How Market Indexes are Used With Indexed Universal Life (IUL) Insurance

The market indexes that insurers use for their interest crediting formulas are usually price indexes, not total return indexes. Price indexes do not include dividends, interest, or other investment income investors would earn if they purchased a mutual fund tracking one of the major indexes, such as the S&P 500. To get index returns comparable to a mutual fund investing in the S&P 500 in an IUL policy, the market index would have to be the S&P 550 Total Return Index, not the S&P 500 Index. Therefore, the rates of return on the indexes used in IUL policies generally will be lower than the rates of return policyowners would earn if they actually bought the investments in the index (or an efficient mutual fund or ETF tracking the index).

There is no reason, in theory, that companies could not use other indexes of financial assets, such as various bond indexes, REIT indexes, commodity indexes, or precious-metals indexes, etc., in their interest crediting formulas and the industry has begun to see IUL products from some insurers that offer additional index choices.

Three other factors, in addition to the performance of one or more market indexes, enter into the interest crediting formula: a guaranteed minimum crediting rate, a cap rate, and a participation rate. IUL policies usually allow insurers to change these key parameters annually, at the discretion of the insurance company.

  1. Guaranteed minimum crediting rate. The guaranteed minimum crediting rate is the minimum rate insurers will apply to cash value balances if the rate determined by their interest crediting formula is less than the guaranteed minimum rate. For most policies, this minimum rate is 0 percent, but some policies have minimum rates of 1 to 2 percent, annual (or about one-twelfth of this rate when the interest crediting formula uses the monthly point-to-point method). This guaranteed minimum rate prevents the interest crediting formula from computing a rate that would reduce principal value in the cash value account.
  2. Cap rate. The cap rate is an upper limit on the equity index rate that the interest crediting rate formula will use to determine the amount the insurer will credit to cash values. For instance if the cap is 8 percent, insurers will ignore any gains in the indexes over 8 percent when they compute the amounts to credit to cash values.
  3. Participation rate. Insurance companies also control interest crediting through participation rates. For example, if a policy earns 8 percent in any given year, uses an annual point-to-point crediting method, and has a 100 percent participation rate, the interest crediting formula will use the full 8 percent rate in determining amounts the insurer credits to policy cash values. However, if the participation rate is only 60 percent, the interest used in the interest crediting formula will be only 4.8 percent (8 percent × 60 percent). If the participation rate is 140 percent, interest crediting formula would use an 11.2 percent rate to determine the amounts credited to cash values. Participation rates typically vary from between 60 and 150 percent. Also, insurers can adjust the participation rates either up or down, making future cash value growth predictions difficult. A low participation rate on a policy is an obvious sign of a reduced interest crediting potential.

Market-index Interest Crediting Formula

The amount that insurers credit to IUL policy cash values depends on four factors:

  • the Gain rate on the selected equity index for the relevant period: G%
  • the Cap rate, if applicable: C%
  • the guaranteed Minimum rate, if applicable: M%
  • the Participation rate: P%

The cash value crediting rate (CV%) is determined using the following formula:

  • CV% = Max(M%, Min(G%, C%)) × P%

Example. Assume G% = 10%, C% = 7%, M% = 0%, and P% = 80%

CV% = Max(0%, Min(10%, 7%)) × 80%

CV% = Max(0%, 7%) × 80%

CV% = 7% × 80% = 5.6%

The insurer would credit cash values with 5.6% interest.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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