Policyowners of index universal life bear virtually all the disadvantages they would bear if they owned regular universal life policies. Many of these disadvantages stem from or are natural consequences of the advantages IUL offers. Disadvantages include (among others associated with all life insurance in general):
- The flexibility associated with premium payments can be a disadvantage because policyowners can too easily allow their policies to lapse. There is no forced savings feature, because IUL policies do not require premium payments as long as the cash value is sufficient to carry the policy. To reduce the likelihood of lapse, most companies have a voluntary provision where the policyowner agrees to let the insurer “bill” the policyowner for a target premium set by the policyowner. (The insurance market has evolved and many insurers now offer UL policies with provisions and guarantees which are designed to ensure that cash values do not fall below levels necessary to keep the policies in force (i.e., do not lapse as a result of paying inadequate premiums).
- In traditional participating whole life policies, insurers guarantee the mortality and expense charges. In contrast, IUL policies only guarantee that mortality charges and expense rates will not exceed certain maximums. Consequently, policyowners bear more risk of adverse trends in mortality or expenses than if they owned traditional whole life policies. The converse is also true. If the trend of mortality costs and expenses improves, IUL policyowners may participate in the improvement through lower charges.
- Some IUL policies, similar to many traditional whole life policies, use what is called the direct recognition method to determine the amounts the insurer will credit to cash values subject to policy loans. Under this method, insurers credit the current rate to only that portion of the cash value not used to secure a loan. Insurers credit amounts backing loans with the minimum guaranteed rate or a rate usually 1 to 2 percentage points lower than the loan rate. Insurers most commonly use the direct recognition method in policies that have fixed loan rates. Typically, policies with variable loan rates, and some others with fixed loan rates, do not employ the direct recognition method and instead credit current rates on the entire cash value without regard to loans.
- Surrender of the policy within the first fifteen years may result in considerable loss because surrender values reflect the insurance company’s recovery of sales commissions and initial policy expenses. In addition, most IUL policies now assess surrender charges rather than up-front fees or loads. These surrender charges generally decline each year the owner holds the policy. Typically, after about seven to fifteen years insurers assess no explicit charges if the owner surrenders the policy.
- The flexibility with respect to premium payments and death benefits permits policyowners to change the policy in such a way that the policy inadvertently may become a Modified Endowment Contract (MEC) with adverse tax consequences. However, insurers always test all proposed changes to policies and will inform the policyowner if the proposed changes will trigger MEC treatment and adverse tax consequences.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM