Many policies are underfunded as a result of the bear market.

Even though the bear market seems to have subsided, the fallout from those three years of losses may have yet to be dealt with if you have clients with variable universal life policies.

That, observers say, is because one of the problems the bear market left in its wake is a rash of variable universal life policies that are underfunded. In many cases, policyholders may not know the problem even exists, which means advisors should be scrupulous about doing periodic reviews of their clients' standing policies.

"That is the single biggest problem with variable universal life, period," says John Olsen, a CLU and ChFC licensee, who owns Olsen Financial Group in St. Louis, Mich. "If you go to a conclave of people who know what they're doing in this area, ask them if it's true the biggest problem with VUL policies is that most of them are underfunded. If you get one person who says, 'no,' I'd like to know his name."

In agreement is Chris Cooper, principal of Chris Cooper & Co., an advisory firm in Toledo, Ohio. Cooper says he's frequently seen clients walk into his office with underfunded policies.

"What I'm seeing is the cash value is not building up sufficiently to make the illustrations come true," he says. "They're not in trouble yet, but they will be from what I've seen."

Advisors cite a number of reasons why the holder of a VUL policy may still be feeling squeezed by the three-year bear market. Part of the problem, they say, is that policies are too often sold with minimal premiums, leaving policyholders with little wiggle room if market returns are significantly lower than projected. "People are buying them as though they're refrigerators, figuring the ones with the cheapest premiums must produce the best deal," Olsen says.

This problem is exacerbated by the fact that projections of annual investment gains used to draw up a policy, particularly if it was done in the bull market of the 1990s, were probably overly optimistic. What will typically happen is an out-of-whack market will lull people into believing the standard benchmarks have changed, says Herbert Daroff of Baystate Financial Services in Boston.

It was easy to expect annual returns of 12% back in the 1980s, for example, because interest rates were around 18% or higher. That type of thinking also spilled into the late 1990s, when the S&P 500 was churning out gains between 20% and 30% and the Nasdaq 100 was giving investors returns of up to 102%. "These policies were sold on some unrealistic assumptions," Daroff says.

Even with the bear market and pumped-up projections, VUL policyholders who are getting their cash value from a well diversified portfolio probably weathered the past few years intact. Others who didn't diversify, went with minimum premiums and overly optimistic projections are facing the possibility of having their policies lapse, he says. "Some people may have to put in 150% more than they're paying just to keep it afloat," Daroff predicts.

There is yet another reason why projections used to sell VUL policies are misleading-more so, advisors say, than they would be if applied to a mutual fund. This has to do with the fact that VUL policies are sold with straight-line projections that assume an average annual return, ignoring the fact that returns will actually vary greatly from year to year.