The term “participation rate” in the context of indexed universal life policies has to do with certain crediting strategies. The most common IUL crediting strategies have some sort of cap on earnings with a floor rate of usually 0% regardless of whether the underlying index goes negative for a year. Some of the top IUL carriers of 2020 with the best performing IUL policies have crediting strategies with a participation rate where you track the index at either an inflated or watered-down percentage rate.
Many carriers offer what are called High-Par strategies that track the S&P 500 using a participation rate greater than 100%. The trade-off is often a lower IUL cap. For instance, an IUL policy may offer a 1-year capped S&P 500 index crediting strategy with 100% participation in indexed growth between a cap of 10% and a floor rate of 0%. However, if you opt for a High-Par strategy with say 140% participation (5% x 140% = 7% crediting), the higher participation rate strategy may only have a cap of 7.5% instead of 10%.
Many uncapped IUL crediting strategies will utilize a participation rate. If it is on an index tracking pure equities like an S&P 500 index, the participation rate will be often less than 100%. This is not because the insurance company offering the IUL product is keeping the additional gains. It is because S&P 500 options needed to hedge this strategy are quite expensive, and a lower participation rate brings the cost down to something feasible to offer to indexed universal life policyholders.
Last, most volatility-controlled index crediting strategies also use a participation rate. Oftentimes the participation rate can exceed 100% giving you greater participation in any upside gains from said indexes. Companies offering indexed universal life insurance are able to provide participation rates exceeding 100% on volatility controlled indexes because typically they are less volatile and therefore cheaper to hedge with options.
You can learn more about how indexed universal life insurance companies are able to use market index options to offer caps, floor rates, and participation rates in our indexed universal life pros and cons article.
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