IUL Cap Rates: Indexed Universal Life Coverage

Indexed Universal Life (IUL) is a permanent life insurance product with both a death benefit and an account value element. These life coverage products can be linked to varied indexes, such as a stock market index, or can have fixed-rate interest features and minimum and maximum interest rates, which dictate the earning potential of your policy.

The IUL cap rates we’re discussing apply to the account value, which earns interest depending on how well the index that underpins your coverage performs. Cap rates may restrict the amount by which your account value can grow each year. For example, if the index rises by 13% but your cap rate is 10%, your policy will be credited with the maximum 10% interest.

However, even with cap rates, policies linked to an index can potentially offer higher returns compared to traditional fixed-interest insurance products, providing a balance between growth potential and risk management. * 

As with all aspects of life coverage, cap rates will depend on the specific life insurance product you select, the index or group of indexes to which your policy is connected, and the terms and conditions of your coverage.

The average cap rate on an IUL product is between 8% and 12%, * although you may also need to consider minimum guaranteed returns. Variables that may influence your IUL cap rates include:

• How well you keep up with your premium payments: If you do not remit the agreed premiums, your life coverage policy may lapse, or you may find that the death benefit and account value decrease.
• The type or number of indexes your life coverage product is connected to: Some IUL policies allow policyholders to select from a list of potential indexes; others may permit you to pick your preferred indexes.
• Any fixed interest or minimum interest product features, where an account value may partly depend on an index and the relevant cap rates, with the balance attracting fixed interest
• Adjustments you make to your policy, such as loans, withdrawals, or changes to your account value that reduce your premiums without lowering the death benefit

It is important to review all these factors and the full range of product features before deciding whether an IUL product is the right fit for you and will meet your expectations and requirements.

We've mentioned the potential for your account value to be split, which means you might have a percentage of the account that attracts fixed-rate interest and a percentage that is linked to the applicable index. In some cases, you can decide what proportion of the account value is allocated to each type of interest earnings or allocate up to a maximum percentage of the account to each category.

Depending on your objectives, the advantage may be that you have the certainty of some interest earnings against your account value each month or year but can also tap into the potentially higher growth potential indexed life coverage offers.

How Does a Cap Rate Apply When Calculating Interest Earnings?

Life coverage interest payments typically work by recording the value of the selected index at the start of the month and comparing this against the closing value at month-end. If the index has grown, the account value is credited by either the same percentage or the maximum cap value if growth exceeds this. Indexed interest earnings can also be paid annually.

Cap rates are one of several policy features, and the ultimate decision about the suitability of a life insurance product will depend on your long-term plans, the type of insurance you require, and whether the premiums and account value growth potential fit your requirements.

The advantage of IUL products is the ability to grow your account value over time, in addition to the death benefit, which remains payable to your nominated beneficiary. Policyholders may use this life coverage product to grow their savings in a tax-advantaged way while protecting themselves from market volatility.

Although some IUL products have a threshold of 0% interest–which means you lose nothing if the index underperforms or shrinks–others do not. Therefore, the floor rate can prevent you from losing value if the index performance drops.

Unlike a conventional investment product, where all your capital might be at risk, having either a baseline 0% interest level (referred to as a ‘floor rate’) that limits your exposure to losses, can be advantageous, especially when markets are subject to fluctuations.

It is more common to have a 0% floor rate alongside a cap rate, although some policies offer a minimum interest rate of 1%. This ensures that your account value grows marginally or not at all if the index underperforms. 

Note that the costs of your insurance remain payable, including administrative fees, regardless of how much interest your account value earns. However, cap rates may not be guaranteed and could be subject to change or revision at the insurance company's discretion.

IUL coverage enables policyholders to participate indirectly in the stock market, with limited exposure and some degree of protection from poor index performance. To offer these features, insurance companies need to use hedging strategies to make indexed account values viable and sustainable while benefiting the policyholder.

While high index performance might mean a more profitable year for the insurance company, since the interest credited to your account value is subject to the cap, they may also be obliged to absorb losses in other periods while honoring floor rates and other fixed interest payments. The key is not necessarily to look for an IUL product with the highest cap rate but to compare all the risks, rewards, features, and terms of comparable life insurance products to ensure you make informed, confident decisions.