Leverage, as a general financial term, is the process of using borrowed money to invest. The hope is that the return on the investment will exceed the cost of borrowing. In other words, you use other people's money to make money. Leverage will magnify results - for better or for worse. If one borrows at 5% and the investment grows at 8%, the person earns money. Conversely, if the investment earns 3%, the investor incurs a net loss.
You may have heard that by using a margin account with a stock broker, a person can leverage his money "two to one". This means that if he has $6,000 of cash in the account, he can own $12,000 of stock. If the stock grows by $1,200 in a year, and if the loan rate is 4%, He has made $1,200 less $240 of interest ($6,000 x .04). The net gain of $960 represents a return of 16% on his $6,000 (960 / 6000). This is positive leverage (sometimes referred to as arbitrage).
If the investor had contributed $12,000 in cash, the $1,200 gain represents a 10% return. Thus, leverage will exaggerate the yield (or loss).
Negative leverage occurs, using the above example, when the underlying investment returns anything less than the cost of borrowing. If the underlying investment returned 1% ($120), then after subtracting the $240 of loan interest, the investor loses $120. His $6,000 cash invested shrinks to $5,880 - a 2% loss.
In the context of indexed universal life (IUL), leverage still has risks, but the advantage of leverage in IUL is that there is no need to pay the loan off at any particular time.(See 6-minute video.)
You are pitting loan interest set by the fixed income market against collateral that grows much like the equity market. And unlike other life insurance products, some IUL policies allow loans to be secured by active index strategies that are not required to be changed over to the Fixed Account in order to act as collateral for such loans. This is known as a "participating loan". Participating loans are made possible because there is usually a zero floor in what will be eventually credited to the index strategy. Thus, the collateral used to secure the loan cannot reduce in value due to poor investment performance in the associated index(es)..
Historically, equities have grown faster than fixed income. Back testing for a large number of years will imply returns of 7% to 11% on certain index strategies. Many participating loans charge a maximum of 6% interest. Hyperfunding has the potential to further enhance returns.
While all leverage has some degree of risk, IUL cash values, which form the collateral for any loans, over time may grow faster than the loans. Over a short number of years, however, the cash value growth may be flat or even decline due to a flat or down market, costs of insurance, and other policy expenses. In the past 120 years, the broad market in the United States has only experienced five instances of being down for 3 straight years, and it has never been down four years in a row. However, thanks to its hedging nature, IUL will never incur an investment loss! Because of ongoing loan interest, cost of insurance, and expenses, it is still a good idea to monitor the total loan-to-cash-value ratio, and to keep it less than 80%.
We are often asked the following question: "If a person embarks upon a systematic pattern of borrowing against his cash value, and the total loans grow over time to a very large amount, how does the loan ever get paid back?" The answer is, assuming again that the loan to value ratio is kept reasonable, one never pays off the loans during one's lifetime. The optimal way to dispose of the policy loan is upon death. Life insurance death benefits will always exceed the amount of policy loans. When the insured dies, the death benefit, which is nearly always income tax free, first goes to pay of the loan, and the remainder is paid to the named beneficiary.
IUL also has other safeguards for leveraged policies. You can change crediting methods for the cash value between index strategies, or even to the company's Fixed Account, which will always show a yearly gain. Some carriers allow you to switch from participating loans to fixed loans, and then back to participating when desired. Some policies state that after around five years, the fixed loan rate is guaranteed not to exceed the rate credited by the company's fixed account. These are called "wash loans".
Also, IUL usually has a provision called "overloan protection" to keep a policy from lapsing in case the loan ever did become as big as the cash value that acts as collateral for that loan. (Back to IUL Table of Contents)