The Underfunded VUL: Stopping Premiums, Borrowing, and Switching Death Benefit Options
Dana, age 58, owns a $2,000,000 variable universal life policy issued six years ago with a level death benefit (Option A). She has paid $30,000 annually, $180,000 total, and the account value is $205,000 spread across six equity-heavy subaccounts. The policy was funded close to the guideline premium limitation at issue, and the current cost of insurance charge is $18,400 per year and rising. Dana was laid off last month. She wants to stop paying premiums immediately, take a $50,000 policy loan at 8% to cover living expenses, and switch to Option B so the death benefit grows with the market. Her emergency fund is $9,000, and she does not expect to resume premiums for at least two years. She asks you to submit all three changes this week and to confirm the policy will pay for itself from here.
1. Evaluate the three requested changes as a package. What is the realistic probability the policy stays in force for five years, and what mechanics drive that outcome?
Read the worked answer
Start with the arithmetic. After a $50,000 loan, net account value is roughly $155,000. Annual drag is the $18,400 cost of insurance plus about $4,000 of loan interest, call it $22,400, or roughly 14.5% of net value. For the policy to break even, the subaccounts must earn about 14.5% net every year, which is not a planning assumption. Option B makes this worse: the death benefit equals face plus account value, so every dollar of growth raises the amount at risk and therefore raises the cost of insurance, which is already rising because Dana is aging. The loan also reduces the death benefit dollar for dollar if unpaid and compounds at 8%. Within two years, charges likely consume the remaining value, the policy lapses, and the outstanding loan becomes a taxable distribution to the extent of gain. The honest answer is that the plan is likely to fail, not that the policy pays for itself. Never confirm a self-funding projection you cannot support.
2. Does the Option B election create a Section 7702 problem or change the policy's tax character?
Read the worked answer
Option B generally helps satisfy the Section 7702 cash value corridor, because the death benefit automatically increases as account value grows, keeping the death benefit above the required multiple of cash value at Dana's attained age (about 130% to 150% in the late fifties). The corridor is a floor, not a problem to be avoided. The real 7702 exposure runs the other way: reducing the face amount or the death benefit can push premiums above the guideline premium limitation and turn the contract into a modified endowment contract. That is why any face reduction must be modeled before submission, not after. Switching to Option B does not change the contract's tax character; it remains life insurance under 7702 and remains a security for securities-law purposes. What changes is the cost structure, since the amount at risk grows with the account and the insurer will likely require underwriting and may reprice the cost of insurance on the change.
3. State what you will submit, what you will refuse to submit, and the alternatives you will present to Dana.
Read the worked answer
I would submit nothing until the numbers are run in the insurer's illustration system and documented. I would refuse to represent that the policy pays for itself and refuse to submit a $50,000 loan combined with zero premium and Option B without showing her the projected lapse year and the tax consequence of a lapse with a loan outstanding. Alternatives to present: keep Option A to hold down cost of insurance; take a partial withdrawal instead of a loan if the policy has gain room, or a smaller loan; reduce the face amount only after checking the guideline premium and MEC impact; pay a minimal premium for two years using the emergency fund plus a smaller loan; or 1035 exchange to a lower-cost permanent contract or to term plus separate investing, subject to replacement and suitability review. Because she is unemployed with a $9,000 reserve, the suitability file should document her liquidity needs, the reason for any recommendation, and her signed acknowledgment of the lapse risk.