Universal Life Insurance: Understanding Your Policy and Your Options

Universal life insurance sits somewhere between term life insurance and whole life insurance. It offers permanent coverage like whole life but with more flexibility. You can adjust your premiums within limits, and your policy builds cash value over time.

But that flexibility comes with complexity. Universal life policies have moving parts that can work for you or against you depending on how you manage them. Understanding how these policies work is essential, especially if you are considering buying one, surrendering one you already own, or selling it for cash.

This guide explains the different types of universal life insurance options, the pros and cons of each, what happens when you surrender a policy, and how to sell your policy if you no longer need it.

What Is Universal Life Insurance?

Universal life insurance is a type of permanent life insurance with three key features.

First, it provides a death benefit that can last your entire life, as long as you keep the policy in force. Unlike term life insurance that expires after 10, 20, or 30 years, universal life is designed to provide long term coverage. However, universal life policies do have maturity dates, typically age 95, 100, 121, or 131 depending on the policy. If you outlive the maturity date, the policy may pay out the cash value or death benefit depending on how it is structured.

Second, it builds cash value over time. A portion of each premium payment goes into a cash account that earns interest or investment returns depending on the policy type. You can borrow against this cash value, withdraw from it, or use it to pay your premiums.

Third, the premiums are flexible. Within certain limits, you can pay more or less than the standard premium amount. This flexibility is the main thing that distinguishes universal life from a whole life insurance policy, which generally has fixed premiums.

Every universal life premium payment covers several costs. The cost of insurance, or COI, pays for the actual death benefit protection, which varies based on the specific risk of the underlying insured (which is carried out by underwriting their health conditions). On top of that, there are administrative fees, premium load rate fees, per thousand fees, and other charges that vary by policy. The COI rate increases every year as you age because you become more expensive to insure as a policyholder. The administrative fees and premium load rates generally stay the same over time, and in some cases may decrease.

Whatever you pay above these costs goes into your cash value account. Here is the catch. If you only pay the minimum premium for too long, your cash value may not keep pace with the rising cost of insurance. Eventually, you may need to pay significantly higher premiums to keep the policy in force, or the policy could lapse.

This is the tradeoff with universal life. The flexibility that makes these policies attractive can also create problems if you do not manage them carefully.

Traditional Universal Life Insurance

Traditional universal life insurance is the most straightforward version of this product. Your cash value earns interest at a rate declared by the life insurance company, typically on a monthly basis. This rate is not fixed. It can change based on market conditions, but most policies have a guaranteed minimum rate, often around 2%, so you know your cash value will earn at least something.

The main advantage of traditional universal life is the flexible premiums. You can pay more during years when you have extra income and less during years when money is tight. If you have built up enough cash value, you can even skip payments entirely and let the policy pay its own premiums from the cash account.

The main risk is underfunding. If you consistently pay only the minimum premium, your cash value may not grow enough to keep up with the increasing cost of insurance as you age. The policy could become underfunded and eventually lapse, leaving you with no life insurance coverage and potentially nothing to show for years of payments.

When you look at an illustration for a traditional universal life policy, you will typically see several premium payment options. There is a minimum premium, which is the least you can pay to keep the policy active. There is a target premium, which is what the life insurance company recommends to keep the policy healthy. And there may be a cash accumulation premium, which is a higher amount designed to build significant cash value.

Most illustrations will also show when the policy is projected to lapse under different payment scenarios. Pay attention to these projections. If you plan to pay only the minimum premium, understand that you are taking a risk.

Traditional universal life works best for people who want permanent coverage with some flexibility but prefer the stability of predictable interest rates rather than market exposure.

Indexed Universal Life Insurance

Indexed universal life insurance, often called IUL, ties your cash value growth to the performance of a market index like the S&P 500. Your money is not actually invested in the stock market. Instead, the insurance company uses the index performance to calculate how much interest to credit to your account.

The appeal of indexed universal life is that you get some upside when the market performs well without the full downside risk. Most IUL policies have a floor, typically 0%, meaning your cash value will not decrease due to market losses. If the index drops 20% in a year, you simply earn 0% rather than losing money.

However, there are significant limitations on the upside. IUL policies typically have caps that limit how much you can earn in any given period. If the cap is 10% and the index rises 25%, you only get credited 10%. Some policies also have participation rates that further limit your gains. If the participation rate is 50% and the index rises 10%, you only get credited 5%.

The combination of caps and participation rates means you will never capture the full upside of the market. The insurance company keeps the difference. Over time, this can result in returns that are lower than what you might expect based on the index performance.

Another issue with IUL policies is how the illustrations are presented. Many carriers show projections based on 7% or 8% average returns, which assumes the index performs at or near the cap every single year with no down years. This is unrealistic. A more conservative illustration at 4% to 4.5% will give you a better sense of how the policy might actually perform.

The cost of insurance still increases every year with an IUL, just like other universal life policies. If you have several years with 0% returns because the market declined, your cash value is not growing but your costs are still rising. This can create funding problems over time.

IUL policies require ongoing attention. You should review your policy annually to see if it is performing as expected and make adjustments if necessary. If the returns are lower than illustrated, you may need to increase your premium payments to keep the policy on track.

Indexed universal life works best for people who want some market linked growth potential without direct investment risk, have a long time horizon, and are willing to actively monitor their policy.

Variable Universal Life Insurance Pros and Cons

Variable universal life insurance takes market exposure a step further. Instead of linking cash value growth to an index, your cash value is actually invested in subaccounts that function like mutual funds. These subaccounts may include stock funds, bond funds, money market funds, and other investment options.

The appeal is straightforward. If your investments perform well, your cash value can grow much faster than it would in a traditional or indexed universal life policy. Over a long time horizon, direct investment in the market has historically outpaced the returns offered by fixed interest rates or capped index crediting.

But the risks are equally significant.

Pros of Variable Universal Life

• Higher growth potential with direct market exposure
• Flexible premiums like other universal life policies
• Tax deferred accumulation of cash value
• Choice of investment subaccounts

Cons of Variable Universal Life

• You can lose money if investments decline
• Higher fees than other policy types
• Requires active investment management
• Risk of policy lapse if investments underperform

First, you can lose money. Unlike traditional universal life with a guaranteed minimum interest rate, or indexed universal life with a 0% floor, variable universal life offers no protection against losses. If your investments decline, your cash value declines. A bad market year can wipe out years of gains.

Second, variable universal life policies are expensive. The investment management fees, administrative costs, and mortality charges can eat into your returns. These policies often have higher costs than simply investing in mutual funds directly.

Third, you have to manage the investments. Variable universal life requires you to choose and monitor your subaccounts, much like managing a brokerage account. If you do not have the time, knowledge, or interest to do this, the policy may underperform.

Fourth, poor investment performance combined with the increasing cost of insurance can create serious problems. If your cash value drops and you cannot cover the cost of insurance, you may face large premium increases or policy lapse.

Variable universal life works best for people who have a long time horizon, are comfortable with investment risk, and want the potential for higher cash value growth. It is not a good fit for anyone who needs peace of mind, predictable outcomes or is uncomfortable watching their cash value fluctuate with the market.

Guaranteed Universal Life Insurance

Guaranteed universal life, sometimes called no lapse universal life, is essentially permanent term insurance coverage. It provides a guaranteed death benefit that lasts until a specified age, typically 90, 95, 100, 105, or older, with fixed premiums that never change, via what is called a no lapse guarantee.

Unlike traditional, indexed, or variable universal life, guaranteed universal life does not build accessible policy's cash value in the traditional sense. The premiums go almost entirely toward the cost of insurance. You will not see a cash value balance that you can borrow against or withdraw from.

However, most guaranteed universal life policies have what is called a shadow account. This is an internal accounting mechanism that accumulates value over time, even though you cannot access it directly. The shadow account is what allows the policy to remain in force with guaranteed premiums. It also creates opportunities to optimize the policy in certain situations, such as through a life settlement.

The advantage of guaranteed universal life is simplicity and reliability. Your premiums are locked in. Your death benefit is guaranteed. The policy cannot lapse as long as you pay the premiums on time. There is nothing to manage and nothing that can go wrong due to market performance or underfunding.

The disadvantage is that you cannot access the value during your lifetime. If you need cash from the policy, there is nothing to borrow against or withdraw. And if you stop paying premiums, you walk away with nothing.

When choosing a guaranteed universal life policy, it is important to select a maturity age that you are unlikely to outlive. Most people choose age 105 or later to ensure the policy remains in force for the rest of their life.

Guaranteed universal life is often a good fit for older buyers who want affordable permanent coverage, do not need cash value accumulation, and want the certainty that their policy will be there when they die.

When a Policyowner Cash Surrenders a Universal Life Insurance Policy

If you own a universal life policy and decide you no longer want or need it, you can surrender it to the insurance company in exchange for the cash surrender value. This terminates your coverage immediately. Your beneficiaries will no longer receive a death benefit when you die.

The cash surrender value is not the same as the cash value shown on your statement. Cash surrender value equals your cash value minus any surrender charges, outstanding loans, and unpaid interest. In the early years of a policy, surrender charges can be substantial, sometimes eating up most or all of your accumulated cash value.

Surrender charges typically decline over time. Most policies impose these fees for the first 10 to 15 years. After that period, surrender charges often drop to zero, and your cash surrender value will equal your cash value minus any loans.

When you surrender a universal life policy, there may be tax consequences. If you receive more money than you paid in total premiums, the excess is considered taxable income.

Before surrendering, understand exactly what you will receive. Contact your insurance company and ask for the current cash surrender value, not the cash value. These are different numbers, and the distinction matters.

Also consider whether surrendering is your best option. There are alternatives worth exploring.

Policy Loan

You can take a policy loan instead of surrendering. Loans against your cash value are not taxable as long as the policy remains in force. You can use the money for whatever you need and choose whether to repay it. If you do not repay, the outstanding balance is deducted from the death benefit.

Partial Withdrawal

You can make a partial withdrawal from your cash value. Withdrawals are tax free up to your cost basis, which is the total premiums you have paid into the policy. However, you can only withdraw up to the amount of cash value available, and some insurers cap the amount. Withdrawals reduce both your cash value and your death benefit.

Use Cash Value to Pay Premiums

You can use your cash value to pay premiums. If you cannot afford to keep paying out of pocket, your accumulated cash value may be enough to cover premiums for months or even years. This keeps your coverage in force without requiring additional payments.

1035 Exchange

You can do a 1035 exchange and utilize this tax advantage. This allows you to transfer the cash value from your universal life policy into a different life insurance policy or an annuity without triggering taxes. If your current policy is not meeting your needs, this may be a way to switch to something better without losing money to taxes.

Selling a Universal Life Insurance Policy

If you are 65 or older and your policy has a death benefit of $100,000 or more, you may have another option besides surrendering. You can sell your policy in a life settlement.

In a life settlement, you sell your policy to a third party buyer who pays you a lump sum, takes over your premium payments, and eventually collects the death benefit when you die. The amount you receive is typically four to seven times higher than the cash surrender value.

Life settlements work with all types of universal life policies, including traditional, indexed, variable, and guaranteed universal life. Even guaranteed universal life policies with shadow accounts can have significant value on the secondary market. The specific value depends on your age, health, the size of the death benefit, and the premium costs.

The process involves working with a licensed life settlement provider who evaluates your policy, gathers your medical records, and determines what buyers are willing to pay. If you accept an offer, ownership transfers, funds go into escrow, and you receive payment once the transfer is complete.

There are tax implications to selling a policy. The proceeds are divided into three tiers. The first tier, up to your cost basis, is tax free. The second tier, representing gains inside the policy, is taxed as ordinary income. The third tier, anything above the cash surrender value, is taxed as capital gains. Talk to a tax professional before selling.

If you are considering surrendering a universal life policy, it is worth exploring whether you qualify for a life settlement first. The difference in payout can be substantial.

How to Decide What to Do With Your Universal Life Policy

If you are trying to figure out what to do with a universal life policy you no longer want or cannot afford, here is a framework for thinking through your options.

1. Understand Your Policy

What type of universal life do you have? What is your current cash value? What is your cash surrender value? What are the surrender charges? What is your death benefit? How much are your premiums? Get these numbers before making any decisions.

2. Consider Your Need for Coverage Amounts

Do your beneficiaries and loved ones still need the death benefit? If your spouse, children, or other dependents rely on your income, surrendering or selling eliminates that protection. Think carefully about who would be affected.

3. Evaluate Your Alternatives

Can you reduce your death benefit to lower premiums? Can you use cash value to pay premiums? Can you take a loan instead of surrendering? Can you do a 1035 exchange into a different product? Make sure you understand all your options before choosing one.

4. Get a Life Settlement Quote

If you are considering surrender, get a life settlement quote first. If you are 65 or older with a policy worth $100,000 or more, you may receive significantly more from selling than from surrendering. It costs nothing to find out.

5. Talk to a Tax Professional

The tax implications of loans, withdrawals, surrenders, and sales are all different. Understanding the tax consequences may change which option makes the most sense.

Universal life insurance is a flexible product, but that flexibility can create confusion. Take the time to understand your policy and your options before making any irreversible decisions.