Index Life Insurance: How Does It Work?

Indexed universal life insurance (IUL) is a type of permanent life insurance that provides a cash value component and a death benefit. IUL policies allow the policyholder to decide how much cash value to assign to an equity-indexed account and to a fixed-rate account. The money in a policyholder's cash value account can earn interest by tracking a stock market index selected by the insurer, such as the Nasdaq-100 or the Standard & Poor's 500. IUL policies offer flexibility, with adjustable premiums and death benefits, but they are also more complex and tend to have higher fees and premiums than other types of life insurance.

Permanent coverage with cash value

Indexed universal life (IUL) insurance is a type of permanent life insurance that provides a cash value component alongside a death benefit. The cash value account can earn interest by tracking a stock market index chosen by the insurer, such as the Nasdaq-100 or the Standard & Poor's 500. Policyholders can decide how much cash value to assign to an equity-indexed account and a fixed-rate account (if available).

IUL insurance policies are more volatile than fixed universal life policies but are less risky than variable universal life insurance policies. This is because IUL does not directly invest in equity positions, although the interest rate derived from the equity index account can fluctuate. To limit losses, the policy offers an interest rate guarantee, but this may also cap your gains.

The cash value in an IUL policy can be used in several ways. It can be used to lower or cover premiums without reducing the death benefit. Policyholders can borrow against the cash value, although any outstanding loans are typically deducted from the death benefit. The cash value can also be withdrawn, but this will reduce the death benefit.

IUL insurance policies offer permanent, lifelong coverage when premiums are kept up to date. They also offer flexible premiums and death benefits. The cash value can grow through an equity index account, and part of it can be allocated to a fixed-interest option.

IUL insurance is a good option for those seeking permanent life insurance with a cash component that earns interest and provides a death benefit. It is more expensive than term life insurance but offers permanent coverage and a tax-free death benefit for beneficiaries.

Death benefit

Indexed universal life insurance (IUL) is a type of permanent life insurance that provides a death benefit. This benefit is permanent and is not subject to income or death taxes, nor is it required to go through probate. The death benefit is paid to the policyholder's beneficiaries when they pass away.

The death benefit can be used for funeral and burial expenses, to cover outstanding debts such as a mortgage or co-signed student loans, to fund college costs for children, or to pay for everyday living expenses.

The death benefit is guaranteed, and the policyholder can adjust the face amount and riders over time. The death benefit may also be flexible, depending on the policy.

If the policyholder borrows against the cash value of the policy and does not pay back their loans, the amount borrowed is deducted from the death benefit.

Interest rate calculation

Indexed universal life insurance (IUL) is a type of permanent life insurance that provides a cash value component along with a death benefit. The cash value in an IUL policy can earn interest by tracking a stock market index, such as the Nasdaq-100 or the Standard & Poor's 500, that is selected by the insurer. The interest rate derived from the equity index account can fluctuate, but IUL policies offer an interest rate guarantee, which limits losses. This guarantee is typically set at 0%, meaning that the account won't suffer losses if the market crashes.

IUL policies usually cap your returns but also guarantee a minimum interest rate. This minimum interest rate guarantee is known as a "floor". The floor rate is the lowest the account rate can go and protects the policyholder if the index underperforms. For example, if the floor rate is 1% and the index decreases by 5%, the policy will still gain 1%. The specific details of the floor rate will be outlined in the insurance policy.

The interest rate of an IUL policy can also be influenced by a "cap" rate. The cap rate is the maximum amount of gains that can be earned. For example, if the cap rate is 10% and the index increases by 20%, the policy will only earn 10%. Unlike the floor rate, the insurer can change the cap rate during the lifetime of the policy.

The interest rate of an IUL policy can also be influenced by the participation rate. The participation rate determines the percentage of the index's performance that the policyholder earns. For example, if the index increases by 6% and the participation rate is 50%, the policy will earn 3%. The insurer can adjust the participation rate over the lifetime of the policy.

There are several methods used to calculate gains in IUL policies, such as the Daily Average method, the Monthly Point-to-Point method, and the Annual Point-to-Point method. These methods vary among policies and insurers, so it is important to carefully review the information provided and consult with an agent to understand the specific calculations used.

Pros and cons

Pros of Index Life Insurance

• Flexibility: IUL offers flexibility in adjusting death benefits and premiums. This adaptability allows policyholders to tailor the policy to their financial needs.
• Steady cash value growth: IUL offers the potential for consistent cash value growth, taking advantage of market growth without significant risk due to the protection of floors.
• Lifelong coverage: As long as you pay premiums, the indexed universal life policy offers lifelong coverage, ensuring that beneficiaries are provided for.
• Higher return potential: IUL policies provide greater upside potential and tax-free gains.
• No social security impact: Cash value accumulation from an IUL insurance policy wouldn't count towards earnings thresholds, nor would any loan amounts that you borrow.

Cons of Index Life Insurance

• Growth limitations: There is a cap on potential growth, limiting policyholders from fully capitalising on substantial market upswings.
• Higher fees: IUL policies often incur higher fees than other life insurance products, which can eat into the cash value and reduce the overall return on investment.
• Active management: Managing IUL accounts requires active involvement and an understanding of market conditions, participation rates and other factors.
• Unpredictable returns: IUL policies offer returns based on an index and have variable premiums over time. This means policyholders must be comfortable riding out fluctuations in returns and budgeting for potentially higher premiums.
• Possible limits on returns: Insurance companies can set participation rates for how much of the index return policyholders receive each year. Returns on equity indexes are often capped at a maximum amount.
• Complexity: IUL policies are highly complex and come with shifting components.

How it compares to other types of insurance

Indexed universal life (IUL) insurance is a type of permanent life insurance that provides a death benefit and a cash value component. The cash value grows based on the performance of a selected market index, such as the S&P 500 or Nasdaq Composite. This type of insurance offers flexibility in premium payments and the ability to adjust the death benefit.

IUL insurance differs from other types of insurance, such as term life insurance and whole life insurance, in several ways. Here are some key comparisons to consider:

• Flexibility: IUL insurance offers flexibility in premium payments and death benefits, allowing policyholders to adjust their coverage as their life circumstances change. This flexibility is not typically available with term life insurance or whole life insurance, which have fixed premiums and benefits.
• Investment Risk: IUL insurance is considered less risky than variable life insurance because it does not directly invest in the stock market. Instead, it tracks the performance of a chosen market index. However, it is more volatile than fixed universal life insurance policies.
• Growth Potential: IUL insurance has a cap on the maximum returns that can be earned, which may limit the growth potential compared to other investment options. Variable life insurance, for example, offers more flexible investing and the potential for higher returns but also carries more risk.
• Complexity: IUL insurance policies can be complex due to factors such as interest rates, caps, participation rates, and market indices. Whole life insurance, in comparison, is typically more straightforward and easier to understand.
• Tax Advantages: The cash value growth in IUL insurance is tax-deferred, and the death benefit is tax-free for beneficiaries. This can be advantageous compared to other types of insurance that may have different tax implications.
• Cost: IUL insurance typically has higher fees and premiums compared to other types of life insurance, such as term life insurance. The cost of IUL insurance can vary depending on factors such as age, health, and gender.
• Suitability: IUL insurance may be suitable for individuals who are comfortable with a certain level of risk but want more flexibility and potential for growth than traditional life insurance policies. It is often chosen by those seeking to balance growth and security and is not considered an optimal retirement savings vehicle.

Frequently asked questions