Life insurance helps ensure family members and/or other beneficiaries are financially supported if a person dies. This is especially important for families with one primary “breadwinner” (income earner). Many life insurance products exist, each with its own benefits and risks. This chapter covers:
Variable life insurance provides coverage for the insured person’s entire life. The insured person may or may not be the policyholder. As long as required premiums are paid, a death benefit is paid to beneficiaries when the insured person dies.
Variable life insurance uses a fixed premium schedule. The premium amount is set when the contract is issued, and the policyholder must make those payments over time. If premiums aren’t paid, the policy lapses. When a policy lapses, the policyholder typically receives the cash value (explained below) minus any applicable fees.
Variable life insurance includes a minimum guaranteed death benefit. The death benefit and the cash value may also grow over time, depending on investment performance. To see how that works, we first need to define cash value.
Variable life insurance builds cash value over time. For example, assume a 30-year-old policyholder buys $250,000 of variable life insurance on themselves* with a fixed $200 monthly premium. Early on, the cost of the death benefit (the cost to insure their life) might be $50 per month. The “extra” $150 would go toward cash value. As the insured person gets older, the cost of insurance typically increases, so less of the premium goes to cash value. At age 60, the cost of the death benefit might rise to $160 per month, leaving $40 per month to contribute to cash value.
*A person buying life insurance on themselves would be considered both the insured person and the policyholder.
Cash value can be used in several ways. In most cases, only the policyholder can access cash value during the insured person’s lifetime. After the policy has been in force for some time (often 3 years), the policyholder may be able to withdraw or borrow against cash value, as long as the insured person is still alive.
For example, assume an investor contributes a total of $50,000 to cash value, and it grows* to $75,000. If the investor distributes $60,000 of cash value, they pay ordinary income taxes on the $10,000 of growth, but not on 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 given one of four options:
Keep death benefit for a shorter period
The policyholder can surrender the whole life policy, take the cash value, and use it to buy the equivalent of term life insurance on the insured person. This option is typically available only if the insured person is under age 80, since many insurers don’t offer term life insurance to elderly individuals.
Retain insurance with lower death benefit
The policyholder can stop paying premiums in exchange for a lower death benefit. Depending on the contract, the cash value may or may not be adjusted when this change is made.
Surrender and receive cash value
The policyholder can surrender (cancel) the policy and receive the cash value minus any applicable surrender fees. Surrender fees are paid to the insurance company when the policy is canceled. Many surrender fee schedules decline over time, meaning fees are higher in the early years and lower in later years. Any gains above the basis (amount contributed) are taxable to the policyholder.
Perform a life (viatical) settlement
In some situations, the policyholder can sell the life insurance policy to a third party. This is called a life settlement or viatical settlement and is typically associated with an insured person who is near death. People diagnosed with terminal illnesses commonly use these settlements.
If the insured person expects to die within a short period of time, the policyholder may sell the policy and use the proceeds for medical or end-of-life expenses. For example, a $500,000 policy might be sold for $300,000. The third party then takes over premium payments and receives the full death benefit ($500,000 in this example) when the insured person dies.
Cash value is contributed to a separate account, similar to the structure of a variable annuity. The policyholder owns the cash value and chooses how it’s invested. The insurer typically offers multiple portfolios of securities that resemble mutual funds, providing access to asset classes such as common stock, preferred stock, and bonds. The policyholder decides how much risk to take, and higher risk generally comes with a higher expected return over time.
Separate accounts have a few important consequences:
To offer variable life insurance, a person must hold both securities and insurance licenses. This typically involves FINRA and NASAA licensing (for example, SIE + Series 6, 7, 63, and/or 66) plus a state insurance license.
*Other forms of life insurance exist beyond the ones covered in this chapter, although they aren’t generally tested on the Series 6. For example, whole life insurance is similar to variable life insurance, but the policyholder doesn’t control the investing. In most non-variable life insurance, the insurance company invests through the general account (similar to the structure of a fixed annuity).
The separate account can drive growth in both the death benefit and the cash value over time. If the separate account performs well, both may increase. If the separate account declines in value, both the death benefit and cash value may decline. Variable life insurance contracts typically provide a minimum guaranteed death benefit (regardless of how far the separate account declines), but there is usually no minimum guaranteed cash value.
Let’s summarize the main test points related to variable life insurance:
There are several similarities between variable life insurance and universal variable life insurance. Both provide coverage for the insured person’s entire life, offer investment opportunities for the death benefit and cash value (through the separate account), and are considered securities*. The key difference is premium flexibility.
*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, and the professionals selling it are subject to registration with both securities regulators and insurance regulators.
The term “universal” is associated with flexibility. Universal life insurance premiums are flexible and may change over time.
After enough cash value accumulates, some policyholders pay premiums from cash value until it is depleted. If cash value is exhausted and premiums aren’t paid, the policy will lapse (terminate).
Premium flexibility is most useful for people with changing financial situations. If a policyholder’s income or family needs increase over time, they can increase premiums rather than applying for a new policy to raise the death benefit (which may be necessary with non-universal policies).
Let’s summarize the main test points related to universal variable life insurance:
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