There are a wide variety of coverage types and options for life insurance, such as whole, term, and universal life insurance. Another option, variable life insurance, is a permanent life insurance policy that combines features of life insurance and investment products. While variable life insurance shares some similarities with other life insurance policies, variable life insurance has some key differences, as well as some pros and cons. To help you better understand these distinctions, let’s examine what variable life insurance is and how it compares with other life insurance policies.
What Is Variable Life Insurance?
Variable life insurance is a type of permanent life insurance policy that features an investment component. This policy comes with a cash value account that works similarly to a mutual fund, where the cash value account is invested into several subaccounts within the policy. The purpose of a variable life insurance policy is to provide a lifelong policy with flexibility and the potential to grow funds by investing cash into these subaccounts. The name “variable” refers to the fact that its cash value can vary depending on the market.
Although it functions similarly to a mutual fund, a variable life insurance policy’s subaccounts have a key difference: you can only invest in the options that the life insurance company offers for that type of policy. The set of investment accounts varies by policy and insurer.You may also have the option to convert your cash value into a higher death benefit amount for your beneficiaries to receive upon your death.
How Does Variable Life Insurance Work?
Variable life insurance consists of a premium, death benefit, loans, and a cash value account. The insurance premium covers account maintenance, death benefits, and building the policy’s cash value account, which is invested into several funds. Policyholders can choose how the money is invested.
A premium is an amount you pay to the insurance company to keep your policy active. For permanent policies, which last for your entire lifetime, premiums are paid until your death to maintain coverage. Typically, premiums are monthly payments, though some policies may allow different payment schedules, such as paying bi-monthly or quarterly. Depending on the exact variable life insurance policy, you may have to pay account maintenance fees as well.
Variable life insurance premiums are fixed throughout the policy, and depending on the policy, you may be able to allocate a portion of your premium to a fixed account. The fixed account pays a fixed rate of interest, such as 3% annually.
A death benefit, which is also sometimes called the policy’s face value, isthe amount of money the insurance company will pay to your beneficiaries if you die while the policy is in force. You must specify beneficiaries within the policy. Unlike with heirs, life insurance beneficiaries will not be assumed. Beneficiaries are typically family members, friends, businesses, charities, or family trusts. If no beneficiary is named, the death benefit will become part of your estate.
Though your policy’s cash value may change throughout the duration of the policy, the death benefit will remain the same. This death benefit is not subject to federal income tax. In some cases, the death benefit may not be subject to federal estate taxes, either.
Cash value is the savings part of a life insurance policy. The cash value earns interest and may be withdrawn in an emergency. Depending on the policy, a policy’s cash value can grow at a variable interest rate or fixed rate. Note that you need to maintain sufficient cash value to cover policy fees. Cash value accumulates tax free, but withdrawals are subject to federal income tax.
Cash value is separate and behaves differently from death benefits. In the event of the insured’s death, their beneficiaries do not receive the cash value. Instead, the cash value goes to the insurance company. If the policyholder surrenders their coverage, however, they may receive the cash value, though it may be subjected to cancellation penalties or tax penalties.
How cash value works with variable life insurance is one of the key differentiators for this type of policy. With variable life insurance, you can invest your cash value in different subaccounts that your insurance company offers. Like a mutual fund, these subaccounts are tied to the stock market and include options such as bonds, stocks, and money market securities. Remember, you can only invest in the set of investment options that the life insurance company offers for that type of policy.
Another key difference in how cash value works with variable life insurance is that your cash value will only grow if your investments perform well. This means your policy can actually lose cash value in poor market conditions.
In general, variable life insurance permits you to take loans on a portion of the policy’s cash value. These loans are not subject to federal income taxes or surrender charges. You will owe interest on the amount borrowed, and your policy’s cash value will serve as collateral. It’s important to note that loans affect the policy in several ways. For one, loans reduce the policy’s cash value and death benefit. As a result, this can increase the likelihood that your policy may lapse, meaning you could lose your coverage. However, if you keep a close eye on your cash value amount before taking out any loans, you could avoid having that happen.
Repayment for life insurance loans is generally more flexible than traditional loans. In the event the policy does lapse with a loan outstanding, the IRS may consider the loan a withdrawal for federal tax purposes.
Variable Life Insurance vs. Other Life Insurance Types
While all types of life insurance share certain features, variable life insurance consists of several key differences. Knowing how variable life insurance differs from other life insurance types can help you not only better understand how each policy works but help you decide which policy is right for you.
Variable Life Insurance vs. Variable Universal Life Insurance
Variable life insurance and variable universal life insurance (often referred to as VUL) share the same features of premiums, cash value, death benefits, and loans. There are some differences, though, in how each policy handles these features.
- Premiums: Variable life insurance premiums are fixed over the life of the policy, whereas universal variable life insurance premiums are adjustable.
- Cash value: Both policies allow for tax-deferred cash value growth. However, variable universal life insurance allows for greater cash value accumulation, and you can borrow or withdraw from the cash value.
- Death benefits: Variable life insurance offers more death benefit guarantees, whereas variable universal life provides no guaranteed death benefit unless you pay a fee. In addition, variable universal life insurance has two death benefit options available: a level death benefit, which is a specified amount; or the death benefit plus cash value. Level death benefits are geared toward building cash value, whereas with the second option, more money is allocated toward raising the death benefit through investing.
- Loans: As with variable life insurance, with variable universal life insurance, you can take out loans against the cash value.
Variable Life Insurance vs. Whole Life Insurance
Whole life insurance is the simplest form of permanent life insurance. Like variable life insurance, a whole life policy also has cash value.
- Premiums: As with variable life policy, whole life premiums are fixed.
- Cash value: A whole life policy has a cash value component. As with variable life, a portion of your premium goes into a cash value account and grows tax free. Policyholders can borrow or withdraw from the cash value account. One difference from variable life insurance, however, is that the whole life cash value grows at a rate fixed by the insurer. Whole life insurance is structured so that the cash value will grow to the same size as the death benefit as the policy matures.
- Death benefits: Like variable life insurance, whole life insurance has a guaranteed death benefit.
- Loans: Like variable life insurance, policyholders may take a loan out against their cash value with whole life insurance.
Variable Life Insurance vs. Term Life Insurance
Term life insurance differs from permanent life policies in that these policies last for a set number of years, such as 10, 20, and 30 years before expiring. In comparison to other life insurance policies, term life insurance is often considered easier to navigate and is usually more affordable.
- Premiums: Premiums are set or will change depending on the type of term life insurance. Forexample, level term insurance has a set premium. In contrast, guaranteed term renewable insurance premiums increase with each successive term.
- Cash value: Unlike variable life insurance, term life does not accrue cash value.
- Death Benefits: Term life insurance comes with a guaranteed death benefit, but only if you die during the policy term. If you outlive your policy term, your beneficiaries will not receive a death benefit. Because of this feature and a lack of a cash value component, term life insurance tends to cost less overall for the same amount of coverage.
- Loans: Since this type of policy does not have a cash value component, you cannot borrow against term life insurance.
Who Should Consider Variable Life Insurance?
Variable life insurance has several pros and cons. To determine whether this policy is right for you, consider your current financial situation and financial goals, taxes, and investment goals. Keep in mind that variable life insurance is well suited for those who prefer flexible policies with an investment option. Those seeking a simpler permanent policy may be better served with whole life insurance.
Advantages of Variable Life Insurance
In addition to a death benefit, variable life insurance has several advantages:
- Policyholders can choose how to invest: Variable life insurance policyholders can control how they want to invest their cash value. Most insurance companies offer policies that have several investment options.
- Tax-deferred savings: Cash value grows tax free with variable life insurance. Remember, though, that withdrawals from cash value are subject to federal income tax.
- Potential for death benefits to increase: With variable life insurance, you may have the option to convert your cash value into a greater death benefit amount. That means your beneficiaries can receive a larger payout upon your death.
- High gains potential: There is a potential for high returns with a variable life insurance policy if you’re wise with your investments within the policy.
Disadvantages of Variable Life Insurance
Variable life insurance has several disadvantages:
- Higher premiums: Premiums for variable life insurance can be higher than other life insurance types, such as term life insurance.
- Higher overall costs: Overall costs for variable life insurance are usually higher than other life insurance policies because most policies have recurring management fees. This can slow the time it takes to accumulate cash value.
- Surrender charges: You must pay surrender charges if you withdraw from your cash value or give up your coverage.
- Risk of losing money: Cash value performance is dependent on market performance. Poor investment choices can lower or possibly wipe out your policy’s cash value. You may use your cash value to cover your premium, but be aware that you must keep the cash value above a certain amount, or your policy could lapse.
How to Buy Variable Life Insurance
To buy variable life insurance, contact a licensed life insurance agent or agency that offers variable life insurance. Once you fill out an application asking for your desired coverage amount and identification questions, you’ll go through the underwriting process. This is where the insurer evaluates your application. A phone interview is often required as part of the application and underwriting process. Underwriters will consider your age, gender, occupation, lifestyle, health status, and financial history, including looking at your assets, income, credit history, and debts. You may also have to undergo a physical examination to assess your health standing.
After evaluation, the underwriter will issue an insurance classification, which determines your policy and, ultimately, your premium. Coverage begins once you sign any final paperwork and make your first premium payment.