For the last few years, one type of life insurance has handily outsold all the rest: variable universal life insurance. Last year alone, while overall life insurance sales remained flat, sales of variable universal life jumped 24%, as measured by the Life Insurance Management Research Association (Limra), the Windsor, Conn.-based industry data group.

Variable universal life, of course, allows policyholders to deposit a portion of their premiums in mutual-fund-like accounts. So their current popularity is undoubtedly related to the powerful bull market. The S&P 500 advanced nearly 30% last year.

But what happens when the market turns—and how can advisors prepare for the inevitable flood of questions and complaints? Perhaps more important, are there smarter, less volatile ways to accomplish what variable universal life claims to?

The Case For VUL
Variable universal life is designed for those who have “a need for life insurance death-benefit protection and a desire to accumulate cash inside the policy for their use while living,” says Ray Caucci, senior vice president of product management, underwriting and advanced sales at the Penn Mutual Life Insurance Co., in Horsham, Pa. Variable life provides all this in “a single vehicle,” he says. “As long as the client has the proper risk tolerance, and funds the product properly, it can weather most market volatility.”

Indeed, if the account appreciates in value, the gains can help defray the steep annual policy costs. Not only are earnings tax-deferred but withdrawals can be made “without taxation through a return basis and via policy loans,” says Russell E. Montgomerie, a CFP licensee at Ameritas Investment Corp. in Boca Raton, Fla., noting that withdrawals will reduce both the cash value and death benefit. “Ultimately, at the policyholder’s passing, the proceeds pass [to the heirs] income-tax free,” he says.

Like standard universal life, variable life policies offer creditor protection. It can also help extend a client’s tax-deferred savings beyond the maximums allowed in retirement accounts, although many advisors would deem a variable annuity a better vehicle for this purpose. Those who “have maxed out their qualified plans, have a stable financial future and want to save more, are potentially viable candidates,” says Montgomerie.

The Ideal Client For Variable ULI
Yet they are clearly not for everyone. “They are not the ideal policies to cover traditional families,” insists Matthew Jehn, a certified financial planner and managing partner at Royal Oak Financial Group in Columbus, Ohio. “Whole life and term life offer better coverage.”

To be sure, variable universal life is expensive and requires a long time horizon to offset market volatility, in addition to a stomach for risk. “Think of a person who is 45 and looking to protect his/her family from a premature death but also needs to save for college tuitions and retirement,” says Steve Roche, vice president of product solutions at Prudential’s Individual Life Insurance division. “This vehicle provides a death benefit for the family, but also an ability to grow cash value for future use, all with powerful tax advantages. Newer features also offer access to the tax-free death benefit if you become chronically ill as you age.”

For affluent, risk-tolerant clients under 50, Thomas Santolli, managing director at Paradigm Financial in Parsippany, N.J., recommends actually overfunding variable universal life. “By overfunding, you’re creating an internal hedge that puts a lot more cash in the policy than is needed,” he says. “So if there is great investment loss, you might not end up in a negative position.” (While state insurance departments set the minimum premiums carriers can charge, he says, the IRS sets the maximum you can overfund.)

Beware Misrepresentations
Concerns have been raised, however, about unscrupulous brokers who use overly rosy illustrations to lure in unsuspecting customers. Santolli emphasizes the importance of “stress-testing your illustrations,” he says. Don’t forget to include periodic random crises. “If the client can handle a 30% loss in the fifth and 15th years, say, that’s great,” says Santolli. “If not, maybe it isn’t the right product.”

This sort of stress testing goes beyond time horizon and risk tolerance. “Present a personalized illustration with conservative assumptions,” says Alyce Peterson, a vice president at Pacific Life Insurance Co., in Newport Beach, Calif. “Have the client look at the life insurance product under different sets of assumptions to understand how volatility or changes might affect the policy. Review and select services that might help manage volatility, such as dollar cost averaging, an earnings sweep from a fixed interest account, or designating a specific account for deduction of policy charges. Diversify premium allocations across multiple choices for the cash value that fits the client.”

Rest assured, variable life is regulated as a security; they fall under the oversight of the Financial Industry Regulatory Authority (Finra). But those protections only go so far. “If I were an insurance regulator, I would require the use of stochastic illustrations in sales presentations,” says Glenn Daily, principal at New York-based Sutter’s Mill Valuation Services, a fee-only life-insurance advisor, referring to a type of probability analysis that takes into account a broader range of variables for a more realistic outcome than the current “deterministic illustrations,” he says.

It’s also incumbent upon brokers and advisors to make sure clients know that variable life insurance products, like all investments, have downside risk. “Advisors should ensure clients thoroughly understand the product and manage client expectations,” says Montgomerie. “These products have surrender charges, too, which can be substantial if [policyholders] decide to surrender their policy early.”

The Case Against
Besides the risk inherent in these products during a bear market, some advisors also object to their cost. “When you compare the expense ratio of the funds you can invest in through a variable universal life policy with the equivalent mutual funds you can invest in outright, you usually find at least 80 to 100 basis points more expenditure within the variable product than in the outside world,” says Dan Yu, managing principal at New York-based EisnerAmper Wealth Advisors.

Yu argues that careful retirement and estate planning can produce many of the same results without the price tag. “I’d design a portfolio that gives you protection from unforeseen events using low-cost 20- or 30-year level term insurance,” he says. “I’d then put the savings into an investment vehicle using low-cost mutual funds and ETFs.”

He would discourage selling shares, to avoid taxes. “Even if I do sell something, if I have done this correctly, it’s going to be a long-term capital gain tax with qualified dividends,” he says. “In other words, I can give you all the things a variable universal life product can, at a lower cost. It’ll just take me two or three different vehicles.”

For others, variable products present a sort of cart-and-horse conundrum. “My problem with variables in general is that the chassis is sold first and investments are secondary,” says Pete Lang, president of Lang Capital in Hilton Head, S.C. “You buy a variable policy and they go, ‘Here is what you can invest in.’ What can happen over time is that those investments are no longer suitable for the investor.”

What Lang prefers is to start by choosing an appropriate investment and then create a variable insurance trust around it. The trust essentially owns the insurance contract. But the single entity can encapsulate a series of funds with multiple investment advisors. “The investment will grow tax-deferred with low fees and commissions,” he says. “It’s the best of both worlds.”

A Forced Investment
Nevertheless, fans of variable life insist they are a good way to induce clients to (a) secure life insurance and (b) save and invest. “Life insurance is a forced investment in the sense that you’re going to get reminders, you’re going to have a broker who calls you to make sure you keep up your payments,” says Santolli.

When he runs the numbers, comparing the performance of a variable policy and a stand-alone investment in a similar mutual fund, Santolli finds, “Nine times out of 10 you’ll end up with significantly more money at the end with the life insurance contract than you would on the outside.”

Indexed Universal Life
Still others prefer a kind of compromise option: indexed universal life. While this product also pays death benefits and gives policyholders some exposure to market rallies, the money isn’t invested directly in stocks or bonds. Instead, insurance companies hold the funds and pay interest to policyholders at a rate that correlates to a market index such as the S&P 500. (Some index policies also allow participants to set aside a portion of their money to generate interest that isn’t connected to stock market performance.)

The interest payments generally have a cap and a bottom, so policyholders won’t get the full benefit of market upturns, as they would with a variable plan, but they also get some protection against downside risk. The average maximum return recently has been about 12% a year, but carriers reserve the right to lower that cap to protect themselves. They could take a loss, but will also profit if returns exceed the 12% cap. They typically invest in high-quality bonds and usually exclude reinvested dividends when evaluating gains. But clearly, some of the risk falls on the insurance company, not just on the policyholders.

Last year, sales of indexed universal life rose 13%, making this the second-best-selling life insurance product after variable life. It’s a relatively young product, though, so its long-term impact isn’t entirely clear. “We are still at the beginning of the learning curve on how to evaluate them,” cautions Daily.

One concern is that some indexed universal life policyholders are being encouraged to borrow against their coverage. “The variable loan feature of IUL has also allowed unscrupulous agents to convince people that you can get rich by borrowing money at a lower rate of interest than the assumed credited interest rate in the policy,” he says. “It’s an old game, and this is just the latest variation.”