Minimum, target and maximum premium in universal life compared

A universal life policy lets the owner choose how much to pay each year, within limits, and that freedom is the whole difference between a policy that quietly lasts for decades and one that lapses at the worst possible moment. The choice is usually framed by three numbers on the proposal: a minimum, a target and a maximum. This post takes one invented policy and funds it all three ways so you can see what each choice does to the account, the risk of running out and the tax status of the contract.

Every figure below is a hypothetical chosen to make the arithmetic easy to follow. None of them is a price or a crediting rate from any insurer.

What the three premium levels mean

The words are used loosely by agents, so it helps to pin them down.

• Minimum premium. The smallest payment that keeps the policy from entering its grace period in the near term. Some contracts define it as a stated amount per month; others simply let you pay anything as long as the account value can cover the monthly charges. See minimum premium. Paying only this amount is permitted, but it does not promise that the policy will last.
• Target premium. A figure the insurer sets, often used to calculate agent commissions and surrender charges, and sometimes the level that the illustration says will carry the policy to a stated age if every non-guaranteed element performs as shown. See target premium. It is a reference point, not a guarantee.
• Maximum premium. The most the policy will accept. In practice the limit comes from tax law, not from the insurer's appetite. If you pay premiums faster than the seven-pay test allows, the contract becomes a modified endowment contracts and the 7-pay test and loses the tax treatment most buyers expect. Separately, the federal definition of life insurance in section 7702 limits how much cash value a policy can hold relative to its death benefit, so even a policy that is not a modified endowment contract cannot take unlimited premium.

The planned premium is a fourth number: the amount and schedule you tell the insurer you intend to pay. It shapes the billing notices and the illustration. It is not binding, and paying less than planned is the most common way these policies get into trouble.

The hypothetical policy

Meet Dana, 45, who is shopping for a $500,000 level-death-benefit universal life policy. Dana will fund it three different ways in three different universes. To keep the arithmetic readable, assume the following. These are invented round numbers, not market figures.

• Premium load: 5% of each premium is deducted before it reaches the account.
• Administrative charge: $120 a year.
• cost of insurance charge: $1,200 in policy year 1, rising by $150 each year as the insured ages. (In a real policy the cost depends on the net amount at risk, which shrinks as the account grows. We hold the charge at this schedule so that only one thing changes between the three universes: the premium.)
• Interest credited: 4% a year.
• Timing: all deductions come off at the start of each year, interest is credited at year-end, and the premium is paid at the start.

The three premium levels in the invented contract are:

The formula for each year is simple: account value at the start, plus 95% of the premium, minus the $120 administrative charge, minus that year's cost of insurance, then multiplied by 1.04.

Year one, step by step

Start with the minimum premium of $1,800.

• Premium after the 5% load: $1,800 × 0.95 = $1,710.
• Add to the opening balance of $0: $1,710.
• Subtract the administrative charge ($120) and the year-one cost of insurance ($1,200): $1,710 − $1,320 = $390.
• Credit 4% interest: $390 × 1.04 = $405.60.

The account holds about $406 after paying $1,800 into the policy. Nearly everything went to the load and the charges, which is normal for the first year of a permanent policy.

For the target premium of $6,000 the same steps give $5,700 after the load, $4,380 after charges and $4,555.20 after interest. For the maximum premium of $18,000 they give $17,100 after the load, $15,780 after charges and $16,411.20 after interest.

The three accounts side by side

Run the same formula forward and the pictures separate. The table shows the account value at the end of the selected policy years.

Under these assumptions the minimum-premium account peaks at roughly $792 in year 3 and then shrinks, because the cost of insurance keeps rising by $150 a year while the amount reaching the account after the load and the administrative charge stays at $1,590 ($1,710 − $120). By year 4 the annual charge ($1,650) is bigger than that $1,590 contribution, so the balance starts to drain. In year 7 the opening balance of about $222 plus $1,590 cannot cover the $2,100 charge, a shortfall of about $288, and the policy lapses. Dana will have paid $12,600 in premiums over seven years ($1,800 × 7) and holds no coverage.

The target-premium account does not just survive; it keeps growing, because the $5,580 that reaches the account each year ($6,000 × 0.95 − $120) is far larger than the charge, which reaches only $2,550 in year 10. After ten years Dana has paid $60,000 and the account holds about $46,866, roughly 78 cents for each premium dollar. The gap is the load, the charges and the cost of the death benefit during those years.

The maximum-premium account holds about $189,211 after $180,000 of premiums. The account is bigger than the total paid because interest compounds on a much larger balance. In this simplified model the premium level does not change the charges, which flatters the high-funding case. In a real level-benefit policy the cost of insurance falls as the account value rises, which strengthens the pattern further.

What each level does to the four risks

Cost, cushion, tax status and lapse risk are the things the funding level moves. The table below summarizes the three universes.

A few points deserve more explanation than a table cell allows.

Cost of insurance and the account cushion

Universal life charges the cost of insurance on the net amount at risk, which is the death benefit minus the account value. On a level-benefit design a bigger account means a smaller net amount at risk and therefore a smaller charge. That is why the high-funding policy gets cheaper per dollar of coverage over time while the minimum-funding policy gets more expensive in relative terms: its account never builds enough of a cushion to reduce the insurer's exposure.

The cushion also protects against changes the owner cannot control. In most universal life contracts the insurer can raise the cost of insurance up to the maximum stated in the contract, and the declared interest rate can fall. A policy with a large account can absorb several years of weaker credits. A policy with a thin account cannot. Our guide to why universal life policies lapse, and how to prevent it describes both failures, and the blog post how cost-of-insurance disputes begin in the contract language explains where the contract language that allows increases comes from.

The seven-pay test and the tax line

A policy that is funded faster than the seven-pay test allows becomes a modified endowment contract, as described in modified endowment contracts and the 7-pay test. The consequence is not that the policy is illegal or that the death benefit changes. It is that withdrawals and loans are taxed gains first, and a 10% additional tax can apply to the taxable portion before age 59½. For a buyer whose plan is to borrow from the policy later, that is usually a serious change to the plan.

In this hypothetical the maximum is set at the highest level that avoids that line. In real life, the owner should ask the insurer what the seven-pay limit is for the specific policy, whether the death benefit or other changes in the first seven years can reset it, and whether the insurer's system will warn before a payment that crosses the limit. Insurers vary in how they handle a payment that would push the policy over; some return the excess, others warn, and others simply accept it. Do not assume the system prevents the problem. A tax professional can confirm how the rule applies to a specific contract.

The target premium is not a promise

The target is often presented as "the amount that keeps the policy in force." Read that sentence carefully. The illustration usually shows the target premium keeping the policy in force to a stated age only under the illustrated, non-guaranteed assumptions. If the guaranteed column shows a lapse at age 75, then the target premium is a bet that the insurer's current charges and crediting will persist. The difference between the two columns is the subject of guaranteed vs non-guaranteed values in a policy illustration, and the way to see it is an how to request and read an in-force illustration run at lower crediting rates, which the blog post stress-testing an in-force illustration at lower crediting rates walks through.

When each funding level makes sense

Neither low nor high funding is wrong in itself. They answer different needs.

Minimum funding can fit when the goal is temporary coverage at the lowest cash outlay and the owner understands that the policy may not last. It is also sometimes a deliberate choice inside a contract that has a no-lapse guarantees on universal life: how they work with its own required premium; there the "minimum" that matters is the guarantee's premium, not the account's. Check which one your statement is showing.

Target funding can fit when the owner wants coverage for life, can pay the same amount each year, and will review the policy annually. It leaves room to raise the premium later if charges rise or crediting disappoints, and it avoids the tax-status line. It does not eliminate the need to check.

Maximum funding can fit when the policy is meant to hold a large cash value, such as for estate planning, business use or a long accumulation plan, and the owner has other, cheaper places to save first. The owner takes on a bigger commitment of cash, surrender-charge exposure in the early years, and the risk of a modified endowment contract if premiums are mismanaged. Premiums above the target also tend to earn less commission for the seller, so ask who benefits from the recommendation and what the surrender schedule looks like.

A decision list for choosing a level

1. What is the policy for? If the purpose is a death benefit that must be there at any age, price it against guaranteed universal life: permanent coverage without the cash or whole life before settling on a thin-funded design.
2. Can you pay the target every year for decades? If not, a lower target with a larger death-benefit reduction later may be safer than a high target you abandon.
3. What does the guaranteed column say? If the policy lapses at 85 under guaranteed assumptions, ask what it would take to fix that, and ask for the premium that makes the guaranteed column last to age 100.
4. What happens if you miss a year? A policy funded at the minimum has no slack. A policy funded at the target has some. A policy funded at the maximum has years.
5. Is a modified endowment contract acceptable? Some owners accept it deliberately, for example in a policy bought mainly for the death benefit and funded by a lump sum. If not, get the seven-pay limit in writing.
6. When will you review? Put a date on the calendar to compare the annual statement with the illustration. The checklist in a universal life annual statement checklist: ten things to verify is built for that.

Questions to put to the agent or insurer

• What are the minimum, target and maximum premiums for this exact policy, and how is each defined in the contract?
• What does the illustration assume about charges and crediting at the target premium, and what does the guaranteed column show?
• At what age would the policy lapse if I paid only the minimum, using current assumptions and using guaranteed assumptions?
• What is the seven-pay limit, and will your system stop or warn me before a payment exceeds it?
• If I pay more than the target in some years, what happens to surrender charges and the commission? Does extra premium count toward the target?
• Can I change the planned premium later without underwriting?

These questions overlap with the longer list in questions to ask a life insurance agent. Write the answers down; the way a policy is described on day one is not always the way it is serviced in year fifteen.

Key takeaways

• Funding level, not the product label, usually decides whether a universal life policy lasts. The same contract can lapse in seven years at one premium and build a large account at another.
• The minimum premium keeps a policy out of its grace period now; it does not promise the policy will last. Charges rise with age, so a flat minimum often falls behind.
• The target premium is a reference point that is often shown as lasting only under non-guaranteed assumptions. Check the guaranteed column.
• The maximum premium is set by tax law. Crossing the seven-pay line turns the policy into a modified endowment contract, with gains-first taxation of loans and withdrawals.
• Pick the level you can pay for decades, then review it every year with a fresh illustration and a tax professional for anything involving loans.