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 (a.k.a. “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 behind more for your heirs or to supplement your own retirement.
In order to spare you from having to endure 8 pages of info on this subject simultaneously, I’m going to break down my original article into small chunks so I can parcel it out to you in smaller doses. Here’s the first installment.
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 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 really expect to achieve better results. Thus, they pass some of the risk of bad performance onto 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 5 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 the 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 policy holders 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, 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 (i.e. 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 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 5 years to reap investment gains on the money he paid in premiums before paying out the death claim. They would also receive 5 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 decided to keep inside the policy.
Anyway, 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 leave less money to pay out policy dividends that year. On the other hand, the policy was presumably priced so that it will be out ahead if a client cancels its 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 investment 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.
So concludes your introduction to Par Insurance Policies. Next time, I’ll talk about about how the insurance companies invest your premiums and your options of what to do when the insurer pays you something called a “policy dividend.”