Universal Life and Variable Life Mechanics
Universal life and variable life both let the owner pay flexible premiums, and both carry a policy value that moves with credits and charges. They differ in who carries the investment risk. The arithmetic of each policy comes first, then Michigan’s rules for universal life (MCL 500.4001, 500.4037 and 500.4038) and for variable life (R 500.841 to R 500.866). The federal tests that decide whether a flexible policy is still taxed as life insurance come last. Names and figures in the examples are invented and are not statutory figures.
What a Universal Life Policy Does Each Month
Michigan defines universal life by its bookkeeping. It is a policy under which separately identified interest credits and mortality and expense charges are made to the policy (MCL 500.4001(g)). The amount to which those credits and charges are made is the policy value (MCL 500.4001(f)). In a flexible premium policy, the owner can vary the amount or timing of premiums, or the amount of insurance, independently of each other (MCL 500.4001(c)). A fixed premium universal life policy is any universal life policy that is not flexible (MCL 500.4001(b)).
Every month the insurer runs the same four steps:
- Add the premium received, less any premium load (a percentage taken off each premium for the insurer’s expenses and taxes).
- Deduct the cost of insurance, called COI. This is the price of the pure protection the insurer is providing that month. It equals a rate per $1,000 times the net amount at risk, which is the death benefit minus the policy value.
- Deduct the monthly administrative charge and the charge for any riders.
- Credit interest on what is left.
Michigan groups the factors that set the price into “policy cost factors”: interest, mortality, expense charges and fees, including any surrender or withdrawal charges (MCL 500.4038(1)). Insurers differ on the order of the steps.
A Six-Month Roll-Forward
Marisol Teague buys a flexible premium universal life policy with a $250,000 face amount and the level death benefit described later as Option A. She pays $250 a month. The policy’s terms for this example are a 6% premium load, a monthly administrative charge of $8, a COI rate of $0.12 per $1,000 of net amount at risk, and interest credited at 0.3% a month on the balance after charges. To keep the arithmetic plain, the example works in monthly rates. It measures net amount at risk as the face amount minus the policy value after the month’s premium is added. Every figure is rounded to the cent at each step.
Month 1 shows each step.
- Premium $250.00 less the load of $15.00 (6% of $250) leaves $235.00.
- The policy value before charges is $235.00, so the net amount at risk is $250,000 minus $235.00, or $249,765.00.
- COI is 249.765 thousand times $0.12, or $29.97.
- The balance after COI and the $8.00 charge is $235.00 minus $29.97 minus $8.00, or $197.03.
- Interest is 0.3% of $197.03, or $0.59.
- The policy value at the end of month 1 is $197.62.
Months 2 to 6 follow the same steps.
| Month | Net premium | Net amount at risk | COI | Admin charge | Interest | Policy value, end |
|---|---|---|---|---|---|---|
| 1 | $235.00 | $249,765.00 | $29.97 | $8.00 | $0.59 | $197.62 |
| 2 | $235.00 | $249,567.38 | $29.95 | $8.00 | $1.18 | $395.85 |
| 3 | $235.00 | $249,369.15 | $29.92 | $8.00 | $1.78 | $594.71 |
| 4 | $235.00 | $249,170.29 | $29.90 | $8.00 | $2.38 | $794.19 |
| 5 | $235.00 | $248,970.81 | $29.88 | $8.00 | $2.97 | $994.28 |
| 6 | $235.00 | $248,770.72 | $29.85 | $8.00 | $3.57 | $1,195.00 |
Marisol has paid $1,500 and the policy value is $1,195.00, so $305 has gone to load, COI and charges. The policy value is not what she can take. A surrender charge is a fee for giving up the policy in its early years, and the net cash surrender value is the policy value less that charge. Michigan defines net cash surrender value as the maximum amount payable to the owner on surrender (MCL 500.4001(e)). Suppose this policy’s surrender charge is $1,000 in the first year. At the end of month 6 she would receive $195.00.
Michigan requires the policy to explain these mechanics. It must describe how cash surrender values are calculated, including the guaranteed maximum expense charges, the guaranteed maximum mortality charges, the guaranteed minimum interest rate and any surrender or partial withdrawal charges (MCL 500.4037(d)).
Current Assumptions and Guarantees
The $0.12 COI rate and the 0.3% credit in the example are current assumptions, which the insurer may change. The policy also states guarantees: a maximum COI rate and a minimum interest rate. Run Marisol’s first year at $250 a month on the current basis and the policy value at the end of month 12 is $2,412.55. On a guaranteed basis, with a maximum COI rate of $0.18 per $1,000 and a minimum credit of 0.2% a month, it is $2,215.33. The $197.22 difference is what the insurer’s current assumptions add in the first year. They are not promised, so a sound plan does not depend on them.
Michigan makes illustrations show both sides. They must carry the corresponding guaranteed factors, clearly identified, and a statement that current rates and charges are not guaranteed and may be altered (MCL 500.4038(2)(a)). A policy value must be shown with the net cash surrender value (MCL 500.4038(2)(b)). If the guaranteed factors would exhaust the policy value before the maturity date, that fact must be disclosed, with a notice that coverage will terminate (MCL 500.4038(2)(f)). The statement of policy information given at application may not show an interest rate higher than the current rate actually being paid or the rate the policy guarantees (MCL 500.4038(3)). A producer who adds a more optimistic column breaks this rule.
If the statement is not given at application, it must be delivered within 15 working days and at least 5 days before the policy. A policy delivered less than 5 days after the statement extends the free look to 15 days (MCL 500.4038(4), (5)).
Premium Level and Value
Flexible premium does not mean any premium works. The same policy at three premium levels shows why. Using the current basis above, the policy value at the end of month 12 is:
| Monthly premium | Premiums paid in year 1 | Policy value, month 12 |
|---|---|---|
| $100 | $1,200 | $685.87 |
| $250 | $3,000 | $2,412.55 |
| $400 | $4,800 | $4,139.27 |
The charges are nearly the same in each row, because the net amount at risk barely changes, so the owner who pays the most keeps the largest share. Two premium terms appear in policy language and sales material. A minimum premium is the amount that keeps the policy in force for a stated period, and in practice many policies promise that coverage will not lapse during the early years if cumulative premiums meet it. A target premium is the planned premium the insurer uses to build the policy’s pricing. Surrender charges and commission schedules are commonly expressed as percentages of premium up to that target. Both describe insurer practice, not statute, and the policy states the actual amounts.
Cost of Insurance Over Time
The COI rate rises with the insured’s age, because the chance of death rises. A premium that is comfortable at 40 can starve the policy at 70. The rates below are invented to show the pattern. They are not a table.
| Attained age | Example COI rate per $1,000 a month | Monthly COI on $200,000 net amount at risk | Annual COI |
|---|---|---|---|
| 40 | $0.10 | $20.00 | $240.00 |
| 55 | $0.32 | $64.00 | $768.00 |
| 70 | $1.10 | $220.00 | $2,640.00 |
A level premium that covers a $240 annual COI with room to spare at 40 may not cover $2,640 at 70. On a flexible premium policy, the annual report must say so when, on guaranteed interest, mortality and expense loads, the net cash surrender value will not keep the policy in force until the end of the next reporting period without more premium (MCL 500.4037(a)(viii)).
The Annual Report
Every universal life policy must provide a free annual report showing the policy value at the start and end of the period, every amount credited or debited identified by type (interest, mortality, expense, riders), the current death benefit, the net cash surrender value and any outstanding loans (MCL 500.4037(a)).
Lapse
A universal life policy does not lapse on a due date, because it has none. It lapses when the policy value can no longer pay the monthly charges.
Take a policy with a $180.00 policy value, no premium paid for several months and monthly charges (COI plus administrative charge) of $95.00. After month 1 the value is $180.00 minus $95.00, or $85.00, plus 0.3% interest of $0.26, which is $85.26. At the start of month 2 the charge of $95.00 exceeds the $85.26 left. The value is exhausted in the second month.
Michigan sets the protection around that event. The policy must provide for written notice to the owner’s last known address at least 30 days before coverage terminates. A flexible premium policy must give a grace period of at least 30 days after lapse, and lapse occurs on the date the net cash surrender value first equals zero, or as the policy otherwise defines it (MCL 500.4037(g)). An owner who pays during that period keeps the coverage.
Death Benefit Options and the Corridor
Universal life lets the owner choose how the death benefit relates to the policy value.
- Option A pays a level death benefit: the face amount. As the policy value grows, the net amount at risk shrinks, because the insurer is covering a smaller gap.
- Option B pays the face amount plus the policy value. The net amount at risk stays equal to the face amount, and the death benefit rises as the value rises.
Take Marisol’s policy at a later date, with a policy value of $40,000, a face amount of $250,000 and a COI rate of $0.35 per $1,000.
| Option A | Option B | |
|---|---|---|
| Death benefit | $250,000 | $290,000 |
| Net amount at risk | $210,000 | $250,000 |
| Monthly COI | $73.50 | $87.50 |
Option B costs $14.00 more each month because the insurer is covering a larger gap, and it pays $40,000 more at death. Option A keeps cost down, and the owner’s cash value is in effect paid out of the benefit. Option B suits a family that needs the benefit to grow.
The Cash Value Corridor
Under the guideline premium test, federal tax law sets a floor on the death benefit compared with the cash value, so a policy cannot become mostly an investment account. The death benefit at any time must be at least an applicable percentage of the cash surrender value, and that percentage falls as the insured’s attained age rises (IRC 7702(d)). This is the cash value corridor. The percentages are set in a table in the Code, and the table controls.
Use a corridor factor of 2.0 in an example, which is not a figure from that table. The policy value is $150,000 and the face amount is $250,000. Twice the value is $300,000, which is more than the face amount, so the insurer must pay at least $300,000. On Option A the death benefit becomes $300,000 and the net amount at risk is $150,000. On Option B the benefit of $250,000 plus $150,000 is $400,000, already above the corridor, so the corridor does nothing. A heavily funded Option A policy can therefore pay a rising benefit.
Variable Life Insurance
A variable life policy places the cash value in separate account sub-accounts, investment funds such as a stock fund, a bond fund and a money market fund that the owner chooses among. The cash value, and often the death benefit, follow what those funds earn. The owner, not the insurer, bears the investment risk. The insurer still bears the mortality and expense risk: Michigan requires that the mortality and expense risk be borne by the insurer, that the charges be subject to the maximums stated in the contract, and that any difference between charges taken and the maximums be credited to the policy account at least annually (R 500.849(a)).
A variable policy’s death benefit has two parts, defined in R 500.841.
- The minimum death benefit is the guaranteed death benefit payable regardless of the separate account’s performance (R 500.841(i)).
- The variable death benefit is the amount that depends on the separate account’s investment performance (R 500.841(n)).
For a scheduled premium policy, the minimum death benefit must be at least the initial face amount if premiums are paid when due (R 500.849(b)). A scheduled premium policy is one in which the insurer fixes both the amount and the timing of the premiums, and any other variable policy is a flexible premium policy (R 500.841(f), (l)).
The Assumed Investment Rate
A variable policy’s premiums and benefits are priced on an assumed investment rate, the return that, after charges for taxes, investment expenses and mortality and expense guarantees, would keep the death benefit exactly at the level the plan would pay if it did not vary (R 500.841(c)). The net investment return is the return actually credited after the policy’s charges (R 500.841(j)). The comparison drives the benefit.
| Net investment return compared with assumed rate | Variable death benefit |
|---|---|
| Higher | Rises above the original amount |
| Equal | Stays at the original amount |
| Lower | Falls, but never below the minimum death benefit |
Michigan requires the death benefit to be redetermined at least annually, and the policy value and cash surrender value at least monthly (R 500.849(e), (f)). The policy must describe the benefit base, the amount to which the net investment return is applied, and the method of applying it (R 500.841(d), R 500.850(d)). Insurers use different formulas, and the policy states its own.
A Year of Variable Universal Life
Variable universal life combines this structure with flexible premiums. Lena Brandt pays $3,600 into a policy with a $300,000 face amount. The policy takes a 5% premium load, leaving $3,420.00. She allocates 60% to a stock sub-account, 30% to a bond sub-account and 10% to a money market sub-account:
- stock: $2,052.00,
- bond: $1,026.00,
- money market: $342.00.
For simplicity, the example takes the annual charges at year end. The policy charges a mortality and expense charge of 0.9% of the account value, COI of $620.00 and administrative charges of $96.00.
| Strong year | Weak year | |
|---|---|---|
| Stock return | +15% | -25% |
| Bond return | +4% | +2% |
| Money market return | +1% | +1% |
| Stock sub-account | $2,359.80 | $1,539.00 |
| Bond sub-account | $1,067.04 | $1,046.52 |
| Money market sub-account | $345.42 | $345.42 |
| Total before charges | $3,772.26 | $2,930.94 |
| Mortality and expense charge, 0.9% | $33.95 | $26.38 |
| COI and administrative charges | $716.00 | $716.00 |
| Policy value, year end | $3,022.31 | $2,188.56 |
Neither year returns the $3,600 she paid, because first-year charges are heavy. The weak year leaves her $833.75 below the strong one. If she surrendered in the weak year and the policy had a $1,000 surrender charge, she would receive $1,188.56. The death benefit is the part that did not fall. The $300,000 face amount stays payable in either year as long as the policy stays in force. A scheduled premium policy would carry a guaranteed minimum death benefit; Lena’s flexible premium policy depends on its value continuing to cover the charges. What the weak year costs is cash value and the cushion against later charges. COI in the following year is higher, because the policy value subtracted from the death benefit to find the net amount at risk is smaller.
Fees on a Variable Policy
Michigan requires the insurer to disclose in writing, before or at delivery, all charges against the separate account.
The list isn’t exhaustive. It includes taxes or reserves for taxes on the account’s gains, brokerage fees, the cost of insurance, administrative and investment management expenses, the mortality and expense guarantee charge at the rate the policy states, and charges for incidental insurance benefits, which are riders such as accidental death or disability (R 500.841(h), R 500.860).
How Michigan Governs a Variable Life Sale
A variable life policy is both insurance and a security. A Michigan agent who sells one must file evidence that the agent holds any license or authorization required by federal or state securities law (R 500.866(a)). The rules then regulate the sale in these ways.
Suitability. No one may recommend a variable life policy, and no policy may be issued, without reasonable grounds to believe the purchase is suitable, based on information gathered after reasonable inquiry about the applicant’s insurance and investment objectives, financial situation and needs (R 500.844(1)). The factors include age, earnings, marital status, dependents, savings and other assets, and the current life insurance program (R 500.844(3)), and the application must ask questions that let the insurer judge suitability (R 500.864(c)).
Disclosure. Before or when the application is executed, and against a written acknowledgment, the applicant must receive a plain-language explanation of the policy’s principal features, the account’s investment policy, its net investment return for each of the last 10 years the account has existed and the charges levied against it in the previous year (R 500.863). A prospectus satisfies this to the extent it contains the information. Illustrations may not project past investment experience into the future. Hypothetical rates are allowed only when it is made clear that they are hypothetical (R 500.863(g)).
Free look. The policy must carry a captioned provision allowing return to the insurer or agent within 45 days of the date the application was executed or within 10 days of receiving the policy, whichever is later, with a refund of all premium payments (R 500.850(a)(iv)). Say Hugo Beneke signs an application on March 3, 2027 and receives the policy on March 20. Forty-five days from March 3 is April 17. Ten days from March 20 is March 30. April 17 is later, so Hugo has until April 17. A variable annuity is different: its refund is any part of the premium not allocated to the separate account, plus the value of the amounts in the separate account on the date the insurer or its producer receives the returned contract (MCL 500.4073(2)). A returned variable life policy refunds all the premium payments.
Exchange to fixed. On a scheduled premium policy, the owner may during the first 18 months, while premiums are paid, exchange the policy for a permanent fixed benefit policy for the same initial amount, with no evidence of insurability, on a substantially comparable plan, with an equitable premium or cash value adjustment (R 500.850(f)). If the insurer materially changes the separate account’s investment policy, an objecting owner may also convert to fixed without evidence of insurability (R 500.850(n)).
Annual statements. The insurer must mail a statement within 30 days after each anniversary showing cash surrender value, death benefit, any partial withdrawal, loan and interest charge, and a notice that values may rise or fall (R 500.865(a)). On a flexible premium policy the statement reconciles the change in cash value and projects the value one year ahead using guaranteed costs. If the projection is below zero, it must warn that the policy may terminate without value in the next 12 months unless more premium is paid (R 500.865(a)).
Grace Periods, Reinstatement and Contestability
The two kinds of variable policy have different grace rules. A scheduled premium policy has a grace period of not less than 31 days from the due date, and a premium paid in it leaves policy values the same, apart from the overdue premium, as if it had been paid on time (R 500.850(b)). It may be reinstated within 2 years from default, unless the cash surrender value has been paid or extended insurance has expired, on written application, evidence of insurability, and payment of arrears and interest (R 500.850(c)).
A flexible premium policy has no due date. Its grace period begins on the policy processing day, the day charges are deducted, when the charges needed to keep the policy in force to the next processing day exceed the amount available. The period ends not less than 61 days after the insurer mails the report required by R 500.865(d). During the grace period the death benefit is the benefit in effect immediately before, less overdue charges. If processing days are monthly, the insurer may require payment of not more than 3 times the charges that were due on the processing day when funds ran short (R 500.850(r)).
An example makes the difference concrete. Charges due on the processing day are $140, and the policy value is $90. The insurer mails the report on June 1, 2027. Sixty-one days later is August 1, 2027, so the grace period cannot end before August 1. The insurer can require up to 3 times $140, or $420, to be paid. If the insured dies on July 10, the death benefit is the benefit in effect before the grace period, less the $140 charges owed.
A variable policy is incontestable by the insurer after 2 years in force during the insured’s lifetime. A death benefit increase made on a new application, with satisfactory proof of insurability, has its own 2 years (R 500.850(m)). The policy may exclude suicide within 2 years of issue, and within 2 years of an increase, to the extent of the increase only (R 500.852(a)).
Loans and Partial Surrenders
A variable life policy must provide for policy loans after 3 full years. The loan provision must let the owner borrow at least 75% of the cash surrender value, and debt is deducted from the death benefit and from any surrender value (R 500.851(b)).
A policy may include a partial surrender provision, and when it does, both the variable and minimum death benefits drop in proportion to the share of cash value taken (R 500.851(c)). Say a policy has a $40,000 cash value, a $300,000 minimum death benefit and the owner takes $10,000. That is 25% of the cash value, so the minimum death benefit falls by 25%, from $300,000 to $225,000, unless the policy sets a different floor. A loan, by contrast, leaves the benefit in place and the unpaid debt is subtracted from the proceeds at death (R 500.851(b)(iii)).
Universal Life and Variable Universal Life Compared
| Feature | Universal life | Variable universal life |
|---|---|---|
| Who bears investment risk | Insurer, above the guaranteed minimum credit | Owner |
| Where the money is held | General account | Separate account sub-accounts |
| Death benefit guarantee | The stated death benefit while the policy stays in force | The face amount while the policy stays in force; a minimum death benefit is required on scheduled premium policies (R 500.849(b)) |
| Michigan’s lapse protection | Notice 30 days before termination, and on a flexible premium policy a grace period of at least 30 days (MCL 500.4037(g)) | On a flexible premium policy, a grace period ending not less than 61 days after the report (R 500.850(r)) |
An interest-indexed universal life policy sits between them. It keeps the general account and the guaranteed minimum, but its interest credits are linked to an external referent (MCL 500.4001(d)), and a sales piece that calls it interest-indexed must describe the index and when the rate is determined (MCL 500.4038(2)(d)).
Why the Tax Tests Matter to a Flexible Policy
A policy’s income tax treatment depends on whether the Internal Revenue Code treats it as life insurance. The Code defines a life insurance contract as a contract that qualifies under state law and also passes one of two tests (IRC 7702(a)).
- The cash value accumulation test says the cash surrender value may never exceed the net single premium needed at that time to fund the contract’s future benefits (IRC 7702(b)).
- The guideline premium test says the premiums paid may never exceed the guideline premium limitation, the greater of the guideline single premium or the sum of the guideline level premiums. A policy using this test must also stay within the cash value corridor (IRC 7702(c), (d)).
A producer sees these tests at work when an insurer refuses or returns part of a premium, or raises the death benefit, to keep the contract qualified. A policy that fails both tests is not a life insurance contract for tax purposes.
Modified Endowment Contracts
Passing section 7702 qualifies the contract as life insurance. A second test, in section 7702A, decides how strictly the owner’s access to cash is taxed.
The Seven-Pay Test
A contract fails the 7-pay test if the amount paid at any time during its first 7 contract years exceeds the sum of the net level premiums that would have been paid by that time if the contract were paid up after 7 level annual premiums (IRC 7702A(b)). A contract that fails it, and was entered into after the Code’s 1988 effective date or received in exchange for one that did, is a modified endowment contract, or MEC (IRC 7702A(a)). The insurer computes the 7-pay premium when the policy is issued.
An example makes the test concrete. Suppose a policy’s 7-pay premium is $4,000 a year. The limit on cumulative premium grows by $4,000 each year:
| Contract year | Cumulative limit | Premiums paid | Result |
|---|---|---|---|
| 1 | $4,000 | $4,000 | Passes |
| 2 | $8,000 | $8,000 | Passes |
| 3 | $12,000 | $20,000 | Fails |
In year 3 the owner adds an $8,000 lump sum to the $4,000 regular premium, paying $12,000 that year. Cumulative premium is $20,000 against a limit of $12,000, so the policy becomes a MEC. A policy paid at or below the limit never fails. Under the Code, a premium returned with interest shortly after the contract year ends is treated as not paid for this purpose (IRC 7702A(e)(1)(B)).
Changes That Re-Run the Test
A reduction in benefits within the first 7 years means the test is applied as if the policy had been issued at the reduced level (IRC 7702A(c)(2)). A material change in benefits or other terms makes the contract a new contract on the day the change takes effect, and the test starts again. The Code lists any increase in the death benefit as a material change, other than an increase attributable to the premiums necessary to fund the lowest benefit level, or to interest and dividends on those premiums (IRC 7702A(c)(3)). So adding coverage to an old policy can create a MEC.
What Being a MEC Means
Death proceeds stay excluded from income under the general rule of IRC 101(a)(1), subject to that section’s exceptions. What changes is how the owner’s access to cash is taxed. A distribution is taxed to the extent of gain first. Loans, and assignments or pledges of the contract, count as distributions (IRC 72(e)(10)). A policy that is not a MEC returns basis first. A MEC taxes earnings first. The Code adds a further tax on the taxable portion of a MEC distribution, with exceptions for older owners, for disability and for a series of lifetime payments (IRC 72(v)).
Two more rules matter to a producer. If a contract fails the test, the MEC treatment applies to distributions in the year of failure and in later years, and also to distributions made within 2 years before the failure, which are treated as made in anticipation of it (IRC 7702A(d)). And all MECs issued by the same company to the same owner in one calendar year are treated as one MEC (IRC 72(e)(12)).
A client who has paid $20,000 into her universal life policy in three years asks to borrow against it. Before quoting a loan, the producer asks the insurer whether the policy is a MEC. If it is, the loan is a taxable distribution to the extent of gain and may carry the additional tax. The same question belongs before a client adds a large premium or raises the death benefit.
Lesson summary
- A universal life policy value is rolled forward each month: premium less load, less cost of insurance on the net amount at risk and other charges, plus interest credited. Michigan defines the policy by its separately identified credits and charges (MCL 500.4001(g)).
- Net cash surrender value is the policy value less surrender charges. Universal life lapses when net cash surrender value first reaches zero, with written notice at least 30 days before termination and a grace period of at least 30 days (MCL 500.4037(g)).
- Option A pays a level death benefit, Option B pays the face amount plus the policy value, and the cash value corridor can force the death benefit above either.
- Michigan limits illustrations: no rate above the current rate or the guaranteed rate, with guarantees shown and current values labeled as not guaranteed (MCL 500.4038).
- Variable life puts the cash value in separate account sub-accounts and puts the investment risk on the owner. The insurer bears the mortality and expense risk, and a scheduled premium policy must carry a guaranteed minimum death benefit (R 500.849).
- Michigan gives variable life a free look of 45 days from application or 10 days from receipt, whichever is later, an 18-month exchange to fixed on scheduled premium policies, and 31-day and 61-day grace rules (R 500.850).
- A flexible policy must pass section 7702 to be taxed as life insurance, and a policy that fails the 7-pay test in section 7702A is a modified endowment contract whose loans and withdrawals are taxed earnings first.