Ben Nguyen 
Indexed universal life insurance (IUL) has garnered a lot of hype recently as a way to gain equity market upside while also having permanent life insurance coverage. But does this complex product truly make sense for most Canadians?
This extensive guide will examine indexed universal life insurance policies in Canada in great detail – how they work, pros and cons, who they fit, and smarter alternatives.
Is indexed universal life insurance a good option for Canadian? Read on for a comprehensive analysis from Life Buzz expert : Ben Nguyen.
How Does Indexed Universal Life Insurance Work?
Indexed universal life (IUL) insurance is a form of permanent life insurance coverage that lasts for the insured’s entire lifetime, provided you continue to pay the required premiums.
Like other permanent life insurance, it has:
- A death benefit that pays your beneficiary when you pass away.
- Cash value that accumulates within the policy over time.
The unique part of IUL insurance is that the cash value is linked to the performance of a stock market index, like the S&P/TSX 60 in Canada. The idea is that the cash value account will be credited interest based on the gains in the chosen index.
For example, if the S&P/TSX 60 rises by 7% in a given month, a portion of that return would get credited to the IUL policy’s cash value balance.
However, life insurance companies in Canada limit the upside (and downside) through two key rates:
Participation Rate: This determines what % of the index return gets credited. For example, if set at 80%, only 80% of the index gain would be added to the cash value.
Cap Rate: This puts a maximum limit on the gain that can be credited, typically around 8-12% in Canada. Even if the index rose 15%, the interest may max out at a 12% cap.
These limits allow the insurance company to manage risk and profitability. When the index declines, a 0% floor protects the cash value from losses.
Let’s walk through an example:
- S&P/TSX 60 Return: +7%
- Participation Rate: 80%
- Cap Rate: 12%
The interest credited would be:
7% Index Return x 80% Participation Rate = 5.6%
However, since that exceeds the 12% cap, the actual interest credited is 12%.
The caps limit full participation in strong index returns. The cash value and death benefit grow tax-deferred within the insurance policy.
What Are The Potential Benefits Of Indexed Universal Life Insurance?
Permanent Lifelong Coverage
IUL provides permanent insurance lasting your entire lifetime. This guarantees a death benefit payout to beneficiaries whenever you pass away.
Market Interest Potential
By linking to an equity index, IUL offers the possibility of greater returns than fixed-interest options on traditional universal life policies.
Downside Protection
The 0% floor protects the cash value from losses when the index declines. However, caps limit the upside when markets rise strongly.
Tax-Deferred Growth
The cash value grows tax-deferred, and the death benefit payout is income tax-free for beneficiaries. This enables faster growth compared to taxable investment accounts.
Premium Flexibility
Depending on the policy contract, there may be some flexibility to adjust premium levels up or down within set parameters.
Policy Loans
You can access some accumulated cash value via policy loans for significant expenses or emergencies without terminating the coverage.
What Are The Drawbacks Of Indexed Universal Life Insurance?
Expensive Premiums
Indexed Universal Life Insurance policies have significantly higher premium costs compared to term life insurance. All permanent insurance with cash value tends to be more expensive.
No Return Guarantees
Interest earnings linked to the index performance are not guaranteed in advance. Some periods will see more substantial returns than others.
Caps Limit Upside
The cap rate limits Your return potential, typically 8-12% in Canada. Even significant index gains may only credit 8-12% interest.
Complex To Manage
IUL policies require close monitoring and management of premiums, cash value, and credited interest. Lapsed policies are prevalent.
Surrender Risks & Fees
Cancelling an IUL policy can result in surrender charges, fees, and tax implications. Terminating the policy is complex.
Not Insured or Guaranteed
Unlike direct stock and bond investments, IUL policies are not insured or regulated. The insurance company alone sets all the rules.
Who Might Consider Indexed Universal Life Insurance?
Due to the limitations and risks, indexed universal life insurance is likely only a wise choice for certain individuals:
Maxed Out Registered Accounts
High-net-worth Canadians who have fully maximized RRSPs and TFSAs may benefit from the additional tax-deferred growth potential. Generally, this applies to those earning $200,000+ per year with substantial disposable income.
Business Owners
Some business owners can utilize IUL insurance for tax benefits, relatively low-risk returns, and leverage capabilities. It can facilitate business continuity and succession planning.
However, the average Canadian is almost always better off using basic term life insurance and maximizing RRSPs and TFSAs for growth. Avoid putting money into IUL policies that could otherwise go into registered accounts.
IUL insurance requires very careful consideration versus simpler options like term, whole life insurance, and standard registered accounts. It is not a product suitable for the general population.
What Are The Alternatives Worth Considering Before Indexed Universal Life Insurance?
For most Canadians, there are typically better options than indexed universal life insurance:
Term Life Insurance
Term life insurance provides affordable pure protection for 10-30 years. It covers your dependents when they need it most at a fraction of the cost of permanent insurance with cash value.
Whole Life Insurance
Whole life insurance offers permanent lifetime protection with premiums that remain fixed over time. The cash value earns minimum guaranteed interest without being tied to market volatility.
RRSPs and TFSAs
Canadians should prioritize using RRSPs and TFSAs first for tax-advantaged investing and wealth growth. You can customize your portfolio and have greater transparency.
Do not put money into IUL policies that could be contributed to available RRSP or TFSA rooms. Max these out before considering permanent insurance.
What Percentage of Canadians Own Indexed Universal Life Insurance?
In Canada, indexed universal life insurance represents only a small fraction of the overall life insurance market. The most recent data shows:
| Policy Type | Percentage of Life Insurance Market |
|---|---|
| Term life insurance | 75% |
| Permanent life insurance | 25% |
| Whole Life insurance | 15% |
| Universal Life insurance | 5% |
| Indexed Universal Life insurance | 3% |
| Participating Life insurance | 2% |
As you can see, only around 3% of Canadian life insurance policies are IUL. It has not gained significant traction versus term or whole life insurance. IUL ownership is limited primarily to high-income earners and specific business cases.
How Many Indexed Universal Life Insurance Policies End Up Lapsing?
One major risk of indexed universal life insurance is having policies unintentionally lapse and terminate due to poor monitoring of cash value and premiums.
Industry data shows approximately 88% of IUL policies end up lapsing before any payout of the death benefit occurs. Only a fraction of issued policies see the full benefits.
Source : https://www.policyme.com/blog/universal-life-insurance
This extremely high lapse rate demonstrates why Canadians must be cautious and do their homework when evaluating complex IUL insurance. Maintaining these policies over decades is very difficult.
What Factors Should You Consider Before Buying Indexed Universal Life Insurance?
If you are a high net-worth candidate considering indexed universal life insurance, here are some key considerations:
No Direct Ownership or Control
While the policy return may be linked to an index, you have no direct ownership or control. The life insurance company determines all aspects of the policy.
Caps Will Limit Your Returns
Even in very strong equity markets, your credited interest will max out at the cap rate, typically 8-12% in Canada. The higher the market return, the more your actual return gets limited.
Downside Protection Has Tradeoffs
The 0% floor that protects your cash value from losses also reduces some of your potential upside. There are always tradeoffs with minimized risk.
High-Income Earners Benefit Most
The premium costs, complexity, and need for active monitoring make IUL insurance unsuitable for average Canadians. The wealthy are the target market.
Lapse Risk is Significant
Constantly tracking the index and cash value and adjusting premiums is demanding. Lapsed policies due to poor monitoring are extremely common.
Understand Surrender Charges
Cancelling the policy early often leads to surrender charges, fees, and tax headaches. Know the termination rules and costs.
IUL insurance necessitates thorough research and budgeting. For most Canadians, simpler term life and registered accounts are preferable. Take great care before committing to an indexed universal life insurance
What Questions Should You Ask Before Buying Indexed Universal Life Insurance?
If you are seriously considering an indexed universal life insurance policy, here are some key questions to ask your advisor and insurance provider:
What Indexes Are Available?
Ask what market indexes can be linked to the policy’s cash value – common options are the S&P/TSX 60 or S&P 500. Understand how each index has performed historically.
What Are The Rates For My Policy?
Request the specific participation rate and cap rate that will determine how much of the index gains get credited to your cash value. These are critical factors.
How Is Interest Credited?
Ask if interest is credited monthly or annually based on index performance. Understand exactly how the gains are calculated.
What Fees Are Charged?
Inquire about all fees charged on the policy, including administrative fees, fund management fees, mortality costs, etc. Fees can significantly erode net returns.
How Flexible Can My Premiums Be?
Find out if you have the flexibility to adjust premiums up or down or if they are locked in. Ask about any limitations or charges for premium changes.
What Happens If The Policy Lapses?
Learn about the risks and costs if you unintentionally let the policy lapse due to insufficient premiums or cash value. Understand how lapses are handled.
Asking the right questions is crucial to evaluate if IUL insurance truly meets your needs and risk tolerance. Research carefully before making long-term commitments.
Should You Consider Indexed Universal Life Insurance?
Indexed universal life insurance can be appropriate for certain high-net-worth individuals like:
- Those who have maxed out registered savings plans
- Business owners using it for specific purposes
However, it is full of complexity, limitations, and risk for the average Canadian. Here are the key takeaways on who should consider IUL:
You Must Actively Manage It
IUL policies require diligent tracking and premium adjustments. If you don’t monitor it closely, don’t buy it. Lapsed policies are extremely common.
It’s Not For Average Families
With high fees, premiums, and complexity, indexed universal life insurance isn’t appropriate for most Canadians. Simpler options like term tend to be better.
Max Out Registered Plans First
Do not put money into an IUL policy that could go into the available RRSP or TFSA contribution room first. Registered plans are superior.
Not A Standalone Investment
View IUL first as permanent life insurance, not an investment. The returns lag a direct equity portfolio in most cases.
Canadians are wise to carefully weigh the limitations before jumping into indexed universal life insurance. Protect your family and future by making informed decisions.
Conclusion: Is Indexed Universal Life Insurance Worth It For You?
While indexed universal life insurance does offer some benefits like equity market interest potential, the realities are that it’s expensive, complex, requires diligent management, and is primarily suited to the wealthy.
The majority of Canadian families are best served by low-cost term life insurance and registered accounts like RRSPs and TFSAs for investing.
In only certain niche cases, for select high net-worth business owners or individuals, could IUL insurance potentially make sense? For everyone else, there are likely better insurance and financial planning options available.
IUL should not be jumped into without a thorough analysis of your situation and alternatives. As Canada’s top life insurance resource, IDC Insurance Direct Canada provides trusted guidance to readers weighing their protection and financial growth options.
Frequently Asked Questions
Is indexed universal life insurance a good retirement investment?
No, IUL is generally not a good retirement investment vehicle compared to RRSPs and TFSAs, given the high costs, fees, and cap on returns. It is first and foremost life insurance.
How does indexed universal life insurance differ from whole life insurance?
Whole life offers guaranteed premiums and minimum cash value interest rates, while IUL offers equity market upside potential but requires closer monitoring and carries more risk.
Can you overfund an indexed universal life insurance policy?
Yes, you can overfund an IUL policy by contributing more than the annual premium limit set by the insurance company, but this can result in tax issues and penalties. It’s important to be aware of IUL contribution limits.
How are premiums calculated for indexed universal life insurance?
IUL premiums are based on factors like the death benefit amount, the insured’s age and health, fees, projected returns, and the minimum required to keep the policy active.
What happens if you stop paying indexed universal life insurance premiums?
The policy may lapse if you stop paying premiums and there is not enough cash value accumulated to keep it active. Premiums may initially be paid from cash value before it depletes and lapses.
Can you borrow from an indexed universal life insurance policy?
Yes, you can take out policy loans against the accumulated cash value in an IUL, but any outstanding loan balance reduces the net death benefit paid to beneficiaries.
Is the death benefit on indexed universal life insurance guaranteed?
The death benefit on IUL is guaranteed as long as you maintain sufficient premiums and cash value to keep the policy active. It can lapse if you stop paying premiums.
Can indexed universal life insurance generate annual dividends?
No, IUL policies do not pay annual dividends. The growth is linked to a market index rather than being eligible for dividends like with some forms of whole life insurance.
Article Sources
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