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by: Zeus Design

Universal Life Insurance

How an Equity Indexed Universal Life Policy Works
Equity-indexed universal life insurance works very similar to traditional universal life insurance with the exception that the equity indexed policy allows an individual to allocate excess premium payments to an account indirectly linked to the movements of a stock index.

Traditional universal life insurance offers a fixed interest rate option with a guaranteed minimum around 2-4% annually depending on the insurance company. The current interest rate for a traditional universal life policy will vary but can never be lower than the guaranteed minimum. An equity indexed universal life policy has a fixed interest rate component as well as an indexed account option that offers the potential to earn higher rates of interest similar to equity market type returns.

Equity Indexed Policy Costs

As is the case with most universal life policies, when the equity indexed policyholder makes a premium payment, the insurance company first deducts a premium load. The premium load is a combination of a premium expense charge plus a premium tax charge and can range anywhere from 3-9% of the total premium depending on the insurance company. After the premium load is deducted, the balance of the premium payment is deposited into a fixed account which earns fixed interest at a current prevailing rate with a minimum guaranteed rate of generally 2-3% annually. On each monthly policy anniversary, deductions are taken from the fixed account for administration charges, expense charges, and costs for insurance including riders. For more information on policy charges and costs with universal life insurance, see “How a Universal Life insurance Policy Works.”

Equity Indexed Premium Allocation Options: Fixed or Indexed

After monthly policy costs are deducted, policyholders have the option to maintain the fund balance in the fixed account at the current interest rate or to transfer a portion or all of the cash value balance directly to an indexed account. Most companies will allow transfers from the fixed account to the indexed account on a monthly or quarterly basis. When a premium transfer is made from the fixed account to the indexed account, an indexed account segment or index period is created. Each indexed segment has a segment date where the beginning value of the underlying equity index is recorded. At the end of the designated segment term or index period, an ending value of the index is recorded and the percentage change in the index value is calculated.

Segment terms and index periods vary by insurance company. Some companies offer a one year index period with index credits calculated at the end of every index segment. Other companies will offer a five or six year segment term with an annual or bi-annual segment anniversary. In the latter case, a segment growth rate is calculated annually or bi-annually at the segment anniversary. However, the segment term would not end until the end of the fifth or sixth segment anniversary respectively.

Equity Index Crediting Methods: Annual Point to Point vs. Daily Averaging

The index crediting method can be thought of as the process of calculating the index growth rate at the end of the index period. There are two primary index crediting methods that are currently used: the annual point-to-point method and the daily averaging method.

Nearly every company offering equity indexed universal life policies today uses the annual point-to-point method to calculate the index growth rate. With the annual point-to-point method, the beginning equity index value is recorded and compared to the ending equity index value at the end of the index period. If the ending index value is higher, interest is credited annually subject to the participation rate and growth cap. If the ending index value is lower then no interest is credited. For more details see below, “How is interest credited in an indexed life policy?”

A far lesser used crediting method; the daily averaging method takes the average daily indexed value over the entire index period and compares this average with the beginning index value at the first day of the index segment. If the average indexed value over the entire index period is greater that the beginning index value, interest is credited subject to the participation rate only as there is no cap with daily averaging.

The daily averaging method may help smooth out the peaks and valleys of a volatile market, but there is no guarantee that one crediting method will consistently produce a higher interest credit. Because of this smoothing trend, the daily averaging method generally allows for a higher non-guaranteed participation rate and in most cases comes without any growth cap.

How is interest credited in an indexed life policy?

Premiums allocated to the indexed account earn interest based on the percentage change in the value of an underlying equity index. Once the percentage change or segment growth rate is calculated for any given period, the actual index credit can be calculated by applying the participation rate and growth cap or growth floor.

The participation rate is the percentage of index growth used in determining the index credit for each index period or segment. Most insurance companies guarantee the participation rate to be 100%. However, depending on the specific index selection, the participation rate maybe changed at the company’s discretion.

At the end of the segment anniversary date or index period, an index credit is calculated by multiplying the applicable participation rate by the segment growth rate. If the ending value of the underlying index at the segment anniversary is higher than the beginning value at the initial index segment date, interest is credited to the policy’s cash value subject to the policy’s growth cap. The growth cap is the maximum interest rate that can be credited to an index segment. The actual growth cap varies for each insurance company but is currently around 10-14% annually. Growth cap rates vary widely from company to company with most companies having contractually guaranteed minimum cap rates at 3-4% annually.

IMPORTANT NOTE: When an insurance company reduces the growth cap rate on an equity index policy, the upside potential for higher interest credits is reduced. Therefore, the integrity of the insurance company becomes a major factor in determining the best equity indexed life policy. For more details see, “What Determines the Participation Rate and Growth Cap?” and “Select the Right Indexed Life Insurance Policy”.

At the end of the index period, if the value of the underlying index is unchanged or is lower value than the value at the initial segment date, the index account will be subject to the growth floor which is guaranteed to be 0%. Therefore, in no case will the index account value ever receive less than a 0% credited interest rate.

Annual Point to Point index crediting method

The examples below illustrate three different segment growth rates and how the index credits are calculated. We will assume a 100% participation rate with a 12% growth cap and a 0% growth floor using the annual point to point index crediting method.

1. Underlying index increases by 19 % from the beginning index segment date to the segment anniversary date.

100% participation rate X 19% segment growth rate = 19 % return subject to the 12% “growth cap” = a net 12% interest credit to the policy’s cash value.

2. Underlying index increases by 7 % from the beginning index segment date to the segment anniversary date.

100% participation rate X 7 % segment growth rate = 7% return subject to the 12 % “growth cap” = a net 7% interest credit to the policy’s cash value.

3. Underlying index remains unchanged or decreases by 1 % or more from the beginning index segment date to the segment anniversary date.

100% participation rate X 0% or -10% segment growth rate = 0% or -10 % subject to the “growth floor” of 0% = a net 0% interest credit to the policy’s cash value.

Is there a minimum guaranteed rate for the Equity Indexed Life Policy?

In addition to the growth floor, most EIUL policies offer a cumulative minimum guarantee which provides for growth of cash values during a falling market and assures the policyholder that a minimum guaranteed effective annual interest rate is realized over a set period of time. For example, one company guarantees that over a five year term, if the segment growth value doesn’t reflect at least a 2% minimum effective annual interest rate, the segment value will be increased to that 2% level. This feature varies with each company but most companies offer a version of this guaranteed minimum. The cumulative guarantee is another feature that makes equity indexed universal life insurance a unique and supreme cash accumulator.

How can insurance companies offer equity type returns without any downside risk to the policyholder? Call Options and Derivatives

You may wonder just how the insurance company can offer a policy that has the upside potential for stock market type gains of equity indexed life without passing the risk off to the policyholder. The truth is, the insurance company is not actually investing any policy premiums in an equity index. Instead, the insurance company invests policy premiums in fixed interest investments and uses the earnings from those investments to purchase call options.

Call options provide the right, but not the obligation, to purchase a specific amount of a given index at a specified price within a specified period of time. If the equity index increases, the insurance company can exercise the right to purchase the index at the previously agreed upon price and then credit interest to the policyholder. If the equity index decreases, the company is not obligated to exercise any options and has incurred no cost other than the cost of the actual options. So if the equity index values decrease, the insurance company does not need to credit a negative interest to the policyholder’s account.

What Determines the Participation Rate and Growth Cap?

As we discussed earlier, participation rates and growth caps are essential components in determining the interest rate credited for any index period. Insurance companies use participation rates and caps to adjust amounts of interest credited compared to the actual index growth. This usually has a limiting affect on the interest credited to an amount lower than the actual percentage change of the index.

The biggest factor affecting the participation rates and growth caps is the quality of the insurance company backing the insurance policy. Remember that equity indexed life insurance policies require no direct investment in the equities market by the insurance company or the policyholder. Instead, call options are purchased by the insurance company which allows them to offer the upside potential of the equity indexed UL to their customers without any downside market risk. However, the price for call options varies based on economic conditions and the interest rate environment. In order to have the flexibility to match options costs with potential benefits to policyholders, the insurance company must have the ability to limit the upside interest credited in times where market conditions dictate. Therefore, when choosing between competing equity indexed policies look carefully at both the participation rate and growth cap and also look at the integrity of the insurance company. Research and compare each insurance company’s history, with respect to changing these two variables.

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