What is Universal Life Insurance?
Universal life insurance (also known as UL policy) is a type of life insurance which combines two elements: a lifetime coverage and a savings account feature. Not only does it offer insurance over a long period of time but also the chance to gain cash value, which acts as a savings account. It accumulates interest over time.
With universal life insurance, you can receive lifelong coverage. The life insurance payout, called a death benefit, is paid to your beneficiaries tax-free. Some universal life policies also build cash value, with gains growing tax-free. Universal life policies build cash value, with gains growing tax-free. And there may be flexibility to adjust your premium payments and death benefit, depending on the policy.
But What exactly is “cash value?
In fact, the cash value is the thing that makes this type of policy so attractive. People feel insured, protected and at the same time have a sense of investing in something.
The cash value can be used to accumulate investment profits (and sometimes get hit with losses, depending on the policy type).
A withdrawal or a loan are two ways to get money out of cash value. If you die, the insurance company will deduct the amount of any withdrawals or outstanding debts from the payout to your beneficiaries. However, for some buyers, having access to cash value is more significant than receiving a full payout to beneficiaries later.
Universal life insurance policies, like other life insurance policies such as whole life and term life insurance, can be customized with a variety of riders. Riders are a way to add extra coverage or features to a policy, usually for a fee.
The following table presents the main pros & cons of universal life insurance:
Universal Life Insurance – Advantages
Let's start with the advantages:
Have you wondered what's the difference between Term to UL policy?
Term life insurance policies offer coverage for a certain period of time. However, death is an unpredictable factor; you never know when it may happen. Unlike them, UL policies provide clients with lifetime coverage which does not expire as long as you make payments on time. Depending on the type (for example, guaranteed universal life policy), you can extend the period of insurance over 100 years up to 120. So, if you want to feel protected for a longer period of time, consider purchasing UL coverage.
Gain Cash Value And Interest
This is one of the most serious advantages that makes universal life policies quite attractive. Cash value plays the role of a savings account. Just like any, it earns some interest over time. If you don't want to pay taxes on your investment returns, you can borrow a loan from your cash value.
Be careful, though:
The interest your cash value will earn changes according to market factors and conditions. Some insurers offer their customers a minimum guaranteed interest rate, which is good. Before buying a policy, do your research and compare different proposals.
Unlike whole life insurances, which require regular and fixed payments, UL policies offer clients flexibility on that part. The premiums you have to pay change, except for the minimum premium amount, which you have to make on a regular basis. Sometimes you can even miss a payment without losing the coverage.
Believe it or not:
As long as there is enough money in your cash value, you can use it to pay your premiums. You have the opportunity to adjust them according to your current financial situation, which is something you cannot do if you have a term life or a whole life policy.
Besides, as already mentioned, you can borrow from your cash value to cover some pressing needs, such as overdue payments and all sorts of expenses. Keep in mind that there are some hefty fees to pay if you want a loan – up to 10% cash surrender fee.
Tax Deferred Returns
No one likes paying taxes. This is yet another serious benefit of UL policies. The growth of your cash value is tax-deferred as long as the money is distributed either as a loan or as a death benefit. Then the amount of money will be tax-free.
In a case of early death of the insured, an amount of money called death benefit should be distributed to their family. You remember that UL policies, unlike other life insurances, do offer the accumulation of cash value over time. Sometimes, in the event of death, the UL policy distributes the death benefit as well as the gained cash value. There are two major options to choose from when it comes to the distribution of death benefit.
Level Death Benefit (Option A)
The first one is a fixed life insurance payout regardless of when the person dies – the second year or the last one of the policy. This option is cheaper but you will not benefit from the cash value since the death benefit is flat. Even though the premium costs are lower, the money received upon death will not increase over time.
Death Benefit Option B
If you want to combine a fixed death benefit as well as the accumulated cash value, choose this one. It combines them both, but the premiums will be higher.
Unlike many other life policies, UL coverage is quite transparent. The policyholder will give you an annual report where you can check all the details – cash value accumulation, how much interest you have generated, expenses, mortality changes.
Why is this important?
Knowing how your policy performs is a good way to manage your finances and make adjustments if need be.
Universal Life Insurance – Drawbacks
Above we listed the most common reasons people purchase universal life insurance. Now let's look at some of the drawbacks and risks associated with it:
Premiums Are Higher And Change
Building a cash value has its cost – higher premiums. Usually, term life policies are cheaper and the premiums lower. This is because universal life offers a cash value option, which needs to be funded regularly.
Keep in mind:
not only are premiums higher but they also change over time. The older you get, the higher they become. You might consider investing the difference in cost between term life and universal life in something else which gives you more freedom.
Cash Value Exhaustion
Unlike whole life insurance, which is another form of permanent life insurance, UL policies do not offer a guaranteed cash value option. You can use the cash value to take out a loan or cover a missed payment, but you have to pay an interest rate. Be aware that the cash value might get exhausted, which can lead to a termination of the policy.
Returns Are Not Certain
What makes UL policies so attractive is the cash value which generates interest over time resulting in returns. However, this is also what makes this type of coverage more expensive than, say, term life policies. Despite that, the interest rate on the cash value is not fixed and certain. It depends on the market and the changing conditions.
Allow me to explain:
Before buying the insurance, the policyholder shows how well your savings account will perform based on an assumptive rate. This is something like an ideal interest rate in ideal conditions. Besides, the rate is revised every four months or so.
Usually, universal life policies have a guaranteed interest rate, which is the minimum interest your cash value will generate. Keep in mind that, the rate on the savings account rarely goes beyond the guaranteed rate.
Fees And Charges
A bit of a downer is all the fees associated with universal life policies. They could range from management fees to mortality costs. There are also administration fees and commissions. If you decide to borrow money from your cash value, for example, the policyholder will charge you with a “cash surrender fee” up to 10%. Also, in the event of a loan, the company will certainly impose an interest rate between 5 and 9%.
All these fees and charges increase the total cost of the UL policy.
Possibility Of Lapse
In insurance terms, a lapse means the termination of a life insurance policy due to missed payments.
Even if you missed to pay some premiums, the cash value will cover them. However, if it is exhausted, it may lead to a lapse in coverage. Keep in mind that most companies offer their customers a grace period. This is a 30-day period in which, despite missed payments, the coverage is still active. However, a final lapse of the policy means that death benefit will not be provided to the beneficiary and the contract is terminated.
Not A Very Logical Investment
When a person invests in something, his idea is to make a profit, right? Undoubtedly, universal life offers the accumulation of cash value which can bring some returns by earning interest over time. But there are some things a person should be careful with:
First of all, the fees and charges as previously discussed could be so high that they can “eat” your cash value. Secondly, the interest rate on the cash value might not be as high as you wished, sometimes not being able to cover the other charges.
Moreover, the policyholder will show you ideal returns with an ideal interest rate, which most probably will never be achieved. For instance, you can use the money you have put into your cash value to purchase other assets – stocks, bonds, etc.
Last but not least, don't forget the taxes. If you want to take advantage of your accumulated cash value and you want to avoid paying taxes, you have to take out a loan… and pay an interest rate on it? That's not a very profitable move, is it?
Universal Life Insurance Alternatives
For everyone's position, universal life isn't the best option. Other types of life insurance may be more suitable based on the term of the coverage and the guarantees you require.
Term Life Insurance
Term life insurance is often provided for five, ten, fifteen, twenty-five, twenty-five, or thirty years. You may outlive the policy since it lacks a cash value component. However, it is the most cost-effective method of purchasing life insurance. You could, for example, get a 20-year policy to cover your young child's growing years and college years. When you buy a house and take out a mortgage, you can choose for a 30-year insurance.
If you outlive your term life insurance coverage, it will expire. There is no monetary value to be had. That's why you should try to match the amount of time you'll require coverage to your term life insurance as closely as possible.
Whole Life Insurance
Whole life insurance, like universal life insurance, provides coverage for the rest of your life. It also has a monetary value component. The cost is the most significant distinction between whole life and universal life insurance: Because of the guarantees included in the policy, whole life insurance is usually the most expensive way to obtain permanent life insurance. Premiums are guaranteed not to fluctuate, the death benefit is guaranteed, and the cash value has a minimum guaranteed rate of return.
In addition, when you acquire the policy, indexed and variable universal life might allow you flexibility with payments and the death benefit amount.
Whole life, on the other hand, ensures that your premiums, guaranteed rate of return on cash value, and death benefit will not vary. Whole life insurance is appropriate for those who value predictability and are ready to pay for it.
Many whole life insurance policies also pay out dividends. These are similar to annual incentives given to consumers by mutual insurance companies, though they are not guaranteed. Dividends can be used to pay premiums, added to your cash worth, or simply taken as cash.
As a final note, let's wrap up the whole article:
|Flexible premiums||Higher cost and premiums|
|Accumulation of cash value||Not certain returns|
|Lifetime coverage charges||Expensive fees and|
|Death benefit||Possibility of lapse|