7.5 Life Insurance Products
Life insurance provides financial protection for beneficiaries upon the insured's death. Some policies also offer investment or savings components. Investment advisers must understand which life insurance products are securities and their appropriate uses in financial planning.
Types of Life Insurance
Term Life Insurance
Term life provides pure death benefit protection for a specified period with no cash value accumulation.
Coverage Period: Fixed term (10, 20, 30 years)
Cash Value: None
Premiums: Lowest initially; may increase at renewal
Death Benefit: Fixed
Is It a Security? No
Types of Term Insurance
Level Term: Premium and death benefit stay constant
Decreasing Term: Death benefit decreases over time (mortgage protection)
Renewable Term: Can renew without medical exam at higher premium
Convertible Term: Can convert to permanent policy without medical exam
In Practice: A young family with limited budget buys 20-year level term insurance to protect against the death of a breadwinner during the child-rearing years. This provides maximum coverage at the lowest cost for the period when protection is most needed.
Permanent Life Insurance
Whole Life Insurance
Coverage Period: Lifetime (to age 100+)
Premiums: Level for life
Cash Value: Yes; guaranteed growth rate
Death Benefit: Fixed
Investment Risk: Insurance company
Is It a Security? No
Key Features:
- Cash value grows at guaranteed rate in general account
- Policyholder can borrow against cash value
- Participating policies may pay dividends
- More expensive than term initially
Universal Life Insurance
Coverage Period: Lifetime (if funded)
Premiums: Flexible (within limits)
Cash Value: Yes; credited interest based on current rates
Death Benefit: Adjustable
Investment Risk: Insurance company
Is It a Security? No
Key Features:
- Flexibility in premium payments
- Transparency in cost structure (cost of insurance disclosed)
- Cash value earns current interest rate (with minimum guarantee)
- Death benefit can be adjusted
Variable Life Insurance Products
Variable Life Insurance
Variable life invests cash value in subaccounts (like mutual funds), with the investment risk borne by the policyholder.
Coverage Period: Lifetime
Premiums: Fixed and scheduled
Cash Value: Invested in subaccounts; fluctuates
Death Benefit: Varies with performance; minimum guaranteed
Investment Risk: Policyholder
Is It a Security? YES
Variable Universal Life (VUL)
VUL combines the investment component of variable life with the flexibility of universal life.
Coverage Period: Lifetime (if funded)
Premiums: Flexible
Cash Value: Invested in subaccounts; fluctuates
Death Benefit: Adjustable; may fluctuate with performance
Investment Risk: Policyholder
Is It a Security? YES
On the Exam: Variable life and VUL are securities because the policyholder bears the investment risk. They require:
- Prospectus delivery
- Registration with SEC
- FINRA licensing for sales (Series 6 or 7)
- State insurance license
Whole life and universal life are NOT securities because the insurance company guarantees the cash value growth rate.
Separate Account vs. General Account
Used In: General Account - Fixed, whole, universal life; Separate Account - Variable products
Investment Risk: General Account - Insurance company; Separate Account - Policyholder
Asset Ownership: General Account - Commingled insurer assets; Separate Account - Segregated for policyholder
Creditor Protection: General Account - May be subject to insurer creditors; Separate Account - Protected from insurer creditors
Returns: General Account - Guaranteed rate; Separate Account - Based on investment performance
Life Insurance Comparison
Cash Value: Term - No; Whole Life - Yes; Universal - Yes; Variable Life - Yes; VUL - Yes
Premiums: Term - Low; Whole Life - High; Universal - Flexible; Variable Life - Fixed; VUL - Flexible
Death Benefit: Term - Fixed; Whole Life - Fixed; Universal - Adjustable; Variable Life - Variable; VUL - Adjustable
Investment Risk: Term - N/A; Whole Life - Insurer; Universal - Insurer; Variable Life - Owner; VUL - Owner
Is Security? Term - No; Whole Life - No; Universal - No; Variable Life - Yes; VUL - Yes
Tax Treatment of Life Insurance
Death Benefits
Death benefits are generally received income tax-free by beneficiaries. However, they may be included in the deceased's estate for estate tax purposes.
Cash Value Growth
Cash value growth: Tax-deferred
Policy loans: Not taxable if policy remains in force
Surrender (cash-out): Gain taxed as ordinary income
Withdrawal: FIFO treatment (basis out first)
Modified Endowment Contracts (MECs)
If a policy is "overfunded" (too much premium relative to death benefit), it becomes a Modified Endowment Contract:
- Withdrawals taxed LIFO (earnings first)
- 10% penalty before age 59 1/2
- Loans treated as taxable distributions
Insurance in Financial Planning
Common Uses
Income replacement: Term (temporary) or permanent
Estate planning: Permanent (whole, universal)
Business succession: Term or permanent
Tax-deferred savings: Permanent with cash value
College funding: Generally NOT recommended
Retirement supplement: Cash value policies
Suitability Considerations
Variable life/VUL may be suitable for:
- Those seeking life insurance with growth potential
- Long time horizons
- Higher risk tolerance
- Adequate assets to maintain policy
Variable life/VUL is NOT suitable for:
- Those who primarily need death benefit (use term)
- Conservative investors
- Those who may not maintain premium payments
- Short time horizons
Key Takeaways
- Term life: Pure death benefit; no cash value; NOT a security; lowest cost
- Whole life: Permanent coverage; guaranteed cash value; NOT a security
- Universal life: Flexible premiums/death benefit; current interest credited; NOT a security
- Variable life/VUL: Cash value in subaccounts; policyholder bears risk; ARE securities
- Death benefits are generally income tax-free to beneficiaries
- Cash value growth is tax-deferred
- Separate account protects variable product assets from insurer creditors
- Variable products require prospectus and securities licensing