Universal life policies are third in popularity behind whole life and term insurance policies. Like whole life policies, universal policies also offer lifetime coverage. Universal policies differ from whole life policies in that they do not bundle cash value with death protection, they remain separate. Growth of cash value is made explicit to the policyholder in their statements. As with whole life policies, the insurance company determines how funds are invested.
With universal life policies, the policyholder bears more of the risk because factors are not predetermined as with whole life policies. Though a minimum interest rate is usually guaranteed, gains rely heavily on interest rates, expenses and other costs incurred by the insurance company. This is why risk is primarily borne by the policyholder. On the other hand, this risk works both ways. In contrast to whole life policies, additional interest above the minimum is added to the cash value of the account. The most common ways of crediting interest is either adjusting it by period or attaching it directly to market rates. If adjusted by period, the insurance company will set rates according to projections. Adjustments for universal policies are typically more common than for whole life policies. If attached directly, as market rates fluctuate so will the rates on which cash value accumulations are based. As alluded to above, universal life policies tend to follow more short-term trends, both in interest rates and with insurer expenses and costs causing changes to have a more direct impact on cash values. This combined with policyholder borne risk contributes to the higher volatility of universal life policies as compared to whole life policies. It is important to remember that insolvency risk always exists.
The cash value accumulation of universal policies is not predetermined as with whole life policies. Because premiums are flexible, so are cash values. Cash values will vary depending on whether premiums are made or skipped, whether additional premiums are paid, the amount of charges and expenses that are deducted and on current interest rates. After the appropriate deductions and additions are made, the excess is added to the cash value. This is how the cash value grows. Compared to whole life policies, universal policies can offer a potentially higher rate of return but the risk of a lower return is also a possibility. The great flexibility in premium payments prevents universal life policies from having the same forced savings feature as whole policies.
Universal life policies vary in whether or not they offer policy loans. Some offer partial surrenders instead of loans, in which the policyholder is able to permanently withdraw a cash value amount without causing the policy to lapse. Policy loans typically have low-interest rates and are easy to secure provided cash values are sufficient.
Death benefits for universal policies offer much flexibility and can be increased or decreased when desired. Universal policies offer choices in terms of how death benefits are distributed. Two of the most common choices are level benefit and cash value based benefit. The level benefit option is similar to whole life in that the face value remains fixed (exceptions occur when certain criteria are met). The death benefit consists of the total cash value of the policy plus death protection. Death protection is equal to the difference between the death benefit and the cash value. The result is that at any given time, the cash value plus death protection equals the death benefit (and the face value of the policy). As time passes and more premiums are paid, the cash value of the policy increases and the amount of death protection decreases though the total death benefit (and face value) remains the same. Unlike whole life, it is possible for the cash value to exceed the policy’s face value (thus eliminating death protection) due to additional premium payments, higher than anticipated interest rates or lower than expected costs and charges. If the cash value of the policy exceeds the face value, the policy would fail to qualify as insurance according to the IRS, thus losing its tax advantaged status. To avoid this, as the cash value nears the face value of the policy, the face value is automatically increased to maintain the minimum amount of death protection. Remember that death protection is paid by the insurance company and accounts for the difference between the face value and cash value balance. The cash value based benefit option operates differently than whole life. With this option the death benefit increases with the cash value of the policy. In this case, death protection is equal to the face value of the policy and remains fixed. What changes is the death benefit, which rises (or falls) with the policy’s cash value.
