Universal life insurance
Universal life insurance combines an insurance component and a savings and investment component. This summary describing how universal life insurance works will help you determine whether this type of insurance might be right for you.
Universal life insurance gives you lots of flexibility, particularly in determining the amounts and timing of your premium payments. Two types of universal life insurance are available: stepped premium universal life (premium increases with age) and level premium universal life (premium is fixed).
You can also choose how the money in your accumulating fundA capitalization fund is the amount accumulated in a universal life insurance policy. is to be invested, although you will still need to comply with the obligations set out in the contract.
Know the difference between “premium” and “cost of insurance”
Premium
With universal life insurance, the premium is any amount that you deposit in your accumulating fund. A portion of that amount goes toward covering the cost of the insurance. The rest is invested in order to accumulate funds.
Cost of insurance
The cost of insurance is the amount that the insurer deducts from your accumulating fund to cover the cost of insuring you.
The insurer will also deduct fees, including for managing the contract. In addition, a 3.48% tax is deducted from the amount you pay into the contract, including from the savings portion. The insurer may assume some or all of the tax. This tax could affect the amounts that will accrue in your accumulating fund. Ask your representative about the impact of the tax.
When you take out insurance, the premium you pay is higher than the cost of insurance. For example, if the cost of insurance is $400 a year, the insurer may allow you to pay up to $1,200. The amount in excess of the cost of insurance, after the 3.48% tax is deducted, accumulates tax-free in the accumulating fund for as long as you don’t make any withdrawals.
Paying the insurance premium from the universal life insurance account
This option is only available when you have enough money in your capitalization fund to pay the premium due in full.
End of the warningSavings and investment component
You can choose to invest the money in several types of investment products (e.g., segregated funds). The accumulated amount can be used to pay the cost of your insurance. You can also withdraw money, if you want, although you may have to pay income tax when you do this. You’re also not required to pay a premiumA premium, or insurance premium, is an amount that a person or company must pay on a regular basis to keep their insurance in effect. For example, if Mary has to pay $200 per year to keep her life insurance in effect, then the premium is $200.
The premium should not be confused with the face amount, or insured amount, which is the amount that the insurance company has to pay out. In the same example, if Mary has life insurance that pays $100,000 to Peter upon her death, then the face amount is $100,000. every year; however, you have to ensure that there’s enough money in the fund to cover the cost of insurance.
The insurer pays income tax
The insurer must pay 15% income tax on the investment income generated in your accumulating fund (some exceptions apply and there are limits on the amounts “invested” in the accumulating fund). Although you don’t pay this income tax directly, the amount may be built into the fees the insurer charges. Also, when you withdraw money, you may have to pay income tax, in which case the 15% tax paid by the insurer on the investment income may be reimbursed to the insurer.
Example of a universal life insurance contract
Anne takes out a $200,000 universal life insurance policy. The policy costs $700 a year. However, Anne can opt to pay up to $1,500 a year. She decides to make an annual payment of $1,300, and let the difference between the $1,300 she is paying and the $700 that goes to the insurer accumulate in her account. Here’s how it breaks down:
Start of first year: | |
|---|---|
Amount paid by Anne: | $1,300 |
Insurance cost, including fees and expenses: | - $700 |
Amount accumulated in the capitalization fundA capitalization fund is the amount accumulated in a universal life insurance policy.: | $600 |
Anne decides to invest $600 in a segregated fund offered by her insurer. She anticipates that her investment will generate a net return of 4% per year.
Start of the second year: | |
|---|---|
Value of account (previous year) | $600 |
Return credited to fund: (4% x $600) | $24 |
Amount paid by Anne : | $1,300 |
Insurance cost, including fees and expenses: | - $700 |
Amount accumulated in the capitalization fund at the end of the second year: | $1,224 |
Anne decides to let the interest accumulate in her account for 25 years.
Start of the 25th year: |
|
|---|---|
Amount accumulated in the capitalization fund: | $24,988 |
With $24,988 in her account, Anne can decide to stop paying her insurance premiums. She could also withdraw the funds and use them as she likes.
Beware! A screening is not a guarantee
Universal life insurance is often sold using projections showing the amounts you would accumulate based on various scenarios. They are not guarantees of the returns you will earn. Ask for projections with realistic figures.
You might even like to see an illustration of an unfavourable scenario, such as a year when your investment loses money.
End of the warning