Life insurance buyers have many options, from the straightforward insurance of term life to investment-driven policies such as indexed universal life insurance.
Is investment-focused life insurance right for you? We look at the inner workings of indexed universal life insurance so you can see if it’s the best life insurance for your needs.
What Is Indexed Universal Life Insurance?
Indexed universal life insurance (IUL) is a type of permanent life insurance. It stays in force as long as you stay current on your premium payments or until you reach the maturity date specified in the policy. Many IULs mature when the insured person reaches age 121.
IUL has a cash value component where the gains are tied to an index like the S&P 500. While the cash value growth is linked to the index, the insurance company actually invests in things like bonds and mortgages.
Universal life insurance offers the added flexibility to change your premium payments, but only within specified limits. The main difference between indexed universal life insurance and other universal life insurance policies is how cash value accumulates.
How Indexed Universal Life Insurance Works
When you pay the premiums on permanent life insurance, a chunk of that money goes toward the death benefit. Another portion pays for the administrative costs of your policy and the actual cost of insuring you. The rest is directed toward your cash value account.
The death benefit is paid tax-free to your beneficiary when you pass away. The life insurance payout typically does not include payment of the cash value to your beneficiaries.
Cash value accumulation
The cash value of an IUL policy is tied to the performance of an underlying index, such as the S&P 500 or the Nasdaq composite.
The cash value portion of an IUL policy is not as volatile as the stock market, explains Eric Tarnow, head of products for AIG Life U.S. For example, variable universal life insurance is more tied to market fluctuations.
“But consumers do not directly invest in that index,” Tarnow says. The insurance company uses the index’s rate of return to determine how much the account should be credited.
If the index has gained value, your cash value will rise. IUL policyholders are generally protected from a drop in the index because of a “floor.” The interest rate credited to the account will never be less than the floor, which is often 0%. So if your index lost 10%, 0% will be credited, and your cash value won’t lose 10%.
You can borrow against your cash value through a policy loan or withdraw cash value. When you die, your beneficiaries receive a death benefit, but the death benefit amount will be reduced by any loans not paid back or withdrawals you’ve taken from the cash value.
You can typically choose from one or several indices, depending on the insurance company. Tarnow notes that most IUL products also offer a fixed (declared) interest rate option in addition to the index-linked investment.
Floors, caps and participation rates
The cash value within an IUL won’t mirror an index’s exact gains and losses:
- Floor: The floor is the minimum rate that will be credited to your cash value. Your floor could be 0%, and that will protect you from losses in the index. The floor is guaranteed and will not change while you own the policy.
- Cap: On the flip side, there is usually a cap, meaning your cash value gains won’t go above a certain percent—even if the index performs above that threshold. For example, if your cap is 10%, and the index goes up 12%, the cash value tied to that index increases by 10%. The cap is not guaranteed and may change while you own the policy.
- Participation rate: Your cash value gains are also calculated according to the “participation rate,” which is set by the insurance company. This is the portion of the index’s return that is credited to your account. It can often range anywhere from 25% to above 100%. If the IUL has a participation rate of 100%, you will earn all of the interest gained by your investments, up to your cap.
Another example is if the participation rate is 50% and the index gained 10% for the month, you’d actually earn 5% for the period. Though the growth is often tracked monthly, the cash value earnings are usually credited to the account once per year or every five years.
The insurer can change the participation rate during the time you own the policy.
Though the internal policy expenses are deducted monthly, the cash value earnings are only credited to your account at the end of the “segment period” you selected. This could be as long as nine years but is most often once per year and can be as frequently as monthly if you elected dollar cost averaging (DCA).
This means your Annual Policy Statement could show no earnings even in an up market if the end date of the selected segment period is after the date of your Annual Policy Statement. “But that doesn’t mean your policy isn’t performing as expected,” points out Barry Flagg, president and founder of insurance analytics firm Veralytic.
While the floor cannot be changed throughout your policy, your insurer will change the cap and/or participation rate in response to changes in market conditions (such as changes in prevailing interest rates, the degree of equity market volatility, and the cost of options in the derivatives market).
Flexible premiums and death benefit
You have the option to adjust your premiums and death benefit amount if needed. If your account accumulates enough value, you could use those funds to pay your premiums.
If you decide to underpay or even skip a premium, the cost of insurance charges and policy expenses will nonetheless be deducted from your cash value account every month. So long as the cash value account is sufficient to cover these monthly deductions, then the policy will remain in force and the death benefit will continue to be payable.
On the other hand, there may be instances when you are required to pay more in premiums for an IUL than you expected. For example, if the index performs poorly and you are credited only 0%, the subtraction of monthly policy charges could cause the cash value to drop and your policy could lapse without an infusion of more premium. If your cash value falls too much, the insurance company could put out a “premium call,” meaning you need to put in more money to avoid a policy lapse.
If your policy lapses, you lose out on all the money you put in, plus the death benefit.
What Happens When an Indexed Universal Life Insurance Policy Matures?
Whenever any life insurance policy matures (including an IUL), the benefits specified in the policy contract are paid out. In some policies, this benefit is equal to only the cash surrender value, even if the cash surrender value is only $1, says Flagg.
In other policies, the benefit paid out at maturity will be equal to the full death benefit. But because the IRS doesn’t recognize that payment as a death benefit under Section 101 of the Internal Revenue Code, these otherwise tax-free proceeds become fully taxable at ordinary income rates.
Some life insurance policies include language that extends policy maturity if the insured person is still living on the maturity date. In these cases, the death benefit is paid at death even after the original policy maturity date and thus received tax-free by the beneficiaries.
Is Indexed Universal Life Insurance Taxable?
While you can access your cash value in an IUL policy, there are certain cases when taking out the money will be taxable. For instance, you can withdraw up to your basis (the amount you’ve paid into the policy) tax-free. However, any withdrawal that includes a portion of your investment gains before the policy matures will be subject to income taxes for that tax year.
Borrowing against the cash value could also create a taxable event. If you allow the loan interest to deplete the current cash value, your policy can lapse, and you must pay taxes on the loan balance.
Is Indexed Universal Life Insurance Right for You?
Tarnow at AIG says IULs could be a good fit for people who want to participate in market performance but who may not want to have full financial exposure to market downturns.
“Also, for consumers who have maxed out their available retirement plans, an IUL could allow them to contribute with fewer age restrictions and potentially grow cash value on a tax-deferred basis,” Tarnow says.
Expect higher costs and risks with IUL compared to most other types of life insurance. You’ll need to manage your cash value more actively than you would with how guaranteed universal life insurance and whole life insurance policies work.
Cost of Indexed Universal Life Insurance
Indexed universal life insurance quotes are determined depending on the type of policy and particular insurer, says Flagg at Veralytic.
And your premium isn’t the only “cost” associated with an IUL. Indexed universal life insurance is known for having a lot of costs, administrative expenses, sales fees and commissions, the cost of insurance, surrender charges and more. These all impact the cost of your premiums and how much you can build in cash value.
When shopping around for an IUL policy, you’ll be shown projections of the policy’s potential growth. These illustrations are based on predicted interest rates, fees and more. However, because it’s impossible to predict what the market will do in the future, these (likely optimistic) numbers are only estimates and not guaranteed. Plus, the illustration may not include certain caps or fees.
Make sure to focus on the guaranteed parts of the policy illustration, and don’t assume your outcome will mirror the non-guaranteed projections.
“Current regulations in most states permit insurers to quote low premiums and/or project high account growth—without disclosure of either costs or the risks of additional premium calls, under-performance or policy lapse,” Flagg cautions. That’s thanks to a provision in the 2010 Dodd-Frank Act that exempts indexed universal life insurance from federal regulation.
It can make comparing the true value, costs and risks of various policy options very difficult.
“Individuals considering IUL must insist that any and all proposals include year-by-year cost disclosures and performance requirements,” Flagg says. Be sure to ask how premiums, fees and interest rates will impact the policy’s overall performance.
It’s also a good idea to request policy illustrations after you have owned the policy for a while, especially if you’re going to take a cash value loan. You’ll want to know if taking a cash value loan could potentially lead to a policy lapse.