Mechanics of IUL

Comparison and contrast between Increasing vs. Level Death Benefit IUL designs, Cash Value vs. Accumulated Value accounts, and Wash vs. Participating loans.

Indexed Universal Life (IUL) policies can be designed with a Level or Increasing Death Benefit (DB), referred to as option A and B respectively. The Cash Value (CV) can be accessed via a policy loan, and the remaining CV gets passed on as part of the DB to the beneficiaries. The gap between the policy DB and the available CV needs to be covered by purchasing life insurance. In a Level DB design, this amount will decrease as the CV grows. In an Increasing DB design, the DB increases by the same amount as the CV growth. The Cost of Insurance (COI) increases with age. However, with the Option A design, since the coverage need reduces with age, the overall COI charge remains contained.

Let us now take a closer look at an IUL policy. IUL has two accounts: Cash Value (CV) and Accumulation Value (AV). CV is the money available to the policy owner at any given time. AV is more for internal accounting, and it can be higher than the CV either because of surrender charge, which typically applies during the first 10 years of the policy, or when a loan is taken. AV is the sum of the CV and the loan balance. Premiums and market credit increase the value of AV/CV, while fees and withdrawals decrease their value.

The income is taken from an IUL by way of a policy loan. Loans are tax-free and need not be paid back. The accruing loan interest increases the outstanding loan balance. Loans reduce CV, but AV is not affected. There are two types of loans: wash loans and participating loans. Wash loans charge a close to 0% interest rate but the outstanding loan balance does not earn any market credits. Participating loans charge a fixed interest rate (typically 4-6%) but the outstanding loan balance continues to earn market credit along with the rest of the CV balance. Based on past market performance, the arbitrage between the loan interest and index credit is expected to be positive, and should generate positive cash flow into the CV. We used the participating loan option to illustrate an IUL investment scenario in our blog “How IUL Works.”

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