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Universal Life Insurance: Pros and Cons

Universal life is among many choices for life insurance. It's meant for those with particular preferences regarding the duration of coverage, the benefits it provides to policyholders while they are still living, and the level of control over the costs and coverage throughout the policy's life.

Key takeaways:

This article will provide insights into the functions and types of universal life insurance and its benefits and drawbacks.

Universal life insurance definition

Universal life insurance provides a death benefit and often features a savings account (a cash value account). As the policyholder pays premiums, a percentage goes toward a cash value account, in which funds accrue tax-free, rolling over from one year to the next.

Cash value not only grows from what's collected in premiums; it grows with interest or by stock market performance (or a combination), depending on the variant of universal life insurance chosen. This policy is a form of permanent coverage, meaning the coverage will last for life.

How universal life insurance works

Universal life insurance is a whole-life policy with a unique mechanism for cash value growth. The process for enrollment is the same as most types of life insurance: contact an insurer, follow a series of steps, and receive a policy. What makes universal life insurance distinct is how it works after you've enrolled.

Premiums serve another purpose beyond keeping your policy afloat; the cash value can build in various ways, and the death benefit may increase due to your cash value accumulation. The process works as follows:

Enrollment

During enrollment, you'll likely have to answer health questions about your lifestyle habits and medical history and undergo a medical exam. Not all policies require medical exams, but the policies that feature medical exams are often the cheaper option.

Premiums

The amount you'll pay each month will vary based on your age, gender, lifestyle, health, and level of coverage. Universal life policies often feature flexible premiums, so you may be able to adjust your monthly payment after a certain amount of time holding the policy.

Cash value

A portion of what you'll pay in premiums will be placed in a cash value account. This will allow you to use your life insurance while you're still alive, allowing you to cover major expenses (e.g., medical emergencies and purchasing a home) and to pay your premiums, effectively giving you the benefit of a policy that you no longer have to pay for out of your own pocket.

Coverage period

This policy will last a lifetime as long as you pay your premiums. However, you can surrender the policy to liquidate your cash value, though this will be a diminished amount due to surrender charges.

Death benefit

The death benefit is the amount your beneficiaries will receive after you pass away. This could be the face value alone (the base coverage amount you signed up for), the face value plus the amount your policy has gained in cash value, or the face value plus the portion of premiums allocated to your cash value account.

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Types of universal life insurance

Universal Life Insurance comes with different policies. Options are available so potential policyholders can find Universal Life more closely tailored to their needs, risk tolerance, and preference for how cash value grows.

Variable Universal Life (VUL)

Variable Universal Life (VUL) insurance involves choosing from an array of investment options, such as bonds, stocks, and mutual funds, and creating a portfolio. This has the highest market participation out of all universal life policies, making it the most significant risk. Conversely, this has the greatest reward potential if the investments perform well.

The policy must maintain a certain amount in cash value to stay active. A poorly performing investment portfolio could cause the cash value to sink below the required amount to keep the policy afloat, which could cause the policy to lapse. The same holds true for paying premiums. Insurance companies can cancel your coverage due to failure to pay premiums.

With VUL, there are numerous expenses, such as transaction, administration, and portfolio management fees, surrender charges, interest rates on loans against the policy, and taxes if the policy lapses and the policyholder has an outstanding balance on loans yet to be paid back.

Before enrolling, it's critical to understand the relationship between your investment risks, policy fees, and the upside potential of a successful portfolio. This is arguably the most complex form of universal life insurance, but policyholders can potentially gain the most cash value if portfolios are managed wisely.

Indexed Universal Life (IUL)

With Indexed Universal Life (IUL) policies, the cash value is directly tied to a stock market index. When you have an IUL, meaning you select a stock market index to invest funds in your cash value account, you have the advantage of a growing market. This policy is for those who want to benefit from market growth but are more conservative. IUL policies impose a floor and a cap to mitigate market risks. A floor limits the percentage of invested funds an investor can lose, while a cap limits the percentage an investor can gain.

For example, you may choose the S&P 500 as the index fund in your policy. The insurance company may set the floor at 0% and cap growth at 12%. If the S&P is down 15% from its value when you invest in it, you won't lose anything. On the other hand, if the market surges 20%, you won't gain any more than 12% since that's your cap. On top of that, you may have a participation rate, which is the percentage of the growth you're entitled to. For instance, if your index fund gains 10% and you have an 80% participation rate, your cash value will actually increase by 8% instead of 10%.

Some may see IUL policies as preferable to VUL insurance because of the safety net of having a floor, but others may see the limited gain as a reason why IUL is a bad investment.

Guaranteed Universal Life

Guaranteed Universal Life (GUL) insurance doesn't have the features commonly associated with universal life insurance. GUL insurance isn't technically permanent, as it expires when the policyholder is at an advanced age. Some policies remain active until the policyholder is 120 years old.

Cash value is either minimal or nonexistent. This isn't useful for those who want a policy to withdraw funds from at a later time or desire a policy that doubles as an investment account. This policy also lacks the premium flexibility featured in other universal life policies. However, the death benefit is adjustable.

GUL may not be ideal for someone who wants an extra savings account, but for someone who desires a simple, inexpensive life insurance policy devoid of market risks and associated policy fees, GUL insurance is the best choice.

Comparing the types of universal life insurance

Type of universal life insurance
Who it's best for
Cash value growth
Coverage duration
Risk potential
Variable Universal Life
Those who have a high risk tolerance and want to get the greatest benefit from investment growth
Based on investment options (e.g. mutual funds, bonds, and stocks)
No expiration
High; poor market conditions may lead to a policy lapsing, leaving the policyholder without a death benefit
Indexed Universal Life
Those who are somewhat risk-averse, but still want to benefit from strong market conditions
Based on stock market index
No expiration
Moderate; policyholder is protected from loss, but the cash value isn't guaranteed to grow
Guaranteed Universal Life
Individuals who do not want to participate in the market, but instead, have a simple life insurance policy with low premiums
N/ALasts until advanced age (can be anywhere from 95 to 120 years old)
Low; this policy has little to no cash value and does not involve any market participation

Universal life insurance provides lifelong coverage, assuring that when the policyholder passes away, his or her loved ones will receive a sizeable death benefit that will be a significant financial cushion. These policies often come with cash value accounts that can be invested. Universal life insurance can be an asset in long-term financial planning tailored to the policyholder's risk tolerance.

Despite this common feature, not everyone seeks universal life coverage for investment growth. Universal life insurance also offers something for those who simply want a policy that disburses a death benefit with low monthly premiums that remain fixed throughout the time the policy is active. Your best universal life insurance option will depend on where you are in life, your goals, and the features you look for in life insurance.

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