Universal Life Insurance

1. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Characteristics • Flexible premium • Policyowner is permitted to select whatever premium he or she wishes to pay (within limits) • Policyowner can adjust, change and skip premiums • As long as cash values are sufficient to cover policy charges • Current assumption • Current interest rates, mortality and expense loads determine what additions are made to the cash value • Adjustable death benefit • Policyowner's are permitted to raise or lower their policy death benefits • Increases may be subject to evidence of insurability

2. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • When is the use of this tool indicated (cont'd) • When policy flexibility is desired • For young families • Flexibility to adjust to changing needs in the future • In the business market • Split dollar plans • Key employee coverage • Funding Buy-sell agreements • Nonqualified deferred compensation agreements

3. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Advantages • Premium flexibility • Death benefit flexibility • Note – decrease are permitted,but reductions in the first seven years could create adverse tax consequences • Policy is transparent • Unbundling of policy allows policyowner to track policy values, loads, expenses and death benefits via policy statements • Death Benefit Options • Option A – Level death benefit • Option B – Increasing death benefit (base face amount plus account value)

4. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Advantages • Cost of living rider • Increases death benefit by increase in the consumer price index without evidence of insurability • Back-end loads • Greater percentage of initial premiums go into cash values • Policyowner directly participates in the favorable investment, mortality and expense experience of the company • Cash value increases accumulate income tax deferred

5. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Advantages (cont'd) • UL policies have typically paid a higher effective rate of interest on cash values than have tax-free municipal bonds • Cash values are not subject to fluctuations in market values characteristic of longer term municipal bonds and other longer term fixed income investments when market rates change • Policies values can be borrowed at a low net cost • Policyowner's can withdraw a portion of their policy values without surrendering the entire policy

6. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Disadvantages • Policyowner can easily allow their policy to lapse due to the flexibility of premium feature combined within inadequate premiums being paid • Policyowner bears risk of of adverse trends in mortality or expense loads • Direct recognition method • Borrowed cash values are credited with a lower interest rate than are borrowed cash values • Considerable surrender charges in the first 5 to 10 years • Policy flexibility may create a modified endowment policy inadvertently

7. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Tax implications • General tax rules • Cash values grow tax deferred • Death benefits are paid income tax free • Policyowner can withdraw up to their basis and take policy loans income tax free • For Non-modified endowment policies • Exceptions to the cost recovery rule • Withdrawals coupled with reductions in death benefits • Years 1-5 • Any withdrawal may be taxable if there is a gain in the policy • Years 6-15 • Taxation of withdrawal based on mathematical test • Cash value corridor test

8. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Tax implications (cont'd) • Modified Endowment Contract (MEC) Rules • Penalty for classification as a MEC relates to distribution • Distributions are taxed under the interest first rule rather than the cost recovery rule • In addition, these distributions are subject to a 10% penalty tax if they occur before the policyowner reaches age 59 ½, dies or become disabled • Distributions include withdrawals and loans

9. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Tax implications (cont'd) • Modified Endowment Contract (MEC) Rules (cont'd) • Ways to run afoul of the MEC rules • Increase in premium payments during the first 7 contract years may push cumulative premiums above the amount permitted under the “seven Pay Test” • A reduction in death benefit during the first seven contract years triggers a re-computation of the seven pay test • A material change in the death benefit at any time triggers a new seven pay test which is applied prospectively • UL illustrations will indicate the maximum amount (the seven pay premium) that may be paid over the first seven years, without classifying the policy as a MEC • If the policyowner inadvertently violates the test, they have 60 days (typically) to reverse the transaction that created the MEC

10. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Tax implications (cont'd) • Modified Endowment Contract (MEC) ) • Alternatives • Current assumption whole life (CAWL) • Also called interest sensitive whole life • Universal life without the adjustable features • Adjustable Life (AL) • Combines elements of fixed premium ordinary life and the ability to alter, within limits to alter the policy plan, premium payments and face amounts • Variable life (VL) and variable Universal life (VUL)

11. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Fees and Acquisition Costs • Surrender charges • Spread over 5 to 10 years • Decline yearly • Explicitly shown on the Illustration • Difference between the account value and the net cash surrender value • Commissions • Based on a percentage of the “Target Premium” • Target premium is generally the level annual premium payable if the policy was configured as a level premium whole life policy • Initial commission generally between 20% and 90% of the target premium • Renewal commissions generally between 2% and 5% of the target premium

12. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Fees and acquisition costs (cont'd) • Policy issue and administrative expenses • Flat dollar amount, or • Percentage of premium, or • Fee per $1,000 of face amount • Typically around $25 - $50 per year plus 5%+ of premium • Selecting the best policy • Complex determination due to the many components of UL policies • One critical element is the amount credited to cash surrender values

13. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Selecting the best policy (cont'd) • Factors involved in crediting amounts to cash values • Expense charges • Fixed fee plus a percentage of premium • Not explicitly stated in illustration • It is defined in the policy contract • There is a current (expected) charge and a guaranteed maximum charge • Mortality charge • Based on a mortality table the carrier selects for this policy • 2001 CSO Mortality Table • 1990 CSO Mortality Table • 1980 CSO Mortality Table • 1958 CSO Mortality Table • Which table they select is up to the actuaries

14. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Selecting the best policy (cont'd) • Factors involved in crediting amounts to cash values (cont'd) • Mortality charges (cont'd) • Current mortality charges • Guaranteed maximum mortality charges • Optional illustration column will show these charges • Formula that created these charges is proprietary to carrier • Net Investment Yield • Insurance companies cannot credit more interest to policies cash values than they earn on their general investment portfolio • Generally, the portfolios are predominately invested in long term corporate and government bonds and mortgages

15. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Selecting the best policy (cont'd) • Factors involved in crediting amounts to cash values (cont'd) • Net Investment Yield (cont'd) • There are differences between insurance companies assets with regard to: • Proportions invested in in each type of asset • Quality • Duration • Yield • Level of Risk • With regard to investment portfolios and investment philosophies • Reasonable and acceptable combination of “Risk and Return”

16. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Interest crediting methods • Linked rates • External well known index of yields • One year T-Bill rates • Intermediate term high quality corporate or government yields • Discretionary • As declared by the insurance company • Portfolio • Rate of return on the companies general investment portfolio • A blend of rates earned on new and old money

17. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Interest crediting methods (cont'd) • Linked rates (cont'd) • New Money • Rate of return being earned on new investments the company acquires with current premium dollars • Average current market return on the company’s new investments • More responsive to changing market interests rates than portfolio rates • New money crediting rates will rise faster and fall quicker than portfolio crediting rates • Blending • Weighted blend of new money and portfolio crediting methods

18. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Interest crediting methods (cont'd) • Linked rates (cont'd) • Modified portfolio • Credits a specific percentage of of cash value and current premium with new money rates • The rest of the cash value gets the “old” new money rates that applied in previous years • Direct recognition • The crediting rates applied to cash values is split • A crediting rate (current) against un-borrowed cash value • A crediting rate against borrowed cash values (typically lower than the policy loan rate. (Some carrier will credit the loan rate against the loaned cash values creating a “wash loan” effect)

19. Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning • Interest crediting methods (cont'd) • What the illustrations do NOT tell you • What investment strategy underlies the crediting method • How the current mortality charges relate to the guaranteed mortality charges • As a percentage • What margin exists for the company to increase mortality charges • The rate of return on death benefit and cash surrender value • Some companies have this as an optional column that you must request to get illustrated