Variable Life Insurance
Variable life insurance is a type of permanent life insurance that combines a death benefit with an investment component, making it a distinct product within the broader financial category of Life Insurance. Unlike traditional whole life policies, the cash value of a variable life insurance policy is invested in a selection of professionally managed investment options, often referred to as sub-accounts, which are typically mutual funds. This structure means the policy's cash value and, potentially, its total death benefit can fluctuate based on the performance of these underlying investments. Policyholders assume the investment risk associated with these sub-accounts.
History and Origin
The concept of variable life insurance emerged in the mid-1970s as a response to market demands for insurance products that offered potential growth tied to market performance, contrasting with the fixed returns of traditional whole life policies. Its development was complex, requiring careful navigation of both state insurance regulations and federal securities laws. Because the cash value of variable life insurance policies is linked to investment performance, these products were deemed securities and thus fell under the jurisdiction of the U.S. Securities and Exchange Commission (SEC). The SEC initially proposed excluding variable life separate accounts from investment company regulation, provided states developed comparable protections. In response, the National Association of Insurance Commissioners (NAIC) adopted a model regulation in 1973. However, the SEC later changed its position, and in 1976, adopted Rule 6e-2 to regulate these products under the Investment Company Act of 1940, making variable life insurance subject to regulation by both the SEC and state insurance departments.7,6
Key Takeaways
- Variable life insurance is a permanent life insurance policy with an investment component linked to market performance.
- The policyholder bears the investment risk of the underlying sub-accounts.
- Both the cash value and the death benefit can fluctuate based on investment performance, though often a minimum death benefit is guaranteed.
- These policies are regulated as securities by the SEC, in addition to state insurance regulations.
- Fees and expenses associated with variable life insurance tend to be higher than other types of life insurance due to the investment management and administrative costs.
Interpreting Variable Life Insurance
Interpreting a variable life insurance policy involves understanding its dual nature as both an insurance contract and an investment vehicle. The performance of the policy's cash value directly reflects the chosen asset allocation within the sub-accounts. If the selected equity investments or fixed income options perform well, the cash value can grow significantly, potentially increasing the death benefit beyond its initial guaranteed amount. Conversely, poor investment performance can reduce the cash value, and in severe cases, may necessitate higher premium payments to prevent the policy from lapsing. Policyholders must actively monitor their chosen investments and understand that the "variable" aspect means values are not guaranteed.
Hypothetical Example
Consider Jane, a 40-year-old professional seeking permanent life insurance with growth potential. She purchases a variable life insurance policy with an initial guaranteed death benefit of $500,000, making regular premium payments. A portion of her premiums, after fees, is allocated to sub-accounts that invest in a mix of large-cap mutual funds and a bond fund.
In the first five years, the stock market performs strongly, and the mutual funds in her sub-accounts generate an average annual return of 8%. As a result, the cash value of her variable life insurance policy grows considerably, exceeding the initial projections. This increased cash value could potentially lead to an increase in her policy's total death benefit, depending on the policy's terms. However, if the market had experienced a downturn, her cash value would have decreased, possibly requiring her to pay more in premiums to maintain the death benefit.
Practical Applications
Variable life insurance finds practical applications in specific financial planning scenarios where individuals seek both permanent insurance coverage and an opportunity for wealth accumulation through market exposure. It is often considered by those with a higher tolerance for investment risk who wish to leverage the potential for tax-deferred growth within an insurance wrapper. Common applications include:
- Estate planning: Variable life insurance can be used to provide liquidity for estate taxes or to transfer wealth to beneficiaries, with the potential for the death benefit to grow over time.
- Long-term savings: The cash value component, linked to market performance, can serve as a long-term savings vehicle, accessible through policy loans or withdrawals.
- Business planning: Businesses may use variable life insurance for key person coverage, where the cash value growth can benefit the company while providing a death benefit.
Because variable life insurance policies are considered securities, they are subject to stringent oversight by the Securities and Exchange Commission (SEC), including specific disclosure requirements designed to help investors make informed decisions.5,4
Limitations and Criticisms
While offering potential benefits, variable life insurance also carries significant limitations and criticisms. The primary drawback is the exposure to investment risk; unlike traditional whole life policies, the cash value is not guaranteed and can decline with poor market performance, potentially leading to policy lapse if insufficient funds remain to cover costs.3
Another significant criticism centers on the relatively high fees and expenses associated with variable life insurance. These can include mortality and expense charges, administrative fees, underwriting charges, and sub-account management fees, which can significantly erode returns.2 Furthermore, policies often come with a surrender charge if the policy is terminated within the initial years, penalizing early withdrawals or cancellation.1 The complexity of these products can also be a point of criticism, making it challenging for some policyholders to fully understand the charges, risks, and performance implications.
Variable Life Insurance vs. Universal Life Insurance
Variable life insurance is often confused with Universal life insurance due to both being types of permanent life insurance with a cash value component. However, a key distinction lies in how the cash value grows and the allocation of investment risk.
| Feature | Variable Life Insurance | Universal Life Insurance |
|---|---|---|
| Cash Value Growth | Linked to the performance of chosen sub-accounts (e.g., mutual funds). | Grows based on an interest rate credited by the insurer; may have a minimum guaranteed rate. |
| Investment Risk | Policyholder assumes all investment risk. | Insurer assumes investment risk for the cash value, as they guarantee the interest rate. |
| Premiums | Typically fixed, but poor performance may require additional premium payments to maintain coverage. | Flexible premium payments are a hallmark, allowing adjustment within limits. |
| Regulation | Regulated as both insurance and a security by state insurance departments and the SEC. | Primarily regulated as an insurance product by state insurance departments. |
While variable life insurance offers the potential for higher returns through market participation, it comes with greater volatility and requires the policyholder to actively manage investment choices and bear the associated risks. Universal life insurance, conversely, offers more predictable cash value growth and premium flexibility, with the insurer taking on the underlying investment risk.
FAQs
Q: Is variable life insurance considered a security?
A: Yes, variable life insurance policies are considered securities because their cash value fluctuates with the performance of underlying investment options. As such, they are regulated by the U.S. Securities and Exchange Commission (SEC) in addition to state insurance departments.
Q: How does the cash value of variable life insurance grow?
A: The cash value of variable life insurance grows based on the investment performance of the sub-accounts selected by the policyholder. These sub-accounts are typically structured as mutual funds, allowing exposure to stocks, bonds, or other asset classes.
Q: Can my variable life insurance policy lapse?
A: Yes, a variable life insurance policy can lapse if the cash value drops too low to cover the ongoing fees and cost of insurance, often due to poor investment performance or significant withdrawals or policy loans that are not repaid.