Variable life insurance in Canada: How it works, fees & risks

Life insurance doesn’t always stop at protection, it can also serve as an investment tool. Variable life insurance takes this concept further by blending lifelong coverage with market-linked investment options that rise or fall with performance. Designed to provide protection for your entire life, variable life insurance offers lifelong protection as long as premiums are paid. For Canadians seeking both insurance and potential tax-advantaged growth, this policy type can be appealing, but it also carries more complexity and risk than traditional plans.

In this guide, we’ll explore how variable life insurance works in Canada, what makes it different from other permanent policies, and who it’s best suited for.

What is variable life insurance?

Variable life insurance is a type of permanent life insurance policy where you pay premiums your whole life. Like other permanent policies, it gives a tax-free payout to your beneficiaries when you die. However, people often buy variable life insurance mainly for its cash value and as an investment, while also providing insurance protection. Unlike other permanent policies with fixed cash value growth, variable life insurance ties its cash value to investments, potentially earning more returns than policies with fixed rates, like whole-life insurance.

Variable life insurance lets policyholders allocate part of their premiums to an investment account within the policy, choosing from different investment options like mutual funds or stocks. Part of the premiums go toward investment components managed by the life insurance company. 

The policy’s cash value goes up or down based on how these investments perform. If the investments do well, the cash value can grow faster than in other permanent life insurance policies. However, if they do poorly, the cash value may drop, and the policyholder might need to pay more premiums to keep the policy in force. The rate of return on the cash value fluctuates according to the performance of the selected sub-accounts.

Cash value in variable life insurance

A variable life insurance policy’s cash value portion operates differently than a whole-life or indexed universal insurance policy. Policyholders can choose from a range of investment funds the insurance company provides, allowing them to tailor their investment strategy based on their risk tolerance and investment goals. The cash value portion can be allocated to different investment funds, which resemble mutual funds and consist of specific securities, such as:

• Index funds such as the S&P 500
• Equity portfolios such as emerging markets fund
• Bonds
• Money market funds

The policy’s cash is invested in these funds, and its performance directly impacts the overall value of the policy. Some variable life insurance policies offer a fixed-interest investment option with lower risk and potentially lower rewards.

Regardless of the chosen investment option, the policyholder incurs management fees similar to expense ratios associated with mutual funds. The costs vary depending on the invested securities and can be significant if the funds are actively managed, involving portfolio managers selecting individual stocks.

Accessing cash value

• When the cash value of a variable life insurance policy experiences positive growth, it can serve several purposes. It can enhance the death benefit, be withdrawn as cash, or be used as collateral for obtaining a loan.

• Policy loans generally have a fixed interest rate; if unpaid, the loan amount plus interest is deducted from the death benefit upon the insured’s death. It’s important to note that outstanding loans can reduce the cash value and death benefit.
• If you no longer need the coverage or want to cancel the policy, you can surrender your variable life insurance policy. Before making this decision, check how much cash value has accumulated in your policy, as this will determine the amount you receive. Surrendering the policy means you get the cash value, but the coverage stops. You may also need to pay tax on any gains if you withdraw or surrender the policy, as certain portions of the cash value may be taxable.

Investment options for variable life insurance

One of the defining features of variable life insurance policies in Canada is the wide range of investment options available to policyholders. Unlike traditional whole life or universal life insurance, variable life insurance policies allow you to allocate your cash value among a selection of investment vehicles, such as mutual funds, index funds, and other professionally managed portfolios. These options can include a mix of asset classes, stocks, bonds, and money market funds, giving you the flexibility to tailor your investment strategy to your personal risk tolerance and financial goals.

With a variable universal life insurance policy, you can actively manage your investments within the policy, switching between different funds or asset classes as your needs or market conditions change.

The performance of these investment options directly impacts your policy’s cash value and, in some cases, the death benefit your beneficiaries receive. For example, strong returns in your chosen mutual funds or index funds can lead to higher cash values and potentially increase the death benefit, while poor performance can reduce both.

Canadian insurance companies typically offer a menu of investment options within their variable life insurance policies, allowing you to diversify your portfolio and potentially enhance long-term growth. However, it’s important to remember that with greater investment choice comes greater responsibility, regularly reviewing your investment selections and understanding the associated risks is key to making the most of your variable life insurance policy.

Tax implications of variable life insurance

Variable life insurance policies in Canada offer several tax advantages, but it’s important to understand how these tax rules work to avoid surprises.

The cash value within a variable life insurance policy grows on a tax-deferred basis, meaning you won’t pay income tax on investment gains as long as they remain inside the policy. This can help your cash value accumulate more quickly compared to taxable investment accounts.

However, if you withdraw cash from your policy or take out a loan against the cash value, you may be required to pay income tax on any gains above your adjusted cost base. Similarly, if you surrender your variable life insurance policy, the amount you receive above what you’ve paid in premiums could be taxable. While the death benefit paid to your beneficiaries is generally tax-free, there are exceptions if the policy exceeds certain limits or is not structured as an exempt policy under Canadian tax law.

It’s also worth noting that variable life insurance policies can be complex from a tax perspective, especially if you’re using the policy for advanced estate planning or as part of a business strategy. To maximize the tax advantages and avoid unintended tax consequences, it’s wise to consult with a tax professional or financial advisor who understands the nuances of life insurance policies in Canada.

Variable life insurance and retirement planning

Variable life insurance can play a strategic role in retirement planning for Canadians seeking both lifelong coverage and investment growth. The cash value component of a variable universal life insurance policy can serve as a supplemental source of retirement income, providing flexibility if you need to access funds later in life. Because the cash value grows tax-deferred, you can potentially accumulate more wealth over time compared to taxable accounts.

When it comes time to retire, you may be able to withdraw from your policy’s cash value or take out policy loans, often on a tax-free basis if structured properly. This can help cover major expenses, supplement your retirement income, or provide a financial cushion for unexpected needs. At the same time, the death benefit ensures your loved ones are protected, offering peace of mind that your financial legacy is secure.

However, it’s important to weigh the fees, investment risks, and potential surrender charges associated with variable life insurance policies. While the tax advantages and lifelong coverage are appealing, these policies are best suited for individuals who are comfortable with market fluctuations and can commit to long-term premium payments. As part of a comprehensive retirement plan, consider how variable life insurance fits alongside other vehicles like RRSPs and TFSAs to create a balanced and effective strategy for your future.

Drawbacks of variable life insurance

Variable life insurance policies often entail several costs and fees, including:

• Mortality and Expense (M&E) charges: These charges cover the cost of insurance and administrative expenses associated with the policy. M&E charges are typically deducted monthly from the cash value.

• Cost of Insurance (COI) charges: These fees represent the cost of providing the death benefit coverage based on the insured’s age, health, and policy features. COI charges are deducted from the cash value every month.
• Management fees: Variable life insurance policies offer investment options, such as mutual funds, within the cash value component. Each investment option has its management fee, similar to the expense ratio of a mutual fund. These fees cover the costs of managing the investments and are deducted from the cash value.
• Surrender charges: Surrender charges may apply if the policy is surrendered or terminated within a specified surrender period. These charges are meant to recoup some of the upfront costs incurred by the insurance company and decrease over time.
• Policy fees: Policy fees are charged to cover the overall costs of managing and servicing the policy. These can include both administrative fees and investment management fees, and they may impact the growth of your cash value and the overall performance of the policy.
• Administrative fees: Administrative fees are part of the policy fees and are specifically charged for handling the administrative aspects of the policy, such as record-keeping and customer service. These fees are typically charged periodically, such as annually or monthly.

In addition to the fees mentioned earlier, other costs and risks are associated with variable life insurance in Canada. Here are some important considerations: Variable life insurance requires more participation from the policyholder than other types of insurance.

• Market risk: Variable life insurance policies are tied to the performance of the underlying investment options. Their cash value can fluctuate based on these investments’ market performance. The cash value and potential returns may be negatively affected if the investments perform poorly.

• Investment risk: As a policyholder, you bear the investment risk in variable life insurance. If the chosen investment options within the policy underperform, it can decrease the cash value and potentially the death benefit. It’s essential to carefully evaluate the investment options and consider your risk tolerance before making investment decisions.
• Lack of guarantees: Unlike other types of permanent life insurance, variable life insurance does not provide guaranteed cash value growth or returns. The cash value is subject to market fluctuations and investment performance, resulting in unpredictable outcomes.
• Higher premiums: Variable life insurance policies have higher premiums than term or permanent insurance options. This is due to the investment component and the associated fees and costs being included.
• Complexity: Variable life insurance is a complex financial product that requires a good understanding of investment concepts and market dynamics. Navigating the various investment options and monitoring the policy’s performance can be challenging.
• Potential tax consequences: While the cash value growth within variable life insurance is generally tax-deferred, surrendering or withdrawing from the policy may have tax implications.
• Long-term commitment: Variable life insurance policies typically require long-term premium payments. Before purchasing, assess your ability to sustain these premium payments over the policy’s life.
• Risk of policy lapse: If your policy does not have enough cash value to cover ongoing policy fees, administrative fees, and other charges, it may lapse or require you to make additional premium payments to keep the coverage active.

Death benefit in variable life insurance

The death benefit in a variable life insurance policy is the money paid out to the beneficiaries upon the insured individual’s death. Variable life insurance provides both life insurance coverage and life insurance protection for beneficiaries, combining a guaranteed payout with the potential for investment growth.

Unlike term life insurance, which provides a fixed death benefit for a specified period, variable life insurance offers flexibility, and there are generally two main types of death benefit options available: Many variable life insurance policies have a guaranteed minimum death benefit, but investment performance can increase it beyond the face amount.

• Level death benefit: The death benefit in this type of policy remains constant and is set at the face value established when the policy was purchased. It does not fluctuate based on the cash value or investment performance.

• Face amount plus cash value: This policy option has a higher cost than the death benefit level. Upon the insured’s death, the beneficiaries will receive the accumulated cash value and the policy’s face value. This provides an extra benefit by including the cash value as part of the overall payout to the beneficiaries.

Premiums with variable life insurance

Variable life insurance allows policyholders to choose the amount and frequency of premium payments. Policyholders are required to make monthly premiums to keep the policy active. This type of policy combines the cash value structure of variable life insurance with the flexibility to use the cash value to cover premiums. It is commonly referred to as flexible premium variable life insurance.

Variable universal life insurance policies typically have minimum and maximum premium limits, but policyholders have control over their premium payments within those boundaries. Here are some options:

• Single premium payment: These are variable universal life insurance policies in which coverage and funding for the cash value are provided through a single payment. Policyholders can contribute more to the cash value beyond the required amount, providing potential for increased growth. When reviewing your policy, you can track how much premium has been paid and see how it impacts the policy’s cash value over time.

• Partial premium payments: If the monthly premium is, for example, $500, policyholders can pay a portion of the premium out of pocket, such as $250, and use the accumulated cash value to cover the remaining amount. This option is usually available once the cash value has reached a minimum threshold.
• No premium payments: If the cash value has grown sufficiently, policyholders can use it to pay the entire premium amount, eliminating the need for out-of-pocket premium payments.
• Exceeding the target premium: Policyholders can choose how much premium to pay, within policy limits, and can contribute more than the target premium, funding the cash value more aggressively. High-income earners often favour this approach, as it allows for quicker growth of investment gains and provides flexibility to stop making premium payments in the future, such as during retirement.

Who needs a variable life insurance policy?

Variable life insurance policies are a type of permanent life insurance policy designed for lifelong protection and are typically suitable for individuals with specific financial goals and preferences.

• High-income earners: Variable life insurance can benefit high-income earners with maximized contributions to other tax-advantaged investment options, such as RRSPs. It provides an additional avenue for tax-deferred growth potential.

• Long-term financial planning: Variable life insurance may be suitable for individuals with long-term financial goals, such as retirement planning or leaving a legacy. As a permanent life insurance policy, it offers lifelong protection, and the investment component allows for potential growth of the cash value, which can be beneficial in building wealth over time.
• Risk-tolerant individuals: Individuals comfortable with market fluctuations and with a higher risk tolerance may be more inclined to consider variable life insurance.
• Estate planning: Variable life insurance can be a key component of estate planning strategies, particularly for high-net-worth individuals. It provides insurance protection for beneficiaries, can help provide liquidity to cover estate taxes, or leave a significant inheritance.
• Charitable giving: For individuals with charitable intentions, variable life insurance policies can support philanthropic causes by designating charities as beneficiaries.

Pros and cons of variable life insurance

Variable life insurance offers growth potential through market-linked investments but also carries higher risk and complexity compared to other permanent policies. Below we go into both the pros and cons of variable life insurance. The cash value of variable life insurance grows tax-deferred, meaning taxes are only paid upon withdrawal.

Pros

• Potential for investment growth: It offers potential investment growth within the cash value component, leading to higher returns than other permanent life insurance options. Variable life insurance allows policyholders to choose from a range of investment options, which can result in greater growth potential compared to indexed universal life insurance. Indexed universal life insurance, by contrast, uses a different investment strategy where returns are linked to a market index, typically offering more stable but potentially lower returns and different fee structures.

• Tax-deferred growth: It provides liquidity to cover estate taxes or leave a significant inheritance for beneficiaries (estate planning and legacy).
• End-of-life costs: It can cover final expenses, including funeral costs and other fees associated with the end of life.

Cons

• Investment risk: The cash value is subject to investment risk, meaning poor investment performance can decrease the cash value and potential returns. Policyholders bear the investment risk.

• Higher costs: Variable life insurance tends to have higher premiums than term life insurance or other types of permanent life insurance, as it includes the fees associated with the investment component.
• Complexity: Variable life insurance is a complex financial product that requires a good understanding of investment concepts and market dynamics. Monitoring and managing investment options can be challenging.
• Market volatility: The cash value in variable life insurance is tied to market performance, specifically the stock market, making it susceptible to market fluctuations. If the stock market experiences a downturn, the cash value can decrease, resulting in potential losses during economic downturns.

Is a variable life insurance policy worth it?

The potential for higher returns can be appealing if you are comfortable with market fluctuations and have a long-term investment horizon.

It can also provide additional avenues for investment and potential tax benefits.

However, variable life insurance is a complex financial product that requires a good understanding of investments and market dynamics. Ensure you are comfortable with the necessary level of involvement. If you are risk-averse or prefer more stability, other types of life insurance with guaranteed or predictable returns may be a better fit.

Who should not buy variable life insurance?

Variable life is not ideal for risk-averse investors, those new to market investing, or anyone who values predictability over performance.

If you prefer low fees, guaranteed cash values, or hands-off investing, it’s best to consider whole life or a term life insurance policy instead. A term life insurance policy may be a better fit for those who want simplicity and lower costs. Variable life requires consistent review and the discipline to adjust allocations as markets shift, qualities not every policyholder has the time or interest to maintain.

Variable vs whole life vs universal life, what’s different?

All three, whole life, universal life, and variable life, are types of permanent life insurance policies, but they differ in structure and investment options.

Whole life insurance offers guaranteed cash value and stable premiums, making it predictable but less flexible. Universal life is a permanent life insurance policy that separates the insurance cost from savings, allowing flexible contributions and potential investment choices. Variable life, another form of permanent life insurance policy, exposes your cash value directly to market performance.

It can outperform in strong markets but underperform or even lose value when markets fall. The right choice depends on whether you prioritize stability, flexibility, or growth potential.

Frequently asked questions about variable life insurance

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