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Universal Life Policy: Is This Flexible Insurance Contract Right For You?

A universal life policy is a type of insurance policy that I am sometimes asked about when talking about life insurance. This is probably the most popular type of permanent life insurance since whole life fell out of favor in the 1980s. What started out as a fad (buy term and invest the difference) became something of a cult following thanks in part to A. L. Williams and then later by E.F. Hutton (who was the catalyst for all of the universal life policies in existence today).

What is universal life insurance?

A universal life policy is a life insurance policy that is "unbundled", meaning the mortality function of the policy is separated from the cash value or investment portion of the policy. This means that - unlike a whole life policy - you can calculate the cost of insurance as it is deducted from the policy's cash value every month.

Initially, no life insurance policy was ever meant to be an investment - not even the cash value portion. It was meant to be a cash reserve that could be built up against the death benefit. Think in terms of a home and the home's equity. The house represents the death benefit and the cash value represents the equity.

Obviously the major advantage of owning a cash value policy is the easier access to equity as versus a home (not that you should consider buying life insurance vs. buying a home).

With universal life insurance, a flexible policy design had been born. Because the product was "unbundled", policies could be designed to maximize death benefit or maximize cash value all within the same policy. Premiums could be paid until sufficient cash had been accumulated to support the policy for the rest of the insured's life.

The premiums you pay towards a universal life policy go into a cash value account. Money is deducted from the account to pay for a death benefit. The policy then pays interest on the money in your cash value account. Many insurers guarantee that your policy will build equity at a minimum effective interest rate (for fixed and equity indexed universal life). The insurance company invests your premium dollars into the insurance company's general account (for fixed universal life policies), mutual funds (for variable universal life), or index call options (for equity indexed universal life).For variable universal life insurance, the company lets you choose from a selection of mutual funds. The performance of the cash value is tied directly to the performance of the mutual funds you choose to invest in. Regardless of the policy design, as long as there is money in the cash value account, then you have insurance. If there is ever a time when the cash value account falls to zero, your policy lapses and you lose your insurance.

For the policy holder the insurance policy is an asset that will increase in value (in the case of fixed and equity indexed) or is expected to increase in value (in the case of variable universal life).

Those premium dollars must be invested to meet the policy obligations and provide the guarantees offered by the contract, if any. In this way, insurance companies act as financial intermediaries. Especially for fixed universal life, they are accepting the risk of the investment activity while the policy holder obtains the value of the underlying investments for a cost that is expected to decrease over time as the value increases (although, it is entirely possible for the cost of the policy to increase over time, causing the costs to overwhelm any investment earnings). Additionally, the policy owner is able to leverage their savings to obtain money in advance (from the death benefit) to plan for an unexpected death.

For example, an individual may not have $1,000,000 to help their family in the event they die before accumulating a massive savings. But they may have $500 every month that they can give to an insurance company in exchange for that $1,000,000.

Saving money and providing a death benefit with a universal life policy

Although insurance was never initially designed as a liquid savings tool, it's always been something of a leveraged savings product. Over the years, it's evolved to offer surrender values that give the policy an equity value.

Because the equity can be accessed rather easy through 0% policy loans and flexible withdrawal provisions from many companies, it has become the preferred method for many Americans (especially upper middle class) to save money for their future. And, while the "sweet spot" for cash value growth is between 35-45 years old, there is room for the death benefit portion of the universal life policy for just about any age.

This entry was posted on March 28th, 2009 by David C Lewis, RFC. Edits may have been made to keep this entry current. · No Comments · Insurance & Savings

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