How does universal life insurance work?

Universal life insurance works in a way that, a policyholder pays on monthly basis and that payment is divided into two parts, one is taken as a cost of insurance and the other is saved as an investment. The minimum limit of policy is set according to the cost of insurance, which consists of the death benefit and administration fees.

What is life insurance?

Life insurance is a legal contract between a policyholder and the insurance company. This contract is represented by a policy, according to which the policyholder pays insurance premiums either annually or monthly and the insurance company provides death benefit to the nominated beneficiary or beneficiaries, in case of his demise.

For those who don’t understand completely that what is life insurance, it is like a fence against the financial problems faced by the heirs in case of policyholder’s death.

After the death of the policyholder, beneficiaries claim for the death benefit by submitting the documents required by the insurance company. After a thorough investigation, the company hands over the death benefit to the beneficiary.

Summary
Life insurance is a contract between a policyholder and an insurance company. Insured pays premiums and when he dies, his beneficiary/beneficiaries receive the death benefit.

What are the types of life insurance?

Depending upon the duration and premium values, there are further types of life insurance policy.

  1. Permanent life insurance offers a cash-value account along with the death benefit and that cash-value account serves as a saving or investment account.

  2. Term life insurance differs in a way that it doesn’t offer a cash value account and gets expired after a pre-determined term. After that term, the policy is either renewed or terminated, according to the plan of the policyholder.

What is universal life insurance?

  • Universal life insurance is a form of permanent life insurance, in which the premiums paid by the policyholder are split into two parts. One part is considered as cost of insurance (COI) while the other one is saved as an investment.

  • UL insurance offers flexibility to choose the premium amount according to the budget of the insured. Any amount paid by the policyholder, that is excessive than the cost of insurance is added in the cash value account of the policyholder.

  • Cash-value account is a kind of saving account that keeps growing because of interest accumulation.

  • However, in indexed universal life insurance, figures may fall according to the stock market fluctuations, to which the account has been tied. Profit or loss both are the fate of policyholders.

Summary

UL insurance is a type of permanent life insurance in which the premium is split into two parts, cost of insurance and cash value account. Universal life insurance premiums are flexible.

Life insurance, the safety of future

Functioning of universal life insurance

After a brief introduction of life insurance and universal life insurance, the next point of discussion is how does universal life insurance work. Proceeds of life insurance depend upon the type of policy that a policyholder has chosen.

When a policyholder pays a monthly premium, it is split into two portions:

  • Cost of insurance
  • Cash value/ investment account.

1. Cost of insurance

  • Cost of insurance covers all the costs including mortality expenses, administrative charges, and some other responsibilities of the insurer.

  • Universal life insurance has a drawback of having high administrative charges as compared to other permanent policies or term life policy.

  • Amount of COI depends upon the risk factor associated with an insured and the age of the insured. With the advancement in the age of the policyholder, the cost of insurance also increases except the guaranteed universal life insurance.

2. Cash-value account

  • Cash-value account is just like a saving account or investment plan. The amount that exceeds the cost of insurance is submitted in the cash-value account.

  • That money is then either invested in stock or bond markets. The rise or fall of cash value depends directly on the high or low rates of stock or bond market and also the interest rates.

  • Policyholders can borrow against the accumulated cash value and even if there is enough money, premiums can be paid from it.

  • But if the cash value amount is not enough to pay the premium and there are some unpaid premiums, it may result in policy lapse.

Summary
Cost of insurance covers mortality expenses, administrative charges, or some other random expenses. A cash value account is an investment account that grows or shrinks according to market or interest rates.

Types of universal life insurance

Different types of universal life insurance policies work in a slightly different way regarding investments, although the basic pattern of proceeds is the same in all the types. These types and their way of working is given below:

1. Traditional or non-guaranteed universal life insurance

  • Non-guaranteed universal life insurance, as the name indicates, offers no guarantee regarding the cost of coverage and it may increase with the advancement of insured age.

  • It offers flexible premiums but it’s supposed to cause unexpected damage to the future of policyholders, for example, the policy may collapse due to the unpaid premiums and low cash value.

2. Guaranteed universal life insurance

  • In contrast to traditional UL insurance, guaranteed universal life insurance offers a guarantee that there will be no increase in the premiums with age and premiums will remain fixed. There is no-lapse of policy as long as the premiums are paid.

  • Monthly premiums for this life insurance are just like term life insurance, i.e. not so high as the whole life insurance. Market rate or minimum interest rates don’t affect the cost of coverage.

3. Indexed universal life insurance

  • As the name indicates, in contrast to the traditional and non-guaranteed life insurance, the indexed universal life insurance is directly linked with the indexes of the stock market.

  • A policyholder with this insurance policy should know that the cash-value account is dependent on the indexes.

  • Hence, if the stock market rises, the cash value will automatically increase. But that value is not equal to the rate of the stock market because of the share taken by the insurance company.

  • Similarly, if the market doesn’t go well, cash-value will fall. So, it’s up to the luck of the policyholder that cash-value rises or falls.

4. Variable-universal life insurance

  • In a variable-universal life insurance, the investment of cash-value can be made in several different accounts, just like the mutual funds. The choice of available account to which the investment is made depends upon the policyholder.

  • The term “variable” indicates the ability to invest in the accounts that are variable regarding their value, because of the investment in the stock market or bonds market. The Premium amount can also be variable from zero to the maximum depending upon the IRC (internal revenue code) for insurance.

Summary
Different types of universal life insurance policies are non-guaranteed, guaranteed, indexed and variable-universal life insurance policies each with a slightly different way of working.

Frequently asked questions

1. What are the pros and cons of universal life insurance?

The pros and cons of universal life insurance are given below:

Pros Cons
1. It offers more flexible premiums as compared to whole life insurance 1. The premium value is not guaranteed in some types as it is available in whole life insurance
2. In universal life insurance, cash value rises as does the stock market 2. If the market is not doing well, the cash value may also fall
3. Cash value may grow depending upon the interest rate 3. Variability in the interest rate may result in low cash value amount

2. What happens when a universal life insurance policy matures?

When universal life insurance reaches its maturity level, there can be two situations. Either a policyholder receives the payment equal to the cash value or the beneficiary gets it in the form of the death benefit.

3. What is the difference between whole life insurance and universal life insurance?

Both the whole life insurance and universal life insurance share the umbrella of permanent life insurance. However, there are some minor differences.

  • Whole life insurance offers regular, fixed premiums, and the cash value amount is accumulated in a guaranteed way. The policyholder can borrow a loan against the accumulated cash value.

  • Universal life insurance offers flexible premiums that are the best thing regarding this policy. According to the variability in the stock market and interest rates, the cash value may rise or fall. The policyholder can borrow loans against the cash value just like the whole life insurance.

4. Is life insurance taxable?

  • Generally, life insurance is not taxable. To justify the question that is life insurance taxable? Here is more detail, that life insurance becomes taxable in some special situations.

  • For example, if the money is kept in the company’s account, even after the death of an insured, the interest is accumulated over it. When the death benefit is received, interest money is taxable.

  • In case of employer-paid premiums, money is considered as income of policyholder and is taxable if exceeds a certain limit.

5. Can you cash out universal life insurance?

Yes, the policyholder can withdraw against the accumulated cash value account. The amount that he withdraws from his cash-value account, is tax-free up to the limit of premiums that have been paid by the policyholder. It remains tax-free throughout the life of the policyholder.

Conclusion

  • Universal life insurance works in a way that the premiums of universal life insurance are divided into two parts. One part is considered as the cost of insurance that covers all the expenses i.e. mortality expenses or administration charges.

  • Another part is invested in a savings account called a cash-value account. Cash value keeps growing depending upon the market/bond rates and the interest rates. That cash value is accessible for the policyholder.

References
  1. https://www.jrcinsurancegroup.com/non-guaranteed-vs-guaranteed-life-insurance/#:~:text=Non-guaranteed%20universal%20life%20insurance%20is%20a%20type%20of%20permanent,investment%20component%20attached%20to%20it.
  2. https://www.investopedia.com/insights/introduction-to-stock-market-indices/#:~:text=There%20are%20approximately%205%2C000%20U.S.,from%20the%20U.S.%20stock%20market.
  3. https://www.daveramsey.com/blog/universal-life-insurance#:~:text=How%20Does%20Universal%20Life%20Insurance,pay%20within%20a%20certain%20range.
  4. https://www.forbes.com/advisor/life-insurance/universal-life-insurance/

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