Variable Life Insurance

Substantial fees, expenses, and tax implications generally make variable life insurance unsuitable as a short-term savings vehicle. Different variable life insurance policies have different features.

A Security Issued by an Insurance Company

Variable life and variable universal life insurance are considered securities and must be registered with the Securities and Exchange Commission, known as the SEC. The policy is issued by an insurance company.

Under a traditional life insurance policy, premium payments are allocated to an insurer's general account and invested, consistent with state law requirements, to enable the insurer to meet its death benefit and cash value guarantees. Premium payments under a variable life policy, in contrast, are invested in an insurance company separate account, which generally is not subject to state law investment restrictions.

An owner can lose money in a variable life insurance policy, including potential loss of the initial investment. The value of the investment and any returns will depend on the performance of the investment options the owner chooses. If the investment options selected for the policy perform poorly, the owner could lose money, including the initial investment. Each underlying fund may have its own unique risks. The financial strength of the insurance company that issues the policy backs all guarantees, including the death benefit. If the insurance company experiences financial distress, it may not be able to pay what it owes under the policy.

Types of Variable Life Insurance

The Financial Industry Regulatory Authority, known as FINRA, describes variable life as a type of security that offers fixed premiums and a minimum death benefit. The rule of the SEC that exempts certain variable life insurance separate accounts, Rule 6e-2, defines a variable life insurance contract as a contract of life insurance, subject to regulation under the insurance laws or code of every jurisdiction in which it is offered, funded by a separate account of a life insurer. So long as premium payments are duly paid in accordance with its terms, the contract provides for a death benefit and cash surrender value which vary to reflect the investment experience of the separate account. It also provides for an initial stated dollar amount of death benefit, and payment of a death benefit guaranteed by the life insurer to be at least equal to that stated amount. The life insurer assumes the mortality and expense risks, for which a charge against the assets of the separate account may be assessed.

FINRA describes variable universal life insurance as combining features of universal life insurance and variable life insurance. It offers flexibility in premium payments and insurance coverage, as well as an investment account. The separate SEC rule for flexible premium variable life insurance separate accounts, Rule 6e-3, defines a flexible premium variable life insurance contract as a contract of life insurance, subject to regulation under the insurance laws or code of every jurisdiction in which it is offered, funded by a separate account of a life insurer, which provides for four things.

First, premium payments that are not fixed by the life insurer as to both timing and amount. The life insurer may fix the timing and minimum amount of premium payments for the first two contract periods following issuance of the contract or of an increase in or addition of insurance benefits, and may prescribe a reasonable minimum amount for any additional premium payment.

Second, a death benefit the amount or duration of which may vary to reflect the investment experience of the separate account.

Third, a cash value which varies to reflect the investment experience of the separate account.

Fourth, a reasonable expectation that subsequent premium payments will be made.

Read side by side, the two definitions differ on the guarantee. The first requires a death benefit guaranteed by the life insurer to be at least equal to a stated amount. The second provides for premium payments not fixed by the life insurer as to both timing and amount, and its death benefit is one the amount or duration of which may vary to reflect the investment experience of the separate account. It does not require the insurer to guarantee a minimum death benefit.

Some variable life insurance policies require the owner to pay a set amount in premiums, and others allow the owner to pay varying premiums as long as the owner contributes enough to cover policy fees and expenses.

The Separate Account

As the Investment Company Act of 1940 defines it, a separate account is an account established and maintained by an insurance company pursuant to the laws of any State or territory of the United States, or of Canada or any province thereof, under which income, gains and losses, whether or not realized, from assets allocated to such account are, in accordance with the applicable contract, credited to or charged against such account without regard to other income, gains, or losses of the insurance company.

A separate account funding a variable life insurance policy most commonly is registered as a unit investment trust under that Act. Separate accounts registered as unit investment trusts are divided into sub-accounts, each of which invests in a different open-end management investment company, or mutual fund, called a Portfolio Company. Both separate account unit investment trusts and the Portfolio Companies in which they invest are registered as investment companies under the Investment Company Act, and their securities are registered under the Securities Act of 1933. Investors in variable life insurance policies receive the prospectuses for both the separate account unit investment trust and the Portfolio Companies.

Premiums

With a variable life insurance policy, the owner is required to pay premiums into an account. The amount of the premium payments that go into the account may be less than the owner paid because fees were taken out of the payments. The money in the account gets invested in a selection of investment options, typically mutual funds, that the owner can choose.

The Death Benefit

Variable life insurance pays a specified amount of money to the owner's family or other beneficiaries when the owner dies. This is called the death benefit. When the owner purchases a variable life insurance policy, the owner selects a face amount, which is the amount the death benefit is based on. A death benefit could be equal to the face amount, the face amount plus the cash value of the account, or the face amount plus the amount of premiums the owner contributed to the policy.

The owner may be able to purchase additional insurance features to increase the value of the death benefit. In addition, the owner may be able to increase the face amount at a later date. Such changes might require another medical examination or other evaluation by the insurance company.

The financial strength of the insurance company that issues the policy backs all guarantees, including the death benefit. If the insurance company experiences financial distress, it may not be able to pay what it owes under the policy.

The Cash Value

The cash value varies depending, in part, on the performance of investments the owner chooses. Unlike whole life insurance, the cash value of variable life insurance is invested in a portfolio of securities. As the policyholder, the owner can choose a mix of investments from those the policy offers.

Fees and Charges

An owner pays several ongoing and transaction-based fees and expenses when investing in a variable life insurance policy. These fees and expenses may be significant and will reduce the value of the account. They may require the owner to pay additional premiums to prevent the policy from lapsing (terminating). The policy may quote fees and expenses on a monthly or yearly basis. It is important to understand all the fees and expenses before investing. Often, variable life insurance fees and expenses include the following.

Mortality and expense risk fees are ongoing fees equal to a certain percentage of the account value. They help cover the risks the insurance company assumes with respect to the policy. Risks might include that the policy owner may die sooner than expected, that administrative and sales costs are higher than expected, and that policy owner behavior does not match the insurance company's expectations.

Sales fees imposed on premiums are a percentage of the amount paid. They reduce the amount of the premium payment applied to the policy. They typically compensate the insurance company for sales expenses.

The cost of insurance is an ongoing fee that varies for each insured based on factors including the insured person's age, gender, health, and death benefit amount. It compensates the insurance company for providing the death benefit.

Administration fees are ongoing fees that help cover the insurance company's costs of issuing and administering the policy, and activities such as processing claims, maintaining records and communicating with the owner. They may be charged as a flat account maintenance fee or as a percentage of the account value.

Transaction fees cover services the owner requests. Some policies assess fees for transactions like transferring money among investment options, partial withdrawals, increasing or decreasing the face amount, or providing additional reports.

Loan interest is charged on any loan amount outstanding if a policy permits loans.

Underlying fund fees arise because the investment options of a variable life insurance policy are typically a range of mutual funds. The owner indirectly pays the fees and expenses of the mutual funds the owner picks as underlying investments, because mutual funds charge fees and expenses to their investors. These fees are in addition to the fees charged by the insurance company and are deducted from the returns of the investment options.

Optional benefit fees apply because the optional features offered by some variable life insurance policies carry additional fees. These fees can vary significantly based on type of benefit and/or the individual insured.

Surrender Charges

A surrender charge applies if the owner surrenders the policy or makes a withdrawal in the early years of the contract. It compensates the insurance company for sales expenses that it would otherwise not recover in the event of early surrender. The length of the surrender charge period should be checked when evaluating a policy.

A surrender charge might also apply upon a full surrender, lapse, or decrease in face amount value of a variable life insurance policy. Unlike variable annuity surrender charges, a variable life insurance policy surrender charge is not tied to premium payments. Instead, it is calculated based on individual characteristics of the policy holder, such as age and other characteristics.

Policy Loans and Lapse

Variable life insurance policies typically permit the owner to take loans on a portion of the policy's cash value without incurring surrender charges or paying federal taxes. Policy loans typically have the following effects on the policy. They reduce the policy's cash value, which increases the likelihood the policy will lapse. They may reduce the death benefit. They are typically not subject to surrender charges. The owner will typically owe interest on the amount borrowed. They may be repaid without the deduction of a sales fee.

If the owner does not maintain sufficient cash value to pay the policy's fees and expenses, the policy may lapse. That means it will terminate without value and the beneficiary will not receive any death benefit. This might occur due to policy fees and expenses, poor investment performance or loans. A significant number of life insurance policies lapse. Some policies offer protection from lapse for an additional fee.

Taxes

The cash value may accumulate on a tax-deferred basis. This means the owner will only be subject to federal income tax when the owner withdraws money from the policy. The policy's gains will be subject to ordinary federal income tax rates rather than lower capital gains rates. The death benefit paid to the beneficiaries is not subject to federal income tax. Under certain circumstances, the death benefit may not be subject to federal estate tax. The owner may take loans from the policy without paying federal income taxes. However, if the policy terminates with a loan outstanding, the owner may owe federal income taxes on the loan. The federal tax rules that apply to variable life insurance can be complicated and may change over time. In addition, there may be state tax implications. Before investing, an owner may want to consult a tax adviser about the tax consequences of investing in variable life insurance.

The Free Look Period

The owner may cancel the policy within a short period, usually 10 to 30 days, of receiving it without a penalty fee called a surrender charge. This is called the free look period. Upon cancellation, the owner will typically receive a refund of premiums. The refund may be adjusted up or down to reflect the performance of the investment options. The contract should prominently state how long the free look period is and how to return the contract.

Replacing a Policy

In some cases an owner exchanges an existing variable life insurance policy for a new policy that has features the owner prefers. As the owner ages, the cost to insure the owner is likely to increase, so a new policy may be more expensive. Surrender charges are typically higher in the early years the owner owns a policy. If the owner exchanges a policy, the owner may be subject to a surrender charge on the existing policy and a new surrender charge period on the new policy. The tax consequences associated with a policy exchange are a further consideration. The existing policy should not be cancelled until the new policy is in effect, so that there is no gap in insurance coverage.

Representative Qualification Exams

FINRA lists variable life insurance among the securities products that a candidate who passes the Series 6 exam is qualified to solicit, purchase and/or sell, together with mutual funds (closed-end funds on the initial offering only), variable annuities, unit investment trusts and municipal fund securities. A candidate who passes the Series 7 exam is qualified for the solicitation, purchase and/or sale of all securities products, including investment company products and variable contracts.

FINRA Rule 2320

FINRA Rule 2320 applies exclusively, and in lieu of Rule 2341, to the activities of members in connection with variable contracts, to the extent such activities are subject to regulation under the federal securities laws. Under Rule 2320(b)(2), the term variable contracts means contracts providing for benefits or values which may vary according to the investment experience of any separate or segregated account or accounts maintained by an insurance company.

Under Rule 2320(e), a member who is a principal underwriter as defined in the Investment Company Act may not sell variable contracts through another broker-dealer unless that broker-dealer is a member and a sales agreement is in effect between the parties. The sales agreement must provide that the sales commission be returned to the issuing insurance company if the variable contract is tendered for redemption within seven business days after acceptance of the contract application.

Rule 2320(g)(4) covers non-cash compensation. It provides that no member or person associated with a member shall directly or indirectly accept or make payments or offers of payments of any non-cash compensation, except as the rule provides. The permitted arrangements must be consistent with the applicable requirements of Securities Exchange Act Rule 15l-1, known as Regulation Best Interest. They include gifts that do not exceed an annual amount per person fixed periodically by FINRA and are not preconditioned on achievement of a sales target, and an occasional meal, a ticket to a sporting event or the theater, or comparable entertainment which is neither so frequent nor so extensive as to raise any question of propriety and is not preconditioned on achievement of a sales target.

The content outline for the Securities Industry Essentials examination lists variable contracts/annuities under Topic 2.1.4, Packaged Products, in Section 2, Understanding Products and Their Risks. It also lists Rule 2320(g)(4), titled Non-cash Compensation, in the FINRA rules list for Section 4, Overview of the Regulatory Framework. Candidates should check the current outline before the examination.

Common Misunderstandings

Variable life insurance is only an insurance product, so it is not a security. Variable life and variable universal life insurance are considered securities and must be registered with the SEC.

Variable life and variable universal life insurance work the same way on premiums. Variable life offers fixed premiums, while variable universal life offers flexibility in premium payments and insurance coverage.

Every variable life contract is defined with a guaranteed minimum death benefit. The definition of a variable life insurance contract requires a death benefit guaranteed by the life insurer to be at least equal to a stated amount, while the definition of a flexible premium variable life insurance contract describes a death benefit the amount or duration of which may vary with the separate account's investment experience and has no such guarantee requirement.

The insurer bears the investment risk on the cash value. The cash value varies depending, in part, on the performance of investments the owner chooses, and an owner can lose money, including potential loss of the initial investment. The financial strength of the insurance company backs the guarantees, including the death benefit.

The premiums of a variable life policy go to the insurer's general account. Premium payments under a variable life policy are invested in an insurance company separate account.

Surrender charges on variable life insurance are tied to premium payments, as they are on variable annuities. Unlike variable annuity surrender charges, a variable life insurance policy surrender charge is not tied to premium payments, and it is calculated based on individual characteristics of the policy holder.

Key Points

Variable life and variable universal life insurance are securities that must be registered with the SEC.

Variable life offers fixed premiums and a minimum death benefit. Variable universal life offers flexibility in premium payments and insurance coverage, as well as an investment account.

The cash value varies with the investment performance of the options the owner chooses, and the premiums are invested in a separate account, not the insurer's general account.

A candidate who passes the Series 6 exam is qualified to sell variable life insurance, a candidate who passes the Series 7 exam is qualified for all securities products, including variable contracts, and FINRA Rule 2320 applies to the activities of members in connection with variable contracts.