Adjustable life insurance was one of two major life insurance variations introduced in the decade before universal life insurance. The other, which was introduced in 1976, is variable life insurance, the first life insurance policy designed to shift the investment risk to policyowners. This product had a long and expensive gestation period. It not only had to run the gauntlet of state insurance department approvals but it also needed (and finally acquired after many years of negotiations) approval by the Securities and Exchange Commission (SEC).

A variable life insurance policy provides no guarantees of either interest rate or minimum cash value. Theoretically the cash value can go down to zero, and if so, the policy will terminate. As the SEC pointed out, in order for policyowners to gain the additional benefit of better-than-expected investment returns, they also have to assume all of the downside investment risk. Consequently, the SEC required variable life policies to be registered with the SEC and all sales to be subject to the requirements applicable to other registered securities. In other words, policy sales can be made only after the prospective purchaser has a chance to read the policy prospectus. The SEC also requires that the insurance company be registered as an investment company and that all sales agents be registered with the SEC for the specific purpose of variable life insurance policy sales. Agents who sell variable life insurance policies must be licensed as both life insurance agents and securities agents.

There were two main stumbling blocks in gaining SEC approval of variable life products. The first one was the maximum compensation to agents for the sale of this product. The SEC wanted the sales load not to exceed 8 percent of the sale price. Keeping in mind that most securities are sold on a cash-sale basis rather than on an installment-sale basis, this presented some serious drawbacks from the insurance companies� standpoint. The insurance companies and the SEC finally compromised on a 20 percent load on the first year�s premiums. This was argued to be the equivalent of an 8 percent load over the lifetime of the policy. The other major stumbling block had to do with whether or not insurance companies would be permitted to allow flexible-premium payments under these policies. Initially the SEC did not relent on this issue. Therefore the first generation of variable life insurance products were fixed-premium products (see figure 5-4). The only real innovation was the variable investment aspect�that is, the policyowner was permitted to select among a limited number of investment portfolio choices, with the death benefit amount varying as a function of the portfolio�s investment performance.

Generally the first generation of variable life insurance policies gave the purchaser three investment options into which the funds could be directed. The policyowner was free to put all of the funds into one of these choices or to distribute the funds in whatever proportions he or she desired among the three options. There was usually a minimum requirement of at least 5 or 10 percent of incoming funds that had to be allocated to any investment option the policyowner selected. The purpose of this minimum requirement was to eliminate administrative costs that exceeded the amount of money being directed into a particular option.

Very often the options were a stock fund, a bond fund, and either a treasury fund or a money market fund. The funds were essentially mutual funds run by the insurance company and set aside as separate accounts (required by the SEC) that do not constitute part of the insurance company�s general investment fund and put such assets beyond the claims of its general creditors. These separate funds have to be reported as separate items on the insurance company financial statements for both statutory purposes and generally accepted accounting purposes. (Stock insurance companies must issue both types of reports; mutual companies are only required to issue statutory reports. See chapters 30 and 31 for a discussion of life insurance company financial statements.)

By allowing the policyowner to direct the funds backing the policy, the policyowner becomes the portfolio director, within limits. Obviously the policyowner has no control over what assets are purchased and sold by the individual funds that can be selected. That portion of the investment decision process is still within the hands of the insurance company�s portfolio management team. The important thing is that the policyowner plays a participative role in portfolio management and consequently can benefit directly from better-than-expected results or bear the full brunt of poor investment performance. The results of the investment performance are credited directly to the policy cash values.

Individuals who are already experienced in equity investments are quite comfortable with the variable life insurance policy. However, this policy is subject to daily portfolio fluctuations and can provoke great anxiety in individuals who are not used to or comfortable with such market value fluctuations.

Part of the challenge of marketing variable life policies is this volatility. Many life insurance agents are reluctant to try to sell any policy whose success depends on the investment decisions of the policyowner. They are afraid that some purchasers will expect the life insurance agent to give them investment advice.

A variable life policy is a market-driven phenomenon, and to some extent its popularity is influenced by general investment market conditions. The policy becomes more acceptable to consumers after a long period of market increases and falls out of favor when the market experiences a general decline in prices. In the early 1990s when interest rates dropped to very low levels, people used to higher yields on bonds and other investment instruments turned to variable life insurance contracts as one alternative to reinvesting in certificates of deposit.

Assuming the right investment choices are made, variable life insurance allows the policyowner�s money to work harder for him or her. But variable life insurance contracts are not exclusively investments. They are in fact life insurance contracts, and they sustain mortality charges for the death benefits they provide. Consequently, the return on the invested funds within a variable life insurance contract will never equal that of a separate investment fund that does not provide death benefits but invests in assets of a similar type and quality.

Variable life insurance should not be purchased as a short-term investment vehicle. The combination of sales load, mortality charges, and surrender charges will significantly reduce any potential gains in the policy�s early years.

Since the primary reason for life insurance is to provide death benefits, it makes sense to link superior investment performance with increases in the death benefit level. Theoretically this is a way of keeping up with inflation. In fact, studies indicate that such a linkage would more than keep pace with inflation. However, there is an important caveat. Although investment performance in equities tends to equal or exceed inflation in the economy over the long term, the correlation is not perfect in the short term. In other words, it is possible for inflation to exceed increases in the investment performance for short durations of time (possibly 2 or 3 years). This is another reason why life insurance should be looked at as a long-term financial security purchase and not a short-term investment.

There is more than one way to link the policy�s death benefit to the associated portfolio�s investment performance. In the early generation of fixed-premium variable life insurance contracts insurance companies settled on two different approaches�the level additions method or the constant ratio method.

Regardless of which linkage design was chosen, all of the early contracts had the purchaser select a target level of investment performance as a benchmark against which actual investment performance would be measured. Performance in excess of the target level would be used to fund incremental increases in the death benefit; performance below the target amount would require downward adjustments in the death benefits to make up for the deficit.

The level additions model uses excess investment returns (return in excess of the target rate) to purchase a level single-premium addition to the base policy. The face amount or death benefit will rise as long as investment performance equals or exceeds the target rate. This model does not cause as rapid an increase or decrease as the constant ratio method of linking the policy�s death benefit to investment performance. The strength of the level addition design is that it does not require an ever-increasing investment return to support incremental increases in death benefits. Additional coverage is added more slowly, but it is more easily supported once it is added. Similarly, downward adjustments in death benefits are less rapid, and they are less likely to accelerate in future years. Furthermore, policies using the level additions design provide a minimum base value guarantee equal to the amount of coverage when the policy was first purchased.

The constant ratio method also uses the excess investment earnings as a net single premium to purchase a paid-up additional amount of coverage. The difference is that under this method the paid-up additional coverage is not a level benefit amount but a decreasing benefit amount because it is designed to maintain a ratio between the death benefit and the policy reserve that satisfies the corridor test. Under this policy design more volatile increments are added to or subtracted from the contract as investment performance differs from the target amount.

Like the level addition model, this design has a minimum death benefit guarantee equal to the initial face amount of the policy. Consequently, if the initial stage of the contract has lower returns than the target level, the policy reserves will drop below the level necessary to sustain the guaranteed death benefit amount. The policy will have to remain in force for the investment returns to exceed the target rate for a long enough period to bring the reserve back up to a level capable of supporting incremental increases in coverage before the policyowner will see increases in the death benefit.

Usually variable life policies have positive excess investment earnings in the early years of the contract and do provide incremental increases in the death benefit before the investment earnings drop below the target rate. Looking at variable life insurance policies since 1976, most policies have experienced investment earnings over the target rate more frequently and for longer durations than they have experienced investment earnings below the target rate. There is no guarantee that this will always be true, but the expectation is that overall investment earnings will exceed the target amount over the bulk of the policy duration. Many variable life policyowners have been pleasantly surprised at how well their policies have done over two decades.

In the long run, regardless of the policy design, the excess investment earnings over the target level must support any incremental additions to the policy. If investment earnings are negative (the actual earnings are lower than the target rate), then the adjustments will have to be downward from any previously attained levels above the policy�s initial face value. If investment earnings are positive (the actual earnings are above the target rate), the adjustments will be upward.

Variable life insurance designs have not been static since their introduction in the mid-1970s. Life insurance companies are now offering many more investment fund options than they made available in the early stages of this product�s development. Some insurance companies have more than a dozen funds to choose from in their current product offering. There are usually a variety of stock funds, including growth stock funds, income stock funds, balanced stock funds, and international stock funds. Bond fund offerings are likewise more robust and include different durations and different types of issuers (large corporations, small corporations, state governments, and federal government) as well as Government National Mortgage Association (GNMAs) funds and collateralized mortgage obligations (CMOs).

In addition, many insurance companies offer a managed fund as one of the portfolio choices. The policyowner can put all of the policy funds in a managed portfolio fund and have the investment allocation decisions made by a professional money manager working for the insurance company. This appeals to policyowners who do not want to spend a lot of time studying the market and making investment decisions. With a managed portfolio policyowners can reap all of the long-term advantages of a variable insurance contract without having to perform the investment allocation function themselves.

Some insurance companies have even formed alliances with large mutual fund groups that make their entire range of mutual funds available. Such alliances make it possible for smaller life insurance companies to gain access to the administrative services already in place in these large mutual fund family groups.

Policy premiums paid under variable life insurance contracts are often subject to an administrative charge; the balance of the premium payment goes into the cash value account. The actual value of the cash component is determined by the net asset value of the separate account funds that make up the policy portfolio. The cash value of a variable life policy fluctuates daily. Each day�s net asset value is based on the closing price for the issues in the portfolio on that trading day. Cash value accounts are further diminished by mortality charges to support the death benefits.

As with traditional life insurance contracts, the policyowner has access to the cash value via policy loans. Variable life insurance policies usually limit maximum policy loans to a slightly smaller percentage of the total cash value than is traditionally available in whole life policies.

The earnings on the cash value are obviously affected by any outstanding policy loans. The policyowner accrues indebtedness at the applicable policy loan interest rate, and that is the yield applicable to the assets associated with the portion of the cash value offset by the outstanding loan. Whenever the policy loan interest rate is lower than the portfolio investment earnings rate, the insurance company experiences a lower effective investment return. The only time the insurance company experiences a financial gain from policy loans is when the policy loan interest rate exceeds that earned by the portfolio backing the policies. Policy loans can be repaid at any time in part or in full, but there is no requirement that policy loans be repaid in cash at any time during the existence of the life insurance contract. For any portion of the loan not repaid interest accrues on a compound basis. Just as in any other form of whole life policy, outstanding policy loans under a variable life insurance policy reduce the death benefit payable. The policy loan is always fully secured by the remaining cash value in the policy. Whenever the outstanding loans plus accrued interest equal the remaining cash value, the net cash value becomes zero and the policy terminates.

The net cash value in the contract is also closely related to the nonforfeiture options available under the policy. Variable life insurance contracts provide the same range of nonforfeiture options as do traditional whole life policies. The net cash surrender value can be obtained by surrendering the contract to the insurance company, or the net cash value can be applied as a single premium to purchase either a reduced amount of paid-up insurance or the same amount of extended term insurance. The duration of the extended term insurance will be the longest period of coverage for the same death benefit amount that can be obtained from the insurance company for the policy�s net cash value.

Variable life insurance policies also contain the usual form of reinstatement provisions, including a specific prohibition on reinstatements if the policy has been surrendered for its cash value. Contracts also have the standard waiver-of-premium option since premiums are fixed and the policy will lapse if they are not paid.

Variable life insurance policies cannot be sold without an accompanying prospectus. The prospectus mandated by the SEC is similar in many respects to the prospectus required of new stock issues. It is a full disclosure of all of the provisions of the contract, including expenses, investment options, benefit provisions, and policyowner rights under the contract. It is a lengthy and detailed document. Most purchasers are reluctant to read the entire document, but it is an important source of information that is not available anywhere else. In fact, one of the authors of this book has observed that the prospectus for a variable life insurance contract offers more information to prospective purchasers than even very aggressive information seekers can obtain for traditional life insurance contracts.

As always, the SEC focus is on providing thorough and accurate information. The prospectus for a new stock issue from a stock life insurance company therefore provides more information about the company to potential investors than would ever be available to purchasers of life insurance products (except for SEC registered variable and variable universal life).

The prospectus has very thorough information about all of the expense charges levied by the insurance company against variable life insurance contracts. This includes commissions paid to soliciting agents, state premium taxes, administrative charges, collection charges, and possibly fees for specific future transactions.

Administrative charges usually differ between the first year of the contract and all renewal years. It is common for first-year administrative charges to run in the neighborhood of $15 to $50 per month. The same administrative charges in the second policy year and thereafter drop to a lower level, perhaps $5 to $10 per month. The prospectus also indicates whether or not there is any maximum guarantee on those administrative fees over the duration of the contract.

In addition, the prospectus sets forth the manner in which charges are made against the asset account to cover the cost of insurance under the contract. This is usually referred to in the prospectus as the cost-of-insurance charge. The prospectus specifies exactly what rate will be used to determine cost-of-insurance charges and explicitly specifies if there is any maximum rate above the intended rate. It also explains the manner in which charges are levied against the separate account itself�essentially the fees associated with managing the various mutual fund type of accounts from which the policyowner can choose. Part of that charge is always some specified percentage (usually less than one full percent) of the assets in the separate accounts themselves. There also may be specific charges to establish and maintain trusts necessary in managing those assets. These charges are very similar to the charges levied by mutual fund administrators on investors in the fund.

One very important item that is clearly spelled out in the prospectus and should always be considered important information when considering the purchase of any life insurance policy�variable or traditional�is the surrender charge applicable to policy surrenders. In most cases this information is set forth in a tabular form, giving the policy year and the applicable percentage for the surrender charge in that year. Under some contract designs the surrender charge is specified in terms of percentage of premiums; under other contracts it is specified in terms of the aggregate account balance in the separate funds. Surrender charges are applicable only if the policy is surrendered for its cash value, allowed to lapse, or under some contracts if the policy is adjusted to provide a lower death benefit. Surrender charges are commonly levied during the first 10 to 15 years of the contract. The actual number of years and specific rates are always set forth in the prospectus.

The maximum duration of surrender charges is usually a good indicator of how long the insurer intends to amortize excess first-year acquisition costs. The surrender charge is applicable only to policies surrendered before the insurance company�s front-end expenses have been recovered. Sometimes these surrender charges are called contingent deferred sales charges.

The prospectus sets forth the investment objectives of each of the available investment funds and a record of their historical performance. There is detailed information on the current holdings of each of the available portfolios, usually supplemented by information about purchases and sales of individual equities or debt instruments by the fund over the previous 12 months. Further information is given about earnings during that same period of time and usually for longer intervals of prior performance if those portfolio funds have been in existence long enough to give investment results for trades over 5 or 10 years. Any investment restrictions applicable to these portfolios as indicated in the trust instruments themselves are fully disclosed.

There are also projections of future performance under the contract if portfolio funds generate a fixed level of investment earnings over the projected interval. Under SEC regulations the permissible rates of return that can be projected are the gross annual rates after tax charges but before any other deductions at 0, 4, 6, 8, 10, or 12 percent. The insurance company can decide which of those permissible rates it chooses to project.

Much of the detailed information in the prospectus concerns ownership and voting rights regarding procedures to change any of the trust documents or restrictions. These elements are very similar to those found in self-standing mutual funds not associated or affiliated with life insurance policies or protection.

As mentioned earlier, fixed-premium variable life insurance contracts are very similar to whole life insurance contracts; the main difference is that the policyowner assumes the investment risk and therefore can participate in favorable investment returns. The fixed-premium provision does not allow the policyowner to increase or decrease the death benefit by negotiated adjustment; favorable results automatically translate into increased death benefit amounts.

One unique benefit is that the policy does guarantee a minimum death benefit level equal to the original face amount of the contract, regardless of how badly the investment performance turns out to be. In other words, if all of the required premiums are paid, the insurance company guarantees that the death benefit equal to the original face amount of the policy will be paid even if the investment funds are otherwise inadequate to support the policy. Therefore the variable feature of this contract can provide additional coverage if investment experience warrants, but the policyowner will never be required to pay more or permitted to pay less than the guaranteed premium.

A fixed-premium variable life insurance policy provides more guarantees to the policyowner than its more recently developed cousins with truly flexible provisions, such as universal life and variable universal life.