Variable Annuities and Variable Life Insurance

Variable annuities and variable life insurance are dual products: the investment component (the separate account) is a security registered under the Investment Company Act (ICA), while the insurance component (the general account) is an insurance product. This dual nature is why Series 6 representatives need both a securities license and a state insurance license to sell them.

What is the difference between a separate account and general account in a variable annuity?

The two-account structure is the central concept. Each account holds different risks and guarantees.

Key point: Sub-accounts are managed by investment advisers (often the same advisers that run retail mutual funds). The insurer does not directly manage the portfolios.

Exam Tip: Gotchas

• Investment risk sits in the separate account and is borne by the contract owner. Insurance guarantees sit in the general account and are backed by the insurer's credit. This is why variable annuities are securities AND insurance products (dual regulation, dual licensing).
• The separate account is protected from the insurer's general creditors. If the insurance company becomes insolvent, the separate account assets cannot be seized to satisfy the insurer's obligations.

What happens during the variable annuity accumulation phase?

The accumulation phase is the period when the contract owner is paying premiums and the account value is growing.

• Premiums purchase accumulation units at the current Accumulation Unit Value (AUV)
• AUV fluctuates daily with the separate account's investment performance
• Number of units varies with the premium amount and current AUV
• Account value = units × current AUV
• Contract owner can transfer between sub-accounts during accumulation (typically without tax or sales charge)

Think of it this way: During accumulation, both the number of units and the value per unit change over time. Each premium payment buys a different number of units depending on the current AUV. This is the opposite of the annuity phase, where the number of units is locked and only the value changes.

Exam Tip: Gotchas

• During accumulation, both units and value fluctuate. During annuitization, only value fluctuates; the number of units is fixed. This asymmetry is a frequent exam trap.
• Transfers between sub-accounts during accumulation are NOT taxable events. The contract is one integrated product; moving money from a bond sub-account to an equity sub-account is like rebalancing inside a single account.

How does the variable annuity annuitization phase work?

Annuitization converts the accumulated value into a stream of payments for life (or a specified period).

• Upon annuitization, accumulation units convert to a fixed number of annuity units
• The dollar value of each annuity unit fluctuates based on the relationship between the separate account's actual return and the Assumed Interest Rate (AIR)
• Number of annuity units stays fixed for the life of the payout; the payment amount varies with performance

Assumed Interest Rate (AIR):

• The benchmark return assumed by the insurance company when setting the first annuity payment
• Typically 3-6%
• Higher AIR produces a larger first payment but requires higher future returns just to maintain the payment level
• Low AIR is more conservative: smaller first payment, easier to meet or beat

How does the Assumed Interest Rate (AIR) determine annuity payments?

The comparison that determines the next payment is always versus the AIR, not versus the prior period.

Think of it this way: The AIR is a benchmark. Every month, the separate account's actual return is compared to the AIR. Beat the AIR and your check goes up; miss it and your check goes down. Match it exactly and the check is unchanged. The prior month's performance does not matter once it has been incorporated into the last payment.

Exam Tip: Gotchas

• The AIR comparison is always to the AIR, not to the prior payment. If the AIR is 4% and the actual returns are 6%, 5%, 3% over three months, both the 6% and 5% months produce payment increases (both beat the 4% AIR); the 3% month produces a decrease (3% < 4% AIR), not an increase relative to the prior 5% month.
• Higher AIR means a larger first payment but lower future growth. A 6% AIR requires sustained 6%+ returns just to keep the payment level. A 3% AIR starts smaller but is easier to beat.

What are the variable annuity payout options?

The contract owner chooses the payout option at annuitization. The options trade monthly income against beneficiary protection.

Exam Tip: Gotchas

• Life only (straight life) produces the largest monthly payment. Why? Because the insurer bears no post-death payment risk. No beneficiary protection equals maximum monthly amount.
• Joint and survivor produces the smallest monthly payment because the insurer has to plan for two potential lifetimes. Paired with lower risk to the survivor.

What riders are available on variable annuities?

Variable annuities bundle investment performance with several insurance guarantees. Riders cost extra and are underwritten separately.

Minimum death benefit (standard):

• Typically the greater of:
  • Account value at death, or
  • Total premiums paid (less withdrawals)
• Enhanced death benefit riders are available for additional cost

Living benefits (available via rider, for extra cost):

Waiver of premium:

• Rider that waives future premium payments if the contract owner becomes disabled

Exam Tip: Gotchas

• Living-benefit riders guarantee a MINIMUM, not a cap. The contract owner still gets the upside of strong separate-account performance; the rider kicks in only if performance is weak.
• Riders are optional and priced separately. The customer pays for each rider through ongoing fees that are not part of the base Mortality and Expense (M&E) charge.

How does variable life insurance work?

Variable life insurance is permanent life insurance with separate-account cash value.

• Minimum guaranteed death benefit: paid from the insurer's general account regardless of separate account performance
• Cash value fluctuates with investment performance; typically no guaranteed minimum cash value
• Sales-charge cap (ICA Section 27): front-end sales charges on variable life limited to 9% over 20 years (averaged); actual first-year charges may be higher
• Free look period:
  • State insurance law typically grants 10 days
  • Federal rule extends to 45 days for variable life where the policy is mailed
  • During free look, the purchaser may cancel and receive a refund

Exam Tip: Gotchas

• Variable life guarantees a minimum death benefit but does NOT guarantee a minimum cash value. The cash value fluctuates with the separate account; it could in theory go to zero if performance is bad enough.
• Free look period is 10 days at state level, 45 days federal for mailed variable life policies. The free look runs from the date of receipt, not the date of purchase.

What fees does a variable annuity charge?

Variable annuities layer multiple ongoing charges.

Right of Accumulation (ROA):

• Breakpoint-style aggregation across variable annuity purchases within the same contract or family

Immediate annuity:

• Annuitization begins immediately upon purchase (typically with a single-premium payment)
• No accumulation phase

Exam Tip: Gotchas

• Variable annuity total cost stacks multiple fees. M&E + admin + sub-account expense ratio + rider fees can easily exceed 2.5% per year. This is why suitability analysis is so important for variable annuities.
• Surrender charges on variable annuities typically last 6-8 years. Early redemption can be expensive.

What does FINRA Rule 2330 require for deferred variable annuity sales?

FINRA Rule 2330 is the supervision rule for deferred variable annuity sales.

• Rep must make reasonable efforts to determine the customer's suitability profile before recommending a purchase or exchange
• Rep must have reasonable basis to believe the customer has been informed of:
  • Surrender charges
  • Potential tax penalties
  • Fees
  • Market risk
  • Living benefits
  • Sub-account expenses
• Principal review and approval required within 7 business days after the Office of Supervisory Jurisdiction (OSJ) receives a complete and correct application
• Special scrutiny of 1035 exchanges: rep must consider whether the exchange benefits the customer (new surrender period, loss of existing benefits)

Exam Tip: Gotchas

• Principal review under FINRA Rule 2330 is 7 business days after OSJ receives a complete and correct application. This is separate from the customer's state-law free look period (typically 10-45 days).
• 1035 exchanges receive heightened scrutiny because the customer restarts a new surrender period and may lose valuable benefits under the old contract. Document the customer's benefit from the exchange.

How are variable annuities taxed?

Variable annuities are tax-deferred during accumulation. Withdrawals and annuitized payments have specific tax treatment.

Accumulation phase:

• Tax-deferred: earnings grow inside the separate account without current-year tax

Annuitization phase:

• Each payment is part return of cost basis (not taxed) and part earnings (taxed as ordinary income)
• The ratio is set at annuitization using the exclusion ratio

Withdrawals before annuitization:

• Last-In-First-Out (LIFO) ordering: earnings come out first and are fully ordinary income; basis comes out last
• Pre-59½ withdrawals: 10% additional federal penalty on the earnings portion, on top of ordinary income tax

Surrender:

• All deferred gains taxed as ordinary income in the year surrendered

1035 exchange:

• Tax-free exchange between qualifying annuity contracts (or from a life insurance contract into an annuity)
• Preserves cost basis and defers recognition
• Surrender charges on the old contract still apply

Death during accumulation:

• Death benefit is ordinary income to the beneficiary (to the extent it exceeds basis)
• No step-up in basis like a stock would receive

Exam Tip: Gotchas

• Variable annuity earnings come out LIFO (last-in-first-out): gains come out first and are fully taxable as ordinary income. This is the opposite of mutual fund withdrawals (FIFO default with cost-basis matching).
• Pre-59½ withdrawals trigger a 10% penalty on the earnings portion in addition to ordinary income tax.
• Variable annuity earnings are ordinary income, NOT capital gains, even if the separate account held equities for 20 years. There is no step-up in basis at death and no Long-Term Capital Gain (LTCG) rate. This is a frequent misconception compared to mutual funds held in a brokerage account.