Life insurance can be very confusing.  There are different types of policies that work in very different ways.  Some policies have cash values, and some do not.  Some policies pay dividends, some pay interest, and some invest the cash value in variable sub account funds.  Each policy has different expenses, features, benefits, and costs.  Choosing between them all can be very confusing.

Two very popular types of life insurance are term life insurance and universal life insurance.  Term life insurance is a temporary form of life insurance coverage, while universal life insurance is a permanent form of life insurance.  There are many significant other differences between them other than the length of coverage.  Each policy may be appropriate for different clients.

Each form of life insurance is used to protect the financial interest of a spouse, child, family, or business against death.  An insured person is named in the policy, and if the insured person passes away any life insurance policy will pay out a claim (as long as payments and all other stipulations of the policy have been met).  Any claims are paid to the named beneficiaries.  Only the owner has the ability to name or change beneficiaries, unless a beneficiary is irrevocable, in which case it cannot be changed.  The owner of a life insurance policy must have an “insurable interest” in the life of the insured person.  Any immediate family member is said to automatically have an insurable interest in the life of an insured person.  These are all ways in which every kind of life insurance policy is the same.

How Term Life Insurance Works

Term life insurance provides coverage for a set amount of time, or term, hence the the name.  After the specified amount of years of the term, the coverage expires.  Most term policies require level premium payments for the duration of the policy, though there are some policies which charge increasing premiums which rise as the insured person ages.  Term life insurance policies provide life insurance in it’s most basic form.  In exchange for making premium payments over a period of (x) amount of years (x being the length of the term), the life insurance company provides financial protection on the life of an insured person and is legally bound to pay any valid claim upon death of the insured person.  For a claim to be valid premium payments must be made timely, and any claim must be filed during the specified coverage period.

Term life insurance is often likened to renting life insurance coverage due to its temporary coverage period.  Most term policies are offered in lengths of 5, 10 , 15, 20, and 30 years.  Generally speaking the longer the coverage period, the more expensive the annual premium payment due.  This is to compensate the life insurance company for the increased risk associated with providing coverage for a longer time (the longer and older someone is covered the higher statistical chance that the life insurance company will have to pay a claim).

Term life insurance is usually the least expensive form of life insurance coverage available, and is a good choice for many clients because of its affordability for large coverage amounts.  Term life insurance does not have a cash value and when it expires, it expires without any value to the policy owner.  The life insurance company keeps all premiums that were paid(except in a special kind of term policy called a return of premium policy).

Most term life insurance policies do allow for conversions to a permanent form of life insurance (as long as the conversion takes place during the specified allowed conversion period).  Term policies also sometimes give the owner the option to renew the policy without any underwriting after the term expires, though this is much more expensive on an annual basis than previous premiums during the coverage period in order to account for the adverse selection inherent in the pool of people who choose to renew a policy without underwriting.

How Universal Life Insurance Works

Universal life insurance is different than term life insurance because it is a permanent form of life insurance.  Universal life insurance is meant to last the entire life of the insured person, no matter how old they are when they pass away.  Universal life insurance is also very distinct from term and whole life insurance because it has a flexible premium requirement, as opposed to the level structure of term and whole life.   Universal life insurance also has a cash value component, which can be paid to the owner upon surrender, withdrawals can be taken, and loans are allowed from the policy.

The Structure of Universal Life Insurance

The way universal life insurance works is a bit more complex than term coverage. As a simple analogy, universal life insurance can be thought of as a term life insurance policy, with an increasing premium, with a companion interest earning cash account. Universal life insurance provides a certain face amount of life insurance coverage.  The cost of the life insurance coverage associated with a universal life insurance policy changes, rising as the insured person ages.

The costs are calculated based upon the amount at risk to the insurance company, with the amount at risk being the death benefit of the policy minus the cash value of the policy.  This is essentially the amount that the life insurance company would have to pay “out of pocket” if a claim was paid.  The cost rises, per dollar at risk to the insurance company, each year of the policy as the insured person ages.  A policy with no cash value can become very expensive if the insured person lives to an old age.

Premium payments for universal life insurance policies are technically flexible, meaning that as long as the owner covers at least the cost of insurance, or sufficient cash value exists to cover the cost of the insurance coverage, the policy will remain in force.  Policy owners are encouraged to pay more than the cost of insurance in order to build the cash value.

In fact the goal of the policy owner is to fund the policy sufficiently by paying more than the cost of insurance each year.  The excess amount paid over the cost of insurance is added to the cash value account.  The life insurance company pays a variable rate of interest (generally fixed for one year periods) on the cash value.  Legally the interest paid can not fall below 2%, and the rate is calculated based upon a formula created by the insurance company which is related to LIBOR.  When the fixed income market is paying higher rates, universal life insurance policies should adjust to pay higher rates as well.

As the cash value rises, the total amount of money at risk to the insurance company is reduced (assuming a level death benefit).  With sufficient funding the amount at risk will reduce enough over time, and growing cash value account will pay enough interest to compensate for the rising cost of insurance.

People Invest In Universal Life Insurance For Flexible Premiums and The Interest Earned

The upside to a universal life insurance policy is the interest paying cash value account.  This typically pays much higher interest rates than other interest earning accounts available to clients.  During times of hardship for the policy owner, premium payments can be temporarily suspended and the insurance can be paid for by the cash value.  With a high enough cash value in a policy, the interest earned may cover more than the cost of insurance, and the policy will persist forever without additional payments.  The owner may even be able to start taking money from the policy through loans or withdrawals without jeopardizing their coverage.

A universal life insurance policy allows a more flexible funding structure than a whole life insurance policy while still providing permanent coverage.  During times of rising interest rates a universal life insurance policy may also increase rates faster than a whole life policies increase dividends.

Taking Loans and Withdrawals

Many people end up taking loans and withdrawals from their universal life insurance policies.  Loans allow the owner to access money without reducing the face amount of the policy.  If the loan is repaid, the death benefit is restored to it’s original level.  A withdrawal will generally reduce the face amount of the policy permanently (except in increasing death benefit policy structures in which the death benefit is equal to the face amount plus the cash value).

Withdrawals and loans are fairly easy to take, most life insurance companies will process them with a simple call to the service line or a written request.  If the owner wishes to surrender the policy before the insured person passes away, any cash value is paid to the owner.

Surrender Charges

Universal life insurance policy withdrawals are usually subject to surrender charges during a certain time frame after the policy is issued.  These charges generally reduce over time, and may last for up to the first 15 years of the policy.  Always inquire about surrender charges before taking any withdrawals from your policy.

Term Or Universal Coverage?

For most people term life insurance provides sufficient coverage.  Most people do not need a permanent form of life insurance, and from an investment perspective they are better served by using a term life insurance policy and saving to a traditional investment account.  For people who need permanent coverage, and are attracted to the flexible payment structure and the interest paid in the cash value account, a universal life insurance policy may be appropriate.

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