Many people see life insurance as a simple, straightforward protection policy that pays out a sum to beneficiaries upon the policyholder’s death. However, life insurance can also be a far more dynamic product. To start, there are two main types of life insurance policies: term life, which lasts only for a fixed period, and whole life, which is guaranteed to cover the death of the policyholder no matter when that occurs.

It gets more complicated as various money-making products can be added to basic policies. Some types of whole life insurance, for instance, provide the opportunity to build money inside your policy—called cash value—on top of the initial guaranteed return.

One such variation is universal life insurance. Like whole life insurance, it remains in effect for an entire lifetime without term limits, but it allows for payment terms to be adjusted as the insured’s needs change.

Another variation is indexed universal life insurance (IUL). IUL policies can grow because they tie the cash value amount to a financial index.

How does IUL work?

When a premium is paid, a portion covers the cost of the fixed benefits, while another portion covers the fees associated with the policy. The remainder is added to the cash value balance, where it can accrue tax-deferred interest at the rate of the designated financial index. It’s important to note that the money is not directly invested in financial markets; it is just tied to the return rate of a specific financial index.

Policies can credit the interest in different ways. IULs usually offer a guaranteed minimum rate of return and a choice of indexes. Some measure index rates monthly, others do so on an annual basis, and others determine the index’s monthly average over the past year. Some policies allow you to choose more than a single index and decide the percentage allocated to the fixed and indexed accounts.

The appeal of IUL is that it provides an opportunity for more significant accumulation potential than traditional universal life insurance while also providing a built-in floor to ensure the cash value will not decrease during a downturn in the market. When the insured dies, the earnings are dispensed tax-free to survivors. Even if the index dips, you’re still safe with a guaranteed minimum interest rate.

However, potential drawbacks to IULs must be considered before obtaining a policy.

Because interest in the policy is tied to a financial index, market returns cannot be generated if the index falls or fails to exceed the minimum interest rate guaranteed by the insurance company. While the policyholder won’t lose any of their invested money, they also won’t make any income.

Secondly, some IULs may come with a stipulation that caps the total amount of money the account can earn. Also, IULs are most beneficial when large amounts of money are invested; smaller amounts are unlikely to generate significant returns.

Finally, all guarantees are based on the issuing insurance company’s financial strength and paying ability. In other words, if the insurance company goes out of business or can’t pay your policy, you might not be able to recover your money.

While not for everyone, indexed universal life insurance policies may be a viable option for people looking for the security of a fixed universal life policy with significant interest-earning potential