Indexed universal life is permanent life insurance with a cash value account credited according to the movement of a stock market index, most often the S&P 500. The policy is not invested in the index. It holds no shares, receives no dividends, and cannot lose value when the index falls.
That last property is what the product is sold on and it is real. It is also only half of the arrangement. The other half is the ceiling that pays for the floor, and understanding the mechanics is the difference between buying an IUL and being sold one.
How the crediting works
The carrier takes your premium, deducts the cost of insurance and policy charges, and puts the rest into the cash value. Most of that money goes into the carrier’s general account, which is invested conservatively, largely in bonds. A small portion buys options on the index.
At the end of each crediting period, usually a year, the carrier measures the index movement and applies your interest according to three settings.
The floor. The minimum credited, commonly 0%. If the index falls 30%, the account is credited 0% rather than losing 30%. The account still bears its policy charges that year, so a 0% credit is not a flat year for the cash value.
The cap. The maximum credited. If the cap is 9% and the index gains 22%, you receive 9%.
The participation rate. The share of the index movement used. At a 70% participation rate, a 10% index gain credits 7% before any cap applies.
Two more details decide what your actual return looks like. Almost every IUL excludes dividends from the index calculation, and dividends have historically been a meaningful part of total return on the S&P 500. And most policies measure the index point to point across the crediting period, so what happened in between does not count.
The critical fact about caps and participation rates is that they are not guaranteed for the life of the policy. The carrier sets them and can change them, subject to a contractual minimum that is usually far below the rate at issue. A policy sold on a 10% cap can be renewing at 6% a decade later, and nothing improper has happened.
What AG 49-A changed
For years the sales problem with IUL was the illustration. Carriers could show a hypothetical rate of return over decades, and the resulting projection made the product look like it produced returns it had no way of guaranteeing.
The National Association of Insurance Commissioners addressed it in two rounds.
Actuarial Guideline 49 arrived in 2015 and set a method for calculating the maximum rate an IUL could be illustrated at. It left carriers latitude in choosing benchmark index accounts, permitting a different benchmark per index strategy within a policy.
Actuarial Guideline 49-A tightened it and came into effect at the beginning of 2021. It requires a single benchmark index account for all strategies in a policy, and it caps that benchmark: it “cannot exceed 145 percent of annual net investment earned rate.” It also cut the illustrated advantage from borrowing, “reducing the difference in the loan interest rate credits and loan interest rate charges from 100 basis points to 50.”
The purpose was to stop enhanced products from out-illustrating plain ones without out-performing them. As the Society of Actuaries put it, the guideline was meant to ensure “that products with enhancements such as multipliers, cap buy-ups, and so on would not show better results than non-enhanced products.”
What that means for a buyer: an illustration produced after 2021 is more conservative than one produced before, and the loan arbitrage numbers in older presentations were not achievable in the way they were shown. If somebody is showing you an IUL projection, check what year the software is from.
How to read an IUL illustration
An illustration is a projection, not a promise, and it contains two columns that matter far more than the one being pointed at.
- The guaranteed column. What happens if the carrier credits the contractual minimum and charges the maximum permitted cost of insurance. It is a worst case and it usually looks bleak. It is also the only column the carrier is contractually bound to.
- The non-guaranteed column. The projection at the illustrated rate with current charges. This is the one in the sales conversation. Nothing in it is promised.
- The illustrated rate. Ask what it is, and ask what happens at two points lower. A policy that only works at 6.5% and fails at 5% is a policy with no margin.
- Policy charges. Cost of insurance rises with age, and in most policies the carrier may increase it up to a contractual maximum. Charges come out whether the index went up or down.
- The premium being illustrated. Many IUL illustrations assume a specific premium paid every year for decades. Paying less than illustrated does not simply slow the growth. It can put the policy on a path to lapse.
Where an IUL fits, and where it does not
It is a reasonable instrument for a specific situation: a permanent death benefit need, a long time horizon, and a premium the household can genuinely sustain for decades. The tax treatment of cash value growth is real, and for somebody already maxing tax-advantaged retirement accounts the additional room can be worth something.
It is the wrong instrument in several common situations.
- A temporary need. If the exposure ends when the mortgage is paid and the children finish school, term insurance covers it at a fraction of the cost.
- A tight budget. An underfunded IUL is a policy that lapses in its second decade, taking the premiums with it.
- A retirement account substitute. It is life insurance with a tax-advantaged account attached, and it carries insurance charges that a retirement account does not.
- A short horizon. Front-loaded charges mean the early years are the worst years, and surrendering early is where people lose money.
The overfunding limit
Where an IUL is bought largely for the cash value, it gets funded as heavily as the tax code allows. There is a hard line.
Internal Revenue Code section 7702A defines a modified endowment contract as a policy that fails the seven-pay test, which it does if the premium paid in the first seven contract years exceeds the net level premiums that would have paid the contract up in seven annual payments.
Cross that line and the tax treatment of living benefits changes. Loans and withdrawals come out gain-first and are taxable to that extent, with a 10% penalty before age 59 and a half. The death benefit stays income tax free. The reason people bought the policy usually does not.
A policy designed to be overfunded has to be designed against that limit deliberately, which is a design decision made at application, not something to discover in year four.
Questions worth asking before you sign
- What is the current cap, and what is the contractual minimum cap?
- What is the participation rate, and can the carrier change it?
- Does the index calculation include dividends?
- What does the guaranteed column show at year 20 and year 30?
- What happens if I pay the illustrated premium for ten years and then stop?
- Is this policy designed to be a modified endowment contract, and if not, how close to the line is it?
- What is the surrender charge schedule, and how long does it run?
If the answers are vague, that is information. Apex quotes indexed universal life across the more than 20 carriers we hold, alongside term, whole life and annuities, and we will show you the guaranteed column without being asked. See the coverage we write, or talk to a member of our team.
Nothing here is tax or investment advice. Policy features vary by carrier and contract. No policy is bound until a carrier issues it in writing.
