Updated August 20, 2019

What is Universal Life Insurance?

Read more about Life Insurance

Universal Life insurance offers a term policy with investment savings. How does it work? And what are the disadvantages of a universal life policy? Read on to find out.

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What Is Universal Life Insurance and How Does It Work?

Universal life insurance is a type of permanent life insurance. It's unique in that it offers flexible premiums with a savings account. You pay the minimum premium to cover the death benefit, and also a little extra to fund a cash value investment account.

The pieces of a universal life insurance include:

  • Cash Value Investment
    A portion of the premium is put into a cash value investment account. The cash value growth is based on the interest rate set by the insurance company (which is based on the market). There will be a minimum guaranteed interest.

    When interest rates are high, this can offer better returns. But when interest rates are low, cash value may not grow so much.

  • Flexible Premiums
    You can pay flexible premium amounts (as long as you pay the minimum). If you pay more, the cash value will grow more. After you have built up enough cash value, you can even use it to pay the premium.

  • Level or Increasing Death Benefit
    With Option 1, level death benefit, you pay a smaller premium and the beneficiary receives the death benefit when the insured dies. With Option 2, fluctuating death benefit, the beneficiary receives the death benefit plus the cash value when the insured dies.

The idea of universal life insurance is that when you've built up enough cash value, you can eventually use it to pay the premium. So then you can get insurance for life, without having to keep paying out-of-pocket.

However, this doesn't always end up the case. Universal life insurance could be risky. Keep reading for the pros and cons.

The sales process for a universal life policy is complicated. A good agent will explain the key features of the policy, show you illustrations of the projected and guaranteed aspects of the policy, and make sure you understand how the features work.

Pros of Universal Life Insurance

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Flexibility is the biggest benefit of universal life insurance.

  • Flexible premiums
    The premiums are flexible. If you pay more, you'll fund your cash value more. If you can't afford to pay the premium one month because your car's transmission blew up, you can skip the payment as long as you have enough cash value.

  • Flexible death benefit
    If you need more life insurance because you have another child, you can increase the death benefit. If you need less life insurance because you get a divorce, you can decrease the death benefit.

    This ability to adjust is unique, because it's usually less expensive to increase the death benefit than it is to buy a new policy.

  • Potential for a better return on investment (ROI)
    Since the cash value growth depends on the market, when interest rates are high, you can earn more than with a whole life policy.

  • Can borrow from the cash value
    You can borrow from the cash value when you're still alive. For example, if you need some money to pay for your children's education, you can take out a loan. However, the loan will keep on accumulating interest until it's paid back.

  • Lower cost than whole life
    At first, universal life insurance is typically cheaper than a whole life policy. This makes it more attractive for people who want a more affordable permanent life insurance with an investment plan. However, the cost of insurance increases later on in life.

Universal life can be a good choice if:

  • You're willing to spend the time it takes to understand a complex financial product.

  • You want as much flexibility as possible.

  • You are willing to take some risks in exchange for potentially higher rewards.

Cons of Universal Life Insurance

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Universal life insurance is not a good choice unless you are willing to take time to understand the moving parts inside the policy. The flexibility also creates increased risk.

  • Running out of cash value
    The greatest risk is that the policy will lapse because the cash value does not grow enough to offset the higher cost of insurance when you are older. When you skip premium payments, the cash value is used to cover the cost. If this happens too often, your policy may not have enough cash value to pay the premium. The policy will then lapse.

  • The cost of insurance is not guaranteed
    The cost of insurance can increase if more insureds die than the insurance company anticipated when it set the rates. And if interest rates are low, the cash values will not grow as projected, which means higher premiums will be required when you are older.

  • Potential for a worse return on investment (ROI)
    If the insurance company earns less interest than it projected when you bought the policy, the premiums can increase, and the cash value can be lower. Both of these give the policy a higher risk of lapsing.

Universal life is a poor choice when:

  • You're not willing to spend the time it takes to understand and track how your policy is doing.

  • It is essential that the policy remain in force until your death.

  • You are averse to the uncertainty the policy's flexibility creates.

How the Cash Value Works

You accumulate cash value from premium payments and the interest. When you pay more on the premium, the extra will go into the cash value.

The cash value inside a universal life policy can be tricky to understand. It is money attached to your policy, but it is not actually your money as long as the policy is in force. You can't take it out of the policy without consequences.

There are two ways to get cash value out of the policy.

  • Borrow (Policy Loan)
    If you need to borrow some money, you can take a loan using the cash value as collateral. The loan will incur interest charges. If you do not repay the loan, when you die, the loan will be subtracted from the death benefit.

  • Withdraw (Partial Surrender)
    A second option is to permanently withdraw the cash value (called a partial surrender). This will reduce the death benefit. The amount of cash value you can withdraw is proportional to the amount of death benefit the policy is reduced by. If you decrease the death benefit by 20%, you can take 20% of the cash value out of the policy.

Difference between Whole Life and Universal Life

Both Universal and Whole Life are types of permanent life insurance. They both can last for the insured's entire life, have cash values, and allow policy loans.

In a whole life policy, everything (premiums, cash values, and death benefit) is guaranteed. In a universal life policy, everything can change.

Whole Life: fewer risks to the client

  • The cash values grow regardless of the investment earnings the company earns.

  • The premium rates cannot be increased.

  • The death benefit is fixed.

  • The insurance company is the one with the risk if they earn too little on their investments.

  • The loan interest rate is fixed when the contract is issued.

Whole life policies generally do not earn any cash value during the first two policy years. The illustration for a universal life policy will show cash values, but if you surrender the policy during the first two years, a surrender charge offsets the cash value and you will not get the cash value.

Universal Life: more risky but more flexible

  • The cash value growth is based on market interest rates.

  • The insurance company can increase premium rates if interest rates are low or as you get older.

  • The death benefit is adjustable if your situation changes.

  • Some of the risk is shifted to you, because cash value is not guaranteed.

  • The loan interest rate is variable and can change if you take out a loan on the cash value, like an adjustable rate mortgage.

Whole life insurance is a better choice than universal life when:

  • It is very important that your life insurance is in force when you die.

  • You don't want the uncertainty and risks that come with a Universal Life policy.

  • You want stable premiums that won't increase as you age.

Universal Life Insurance vs Term

Term insurance is not permanent. It only lasts for a specific term (10, 20, 30 years, for example). It's the cheapest and easiest type of life insurance to understand.

Term: temporary coverage and simple to understand

  • The insurance lasts for a specific number of years.
  • The premium remains the same throughout the entire term.
  • There is no cash value. If you outlive the term, the policy expires and that's it.
  • If you don't pay the premium, the policy lapses.

Universal Life: can be lifelong coverage

Universal life can be thought of as a term insurance policy that does not have guaranteed premium rates with a savings account on the side.

  • Coverage can last a lifetime as long as you keep on paying the premium.
  • Premium payments are flexible. The premium can increase as you get older.
  • Has a cash value investment account that can grow based on your funding and market rates.
  • If you don't pay the premium, you can use the cash value to cover the cost.

Term insurance is a good option when:

  • You prefer a simple, straightforward uncomplicated product.
  • You want to know exactly what you will be required to pay.
  • You only need coverage for a temporary period of time (such as until the kids graduate college).

For most people, term insurance is enough. It's an affordable way to protect your family. Buying term insurance and investing the rest is a better option for many people. Because coverage is only temporary, it's not a good option if you must have insurance when you die, regardless of how old you are.

Bottom Line

A universal life policy gives you flexible premiums, adjustable death benefits, and an investment account. It sounds great, but you have to be careful. Everything in a universal life policy can change. This is a two-edged sword.

On the one hand, it provides great flexibility. On the other hand, it increases the risk of lapsing if you cannot make the premium payments or when you have no more cash value. It is easy to make a costly mistake if you do not understand the potential consequences of your choices.

Write to Jeanine J at evan@creditdonkey.com. Follow us on Twitter and Facebook for our latest posts.

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