Whole life and universal life are the two main types of permanent life insurance. Universal life is the new kid on the block and was developed to provide flexibility compared to the traditional whole life insurance policies. Universal life is sometimes referred to as whole life unbundled. The trade-off between the two types is a question of guarantees vs. flexibility.
Whole Life Insurance
Whole life insurance lives up to its name. A whole life policy is designed to stay in effect until the insured individual dies and the death benefit is paid out to the beneficiaries. A standard whole life policy has a level annual premium that must be paid each year for as long as the insured lives. Whole life insurance builds up an internal cash value that reduces the amount of death benefit the insurance company has at risk. If a policy is surrendered, the cash value would be paid out to the owner. A participating whole life policy can earn dividends or interest on top of the guaranteed cash value, based on the insurance company's results. The extra cash can be used to increase the death benefit or pay a part of the annual premium.
Universal Life Insurance
With a universal life insurance policy, the premium paid is divided into several pieces. One part pays for the life insurance coverage, another is policy fees and the remainder goes into a cash accumulation fund. The plan is for the cash accumulation fund to grow so the insurance amount to cover the remaining death benefit goes down as the insured individual gets older and the cost of the insurance per unit becomes more expensive. The cash accumulation value earns interest based on the insurance company's investment results. The amount of premium the owner pays is flexible and the policy holder can decide to increase or decrease the amount paid each year.
Lower Cost Choice
The primary attraction of universal life is the ability to buy permanent life insurance with a lower annual premium than the cost of a whole life policy for the same amount of death benefit. The ability to change the premium also allows flexibility in a financial plan. For example, a young person may choose to pay a low premium to get the policy started and obtain life insurance coverage and increase the annual premium paid in later years to boost the build-up of cash in the policy.
The high relative premium of a whole life policy guarantees the death benefit will stay in force and be paid upon the owner's death. With a universal life policy and a lower premium amount, the interest rate assumptions must be met for the policy to grow cash value fast enough for the policy to stay in force. If credited interest rates are lower than the projections when the policy was purchased, a universal life insurance owner may need to pay higher premiums to keep the policy active. If the premium paid on a universal life policy is the same amount charged for a whole life policy, the two policies will provide similar performance in regards to cash build-up and death benefits.
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