Variable Life Insurance: What You Should Know

Lots of things in life are variable, from kids’ bedtimes to what we’ll (try to) cook for dinner. Of course, in the middle of a pandemic, things are more variable these days than ever.

One constant is that many parents rely on life insurance to help protect their families from the unknown—but even within life insurance there is literally a variety called “variable life insurance.”

In a nutshell, variable life insurance exposes people to market conditions, which can mean a higher upside but also a potentially worse downside. 

Here’s how variable life insurance works and whether it’s right for you. 

What Is Variable Life Insurance?

Variable life insurance is a type of permanent life insurance in which the cash value component is invested in the market. That means there’s more potential upside, but also more potential downside. 

Not sure what exactly all of that means? Let’s back up and explain how variable life insurance fits into the bigger picture.

NOTE: Fabric doesn’t offer variable life insurance options. That said, we think it’s important to understand all your life insurance options when making a decision to help protect your loved ones.

Thinking About Term and Whole Life Insurance

Life insurance is a contract between two or more parties where one party (the insured), agrees to pay a specified amount of money in the form of a premium to another party (the insurer). In exchange, the insurer agrees to compensate the insured for specific future losses. The contract itself is called a policy. 

The two biggest types of life insurance you’ll likely hear about are term and whole (sometimes called “permanent” life insurance because it covers you for your whole life rather than expiring). 

With term life, you pay a fixed premium for a fixed number of years. In other words, a policy covers you for a certain predetermined amount of time like, say, 20 years of coverage. That’s called your “term.” Your beneficiaries will receive a guaranteed death benefit should you pass away during that time period and all your premiums have been paid to date. After your term is over, you’d either need to buy a new life insurance policy or let your coverage lapse. Term life insurance is often one of the cheaper options (though life insurance gets more expensive as you get older).

Whole life insurance is more expensive but it’s permanent. In other words, this would cover you until you’re 121 years old (which, in today’s day and age, means your entire life). What makes whole life different is there is a savings element or cash value. 

Cash value is a whole life insurance policy’s savings element or living benefit. This means when you pay your life insurance premiums, a portion of your premium goes to increasing your cash value amount. 

With “cash value,” your premium payments accumulate over time and are scheduled to equal the coverage amount of your policy once you reach age 100. 

(Here’s the full rundown on term vs. whole life insurance.)

How Does Variable Life Insurance Fit in the Mix?

Variable life insurance is sometimes referred to as “variable whole life insurance” because it’s a permanent life insurance policy. 

The key components of variable life insurance are:

• A monthly premium that goes toward covering the cost of insurance and building your cash value.

• Death benefit, which is the amount your beneficiary will receive if you pass away while your policy is active

• Cash value component, which you can access while you’re still alive 

The big difference between a variable life and a whole life insurance policy is that with a variable policy the cash value is invested in the market. That means it is tied to a variety of stocks, bonds, mutual funds and other securities; as a result, that value is not guaranteed and fluctuates just like an investment. As we all know, the market fluctuates—so variable life insurance policyholders will experience increases and decreases in their policy’s cash value over time. 

Note that your premium payment might change as well over the years as the cost to insure your life changes (as you age), which could impact the cash value you accumulate.

How Does Variable Life Insurance Work?

Although the cash value component of variable life insurance is subject to market fluctuations, your death benefit isn’t. 

With variable life insurance, as you make your monthly premium payments, a portion goes toward the insurance company’s fees to secure the death benefit amount. If you pass away with a variable life insurance policy and are current on your premium payments, your beneficiary would receive the death benefit amount outlined in your policy. 

The other portion of your premium goes toward your policy’s cash value, which is invested based on securities of your choice. (Of course, these are what’s available through your insurance company so there are some limitations.)

If your cash value increases after being invested in the market, you can use that money while you’re alive and well. There are fees required to manage your variable life insurance policy and investments. The fees can be deducted from policy’s cash value. 

Jay Judas, a life insurance advisor and founder of Life Insurance Strategies, LLC, explained how variable life insurance fees typically work: “With retail VUL (variable life insurance), a policyholder can not pay the fees directly. They must all come from the policy’s cash value.”

These fees include:

• Your carrier’s administration charges

• Insurance fees to pay for the death benefit

• Fees paid to the investment manager

“Once all these fees are deducted, the rest of the cash value grows,” added Judas. “This means a policyholder will have a ‘gross return’ and then a ‘net’ return after all these charges.”

Tax Deferred Growth

One of the perks of having a variable life insurance policy is the tax deferred growth. All the investment earnings within the policy including interest, dividends, and capital gains accumulate tax free until the policyholder makes a withdrawal or distribution.

You can also take out a tax-free loan against your policy so long as it remains in force. Your policy’s death benefit will go to your beneficiary as a tax-free payment.

All variable life insurance policies are dually regulated by the state and federal government. This means life insurance representatives must be licensed and registered with the Financial Industry Regulatory Authority (FINRA) in order to sell you one of these policies.

Variable Universal Life

One type of variable life insurance is variable universal life. This, too, is a type of permanent insurance. Variable universal life insurance combines: 

• Many features of whole life 

• The flexible premium of universal life 

• The investment component of variable life

In other words, a variable life insurance policy includes fluctuations of your policy’s future cash value. Meanwhile, a universal life insurance plan includes even more variability. 

The features include a flexible premium that can be increased, decreased or even skipped if there’s enough value in the policy to fund the death benefit. These kinds of policies let you increase or decrease the coverage amount after your policy is already in force. Plus, they include cash withdrawal and policy loan options like with whole life.

As with variable life insurance, a portion of your premiums can be invested in the market through several sub-accounts and returns are not guaranteed. Variable universal life insurance policies have a maximum cap as well as a floor on the returns you receive. Management fees for your invested funds might range from 0.05 percent to 2 percent.

Opportunity to Pay Higher Premiums

There are many working parts to variable life insurance. While your premiums can be fixed, some policyholders prefer to pay extra premiums to grow their cash value quicker. Why would someone want to pay extra premiums on their life insurance?

As you get older, the cost of life insurance increases. That means more of your premium payments will start to go toward insurance costs as you age, rather than contributing toward growing and investing your cash value.  

While you aren’t required to pay extra premiums, think of it as similar to how an investor may contribute more to an account in an effort to grow their portfolio at a faster rate. 

“In the beginning of your policy, very little of your early premiums go to pay the low cost of insurance and more of it goes to build the cash value,” Judas says. “Then, at older ages, the cost of insurance might exceed the premium. But the cash value has grown so much that the policyholder can use some of the cash value for insurance costs too, and still witness it increase with time.”

According to Judas, the costs to insure your life can increase each year. So in the beginning your monthly premiums may seem reasonable but the costs of the insurance component could become very high as you age. The cash value element and variable growth may make this type of policy more appealing, since you could call upon the cash component to fund your monthly premiums. 

How Investing With Variable Life Insurance Works

The investing component is a core highlight of variable life insurance policies. So how does it work, exactly?

Your insurance company will give you a variety of different fund options to choose from. These funds are basically the life insurance version of mutual funds, which are called insurance dedicated funds (IDF). IDFs can be a mirror of the publicly available market options and therefore can only be offered by an insurance company. Yet they work just like mutual funds. 

According to Judas, who has been a life insurance advisor for over 23 years, there are more risks and fees associated with variable life insurance than with “regular” whole life insurance. In some cases, these could be worth it, and in others they could leave you winding up with less than expected. 

“In a variable life product, the cash value growth is usually linked to the value of an index fund or variety of funds,” says Judas. “If, for example, the policyholder elected to invest their premium in the S&P, their 2020 return would have been 18.4 percent, less about 2.5 percent for policy expenses and insurance costs.”

When Variable Life Insurance May ‘Beat’ Whole Life

Let’s say the market is doing very well and you have a $10,000 variable life insurance insurance policy. So let’s say it grows at 15.9 percent (that’s the 18.4 percent return from 2020, minus 2.5 percent in costs) to $1,590.

By contrast, if you had a whole life insurance policy, the dividend might be just under 5 percent per year (returns are often capped and conservative). Expenses and insurance costs would be deducted after that so the cash value growth would typically be about half that, Judas says. This means, with a $10,000 premium, the cash value of a whole life policy might grow around $250 that year compared to almost $1,600 with variable life. 

A Worse-Case Scenario With a Variable Life Policy

What if the market didn’t perform as well? Your variable life insurance policy cash value would certainly take a hit, so this is a risk you’ll need to be willing to take. 

Let’s take that same $10,000 variable life policy and say that the market tanked the way it did in the Great Recession. In the one-year period from September 1, 2008 to September 1, 2009, the S&P 500 dropped more than 12 percent. So if the market fell 12 percent during the period in which your gains and losses were calculated, your cash value would decrease by 12 percent plus you’d have to pay your usual 2.5 percent in fees.

The question you might ask yourself is whether you’re ready to deal with a potential loss of value, including the value of your initial investment. With variable life insurance, there is no floor. That said, your minimum death benefit remains stable so even if the market crashed, your family would receive your basic death benefit if you were to pass away while your policy was active.

Why You Might Opt For More Conservative Whole Life Insurance Returns

If you are not willing to take on a risk like that, you can still earn a conservative amount with a whole life policy. With a normal whole life policy, your insurance company may give you a guaranteed minimum return like 3 percent, even if the market underperforms, or you will just take the market loss.

Whole life tends to have lower premiums, too. That can be good or bad, depending on how you look at it. On one hand, that means your policy is more affordable on a monthly basis or if you encountered financial difficulties later on. On the other hand, you wouldn’t have the opportunity to help your cash value grow with the market, which could yield higher earnings.

Pros and Cons of Variable Life Insurance

Pros 

• Your premium payments go toward building cash value

• Guaranteed death benefit so long as you keep making premium payments

• Invest in a variety of securities like stocks, bonds and mutual funds and take advantage of some of the market’s gains

• Tax-deferred growth

• Tax-free loans can be taken out against the policy

• Cash value could help cover premiums if you fall on hard times

Cons

• Cash value is not guaranteed

• Complex type of insurance

• Returns could be capped, so you might earn more investing in a 401(k) or IRA

• Limited options when choosing where to invest your premiums

• May earn less cash value than with a whole life insurance policy, depending on the market

• Fees to manage your investments

Who Needs Variable Life Insurance?

Your insurance needs will depend on your individual situation. 

A variable life insurance policy may be a go-to option if you’re already considering whole life insurance but want faster growth for your cash value. If you’re trying to build wealth or leave behind an additional tax-free inheritance for your beneficiaries, this type of life insurance may sound appealing. 

“Someone would choose a variable policy over a whole life policy if they felt comfortable accepting more of the risk for investing the premium,” says Judas. “In a variable product, the policyholder calls the shots regarding where the premium is invested after expenses and if insurance costs are deducted. As a result, you’ll have a possibility of obtaining a higher return on your premium and this will result in greater cash value growth inside the policy.”

With a whole life insurance policy, your investment risk sits with the insurance company who makes conservative investments so you can expect to earn around or under 5% per year.

If you aren’t interested in the market risk, or are looking for a more affordable monthly premium, a term policy may be better for you. Term life insurance is more straightforward and you can rest assured with a fixed low monthly premiums and fixed coverage amount. 

Deciding on a life insurance policy is much more important and involved than walking into the store and choosing what vegetables you’ll want to (try to) force your kids to eat for dinner that night. 

That said, as you explore your options, it’s important to understand all the different types of life insurance and whether they may or may not fit your family’s needs. And of course, Fabric can always help you with your term life insurance needs if you’re looking for affordable and reliable coverage. 

Fabric exists to help young families master their money. Our articles abide by strict editorial standards. This article has been reviewed and approved by a compliance professional who is a licensed life insurance agent.

Fabric by Gerber Life exists to help young families master their money. Our articles abide by strict editorial standards.

Information provided is general and educational in nature and is not intended to be, and should not be construed as, financial, legal, or tax advice. Laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy, or completeness of this information. Federal and state laws and regulations are complex and are subject to change. We make no warranties with regard to the information or results obtained by its use, and disclaim any liability arising out of your use of, or reliance on, the information.

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