If you’re looking for a type of life insurance that offers flexibility—as well as the opportunity to have some of the upsides of the stock market with less risk—you might want to consider indexed universal life insurance.
Universal life insurance that is indexed, or IUL, gives you the opportunity to experience some of the upsides of the stock market without the risk of losing money.
There are a lot of options and fees to consider before buying an IUL policy. This type of life insurance ties your cash value to the stock market, so there is an opportunity for greater interest earnings than traditional universal life or whole life policies.
The IUL policy can be a great option for any savvy investor who wants flexibility combined with low risk. Now we’ll answer the question we are asked most often, “How does IUL not lose money?”
What is Indexed Universal Life Insurance – IUL?
Indexed universal life insurance is a permanent life insurance policy and lasts your entire life as long as the minimum premiums are paid. Instead of just a low-interest cash-value account, this type of policy’s cash value account is tied to a stock index or indices, such as the S&P 500.
In comparison, the cash value in traditional Universal Life policies earns interest based on market interest rates.
To clearly understand Indexed Universal Life Insurance, you should understand the mechanics of permanent life insurance compared to universal life insurance. Usually the goal with an IUL policy is cash accumulation as opposed to having a high death benefit. For example, with an indexed life insurance policy, you will generally pay more premiums than are needed to cover the cost of the death benefit in the early years of the policy.
As a result of these overpayments, a cash value account is funded and earns tax-deferred interest that is sufficient to cover the cost of your life insurance coverage in the latter years of the policy.
For example, you do not have to follow a rigid premium schedule with an indexed universal life plan. This is different from Whole Life insurance plans, which require you to come up with the established periodic premium payments for the policy to remain in force. You may also be able to skip one or more premium payments if your finances are tight, or your IUL policy’s cash value account is sufficient to cover the cost of the plan.
This flexibility plus the opportunity to earn significantly higher interest payments is what makes Indexed Universal Life insurance so popular.
How Does Indexed Universal Life Insurance Work?
When you pay a premium into your IUL, a portion of it is used to pay for the cost of life insurance and any applicable fees. Then, the remainder of the premium is credited to the policy’s cash value account.
The cash value in the policy, which is tied to one or more equity indexes, earns interest based on the performance of the equity index account(s) which is credited to the policy’s cash value.
More importantly, the cash in your policy is NOT invested in the stock market. This means that the cash in your policy is not subject to market downturns like it would be if you were directly investing in the stock market.
Moreover, policyholders can choose between a minimum guaranteed interest credit or a choice of one or more indexes, or both. Additionally, the policyholder can also decide the percentage of cash they want to earn a fixed interest and the percentage they want in the indexed account(s).
The selected index is the key component in your IUL. If the index increases during the month, then the interest is added to the cash value and returns are credited back to the policyholder either monthly or annually.
How does an IUL Not Lose Money in a Down Market?
You will select index options within your IUL policy that will determine the interest rate credited to your cash value account. These index options are not directly invested in the stock market, so no risk of market loss. Most of your money goes into very safe bond fund investments. A small portion of your premium is used to purchase options on the market that you are selecting. If the market increases in value, the options are exercised and the earnings are credited to your policy. If the market declines, the options are not exercised, and no interest is credited to your policy. This is all done internally so there is nothing for you to have to do. This same strategy happens every year.
Eliminating the risk of losing money in a down market is typically the most exciting attribute of Indexed Universal Life insurance and this risk mitigation results from two very important facets contained in the IUL:
Participation Rate – The participation rate is what governs the amount of the interest credit your policy receives based on the performance of the index or indexes your cash account is linked to.
The participation rate is determined by the insurer and is generally anywhere between 25% to 125% or more. For example, if the gain of an equity account is 8% and your participation rate is 125%, your account would be credited with 125% of the 8% which would give you a 10% return.
Cap Rate & Floor Rate
To help reduce large swings in interest-earning, your IUL policy will be subject to cap and floor rates established by the insurance company. The cap represents the maximum amount of interest your account can be credited on the performance of the index accounts you have selected.
On the other hand, the floor is the minimum amount you can earn from the index accounts you have selected. Since many insurers offer a floor rate of 0%, if your index accounts experience negative returns (a down market) your account will not suffer a loss in the cash value account.
Some IUL policies offer a 1% floor meaning you will have a positive 1% return even if your chosen index has a negative return.
The floor established in your policy is how your IUL will not lose money in a down market!
To clarify how the Cap and Floor can benefit you financially, take a look at some typical scenarios using a 100% participation rate:
| Index Performance | Floor Rate | Cap Rate | Credit Rate |
|---|---|---|---|
| -4.5% | 0% | 10% | 0.0% |
| 19.5% | 0% | 10% | 10.0% |
| 9.5% | 0% | 10% | 9.5% |
| 4.0% | 0% | 10% | 4.0% |
Advantages and Disadvantages of Indexed Universal Life Insurance
Similar to most life insurance products, there are pros and cons to consider when looking at an IUL as an alternative to traditional investment products.
Advantages:
Permanent Life Insurance: Unlike traditional investment products, an IUL will deliver a guaranteed death benefit to your beneficiaries. Additionally, the death benefit is typically tax-free to your beneficiaries and the money is not subject to probate.
Market Participation: Your IUL policy allows you to participate in the positive performances of the stock market without actually investing money in it. When your selected indexes go up, you benefit from the market which gives you the option of paying less into your policy, providing a larger death benefit than expected, or using the cash value as an income stream in retirement.
No losses from negative returns: In the event that any of your selected indexes lose value, your account is not subject to those losses because of a 0.0% floor rate.
Disadvantages:
Cap on returns: Although you are protected from losses because of a 0.0% floor rate, you can also miss out on large market gains because of your cap rate.
IUL insurance can be confusing: Although many people who are looking at Indexed Universal life insurance get excited about the possibility of significant returns with no risk of losing money, most people are unwilling to learn the mechanics of Indexed Universal Life insurance. For this reason, considerable time must be invested to completely understand your policy for you to set legitimate expectations of its value over time.
Fees can get expensive: When you consider administrative fees, cost of insurance, and premium charges, your total fees can get expensive and considerably impact your cash value in a consistently down market. Even though you are not subject to market losses, you are still responsible for policy fees.
