Universal life insurance explained
What Is Universal Life Insurance?
Universal life insurance is a permanent life insurance policy that’s similar to whole life in that it combines a savings vehicle with lifelong (hence, “permanent”) coverage. If the premiums are paid as required, the policy will not expire and death benefits will be paid out to the beneficiary. Typically, universal life provides a “cash value” that mimics a whole life policy on the surface but offers greater flexibility. With universal life policies, the savings element, premiums, and death benefit can be changed as the policy holder’s situation changes.
Depending on the specific product, the cash value in a policy can be tied to a money market account or a major stock index, or it can be invested into equity funds and bond funds. Once you purchase a policy, the insurance company establishes a minimum interest crediting rate per the amount stated in the contract. If the company’s portfolio earns more than expected, a portion of the additional amount is credited to your account, up to the cap rate. This is how policies can accumulate more cash value than whole life policies can.
- What Is Universal Life Insurance?
- Uses for Universal Life Insurance
- How the Death Benefit Works
- How the Cash Value Works
- Comparing Rates
- Term Life vs. Universal Life
- Whole Life vs. Universal Life
- Universal Life Insurance Offers
- Different Structures Of Universal Life
- Types of Universal Life Insurance
- Pros and Cons
- Real-Life Questions
Uses for Universal Life Insurance
For the most part, universal insurance serves the same purpose as other forms of life insurance — it serves as a financial protection and income replacement vehicle in the event of death. In the insurance world, you’ll see these types of life insurance policies being used more in advanced estate planning, after other tax-free/tax-deferred options (such as 401(k)s and IRAs) have been maxed out and people are looking for ways to minimize their current tax obligations that can’t be achieved with other investment vehicles.
How the Death Benefit Works
When it comes to the death benefit, you basically have two options: level or increasing.
With the level death benefit, the amount the policy pays out stays level throughout the life of the policy, and the policy will pay out either the death benefit or the cash value, whichever is greater. With an increasing death benefit, both the cash value and the death benefit increase over time, and both are paid out as part of the death benefit.
How the Cash Value Works
Like whole life, universal life is permanent insurance. The difference between them lies largely in the cash value accumulation process. With universal life, the insurance company sets a minimum interest rate based on the contract for the policy (usually a low 2-3%). From there, if the insurance company’s overall portfolio gains in value, then part of the increase is added to the cash value of the company’s universal life policies, up to the maximum percentage amount listed in the policy contracts. If the company’s portfolio does not have a gain, or if it takes a loss, the insurance company is still obligated to pay the minimum interest stated in the policy contracts.
A major advantage to a universal life policy is that the cash value can be used to pay the policy’s premiums after a certain point — if the account has been built up enough to pay for the continual cost of insurance — although there are usually limitations as to how long you can do this. A whole life policy, on the other hand, will automatically take out a loan against the cash value if premiums are not paid.
With a universal life policy, premium payments go toward funding the savings component and the insurance component (i.e., the death benefit and administrative costs). For coverage to remain in force, the insurance component must be funded either through premium payment or a reduction of the cash value (if it has accrued enough). As long as the insurance component is funded, the contracted coverage is guaranteed to stay in effect.
How can you use the cash value that builds up in a universal life policy? You can either borrow against it (as in a loan) without tax implications, or you can withdraw part of the cash value, which may be subject to taxes. Always check with your financial adviser about potential pitfalls before withdrawing funds from a cash value policy.
From the example below, you can see that not all companies are competitive in their pricing for life insurance.
While Sagicor and American National (both great companies) are pretty close to 5star’s price, State Farm’s policy is twice as expensive for the same basic coverage.
This is why we strongly encourage you to talk to an independent agent who works with dozens of companies to find you the best price, like a True Blue personal shopper, rather than buying life insurance from someone who works only for one company.
Example: 37-year-old male in Alabama, non-smoker, average health, for $100k in coverage.
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Term Life Insurance vs. Universal Life Insurance
Universal life insurance is best understood as a “hybrid” of term life insurance and permanent life insurance, taking the best of both and adding in some unique features. The major difference between universal and term life insurance is that universal is meant to protect you for your entire life, whereas term is designed to protect you for a predetermined period. In addition, term life insurance does not have a cash value feature, and if a term life policy is canceled, then nothing is returned to you (unlike with a permanent life policy).
Universal life and term life insurance use pretty much the same calculations to establish premiums, but universal life averages the premiums for coverage to age 100 and charges you that average price for coverage. That’s why you pay more for this type of protection than for term life insurance.
Whole Life Insurance vs. Universal Life Insurance
The major difference between universal life insurance and whole life insurance is the overall flexibility of the premiums. As noted above, under certain circumstances universal allows you to use the cash value of your policy to pay your premiums if you need to — as long as the cost of insurance is covered. Whole life does not give you that option.
Both types of insurance allow for tax deferment of the cash value account and permit loans against the cash value. However, whole life does not let you increase or decrease the death benefit as your financial needs change throughout life. And although both policies offer the ability to skip premium payments (which is never advised) as long as certain conditions are met, a whole life policy creates a loan against your cash value that must be paid back, plus interest. With a universal life policy, the skipped premium is deducted from the policy’s cash value component.
The way interest accumulates is different, too. With universal life, interest is adjusted monthly, allowing for faster growth of the cash value. With whole life, interest is calculated on a yearly basis, which means the cash value increases more slowly.
Universal Life Insurance Offers:
- A cash value component that allows you to skip premium payments as long as there are enough funds built up to cover the cost of insurance. There may be an initial period — for example, the first year — in which you cannot access this feature of the policy.
- The ability to increase and decrease death benefits, as needed, based on your current circumstances.
- The ability to borrow against the cash value (in most cases).
- The opportunity for the cash value component of the policy to grow on a tax-deferred basis (and so does universal life). Most whole life policies allow for withdrawals and loans.
- A locked-in death benefit that will not increase or decrease while the policy is in force.
- The ability to skip premium payments under certain circumstances. But the premium is deducted from the policy’s cash value as a loan you must repay, often with added interest.
Different Structures Of Universal Life Insurance
Universal life insurance comes in three basic structures. Availability largely depends on the insurance company.
This is the typical policy offered by almost every life insurance company. Simply put, it’s individual coverage that insures only one person.
Joint covers two people. The death benefit is paid when the first person dies. Typically, couples purchase this type of policy to provide protection to the remaining spouse and the household. In some cases, it might make more sense to purchase a term insurance rider for the spouse on a different type of policy, if that option is available. It’s best to review all of your options before making a decision. We recommend discussing your choices with a licensed independent agent.
Survivorship looks a lot like joint, but it’s a “last to die” policy that only pays out when both insured parties die. This is not a practical policy for most people. It’s largely used in advanced estate planning to help prepare for coverage of estate tax if the insureds’ estate exceeds the overall federal threshold on estate taxation. Unless your estate is worth more than $10 million, you can most likely find better coverage with a different type of policy.
Types Of Universal Life Insurance
Traditional Universal Life
Traditional policies are the ones most often discussed when people talk about universal life insurance. These policies generally accumulate cash value more slowly than the other types do but they’re also safer, as the cash value accumulates in money market accounts. Many people use this type of policy to supplement their retirement income needs by taking loans against the policy after retirement.
Indexed Universal Life
Indexed life insurance policies policies are invested in index funds that usually follow the S&P 500 or a similar equity index. Many of the features and options of an indexed policy mimic those of a traditional policy; the biggest difference is that the gains are usually larger. These policies are usually used to augment other investment options in a long-term strategy, combining protection with growth of wealth.
Variable Universal Life
Variable policies have options and features similar to those of indexed, but variable universal life attaches the cash value account in the policy to actual investment funds that trade largely in equities and bonds. The cash value can increase very quickly, making this type of policy seem lucrative. However, the risk is also greater — if there’s a severe downturn in the markets, the cash value can be wiped out even faster than it grew. In addition, the fees that accompany these policies make them a less-than-ideal option for 99% of the people we talk to. If you’re considering a variable policy, we encourage you to talk to an independent FINRA registered adviser.
Guaranteed Universal Life
Guaranteed policies are probably the closest to normal term life insurance. They typically build up little to no cash value and do not offer the same kind of flexibility on premiums as other universal life insurance products. Guaranteed universal life insurance mimics term life insurance, only it offers coverage for the entire life of the policy holder instead of for a predetermined amount of time. These policies are often less expensive than a traditional policies.
Pros and Cons
Your financial needs rarely stay the same throughout your life. And, during economic downturns, you may want to pay less to minimize potential losses (depending on the type of universal life policy you own), or you might want to pay the minimum required to keep the policy active. Universal gives you many options to customize your coverage.
Choice of interest strategy
Depending on the type of policy, you may be able to choose where your cash accumulation goes.
As long as you pay the premium, you will have life insurance for the rest of your life.
Cash value accessibility
Similar to a whole life policy, you have access to the cash value of your policy for loans and withdrawals if you need it.
All growth in policies is tax-deferred, which means the IRS won’t bother you right away for taxes on the gains. Always consult with your independent financial adviser about potential tax obligations before withdrawing money from the policy.
Because of the fees and higher premiums, policies will usually cost you about four times more than a standard term policy.
Cost of insurance
When it comes to premiums, there are two types of universal life policies: LCOI and yearly renewable term.
LCOI, or level cost of insurance, is where the insurance company calculates the total cost to insure you and makes the premiums level — they never change throughout the life of the policy.
Yearly renewable term is similar to buying a new term life insurance policy every year, so the cost of insurance gradually increases. This method allows for lower overall cost during the early years, but coverage becomes more expensive the longer the policy continues.
Repayment of loans
Borrowing against your universal life policy could lower your death benefit, and you’ll be charged interest.
Monitoring cash value
Most policies are not “set and forget” policies. Indexed and variable are meant for people who have some knowledge of investing, as the overall performance of the cash value of these policies needs to be monitored closely.
Super-low interest rates
The interest rates on most policies are extremely conservative (2-3%) and may not even offset inflation. You won’t get rich by owning a universal life insurance policy.
Are universal life insurance policies a good investment?
They can be, depending on your overall goal. In many cases, people just want simple and basic coverage at the lowest price possible. In that scenario, a universal life policy may not be the best choice.
Other people are open to having lifelong coverage with a forced savings plan, and they understand that a universal life policy may not be the least expensive way to go. Overall, it depends on what you’re looking for when it comes to life insurance.
How much does a universal life policy cost?
The cost of the insurance is like any other form of insurance — it depends on the policy and the insurance company. A general rule of thumb is that it costs more than term life insurance and less than whole life insurance.
What is the best way to buy?
While exclusive or captive agents (e.g., those at State Farm and Allstate) may sell universal life coverage, they can only offer you the product their company sells.
An independent agent, like one of our True Blue personal shoppers, does business with multiple companies.
That makes it possible for an independent agent to shop around and find the best price and the best underwriting for your unique situation. We’ll help you understand your options. This gives you more control over your life insurance.
Why would a universal policy not be a good choice?
These policies are not for everyone. Most people are quite satisfied with term life insurance and don’t need or want the lifelong coverage of a permanent policy.
It just depends on your long-term plan and what you want life insurance to do for you. It’s best to talk with an experienced professional to determine whether a universal policy is a good fit for you.
When is the best time to buy?
As with any life insurance policy, the younger you are when you apply for coverage, the better. Your risk of death is lower, and you’re less likely to have a medical condition that would put you in a lower health rating class — which could negatively affect your overall premiums.
Where is the best place to buy?
Your best option is through an independent agency like True Blue. An independent agent can act as your personal shopper, checking with dozens of insurance companies and providing you with multiple options that could work well for you. Independent agents know the intricate details of different insurance companies’ underwriting requirements and can ensure that you get covered by a company that’s right for you.