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What indexed universal life insurance is

Published By JM Agency 7 min read

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Indexed universal life insurance is a kind of permanent life insurance. FINRA places it under the universal life umbrella: like other universal life policies, it covers the insured for life, builds a cash value, and offers flexible premiums. What makes it indexed is how the cash value is credited. The insurer adds interest by a formula that follows a set stock index, within limits the insurer sets, such as a cap. You do not choose investments, the money is not placed in the index itself, and the policy is life insurance first.

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How is indexed universal life different from other life insurance?

Life insurance comes in two broad families. Term life covers you for a set period and ends with the term if it is not renewed. Permanent life insurance covers you for life while the policy stays in force, and it can build a cash value inside the policy.

Universal life is a form of permanent life insurance built for flexibility. Once the cash value has grown, the owner may be able to change the premium payments, as long as there is enough in the account to cover the policy charges. Indexed universal life keeps that flexibility and changes one thing: how the cash value grows.

Policy How the cash value grows Premiums
Term life No cash value For most policies, they go up with age or at each renewal
Whole life A savings feature that builds over the life of the policy Typically the same for life
Universal life Interest the insurer credits to the cash value account Flexible, within limits
Indexed universal life A credit set by a formula that follows a stock index, within caps and other limits Flexible, within limits
Variable universal life Invested in a portfolio the owner chooses; it is a security and can lose value Flexible, within limits

The term vs whole life comparison sets term and whole life side by side.

How does the cash value get credited?

In an indexed policy, the insurer credits interest to the cash value by a formula tied to data from outside the policy, usually a stock index such as the S&P 500. Vermont's insurance regulator, in a 1998 bulletin, described these products as life insurance whose additional credited interest is not guaranteed and depends on such a formula.

Three points follow from that.

  • The money is not in the market. The index is a measuring stick for the credit, not an account the money sits in.
  • The formula matters as much as the index. Two policies that follow the same index can credit very different amounts, because their formulas differ.
  • The credit can be low. Many policies set a floor, the least they will credit for a period even when the index falls. Policy charges still come out, so the cash value can shrink in a period with little or no credit.

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What are caps and participation rates?

Insurers limit how much of an index rise reaches the cash value. The common limits are:

  • A cap. The most the insurer will credit for a period, however much the index rises.
  • A participation rate. The share of the index change that counts toward the credit.
  • Other features. Some policies use other limits, and some lock in each credit once it is added, called a ratchet.

Vermont's bulletin required insurers selling there to tell buyers which limits a policy uses, the current caps or rates, and how often the insurer can change them. Whatever state you buy in, ask the same three questions. A cap that looks generous today can be lowered later, within the limits the policy allows.

What makes an indexed universal life policy lapse?

Every universal life policy has charges, including the cost of the insurance itself, taken from the cash value each month. The cash value has to cover them.

A policy can lapse, and the cover end, when the premiums paid and the credits earned fall short of those charges for long enough. This is the risk that flexible premiums carry. Paying less, or pausing payments, works only while there is enough cash value to pay the charges. If you plan to reduce or stop premiums for a long time, ask your agent first what that does to the policy.

Credits that come in lower than an illustration assumed have the same effect over time. A policy funded on the hope of strong credits can need more premium later to stay in force.

What should I read before I buy one?

Indexed universal life is sold with an illustration: a projection of how the policy might perform under stated assumptions. Vermont's bulletin barred insurers from using long term illustrations to imply future performance, and that is the right way to read any illustration: as one scenario, not a promise. Illustration rules are set state by state, so ask what the illustration you are given assumes.

Before you decide, ask for these in writing:

  • The values the policy would show assuming its highest charges and its lowest credit, not only the projected values, and what happens to the policy if credits are low for years.
  • Every cap, participation rate or other limit, and how often the insurer can change it.
  • The policy charges, including the cost of insurance, and how they change over time.
  • The premium needed to keep the cover in force on those same low assumptions.
  • What happens if you take money out or borrow against the cash value.

Federal tax law also sets a definition a policy must meet to be treated as life insurance for federal tax purposes. The law gives two ways to qualify: a limit on the cash value relative to the death benefit, or a limit on the premiums paid together with a rule that the death benefit stay above a set multiple of the cash value. How any of this applies to your own taxes is a question for a tax professional.

The life insurance page explains term and permanent cover in plain words, and the life insurance cost guide explains what drives the price.

Have a question about life insurance? Ask Jodi a question, or call (480) 228-0591. Jodi Morris is a licensed Arizona insurance agent based in Phoenix with a Life line of authority.

Frequently asked questions

Is indexed universal life an investment?

It is life insurance, and FINRA says it is generally not considered a security. The cash value is credited by a formula that follows an index; you do not choose investments, and the money is not placed in the index itself. Its first purpose is the death benefit.

Can an indexed universal life policy lapse?

Yes. The cost of the insurance and other charges come out of the cash value. If the premiums paid and the credits earned do not cover those charges, the cash value can run out and the cover can end.

What is a cap on an indexed universal life policy?

A cap is the most the insurer will credit for a period, however much the index rises. The insurer sets it and can usually change it within the limits the policy states.

Is indexed universal life the same as variable universal life?

No. In variable universal life the cash value is invested in a portfolio you choose, and FINRA treats the policy as a security. In indexed universal life the insurer credits interest to the cash value by a formula tied to a set index, within caps and other limits.

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About the author

Published by JM Agency. Jodi Morris is a licensed Arizona insurance agent based in Phoenix with Property, Casualty and Life lines of authority. This article explains indexed universal life in general terms as life insurance; the policy contract decides what any one policy does, and an illustration shows one scenario, not a promise.