What Is Indexed Universal Life Insurance?

Life insurance provides a death benefit to beneficiaries upon the policyholder’s passing. Universal life insurance offers flexibility in premiums and death benefits, alongside a cash value component. Indexed Universal Life (IUL) insurance is a specific type of universal life policy known for its unique approach to cash value growth.

Understanding Indexed Universal Life Insurance

Indexed Universal Life (IUL) insurance is a permanent life insurance type combining a death benefit with a cash value component. Unlike term life insurance, which covers a specific period, IUL policies are designed to last for the policyholder’s entire life, provided premiums are paid and the policy remains in force. A portion of premiums covers insurance costs and administrative fees, with the remainder allocated to the policy’s cash value.

IUL’s cash value growth is linked to a stock market index, such as the S&P 500 or NASDAQ Composite, without direct investment in the index. This means the cash value can benefit from positive market performance but is not directly exposed to market losses. Policyholders can allocate their cash value to one or more index accounts. The cash value earns interest based on the index’s performance, but with certain limitations that aim to reduce risk. The cash value accumulation within an IUL policy grows on a tax-deferred basis, meaning taxes on gains are not paid as long as the money remains within the policy.

Key Components of Indexed Universal Life Insurance

An IUL policy includes a death benefit, a cash value account, an indexing strategy, and various policy charges and fees.

Death Benefit

The death benefit is the sum paid to beneficiaries upon the policyholder’s death and is income-tax-free. Policyholders have options for structuring the death benefit. A “Level Death Benefit” remains constant, equal to the policy’s face amount. An “Increasing Death Benefit” equals the policy’s face amount plus the accumulated cash value. The ability to adjust the death benefit amount is a feature of universal life policies, though increasing it may require a new medical examination.

Cash Value Account

The cash value account is the savings component. A portion of premiums contributes to this cash value, which can grow over time and be accessed by the policyholder. Cash value accumulation is tax-deferred, meaning earnings are not taxed until they are withdrawn.

Indexing Strategy

The indexing strategy determines how the cash value earns interest. Growth is linked to an external market index, but the money is not directly invested. The insurance company uses the index’s performance to calculate interest credited to the cash value. This linkage is governed by specific mechanisms designed to manage risk and potential returns:

Participation Rate: Defines the percentage of the index’s gain that is credited to the policy’s cash value. For example, if an index increases by 10% and the policy has an 80% participation rate, the cash value is credited with an 8% gain.
Cap Rate: Represents the maximum percentage of gain that can be credited to the cash value in a given period, regardless of how much the underlying index performs. For instance, if the cap rate is 12% and the index returns 15%, the cash value is credited with a 12% gain. Cap rates can vary, influenced by the cost of options used by the insurer to manage the indexing strategy.
Floor Rate: Provides downside protection by setting the minimum percentage of gain credited, often 0%. If the index performs poorly or has negative returns, the cash value does not decrease due to market losses, instead receiving a 0% return.
Spread/Margin: A deduction from the index return before the gain is credited, acting as an additional fee.

These mechanisms determine the actual interest credited to the cash value.

Policy Charges/Fees

IUL policies involve various charges deducted from the cash value:

Premium load: An upfront charge taken from each premium payment before it’s allocated to cash value, often ranging from 5-10%.
Administrative fees: Ongoing fixed monthly charges, such as $5-15, covering policy maintenance.
Cost of insurance (COI): Deducted to cover the death benefit, which increases as the insured person ages.

These fees, along with potential surrender charges if the policy is canceled early, can impact the policy’s cash value accumulation.

Policy Management and Financial Mechanics

IUL policies offer flexibility in managing cash value.

Premium Flexibility

Policyholders can adjust premium payment amounts and frequency. This allows for lower payments during periods of limited income or additional payments to accelerate cash value growth. However, sufficient cash value must be maintained to cover ongoing charges, as underpaying premiums could lead to the policy lapsing.

Accessing Cash Value

Policyholders can access cash value through loans or withdrawals.

Policy loans: Allow individuals to borrow against their cash value, using the policy as collateral. These loans are tax-free and offer a source of funds without directly depleting the cash value. Interest accrues on these loans, and if not repaid, the outstanding loan balance will reduce the death benefit paid to beneficiaries.
Withdrawals: Tax-free up to the amount of premiums paid into the policy, which is considered a return of the policyholder’s basis. Any amount withdrawn exceeding the total premiums paid is subject to income taxes. Unlike loans, withdrawals directly reduce the policy’s cash value and may reduce the death benefit. Monitoring withdrawals is important to avoid unintentionally depleting the cash value to a level that jeopardizes the policy’s ability to remain in force.

Lapse Protection

A policy can lapse if the cash value falls too low to cover the cost of insurance and other fees. This occurs if premiums are consistently underpaid or if significant withdrawals or unpaid loans erode the cash value. To prevent a lapse, policyholders must ensure that sufficient premiums are paid to maintain a positive cash value balance. Some policies may include a no-lapse guarantee feature, which, for an additional cost, ensures the policy remains in force for a specified period even if the cash value drops, provided certain minimum premiums are met.

Comparing Indexed Universal Life with Other Insurance Types

Understanding IUL insurance is aided by comparing it with other common types of life insurance policies. Each type serves different financial needs and offers distinct features regarding coverage duration, cash value growth, and premium structure.

Term Life Insurance

Term life insurance covers a specific period (e.g., 10, 20, or 30 years) and does not accumulate cash value. It is more affordable than IUL, offering a death benefit for a defined term without a savings component. IUL provides lifelong coverage and a growing cash value, making it more complex and expensive.

Whole Life Insurance

Both IUL and Whole Life Insurance are permanent policies with a death benefit and cash value. Whole life features guaranteed cash value growth at a fixed interest rate and fixed premiums. IUL links cash value growth to a market index, offering potential for higher returns, but these are not guaranteed and are subject to caps and participation rates. IUL also provides greater premium flexibility.

Variable Universal Life (VUL) Insurance

Both IUL and VUL are permanent policies with flexible premiums and cash value. With VUL, cash value is directly invested by the policyholder into sub-accounts, exposing it to direct market risk and potential for both higher gains and losses. VUL policies do not have caps or floors on returns. IUL’s cash value growth is linked to an index without direct investment, incorporating cap and floor rates to limit potential gains and losses. This makes IUL less risky than VUL, as it offers a degree of protection from market downturns.