How Universal Life Works

Understanding the mechanics of universal life is essential for the exam. This section explains how premiums flow through the policy and how cash value accumulates.

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The UL Cash Flow Process

When a premium is paid on a universal life policy, it flows through several steps:

The Monthly Cycle

Each month, the following occurs:

1. Mortality charge (COI) is deducted from cash value
2. Expense charges may be deducted
3. Interest is credited to the remaining cash value

If cash value falls to zero and no premium is paid, the policy lapses.

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Cost of Insurance (COI)

The cost of insurance (COI) is the monthly charge for death benefit protection. It represents the pure mortality cost.

How COI Is Calculated

Net Amount at Risk

The net amount at risk is the difference between the death benefit and the cash value. This is what the insurer actually "risks" paying from its own funds.

Example:

• Death benefit: $500,000
• Cash value: $100,000
• Net amount at risk: $400,000

The insurer charges COI based on the net amount at risk, not the full death benefit.

Exam Tip: As cash value grows, net amount at risk decreases, potentially lowering the COI charge. This is one reason why building cash value can be beneficial.

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Expense Charges

Universal life policies include various expense charges:

Front-End vs. Back-End Loads

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Interest Crediting Rates

Cash value earns interest based on rates set by the insurer.

Current Rate vs. Guaranteed Rate

How Interest Is Credited

• Insurer declares the current interest rate periodically
• Interest is credited to cash value monthly or annually
• Rate can change but cannot fall below the guaranteed minimum

Example

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Corridor Requirements

To maintain its status as life insurance (rather than an investment), a UL policy must maintain a minimum corridor between the death benefit and cash value.

What Is the Corridor?

The corridor is the required difference between:

• The death benefit (what's paid at death)
• The cash value (the accumulated account)

IRS Requirements

The IRS requires that the death benefit always exceeds the cash value by a certain percentage. If cash value grows too large relative to the death benefit, one of the following must occur:

Why It Matters

If the corridor requirement is not maintained, the policy could lose its tax-advantaged status:

• Death benefit would not be income tax-free
• Cash value growth could be currently taxable

Exam Tip: The corridor requirement prevents people from using life insurance purely as a tax-advantaged investment with minimal death protection.

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Minimum and Maximum Premiums

Minimum Premium

The minimum premium is the least amount needed to keep the policy in force:

• Must cover at least the monthly deductions (COI + expenses)
• If cash value is sufficient, no minimum may be required temporarily

Maximum Premium

The maximum premium is the most that can be paid without causing the policy to become a Modified Endowment Contract (MEC):

• Based on the 7-pay test
• Exceeding this limit triggers MEC treatment
• MEC policies have less favorable tax treatment for withdrawals and loans

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Policy Monitoring

Universal life policies require regular monitoring:

What Can Go Wrong

• If cash value is depleted, policy lapses
• Lower-than-expected interest rates can accelerate depletion
• COI increases faster as insured ages
• Original premium may become insufficient over time

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Key Takeaways

• Premium flows through expense charges → cash value → COI deductions → interest crediting
• COI is based on the net amount at risk (death benefit minus cash value)
• Cash value earns current interest rates with a guaranteed minimum
• The corridor requirement ensures death benefit exceeds cash value
• Minimum premium keeps the policy active; maximum premium avoids MEC status
• UL requires monitoring to prevent unexpected lapse