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Life insurance may be an essential component of your financial plan, but that doesn’t mean you should buy the first policy you find. The reality is that there are many different types of life insurance to consider, and some may work better for your needs than others.

For example, if you want a policy that offers a guaranteed death benefit until the day you die, you’ll need to focus on permanent life insurance. But even then, there are several types of permanent life insurance coverage, and the details within each type of policy can vary even more.

Universal life insurance is one type of permanent life insurance to consider, but how does it work? Let’s dive into the different types of universal life insurance you can buy and the reasons a person might want to purchase this type of policy.

What is universal life insurance?

Universal life insurance — which may also be referred to as adjustable life — is a type of permanent life insurance that’s intended to provide benefits until the day you die. However, this type of policy may be more flexible than a traditional whole life insurance policy.

While both whole life insurance and most universal life insurance policies build cash value, universal life insurance policies generally earn “a market rate of interest,” according to the Insurance Information Institute, which is used in part to keep your premiums lower and to add to the cash value portion of the policy.

However, unlike standard whole life policies, which have fixed premiums for the life of the policy, the premiums on universal life insurance can fluctuate depending on the market and the policy’s related investments. That means you could be looking at higher premiums if the market or the investments you choose don’t pan out as expected.

Since the policyholder is taking on more risk with a universal life insurance policy, the cost of universal life insurance is generally lower than regular whole life policies.

How does universal life insurance cash value work?

One of the attractive features of universal life insurance policies is its cash value component, but what exactly does this term really mean, and how does it work in practice?

Generally speaking, the cash value component describes the investment portion of any life insurance policy, including universal life insurance. To build cash value, insurers set aside a portion of your life insurance premiums in a separate account, which are then invested over time.

Life insurance policies that build cash value provide options for accessing that cash in an emergency.
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Life insurance policies that build cash value provide options for accessing that cash in an emergency.

Some people borrow against the cash value of their life insurance policy when they need it for major life events or in an emergency. Others might use it to help pay their life insurance premiums later down the line when their income is lower after retirement. Another option is to access part of the cash value of your policy by surrendering it if you no longer want to keep paying for the policy.

A universal life insurance policy that builds cash value can be useful if you want to have a cushion down the road. It can also help if the premiums on your policy become difficult to manage, as you can rely on the cash value to extend the policy for a while even if you stop paying the premiums. But keep in mind that using the cash value in this way will lower your overall death benefit.

Types of universal life insurance

Under the universal life insurance umbrella, you can drill down to find specific types of universal life insurance. Policy options include the following:

Indexed universal life insurance

This is a type of permanent coverage that offers its own cash value component, but the main difference is where that money is kept. With indexed universal life insurance, you can invest the money in your cash value account and earn interest based on a stock market index, such as the S&P 500. In addition, many indexed universal life policies offer a guaranteed interest rate “floor” that promises you’ll never receive a return lower than that rate.

The main benefit of this type of policy is the fact that you have the potential for greater returns over time, and that you also receive a guaranteed minimum rate of return. You also get tax-deferred growth on the cash value of your policy as well as a death benefit that won’t require any federal taxes to be paid by your heirs.

On the downside, your returns with indexed universal life insurance may be low if the stock market isn’t performing well, and your returns will always trail an index since your insurer makes money by keeping a portion of the gains.

Guaranteed universal life insurance

If you’re looking for life insurance with near lifetime coverage for a lower price point, you might consider a guaranteed universal life insurance policy. Unlike other forms of universal life insurance, there’s no cash value component with this type of policy, which means the premiums don’t change over the life of the policy.

However, the flip side of that trade-off is that since there’s no cash value, if you stop paying the premiums, your policy will lapse since there’s no cushion to fall back on to cover the cost of the policy.

While the lack of cash value may dissuade some people from considering this option, keep in mind that the premiums on guaranteed universal life policies are significantly lower when compared to other permanent life insurance options.

Guaranteed universal life can be an interesting “middle ground” choice for people in their 60s to consider if they previously had a term life policy that expired and don’t want to commit to the high cost of a new permanent whole life policy in the retirement stage of their life.

Guaranteed universal life insurance can be an option for people in their 60's looking for a new policy at a lower cost.
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Guaranteed universal life insurance can be an option for people in their 60's looking for a new policy at a lower cost.

Variable universal life insurance

With variable universal life insurance, you get permanent life insurance coverage that comes with a cash value component. The main difference is that you have the option to put some or all of your cash value into a separate account that’s made up of investments you choose.

This type of life insurance provides a tax-free death benefit to your heirs, but you also get more control over how the cash value component of your policy is invested and managed. This gives you the potential for much higher returns based on how aggressively you invest, yet you’ll also endure the market risk that comes anytime you invest in the stock market.

Variable universal life insurance also lets you pay flexible premiums, so it may sound like it represents the best of all worlds. However, many experts don’t recommend variable universal life insurance due to the high fees these policies often require.

How does universal life insurance compare to whole and term life policies?

Broadly, the main two types of life insurance are term life insurance and whole life insurance. Term life insurance only lasts for a specific length of time — usually 10 to 30 years — while whole life insurance lasts for a lifetime and often has a cash value component.

Universal life insurance typically comes in the form of whole life insurance, which means that like most whole life policies, premiums usually cost significantly more than a comparable term life policy, since your heirs are guaranteed to receive a death benefit so long as you continue to pay the premiums over the course of the policy.

Also, term life insurance policies are occasionally offered without a medical exam, whereas whole life policies — including most universal life insurance policies — generally require you to go through a physical to qualify for coverage.

Is universal life insurance a good choice for you? Many people who expect to have lower costs later in life don’t need permanent life insurance and shouldn’t pay the higher costs associated with a universal life policy. But if you think you do need that coverage and don’t want to have to worry about being covered as you get older, you may want to consider universal life insurance as an option.

Read CNN Underscored’s guide on all the different types of life insurance.

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