Life insurance helps ensure family members and/or other beneficiaries are financially supported if someone dies. This is especially important in households that rely on 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, whether or not the insured person is also the policyholder. As long as required premiums are paid, the insurer pays a death benefit to the beneficiaries when the insured person dies.
Variable life insurance uses a fixed premium payment schedule. The premium amount is set when the contract is issued, and the policyholder is expected to make those payments over time. If premiums aren’t paid, the policy lapses, and the policyholder receives the cash value (discussed below) minus any applicable fees.
Variable life insurance includes a guaranteed minimum death benefit. The death benefit and the cash value may also grow over time. To see why, 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* and pays a fixed premium of $200 per month. Early on, the cost of the death benefit (the cost to insure their life) might be $50 per month. The remaining $150 would be credited to cash value. As the insured person ages, the cost of insurance typically rises, which means less of each premium goes toward cash value. At age 60, the cost of insurance might rise to $160 per month, leaving only $40 per month to add 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 for several purposes. In most cases, only the policyholder can access the 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, which grows* to $75,000. If the investor takes a $60,000 distribution, ordinary income taxes apply to the $10,000 of growth, but not to 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, use the cash value, and purchase the equivalent of term life insurance on the insured person. This option is typically only available to insured persons under age 80, since many insurers don’t offer term life insurance to very elderly applicants.
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 the policy and receive the cash value minus any applicable surrender fees. Surrender fees are charges paid to the insurance company when the policy is canceled. Many surrender fee schedules decline over time (higher in 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 or viatical settlement, and it’s 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, 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 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 a menu of portfolios that resemble mutual funds, providing exposure to asset classes such as common stock, preferred stocks, 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:
*Other forms of life insurance exist than the ones discussed in this chapter, although not generally tested on the Series 7. 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 non-variable life insurance, which is performed in the general account (similar to the structure of a fixed annuity).
The separate account is what allows the cash value (and potentially the death benefit) to grow over time. If the separate account performs well, both may increase. If the separate account declines, both the cash value and the death benefit may decline as well. Variable life insurance contracts typically provide a minimum guaranteed death benefit regardless of how far the separate account falls, 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 whole life insurance and universal life insurance. Both provide coverage for the policyholder’s entire life, include a death benefit, and invest cash value in the insurance company’s general account. Neither is considered a security. The key difference is how premiums work.
Let’s summarize the main test points related to universal 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 options for the death benefit and cash value through the separate account, and are considered securities*. The main 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, plus the professionals selling this type of product are subject to registration with both securities regulators and insurance regulators.
The term “universal” is associated with flexibility, especially for premiums. With universal life insurance, premiums are flexible and can change over time.
After enough cash value accumulates, some policyholders pay premiums from cash value until it’s depleted. If cash value is exhausted and the policyholder doesn’t resume premium payments, the policy will lapse (terminate).
Premium flexibility is most useful for people whose financial situation changes over time. If income or family needs increase, the policyholder can often 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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