5.1 Variable Life and Variable Universal Life (securities regulation)

Variable Life and Variable Universal Life

Variable life insurance (VL) and variable universal life (VUL) are permanent life policies whose cash value is invested in separate account subaccounts that resemble mutual funds. Because the policy owner bears the investment risk, these are treated as securities in addition to insurance.

The defining trait is that cash value and a portion of the death benefit fluctuate with investment performance. There is no guaranteed minimum cash value, and poor returns can drive cash value toward zero.

VL versus VUL at a glance

VL keeps the rigid fixed premium of whole life but swaps the guaranteed cash value for market exposure. VUL adds the premium flexibility of universal life on top of that market exposure.

The separate account

General account assets back guaranteed products (whole life, fixed annuities). Variable contracts use the separate account, which is not part of the insurer's general assets and is shielded from the insurer's general creditors. Subaccounts may include equity, bond, balanced, and money-market options. The policyowner selects the mix and may reallocate, often with a limited number of free transfers per year.

Dual regulation: insurance plus securities

Variable products sit under two regulators:

• State insurance departments regulate them as life insurance (licensing, contract approval, replacement rules).
• The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) regulate them as securities.

To sell variable contracts a producer must hold both a state life insurance license and a securities registration (a FINRA Series 6 or Series 7, plus the state Series 63). The producer must also be an associated person of a FINRA member broker-dealer.

The prospectus requirement

Because the separate account is a registered security, the prospect must receive a prospectus that discloses subaccount objectives, risks, and fees. A purchase solicitation cannot occur before or without delivery of the prospectus. Sales literature must be filed and must not promise specific returns.

Suitability and fees

FINRA imposes a suitability obligation: the recommendation must fit the customer's financial situation, objectives, and risk tolerance. Variable products carry layered costs:

Worked scenario — fee drag. A subaccount earns a gross 8%, but charges total 2.1% (M&E 1.2% + admin 0.3% + fund 0.6%). The owner's net credited return is 8% - 2.1% = 5.9%. On a $50,000 cash value, that is $2,950 credited instead of $4,000 - a $1,050 annual drag that compounds against the policy.

Tax treatment

Variable life still receives life-insurance tax treatment: inside cash-value growth is tax-deferred, the death benefit is generally income-tax-free, and policy loans are not taxed while the contract stays in force and is not a Modified Endowment Contract (MEC).

The MEC 7-pay test

Funding a variable policy too quickly can turn it into a Modified Endowment Contract. The 7-pay test compares cumulative premiums paid in the first seven years against the premiums that would have paid the policy up using net level annual premiums. If cumulative premiums exceed the 7-pay limit at any point, the contract becomes a MEC.

Worked example. Assume the 7-pay annual limit is $6,000. If the owner pays $6,000 in year one, the contract is fine. If the owner instead dumps $10,000 into year one, cumulative paid ($10,000) exceeds the 7-pay cumulative limit ($6,000), so the policy is a MEC.

MEC consequences hit living distributions, not the death benefit:

Once a contract is a MEC it is always a MEC, so exam questions stress that aggressive funding of a VUL can quietly forfeit the tax-free access that motivated the purchase.