What’s Universal Life Insurance? Pros, Cons + Premiums

Updated

Even though today’s interest rates are much lower than in the 1980s when universal life insurance was released, universal life continues to be a popular product for life insurance buyers. 

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Universal life insurance has numerous tax advantages, including tax-deferred cash value growth, tax-free policy loans, and a tax-free death benefit. These advantages make universal life an excellent option for someone who needs life insurance protection for their loved ones and wants investment growth that they can use in the future. It also has an advantage that other types of life insurance don’t have: flexible premiums, which we will discuss in this article.

Let’s look at universal life insurance; what it is, its pros and cons, who can benefit from it, alternatives to universal life, and more.

Definition of Universal Life Insurance / How it Works

Universal life insurance is a type of permanent life insurance that contractually obligates a life insurance company to pay a death benefit to beneficiaries named in the policy.

The statement above is a good textbook definition of universal life insurance, but there is much more to it than that when it comes to policy features and benefits. Let’s look at the various elements that make up universal life, and we’ll take a look later at their pros and cons.

Premiums: The premiums for universal life insurance are competitive with other types of permanent life insurance, like whole life insurance and survivorship life insurance. They can pay monthly, quarterly, semi-annually, or annually and are usually paid by automatic bank draft.

Premiums for a universal life insurance policy are flexible, meaning that the premium can be paid in full or in part by the cash value (explained below) of the policy, as long as there is a sufficient amount of money in the policy to make the premium payment. 

Face amount: The face amount of a universal life insurance policy is the stated amount of the death benefit when the policy is issued. 

Cash value: When a life insurance premium is paid by a policy owner, a portion of that premium is deposited into a “cash value” account, which is part of the policy. The cash value grows tax-deferred at an interest rate set by the insurance company and is available to be withdrawn or borrowed as the policy matures and ample cash value has accumulated.

Death benefit: The death benefit of a universal life policy is the face amount of the policy minus any outstanding policy loans. There are two types of death benefits someone can choose from when they are applying for a universal life policy called Death Benefit Option A and Death Benefit Option B.

  • Option A: Pays the death benefit of the policy (face amount less any outstanding policy loan balances).
  • Option B: Pays both the death benefit of the policy and any cash value that the policy has accumulated.

Beneficiary: The person or persons named in the policy who will receive the death benefit from the insurance company.

These are the primary components of a universal life insurance policy. Let’s now compare universal life with other types of life insurance.

What’s the Difference Between Universal Life Insurance and Other Types of Life Insurance?

As mentioned in the definition above, universal life insurance is a kind of permanent life insurance. Permanent life insurance is exactly what the name implies—it is life insurance that can be kept permanently by the policy owner, unlike some other types of life insurance that only stay in force for a specified period (term).

Let’s compare universal life to other types of life insurance, both permanent and term life insurance.

Whole life insurance

Whole life insurance is the oldest type of permanent life insurance. Similar to universal life insurance, a whole-life plan has a face amount of insurance that the insurer must pay to beneficiaries when the insured person dies.

Another similarity between whole life and universal life is the cash value component in the policy. A portion of every premium dollar paid goes into the cash value account and earns interest at a rate set by the insurer. The cash value also grows tax-deferred and can be borrowed or withdrawn as the policy matures.

As you can see, there are similarities between whole life and universal life. However, there are a couple of significant differences.

One big difference between the two types of policies is that whole life does not offer two types of death benefits like universal life does (Option A and Option B). Instead, whole-life only pays out the face amount stated in the policy, minus any outstanding policy loan amount. Any cash value left in the policy when the insured dies is kept by the life insurance companies.

Another significant difference between whole life and universal life is the flexibility of premiums. Universal life insurance policies are configured so your cash value can pay your premium as the policy matures. This can be very helpful if your financial situation changes and it becomes challenging for you to pay your premiums each month. In addition, paying your premiums from the cash value will prevent your policy from lapsing.

A considerable differentiator between these two types of policies is the cost. Whole life is the most expensive type of life insurance you'll find and is substantially more costly than universal life insurance. 

All things being equal, the cash value of a universal life insurance policy will grow to be larger than that of a whole life policy. This is because insurers' interest rates credited to universal life policies are typically higher than those for whole life insurance policies.

Term life insurance

Term life insurance is the least expensive type of life insurance you’ll find on the market. The primary reason is that term life doesn’t accumulate any cash value. Every dollar of premium paid goes toward the cost of life insurance; there is no cash growth of any kind within a term life policy.

Also, whereas universal life insurance is a type of “permanent” life insurance, term life is a “temporary” type of life insurance. When you apply for a term life policy, you specify the amount of time you want your policy to stay in force, typically 1, 5, 10, 15, 20, or 30 years. When that term of time expires, your life insurance protection goes away, and your beneficiary will receive no death benefit.

Who Typically Buys Universal Life Insurance?

Universal life insurance is common amongst people who are established financially and want to have life insurance coverage but also want to accumulate some cash value, which term life insurance doesn’t offer.

Whereas term life insurance buyers are often younger families just getting started, universal life buyers are usually older. This age difference usually means they have more discretionary income and can afford to pay a higher cost for their life insurance coverage.

Some people buy universal life insurance because their income fluctuates, and they need the premium flexibility that universal life offers. For example, a commissioned salesperson who sells a seasonal product (think swimming pools) and whose income dips substantially during the winter months can benefit from the flexible premium payments by having the cash value pay the premiums.

People who buy universal life insurance policies want cash value accumulation and permanent insurance coverage. They want insurance protection to leave money behind for their heirs no matter how long they live, along with cash value that they can access and utilize while they’re alive. This accessible cash value helps with various expenses, such as college tuition, pre-paying a mortgage, or using it to pay for medical expenses not covered by their health insurance.

How Much Does Universal Life Insurance Cost?

The cost of universal life insurance is very similar to that of other types of life insurance. Premiums are based on certain factors common to all life insurance policies:

  • Age 
  • Gender
  • Geographic location
  • Tobacco use or non-use
  • Current health status
  • Pre-existing medical conditions

In addition to these factors, universal life insurance premiums also are determined by the amount of money the policy owner wishes to pay towards their cash-value account. There are minimums and maximums that insurance companies and the Internal Revenue Service (IRS) set that restrict how much an insured can pay in premiums for a given face amount of coverage. 

Life insurance companies establish a minimum premium amount someone can pay for a universal life policy to prevent it from lapsing. The IRS sets a maximum premium payment on a given face amount to avoid a life insurance policy from becoming more of an investment than a life insurance policy.

What Are the Pros and Cons of Universal Life Insurance?

While many people benefit from owning a universal life insurance policy, it’s not the best type of protection for others. Let’s look at the pros and cons.

Pros

  • It’s permanent life insurance that lasts a person’s lifetime.
  • The interest rate applied to the cash value never drops below 0%.
  • All cash value growth is tax deferred.
  • The premium payment can be paid from the cash value if the policy owner chooses to do so.

Cons

  • It is much more expensive than term life insurance.
  • Interest rates are low compared to some other savings vehicles.
  • The cost of the life insurance portion of the premium increases over time, meaning a decreased amount is allocated towards the cash value.
  • A policy can lapse if premiums are being paid by the cash value and there is no longer enough money to support the premium payment.
  • Universal life requires much more active management by the policy owner because of its flexibility and fluctuations in value.

How Do Premiums and Payouts Work With Universal Life Insurance?

As mentioned, perhaps the most significant benefit of a universal life insurance policy is the flexibility of the premium payments. 

Suppose a policy owner is experiencing financial difficulty. In that case, they can stop paying their premiums out-of-pocket and have premiums deducted from the cash value to pay for the cost of the life insurance. They must be careful, though, not to let the cash value become so depleted that there isn’t enough left to keep paying the premiums, which could result in a policy lapse.

How long it takes to get a life insurance payout will not vary much from other types of life insurance policies. The only factor that could slow down payment to beneficiaries is whether the policy owner selected Death Benefit Option B. If so, the insurance company needs to calculate the exact cash value on the date of the insured’s death. 

Are There Any Good Alternatives to Universal Life Insurance?

If there is one thing that detractors of universal life insurance could cite, it’s the interest rate used by the insurance company and applied to the policy’s cash value. Insurance companies are very conservative (some would say “frugal”) when it comes to determining how much interest to credit life insurance policies.

For that reason, some people use other financial products than universal life for their future financial security. Some of those are:

Individual Retirement Accounts (IRAs)

IRAs are tax-favored accounts offered by financial institutions. They have no life insurance component; money deposited into an IRA can be tax-deductible, tax-deferred, and withdrawn tax-free (depending upon the type of IRA: traditional or Roth IRA).

Regardless of the type of IRA, deposits usually purchase mutual funds, which typically have a greater appreciation than universal life insurance. However, there is much more risk associated with IRAs than universal life since negative investment performance for an IRA can result in loss of capital, which can’t happen with a universal life policy.

Variable universal life insurance

As you can tell by the name, variable universal life insurance is closely related to universal life insurance.

The differentiator is how the cash value grows. With a variable universal life insurance policy, the cash value buys shares of mutual funds, which, like IRAs, will experience more significant fluctuations in value and can result in cash value loss. This could result in the policy owner paying additional premiums to prevent the policy from lapsing. 

Consult With a Life Insurance Professional

Universal life insurance is one of the more complicated types of permanent life insurance. For that reason, it will benefit you to consult with a licensed life insurance agent or financial advisor who can outline a universal life insurance policy to help determine if it’s the right type of coverage for you. In addition, the agent can also tell you how much life insurance you should own.

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