Sunday, March 18, 2012

Know your Variable Life Insurance Policy

Financially speaking, life insurance is probably the most important thing a family can own. Problem number one is that many families do not have life insurance. Problem number two is that for the families that do have life insurance; many are either over-premiumed or under-insured or both. I think the main reason for this is that many people are enticed into purchasing the more expensive and complicated policies because their associated savings accumulation (Cash Value) growing over the life of the policy.

My belief is that you should buy the cheaper and less complicated Term Life Insurance and invest the difference that you would have paid for the more expensive Cash Value policy. To see more information backing up my beliefs, please feel free to visit:
Today I want to mainly concentrate on the Variable Life Insurance policy, but first, I feel it necessary to give you some background on life insurance in general.

First of all, there are really only two types of life insurance – Term Life Insurance and Cash Value Life Insurance. Term Life Insurance, the cheapest form of life insurance, is simply a life insurance policy that lasts for a certain term or period of time. If you are to die during the term, your beneficiaries receive a death benefit and if you outlive the term they receive nothing. Sort of like car insurance, if you never get into an accident while you have the insurance, you paid the premiums and have nothing to show for it. Term Life Insurance can be bought on a year to year basis (Annual Renewable Term) where the price increases every year, but it is usually purchased at a level price for 10, 20 or 30 year Terms.

Cash Value Life Insurance is, to put it simply, is just a type of life insurance policy that has some sort of savings program associated with it in addition to the death benefit. These types of life insurance policies are typically much more expensive then Term Life Insurance. There are many different flavors of Cash Value like Whole Life, Universal Life, Variable Universal Life, etc.

Whole Life was the original player in the Cash Value Life Insurance game – it was very predictable, but it was also the most expensive. So, in order to compete with less expensive Term Life Insurance, the traditional life insurance industry had to come up with many different mutations of Whole Life Insurance which, not only decreased the cost and made them more competitive, but increased the complexity as well as unpredictability.

Today I am going to concentrate on pointing out the characteristics of and explaining some of the complexities of one of these aforementioned mutations - the Variable Life Insurance policy:
  1. What does “Variable” mean? First of all, when talking about life insurance and you hear the word “variable”, it just refers to mutual funds. The Cash Value in a Variable Life Insurance policy is allocated among sub-accounts, which are merely clones of popular mutual funds. This should be red flag number one, because since they are clone funds, they cannot be followed on the stock market. By definition clone funds are mutual funds that replicate the performance or strategy of an existing mutual fund or index through the use of derivatives.
  2. There are high expenses (mostly hidden) associated with Variable Life Insurance policies. Because the mutual fund managers typically also manage their cloned Variable Life Insurance sub-accounts, the internal fees for investing Cash Value in those options are much greater. Don't get too excited if you feel that you have very cheap premuims for your Variable Life. Chances are in this case, you have frontloaded the policy with a large sum of money up front or from the transferral of the Cash Value built up from a previous Cash Value Life Insurance policy.
  3. Variable Life policies are a lot of times marketed towards more affluent people as a means to shelter their money from taxes. Unlimited amounts of money can be put into a Variable Life Insurance policy. But one thing that is not always explained to the customer is that because of the corridor, the face amount (death benefit) has to go up. Because the face amount goes up, the premium goes up as well. The definition of corridor is the space created between the total death benefit and the Cash Value of a Variable Life Insurance policy. An automatic increase in the death benefit results when the Cash Value approaches the initial face amount as defined in the fine print. If this space did not exist, the Variable Life Insurance policy would not qualify as a life insurance policy under the definition of life insurance by the Internal Revenue Code (IRC) and would cease to reap the favorable tax treatment afforded life insurance policies by the IRC. Basically, this corridor is in place because life insurance is not supposed to be used as an investment, even though many times it is sold as such.
  4. Figure 1
  5. Who owns the Mutual Funds in your Variable Life Insurance? By law, all Mutual Funds must distribute at least 90% of earnings to the owner of the mutual fund shares --- the shareholder (See Figure 1for how investments and insurance are kept separate when buying Term Life Insurance). With Variable Life Insurance, the Mutual Fund pays the Insurance Company; however, nothing regulates what the Insurance Company gives back to the policy owner (See Figure 2 for how investments and insurance are bundled when buying Variable Life Insurance).
    Figure 2
    Remember life insurance is not supposed to be used as an investment, so why are you using the life insurance company as a middleman for your investing?
  6. Are flexible premiums really a benefit? Variable Life policies allow for flexible premiums. You can choose at any time to skip a premium or pay lower premium. The one thing they don’t tell you is that even if you do not pay your premium or make a reduced payment, they will still get their money. Remember, there is no free lunch. As long as you still have enough cash accumulated in your Cash Value, the unpaid premiums will be deducted from there. Once the Cash Value is depleted, then the policy will self-destruct or the policy holder will have to make an astronomical payment in order to revive the policy.
  7. What “Option” did you sign up for? Here is another interesting fact that most people that I have talked to that have a Variable Universal Life Insurance policy (This is only applicable to Universal Life and Variable Universal Life Insurance policies) don’t know. These policies usually have two options – Option 1 and Option 2 or some companies call them Option A and Option B.
    Option 1 or Option A: Most people choose this option because it is the cheaper option. In this case, if the policyholder were to die, the Cash Value accumulated would go towards paying the beneficiaries the death benefit and the life insurance company would only have to pay the difference. In a way, with this option, the policyholders are actually tricked into helping pay their own death benefit.
    Option 2 or Option B: This option is called something like “Cash plus face value” - the keyword here is “plus”. For the policyholders that chose this option, their beneficiaries will get both the death benefit and the cash value. However, like I said earlier that there is no free lunch, they are definitely paying for this benefit with higher premiums.
  8. The Cash Value accumulating is not your money. Another thing many people don’t realize is that they do not own their Cash Value. In the fine print there will be a clause stating that the Cash Value is owned by the insurance company not the policy owner. When you borrow money from your Cash Value policy, two very bad things happen. First, you are charged interest and second, the amount borrowed is deducted from the death benefit.
  9. When does the Cash Value start accumulating? Another nice thing is that your Cash Value doesn’t start accumulating on day one. Usually there is a waiting period of three years (the first three years is when the potential Cash Value accumulation is used to pay sales commissions and administrative expenses) before there is even a positive balance accumulated in the Cash Value. Also, when trying to cancel a Cash Value Life Insurance policy, you do not even automatically get all of your built up Cash Value back as well. If you have not owned the policy long enough, you will be charged a surrender fee. Depending on the length of time you owned the policy, will decide the amount of the fee, not to exceed the full amount of the Cash Value accumulated in the policy. It may take fifteen to twenty years of owning the policy to avoid any surrender charges.
So, now I hope you understand your Variable Life Insurance, however, I must preface my next statement with the following disclaimer: Do not cancel any life insurance policy unless you are wealthy enough to be self-insured or unless you already have a replacement policy in place.

And now that you understand your Variable Life Insurance policy, take the steps necessary to get out of it as soon as possible!

Just remember to keep it simple and keep your investments separate from your life insurance. Only buy Term Life Insurance and invest the difference that you would have spent on your Cash Value Life Insurance policy for yourself. Only choose the Cash Value route if you’d rather have someone else earn interest on your investments.

I'm so excited to share this information with you. If you have enjoyed the information or feel that it would benefit someone else, please share it. If you have any comments, please post them below, otherwise, feel free to contact me.
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