Variable universal life insurance is one of the most recently developed variations of whole life. This policy incorporates all of the premium flexibility and policy adjustment features of the universal life policy with the policyowner-directed investment aspects of variable life insurance. Obviously this design discards the fixed-premium features of the variable life insurance contract (see figures 5-10 and 5-11).

One of the most interesting aspects of variable universal life insurance is that it eliminates the direct connection between investment performance above or below some stated target level and the corresponding formula-directed adjustment in death benefits. Instead variable universal life insurance adopts the death benefit designs applicable to universal life policies, namely, either a level death benefit or an increasing death benefit design where a constant amount of risk is paid in addition to the cash accumulation account. Under the first of those options the death benefit doesn�t change, regardless of how positive or negative the investment performance under the contract turns out to be. If the policyowner

wants to have the death benefit vary with the performance of the investments under the contract, he or she must choose the increasing death benefit design. All of the increase or decrease is a direct result of the accumulation account balance, rather than the result of purchasing paid-up additions (or some form of modified premium addition) as is the case under fixed-premium life insurance.

Variable universal life policies offer the policyowner a choice among a specified group of mutual fund types of separate accounts that are usually created and maintained by the insurance company itself. Some insurance companies have made arrangements with other investment companies to utilize separate account portfolios created and maintained by those investment management firms.

Like variable life insurance, variable universal life insurance policies are technically classified as securities and are subject to regulation by the SEC. The SEC requires registration of agents marketing the product, the separate accounts supporting the contracts, and the contracts themselves. In addition, policies must conform with the SEC requirements that the investment funds be separate accounts that are segregated from the insurance company�s general investment portfolio and therefore not subject to creditors� claims applicable to the insurer�s general portfolio in times of financial difficulty. Variable universal life contracts are also subject to regulation by the state insurance commissioners. Nearly 80 percent of the states have adopted the National Association of Insurance Commissioners (NAIC) model variable life insurance regulation in its modified form (which is less restrictive than the original model regulation). (See chapters 26 and 27 for a thorough discussion of life insurance regulation.)

Because variable universal life is a registered investment product, policies must be accompanied by a prospectus, which is governed by the same rules applicable to prospectuses for variable life policies. The prospectus provides the necessary information for a meaningful evaluation and comparison of policies.

Probably the easiest way to describe variable universal life insurance is to say that it is a universal life insurance policy with the added feature that the policyowner gets to choose the investments, as under fixed-premium variable life insurance contracts. Variable universal life offers the ultimate in both the flexibility afforded to the policyowner and the amount of risk shifted to the policyowner. There are no interest rate or cash value guarantees and very limited guarantees on the maximum mortality rates applicable. Policyowners have wide-open premium flexibility under this contract and can choose to fund it at whatever level they desire as long as it is at least high enough to create coverage similar to yearly renewal term and not in excess of the amount that would drive the cash accumulation account above the maximum threshold set forth in I.R.C. Sec. 7702. Policyowners do not need to negotiate with the insurance company or inform the insurer in advance of any premium modification or cessation.

These contracts permit partial withdrawals that work just like those under universal life policies. Early partial withdrawals may be subject to surrender charges, and surrender charges are applicable to total surrenders in the policy�s early years when the insurance company is still recovering excess first-year acquisition costs. The surrender charges vanish at a specified policy duration.

Variable universal life can be aggressively prefunded so that the policy can completely support itself from its cash value. If adequate premiums are contributed to the contract, this can be accomplished in a relatively short number of years. As with universal life and current assumption whole life, variable universal life policies have no guarantee that once the cash value is large enough to carry the policy it will always be able to do so. The policyowner assumes the risk of investment return and, to a limited extent, some of the risk of mortality rate charges. Consequently the policyowner has to make adjustments and either pay more premiums or reduce the death benefit at some future time if in fact the cash value subsequently dips below the level needed to totally prefund the remaining contract years.

By choosing the increasing death benefit option under this contract policyowners are afforded an automatic hedge against inflation. This inflation protection is general in nature and subject to a timing mismatch in that investment experience may not keep pace with short-term bursts of inflation. Over the long haul, however, the investment-induced increases in coverage should equal, if not exceed, general increases in price levels.

Many variable universal life policies offer an additional cost-of-living adjustment rider to further assure timely death benefit increases associated with increases in the consumer price index. These riders trigger death benefit increases paid for by term charges against the policy�s cash value.

As with variable life, the policyowner is able to switch investment funds from one of the available choices to any other single fund or combination thereof whenever desired. Some insurance companies put a limit on how many fund changes can be made without incurring explicit costs for those changes. Some companies allow one change of funds per year at no cost, others allow one change per open fund per year with no explicit charges, and others specify in the prospectus a given number of fund changes that can be accomplished during any given time interval (usually annually but sometimes other intervals such as quarterly or monthly) without incurring additional charges. Within some companies there is a banding of charges, depending on the number of fund reallocations or redirections during the specified period of time. The cost per transaction goes up as the number of transactions increases in the time interval. Theoretically policyowners could redirect funds on a daily basis, but such aggressive reallocation could generate significant internal expenses and would probably be a strong indication that the policyowner is attempting to be more aggressive than warranted for this type of contract.

Switching investment funds is accomplished without any internal or external taxation of inherent gains in the funds. The internal buildup of the cash value is tax deferred at least as long as the policy stays in force and will be tax free if the policy matures as a death claim.

Variable universal life insurance policies are still primarily life insurance contracts that generate cash value as part of the prefunding level premium mechanism. They are not strictly investment contracts and should not be viewed as such. Philosophically there seems to be a conflict when policyowners manage variable life or variable universal life policies for maximum aggressive growth when in fact the reason for the contracts is to provide a financial safety net for beneficiaries. If the primary coverage is for its death benefits, it seems more appropriate that the investment allocations not pursue the most aggressive growth objectives. A more conservative growth approach is suggested.

On the other hand, if the primary objective for acquiring the contract is for its cash value and the policyowner intends to use the policy�s cash values prior to the insured�s death, perhaps the more aggressive growth stance is acceptable. In this case the policyowner is likely to be the beneficiary and the risk bearer.

Variable universal life policies should not be utilized as short-term investment vehicles. There are two potential traps for policyowners who significantly deplete the policy�s cash values at various intervals during the first 15 policy years. These income tax burdens are in addition to any surrender charges that may be applicable within the policy itself.

One potential trap is the modified endowment contract provisions of the Tax Code, which treat all cash value distributions as taxable income until all investment returns have been taxed before the remainder of the distribution is treated as recovery of capital. Such treatment is possible whenever material policy changes are made and the policy fails the seven-pay test (reaching the cash value amount for a policy paid up after 7 years). If the policy fails the seven-pay test, not only will the distributed amounts be subject to income tax (up to the extent of the gain) but there may also be a 10 percent penalty tax applicable to those taxable gains if the policyowner is younger than 59 1/2 years of age. High cash value/high premium configuration variable universal life policies are the most likely candidates for this tax trap. Making sure that the cash value before and after any material change is lower than what it would be if the policy were fully paid up after 7 years will, in most cases, avoid this potential problem.

The other potential trap again deals with high levels of cash value approaching the upper limits permitted under the Tax Code. If a reduction in the death benefit level forces a distribution of the cash value in order to retain life insurance status under the Code, those distributions may be taxable income to the extent that they represent gain in the policy. The most stringent constraints apply to such "forced out" withdrawals during the first 5 years of the policy�s existence. Slightly less binding constraints are applicable for policy years 6 through 15. Any policyowner contemplating a switch from the increasing death benefit design to the level benefit design during the policy�s first 15 years should consider these rules before making the switch. As long as there is no forced distribution or concurrent request by the policyowner for a discretionary distribution of cash value funds, there will be no problem. Conversely, if the increasing death benefit form of the contract is already prefunded near the maximum limitations, there is the possibility that some cash value will be forced out to maintain compliance with the Tax Code limitations on life insurance policies.

Neither of these tax traps has any consequence if there are no gains in the contract (premiums paid exceed cash value) when distributions are made. Also under Modified Endowment Contract (MEC) provisions the taxation will be applicable only if there are distributions of the cash value. If the funds are left in the contract and allowed to remain part of the cash value, there will be no taxation even though the potential still exists for any distribution once the policy has become classified as a MEC.

Variable universal life contracts are not desirable for policyowners who do not wish to assume the investment risk under the contract. Potential policyowners who say they want to assume the investment risk but become extremely anxious over any short-term fall in the value of the selected investment portfolio funds should also be cautioned. A successful life insurance agent once facetiously suggested that anyone purchasing variable life or variable universal life insurance should cancel his or her subscription to the Wall Street Journal to minimize the likelihood of daily assessments of the investment fund performance. Realistically, maybe the best prospects for variable life contracts and variable universal life contracts are those who do in fact have a subscription to the Wall Street Journal and are more attuned to the daily fluctuations in fund values. Policyowners are not likely to find asset value information regarding the specific funds backing their policies in the Wall Street Journal anyway. The separate account requirements imposed by the SEC have prompted most insurance companies to use funds that are not available to the general public. These funds are very rarely publicly traded and therefore not included in the Wall Street Journal�s daily listing of funds.

Variable universal life insurance has become a viable contract for corporate-owned life insurance. Its flexibility is compatible with the constantly changing needs of the corporation owning the policy. Corporate management is usually fairly sophisticated in understanding the investment process and the short-term upward and downward fluctuations in portfolio holdings.