Tier One: How Do Life Insurance Companies Invest Premiums Paid into Indexed Universal Life Policies?

Indexed Universal Life (IUL) is routinely described as “market-linked growth with downside protection.” That shorthand is directionally accurate, but it often creates a misunderstanding that matters in real-world planning. IUL policy values are not directly invested in the stock market index you select. Instead, the insurer invests premiums primarily in its general account and then uses a portion of the general account’s economics to support an options-based hedging program that drives index-linked interest credits.

For sophisticated buyers, especially those stress-testing illustrated outcomes, understanding this investment-and-hedging “plumbing” is essential. It explains why caps and participation rates change, why “0% floors” are feasible, and why carrier balance-sheet strength and risk management discipline can matter as much as the index menu.

We at Life Insurance Strategies Group, LLC are often retained by wealthy individuals and institutions to evaluate transactions like these from the client’s side of the table. With that in mind, this article is educational in nature and does not recommend any specific product or carrier.

Step 1: Premium becomes policy value only after policy charges and reserves

A common planning mistake is to assume that every premium dollar is “invested.” In practice:

1. Premium is received.

2. The policy applies expense loads, cost of insurance (COI), and other charges as described in the contract.

3. The remainder contributes to account value (cash value), which is an internal policy ledger entry backed by the insurer’s assets and liabilities.

   
   

This is not unique to IUL; it is part of the universal life chassis. What is distinctive is how the insurer supports the index-linked crediting method.

Step 2: Most IUL premium economics live in the insurer’s general account

In a traditional IUL design, the assets supporting policy obligations are held in the insurer’s general account, the same balance-sheet pool used to back many other non-variable life products and obligations.

General account portfolios at life insurers are typically built to match long-duration liabilities and are commonly dominated by high-quality fixed income (for example, investment-grade bonds, structured assets, and other long-duration instruments), managed under asset-liability management constraints. The objective is stability and predictable portfolio earnings, not equity-like volatility.

This matters because the general account’s expected yield is a key input into what the insurer can spend on hedging to produce index credits over time.

Step 3: The “index link” is typically created with options, not index ownership

When a policyholder allocates account value to an “index account,” the insurer generally does not buy the index. Instead, the insurer buys derivative exposure, commonly call options (or option spreads), tied to the chosen index over the crediting period (often one year).

Conceptually, many carriers follow an economic pattern that looks like this:

• The general account earns a bond-like return.

• The insurer uses a portion of that expected return (after allowing for expenses, profit, and risk margins) as the hedge/options budget to purchase options intended to support index credits.

  
  

This approach can support a “floor” (often 0%) because the premium economics are not actually placed into the index; the downside in the index is not directly borne by policy values the way it would be in a variable product.

Step 4: The hedge budget largely determines caps, participation rates, and “multiplier” features

The practical question for policyholders is if the index does well, how much of that upside is credited? That is where crediting levers, cap rate, participation rate, and/or spread come in. These levers are tightly linked to the cost of the insurer’s hedging program and the size of its hedge budget.

Two drivers are especially important:

1. Interest rates / general account earnings. Higher general account yields can increase the economic budget available for hedging; lower yields can compress it.

2. Market volatility / option pricing. When options become more expensive (often during volatile periods), the same budget buys less upside, which can pressure caps or participation rates.

   
   

This is one reason many carriers introduce or emphasize volatility-controlled indices. Lower realized volatility can reduce hedging costs and make crediting terms easier to support, though the index itself is designed to dampen upside and downside.

Step 5: “General account” vs. “separate account” matters, especially for risk and transparency

Clients sometimes conflate IUL with variable products. Variable universal life (VUL) uses separate accounts (or separate account structures) that are distinct from the general account and are commonly used for variable annuity or variable life product investment features.

IUL, by contrast, is typically a general account-backed promise with an options overlay, rather than direct equity ownership. The distinction matters for:

• Creditor claims and insurer solvency exposure (general account obligations are backed by the insurer’s balance sheet)

• Investment transparency (you are relying on the carrier’s hedging execution and ALM discipline)

• Policy behavior under stress (charges, COI, and crediting terms can interact in complex ways)

Step 6: Regulation and illustration guidance tries to keep the story disciplined

Because IUL marketing historically leaned heavily on illustrations, regulators and actuarial bodies have spent significant effort on guardrails, particularly around how index accounts, hedge budgets, and “disciplined current scale” assumptions can be represented. AG 49 and AG 49-A (and subsequent discussions) are aimed at curbing illustrated leverage that can outpace what hedging economics can reasonably support.

Notably, under AG-49 regulation about how IUL can be illustrated, the life carriers are allowed to assume a 45% annual options profit as a default for projecting IUL illustations. Based on various cap rates, this would be the equivalent of running variable products invested in S&P 500 (with dividends) at 11% to 11.5% with the added risk on the IUL the carrier can cut the cap.

The takeaway for policy owners is simple: the illustration is not the investment strategy. The true “engine” is the insurer’s general account earnings capacity and its hedging program effectiveness over time.

Questions Prospective IUL Policyholders Should Ask

When evaluating an IUL policy, especially for long-duration objectives, consider focusing on questions that connect directly to the investment-and-hedging mechanism:

• What has the carrier’s cap/participation history been across different rate and volatility regimes?

• How is the hedging program governed (risk limits, counterparties, rebalancing cadence, stress testing)?

• How sensitive are illustrated outcomes to changes in caps, participation, COI, and policy charges?

• What is the insurer’s financial strength profile and how does it manage general account risk?

• Are volatility-controlled indices used, and what are the trade-offs versus traditional benchmarks?

  
  

Q&A for Prospective Policyholders and their Advisors

Q: Is my IUL cash value invested in the S&P 500 (or other index)?

A: Typically, no. Policy values are generally supported by the insurer’s general account, while index-linked credits are commonly supported through options or other hedging instruments tied to the index.

Q: Why do caps and participation rates change over time?

A: Because the carrier’s hedge budget and the price of options change. General account yields, expenses, and market volatility can all influence what upside the insurer can economically support.

Q: Does “0% floor” mean there is no risk?

A: Not exactly. The floor typically applies to index crediting (you may not be credited negative index interest), but policy charges and COI still apply and can drive performance. And you retain insurer credit risk because obligations are backed by the carrier’s general account.

Our Perspective

IUL is best understood as general account investing plus a structured hedge designed to translate a portion of bond-like economics into index-linked crediting subject to caps, participation rates, and contractual charges. When clients evaluate IUL using that framework, the due diligence naturally shifts from “Which index?” to “Which balance sheet, hedging discipline, and contract mechanics and how do they behave under stress?”

Life Insurance Strategies Group, LLC does not sell products.  We help our affluent individual and institutional clients make decisions about complex transactions involving life insurance.