What is Indexed Universal Life Insurance (IUL Explained)

Hello and welcome to the channel. Today we're talking life insurance, specifically indexed universal life, also referred to as the IUL. And I wanna start off by giving you a basic foundation of life insurance because whether you're experienced or this is your first time learning about life insurance, I want you to be able to follow along with this video with no problem. So when it comes to life insurance, it's pretty much broken in two different categories. You have term life insurance and you have permanent life insurance. Term life insurance is pure insurance, meaning it has no cash value at all, only a death benefit. And typically these policies last anywhere from 10 to 20 years. And when that specific timeframe is over, your policy ends. And because of that, term life insurance is extremely affordable. So it's pretty straightforward. Now, unlike term insurance, permanent insurance is designed to last you for the rest of your life. And that's considered to be until age 100 or age 120, depending on the policy. And that's why they call it permanent because term is temporary and permanent will last you till the day you die, just as long as you pay your premiums. Another thing that permanent life insurance has is cash value. And I'll be taking a deeper dive into exactly how the cash value works based on this specific policy. Now, when it comes to permanent insurance, there are several types you can choose from. But again, for this specific video, we're gonna focus on indexed universal life or IUL. Now, the first thing I wanna clear up is that indexed universal life is not the same as whole life insurance. And that's one of the biggest misconceptions I always run across. I hear these two policy types used as if they're the same thing, but they are completely different. And I'll make a separate video specifically on whole life. That way, once you watch that video and then watch this video, you'll have a clear understanding of all the similarities and all the differences because there are quite a few. And I know for some of you, the IUL may be something that you just recently heard about or just recently decided to learn about, but it was actually created back in 1997. Ironically, the same year the Roth IRA was created. And I say that because if you look online, you'll find a ton of articles comparing the two products. And I'll probably do a future video on that as well. So when it comes to the basics of IUL, here's exactly how it works. The policy has what's called a premium payment. And that's just the terminology used when you're sending your money directly to the insurance company. Now, these premium payments can be done monthly, quarterly, semi-annual, or even annually. And when the insurance companies receive these premium payments, the first thing they do is deduct any costs associated with the policy to cover that month. Then any money you have above the cost of the policy is what lands inside of your cash value. And your cash value is just an internal savings account inside of your policy. So it's money you'll have access to in the future if you desire. Now, when it comes to the cash value of an IUL, it's very important to understand the main goal is to capture market appreciation while eliminating downside risk. So here's how that works. Typically, your IUL will have two different cash value accounts. One is an interest-bearing account that generates a fixed rate of return, and that's often referred to as the general account. So that means your cash value will earn interest credit based on a fixed rate of return. For example, if the fixed rate of return was 3%, you know exactly what you'll be earning for that entire year. And the other type of cash value account tracks one or more market indexes. And a market index is something like the S&P 500. And the S&P 500 represents the performance of about 500 large-cap companies in the US. So usually, all the big companies that you know by name are part of the S&P 500. And different companies will give you access to different indexes. So this cash value account doesn't link your index credits to a fixed rate of return, but instead, the index credits are linked to the performance of whatever market it is that you're following. So here's an example of that. As the index you're following grows, your cash value will receive index credits based on the performance of that index up into a cap. So let's say that cap was 10%. If the net dividend index growth rate was 5%, then your index credit will be 5%. And that credit goes directly towards your cash value. And if the index grew 10%, then your index credit would be 10% towards your cash value. However, if the index grew 15%, your index credit would still only be 10%. And the reason for that is that 10% cap that I mentioned. You have to understand that your index credits will never be more than your cap, regardless of how great the index performs. And for the most part, the cap is determined by whatever IUL company you use, because different companies have different cap rates. So that gives you a basic understanding of how you get growth inside of your cash value when it comes to IUL. Now, in addition to your cash value having a cap on the interest credits you can receive, there's also a floor that gives you downside protection against losses. And that floor is usually 0%. Meaning if the index you're following stayed flat and received a 0% rate of return, you would get 0% interest credit towards your policy, which means you get nothing. Now, let's say the market crashed and did negative 10% for that same year. In that scenario, your interest credit will also be 0%. Because no matter how poorly the index performs, you will never receive a negative interest deduction from your cash value because of that negative performance. So that's what's considered downside protection. And all your gains from previous years will not be affected either. So the interest credits towards your cash value can only go up or be flat at zero. It can never be a negative deduction from your account based on the performance of an index. Which means you'll never see the market crash 10% and then see your cash value decrease by 10% because of that crash. So your cash value is protected from those losses. So now that you understand the caps and floors when it comes to the IUL, next I wanna take an even deeper dive and tackle the number one question people have when it comes to index universal life. And unfortunately, I see this question dodged by social media influencers, YouTubers, and even life insurance agents themselves. And mainly because to answer this question, you really have to understand how the IUL works. Because this part you can't fake. And that question is how in the world is it possible to capture market appreciation while at the same time eliminating downside risk? It almost sounds too good to be true. And you might be thinking the exact same thing right now while you're watching this video. So if that's the case, I got you covered. So the quick and simple answer to that question is that the insurance company buys options. And that's how they're able to capture the market appreciation while eliminating the downside risk. But I don't wanna leave you with just a simple basic answer to that question. I want you to walk away from this video really understanding what's going on when it comes to the cash value. So let's first start by learning what options are and how they work. So options are contracts giving the owner the right to buy or sell an underlining asset at a fixed price on or before a specific future date. So an option allows you to buy something in the future if you choose to. So here's a really good analogy for understanding options. Let's say you wanna buy a house for $300,000. But the market seems a little shaky, it's a little unstable, so you're not really sure what direction the housing market is gonna go in. I mean, the last thing you wanna do is buy a house and then have the housing market crash on you. But at the same time, you don't wanna miss out on the opportunity to buy, and then you see the house that should have been yours start to appreciate an increase in value. So you're pretty much torn between the two ideas. But what if there was a way for you to look into the future and base your decision on what you know is going to happen for sure? Well, options don't really do that, but they get really close to that. Here's what I mean. Let's say the seller allows you to buy an option on that property for $5,000. And that option will give you the choice to purchase that home one year from now at today's price of $300,000. So now let's fast forward to a year from now, and we're gonna assume that that house is now worth $400,000. Now, because you purchased that option, the owner is now legally obligated to sell you that home for that original $300,000 price. So you instantly walk into $95,000 of profit as soon as you take ownership of that home. So that option will be considered in the money because you made an instant profit. But now let's say over that same year's time, the house decreased to $200,000. With that option, you also have the choice to not purchase that home for $300,000 knowing it's only worth $200,000. So in that scenario, the owner still keeps the $500,000 you paid for the option, but you get to walk away with no other obligations. And that will be considered allowing the option to expire worthless. So that's the overall concept of how options work. It allows you the choice or option to purchase something in the future after you already know the price. So what the insurance company does is buy options on the index with a cap. And when the market is positive, the insurance company chooses to exercise those options because it's considered in the money. And those gains are what's used to credit your cash value. And if the index performs at a negative number, the insurance company does not exercise those options, they allow them to expire worthless because they'll never buy a negative performing index. And that's why you don't get any negative interest deductions when the market is down. So now, what about the money actually used to purchase the options? From the example, it seemed like that money would be lost, right? Which technically is true, but let me show you how it was done so you can see how it doesn't affect your cash value. Let's say you have a cash value of $10,000. That $10,000 is put inside the life insurance general account. And for this example, we're gonna assume that general account is earning a fixed rate of return of 3%. So based on the math, that $10,000 is gonna earn $300 of interest. Now, remember inside the IUL, there are two different cash value accounts. There's a fixed account and there's also an index account. So let's say for whatever reason, you want your money allocated towards the fixed account only. In that scenario, you'll be credited $300, which will bring your cash value account balance to $10,300 at the end of that 12 month period. So that's how you get guaranteed growth if that's something that you're looking for. Now, let's say you wanna choose the index option. Instead of the insurance company giving you the $300, they'll use that $300 as a budget to go buy options on the market index with the cap. And if that index performs well, those options become in the money. And again, that just means profits were made. And those profits are what allows you to earn those interest credits to your cash value up until the cap. And on the flip side, if the market index crashes or performs negative, the insurance companies just allow those options to expire worthless. But your original $10,000 is not affected because it literally was never touched. Only the interest earned was used as leverage to buy the options. And that's how you're able to capture market appreciation while eliminating downside risk. And having the flexibility of both fixed accounts and index accounts can be very useful, especially when it comes to your goals or market conditions at the time. Now, when it comes to structuring your policy, your goals are an important factor to take into consideration because you always want your policies set up to meet your specific needs. And one way you can structure an IUL is more for a death benefit focus. And this will be for someone that likes the way the IUL performs, they like the way the indexes credit, but at the same time, they want a permanent death benefit, which means term life insurance wouldn't fit their overall goal. So the idea would be to get the highest death benefit possible while at the same time keeping the policy affordable. And what's considered affordable will vary from person to person. Now, when you get an IUL, your agent will give you what's called a policy illustration. This illustration will give you future projections on your cash value and your death benefit. So here are a few areas I want you to look at. I want you to look at the guarantee column because that'll show you the worst case scenario. And the example of a worst case scenario would be if the market were to crash every single year for the next 100 years straight. And I'm not sure the statistical odds of something like that realistically happening, but I'm pretty sure it's extremely small, but I want you to look at it anyway. Next, I want you to look at the fixed rate of return so you can see what that projection looks like. And lastly, look at a very conservative index example. And the reason I say this is because I believe transparency is very important in anything you do financially. And I also love the idea of under-promising and over-delivering because I'm sure you won't be upset if the index credits are a lot higher than you planned them to be. Now, another way your policy can be structured is more for a cash value focus. And this is definitely the more popular of the two options. And it's the complete opposite of the first example. You're not looking for a high death benefit, you're actually looking for the lowest death benefit possible according to the IRS guidelines. And the death benefit amount is determined by how much you plan on putting into the policy. And the reason you wanna lower death benefit is because that lowers the overall cost of the policy, which means when you put money in, less money is paying for the death benefit and more money's going towards the cash value. Because remember, all the money you put in above the cost of the policy is what lands inside of your cash value. So when you hear people who use the term properly structured, this is what they're referring to. And that's a low death benefit with a high cash value focus. So I always recommend that you use a good and ethical agent to help you design these policies to meet your specific needs. Now next, I wanna go over how you actually access the money in your cash value. So when it comes down to it, there's two options you can use. The first is a withdrawal. And that's pretty straightforward. You just request withdrawal directly from your cash value. And most companies will just send you a check in the mail. But you must understand that any withdrawal above your cost basis, which is just what you put in out of your own pocket, will be subject to income tax. So because of the tax liability, this option is rarely used. I mean, it's so seldomly used that a lot of people don't even know it's an option for them. Now the other way to get your money out is through a policy loan. Now when you get a policy loan, you're not actually borrowing money from your own cash value. You're actually getting a loan directly from the insurance company. And what they'll do is they'll use your cash value as collateral to help secure that loan. And there are a few reasons why somebody would choose to take a loan instead of taking a withdrawal. And one of them being taxes. Because loans are not taxable, so it's a way you can access the money without getting hit with a tax bill. And the next reason are interest credits. Because remember, your loan is coming directly from the insurance company and not from your cash value. So because of that, your cash value is still able to earn interest because it technically was never removed from your policy. And the third reason is because you're able to pay back the loans on your own terms. You won't be hit with any required loan repayment bills or anything like that. If you want, you can pay back the loan in five years, 10 years, or even not at all. Which means if you were to die with an outstanding loan, what happens is the insurance company will pay themselves back from your net death benefit. Then whatever's left over will pay to your beneficiaries 100% income tax free. So the fact that you have two different cash value accounts inside of your IUL gives you two different loan options. The first type of loan you can use is a fixed loan. So here's how that works. So let's say you have $50,000 inside your cash value index account. And you decide you wanna take a fixed loan for $10,000. The insurance company will be the one giving you the loan. And we're gonna assume they're gonna charge you an interest rate of 3% fixed. So what they'll do is take $10,000 out of your index account and move it to the general account. And that general account is earning a 3% fixed interest rate. And since that $10,000 was moved from the index account to the fixed account, that means your index account now holds $40,000. So because you're being charged 3% interest on $10,000 and at the same time you're earning 3% on $10,000, that creates what's called a zero net loan or a wash loan. And that happens when the interest rate you're being charged is the same as the interest rate that you're earning. So they pretty much cancel each other out. So this would be considered the most conservative way to take out a policy loan because everything that's gonna happen for that year is predictable. Now the other type of loan you can get is an alternate loan. Now with an alternate loan, you're still getting the money directly from the insurance company, but they're gonna charge you a higher interest rate. Let's use 5% for this example. Now here's why someone may be willing to pay a higher interest rate on this specific type of loan. Because with this type of loan, the insurance company is not gonna move $10,000 from your index account and put it into a general account earning 3%. They're gonna allow your cash value to stay exactly where it is, earning whatever interest credits come from the performance of the market. So here you have an opportunity to create an arbitrage or a spread on the actual loan. Because if the index credit produces 7% and your loan charges only 5%, you actually make a 2% spread. And that happens anytime the index credit is higher than the interest charge. And the potential for earning a spread is why this type of loan can be intriguing for some people. However, if the market were to crash or perform at a zero, you won't get any interest credits, but at the same time, you're still gonna be charged that 5% for the loan. So in this case, you'll have a negative 5% spread. So pretty much the loan type you choose is depending upon how you feel the market's gonna perform in the future. And a lot of companies allow you to switch from one loan type to the next loan type every anniversary of that loan. So you don't have to be stuck in one loan type forever if you don't wanna be. And as far as how soon you can take a loan from your policy, most policies allow you to take a loan after about one month. And that loan is based on the percent of your surrender value, not your cash value. Because for about the first 10 years of the policy, your surrender value will be a smaller number than your actual cash value. And that's part of the projected illustration that I mentioned earlier. So you'll be able to see the approximate surrender value each year of the policy moving forward. That'll help you manage your expectations and help you properly plan for the future. And just like any financial product, you definitely wanna know what the downsides are. So I'm gonna give them to you in no particular order. The first is that if you're looking for life insurance coverage, the cost of an IUL will be more than the cost of term life insurance. Mainly because term only lasts for a set amount of years, usually 10, 20, or 30 years, and then the policy's over. And term also doesn't have the cash value component. So side by side, term insurance will definitely be more affordable than IUL. The next downside is that if you're in an index account and the market performs flat or negative, you will not get any interest credit towards your cash value. Now you won't get any interest deductions either, but your account won't grow that year. Because remember, your cash value only receives interest credits when the market is up. So that's something you definitely wanna be aware of. Next is the fact that your growth is unpredictable. Because since you're following the market, every year can be different. Actually, every year will be different. So that's why I mentioned to look at conservative illustration growth rates. Because that way, great years will be a bonus for you versus being a necessity for you. And I feel that's the safest route to go. Because you have things like interest rates, option prices, and market performance that determine your interest credits and determine the caps. Because the truth of the matter is you have some people that are very confident in the market and they believe the market's gonna do a certain projection over a certain period of years. And then you have others that may not know how the market works at all. So the IUL's more of a middle ground between someone that's extremely aggressive and someone that's extremely conservative. Because remember, the IUL's designed to capture market appreciation while at the same time eliminating the downside risk. So I hope this video was helpful. If you have any questions, feel free to leave them in the comments section below. And don't forget to like this video so YouTube knows to send it to more people. And of course, subscribe to the channel for more financial content. And I will see you in the next video.