Life insurance is a valuable tool to protect your loved ones in the event of your untimely death. There are several different kinds, including term, whole, and universal life insurance, and understanding their differences is crucial to determining which is the best fit for you. In this article, we'll look at how universal life insurance works, its pros and cons, and how it stacks up to the other types of life insurance.
What is universal life insurance?
Universal life insurance is a type of permanent life insurance. It protects the policyholder for the rest of their life or until they reach a certain age -- often somewhere between 90 and 120 -- assuming they keep up with the monthly premiums.
The insurer pays a death benefit to the policy's beneficiaries after the policyholder's death. Some universal life policies also build cash value, which policyholders can borrow against, withdraw, or use to combat rising premium costs as they age.
How does universal life insurance work?
When a person purchases a universal life insurance policy, they're entering into a contract with the insurer. They agree to pay monthly premiums. In exchange, the insurer agrees to pay a death benefit to the beneficiaries when the policyholder dies.
Unlike whole life insurance, which has fixed premiums, universal life insurance premiums are often variable, and they typically rise as the policyholder ages. But they can also be more flexible than whole life premiums. See the section on cash value below for more information.
The best life insurance companies also enable policyholders to customize their policy with riders. Exact options will vary from one insurer to the next.
The policy only remains in effect as long as the policyholder continues to pay the premiums. If they fail to make even one payment, they could lose their coverage.
Types of universal life insurance
Universal life insurance comes in three main types: indexed universal life insurance, variable universal life insurance, and guaranteed universal life insurance.
Indexed universal life insurance
In addition to providing a death benefit, indexed universal life insurance (IUL) enables policyholders to allocate a portion of their cash value -- the extra money paid to the insurer beyond the cost of the insurance -- to an equity index account.
This means that the money left over after paying the policy's fees goes into an account where it can earn interest. The interest rate depends on the performance of a market index, like the S&P 500. However, the money isn't directly invested in any stocks.
These policies are less risky than variable universal life insurance, but there are often caps on how much interest the policyholder can earn. Also, if the index reports a loss, the policy may not earn any interest for a given year.
Variable universal life insurance
Variable universal life insurance (VUL) is similar to indexed universal life insurance, but it has investment subaccounts that enable policyholders to invest their cash value in actual securities. This could generate significant returns if the policyholder invests wisely. But it opens up the possibility of huge losses if their investments perform poorly. In some cases, they could lose all the cash value they've accumulated.
Besides being more complex than the other types of life insurance, variable universal life insurance also tends to be more expensive.
Guaranteed universal life insurance
Guaranteed universal life insurance (GUL) is the simplest and cheapest form of universal life insurance. This type of policy usually doesn't offer any cash value. It has fixed premiums, but policyholders usually don't have the flexibility to adjust their premium payment or death benefit amount as they can with indexed or variable universal life insurance.
Universal life compared with other types of life insurance
A universal life insurance company also typically offers term and whole life insurance policies.
Universal life insurance vs. whole life
Whole life insurance is another type of permanent life insurance. It's more expensive than universal life insurance coverage, but it provides more guarantees. These policies provide guaranteed premiums that won't go up. They also provide guaranteed death benefits and a minimum guaranteed rate of return for the cash value component of the policy. Some whole life insurance policies also pay dividends, though these aren't guaranteed.
These policies could be a good fit for someone who wants lifelong coverage and is willing to pay extra for these added guarantees.
Universal life insurance vs. term life
Term life insurance only covers the policyholder for a certain number of years. If the policyholder dies within the term, the insurance company pays the benefit to the policyholder's beneficiaries. If the policyholder is still living at the end of the term, the insurance company keeps all the money.
These policies are more affordable than permanent life insurance. They're popular choices for parents of young children who want to ensure that their families could still continue to pay their bills following their death.
Universal life insurance pros and cons
Here are some of the advantages and disadvantages of universal life insurance.
Pros
- Coverage for your entire life
- Flexible premiums
- May accumulate cash value, which the policyholder can borrow against or withdraw as needed
Cons
- Coverage can lapse with a single missed payment
- More complex than term life insurance
Universal life insurance cash value
To keep a universal life insurance policy, you must pay premiums that cover the cost of the insurance. But with indexed or variable universal life insurance, policyholders can also pay more than the minimum cost of insurance. The excess gets added to the cash value of the policy and can earn interest.
Policyholders can use this cash value in a few different ways. One option is to cover the cost of future premiums. This allows the policyholder to skip a payment or two or possibly stop making payments altogether if their cash value is substantial.
They can also withdraw the cash value to use for their own purposes. But they'll pay taxes if they do this and it will reduce the death benefit available to their heirs. Another option is borrowing against the life insurance policy's cash value. The policyholder won't face taxes if they do this, but they must pay back what they've borrowed with interest. If they fail to pay back the loan, the insurer subtracts the outstanding balance from the death benefit upon the policyholder's death.
Who should buy universal life insurance?
Universal life insurance is a good choice for those who are looking for an insurance policy that protects them for their whole life. Those interested in the investment opportunities a universal life insurance policy can offer should also give them a closer look.
If you don't think universal life insurance is the right option for you, compare whole vs. term life insurance to determine if one of these is a better fit.
