What is variable life insurance and how does it work?

Variable life insurance is a form of permanent life insurance. It provides life insurance protection that has no expiration date and builds cash value, which is tied to investment vehicles or sub-accounts chosen by you. The rate of return on the cash value fluctuates according to the performance of these sub-accounts.  

Variable life insurance is more complex than whole life insurance and requires more participation from the policyholder. As such, it may not be the best option for the average consumer. However, it may be worth considering if you want life insurance coverage with an investment option and are confident about making good investment decisions.  

Keep on reading to find out how variable life insurance works and whether it is right for you.

What is variable life insurance?

Variable life insurance is a type of permanent life insurance. Like other permanent life plans, it offers coverage as long as the premiums are paid and includes an investment component (the cash value).  

The cash value is tied to sub accounts similar to mutual funds. A typical variable life plan offers policyholders a choice of many sub-accounts, with some offering more than 50 investment options.  

Unlike whole life insurance, variable life lets you choose the investment options that you like best. The cash value grows at a variable rate - hence the name. If your investment vehicles perform well, the value will grow at a faster rate. But if they underperform, you could lose money.  

Keep in mind that the cash value of a variable life insurance policy is for you to use in your lifetime. Typically, the beneficiary receives only the death benefit upon the insured’s death. At that time, if there is any unused cash, it will go into the insurance company’s pocket.  

How does variable life insurance work?

Most permanent life insurance policies have two components: death benefit and cash value. The same is true for variable life insurance. However, unlike other permanent policies, variable life insurance policies gives you the freedom to decide how your money is invested.  

With a variable life insurance policy, you can potentially earn better returns compared to whole life insurance. But like any investment, there is risk involved. Poor investment choices can deplete your cash value fast.  

Each variable life premium payment is divided into two parts. One portion covers the cost of insurance, while the other goes toward building the cash value.  

Cash value component

When you apply for variable life insurance, the insurer will hand you a prospectus listing all available investment options, fees and expenses, and other information. The investment options include a series of investment vehicles such as mutual funds, equity, index funds, bonds, and more. Of all these, mutual funds are the most popular.  

To minimize the risk inherent in investment, the insurer may give the option to invest a portion of the cash value into a non-investment account. Unlike a mutual fund, this account earns a fixed rate of interest. The rate of return of the non-investment account, the maximum percentage of the cash value you can put into it, and other details vary from one variable life insurance policy to another.  

All variable life insurance policies have a maximum return rate. That means the gain potential is not unlimited. Let us say your cash value is tied to a sub-account that grows 30% in a particular year. But since the maximum return rate is 9%, your cash value will grow at 9%, not 30%, that year.  

Your variable life insurance policy is likely to have a minimum floor (generally 0%) on the investment return. But you can still potentially lose all of your cash value. If the cash value is not sufficient to pay the policy fees and expenses, there is a risk of losing coverage.  

The following example illustrates this point clearly. Sarah owns a variable life insurance policy, which has a cash value of $30,000. She uses the money to pay the annual premium, fees and expenses. All of that comes to $6,000. If Sarah’s cash value does not grow at all; her variable life insurance policy will lapse in 5 years. But this can happen sooner if the underlying investment accounts perform badly or if she takes a policy loan or makes a withdrawal.  

Some variable life insurance policies offer a no-lapse feature for an extra fee. It ensures your policy does not lapse even if the cash value is not sufficient to pay the policy’s charges. The exact terms of a no-lapse feature depend on the policy and insurer, but it may considerably lower the death benefit.  

As a policyholder, you can access the cash value of variable life insurance policies at any time. You can take a loan against it or withdraw money from it. You may even be able to use it to pay future premiums or increase the death benefit.

For example, you pay an annual premium of $500 for a variable life insurance policy, out of which $300 goes toward the cash value account. You get to choose the accounts in which this $300 is invested. Let us say, in eight years, the cash value grows to $3,000 and you decide to tap into it. You can either withdraw the cash value fully or partially, take out a policy loan against it, use it to increase the death benefit or use it to pay future premiums. Remember that a small portion of your cash value will go towards paying fees.  

Since the cash value grows tax-deferred, you pay tax only when you withdraw it or take a loan on your variable life insurance policy. You will not pay tax on the entire amount you withdraw or borrow, only the borrowed or loaned amount that exceeds the amount paid in premiums.  

Whichever investment option you choose, the cash value growth is tied to the stock market. In a favourable market, it will grow faster. However, if the market goes into a prolonged bearish phase, you may lose most or all of your cash value. Since there is no guaranteed return rate, variable life may not be the right choice for people who do not like taking risks.  

Pros and Cons of Variable Life Insurance

Like any financial product, variable life insurance has both upsides and downsides.  

Pros

• Financial protection for your loved ones

Variable life insurance includes a death benefit that your beneficiaries receive upon your passing away. It can help them offset the financial impact of losing you. Your family can use the death benefit to cover your end-of-life expenses, pay off debt, take care of monthly bills, and pay future expenses.  

• Builds cash value

Variable life insurance accumulates cash value, which you can access any time and for any purpose. If you make smart investment choices, you can accumulate more cash than with whole life insurance.

• Control over how the cash value is invested

With whole life insurance, you have no say in how the cash value is invested. That is not the case with variable life insurance. It lets you choose the investment vehicles that best match your investment goals and risk tolerance.  

Cons

• Pricier

Variable life insurance generally has higher premiums than other types of life insurance. On the top of the steep premiums, there are several other fees and expenses that can considerably increase your overall cost of insurance.

• Capped returns

The maximum rate of return on cash value is capped. Even if your investment choices perform exceedingly well, there is only so much you will gain.  

• Risk of losing money

Poor investment performance may lower your cash value significantly or even wipe it out completely. If you depend on the cash value to cover premium payments, your variable life insurance policy will lapse if it drops below a certain level. That means the coverage will end without value and your beneficiaries will not receive the death benefit when you die.  

Variable Life Insurance Fees

In addition to premiums, variable life insurance policies charge several fees. These include:  

• Surrender charge – If you surrender your variable life policy for its cash value, you will have to pay a surrender fee. This fee varies greatly depending on the age of your policy. In the first few years, the surrender charge can be as high as 30%. After 10 or 15 years, you may pay minimal or no surrender fee.  
• Underlying fund expense – Variable life insurance policyholders pay ongoing fees for the underlying investment vehicles, like mutual funds, in which they invest the cash value.  

• Loan interest – If you take out a policy loan with cash value as collateral, you will pay interest on the borrowed amount.  

Who is Best Suited for Variable Life Insurance?

Like any other investment, variable life insurance involves a certain degree of risk. Its premiums are expensive compared to whole life insurance. Given the high cost and the risk, variable life insurance is suitable for a small number of people.

If you want life insurance with an investment component that can potentially give better returns than whole life insurance, variable life insurance is a good choice.  

Alternatives to Variable Life Insurance

Whether you want life insurance with an investment account or without it, there are several other options available:  

Term Life Insurance

For most people, term life insurance is sufficient. It is 10 to 15 times cheaper than a permanent life insurance policy and provides coverage for only as long as you need it. Term life plans do not have a built-in savings or investment account, only a death benefit.

Here are the main differences between variable life insurance and term life insurance:

‍

Whole Life Insurance

Whole life insurance is a form of permanent life insurance. It does not have an expiration date for the death benefit and grows cash value but is different from variable life insurance in several aspects.  

Variable Universal Life Insurance

Variable universal life insurance is a type of permanent life insurance. As such, it provides coverage and a death benefit as long as you pay the premiums and builds cash value. But unlike most permanent life plans, the cash value does not grow at a fixed rate. While that sounds like variable life insurance, there is a key difference between it and variable universal life insurance.  ‍

‍

Final Expense Insurance

Final expense insurance — also called funeral insurance, burial insurance, or pre-need insurance — is a type of permanent life insurance intended to help your family pay off your funeral expenses and other end-of-life expenses. That is why these policies have smaller death benefits compared to traditional term and permanent life policies and do not build cash value. Also, you do not have to take a medical examination to prove insurability. The insurer only requires you to answer a few simple health questions, and based on your answers, decides whether or not to extend you coverage and how much premium to charge you.

Here is a rundown on the main differences between variable life insurance and final expense insurance:

Conclusion

Variable life insurance provides lifelong coverage with a death benefit and builds cash value, but not at a guaranteed rate. Cash value growth depends on the investment options chosen by you. You can potentially earn better returns than with whole life insurance. But if the underlying sub-accounts do not perform as expected, you could lose money.  

Variable life insurance is best for investors who love to watch the market. If you are interested in variable life insurance, Dundas Life can help you get the best rates.  

Frequently Asked Questions

Is variable life insurance expensive?

Permanent life policies provide lifelong coverage as a death benefit and also act as an investment tool. As such, they are quite expensive, and variable life insurance is no exception. However, it is generally costlier than whole life insurance and most types of universal life insurance plans. Apart from the policy premium, you will have to pay management fees, which may vary depending on the investment vehicles chosen by you.  

What risk is involved in variable life insurance?

In variable life insurance, the rate of return on cash value is not guaranteed. Rather, it fluctuates according to the performance of the sub-accounts selected by you. If your investment choices perform badly, you can lose most or all of your cash value. This is bad enough in itself, but it can turn into a huge problem if you are using the cash value to pay premiums and various fees associated with your policy. If the cash value drops below a certain level, your policy will lapse due to non-payment.  

What are the tax benefits of variable life insurance?

The cash value of your variable life insurance grows tax-deferred. This means it will not be taxed while it’s growing. Since the cash value is not reduced by taxes every year, it grows at a faster rate compared to money in a taxable account. You may have to pay tax when you withdraw it, though. However, if you play the cash value smartly, you can reduce your tax bill.  

Let us say you take out a variable life insurance during your prime earning years — that is, when you are in a higher income bracket. Post retirement, you will likely fall in a lower income bracket because you will not be earning a regular paycheck. If you delay accessing the cash value until then, you will be taxed less.