Worried About Your Variable Life Insurance Policy in a Volatile Market? Consider a Fully Guaranteed Universal Life Policy

October 2008 may go down as one of the stormiest months in stock market history—and holders of variable life insurance policies are certainly feeling the pinch.

“I see people who are literally losing sleep because they’re worrying about their variable life insurance policies,” says Michael Kortz, a San Clemente, California, financial planner who specializes in life insurance.

That’s because the value of a traditional variable life insurance policy depends on the market’s performance—and lately, the market’s performance has been dismal.

As a result, Kortz has sought—and found—a way to help his worried clients. “People need to sleep at night, and a policy that is isolated from market ups and downs and is rich in guarantees could help them do that,” he says.

Life insurance 101

First, let’s review how life insurance works. You pay an insurance company an agreed-upon sum called a premium, usually at regular intervals. In exchange, the insurance company agrees to pay you or your beneficiaries a specific amount upon your your death (or, in some cases, when another major event, such as a critical illness, occurs). In this way you can ensure that your loved ones are provided for after your death or disability.

Variable life insurance is a type of life insurance. It allows you to allocate a portion of your premium to a “separate account,” which is simply a portfolio of investments. In a way, then, it’s much like investing some of your life insurance policy in a mutual fund.

The benefits of variable life insurance

Variable life insurance can be more expensive than other types of life insurance. Why, then, would someone consider it?

To start, it allows you to grow the “cash value” of your policy. When your premium payments exceed the cost of your policy, the extra money goes into a special account called a “cash value account.” If necessary, you can withdraw the cash value in the form of a loan. Or, if you need to cancel the policy, you can receive the cash value as a lump-sum payment.

Clearly, then, it’s ideal to grow your cash value as much as possible. Traditional life insurance policies pay interest on the cash value, like savings accounts pay interest on deposits. But variable life insurance policies let you increase your potential returns by investing in separate accounts of stocks and bonds. Moreover, earnings on these investments in the form of dividends and capital gains aren’t taxed until you “cash out,” creating even greater growth potential.

Moreover, you can apply the earnings on the separate account investments toward your premium payments, potentially lowering the amount you pay out of pocket.

Potential pitfalls

Variable life insurance policies can generate significant returns when the markets are up, but when the markets are down—as they are today—they can underperform. That reduces the policy’s cash value and creates problems for policyholders who use investment earnings to pay their premiums.

“Variable life insurance policies have become increasingly popular because of the potential for large gains in the policy’s cash value substantial tax advantages,” says Kortz. “But there’s no doubt that these policies expose you to higher risk because your policy’s value is directly tied to the investments you make.”

As an example, Kortz points to a 50-year-old man who owned a $1,000,000 variable life insurance policy with a current cash value of $100,000.

Assuming he could achieve an average annual return of 8%, this man would need to fund his policy at $4,900 per year to keep it in force until he reached age 100.

But look at what happens if the market declines. If the policyholder’s current cash value were to fall by 20%, he would have had to fund the policy at $6,500 per year—an additional $1,600 per year, or 32% more. If his current cash value were to fall by 30%, he would have to fund the policy at $7,200 per year—an additional $2,300 per year, or 47% more. And if his current cash value were to fall by 40%, he would have to fund the policy at $8,000 per year—an additional $3,100 per year, or 63% more.

Kortz says that despite the recent market decline, variable life insurance still has a place in a balanced financial plan—but the policyholder needs to be knowledgeable about the risks involved.

“It’s important to understand not just the risk of a market decline, but the risk that your policy could lapse,” Kortz explains. “For those individuals who aren’t comfortable with this risk, it may be time to consider other options.”

Other options

Variable life insurance policyholders who are tired of unpredictability have a number of options, says Kortz.

First, they can “super-fund” their existing variable life insurance policies to compensate for even the most dramatic market downturns.

Second, they can be diligent about systematically rebalancing their investment portfolios to ensure that their asset allocations are appropriate for their risk tolerance and time horizon. “Review, review, review,” says Kortz. “A variable life policy needs to be reviewed at least once a year, and you should be sure to overweight more stable investments, such as cash equivalents, as you get older.”

The fully guaranteed universal life policy

If the first option isn’t financially feasible, and the second option isn’t appealing, you still have another choice, says Kortz: Consider switching to a new type of policy called a fully guaranteed universal life policy. (should quotes be used?)

These policies are guaranteed to provide coverage that is guaranteed for life, no matter what the stock market does, as long as the premiums are paid.

“People shouldn’t be subjected to unpredictable premium increases, so I’m recommending policies with level premiums that are guaranteed for life to many of my clients,” says Kortz.

According to Kortz, many clients are taking him up on the recommendation. “Sometimes it becomes less of an investment decision and more of a ‘Can I sleep at night?’ decision,” he says.