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. The death benefit is paid to your beneficiary upon your death. It's important to know that the cash value of a life insurance policy often doesn't go to the beneficiary when you die; it returns to the insurer.

How does universal life insurance work?

With universal life insurance, you pay the premiums, and when you die, your beneficiary gets the death benefit. Universal life insurance premiums also build cash value, which 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?

The different types of universal life insurance policies are guaranteed universal life, indexed universal life, and variable universal life. Each differs in premium and death benefit flexibility and in how the cash value account is handled, with some types carrying more risk.

• 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 offers a guaranteed death benefit, similar to term life, but lasts for your lifetime. It typically has a minimal cash value account, making it more affordable. 
• Indexed universal life insurance. With indexed universal life insurance policies, the interest on the cash value account is tied to an index, such as the Standard & Poor’s 500 stock index or a bond index. Universal indexed life insurance products also typically include an interest-rate guarantee but may have high 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: it provides lifelong coverage with flexible premiums and death benefits, but premiums may increase and the investment side of the policy may underperform; without a guarantee, you could lose money.

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

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 returned to the insurance company when you die, depending on the policy terms
• There is a risk of losing money with a universal life policy as it often lacks a guarantee.

“It appeals to customers who are interested in the potential growth of tax-deferred savings through the policy’s cash value, which provides future flexibility,” Kenny says.

Whole life vs. universal life

Whole life and universal life insurance are similar in that they are both forms of permanent life insurance. Your benefits remain in place for your lifetime as long as you pay the premiums, but whole life premiums and benefits remain fixed, while universal is more flexible.

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

Term life is a policy that remains in force for a specific period of time and has no cash value, while universal life is permanent as long as premiums are paid, and includes a cash value account.

Main differences include:

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