- A flexible premium and adjustable equity indexed life insurance policy is a universal life insurance policy with an equity-indexing feature. The insurance company accepts your premium payment and deposits the premium into your cash value account, which is set up with the policy. Then, the insurance company deducts the cost of insurance from the cash value account and invests the premiums into long-term bonds. The interest generated from the bonds is then invested into index call options. A call option is the right, but not the obligation, to purchase a particular stock for a preset price. With index call options, the insurer is purchasing the right to the value of the underlying stock market index. This is how the insurer can promise to credit the policy with any gains in the stock market while avoiding losses. All market declines are ignored in the policy, because if the stock market declines, the bonds that the insurer purchased guarantee the money that you put into the policy.
- The benefit of an equity indexed policy is that you are able to capture most of the upside potential of a stock market index without actually investing in the stock market. Stock options provide leverage. This means that a large amount of a stock -- in this case, the entire stock market index -- can be controlled without ever owning the index. The insurer profits when the stock market rises and can then sell the option contract and credit your policy with the gains it receives. The insurer takes all of the risk of investing while you enjoy the benefits of the insurer's investment experience.
- The disadvantage to an equity indexed policy is that the policy contains many variable components. In order to make sure the insurer can pay its promises in the contract, the insurance company must be able to put a cap on how much you can earn on the policy. The options contracts the insurer purchases may become expensive over time, and the insurer also has to make sure that these costs are covered. Because of this, the insurance policy uses participation rates -- how much of the stock market you are able to capture -- cap rates -- a maximum interest rate that you can earn in the policy -- and mortality charges -- how much the insurer charges you for the death benefit -- to control costs and profits for the insurer. If the insurance company lowers the cap rate and participation rate, while increasing the mortality charges in the policy, then your returns on the policy could be far less than what the insurance company originally illustrated. Since there is no way to know what the insurer will need to do in the future, you enter into this type of contract with the understanding that your policy values may differ significantly from what the insurance company promises to you when you first take out the contract. In this sense, there is no guarantee on what you will receive from the insurance policy.
- Before buying an equity indexed life insurance policy, make sure you understand the contract you are buying. Each insurance company has a minimum interest rate it will pay, as well as a minimum participation rate they will offer you in the contract. On top of this, all insurers tell you the maximum mortality charges that the insurer will charge. This will give you an idea of the worst case scenario so that you can make an informed decision about how to proceed with the policy.
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