Permanent life insurance products provide protection throughout the life of the insured person. The distinction is that permanent insurance does not have an expiry date and it does not have an increasing premium every 10 or 20 years, whereas term insurance will expire typically at age 80. Permanent insurance has a level-premium structure and pays a death benefit when the life insured dies, regardless of his/her age.
Whether a particular person requires term or permanent insurance and which particular product is most appropriate, depends on the person’s specific circumstances. Relevant considerations would include:
- The need for the insurance (i.e. temporary, long term or permanent).
- The need or desire of an increasing death benefit over time (i.e. is the purpose for a level amount or is the need growing?).
- The need or desire for the tax-exempt investment features within a permanent policy.
- The ability to fund the premiums (both in the short term and the long term).
Permanent policies can be designed so that the premiums are payable for a limited duration (i.e. for 10-20 years).
Another unique feature of a permanent policy is its capability to earn tax-exempt interest or dividends. The tax-free death benefit will include the initial face amount of insurance and the growth in the death benefit as a result of tax-exempt earnings.
Permanent life insurance comes in two primary types;
- Whole Life insurance
- Universal Life insurance
Whole Life Policies
As the name states, whole life insurance policies are meant to insure someone for their “whole life”. The policy has an initial death benefit, which can grow through the purchase of paid-up additions. The investment account within a whole life policy is a multi-billion dollar, conservatively-managed portfolio. The premiums can be designed to be paid over a specific period of time, either on a guaranteed basis or based on the projected dividend scale of the policy. Whole Life policies have a long history in the Canadian market and are known and trusted for their stability.
Whole Life Investment Account
The investment fund, or Par Fund, within a Whole Life policy is a very conservatively-structured, balanced fund. The fund is invested in assets; such as bonds, mortgages, real estate, alternative fixed-income assets and a small percentage (usually less than 20%) in stocks. The returns are amortized, or smoothed, so as to eliminate volatility. Therefore, Whole Life policies will typically offer a stable rate of return, and are more attractive to the risk-averse investor.
Typical Participating Whole-Life Account
Participating vs. Non-Participating
Whole Life policies are issued as either participating or non-participating. Both typically have the same product features and structure, with some points of differentiation which are explained below.
Participating “par” policies are offered by Sun Life, Great-West Life, Canada Life and London Life. These policies pay an annual dividend, referred to as the “current dividend scale”. The participating nature of the policy is that the dividend scale includes not only the performance of the investment fund, but also the mortality experience of all policies held in the Whole Life block of business. As people have been living longer, companies have not had to pay claims that were originally anticipated, resulting in a “mortality gain” component in the dividend scale.
Manulife Financial offers a non-par whole life policy. The cost of insurance and policy expenses are guaranteed. The policy earns a “performance credit” as opposed to a policy dividend. Additionally, the performance of the policy is purely based on the investment fund, whereas a par policy includes a gain or loss on the mortality experience of the block of business.
In both par and non-par policies, the gains and losses within the investment fund are amortized over time, which is referred to as “smoothiung”. As a result, when the interest rate is falling (such as over the last decade), the dividend scale or performance credit will be declining, meaning the policy rate lags current market rates. The whole life policy is guaranteed not to give a negative rate of return.
Whole Life dividends have been declared every year over the last 125+ years by Sun Life, Manulife, Great-West Life, Canada Life and London Life through both of the world wars, the Great Depression and the recent financial crisis of 2008/09.
While in theory the policy owner has options as to what to do with the dividends paid, in nearly all cases the option is to use these dividends to purchase “paid-up additions” (PUA’s) also known as “paid-up insurance”. These PUA’s are additional insurance that provide for growth in the policy. They in turn will earn dividends and more PUA’s are purchased into the future.
A rising dividend scale will result in higher cash values and hence a higher death benefit, and may allow for the policy to be placed in premium offset sooner than projected. Conversely, a reduction in the dividend scale will have the opposite effect, resulting in lower cash and death benefit values and possibly a delay in being able to use premium offset.
The smoothing of the performance of the investment fund results in the dividend scale lagging the current investment climate. This means that as interest rate returns on bonds are falling, for example, the dividend scale will decrease over time but well behind the drop in rates. The same is true as rates begin to increase. The smoothing of investment returns also eliminates the volatility of short-term moves in the market.
Whole Life Premiums
A whole life policy can be designed with three premiums options.
- Basic premium only:
- Basic plus Term Option (or Enhancement): The combination of basic and term option premium is done to allow the person to buy a larger amount of coverage because it is a combination of whole life and term that reduces over time. The result is that premiums will have to be paid over a longer period of time.
- Basic plus Deposit Option: The additional premium, known as “Additional Deposit Option” (ADO) allows the policy to be either “paid up” sooner or achieves higher policy values. There is a maximum allowable ADO permitted so as to maintain the policy as a tax-exempt policy.
Whole Life policies have a cash value which is a combination of a guaranteed cash value and excess cash that will depend on the dividend scale. A policy can be illustrated so that a specified number of premiums are paid, for example over 10 or 15 years. After this time, the policy can be placed into “premium offset”, meaning no further premiums are paid by the policy owner, rather future premiums are paid from the policy. PUA’s are surrendered along with policy dividends to pay the future premiums.
Structure of the Policy
Whole Life policies can have two internal insurance cost structures: either a life-pay or a 20-pay (meaning no cost of insurance is charged after 20 years). In comparison, the 20-pay option requires higher premiums in the early years and provides lower early cash values.
It is also possible to design Whole Life policies with either high early cash and death benefit values, or alternatively, high long-term cash and death benefit values. The crossover, as to when high long-term value policy exceed the high early value policy, is around year 20.
- A higher early value policy will provide for strong balance sheet management, meaning by the policy’s 6th or 7th year, the cash value of the policy equals or exceeds the premiums paid.
- The high long-term value policy is for those who wish to maximize the long-term values and early cash values are less important.
Finally, as mentioned in the whole life premium section above, a whole life policy can include some term coverage, known as “term option”. This option allows for reduced premiums. However, it also makes the future performance of the policy more sensitive to changes in the dividend scale and does not achieve growth in the death benefit until the term option amount has
A universal life insurance policy is designed as an “open architecture” type of policy. This means that all the various components of the policy; the investment options, investment management fees, policy fees and cost of insurance are identifiable.
The universal life policy was originally designed in the early 1990’s to provide for greater flexibility and control by the policy owner. For example:
- If the policy owner pays only the cost of insurance and the applicable policy fees, then the policy will essentially operate as a level term-to-100 policy, with no cash value or increasing .
- If the owner deposits premiums in excess of the cost of insurance, then this excess premium can be invested in one or more of the investment options available within the policy, as chosen by the owner. The death benefit will then be the face amount of the policy plus the investment portion, referred to as Face Plus.
Any income earned from the universal policy’s investments is exempt from tax. However, unlike Whole Life, a universal life policy can have negative rates of return if any of the excess premiums are invested in non-guaranteed funds (such as equity or bond funds), depending on the returns achieved in those funds.
To avoid the risk of negative rates of return, excess premium deposits can be invested in the available guaranteed interest rate accounts.
The investment options within a universal life policy are flexible and include a wide range of options, depending on your risk tolerance. This means you can choose your ideal mix of equity, bonds, mutual funds and more, and make changes between those funds at anytime.
The policy typically has two types of insurance costs, both of which are guaranteed. The first is a level cost to age 100, known as “level cost of insurance” (or LCOI). The second is yearly renewable term (YRT). The YRT cost of insurance has a very low cost of insurance in the early years and then rises quite sharply as one approaches life expectancy. The result of using YRT is that it will produce higher early cash values as a result of the low insurance cost. However, in the later years the cash value or premiums will have to be sufficient to cover the much-higher insurance costs.
It is important to examine the projected rate of return in the universal life policy. If any funds are invested in mutual funds, they can achieve a negative rate of return due to the high degree of risk. As a result of the lower current interest rates, the guaranteed investment funds currently offer a guaranteed minimum rate of return of approximately 1.5%.
A universal life policy allows the policy owner to modify their premium payments year to year, as long as there are sufficient funds in the policy to cover the cost of insurance. This gives it a degree of flexibility.