The Gravitational Pull on IUL Cap Rates

Why policy performance tends to compress over time and what advisors must understand

By Bill Boersma

Introduction: A Structural, Not Cyclical, Phenomenon

Indexed Universal Life (IUL) has become a widely used planning tool across estate planning, executive compensation, and tax-advantaged accumulation strategies. Its appeal is straightforward: participation in equity upside with protection against market losses.

At the center of that value proposition sits the cap rate, the maximum annual interest credited to the policy. Yet across nearly every major carrier and product generation, one pattern has often emerged: Cap rates tend to decline over time.

This is not merely the result of interest rate cycles or isolated carrier decisions. Rather, it reflects a structural “gravitational pull” embedded in the economics of IUL design. For attorneys, CPAs, trustees, and family offices, understanding this dynamic can be essential. It directly affects long-term policy performance, illustrated assumptions, and the reliability of planning outcomes.

How IUL Crediting Works (Without the Marketing Layer)

Stripped of product language, IUL operates on a relatively simple financial structure:

• Premiums are invested in the insurer’s general account (primarily bonds)
• The insurer uses a portion of its yield to purchase call options on an index
• The payoff from those options determines policy crediting, subject to caps

The constraint is the options budget, which is driven by:

• Net portfolio yield
• Policy charges and expenses
• Required profit margins
• Hedging costs

At its core, the cap rate is a function of the available options budget divided by the cost of options. Changes to either side of that equation can influence caps.

The Forces of Change

Net Investment Yield

Even in today’s environment, insurers face structural limitations:

• Legacy bond portfolios dilute new higher yields
• Capital requirements constrain asset allocation
• Credit risk tolerance remains conservative

The result is that incremental increases in rates do not fully translate into higher options budgets.

Rising Cost of Options

Option pricing is influenced by:

• Implied volatility
• Dividend expectations
• Interest rates
• Institutional demand

Over time, providing equity-linked upside has become more expensive relative to available yield, compressing what insurers can offer.

Regulatory Constraints (AG 49 / AG 49-A)

Regulation has reshaped how products are illustrated and designed:

• Limits on illustrated rates
• Greater scrutiny of assumptions
• Incentives to redesign crediting methods

Carriers have adapted, but largely through restructuring optics rather than improving economics.

Competitive Product Cycles

New products are often launched with attractive caps to gain market share. However:

• Initial pricing may assume favorable conditions
• Over time, experience forces recalibration
• Caps may be adjusted downward to maintain profitability

This creates a familiar pattern: strong entry pricing shifting to gradual in-force compression.

Long-Duration Policy Behavior

IUL is highly sensitive to:

• Persistency
• Loan utilization
• Premium patterns

When real-world behavior differs from pricing assumptions, carriers rely on adjustable levers, primarily caps, to rebalance outcomes.

Takeaway: caps have often declined from original levels over long durations.

The Asymmetry Problem: Caps Fall Faster Than They Rise

A critical but often overlooked dynamic is that cap adjustments are asymmetric:

• Downward adjustments: quick, frequent, operationally easy
• Upward adjustments: slow, cautious, often limited

Even in rising rate environments:

• Portfolio lag delays benefit
• Hedging costs offset gains
• Carriers rebuild margins first

This can lead to a one-directional bias and downward pressure can have greater effects over time

Volatility-Controlled Indices: A Shift, not a Solution

The rise of volatility-controlled indices (VCIs) is often presented as an innovation. In reality, it is better understood as a reallocation of constraints.

VCIs:

• Reduce volatility (typically ~5%)
• Lower option costs
• Allow higher participation rates or caps

But lower volatility equals lower expected return. In a traditional index there is higher upside and higher option cost. In a VCI there is a smoother path with structurally lower ceiling. The gravitational pull still exists, but it has simply moved from the cap rate to the index design itself.

Why This Matters for Advisors

Illustration Risk

Illustrations often assume:

• Stable caps
• Historical index behavior

But if caps decline actual IRRs may fall materially short of expectations and the sequencing and variability of returns can have a meaningful effect on crediting.

Compounding Drag

Small changes in caps create large long-term compounding effects. Using my financial calculator I calculated the following:

• 7% vs 5.5% crediting over 30 years
• Can result in: 25-35% lower accumulation value

Premium Financing Sensitivity

For leveraged strategies:

• Lower crediting rates reduce spread
• Increased risk of policy underperformance
• Potential for collateral stress or unwind scenarios

Cap compression is not just a performance issue; it’s a risk factor that can materially impact a financed policy and result in millions of dollars in losses. In my experience, worst case scenarios have resulted in adverse income tax consequences and loss of death benefit, cash value and external collateral.

Fiduciary Exposure

Trustees and advisors must:

• Actually understand the transactions
• Distinguish reality from fantasy
• Avoid reliance on best case illustrations
• Perform real sensitivity testing and stochastic analysis
• Document due diligence
• Strongly consider hiring an independent, objective voice to vet proposals

A More Durable Planning Framework

Instead of focusing on current caps and crediting rates, advisors should:

Stress-Test Assumptions

• Reduce caps by 200-300 basis points
• Model persistent compression scenarios
• Stochastic modeling

Focus on Net IRR Rather than Gross Crediting

• After charges
• Analyze loan details and assumptions
• Understand expenses

Evaluate Carrier Behavior

• History of cap management
• Transparency
• Consistency across cycles

A Practical Rule of Thumb

A useful framing for advisors: “Assume all variables will trend the wrong way.” If the strategy still works under that assumption, it is more likely to be durable. If it falls apart under modest reductions in crediting or increases in expenses or lending rates, build it differently or run away.

Understanding the Gravity

The gravitational pull on IUL cap rates is not:

• Temporary
• Accidental
• Carrier-specific

It is the natural result of:

• Bond-based funding
• Option-based crediting
• Regulatory constraints
• Competitive pressures

For advisors, the goal is not necessarily to avoid IUL, but to understand its mechanics. Because in long-duration planning, what matters most is not what a product can do today, but what it is structurally likely to do over time.

Moving Forward

Considering that options costs have risen, regulatory oversight has increased and alternative index designs have produced mixed results, is it still possible for cap rates to be reduced in the future when delinked from new product sales?

Short answer: yes, cap rates can still drift downward over time even if interest rates, regulation, and option costs are stable, particularly for in-force blocks that are no longer tied to new sales.

But the reason why shifts. It becomes less about external economics and more about closed-block dynamics, margin management, and behavioral experience.

The Key Distinction: Open vs. Closed (“De-Linked”) Blocks

When a product is actively sold, cap rates are influenced by:

• Competitive positioning
• New money yields
• Distribution pressure

But once a block is effectively closed or de-linked from new sales, those forces can weaken significantly. At that point, the governing objective changes from “win new business” to “manage profitability of an existing liability block.” That shift alone introduces a persistent downward bias.

Even in a “Stable World,” Three Forces Remain

Assuming interest rates are stable, no new regulation and stable options pricing, even then internal forces continue to exert pressure.

Margin Optimization in a Non-Competitive Environment

Once a block is no longer competing for new sales:

• There is little upside to maintaining generous caps
• There is clear financial benefit to reducing them

This creates a structural asymmetry:

• Lower caps lead to immediate profitability improvement
• Higher caps result in no new revenue (no new sales attached)

So even with no external pressure carriers have an economic incentive to gradually tighten crediting, not aggressively, but incrementally and persistently.

Adverse Selection Within the Block

Over time, policyholder behavior is not random and policies that tend to persist include:

• Policies with strong performance
• Policies actively managed (often by present/sophisticated advisors)
• Policies with loan strategies in place

Who lapses?

• Underperforming policies
• Lightly funded or poorly designed policies

This creates a selection effect, and the remaining block becomes more economically demanding. In response, even if external economics haven’t changed, carriers may:

• Reduce caps
• Adjust participation rates
• Tighten spreads

Increasing Liability Duration and Cost

As policies age:

• Cash values grow
• Duration extends
• Guarantee exposure may increase
• Policy loans may accumulate

This creates a growing liability profile relative to the original pricing assumptions. Even with stable inputs the cost of supporting the block increases over time. Cap reductions become a tool to:

• Maintain target returns
• Offset longer-duration liabilities
• Manage tail risk

The Quiet Driver: “Profit Smoothing”

Insurers manage earnings over long time horizons. Even in a stable rate environment, internal realities shift:

• Actual experience vs. pricing assumptions
• Hedge effectiveness
• Expense ratios
• Persistency patterns

Rather than allowing volatility in earnings, carriers often use crediting levers (like caps) to smooth results. This is subtle, but powerful. Caps are not just economic tools, they are earnings management tools.

Why Caps Rarely “Drift Up” in Closed Blocks

Even if conditions are stable (or slightly favorable), upward movement is constrained:

No Competitive Pressure

No need to improve caps to attract new business.

Irreversibility Risk

Raising caps sets a precedent. Lowering them later can create reputational or legal friction.

Embedded Conservatism

Actuarial management tends to favor:

• Stability
• Predictability
• Margin preservation

So even neutral conditions often lead to flat-to-downward bias, not upward movement.

What This Means Practically

For an in-force, de-linked block, the expected pattern is:

• Caps do not collapse suddenly (absent shocks)
• But they tend to step down gradually over time
• Rarely return to prior highs

Think of it less like a drop, and more like a slow ratchet downward.

Not All Blocks Behave the Same

There are meaningful differences based on:

Carrier Philosophy, as Some Carriers:

• Actively manage margins resulting in more cap pressure
• Emphasize policyholder value resulting in more stability

Product Design

• Older designs with richer guarantees result in more pressure
• Newer designs with flexible levers result in more gradual adjustments

Hedge Strategy

• Dynamic hedging programs vs. static
• Internal vs. external hedge management

So, while the directional bias exists, the degree varies.

A Useful Mental Model for Advisors

Instead of asking: “Will caps go down?” A better question is: “What forces exist that would push caps up, and are they strong enough to overcome internal pressures?” In a closed block, the answer tends to be: No.

Implications for Policy Review and Advice

For attorneys, trustees, and family offices, this leads to several practical conclusions:

Don’t Anchor to Current Caps

Current caps are not a stable assumption, they are:

• A point-in-time setting
• Subject to future adjustment
• Influenced by internal economics

Model Flat-to-Down Scenarios

A prudent framework:

• Base case: modest decline over time
• Sensitivity test at modest reductions of .5% to 1%
• Stress case: 200-300 bps reduction

If the plan still works, it’s more robust. “Still works” doesn’t mean full steam ahead. Is it still a judicious use of capital and an acceptable lending risk?

Revisit Older Policies Periodically

Especially those:

• 10+ years old
• Originally illustrated at higher caps
• Supporting distribution or loan strategies

These are most exposed to the cumulative effect of cap compression. However, an independent review of much newer policies, even brand new, is still important as there’s no assurance they were built correctly. The modest cost of independent modeling is a pittance compared the loss of an unsupportable policy or transaction.

Evaluate Carrier Behavior, Not Just Product Specs

Two policies with identical caps today may behave very differently over time depending on:

• Carrier track record
• Governance discipline
• Willingness to adjust in-force terms

Bottom Line

Even in a world where:

• Interest rates are stable
• Regulations are unchanged
• Option costs are constant

Cap rates in a de-linked IUL block still tend to drift downward over time. Not because of external pressure, but because of:

• Profit optimization
• Adverse selection
• Liability evolution
• Earnings management

Final Framing for Advisors

The most accurate way to think about IUL cap rates is that they are not fixed features; they are managed variables. And managed variables, over long durations, tend to move in the direction that preserves carrier profitability, not policyholder upside. Understanding that distinction is critical when evaluating long-term outcomes, especially in fiduciary or institutional contexts.

Bill Boersma is a CLU, AEP and LIC and the founder and owner of OC Consulting Group. More information can be found at www.OC-LIC.com, www.BillBoersmaOnLifeInsurance.info or email at bill@oc-lic.com or call at 616-456-1000.

Securities offered through Valmark Securities, Inc. Member FINRA, SIPC. Investment Advisory Services offered through Valmark Advisers, Inc. a SEC Registered Investment Advisor.

OC Consulting Group and its affiliates are separate entities from Valmark Securities, Inc. and Valmark Advisers, Inc.

The information provided has been derived from sources believed to be reliable, but is not guaranteed as to accuracy and does not purport to be a complete analysis of the material discussed. Indices are unmanaged and do not incur fees. One cannot directly invest in an index. Past performance does not guarantee future results.