In recent years as life insurance has lost some popularity, there has been an uptick in some of the more unique forms of coverage, like indexed universal life. But you've likely found an array of mixed opinions about this type of policy online.
For instance, the biggest benefit, by a long shot, to IUL is that you get more room to play the markets with your policy, like with variable universal life. But there's supposedly no downside. If the equity index hits rock bottom, your cash value stays safe and sound at 0%, but if the market does well, your interest rates go up.
How is this even possible? Clearly there must be a catch here because no way you can “invest” in the stock market without having a downside. If that were possible, we'd all be rich.
True. And you're right that there is a catch, though perhaps not in the way you think.
Before we get to that, let's make one thing clear:
Life insurance was never meant for investment purposes. It's meant to create a death benefit that pays for your funeral costs, provides for your family after you're gone, settles your estate, and perhaps fulfills some other important obligations.
Having said that, why are there life insurance policies out there that behave like investments or implement investment-like features?
They aren't meant to make you rich – they are meant to provide an opportunity to maximize your interest rates, which make your insurance possible, and possibly grow your cash value accounts so that your loved ones are rewarded even more money. In some cases, you can even access these gains yourself later in life for retirement or long-term care.
The reason we bring this crucial point up is to point out that most people are looking for a balance between opportunity for gain and minimization of risk when shopping for insurance – putting the death benefit that's meant to serve your family in jeopardy takes the “playing the markets” side of these policies too far.
Here's the way it pans out.
IUL is a type of permanent, or whole life insurance, that has a cash value component and an insurance component. But with traditional whole life policies, the return rates are often a bit too low, even though we're looking for security over all.
Indexed universal allow you to play the markets, tying your interest rates to a financial index (or several) like the S&P 500 or Nasdaq 100.
As mentioned before, there's a floor so that you can't lose, but the big catch is that this is made possible by capping how much you can gain – typically 12% at the most. In these times, the company pockets additional profit, but you still see a higher-than-normal return on your cash value.
That's a trade-off, to be sure, but it's balanced by the fact that you don't lose money when the markets go down.
Well, while it seems you're being given a chance to "invest," you're not actually purchasing investments. And you're fine with that – remember, your insurance policy isn't supposed to be an investment; you're just maximizing gains.
Rather, the insurance company is the one investing. They purchase the market indices for you, buying options and derivatives to get their hands in the game and simulate performance.
So you pay the premium payments, part of which go to maintaining your "annual renewable term" and ensuring you have a death benefit. Fees are also extracted, as always, and the rest goes towards your cash value.
Remember, the how much is subjective, given that you can choose how much to pay on your premiums with these universal policies.
The cash value in your account creates interest based on the equity index you've chosen (you can also allocate some or all of the money into fixed interest accounts), and you can choose multiple indexes as you desire.
The company looks at the market performance at the end of the month, noting the value relative to the beginning of the month. If the index increased, your cash value account is credited with interest. If the index went down in this time span, no interest is credited, but nothing is taken out either.
The interest is credited periodically, usually every one or five years.
As you can see, when you buy these policies, your money isn't at risk because it is only placed in accounts that mimic the performance of the overall stock market. The insurance company wins because they stand to make money with the actual investments, and you stand to win because you get access to higher interest rates without putting your death benefit in the hands of Fate.