What is universal life insurance?

What is universal life insurance?

Life insurance is a contract between an insurance company and an individual, known as the policyholder. The policyholder agrees to pay a specific sum, called the premium, to an insurer. In exchange, the insurance company agrees to pay a set amount of money, called the death benefit, to the designated beneficiary (or beneficiaries) if the insured person dies.

Universal life insurance is a form of permanent life insurance that is intended to last for the duration of the insured person’s lifetime — so long as premium payments are current.

Also, some forms of universal life allow you to invest your policy’s cash value in stock or bond funds, offering the potential for greater returns (but more risk) than whole life.

A typical universal life insurance policy pays a tax-free death benefit upon the insured person’s passing and contains a savings component that can be accessed by the policyholder. Death benefits can range from less than $25,000 to $500,000 or more, depending on the insurer and policy.

Universal life insurance vs. whole life insurance vs. term life insurance

Universal life differs from term or whole life insurance in the way premiums are paid. Unlike with these other forms of insurance, universal life premiums are adjustable, meaning the policyholder can increase or decrease payments over time.

In addition, the cash value of a universal life policy typically grows at a variable market rate rather than at a fixed rate.

Some insurers may offer universal life insurance with additional investment options, allowing you to invest the cash value in stock or bond funds, offering the potential for greater financial gain than with a fixed rate of return. Policyholders can access this cash value through withdrawals or loans, but doing so can diminish or deplete any potential death benefit.

The advantage to this kind of life insurance is financial flexibility — you can adjust your payments to fit your budget or use the policy’s cash value to fund your premium.

“Compared to whole life, universal life generally offers lower premiums while still building cash value,” said Randy VanderVaate, a licensed insurance agent in Dallas and CEO and founder of Funeral Funds of America. “This can be a good option for those who want some cash value growth but prioritize affordability over a guaranteed cash value amount.”

How whole life insurance compares

Whole life insurance is another form of permanent life and also has a savings component that builds cash value.

Unlike universal policies, whole life insurance typically invests the policy cash value at a low, fixed rate of return. Premiums are level in most cases, and the death benefit is guaranteed.

“People who want predictable premiums will benefit from whole life insurance because this policy comes with fixed premiums that remain constant throughout the policy,” VanderVaate said. “This provides stability and ease of budgeting compared to term life, which will significantly increase in price after the policy contractually terminates.”

How term life insurance compares

Term life insurance is temporary life insurance that lasts for a specific period of time, typically five to 30 years. Premiums are level, meaning they won’t increase, and the death benefit is guaranteed. Unlike permanent life insurance, term life policies contain no cash value to invest.

“People with temporary financial needs will also benefit from term life insurance because term insurance can cover specific needs during a certain period,” said VanderVaate. “If you have a young family or debt that needs covering for the next 20 years, term life is a good fit. As your needs change, you can re-evaluate your coverage.”

» MORE: Term vs. whole life insurance

How universal life insurance works

Before you buy a universal life insurance policy, think how much of a death benefit you want to leave your beneficiaries, whether there are any optional riders you require and what you can afford. You can find free online life insurance calculators on many insurer websites that can help you determine how much coverage is ideal.

Next, you’ll want to get a quote from at least three or four insurance companies to get an idea of what premiums are like. You will likely need to speak with a company representative or agent in order to get a quote, and you also may need to undergo a medical exam before you’re approved to purchase a policy.

In addition, you’ll need to designate a beneficiary (or beneficiaries), who will receive the death benefit upon the insured person’s death. Beneficiaries can be individuals such as friends or family, or be an institution such as a charity or college.

A typical universal life insurance policy includes the following:

• A death benefit, which will be paid tax-free to the policy beneficiaries upon the death of the insured.
• A savings component, which invests the cash value in a variety of market-rate options, such as mutual funds or stock or bond market indexes.
• A variable rate of return, based on market performance, rather than a fixed rate of return.
• Optional riders and add-ons, which can provide additional coverage for yourself, your spouse or your children.

Types of universal life insurance

A standard universal life insurance policy contains a savings component that accrues cash value based on market rates, which can vary over time.

Like other kinds of life insurance policies, a universal life policy also has a death benefit that will be paid to the beneficiaries once the insured person has died. Unlike other types of life insurance, however, the death benefit is not guaranteed.

Other types of universal life insurance include:

• Indexed universal life insurance (IUL) policies invest the cash value in stock market index funds, such as the Nasdaq or S&P 500, rather than in a money market like a regular universal life policy. This offers potential for greater returns on your investments, but comes with greater risk for loss as well. To provide some security, IUL policies typically have a minimal rate of return guaranteed.
• Variable indexed universal life insurance (VUL) is another form of permanent life insurance. It, too, comes with a savings component that builds cash value over time. But policyholders can invest that cash value in stocks, bonds and mutual funds, as well as more conservative options. VUL policies carry even greater financial risk and reward than traditional universal or IUL policies.

» MORE: Types of life insurance

Pros and cons of universal life insurance

As with whole life, universal life policies contain a savings component that can accumulate cash value over time and be accessed by the policyholder in the form of withdrawals or loans.

Unlike whole life, premiums and death benefits can be adjusted up or down, and policyholders have more options for how the cash value is invested.

Bottom line

With universal life insurance, you can increase or decrease your premium payments, make them on an irregular basis or even use the accumulated cash value to cover your premium. While this offers a greater degree of financial flexibility than whole or term life policies, you also run the risk of diminishing or depleting the policy death benefit if you don’t make regular premium payments.

Depending on the policy and the insurer, universal life can offer you a wider range of options for growing the cash value, including investing in stock or bond index funds. This offers the potential for greater return, but also increased risk for loss, which can negatively impact the death benefit.