Variable Life Insurance: How It Works, Risks, and Who It's For

What Is Variable Life Insurance?

Variable life insurance is a type of permanent life insurance that provides a death benefit and builds cash value. What sets it apart from other permanent policies is how the cash value is invested. Instead of earning a fixed interest rate or tracking a market index, your cash value goes directly into investment sub-accounts that you choose.

These sub-accounts work like mutual funds. They may invest in stocks, bonds, money market instruments, or a combination. You decide how to allocate your cash value among the available options. This gives you more control over your investment strategy than any other type of life insurance.

With that control comes risk. Your cash value can grow when markets rise, but it can also shrink when markets fall. There is no floor or guaranteed minimum return on the sub-account investments. This makes variable life the highest-risk, highest-potential-reward type of permanent life insurance available.

Because of the investment component, variable life insurance is classified as a security. It is regulated by the SEC and FINRA in addition to state insurance regulators. You will receive a prospectus before purchasing, just like you would with a mutual fund.

How Variable Life Insurance Works

When you pay your premium, the insurance company deducts the cost of insurance and administrative fees. The remaining amount goes into your cash value account. You then direct that cash value into one or more investment sub-accounts offered within the policy.

Variable life insurance has fixed, scheduled premiums. Unlike universal life, you cannot skip payments or change the premium amount. You pay the same amount on the same schedule for the life of the policy. This is similar to whole life insurance in that regard.

The performance of your sub-accounts determines how your cash value grows or shrinks. If your chosen investments do well, your cash value increases. If they perform poorly, your cash value decreases. The insurance company does not guarantee any rate of return on the sub-account investments.

Investment Sub-Accounts Explained

Sub-accounts are the investment options inside a variable life policy. Each sub-account invests in a specific type of asset. Most policies offer a range of choices so you can build a diversified portfolio within the policy.

Common sub-account categories include the following.

• Stock funds. These invest in equities and offer the highest growth potential. They include large-cap, small-cap, international, and sector-specific options. They also carry the highest risk of loss.
• Bond funds. These invest in government or corporate bonds. They are generally less volatile than stock funds and provide more stable returns. They are a common choice for policyholders seeking to reduce risk.
• Money market funds. These invest in short-term, low-risk securities. They offer the most stability but the lowest growth potential. Some policyholders move cash value here during market downturns.
• Balanced funds. These hold a mix of stocks and bonds in a single sub-account. They offer a middle ground between growth and stability.

Most policies also offer a fixed account option that earns a guaranteed interest rate. This provides a safe harbor for part of your cash value, though the rate is typically low. You can usually reallocate your cash value among sub-accounts at any time without tax consequences.

Death Benefit Options: Fixed vs. Variable

Variable life insurance typically offers two death benefit options. Understanding the difference is important because it affects both your beneficiaries and your cash value growth.

Option A: Fixed death benefit

With the fixed death benefit option, your beneficiaries receive a guaranteed minimum death benefit regardless of how your investments perform. If your sub-accounts perform well and the cash value grows beyond a certain threshold, the death benefit may increase to maintain the required ratio between cash value and death benefit under IRS rules. But if your investments lose money, the death benefit stays at the guaranteed minimum.

This option provides more certainty for your beneficiaries. They know they will receive at least the stated face amount. Most policyholders choose this option because it provides the protection that is the primary reason for buying life insurance.

Option B: Variable death benefit

With the variable death benefit option, the death benefit equals the face amount plus your cash value. If your investments do well, the death benefit can be significantly larger than the original face amount. If your investments do poorly, the death benefit shrinks. There is still a guaranteed minimum, but the total payout fluctuates with investment performance.

This option costs more because the insurance company must maintain a higher net amount at risk. It is best suited for people who want to maximize the legacy they leave to beneficiaries and are comfortable with the fluctuation.

Fees and Costs in Variable Life Insurance

Variable life insurance is one of the most expensive types of life insurance. Multiple layers of fees reduce your net returns. Understanding these costs is critical before purchasing a policy.

• Mortality and expense risk charges (M&E). This is an annual charge, typically 0.5% to 1.5% of the account value, that compensates the insurer for the death benefit guarantee and administrative overhead. It is deducted from your cash value.
• Administrative fees. These cover the cost of policy administration, statements, and record-keeping. They may be a flat monthly charge or a percentage of your account value.
• Fund expense ratios. Each sub-account has its own expense ratio, just like a mutual fund. These typically range from 0.3% to over 1% annually. They are deducted from the sub-account returns before your cash value is credited.
• Surrender charges. If you cancel the policy within the first 10 to 15 years, the insurer keeps a percentage of your cash value. Surrender charges start high and decrease over time until they reach zero.
• Premium loads. Some policies deduct a percentage of each premium payment before it reaches your cash value. This is a front-end sales charge that reduces the amount working for you from the start.

When you add all these fees together, the total annual drag on your cash value can be 2% to 3% or more. Over 20 or 30 years, this significantly reduces your net returns compared to investing the same amount in low-cost index funds outside an insurance wrapper.

Risks of Variable Life Insurance

Variable life insurance carries risks that other types of permanent life insurance do not. Before purchasing, you should understand each one clearly.

• Investment risk. Your cash value is directly exposed to market fluctuations. In a prolonged market downturn, your cash value can lose a significant portion of its value. Unlike indexed universal life, there is no floor protecting you from losses.
• Lapse risk. If poor investment performance drains your cash value and you cannot cover the cost of insurance charges, the policy can lapse. You lose your coverage and may owe taxes on any gains if you had outstanding policy loans.
• Fee drag. The layers of fees in a variable life policy are significantly higher than those in a typical brokerage account. Even in years when your sub-accounts earn decent returns, the fees can eat into your gains substantially.
• Complexity risk. Variable life requires you to make investment decisions. If you lack investing experience, poor allocation choices can lead to unnecessary losses. You need to monitor and rebalance your sub-accounts over time, which requires ongoing attention and financial knowledge.
• Surrender charge risk. If you need to cancel the policy in the early years, surrender charges can take a large portion of your cash value. You may walk away with far less than you paid in premiums.

Tax Advantages of Variable Life Insurance

Despite its costs, variable life insurance offers meaningful tax benefits. These benefits are the main reason high-income earners sometimes choose variable life over a standard investment account.

• Tax-deferred growth. Your cash value grows without being taxed each year. You do not owe capital gains taxes when you switch between sub-accounts. In a taxable brokerage account, selling one fund and buying another triggers a taxable event.
• Tax-free death benefit. Under IRC Section 101(a), your beneficiaries receive the death benefit free of federal income tax. This makes variable life a tool for passing wealth to the next generation in a tax-efficient manner.
• Tax-free policy loans. You can borrow against your cash value without triggering income tax. As long as the policy stays in force, the loan proceeds are not considered taxable income. This allows you to access your cash value in retirement without creating a tax bill.

Keep in mind that these tax advantages come with conditions. If the policy lapses or is surrendered with outstanding loans, the gains above your cost basis become taxable income. The IRS also imposes limits on how much you can pay into the policy through modified endowment contract (MEC) rules. If you overfund the policy and it becomes a MEC, loans and withdrawals lose some of their tax advantages.

SEC Regulation and the Prospectus

Variable life insurance is the only type of life insurance regulated by the Securities and Exchange Commission. This is because the sub-accounts are securities, just like mutual funds. The policy is registered with the SEC and must comply with federal securities laws.

Before you purchase a variable life policy, the insurer must give you a prospectus. This legal document describes the investment options, fees, risks, and terms of the policy. Read it carefully. The prospectus discloses all the costs that may not be obvious from a sales presentation.

The agent selling you a variable life policy must be registered with FINRA and hold a securities license, typically a Series 6 or Series 7 registration. They must also hold a state life insurance license. This dual licensing requirement exists because the product is both insurance and an investment.

The SEC regulation provides an extra layer of consumer protection. It requires standardized disclosures that make it easier to compare variable life policies from different insurers. However, the prospectus can be dozens of pages long and dense with legal language. Ask for a summary of fees and charges if the full document is overwhelming.

Policy Loans and Withdrawals

Variable life insurance allows you to access your cash value in two ways: policy loans and withdrawals. Each has different tax consequences and effects on your policy.

Policy loans let you borrow against your cash value. The loan is not taxable income as long as the policy stays in force. You do not need to repay the loan on a fixed schedule, but interest accrues on the outstanding balance. The loan amount plus any accrued interest reduces your death benefit. If the total loan balance exceeds your cash value, the policy lapses.

Withdrawals, also called partial surrenders, remove money from your cash value permanently. Withdrawals up to your cost basis, the total premiums you have paid, are tax-free. Any amount above your cost basis is taxed as ordinary income. Withdrawals also permanently reduce the death benefit.

Be careful with both options. Excessive loans or withdrawals can drain your cash value and cause the policy to lapse. A lapse with an outstanding loan balance can create a large, unexpected tax bill.

How Variable Life Differs From Whole Life

Whole life insurance and variable life insurance are both permanent policies, but they manage cash value very differently.

• Cash value growth. Whole life earns a guaranteed fixed rate plus potential dividends. Variable life returns depend entirely on sub-account performance, with no guaranteed return.
• Risk. Whole life has no investment risk. Your cash value never decreases due to market conditions. Variable life puts your cash value at full market risk.
• Control. With whole life, the insurer manages everything. With variable life, you choose your investments and bear the consequences of those choices.
• Premiums. Both have fixed premiums. Neither allows you to skip or change payment amounts.

Whole life is the safer, simpler choice for people who want guaranteed growth and predictable outcomes. Variable life is for people who believe they can earn higher returns by managing their own investments and are willing to accept the risk of loss.

How Variable Life Differs From Universal Life

Universal life insurance earns a fixed interest rate set by the insurer, with a guaranteed minimum. Your cash value grows slowly but steadily. You cannot lose money due to market conditions. Universal life also offers flexible premiums, letting you pay more or less as your finances change.

Variable life has fixed premiums and investment sub-accounts instead of a fixed interest rate. You get more growth potential but take on investment risk. If you want both flexible premiums and investment sub-accounts, you need variable universal life, which combines features of both products.

Variable Life vs. Variable Universal Life

These two products are often confused because they share the word variable and both offer investment sub-accounts. But they are different policies with different structures.

• Premiums. Variable life has fixed premiums. Variable universal life has flexible premiums. This is the biggest structural difference.
• Death benefit. Variable life typically guarantees a minimum death benefit. Variable universal life may or may not, depending on how the policy is funded and how investments perform.
• Lapse risk. Variable universal life has higher lapse risk because flexible premiums allow policyholders to underfund the policy. Variable life's fixed premiums provide more structure, reducing the chance of underfunding.
• Complexity. Variable universal life is more complex because it combines investment decisions with premium flexibility decisions. Variable life is somewhat simpler because the premiums are fixed.

Today, variable universal life is more commonly sold than variable life. The premium flexibility makes it more appealing to buyers. However, that flexibility also increases the risk that the policy will be underfunded and lapse in later years.

Who Should Consider Variable Life Insurance

Variable life insurance is appropriate for a narrow group of people. You should only consider it if you meet several specific criteria.

• You need permanent life insurance. If your need for coverage is temporary, term life is far more cost-effective. Variable life only makes sense if you need coverage that lasts your entire life.
• You have maxed out other tax-advantaged accounts. If you have already contributed the maximum to your 401(k), IRA, HSA, and any other available tax-advantaged vehicles, variable life can provide additional tax-deferred growth.
• You are comfortable with investment risk. You must understand that your cash value can lose money. If the idea of your life insurance cash value declining by 20% or more in a bad year makes you uncomfortable, variable life is not for you.
• You want investment control. If you prefer choosing your own investments over relying on the insurer's fixed rate or index-linked crediting, variable life gives you that control.
• You have a long time horizon. Variable life needs time to overcome its high fees and generate meaningful returns. If you are buying in your 30s or 40s with 20 to 30 years before you need to access the cash value, the math is more favorable.

Who Should Avoid Variable Life Insurance

Variable life is not appropriate for most people. Here are the situations where you should look at other options instead.

• You primarily need income replacement protection. Term life insurance provides far more death benefit per dollar spent. A healthy 35-year-old can get $500,000 of 20-year term coverage for about $25 per month. The same budget in a variable life policy would buy a fraction of that coverage.
• You have not maxed out your 401(k) or IRA. These accounts offer the same tax-deferred growth without insurance costs eating into your returns. Always fill these buckets first.
• You are uncomfortable with investment risk. If you want guaranteed cash value growth, whole life or traditional universal life are better choices. Indexed universal life offers a middle ground with downside protection.
• You do not want to actively manage investments. Variable life requires ongoing attention to your sub-account allocations. If you prefer a hands-off approach, this product is not a good fit.

Tips for Evaluating a Variable Life Policy

If you are considering variable life insurance, take these steps to make an informed decision.

• Read the prospectus. Do not rely solely on the agent's presentation. The prospectus discloses all fees, risks, and sub-account options. Focus on the fee tables and the list of all charges.
• Compare total costs to investing outside the policy. Calculate what your returns would be if you bought term life and invested the premium difference in low-cost index funds. In many cases, the buy-term-and-invest-the-difference approach produces better results.
• Understand the surrender schedule. Know exactly how much you would lose if you need to cancel in the first 5, 10, or 15 years. Surrender charges can be steep.
• Consider working with a fee-only advisor. Variable life insurance pays high commissions to the selling agent, which can create a conflict of interest. A fee-only advisor who does not earn commissions can give you unbiased advice about whether this product fits your needs.

The Bottom Line

Variable life insurance combines permanent life insurance with direct investment in market sub-accounts. It offers the highest growth potential of any permanent life insurance product, along with tax-deferred accumulation and a tax-free death benefit. For high-income individuals who need permanent coverage and want investment control, it can serve as a supplemental wealth-building tool.

However, variable life comes with significant risks and costs. Your cash value can lose money. Multiple layers of fees drag down your returns. The product is complex and requires active management. And for most people, simpler strategies like term life insurance combined with low-cost retirement accounts produce better financial outcomes.

Before buying a variable life policy, make sure you have maxed out every other tax-advantaged account available to you. Read the prospectus in full. Understand every fee. Compare the total cost to buying term and investing the difference. And consider getting advice from a fee-only financial advisor who does not earn a commission on the sale. Variable life can work for the right person in the right situation, but it is not the right choice for most.