As trendy products go indexed universal life insurance isn’t exactly on a par with organic food or man caves, but it was recently touted in the Wall Street Journal as “this year’s hottest life-insurance product.” The June 5, 2010 WSJ article noted that universal life insurance “appeals to people eager to capture stock-market gains while avoiding undue risk” while also pointing out that you might “need a Ph.D. in finance” to understand the product. Here’s a quick look at what indexed universal life is, along with the relative pros and cons.
Indexed Universal Life Insurance Definition
Indexed universal life insurance is a form of permanent life insurance just like whole life insurance, meaning the death benefits never expire like they do with a term life insurance policy. There are, however, some critical distinctions:
- Unlike traditional whole life insurance products, indexed universal life purports to provide more flexibility in the cost and timing of the premium, which can be paid monthly, quarterly or annually. As your policy’s cash value accumulates, you can use your cash account to pay your policy premiums. You can also adjust the death benefit by either withdrawing from your policy’s cash account or by paying additional premiums.
- With universal life insurance, the interest credited to your cash account fluctuates with the financial performance of a market index like the S&P 500. And this is where it can get complicated for the average consumer/investor, because the changes in the index are determined by a participation rate, which is spelled out in your policy contract. For example, if the index increases 10% and you have a participation rate of 75%, you account would realize a credited interest rate yield of 7.5%.
- Your policy contract will also spell out the minimum rate of return allowed (the “avoiding undue risk” part). This typically zero so that a significant decrease in the index rate can’t reduce your cash account’s principal. But, your credited interest rate may also have an annual cap on the allowable maximum rate of return.
- Your contract states that the participation rate and maximum and minimum rates of return can be altered annually by your insurance company.
The Upsides and Downsides of Indexed Universal Life Insurance
An indexed universal life insurance policy has many of the benefits of any permanent whole life insurance product, including tax-deferred cash accrual, tax-free death benefits and the ability to take tax-free loans against your policy’s cash value. The downside, besides the inherent complexity of the product itself, is the fluctuation of the indexed rate: essentially, you’re agreeing to settle for an average rate of return from the companies your policy is indexing. In summary, your risk is higher than with a traditional whole life insurance policy, but less than with a variable life insurance policy.