Both universal life and variable life insurance policies can offer you:

• Flexibility in the amount and timing of premium payments.

• Death benefit guarantees and options, depending on the type of policy.

• Potential for income tax-deferred cash accumulation.

In addition, universal life offers you the security of a minimum guaranteed crediting rate, and variable life offers you a choice of investment options.

* Loans are at interest and are generally not taxable, but withdrawals are taxable to the extent they exceed cost basis in the contract. Loans outstanding at policy lapse or surrender prior to the death of the insured will cause immediate taxation to the extent of income in the contract. For policies that are modified endowment contracts (MECs), distributions (including loans) are taxable to the extent of income in the contract, and an additional 10% federal income tax penalty may apply. Consult your tax adviser regarding your particular situation.

Universal life works much the same way as whole life. The premium more than covers the requisite death benefit, and the amount that isn't used to pay expenses and mortality fees is invested. That investment builds up a cash value that eventually whittles away at the amount of pure insurance coverage--the death benefit--that you will need.

But this type of insurance offers two things whole life doesn't: flexibility and transparency.

A universal life policy is broken down--or, in insurance lingo, "unbundled"--to indicate which portion of the premium is paying purely for insurance, which portion is paying for fees and how much is going into the savings element of the policy. In addition, these policies allow individuals to adjust the premium and death benefit. So if your circumstances change markedly--leaving you with less or more insurance need--you can cut or boost the death benefit of the universal life policy. (If, however, you're adding to the death benefit, you may be subject to additional physical examinations to prove you're still insurable.)

Meanwhile, this type of policy gives you the ability to invest more money and let the cash buildup accrue on a tax-deferred basis if you like the investment returns you're earning. If, on the other hand, you aren't impressed with the investment returns, or if you simply can't afford the whole premium during a given year, you can use the cash buildup in your account to pay the mortality fees and expenses.

Because a portion of the policy's cash value is likely to come from investment returns that grow on a tax-deferred basis, you can, in effect, pay for the term insurance portion of the policy with pretax dollars. But this also reduces the amount of cash value in the policy, and that could eventually cause the policy to lapse if the investment returns don't keep pace with the mortality expenses and fees.

The cash value of a universal life policy is invested in bonds, mortgages and other fixed-income instruments that both insurance company executives and state insurance regulators have determined are safe enough for a regulated company investing other people's money.

In the late 1970s and early '80s, fixed-income investments were posting double-digit returns, so the returns on universal life--were impressive. But by the mid-1980s, interest rates had dropped dramatically. Returns on fixed-income instruments became lackluster. The stock market began to take off, and suddenly, investing your money through an insurance policy locked into fixed-income returns seemed less wise than before.

Variable universal life dates to the mid-1970s, and in effect, variable universal life offers policyholders the structure of a traditional universal life policy--a set death benefit that will be partly funded by insurance and partly by the investment buildup in the policy--and premium flexibility. However, the investment portion of the policy resembles a 401(k) plan. 

Policyholders are generally given investment options that range from safe but often low-yielding fixed-income funds to higher-risk, higher-reward options such as stock and bond funds. You can invest all of the cash buildup in your policy in one option or several. And if you want to switch investments, you can do that too--without triggering a gain from the sale that could be taxed--as long as you choose another investment offered through the policy.

Of course, the resulting cash buildup in the policy can't be predicted--it will vary based on the investment choices made and how well those investments fared. In effect, you are buying term insurance and investing the rest. But you're doing it through an insurance vehicle, which gives you tax-favored status.

What's the downside? Fees. When you buy an insurance product married to an investment product, you get hit with fees that pay the insurance company and insurance agents, and fees that pay the investment companies and investment managers.

With some policies, these fees are relatively low. A savvy investor may find, then, that the tax benefit of investing through an insurance policy outweighs the additional costs, so variable universal life works better than other investment alternatives. However, that may not be true with higher-cost policies--or if an investor has less need for the insurance guarantees or the tax benefits

What follows is breakdown of the mechanical structure of how Universal Life and Variable Universal Life policies work.

Source: Mortality cost per $1,000 based on 1980 CSO tables for male, non-smoker, age 25