What is Universal Life Insurance and How Does it Work

An Explanation of Universal Life Insurance

Universal life insurance was launched in the early 1980’s at a time when interest rates were historically high and its forebear, whole life insurance couldn’t satisfy consumer appetites for high returns that were available in bank CDs and money market accounts.  Universal life offered an alternative means to purchase a permanent form of life insurance that also provided flexibility, low costs, and the ability to earn competitive rates of return all of which was not available in the more rigid and low yielding whole life policy.

Although interest rates have come back down to earth, universal life remains a popular choice for people due to its relatively low rates and adjustable premium capabilities.  For many people, universal life is easier to understand than whole life because of its transparent structure consisting of a death benefit, a separate interest bearing savings account and clear withdrawal provisions.

Universal Life Companies

Life insurance companies, anxious to stem the flow of premium dollars from their low yielding whole life policies had to figure out a way to create a permanent life insurance plan that offered attractive yields. To do that, they took the key components of a whole life plan, the cash value, expenses and the death benefit, unbundled them and stripped away some of the guarantees. By transferring some of the risk back to the consumer, the life insurers were able to offer a more flexible policy with a competitive rate of return.

The new, unbundled structure provided more flexibility in the way the policyholder wanted to modify the premium schedule and the death benefit.  The withdrawal provision, allowing policyholders to access a portion of their cash value without a charge, added even more flexibility. The resulting universal life policy became a valuable financial management tool that had the ability to change as a person’s financial situation changed.

What is Universal Life Insurance

For a set minimum monthly premium amount, a universal life policy provides a minimum, guaranteed death benefit.  The entire premium is put into the accumulation account from which mortality and administrative expenses are deducted. The remaining balance is left to earn interest at a rate that is competitive with bank CDs.  Unlike whole life policies, the policyholder receives a statement from the insurers that fully discloses all of the internal transactions including interest earned and expenses deducted.

Universal Life Policy Elements

Universal life policies all have basic elements:

Surrender Charges

If a policy is surrendered early in the contract, the life insurer may charge a surrender fee which can be substantial in the earlier years.  They tend to start out high and then decline based on a set schedule that can last anywhere from seven to 15 years.

Partial Withdrawals

Most universal life policies include withdrawal provisions that enable the policyholder to take a portion of the cash value without surrendering the policy.  The withdrawal can have the effect of reducing the death benefit.  As long as the policy continues to qualify as a life insurance contract, withdrawals can be received tax free until they exceed the cost basis of the policy.

Policy Loans

Most universal life policies include a loan provision that allows the policyholder to borrow from the accumulated cash value.  The insurer charges interest at a rate that is typically below prevailing interest rates. If the loan is not repaid, the death benefit will be reduced as well as the cash value account if the policy is surrendered early.

Surrender Options

If a policy is surrendered, the policyholder can choose to receive the cash value from several options.  The cash value less any surrender charges can be paid directly to the policyholder.  It can also come in the form of a paid-up life insurance policy at a reduced amount. Or, it could come in the form of paid-up term policy with the same death benefit amount as the original policy.

Types of Universal Life Policies

There are two basic forms of universal life that offer two levels of death benefit. A Type I policy offers a level death benefit  and a Type II policy offers a death benefit that pays both the face amount of the death benefit plus the accumulated cash values. In a Type II policy, the death benefit will continue to grow as the cash value increases.

Additional Options

As with many other types of life insurance, universal life has available options or riders that can be added for an additional cost.

Waiver of Premium

If the policyholder is unable to work due to a disability, the deduction for mortality expenses is waived.

Living Benefits

Should the policyholder develop a critical illness that is likely to result in death, the policy will pay a portion of the death benefit to the insured.

Accidental Death

This is a standard rider that will double the death benefit if death occurs as a result of an accident.

Term Rider

The policyholder can purchase term insurance on a spouse’s life or on the children’s lives.

Uses for Universal Life Insurance

Universal life insurance is most appropriate for policyholders that anticipate that their financial situation will likely change over a period of time.  The ideal situation is a young family that foresees the need for permanent life insurance through the dependency years and beyond. The flexible premium schedule enables the policyholder to raise premiums during years with excess cash flow which could result in lower premium requirements in other years when cash flow is tight.  A growing family also means a growing need for additional death benefit which can be increased through additional premium contributions.

The cash value account has the potential to accumulate enough funds to supplement family needs such as a college education or additional retirement income. With access to cash values through withdrawals or loans, a family can count on a universal life policy as a source of funds for short and long-term needs.


The appeal of universal life insurance is in its simplicity and transparency.  Once it is understood, a universal life policy can be valuable financial management tool for any family.  It is recommended that a qualified financial professional be consulted to discuss how to best structure a universal life policy to meet your specific needs.

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