Index Universal Life Pros and Cons
With indexed universal life, the insurer doesn’t invest your premium dollars into the general investment account. Instead, it uses a very precise mix of bond investments and index call options to pay interest based on the upward movement of a stock market index.
A call option is the right, but not the obligation, to buy a specific number of shares of a specific stock for a specific price within a specific time frame. For example, a stock option may give you the right to purchase 1,000 shares of Microsoft stock at $10 per share for the next three months. This contractual right to buy Microsoft may only cost you $500. So, instead of paying $10,000 for 1,000 shares of stock (i.e. 1,000 shares at $10 per share = $10,000) and hoping the price increases, you pay a paltry $500 for control over that stock for the next three months.
If Microsoft shares were trading for $9 per share, but jumped to $11 within the next three months, you would either exercise your option or sell it. With a right to buy the stock at $10 per share, you’re making a guaranteed profit of $1 per share if the stock moves to $11 per share. What if Microsoft stock doesn’t jump? What if it falls? Well, your option will expire worthless. You won’t make any money, but you’ll only lose what you paid for the option
With an index call option, insurance companies buy the value of an entire stock market index (i.e. the S&P 500, the Dow, or the NASDAQ).
When the stock market moves up, the insurer sells the option or exercises it, and credits you with the majority of the gains, up to a specified interest rate cap or participation rate cap. For example, if the insurer sets an interest rate cap of 16 percent on its indexed UL policy, and the market moves up 7 percent, your cash value is credited with 7 percent.
If, however, the market jumps up 20 percent, you’re only credited 16 percent because of the 16 percent cap on interest gains.
Why would you accept this deal?