What is Universal Life Insurance and How Does it Work?

By Hetal Bansal

Universal life insurance is a type of permanent life insurance that offers greater flexibility and control over the policy than traditional whole life insurance. Unlike whole life insurance, universal life insurance allows policyholders to adjust their premium payments and death benefits over time, giving them the ability to tailor the policy to their changing needs. Universal life insurance policies also have a cash value component, which grows tax-deferred and can be accessed by the policyholder during their lifetime.

Types of universal life insurance

Traditional Universal Life Insurance

This type of universal life insurance offers a fixed interest rate on the cash value component of the policy. The premiums paid into the policy are split between the cost of insurance and the accumulation of cash value. The policyholder can choose to increase or decrease their premiums as long as they pay the minimum required to keep the policy in force. This type of policy offers more flexibility than whole life insurance but typically has lower premiums than variable or indexed universal life insurance.

Indexed Universal Life Insurance

This type of universal life insurance allows the policyholder to allocate the cash value of the policy to an index such as the S&P 500. The policyholder earns a portion of the index's growth, subject to caps and floors, with the ability to earn interest on their cash value. This policy offers more potential for growth than traditional universal life insurance but with less risk than variable universal life insurance.

Guaranteed Universal Life Insurance

This type of universal life insurance offers a guaranteed death benefit and premium payment but no cash value accumulation. The policyholder pays a fixed premium for the duration of the policy, which can be up to age 121. This policy is ideal for those who want to provide their loved ones with a guaranteed death benefit but don't require the cash value accumulation of other universal life insurance policies.

Variable Universal Life Insurance

This type of universal life insurance allows the policyholder to invest the cash value of the policy in sub-accounts, which are similar to mutual funds. The policyholder has the ability to select their own investments, and the value of the policy can fluctuate based on the performance of those investments. This policy offers the highest potential for growth but also carries the highest risk.

How does universal life insurance work?

The Basics

Universal life insurance policy provides a death benefit, just like the traditional term life insurance policy. However, unlike term life insurance, which only pays out a death benefit if the policyholder dies within the term, universal life insurance covers the policyholder's entire life. This means that the beneficiaries will receive a death benefit no matter when the policyholder dies.

In addition to the death benefit, universal life insurance also has a savings or investment component. A portion of the premiums paid by the policyholder goes toward a cash value account that earns interest, typically at a fixed rate.

Premiums

One of the primary benefits of universal life insurance is the flexibility it offers in terms of premiums. The policyholder has the option to adjust the amount and timing of their premiums as long as they pay the minimum premium amount required to keep the policy in effect.

The premium consists of two parts: the cost of the death benefit and the savings component. The cost of the death benefit is based on the policyholder's age, gender, health condition, and other factors that may affect life expectancy.

The savings component, also known as the cash value, is invested in different investment vehicles, such as stocks, bonds, and mutual funds. The cash value earns interest, and the policyholder can withdraw or borrow against it.

Death Benefit

The death benefit is the amount paid to the beneficiaries of the policyholder upon their death. The policyholder can choose a fixed death benefit amount or a variable death benefit that increases or decreases based on the cash value of the policy.

If the policyholder dies, the death benefit is paid to the beneficiaries tax-free. The beneficiaries have the option to receive the death benefit as a lump sum or in installments over a period.

Cash Value

Cash value is one of the hallmarks of universal life insurance. It serves as a savings or investment account that earns interest over time. The policyholder can withdraw funds from the cash value account or borrow against it.

The cash value earns interest at a fixed or variable rate, and the interest is tax-deferred until the funds are withdrawn. The policyholder can also choose to allocate the cash value to different investment options, such as stocks, bonds, and mutual funds.

The cash value can help the policyholder pay premiums, take out loans, or enhance the death benefit amount. It can also provide an extra source of income during retirement.

Adjustable Features

Universal life insurance policies offer several adjustable features that allow the policyholder to customize their coverage to meet their changing financial needs and circumstances.

One such feature is the ability to adjust the premium amount. The policyholder can change the amount of the premium to reflect changes to their income or other financial obligations.

The policyholder can also adjust the death benefit amount, which may increase or decrease based on the policy's cash value.

Additionally, the policyholder can adjust the investment options to allocate the cash value to different investment options, such as stocks, bonds, and mutual funds.

Suitability

Universal life insurance is not for everyone. It is suitable for individuals who:

• need permanent life insurance protection
• want to build cash value over time
• prefer flexibility in premium payments and death benefit amounts
• are willing to tolerate investment risk
• have a long-term outlook for their insurance and investment needs.

What makes Universal Life different from other long-term insurance policies?

Flexible premium payments

One of the key advantages of universal life insurance over other long-term policies is the flexibility it provides in premium payments. Unlike other policies, the policyholder can choose the amount and frequency of premium payments and also have the option to make additional payments to the policy. This provides policyholders with an added convenience and the option to adjust their premium payments based on their financial situation.

Cash value accumulation

Another major factor that sets universal life insurance apart from other long-term policies is the cash value accumulation feature. As premiums are paid into the policy, a portion of the premium goes towards the cost of insurance while the rest is invested in a cash accumulation fund. This cash balance earns interest and can be used to offset future premium payments or taken out as a tax-free loan. The cash value accumulation varies based on the policyholders investment choices, and this feature is not available in other insurance policies.

Adjustable death benefit

Universal life insurance allows the policyholder to adjust the death benefit (the amount paid out to beneficiaries upon the policyholders death) based on their changing financial or personal circumstances. Policyholders can increase, decrease or even skip a premium payment if the policyholders financial situation changes. This flexibility provides policyholders with greater control and makes it easier to adjust the policy to meet changing needs.

Tax advantages

Universal life insurance policies come with several tax advantages. The cash value accumulation portion of the policy is tax-deferred, meaning policyholders are not required to pay taxes on interest earned until they withdraw their funds. The death benefit payout also passes tax-free to the policyholders beneficiaries. Additionally, policyholders can borrow against the policys cash value, which is also tax-free.

Greater transparency

Universal life insurance policies provide a greater level of transparency than other policies. Policyholders receive regular updates on the policys cash value accumulation and investment performance. Policyholders also have online account management functionality that makes it easy to view and make changes to their policies.

Conclusion

Universal life insurance is a popular choice for individuals who want a flexible and customizable life insurance policy. With its adjustable premium payments and death benefits, policyholders can adapt the policy to their changing needs throughout their lifetime. Additionally, the cash value component of the policy provides a tax-deferred savings option that can be accessed during the policyholder's lifetime. While universal life insurance offers a variety of benefits, it's important to carefully consider the policy's features and costs before making a decision. Working with a trusted financial advisor or insurance professional can help individuals make an informed decision about whether universal life insurance is the right choice for their unique needs.

FAQs

What are the 4 types of universal life insurance?

The four types of universal life insurance are traditional universal life insurance, indexed universal life insurance, guaranteed universal life insurance, and variable universal life insurance.

What are the benefits of a universal life insurance policy?

The benefits of a universal life insurance policy include flexibility in premium payments and death benefits, the ability to build cash value over time, and the potential to earn interest on that cash value. Additionally, universal life insurance offers a level of protection for loved ones and can provide financial security in the event of the policyholder's death.

What is the biggest disadvantage of universal life insurance?

The biggest disadvantage of universal life insurance is the potential for the policy to lapse if the cash value is insufficient to cover the cost of the policy. This can happen if the policyholder takes out too much cash value or if interest rates are lower than expected.

Which is better: whole life or universal life?

There is no definitive answer as to which is better - whole life or universal life - as it largely depends on individual financial needs and goals. Whole life insurance offers stable premiums and a guaranteed cash value, while universal life insurance offers more flexibility in premium payments and death benefits.