What it means
A term life policy covers a fixed period and has no savings element, while a permanent policy is designed to last for life. Universal life is permanent, but it separates the insurance charge from the savings part, so the policyholder can see how each works.
Each month the insurer takes charges, including the cost of insurance and expenses, from the cash value, and then credits interest to what remains. Flexibility is the main feature.
Within limits the policyholder can pay more or less in a given year, and can ask to raise or lower the death benefit, provided the cash value is enough to cover the charges. If premiums are too low for too long, the cash value can run out and the policy can lapse, leaving the family without cover.
The interest credited to the cash value is declared by the insurer, usually with a guaranteed minimum rate. Some versions, such as indexed universal life, link the credited interest to a stock market index with a cap and a floor, and variable versions let the policyholder invest in funds and bear the investment risk.
Each has a different balance between risk, growth and guarantees. Tax treatment is a significant attraction in many countries.
Growth in the cash value is often not taxed while it stays inside the policy, and death benefits are often paid free of income tax to beneficiaries, though rules differ and should be checked locally. Borrowing against the cash value can be possible, but loans reduce the death benefit and can cause the policy to lapse if unmanaged.
Businesses sometimes use universal life for key person cover, buy-sell agreements and executive benefits. The costs, however, are higher than for term insurance, and surrender charges may apply in the early years.
A buyer should ask for an illustration showing what happens if interest credited is lower than projected.
In practice
Real-world examples.
Example
A company director buys universal life with a death benefit of $1,000,000 to protect her family. In years when her income is high she pays extra premium, and in a lean year she pays the minimum needed to keep the policy in force.
Example
A software firm takes out a policy on its chief technology officer to cover the cost of recruiting and training a successor. The policy builds cash value that the company can later draw on if its needs change.
Example
A couple in their forties use universal life to leave an inheritance to their children. They check an annual statement to make sure the cash value covers future charges, and increase their premium when interest credited falls.
Formula
Calculation
Ending cash value = beginning cash value + premiums paid - charges + interest credited
A policy starts the year with a cash value of $20,000. The policyholder pays premiums of $6,000, and the insurer deducts cost of insurance and expenses of $2,000. Interest of 4% is credited on the opening balance, so interest = 20,000 x 4% = $800. Ending cash value = 20,000 + 6,000 - 2,000 + 800 = $24,800.Case study
Seen in the real world.
Linden Hollow Partners is an illustrative, fictional two-owner firm that bought universal life policies on each partner to fund a buy-sell agreement. Each policy had a death benefit of $2,000,000 and was set up on the assumption of 6% interest credited.
After five years the credited rate had fallen to 3.5%, and the annual statements showed that the cash value was growing more slowly than planned. The finance manager asked the insurer for an updated illustration and found that, without higher premiums, the policies could lapse in their late sixties.
The partners increased their annual premium by $4,000 each, which restored the projection. The illustrative lesson is that flexible policies need regular review, and that assumptions about interest are not guarantees.
Watch out
Common mistakes.
- Believing the projected cash value is guaranteed, when only the minimum rate in the policy is guaranteed.
- Paying the minimum premium for many years without checking, which can exhaust the cash value and cause the policy to lapse.
- Treating universal life as a pure investment, when charges and the cost of insurance reduce the savings element.
Questions
People also ask.
How is universal life different from whole life?
Whole life has fixed premiums and a fixed death benefit, while universal life lets you adjust both within limits and shows the savings element separately.
Can I borrow from a universal life policy?
Often yes, against the cash value, but the loan and interest reduce the death benefit and can cause a lapse if the cash value is exhausted.
What happens if the cash value runs out?
The policy can lapse unless you pay additional premium, so you could lose cover and any benefit you were counting on.
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