Doing the Perm/Term Squirm Part 3 Participating Whole Life Policies

In some ways, life insurance is like fashion: today’s trend is next year’s embarrassment and next decade’s craze. Participating whole life (“par”) policies are a great example of this phenomenon. They have been around a long, long time but fell out of favour when universal life (“UL”) policies came into vogue. In fact, many of the larger companies even stopped issuing new Par Policies for several years until low interest rates, high investment management fees and rocky stock market returns made UL Policies a touchy subject in some circles and Par Policies an exciting “new” way to leave more behind for your heirs or to supplement your own retirement.

What Is A Par Policy?

What is a “Par Policy,” you ask? Essentially, it is a whole life insurance policy that also allows you to participate or share some of the company’s risks in order to reap some of its rewards. The insurance company charges you a larger premium than it would on other permanent policies because they price the costs of providing your insurance very conservatively so they will have extra money on hand if things don’t go as hoped. In other words, they assume the worst and price the product accordingly, even though they really expect to achieve better results. Thus, they pass some of the risk of bad performance on to you.  In return, you may receive a refund or rebate of some of your premiums if the company’s costs and performance aren’t as dire as their pessimistic pricing predicts.

This money is returned to you through something called “policy dividends.” Don’t let the name fool you: policy dividends aren’t taxed like dividends paid to investors in public or private companies. You have at least five choices of what to do with these policies' dividends, each with different tax consequences. I’ll have more to say about that later.

How likely is it that you’ll receive policy dividends each year? Very. Canadian insurance companies have a long and stable record of paying these dividends, although the rates do change from time to time because of investment performance, interest rates and company expenses. Moreover, the companies “smooth” returns to make each year’s payout more consistent. In other words, they don’t pay out as much as they might in good years so that they can maintain payments (or at least minimize the reduction) during bad times.

How Are Policy Dividends Calculated?

For some people, the answer to this question remains something of a riddle wrapped inside of an enigma. While I can provide some guidance on this, I can only take it so far, as part of the determination comes down to personal opinions of actuaries and the insurer’s board of directors, rather than balance sheets and basic math. The actuaries and board of directors look at the insurer’s business costs related to the policies, claims payouts for that class of policyholders, how many policies were cancelled that year and how the premiums invested by the company have performed that year before deciding the appropriate payout. This amount is expressed as a percentage called the “dividend scale” although I have yet to get a clear answer as to what this percentage is applied against.

In any event, here is more information on the various factors that go into determining the appropriate dividend scale each year:

A. Business Costs

Insurance companies are businesses. They have to pay for staffing, advertising, commissions and a bunch of other business expenses. If costs are lower than expected, then some of these savings get passed along to you. Unfortunately, it isn’t quite that simple. The actuaries have to also decide what general business expenses incurred by the company are related to this business unit and which class of policyholders and, if it is related, whether all or only a percentage of these costs are linked. Only the related portion is taken into account when calculating the dividend scale. Obviously, it is in the par policyholders’ best interests for as few of these general expenses to be linked to their class of policies as possible: the lower the costs, the more money left to pay out policy dividends. On the other hand, it is generally in the insurer’s best interests for as many of the expenses to be allocated to the par policyholders. This leaves more money in its hands, and leads to greater corporate profits and happier shareholders.

B. Claims Experience / Mortality Rates

The insurer’s results each year are also affected by how many death claims they need to pay out. Par policyholders of a similar type (e.g., age, smoking status) are grouped together and the dividend scale for that group is affected by the number of deaths in that class compared to what was expected. As you might expect, the fewer the death claims, the more money is left to pay out policy dividends. Moreover, besides getting to hold onto and invest more premiums for a longer period, it also means that they receive more total premiums. Think of it this way: if a policyholder who was supposed to die at 45 lives until 50, the company would not only get an extra five years to reap investment gains on the money he paid in premiums before paying out the death claim, but they would also receive five years’ worth of additional premiums from age 45 to 50 as well. Although I have provided an individual example, insurers do these sorts of calculations for each class as a whole.

C. Policy Lapses

This term refers to policies in a specific class that are cancelled each year. For term insurance policies, policy lapses are always a good thing for the insurance company, as they get to keep all the premiums paid in and will never have to pay out a death claim. It might also be a good thing for other term customers, as the insurers may be able to offer lower premiums if they can count on a certain percentage of customers cancelling their policies along the way, thereby reducing the insurer’s costs.

For Par Policies, things aren’t quite that simple. Par Policies have something called a cash surrender value (“CSV”), which is what the insurers will pay to the policyholder if he wants to cancel the insurance. Generally, the CSV is based on a couple things. Most Par Policies provide a schedule of guaranteed cash values for each year of the policy upon reduction. This cash surrender value may be also bumped up by any policy dividends that this customer has earned along the way and has decided to keep inside the policy.

Unlike term policies, since the insurer has to pay back some of the premiums to the client in the event he redeems a policy, policy lapses aren’t a clear-cut good news story for the insurer or other members of that class.  If there are more redemptions than expected, this leaves less money to pay out policy dividends that year. On the other hand, the policy was presumably priced so that the insurer will be ahead if a client cancels his policy, even after paying out the cash surrender value. Think of it this way: would you rather pay out a $400, 000 cash surrender value to a client at age 60 or a $1,000,000 death claim to that client at age 70, even if you received an extra 10 years of premiums along the way? Accordingly, although policy lapses might increase company payouts in the short-term, they should decrease long-term payouts. Thus, par policy lapses are both good and bad news for insurers and other members of that same class.

D. Investment Returns

The biggest influence on the dividend scale is the performance of the insurer’s investment portfolio. When the insurer receives premiums, it invests them in the expectation that they will grow in value and be more than enough to pay out all death claims and policy redemptions from that class of policyholders. Accordingly, if the investments grow in value more than anticipated, both the insurer and par policyholders will reap the rewards.  Moreover, since the premiums are higher for Par Policies, there will be more money for the insurer to invest in the first place, which can mean better returns for par policyholders in good years.

More On The Dividend Scale

Insurers generally provide a historical listing of their dividend scale over time and, in today’s investment climate, the numbers look pretty impressive. Currently, the dividend scales I have seen from Canadian companies range between just under 7% and a bit over 5.5%, although I don’t pretend that this is an exhaustive list.  Interestingly enough, insurers are quick to point out that the current rates are considerably lower than the historical averages. On the other hand, as described further in the next section, since the investment returns are interest rate sensitive, further declines in the years to come are likely possible, especially if interest rates stay low. In fact, many insurers have decreased their dividend scales over the last few years, although these changes are generally done in small increments.

The gaudy numbers mentioned above might make some of you wonder why Par Policies ever fell out of public favour. Briefly, here are a few reasons (or at least plausible theories):

A. Although today’s dividend scale looks pretty attractive, it didn’t look so attractive in the past during times of higher interest rates and a booming stock market.

B. Demutualization of some of the big insurance companies. When insurance companies were owned by the policyholders (i.e. “mutual insurance companies”), the policyholders’ best interests and the company’s best interests were the same. When the companies changed their ownership structure, traded on the stock market and were owned by shareholders instead of policyholders, it became the companies’ responsibility to satisfy shareholders. It is arguable that insurance companies then directed their focus to promoting other types of insurance policies that generated greater profits which they didn’t have to share with policyholders.  In fact, some companies stopped offering Par Policies for several years. I have heard different stories on the pricing of more recent Par Policies compared to old school versions. In some circles, I’ve heard advisors claim that the older policies had more features and better pricing. On the other hand, an advisor friend of mine from Sun Life named Gordon Mayede actually did a comparison of old and new policies to show that the costs really haven’t changed.

C. The mystery of how the dividend scale is calculated and how Par Policies work.  Perhaps some people simply wanted a more transparent type of policy that was easier to understand.

D. Universal life insurance policies. For many years, Canadian insurance companies seemed to focus most of their energy on selling universal life insurance policies and clients became excited at the possibility of reaping substantially higher investment returns on UL Policies. UL Policies also offered a lot more flexibility than par products, allowed clients the ability to choose how their excess contributions were invested and whose investment returns were easier to understand.  Of course, when the stock markets tumbled and the value of funds within many UL Policies also plummeted, many people looking at insurance decided to return to the safe shores of Par Policies, where policy dividends taken as “paid up additions” inside the policy were protected against subsequent losses while still earning additional dividends for policyholders.

How Insurance Premiums Are Invested

In many ways, an insurer’s investment portfolio is a lot like an income fund. It is designed to provide a diversified stream of income that should grow in value steadily over time while minimizing the risks of significant investment losses. In fact, our government mandates what type of investments insurers can select and the maximum percentage of each type they can hold. Generally, the money is invested in different types of bonds, real estate, mortgage, private loans and a relatively small portion of equities, including preferred shares.

Our government has mandated these limits in order to reduce the chances of insurers suffering huge investment losses and being unable to pay out the death claims. This rationale also takes into account the fact that the portfolios need to continue generating income along the way to pay death claims, while also ensuring that the underlying capital retains its value if more redemptions than expected are required, even during a down market.

Want more information on the underlying investments for each insurance company’s Par Policies? Although most insurers don’t readily list the exact holdings of their portfolio, they do provide a general breakdown on how the money has been invested on a percentage basis.

One final thought on this subject. As you might expect when looking at the type of investments it owns, an insurer’s investment returns are generally lower during times of low interest rates (although they may still benefit on the real estate side since low rates can increase property values and decrease mortgage costs on the portfolio’s real estate holdings.) Generally, decreases to the dividend scale lag behind decreases in interest rates by a few years. One reason for this is the money set aside by insurers to “smooth” returns in bad years. Secondly, because insurers may already own a variety of interest rate sensitive investments that gradually come due over time, it might take several years of low rates to significantly impact the performance as a whole. Ultimately, it appears that Par Policies are able to maintain their current payouts longer than some other investments during times of low interest rates. On the other hand, for the same reasons, they may be slower to increase the payout during rosier economic times.

Policy Dividends

Now that you are (hopefully) more familiar with the dividend scale and how policy dividends are calculated, let’s investigate your choices on how to direct your policy dividends and the tax consequences that go along with each choice.

To begin, policy dividends are a completely different kettle of fish for tax purposes than dividends that are paid out by public and private companies to their shareholders.  More specifically, policy dividends do not qualify for either the enhanced or the small business dividend tax credits. The taxable portion of any policy dividend is taxed as income. How and if you are taxed on policy dividends depends on what you elect to do with them.

Some of your options and choices are as follows:

• Receiving them as cash. Either you will be taxed on them as income (with no dividend tax credit) or you will get them tax-free. This depends on something known as the “adjusted cost basis” of the policy. This is a calculation that takes into account all the premiums you’ve paid and subtracts things like withdrawals (including previous policy dividends) and the “net cost of pure insurance” (which is the running total of what you would have paid in premiums if you had paid for coverage based on your age each year rather than through a level premium.) Fortunately, the insurance company calculates this for you and, until your adjusted cost basis reaches zero, you will be able to get your policy dividend payments tax-free.

• Depositing your dividends into a daily interest account with the insurer. This is called having “dividends on deposit.” It is a lot like the previous option, except that the insurance company holds onto the money for you, rather than writing you a cheque. The tax consequences are identical to the previous option and you will also be taxed on any interest paid on the dividends that accumulates after they are transferred into the daily interest account.

• Using them to pay or reduce that year’s premiums.  As the dividends are essentially staying within the policy, they are not taxed. If your policy dividends are large enough, you even may be able to pay all of that year’s premiums using your policy dividends. This happy event is known as a “premium offset.”

• Purchasing additional term insurance. This boosts up your death benefit while the extra coverage remains in force (no new medical evidence is required) and the policy dividends used in this way are not taxable. On the other hand, since it is term coverage, this does not increase the cash value of your policy or generate additional policy dividends down the road.  You may also have the option of converting some of this additional insurance into new permanent coverage.

• Permanently Increasing the Death Benefit.  This is called purchasing “paid up additions.”  Essentially, your policy dividends are used to both bump up the cash value of your policy if you want to cash it in and also to permanently increase your tax-free death benefit without increasing your premium payments.  The bump up to your death benefit is a lot less than if you use the dividends to pay for term coverage, since paid-up coverage costs a lot more. Moreover, your paid-up additions are also eligible to earn their own policy dividends going forward, which can further grow your death benefit and yearly policy dividend payments. It is also great to know that once you’ve received these paid-up additions, they are yours to keep, even if the company’s future returns are dreadful.

As you might expect, it takes time for the extra money you contribute each year to participate in the insurer’s profits at a meaningful level. Because of this, tax reasons and the fact that this is a long-term strategy, many people initially use their policy dividends towards tax-free paidup additions. This allows the policy to grow more quickly and provides more flexibility down the road. Although it is a wonderful thing when your policy reaches premium offset, if finances permit, you may want to keep purchasing paid up additions, knowing that you can always switch to premium offset later and even withdraw some of the extra cash value created by the paid-up additions.

Of course, what option is right for you depends on your current income needs and financial situation.

Different Options Within Par Policies

Just as car companies offer different versions of the same car, insurers offer different versions of Par Policies tailored to suit different clients. Here are two of the most common options:

A. Limited pay policies. Rather than signing on to pay premiums for life, some people may want to cap how long they need to pay into their policies, even if this means paying higher premiums until the policy is “paid up.” This means a lower return on your investment if you die earlier, as you will have paid more into the policy by that point than if you selected a pay for life option. It may also result in building cash value inside the policy more quickly, since you have paid more into the policy. You may also be able to continue to pay into the policy after it is paid up, if you have the necessary cash and you want to grow the death benefit or have more funds available for retirement funding strategies.

B. Cash value options. Some polices may offer a higher guaranteed cash value sooner but less growth later on while others may prefer policies with a lower cash value in the early years but which has the potential to grow both the death benefit and cash value to higher levels over the long term.

Retirement Funding By Using The Cash Surrender Value As Collateral

I plan another article focused on using life insurance for retirement funding purposes, but, for now, I just want to ensure that you are aware of this option. This strategy involves using a personally- or even corporately-owned life insurance policy as collateral for a bank loan. Some institutions will require you to make annual interest payments on the loan while others will simply add the interest to the outstanding balance. Ultimately, the plan is to continue borrowing against the policy for life and then use the tax-free death benefit to pay off the debt at death.

Many people like this strategy because it allows them to access tax-free money during retirement without screwing up their OAS pension or other income-related benefits, or shooting them into a tax bracket located in the upper stratosphere. In other words, they expect their money will go farther if they pay interest on the loan to the bank rather than paying tax on other investment options or from pulling money out of the policy in other ways.

While this option may be a wonderful opportunity for many people, it is also important to understand the pros and cons in greater detail before taking the plunge. I’ll save that analysis for another day.

Things To Consider When Comparing Par Policies

If you are looking at purchasing a Par Policy, here are a couple suggestions to keep in mind before signing on the dotted line:

A. Compare the dividend scales. Obviously, the higher the better, which can mean a higher cash value or reaching premium offset sooner if nothing changes.

B. Look at history rather than just the present.  Just as you would when looking into a dividend paying stock, check out the company’s past performance. I suggest that you opt for a company that historically has provided high and relatively stable rates over time rather than just looking at the current payout.

C. Compare the companies’ own financial history. I prefer dealing with the bigger insurance companies with a good reputation that have been around for a while. You want reputable companies that will stand behind their policies and have solid balance sheets.

D. Compare cash values. Although most of us don’t buy permanent life insurance with the intention of cashing it down the road, life is full of surprises. Accordingly, it matters to me how much the different policies are guaranteeing a different times if I want to cancel my policy or borrow against this cash value.

E. Premiums, premiums, premiums. Regardless of the dividend scale and cash values, don’t forget to compare premium costs. Although one company may offer a higher dividend scale, this may lose some of its lustre if you discover that you have to pay a higher premium in order to get it. This may simply mean that the higher payer was even more pessimistic when first calculating premiums rather than doing a better job managing money and its investments.  As well, different companies may have different opinions about your current health.  Even if a company offers a higher dividend scale and lower premiums for clients in top health, this may not be your best choice if another insurer charges you standard rates while your first choice wants to increase your premiums because they think you should work out more and eat less bacon.

F. Run multiple illustrations. When an advisor shows you the potential performance of the policy over time, this is called an illustration.  The fine print says that they can’t guarantee what the dividend scale will be going forward.  Noting today’s low interest rate environment and because I want all of my surprises to be good ones, I suggest getting your advisor to illustrate the policy’s dividend scale in lower rates than today’s in the future. This helps you plan and prepare for unpleasant changes and give you some wiggle room when making your future plans. I suggest getting illustrations done at both 1% and 2% lower than the policy’s current dividend scale. Perhaps the dividend scales will stay around the same point or even increase over the long term, but I suggest erring on the side of caution, especially if you are comparing potential returns to other investment choices or planning on using the cash value to help fund your retirement.

Conclusion

Although universal life insurance policies may offer more features and flexibility than Par Policies, I strongly suggest making Par Policies part of the discussion when deciding which type of permanent insurance works best for you. Although they are hard to understand and how their payouts are determined remain something of a mystery, most companies have a solid track record of providing solid returns over a long timeframe. While they might not be right for every situation, the only way to know for sure is to ask the right questions and determine this for yourself, along with the advice of a good financial planner or insurance advisor.

As always, I welcome your comments, questions and suggestions for future articles. Stay tuned for my next article, which will probably be on universal life policies.

Colin S. Ritchie, LL.B., CFP, CLU and FMA,

is a Vancouver-based fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice. To find out more, visit his website at www.colinsritchie.com