The universal life crisis: a potential fix for an underperforming policy.

• Author: Bruno, Susan J.

The many advantages and disadvantages of a prolonged low-interest-rate environment affect almost all areas of clients' personal financial plans. For example, low interest rates may be attractive to a young couple applying for a mortgage to buy their first home, but those same low interest rates on bonds and CDs hinder the lifestyles of many retirees on a fixed income. The interest-rate environment can also have a dramatic effect on universal life insurance policies.

Universal Life: How It Works

Flexible premium adjustable life insurance is the technical name for universal life insurance. Unfortunately, it is commonly confused with whole life insurance, since, unlike term insurance, it can remain in force for an insured's "whole" lifetime. Universal life operates differently from whole life, however, primarily due to its flexibility in making premium payments and transparency in policy illustrations.

A universal policy combines term insurance with an interest-bearing savings account. Just like whole life, the account value builds inside the policy tax free if used to support the cost of the risk at older ages. Unlike a whole life policy, a universal life policy can be funded in ways that best match a client with unpredictable cash flow. This premium flexibility therefore makes regular monitoring especially important to avoid unpleasant surprises.

Issue: Lack of Regular Monitoring

Universal life policies are highly sensitive to both the interest crediting rate and the choice by the policy owner to adhere to the premium funding schedule. The good news is that there is no requirement to make a premium payment, or even take a policy loan to make the premium payment, as long as the cash value can otherwise support the policy. That is the bad news, too. Not unlike saving for a child's education, the flexibility to choose not to make a payment may cause a shortage when the policy is needed most. Coupled with an assumption that interest would be credited at a higher rate than actually achieved in the policy, this could translate into a double disaster.

When any "permanent" insurance policy is purchased, certain assumptions have to be made by both the buyer and the company selling the policy. With universal life, the main assumption is the future crediting rate of the policy, which in turn determines the annual premium. This means that the higher the interest crediting rate, the lower the premium, based on current insurance charges.

The buyer also...