Equity-indexed universal life insurance, or indexed universal life insurance (IUL), is permanent life insurance that offers all the benefits of universal life with accumulation values tied to a stock market index. An EIUL policy has a fixed interest rate component as well as an indexed account option. Whereas traditional UL may credit 4 percent to 6 percent, EIUL has the ability to receive index-linked gains as high as 18 percent or more. In years in which the index does well, interest-crediting rates will rise, and in years in which the index performs poorly, interest crediting will fall. The policyowner can reap the rewards of stock market-type gains and be protected with minimum-guaranteed interest rates in case of stock-market losses. EIUL otherwise has all of the typical features of traditional UL and operates under the same policy mechanics.
The major difference with EIUL is the option to participate indirectly in the upward movement of a stock index without accepting the normal risk associated with investing in the stock market. The actual interest credited to a policy?s cash value is determined by the changes of an equities index. Most insurance companies use the S&P 500 Index as the underlying index for their EIUL product. This combination of the potential to realize higher upside returns without the downside risk makes the EIUL policy a unique and attractive cash-accumulation vehicle.
This product has seen increased sales and an increased number of companies offering it. While many variable universal life policies recorded big losses in the stock-market drop in 2000 and after, EIUL owners recorded no losses or even small gains. In addition, while the low interest-rate environment hurt returns on fixed UL policies, EIUL policies were crediting higher returns due to their links to stock-market indexes.
Using the index
Policyowners can direct premium in the fixed account at the current interest rate or all of a portion of the cash value balance into the indexed account. When premium is transferred into the index account, an indexed account segment is created. Each indexed segment has a segment date where the beginning value of the underlying equity index is recorded and the percentage change in the index value is calculated. Segment index periods vary by company.
Minimum EIUL guarantees are not always credited annually; some companies credit over a five-year period or even the lifetime of the policy. There are several methods of excess interest crediting based on rate changes over daily, monthly and annual periods, such as annual point-to-point, monthly averaging, daily averaging and variations on these methods.
The index-crediting method is the process of calculating the index growth rate at the end of the index period. Nearly every company offering EIUL today uses the annual point-to-point method. With this method, the beginning equity-index value is recorded and compared with the index value at the end of the period.
The stock index is the EIUL?s benchmark upon which the crediting of excess interest is based. Most policies use a participation rate, which is the percentage of positive movement credited to the policy. For example, if the S&P 500 increased 10 percent, and the EIUL had an annual participation rate of 60 percent, the policy would receive interest credited of 6 percent at the policy anniversary. Participation rates today range from 60 percent to 135 percent. There is a maximum interest rate that will be credited to the EIUL policy for the year or period, called the cap rate. The actual growth cap rate varies by company, but is currently around 10 percent to 14 percent annually, with guaranteed minimum cap rates around 3 percent to 4 percent. Participation and growth cap rates may be changed at the company?s discretion.
In years in which the underlying equity index is flat or loses value, the cash value is subject to the growth floor. The floor is generally guaranteed to be 0 percent if the return is negative. Additionally, most companies offer a cumulative guarantee that ensures a minimum effective interest rate over a given period. For example, one company guarantees that over a five-year period, if the segment growth rate does not reflect at least a 2 percent minimum effective annual interest rate, the segment value will be increased to that 2 percent level.
Product innovations are developing rapidly with this product. A few companies offer an extended no-lapse product similar to no-lapse UL. Among cash value products, these provide the most insurance for the lowest premiums. Several carriers offer ?rainbow? crediting methods, involving the use of more than one index. Insurers then credit the greatest percentage from the best performing index and correspondingly lower proportions of the others. One carrier, for example, credits 75 percent of the return from the best performing index, 25 percent from the next best and 0 percent from the third index. One company has introduced a return-of-premium product. Several companies have a single premium product, and there are indexed survivorship UL products on the market.
Behind the EIUL Scenes
How does the insurance company offer a policy that has the upside potential for stock market type gains without passing the risk to the policyowner? The truth is that the insurer is not actually investing in an equity index. Instead, it is investing premiums in fixed-interest investments and using the earnings from those investments to purchase call options.
Call options provide the right, but not the obligation, to purchase a specific amount of a given index at a specified price within a specified period. If the equity index increases, the insurance company can exercise the option at a previously agreed upon price and then credit the interest to the policyowner. If the equity index decreases, the company will not exercise the option, and has lost only the cost of the option, so the insurer does not need to credit a negative interest rate to the policy?s account. The price for call options varies by economic conditions and the interest rate environment. To have the flexibility to match options costs with potential benefits, the insurer must limit the upside interest credited, through participation rates and growth caps, in times when market conditions dictate.
Glenn E. Stevick Jr., CLU, ChFC, LUTCF, a member of Tri-County AIFA (N.J.), is an LUTC author and editor, and assistant professor of insurance at The American College. Contact him at Glenn.Stevick@TheAmericanCollege.edu.