How does universal life insurance work?
Traditional life insurance
In traditional life insurance premium is based on a given level of insurance cover. If the insured event happens, then the agreed insurance cover is paid out. If the insured event does not take place, or the policyholder stops paying the premium, then the sum of all premiums paid so far is lost. Premiums therefore form a pure cost for the policyholder, unless the insured event actually happens.
Universal life insurance
Premium paid for a universal life policy might be better termed a ‘deposit’. A sizeable cash payment (‘deposit’) is made to the insurer to obtain the universal life insurance policy and the policyholder immediately receives the agreed insurance cover; e.g. a premium of USD 3 million is paid and the beneficiaries receive USD 9 million when the insured life passes away*. In addition, the universal life insurance company annually credits a (guaranteed) interest to this ‘deposit’ of the policyholder’s. The insurance company calls this ‘deposit’ the Cash Value. It consists of the full premium a policyholder has paid, minus the costs of insurance and other costs, such as the insurance company’s and the broker’s fees.
* The tax consequences of a life insurance are different for every country.