What is Universal Life Insurance

Universal life insurance is a relatively new type of policy. Unlike term life insurance, which is temporary, universal life insurance is permanent. As long as the premiums are paid, the policy remains in force until it matures. The policy matures when the insurance company pays the death benefit upon the death of the policyholder, or when the policyholder reaches age 95 or 100. Policy maturity based on the age of the insured depends on the state in which the policy was issued.

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Univeral Life Contract

A universal life contract typically pays a guaranteed return, although the return may be smaller than that guaranteed by a traditional whole life policy. Universal life is similar to whole life insurance in that a portion of the premium paid to the insurance company is applied to cover the cost of the insurance. The balance is invested by the insurance company in it’s own portfolio and managed by the portfolio managers it chooses.

While it has the potential to build cash value over time, an owner of a universal life insurance policy has to trust that the fund managers are investing low risk, high quality financial instruments such as Treasury bonds and highly rated stock and bond mutual funds. Applicants are always advised to make sure the insurance company has at least an A+ or better rating from AM Best, Standard and Poor’s and Moody’s.

One significant advantage of a universal life policy over a whole life policy is the ability to vary the premium amount and payment schedule to meet ever changing financial needs. For example, a universal life policy owner has the option of reducing the amount of the premium payment should he or she need to due to an unexpected financial crisis. He or she can also choose to have the premium payments deducted from the built-up cash value of the policy. The downside to this is that it leaves less cash to compound and may also reduce the death benefit that would be paid to the beneficiary should the owner die before the deducted payments are returned.

Universal Life Death Benefits

Universal life insurance policies can be fixed, variable or indexed, meaning that the interest rate paid by the insurance company on the cash value of the policy is either a fixed rate, a variable rate or a rate tied to a specific market index. Fixed rate policies are known as “interest sensitive”. The premiums paid on a universal life policy are credited toward the cash account portion of the policy. Some insurance companies guarantee a minimum interest rate while others do not. Unlike whole life, where mortality and expense charges do not reduce the death benefit, these expenses do decrease the death benefit of a universal life policy.

A universal life policy may build cash value more quickly over time as it can achieve a higher rate of return based on interest rates at the time it is credited to the account. And, unlike a traditional whole life policy, the owner of a universal life policy can cease to pay premiums once the cash value has built up to cover the premiums and still have the policy remain in force.

An owner of a universal life policy also has two options when choosing the death benefit, level or increasing:

Universal Life Level Death Benefit

The face amount of the policy is paid at maturity (death of the policyholder or when he reaches age 95 or 100, as required by the state in which he or she lives). Because the cash value of the policy is not paid, the owner in effect reduces his or her cost for insurance until the cash value equals the face amount of the policy when it matures.

Universal Life Increasing Death Benefit

The increasing death benefit pays both the face amount and the built up cash value. This means that the death benefit increases each year that the policy remains in force. However, this means that the cost of the insurance does not decrease as the premiums are paid. As the policy owner ages, he or she is paying increased costs for insurance.

Calculating Interest on a Universal Life Policy

An equity indexed universal life policy is a variation on a standard fixed, or interest sensitive, policy. Interest is credited based on an increase in the underlying market, most often the S&P 500. While the method of calculating and posting interest varies among insurance companies, the most common method is the point-to-point method.  It uses the anniversary date of the contract to calculate the interest to be credited from one year to the next.

While it is possible to achieve a larger credit than with an interest sensitive policy, the drawback with an equity-indexed policy is that the market may increase more at a different point in time. For example, if the anniversary date is June 15, the owner is paid the rate from June 15 to June 15. If the S&P 500 were higher at any other point, that additional gain would not be credited. Additionally, most companies cap the amount of interest that can be credited. If the rate is capped at 12% and the S&P 500 increases 18%, a maximum of 12% of the 18% gain would be credited. However, if the S&P 500 is lower from point-to-point, the loss is not deducted from the cash value of the account.

With a variable universal life policy, the investments are made at the direction of the policy owner, not by the portfolio managers at the insurance company. If the investments increase, the entire amount of the gain is credited to the cash value account. However, if the investments lose money, the value is deducted from the cash account and the owner can lose money.

As with any insurance product, the best policy for one individual or family may not be the best for another. A life insurance policy should not only be affordable and offset risk, it should enable the policy holder to feel confident that his or her family will be protected should the need arise.

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