The 0.00% floor sounds too good to be true, doesn’t it?

Years ago when I first heard about this IUL feature, I thought the same thing.  Most people do not truly understand how this feature actually works, and this seemingly mysterious black box makes intelligent people skeptical (as they should be).  I am still shocked that the life insurance industry does not do a better job of explaining how the floor & cap proposition mechanically works in practice, because once you understand it, you will appreciate just how well thought out (and how sustainable) this design element truly is.

To understand how an IUL’s crediting method works, we must first discuss the origin of permanent life insurance policies in general.  We will start with one type of permanent life insurance policy: Whole Life.  

Whole Life is not synonymous with the category of ALL permanent life insurance policies.  Whole Life is one of several different types of permanent life insurance.  Compared to Term life insurance (which expires after the term period), Whole Life was originally designed to give a person life insurance coverage that would last for their whole/entire life, hence the name Whole Life.

The general concept was that the premiums (approximately four times greater than Term insurance premiums) would not only pay for the cost of insurance, but the excess premiums would be invested in the life insurance company itself (somewhat similar to buying stock in the insurance company – not exactly, but similar).  These excess premiums invested in the life insurance company would yield a dividend based on how well the life insurance company’s overall investment portfolio did in the previous year.  A dividend would be declared, then it would be credited to the policy’s cash value the following year.  The cash value would then be used to pay for the ongoing Cost Of Insurance (long after the insured person stopped paying premiums) which enabled the policy to last until the end of the insured person’s life – insuring them for their whole life.  In addition, most Whole Life products also guarantee a minimum annual return (typically around 4.00%). 

One of the main benefits of the cash value accumulation inside a life insurance policy is tax-free growth (due to IRS tax code 7702).  This favorable tax treatment eventually led to the category of permanent life insurance expanding into several additional products with more aggressive underlying investments.

When Variable Universal Life (VUL) insurance products hit the market, the idea was to use mutual funds as the underlying investments instead of the life insurance carrier’s guaranteed return and dividend crediting method.  In concept, the client could use the same mutual funds they were already investing in, but by housing them inside a life insurance construct, the gains on these mutual funds would be tax-free. 

It was a great concept in theory, especially when mutual fund returns were sky-high like they were in the mid-80’s and 90’s.  But when the tech bubble burst in the early 2000’s, it was a rude awakening for VULs because in order to offset the high policy expenses that were built into the VUL construction, the underlying mutual fund returns needed to perform as they did in the previous two decades.  When this did not happen during The Lost Decade (2000-2009 wherein the S&P 500 produced several negative returns during this ten-year run), these expense charges began to outpace the VULs’ credits.  Today, many advisors and consumers have shifted their interest away from VUL policies towards IUL policies. 

Unlike a VUL policy that can experience negative returns, IULs have a floor – a minimum index credit – which is typically 0.00%.  The question is, “How is this possible and how is this sustainable?”

If you recall, the Whole Life product crediting method included a guaranteed return plus a dividend based on how profitable the life insurance company was in the previous year.  In an IUL product, the carrier essentially takes the guaranteed return they were going to automatically credit in the Whole Life policy and uses that amount as the budget to purchase options contracts. 

I am going to attempt to explain the general mechanics of how this works without getting too overly detailed, for the full explanation would require a 1,000+ page book.  In my attempt to teach you the basics, I will articulate this as succinctly as possible.  Additionally, in the spirit of full disclosure, there are details that vary from carrier to carrier, product to product. 

For example, Allianz does not currently use investment banking firms to purchase their options contracts.  They do it in-house due to the massive amount of options purchasing they do to support both their IUL products and their Indexed Annuities, so their method of utilizing S&P 500-correlated options contracts is different.  I am not saying the Allianz’s IUL products are necessarily better or worse than other carriers’ IULs.  I am just mentioning their unique way of buying options.

As another example of differentiation, Pacific Life applies their index credit to the Average Monthly Accumulated Value, whereas most other carriers apply their index credit to the EOY Accumulated Value, which is a lower value.  Again, I am not saying that Pacific Life’s IUL products are necessarily better or worse than other carriers’ IULs.  I am just mentioning their unique way calculating their index crediting method.

These are just two of many examples of how each product from each carrier is built slightly differently, however learning about IULs in general is best done by using one hypothetical example.

In this hypothetical example, the carrier purchases options from an investment banking firm – S&P 500-correlated options with a 0.00% floor.  The budget for this type of arrangement is approximately 4.00% of the life insurance premium ($4,000 per $100,000 in insurance premium).  But remember, that was the amount the carrier was going to automatically credit the Whole Life policy’s cash value anyway, so in this scenario, the carrier has zero exposure because that allocation was already built into the pricing. 

The investment banking firm takes the $4,000 as the options premium, and if the S&P 500 produces a negative return, they absorb the losses and pass the benefit of the 0.00% floor on to the carrier, who then passes the benefit on to the policy.  Though the investment banking firm absorbs the loss below 0.00%, they do get to keep the $4,000 options premium.

If the S&P 500 produces a positive return, they pass that return through to the carrier, who then passes the return through to the policy, up to a maximum allowable return (the cap), and any return above the cap is then retained by the investment banking firm in addition to the $4,000 options premium per $100,000 in insurance premium.

The carrier does not incur any risk in a negative S&P 500 return scenario, and they do not participate in any of the upside above the cap either.  Remember, the $4,000 options premium they paid the investment banking firm was already budgeted into the contract pricing, so for the policy owner, the decision to buy an IUL instead of a Whole Life policy is based on the belief that over time, the returns of the S&P 500-correlated index fund with a floor and cap with outpace the dividend returns of a Whole Life product. 

This decision could be based on the client analyzing historical S&P 500 performance using the floor and cap assumptions, and comparing them to historical Whole Life dividend returns.  This decision could also be influenced by the conservative nature of the Whole Life dividend crediting history which has never produced a 0.00% return, let alone a negative return. 

However, there are several elements in addition to the dividend or index return that also determine the actual cash value yield over time.  For example, policy charges need to be factored into the equation.  The actual sequence of returns that a policy experiences also plays a major role in accumulation. 

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