What is universal life insurance and how does it work?

What is universal life insurance?

A universal life insurance policy is a type of permanent life insurance. Like whole life, it stays in place until you die, as long as you pay the premiums.

Universal life gives you more flexibility than whole life, including how you pay premiums and the ability to adjust the death benefit over time. There are two components to a universal life policy: the death benefit and the cash value account. The universal life cash value account earns interest over time, is tax-deferred, and can be accessed via a loan or withdrawal.

How does universal life insurance work?

Universal life insurance works like any other insurance policy; you pay the premiums and when you die, your beneficiary gets the death benefit.

Universal life insurance premiums also build cash value, just like a whole life policy.

The money in the cash value portion of your policy earns interest. Depending on the type of universal life insurance, the interest on your cash value can grow at modest rates, such as those in a money market account, or at more aggressive rates, such as those tied to the stock market. The interest you earn on your cash value is income tax-deferred.

Eventually, this money builds to the point in which you can begin withdrawing or borrowing against it if you want. Each life insurance company has its own rules about when you can dip into this amount. You can also use this amount to pay your premiums.

While this is similar to whole life, universal life differs in that it offers flexible premiums.

“Customers can choose to pay level premiums every year, but they also can choose to overfund their policies in early years or even pay with just a single large premium,” says Joe Kenny, vice president and actuary, life product performance, at Mutual of Omaha.

A universal life policy also allows you to increase or reduce the amount of your death benefit.

“The death benefit can be decreased or increased without needing to issue a different policy,” Kenny says.

However, he notes that increases in the death benefit will typically require new underwriting, so you may need a medical exam and answer health-related questions. It will also impact your premiums.

What are the types of universal life insurance?

There are several different types of universal life insurance policies, with differences in premiums and how the cash value account is handled.

• Guaranteed universal life insurance. Guaranteed universal life insurance is sometimes described as occupying a middle ground between term life insurance and whole life insurance. It combines the term insurance’s level premium and the investment elements of whole life. 
• Indexed universal life insurance. Indexed universal life insurance policies, the interest on the cash value account is tied to an index of investments, such as the Standard & Poor’s 500 stock index or an index of bonds. Universal indexed life insurance products also typically have an interest-rate guarantee, but can have a lot of fees and a cap on investment returns.
• Variable universal life insurance. A variable universal life policy is a blend of variable life and universal life policies. You can adjust the insurance premiums and you have the option of investing the cash value in financial markets.

All universal life policies have some level of risk. Make sure you speak to a financial advisor before choosing a policy.

Pros and cons of universal life insurance

There are both advantages and disadvantages of universal life insurance.

Some of the potential benefits of universal life include:

• Permanent coverage
• Flexible premiums
• A flexible death benefit
• Cash value that can be accessed when needed

On the hand, potential cons include:

• Premiums are not guaranteed and may go up over time
• Investments may not perform well, affecting the cash value
• The cash value may be lost when you die
• There is a risk of losing money with a universal life policy as it often lacks guarantee.

Whole life vs. universal life

Whole life and universal life insurance are similar in that they both are forms of permanent life insurance. Your benefits remain in place for your lifetime as long as you pay the premiums.

Both of these types of policies typically allow you to build cash value. If you cancel either type of policy, you receive the cash value minus fees.

However, there are some key differences:

• Whole life has fixed premiums and death benefits.
• Universal life allows policyholders to change premium and death benefits.
• Whole life offers a steady interest rate for cash value, while the interest rate on universal life cash value can fluctuate.

Term life vs. universal life

There are significant differences between term life and universal life:

• The cost of insurance is usually lower for term life.
• Term life lasts for a specified period of time, usually 10 to 30 years.
• Term life doesn’t have cash value.