Most insurance products aren’t considered securities, but these meet the legal definition:
Both involve investing in products tied to the securities markets, but each serves a different purpose. Life insurance pays out when the insured person dies. Annuities typically provide income to a retiree until death (covered in the next chapter). This chapter focuses on variable life insurance.
Life insurance helps provide financial support to family members or other beneficiaries if a person dies. This is often most important when a household relies heavily on one primary income earner.
Variable life insurance is a type of permanent life insurance. It provides coverage for the insured person’s entire life as long as required premiums are paid. When the insured person dies, the insurer pays a death benefit to the beneficiaries.
Variable life insurance uses a fixed premium 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 can lapse. When that happens, the insurer returns the policy’s cash value (explained below) to the policyholder, minus any applicable fees.
Variable life insurance also provides a minimum guaranteed death benefit. The death benefit and the cash value may increase over time, depending on investment performance. To see why, we need to understand cash value.
Variable life insurance builds cash value over time. For example, 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** (the cost of insuring their life) might be $50 per month. In this example, the remaining $150 is treated as cash value. As the insured person gets older, the cost of insurance typically rises, which reduces the amount going toward cash value. At age 60, the death benefit cost could increase 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.
**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 cases, the policyholder can access cash value only while the insured person is alive. After the policy has been in force for a period of time (often three years), cash value may be withdrawn or borrowed, as long as the insured person is still alive.
Any cash value that’s withdrawn or borrowed and not repaid is usually subtracted from the death benefit. Also, 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
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, since many insurance companies don’t 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 fully surrender 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 fees follow a sliding time scale: fees are higher in the early years and lower in later years. Any gains above 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 chooses how it’s invested. Typically, the policyholder can select from multiple portfolios of securities that resemble mutual funds, providing exposure to asset classes such as common stock, preferred stock, and bonds.
Because the policyholder controls the investment choices, the policyholder also chooses the level of risk. In general, taking more risk increases the potential for higher returns over time, but it also increases the chance of losses.
Separate accounts have a few important consequences:
First, the policyholder - not the insurance company - accepts the risks of investing (for example, market risk). This differs from other types of life insurance, where the insurance company typically bears the investment risk.*
Second, insurance products with variable features are considered securities. That means they’re subject to registration and securities regulations (covered in future chapters). To offer variable life insurance, a person must hold both securities and insurance licenses. 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 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 performs poorly, both may decline. 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:
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