Chances are good that, if you’ve shopped for life insurance, you’ve come across something called “Universal Life.” You’ve probably wondered what it is and how it works. If that’s the case, you’ve come to the right place. I will break it down for you in layman’s terms and avoid technical jargon as much as possible so you can get a better idea of how it works and if it makes sense for you to purchase.

I hope you don’t feel bad about checking further into this. In fact, I commend you for it. My experience has shown me that 99% of everyday people and over 50% of life insurance agents don’t understand this product. I’ve constantly seen bad advice being given by agents and it can lead to a lot of frustration if a policy lapses and it’s too late to do anything about it. So, let’s break it down.

Universal Life(UL) came into existence as a direct response to the rising popularity of the “Buy Term and Invest the Difference”(BTID) mantra several decades ago. Insurance companies wanted to keep people in a permanent product while offering less premium outlay than a whole life product. New whole life sales were declining, and existing whole life product holders were dropping policies, so this is how the industry responded. They created a hybrid of the whole life and term policy, something we now call Universal Life. Now, I’m not commenting on the BTID strategy here. That will come at another time. I am only telling you about Universal Life for now.

Some of us in the life insurance industry jokingly referred to Universal Life as “Perm Term,” meaning it was like a term product with no temporary time frame. Now that I’ve told you what it is, let’s breakdown what it looks like in an example.

Let’s say a person wants to buy $100,000 in life insurance and is price shopping. He may find the following monthly premium quotes:

$100,000 Whole Life = $100/mo

$100,000 20-year Term = $20/mo

$100,000 Universal Life = $40-$90/month

You may immediately notice 2 things about these quotes: 1) There is a big difference in premiums between these 3 types of policies. 2) Universal Life has a range whereas the other 2 are fixed.

I will address point #1 elsewhere. For our discussion, let’s look at point #2. The reason there is a range is because there are various “guarantees” within a UL policy. The low end of the premium range will be the “Guaranteed Minimum” required to prevent your policy from lapsing. That means you must fund the policy at least by that amount every month or else you lose the contractual guarantee that says your policy will never lapse. You could also pay closer to $90/mo, which I address below. Hypothetically, you could pay $30/mo on the policy above, and the funding won’t be enough to keep the policy going, and it could lapse 10 or 20 years later, leaving you with nothing to show for it(like a term policy). Or…and I hate to add this because it may be confusing, but I like being thorough…your policy could still move along just fine for the rest of your life, even if you only pay $30/month. The difference is that you lose the contractual guarantee. If your policy still doesn’t lapse, then you got lucky. I’ll address this point shortly.

To further clarify point 2 above, $40 is the contractual minimum guarantee to avoid a policylapse. The higher amounts will be additional scenarios. For example, your policy may say something like, “If you pay $70/mo, then your cash value will at least be X after so many years. If you pay $90, then you are guaranteed to have 2X after so many years” and so on. There will be varying degrees of guarantees depending on the company you are applying with. Some policies look more complicated than others, but the idea is the same: you have a guaranteed minimum to keep your policy in force, and you have a higher amount that will guarantee a certain performance above the minimum. There is always a premium range with at least a contractual minimum.

Now, what did I mean by paying $30/month and getting lucky? Basically, UL policies accumulate cash values like Whole Life. They typically don’t accumulate those values as fast, but you also aren’t paying as much for them either, so it makes sense. The cash values assume an interest rate. Think of it like having a savings account that you fund each month. When you open the account, the bank may say that you are going to be paid an interest rate of .5% today, but it could go up or down later. With UL, an interest rate is “assumed” for the life of the policy, because the company has to show what your policy will look like years down the road. This means that your contractual guarantees are based on an assumed interest rate, and the numbers are calculated accordingly. For those of us in the real world, we know that interest rates change. Your UL policy assumptions won’t change, but interest rates in the real world do change from time to time.

So, what happens when the actual interest rates change? If interest rates in the real world go down and drop below the assumed contract rates, then your policy will still be in force as long as you pay the required minimums, but your cash value will be less. For example, if the assumed rate is 5%, but actual rates drop to 2%, then your cash value is getting paid 2% instead of 5%. When that happens, you make less than you would have at 5%. Hopefully this makes sense so far. Comparing again to your savings account, if your account makes 2% instead of 5%, then your account grows at a slower pace. This is true of any account you have that earns interest. However, in a UL policy, you also have account fees that are being deducted over time. There is usually an annual fee and a “cost of insurance” fee that are deducted from the internal values of the UL policy. The annual fee is very basic, but the cost of insurance is how much it is costing the insurance company to keep your policy in force. This is already factored into your premium cost, but it is also being deducted from your internal value. (Think of this like investing in a mutual fund. You pay a certain amount to invest, and a portion of that is deducted on an annual basis, and a portion is taken at some other point as a cost for having the fund.) I realize I may have just confused you about the cost of insurance at this point, but I don’t want to stay on this point because this page is about UL policies. So, don’t worry about that detail here. The point is the UL policy has deductions that your savings account doesn’t have, so it could drop in value. Let’s move on…

Now, let’s flip our previous scenario. What happens if interest rates go UP to 8%? If that happens, then your account makes MORE than the assumed rate, which is good news for you and your policy. In this scenario, your cash value builds more than anticipated, and that benefits your policy’s internal values in several ways. The most noticeable benefit to the policy owner is that he could then pay less per month in premium and the policy would still be ok. He may even be able to stop paying premiums completely for a time and still be ok. (By being “ok” I simply mean that the policy would not lapse. It would still be in force.) This isn’t a strategy to put too much faith in because it affects your contractual guarantees, but you may be able to reap these benefits if rates go up. This is what I mean by saying “you got lucky” earlier: interest rates went above the assumed rates, so you got to earn more money faster.

One point I want you to fully grasp is this: your premium is flexible. You can pay more or less than what your policy expects you to pay. Why would someone do that? You can pay less than your standard premium(in our example, this would be somewhere between $40-$90, probably something like $65) if you have a tighter month financially, and you need to free up some cash flow. If you pay less than the guaranteed minimum(in our example this would be the $40 premium), you risk voiding that part of your policy, which I certainly would not recommend. If you pay more on your premium, your cash value will grow faster. That’s why I listed a premium range of $40-$90 instead of a fixed premium like the other 2. Could you pay more than $90? Yes, but there are limits which I won’t go into here. For simplicity’s sake, just know that the premium is flexible within reason.

This is how I can explain how a UL policy works in the simplest terms possible. If I lost you, I’ll summarize again here: 1) a UL policy is a hybrid policy created with a combination of features taken from Whole Life and Term policies. 2) The premiums will be higher than a term policy and lower than a whole life policy. 3) As long as you pay the contractual minimum, your policy will never lapse. 4) Your UL policy assumes a certain flat interest rate. 5) Since interest rates change over time, your internal cash value may be more or less than what your contract assumes. 6) If your internal values go to $0, but you still paid your guaranteed minimum premium, your policy will never lapse. Your contract guarantees it. 7) If your internal values are more than your contract assumptions, you have some flexibility to move the premium around a bit, but be careful not to void your contract guarantee.

Since UL policies involve interest rates, you may be thinking, “When is the best time to buy one?” Here is a simple answer to that question: Your assumed interest rates will reflect the economy at the time you bought it. If you purchased a UL in 2021 when rates were very low, then your contract assumes rates will always be low. Today(2024), rates are much higher than they were in 2021. Therefore, your policy would be doing quite well today. Conversely, if you bought a UL policy today, rates are the highest they’ve been in many years. Your contract will assume high interest rates. If rates drop again to 2021 levels, your policy will not perform well at all. You may run into low or no cash value before long. You can still pay your standard premium, but all you’ll get is a permanent policy that has no real cash value benefit to it. Rates would need to go back to where they were at the time you purchased the policy for you to at least get to the expected rate of return. If it were me, I wouldn’t buy this policy when rates are high. I’d wait until rates were lower. This statement is based solely on interest rate assumptions, which is only one reason you would purchase life insurance. Don’t forget the #1 reason you buy life insurance: for the death benefit. Don’t wait to buy this because of interest rates because you may become uninsurable between now and when you would have bought the policy. Don’t play that game.

I truly hope this article helped you get a better grasp of Universal Life. It is widely misunderstood, and it’s important to understand it at least at the level I’ve explained it here. It can look very complicated, but hopefully this article made it look less daunting for you.

"Do you know where UL policies came from? They were whole life policies once..."

What is Universal Life?