Variable Life Insurance: A Pain in the Asset Allocation for Trustees

Eric Scow, CFA

General Manager

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When purchasing a life insurance policy, the potential to achieve a higher rate of return than a fixed-rate product has made variable life insurance an increasingly attractive option for consumers over the last two decades. With the option to invest the policy’s cash value in separate accounts (commonly referred to as “sub-accounts”), which function similar to mutual funds, policy owners can participate in gains from the equity and fixed-income markets that can far exceed the earnings available with an insurance company’s fixed-rate products. Of course, the downside of this market participation is the potential to also achieve negative investment returns over any given period.

By choosing a variable life insurance policy and investing in the policy’s sub-accounts, much of the risk of the policy’s performance is transferred from the insurance company to the policy owner. While the insurance company can still adjust a policy’s costs (within contractual limitations), the investment decisions regarding the policy’s cash value fall to the policy owner. With trust-owned variable life insurance policies, this adds an extra layer of responsibility and duty for the trustee beyond the challenges already faced with fixed-rate products.

Some Challenges with Variable Life Insurance

Each variable policy and situation can present its own unique challenges. Some of these may begin prior to a trustee’s involvement with a policy. Expectations of how a variable life policy will perform are typically first set by the agent when it is presented to the purchaser at sale. While the trend of utilizing illustrations projected at 12% earnings or more appears to have slowed in recent years—RIC typically recommends evaluating a policy’s performance at 6% and 8% earnings—an overly aggressive earnings assumption at sale can have a lasting impact in the mind of the purchaser. If investment management of the policy is then ceded to the trustee—and especially if the selling agent is no longer in the picture—this can create difficult communications with a client if the policy is failing to achieve the at-sale expectations.

Ultimately, it is the selection of the policy’s sub-accounts that will determine the policy’s performance. While most variable life policies offer enough sub-accounts to cover the major asset classes, the number of sub-accounts available and their respective quality can vary widely from policy to policy, even with products offered by the same insurance company. Some policies may offer only several sub-accounts while others may offer well over one hundred sub-accounts. Furthermore, many newer variable policies offer the addition of policy riders that guarantee the policy will remain in force for a fixed amount of time, regardless of policy performance. By selecting one of these policy riders, however, the insurance company will often limit the sub-accounts that may be chosen. All of these myriad factors in sub-account selection, therefore, can become a burden for investment officers, as all variable life insurance policies in their portfolio could have markedly different options available.

Most variable life policies offer a fixed account option, where the policy owner can invest all or part of the cash value and earn a fixed rate (typically 4% – 5%). There are many valid reasons for utilizing a variable policy’s fixed account option; however, it is often utilized as a safe harbor during volatile market conditions (or as a one-stop solution in the face of—potentially—evaluating more than one hundred available sub-accounts). Ostensibly, this may seem like a prudent investment decision but, to prevent excessive trading and market timing transactions, most insurance companies severely restrict the amount of money that may be transferred out of a fixed account. In some cases, it may take several years to become fully invested in variable sub-accounts again once funds have been moved into the fixed account. This can nullify what was likely the original intent of purchasing a variable life policy: the opportunity to participate in favorable market returns.

Annual Review and Asset Allocation

Fortunately, many of the challenges and difficult decision-making inherent with variable life insurance can be mitigated with an annual review of the policy and having a consistent process for asset allocation in place. Procuring illustrations projected at 6% – 8% earnings assumptions on an annual basis will give a realistic perspective as to whether the policy is adequately funded—does it lapse, or does it mature?—and how the policy’s cash value might grow in the future. This may require a resetting of expectations if the policy was sold or previously projected assuming much higher rates of return, but going forward, an appropriate long-term benchmark will be in place to measure the policy’s overall performance.

Additionally, having a consistent process for asset allocation in place can make sub-account selection less burdensome. Asset allocation for variable life insurance refers to the mix of sub-accounts in which the cash value is invested. Typically, an effective asset allocation strategy for variable life insurance is one that ensures the mix of selected sub-accounts is diversified and aggressive enough to preserve (or prolong) the death benefit of the policy without unnecessary risk.  Accordingly, a suitable mix of equity and fixed-income sub-accounts can be chosen with the major asset classes represented.

The life expectancy of the insured(s) and the funding adequacy of the policy are critical components for selecting the appropriate asset allocation strategy. As with composing an asset allocation strategy for a traditional investment portfolio, the younger the insured(s)—therefore, the longer the life expectancy—the more aggressive the strategy may be due to the longer time horizon.  Similarly, in analyzing the funding adequacy of the policy, a more aggressive asset allocation strategy would be appropriate if the policy is underfunded. That is, if the policy lapses prior to maturity, a portfolio designed to achieve higher earnings, albeit with more risk, could extend the policy’s years in force if those higher earnings are indeed achieved. If the policy is already projected to mature at a reasonable earnings assumption, a more conservative asset allocation strategy would be appropriate to limit the downside risk of too low—or negative—earnings.

By reviewing a variable life insurance policy annually, along with its continued suitability for the trust, it can be determined whether or not the asset allocation strategy currently employed needs to be adjusted. A drastic change in the health of an insured or—in the case of survivorship policies—the death of one of the insureds may affect the time horizon of the policy. Likewise, a change in premium may alter the policy’s funding adequacy. In situations where the time horizon is very short or the policy is being minimally funded, a decision to invest the cash value in a fixed account may even be necessary to avoid an unexpected lapse.

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The risk inherent in variable policies is not eliminated through diversification and sound asset allocation strategies, but these practices can demonstrate a trustee is exercising their fiduciary responsibility—even in instances of earnings negatively impacting the policy’s performance. Having consistent asset allocation processes in place, along with annual reviews of the policy, provide templates for dealing with complex issues that may arise in the sub-account selection process or expectations of the client. And these tools can facilitate easier and better communication with clients as well.

In addition to being a nation leading provider for independent Trust Owned Life Insurance policy reviews and ILIT Administration solutions, RIC is also a Registered Investment Advisor (CRD #135472).  As such, RIC can be retained to implement an asset allocation program and assist in the active management of the investment component of variable life insurance and annuity contracts.


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