How Universal Life Insurance Works

Universal life insurance is a form of whole life insurance — but with much greater flexibility. Like whole life, you have two components: a term insurance policy and an investment account from which the term insurance premiums are paid. But with universal life, you get to choose your options, and the choices are generally laid out in front of you. You know how the premiums may change the death benefit and cash value, and it’s much clearer how much of the premiums go toward your insurance protection, how much toward your cash value, and how much toward administrative expense (including commissions).
Start with a planned death benefit that you work out with your agent. You determine your planned premium, based on how much you can afford and the cost of the insurance. The company subtracts an expense charge based on its fees, usually a fixed percentage of the premiums. You’re left with a cash value that generates interest.
But understanding universal life insurance doesn’t end there. From the cash value, the company subtracts the current cost of insurance (the mortality charge), including the charges for any options (or riders), and monthly administrative expenses. Then the company adds in interest that your investment money earns. Your ending cash value is the accumulated value that belongs to you when you cash out (or to your beneficiary when you die).
Often, companies charge you a surrender charge to cash out, leaving you with the surrender value. The surrender charge is usually a small percentage of the total cash value.
Other aspects of universal life to consider include:

•  All the earnings in your investment account are taxdeferred.
• If you stop paying premiums, the company continues to pay the premium for you by deducting from your policy’s cash value. The company does so until no cash value is left. This is one way to continue coverage without paying premiums.
• The interest rate is a fixed rate, although it may be a tiered interest rate, in which part is paid at one rate while the balance is paid at a higher rate. For example, your interest rate may be 4 percent for the first $500 and 7 percent for the balance.
• You can withdraw money that has accumulated in your cash value. If you do, your death benefit decreases because it depends partially upon the accumulated cash value.
• You can borrow against the cash value of your policy at a fixed rate, generally below market rates.
• If you increase your coverage, you may have to requalify by taking a medical exam.
  
• You probably have to pay a termination fee or surrender charge (backloading). This fee decreases each year you have the policy, but it does lower the amount of your cash value.