What Is an Indexed Universal Life Insurance Policy?

An Indexed Universal Life (IUL) insurance policy offers permanent life insurance coverage combined with a cash value component that grows based on a market index’s performance. It provides a death benefit and builds cash value accessible during the policyholder’s lifetime. The policy links cash value accumulation to market performance without direct investment in the stock market, blending features of traditional universal life insurance with an indexing strategy.

Defining Policy Elements

An Indexed Universal Life policy integrates core features of universal life insurance with an innovative indexing component. The universal life aspect provides permanent coverage, meaning the policy remains in force for the policyholder’s entire life, provided premiums are paid and the policy maintains sufficient cash value. This permanent nature contrasts with term life insurance, which covers a specific period.

This cash value offers flexibility regarding premium payments and death benefit amounts. Policyholders generally have the ability to adjust their premium payments within certain limits, or even skip payments if the cash value is sufficient to cover policy costs. Similarly, the death benefit can often be adjusted upward or downward, subject to underwriting and policy minimums, to meet changing financial needs. These flexible features are fundamental to the “universal life” designation.

The “indexed” aspect links cash value growth to a chosen market index, such as the S&P 500. The policy does not directly invest in the market or index itself. Instead, the cash value is credited with interest based on a portion of the index’s gains. This crediting mechanism involves specific parameters that define how the cash value participates in market upswings.

Key elements governing this indexed growth include participation rates, caps, and floors. A participation rate determines the percentage of the index’s positive movement that is credited to the policy’s cash value; for instance, a 100% participation rate means the policy credits the full index gain up to any cap. A cap, or rate limit, sets the maximum interest rate that can be credited to the cash value in a given period, regardless of how high the index performs. Typical caps might range from 8% to 12% annually, ensuring a ceiling on credited interest.

A floor, on the other hand, establishes a guaranteed minimum interest rate, which is often 0%. This 0% floor protects the policy’s cash value from market losses. These mechanisms determine how the cash value benefits from index performance while protecting against downturns.

Policy Mechanics and Value Growth

Premiums paid into an Indexed Universal Life policy are not immediately deposited into the cash value as a lump sum. Instead, these payments are allocated to cover various policy costs and to fund the cash value component. A portion of each premium payment or the policy’s cash value is used to cover the cost of insurance and administrative fees associated with maintaining the policy. This allocation ensures the policy remains in force and provides the promised death benefit.

The cost of insurance (COI) represents the mortality charges for the death benefit coverage and is influenced by factors such as the insured’s age, health, and the death benefit amount. Additionally, administrative fees, such as policy maintenance charges, are deducted to cover the insurer’s operational expenses. These costs are deducted monthly from the policy’s cash value or from premium payments, reducing the amount available for cash value accumulation.

Cash value growth is tied to a selected market index over a defined “indexing period,” commonly one year. At the end of each indexing period, the change in the index’s value is calculated. If the index has a positive return, the cash value is credited with a portion of that gain, subject to the policy’s participation rate and cap.

For example, if the index gains 10% and the policy has a 100% participation rate with an 8% cap, the cash value would be credited with 8% interest for that period. If the index gained 6% under the same terms, the cash value would be credited with 6%. Conversely, if the index experiences a negative return, the 0% floor ensures that the cash value does not lose money due to market performance in that period.

The death benefit structure in an IUL policy offers two main options. Option A, often called the level death benefit option, maintains a specified death benefit amount, with the cash value growth increasing the net amount at risk for the insurer. Option B, or the increasing death benefit option, provides a death benefit that is equal to the initial face amount plus the accumulated cash value. This means the death benefit grows as the cash value increases, offering a potentially larger payout to beneficiaries over time.

Accessing Policy Value

Policyholders can access the accumulated cash value within an Indexed Universal Life policy through several distinct methods during their lifetime. One common method is taking a policy loan. A policy loan allows the policyholder to borrow money against the cash value, with the policy remaining in force. The loan amount is limited to a percentage of the cash value, and interest is charged on the outstanding loan balance.

Repayment of a policy loan is generally flexible, with no strict repayment schedule. However, any unpaid loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries if the insured passes away before the loan is fully repaid. This reduction ensures the insurer can recover the loan amount from the death benefit.

Another way to access cash value is through withdrawals. A withdrawal directly removes funds from the policy’s cash value, which permanently reduces both the cash value and the death benefit. Any amounts withdrawn that exceed the premiums paid into the policy may be subject to ordinary income tax. Withdrawals are generally not repaid, making them different from policy loans.

Policyholders also have the option to surrender the policy for its cash surrender value. Surrendering the policy means terminating the insurance coverage entirely. Upon surrender, the policyholder receives the cash value minus any outstanding loans or surrender charges. If the cash surrender value exceeds the total premiums paid into the policy, the difference is considered a taxable gain.