High Risk Life Insurance Policy
A variable universal life (VUL) insurance policy is a high-risk life insurance policy. It's high risk because the policy relies on investment returns from the stock market to cover the cost of insurance. So, if a condition exists where the stock market is down and the internal cash reserve in the policy is not sufficient to cover the cost of insurance, the life insurance policy could lapse. On the other hand, because a percentage of the premium is invested in the stock market, the cash value of the policy tends to be much larger than the more traditional and conservative whole-life policies.
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Variable Universal Life
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A VUL insurance policy is best defined as a cash-value policy where the cash value is invested into a separate investment account, usually mutual funds. For this reason, the returns and the growth of the cash value is significantly higher than other cash value type policies. In addition, since the cash value grows in a separate account, upon death of the insured, the beneficiary receives both the life insurance and the cash value whereas with other cash value policies, the beneficiary only receives the life insurance proceeds upon death of the insured.
How it Works
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As VUL owners fund a VUL, a portion of the funds go to buy insurance and the remainder is placed into a separate investment account. As the investment account grows, the cash value builds. The separate investment account is invested in stock, bonds and mutual funds. Unlike other cash value policies, the policy owner has the flexibility to decide how he wants to fund the policy. They can fund it with a lump sum investment up to limits defined by the IRS. Or, they can fund it with monthly premiums sufficient enough to fund both the insurance cost and investment account. Or, they can fund it at the bare minimum required to keep the policy in force. This funding flexibility is the "universal" in the name variable universal life.
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Advantages
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The VUL has many advantages. In addition to the high return possibility and funding flexibility noted, it has many tax and estate planning benefits made possible by the life insurance component. Upon the death of the insured, life insurance proceeds are not taxed and they do not have to process through probate. For this reason, individuals should have a life insurance policy throughout their whole lives as an estate planning asset. Given reasonable performance in the VUL separate account, a VUL can serve as a permanent insurance solution because the policy owners can always purchase more life insurance internal to the policy or maintain the existing policy for as long as they live.
Disadvantages
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Disadvantages comes into play when the VUL is under funded and the stock market is down. In this scenario, unless the policy owner is in a position to lump sump more funds into the VUL, the policy could lapse. Another disadvantage along these lines is simply poor performance in the stock market. Because of the mortality table, the cost per $1,000 of life insurance increases with age. So, if the separate account is not performing to cover that increasing cost, especially as the insured ages, the policy could self-destruct or lapse. In this scenario, the VUL is a high-risk insurance policy.
Applications
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VULs should be purchased only by people who can afford to properly fund them. It is not a "budget" product. As with any 401k, IRA or mutual fund account, the returns will fluctuate with stock market. So, VULs, should be properly funded to account for these fluctuations. If not properly funded, VULs represent the most risky and the most costly way to obtain and maintain life insurance.
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References
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