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Personal Finance

Variable and Universal Life Insurance

These policies have more flexibility than traditional whole life.

Once upon a time, there was term life insurance, which paid only in exchange for a premium, and whole life insurance, which offered a death benefit plus accumulating cash value available for your use if you didn't die first. But inflation and soaring interest rates in the 1970s, in addition to the rigid structure of whole life, caused many to see whole life as a poor "investment."

To make cash value life insurance more interesting to customers, insurance companies invented variable and universal life policies.

Combining Insurance and Investment Needs in One
Universal and variable life insurance policies, like whole life, combine life insurance protection with the opportunity to build cash value on a tax-favored basis. Better than whole life, these modern policies provide you with desirable flexibility and control.

You have flexibility and control over the premium structure, death benefit size, and/or investment of the cash value. If you like the idea of having one product take care of both your insurance and investment needs and you can afford to make a long-term commitment, these policies may be attractive to you. Otherwise, you may wish to use term insurance and place your investment money elsewhere.

Universal Life Insurance
Universal life insurance is a form of cash value life insurance. Like whole life, the more traditional variety of cash policy, universal life is two things in one. It provides a set death benefit during the term of the contract. At the same time, the premiums you pay build cash value that one receives in the form of lump sum or monthly payments at the end of the contract typically when you're ready to retire or die.

However, unlike traditional whole life policies, in which the premiums and death benefit are fixed and guaranteed at the outset of the policy, universal life policies have a very flexible structure. Within certain limits, you can adjust the amount and timing of your premiums as well as the size of the death benefit each independently of the other.

The insurance company invests the part of your premium that doesn't pay for the death benefit and administrative costs into a managed, tax-deferred account paying rates of interest comparable to those of investment-grade bonds. By paying more premiums than necessary to cover the insurance and expense charges, you can greatly enhance your policy's cash value. When there is sufficient cash value to cover the monthly charges, you can even skip premiums.

Because of this flexible structure, universal life policies, in contrast to whole life policies, do not provide a schedule of guaranteed future values; however, they do provide guaranteed maximum charges for insurance and expenses and a guaranteed minimum interest crediting rate.

Another distinction between universal life and whole life is the fact that universal life separates and discloses the components of insurance costs and expenses in addition to the interest crediting rate that both will disclose. The key points to remember about universal life are its flexibility and disclosure of costs. With universal life, you can change the policy as your needs change over time (for instance, as you gain or lose dependents).

Now let's turn to another variation of cash value insurance, the variable life policy.

Variable Life Insurance
Variable life insurance policies have a fixed premium and carry life coverage just as whole life policies do. What makes variable life insurance unique is the opportunity it provides to the policyholder to direct the investment of his or her policy's cash value.

With variable life, you can direct the cash value of your policy to your choice of investment funds: stock funds, bond funds, or money market funds. The performance of the investments in the funds determines the amount of cash value available for payout. Most policies make it fairly easy to transfer money among funds, to take advantage of changing market conditions.

And yet another variation combines the investment options of variable life with the ability to change coverage, premium, and savings levels found in universal life policies: the variable universal life policy.

Strategic Considerations  
People sometimes refer to whole life policies as a "forced savings program" because of the rigid premium schedule. You pay your life insurance premiums, and save for the future while you're at it. Variable and universal life policies have a similar benefit and provide increased flexibility.

With all cash value life insurance, your account's earnings are tax-deferred, which enables the cash value to grow more efficiently. One of the often-overlooked benefits of this tax-deferred growth is that it provides essentially tax-free dollars that can be applied toward paying the insurance costs.

The higher potential return rates of variable life do provide some inflation protection as well. You can even borrow cash from your account on very favorable terms, and within certain limits, you can even withdraw cash on a tax-free basis. As in the case of all life insurance, the death benefit is usually free of income taxes.

There are drawbacks to consider, however. The cost of the life insurance coverage included with these policies may be higher than if you were to buy the same coverage in a term insurance policy, usually depending on the length of your time horizon.

You are taking on market risk by participating in the separate investment accounts, which are generally not guaranteed. There are usually stiff surrender charges by the company for cash withdrawals in the early years, and unpaid loans can sometimes generate income taxes at the death of the insured.

This article is provided by the editors of The Encyclopedia of Personal Finance. Click here to learn even more.

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