A Comparison of Term Insurance Rates to Protection-Related Charges in Universal Life Insurance

Abstract

Universal life insurance unbundles the protection and savings elements of traditional whole life insurance products. The product consists of periodic deposits into a fund, from which mortality and expense charges are deducted, leaving a net fund, to which interest is credited. The mortality charges usually are assessed monthly. In essence, universal life insurance allows the policyowner to pursue a strategy within a single contract, but with the advantage of tax-deferred accumulation on the savings/investment element.(1) This study examines the cost of the protection element in a sample of universal life insurance contracts vis-a-vis the cost of protection through the same insurers' annual renewable term policies. Several researchers have studied the return on the investment fund in universal life insurance (Cherin and Hutchins, 1987; Chung and Skipper, 1987; D'Arcy and Lee, 1987). As with studies that have examined the rate of return in universal life insurance, this study compares the cost of protection in universal life insurance to the cost of protection in an alternative policy. However, the focus of this study is not on universal life's implicit rate of return. The study's results provide insight into insurer universal life pricing practices and will be of value to insurance purchasers and other researchers. Literature Review We studied insurance contracts that combine death protection with savings to determine whether policyowners are better off purchasing the contract bundled or in separate parts (Cherin and Hutchins, 1987; Chung and Skipper, 1987; D'Arcy and Lee, 1987). Cherin and Hutchins (1987) examined the investment portion of a universal life insurance contract. They constructed an unbundled alternative to universal life comprised of annual renewable term insurance and an investment fund. Cherin and Hutchins solved for the interest rate that would cause the accumulation of the alternative fund to equal the investment accumulation in the universal life contract. Using the term insurance rates from a random sample of twenty insurers, they found that policyowners are typically better off purchasing a combination of annual renewable term insurance and an investment fund rather than buying universal life. They concluded that the substantial expense charges associated with universal life were the reason that it was outperformed by the unbundled alternative. Chung and Skipper (1987) examined the correlation between the current interest rates for universal life contracts and the surrender values generated by the contracts. They found that the universal life policies with the highest current interest rates do not necessarily generate the highest surrender values. They concluded that, for holding periods of five years or less, surrender values are affected more by expense loadings, mortality charges, and surrender charges than by the current interest rate. D'Arcy and Lee, like Cherin and Hutchins, studied the investment portions of both variable universal and universal life. They developed a model that compares universal life with a buy-term-and-invest-the-difference alternative. D'Arcy and Lee found that the tax advantages inherent in universal life contracts typically outweighed the expense and surrender charges when compared to alternative investments other than individual retirement accounts and other tax-deferred media. The D'Arcy and Lee model is able to vary the competitiveness of the death protection in the universal life when compared to term insurance. However, they assumed that the cost of death protection was the same in universal life as in term insurance. This study implicitly examines that assumption. Methodology Like the studies cited above, this study's methodology implicitly partitions the universal life contract into death protection and savings. All expense charges are allocated to the death protection part of the universal life contract. …