Variable universal life insurance

Variable Universal Life Insurance (often shortened to VUL) is a type of life insurance, that builds a cash value. In a VUL, the cash value can be invested in a wide variety of separate accounts, similar to mutual funds, and the choice of which of the available separate accounts to use is entirely up to the contract owner. The 'variable' component in the name refers to this ability to invest in volatile investments similar to mutual funds. The 'universal' component in the name is a bit of a misnomer that is used to refer to the flexibility the owner has in making premium payments. The premiums can vary from nothing in a given month up to maximums defined by the IRS code for life insurance. This flexibility is in contrast to whole life insurance that has fixed premium payments that typically cannot be missed without lapsing the policy.

Variable universal life is also considered to a type of permanent life insurance, because the death benefit will be paid if the insured dies any time up until age 100 as long as there is sufficient cash value to pay the costs of insurance in the policy. This is contrasted with term life insurance that provides coverage for only a specific period of time (the 'term' in question). Studies by the life insurance industry show that in term life insurance policies, the death benefit is paid less than 3% of the time. Therefore people that prefer not to pay for something they are not likely to get any benefit out of, are drawn towards permanent types of life insurance.

Contents

1 Uses

2 Contract Features

3 Premium Flexibility

3.1 Maximum Premiums

4 Investment Choices

5 Tax Advantages

6 Criticisms of Variable Universal Life

7 External links

Uses

Variable universal life insurance is used to provide an efficient way of obtaining life insurance protection. Life insurance receives special tax advantages in the United States Internal Revenue Service code. The cash value in life insurance is able to earn investment returns without incurring current income tax as long as it meets the definition of life insurance and the policy remains in force. The tax free investment returns could be considered to be used to pay for the costs of insurance inside the policy. See the 'Tax Benefits' section for more.

In one theory of life insurance, needs based analysis, life insurance is only needed to the extent that assets left behind by a person will not be enough to meet the income and capital needs of his or her dependents. In one form of variable universal life insurance, the cost of insurance purchased is based only on the difference between the death benefit and the cash value (defined as the net amount at risk from the perspective of the insurer). Therefore, the greater the cash value accumulation, the lesser the net amount at risk, and the less insurance that is purchased.

Contract Features

By allowing the contract owner to choose the investments inside the policy, the insured takes on the investment risk, and receives the greater potential return of the investments in return. If the investment returns are very poor this could lead to a policy lapsing (ceasing to exist as a valid policy). To avoid this, many insurers offer guaranteed death benefits up to a certain age as long as a given minimum premium is paid.

Premium Flexibility

VUL policies have a great deal of flexibility in choosing how much premiums to pay for a given death benefit. The minimum premium is primarily affected by the contract features offered by the insurer. To maintain a death benefit guarantee, that specified premium level must be paid every month. To keep the policy in force, typically no premium needs to be paid as long as there is enough cash value in the policy to pay that months cost of insurance. The maximum premium amounts are heavily influenced by the IRS code for life insurance. The IRS code section 7701 sets limits for how much cash value can be allowed and how much premium can be paid (both in a given year, and over certain periods of time) for a given death benefit. The most efficient policy in terms of cash value growth would have the maximum premium paid for the minimum death benefit. Then the costs of insurance would have the minimum negative effect on the growth of the cash value. In the extreme would be a life insurance policy that had no life insurance component, and was entirely cash value. If it received favorable tax treatment as a life insurance policy it would be the perfect tax shelter, pure investment returns and no insurance cost. In fact when variable universal life policies first became available in 1986, contract owners were able to make very high investments into their policies and receieved extraordinary tax benefits. In order to curb this practice, but still encourage life insurance purchase, the IRS developed guidelines regarding allowed premiums for a given death benefit.

Maximum Premiums

The standard set was twofold: to define a maximum amount of cash value per death benefit and to define a maximum premium for a given death benefit. If the maximum premium is exceeded the policy no longer qualifies for all of the benefits of a life insurance contract and is instead known as a modified endowment contract or a MEC. A MEC still receives tax free investment returns, and a tax free death benefit, but withdrawals of cash value in a MEC are on a 'lifo' basis, where earnings are withdrawn first and taxed as ordinary income. If the cash value in a contract exceeds the specified percentage of death benefit, the policy no longer qualifies as life insurance at all and all investment earnings become immediately taxable in the year the specified percentage is exceeded. In order to avoid this, contracts define the death benefit to be the higher of the original death benefit or the amount needed to meet IRS guidelines. The maximum cash value is determined to be a certain percentage of the death benefit. The percentage ranges from 30% or so for young insureds, declining to 0% for those reaching age 100.

The maximum premiums are set by the IRS guidlines such that the premiums paid within a seven year period after a qualifying event (such as purchase or death benefit increase), grown at a 6% rate, and using the maximum guaranteed costs of insurance in the policy contract, would endow the policy at age 100 (ie the cash value would equal the death benefit). More specific rules are adjusted for premiums that are not paid in equal amounts over a seven year period. The entire maximum premium (greater than the 7 year premium) can be paid in one year and no more premiums can be paid unless the death benefit is increased. Because the 7 year level guideline premium was exceeded the policy becomes a MEC.

To add more confusion the 7 year MEC premium level cannot be paid in a VUL every year for 7 years, and still avoid MEC status. The MEC premium level can only be paid in practice for about 4 years before additional premiums cannot be paid if non MEC status is desired. There is another premium designed to be the maximum premium that can be paid every year a policy is in force. This premium carries different names from different isurers, one calling it the guidline maximum premium. This is the premium that often reaches the most efficient use of the policy.

Investment Choices

The number and type of choices available is dependent on the insurer, but some policies are available with a wide variety of separate accounts, also known as sub-accounts. Some insurers offer over 50 separate accounts with investment styles from very conservative guaranteed fixed accounts, to bond funds, to equity funds to highly aggressive sector funds.

Separate accounts are organized as trusts to be managed for the benefit of the insureds, and are named because they are kept separate from the general account which is the other reserve assets of the insurer. They are treated, and in all intents and purposes are, very much like mutual funds, but have slightly different regulatory requirements.

Tax Advantages

Tax free investment earnings while a policy is in force
FIFO withdrawal status after 10 years
Tax free policy loans from non-MEC policies

Criticisms of Variable Universal Life

Some general Criticisms

High Costs - the total cost of insurance in a VUL policy will be greater over its lifetime than a term policy and therefore more profitable to the insurer, however it is still possible for the insured to get a greater benefit from the VUL over term at the same time (Both win). High Costs can also be offset by competition among insurers. Some policies with higher costs are not as competitive as others. Term life insurance however generally becomes more expensive as one gets older, although insurance is less likely to be needed at this point.

Limited investment choices, confined to the (sometimes expensive) separate accounts that are run or set up by the insurance company.

Some assert that the tax benefits are unfair and only benefit the wealthy who can afford to pay the higher premiums necessary to make them efficient and receive the greatest tax benefits.

Many criticisms of VUL policies are not about the product in and of itself, but rather how it is sold by many insurance agents

VUL is more profitable to the insurance company and to the agent which creates a perverse incentive to sell it when term life insurance would be better for the customer.

Policy purchasers may not be aware of the investment risk involved. This is, however, a clear violation of basic NASD rules, and is a fineable (at the minimum) offense for the agent.

In order to emphasize the tax free savings aspect of VUL, many agents do not disclose the other tax free savings options open to people, such as Roth IRAs or section 529 plans, which might be better. Also other tax advantaged savings options such as the 401(k) or other pre-tax retirement plans may be more appropriate in a given situation. There are agents promoting themselves primarily as "investment consultants" and who primarily market the policies as "tax free savings" instead of "life insurance with an accumilation benefit", which is illegal. Prudential Insurance was fined heavily for this practice.

Some insurance companies or agents do not actively encourage the maximum efficient use of the policy by paying the greatest possible premium. Thus cash values do not grow well and costs are maximized.

While certain Universal Life insurance fees are scrupulously disclosed, there are some who claim that certain additional investment account management fees (MERs) are not fully disclosed in some VUL policy projections. These additional fees can potentially cut the net yield of a VUL policy by a significan margin, compared to the identical investments held outside the VUL.