How Universal Life Insurance Works

Universal Life Insurance is a Two-Part Process

A Universal Life insurance policy has two components: insurance and a cash account. The insurance component of a universal life policy is actually annual renewable term insurance---in other words, term insurance with an investment assigned to it. This cash account builds up on a tax-deferred basis each year and earns either a guaranteed contract rate, or the current rate, whichever is higher.

Expenses Incurred

When the policy owner pays the premium for a universal life policy, certain expense charges are deducted and the balance---the net premium---is added to the cash value account. These expenses, called "loads," include mortality costs---the cost of the insurance or death benefit---sales expenses incurred in marketing and distributing the policy, and expenses involved in issuing the policy. But the cash value account earns interest, remember.

A Cashing Out is Possible

Universal Life products permit the partial withdrawal of the policy cash value if needed. However, there may be a charge for each withdrawal and there are usually limits to how much and how often a withdrawal can be made. In addition to withdrawals, a partial or full surrender is allowed, subject to the possibility of taxation, depending upon the plan.

Flexible Payment, Premium Paying Period and Cash Value

At the time the individual applies for a universal life policy, he selects the level of premium, cash value, death benefit and premium-paying period that is best for him. So it offers flexibility. If the policyowner wishes to accumulate a certain amount of cash value by a certain period of time, say after 20 years, the cash value can be targeted to accumulate to that amount by the 20th year and the amount of premium required to accomplish that objective will be figured out. If no cash value is ever factored into the premium, or, in other words, zero cash value is targeted for age 100, the policy will look and function just like an annual renewable term policy.

When the policyowner selects these aspects of coverage, he also selects the death benefit option; the payout. Universal life offers one of two death benefit options to the policyowner. Option A is the level death benefit option and Option B is the increasing death benefit option.

Option A and Option B

Under Option A, the death benefit remains level while the cash value gradually increases. The target premium---a "specified corridor"amount---keeps universal life from lapsing.

Under Option B the death benefit includes the annual increase in cash value so that the death benefit gradually increases each year by the amount that the cash value increases. At any point in time, the total death benefit will always be equal to the face amount of the policy plus the current amount of cash value. Of course there is an extra premium charged for this option on this policy.

Pros, Cons and Some Advice

The positive with Universal Life is that it is similar to whole life but generally costs less. If the person buying the policy has inconsistent income, this might be good for them.

The disadvantage is based on how well the insurance company makes its investments. You don't want a diminishing return on the cash portion of the policy because then less money would be available for the death benefit.

A potential buyer for Universal Life should shop around, talk to several insurance agents and see how plans can vary from company to company or state to state.