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