How Indexed Universal Life Insurance Works (IUL)

Reduced risk, flexibility and the opportunity to increase your cash value is what Indexed Universal Life Insurance (IUL) promises for those who are looking for a permanent life insurance policy.  The objective goal of an IUL policy is to “outperform the index”[i] on which the IUL is depending on for its cash value growth.

IUL is a mixture of a one year renewable term life insurance policy and a variable, or flexible, premium life insurance policy. It is a fairly recent product which has experienced massive sales increases over the past 15 years.[ii] In this article, we’ll discuss the Indexed Universal Life Insurance pros and cons

So What Is Indexed Universal Life Insurance?

Like all life insurance policies, an Indexed Universal Life policy provides a death benefit. Indexed Universal Life Insurance, as all universal life insurance products, is built upon term life insurance for the coverage they provide.  This means that, like all term life insurance policies, the cost of the coverage will go up over time.  But it is because of this term coverage that all universal life insurance, including IUL policies, have a flexible premium associated with them.

This flexibility is possible only because the insurance company charges more for the coverage provided than what they would charge for the same coverage if Term insurance was purchased.  This extra premium paid goes into an accumulated cash value account.  And it is from this accumulated cash value account that your premium is actually paid each year.

When there is enough cash value in the accumulated cash value account, the option to have the premium paid from this account makes the out-of-pocket premium flexible or variable.  If money in the accumulated account is not sufficient to cover or reduce the out-of-pocket expense for the premium, then the policy will lapse unless there is an added premium paid for a rider that guarantees the policy not to lapse.  Thus, the flexibility that all universal life insurance policies provide, is based on the money that has been overpaid for the premiums or is the interest earned on those overpaid premiums.

In the first years of an IUL policy (typically 10-15 years), the cash values are subject to a surrender fee.  This fee reduces the ability of the policy owner to access 100% of the cash values until the insurance company has collected enough premiums for the policy to offset the company’s costs of issuing the policy.

The risks associated with managing the cash values as well as face value growth, are shifted from the life insurance company to the owner, in an IUL contract.  This limits the value of IUL products for those who are trying to:  build sustainability, secure a loan payoff (like a mortgage), avoid financial risk, use buy-sell agreements, create retirement plans, and do anything else that needs binding contractual guarantees.

What Are Your Risks Associated with Owning Indexed Universal Life Insurance?

There are some disadvantages of universal life insurance and risks that come from owning an IUL policy. The risks you assume when owning Indexed Universal Life Insurance are:

  1. You no longer earn a rate of return on money borrowed from your policy cash value
  2. You may be charged a premium fee on money used to pay premiums
  3. You may be subject to interest charges when using cash values to pay premiums
  4. You may reduce your opportunity to generate greater cash value when you use money from your cash value
  5. Your policy may lapse if you depend on the cash value to pay premiums
  6. You may be taxed on the premiums paid, if the policy lapses or is canceled
  7. Your guarantees are nominal and your earnings are capped

The Internal Workings of an Indexed Universal Life Insurance Policy

Indexed Universal Life Insurance (IUL) policies are difficult to explain because there are so many variations, not to mention how each variation functions.  But all IUL policies have the option for you to have your accumulated cash values mirror the returns of an index like the S&P 500 or Russel.  You may allocate a certain percentage to one index, another percentage to another index, and you may opt to keep a percentage in a guaranteed account that earns a nominal rate of return of 1% or less.  The guarantee typically provided is that the IUL will never earn a negative rate of return.

This guarantee is confusing as it implies that you are guaranteed never to lose money when you purchase an IUL policy. But that is not what an IUL guarantees.  An IUL simply guarantees that the policy will never earn less than 0.0% on the balance of accumulated cash value at any given period of time. Obviously, if the accumulated cash values are zero you will have to come up with more money to keep the policy from lapsing.

What About Fees?

There are fees associated with all life insurance policies. With IUL polices these fees are based on a percentage of what your premium payment is for the year, month, quarter, (however the contract states the premium is to be paid).  And, these fees typically run about 6% for the first 10 to 15 years of the IUL contract, after which they can be reduced.

The money paid into an IUL policy does not directly pay the premium but is put into an accumulated cash account. This account pays the fees, the interest and the premiums associated with an IUL policy. What is left in the account after that earns interest. That interest is based on what the index(s) that the policy is mirroring produces.  This interest rate is capped, around 12-15%, in most typical IUL policies.  Meaning that if the index returns 30% for the year, the IUL would not benefit from 50%, or more, of that gain.

On the other hand, If the index(s) has a negative return, then the guaranteed 0%-1% would kick in to provide the nominal guaranteed rate that IULs provide for the year.  As fees, then interest, and finally premiums are paid out of the accumulated account first, the IUL cash values reflect only what extra money the policy owner has paid, plus any interest previously earned on that extra money.  Interest is only earned on the balance remaining in the accumulated cash value account after all premiums, fees, interest on policy loans, etc., have been met, therefore the probability of an IUL out-performing the market is highly unlikely. This dependency on the market and low probability of success is one of the main disadvantages of universal life insurance

Overall Performance

Potential cash value growth in an IUL is largely speculative for the aforementioned reasons and due to the fact that the guarantees can be eroded by the ever-increasing cost of term insurance over time.  But IUL policies are sold frequently today because they reduce the risk for the insurance company by placing that risk back on the owner of the policy.

Simply put, an IUL policy is a life insurance policy coupled with an investment where neither the insurance coverage or the returns are guaranteed by the insurance company.  And this is because the nominal, zero to 1%, return can easily be consumed by the annual increasing price of insurance and the high premium fees.

Growth and Interest Rates

How the interest is added to an IUL policy varies from contract to contract. Some IUL policies calculate the cash value gains by multiplying the period gain in the index by the money in the accumulated cash value account.  Other IUL contracts use the sum of the changes in the index for the period as the multiplier, and still other IUL contracts take the average of the daily gains in the index for the month as the multiplier.  This adds complexity to the contract and the more complex life insurance contracts become, the more likely the insurance company attorneys are adding protection for the insurance company and not the owner of the policy.


Unlike the participation that takes place in whole life insurance policies, where the policy owner benefits from the profits of the insurance company, IUL policies have participating rates, which can cap the growth.  The policy owner can select what percentage of participation they desire to mirror in any given index. This participating rate typically has to be a minimum of 25%, but can be as much as 100%, of the accumulated cash value. Then, based on the participation rate and the capped index rate, the multiplier is determined and applied to the accumulated cash value.

What About Dividends

Dividends paid by the insurance company are not earned by IUL policies.  This means that IUL growth is based solely on extra money paid by the policy owner, which then is subject to earning a capped interest rate based on what one or more stock indexes have performed for a certain period.

Furthermore, the dividends which the stock indexes report, are not part of the earnings of an IUL policy either.  Consequently, for lack of these dividend earnings, IUL policies returns are handicapped.

Dividends are a way to share the profits of a company and should be passed on to those who are assuming the risk to make that profit possible.  With IUL, the insurance company is merely mirroring those indexes, instead of assuming this risk, so the insurance companies have no ability to pass any of those dividends on to the IUL policy holder.

What is the Value of Owning Indexed Universal Life?

  • Initial costs can be lower than Whole Life
  • Premiums can vary widely without triggering tax liabilities
  • Cash value growth occurs tax deferred
  • Surrender values of the accumulated cash value can be accessed for any reason
  • Out of pocket premium expense can be flexible as long as accumulated cash value is sufficient to cover the premium cost
  • Adding paid riders can guarantee face value increases as well as no-lapse contracts

What are the Disadvantages of Universal Life Insurance? 

  • Growth is capped
  • Participation rates can be less than 100%
  • Smaller policies tend to under-perform large policies
  • Gains are only possible with upward movement of the market
  • Policy contracts are complex. Complexity never favors the policy owner
  • The probability of outperforming the market with an IUL is very low
  • IUL contracts don’t pay dividends

It is All About What You Want.

What do you want to accomplish?

  • Do you want to pay more for less?
  • Do you want to face ever increasing costs year after year?
  • Do you want strong binding contractual guarantees?
  • Do you want to speculate?
  • Do you want coverage that will last a life time?

These are the questions that need to be addressed before you purchase life insurance, not afterwards.  Thoughtful consideration of How Indexed Universal Life Insurance Works will help you to know the answers to these questions and keep you from being sold something you don’t understand or something that won’t fit your needs. Weigh the Indexed Universal Life Insurance pros and cons before choosing any policy or being talked into one. Here at Life Benefits we provide complementary  strategy sessions to help you find a life insurance policy that will work for you. 

Dr. Tomas McFieDr. Tomas P. McFie

Most Americans depend on Social Security for retirement income. Even when people think they’re saving money, taxes, fees, investment losses and market volatility take most of their money away. Tom McFie is the founder of Life Benefits which helps people keep more of the money they make, so they can have financial peace of mind. His latest book, How to Build Sustainable Wealth, can be purchased here. 



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