Life Insurance
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Types of Life Insurance
Life insurance can be divided into two basic categories: term and permanent. Term insurance is meant for a specific period. For example, an investor might take a 10-year policy to insure against early death, thus providing a legacy for a spouse and/or children. Permanent insurance is intended as an investment to leave a tax-free legacy upon death. It comes in two types: universal and whole life. However, Term-to-100 policies blur the lines somewhat between term and permanent policies, offering lifetime coverage without, however, building a cash surrender value.
Cash surrender value is the moving part that distinguishes traditional permanent policies. Cash surrender value is the investment gain that is accrued beyond the cost of insurance: the premiums needed to pay the face value or mortality guarantee or death benefit of the policy. The death benefit plus the accumulated investment gains are paid out to the estate. If an insurance policy is cashed in before death, the cash surrender value — the accumulated investment gain — is taxed somewhat like a capital gain.
Bonuses and Premiums
Insurance policies are a form of risk transfer. The lifeco assumes the funding risk for a level death benefit provided tax-free. But this is not simply tax arbitrage. Lifecos are subject to capital tax; they also pay a tax on premiums collected. Of course, they also seek to earn a profit through policy fees. Most lifecos in Canada demutualized in 1999. Instead of being owned by their policyholders, they listed themselves on the stock market.
That changed how lifecos paid out earnings. Nevertheless, policyholders with permanent policies are eligible for a number of bonuses that can be considered a return of premium. There are often bonuses for keeping a policy in force for at least five years; looked at objectively, the policyholder has paid higher-than-normal initial premiums. In turn, this interacts with lapse and mortality experience.
Lapse experience refers to the proportion of policyholders who cease to keep their policies in force. Mortality experience concerns how well the underwriters (and their actuaries) have priced their liabilities. Higher-than-expected mortality reduces profitability and vice-versa.
When buying a permanent policy, policyholders have a choice between two different premium schedules. Level cost of insurance means the same premium is paid year in and year out. This means that a younger policyholder is probably paying more in the initial years of the policy for that guarantee of price stability. It can work in the policyholder's favour if the lifeco has mispriced the product. Yearly renewable term (YRT) means that insurance costs rise, year by year. Healthy under-45s pay less than a 55-year-old would. But as they reach 55, for example, and as their mortality risk changes, they face higher premiums. This may be offset, however, if cash surrender values accrue at a fast clip. It is possible for investment gains to prepay the policy.
Term to 100
While term policies are generally time-limited, there is a growing class of longer-term policies. Most coverage expires by age 75; however, many term policies are renewable and convertible into permanent policies, depending, of course, on the health of the policyholder.
Whole Life
For many years, until changes in the Income Tax Act in 1982, whole life was the dominant permanent policy sold in Canada. Very few insurance companies offer it today. Whole life comes in two forms: participating and non participating (or par and non-par).
In a participating whole life policy, premiums are invested by the lifeco itself. To the degree the lifeco is successful, profits are returned to policyholders as policy dividends (which are not to be confused with ordinary dividends). This is not the sole source of dividends; lapse and mortality experience also play a part. Policy dividends will fluctuate, depending on market conditions. Notably, the end of the great bond market bull has reduced the potential for high policy dividends that policyholders experienced in the 1980s and early 1990s.
While lifecos are experienced investors, their risk exposure is constrained by federal regulation, specifically through the Office of the Superintendent of Financial Institutions, which, for each category of asset, enumerates the reserves to be set aside in accordance with the volatility of the investment instrument. More reserves, for example, will have to be set aside against emerging market equities than for government bonds.
Non-par policies offer a guaranteed cash surrender value, with higher initial premiums. They pay no policy dividends.
As with universal life, there are various payment schedules. For example, a policy could be paid up with five, 10 or 15 years of premiums. In the industry, the first is referred to as a "quick-pay" policy; a 10-year premium schedule would be a "10-pay," and so on.
Universal Life
Universal Life policies are more complex to understand because they contain a number of unbundled bells and whistles. Unbundelling means that there are more options for policyholders to consider (rather than the "any-car-you-want-so-long-as-it-is-black" model provided by whole life. Increasingly, there are separate riders attached for disability, critical illness and long-term care coverage that can provide for early withdrawals tax-free. (With the focus on taxes, remember that insurance premiums are paid in post-tax dollars).
Universal life, developed as a tax shelter under the high capital gains taxes that reigned in Canada until 2000. As against an inclusion rate of 75% for capital gains (and dividends too), a 1% higher management expense ratio seemed to make balance-sheet sense for those who had run out of RRSP contribution room but still wanted to earn tax-free investment returns.
What really distinguishes universal life policies from whole life policies is that policyholders choose the investment options themselves for the investment component (the capital account or accumulation fund) of the policy. Thus one could hold stock indexes, or mutual funds, within the policy. As a result, cash surrender values could accumulate more quickly than in a whole life policy — within limits. But the key to this strategy was overfunding the policy in its initial years, with a low YRT.
Exempt versus Non-Exempt Policies
Even with insurance, there are limits on the tax shelter. For one thing, the increase in the death benefit can be no more than 108% of what it was on the previous policy anniversary. Thus, policy growth is limited to 8%. Excess earnings are either dumped into a taxable side account, or the face value of the death benefit is increased (with a higher cost of insurance, i.e., premiums). The relevant mechanism is known as the Maximum Tax Actuarial Reserve, or, the maximum prepayment of premiums, as if investment gains were used as a sinking fund.
There is also an anti-dump-in provision. On the 10th policy anniversary, the value of the policy can be no more than 250% of what it was on the seventh anniversary. Overfunding, then, should occur at the beginning of the policy.
Taxation of Cash Surrender Value
As with capital gains, a partial or full disposition of a policy involves an adjusted cost base (ACB) calculation. The ACB consists of the total premiums paid and is reduced by the amount of insurance actually paid for, the net cost of pure insurance (NCPI). As policyholders age, the NCPI tends to reduce the ACB: in other words, cash surrender values have accumulated faster than needed to pay the premiums for the face value or death benefit of the policy.
