How to Avoid the Underfunded Universal Life Insurance Trap

A while back, a family member of mine bought a life insurance policy they thought was going to last their whole life. They paid the premium the insurance company told them to pay when they got the policy. They never missed a premium. They paid on this policy for 10 years.

However, when they reached 65 years old, they got a letter from the insurance company that let them know the insurance company would have to raise the premium because there wasn’t enough cash value in it. Since they couldn’t afford the premium, they had to let the life insurance policy lapse.

The end result?

Essentially, the life insurance company got out of the life insurance even though my family member did everything they were asked to do.

The sad thing is that his isn't an isolated case. Here's a story in Forbes, another one in the New York Times and yet another in InsuranceNewsNet.com. These articles and many others I found detail the same problem.

I call this problem the underfunded universal life insurance trap.

What is the Underfunded Universal Life Insurance Trap?

The underfunded universal life insurance trap is when the insurance company creates a life insurance policy that transfers interest rate risk from the insurance company over to the policyholder.

Interest rate risk is when the rate of return isn’t high enough to support the policy for life. And when there isn’t enough money, the insurance company eventually asks you to pay more money to them (like happened to my family member above).

In exchange for accepting the interest rate risk, the insurance company allows the policyholder to pay a lower premium. In most cases, this lower premium “underfunds” the policy almost guaranteeing that it will not last for life.

The problem is that most people don’t know they’ve assumed this risk when they buy a universal life insurance policy until years down the road. By the time they find out, they are much older, maybe in their 60’s and 70’s.

When faced with being forced to cough up more money, most people opt not to and just let the policy lapse.

What Causes Underfunded Policies

There are five reasons you might have an underfunded policy. Let's talk about each of those.

1. Premium too low If the premium is the lowest the insurance company will accept, there's a good change it'll be underfunded down the road.
2. Not paying your premium If you don't pay your premium, then your policy will eat away at the cash value and cause it to be underfunded.
3. Borrowing against the universal life cash value If you borrow from the cash value, you increase your chances of underfunding (especially if you don't pay the interest).
4. Returns too low If you don't earn a high enough return, there will be less money in the policy. This creates an underfunded situation.
5. Cost inside the policy have increased If the insurance company increases the costs inside the policy, it will also increase the likelihood the policy will be underfunded.

The biggest problem I see is that most people pay the minimum required premium. The other causes of underfunding make the problem much worse.

How to Tell if You Have an Underfunded Universal Life Insurance Policy

If you have a universal life insurance policy, obviously you need to take a closer look at it. To find out if your policy is underfunded, there are three things you can look at to start the process of figuring it out.

Those places are:

1. The sales illustration provided when you bought the policy The illustration should provide additional details on what to expect from the policy.
2. The life insurance policy The policy will you give you more information into what premiums are needed to keep the policy inforce.
3. The annual statement The annual statement usually says how long the policy will stay inforce under the current assumptions. Figure out how old you’ll be and that’s how long the policy will stay inforce.

I always thought the annual statement is the easiest place to find out if your life insurance policy is underfunded.

Actual Example of an Underfunded Universal Life Insurance Policy

A couple of years ago, my wife’s employer offered a universal life insurance plan to their employees. The offer was guaranteed issue which means we could get the life insurance without any medical questions.

As you can probably guess, I’m not big on universal life insurance but since my son has a medical issue, I told her to sign up for it.

After we got the policy, I read it carefully and found the following language:

• Based upon guaranteed maximum cost of insurance rates (the highest rates We may charge) and the guaranteed minimum interest (the lowest interest rates We may credit), coverage will expire before the Final Policy Date unless premiums in excess of the Minimum Premium Due at Issue are paid.

The language right in the policy warns me right up front that I might need to pay more than what the insurance company pays.

When you read language like that, I think it’s important to realize that you will most likely pay more than you are being told you have to pay now.

There's also the very real danger that years down the road, you may lose that policy.

Steps to Avoid Losing Your Life Insurance When You are Older Because it's Underfunded Now

Now that you know how to identify this problem, let's talk about a few things you can do to avoid this problem

1. Don't buy universal life insurance Unless you know what you are buying just don't buy it. Most people have no clue that they may have problems with their universal life policies down the road. I never offer universal life insurance to anyone for purchase.
2. Pay more than the minimum premium Look at your life insurance documents to identify the best premium to pay and then pay that. For my son's policy I talked about above, that meant I needed to pay about $100 more per year than what the insurance company told me I needed to pay.
3. Pay every premium on time If you don't pay your premiums, then a universal life insurance policy is almost guaranteed to fail down the road.
4. Review your policy annually When that annual statement arrives each year, evaluate if you have to put more money into the policy. The best way to do this is take a look at the illustration you received when you bought the policy. If the value you are supposed to have is less than what you actually have, then pay that difference then.
5. Don't borrow against the universal life policy Never borrow against a universal life policy.
6. Buy whole life insurance instead of universal life insurance if you want permanent coverage If you really want a permanent life insurance policy that lasts your whole life, then buy a whole life policy which moves the interest rate risk back to the insurance company where I think it belongs. Here's a video I did that talks about the difference between universal life and whole life insurance.
7. If you can't fund your universal life policy properly, consider buying term insurance instead If you don't fund a universal life policy properly, it'll lapse at some point. If it's going to lapse, then it's basically an expensive term policy. You'd be better off buying a term policy in that scenario.

These tips won't guarantee you that you won't have an underfunded policy but they will lessen the risk of it being a problem. The key is you have to really stay on top of your policy every year and fund it properly.

In addition to that you also want to avoid a huge list of other life insurance mistakes as well.

Conclusion

If you can't tell, I dislike universal life insurance policies. That's because the life insurance companies transfer interest rate risk over to you, the policyholder.

There's a reason that insurance companies transfer that risk over to you. That's because insurance companies aren't stupid. They don't want to take on that risk.

You have to ask yourself this.

If the insurance company is an expert on risk, and they don't want to accept that risk, why do you think you should? 

The answer is you shouldn't.

Stick to term and traditional whole life insurance instead.

Let me know in the know in the comments if you have any questions.

Also, if you need some individual life insurance, and want to help support this site, why not let me be your life insurance agent. Click the blue button just below or click ask for a proposal.