What Is Index Universal Life Insurance?

Life insurance provides a death benefit to beneficiaries upon the insured’s passing. Some policies combine this protection with a savings component designed to accumulate value. Index Universal Life (IUL) insurance is a type of permanent life insurance that integrates a death benefit with a cash value feature. This cash value component’s growth is linked to stock market indexes.

Defining Index Universal Life Insurance

Index Universal Life insurance is a permanent life insurance policy providing coverage for the insured’s life, as long as premiums are paid. It includes a death benefit for beneficiaries and a cash value component that grows over time. The “universal life” aspect allows flexibility in premium payments and the death benefit amount.

The “index” component means cash value growth is tied to a stock market index, such as the S&P 500 or NASDAQ 100. Funds are not directly invested in the market. Instead, the cash value is credited interest based on the index’s performance, balancing growth potential with protection from direct market losses. This differentiates IUL from whole life insurance, which offers fixed premiums and often lower growth rates, and from variable universal life insurance, which involves direct investment and carries higher market risk.

Key Policy Elements

An IUL policy is structured around core elements that provide both protection and cash value accumulation. These components define how the policy operates and serves a policyholder’s financial goals.

Death Benefit

The death benefit is the primary purpose of any life insurance policy, representing the sum paid to designated beneficiaries upon the insured’s death. In an IUL policy, this benefit can be adjusted over time for flexibility. Policyholders choose between two options: Option A provides a level death benefit, where the payout remains constant. Option B offers an increasing death benefit, which includes the growing cash value for a potentially larger payout.

Cash Value Account

The cash value account functions as a tax-deferred savings component within the IUL policy. This accumulated cash value can be accessed by the policyholder during their lifetime for various needs. Its growth is influenced by the linked market index’s performance, and policy costs and fees.

Premiums

Premiums are payments made by the policyholder to maintain coverage and fund the cash value. IUL policies offer flexibility in premium payments, allowing minimum premiums to keep the policy in force or higher “target” premiums to accelerate cash value growth. A portion of each premium covers insurance costs and policy fees, with the remainder allocated to the cash value account.

How Cash Value Accumulates

Cash value accumulation in an Index Universal Life policy is distinct from direct market investments, offering a blend of growth potential with built-in protections. Growth is determined by an index crediting strategy, where the insurer credits interest to the cash value based on a chosen market index’s performance. The policy does not directly invest in the stock market; instead, it uses financial instruments to link cash value growth to the index’s performance.

Participation Rate

The participation rate determines the percentage of the index’s gain credited to the cash value. For instance, if an index gains 10% and the policy has an 80% participation rate, the cash value is credited with 8% of that gain. Some policies may offer participation rates exceeding 100%, though standard S&P 500 tracking often has rates less than 100% to offset hedging costs.

Cap Rate

The cap rate sets the maximum interest percentage credited to the cash value in a given period, regardless of index performance. For example, if the index rises by 13% but the policy’s cap rate is 10%, only 10% interest will be credited. Average cap rates fall between 8% and 12%, though insurers can adjust these rates. This cap limits upside potential during strong market growth.

Floor Rate

A floor rate, or guaranteed minimum interest rate, provides downside protection by setting the lowest interest rate credited to the cash value. This rate is often 0%, meaning the cash value will not decline due to negative index performance, even during a significant market downturn. Some policies offer a low positive floor rate, such as 1%. This feature protects accumulated cash value from market losses, offering security not found in direct market investments.

Interest Calculation and Loan Rates

Interest is calculated and credited over specific indexing periods, which can be annual or monthly. The loan interest rate is relevant when policyholders consider borrowing against their cash value. Policy loan interest rates vary, ranging from 5-8%. While the loan itself may not be taxable, interest accrues, potentially reducing the death benefit if not repaid.

Policy Costs and Fees

The various costs and fees associated with an IUL policy impact its long-term performance and cash value growth. These charges are deducted from either premium payments or the accumulated cash value.

Mortality Charges

Mortality charges cover the cost of life insurance protection. These charges are determined by the insured’s age, gender, health status, and death benefit amount. Mortality charges increase with the insured’s age, reflecting the higher risk of mortality. They are deducted monthly from the policy’s cash value or premium payments.

Administrative Fees

Administrative fees are recurring charges covering the insurer’s costs for maintaining the policy, including record-keeping, billing, and customer service. These fees vary by insurer and policy, ranging from $5 to $15 per month. Some policies have higher administrative fees in early years that decrease over time.

Expense Charges

Expense charges, also known as premium loads or sales loads, are deductions taken from each premium payment before funds are allocated to the cash value. These charges compensate the insurer for sales expenses, commissions, and state premium taxes. Premium loads can range from 5% to 15% of each premium payment and significantly impact cash value growth, especially in early policy years.

Rider Charges

Rider charges apply if the policyholder opts for additional benefits or features (riders) that enhance coverage or flexibility. Each rider, such as those for accelerated death benefits or long-term care, incurs an additional fee. These charges are deducted from the policy’s cash value.

Surrender Charges

Surrender charges are fees incurred if the policy is terminated or “surrendered” during its early years. These charges help the insurer recover initial costs of issuing the policy, including commissions and underwriting expenses. Surrender charge periods last for the first 10 to 15 years, with charges gradually decreasing over time. If a policy is surrendered early, the surrender charge is deducted from the cash value before payout.

Using Your Policy’s Cash Value

The cash value component within an Index Universal Life policy offers various ways to access funds during the policyholder’s lifetime, providing financial flexibility. These methods allow access to the accumulated value, but each has implications for the death benefit and ongoing policy performance.

Policy Loans

Policy loans enable policyholders to borrow against their accumulated cash value. When a loan is taken, the cash value serves as collateral, and the policy continues to earn interest. The loan accrues interest, which must be repaid to prevent the balance from growing. If the loan and accrued interest are not repaid, the outstanding balance reduces the death benefit paid to beneficiaries. Policy loans are not considered taxable income, provided the policy remains in force.

Withdrawals

Withdrawals allow policyholders to take money directly from the cash value account. Unlike loans, withdrawals permanently reduce the policy’s cash value and death benefit. Withdrawals are tax-free up to the amount of premiums paid into the policy, considered a return of the policyholder’s cost basis. Any amount withdrawn exceeding total premiums paid may be subject to income taxes.

Partial Surrenders

Partial surrenders are a specific type of withdrawal where a portion of the cash value is taken out, reducing both the cash value and the death benefit proportionally. This method accesses funds while keeping the policy active, albeit with reduced benefits. Tax implications are similar to withdrawals, with amounts up to the basis being tax-free and gains potentially taxable.

Full Surrender

A full surrender involves terminating the policy for its net cash surrender value. The policyholder receives the accumulated cash value minus any outstanding loans and applicable surrender charges. When a policy is fully surrendered, all insurance coverage ceases, and no death benefit is paid to beneficiaries. If the cash surrender value received exceeds total premiums paid into the policy, the excess is considered taxable income.