Variable life insurance policies stand out for their investment component. As a policyholder, you can control the way your cash value is invested, but there are no guarantees on return.
What is variable life insurance?
Variable life insurance is a permanent policy that builds cash value over time — and a portion of that cash value is invested in the market. Your provider will present you with a portfolio of stocks, bonds and mutual funds to choose from, and you can allocate your funds accordingly.
While the investment is professionally managed by the insurance company and may boost your returns, your money is subject to the ups and downs of the market. For this reason, variable life insurance is considered a security, and is the only kind of policy that’s sold with a prospectus.
Like other permanent policies, variable life insurance offers lifelong protection as long as you keep up with your premiums, plus the ability to take out a loan against your policy. The premiums are adjustable, and the policy pays out a tax-free benefit to your beneficiaries when you die. The amount your beneficiaries receive depends on the performance of your investments, so there’s no guaranteed or minimum rate of return.
Is this the same thing as variable universal life insurance?
As the name suggests, variable universal life insurance is a hybrid of variable and universal life insurance. With this policy, you can invest in the market and change the amount and frequency of your premium payments. The key difference is how you pay your premiums.
Choose to make a larger lump sum payment within the minimum and maximum limits, or use your accrued cash value to cover your premiums. This is why these policies are sometimes referred to as flexible premium variable life insurance.
Let’s say your premium is $400 per month. Once your cash value hits a certain number, you can opt to pay $100 out of pocket and use your cash value to pay the rest.
How does variable life insurance work?
Variable life insurance is unique when it comes to the way the cash value is invested.
Every time you pay your premium, a percentage of it will go toward the cash value of your policy. That cash value will then be invested in a number of sub-accounts. Think of these sub-accounts as mutual funds: They’re managed by your insurer and you wouldn’t be able to invest in them outside of the variable life insurance policy.
Since the cash value is an investment, it carries a degree of risk. It can and will fluctuate with the market.
If you purchase variable life insurance, you need to be comfortable with bearing that risk, as it may affect the death benefit as well as the amount of money you can borrow against your policy while you’re alive. You could surrender your policy to collect the cash value, too.
Like all life insurance policies, your beneficiaries will receive a death benefit when you die.
How can I borrow against my policy?
Once you’ve accumulated enough cash value, you can begin taking loans against your policy. The amount you can borrow varies, but many insurers will allow you to withdraw up to 90% of the cash value amount.
The loan is tax-free and charged at a lower interest rate than traditional loans — but if you don’t pay it off, your insurer will dip into the death benefit when you die. This means your beneficiaries may not receive as much money as you intended to leave them.
Why choose variable life insurance?
Variable life insurance could be an attractive choice for these reasons:
There’s potential to significantly increase the value of your policy. With variable life insurance, your cash value is invested differently and more aggressively for higher returns.
You’ll achieve more growth than you would with a whole life policy. The cash value of a whole life policy is guaranteed to grow a certain amount, but doesn’t compare to the growth you could get with variable life insurance.
The cash value is tax-deferred. The year-on-year growth of the cash value portion of your policy isn’t taxed as ordinary income. This makes variable life insurance an ideal vehicle for those who want to build a tax-free inheritance for their beneficiaries. It’s also why these policies are sometimes called super-IRAs.
Policyholders can access the cash value via a tax-free loan. Once you’ve built up enough cash value, you can take out a loan against your policy using the cash value account as collateral. That way, you won’t be charged income tax.
Premium payments are flexible. Policyholders have the option to adjust their premium payments and use the cash value of their policy to cover the payments. But keep in mind that this can make a dent in the cash value.
Is variable life insurance right for me?
These drawbacks may sway your decision:
It’s expensive. The premiums are typically much higher than term and whole life. Plus, administrative costs, management fees and the agent’s commission eat into the premium. It may be awhile before you accumulate significant cash value.
There are no guarantees on return. The minimum death benefit — the policy’s face amount — is guaranteed, but the cash value isn’t. You assume all the risk. If your investments perform poorly, you may end up with a much smaller cash value than expected. On the other hand, solid investments can lead to an exponential increase in returns.
You’ll need to take an active role in the investment portion of the policy. The policyholder chooses and changes the investments, so you’ll want to learn about stocks, bonds and mutual funds before going ahead with the policy purchase.
Your premiums might rise if the investments aren’t doing well. Your life insurance provider might hike up your premium so they can funnel more money into your sub-accounts.
There may be caps on your growth. On the flipside, some insurers place a limit on the growth of your sub-accounts, which means that even if they’re performing well, they may never reach their full potential.
There’s a risk of losing coverage if you can’t make the premium payments. The payments are much higher than they are with term or whole life. If you can’t keep up, your policy may lapse and you’ll lose the cash value.
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For the average person, variable life insurance isn’t the best life insurance or investment product. While there’s potential for significant growth, the returns aren’t guaranteed.
Variable life insurance is best suited to high-income earners with a high risk tolerance to match, as well as people who want to make the most of the policy’s tax advantages.
Alternatives to variable life insurance
If you only need coverage for a set period of time, look into term life insurance. The cheapest and simplest type of coverage, these policies have steady premiums and don’t feature a savings or investment component.
If you need lifelong protection or want your policy to build cash value, you could explore:
Whole life insurance. The most basic permanent policy, whole life insurance earns a fixed rate of return your insurer sets.
Universal life insurance. With universal life insurance, the cash value is tied to a stock index, such as the S&P 500, and earns interest based on the current market rate. Since it’s subject to market conditions, the returns may fluctuate over time — but there’s a minimum rate of return.
Variable universal life insurance. This hybrid policy offers a tax-deferred death benefit and flexible premiums, and you get to choose the subaccounts to invest in. However, it’s just as complicated as a standalone variable insurance policy, so you may want to explore the other options on this list first.
Bottom line
Variable life insurance policies suit those who have a high risk tolerance and a good understanding of what’s happening with the market. Along with providing lifelong coverage, these policies offer flexibility and the potential for rapid growth — but there’s no guarantee when it comes to returns.
My insurer offers variable life insurance by prospectus only. Why? Since they’re investments that come with a degree of risk, variable life insurance policies are classified as securities contracts. To comply with federal regulations, insurers must give potential buyers a prospectus of investment products.
I changed my mind. What’s the process to cancel my variable life insurance policy? Most providers allow you to cancel your policy within 10 days, though this free look period can vary between states. You’ll receive a refund of premiums, but keep in mind that it may be adjusted to reflect the performance of your investments.
What happens if I can’t pay my premiums? Typically, you’ll have a grace period of 30 days to make your premium payment. If you don’t maintain enough cash value to cover your policy fees and expenses, your policy may lapse. It’ll terminate without value, which means your beneficiary won’t receive a death benefit.
Katia Iervasi is a lead writer and spokesperson at NerdWallet and a former editor at Finder, specializing in insurance. Her writing and analysis on life, disability and health insurance has been featured in The Washington Post, Forbes, Yahoo, Entrepreneur, Best Company and FT Advisor. She holds a BA in communication from Australia's Griffith University.
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