What Is Indexed Universal Life Insurance & How Does It Work?

Amanda HesterAugust 31, 2021

Life insurance is difficult to understand. The only thing that is obvious is what financial advisor Dave Ramsey said about it. “Its only job is to replace your income when you die,” especially if family members will still depend on you. There are basically two different ways to provide income for your family, which include term life insurance and permanent life insurance. Universal and indexed universal life insurance fall under the permanent life insurance umbrella. A thorough understanding of how indexed universal life (IUL) insurance works is necessary to determine if it might be right for you and your family. Here is our IUL policy guide. 

What is Indexed Universal Life Insurance?

Universal and indexed universal life insurance are types of permanent life insurance. They offer low premiums and ways to build cash value through investment savings. They offer more flexibility than whole life insurance because premium payments and death benefits can be adjusted at any time during the length of the policy. The main difference is that indexed universal life insurance is not based on a fixed interest rate. Instead, its performance is linked to a stock market index like the Dow Jones, Nasdaq, or the S&P 500. When the market does well, the policy’s cash value grows, but at the same time, no money is lost if the market falls.

How Does Indexed Universal Life Differ from Other Forms of Life Insurance?

All life insurance policies fall under one of two definitions:

• Term Life Insurance – Just like it sounds, term life insurance can be in effect for a period of one to thirty years, during which fixed payments and a predetermined death benefit have been agreed upon. The catch is that the policyholder must die during the term for death benefits to be paid to beneficiaries. If the policyholder outlives the term, it must be recalculated and the premiums adjusted to extend the coverage depending on the holder’s life expectancy. The accumulated savings can serve as a source of equity, but there is no investment component. Additionally, term life insurance premiums can be less expensive than other types of insurance.

• Permanent Life Insurance – This term is applied to all life insurance policies that don’t expire, meaning that the policy remains in effect regardless of how long the policyholder lives. Whole life insurance, universal life insurance, and indexed universal life insurance do not expire. Whole life policies combine coverage with an investment fund, so buying this kind of policy guarantees a fixed payout amount upon the policyholder’s death and the ability to increase the cash value by allowing the insurance company to invest some of the money from the premiums.

What is indexation in life insurance? In the case of indexation in life insurance, the money is invested in a stock market index.

How Does Indexed Universal Life Insurance Work?

When the monthly premium is paid, the money is divided for different purposes. Some of it pays for the insurance itself, and some of it pays for fees or other costs. The rest of it is designated toward the cash value of the policy. This occurs when the insurance company invests this money in the equity index of a stock market index. In general, indexed universal insurance policies offer a guaranteed minimum fixed interest rate and a choice of indexes for the policyholder.

Investing in an index is not the same thing as investing in the stock market. Rather than measuring the performance of an individual stock, the overall performance of the index is measured. For example, the value of the chosen index is recorded at the beginning of each month so that it can be compared to the value at the end of the month. If an increase is seen, the interest from the investment is added to the cash value of the policy either monthly or annually as set forth by the insurance company.

When the value of an individual stock goes down, the stockholder loses money. Conversely, if the value of the index goes down, the policyholder gains nothing and loses nothing, but the value must increase for the policyholder to gain anything.

Comparing a 401K to Indexed Universal Life Insurance

The purpose of both programs is to ensure future income, but there are drastic differences. A 401k is an investment and savings plan that offers tax breaks on money contributed by the employee, while the indexed universal insurance is paid for using after-tax dollars. The resulting income stream is then tax-free.

Benefits

Indexed universal life insurance policies are attractive for many reasons, including:

• Lower premiums – since the policyholder carries the risk of the investments, the premium costs are lower.

• Flexible options – the policyholder can decide how much money to invest in an equity index, adjust the death benefit amounts, and add riders like no-lapse guarantees and death benefit guarantees.

• Permanent death benefits – the benefits don’t go through probate and are not subject to death or income taxes.

• No stock market involvement – since the money is invested in the equity index rather than actual stocks, the risk of loss is not nearly as great.

• No contribution limits – annual contributions are not limited in any way.

• Tax deferment – the growing cash value is tax-deferred so if it is large enough, the policyholder can use it to pay the premiums and eliminate out-of-pocket costs.

• No distribution limits – the cash value can be accessed at any time with no penalties and with no specifications as to the policyholders’ age.

Disadvantages

These policies also present some drawbacks, including:

• Limits on index returns – caps can restrict the percentages of index gains returned to the policy to the detriment of the policy owner.

• Polices with lower face amounts don’t see any appreciable gains – there is no real advantage of investing in an indexed universal insurance policy over a regular universal policy.

• Failure to outperform the equity index – adding value to the policy is based on the premise that interest will be earned from increases in the monthly equity index. If that doesn’t happen, the cash value of the policy doesn’t increase.

Buying an Indexed Universal Life Policy

Choosing a policy can be just as confusing as understanding how a policy works. Depending on who you seek advice from, you may be presented with skewed views about the appropriateness or the pitfalls of indexed universal life insurance policies. For example, a life insurance agent who wants to push you toward an indexed universal policy will only tell you about the pros of your decision and will ignore or skirt the possible cons. On the other hand, agents who want to sell other whole life policies will exaggerate the possible downsides of indexed universal insurance policies according to their own agendas. If you decide to do some research online, be prepared for a myriad of opinions, some qualified and some not, from people who may misuse the information to steer clients toward other insurance options.

Your best course of action is to find an insurance agent who has a reputation for being honest and who will present all your options without bias. Ideally, he or she will be able to provide an indexed universal insurance policy guide and fully inform you about IUL insurance pros and cons.

Is an Indexed Universal Life Insurance Policy Right for You?

Not every policy is right for everyone, but there are people who are better suited for indexed universal policies. People who want to be able to earn interest while knowing that their benefits are fixed and guaranteed will find indexed universal policies most attractive. A qualified insurance agent or financial planner should be able to evaluate your needs and recommend the right policy for you.