Indexed universal life insurance

Indexed universal life (IUL) insurance is a type of permanent life insurance that combines a death benefit with a cash value component, offering policyholders the opportunity to grow their savings with a level of risk tied to a market index. IUL policies are inherently complex, providing flexibility in premium payments and the potential for adjusting death benefits to align with evolving life circumstances. Bankrate’s insurance editorial team is dedicated to helping you make informed financial decisions. This guide will explain the essentials of indexed universal life insurance to help you determine if it’s the right choice for your needs.

Indexed universal life insurance defined

Indexed universal life insurance is a type of permanent life insurance that has both a death benefit and a cash value element. The cash value grows based on the performance of a selected market index, such as the S&P 500 or Nasdaq Composite.

With each premium payment you make it’s essentially divided into two parts. One portion goes toward maintaining the death benefit, which provides financial protection to your beneficiaries. The other portion is allocated to the cash value element, which can earn interest based on the linked index. It’s important to note that, depending on your premium payment structure and the age of your policy, how much is allocated to maintain the policy and how much goes to the cash value can vary.

While the interest rate is influenced by market performance, IUL policies typically include a minimum guaranteed crediting rate to protect against market downturns. While this is a nice benefit, IULs also have a cap on the maximum returns you can earn.

Permanent life insurance policies like IUL are designed to provide lifetime coverage, although the maximum coverage age range is 95 to 121, depending on the policy, as long as premiums are paid. As the cash value builds, you can borrow against it, but unpaid loans will reduce the death benefit. You can also withdraw from it without being required to pay it back, but this also reduces the death benefit.

The flexibility of IUL policies allows for adjustments in premium payments and death benefits, depending on the accumulated cash value, offering adaptable financial planning options. We’ll investigate these features more below.

How an indexed universal life insurance policy works

IUL policies offer flexibility and the potential for growth through market-linked returns. They provide lifelong coverage, assuming premiums are paid, and have a cash value component that grows based on an index, such as the S&P 500. Understanding how IUL policies work can help you decide if this type of insurance fits your financial goals.

Cash value component

The cash value component of an IUL policy is a significant feature that differentiates it from other life insurance types. The policy’s cash value grows based on the performance of a selected market index. However, IUL policies typically include a “cap”, “floor” and participation rate.

• Cap: This is the maximum interest rate your policy can earn, even if the index performs better. For example, if the cap is 10 percent, and the index gains 12 percent, your earnings will be limited to the 10 percent cap.
• Floor: This is the minimum interest rate your policy is guaranteed to earn, protecting your cash value from market downturns. Even if the index performs poorly, your cash value won’t drop below the floor rate, which is often set at 0 percent.
• Participation rate: The participation rate dictates how much of the return is credited to the policyholder. While it’s usually 100%, the insurance company can lower it. For example, with a 10% cap and an 80% participation rate, the policy would be credited with an 8% return rate.

Loans versus withdrawals

Once your IUL policy has accumulated sufficient cash value, you can access these funds through loans or withdrawals:

• Loans: You can borrow against your policy’s cash value at relatively low interest rates for any reason you wish to. Insurers will typically lower the crediting interest rate to the portion of your cash value associated with the loan, thereby reducing the overall amount your cash value can earn while there is an outstanding loan. Additionally, if you do not pay back the loan during your lifetime, the loan amount plus any unpaid interest will first be deducted from the policy’s death benefit before a claim is paid to the beneficiaries.
• Withdrawals: With IUL policies, you also have the option to withdraw funds directly from the cash value. There is no charged interest, nor do you pay it back. However, like an outstanding loan, this amount is deducted from the death benefit and the cash value fund left to earn interest is also reduced by the withdrawn amount. Withdrawn amounts are typically tax-free income up to the amount you’ve paid in premiums, but any excess may be taxable.

Regarding both withdrawals and loans, if the cash value drops too low — meaning it’s inadequate to cover the policy’s expense and mortality charges — the policy can lapse and terminate. Should you choose to make withdrawals or take out loans against an IUL, it’s crucial to monitor your policy’s performance.

Flexible premiums

A convenient feature of IUL policies is that they offer flexibility in premium payments, allowing you to adjust them based on your financial situation:

• Minimum premiums: After the first year, you can choose how much to pay, including only making minimum payments, skipping payments or making no payments at all, as long as the policy’s cash value covers the cost of maintaining it. If the cash value drops too low, the policy could lapse. If you choose to only make minimum payments, as you age, increased premiums or reducing the death benefit may be required to keep the policy inforce.
• Targeted premium strategy: This involves paying a set premium intended to keep the policy active through age 95 or 100, similar to whole life insurance. However, these target premiums are not guaranteed, and if the cash value falls short, you may need to increase your premium or reduce the death benefit.
• Prefunding: Policyowners can make large payments early on to build cash value faster, potentially reducing required premiums later.

Death benefits

IUL policies also provide flexibility in how the death benefit is structured:

• Level death benefit: This option keeps the death benefit constant throughout the policy’s life, similar to whole life insurance.
• Increasing death benefit: This option increases the death benefit as the cash value grows, providing more significant protection but usually at higher premium costs. With this design, beneficiaries are paid both the death benefit and the cash value upon the insured’s death — a unique feature in the world of permanent life insurance.

Pros and cons of IUL policies

Indexed universal life insurance policies offer a mix of benefits and drawbacks that can influence your decision on whether they are the right fit for your financial goals. Here’s a breakdown to help you weigh these pros and cons.

How much does indexed universal life insurance cost?

The cost of indexed universal life insurance varies depending on several factors, including personal details and policy specifics. Understanding these elements can help you gauge what to expect when considering this type of life insurance. Here are several factors to keep in mind and how they might influence what an IUL policy could cost you.

1. Personal factors: Your age, health, lifestyle and gender significantly impact the cost of IUL insurance. Younger applicants and healthier individuals typically pay lower premiums, while risky behaviors like smoking can increase rates. Additionally, premiums can vary between males and females.
2. Policy details: The coverage amount and any added riders also influence the cost. Higher death benefits result in higher premiums, so a $3 million death benefit will cost more than a $500,000 death benefit. Adding riders, such as a child rider or waiver of premium, usually increases the price as well.
3. Market factors: The participation rate, cap rate and floor rate of your policy play crucial roles in determining costs. The participation rate dictates how much of the index’s gain is credited to your cash value, with a higher rate leading to greater accumulation and potentially lower premiums over time. The cap rate limits the maximum interest credited to your cash value, while the floor rate guarantees a minimum interest, protecting your policy from market downturns but also affecting premium costs.
4. Premium flexibility: As discussed, IUL policies have minimum premium requirements to stay active. If the cash value gets too low, additional premiums might be needed to prevent lapse, potentially increasing costs. Some policyholders choose target premiums for consistent payments, aiming for longevity, while others opt to pre-fund to reduce future premiums.

As you can see, the cost of an IUL can be an ever-moving target. To better understand all these nuances, it can be helpful to talk with a licensed agent or utilize an IUL calculator to help narrow down your specific costs.

Who is an indexed universal life policy good for?

IULs might be a suitable option for individuals who are comfortable with a certain level of risk but not willing to take on the full investment risk associated with variable universal life policies. IUL policies typically provide some guarantees, making them appealing to those seeking a balance between potential growth and security. This type of policy could be ideal for people who desire flexibility in their insurance policy, allowing for adjustments in premium payments and death benefits as their life circumstances change.

However, it’s important to note that policyholders should be willing to monitor their policy closely to ensure it does not lapse due to low cash values. Although IULs have a cash value component, it is important to remember that life insurance should not be viewed as a replacement for retirement plans such as 401(k)s or IRAs.

Alternatives to indexed universal life insurance

Indexed universal life insurance is not for everyone. The insurance market offers a variety of life insurance policies. Depending on your individual case, one of the following types of life insurance may be able to better meet your needs and budget.

Term life insurance

Term life insurance covers the insured for a specified period, typically 10 to 30 years. While term life policies feature a death benefit, they do not build a cash value. Many term life policies are renewable, which enables policyholders to extend their coverage for another term, usually at a higher rate due to their increased age. Most term life policies do not return any of the premiums when the coverage ends and only offer coverage up to a certain age, usually around 80. Typically, term life insurance is the cheapest coverage, especially for people who purchase a policy when they are young and healthy.

Whole life insurance

Whole life insurance is a type of permanent life insurance that typically features fixed premiums and a level death benefit. Like IUL coverage, whole life insurance policies build a cash value component that you can borrow against. While whole life policies offer lifetime coverage, it’s important to note that most policies end coverage at a specified age, typically ranging from 95 to 121, depending on the policy terms. This ensures that you can remain protected for your entire life, provided you continue to pay the premiums.

Variable life insurance

Variable life insurance, a type of permanent life coverage, features a death benefit and cash value element. Variable life policies put the insured in the investment driver’s seat, allowing them to choose the type of investments they prefer, which may include mutual funds and exchange-traded funds. While variable life policies offer more flexible investing than IULs, they can pose more risk. If investments do not perform well, the policy’s cash value and death benefit can decrease.

Universal life insurance

Universal life insurance works the same way as IULs, except it builds a cash value based on a rate of interest declared by the insurer instead of a market index. This type of permanent life insurance also allows policyholders to adjust their death benefits and premiums.

Variable universal life insurance

Variable universal life insurance, a form of permanent life coverage, combines the features of variable and universal life policies. This type of policy enables you to invest your savings as you choose and allows you to alter your premiums.

While indexed universal life insurance is a unique type of life insurance, it should not be viewed as a retirement savings vehicle. While it offers flexibility and potential growth through its cash value component, it is essential to remember that its primary purpose is to provide a death benefit and financial protection for your beneficiaries.

Frequently asked questions

• What is the best life insurance company?

  What may be the best life insurance company for one person may not be the best one for someone else. Your individual life insurance needs are unique to your circumstances, and with life insurance you not only have a breadth of coverage options but a variety of providers to choose from. When considering which provider to go with, it can be helpful to look at third-party agency ratings like J.D. Power for customer satisfaction rankings and AM Best scores for carriers’ historical ability to pay out claims. Additionally, it’s wise to compare quotes from multiple companies, as different insurers underwrite risk factors differently, leading to potentially significant variations in cost. Speaking with a licensed life insurance agent may help you narrow down which carrier and plan makes the most sense for your financial situation.

• What impacts my life insurance rates?

  Life insurance is calculated differently than other kinds of insurance, like car and home. Life insurance carriers take characteristics such as your age, health status, medical history, tobacco use, occupation (race car driver, pilot, etc.) and hobbies (skydiving, scuba diving, etc.) into account when calculating your premium. Another contributing factor to overall cost is the type of policy you buy and the amount of coverage you choose.

• What is the difference between term and permanent life insurance?

  Term life insurance provides coverage for a specified period, usually between 10 and 30 years. It may be suitable for those who want coverage for a particular time frame, such as during the length of a mortgage or while their children are young. Permanent life insurance, however, is designed to last until the policyholder passes away, offering coverage to maximum ages of 95 to 121, as long as premiums are paid. Unlike term life, permanent life insurance includes a cash value component that can accumulate over time. However, permanent life premiums are generally much higher than those for term life insurance.