Transamerica introduced the first Indexed Universal Life (IUL) insurance in the late 1990s, and since then it has grown to be over 50% of all of the Universal Life insurance premium in force and over 20% of the total premium for individual life insurance. While Indexed Universal Life insurance or IUL has become a widely sold and very popular insurance product, the mechanics of how it works are not widely understood.
The majority of our clients are purchasing IUL life insurance to use as a life insurance retirement plan or LIRP.
We now have over 40 life insurance companies offering indexed universal life. Some of the best companies for building cash value and taking a tax-free income at retirement are:
- North American
- Allianz Life
- National Life
- Minnesota Life
Let’s examine what makes Indexed Universal Life (IUL) insurance “tick” and how it works.
Why buy IUL?
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IUL insurance products are an ideal solution for folks who have a need for a death benefit and also want the potential for cash value growth that is tax free and risk-free. It occupies the space between traditional universal life (ultra-conservative) and variable universal life insurance (risk involved). Today’s low-interest-rate environment has made universal life less attractive to many consumers, plus the back-to-back recessions of 2000 – 2002 and 2007 – 2009 have left other consumers wary of investing directly in the market because of the volatility. These conditions have essentially shined a spotlight on IUL life insurance.
How Interest is Determined and Credited
When you purchase an indexed universal life insurance policy, you are not investing in the stock market. Even though the interest credited in an IUL account is based on a selected index, funds are not directly invested in the stocks that make up each index, therefore, an index does not include dividends that may be paid by the underlying companies. In other words, your account will not benefit from dividends.
As premiums are paid, a portion of the payment is used for the cost of the life insurance coverage and the balance is directed to an account that earns interest based on the performance of the indexes selected.
Policyowners can choose to have premiums allocated to an account that offers a fixed rate of return (called a fixed account), to an index account, or to a combination of both.
With an index account, the interest credited is linked to the growth (if any) of a stock market index, which is a well-known numerical value used to measure the performance of a group of stocks (S&P 500, Nasdaq, etc.).
When the premium is allocated to an index account, an index segment is created, and the beginning value of the index is recorded. At the end of a designated period (also known as an “index period”), the index value is used to calculate the index growth for the index period. The specific calculation depends on the index crediting method.
If the index growth is positive, interest is credited to the policy’s cash value account; the interest for that period is locked in and a new index period begins. Interest credited is might be subject to an index cap. The cap rate is the maximum amount of interest credit as determined by the movement in the market index and specified in the policy contract.
If the index growth is negative, the value in the index account will remain the same. In no case will the interest credited be less than zero percent. This rate is called the floor rate. In this way, Indexed Universal Life provides the opportunity for clients to earn interest based on the upward movement of the selected index (the market) but offers downside protection from a declining market because of the floor.
On each monthly anniversary, deductions (fees and expenses) are made from the IUL account value. The monthly deductions will reduce the amount in the index account and/or the fixed account.
How Index Cap rates and Floor Rates work in an IUL
Next, we’ll examine the cause and effect relationship between the index and the index account using a fictional index. There are three different scenarios that could happen — the cap year, the floor year, and the between year.
The Cap Year
In the cap year, the index grows beyond the cap rate, so interest is credited at the cap rate. In this example, the index gains 18% for the year. The policy’s interest cap of 12% applies, so although the index gained 18%, interest credited to the index account will be 12%.
The Floor Year
In the floor year, the index has negative growth, so the zero percent floor rate comes into effect. At the end of this year, we find that the index is down 11% for the year. However, because of the policy’s zero percent floor, interest credited to the index account is 0% instead of –11% and the account value is not reduced by the losses of the index accounts.
The Between Year
In the between year, the index grows at a rate higher than the floor rate, but lower than the cap rate. At the end of this year, we find that the index has grown by 6%. The cap and floor do not come into effect. The interest credited to the index account is 6%.
Putting It All Together with the Annual Reset
For the purposes of this example, we’ll assume in our IUL calculator that the cap year, floor year, and between year happen in the order shown below, although they can and do occur in any order throughout the lifespan of a policy. The zero-percent floor rate and the index starting value are reset each year. Let’s take a look at what that means in the graph below.
The Mechanics of IUL Insurance
As we explored earlier, an IUL life insurance policy’s index account is linked to the performance of an index, with a cap rate and a floor rate. Exactly how does that linkage happen? Below is a simplified diagram of how an insurance company invests the client’s premium in the general account while at the same time providing upside potential to the consumer. Assume a client was to pay $10,000 in premium into an IUL policy. Here’s what the IUL calculator displays:
- The insurance company will invest approximately $9,500 of the premium into fixed investments such as high-grade corporate bonds that become a part of the insurance company’s general account. In this example, we will assume the general account portfolio as a whole is yielding 5%. This amount will grow to $10,000 in one year, guaranteeing the index account’s floor rate.
- The insurance company then uses the remaining $500 of premium to purchase a “bull call spread.” This purchase is actually a series of purchases and sales. It starts with a purchase of a call option on the S&P 500 that is in-the-money (the option is worth exercising).
An in-the-money call option will provide a gain should the change in the S&P be positive at the end of the index period, generally one year later.
- If the insurance only bought this one in-the-money call option, the sky would be the limit to the upside potential. However, this type of call option is generally expensive. In this example, we will assume this call option costs $600, which is $100 more than the amount the insurance company has to work with.
- To make up this difference, the company sells a call option to somebody else. That person or entity would participate in the gains beyond a certain point.
Looking at the figure below, the arrows indicate the different kinds of call options that might be available. The insurance company could sell an option that is “out of the money” until the index reaches a 10% gain from its current level, which is 1,100 in this example. The sale of this call option generates $200 to the insurance company. The insurance company only needs $100, so it can sell the call option on the far right, which is a 12% out of the money call option. Therefore, because anything above 12% growth is passed on to somebody else, the cap on the index account is set at 12%. Neither the life insurance company nor the client participates in any gains above 12% but the outcome is still typically better than an IUL vs 401k.
The Mechanics of Changing Cap Rates
The interest rate environment has a significant effect on where an insurance company sets cap rates. We will look at the effect of interest rate changes and option pricing on our hypothetical example. We will first consider what happens when rates don’t change. It is now policy year two and interest rates have not changed on the general account. The $9,500 that was placed in the general account has grown to $10,000 due to the general account portfolio’s 5% yield. If the general account is still yielding 5% in policy year two, the insurance company would repeat the same actions as in policy year one. Take a look at the figure below:
The next figure shows essentially the same scenario as in policy year one if we assume that option costs have not changed. However, if the in the money option (beige arrow) were to get more expensive than $600, the insurance company would need to sell a more expensive out-of-the-money option (purple arrow), which would then require the insurance company to
lower the caps. The start of the purple arrow illustrating the out-of-the-money option would reach further down below the 1,200 index value. This option would be more expensive because it has a higher probability of being in-the-money by year’s end.
The Effect of Declining Yields
Consider what would happen if the general account portfolio yield has decreased to 4.5% before the start of policy year three. Assuming a $10,000 premium, the insurance company would need to allocate $9,550 to the general account to create the zero percent floor, leaving a smaller call option budget of 4.5% or $450. The figure below illustrates this scenario:
The graphic below illustrates the year three option purchase scenario. The insurance company would purchase a call option for $600 and simultaneously sell a call option that is 11% out-of-the-money because it generates $150 of income. This results in a lower cap of 11% on the index account.
The next graphic below illustrates the mechanics for a scenario where the call option budget is reduced by the insurance company.
The Effect of Low-Interest Rates on the Portfolio Rate
So what happens in a long-term and low-interest-rate environment? The impact can be substantial if “current rates” stay low for a long period of time and the insurance company continues to invest in those low rates.
As time goes by, the general account of the insurance company’s portfolio gets watered down because of new investments that the insurance company is buying in that low rate environment. The low-interest-rate environment will likely continue to challenge the insurance companies for the foreseeable future.
The Effect of Market Volatility
One of the major components that determine the price of options is the volatility in the stock market. The “VIX Index” measures stock market volatility. As market volatility rises, the price of options rise. As options get more expensive to buy, the pressure to lower the index account’s cap rate rises. The options budget might not be enough to afford to purchase the call option for a high cap, even with selling a call option to make up the difference. There might not be a buyer for the high-priced call option the insurance company would need to sell.
Frequently asked Questions
Is Universal Life Insurance complicated?
Except for Term Life Insurance, most life insurance policies can be complicated. The IUL policy has several moving parts that policyholders should be aware of. Most important are:
Market Index historical performance
What is a Cap rate in an IUL?
The Cap rate represents the maximum credit that will impact your cash account in any given crediting period. For example, If the index your account is linked delivers a 16% increase at the end of a reporting period, and your Cap is 13%, your cash account will be credited 13% for that index.
What is the Floor rate is an IUL policy?
The Floor rate in an IUL represents the minimum amount of interest your cash account will earn in any given crediting period and is typically zero or higher. For example, if during a downmarket your index or indices end up losing 4% but your Floor rate is 2%, your cash account would earn 2% rather than lose 4% for that reporting period.
Are the fees high with an IUL policy?
The fees that are charged in an IUL are based on the death benefit rather than the cash account value. Because of this, the fees are commonly lower than what you would be charged for an IRA or a 401(k) plan.