Variable Life Insurance: Is It the Right Type of Life Insurance for You?

It used to be that there were two types of life insurance – whole life and term.

Whole life is life insurance with a cash accumulation feature. Not only do you get life insurance, but it also serves as an investment account to build up savings.

Term life is simply pure life insurance. You get a death benefit, but there’s no cash accumulation or investment feature. Its main benefit is that it’s much cheaper than whole life.

But, in recent decades, the industry has come up with different flavors of whole life insurance, having a stronger emphasis on the investment side of the equation.

One of those investment-specific policy types is variable life insurance.

If you like the idea of combining investing with a life insurance benefit, variable life insurance is worth investigating.

What is Variable Life Insurance?

Much like whole life insurance, variable life insurance is permanent insurance.

Unlike term life insurance, your policy can never be canceled as long as you make your premium payments.

And again, much like whole life insurance, variable life insurance also has a cash value account. But that’s where the similarities end.

Variable life insurance plus a greater emphasis on investing your cash accumulation balance.

Instead of sitting in a cash account that earns a specific rate of interest (or an interest rate range), the funds are invested in sub-accounts that offer the potential to grow with the underlying investments they’re attached to.

That means:

A variable life insurance policy can build up a larger cash value than a typical whole life insurance policy.

What’s more, variable life insurance policies have certain tax advantages.

For example, the investment income earned on your cash value accumulates on a tax-deferred basis.

As long as the funds remain in your policy, there’s no tax liability. That will keep more cash in your account, enabling you to earn still more investment income.

How Does Variable Life Insurance Work?

The main difference between a variable life insurance policy and whole life is the way your cash value is invested.

And as you might expect, while the potential is real to earn higher returns on your cash value, there’s also the risk of underperformance.

However, both the premiums and the death benefit in your policy are typically fixed regardless of the performance of the investments held.

The cash value is invested in dozens of different sub-accounts. Those sub-accounts are the key to the way variable life insurance works.

Sub-accounts

The sub-accounts are essentially the insurance equivalent of mutual funds. They can be invested in stocks, money markets, bonds, and other asset types.

However, being insurance funds, they’re not publicly traded.

You won’t find them listed on any public exchanges.

The sub-accounts offered within any life insurance policy will be specific to the insurance company you’re purchasing the policy from.

And since the sub-accounts are true investments, the policies themselves are covered under federal securities regulations.

As the owner of the policy, you can choose the sub-accounts your cash value is invested in, and even the specific allocations.

Under a variable life insurance policy, the owner can manage the investments within the policy.

But if you don’t have an understanding of investing or the risks involved, you’ll be better turning the job over to a licensed financial advisor who can do it for you. It’s very much a process of portfolio management, and that does require specific skills.

As the owner of the policy, you’ll be able to access the cash value in the policy. To do so, you’ll have a choice to either take a loan against the policy or make direct withdrawals.

You can also use some of the cash value to increase your death benefit.

Investment caps and floors

Be aware:

Insurance companies typically set caps and floors on how much can be earned or lost in a sub-account.

The company may set a floor of 0% on losses.

That means if the value of a subaccount drops by 20%, you won’t lose any money that year.

But payback for that limit comes on the upside.

The insurance company may set a maximum investment return of say, 8 percent.

If the market on that subaccount rises by 25 percent, you’ll only get the benefit of 8 percent. The remaining 17 percent will be forfeited to the insurance company.

That can be viewed as a negative, which it certainly will be in years when the underlying market performs especially well.

But the offset will occur in years when the underlying market does poorly, and you don’t lose any money.

Policy and Investment Fees

As is the case with all life insurance policies, part of your premium will go toward the payment of fees.

Some of this is for the setup and administration of your death benefit – the insurance policy itself.

Other fees are associated with the investment of your cash value.

The company may charge a general fee for the investment provision, and there will usually be fees associated with each individual sub-account.

Investment fees charged by the insurance company will be deducted from your investment earnings.

For example, if the fee on a particular sub-account is 1%, and you earn the maximum return of 8% for the year, the fee will be deducted, and your net return will be 7%.

Surrender fees

As is typical of cash value life insurance policies, you should expect a schedule of surrender fees should you attempt to cash out your policy in the first few years of ownership.

The surrender fees can apply for anywhere from five to 15 years and are often imposed on a tiered basis.

For example, there may be an 8% surrender fee in the first year, and 3% after five years. The specific surrender fee set up will be different for each insurance company issuing the policy.

Death Benefit Options

Variable life insurance policies come with multiple death benefit options, depending on the issuing company. But the two most common are level death benefit and face amount plus cash value.

Under a level death benefit, your beneficiaries will receive the face amount of your life insurance policy. The cash value portion will be forfeited.

Under a face amount plus cash value provision, your beneficiaries will receive both the face amount of the policy plus the accumulated cash value. This option will provide your beneficiaries with a larger death benefit, but the premiums will be higher throughout the term of the policy.

If you are shopping for a variable life insurance policy you should ask the insurance representative what the various death benefit options are, and select the one that’s best for you.

Where to Buy Variable Life Insurance?

If you’re interested in purchasing a variable life insurance policy, the best strategy may be to use an independent insurance broker.

He or she will work with many different companies, and be in a position to introduce you to the ones that will best suit your needs and preferences.

Should you decide to purchase a policy directly from an insurance company, it’s best to go with large, well-established providers.

They’ve been at it longer and have the financial stability that’s needed for the long-term financial commitment that a variable life insurance policy requires.

Companies like Prudential, Principal, MassMutual, Nationwide and Pacific Life are solid choices.

Pros

• Variable life insurance combines life insurance and investing in the same plan.
• The investment component holds the potential for the policy owner to earn higher returns on the cash value than will be possible with whole life insurance.
• The investments in the policy accumulate on a tax-deferred basis.
• Sub-accounts typically include floors, to prevent you from losing money when the underlying market goes negative.
• As the cash value portion of your policy increases, you’ll have the option to make withdrawals, take a loan against the policy, or use some of the funds to increase your death benefit.
• Both the premium and the death benefit will remain constant throughout the existence of the policy.
• Variable life insurance is permanent life insurance and cannot be canceled due to deteriorating health. The only way to lose the coverage is for non-payment of the premium.

Cons

• The owner of a variable life insurance policy will need significant investment knowledge, otherwise he or she will have to employ the services of a licensed financial advisor.
• There’s real potential for the cash value in the policy to lose money if the investment sub-accounts don’t perform well.
• Sub-accounts have earnings caps that will limit how much your investments will earn in a year when the underlying market performs especially well.
• Like all cash value type life insurance policies, variable life insurance does involve the payment of significant fees to the insurance company, especially in the early years of the policy.
• The investment fees associated with the sub-accounts are often higher than they are for publicly traded mutual funds, and much higher than exchange traded funds.
• Like all cash value life insurance policies, you will be required to pay a surrender fee if you want to cash-out your policy in the first few years of ownership.

Who is Variable Life Insurance Best For?

A variable life insurance policy is best selected by someone who likes combining life insurance with an investment account.

You should also have experience managing your own investments because that will be integral to the returns you’ll earn on your cash value.

You should also be comfortable with the potential risk of your investments underperforming, or even losing money.

Because of the nature of the investments in a variable life insurance policy, returns are not guaranteed.

Other Options to Consider

If you like the idea of combining life insurance with investing, but you know little about investments and have a low risk tolerance, the better option will be a regular whole life insurance policy.

Whole life insurance

Whole life insurance comes with a guaranteed minimum rate of return, and while it doesn’t have the potential to perform as well as a variable life policy will, there’s virtually no risk of loss.

But even if you are comfortable managing your own investments, you may prefer more direct control – absent but many fees associated with variable life insurance policies.

For that reason, the better choice will be to select a low-cost term life insurance policy and invest your money directly through an investment brokerage firm or even a robo-advisor.

You won’t have the guaranteed protection on the downside that you will with a variable life policy, but your investment earnings won’t be capped either.

That will hold the potential for much higher long-term returns.

Bottom Line

As you can see, variable life insurance is a very specific type of life insurance -- and a pretty complicated one at that.

It will only appeal to a very limited number of consumers, who have precise insurance and investment needs.

But because of the high fee structure, it will be better for most consumers to consider other options.

After all, when it comes to long-term investing, fees do matter – especially high ones.