Tier One: Understanding Indexed Universal Life (IUL)
Over time, there has been a shift in permanent life insurance polices from the insurer shouldering most of the investment risk to the policyholder taking on more of that risk in-exchange for an opportunity for greater policy performance. An evolution in life insurance policy types followed this risk shift, starting with whole life contracts, and moving to flexible premium universal life contracts.
In a traditional whole life insurance policy, the insurance company states a rate of return, also known as a crediting rate, in return for an inflexible schedule of premiums, usually paid monthly, quarterly or annually. The crediting rate is typically low and represents the investment spread between what the insurer receives investing the premium and what is credited in a return to the policy’s cash values. Additional investment success by the insurer might be shared with the client with a dividend payment to the policy.
When policyholders demanded more flexibility and policy transparency, flexible premium universal life entered the marketplace. A type of whole life, universal life allows for a flexible premium where the client can choose when and how much to contribute to the policy and also to adjust the policy death benefit. The insurance company declares a credited rate, usually guaranteed for a year, and deducts policy charges such as the cost of insurance (COI) and the insurance company’s administration fees at regular intervals. Premiums must be of sufficient size to cover these policy expenses. The remaining cash in the universal life policy is the cash value saving component which may be withdrawn or loaned against.
What is IUL?
Indexed universal life (IUL) gives the policyholder the opportunity to earn interest and grow the cash value of the policy faster than with a regular universal life contract. Instead of the insurer only declaring a crediting rate, the policyholder also has the option of linking performance to an index and earning, to a degree, what that index earns. Popular indices include the S&P 500 or the NASDAQ 100.
If the linked index performs well, the policy’s cash value grows at a faster rate and has the potential of decreasing the amount of future premiums. However, there are a few caveats to IUL policies of which policyholders should be aware. An index may be assigned a cap to performance, which is the maximum crediting rate permitted. If, for example, the policyholder has chosen the S&P 500 index with a 10% cap and that index has a 15% return, a maximum of 10% will be credited to that portion of the policy’s cash value that is participating in the S&P 500 index.
Conversely, most IUL contracts will have a guaranteed minimum floor crediting rate to protect a policyholder from negative index performance. This rate is usually between -2% and 0% and balances the need for a cap on the upside.
The value of the selected index is logged at the beginning of the month and compared to the value at the end of that month. Interest increases and/or decreases during the month are added or deducted from the policy’s cash value to the participation rate of any selected index either monthly or on an annual basis. If the guarantee minimum crediting rate is 0%, no decreases in an index’s performance is credited.
From the Insurance Company’s Perspective
How are life insurance companies investing to meet the potentially volatile crediting rate of IUL policies? An insurer’s investment choices backing whole life policies are almost entirely conservative with very little risk. Bonds, treasuries and cash-life investment are common and that is why most universal life crediting rates are around 2-3%. When investing for IUL, an insurer will allocate a portion of invested premium to options to better address wide swings in index performance.
The Pros About IUL
Flexibility in controlling crediting rate to obtain better performance
Unlimited annual premium contributions
Guarantee in minimum crediting rate
Less risk due to the lack of direct investment in the market
Death benefit is tax-free and may be guaranteed
Cash value accumulates tax-free
The Cons About IUL
Caps on crediting rate increases where a linked index has performed higher
Possible limits to participation rates permitted by the insurance company
Crediting rate is based upon indexes where the goal is not to outperform the index but to benefit form the upward movement of the index
Read our companion Tier One Interview with Farah F. Rehman by clicking here.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.