What is indexed universal life insurance?

As we’ve already noted, the answer is a little complex. To better understand how this type of UL works and the benefits it can provide, it helps to get some context by reviewing the other main types of universal policies – standard and variable UL.

standard universal life policy (sometimes called fixed-rate UL) provides permanent death benefit protection plus a cash value component while allowing you to raise or lower your premium payments within a certain range – and at the low end of that range, premiums may be comparable to term policy premiums4. The death benefit is also adjustable. Flexible premiums may have appeal for people with fluctuating incomes, because it makes the advantages of permanent coverage more easily attainable. These UL policies can provide guaranteed cash value growth similar to a whole life policy, while providing the same kinds of tax deferral, loan collateral, and death benefit. But it’s also important to note that minimum premium payments means less cash value for growth, and expenses can ultimately erode its value, resulting in a need to pay higher premiums in later years or face amount reductions to keep your insurance coverage. 

The key difference between standard UL and the other types lies in how cash value accumulation is calculated. In a standard UL policy, the cash account balance is guaranteed to grow at an interest rate based on either the current market or a minimum interest rate, whichever is higher. So for example, in a standard Guardian UL policy, the annual interest rate will never go lower than the current minimum rate, 3.5%, but it can go higher.

People looking for potentially higher returns may choose a variable universal life (VUL)5 policy instead. These policies give you the option to tie cash value growth to investment funds. These policies are sold by prospectus and the insurance company gives you the performance history and fee information, and you can decide how much of your cash value to invest in each option.

With reward comes risk: growth in a VUL policy is not guaranteed the way it is in a standard UL policy. With VUL, funds in your subaccounts are subject to market risk: In a good year for the market, the value of your subaccounts (and cash value) can rise. In a bad year, the subaccount value can and will decrease.

Indexed UL provides more growth potential than standard UL, with less risk than VUL. These policies let you allocate all or part of your cash value growth to the performance of a broad securities index such as the S&P 500 Index6. However, unlike VUL, your money is not actually invested in the market – the index just provides a reference for how much interest the insurance credits to your account, with a floor and a cap for the minimum and maximum rates of return. While you won’t realize all the gains of your reference index, you won’t suffer any of the losses either. Since the floor is usually set at 0%, in a down year for the markets your cash value amount will remain steady or even grow slightly (because some policies set the floor above 0%).

How cash value grows in an indexed UL policy

First of all, you have to choose how you want your cash account to be allocated for growth. Each insurance company has its own selection of indices available and you may be able to choose more than one. You may also be able to allocate a portion to a fixed-rate interest account.

The cap is usually max credit for a specified segment of index participation. Most policies have annual caps, but some policies may have monthly caps. Caps can change at the end of any segment.

Additionally, performance can be impacted by a participation rate set as a percentage of the index’s gain, which is called the “participation rate.” For example, if the reference index rises 10%, and the policy’s participation rate is 50%, the amount allocated to the index would grow by 5%. Most IUL’s have a participation rate set at 100%, but that can also change.

So, what would actually happen to the cash value in your account in a good year? And what about a bad year?

Here’s an example based on how the S&P 500 did in 2017 and 20187. In the decade of the 2010s, 2017 was one of the best years: the index rose 21.83%. 2018 was the worst: the index lost 4.38%.1

We’ll assume you started with $10,000 in your cash account on Jan. 1, 2017, and you allocated 80% to the S&P 500 with an 11% cap, a participation rate of 100% and a floor of 0%; to hedge your bets, you put the other 20% in the fixed-interest account which paid 3%. And to simplify things, we’ll assume nothing else was added via premium contributions.

2017 IUL Cash Value Performance (S&P 500 up 21.83%)

Allocation Starting amount Index performance Participation rate CAP Adjusted return Gain
Ending amount
80% S&P 500 Index $8,000 +21.83% 100% 11% 11% $880 $8,880
20% Fixed-rate $2,000 NA NA   3% $60 $2,060
          Total   $10,940

All in all, you would probably be pretty happy: your cash value grew by about 9.4%. In this hypothetical example, the growth rate was more than you would typically get with a standard UL policy or even with a whole policy that pays dividends; yet you had no risk of loss. Assuming you made no adjustments to your allocation, here’s what would have happened the next year:

2018 IUL Cash Value Performance (S&P 500 down 4.38%)

Allocation Starting amount Index performance Participation rate Adjusted return Gain ($) Ending amount
80% S&P 500 Index $8,880 -4.38% 100% 0% (floor) $0 $8,880
20% Fixed-rate $2,060 NA NA 3% $62 $2,122
        Total   $11,002

Over this admittedly volatile two-year span, your average cash value growth rate would have been close to 5%. That’s still typically better than a standard UL policy, with much less investment risk than a VUL policy. However, it’s important to remember that this example shouldn’t be taken as “typical.” There are a large number of variables that would have altered the 2-year performance outcome, including but not limited to the policyholder’s decisions regarding premium amounts and cash value allocation; the policy’s cap, floor, participation rate, and fixed interest rate; and of course, the performance of the reference index, not to mention the expenses deducted for the cost of insurance. 

Index universal life insurance pros and cons

Compared to other forms of UL, an index policy offers the same permanent coverage and premium flexibility features, with the following basic differences based on the cash value growth calculation:

  • Upside potential – IUL offers more growth potential than a standard UL policy, but less growth potential than a variable UL without performance caps
  • Downside risk – While a standard UL policy guarantees cash account growth, in an IUL policy only the amount allocated to a fixed-value option is guaranteed to grow – if the reference index drops, it won’t grow at all (assuming a 0% floor); however, IUL has less downside risk than a variable UL policy with no performance floor to limit subaccount losses. 

Indexed universal life insurance vs. whole life insurance

Both types of policies provide permanent protection with an investment component that can grow over time, but IUL (like other UL policies) provides more flexibility to deal with changing circumstances by allowing you the policyholder the option of raising or lowering your premium payments8. In addition, an indexed UL policy gives you one or more index-based options that can help your cash value grow faster while still limiting your downside risk. But there are downsides as well: IUL policies are more complex, the cash value growth and the expenses are decoupled, so the cash value needs to be managed to some degree, if only to ensure that your cash value doesn’t drop below a minimum threshold. Your cash value can stop growing and, in some cases, if the expenses exceed the cash value growth, even go down, especially if you only make minimum premium payments. This could force you to make higher payments later on, lower the death benefit amount, or forego your coverage altogether.

Whole life insurance policies are much simpler in comparison, with level premiums, more cash growth guarantees9 (albeit with less upside potential), and fewer (if any) investing options. However, whole life policy premiums tend to be more expensive, especially compared to the minimum amounts in an IUL policy.

Indexed universal life vs. term life insurance

Term life is the simplest form of life insurance protection: With a typical term policy you pay a set monthly premium for 10, 20, or 30 years, and if you pass away during that term a death benefit is paid to your family. The downside is, the coverage is temporary with little flexibility to deal with changing circumstances and there’s no cash value. Typically, the only substantial change you can make after your term policy is in effect is to convert it to a whole life policy. 

By contrast, indexed UL gives you a more flexible – and complex – financial tool with benefits that can last a lifetime. You get permanent life insurance protection with the freedom to lower your premiums (within contract limits) to a level that may be comparable to a typical term premium. You get the advantages of cash value with the potential for greater growth (compared to other kinds of permanent life) along with the assurance of a performance floor that can help reduce risk. IUL (like a whole life policy) can also provide tax-advantaged estate planning benefits not available with temporary term coverage. 

How to buy an indexed universal life policy

This can be a useful and quite specialized product. If you think these financial products are right for you, we suggest getting professional guidance to arrive at the right solution for your needs. Discuss your situation with a financial professional experienced in helping people get permanent life protection. If you don’t know such a professional, ask a friend or colleague for a recommendation.

Learn more about how to buy life insurance.

Frequently asked questions about indexed universal life insurance coverage

Is indexed universal life insurance an asset you should consider?

If you’re looking for a financial product that combines permanent life insurance protection, flexibility, and upside growth potential in a way that can help limit risk, then this could be an option to consider.   

How does indexed universal life work? 

This type of UL provides many of the same permanent protection and tax-advantaged cash value accumulation benefits as whole life along with added flexibility. In addition to flexible premiums, these financial products let you allocate all or a portion of your cash in an index-based option, giving you the potential for more growth tied to the reference index. On the other hand, your cash account is not guaranteed to grow, particularly when the reference index is negative. This also means you have to keep an eye on your cash value balance over time: If it goes down to zero your premiums could go up, the death benefit can be reduced, or your coverage can be cancelled.

What are the pros and cons of indexed universal life insurance?

This type of coverage offers permanent life insurance protection with tax-advantaged cash value growth and flexibility, but like other types of financial products, it isn’t for everyone. One of the disadvantages of indexed universal life insurance is complexity. Term life insurance policies are much simpler, but they only provide temporary coverage with no cash value component. If you want the simplest form of permanent life insurance with the strongest guarantees for cash value growth, then a whole life policy may be an option to consider. On the other hand, if your income can vary from year to year, and you want permanent life protection with the option of being able to raise or lower your premiums, then a standard UL policy offers more predictable growth, albeit with less upside potential. Finally, a variable UL policy offers even greater growth potential but with more risk – you can actually lose cash value if the value of your investment subaccount decreases.

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1 Dividends are not guaranteed. They are declared annually by Guardian’s Board of Directors. Some whole life polices do not have cash values in the first two years of the policy and don’t pay a dividend until the policy’s third year. Talk to your financial professional and refer to your individual whole life policy illustration for more information.

Guardian, its subsidiaries, agents and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation.

3 An Indexed Universal Life (IUL) policy is not considered a security. Premium and death benefit types are flexible. It’s crediting rate is based on the performance of a stock index with a cap rate (i.e. 10%), a floor (i.e. 0%), and a participation rate (i.e., 100%). This type of universal life policy may lapse due to low or negative performance of the stock index, inadequate funding, and increasing cost of insurance rates

4 A Fixed Universal Life Insurance (UL) policy provides a flexible premium, choice of death benefit options, and a guaranteed crediting rate (i.e. 2%). Policy growth is based on adequate funding, increasing crediting rates, and if costs of insurance is lower than expected. If any of the three factors just mentioned are lower than expected (policy funding and crediting rates), and/or higher than expected (cost of insurance), the policy may lapse. Universal Life Insurance may lapse prematurely due to inadequate funding (low or no premium), increase in cost of insurance rates as the insured grows older, and a low interest crediting rate. This does not apply to universal life policies which have a secondary guarantee, but if the secondary guarantee requirements are not met the policy will most likely lapse.

5 A Variable Universal Life (VUL) policy is considered both life insurance and a security and is sold with a prospectus. Premium and death benefit types are flexible. It’s crediting rate is based on the performance of the underlying investment options provided in the policy. There is no guaranteed interest rate. This type of policy may lapse due to low or negative performance of the underlying investment options, inadequate funding, and increasing cost of insurance rates. See your policy prospectus for more information.

S&P 500 Index is a market index generally considered representative of the stock market as a whole. The index focuses on the large-cap segment of the U.S. equities market. Past performance is not a guarantee of future results. Indices are unmanaged and one cannot invest directly in an index.

Hypothetical examples are not intended to suggest a particular course of action or represent the performance of any particular financial product or security.

8 Permanent life insurance consists of two types: whole life and universal life. Cash value grows in a participating whole life policy through dividends, which are declared annually by the company's board of directors and are not guaranteed. Cash value grows in a universal life policy through credited interest and decreased insurance costs. The cash value of both policy types benefits when the policyholder pays an amount above the required premium.

All whole life insurance policy guarantees are subject to the timely payment of all required premiums and the claims paying ability of the issuing insurance company. Policy loans and withdrawals affect the guarantees by reducing the policy’s death benefit and cash values.

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