Variable life insurance is an insurance product that integrates both insurance and investment components. This offers policyholders the potential for financial growth of the cash value within the policy while ensuring a death benefit for their beneficiaries. In this blog post, we will delve into the intricacies of variable insurance, exploring what it is, how it works, and the unique risks it presents compared to more traditional types of life insurance, like whole life insurance and term life insurance policies.
Understanding Variable Life Insurance
[Disclaimer: Before delving into variable life insurance, it's crucial to note that it is considered a security, requiring representatives that sell these products to hold both insurance and securities licenses. Additionally, it is subject to market risk, with investment performance impacting cash value and returns. Seek guidance from qualified professionals for accurate and tailored advice in navigating this complex financial product.]
A life insurance policy operates as a contractual agreement between the policyholder and the insurance company. In this arrangement, the insurance company commits to paying out a guaranteed minimum death benefit to the designated beneficiary upon the policyholder’s death. This commitment is secured through the payment of a monthly premium by the policyholder (Kagan, 2023).
Most Common Life Insurance Policies: Whole & Term
There are two main types of life insurance policies sold by licensed life insurance brokers: whole life insurance and term life insurance.
Whole life insurance, as the name identifies, is a life insurance policy that guarantees payment to beneficiaries for your whole life. This type of insurance requires premiums to be paid from the time the contract is initiated until the death of the policyholder. Whole life also includes a cash value component.
Term life insurance is a policy that guarantees payment to beneficiaries during a specific period of time. If you pass away during that period of time, as long as the premiums have been paid, your beneficiaries will receive a death benefit. Term tends to be much cheaper than whole life insurance since the risk differs between products.
For more info, see “Term vs Whole Life Insurance: What’s The Difference” (Kurt, 2024) on Investopedia.
In variable life insurance, the policy's cash value is invested in securities, aiming for growth that matches or exceeds the insurance’s cash value, in hopes of achieving a higher return on the existing cash value of the insurance policy. This differs from whole life insurance, where the cash value may diminish over time due to inflation or other factors. In contrast, term life insurance lacks a cash value component, meaning there are no investments in securities with growth expectations. Hence, it is safe to assume that there isn't a variable component present in term insurance.
Mechanics of Variable Life Insurance
Each monthly premium is divided into two components. A portion of the premium is directed to the insurance company. This premium covers the cost of the death benefit and administrative expenses associated with the policy.
While another portion is allocated to the cash value within policy. What sets variable life insurance apart is the investment component linked to the cash value. Policyholders have the flexibility to invest this portion into financial instruments such as mutual funds via subaccounts. The advantageous aspect here lies in the tax-deferred nature of these investments, providing an opportunity for potential growth based on market performance. (U.S. Securities & Exchange Commission, n.d.)
[Note: Please be aware that if your withdrawals from the variable life insurance policy surpass the total premiums paid, the gains may be subject to ordinary income tax. Early withdrawals or those exceeding specified limits may also incur penalties. Consult a tax advisor or financial professional for personalized guidance on the tax implications of your policy.]
Variable life insurance distinguishes itself from traditional whole life insurance policies by engaging policyholders in investment decisions. The cash value is invested in securities like mutual funds, index funds, and ETFs, offering a potential for financial growth beyond traditional life insurance structures. In this setup, policyholders have control over allocating portions of their monthly premiums to different investment subaccounts, directly impacting the cash value. While positive performance leads to growth, poor performance results in a decline in the cash value. It underscores the importance for policyholders to adopt proactive and informed investment strategies while considering a variable life insurance. (U.S. Securities & Exchange Commission, n.d.)
For instance, if you invest $100,000 with a 50-50 allocation to a stock fund and a bond fund, and the stock fund yields a 10% return while the bond fund yields 5%, your account value at the end of the year would be $107,500, minus fees and expenses.
[Example via: (U.S. Securities & Exchange Commission, n.d.) ]
Risks of Variable Life Insurance
Variable life insurance carries unique risks not found in traditional policies. There's a chance of losing money, including your initial investment. Each fund has its own risks, so reviewing prospectuses is crucial for making informed decisions. (Valentine, 2024)
The risk of policy lapses is real but can be reduced by maintaining sufficient cash value through positive investment performance and additional premium payments. A Policy lapse means termination of the contract without value, leaving beneficiaries without the intended death benefit. If a stock faces challenges, the policy's cash value could be impacted. Poor investment results or withdrawals may expedite the risk of lapses, leading to termination without value for beneficiaries.
Some variable life policies offer a solution – investing in fixed-interest accounts. These provide a stable and guaranteed return, balancing potential growth with a secure option, reducing exposure to market risks.
The Death Benefit and Policy Options
The death benefit of a variable life insurance policy is the value paid to the beneficiary upon your passing... This benefit is based on the face amount you choose when purchasing the policy. The face amount can be determined in different ways:
- Face Amount Only: The death benefit equals the face amount.
- Face Amount Plus Cash Value: The death benefit includes the face amount plus the current cash value of your account.
- Face Amount Plus Premium Payments: The death benefit comprises the face amount plus the total premium payments you've made.
For instance, if you paid $100,000 in premiums and your policy's face amount is $1,000,000, your death benefit could be $1,000,000, $1,150,000, or $1,100,000, depending on your selected option.
Other Optional Insurance Features
Variable life insurance policies often allow the inclusion of various optional features to enhance the policy's value. Here are some common options:
- No-lapse Features: Maintain policy coverage even if the account value is insufficient to cover charges. Note that these features may have limitations based on premium payments or specific policy years.
- Additional Term Insurance: Allows the purchase of additional term life insurance within the variable life insurance policy.
- Disability Rider: Keeps the policy active if you become disabled and cannot pay charges.
- Accelerated Death Benefit: Provides a portion of the death benefit if you are chronically or terminally ill while still alive.
- Long-term Care Insurance: Coverage for the cost of long-term care.
- Income Benefit: Guarantees a minimum monthly income to you or beneficiaries for a specified period.
- Accidental Death Benefit: Offers an extra death benefit in case of death due to an accident.
Consulting a financial professional who can give you a broader perspective on the value of these features given your overall financial plan and objectives is extremely valuable when considering any type of financial product, particularly insurance.
You can learn how to choose a financial professional with our Earn course.
Important Considerations for Personal Needs
Certain charges are influenced by personal factors (age, health, dependents, etc.), potentially being more significant for individuals presenting a higher risk to the insurance company. It's crucial to be aware of the following when opting for these features:
- Optional features come with additional fees, so understanding the costs is vital.
- Assess the necessity of each feature and explore whether similar benefits can be obtained more affordably through separate policies.
- These features are intricate, with associated risks and limitations.
Navigating Variable Life Insurance Fees and Expenses
Understanding the costs of variable life insurance is vital for potential buyers. Sales fees, which are a percentage of premiums, impact the applied policy amount. Additionally, surrender charges apply if you surrender the policy early, compensating for unrecoverable sales expenses. Mortality and expense risk fees are pivotal for policy sustainability, as higher fees can add up based on the frequency of the trades and require careful consideration. The cost of insurance, which varies per individual, depends on factors like age, gender, health, and death benefit amount. Administration fees cover essential policy activities, and loan interest affects the feasibility of repaying any loans you take out against the policy.
It's crucial to be mindful of various expenses, fees for optional features, and transaction charges associated with a policy. Buyers should seek comprehensive explanations from financial professionals and consult the prospectus for a detailed breakdown of the fees and limitations of the policy before committing to a variable life insurance policy.
Conclusion
In conclusion, variable life insurance is a nuanced financial product that blends protection and investment. Understanding its mechanics and associated risks is crucial for making an informed decision on whether it is a good financial tool to meet your needs. As you explore variable insurance options, consider factors like premium flexibility, investment allocations, and potential risks.
Resources:
