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Demystifying universal life policies
WE have advocated the use of term insurance instead of whole life policies since 2003. The thinking is pretty straightforward: the primary purpose of insurance is to replace income loss due to death, disability and a medical crisis.
Since there will come a time in our lives when we either no longer earn an income (as when we are retired) or no longer have dependents, there is no need for permanent insurance coverage. There are only a few situations where permanent insurance coverage is required - legacy planning and gifting are among them.
In recent years, the purchase of universal life policies (ULP) for legacy planning and gifting has become very popular among the high net worth and ultra-high net worth. This is partly due to aggressive marketing by many financial institutions.
What is a ULP?
Two main types of ULP are available in Singapore - traditional ULP and variable ULP. Variable ULP functions more like an investment-linked policy where premiums are invested in professionally managed funds chosen by the policyholder. Traditional ULP is similar to a whole life plan where the premiums are invested entirely by the insurer.
Traditional ULPs can be sold as a regular premium product but in Singapore, it is usually sold as a single premium plan with premium financing (taking a loan to fund a substantial portion of the premium) to reduce upfront premium outlay while enjoying a huge insurance cover.
For every $1 of the premium paid to the insurers to buy a ULP, a portion of it will be used to pay distribution and other costs, and the rest is invested. In Singapore, these policies are usually denominated in US dollars, and come with an annual minimum guaranteed return (crediting rate) that provides life protection coverage up to age 100 or 125. Due to space constraint, I will only be discussing traditional ULP here.
Some key features of traditional ULP:
1. Crediting rate
The crediting rate is the return you get from the investment portion of your ULP. It comprises a guaranteed portion - in Singapore, this is usually around 2 per cent - and non-guaranteed portion which depends on the insurer's performance. The guaranteed crediting rate for ULP ensures that the cash value of the ULP will increase by at least 2 per cent over time.
2. Sum assured = Higher of death benefit or cash value (CV)
After deducting premium charges (can range from 7 to 9 per cent of your single premium paid) and other distribution costs, the cash value of ULP normally starts at 70 to 80 per cent of the single premium paid. This cash value, after deducting ongoing costs like mortality charge, is expected to build up over time and may exceed the sum assured if the investment returns for the plan's underlying funds are very good.
3. Mortality charges (cost of insurance)
The coverage provided by the ULP is funded by deducting the mortality charge from the cash value on a periodic basis. The mortality charge usually increases across age bands at an increasing rate due to a higher claim risk at older ages. However, the absolute amount of mortality charges that will be deducted is dependent on the sum at risk.
Sum at risk = sum assured - cash value
As cash value increases over time, the sum at risk decreases. If cash value exceeds the sum assured, there is no more insurance element (sum at risk), hence no further deduction for mortality charges.
4. Fees and Charges
This includes premium charges, mortality charges, policy fee (admin charge by insurer and usually for the first five years of the policy term and surrender charges (surrendered early)
This mainly includes investment risk (lower than expected returns), currency risk (as the policy is usually in US dollars) and interest rate risks (for those on premium financing, an increase in interest rate makes loan servicing more costly).
How are ULPs marketed?
ULPs are usually touted as good instruments that allow the affluent to free up more cash for their retirement while still leaving a significant legacy.
Say an affluent individual has accumulated US$10 million at retirement but wishes to set aside US$5 million for legacy upon his demise. In this case, he can only retain US$5 million for his own retirement spending.
However, if he were to use US$1.3 million to buy a ULP with a sum assured of US$5 million, he can now have US$8.7 million for his own retirement spending instead.
But one can also use the cheaper alternative of a term insurance to achieve a similar outcome.
From the accompanying graphic, we can see that a term plan is still a more cost-effective option for legacy planning. However, the key risk of using term insurance is that one may live past 100 years old. The main attraction of a ULP is that the coverage goes beyond age 100.
In addition, ULP is eligible for applicants as old as age 80, while most retail term or whole life insurance has a maximum entry age of around 65 to 75. Healthier applicants might also be eligible to buy the policy at a discount due to good health. In addition, you can take a loan to finance the ULP premium.
But for all these advantages, you pay a higher premium than term insurance. While we do not rule out the usefulness of ULP, we don't think it is the holy grail to legacy planning.
So before you buy a ULP, do consider if you really want to spend so much. It is always good to consider other more cost effective options while understanding the trade-offs.
- The writer is CEO of Providend Ltd, Singapore's first and probably sole fee-only comprehensive wealth advisory firm. He can be contacted at email@example.com