Understanding Indexed Universal Life Insurance: A Canadian Guide

When it comes to life insurance, buyers have many options, from easy-to-understand term life insurance to complex financial products such as indexed universal life insurance (IUL).

Indexed Universal Life insurance offers permanent life insurance coverage that lasts the entire life of the policyholder, higher cash value growth potential, and flexibility in premium payments. You can adjust the size of your premium payments and death benefit, and the cash value component is linked to the performance of an underlying index you usually get to choose — which could mean faster cash value growth.

However, indexed universal life insurance is not your regular buy-it-forget-it permanent coverage. It is a complex financial product and requires close monitoring. This blog post tells you everything you need to know about IUL so that you can objectively decide if it is the best fit for you.

Key Takeaways: 

• Compared to term life insurance which offers coverage for a fixed number of years, indexed universal life provides lifelong insurance coverage and grows cash value
• The cash value growth rate is tied to the performance of a stock or bond index
• Compared to term life insurance, Indexed Universal Life insurance protects you against market volatility by guaranteeing a minimum interest rate, but there’s also a cap on your returns
• You can adjust premium payments and death benefits within specified limits

What is indexed universal life insurance? 

An indexed universal life policy combines death benefits with a cash value component. You get coverage for as long as you live, provided you don’t default on premium payments and can access cash value that grows tax-deferred. You can take a loan against it, withdraw from it, or use it to pay policy premiums.

The cash value growth is tied to the performance of a bond or stock index, though your money is not actually invested in the market. With most Indexed Universal Life insurance policies, you also have the fixed interest rate option.

As circumstances change, IUL products allow you to increase or reduce your premiums and death benefits within prescribed limits.

How does indexed universal life insurance work? 

Like other types of permanent life insurance policy, Indexed Universal Life insurance (IUL) has:

• A death benefit that your designated beneficiary or beneficiaries receive upon your death
• Cash value that grows over time

When you pay premiums, a big part of it goes toward the death benefit. Another part goes toward covering administrative expenses and the actual cost of insuring you. The remainder is put into your policy’s cash value component, which acts as a tax-deferred savings account.

Typically, the insurer pays only the death benefit upon your demise, not the cash value. Your policy’s cash value can grow either at a fixed rate or at a rate that fluctuates depending on how the underlying indices perform.

You can choose how the cash value will grow at the time of purchase. You can put all of the cash value in an indexed or fixed account or put some of it in both.

Fixed Account

The cash value grows at a fixed rate set by your insurance company. There’s no element of risk involved, nor is there any potential to accumulate cash value quickly. 

Indexed

The insurer credits interest based on how the selected index performs. The insurance company will likely offer you several sub-account options, all of which are linked to a stock or bond index, reflecting the performance of the stock market. You can pick the sub-accounts to invest cash value in from the available options.

Remember that the insurer doesn’t invest your money in the selected index. Instead, it uses that index’s rate of return to determine your cash value interest rate. It is in variable universal life insurance that you can invest money in stocks or bonds. As you may guess, the element of risk is far greater in these policies.

Some of the terms unique to indexed universal life insurance that you should be familiar with are:

Floors

Your policy’s “floor” refers to the minimum rate at which your cash value will grow, regardless of the market performance. The floor is guaranteed for the duration of your policy and is usually set at 0%. It prevents your cash value from eroding if the underlying index performs poorly.

For example, if the underlying index tanks 15% in a given year, your cash value won’t lose 15%. Instead, 0% will be credited to your cash value. However, a 0% interest rate doesn’t automatically mean your cash value will remain the same as the previous year’s.

Unless you pay extra premiums during the lean growth period, the insurer will deduct the monthly charges from the cash value account, causing its value to dip. In the worst-case scenario, your policy could even lapse if not infused with more premium.

Caps

Since your account doesn’t share all the losses of the underlying index, it’s only fair that it won’t get to share all the gains, either.

Your policy’s cap is the maximum rate that can be credited to your cash value account. For instance, if the policy is capped at 8% and the underlying index jumps up by 12%, your cash value will grow at 8%—not 12%.

The cap is not guaranteed. Your insurer may change it from time to time.

Participation rate

The participation rate determines the portion of index returns that will be credited to your cash value account. If the participation rate is set at 100%, you’ll receive 100% of the interest interest earned by the underlying index up to your account’s cap. 

For instance, if your account’s participation rate and cap are 100% and 10%, respectively, and the index gains are 10%, your returns will be 10%. On the other hand, if your policy has a 50% participation rate, your cash value will be credited with 5% (i.e., 50% of the interest earned by your investments). 

The participation rate is not guaranteed. The insurance company could change it during the life of your policy. 

Flexible premiums and death benefit

Indexed Universal Life insurance allows you to raise or reduce your premiums and death benefit amount within certain limits. Overpaying may help you accumulate more cash since the insurer will route more money into this account. People often opt for this strategy during the years when the market is having a good run. When your policy accumulates cash value, you can even use it to cover the policy premiums. 

But if you are planning to underpay or skip a few premium payments, keep an eye on the policy’s cash value. Your policy remains in force only as long as the cash value is large enough to cover the premium shortfall. 

If the cash value becomes dangerously low, the insurer will contact you and ask you to put more money into the policy. Failure to do so will cause the policy to lapse, meaning your beneficiaries will not receive the death benefit upon your demise. 

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Universal vs. Whole life insurance 

Both universal life and whole life are types of permanent life insurance policies. They share many similarities, and both are good options for someone who wants lifelong coverage with a cash value component. While universal life offers flexibility, whole life’s USP is that many of its features are guaranteed for life.

Some crucial differences between the two are as follows:

Cash value. Both accumulate cash value tax deferred over time. However, universal life plans don’t offer a fixed rate of return, while whole life plans do. Universal life policies offer the potential for more significant cash value accumulation, but your return rates may also be lower at times. With universal life plans, you can use the cash value to pay premiums, but not with whole-life policies.

Premiums. Universal life plans are less costly than comparable whole-life policies. In addition, universal policies let you increase or reduce the premiums within certain limits as your circumstances change. Whole-life premiums, by contrast, remain the same throughout the duration of the policy.

Dividends. Some whole-life policies may pay dividends to you. These policies are called participating whole life insurance policies. You can receive the dividends as cash payments or use them to buy additional coverage or pay the policy premiums. Not all providers offer participating whole-life plans, and for those that do, dividends are subject to change and are not guaranteed. Universal life plans, on the other hand, never pay dividends.

Pros and Cons of Indexed Universal Life Insurance

Pros

• Flexibility: IUL insurance offers flexibility in premium payments and death benefit options. If needed, you can raise or lower your premiums within specific limits. You can also raise or lower the death benefit amount, though you may have to take a medical exam to increase coverage. 
• Potential to grow more cash value: With an IUL policy, you can potentially accumulate more cash value than a comparable whole-life plan since the cash value growth is tied to an index. You also have the option to hedge your risks by putting some of the cash value in a fixed-rate account. 
• Pay premiums using the cash value: This feature can be particularly attractive if you have a variable income. During an exceptionally lean period, you can use the cash value to keep the policy in force. When things return to normal, you may inject more money into the policy to beef up the cash value. 
• Death Benefit: Your beneficiary receives a tax-free lump sum upon your death. 

Cons

• Complexity: Indexed universal life insurance is more complex than whole or term life insurance. You need to have a fair understanding of index performance and terms such as floors, caps, and participation rate. 
• Close monitoring: Indexed Universal Life insurance requires a more hands-on approach, especially during low-return periods. If the cash value drops below a certain level, your policy could lapse, causing you to lose the money you had put in it and the death benefit amount. 
• Risks: The underlying index may not perform as well as projected. If this happens, not only will the investment returns be below par, but you may also have to pay extra premiums just to keep the policy in force. 
•  Fees: Administrative fees for Indexed Universal Life plans are significantly higher than for whole-life policies.

Is indexed universal life insurance right for you? 

Indexed universal life insurance could be a right fit for you if:

• You want a permanent life insurance plan that can potentially accumulate cash value than a whole life 
• You want greater flexibility in premium payments and death benefit options
• You don’t mind closely monitoring your policy

Conclusion

Indexed universal life insurance includes a cash value component along with permanent life insurance coverage. The cash value typically earns interest based on the movement of the underlying index, though your money is not directly invested in stocks or bonds. It is a highly complex product, but it can benefit some. 

Canadian insurance companies generally do not offer indexed universal life insurance. However, thanks to a wide pool of life insurance products available in Canada, and new US competitors entering the market, there are many great options available. If you’re unsure where to start, let Dundas Life help you. Our advisors will take the time to understand your financial goals and offer you transparent, unbiased advice. 

Frequently Asked Questions (FAQs)

Is there any life insurance company in Canada that offers IUL insurance? 

Many Canadian life insurance companies do not sell indexed universal life insurance. However, there are a few insurers that recently started offering this. Reach out to one of our advisors for more details.

How much does indexed universal life insurance cost? 

How much you’ll pay for indexed universal life insurance depends on factors such as age, overall health profile, smoking status, coverage amount, and riders. Your choice of insurer will also impact the coverage cost, as some insurers may offer you a lower price than others. The best way to lower the cost of insurance is to get quotes from multiple providers. 

Can I lose money in an Indexed Universal Life insurance policy? 

Even when the market has a downturn, you’ll unlikely lose money on a life insurance policy. This is because IUL insurance plans come with a guaranteed minimum rate — usually set at 0% — to protect you against sharp market declines. However, there’s also a cap on the maximum interest rate you can earn. 

How does the death benefit work with Indexed universal life insurance? 

The insurer pays the death benefit to your beneficiary upon your death. The death benefit is tax-free unless your estate is the beneficiary. The payout to your beneficiary typically doesn’t include the unused cash value in your policy at the time of your death.