A common question we get asked involves indexed universal life insurance pros and cons. The internet has a very difficult time telling the difference between whole life insurance and universal life insurance (in fact it often considers them the same thing) so it comes as little surprise that people are often very confused about what exactly indexed universal life insurance is and why someone might want it or want to avoid it.
Let’s start with the negative elements of indexed universal life insurance.
Universal life insurance is generally not a participating life insurance product. In other words, it does not earn dividends. Instead, indexed universal life insurance policies earn interest. The interest rate is determined by the movement in an index. It is most often a stock index, but there are other iterations.
But, life insurers are not obligated to return certain universal life profits to policyholders. This is different for participating policies (generally participating whole life insurance). Such policies must return a certain percentage of earnings to policyholders.
The index movement determines the interest earned on an indexed universal life insurance policy. That timeframe for the movement could be one year, one month, five years, etc.
Let's say the index is up 10% in one year. The account is tracking the one year movement in the index. The interest earned on the cash value in the indexed account policy is 10%. This occurs up to a cap placed on the index account. If the cap is 12% and the index is up 15%, then the interest earned on cash values in the policy is 12%.
These caps can change either decreasing or increasing. They do have minimum guarantees below which they will not fall. Those minimums are generally around 3 to 4%. A serious reduction in the cap rate alters expectations for returns on cash value.
The participation rate measures how much the policy's cash value moves the index. Using the example above, let's say the participation rate is 100% and the index is up 10%. Then, the interest rate earned is 10%. If the participation rate is 90%, then the interest earned on cash values would be 9%.
Changing participation rates could also alter expectations on cash value returns.
Life insurance contracts have two basic charges: administrative and cost of insurance. Administrative charges include home office employee salaries, paper, utility bills, etc. The cost of insurance charge is for providing the death benefit for the policy.
These expenses are not fixed in a universal life insurance contract and could increase. There is a limit to how much these expenses can increase. But, if an increase were to occur, it would adjust the expected returns on the policy.
Universal life insurance policies assess surrender charges. A surrender charge is an amortized expense – spread out over several years. No large upfront expense is necessary to become a universal life policyholder. But, universal life insurance contracts do come with a cancellation fee. This fee is only applicable within a certain period. In this sense, it is somewhat like a contingent deferred sales charge.
Because of this surrender charge, the available cash values may be low for a time. Minimizing the death benefit of a planned premium reduces the surrender charge. One can't do much more to further reduce the surrender charge.
Indexed universal life insurance also has some good features to offer!
An index determines the interest rate earned on an indexed universal life insurance policy. Thus, indexed universal life offers higher potential returns than some other fixed insurance contracts. Fixed rate universal life insurance and whole life insurance come to mind.
Most indexed universal life insurance contracts have seen interest rates in the double digits. Sometimes, they have such interest rates for years. This far exceeds the interest and dividend credits to comparable fixed insurance contracts.
Universal life insurance by its nature is easy to reconcile. The interest rate paid is credited against the cash surrender value. Indexed universal life indexing reports state the index return. It’s usually easy to cross reference this since the index followed is public.
This is unlike the “black-box” nature of whole life insurance. It's difficult to check the insurance company’s math on the appropriate dividend.
Universal life insurance has no set premium. Expenses can be covered with premiums or cash in the universal life policy. The policy won’t lapse if you have enough cash value to cover expenses and pay no premium.
Expenses for an indexed universal life policy should be far smaller than the premium. This affords flexibility to the policyholder if the need arises to cut premiums for a while.
Further, premiums not paid up to the regulatory maximums can be made up in future years and since universal life insurance does not require additional riders to place extra cash into the policy (like whole life insurance does with paid-up additions), there’s no contractual function that stops a policyholder from significantly increasing his or her premiums paid to the policy.
Speaking specifically to the design and use of life insurance as an asset–where cash accumulation is key–universal life insurance in general affords greater opportunity to reduce expenses. Since universal life insurance can qualify as life insurance differently, the policyholder can have a lower death benefit per incoming premium dollar. This lower death benefit to premium reduces insurance expenses both initially and long term in the policy.
Additionally, this feature to universal life insurance allows for much more liberal parameters to the modified endowment contract rules and this further helps the insured place additional cash into the policy while maintaining its classification as a life insurance contract.
Universal life insurance contracts generally have specific intended objectives. Some examples are low expense per death benefit or cash accumulation. Potential buyers and insurance agents can select the correct contract for an intended goal.
There’s also an actuarial purpose for this. It allows universal life insurance contracts to excel at their intended purpose. For example, death benefit and cash accumulation policies will have different calculated reserving assumptions.
Almost all indexed universal life insurance policies have a non-direct recognition-like policy loan option. This means policy loans do not affect the index account and whatever index calculated interest rate due on cash values is paid regardless of loans outstanding. Since most indexed universal life insurance policies have index caps that are in the double digits, the spread between loan interest (average is currently between 4-6%) and interest paid on cash values can be substantial.
It’s also worth noting that given this feature, there is far less worry among indexed universal life insurance policyholders about borrowing money at an inopportune time and missing out on a large interest payment from a high return in the index followed.
There’s also an actuarial purpose behind this that better allows universal life insurance contracts to excel at their intended purpose–e.g. death benefit focused policies have different calculated and regulated reserving assumptions than cash accumulation focused policies.
Indexed universal life insurance policies are well reputed for their indexing feature. But, all contracts also have a fixed interest rate option. This option seeks to compete with comparable fixed interest rate savings options.
A dramatic increase in market interest rates is often a prescription to high inflation. A fixed account within these policies would likely match rising interest rates. A stall-out in the stock market could make the indexing account less attractive. But, as interest rates rise the fixed account would follow trend. Thus, it would likely become a more and more attractive place to park money for a while.
Ask us if you need further explanation!
Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. Brandon was born in Northern New England, and he currently calls VT home. He attended Syracuse University and graduated with a triple major in Economics, Public Administration, and Political Science.