Variable life insurance and the securities rules that govern it

Variable life insurance, including Variable universal life (VUL) insurance, is regulated twice. It is life insurance, so state insurance departments license the insurer and the agent and approve the policy. Because the cash value is invested in funds whose value can fall, it is also a security, so the SEC requires registration and a prospectus, and the person selling it must be registered with a FINRA-member broker-dealer. Fixed life insurance and most indexed universal life policies are not securities.

Why variable products count as securities

The test is where the investment risk sits. In a whole life or fixed universal life policy, the insurer invests its general account and promises a result. In a variable policy, the money is placed in a separate account divided into subaccounts, each of which invests in a fund. The policy owner, not the insurer, bears the investment result. Federal securities law treats that as an investment contract. FINRA's rulebook defines variable contracts as contracts "providing for benefits or values which may vary according to the investment experience of any separate or segregated account or accounts maintained by an insurance company" (FINRA Rule 2320).

Who regulates what

A question about a variable policy may therefore go to more than one regulator. The insurance commissioner in your state handles insurance complaints; the SEC and FINRA handle securities complaints.

The prospectus

A buyer must receive a prospectus describing the product, the separate account and the underlying funds. The SEC's registration form for variable life insurance is Form N-6, which was designed to focus on information that helps an investor decide, and to improve disclosure of fees and charges. In 2020 the SEC adopted Rule 498A, which lets an insurer deliver a shorter initial summary prospectus (a key-information table of fees and risks, an overview and more detailed sections) in place of the full statutory prospectus, as described in the SEC's March 2020 announcement and a summary in the Federal Register. The summary is easier to read, but the full prospectus remains available on request.

When you read it, look for:

1. The fee table: premium charges, cost of insurance, administrative, Mortality and expense (M&E) charge and surrender charges.
2. The list of subaccounts and each fund's expense ratio.
3. The risks section, especially the one on lapse if investments do poorly.
4. Limits on transfers and loans.
5. The right to cancel after purchase, which has its own rules in the prospectus and state law. See the free-look period: returning a policy for a refund.

Who may sell it

To sell a variable policy, a person generally needs two credentials: a state life insurance license with authority for variable products, and registration through a FINRA-member broker-dealer, typically by passing a FINRA qualification exam such as the Series 6 or Series 7 plus the SIE, and some states also require a Series 63 or 66. FINRA's rule on variable contracts also restricts how sellers are paid. Among other limits, it bars accepting compensation in the form of securities and sets rules on non-cash compensation such as gifts and trips.

An agent who holds only a life license cannot lawfully sell you a variable policy. If the seller asks you to write a check without mentioning a prospectus or a broker-dealer, stop.

How to check a seller

1. Search the seller's name on FINRA BrokerCheck (brokercheck.finra.org) for registrations, employment history and disciplinary events.
2. Check the state insurance department's producer search for a life license in your state.
3. Ask which broker-dealer is responsible for the sale and get the answer in writing.

Standards of conduct

When a broker-dealer recommends a securities transaction to a retail customer, the SEC's Regulation Best Interest requires it to act in the customer's best interest and not place its own interests ahead of the customer's. Variable life is covered because it is a security. The standard concerns disclosure, care, conflicts and compliance. It does not guarantee a good outcome, and it is not the same as a fiduciary duty at all times. State laws, such as the NAIC's best-interest model for annuity recommendations adopted in many states, address annuities rather than life insurance, so do not assume they apply to a life policy.

Replacing a policy

Swapping a policy for a variable one, or the reverse, can trigger new surrender charges, a new contestability period and a new set of fees, and it has tax effects. A 1035 exchanges: swapping policies without tax can avoid tax in some cases. Ask for a side-by-side comparison, and see policy replacement and churning for the warning signs.

Hypothetical checklist before you sign

Say a seller proposes a VUL. Before you pay:

• Do you have the prospectus (or summary prospectus) and have you read the fee table?
• Do you know the seller's FINRA registration and state license?
• Have you seen an illustration at a low return, not only the steady-return version?
• Do you know what happens if you stop paying?
• Do you know how to cancel in the free-look window?

Key takeaways

• Variable life is both insurance (state-regulated) and a security (SEC- and FINRA-regulated); fixed and most indexed policies are not securities.
• You are entitled to a prospectus, and the SEC allows a shorter initial summary prospectus under Rule 498A, adopted in 2020.
• The seller needs a state insurance license and a FINRA-registered broker-dealer; verify both before paying.
• Complaints may go to the state insurance department, the SEC, FINRA or your state securities regulator, depending on the issue.