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By Steve Savant, syndicated financial columnist and host of the daily talk show, “The Business Insurance Zone”

What Is Universal Life Insurance?

Universal life insurance contracts differ from traditional whole life policies by specifically separating and identifying the mortality, expense, and cash value parts of a policy. Dividing the policy into these three components allows the insurance company to build a higher degree of flexibility into the contract. This flexibility allows (within certain limits) the policy owner to modify the policy face amount or premium, in response to changing needs and circumstances.

A monthly charge for both the mortality element and the expense element is deducted from a policy’s account balance. The remainder of the premium is allocated to the cash value element, where the funds earn interest. Unlike traditional whole life policies, complete disclosure of these internal charges against the cash value element is made to the policy owner in the form of an annual statement.

Many universal life policies have several different provisions by which the accumulated cash value can be made available to a policy owner during life, without causing the policy to lapse. If a policy is terminated without the insured dying, there are various surrender options for the cash value.

Policy Variations

There are two primary types of universal life, based on the level of death benefits:

Type I universal life
: Also known as option A, type I universal policies pay a fixed, level death benefit, generally the face amount of the policy.

Type II universal life: Also known as option B, type II universal policies generally pay the face amount of the policy plus the accumulated cash values. As the cash values grow, so does the potential death benefit.

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Common Uses of Universal Life

Universal life policies are useful for policy owners who expect their needs to change over time. Within certain guidelines, a universal life policy can be modified by changing the death benefit or premium payments. Some common uses are:

Family protection: To provide the funds to support a surviving spouse and/or minor children, or to pay final bills such as medical or other estate expenses, as well as federal and state death taxes.
Business planning: Because of its flexibility, universal life insurance is often used for many different business purposes, such as insuring key employees, in split-dollar insurance arrangements, and funding nonqualified deferred compensation plans. Business continuation planning often involves using universal life as a source of funds for buy-sell agreements.
Accumulation needs: Some individuals will use the cash value feature of universal life as means of accumulating funds for specific purposes, such as funding college education, or as a supplemental source of retirement income.
Charitable gifts: To provide funds for a gift to charity.
Modified Endowment Contracts (MECs)

A life insurance policy issued on or after June 21, 19881 may be classified as a modified endowment contract (MEC) if the cumulative premiums paid during the first seven years (7-pay test) at any time exceed the total of the net level premiums for the same period.

If a policy is classified as a MEC, all withdrawals (including loans) will be taxed as current income, until all of the policy earnings have been taxed. There is an additional 10% penalty tax if the owner is under age 59