Guides
IUL caps, participation rates and floors
How caps, participation rates, spreads and floors turn an index's return into an IUL credit, with worked examples and what insurers can change each year.
In an indexed universal life policy, the interest credited to your account is not the index's return. It is the index's change after a formula applies a cap (a ceiling on the credit), a participation rate (the share of the index gain you receive), sometimes a spread (a deduction), and a floor (the minimum credit, usually 0%). Those terms are set by the insurer, can change, and determine most of what an index account is worth.
The four terms
| Term | What it does | Typical effect |
|---|---|---|
| Cap (see cap rate) | Maximum credit for the period | Limits gains in strong years |
| participation rate | Percentage of the index change that is credited | Below 100% reduces every gain; above 100% is possible on some accounts |
| Spread (margin) | A percentage subtracted from the index change before crediting | Reduces gains, and removes small ones |
| floor | Minimum credit | Usually 0%; some policies use 1% or a negative floor |
Some accounts use a cap and a 100% participation rate. Others use a high participation rate with no cap, or a spread with no cap. An account rarely uses all four at once.
Worked examples (hypothetical)
These figures are invented to show the arithmetic. They are not current rates from any insurer.
Cap account. Cap 10%, participation 100%, floor 0%.
| Index change over the year | Credit |
|---|---|
| +18% | 10% (capped) |
| +6% | 6% |
| 0% | 0% |
| −12% | 0% (floor) |
Participation-rate account. Participation 50%, no cap, floor 0%. An index gain of +6% credits 3%; +18% credits 9%; a loss credits 0%.
Spread account. Spread 3%, participation 100%, no cap. A gain of +6% credits 3%; +2% credits 0%.
Now consider the cap account over three years where the index returns +25%, −20% and +25%. The credits are 10%, 0% and 10%. The account compounds to about 1.21 times the starting balance before charges, while the index itself compounds to 1.25 × 0.80 × 1.25 = 1.25 times. The floor avoided the −20% year, but the cap gave up more than the floor saved. In steadier markets, or ones with a loss at the start, the comparison can go the other way. Which outcome you get depends on the sequence of returns, not just the average.
Crediting methods
The formula is applied to the index change measured in one of several ways (index crediting method):
- Annual point-to-point. Compare the index at the start and end of the year. Simple and common.
- Monthly sum or monthly cap. Add up each month's change, with each month's gain capped (for example at a monthly maximum) and losses counted in full, then apply the floor to the annual total. A single bad month can offset many good ones.
- Monthly or daily averaging. Average the index level over the year and compare to the starting level. This smooths timing risk but usually produces a lower credit in a rising market.
- Multi-year point-to-point. Measured over two to five years, sometimes with a higher cap.
Who controls the numbers
Caps, participation rates and spreads are usually declared by the insurer and can change, typically once a year, for existing policies. The contract states guaranteed minimums (for example a minimum cap or a maximum spread), but those are normally far less attractive than current figures. Insurers set the numbers based partly on the cost of the options they buy to hedge the credits, and that cost changes with interest rates and market volatility. Higher interest rates generally let insurers offer higher caps; lower rates push caps down. A cap that looks attractive in an illustration is not locked in.
The same is true of charges: the cost of insurance can be raised up to the contract maximum. Ask for the guaranteed illustration column; see guaranteed vs non-guaranteed values in a policy illustration.
What the floor does not do
A 0% floor means the index credit cannot be negative. It does not mean your account cannot fall. Each month the insurer deducts the cost of insurance and fees, so in a year with a 0% credit the account shrinks. A floor of 0% protects the credited interest from index losses, not the policy from its expenses. Some insurers charge a higher cost, or offer a smaller cap, in exchange for a floor above 0%.
Multipliers, bonuses and volatility-controlled indices
Some accounts add a "multiplier" or a "bonus" in exchange for an extra annual charge, and some use proprietary volatility-controlled indices that carry a higher cap. The NAIC's Actuarial Guideline 49-A limits how such features may be illustrated: multipliers and bonuses are credited back net of their charges, and, according to Lincoln Financial's summary, non-benchmarked accounts may not illustrate better than a benchmark index account. That limits the sales illustration. It does not tell you how the account will actually perform. See IUL illustrations and Actuarial Guideline 49.
How to use this when comparing policies
- List each index account's current cap, participation rate, spread and floor, and its guaranteed minimum or maximum.
- Ask for the crediting history of that account for the past 10 or more years, using the cap actually in force each year, not today's cap applied backward. Be cautious of back-tested illustrations of indices that did not exist then.
- Compare the monthly charges that take place regardless of credits.
- Ask which allocation the illustration assumes and whether the illustrated rate matches the cap you would choose.
- Run the illustration at a lower rate, such as 4% or 5%, and see when the policy would lapse or need more premium.
Key takeaways
- The IUL credit equals the index change after the cap, participation rate, spread and floor; it is not the index return.
- Caps, participation rates and spreads can be changed by the insurer on in-force policies, within contract minimums or maximums.
- A 0% floor protects against index losses but the account still pays monthly charges.
- Outcomes depend on the sequence of index returns, so test the illustration at lower rates.