Proceed With Caution On Variable Life Insurance
I met a young couple recently on their third “financial adviser.” This one sold them a flexible premium variable life insurance plan. Insurance agents are held to a “suitability” standard, but this case pushes the limits of my definition of suitability.
Insurance is designed to transfer risk from the individual to the insurance company. It works because of the “law of large numbers.” Think about homeowner’s insurance. The probability of any one homeowner filing a claim is low, but the results could be catastrophic for that individual or family. Life insurance works the same way. Statistically, the chances of making an individual death claim in any one year are low. The financial implications of an individual’s death vary over time and circumstances.
There are basically two types of life insurance: term and cash value. Term insurance is only life insurance, is issued for a set number of years and is much cheaper than a cash-value policy. Cash-value policies have higher premiums because they add an investment or “cash value” component on top of the insurance. Your premiums are split between covering the cost of insurance and adding to an investment account. The treatment of those investment dollars varies depending on the type of cash-value policy you are sold.
Whole-life policies consist of level premiums for life, a guaranteed death benefit and a generally low guaranteed return on the cash value accumulated in the policy. The guaranteed return can be supplemented by non-guaranteed dividends. Before the 1980s, insurance companies sold only whole-life or term-life policies. The insurance companies assumed the risk associated with meeting the guarantees they gave policyholders.
As interest rates rose in the late ’70s and ’80s, the guaranteed rate and dividend rate did not keep up with other investment returns and people started cashing in their policies to invest their accumulated cash value in other financial investments. To counteract this trend, universal-life policies were introduced. The cash-value savings component can be structured to participate in various investment options. These instruments transfer the risk from the insurance company to the individual. There are no guarantees.
In addition to broader investment options, universal-life policyholders have the flexibility to vary their premium amount and/or the death benefit depending on the performance of the underlying securities. Universal-life policies can be linked to a fixed rate of return, an index (indexed universal life) or a broader variety of investment choices (variable life).
The ability to participate in the vast array of investment choices moves these insurance policies into the securities arena. They are more complicated and more expensive. They are investments that need to be monitored and have periodic adjustments made to underlying investments. It is not a set-it-and-forget-it product. It is possible to lose money and be required to make higher premium payments to keep a smaller death benefit in force.
Variable universal-life policies could be appropriate if you are a super savvy investor with lots of extra cash flow and are or anticipate being in a higher tax bracket later in life. You should also have a 30- to 35-year time horizon and be committed to making the maximum premium possible the first 10-15 years.
Insurance is a fundamental base for financial security. Investments are important for creating long-term wealth. Selecting the amount and type of insurance needed should be done in conjunction with all financial priorities. Going back to my young couple, they do not fit the profile where a variable life policy makes sense. They would be better in the long run to focus on maximizing 401(k) contributions, saving in a college 529 plan and paying down student debt.