How Does Universal Life Insurance Work?

Universal life insurance is a flexible, permanent life insurance policy that combines a death benefit with a cash value account. Unlike whole life insurance, a universal life insurance policy gives you more control over how much you pay and when — within limits set by federal tax law. Here’s a breakdown of how universal life insurance works, from premium payments to cash value growth.

Step-by-Step: How Universal Life Insurance Works

1. You Choose Your Premium Payments

With universal life insurance, you decide when and how much to pay in premiums, up to limits regulated by federal tax law. There is a minimum required premium, which is based on:

• The insurance company’s expenses
• Premium taxes
• The cost of pure insurance for your policy

2. The Insurer Deducts Sales Expenses and Taxes

When you pay your premium, the insurance company first deducts its sales expenses and applicable premium taxes.

3. The Remainder Goes Into Your Cash Value Account

What’s left of your premium is credited to your universal life insurance cash value account. Each month, the insurer charges this account for:

• Other policy expenses
• The cost of pure insurance — also called the mortality cost, or the net amount of risk coverage

4. Your Cash Value Earns Interest

Your cash value earns interest at a rate that fluctuates based on returns from a segregated portfolio within the insurance company’s general account. Every universal life insurance policy states a minimum guaranteed interest rate, so your cash value has a floor even when market performance is low.

5. Excess Interest May Be Credited to Your Policy

If the insurer’s portfolio earns more than the guaranteed rate, that excess interest is credited to your policy’s cash value, helping it grow faster than the guaranteed minimum.

6. What Happens if Cash Value Runs Low

If your cash value isn’t enough to cover monthly expenses and the cost of pure insurance — and you don’t add more premium — one of two things can happen:

• Your coverage amount may be reduced, or
• Your policy may lapse entirely

This is similar to a container running empty from the top: without enough funds coming in, the policy can no longer sustain itself.

7. Taking a Policy Loan

You can borrow against your policy through a loan, generally up to the policy’s cash surrender value minus the annual loan interest. A few things to know about policy loans:

• Repaying the loan replenishes your cash value.
• If the policy terminates before the insured’s death, there may be a tax liability on the outstanding loan.
• Any unpaid loan balance (plus accrued interest) at the time of the insured’s death is deducted from the death benefit paid to your beneficiary.