Variable life insurance is a life insurance contract that provides a death benefit to your survivors when you die and has a cash value component that you can invest. The cash value grows based on your investments’ performance.

But because your cash value fluctuates and can drop in a bear market, variable life insurance is riskier than other types of life insurance.

We’ll explain how variable life insurance works, the pros and cons, how it compares with other types of life insurance, and some factors to consider before buying a policy.

How does variable life insurance work?

When you buy a variable life insurance policy, your insurance company uses the premium to insure your life and pay for its administrative costs, plus profits. In the early years of the policy, the amount the insurer charges you for premiums often exceeds these costs.

The insurer takes the money that’s left over and funnels it into the policy’s cash value. You can then invest the cash value in the subaccounts you choose. Your cash value isn’t guaranteed by the life insurance company — your money grows based on how your investments fare.

Here are some defining features of variable life insurance:

• It’s permanent life insurance. Unlike term life insurance, which expires after the policy’s term – often 20 or 30 years – variable life and other permanent policies cover you for your entire life or until you reach an advanced age, like 100 or 110. As long as you keep your policy in force, your survivors will receive a death benefit.

• The death benefit and premiums are fixed. Note that this isn’t the case with variable universal life (VUL) insurance, which we’ll discuss in greater detail later.

• It builds cash value. Permanent policies, including variable life, differ from term policies in that they have a built-in savings component called cash value.

• You can invest the cash value. You have a lot of discretion over how you invest the cash value account. You can choose investments that range from conservative choices, like bond and money market funds, to aggressive growth stock portfolios.

The investment component is what makes variable life insurance different from other types of permanent life insurance. A whole life insurance policy earns interest at a rate guaranteed by the insurer. Universal life policies also earn interest, usually at a rate similar to money market funds. Because you can invest your variable life cash value in equities, the potential returns are much higher, but you assume a lot more risk. If the stock market crashes, your cash value could plummet, which could even put your policy at risk of lapsing.

Variable life insurance pros and cons

There are both upsides and downsides to variable life insurance that you should be aware of if you’re considering a policy.

Variable life pros

• Permanent life insurance: Variable life insurance offers permanent coverage, which means the policy will probably last your entire life.

• High growth potential: Because you can invest in portfolios of stocks and bonds, your cash value can generate higher returns than you could with a whole life or universal life policy.

• Tax advantages: Your money in a variable life insurance policy will grow on a tax-deferred basis, which means you aren’t taxed on your investment earnings until you withdraw money. If you’re already maxing out your 401(k) and individual retirement account (IRA), variable life insurance could be an appealing way to invest extra money.

Variable life cons

• High risk: You can lose money if your investments perform badly. If your cash value drops significantly and you don’t have enough to cover your policy fees, the policy could lapse. You may have to pay higher premiums to keep the policy in force.

• Complexity: Variable life insurance is one of the most complicated insurance products out there. You’re responsible for deciding how to invest the cash value and monitoring the policy’s performance.

• Expense: Variable life and other permanent policies can be up to 15 times more expensive than 20- or 30-year term policies with the same death benefit. Commissions and other fees are substantial. With a variable life insurance policy, you’re not just paying policy fees but also the fees of the underlying mutual funds you invest in.

Premiums and premium payments

Variable life insurance has fixed premiums, meaning they don’t change as you get older. Your premium gets split into three buckets:

• The cost of insuring your life and eventually paying a death benefit

• Your insurance company’s expenses, including profits

• The policy’s cash value, which you can invest in a range of underlying subaccounts.

As you get older, your mortality risk, i.e., your risk of dying, gets higher. Your life becomes more expensive to insure, which means more of your premiums go toward insurance costs and less goes toward cash value. That’s why even though the premiums are fixed, some policyholders opt to pay more than minimum in the early years to build cash value faster.

Death benefit and beneficiaries

WIth any life insurance policy, you’ll need to choose a beneficiary to receive your death benefit. While most people name a loved one, you can also name an entity, such as a trust or charitable organization. Life insurance death benefits avoid probate and are usually income tax-free for beneficiaries.

The death benefit amount in a variable life policy is guaranteed and is most commonly structured in one of two ways:

• Level death benefit: Your death benefit is the policy’s face value at the time you purchased it. So even if you bought a $500,000 policy and your cash value grew to $100,000, your beneficiaries only receive $500,000.

• Face amount plus cash value: Your beneficiaries receive the policy’s face value plus cash value as their death benefit. In the example above, your survivors would receive $600,000 – the $500,000 face value plus the $100,000 cash value – as their death benefit. Not surprisingly this option costs more.

Cash value and investment options

One advantage of variable life insurance is that it builds cash value that you can use as an investment account. You can later use that money to supplement your income or borrow against it. Depending on your policy, you may be able to add it to the death benefit.

When you buy a variable life policy, you’ll decide how to invest your cash value. You’ll typically choose from a selection of mutual funds. Some policies also let you put part of your cash value in an account that pays a fixed interest rate, e.g., 2% or 3%, that the insurer can reset periodically. Your cash value’s growth depends on the investment performance.

Policy loans and withdrawals

Permanent life insurance policies usually let you take a loans using the cash value as collateral. Many policies allow you to borrow around 90% of the cash value. Any amount you borrow must be repaid with interest. You can also make partial withdrawals from your cash value. However, any money that you borrow or withdraw that you don’t repay before you die will be deducted from the death benefit.

Policy loans and withdrawals can put a variable life policy at risk of lapsing if you don’t maintain sufficient cash value to cover fees and expenses. With variable life insurance, that’s a major concern when your investments perform poorly.

Policyholders also have the option of canceling the policy for its cash surrender value, which is the cash value minus surrender fees. In the early years of the policy (when there’s typically not much cash value to begin with), surrender fees can be substantial.

Tax implications

Money in a variable life insurance policy grows on a tax-deferred basis, similar to money in a retirement account. You don’t pay taxes on your cash value growth unless you withdraw the money. If you do withdraw from the cash value, you’ll only owe money if you withdraw more than you paid in premiums. If your withdrawal exceeds the amount you paid in, you’ll only owe taxes on the growth portion.

Variable life insurance vs. other types of insurance

You have an array of options when you’re choosing a life insurance policy. Here’s how variable life insurance compares to the alternatives.

Variable life vs. term life

Term life is a type of policy known as pure life insurance because it insures your life but offers no savings or investing component. It often makes sense for people who need to replace their income during their working years but don’t need lifelong coverage.

Variable life vs. whole life

Whole life is the most common type of permanent or cash value life insurance. Because it guarantees both the death benefit and the cash value growth, it’s often a good fit for people who are risk-averse, whereas variable life insurance only makes sense for those with a higher risk tolerance.

Variable life vs. universal life

Both variable life insurance and universal life insurance are permanent life insurance policies, but they each offer fewer guarantees than whole life insurance.

Variable life vs. variable universal life

Variable life insurance and variable universal life insurance (VUL) are sometimes used interchangeably, but there are a few key differences. In short, VUL combines the investment component of variable life with the flexible premiums and death benefit of universal life.

Considerations and downsides

Variable life insurance can be extraordinarily complex and isn’t suitable for everyone. Because you’re exposed to market risk in your life insurance policy, it’s only appropriate for those with a medium to high risk tolerance. For many, the premium payments will be prohibitively high.

If you’re thinking of buying a variable life insurance policy, consider working with a fee-only financial advisor to determine whether this type of coverage meets your insurance needs. They can also help decide if you should purchase additional life insurance riders. The benefit of working with a fee-only planner is that they won’t get paid a commission for selling you on a policy.

Be sure you weigh the alternatives to variable life insurance as well. Many people don’t need permanent life insurance. For example, a term policy is often sufficient when your goal is to support your children until they become self-supporting or to pay off your mortgage. Buying term life insurance and investing the savings for retirement is a variable life alternative to consider.

Finding the right policy

If you’ve decided variable life insurance is appropriate for you, you still need to pick a policy. Follow these tips for finding the right variable life policy.

• Read the prospectus. By law, variable life insurance must be sold by prospectus. The prospectus is a document that spells out the policy’s fees and expenses, investment options and death benefit. This isn’t thrilling material, but it’s essential that you read the prospectus and ask a professional about anything you don’t understand.

• Look at the number of complaints. You can use the National Association of Insurance Commissioner’s complaint index to find out if an insurer receives a high number of complaints relative to its size. A score of 1.0 indicates an average number of complaints; look for a company with a score of 1.0 or less.

• Check out the company’s financial health. Verify that the life insurance company you’re considering is financially sound by checking out its ratings from at least two of the five independent agencies that rate the financial health of insurers: A.M. Best, Fitch, Kroll Bond Rating Agency, Moody’s, and Standard & Poor’s.

• Consult with a neutral third-party professional. Before you buy a policy, hire a fee-only financial planner or insurance consultant to review it. You want the opinion of a professional who doesn’t stand to earn a commission before you sign a contract.

Conclusion

Variable life insurance is only suitable for those who are comfortable with risk and can afford to pay high premiums. Before you buy a policy, discuss your needs with a financial planner and explore all life insurance options.

If you’re looking for a hybrid investment/insurance product, variable life insurance may be appropriate. But be sure to weigh the alternatives. If your main goal is financial protection for your loved ones, picking a cheaper term policy and investing the money you save is often the better option.