What is Universal Life Insurance?

Universal life insurance is kind of like a bond mixed with a life insurance policy...

When you have a universal life insurance policy, you pay for the cost of insurance. But you also pay more than your minimum insurance premium and put that money into your policy’s cash value, which accrues interest to help it grow over time. The idea is that overtime your premiums and interest payments grow to a point where you can have access to some of the cash value without lapsing the policy.

Universal life insurance is a type of life insurance designed to cover the insured for their entire life and offers increased flexibility compared to other types of insurance coverage. Universal life insurance can be thought of as permanent life insurance with a flexible payment structure and a savings or investment component.

Each month, you’ll pay two things: the cost of insurance (COI), which covers mortality and administrative fees, etc., and any additional money you’d like to add to your account, aka your cash value.

The COI is the minimum payment required to keep your life insurance policy active. Think of it like a premium: With some insurance providers, if you don’t pay the COI, you’ll lose coverage. The COI covers all the costs of administering your policy, and it typically increases with age (a 70-year-old has a higher mortality risk than a 50-year-old, for example). So, even though you might have a $30 COI at 40, that could turn into $100 by the time you’re 80. Ideally, the cash value you build up will be able to cover that increase. But if you withdraw cash, your COI will go up.

The cash value is the flexible part of a universal life insurance policy. The contribution is not set in stone (although there is a minimum amount to maintain the policy), and policyholders can contribute more if they like.

In essence, the cash value portion of a universal life insurance policy functions like an investment account: You deposit money, it has the potential to grow over time, and in later years you have some flexibility to withdraw some of it.

An important feature of universal life insurance is that it is designed to last for the entirety of a policyholder’s life — as long as they continue to pay their COI, that is.

This differentiates it from term life insurance, which only covers the insured for a specific time period (until they’re 80, for example). Universal life insurance is most similar to whole life insurance, which is another type of permanent life insurance, but it differs in that it can provide some extra flexibility in regards to premiums.

For the most part, a universal life insurance policy works just like any other type of permanent life insurance policy (one that lasts for the insured’s entire life). Each month, the policyholder will pay a premium, which consists of the cost of insurance (COI) plus an additional cash value contribution.

Because of this extra cash value component, universal life policies offer flexible premiums: Policyholders can elect to only pay the minimum COI or the COI plus an additional cash value contribution.

This extra contribution is then treated like a deposit into a savings account: The policyholder will earn interest on it, and they can withdraw it to cover expenses (but there can be fees or taxes for withdrawals). They can also take out a tax-free loan against their cash value, though this may reduce the death benefit.

Universal life policies offer more flexibility than other types of life insurance policies because policyholders can adjust their premiums, and the cash value can be used to pay the COI — If the cash value is high enough, the policyholder can skip payments.

This arrangement allows the insured to stop making payments for a while, assuming they’ve built up enough cash value to cover the COI. Eventually, the interest accrued on the cash value can lower the premiums.

When the policyholder dies, their beneficiaries will be paid a sum of money called a death benefit. This sum is also tax-free (they don’t need to pay income tax on it). However, the insurance provider will typically absorb any leftover cash value when the policyholder passes away — It will not be passed onto the policyholder’s beneficiaries unless that is specified as a benefit of the policy. That said, since the cash value reduces the COI over time, you effectively get your cash value back as part of the death benefit.

A universal life insurance policy typically matures at a predetermined age that very few people reach, usually somewhere between 85 and 121 years old. Because of this, universal life policies tend to end upon the policyholder’s death, at which point their beneficiaries receive a death benefit.

The death benefit is a sum of money that can be adjusted at any time (subject to minimum converage) during the life insurance policy. However, you may need to pass a medical exam to increase it. This sum is transferred to the beneficiaries tax-free — one of the reasons that life insurance policies are so popular.

Generally, the insurance provider will keep any leftover cash value if the policyholder dies before the maturity age (however, the cash value is often passed on to the recipient as part of the net insurance benefit). If the insured survives to the policy’s maturity age, then they will receive the cash value.

Universal life policies and whole life policies have a lot in common: Both are permanent life insurance policies, which means they are designed to last for the entirety of the insured’s life. Once the insured dies and the policy reaches maturity, both will pay a tax-free death benefit to their beneficiaries.

Both types of policies also have a savings component, which is referred to as the cash value.

However, whole life and universal life insurance policies differ when it comes to flexibility. Whole life insurance policies have fixed premiums, and if a payment is missed, it needs to be paid for within a specified time period to keep the policy active. Whole life also typically gives more guarantees, has a larger premium, and has larger cash values than universal life policies.

Universal life insurance policies, on the other hand, offer flexibility with premiums — policyholders can sometimes even skip payments without having their policies canceled, so long as there’s enough cash value to cover them (though this may decrease the death benefit).

Universal life insurance is a type of permanent life insurance, while term life insurance is temporary — it is not a permanent policy. That means that a term life insurance policy will only pay a death benefit if the policyholder passes away during the period of time specified by the policy.

Term life insurance policies also don’t have a cash value component. When you purchase a term life policy, the entirety of your premium payments goes towards the cost of insurance.

Unlike a whole or universal life insurance policy, you can’t borrow against your cash value or withdraw money from your policy.

Term life insurance policies are generally cheaper than whole or universal life policies. In many ways, universal life insurance policies are thought of as a middle-ground between whole and term policies, thanks to their cash value component mixed with flexible payments.

In a regular (non-guaranteed) universal life policy, there typically isn’t a no-lapse guarantee, and there’s a cash value component. Guaranteed universal life insurance, however, has little to no cash value component, but it is designed to provide a no-lapse guarantee.

One of the main benefits of a guaranteed universal life policy is that the premiums are fixed. Unlike an indexed universal life insurance policy, there won’t be a lapse in coverage if the cash value ends up not covering the premium — hence “guaranteed.” If you make your premium payments, your policy will stay active, no guesswork involved.

Plus, since there’s little to no cash value component, it often ends up being one of the lowest-cost options for permanent life insurance coverage — Your premium is fixed, and you only need to cover the COI, nothing more.

In an indexed universal life policy, the interest on the account’s cash value is tied to an index, such as the S&P 500 or Russell 2000. This means the interest rate can change — for better or for worse. This adds an extra element of risk.

Universal life insurance is a consideration for people who are interested in permanent life insurance policies, who want to earn interest on investments, and who want a flexible option for life insurance.

Because universal life insurance policyholders can adjust their premiums and even skip premium payments, it can be a good option for people with inconsistent cash flow.

Universal life insurance offers the following advantages:

• Flexible payments: Universal life policyholders can adjust their premium amount and frequency throughout their policy and even skip premium payments (as long as they have sufficient cash value).
• Withdraw funds or borrow against your cash value: Universal life policies allow policyholders to take out tax-free loans against their cash value. Policyholders can also withdraw their cash value if they need to.
• Cash value grows: The cash value component of a universal life policy can grow over time.
• Policy lapse protection available: Some policies provide greater protection against lapses meaning better chance of maintaining coverage.

Here are some of the cons of universal life insurance:

• High fees: Universal life policies often have higher fees than other similar investment accounts (without insurance), which can eat into your gains.
• Premiums vary with age: Unlike a whole life insurance policy, which has a fixed guaranteed premium, a universal life insurance policy’s premiums can fluctuate as you get older. At some point, the cost of insurance can begin to reduce your cash value, increasing the chance of a policy lapse.
• Risk of undercoverage: Universal life insurance has high premiums, which often makes its coverage insufficient for younger families with large insurance needs. For more temporary insurance needs, such as for the next five to 20 years, you can purchase much more term life coverage than you can permanent coverage for the same price.

Robinhood Markets is not an insurance company nor a licensed insurance agency.