Index Universal Life Insurance vs. Variable Universal Life Insurance

Helping secure your financial legacy may involve choosing permanent life insurance to help protect your loved ones. It can also be an essential aspect of a long-term financial strategy. This comparison delves into index universal life insurance (IUL) versus variable universal insurance (VUL), two policies that offer lifelong coverage and can accrue cash value. It’s worth noting that there are other forms of life insurance that may be more aligned with your goals, and this article is not intended to compare all forms of life insurance. For more information, you should consult with your licensed insurance agent.

The two options we’ll discuss today – IUL and VUL – are not only about helping provide a financial safety net for your loved ones but also about providing some financial agility during your lifetime, with opportunities to leverage cash value for loans, retirement income, or other financial goals. Both IUL and VUL policies offer flexibility with their premium payments, allowing policyholders to adjust their financial commitment according to their changing circumstances. Index life insurance is generally more adaptable, while variable universal insurance may necessitate higher premiums, particularly if the chosen investments underperform.

Index universal life insurance (IUL) is a form of permanent life insurance that has a cash value component that can grow based, in part, on the performance of a stock market index. IUL is not an investment, and you cannot invest in an index directly. IUL offers index interest crediting potential by tracking the performance of an underlying index. This means policyholders may enjoy a potentially higher interest as compared to a whole life product that usually has a fixed interest rate. However, if the underlying index does not perform well during the specified index crediting period, you may earn no interest.

UL policies offer downside protection but, in turn, may limit the amount of index interest credited through participation rates or caps on the index interest earned. A participation rate on index interest describes the percentage of an index’s positive performance. For example, let’s say the underlying index increases by 10% and the participation rate is 50%. In this example, the credited interest would equal 5% (50% of 10% equals 5%). The participation rate is set by the insurance company and applies to a specific index interest crediting period. It can change at the beginning of a new crediting period.

Some accounts utilize a cap to limit upside potential.  So, if your index interest crediting account has a cap of 8%, then, using the hypothetical performance above  of10%, your index interest would be capped at 8%. Like participation rates, caps are set by the insurance company at the beginning of a crediting period and can change at the beginning of the next crediting period.

However, IULs also usually have a floor rate, which means there is a guaranteed minimum interest rate, though in some cases the floor may be set at zero. This can be beneficial when the index posts a negative return, because it means you will always have a minimum return and cannot lose money due to negative index performance (though cash value can be reduced due to fees and expenses). These floors tend to be relatively low, usually ranging from 1% to 3%.

Variable universal insurance, like IUL, is a form of permanent life insurance. In fact, it shares many of the same features of an IUL in most cases, including tax-advantaged growth potential and a typically tax-free death benefit, the ability to pay flexible premiums, and cash value accumulation potential.

So, what’s the difference? Let’s take a look at how the funds in the cash value subaccount are managed. In a variable universal insurance product, the cash value can be invested directly into securities through subaccounts that are similar to mutual funds. These policies, however, don’t have participation rates, caps, or floors the way IULs usually do.

What does that mean? In a variable universal insurance policy, the cash value will typically reflect the actual performance of the subaccounts without any limits. This can be beneficial because it means you may be able to earn a higher return than with an IUL. The downside? You could also get a lower return or even lose money. This can have a negative impact on the death benefit.

Cash Value Comparison

Index universal life insurance offers a measured strategy for cash value growth, ensuring protection from market declines with its guaranteed minimum interest rates. Because it is not an investment, you cannot suffer a loss due to market performance. Variable universal life insurance, in contrast, embraces the full spectrum of market performance, potentially leading to higher rewards and higher risks. It’s important to note that the cash value of both types of policies can be reduced by fees and expenses.

Risk and Returns

The risk-reward spectrum of index and variable universal insurance is defined by their growth structures. Because index universal life insurance is not an investment, it provides a floor, allowing the policy owner the comfort of knowing their cash value will not be eroded due to market loss. Caps and participation rates limit the upside potential. Variable universal insurance foregoes any guarantees, prioritizing growth potential at the cost of exposing the policy's cash value to market volatility. 

To make an informed decision between IUL and VUL, you should work with an insurance-licensed agent who is also registered as a registered representative through a FINRA-registered broker-dealer to assess your risk tolerance, objectives, and insurance needs. You should also consider policy fees and the potential for additional costs. 

If you are concerned about downside risk but still want the opportunity for attractive growth potential of your cash value, IUL could be the match for you. Conversely, if you embrace higher risk and reward potential when considering life insurance, VUL might be the path to take. Both policies offer the lifelong protection and cash value growth potential sought in life insurance, but the right choice is individual to your circumstances and goals.

Both IUL and VUL life insurance policies have their own pros and cons, but ultimately, it depends on you and your goals regarding life insurance, your objectives, risk tolerance and other needs. IUL may be a better fit for someone who wants a little more certainty with their cash value account because these products offer a floor to protect against market downturns and often include a guaranteed minimum interest rate.

These policies can also offer flexible premiums, because policyholders can use the cash value account to help pay their monthly premiums, reducing their out-of-pocket cost. It’s important to understand the limitations, because insufficient cash value can cause the policy to lapse. However, variable universal products can be attractive for those who are willing to take a chance on higher growth potential. 

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