As we have seen, life insurance involves calculations about life expectancy, costs, investment yield, probability of the person dying and the rate at which similar policies lapse. In term insurance and some others, the insurer takes all the risk. If rates are low or people die faster than expected, too bad for them. Universal life takes out their risk for yield but they guarantee the rest and can lose badly. As we speak, Term to 100 contracts are being repriced and have been going that way for a decade. Guarantees can be good for the client or the insurer but never both.
Guaranties are expensive for the client, so there is another form that will be less expensive. It is called “Participating” whole life insurance. It works on the same principles as any other life insurance, but the risk or gains from variation of the premium elements is shared. The client “participates” in the risk and the reward.
When setting the premium for a participating policy the company makes very conservative estimates of how they will behave and they guarantee that minimal performance. Costs will be higher than now, yield will be less, lapse will be zero, mortality will be based on experience from 1992 or even earlier. Duration of coverage is not a factor here. The assumption is until death. The policy cannot expire before then.
The conservative assumptions yield a high premium, but the company offers to share the win in actual experience with the policyholders. They do it by a “policy dividend.” A rebate of the extra. The policy owner has choices about how to use that dividend.
The insurer does not know with certainty what future dividends will be, but they can estimate them based on what they know about current mortality, yield, costs and lapse rates. They will give you a not guaranteed illustration for purposes of your own planning.
The cynics among you may say, “Sure, but who decides how much the dividend will be?” Fair question and the answer is the company, subject to some rule making by the federal government. The company and their actuaries decide based on the actual mortality experience in the year, and the investment yield of the “Par pool,” the investments that support the portfolio reserve. Costs are not too significant but taken into account. Lapse can be a big factor or not depending on plan design.
If there is a win, the gain is allocated partly to the policy owners and partly to the company. The government permits the company to keep up from 2.5% to 10% of the gain. Smaller share for larger blocks of par insurance. Clients keep from 90% to 97.5% of any gains.
Of the factors, the only one that is easy to see is yield. Suppose the guarantee is 2.75% and actual is 5.2%. The gain of 2.45% is allocated to both. Roughly 0.098% to the company and 2.352% to the policy owner. All good, but what does it all mean?
In a financial sense, the par pool is a very conservative balanced fund. Probably 80% or more fixed income and the rest, equities, real estate and some cash. So the owner received the guarantee of 2.75% and the dividend of 2.352% at a cost of .098%. Not many balanced funds have a Management Expense Ratio lower than 2%. So big advantage to owners.
Mortality tends to be quite a bit better now and the win there is shared in the same way. Lapses and costs saving contribute too. We can expect that science will improve lifespans over the future so the gain on mortality should grow. Cost will decline with network technology and lapse can be designed in.
When you look at the components and how the return is earned, a participating policy has characteristics of a very conservative balanced investment fund with an extremely low MER, and with tech and biotech components.
The gains are allocated to owners in many ways. The most common is a “Paid up addition.” The dividend buys a single premium paid up amount of insurance that is added to the death benefit and to the cash value of the policy. Over time these can accumulate to quite large amounts. Each owner should make their own assessment of their dividend option. Paid up additions must be elected in the beginning if you want it. Most of the others can change.
Participating life insurance is a very powerful financial tool that works best if the owner is indifferent to the amount of the premium. That condition is not the norm, but when it works it is a very inexpensive way to accumulate wealth for estate and late life purposes.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
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