What is Indexed Universal Life Insurance?

Quick Article Guide

Here’s what we'll cover in this post:

• Understanding Indexed Universal Life Insurance
• How IUL Interest Rates Are Calculated
• Downside Protection and Interest Crediting
• Insurance Company Investment Strategies
• Budgeting for Options
• Factors Influencing Cap and Participation Rates
• IUL Illustration Practices
• Real-World Performance of IULs
• Best Strategies for IUL Allocation
• The Takeaway
• How We Can Help

Understanding Indexed Universal Life Insurance

Indexed Universal Life (IUL) insurance is a cash value life insurance product that offers upside potential based on the performance of an external equity index, typically the S&P 500, while providing guaranteed downside protection. The upside potential is adjusted via a participation rate and an interest cap. Most account options within IUL products guarantee one of these limiting factors while allowing the other to float.

How IUL Interest Rates Are Calculated

The most common account option in IUL policies features a floating annual interest cap between 5% and 9% in current market conditions and a guaranteed 100% participation rate. The interest earned equals the index return if it is less than the cap but is capped if the index return exceeds the cap rate. For instance, if the cap rate is 10% and the index return is 15%, the carrier credits 10% to the account.

Other account options might include a floating participation rate, such as 50%, with no cap, meaning the interest credited would be half the return of the equity index. A spread account credits interest above a floating “spread rate.” For example, if the spread is 6%, the interest credited would be 15% if the index return is 21% but 0% if the index return is 5%.

Downside Protection and Interest Crediting

The downside protection in IUL policies guarantees that the interest credit on cash value will not be less than a minimum interest rate, typically 0%, even if the equity index is negative. Interest is usually credited on an “annual point-to-point” basis, meaning the gain in the index is calculated from the point the premium entered the account to exactly one year later. All caps and participation rates are then applied, and the resulting interest is credited to the policy. These rates are adjusted annually and used as the basis for calculating gains for the following year.

Insurance Company Investment Strategies

Insurance companies do not invest directly in the equity index. Instead, they use options to pay the interest promised by the IUL contract. A call option is a financial contract that gives the option buyer the right, but not the obligation, to buy an asset at a specified price within a specific time period. The insurance company buys from an investment bank the right to “buy the index” if it exceeds a certain level, known as the “strike price.”

The carrier could hedge its capped index liability by purchasing a call option at a 0% gain strike price and writing a call option at an 8% gain strike price. This strategy allows the carrier to receive a return in lock-step with the index from 0% to 8%, producing a net-zero payoff above 8%.

Budgeting for Options

The budget that the insurance company has to purchase options depends on the yield from its general account. For example, if the carrier has $1,000 net premium after deductions and a 3% yield from its general account, it would allocate $970.87 to its general account to grow to $1,000 by year’s end, using the remaining $29.13 to purchase options.

If the IUL policy projects a 5% return, the $1,000 net premium would need to grow to $1,050, requiring a 71.6% return on the $29.13 invested in options. This is a high return expectation, reflecting the undervaluation of options in the market.

Factors Influencing Cap and Participation Rates

The two largest factors influencing floating cap and participation rates are the yields on the insurance company’s general account and market volatility. Carriers’ general accounts primarily consist of fixed-income assets such as bonds and mortgages. As yields on these assets have declined, carriers have had smaller budgets for purchasing options, leading to reduced cap and participation rates. Market volatility also makes options more expensive, further reducing cap and participation limits.

IUL Illustration Practices

Carriers typically illustrate future performance based on the historical performance of the index, applying current, non-guaranteed cap and participation rates as a proxy for future performance. However, this method may not be realistic, as historical projections often reflect higher past interest rates and assume consistent caps and participation rates despite varied market conditions.

Real-World Performance of IULs

IULs gained popularity after 2009, offering capital preservation with upside potential in a low-interest, low-volatility market. From 2009 through 2019, IULs performed well due to cheap options and steadily growing equity markets. However, as carriers invested new premiums at lower rates, the overall portfolio rates fell, reducing the budget for options and, consequently, cap rates. Increased market volatility has further decreased cap rates, making IULs less attractive.

Best Strategies for IUL Allocation

When choosing an indexed crediting strategy, consider avoiding capped accounts, as they involve buying relatively expensive options and selling relatively inexpensive ones. A better strategy might be allocating to an uncapped participation account or a spread account, which involve buying relatively inexpensive options. These strategies, however, are less stable than capped accounts and may require frequent adjustments by the carrier to reflect market conditions accurately.

The Takeaway

The narrative that IULs are conservative products delivering equity-like returns is no longer sustainable. IULs are more akin to traditional Universal Life (UL) products than equity-based products like Variable Universal Life (VUL). With realistic expectations of options returns and a shrinking budget for purchasing options, IULs may provide marginally higher returns than traditional ULs but not equity index returns.

Prospective buyers should run illustrations at 0.5% above the interest rate credited to traditional ULs to assess whether the policy is properly funded and capable of delivering promised performance.

How We Can Help

Choosing to work with an independent life insurance agency like JRC Insurance Group offers several distinct advantages when securing an Indexed Universal Life (IUL) policy. As a trusted partner, we collaborate with 63 top-rated insurance companies, ensuring you have access to a diverse range of options.

Our services are completely free, and our expert advisors provide unbiased advice to help you find the best coverage tailored to your needs and budget. Partnering with JRC Insurance Group means you receive personalized service, competitive rates, and peace of mind knowing your financial future is in capable hands.

Give us call today at 855-247-9555 to connect with one of our experts or select your state from the map below to get started. We helped thousands of families with their life insurance needs and we can help you too.