What it means
In a traditional whole life policy, the insurer decides how to invest the cash value and promises a guaranteed return. A variable policy hands that decision to the policyholder, who picks from a menu of investment options called sub-accounts, which work much like mutual funds sitting inside the policy.
Premiums are normally fixed and are paid at regular intervals. After the insurer deducts charges for the cost of insurance, administration and sales, the rest goes into the chosen sub-accounts.
If the investments do well, the cash value grows faster than it would in a conservative policy, and the death benefit can rise above its minimum level. If they do badly, the cash value falls, and the policyholder may need to pay more to keep the policy in force.
The policyholder can usually borrow against the cash value or withdraw part of it, although loans and withdrawals reduce the death benefit and can have tax consequences. Gains inside the policy generally grow without annual tax, but the rules vary between countries and change over time, so advice should be taken locally.
Because the investments carry risk, these policies are treated as securities as well as insurance in the United States, and sellers must provide a prospectus, which is a detailed disclosure document. The charges are often higher than those of a plain investment fund, so the policy only makes sense for people who need lifelong cover and want a tax-advantaged way to invest.
A common mistake is to treat the policy as an investment product first. The insurance protection is the purpose, and the charges for it reduce the investment return.
In practice
Real-world examples.
Example
A 35-year-old with young children wants lifelong cover and is comfortable with investment risk. She chooses a variable policy and puts most of the cash value into a global share fund. Over twenty years the cash value grows well, but it dips sharply in one bad market year.
Example
A business owner buys a variable policy to build funds for a future buy-out of a partner. He splits the sub-accounts between bonds and shares. When shares fall, he reduces his borrowing against the policy to protect the death benefit.
Example
A couple use a variable policy as part of their estate plan so that their heirs receive a tax-efficient payout. The adviser explains the annual charges and asks them to review the investment mix each year. They set a reminder to do so.
Formula
Calculation
Year-end cash value = Opening cash value + Premium after loads + Investment return - Charges
A policy has an opening cash value of $20,000. The policyholder pays an annual premium of $5,000, of which a 5% load is taken (5,000 x 0.05 = $250), leaving $4,750 invested. The investment return is 6% on the opening balance, which is 20,000 x 0.06 = $1,200. Insurance and administration charges for the year total $1,500. Year-end cash value = 20,000 + 4,750 + 1,200 - 1,500 = $24,450. This is a simplified model that applies the return only to the opening balance.Case study
Seen in the real world.
This illustrative story involves a fictional customer, Priya, who bought a variable life policy from a fictional insurer, Aldermoor Life. She paid a $5,000 premium each year and selected a high proportion of shares in her sub-accounts.
In the first six years markets rose, and the cash value reached $34,000, well above the figure she had expected. In year seven a market fall cut it to $26,000 within months, and she began to worry about whether the policy would stay in force.
Her adviser showed her that the guaranteed minimum death benefit was still in place and that the cash value was enough to cover the charges for several years. She moved part of the balance to a bond sub-account to reduce the risk. The story is fictional, but it reflects how this type of policy can behave in different markets.
Watch out
Common mistakes.
- Assuming the cash value is guaranteed. Only the minimum death benefit is typically guaranteed, and the cash value can fall.
- Ignoring the charges. Insurance costs, administration fees and fund fees together reduce the net return.
- Borrowing heavily against the policy. Large loans can cause the policy to lapse if the cash value falls, with possible tax consequences.
Questions
People also ask.
What is the difference between variable life and universal life?
Variable life has fixed premiums and investment sub-accounts, while universal life has flexible premiums and, in its basic form, a declared interest rate.
Can I lose money in a variable life policy?
Yes, the cash value is invested and can fall, although the minimum death benefit is normally guaranteed while the policy stays in force.
Who regulates these policies?
In the United States they are regulated both as insurance and as securities, so they are subject to more disclosure than traditional policies.
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