Permanent life insurance

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Permanent life insurance is a type of life insurance that lasts until you die, as long as you pay your premiums. Permanent insurance is intended as an investment to leave a tax-free legacy upon death. You can also surrender (quit) the policy in exchange for a cash surrender value. Permanent insurance comes in two main 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.

According to one source, "using a permanent insurance policy as a tax shelter makes sense only when your Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs) are maxed out, you have a significant amount invested in bonds or other fully taxable investments, and you are virtually certain you won’t need the money in your lifetime."[1]

In many situations, Term insurance is suitable for most Canadians.[1] Permanent insurance is substantially more expensive than term insurance, especially in the early years of a policy. It is best suited for long-term insurance needs.[2]

Sales commissions, suitability and conflicts of interest

Commissions

Life insurance agents get much larger sales commissions by selling permanent insurance than term insurance, for the same amount of face value (death benefit). Policyholders will also pay much higher premiums.

Barney[5] gives an example of 40 year old male, non-smoker, looking to get $500k of coverage. At 2006 rates, 10 year term life insurance was $310 a year whereas Term to 100 was $2400 per year in premiums. He then adds that

The $310 term premium, assuming a 50% commission rate, pays the agent $155. By contrast, the $2400 (permanent) premium at 75% commission pays the agent a commission of $1800. That’s over 11 times as much commission as the term sale. Do you see the conflict of interest? (...) Life companies want consumers to buy (permanent insurance), and that’s why they pay higher commissions, which gives agents a bigger incentive to sell that product.

Suitability

In 2021, in Canada, 393,345 term insurance policies were sold, compared with 187,612 whole life and 110,732 universal life policies.[6] It is not clear how Term to 100 policies are counted in those statistics, but ignoring those, 43% of consumers purchased permanent life insurance (whole life or universal life), as opposed to term life insurance. Did these 43% of consumers really make a fully informed decision that was entirely in their best interest?

Prospective buyers of permanent life insurance should make sure that their need for life insurance is really permanent, as opposed to temporary, and that their primary purpose in buying a policy is actually getting life insurance (and not investing).

In a 2023 report, the Financial Services Regulatory Authority of Ontario (FSRA), which regulates the sales of life insurance in this province, looked at 24 randomly selected client files (from agents contracted with three specific managing general agencies), most of which involved universal life insurance.[7] They gathered "as much information as possible as to the product’s fit given the client’s specific circumstances". They concluded that, quote:

  1. UL insurance was generally sold on the premise that it is appropriate for almost everyone, without regard to risk, and regardless of client need, financial sophistication, or personal circumstances;
  2. lower cost, lower risk strategies, specifically the use of TFSAs and RRSPs, were generally not considered or discussed as alternatives to overfunded UL;
  3. needs analyses were either performed incorrectly or not at all, or the products recommended not well-matched to the clients’ stated need;
  4. recommendations for the type (UL) and amount of insurance were based on specious, incomplete, or non-existent reasoning, and often used boilerplate wording;
  5. policy illustrations were either missing entirely or misleading, including the use of selective or aggressive assumptions and/or ignoring TFSAs or RRSPs in comparative analyses;
  6. agents were recommending overfunded UL without consideration to a client’s existing high-interest personal debt;
  7. underlying investment recommendations for overfunded premiums were given little attention, and did not consider investment risks;
  8. critical illness riders, and corresponding additional premiums, were automatically added to policies, with no discussion or documented options presented to the customer; and
  9. existing permanent insurance policies were replaced with new UL policies, without clear rationale or benefit to the customer.
Further, quote:
  • in 83% of the files reviewed there was no indication that the client had any TFSA or RRSP, and in almost 30% of the cases the client was carrying high interest personal debt, which was not factored into the recommendations;
  • 80% of the files did not demonstrate a specific life insurance need, or the stated need was boilerplate in nature and not specific to the customer’s circumstances;
  • in 50% of the files, there was no needs analysis performed. In 70% of the cases where there was a needs analysis, it was often fundamentally flawed;
  • in almost 90% of the cases, there was either no rationale provided for the specific insurance being recommended, or it was boilerplate in nature;
  • many of these cases involved young people with modest means, no savings and carrying high interest debt.

The FSRA concluded that there was a "real and significant risk of poor consumer outcomes" including opportunity costs (the clients should have been paying back high interest consumer debts or investing in a TFSA first) as well as a risk of "catastrophic loss due to policy lapse", with a "corresponding loss of all premiums paid into the plan, including overfunded amounts".

Basic features

Permanent insurance policies are desired to provide coverage for your entire life. Some can be sensitive to interest rate and/or stock market fluctuations and others provide written guarantees. These, in turn, affect the policy premium that you are charged.

There are four basic features of permanent life insurance policies: level premiums; cash values; participating policy dividends and non-forfeiture options.[8][9]

Level premiums

Most permanent life polices have premiums that remain level, but not necessarily the same, over the policy lifetime. It means that the premiums you pay in the early years of the policy when you are younger are higher than the risk you represent to the insurer, and when you are older the premiums you pay are lower than the risk you represent.[8][9]

Cash value

Many permanent life policies (although not term to 100 policies) have a cash surrender value, the amount that builds up in the policy.[8][9]

Participating policy dividends

Participating policies share in the financial experience of the insurance company and receive annual dividends. Non-participating policies do not.[8][9]

Non-forfeiture options

These are options available to you if you miss or decide to discontinue paying premiums on your policy. The options will allow you to keep the policy in force or take a cash settlement.[8][9]

Comparison

The following table, simplified from ([9]), compares the three main types of permament life insurance.

Policy type Term to 100 Whole life (WL) Universal life (UL)
Premium Guranteed. Usually remain level. Guranteed. Usually remain level. Flexible. Can be increased or decreased by policyholder within certain limits.
Death benefits Guaranteed in contract. Remain level. Guaranteed in contract. Remain level. Dividends may be used to enhance death benefits in participating policies. Flexible. May increase or decrease according to fluctuations in cash value fund.
Cash values Usually none. Guaranteed in contract. Flexible. May increase or decrease according o investment returns and level of policyholder deposits.
Other non-forfeiture options Limited. Guaranteed in contract. Guaranteed in contract.
Dividends Typically not. Payable on "participating" policies. Not guaranteed. Typically not.

Term to 100

Because almost everyone dies before age 100, a term to 100 (T100) policy is a form of permanent insurance. However, there is no cash surrender value, so term to 100 should be a less expensive form of permanent insurance.[10] Note that coverage continues after age 100.[10]

If you buy permanent life insurance to leave something to your beneficiaries after you die, and you can readily afford the premiums, then in theory, the lack of cash surrender value of T100 policies should not be a major consideration[10] since you can either have the cash value or the death benefit. On the other hand, in practice, despite the best intentions, lapse rates on permanent life insurance are high (see below), which suggests that prospective buyers should also look at other forms of permanent life insurance (which do have cash surrender values) and compare prices.

Whole life

For many years, until changes in the Income Tax Act in 1982, whole life (WL) was the dominant permanent policy sold in Canada.[citation needed] It is still available today, but can be the most expensive form of permanent life insurance because of the guarantees: the premiums are level, the death benefit is typically fixed, the cash values can be guaranteed, and the lifeco takes care of the investing within the policy.[11]

There are various payment schedules. For example, a policy could be paid up with five, 10, 15 or 20 years of premiums. In the industry, the first is sometimes referred to as a "quick-pay" policy; a 10-year premium schedule would be a "10-pay," and so on (e.g., [12][13]) The policyholder can also select a "pay for life" option.

Cash surrender values

Barney[14] stresses that "cash values" should really be called "cash surrender values". In a WL policy, the only way to access the cash value and keep it permanently (which rules out policy loans) is to surrender the policy, which means the insurance coverage stops and the death benefit will not be paid. Alternatively, if you die and your estate/beneficiary gets the death benefit, they will not also get the cash surrender value.

The reason a cash surrender value builds up in a WL policy is that compared to a term policy, the WL policyholder is paying a lot more premiums in the early years, so that premiums can stay level. "The extra money, over and above the cost of actually insuring you that year (the term insurance that’s inside the whole life), goes into a reserve that the company builds up in order to pay the future costs for insurance. That way, when those higher internal term costs in the whole life start to really go up (while at the same time you are continuing to pay the same old level premium, which is now lower than the price of term insurance would be at your older age), the company can dip into that built-up reserve to keep the policy going."[14]

Non-participating

WL insurance comes in two forms: participating and non participating (or par and non-par). In Canada, as of 2021, 11 insurers sell non-par WL while 12 sell participating policies.[15] These numbers include 7 lifecos offering both types.

Non-par WL policies offer a fixed face value (death benefit), and guaranteed cash surrender values. They pay no policy dividends. The premiums should be lower than on par WL policies.[16] Non-par policies are also simpler to understand than par policies.

Participating

In a participating WL policy, premiums are invested by the lifeco. It will "price the costs of providing your insurance very conservatively so they will have extra money on hand if things don’t go as hoped".[17] As this dire scenario typically does not materialize, the lifeco can give you some money back every year in the form of "policy dividends". These are not to be confused with ordinary dividends paid on equity investments.

The amount of policy dividends depends on the lifeco investment returns (which are influenced by interest rates), insurance lapse rates and mortality experience, among other factors.[17] Therefore, policy dividends will fluctuate from year to year and are not guaranteed. 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.[citation needed] More reserves, for example, will have to be set aside against emerging market equities than for government bonds.

There are several choices for what to do with policy dividends:[17]

  • Recieving them as cash (which may or may not be taxable)
  • Placing them into a daily interest account with the insurer
  • Using them to pay or reduce insurance premiums, with no tax consequences
  • Purchasing additional term insurance
  • Permanently increasing the death benefit

Universal life

Universal life insurance is perhaps the most complex form of permanent life insurance. A simplified way to think about it is "a policy and investment account in one: a portion of your premiums is used to cover the cost of your insurance, and the remaining funds are yours to invest".[18]

Life insurance component

The two basic choices for the life insurance component of a UL policy are ART/YRT (annually renewable term / yearly renewable term) or T100.[4]

With ART/YRT, insurance costs are initially low, but rise every year. The idea of choosing that option is likely that more money initially goes to the investment side. If the growth rate of these investments is high enough, that can perhaps compensate for the rising insurance premiums later on. However, some UL policies may have been sold with unrealistic investment growth expectations, so could become underfunded.[19]

In contrast, with a T100 insurance cost component within a UL policy, the insurance cost is initially higher, but stays level, decreasing the risk of future problems.[19] Note that level premiums do not necessarily mean that T100 is being used for insurance costs.[20]

There is now the option of starting with insurance costs that increase yearly but switching to level costs later.[21]

The insurance costs portion of the premiums go the lifeco, is pooled with money from other clients, and is used to pay the face value upon death.[3] The face value can be ajusted up or down by the client in certain policies, which will influence the insurance costs and therefore the premiums.[3]

Investment component

The investment component of UL is called the "accumulating fund". More specifically, "the accumulating fund is the total of any extra money you contribute above the minimum premium and subsequent investment gains minus any premiums for the face value that you don’t pay for directly".[3] The size of the fund depends on how much the policyholder decides to contribute, subject to a minimum determined by the lifeco and a maximum determined by fiscal authorities. It also depends on investment performance, minus fees.

What really distinguishes universal life policies from whole life policies is that policyholders choose the investment options themselves for the investment component. Typical options are mutual funds and the equivalent of GICs.[3] Those "GIC" equivalents are called Guaranteed Interest Accounts (GIAs). There might also be an option equivalent to a HISA. Some of the mutual funds contain exchange-traded funds (ETFs). Less common options include a "mortgage investment corporation", something resembling a market-linked GIC, and even accounts that include private equities.[21]

The fees on investing inside a UL policy can be substantial. For example, one well-known provider of both life insurance and ETFs offers a Canadian bond index ETF with a management expense ratio (MER) of 0.09%, as well as Canadian, US and international equity ETFs with MERs of 0.06-0.22%. Bond and equity ETFs are typical portfolio building blocks and are highly recommended on the Financial Wisdom Forum: so far, so good. But on top of that MER, the lifeco adds "UL fees" of 1.75-3.00%[22], bringing the total fees well into actively managed mutual fund territory. In another example, the same provider offers an in-house Canadian equity mutual fund with a MER of 2.42%, plus UL fees of 0.50-2.25%[23], bringing the total fee to over 4% in some cases.

Nevertheless, the general idea is to shelter the growth on the investments from tax, and then the money is paid tax-free to beneficiaries[3], assuming the policyholder has chosen a death benefit corresponding to the face value plus the accumulating fund. However, with the high fees of investing inside a UL policy, the consumer has to ask if the tax advantages will actually outweigh the very significant extra costs, relative to investing in the same mutual funds or ETFs in a non-registered account.

Historically, UL developed as a tax shelter under the high capital gains taxes that reigned in Canada until 2000.[citation needed] As against an inclusion rate of 75% for capital gains (and dividends too), a higher management expense ratio seemed to make balance-sheet sense for those who had run out of Registered Retirement Savings Plan (RRSP) contribution room but still wanted to earn tax-free investment returns.[citation needed]

Options

Universal Life policies can contain a number of unbundled bells and whistles.[citation needed] Unbundling 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.[citation needed] (With the focus on taxes, remember that insurance premiums are paid in post-tax dollars).

Lapse rates

A life insurance policy lapses when the policity holder stops paying premiums, or cancels the policy. According to one US survey, only 3% of consumers "said that they planned to stop their policy before its expiration".[24] Yet the lapse rates are much higher. A possible reason for not continuying to pay the premiums is losing a job or another financial shock. Depending on the contract, there could be a cash value paid back to the policy holder, or not. In any case, no death benefit will be paid, which was the original point of getting the policy. One US study using data from years 2007-2009 shows that "conditional on the policyholder surviving, only slightly over 35% of all policies are active after 20 policy years and a mere 28% make it beyond policy year 30".[25] Another US study cited by Gottlieb & Smetters[24] mentions that "nearly 88% of universal life policies ultimately do not terminate with a death benefit claim".

One possible explanation for this striking behaviour is called "differential attention": consumers a well aware of their mortality risk (this is why they get life insurance), but severely underestimate the likelihood of "background shocks" that lead to liquidity demands, such as "unemployment, medical expenses, stock market fluctuations, real estate prices, new consumption opportunities, and the needs of dependents".[24] Unexpected events happen, so they eventually let their policies lapse, and subsidize the policy holders who actually die with insurance still in force.

No medical exam

Some insurers offer life insurance with no medical exams, or limited medical questionnaires (without urine or blood tests). What is the catch? According to one source:[26]

  • The premiums will probably be more expensive than those for medically underwritten policies
  • In some cases, within the first two years, no benefits will be paid for death due to medical reasons
  • If you have to fill out a medical questionnaire, you will get little assistance from the insurance company, and if mistakes are made, the company may use that excuse to deny the claim.

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.[citation needed] 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.[citation needed]

That changed how lifecos paid out earnings.[citation needed] Nevertheless, policyholders with permanent policies are eligible for a number of bonuses that can be considered a return of premium.[citation needed] 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.[citation needed] Mortality experience concerns how well the underwriters (and their actuaries) have priced their liabilities. Higher-than-expected mortality reduces profitability and vice-versa.[citation needed]

When buying a permanent policy, policyholders have a choice between two different premium schedules.[citation needed] 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.

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[27], 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)[28]. 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.

References

  1. ^ a b Dan Bortolotti, Life insurance: Is term life always enough?, MoneySense, January 27, 2012, viewed January 29, 2017
  2. ^ "Permanent life insurance". GetSmartAboutMoney.ca. June 17, 2017. Retrieved February 20, 2021.
  3. ^ a b c d e f Colin Ritchie, Doing the Perm / Term Squirm Part 4: Universal Life Insurance, Canadian MoneySaver, October 2014 issue(subscription required), viewed October 10, 2022.
  4. ^ a b Robert Barney, Universal Life (Part 1) – Fits All Life Insurance, Canadian MoneySaver, October 2007 issue(subscription required), viewed January 29, 2017.
  5. ^ Robert Barney, The Great Debate – Term versus Whole Life (Part 2)(subscription required), Canadian MoneySaver, June 2006 issue, viewed October 12, 2022.
  6. ^ Insurance portal, Universal life insurance grows faster than whole life, May 4, 2022, viewed October 13, 2022.
  7. ^ Financial Services Regulatory Authority of Ontario (FSRA), Observed practices in the distribution and sale of universal life insurance, October 2023, viewed November 16, 2023.
  8. ^ a b c d e "Types of Life Insurance". Financial Services Commission of Ontario (FSCO). Retrieved February 19, 2021.
  9. ^ a b c d e f "A Guide to Life Insurance" (PDF). Canadian Life and Health Insurance Association. Retrieved February 19, 2021.
  10. ^ a b c Robert Barney, Term to 100 – No Frills Whole Life - Part 2, Canadian MoneySaver, September 2007 issue(subscription required), viewed January 28, 2017
  11. ^ LMS Insurance (a broker), Whole Life vs Universal Life Insurance, undated, viewed October 12, 2022.
  12. ^ RBC Insurance (a provider of life insurance), Whole Life Insurance, viewed November 19, 2023.
  13. ^ SunLife (a provider of life insurance), Sun Par Protector II Life Insurance, viewed November 19, 2023.
  14. ^ a b Bob Barney, It's Not "Both/And"– It's "Either/Or"(subscription required), Canadian MoneySaver, March/April 2015, viewed October 9, 2022
  15. ^ Insurance Portal, Whole life insurance: close to 30 options available in Canada, July 15, 2021, viewed October 13, 2022.
  16. ^ LSM Insurance, Participating versus Non Participating Whole Life Insurance, updated November 6, 2020, viewed October 13, 2022.
  17. ^ a b c Colin Ritchie, Doing the Perm/Term Squirm Part 3; Participating Whole Life Policies(subscription required), Canadian MoneySaver, June 2014 issue, viewed October 12, 2022; available from the author.
  18. ^ Sandra MacGregor, What is universal life insurance?, MoneySense, June 24, 2022, viewed October 9, 2022.
  19. ^ a b Robert Barney, Universal Life (Part 3) – “Tax Deferred Black Hole”(subscription required), Canadian Money Saver, February 2009 issue, viewed October 10, 2022.
  20. ^ Bruce Cappon, Will You Outlive Your Life Insurance?(subscription required), Canadian MoneySaver, June 2013, viewed October 10, 2022.
  21. ^ a b Colin Ritchie, Investing Inside An Insurance Policy – Part 3; Universal Life Insurance As An Investment(subscription required), Canadian Money Saver, February 2018 issue, viewed October 14, 2022.
  22. ^ BMO InvestmentPro, BMO Aggregate Bond Index ETF (ZAG), viewed October 11, 2022.
  23. ^ BMO InvestmentPro,BMO Canadian Equity Class Advisor Series, viewed October 11, 2022.
  24. ^ a b c Gottlieb D, Smetters K (2021) Lapse-Based Insurance. American Economic Review 111: 2377-2416, earlier version available Wharton School.
  25. ^ Bauer D, Gao J, Moenig T, Ulm ER, Zhu N (2015) Policyholder Exercise Behavior in Life Insurance: The State of Affairs, Georgia State University, Risk Management and Insurance Faculty Publications
  26. ^ Glenn Cooke, Beware No Medical Exam Life Insurance, Canadian MoneySaver, September 2014 issue(subscription required), viewed January 24, 2017
  27. ^ Income Tax Regulations, pg. 78, viewed November 20, 2012.
  28. ^ Income Tax Regulations, pg. 28, viewed November 20, 2012.

Further reading

External links

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