fraudulent investment changes without our consent, including forging our signature. Suing them result in the broker agent and insurance people covering themselves and lying left and right; as well, the OBC and other regulatory bodies are totally useless organizations in helping you. Bottom line, since the costs are so well hidden in a highly secretive industry and not communicated to you, you yourself find out about them through third parties or poor investment performance… Too late to do anything.

    • LifeInsuranceCanada.com July 28, 2015, 4:39 pm

      M, A cursory glance suggests only two of those items would be out of line.

      If the deposit load is actually a deposit load, fair enough. But I think that may not be a deposit load, but a premium tax (I could stand to be corrected). Premium tax is 2-3% on all policies including term. But it’s only disclosed on UL. The premium tax is hidden on other types of insurance.

      Policy charges and rider option charges may have been high but they don’t seem that far out of line with other policies. $5-$10/month policy fee is common, including on term policies.

      The Maximizer option, that sure looks like not a cost option, but instead a plan design that reduces the insurance automatically. Reducing the insurance means lower insurance costs (allowing more of your premiums to go towards investments). If you’re trying to leverage the policy as an investment, this would be a good thing. IF you’re trying to leverage the policy that way :).

      Management fees and surrender charges – absolutely a fair criticism. I don’t think these are understood by consumers until too late. They’re one of the main reasons not to use UL as an investment vehicle.

      As for the taxation, again, not a drawback – this is no different than an RRSP. You don’t pay taxes on the growth until you withdraw funds – then you pay taxes. Gotta pay the tax man at some point, UL is not unique in that respect.

      If you find yourself not wanting the policy after you’re in to it too far, sometimes cutting and running works – as you did. Alternatively, sometimes it makes sense to reduce the coverage to as low as possible (lowering the insurance costs) then sitting on the policy until the surrender fee period is over – then cashing out.

      I would disagree that the costs are hidden in a universal life. They’re one of the most open contracts out there. The problem is, nobody reads the contract. The policies may be being missold, but caveat emptor applies – if you’re purchasing what amounts to a contract, you better read the contract. You have 10 days to read the contract when you receive it.

      Curiously, one of the things we can’t do in Canada is switch funds from one UL policy to another without collapsing the policy and triggering taxes. We can do it for RRSP’s and TFSA’s, and they can actually do this in the U.S. (it’s called a 1035 transfer). I’d love to have a 1035 transfer option here, for the odd time a consumer wants to keep a permanent UL policy, but wants to switch policies.

  • jer July 28, 2015, 12:57 pm

    I used to love coming to this website for good information, but now with all the ads for nebulous products like investment newsletters and now this totally unbalanced post about insurance that will work against the vast majority of people, I feel like this is not doing a good service anymore.

    I understand generating content all the time may be difficult but I really feel the value these personal finance blogs provide is unbiased advice. I feel like this site is straying from that message.

  • Dwilly July 29, 2015, 11:29 am

    For most people, these are probably a horrible idea. Like most “advanced financial engineering” instruments, they are confusing, nearly impossible to understand all the details and implications, and generally designed to be fairly safe (high chance of benefit) to the issuer at the expense of the consumer, who cannot hope to understand the product. These rank right up there with market-linked GICs and the RESP lady at the fair for me.

    If you very clearly understand the product and its implications (which 99% of people don’t), and have a very specific need in line with that (which 99% of people don’t), then there may be some limited application. For just about anyone else reading this, avoid these like the plague in favor of simple investments and simple term policies, as other commentators have pointed out above.

    (And BTW, like with any financial advisor, you ought to ask any insurance broker/advisor how they are paid, and to understand what their incentive might be for selling more sophisticated products. Just because one titles himself an “advisor” does not guarantee that he is acting properly as your fiduciary.)

  • Brian Poncelet,CFP August 24, 2015, 1:26 am

    Hello FT,

    TAXES. One reason owners who run cash rich companies (which of course are incorporated is taxes and long term planning).

    Cheaper After-Tax Dollars
    Generally, premiums paid under a life insurance policy are considered capital outlays and not outlays or expenses made or incurred by a taxpayer for the purpose of gaining or producing income from a business or property. Therefore, a deduction is generally prohibited under the general limitation for payments on account of capital in paragraph 18(1)(b) of the Income Tax Act (the “Act”). As a result, life insurance premiums are usually paid with after tax dollars. Often it is desirable to fund a policy with the cheapest after-tax dollars
    available. The taxpayer with the lowest tax rate requires less pre-tax income to pay the premiums; their dollars are “cheaper”.

    The other big factor is of course TAXES. (Why term loses over the long haul and the buy term and invest the difference is very difficult for people who have built a large nest egg).

  • Steve D September 12, 2015, 12:48 pm

    It pains me to say, but this reads as aa bit so thinly veiled paid advertisement for universal life insurance, and the author’s insurance brokerage. I don’t mean to be out of line, but frugal trader and MDJ you’re better than this. There are already myriad ptions on the internet that are actually just sales pitches, but subtly written as though they are informative and objective. Frugal trader, please don’t sell out what you’ve created and instead stick to the information and honest authorship that made your site such a success! This is disappointing.

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