Universal life (UL) insurance is one way to provide a permanent death benefit for your loved ones, no matter how old you are when you die. Plus, it offers more flexibility than whole life insurance policies. This includes the ability to alter premium payments and choose how the death benefit is determined. But flexibility can come with uncertainty, particularly when it comes to the death benefit.
To help you decide what’s best, we’ll consider the advantages between death benefit options, the disadvantages, and when one or the other makes the most sense.
What Is Universal Life Insurance?
UL insurance provides life insurance coverage for an insured person, paying out the death benefit to the beneficiaries named in the policy when that person dies. It also offers an internal account value, similar to a savings component, known as the cash value. The policyholder can access this money at any time.
Unlike whole life insurance, with UL insurance you can increase or reduce premium payments. You may also pause those payments as long as there is sufficient cash value to pay premiums and prevent the policy from lapsing. You may also be able to adjust the death benefit without purchasing a new policy.
Variable universal life insurance works in a similar way but allows you to invest the cash value in subaccounts, which are like mutual funds, that invest in stocks and bonds.
Unlike permanent life policies, term life insurance pays out if the policyholder dies within the set term (often 10-30 years). It has no cash or savings component.
Universal Life Insurance Death Benefit Options
UL insurance policies typically offer two death benefits options. When reviewing these options, keep in mind that there are three main components to a UL policy:
- Face value: the initial death benefit of the policy
- Death benefit: the amount your beneficiaries receive when you die (determined by which death benefit option you select)
- Cash value: an internal tax-deferred account, similar to a savings account—you’re typically not required to pay taxes on any gains in the account unless those gains are withdrawn
Death benefit options are sometimes referred to as Option A or Option B. And some insurance companies offer other options as well.
Option 1: Death Benefit = Face Value
Under Option 1, the death benefit remains level and equals the face value, or the face amount, of the policy. The cash value is not paid out separately or on top of the death benefit but is rather used to reduce the cost of insurance throughout the life of the policy.
The net amount at risk to the insurance company—that is, the amount it’s liable to pay out—is the difference between the death benefit and the cash value. Because the death benefit stays consistent throughout the life of the policy, the net amount of risk to the insurance company decreases gradually. This is because the policy’s cash value accumulates over time.
For example, if your universal life insurance policy has a $2 million death benefit and a $200,000 cash value, you would pay insurance costs on $1.8 million. If, in five years, the same $2 million policy had a cash value of $300,000, you would pay insurance costs on $1.7 million.
Insurers determine your premium based on how large the death benefit is and how soon they expect to pay it.
Option 2: Death Benefit = Face Value + Cash Value
Under Option 2, the death benefit increases gradually, because it equals the policy’s face value plus the accumulated cash value. The total risk to the insurance company remains the same: It equals the face value of the policy. As a result, premiums are typically higher than on an Option 1 policy.
Universal Life: Option 1 vs. Option 2
Consider the relative advantages, disadvantages, and applications of choosing death benefit Option 1 or Option 2.
Option 1: Pros and Cons
- Premiums are usually lower
- You get the same initial death benefit as Option 2
- The death benefit does not increase over time
- Increasing the death benefit after the policy is issued, if possible, requires paying higher premiums and possibly a medical exam
With Option 1, you pay for less insurance throughout the life of the policy. Since the cash value accumulation offsets the insurer’s risk, premiums are lower for a policy when you select this death benefit option. Plus, you get a higher initial death benefit for the same amount of premium relative to Option 2.
Unlike Option 2, the death benefit does not increase over time, which means that beneficiaries receive less money when the insured person dies. Increasing the death benefit after the policy is issued may require that you prove insurability by taking a medical exam. Plus, premiums will increase.
The death benefit may increase even with Option 1 selected, typically during the policy’s later years. Insurance is strictly regulated so that if the cash value accumulates past a certain point, the death benefit will be increased. This way, the policy still falls under the definition of a life insurance contract.
Option 2: Pros and Cons
- The death benefit increases over time
- You can put more money into the insurance policy (to grow on a tax-deferred basis in the cash value account)
- Premiums are usually higher, which could ultimately make coverage unaffordable
Option 2 can be advantageous if you want to increase the death benefit over time (for example, to deal with inflation or cover growing obligations). It also enables you to put more money into the insurance policy so that the cash value can grow more quickly relative to Option 1.
But Option 2 tends to be more expensive because the cash value is not used to offset the cost of insurance. Premiums must be paid on the full face value of the insurance policy for as long as the policy is active, regardless of what the cash value accumulates to. However, reducing the death benefit is usually an option if the policy becomes unaffordable.
You can access the cash value in permanent life insurance policies via policy loans and direct withdrawals.
Which Death Benefit Should You Choose?
There are a number of factors to consider when choosing a death benefit.
Scenarios for Choosing Option 1 or Option 2
Option 1 is the more affordable choice and might work better if you want a specific “known” death benefit. For example, you might have several beneficiaries, such as children and grandchildren to whom you want to leave a specific dollar amount, or you may want to donate a certain amount to a charity when you die.
It’s also a good choice if you’re concerned about the cost of insurance and affording premiums as you age.
Option 2 might work better if you’d benefit from accumulating money in a tax-deferred account (the cash value account). These funds can grow at a faster rate, by the benefit of being sheltered from taxes, and they become tax-free when received as a death benefit by your beneficiaries.
Withdrawals in excess of the amount paid in premiums may be taxed as income.
Parents might also choose this option when purchasing an insurance policy on behalf of their children. This is because the younger—and healthier—you are, the lower your insurance rates will cost. Plus, the longer the policy is in force (your lifespan), the more time the cash value has to compound.
Switching Between Options
In some cases, policyholders can switch their death benefit option. The most common change is from Option 2 to Option 1 (a net reduction in the death benefit). You might do this if you need to reduce the amount you pay for life insurance.
While it is possible to change from Option 1 to Option 2, this process is more involved. Increasing the death benefit (by adding the cash value accumulation to the face value) will require the policyholder to prove they are still insurable. This would likely require medical underwriting and undergoing a medical exam.