Variable life insurance

Most insurance products are not considered securities, but these meet the legal definition:

• Variable life insurance
• Variable annuities

Both involve investing in products tied to the securities markets, but each has its own unique purpose. Life insurance provides a payout upon the death of an insured person. Annuities typically offer income to a retiree until their death (we’ll cover this in the next chapter). In this chapter, we’ll discuss variable life insurance.

Variable life insurance

Life insurance is a vital tool to ensure family members or beneficiaries are financially supported in the event of a person’s death. This is especially important for families with one “breadwinner” (money earner). Variable life insurance offers coverage throughout the insured person’s life, regardless of whether they’re the policyholder or not. As long as required premiums are paid, a payment (known as a ‘death benefit’) is delivered to beneficiaries upon the insured person’s death.

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. The policy lapses if premiums go unpaid, and a payout of the cash value (discussed below) minus any applicable fees is returned 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) might be $50 per month. In this example, the “extra” $150 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.

**The cost of insuring a person’s life is arbitrary and determined by the insurance company. The younger a person is, the less likely they are to die unexpectedly. Therefore, the cost of the death benefit is lower for younger insured persons, but the cost will rise over time.

Cash value can be used for several purposes. In most instances, the policyholder may only access the cash value during the insured person’s lifetime. It can be withdrawn or borrowed after the policy has been in place for some time (usually three years) as long as the insured person is still alive. Any cash value withdrawn or borrowed and not repaid is usually 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 below.

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

• Keep death benefit for a shorter period
• Retain insurance with a lower death benefit
• Surrender and receive the cash value

Keep death benefit for a shorter period
The policyholder can essentially surrender the 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.

*Term life insurance is the most basic form of life insurance. The policyholder pays a fixed premium to maintain a death benefit over an insured person for a specified period (term). For example, a person pays $50 monthly to insure their life over the next ten years for $250,000. The policy expires if the person survives the term (10 years in this example).

Retain insurance with lower death benefit
The policyholder can stop paying premiums in exchange for a lower death benefit. 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.

Cash value is contributed to a separate account, similar to the structure of a variable annuity (discussed in the next chapter). The policyholder owns the cash value and determines how it is invested. They are typically provided access to numerous portfolios of securities that are similar to mutual funds, giving them access to a variety of different asset classes like common stock, preferred stock, and bonds. The policyholder determines 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). 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 SIE exam. For example, whole life insurance is similar to variable life insurance, but the policyholder does not maintain control of investing. This is handled by the insurance company, which accepts the relevant risks (e.g., market risk).

The separate account provides for the growth of both the death benefit and the cash value over time. If the separate account performs well, both will grow. However, the death benefit and cash value may decline if the separate account declines. Variable life insurance contracts typically provide a minimum guaranteed death benefit, no matter how far the separate account declines, 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 a separate account
• Cash value grows based on investment performance
• Policyholder is 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