What is indexed universal life insurance (IUL)?

Understanding indexed universal life insurance

Indexed universal life insurance is a type of permanent life insurance. Unlike term life insurance, which lasts for a set time period, permanent coverage lasts a lifetime, provided premium payments are made on a regular basis.

Also, unlike term coverage, permanent life policies like IUL contain cash value, which can grow on a tax-deferred basis over time and can be accessed through loans or withdrawals while the policyholder is alive.

Indexed universal life vs. whole life insurance

IUL and whole life are two types of permanent insurance coverage. Both have a death benefit and cash value, but they differ in notable ways.

A typical IUL policy has adjustable premiums, meaning you can raise or lower them (within policy limits) as your financial situation changes. The drawback is that if you underpay your premium for too long, you risk diminishing the death benefit or having the policy canceled.

With an IUL policy, you can invest the cash value in one or more index funds as chosen by your insurer; you may also have the option of investing in a fixed-rate money market fund. Insurers impose a floor on the rate of return on your cash value, commonly 0%, meaning you can’t lose money, but returns are also capped at a certain rate.

The standard whole life insurance policy has level premiums and a guaranteed death benefit. The cash value is invested in a money market fund or similar with a relatively low, fixed rate of return.

The advantage of whole life insurance is its predictability. With fixed premiums and returns, it’s easy to budget for future financial needs. But you also sacrifice the potential for greater gains that a universal life or IUL policy could return.

» MORE: Term vs. whole life insurance

How indexed universal life insurance works

As with universal life coverage, IUL has adjustable premiums, and the premium payment is allocated to three things:

1. The death benefit
2. The cash value
3. Any related policy management or service fees, charges, etc.

But whereas a universal life insurance policy typically invests the cash value in a fixed-rate money market account, an IUL policy offers you a say in how those funds are invested.

“Tax advantages are the number one advantage of an IUL policy,” said Randy VanderVaate, a licensed insurance agent in Dallas. “Cash value in an IUL policy grows on a tax-deferred basis, allowing for potential accumulation without immediate tax implications.”

Most IUL policies offer a choice of stock and bond market index funds, such as the S&P 500, as well as more conservative money market accounts. Your policy’s cash value isn’t invested directly into the market. Rather, the insurer trades in options that mirror the index’s performance.

“IULs offer potential for growth tied to a market index, but unlike directly investing in the stock market this insurance comes with a buffer and a minimum guaranteed interest rate,” VanderVaate said. “This can suit people who want some market exposure but with downside protection.”

Because the company is managing your investments, an IUL policy is subject to some unique terms and conditions:

• Limits on gains: Many insurers cap gains on returns at 8% to 12%, and they can adjust this cap up or down over time.
• A floor on losses: IUL policies often set a minimum rate of return of 0% to prevent losses should the market suffer a downturn.
• A participation rate: When the market is up and you’re earning a positive rate of return, the insurer will often take a cut of the proceeds. For instance, if the index you’re invested in rises by 10% and your participation rate is 90%, then you would in effect receive 90% of that 10% gain, or an effective return of 9%.

Indexed universal life insurance example

Let’s say you have an IUL policy with $100,000 in cash value. You opt to invest $75,000 in an index fund that tracks the Russell 2000 and the remaining $25,000 in a money market account with a fixed rate of return.

Here’s what a hypothetical one-year return might look like:

Pros and cons of indexed universal life insurance

Indexed universal life insurance may appeal to someone seeking lifelong coverage along with the option of having a say in how the policy’s cash value is invested.

But it may not be the best option for someone who prefers a policy with fixed premiums and returns, such as whole life insurance.

“People who don't understand the risks should also avoid IUL because it is a complex insurance product,” VanderVaate said. “People who don't understand the underlying market exposure and fees associated with IUL might be better off with simpler insurance products like term life insurance.”

» MORE: Types of life insurance

Where to get indexed universal life insurance

Generally speaking, you have three options for buying IUL:

• Online: Some insurers, like Progressive, will allow you to begin the quote process on their website for universal life insurance, then connect you with a telephone representative to complete the process.
• From a company representative or agent: Some insurers, such as State Farm and New York Life, make you work with a local agent to get a quote and purchase coverage. These agents are typically salaried company employees and work only for one insurer.
• From an independent agent or brokerage: Unlike a company agent, who can offer policies from only one insurer, an independent representative can give you quotes from several insurers, potentially offering more options and savings than a single-company agent.

Note that not all companies that sell life insurance policies offer an IUL option.

» COMPARE: Best life insurance companies

Bottom line

If you’re looking for life insurance that offers lifetime coverage, a death benefit for your heirs, cash value for your own needs, plus the flexibility of adjustable premium payments and the option of choosing how your cash value is invested, an IUL policy may be worthwhile.

However, if you want permanent life insurance with predictable premiums and a fixed rate of return, a whole life insurance policy may be a better choice. Similarly, if you need coverage for only a limited period of time, a term life insurance policy may be more economical. Talk with a financial advisor or insurance expert for more information.