IUL: Definitions you should know

By Drew Gurley

The many variations of universal life insurance are almost always confusing to clients and, often, their agents. One of the most confusing is indexed universal life.

In this article, we define the primary components of an IUL policy and provide guidance on how to communicate them to clients.

Cash value

Cash value is the policy’s savings component. A portion of the premiums go towards building this value, which can grow over time based on the performance of a market index, like the S&P 500. Unlike whole life insurance, which guarantees a fixed return, the cash value of an IUL has the potential for higher returns, although it is subject to caps and floors.

Indexing and crediting

Indexing refers to how the policy’s cash value is tied to a market index. The insurance company determines how much of the index's performance is credited to the policy’s cash value. So while the growth is based on the index’s performance, the cash value doesn’t directly participate in the stock market.

This is confusing for many clients. Let them know that the insurance company uses a formula —called a crediting method — that determines how much of the index’s gains are applied to their policy. The safety net here is that even if the index performs poorly, the policy’s cash value won’t decrease because of the guaranteed floor.

Cap and floor

The cap is the maximum rate of return the policy can earn in any given crediting period, regardless of how much the actual market index increases. The floor is the minimum credited return, often 0%, which means the cash value won’t lose money even if the index performs poorly. A crediting period is typically one year, although it can vary depending on the policy.

For clients, explain that the cap and floor protect both the client and the insurance company. The cap ensures the insurance company can meet its obligations without being exposed to unlimited risk if the market performs exceptionally well. Meanwhile, the floor protects the client from losing money due to negative market performance.

IUL participation rate

The participation rate determines what percentage of the index’s growth will be credited to the cash value. This can change annually. If the index increases within the floor and cap of the policy, the participation rate limits how much of that growth is applied to the policy. For example, if the index grows by 10% and the participation rate is 80%, the cash value will be credited with 8% growth. However, some companies create high caps which appear strong but add a participation rate which reduces the actual credit to the policy.

Think of the participation rate as the client’s “share” of the market growth. This ensures the insurance company can still manage the risk associated with the policy.

Cost of insurance

The cost of insurance represents the charges deducted from the cash value to cover the insurance company’s cost of managing the policy and providing the death benefit. This cost increases as the policyholder ages because the insurance company is taking more risk to insure an older individual. The COI includes mortality charges and administrative fees and, sometimes, costs of additional riders.

Make sure clients understand that the COI is covered by their policy’s cash value and increases over time.

Finally, COI is one of the primary reasons for using permanent life insurance as an accumulation strategy. Getting life insurance while you’re young is most advantageous because the cost is lower, allowing for stronger cash accumulation potential versus premium dollars being allocated to the COI.

Surrender charge

A surrender charge is a fee imposed if the policyholder cancels the policy or withdraws funds from the cash value within a certain period, typically the first 10-15 years. This charge decreases over time and eventually disappears. Surrender charges can range from 5% to as high as 20% of the cash value, depending on the policy and how early the withdrawal occurs.

The insurance company charges this fee to recover its upfront costs (e.g., issuing the policy and paying agent commissions). Encourage clients to view their IUL as a long-term strategy.

IUL death benefit options

IUL policies offer two types of death benefits:

Level death benefit: The death benefit remains the same throughout the policy, regardless of cash value growth. This option generally results in lower premiums, as the insurance company isn’t factoring in potential cash value growth. It’s often a good fit for clients who want predictable, affordable premiums.
Increasing death benefit: An increasing death benefit grows over time as the cash value increases. With this comes higher premium commitments. This is a good option for clients who want to maximize the amount passed on to their beneficiaries or who anticipate needing a larger benefit in the future to cover financial obligations.

Loan and withdrawal options

Policyholders can take loans or withdrawals from their IUL’s cash value. Loans accrue interest but don’t directly reduce the death benefit unless they are not repaid. Withdrawals, on the other hand, permanently reduce the cash value and may reduce the death benefit as well.

Make sure clients understand that loans come with interest and need to be repaid to prevent reducing the overall cash value and death benefit. It is a bit like borrowing from their retirement account: It’s a flexible option but should be used with care to avoid penalties down the road.

Communicating effectively with clients about IUL

Keep it simple when explaining IUL concepts. IULs contain potentially confusing financial concepts as well as confusing insurance concepts. Together, they are a recipe for how to lose a sale.

Drew Gurley is a licensed life insurance expert with nearly 15 years of experience. During his career as both a licensed life insurance agent and industry executive he has helped thousands of clients with their life insurance needs through his work at Redbird Advisors and Senior Market Advisors.