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Variable life insurance was first sold in 1976, and variable universal life policies (VUL) were rolled out in the 1980s. However, VUL did not take off in popularity until the 1990s and sales have been up and down as the stock markets have gone through bull and bear cycles. According to LIMRA, in 2014 VUL sales were up, but still only represented about 6% of all life insurance premium sold.

What is VUL?

VUL a permanent life insurance policy that builds cash value, has flexible premiums and allows for loans. VUL also offers the policy owner the potential to earn a higher rate of return. Unlike whole and universal life policies that invest the cash value in a fixed account, VUL allows the policy owner to invest in a selection of mutual fund subaccounts. Mutual fund subaccounts are essentially clones of retail mutual fund shares offered in life insurance and annuity products. (See also: Subaccounts as Good Their Clone Funds?)

With VUL, the policy owner manages the allocation and decides how and when to invest the cash value into the subaccounts or a fixed account.  Most policies do place restrictions on transfers in and out of the fixed account (unless it part of an automatic dollar cost averaging program) and limits on frequent transfers between subaccounts.  If the investments don’t provide an adequate return, the policy owner may have to make additional premium payments and/or reduce the death benefit to keep the policy from lapsing. If the policy is properly managed, the cash value can grow, and distributions can be taken from the policy as low-cost loans and/or tax-free recovery of premiums paid (cost basis). Distributions may be limited and subject to with drawl or surrender charges.

As long as the policy stays in force any appreciation or income in the subaccounts is not taxed. However, if the policy lapses, any distributions, in excess of the cost basis, would be taxed as ordinary income. Consequently, the policy owner, rather than the insurer, is taking all the investment risk, since there are no guarantees.

How Does VUL Work?

Since VUL offers mutual fund subaccounts, it is sold with a thick prospectus (some are more than 100 pages).  The policies have a lot of moving parts and can be difficult to fully understand, even for advisors.  

When a premium payment is made, a sales or premium charge, which vary and can be as high as 8-10% is deducted. The premium charge allows the insurer to recover sales costs and pay taxes. VUL is subject to a premium tax that varies by jurisdiction and currently range from 0% to 3.5%. In many policies, the high initial premium charge is reduced in later years. The remaining premium is added to the policy cash value and invested in the selected subaccounts. Each month, the cost of insurance, administrative costs, asset-based charges (in addition to the subaccount management fees) and other expenses are deducted from the policy cash value. These costs vary by product and company.

Premium Payments

The planned premium is calculated based on a variety of factors including the insured’s age, sex and health; assumed rate of return; level or increasing death benefit; additional policy riders, such as a disability waiver of premium. Many policies also offer a no-lapse premium, which if paid guarantees that the policy will stay in force for a certain number of years (in some policies up to 20 years) even if the cash value in the policy dropped to nothing.

Once the policy has been issued, the policy owner can pay whatever amount of premium they want as long as it does exceed a maximum that is governed by federal tax laws and limit premium payments relative to the amount of insurance in the policy. If they exceed the maximum, the policy can become a modified endowment contract.  

The appreciation potential of the subaccounts and premium flexibility are reasons why VUL is often used in non-qualified executive benefits plans, such as split-dollar plans. These individuals have typically maximized contributions to qualified plans, and the goal is to build cash value while buying as little insurance as possible.(See also: Can You Fund Nonqualified Deferred Compensation Plans With Life Insurance?)

Managing the Policy

Unlike more traditional, whole and universal life policies, VUL needs to be actively managed. The subaccounts performance needs to be monitored, and the allocation of the cash value should be rebalanced periodically. Also, other strategies, such as paying the premium monthly to dollar cost average into the subaccounts and having the cost of insurance drawn from the fixed account, rather than the variable accounts, can make sense.

The Bottom Line

Due to its flexibility, some advisors call VUL the Swiss army knife of insurance products. And illustrations with soaring cash values based on a hypothetical 8% gross return can be appealing. However, you really need to stop and think about why you are buying insurance and where you want to take investment risk?  If you want a guaranteed premium and death benefit, then VUL may not be the best choice.

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