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 separate accounts whose values vary—they vary because they are invested in stock and/or bond markets. The 'universal' component in the name refers 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 Internal Revenue 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 a type of permanent life insurance, because the death benefit will be paid if the insured dies any time as long as there is sufficient cash value to pay the costs of insurance in the policy. With most if not all VULs, unlike whole life, there is no endowment age (which for whole life is typically 100). This is yet another key advantage of VUL over Whole Life. With a typical whole life policy, the death benefit is limited to the face amount specified in the policy, and at endowment age, the face amount is all that is paid out. Thus with either death or endowment, the insurance company keeps any cash value built up over the years. However, some participating whole life policies offer riders which specify that any dividends paid on the policy be used to purchase "paid up additions" to the policy which increase both the cash value and the death benefit over time. With a VUL policy, the death benefit is the face amount plus the build up of any cash value that occurs (beyond any amount being used to fund the current cost of insurance.)
If investments made in the separate accounts out-perform the general account of the insurance company, a higher rate-of-return can occur than the fixed rates-of-return typical for whole life. The combination over the years of no endowment age, continually increasing death benefit, and if a high rate-of-return is earned in the separate accounts of a VUL policy, this could result in higher value to the owner or beneficiary than that of a whole life policy with the same amounts of money paid in as premiums.

Regulation of VUL Providers

Because the separate accounts are securities, the representative providing a VUL must be working in accordance with the securities regulations of the country or province in which he operates. And because they are life insurance policies, VULs may only be sold by representatives who are properly licensed to sell life insurance in the areas in which they operate. The insurance company providing the policy must also be licensed as an "insurer."
This dual regulation helps protect consumers, who can look up the track record of offenses of any provider listed by the regulating SRO (Self Regulatory Organization) or provincial securities commission.
United States. VULs may only be sold in the United States by representatives who have a "producers" life insurance license in the state(s) in which he operates. The insurance company providing the policy must also be licensed in the state(s) as an "insurer." Because the separate accounts are securities, the representative must be working through a broker/dealer registered with the United States' SRO, the Financial Industry Regulatory Authority (FINRA) and himself be registered with FINRA. (FINRA has an online database an investor can use to look up offenses and regulatory actions of any broker or broker/dealer.) The fact of a representative's securities registration will show on his state insurance license as "Variable" as in "qualified for Life and Variable Products." (The exact wording could vary from state to state.) Canada. VULs, as securities, may only be sold in Canada by representatives duly registered with their provincial securities commission to sell mutual funds. And as VULs are life insurance policies, providers must comply with the regulations of the Canadian Life and Health Insurance Association (CLHIA). In Canada, there is no real differentiation between universal life and variable universal life. The Canadian Securities Industry is also regulated by 2 self-regulatory organizations: the IIROC {Investment Industry Regulatory Organization of Canada} and the MFDA (Mutual Fund Dealers Association). The Canadian Securities Administrators oversee these self-regulatory organizations and rely on them as front-line regulators of securities dealers and their representatives.

Uses

Variable universal life insurance receives special tax advantages in the United States Internal Revenue 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.
Another use of Variable Universal Life Insurance is among relatively wealthy persons who give money yearly to their children to put into VUL policies under the gift tax exemption. Very often persons in the United States with a net worth high enough that they will encounter the estate tax give money away to their children to protect that money being taxed. Often this is done within a VUL policy because this allows a tax deferral (for which no alternative would exist besides tuition money saved in an educational IRA or 529 plan), provides for permanent life insurance, and can usually be accessed tax-free by borrowing against the policy.

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 month's cost of insurance. The maximum premium amounts are heavily influenced by the code for life insurance. Internal Revenue Code section 7702 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 received 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 insured persons, declining to 0% for those reaching age 100.
The maximum premiums are set by the IRS guidelines 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. If the 7 year level guideline premium is exceeded, then the policy becomes a MEC.
To add more confusion the seven 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 insurers, one calling it the guideline 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. 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 on principal paid into the contract Tax free policy loans from non-MEC policies The death benefit is paid income tax free if premiums are paid with after tax money Taxes are the main reason those in higher tax brackets (25%+) would desire to use a VUL over any other accumulation strategy. For someone in a 34% tax bracket (Federal & State), the investment return on the separate accounts may average 10%, and at say age 75 the policy's death benefit would have an internal rate of return of 9%. In order to get a 9% rate of return in an ordinary taxable account, in a 34% tax bracket, one must earn 13.64%. Another alternative is a Roth IRA, because one would get the 10% tax free. The contribution limits on the Roth are $5,000 in 2009, and is normally unavailable to those in the 34% tax bracket. An alternative for this in the 34% tax bracket would be to consider using Variable Annuities which does not limit the contributions and withdraw from it without letting it annuitize.
Other alternatives for those in the 34% tax bracket that own their own companies would be to consider SEP IRA's, company 401k's or retirement arrangements from a company perspective, or to incorporate and consult a tax specialist.
These numbers assume expenses that may vary from company to company, and it is assumed that the VUL is funded with a minimum face value for the level of premium. The cash values would also be available to fund lifestyle or personally managed investments on a tax free basis in the form of refunds of premiums paid in and policy loans (which would be paid off on death by the death benefit.)

Risks of Variable Universal Life


Cost of Insurance - The cost of insurance for VULs is generally based on term rates and as the insured ages, the risk of mortality increases, increasing the cost of insurance. If not monitored properly the cost of insurance may eventually exceed the cash outlay depleting savings. If this continues long term the savings will be depleted and insured will be given an option to increase the cash outlay to cover the higher cost of insurance or cancel the policy leaving them with no savings and either no insurance, or very expensive insurance.
Cash Outlay - The cash needed to effectively use a VUL is generally much higher than other types of insurance policies. If a policy does not have the right amount of funding, it may lapse.
Investment Risk - Because the sub accounts in the VUL may be invested in stocks and bonds, the insured now takes on the investment risk rather than the insurance company.
Complexity - The VUL is a complex product, and can easily be used (or sold) inappropriately because of this. Proper funding, investing, and planning are usually required in order for the VUL to work as expected.

General Uses of Variable Universal Life

These are the features typically marketed by insurance companies, however the VUL in most cases will limit the insured to being able to take advantage of only one of these features listed not all. Each of these features can be achieved through other means.
Financial Protection - As with all life insurance programs, VULs can be used to protect a family in the case of a premature death. Tax Advantages - Because of its tax-deferred feature, the VUL may offer an attractive tax advantage, especially to those in higher tax brackets. To attain them, the policy must be highly funded (though still non-MEC), for the tax advantages to offset the cost of insurance. These tax advantages can be used for either...
Education Planning - The cash value of a VUL can be used to help fund children's education, as long as the policy is started very early. Also, putting money into a VUL can be used to help children qualify for federal financial aid, since the federal government does not consider the cash value when calculating EFC (Expected Family Contribution).
Retirement Planning - Because of its tax-free policy loan feature, the VUL can also be used as tax-advantaged income source in retirement, assuming retirement is not in the near future and the policy is not a modified endowment contract. Again, the policy must be properly funded for this strategy to work. Estate Planning - Those with a large estate (A filing is required for estates with combined gross assets and prior taxable gifts exceeding $3,500,000 effective for decedents dying on or after January 1, 2009 can sometimes use a VUL as part of their estate planning strategy to reduce or avoid estate taxes by setting up a life insurance trust sometimes known as an ILIT. For most people this will not be an issue as the current estate tax is set to be repealed in 2010.

Criticisms of Variable Universal Life

Some general Criticisms
High Costs - VULs tend to be more expensive than other types of insurance, including Whole Life, Term, and Universal Life (in that order). 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 (see Buy term and invest the difference). Tax savings however may more than compensate for the costs, assuming the individual has already taken advantage of Roth contributions. Limited investment choices, confined to the (sometimes expensive) separate accounts that are run or set up by the insurance company. Policy expenses may increase if the company has negative experience with mortality. Usually there is a cap on those expenses. It should not be assumed that the policy will continue to grow and stay robust, particularly if subjected to withdrawals and loans. 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 conflict of interest to sell it when term life insurance would be better for the customer. Policy purchasers may not be fully aware of the investment risk and complexities involved. 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. 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 significant margin, compared to the identical investments held outside the VUL.