Final answer:
Since the insurance company does not insure the investment risk in a variable policy, the policyowner bears the investment risk. Variable policies offer the possibility of higher returns, but with the risk of market fluctuations impacting the policy's value. Imperfect information and moral hazard are inherent challenges in the insurance industry.
Step-by-step explanation:
Since the insurance company does not insure the investment risk in a variable policy, the investment risk is borne upon the policyowner. A variable life insurance policy is a form of permanent life insurance where the cash value can be invested in a variety of separate accounts, similar to mutual funds, and the choice of account(s) can affect the value of the policy over time. Unlike a whole life insurance policy, which has a guaranteed cash value growth, the returns on a variable policy are subject to market fluctuations, and thus the policyowner assumes the investment risk.
Insurance operates on the principle of protecting individuals from financial loss, but it comes with the challenge of imperfect information. Insurers have difficulty in accurately predicting who will file a claim and when, because risk is influenced not just by broad statistics but also by individual characteristics and choices. This is a crucial aspect of an insurance contract and can be highlighted by the concept of moral hazard, where having insurance might lead to riskier behavior since the insurer will cover the losses.
Therefore, in variable life insurance policies, insurers provide the flexibility of potentially higher returns, but with the trade-off that policyowners must shoulder the risk of investment performance. If the invested assets perform poorly, the policy's cash value and death benefit may decrease. Conversely, if the investments perform well, the policy may see significant growth in value. It's essential for policyowners to understand this dynamic and manage their policies accordingly.