Oct 15, 2020 4 min read

Universal life insurance contracts differ from traditional whole life policies by specifically operating and identifying the mortality, expense and cash value parts of a policy.

Dividing a policy into these three components allows an insurance company to build a higher degree of flexibility into a contract. This flexibility allows a policy owner to modify the policy face amount, or premium, in response to changing needs and circumstances. In simple terms, the death benefit and cost of the insurance can be changed without surrendering the policy.

A monthly charge for both the cost of the death benefit and the expense of issuing the policy is deducted from the policy’s account balance. The remainder of the premium is allocated to the cash value, where the funds earn interest. Unlike whole life policies, complete disclosure of these internal charges against the cash value elements is made to the policy owner in the form of an annual statement.

Many universal life policies have several different provisions by which the accumulated cash value can be made available to a policy owner during life, without causing the policy to lapse. Universal life policies permit the policy owner to borrow at interest a portion of the accumulated cash value.

A policy loan will reduce the death benefit payable if the insured dies before the loan is repaid; a policy loan will also reduce the cash surrender value if a policy is terminated. Most universal life policies allow the policy owner to withdraw a portion of the cash value, without terminating the policy. Such withdrawals reduce the amount of death benefit payable.

There are two primary types of universal life policies, based on the level of death benefits. Type 1 policies pay a fixed, level death benefit, generally the face amount of the policy. Type 2 policies generally pay the face amount of a policy, plus the accumulated cash values. As the cash value grows, so does the death benefit.

If your goal is a large cash value at the end of the contract, then type 2 is for you. People who want an increasing death benefit, perhaps to overcome the effects of inflation, would chose type 2.

A primary purpose of a universal life policy is the death benefit provided. Universal life policies also are useful for policy owners who anticipate that their needs will change over time. A universal life policy can be modified by changing the death benefit or premium payments.

Common uses of UL policies are family protection; business planning; insuring key employees; funding non-qualified deferred compensation plans; and funding buy-sell agreements. Some individuals will use the cash value feature of universal life as a means of accumulating funds for specific purposes, such as funding college education, a supplemental source of retirement income and to provide funds for a gift to charity.

Unlike whole life insurance policies, where the insurance company provides guarantees, a universal life insurance policy passes the risk of investment returns on to the policy owner. When these policies were first developed, interest rates where higher.

Universal policies have minimum interest rates, and because of that, UL policies need to be reviewed annually to make sure they are performing as anticipated. The flexibility of the polices enables the policy owner to increase premiums or reduce death benefits to offset the reduced interest environment.

I would advise readers to make sure you over-fund UL policies. This means don’t pay the minimum premiums. Ask for an illustration and make sure the policy premium shown provides a death benefit to the end of the contract, based on the guaranteed interest rate and maximum insurance cost.

Most universal life polices have substantial surrender charges if a policy is terminated. These charges are generally highest in the early years of a policy, and decline over time, usually from seven to 15 years.

Bob Hollick is a State Farm Insurance agent based in Washington. His column appears every other Thursday in the Observer-Reporter.

To submit columns on financial planning, investing or business-related matters, email Rick Shrum at rshrum@observer-reporter.com.