What is an Indexed Universal Life Insurance Policy (IUL)?
Indexed universal life insurance works very similar to traditional universal life insurance with the exception that the indexed policy allows an individual to allocate excess premium payments to an account indirectly linked to the movements of an equity index (like the S&P 500®). Sometimes you will hear these policies referred to as “EIULs” or “Equity Indexed Universal Life.”
Traditional universal life insurance offers a fixed interest rate option with a guaranteed minimum around 2-4% annually depending on the insurance company. The current interest rate for a traditional universal life policy will vary but can never be lower than the guaranteed minimum. An indexed universal life policy has a fixed interest rate component as well as an indexed account option that offers the potential to earn higher rates of interest similar to equity market type returns.
How Does a (regular) Universal Life Policy Work?
Universal life (UL), also known as “flexible premium adjustable life”, combines features of term and whole life insurance to provide affordable death protection with considerable policy flexibility. The unique policy design of universal life insurance makes it easy to separate administrative costs, insurance charges and earnings which is very useful in determining how a specific policy is performing.
How do Universal Life Premiums Work?
The premium payments for universal life insurance policies are flexible and may be increased or decreased depending on changing needs. The policy owner has the option of paying the minimum premium necessary to cover policy costs and insurance charges or can pay a significantly higher premium and accumulate more cash value. As long as there is sufficient cash value in the policy, premiums may even be skipped. If the cash value is insufficient to cover policy costs and insurance charges, an increased premium must be paid. If the premium payment does not cover policy expenses and insurance charges, and there is no cash value available to meet these costs, the policy will lapse and the insurance coverage will no longer be effective.
As long as the policy retains enough cash value to pay insurance costs and fees, taxes can permanently be avoided using the withdrawal to basis then policy loan approach. If however, the policy lapses due to lack of cash to pay policy costs, all cash received from the policy in excess of the policy basis will be subject to income taxes. Policy loans do not have to be repaid as the loan amount with interest can be deducted from the policy face amount at death.
How is interest credited in an indexed life policy?
Premiums allocated to the indexed account earn interest based on the percentage change in the value of an underlying equity index.
Is there a minimum guaranteed rate for the Indexed Life Policy?
Many will offer a minimum guaranteed rate. Some will not or offer a very small guarantee.
How can insurance companies offer equity type returns without any downside risk to the policyholder? Call Options
The insurance company is not directly investing any policy premiums in an equity index. Instead, the insurance company invests policy premiums in fixed interest investments (like investment grade bonds) and uses the earnings from those investments to purchase call options.
Call options provide the right, but not the obligation, to purchase a specific amount of a given index at a specified price within a specified period of time. If the equity index increases, the insurance company can exercise the right to purchase the index at the previously agreed upon price and then credit interest to the policyholder. If the equity index decreases, the company is not obligated to exercise any options and has incurred no cost other than the cost of the actual options. So if the equity index values decrease, the insurance company does not need to credit a negative interest to the policyholder’s account.