Indexed Universal Life Insurance: What You Need to Know

Indexed universal life insurance is a life insurance product that offers the potential to accumulate significant cash value. However, it's only suitable in certain circumstances. Below, you can learn how indexed universal life insurance works and whether it's a good option for you.

What Is Indexed Universal Life Insurance?

Indexed universal life insurance (IUL) is a form of permanent life insurance. It pays out a death benefit to your beneficiary when you die and has a cash value account that earns interest. Unlike other cash value policies like variable life insurance, your money isn't actually invested. Instead, your insurer selects a stock market index, such as the Nasdaq Composite or Russell 500 indices, and pays interest in line with that index. 

How Does Indexed Universal Life Insurance Work?

You pay premiums into an IUL account like any other life insurance policy. The insurer deducts account fees and then distributes the remainder between the insurance element and cash value account. 

Some insurers select a single stock index for each account while others allow the owner to allocate the cash value funds between several indexes or fixed accounts. The insurer then credits the cash value account with interest depending on the performance of the selected indices. How much interest you receive also depends on a rate known as the participation rate. For example, accounts with a 100% participation rate receive 100% of the index gains while a 50% participation rate yields half the index gains. 

IULs are less predictable than fixed universal life insurance policies because they don't guarantee a particular interest rate. However, there's a possibility to earn more than you would on a fixed UL if your index performs well. On the other hand, an IUL is a less risky option than variable universal life insurance because your money isn't invested, so you won't lose your cash value if the market drastically underperforms.

Are Indexed Life Insurance Policies Securities?

A security is an asset that can be traded, like stocks and bonds. Indexed life insurance policies aren't securities because your funds aren't invested in stocks or indices, but they work similarly to securities. Instead, the index fund chosen by your insurer is used to determine the interest rates earned on your money. 

Can You Lose Money in an IUL?

Most IUL accounts come with a guaranteed minimum interest rate. This means that you'll receive a minimum interest rate even if the index attached to your account underperforms. Therefore, it's not generally possible to lose your funds because the interest rate won't go below 0%. 

However, many companies selling IULs charge high up-front fees, and your premiums can increase year on year. You risk losing your contributed funds if you don't pay the increased premiums. Therefore, premium increases on top of account fees could exceed your interest gains, effectively constituting a loss. 

Advantages of Indexed Universal Life Insurance

The primary advantage of an IUL policy is that it lets you accumulate cash value on your account without the risk associated with variable life insurance. This policy type also offers decent flexibility because you can adjust your death benefit and withdraw some of the cash value without incurring penalties. You may also be able to adjust your death benefit amount if your circumstances change, but some companies require a medical exam before you can raise the death benefit.

Generally, you can contribute as much as you like to an IUL account. If your account performs well, you may be able to use your accumulated cash value to cover the premiums. This could be an advantage if you want the option to reduce or stop paying your insurance premiums later. 

Disadvantages of Indexed Universal Life Insurance

IULs are less suitable for people who can't contribute a large face value because the high account fees mean that you're unlikely to accumulate more cash value than fixed universal life insurance. Some providers also cap the interest you can earn on your account by setting the participation rate below 100%. 

Another potential disadvantage of an IUL is that you could earn nothing on your account if your index underperforms because you don't get the guaranteed rate of fixed universal life insurance. This situation could end up being expensive if your premiums increase and your insurance company charges high fees. 

Is Indexed Universal Life Insurance Right for Me?

Indexed universal life insurance could be a good option for you if you need permanent life insurance and want the potential to accumulate cash value in addition to a guaranteed death benefit.

Whether it's the right choice ultimately depends on whether you can afford the relatively high contributions required to make an IUL worthwhile and your appetite for financial risk. For example, you may prefer IUL if the risk of losing your contributions in a variable account makes you uncomfortable but you want the potential to earn more interest than a fixed policy. However, bear in mind that IUL doesn't guarantee an interest rate, which could be a problem for people who want to ensure growth.