CHAPTER EIGHT - VARIABLE UNIVERSAL LIFE

 

Variable Universal Life (VUL) is discussed in a little more detail than other types of policies because it is the most versatile of the life insurance products and is very popular.  VUL is a policy that has the premium flexibility and policy adjustment features of Universal Life with the investment options of Variable life, which helps to explain the popularity.

From the viewpoint of a “contract,” a VUL policy is Universal Life as flexible premiums, death benefit options (A and B) and the other standard provisions of a UL policy are present in a VUL policy.  There is really only one big difference, and that is the variable nature of the account value of the policy.  UL account values are gathered in the insurance company’s general account and then credited with a guaranteed rate of return, or a higher value if justified by the interest rates of the insurer.  VUL policyowners can place their cash value in any of a wide variety of separate accounts or subaccounts – including a fixed interest guarantee from the company’s general account.  (At this point there would be no difference between a VUL and a UL policy, except that they could later change the investment option to a separate account.)  The accounting for the separate account unit value is the same as with Variable life.

FEATURES OF THE VARIABLE UNIVERSAL LIFE POLICY

Even though the features and the benefits are the same as with UL policies, with the flexibility of VLI in premiums, a “mixture” of the two policies, various features and benefits should be considered.

As with any whole life plan, VUL policies provide lifetime insurance protection.

1. For tax purposes, VUL is a type of life insurance, therefore net premiums goes into separate accounts where they earn a current rate of return, and earning are  accumulated on the same tax-advantaged basis as cash values of more traditional whole life policies.  Note, however, that if the death benefit is to be increased, the policyowner can pay additional premiums, but if the amount is above a certain amount, evidence of insurability may be required or the policy may become a modified endowment contract and lose its tax-advantaged basis.
2. Separate accounts are accounts into which the policyowner’s funds are invested and are called “separate” because they are separate from the company’s funds.  These funds earn a variable return.  As with mutual funds, these funds provide returns or losses based upon the performance of the separate accounts, and they are NOT guaranteed by the insurer and the returns on the separate accounts are NOT guaranteed.
3. Policyowners can transfer funds from one account to other accounts, and without charge.  The number of transfers is established by the contract, usually between 4 and 12 a year. 
4. VUL policies offer a multitude of account choices, often 10 or more, including a wide variety of stock accounts, multiple bond funds, managed funds and asset allocation funds.
5. The cash value in a VUL policy is constructed of premiums paid, less fees charged, less periodic deductions for the cost of insurance, plus (or minus) returns generated by the individual policyowner’s accounts.  Obviously, cash values are not guaranteed by the insurer and neither the insurer or the policyowner (or the agent) can accurately predict future earnings.
6. Death benefits are the same as with Universal Life – Option A or Option B.  While the insurers do not guarantee death benefits, many of the newer policies offer some protection against falling death benefits; some guarantee the death benefit to age 65.  Other companies offer guaranteed death benefit riders (with an additional, but quite modest, charge), which will guarantee that the policy will remain in force even if the cash value is zero.
7. The expenses and charges of a VUL are “transparent” (or “unbundled” as some say) and take many forms.  Most VUL policies have a system whereby deductions are taken from premiums as paid, and these deductions cover marketing costs, premium taxes and other expenses.  First year deductions are shown and are designed to cover the marketing costs accumulated the first year.  Deductions are guaranteed not to exceed an amount stated in the policy, but can be lower.  VUL has a reputation of having high expenses charges when compared to UL or VLI and traditional policies, but recently policy expenses have decreased so now it is more “cost-efficient.”
8. A policyowner must be given a prospectus (and a buyers guide in many states) at some stage while the policy is being discussed with the prospective policyowner.  The prospectus contains the specifics of the policy and the separate investment accounts and fees to be charged.  The policyowner also receives an annual report, which provides the latest status of all policy transactions, including cash values and deductions.
9. The VUL policy form contains most of the standard provisions and options available under traditional insurance policies.

STANDARD PROVISIONS

 

While most of the standard provisions of the VUL are the same as those of other life insurance policies, there are three provisions that differ, two that are unique to VUL, and certain riders are available.

Grace Period

Since the VUL is an “unbundled” policy, there really is no connection between the payment of the premium and the continuation of the coverage, but whether the policy continues is a function of the cash value.  If the cash value is insufficient to maintain the cost of insurance, the policyowner will be so notified that a premium must be paid.  From that date – date of notification – the required premium to keep the policy in force must be paid within 61 days or the policy will lapse.  Full coverage remains in force during the 61 days.

Reinstatement

If a VUL policy should lapse, it may be reinstated at any time within a stated period of time (usually 2 years), subject to specified requirements and conditions:

1. An application for reinstatement must be sent to the company, signed by the policyowner.
2. The policy must not have been totally surrendered, i.e. it must not have been surrendered for its net cash surrender value.
3. The company may require evidence of insurability, and if so, it must be provided to the company.
4. Premiums must be paid, which, with interest, are sufficient to keep the policy in force for a stipulated period of time (3 months usually).

Free-Look Provision

As required by law, after the policy is issued, the policyowner has a stipulated period of time (usually 10 days after receipt of the policy by the policyowner, or 45 days after the application has been signed) to return the policy to the insurer and receive a full refund of all premiums paid, no questions asked.  In some states, the refund will reflect earnings or losses in the cash value accounts, due to investment(s) performance, for the period of time that the money was in the control of the insurer.

Conversion Privilege

Unique to VUL policies, the VUL allows policyowners to exchange the VUL for a comparable non-variable plan, or they may transfer all values in the subaccounts of the VUL to the general and fixed account within 24 months after issue of the VUL.  The new policy, if the VUL is exchanged, will have the same effective date, same issue age and the same underwriting classification as the VUL.

Annual Report

At the time the policy is issued, it is impossible to project what the cash values will actually be because of the fluctuations of the investment accounts.  The SEC also requires “full-disclosure”, so for these reasons, the policyowner is sent an annual report that explains the current status of the policy, in full detail.  The annual report will contain the following information:

1. death benefit;
2. total cash value, by account and by percentage allocated to each account;
3. net cash surrender value;
4. total premiums that were paid since the previous report;
5. policy loans and interest charged on loans made during the previous year, if any;
6. partial surrenders made since the last report; and
7. the transfers of funds among the accounts.

Semiannual reports are also sent to the policyowner, which show the 6-month performance of the cash value accounts in which the funds of the policyowner has invested and a complete listing of all investments in the policy.

Riders & Options Available

The same options that are available for Universal Life and some traditional products are generally available for VUL policies.  Following is a list of those that may be included:

1. Waiver of Premium in case of disability;
2. Cost of Living Riders (COLA) which may be either a rider or part of the policy and may or may not have a separate premium;
3. Accidental Death Benefit;
4. Accelerated Death Benefit;
5. Term insurance rider;
6. Family Insurance rider; and
7. Guaranteed Insurability Rider (GIR), or option, which allows the increasing of the specified amount on each option date, without evidence of insurability and at standard rates.

TAXATION AND REGULATION

 

Even though it is regulated as a Security, it still retains its originality as a life insurance policy for taxation purposes. 

Obviously, premiums are not tax deductible.  Cash values accumulate free of current income taxes (but the legal guideline corridor ratio between cash value and death benefit must be maintained within the policy).

Death benefit proceeds are tax-free, and lump-sum benefits paid to a beneficiary are excluded from the beneficiary’s gross income for tax purposes.

Policy loans are viewed as a debt of the policyowner, and not as income or a taxable distribution.  Interest paid on a loan (for non-business purposes) is not tax deductible.  Also, if a policy fails the “7-pay test” it then becomes an “MEC” and loans and withdrawals are then subject to current income taxes plus a 10% penalty if the policyowner is under age 59 ½. (See discussions of modified endowment contracts, MECs.)

In some cases, surrenders, withdrawals, and the right to change death benefits options, can have tax consequences. For instance, upon total surrender, any amount received by the policyowner that is in excess of the total premiums paid into the policy, is treated as ordinary income and is taxed as such.

In total, taxation of the VUL benefits has created a very appealing product to many persons, particularly those who are in a higher tax bracket which was certainly one of the reasons that while individual life insurance doubled from 1986 to 1996, over the same period of time, Variable life insurance (including VUL) grew from approximately $65 billion, to $591 billion.

In order for a VUL policy to meet the definition of an insurance contract and obtain the favorable tax treatment, three tests must be met:

 

1. Cash Value Accumulation Test

When the cash value of a permanent life insurance policy exceeds the single premium that would pay for all future benefits, at that point the policy no longer meets the IRS definition of life insurance.  If a policy does not meet this cash value accumulation test, the policy is “disqualified,” with the disqualification retroactive to the policy issue date.  All income credited to that policy becomes taxable to the policyowner.

Since the insured or the insurance company’s producers do not have access to the mortality tables and the present value tables necessary to make this “test,” the insurance company’s home office will provide the necessary expertise to make sure that the policy meets the test and is considered as life insurance.

2. The Corridor Test

All VUL contracts contain a provision that defines the minimum of pure insurance protection in comparison to the cash value amount.  This minimum amount, technically guideline minimum sum insured, is the amount that is necessary to prevent the policy from violating the IRS Corridor rules.

To further make this complicated, the IRS considers the minimum sum insured by using a published ratio between the face amount of the policy and its cash value.  (See table below) For example, for those under age 40, the death benefit must be 250 percent as great as the cash value at that age.  The ratio decreases each year, eventually reaching 100 percent around age 95, at which time it is said to “mature”.

In the previous discussion of Universal Life, the illustrations show how the face amount increases after the cash value grows to a certain point, and after that point, the “amount at risk” continues to grow, with the “corridor” between the cash value and the death benefit.  The reason for the corridor is that if a policy matures before age 95, under the IRS Code it is no longer considered as life insurance.  Therefore, in order to maintain this ratio, insurance companies reserve the right to refuse additional payments of premium if they would cause the cash value to increase beyond the upper limits relative to the death benefit.  If the policy fails to meet the corridor test in any year, the policy is disqualified from inception and all income credited to that policy becomes taxable income to the policyowner.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

3. The Seven-pay Test

Another test!  However, if a policy fails the 7-pay test, it still remains as a life insurance policy, even though it loses the tax advantages of policy loans and withdrawals.  This has been mentioned previously, during the discussion of MECs. 

Basically, the test considers that if the total amount a policyowner pays into a life insurance policy during its first years, exceeds the sum of the net level premiums that would have been payable to provide paid-up future benefits in 7 years, then the policy is a MEC.  Once a policy is an MEC, it will always be an MEC.  Moreover, to repeat the earlier discussion of MECs, if the policyowner receives any amount from a loan or withdrawal, that amount is taxed first as ordinary income, then as return of premium.  In addition, the 10% penalty if the policyowner is under age 59 ½.

 

One other point on taxation of VULs.  If interest accrues after a date of death because of a delay in settlement, the interest may be taxable.  If the interest-only settlement option is chosen, the tax exclusion does not apply, and it does not apply to any option selected by the beneficiary.

 

CORRIDOR RATIO

 

NASD CONDUCT RULES

An outline of the NASD Conduct Rules was indicated earlier.  At this point, it would be advantageous to discuss some of those rules in a little more detail as they are very important to the marketing of Variable Universal Life.

1. Advertisements and all sales literature must not attempt to mislead investors, in any fashion or in any way, and must be filed with the proper department of the NASD.
2. Any discussions or communications with customers or potential customers regarding securities must be done in good faith, which means that there must not be any misleading information, omission of key information, exaggeration or other such guarantees, particular when comparing funds or accounts.
3. Any recommendation given must be reasonable, and if the representative has an interest in any security’s or product’s success, this interest must be fully disclosed.
4. The firm or the individual representative may not advertise in any other identity or name, or anonymously, and the firm must display their name prominently on all advertising and sales literature.
5. If the product’s name does not adequately identify it as a Variable life insurance product, the representative must fully describe what the product is.  Further, an agent should never suggest that VUL policies or their separate accounts are mutual funds.
6. As explained earlier, every prospect must be furnished a prospectus, either at the time of the first presentation, or mailed to the prospect in advance.
7. Under no circumstances should the agent suggest, or even imply that the any variable product, including VUL, is a “short-term” or “liquid” investment.
8. Obviously, the agent must be extremely careful about representing as to what is “guaranteed” and as to what is not, under a VUL or other variable product.
9. Even though separate accounts are, for the most part, patterned after mutual funds – an agent must not represent or indicate that the separate accounts are mutual funds. However, it is deemed proper to use the experience of a mutual fund invested in the same products as the separate account so as to be shown what did occur with the mutual fund.

ILLUSTRATIONS

Because the variable products are rather complex and the outcomes are not readily and accurately forecast without considerable explanation and assumptions, it is rather difficult to describe to the average consumer exactly how a VUL functions.  The life insurance industry has a checkered past in using illustrations as a sales tool, so the  insurer’s representative or agent must be extremely careful and must always tell the prospect that all illustrations are hypothetical and based on assumptions, and are certainly not a guarantee of cash value accumulations.  A statement to the effect that the prospect understands that the illustrations are not guarantees, etc., is required to be signed by the prospect by some insurers as a precaution. 

Illustrations may use any combination of returns up to a maximum gross rate of 12 percent, but only if the present market conditions warrant such expectations and an illustration with a “0” return is also provided.  The major difficulty suffered by insurers today with existing blocks of Universal and other interest-sensitive life products is that the interest rates have declined recently, to levels beyond the comprehension of most people just a few years ago.  Unfortunately, in the past many illustrations were shown with an investment return of a level 10% interest rate. 

All illustrations must show that separate account returns are what determines the cash values as well as the death benefits, and they must show maximum mortality and expense charges. 

It is NOT appropriate to compare one policy to another based on hypothetical performances.  Further, a hypothetical illustration can only show the relationship between the cash value and the death benefit value, not whether it is “better” than another policy.  Illustrations comparing VUL to the “buy term and invest the difference” strategy is considered as appropriate, if the hypothetical returns are identical and other such stipulations are met.

SPECIAL NASD VARIABLE CONTRACT RULES

Variable contracts have special rules as part of the NASD rules and they apply mostly to the construction of the policy and not specifically to agent’s conduct.

Obviously, when the values of a contract can change daily, it is necessary that the value must be determined at a specific time, in this case when the payments have been received—they are considered to have been received when the application has been received.  This further emphasizes that all applications and premiums must be submitted to the insurance company’s home office promptly.

A representative may not sell contracts through another broker-dealer unless the other broker-dealer is also a member of the NASD.  This also means that an agent cannot sell a product that his broker-dealer is not licensed to sell or does not have a valid sales agreement. 

Sales charges may not be excessive and the NASD Rules set forth what is considered as “excessive.”

When a sales charge has multiple payments, they cannot exceed 8.5% of the total payments due in the first 12 years of the contract or for total length if the contract length is less than 12 years.

If the contract has a single payment of the sales charge, the maximums are 8.5% of the first $25,000 (of the purchase payment); 7.5% of the next $25,000; and 6.5% for any amount over $50,000.

Section 2300 of the Conduct Rules addresses “suitability” which is the recommending of products for customers only when the product suits the customer’s needs.  This is addressed to some degree in the following section discussing the uses of VUL.

 

USES FOR VARIABLE UNIVERSAL LIFE INSURANCE

“Suitability” under the NASD Rules is a difficult prerequisite because of the changing economic climate in the U.S.  VUL can be “used” in many different ways and all the ways that it can be used, whether “suitable” or not for a particular situation, is beyond the scope of this text.  A few of the uses for VUL are addressed below.

 

1. A person does not need a variable insurance policy unless they need life insurance – obviously.  Therefore, those who have legitimate life insurance needs can usually benefit from VUL.  Those that choose VUL are generally those with above-average incomes.
2. VUL is an important vehicle for those who use insurance to build or transfer their estates.  Life insurance is the best vehicle for transferring wealth with fewer hurdles, and the VUL product allows them to transfer their business interests to family members or to business partners.
3. The VUL allows an insured to reduce (or skip) premiums when cash flow of the insured is reduced, and to channel excess dollars into the plan where earnings will be tax deferred.
4. For an executive bonus plans, the VUL allows more flexibility so that a bonus does not need to coincide with a fixed-premium schedule, and the employee can determine how much coverage they wish and how the cash value is to be invested. 
5. For buy-sell agreements, the potential of growing cash values and death benefits makes the VUL an attractive funding mechanism. As the business value changes, so can the coverage without having to lapse or create a new policy.  Additional premium dollars can be put into the plan to help fund lifetime buyouts if desired.
6. For split-dollar plans, by using VUL, the premium can be reduced in the early years because of the creation of an immediate cash value.  Moreover, when the employer receives values as repayment of cash-value matching-funds, these values can grow through investments that the employer selects.
7. VUL can also be used for deferred compensation.  It has the advantage of an above-average accumulation of funds that helps the employer to meet the promise to pay future benefits.  Since these agreements are generally renegotiated periodically, the coverage can be updated easily.
8. If a person has securities or securities-based accounts, the VUL offers stability, and if a person already has life insurance, it would probably be better for them to add a VUL policy to their insurance portfolio instead of surrendering old policies. 

THE ATTRACTIVENESS OF VUL

Variable Universal Life has a variety of attractive features to consumers, but probably the most attractive feature is that of flexibility.  As any good financial planner can attest, few financial plans continue in a “straight line,” but fluctuate as circumstances change (as they always do).  VUL gives the policyowner the ability to fluctuate or remain static, depending upon the situation.

1. VUL is also noteworthy because of its ability to compensate for financial difficulties, as the policyowner can skip or reduce premiums if things get “tight” financially, and there would be (usually) funds that would be available in case of an emergency.
2. Policyowners not only control the amount and frequency of premium payments, but they also determine how the net premiums and cash values will be invested
3. Americans are becoming more and more sophisticated investors and appreciate the value of professional fund management.  This professional fund management of the separate accounts is a very attractive feature, particularly if the individual has suffered through a period of making wrong choices in investments without professional guidance. 
4. When the overall financial and economic conditions change – as they have in early 2001 – the separate accounts can change to meet these changes as the policyowners will make their investment choices based upon their personal and present objectives and the current performance of the fund(s) that they choose, with the knowledge that they can change funds as the situation changes and can adjust to economic swings.

TAXATION OF PROCEEDS

Death benefits paid to a named beneficiary as a single sum, are tax free.  This rule included the Variable Universal Life under the 1986 Tax Reform Act.  This rule still holds, even if because of cash value returns, the benefits exceed the guaranteed minimum.

Note, however, that the exclusion from tax does not extend to any interest accrued after the date of death if the policy proceeds are paid later than the normal period to pay claims.  The exclusion does not apply to an interest-only settlement option, or an option selected by the beneficiary.

 

STUDY QUESTIONS

1.  The major difference between a variable Universal Life (VUL) policy and a Universal Life (UL) policy is

     A.  the treatment of the death benefit of a VUL is level and guaranteed, UL is not.

     B.  the variable nature of the account value of the policy.

     C.  UL has flexible account values, VUL account has no flexibility.

     D.  the cost as VUL is much more expensive.

 

2.  Net premiums for a VUL

     A.  goes directly to the general account of the life insurance company.

     B.  goes directly into separate accounts.

     C.  are payable only on an annual or single premium basis.

     D.  are set and are not flexible.

 

3.  Death benefits of a VUL

     A.  are set and never vary.

     B.  may decrease but cannot increase without Ins. Dept. approval.

     C.  are the same as UL—Option A or Option B.

     D.  are always guaranteed for 15 years.

 

4.  The grace period for VUL

     A.  is the standard 31 days.

     B.  there is no grace period.

     C.  is 61 days as if the cash value is not sufficient to maintain the cost of insurance, the premium must be paid within 61 days.

     D.  is based upon the death benefit—anywhere from 30 days to 6 months.

 

5.  VUL conversion privileges

     A.  allows a conversion only to a policy with a higher death benefit.

     B.  are available only upon evidence of insurability.

     C.  allows policyowners to exchange the VUL for a comparable non-variable plan or to transfer subaccount values to the general account within 24 months after issue of the VUL.

     D.  allows for a conversion to a Variable life or UL with comparable values.

 

6.  The separate accounts within a VUL policy receives the same favorable tax treatment as other cash value life insurance policies because

     A.  the congress wanted to promote the sale of VUL.

     B.  the SEC wants to discourage security dealers from selling insurance.

     C.  it builds cash values within a life insurance policy.

     D.  the IRS or congress has not taken time to correct this.

 

7.  When the cash value of a permanent life insurance policy exceeds the single premium that would pay for all future benefits, then for tax purposes, it is no longer a life insurance policy; this test is

     A.  the cash value accumulation test.

     B.  the corridor test.

     C.  the seven-pay test.

     D.  the net amount at risk test.

 

8.  In order for a VUL to be qualified as a life insurance policy, the IRS also requires a VUL contract to contain a provision

     A.  stating that this contract is a life insurance policy.

     B.  setting forth the tax savings since it is a life insurance plan.

     C.  defining the minimum of pure insurance protection compared to the cash value amount.

     D.  requiring the insured to file an exhibit to his Form 1040 each year.

 

9.  With a VUL, if interest accrues after a date of death because of a delay in settlement

     A.  the interest will always be taxable at capital gains rate.

     B.  the interest will not be taxable.

     C.  the insurer may be in violation of SEC regulations and subject to a stiff fine.

     D.  the interest may be taxable and if the interest-only settlement option is chosen, the tax exclusion does not apply.

 

10.   There are special NASD Variable Contract rules, which includes a rule that

     A.  a representative may not sell contracts through another broker-dealer unless the other broker-dealer is also a member of the NASD.

     B.  a representative may not, under any circumstances, receives compensation in excess of 2% of the total annual premium.

     C.  the values of the contract are considered to start 30 days after the insured has received a duly executed copy of the contract.

     D.  the representative may also have an insurance license but it must be with a mutual company.

 

 

ANSWERS TO STUDY QUESTIONS

1B     2B     3C     4C     5C     6C     7A     8C     9D     10A