Navigating the Waters of Indexed Universal Life Insurance

The history of Indexed Universal Life does not stretch all too far back into history.  However, since its inception only about 10 yrs ago, the products have grown from a relatively easy to understand concept of simple downside protection and limited upside potential to a complex set of moving parts.  As we peel the onion back so to speak regarding these products, we can begin to identify their key components so that we can properly compare them and understand them

THE BASICS

The underlying concept of Indexed Universal Life insurance (IUL) is that a traditional universal life chassis is used and the crediting rate or interest rate associated with the policy is tied to a recognizable and definable market index. 

THE CREDITING RATE

As with most all universal life insurance policies, Indexed Universal Life has a premium load/fee that is initially applied to premiums deposited by the policy owner.  From there, the policy’s charges are then deducted (administrative fees, expense charges, Cost of Insurance charges, etc) from the policy account value on a monthly basis.  After all charges have been deducted the policy’s net value is credited at an interest rate set forth in the policy. 

The crediting rate of an IUL policy in 2010 is usually somewhere between 0% and 14% annually depending on the components which define the rate.

THE COMPONENTS

The components of what leads to the calculation of the crediting rate each year can be defined by 6 areas including the following:

1.       The underlying index which is tracked

2.       The time period which is tracked

3.       The methodology of tracking (Annual Reset, Monthly Avg, etc)

4.       The Cap rate (“Ceiling”)

5.       The Floor rate (“Floor”)

6.       The Participation rate (“Par Rate”)

1.                   The Index – in the beginning of IUL, the only real index which was used was the most recognizable U.S. based index – the S&P 500.  However now there are many other choices a carrier can offer its policyholders.  There is everything from smaller U.S. based bond indices ranging to European, Asian, and even South American indices that can be tracked.  While offering global diversification, outside indices can get confusing to the client quickly and the underlying hedge pricing that the carriers rely on can fluctuate much more dramatically than the S&P 500 which can lead to changes in non-guaranteed elements within the policy.

2.                   The Time Period – traditional IUL usually used a simple 1 yr time horizon to track the given index.  However, now many products offer 2 year, 3 year, and even 5 year tracking periods.  This can be good in the sense it can mitigate the chances of a “bad year” however the tradeoff is that the policy account value may not see the bulk of the credit until the end of the term (2 yrs, 3 yrs, or 5 yrs).  Many carriers are also able to offer more attractive Caps and Par rates because the hedging that is done by the carriers costs them less as the time period extends.

3.                   The Methodology – the most common crediting methodology is an “Annual Point-to-Point with Annual Reset”.  What this means is that once per year the index is tracked from a beginning point to an end point.  The Annual Reset points to the fact that at the end of the year when the calculation is performed, the value resets and can never go back down thereby “locking in” the value the policyowner earned.  There are various other methodologies such as Monthly Averaging, Monthly Cap, and others that can also be used to calculate index credits

4.                   The Cap Rate – most indexed UL policies have a Cap Rate which sets the maximum crediting rate the policy can earn in the given time period.  The policy/contract will state a guaranteed minimum Cap Rate (maybe 3%) and will usually offer a higher “current” non-guaranteed Cap Rate (maybe 12%).  There are products on the market today that are completely uncapped while still guaranteeing a 1% annual minimum/floor.  This can be tremendously powerful as clients can be guaranteed growth year-over-year with truly unlimited upside potential!

5.                   The Floor Rate – most IUL products offer a 0% guaranteed floor which is the minimum the policy can be credited in any given time period.  There are some products which offer a higher guaranteed floor rate of 2% or 3% on the market currently as well.  Additionally, there are some products that may have a 0% floor but will retroactively credit at least 3% in the event of Full Surrender of the policy.

6.                   The Par Rate – the Participation rate is the percentage of the gain the policy earns in relation to the index yield.  For example if the participation rate is 90% and the index earns 10% then the policy is credited 9%.  The Par Rate may be guaranteed in the contract or may have both a guaranteed and non-guaranteed element to it.  On traditional 1 yr Annual Pt-to-Pt strategies many companies will guarantee 100% participation for the life of the contract.  Conversely some of the other strategies may only offer a smaller participation rate.

IN SUMMARY

While IUL products may seem similar on the surface, once the skin of the onion is peeled back we can really begin to see the inner workings and the components which will affect future performance to the policyholder.  There are many components to consider and many “moving parts” that the consumer and the agent need to be aware of as each life insurance company has different ways of applying these to their products.

It is also very important not to try to compare “apples-to-oranges” when looking at 2 or more indexed universal life policies side by side.  The internal components of one indexed product are rarely the same as another indexed product and this leads to potential differences in what rate actually gets credited to a policy.  For example the S&P may grow from 1,000 to 1,150 and share the same 15% growth amongst all products, but one policy may credit 11% while one may credit the full 15%.  Consequently, it is flawed logic to do what many clients or insurance often ask for – “lets run all the products at 7%”.  Logically that may sound “fair” but in reality the internal components of each policy will rarely produce the same return.  It is important to look at the historical performance of a given product based on the 6 components identified above.  We know history cannot predict future performance, but it can give us a glimpse of how 1 product compares to another based on the same quantifiable index performance.

With many of the 6 components changing so often, it is imperative the consumer and life insurance professional stay informed.  A quality life insurance marketing organization will be a tremendous resource to assist in which products to offer to clients and which products will suit their needs the best.

-J.T. Bell

Chief Marketing Officer

© Bell & Associates - 2010