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 profit from the upward movement in the underlying index[i] on which the IUL is depending for its cash value growth.

IUL is a mixture of a one year renewable term life insurance 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 Indexed Universal Life Insurance pros and cons. 

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What Is Indexed Universal Life Insurance?

Like all life insurance policies, an Indexed Universal Life policy (IUL), provides a death benefit. Indexed Universal Life Insurance, as all universal life insurance products, is built upon term life insurance. This means that, like all term life insurance policies, the cost of the coverage will go up over time. It is because of the underlying term insurance that all universal life insurance, including IUL policies, can 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 level-term insurance was purchased. This extra premium paid goes into an accumulated cash account. It is from this accumulated cash account that your cost of insurance is actually drawn each year.

When there is enough cash value in the accumulated cash account, the option to have the premium paid from this account makes the out-of-pocket premium flexible or variable. If the 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 additional 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 premiums or the interest earned on those overpaid premiums.

In the early years of an IUL policy (typically the first 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 to offset the costs of issuing the policy.

The risks associated with managing the cash value 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, build retirement savings, and do anything else that needs binding, contractual guarantees.

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The Disadvantages of Universal Life Insurance – IUL specifically

There are some disadvantages of universal life insurance and specifically some 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 fee/load on money used to pay premiums
  3. You may be subject to interest when using a policy loan to pay premiums
  4. You may reduce your opportunity to generate greater cash value when you use money from the cash account
  5. Your policy may lapse if you depend on cash value growth to cover increasing premiums for the underlying term insurance
  6. You may be taxed on extra premiums paid automatically from the cash account via policy loan if the policy lapses or is canceled when the policy loan balance has exceeded your out-of-pocket cost basis
  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 variables, not to mention how each of these variables actually function. 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 Russell. 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 – often 1% or less. One guarantee typically provided in an IUL contract is that the cash account  will never be exposed to a negative rate of return from the index(s) being mirrored.

    This guarantee is confusing as it may seem to imply that you are guaranteed never to lose money when you purchase an IUL policy. But this 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 decreasing to zero as the cost of insurance and/or other fees increase, you will have to come up with more money to keep the policy from lapsing.

    What Fees Come with an IUL Policy?

    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, or quarter, (however you choose to pay your premium). These fees typically run about 6% for the first 10 to 15 years of an IUL contract, after which they may 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 produce. This interest rate is capped, around 12-15%, in a typical IUL policy. This means 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. As fees, then interest, and finally premiums are paid out of the accumulated account, 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 indexed universal life insurance. 

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    Overall IUL Policy 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 0-1% return can easily be consumed by the annual increasing price of insurance and the high premium fees.

    Interest Crediting in IUL Policies

    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.

    IUL Policy Participation Rates

    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 participation rates which can limit the benefits you receive from growth in the index(s) your policy is mirroring. This participation rate typically has to be a minimum of 25%, but can be as much as 100%. Then, based on the participation rate and the capped index rate, the multiplier is determined and applied to the accumulated cash value. Read more on “How Whole Life Insurance Works.”

    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 and perhaps further limited interest rate based on the way one or more market-based indexes have performed during 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 policy 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 risk, so the insurance companies have no ability to pass any of those dividends on to the IUL policyholder.

    Indexed Universal Life Insurance Pros and Cons


    • 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 the accumulated cash value is sufficient to cover the premium cost
    • Adding riders may guarantee face value increases as well as a no-lapse provision under certain conditions


    • 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 lifetime?

    These are some questions that need to be addressed before you purchase life insurance, not afterward. Thoughtful consideration of how Indexed Universal Life Insurance works will help you to know the answers to these questions and save you from buying 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 McFie Insurance, 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 McFie Insurance which helps people keep more of the money they make, so they can have financial peace of mind. His latest book, A Biblical Guide to Personal Finance, can be purchased here. 


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