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Understanding Indexed Universal Life

The purpose of this article is to help you understand how Indexed Universal Life (IUL) policies work and to dispel the myths surrounding IUL. I want you to take a look under the hood and show how they are not much different from other policies like Whole Life. I also want to address all the common terms that you will come across like participation rates, caps, and floors. And lastly, if you’ve spent any time researching IUL, you know there is a lot of conflicting information (to put it mildly!) I hope to address some of the common myths.

I know that as you have been out there doing your research and trying to separate BS from reality, you have more than likely come across a lot of negative press about Indexed Universal Life. What I want to do is separate the marketing hype from the reality. So what we are going to do is take a peek under the hood of permanent life insurance and show how both Whole Life and Indexed Universal Life are alike. But once I start explaining the differences, and giving you the real data, you will find that an Indexed Universal Life is the best financial tool for The Double Play–putting your money to work in two places at one time by leveraging the cash value of a maximum over-funded cash value life insurance policy.

I am sure all the Whole Life guys would like to argue about that, but if you take an unbiased and analytical look at both products, you will come to the same conclusion that I have.

Under the hood all insurance policies work exactly the same. The only thing that is different between an index Universal Life and a normal Whole Life is the way that the interest is credited. Moreover, because the interest crediting will result in a greater cash value rate of growth, the index Universal Life will ultimately outperform a Whole Life, making it superior to Whole Life for The Double Play.

Life Insurance 101 

I’m going to get started by covering a little bit of what I call Life Insurance 101. These are the basic fundamentals of permanent life insurance: cash value, mortality costs, policy design, etc. If you want more information on the basic fundamentals, be sure to check out my free eBook Life Insurance 101. If you are more of a visual learner, you can check out the YouTube version of Life Insurance 101.

Cash Value

The key to understanding any permanent life insurance policy is to understand that the cash value represents the policy owner saving up the death benefit on the insured over the insured’s expected lifetime. The risk passes from the Insurance Company to the Policy Owner over time. At the beginning of the policy the risk of paying out the death benefit is almost entirely on the insurance company. But by the time the insured is reaching the end of their natural life expectancy, the cash value of the policy is nearing the death benefit.

Policy Design

This graph shows a minimally-funded life insurance policy. A base Whole Life policy is an example of a minimally funded life insurance policy. If you call up an agent and ask for a quote, you are going to get the lowest price that will allow the insurance company to collect enough premium to perform on the obligations of the policy.

The cash value of the policy is represented by the blue line that starts off at zero and slopes up into the right as the Insured ages. The death benefit is shown by the horizontal orange line at the $1,000,000 mark on the vertical axis.

Dividends/Interest Crediting

The insurance company clearly has to make some assumptions about the growth of the cash value to determine when it will intersect with the death benefit around the end of the Insured’s life expectancy (red circle). If they over-estimate the rate of growth, the policy premium could have been lower making the product more competitive with products from other companies. If they underestimate the growth rate, the policy may not have enough cash value to sustain the mortality costs late in the insured’s lifetime. 

The “Guaranteed Rate”

Since the insurance company has to compete against other insurance companies, they need to make sure that they collect as little premium as absolutely necessary to perform on the policy obligations. This “worst-case” assumption also goes by a name you may have heard before: “The Guaranteed Rate”. That is the interest rate that the insurance company is confident that they can achieve over the lifetime of any Insured.

The insurance company must also collect enough additional premium to cover the risk of having to pay the death benefit at any given time. The risk to the insurance company is represented by the difference between the death benefit – the horizontal line at the top – and the cash value. The brackets on the chart show this gap at two different ages. As the client gets older, the amount at risk gets smaller.

You will notice that the insurance company has an incentive for the cash value to grow as quickly as possible. If the cash value does grow at a faster rate, it will intersect with the death benefit earlier. The quicker it grows and reaches the death benefit, the quicker the risk is eliminated. The crossover point (the red circle) would shift left if the cash value grows faster.

This is important to understand: Insurance companies want to maximize the growth rate of the cash value. So how does the Insurance company invest the cash value? Let’s take a look.

Indexed Universal Life and Whole Life Similarities

Insurance companies need to accomplish two goals: 

  1. They need to protect the principal.
  2. The need to maximize the growth rate.

Life Insurance Company Assets

Insurance companies typically invest the bulk of their assets in US treasuries, bonds, and mortgages from the banks. These are safe, secured debt instruments. This is true for both Whole Life and IUL policies. Remember, there is no such thing as a “Whole Life Company” or an “Indexed Universal Life Company”. Companies that offer Whole Life policies can also offer Indexed Universal Life. Penn Mutual is a good example. They have Whole Life, IUL and UL in their product mix. Most of the top IUL market leaders also offer a Whole Life Product. Their underlying assets are all invested the same way. 

As a result they earn a nice steady, secured rate of return. Let’s call this “The Debt Market Return“. The return on stock indices like the S&P 500 represents “The Equity Market Return“. Higher risk generally translates into higher expected returns: The Equity Premium.

Whole Life “Companies”

In order to show you that all insurance companies do the same thing with their funds, I grabbed some screenshots from the annual reports of two different companies. One of the companies is one of the highest dividend paying Whole Life companies. The other is a market leader in the Index Universal Life market.

As you can see from the asset allocation of Mass Mutual, most of their assets are invested in bonds and mortgages. One item of note, is there is a significant allocation to policy loans. Policy loans are loans from the insurance company to their policy owners secured by the cash value of their policies. As a result, those policy loans represent an asset of the insurance company and a source of interest income.

Here is the breakdown within the bond category. Note the risk profile.

IUL “Companies”

Now let’s take a look at the asset allocation for Minnesota life. 

You can see that both companies invest in similar assets. Primarily Bonds and Mortgage securities. However, you can see that the asset allocation for Minnesota Life is weighted toward higher quality debt and is more conservative than Mass Mutual. If you look at the allocation to assets to bonds and mortgages as a percentage of the total assets, Mass Mutual has 71.6% of their assets in bonds and mortgages and the rest spread across policy loans, preferred and common stock, derivatives, Partnerships and LLCs, short term and cash, and real estate.

Minnesota Life (Securian), on the other hand, has over 90% of their Assets in bonds and mortgages with the balance labeled as “other invested assets” and “Equity securities”. 

If you assume that the mix of assets across all insurance companies is similar, then we should expect all of their portfolios to earn about the same amount of interest income. However, in this comparison, you can see that the risk exposure for Mass Mutual is a bit higher than the risk exposure for Minnesota Life. As a result, we should expect higher risk adjusted returns for the Whole Life company. Right?

So if the underlying investments in an “IUL-focused company” are more conservative, then how can the cash value of an IUL possibly outperform that of a similarly designed Whole Life policy? To answer that, we need to look at the differences between Whole Life and Indexed Universal Life.

The Difference Between Whole Life and Indexed Universal Life

Where Whole Life and Index Universal Life differ is in the way that they credit the cash value with the earnings on their holdings. A Whole Life company pays a dividend and a Universal Life company credits interest to the cash value.

In a true Universal Life policy (not “Indexed”), what they make on the cash value is what they pay to the cash value. It’s an entirely mechanical process. And if we assume that the risk exposure of the underlying portfolio is the same, then we should expect that the return on the portfolio is roughly the same. This makes the guaranteed interest rates a moot point. It is not a return that the insurance company ever expects to have to pay. They expect to do much better.

In both Whole Life and Universal Life the companies have an incentive to earn as great a return as possible and both should be making the same amount of money with or without a guarantee. And if you remember the Life Insurance 101 discussion, the guarantee is simply a worst case planning scenario. The insurance companies don’t ever expect to have to pay that rate over the lifetime of the policy.

Now where an Indexed Universal Life policy differs from Universal Life is in the way that the interest is credited to the cash value. The insurance company takes the earnings they would have otherwise credited to the cash value as a dividend and they go to the equity index options markets with a simple goal of buying as much movement in the market as they can get with the money that they have.

The insurance companies employ hedgers to purchase options to capture the movement of the underlying index.

Caps and Floors and Participation Rates, Oh My! 

So this brings us to some of the terms that are used in Indexed Universal Life. The first is caps and floors. And if you understand that they are using options in the background, then it is very easy to understand why there is a cap and a floor.

The cap represents the strike price of the options. If the market goes up past that, the option is simply exercised and the movement is captured. If the market declines, the value of the option falls to zero because you could purchase the index in the market at a lower price than exercising the option contract. When the market goes down, the options expire worthless and the only thing that you lose is the interest that you would have otherwise been paid as a dividend in a Whole Life policy.

There are lots of different index crediting strategies and there are many different indices to choose from as well as different ways of capturing movement. 

For example, if you spent all of your budget on capturing as much movement as you could, you might end up with a 10% cap, for example. However, you may also be able to purchase more options with a lower cap. This would create a multiplier effect. The cash value would be credited with greater than the movement of the market.

The participation rate represents the percentage of the market movement that will be credited. For example, if the participation rate is 100% and the market moves 10%, the crediting will be 10%. but if the participation rate is 75%, and the market moves 10%, the interest crediting will be 7.5%.

The point of an Indexed Universal Life is not to capture the equity market return, it is simply to beat the debt market rate of return. 

This is important. Remember, the insurance company wants to protect the principal and grow the cash value as fast as safely possible. They just hope to do a little bit better than they could have. Otherwise, there would be no incentive to go to the trouble of hedging when you could simply credit the interest from the bond investments.

The cap rates on an index Universal Life policy are a function of interest rates. If interest rates are higher, the insurance company earns more on its bond holdings and has a greater budget with which to use for hedging and capturing movement in the market index. In high interest rate climates, the cap rates are higher, and the interest credited is typically much higher. However, as interest rates fall, as they are right now, the insurance companies have less interest income and less budget with which to purchase options so the cap rates decline. The lower cap rates lead to a lower expected return on the cash value. 

But the important thing to keep in mind is that there is no point in going through this exercise unless you can capture sufficient movement of the market to make it worthwhile compared to simply paying the interest to the cash value. So when interest rates are high you would expect to earn something greater than what you could have paid as a high interest dividend. But, at the same time, when interest rates decline, you can reasonably expect to earn a similar margin over the debt rate of return.

So yes, the expected rate of return does go down when interest rates go down and cap rates decline. But remember, the goal of an Indexed Universal Life is not to capture the equity market movement, it is simply to beat the debt market rate of return. So even in a low interest rate climate, you can still capture a premium over the debt market return. And you can see that works in both in high and low interest rate climates.

Performance Comparison of IUL vs. Whole Life 

So let’s look at a graph of a maximum overfunded Whole Life policy. 

And let’s compare that to a maximum over funded index Universal Life policy. 

Just kidding, they are exactly the same. Two identically designed life insurance policy illustrations: one an Indexed Universal Life and one a Whole Life, will show exactly the same performance. If both policies are collecting the same amount of premium and both policies have the same death benefit, then both policies have or should have the same mortality costs. What really separates an Indexed Universal Life from the Whole Life is that we have a reasonable expectation for the cash value of an IUL to grow at a faster rate than the cash value of a Whole Life. 

IUL Myths 

So let’s discuss some of the myths around Indexed Universal Life. If you’ve done any searching on the internet, you have undoubtedly heard people typically selling Whole Life, writing that Indexed Universal Life is a terrible life insurance product. “It doesn’t have guarantees” and supposedly “the cost of insurance will rise as the insured gets older causing the policy to lapse”.

So let’s just deal with those two common myths. 

Let me start by drawing your attention to is the point on the previous chart where the death benefit drops after year 10 of the policy. In both a Whole Life and in an Indexed Universal Life, once you have paid all the premium into the policy, you want to reduce the death benefit in order to drive cost out of the policy. The cost of the death benefit protection is the primary cost that impacts the growth of the cash value. Both types of policies run the risk of lapsing if the death benefit is kept high. Both types of policies will have similar insurance costs because they’re working off the same mortality tables.

Because the death benefit in a properly-designed Indexed Universal Life is reduced to the minimum non-MEC death benefit when the premiums cease, the policy is NOT going to lapse because of rising mortality costs. The same portion of every dollar of cash value is going to be used to purchase death benefit protection. If mortality costs rise, the result is that less death benefit is purchased. The cost is the same.

MYTH: Busted.

If we go back to the graph of the minimally funded policy, you can see that if the cash value were to grow at a faster rate, the risk would be eliminated faster. All insurance policies face rising mortality costs as the insured ages. What drives down the mortality cost is the fact that the cash value is rising and minimizing the Net Amount at Risk (the gap between the death benefit and the cash value). 

In a minimally funded policy design, an Indexed Universal Life would more quickly reduce the insurance risk to the insurance company because the cash value is growing at a faster rate. As a result, the rising mortality cost actually impacts a Whole Life more than it does an Indexed Universal Life. The only thing that could have an impact on a minimally funded Indexed Universal Life, is the year to year variation in indexing credits. due to the ability for the cash value to earn a zero in multiple years. However those multiple years of zeros are likely to be offset by years in excess of the average or illustrated rate.

The result here is that the Guarantees don’t matter. The policies are going to pay what they pay. The performance of the cash value of an IUL should exceed the performance of a Whole Life over time. Only in a very short time horizon are the potential zero percent returns likely to result in the peformance of an IUL lagging the cash value of a Whole Life. And since the Guarantee was only the insurance company’s worst-case planning scenario for pricing the policy, the policy performance will very likely well exceed the guaranteed rate.

Conclusion 

  1. The guarantee doesn’t matter. The policy makes what it makes. If you understand the mechanical process, then you know exactly what you can expect to earn over the long run.
  2. For two identically-designed policies, one Whole Life and one Indexed Universal Life, I would expect the cash value of an Indexed Universal Life to far exceed the cash value performance of the Whole Life due to the ability for the cash value to earn a portion of the equity premium.
  3. People who make statements that the rising cost of mortality will cause the policy to lapse simply don’t understand what is going on under the hood of a policy: IUL or Whole Life. They are simply reciting their company’s pitch lines without truly understanding what they are saying.

You are certainly welcome to message me and let me know if you think anything that I’m I’ve shown you here would lead you to believe that what I’ve said is incorrect.

If you truly understand what is going on under the hood of the insurance policies, you will understand that much of the information that you see on the internet is bunk. 

The risk of any maximum over-funded policy lapsing is almost zero. I certainly can’t guarantee that or state with absolute certainty because the market could go down for 20 years in a row and the policy could lapse. However, I live in the real world and I don’t think that the market will go down for any more than a few years in a row on any regular basis.


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No Rendering of Advice: The financial content in this document is provided for your personal information only. It is not intended for trading purposes, and cannot substitute for professional financial advice. Always seek the advice of a competent financial advisor with any questions you may have regarding a financial matter. Information in this document is not appropriate for the purposes of making a decision to carry out a transaction or trade nor does it provide any form of advice (investment, tax, or legal) amounting to investment advice, or make any recommendations regarding particular financial instruments, investments, or products.

The primary reason for purchasing life insurance is the death benefit protection. Any other benefit is purely ancillary.