Avoid Underfunded Universal Life Pitfalls (2025 Guide)

Universal life (UL) insurance can be a powerful tool for long-term financial planning, offering flexible premiums and a potential cash value growth component alongside a death benefit. However, this flexibility comes with a crucial responsibility: ensuring the policy remains adequately funded. An underfunded universal life insurance policy can lead to devastating consequences, including unexpected lapses and significant financial loss. Understanding how underfunding happens and how to prevent it is essential for policyholders.

This guide, updated for 2025, delves into the complexities of underfunded universal life insurance. We’ll explore how these policies work, the common causes of underfunding, the serious risks involved, and most importantly, how you can protect yourself. At Insurance By Heroes, we believe informed decisions are the best decisions. As an independent agency founded by a former first responder and military spouse, and staffed by professionals with similar backgrounds in public service, we bring a unique perspective grounded in trust and dedication. We understand the importance of reliable protection, and our mission is to help you navigate the insurance landscape effectively. Because we partner with dozens of top-rated insurance carriers, we can shop the market to find coverage tailored specifically to your needs and budget, ensuring you don’t fall into common traps like policy underfunding.

Understanding Universal Life Insurance Basics

Before diving into underfunding, let’s quickly recap how universal life insurance generally works. Unlike term life insurance, which covers a specific period, UL is a type of permanent life insurance designed to last your entire lifetime, provided premiums are paid and the policy remains in force.

Key components include:

• Death Benefit: The amount paid out to your beneficiaries upon your death. In many UL policies, you can choose between a level death benefit or an increasing death benefit (the specified face amount plus the accumulated cash value).
• Cash Value: A portion of your premium payments goes into a cash value account, which grows tax-deferred based on interest crediting rates set by the insurer. These rates can be tied to market indexes (Indexed UL) or declared by the company (traditional UL), and they often have a guaranteed minimum floor.
• Premiums: This is where flexibility comes in. UL policies have minimum premium requirements to cover the cost of insurance and administrative fees. However, you can typically pay more than the minimum (target or guideline premiums) to accelerate cash value growth. You can often adjust your premium payments within certain limits, and even skip payments if there’s sufficient cash value to cover the policy charges.
• Policy Charges: Insurers deduct various costs from your premium payments or cash value. These typically include the Cost of Insurance (COI), administrative fees, surrender charges (if you cancel the policy early), and charges for any policy riders. The COI usually increases as you age.

This flexibility is attractive, but it’s also the primary reason policies can become underfunded if not managed carefully.

What is an Underfunded Universal Life Insurance Policy?

An underfunded universal life insurance policy occurs when the premium payments being made, combined with the existing cash value, are insufficient to cover the ongoing policy charges (primarily the cost of insurance and administrative fees). Over time, these charges deplete the cash value. If the cash value hits zero (or falls below a minimum threshold), the policy enters a grace period. If sufficient funds aren’t added during this grace period, the policy will lapse, leaving the policyholder without coverage.

Think of it like a savings account (cash value) from which monthly bills (policy charges) are automatically deducted. You deposit money (premiums) into the account. If your deposits aren’t large enough or frequent enough to cover the withdrawals, the account balance shrinks. If it hits zero, the service (insurance coverage) stops.

The danger lies in the fact that the cost of insurance within a UL policy typically increases each year as the insured person gets older. Even if minimum premium payments were sufficient initially, they might not be enough to sustain the policy in later years, especially if interest crediting rates are lower than originally projected or if policy loans have been taken.

How Does Universal Life Insurance Become Underfunded?

Underfunding isn’t usually a sudden event; it’s often a gradual process resulting from several factors. Understanding these causes is the first step toward prevention.

1. Paying Only the Minimum Premium

Many UL policies are sold illustrating a “minimum premium” designed only to keep the policy barely afloat under specific, often optimistic, assumptions (e.g., high interest crediting rates, low policy charges). Paying only this minimum, especially over the long term, rarely builds enough cash value to weather increases in the cost of insurance or periods of lower interest rates. The policy is essentially designed to tread water initially but starts sinking as costs rise later in life.

2. Misleading Sales Illustrations

Policy illustrations are hypothetical projections, not guarantees (unless explicitly stated). Some illustrations might project high, non-guaranteed interest rates to show faster cash value accumulation and suggest lower premiums are viable. If actual interest crediting rates are lower than illustrated, the cash value won’t grow as expected, and the policy can become underfunded much sooner, even if you’re paying the initially illustrated “recommended” premium.

This highlights why working with an independent agent you trust is crucial. At Insurance By Heroes, our public service background instills a commitment to transparency. We help clients understand the difference between guaranteed and non-guaranteed elements in illustrations from various carriers, ensuring you grasp the real risks and potential outcomes.

3. Rising Cost of Insurance (COI)

The COI is the mortality charge – the actual cost of providing the death benefit protection. This cost is based on the insured’s age, health rating, and the “net amount at risk” (the difference between the death benefit and the cash value). As you age, your mortality risk increases, and so does the COI. If premium payments don’t keep pace with these rising internal costs, the cash value will be eroded more quickly.

4. Lower-Than-Projected Interest Crediting Rates

The cash value in a UL policy grows based on interest credited by the insurer. These rates can fluctuate, especially in traditional UL or Indexed UL policies. If the credited rates are consistently lower than what was initially illustrated or expected when setting the premium payment schedule, the cash value growth will be slower, making the policy more vulnerable to underfunding.

5. Policy Loans and Withdrawals

Taking loans against your policy’s cash value or making withdrawals reduces the amount available to cover policy charges. Furthermore, outstanding loans typically accrue interest. If this loan interest isn’t paid out-of-pocket, it’s added to the loan balance, further decreasing the net cash value and increasing the likelihood of the policy becoming underfunded. Unpaid loan interest combined with ongoing policy charges can create a dangerous spiral leading to lapse.

6. Skipping Premium Payments

While UL policies offer premium flexibility, consistently skipping payments relies heavily on having substantial cash value to cover the charges. If the cash value is modest, skipping even a few payments can put the policy on a path toward underfunding, especially if COI charges are rising.

7. Changes in Policy Options or Riders

Adding certain riders (like long-term care riders or critical illness riders) or changing death benefit options can increase the policy’s internal costs. If premium payments aren’t adjusted accordingly, this can contribute to underfunding.

The Significant Dangers of Underfunded Universal Life Insurance

An underfunded UL policy isn’t just an inconvenience; it can lead to severe financial and emotional consequences.

• Policy Lapse: This is the most critical risk. If the cash value is depleted and premiums aren’t paid during the grace period, the policy terminates. All the premiums paid over the years are lost, and there is no death benefit for beneficiaries. This is particularly devastating if it happens when the insured is older or in poor health, making it difficult or impossible to obtain new coverage.
• Loss of Premiums Paid: Years, sometimes decades, of premium payments can be completely wasted if the policy lapses due to underfunding.
• Inability to Secure New Coverage: If a policy lapses later in life, the insured’s age and potentially changed health status can make qualifying for new life insurance prohibitively expensive or altogether impossible.
• Unexpected Tax Consequences: If a policy lapses with an outstanding loan exceeding the total premiums paid (the policy basis), the difference may be treated as taxable income by the IRS. This can result in a surprise tax bill when you are least prepared for it.
• Reduced Death Benefit: Even if the policy doesn’t lapse immediately, ongoing underfunding erodes the cash value. If the policy has an increasing death benefit option (face amount plus cash value), the total payout will be less than anticipated. Outstanding policy loans also directly reduce the death benefit paid to beneficiaries.
• Emotional Stress: Realizing that a policy meant to provide security is instead at risk of failing can cause significant anxiety and stress for policyholders and their families.

Avoiding these dangers requires proactive management and understanding the specific mechanics of your policy. It also underscores the importance of having an advisor who prioritizes your long-term security over simply making a sale. At Insurance By Heroes, we see our clients as partners. Our background in service means we focus on building lasting relationships based on trust and sound advice, helping you select and manage policies designed to perform as intended, not just for today, but for decades to come.

Is Your Universal Life Policy At Risk? Warning Signs

How can you tell if your existing UL policy might be heading towards an underfunded state? Look out for these warning signs:

• Receiving Lapse Notices or Warnings: This is the most obvious sign. Insurers are required to notify you if your policy is in danger of lapsing due to insufficient value. Don’t ignore these notices.
• Paying Only the Minimum Premium: If you’ve consistently paid only the absolute minimum required premium, your policy is at higher risk, especially as you age.
• Policy Performance Significantly Lower Than Illustrated: Compare your annual policy statements to the original sales illustration (if you still have it). If the cash value is much lower than projected for the current year, investigate why.
• Interest Crediting Rates Have Dropped: Check your annual statements for the actual interest rates credited to your cash value. If they have been consistently low or lower than the non-guaranteed rates shown in your illustration, your policy’s funding may be strained.
• Increasing Policy Loans: If you have an outstanding policy loan and the balance is growing due to unpaid interest, it’s actively working against your policy’s sustainability.
• Receiving Requests for Higher Premiums: Sometimes, the insurer might send notices suggesting or requiring higher premium payments to keep the policy on track, especially if based on current (lower) interest rates or higher COI charges.
• Policy Issued Many Years Ago with Low Initial Premiums: Older UL policies sold with very low illustrated premiums based on high-interest-rate environments of the past are particularly susceptible to underfunding in today’s lower-rate world.

If any of these signs apply to you, it’s crucial to take action immediately.

How to Prevent or Fix an Underfunded Universal Life Policy

The good news is that if caught early enough, an underfunded universal life insurance policy can often be salvaged or managed. Prevention is always the best strategy.

1. Request and Review In-Force Illustrations Annually

Don’t just rely on the initial sales illustration. Contact your insurance company or agent annually and request an “in-force illustration.” This projection uses your current cash value, loan balances (if any), and the insurer’s *current* COI charges and interest crediting rates (both guaranteed and non-guaranteed assumptions) to show how the policy is expected to perform moving forward based on your current premium payments. Ask for illustrations based on:

• Current assumptions (non-guaranteed rates).
• Guaranteed assumptions (minimum interest, maximum charges) – this shows the worst-case scenario.
• Different premium levels to see how increased payments would affect longevity.

This is the single most important step in monitoring your policy’s health.

2. Understand Your Premium Structure

Know the difference between the minimum premium, the target premium, and the guideline level premium (maximum allowed). Aim to pay a premium designed to build sufficient cash value over time, not just scrape by. A knowledgeable agent can help determine an appropriate funding level based on realistic projections, not just the minimum required.

3. Increase Premium Payments

If your in-force illustration shows the policy might lapse prematurely based on current funding, the most direct solution is to increase your premium payments. Even a modest increase can significantly extend the life of the policy by offsetting rising COI charges and potentially boosting cash value growth.

4. Make Lump-Sum Contributions

If possible, making a one-time or occasional lump-sum payment (within policy limits) can inject much-needed funds into the cash value, helping to stabilize a struggling policy.

5. Reduce the Death Benefit

If maintaining the current death benefit is proving too costly, reducing it can lower the net amount at risk and, consequently, the COI charges. This can make the policy more sustainable with lower premium payments, although it obviously reduces the final payout to beneficiaries. This requires careful consideration of your actual insurance needs.

6. Explore a Policy Restructure or Exchange (1035 Exchange)

In some cases, it might be possible to restructure the existing policy. Alternatively, a Section 1035 exchange allows you to transfer the cash value from your current policy directly into a new life insurance policy (or sometimes an annuity) without triggering immediate taxes. A new policy might offer lower internal charges, better guarantees, or different features that better suit your current situation. However, you’ll need to medically qualify for a new policy, and surrender charges might apply to the old one. This is a complex decision that absolutely requires professional guidance.

This is another area where the independence of Insurance By Heroes provides significant value. We aren’t tied to any single carrier. If your current policy, regardless of the company, is underperforming or at risk, we can objectively assess whether restructuring, increased funding, or a 1035 exchange into a policy from one of the dozens of carriers we represent is the best course of action for *you*. We compare options side-by-side to find the most suitable solution.

7. Be Cautious with Policy Loans

If you need to access your cash value, understand the impact of loans. Try to pay loan interest out-of-pocket if possible. If taking a large loan, request an illustration showing its long-term effect on policy performance and sustainability.

Why Partnering with an Independent Agency Like Insurance By Heroes Matters

Navigating the complexities of universal life insurance, especially avoiding the pitfalls of an underfunded policy, requires more than just buying a product. It requires ongoing monitoring, understanding intricate policy mechanics, and having access to objective advice.

This is where Insurance By Heroes stands apart. Founded by individuals with backgrounds dedicated to serving the community—a former first responder and a military spouse—our agency operates on principles of trust, integrity, and education. We know firsthand the importance of dependable protection when it matters most.

Here’s why working with an independent agency like ours is crucial, particularly concerning universal life insurance:

• Access to Multiple Carriers: We aren’t captive to one insurance company. We work with dozens of highly-rated carriers. This means we can compare policies, features, pricing, and underwriting standards across the market to find the UL policy that genuinely fits your specific needs and financial goals. We help you find the right structure to minimize the risk of future underfunding.
• Objective Advice: Our loyalty is to you, our client, not to any single insurance company. We provide unbiased recommendations based on what’s best for your situation. We explain the pros and cons of different policy designs and illustrate them realistically, focusing on both guaranteed and non-guaranteed elements.
• Tailored Solutions: Not every universal life policy is right for every person. Factors like your age, health, risk tolerance, premium flexibility needs, and long-term goals dictate the best approach. We take the time to understand your unique circumstances and tailor our recommendations accordingly, rather than pushing a one-size-fits-all product. We ensure the premium strategy aligns with the policy’s long-term viability.
• Focus on Education and Transparency: We believe an informed client makes the best decisions. We take the time to explain how UL policies work, the potential risks like underfunding, and how different choices impact performance. We demystify policy illustrations and annual statements.
• Ongoing Policy Reviews: Our commitment doesn’t end after the sale. We encourage regular policy reviews, including requesting and analyzing in-force illustrations, to ensure your coverage remains on track and address potential issues like underfunding before they become critical problems.
• Understanding Service and Commitment: Our team, many with backgrounds in public service, understands the value of long-term commitment and reliability. We bring that same dedication to helping you secure your financial future.

Choosing the right universal life policy and managing it effectively is a long-term commitment. Having a dedicated, independent partner like Insurance By Heroes can make all the difference in ensuring your policy performs as intended and avoids the serious risks associated with becoming an underfunded universal life insurance policy.

Take Control of Your Life Insurance Future Today

Universal life insurance can be an excellent tool, but its flexibility demands attention. An underfunded policy can unravel years of planning and leave your loved ones unprotected. By understanding how these policies work, recognizing the warning signs of underfunding, and taking proactive steps—including regular reviews and appropriate funding—you can maintain the security you intended to create.

Don’t leave your policy’s health to chance or rely on outdated, potentially optimistic projections. Whether you’re considering a new universal life policy or worried about an existing one, expert guidance is essential.

The team at Insurance By Heroes is ready to help. With our commitment to service, access to dozens of top carriers, and expertise in tailoring insurance solutions, we can help you assess your current situation, understand your options, and implement a strategy to ensure your life insurance provides lasting protection. We’ll help you compare options and understand the fine print, ensuring you get a policy designed for stability and long-term performance.

Take the first step towards peace of mind. Fill out the quote form on this page today for a free, no-obligation review and consultation. Let Insurance By Heroes put our experience and market access to work for you, ensuring your life insurance is a reliable asset, not a potential liability.