Variable Life Insurance, Universal Life Insurance, and Variable-Universal Life Insurance

Like whole life insurance policies, variable and universal life insurance are cash value policies, distinguished by having an investment component that may increase the cash value of the policy or reduce premiums. With universal life insurance, the insurer decides where to invest the premiums; for variable and variable universal life insurance, the policyowner decides where the premiums are invested.

Variable Life Insurance

Variable life insurance was introduced in late 1970's as a way for insurance companies to compete for investment dollars. Variable life insurance allows the insured to invest premiums in securities for a greater return; hence, the variable life insurance is regulated under the Investment Company Act of 1940.

These policies require a fixed premium paid into a separate account for investing. The death benefit and cash value depend on the investment success of the separate account. The policyowner can choose to invest in bonds, stocks, mutual funds, or international funds.

There is no guaranteed cash value or cash surrender value, which depends on investment success. However, the death benefit cannot fall below the face value of the policy. The insurer bears the risk of increased mortality, while the insured bears the risk of a lower cash value from poor investment results.

Universal Life Insurance

Universal life insurance (aka flexible premium life insurance) separates the saving, expenses, and insurance components, and allows the payment of flexible premiums. The insured must pay the 1st premium, which is consideration for the contract, but the amount and frequency of subsequent premiums is determined by the insured. The death benefit can also be changed, but if it is increased, the insured must provide evidence of insurability. Money can be borrowed from the cash value of the policy at very low interest rates, and if the policy allows, additional people can be insured.

Of course, this flexibility is possible because of the payment of higher premiums than would be required for term insurance, and the less premiums paid in, the less cash value the policy will have, and it may even lapse, if premium payments are insufficient to cover the mortality charge, the amount necessary to cover the death benefit for the insured's age group.

The premiums, minus expenses and a mortality charge, are paid into a cash account — the accumulation fund, which pays interest. Cash withdrawals are permitted, but there is a modest cash surrender charge of about $25.

The policyowner receives an annual statement listing the premiums paid, the death benefit, and the cash value. The mortality charge, expenses, and the interest earned on the cash value is also listed. The mortality charge equals the death rate for the insured's age group multiplied by the net amount at risk, the difference between the death benefit and the cash value of the policy. The mortality charge has a maximum, stipulated in the policy.

Mortality Charge = Mortality Rate × Net Amount at Risk

Expenses can range from 5% to 10% of each premium. There is a monthly administrative expense of $5 or so, and a surrender charge that declines continually, and is eliminated in 10 to 20 years, including a charge for partial cash withdrawal.

Although the premium is flexible, there are some constraints. Most policies have a target premium that will keep the policy in force for a specified number of years; however, the policyowner does not have to pay the target premium. Most policies also have a no-lapse guarantee where a minimum premium payment will keep the policy in force for a specified number of years. Often, the no-lapse guarantee premium equals the target premium.

Some insurance companies sell low-load policies directly to the public, eliminating the sales charges and commissions of salespeople. Most of the 1st year premium of a low-load policy goes into the accumulation account, but there is usually a back-end surrender charge to recover expenses, if the policy is surrendered within, typically, 5 years.

Universal life insurance policies pay a minimum guaranteed interest rate on the accumulation fund, but may pay a higher interest rate — the excess interest rate — if current interest rates are higher, or if the insurer's investments appreciate substantially.

There are 2 different universal life policies regarding death benefits. Option A has a level death benefit in the early years, but increases once the cash value reaches a certain level. This is because the policy must pass the corridor test to receive favorable tax treatment — the cash value cannot be too large compared to the insurer's net amount at risk, the difference between the death benefit and the cash value. An increasing death benefit prevents this.

The death benefit in Option B increases as the cash value increases, but this only happens if the policyholder continues to pay premiums. Otherwise the death benefit will level off and eventually decline.

Graph showing the relationship of the death benefit to cash value of Plan A and Plan B of universal life insurance policies.

As with most life insurance policies, the earned interest is tax deferred, and the beneficiary receives the life insurance proceeds tax-free. Survivorship universal life insurance is a variant of universal life that covers 2 people and pays a death benefit only after the 2nd person dies. Consequently, premiums are lower than with a regular universal life insurance policy. Survivorship universal life is frequently purchased to pay for estate taxes, since the payment of estate taxes cannot be delayed as it could when the 1st spouse died, by using the unlimited marital deduction.

Disadvantages of Universal Life Insurance

The main disadvantage of universal life insurance as with other insurance policies is that the cash value does not grow as much as it would in other investments because of the high fees, which are even greater than most mutual funds. The advertised rate is usually the gross rate before expenses: sales charges and the mortality charge are subtracted. The true rate is much less than the advertised rate. Also, projections may be much rosier if they were based on a higher interest rate than is likely in the future.

Another disadvantage is the insurers' right to raise the mortality charge up to a maximum limit specified in the policy, and, often, it is raised because of tacked on expenses. Many people think that the rate increased because they got older, but often, the insurer adds other hidden expenses that were not explicitly listed.

Because the policyholder does not have to pay premiums, the cash value of the account may fall too far, causing the policy to lapse.

Variable-Universal Life Insurance

This policy combines the characteristics of variable life insurance and universal life insurance — hence the name. It has most of the flexibility of the universal life policy, but the policyholder can choose the investments. Consequently, the insurer does not guarantee any interest rate or cash value, unless the money is invested in a fixed income account.

Insurers generally have 10 or more accounts with differing amounts of risk and profit potential that the policyholder can choose from: stock funds, bond funds, international funds, etc. The cash value is measured as the number of accumulation units, which are like mutual fund shares, and is calculated like the NAV of a mutual fund, dividing all securities held in the account by the number of accumulation units in the account. Sometimes the insurer will have subaccounts with mutual fund companies, such as Fidelity Investments or the Vanguard Group. However, a drawback to using an outside fund is that the expenses of the outside account are added to the expenses charged by the insurance company. One of the main benefits of this type of policy is that the policyholder can switch to different funds without incurring an income tax liability.

Most variable-universal life policies do guarantee a minimum death benefit regardless of the cash value of the account as long as the policyholder pays a minimum of premiums.

Private Placement Life Insurance

Another form of VUL is Private Placement Life Insurance (PPLI), which allows the client to invest in almost any type of asset. A PPLI is usually purchased, not for the death benefit, but to allow earnings to grow tax-deferred.

Offshore PPLIs are also available, which are held in offshore accounts that offer greater investment opportunities, such as hedge funds, than would be available with a regular VUL. An additional benefit is that the insurance company does not pay premium or DAC taxes on the account. Although an excise tax must be paid, it is generally lower than the combined premium plus DAC taxes.

A major drawback to an offshore PPLI is that the insurance company may not be well-managed, since it is not subject to the laws of the United States, and it may be more difficult to find reliable information about the company.