What Is Universal Life Insurance?
A life insurance policy is a contract between a policyholder and an insurance company. The policy specifies a guaranteed amount of money to be delivered to a designated beneficiary upon the death of the policyholder. The phrase “life insurance” is sometimes mistakenly taken to mean the policy protects against the risk of death. The policy protects against the risk that the policyholder will die sooner than expected or at an inconvenient time for his dependents.
Life insurance policies come in different forms to suit multiple purposes. Universal life insurance includes features that regular life insurance does not. Universal life insurance is a subset of whole life insurance. Universal life insurance offers accumulated cash savings that earn a rate of return predetermined by the insurance company. The main advantage of universal life insurance is that it allows the policyholder to adjust their premiums up or down, depending on their circumstances.
The savings accumulate throughout the life of the policy. Since the policy is in effect for the policyholder’s entire lifespan, the savings pool can become quite substantial over the years. The savings represent excess cash value that can be borrowed against. Unlike a bank loan, the borrower does not have to repay the policy. If he does not, however, the outstanding balance is deducted from the death benefit when he dies, before it is distributed to his beneficiaries.
How Does Universal Life Insurance Work?
The savings pool is accumulated by charging the policyholder higher premiums. A portion of the premium pays for the insurance, a portion pays administrative costs and the remainder is set aside. Over time, the higher premiums translate into a large accumulation of cash. The earnings generated from this cash are usually tax-deferred, but only up to the policyholder’s basis. The basis consists of the total amount of the premiums paid into the policy to date, minus any prior withdrawals. Any cash withdrawn that is above the basis amount may be taxed as ordinary income.
The policyholder can adjust their premium payments up or down based on the accumulated savings. When the premium payments are adjusted downward, the insurance company draws on the cash balance to cover the extra costs. The policyholder must eventually raise the premium payments to replenish the savings pool. Otherwise, the insurance company could let the policy lapse and cancel the coverage due to lack of payments.
The interest earned by the accumulated cash balance is preset by the insurance company. This preset rate is based on how well the company’s other investments are doing. Usually the rate of return has a guaranteed lower limit, which is a floor below which the company will not set the rate. This is an added bonus to the policyholder. As the policyholder ages, the portion of the premium that goes to the savings pool decreases because the costs of insuring the policyholder increase. If the policyholder makes no withdrawals, the accumulated cash balance is kept by the insurance company and not disbursed.
