Universal Life Insurance: How it Works, Options, Pros & Cons

If you’re currently shopping around for a new life insurance policy or even doing a little research on some of the different available coverage options, then it’s very likely you’ve come across one option called universal life insurance.

Universal life insurance is a popular permanent life insurance option, but it can be a bit confusing. One reason it can be confusing is because of the different variations that it comes available in.

The article below will discuss in detail what exactly universal life insurance is, how it works, the various options, and their pros and cons.

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What is Universal Life Insurance?

Before we get into the details as to what a universal life insurance policy is, it’s important to understand that it is not whole life insurance. Universal life insurance and whole life insurance are commonly mistaken for being the same, and although they have similarities, they are different in many ways.

The two biggest similarities are that they both provide permanent life insurance protection along with cash value growth potential. In fact, this is often the reason why the two coverage options are mistaken for being the same coverage.

However, the biggest differences between the two permanent life insurance options are within their flexibility to the insured.

Universal life insurance allows for premium payments, as well as the death benefit, to be adjusted based on changing insurance needs. Whole life insurance does not offer this. For example, any potential cash build-up within the policy can be used to pay premium payments in place of regularly scheduled premiums. This is assuming that there is enough built up cash within the policy.

Some universal life insurance policies will also allow for changes in the death benefit, such as increases or even decreases if needed. Also, universal life insurance is much more affordable than a whole life insurance policy.

Lastly, whole life insurance does have its advantages. Outside of it being permanent life insurance coverage, there is the potential to grow higher cash values than a universal life insurance policy can offer. Whole life insurance has both guaranteed cash values as well as the potential to earn dividends.

What’s the definition of universal life insurance?

In short, a universal life insurance policy is a form of permanent life insurance coverage that provides the flexibility to adjust premiums, death benefit, and build potential cash build value growth.

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What are the Different Types of Universal Life Insurance?

Now that we covered what the basics are and how it is different from a whole life insurance policy, we can discuss some of the various available types.

Universal life insurance is available in three different variations:

• Traditional Universal Life Insurance (UL)
• Guaranteed Universal Life Insurance (GUL)
• Indexed Universal Life Insurance (IUL)

The biggest question for you will be deciding on which of these three variations will be the best universal life insurance policy based on your own life insurance needs and goals.

One important thing to remember is that with all three variations, each allows for flexibility as well as can provide permanent life insurance protection. These are two factors that all three options have in common.

Traditional Universal Life Insurance

Up until the early 2000s, traditional universal life insurance was one of the primary forms of universal life insurance coverage. As time has gone by, newer forms have appeared, often making them a better choice than purchasing a traditional universal life insurance policy.

Traditional universal life insurance, which is also known as “UL” or current assumption and more recently referred to as non-guaranteed, is your most common form of universal life insurance.

As we touched on earlier, life insurance is designed to be a form of permanent coverage with the flexibility to adjust both your premiums as well as the death benefit if needed.

In addition to flexibility, there is also the potential to earn tax-deferred cash growth. The cash value growth can eventually be accessed through the use of policy loans or even partial surrenders if needed.

Universal life insurance works in which a portion of your premium goes towards paying the actual cost of the insurance and then the remaining portion going towards a cash value account. The cash value account grows based on an interest rate declared by the insurance company. Interest rates often have a guaranteed minimum, usually around 2%.

The problem with traditional universal life insurance

The biggest problem with traditional universal life insurance is that your rates are not guaranteed to remain the same. Most quotes and illustrations will show the insurance coverage performing for a lifetime, but it’s often based on non-guaranteed projections.

A change within the interest rates or a rise in the actual cost of insurance can disrupt the insurance altogether. For example, cash growth within a universal life insurance policy is important as it can be used to help keep the life insurance premiums level as the cost of insurance rises with age. Since interest rates are so low, it’s often difficult to accumulate a large portion of cash value growth.

As the cost of insurance increases with age, you could run the chance of having to either adjust your premium payments to match the current cost of the insurance or have the difference from what you’re currently pay taken from the cash value.

If you do this, after time, your cash growth could be entirely consumed by the rise of the cost of insurance eating away at all cash value. If this happens, you would need to adjust your premiums to stay in line with what the current cost of insurance is year after year. This can become very costly, especially in your senior years, when it would most likely happen.

Pros & Cons of Traditional Universal Life Insurance

PROS:

• Allows for changes in both premium and death benefit
• Potential cash value growth
• Can borrow from the cash value
• Coverage can last a lifetime

CONS:

• Coverage is not guaranteed
• If you borrow you need to repay the cash
• Could become very expensive later in life
• Not likely to gain large cash values

Guaranteed Universal Life Insurance

Guaranteed universal life insurance or GUL for short is the newer and much-improved form of universal life insurance that was introduced in the early 2000s.

This type of life insurance is the complete opposite of traditional universal life insurance as it provides several guarantees. For starters, guaranteed universal life insurance has a fixed premium that is guaranteed never change. Regardless of the cash value or cost of insurance, your premium will remain the same price for the length of the contract.

The standard contract duration is generally paid to age 121, but depending on the insurance company, you can find options such as pay to age 85, 90, 95, 100, 105, 110, 115, and 120.

One of the most prominent features of guaranteed universal life insurance is the no lapse protection. This feature guarantees that your life insurance policy will not lapse even if the life insurance policy has no accumulated cash value provided you pay your premiums on time.

Guaranteed universal life insurance is often considered to be one of the best types of permanent life insurance. It’s much more affordable than a whole life insurance policy, and it doesn’t have many complex components behind the coverage. The only thing you need to remember is to make your regularly scheduled premium payments on time.

Also, many companies offer additional features, as well as policy riders, to really enhance the overall life insurance coverage. Some of these features and riders include long term care, living benefits, and even return of premium if you decide you no longer need the life insurance coverage later in life.

Are there any drawbacks to guaranteed universal life insurance?

If cash value growth is an objective in your life insurance planning, then guaranteed universal life insurance is not the coverage you want. This type of life insurance coverage is not designed for cash growth. In fact, it gains very little to no cash value at all.

The main focus with guaranteed universal life insurance is permanent life insurance protection at an affordable price.

If the cash value is an objective, then let’s move onto indexed universal life insurance.

Pros & Cons of Guaranteed Universal Life Insurance

PROS:

• Guaranteed fixed premium
• Guaranteed death benefit
• No lapse protection
• Several optional contract durations
• Affordable permanent life insurance solution

CONS:

• Very little to zero cash growth potential
• Premiums not as flexible and need to be paid on time

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Indexed Universal Life Insurance

Our last type of universal life insurance is called indexed universal life insurance or IUL for short. Indexed universal life insurance is the newest type of universal life insurance and has become very popular.

This type of coverage has several of the same similarities of traditional universal life insurance, such as flexibility with both premiums and death benefit.

The most significant difference, however, is that an indexed universal life insurance policy has a much greater potential to earn higher cash values than a traditional universal life insurance policy.

Indexed universal life insurance can be a bit confusing, as well as misunderstood. This confusion often comes with how the life insurance policy earns its cash values.

With an indexed universal life insurance policy, there are two ways for cash to accumulate within the policy. One method is through a fixed interest account, and the other is through an indexed account.

The fixed interest account allows for cash to grow at a specific interest rate that is determined by the life insurance company. The indexed account builds cash based on the performance of popular stock market indexes such as the S&P 500, NASDAQ 100, Russell 2000, Hang Seng, and EURO STOXX 50.

How does an indexed universal life insurance policy work?

With any permanent life insurance policy that cash value potential, a portion of your premium payment goes towards the actual cost of insurance with the remaining portion going towards the cash value account.

Since an indexed universal life insurance policy has both a fixed and an indexed account, you get to choose where that remaining portion of the premium gets invested. You can invest it into the fixed account, the indexed account, or even both.

The fixed account can grow cash values that are based on an interest rate determined by the insurance company. These rates are generally not too high and can fluctuate. On the plus side, they do have a guaranteed minimum.

The indexed account has the greatest potential to earn cash growth, as the interest rate is determined based on the performance of specific stock market indexes.

IMPORTANT:
Premiums are in no way invested into the stock market. Cash value growth is determined based off interest rates that are calculated based on the performance of the stock market indexes.

If the stock market index performs well, the credited interest will be higher, resulting in an increase in the cash value. It is important to know that there is generally a cap on the amount of interest the policy can earn.

The insurance company sets the cap on the maximum amount of interest that can be earned.

On the other hand, if the indexes perform poorly, your interest rate will go down. However, one of the best features of any indexed universal life insurance policy is what is called the floor.

The floor is a guaranteed minimum interest rate set by the insurance company that protects your cash value due to negative index performance.

In addition to greater cash value gains and protection against poor index performances, an indexed universal life insurance can also offer several great policy riders.

Pros & Cons of Indexed Universal Life Insurance

PROS:

• Flexible death benefit and premium payments
• Greater potential for higher cash value growth
• Protection from negative index years
• Can borrow from the cash value
• Coverage can last a lifetime

CONS:

• Caps on the amount of cash growth that can be made
• Could require more premium later in life
• Coverage is not guaranteed to last forever

Cash Value Life Insurance

To better understand which type of universal life insurance is best for your needs, it helps to understand precisely what the investment portion of the policy is all about and what is meant by cash value.

The cash value of a life insurance policy acts much like a savings account by earning interest. In a universal life insurance policy, the interest earned is based on either the insurance company, current market rate, or minimum interest rate, whichever is greater.

Cash value of life insurance can be used to help supplement retirement income or provide emergency funds in which money is needed quickly. But, it is important to note that in most cases, the beneficiary of the policy does not get the cash value upon the death of the policyholder. The cash value will revert back to the insurance company, and the beneficiary will only receive the total amount of the death benefit.

One of the greatest benefits of cash value life insurance is tax-deferred growth that occurs over time. However, cash values can become taxable if and when you decide to surrender the life insurance contract. The taxable portion will be based on any gains above the total amount of premiums that have been paid towards the policy.

EXAMPLE: Let’s say you have had a cash value universal life insurance contract for the last 30 years. In the last 30 years, you have paid $245,280 towards the life insurance contract, and the cash value has accumulated up to $318,524. You have decided that you no longer need the coverage and would like to surrender the policy. The taxable portion would be total premiums paid minus the total cash value amount. In the example, the total taxable amount is $73,244.

When it comes to policy loans, it is also important to know that you will need to repay the money taken. You will also be charged an annual interest rate on the loan amount. If you don’t pay the interest rate, it will be deducted from any remaining cash balance within the life insurance policy. Should a policyholder pass away while there is an outstanding loan, the balance will be deducted from the death benefit before being paid out to the beneficiary.

What’s the Best Universal Life Insurance Policy?

No matter the type of life insurance policy you choose, it is important to research your options to make the best choice that meets your needs.

With regards to the available types of universal life insurance coverage, they each have their pros as well as cons.

A guaranteed universal life insurance policy is your safest option if your primary concern is to have permanent coverage at an affordable price. Again, don’t expect to make any cash, but rest assured, you won’t need to worry about any changes being made to the premiums, especially later in life.

If you like the idea of life insurance with potential cash values, I would recommend the indexed universal life over the traditional. However, understand that neither of these cash value options offers the guarantee that they will not require additional premium later in life, should they not perform as projected. This is something that needs to be taken into account when considering a cash value universal life insurance policy.

For more information or questions on life insurance products or quotes, please be sure to reach out to us for assistance. Top Quote Life Insurance is an independent life insurance agency that can provide both life insurance products as well as quotes from dozens of top-rated insurance companies.

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