What is Indexed Universal Life Insurance?
IUL vs. other types of permanent life insurance
Permanent life insurance lasts the policyholder’s lifetime and includes a cash value component. This is a savings vehicle within the policy that can build value over time. The insured can use that cash value in specific ways, like as collateral for a low-interest rate loan or to pay some of their policy premiums.
Different types of permanent life insurance grow the cash value in different ways. Whole life policies generally grow at a fixed rate set by the insurance provider, while universal life policies provide variable-rate growth based on market interest rates. Indexed universal life insurance is a type of universal life coverage.
With IUL coverage, it gets a little bit more complicated. That’s because the cash value growth corresponds with the performance of a specific market index. When that index is performing well, the cash value amount grows more quickly. But when it’s performing poorly, the insured will see less impressive gains — or none at all.
To make cash value growth more reliable for the insured and predictable for the insurance provider, most providers set a guaranteed minimum interest rate and a cap for the maximum rate at which the cash value component can grow.
Some providers set their minimum interest rate at 0%. That means that if the index is underperforming, the insured won’t lose any money, but they also won’t see any interest rate-based cash value growth. Similarly, if the index starts soaring, they’ll likely hit a ceiling that prevents their cash value from growing faster than a specified rate.
To truly understand how IUL policies work, you need to understand the thing that determines the cash value’s growth rate: the market index. You might already be familiar with some indexes, like the S&P 500, NASDAQ Composite, and Dow Jones Industrial Average.
Basically, an index is just a way to track the performance of a group of stocks. Your insurance provider may pick the index tied to your IUL coverage or may give you the option to pick one or multiple indexes yourself.
Other features of IUL insurance policies
Adjustable death benefit
Most IUL policies will give you the option to adjust your death benefit up or down as your financial needs change through the years. There may be a cap on how much you can increase your death benefit before you need to submit to a supplemental medical exam, though.
Like most universal life insurance policies, indexed universal life insurance policies have three death benefit options:
The death benefit stays the same throughout the policy years. Or at least until the cash value catches up to the death benefit. In this option, the total amount of the insurance benefit actually goes down as the cash value rises because cash value fills the gap. This helps offset the rising cost of insurance in later years when this benefit option is selected. Many people will choose option 2 and then switch to option 1 when they age in order to manage costs.
The amount at risk stays the same throughout all policy years. The cash value amount adds to the death benefit, dollar for dollar. Because the death benefit amount never changes, the cost of insurance constantly rises.
This option gives the death benefit plus all premiums paid upon the passing of the insured. In terms of cost, it is midway between level and increasing benefit options.
Set or “Target” Premium
The cost of insurance of an indexed universal life insurance policy rises every year. If all you were to do is pay that cost, also known as the “Minimum Premium,” you would most likely be better off purchasing an Annual Renewable term, due to the lower overall price. Additionally, if nothing above the minimum premium is deposited into the policy, the cash value will never get a chance to develop. It will most definitely never outpace the rising insurance costs either.
For this reason, the Target premium was created, this amount is the optimal or ideal amount, at a minimum anyway, of where your premiums should be. If you hit your target, the cash value will most likely outpace the rising cost of insurance.
Insurance companies encourage you to pay more than the target, all the way up to the maximum amount allowed for tax purposes so that the policy does not become a Modified Endowment Contract. Read our explanation of the taxation of life insurance policies and modified endowment contracts.
Paying more than the target allows for more of your money to grow based on your index choices. Keep in mind that the premium charges may vary for the monies below and up to target and those above the target amount.
Premium payment options
With IUL coverage, you will likely be able to use your cash value to pay your policy premiums once you accrue a certain amount. This can be particularly helpful for people during their retirement years.
Because IUL policies require the life insurance provider to monitor the relevant market indexes, they usually come with several different, potentially costly fees. And if the index to which your cash value is tied isn’t providing you with a rate of return, you could potentially see your cash value decline over time as fees eat into it.
Here is a list of typical fees that you may find on an index universal life insurance policy:
- Administrative Charge
- Face Amount Charge Per $1,000. A small fee per $1,000 of life insurance coverage, an example insurer would charge 12 cents per $1,000 of insurance a year. The total annual cost for a $1,000,000 policy would be $120 a year.
$1,000,000 / 1,000 = 100 x $0.12 = $120
- Cost of Insurance. Based on the insurance company’s experience but not to exceed CSO mortality tables, this is a rising cost as previously discussed.
- Indexed performance charge. Essentially a “funds under management” fee. Where you get charged based on the index you choose to have your cash value based on.
- Premium Charge In other words a “load fee.”
- Surrender Charge.
If you surrender your policy for its cash value, the surrender charge will be deducted from the total cash value amount. Depending on the insurance carrier, this will usually fall off between years 10 and 15.
Cash Value Components
Cash value has a few features and limitations that one must be aware of prior to purchasing an indexed universal life insurance policy:
- Interest Rate Floor
- Growth Rate Cap
- Participation Rate
Interest Rate Floor
This is perhaps the most enticing feature of an indexed universal life insurance policy. It guarantees that your policy will always have a “positive year.” In other words, you only experience the upside of the market and no downside. If the market dips—even to 2008 levels of close to 40%—your indexed universal life policy will still grow (or, at least, not lose) based on the minimum floor amount.
This amount is usually 0%-3% and varies from carrier to carrier.
It’s important to note that while the cash value amount does not go down during a bad year in the market, you will still be charged all of the built-in policy charges. This means that your overall policy may still decrease in value, especially if this down-market year happens later in the policy when the cost of insurance is substantial.
Growth Rate Cap
Likely the most limiting feature of an indexed universal life insurance policy, a cap rate limits the maximum amount of growth you will get based on the index you choose. For example, if you have a 14% cap and the market earns a 22% return, you will still only get a maximum of 14%.
Aside from the cap rate, some companies also limit what percentage of the overall index you get to participate in. For example, if the index returns 10% in a given year, if your policy has an 80% participation rate, you will only receive an 8% return.
You will usually have the option to choose between different common indexes such as the S&P 500, Russell 2000, etc. There are also fixed accounts within an indexed universal life insurance policy, but if you’re looking for a fixed growth rate, traditional universal life or whole life will probably be a better bet.
Generally, insurance professionals recommend indexed universal life insurance policies for people who have a decent risk tolerance and want life insurance premiums and death benefits that can adjust with them over time.