Life insurance

Life insurance is an important tool to ensure family members and/or beneficiaries are taken care of in the event of a person’s death. This is especially important for families with one “breadwinner” (money earner). A number of different life insurance products exist, all with their own benefits and risks. We’ll discuss the following types of life insurance in this chapter:

• Variable life insurance
• Universal variable life insurance

Variable life insurance

Variable life insurance offers coverage throughout the life of the insured person, regardless of whether they’re the policyholder or not. As long as required premiums are paid, a death benefit will be paid to beneficiaries upon the death of the insured party.

Variable life insurance maintains a fixed premium payment schedule. The amount of the premium payment is determined when the contract is initially agreed upon, and the policyholder is required to make these payments over time. If premiums go unpaid, the policy lapses, and a payout of the cash value (discussed below) minus any applicable fees is paid out to the policyholder.

A minimum death benefit is guaranteed on variable life insurance. However, the death benefit and cash value may grow over time. Before we dive further into this topic, let’s discuss cash value.

Variable life insurance builds cash value over time. For example, let’s assume a 30-year-old policyholder obtains $250,000 variable life insurance on themselves* with a fixed $200 monthly premium. In their younger years, the cost of the death benefit (cost of insuring their life) may be $50 per month. The “extra” $150 in this example would be considered cash value. The older the investor gets, the higher the death benefit cost and the lower the cash value contribution. At age 60, the death benefit could increase to $160 per month, allowing a reduced $40 monthly cash value contribution.

*A person buying life insurance on themselves would be considered both the insured person and the policyholder.

Cash value can be used for several purposes. In most instances, the cash value may only be accessed by the policyholder during their lifetime. It can be withdrawn or borrowed after the policy has been in place for some time (usually 3 years) as long as the insured person is still alive. Any cash value withdrawn or borrowed and not repaid is generally subtracted from the death benefit. Additionally, ordinary income taxes are due on any distributed cash value above the investor’s contributions (basis). For example, assume an investor contributes a total of $50,000 to their cash value, which grows* to $75,000. If the investor distributes $60,000 of cash value, they will pay ordinary income taxes on the $10,000 of growth, but not the $50,000 basis.

*Cash value is invested in the separate account, which is discussed further below.

If a policyholder wants to stop paying premiums, they are typically provided one of four potential options:

• Keep death benefit for a shorter period
• Retain insurance with a lower death benefit
• Surrender and receive the cash value
• Perform a life (viatical) settlement

Keep death benefit for a shorter period
The policyholder can essentially surrender the whole life insurance, then take their cash value and purchase the equivalent of term life insurance on the insured person. This option is typically only available to insured persons below the age of 80, as most insurance companies do not offer term life to elderly persons.

Retain insurance with lower death benefit
In exchange for a lower death benefit, the policyholder can stop paying premiums. Depending on the contract and agreement, the cash value may or may not be adjusted during this change.

Surrender and receive cash value
The policyholder can completely surrender their cash value, allowing them to keep the cash value minus any applicable surrender fees. These are fees paid to the insurance company upon cancellation of the policy. Many surrender fees are based on a sliding time scale, meaning the fees are higher if surrendered in early years, but lower if surrendered in later years. Any gains above and beyond the basis (amount contributed) are taxable to the policyholder.

Perform a life (viatical) settlement
In some circumstances, the policyholder can sell their life insurance to a third party. Known as a life or viatical settlement, this type of transaction is typically tied to an insured person near death. In particular, people diagnosed with terminal illnesses routinely utilize these types of settlements. If the insured person knows they’ll die within a short period of time, the policyholder can sell their life insurance to a third party and potentially use the funds for medical or end-of-life expenses. For example, a $500,000 life insurance policy might be sold for $300,000. The third party takes over the responsibility of paying premiums and will receive the total death benefit ($500,000 in our example) upon the death of the insured person.

Cash value is contributed to a separate account. similar to the structure of a variable annuity. The policyholder owns the cash value and determines how it is invested. They are typically provided access to numerous portfolios of securities that are very similar to mutual funds, giving them access to a variety of different asset classes like common stock, preferred stock, and bonds. They decide the amount of risk they’re willing to take. And, of course - the more risk taken, the greater the expectation for return over time.

There are a few prominent consequences related to separate accounts. First, the policyholder accepts the risks related to investing (e.g. market risk), as opposed to the insurance company accepting this risk with other types of life insurance*. Second, insurance products with variable features are considered securities. This makes the product subject to registration and securities regulations (discussed in future chapters). In order to offer variable life insurance, a person must attain both securities and insurance licensing. This typically involves FINRA and NASAA licensing (e.g. SIE + Series 6, 7, 63, and/or 66) plus a state insurance license.

*Other forms of life insurance exist than the ones discussed in this chapter, although not generally tested on the Series 6. For example, whole life insurance is similar to variable life insurance, but the policyholder does not maintain control of investing. The insurance company is responsible for investing in most forms of non-variable life insurance, which is performed in the general account (similar to the structure of a fixed annuity).

The separate account provides for the growth of both the death benefit and the cash value over time. In the event the separate account performs well, both will grow. However, both the death benefit and cash value may decline if the separate account declines in value. Variable life insurance contracts typically provide for a minimum guaranteed death benefit (no matter how far the separate account decline), although there usually is no minimum guaranteed cash value.

Let’s summarize the main test points related to variable life insurance:

• Coverage for the entire life of the policyholder
• Fixed premiums
• Guaranteed minimum death benefit
• No minimum guaranteed cash value
• Cash value invested in separate account
• Cash value grows based on investment performance
• Policyholder subject to investment risk
• Cash value may be
  • Withdrawn or borrowed
  • Returned to the insurance company upon death
  • Kept upon surrender of the policy
  • Retained and potentially paid with a death benefit
• Considered a security

Universal variable life insurance

There are several similarities between variable life insurance and universal variable life insurance. Both offer coverage through the life of the insured person, provide investment opportunities for the death benefit and cash value (in the separate account) and are considered securities*. The big difference between the two relates to the flexibility of premiums.

*Any insurance product with the term ‘variable’ in its name can be safely assumed to be a security. This makes the product subject to registration, plus the professionals selling this type of product are subject to registration with both securities regulators and insurance regulators.

The term ‘universal’ should be associated with flexibility. In particular, universal life insurance premiums are flexible and may change over time. The policyholder can increase their premium payments in order to attain a larger death benefit. Conversely, they can also decrease or skip their premium payments, as a trade-off for a lower death benefit or a deduction from the cash value. Once a large amount of cash value is accumulated, some policyholders make all their premium payments from cash value until their cash value runs out. If the cash value is exhausted and premium payments are not made, the policy will lapse (terminate).

The premium flexibility is most beneficial to those with changing financial situations. If a policyholder’s family or income grows over time, they can simply begin contributing more in premiums. Otherwise, they would be required to obtain a new policy to increase their death benefit, which is sometimes necessary for those utilizing non-universal forms of life insurance.

Let’s summarize the main test points related to universal variable life insurance:

• Coverage for the entire life of the insured person
• Flexible premiums
• Flexible death benefit (some maintain minimums)
• No minimum guaranteed cash value
• Cash value invested in separate account
• Cash value grows based on investment performance
• Policyholder subject to investment risk
• Cash value may be:
  • Withdrawn or borrowed
  • Returned to the insurance company upon death
  • Kept upon surrender of the policy
  • Retained and potentially paid with a death benefit
• Considered a security