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.

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.

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.

ITM/RIC can be retained to perform the asset allocation analysis and recommendations for variable contracts. For more information, please reach out to John Barkhurst or Greg Kizer.