The principal behind universal life is the same as with any other form of life insurance. In exchange for payments, a life insurance company promises to pay you a specified some at the time of your death. The way universal life differs is in how you pay for the insurance.
How Universal Life Works
Universal life insurance typically uses investment returns to lower monthly premiums while keeping a life insurance benefit intact. There are many different forms of universal life, some using more aggressive investment returns and others providing a guarantee of insurance. Even with guarantees, UL policies carry a degree of risk.
Universal life offers you more flexibility in that you can vary the amount of your monthly premium. Money you put into the policy is placed into an investment account that generates interest. After the deduction of the cost of your insurance, any excess amount grows in value as interest is credited. You can use this cash to buy more insurance, thereby raising your death benefit. Or, if you prefer, you can use the money to pay part of your premium, meaning there is less coming out of your pocket on a monthly basis.
Guaranteed universal life will remain in effect as long as you maintain your payments, regardless of the interest rate credited to the account. Certain non-guaranteed policies run the risk of having their death benefits lowered if the cost of insurance rises more than the cash value of the account.
One of the main benefits of universal life is its flexibility. Since a portion of your payment goes towards an investment account, you may generate additional returns that you can use to tailor the policy to your needs. With traditional insurance, your death benefit and payments are fixed, and you're locked in to a schedule. With universal life, you can increase your death benefit if that suits your needs, or you can trim your payments if your monthly budget gets tight.
Universal life also carries various tax benefits. Any earnings you generate within a universal life policy grow tax-deferred until you withdraw them. If you do take money out of your universal life policy, your contributions will come out first, and those withdrawals will be tax-free.
Your heirs also benefit from the tax structure of a universal life policy, as your death benefit will be paid out on a tax-free basis to them as well.
The main risk of universal life insurance is that your level of coverage may fall if either the cost of your insurance rises or if the interest rate credited to your account falls. As you age, the cost of insuring your life rises, so your costs typically do as well. Many policies issued in the 1980s, when interest rates were at all-time highs, were devastated when those rates tumbled in the ensuing decades. Many policyholders had to increase their payments simply to keep their insurance in place, and others had to start paying again on policies they anticipated were already paid in full. While current policies use more conservative interest rate models, the potential for decreases in coverage and rising payments still is a risk due to the general structure of universal life policies.
Any withdrawals from a universal life policy may carry heavy consequences or may not even be allowed at all. Most universal life policies have surrender charges that can cost you 10 percent or more of whatever you take out of your policy. While these charges typically decline over time, they can last 10 years or more, greatly restricting your access to any cash in your policy.