by Richard White
During the last five years, the large Canadian mutual life insurance companies de-mutualized and listed their shares on the stock markets. These companies had been owned by their participating policyholders, each of whom received a certain number of shares based on the age
and cash value of their policies, which they were in turn able to hold or sell on the open market. De-mutualization provided an unexpected windfall for many people, as policy values remained intact, and were not altered when the shares were distributed.
Life insurance options
When considering the purchase of life insurance, individuals must choose between term insurance, which offers coverage only to a certain age, and whole life insurance, which pays a death benefit whenever the insured person dies.
Term insurance premiums are based on attained age. The simplest form of term insurance is yearly renewable term, in which the premium rises each year to reflect the increasing cost of the insurance as a person grows older.
In other instances, rather than have the cost change every year, companies have the insured pay a little more initially, and thus the premium changes only every 10 or 20 years as the insured person ages.
Term insurance usually cannot be purchased past age 65, and the plan coverage usually stops at age 75. Most term insurance is allowed to lapse, or is dropped when the coverage is no longer needed or the cost becomes prohibitive — very few policies actually pay a death benefit.
Term insurance policies usually have no cash surrender value (the dollar value of the plan if you decide to cancel the coverage). Term insurance is less expensive initially than whole life insurance, and is often used to protect young families, or meet short-term needs.
Under a whole life insurance plan a premium is established, which is usually payable until the death of the life insured, whether that occurs at age 50 or age 80. This premium is set at a level higher than for term insurance at the same age, and the premium paid above the term insurance cost each year is placed in a reserve, which helps pay the premium in the future, when the annual cost of the insurance is very high.
All or part of this reserve is returned to the policyholder through the cash surrender value if the coverage is cancelled. If the owner does not want to continue paying premiums, a smaller amount of insurance, called the “paid up value,” may continue in force based on the amount in the reserve in the policy.
A whole life insurance policy has an investment component (the reserve) and an insurance component. The insurance company actuary uses mortality rates, investment rates (the income earned on the reserve) and expense factors (the cost to set up and maintain the policy) to determine the premium on a whole life policy.
There are basically two types of whole life insurance: universal life insurance, and participating whole life insurance.
With universal life insurance, the cost of insurance, investments and expenses are separated for the policyowner to see.
The policyholder directs the investment of any reserves in any number of investment choices, and enjoys a tax-deferred accumulation under the cash value of the policy.
The cost of insurance inside a universal life policy can increase annually, like yearly renewal term insurance, or can be guaranteed at a level amount throughout the duration of the policy.
Participating whole life insurance has a guaranteed premium set for the lifetime of the policy based on conservative long-term mortality, investment and expense assumptions. The insurance company returns an annual policy dividend to the policyholder based on the investment, mortality and expense performance of the company. The final cost of the insurance will only be known upon death of the insured.
Most recent purchasers of whole life insurance have chosen to buy universal life, with its flexibility and increasing array of investment options. However, while participating insurance no longer offers the company ownership feature described in the opening paragraph, the basic concept has not changed. It remains a viable, cost-effective and flexible way to purchase lifetime insurance, and is an attractive alternative to universal life insurance.
The potential purchaser of whole life insurance should examine how participating insurance works, and determine whether this approach fits within his or her long-term financial goals.
Participating whole life insurance
All insurance is a pooling of risk. Insurance provides an opportunity for a small premium to provide a large sum of money for loved ones and other dependents in the event of an untimely death.
A participating whole life insurance policy can extend for a very long period of time. For example, a 25-year-old purchaser has a life expectancy of more than 50 years, and will pay premiums for the entire period. How can the insurance company guarantee the premium for the life of the plan so that it can ensure that the death benefit will be paid when the individual dies?
Investment returns are particularly hard to predict. The longest available investment is perhaps a government bond, which can have a maximum term of 30 years. The investment climate is ever changing, and it is difficult for an insurance company to predict what the investment returns will be, for the duration of a policy, by the time the second annual premium is due.
Mortality statistics are usually kept by the larger companies, based on their own policyholders, and are adjusted constantly. However, fluctuations can occur (such as the 1918 flu epidemic), which severely affect statistical outcomes. As well, medical science may extend life expectancies significantly, or a disease such as AIDS may take a large toll.
It should be noted that unlike automobile or homeowner insurance, where claims can fluctuate widely from year to year, and are subject to many external influences, life insurance policy claims are relatively predictable over the long term.
Future policy expenses must be forecast. Most of the expenses are incurred at the issue of the policy, such as medical underwriting, policy issue, and sales expenses. However, some expenses, such as the cost of premium collection, must be estimated for many years into the future.
The insurance company actuary solves these dilemmas under a participating life insurance policy by setting the basic guaranteed premium using conservative investment returns, mortality costs, and expenses. These values are also used to set the guaranteed cash values and paid-up insurance values (the guaranteed amount of insurance remaining if premiums are stopped in a particular year) under the plan.
For example, the long-term investment return might be 2.5 per cent to three per cent, which does not actually seem that conservative today. Mortality rates might be those used in a reserve table developed a number of years ago, with higher than current mortality rates, and which also includes allowance for adverse fluctuations.
Policy dividends
A dividend is declared each year under a participating policy, and is viewed as a return of excess premiums paid. (This is not quite the same as a dividend on common shares, which is a sharing of company earnings.)
The dividend is calculated by comparing the actual insurance company investment performance on the portfolio of invested assets with the assumed investment return, the actual mortality experience in the company with that assumed in the premium rates, and the actual expenses incurred with those assumed in the costing of the policy.
From the pool of excess funds created, the insurer sets aside surplus funds to cover future fluctuations and contingencies, and the balance is shared among the participating policyholders as a dividend in proportion to the size and values under each policy.
The dividend represents the way the policyholder effectively receives his or her insurance at cost over the long term, based on the policy’s share of the pool of all similar policies sold by the insurer. Any future improvements in investment returns or mortality rates will benefit the plan-holders.
Dividends can be used in a number of ways. The policy-owner can receive them in cash, or use them to reduce premiums. The dividends can be left to accumulate interest, much like depositing them in a bank account.
A popular option is to purchase extra insurance, called “paid-up additions,” which increase both the cash values and death benefits under the policy. The paid-up additions also generate dividends in the future. A portion of the dividends can be used to buy term insurance, which may substantially increase the death benefit under the policy in the immediate future.
A key consideration is the return on the diversified investment portfolio of the insurance company over the years. Because these are very long-term investments, the portfolio will often contain common stocks, real estate, commercial mortgages, and long-term bonds. The participating policyholder shares in the results of this professionally managed and diversified investment portfolio, often to great advantage, which is directly reflected in the dividend paid.
The returns of the insurance company investment portfolio usually lag behind current interest rate levels. For example, when interest rates rose sharply in the late 1970s and early 1980s, insurance company portfolio returns, with their older investments, performed well below soaring interest rates. It was during this time that universal life had great appeal because premiums could be invested at current investment rates.
As interest rates fell through the 1980s and 1990s, insurance company portfolio returns eventually exceeded the current interest rates. Interest rates have dipped very low in recent times, and the insurance company portfolio returns remain above current interest rate levels.
Participating life insurance plans are often illustrated assuming that the current level of dividends will be paid into the future indefinitely, thus, purchasers should exercise caution when looking at sales illustrations.
Many companies also insist on illustrating their plans with a second or third set of figures using dividends based on lower, and sometimes much lower, investment assumptions, to ensure that potential policy-owners understand how the dividends work, and that they are not guaranteed in the future, but depend each year on the performance of the insurance company.
It is in the purchaser’s best interest to fully investigate and understand the plan features of participating whole life insurance. It is also important to make sure that the insurance company is reputable, and has a good track record over a long period of time.
The services of a reliable agent or broker should be sought to evaluate all the insurance options and the insurance company before making a purchase.
Doctor’s Business is a monthly feature provided by Richard White, FSA, FCIA, CFP, RFP, retirement, estate and employee benefits consultant.