Variable Life Insurance Overview

Variable life insurance is a permanent life insurance policy where the cash value is invested in separate accounts (similar to mutual funds), and the policyowner bears the investment risk. Unlike traditional whole life or universal life, variable products offer the potential for higher returns but also the risk of investment losses.

Key Characteristics

Investment Component

• Separate accounts: Cash value invested in subaccounts (stocks, bonds, money market, etc.)
• Policyholder chooses: Select from available investment options
• Market risk: Cash value fluctuates based on investment performance
• No guaranteed cash value: Unlike whole life, cash value not guaranteed (can decrease)
• Higher potential returns: Can outperform fixed-rate policies in strong markets

Securities Product

• Regulated as security: Subject to SEC (Securities and Exchange Commission) regulation
• Prospectus required: Must provide prospectus to potential buyers
• Dual licensing required: Must have life insurance license AND securities license
• FINRA oversight: Subject to Financial Industry Regulatory Authority rules

Permanent Coverage

• Lifetime protection: Designed for permanent coverage like whole life
• Minimum guaranteed death benefit: Traditional variable life guarantees minimum
• Death benefit can increase: Can grow if investments perform well
• Premium requirements: Must pay sufficient premiums to maintain coverage

Licensing Requirements

To sell variable life insurance, agents must have both:

1. State Life Insurance License

• Standard requirement: Same license for selling whole life and term
• State-specific: Licensed in state where policy sold

2. FINRA Securities Registration

• Series 6: Investment Company and Variable Contracts Products license (limited)
• Allows sale of mutual funds, variable annuities, variable life
• Does NOT allow stocks, bonds, or other securities
• Series 7: General Securities Representative license (comprehensive)
• Allows sale of all securities including variable products
• More comprehensive than Series 6
• Series 63: Uniform Securities Agent State Law (often required in addition)

3. Firm Registration

• Broker-dealer: Must be associated with registered broker-dealer
• Supervision: Subject to supervisory review of variable product sales

Traditional Variable Life Insurance

Structure

• Fixed premiums: Level premium like whole life (not flexible)
• Scheduled premium: Must pay specified premium amount
• Separate accounts: Cash value invested in subaccounts
• Minimum death benefit: Guaranteed minimum (usually initial face amount)
• Increasing death benefit potential: Can increase if investments perform well

Death Benefit

• Guaranteed minimum: Typically the initial face amount (e.g., $250,000)
• Increases with performance: If cash value growth exceeds certain level
• Decreases with poor performance: But not below guaranteed minimum
• Net amount at risk: Difference between death benefit and cash value

Example:

Initial face amount: $250,000 (guaranteed minimum)
Cash value after 10 years: $80,000 (strong market performance)
Actual death benefit: $280,000 (increased due to cash value growth)

If investments later decline:
Cash value drops to: $40,000
Actual death benefit: $250,000 (reverts to guaranteed minimum)

Cash Value

• No guarantee: Can increase or decrease based on investment performance
• Can lose value: Poor investment returns reduce cash value
• Potential for growth: Can outperform whole life in bull markets
• Access: Can borrow or withdraw (like other permanent policies)

Premiums

• Fixed level premiums: Same amount due each year (not flexible)
• Must be paid: Missing premiums can cause policy to lapse
• Higher than whole life: Typically more expensive due to investment features
• Insufficient premiums: If cash value depleted and premiums not paid, policy lapses

Variable Universal Life (VUL)

VUL combines the investment features of variable life with the flexibility of universal life.

Key Features

• Flexible premiums: Can adjust premium amounts (like UL)
• Adjustable death benefit: Can increase or decrease face amount (like UL)
• Separate accounts: Invested in subaccounts (like variable life)
• Market risk: Policyholder bears investment risk
• No guaranteed cash value: Cash value can decrease to zero
• Minimum guarantees: Some VUL policies offer no-lapse guarantees

Premium Flexibility

• Variable payments: Can pay more, less, or skip premiums
• Minimum required: Must maintain minimum to keep policy in force
• Overfunding option: Can add extra to build cash value faster (MEC limits apply)
• Underfunding risk: May cause policy to lapse if cash value insufficient

Death Benefit Options

• Option A (Level): Fixed face amount
• Option B (Increasing): Face amount plus cash value
• Adjustable: Can change between options (may require underwriting)

Lapse Risk

VUL has higher lapse risk than traditional variable life: - Market downturns: Poor investment returns deplete cash value - Rising COI charges: Cost of insurance increases with age - Insufficient premiums: Flexible premiums may lead to underfunding - No minimum guarantee: Cash value can drop to zero

Separate Accounts

Separate accounts are the investment vehicles in variable products:

Structure

• Legally separate: Assets held separately from insurer's general account
• Not subject to creditors: Protected from insurer's creditors if insurer fails
• Divided into subaccounts: Each subaccount is like a mutual fund
• Professional management: Each subaccount managed by portfolio managers

Investment Options

Typical subaccount choices: - Equity funds: Stocks (aggressive growth, growth, value, international) - Bond funds: Fixed income (government, corporate, high-yield) - Balanced funds: Mix of stocks and bonds - Money market: Cash equivalents (lowest risk, lowest return) - Index funds: Track market indexes (S&P 500, etc.) - Sector funds: Specific industries (technology, healthcare, etc.)

Asset Allocation

• Policyholder chooses: Select percentage in each subaccount
• Can change allocation: Typically can reallocate quarterly or more often
• Dollar cost averaging: Some policies allow automatic monthly transfers
• Rebalancing: Can rebalance to maintain target allocation

Example Allocation:

40% - Large Cap Stock Fund
20% - International Stock Fund  
25% - Bond Fund
10% - Small Cap Stock Fund
5% - Money Market Fund

Investment Risk and Returns

Policyholder Bears Risk

• Market risk: Value declines with poor market performance
• No guaranteed returns: Unlike whole life's guaranteed rate
• Can lose principal: Cash value can decrease below premiums paid
• Volatility: Cash value fluctuates with market conditions

Potential for Higher Returns

• Upside potential: Can earn higher returns than fixed-rate policies
• Long-term growth: Historically, stocks outperform bonds and cash
• Tax-deferred growth: Investment gains grow tax-free until withdrawn
• Compound growth: Reinvested gains grow over time

Diversification

• Multiple subaccounts: Spread risk across different investments
• Asset classes: Mix of stocks, bonds, money market reduces volatility
• Professional management: Expert portfolio managers make investment decisions

Fees and Charges

Variable products have multiple layers of fees:

Insurance Charges

• Mortality and expense (M&E) risk charge: Typically 1-1.5% annually
• Compensates insurer for insurance risks
• Covers guaranteed death benefit
• Cost of insurance (COI): Monthly charge for death benefit
• Increases with age
• Based on mortality tables
• Administrative fees: Policy maintenance ($5-15/month)

Investment Charges

• Subaccount management fees: Typically 0.5-2% annually
• Like mutual fund expense ratios
• Paid to investment managers
• Varies by subaccount
• Transfer fees: May charge for excessive transfers between subaccounts

Surrender Charges

• Early withdrawal penalties: Typically 7-15 year declining schedule
• Percentage of premium or account value: E.g., Year 1: 10%; Year 10: 0%
• Applies to surrenders: Full or partial withdrawals may trigger charges

Other Charges

• Premium load: Front-end charge on premiums (if applicable)
• Rider charges: Additional costs for optional riders
• CDSC (Contingent Deferred Sales Charge): Back-end load on some contracts

Example Total Annual Cost:

M&E risk charge: 1.25%
COI charge: 0.50% (age 45)
Subaccount fees: 0.75% (average)
Admin fee: $120/year
Total effective cost: ~2.5% + $120/year

Tax Treatment

Tax-Deferred Growth

• No current taxation: Investment gains not taxed annually
• Compound growth: Money that would go to taxes stays invested
• Tax benefit: Significant advantage over taxable accounts

Distributions

• Withdrawals: Taxed as ordinary income to extent of gain (FIFO basis)
• Loans: Not taxable if policy maintained
• Surrender: Gain taxed as ordinary income
• Modified Endowment Contract (MEC): Loans and withdrawals taxed less favorably

Death Benefit

• Income tax-free: Beneficiaries receive death benefit tax-free
• Estate taxes: May be subject to estate tax if large estate
• Step-up not applicable: Unlike inherited investments (no step-up in basis)

Regulatory Requirements

Securities and Exchange Commission (SEC)

• Registration: Variable contracts registered with SEC
• Prospectus: Must be delivered before or at sale
• Disclosure: Full disclosure of risks, fees, features required
• Advertising rules: Subject to SEC advertising regulations

FINRA (Financial Industry Regulatory Authority)

• Suitability: Must determine product suitable for client
• Know Your Customer (KYC): Understand client's financial situation
• Supervision: Sales subject to broker-dealer supervision
• Record keeping: Detailed records of recommendations and sales

State Insurance Regulation

• Insurance license: Subject to state insurance regulations
• Suitability standards: State insurance suitability rules apply
• Replacement regulations: Special rules if replacing existing policy

Prospectus

Must include: - Investment options: Description of all subaccounts - Fees and charges: Complete fee disclosure - Risks: Investment and insurance risks - Historical performance: Past subaccount returns - Guarantees: What is and isn't guaranteed

Advantages of Variable Life

1. Higher return potential: Can outperform fixed-rate policies
2. Investment control: Choose how cash value is invested
3. Tax-deferred growth: No annual tax on investment gains
4. Death benefit protection: Minimum guaranteed death benefit (traditional VL)
5. Professional management: Expert portfolio managers
6. Inflation hedge: Equity investments can keep pace with inflation
7. Separate account protection: Assets protected if insurer fails
8. Flexibility (VUL): Adjustable premiums and death benefit

Disadvantages of Variable Life

1. Investment risk: Cash value can decrease or be lost entirely
2. Complexity: More complicated than traditional life insurance
3. Higher fees: Multiple layers of charges reduce returns
4. No guaranteed cash value: Unlike whole life's guaranteed growth
5. Market volatility: Cash value fluctuates with market conditions
6. Lapse risk: Policy can lapse if cash value depleted
7. Licensing requirements: Requires securities license to purchase
8. Requires active management: Must monitor investments and make allocation decisions

Comparing Variable Life Products

Comparing to Other Permanent Products

When to Choose Variable Life

Best For:

• Investment-savvy individuals: Comfortable managing investments
• Long-term planning: Time horizon of 15+ years
• Higher risk tolerance: Can accept market volatility
• Maximum growth potential: Want upside potential over guarantees
• Tax-deferred accumulation: High-income earners seeking tax advantages
• Younger insureds: More time to recover from market downturns

Not Ideal For:

• Risk-averse individuals: Cannot tolerate market losses
• Simplicity seekers: Prefer straightforward products
• Guaranteed income needs: Require predictable cash value growth
• Short-term needs: Need coverage for defined period (use term instead)
• Seniors: Less time to recover from market losses
• Those without securities license: Cannot purchase without proper licensing

Key Exam Concepts

• Variable life = separate accounts + investment risk + securities product
• Dual licensing required: Life insurance license + FINRA registration (Series 6 or 7)
• Prospectus required: Must be delivered before or at sale
• Policyholder bears investment risk: Cash value can increase or decrease
• No guaranteed cash value: Unlike whole life
• Minimum guaranteed death benefit: Traditional variable life (not VUL)
• Separate accounts: Protected from insurer's creditors
• VUL = variable life + universal life flexibility
• VUL higher lapse risk: Due to flexible premiums and no cash value guarantee
• M&E charge: Mortality and expense risk charge (1-1.5% typically)
• Subaccount fees: Like mutual fund expense ratios
• Tax-deferred growth: Investment gains not taxed until withdrawn
• Death benefit tax-free: To beneficiaries (income tax)
• Suitability required: Must determine product appropriate for client
• SEC and FINRA regulation: Subject to securities regulations
• Can reallocate: Change investment mix among subaccounts
• Dollar cost averaging: Automatic periodic transfers available