What is Universal Life Insurance?
Universal life insurance is a type of permanent life insurance that comes with flexible premiums. Some universal policies also offer flexible death benefits. The growth rate of the cash value of a universal life policy depends on the policy type you choose.
Universal life’s flexible premiums
The main factor that differentiates universal policies from other types of permanent life insurance policies is the premiums. This is the amount the policy owner needs to pay in order to keep the policy active.
With all permanent policies, when you pay premiums, a portion of that money goes toward covering the cost of insurance and the rest goes into the policy’s cash value component, which acts as a sort of savings vehicle for you.
When you choose universal life insurance, you’re locked into covering the cost of insurance. In other words, the insurance company sets a minimum premium that you need to pay. This covers the death benefit and administrative costs.
But you can pay more than the minimum premium, and any extra you put toward the policy will go into the cash value. This gives you the flexibility to adjust your premium payments as your budget allows.
Once that cash value reaches a certain threshold, you can use it to cover all or a portion of your premiums. But that only applies as long as there is money in the cash value account. If you use it to pay your premiums to the point that the cash value reaches a zero balance, your policy will lapse.
Many people assume that paying more than the minimum premium will allow them to build a significant cash value that they can use to cover their premiums during retirement. That might be true, but the flexible premiums that come with a universal life insurance policy are something of a double-edged sword.
Yes, the insurance company lets you determine if you want to pay more than the minimum premium. But they also get flexibility on their end. Specifically, they will increase your fees as the cost to insure you goes up, which happens as you age. This is also known as the “cost of insurance.”
That could mean expending your cash value faster than anticipated, leaving you facing higher minimum premiums or a policy lapse.
The cash value component
Like other forms of permanent life insurance, universal coverage comes with a cash value component. To reiterate, you can use that savings component within your policy to cover all or part of your premiums, but be careful that you don’t use all of the cash value up or your policy could lapse.
Beyond applying it to your premiums, you also have a few other options for using your cash value:
- Withdrawals. You can also withdraw your cash value, but that could impact you and your beneficiaries in a couple of ways. First, cash value withdrawals over a certain threshold can be subject to taxes. Secondly, the insurance company will likely deduct the amount you withdraw proportionately from the death benefit your beneficiaries receive.
- Loans. You can also borrow against your cash value, allowing you to get a low-interest loan using the cash value as collateral. But if you have any unpaid loan amount when you die, the insurer will subtract that, plus any interest owed, from your death benefit before disbursing it to your beneficiaries.
- Payout after policy surrender. You can choose to surrender some universal life insurance policies. When you surrender your policy, you give up your coverage and the life insurance company gives you the policy’s cash value.
Like other permanent policies, universal life insurance doesn’t distribute the cash value to your beneficiaries when you pass away. Instead, the insurance provider absorbs any amount remaining when you die. That is, unless you specifically choose the option that universal life insurance offers where the death benefit (or the amount of premium paid, either/or) gets added to the death benefit dollar for dollar. This option will have a higher cost of insurance as the amount at risk will remain static, but you will get older every year.
Types of universal life insurance
The aforementioned cash value grows at a rate that depends on the universal policy type you choose.
Whichever of the below options you select, many insurance providers give your cash value a minimum guaranteed rate of growth (except for variable universal life insurance, unless you pay extra). Read the fine print, though, because that minimum could be 0%. Essentially, that protects you from losing cash value if the relevant metric performs poorly, but it doesn’t mean you can rely on cash value growth through the years.
Here are your options for universal life insurance policies:
- Standard universal life insurance. These policies tie cash value growth to the interest rates in the market, e.g., LIBOR.
- Indexed universal life insurance. These policies link your cash value growth to the performance of a specific stock market index, like the Dow Jones Industrial Average or S&P 500. Your cash value is subject to a cap, floor, and participation rate.
- Variable universal life insurance. When you choose this coverage type, you get to pick investment options. Your cash value grows, stagnates, or shrinks based on how those investments perform.
- Guaranteed universal life insurance. This coverage is designed to be the most affordable. It comes with a slower rate of cash value growth than any of the policies above and should not be purchased for its cash value. But with these guaranteed policies, your universal coverage won’t lapse if your cash value reaches zero. Think of it as a term policy that lasts forever with a level premium for life.
Flexible death benefit
Some universal life insurance policies also come with the option to increase or decrease your death benefit. If you want to increase coverage, you’ll likely need to pay higher premiums and you may be subject to another medical exam.
Death benefit flexibility lets you drop the face value of your policy if you need less coverage over time (for example, if you paid your mortgage in full). With a smaller death benefit, your premiums should decrease, helping you keep coverage more affordable through the years.
