What is a Variable Life Insurance Policy?

A variable life insurance policy allows the account holder to invest a portion of the premium paid for the policy.

How Does a Variable Life Insurance Policy Work?

Let's say John Doe buys a variable life insurance policy and pays $10,000 a year in premiums. Under the terms of the policy, $5,000 of the $10,000 goes toward the death benefit -- a check for $1 million made out to his wife and children when he dies.

The other $5,000 is invested in various instruments -- stocks, bonds, mutual funds, etc. The value of those instruments changes daily (hence the name 'variable life insurance policy'). If the value of these securities rises, John can apply those paper profits toward his premiums (which saves him money). Of course, if the investments don't do well, John still has to pay the full $10,000 premium every year.

If the securities perform really poorly, the insurance company might reduce the value of that $1 million death benefit, though the insurance contract should set forth a minimum death benefit (a 'guaranteed death benefit') that his wife and kids will receive no matter how poorly the investments perform (though an absolute guarantee often means paying extra premiums).

The investments in a variable life insurance policy grow tax-deferred, which means that your returns compound at a higher rate than if you had to pay taxes on the gains every year. This can significantly boost the amount that accumulates in the investment accounts.

Why Does a Variable Life Insurance Policy Matter?

Variable life insurance policies are regulated as securities, which means your advisor or insurance agent should give you a prospectus that describes the policy in detail, as well as all the investment options. The important thing about this instrument is that the death benefits and value of the investments can fluctuate with the market. In some cases, the policyholder can borrow against the value of the investments in the account. It is important to note that investors should consider the financial stability of the insurer with which they do business; ratings services such as Standard & Poor's and AM Best help.