What Is Universal Life Insurance and How Does It Work?
Universal life insurance is a type of permanent life insurance coverage.
Like traditional whole life insurance, it offers a tax-deferred cash value component that serves as an investment or savings account. But unlike whole life insurance, which features fixed premiums and guaranteed returns, premiums and returns for universal life insurance can vary.
Table of contents
- What is universal life insurance and how does it work?
- Elements of universal life insurance
- Universal life insurance FAQs
- Summary of Money’s guide to universal life insurance
What is universal life insurance and how does it work?
Universal life is similar to whole life insurance in that both can last the entire life of the policyholder and have a cash value component — a type of interest-accruing account the policyholder can take loans from or use to cover premium payments — but universal life offers more affordable and flexible premiums.
Let’s take a closer look at how these policies compare against each other and the more affordable life insurance option, term life insurance:
| Term Life Insurance | Whole Life Insurance | Universal Life Insurance |
| Provides coverage for a set period of time or "term" (10, 20, 30 years) | Permanent coverage and guaranteed returns on cash value | Permanent coverage but cash value returns are not guaranteed |
| Features premiums typically cheaper than permanent life insurance | Features fixed premiums for the life of the policy that are typically more costly than term and universal life | Features flexible premiums that can be more affordable than those of whole life — but often pricier than term life coverage |
Elements of a universal life insurance policy
Similar to whole life insurance, universal life has two main parts: a death benefit and an investment or savings account called the cash value.
Let's go over these and other elements of universal life insurance in more detail.
Death benefit
| Level death benefit | Increasing death benefit |
| Beneficiaries receive a death benefit equal to the policy's face value, while the insurer keeps the policyholder’s accrued cash value. | Beneficiaries receive a death benefit equal to the policy’s face amount, plus the accrued cash value. |
A key factor that affects life insurance premiums is the death benefit amount. Simply put, policies with a higher death benefit costs more.
Upon the death of the insured, the insurance company will deduct any outstanding loan balances from the death benefit amount. Any interest accrued on outstanding loans will also be deducted from the remaining cash value.
Cash value account
Permanent life insurance policies like whole life or universal life insurance have a savings account component called the cash value.
When you make premium payments, a portion of that money goes toward funding the death benefit while another portion goes toward funding the cash value.
For universal life insurance, the cash value is typically reliant on stock market performance. This means the balance could drop if stocks and securities perform poorly, but it could also grow faster than if in a whole life policy's cash value account.
However, gains are capped at a percentage of the actual gains for the investments, and losses at 0% — meaning the balance never drops below the total principal added to the account.
How to use your policy’s cash value
As a policyholder, you can use the cash value in a variety of ways:
- Cover premium payments: Fully or partially cover your premium payments with the investment account’s proceeds.
- Make withdrawals: Withdraw money from the policy’s cash value. Different tax treatments may apply depending on whether you withdraw from the basis (what you paid into it) or the excess cash (what accrues over time).
- Borrow against cash value: Take tax-free policy loans from the cash value account, but if you don’t repay the loan with interest, the insurer will deduct the outstanding loan balance from the policy’s death benefit. If the death benefit is not enough to cover the loan, the policy lapses.
- Cash-out: Cancel the coverage later in life and cash out the value of the policy. Typically you’d have to pay surrender charges and then income taxes on the policy’s surrender value.
- Donate: Donate the entire policy to a charity or foundation.
Types of universal life insurance
There are three types of universal life insurance coverage: indexed, guaranteed and variable. Each options provides different investment options and terms to fit different needs and levels of risk tolerance.
| Indexed | Variable | Guaranteed |
| Cash value appreciates in step with a market index, with gains and losses capped. Option to choose a fixed-rate account instead | Allows policyholders to tie their cash value to gains (and losses) in bonds, stocks and mutual funds | May have little or no cash value portion |
| Gives policyholders more control over investments | Most flexible universal policy option | Most secure universal policy option |
| Riskier than traditional life insurance | Requires hands-on management | Premiums are guaranteed never to increase. |
Eligibility
Eligibility requirements for universal life insurance vary by insurer. However, most insurance companies require a medical examination.
The medical exam may include:
- A physical checkup
- Lifestyle and health questions
- Information about prescription medications
- Access to your medical history records
- Access to credit and DMV records
Lying or omitting the truth about your medical history, weight, lifestyle or habits on a life insurance application could be construed as a material misrepresentation and lead to policy cancellation or your beneficiaries' death benefit claim being denied.
Duration of coverage
Most universal life insurance products come with a “maturity date,” which could coincide with your 105th birthday or your 121st birthday. Some maturity dates can be as low as 85 years, so read the contract thoroughly before buying a policy.
If you live long enough to reach your policy’s maturity date, you will receive a lump-sum payment equal to the cash value of your policy. If you pass away before the maturity date, your beneficiaries will receive the policy’s death benefit.
Riders
Riders are optional benefits not included in your life insurance policy. You can purchase riders to tailor your policy to your needs.
Some of the most common riders include:
- Waiver of premium: the policy will remain active if you become disabled by a specified age (around 60-65) and cannot pay your premiums.
- Accidental death: pays additional money to the beneficiaries if the insured perishes in an accident.
- Disability income: if the insured becomes disabled, the insurance company provides a monthly income as long as the disability lasts.
- Additional insured: provides coverage to other family members, such as a spouse or children.
- Accelerated death benefit: in the case of terminal illness, the insured can collect part or their full guaranteed death benefit before passing.
- No-lapse guarantee: keeps your policy active during the no-lapse period, even if the cash value drops to zero.
Cost of universal life insurance (COI)
The cost of insurance, or COI, is a charge or rate that applies to certain types of life insurance, particularly universal life. It's the minimum premium amount that must be paid to fund the death benefit and keep the policy active, and generally includes mortality costs, administrative fees and other expenses.
Universal life insurance premiums vary widely, and the ultimate cost is based on factors like your age, health history, pre-existing conditions, occupational risk, driving history, lifestyle, hobbies and selected death benefit amount will affect the cost of your insurance policy. For a $1 million policy, a typical 30-year-old can expect to pay between $300 and $500 per month.
Life insurance premiums increase as you age (with the exception of guaranteed universal life insurance). If you're using the cash value of your universal life policy to cover premium payments, you run the risk of not having enough in the policy’s cash value to cover the higher premiums.
Missed premium payments could lead to a lapse in coverage.
Underwriting process
The underwriting process starts after submitting your insurance application. Each insurance company has underwriting guidelines with specific requirements in order to determine final premiums.
An underwriter could take the following factors into consideration when calculating your life expectancy and premiums:
- Age and gender
- Height and weight
- Medical and prescription history
- Citizenship status
- Address
- Tobacco use
- Occupation and employer
- Income
- Other insurance policies
- Hobbies
- Criminal history
- Foreign travel
Universal life insurance FAQs
Is universal life insurance for me?
Universal life insurance is a suitable option for high-income earners who:
- Have exhausted other retirement savings options such 401k, IRA, and Roth IRA accounts.
- Have long-term dependents such as adult children with disabilities or parents that require long-term care.
- Want to cover state taxes for their heirs.
- Prefer flexible premiums over the fixed premiums of whole life insurance.
- Don't mind that the cash value growth is usually tied to the market, which will determine how much the account will earn.
How much universal life insurance do I need?
The amount of life insurance you purchase should be based on your financial plan.
Some insurance agents recommend purchasing a policy valued at 10 to 15 times your annual salary. However, that should really depend on the use you want to give the policy and your financial obligations.
If you're purchasing insurance as income replacement for your loved ones, don't forget to factor in the following:
- The number of years your beneficiaries will need to replace your income
- Outstanding debts such as your remaining mortgage balance
- Future expenses like college tuition payments for dependent children
How do I buy universal life insurance?
Before you buy universal life insurance, speak to a financial planner as well as a certified insurance agent. They can guide you to find the best insurance options for your needs.
To learn more about the types of life insurance available on the market, check out Money’s top picks for the best life insurance.
When choosing an insurance company and policy, consider the following:
- Obtain quotes from different companies and compare quotes in order to reach a decision
- Narrow your choice to companies that are financially stable
- Consider policy options, including the investment opportunities of permanent life
- Be complete and honest about your health history
- Research ratings and review
How can I lower my premiums?
You can lower the cost of your premium by:
- Reducing the death benefit payout amount
- Using the cash value to pay a portion or the entirety of the premium
- Reviewing your policy regularly to see if it still meets your needs
What can cause a claim denial?
While it's rare for a life insurance company to deny a death benefit claim, it can still happen.
Here are some common reasons for life insurance claim denials:
- Providing incorrect or incomplete information during the application
- A death by suicide during the contestability period (typically the first two years of the policy)
- Failure to pay premiums
- Using alcohol or drugs before death
Your life insurance premiums will depend on your age, health history, gender, occupation, lifestyle and habits, and the policy type and coverage amount you choose.
Life insurers have different underwriting guidelines, which means they do not all assess risk differently. Shop around for quotes from a number of life insurance companies to get the lowest possible premium, and for other policy features that matter to you.
If you're looking at your insurance policy as an investment, know that universal life isn't without its risks.
Your policy's cash value growth will depend on stock market performance. Also, the complexity of some policies — including universal life insurance — makes it difficult to compare competing products. Consult with a financial advisor before purchasing a universal life policy.
Summary of Money’s guide to universal life insurance
Universal life insurance may be worth your consideration if you are a high-income earner seeking lifelong coverage with an adjustable death benefit and flexible monthly premiums.
But the product is unusually complex compared with other types of life insurance, such as term. Before you purchase a policy, take the time (at minimum) to weigh the pros and cons of universal life insurance:
- With universal life insurance, your policy's cash value can rise by the stock market by a percentage of gains.
- Similar to other types of permanent life insurance, you can take tax-free loans from the cash value account.
- The interest your account generates is tax-deferred
- You can adjust the death benefit, and so the premium payments for the policy.
- If the market goes down, there will be little to no investment growth in the cash value.
- If you're using the cash value to cover premiums, or even help in doing so, the policy could eventually lapse if there aren't enough funds in the account.
- Premiums are considerably higher than for other types of life insurance
- You must manage and monitor your policy.