Understanding index choices and calculations in an IUL

One of the primary benefits of an indexed universal life (IUL) insurance policy that is used in a LIRP is its ability to provide a nice return by tracking one or more stock market indexes. A market index is defined as a hypothetical “portfolio” of investment holdings, which represents a segment of the financial market. Indexes can be powerful indicators for both national and international economies.

There are approximately 5,000 indexes that make up the U.S. equity market. Some of the most commonly-followed United States indexes include the S&P 500 (Standard & Poor’s), the Dow Jones Industrial Average (DJIA), and the Nasdaq Composite.

How an Index Works

A stock market index measures a subset of the overall market. This can help investors to compare current price levels with past prices in order to determine market performance. The determination of an index’s value comes from the prices of the underlying holdings.

Indexes can be national, international, global, or even regional. They may also be allocated by industry sector or based on whether or not the companies included meet certain social or ecological criteria.

Common IUL Index Choices

Although there are literally thousands of market indexes to choose from, some of the most common ones that you will find in the indexed universal life insurance policies used with LIRPs include the:

Indexes Commonly Used in IUL’s

  • S&P 500 Index
  • Dow Jones Industrial Average (DJIA)
  • Nasdaq Composite
  • Bloomberg
  • Pimco

For example, the S&P 500 Index includes 500 of the top companies in the United States. The stocks are chosen for the index based on a number of factors, including:

  • Capitalization
  • Liquidity
  • Public float
  • Sector classification
  • Financial viability
  • Trading history

How the Return on an Index is Determined

In order to determine the return on an index, you first need a start and an endpoint, as well as the corresponding figures. As an example, let’s say that you wanted to calculate the return on the S&P 500 Index for the month of October 2015. In this case, the S&P 500 Index opened at 1,919.65 on the morning of October 1st, and it closed at 2,079.36 on the afternoon of October 30th.

Because the October 30th figure is higher than the figure for October 1st, we can see that the index had a positive return for this particular time period. The amount of that positive return is further determined by using the following formula:

2,079.36 (end of the period figure) – 1,919.65 (beginning of period figure) = 159.71 (difference)

By then taking the difference of 159.71 and dividing it into the initial figure of 1,919.65, we come up with the percentage difference, which in this case is a positive 8.3%.

159.71 / 1,919.65 = 0.083 (or 8.3%)

Many insurance companies that offer indexed universal life insurance will credit the interest by using what is called the annual point-to-point method. Here, the equity index value at the end of every contract year will be compared to the value at the beginning of that contract year.

If the index value is greater at the end of the year, the policy is credited with the percentage increase, oftentimes subject to a specified maximum, or cap. The annual cap rate is the most that may be credited in that contract year. (While the cap rate may be changed by the insurance company, there will typically be a guaranteed minimum cap rate below which the rate may never fall).

0% Floors (never lose money)

One of the primary benefits of a LIRP funded with indexed universal life insurance is that, while you are able to benefit from the growth of the underlying index(es), you will not incur any losses if the index(es) has a negative return in any given year. (This can be considered a “tradeoff” for the limited “capped” upside potential – and it can be extremely beneficial during a downward moving market like during the 2008 recession or the 2020 COVID-19 crisis and corresponding market drop).

For instance, if the underlying index(es) performs well in a given contract year, your account will be credited with a positive return, typically up to a set “cap,” or maximum. But, if the underlying index performs poorly, your account value will not be reduced. Rather, there is a guaranteed minimum “floor” – such as 0% or 1% – that will be credited.

Because of this, your money can continue to build upon previous gains, without the need to “make up” for any losses. This, in turn, allows the account value in an IUL to grow and compound significantly over time.